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SHADOW OPEN MARKET COMMITTEE
Policy Statement and Position Papers

September 6,1974

1.

Policy Recommendation of the Shadow Open Market Committee Meeting, September 6,1974

2.

Position Papers




Assessment of Monetary Policy - Karl Brunner, The University of Rochester
Failures of Banks and Other Financial Institutions - Allan H. Meltzer
Forecasts of Economis Activity and Prices in 1974 and 1975 -James W. Ford, Ford Motor
Company
Pouring Trouuble on Oiled Waters: A Briefing for the Shadow Open Market Committee,
September 6 , 1 9 7 4 - Wilson E. Schmidt, Virginia Polytechnic Institute
The Current State of the Budget Estimates - Unknown Author

Policy Recommendations of the Shadow Open Market Committee
Meeting - September 6,1974
Inflation is continuing at a high rate because demand has not yet slowed sufficiently to eliminate shortages and
bring about a slowdown in price increases. At its meeting today, the Committee considered domestic and international
policy actions to slow inflation without incurring unacceptable social costs.
Domestic Policy
Money has grown over the past year at a 5%% rate. This is a lower rate than was achieved in the preceding year,
but the dechne results in the main from almost no growth since June 1974 after a very rapid rise from February through
May.
For the next six months the Committee recommends the objective of a 5-5%% annual increase in money. It should
be the goal of the Federal Reserve to attain that growth rate and reduce variability. This is the same short-term monetary
policy that we recommended last March. A rate of growth of 5-5%% would be appropriate as a step toward further
reduction to an ultimate non-inflationary rate of about 4% a year.
We recognize that this monetary policy will entail below-normal expansion of output and employment during the
transition period. In our view, inflation cannot be reduced without a period of slow growth and possibly a recesssion. As
discussed below, we recommend that the Federal Government undertake certain actions to ameliorate the hardships that
will result from anti-inflationary policies.
Attempts to curtail inflation through "jawboning" are examples of mis-directed efforts. We fear that establishment
of the Council on Wage and Price Stability will divert attention from the government that produces inflation to labor and
business, which are the victims of inflation. Jawboning can have no effect on the rate of inflation.
Some now urge controls on the allocation of credit, tax cuts, and Federal spending increases. These programs, if
adopted, would shift the costs of inflation and costs of ending inflation from one group to another, but the increases in
spending and tax cuts would increase inflation and the total costs of ending inflation.
The most frequent argument against monetary restraint is that monetary restraint was tried and failed in 1966-67
and in 1969-71. This argument is false. In 1966-67, the growth rate of money was reduced by more than 50% in a year.
The reduction lowered the annual rate of increase in consumer prices by one percentage point to 2.6% in the second
quarter of 1967. The unemployment rate never rose above 3.8%, and the rate of interest on longest term government
bonds was 6% when the anti-inflation policy was abandoned as too costly.
In 1969-71, the growth rate of money was reduced again by more than 50%. The rate of inflation fell more slowly
this time. However, before controls on prices and wages were instituted, the rate of inflation had been brought to below
4.5% and was substantially lower than the peak rate of 6.2% that prevailed in the first quarter of 1970. The
unemployment rate was 5.9%. On average, a worker spent 11 weeks between jobs. The latter figure should be compared
to the post-war minimum annual average of 8 weeks or the average of 10 weeks in the booming economy of 1973.




-2-

Review of the 1969-71 experience also brings out the very rapid 7.2% rate of increase in the growth rate of money
in 1970 and 1971. The policy of monetary restraint was abandoned in the second quarter of 1970 long before price and
wage controls were introduced. In addition, the Government budget changed from $3 billion surplus to a $23 billion AeHo
between the fiscal years 1969 and 1971. The Federal Reserve chose to finance a large part of the deficit instead of
continuing the policy of ending inflation. Those who now urge increased spending or tax reductions to compensate the
victims of inflation or to alter the distribution of income ask us to repeat these policies. Their programs are more likely
to bring higher than lower rates of inflation. Past experience indicates that the Federal Reserve, is likely to finance a large
part of the increased budget deficit by increasing the growth rate of money,.
Current short and long-term interest rates are at historic highs. These levels reflect the current high inflation rate
and anticipation of continuance of these high inflation rates on the part of borrowers and lenders. The only way to bring
interest rates down permanently is to bring inflation rates down.
The ceiling rates on savings deposits that are legally*imposed are far below current market rates. Hence savings
institutions are suffering tremendous outflows of funds. Our Committee recommends that the respective agencies raise
the ceiling rates to enable savings institutions to pay market rates for funds. The increased cost of fund to these
institutions will sharply reduce their earnings. Their difficulties, however, should not occasion any relaxation of the
policy of overall monetary restraint that we advocate. Assistance can better be provided by temporary financial relief
during a period of transition.
Similarly, we believe that Government assistance to those experiencing long-term unemployment during the
transition to lower inflation should be consistent to the maximum extent possible with the efficient operation of labor
markets. Accordingly, we recommend, first, lowering the statutory mimimum wage for teen-aged workers. We
recommend that consideration be given to extending the period of unemployment compensation. We also recommend
that long-overdue reform of public assistance finally be effected. Proposals to create new jobs at public expense would
result in little if any net increase in total employment.
International Policy
The current system of floating exchange rates improves the prospect for success of anti-inflation policy. In a
floating rate system, countries can more readily pursue independent monetary policies. This year Germany, Switzerland,
and the Netherlands have chosen to reduce their rates of inflation by reducing the growth rate of their money stocks.
They have succeeded, despite all the special factors frequently blamed for inflation here and elsewhere.
Their experiences show that it is possible to reduce the rate of inflation, despite the special factors, by reducing
the growth rate of money. If the fixed exchange rate system had remained in effect, or had been reestablished, their
anti-inflation policies would have been much less successful.
We urge the U.S. Government to continue floating rates and to avoid any agreement requiring intervention. We
regret that the Government has agreed to "guidelines" for floating. Such guidelines mask a return to fixed exchange rates
and make the return to price stability more difficult.




-3-

Old slogans and old concepts about the balance of payments still prevail even though we are floating. Specifically,
the Government still reports several different balance of payments deficits on a monthly and quarterly basis. The official
settlements deficit, for example, was established during the era of fixed rates, to measure pressure on the foreign
exchange markets. This measure showed how many surplus dollar*foreign central banks bought in order to keep their
exchange rates steady. But now exchange rates are free to fluctuate, so the official settlements measure is no longer
relevant. Indeed, it is now misleading. If all the surplus petroleum money were voluntarily invested in liquid assets in the
United States, it would be recorded under current conventions as a $50 billion deficit in our balanoeof payments. It is
easy to imagine how the report of such a large ostensible "deficit" would be used by protectionists, export promoters,
and would-be capital-controllers, whose policy positions and budget requests are not in the long-run interest of the
United States. We, therefore, recommend that the official settlements measure of the deficit be discontinued.




ASSESSMENT OF MONETARY POLICY
Position Paper for the Third Meeting of
the SOMC on September 6, 1974
Karl Brunner

The last meeting of the SOMC in March 1974 recognized that
monetary growth moved over the second half of 1973 in the direction recommended at the first meeting of the SOMC in September 8 > 1973,

The SOMC

reaffirmed at the second meeting in March 1974, the original recommendation
and proposed that monetary growth should continue at 5% to at most 5 1/2%
per annum.

This proposal was essentially justified by the SOMC's deter-

mination to lower gradually and systematically the inflation rate over the
next years*
The position paper prepared for the third meeting examines in a
first section recent monetary developments and assesses the prospects for
the realization of our recommendation.

The second section attends to some

important issues raised by James Tobin's critique of our recommendation
published in the Brookings Papers on Economic Activity.

It also covers some

proposals made by influential Congressmen with serious implications for
future policies9

I.

Recent Monetary Developments and the Prospects of Monetary Growth.

The major contours of the development are summarized in table I.
Until June 1973, monetary growth persisted on a comparatively high level,
decelerated subsequently from 8.4% p,a. to 5»3% p.a. in January 1974.




Mone

/
Table I:

The Percentage/of the Money Stock Between Corresponding Months
anc
* the Contribution Made by Proximate Determinants.

12 month period
ending \?ith

M

B

k

t

. r+1

d

January

1973

8.62

8.'01

.46

-1.33

+1.47

.01

February

1973

7.95

7.74

.10

-1.69

1.97

-.17

March

1973

7.06

7.89

-.38

-2.40

2.09

-.14

April

1973

6.94

7.97

-.74

-2.70

2.41

0

May

1973

7.76

7.85

-.32

-2.46

2.53

.15

June

1973

8.36

7.96

-.29

-2.16

2.87

-.01

July

1973

7.72

8.31

-.41

-2.37

2.09

.11

August

1973

7.16

7.76

-.63

-2.66

2.56

.14

September 1973

6.21

7.91

-1.07

-2.87

2.15

.08

October

1973

5.91

7.37

-1.03

-2.75

2.19

.14

November

1973

6.36

7.28

- .77

-2.34

1.96

.23

December

1973

5.96

7.31

- .98

.-2.38

1.94

.07

January

1974

5.34

7.11

-1.26

-2.73

2.18

.04

•February

1974

5.95

7.42

-1.29

-2.41

1.98

.24

March

1974

6.78

6.96

-1.03

-1.75

2.30

.31

April

1974

6.96

7.38

- .88

-1.88

2.14

.21

May

1974

6.21

7.53

-1.36

-2.22

2.21

.05

June

1974

5.67

7.45

-1.43

-2.52

2.02

.14

July

1974

Remarks:

M =

money stock, B -

t =

time deposit ratio, r+1 -

d «

Treasury deposit ratio.




monetary base, k ~

currency ratio,

adjusted reserve ratio,

J
>

developments thus adjusted in the second half of the last calendar year
to the range of 5% to 5 1/2% recommended in the statement of our first
meeting.

The table indicates that all the proximate determinants contributed

to this deceleration.

It should be emphasized, however, that monetary

policy not only permitted the retarding effect of the changes in currency
and time deposit ratios, but actually reinforced this trend somewhat.
My previous position paper prepared for the second meeting of
the SOMC predicted on the basis of the data available at the time (monthly
data U P to and including January 1974, and weekly data up to the middle of
February 1974) that we should expect the gap between monetary groivth and
the growth rate of the monetary base to diminish in the near future.

The

statement concluded in particularthat substantial deviations of monetary
growth from the growth rate of the base will not persist under present circumstances * The future course of the monetary base thus acquired a strategic
role in our evaluations.

The expectations of a rising budget deficit suggested

on the basis of the Federal Reserve's past behavior that further retardations
of the base should be assigned a somewhat lower probability.

The previous

position paper thus recognized a serious danger of accelerated monetary
growth beyond the anti-inflationary range recommended in our first two statements.
An inspection of table I. informs us that an acceleration did
actually emerge from January to April, 1974.
5.3% p„a. to almost 7% p. a.

Monetary growth expanded from

This acceleration was essentially due to the

operation of the factors discussed in the previous'position paper:

The

negative contribution of the changes in currency and time deposit ratio subsided substantially over this period and monetary growth moved closer to the
"gravitational center11 determined by the growth rate of the monetary base.
A new pluise emerged hov/ever in late spring.

Monetary growth decelerated again

from 7% (April) to 5.7% (June) and probably decelerated further in July and




4

August*

The monetary base continued on the other hand on the general

trends followed since August 1973.

The previous position paper also

noted that this track is beyond the range required for an exfective long-run
anti-inflationary' policy.
attention.

The current trend thus deserves some careful

It should be noted at this stage, that the data used in both

tables should be replaced by revisions published in the middle of August,
The revised data probably lower the acceleration of the money stock noted
in table II. .
Table II offers supplementary information for our assessment.
It summarizes monetary growth patterns and the contributions made by
proximate determinants over shorter run periods.

All percentages refer

to changes between shifting non-overlapping three month periods.

Monetary

growth reached a high peak of 9.6% in the middle of 1973 and decelerated
in the late fall to 1.6%

This rapid deceleration under way at the time of

our first session dominated the decline of the year to year changes noted
in table I.

Inspection of the various columns in table II establishes that

the dominant portion of the deceleration resulted from the movements of the
proximate determinants beyond the monetary base.

The sharp divergence in

the development between money stock and base did not persist however.

We

note an acceleration of the money stock from a growth rate of 1.6% in late
fall of 1973 to about 8.5% towards the central portion of 1974.

This

acceleration exhibits again the "gravitational pulln exerted by the monetary
base.

We note, furthermore, that the monetary base also accelerated from

5.9% to a growth rate beyond 8%.

The shorter-run patterns presented in table II

thus confirm the sense of uncertainty and apprehension concerning the monetary
developments expressed in the previous position paper.

The pronounced retarda-

tion experienced in the fall of last year brought the year to year monetary




5

Tab 1e II:

Annual Percentage Changes of Money Stock -Between Non-Overlapping
Three Month Periods.

Period

M

B

k
.

t

r+1

d

12/72 -

3/73

6.84

8.91

- .74

-3.06

1.93

-.25

1/73 -

4/73

5.40

7.93

-1.57

-4.27

3.58

-.27

2/73 -

5/73

4.95

8.08

-1.94

-4.89

3.78

-.08

3/73 -

6/73

7.49

7.48

-1.10

-3.70

4.42

.38

4/73 -

7/73

9.63

7.07

.57

-2.06

3.41

.63

5/73 -

8/73

9.28

5.98

.99

-1.35

3.05.

.61

6/73 -

9/73

5.50

5.16

- .13

-2.23

2.08

.63

7/73 - 10/73

2.06

4.72

-1.84

-3.09

1.90

.35

8/73 - 11/73

1.55

5.88

-2.39

-2.56

.58

.04

9/73 - 12/73

4.48

7.72

-1.70

-1.03

- .27

-.24

10/73 -

1/74

6.46

9.22

-1.16

- .56

- .73

-.31

11/73 -

2/74

7.22

9.19

-1.33

-1.28

.80

-.16

12/73 -

3/74

6.63

8.29

-1.80

-2.27

2.43

-.03

1/74 -

4/74

8.10

8.00

-1.78

-2.41

4.00

„28

2/74 -

5/74

8.54

8.10

-1.65

-2.70

4.46

.31

3/74 -

6/74

8.49

8.63

-1.30

-3.36

4.28

.23

Remarks:




The symbols were defined in Table I.
should.be interpreted as follows:

Tire indication of the periods

12/72 • 3/73 refers to percentage
-

changes at an annual rate between the three month period ending with
12/1972 and the subsequent three month period terminating with 3/1973.

growth into the neighborhood of our recommended level.

But this retardation

resulted from transitory events and monetary growth was bound to adjust over
the longer-run to the path determined by the monetary base, and this path
proceeded until the past weeks on a relatively high level*

There remains,

thus, the danger 'that monetary growth may evolve at a rate not sufficiently
adjusted to lower the rate of inflation by a substantial margin.
An examination of shorter-run patterns of monetary growth since the
turn of the current calendar year reinforces the reservations bearing on
the current state of monetary affairs.

Percentage changes of the money stock

and contributions by proximate determinants were computed between non-overlapping four week periods sucessively shifting the periods by one week.

The

groifth rate of the base averages over the whole interval from the beginning
of this year to the four weeks ending 7/24/74 at 7.8%.
averages at 7%.

Monetary growth

Moreover, in exactly half of the 26 periods examined, monetary

growth exceeded the growth rate of the base and dropped below in the remaining
13 periods.

The shorter run patterns thus also exhibit the remarkable strength

of the "gravitational pull" exerted by the base.

We conclude thus, once

more, that the monetary'developments over the next 6 to 12 months is essestially
determined by the behavior of the Federal Reserve Authorities.. This behavior
will be particularly conditioned by the response of our Central Bank to the
evolving budget deficit and the (probably) growing political pressures to use
financial policies in the hope to control the official rate of unemployment.
But this consideration opens a fundamental issue concerning trend and assessment
of our future financial policies.

* * * The Real Rate of Interest, the Inflationary Bias of Modern Societies,
Congressional Labor Market Policy, and Permanent Inflation.




James Tobin contributed recently a paper on "Monetary Policy in

7

1974 and Beyond1' to the house organ of the Brookings Institution (The *
Brookings Papers on Economic Activity).

This paper was explicitly

addressed to the views and recommendations of the SOMC.

I also understand

that this paper was presented and discussed at a meeting of the Federal
Reserve Consultants at the Board of Governors.
to examine the arguments by Professor Tobin.
be discerned for our purposes.

It appears thus important

Three distinct strands should

Tobin argues first that real rates are rela-

tively high and should be lowered by suitable monetary policies in order
to prevent economic retardation or stagnation.

He proceeds then to assess

with the aid of some econometrics the implications of our recommendations
with respect to unemployment.
our policy proposal.

This evaluation bears on the social cost of

And lastly, Tobin find an ineradicable inflationary

„b-®£4« deeply anchored in our social structure-which confronts our policy
makers with an immutable dilemma between unemployment and inflation.

All

three strands of arguments raise fundamental issues of analysis and judgment,
and it should be clearly noted where and in which manner our evaluation
radically departs from-Tobin's analysis.

This characterization should enable

and encourage a more searching examination of the issues in order to offer
better grounds for discrimination between the alternative views.
It seems best to open the first issue with a quote from Tobin:
"In my opinion, it is fallacious to conclude that real rates of interest are
low simply'because current rates of inflation are high compared with normal
market interest rates....

The important thing...is the comparison of earnings

prospects and interest rates.

This is the comparison the stock market makes

and it is hard to argue that real rates have declined in any meaningful sense
after price-earnings ratio have declined by a third over a year j 1




Tobin

8

reinforces his argument with a computation showing that the ratio of
market value to replacement costs of corporate real capital has dropped
below unity, whereas, real profitability of the corporate sector seems
to have substantially declined since the middle 1960*s.

Tobin appears

thus to conclude that the real rate of interest is too high and monetary
policy should be exercised to lower the real rate.
The analysis underlying our assessment and guiding our policy
recommendations radically departs from these contentions.

Tobin seems to

interpret most of the difference in nominal rates of interest observed in
1964 or in 1973-74 to an increase in the real rate.

We argue on the other

hand that the real rate remained essentially on the level reached in the
early 1960fs.

The large increase in the nominal rate of interest is thus

completely attributed to the emergence of inflation and the incorporation
of an inflation premium in nominal rates.

The occurrence of such inflation

premia has been well established by now in the literature.

This compara-

tively low and relatively unchanged real rate of interest is quite consistent
with the behavior of the stock market observed by Tobin.
formulation thus seriously misleads the reader.
"simply11 from

Tobin!s suggestive

First, no inference is made

observations of inflation rates in 1974 which are high relative

to market rates of interest.

The inferences are based on substantial studies

bearing on the systematic and persistent relation between inflation and nominal
interest rates.

And secondly, nobody argued seriously that real rates declined.

The contention centers on the denial of Tobinfs assertion, viz., that the large
increase in nominal rates expresses a substantial rise in real rates.
Tobin refers to the behavior of the stock market to support his
claim concerning relatively high real rates of interest.

Once again the

issue is not whether or not real rates have declined over the past two years.
The question addressed involves the interpretation of the decline in stock
market values and the implications for monetary policy.




In order to clarify

9

this issue, we consider current market values as the discounted values of
future net cash flows of firms having issued the equities.

Two major

developments substantially lowered in these recent discounted values.

We

note first an increasing volume of investment expenditures for environmental
purposes or for purposes of occupational safety and health.

These investment

expenditures exert little, if any, effect on future gross receipts of the
firm.

They raise thus outlays over the shorter run without inducing much

of an increase in future receipts.
cash flow is thus bound to fall.

The discounted value of a firms net

This trend will not subside over the next

few years and we should expect consequently relatively lower values on the
stock market.

But the expansion of investment expenditures internalizing

social costs of production does not completely explain the persistent decline
in market values of firms.

Economic policy in general, legislation and

regulations are increasingly hostile to private property and profits,
subtle and pervasive

attrition of property rights characterizes

course of western societies future developments.

A

the general

This course is well under

way in Western Europe and is also expressed by many detailed events in the
USA,

The sequential phases of price-wage controls form only a minor segment

of the general trend.

This trend necessarily lowers the present value of expected

net cash flows generated by business firms.

It follows thus that the decline

of stock market values must be attributed dominantly to influences emitted by our
general economic policies affecting the "real structure" of our economy.

This

analysis of our recent development also implies tfiat monetary policy cannot cope
with their phenomena.

An expansionary policy will not lower apparently high

real rates of interest.

It would only raise the rate of inflation still further

and also raise the nominal rate of interest. Neither would an expansionary
financial policy affect the real conditions dominating the evaluation of the
stock market.

A new surge of inflationary policies would actually only reinforce

the growing institutional and social uncertainties




imposed on the market's

10

evaluation of business firms

future prospects.

The second argument presented by Tobin criticizes the recommendations advanced by the SOMC on the basis of the social costs apparently attached
to our recommendations.

He uses for this purpose estimates of the unemployment

rates implied by the n St. Louis model11 and some "Philipps curve model."

He finds

that the model simulations associate comparatively high rates of unemployment
with our proposal.

He seems to suggest, therefore, that our policy recommendation

is therefore inappropriate or unacceptable.

But this categoricalconclusion

simply does not follow from the model simulations presented.

Neither of the

two models has been especially justified as a useful hypothesis about the
behavior of unemployment rates.

Unemployment rates have generally been difficult

to predict and most models were specifically quite unreliable in this respect.
The Philipps curve models showed in the recent past repeatedly deviations
from observations sufficiently large to question relevance of the longer-run
simulation exercised by Tobin,

But these longer-range simulations are really

made quite dubious and probably also quite irrelevant by a property of economic
systems recently emphasized by Robert Lucas at a Carnegie-Rochester Conference
on price-wage controls (November 1973).

The structural properties and response

patterns of an economic system are not invariant relative to different policies
and policy patterns.

The mechanical simulation of a policy program substan-

tially different from the policy patterns prevailing over the sample period
used to estimate the model yields thus little information about the consequences
of the program proposed.

In particular, the simulations of a model estimated

over a period of accelerating inflation probably exaggerates the longer-run
unemployment effects of an anti-inflationary program.
. The unreliability of Tobin's assessment is not the only flaw of his
critique.




Even if one accepts the simulations the objection to our recommendation

11

still does not follow.

Tobin totally disregards the social cost of inflation,

particularly of an erratic inflation, including the social cost of controls
and associated policies systematically associated with inflationary spurts.
It is not obvious that the unemployment rate measured by Tobin produces a social
cost naturally exceeding the social cost of permanent erratic inflation to be
suffered under Tobin's prescription of policy.

It is even less obvious that

the social costs associated with the most probable course of unemployment attributable to anti-inflationary policies exceeds the social cost of permanent
inflatioiu

It is actually our judgment that the balance of social costs justifies

a steady and long-range policy of financial moderation.

This judgment forms

the basis of our proposal and not, as Tobin claims, any unwillingness to
recognize the existence of social costs associated with anti-inflationary
financial policies*
The general argument developed by Robert Lucas also bears on Tobin*s
conception of contemporary inflation:

"The tormenting difficulty is that the

economy shows inflationary bias even when there is significant involuntary
unemployment.

The bias is in some sense a structural defect of the economy

and society, perhaps a failure to find and to

respect orderly political and

social mechanisms for reconciling inconsistent claims to real income.

Chronic

and accelerating inflation is then a symptom of a deeper social disorder, of
which involuntary unemployment is an alternative symptom..
the Federal Reserve can shift from one symptom to the other.

Within limits
But it cannot cure

the disease.
This passage requires some comments% The views advanced approximate
closely the Msocial conflict explanations11 fashionable in January.

My age

permits me (unfortunately) to remember the time when many economists elaborated
on the deflationary bias of modern economies and stressed the difficulty, if not
impossibility, for persistent inflationary pressures to emerge in modern
economies.




The expectation of a deflationary bias dominated the views for

12

several years beyond World War II.

But the scene gradually changed and now we

experience the vistas of &n inflationary bias.
deeply anchored in the social process.
"deep", it must be sociological."

And as before, the new bias is

One feels occasionally, that it is so

The meaning of such statements bearing on

inherent inflationary (or deflationary)biases remains, however, somewhat obscure,
need not at this stage attend to the precise nature of the social mechanisms
envisaged by Tobin.

It is sufficient to examine his contention that financial

policies can only shift "from one symptom to another."

The analysis developed

by Lucas bears actually with some importance on this issue.

The properties

and appearances of the social process unobscurred under the labels "deflationary
or inflationary biases" are probably substantially conditioned by the financial
policies pursued in the recent past.

"Inflationary biases" do not emerge

independently of the policy patterns pursued by the governments over many years.
It follows, therefore, also that such "biases" are effectively moderated by a
persistent course of anti-inflationary policies.

In particular, the policy

patterns followed determine to a large extent the range available for "shifting
between the symptoms."

The trade-offs between unemployment and inflation decline

with experiences of erratic inflationary policies interspersed with unreliable
phases of anti-inflationary reversals.

The greatest danger of a "social conflict

theory" of inflation follows from its effect on inflation itself.

It directs

attention away from the crucial conditions of inflation and tends to generate
social policy patterns perpetuating inflation.
Among these patterns we note specifically two proposals more frequently
mentioned again in recent weeks.
agency and credit controls.

These proposals pertain to a man power service

The first proposal is closely associated with Tobinfs

emphasis, on involuntary unemployment.

The unwary reader of Tobin1s piece will

probably understand that all unemployment is entirely involuntary, jmposed by
the system and to be suffered with passive acceptance.




Pertinent observation

does not support such a view.

The social cost of unemployment substantially

exceeds the private cost of unemployment,

Martin Feldstein's examinations of

the structure of unemployment prepared for the 4 2 s r k Economic Committee established
^4^i
in particular the comparatively high compensation ratio implicit in unemployment
benefits.

This ratio apparently is close or above unity for a substantial fraction.

The implicit subsidy built into the unemployment compensation is bound to increase

as
the average unemployment ratio/officially measured.

The incentives to lengthen

intervals between jobs or to increase the frequency of such intervals over the
year unavoidably raises the official measure of the unemployment ratio.

Changes

in social policy expanding the built-in subsidy thus raise the long-run unemployment rate and sharpen thus Tobin's dilemma.

Any attempt to exploit financial

policies to lower the unemployment rate are bound to fail urder the circumstances.
They will only accelerate inflation and generate patterns of an apparently-intractable inflation.

Or alternatively, the higher unemployment rates produced

by these policies induce Congressional responses worsening both labor market
allocations and inflation.
service agency.

This conclusion applies immediately to the man power

The absorption of unemployed for service jobs by such a govern-

ment agency strengthens the incentives noted above.

Its operation implies that

the ratio of unemployed plus service job

will rise in the average.

employees

This trend is augmented by the inclusion of a bureaucracy attending to the
service job agency.

Moreover, the marginal social productivity of both-unem-

ployment and service job employees
of

employment•on the market place.

an agency*

remains below the marginal social productivity
Economic welfare is thus lowered by such

Furthermore, the agencies financial requirements expand the budget

deficit and contribute to the

!,

social disorder" of most immediate concern for

our problem, viz., the inability of our political process to control the budget,
The persistent deficits combined with the political pressures conditioning the
the responses of a Central Bank obstruct under the circumstances a monetary
policy lowering the rate of inflation over an extended period.




The second proposal involves a somewhat typical political response
to a problem produced by our past inflationary policies in conjunction with
the peculiar structure of our thrift institutions.

Inflation created high

nominal rates of interest and also removed the ascending yield curve benefitting
for many years the thrift institutions.

The^e developments occurred in the

context of rigid price fixing constraining the liabilities of thrift institutions
essentially adjusted to issue de facto demand to short-term liabilities.
supply of mortgages suffered under the circumstances.

The

The proposal to introduce

credit controls emerges of course as an obvious response favored by a variety
of politically influential groups.

Such controls should direct the supply

of credit coercively to politically approved activities,, including of course, the
securities issued by the government sector.

It is necessary to emphasize that

credit controls are a useless investment to cope with inflation.
furthermore, social costs on the economy.

They do impose,

First, they direct attention from the

course of monetary policy required to moderate inflation.

Second, they produce

malallocations of resources, and third, they intensify political conflicts
and raise incentives to invest in such conflicts.

They offer an open invitation

to various groups to exploit the political apparatus for purposes of wealth
transfers and to move resources in their direction.

The unfortunate consequences

will be borne by the zmzi of the public for the benefit of a small minority with
superior competitive skills in the political process determining the operation
of the controls.
housing/1

Credit

controls are a «sfesa»25^i5& costly device to "help

It makes little sense to "offset" the results of bad policies and a

poorly designed institutional structure with another round of bad policies and hasty
constraints.

We should hope very much that the responsible Congressional Committees

may seriously consider to propose removal of the underlying conditions creating
the major problem for our thrift institutions.




The Hunt Commission offered some

15

relevant recommendations in this respect.

Their recommendations should be

usefully supplemented with a determined anti-inflationary course of financial
policies.




B a ckg round pap e r for
Shadow Open Market
C o mm i 11 e e M e e t: 1 n g
S eFn t o m b e r ^ 1 97A
"*

Failures of Banks and Other Financial Institutions
by Allan H« Meltser

The illiquidity of the Franklin National Bank and rumors of
liquidity problems at other banks and financial institutions at home and
abroad awaken dormant memories of the banking collapse and fears of a new
collapseo

We have no reason to believe that the rumors are true©

However,

we believe it is prudent to.develop appropriate general policies in the event
of insolvency or illiquidity of banks and other financial institutions0
The Federal Reserve 1 s response to the actual and expected loss of deposits
at Franklin National creates doubts about their understanding of the proper
role of a central bank and the proper response to financial failures.
three reasons for this conclusion0
illiquid bank*
market ratese

There are

First, the loans were made to the

Second, the loans were made at rates lower than prevailing
Third, the loans have longer maturity than Federal Reserve

discounts and advances to other banks e

As a result, costs that should be

borne by the owners of Franklin National and the holder's of Franklin's large,
uninsured certificates of deposit were shifted to taxpayers0

These costs

continue«
Other consequences of the policy are much more serious0

The policy

encourages bankers and large depositors to believe that in similar
circumstances they will be treated in a similar way 0

Instead of accepting

the full risk of a highly levered position, they can expect to share the risk with
taxpayers.

They are encouraged to accept risks they would otherwise avoid.

The appropriate response in the case of temporary illiquidity is for
the illiquid bank to borrow in the market,,

The Federal Reserve should remain

willing to lend to any bank on eligible paper at: a penalty rate*




If lenders,

-2fearing failure, demand a risk premium that is high relative to expected
return on loans, the owners may prefer to close the bank.

Or, depositors,

fearing insolvency, may withdraw deposits forcing the bank to close.
Insolvency creates a problem for the Federal Pveserve particularly if
there is a flight from deposits into currency. A flight from deposits at
many banks is a form of financial panic.

The money stock shrinks and interest

rates rise. Banks are required to sell assets at declining prices to pay
depositors.

Bank failures rise, as in the early thirties.

A century ago, Walter Bagehot described the appropriate policy for a
central bank in a time of financial panic.
as applicable now as at the time he \\7rote.

His advise and criticism are
"Lend freely, at a penalty rate,"

he advised.
The Bank of England followed a policy of lending in time of crisis.
Bagehotfs trenchant criticisms of the Bank stressed the Bank's failure to
act promptly and the failure to acknowledge in advance that the Bank v/ould
be the lender of last resort in any future panic.
Prevention of financial panics did not mean then -- and does not mean
now -- that a bank or a large bank should not be permitted to fail.

The

failure must not spread to solvent, liquid banks or institutions.
The Fedfs response to the Peirn Central crisis of 1970 contrasts with
the response to the Franklin National probleme

In 1970, the Fed did not try

to prevent the failure; it prevented the failure from spreading through
the financial markets.

The Fed acted as if it recognized that the lender

of last resort has a responsibility to the market and the institutions in the
market and not to the particular issuer of securities.




-3Once the Fed recognizes the extent of its responsibility, doubts are
removed about the proper response to a failure of a savings and loan association*
a foreign participant in the Euro-dollar market, or any other issuer of
financial paper*
the failurec

The Federal Reserve has no responsibility to prevent

It should publicly accept responsibility for preventing

the panic from spreading through the market*
The Federal Reserve should issue a policy statement accepting responsibility
as lender of last resort to the financial system and denying responsibility
to protect any private financial institutions from the consequences of errors
and misjudgments0

Such a statement should make clear that the policy will

not prevent every failure but will seek to prevent a financial panic. The
responsibilities of the Fed to the deposit and savings and loan insurance
corporations should be clarified to remove any doubt about the ability
of the Federal insurance corporations to obtain currency in the case of
widespread or spreading failures.
The nature of this statement makes it useful to repeat that we have
no information suggesting that a financial panic is likely.

Nor, do we

believe that the risk of bank failures should prevent the Federal Reserve from
restricing the growth rate of money and reducing the growth rate gradually.
Bagehot reminds his readers that whenever the central bank responded
appropriately, the panic ended within a few days.

We have no reason to

doubt that his conclusion is as correct now as it was a century ago.




FORECASTS OF ECONOMIC ACTIVITY AND PRICES III 177k AND 1975
Recent Develotaments
Gross National Product in 1953 prices declined at an annual rate of 1.2$
in the second quarter, following a J% decline in the first quarter. Small increases
in consumer and government spending in the second quarter were more than offset by
declines in housing and net exports. Final demand in 1958 prices was virtually
unchanged from the first quarter. The G1IP Deflator increased at a 12*3$ annual rate
in the first quarter and an 8.8$ rate in the second quarter.
Industrial production was essentially unchanged in June and July. Retail
new-car sales (including Imports) were at a 9.8 million seasonally-adjusted annual
rate in July (using our seasonal adjustment factors), up sharply from a 9*1 million
rate in the first half. Sales in June were depressed because sales contest programs
ordinarily held in June were moved up to I lay this year. The present sales rate
reflects abnormally high incentive payments; we expect sales to continue at about
the present rate through the balance of the model year (until late September). Truck
sales, which were depressed much less than car sales by the gasoline shortage, were
at an annual rate of nearly 3 million in July, up slightly from 2.8 million in the
first half (sales in 1973 were 3.2 million).
The Consumer Price Index increased at seasonally-adjusted annual rates
of 12$ in June and 10$ in July. The increase in both consumer and wholesale prices
in recent months include large increases in goods and services released from
controls at the end of April. In addition, however, wholesale farm prices rose
sharply in July* It appears that the drought will limit supplies sufficiently to
cause sharp increases in retail food prices at least through the rest of this year.
Forecasts
We forecast that real GNP will increase at a 2$ annual rate in the second
half of 197^ and at a 3.2^ rate from the fourth quarter of 197^ to the fourth quarter
of 1975• (On this basis, output will decline about 1% during 197^.) We project that
the GNP Deflator will increase at a 9«7$ annual rate in the second half of 197^, for
a 10.1$ increase from the fourth quarter of 1973 to the fourth quarter of 1974. We
expect the Deflator to increase 8.5$ during 1975• Forecasts by quarter are shown in
the following table.
Projected Gross national Product
~
VPh
1975
Third Fourth First Second Third Fourth Full
Quarter Quarter Quarter Quarter Quarter Quarter Year
$1,^21 $1,460 Ol,501 $1,5^5 &L,590 £,636 $1,563

GNP in Current Prices (Bile.)
% Over Previous Period
(Seasonally-Adjusted Annual Rate) 11.3£

11.62

11.6%

GNP in 1958 Prices (Bils.)
$ 831 $ 835 s 0^0 §
=
% Over Previous Period
(Seasonally-Adjusted Annual Rate) 1.5$
1.955
2.k%
GNP Deflator (1958 = 100)
I71.O 17^.9
% Over Previous Period
(Seasonally-Ad justed Annual Rate) 9.1[%
9.k%




74.*

1*1-

178.7
9.0£

12.2£
\jq
3.1%

182.5
3.3£

12.25b
, 85k
3.6£
136.2
QM

12.2£
v 8^2
3.8>i
189.3
S.<#

11.%
$

351
2.3'
184.3
8.9£

Quarterly rates of increase in the money stock (ll^) declined from the
second half of 1972 through 1973* In the first two quarters of this year, the
money stock accelerated, but since April, the growth rate has slowed again, to
a 5$ annual rate.
Quarterly Growth Rates of the Honey Stock (Ml)
1972
1973
1974'
Third Fourth
First Second
Third Fourth
First Second
Qua, rter Quarter Quarter Quarter Quarter Quarter Quarter Quarter
Money Stock (Bils.)
Percentage Increase
Over Prior Quarter
(Annual Rate)

$2^8.0

8.5$

$253.2

8.7$

$257.6

7.0$

$262.4

7.6$

$266.1

5.7$

$269.0

If.5$

$273.6

7.0$

$279.^

3.7$

The slowing of inflation we project for 1975 is based on projected
acceleration of output, reflecting an expected increase in open industrial capacity
and greater availability of raw materials. Our projections of GIJP and the money
stock (increasing at a 6% annual rate) imply that income velocity (GNP divided by
Mi) will continue to increase at the same rate throughout the six quarters beginning
at the middle of 197*+ • If our forecast is correct, therefore, reduction of money
growth to a 6% rate will not diminish the expected rate of price increase, and thus
lead to a flattening of the increase in velocity, -until after 1975.




James W. Ford
August 21, 197^

POURING TROUBLE ON OILED WATERS:

A BRIEFING FOR THE

SHADOW OPEN MARKET COMMITTEE, SEPTEMBER 6, 1974
by Wilson E. Schmidt*
Six months ago when we last met, the world was expecting

a major

international financial crisis because of the rise in petroleum prices.
Projections of woe,

malaise, and disaster abounded; the rhetoric was

that of crises and of the evil times coming.
Not because the problem went away.

They did not happen.

We still face the largest

structural shift in international payments since the German reparations
problem after World War I.
1974 still looks wild.

The OECD recently projected a shift in

the combined current account of its members from a $4.5 billion surplus
last year to $38.5 billion deficit this year.

It appears that the

petroleum exporters will raise their oil receipts to $100 billion, from
$22 billion last year.

And it now looks like U.S. imports of petroleum

will rise around $20 billion.
I.

IF WE HAD BEEN FIXED, WHAT?

It is obvious to all observers, even the most casual, that the
fixed exchange rate system could not have withstood this prospect of
potential strain.

Governments would have undertaken crash decisions

and programs to solve whatever they conceived to be the problem.

With

floating, very little had to be done.

^Professor and Head, Department of Economics, Virginia Polytechnic
Institute and State University,Blacksburg, Virginia; Deputy Assistant
Secretary of the Treasury, 1970-72.




2

Look back over the great changes in U.S. balance of payments
policy since our deficits arose in the late fifties.

Compare the

scale of the problem each time a new policy was introduced with the
scale of the problem now.
The following table shows the changes in imports and the current
account between the year the policy action was taken and the year before
and also shows the official transactions to support the exchange rate
dollar in the year of the policy action.

It is pretty obvious that

the past record indicates that the oil crises would have induced
drastic policy changes had we been fixed.
Change
in U.S.
Imports

Change in
Official
Current
Reserve
Account
Transactions
(Billions of
Dollars)

Tied Procurement (1959)

+2.3

-.6

-2

Interest Equalization
Tax (1963)

+ .8

-.6

-1.9

Direct Investment
Controls (1968)

+1.4

+.2

-3.2 a

1971 Devaluation

+5.7

-2.3

-29.7

1973 Devaluation

+10.2

-5.5

-10.4 b

- 7 1967
b/ 1972
Compared with those events, it is obvious that the civil servants
and policy makers in Washington would have had to do something, something
cosmetic, something real. After all, they are paid to solve problems.




3

The Under Secretary of the Treasury for Monetary Affairs did not
have to slip secretly in and (until his cover was blown) out of capitals
negotiating exchange rate changes.

There was no public clash, so

necessary but unfortunate, between the great powers over exchange rates
as in the Fall of 1971, a clash recently lamented yery bluntly by
the German Chancellor as endangering trust in the U.S.
Nobody had to close foreign exchange markets, as happened eleven
times in at least one or more of the major financial markets between
1967 and 1973. American Express did not advertise that its card was
better than dollars.
In its classic way, the market replaced negotiations, replaced
trips, meetings, replaced civil servants.

They could tend to other

things, like weights and measures, the things for which we really
require government.
As I said, nothing happened.

The dollar stood last June at just about

the same level as it did on average in 1973. To be sure, it appreciated
from November of last year through January and then fell to March, and
rose to June. What is so utterly amazing about the float is that
the

fluctuations were close to being within the margins that would have

prevailed if we were fixed again.
II.

WHAT WE SURVIVED AND HOW

In their own impersonal way without the benefit of rhetoric, the
statistics are slowly coming in to tell us what has happened.




Probably the three key facts to date are these:

(1) The

4

international reserves of those oil producers for which we have data
rose by $13 billion during the first half of 1974; (2) U.S. petroleum
imports rose from $3.6 billion in the first seven months of 1973 to
$13.2 billion during the same period this year;

(3) the average U.S.

exchange rate recently has been about equal to the average of 1973
and about four to five percent higher than in the early Fall of 1973
when the crisis started.
So far as the United States balance of payments is concerned,
our investment income from petroleum operations rose about $2.5 billion
and the value of our petroleum and product imports rose by $2 billion
between the last quarter of 1973 and the first quarter of this year.
There is still substantial uncertainty surrounding the investment income
figures, despite the fact that the Department of Commerce has cleaned
up some substantial oddities in reporting practices, because the effect
of the participation agreements on earnings still cannot be estimated.
Also, first quarter earnings probably do not show the full impact of
the higher OPEC taxes.
The data suggest substantial recycling through the United States.
It is not clear precisely from the data how much money owned by
petroleum producers has come to the United States because data do not
provide sufficient geographical detail.

However, the inflow of money

from oil producers, based on data for certain regions and selected
countries suggests an inflow of about $7.5 billion (annual rate) during
the first half of 1974. During the first half of the year we ran an
official settlements deficit of about $7 billion (annual rate) as foreign




5

official institutions increased their liquid assets here.

Every major

geographical area appears to have participated in this through May,
except Western Europe which reduced its holdings here.
These inflows were recycled through a huge shift in the flow of
U.S. private capital, some in anticipation of the petroleum financing
problem abroad.

U.S. claims on foreigners reported to U.S. banks rose

by more than $11 billion in the first half of the year, and wery little
of this increment was loans to official institutions, suggesting the
dominant role of the private market.
There was also recycling abroad.

In the first quarter alone, U.K.

banks loaned $4.5 billion to their EEC partners. The Euro-currency
market continued to rise through May at the 50% growth rate observed
in 1973. Data for the first half of 1974 show that medium-term and
long-term publicly announced credits in the Euro-currency market
were almost $20 billion, compared with $22 billion for the whole of
1973.

OPEC borrowing in that market has dropped substantially.
III.

SOME TROUBLE AREAS

There are some yery troublesome features on the terrain.
First, it is not just existing reserves that are being recycled.
The reserves of selected petroleum producers grew by $13 billion through
June from the end of the last year whereas total international reserves
rose by $11 billion through May.

This suggests that the expansion of

credit from reserve centers such as the United States and the United
Kingdom and in the Euro-dollar market is financing much of the growth




6

of petroleum producer reserves.

If we imagine that all of the $40-60

billion of increased petroleum producers reserves this year were
financed by credit expansion, that would imply another 25% or more increase
in the world reserves, approximately equal to the annual growth of
reserves which caused so much of the inflation in the rest of the world
in 1972 and 1973.
It might be thought that to let the petroleum producers take $50
billion of reserves away from the rest of the world would be seriously
deflationary there.

But the petroleum producers must put the money

somewhere, returning the rest of the world's money stock to what
prevailed before.

Of course, if the authorities in the rest of the world

become nervous about their liabilities to the oil producers, excessively
deflationary measures could ensue.

But with floating rates, they need

not worry if they think about it, since their international reserves
are protected.
Second, old slogans and old concepts about the balance of payments
still prevail even though we are floating.

Retention of outmoded

doctrines and concepts could induce inappropriate policy actions.
Specifically, the United States Government still reports a myriad
of deficits on a monthly and quarterly basis.
settlements deficit.

Take one, the official

This was established during the era of fixed

rates to measure pressure on the foreign exchange markets.

Specifically,

it told how many surplus dollars foreign central banks bought in order
to keep their exchange rates steady.

But now exchange rates are free

to fluctuate so it is no longer needed.




And in fact the recorded

7

deficit is now misleading.

While our accounts showed a deficit at

an annual rate of $7 billion in the first half of the year, the value
of the dollar on the exchange market was rising, the opposite of what
one would expect from a surplus of dollars on the foreign exchange
markets. When foreign governments invest here it is not because they
have to support the dollar but because they prefer dollar investments.
Retention of the concept of the official settlements deficit could
present a real problem.

If all of the surplus petroleum money were to

be invested in liquid assets in the United States it would be recorded
under current convaitions as a $50 billion deficit in our balance of
payments.

This would top our deficit in the quarter in 1971 when

President Nixon took us off gold and started the train of events that
lead in March of 1973 to the float.

It is easy to imagine how this

number would be used by the protectionists, the export promoters, and
the capital-controllers whose policy positions and budget requests are
not in the long-run interest of the United States.

The simple truth is

that, with floating, there is now only one true deficit in the balance
of payments; it is the entry for Errors and Omissions which serves as
a measure of the deficit in the quality of the data.

An interim solution,

while the United States Government thinks about this problem, is to
have all press releases refer to deficits as surpluses and vice versa.
Third, we should begin to contemplate revising our growth target
for the money supply in the light of international conditions.

In

previous meetings of the Committee we have agreed that international
transactions have very little to do with the internal state of the




8

economy because since August 15, 1971 the money supply has not been
significantly affected by international transactions.

Of course, this

elementary truth has largely been disregarded by those who find excuses
for our poor past performance in international events, in Russian wheat
sales, in anchovies, and in devaluations.
But it has always been clear to monetarists that major changes
in the terms of trade of the United States, the prices at which we
exchange our goods and services for foreign goods and services could
have, under special circumstances, a significant impact.

Few would

deny, for example, that a permanent downward shift in American productivity
would raise prices. An adverse shift in our terms of trade amounts to
precisely that.

If the prices we pay for imports rise more than the

prices we get for our exports, our national productivity has declined.
We get fewer goods back for the goods we send out.
As a result of the oil price change and general world inflation,
the import prices paid by the United States in the second quarter of
1974 were 50% higher than the second quarter of 1973. At the same time
our export prices rose less than 30%. Together these have imposed a
13% adverse shift in our terms of trade.

(Twenty percent since 1971.)

Given the fact that exports of goods and services now run almost 8%
of our GNP, the implied reduction in our real output is 1 percent.
(1.6 percent since 1971.) This suggests that whatever monetary growth
target was appropriate before the oil price rise might well be shaved
a bit to adjust for what appears to be a once-for-all shift in our
terms of trade.




9

(There is the possibility that the income of the American petroleum
industry from its foreign operations could rise by enough to offset
the rise in the price of our petroleum imports.

But, as said before,

this is uncertain.)
Fourth, the creeping deform of the international monetary system
continues. Already, the member governments of the International
Monetary Fund has agreed on changes in the SDR which will make it more
usable. In the terms of possibility of returning to fixed exchange
rates, this is probably more significant than it appears. The United
States Government is unlikely to return to convertibility unless it
has an assured right to devalue and this, for political reasons abroad,
is enhanced by the effective existence of the SDR.
Early in June, the Chairman of the Deputies of the Committee
of Twenty, the group responsible for drafting a deform of the international monetary system, said "...it is evident

that governments in

the seventies, as in the thirties, are unwilling -- except for relatively
brief periods when the hurricane rages or the dykes break -- to let
their exchange rates go where they will."
Governments have now agreed through the International Monetary
Fund on a set of guidelines for the management of floating rates.
These guidelines are innocent looking things at the start but the
ghost of Bretton Woods is quickly evidenced; the new-fangled paraphernalia for exchange rate fixing are all about.
The first guideline calls on member governments to intervene in
the foreign exchange market as necessary to prevent or moderate sharp




10

and disruptive fluctuations from day to day and from week to week
in the exchange value of its currency.

The second guideline extends

the horizon from month to month and quarter to quarter, and it adds
that intervention to speed the movement of the exchange rate in the
same direction as the market should not be done.
The third guideline extends the horizon to four years.

Under it

the Fund may encourage a member government to intervene in the market
to bring "equilibrium in the 'underlying balance of payments,1 i.e.
in the overall balance in the absence of cyclical and other short-term
factors affecting the balance of payments, including government policies
which are, or, on internationally accepted principles, ought to be
temporary."
It is indeed unfortunate that governments have agreed to this.
As is widely known, the IMF multilateral exchange rate model was
employed extensively in the negotiations which led to the first
devaluation of the dollar and was very influential in the determination
of the new rates. The simple, unassailable fact is that the set of
rates established in 1971 failed to produce equilibrium in international
payments and broke down beginning in January 1973, ending in the float
in March, 1973.
There was an enormous cost in the failure to obtain equilibrium
rates, a cost which governments, people and politicians, poor and rich
have had to pay in the form of world-wide inflation.

As my colleague,

David Meiselman, has convincingly demonstrated, the cause of that
accelerated inflation in the rest of the world in 1972 and 1973 lay
at the door of the U.S. balance of payments deficit in 1972 and early




11

1973 which expanded the monetary base abroad.

Had there been a float,

history would have been far more pleasant.
There are enormous technical problems in any exchange rate
model that should make a practical man of affairs extraordinarily wary
of it as a feasible guide to exchange rate fixing.

The essence of any

exchange rate model is its estimate of the impact of exchange rate changes
on the volumes of exports and imports.

This requires an estimate of

underlying elasticities of demands for imports and exports in terms
of prices.

But the quality of the data will simply not allow such

estimates, even for the United States which has the best balance of
payments data.

Because our tariffs are low and cover only a small amount

of the goods exchanged, customs valuations are poorly checked.
in the flows are >/ery large.

Errors

For example, the Department of Commerce

after hard work has reconciled our data on trade with Canada; the average
error for 1970-72 was about $700 million in our net trade.

The unit

value indicies we produce cover 40% of our exports and 50% of our
imports.

Being unit value indices rather than price indices , their

levels change simply when the unit measured changes, e.g., the unit
value of our aircraft exports rose when we began to export jumbo jets
some years ago.

The wholesale price index for the United States has

so much double counting that a recent study of the role of import prices
in our inflation estimated that imports were twice as important as
recorded.

And the consumer price index is so far removed from inter-

national trade as to be virtually useless.




Quite correctly, at least in theory, the guidelines tell governments

12

and the Fund to seek rates that will produce equilibrium in the absence
of cyclical and other short-term factors.

This involves estimating

what imports and exports would be if all countries were at high employment.

This in turn requires an estimate of potential income and

potential national output.
measure.

But this is a very tricky concept, hard to

Edward Denison, a very close student of our national economic

statistics, recently compared his newly-developed series on potential
output with those employed by the Council of Economic Advisers.

He

writes, "...my series shows that actual output declined relative to
potential output in both 1968 and 1969, the CEA series based on the
unemployment rate shows that it increased in both 1968 and 1969, and the
CEA series based on the use of trend values shows that it increased
in 1968 and declined in 1969."
The Fund is indeed fortunate in having an excellent research
team.

And the United States Government is fortunate in having many

good civil servants who are laboring hard and precisely to improve
the quality of the data with, I might add, much less budget support
than their responsibilities would require if we were to return to a
fixed rate system.

What I am saying is that the real world is still

not ready for another computer-assisted exchange rate determination.
The market is still the better calculator.




At our peril, we are pouring trouble on oiled waters.

The Current State of the Budget Estimates
The most recently available official estimates of the Federal Budget
for Fiscal 1975 are in the Mid Session Review of the 1975 Budget by the Office
of Management and Budget, prepared June 1, 1974 (house Doc, 93-312)•

These

include relatively minor revisions from the February estimates; revenues are
revised downward by one billion dollars, and expenditures are revised upward
by one billion, so that the unified budget deficit is increased by two billion
from an estimated 9*4 billion dollars to an estimated 11.4 billion dollars.
These relatively minor changes perhaps generate the misleading expectation of a high degree of precision in the estimates.

In fact, there is a

great deal of uncertainty about the ultimate outcome.

On the expenditure

side of the budget, the OMB, on June 1, was projecting outlays of $305.4
billion dollars on a unified basis. At the same time, a footnote to the table
detailing current projections of outlays by agencies (HD. 93-321), p. 13)
announces "If interest rates remain high, mortgage committments under this
plan (the housing policy recommendations announced May 10, 1974) could cause
outlays in 1975 to be up to $3 billion higher."

It seems unrealistic to

believe that there will be substantial reductions in mortgage rates during
the remainder of fiscal 1975, so we should presumably adjust upward the current
estimate of outlays to 308.5 billion, and the deficit to 14.4 billion.

In

examining the changes by agency (Table 1) the largest reduction appears in
the Agriculture Department.

Since the mid year budget review, however, the

Agriculture Department has announced (August 22, 1974) that the drought this
summer in the mid-West will require an estimated 500 million dollars in
subsidies under the provisions of the Agriculture and Consumer Protection




TABLE 1.—Changes in Budget Outlays by Agency, Fiscal 1974-75,

Billions $
Defense
Agriculture
Commerce
H.E.W.
(Social Security Trust Funds)
H.U.D.
Interior
Justice
Labor
(Unemployment Trust Fund)
State
Transportation
Treasury
(General Revenue Sharing)
(Interest on Debt)
Corps of Engineers
A.E.C.
E.P.A.
G.S.A.

7.3

.20

- .9

-.03

.2
17.0
(11.6)
1.1
.5
.2

.01
.47
(.32)

2.7
(1.8)
.1
1.0

.03
.01
.01
.08
(.05)
.002
.03

2.6
( .1)
(2.1)
.0

.07
.003
.06
.00

.7

.02

1.5
- .7

.04
-.02

N.A.S.A.
V.A.

.1

Foreign Economic Assistance
Other Agencies
Allowances (Energy Research,
Civilian Paying)
Undistributed Intragovemmental
Transactions

.5




Percent
Total Change

.7

.003
.02

1.4

.01
.04

.9

.03

- .9

-.03

35.9

Act of 1973, which requires payments on wheat, feed grains and cotton, if
yields fall below 2/3 of "normal" due to natural forces. Thus, total projected outlays increase to 309.0 billion, and the deficit to 14.9 billion.
The Ford Administration has announced its intent to hold total outlays
for fiscal 1975 to the 300 billion dollar level in the attempt to relieve
inflationary pressures.
come about.

Is it realistic to believe that any such cuts can

Table 1 indicates the changes in outlays by agencies on the basis

of a total of 304.5 billion.

Four categories which are certainly immune to

any budget cutting are Social Security Trust Funds, Unemployment Trust Funds,
Interest of Public Debt, and the Veterans Administration.

These four categories

alone account for 45 percent of the projected change in outlays from fiscal
74 to fiscal 75. President Ford stated in his address to the joint session
of Congress that the defense budget would be protected from any unwarrented
cuts.

This is another 20 percent of the change projected by OMB.

Added to

the 45 percent indicated above, that totals to 65 percent or 23 billion dollars.
Since our 309 billion of projected outlays is only a total of 39.5 billion
higher than the estimate of 269.5 for fiscal 1974, this means that 9 billion
of a total increase of 16.5 billion (or 54.5 percent) would have to be cut
from the budgets of all other agencies to achieve the 300 billion target.
This hardly seems realistic given the current inflationary experience.
What possibilities are offered by the recent cuts in Congress of the
Urban Mass Transit Bill, and the Department of Defense Appropriation.

In

the February budget proposals, the projected outlays for fiscal 1975 for
the whole of the Unified Transportation Assistance Program amounted to only
If we make the further assumption that the 3.5 billion of adjustments
to housing and agriculture cannot be cut, the 9.0 billion would have to come
out of the projected increase of 13.0 billion to all other agencies (70%).




2.5 billion dollars.

Of this 1.1 billion is for urban highway grants.

Note

that the total change in the D.O.T. outlays from fiscal 74 to fiscal 75 as
projected by OMB is only 1.0 billion, including the increase associated with
the initial phases of the Urban Mass Transit Program.

Clearly, this action

is going to be an insignificant drop in the bucket during the current fiscal
year.

The Department of Defense outlay projections cited in Table 1 are 85.8

billion for fiscal 75.

Various cuts imposed by the House and Senate suggest

an initial appropriation for fiscal 1975 of around 82 billion.

If this cut

of approximately 4 billion is permanent, then the estimated expenditures are
only about 5 billion over the 300 billion administration target level.

Since

the Department of Defense received a 4.1 billion supplemental appropriation
in the late Spring of 1974 to cover unanticipated increases in costs associated
with inflation, the Arab-Israeli War, etc., it is perhaps unrealistic to
believe that the full cut will stick for the whole year.
On the receipts side of the budget, there is additional reason to
doubt that the projections of OMB will be completely realized, and again the
evidence suggests that the forecasting error is such to under estimate the
magnitude of the deficit.

OMB projects revenues on a unified budget basis of

294 billion, associated with

an

estimate of current dollar

Gross National Product of 1401 billion dollars for calendar 1974.

This in-

cludes the assumption that the proposed reduction in oil depletion allowances
and the implementation of a windfall profits tax which has been proposed by
the House Ways and Means Committee will be enacted (HD. 93-312, p. 3). This
revenue projection is considerably higher than some private forecasters are
currently projecting on the basis of essencially the same current dollar
for calendar 1974.




Wharton, for example, is about 5 billion dollars less.

GNP

The current OMB revenue projection is changed from the February estimate
by only one billion dollars.

Even last February there was considerable comment

among observers that the revenue projections were unlikely to be realized.

As

of June, OMB was admitting that its projections of revenues for fiscal 1974
last February were over estimates of about 3 billion, even after allowing
for the fact that the Congress did not pass the proposed windfall profits
tax.

If we assume that fiscal 75 revenues of 290 billion is a more realistic

projection, then the unified budget deficit for fiscal 1975 could be projected
at around 20 billion dollars, based on presently available evidence.
What are the implications of a budget deficit of this magnitude for
Treasury financing?

In the February budget message, the Administration pro-

jected that a unified budget deficit of 9.5 billion dollars, would require
an increase in Federal debt held by the public (including the Federal Reserve
System) of 12.5 billion dollars (see Table 2 ) . As of June, the size of the
estimated deficit has grown by 2 billion, but the change in the estimated
Federal debt held by the public from the end of fiscal 1974 to the end of
fiscal 1975 remains at 12.5 billion.

Even if we accept this figure at face

value, the increase in the estimated deficit to the order of 20 billion,
suggests a required new debt issue of about 21 billion.

However, not all

of the borrowing by the government is reflected in the treasury debt.

There

are a total of seven government sponsored enterprises: the Federal Home Loan
Banks, Federal National Mortgage Association, Student Loan Marketing Association, Federal Home Loan Mortgage Corporation, Farm Credit Administration (Banks
for Cooperatives), Farm Credit Administration (Federal Intermediate Credit
Banks), and the Farm Credit Administration (Federal Land Banks).

As of Feb-

ruary, 1974 these enterprises were projected to borrow 13.6 billion during
fiscal 1974.




(Federal Budget for Fiscal 1975—Special Analyses, pp. 44 ff.)

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Increase or Decrease
in Liabilities for
Checks Outstanding &
Deposit Fund Balance

Total Financing
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Net Government
Sponsored Borrowings
From Public

Change in Federal
Debt Held by Public

Increment on Gold

Outlays of OffBudget Agencies

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(-)

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Deficit
(Unified Budget)

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As of the end of May, 1974, six of the seven (excluding the Student Loan
Marketing Association) had borrowed a total of 12.7 billion dollars (Federal
Reserve Bulletin, July, 1974, p. A40). The February, 1974 projection for
borrowings by these enterprises for fiscal 1975 was only 1.27 billion dollars.
The reason for the reduction in the rate of borrowing was a projected decrease in borrowing by FNMA from 4.7 to 2.0 billion, fiscal 1974 to 75, and
a change in the borrowing status of the FHLB from a borrower of 5.5 billion
in fiscal 1974 to a net repayer of 5.2 billion in fiscal 1975 (Federal Budget
for 1975—Special Analyses, p. 44). Both reductions were projected on the
assumption on improving conditions in the mortgage market, and in particular
for the FHLB's, the assumption that savings and loan associations would be
repaying outstanding advances during fiscal 1975.
into fiscal 1975.

We are now almost two months

During July, 1974, savings and loan associations experienced

a net outflow on deposits of 500 million.

There are estimates that the net

outflow of deposits in S&L's during August may reach 1.6 billion (Business
Week, August 24, 1974, p. 12). Under these circumstances, it seems highly
likely that the FHLB's and FNMA will be heavy borrowers during the current
fiscal year to prop up the mortgage market and in particular to prop up the
S&L's who are excluded from effectively competing for funds in the current
economy by the various ceilings on deposit rates.

It is easily conceivable

in the current economy, that these enterprises would be at least as heavily
into the capital markets during fiscal 1975 as they were in fiscal 1974, and
highly probable that they shall have to borrow even more than in 74.

Assuming

net borrowing by these agencies at the 74 level of 13.5 billion, our estimates
of the total financing requirements for the fiscal year increases to 34.5
billion dollars.
mistic.




It could be argued that these estimates are extremely pessi-

While it is possible to postulate circumstances under which smaller

8

financing requirements would prevail, it is also fairly easy to postulate
circumstances under which the requirements could be even heavier:

for example

failure of inflation to subside over the next nine months; rapidly increasing
unemployment; and continuing deterioration of the competative position of
the savings and loan associations relative to capital markets at the rate
of the last two months.





Federal Reserve Bank of St. Louis, One Federal Reserve Bank Plaza, St. Louis, MO 63102