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THE DOLLAR RESCUE OPERATIONS AND
THEIR DOMESTIC IMPLICATIONS
-
REFERENCE LI BRARY
RE fj ' : ~.'-I G- u.. T ·;; L NT
FED :: r AL ru~.St ~~ c 8A K
l
IfE~it~GS
BEFORE THE
SUBCOMMITTEE ON INTERNATIONAL ECONOMICS
OF THE
JOINT ECONOMIC COMMITTEE
CONGRESS OF THE UNITEU STATES
NINETY-FIFTH CONGRESS
SECOND SESSION
DECEMBER 14 AND 15, 1978
Pr.inted for the use of the Joint Economic Committ:ee
U.S. GOVERNMENT PRINTING OFFICE
43-286
0
WASHINGTON : 1979
For sale by the Superintendent of Documents, U.S. Government Printing Office
Washington, D.C. 20402
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Federal Reserve Bank of St. Louis
JOINT ECONOMIC COMMITTEE
(Created pursuant to sec. 5(a) of Public Law 304, 79thCong.)
RICHARD BOLLING, Missouri, Ohalrman
LLOYD BENTSEN, Texas, Vice Ohairman
HOUSE OF REPRESENTATIVES
HENRY S. REUSS, Wisconsin
WILLIAM S. MOORHEAD, Pennsylvania
LEE H. HAMILTON, Indiana
GILLIS W. LONG, Louisiana
FARREN J. MITCHELL, Maryland
CLARENCE J. BROWN, Ohio
GARRY BROWN, Michigan
MARGARET M. HECKLER, Massachusetts
JOHN H. ROUSSELOT, California
JOHN R. STARK,
SENATE
JOHN SPARKMAN, Alabama
WILLIAM PROXMffiE, Wisconsin
ABRAHAM RIBICOFF, Connecticut
EDWARD M. KENNEDY, Massachusetts
GEORGE McGOVERN, South Dakota
JACOB K. JAVITS, New York
WILLIAM v. ROTH, JR., Delaware
JAMES A. McCLURE, Idaho
ORRIN G. HATCH, Utah
liJa,ecutive mreotor
SUBCOMMITTEE ON INTERNATIONAL ECONOMICS
HENRY S. REUSS, Wisconsin, OochGinnan.
GILLIS W. LONG, Louisiana, Oochairman.
HOUSE OF REPRESENTATIVES
WILLIAM S. MOORHEAD, Pennsylvania
LEE H. HAMILTON, Indiana
MARGARET M. HECKLER, Massachusetts
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Federal Reserve Bank of St. Louis
SENATE
ABRAHAM RIBICOFF, Connecticut
JOHN SPARKMAN, Alabama
GEORGE McGOVERN, South Dakota
WILLIAM V. ROTH, JR., Delaware
JACOB K. JAVITS, New York
(II)
CONTENTS
WITNESSES AND STATEMENTS
THURSD AY, DECEMBER
14, 1978
Reuss, Hon. Henry S., cochairman of the Subcommittee on International
Economics: Opening statement_ ______ __ ______ _____________________
Blumenthal, Hon. W. Michael, Secretary of the Treasury _ _ __ __ __ __ __ __
Schultze, Hon. Charles L., Chairman, Council of Economic Advisers _____
Page
1
8
32
AFTERNOON SESSION
Houthakker, Hendrik S., Henry Lee Professor of Economics, Harvard
University__ ____ __________ ____ ___________ ________ _______________
Solomon, Robert, senior fellow, the Brookings Institution _____ ____ ______
Keyserling, Leon H., president, Conference on Economic Progress_ ______
Willett, Thomas D., Horton Professor of Economics, Claremont Graduate
School and Claremont Men's College, Claremont, Calif__ __ ___ ____ ____
FRIDAY, DECEMBER
54
60
69
111
15, 1978
Miller, Hon. G. William, Chairman, Board of Governors of the Federal
Reserve System _______________ ________________ ____________ ____ __
129
AFTERNOON SESSION
Miller, Hon. G. William, Chairman, Board of Governor of the Federal
Research Seminar in Quantitative Economics, University of Michigan __
Pierce, James L., professor of economics, University of California, Berkeley_
Yeo, Edwin H., III, chairman, Asset and Liability Management Committee, First National Bank of Chicago-___ __ _______ ____ __ _____ __ ____ _
Modigliani, Franco, professor of economics and finance, Massachusetts
Institute of Technology_ _ _ ____ __ __ __ __ __ ____ __ __ __ ___ __ __ __ __ __ __ __
184
194
197
207
SUBMISSIONS FOR THE RECORD
THURSDAY, DECEMBER
14, 1978
Blumenthal, Hon. W. Michael: Prepared statement_ ____________________
Reuss, Hon. Henry S.:
LetterTo Secretary of the Treasury W. Michael Blumenthal, dated
November 24, 1978, requesting the Treasury's views on a proposal made at the International Monetary Fund's September
meeting in Washington by Governor Xenophon Zolotas of the
Bank of Greece, whereby the U.S. Treasury would issue nonnegotiable, medium-term obligations, denominated in dollars,
to leading commercial Eurodollar banks__ _ _ _ ___ __ __ __ __ __ __
Of response from Secretary of the Treasury W. Michael Blumenthal, dated December 13, 1978, regarding a proposal made by
Governor Xenophon Zolotas of the Bank of Greece that the
Treasury sell medium-term, non-negotiable, dollar-denominated,
variable interest rate securities to leading commercial banks
in the Euromarket and perhaps to foreign central banks_____ _
From Governor Xenophon Zolotas of the Bank of Greece, dated
January 5, 1979, expressing his views on the difficulties the
dollar is experiencing in foreign exchange markets ____ - __ __-Schultze, Hon. Charles L. : Prepared statement__ __ ___ _______ __ _______ _
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4
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38
IV
AFTERNOON SESSION
Page
Houthakker, Hendrik S.: Prepared statement__________________________
Keyserling, Leon H.: Prepared statement, together with charts __ - - ·-- __ __
Solomon, Robert:
Prepared statement ___ ___ __ ____ - -- --- -- ---- -- -- ---- - --- -- -- -- -·Articles:
"Should We Welcome a Recession?"--------- - ----- - - ----- ·-- "Courting Recession To Spur the Inevitable Dollar Bouncell --Willett, Thomas D.: Prepared statement____ ___________ ________ _____ _
FRIDAY, DECEMBER
58
73
63
65
66
114
15, 1978
Javits, Hon. Jacob K.: Opening statement______________ _______ __ ___ __
Miller, Hon. G. William: Prepared statement, together with charts______
Reu ss, Hon. Henry S.: Letter to Hon. G. William Miller, Chairman, Board
of Governors, Federal Reserve System, dated January 9, 1979, from
Representative Reuss and Senator Javits, requesting his views c,n how
the development of broader markets could be financed __ __ _______ ·-·----··
168
133
171
AFTERNOON SESSION
Hymans, Saul H.: Prepared statement______ _____________________ ____ _
Yeo, Edwin H., III: Prepared statement____ __ ______ ______ ___ ________
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199
THE DOLLAR RESCUE OPERATIONS AND THEIR
DOMESTIC IMPLICATIONS
THURSDAY, DECEMBE:8' 14, 1978
CONGRESS OF THE u NITED STATES,
SUBCOMMITTEE ON I NTERNATIONAL ECONOMICS
OF THE JOINT ECONOMIC COMMITTEE,
Washington, D.O.
The subcommittee met, pursuant to notice, at 9 :32 a.m., in room
2128, Rayburn House Office Building, Hon. H enry S. Reuss
(cochairman of the subcommittee), presiding.
Present: Representatives Reuss, Hamilton, Brown of Ohio, and
Fenwick.
Also present: John R. Stark, executive director; Louis C. Krauthoff II, assistant director; Lloyd C. Atkinson, Thomas F. Dernburg,
Dianne Kahn, George D. Krumbhaar, Jr., L. Douglas Lee, Katie
MacArthur, Paul B. Manchester, and Robert Ash Wallace, professional staff members; Mark Borchelt, administrative assistant; and
Robert H. Aten, Stephen J. Entin, and Mark R. Policinski, minority
professional staff members.
OPENING STATEMENT OF REPRESENTATIVE REuss, CocHAIRMAN
Representative REuss. Good morning. The subcommittee will be in
order for our hearings on the dollar rescue operations.
These will be the last hearings of the Joint Economic Committee in
the 95th Congress. I know that Chairman Bolling and all members of
the committee join with me in expressing our deep debt of gratitude
to Senator John Sparkman, a dedicated public servant, whose retirement from Congress brings to an end 31 years of service to the Joint
Economic Committee. Senator Sparkman is the last remaining original charter member of the committee. When he retires, he will divide
his time between Washington, D.C. and Huntsville, Ala., where he
intends to open a law firm with his grandson. We all wish him every
future success.
On November 1, the administration announced its dollar rescue
operations. This included an austere budget policy and a shrinking
budget deficit, tighter monetary policy, and joint intervention in support of the dollar with West Germany, Japan, and Switzerland, to
which we committed $30 billion of our own resources.
Because of the drastic drop in the dollar's externa! value l~st summer and fall, drastic steps were clearly necessary. This committee has
thus supported rthe administration's actions as an emergency measure.
So far the erosion of the dollar has been checked and, on the average,
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(1)
2
10 percent of its external value against other leading currencies has
been restored. Two questions of large importance will dominate these
hearings.
1. On the domestic side, can the dollar rescue program, combined
with our domestic anti-inflation program, be fine-tuned sufficiently
so as to avoid recession, or at least a shortfall in growth that could
bring unneeded hardship and inequity at home, and set in motion a
self-defeating switch of foregin capital a.way from our shores?
I can see at least four hazards in the present program :
(a) Budget austerity could fall disproportionately on programs to
aid the structurally unemployed and our cities, so that dollars instead
might go for programs like military spending and space. Is a military
overkill potential, and the undertaking now of postponable scientific
probes in outer space, really going to enhance the well-being and security of the American people, if the risk is that Newark and Cleveland and Detroit and Los Angeles will once again be the scene of civil
strife?
The teenage unemployment rate, currently mired in the 35-40 percent range, is bound to get worse if the economy slows significantly in
1979. Teenage unemployment, primarily a structural problem, is thus
cruelly compounded by an overall slowdown.
(b) The current dollar rescue program apparently entails tighter
money and higher interest rates than would be necessaTy simply to fight
domestic inflation. Higher interest rates, it is argued, will lure foreign
capital here and thus improve our balance of payments.
The factual basis for this belief is hard to find. It seems much more
likely that an unnecessarily tight money policy .will seriously slow
down research and development, and investment in plant and equipment-both needed for increased productivity, which in turn is the
soundest method of fighting inflation.
With Germany's inflation for next year predicted at 2 to 3 percent,
and ours at 7 percent or more, supertight money could simply lead
to greater pressure on the dollar, and see the departure from these
shores of foreign capital destined for either our stock market or for
direct _investment here. Would it not be better, then, to confine monetary tightness to that needed to fight domestic inflation, and not to
try to use an extra dollar of it to "defend the dollar"?
( c) Our intervention in the last month has already absorbed billions
and recent figures released by the Federal Reserve show that interventions can involve substantial monetary loss to t.hjs country, more than
$400 billion in this year alone and more than $1 billion in the 1970's.
In £act, we can intervene until our cupboard is bare--and go further
in debt to get the marks and yen with which to intervene-yet not
really rescue the dollar, especially if there is a $700 billion overhang
in the Eurodollar market, as many analysts allege.
We should explore, therefore, whether even our short-term program
· should not include measures to sterilize some part of this overhangif it exists-and thus reduce the incentives of holders to dump dollars.
Specifically what about the proposal of Governor Xenophon Zolotas
of the Bank of Greece and others to float medium-temn Treasury
obligations, denominated in dollars, to the Eurodollar commercial
banks, with the Treasury sterilizing the proceeds? This would remove
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the volatile marginal amount from the overhanging pool during the
critical years immediately ahead, and could well insulate the world
from additional inflationary pressures.
In this connection I addressed a letter to the Secretary of the
Treasury on November 24, asking for his views on the proposal and
the Secretary was good enough to write me a compendious letter,
dated December 13, giving Treasury's views which are stated in Secretary Blumenthal's letter. I think it is useful to have these two positions out on the table for public examination and debate, and I accordingly ask unanimous consent that my letter of November 24 and the
December 13 reply by Secretary Blumenthal .be made a part of the
record at this point.
[The two letters referred to, together with a third letter subsequently
supplied for the record, follow :]
CONGRESS OF THE UNITED STATES,
HOUSE OF REPRESENTATIVES,
Washington, D.O., November 24, 19'18.
Hon. w. MICHAEL BLUMENTHAL,
Secretary of the Treasury, Depa,rtment of the Treasury,
Washington, D.O.
DEAR SECRETARY BLUMENTHAL: I believe that our current dollar rescue operation is appropriate and helpful.
In addition to the measures for defending the dollar included in the United
States program, a proposal suggested i:it the International Monetary Fund
meeting in Washington last September ~6 ::,~- Governor Xenophon Zolotas of
the Bank of Greece merits, in my judgment, serious consideration. Under the
prioposal, the U.S. Treasury would issue non-negotiable medium-term-six months
to, say, five years-obligations denominated in dollars to leading commercial
Euro-dollar banks. The obligations would be available to such Euro-dollar banks
as agreed not to switch dollar deposits in the United States to Europe for the
purpose of buying these special obligations. The obligations would carry a :floating interest rate linked to the three or six month London Interbank Offer Rate
(LIBOR).
Dr. Zolotas envisages that the scheme might also include central banks as
purchasers. Since they now traditionally keep reserves in negotiable Treasury
obligations presently paying a lower interest rate than LIBOR, their participation would be based on a percentage of the growth of their dollar reserves following the date of announcement that the Treasury would und~rtake the proposal.
To reduce the Euro-dollar over-hang, the Treasury would place the dollars received for the speci,a l obligations in a sterilized account, similar to our existing
Exchange Stabilization Fund.
Issuance of these special ob1igations would be discontinued as soon as· the
Euro-dollar over-hang is pe~eived as no longer causing appreciable dollar
instability.
The great advantage of the Zolotas proposal is that instead of letting our deficits continue to pile up abroad, and then attempting to intervene to steady the
dollar with German marks or Japanese yen obtained by the United States by
swaps, or by sales of obligations denominated in foreign currencies (both contemplated portions of our present proposal), we put a damper on our deficits
in the first place. While the LIBOR interest rate would be slightly more costly
for us than the rates charged under swaps or obligataions denominated in foreign currencies, the dollar-denominated obligations would not contain the risks
of loss to the United States through dollar depreciation inherent in both swaps
and sales of obligations denominated in foreign currencies. Furthermore, ·interest
received on the proposed dollar denominated obligations by subsidiaries of U.S.
banks would be subject to U.S. taxation when repatriated.
I believe that the Zolotas proposal would be a useful substitute for all or part
of the proposed swaps and foreign-eurrency obligations. I shall appreciate your
giving me your views on it when you appear at our Joint Economic hearing
on December 14.
Sincerely,
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Federal Reserve Bank of St. Louis
HENRY
S.
REUSS,
Member of Oongress.
4
THE SECRETARY
OF
THE TREASURY,
Washington, D.O., December 13, 1978.
Hon. HENRY
s. REUSS,_
House of Representatives,
Washington, D.0.
.
DEAR MR. REUSS: You have asked me to comment durmg my December 14
timon on a proposal made by Governor Zolotas of the ~ank of Gr~c.e for
~~! issulnce abroad of special U.S. Treasury dol!ar-de:µo~nnated. secuntie~. I
ld like to comment in some detail and am takmg the llberty of respondmg
roo~our request by letter. Please feel free to include this letter in the record of
1 t
·
the hearings.
Briefly, Governor Zolotas suggested 3:t the IMF/IBRD a~mual meetmgs as
September that the Treasury sell D?e.dmm-term,. non-negotia~le, dollar-~enominated variable interest rate securities to leadmg commercial banks m the
Euro~arket and perhaps to foreign central banks. The purpose, as express~ by
Governor Zolota'S , would be to "offset" the U.S. balance of payments ~e?~it by
absorbing dollars held abroad, presumably in order to reduce the possibihty of
moves by foreign holders of dollars to diversify into other currencies. Governor
Zolotas proposed that transfers of dollars out of the United! States for purchase
of these securities be subject to some form of control, and that purchases by
central banks .be limited. The proceeds of the securities would b placed in a
special sterilized account, in order to avoid an expansionary monetary impact
in the United States.
In general, I do not feel this proposal would be a desirable ?r effective means
of dealing with the exchange market situation, for the followmg reasons_.
First it is important to bear in mind that the amounts of dollars which can
enter the exchange markets are not limited to existing foreign holdings, and
an effort to "fund" a relatively small portion of those holdings could not be
expected to have much effect on the exchange markets. American residents can
convert their dollars into foreign currencies, and both foreigners and Americans
borrow dollars and sell the proceed in the exchange market at times
are free
when real or psychological market factors are adverse for the dollar. Thus the
suggested approach would not be an effective way of eliminating possible pres·
sures on the dollar.
Second, I believe the proposal mistakes cause and! effect by confusing the
existence of foreign dollar holdings with the more fundamental reasons which
motivate currency diver~ification. Foreign-held dollar balances are not an independent source of dollar instability, but a source which can come into play
when the underlying U.S. economic conditions and balance of payments position are unstable. Foreign holders of dollars respond to the same factors as
domestic holders of dollars or holders of any other currency-performance and
prosp cts for growth, inflation, relative interest rates, trade and current account positions, etc.-and our policy efforts must be directed. at these underlying
factors.
Third, Governor Zolotas envisages some technique of limiting transfers of
dollars out of the United States to purchase the U.S. securities. Given the very
large variety of channels for flows of dollars, direct and indirect, I see no
practicable way to achieve such limitations. Voluntary undertakings would not
be enforceable or effective, and-given the potential damage of such controls
t? the U.S. and world economies-we would not want to con ider implementation of exchange or capital controls to make such limitations effective.
Fourth, the proposal to "sterilize" the proceeds of these securities would, in
effect, mean that the borrowed funds would not be available to the Treasury
as part of its financing operations. The U.S. monetary authorities have a variety
of instruments for offsetting any expansionary effects of such issues, and there
would be no need for SIUch sterilization. Moreover, the U.S. domestic money
supply is not significantly affected by a transfer of dollars from foreign to U.S.
ownership.
Fifth, various elements of the proposal suggest that it could be very costly
to the United States. In order t o have any discernible impact on the exchange
markets, the proposal might require Treasury borrowings abroad on a very large
scale. The foreign institutions involved are already free to inve. t in the wide
r~nge of available Treasury securities, and it is clear that they would have to be
given a relatively attractive yield to induce them to purchase these non-marketable securities. And sterilization of the proceeds would mean there would be no
fo
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offsetting reduction in domestic Treasury borrowing to carry out our regular
debt management operations. It is true that the borrowings would entail no
risk of exchange loss-or gain-to the United States, but because of the above
factors, they could well involve significantly higher total costs to the United
States than borrowings we are undertaking under swap arrangements and for•
eign currency denominated securities.
Sixth, the Zolotas proposal does not put a "damper" on our balance of payments deficits, which you suggest is its principal advantage. The proposal is a
technique of financing the deficits while they continue, and Governor Zolotas
makes clear in his statement that he believes a comprehensive policy-involving
"drastic" anti-inflationary monetary and fiscal policies in the United States as
well as stronger growth performance abroad-is needed to corr ect the U.S. balance of payments situation and strengthen the dollar.
The measures announced by the United States on November 1 are part of a
comprehensive approach to improving U.S. economic perfor_m ance in way that
will promote our basic economic objectives. The specific measures announced
on that date are also designed to correct a situation in the exchange markets
which was damaging to those objectives and which could not be tolerated any
longer. The foreign currency obtained under the $30 billion program can be used
directly to improve the exchange market situation, as needed in light of specific
exchange market developments, and I believe this approach will have a much
more selective, immediate and forceful impact than would attempts to abso rb
some portion of existing foreign dollar holdings through issuance of the securities proposed by Governor Zolotas.
Although I regard it unlikely, some types of overseas dollar issue by the Treasury may prove to be desirable at some point in terms of our international monetary or debt management objectives, and we will continue to keep this possibility
under review. H owever, in terms of dealing with the situation faced by the
United States this fall, I do not believe the proposal by Governor Zolotas would
provide a realistic or effective alternative to the program announced November 1,
including the foreign currency borrowings, or to our broader efforts to correct
U.S. economic problems.
Sincerely,
W.
MICHAEL BLUMENTHAL.
BANK OF GREECE, THE GOVERNOR,
Hon. HENRY
s.
Athens, Greece, January 5, 1979.
REUSS,
Oochairman, International Economics Subcommittee,
U.S. House of Representatives, The Capitol,
Washington, D.O.
Mr. CocHAIRMAN: In your letter to Secretary W. Michael Blumenthal, dated
November 24, 1978, you aske.d him to comment on my proposal for the issuance
abroad of dollar-denominated securities, in order to deal with the current pressures on the U.S. dollar. The Secretar y's answer to your letter r eflects in my
opinion some misunderstanding of my views. I therefor e feel I should state my
position 1 once again a nd describe the a reas of agreement and disagreement.
There is, I believe, agreement on several important points. The difficulties
the dollar is experiencing in foreign exchange markets a rise mainly from the
relatively high rate of inflation in the United States over a long period of time,
which largely contributes to the trade and current account deficits. It follows
that the remedy needeo. must first and foremost include appropriate monetary
and fisca l policies in the United States and concerted action by the monetary
authorities of the principal industrial nations. It should be noted in t his connection that the anti-inflation program recently announced by the U.S. Administration is in the right direction and I wish it every success. Nevertheless, until
it produces the desired results, the U.S. balance of payments deficit is likely to
con tinue, all the more so after the price increases r ecently decided by OPEC.
In this context, my proposal was conceived as a temporary measure to alleviate pressure on the dollar " until the underlying economic conditions in the
U.S. economy are substantially improved". Unlike borrowing in foreign currencies, it does not rely on market intervention only in times of crisis, but
1
See my Statement at the Annual Meeting of the IMF on Sept. 26, 1978.
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stresses the need fur the orderly mopping up of excess dollars whenever this is
considered necessary. Therefore, it can be presumed that, because it would operate before the need for central bank intervention arises, much smaller amounts
will be required compared with the Secretary's scheme of borrowing for intervention purposes by issuing bonds denominated in foreign currencies.
The latter scheme allows the surplus dollars to depress foreign exchange
markets and it mops them up only after the damage has been done, by intervening
to support the dollar with borrowed foreign exchange resources. Protracted
support for the dollar on too large a scale might aggravate the pessimism prevailing in foreign exchange markets, especially if the United States had to
replenish repeatedly borrowing facilities negotiated with other countries. Moreover, an unduly heavy reliance on foreign debt, indeed for the first time in U.S.
history, could further undermine confidence and generate speculation. Inter alia,
there might conceivably be an outflow of dollars from the United States for
speculative purchases of the securities denominated in foreign currencies, which
are being sold as part of Mr. Blumenthal's package to finance market intervention.
In contrast, I propose the issue abroad of securities denominated in dollars.
Sales of such bonds would deal with the problem at its root, since they woulld
absorb the surplus dollars directly, befpre they cause trouble in foreign exchange
markets. My scheme does not eliminate the need for occasional market intervention to support the dollar, but this need would be significantly reduced. Only
if this scheme were adopted, would the amount of $30 billion being raised
through the swaps, the use of SDRs and drawings from the I.M.F. prove to be
sufficient for such interventions in the foreseeable future. Consequently, the
mobilization of additional bonds denominated in foreign currencies would be
unnecessary.
Let me now comment on a number of the Secretary's specific objections. In
the first place, he feels that if my scheme were implemented, it would be necessary to improve capital controls in order to make sure that the bonds I am
proposing would not be purchased with funds sent out of the United States. I
have already suggested that the securities issued would be nonmarketable and
available exclusively to a select circle of Eurobanks. Special agreements with
each of the eligible banks would prevent any transfers of funds from the United
States. Anyhow, the danger of such transfers would be much greater in the case
of Secretary Blumenthal's securities, given that U.S. residents would have a
speculative motive to buy them. Hence the need for mandatory controls would
be much stronger. Yet the safeguards imposed so far appear to have been very
weak. According to press reports, German commercial and savings banks wishing to buy such securities were required to pledge only that they would not
resell the securities to Americans (what about Germans and others?) , at least
not for a certain period of time.
Second, Mr. Blumenthal took exception to my idea that the proceeds of the
dollar bonds should be sterilized. However, I still think that these proceeds should
not be allowed to increase the money supply and effedive demand in the United
States. But I would not object to their being spent, if domestic borrowing were
reduced by an equal amount, or if monetary instruments were used, as suggested
by the Secretary, to offset any expansionary effects of the proceeds of the bonds.
Actions of this nature would virtually constitute sterilization.
Third, although Eurodollar rates are admittedly higher at present than comparable rates of strong currencies, the final cost of the scheme I am proposing can
only be determined after changes in exchange rates are taken into consideration.
The experience of the last few years indicates that interest costs are more than
offset by changes in exchange rates. Moreover, my scheme not only eliminates
foreign exchange risks, but also considerably reduces the need for foreign borrowing. As I have already indicated, by controlling the additional dollar outflows,
~peculation would be dampened and confidence in the dollar bolstered. Consequently, this scheme would prove to be less costly for the Treasury than borrowing in foreign currency bonds.
Fourth, the Secretary argues that my proposal amounts merely to a financing
technique and does not agree with you, Mr. Chairman, that it might put a damper
on the U.S. balance of payments deficit. I myself thought of it mainly as a method
of dealing with the current difficulties of the dollar in foreign exchange markets.
In addition, if this were achieve<l. it would also contribute to an improvement in
the psychological climate and have an important effect on U.S. balance of payments developments.
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I uoted with interest that, in the last paragraph of his letter, Mr. Blumenthal,
despite his objections, states that: "Although I regard it unlikely, some types of
overseas dollar issues by the Treasury may prove to be desirable at some point in
terms of our international monetary or debt management objectives, and we will
rontinue to keep this possibility under review."
If you think it would be useful, Mr. Chairman, please feel free to include this
letter in the record of the hear.in.gs on the "Dollar Rescue Operations and Their
Domestic ImpliC'ations."
Yours sincerely,
XENOPHON ZoLOT.AS.
Representative REuss. ( d) How far are we willing to drive the value
of the dollar by our intervention i Since an increase in the value of.the
dollar favors the export industries of Germany, Japan, and Switzer-land and harms our own export- and import-competing industries, how
and where do we stop before we "support ourselves" out of our export
markets i Does the administration have in mind some "reference" or
"target zone" rates of exchange to determine when and how it ought to
intervene i Are we abandoning our commitment to floating exchange
rateb i
The second large question befoi-e us is : On the international side, can
we afford to contmue the dollar as the world currency, shoring it up by
endless interventions that disregard the instability inherent in the
world economy, and in the enormous apparent dollar overhangi
The present system continues to tempt us to print more dollars so
that we may live and invest beyond our means. Every indication is that
the other countries of the world are fed up with what the late General
DeGaul1e called "this exorbitant privilege." The new European Monetary System is but one example of their effort to render themselves
independent of our bootstrap-lifting of our international monetary
power.
For the sake of our own economy, and of a stable and orderly world,
we should now take the lead-at the Guadeloupe Summit meeting in
January, in the International Monetary Fund, in negotiations over the
new European Monetary System, and on all fronts-to gradually relinquish our key currency role, and to move instead toward a basket-ofcurrencies unit under the aegis of a reinvigorated IMF.
Flexible exchange rates are not, in my judgment, what has brought
us to our troubles. In the face of disparate growth and inflation policies
among the world's economies, floating is the only realistic exchange
rate regime that permits each country the kind of flexibility it needs to
realize its domestic goals without at the same time creating major problems for other countries. Once the world economy gets the "fundamentals" in line, stable exchange rates will follow.
Many people al1ege that the current dollar problems stem :from the
exjstence of the huge volume of dollar-denominated assets in the hands
of foreigners-a portion of which are "unwanted," and therefore a
source of the downward pressure on the dollar. If this is a source of the
problem, intervention is a very weak weapon to use to rectify it. This
issue should be settled by providing an international currency to supplement the dollar, not through United States and foreign intervention
in foreign exchange markets.
What is··needed is some sort of substitution account in tJhe IMF
whereby foreign monetary authorities not wishinP.." to hold so many
dollars may turn in their unwanted dollars for enlarged and rechris-
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tened special drawing rights. This w~uld relieve pressure on the dollar,
help stem world inflation, and allow flexible exchange rates to perform
their proper adjustment t ole for the long period between now and the
millennium when countries will have learned to coordinate their macroeconomic policies in a manner consistent with the smooth functioning
of our international monetary system.
This country, unforturnately, still appears to cling to the idea that
the dollar's key currency role must not be diluted. vVe have thrown
cold water on proposals for ·a new parallel key currency which can
partially substitute for the dollar, as recently as at the mooting of the
Interim Committee of the IMF in Mexico City last May. The basic
reforms were outlined by the IMF executive directors in their 1972
report, and by the Committee of Twenty in 1974, but were unfortunately jettisoned in Jamaica in 1976.
This country must take the lead in suggesting that the time has
come to deal with the disease that is destroying the interna~iona1
monetary system, and to go beyond the bandaid process of mtervention.
I am delighted to welcome my colleagues, Representatives Hamilton
and Brown of Ohio.Welcome back.
Do you have anything to present ·a t this point~
Representative HAMILTON.No.
R epresentative BROWN of Ohio. I will await the Secretary's
statement.
Representa tive REuss. Mr. Secretary, we appreciate your be.ing_wi!h
us this morning. I want to congratul ate you on your recent tnp m
which, as I understand it, vou talked with the Kremlin about trade
and similar matters that help in the erection of n·e•ace, and then in
"l?ucharest where you visited to congratulate Presi dent. Ce a11se cu on
turning back increased military spending demands, citing Romanian
domestic economic considerations ,as the reason why they should not
increase their military spending.
I think you did a good job in both places. Incidentally, is there any
chance of getting Ceausescu over here to give us the ~ame advice~ That
might be help:ful.
1
1
1
STATEMENT OF HON. W. MICHAEL BLUMENTHAL, SECRETARY
OF THE TREASURY
Sooretary BLUMENTHAL. Mr. Reuss, Mr. Ceausescu was in this
country in April of this year. I have no ide;a when he will be returning.
But I would like to express my appreciation to vou and to the members
of your committee for inviting me to appear here and providing me
'a n opportunity tQ deal with the very important questions that you have
·
raised jn calHng this hearing.
I have submitted to yon and to the members of the committee, Mr.
Reuss, a prepared statement which I would like to submit £or the record
in its entir ty, given the importance of the i ne and the importance
moreover of not being misunderstood.
Representative R.Euss. Without obj ection, your entire stJatement will
be received, and we would be pleased to have vou present it eitheT verbatim, or go beyond it or eliminate some things but your prepared
statement will be in the record.
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Secretary BLUMENTHAL. In the interest of time, I will present
parts of it verbatim, but parts of it I will merely summarize.
Let me say at the outset that it is, of course, clear that the actions
which the President initiated on October 4, but more importantly on
November 1, were intended to deal with the interrelated problems of
inflation ·a nd the dollar.
There was clearly a situation that had gotten out of hand. There was
a question of whether or not this country had the resolve to deal with
the problem of inflation which is the No. 1 economic problem of this
country, and there was a question of whether or not we would take
action to counter what had become totally irrational conditions in
the exchange markets relating to the dollar.
We appredate your support, your committee's support in this effort
as it was announced. I think the results have been positive and I think
that the -actions that have been taken should allay any doubts -as to
our resolve with regard to the basic objectives that I have stated, for
we have now committed the major tools of economic policy in an interrelated fashion to the task of unwinding inflation as well as to insuring
that instability -and speculative activity, whioh have become totally
excessive and diV1orced from the underlying fundamentals, are stopped.
Let we say that there will be no wai vering and no waffling in our
determination to continue this policy. We feel strongly that until we
succeed, we cannot assure the kind of economic goals which I am sure
you and the President share. The economic goals of seeing stable expansion of our economy and assuring the benefit of that expansion on a
fair and equitable ba is is important to all sectors of our society.
Mr. Reuss, I will not go in any detail or read the description of the
economic situation faced within the United States at the time at which
this action was taken. I think i:t is laid out clearly in my prepared
statement in summary fashion. I will, of course, be glad to answer
questions ·a bout it.
Let me just make this point.
We were :facing ,a situation in which, domestically, inflation was
accelerating at a rate that was dearly completely excessive. We began
with a situation in whioh inflation was already ingrained in our
economy, steadily moving upward from the 1960's 'into 'the 1970's, with
some occasional downturns, but really with a continuing upward pressure, with wages chasing prices and price , in turn, chasing wages even
during periods of relative economic slack.
Given the good expansion of economic activity in the last 2 years
durinp· the Carter administration, we now begin to see signs of tightming in the economy, demand-pull signs, with industrial capacity
moving higher, with rates of unemployment for critic~l categori~s of
workers becoming very low, and the market becommg very tighti
and. therefore, additional inflationary pressures g-rowing.
At the same time we began to see very, very clearly the feedback
effect of a declining dollar on the domestic inflation rate and we
learned the vicious cycle in which we were caui:rht between these two
phenomena. We estimate the decline in the dollar, which was in part
due to the observ::ttion by others of accelerating inflation in th~ Uni~ed
States, h::ts added at least 1 percentage point to the rate of 1:n.flat10n
and possibly more. That added inflat10n indeed led to greater weak1
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ening of the dollar and, in turn, a kind of vicious circle began to accelerate. It is not only that depreciation caused import prices to rise
jn the United States, adding to inflation, but depreciation provided a
kind of umbrella under which domestic prices for products that are
competitive with imports and intermediate products, are also raised
and in this way the cycle is perpetuated.
The foreign exchange markets did react very adversely to thi? situation. In the month of Octdber the dollar declined sharply agamst all
major currencies, therefore raising the specter of further inflation
down the road from this :factor. The dollar fell by 6 percent against the
Swiss franc in 1 month alone, 7 percent against the Japanese yen,
by 12 percent against the German mark. On a trade weighted average
basis the dollar fell by 8 percent. All told, in the 13 months preceding
the November 1 initiative, the dollar had fallen 38 percent against the
Swiss franc, 34 percent against the yen, and 26 percent against the
Deutsch mark.
So we clearly had a situation on our hands where even though the
fundamentals were beginning to improve, this 1.--i.nd of situation was
perpetuating itself and making any effective measures to _deal with
domestic inflation a very, very difficult task for the President and
:for the administration.
Let me briefly mention the improvement in the fundamentals that
were clearly becoming apparent.
We had a budget deficit of $66 billion in 1976 representing 4.4 percent of GNP. The President is in the process of preparing a budget for
fiscal year 1980 which he has said and did say on October 24, would
have a deficit of $30 billion or less, which would represent somewhere
in the range of 1 percent of GNP, and which clearly puts into view
the possibility of moving toward balance in the budget in the period
beyond that.
Representative BROWN of Ohio. Could you give us the intervening
figures also, 1977 and 1978 ~
Secretary BLUMENTHAL. I will submjt the precise figures for the
record.
Representative BROWN of Ohio. Just generally.
Secretary BL?MEN'fl1:AL. I believe that the fig~re-I am going from
memory now, sir-I thmk for fiscal 1979 we estimate a budget deficit
of somewhe.re around $40 billion. For the period fiscal 1978 I believe
the budget deficit was $48.5 million; and for fiscal 1977 it was $45
billion.
'
. S_o it :was $66 billion in fiscal 1976, $45 billion in fiscal year 1977, $49
billion m fiscal year 1978, and $39 bil1ion for the fiscal year in which
we are now in, and $30 billion or less is the taro-et that the President
has publicly stated for the budget he wi11 submit next month .
. In_ spite of that reduction, a1:d the v_ery tight fiscal policy that underhes it, confidence had eroded m the mternat.ional markets to such an
~xtent that any improvements in the underlying situation were being
1gn_ored. Thi~ inclu~ed the energy legislation which had been passed,
w~ich we estimate m 1979 alone will mean a reduction in import reqmrements, because the natural gas part of it, by at least 500,000 barrels a day. But more importantly, the market ignored that the current
account and trade balances of the United States were substantially im
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proving, from a current account deficit of some $17 billion this year to
an expected figure of as low as $6 or $7 billion next year.
Despite all of these factors, the dollar continued to decline along the
lines that I have indicated. It is in that situation and that context that
the administration decided to act and act forcefully. I will not go into
the details of precisely what that action was. It is indicated in my
prepared statement.
May I merely say that it represents a coordinated, comprehensive,
~nd i:r_iter~elated set ?factions whic~ de~l b<;>th with the goal of fighting
mflat10n m the U mted States by mstitutmg a very tight fiscal and
· monetary policy, to complement the· voluntary cooperation of labor
and management and business, and stopping this deteriorating situation in the exchange markets which had become a part of our inflation
problem.
Let me then turn to tihe results of these measures. We are gratified
that the reaction to these measures has been good. I believe that there
now is a realization among governments and in the financial community as well as in the general public, that the U.S. Government is determined to deal effectively and decisively with our economic problems,
that we will act to bring inflation under control, that we will strengthen
the dollar at home and abroad. In my travels, both to the Middle East
and more recently, as you indicated, to Germany, to England, to the
Soviet Union, to Romania, wherever I went, I found a sense that we
have taken charge of dealing with these problems ·a nd a sense of satisfaction, both publicly and privately, that we seem to be on the right
track.
This regeneration of confidence in the dollar rests on the measures
announced on November 1 and the reaffirmation by the President of his
determination to exercise fiscal austerity. Let me repeat, that the Presiderut intends his 1980 budget to be tight with a deficit of $30 billion or
less, and that a balanced budget is now -a realistic goal for years thereafter.
Coordinated with this thrust on the fiscal side is increasing restraint
being exercised by monetary policy. Monetary policy is a responsibility
o_f the Federal Reserve and it should stay that way, but the. administmtion has •~ view as to how it should be managed. That view is that monetary policy has to dovetail with tight fiscal policy. Monetary policies
must be kept tight until inflation has been brought under control. ·
In con.cert, the major tools of economic stabilization win be used in
support of the President's wage-price deceleration program to attack
the causes, not just the symptoms, of inflation.
It is too early, of course, to see a reflection of recent policy actions in
the statistics oo inflation, but we have seen a change in the confidence
exhibited in the financial markets. The stock market has recovered
some of its October losses, ,as have the prices on long-term securities.
In fa.ct, though some short-term rates have risen nearly a full percentage point since the November 1 announcements, interest rates on
long-term instruments have remained re1atively unchanged. This suggests an improvement in inflationary expectations over the longer
term.
Some apprehensions are being expressed that the proo-ram may become too effective :and throw the economy into a recession. There are
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risks, to be sure; economic forecasting is at best an imprecise art. But
certainly the risks of recession with the program are far less than the
certainty of recession if inflation were allowed to accelerate unchecked.
Indeed, the program we have launched is the best guarantee of avoiding recession.
Although recent inflation rates have been in or nea.r the double-digit
range, the economy remains fundamentally strong and in good balance.
Real economic growth so far this year has Leen almost 4 pel'cent, aud
there are few distortions in the composition of output.
·
Employment continues to grow at an exceptionally strong rate. The
most recent data on retail sales show that consumers are still illl a buying mood. Inventories remain in balance with sales. The flow of new
orders for durable goods-particularly £or nondefense capital goodsis high and order backlogs are rising.
.
Housing activities continue at a high rate of over 2 million new
starts. The introduction of a new financial instrument, the money
market certificate, has enabled thrift institutions to compete for funds
and maintain the supply of funds in mortgag~ ~arkets. Ex?orts, pa;rticularly of manufactured goods, have been r1smg_ s_ubstantially while
our imports other than of petroleum, have been nsmg more slowly.
Mr. Reuss', these are not the symptoms of a sick economy unabl~ to
sustain momentum under the weight of fiscal and moneta~7 restramt.
Rather, these ·a re the signs of a strong economy approachmg the realistic limits of resource capacity which needs and can affor~ 01:1e moderation in pace. May I say here that I had ·a n opportumty Just l~t
Illight to visit with a wide range of chief executives from major Ameri~an corporations, who are in town for a meciing of the Business Council. While it is certainly an unscientific sampling procedur . I did my
own private sample in talking to -a good many of them as to their view
on where their own business is and where it is goinis, and I must say
that virtually uniformly these chief executives of major corporations in
every area of eoonomic activity, told me that business is good, that
they are confident that the prospects are encouraging, that they read.
in the_ paper that certain :forecasting organizations are :forecasting a
rec~ss1on, but they ca~not se~ i~. They can't. see it _in the ring of the cash
re0'1ster and the~ can~ s~e 1t m terms of mcommg order~ for capital
goods. They oan t see 1t m terms of the labor mrurkets or many other
way.
I think that is somewhat encourarring in terms of the impact of these
kinds of programs on the future of the economy.
. The President, however, intends to bring inflation down and to keep
it dow1;1. He realizes that this is the only sure way to maintain an increase m the standard of living :for all Americans, es pecially the poocr
~nd the elderly who depend on fixed incomes. We cannot at this stage
m the economy opt :for growth at the expense of ~nflation. R estraint on
the. monetary and fiscal fronts must now be pursued to assure real
growth later. Fortunately the economy is strong and able to stand the
discipline re.quired.
It is apparent that this commitment to responsible economic management is beginning to take hold. We are beginninO' to see a change in
tone, a modification ~n expectations in the foreignhexchange -and domestic money markets. As the :full realization of the extent of our
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measures and the degree of our determina~ion to persevere spreads, I
believe we will see further dollar strength m the markets.
In summary, Mr. Reuss, the response here and abroa~ to the measures announced November 1 has been very encouragmg. The announcement has been interpreted rightfully 3:s a ~igna~ that ~ e a~e determined to deal effectively and decisively W1th mflat10n, which is our
primary economic problem, and so maintain the s~rength of ~he doll~r.
That interpretation is correct. Wear~ fully committe~, we wi~l pe~sist
as long as is necessary to control inflation. We will e~e_rci~ tight
budo-etary restraint, maintain responsible monetary policies, implement effective wage-price guidelines and work for stable, orderly con.
.
.
ditions in the foreign exchange markets.
This is the right way and the only way to achieve our basic economic
goals.
Mr. Reuss, let me now turn to address~ng some of .the spec~fic
concerns which you have raised. The first mvolves our mtervent10n
objectives.
The shift in intervention practices announced on November 1 was
aimed at correcting a particular situation. Our objective is to restore
order and a climate in the exchange markets in which rates can respond
to the economic fundamentals, in this case to the improved outlook
for the fundamentals that underpin the dollar s value. We are not
attempting to peg exchange rate or establish targets or pu h the dollar
beyond levels whioh r eflect the fundamental economic and financial
realities.
On the subject of the competitive position of U .. exports, let me
make one thing absolutely clear. There are those who feel that continuing decline in the dollar is good for trade. This i a dangerous
misconception. The United State does not need to pursue dollar
depreciation to buy market position. To have argued on October 30
or to argue now for more dollar depreciation as a way of correcting
our trade deficit is a simplistic and nonsensical view that could force
a collapse of an open capital and trading system. The administration
firmly rejects such tactics.
Se_cond, Mr. Reuss, you ask in the· press relea e that announced these
hearmgs why differentials in interest rates between the United States
~nd oth r_strono- _countries would be any more effective now than before
m attractmg capital . The answer lies in investor expectations about the
future. The key to attractina investment is to offer investors a real
rat~ of return .. Whi~e nominal interest rates have been high in the
pmted States i1:-flat10n has rend red them negative in real terms. I:f
mve tor are bemg offered the promise of le inflation and a real
return on their investments, it should be easier to attract the capital
needed to finance our current account deficit.
. ~hird, your ~;taff has questioned the Treasury decision to issue $10
b1lhon ?f foreign currency denominated bonds.
To _re!ter~te the Treasury did announce its intention to issue up to
$10 b1Jbon m securities denomjn~ted in forei!m currencie . The first
of these issues-for DM2.5 to DM3 billion-~ill be issued tomorrow.
In fac~, ~he amount will be just slightly in excess of the equivalent of
$~ -~ b1lhon .."\iVe p_lan a wiss franc i sue in January and we are· also
gwmg cornnderat1on to a yen denominated borrowing in Japan in
1979.
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It is important to realize that these securities are being issued only
for the purpose of acquiring foreign currencies for the intervention
effort. They are not intended as an effort to "mop up" unwanted
dollars. They are being sold only to residents of the country issuing
the curretr1cy in which the securities are denominated. We are seeking
to minimize the extent to which purchasers switch out of dollars to
effect these purchases.
There were important reasons for including foreign currency denominated securities in our package. The issuance of securities with,
in case of DM, 3- to 4-year maturities, provides us with additional
foreign currency resources, for a longer time period, and gives assurance to the market that the United Stales will not be pressured
to reverse its intervention operations too soon because of its need to
accumulate the foreign currencies needed to repay swaps. In ·a ddition, the issuance of these securities demonstrates that we are firm~y
committed to strengthening of the dollar over time and that we will
.
use all means at our disposal.
With the issuance of foreign currency-denominated notes, t~ere is
the potential for exchange rate gains and lo:sses. The calcul3:t10n of
the total "cost" of such borrowing must take :nto account the mterest
rate differential between domestic and foreign markets, as well as
possible gains and losses because of exchange rate changes. 0~ ?ourse
there is a risk. But the alternative cost to the economy of failmg to
move with adequate and comprehensive measures constituted an ev_en
greater risk. If you will permit me, this is a case of being penny-wise
rather than pound-foolish. The importance of assembling a comprehensive and credible package to strengthen the dollar justifies the
lesser risk we have assumed.
Finally, there is the question of the role played by the IMF in our
November decision. The actions we took on November 1 were fully
in keeping with our obligation "to assure orderly exchange arrangement and to promote a stable system of exchange r·a te * * *" by
"fostering orderly economic growth with reasonable price stability.':
Since part of the November 1 package consisted of a reserve tranche
drawing from the IMF and sales of SDR's, we, of course, discussed
these plans with the Fund management prior to the announcement.
The U.S. program was also explained subsequently to the IMF
Executive Board in connection with activation of the general arrangements to borrow (GAB) for financing part of the U.S. drawing. The
proposal was supported by the IMF and the GAB participants. On
December 13 the Board discussed the U.S. program in more detail,
under IMF surveillance procedures, and expressed support for the
U.S. action.
Mr. Reuss, you have also asked whether the IMF has undertaken to
reduce the key currency status of the dollar. And questions have been
raised as to whether reduction or elimination of the dollar's role as a
reserve currency would remove pressure on the exchange rate and
make domestic restraint less necessary.
Let me make two points. First, any such fundamental change in the
international monetary system would have far-reaching effects on
other parts of the system and could not be considered in isolation. Nor
could such a restructuring of the system be simply mandated by the
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IMF. It would require detailed . study and negotiation, looking
toward arrangements that would be acceptable to all countries.
We would need to know what system we would be moving to before
dismantling the one we have. There were extensive studies of possible
changes in the monetary system earlier in this decade, many of which
would have meant a sharply reduced reserve role for the dollar. Ultimately, none of these changes appeared practical or widely desired. I
stress this point not because we are unwilling to consider change, but
because the full implications of such change need to be recognized and
assessed.
Second, the United States is going to be in difficulty if it continues
to run an inflationary economy, regardless of the reserve role of the
dollar, and no reform of the system can obviate the need for us to
pursue policies of restraint to counter inflation, or to maintain a reasonably strong external position.
As international economic and financial relationships evolve, the
role of the dollar can be expected to evolve to reflect changes in underlying economic realities. There is widespread agreement on progressive
development of the SDR's role in the system, and other currencies may
also take on a larger role. But such changes will come about gradually
over a.n extended period of time and they must come about in an orderly manner.
As a practical matter, the dollar will continue to play an important
role in international monetary relationships for the foreseeable future
if the world is to continue to achieve growth and progress. Accordingly, it is our duty to manage the dollar in a manner which benefits its
central role in the system. This is precisely what President Carter,
Chairman Miller, and colleagues intend to do.
Thank you very much.
[The prepared statement of Secretary Blumenthal follows :]
PREPARED STATEMENT OF HON.
W.
MICHAEL BLUMENTH,t\L
INTRODUCTION
Mr. Chairman, it is a particular pleasure to appear here today to discuss
the a,c tions announced by the President, Chairman Miller and myself on November 1, 1978 to strengthen the dollar at home and a:broad. The actions were taken
in the context of persisting inflation and financial market conditions-domestic
and international- which reflected doubts about the determination of this
Administration to stop inflation and defend the value of the dollar.
Our actions should allay these doubts. We have committed the major tools
of economic policy to the task of unwinding the inflation that has plagued us
for the past decade. Let there be no mistaking our determination : there will be
no waffling and no wavering. We intend to persist because controlling inflation
is absolutely essential to the achievement of the s~cial and economic goals
which are at the core of President Carter's policies.
Obviously, the dramatic circumstances in which the November actions were
taken should not overshadow the very important measures taken earlier to deal
with our fundamental economic problems. Each of these measures must be seen
as part of an integrated array of policies. Any one of them alone is not sufficient,
but together I believe they do the job.
THE ECONOMIC SITUATION WE FACED IN OCTOBER
Even with the full force of economLc policies addressing the inflation problem,
it will not be an easy or a painless task to reduce inflationary pressures. Inflation
has become deeply ingrained in our society, and in the expectation on which private sector decisions are based. And as inflation has persisted and accelerated,
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there is the threat of adding demand-pull pressures to the worst elements of costpush forces.
In the early stages of recovery from the 1974-75 recession, the persistence
of a high underlying rate of inflation, despite significant slack in resource
utilization, reflected largely a pattern of wages-chasing-prices-chasing-wages.
As the recovery from the recession continued, and as inflation persisted, an
overall environment of inflationary expectations was fostered, with the expectation of further inflation distorting costs, prices, the structure of production, and
decisions on saving and investment.
To the intensifying expectation of further inflation have been added some
signs that real presures on resource availability may be emerging-scattered
signs to be sure, but still troublesome. The economy has maintained strong momentum since the winter lull of 1977; real growth has averaged close to a 4
percent annual rate this year, and in some sectors of the labor market and in some
industries, demands have begun to press on available resources. While the
overall unemployment rate has remained close to 6 percent during much of the
year, unemployment among skilled workers and others characterized as part
of the "prime labor force" has declined. For example the unemployment rate
for married men, at 2.5 percent, is not far above the rate during most previous
periods of peak labor demand. Non-union wages have been rising more rapid~y this
year than unions wages, reflecting both the strength of demand factors m t~e
labor market and the increased minimum wage. The employment rate ( the ratio
of people employed to the working age population) continu~s to r_ise.
While industrial capacity utilization overall has remamed m the area of 85
percent-leaving some margin for expansion--capacity limits are approaching
for son;ie industries. Moreover, the 01?~ial ~tatistics may ?e overstatmg the extent of \spare capacity that can be utilized m a cost-effective manner.
It has be.come increasingly clear that, in recent months, the economy has
entered the zone of resource utilization within which demand pressures are more
easily translated into rising prices. Thus, there is a danger of adding demandpull to the existing cost pressures.
Moreover, the inflation has incorporated a new "feedback" mechanism : as
the rise in domestic prices weakened the dollar, this has resulted in higher prices
for imported goods and through an "umbrella effect," in higher prices for
many domestic products competing with imports. Perhaps as much as one
full percentage point of inflation this year reflects the effects of the depreciation
of the dollar, and this has given the inflationary spiral a further turn.
The combination of inflationary expectations, emerging demand pressures
and the domestic price effects of a weakening dollar have been reflected in an
a~celeration in the underlying rate of inflation. Over the past three months,
wholesale prices rose at about 10½ percent annual rate; even excluding food,
the rate was near 8 percent. Consumer prices rose at nearly a 9 percent rate in the
last. t~ree month~, at _a 9½ percent annual rate excluding food. The growing
pess1m1sm about mflat10nary prospects was reflected in financial markets. Stock
price~ fell precipitously in the last two weeks of October, and prices of long-term
debt mstruments also de.clined.
In the foreign exchange market, severe and persistent disorder and excessive
declines in the dollar were undermining our efforts to control inflation and were
ad~ersely affecting the climate for continued investment and growth in the
Umted States. In the month of October the dollar declined sharply against
virtually all major currencies. The dollar fell against the Swiss franc by 6 percent,
the Japanese yen by 7 percent, and the German mark by 12 percent. The tradeweighted dollar fell by 8 percent. All told, in the 13 months preceding the November 1 initiative the dollar had fallen 38 per.cent against the Swiss franc, 34
percent against the yen and 26 percf'nt against the DM.
As November approached, it became clear that the market was failing to take
aocount of the improvements that were being made in the underlying conditions
that determine the dollar's value. The Administration had inherited a budget
deficit of over $66 billion in 1976 or roughly 4.4 percent of GNP; it was paring
the budget for 1980 to $30 billion or below, roughly 1 percent of GNP. Energy
legislation had been passed which would result in savings of at least 500,000
barrels per day by 1979 from levels that might otherwise be expected. The volume
of trade flows had begun to reflect improvements in our competitive position.
The ~rade balance of the United States had receded to a $31 billion annual
rate m the second and third quarters of the year from a $45 billion rate in the
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first and was heading further down. The nation's surplus on investment income
and other service transactions bad grown sharply. The outlook for the current
account wa-s dramatically improved, allowing us to predict with confidence that
it would drop by 50 to 60 percent from the $17 billion in 1978 to as little as $6
billion in 1979. And to reinforce these trends the President bad instituted a determined anti-inflation program and an enhanced national export effort. Yet the
dollar continued to be sold. The psychology of the market during the month of
October was such that these favorable developments in underlying e.conomic
conditions, and Administration statements reaffirming its determination to follow
through on our anti-inflation program, were unable to halt a wave of pessimism
about the prospects for the dollar.
The consequences of a contin ued deterioration of the dollar were grim. The
precipitous decline of the dollar threatened to erode our anti-inflation effort.
Foreign official and private portfolio managers were already showing signs of
selling off U.S. securities and would have lJeen tempted to sell more, further
disrupting the stock and bond markets. Dollar ho1der s abroad would have been
encouraged to sell more of their outstanding dollar holdings for assets denominated in other currencies. Th e OPEC countries would h ave been pressured to
substantially raise oil prices to recoup exc.~ssive dollar losses. The world economy- indeed, the whole world financial system-would have been impaired-and
with it, the economy of the United States. The leadership of this nation in world
affairs, political as well as economic, would haYe IJeen severel y damaged.
We could not tolerate this situation. Firm action was needed to strengthen
the dollar both at home and al>road.
OUR NOVEMBER 1 ACTIONS
Thus, on Noveml)er 1 we took the direct and forceful measures that were
needed. You are familiar with the specific measures announced on that date.
'l'hey entailed:
A $3 billion increase in reserve requirements on la rge certificates of deposit
and a rise in the discount rate by a full 1 percent;
An increase in Treasury's monthly sales of gold to at least l½ million ounces
per month, startino- with thi. month's auction;
A decision to join with Germany, Switzerland and Japan in closely coordinated exchange market intervention;
Th e mobilization of $30 billion in DM , Swiss francs and yen to finance that
portion of the intervention undertaken by U.S. authorities.
The U.S. financing involves an approximate doubling of Fed,2ral Reserve swap
lin es with the central banks of Japan , Germany and Switzerland, to a total of
$15 billion; U.S. drawings on the IMF of $3 billion; U.S . sales of about $2 billion
of Special Drawing Rights; and issuance by the Treasury of foreign currency
denominated securities in amounts up to $10 million.
.
Most of th e foreign currency resources ha Ye already been mobilized. Th e
in crease in the central bank swap lines took effect immediately on announcement .
Dra_wings on the IMl!' in DE>utsche Marks and Japanese yen amounting to the
eqmva lent of $2 billion and $1 billion were made on Xovember 6 and 9. We sold
about ~1.4 billion equiYalent in SDR's for D eutsche Marks and ven on November
2~. The _first tranche of DM-d.enominated securities, about $1¼ to 1½ billion
will he issued tomorrow.
By so massing- a sizalJle ::ind broad r eaching pool of resources, we intend to
signal to the world that the dollar had been pushed too far and that the U.S .
authorities were determined to correct the situation.
THE RESULTS OF OUR MEASURES
Mr. Chairman, reaction to our measures has b.een good. I believe there is a
1·ealization among governments and in the financial community as well as in the
general public, that the U.S. government is determined to dea l effectively and
clecisively with our economic problems-that we will act to bring inflation under
control; that we will strengthen the dollar at home and abroad.
'IhiP. regeneration of confidence in the dollar r est on th e measures announced
November 1 and on the reaffirmation by the President of hi s determination to
exer cise fi. ·cal austerity. Let me repeat that the Pres ident intends his 1980
budget to be tight, with a deficit of $30 billion or less. A balanced budget is now
a realistic goal for the years thereafter.
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Coordinated with this thrust on the fiscal side is the increasing restraint being
exercised by monetary policy. Monetary policy is the responsibility of the Federal
Reserve and it should stay that way. But the Administration has a view as to
llow it should IJe ma:naged. Let me make clear our view. It is that monetary
policy has to dovetail with tight fiscal policy. Monetary policy must ue kept
tight until inflation has IJeen brought under control. In concert, the major tools
of economic stabilization will be used in support of the President's wage-price
deceleration program to attack the causes, not just th,e symptoms of inflation.
It is too early, of course, to see a reflection of recent policy actions in the
statistics on inflation. But we have seen a change in the confidence exhibited in
financial market behavior. '.rhe stock market has recovered some of its October
losses, as have the prices of long-term securities. In fact, though some shortterm rates have ri.sen nearly a full percentage point since the November 1
announcement, interest rates on long-term instruments have remained relatively
unchanged. This suggests an improvement in inflationary expectations over the
longer term.
Some apprehension is being expressed that the program may become too
eff,ective and throw the economy into recession. There are risks to be sure-economic forecasting is at best an imprecise art-uut certainly the risks of
recession with the program are far less than the certainty of recession if inflation
were allowed to accelerate unchecked. Indeed, the proO'ram we ha ,·e launched
is the best guarantee for avoiding recession.
Although recent inflation rates have been in, or near, the double-digit rang~,
the economy retains fundamental strength and good balance. Real econorrnc
growth so far this year has lJeen almost 4 percent and there are few dist?rtions
in the composition of output. Employment continues to grow at an except10nal!Y
8trong rate. The most recent data on retail sales show that consumers are still
in a buying mood. Inventories remain in good lJalance with sales. The flow of
new orders for durable goods-particularly for nondefense capital goods-is
high and order backlogs are rising. Housing activity continues at a high rate
of over 2 milliofr new starts; the introduction of a new financial instrumentthe morn~y market certificate--has E>nabled thrift institutions to compete for
funds and maintain the supply of funds in mortgage markets. Our exports, particularly of manufactured goods, have been rising substantially while our
imports-other than of petroleum-have risen more slowly.
These are not the symptoms of a sick economy, unable to sustain momentum
under the weight of fiscal and monetary restraint. Rather, these are signs of a
strong economy approaching the realistic limits of resource capacity which needs
and can afford some moderation in pace.
The President intends to bring inflation down and keep it down. He realizes
that this is the only sure way to maintain and increase the standard of living
for all Americans, especially the poor and the elderly who depend on fixed incomes. We cannot at this stage in the economy opt for growth at the expense of
inflation. Restraint on the monetary and fiscal fronts now must ,be pursued to
assure real growth later. Fortunately the economy is strong and able to withstand
the discipline that is required.
It i s apparent that this commitment to responsible economic management is
beginning to take hold. We are beginning to see a change in tone, a modification
in expectations in the foreign exchange and domestic money markets. As the
full realization of the extent of our measures and the degree of our determination
to persevere spreads, I believe we will see further dollar strength in the markets.
In summary, Mr. Chairman, the response here and abroad to the measures
annoupced November 1 has been very encouraging. The announcement has been
interpreted rightfully as a signal that we are determined to deal effectively and
decisively with the inflation which is our primary economic problem arid to maintaining the strength of the dollar. That interpretation is correct. We are fully
committeed. We will persist as long as is necessar y to control inflation. We will
exercise tight budgetary restraint, maintain responsible domestic monetary
policies, implement effective wage-price guidelines, and work for stable, orderly
conditions in the foreign exchange marketi::. This is the right way, and the only
way, to achieve our basic economic goals.
Mr. Chairman, let me now turn to addressing some specific concerns.
The first involves our intervention objectives.
The shift in intervention practices announced on November 1 was aimed at
~orrecting a particular situation. Our objective is to restore order and a climate
m the exchange markets in which rates can respond to the economic funda
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mentals, in this case to the improved outlook for the fundamentals that under)i>in
the dollar's value. We are not attempting to peg exchange rates or establish
targets or push the dollar beyond levels which reflect the fundamental economic
and financial realities.
On the subject of the competitive position of U.S. exports, let me make one
thing absolutely clear. There are those who feel that continuing decline in the
dollar is good for trade. This is a dangerous misconception. The United States does
not need to pursue dollar depreciation to buy market position. To have argued on
October 30 or to argue now for more dollar depreciatiop. as a way of correcting
our trade deficit is a simplistic and nonsensical view that could force a collapse
of an .9pen capital and trading system. The Administration firmly rejects such
tactics.
Second, Mr. Chairman, you ask in the press release that announce these hearings why differentials in interest rates between the U.S. and other strong countries w·o uld be any more effective now than before in attracting capital. The
answer lies in investor e:1-."l)ectations about the future. The key to attracting
investment is to offer investors a real rate of return. While nominal interest rates
have been high in the United States, inflation has rendered them negative in real
terms. If investors are being offered the promise of less inflation and a real return
on their investments, it should be easier to attract the capital needed to finance
our current account deficit.
Third, your staff has questioned the Treasury decision to issue $10 billion
of fore_ign currency denominated :bonds.
To r:.eiterate, the Treasury did announce its intention to issue up to $10 billion
in securities denominated in foreign currencies. The first of these issues-for
2½ to 3 billion DM-will be issued tomorrow. We plan a Swiss franc issue in
January and we are also giving consideration to a yen denominated borrowing
in Japan in 1979.
It is important to realize that these securities are being issued only for the
purpose of acquiring foreign currencies for the intervention effort. They are not
intended as an effort to "mop up" unwanted dollars. They are being sold only to
residents of the country issuing the currency in which the securities are denominated. We are seeking to minimize the extent to which purchasers switch out of
dollar~ to effect these purchases.
There were important reasons for including foreign currency denominated
securities in our package. The issuance of securities with, in case of DM, three
to four year maturities, provides us with additional foreign currency resources,
for a longer time period, and gives assurance to the market that the United States
will not be pressured to reverse its intervention operations too soon because of its
need to accumulate the foreign currencies needed to repay swaps. In addition,
the issuance of these securities demonstrates that we are firmly committed to
strengthening of the dollar over time and that we will use all means at our
disposal.
With the issuance of foreign currency-denominated notes, there is the potential for exchange rate gains and losses. The calculation of the total "cost" of such
borrowing must take into account the interest rate differential between domestic
and foreign markets, -as well as possible gain,s and losses because of exchange rate
changes. Of course there is a risk. But the alternative cost to the economy of
failing to move with adequate and comprehensive measures constituted an even
greater risk. If you will permit me Mr. Chairman, this is a case of being pennywise rather than pound-fooli,sh. The importance of assembling a comprehensive
and credible package to strengthen the dollar justifies the lesser risk we have
assumed.
Finally, there is the question of the role played by the IMF in our November
decision. The actions we took on November 1 were fully in keeping with ou~·
obligation "to assure orderly exchange arrangement and to promote a stable
system of exchange rate * * *" by "fostering orderly economic growth with
reasonable price stability." Since part of the November 1 package consisted of a
reserve tranche drawing from the IMF and sales of SD Rs, we of course discussed
these plans with the Fund management prior to the announcement. The U.S. program was also explained sub.sequently to the IMF Executive Board in connection
with activation of the General Arrangements to Borrow (GAB) for financing part
of the U.S. drawing. The proposal was ,supported by the IMF and the GAB
participants. On December 13 the Boa-rd discussed the U.S. program in more
detail, under IMF surveillance procedures, and expressed support for the U.S.
action.
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Mr. Chairman, you have also asked whether the IMF has undertaken to reduce
the key currency status of the dollar. And questions have been raised as to
whether reduction or elimination of the dollar's role as a reserve currency would
remove pressure on the exchange rate and make domestic restraint less necessary.
Let me make two points. First, any such fundamental change in the international monetary system would have far-reaching effects on other parts of the
system and could not be considered in isolation. Nor could such a restructuring
of the system be simply mandated by the IMF-it would r equire detailed study
and negotiation, looking toward arrangements that would be acceptable to all
countries. We would need to know what system we would be moving to before
dismantling the one we have. There were extensive studies of possible changes in
the monetary system earlier in this decade, many of which would have meant a
sharply reduced reserve role for the dollar. Ultimately, none of these changes
appeared practical or widely desired. I stress this point not because we are unwilling to consider change but becau.se the full implications of such change need
to be recognized and assessed.
Second, the United States is going to be in difficulty if it continues to run an
inflationary economy, regardless of the reserve of the dollar, and no reform of the
system can obviate the need for us to pursue policies of restraint to counter
inflation, or to maintain a reasonably strong external position.
As international economic and financial relationships evolve, the role of the
dollar can be expected to evolve to reflect changes in underlying economic realities. There is widespread agreement on progressive development of the SDR's
role in the system, and other currencies may also take on a larger role. But such
changes will come about gradually over an extended period of time and they
must come about in an orderly manner. As a practical matter, the dollar will continue to play an important role in international monetary relationships for the
foreseeable future if the world is to continue to achieve growth and progress.
Accordingly, it is our duty to manage the dollar in a manner which befits its
central role in the system. This is precisely what President Carter, Chairman
Miller and I intend to do.
Representative REuss. Thank you, Secretary Blumenthal, for a very
incisive and helpful statement.
We will now proceed under the 10-minute rule.
Until very recently, the U.S. scenario for our international monetary
troubles was to say to the Germans and Japanese, "Why don't we all
have a forward moving growth rate, and why don't you two fellows
grow a littl~ more~' :which they, ill: general, agreed to do. But quite
recently_, Pnme M11;11ster Elect Ohua of Japan said that there won't
be any mcreased ~timulus llleasures for 1979, which constitutes a departure from their growth targets; and OECD has disclosed that
Germany is unlikely t o reach its targeted growth rate.
. Now we _come alo~g and say-I am not saying this is right or wrong,
Just what is h_appenmg-we come along and say, OK, we are goi!lg to
purs~e austerity and check our growth rate in order to get a grip on
mflat10n at home and a wobbling dollar abroad.
Does this not mean, in effect, that the three great industrial powers
have gone from a "let's all grow" policy, to a let's all-I won't say
stagnate-but "let's all grow a lot less" policy~
Secretary BLUMENTHAL. I don't believe so,~Mr. Reuss. The Japanese. indicated in Bonn at the summit meeting that they were setting a
rate of 7 percent for growth in real terms, which, of course, is very,
very fast. They will not, as I understand it, reach that target.
Our estimate is that they may reach 5 or 51/2" percent in real terms; 5
or 51/."> percent i not, by my definition, " tagnation." I think it i a
positive and substantial rate of growth.
~ow, our concern is that it isn't fast enough to help in correcting
the imbalances that have existed internationally. That is why we wel
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corned the goal of 7 percent. But certainly even a shortfall from that
is not really an example of stagnation.
.
Similarly, the Germans are expecting in 1979 a real rate of growth of
almost 4 percent, and compared to the stagnating level of Ge~man economic activity a year ago, that, too, represents an encouragmg trend
in the right direction.
_
As to the United States, we had been growing very rapidly. As you
know, we came out of the worldwide recession, more quickly than the
others in an ear lier period. We are slowing down and we should slow
down, in order to deal with this inflation problem because if we don't
deal with it now, we are going to have a worse situation on our hands
later and will really then have the risk of a recession substantially
increased.
·
·
So, I would say what has happened is that there has been a change
in the pattern. We were growing faster, the other two countries were
growing more slowly. Now the other countries are accelerating and we
are slowing down and that will be one of the reasons why the external
situation is likely to be much more favorable to exchange markets.
Representative REuss. Thank you.
In response to our question about our Government's intention with
respect to intervention in foreign exchange markets, you give a very
clear answer in your statement: "We are not attempting to peg exchange rates or establish targets or push the dollar beyond levels which
reflect the fundamental economic and financial realities."
And you also state, "Our objective is to restore order and a climate
in the exchange markets in which rates can respond to the economic
fundamentals."
I find that an admirable statement. My question is : As a result of
the November 1 program, have we now reached approximately those
levels?
Secretary BLUMENTHAL. This is a delicate area, £or the one thing
one must not do is to be too precise in public about that kind of situation because it is almost certain to be misunderstood or misinterpreted.
Certainly there has been much less disorder and speculation and
chaos in the markets than prior to November 1, and we have been
encouraged by the upward movement in the value of the dollar from
the levels that had been reached, which were totally unrelated to
underlying realities.
We will watch the situation carefully, but I don't think it would be
fruitful for me to indicate whether a particular level at a particular
point of time is the right level.
We have a system in which movement will occur; I have indicated
that we think ,t he American economy is strong and healthy. I have
indicated the improvements in our external accounts and the strong
measures being taken domestically on inflation.
I think these are all factors that indicate strength of the economy,
and I think the markets will reflect that.
Representative REuss. Mr. Secretary, in my communications with
you prior to the hearinO' I indica,ted my viO'orous upport for the idea
of getting started right now on some kind 0£ a substitution account in
the International Monetary Fund so that central banks aren't so
almost exclusively dependent on the dollar as key currency. The sub
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stitution account is not, in heaven's name, intended to replace the dollar, but to take some small part of the $700 billion overhang, or what. ever amount it is, out of the market if that is what people want to do
with it.
You very forthrightly answered toward the end of your statement
that you were not favorably disposed toward the idea, which is quite
consistent with what the Treasury has been saying in Mexico City
and other places. Since this is likely to be the subject of an ongoing
and friendly debate between us, let me make sure that I am not being
misunderstood, and I am not sure that I am being understood
correctly.
In your prepared statement you say, speaking about the points I
have raised, "Questions have been raised as to whether reduction or
elimination of the dollar's role as the reserve currency"-let me be
clear, I am talking about a reduction, not an eHmination, God forbid"would remove pressure on the exchange rate and make domestic
restraint less necessary."
Well, that is just the opposite of what I have in mind. What worries
me about the present system is that, as must be evident to all of us,
there is precious ·little domestic restraint. We are in the enviable position enjoyed by no other country in world history so far as l know
of being able to print dollars thereby ena:bling us to live beyond our
means and invest abroad beyond our means.
·
The removal of what DeGaulle called the exorbitant privilege, or at
least partial removal of it, would, I should think, impose a very
sensible restraint on us.
So I am hopeful that the discussion could proceed clearly in the
recognition that there are those of us who think it would be a good
thing for this country to put before the people at Guadalupe, the
people at the IMF, and so on, the idea that we are quite willing, and
wouldn't have our noses bent out of joint one bit to accept an international SDR-tyPe, ECU-type currency, as a partial replacement for
the dollar.We think that that wouldn't be a bad idea at all.
The suggestion of a substitution account is not advanced by me as
a method of making domestic economic monkeyshines easy; I want
to malie them more difficult.
·
.
Secretary BLUMENTHAL. If I could make a few comments, Mr.
Reuss. I would begin by saying that the goal of making domestic
economic monkeyshines as difficult as possible is one that you and
I share, and I suspect that my good friend and colleague, Chairman
Schultze, who has just arrived, would enthusiastically endorse that
goal as well.
I think first of all the foreign dollar holdings-the so-called overhang-is in itself such a massive number that it tends to obscure the
un.d erlying facts. I think it is important to bear those in mind. Also,
!h~ $700 billion figure for the eurocurrency market is a gross figure;
1t 1s not a net figure.
W e estimate that roughly half of that represents obligations owed
by some foreign entities to other foreign entities or individuals.
We further estimate that the remaining $300 billion, which are
amounts owed by Americans to foreigners, is offset by an amount
somewhat greater of claims by Americans on foreigners, albeit in
less liquid form.
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Second, I think the point needs to be made that it is not the overhang which is causing or has caused in the past the instability of the
dollar and the decline of the dollar· unrelated to the fundamentals
and the chaotic conditions that were created. The owners of those
resources react in the same way as you and I would react, and that is
they react in terms of their expectations as to the fundamentals of the
U.S. economy.
If they see us acting responsibly domestically, following the kind
of economic policies that I have described this administration is fol lowing, then the fact that there is this free international capital market
out there is not really a deterrent.
If they see us with the deteriorating situation-declining current
account, a declining trade balance, inflation rising, and the United
States pursuing a policy of growth-come-what-may-there is going
to be trouble for us whether you have 300, 500, or 700 out there, or
whether you have no overhang out there.
Now, as to the substitution account, itself, central banks-which
under that proposal, as I understand it, would be exchanging dollars
£or SDR's-represent a relatively small cause of the volatility in the
exchange markets in the past.
. The far greater reason for that volatility is the private dollar holdmgs and not the central bank or the official ones.
.So the substitution account in and of itself would not really deal
with the volatility question either.
Having.said that and bearing in mind that we want to have an open
world capital market and that the United States is a big factor in the
system, we do not object to an orderly evolution; in fact, we favor, as
YOl~ do, _an orderly evolution of the international monetary system in
a direction thait may, over time, lead to a decreased role of the dollar
as the central currency in the world.
We do believe that this is not something th at can be ordained. We
do believe that that is something that countries can't get around and
make a decision on and then will it.
Given the size and importance of the United States in the world .
this is something that has to evolve over time. We are not stonewalling this; we are not trying to prevent it. We merely recognizr
that :for a long time to come we will have to play a central role, the
dollar will continue to be very important, and that we have to conduct ourselves dof!lestically and internationally, and in an interrelated way, accordmgly.
Representative REuss. My time is up, and I am slightly more encouraged bv what you just said.
I would add to that that I can't see a better way of getting foreign
monet.ary authorities more relaxed than to express a willingness to
consider some method whereby, if tl ey wish, they could diversify
some of their risk and not be in a position where their rewards for
being &ood soldiers for holding dol1ars is tht the dollar did that
which 1t did last August, September, and October, when a lot of
central banks sustained very discombobulating-looking paper losses.
Some more on this later.
Congressman Brown.
Representative BROWN of Ohio. Thank you, Mr. Reuss.
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Mr. Secretary, I am not sure that you can please both Mr. Reuss
and me this morning because I am one who believes that we may have
to take a little bit of a bruising next year in order to avoid a catastrophe that may just flatten us out atlogether later on.
I would like to talk about the psychological factors here for just
a minute.
You know we were told by the President ea.rlier this fall~and I
guess others in the administration-that if we passed an energy bill
the problems of the dollar would be largely resolved, and we passed
that energy bill of October 15, and during the next week the dollar
·
collapsed somewhat more rapidly than it had previously.
Then we were told that if we just simply put in voluntary wage
and price controls, he told us that on October 24, that that would
resolve the problem, and in the week that followed that first speech
•on voluntary wage and price controls the dollar collapsed at a record
rate.
It wasn't until you took the steps on November 1-am I correctthat this thing really began to turn around i
Secretary BLUMENTHAL. Yes.
Representative BROWN of Ohio. So the original information in
,your statement was incorrect; right i
Secretary BLUMENTHAL. No; that the dollar began to appreciate
-a fter November 1 is correct. But the original information was not
correct.
In the first place, sir, I don't really believe anyone said that if
Congress passes the energy bill the problem of the dollar would be
ilargely resolved. I certainly never said that. I don't recall-Representative BROWN of Ohio. I think a lot of chief executive officers who called early in August to discuss whether there should be
an energy bill-Secretary BLUMENTHAL. I think what we said and what I continue
t? believe to be the case is that, first of all, failure to pass the energy
hill wo:u,ld have had a very serious additional negative consequence
on foreign exchange markets.
Se_cond, tha~ passi~g the energy bill and thus bringing about a _reduct10n both immediate and eventually even greater in the foreign
exc~~nge resources ~eeded to import oil into this country, will be a
positive :factor. It will be one of the pluses, but certainly not that that
would resolve the dollar situation.
Representative BROWN of Ohio. Let's talk about a couple of the other
1>svchological factors.you mentioned there was a $66 billion deficit in 1976, the year in
which we were recovering from perhaps the worst recession that the
-c ountry has experienced since the thirties. And I recall that President
F _o rd recommended a deficit figure of about $45 billion for 1977.
Could you tell me what President Carter recommended that year~
Secretary BLUMENTHAL. For 1977 the deficit, if I remember correctly, was $44 billion.
Representative BROWN of Ohio. But President Carter recommended
58, as I recall.
Secretary BLUMENTHAL. The original budget was higher because at
that· point we had an 8-percent rate of unemployment in the United
1
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States, we had a situation developing in which it looked as if the econ omy would be in increasing difficulty. The stimulus program that the
President then initiated resulted in a reduction of unemployment from
8 percent to 5.8 percent. When he saw that the-:e was add_itional
strength in the economy, he reduced the budget by virtue of askmg the
Congress to cancel the idea of the then-discussed $50 rebate.
And, by virtue of these decisions which President Carter made, we
came in with a budo-et deficit that was slightly below what had been
recommended by P~esident Ford just before leaving office.
Representative BROWN of Ohio. And as another factor, bureaucracy
conldn't spend the money fast enough, as I recal1, they had a shortfall
in spending.
In 1978 what deficit was recommended?
Secretary BLUMENTHAL. "'\Vell, that's been true for some time, it's
either that they couldn't spend it or that they overestimated. .
Representative BROWN of Ohio. ·what was the recommendation for
rleficit by the administration in 1978?
Secretary BLUMENTHAL. In 1978 the recommended deficit, I believe,
was $60 billion.
Mr. SCHULTZE. $61, or $60 to $61 billion.
Repr~sentative BROWN of Ohio. So, we wound up recommending t)rn
same high-level deficits that we had, and the dollar began to deter10rate.
unfortunately, we didn't achieve those deficits, and I gness for
their benefit fortunately the Germans and the Japanese didn't buy off
on our suggestion that they try to inflate their economies in the same
pattern that we were following.
Let me turn to a comment in the openin.o- statement of the chairman:
~°'',
We can intervene until our cupboard is bare--and go further in debt to get
the marks and yen with which to intervene--yet not really rescue the dollar,
especially if there is a $700 billion overhang in the Eurodollar market.
I have heard that figure described to be anywhere from $400 to $700
billion. I have bern usinu: $600 billion. Do you have any idea what actua 11 y is correct?
Secretary BLUMENTHAL. I think $600 or $700 billion for the Euroenrrency market, on a gross basis, is probably accurate. Since it is an
open market, nobody can tell for sure.
Representative BROWN of Ohio. Let's talk about some of the steps
that were taken on November 1.
With reference to the sale of gold, aren't we reallv putting ourselves
a. little bit in the position of the farmer who is selling off some of his
lrund or seed corn? Perhaps not quite thRt, but a.t least he is selling- off
the woodlot principle jn order to sustain the situation for a while~
Tsn't that about right?
Secretary BLUMENTHAL. I don't reallv think so. "'\Ve han:>. I believe.
275 million ounces of gold. vVe have bern importing gold into the
ITnited States. "'\Ve are t.lrns using some of our own gold and selling it,
mstead of importing. That has a positi, e, impact on our balance of
trade, onr currem..t account. That strengthens the doll.ar. I think that is
a sensible policy. It's utilizing an asset to substitute what we would
otherwise be paying out in the way of importing gold.
Representative BROWN of Ohio. So we are. paying with assets, in
effect, rather than income ~
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,v
Secretary BLUMENTHAL. ell, we have all ranges of resou_rces.
Representative BnowN of Ohio. We have to because we don't have
the income to pay with. Isn't that essentially correct~
Secretary BLUMENTHAL. It's always open to us to use our resources.
You can say the same thing for the drawing on our reserve position in
the IMF. It's there for that purpose.
Representative BROWN of Ohio. Let me go to that, to the mobiliza.tion of the $30 billion and so forth. Aren't we, in effect , like the person
who has made credit purchases and has to refinance at the bank~ Aren't
we, in effect, merely putting off the day of reckoning by some of these
other steps, those which you have described in your prepared stafoment ~ Aren't those merely refinancing methods~
I refer to:
•**a decision to join with Germany, Switzerland, and Japan in closely coordinated exchange market intervention ; • * * the mobilization of $30 billion in
deutsche mark, Swiss francs and yen to finance that portion of the intervention
undertaken by U.S. authorities.
The U.S. financing involves an approximate doubling of Federal Reserve swap
lines.
Now, I have been told that the Federal Reserve staff suggests that
when we swa.p currencies with Germany, the Germans to some extent
use the dollars to buy Treasury bills and then the Treasury spends the
dollars.
So they go right back into circulation.
Isn't it true that the swap ·a rrangements are used only to handle disorderly trading of dollars and that the real longrun condition of the
dollar depends on the monetary policies of the Federal Reserve
System~
Secretary BLUMENTHAL. The real longrun condition of the dollar
you are quite right, depends on the fundamental conditions and outlook for the U .S. economy, which involves, of course, monetary policy,
fiscal policy, overall economic policies, and policies related to the
dolJar.
As I indicate in my prepared statement, there is a close interrelationship between these policies. The particular measures to which you
~~fer and which are listed in my prepared statement are part of an
mtegrated program.
They are designed to stabilize the currency and reduce the inflationary impact of a declining dollar, as tight fiscal and monetary policy
works within these United States.
Representative BnowN of Ohio. Now, the other day Alan Greenspan
and Michael Evans of Chase Econometrics appeared before the Joint
Eco~omic Committee and said we would be very lucky to hold the
deficit next year, even if the President sets the $30 billion target, to
$50 billion.
I agree our fis<;-al policy is very important, our monetary policy perhaps even more important. My concern is that, if in fact we have any
kind of a recession, that you will not have the inflow into the Treasury
of dolla.rs that you might otherwise have anticipated and that that $30
billion deficit could grow to $50 billion. Indicators are currently not
good.
We are only going to get that capital investment that will level out
the recession if the Government doesn't crowd out credit or if the high
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cost of money isn't such a great disincentive to private investors that
they decide that they don't want to borrow at these rates.
The real interest is quite low-the nominal rates ~re boosted by
inflation-and I am concerned you will not get a boom m the economy
next year if we have a heavy fiscal deficit and a tightening of the
money supply by the Federal Reserve System.
Now, would you reassure me that you are ~oing to_ hold that ~eficit
to $30 billion and that the Federal Reserve 8ystem 1s really gomg to
tighten up on the money supply~
Secretary BLUMENTHAL. Well, Representative Brown, obviously on
the latter pointr-Representative BROWN of Ohio. There are a lot of increased taxes to
pay, too, social security taxes and others.
Secretary BLUMENTHAL. I understand. Obviously on the latter point
I believe you are going to have Chairman Miller here, and I think you
would probably be best advised to address that latter question to him
because that is squarely in his responsibility ..
As to the $30 billion deficit in the budget, it is the President's full
intention .t o submit a realistic budget that has a deficit no larger and
possibly, if at all possible, below $30 billion.
Now, clearly that is based on certain assumptions as to what will
happen with economic activity in the United States.
I wouldn't be concerned about crowding out. With a budget deficit
of the kind that we have indicated, which is around 1 percent of
GNP, as compared to what we had in the last several years when
we were at 2, 3, 4 percent, or more, of GNP, we are in really good shape.
Second, the borrowing abroad that we are doing-because of the
way in which we are handling the operation-actually relieves pressure on the U.S. capital markets. There is a further positive factor
because we borrow in deutschemarks and have an arrangement between the Federal Reserve and the Bundesbank which will allow us
to reduce the dollar borrowing we do in this country.
Now, the basic ·a ssumption under which we operate is that the
economy will not go into recession. We do not see, and I think I tried
to indicate that clearly in my prepared statement, at this point any
of the signs that lead to two or more successive quarters of negative
growth which is the generally accepted definition of a recession.
We don't see a boost in the economy as you see it; we see a slowing
down of the rate of growth next year somewhere between 2 and
3 percent in real terms, and we think that that is appropriate to the,
circumstances.
Under those conditions and with a rate of inflation that begins to
slow as the year proe:resses, the impact of tight monetary and fiscal
policy and of the voluntary wage and price guidelines, we will have
this kind of deficit.
Now, if you say, "Well, this is not what is going to happen, you
are going to have a recession, you are going to have a different inflation situation, you are going to have a different import situation,"
then obviously the administration and the Federal Reserve will have
to act and react in the light of these changing circumstances.
We don't expect those to happen. That is all we can tell you.
Representative REuss. Thank you.
Representative Hamilton.
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Representative HA:-fII:TON. M~. Secret~~Y, the President on a number of occasions has mdicated his opposit10n to mandatory wage and
price controls. I t~ink rou probably have, to?.
.
Does the admimstration have under consideration at the present
time submitting to the ·Congress a bill to permit the President to
impose mandatory price and wage controls~
Secretary BLUMENTHAL. Absolutely not.
Representative HAMILTON. You say in your prep!Lred ~tatement, ~r.
Secretary, that with regard to the fight agamst mflat10n there will
be no waffling or wavering.
.
. .
The paper this morning reports that the wage and price gmdelmes
are going to be altered again. Apparently one of the reasons those
wage guidelines are going to be altered is to relax the pay standards
with regard to fringe benefits.
There has been a lot of speculation that maybe on~ o~ the reasons
that that's being done is because of some of the negotiat10ns that are
coming up, specifically negotiations relating to the T~amsters.
I appreciate your statement that there will be _no waffling ?r wavering. But doesn't it appear that you are wavermg or waffimg when
you announce a further guideline and within a few weeks thereafy,er
you begin to make changes in that guideline because of specific
circumstances~
Seicretary BLUMENTHAL. Mr. Hamilton, let me put it this way: In
the first place, the fight against inflation is being conducted by the
President, and this administration, throuo-h an integrated interrelated
program. The fiscal policies and monetary policies that we have discussed earlier this morning are a key part of that, just as key a part
as are the wage and price guidelines and the dollar policies that the
President announced on November 1 are a key part of that.
~owe 'have_ a total program. Now, as to the one part that you have
raised a quest10n about, we made it very clear that what we announced
originally were suggested guidelines out for comment.
What is the purpose of comment if not to receive it and to evaluate
it and to use that information intelligently.
We are not ~mniscient. I certainly, -as a businessman, found sitting
on the o~her. side that Government bureaucrats were anything but
all-knowmg m these matters and, with the best of intentions, do not
always find it possible initially to anticipate all of the technical
complications that can arise. ·
Represe~tative HA~ILTON. Would that suggest, Mr. Secretary, then,
that w_e will_ see_ a series of changes in the presently announced wage
and price gmdelmes ~ Are we going to see changes every couple of weeks
or couple of months~
Secretary B!,,UMENTHAL. No ~ definitely not.
Representative HAMILTON. Do we now have a firm set of guid~lines
that you would not expect to be altered~
Secretary 1?LUMEN~AL. We have a firm set of guidelines. It may
be that ove: time as we gain experience with them and actually implement ~hem m the course of the next year that there might be conditions
and circumstances that change, which require some further amendment
to them, but these guidelines that are now announced are the final
ones; they reflect the results of the consultations that have been conducted. And let me make one final point.
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It is not a loosening; .they do not represent a loosening:. They represent in some instances ,run introductJion of greater flexibili,ty and in
other instanc~ a greater tJightening.
.
I suggest if you want to go mto tJhe details of ,t hat, ,fu8At Mr.
Schultze will be glad to respond because he has been spending more
time on details of it than I have ,a nd can speak well to it.
But basically I don't see .t;his as ,a weakening o:f the stJanda~ds, and
I am not at all apologetic that we put them out for consultation and
then made the ,a djustment before we put the final ones in.
Representative HAMILTON. OK. I want to get clear ithen, you•now
view thes·e ·as final as ohey are presently oon'Stituted and that the 7percent guideline as originally announced was a proposal ; is that correct? And not a final guideline? Is thait your interpreJtation?
Secretary BLUMENTHAL. That still has not changed. Those numbers
have not changed. It is the interpretation-the definitions thwtr-Repres~ntative HAM~LTON. I j~st ~ant to get clear what_your fra~e
o:f mmd is. You now view rthe guidelmes •as final and we will not see m
the ooming immediate weeks any way alteraitions in those guidelines?
Secretary BLUMENTHAL. That is correct.
That is my expectation.
Representative HAMILTON. Where did the 7 percent come from?
How did you ,a rrive ,a t rtha;t figure, just as :a matter of my own curiosity? I don't know the basis of it.
Secretary BLUMENTHAL. Mr. Schultze is here, and he has been working with the details of it. I think I can do it, but he can do ,~t wtter.
Representative HAMILTON. It doesn't matter who responds.
Mr. SCHULTZE. Essentially the 7-percent guideline on wages represents a moderate deceleration :from the rate o:f wage increase, wage 'a nd
fringe increase, which the economy is experiencing this year, and
which-taking wages and ,private fringes-is something on the order
of magnitude o:f 8 to 8.5 percent, depending on exactly how you measure. It is a number chosen on the one hand not to be unrealistic.
W e have had 10 years of inflation -and this is now a question of unwinding it gradually. At the same time the standard must be large
enough to represent significant progress.
Now, why 7 'Percent instead o:f 6.75 or 7.25? Trhere is no magic to
that. But iit does r epresent a ibafance between wanting to make pay
increases significantly lower, but not adopting 1a numerical standard so
low ,as to make it impossible to have any chances of success.
Second, as the Secretary points out to me, it is carefully relaited to
the price guideline where in the price area our basic core standard is
deceleration of 0.5 percent below the rate o:f price increase in 1976 and
1977. If you compare the two, they are consistent. That is, the rate of
decrease in wages and :fringes and the rate o:f decrease in prices on the
average-not for firm, but on the average-are quite compatible.
Representative HAMILTON. Now the Secretary said he did not view
the announcement yesterday as any kind of relaxation of the guidelines, I think he said. But you do permit, do you not, an extra allowance in there for the cost of health care benefits in these contracts and
pensions under the new guidelines, the altered guidelines as announced
yesterday, and is that not a relaxation?
Mr. SCHULTZE. In that particular part of it it is. Let me put that in
context.
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While there are .a number of detailed changes, the three large ones,
two of them relate to pay and one to price, in the case of the pay
standards what we are allowing is any excess over 7 percent in simply
maintaining the cost of existing health benefits. That is, any improvement in benefits has to be charged against the standards. It is only the
excess of the cost of maintaining current benefits because of medical
costs, inflation over 7.
Representative H AMILTON. What does that do to your 7 percent~
Doesn't it jack it up a little bit~
Mr. ScHULTZE. That, plus what is also done in the case of actuarially
required changes in pensions. We estimate that the two together would
add about one-tenth to two-tenths of 1 percent to the pay package
nationwide. Conversely, we have tightened up the price standard and
while you can't figure exactly what that is going to mean, the changE:8
should be roughly offsetting. So these changes, in essence, provide additional flexrbility. They improve the standards, but on balance in effect
don't really add to the pay and price increases.
Representative HAMILTON. Thank you, Mr. Schultze.
Let me return to the Secretary while he is here.
You mentioned in your prepared statement that it is too early to
see any impact on the inflation rate as a result of the measures that
have been taken. When would you expect to see any impact on the
inflation rate~
Secretary BLUMENTHAL. It is ·very difficult to say. I also indicated
that the art of economic prognostication is imprecise. I would certainly
expect that sometime by the spring or summer of next year, as we move
into the second part of next year, that we should begin to see the results
in the inflation figure.
Representative HAMILTON. If I may switch to this change that has
occurred in the European monetary system now, I would like to get
your comments on that. Is that going to help the dollar or hurt it; and
if it helps, how is is going to help~
·
The immediate impact was another siege-temporary, I presumeon the dollar.
Secretary BLUMENTHAL. Well-Representative HAMILTON. Would vou care to comment~
Secretary BLUMENTHAL. Mr. Hamilton, I wouldn't really call it a
"siege."
Representative HAMILTON. Well. I don't care what you want to call
it. It dropped.
Secretary BLUMENTHAL. Well. then it went up again, you know. It
moves around. It has been moving around so much. There have b~n
a number of important developments. There are problems in Iran with
oil production, which is substantially reduced at the present time, of
course. There was the announcement of the EMS, there was then the
announcement of Norway that that country was leaving the "snake."
Representative HAMILTON. Right, I understand.
Secretary BLUMENTHAL. So there are a lot of things that ha.ppene<l.
Representative HAMILTON. But what I want. to get at, Mr. Secretary.
is how you viewed that development.
Secretary BLUMENTHAL. The EMS as such-- ·
R epresentative HAMILTON. Will that strengthen the dollar in the
long run, as such~
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Secretary BLUMENTHAL. We expect the EMS to be a positive factor
based on the way in which we understand it will _be <?P~rated.
.
It will be a positive factor to the extent to which it_1s 3:ble to br~ng
about greater stability in Europe, to the extent to which mtervent10n
in the European currency markets will be conducted less in dollars
and more in other currencies and since we have been assured and :fully
expect that the system will be operated in :full conformity with the
obligations that these countries have together with us and the IMF,
we really think it will be a positive factor.
Representative HAMlLTON. Does the move in Europe suggest in itself
a lack of confidence in the dollar?
Secretary BLUMENTHAL. We don't see it that way.
Representative HAMILTON. Thank you, Mr. Reuss.
Representative REuss. We are honored to have with us our respected
colleague, Millicent Fenwick. Do you have questions?
Representative FENWICK. I do have a question that concerns me, the
EMS .
. I would like, Mr. Secretary, to ask if you have any suggestions or
if you are contemplating any tax changes that might help to increase
our export situation. I gather we are now importing some $147 billion
a year of manufactured goods and I understand that governments
abroad have made or have tax arrangements that encourage the export
of their goods to other countries. I wondered if you had any suggestions or contemplated tax changes that might increase the position of
our exporting companies.
Secretary BLUMENTHAL. The :fundamental way in which to increase exports, encourage exports from the United States is, of course,
to make us as competitive as possible. I think the kind of measures
that we are taking in the economy as a whole, getting inflation down,
et cetera, will do that to some extent.
Second, we do have some tax incentives now in effect, particularly
through the DISC (Domestic International Sales Corporation).
Representative FENWICK. Do you think that is valuable, that DISC
does improve our exporting position?
Secrefary BLUMENTHAL. Well, I think it may have some marginal
benefit. It is at very high cost to the Treasury, so we don't like it much
and it is very difficult to see any real relationship between the volume .
of exports and that particular device. You may recall that we actually
recommended the elimination of it because we felt that the money
could be used more effectively to help the economy overall than to
spend it on that.
Representative FENWICK. What is the loss~
Secretary BLUMENTHAL. If I remember correctly, it is about $2
billion a year. ·
We are-to answer your question specifically-doing all sorts of
things. The President announced a program of promoting exports,
but we are not contemplating as a part of that, recommending any
additional tax incentives to people who export.
Representative FENWICK. There is no way balancing it somethin~
like the value added tax, which I understand helps1
Secretary BLUMENTHAL. I don't believe the value added tax would
have any--
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Representative FENWICK. I am not in :f.avor of it myself, but I
wonder if there would be something that we might have that would
counterbalance that.
· Secretary BLUMENTHAL. We, of, course, have a variety of taxes, but
we tend to rely more on direct taxes and the Europeans more on indirect taxes. In theory at least, that should not be a factor. That
should neutralize.
.
Representative FENWICK. But we know what is happening, don't
we1
Secretary BLUMENTHAL. It has probably some impact, but that
again, I would say, is not the reason why we have a trade problem.
Our trade problem is due to a whole range of reasons, many of thei:n
historical. They have to do with the fact that in many parts of this
country, perhaps not in New Jersey, but perhaps more in the MiddlP
West, medium-sized and smaller manufacturers have the whole big
U.S. market and when they move out from their State or their triState area, for them the next part is the big, wide world of the Unit.eel
States.
You can't do that in Belgium. You are at the border very quickly,
so you export. It, becomes second nature even for a smaH compainy. For
small comprmies in the United States that is not the case. It is that
psychology of n~t going and reaching beyond the borders thait---:Representative FENWICK. It is ,also, Mr. Secretary, if one can believe
the experience of people that there is nothing rto compare to dose cooperation of Government in promoting export$ from other countries.
I mean, everything is arranged to facilitate their operation and I
wondered if we shouldn't begin to think somewhat along those lines.
Secretary BLUMENTHAL. I think you are absolutely right. That kind
of collaboration is much closer. It has historically been. We have a
lot to learn there. We have more to do there. The President's program
is intended to be a step in that direction. I personally think it is not
the }ast step that needs to be taken. I certainly agree that more needs
to bedone.
We hiave increased as a percentage of our GNP our trade from 4
percent to 8 percent over the course of tJhe last couple ye.ars.
· Representative FENWICK. I understand, but I think we oon use
much more.
Secretary BLUMENTHAL. We are moving in, that direction.
Reprooentative FENWICK. Thank you, Mr. Reuss.
Representative REuss. Thank you, Mr. Secretary. You have been
very helpful. We want to wish you a Merry Christmas, and good luck.
Mr. Schultze, you are already at the pulpit, so consider yourself
weloome:
We have your prepared statement. Without objection, it will be
received in the record. Would you now proceed in yonr own way and
then respond to our inquiries~
1
STATEMENT OF HON. CHARLES L. SCHULTZE, CHAIRMAN,
COUNCIL OF ECONOMIC ADVISERS
Mr. SCHULTZE. 'Dhank you, Mr. Reuss.
In !Jhe interest of brevity I will ·go through my prepared statement
seloot1vely.
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Representative REuss. It is my u·n derstanding that you have to be at
the "White House by noon.
.
Mr. ScHULTZE. I have to be at the White House by noon, yes, sir.
Representative REuss. We will make it possible for you to be at the
White House at noon.
Mr. SCHULTZE. As I say, in the interest of brevity, I will go through
my prepared statement selectively, and request it be. put in the reoord
with tlhe understanding that the mere fact of skipping any part doesn't
mean that I downgrade its imporbance.
Let me be:gin my remarks by reviewing the economic developments
of 1978 that underlie the necessity for the economic policies that this
administration is pursuing. As you know, the rate of inflation remained
relatively stable, but uncomfortJably high, during the fir.st 2½ yea::8 of
the current economic recovery. Movements of food prices sometimes
moderated the overall mte of inflation, as in 1976, and at other times
aggravated it, as in 1977. But outside of :food commodities, prices of
consume.r goods ·a nd se:rvices rose at around 6 to 6.5 percent a yeiar from
the middle of 1975 through the end 0£ 1977.
Increases in pay were also relatively stable during this period,
averaging about 8 to 8.5 percent per year. During the first year of the
recovery, productivity growth improved substantially, ·as it typically
does at that stage of the business cycle, and the rise in unit labor costs
moderated. By mid-1976, however, cyclical improvements in productivity were largely over, and unit labor costs-along with prices-were
advancing at a 6 to 6.5 percent annual rate.
In short, until late in 1977, the underlying rate of inflation hovered
a.round 6 to 6.5 percent, and there were few signs that the rate of
inflation outside of the volatile food sector was accelerating.
Early in 1978 signs began to emerge that an acceleration 0£ inflation was underway. During the most recent 12 :months, producers'
prices for finished goods have risen more than 8.5 percent, and consumer prices almost 9 percent. While sharp increases in the cost of
food, housing, and medical care have led the surge in prices, an
acceleration in inflation can be detected across a wide range of items at
both the wholesale and retail levels.
The acceleration of inflation that we have gone through this year can
be traced to three distinct problem areas: The very poor performance
of productivity, strong inflationary pressures in food, and the depreciation of the dollar in foreign currency markets. I will deal briefly
with each of these areas in turn.
PRODUCTIVITY GROWTH
Growth in productivity has been slowing in the American economy
for approximately a decade. We were aware of that slowdown -a yea.r
ago, and had taken it into account in our calculations of possible price
and cost developments in 1978. But compared with the 1.5- to 2-percent
rate we expected on the basis of recent trends, output per hour over
t.he past four quarters has risen only one-quarter of 1 percent.
The weakening of productivity growth added directly to inflation
through its impact on unit costs of production. It added indirectly as
well by contributing- to an exceptionally sharp rise in the demand £or
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labor. In the past :four quarters, the g.ross national product has increased by a little under 4 percent, only moderately greater than the
longer run trend, but employment rose at an extraordinary rate.
About 3.3 million new jobs have been created in our economy_, a~d
the .rate of unemployment has fallen almost a full percentage pomt m
that short period of time. Employment has grown so rapidly, and
unemployment has declined so fast, that upward pressure on wages
has developed as a consequence. For example, the employment cost
index, which rose 7 percent during 1977, increased 8 percent during the
12 months that ended in September. In part, that acceleration is due
to the effects of the increase in the minimum wage last January. However, a significant part came from the sheer speed at which demands
for new workers increased.
Altogether, the direct and indirect consequences of poor productivity growth ,this year probably have added well over a percentage
point to the rate of inflation during 1978.
The second factor underlying the recent acceleration of inflation
has been very sharp increases in prices of food products. Average food
prices at the grocery store have risen more than 11 percent during the
past 12 months, with the sharpest increases in meat products. Beef
supplies have been very limited because of the reduction in cattle herds
over the past 4 years. Moreover, pork production has been unexpectedly low, due in part to the impact of harsh winter weather that also
caused short supplies of vegetables and citrus crops again .this year.
Altogether, these developments jn the farm economy probably added
about three-quarters of 1 percent to the rate of inflation in 1978.
Finally, the depreciation of the dollar in world markets is the final
element contributing to the acceleration of inflation in 1978. Even
after its recent increase, the value of the dollar measured against a
weighted average of the currencies of our major trading partners,
is currently about 14 percent below its September 1977 level ; after adjusting for inflation differentials, the decline is still about 12 percent.
Analysis suggests that such a change in the exchange rate above and
beyond what is implied by inflation differentials would raise the domestic price level, directly and indirectly, by a;bout 1 percent in 1978
and continue to put pressure on domestic price levels, thot1gh with
diminishing force for am,iher year or so.
Let me turn with this background to the structure and rar.ionale of
the President's anti-inflation program to deal with the problem.
The actions which were announced on October 24 indicated clearly
that the Government would take the lead in fighting inflation. That
step was essential. Private cooperation with the pay and price standards proposed by the President could hardly be expected if the Federal
Government itself were unwilling to set its own house in rder if
budgetary policies we are pursuing are designed to create an overall
economic climate in which the pay and price standards ~ill not be
undermined in the marketplace by excess demands.
The steps we are taking in the regulatory area will help control an
important source of cost increases. The key element in the Government's own actions to curb inflation is to pursue· the stringent budgetary policies. Aside from signs that employment growth in the early
months of 1978 was-faster than the economy could digest, ·as I pointed
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out earlier, the inflation problem of the past several years has rn?t been
traceable to classic conditions of excessive demands. But excess1ve demand would become -a problem in the period ahead unless we took
action to restrain the growth of economic activity.
As a consequence, a prudent and cautious and stringent bud~et
policy is essential. This is precisely the kind of policy we are pursumg
and will pursue. The Secretary has spelled <mt what that budgetary
policy is. I need not repeat it.
The goals we have set for ourselves in this area will not be achieved
without very difficult choices among competing demands on Federal
resources. But a strict budgetary stance is essential to success in our
fight against inflation. We have to demonstrate to both business and
labor that their own moderation in private wage and price decisions
will not be frustrated by the measure of excess demands.
These steps in the area of overall economic policy will not alone
be sufficient to stem the momentum of inflation. For that reason the
President also set forth on October 24, standards for wage and price
increases in the private sector that are designed to break the price-wage
spiral and gradually reduce the momentum of inflation.
The standards have been widely publicized and I need not reiterate
them for you this morning.
I will note that we are increasingly encouraged by the response
to the standards that we have received from the public. We have every
indication from frequent consultations and from visits to cities across
the country that businesses are taking the President's standards very
seriously and intend to comply with them.
Although the response from the leaders of labor organizations have
been measured and occasionally critical, we remain convinced that
these standards are sufficiently fair and flexible to warrant the cooperation of America's working men and women. The combination of
firm but measured demand restraint and voluntary wage-price standards gives us the balance we need to deal with the inflation problem
we face.
Demand restraint will provide an overall economic environment
in which excess demand pressures are absent and market forces are
conducive to reduction in inflation. The wage and price standards will
help break the inertia and momentum in wage and price decisions
inherited from the years of inflationary experience. Attempt to rely
exclusively on either wage-price guidelines or overall demand restraint
would be doomed to failure. Wage and price standards would simply
not stand up under the pressure of market forces in the absence of
demand restraint.
In the application of very severe monetary and fiscal restraints, in
order to cure inflation by deliberate creation of a recession wouldn't
work either. Experience during the recessions of 1970, 1974, and 1975
indicate that wage and price increases moderate very little in response
to increasing unemployment until that increase becomes very extensive. A recession would not cure your inflation problem. It would, however, cause the existing political consequences on the need to do something about inflation to evaporate.
We do not need another episode of stop-and-go economic policies
that address neither inflation nor unemployment successfully.
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Curing inflation is going to take patience, persistence and firmness
for a number of years. Extreme solutions, excessively severe demand
restraints on the one side or mandatory wage and price controls on
the other carry within themselves the seeds of their own destruction.
They cannot stay the course.
Because of the economic efficiencies and social costs they impose
they are inevitably abandoned in short order, leaving us with large
costs and few inflation-reducing benefits. The President's anti-inflation program is a measured and balanced approach that can last
the course.
Let me turn, if I may, to the oversea. implications of this program.
At the time that the President's anti-inflation measures were announced, a favorable response in the foreign exchange markets was
generally anticipated. As events unfolded, however, foreign confidence in th_e program was less than we had hoped. Financiers a~d
others abroad may have misinterpreted the firmness of our commitment to reduce inflation, but whatever the reason, the value of ~he
dollar in exchange markets slid dramatically in the days followmg
the October 24 announcement. Had the slide been permitted to persis~,
the resulting inflationary pressure would have underlined the ant1inflation.
The stock market fell from mid-October to the end of October by
more than 100 points and thus caused the weakening of the dollar.
Throughout the economy business and consumer confidence was rocked
by the development of foreign currency markets.
By the fall of this year the devaluation of the dollar had proceeded
far beyond anything justified bv fundamental economic forces. For
example, the magnitude of the decline was not warranted by relative
inflation rates between the United States and our major trading partner~.- Moreover, during the course of 1978, differentials among the
growth rates of the industrial economies had narrowed considerably,
and that trend could be expected to continue in 1979.
Reflecting the, sharp decline in the dollar's value earlier in 1978,
and the relative cha~ge in growth rates, trade flows increasingly have
been moving in our favor. Forecasts of the U.S. current account balance by various international institutions all showed a substantial
improvement in prospect.
For these reasons, the President announced the steps taken on November 1 to reaffirm the U .S. Government's commitment to fight
inflation and to counter disorder in the foreign exchange markets
through active intervention to support the value of the dollar.
The response to the November 1 announcement has been very
heartening. The value of the dollar rose by 8 to 9 percent in the
month following the announcement. Moreover, there appears to be
a genuine recognition abroad that this administration inten~s to deal
forthrightly with the problems facing our economy. I believe that
such a development can only augur well for future developments
.
affecting the dollar.
Let me turn, in conclusion, to the economic outlook for 1979 with
these policies in place.
The actions taken by th~ administration on November 1 have l~d
some observers to forecast a recession in 1979. I can understand their
concerns, but I do not share their forecasts.
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The American economy still is fundamentally healthy and is gro:Ving with considerable momentum. For example, employment gams m
recent months have been extremely large, and pe~on~l inco!lle has
been moving up strongly. The annual rate of gam m retail sales
between the third quarter of this year and the October-November
average was 16 percent. Orders for durable goods, which are an in_dicator of business attitudes as well as a sign of future production
~eve]s, also have been strong. Tr.ese orders have ~isen by 8 percen~ in
Just the past 2 months. Moreover, orders for capital goods have risen
even faster than the total and a.re now almost 30 percent above levels
a year earlier.
Recent surveys of business plans for investment have indeed raised
questions about the strength of plant and equipment early next year.
These advance surveys, however, have sometimes underestimated the
strength of actual investment. There is no slowdown yet evident in
recent orders and contracts for plant and equipment.
Most importantly, the economy today shows few signs of the sorts
of imbalances that can tip it into recession. Inventories are in good
balance with sales; there are few signs of shortages or bottlenecks;
there has been little or no overbuilding of shopping centers, office
buildings or apartments; and liauidity positions of lenders and large
non-financial corporations are relatively good.
An added source of optimism that this expansion will continue is
the fact that financial restraints are not affecting the economy in
the same way that they have in the past. Earlier periods of credit
restraint saw the suµply of funds dry up first in mortgage financing.
As a result, the pinch of credit rationing hit the housing sector
abruptly and with devastating consequences.
Earlier this year, however, financial authorities provided banks
and thrift institutions with the right to issue "money market certificates," relatively short-term certificates of deposit that pay a maximum interest rate somewhat above the rate on ' 6-month Treasurv
bills. As a result, deposit flows into mortgage lenders have remained
strong. And housing starts are as high now as they were a year ao-o,
when interest rates were lower.
·
.
In general. rising nominal rates of interest are proving less dis?uraging to borrowers in the current inflationa.ry environment than
m the past. InterPst rates do make a difference, and it is indeed likely
that investment in housing and in other forms will be restrained
next year by the rise in interest rates that has already occurred. But
there is no reason to expect that credit tightening will have the sort
of disastrous consequences for the housing industry that in the past
have nosP<l th<.> economv clown into recession.
Economic r-rowth ~ilL and should, moderate in 1979 to something
under 3 percPnt. The imnn.ct of slower g-rowth on the rate of unemployment is goinQ" to hing-e imporbmtlv on whether productivity
growth improves substantially, reduciP.!! t.he demand for labor, or
continues at the sluggish pace of 1978. The ontlook for unemplovment is uncertain, but the unemployment ra.te is likely to remain ·i n
the vicinity of 6 percent or perhaps edge up sl;ghtl:v in 1979.
Mr. Reuss, I think I snmmarize<l the essence of my prepared statement and I won]d be r_-lad to answer questions.
rThe prepared stntemrnt of Mr. Schultze fo11ows :]
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PREPARED STATEMENT OF HON. CHARLES
L.
SCHULTZE
I am pleased to appear before this Committee today to discuss the President's
recent initiatives to support the value of the dollar abroad and to reduce the
rate of inflation here at home. Your hearings this week focus on the implications
of the President's actions on November 1 to correct the clearly excessive decline
in the value of the U.S. dollar that bad occurred in earlier months. Those actions
are most appropriately viewed as one part of a larger effort to moderate infl~tion. Therefore, I will begin my remarks this morning by r eviewing the economic
developments of 1978 that underlie the necessity tor the overall economic policies
·
the Administration is pursuing.
THE ACCELERATION OF INFLATION IN 19 7 8
The rate of inflation remained relatively stable-but ur:.comfortably high during the first two and one-half years of the current economic recovery. Movements of food prices sometimes moderated the overall rate of inflation, as in
1976, and at other times aggravated it, as in 1977. Outside of food commodities,
prices of consumer goods and services rose at around 6 to 6½ percent from the
middle of 1975 through the end of 1977.
Increases in compensation for hours worked were also relatively stable during this period, averaging about 8 to 8½ percent per year. During the first year
of the recovery, productivity growth improved substantially, as it typically
does at that stage of the business cycle, and the rise in unit labor costs moderated. By mid-1976, however, cyclical improvements in productivity were largely
over, and unit labor costs-along with prices-were advancing at a 6 to 6½
percent annual rate.
In short, until late in 1977, the underlying rate of inflation hovered around
6 to 6½ percent, and there were few signs that the rate of inflation outside
of the volatile food sector was accelerating.
Early in 1978 signs began to emerge that an acceleration of inflation was
underway. During the most recent 12 months, producers' prices for :finished
goods have risen more than 8½ percent, and consumer prices have increased
almost 9 percent. While sharp increases in the cost of food, housing, and medical care have led the surge in prices, an acceleration in inflation can be detected
across a wide range of items at both the wholesale and retail levels.
The acceleration of inflation in 1978 can be traced to three distinct problem
areas: The very poor performance of productivity, strong inflatJionary pressures
in food, and the depreciation of the dollar in foreign currency markets. I will
deal with each of these areas in turn.
Productivity Growth. Growth in productivity has been slowing in the American
economy for approximately a decade. We were aware of that slowdown a year
ago, and had taken it into account in our calculations of possible price and co t
developments in 1978. But compared with the 1½ to 2 percent rate we expected on
the basis of recent trend'S, output per hour over the past 4 quarters has ri en onI~one-quarter of one percent.
The weakening of productivity growth since late 1977 added directly to inflation
through its impact on unit costs of production; it added indirectly as well by contributing to an exceptionally sharp rise in the demand for labor. In the past four
quarters, the gross national product has increased by a little under 4 percent, only
moderately greater than the longer run trend . But employment rose at an extraordinary rate. About 3.3 million new jobs have been created in our economy, and the
rate of unemployment ha-s fallen almost a full percentage point. Employment ha
grown so rapidly, and unemployment ha declined so fast, that upward pres ures
on wages have developed as a consequence. Ifor example, the employment cost
index, which rose 7 percent during 1977, increased 8 percent during the 12 months
that ended in September. In part, that acceleration is due to the effects of the 15
percent increase in the minimum wage last January. However, a significant part
came from the sheer speed at which demands for new workers increa ed. In a
sense, the economy exceeded the "speed limit" for the growth of jobs and put
added pressure under wages. This speed-limit effect may be transitory-there
already is evidence that wage increases are slowing-but it contributed powerfully to infl,a tion in 1978. Altogether, the direct and indirect consequence of poor
productivity growth this year probably have added well over a percentage point t0
the rate of inflation during U)78.
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The second factor underlying the recent acceleration of inflation has been very
sharp increases in prices of food products. Average food prices at the grocery
store have risen more than 11 percent during the past 12 months, with the sharpest increases in meat products. Beef supplies have been very limited because of
the reduction in cattle herds over the past four years. Moreover, pork production
has been unexpectedly low, due in part to the impact of harsh winter weather that
also caused short supplies of vegetables and citrus crops •a gain this year. Altogether, these developments in the farm economy probably added about threequarters of one percent to the rate of inflation in 1978.
The depreciation of the dollar in world markets is the final element contributing
to the acceleration of inflation in 1978. Even after its recent increase, the value of
the dollar measured against the currencies of our major trading partners is about
11 percent below its year-earlier level. Econometric analysis suggests that such a
change in the exchange rate would increase domestic prices--directly and indirectly-by about one percentage point. Most of that rise has probably already
occurred, but some effects of past depreciation may continue to influence prices
early next year.
It is important to note, of course, that the causal relationship between dollar
depreciation and inflation runs in both directions. The acceleration of inflation in
our country has helped to drive the dollar down and this, in turn, has made the
inflation worse. It has been, and remains, the policy of the United States government to permit exchange rates to be determined by the basic forces of demand and
supply--'so long as markets do not beoome disorderly or clearly out of touch with
the fundamental considerations that determine competitive conditions and trade
and capital flows among countries. In the long run, a system of :floating exchange
rates benefits the United States economy and the rest of the world economy substantially. At the same time, exaggerated movements in the foreign exchange
markets can constitute an independent source of inflationary pressure. As I will
discuss later, that w;as one of the basic reasons for the President's decision to take
action to support the dollar on November 1.
ANTI-INFLATION
ACTIONS
IN
1978
During the course of this year, as the worsening inflation situation became
apparent, the Administration took a series of actions to reduce inflationary
pressures in the economy- The President's original January 1978 budget recommendations reflected his decision to support the economic recovery through tax
reductions while maintaining strict control over the growth of Federal outlays.
As the year progressed, and as the surprising growth of employment and reduction in unemployment became evident, the President concluded that the economy
required less stimulus than he had previously recommended. For that reason,
the Administration, in cooperation with the Congressional budget committees,
recommended in May that the tax reduction enacted last year be reduced to about
$20 billion and r,ostponed for three months. That recommendation ultimately
was concurred in by the Congress as a whole. In addition, growth of Federal
<>Xpenditures during the year fell short of levels originally anticipated in the
President's budget. In light of the Administration's increasing concern over
inflation, no effort was made to restore outlays to the levels originally forecast
in the President's budget. In combination, these deve1opments in expenditures
and taxes constituted a significant shift toward fiscal restraint during the course
of 1978.
At the same time, the Federal Reserve was acting to hold down the growth
of the monetary aggregates. Since economic growth , combined with rising prices,
bad increased the demand for money and credit in our economy, the Federal Reserve's actions to restrain the increase of money and credit translated into very
sharp increases in interest rates. The current interest rate on 6-month Treasury
bills- 9¼ prcent-is almost 3 percentage points above the level in December
1977. Long-term interest rates have not risen as rapidly, but they, too, are significantly above year-ago levels. The Federal Reserve's credit tightening actions
have complemented the Administration's movement toward fiscal restraint, so
that money and fiscal policies are working together in the fight against
inflation.
During the late summer and fall of this year, however, it became apparent
that the inflation problem required more direct and dramatic action. Accelerating rates of inflation in non-food commodities. combined with less relief from
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food prices than we had hoped for, suggested that the inflation problem
had worsened seriously. Moreover, the acceleration of inflation was becoming a serious concern to our trading partners and was undermining the
value of the dollar. After deliberating on a range of possible policy approaches,
the President on October 24 announced a major new anti-inflation program. This
program involves actions both by the Federal Governn, ent and the private sector.
THE PRESIDENT'S ANTI-INFLATION PROGRAM : OVERALL ECONOM I C POLICY
The actions announced on October 24 indicated clearly that the government
would take the lead in fighting inflation• That step was essential. Private cooperation with the pay and price standards proposed by the President could hardly
be expected if the Federal Government were unwilling to set its own house in
order. The budgetary policy we are pursuing is designed to create an overall
economic climate in which the pay and price standards will not be undermined
in the marketplace by excess demand. And the steps we are taking in the regulatory area will help to control an important ,s ource of cost and price increases.
The key element in the government's own actions to curb inflation is the pursuit of stringent budgetary policies. Aside from signs that employment growth
in the early months of 1978 was faster than the economy could digest, the inflation problem of the past several years has not been traceable to classic conditions
of excess demand that stem from Federal deficits that are too large, or growth
in money and credit that is too rapid. But excess demand would become a problem
in the period ahead unless we took action to restrain the growth of economic
activity. Therefore, a prudent and cautious budgetary policy is essential. That
is precisely the kind of policy we are pursuing.
In fiscal 1976, Federal expenditures represented 22½ percent of the nation's
GNP and the deficit was $66 billion, an all-time record. Next January , the Administration will submit its budget for fiscal 1980-the year beginning October
1, 1979. In the context of an overall economy growing at a modernate rate, the
President has set planning targets under which :
The share of total spending in GNP will be reduced to about 21 percent, a
goal originally scheduled to be reached one year later; and
The 1980 Federal budget deficit will be reduced to $30 billion or less.
In addition, the President has stated that he will oppose further reductions in
Federal income taxes until we have convincing evidence of progress against
inflation.
These goals will not be achieved without very difficult choices among competing
demands on Federal resources. But a strict budgetary stance is utterly essential
to success in the fight against inflation. We must demonstrate to both business
and labor that their own moderation in private wage and price decisions will not
be frustrated by the pressure of excess demand.
REGULATORY POLICY
During the past decade, we have expanded dramatically our efforts to protect
the environment and the health and safety of workers and consumers. Clean air
and water, a safe and healthy workplace, and protection for consumers against
unhealthy and hazardous products are important national goals. But we must
recognize that their achievement has added appreciably to costs and hence to
consumer prices. We must not abandon our goals, but we must attain them at a
reasonable pace and without imposing unnecessary costs. With this principle in
mind, the President has stated his intention personally to exercise his authority
if necessary to ensure that the regulatory process is balanced and well managed,
and he has directed important steps within the government to improve the
regulatory process.
Among those new steps is the establishment of a Regulatory Council consisting
of •the regulatory agencies in the Executive Branch. The new Council will be
charged with coordinating the regulatory process in ways that avoid duplicative
or overlapping regulations and with preparing semi-annually a unified calendar
of major regulations. We will, for the first time. have a comprehensive list of
regulations that the Federal government is proposing-together with information on their costs ·a nd objectives. The President also has announced his intention
to work with the Congress to reduce relrolation in the railroad and trucking industries. During the past year, the Civil Aeronautics Board has taken constructive steps to free the airline industry of outmoded regulatory burdens, and the
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Congress has passed and the President has signed an airline deregulation bill.
We must now extend these gains to surface transportation and the Administra•
tion will be presenting proposals to the next session of Congress.
These steps, although significant, will not alone be sufficient to stem the
momentum of inflation. For that reason the President also set forth on October 24 standards for wage and price increases in the private sector that are
designed to break the price-wage spiral and gradually reduce the momentum of
inflation. These standards have been widely publicized, and I need not reiterate
them for you this morning. I would note, however, that the Administration is
increasingly encouraged by the response to the standards that we have received
from the public. We have every indication from frequ ent consultations and from
visits to cities across the country that businesses are taking the President's
standards very seriously and intend to comply with them. Although the response from the leaders of labor organizations has been measured and occasionally critical, we remain convinced that these standards are sufficiently fair
and flexible to warrant the cooperation of America's working men and women.
The combination of firm but measured demand restraint and voluntary wageprice standards gives us the balance we need to deal with the inflation problem
we face. Demand restraint will provide an overall economic environment in
which excess deman d pressures are absent and market forces are conducive to
a reduction in inflation. The wage and price standards will help break the
inertia and momentum in wage and price decisions inherited from the years of
inflationary experience. An attempt to rely exclusively on either wage-price
guidelines or overall demand restraint would be doomed to failure.
The wage and price standards would simply not stand up under the pressure
of market forces in the absence of demand restraint. And the application of very
severe monetary and fiscal restraints-in order to cure inflation by deliberate
creation of a recession-wouldn't work either. Experience during the recessions
of 1970 and 1974-75 indicates that wage and price increases moderate very little
in response to increasing unemployment until it becomes very extensive. A
recession would not cure our inflation problem. It would, however, cause the
existing political consensus on the need to do something about inflation to evaporate. We do not need another episode of stop-go economic policies that address
neither inflation nor unemployment successfully. High rates of inflation have
been with us for ten years.
Curing inflation is going to take patience, persistence. and firmness for a number of years. Extreme solutions-excessively severe demand restraints on the
one side or mandatory wage and price controls on the other-carry within
themselves the seeds of their own destruction. They cannot stay the course.
Because of the economic inefficiencies and social costs they impose, they are
inevitably abandoned in short order, leaving us with large costs and few
inflation-reducing benefits. The President's anti-inflation program is a measured
and balanced approach that can last the course.
RESPONSE TO THE PRESIDENT'S PROGRAM ABROAD
At the time that the President's anti-inflation measure were announced, a favorable response in the foreign exchange markets was generally anticipated. As
events unfolded, foreign confidence in the program was less than we had hoped.
Financiers and others abroad may have misinterpreted the firmness of our commitment to rerlnce inflation. Whatever the reason. the value of the dollar in
eYchange markets slid dramatically in the days following the October 24 announcement. Had the slide heen oermitted to persist, the resulting inflationary
nressures would have undermined the anti-inflation program. The stock market
fell from mid-Ortoher to the end of October by more than 100 points in response
to the weakening of the dollar. Throughout the economy, business and consumer
confidence was rocked by the developments in foreign currency markets.
By the fall of this year the devaluation of the dollar had proceeded far be_:vond
an:vthing justified by fundamental economic forces. For example, the magmtude
of the decline was not warranted b:v relative inflation rates between the United
Rtates and our major trading partners. Moreover, during the course of 1978.
differentials among the growth rates of the industrial economies had narrowed
ronsiderably, and that trend could be expected to continue in 1979. Reflecting
the sharp decline in the dollar's valne earlier in 1978, and the relative change in
growth rate~. trade flows increasingly have been moving in our favor. Forecast~
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of the U.S. current account balance by various international institutionas all
showed a substantial improvement in prospect.
For these reasons, the President announced the steps taken in November 1 to
reaffirm the U.S. Government's commitment to fight inflation, and to counter
disorder in the foreign exchange markets through active intervention to support
the value of the dollar.
The response to the ovember 1 announcement has been very heartening. The
value of the dollar rose by 4 percent in the month following the announcement.
Moreover, there appears to be a genuine recognition abroad that this Adminis_tration intends to deal forthrightly with the problems facing our economy. I believe
that such a development can only augur well for future developments affecting
the dollar.
ECONOMIC OUTLOOK FOR 1979
The actions taken by the Administration on November 1 have led some observers to forecast a recession in 1979. I can understand their concerns, but I do not
share their forecasts.
The American economy still is fundamentally healthy and is growing with considerable momentum. For example, employment gains in recent months have been
extremely large, and personal income has been moving up strongly. The annual
rate of gain in retaH sales between the thi rd quarter and the October- ovember
average was 16 percent. Orders for durable goods, which are an indicator of b~siness attitudes as well as a sign of future production levels, also have been strong.
These orders have risen by 8 percent in just the past two months. Moreover, orders for capital goods have ri en even faster than the total and are now almost 30
percent above levels a year earlier. Recent surveys of business plans for investment have indeed raised questions about the strength of plant and equipment
early next year. These advance surveys, however, have sometimes underestimated the strength of actual investment. There is no slowdown yet evident in
recent orders and contracts for plant and equipment.
Most importantly, the economy today shows few signs of the sorts of imbalances that can tip the economy into recession. Inventories are in good balance with
sales; there are few signs of shortages or bottlenecks; there has been little or no
overbuilding of shopping centers, office buildings, or apartments; and liquidity
positions of lenders and large nonfinancial corporations are relatively good.
An added source of optimism that this expansion will continue is the fact that
· financial restraints are not affecting the economy in the way that they have in
the past. Earlier periods of credit restraint saw the supply of funds dry up first
in mortgage financing. As a result, the pinch of credit rationing hit the housing
sector abruptly and with devastating consequences. Earlier this year, however,
financial authorities provided banks and thrift institutions with the right to
issue "money market certificates," relatively short-term certificates of deposit
that pay a maximum interest rate somewhat above the mte on 6-month Treasury
bills. As a result, deposit flows into mortgage lenders have remained strong. And
housing starts are as high now as they were a year ago, when interest rates were
much lower.
In general, rising nominal rates of interest are proving less discouraging to
borrowers in the current inflationary environment than in the pa t. Interest
rates do make a difference, and it is likely that investment in housing and in other
forms will be restrained next year by the rise in interest rates that has already
occurred. But there is no reason to expect that credit tightening will have the sort
of disastrous consequences for the housing industry that in the past have nosed
the economy down into recession.
Economi~ growth will-and should-moderate in 1979, to something under 3
percent. The impact of slower growth on the rate of unemployment binges importantly on whether productivity growth improves substantially, reducing the
demand for labor, or continues at the sluggish pace of 1978. The outlook for unemployment is uncertain, but the unemployment rate is likely to remain in the vicinity of 6 percent or perhaps edge up slightly in 1979.
We must recognize, also, that when the rate of economic growh slows at this
stage in a recovery, the risks are greater that growth will be slower than expected
than t_hat it will accelerate. The policy path we must walk, therefore, is narrow
and difficult, b~t t~1e _m agnitude of our inflation problem requires us to walk it.
If we make s1gmficant progress in 1979 on the inflation front, as I believe we
will, the dangers we now face of an economy weakened by unbridled inflation
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will lessen. Confidence will improve ; pressures on financial markets will lessen ;
the dollar will strengthen in exchange markets ; and the prospects for continued
recovery will be enhanced. But it will take time before visible results show
through in the price indexes. Food price increases and the pass-through of past
rlepreciation of the dollar into consumer prices may keep the monthly inflation
statistics uncomfortably high for several months. As businesses and workers begin
to cooperate with the President's pay and price standards, however, we expect to
see signs of a significant deceleration in the rate of cost and price increase during
the course of 1979.
CONCLUDING REMARKS
In summary, the sharp acceleration of inflation during 1978 has required the
Administration to alter markedly the course of economic policy. We have not
altered our long-range objectives for the economy, but we have recognized that
we cannot reach our ultimate goals for output, employment, and unemployment
without significant progress against inflation.
Such progress can be attained through a combination of prudent economic
policies to support modest growth and standards to reduce the rate of wage and
Price increase in the private sector. Such a strategy does carry the risk of
some rise in the rate of unemployment, and we recognize that our policies will
not cure inflation overnight. But the course we have laid out can work, and I
believe it will work. And it is far better than the agony of recession or the
nightmare of mandatory controls.
Success over the next year in this program will shift the momentum of inflation in our favor. As ships of cooperation with the President's program appear,
businesses and consumers will begin to plan on declining, not accelerating, inflation. And financial markets will also respond. Together, these events will bolster
confidence in our long-term economic prospects and we will be able to look forward to a strengthening of economic activity in 1980 and beyond.
Representative REuss. Thank you very much, Chairman Schultze.
In last July 24th's U.S. News & World Report there is an interview with you in which the question was asked, "What do you mean
when you say that you are assuming there will be no significant tightening o:f credit :from here on~ What is the significance~" Answer: "I
don't have any specific number and obviously the Federal Reserve cannot simply peg interest rates to some preannounced level. At the other
e.xtreme, i:f interest rates continue to rise at the same clip they have
been rising, that is going to cause trouble."
When you made that statement last July 24, interest rates on 6-month
Treasury bills were 7.27 percent. Yesterday they were 9.20. Interest
rates on Federal :funds, as o:f July 24, were 7.89 percent; today they
are 9.94 percent.
In your prepared statement today you point out that "Recent surveys o:f business plans for investment have indeed raised questions
about the strength o:f plant and equipment early next year."
You also have indicated-and I thoroughly agree with you-that
one of the best ways of getting a long-term handle on inflation is to
increase productivity through investment in new plant and equipment.
Therefore~ my question, "Wasn't Charlie Schultze right on target on
.Tuly 24 when he said that if interest rates continue to rise, that is going
to cause trouble~"
Mr. SCHULTZE. Yes.
Representative REuss. They sure have risen. They had not risen
much before that. They had been quite stable. Now we have had a 20 or
25 percent increase-a significant rise-in interest rates on Treasury
bills; on Federal :funds; in the prime rate; and so on.
Isn't this a serious problem~ Are you indicating "yes"~
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Mr. ScHULTZE. Mr. Reuss, before I respond, let me note an important typo in my paper in which I noted that the dollar had risen
in the month after the action taken in November by 4 percent. That is
not in a month, that is in 1 day. It has risen actually about 10 percent
in the month.
I just wanted to be sure that was recognized.
Representative REuss. That correction is very well received.
Mr. SCHULTZE. With respect to the interview, aside from demonstrating the occasion "unwisdom" of on-the-record interviews, it seems to
me the basic thing that has happened, of course, is that the rate of inflation has significantly accelerated. We were still thinking in April,
May, June, in that area, of an underlying rate of inflation of perhaps
6.5 percent, but with the food price ·bulge, it turns out that the actual
rate of inflation has accelerated significantly so that the increase in
nominal interest rates has indeed occurred, but the increase in real interest rates has been substantially less.
Obviously in terms of measuring the impact-I don't want to subscribe to the doctrine that nominal interest rates are not important,
that real interest rates are the only ones that are important. I think
it is important to deal in context w"ith the rate of inflation having accelerated substantially.
Representative REuss. It is also true, however, that real interest rates
have increased.
Mr. SCHULTZE. Real interest rates.
Representative REuss. Since July.
Mr. SCHULTZE. It depends again where you look. If you look at longterm interest rates-Representative REuss. Let's not look at them-Mr. SCHULTZE. As a matter of fact, it is the other way. In the case
of short rates that is true, but in terms of moving to provide an appropriate level of demand restraint in the face of accelerating inflation,
what has happened has been appropriate. In the case of the situation
in which inflation has not been acccelerating, that is a different kettle
of fish. But, unfortunately, we are not living in that world.
It is undoubtedly true, it is clear that a combination of the budgetary
restraint and monetary restraints which have occurred are · going to
provide, as they are intended, a dampener on the growth of demand
and slow the rate of economic activity growth, but, we think, slowing it
in a balanced way and not overdoing it.
Representative REuss. Let me try to put in sharp focus what I think
is the difference between me an<l the administration on this interest
rate point. I ·am all for you and the Fe<leral Reserve tightening money
and raising interest rates to the extent necessary to combat domestic
inflation. No complaints at all. Right on.
·
Rnt. I gather that on November 1. a new element was added~ namely-and higher interest rates were a portion of the November 1 program-that for international reasons, we shoul <l tighten money and
raise interest rates more than we vonl<l otherwise do for anti-inflati~nary reasons. To that exten~ I think we are going astray. For one
thmg, I can't find any real evidence that capital movements charge
around after the kind of mild extra differential in the intere t ra'tes
tha,t w~ are talking about.
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I can see great danger where interest rates are higher than those
necessary to combat domestic inflation. We get sluggish productivities,
inflation and lack of growth all at the same time. As a result of such
stagflation, capital actually ]eaves this country; it gets out of the
sinking stock market, gets out of the unhappy bond market and withholds foreign direct investment in other ways not contemplated.
So I think we are on a very risky course here without-so far as I
can see-any factual evidence that this old central bankers' whimsy
about high interest rates solving our capital problems.
Mr. SCHULTZE. Mr. Reuss, let me note that I think it is very important to realize that this is not and was not an action taken simply
to try to deal with the dollar by changing-simply by changing the
interest rates and attract capital inflow to handle the problem. In other
words, if that is all it were, you might have a point. But it wasn't.
You have to remember that the 10 percentage point additional devaluation or depreciation of the dollar that we have recovered is worth
on the domestic inflation rate when it works its way through the system-worth a number that is very hard to calculate, but taking into
account all the repercussions something significantly over 1 percentage
point on the inflation rate.
And here is a me.asure of providing in the face of accelerating domestic inflation and of the independent impact of excessive depreciation of the dollar on domestic productivity where you take demand
restraint measures to deal with that problem, which at the same time
do have some-I can't pretend to measure it-on the attractiveness of
capital flows. But I wouldn't suggest that was the major part of it.
Representative REuss. But to the extent that it is a minor part of
it, otherwise the November 1 pronouncements wouldn't have ballyhooed the international effects so much.
Mr. SCHULTZE. But the international effects, Mr. Reuss-Representative REuss. To the extent that the minor part of its was
in excess of what was needed to heroically and rigorously attack
domestic inflation, I think it was a mistake.
Mr. ScHULTZE. I ·am not so sure we are so far apart in terms of the
basic philosophy, but it is in terms of interpretation that attacking
domestic inflation includes not merely what one does to domestic
demands, but in this particular case what one did in term,s of its
impact on demand and changing attitudes and expectations about
the dollar and therefore attacking domestic inflation.
You cannot put it just in terms of creating an interest rate differential itself. That is part of it, but you can't untangle it to what
part is and what part isn't. I think one might say that making a
move all at once like that rather than doing it in a couple of steps
probably did help with the dollar substantially and did and will
have an important ameliorating impact on inflation.
So that is all part of the package. It isn't just creating the differential exchange rates. I can't put weights on it, Mr. Reuss.
Representative REuss. Well, I will not belabor the point, but whatever had to be done from the standpoint of domestic inflation ratesand not enough was done before November 1-had to be done, but
on November 1, there was something extra, and that something extra
as far as I am concerned should be leeched out of our monetary
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policy as quickly as possible lest the prediction you made on July
24-which I find to be extremely thoughtful-comes true.
Specifically, don't you think that in the mix of economic policy
we can well afford to be quite rigorous overall in our fiscal policy
to decrease the deficit, and be a little less rigorous in monetary
policy? We could then get our kicks out of monetary policy because
that is what helps capital investment, and it doesn't create a deficit.
That is what is so nice about it.
So -without getting down to specific numbers, when you are planning the total mix, shouldn't you be a little more rigorous in your
fiscal policy, and a little less rigorous in your monetary policy?
fiscal policy, and a little more rigorous in your
Mr. SCHULTZE. Obviously I think we both agree we need some
elements of both. That is No. 1.
We are now dealing at the margin with the proper mix.
Representative REuss. Right.
Mr. SCHULTZE. It is a very difficult set of calls to make. I would
orrly suggest that as you see the 1980 budget as it comes up, you and
your collea~es will find that there has been, indeed, a major effort
by way of 'rigoring" the budget and that the tradeoff between further rigor there and monetary policy is not quite as easy as it might
sound in the abstract.
Representative REuss. Well, I hope so, very deeply. And in that
context, another place to apply a good mix is on the budget taxing
and spending side; there I should think a mighty broad sword
ought be wielded against those elements in the budget which actually cause inflation. For example-so that I may be clear-Congress,
obsessed by I know not what last fall in its consideration of the tax
bill, in the process of reducing the capital gains tax on common
stocks, which was an excellent thing-more of it should be done, I
think-grossly and drastically reduced the capital gains tax on land,
the most inflationary element in the economy, the price of which
has gone up exponentially, which is deeply responsible for the terrible
inflation in food and housing.
Why do we not repeal that portion of that which we did and put
that $1 or $2 billion sav.ing where it will do the most good?
Mr. SCHULTZE. I think, Mr. Reuss, as you undoubtedly gathered
during the course of the tax debate last year, the administration's
position on capital gains was not precisely the same as that of the
Congress.
Representative REuss. Right.
Mr. SCHULTZE. That was a very long and difficult battle, and it
came out the way it did ,i n terms again of a commonsense approach
to try to get cooperation in a tight budget1 and to reopen that problem-however you or I might feel on capital gains taxes on landI .am not sure would be productive. In fact, I am quite sure it would
be unproductive.
Representative REuss. The President did have good luck with his
veto of the Defense bill to get rid of the B-1 bomber which I think
he rightly thought was a problem.
Mr. ScHULTZE. I understaJ1d.
Representative REuss. I commend that action and I will bring up
another one. We are merrily going ahead paying the States $2 bil
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lion plus £or State revenue sharing at a time when the States, half
of them at least, are getting ready to put potentially inflationary
spending power in the hands of our people by distributing some of
the surpluses they had kicking around.
That is the current preoccupation within Congress. Why do we
supply them with the tickets to do that~ They ought to be giving
us revenue sharing, not the other way around. LLaughter.]
So I really think that more microeconomics, and less macroeconomics, in the budget would be saving grace that could bring us
all together. If that involves vetoes by the President, well, that is
what makes the President look good.
Mr. ,SCHULTZE. As you are aware, the President is prepared ,to use
his veto power appropriately with reason and as is necessary. Let me
note that I expect we could spend a lot of time talking about the particular composition, microcosm composition of the budget as i,t will come
up, although we don't quite know what it is going to be so it is a
little hard to do.
One sidepoint with respect to the States, just an economic point, is
that to the extent the States are reducing property and sales taxes, this
does have a direct impact on CPI.
Representative REuss. Right. To the extent that they are dishing out
income taxes in which-Mr. SCHULTZE. It doesn't. That is correct.
Representative REuss. In which the people who add to the demand
which is hovering over the economy get their pockets filled-Mr. SCHULTZE. I understand-Representative REuss [continuing]. And spend it. You can't tell me
that is a good thing.
Mr. SCHULTZE. That's right.
Representative REuss. And is it really a Wizard of Oz-like economy
in which you can sit around claiming we can't do anything about it~
Mr. ScHULTZE. I am not suggesting we can'it do anythmg about it.
I was suggesting that there are all sorts of difficult calls that are going
to have to be made and I hope we can get general consensuses on it, but
I am sure that there will be a lot of microquestions ,that will arise as
that budget comes up.
Representative REuss. Thank you.
Mr. Hamilton.
Representative HAMILTON. Thank you very much, Mr. Reuss.
Mr. Schultze, a moment ago you were talking about the veto. I asked
Secretary Blumenthal about the mandatory wage and price controls.
You have probably seen the public opinion polls that show an increasing number of people support mandatory wage and price controls. If
the Congress were to pass such a bill, would the President veto it~
Mr. SCHULTZE. Mr. Hamilton, I have learned from long experience
that it probably isn't good policy for an administration official before
anything ever happens to say what the President will or will not veto.
But in this particular case, in this particular case I am convinced he
would get a unanimous recommendation from his economic advisers to
veto it and I am convinced he will veto it.
Literally, it is so out of the can of what we want to do we have not
even ,talked about the possibility of a veto. I can't imagine given what
I have heard from the chairman and the members o:f the two commit
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tees who would -be involved, I can't conceive of it ever getting out of
committee. Let me make one other point on mandatory wage and
price controls.
I have seen the polls which indicate people in general seem to want
wage and price controls. I think I would be willing to bet more than
a single good dinner, several good dinners, that that would last somewhere between 6 months and a year. I don't know the number, but I
suspect there are probably 5 million commodities of different kinds
in this country.
While for 6 months you can find ways of putting lids on them
in some mandatory across-the-board sense, it will gradually deteriorate. Quite apart from the economics of it, the social and political
pressures, et cetera formally to get rid of them or to do the same
thing by issuing interpretation, would be so great that we maybe
would by ourselves in 6 months, maybe 9, and would end up putting
the economy in a straitjacket and get nothing out of it.
So that popularly would be very evanescent as we found in 1971.
Representative HAMILTON. You have a lot of business people who
expect mandatory wage and price controls to come about. You have a
lot of people that want them. Would it, therefore, make sense for the
President just to say now he will veto it if it comes up~
Mr. SCHULTZE. I think-although I don't actually remember him
saying it in that way-he has sure indicated his strong hostility and
opposition to it. I don't even want to say it that way, because it does
kind of imply that maybe he will be faced with it and literally I can't
imagine it even getting out of committee.
I could be wrong. I have been in the past.
Representative HAMILTON. I appreciate your very clear statement on
it, Mr. Schultze.
Let me ask you a question or two about this real wage insurance. I
may not be up to date on that. You have not actually submitted that
to us yet; have you~
Mr. SCHULTZE. We have not. We are in the process of. drafting the
detailed specifications. We are discussing it with the staffs and the
members of the tax-writing committees, but we have not sent it up yet.
Representative HAMILTON. Can you make any comment to us about
who will be covered under it and who will not be covered~ For example, another big factor discussed is the cost of it. Could you comment a little about it to the extent that you feel that you can~
Mr. SCHULTZE. It is very difficult to be specific until we have, you
know-to speak out ahead of that which we are now working on. ·
Let me note several things that, in effect, all employees would be
eligibl~ in the sense if they, as a group, comply with the basic 7percent standard.
Representative H AMILTON. But that would not include self-employed
. people~
Mr. SCHULTZE. No, ther e is no way of doing that.
.
With respect to the cost, it again depends on precisely how you wn~e
it. There is some self-limiting aspect to it. It is not complete. That 1s,
if you have very widespread participation and observance of the
standards, the likelihood of getting a price increase significantly over
7 percent is pretty low. On the other hand, if not, many people observe
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the standards, the likelihood of having to pay out is fairly high, but
the number you have to pay it to is fairly low. I don't want to suggest
there is no risk of payout. There mj ght well be, but it does ha e !=;ome
very important self-limiting feat ure .
.
Representat ive H AMILTO r . The discussion in the p ress was that tlus
ideu.. the real wage jnsurance propo~a1 , really did not o-ct very much
di scus. ion and lebate within the administration prior to its announcement.
The fact that you are fairly slow in giving us the details of it would
add some credence t o that. Was it a thorouo-hly discussed, thoughtout matter within the administration ?
Mr. SCHULTZE. Yes, sir, it was. I think - Representative HAMILTON. If so, why haven't we had more detai!R
on it right after the statement of it?
Mr. SCHULTZE. Let me put it this way. I think one of he thino-s that
puzzled people was that ev ry other part as far as I can t ell of t hat
particular program that the President announr.ed on October 24 found
its way into the press before the P resident announced it. T his one
didn't and therefore there is some view, well, this mu t have come in
at the last minute. I guess I "·ou]d have to say-it didn't come along
late in the game. It came along some.what later than some other eleme~1ts. Th3:t is, we were discussing the wao-e-price ?tandards for: a long
penod of time before the real wage insurance, . o m that ense 1t came
along later. But it was subje ted to a good bit of analysis.
What we did not have and what proves complex is t ranslating it
into specific legislative lano-uage. That does take some time.
Representative HAMILTON. You mentioned quite a bit in your prepared statement about productivity and you identify that as one o:f the
factors which accelerated inflation. ,vhat do vou recommend with respect to Government action to increase productivity?
Mr. SCHULTZE. vVell, I fir t have to start by saying there are literally
no nice, neat buttons you an push and get productivity going. There
are things we can do to influence the climate and a number of other
thino-s. I will discuss some of those.
I would pay particular attention, I think to three. F irst, the tax
bill that the Congress did pass even though there is some quarrel about
the composition of it, nevertheless dtid provide some $7 to $7.5 billion
in reduced taxes on income from capital, which should provide incentives to investors, which in turn is important to productivity.
Second, up until about 1 year ago, I hope I have my dates right-but about 1 year ago for the 10 years prior to that the real value o:f
governmental support for research and development had declined. If
you adjust for inflation, Government investing in R. & D. declined.
Since there are a number o:f areas, particularly in the basic area of research and development, where it almost has to be supported by Government, that probably did contribute to the productivity decline. Even
in a tight budget the real research and development expenditures
should increase.
·
. They did last year and they should increase again. So the presumption-Representative HAMILTON. I n the new budget it does?
Mr. SCHULTZE. I hope I am not going beyond mysel:f because I have
not seen final markups, but I think so. I will make that qualification.
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But the basic premise is that we are interes~d in turning around that
real decline in research and development.
The third thing is an ephermeral thing. It is not something you pass
a piece of leg,islation on, but I think productivity is importantly related to being willing to undertake new things, innovation, risk, and
quite apart from investment, incentives that depend, I think, on a
climate in which business firms have some sense of be.ing able to plan
for the future with some kind of stability. And I think a program, a
moderate, firm, restrained program which tries to give us p~om~se.of
sustamed and reasonable economic growth with some reduction mmflation, as we proceed to demonstrate that, I think it will instill the
confidence needed to take the steps which are very important to raising
productivity.
Representative HAMILTON. Would you, therefore, expect productivity to begjn to turn up in 19791
Mr. ScHUL'l'ZE. I would certainly hope so. It only grows at about a
quarter percent, less than half a percent in the prior 4 quarters.
I would certainly hope and expect it would grow faster. On the other
hand, I have to say that the fact of, first, the longer term decline over
the past 10 years and then the very specific 1-year decline last ~ear
makes one very cautious in predicting that turnaround as a position.
But, yes, I would, but I would be cautions in predicting a very large
one initially.
Representative HAMILTON. Looking at those three factors that you
singled out that accelerated inflation in 1978, the appreciation of the
dollar ought to improve 1
Mr. ScHULTZE. That is correct.
Representative HAMILTON. You suggested productivity may improve modestly 1
Mr. SCHULTZE. Yes; that's right.
Representative HAMILTON. And food, I guess, is much tougher to
call. Do you have any call on food for 1979 i What is your projection
on thati
Mr. ScHULTZE. Well, not a call, I am not prepared to make such a
call in a quantitative sense at the moment.
We are in the throes of trying to nail down our formal forecast. This
year food prices have been rising something like 12-13 percent annually. I am con~dent it_ '"!ill be significantly lower than that next year,
but I am not yet ma position to throw it up for you.
Representative HAMILTON. Mr. Schultze, if I have the time; let me
observe on the part where you talk about being increasingly encouraged by the response to the standards, you indicate that businesses at
least ~1ave sugges~ed t_hey are going to comply. Then you say that leaders of labor orgamzat10ns' response has been measured and occasionally
critical.
. My impression is that labor. has been rather vociferous and rather
constantly critical. What do you mean "occasionally critical and
measured" i I just had the impression that organized labor has not
given too much cooperation at all on the standards. Is that a false
impression i
Mr. SCHULTZE. It has varied. Mr. Meany, as even a casual reader of
the newspapers can note, has been in opposition. You note in his oppo~
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sition he has reiterated the fact that he is not asking his individual
union presidents, the leaders, not to cooperate. He is expressing hi:::i
personal opposition. But of course, the basic bargaining strategy and
everything else is determined union by union.
So the statements that have been made by the president of the Communications Workers, the Auto Workers and Teamsters have varied,
but basically they have had significant notes of cooperation in the1;t1,
It is not to suggest there isn't beginning to be, you know, a year rn
which there will be difficult negotiations and I don't want to be a Pollyanna, but I don't think one can take just Mr. Meany's statements as
an indication of how labor will deal with this.
As I say, even Mr. Meany indicated that he is not asking for cooperation ,by the unions.
Representative HAMILTON. Does the real wage insurance proposal
become critical in labor's attitude toward these standards i
Mr. ScHULTZE. I think it is very important, not mereiy in terms of
organized labor, but also in terms of cooperation from management
and workers in whatever it is, approximately 70 percent of the labor
force that isn't organized.
Representative HAMILTON. Thank you, Mr. Reuss.
Representative REuss. I share Mr. Hamilton's feeling that it is too
bad that the real wage insurance program isn't now before the Congress. Specifically, it seems to me that it would have been useful to have
had even a lameduck Ways and Means Committee, or .Finance Committee, considering it now so that Congress could act very promptly
on January 15.
What I fear is that you are going to have teamsters and oil workers
and everybody else negotiating early in 1979 without the benefit of a
real wage insurance program. I presume Congress will <lo a little 1b etter
than it did on the energy bill, which took 2 years, but-Mr. SCHULTZE. If it doesn'·t , then-Representative REuss. What does poor Mr. Kahn, or whoever, tell a
union that is negotiating tJhat he can't produce a bird in the hand on
the real wage insurance program~
Mr. SCHULTZE. Mr. Reuss, we are, as I indicated earlier, now in the
process of not merely doing or working on it ourselves and we have
done an awful lot, but we are now discussing it with the staff of the
relevant tax-writing committees and with the members, and hope to
have something up basically as the Congress gets here i:f not before. So
that you are quite right, it is an urgent matter in tern~s of speed.
We are aware of that and are working already cooperatively to have
something.
Representative REuss. Well, I wish it could have been faster.
Let me go into one of those boring arithmetical exercises.
I am having difficulty in seeing this $30 billion deficit which you prefigure for fiscal 1980. Tell me where I am going wrong, if you will.
'J.lhat $30 billion difference between spending of $535 billion, and receipts of $505 billion. Revenues of that order suggest a GNP of about
$2.6 trillion, but to get there the economy is going to have to grow jn
nominal terms at around 12 percent a year.
Since you have a target infl.a;tion rate of 6.5 percent, that sounds like
a real growth rate of 5.5 percent, and this is much higher than anyone
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is predicting. So what my arithmetic leads me to suggest is not -a $30
billion deficit, but one of those awful $50 billion or so deficits.
Wherein am I going astray?
Mr. ScHULTZE. At ,the l!loment I can't go through the arithmetic with
you. Let me simply note-again without wanting to indicate that those
are the specific numbers one would have to have-the kind of increases
of revenues you are talking about, •a nd we have done our homework,
don't require anything like that nominal GNP.
In terms of specific numbers I am not prepared to go through with it
here, but we see a 12-percent growth in nominal GNP is just not required to get there. We don't.
I would have to go back and go through the arithmetic. There
are a number of things occuring: On the one hand, you have a tax
reduction coming in ; on the other hand, you have an increase in the
social security taxes coming in, but I would have to go back and do my
own homework to see exactly where the arithmetic is off. But I know
12 percent doesn't jibe with what we think is necessary to get there.
Representative REuss. Well, we are all going to learn a lot in the
next 60 days.
Representative Fenwick.
Representative FENWICK. Thank you, Mr. Reuss.
I am really puzzled. We have been told by witnesses coming before
this committee that the automatic rises in the sociail security, minimum
wage, are highly inflationary, that we have been cautioned that we
should have not taken those steps, we should have done it when it was
appropriate by vote rather than linking it to cost of living and other
indexes and that is very inflationary.
Now, we are going to add real wage insurance, which I understand
is going to affect it. Isn't that another inflationary push? What do you
feel about the rise in the minimum wage and social security tax and
the social security benefits tied to the cost of living? Are these not all
inflation causes?
Mr. SCHULTZE. Let me respond on several points. One, with respect
to real wage insurance. It is not, I underline, an escalator-type
provision.
Representative FENWICK. What is it?
. Mr. S~HULTZE. In fact, it explicitly is directed toward giv~ng s?me
kmd of msurance to those who take action to help reduce mflation.
It is not a way to limit inflation. It is unlike the other escalators,
precisely addressed to those who take action to reduce their real wage
increases. Therefore, it is quite different from an escalator.
Representative FENWICK. You say it stays within 7 percent?
Mr. SCHULTZE. That's right.
Representative FENWICK. So, in other words, it would compensate
those who stay at 7-percent rise in inflation caused by others who don't;
is that it?
Mr. SCHULTZE. That is the basic idea. Again only the rise over 7
percent, it doesn't compensate up and down.
Representative FENWICK. Would that be automatic or do we have to
vote on that?
Mr. SCHULTZE. Yon wonkl have to get there on the law---excuse
me?
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Representative FENWICK. Would that ,become automatic?
Mr. SCHULTZE. No; we would not propose to have this as a long-term
thing that becomes automatic. vVe might want to ask for it for 2
years, maybe 1 year, but clearly it would not be a long-term automatic
program.
Representative FENWICK. What do you feel about the rise in the
social security tax and the minimum wage as an effect on human
production?
Mr. SCHULTZE.Well, let me note that with respect to the rise in social
security taxes that in 1977 when this was clearly necessary to do something about the system, the administration had proposed in a modest
way a particular way of injecting general revenues into the system
to moderate that. It was not a large amount, but it was a good programing.
The Congress couldn't even get it considered, to my recollection.
Representative FENWICK.Would you advise that?
Mr. SCHULTZE. Pardon.
Representative FENWICK. Will you advise that?
Mr. SCHULTZE. Again I submit at this stage it is a bit like the answer
to the chairman on capital gains taxes on land. At this stage the Congress has spoken. However, let me note that there are large increases
in social security taxes coming up again in 1981 and I don't want to
suggest-in fact, I am fairly sure the administration and the Congress will be wanting to take a look at that whole thing. On the other
hand, in terms of reversing an immediate action taken by the Congress, that is another matter.
Representative FENWICK. I know what has happened, Mr. Schultze.
I am asking you what you would advise?
·
Mr. SCHULTZE. I am saying that in terms of the upcoming budget
and the upcoming year, the deficit considerations are such that to reduce social security taxes to get rid of some of those increases in the
year ahead, I don't see how they could be fitted into a reasonable fiscal
µoli cy. If you look at seveTal years, that is another matter and there
is a chance, but not in 1979.
Representative FENWICK. I see. I want to go to another subject, cost
of food.
Some 4 years ago Lewis Engman, I think Chairman of the Federal
Trade Commission, said that if we could make food exempt from the
ICC regulations, as all fresh produce is now, we would cut the cost
of its distribution by some 35 percent. This happened when fresh
chickens were declared to be, as you know, fresh produce and the cost
of distributing- them dropped by that amount.
What would you think in an effort of eliminating inflationary costs
for food, if all food, processed and fresh, were exempted and could
be carried .without regard to the Inte.rstate Commerce Commission?
Mr. SCHULTZE. As you know, the President has indicated he is going
to be submitting legislation in the area of regulatory Teform in the
surface transportation-rail and truck, in other words.
At this stage, since I must confess I have never thought of that particular approach, I don't know whether it would be the most effective
way of dealing with it. However, I do want to make the caveat that
there may be better ways to get deregulation. There is nothing magic
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in food, per se. I:f you save the consumer whatever it is, maybe $100
a year, it is important to save the consumer $100 a year, and it may
be better to do it in more ways that are general than to pick one
commodity.
I am making the caveat on :food.
Representative FENWICK. Of all things that is the one thing we
would want to work on.
Thank you, Mr. Reuss.
Representative REuss. Thank you. Taking notice of your important
date, we thank you very much, Mr. Schultze. As always, you have been
a super witness, and we want to wish you a Merry Christmas and good
luck, and remember that word "micro."
Mr. ScHULTZE. Yes; I shall. Thank you.
Representative REuss. Thank you. ·
We will reconvene here at 2 o'clock for the oontinuation of this
hearing.
[Whereupon, at 11 :54 a.m., the subcommittee recessed, to reconvene
at 2 p.m. the same day.]
AFTERNOON SESSION
Representative REuss. Good afternoon.
The subcommittee will be in order for its continued hearings on the
dollar rescue missjon and its domestic imolications.
We are honored to have before us a blue-ribbon panel of witnesses:
Mr. Hendrjk Houth9kker of Harvard lTnjversity; Leon Kevserling,
president of the Conferenec on Economic Progre.ss; RobP-rt Solomon,
senior fellow at Brookings; and Thomas Willett, professor of economjcs, Claremont Graduate School.
Thank you for getting to us vour verv helpf11l nrepared statements
which, under the rule and without objection, will be received in full
and placed in the record.
I would now like to ask each member of t1'e panel to proceed, trying
to restrict, if possible, his summary to 10 minutes or so, and then we
will have an ooportunity to ask questions.
Mr. Houthakker, would you lead off~
STATEMF-NT OF HENDRJK S. HOUTHAKKER, HENRY LEE
PROFESSOR OF ECONOMICS, HARV ARD UNIVERSITY
Mr. HouTHAKKER. Thank you, Mr. Reuss.
I am always.grateful for the opportunity to appear before you and
perhaps I may remind vou that·nnlike most economists, I was never
a proponent of free and floating rates and preferred a reform of the
Bretton Woods system to make it more flexible.
However, when the necessary reforms were not undert~ken and the
Bretton Woods system collapsed, my view was that floating rates
should be used to best advantage, and that Government intervention in
the exchange markets should be kept to a minimum.
The theoretical case £or floatjng rates was based on the notion that
countries could combine full employment and price stability with
equilibrium in the foreign exchange markets, surely the best of all
possible worlds. Actual experience during the last 5 years has hardly
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confirmed these claims; indeed, it would be more correct to say that
the opposite happened.
In most industrial countries -inflation and unemployment levels have
been at higher levels than at any time since World War I. Unemployment has been at its greatest level since the Great Depression. Surplus~ and deficits in the balance of payments have been at least as
persistent, and often larger, than they were under Bretton Woods.
A cynic might well say that floating ra.tes have brought us the worst
of all possible worlds.
Not being a cynic, I would not want to draw this conclusion, nor
would I attribute all the present ills of the world economy to floating
rates. It seems fair to say, however, that the leading countries of the
world have simply been unable to ·adjust their economic policies to the
prevailing re_gime.
The proponents of floating rates will no doubt say that if they have
not worked, it is because there has been much government intervention. There is much merit to this view. Too many countries have tried
to prevent the appreciation of their currency by massive :purchases of
dollars, and some of them even have deliberately kept their economies
below the full employment level with a view to maintaining exports
and holding down imports.
The United States, however, has by and large played the floating
rates game by the theoretical rules. Yet at the beginning of last month
we were also forced to reverse the nonintervention policy.
The economic theory underlying floating rates assumes that the
foreign exchange markets are stable, both in the short run and in
the long run. The experience with the last several years has belied
this assumption, particularly as regards shortrun stability, although
there is as yet little reason to question the longrun stability of the
exchange markets. The shortrun instability appears to be so overwhelming that the longrun is largely of academic interest.
The reason for the shortrun instability of the exchange market is
threefold:
1. The lags in the adjustments of exports and imports to changes in
exchange rates are fairly long, probably of the order of 2 years. In
the shortrun, the effect of depreciation or appreciation is often
perverse.
2. The capital movements associated with changes in currency values are frequently destabilizing, a factor aggravated by the huge size
of private holdings in the world capital market.
3. Most countries are unwilling to leave the size of their imports
and exports to be determined by market forces only.
Of these three reasons, the first two are probably decisive.
While I believe that the only permanent solution to these international monetary problems is a return to a suitably modified Bretton
Woods-type system, I have no wish to exaggerate the present di~ culties. Despite the serious shortrun instability that has become obvious to most observers, tp.ere are signs of return to bette:r bala~ce.
The depreciation of the dollar, in particular, has led to an mcreasmg
demand for our exports exceeding the growth in our imports. If
continued this development could bring us close to balance in the
current ac~ount within 1 year.
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This outcome could be made more likely if countries such as West
Germany and Japan fulfill their promises of more stimulative domestic policies, and if we ourselves put our energy policies on a more rational basis by permitting domestic oil and gas prices to rise to wor Id
market levels.. With this relatively optimistic prognosis in mind, I
·
would like to turn now to the recent intervention.
First of all, I commend the administration and the Federal Reserve,
not only for taking strong action when it was needed, but also for not
doing much of anything until that time. A substantial depreciation of
the dollar was necessary to bring our current account into better balance. It would no doubt have been better if other countries, especially
Japan, had been more cooperative in increasing their imports, but in
the absence of such cooperation, we had little choice.
·T he administration can be criticized, though, for making occasi<?nal
statements suggesting intervention when there actually was no serious
intention of intervening; the only effect of these tactics was to undermine credibility and to make the private international capital ~a~kets more susceptible to instability. In foreign exchange markets it is
action, not words, that count.
In October 1978 it became clear that private international capi_tal
movements were getting out of hand. The statistical data against which
this inference should be tested will not be available for several months~
but the behavior of the exchange markets spoke for itself. The Swiss
franc, the favorite counterpart for speculation against the dollar, rose
by leaps and bounds, rising to a premium of more than 30 percent over
the German mark.
The newspapers were full of statements by presumably responsible
financiers implying that the dollar had no way to go but down.
These prophesies threatened to become self-fulfilling. Moreover, the
dollar was falling to a level much lower than needed to restore current
account balance, and the depreciation itself was beginning to pose a
serious threat to domestic price stability in the United States.
Whether by foresight or by procrastination, the administration h~d
waited until it saw the whites of the enemies' eyes. Not only was its
a.ction of November 1 perfectly timed, but it also was sufficiently mas·
~iv~ to convince a demoralized market that the United States meant
business at last.
H~ving put on record my strono- general approval of the il\tervention of November 1, I should nevertheless raise a few quest10ns
about the components of the intervention package. The increase in
the discount rate and in the reserve requirements was entirely appropriate; until that time interest rates had been kept at an unduly low
level, at which the r eal return on assets was negatjve, given our
inflation rate.
We are now at last seeing the positive real rates of. return without
which domestic price stability is not conceivable. No doubt these
monetary actions have increased the risk of a recession, but in my
opinion not to an unacceptable extent. In fact, the administration
could have done something on the domestic front and also had a more
restrictive fiscal policy.
.
I am less enthusiastic about the various international credit transactions that were an important part of the November 1 measures. While
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there is no great harm in drawing on the International Monetary Fund,
t~1e previous experience with Roosa bonds should have suggested considerable caution in borrowing in foreign currencies. The interest rates
3:broad may be attractive, but there is a considerable currency risk in
hght of the apparent long-run tendency toward depreciation of the
dollar.
. Another component of the November 1 package was an increase
m Treasury gold sales. This was a wise decision; indeed, I would have
gone further and introduced weekly sales at a rate of, say, 1 million
ounces per week. The U.S. gold stock stands at about 275 million
ounces, worth more than $55 billion at present prices.
I am certainly not suggesting that this is the course we should
adopt. It should be recognized, however, that the gold serves no
purpose whatever unless it is used at least occasionally. Our international reserves consist almost entirely of gold; if gold is not used 1
we have no reserves to speak of.
Of course, I am not suggesting that we return to the gold standard 1
but greater reliance on our gold stock would have considerable advantages over borrowing abroad. Since the gold does not earn any interest, the cost of using it is very low. To the extent that individual
investors want to hold gold as a hed_ge against inflation, it would be
in the public interest to make it available to them rather than keep
it unproductively in Fort Knox.
Gold no longer has any role in the internaitional monetary system;
it has become simply -a commodity of which we happen to hold a large
stock because of past history. The idea of selling gold by regul,a r auctions is basicially sound; ~f the price of gold were to drop sharply, we
could always suspend the auctions. Greater emphiasis ·on Treasury gold
sale,s would also serve to remind the international capital markets of
our assets position.
While I am fairly optimistic concerning :the immediate prospects for
the dollar, I do not think we ·a re out of the woods in the longer run.
International monetary reform should remain high on our agenda, but
the results are not likely to be visible soon. Moreover, we should
strongly resist foreign pressures to run our economy at .a lower level of
employment merely to preserve the external value of the dollar.
We need effective :mti-inflrution policies for domestic roorons, but
the question of the exchange rate is ·a n entirely separate one. The fall in
the doUar is not primarily the result of higiher inflation in the United
Strutes; even now our infl.ation rafo is not substantially different from
the average of other industrial countries. When it comes to the point,
the world at large has a greater interest in continued real growth in
the United States than it has in the ext~rnal value of tJhe dollar.
In summary, our international economic policies should continue
to be governed primarily by domestic considerations, including both
price stability and full employmoot. Until there is agreement on a new
internation·a l monetary ssytem, we should not lock ourselves into any
particula;r external value of the dollar, and intervention should be
practiced only in cases o:f short-term instability. It is only by this strategy that we can hope to induce other countries to pursue similar domestic policies, -and to protect our own interests if they fail to see
things our way. Thank you.
[The prepared statement of Mr. Houthakker follows:]
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PREPARED STATEMENT OF HENDRIK S. HOUTHAKKER
U.S. Policy Toward the DolZar
Mr. Chairman, I am as always grateful for the opportunity to appear before
your subcommittee, which has done so much over the years fur a better understanding of international monetary affairs. Perhaps I may start out by reminding
you that, unlike most economists at the time, I was never a proponerut of freely
floating rates and preferred a reform of the Bretbon Woods sysrem to make it
more flexible. However, when the necessary reforms were not undertaken and
the Bretton Woods system collapsed, my view was that floating rates shoold be
used to best advantage, and thrut ,government intervention in the exchange
markets should be kept to a minimum. Although floating rates 'had come into 1bcing
by default rather than by design, here at least was an opportunity tx> rtest the
claim of the .propcments that they would permit simultaneous attainment of internal and external balance. The theoretical case for floating rates was ba ed
on the notion that countrie could combine full employment and price tability
with equilibrium in the foreign exchange markets, surely the best of all po sible
worlds.
Actual experience during the last five or six years has hardly confirmed thes~
claims; indeed it would be more correct to say that the opposite happened. In
most industrial countries inflation has been at higher levels than at any time
since World War I. Unemployment has been at its greatest level since the Great
Depression. Surpluses and deficits in the balance of payments have been at
least as persistent, ~nd often larger, than they were under Bretton Woods. A
cynic might well say that floating rates have brought us the worst of all possible
worlds.
Not being a cynic, I would not want to draw this conclusion, nor would I
attribute all the present ills of the world economy to floating rates. It seems fair
to say, however, that the leading countrie of the world have simply be n unabl
to adjust their economic policies to the prevailing regime. In fact, the only countries that have operated floating rates successfully are those in the southern
part of Latin America where inflation has become endemic.
The proponents of floating rates will no doubt say that if they have not
worked, it is because there has been much government intervention. There is
much merit to this view. All too often countries have tried to prevent the appreciation of their currency by massive purchases of dollars, and some of them even
have deliberately kept their economies below the full employment level with a
view to maintaining exports and holding down imports. The United States,
however, has by and large played the floating rates game by the theoretical
Tules. Until recently we have intervened very little, while working towar<l:s full
employment and indeed coming close to accomplishing it. Yet at the beginnmg of
last month we were also forced to reverse the non-intervention policy.
The economic theory underlying floating rates assumes that the foreign exchange markets are stable, both in the short run and in the long run. The
experience with the last several years has belied this assumption, particularly
as regards short-run stability, but there is as yet little reason to question the
long-run stability of the exchange markets. The shor-run instability appears to
be so overwhelming that the long-run is largely of academic interest. The reason
for the short-run instability of the exchange market is three-fold :
1. The lags in the adjustments of exports and imports to changes in exchange rates are fairly long, probably of the order of two year . In the very
short run, the effect of depreciation or appreciation is often perverse.
2. The capital movements associated with changes in currency values are
frequently destabilizing, a factor aguravated by the huge size of private
holdings in the world capital market.
3. Most countries are unwilling to leave the size of their imports and
. exports to be determined by market forces only.
Of these three reasons, the first two are probably decisive. If there were more
stability, countries might als'◊ be more willing to let foreign trade take its
course. As it is, they intervene because they are not willing to entrust the fate
of their econoonies to a long-run stability that has not been demonstrated. Since
the interventions by different central banks tend to be contradictory, they are
themselves a further source of short-run instability.
Although I believe that the only permanent solution to the e international
monetary problems is a return to a suitably modified Bretton Woods-type system,
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59
I have no wish to exaggerate the present difficulties. jDespite the serious shortrun instability that has become obvious to most observers, there are signs of a
return to better balance. The depreciation of the dollar, in particular, has led to
increasing demand for our exports exceeding the growth in our imports. If
continued, this development could bring us close to balance in the current account
within a year. This outcome could be made more likely if countries such a s West
Ger,many and Japan fulfill their promises of more stimulative domestic policies,
and if we ourselves put our energy policies on a more rational basis by permitting
domestic oil and gas prices to rise to world market levels. With this relatively
optimistic prognosis concerning our current account_ in mind, I would like to
turn now to the recent intervention.
First of all, I commend the Administration and the Federal Reserve, not only
for taking strong action when it was needed, but also for not doing much of
anything until that time. A substantial depreciation of the dollar was necessary
to bring our current account into better balance. It would no doubt have been
better if other countries, especially Japan, had been more cooperative in increasing their imports, but in the absence of such cooperation we had little choice.
The Administration can be criticized though, for making occasional statements
suggesting intervention when there actually was no serious intention of intervening ; the only effect of these tactics was to undermine credibility ad to make
the private international capital markets more susceptible to instability. In for
foreign exchange markets it is action, not words, that count.
In October 1978 it 1.J ecame clear that private international capital movements
were getting out of hand. The statistical data against which this inference
should be tested will not be available for several months, but the behavior of the
exchange markets spoke for itself. The Swiss franc, the favorite counterpart
for speculation against the dollar, rose by leaps and bounds, rising to a premium
of more than 30% •o ver the German mark. The newspapers were full of statements by presumably responsil.Jle financiers implying that the dollar had no way
to go but down. These prophesies threatened to become self-fulfilling. Moreover.
the dollar was falling to a level much lower than needed to restore current
account balance, and the depreciati<on itself was beginning to pose a serious
threat to domestic price stability in the United States. Whether by foresight or
hy procrastination, the Administration had waited until it saw the whites of the
enemies' eyes. Not only was its action of November 1 perfectly timed, but it also
was sufficiently massive to convince a demoralized market that the United States
meant business at last. In the few weeks since November 1, the exchange markets
have been remarkably quiet.
Having put on record my strong general approval of the intervention of November 1, I should nevertheless raise some questions about the components of
the interventi on package. The increase in the discount rate and in the reserve
rt'quirements was entirely appropriate; until that time interest rates had been
kept at an unduly low level, at ,vhich the real return on assets was negative,
given our inflation rate. We are now at la t seeing the positive real rates of
return without which domestic price stability is inconceivable. No doubt these
monetary actions have increased the risk of a recession, but in my opinion not
to an unacceptable extent. Except for the abnormally low savings rate, our
do1;1estic ec~nomic performance has been reasonably well balanced, without the
build-up of mventories that bas usually been the immediate cause of a recession.
Indeed. I feel that the AdminiRtration could have gone further in this direction
nnd also announced a more restrictive fiscal policy.
I am less enthusiastic about the various international credit transactions that
were an important part of the November 1 measures. While there is no great
harm in drawing on the International Monetary Fund. the previous experience
with Roosa bonds should have suggested considerable caution in borrowing in
foreign currencies. The interest rates abroad may be attractive, but there is a
considerable currency risk in light of the apparent Iongrun tendency towards
depreciation of the dollar, a tendency that has been apparent from econometric
studies for several years.
Another component of the November 1 package was an increase in Treasury
~old sales. This was a wise decision: indeed, I would have gone further and
rntrodnced weekly sales at a rate of, say, one million ounces per week. The U.S.
gold stock stands at ahoot 275 million ounces, worth more than 55 billion dollars
at present prices. This amount would be large enough to cover our current
account deficit for a number of years, although I am certainly not suggesting
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60
that this is the course we should adopt. It should be recognized, 'h~wever, that
the gold serves no purpose whatever un~ess it is used_ at lea~t occasionally. Our
international rese,rves consist almost entirely of gold; 1f gold 1s not used, we have
.
no reserves to speak of.
I am not suggesting that we return to the gold standard, which would m_ any
case be impractical, but greater reliance on our gold stock would have c:onsi~erable advantages over borrowing abroad. Since the gold does not earn an_y mterest,
the cost of using it is very low. Of course, it is conceivable that the price of gold
will rise further in the future, but the opposite is also arguable. A_ l_arg~ part
of the world's gold stock is now in private hands, much of it in ant1c1pat10n- of
future price increases. If these increases are not forthcoming, the gold may be
unloaded, leaving the United States with a large Ca'Pital ~oss. _'l'o th:e ex~ent that
individual investors want to hold gold as a hedge agamst mflation, ~t would
be in the public interest to make it available to them rather than keep it unproductively in Fort Knox.
.
Gold no longer has any role in the international monetary system; it has
become simply a commodity of which we happen to hold' a large stock because
of past history. The idea of selling gold by regular auctions is basically so1;1nd;
if the price of gold were to drop sharply, we could always suspend. the auc~10ns.
Greater emphasis on Treasury gold sales would also serve to remmd the mternational capital markets that the United Statoo is not without reserve assets
and does not need to borrow abroad in case of a deficit.
While I am fairly optimistic concerning the immediate prospects for thE: dollar, I do not think we are out of the woods in the longer run. International
monetary reform should remain high on our agenda, but the results are not
likely to be visible soon. Moreover, we should strongly resist roreign pressures
to run our economy at a lower level of employment merely to preserve the external value of the dollar. We need effective anti-inflatiion policies for domestic
reasons, but the question of the exchange rate is an entirely separate one. The
fall in the dollar is not primarily the result of higher inflation in the United
States; even now our inflation rate is not substantially different from the
average of other industrial countries. When it comes to the point, the world
at large has a greater interest in continued real growth in the United States
than it has in the external value of the dollar.
In surpmary, our international economic policies should continue to be governed primarily by domestic considerations, including both price stability and
full employment. Until there is agreement on a new international monetary
system we should not lock ourselves into any particular external value of the
dollar, and intervention should be practiced only in cases of short-term instability. It is only by this strategy that we can hope to induce other countries
to pursue similar domestic policies and to protect our own inter ests if t hey
fail to ee things our way.
'
Representative REuss. T hank you, Mr. Houthaklrnr.
Mr. Solomon, would you come up next with your statement~
STATEMENT OF ROBERT SOLOMON, SENIOR FELLOW,
THE BROOKINGS INSTITUTION
Mr. SOLOMON. T hank you, Mr. Reuss.
I n this statement I attempt to assess the wisdom of the actions
announced on N ~vember_ 1 3:nd designed, in the President's words, "to
correct the excessive declme m the dollar which has recently occurred" .
. The dollar _had been declining for more than a year when the November ; act10ns were taken. After 2 years of relative stability, the
trade~weighted average value of the dollar-otherwise known as the
-effect~ve excha1;ge rate-against the currencies of the 10 largest industnal countries, £ell about 5 percent in the fourth quarter of 1977
3½ percent in the first quarter of 1978, and one-half percent in th~
second quarter.
Tihe_do:Vnward movement accelerated again in the summer, with
a declme m the dollar's effective exchange rate of 5½ percent in the
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third quarter. Then in the first 3 weeks of October the dollar's average value fell about 1 percent per week. It feel more than 2 percent
in the week from October 18 to October 25, and 2.7 percent from
October 25 to October 30.
. .
Of course, the downslide of the dollar corre~ponded to a simi~ar
accelerating upward movement of the currencies of the ?ther mdustrial countries, most notably Germany, Japan and Switzerla1;-d.
In the last two weeks of October the dollar value of the D-mark mcreased almost 3½ percent per week.
It is clear that exchange rates were moving further and more
rapidly than could be justified by any economic criterion. At the
low point on October 30, the dollar was down 22 percent from September 1977 on a weighted average basis against the currencies of ~he
other industrial countries. And the daily movement was becommg
v~ry larg~ indeed. A1:1ong the various conseque1;-ces wa_s the imp:1ct
o-f the nsmg cost of imports, at least from the mdustrial countnes,
on the President's wage-price program. It is my judgment therefore
that forceful action was called for to arrest the exchange rate movement.
In the circumstances I have just described, intervention was justified. The underlying balance of payments position of the United States
was improving. But, the halving-cutting in half-of the current-account deficit between the first and second quarters of 1978 had been
completely io·nored by the foreio·n exchange markets. And the prospects for a convergence of rates of economic expansion between the
~Tnited States and the other industrial countries promised a further
~mprovement in the U.S. balance of payments. These facts, too, were
ignored by the foreign exchange markets. So, the intervention was, in
my mind, justified.
Having presented this rationale for the foreign exchange intervention part of the November 1 program, I would like to register some
concern about the monetary policy component of that program. It is
traditional for central banks to rnise interest rates or take other tightening action when an effort is being made to stabilize an exchange
rate. And conventional wisdom in the minds of participants in the fore~gn exchange markets no doubt expected some monetary policy action .. But the fact is that monetary policy had already been tightened
considerably. Over the year from September 1977 to October 1978, the
Federal funds rate was raised almost 3 percentage points. Immediately
after the November 1 announcement, many economic forecasters
raised the probability they were assigning to a recession in 1979.
Yet, a recession is in the interest of neither the United States nor
of its trading partners. As we learned in 1969-70, a mild recession
would do little to cure inflation, and I don't think anyone wants to
have a deep recession. A recession would have adverse impacts on the
prosperity of the rest of the world as well as of the United States.
And, ironically, it could lead to a further weakening of the dollar. One
cannot imagine that interest rates would not fall in a recession, partly
because of reduced demand for credit and partly because the Federal
Reserve would adopt a more stimulative policy.
The decline in interest rates could induce capital outflows large
enough to outweigh the effects of an improved trade balance. The result would be a depreciation of the dollar. Mr. Reuss, I have spelled
43 - 286 0 - 79 - 5
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out the case against a recession in a column in a recent issue of The
Journal of Commerce. I am attaching a copy of that column to this
statement.
Representative REuss. It will be made a part of the record.
Mr. SoLOMON. If I may, I would like to elaborate a bit on the reasons
:for the rather sizable movement of exchange rates in the past year.
A good part of the explanation of the large trade deficit, apart from
oil imports in 1977, was the sluggish expansion in Europe and Japan.
This sluggish expansion was holding down American expor_ts. ~n
fact, :for a while in 1977, -industrial production was actually falling m
Western Europe and Japan. From the fourth quarter of 1976 to the
fourth quarter of 1977, the volume of imports declined in five of the
six major industrial countries other than the United States. The single
exception was Germany where imports in real terms increased by 3
percent during that period in 1977. Meanwhile, U.S. import volume
rose 8½ percent as the U.-S. economy expanded vigorously.
I assign great importance to these facts in explaining the development of the enlarged trade deficit of the United States which in tu~n
had an impact on expectations in the foreign exchange market. As m
other relatively free markets, expectations tend to become self-fulfilling.
In trying to understand the movement of exchange rates one can
:focus on the U.S. deficit or on the surpluses of a few other industrial
countries. Correspondingly, one can focus on the downward movement of the dollar or on the upward movement of other currencies.
While the trade-weighted average value of the dollar fell about 15
percent from late September 1977 to late September 1978, the corresponding upward movement of other currencies was far from uniform.
Thus, the effective exchange rate of the French franc and the pound
sterling were absolutely unchanged over the year. The Italian lira fell
more than 5 percent, while the Canadian dollar's effective exchange
rate decreased about 20 percent. The average value of the German
mark increased only 6 percent during that period from September 1977
to September 1978. The really large appreciations in effective rates
corresponding to the U.S. dollar's depreciation were in the Swiss
franc, which rose more than 33 percent, and the Japanese yen which
went up 28 percent.
It is no coincidence that, apart from one or two OPEC countries,
Switzerland and Japan are the countries with the largest current-a?count surpluses relative to their economic size. In the first half of this
year, Japan's current account surplus was equal to 18 percent of its
exports and Switzerland's current-account surplus was equal to 21
percent of its exports. In the case of Germany, the current-account
.surplus was less than 6 percent of exports. Thus, it is not surprising
that the yen and the Swiss franc rose so much more than the deutsche
mark. With these currencies rising in value, other currencies had to
fall by arithmetic necessity. One of those that fell was the U.S. dollar.
Thus, Mr. Reuss, there is more than one way to look at the exchange
rate movement of the past year. If I ma:v out in one more plug, this
is a point that I have elaborated in an article in the New Reoublic £or
November 11, a cooy of which I should like to submit, if I may.
Representative REuss. That, too, will be entered into our record.
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Mr. SOLOMON. What one concludes from all this, at least from the
way I look at it, is that it takes two to tango. Exchange_ rat.es reflect
the interactions among economies. Whether or not otticial mtervention in the exchange markets will 'have an effect depends on the und_erlying economic relationship among countries. The November 1 action
was justified and seems to have been successful because the underlying conditions were improving.
Growth and imports have speeded up in Europe and Japan. Jap3:n's
exports are falling and export orders in Switzerland are droppmg
off. The large surpluses of these countries seem to be on the downswing, just as the U.S. deficit is decreasing.
,
Thus, I conclude with the view that stabilization operations in
foreign exchange markets are futile when underlying conditions are
not oonducive to a stabilization or reversal of an exchange rate movement. But when underlying conditions are pointing to a change and
the market is ignoring these conditions, official intervention can be
justified. Thank you.
[The prepared statement of Mr. Solomon, together with the articles
referred to, follows :]
PREPARED STATEMENT OF ROBERT SOLOMON
1
In this statement, I attempt to assess the wisdom of the actions announced
on November 1 and designed, in the President's words, "to correct the excessive
decline in the dollar which has recently occurred."
The dollar had been declining for more than a year when the November 1
actions were taken. After two years of relative stability, the trade-weighted
average value of the dollar (or effective exchange rate) against the currencies
of the ten largest industrial countries fell about 5 percent in the fourth quarter
of 1977, 3½ percent in the first quarter of 1978, and ½ percent in the second
quarter. The downward movement accelerated again in the summer, with a decline in the dollar's effective exchange rate of 5½ percent in the third quarter.
Then in the first three weeks of October the dollar's average value fell about 1
percent per week. It fell more than 2 percent in the week from October 18 to
Oct~ber 25, and 27 percent from October 25 to October 30.
Of course the downslide of the dollar corresponded to a similar accelerating
upward movement of the currencies of the other industrial countries, most
notably Germany, Japan and Switzerland. In the last two weeks of October
the dollar value of the D-mark increased almost 3½ percent per week.
It is clear that exchange rates were moving further and more rapidly than
could be justified by any economic criterion. At the low point on October 30, the
dollar was down 22 percent from September 1977 on a weighted average basis
against the currencies of other industrial countries. And the daily movement
was becoming very large indeed.
Among the various consequences was the impact of the rising cost of imports,
at least from the icdustrial countries, on the President's wage-price program.
It is my judgment therefore that forceful action was called for to arrest the
exchange rate movement.
In the circumstances, intervention was justified. The underlying balance of
payments position of the United States was improving. But, the halving of the
current-account deficit between the first and second quarters of 197 had been
completely ignored by the foreign exchange markets. And the prospect for a
convergence of rates of economic expansion between the United States and the
other industrial countries promised a further improvement in the U.S. balance
of payments.
Having presented this rationale for the foreign exchange intervention part
of the November 1 program, I would like to register some concern about the
1 The views expressed
in this statement are the sole responsibility of the author and
do not purport to represent those of The Brookings Institution, its officers, trustees, or
other staff members.
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monetary policy component of that program. It is traditional for centr~l banks
to raise interest rates or take other tightening action when an effort is bemg made
to stabilfae an exchange rate And conventional wisdom in the minds of participants in the foreign exchange markets no doubt expected some 1:1onetary
policy action. But the fact is that monetary policy had already beep. tightened
considerably. Over the year from September 11)77 to October 1978, the federal
funds rate was raised almost 3 percentage points. Immediately after the November 1 announcement, many economic forecasters raised the probal>ility they were
assigning to a recession in 1979.
.
Yet a recession is in the interest of neither the United States nor of its trading partners. As we learned in 1969-70, a mild rece. sion would do little to cure
inflation. It would have adverse impacts on the prosperity of the rest of the world
as well as of the United States. And, ironically, it could lead to a further weakening of the dollar. One cannot imagine that interest rates would not fall in a
recession, partly !because of reduced demand for credit and partly because the
Federal Reserve would adopt a more stimulative policy. The decline in interest
rates could induce capital outflows large enough to outweigh the effects of an
improved trade balance. The result would be a depreciation of the dollar. Mr.
Chairman, I have spelled out the case against a recession in a column in a recent
issue of The Journal of Commerce. I am attaching a copy of that column to this
statement.
BACKGROUND OF EXCHANGE RATE MOVEMENT
If I may, Mr. Chairman, I would like to elaborate a bit on the reasons for
the rather sizeable movement of exchange rates in the past year As the year
progressed, the consensus view on the causes of the dollar's depreciation shifted.
In the autumn of 1977, much tof the blame, if that is the right word, was placed on
remarks made by Secretary Blumenthal, who was accused of "talking down
the dollar." Then market talk focussed on the voracious American appetite for
oil, for in 1977 our oil impor ts increased in value by $10 billion, accounting for
half of the increase in the U.S. trade deficit in that year. More recently, the
blame has shifted to the U.S. inflation rate, which has worsened in 1978 while
inflation abated in other industrial countries.
There could be some degree of merit in all of these alleged explanations but
what was not adequately appreciated was that sluggish expansion in Europe
and Japan was holding down U.S. exports. For a while in 1977, indus'trial production was actually falling in Western Europe and Japan. From the fourth
quarter of 1976 to the fourth quarter of 1977, the volume of imports, declined
in five of the six major industrial countries, other than the United States. The
single exception was Germany, where imports in real terms increased about 3
percent. Meanwhile U.S. import volume rose 8½ percent, as the U.S. economy expanded vigorously.
·
In the circumstances, the United States trade deficit increased and the trade
and current-account positions of other industrial countries moved to smaller
deficit or larger surplus.
In trying to understand the movement of exchange rates one can focus on the
U.S. deficit or on the surpluses of a few other industrial countries. Correspondingly, one can focu s on the downward movement of the dollar or on the upward
moYement of other currencies.
While the trade-weighted average value of the dollar fell about 15 percent
from late September 1977 to late September 1978, the corresponding upward
movement of other currencies was far from uniform. Thus the effective exchange
rate of the French franc and the pound sterling were unchanged over the year.
The Italian lira fell more than 5 percent, while the Canadian dollar's effective
exchange rate decreased about 20 percent. The average value of the German
mark increased only 6 percent. The really large appreciations in effective rates
corresponding to the U.S. dollar's depreciation were in the Swiss franc, which
rose more than 33 percent and the Japanese yen, which went up 28 percent.
It is no coincidence that, apart from one or two OPEC countries, Switzerland
and Japan are the countries with the largest current-account surpluses, relative
to their economic size. In the first half of this year, Japan's current account surplus was equal to 18 percent of its exports and Switzerland's surplus was equal
to 21 per~ent of its exports. In the case of Germany, the current-account surplus
wa~ less than 6 percent of exports. Thus it is not surprising that the yen and the
Swiss franc rose so much more than the D-mark. And with these currencies rising in value, other currencies had to fall. One of those that fell was the U.S. dollar.
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Thus, Mr. Chairman, there is more than one way to look at the e~change r~te
:movement of the past year. This is a point that I have elaborated m an arti~le
~n The New Republic for November 11, a copy of which I should like to submit,
1f I may.
The fact is that it takes two to tango. Exchange rates reflect the interactions
a1~iong economies. Whether or not official intervention in the exchange markets
W~ll have an effect depends on the underlying economic relationship among countries. The November 1 action was justified and seems to ba ve been successful be. cause the underlying conditions were improving. Growth and imports have
~l)eeded up in Europe and Japan. J apan's exports are falling and export orders
~ Switzerland are dropping off. The large surplus of these countries seem to
on the downswing, just as the U.S. deficit is decreasing.
Thus I conclude with the view that stabilization operations in foreign exchange markets are futile when underlying conditions are not conducive to a
st abiliaztion or reversal of an exchange rate ~ovement. But when underlying
c~n~iti?ns are pointing to a change and the market is ignoring these conditions,
0 cial mtervention can be justified.
[From the Journal of Commerce, Dec. 7, 1978]
SHOULD WE WELCO ME A RECESSION?
( By Robert Solomon)
f ~s the Federal Reserve has moved to tighten monetary policy further, economic
01 ecasters are assigning a higher probability to a recession in 1979. While the e
~~reca _ts a rE: understandable, what is difficult to comprehend is the growing vie\Y
at a Ieces 10n would be desirable.
This opinion has been expressed mo t strongly in Wall Street and has brought
'.1- rebuke from Federal Reser,e Chairman :Miller, who "as quoted in the Wash~ng~o~ Post as saying, "'' all Stre t may ,vant a recession. You know, there is a
theory that you can wash it out, and then get a new buying base for
sir
hoc s and make a killing ... as long as you're one of the insiders and know
ow to do it. But I don't think thats good national policy."
tin
TO SLOW INFLATION?
w Those ,, ho "ould welcome a recession presumably believe that it is the only
h:Y
to re?-uce the rate of inflation. It is useful, therefore, to examine what
m 1969- 70, the last time \Ye had a mild recession. (The experience of
197PPene~
co 1-75 _is no~ relevant, since it involved a reversal of the explosion in world
evmmodity Prices and adjustment to the quadrupling of oil prices. Furthermore,
to en the most masochistic of those who would welcome a recession are unlikely
Want to see one as deep as in 1974-75.)
at The U.S. economy turned down in the latter part of 1969. Real GNP declined
qua~ annual rate of about 4 percent from the third quarter of 1969 to the second
to ~r er of 1970, unemployment rose from 3.6 to 5.2 percent, and then climbed
Percent, where it remained throughout 1971.
r ~hat _happened to prices and wages? It is true that consumer prices rose less
1
o?f dly m 1970 than in 1969, but thi was entirely the result of a slower advance
_ood Prices in 1970. Consumer prices other than food did not decelerate at all
d uring
1970.
On_ly in 1971, when the economy was expanding again and productivity speeded
up, did the price rise abate.
WAGE RATES CLIMB
Meanwhile, wage rates continued to increase through the recession without
s~~Wdown. Average hourly earnings, adjn~ted for overtime and inter-industry
s ifts of employment, remained tuck at a 6.6 percent incr ase in 1969- 70 and
accelerated to 7 percent in 1971.
Thus, from the 1969- 70 episode, there is no basis for looking to a mild recession
£.ts a means of reducing the rate of inflation.
i Furthermore, the other effects of a rec ssion should be considered. A reduction
.aggregate demand, if not brought about by a slowdo,·vn in business outlays
or Plant and equipment, would very likely induce such a slowdown.
r°
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Yet there is a widespread belief that the nation needs a highe_r :i-·ate of business
investment to increase the capital stock and improve productivity.
The extent to which a recession would bring a reduction in interest ra~es
cannot be predicted with confidence, but every reces ion in the postwar peno~
has been accompanied by falling interest rates. 'rhis has occurred for two rea ons ·
a reduced demand for credit as spending lJy busines and consumers fell and an
increased supply of funds as the Federal ~eserve acted to stimulate the e~onomy.
It is highly unlikely that the Fed would not act in a similar manne~ _1~ 197_9
if a recession began. Indeed the Fed would be subject to severe criticism if
it did not combat a recession.
In these circumstances, the effect on exchange rates might turn out to be
different from what the recession advocat s expect. The conventional wisdom
is that a slowdown in the U.S. economy, by improving the trade balance, would
strengthen the dollar. But if interest rates are falling here while they ri e
abroad, capital outflows could outweigh the trade balance improvement and
put downward pressure on the dollar again.
Finally, the human effects of recession should not be ignored. nemployment
would increase and, in an accordian-like manner, youth unemployment would
rise sharply. Those who have been most vocal about the medicinal effect. of
recession are not among the ones in danger of losing their jobs.
The conclusion to which these considerations point is that the government's
wage-price program is our best hope of reducing the rate of inflation. That program should be supported by a fis cal and monetary stance that keeps aggreO'ate
demand expanding in line with the economy's growing potential. If this sounds
like fine tuning, it should be realized that those who fayor a recession are, perhaps implicitly, counting on fine tuning to keep a mild recession from becoming
severe.
Chairman Miller's public statements suggest that he agree with the above
prescription for economic policy. One must hope that he can bring the Federal
Open Market Committee along. And, since President Carter has also rejected
the idea of a recession, he should face the implications for fiscal policy.
Whether the President's budgetary aims are consistent with preventing a
recession cannot be dealt with here, but the question is worth asking.
[From the New Republic, Nov. 11, 1978)
COURTING RECESSION To SPUR THE I NEVITABLE DOLLAR Bou ~cE
(By Robert Solomon)
It has been a steady and, to many people, a disconcerting refrain : "The dollar
hit record lows on European and Japanese money markets again today ... " "The
price of gold went up again yesterday, as money traders continued selling dollars . . ." "The Japanese yen and the German mark reached new high against
the dollar today ... " Ordinary citizens no doubt have been troubled by a seeming collapse of their currency, and some of them may be wondering if it portends a collapse of their economy or even of America's leadership role in the
world. I would stress that a strong economy does not necessarily have a high
valued currency, nor does a strong currency always signify a strong economy.
Th causes of the dollar's decline are complex; its effects are confusing and it is
not entirely clear what should be done about it. Yet dollar fluctuations are not
unprec~dented: to the contrary, the rule in money trading seems to be that
whatever goes down must come up, and vice versa. By every indication of past
performance, it is now time for betting in favor of the dollar again, instead of
against it. In fact, we may have begun seeing the dollar bounce back before the
Carter administration intervened in international money market last w ek.
To begin understanding what bas been happening in foreign exchange markets, one should recall that since March 1973 the major currencies of the world
have been floating in relation to one another. In contrast to the exchange rate
~ystem that prevail~d from the end of World War II until 1973, governments
m. the larger countries no longer fix their exchange rates and attempt to maintam them by buying and selling currencies. That earlier arrangement, the socalled Bretton .'VI?' oods. system, came under increasing strain in the late 1960s and
early 1970s, giving rise to frequent international monetary crises.
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Following the abandonment of fixed exchange rates, the dollar went through
three cycles, each downward movement being followed by an upswing. Then,
fo~ the two years from the autumn of 1975 to the autumn of 1977, the dollar was
qui~e stable as measured against an average of the currency values of the other
maJor industrial countries. And this stability was at a level slightly higher than
When floating started. Beginning in September 1977, another downswing got
und_er way and, except for a reversal in the spring of this year, it has continued
until the past week.
th Just as the dollar has not been the victim of one steady, uninterrupted decline,
e extent of its drop has not been as great as news reports might indicate. An
exchange rate is the price of a currency in terms of other currencies. Since there
ar~ as many currencies as there are nations, no clear-cut and unequivocal measure
exists of the value of any one currency. Should it be valued against all other
~1rrencies, against those of the larger countries, or simply against the dollar·t
f e dollar, we should remember, is not just the currency of the United States
0
• America, but it is also a world money. It is held in reserve by other countries, and used as a standard of value of other currencies. Each day when the
~ewspapers tell us about a shift in the value of the dollar, they are also reporting on shifts in the value of other currencies-the German mark, the Japanese
Yen, the French franc, etc.-measured in dollars. During the past year, the
~illar value of the Swiss franc has gone up about 50 percent, the yen, 45 percent,
e ~ark, 28 percent and the French franc, 17 percent.
T~is practice is misleading. Valuing the mark, the yen and the other cur~~ncies only in relation to the dollar exaggerates their upward movement and
e dollar's decline. Germany and Japan do not trade only with the Unitel
8t ates, but with many other countries as well. To get a truer picture of the up~8:rd movement of other currencies and the downward movement of the dollar,
lt is necessary to take an average of the value of each currency against the currencies of at least its major trading partners.
By a_ll measures, though, the value of the dollar has fallen in the past year.
According to a Federal Reserve weighted a verage, the dollar depreciated 16
g;rfin.t from late September 1977 to mid-October 1978 against the currencies
t
llldustrial countries. These 10 countries account for about half of world
c~ad~, and it's important to note that the dollar's decline against them has been
S n_siderably smaller than the 50 percent or 45 percent recorded against the
juwtss franc and the yen. If the dollar is measured against all countries and not
s these 10, the depreciation over the last year is even smaller.
th The causes of the dollar's depreciation are not easy to pin down. In fact, over
a e Past Year, public commentary has shifted .from one cause to another. A year
i;0fomuch stress was placed on American oil imports, which increased $10 billion
d .77 and accounted for about one half of the enlargement of the US trade
ttficht for that year. US oil imports are no longer increasing, and lately attenon a~ focused on two other explanations for the dollar's decline.
in~ne ~s the difference in economic performance between the US and the other
E ustrial countries. In 1977, recovery from the recession of 1975 faltered in
wU:0 P~ and Japan, which are important markets for US exports. In fact, for a
Mhile in_ 1977, industrial production was actually declining in these countries.
eanwh1le, the American economy continued to expand at a vigorous pace. The
~esult was that the US "sucked in" imports faster than its trading partners took
in_ US exports. Now things are changing. It's expected that economic activity
Will accelerate in Europe and Japan while it slows down somewhat here. This
should lead to faster expansion in US exports and a slower increase in imports.
~n fact, this is already happening, as US trade statistics for recent months show.
tut the contraction of the US trade deficit and of the broader measures of US
rasnactions, the balance on . current account-which includes not only mer~handise trade but purchases and sales of services, travel and income on foreign
investments-has not yet affected foreign exchange rates as one normally would
expect. Puzzingly, the dollar has continued to fall.
h Currently, the most popular explanation for the continued decline of the dollar
t as b~en the worensing of inflation in the United States. However, it is difficult
believe that the small increase in US inflation could account for the very
1
da~ge movement in the exchange rate between the dollar and the yen or the
0
lar and the Swiss franc.
What does explain the movement? 'fo understand it, we have to look not only
at What is happening in and to the US economy, but at what is happening abroad.
°
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Largely as a result of its slow economic expansion, Japan has developed an
enormous surplus in its trade and current account balances. Its imports have
increased slowly because of its sluggish economy. Its producers, facing slack
demand at home, have actively sought to sell abroad. As a result, Japan is e~pected to have a current account surplus of $15 or $20 billion thi_s year. ~his
extraordinarily large surplus is not matched by an outflow of private capital
from Japan, and the result is an upward movement of the yen. Much the same
thing has happened in Switzerland and, on a smaller scale, in Germany.
We can conclude from this is that the dollar decline is only part of a larger
world currency story. I)n part, the decline is a reflection of upward pressur~s
on other currencies, just as the large trade deficit in the United States 1s
the counterpart of the large trade surpluses of those countries. Some of the underlying causes of the dollar decline, such as US infla tion, reflect weaknesses in the
American economy, but others, such as lagging growth abroad, reflect comparative US strength. In any event, perceptions of the trade deficit and inflation
have created expectations of a weak dollar, and in foreign exchange markets,
as in the stock market, expectations become self-fulfilling.
If the causes of the exchange rate movement are mixed, one result is certainly
bad for us: import prices have increased and have aggravated our inflation. And
not only are imports more expensive (not to mention travel in Japan and Europe),
but increases in prices of import commodities lead American producers of similar
items to raise their prices, too. There should be a brighter day coming, however.
A depreciated dollar, coupled with more rapid economic growth in Europe and
Japan, should result in increased US exports, correction of the US balance of payments deficit and stJability for the dollar.
Sometimes it is said that the dollar's decline lias a depressive influence on other
economies by reducing their exports. But in fact, other countries have been relying
too heavily on exports and not enough on domestic consumption. This point appears to have been agreed upon at the recent annual meeting of the International
Monetary Fund in Washington. The prospect for more expansive policies in
Europe and Japan led to optimistic pronouncements at that meeting concerning a
reduction of international imbalances and a stabilization of exchange r ates.
There is every reason to expect that the dollar's plunge will stop, but what
should we do to make sure? Apart from urging other countries to pursue sensible
(that is to say, expansionist) policies, we ought to do things we should be doing
even if we didn't have a dollar problem. That is, we ought to c<mserve energy and
we ought to deal with inflation. On both fronts, there has been some progress
recently. The energy bill passed by Congress probably isn't all that it should be,
but it is a start. Even before the bill was passed, US oil consumption had begun to
taper off. President Carter's inflation program has opened to better reviews than
one might have expected, and one can only hope that it will succeed.
To the extent that world money traders lack confidence in the US energy program and the anti-inflation policy, they will continue betting for a while against
the dollar, and it will continue to fall. But this can not and will not continue
indefinitely. The underlyi ng realities of the world economy will fak e hold. and
those realities are that US energy consumption is slowing and US inflation is not
running out of control. Meanwhile. other economies are moving into higher gear.
The result will be a strengthening of the dollar, particularly against those few
currencies that have been moving up sharply.
If there is a single lesson in all this, it is that it takes two to tango. The dollar
problem is not purely an American problem. It reflects the interaction between the
American economy and the economies• of other countries. The lead ers of other
countries may find it p(}litically convenient to blame the United States for some of
their domestic problems, but unless they deal with their own problems-by improving the domestic performance of 1their own economies--the yen problem, the
mark problem and the Swiss franc problem will be prolonged. Anrl for as long as it
lasts, it will continue to be 1ahelleo, incorrertly. as a dollar problem.
On November 1 the Ff'rlf'ral Reserve ano th f" T.rf>a.f'lm:v. acting at the rf>cpiest of
the President, announced a series of measures designed to strengthen the dollar.
The Federal R eserve is incrf'af'ling the disf'ount rate an<l is irnpo!'; ing a snpplementary reserve require!lilent of two percent on large time deposits. Th e latter
measure will inhibit banks from issuing certificates of deposits, an important
source of funds for lending. Along with further increases in interest ratrs that
will result from the oiscount rate hike, thi s will tend to slow expan sion of the
US economy. It would strengthen the dollar, but it could also cause recession in
the United States.
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The other measures include a step-up in the Treasury's monthly gold sales to
1.5 billion ounces ( about $4.3 billion per year at the current price) and various
means of mobilizing foreign cnrrencies. These steps are designed t~ persu~de
money traders that the US government is prepared to intervene heavily, sellmg
gold and currencies, and buying dollars, to .increase the value of the dollar.
Two observations may be made about these actions. First, the dollar strengthened significantly on the day llefore the announcement. It may have come ju t as
the markets were turning around anyway. If that is so, little of the newlymobilized resources will have to be used. Second, the fundam entals set forth
e~rlier in this article still apply. Unless other countries' economic polices are
dir~cted toward reducing their large balance of payments surpluses. no amount
ff intervention in foreign exchange markets by the United States will have a
asting effect on exchange rates.
Representative REuss. Thank you, Mr. Solomon.
Mr. Keyserling.
STATEMENT OF LEON H. KEYSERLING, PRESIDENT, CONFERENCE
ON ECONOMIC PROGRESS
Mr. KEYSERLING. Mr. Reuss and members of the subcommittee, first
of all, to the extent of propriety, I want to endorse the brilliant statement appearing in the press today and made yesterday by the chairman of this subcommittee expressing at least some doubts about the
current program, which vindicates again my belief that among the
Members of the Congress h is one of the most perceptive economically
and economically ,:vise and one of the most willing to express his views.
I have been knocking around here for 45 years, and I have been
knocked around quite a lot, and I ,Yould like to exercise restraint with
reP-ard to the current program. I cannot do so because of the reckless
~d u!1restrained nature of that program. It strikes havoc with the
_ men can economy: not recognizing that the fundamental source of
tdhe str~ngth of the dollar is the strength of the economy of which the
0 llar 1s but a medium of exchange.
It strikes havoc with our social purposes. It postpones indefinitely
some of our mo t important programs.
Now, to illustrate that in detail, let me give a few facts. I won't
resume the President' program, because it i familiar, but I have
computed the results of it.
Takino- the statements of the President and his advisers at face
value, the Secretary of the Treasury has recently stated that the program will result and should result in an economic growth rate, real,
or 2 percent or less for a number of years ahead.
The President and other spokesmen have had ranges of between 3
and 3.5 percent.
The head of the Federal Reserve Board has aid that it will take 5
to 8 ~ears under this program to get price stability, and this supports
a deliberately contrived very low rate of real economic growth for
that purpose.
ow, let me estimate just what this co ts. In the first place, in 1979
alone it will mean 1.1 million Jess man-""'oman-teenao-er-years of employment and half a million more of unemployment than if we proceeded with policies designed to accomplish the purposes of the Humphrey-Hawkins legjslation to reduce unemployment to 4 percent and
3 percent, respectively, in 1983.
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By 1983 it will result in 5 million less employed and 2.5 million more
unemployed than the appropriate ~rogram, the_ difference between the
employment and unemployment bemg due to higher growth rates under conditions of high employment of the labor force.
Now, I would like to state that the current program merely repeats
almost precisely all o_f the mistakes which _preceded the last _five rec~ssions. It learns nothmg. It does substantially the same thmg agam.
It will produce substantially the same results.
I would like to call very briefly your attention to my chart No. 3,
which illustrates that during 1953-78 we sacrificed $5.9 trillion of total
national production and 75 million man-woman-teenage-years of ~mployment opportunity through trying to do substantially what is bemg
tried to do again.
On the next chart, which is No. 4, I compute the estimates fo~ the
years ahead, coming to a difference of $818 billion of total national
production and almost 17 million man-woman- child-years of employment.
We cannot afford to do it. We should not do it. We cannot withstand the final cost. Vv e cannot afford the effect on the Federal budget.
Vve cannot afford the danger of civil and civic unrest.
Now I come specifically to some of the programs. The first is the
anti-inflation, tight money policy. I have a series of charts on that ..
Those charts -run through Nos. 9, 10, 11, and 12. Chart 9 shows irrefutably, and this is agreed to by most analysts, that there has been a
positive correlation between the tightening up or the money supply and
the movements toward stagnation, recession, and higher unemployment. I would say that most of the discussion or the inadequacy or the
growth in the money supply does not take account or the fact that the
growth rate does not allow properly for the general inflation, and even
Paul Samuelson has agreed with me and with others that, in order to
get an adequate expansion of the money supply, it has to take some
account or the general trends in the price level.
My next chart in that series, which is chart 10, details an entirely
intolerable situation. What it does, this chart shows that more than a
trillion and a half billion dollars have deliberately been transrerred
by central bank policy from those who borrow to those who lend since
1952.
I do not need to portray either the economic or social significance o:f
that.
It_has more than counteracted many efforts in other ways to transfer mcome to those who need help most, not only for social reasons,
but to the general benefito:f the performance or the American economy.
This is a demoniac weapon, and I cannot understand now how any
reasonable people can condone or accept a further increase in this
policy.
·
In the chart 11, I show that this policy is now costing more than $20
billion in the Federal budget alone in excess interest payments or ·a bout
40 percent of the total Federal deficit. This is advocated by the very
people who say that the Federal deficit is the main reason for the inflation o_f the American economy.
An<l m c~art 12 I show that the excess payments in the Federal
b~dget for mterest rates in one year come to two or more times the
size of most of the vital dom~stic priority programs which we say we
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71
cannot afford because the economy is going to slow, and it's going ~oo
slow
in larae
measure because of what the Federal monetary pohcy
•
E>
1s doing.
.
;Next I come to a chart which is my chart 13, ~h1_ch shows very
briefly that, despite all the talk, most of the _deficit m th~ Federal
budget is caused by the deficient performance m the American economy, and there is nothing I can forecast more confidently than that
the hammer blows being struck on the American economy by the current program will not only make it impossible to balance the Federal
~udget, but will also increase the Federal deficit rather than decrease
It.
. Next I come to the tax policy which is related. I have here a review
in two charts numbered 14 and 15 of Federal tax policy for a great
~umber of years, and that consequence is to increase the disposable
income of those higher up tremendously more than those lower down,
~nd the 1978 tax program has doubled this in spades. In it also, the
mcre~s~s in taxes are greater than the decre:ase~.
.
This 1s bad for the economy as well as bemg me,qmta;~le.
.
. I con:ie finally to the guidelin~. When properly exammed, the gmdehn_es will result, if effectuated, m wage rate mcreases 2 or 3 percentage
pomt_s lower than the price rate increases.
.
This means that in terms of the hammer blows upon the American
economy-a no-growth budget progra_m, a r~pressiv~ interest rate
P~ogram, a repressive tax program-is combmed with _a program
directed to two-thirds of all consumers who are two-thirds of the
wh?le economy, which would actually reduce the buying power of
the~r w_ages and, in fact, this has been the trend for 10 years in our
maJor industries. Charts 16 through 20 relate to this aspect of the
problem.
N:ow, this is a weird witches' brew compound of policies to direct
agamst the American economy.
N?w, I have something here about housing. Chart 24 sh6ws the
terrific effect of rising interest rates upon the housing program.
Chart 23 shows the immense role of housing in the national economy,
~nd chart 25 shows, although it's out of date, the impact of van-able
~nterest rates upon the cost of housing and how every few percentage
inc~ease in interest rates de-bars millions of families from housing
which it can ·afford and certainly the purchase of new housing. Charts
21 a!ld 22 also relate to housing.
. Fmally, I come to the effect of the current program upon inflation
itself .
.Surely it would be a horrible thina, if this program were to accomplish its purposes, to think that we are a one-purpose Nation which
must defer indefinitely four or five or six of our greatest national
purposes in order to pursue this one alone at the cost of the others.
Su~ely we can find ways to prevent inflation and to protect the dollar
w h1ch do not do this.
But infinitely more important, this hammer blow struck upon the
American economy will wreck the efforts to stabilize the dollar or
reduce inflation.
The main reason is shown on my charts 6, 7, 8, and 9, which trace
as I _traced many times before for this committee, the interest cor~
relat10n between the rate of unemployment and the amount of price
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stability. It's upside down. The Congress in the Humphrey-Hawkins
bill by overwhelming major repudiated the tradeoff.
Arthur Burns at one time repudiated it. The President at one time
repudiated it. Economists no longer acknowledge it. Why do we go
in for it again and again and again, when it produces the same resultmore inflation, more unemployment, less attention to social needs, less
economic growth and unbalanced Federal budget~
Finally, I want to say this. I have a chart here-it's chart 2ti-,
which tmces the growth rates in the United States and Japan and
Germany, and some other countries. As we see, as to Germany and
Japan, their economic growth rates for a number of years have far
exceeded ours and they are our primary competitors. Can we afford
to signal to them that we are going to widen that gap by the deliberate
efforts of our Government, and how are we going to bolster confidence
in the dollar by signaling to these other countries that we are going
to increase unemployment, increase inflation in terms of the real results, keep the Federal budget unbalanced and make a record in all
respects tremendously worse than theirs.
Now, I would just like to read a peroration of this problem of the
confidence of other nations.
I am sorry to have gotten wound up, but I feel rather strongly about
tJhis.
I do want to say, Mr. Reuss, that it's a strange thing, in all due respect to my colleagues :a nd others, that we have become so confounded
and dismally near sighted that we talk only about one thing in
economics as if we can talk about exchange rates and money rates
and the value of the dollar, and not relate these inseparably to the
infinitely bigger question of what is happening to the American
economy, of which it-is a part; or that we can cure these limited but
vital problems by neglecting and postponing treatment of all of the
others.
So let me just conclude with what I say about the effect upon the
dollar.
But the predominant reason why the current policy to reduce the
dollar will fail in the long rm1 111 niy judgment is that they are based
upon a narrow and misguided explanation of why the dollar has become so weak.
The overwhelmingly important reason why the dollar h as become
so weak and our international balances so huge in terms of balances
of payments and international trade and services account is because
confidence in the American economy has been reduced by the poor performance and poor prospects of the U.S. economy.
What could be more disruptive of confidence in the currency of a
country than prolonged evidence that its national policies have learn~d
only how to prevent stagnation and inflat.ion and have succeeded
only coining a word which covers both, while making clear an inability to remedy it, and instead now is sharpening up the weapons that
produced both~
It is high time we start listening to any commonsense person who
will point out to the economists that the real wealth and strength of
nations is what is happening to the growth of production, reduction
of unemployment, use of available potentials for real growth, the re-
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du_c~ion of shortages, the awareness of critical social and civil dangers
arising from not meeting the most basic needs of so large a part of our
population.
What other civilized nation has tolerated for so long a rate of unemployment as high as that in the United 8tates ~
There is no nation in the world so richly endowed as we are with a
potential for economic grov,rth at home and fair competition with other
parts of the world, but as to the latter, what is more closely related to
the oversea attitude toward the dollar and what has been happening to
us as against other countries?
vVould anyone have be]jevecl 10 or 15 years ago, before economists in
the public services seemed to have lost a part of their discernment, that
~he_ United States would attempt to strengthen the oversea confidence
In its currency enduringly by deliberately and proudly announcing to
the rest of the world that it's going to widen the gap between its fundan:iental economic performance and its prime competitors and court a
sixth economic recession since 1953 which the rest of the world fears
lrlore than all else?
Let me just say that one of the most corrosive effects upon confidence
at h~n~ie and overseas is the flagrant violation and dis_regard by the
adnnmstration as of now of an act, the Humphrey-HawkmsAct, passed
by a majority of 100 in the House of Representatives, by a division of
~-to-1 in the Senate, signed by the President_ with promises to perforI!l
it_, and now everv element, every element m the current program is
directly in violad:on of that act, and more importantly, in violation of
~he great lessons of experience which we have learned during 25 years
In the laboratory of the American economy.
'l'hank you very much.
~'l'he prepared statement of Mr. Keyserling, together with the charts
referred to, follows :J
PREPARED STATEMENT OF LEON
H.
KEYSERLING
1
Domestic and Other Implications of Dollar Rescue Operations
~r. Chairman and members of the subcommittee, I appreciate this opportumty _to appear before you, and by your request will concentrate upon the
do;ID-estic_effects of the dollar rescue operations, although I shall als•J have somethmg to say about the impact of these domestic effects upon the dollar rescue
operation itself.
Reluctance to crUicize President's policies; but these policies need change
It will not take the Committee long to discover that what I shall say is in
sha rp disagreement with what you have been hea ring from representatives of
the Administration, and therefore is in harp disagreement with policies r ecently
a~nounced by the President of the nited States. I particularly regret my criticisms of President Carter's recent decisions in the matter of such grave domestic
and international significance. These regrets are not because I am a Democrat
and served for twenty years in Democratic Administrations, but rather because
th at very service made me keenly a\.Yare of a President's unique responsibilities
and unequaled access to relevant information. This awareness, warns me against
c~nsuring any President's policies lightly. More•:.>ver, having worked very extensively with two of the eight Presidents since I entered the Government in early
1933, helped at times two of the others through direct contacts, and carefully
observed the action of the other four, I have reached the conclusion that President Carter is well above the average of the seven other Presidents in intellec1
Chairman, Council of Economic Advisers under President Truman. President, Conf erence
on Economic Progress.
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tual range, and the equal of any in the firmness of his determination to do what
is best for our c,:mntry and in willingness to change his policies when he becomes
convinced that they need change.
I do believe that Pres-ident Carter's economic policies now need drastic change,
and I believe it to be the moral responsibility of those who have wmked and
studied in this area to the degree I have to speak out fully and frankly. I could
not substitute another President for Jimmy Carter now if I wanted t•J, and as
of now I would not want to if I could. But I have learned from much experience
that no President can be really expert about all of the c..Jmplex problems confronting him, -a nd therefore his views and his actions must be shaped greatly by
what his advisors tell him. I think that President Carter needs very much to
change some of his economic advisers who are not limited t•J the Council of
Economic Advisers. I submit that it would be good both for the President and
the public if there are not so many economic advisers at top levels, competing
with one another and confusing the public if not the President. And there are
some outside the Government whose advice would be useful.
My conclusions in summary
To capsule what I shall say, I am firmly convinced that the dollar rescue
operation in the form thus far announced will have very serious adverse effects
upon our domestic economy, and maybe even devas tating effects. These effects
include a severe further decline in the real economic grnwth rate below levels
which have already trended far too low, including what I regard as large prospects of another absolute reces,sion; large increases in unemployment ahove
levels which have been intolerably high for a long time, and still are; intensified
rather than decreased pressures upon rates of inflation which have also been
intolerably high for a long time, and still are ; further costly consequences
through further inexcusable neglect of great domestic nati•Jnal priorities,, both
economic and social; and large adverse impacts upon attempts to move toward
a balanced Federal Budget. I further submit, and will endeavor to demonstrate,
that these terribly adverse effects upon the d•Jmestic economy will work in the
long run against improving the position of the dollar overseas, because the
strength of the dollar depends ultimately and in the long run upon the fundamental performance of the U.S. ec•:momy as I Rhall shortly define it and the
degree of confidence or lack of confidence which this generates overseas.
And I further submit, as a matter of prime interest to the Congress at large
and especially to the Joint Economic Committee, that the program in its current
form to protect the dollar is clearly -and sharply in conflict with the mandates and
objectives of the Humphrey-Hawkins Full Employment and Balanced Growth
Act of 1978. This Act was recently approved by both Houses of the Congress by
tremendous majorities, and thereafter signed by the President with a declaration
of his intent to labor constantly to fulfill its purposes. More on this, later on in
my testimony.
The real source of our economic strength and progress is not price stability alone
The towering and almost inexplicable error in the current program to protect
the dollar by obsessive preoccupation with reducing price inflation as the allegedly
main cause of the weakness of the dollar is abundantly clear. The error fails to
recognize a core proposition, the acceptance of which is dictated by all sound
reasoning and all empirical evidence. This core proposition is that the reasonably
full use of our resources for the increased production of goods and services in
accord with our full potentials, reasonable attention to our great domestic priorities, the adequate servicing of human needs, and the doing of social justice are
the indisprm:ihle and fonndfltionnl re(Jnirements for building find maximizing
our economic strength and 5ecurity and successes on all fronts, both at home and
overseas. The egregious losses suffered through huge and constant departures
from fulfilment of these purposes incalculably outweigh any other benefits
alleged-I believe incorrectly-to result with respect to other purposes, important
though these are.
To be sure, the attainment of reasonable price stability as soon as feasible
is an essential objective of national economic policy. But efforts recurrently
during a quarter century, nnd especially during the past ten years and now, to
reduce inflation by stunting and misdirecting the fundamental performance of
the American economy as defined above has resu1ted only in a chronic increaRe in
the rate of inflation which is still continuing. This has now been recognized by
the Humphrey-Hawkins legislo.tion an.d by powerful statements on the Senate and
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Bouse floors by leading members of both political parties in support of this
legislation .
. Even more important, and almost entirely overlooked in the ~urrent economJc
discourse at high levels of the Administration and elsewhere, price movem~nts m.
themselves are not ultimate purposes or ends in our economic system or m our
national values. Prices are but one of a number of means of allocating resources
and incomes in a balanced mann.er conducive to achievement of these ultimate
Purposes or in an imbalanced manner inimical to this achievement. And neither
a rising nor a stable nor a falling price level works per se and automatically in
favor of or against this balanced allocation of resources and incomes. During
1922-1929, a remarkably stable price level did not prevent growing maladjustments in the economy which brought on the Great Crash. Although prices
remained stable productivity increases and the profits which they yielded were
translated exce~sively into investment which increased production capabilities.
But in other major sectors, tlle wages, farm income, other consumer income and
Public outlays which support ultimate demand lagged very greatly. During the
Years of the Great Depression, a sharply falling price level, with wheat falling
to 25 cents a bushel 1 and labor obtainable at 50 cents a day, did not cure anything.
The dollar was wor th more during the early 1930s than at any time since, but the
~ell-being and productivity of the American economy were becoming less and less
m the course of the greatest economic debacle in modern history. From 1933 to
1937 at least, a sharp reflation of prices was an essential element in a very strong
economic recovery. Prior to the recessions of 1953 and 1957-1958, the second one
being quite serious there was reasonable price stability. On the other band, during
l947- 1953, and dur ing 1961-1966 very strong economic performances were accompanied by and indeed facilitat~d reasonable price stability. Since then, in the
main, we have experienced on the average an abysmally low fundamental economic performance accompanied by intensification of price inflation. 'l'llese examples _co1;1a be multiplied, but they demonstrate more tha~ adequately the lack of
end in itself, while failing to evaluate price movements m the larger framework
of their impact upon the allocation of resources and incomes an.d upon economic
balance, and thus upon the ultimate economic and social purposes which I have
?efined. Yet the Administration's obsessionary preoccupation with price trends
is now mounting, with increasing neglect of the larger problems of which trends
are only one. And the course is really inflationary, not anti-inflationary.
1
The glaring failure to achieve our fundamental economic and social purposes
Comi1;1g now to the empirical and documentary evidence in support of what I
have said. It is necessary first of all to depict the almost unbelievably high costs
an~ hardships resulting from the failure of national economic policies to assume
then· appropriate role in helping to achieve and maintain an acceptable fundamental economic performance as I have defined it, and as it is defined in the
Employment Act of 1946 and now in ,t he Humphrey-Hawkins legislation of 1978.
And in order to stress the evil of so much attention to the so-called emergencies
or ~rises of the moment while overlooking longer range and systematic difficulties
wdhich also have been primary causes of the so-called emergencies including the
Ollar crisis, we must view the situation in a meaningful long-term perspective ..
We will never get anything straightened out by acting from month to month or
even from year ,t o year, because the American economy, like Rome, was not
built in a day .
. As my Chart 1 depicts, the roller-coaster performance of the U.S. economy
smce 1953 to date, with respect to the real rate of economic growth which is
fundamental to all else, has been shocking and inexcusable. Compared with an
average annual real economic growth rate ranging from 4.6 percent to 6.5 percent during periods when we were doing well, the average annual rate was only
3.3 percent from 1953 through 1978, and only 2.8 percent from 1969 through ll:178.
The real growth rate was only 3.9 percent from 1977 to 1978. And today, the
Administration and the Federal Reserve are contriving economic policies in the
name of protecting the dollar which, according to their own estimates. will reduce the rate of real economic growth to somewhere between 2.5 percent and
3:5 percent dui'ing the year ahead, will lift the rate of unemployment substantially, will set aside efforts to service better the great domestic priorities, and will
run very serious risks of a sixth recession since 1953 which could be more severe
than the most recent one if the trends over the past five recessions continue. I
share the general thrust of these estimates within official circles, although my own
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appraisal is even more pessimistic. But I reject entirel~ the cu~rent dol;ar rescue
.
policies which are likely to translate these gloomy estimates mto reality.
To take into account the human factor, and as an index of overall costs which
go beyond unemployment and cover every sector of the economy, my Chart 2
depicts the levels of officially recorded and full-time unemployment from 1953
through 1978. The chart also depicts the unequal distribution of the _unempl~yment burden among various groups, a situation fraught with horrible social
costs and menacing civil dangers.
Is just avoiding a recession good enough?
The Administration is now confessedly contriving a further slowdown in a
very low rate of real economic growth and a large rise in unemployment. Meanwhile, the Administration appears to derive satisfaction from its claim that an
absolute recession is unlikely. This assurance may well turn out to be unwarranted, for every serious slowdown in real economic growth and rise in unemployment since 1953 have ended up in absolute recession. But even if this assurance were correct, what a pitiful appraisal ,t his is of the real needs and powers
of the American economy and its people. It is not within a million miles of good
enough for the American economy to achieve an average annual rate of real
economic growth of only 2.8 percent during 1969-1978, when somewhere between 4 and 5 percent would have been optimum and practical. As my Chart 3
shows, an average rate of real economic growth of only 3.3 percent during 19531978 caused us to forfeit, on a conservatively estimated basis, more than 5.9
trillion 1977 dollars worth of total national production, and to suffer more than
76 miilion man- woman- and teenager- years of unemployment in excess of the
amount of unemployment consistent with reasonably full employment. If these
dismal trends continue, as they are .more than likely to do in the face of the
current complex of national economic policies (and in acco-rd with the current
economic growth rate forecasts of some spokesmen for the Administration and
of many other economists and analysts), my Chart 4 contains my own projections
that, during 1979-1983 inclusive, we would forfeit another 818 billion 1977 dollars
worth of total national production, and have about 16.7 million man- woman- and
teenager-years of excessive production. In 1969, employment would be
1.1 million lower and unemployment 0.5 million higher under the low economic
growth rate than under the high, and in 1983 employment would be 5 million
lower and unemployment 2.5 million higher .2 My low projections involve a 3.2
percent average annual real growth rate; the Treasury Secretary last week
suggested as low as 2 percent. My high projection is at the 5.5 percent real growth
rate needed to reach the 1983 goals of the Humphrey-Hawkins Act.
These production and employment forfeitures do not t ell the full story of their
ramifying effects throughout the economic and social structure. Among other
things, the total national production forfeitures during the past quarter century
have meant forfeiture of about a trillion and a quart.€r 1977 dolla rs in Federal
and State and local revenues at actual tax rates. Thus, the financial plight of the
cities, and the shortchanging of every major human and social purpose which
depends largely upon public outlays or upon an admixture of public and private
outlays. And thus the current claim that this shortchanging must continue as
the only way of reducing inflation and protecting the dollar. What a distortion
of values this claim involves. What a lack of understanding of how our American
economy really works is involved in unawareness that the neglect to date of these
priority purposes has been a major factor in the poor overall economic performance, and if continued will make impossible the movement to full economic recovery which we so much need. And how a stigmatic are those who do not see
that the selective shortages caused by some of these neglects have caused some of
the most extreme instances of price inflation.
Yet Federal Reserve Board Chairman Miller joins the Administration in th,~
"comforting" assumption that we will not have another absolute recession. What
an intelligent and heart-warming assurance that would be, even if one could
accept it at its face value. These comforters in our midst are like the proud
parents who are delighted that their child is not going to be demoted from the
sixth grade to the fifth, instead of worrying that the child is getting very bad
marks in the sixth grade and is likely to take two years to r each the seventh. Mr.
Miller goes even further than that. In a speech on December 6, he estimated that
2 The differences in employment and unemployment are not the same because of differences in labor force growth under the two projections.
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it would take five to eight years to restore an acceptable degree of price stability,
and that consequently we should plunk for several more years of sharply reduced
real economic growth and rises in unemployment. H ow much unemployment by
1981?
To depicit what we should be starting now to achieve, in vivid contrast with
where we are now heading, my Chart 5 depicts goals for various sector of the
economy consistent with reducing officially reported unemployment to 5.6 percent
for 1979, and to 3 percent for ad ult and 4 percent overall by mid-1983 in accortl
with the goals of the Full Employment and Balanced Growth Act of 1978. The
contrast between these feasible goals and where current national policies in
defense of the dollar are now beading us is truly appalling.
Th e program to r escue the dollar by repressing a forw ard economic movement
will not r estrain inflation
As I have already stated, the obsessionary preoccupation with price trends as
the top priority of national economic policy would be wrong even if it worked to
trade off less unemployment to get more price stability, because price trends arC'
not an end in themselves, and because marginal differences in the rate of inflation would not justify sacrifices in production and jobs of the magnitudes which
I have already depicted. But this consideration may be of relatively slight significance, because by now the empirical evidence has become compelling that abnormally low growth or recessions and higher unemployment bring more inflation. l
have been making this evidence available for so long and so many times to this
Committee and other Committees of the Congre s, as well as elsewhere, that it
would seem improper to go extensively into the matter at length again today.
But I do call attention to my Cha rt 6, which summarizes the empirical evidence
all the way from 1947 through 1978. And my Chart 7 adds to the empirical evi dence by dealing more definitively with the mor•e recent experience. This chart
indicates that the highest rate of inflation since the Civil War was accompanied
by the most severe economic downturn since the Great Depression; that prke
inflation decreased by extraordin ary amoun ts when the rate of real economic
growth was extraordinaril y high from the fourth quarter of 1975 to the first
f(uarter of 1976 ; and that the great slowdown in the rate of real economic growth
from the fourth quarter of 1977 to the fourth quarter of 1978 was marked by
a rate of price inflation corning again close to double digit levels with r espect to
consumer prices.
I will not deal at length with the many reasons why a stunted economy
e:enera tes more price infl ation. These include the scarcities created, the tendence
in the adm ini stered price areas to raise prices fast er v;1 hen the volume of bu iness
is disappointing, and the rising per unit coPts of production due to a declining
or negative rate of productivity growth when plant underutilization is very
high. There is great concern now ahout how to inrrease the rate of productivity
growth. but mm:;t of the talk and measures directed toward this end are misnlaced and in some cases damaging because they ignore the empirical evidence.
Th e plain fact, as dPmonstrated by my Chart 8. is that productivity growth in the
nrivate economy ii::'high and tends to acceler ate on a secular basi s ,vhen resources
a.re reasonably well usNl and tends to reduce greatly or become negative when
the onpo ite is the case. Moreover. as shmvn by th e pPriod from fourth quarter
rn77 to fourth (fUarter 197R. th e imnact of excessive underutiliza tion of resources
over a very long period of time continues to oner~te against uroductivity grm,v th
even when in a hsolute terms the Pconom:v is moving 11pward hut mncll too slowly
and i~ still nQ\,;rhere near reasona bl:v full resource use. If we ma de the s11ccessful
efforts ,11,e ought to be rnaldng to hring the econornv back to rea sonably full
r esource m~e, we ro11ln well afford to forget abont mnRt of the spnrious efforts
to increase .I>roductivity while applying economic policies which continue to
militate against it.
TJ etailen anal.11.n-~ of h011 the ilolla,r-r,rotectfnn r,ror,rrrm 1rfll r,rave ly iniur e the
domestic economy : and tir,ht mone11 rrnd rfsin.r, 1n t Prest ra,tes rome first
T come now to a more dPtailed ae~crintion of the Arlmini stration's policif's to
nrotect the dolll:tr. ThP main elements in these noliciPs mav he stated CJUickly .
Th ey inclnrle Administriition acouiesrence in and Pnronragement ·o f a renressive
and r egressive F Pderal Reserve nolicy of tightening nn money and driving interest r a tps np to near rrcord levels which may soon he r eached or surpa ssed;
a fiscal policy of no growth ju th e F eder al Brn'lget. arcompanied by at least approval of repressive tax legislation on net balance. including regressive tax
4 3 - 286 0 - 7 9 - 6
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eduction for the wrong recipients at the wrong time; an attempt to balance
~he Federal Budget at the expen~e of the national economy and the great national
priorities of economic and social needs; and a price-wage guidelines policy
which becomes more repu~nant th:e _harder one tries to understand it.
The absolutely indefensible policies of the Federal Reserve have been in effect
since the Federal Reserve-Treasury accord of 1951-1952, have accelerated with a
vengeance during the more recent y~a.rs, and have become. fantastic during the
most recent months. These FRB policies have been and still are a main factor
in the abnormally low rate of real economic growth with all of the inseparable
evils and costs occasioned thereby.
My Chart 9 indicates the general though not entirely uniform positive correlation between the tightening up of the non:Federally held money supply and the
advent of the reduced rates of real economic growth and then the reces ions. The
inadequate expansion of the money supply to sup.port healthy economic expansion
is grossly understated because no allowance is made (on my chart or elsewhere)
for the rate of general inflation. For example, if the growth rate in the money
supply from the fourth quarter of 1977 to the fourth quarter of 1978 took account
of the rate of general inflation of 9.2 percent during the same period, it would
·become clear that the real growth rate in the money supply was negative when
u needed to increase greatly to support an appropriate rate of real economic
growth. The same chart fortifies the earlier stated conclusion that deficient
economic growth and high disutilization of productive resources are highly
inflationary. Thus comes a cropper the claims of the Federal Reserve that its
monetary policies restrain inflation; they do just the reverse.
There are other reasons, almost completely ignored in examination of the
problem, why rapidly rising int~rest rate~ a_re inflationary. Interest rates are
a cost like all other costs, and increases in interest rates are transferred and
pyramided throughout the whole economic structure. My Chart 10 portrays the
rise in computed averag_e inte:est rate. on the total publ~c and pri~ate debt during
the 17 years 1952-1978 inclusive, and also portrays the increases m interest costs
on the private debt, the State and local debt, and the Federal public debt. The
bottom half of this chart translate~ the perce~tage rate increases in interest
costs into dolla_r figures. Thu~, during ~he period as a whole, more than 1 .5
trillion dollars in the form of increased intere t costs have been transferred by
national monetary policy from borrowers to lenders. This is intolerable in social
terms. And, as will be disclosed, it is highly detrimental to balanced economk
development and conducive to the abnormally low average annual rate of reai
economic growth and the recurrent recessions.
The inordinate increa e in the interest rates on the private debt has bo
down with tragic severity upon private borrowers in the lower half of the inc rne
structure. It does much to explain the increase in the total inflationary b ~me
borne by these groups and the dangerou increase in the expansion of the ur
burden imposed upon them. The increases in the interest costs impo ed ere i
the Federal Budget explain a major portion of the Federal deficit even u:pon
out allowing for the part of the Federal deficit stemming from ::i.bn'ormall wthgrowth and very high unemployment. It app ars strange that those wh Y
upon the Federal deficit a a major cause of inflation favor monetary O r10.0
which have done so much to increase the Federal deficit.
po icies
My Chart 11 compares the excessive interest cost in the Federal Bud
.
outlays for high priority Federal programs, looking at both the annual get wi th
during 1965- 1978 and the figures for 197 alone. In calendar 197 alaverages
exces ive interest co ts in the F ederal Budget, hurtful in all econom· one, th e
as indicated above, came to somewhere in the neighborhood of one-ha\~ respects
of the total F deral deficit for that period. Again for calendar 19'.7 th or more
costs in the Federal Budget came to immensely more than Feder~l8B de excess
lays for education or housing and community development or manpo . u get outfor fiscal 1979. Yet the Administration, which i. claiming that we :e\program
on these vital programs because we "cannot afford them,, is enco u :ut back
further increa e in the interest co t impo ed upon the F deral B u~aging huge
An~ my Ch~rt ~2. portrays the impact of the rising interest costs u u get.
.
familie and ind1v1duals, and al o portray bow a very mall f P?n American
increased interest costs could be u ed to wipe out poverty in thra~ion of these
recent, current and prospective monetary policies are eco
• \
.S. In short,
and ocially infamous.
n Omica 1Y destructive
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The "no u.rowth" Federal budget policy is 1//ighly damaging to the domestic
economy
The iniquitous Federal Reserve policies are accompanied in the current program to protect tlle dollar by a "no growth" Budget :volicy, except for national
defense. Coupled with the repressive effects of the monetary policy and the tax
and wage-price guideline policies subsequently to be discussed, the "no growth"
Budget policy puts the stamp of certainty upon a further decline in real economic
growth and increase.3 the probability of another severe recession. More importantly, the "no growth' ' lfeaeral Budget policy unconscionably assumes that
meeting the real human and social needs of the American people is postponable
and is of lower priority than protecting the dollar overseas. Actually, there is no
real dichtotomy l>etween economic error and social error in the context of the
~merican economy. Proper investment in the human and social programs is an
integral a spect of the task of restoring the American economy to full economic
b.eaitb. And quite apart from the obvious fallacy of trying to balance the Federal
Budget at the expense of even minimally-adequate human services, the effort to
balance the Federal Budget by policies which will hurt the American economic
Performance is hard to understand when it is so clear that the blood of adequate
F ede1·a1 revenues cannot be squeezed from the turnip of a stunted economy. As
my Chart 13 shows, the increases in the Federal deficit from 1947 through 1978
~ave been almost entirely in consequence of mounting deficiencies in gross national product and in economic activity when measured against our potentials.
It Ls hard indeed to argue that the r epeated tax cuts from 1945 to date compensate for the repressive nature of the other policies described above. For these
Personal tax cuts, on net balance, have greatly favored those in the higher ranges
of the economic structure at the expense of those lower down. This is demonstrated by my Charts 14 and 15 which measure correctly the impact of these
tax cuts, not by the differing percentages in tax cuts at various income levels
but by the differing percentages of gains in after tax income. It is a matter of
common knowledge that the 1978 tax cuts were far worse in this regard than
the earlier tax cut;-. .
. Further, the 1978 tax cuts impel a commentary upon the curious inconsistencies, planlessness, and improvisations in the Administration's economic policies.
To illustrate, the tax recommendations which the President sent to the Congress
Were clearly for large tax reductions although of a different nature from those
Subsequently enacted, and the President did sign the tax: bill which the Congress
aI;>proved. If the tax bill as signed is regarded as a measure to provide large
~timuiati.on to the economy, it does not do this because the repressive increases
in the socia.11 security taxes outweigih the stimulative decreases in other taxes, and
doubly so in view of the regressive distribution of the latter. And if the tax bill
~ere in fact well-designed to stimulate the economy greatly, it would be in
irreconcilable conflict with dollar protection policies (initiated so shortly after
th e President signed the tax bill) designed avowedlly to restrain the ~onomy.
Pubuc spending versus taa; reduction, and private spending versus pubUc spending
Beyond what has just been said, the combination of a veritable ~Y of ~
reduction over the yea;rs with an increasing animadversion to publlc spending
hardly makes any sense at alQ. If the objective is to stimulate the economy, even
th e .D?-ore conservative of responsible studies have found th.at each _d?llar of
~dditionruJ. public spending adds more to empk>yment :a nd busmess activity, a nd
is therefore _less eootly to the Federal Government, than each dollar of tax reduction. If the great priorities of domestic needs in such fields as ma~s transPortation, energy expansion, urban revitalization, and health, h?usmf, a nd
education are to be well served it must be obvious that each dollar of_mtell~gently
Programmed public investment including marginal a1Ssistance to pnvate mveS t Inent, must be immensely mor~ efficient than tax reductions handed down for
everybody to spend or not to spend as they please.
.
The arg;ument is also advanced that tax reduction serves better_than mcrea.sed
PUblic spending to honor the principle that private employment is ~referable ~o
iublic employment. This overlooks the fact that well-engineered mcreas~s m
PUl>lic outlays add far more to private employment tha,n badly designed
or even well-designed tax reductions. More impo~tant, the whole tre nd
toward the notion that, despite technological trends, ,p r~vate employme~t almoS t
alone can solve the unemployment problem, or the not1-0n thi~t any pnv~te emIYloyment is preferable to any public employment, or the notion now voiced by
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at very high levels to the effect that public employment is intrinsically
mars·rable-these are all notions which would bring about the demise of inr:iu~:nt or humane national e~onomic and S?cial ~oli~ies if these notions w~re
ermitted to grow from dis turblilg snowballs mto blmdmg snow_storms. A portion
~f the Administration's program ~o defen?- the dollar ~Y cuttmg bac~ severely
public service jobs is a good illustration of what 1s now happenrng. l\1any
~rher examples include what is happening to proposed welfare reform and health
insurance programs.
. .
Unfortunately, the "no growth'_' Budg:e t aspects of the policies to de~end the
dollar have forgotten that the primary purpose of the Federal Budget 1_s . not to
otect private enterprise nor to balance the Budget, nor even to stab1Qize the
P\nomy These purposes are valid in degree. But the primary purpose of the
;ederal. Budget is to accomplish what Lincoln meant when be said that the
function of Government is to do for _th~ ~ople wba~ !hey need to have done or
cannot do so well in their separate or mdindual capacities.
The wage-price guidelines to protect the dollar, if effectuated, would be highly
damaging to the U.S. economy
In some ways, the most importa!1t ele~en_t in the Administration's program to
protect the dollar are the wage-price ~idehnes and, unle~s they are drastically
altered, one can only hope that they will not become effective because their effecttive use would strike hammer blows at the_ economy. and do much inju tice besides. The guidelines provide for about a 6.D pe~·cent mcrease in prices, with de·tails too complex to discuss here today. Suffice 1t to say that the average actual
increase in prices would tend to be at least as high as the guideline figures in the
absense of adequate policing. Further, it is unparalleled to set a guideline for
price increases of 6.5 percent, piled 01;1 top of all the price increases we have bad
already. Eeffective price controls d_unng ";~rld ".7'ar II were ba ed upon the immediate objective of reasonable pnce stability, with some exceptions to iron out
inequities and lags in the st~cture. The price con~r?l~ duri_ng the Korean War,
after the Chinese entry therem produced double digit 1I1flat10n were al O aimed
at price stability and price increases averaged only one percent in 1952 and o.
percent in 1953. Price stability cannot be accompli hed by giving Government approval to high price inflati?n. .
.
Meanwhile, the wage gmdelmes provide for avera?"e wage rate increase of 7.0
percent. But allowin~ for the f~ct that a ~arg~ majority of the employed labor
force would not achieve anythmg approx1matmg these rates of wa(J'e increa e
and noting also that the 7.0 percent figure includei fringe benefits which do not
add to immediate purchases, the net effect if the guidelines were effective would
be average spending-orientated wag·e rate increas s of 3-4 percent, contrasted with
average price increases of 6.5 percent or higher. '.rlrns, on top of the fact that
average weekly earnings in ~11 nonagricultur_al e_stablishments were lower in real
terms in October 1978 than m 1969, such gmdelmes would mean a progressively
larger decline in t~e real purchasing po~er of average wage rates. Combining this
with the increase m unemployment which the Administration expects wage purchasing power an_d _consumer I_>Urchasing power in general would fall progres ively short of the mmunu!11 reqmrement for the rate of economic progre s required
to restore our economic. he~ltb: In these connections, my harts 16, 17, and 1
depict the growi_ng de~cienc1es m consu~er spending, based upon an inadequate
income growth, mcludmg adverse trends m wages and salaries
The Administration's price-wage guidelines are therefore gros ly unfa· F
m~re ~mportant than any ab. t~act con~ept of fairnesl , however, the pric~~~a a~
gmdelmes are based up~n the mdefe? 1ble a , umption that exces ive wage ra1e
gains have been the maJor ca~se of rnflation. :rnd that ho1ding hack wage t
gains is the central weapon aga1~st inflation. But it is generally admitted th t ~
wage rate gains should app:ox1mate pro~nctivity gains in the private ecinom~
and my C~art 19 sh?ws that Just th~ opposite has been the general rule. Since
1960·
and especially durrn(J' 1977-1978 this h3:s been_ tartlingly true in manufacturin
'
w~ere the greatest hue and cry has arisen with respect to "excessive" wage raf~
1
grun&
·
To be sure, wage rate (J'ains .have exceeded productivity
.
.
,gains, 1·n th t t
non-farm economy (b n t no t m mannfactnrmg) when the rate of e o a 1 private
.
1
·
1
1
<
r(la economic
growth ha_s averaged ~enous Y ow and when unused plant capacity
has been extreJ:?,ely high, this bemg one reason as stated above for inflation durin th
periods. But any attempt to reduce real wage rate gains to make them com~arat~!
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Wit? a seriously deficient economic performance would manifestly worsen the
en_tire 'economic performance all along the line, and this criticism is doubly applicable to the Adminh;tration's current attempt to encourage la rge real wage
r~te losses in the private economy even while profits have been soaring, as will be
dis~ussed below. And even if the wage rate gains needed to _play their part in
satisfactory economic recovery were to cut profits, even that cut should be borne
for a while in the longer range interest of business, or the Gonrnment should find
?ther ways of supplementing the ability of business to pay the needed wage
increases.
That the Administration is considering asking for postponement of minimum
wage rate increases scheduled fur January next is another indication of upsidedown thinking on the whole wage problem.
The real causes of low growth and recessions are enlarged by the current policies
to protect the dollar
The Administration's highly repres,s ive approach to wage rates, coupled with
the repressive monetary and fiscal policies described above, are virtually im~ervious to the real troubles of the American economy and the real causes of the
~ve previous recessions. The dominant cause of these five previous recessions has
_een that investment in the plant and equipment which add to production capabiliti~s has raced ahead very much faster than the ultimate demand represented by
Pnvate consumer expenditures and public outlays combined, and the regressive
~ax reductions abetted this racing ahead. When. for these reaBons, the so-called
boom" periods moved into stagnation and then recession, investment was cut
back very sharply. And the combination of this with the larger and more endudng
deficiencies in ultimate demand brought on the manifold troubles which ensued.
My Chart 20 depicts this entire process very clearly, and yet those who refuse to
learn from experience are doing all of the same tbing,s again with the same likely
results.
The avoidance of proper treatment of the housing problem
There is only one additional aspect of the gapi::; and deficiences in national
~conomic policies which I wish to discuss because of its immense importance. This
bs the complete failure to recognize the role of housing in the national economy,
_0 th as to home construction and home occupancy. This chronic Federal dereliction, evidenced again by current and proposed cutbacks in the HUD program and
also by the soaring interest rate policy, has been both inflationary and severely
damaging to our overall economic performance and attention to social needs .
. As shown by my Chart 21, borne construction represents a feast and famine
situation. At times as in 1972 and to a lesser extent in 1977 and 1978, the construction of homes for those mostly in the upper portions of the income structure
has seemed on the surface to represent a satisfactory overall performance. But
as thes'e particular markets have become saturated, this plus the sorely deficient
Production of homes for those lower down in the income structure has brought
on the recurrent famines. Indeed, for the period 1969-1978 as a whole the :iverage
annual production of homes was more than 200 thousand less than m 1952,
~lespite very large increases in population, extensive population shifts, la;ge
~ncreases in substandard or unsatisfactory housing, and recun-ent overcrowd~ng
111 some jmportant locations. The average annual production of homes durmg
19 69-1978 was only 1.749 million, contrasted with estim~t~s made_ by the Government it~elf that the avera.e:e i::;hould hnve been 2.2 nulhon durrng 197~-l980
inclusive. Allowing for the cumulative deficiencies over the years, I now. estimate
th at we need almost 3 million homes a year on the annual average dunng 19791983 to meet real housing needs and to exert the needed role of home construction in halanced economic growth at the rates needed to re~uce· un_emP! 0 Ytnent to 4 percent bv 1983 in accord with the Hnmphre;v-HawJnns legislation.
Correspondingly, my.Ch-art 22 reveals that the rate of unemployment in contract
con. truction usually has run abont twice aR hi.~·h flfl the overall un employment
.
rate, and even now is running about 50 percent higher.
I have also attempted to estimate (in a study to which I devo_ted abou.t a
Y~ar's time) the imp1f'ts of the deficits in resiclential and commercrnl ~011st rnc~Io~ upon the general economy. My Chart 23 se~s forth th_
e resu!ts of t_!11s study,
lndicating among other things that the cornbrnecl deficit. durrng: 1903 -1976 (I
have not ,et been able to brino- this study up to date) directly _account~d for
G.N.P. forfeitures of almost one~fth of the total national product10n forfeitures
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during this period, with correlativ e losses in e1;Ilployment opportuni ty, Federal
ues and State and local property tax collect10ns.
rev,;:e m'ost important single factor in making satisfacto ry housing unavailab le
t scores of millions of families, or availal>le only at costs so inflationa ry that
t~ey have deprived these families of other necessities or caused them to go
excessively into debt, have been and still are the PE:rverse policies of the Fedal Reserve As shown on my Chart 24, the average mterest rates on new home
:ortgages r~se from about 4.3 percent in 1952 to 9.54 percent in 1978,
or far
more than a doubling of the rate. The percentag e increase in average interest
rates on new home mortga~es over the sam~ period of time was 122.4 percen!.
In the comprehensive housmg study to which I have already referred, I estimated the impact of various interest rates upon home owners at various income
levels and the extent to which excessively high and rising interest rates worked
ad~ersely. The results are shown on my Chart 25. This exercise is very re80
vealing even though the results would be enormously worse if the chart
was
brought up to date by using a 10 percent instead of a 6 percent interest rate
and by taking care of changes in the income structure since 1974.
Again I state that a national policy which so grievously _omits proper
tion to the housing problem cannot be regarde!1 as responsible or matureattenwith
respect to education , health, or othe~ great national and economic social priorities set forth in the Humphrey -Hawkms Act.
Discussio n of other questions posed by subcommittee chairman
In a letter to me dated November 28, the subcommittee chairman noted that
rising interest rates have not thus far caused the usual crunch i~ the
market, and asked whether if this co~tinues (unlike earlier periods ofhousing
credit
tightening ) the res~1lt would be a slowmg of expenditu res for capital formation
more sharply than. befor~.
.
As my above d1scuss1on of the housmg problem reveals, excessively hio-h
interest rates have been seriously reducing home ronstructi on with great dam:ge to
the economy for a long number of years, and this is not gainsaid in the slightest
by the observatio n that housing constructi on has been at a high rate (it ought
to have been still hi~her) in 1978. Second, a~ interest rat~s are considerably
higher now than dunng 1978 as .a whole, as 1t takes a while for increases in
interest rates to impact upon home construc!i~n, an~ as interest rates may well
go still hi~ber than they are now (the Admm1strat10n and the Federal Reserve
appear inclined 1n this direction) , I agree with many other analysts that home
constructi on will be very m1.1ch loyve_r in ~97~ than in_ 19!8. The usual crunch
on housing has not been avoided; it 1s begmmng, and 1s hkely to become much
more severe.
Third, even if there were to be no significant slowing of housing constructi on
excessive tightening of the m?ney suppl_y and excessivel y high interest rate~
would operate even more seriously against other types of ca,pital formation
than if the impact upon housing were more severe. This merely reflect the
truism that one cannot pull too short a blanket up over his shoulders witho
exposing his feet. And fourt_h, so !on~ as the Federal Reserve believe al~tt
mistakenl y that the overall tI?htemng 1s necessary, then that agency should t
aside its unwarran ted -objections to some rationing of credit, as was don P'.1
earlier times with great success. The way things have been for some time e 1~
still are, the blunderbu ss tightening of credit has not had much effect an
some who should be curbed, and has made it even harder for others to ma~~o~
go of it.
As I have just indicated, the changing distributiv e impacts of monetary
should be remedied in part by a more selective monetary policy No at~oric~
should be made to remedy it by still higher interest rate becau~e th t temp
alone would further increase the distortion s in the di tributive impactsa H·aten
interest rates are not now needed to achieve a given reduction in a· ig ~
spending, first because (as I hav~ analyzed fully above) a deficienc ;~!~er
than an excess of aggregate spendmg ha been the problem for a lo t·
certainly is now, even with regard to the true causes of inflation (defin~ ~~ a nd
mental economic performan ce), and second because if a decrea .rien
nd aspending were assu?Ied to be_ n~ded, that should b~ on a hi hl
m aggrega_te
while blunderbu ss increases m mterest rates would impose gth: ~elected h~SI ,
wrongful pattern on both economic and social grounds.
ecreases m a
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~s is clearly revealed on some of the charts related to what I have already
said, w_e need for full economic recovery and for reduction of price inflation a
sharp !ncrease rather than a slowing down of the rate of capital formation.
Including both plant anct equipment and housing, this rate o.t increa e hould
be grea~r than for ?ther parts of the economy. But :so far as inve tment in plant
and eqmp~1ent and m other durable producer goods other than housing is concerned, neither defects in the monetary-fiscal policy mix nor levels of interest
ra_tes, n?r the inadequate real growth in the money supply, have much to do
with this problem. The wrongful monetary policy has caused capital shortage
problems for small business and farmers and home occupants. But our large
mass production industries. in the main. have not suffered from capital shortages, and have not been much affected by rising interest rates because they
finance so large a portion of their investment out of retained earnings and
through increases in prices to cover increased interest costs.
My Chart 20, eulier referred to, shows that before each economic downturn,
and again during the recent period to date, profits and other incentives have
induced the growth of investment in plant and equipment at a much more rapid
rate than the growth in ultimate demand represented by consumer and public
outlays. Thus again today, before an absolute downturn occurs, one basic need
is to provide more incentives to investment in plant and equipment by appropriate expansion of ultimate demand. All of the major policies in the save the
dollar operation-the rising interest rates, the "no growth" Budget policy, the
guidelines, and the upside-down nature of the recent tax legislation, move in
the opposite direction. This is just what happened before the five recessions
since 1953 to date. Many busine<:s leaders may not agree with my analysis as
stated. But they do correctly appraise the consequences of the facts which my
analy is describeR, anrt trflt i wh:v the most rPcrnt Government reports indicate a sharp downward revision in business investment plans for early 1979. These
reports also urge that abandonment of this downward revision depends upon a
large upward surge in consumer spending.
Why damauinfJ the U.8. economic performance is profo1tndly hurtful to attempts
to protect the dollar
What I have said thus far completes my analysis of the damaging and maybe
devastating effects upon our domestic economy which, in my judgment, would
result from the current program to rescue the dollar. For it would ~oon. beco~e
apparent to all that the effort to rescue the dollar mainly by reducrng mflatwn
was an effort very unlikrly to achieve its anti-inflationary re ults. Under the
going effort, inflation during 1979 might well average ~h.er than during
1978, even though unlikely to average as high as the double d1g1t rate of today.
But the predominant reason why the current policies to rescue the dollar
Would fail in the long run, in my judirmrnt, is that the:v are ba ed upon :
narrow and misconceived explanation of why the dollar has become so w~a ·
The dollar has not become so weak primarily because of in.flati_on in the Um~ed
States, nor primarily hecPnRP. nf ('lifferential intereRt rate!'s m different countr;::
With rates lower in the United States than in some other places. Nor h!3-S
dollar become so weak primarily because of highly unfavorable trends Ill .our
• ~~
tional goods and services
balance of payments accounts and in our m1-~rna
·
·
t
by the dollar bas becom e
accounts. The overwhelmmgl.v 1mnortan
reaRon w b
th dollar's value
so weak and our international imba1'ance~ so huge is ec~used
the poor perand the degree of overseas confidence in it have been r~ uceld be more disrupf?rmance and poor prospects of the U.S. economy. Wba rifin ed evidence that
~1ve of confidence in the currency of a country th an 1o abe1 both stagnation
tts national economic policies have lear~ed 0?1.Y how word which covers both.
and inflation, and have succeeded only m co~nmg a d instead sharpening up
While making clear an inability to remed~ e~!h~\~e that our national policy
the weapons which have produced bot~? It is
~iews of international and
tnakers. stop Ii tening almost exclusively to
e weak or strong, and start
~omestic financiers as to what makes an eco~~mijnt ont that the real wealth
listening to an:v rommon ~enRP n~r~on who won
he rowth of production, the
and Rtrength of nations is what is happenlrgbio ;ote!tials for real growth, the
reduction of unemploym'ent, tbe use of ava af e 'tical social and civil dangers
reduction of shortages, and the awaren~SR O
of so large a portion of the
arising from not meeting the most basic nee s
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le What other civilized nation has tolerated for long the rates of unemploypeopt ~e have here in the United States? Moreover, the needed policies just
::~tioned bring higher tax receipts, lower Federal deficits, reduce price infla.
.
. .
tion, and increase exports.
There is no nation in the world which is so richly. endowed. fl:S we _are with
th potentials for economic progress at home and fair competition with other
e ts of the world. But a s to the latter, which is most closely related to the overpar attitude toward the .S. do1lar , what ha. been happenino- i , hown graphicon my Chart 26. During the p~st quarter century or t he p~st eig~t years, the
real annual economic growth rate rn Japan has made us lo_ok hke snails. The real
conomic growth rates in Germany and France and Mexico have made us look
fke a rabbit with one of its legs tied to its ear. Would anyone have believed ten
~r fifteen years ago, before economists ~n the public service seemed to have lost
part of their discernm ent, that the Umted Rtates could strengthen the overseas
:onfidence in its currency enduringly by deliberation and proudly announcing
to the rest of the world that it is goi_ng to _widen the g_ap between its fundamental
economic performance and that of its prime competitors, and court a sixth domestic economic recession since 1953, which the rest of the free world fears more
.
than all else.
It is high time, I respectf~lly submit, that ~hose who wo~ld seek to protect
the American dollar qY de!1berately weakenmg t~e Ai_ner1can economy, and
those who believe that inflation can be_ red~1c~d by Jammmg on the brakes <)f a
forward economic movement and puttmg it mto reverse, should read the Full
Employment and Balanced Growt~ Act of 1978. The_y should then muster up
the determination to obey the specific mandates of this law because these mandates embody the reflections ~nd decisions of _those in the Congres§I of the lJnited
States who have been steepmg themselves m problems of ?COnomic policy at
least since the Employment Act of 1946 was enacted. And 1f these readers of
the Humphrey-Hawkins Act are high in the public service and dealing with
national economic policies, they should obey the mandates of that Act because
it is their specific duty to do so.
More important still. those high in the public service should learn to live by
the spirit as well as letter of that Act so recently approved after such careful
consideration. Tha.! Act i~ based upon the prop?sition that we have the power
to develop upon this continent an economy dedicated to the principle of abundance, equitably shared. The Act does.not contemplate that, in th'e year 1979, we
take one frightened step •b ackward mstead of one confident step forward It
does not contemplate that we dedicate ourselves to financial policies such· as
higher and higher interest rates and regressive taxation, which feed the fat and
starve the lean. It does not contemplate continuation of the tax injustice of
making larger and larger numbers of unemployed bear the major burden of th
fight against inflation,. and ~ misguided one ~t th~t .. It does not contemplate tha1
we become so preorcup1ed w~th one problem-m this mstance, the dollar problemthat we forget all else, as if we were a one purpose nation instead of a natl
with many problems a~d plu~a~is_tic pur~ses. It does not contemplate that ~~
trap ourselve_s foreve~ ~n a disJomted _series of emergency actions, but inste d
a
plan our nat10nal policies comprehensively and harmoniously on a long
range
basis, with the President and the Congress working together.
I have not in this statement dealt extensively with details of remedial ti
altho'!gh many_ of t~em are implicit in what I have said. I believe that t~c on,
propriate details will em_erge when the mandates of the Humphrey-H e k~Plegislation are observed instead of being ignor d or depreciated Some O~~h ms
details I will suggest next year in tei;;timony before or invited· comm t f ese
nished to the .Joint Economic Committee. Far more important I b 1~n t urhat
(hopefully with some ai;;sistance from what I have had the opp~rtu ~t ie;e
O
here today) this Committee and the Congress will fullv rise to it ~ Y offer
0
~he
responsibility and high opportunity to reconstruct national eco:o s .are
so that we will move forward rather than backward and with 1 .fie policies,
egi imate confi'
dence replacing megitimate fears.
~1fys
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THE "ROLLER-COASTER." ECONOMIC PERFORMANCE:
ECONOMIC GROWTH RATES.I922-1929. 1941-1945. AND 1947-1978_!/
( Uniform Dollars )
_ _ _ _ _ _ _ _ _ _ _ _ _ _ ____. ANNUAL GROWTH RATES ,___ _ _ _ _ _ __ _ _ _ _ _ _ _ __
Up
8.7%
Down
Down
1.3%
1.4%
r - - - - - - - - - - . - - - - - - -------i AVERAGE ANNUAL GROWTH RATES ,___ _ _ _ __ __
Down
1.3%
_ _ _ _ _ _ __
9 .0%
6 .5%
19221929
19411945
19471978
19531978
19471953
19471949
19491953
19531961
19611966
J./ 1979 estimated .
..fu'Recession durin9 part of period.There were five recesslons,1953-1978 ,but some were entirely within one year.and be9an and ended in different years.
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19661969
19691978
19761977
19771978
86
Chort2
UNEMPLOYMENT,% RATES & DISTRIBUTION, 1953-1978
12%
11%
10%
12%
11%
10%
9%
8%
7%
6%
5%
4%
9%
8%
7%
6%
. - - - - - - - - - - 1 %RATES
OF UNEMPLOYMENT, BY COLOR~ 1 - - - - - - - - - ,
llllll!IIITotal
tm5.JWhite
-
Black a Other
1953
1954
r---------1
1958
1978
1977
1975
1969
1965
%RATES OF ADULT UNEMPLOYMENT, BY SEX-~ 1 - - - - - - - - - .
11!11111 All Adi.Ill$ (a(Jlld 20 &over)
CSlEJMen
women
~, 4.9 5.5
6.2 6.2 6.1
7.3 6.7 8D
3.6 12 4.5
em•
Bi
■ l@I
a1953
□• 111@1
1954
1958
1965
1969
2.7 2.1 3.7
g11
1975
"u
7.0
4.9 4Z 6.0
■
■1977
nl 10
1978
%RATES OF TEENAGER UNEMPLOYMENT.BY COLOR~L - - - - ~
mm!'il All Teenagers(O(J8d 16-19)
36.9
rrz!JWhite
~ Black a Other
27.4
26.2
38.3
36.0
24.7
.!Jin deriving these percentages, the officially reported civilian labor force is augmented by concealed unemployment. Thus,
some of the rain for full-time unemployment are very slighly lower than in the official reports of fulHine ~ n t
EJ Withdrawals from labor fOl'Ce,due to scarcity of job opportunity.
~Officially reported concept of full-time unemployment.
.iloistribution by color unYOiloble.
Note:Some totals affected by r011ndi119. 1978 estimated.
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Federal Reserve Bank of St. Louis
COST OF DEPARTURES FROM FULL ECONOMY, 1953-19781/
2~00 - - -- - - - - - - - - - - - - - - - - - -
G.N. P.
.......
8 ,1 li ons of 1977 Dolla r s
2,300
.
........
.............
~ ·•···•·······
FULL ECONOMY PERFORMANCE~
.....
~953 '54
'55
'56
'57
--■--■■■•11•11•••••••
'58
'59
'60
'61
'62
-···············••'"
••••••••••••••~FFERENCE:5,937.5 _ __,
.............
1,800
1,300
••••
__.................
ACTUAL PERFORMANCE ll
'63
'64
'65
1
66
'67
1
68
'69
'70
'71
'72
'73
'74
'75
'76
'77
'78
'69
'70
'71
'72
'73
'74
'75
'76
'77
'78
105 ,---- - -- - - - - -- - -- - - - -- ----;
90
FULL ECONOMY PERFORMANCE .11
75
-
........
6?953 '54
'55
'56
'57
'58
~
_
..............
..
.................
'59
'60
'61
'62
'63
'64
J/ 1979 estimated.
~ Real averoge annual vrowth rate of 4 .4 percent.
~Reol overoge cntual i,owth rote of 3 .3 percent, !he 1953-1978 avtr0Qe .
.1/AYffllge true level of unemployment of 4.1 perctnt, or 2 .9 percent full-time ooemployment.
~Awrooe true level of unemployment of 7 .8 percent, or 5. 2 percent fu II-time u~oyment .
Boak: Data : Dept. of Commerc.; Dtpt. of Labor
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Federal Reserve Bank of St. Louis
'65
1
66
'67
1
68
BENEFITS OF FULL ECONOMIC GROWTH. 1979-1983
- - - - - - - - - - - - - - - - - - - - - - - - - , 2,800
2,800 .---- -- -- -- - - - - -- - - -- - - - -
.............
2,600
•"•••11••11•••11••
....••••••11••11•.......
.................
..............
.............. ..........
FULL ECONOMIC GROWTH PERFORMANCEJ;
2,400
2,200
.... ..
2,000
DIFFERENCE :818. 1
2,600
2,400
2,200
LOW ECONOMIC GROWTH PERFORMANCE~
2,000
1,800 ~ -- -- -- ~ - - - - - - - ~ - - - - - - -- ~ - -- - - - ~ - - - - - - - ~ - - - -- -- ~ 1,8 00
1978
1979
1980
1981
1982
19 83
105 - -- --
-
00
00
--------------
100
100
..........
95
LOW ECONOMIC GROWTH PERFORMANCE
90
95
90
85 ~ - - - - - - - ~ - - - - - - - ~- -- -- -- ~ - - -- -- - -~ - - - - - - - ~ - -- - - - - - ' 85
1978
1979
1980
1981
j,, Real IJ"0Wth rate of 5 .7%, 1978-'79. Real average annual growt h rate of 5 .5%, 1978-1983.These growth rates would be consistent with reducing
overallunemplayment to 4% by the middle of 1983.
l../ Real average annual growth rate of 3 2",
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Federal Reserve Bank of St. Louis
compared with 2 .8%, 1969-1978.
1982
1983
89
Chart5
MAJOR GOALS FOR 1983, CONSISTENT WITH 1983
GOAL FOR REDUCTION OF UNEMPLOYMENT
Total Percentage Changes
(Dollar Items in 1977 Dollars, Absolute Data in Parentheses)
CIVILIAN EMPLOYMENTb'
TOTAL PRODUCTION
(G.N.P.)
CONSUMER SPENDING
Up
($604.28)
30.8%
19781979
GROSS PRIVATE
BUSINESS INVESTMENT
1978- 1983
GOV'T. OUTLAYS FOR
GOODS AND SERVICES
(Including net foreig.n)
Up
($365.78)
29.2%
19781979
1978-1983
INVESTMENT IN
RESIDENTIAL STRUCTURES
Up
($44.08)
47.1%
197819 7 9
1978 - 1983
19781979
1978 -1983
19781979
1978-1983
.l.; Narrower bars fOI' 1978- 1979 of no signif icance.
Y
Full-time unemployment down from6.0%(6Dmill ion) in 1978 to5.6%(5.7million) in 1979 and4.0%(4.4million) in 1983.
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Federal Reserve Bank of St. Louis
REAL ECONOMIC GROWTH RATES. EMPLOYMENT 8 UNEMPLOYMENT. INFLATION.
AND FEDERAL BUDGET CONDITIONS. DURING VARIOUS PERIODS. 1947-197811
Real Ave. Ann.
Ave. Annual
Econ--:-Growth Rote
Unemployment
Unemployment
Last Yr.
First Yr.
Ave. Annual
Inflation
(full-time)
Inflation Rate
First Yr. Last Yr.
(C.P. I.)
Ave. Ann. SuJplus
or Deficit
F~. Bud9et
(Fiscal Years, BllliQOS)
7.8%
1947-1953
1953-1961
1961-1966
1966-1969
1969-1978
1977-1978
J;1978 estimated. To ol low tor momentum effec1s of policies, the first yeorof one period Is also treated as the
Source: Economic Reports of the President, and Economic Indicators.
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Federal Reserve Bank of St. Louis
lost year of the preceding period.
-$46.9
91
Chorti
RELATIVE TRENDS IN ECONOMIC GROWTH
UNEMPLOYMENT. ·a PRICES,.1952-1978
PRODUCTION AND EMPLOYMENT
f<~~ ,,j Total Notional Production in Constant Dollors,Averoge Annual Rotes of Change
-
Industrial Production.Average Annual Rotes of Change
l!it!lil',!i/1 Unemployment as Percent of Civilian Labor Force,
Annual Averages*
12.4%
9.3%
8.1%
6.8%
6.2% 6.1%
6.2%
6.0%
3.9'1,
1952-1955 1955-1958 1958-1966 1966-1969
1969-1978
111!!11 Consumer Prices
Producer Prices-MAI i Finished Goods
-~-
. -10.6%
(onn.rate)
IQ'ili- IQ'75 4d75-IQ'7640'77-4Q'
... . Producer Prices-- Consumer
IM%fil1Finished Goods Excluding Food
16.7%
!:;;I
1952-1955 1955-1958 1958-1966 1966-1969 1969-19
78 IQ'74- tQ'75
Average Annual Rotes of Change
"!:I
~~ 4Ct77-4C/78
These onnuol overooes(os differentiated from the_~nnuol t Of hongel ore based on full-time officially
ro es c_ . .
Force
reported unemployment measured against the offte10lly
reported Ctvtlton Lobar
·
Source: Dept. of Lobar, Dept. of Commerce, a Federal Reserve
System
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Federal Reserve Bank of St. Louis
92
IMPACT OF ECONOMIC GROWTH
UPON PRODUCTIVITY GROWTH
Chort8
GNP
( Average Annual Real Growth Rote)
1970-1972 1972-1978.!I
1947-1953 1953-l960 1960-1966 1966-1970
ECONOMY
IN U.S. PRIVATEMan
PRODUCTIVITY Growth
hour)
,n Ou tput Per
(Average Annual
J.J 1978 ond 40 '78 ..,1mot1d.
rce
Source : Dept.of Lobor,,Dtpt.of Comme
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Federal Reserve Bank of St. Louis
40'7740 '7a.!t
93
Chort9
COMPARATIVE TRENDS IN NON-FEDERALLY HELD
MONEY SUPPLY, G.N.P., AND PRICES, 1955-1978 J;
ANNUAL GROWTH IN NON-FEDERALLY HELD MONEY SUPPLY
( Based on Seasonally Ad Justed December Doto)
ANNUAL GROWTH IN GNP
( Uniform Dollars )
u,
u,
6.07.
6.0'4
ANNUAL TRENDS, C.P. I.
Up
11.0"£
u,
,.n.
Up
9.1'1,
u,
1.1"
Up
u,
"*
195,t9 7f 1956
,_NJ
4.3'1
Up
3,6'1.
3.e,.
1956- 1957· 1958- 19'9- lffO · IHI·
19'7 1951 t959 IMO IH I 1962
1962·
19'3
.!J 1978 estimated .
Doto: Dept. of Commerce; Dept. of Labor ; Federal Reserve System
43 - 28 6 0 - 79 - 7
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Federal Reserve Bank of St. Louis
94
ChartlO
NO
INCREASES IN AVERAGE INTEREST RATES.A
SES,
REA
INC
-EXCESS INTEREST COSTS DUE TO THESE
1952-1978.!J
1978
COMPUTED AVERAGE INTEREST RATES,1952Up
161 .7%
Up
160.0%
Up
123.5%
Up
95.8%
Federal Public Debtg,,
State and L.ocol Debt
Private Debt~
Total Public and
Private Debt
EXCESS INTEREST COSTS), 1953-1978
( B,11,ons of Dollars
$1,542.8
$1,350.3
--$151.7
Federal Public Debtg,,
$40.8
State and Local Debt
Private Debt~
Total Public and
Private Debt
.!t 1977 and 1978 estimated.
1.J Includes net foreiQn interest.
010
l>Ublic anc:t
Government and state and local debt from total
l'1ISidual by subtrac ti~ ~ I s.
d
}/ Compute
debt of federally - sponsored credit 0Qenc1e
Source: Dept. of Commerce; Economic Report of
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Federal Reserve Bank of St. Louis
the President
private debt. nc ude s
1 1
95
EXCESS INTEREST COSTS IN THE FEDERAL Cha,tu
BUDGET 1965-1978 CONTRASTED WITH OTHER
COSTS FOR SELECTED BUDGET PROGRAMS.!,,
Millions of Current Dollars
EXCESS INTEREST
COSTSIN TH£
FEDERAL BUDGET
BUDGET OUTLAYS
FOR EDUCATION
BUDGET OUTLAYS
FOR HEAUH SERVICES
AND RESEARCH
$20,760
AMuol AverOQe
1978
1965-1978
Annual Averaoe
1966-1978
BUDGET OUTLAYS
FOR HOUSING ANO
COi/i/UNiTY 0£V£LOPl/£NT
'
BUDGET OUTLAYS
FOR
PUBLIC ASSISTANCE
ANO OTHER
INCOME SUPPl£11£NTS
BUDGET OUTLAYS
FOR 1/ANPOWER
PHOGRAIIS
Hi
$27.800
Annual Average
1979 ~
1966-1978
AmuolAverooe
1966-1978
J/ lnterell costs, calendar years; budget outlays, fiscal yeors.1978 lntel'elt costs and 1979 budoet outlays estimated.
.l!Praposed in fiscal 1979 Budget of President Carter.as revised October 27, 1978.
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Federal Reserve Bank of St. Louis
96
Chart 12
IN
THE BURDEN OF $I,542.SBILLION
978 21
EXCESS INTEREST COSTS, 1953·1
UPON THE AMERICAN PEOPLE
Calendar Years
Excess Interest Cost Per Family of Four
Excess Interest Cost Per Capita
{ Note Different Scale)
$29,596.84
$7,399.21
it
I
.
I
$6.24
$24.96
1953
1953
1960
1953-1978
Total
3 - 1978
HOW $59.3 BILLION A YEAR, 195
EREST- EQUAL TO ANNUAL EXCESS INT
E FAMILIES
MIGHT HAVE HELPED LOW-INCOM
Families
With Incomes Under
$4,000:
(3.6Mi llion lnl978 l
Families
With Incomes Under
$3,000
(2.1 Million inl978 )
Families
With Incomes Under
$2,000
( I.I Million in 1978)
$2,301
$1,368
· $ 59.3 Billion
More o Year
Received
By These Families
Would Hove Meant
$28,870 More
For Each Family
Average Income
of These Families
in 1977
.!J 1978 estimated.
Average Income
of These Families
In 1977
$ 59.3 Billion
$230
Average Income
of These Families
In 1977 :
Bureau of the Census .
Presldent1 Dept. of Commerce,
Source: Economic Report of the
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Federal Reserve Bank of St. Louis
More o Year
Received
By These Families
Would Hove Meant
$52,293 More
For Each Family
97
Chart 13
G.N.P. DEFICIENCIESJJAND BUDGET DEFICITS
CALENDAR 1947-1978 AND FISCAL 1948-1979
G.N.P. DEFICIENCY
B1ll1ons of 1977Dollors
Averoge,Calendor Years
479.7
6 .0
1947-1953
1954-1961
1962-1970
197H97 8g;
BUDGET DEFICITS AND SURPLUSES
Bill1ons of Current Dollars
Averoge,F,scol Years
0.9
1963-1971
1972-19 79~
1948-19 54
-36.4
.!J Production deficiencies represent differences between actual
production and production at full economy
rate of growth. Projections from 1946.
~ 1978 estimated.
}/ 1979 estimated.
source : Dept. of Commerce; Office of Manageme nt and
Budget, for actual figures
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Federal Reserve Bank of St. Louis
98
Chort 14
PERSONAL TAX CUTS, 194 5-1 963 :
In After -Tax Income
Percent Federal Ta~ Cut And Percent Gain
us _lncome Levels..!/
Vario
Marr ied Couple With Two Children At
$3,000 Income
(Tax Rote Cut from 6.9'1. To 2.0'1.
$5,000 Income
( Tax Rote Cut From 12.6'1. To 8.4%
Toi Cut frOIII $206. To $60.)
Tox Cut from $630. To $420.)
$7,500 Income
(Toi Rote Cut From 16.3'4 To 11.7,.
.Tax Cut Fr0111 $1,223 To $877. )
70.9%
33.3%
I
Percent
Tax Cut
Percent
Tax Cut
4.8%
m:,
Percent Goin In
Afler-Tox Income
$10,000 Income
$15,000 Income
28.4%
30.9%
I
Percent
Tax Cut
5.5%
[JJj
Percent Goin In
After-Tax Income
$25,000 Income
24.0'lt To 16.6'1t ( Tax Rote Cut From 32.8'1. To 21.3%
(Tox Rote Cut From 19.2'1. To 13.7% (Tox Rote Cut From
. To $2,486.) Tax Cut From $8,200. To $~318.)
$3,600
..
Fro
Tox Cut Fro.. $1,915. To $1,372.). Toa Cut
I
Percent
Tox Cul
6.7%
E%J
Percent Goinin
After-Toa Income
$50,000 Income
I •
9.8%
Percent
Tox Cut
Percent Goin In
After-Tax Income
$100,000 Income
_i._._
17.2%
Percent
Tax Cut
Percent Goin In
After-Toa Income
$200,000 Income
59.6% To 44.7 'r. ( Tox Rote Cut From 7l.2'1t To 57.6'1t
(Toi Rote Cut From 46.3'It To 32.0% (Toi Rote Cut From
5.To $44,724.) Tox Cut From $142,405. To $115,224.)
$59,6~
From
Cut
01
.)
Tax Cut from $23.145 To $15,976
Ii
Percent
Toi Cul
Percent Goin In
After-Toa Income
47.2%
36 .9%
_(_I_
Percent
Toi Cut
Percent GoinIn
After-Toi Income
19.1%
Percent
Toi Cut
Percent Goin In
After-Toa Income
for
odjuated Qroaa income, woa Htimot ed
amount of Federal lox, 01 applied to
ion for 1945 ,
deduct
t
percen
10
011um1
t11
11timo
Dept. Both
19~3 by Tre_osury
by CEP and fo_rut1on1
10111
, m1d1col core, etc .
inter11 t, contrib
rotes.
tax
e
effectiv
ore
shown
rot11
Toa
Note:
.J/ The
https://fraser.stlouisfed.org
Federal Reserve Bank of St. Louis
PERCENTAGE TAX CUT AND PERCENTAGE INCREASE IN INCOME .
AFTER TAX, VARIOUS INCOME GROUPS, 1963-1973 .!t
PERCENTAGE TAX CUT
l ncome
2
Group 9
Under
$~000
$3.000$5,000
$5.000$10,000
$10,000$20,000
$20,000$50,000
PERCENTAGE INCREASE
IN INCOME AFTER TAXES
Under
$3,000-
$~000
$5.000
$5,000$10,000
$10,000$20,000
Over
All
$50,000
Groups
6.1%
$20,000$50,000
over
$50,000
All
Groups
l.!Ettects due to changes in personol tax under Revenue Act of 1964,Tox Reform Act of 1969,ond Revenue Act of 197 1 (H.R. 10947, os reported by the House-Senate Conference Committee,excludino the
effect on personal taxes cl removing the first year convention under the Asset Depreciation Range system).
[_
gross income class.
Basic Doto : HouseWoys and Means Comm ittee and Senate Finance Committee Reports, and Congressional Record
ui
1..1 Adjusted
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Federal Reserve Bank of St. Louis
,
100
Chortl 6
ING
THE GROWTH IN CONSUMER SPEND
.!J
HAS BEEN MUCH TOO SLOW, I96O- 1978
1
stont Dollars)
(Average Annual Rotes of Chonge,Con
Needed Rote of Growth
-
[ s' ']
Actual Rote of Growth
4.4%
3.8%
3.5%
19601978
1960 1978
19661978
l9601966
3.6%
3.4%
19691978
19771978
4Q 19774019 78
ING
AND THE LAG IN CONSUMER SPEND
Pl/
DOMINATES THE TOTAL GAP IN GN
s of 1977 Dollars)
(Average Annual Deficiency in Billion
1966- 1978
1969- 1978
1977-1978
__,--'
Deficiency In Private
conauaer Expenditures -'
,n,
r ·'
f'
l
_____ _
Deficiency In Orosa
Private 1nvest111e11t _ ---(Inc Net Foreign) --
.......... ,
I~~ for ___,--' ,,,,,,- 365.4
~~l~~~
and Servicea -'
,-~;;. ...;;. Goods
Deficiency In Total ,,,,,,,, ,
National Production '
(ONP)
628.9
664.2
base. 1978 based upon estimated G.N.P.
Deficiencies ore projected from 1953
of Business Economics
ce
Basic Doto: Dept. of Commerce,Offi
.!J
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Federal Reserve Bank of St. Louis
101
'chortl7
INADEQUATE CONSUMPTION GROWTH STEMS
FROM INADEQUATE INCOME GROWTH_!;
Average Annual Rotes of Change in Constant Dollars
-
Total Private Consumer Spending
ii Total Personal Income After Taxes
4 .7%
1960-1966
1966-1978
1969-1978
1977-1978
401977-401978
THE PRIVATE CONSUMPTION DEFICIENCY OF
$2,481 BILLION, 1960--1978, REFLECTED
A $3,621 81.LLION INCOME DEflCfENCY 11
BIiiions of 1977 Dollars
Deficiency in
Private
Consumption
Excess
in Consumer _
Interest
Poymentsb'
Deficlencyin
Personal
Outlays
+
D~~ii!~~c:in
Saving
=
Deficiency in
Consumer Income
Before Tom
$45
.!toeficiencies ore projected from 1953 base. 1978 based on estimated 1978 G.N.P.
YAfso includes personal transfer payments to foreigners, which is a minimal amount.
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Federal Reserve Bank of St. Louis
$3,621
102
Chortl e
S
DEFICIENCIES IN WAGES AND SALARIE
S IN
ARE LARGE SHARE OF DEFICIENCIE
TAXEsv
TOTAL CONSUMER INCOMES BEFORE
Billions of 1977 Dollars
19531966
1969
19691978
---
1978
40197 8
Deficiency in
~Other
Consumer
Incomes
Deficiency in
434.1◄ :~me r
Incomes
1978
Y Deficiencies ore projected from 1953 base. All
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Federal Reserve Bank of St. Louis
based on estimated 1978 GNP.
Betoremes
103
THE LAG IN WAGES AND SALARfES
BEHIND PRODUCTIVITY GAINS, 1960-1978.!;
( Average Annual Increases, Constant Dollars)
4.9%
3.9%
3 .6%
2 .9%
1960-1978
1960-1966
1966-.1978
1977-1978
PRODUCTIVITY, a WAGES a SALARIES
TOTAL PRIVATE NONFARM ECONOMY
1960-1978
1960-1966
3.4%
1966-1978
1977-1978
2.2%
1.6%
1.2%
tr&i:1 I
Output
Wages
and
Salaries
PER MAN-HOUR
Wages
and
Salaries
Output
PER MAN-HOUR
Output
Wages
and
Salaries
PER MAN-HOUR
Output
J
Wages
and
Salaries
PER MAN-HOUR
PRODUCTIVITY, a WAGES a SALARIES
TOTAL MANUFACTURING
1960-1978
1960-1966
1966- 1978
19TT-1978
4 .0%
2.8%
2.2%
Output
Wages
and
Salaries
PER MAN-HOUR
Wages
Output
and
Salaries
PER MAN-HOUR
.ll 1979 estimated.
Baaic Data : Dept. of Commerce; Dept. of Labor
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Federal Reserve Bank of St. Louis
Output
1.7%
Wages
and
Salaries
PER MAN-HOUR
Output
Wages
and
Salaries
PER MAN-HOUR
Chartl9 -
104
Chart20
11
COMPARATIVE GROWTH RAtES, 1961-1978
la rs)
( Average Annual Rates of Change, in Uniform Doi
~ Investment in Plant and Equipment
Private Consumption Expenditures Plus Total Public
lffl!llll Ultimate Demand :Total
and Services
Outlays For Goods
INVESTMENT AND ULTIMATE DEMAND
0
1st Half'610
lst Half 66
"Boom"
1st Half 664th Qtr.'70
"Mixed Period
Including
Recession"
4th Otr. ' 704th Otr. '73
"Inadequate Upturn
and Stagnation"
4th Otr. ' 734th Otr. '75
"Recession and
Inadequate Upturn•
0
4Q '774th Otr. 754Q '78
4th Otr. '77
•~~
"Reduced Upturn"
Down
8.2%
c:::J Corporate Profits (and IVA)
~
Wages and Salaries
CORPORATE PROFITS AND WAGES AND SALARIES
0
1st Half ' 61lst Half '66
"Boom"
1st Half 664th Qtr. '70
"Mixed Period
Including
Recession"
4th Otr. '704th Otr.'73
"Inadequate Upturn
and Stagnation"
Up
13.5%
Dawn
8.7%
J/ 1978 estimated. .1/ Narrower bars of no significance .
Basic Data:Oept . af Commerce
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Federal Reserve Bank of St. Louis
4th Otr. '734th Otr. '75
"Recession and
Inadequate Upturn"
0
40 '774th Otr. 7540 °78
4th Otr. '77
"~~~~i,ll
"Reduced Upturn"
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Federal Reserve Bank of St. Louis
HOUSING STARTS.195O-1978 AND GOALS FOR 1979-1983
(Thousands of Units l
1950
1969
1972
1975
1976
1977
1978
1969-1978.Y
Goals for 1979-1983~
Ann.Ave .
t ~~;i~";!
form not available.
ill Inclusive.Based on earl ier officiolly estimated needed annual overoqe of 2.2 million dur in9
Source, Dept of Commerce, 8ureou of the Census
1970 - 1980 inclusive, but adjusted in this study to ollow for deficiencies dll:i091970-1978.
Ann.Ave.
106
Chorl22
AVERAGE UNEMPLOYMENT RATE,
CONTRACT CONSTRUCTION COMPARED
WITH OTHERS,1953- AUGUST 1978.!!
Conttoct
AQrlct,ilturt
Conttr tJC1lon
tomract
CoN,tructlon
Aqrk:unurt
c:a,troet
con11ruc t lon
l/ 1978 eslimoted.
s-co: Dept. of Lobar, Bureau of Lobar Slotistics
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Federal Reserve Bank of St. Louis
Govt & Govt.
Enttrp,riM•
Tota l
Economy
107
Cha r t 23
IMPACTS OF DEFICITS IN RESIDENTIAL 8 COMMERCIAL
CONST. 1953-1976, AND PROJECTED 1977-1980
(All Dollar Figures in Billions of 1976 Dollars)
(Note Different Scale In Each Box)
CONSTRUCTION DEFICITJ/
I
$74£
i
1953-197~
1977-1980
- - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - ___ _ ___ .&, _ _ - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - -
DEFICIENCIES IN MAN-YEARS OF EMPLOYMENT IN CONSTRUCTION INDUSTRY
(Millions)
6.0
1.0
:,I
i
lifffaJifJ~~-i~-Z1:~k;JJ.I
----------------~~!..~=~~~<?____________ .· --·
__ ····--- ·----- .. . -- 1953_-1976 -----------RESULTANT GNP LOSS~
I
I
I
I
I
$149:2
I
I
- -
!
1953- 1976
1977-1980•• - - - - - · - - - - - - - - - - - -
-- - - - - - - - - - - - - - - - - - - - - - - - - ________ _ ___________ _ _ __ J, __________ - - - - - - - - - - - - - - - - - - - - · -
RESULTANT MAN-YEARS OF WORK LOST11
(Millions)
14.0
I
I
I
I
2.2
--_··· -----------___}~~-~=-!?..?~ ________j____________________ 1977-19~~--------·----·····---FEDERAL REVENUES LOST§/
$158.4
-
'
I
I
:
$298
l
!11111111111111111111111111111111111
_____!~~.:--'-~?~--------------------~----------~~!..?_:-_I~~~ ..
$ 31:TATE ANO LOCAL
~:IOPERTY TA~S
1953-1976
ws::o
19n-190O
Ji Deficits measure actual (estimated for 1977-1980) performance 090inst estimated needed performance in terms
of model for total economy.
sJ Actual averaCJ8
annual orowth 2% ;needed,
5%,or higher than needed orowth rote of 4.4% for total economy.
b Based on multiplier of 2.0.
.it Based on G.N.P. loss, after allow ino for that port of the G.N.P. loss due to repressed productivity orowth omo119
those employed even in slowly orowi119 economy.
~ Equals 20% of G.N.P. loss.
~ Assumes property tax loss ia 2% of private construction deftcit,cumulated.
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Federal Reserve Bank of St. Louis
INTEREST RATES ON NEW HOME MORTGAGES, 1952-1978'1
AVERAGE INTEREST RATE
Percent
IC.O r - - - -- -- - - - - - --
PERCENTAGE INCREASE
- - - - -- -- - - - - --
--,
UP
122.4 %
1---'
0
00
1
54
1
56
1
58
1
60
1
62
1
64
1
68
'70
1
72
1
74
.l./1975 estimated. FHA mortQC9es throu9h 1976. Fed1irof Home Loon Bonk Boord conventional mort909es, 1977-1978.
Doto , Economic Report of the President,Economic Indicators
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Federal Reserve Bank of St. Louis
1
76
'78
1952-1978
109
Chart 25
%OF NEW SINGLE FAMILY HOMES AT VARIOUS PRICE RANGES;'
MINIMUM ANNUAL INCOME REQUIRED TO PURCHASE HOMES
IN THESE RANGES.ASSUMING INTEREST RATES OF
6.4, 2, 8 0% FOR THIRTY YEARS, 8 %OF FAMILIES
WITH INCOMES APPLICABLE TO THESE RANGES, 1974
Chart 33
% OF HOMES IN VARIOUS PRICE RANGES
35
6% INTEREST RATE
6% INTEREST RATE
...&._ _
!!! !!!!!!
$20-$25
$15-$20
Under $15
114
B
$25-$30
$30-$40
$40 - $50
$50 and over
INCOME REQUIRED TO PURCHASE NEW HOMES
4% INTEREST RATE
IN VARIOUS PRICE RANGES_g_;
%OF FAMILIES WITH INCOMES APPLICABLE
4% INTEREST RATE
TO VARIOUS PRICE RANGES
111
~
■ lffi
137
q
23.6
RI
rsm
2% INTEREST RATE INCOME REQUIRED TO PURCHASE HOMES 0% INTEREST RATE
IN VARIOUSJ>RICE RANGES EJ
$3,3 10- $4,940- $6,580- $8,260
I
_ $9,890- $13,150- $16,460
$13,149
ondover
----· ■
$10-$15 $15-$20 $20-$2~ $25-$30 $30-$40 $40-$50 $50ondOYer
% OF FAMILIES WITH INCOMES APPLICABLE
TO VARIOUS PRICE RANGES
0% INTE
ST RATE
J; Price ranges in thousands of dollars .
.£/Money income. Includes allowance for taxes, insurance, maintenance, repairs, and utilities.
~ Under $4,700, 11.6%. ~Under $4,180, 9.6%.
~ Under $3,700, 7.7% . .§funder $3,310, 6.2% .
.
Source: Bureau of the Census ; Dept. of Housing and Urban Development; Federal Home Loan Bank Board; L1.brary of Congress
43- 286 0 - 79 - 8
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110
Chort2 6
TH RATES
COMPARATIVE REAL ECONOMIC GROW
1969-1977.!I
VARIOUS COUNTRIES, 1953-1977 AND
Average Annual Rates of Growth
JAPAN
U.S.
GERMANY
8 .6%
1953-1977
1969-1977
FRANCE
1953- 1977
1969-1977
1953-1977
1953-1977
1969-1977
ARGENTINA
MEXICO
1953-1977
1953-1977
1969-1976
s.
ic product for on other count~ie
J/G.N.P. for U.S., Jopon, 6 Germany. Gross domest
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Federal Reserve Bank of St. Louis
1969-1977
1969-1976
111
Representative REuss. Thank you very much, Mr. Keyserling.
Mr. Willett.
STATEMENT OF THOMAS D. WILLETT, HORTON PROFESSOR OF
ECONOMICS, CLAREMONT GRADUATE SCHOOL AND CLAREMONT
MEN'S COLLEGE, CLAREMONT, CALIF.
Mr. WILLET!'. Thank you. I am very glad to be here.
Perhaps I should start with the background from which I approach
these issues. I am not an enthusiast for heavy, formal management
of exchange rates.
I think there is no question that exchange rates have been extremely
volatile during our period of floating exchange rates. But in my
judgment, based on a fairly large set of empirical studies, I do not
believe this has been due primarily to failures of the private market.
'Indeed, while private speculation has not been perfectly stabilizing
by any means, neither have attempts at official intervention, as was
very nicely pointed out in the announcement for these hearings. On
average, I would judge that the private market has done somewhat
better than official speculators in attempting to set equilibrium
exchange rates.
The vast majority of the fluctuation in exchange rates that we have
observed, I believe, has been caused by reasonable market responses
to the highly variable and uncertain economic environment, economic developments, and economic policies.
Having said this as general background, I do strongly support the
President's rescue operations of November 1. I think that this was
one o:f the fairly rare occasions in which there was an opportunity for
exchange market intervention to have a favorable impact.
By and large, where market expectations are held very strongly,
there is very little chance that official intervention is going to have a
long-run impact on the market, whether correctly or wrongly
perceived .
. There are just too many dollars out there. International liquidity
IS too high. But large movements in exchange rates are not always
caused by actively destabilizing speculative capital movements. In
fact, I think that is only very rarely the case.
·
The situation with respect to the dollar during these circumstances,
I think, was that a large decline in the dollar which was economically
justified, partially on inflation grounds but in much larger part for
various real economic reasons which I outline in more detail in my
prepared statement. There was the large increaase in oil imports and
the slower growth rates abroad relati':e to ~he United States. All of
these gave rise to the large trade deficit whrnh had to be correcte~.
For this to be corrected the dollar exchange rate had to depreciate
far below relative rates of inflation to allow these real adjustments
to take place.
.
.
Now, did the dollar depreciate too fad I th1~k that 1s. hard to sa;y.
We don't have a really good idea of how respons1ve_trad~ 1s, exactly, m
a quantitative sense, to exchange rate changes. Puttmg different sets of
elasticities into different models, you can get answers that the dollar
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112
depreciated too far or, perhaps, that it didn't depreciate quite far
enough.
I would be hesitant to argue that the dollar had fallen completely
outside of a reasonable range. But it was at least toward the bott?m
of that range. There is also a lot of suggestive evidence, from talkmg
with foreign exchange market dealers and forecasters that a number
of these experts thought the dollar had depreciated t~)O far, that the
economic fundamentals that Bob Solomoi~ was t_alkmg ab_out were
coming into play, and the dollar would .bE: improvmg over time:
But the same exchange market participants were not sufficiently
confident of their expectations that they were willing to put up enough
money to fully back up those expectations. Otherwise the dollar would
have started to rise immediately.
In these kinds of circumstances the intervention program of the administration could be seen as aiding the operation of market forces
rather than conflicting with them. This is one of the fairly rare types
of circumstances in which I think exchange market intervention can
have a significant and favorable impact on the exchange market.
I do however, believe that the tightening of monetary policy was
an int~gral part of the rescue operations, because superimposed upon
these underlying favorable economic trends in terms of trade balances
was a situation of worsening inflation, so that you were having two
conflicting economic factors operating on the market.
It is very hard to say to what extent the market did not take into
account sufficiently the underlying improvement in the trade balance,
which was already underway, and how much it was rationally discounting increased inflationary fears.
I am very glad we did not see a test of these two conflicting
strengths. It made a lot of sense for the package to be combined.
It is important that we not become too overjoyed with the success
of the proITTam so as to draw the implications either that we can control the dollar precisely with heavy official intervention, or that
because the dollar has now appreciated substantially, we can substantially ease off on monetary policy and keep the dollar from depreciating again.
My_ fear, <_>f course, is that if v:e did have a failure to follow through
on a tightenmg of monetary pohcy, we would further reduce the credibility of Governm~nt policies in this area. The impact on expectations
in both the domestic economy and the foreign exchano-e
market would
0
be quite devastating.
I think th~ dollar ~ould plummet ao-ain in the foreign exchange
markets and m those circumstances the $30 billion or what is le.ft of
it, wo~ld buy only very littl~ time. Thus, ~n my j~dgment, the somewhat t~ghtened monetary pohcy was a crucial ingredient of the rescue
operation.
In the_prese1;t, ~ do not think there is a basic conflict between monetary policy obJectives for the domestic economy and those for the internati~mal ~conomy or for the exchano-e rate of the dollar.
H.avmg said that I w~nt to emphasize that where there is a conflict
I thmk that the domest~c economy hou!d r~ceive substantial priority.
!her~ has be~n a lot of :mcreased attention m the last few year to the
mflat10nary impact which an exchange rate decline can have. This is
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Federal Reserve Bank of St. Louis
113
yery real and considerable one that can have a sizable inflationary
impact.
.
But work they have done recently suggests that the pendulum may
have swung too far and that many of the current estimates of inflationary impacts of exchange rate declines may be as much too high as
some of the earlier estimates were too low.
The domestic inflationary impact of the declining dollar is something
which clearly should be taken into account in setting monetary
policy. But it is not so powerful that it should be an overriding determinant of monetary policy.
Today we have a basic conflict among many people as to what our
domestic priorities for monetary policy should be. Orthodox monetarists argue strongly that we need to be reducing the rate of monetary expansion to fight inflation. Orthodox Keynesians are much less
convinced of this and are much more concerned about the short- or
medium-term effect on economic output.
This is an onerous situation in w-hich we have knowledgeable people
having quite differino- views of what the domestic impact of these
policies will be. Whether you have a conflict between domestic and
i~tern3:tional policies right now depends very crucially on these cons1derat10ns. There is a vast area of nncertamty about what the domestic impacts of monetary policy would be.
I personally come out somewhat closer to the monetarists' side of this
question, but we should admit that we do not know nearly enough to
answer with precision. We have not had the economy operating- long
enough in this period of stagflation, with both high inflation and hio-h
un~mployment, to have a good understanding of what the precise relation hips are in this kind of environment. Therefore, it is not surpri ing that you have many people having quite different views today
about what these relationships are.
l? my own judgment, however, a somewhat tightened monetary
policy and a very gradual policy of slowing down the growth of monetary aggregates over time probably is desirable for domestic rea ons.
Such a strategy will have desirable effects on the exchange rate of
the dollar. I do not believe, however, that setting the exchange rate of
the dollar should be the overwhelming goal of our domestic monetary
policy.
Having mentioned the parts of the President's program which I
strongly support, I should say that I am somewhat less enthusi~$tic
about some of the international financing arrangements. I am a little
·. ke~tical of the proposals and there.fore the implementa!i?n of the
1ssmng of the foreign- currency denommated Treasury securities.
I don't think it is a great mistake, by any means. Ho';Vever, I probably would not have advocated it. I don't think we will have great
benefits from it.
One point I would like to speak to briefly is that in many of -~he discussions the issuing of the securities abroad is co1;nected ur wit~ the
general problem of the dollar overhang. I would hke to ~~y m .this regard that I do not believe -that issuing of Treasury securities will have
a fundamental effe t on the problem of the dollar ov~rhang.
In fact, in my interpretation, the doll3:r overhang 1s not _a problem
as such; it does not make a great deal of difference to the U mted States
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whether we count up that there are $100 billion held aboard or that
there are $600 billion abroad.
There are lots of interesting debates which I have engaged in on
just how much we should measure these aggregates, what procedures
should we use, and how much is double counting. But I think all of this
is fairly irrelevant from a policy standpoint. I think the major point
is that international capital mobility is very high. It is going to be very
high whether the numbers we come up with for the dollar overhang are
200 billion or whether they are 400 billion. It will stay high whether
we marginally increase or decrease the Reserve currency role of the
dollar. I think it is a fact of life which we have to adjust to.
High capital mobility means that expectations about developments
in the U.S. economy are going to have a major impact on international
capital flows and may have a major impact on the dollar.
In my own judgment, there.are some things which we may be doing
that will make it a little less of a problem, but I don't think that this
could be fundamentally eliminated as a prob]em short of massive capital controls, if then. The basic problem again is one of international
capital mobility in general, not one of a dollar overhang. In this regard, I think we should again give consideration to the creation in the
International Monetary Fund of a substitution facility that cou]d
handle some of the potentially unwarranted dollars held by foreign
central banks. I do not thi~k, h?w.ever, that.this would be a major solution to the problems. I thmk it is somethmg we should give serious
consideration to and which may well be desirable, but the benefits
from this, I think, would tend to be fairly marginal rather than fundamental.
To conclude, my basic analysis suggests that a lot of the attention
on the doUar overhang per se is not wen focused. There is not a dollar
overhang that we can do something about by issuing $20 billion in foreign securities or creatin_g a new substitution account that will take a
few billion dollars of this off the market. The latter may be desirable,
but it wou]d not get around the basic problem, which is that we do have
a highly interdependent world economy. What goes on in the U.S.
economy is going to have a big i!Ilpact on our exchange rates and on
effect~ in our c_ount:Y· I am afraid the best we can do is just learn to
live with that situat10n. Thank you.
[The prepared statement of Mr. Willett follows:]
PREPARED STATEMENT OF THOMAS
D. WIT.LETT
The Fall and Rise of the Dollar
J.
Introduction and summary
I believe that the !lleasur~s anno~nced by the President on November 1 to help
stabilize the domestic. a~~ m_ternational ~alues of the dollar were desirable. on
balance and that the 1mtial 1mplementat10n of these policies was handled well.
1 do have reservatioD;s a.bout some pa:ticular aspects of the rescue package, however, and there are 1mpo~tant questions about how we should interpret the recent beba vior of th: fore1~n exchange markets and what implications this has
for future intervention polices.
While I am an advocate of flexible exchange rates, there are particular sets of
circumstances in which I believe that official intervention in the foreign exchange markets c~n be usefu!. It appears that the dollar may well have been in
just such a situation. There is ~ danger, how~ver, that the initial success of the
recent rescue moves in generating a s~bstantial appreciation of the dollar may
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Federal Reserve Bank of St. Louis
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inappropriately contribute to views that the private market had been dominated
by irrationality and destabilizing speculation, that heavy official management
of the dollar should be the general rule for the future, and that the need to follow
through on anti-inflationary macroeconomic policies has diminished.
Such views would be greatly mistaken, I believe. The fall of the dollar was due
primarily to underlying economic factors. To the extent that the dollar may have
fallen too far, I believe that this has been due to insufficiencies of the amount of
stabilizing private speculation, not to actfrely destabilizing speculation and widepread irrationalities in the foreign exchange markets. A considerable portion
of the appreciation of the dollar was due to the success of the President's message in changing expectations about the future course of macroeconomic policies
in the U.S. If these expectations are disappointed, the credibility of government
announcements will take another major blow, domestic inflation will accelerate,
ancl the dollar will plunge again.
I do not believe that the domestic inflationary effects of dollar depreciation
nre so great that attempts to stabilize the international value of the dollar should
be an overriding objective of domestic economic policies. At the present time,
however, if we are to bring inflation under control, our domestic and international
objectives coincide rather than conflict.
Attempts to stabilize the international value of the dollar through intervention
_policies alone would be bound to fail. This is well recognized by our monetary
and financial officials and they appear to have little intention to follow the mistakeR of others by attempting to define and defend a narrow range of exchange
for the dollar. I am concerned, however, that the availability of large quantities
of funds for potential inten-ention, combined with widespread interpretation that
the dollar had previously depreciated much too far, could lead to a tendency to
attempt to manage the exchange rate of the dollar too closely. I believe that more
attention should be given to monitoring how successful our authorities are in
their intervention.
I am less enthusiastic about the issuing of foreign currency denominated U.S
securities than I am about the other parts of the rescue package. I am not fully
convinced that these measures are necessary or desirable, but neither am I greatly
troubled by them.
Some have welcomed the announcement of the intention to issue such securities as evidence of recognition that something must be done about the key currency roles of the dollar. I am doubtful, however, that there is a great deal which
can or should be done about the international roles of the dollar. While a case can
he made for reconsidering the creation of some kind of substitution facility in the
I .M .F. to help reduce the reserve currency role of the dollqr, I think it unlikely
that we could expect great benefits from such a plan. Stories of the demise of the
dollar as an international currency have been greatly overstated. The fact is
that international financial interdependence has reached a point where the international roles of the dollar could be substantially reduced only through mas ive
controls over the freedom of international financial transactions or through domestic economic instability.
Bi:isically, international financial interdependence increases the already strong
case for promoting domestic economic stability. I believe that the President's
November 1 announcement represents an important step in this direction and my
major concern is that its initial success not be abused.
Il. Was the decUne of the dollar caused, by irra,tionaZ destabilizing speculationf
.Many commentators have argued that over the past year irrational market
phyehology, rather than underlying economic fundamentals, has been the major
cause of the decline of the dollar on the foreign exchange markets. The inference usually drawn from such views is that heavy official management is needed
to offset the deficiencies of the private market.
I do not believe that this interpretation of the fall of the dollar is correct,
however. Furthermore, even if it were correct. I am doubtful that official intervention on a feasib-le scale would be able to substantially alter the course of the
dollar.
As many observers have commented, the amount of internationally mobile funds
iR hug-e. It -is doubtful that official intervention could long maintain an excihange
rate that differed substantially from strongly felt market views. As was mentioned in the announcement for these hearings, we have had numerous instances
in which official attempts to maintain exchange rates in the face of heavy market
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Federal Reserve Bank of St. Louis
116
pressures have failed. But what I think is particularly notable about such episodes is that in the substantial majority of such cases, it was the private market,
rather than the official managers, who turned out to be correct.
I certainly do not want to argue that the private market is always magically
correct in its composite judgments, and that the :fioreign exchange markets always
operate with ideal efficiency. There is little evidence, however, to support the
views that massive destabilizing speculation has commonly dominated the foreign exchange markets and has been a major cause of observed exchange rate
volatility.1
Market ,psychology certainly has an impact on exchange rates, and such attitudes are not always rationally formed. In general, however, I would argue that
private market expectations about exchange rates have been formed on a fairly
reasonable basis. The arguments that the market is behaving irrationally are usually -based on differing views and hopes about the future course of economic developments andjor highly oversimplified views about what should determine
exchange rates.
In recent years there has been increased general recognition that exchange
rates neither can nor should remain unchanged in the face of substantially different rates of inflation among countries. There has been an unfortunate tendency, however, to replace the old popular fallacy of assuming that equilibrium
seldom change, with a new fallacy that only changes in national price levels
should inlfluence exchange rates.
Behind many of the ~tatements made over the past year that the dollar was
demonstrably undervalued was simply the observation that the dollar had fallen
considerably more than was required to offset differences in rates of inflation.
But on the basis of consideration of a fuller range of economic fundamentals a
substantial drop in the dollar is just what should have occurred. Inflation rates
a.re not the only factors which influence equilibrium exchange rates.
Nor do foreign exchange markets act merely as a mechanical mechanism to
balance the transactions generated by past economic developments. Just as other
financial ma.r kets, they react also to the anticipations of future developments.
And we are lucky that they do so. Otherwise the dollar would have fallen much
further than it did.
Many factors besides prices affect the balance of payments and exchange
rates. Most of the huge rise in the U.S. trade and current accounts deficits over
the last several years has been due to factors unrelated to general price competitiveness, particularly the effects of more rapid real income growth in the U.S.
relative to our trading partners, and the second substantial increase in our oil
imports. 2 The value of U.S. on import payments grew .by almost as much over
1976 and 1977, as they did in 1974 following the huge oil price increases of that
year. This second s urge i_n oil imports was caused primarily by the combination
of the rapid real economic growth noted above, and the failure to implement an
effective energy policy which included a substantial rise in energy costs toward
market levels. Since there was no comparable shift in the basic desires of OPEC
and other countries to invest in the U.S., the restoration of equilibrium would
require a decline of the dollar su:ffi~i~nt, not just to offset inflation differentials,
but also to stimulate enough additional exports and reductions in imports to
offset these noninflation related developments.
As is well known, the responsiveness of exports and imparts to changed price
incentives is much gr~ater in. the long run than in the short run. The size of
the exchange-rate declrne reqmred to restore better balance in the trade accounts
over the short run would_ have be~n enormous, if indeed it would have been
passible at all. However m such circumstances private speculation will have
profit incentives to help buoy up a currency until stronger trade responses come
1 Discussions of a number of st?dies. on speculation and exchange rate behavior during
the current float may_ be found m ,l;'l1 chard Levich, "Further Results on the Efficiency
f Markets for Foreign Exchange. Federal Reserve Bank of Boston International
~onetary Conference. October 1,97_8 ; Dennis . Logue, Richard Sweeney and Thomas D.
Willett, "The Speculati.ve Behavoir of Foreign Exchange Rates During the Current
Fl at" Journal of Business Research, No. 2, 1978; Susan Schadler "Sources of Exch~nge-Rate Variability," I.M.,F. s_taf!. P apers, July 1977; and Thomas D. Willett.
Floatinq Exchanqe Rates and Inte1national Monetary Reform (Washington: American
Enterprise Institute. 1977). Chapter 2.
2 For further discus~ion on th1 s see ';rhomas D. Willett. "Economic Fundamentals,
Purchasing Power Parity. and the Decline of the Dollar," Claremont Economic Discussion Papers, 1978.
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Federal Reserve Bank of St. Louis
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into play, thus tending to limit the decline in the exchange .rate to that required
to restore equilibrium over a longer period of time. There are similar profit
incentives to . peculate out the price or exchange rate effects of developments
which are expected to be soon reversed. The dollar did not fall mechanically as
the trade deficit worsened. Initially it -wa s widely expected tbat the major nonprice factors causing the deterioration of the trade balance would be reversed
within not too long a time period. Growth rates in Europe and Japan were
expected to accelerate, reducing a substantial part of the increased trade deficit.
It was only when it became increasingly clear that the initially expected rates
of growth in Europe and Japan were not going to be met and that the outlook
for substantial energy regulation in the U.S. was poor, that the dollar began its
significant decline in 1977.
The rise of inflationary expectations in the U.S. at the same time further contrilrnted to the fall of the dollar. It has been argued that the dramatic plunge
of the dollar cannot be explained fully in terms of the direct effects of plausible
increases in expected national inflation rate differentials. I quite agree, but would
not accept the corollary sometimes drawn, that this shows that the dollar
dropped much to far and became substantially undervalued. To repeat, past and
expected future inflation differentials have an important impact on exchange
rates, but they are not the only economic fundamentals which influence exchange
rates. Exchange rate movements which differ substantially from inflation differentials do not neces"=a rily mean that the foreign exchange markets are out of
touch with economic reality.
Furthermore as was emphasized by my colleague, Richard Sweeney, at a recent
monetary conference held hy the F ederal Reserve Bank of San Franci co,3 a
worsening of inflntionary expectntions may have a suhstantially lar.e:er impact
on exchange markets than jn. t th e shift in the mean of expected inflation differential s. As has I:ecome increasingly recognized. higher inflation rates tend to
prodnce greater uncertainty. 4 In addition to the substantial domestic costs which
this imposes. it makes the U.S . a less attractive place to invest for foreigners
:rn well as for l .R. firms and citizens. This becomes particularly important at a
time when the United States needs to attract capital inflows over the medium
term to a llow the large trade and current account deficits time to adjust gradually
to lower levels which would be sustainable.
The fall of the dollar was caused not by destabilizing speculation, but by
insufficient autonomous private capitnl inflows to finance our large trade and current account deficits. Private speculation vis-a-vis the dollar bas been predominantly stabilizing, rather than destabilizing, in the sense that it has tended to
move market rates toward. rat-her than away from. medium terms equilibrium
rates.
In the Hbsenf'P. of private speculation. the decline of the dollar would have
heen much greater. The real qnestion is whether there has been sufficient private
stabilizing speculation.
III. Has there been insufficient stabilizing sveculation in fav or of the dollar'!
There is not a drar cut answer to this que tion. We do not have any single
unamhiguous concept of sufficiency, nor do we have the necessary facts to judge
conclusively whether particular concepts of sufficiency have been met. I cannot
hope to resolve this qnestion today. hut a few comments can be made.
Clearly speculation hasn't been sufficient to keep the exchange value of the
dollar from falling suhstantiall:v over the pa. t year. But this is not a reasonable
criteria. As has hcen argued ahove. there are many economic reasons for a substantial declin e of the dollar. 'l'he question is whether the decline went too far
in the sense that it could be rensonahly confidentialy judged that the dollar had
overshot its medium term equilibrium vn lne and would therefore he expected
to appreciate again in the future.
.
.
.
There is room for con.::iden1hle disagrerment over t}11s 9uesbon. ev.en 1f we
can succeed in ruling out views hased on highly overs1rnpllfied analysis. There
3 Ri chnrrl .Tam es SwP.eney. "Risk. Inflation . and E.x change Rates," Claremont Economic
Di8c11 ssion Papers. 1978.
•
· t
A th
Ok
"Th
◄ For earlv 11 nruments And empi ri cal evidence on this p_om s~e
r ur
11n.
e
M'
f s·t d Inflation " Brookings Paper,; on Eronom1c Activity. No. 3. 1971 and
Lo e~/and Thomas D. Will ett. "A ote on the Relation Between ,th e Rate and
Variabllit·v of InflRtion." TiJcoriomica. May 19'.76. F~r an excellent recent d1s~?ssion and
referencf>s to the pxpanding literatu.re on thrn subJ ect . ee Gardner Ackley, The Costs
of Infl ation." American Economic Re?;iew, May 1978.
n~~~1: i
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is wide scope for differing opinions about the future outlook for inflation in the
U.S. and abroad, about the relative weight of various price indices, e.g. consumer
prices, wholesale pric.es, and export prices, in influencing exchange rates, about
the outlook for nonprice developments such a s rates of real economic growth in
the U.S. and abroad, and about the size of exchange rate adjustments necessary
to offset the effects of non price factors.
In my judgment the dollar, despite its very substantial fall, had not dropped
below a reasonable range of estimates of equilibrium values over the medium term.
This is not to say that I am confident that the dollar had not fallen "too far,"
but rather that there is sufficient uncertainty .about the economic and financial
outlook and structural relationships that strong judgments should be not made
about the correctness of exchange rates except within a fairly wide range.
There would probably be fairly wide agreement, however, that if the dollar
had not fallen below a reasonable range, it was at least well towards the
pessimistic end of that range. The administration bas reiterated its view that
equilibrium exchange rates cannot be determined with a high degree of accuracy,
and that it would not be appropriate for the U.S. to defend a particular value
of the dollar. It has been argued, however, that prior to the November 1 rescue
measures, the dollar had fallen too far-that the market was being too pessimistic
about the outlook for the dollar.
There are two major issues involved here. The first is whether the market
was being unreasonably pessimistic in its outlook for economic developments
which would influence the dollar. The second is whether the current value of. the
dollar was fairly accurately reflecting the composite outlook of foreign exchange
market participants.
(a) was the market too pessimisticf
With respect to the first question, it should be recognized that the administration has strong reasons for desiring the market to adopt optimistic expectations about the future course of government policies and the economy. It is
understandable that the failure of the President's anti-inflation speech in October
to significantly strengthen the dollar was quite disappointing to the administration. It is not really clear, however, whether the administration was being too
optimistic or the market was being too pessimistic.
( b) Had the dollar fallen below the ma.rket' s composite ea:pectations,
The second issue is also murky. Exchange rates usually reflect the composite
of the expectations of exchange market participants. If a substantial majority
of participants believed that the dollar had fallen too far and should appreciate
in the future, then they would have economic incentives to buy dollars now and
profit from the expected future appreciation. In the process this buying would
usually bid up the dollar to a value roughly in line with the average of the
expectations of market participants. Conversely if a substantial fall in the
dollar were anticipated in the future, the dollar would tend to be bid down immediately.15
Where there are large underlying payments imbalances and the situation is
quite uncertain, this ~echanism for bringing market rates into line with composite market expectations may not always work well. While a market participant may believe the o~ds are relatively hi~h that the dollar should appreciate
he may also foresee a wide range of uncertamty. In such circumstances he, quite
rationally, might be hesitant to put up large amounts of funds to back up his
expectations. With the large U.S. payments deficit on current and autonomous
private capital accounts, it is entirely possible that the market could on average
believe that the dollar should appreciate, but be unwilling or unable to back
such views with sufficient funds for the dollar to appreciate substantially before
the anticipated improvements in the balance of payments position clearly began
to come about.
11 A qualification should be noted. Exchange markets may display trends based on
different rates of inflation. etc. In such cases, interest-rate differentials are likely to
roughly mirror these differential trends and neutralize the incentive for speculation.
For example, in the absence of other developments. a country with a higher rate of
inflation would be expected to hav~ a currency which depreciated over time. but it
would also tend to have higher nomrnal interest rates which would offset the effects of
tbe exnected depreciation of the currency on the incentives to move funds internationally.
Thus by and large it is expectations of exchange-rate changes which differ from inflation
differentials which wonlrl motivate the t:vpe of speculative behavior discussed tn the text.
While there may also be some direct speculation in currency which would be unatrected
by interest rates, the magnitude of such speculation ls likely to be relatively small.
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In other words, while I believe that the supply of stabilizing speculative funds
has usually been reasonably adequate, where there are extremely large temporary payments imbalances this may not always be the case, especially where a
great deal of uncertainty is present.
In such circumstances the dollar could depreciate "too far," but this would not
be the result of destabilizing speculation and irrationalities in the foreign exchange market. Furthermore this would be a case in which official intervention
would be aiding rather than attempting to thwart the operation of market forces. ·
Consequently it is in such circumstances, along with situations of short term
disorderly market conditions, in which official intervention in the exchange market can be effective, even though it is only a tiny fraction of total potential
international financial flows.
Of course, pointing out the theoretical possibilities of such cases does not ensure
that they have actually occurred, or that they are diagnosed correctly by officials
when they do occur. Likewise there can easily be a tendency toward wishful
thinking in interpreting why one's currency has fallen. However, while it is difficult to offer conclusive evidence, it does appear quite plausible that there was
insufficient stabilizing speculation in the period just prior to the November 1
rescue operations. The very rapid and substantial appreciation of the dollar in
the wake of the President's announcement is quite consistent with such an
interpretation.
IV. Macroeconomic policy and the dollar
A qualification and a warning are in order, however. A major aspect of the
President's announcement was a strong signal toward tightening monetary
policy. I would suspect that it is this part of the rescue package which has had
the greatest impact on the exchange markets.
The sharp appreciation of the dollar following the rescue announcements
should not be taken as proof that the market had been behaving irrationally.
Nor should this appreciation lead officials to believe that there is therefore no
need to maintain a credible policy of gradually ·s lowing the rate of growth of
U.S. monetary aggregates and reducing th'e size of the federal deficit. Such a
course is not without considerab'l e short term domestic costs, and the short term
in this case may be a number of years. But I am convinced that such a course is
the lesser of two evils. The consequences of not slowing the rate of monetary
expansion would be even more pernicious over the longer run.
/Where there is a conflict between domestic and international objectives for
U.'S. macToeconomic policy,. _I beliece hat much greater weight should be given
to domestic objectives. While direct domestic consequences of exchange-rate depreciation neet to be taken into account in designing wise macroeconomic
policies, many popular discussions of the hypothesized vicious circle relationships
between depreciation and/ inflation, trend to greatly exaggerate the influence of
exchange rate changes on inflation.
It is quite true that the effects of exchange rate changes range well beyond
the impact on prices of internationally traded goods alone. An increase in import
prices is likely to influence the prices of many domestic producers as well. A few
estimate the inflationary impact of exchange rate changes. Today, however, the
years ago there probably was a tendency for most analysts .in the U.S. to underestimate the inflationary impact of exchange rate changes. Today, however, the
balance mfl y well have swung too far in the opposite direction.
Typical econometric estimates have suggested that a one per cent depreciation
of the dollar is likely to increase domestic prices over a period of time by
between 0.2 and 0.3 per cent. This contrasts with the Jess than 0.1 per cent direct
impact from increased import prices 'alone. Recernt research by Charles Pigott,
John Rutledge and myself suggests, however, that because they have typically
failed to delineate the causes of exchange-rate changes, current econometric
estimates may well be as biased upwards as the earlier import ratio calculations
were biased downwards. 8
The interrelationships between domestic inflation and exchange rates are complex. There is no simple mechanism of domestic infloation exclusively causing
PXchange-rate changes, nor of exchange rate changes exclusively causing domestic
inflation . Often, but not always. price level and exchange rate changes are both
responsPs to the same underlying economic and financial developments. This
makes it difficult to tell in what circumstances an ex-change rate depreciation is
8 Charles Pigott. John Rntledge. and Thomas D. Wlllett, "Some Difficulties In Estimating the Inflntionary Effects of Exchange-Rate Changes," presented at the annual
meetings of the Western Economic Association, June, 1978.
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· dependent cause of additional inflationary pressures, as opposed to merely
~!fl:ting domestic inflationary pressures. !t ·also makes it difficult to estim~te
accurately the domestic effects o~ the portions of ex~~nge-;a te changes which
.
should be considered independen t mfluences on domestic iD:flat10n.
A stable internation al value of the dollar would certamly be desirable, but I
do not believe that the consequences of depreciatio n of the dollar ar~ ~o dam~ging to the U.S. economy that its avoidance should be made an overndmg policy
t
·
t h
.
objective.
I am not a ful'l fledged monetarist, but I do believe that at presen t ere is no
objecthe
and
:policies
a basic conflict between present domestic macroeconomic
tive of avoiding •a rapidly depreciatin g dollar in internation al markets. Should
monetary policy soon turn more expansiona ry again, the dollar ,:7m drop and t~e
remainder of the $30 billion rescue package would not be sufficient to stoy this
for an extended period of time. However, the greatest costs of such a policy
reversal would be those imposed directly on the U.S. economy through worsening
domestic inflation, rather than those which operate through the foreign exchange
market.
v. Monitoring exchange market intervention
A second word of warning concerns the danger that beliefs that the private
exohange markets have behaved badly combined with the availability of large
quantities of funds for intervention could undul y increa e the ba ic propensity
of our money manager to attempt to manage the foreign exchange market.
To date U.S. monetary and financial authorities appear to have exercised
considerabl e wisdom in their exchange market intervention s. The litany of
illustrious failures of government intervention attempts during the current
float does not include examples from the U.S.
As argued above, there appear to be sound arguments for the current rescue
operation, but we need to be on guard that the funds raised do not end up being
misu ed for exce sive intervention . It is, of course, too much to expect that our
financial authorities never make a mistake, and there is no feasible alternative
to giving such authorities considerabl e discretion in implementi ng the inevitably vague policy guideline of avoiding di orderly market conditions. I
believe that it would be desirable, however, for the track record of such intervention to be made more easily available to committees such as this and indeed
'
to the general public.
of
forthcoming
t
mo
the
probably
are
Reserve
Federal
and
Treasury
The
financial authorities of any of the major countries in reporting (with a lag)
their exchange market int rventions. It is not possible, however from the information currently published to tell to what extent official intervention has
been successful. For example, to what extent has it tended on average to move
the dollar toward or away from trend, as observed ex post. .
Some light can be shed on. such questions from analysis of profits and losses
on exchang market operations. Such statements mu t be interpreted with
considerabl e care however. The data traditionall y publi hed is not usable for
such anal~sis. R~cently t?ere has been movement in the direction of presenting
more pertment rnformat10n, however. Profits and losses on current exchange
market operations had typically been buried in general profit and loss statements which were dominated by liabilities acquired before generalized :floating
began. However in the Sep~ember 1978 report on Trea ury and Federal Reserve
Foreign Exchange Operat101:s, . the ag~regate lo ses from current operations
were reported separately. This is a_ de irable practice and hould b continued.
More ~tten_tion should a~so be given: how~ver, to presenting and analyzing
our
information m a way which would give till better clues to how wi
exchange market. intervention s have t~rne? out to be. For example, where
there are trends m exchange rates .official mtervention which was stabilizing
around a downw_ard tren~ could still make los es. LikewiRe with an upward
trend, profitable mtervention 'Yot~ld not nece~sarily be stabilizing. Furthermor e
trends are not cons-tant, nor is it al~ays clear from an economic standpoint
what purchases should be compared with what sales in determining profit and
loss calculations . This. can become quite important when some intervention s
are quickly reversed while others are not.
There a1:e many ?iffi~ulties invo_lved in monitoring the ucce es and failures
of official mte1;vel)t1on m the _foreign exchange markets, but I believe that this
is an area which sho1;1ld recei~e a good d_eal more attention, especially if generally higher levels of mtervent10n are contmued.
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YI. Foreign currency securiHes, speculation, and the key currency roles of the
dollar
A final set of issues which I would like to discuss briefly concerns the key
currency roles of the dollar and the decision to issue Treasury securities abroad
denominated in foreign currencies. I am considerably less enthusiastic about
this latter decision than I am about. the r est of the rescue operations.
]I'or the last several years a number of people in the U.S. and abroad have
been advocating the issuance of such securities, and I suspect that it may have
been primarily because of this, that the Administration decided to include
such measu res in its rescue package. Some of the advocates of issuing such
securities have been quite naive about what they could hope to accomplish,
however. It bas sometimes been argued that issuing such securities would soak
up speculative funds abroad and in this way substantially reduce the pressures
on the dollar. "Skim off the speculation froth" was an expression used. While
i<=suing such securities for dollars could strengthen the dollar a little on balance
in the short run, many of the purchases would be likely to come from people
who were not getting ready to dump dollars. Thus I do not believe that there
was really much mileage in trying to use such security issues to soak up dollars
abroad.
'l'he strategy being followed by the Administration is a different one. Paymeut
for the new securities will be in forei gn currencies which will be used to accumulate owned currency reserves, available for use for U.S. intervention in
the foreign exchange market. At present foreign currencies to be used for intervention are -obtained almost entirely from our swap lines. These require repayment within fairly short periods of time unless they are r olled over. Holding
owned f or eign currency reserves gives our financi a l authorities greaater freedom
to engage in open-ended intervention. This may have had some direct psychological effect in bolstering confidence in the dollar, but I am inclined to
think that such an effect by itself would not have been large.
l!,rom a longer-run standpoint, whether one believes that the accumulation
of substantial owned reserves by the U.S. would be desirable or undesirable,
is likely to depend heavily on whether one feels that U.S. authorities would otherwise be likely to intervene "too little" or "too much." I personally do not think
that the traditional use of borrowed currency through the swap lines bas unduly
constrained U.S. intervention, and thus am doubtful that the accumulation of
f:0r eign currency r eserves is necessary.
It should als:o be noted that unlike issuing securities abroad for dollars, the
direct initial effects of issuing U.S. government securities for for eign currencies
will be to increase the demand for :f oreign currencies relative to dollars. This
will in turn tend to cause the dollar to depreciate rather than appreciate, unless some of the acquired currencies a re immediately used for intervention to
support the dollar.
I am doubtful that the resulting downward pressures on the dollar would be
very great, but they should be recognized. Issuing U.S. securities in foreign capital markets would tend to bid up interest rates. This would tend to attract
capital inflows, including ones from the U.S., thus tending to bid up the foreign
currency relative to the dollar. Likewise the direct demand for foreign currency
to be u sed to purchase the U.S . securities would be increased. There would be
some tendency for dollar holders to exchange dollars for foreign currency in order
to purchase the new securities. Again downward pressure would be placed on the
dollar. Prohibiting purchases by Americans would r educe, but not eliminate, this
tendency, and is a policy of discrimination against American citizens which I
fin ct objectionn hie in principle.
The costs of such borrowing will of course not be known until we know the
future course of the dolla r vis-a-vis the currencies in which the securities are
denominated. If the dollar appreciates or depreciates less than buyers anticipated,
the financino- will have been cheap. On the other hand, if the dollar depreciates
substantiall;, the final cost of paying back the s~curities in foreig_n currencies ~ :=1-Y
be much greater than the savings ,o,f the lower rnterest rates which the securities
should carry.
Another type of argument that has been made abroad in support o~ the new
securities is that they signal recognition that the U.S. must do somethmg about
the key currency role of the dollar. It is not at all clear to me whether a nything
very significant can or should be done about the key currency roles of the dollar.
however.
·
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This is a complex area, with the dollar playing a number. of different roles
in the operation of our international monetary system. With respect to the
private uses of the dollar I do not see maj:or policy actions which ~e sho~ld
take Concern is often expressed about the huge amounts of dollars m fore1g_n
hands. Such discussions often incorr~tly include fls:ures ~or E~rodollars, as if
they were full-fledged dollars, and give a hugely m1sleadmg picture of the a~leged inability of the Federal Reserve Board to control U.S. monet~ry conditions. Such developments can infl1;1ence wha~ desira~l~ monetary policy should
be, but they cannot in fact unde_rmme the ultimate ability of the Federal Reserve
to determine U.S. monetary policy.
.
.
The important point is that international capital mobility is relatively high,
and that this can have significant effects on the exchange value of the d?llar.
This would be true, however, whether foreign held dollars, the ~o-called_p~1va~e
dollar over-hang, were $100 billion or $600 billion. We must adJust to llv~ng m
a world of significant ca,pital mobility. This cannot be avoided by attempting to
regulate the Eurodollar market or discouraging thE: international use ~f !he
dollar. What it does do is increase even further the importance of establlshmg
and maintaining a stable economy.
A second set of issues concerns the official use of the dollar as a reserve currency. Again there has been much concern expressed about the official dollar
overhang, and many have argued that centr.al bank desires to diversify out of
dollars have had, or are likely to have, a majo1· effect on exchange rates.
There has been a tendency for some central banks to diversify out of dollars,
but in aggregate this tendency has been quite small. Indeed it is often not rec•
ognized that according to the I.M.F.'s statistics, the portion of dollars in foreign
official currency holdings was almost exactly the same at the end of 1977. as it
was in 1970 (roughly 81 percent) .7
With the initiation of floating in 1971 and again in 1973, central banks did
take the opportunity to reduce their dollar holdings. In 1971 the proportions held
by the I.M.F. sample of 53 countries (which account for the vast majority of total
reserves) dropped significantly from 81.3 to 77.6 percent. The proportion rose
again to 81.0 in 1972, however, before dropping slightly to 79.7 percent in 1973.
Since then the ratio has remained remarkably stable, varying only between 80.4
and 81.2 percent. The demise of the dollar thus appears to have been greatly overstated in many discussions.
It may again be desirable to consider whether the I.M.F. should create some
kind of substitution account so that -central banks who wished to, could reduce
their proportions of dollar holdings without immediate effects on exchange markets. Countries could convert their dollars into newly created SDR's with the
U.S. perhaps being expected to earn back the I.M.F.'s new dollar holdi~gs over a
period of years. However, as became quite clear in the previous negotiations on
monetary reform, there are a great many complications in designing such a
facility, and I suspect that the prospective benefits would not be great.
Perhaps the best step in this regard was the decision to begin to allocate new
SDR's again, thus allowing countries to have reserve increases without necessitating increased holdings of dollars or other currencies.
There is not time to _dicuss all. of t_he other aspects of the key currency roles of
the _dolla~, but my. basic con~lus1on 1s the following: we do not have any strong
national interest m attempting to force an increased key currency role of the
dollar o_n the world economy, but the international uses of the dollar have evolved
t~ a. P_ornt where there is also relatively little that we can do to substantially
d1mm1sh th_ese roles of the do~lar, without taking drastic actions which would
interfere with the freedom of mternational capital flows.
In short, we should learn to live with continued substantial international use
?f the d~llar. The costs a~d benefits which this has for the U.S. largely those of
internati?nal capital mobility in general, and should be interfered with only with
grea~ hes1t~ncy. We. should not attempt to deflate the economy just to obtain some
particular international value of the dollar, but international financial inter•
depe!1dence ~oes strengthen the already strong case for pursuing domestic e<!Onom1c stability.
Repr~sentativ~,REus~. T?ank you.
The _idea of a substitution account" in the International Monetary
Fund is one .that currently appeals to a number of people including
7
See I.M.F. Survey, May 22, 1978.
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Federal Reserve Bank of St. Louis
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Senator J a vits and myself. What we have in mind is something
designed to answer the criticism of some foreign monetary authorities
that, since there are some $700 billion of Eurodollars floating around
plus the United States' money supply plus frequent additions caused
by our deficits, foreign central banks are almost forced to accept dollars
with an unreliable store of value. This, at least at the margin, may add
to the instability of the dollar and, as a result, a number of us have
taken the view that the United States would do well to make it clear
that we have no objection whatever-in fact we favor-an exploration
by the leading countries into the possibility of using some rechristened
"special drawing rights," not for the purpose of adding to world
reserves, since there is already abundant liquidity around the world,
but as a partial substitute for the reserves now held. We are talking
about $5 or $10 billion or so. We have heard from Mr. Willett on this
subject.
How about you, Mr. Houthakker. You have spoken of the need for
further international monetary reform.
What did you have in mind and what do you think of the substitution account proposal ?
Mr. HoUTHAKKER. In general what I have in mind by new attempts
at international monetary reform is an attempt to reestablish rules of
international behavior which to my mind have gone by the board in
the last 5 or 6 years. Countries do exactly what they please without
regard to international obligations.
This, I think, is by itself a source of instability in the world economy.
I would be glad to spell this out in more detail, but I am afraid I
~ould not be answering your main question concerning the substitution account.
It is not clear to me what interest there is in that for the United
States. I can see why foreign central banks, after they have acquired
dollars for the purpose of preventing their own currencies from
depreciating would like to get something else instead, but this is not
something to which the United States should be very responsive.
On the whole, during the floating rate period, we have followed a
policy of not intervening, of not trying to influence the value of the
dollar. Other countries have not followed such a policy. Japan, in particular, has amassed huge amounts of dollars in vain attempts to stabilize the yen. Now, at this point, for us to agree to a means by which
they can unload some of these dollars is .to sanctify the policy which
they have followed earlier in defiance of sound internation~l practice.
So, unless there is a better agreement on exchange rat~ a~Justment, I
would not like to see the United States agree to a subst1tut10n account
for any similar scheme.
Representative REUSS. You say that you do not see any advantage
to the United States in a "substitution account." Let me suggest to you
one reason that I should think would be fl, consideration. Many foreign
monetary authorities, like good soldiers, have been holding dollar
reserves ao-ainst
undue depreciation. As a good member of the world
0
'
community
we ought to give some thought toth.
e1r ne~ ds. .
.
Let me finish and then you can react to it as you will because I thmk
this is important.
.
.
Second it would seem to me that, at the margm, a method of dissuading f~reign central banks from dumping dollars and driving down
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Federal Reserve Bank of St. Louis
124
the price, if the dollar is already on the low side, would be well worth
doing.
.
.
Third, from our own standpomt, it seems to me, at least, that ~mr
unique ability to finance our deficits with dollars as a means of en~bhng
us to live higher on the hog than we otherwise would, and to mvest
more abroad than we otherwise would, is not really in the interests of
the United States.
At any rate, if I had to respond to your "What's in it for us" argument, I would say something like that. Maybe you would like to whittlP
away at my views.
Mr. HouTHAKKER. Yes, I would like to, Mr. Reuss, because the diplomatic point that other countries would like this to happen does, of
course, have some merit. In a negotiation, you have to give away something, and if we were going to get something really worthwhile, then
maybe we would throw this in as a concession. But I don't see any
danger of dumping of dollars by foreign central banks. That is exactly
the contrary of what has happened, not only during the last 5 or 6 years
but also in earlier periods.
The evidence is that foreign central banks are always trying to prevent their currencies from appreciating. The Germans are perhaps an
exception. They have at times consented to appreciation of their currency over short periods, but most countries are not of that mind.
Therefore, by giving them an oppo:rfonity to get rid of dollars
they acquire in the course of holding up the dollar value in terms of
their own currencies, we are just encouraging more of the kind of
behavior that to my mind has been destabilizing.
The Japanese Central Bank, as I said earlier, has done so most of
all and has a lot of dollars as a result. This was not our wish-far from
it. Before 1~71 we pointed out that the Japanese yen was too hi o-h.
We have said so more recently although perhaps in a different way.
The fact is that the Japanese Government has tried to keep the yen at
unrealistic levels, and this is where the dollars come from. They do
not come from any serv~ce rendered to the United States. They have
not held dollars to be n~ce to us. We would just as soon they did not
hold these dollars an~ did not_have them in the first place. The dollars
were the results of mtervent10n, and the intervention on the whole
was d~st3:bilizing, contrary to our interests and probably also contrary
to their mterests.
That is the kind of behavior which I would not like to encourage
by making it easier through a substitution account.
Representative REuss. Mr. Solomon.
Mr. SOLOMON. Thank you, Mr. Reuss.
I woul~ like to say a_word or two a.b?ut this isssue, if I may.
You raised the question of the substitution account in the context
of trying to ~eep the international .monetar~ system more stable.
Repre~entative REuss. Yes; and if I c3:n mterrupt, I completely
agree with Mr. Houthakker that we need mternational rules of conduct. The surveillance role of the IMF seems to have been foraotten
about. At least I haye not h_eard anything about it, not since J a~aica,
and that kind of mternatlonal monetary reform is surely needed.
However, I directe~ ~y question to this little part of the' package;
namely, the "substitution account."
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Mr. SoLOl\fON. I just wanted to say a word on that. I happen to
agree. In principle, I have no objections to a substitution account.
In fact, I have said so in writing. I happen to have been involved with
the Committee of 20 where this idea first, I think, was developed.
But I think it is correct to say that the effects would be marginal.
No. 1, just to my friend, H endrik Houthakker, much of what he
says is correct. Japan and Germany did acquire dollars by intervening. It is also true that these countries and many others acquired a
very large portion of the dollars they hold long before the floating
system came into effect. They acquired them in the sixties and fifties.
More importantly, I believe it is correct that the downward movement of the dollar in the past year, which is presumably what we are
focusing on, was not in anyway influenced by the selling of dollars
by Germany or Japan or other large central banks. I am reasonably
sure that .the central banks of the industrial countries, the group of 10
countries, have not been dumping dollars. Therefore, the proposal
that Congressman Reuss and Senator J a vits are talking about would
have to be aimed primarily at the central banks of the smaller countries, primarily the developing countries.
I suspect if there has been any diversification out of dolJars into
other currencies by central banks in the past year-and we do not have
adequate facts on that-but if it has been true, and I think your proposal assumes it has been true, Congressman Reuss, if it has been true,
this has been done by the smaller central banks, and you would have to
make this substitution account attractive to them in order to achieve
your purposes.
I j?st wanted to put that perspective on the proposal, therefore, emphasizing while there is no objection in principle to it, I don't think one
should expect enormous results in the way of greater stability of exchange rates out of it either.
Representative REuss. Before I end this colloquy with you, it occurs
to me that you have had quite an historic role in this, you were on the
Committee of 20 in 1974, I believe.
Mr. SoLOMON. 1972-74-2 years of my life, Congressman.
Rel?resentative REuss. And you were around in January 1976, at
,Jama1ca, and shortly thereafter you retired.
Mr. SOLOMON. Yes. If I may correct you, I changed my occupation.
Representative REuss. You retired from the Federal Reserve, of
course. So, you were around at the high tide of "substitution accounts."
What happened? Jamaica came, they all assembled, and somehow the
substitution account got swept under the steel drum.
Mr. SOLOMON. Well, without going into any lengthy history, I think
primarily what happened was that the idea of a thorough-going reform of the international monetary system was dropped. It was not
dropped at Jamaica. It was dr?pped i:r:i January ;974, rig~t a~ter
O;pEC quadrupled the price of 011. Th~t 1s wh~t did m the aspirat10n,
widely held aspiration, to reform the mternat10nal monetary syst~m.
It was simply forgotten after the price of oil went up, _because that mtroduced, as you remember, enormous short-term worries and concerns
and confusion.
The idea of a substitution account wa~ intimately connected with the
nation of a reformed international monetary system with par values,
4 3- 286 0 - 7g - 9
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not a floating system. It was intimately connected with the idea of a
dollar that would be convertible into some other reserve asset-SDR's
if not gold. In such a system with dollar convertibility and par values,
you had to hav_e a substitution account, or it wou~d. ~ot work.
Since those ideas of a par value and convertibility were dropped
with the idea of reform, perhaps wisely-I am not making a judgment
now; I am just trying to give you the history-since those ideas were
dropped, the idea of a substitution account went with them.
Representative REuss. That is very interesting.
During the 1974-76 period, because of the OPEC price increase, the
general word was "Head for the hills, boys, the dam has busted."
Floating exchange rates seemed to be working pretty well; the zest
went out of it. Isn't there now, though, a situation where it makes sense
to talk about "substitution .accounts" once again, because while we certainly have not moved back to fixed exchange rates-Mr. SoLOMON. I hope not.
Representative REuss. There is now somewhat of a disillusionmen t
with the operation in practice of floating rates. I think Professor
Houthakker gave an account of the system's progress pretty well.
So since we now have the European monetary system moving toward an ECU, and since we are intervening in other than what used to
be called disorderly conditions, we have not quite abandoned floating
but have something less than full flexible exchange rates. Thus, isn't
there reason now to reopen the discussion of the substitution account 1
Mr. SoLOMON, Well, l simply repeat that there may be reason to reopen it, but I don't think one should expect too much from it. You just
mentioned the disenchantmen t with the floating system. That is a disenchantment which I don't share very strongly. Nevertheless, I recognize that it exists, perhaps for the wrong reasons-for all the reasons
that you stated either implicitly or explicitly.
yes; there is good reason to reo{>en the question of a substitution
account, but I just want to repeat, it is not going to get at or give us
stable exchange rates for the rest of the time. ·It is going to make a
very very marginal contribution at most.
R~presentative REuss. 'Yell, thank you for your observations on
that. I would not quarrel with the margmal evaluation you have made,
but even marginal is better than nothing.
Mr. Keyserling, in your prepared statement, you come out in favor
of credit rationing. you_ say, and I quote, "So long as the Federal
Reserve believes, albeit mistake~ly, ~hat overall tightening is necessary,
then that agency ~hould put asid~ its u~war:anted objections to some
rationing of credit as was done m earlier times with great success."
I would like to have you spell that out a little more in terms of the
immediate pro~lem_. Obviously, because of other dem3:nd~, it is a poor
thing that capital mvestm~nt and~- & D. are l~n~ishmg at a time
when a great deal of American credit has been gomo- mto very dubious
overseas ventures, when a great deal has been going to finance Atlantic
City's gambling adventures, and wh~n a gre~t deal has been going into
conglomerate ta~eovers, and a l?t gomg to bid up the prices of existing
assets like land, Jewelry and antiques.
However if you were at the levers of power, what would you do
about that What kind of allocatory powers should the Fed use 1 I
i
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th~nk they probably have some legal powers now to do a good many
tlungs. But what should they do i
~r. KEYSEfili!NG. ~r. Reuss, first of all, I want to apologize for not
ha vmg dealt with this from my prepared statement which is directly
~esponsi_ve to questions tha~ ":ere pose~ in a letter that I got from you.
It was simply a shortage of time. Commg to the matter of credit allocation, the problem is not with the techniques. The problem is that if
the Federal Reserve Board now determined to allocate credit it would
have no basis or not much basis on which to decide where to allocate it.
Now, this illustrates the larger problem of what makes the President's current program all wrong, and what makes most of what has
b~en tried to be done in the past 10 or 15 ye,a rs all wrong. We pass tax
bills, we change money policy, we enact other programs and similarly
resort to credit but unless we have a basic-what for lack of a better
term I call "model"-model of what the dislocations in the economy
are, what the relative priorities are, what the essential components are
in fulfilling ,the. three great purposes of the Nation, which are full use
of its resources, meeting of priorities, and doing a modicum of social
justice, until we have that first we really have no basis for allocating
credit or anything else.
That is why everything is breaking down.
I don't say that as· a dodge. That is the fact of the case.
Furthermore, the reason that we could allocate credit successfully,
not only during World War II, but during the period when I served
with Truman, was that we did have these other things, and I might
say this is one of the great contributions of Humphrey-Hawkins if the
President would pay attention to it. That is, it calls for a composite,
integrated picture of the American economy as to where we are going
as a guide to specific policies.
Now, during the Truman administration, particularly during the
Korean war, w.e-the Federal Reserve-used allocation of credit. There
were regulations X and Y related to automobiles, housing, related to
other things ; and, that could be done again. I think that should be
done again.
I don't think it should be left to banks. I think it is a natural and
proper function of the central bank in our modern economy, _bu~ I
want to emphasize most of all that unless we move to a quantitative
portrayal of where we want the income to flow and where we want the
credit to flow in accord with a balanced picture for the development of
the. AmP-rica.n economy~ we don't. have any guide.l~nes by_ which t.o
nllocate credit. We. will simply have myriads of cla1m~nts Just as we
now have myriads of cl~imant~ for G?vernment spendmg, for tax .reduction all of them servmg their own mterests and ~ome of them being
right in' terms of the national interest and some bemg wrong.
But the Government has no evaluation of what _it wants to do first,. or
where to do 1t. With that contention, I go to th1~ length, becau~e it's
such an important question. This is really dealt with on char~ 20 ;n my
prepared statement. That illustrates w13:t has _been happenmg m. the
American economy and what it shows basically 1s what we are COIJ.tmh
ing through tax reduction, through no:growth bu~get, and_ t~roug
the reckless preference for tax reduct10~ as agai_nst pubhc mv_estment on which I think the chairman has said somethmg on on occasion.
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We are doing all of that, and we are doing that because we have no
re.al ta:bleau affecting the Government policy and what it does. Now,
what this chart 20 shows is that before every recession, as we moved
into a period of stagnation-and more :profoundly now than. i!1 anyi
previous time-what was really happemng was that the addition to
plant and eq~ipment, which is fed by inyestment, was growing several
times as rapidly as the growth of ultimate demand represented by
consumer expenditures and public outlays.
Now, near the bottom, as you can for the period 1977 to 1978, you
will see that investment in plant and equipment-despite the claims
of capital shortage-was growing more than twice as fast in real terms
as ultimate demand.
At the bottom-despite the talk about profit shortages-you see, and
I am for profits, the profit rate was growing more than three times as
fa.~t as the incomes that enter into ultimate demand.
And, yet, every one of these current policies-and more so in the
current program of the President than anything else, and, therefore, I
say it will produce a disastrous recession-is allocating in the same
wrong direction.
The same applies to credit. You have a form of allocation by banks.
Somebody is allocating credit. Somebody is deciding where the loans
goNow, the loans II?-ostly are.going in an improper direction related to
the need. and star".mg what is needed most, serving wha.t is not needed,
not servmg what is needed most; and serving what is needed least. I
would certainly recommend action by the Congress to require the
Federal ;Reserve Board to allocate credit and the techniques are clearly
written m the successful use made of that power in the past. I would
advocate it be leo-islatively done, but I would also advocate that the
Congress and particularly this committee equally push for the foundational basis on which the credit can be allocated more successfully
than it is being allocated by the banks.
Thank you.
Representative REuss. On behalf of the subcommittee, I want to
thank each member of the panel. You have given us a memorable afternoon, and much help in our attempt to understand the dollar rescue
operation and their domestic implications.
So with our gratitude we will now recess until 10 o'clock tomorrow
morning in this room.
[Whereupon, at 3 :20 p.m., the subcommittee recessed to reconvene
at 10 a.m., Friday, December 15, 1978.J
'
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THE DOLLAR RESCUE OPERATIONS AND THEIR
DOMESTIC IMPLICATIONS
FRIDAY, DECEMBER 15, 1978
CONGRESS OF THE u NITED STATES,
SUBCOMMITTEE ON INTERNATIONAL ECONOMICS
OF THE JOINT ECONOMIC COMMITTEE,
Washington, D.O.
The subcommittee met, pursuant to recess, at 10 :03 a.m., in room
2128, Rayburn House Office Building, Hon. Henry S. Reuss ( cochairman of the subcommittee ) presiding.
Present: Representatives Reuss, Hamilton, Brown of Ohio, and
Heckler; and Senators Proxmire and J a vits.
Also present: John R. Stark, executive director; Louis C. Krauthoff II, assistant director; John 'M. Albertine, Lloyd C. Atkinson,
Thomas F. Dernburg, L. Douglas Lee, Katie MacArthur, and Paul
B. Manchester, professional staff members; Mark Borchelt, administrative assistant; and Robert H. Aten, Charles H. Bradford, Stephen
J. Entin, and Mark R. Policinski, minority professional staff members.
Representative REuss. Good morning.
The subcommittee will be in order.
I am delighted that Lee Hamilton is here again and my colleague,
Senator Proxmire. We thank you, Chairman Miller, for being here.
We have your prepared statement •a nd under the rules, and without
objection, it will be placed in full in the record.
Would you now proceed with your statement in whatever way you
wish.
STATEMENT OF HON. G. WILLIAM MILLER, CHAIRMAN, BOARD
OF ·GOVERNORS OF THE FEDERAL RESERVE SYSTEM
Mr. MILLER. Thank you very much, Mr. Reuss.
I want to stress my good wishes on your recovery from bronchitis.
I am not used to appearing before this particular subcommittee when
the chairman is not able to keep up with me in decibels.
With your permission, I think it would be appropriate to submit my
prepared statement for the record, and perhaps it would be helpful if
I could just take a couple of minutes to make some remarks based upon
the accompanying charts, which I believe have ~men placed before t~e
subcommittee and made available for those m attendance at this
hearing.
·
I won't take a great deal of time on these particular charts_, but I
think they highlight some· issues that are of concern to this subcommittee.
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180
On chart 1, looking at the top panel, we see the trend in GNP
prices-the inflation rate, if you will. It shows the decline in the years
1974 through 1976, and the resurgence of infl~tion to bec<?~e the No. 1
problem in our economy. If you look at the middle panel, it is apparent
that even without food, which has been a main contributor to some of
the inflation this·year, the inflation rate is running far too high.
On the other hand, the bottom panel shows that the unemployment
rate has been declining steadily and that in the last few months we
have a rather stabilized condition.
On chart 2, the upper panel indicates the growth in utilization of
industrial capacity and economic capacity from the trough of 1975 to
the present point in the current expansion. The lesson to be learned
from this chart is that we are approaching once again, a level of capacity utilizati?n siJ?ilar to the level at the peak of 1973, when we
had enormous mflationary pressures.
The bottom panel of chart 2 here gives a little more detail on the unemployment rate, separating out the overall rate into that for bluecollar skilled workers and that for heads of households. Unlike the
overall rate, these two particular rates show a rapid decline in unemployment. They represent a particular kind of capacity limitation
in our economy. The unemployment rate for heads of households in
November was 3.4 percent, substantially below the overall national
average of 5.8 percent.
I would, of course, recognize--as you have often pointed out, Mr.
Chairman-that this does mean there are segments in our population
who are unduly burdened by unemployment. This is largely structural
and requires intensive, targeted programs that set a national objective.
But in terms of current capacity to produce goods and services among
those who are skilled and those who are heads of households, the unemploym~nt rate ~or these groups has been substantially reduced.
In the mternational sector, chart 3, you are all aware of the shift
from the balance~ condition of 1975 and part of 1976 to a deficit position in trade and m current account balances. This situation has been
improving as ~978 has progressed and the projection is for continued
improvement m these balances through 1979.
Chart 4 illustrates one of the problems that we have in our national
economic poli?ies a!ld that is to de:tl with what has been a divergence
between the mflatlon rate experienced by the United States and
the rates experienced by the foreign industrial nations. The dotted
line shows the inflation rate of G- 10 countries plus Switzerland and
the solid line shows the U.S. inflation rate. In 1977, the U.S. rate of
inflation was equal to or less than the rate of these other countries
but, of course in 1978 thi~ rapi~ divergence occurred so that U.S. in~
flation rates are substantially higher than rates in other parts of the
world, and_ this h~s. put .considerabl~ pressure on exchange rates and
on economic conditions m these nations.
·
The most recent international figures were released in September
and at that time the inflation ra~e in t?e t;Tnited States was 4.8 percent
higher than the average rate of mflati?n 1_n these 10 other countries.
Chart 5 s~ows one of th~ effects of. this divergence; that is that while
short-term mterest rates m the Umted States started off in 1977 con-
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131
siderably below the rates- in the other industrialized countries, as our
inflation rate increased and theirs declined, short-term interest rates
in the United States have increased to the· point where the rate for
short-term money in the United States is about 4 percent higher than
the average rate in the other G-10 countries plus Switzerland.
Short-term interest rates are shown in chart 6 and they do track very
closely with the inflation rate. As the Consumer Price Index-the
dotted line-goes up and down, there is a tendency for short-term
rates to follow along with it. Interest rates are made up of two components : One part takes account of maintaining the purchasing power
of invested funds; the other, of realizing a real return on invested
funds.
Short-term rates track the inflation rate very closely. The significance of the components of interest rates shows up when we begin to
look at home mortgages, in chart 7.
From 1955 through 1965, the average home mortgage interest rate
was 5.5 percent. The unshaded section of the right bar is the Consumer
Price Index. During the 10 years from 1955-65 the CPI increases 1.6
percent per year on average, so that the real interest rate, which is
shown in the upper part of the right bar, was about 3.9 percent.
In the next period, 1966-72, mortgage interest rates went up to
7.4 percent, but inflation went up to 4.2 percent, so there was actually
a decline to 3.2 percent in the real rate on mortgages.
But look at what has happened this year, the bars on the right side
of the chart. The mortgage rate has crept up to an average of 9.6 percent in 1978, but inflation has been 9.5 percent, so in real terms there
has been practically no interest paid on mortgages. This is one of the
reasons it has been so hard to restrain the demand for housing and, of
course, this consideration also applies in the public's preference for
other durable goods: Inflation rates have caused households to purchase homes and durables rather than to store their resources in money
which has been depreciating.
Chart 8 deals with the exchange rate of the dollar. As we all know,
the dollar has been under considerable downward pressure for the past
year. If we look back to the period from September 1977 until the
end of October 1978, a period of just. over a year, the dollar declined
on a weighted average basis by about 20 percent. The bottom panel,
incidentaJly, shows the daily average exchange rate, and it demonstrates the disorders in the markets and the rapid decline of the
dollar in October and also the sudden improvement in the dollar
with the intervention and monetary actions taken on November 1,
as part of the campaign forcefully to support the dollar and correct
the imoalances.
Tu_rning to chart 9, it is interesting to note ~hat given the effects
that mflation has had on short-term rates and given the effects of the
decline of the dollar on inflation and therefore interest rates, the recent
impact on long-term rates has been quite moderate.
The top left panel shows interest rates over several years for new
utility bonds and for municipal bonds; the right part of the panel
shows the weekly averages for October, November, December. So when
action-including strong monetary action-was taken at the 1st of
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November, although short-term interest rates were affected, long-term
interest rates have been more or less stable, which would indicate an
assessment of the action as being positive in its anti-inflation aspects.
Likewise, the bottom panels show that the stock market which had
been declining consistent with international market disorders, has been
generally trending upward since November 1-not each day, but the
general tone of the market has improved.
Part of the economic pattern that affects our current planning relates to the question of Federal deficit, as shown in chart 10. On a
unified budget basis-that is the top panel, the solid line-as we all
know, during the recession years and following the recession we ha_ve
had heavy Federal deficits. If we add in the offbudget Federal agencies
and their borrowing, we increase the deficits as represented by the
dotted line.
Now the anti-inflation actions that have been taken recently by the
administration, including the November 1 action, have contemplated
a considerable reduction in the Federal deficit; the President has announced that his budget proposal for fiscal year 1980 will involve a
Federal deficit of $30 billion or less. But the deficits that have been
accumulated over the last few years have added tremendously to the
outstanding debt of the Treasury.
The bars in the bottom panel show cumulative increase in Treasury
debt. The Treasury debt in 1971 stood at about $400 billion; by the end
of 1978, $370-plus billion will be added to that debt; and by 1979, the
debt will have doubled from 1971.
Now, this kind of requirement by the Federal Government for
financing, as we see on chart 11, means that the Federal Government
has had high demands in the credit markets. While the private sectoras shown by the bar without any shading-had relatively higher demands in the years of higher economic activity-1972, 1973 and 1974-you can see that beo-inning in 1975 there was a substantial increase in
demand :for Federal financing, thereby putting pressures on credit
markets. As we have recovered from the recession and private demand
has increased to help finance the expansion and reflation of the economy, the continued high level of Federal spending has put considerable
pressure on markets and has contributed to the upward pressure on
interest rates.
Chart 12, the last chart, shows the pattern of growth in the expansion, when real GNP recovered from the deep recession of 1974 and
steadily expanded through 1977. Recently, there has been a moderation in economic activity, as represented by the slower rate of real
growth ~n the first. half and t~e third quarter of 1978. One of the factors that has contributed to this g neral moderation has been the moderation in ~ers~nal consumpt_ion expenditures. The housing market
has been mamtamed at a rela_t1vely h10-h level because of the availability of funds due to the _new money market instruments, but generally
real personal consumption has been lower than in the prior year and
this has contributed to a moderation.
'
Mr. Chairman, I_ wo_uld say t~at over t~is year the monetary policy
has had several_ obJectives, seeku~g to ~hieve the high priority of restraining inflationary_~or?es wh1J.le mamtaining conditions for moderate growth. One obJective of monetary policy has been to apply
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restraint, to apply some dampening to the growth of the economy
during the maturity of its expansion cycle in order to cool the forces
of inflation. But a second objective has been to apply this restraint
smoothly so that we would not have dislocations or disruptions in the
economy that could be destabilizing.
A third objective has been to maintain balance in the economy so
that no sector is unduly burdened by the degree of moderation. lt is
for this reason, for example, that the new money market certificates
w~re authorized for the thrift and banking institutions. This has permitted competition for funds and a flow of :funds that has sustained the
housing industry, thus avoiding the kind of depression in housing
which was expenienced in 1973-74.
A fourth objective of monetary policy has been to accomplish as
smooth and as balanced a restramt as possible without tipping the
economy into a recession. It would be far preferable, as a matter of
economic policy, to adopt a posture of slower, more moderate, balanced
growth, rather than to have the ups and downs of excessive expansion
and recession which themselves contribute both to inflationary pressures and to distress in the economy. So these have been our objectives.
The economy is now well-balanced, and there are no particular overextensions or underutilizations in the economy which would indicate
conditions for recession in the near term.
Now, the action taken on November 1, as you well know involved
a combination of policies : it was directed to correcting the fundamental problems of our economy-domestically and internationallyout it also included some bridging actions to insure an orderly process in the dollar and foreign exchange markets until the recovery of
our economy and our dollar is confirmed by correction of the fundamental problems. The action included strong monetary action as well
as the marshaling of $30 billion in foreign currency resources to use
in the bridging activities.
So far the action has generally been favorably received and has
been effective in stabilizing the dollar and creating improved conditions for the domestic economy. If the unsettled markets that existed
in October had continued the feedback into our domestic economy
would have been serious and, I believe, would have put downward
pressure on economic activity and increased the risk of recession.
But, by taking those forceful actions and demonstrating to the
world and to the domestic analysts our determination to show discipline in fiscal and monetary matters, it appears that conditions have
improved for maintaining moderate growth and a voiding the distress of a recession.
Thank you very much for your attention. I hope this has been helpful as a supplement to the prepared stat~ment.
.
[The prepared statement of Mr. Miller, together with the charts
referred to, follows :J
PREPARED STATEMENT OF HON. G. WILLIAM MILLER
Mr. Chairman, members of this subcommittee, thank you for ·t~e opport~1;1ity
to participate in this important dialogue. At present, the economy IS at a critical
juncture. Economic growth has continued at. a moder3:te pace, but the rate. of
inflation i3 unacceptably high and poses an ever-grow~ng th~eat_ to our social
and economic structure. While the challenge for pubhc pohcy IS clearly for
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midable, these problems are not insurmountable. The Federal Reserve, for its
part is continuing to pul'Sue a monetary policy that aims at a reduction of
infla'tionary pressures while encouraging continued economic growth and high
levels of employment.
The rise in economic activity has been both vigorous and generally well
balanced since the present expansion began in early 1975. The sharp swings in
inventories and production that have ended previous cyclical upswings have
been avoided. Growth in the latter part of this year-well into the fourth year
of expansion-ha,s moderated, but this represents a desirable adjustment in the
pace of activity, given the intensification of inflationary pressures, the rise in
capacity use, and the decline in unemployment that has occurred over the
expansion period.
'£he persistence and recent intensification of high inflation has been the most
serious problem in the present expansion. Consumer price increases generaUy
remained in the 6½ per cent r,ange over the 1975-77 l)eriod, but these prices have
risen at a 91/!l per cent pace thus far this year. Some of this acceleration can be
attributed to weather-related disturbances and to unexpected developments in the
farm sector. Labor cost pressures also have played an important role as wage
gains have moved up to about 8½ per cent during a period when productivity
growth has slowed to a virtual standstill. At the same time, Government-mandated
increases in the minimum wage and in payments for social security and unemployment insurance have added a further premium to labor compensation. Finally,
the cumulative depreciation of the dollar's foreign exchange value has had an
adverse impact on domestic prices that has yet the run its course.
Looking ahead, there is a threat that wage demands could be further escalated,
especially with a heavy collective bargaining calendar for 1979 in an environment
where inflationary expections are intense. Cost pressures are also likely to be further exacerbated by another roun..d of legislated increases in payroll taxes and
the minimum wage. However, the Government's over-all anti-inflation program
holds out the real hope that inflationary pressures can be contained, and that the
groundwork can be laid for gradual attainment of price stability. The success
of the program requires cooperation, perseverance, and patience from an groups
of our society. An important new ingredient of the program is the quantitative
standards. If adhered to, these standards could very well help unwind the intractable spiral of wages and prices. But it is particularly important that the program
recognizes that Government actions can, in themselves, be important sources of
inflation; consequently, fl.seal restraint and regulatory reform are essential components of this comprehensive set of proposals.
Inflation in the United States not only has eroded the value of the dollar domesticaHy, but has also been associated with a decline in its international value. As
the exchange value of the dollar dropped, this in turn adversely affected the
domestic price level. It raised the cost of imported goods, .and also resulted in a
further ratcheting up of domestic prices for those goods competing with imports.
While the dramatic drop of late October underscored the problem of deteriorating
international confidence in the value of the dollar, the period of decline in this
current episode dates back to late September of 1977.
From that date to its low in late October of this year, the dollar's exchange
value declined by 21 · per cent on a weighted average basis against the currencies of the G-10 countries and Switzerland. Against some individual currencies, of course, the decline was even greater, amounting to 26 per cent against
the German mark, 34 per cent against the Japanese yen and 38 per cent
against the Swiss franc. Since important external imbal~nces between the
United States and major foreign countries have existed for several years-most
notably differential growth and, more recently, disparate inflation trends-some
depreciation of the dollar could be viewed as a necessary correction. However, by
mid-summer it was clear that the dollar's decline was continuing in trading th.at
was increasingly disorderly. Consequently, in August the Federal Reserve announced a half point increase in the discount rate and an elimination of reserve
requirements on Euro-dollar borrowings. At the same time, the Treasury indicated that it would in~rease and extend its regular monthly gold auctions.
These measures, which produced a brief rally and then a few weeks of stability
for the dollar, were followed by another three-quarter percentage point rise in
the discount rate between mid-September .and mid-October. But the dollar's slide
soon resumed, and it dropped alarmingly to a level well below that warranted by
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basic economic considerations. As a result, the severity of this latest decline
threatened to undercut t.lle anti-inflation program at home and lead to an even
greater erosion of confidence abroad.
Una.er these circumstances, more forceful action was clearly necessary. Accordingly, on Novemuer 1 the ..l!'edera•l Reserve increased the discount rate by 1
percentage point .and imposed a 2 per cent supplementary reserve requirement on
large time deposits. In addition, the l!'ederal Open Market Committee voted to
tah.e furt.lle1· actions to tighten conditions in the money market and thereby resist
excessive expansion of money and credit. Furthermore, in order to provide a
substantial increase in foreign exchange available to finance exchange market
intervention, swap lines \Vere increased with the central banks of Germany, Japan,
and Switzerland by a total of $7.6 billion. 'l'he U.S. Treasury simultaneously
announced its intention to draw a portion of the U.S. reserve position in the IMF,
to sell SDR's, and to issue foreign currency denominated securities. Over-.all, $30
biHion in key foreign currencies was mobilized by the United States for forceful,
coordinated intervention to support the dollar in foreign exchange markets. In
addition, the Treasury announced a further step-up in its rate of gold sales.
'l'he objective of this coordinated set of measures was to correct the excessive
depreciation of the dollar as part of the governmental effort to reduce upward
pressures on domestic prices and to restore contictence at home and ab-road. When
viewed in its entirety, the policy initiatives oi the Administration and the Federal
Reserve provide a clear message that U.S. economic policy is one that recognizes
fully the need for an integrated avproach in dealing witl} foreign and domestic
economic problems.
The measures taken on November 1 produced a dramatic jump in the dollar's
exchange value. On that day alone the dollar advanced by 5 per cent on a
weighted average basis, and by about the same amount against the mark, yen,
and Swiss franc. SuiJstantial cooperative central b,auk intervention over the following few weeks provided support for the dollar as market participants tested
the authorities' resolve. 'l'he strength of the dollar generally has been sustained
as the market appears to have adjusted to a more tavorable outlook generated
by the recent policy measures.
To date, the observable repercussions in domestic capital markets also have
been generally favorable. In the stock market, most composite share price measures are up from the November 1 announcement date following relatively sharp
declines in the preceding two weeks. Short-term interest rates have moved as
much as 1 percentage point higher since the announcement; however, over this
same period interest rates for longer-term maturities have been essentially unchanged. The comparative stability of most long-term bond rates, as well as the
improvement in the dollar's exchange value, is most encouraging and suggests
that we may be beginning to reduce inflationary expectations.
A downward adjustment of price expectations is an essential condition to slow
the treadmill of inflation, and monetary policy has an important role to play in
this regard. However, at the same time, the Federal Reserve will continue to
encourage a moderate expansion of over-all activity, thus also facilitating the
achievement of the Nation's longer-run goals of growth and full employment.
Moreover as I have emphasized before, monetary policy should not be expected
to should~r the burden alone, and to be effective, it must also be accompanied by
prudent restraint of fiscal policy.
Since April, credit conditions have become progressively tauter as Federal
Reserve policies have allowed market rates to rise appreciably in order to help
restrain expansion in money and credit. Yields on most short-term market instruments such as ]'ederal funds and commercial paper, have risen more than 3
perce~tage points during this period, while interest rates at the longer end of
the maturity spectrum generally have risen by less than a perc~ntage. poin!.
Experience over recent years _has t~ught us, however, th~t rn an rn~atl?nary
environment, expectational cons1?erat10ns_ t~nd to _buffer the impact of high_ mterest rates on spending. Expectations of n s11_1g _prices of real assets m~y mduce
borrowers to incur high interest costs, as 1s illustrated by the sustamed pace
of activity in the housing market thus far this J:'ear. !ndeed, real interest ratesor observed rates adjusted to take ac~ount of mflation~appear t_o be ~enerally
lower than in prior periods, especially 1f taxes are taken mto cons1~eratlon.
Not only have expectations of borrowers a_nd ~en~ers changed m ~he cours.e
of the current expansion, but also monetary mstltut10ns have been given add1-
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tJional flexibility to compete for funds. This has helped smooth adjustments
of credit markets to developing tightness and, as a result, has helped a void the
repetition of "credit crunch" episodes such as in 1969 and 1973-74. The new
6-month money market certificates, introduced half a year ago, have buttressed
deposit growth at mortgage lending institutions when prevailing market interest rates m1ght otherwise have produced disintermediation. Consequently,
total housing starts have remained at a very high rate-2 million units-during
the first three quarters of this year. Building activity may soon begin to decline,
but the drop-off next year should be relatively moderate, making it unlikely
that the economy will be thrown into a recession by a sharp housing cycle.
Furthermore, signs generally remain on the positive side for consumer spending,
as real consumption outlays currently are rising at a·b out the pace of overall demands. Nonetheless, this represents a marked slowdown from the rate of
expansion earlier in the current upswing. Near-term growth in consumer
spending probably will be somewhat restrained by high debt repayment burdens
as well as by efforts to boost personal savings rates back to more normal levels.
In the business sector, capital spending activity continues to be characterized
by substantial momentum as equipment orders have moved up briskly in recent
months and construction contracts have been maintained at a high level. However, the early surveys of 1979 investment plans suggest that businessmen maintain a lingering caution about embarking on major expansion programs. These
surveys-largely taken before the November 1 measures-undoubtedly reflected
the uncertainty associated with an economy plagued by high inflation.
On balance, private demands appear healthy at present, but a further modera•
tion of growth is likely over the year ahead. In this environment the Federal
Reserve w111 continue to strive for a gradual deceleration of monetary and
credit expansion in an effort to facilitate an easing of inflationary pressures.
We believe that the actions taken in late October and early November will prove
to be instrumental:in the restoration of both domestic price stability and orderly
conditions in foreign exchange markets. At the same time, you can be assured
that recent measures in the international area were designed to reinforce and
not to sacrifice the achievement of longer-term domestic aims.
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Chart 1
Change from previous period,
annual rate, per cent
GNP PRICES
TOTAL
12
H1
03
Change from previous period,
annual rate, per cent
GNP PRICES
TOTAL LESS FOOD
12
3
H1
UNEM PLOYM ENT RATE
03
Per cent
8
5
1974
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1976
1977
1978
138
Chart 2
Per cent
CAPACITY UTILIZATION IN MANUFACTURING
90
70
UNEMPLOYMENT RATES
Per cent
BLUE-COLLAR
SKILLED WORKERS
6
' ' .... _,.. .... ,,
-- ..........
~--------
1972
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....
,_ ',
HEADS OF
HOUSEHOLDS
1974
1976
' , ___ .
1978
139
Chart 3
U.S. MERCHANDISE TRADE
AND CURRENT ACCOUNT BALANCE
Annual rates, seasonally adjusted,
billions of dollars
50
40
30
20
CURRENT ACCOUNT
BALANCE
10
10
TRADE BALANCE
International Accounts Basis
-~
20
V
30
40
L...---.L..----L----_.,---..J.-------1----.__--_....,____.50
1971
1972
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1974
1975
1976
1977
1978
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Federal Reserve Bank of St. Louis
Char t 4
U.S. and Foreign Consumer Price Inflation
Percentage change at annual rates, 3-month moving average centered on month shown
Per cent
12
U.S.
I
t---- - .., ,,.
.,..--
I ,/\
r/
,,..,..
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* Weighted average of G · 1O countries plus Swltz ertand.
Weights are 1972-76 globat trade of each of the countries .
1978
Chart 5
"'
C0
"'0
U.S. AND FOREIGN 3-MON TH INTEREST RATES
Per cent
__,
"'
:;
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9
., .,-...
.,.-✓
r
.,,
, ___ .,
_✓
NK RATES•
WEIGHTED AVERAGE OF FOREIGN INTERBA
1977
1 O countries plus Switzerland .
* Weighted average of G-global
trade of each of the countries .
Weights are 1972 •76
1978
-✓
,,
--✓
142
Chart
e
Short-term Interest Rates and lnflatlon
Per cent
12
10
4-6 MONTH PRIME COMMERCIAL PAPER
8
I
I"
r,l ,,I
1
II'
~I
,,,
I 111I A1' I \I\ 1\1 •
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' l ,,
I .,.
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~
'57
• Ann ual rate
'60
or change from prevloua period.
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+
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\
'63
' 66
'69
' 72
'75
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143
Chon 7
HOME MORTGAGE INTEREST RATE
AND INFLATION
Per cent
lIIII] Home Mortgage Interest Rate
0
Consumer Price Index
10
*
EI] Real Mortgage Rate
1955-19 65
Average
* Annual rate or change .
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Federal Reserve Bank of St. Louis
1966 -1972
Average
1973-19 78
Average
1978
Average
144
Chart 8
*
E VALUE OF THE U.S. DOL LAR
WEIGHTED-AVERAGE EXCHANG
March 1973 - 100
108
Monthly
104
100
96
92
88
84
80
1977
1978
96
Daily
92
88
84
80
1 Sept. ' 78
29 Nov. ' 78
and.
of G· 1 O countries plus Switzerl
* Index of weighted averageglobal
s.
trade of each of the 10 countrie
We ights are 1972 - 1976
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Chart 9
Long-term Interest Rates and Stock Prices
Per cent
WEEKLY
8
r..-,
_r
\
\I
I
I
\
MUN ICIPAL BONDS
...
I
\I'
.,
\
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6
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· 0c1
Nov
Dec
December 31 , 1965c 50
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\
55
WEEKLY
55
50
50
45
45
40
40
NYSE COMPOSIT E STOCK PRICE INDEX
1975
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1977
1978
146
Chart 10
Federal Budget
BIiiions of dollars
DEFICIT
0
Fiscal Years
-10
~
\
\
\
\
-30
\
\
\
\
\
\
',
INCLUDING OFF-BUDGET ' ,
\
AGENCIES
/
✓
........
~. _ . _ - _.
., ... --
-50
_, ✓
' ' ,, ,,
-70
"
CUMULATIVE GROWTH IN TREASURY DEBT
Billions of dollars
Since 1971
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400
300
200
100
0
1976
1978
1979
147
Chart 11
TOT AL FUNDS RAISED IN CREDIT MARKE
TS
lIIIIl
Government
BIiiions of dollars
r,
*
II
□ Private
I
I
I
I
I
I
I
I
250
150
50
1972
* Includes debt 111ued by U. S. Treasury and Government aponaored agencies .
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Chart 12
Change from previous period,
annual rate, per cent
REAL GNP
1972 Dollars
+
0
Hl
HOUSING STARTS
03
Millions of units
2 .0
1.5
1.0
REAL PERSONAL
CONSUMPTION EXPENDITURES
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Change from previous period,
annual rate , per cent
+
0
H1
1974
1975
1976
1977
03
1978
149
Representative REuss. Thank you for a very clear statement.
I am heartened by the comment in your prepared statement in which
you say, and I quote, "The Government's overall anti-inflation program holds out the _real hope that inflationary pressures can be contained and that the groundwork can be laid for gradual attainment
of price stability."
By that I take it you mean that you believe the program, if implemented, will work, and that prices should come down from their
present level.
Mr. MILLER. Mr. Reuss, that is correct. This prediction of course,
addresses itself not to just any individual action in the anti-inflation
effort, but to the broad range of actions. It seems to me that
we have seen a rather dramatic marshaling of resources to combat
recession in the last few months. We have seen, thanks to the commendable action by the Congress and by the administration, a change
in the pattern of fiscal policy toward more restraint and toward
reducing the Federal deficits. This kind of approach, this restraint, is
continuing.
So one weapon in the anti-inflation arsenal has been fiscal policy.
Another, of course, has been the incomes policy that the President
introduced on October 24-now being perfected-that seeks the cooperation of management and labor in programs for moderation and
includes a series of incentives for compliance.
A third area of effort has been the initiative by the Congress and the
adn:ii!listration to adopt a more comprehensive ene;rgy program and
policies that would reduce our dependence on imported oil. Some
progress was made on that in this Congress, but it will undoubtedly
require further attention.
We have also begun to focus on promotion of increased exports
which is important in achieving a better balance of trade and improvement in our current account deficit.
. We have begun policies directed at improving productivity, which
is essential if we are to break the spiral of wages chasing prices and
prices chasing wages.
And we have seen forceful action to correct the disequilibrium in
the foreign exchange markets, to stabilize the dollar, which will prevent inflation from leaking back into our economy through a weak
dollar. And we have seen disciplined monetary policy in coordination
with these actions.
When you put all of these efforts together, there is hope that we are
.
beginning to get inflation under con~rol. .
Representative REUSS. Now turnmg to mterest rates, the prime rate
i!:, already a very unsatisfactory_ ll½ percent. Many ~nowledgeable
Qbservers, including Time magazme's stable of eco?om1_c experts, are
predicting that the rate is going to go up to somethmg hke 13 percent
.
this next year. Say it ain't so. [Laughter.]
Mr. MILLER. I ·have been a-slow learner in Washington sometI?1es,
but I have learned that the best way to deal with interest rates_ 1s to
point to what they are and to what they _have been, and to ?m1t the
predicting. I don't think any of us can, with confidence, predict what
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interest rates will be, because that depends on how our present policies are affecting inflation and inflationary expectations; it depends
upon external factors.
.
Our objective, of course, is to arply the Nation's :full r.esources; mcluding a prudent monetary pohcy, to dampen mflation. As that
happens, then, of course, the normal expectation is that nominal interest rates can adjust accordingly. It is the real rate of return that seems
to govern the expectations of those who lend their funds.
Representative REuss. Well, you have earlier said that it is your hope
and expectation that inflation starting right now, will come down, not
go up. If your hope and expectation comes to pass, and in view of the
fact that the Federal Reserve has been tightening the money and seeking a higher target for the Federal funds rate which quickly transmits itself to the prime rate in this country, it would seem to me that
your goal is to have interest rates not go up.
Mr. MILLER. Mr. Reuss, our goal is to wring inflation out of the economy and to do so on a steady basis so that we mak~ the permanent
changes that are essential. I think we have, perhaps, had periods in the
past where there was a tendency to treat the symptoms rather than to
treat the disease; we need now to treat the disease.
This objec_tive has al.ways seemed to me to involve a considera?le
need for patience and time. It has been my feeling that we are facmg
many years of necessary disciplines in order to wring out inflation
in our economy. Inflation has been built up over 12 years, and it has become deeply embedded. I have often said that I can see 5, 6, or 7 years
of discipline ahead in order to accomplish our objective.
You are absolutely correct that when we have reduced inflation, nominal interest rates will come down in relation to that accomplishment.
For this period of turning around inflation and inflationary expectations, ~omething like a sine curve is in operation: As yon come up, the
curve 1s very ste~p; whe?- you c<;>me near the _top, there is not much
change for a wh1]e, and 1t sometimes takes qmte a bit of time before
you go down the other side.
Once we turn down, then I would think that the probabilitv is that
we can conti!1ue that trend. Less pres.sure on money markets ·and less
pressure on mterest rates would be with us. When that turn wiH take
place, none of us can ten at the moment.
Representative REUS . I tliought I understood you to say that it is
your hope and expectation that the inflation rate would turn.downward
very soon, in 1979.
Mr. MILLER. I would think that the inflation rate would be about
three-quarters to 1 percent less in 1979 than it is this year if our plan
continues to have the effect we expect.
Whether or not th~t means t~at interest rates will change quickly, I
um not sure. As I pomted out m these charts, at the moment it would
appear that we have a -yery t~nusnal sH:n~tio~ with thP nominal interest
rate very close to the mflat10n rate· H1stor1callv this means that the
real interest rate is inadequate. How lonP: the adjustment will take 1
am not sure.
Representative REuss. Well, I should think if :vour hopes and expectations are satisfied and inflation starts going down, that you cer-
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tainly don't need to further tighten money and raise interest rafos
through your control of the Federal funds rate. Therefore, the prime
rate ought not to go up from 11½ percent; where it is now, ,to 13
percent.
Mr. MILLER. We have some reason to be encouraged slightly, recently.
I think, Mr. Reuss that you probably have noted that the growths of
monetary aggregates have recently slowed considerably. This is a matter that we have, of course, discussed in our other hearings on monetary
policy. It has been rather discouraging at times during the year to see
the stubbornness with which these aggregates have continued to grow
given ,t he particular pattern of the economy, the difficulty of inflat~on,
and the etl'ect of inflation upon demands and expectations. But the
growth of the aggregates has begun to slow recently, consistent with
earlier testimony 1 have given on the lag effect; I ,t hought they would.
_This is an encouraging sign. If that can continue, then I would certamly agree with you that the pressures are lessened on monetary policy
because we will have returned growth to ranges consistent wi.th our
objectives of moderate economic growth-ranges which we have sought
with your guidance to achieve.
Our M1 figures, even taking account of the new automatic transfers,
are showing a much more moderate growth rate. M1 has been growing,
as you know, at about an 8 percent rate for about a year and three
quarters, and it has been quite difficult to get it turned down. It is
encouraging to see this happening now. The other aggregate measures
are also turning downwards.
But I would not want to mislead you by a prediction because the
~conomy has proved so difficult to judge recently. Its behavior is so
influenced by how individuals and businesses make their own predictions as to inflation. Because of that, i.t's been very hard to gage the
~nderlying economy, and therefore I don't want to give you a misleading forecast. But I certainly agree with you that, if we can continue
to see the aggregates .trending this way, then the pressures will be less.
Representative REuss. I have one more question. Most people agree
tha~ a prominent element in fighting inflation is a greater rate of
ca~1tal investment in plant and equipment; this helps productivity,
which, in turn, helps fight inflation; Congress, of course, has been extremely interested in stimulating capital investment: it has enacted and
added to our investment tax credit; it has cut markedly the capital
gains tax on common stocks so as to make the financing of plant and
equipment more feasible.
You point out that one of the usual early victims of a tight money
policy, housing has been somewhat insulated by the invention, and a
good one, of 6-~onth money market certificates which the thrifts and
others can put out in order to lay their hands on lending money.
. If, therefore, housing is to a degree spared from the brunt of a
t1g~ter _money policy, won't most. of the bu~den fall upon. the v~ry
capital mvestment in plant and eqmpment, which everybody, 1_n~ludmg
the 9ongress, agrees is the royal road toward greater productivity and
less mflation ~·
.
.
Mr. MILLER. Mr. Reuss, you have raised an is~ue that I thmk 1s
particularly critical in our strategy, and I would hke to elaborate for
Just a moment.
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It seems to me that in the past for undoubtedly justifiable reasons,
we have had circumstances in our economy that have resulted in a lack
of application of the principles of the marketplace to housing. Housing
has been more like a controlled area.
Until this decade, of course, this country had not experienced high
rates of inflation except in wartime. So, as we came into this period
when we have experienced high rates of inflation that were buil.t up
over time, we didn't have a good mechanism to deal with housing.
Because of the Reg Q ceiling on savings interest rates, we had limited
what the traditional financers of homes-the thrift institutions-could
pay to compete for funds for housing.
As inflation drove up other interest rates, we had massive disintermediation. People did not want to limit .the yield on their savings to
the rates that could be paid by thrifts.
At the beginning of 1973, housing starts were running at an annual
rate of about 2½ million. This was too high, actually; i,t was an overstimulated situation. But in any case, because of that massive disintermediation, housing dropped to a rate of 900,000 annual starts within
2 years. This was not a recession; it was a depression.
Of course, when housing collapsed like ,that, it dismantled many
homebuilders. The demand for home furnishings and the durables that
go into housing collapsed, and this helped lead us into the great recession of 1974-75.
In this particular cycle we have tried to avoid that, believing-at
least I have been believing, the Federal Reserve has been believing, and
the other bank regulatory agencies have been believing-that this is
not good economic policy; that housing should be given a more equitable chance to compete m the marketplace for funds on its own, that
the marketplace should decide whether people's preference is for the
purchase of homes or other investments.
The result has been a much more stable situation, a much more
balanced situation. It does have some costs associated with it. Undoubtedly, allowing housing to compete for funds while trying to restrain
the total amount of credit available may have had a slight upward
effect on interest rates. We may have a little bit higher interest rates
than we would have had if we had let housing go into a recession.
But the Nation has benefited, because I think it costs the Nation
more to have a depression in housing than it does to allow housing to
compete more fairly.
That is the first part of my answer to your very penetrating question.
The next part of the question is, doesn't that make it more difficult to
finance the business fixed investment we need to get productivity~
My answer to that is-to the extent that we have been able to demonstrate our commitment and determination to fight inflation, to the extent that we have been able to take forceful action, we have actually
created conditions for lower long-term interest rates. That is why longterm interest rates have really been rather stable; they are no higher
now than they were in July.
That being so, it seems to me that we have maintained conditions for
the financing of long-term investments. To the extent that we can
continue to succeed in dampening inflationary pressures, I think longterm markets will show further capacity for financing these business
fixed investments.
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This process does involve distress in the form of higher short-term
interes ~ rates, but it does have the advantage of relieving the pressure
on longer term commitments because of the belief that inflation will
come down and funds can be committed for the future.
Representative REuss. Thank yo·u. My time is up.
Congressman Hamilton.
Representative H AMILTON. Thank you very much, Mr. Reuss.
. l\~r. Miller, just to get on the record here, I want to get your proJect10ns for 1979. You commented on this briefly in response to one of
the chairman's questions, but what is your projection on the inflation
rate for 1979 ? You said something about three-quarters of a percent
below the present rate.
Mr. MILLER. Mr. Hamilton, I might_give you the personal estimates
that I gave to the Senate Banking Committee, chaired by Senator
Proxmire, just a few weeks ago.
My outlook for 1979 is for a rate of real growth in the economy
between 2.5 and 3 percent. This is a low rate of growth, but it does
indicate a recession. My outlook for unemployment is in the 5¾,'s to 6¼
percent range.
M'y outlook for inflation, measured by the GNP deflator, is in the
6¾ to 7½ percent range, compared with a probable rate of about 8
percent this year. I am sorry that I didn't give those estimates earlier.
Representative HAMILTON. No; that's helpful; I appreciate that very
much.
One of the things that strikes me in listening to your testimony and
the testimony of Mr. Schultze and Mr. Blumenthal yesterday, and
c?mparing that to. a number of ~tatements you read in the press, particularly from busmess leaders, is that the Government sector is confident of being able to avoid a recession next year. You certainly indicate that in your statement this morning. The witnesses yesterday did.
Yet, when yon talk to businessmen and other economists, I have the
feeling that most of them really anticipa'"e a recession.
How do you explain this gap, and do you think it's changing in recent
weeks?
. Mr. MILLER. Perhaps I should not do so, but I might say, somewhat
m jest, that to the ex' ent there is a wide consensus on recession, you
reduce the prospects for it, because economists quite often seem to be
wrong in their forecasts. That is one reassuring thing.
But, to look at it more substantively-Representative HAMILTON. Mr. Miller, the President said just the
~everse yesterday. He said that if people think there will be a recession,
it becomes a self-fulfilling prophecy.
.
Mr. MILLER. I have also said that is true. I believe we can talk ourselves into one. I believe we should not do so because we can change
people's expectations and discourage them from investment on the
Pxpectation of recession.
But to be serious about it I think there is a natural human clement,
an emotional and subje.cti;e element that creeps in. The_ actions on
N ovem'ber 1 were powerful actions? and th~y led to_ the belief that_ the
amount of restraint involved to brmo- our mternat10nal accounts mto
better perspective-which was ~ es1ei:itia.l-that th_at restraint was
apt to show up in lower economic activity and re.cession.
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I think several things were overlooked in that time period. One
thing that was missed was that the destabilizing conditions in t~e
foreign exchange markets were far more threatenmg to the domest~c
economy than t~e st~bilization effort._ Actual~y, creat~ng the cond1,
tions for a contmuat10n of enhanced mternational activity and flow
of goods and seryices would improve prospects. It would improve the
prospects, for example, that the growth rates in Germany and Japan
will be higher than they have been and therefore have some effect on
demand for our goods and help our economy; a weak dollar or an
uncertain dollar would have dried up a lot of that activity.
The other thing that's missed, it seems to me, is a careful look at
the balance in the economy. It's very hard, when you study the economy sector by sector, to make a case for why there should be a recession. For a recession you need to have something going down.
Let's take personal consumption. I think everyone's lot has been
improved by the tremendous increase in employment, by people at
work in America whose earnings create the capacity to add to personal
consumption. Now, in November, we have seen one of the most remarkable increases in employment we have seen in a long time. Looking over
the past 2 years, we have just seen an ama:ling capacity of this country
to absorb the growth in our labor force. We now have, for the first time
in history, more than 59 percent of our adult population employed.
That means that we do have capacity for continued personal consumption. It will moderate, ·as we see in some of the current figures on
retail and other activities. Although there have been some strong figures in the earlier part of this quarter, it looks like there is moderation now.
So when we look at that sector, personal consumption, it is not in a
recessionary mode. We are not seeing a lack of capacity to consume.
The housing sector is the one area-because of the restraints and
levels of interest rates-where we can e.x pect about a 15 percmt decline
to around 1.7 million starts from 2 million. But that is nothing compared to the 50 percent declines we have seen in the past, and it is
really kind of healthy.
Let's look at business fixed investment. A recent survey showed
expectations of only moderate real increases next year. But orders
placed recently, apparently out of confidence that is building about the
anti-inflation program, would indicate that that survey is on the low
side. Businesses are actually making commitments now that show a
little more strength than the survey would have indicated a month ago.
When we look at inventories, we look at •a well balanced condition.
When we went into the last re.cession, we had inventories that had been
over-accumulated; the ratios were not healthy. In the first part of 1974
there was a dramatic $80 billion adiustment, at an annual rate, from
inventory accumulation to liquidation in one quarter, which meant
that lots of factories were shut down. We don't have that now. We
have low inventory-to-sales ratios and a very healthy condition.
When we look at the international sector, the higher growth rates
in other countries, combined with our lower growth rate, is showing
an effect that should improve our exports next year over this year,
while our imports are relatively reduced.
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So I don't see, when you add this up, conditions that would bring
about a recession.
Representative HAMILTON. Has there been a shift in business opinion in recent weeks, then, toward the view that there will not be a
recession?
Mr. MILLER. In fact, we were at the business council dinner W ednesday night at which the President spoke, and just from talking to
people there, I felt there was somewhat of a changing attitude, an attitude that there is a better prospect for avoiding a recession. That was
my impression. A number of the business people, reporting on their
own companies, seemed to have a better outlook than would have been
reflected in early November.
Representative HAMILTON. What is your recorhmendation for steps
that we can take in Government to increase productivity?
Mr. MILLER. The most important thing that needs to be done-as
soon as it can be done, in my opinion -is to liberalize substantially the
depreciation allowance for new investments.
I believe that the way business decisions about new investments are
made relates not only ,to assessment of markets and costs and prices
-which tell what kind of yield might be achieved from an investment
-but also to the time period during which the investment will be exposed. The longer the time period and the more uncertainty in the
economy, the more difficult the decision is. The shorter the time period
-or, if you will, the more quickly there is a recapture of the investment-the more business is willing to take the risk. Higher rates of
depreciation increase the discounted cash flow and, therefore, have
u powerful influence on business investment decisions.
From the point of view of the Government, higher depreciation alIowa~ces do not reduce taxes, they only defer them, so they are more
effective from the Government's point of view than investment tax
credits which are a forever forgiveness. If you take a depreciation allowance this year instead of next; then next year you have to pay
faxes on more income because you don't have the deduction.
So, from both points of view, I think you get more bang for your
buck.
. If we can more progressively toward a 5-year writeoff for product10n equipment and machinery, and a 10-year writeoff for production
stl'1;lctures, then I think that we would really create the conditions
which are essential to step our business fixed investment uv to the 12percent range. In that way, we can become more competitive, we can
red~ce our costs per unit of production, we can become more energy
efficient in production, and we can reestablish our technology, which
usually goes along with fixed investment.
Represe;ntative HAMILTON. Just one other question, if I may, Mr.
Miller.
You have already referred to these money market certificates in
response to Mr. Reuss' question. Am I correct there is a minimum
purchase on those of $10,000?
Mr. MILLER. Yes, sir, that is correct.
Representative HAMILTON. Now, thiat always bothers me because of
the problem with the small saver. What kind of a hedge does the small
investor have with regard to inflation ?
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He can't buy those certificates. He puts his money in savings and
loans, and he doesn't even keep up with inflation.
What oan we do to help him out?
Mr. MILLER. It has bothered me that we have this structure. Unfortunately, it's one that I have inherited, :and an areia in which there
have been widely differing opinions. I would like to take a moment
on this because I think it is important. As long as we have had regulation Q ceilings that have limited what oan be paid on small savings
a;ocounts, and as long as inflation has been low, that was all right.
But, as inflation has gone higher-and consequently as interest rates
hiave gone higher to mamtain the purchasing power of invested fundswe have left the small saver behind, and we have created a number of
effects which are unfortunate. One of these is that, since saving is
not attractive there is more pressure to spend, and that's exactly the
opposite of what we want to -accomplish. So we are doing a disservice.
On the other hand, to have ohanged that structure this year would
have cerated such a massive increase in the cost of funds for thrift
institutions as to make it impossible for them to maintain their profits
•a nd, I believe, their services. We were in a dilemma, so we did the best
,t hing we could. We created ian instrument similar to a Treasury bill
as what I hope ~ill b~ an interim step. I hope Congress will look w_ith
favor, as we get mflat10n down to more normal conditions, on workmg
with us to phase out those kinds of limitations on small savers, which
I think are unfair and work against us in times of stress.
The trouble is, when times are good, we don't take the ceilings off;
when they get tough, it's too late. It's like the old story about the Arlmnsas traveler-lJlever fixed his roof when it was sunny because he
didn't need it, and, when it was rainy, he couldn't. We have done that
with regulafam Q, I think.
Representative HAMILTON. Thank you very much.
Repre.sentJative REuss. Congressman Brown.
Representative BROWN of Ohio. Thank you, Mr. Reuss.
Mr. Miller, it's nice to see you.
I would like to throw in -a suggestion for you and Mr. Hamilton,
concerning the small investor. I have a bill which would give the invest-OT in a savings account or bank ·account a tax credit if his rate o:f
savings is beyond what is the normal or the average rate, and that
would not necessarily come out of the savings institutions in
higher interest mtes; it would come out of the Federal Government1
in effect, in lower taxes collected for the Government. I will send that
around to you and direct your attention to it.
I want to compliment you, Mr. Miller, on this chart, which I think
does effective explaining of what has happened to interest rates. It
isn't the bankers and the -people with the money who ·a re making the
money on that money. It's the Fooeral Government that is making the
money, if you will, on inflation.
I aiso want to commend you for coming very much closer to meeting
the money growth targets that you have se~ than had been the case
previously, or, rather, I should say for settmg lower money growth
targets and ,a chieving them.
I also want to commend you £or convincing the President that real
steps should have been taken, as they were on November 1, to bolster
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the dollar, rather than just the cosmetic steps that he took in his October 24, speech. That resulted in the dollar dropping at a record mte
during that week until the steps were taken to increase the reserve
re9uirements by $3 billio,?, which I think was an implicit pledge to
brmg the money supply m this country under control. Already the
gnomes in Zurich, London, and other places have taken into account
and stiffened their position a little on the doUar.
. Yau stressed that r -al interest rates are low, and, ,as I said, the chart
!ndicates that. I don't think it's the interest rates themselves, that
1s, the return on the money, that is choking off investment; as a matter
of fact, tJhere seems to be a sale on money in that regard right now.
But, rather, i,t is the inflation within that interest rate that is doing it.
I would like to go back to something that you talked to Mr. Hamilton
about. Both you and I have run businesses; yours was a little larger
than mine. [Laughter.]
Mine was a weekly newspaper in western Ohio, but I want to cite
to you a situation here that I think makes sense and why I would say
that the President's early steps were cosmetic.
You know, he asked business to limit its profit to 5¾ percent, but,
when your cost is going up at the rate of 10 percent, unless you've got
~ lot of money in the bank-and my guess is your company has more
m the bank than ours does, and it's •a public company and you can go
out and sell stock; I ca.n't-it's a family held bu iness-so I haw to rely
on the friendly banker. Unless you oan do that, or have a big enough
reserve, when your costs go up at the rate of 10 percent and your
prices can only go up 5¾, you oan target specifically when you go
broke. That also applies to the individual, because, whoo he is asked
to limit his wage increase to 7 percent and the cost of living is going
up 10, he oan pick out-for some it will be next week, fur some it will
be 2 or 3 years off-when he goes broke. So those thino-s don't work.
Let me give you an example of my problem, and you addressed it,
but I want to make it specific.
Ten years ago I bought ·a new offset press for my little weekly newspaper business; it cost me $100,000. I got a good deal on it. Now,_I
recaptured that $100,000 at the rate of about 10 percent a year m
depreciation, and this year I've got my $100,000 accumulated . .
The depreciation, of course. rednced my income tax accordmgly,
because it's a cost to the business. The problem is that I go out and
price those new presses and, yon know, they are over $300,000 now.
My question is, where do I get the other $200.000?
Because the Government-that's you-[lauo-hter J has taken the
money from me haJf of all I made, jn higher taxes because I couldn't
depreciate the $300 000 only $100,000. and so I don't have the profits;
I have had to pay 'som'e of that ont in divid~nds, _and I have_ had to
make improv ments in the pla!1t and keep 1t _pamted. Th~ !n~erest
rates
are so hio-h-even
thouo-h it's not the real mterest rate, it s mfla•
f-,
bon- that that discourages me.
. .
And. frankly , if I go out and borrow that $20~,000_ at those hwh mterest rates th·e return on that investment doesn t qmte meet my need
for the mon'ey to pay the jnterest on th_e $200,000. . .
Now, true·, I will get somewhat hurher deprec1at10n becauc::e I nm
going to spend $300,000 rather than $100,000. I understand that that
1
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overtaxing that the Government has done, because of those low depreciation alowances amounts to $20 billion that the Federal Government
has taken out of prospective investment.
Now, what can you do to help me 1 [Laughter.]
Mr. MILLER. Here we have got the fundamentals of one of our
critical problems. The depreciation allowances now in place are insufficient to fund replacement of plant and equipment, not to mention
either expansion of capacity or modernization with new technology.
Now, therefore, we have a serious problem. The fact that these factors have contributed to lower investment levels in the United States
for a long period of time is of deep concern to me, and I know to many
of you here, because we have discussed it in some of our other hearingB.
Representative BROWN of Ohio. We have overstated profits. The
total profit rate in the economy has been low in recent years. Not
the last 2 or 3, but over the longer period, it has been much lower than
it was previously; isn't that correct 1
Mr. MILLER. That's correct. You know, I am in the Government and
not in the private sector, but let me give you a couple of worries we
have to have.
Ideally one could make a case that depreciation should be allowed on
the replacement value of an asset, which would help. The trouble with
that-Representative BROWN of Ohio. I would be happy if you indexed
it on the basis of inflation.
Mr. MILLER. Yes.
Representative BROWN of Ohio. And it wouldn't always be the same.
Mr. MILLER. One of the problems with that, of course, is that it
may work against our objective. If old assets continue to be depreciated, then there is a disincentive to add new assets which may be
needed to maintain productivity in the future and to deter inflation.
What I am saying is that that is one way to go, but to suddenly shift
to replacement value for depreciation would have a large impact.
Therefore, I tend to be-Representative BROWN of Ohio. Excuse me just a moment. If you
do it on new assets only, not on the-Mr. MILLER. That's what I was coming to.
So, therefore, I would favor this approach to new assets: what I
would be in favor of is a very rapid writeoff on new assets~ you get
your money back so fast that you have less problem that it's locked
up, as yours was, for 10 years and-Representative BROWN of Ohio. The Government wouldn't tax it
away from me either.
Mr. MILLER. That's right.
Representative BROWN of Ohio. Because I could take that off my income tax.
Mr. MILLER. That's correct. The whole theory behind the recapture
of your investment is that with a 5-year writeoff and accelerated depreciation in a double-digit system. you wou]d have your investment,
and you could capture back that $300,000 that you would have to pay
for an offset press today in less than 5 years; your risk because of the
inflation would be reduced.
If you index that in addition, then I do think you have a problem.
When do you cut i,t off 1 You should be only able to recapture it once.
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Representative BROWN of Ohio. Certainly. I only want to recapture
it once, but I want to recapture all of it.
Now you have given me hope for the future, if I can find the friendly
banker and get those interest rates down.
If I could just work with the bottom part of the chart, not the white
part that is inflation, I would borrow the money tomorrow. But I
wonder if :vou could give me any other hope for a tax reduction of
some sjgnificance so that I could at least say in the future that my
return on that investment, my profit, is going to be a little higher.
Then I could tell the banker that I am going to be making more money
and I can pay the interest out of that additional profit.
Would you be good enough to do that for me~
You encourag-ed me to expand.
Mr. MILLER. Your friendly Federal Reserve is very much in favor
of this.
I hope the administration can come up with a solution.
~fay I say that you have given here a very practical, specific kind
of 1Jlustration that helps everybody understand the dangers, the threat,
the inequities of inflation and how it could destroy our society.
Your example is just right; 10 years ago you bought a press for
Sl00,000; today it would cost $300,000. That $200,000 difference represents inflation.
In addition, you have to pay a higher interest rate to buy the
$300,000 press, which represents inflation; so you have a double
whammy.
No matter what we say or do in terms of temporary solutions to the
problem, the truth is that if we don't wipe inflation out there is just
not enough capacity in the system to avoid disaster.
We need a system that will accommodate and encourage and incenti vize the business investment we need to contribute to reducing inflation. But we also need all the other polie.ies-including the willingness
to be austere in our aspirations for Government services, and the willingness to be austere even in monetary nolicy-in order to choke this
inflation disease out of the system and get back to where you can buy a
press for $100,000 today and you can buy it for $100,000 5 years
from now.
Representative BROWN of Ohio. If I can hold out, Mr. Miller, I am
going to be all right; but let me just tell you that up at the Washington
Hilton today they -are in the second day of a conference with the Federal Trade Commission on the concentration of control of the media
and newspaper business, and I am not sure whether I can hold out.
The only answer then for me perhaps is to sell out at an inflated
price rto Gannett or Thompson-and, you know, he is hardly a localto sell my little string of weekly country newspapers, and I don't want
to do that even .. Frankly, I don't want to go to work for somebody
else. I would like to be able to stand up and write my nasty editorials
that way I want to. But the problem I have is one of immediate desperation, and I really do hope that you can find a w~y to do more
than just talk about this; maybe get the Co11gress convmced, and the
~resident encouraged; so I will pray for you, and you can pray for
him.
I do have some other questions that I want to ask, but my rtime is up,
and I will come back.
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Representative REuss. Thank you.
Senator Proxmire.
Senator PROXMIRE. Chairman Miller, although you may doubt this
sometimes, I have great faith in your intelligence. You are an extra~rdinarily articulate and able man. However, I wonder if any Chairman of foe Federal Reserve Board or Chairmen or Secretary of the
Treasury or Chairman of the Council of Economic Advisers could
come up here in public and predict a recession or predict that infl-ation
won't get better or predict that the economic factors thait affect all
of us are not going to improve.
The difficulty with this kind of a hearing is that there is a problem
of credibility regardless of the faith we may have in the integrity
and honesty and ability of the person who is testifying.
Can you help us with that at all? You told us you think inflation is
going to get better. You say we are not going to get a recession, but I
cannot imagine you or any other chairman coming up here and saying the reverse no matter how strongly you felt it.
Mr. MILLER. I have a character witness to call on. Mr. R euss, you
will recall that I was sworn in on March 8th and I rtestified before
your committee on March 9.
My statement then was that "Inflation is going to get worse." So I
have at least one statement on the record that I came here and said,
"Problems are going to get worse; let'is do something."
Senator PROXMIRE. "Unless." You always say "unless."
Mr. MILLER. No, I said inflation was going to get worse and it did.
,Senator PROXMIRE. You said that no matter whaJt we did, if we moderated our budget, our fiscal policy, and so forth?
Mr. MILLER. I said at that time, "Inflation is our biggest problem.
It has not yet been perceived to be the problem, but irt is going to
accelerate on us. Therefore, we should start doing things to win the
battle." But, you know, I think your point is well taken. I think thait
the natural responsibility of those in the Government in making public presentations is not to create a lack of confidence in the economic
progress. Bu~ ~ do believ~ there has been a change, and that there has
been more w1llmgness this year to admit the shortcomings - Senator PROXMIRE. You may be right about that. For 20 years.c21 years I have been on the Banking Committee or this committee
hearing these predictions and they are always optimistic. They project
things are going to be good. Sometimes they are right because, of
course, sometimes things do get better and sometimes they are wrong
and they are almost always wrong when the situation does then worsen.
Let me put it this way. Let me ask yon about this notion that really
disturbs many people in the country, particula.r ly in the business community, but also here, too, that if you are going to blink when we come
to a situation where you have to choose between stepping in and following a more easy policy in order to stem the possibility of a deep
recession, or stopping inflation, that you will take the course of easing
the recession. Maybe you should, but it seems to me you are pretty clear
that you are likely to do it, but let me put it to you :
Suppose there is a 1973-74 price rise and unemployment rises more
~harply. We have a 10-percent inflation as we did then, tmPmployment rose sh~rply •a t the same time as it did then, the dollar weakens
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as it m_ight if inflation C?~t~nues to be in bad shape. Would you then
rec?gmze your responsibility under the Humphrey-Hawkins bill
w~ich we just passed last year and give precedence to unemployment
with monetary policy that will help our unemployment situation; or
under those circumstances, ,vould you feel that you had to persist in
overcoming inflation ?
Mr. MrLLER. Sena.tor Proxmire, it is hard to answer hypothetical
questions premised on the experience of the past because those experiences are so fraught with mistakes that I assume we would not want to
make. For example, one reaction to the upturn of inflation earlier in
th~s decade, jn the 1971-73 period, was to put on mandatory wage and
price controls, and that created the circumstances where, incorrectly,
the economy was stimulated and the desire for rapid economic growth
was accommodated by holding a lid on. Of course, the lid couldn't prevent the building up of excesses and bottlenecks, and since the United
States does not have an isolated economy, it did not prevent the
driving up of the world price of all commodities which contributed to
the period you just described in 1974. If you will recall, there was
literal chaos in the economy, with duplicate ordering, excessive accumulation of materials for fear they would never be available again,
hoa.rding of labor; everythjng was done wrong. The result was a big
collapse.
Those conditions don't exist, and I hope they never exist again, but
to the extent that there could. be a s]ackening in the economy at some
future date, I think we have a commitment in monetary policy to maintain a position consistent with the real economy. You know, it was just
as bad to have an overexpansion of money in 1971-73, while there
were controls on, as it was to have an overrestraint on capacity in
1974, after we had already turned the corner. You know, we had
already headed down and we were still restraining the economy.
So I thjnk the real way to run monetary policy is to be more pr_omJ?t
to adust to the realities of the economy, up or down, and not dnv:e it
into an unnecessarily severe recession nor allow it to bubble up mto
excessive demands.
Senator PROXMIRE. But we still pernjst in assuming there is necessarily a tradeoff, that if we move jnto a period of slower arO\yth or
into a period of recession, that prices will moderate. That 1s not
necessarily the case.
Mr. MILLER. No, sir.
.
Senator PROXMIRE. As you know-Mr. MrLLER. No.
Senator PROXMIRE [ continuing]. There are many, many elements
in inflation. Energy prices may change regardless of what happens
to the economy.
Mr. MILLER. We may have a famjne.
Senator PROXMIRE. The crop situation may change so that foo~
prices go up sharply. 1iVe don't know what will happen, on th~ lab 1
front we h:we hiah hopes but we don't know. W e cant predict. ~
the q~estim~ I ask you and I persist in . as~ing_ is, .will ~he F~de~a
Reserve give the recession priority or will it gwe mflatwn prwrity
in those circumstances?
.
·
h ·t
t
It is a tough question, but it is the big quest10n, t at 1 seems o
me we need an answer from you on.
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Mr. MILLER. I am not sure I can answer you or that I have the
capacity to :answer you because, as you point out, there is not just
one kind of recession, there are two kjnds of recessions, there are three
kinds of recessions. If you have a recession which is deflationary and
is itself going to create w consequences, you would react a certain way.
I am not trying to duck your question, but I think to try to answer
in advance wh:at the policymakers will do, without knowing all of the
circu~stances, creates some dissatisfaction because it may lock us into
commitments we can't fulfill.
My view is that a recession at this time is not only not likely, but
not good policy, because I do not see a recession a;s contributing to
eradicating inflation.
I see inflation as imbedded deeply and structurally in our system.
I see a number of years being necessary to wring it out. And I see
the best pattern for wring-ing it out is to adopt a posture of moderate
growth, which will allow us to consolidate and digest our problems
and work them off, rather than a recession, which would immediately
lead to very high Federal deficits, very high demands for borrowing
money :and which would get us back on the treadmill of more inflation.
Senator PROXMIRE. As I understand that answer then, you are say:..
ing that in the event we move toward a recession, the Fed would ease
monetary policy regardless of the effect on the dollar, regardless of
the effect on inflation, because recession would have a perverse effect
both on the dollar and on inflation in the long run. Is that right~
Mr. MILLER. No, I am saying that today I don't see the conditions
for a recession, nor do I see that we should' deliberately exercise policy
as though there were a threat.
Now if a recession is coming for other reasons-reasons that we
cannot now predict-I would want to look at whether or not it is
accompanied by conditions that will contribute to a reduction of
inflation or whether it isn't. At the present time, I don't see a recession as contributing to a reduction of inflationary forces.
Again, I am not trying to avoid your question, but I don't think
one can judgf' in advance. fa a recession canse<l. because of some upset
in the world~ Is it cause.d simply he.<'nnsf' the.re i~ 'a - Senator PROXMIRE. Supposing it is caused in part hy higher inte_re~t
rates, and we have already seen some slowdown in housmg and it is
likeJy to get more severe, many people feel so anyway. We mi_g ht get
more of a slowdown in business investment capital and eqmpment.
Under those circumstances we might move into a-not what you s~y,
a 2 percent growth, but after all, these predictions are extraordinarily
difficult, as you know.
Mr. MILLER. Very.
.
Senator PROXMIRE. There might be a 2 percent declme and we have
a recession. Under those circumstances would you moderate your
monetary policy so that interest rates would tend to come down even
though inflation had not been, or the corner had not been turned on
inflation~
Mr. MILLER. Senator, I just real1y don't know. I think we ~ave a!1
obligation to continue restraint on our economy until _we wrmg this
inflation out. I don't think we can show weakness and give up on that.
I think we have to be constant in our purpose. But, on the other hand,
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I don't think we intend to cause a recession that doesn't contribute
anything to the solution.
Senator PROXMIRE. I agree with that, but I would call your attention
once again to the ,law, the fact that we passed the Humphrey-Hawkins
bill just last year, and I have ,a n amendment in the Humphrey-Hawkinsbill that provides we shall adopt policies to stem the inflation that will
not aggravate unemployment.
Now, we construe that to mean that as to the conditions of a recession
under those circumstances, fighting recession would take precedence
and since the Fed is a creature of the Congress, I would follow the
law.
.
Mr. MILLER. I would assume that if the conditions were as you
described, the best policy would be one of dampening the decline, as it
were. As I say, the present conditions are such that a serious recession
would actually add to long-term inflationary pressures and we have
to take that into account. The whole objective, it seems to me, is to
keep ourselves in a channel that allows much narrower economic divergence than we have had in the past.
As you know, in the decade of the 1970's, we have seen rather high
amplitude swings in the business cycle. Those, to my view, ·a re destabilizing and contribute to our problem rather than to our solution.
What I am suggesting to you now are policies that begin to put on
restraint to avoid the peaks, and begin to adjust the economy to prevent the slides-policies to keep, the economy on track.
Senator PRoxMIRE. Thank you, Mr. Reuss.
Representative REuss. Thank you.
Mrs. Heckler.
Representative HECKLER. Thank you, Mr. Reuss.
Good morning, Mr. Chairman. Have you, Mr. Miller, discussed what
positive signs that you have seen that the dollar rescue operation has
been successful? I am referring to the response immediately following
your November 1 announcement. Have you had any further indication
of the s~ccess or what hard date do you have to show that the operation
was a wise move by the Government?
Mr. MILLER. The immediate effects, of course, are measured by the
changed attitudes of those people who hold dollars as to how they
assess our policies. There has been weakness in the dollar because of
the fundamental problems of differential inflation rates between the
United States and other countries and our current account deficit,
which must be financed. Some adjustment would have _been expected
but as you know, in August and again in October the act10n·on the ~ollar could not be explained by any normal adjustment process relatmg
to those factors.
It was obvious that the holders of dollars were diversifying out of
dollars because of their lack of confidence in our aggregate policies
to curb inflation and correct that situation. Since November 1 markets
have behaved which means that people who make the decisions as to
whether to seh dollars or not have been more willing to hold dollars.
This improvement in the exchange rate of the dollar is itself proof of
a change of attitude.
.
.
.
.
I have iust come back from Europe, discussmg this pr<?gram w:ith
officials of the major central banks of the world and with leadmg
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bankers in Europe. They confirm a very positive attitude about these
steps and a conviction that we not only dealt with market conditions by
marshaling resources, but that we also showed-in our monetary action, and in the President's continuing action to bring discipline to
fiscal policy-that we were determined to deal with the fundamentals.
This is what has been effective.
Now, measured in terms of how we have had to use our resources,
I am so mewhat concerned that there have been discussions that we
have had to apply considerable amounts of our $30 billion resources
in intervention. Maybe, the concern behind your question is, have we
just been pouring money in to prop up the dollar~
The answer to that is "No." We have used far less resources than has
been rumored. The figures will not be reported for the 3 months, including November, December, and January, until early March. The
resources employed have been far less than rumored, which is again
confirmation that there has been some real change of attitude rather
than just a propping up of the market.
Representative HECKLER. You spoke of your persuasive powers in
terms of convincing the central bankers of Europe that we in the
United States were going to deal with the fundamental question of
inflation, not the symptomatic issues that are the current monetary
policy agenda. In terms of the fundamental questions on flation, what
exactly were the ingredients of your commitment~ What do you see
as the necessary ino-redients of that fundamental change and how do
you see this as a commitment of the Government~ Is it the President's
commitment or the Congress~
Mr. MILLER. Cono-resswoman Heckler, the commitment and the
chano-es in policy that have already taken place involve the President,
the Congress, and the monetary authority.
Let me go back for a moment. Major policy changes do come slowly
in a democracy because they involve interaction among branches of
Government. Even when those policy changes are being made, they
are perceived slowly because there is always the view of those outside
the process that perhaps the change is only superficial and does not
represent a true redirection.
The evidence is now overwhelming that Congress and the administration and the other governmental authorities have made a few
major changes of policy ~hat greatly improve the perception of the
outside world of our apac1ty to curb inflation.
One major piece of evidence of the shift in fiscal policy is the fact
that the Pre id nt proposed, last January, a plan for the fiscal year
1979 that started October 1 that would have invoh ed a Federal deficit
of $60 billion. Through the course of the year, the Congress and the
President onsciously and deliberat 1y reduced that by $22 billion, and
that is a forceful change and speaks very lou L It is not superficial~ it is
$22 billion less stimulus in the current fiscal year than was planned last
January.
Followed np by a commitment to reduce the deficit even further in
fiscal ye_a~ ~980 it_is be~oming accepted as convincing evidence of fis?al
respons1b1hty, qmte different from what was perceived at the begmning of this year.
A second change in policy is that the perception of the worldrightly or wron~ly- that we were not particularly concerned about
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the value of the dollar has now been reversed completely. This Government has demonstrated in every way it can-and the President has
become per onally involved in this-a commitment to a stable dollar.
That is a shift of policy that is now accepted.
ow, add to that the income policy that began relatively mildly
in April and built up to the October 24 proposal. You must remember
that an income policy is itself only a bridging action to help until the
fundamental fiscal and monetary policies take effect. But with inputs from labor and business, and with adju~tment of the regulations
and the final publication of the standards, and given the fact that
many major corporations are now pledging to comply and that many
labor unions have involved themselves in discussing the techniques of
compliance rather than refusing to even look at the program, we see an
indication that some progress and some contributions can be made on
this front.
Add to that the fact that there is, I believe, a serious effort underway to look at how we can improve our exports. I believe there is also
a serious effort underway to see how we can reduce the regulatory burden. I believe there is a new shift in our policy of dealing with the dollar-I should have mentioned this earlier-that involves the willingness of this government to sell foreign currency denominated securities. This major shift in policy was demonstrated with a very successful i. sue this ,rnek. For the first time in history the United States was
scllina foreign currency denominated securities. That is the way a
nati~n sh011 ld behave if it is taking seriously its current account
deficits. That peaks louder than all the speeches in the world. It was
n. decision; it was carried out.
I must say that add to that the monetary policy which the Fed has
been pursuing-and which now, I am gratified to report, has much
more support from the Congress and from the Executive than tio-ht
monetary policy has had in the past-and I think we have built up a
sense of confidence and a belief thnt these are fundamental changes.
Representative HECKLER. I am delighted that you see the Congress
as being a partner in promotin¥ some of these changes at least in the
terms of the reduction of the deticit.
Mr. MILLER. Very importantly, yes.
Representative HE KLER. I am concerned about conversations ih the
business community on the question of the P~esid~nt's wage and price
standards and whether or not this approach 1s gorng to be successful.
· I understand that you have sai_d that yon expect inflation to run at
about 6.5 percent in 1979 and pnvate forecasters seem to see a much
higheT inflationary rate. That perhaps suggests that they do not believe that the current approach taken by ~fr. C~rter would be an effective one in terms of controlling the rate of mflation.
Is your estimate of the rate of_ inflation related to your sense of
credibility of this new wage and pnce standard proposal~
Mr. MrLLER. Mrs. Hieckler, may I just correct for ~he recor~ the
information that was perhaps misinterpreted. My estimate of mflation n xt year is in the range of 6.75 to 7.5 percent.
Representativ HECKLRR. Thank you.
Mr. MrLLER. This would be down fro_m 8 percent.
.
,
R epr sentat.ive HECKLER. That is still below the pnvate forecasters
estimates, isn't it~
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Mr. MILLER. No. I think some of them are in the 7.5 percent range.
Some of them feel we will stay-about the 8 percent range, that is
true.
I don't believe that my view of inflation indicates a breakthrough.
I suppose I have tried to be as realistic as I can, and I hope I shall continue to be so in pointing out to Congress and to Americans generally
that this whole process of wringing out inflation, which is critical to
our well-being as a society, is going to take time. It is going to test
our will, our patience, our perserverence, our commitment.
We are going to have to stick with policies that give this priority
for the next 5, 6, 7 years. Americans are used to instant solutions. They
like quick fixes because, frankly, this Nation has quite often had so
much strength that it could cottne to an issue and solve it rather quickly.
It is haTd to believe that within a relatively short time, a couple of
years after Pearl Harbor, a world war was under control. But we can't
get rid of inflation in even as short a period of time as it took to win
the toughest war that the world has ever been involved in.
The truth is that inflation is different, deeply embedded. We have
built it up over 12 years, and we have to give ourselves enough time to
wring it out-or else take action that will so distress our society as to
shake it to its roots, which will not solve the problem either. So we must
be committed to this task.
My projections on inflation is based on the analysis of the restraints
being put on and the trends that are taking place. I admit that there is
room for error; if something should happen in the world that would,
for example, affect oil prices, we will have to look at the analysis againWe are assuming that oil prices will be within the range that was
indicated by the OPEC countries prior to the Iranian situation. We
are assuming there is not going to be a crop failure, because we have
stores on hand that should tide us over.
But these are fragile forecasts. I know over 5 years we will wring
inflation out, but at what rate we reduce it each year is hard to say.
Representative HECKLER. One final question, Mr. Miller, and that
relates to the problem of adjusting our international trade relationships. Now, you and I come from a section of the country where we
see the textile and apparel industry, particularly in Rhode Island and
Massachusetts, but also in other sections of the country as well, where
foreign imports are threatening really to a very, very substantial
measure jobs at home.
I think that most of us would never want to return to either the
psychology or the reality of Fortress America, a protectionist policy
that does not have a fair trade !balance. We realize that that would
be suicidal. But at the same time how do we address this problem of
very, very heavy foreign compe~ition t~reatening American jobs at
the same time that we have a maJor deficit~ How do we deal with our
domestic problems while treating the international dimension of our
monetary problem at the same time~
. How are we going to adjust the equities and whait proposals would
you favor~
.
.
Mr. MILLER. You certainly are correct, the national well-bemg requires that we have a concept of fair trade among nations. The concept includes an appropriate division of labor and the impo~ance _of
prosperity in other countries in order to create stable conditions m
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stead of conditions of tension. But the emphasis must be on the word
"fair." Where we have had a problem in trade is not so much from
the adjustments in the world that depend on the availability of raw
materials which are processed before they come to us, or that depend
on the existence of labor resources, but-in the transition periods
of recent years-from nations who, faced with higher unemployment themselves, quite often subsidize exports to the very large and
very attractive American market.
. I 'believe the way to correct this is on a case-by-case basis by assurmg that there is fair competition, that there is not predatory pricing.
I think American industry by and large should be and can be and
will be able to compete, particularly if we can create conditions that
favor the business investment that we were discussing with Congressman Brown. If we can do that, then we can return our Nation to
what it traditionally has been-to what it was for 25 years after World
War II-and that is the most efficient goods-producing nation in the
w.o rld based upon its input of capital, its intelligent and well-trained
labor force, and a scale of activity that allows it to compete fairly.
In the meantime I do think that we are and will be adjusting to make
sure that, as other nations try to solve their problems, we don't berome the dumping ground for unfair distribution of g-oods. That is
beo-inning to come into a little better focus and it is a little bit
encouraging.
We can understand the pressures on other nations because we have
had them, but we must avoid them. We must persuade everyone that
we nood an economic order and an international monetary stability
that will allow us to build a bigger pie and to be sure that we are using
the productive capacities of the world to increase standards of living,
rather than let idle capacity result in trade wars which contribute to
destabilization and defeat all of our objectives.
Representative HECKLER. And your emphasis wiJl be on the present
mechanisms, perhaps stricter enforcement of the antidumping laws.
Do you feel our domestic unemployment in certain areas that are
heavily impacted by foreign competition, should that domestic employment rate be a factor in our trade policy i
Mr. MILLER. We nood an adjustment process, case by case, and we
probably nood a better one. In· the aggregate it appears that international trade creates more jobs in the United States from exports than
we lose from shHtinO' to certain imports. But in particular sectors, the
dislocations have b~en quite painfulJ _and we n~ed to she~ter those
people and to provide for their trans1t10n , there 1s no question about
that.
Representative HECKLER. Thank you, Mr. Reuss.
Representative REuss. Thank you.
Senator Javits, welcome back.
.
. .
.
Senator J AvrTs. Thank you, Mr. Reu~. I appre?iate 1t. I appreciate
the opportunity to question my good friend who 1s such an able man,
Chairman Miller.
.
.
Mr. Reuss, I have an _openi~g statem_e nt today ~h1ch I failed ~o
deliver because of delay m gettmg here m the mornmg. I ask unammous consent that it may be made part.of ~he r~cor~.
.
Representative REuss. Without obJoot10n, 1t will be entered m the
record.
[The opening statement of Senator J av1·ts f oIIows: J
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OPENING STATEMENT OF SENATOR J ACOB K. JAVITS
I am pleased to be able to join you in the second day of the JEC hearings on
the Domestic Implications of the Dollar R escue Operations. I regret that I could
not attend yesterday's session with Secretary Blumenthal and Chairman Schultze
but I had only arrived on Wednesday from an extended overseas trip, which,
unfortunately, was made longer by my attendance at the funeral of a dear and
close friend and gr eat statesv,,oman, Golda Meir.
I have been seriously concerned about the severe problems facing the United
States economy and the international monetary system for sometime, and on
numerous occasions have spoken out on the need for a restructuring of the present international monetary system. Last April, together with nine other Senators, I introduced a resolution calling on the President to begin immediate discussions with the other major currency countries to supplement the reserve role
of the dollar with that of the other major currencies and the SDR. Most recently,
last August 17 in a speech on the floor of the Senate, I called for a tripartite
solution to the dollar problem which would involve more vigorous intervention
in the daily operations of the foreign exchange markets; resolution of the fundamental problems, especially inflation., facing our economy ; and the restructuring
of the international monetary system by supplementing the reserve role of the
dollar with that of the other major currencies.
Although I am concerned that Chairman Reuss' call for the creation of substitution accounts in the IMF would not effectively deal with the problem of the
dollar overhang, I believe that he is on the right track in calling for a long-term
solution to the structural imbalance in the international monetary system that
total reliance on the dollar as the international reserve asset has created.
Mr. Chairman, the actions taken by the Administration on November 1 to
defend the dollar were bold, and I once again highly commend the Administration for that action as I did at the time. These actions, however, came too late
and should have beE"ll taken when the crisis first became evident earlier in the
year. Our foot dragging has compounded the problem and has made the remedy
more bitter. For example, in my speech of last August, I called on the Federal
Reserve Board to tighten the money supply by raising the Federal Funds Rate
from 8 percent to 9 percent as a demonstration of our concern for the international position of the dollar. At the time, I was severely criticized for calling for
such a drastic increase; so we let time slip by and on November 1, the rate was
permitted to go to almost 10 percent to achieve the same psychological effect.
I am afraid it will go even higher.
Stability of the dollar in the foreign exchange markets will depend on our
ability to allay the Market's expectation about inflation in the United States.
Thus, as a matter of overall economic policy. rech1cing inflation m1H,t be our
primary objective. We must be willing to accept the burden of continued tight
fiscal and monetary policies. We must, however, be selective in our budget cuts
to ensure that the ones who can least afford it are not the only ones who will
bear the brunt of our fight against inflation.
Stability in the foreign exchange markets is also essential for the structural
reform that we seek. Calm markets provide the proper "environment" for such
far-reaching discussions. Without calm, there iR a natural concern, that I share,
that such talk would further destabilize the market.
Mr. Chairman. I share your view that the President should take adv:rntage
of the opportunity afforded to him by the upcoming meeting at the Guadeloupe
Summit in January to begin serious discussionR on a new monetary plan. Such
a plan should seek to gradually replace the present exclusive reliance on the
dollar as the key reserve asset by a relianre on a combination of reserve assets.
which would. include the currencies of the major induRtrialized countries and
the SDR. The world leaders should instruct their finance minister. to look into
this question and report back to them by the time of the next summit in Tokyo
next summer.
While w~ will no longer be able to continue to meet our international obligations solely with dollars, this new arrangement. wonld make the monetary
system more responsive to international finanrial reality.
In conchrnion, I wish to reiterate that the eStsential element in getting such a
program off the ground will be fl continued demonstrnt.ion-hy acts. not wordsof the Administration's determination to fight inflation. The Administration's
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actions of November 1 to defend the dollar were laudable. The Administration
cannot, however, rest on its laurels. Any slackening in its determination to fight
inflation will immediately bring pressure on the dollar. Not only will the U.S.
economy suffer, but the international monetary system will be severely tested.
We cannot let this happen again.
Senator J AVIT S. L et me say I agree with Mr. Reuss' call for a substitution account in the IMF to deal with the dollar overhang, but I
point out that that relates to central banks which have a minoritynot a majority-of the money. Most dollars abroad are in private
hands. Therefore, we need a much broader reform structure in the
International Monetary System in order to deal with what is now
estimated at a $500 billion overhang-which is very, very critical in
absolute terms, but infinitesimal when compared with a soon to be $3
trillion U.S. annual economy.
Now, Chairman Miller, what I would like to ask you is this : You
mentioned the real guts of this matter, which is "the most efficient
goods-producing nation in the world." Now we can affect interest rates,
make and carry out international monetary agreements and assist the
development of an EMS and everything else, but government does
make, government takes; and the questions are: What are we producing? What is the cost of producing it? Where are we going to sell it~
Now, I don't want you to get embarrassed with the admmistration,
but don't you think there hasn't been nearly enough initiative, enough
emphasis, enough thought on those three propositions, what we produce, what the cost is of producing it, and where we sell it, in relation
to the current impasse in which we, our economy and the world's economy find ourselves?
. Mr. MILLER. Yes; I think we have been short in addressing those
issues. vVe have underinvested. We have not created either the attitude
?r the support for market development amund the world. By undermventing, which we have done rather continuously, our productivity
has fallen so low we have not been to get unit costs to where we can be
competitive. It would be far better to increase our markets through
investment and efficiency than through weak dollars. A weak dollar has
so many terrible results that it is a poor way to make our goods less
expensive for foreigners. We should make them less expensively instead of selling them cheaper.
Senator J AVITS. Exactly right. That leads to my next questionJ for
t.~e r~al trick is productivity improvements no matter what yom: s1tuat10n 1s, and we found that out before World War II. We were m bad
shape, we had 12 million unemployed, our credit was low, and we had
just come throuo-h the greatest depression without a revolution that
this country haa°even seen. Nonetheless w~ entered World War II and
we raised $100 billion a year for war-which at present rates would be
$300 billion a year, or $1.2 trillion in 4 years.
. .
Now, you are the Chairma~ of the Fe~era~ ~eserve B<;>a_rd, wluch _1s
the central agency for insurn7-g the ava1lab1hty of add1t10nal credit.
I want you to think about this, and tell me n~w or later. I ·am not a
newspaper so you don't have to give me a qmck answer, but I ~ope
you and y~ur colleagues would think abou~ it-~hat ~an we do ma
peacetime economy to create a pool ?f credit which will enable us to
be as enterprising in peace as we are m war?
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Now let me be specific. The LDC's are now in hock for about $170
billion up to probably $200 billion by the end of this year, of which
the U.S. banks have loaned them probably about $80 billion. Now that
pretty much soaks up the capital surplus. Nothing wrong with the
fundamental status of banks because of those outstanding debts, but
their stockholders may not get ·a nything back if there is a re.al crunch.
Now, the LDC's are planning to obtain a bigger market share, especially in the industrial field. As yet , there is not too much question of
import substitution. Many LDC's are importing food, for example,
which is unbelievable.
These activities all need financing so that. three-quarters of the
world's customers deal in markets which are transformed, instead of
being as they are today: so that they become largely makers, instead
of takers. One major problem results from the fact that they too must
pay oil price increases. Don't you think, sir, therefore, that it is a rool
challenge to break out of this laundry in which we find ourselves in
which we are taking in each other's washing without doing anything
to break through and really determine what our country is capable of
doing1
What can we do at the Tokyo Summit in June 1979 in order to break
this matrix in which we seem to be caught, a matrix in which all of
us are ar<Yuing about relatively little things instead of what can rea.lly
crack the world open for a major advance, even accepting this unbelievable tax for nuclear and other arms which we and the Russians
have put upon our backs and therefore upon the backs of the rest of
the world 1
Mr. MILLER. You raise a very fundamental question, Senator Javits.
The financing of economic growth in the world under present conditions is a very difficult subject. We do not have, strangely enough,
even a good balance sheet of capital "ins" and "outs," so we don't
even know where to start. With the central banks of the G-10 group
we have been discussing the prospect of assembling information so
we could at best look at the sources of capital and where it is required.
We have this information for our own country, but we don't have it
for the world. We ought to see if we cannot find some new mechanism, as you suggest, or some new institutional way for accommodating these needs in a manner that rrs stable and also noninflationary.
So I have to agree with you. I am not sure I can give you an immediate answer because these are institutional changes that involve concepts of sovereignty and issues of a high order of magnitude. But you
have put the issue in the right form; it belongs with heads of state
and heads 0£ government.
Senator J A vrrs. Mr. Chairman, may I make a request of you if my
colleagues do not objecU We are the J oint Economic Committee, we
are a think committee. Let us give the Fed a month to submit to us
their ideas on this subject. Let's give them untiL say, the end of J anuary, in which to submit to us their ideas on how enouO'h credit can be
released in the world to do the job which we agree nee~s to be done. to
wit, an adequate acquisition of markets for the world, to really service
not only what the world already owns but also the degree to which
the world is entitled to advanoo.
Represent ative BROWN of Ohio. Well, Mr. Chairman-
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Representative REuss. I would say that Senator Javits is on a good
inquiry. However, since we are asking the Federal Reserve to respond
to a very difficult and central question, I think we ought to phrase our
request very precisely, not that the Senator didn't, but maybe they
need a letter. Why doesn't the Senator prepare such a letter? I am sure
I would endorse it. Let's submit it to the cochairmen. However, I
think 30 days may be a little abrupt.
Senator J A VITS. Fine.
Representative REuss. Let's simply ask for a reply as soon as
possible.
Mr. MILLER. I think rrt may take a little more time. May I just elaborate on this a little more?
In my 9 months of experience at the Federal Reserve, we have had
the enormous priority of inflation, which certainly implies and requires that we become involved in the international arena, because it
is so closely linked with our own problems of inflation and growth.
But we also have a very large agenda of subjects beyond inflation.
The condition of Euromarkets is one such subject; the question of a
more stable international monetary order is another and the EMS is
a part of that question as, perhaps, the zone of stability for some countries in Europe. Beyond that, we have the whole question of financing
and flows of capital :in the world, and I know these questions are going
to be with us for a good many years.
In getting to you a paper as soon as we can, exploring these questions would be helpful, and I think we should endeavor to do so. I hope
you appreciate that it may have to be less than perfect at this point
because we are looking for inputs and ideas and concepts that haven't
been in vented yet.
Senat<:>r. JavrTs. May I say, Mr. Chairman, this is not a challenge
or oppos1t10nal suggestion?
Mr. MILLER. No.
Senator tTA VITS. It is something I hope to work out with Mr. Reuss
and with all the members. We hgve some extremely able members here.
We h?pe to phrase the question and then begin to develop an answer.
That 1s all I s~all hope to try to accomplish.
[The foll?wmg letter was subsequently supplied for the record by
Representative Reuss:]
CONGRESS OF THE UNITED ST.ATES,
JOINT ECONOMIC COMMITTEE,
Washington, D.O., January 9, 19'19.
Hon. G.
WILLI.AM MILLER,
Chairman, Board of Governors,
Federal Reserve System, WasMngton, D.0.
DEAR BILL: During your appearance before the Joint Economic Committee on
Decemher 15, 1978, it was agreed that we would communicate to you in writing
our request for your views on how the development of broader markets could
be financed.
In response to an earlier question that was posed to you, you indicated that,
"We have underinvested. We have not created either the attitude or the su_pport
for market development around the world ... " Your answer succinctly but forcefolly describes what we believe to be one of the main structural problems facing
the international economy, to wit, the inability of the nations of the world to
develop adequate markets for their increasing output of goods and services.
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This is a concern not only to the industrial countries but also to the µiore
advanced developing countries whose manufacturing facilities are beginning to
compete with those of the industrialized countries. Whether or not the mounting
pressures of protectionism will culminate in serious international and economic
instability depends on how we meet the challenge .ip. this central question.
The development of markets both in the poorer developing countries and the
Eastern Bloc, including the Peoples Republic of China, is dependent on adequate
economic growth in those countries. An essential factor in fostering that
growth will be the provision of sufficient credits, assuming a receptive investment climate, to permit the investment of large amounts of capital in a
variety of sectors of economic activity ranging from basic human needs, such as
housing, education, and health, to extensive agricultural, agribusiness, and manufacturing projects. We believe that incentives must be undertaken to ensure that
the huge capital surpluses that both the OPEC and the surplus industrialized
countries have accumulated are used for these purposes-which is not the case
now.
With the free world beset by hig};l inflation and low productivity, it is essential
that serious thought be given to how these surplus funds that are available can
be best channeled and what mechanism could best accomplish this global recycling of capital. We would appreciate having your views not only on the nature
of the problem but also on possible approaches to financing world economic
growth under present conditions.
At this time, it is vital to consider the more long-term conceptual issues. As
we indicated during your appearance, we are looking for a considered response.
Thus. while we would like to have your response within thirty ·days, we would
certainly understand it should you need more time to provide a more considered
respoilse.
As always, we found our exchange of views on the fifteenth last to be highly
informative and look forward to your response.
With warm regards,
Sincerely,
S. REUSS,
Member of Congress.
JACOB K. J AVITS,
U.S. Senator.
HENRY
Senator JAvITs. My time is about up, and I would like to ask a
question about the multnateral trade negotiations (MTN), and about
the European monetary system (EMS).
First, about the EMS. Do you understand it to be the official policv
of the UnitPd States now, or is it the policy of the Fed, to favor and
encourage the EMS, as it is not inimical to the interests of the United
States, either monetarilv or in terms of our general economv ~
Mr. MILLER. Se~ator. J ~vi.ts, that_ wou]d be the policy of the Federal
Reserve and I beheve 1t rn the policy of the Government as I understand it.
·
The U.S. Government and, I believe, the American people have
favored economic integration in Europe for the past 30 years. It is
absolutely consistent. in order to have rconomic integration· to a higher
degree, that there be monetary integration. If we believe that a sound
economy in Europe, one that can take advantage of its large population and potential scale of production, rontributc:>s to stability in the
world and creates a new order in the free world-that s11ch an economy
avoids the tension of nfttionalism that has impended Europe's progress in the past-if we bP.lieve. that. then we must be in favor of such
~xplorations as the EMS.
The EMS is an innovative and courageous proposal. It involves
risk because it do~s me,an coordinating economic policies among nations that have divergent inflation rates. It does mean committing
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existing reserve resources of one nation to help the common cause
which may use up the resources of that nation. I think we should en:
courage and support and wish the Europeans complete success in that
effort.
Senator J AVITS. Thank you. I .thoroughly agree with that.
Lastly, on the MTN, do you consider its suocessful negotiation and
approval to be essential to the fight on inflation? And do you consider
jt desirable for the Congress to facilitate the consummation of ,the
negotiations by the early enactment of authority to waive countervailing du ties~
Mr. MrLLER. There is nothing that could help the MTN negotiations
more than j f the new Congress were by acclamation immediately in
the first session to reinstate the President's authority to waive the
countervailing duties. That would set the stage for a more fruitful
MTN, which we need in order to make accommodations in world
trade and commerce to our mutual benefit and avoid the trends toward
protectionism, which inevitably will hurt us all.
Senator JAVITS. Thank you ·very much, Mr. Miller.
Representative REuss. Just ,briefly, I have been a little concerned
that the whole discussion of these hearings has been too much under
the aura of the Phillips curve; that is to say, one side says we have
to tighten money and restrict the budget, to fight inflation and help
the international dollar; and the other side says we have to fight
!:ecession by stimulating the economy. In fact, isn't the social problem
m this country largely a problem of structural unemployment, with
its chief exempJars being young people in our central cities, and isn't
the solution to that a set of specific ad hoc policies which come to
grips with that problem, rather than an overall pumping up of the
economy?
And if that is so, shouldn't you be using your good offices within
t?e administration to say, in effect, "Look, there is a need for a
tight fiscal policy and for a policy of monetary restriction. But those
things are macroeconomic, and, therefore, in heaven's name, don't cut
programs designed to deal with the problems of central city youth
unemployment, but find within the $500 billion spending budget the
$2 or $3 billion necessary to reduce youth unemployment."
Based on everything I know about you, you ought to be willing to
exert that kind of influence in administration circles, and it would
be every bit as beneficent ns that which you did earlier this year when
you pointed out the dangers of a $60 billion budget deficit and of an
almost unlimited tax cut.
Mr. Mn,LER. Mr. Reuss I think you have stated it very well. The
most humanistic viewpoi~t of our· economic policies we ?an t3:ke is
to realize the permanent damage we can do to all .A1!1er1cans if we
allow inflation to remain unfettered. Your analysis 1s correct; we
need the restraint in macropolicies to curb inflation, but we also .need
to look at where the distress is in the employment area. There 1s no
doubt that it exists principally among the young, among the black,
and among urban people.
.
I am absolutely committed, as you know, to en~ancmg targeted
programs to deal with that. p_roblem rather than trymg to affect the
whole society with macropohcies that could.react agamst us.
4 3 - 286 0 - 79 - 12
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One of the most encouraging things this year, which I hope will
gain continued support in the Congress, is the development of local
productivity councils, which goes to the issue of how you deal with
these problems in their own locale and with the people who can identify the individuals who need help and can work with them. These
councils deal with specifics and not general theories.
I can also say that I shall be pleased to add whatever voice I have
in the administration in favor of what you have suggested. I believe
the President is striving very hard to come forward with a budget
entailing a $30 billion or less than $30 billion deficit, but one that
retains these programs. I believe he is trying to be sure that they are
strong in terms of dealing with human problems and assisting the
demographic elements and the urban elements that need to be given
their opportunity.
Representative R.Euss. Good.
Senator Proxmire.
Senator PROXMIRE. No, Congressman Brown was first, I think.
Representative REuss. Excuse me. Congressman Brown.
Representative BROWN of Ohio. Thank you, Mr. Reuss.
Mr. Miller, I stated I wanted to change the subject a little bit after
talking about the accelerated depreciation rates last time around. I
have a couple of different articles here about you and M1 • There is
one from the Continental Bank indicating that they think you are
doing a reasonable job-well I don't know that they conclude that,
they just observe that M1 seems to have gotten under control in September, October, and November of this year, although it seems that
there is always a rather sharp reduction in M1 in November, at least
over 1976, 1977, 1978. That has been true.
But there is another article, entitled "Bill Miller is a Faint-Hearted
Inflation Fighter," in Fortune magazine, which is not quite so nice,
and it suggests that the monetary base, and I am quoting now, ''has
been growing at breakneck pace under Chairman Miller, from an already excessive rate during the second half of 1977. It appeared to be
slowing by early this spring, but in May the growth rate picked up
again and has remained high since then."
I am curious, first, whether you have read the article; second,
whether it reflects accurately what has happened to the money supply;
and, third, whether the targets are apt to be lower.
Let me paraphrase just one other comment from the article if you
have not read it. Maybe it is too soon to get a clear fix on the Fed's postNovember 1 policy, but the tentative conclusion has to be that its actions were largely cosmetic. Despite the full percentage increase in the
discount rate to 9.5, the Federal funds rate rose only half a point to
9.87 in the 5 weeks following Blumenthal's announcement.
So even when the tightening is measured by the Fed's yardstick, it
appears to be minor. Moreover, the Fed offsets its mandated $3 billion
increase in the bank reserve requirements with open market purchases
of Treasury securities.
Would you want to comment on that, Mr. Miller~
Mr. MILLER. Congressman Brown, I have not had a chance to see
that article. I am not sure I know its content. I would say that we perceive the world slightly differently. Th~ decisions on November 1 were
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part of~ continuing process and involving the four elements of monetary pohcy that I have outlined :
First, that we would apply constraint progressively to slow the
rate of growth in the economy in order to bank the fires of inflation.
Second, that we would apply the brakes smoothly to avoid the disruptions and dislocations that come with abrupt shocks.
Third, that we would do so in a way that maintains balance in the
economy.
And four, that we would bring down the growth rate as low as
appropriate without having a recession.
We have pursued that strategy. The actions on November 1 were
strong actions and supported that strategy. What is often missed is
that, by coincidence, November was a month in which many other
activities happened that influenced bank reserves. First, was the beginning of the shift of Treasury tax and loan accounts out of the Federal
Reserve into private banks; we had a need to offset that kind of activity.
Second, was the authorization made 6 or 7 months earlier £or the
automatic transfer accounts to go into effect, which created some shifts
in the aggregates and, of course, in reserve requirements.
The truth is that the Fed was taking steps to drain what otherwise
would have been a rather rapid growth in the reserves. Any one who
reads into the $3 billion increase in bank reserve requirements reserve
the idea that we put reserves right back in is just misreading the realities. The realities are that the Fed has continued to exercise tough
and tight policies to draw down the growth of money and credit, and
we intend to maintain our posture consistent with the overall goal
that we have discussed this morning, believing that it is not in the
national interest to precipitate a recession nor to allow growth which
strains our resources and augments inflation.
We have to walk through a fairly narrow channel. I know the channel is narrow because, as you know, we hear cannon to the right of us
and cannon to the left of us. There a.re those who say, on the one hand,
"My goodness, stop that, it is hurting," and, on the other hand, those
who say, "You haven't even touched us." So when we get cannon to
the right side and cannon to the left, we must be right on target.
Representative BROWN of Ohio. I would want to congratulate you
on this, but you sure have to apply them. Can you tell us what the current targets for M1 and M2 are i
.
Mr. MILLER. Yes, Senator Proxmire will probably jump out of his
chair on hearing these numbers.
.
.
Representative BROWN of Ohio. Well, he'll have to do 1t on his own
time though. [Laughter.]
Mr. MILLER. The targets ahead of us at the moment are a growth
rate of 2 to 6 percent to M1. That is reduced from the 4 to 6.5 percent
that previously existed.
. .
Recently we have reduced the growth of M1 to get :w1thm our old
.
ranges and we will be within our new ranges most hkely.
Now' the reason we have such a wide range when Senator Proxm!re
encourages us to have a narrow range is that we frankly can?ot predict
at this point what effect the new autoI?at_ic trans_fers will have on
funds beino- shifted from demand deposits rnto savrngs accounts. We
are going to address that issue.
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The growth rate ranges for M2 are 6.5 to 9.0 percent; and for M3 9.5
to 10 percent. We have been more or less within those ranges.
We have also set out a 5.0 to 7.5 percent target range for what is
known as "M 1 -plus," which is an initial stab at setting more helpful
monetary measures.
Let me just say that, along with the very important legislative initiative that Representative Reuss and Senator Proxmire will be taking in
connection with reserve requirements in the new Congress, we are
planning to share information and to seek inputs from everyone on better definitions of money.
The staff will be publishing in January an analysjs of the measures
of money and seeking inputs with the thought that by next summer we
will have some new, more useful measures. M1 was supposed to measure
the basic money supply-that is, spendable money that can have high
impact on the economy-by counting currency in circulation and demand deposits. And some years ago that definition worked because
when people put money in their savings accounts they were truly
putting it .a way for a rainy day. It required an emergency or unusual
expenditure for them to take it out.
That has changed. Today, people put money in savings accounts for
3 days or 6 weeks and they intend to spend it like M1 money. Now
we-Representative BROWN of Ohio. That is because they make a little
more and put it in the checking account, but they still fall behind.
Mr. MILLER. So I think that M1 is changing and we want to find
again that which is immediately spendable money and that which is
being set aside for the future. We want everybody's input in the search.
I .a m happy to inform Senator Proxmire that the Deutsche Bundesbank has just announced that they are joining the Americans in using
a range rather than a single target for the money supply. Senator
Proxmire has always told me I should have an exact target like the
Germans.
Representative BROWN of Ohio. Mr. Miller, I feel like I am-Mr. MILLER. The Ge,r mans have now-Representative BROWN of Ohio. I feel like I am only the shuttlecock
in this ballgame. [Laughter.]
I would like to have you address yourself to me-and not worry
about Senator Proxmire, although I knew that you do worry about
him-Senator PROXMIBE. Keep it up, Mr. Miller. [Laughter.]
Representative BROWN of Ohio. Let me ask how rapid has the growth
been in previous recoveries, particularly 1971 to 1973 ~ And how
rapidly did inflation build up then~
.
.
What occurs to me is that we seem to be havmg much more rapid
buildup of inflation in this period than we have had in previous
periods.
.
.
.
.
Mr. MILLER. I think the most rapid expans10n of rnflation we have
ever experienced in our country since the twenties was in 19~2 through
1974; the inflation rate was .a bout 4 percent in 1972, and it went to
about 12 percent by late 1974.
.
.
.
Representative BROWN of _Ohio. Howeyer, that was, a period m
which we had wages and price controls lifted. But let s go back to
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1971 to 1973. Perhaps all that is skewed by the wage and price controls
and therefore the system doesn't really work when we have those
automatic or forced restraints.
Mr. MILLER. Yes, especially by the way we behaved, we pushed inflation into that period.
Representative BROWN of Ohio. And the same could happen again
with wage and price controls, would it not?
Mr. MILLER. Yes. But despite these controls and the double-digit
rates in their aftermath we have had an underlying rate of inflation
of o to 6•.5 percent pretty much through this decade.
Currently we are running at about 8 percent. We were at a 6-percent
rate last year , so that the runup has been a very serious matter. I am
talking of the GNP figures, not the CPI; the CPI has performed a
little worse. The figures are dreadful, and we have got to bring them
down, but I don't think they represent the kind of dramatic shift that
took place when we removed controls after a period that combined
mandatory controls and a stimulus to the economy.
Representative BROWN of Ohio. I have two other questions.
Do you still favor or do you favor, I should say, a delay in the minimnm wage increase scheduled for January 1?
Mr. MILLER. Yes, I think that would have been a wise action--either
a delay or the creation of a youth differential. But I appreciate that
that can no longer be done because the Congress is not in session. The
increase will become effective, and once it is effective I don't see how
yon can unwind it.
It would be very reasonable for Congress to look at the increase
scheduled for next year and see if it couldn't be delayed or a youth differentiation established.
Representative BROWN of Ohio. And the social security tax?
Mr. MILLER. The social security tax doesn't involve quite the same
problem. There will be a slight increase in rate on January 1. But the
increase in the social security tax base that also goes into effect on
January 1 will not have any impact until later in the year-Representative BROWN of Ohio. It does have impact on small businesses though when that question of replacing equipment and a :few
things like that, does it not, comes along?
Mr. MILLER. Yes. As you know, I would be in favor of postponing
those changes, but only on condition that Congress undertakes to reduce the long-term costs of the system. There are a number of ways to
do so which would not detract from the purpose of social security
·
which is to provide a basic pension upon retirement.
I would still like to see that done.
Representative BROWN of Ohio. Finally, the other ~fay ~e had Mr.
Greenspan and Michael Evans of Chase Econometrics with us and
they suggested that if there is a slowdown in t~e ~conomy, that t~e
deficit that the President is targeting now at $30 bill10n, or at least this
is the story that is in the financial press, may, in fact, exceed that, because there would be reduction in receipts to the Federal Treasury because of the business slowdown. The result might be that we would
have a deficit as high as $50 biJlion again, which is what President
Carter recommended-well, actually he recommended more than
that-in both the previous 2 fiscal years.
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What impact does that have when it occurs, and how can we avoid
that~ Is it possible, goino- back to my depreciation question earlier,
to stimulate capital expansion and some other things by some tax
reductions that would balance out the dampening impact of high interest rates and reduce the possibility of a slowdown that would create
a deficit~
Mr. MILLER. That js an observation of the possible impact on the
Federal deficit of an unknown kind of recession. You first have to
measure the kind of recession you are talking about before you can
project a deficit. But your question does illustrate the point I have
been trying to make for some time, and that is that a recession which,
because of existing programs that would have shortfalls of revenuewith less people employed and more transfer payments-results in
higher Federal deficits, puts us back on the treadmill of inflation being
stimulated by excessive Government borrowing.
If anything, this is reinforcement for what I think should be our
policy objective, and that is not to have a recession, but to have low
rates of growth. And - Representative BROWN of Ohio. Couldn't that be encouraged by tax
reduction on the capital expansion kind of growth which would build
strength for another expansion in the country ~
Mr. MILLER. If there is any stimulus neerled in the. economy to avoid
falling into a recession, the most helpful stimulus would be to business
investment and not to consumption, because we need continued investment over a number of years to improve productivity. You are absolutely right; if we had to stimulate somewhere, that would be the
place .
. Representative BROWN of Ohio. I will now concede that my time
IS
up.
Thank you, Mr. Miller.
Senator PROXMIRE presiding]. Mr. Miller, you referred to that appearance that you had before the Banking Committee shortly or just
a few days after you were sworn in and there. are three references to
inflation in that hearing. I don't mean to harp on it except I think it is
very_ impo~t.ant for us to put in context the statement of the top economic officials of our Government. You said :
r
There is, however, less reason to be sanguine about progreBs in curbing 'the
rate of inflation. Food anfl matnial prices have riRen substantially in recent
months and labor costs continue to rise at a relatively rapid rate.
That is hardly a prediction of inflation. That was the only statement
on inflation in your prenared statement.
Then in response to Chairman Reuss, you said:
Macroeconomic policies will not be able to produce the reduced level of unemploym'ent that all of us seek as a national goal without unleashing a greater
degree of inflation that would be self-defeating. In fact, we would unleash
inflationary forces that would bring us right back to high unemployment.
Again that is certainly not a prediction of inflation.
The final statement I presume to be closest to it, where you say,
"I am more concerned about inflation today than I was before. I
think we are going to have to begin to focns· stronger and harder on
the remedie_s and see if we can find the wilt not only in the private
sector, but m the Government sector, to begin to take some steps to
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show that we are serious. I£ we don't take those steps, I am afraid
the consequences will be ones that none of us will like. The sooner we
realize that inflation is a very _serious matter, the sooner we can begin to control it."
Now, I submit that none of this constitut:Bs a prediction that inflation is going to get worse. There are no figures given, there was
an indication that you were very concerned about inflation and you
urged, very effectively, anti-inflationary policies on the committee.
Now the other point I would make is that it was your first appea.rance and you had only been in office 2 days, so obviously you
couldn't be held responsible. Second, you were like Alfred "Top
Banana" Kahn, who is new, and ihadn't been around very much; and,
therefore, you were like Mr. Kahn willing to make blunt and clear
statements without as much concern about their conse.q_uences.
Mr. MILLER. And now~ [Laughter.]
Now my answers are very obscure and cautious ones~
Senator PROXMIRE. No, no, no, they are very clear, but you are
predicting that things are going to get better, which you have said
so consistently. You said interest rates are peaking out. You said
inflation is likely to improve. You are saying there is no recession.
I say that we have to discount that.
Mr. MILLER. Your point is well taken in that I hope I am not
guilty of wearing rose-colored glasses. I hope I am learning the
technique of how to report as best I can to this committee. Someday,
I hope to be able to predict good news and have it come true; then
I would have a chance to predict bad news and have it come true
just to improve my credibility-but not now.
Senator PROXMIRE. The second point is this : Last night on a televis~d i~terview, Presid~nt Qarter said he would consider signing
leg1slat10n th:1-t would give him standby authority to impose mandato~ wage-price controls. Now he did hedge that very carefully. He
said such a proposal would have to insure that economic controls
would only be used in case of a threat to our Nation's security; and
he did not desire that kind of approach. Nevertheless, that does seem
to be ~ backdown from the President's previous position of adamantly
oppos1~g standby or any kind of mandatory wage-price controls.
Obv10usly once we got into a military emergency the Congress
w~uld act very promptly, but what is your view on this i Do you
tJunk standby controls for the President with any kind of a provision in it would be appropriate i
Mr. MILLER. They would be undesirable. Through the process of
considering standby controls, Congress would create the expectation
of controls and thereby a rash of anticipatory pricing and wage demands that would be.very damaging.
I am sorry; bu.t the way the country b~haves is t~at every_th;1e mandatory controls are mentioned-every time there 1s 3; pred1ct10n that
they are eventually going to be put i~to effect-there 1s a ras~ of pressures for getting ahead of the potential controls. The best th1~g to do
would be to put to rest the idea that mandatory wage and price con.
trols have any role to play at this particular time.
I don't think they have any role to play ~wen what we have to do m
the next few years. ·Whether they have a role in some potential war or
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national emergency-~r in S?me future generati?n-I don't know 'but
I think even their conS1derat10n would be damagmg.
Senator PROXMIRE. I appreciate that very very much. I can tell you
that our committee as far as I know, the Banking Committee in the
Senate is unanimously opposed and, of course, it would have to come
before' our committee. Everybody is adamantly opposed, even for
standby controls.
Now, some economists are beginning to raise concerns that the Federal deficit will rise next year rather than decline, because with the
best will in the world we cannot, of course, determine what the economy is going to. do. So that with a we.a k economy, transfer payments
would rise receipts would fall.
Can you tell me what jg the Federal Reserve's current estimate of the
deficit under current policy assumptions for both 1979 and 1980?
Mr. Mn,LER. For fiscal year 1979 our cnrrent estimate is $39 billion,
as I recall. For fiscal year 1980, in our recent -projections we are using
the $30 'billion that the President has indicated.
Senator PROXMIRE. That assumes no tax cut; right?
Mr. MILLER. That assumes no tax cut.
Senator PROXMIRE. That assumes that we have a 3-percent increase
in real spending on defense?
Mr. MILLER. No; it does not. It assumes a $30 billion deficit without
trying to decide whether cuts will come jn Defrnse or from other areas.
That debate is bevond the realm of the Ferleral ReservP-.
But it is important that we all determine to stand firm on our commitment to fiscal discipline. It is very important that we don't begin to
anticipate with hypothetical guesses what the condition of the economy
may be 12 months from now, which would determine whri.t. the dP-ficit
would be in the fiscal year 1980; this is what we are talking about.
Senator PROXMIRE. Chairman Mi.ller, wJ1en vou testified before the
Banking Committee, you indicated we should expect a $20 billion
rather than $30 billion deficit?
Mr. MILLER. Yes.
Senator PROXMIRE. I take it you maint·a in that position although the
ex_pectation is that given policy assumptions we probably would nave a
$30 billion deficit; is that correct?
·
Mr. M1LLRR. I agree with that.
I said at the t,jme that I thought it woulrl be better if we. took the
deficit of roughly $39 or $40 billion foreca t for this year) cut it in hal£
in fiscal year 1980 and balanced the budget in 1981. That would be the
id al situation.
Senator PROXMIRE. Now. part of the Prrsident's inflation program
is the real wage insurance that was given a lot of attention for a whHe.
There ·h as been some criticism by many people lately. They thjnk it
isn't practical, that is, for workers that abide by the wage guidelines.
Given the outlook for inflation, what is your opinion on the real
wage insurance proposals?
Mr. M1LLBR. It would be applied, as I understand it-Senator PROXMIRE. Do you favor it~
Mr. MTLLER [ continuing]. To the difference betwren 7 percent and
the inflation rate in 19i79, with a tax refund or a credit.
Senator PROXMIRE. It could be a rather massive tax cut, couldn't it~
1
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. ~r: MILLER. It ~ould ha~e to include some ceiling on the credit per
rndividual t o av01d an unlimited Federal Government commitment
it seems to me. The financial risk would have to be constrained both by
the numbers who comply- which would limit the number who qualify-and by some ceiling on the amount of credit per individual.
Otherwise, I am afraid wh at you would have is a rather unpredict able situation which, from a .financial point of view, would be a bit
undesirable.
Senator PROXMIRE. Do you favor it i
Mr. MILLER. I have not yet seen plans for how it is going to work.
The idea, to my mind, is innovative and creative, and if it contributes
to lessening inflation, it ,also lessens the amount of real wage insurance
to be applied. I look favorably upon it , but before I take a precise
position I would like to see how it is going to work; I h ave not yet
seen that.
Senator PROXMIRE. Now are the banks going to have to abide by the
wage guidelines and on the price side abide by the profit margin test i
Has the Federal Reserve made any effort to determine whether the
banks are going to do that or are doing it; and what plans do you have
to monitor that situation to see that the banks are abiding by the pro.fit
margin i
Mr. MILLER. At the moment the solicitation of bank compliance is
being done by the administration.
I have felt-Senator PROXMIRE. By the Comptroller~
Mr. MILLER. I believe it is being done by the director of the Council
on Wage and Price Stability wi~h perhaps the inv_olve~ ent of the
Secretary of Treasury who has written to banks on this sub] ect before.
But I have felt that as an independent monetary authority it was not
appropriate for us to enter into that particular solicitation at this
point.
· 1z it
. wou Id b e an issue
.
Our role if we are ilsked-and I t h m
on1y i. f
we are ask~d to-would be to monitor for the Gover?-~ent. But-.Senator PROXMIRE. You a1·e in so mu?h stronger positrnn to, momtor,
you have a larger staff, you are expert m the field, and you can handle
it better.
Mr. MILLER. Between the Comptroller an~ th~ Federal ;Reserve we
can do very well. The Comptroller has e~ammat10n authority over the
nat ional banks, of course, and we ·h ave it <;mly over the State member
b~nks, about 1,100. Bnt I think you are right, t hree _of us togeth~rthe Comptroller , the Fed, and the FDIC-could morntor better, given
l
bo
h h
··
existing resources.
rl\..-IRE Now vou have already spornn a ut t e ousrng
. t
t tes
S ena.t or· P ROX ·hi·oned and shows some reaction .t o h.igh rn
ems ra ·
] tb
' '
.
h ave i...ue-en
·mar rn· emg
f thcust si·x-month
certificates
very h eIP f u I to
m sp-1
aff· t ' but tJhere are some signs
·
· te o
t h at some th TI· fts WI·11
cushion those e ~cs, · .fi t
Also we hear that the thrifts are
turmg certi ca es.
.
.
no t renew ma
. d •th tl10 6-month certificates and not puttrng
taking the fund s raise wi th
· vestino- them in bank CD's.
· t o mortg,ao-ec:
but. ra• er, ,m amounts
o
.
tJ1em m
b ~,
the certifica.
t es are not
1ar ge
t
.
hap•
p
ernnom
,
'
.
N ow i.f th
·. a is
. B d d t O do Do yon have any evidence
of
•
• ·
•
·
h
·
b
tl
are
m
ten
e
do_mg _t e ~o .i ey d
d do you thi nk it appropriate or do you
this di vers10n of fun s an
think we can act on it i
'.L
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.,
•
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Mr. MILLER. Senator Proxmire, the evidence we have at the moment
is that the only significant parking of these kinds of funds in CD's is
where the funds are being held in liquid form for mortgage commitments. We have not seen any significant evidence that funds are merely
being acquired and invested and not working to be more effective.
The reverse has been true, they seem to work more effectively. Offerings of these certificates are being made continuously and funds flow
is based in on the choice of savers rather than on the thrifts. As they
are accumulated, they allow the thrifts to make mortgage commitments. Mortgage commitments have held up remarkably well, and
they have been funded by these resources.
So the mechanism has been working. It could be that we will come
to a point where there will be more hoarding of money to see what
happens in the market, but that has not happened significantly yet.
Senator PROXMIRE. Now the Board of Governors has two vacancies
right now of the Federal Reserve Board, that is. You have been quoted
as indicating you think the Board has enough economists now. I £eel
very strongly that it is very important to have people who can technically do the job and really understand monetary policy, and I just
wonder if you would recommend against having more trained economists on the Board.
Mr. MILLER. No; I would not recommend against it. Perhaps I £eel
lonely as the only noneconomist on the Board at the moment. It seems
to me that you are right, you need poople who are qualified. But on
the other hand, monetary policy, which is the critical role of the Federal Reserve, must relate to the whole world of money and credit. It
would be sensible to consider people who have been experienced in
commercial banking, for e~ample, and we have no one on the-Sena.t or PROXMIRE. How about experts in housing~ I notice jn the
Wall Street Journal they talk about Nate Rogg and Mike Sumichrast
as possibilities.
Mr. MILLER. Governor Jackson was experienced in mortgage banking rund he brought that k:iind of skill.
Senator PROXMIRE. Yes; he was.
Mr. MILLER. 0£ course, there are people who have good backgrounds
in agriculture or in labor who should be legitimate considerations for
a balance. It seems to me that when you have seven members of a Board,
it would be well to select a balance of skills.
We now have on the Federal Reserve Board an economist who has
spent ia very substantial part of his career with the system and therefore understands the technical aspects of mon~ary policy from the
ground up. We have another Governor who has been involved in academia and who has had internat.i-Onal experience. and he brings another
series of skills. We ha,ve another Governor who has boon involved
heavily in the congressional side and understands budgets and Government, which is very helpful. And there is another Governor who is
knowledgeable in Federal Reserve Rank operations.
So I think it would be useful to balance these skills with some other
ski.lls.
Senator PROXMIRE. I just have one more question and it relates to the
same kind of thing. It is an interesting problem for the Banking Committee-I apologize for asking in this committee, hurt when you were
appointed to the Board, you were appointed from California, as I
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183"
understand it, that was t~e area that you were appointed from, although you_h~ ve been a resident of Rhode Island for some time and you
have been hvmg for many years away from California.
Now we have one of the leading candidates from North Carolina;
we have a m~n on the B?ard who comes from Richmond. Supposing we
sho~ld consider changmg that law, that law seems to me--in the
national eco1;1omy we have, that you have to have members of the Board
who at one time or another in their lives come from particular sections
of the country-to be outdated. It prevents us from getting the best
'}Ualified people.
Do you feel we ought to consider modifying, changing, or repealing
that l,a,w~
Mr. MILLER. I think it is an outdated requirement. I can understand
why it was or~gi~ally enacted because in 1913 the methods o! traveling
and communrnat1on were much slower and the general mteraction
amoog the regions was less immediate. At that time, the idea of regional representation was important and wise.
But now I would think you would be well advised to consider eliminating that provision, but "if you do you should have some oversight to
make sure that the Boa.rd is made up with due regard to a balance of
skills and experience and geography. You could do that t;hrough general oversight rather than specific statutory limitations.
Senator PROXMIRE. Would you suggest we might modify the law to
provide that simple language with due regard for geography, but without requiring that they come from various places~
Mr. MILLER. I think so, simila.r to what you require for the Directors
of Federal Reserve Banks : they have to come from a broad range of
backgrounds. As you recall, there is a provision looking to represerutation from industry, from agriculture, from labor, and so on.
Senator PROXMIRE. Yes; it is my understanding that other members
have no more questions. Is that correct~
Representative Reuss indicated that he unfortunately had a commitment he had to keep so he therefore had to leave. We want to thank you
very, very much, Chairman Miller, for .a fine presentation as always and
for your responsivemess to our questions.
Mr. MILLER. Thank you very much, Senator.
Senator PROXMIRE. The subcommittee will stand in recess until
2 o'clock this afternoon.
[Whereupon, at 12 :30 p.m., the subcommittee recessed, to reconvene
at 2 p.m. the same day. J
AFTERNOON SESSION
Representative RED/~S. G~d 3:fter~oo1;1. The subcommittee will be in
order for the final session of its mqmry mto the dollar rescue program
and its domes6c implications.
.
This afternoon we are privileged to hea: fro~ a blu~ n°?bon panel
consisting of Prof. Saul HyJ?ans of t~e U n_1vers1ty of M1ch1gan, Prof.
lames Pierce of the University of Cahforma at Berkeley, and E~ Yeo,
an old friend and former Under Secretary of the Treasury,_who 1s now
·
f the Asset and Liability Management Committee of the
ch airman o •
·
d' 1· · ·11 · ·
First National Bank of Chicago. Professor Mo 1g 1am w1 Jorn us
momentarily.
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Under the rule and without objection your respective prepared
statements will be-and we appreciate your getting them to us-received in full into the record. We would ]ike to ask each of you to proceed, trying to summarize your position in 10 minutes or so.Would you
start out, Mr. Hymans.
STATEMENT OF SAUL H. HYMANS, PROFESSOR OF ECONOMICS
AND STATISTICS, AND CODIRECTOR, RESEARCH SEMINAR IN
QUANTITATIVE ECONOMICS, UNIVERSITY OF MICHIGAN
Mr. HYMANS. Thank you very much, Mr. Reuss. I am delighted to
have the opportunity to discuss my views about the economic outlook
before this committee. This is a particlarly crucial time in the evolution of the U.S. economy and the near-term outlook is beino- heavily
influenced by fiscal policies which have recently been enacted by the
Congress and by monetary policies which have recently been announced jointly by the administration and the Federal Reserve. Let me
outline those policies in terms of their features which are of central
importance to the macroeconomy.
In the area of fiscal policy, one of the crucial elements is the Revenue
Act of 1978, which is estimated to reduce taxes by about $18.5 billion in
calendar 1979, or about twice the amount by which payroll taxes are
scheduled to rise in 1979 as a result of previously legislated increases in
the rate and ba e for social security taxes. On the expenditure side of
the budget, I am projecting a Federal expenditure increase of about
$40 billion for fiscal year 1979 (NIPA basis)-virtually the same as
the dollar increase in fiscal year 1978 and thus a good deal less in either
percentage or real terms. For fiscal year 1980 I expect an expenditure
increase of $44 billion. In my view, expenditure increases of this size
would represent a considerable, though not unlikely, amount of success in the stated goals of the President and Congress to hold down
Federal spending. In conjunction with the Federal revenues derived
from our control forecast, these expenditure levels imply Federal defiits, national income and product basis, of about $2 .5 billion in each
0£ fiscal year 1979 and fiscal year 1980.
Regarding monetary policy, the monetary base, as measured by the
Federal Reserve Bank 0£ St. Louis, is projected to grow at an annual
rate 0£ about 8.5 percent through the first half 0£ 1979. This represents
a substantial decline in the growth rate of the monetary base as compared to the 9.5-percent rate over the past year or the nearly 10-percent
rate over the past two quarters. The discount rate is expected to remain
at its current level of 9.5 percent throu _g h the first half of 1979.
Our forecast projects an easing of monetary restraint beginning in
the third quarter of 1979. The projected easing of policy is assumed to
include a reduction in th_e discount rate in two steps to 8.5 percent in
1979.3 ,a nd then to 7.5 percent in 1979.4 •a nd slight rise in the growth of
the monetary base to a 9-percent rate after midyear. I hope to make
clear the reasons for the projected change in monetary policy later in
my testimony.
I turn now to the ontlook itself. Compared with the 3.8-percent rate
of_growth of real q-NP now being estimated for 1978, our £ore.east contams a sharp declme to a 2-percent growth rate for the year 1979.
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Federal Reserve Bank of St. Louis
185
Corresponding to ·a n incroo.se in aggregate production of only 2 percent
for the year as a whole is a substantial increase in the unemployment
rate to an average of 6.7 percent for the year 1979 and 7.2 percent for
the fourth quarter of next ye•ar.
·
The aggregate price level, as measured by the GNP deflator, is expected to be up by 7.9 percent for 1979, compared with a 7.4-percent
increase for 1978. The Treasury bill rate is forecast to average 7.8 percent next year compared with 7.2 percent this year; and the rate of
~rowth of the money stock, as measured by M 2 , is forecast to decline
from 8.9 percent this year to 8.4 percent next year. However, characterizing 1979 as a 2- percent growth per year is really doing violence to
the underlying forecast.
The forecast implies virtually no growth at all in the second and
third quarters of 1979. My point forecast manages to avoid any negative growth quarters, but I am forecasting annual growth rat:Bs of 0.5
and 0.2 percent in the two midyear quarters, and that simply has to
mean that the chances of a true recession developing •a fter the early
months of 1979 should be regarded as almost "50-50." In other words,
I would say the chances of avoiding a recession in 1979 seem to be only
slightly better than the chances of experiencing a true recession in
whic:h aggregate output actually declines for a time.
Monetary restraint oan be expected to produce a substantial decline
in residential building activity. The major quartely declines are forecast to occur during the first :three quarters of 1979, after which the assumed easing of monetary restraint plays a major role in reversing
this drop in housing activity.
Business capital formation is forecast to be on a downward trend, in
real terms, throughout the forecast horizon-the result both of high
interest rates and the induced effects of the economic slowdown. Consumer purchases of durable goods are forecast to be declining throughout most of next year, followed by a substantial pickup in the closing
quarter of 1979. Much of this recovery in durable goods activity, especially the strength of the recovery in late 1979 and early 1980, is heavily dependent on the change of policy toward an easing of monetary
restraint which I have assumed will be underway in the summer
quarter of next year.
As I said, I will return to that.
.
The reason why I believe a change in the stance of monetary pohcy
will be necessary jn mid-1979 is shown in charts 1 and 2. Chart 1 shows
two alternative o-rowth paths for real GNP, one for the control forecast and one £of what I have called the continued tight money program. The continued ti_ght ~oney alternati~re eliminates the easing ~f
monetary poljcy contamed m the control mputs. _In other word~, 1t
maintains what we now call current monetary policy. The _result 1s. a
marke<l retardatinn of the GNP growth path compared with that m
the control forecast.
.
.
To be specific, in our forecM,t when monetarv pohcy begms to ease
next year, growth of real GNP ac?elerates an~ gets to 4 percei:it. by
the third quarter of 1980. Alternatively, the d1sc~unt rate remamrng
at 9 5 percent Jevel and the monetary base growmg a~ about an 8.5
' · t t wo lcl continue to prodnce a verv lethar:nc real growth
prrccn ra. e f 11example
t
•
h
th t f ·1 t
ra t e w h ei e, or . (
, even by. mid-1980 t e grow ra e a1 s o
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Federal Reserve Bank of St. Louis
186
reach 2 percent and by third quarter 1980 just manages to exceed 2
percent.
So there is a considera:ble difference in the rate of growth of the
economy according to whether or not monetary restraint eases off
after mid-year.
These alternative forecasts have very widely differing implications
for the unemployment rate as well. In the control forecast in which
monetary restraint is relaxed in midyear, the unemployment rate tops
out at 7.5 percent in mid-1980; with the continuation of monetary restraint the unemployment rates goes through 8 percent by the third
quarter of 1980. In the short run the economic cost of this alternative
to the control forecast, the continued tight money forecast, is a substantially higher rate of unemployment, but with a sufficient underutilization of resources that the resulting losses in the growth of productivity negate any of the reduction in inflationary pressures which
might otherwise be thought to derive from greater economic slack. In
effect, the prolonging of a growth recession has its greatest immediate
impact on employment and productivity, not on the rate of inflation.
The real question is whether the situation in the first half of 1979
will produce enough signals to induce the policymakers to begin to
ease off along the lines assumed and suggested in the control forecast. In the Michigan model the initial sharp hike in interest rates and
the dramatic economic slowdown produce a marked reduction in the
rate of growth of M2-sufficient reduction in the growth of M2, in fact,
to bring short-term interest rates down even before the assumed easing
of monetary policy begins.
At the same time price and wage inflation-except for the payroll
tax effects on compensation-are forecast to be moderating throughout this :forecast horizon. The trouble is that the moderation of inflation in the first half of 1979 is apt to be distinctly modest. An assumed OPEC price increase, the likelihood of fairly large increases
in import prices excluding oil, and the substantial hike in payroll
taxes, pile a good deal of upward price pressure into the first half of
1979.
Aside from money and prices, another critical factor in the policy
decision will be the extent to which the trade balance improves. I am
forecasting that current dollar net exports will have shown a substantial improvement in the first quarter of 1979, and may even be
quite close to a zero balance in the spring months of next year. Thus,
a possible-and in my view likely-scenario as the summer of 1979
approaches is the following: Six months of distinctly moderate growth
of the money stocks; nonaccelerating inflation, and perhaps even
evidence of some deceleration in a number of key domestic price measures; a substantially improved trade balance; and all this with the
eco:r:iomy dangerously close to a recession.
If this conjunction of events materializes, one might reasonably
expect that the dollar would already have stabilized, if not appreciated,
in the wor Id money markets. That is a basketful of "ifs " but if so, I
would expect, and regard as highly desirable, some easing of monetary restraint by next summer.
Thank you, Mr. Reuss.
(The prepared statement of Mr. Hymans follows:]
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187
PREPARED STATEMENT OF SAUL H. HYMANS
l
M acroeonomio Policy and the Economic Outlook for 1979-80
Let ne begin by thanking
}"OU
fur this _opportturity ta cli.s-::uss my v.i.ews al:xnlt
the e.roranic outlock befu:te this Cbmri.t~.
the evoiuti.oo r.;f the u. s. ecorx:xcy
•ihis is a particularly crucial tiloo _in
aniJ the reaI""1:P...i:ni outlook is being heavily
.
.
influenced by f.iscal .P::,licies which h~ reoently been. enacted by the O:ngress arrl
by m:,netary rol.i.cies which have recently been
and the Federal reserve. · Let
ioo
~ jointly
by
the Mnini.stratkn
outline those ix>licies in· tenus of their features
which are of oentral :urpo:rtance tx:J the
1recroecx:macy.
In thF.! area of fiscal. policy, one of the crucial elarents is tbe Revenue Act of
1978 wrdch is e.<Jtilrat-..ed to red~ taxes by about $18 1/2 billion in calendar 1_9 79 --
or about twice the anrnmt by which payroll trures are sdleduled to rL~ in 1979
result
tif
as a
previot1sly legislated incrP...ases in the rate and base for social secur:U.y
taxes. ()) the e.xperrli.ture side of the bud~t:, I am projecting a Fede.ral exp.::..nditure
increase of about $40 billion for F'i'79 {NIPA ·basis) - ,.r.irtually the sane as the dollar
increase in F'i' 78 and thus a g:iod deal _less _in either perrentage or real terms.
w'
.
. .
:
. .
..
For
I am grat.eful t.n rcy oolleague m the Ieseardl Seminar in Quantitative ·
F.oonariics, M:J. Joan M. Porter, for her help and advi~ in the preparation of
this testim::ey.
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Federal Reserve Bank of St. Louis
.
188
FY' BO I ~ an expenditure increase of $44 billioo.
In IT¥ view, expenditure
inc:.re;>..se£1 .cf his size 'WOUld repxesent a cx:nr.ide.rabl~ - th)ugh rot unlikely arrcll.mt·~ r ~1~ in the stated goals of .. t~ President c.:nd ~ to mld ixMn
-~
spendirq.
forer...ast, tlleSe
In oo...-ijunct..-\.m wit.ii the. Federal revenues derived £ran our Cbnt:rol
~tu....:e levels iuply Federal &ill.cits
(NIPA basis) of aboot
$20.5 b:i,.l.l.i.on in each of FY'79 and FY'80.
PJega:r:di.ng xroootaxy policy,
too
6.mk of St, Louis, i:H proj~ to
rtJ:ft!tar.y base, as zreasured tfJ the Federal Reserve
(JI:O;i
at an annu-'J.l rate of about
. ~ first ha.l~ of .1979 .
8 1/2 pt?xoent t.hrou;h ·
'01is represents a
substantial de<"'.J.ine in the growth rate of the .ntirieta.ey base as COlpared tx:> the ·9 1/2
pex:oent rate over the f--"ISt year or the nearly 10
perca:it
rate over the pa.9t 2 quarters.
"I.h e ::llil<::loimt rate is expecterl to remain at 9 1/2 pex:rent throu#l the first half of
1979.
~lr
fo.!eel.St .1:4-ojects· ·an easing of rronetaey restraint beginning in the third quarter
of 1979
The p..roject.ed easing of p:>Ucy is asSU!m to inchrle a roo.uctioo in the
d.iso::>unt rat.e to 8 1/2 percent in 1979.3 arrl t.~ to 7 1/2 percent in 1979.4 and
~
of the m:net:ary base at a 9 percent rat.e aftEr mid~ar.
I tqJe to rreke clear
the re sons fur the projected mange in n o ~ policy later in ff¥ testim:Jny.
I tum rOl to the outlook. itself. ··0:rrpared· with the 3.8 pe.....-c,ent rate of grcwth
of re.al CBP
rrM
beinJ estimated for 1978, I am forecasting a sharp decline to a
gro.,.r--..h _rate for
the year 1979. 0:>1:respcnli.ng to an increase in aggregate
product.ion of only 2. percent for the year as a whole is a substantial incre.ase in the
2 percent
une:ip:toyrrent. rate to
~
f u ~ quarter c~ ~
?~ge of ti. 7 P=,ra?nt for the year am 7. 2 paramt for the
year.
'1;he a~-<.Ja·!:P. price level, as neasured by the GNP
de:fl.a.t or, is ~~- to beup by 7.9 pe.~t for 1979, <Xllpa.red with a 7.4 pe.rrent
:i.ncrease .t:or 1978. . '.the Treasucy Di.ll Rate is fo:recast to average 7. 8 percent next
year, carparoo with 7. 2 parcent thi~. year; and the rate of gra,.,th of the m:ney stock,
as meas~ by M2, is forec-.ast
'ltie
U)
decline from 8.9 percent this year to 8.4 percent
qu..,rte ~ly de tai.l contained. in the ~ttached table makes it clear that
~racterizing 19_79 as a 2 ~ t gt'(Mth ~u- is hiding a cp:,d deal of itrp:>rtant
ir.t:onna:t.i.m . 'n1C fon..->east inpUes virtually . m gxolt:h ~t al1 .i n the seo::md and third
qua..-ters of 1979. My FOint forecast manages to avoid aey regative gro;,rth quarters,
but I am fur ecasting annual gr-::wtn =ates of _0.5
aro_0.2
percent in the bA'.> ll".id-year
quarters , arrl t..:iat has to r.ean t."la'- the ct.ian:es of a true recessicn developing after
the early rrrmths of 1979 should be regarded as a.lnnst "fifty-fifty."
the ~.noes of a"'.°i ding a recessicn in 1979
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383Ti
In other \To'Ords,
to be cnly slightly better than the
~
of
~
Cootrol ~ :
~ . r 19 78
""I
'"'
N
"'a,
..,
"'
Fe.rrent Chi:mges at A.-i.nual Rate
A~
;;;
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Federal Reserve Bank of St. Louis
Feal GU? a."1tl
ca~c.s
II
!ll
-5.4
0.5
1.1
-3 ..8
1.0
-1.2
0.2
l.S
- 2.2
-2 .7
-22.9
'IV
l
2. 6
2.3
1.3
-1.3
4.4
-n
IV
. I
1.6
2.6
3. 1
3.3
7.1
-2.9
16 . 3
3. 8
3.2
6.5
-l. (
2.?
3.0
25.2
3.2
Ill
}_;9i8
!97Cc
( ' 72 $'s)
Gross 1:-l a tio."\itl Product
Personal Consmption Ex:penlib.D:es_
D.milile
1950
13i9
_!978
0
Q.")005
Business Fi'lID:l L"l'Vl""...stm:mt
:t .l
4.3
3.5
!i.8
0.5
2 ,0
3.8
3. 7
3.9
7.8
3.2
-14 ....
2 .1.
l. ~
7.4
7.9
2.,
-1. 4
l.~
o.s
-3.8
·-7.l
1.8
7.2
7.9
7.5
8.2
6.9
7.1
6.6
6.8
6.2
6.5
6.0
6.9
7.3
7.1
6.9
9.4
10.2
9.5
10.4
10 . 4
8. 9
8. 4
· 2.9
3.l
18.0
-27 . 6
7.3
19.5
-33.6
U .3
-34.9
16.2
19.2
22.6
23.4
-30.3 · -24. 8
22.0
24.2
-23.8
-11.2
14.3
27.6
2.0
1.9
1.8
1.7
1.7
1.7
l.S
l.P
2.0
6.0
5.0
8.8
9.0
6.2
5.4
6.5
5.4
8.4
6.9
5.6
7.2
9.2
7.2
5.5
6.2
9.2
7.5
5.2
7. 6
1.'5
5.0
6.3
9 .2
5.1
6.6
9.3
6.0
5.3
7.2
8.7
- G. l
Residential O::ln:stz.uetion
Gove.rrnent Purr.hases
1.9
3.6
- 7. 2
-0.4
"-25.9
1.4
8.2
7.3
7. 7
'1.-4
7.4
8.8
-8.6
11.5
- -24.8
2'3 . 4
Pri..::es (1972 = 100)
Gross National Pl.'Oduct.
Daflat.or
Personal (bnsurption
~ t u r e s Defl3tor
>--'
00
Mr.ne',i Stock (M2)
B.
Levels
~t Exr,orts (billions of $'s)
Net Exports (billions of ' 72 $' s)
Federal Bu:lget Sw:pll.l:3
(billions
of
9.3
-39.3*
4 .9
18.3
- 28.4*
$'s)
Total Private Housing Starts
(millions of units) .
tID3!'pl~irent Fate (%)
Personal Saving Rate (%)
90 Day 'l'reasury Bill Fate (%)
.Aaa
21.3
Cbrporate Bond Fate (%)
"'Fiscal
1978 and fiscal 1979.
9.2
9.2
9.3
G.fi
9.3
1.8
6.7
5.S
7. 8
9.2
co
190
chances of
expe:i:iericing a true r.eceasion in which aggregate outpit actually declinas
for a tine.
A3
soown
in _the table, na,etary restraint can be expected to prodooe a
Sli:>stanti.al dee.tine in- res_identi.al building activity.
'!be major -quarterly declines
are forecast to ooour during the fil:st th...-ee quarters of 1979, aft.er whidl .the
assunea.
msing of m:>uetary :cest:raint plays a najor role in :reversing the diq) in lx:iusing
llCti.vi.ty.
.
txend_,
in real terms,
of hic;#l i.nt:elest rates and the
iridwerl e:ffect:t.. 1'f the ean::mic: elowoown. COnsu.uer pn:-chases of durable goods~
forecast t.o be declining througoout noot of next year, fulJ..o,Jied by a substantial
pick-~ in the cl osing qu.axter of 1979. ~ of the rea:,veey in durable ~
Business c-ap:ital fuunati.on is forecast to be on a oownrmxd
throughout.
activity -
tne funicast horizon -
t."le :testtlt both
e.:;pac.i.a!.ly the strength of tbe rect:1Y&Y in late 1979 and early 1980 ~
ia heavily depement on the dW\gl! of P9licy to an e.:.,sing_ of m:net.ary oc:muaint
which I have MsUll!!rl will be underway in the smmer quarter of next year.
0-.art:&
r
and 2 indicate
wh<J l believe a
will be nec::essacy Jn nrl.cH979.
change in the stance of nonetaxy
poHcy
Oiart 1 ~ 1:J«l alternative growth paths fur
real GNP,
one for the Control forecast a.~ orie for what I've called the "CXlntinued tight~"
program. 'Iha continued tight mney alternative eliminates the easing of mnet:aey .
policy ~tainoo. in the o:mtrol ilpits. 'l1'le result is a nazked w-..ardaticn of the
GlP growth path cx:r:pa.red with that in the control forecast.
'l11.e ~ t s of aggregate derMm which suffer the nest in the alternative
forecast are, o,f oourse, ras_idential bu.Uding and pun:hases of
c:onsUter
durables.
A good part of the story is cor1tainad in the fact that the cxntinued tight m:iney
alternative produce.s a Treasazy Bill Rate of 8.2 pE'..roent in 1980.3, a full 160
basis
points. a.oove the carparable im.lue eh:Mn for the Conttol fomcast in the attadled table.
Chart 2 sl'ICJWS tl-..e a1.tcmative unexployment rates for t.~ t'.Wo forecasts. In
t.he Cbr.txol foreca...et tbe 'lma:tQloyment rate tops out at 7.6 peroent in inid-1980; with
the ~tinuation of Honetacy J:estraint the urenploynent rat:e goes through 8.0 percent
by the · thixd ~ of 1980. In the sh:>rt r.1:l the ecxll'dllic CX>St of this alternative
to the 0:mtl:ol forecast is a ~ubstantially
sufficient
higmr
rate
of llrlSIPlo.Yirent but with a
'IJI¥3arutilizationof resources that tlP. resulting losses
~ t ivity negate any
(?f ,the mductia1
in
irl
the growth of
inflatiaw:y ·~:ires ·which raic;#lt
otherwise be trought t.o derive ·fl'OOI greater ean:mic slack.. In effect, . the prol.cr,;Jing
of a growth recession has its great.est imnedi.ate inplct a,. ~nent and product.l.vity,
mt on the rate 9f inflation.
'!he real question is -whether the situatioo in the first half of 1979 will produoe
enoo;Jh signals to :induce the fOli<..y-mal-.:.ers . to begin to ease off al<D;J the lines
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Chart l
ALTERNATIVE REAL GNP GROWTH PATHS
~z
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ACTUAL
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1979
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AE!fARCH SEMINAR IM QUANTITATIVE ECONOMICS. UNIV OF MJCttJGA~. OEC 1871
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ALT ERNATIVE UNEMPLOYM ENT RATES
8.S
,------,---.--------------~-----8.5
·. -
6.0
CONT RO l.
·-·- CONY l NU£0
__
~,A
TIGHT HONEY
w 7.. S
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RESEARCH SENINAR IN QUANTITATIVE ECONONICS. UNIV OF NJCHIGAN. OEC ta7a
193
Bt~t.erl ill the c.t:atro.l fo:r:eca.!3t. In the. Michigan rrooel the initial Bharp hlke in
interest :ta,.es ,:md the cL~).t ic: ecn.icmi.c s ~ pi.udtx:e a nm:Jt.e:i redl1Ct::l.on in the
xa~ o f 'ST.JWth of Ml -
wfficient, in fact ,. b'J br.ing soort-tenn int:erest rates dcMJl
e<."Bl o~fu:tB t.he ;;:sstl!l'Sd easii.".g of ua:ietaty policy beg.ins.
wage i.rifJ..Citi.an -
At the sarne time price
are
~capt : or too payroll ta."\: effects on c:mpensa:tion ·- are fm:ec:a6t
to Le r:..-xleratir-r:; , '.Ib(? trrAJble is that too node-.:cit:ioo of inflat.ioo in the fifflt half
of the year i.s apt to be distinctly nodeat. hi as.'31.ned 0Pa: pricn f o ~ , the
likclihood of foit-ly 1,:uge inciaaSC..-..i in ir.rp:>rt prices e:<elwing c,il, and the
·price pressure intx> the
sul::e.bnti,,,_l hike fa pay:roll taxe!l f pile a good deal of ~
fiurt half: of 19-79.
Aaide frou rrcJr£'i c)n,d pri.oee, another critical f.actor in the policy decis.ia'i W'...U
.bi.~ the e.d:cr.t t.c h'hid:. tha trade balazce inpzoves. I aru foreca.st.in,J that cm:xent
oollar net e..~rts will ha'l!i.¼ .!.hown a Sti.~tantial. inprova:nent in the first quarter Qf
197!?, and rray ~?:l be cr-1.'.. te close to a zero bal~ in t."ie sp,:-inJ roonths of ne>rt. -yp.ar.
1.hus, a rx,:;.sibl e - aoo in rri'.ll view likely - aoenario as. the sumer of 1979 aR',t ooches
iJ3
tr.a fnlJ.owir.J:
(' six ronths of cis-'",.ir1ct.ly rroce.rate growth of the rronet stoc.1c,
,, non-sc.-cnlere.t.in,1 infJ..ation, roY! pi"...rhJ,..pe even evider!O:! of sane
dP...cele.rr.1t i.on in a nu'lh'..r. of oo,e:;tic pdoo :ireasures,
9
<".nd
a ~mbstantially illproved t.rade
tel,~ ,
" the ~ da.".lge!'.'Ously close to a recession.
If this conjwction of events nateriall7.e5 ooe Il\ight rea.5CX\ably eq>eet that the
ooll.'IX" WC".lld i:tln>.£:.:ly l1ilve f,tab.i l i ~ . if rot eypreciated, fo the ~ld m:reJ marlcets.
'>.hat's a basketful of "ifs",
desirabl4! -
~
bl..>t if oo, I 'wOI.Jld expect -
a n d ~ as highly
easili.J of m."'letarf restraint by next mmoor.
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Representative REuss. Thank you very much, Mr. Hymans.
Mr. Pierce.
STATEMENT OF JAMES L. PIERCE, 1 PROFESSOR OF ECONOMICS,
UNIVERSITY OF CALIFORNIA, BERKELEY
Mr. PIERCE. Thank you, Mr. Reuss.
My prepared statement is so short, let me just try to read it rather
than figure out how to summarize it.
I am happy to provide one more voice to the confusing array o:f
policy analyses and advice that you have heard in recent days. I
doubt that my statement will eliminate the confusion, but perhaps
I can succeed in isolating some potential dangers for the domestic
economy of the administration's current economic program.
It seems fair to characterize the policy moves announced by the
administration in recent weeks as being a consequence of a feeling of
frustration. Economic events were not proceeding according to plan.
While employment and production experienced impressive gains from
the 1974-75 collapse, inflation was accelerating and the international
value of the dollar was plummeting.
In response to the worsening inflation and international situation,
the administration apparently decided that it had to "do something,"
and to do it fast. As a result, a massive dollar-support program was
announced; the Federal Reserve signaled a sharp increase in interest
rates through a large increase in the discount rate; wage-price guidelines and general enforcement procedures were announced; and an
aus~ere Federal budget was proposed.
Smee the program was announced, interest rates have shot up
and the dollar has rallied in international markets. It is too early
to tell whether the dollar wm continue to appreciate, and it is too
early to see many domestic consequences of the program, except
heightened uncertainty about the future. The important questions
have to do with the future.
There appears to be little disagreement among economists and other
. observers that the economy will experience a pronounced slowdown
next year and probably slip into recession. The administration, however, continues to announce that it expects no recession at all.
I have reviewed several private forecasts and have even attempted
to do a little forecasting mvsel:f. Based on these exercises, I conclude
that it is very likely that the economy will experience a recession
next year. The recession is apt to be relatively mild, with recovery
commencing early in 1980. Assuming that a classic inventory recession
does materialize, the decline in real output should be modest and
unemployment might not rise much above 7 percent.
With these developmPnts, inflatioPary pressures shonld weaken
somewhat and the rate o:f inflation may :fall to about a 7 percent
annual rate. Thus, economic slowdown and recession can be expected
to take the economy part way toward the administration's wage-price
goals. It is unlikely, I believe, th::it the wage-price guidelines themselves will make a significant contribution.
1 Former Associate Director of the Division of Research and Statistics, Board of
Governors of the Federal Reserve, 1965-75.
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In assessing the implications of policy actions, it is sometimes helpful to .e xamine the nature of the uncertainties that face the economy.
I~ the case at ham~, it is useful to consider optimistic and pessimistic
views of the admmistration's program. In the optimistic version,
the austere monetary and fiscal actions will produce only a slowdown
in economic activity. This slowdown will itself help to reduce the rate
of inflatio~. The wage-price guidelines will then be easier to apply.
By public censure and selected enforcement activities, the administrat10n could then achieve its goal of reducing inflation to under 6
percent. This would be achieved in large part by reducing inflationary
expectations that would hold down wage settlements and lessen price
hikes. In this optimistic world, American society realizes that slow
economic growth and Government wage-price guidance are necessary
measures for solving the Nation's inflation and balance of payments
problems. Society falls into line and supports the administration's
program. This optimistic views seems to be the one held by the
administration.
The pessimistic view can be summarized by a single phrase: "Here
we go again." The economic mistakes of the Nixon-Ford years are
going to be repeated. During those years, a recession was generated
in 1969-70 by monetary arid fiscal policies. The recession was expected
to slow inflation and aid the dollar overseas. The recession accomplished little on these scores, and it was followed by wage-price
controls.
With the controls, monetary and fiscal policies turned highly expansionary in 1972. Inflationary pressures built up and the controls
had to be abandoned. With the dropping of controls and the actions
of OPEC, the United States experienced tremendous inflation. The
Government responded by pursuing extremely restrictive policies. As
a result the economy experienced its worst collapse since the 1930's.
The pessimist would view the administration's recent policy moves
as the first step along the path to the stop-go policies of earlier years.
Unfortunately inflation and international problems are far worse
today than they were when Nixon began the series of policy blunders
that followed. If the same policies are followed this time, the consequences could be even worse.
I believe that the recently anounced policies have created a great
deal of uncertainty in the private sector of the economy. One can
neither accept nor reject either the optimistic or the pessimistic
view. If the popular forecasts are correct, the outlook for the economy
is fairly favorable. Unemployment will rise somewhat, but not a great
deal and there will be some progress in reducing inflation because of
slackening demand.
. .
. .
But what i£ the forecast does not materialize~ There are two distmct
dangers that. face the econo~y and mi:tkP, 1:1any participants in the
private sector very uneasy. First, the recession might be worse ~h!l'n
most observers expect. This would occur if monetary and fiscal pol~cies
continue to tighten or if consumers and business becomes more cautious
than expected in their spending, or if some unexpected external
development occurs such as crop failures. If the recession is worse
than anticipated, it is necessary to try to guess how the Government
will respond.
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One possibility is that with the falling receipts and rising nondiscretionary expenditures induced by the deeper recession, the administration would attempt to adhere to its target for the deficit by
:further restricting discretionary spending. Such an act would serve to
worsen, :further, the recession. Alternatively, the administration could
respond to the recession by calling for mandatory wa~e-price controls.
With controls it could then pursue expansionary policies, relying on
the controls to limit inflation.
The second danger is that inflation could be worse than anticipated.
Here again there are two possible responses by the Government. It
could pursue more restrictive general policies to bring down the inflation rate through classic aggregate demand management. Alternatively
it could seek to impose manaatory wage-price controls.
It is informative that in assessing t he implication o:f either a worse
recession or a worse inflation,' or both, it is not possible to guess even
the direction the Government might move. It might pursue restrictive
policies to combat the budgetary effects of recession, it might pursue
a stimulative policy in the face of accelerating inflation because it
plans to use mandatory wage-price controls to combat the inflation.
It is a disturbing commentary that one of the greatest uncertainties
about the future of the economy involves the direction and character of
governmental policies. There currently is great uncertainty about
:future expenditure and tax policies, about future monetary policy and
about future wage-price policy. Business and private citizens have
every right to be upset with the uncertainty that the Federal Government adds to an already uncertain environment.
I think that the Federal Government could do a great service to the
economy by announcing how it would respond to such dangers as a
sharp recession or accelerating inflation. It serves no useful purpose
for the Government to paint a more rosey picture than events justify,
and it does no good for the Government to keep its contingency plans
to itsel:f. The public will have to make its own contingency plans
whether it_ hears from policymakers or not. If the public guesses the
wrong pohcy because none has been announced, expectational effects
can swamp the Government's efforts to respond to different contingencies.
I would like to end my testimony with some comments on the current
mix between monetary and fiscal policy. With the recent]y announced
6-month money market certificates issued by thrift instltutions and
banks, and with massive Federal mortgage support programs, the
mortgage market has managed to withstand the current upsurge in
interest rates quite well. Housing has become more protected from
swings in monetary policy. The insulation of housing implies that if
monetary policy is to have an effect on reducing aggregate demand,
it must affect markets other than the mortgage market. This can be
achieved with sufficiently high interest rates.
If interest rates rise more rapidly than expected inflation, and if
they rise high enough, borrowing to finance capital expenditures will
be reduced; investment will be retarded. Such retardation seems unfortunate in light of the need to improve the Nation's productivity
and modernize its productive capacity.
It seems appropriate in the current context to seek a shift of emphasis away from restrictive monetary policy to more restrictive fisca]
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197
measures. With such a shift could come lower interest rates and more
capital :formation.
In conclusion, however, I think that the greatest contribution that
this administration and this Congress could make to controlling inflation and maintaining real output growth lies in a commitment to a
gradual and predictable policy designed to slowly reduce the inflation
rate.
Drastic measures and crash programs .rarely work. What is needed
is a willingness to be moderate, but persistent in reducing inflation.
With moderation and persistence will come a public awareness that
the Government can pursue sensible policies and that the Government
will cease being a source of uncertainty and, instability. If this awareness is justified by Government action, it will materialize. When it
materializes, the Government's own job will become much easier.
Thank you.
Representative REuss. Thank you, Mr. Pierce.
Mr. Yeo, your entire prepared statement, as well as those of the
other witnesses, wm be received in full into the record. You may proceed in whatever way you like.
STATEMENT Ol' EDWIN H. YEO III,1 CHAIRMAN, ASSET AND
LIABILITY MANAGEMENT COMMITTEE, FIRST NATIONAL BANK
OF CHICAGO
Mr. YEO. Vhll, Mr. Reuss, it is a pleasure to be here before you again.
I don't think that I will .r ead my prepared statement instead, with
your permission, I will summarize it and proceed from there.
I think I ought to begin by saying that I am personally quite concerned about the circumstances in which we find ourselves. My concern
stems largely from a substantially different analysis of where we are
and where we are g-oing in terms of the domestic economy. I think the
key point was made by one of my colleagues at this hearing just a
moment. or two ago in the phrase "Here we go again."
Americans have been conditioned by the past. They are extremely
jntelligent, well informed people, and they have noticed a pattern
that has Jed them to say their expectations have changed. The key
element in the American economy in 1978-as far as I am concernedhas been tangible evjdence that people expect inflation to continue
and to worsen, and that they have started to conduct their affairs in a
different manner as a result of those expectations.
First, there is the evidence-summarized in my prepared statement- that individuals have conditioned their expenditure decisions
on the expectation of higher prices-anticipatory buying-. Advertisements in the "New Yorker" and other magazines, for silver medallions-in my opjnion, ghastly looking, th~ugh th~ adve~tising says th~t
they are attractive, are an example. The mterestrng thmg, however, 1s
t.hat they are claimed to be stores of ~alue. The deman~ f~r these
medallions or bars or vario11s other art1fa?ts refle?ts a. shift m a~set
preference, away from financial assets and rn the d1rect10n of holdrng
real assets.
1
Former Under Secretary of the Treasury for Monetary Affairs.
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This is a very rational, logical development based on our experience
of past inflation. As an intelligent people, we are drawing on this experience and extrapolating it to the future. You could say that this is
consumer inventory accumulation. It has required enormous financing
and is the reason why we have witnessed, month after month, reports
by the Board of Governors of large increases in consumer credit. As
you know, various relationships, such as measurements of consumer
debt burdens relative to income, or relative to assets, have shown an
appreciable erosion in consumer liquidity-a logical result of the kinds
of attitudinal shifts that we think we discern.
Businessmen also have charged their attitude, based on their experience in 1974-75 and the horrible inventory excesses that were revealed
by that recession. To date, they have run quite lean inventories as a
whole. They have operated with a set of expectations that, in effect,
involved a fear of recession in the future, and a memory of recession
in the past.
We think that is beginning to change. Month after month of pricing
increases, particularly in the crude materials area, and developing
shortages, lead us to believe that ex ante inventory preferences by some
sectors in business are changing-and changing very rapidly.
These two areas-consumer behavior and the change in inventory
preferences-are likely to propel the economy in money terms quite
rapidly into 1979. Frankly, the economy has been moving a little bit
more swiftly than we had expected, particularly in the fourth quarter.
We expect that this strength will continue into the first half of the year.
However, these are the symptoms of a warped expansion, an expansion characterized by a consumer boom which has been fueled by expectations of continuing inflation and financed by enormous amounts of
credit.
Federal Reserve policy has largely facilitated this process-at least
until recently. We do not interpret the increases in interest rates up to
November 1 as attributable to the Federal Reserve. If anything, the
rise in interest rates up to that point did not fully reflect expectations.
We are near full employment both in terms of real resources, and in
terms of people, at current price levels, and, we think, at full employment in financial terms.
Another manifestation of the kind of economy we are living in is the
depreciation of the exchange rate. Our current account deficit is another understandable and lamentable consequence of this situation.
The question is, What can we do about it at this stage~ The administration's program, as I understand it, contained, first, a financing
package, a very large financing package. That is what it amounted to.
They said $30 billion-well, we will call it $30 billion. But it also involved a change in the nature of the financing-including, they said,
and they have done so in their DM issue, some longer term financing.
Second, it involved a change in monetary policy, the substantive part
represented by an increase in reserve requirements on large denomination CD's. And the third part was the promise to the American people ;
namely, that there was going to be continued change in policy so that,
"Well, fellas, we didn't get it right, but we are going to get it rig-ht."
I think that our discussions about appropriate policy initiatives
should involve much more restriction in terms of Federal Government
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Federal Reserve Bank of St. Louis
199
expenditures. For example, I think that we ought to freeze expenditures at 1978 levels. And I think that we ought to legislate a prohibition against wage and price controls because, frankly, this is another
area where Americans have very, very, active memories. Their attitudes and actions today are conditioned by their memories and interpretations of the past. Voluntary wage and price efforts simply
titillate-the memories of the past and might prompt action-no matter
how well intended everybody is-that really is countervailing in terms
of overall policy.
In terms of our external situation, we have experienced some
improvement in the foreign exchange markets. As you know, Mr.
Reuss, the test is not how the dollar is beh~ ving in the short run, but
rather, how much intervention or lack thereof was required to make
it behave in a certain way.
I personally wish that interest rates were lower. The easy way to
reduce interest rates is more policy, more conditionality. The process
is like a pair of scissors, one blade is interest rates and monetary
policy, the other blade is Federal expenditures and fiscal policy; both
must move.
What we have to do, both interna1ly and externally, is to change
expectations regarding future price performance in this country. As
soon as those expectations are changed, interest rates will appear to
be high, at whatever level. That, in turn, will elicit capital inflow,
stabilize the dollar, and will obviate the' need for large-scale
intervention.
·
In summary, Mr. Reuss, we don't see any difference between external
considerations and interests and our domestic considerations and interests. We think they are one and the same.
We are hopeful about the administration's package, its program.
·we interpret it as a beginning, not the end, and we feel that we are
going to have to do more if we are to safely stabilize the American
economy.
[The prepared statement of Mr. Yeo follows:]
PREPARED STATEMENT OF EDWIN
H. YEO III
INTRODUCTION
Mr. Chairman, it is a pleasure and an honor to appear once again before this
distinguished committee. I confess, in looking back over the times that I have
appeared before you, that the learning process has always been invertedI have acquired more knowledge than I have given. I expect that it will be the
same today;
In its broadest outlines, the committee's inquiry is based upon the policies that
have come to be called the "November 1st Package", viewed in the context of
the policy announcements that preceded it and further refinements that have
followed. A frequently heard description of this "package" would be :
A $3 billion increase in reserve requirements on large certificates of deposit
and a rise in the discount rate by a full 1 percent;
An increase. in Treasury's monthly sales of gold to at least 1½ million ounces
per month, starting with this month's auction;
A decision to join with Germany, Switzerland and Japan in closely coordinated
exchange market intervention;
The mobilization of $30 billion in DM, Swiss francs and yen to finance US
intervention including $15 billion in swaps with Japan, Germany and Switzerland; IMF drawings of $3 billion; sale of about $2 billion of Special Drawing
Rights ; and issuance of foreign currency denominated securities in amounts up
to $10 billion. _
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The word package, so often used in everyday conversation, arouses apprehension. "Package" connotes something finite and something placed upon the
table in completed form. My interpretation of November 1st is different. It appears to me that the announcements on that date could be divided into three
parts:
A change in monetary policy (the substantive component being the increase in
reserve requirements) ;
An enlargement of and a shift in official financing facilities;
And a promise.
On the basis of the above interpretation, I congratulate the Administration
and support these initiatives. Of the three parts, the promise is the most important. It was, as I interpret it, a promise to the American People that economic
policy in this country would change. A change based on the delayed recognition
that an overheated US economy poses a threat to our livelihoods and those of our
friends throughout the world. The promise implied a process of informing the
American people as to the nature of our circumstances and our alternatives. Such
a process is inconsistent with the term "package".
I would like to think that these hearings are an integral part of this process. In
this spirit let me begin with a discussion of current economic conditions-facts
that should not be a source of disagreement. Do the measures taken since October
29 contribute to the achievement of our basic policy objectives-the maintenance of a steadily expanding economy and increasing standards of living in
the environment of stable prices?
THE ECONOMY IN 19 7 8
The facts, as I know them, are the following :
Income and Employment Gains Continue Strong
Since January civilian employment has increased by three million; since the
trough of the last recession the economy has added eleven million jobs. At the
same time overall unemployment has fallen. In November the unemployment
rate for married men stood at only 2.5 percent and the most sensitive indicator
of labor market conditions-wages-has indicated progressive tightening. Compensation per manhour for the non-farm business sector has steadily risen from a
7.7 percent year-to-year increase in the fourth quarter of last year to 9.4 percent
in the third quarter of 1978.
Consumers E:xpect Further Gains in Income and Employment
Retail sales grew very rapidly in October and November. Savings rates have
sunk to historically low levels. We estimate that the savings rate in the fourth
quarter declined further from the 5.1 percent rate of the third quarter.
Industrial Activity Is Stronu
Industrial production gains have not slackened, contracts and orders for capital goods, in real terms, show year-to-year gains near 20 percent. Some might
point, Mr. Chairman, to the relatively modest gains in inventory as evidence that
the recovery remains well-balanced. But, this balance is a very fragile, and
perhaps illusory.
We Are At Full Employment Of Capital and Labor
Inflation is unlikely to decline in the foreseeable future. We have entered the
phase of the expansion where marginal additions to output can be realized only at
progressively higher costs. Capacity strains have been evident for some time.
The upward pressures on prices from increases in aggregate demand are continuing.
One evidence of capacity strains has been the rapid rise of raw material prices
and backlogs. Backlogs rose at a 16 percent annual rate in the six months ending
October-and there has been a comparable rise in prices. The rapid accelerations
in raw material prices and backlogs may be the first concrete signs of a change
in businesses' previously cautious attitudes toward inventory, both on hand
and on order.
Such a shift would help propel the economy into next year but would also
further strain productive capacity. As measured by the Federal Reserve's index
of capacity utilization, the economy was operating at 85.3 percent of capacity in
October and will likely reach 86 percent by the end of the year. This would be the
highest level in recent years. In the second quarter of 1974, when measured
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Federal Reserve Bank of St. Louis
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utilization reached 85.8 percent, severe capacity constraints bad begun to emerge,
particularly in raw materials industries. The only reason that we have not faced
similar prol:>lems up to this point is that capacity rates have been more balanced
across sectors and, as a result, we have not yet seen more evidence of speculative
inventory behavior.
We A.re Approaching the Limits of Our Financial Capacity
Federal government credit demands remain unusually high for an economy in
its fourth year of expansion. The Federal deficit is currently running at an annual
rate in excess of $40 billion, while the aggregate operating surplus of state governments is likely to have been virtually eliminated in the course of 1978. Investment and inventory expenditures have made the -b usiness sector which was a net
provider of funds to the economy between 1975 and the first half of 1977, a heavy
demander of funds. Loans through the domestic banking system and commercial
paper markets to non-financial corporations increased 16 percent between November 1977 and November 1978 and may expand at an even more rapid rate during
the coming months. Businesses' response to rising prices has been to add liabilities
at the expense of liquidity. The domestic liquidity ratios of non-financial corporations have fallen back to the very low ievels reached in early 1975, in one of the
sharpest such declines during post-war period.
The strains on our financial capacity have led to higher interest rates. We have
failed to recognize the strains, Mr. Chairman; we have attempted to offset these
pressures on interest rates by pursuing more accommodating monetary policies.
It is not correct to say that our monetary policies have been directed towards
raising interest rates. Our monetary policies--with money growth, year-to-year,
at roughly 7 percent have had the effect of initially preventing interest rates from
reflecting financial realities and then only with a lag increasing upward pressures
on rates.
Let me explain.
INFLATION AND INTEREST RATES
When individuals expect rising inflation, it requires that interest rates rise
well above the anticipated inflation rate to dampen the demand for credit and
slow inflation. A 10-percent mortgage .r ate doesn't deter home buying if home
prices are expected to keep rising at 15 percent a year, and a 12-percent rate
doesn't dampen a businessman's urge to accumulate crude materials if these prices
are expected to keep rising at a 20 percent or more rate.
Expectations of higher prices, unless interest rates fully reflect them, undermine our ability to attract the pool of savings-foregone consumption-necessary
if we are to add to our productive capacity. What attraction has a savings
account to a small saver if he expects that prices will rise by 10 percent in the
next 12 months?
Consumers have learned to look at interest rates in real terms. Credit card purchases willingly financed at an 18 percent interest rate when expected inflation
was 6 percent are even better bargains today when inflation is expected to be 10
percent.
By refusing until recently to allow interest rates to mirror the increase in
expected inflation, the Federal Reserve has encouraged consumers to bo~r.ow
heavily. Their response has be'en predictable. Encouraged by apparent nsmg
equity values in housing and other assets, the consumer in the first ten months
of this year has added roughly 27 cents to his installment debt burden for every
dollar increase in personal income.
. .
Accelerating expectations of inflation ge?erate massive demahd~ for ~red1t m
order to beat price increases, t? hedge agamst ~r to speculate on mflation. .
This new recognition of inflation helps to explam how the share o_f consumption,
• 1 d'
consumption outlays by the government sector, has risen from less
~~~; ;;~ercent of output in 1970-73 to roughly 77.5 percent in the past three
ye;~s~ effect of the declining consumer savings_ rate on the eco~omy has been
•
b 1
verage returns to the busmess sector. New mvestments by
compllcated by e ow~
. h'bi'ted by two difficulties-inadequate return on
·a1
corporations
m 1 of government
·
. market.
eare
weig-ht
no~- fl_na~ C1
borrowing in the credit
th
ex1stmg mvestment 8 -?,d
r orations reported pretax earnings of $143.5 billion,
In 1977, non-financial co P these profits are adjusted for inadequate depreciabalance depreciation) and to reflect invento.r y
10 percent above 1976. Wb~n.
ti-on (including double-d eclltnhmge corporations had just $3.5 billion (after taxes,
costs at reptacement va 1ue, es
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dividends, and manda ted EPA/OSHA requirements), to meet the need for new
additions to the capital stock. Over the past five years, retained economic profits
by this measure total a negative $22 billion, providing no incentive to add new
capacity longer-term ; in 1978, retained economic profits a re again likely t o come
in negative.
This might not be an insurmountable obstacle to new investment, but it is made
more difficult by the ubiquitous presence of government borrowing in the
credit markets. Even with the proposed reduction in the Federal deficit, the
overall level of government borrowing will rise in 1979 because of higher borrowing of states and localities-now moving into deficit on their overall current
accounts-and off-budget agencies of the Federal government.
In the past, large government deficits would have given .the economy a temporary boost. People were slow to translate more rapid monetary growth into
expectations of higher inflation. We face an entirely different game today, and
one with different rules. What is particularly unique about the current situation
is that people not only full anticipate inflation, but may even have exaggerated
expectations of future inflation.
This process runs the risk of the "greater fool" syndrome. Consumers are
bent headlong on taking on more monetary debt relative to monetary assets in
order to acquire a variety of illiquid real assets-a process that leaves them vulnerable if anticipated income gains fail to materialize. Furthermore, the prices
of supposed hedges against inflation (including houses) already incorporate
the expectation of considerable future inflation. And many hedges (such as gold)
share the volatility of commodity prices in general. Even if such prices continue
to keep ahead of inflation over long periods, they might lose value in hard times
when people most need to acquire cash. Buying things to hedge or speculate
against continued inflation can only continue so long as others are both willing
and able to bid up the affected prices. When financial constraints put a lid on
the process, as sooner or later they must if inflation is to be tamed, the notorious
search for a "greater fool" IJlUSt come to an end.
The behavior of the foreign exchange markets closely parallels this new "rationality" on the part of the consumer and business. The dollar's precipitous de•
cline against the yen, the mark, and the swiss franc in international capital
markets reflected the markets' expectations of accelerating inflation in the
U.S.
It is important to realize that the marked weakness of our balance of payments
during 1977 and 1978 was only partly caused by relatively faster growth in the
U.S. than abroad. The dollar fell as we accumulated a massive trade and current account deficit to meet growing demands for imported goods and services. Relatively slower growth in our major trading partners meant that foreign demand for our exports remained depressed.
Countries import and export capital as well as goods. The effect of trade and
current account imbalances on a currency can be reinforced or offset by capital
flows. If we run a deficit on current account and also experience a capital outflow, then the dolJar is likely to come under sustained pressure. Foreign central
banks and the Federal :Jteserve can offset only some of this pressure through
exchange market intervention; inevitably the exchange value of the dollar will
fall.
.
During much of the last two years, with the U.S. current account strongly in
deficit, there has also been a large net outflow of capital, especially private capital. International capital flows are conditioned by relative financial rewards and
risks between assets denominated in different currencies. At the margin, investors were unwilling to hold dollars despite higher nominal short-term interest
rates in the U.S. ·than in other major countries. Although interest rate differentials have progressively widened in favor of the United States, capital flows
have not responded. Clearly the differential has not been great enough to compensate for increases in expected U.S. inflation, which is another way of saying,
·
expected dollar depreciation.
In this situation, other countries have two alternatives:
First, to adopt policies intended to rapidly increase domestic output, at the
potential cost of higher domestic inflations rates. in order to accommodate higher
aggregate demand from the United States without reducing their own expenditures, or
Second, to maintain cautious economic policies, continue to reduce inflationary
pressures, and divert output from domestic consumption to exports.
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The response to the huge expansion of dollars internationally in 1977 and
1978 was mixed. Initially, most major industrial countries intervened to slow
their currencies' appreciation while others intervened only to smooth the dollar's
decline, to avoid the potential inflationary pressures caused by the expansion of
their monetary bases. Countries like Italy and Spain depreciated along wth
the dollar, improving their own competitive positions against strong currency
countries. As the fall of the dollar accelerated, European countries generally
a bandoned the support operations, in effect trying to insulate themselves from
the inflationary pressures being generated in the U.S. economy.
The developing countries, on the other hand, have mainly depreciated against
the dollar, seeking continued high nominal growth rates at the cost of accelerating inflation. Many developing countries including several Asian countries,
have taken the opportunity afforded by capital outflows from the U.S. to increase
their long-term borrowing. An excess supply of dollars has allowed countries to
borrow on better terms regardless of their domestic situations.
These countries are acting with somewhat the same motivations as nonfinancial corporations and households in our domestic markets. Like domestic
borrowers, foreign borrowers of dollars base their decision on the expectation
that continued inflation in the U.S. will progressively reduce the real burden
of the debt repayment.
Higher long-term borrowing by these countries carries with it an increase
in their debt service requirements which is not necessarily offset by higher
export revenues. Itis one of the ironies of the current situation that our country,
which professes great concern about debt service problems in developing countries has pursued policies that have bad the direct result of encouraging higher
rates of debt formation.
Thi s should be a point of fundamental concern. Our domestic insta bilityinflation-has contributed to external instability in the form of capital outflows
and payments imbalance. There are not separate domestic and foreign dollar
markets. There is only one dollar market, and we should not be surprised to find
that excesses that are developing domestically are simultaneously emerging in
the international arena.
THE DOLLAR "RESCUE" AND ANTI-INFLATION POLICIES
Expectations of double-digit inflation domestically were matched by the
precipitous fall of the dollar on foreign exchange markets. As October progressed, external financial instability spilled over into domestic financial markets.
The bond market weakened, and the stock market sagged. This was the uncertain
environment which the Administration attempted to address with the October
and November fiscal and monetary measures.
There are five dimensions to the Administration's program. •
Moderate reductions in the budget deficit during the current ,fiscal year and
the next,
Wage and price guidelines intended to dampen price expectations,
A commitment to deregulation and increased competition,
Higher interest r::ites, and
More aggressive U.S. intervention in the foreign exchange markets.
The fiscal policy proposals-to reduce the deficit to $39 billion in FY 1979
nnd to $30 billion in FY 1980--are simply inadequate. They do not stem the rise
in government spending. They will not reduce the total of government pressures
on the credit markets. The reduction in the deficit at the Federal level will be
dwarfed by the swing towards deficit in the aggregate operating accounts of the
state and local levels.
What is not recognized in these moderate reductions is the importance of
changing expectations. Until a major shift in government expenditure policies
is broadly perceived, there is little likelihood that minor reductions in the
deficit will play any role in restoring confidence in government or in our ability
to pursue policies directed towards price stability.
This is equally true of guidelines. Whether voluntary or mandatory, they do
not enioy a distinguished track record either here or abroad. Controls attempt
to alter market behavior. They do not slow the rate of increase in spending or of
money incomes, which ultimately parallel the growth of the money supply. If
money is still pouring into the economy, somebody is going to spend it and
somebody is going to receive it. Guidelines only affect the distribution of the new
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money-that is, they are a device for shifting the burden of inflation. Economic
controls tend to demand irrational individual behavior-to forsake real or
financial protection from inflation-in the interest of trying to lower the overall
rate of price increases.
Regulation is strangling our markets and eroding our effective capacity. Overregulation breeds more regulation to regulate t he regulators. But I am concerned
that Administration sentiments for deregulation are not being translated into
actions, and evidence that for every well publicized deregulation victory there
seem to be three new regulations. I propose a simple test: will there be a meaningful reduction in the number of new pages being added to the Federal Register.
INTEREST RATES
The government's dollar support program included a percentage point increase in the discount rate and some tightening of the federal funds rate. I
have -a lready suggested in effect that high interest rates are not necessarily
synonymous with tight money. Since both demand and supply curves determine
the price of money, high nominal interest rates can be caused by demand outpacing steadily expanding supply. The increase in the discount rate at least
validated market pressures and allowed interest rates to align more closely
with inflationary expectations.
The new monetary targets for Ml (2 percent to 6 percent) for the hybrid
aggregate Ml+ (5 percent to 7½ percent) lower the upper bound on Ml growth
by one half percentage point. But the new approximation to "transactions"
balances, Ml+, now has a growth target even higher than the range formerly
used for Ml ( 4 percent to 6.5 percent).
As you are well aware, Mr. Chairman, the credit markets now scan every
nuance of our monetary policies. They have developed an extraordinary sensitivity, as manifested in the attention paid to weekly money data. This attention
would be frivolous except that in the past we too often have made policy on the
basis of short-term crises. A part of the November 1 promise to the American
people and to the world at large must be evidence of the long-term sincerity of
our commitment to moderate monetary growth. It is far too early to say that
we have made progress in this commitment, and we must realize that we will be
evaluted relative to our past excesses. Our word alone does not carry the
weight it once did.
INTERVENTION
The U.S. has committed itself to more active intervention in foreign exchange
markets. Such operations address symptoms rather than causes and by increasing liquidity in foreign financial systems run the risk -0f increasing inflation
abroad. Moreover, intervention must be viewed in a global context. The policy
of buying dollars in Frankfurt and then selling them in New York through domestic open market operations is inconsistE>nt. Such policies can achieve only
temporary exchange rate stability. The location of dollars-the distinction between domestic and Eurodollars-has little meaning in a world of integrated
and increasingly efficient capital markets.
Exchange rate management cannot substitute for market determination of
exchange r ates except at great risk. Exchange rates must reflect fundamental
economic conditions.
Financial bridging operations basically assume that the exchange markets
are irrational. Massive intervention presumes that markets do not understand
prP.sent or anticipate future economic conditions. However, to m:v mind the
evidence on this score favors the markets and not the intervenors.
The dang-er that the November dollar "rescue" ·o peration may become primarily an international financing operation should not be di~counted. Without the
support of appropriate domestic policies. such an operation cannot nrovide a
lasting basis for dollar strength and the "$30 billion" could be quickly exhausted.
Foreign willingness to import U.S. inflation by supporting the dollar wonld
disappear at the same pace.
DOMESTIC RISKS
A .policy of moderation is not without risks. A much Jrreater risk. however. is
that if policies have not been changed and that in:flation,u:v exnectations continue. while actual inflation risP.~. A cure which appears risky and, potentially
painful, may prove excruciating if delayed.
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we must realize_ that a mo_dest r~cession--:-the "soft landing" conceived by
many forecasters- is not only mcreasmgly unlikely, but also will not succeed in
modifying inflationary pressures. In 1974-75 it proved quite difficult to get inflation down from more than 12 percent · to less than 5 percent; that alone should
serve as a warning of the peril of delay or dilation. It should have proved easier
to reduce price increases from that point to our postwar low of less than 2 percent. But we were seduced by an economic fallacy. We associated high levels of
unemployment with low pres~u.res on P:ices. We believed that the economy was
characterized by an underutihzed capital stock, and were lulled into a false
sense of security even as excesses developed.
The key question remains : Is the US economy headed toward a recession
next year because of the measures adopted in October and November? And the
answer has to be exactly the opposite. If the U.S. economy is headed for recession it is because measures were not adopted before Novemmber. The :importance
of the November decisions is that they began a process of policy adjustment- the
bridge and the promise.
U.K. REVISITED?
Some analysts have compared the current economic and financial situation
in the United States to the situation which existed in the United Kingdom in
1976-and there are similarities. Both the pound and the dollar were under
significant exchange market pressures, suffered from weak external payments
positions, sought international financing arrangements to bridge the economic
adjustment process, and adopted measures to both reduce the public sector
deficits and raise nominal interest rates.
There are other similarities. During 1976 credit demand in the U.K. was
rapidly increasing: private sector demand for sterling liabilities increased at the
same time that the government's borrowing r equirement remained large. Simultaneously, Britain's price performance began to deteriorate• Inflationary expectations began to re-accelerate.
The analogy between the U.K. and U.S . situations has several glaring weaknesses. The Briti-sh economy in 1976 was at the beginning of a cyclical recovery
from its ,deepest post-war recession. Productive capacity was significantly underutilized. Industrial production remained below levels attained three years earlier;
unemployment was rising even while wage pressures increased.
As the British crisis unfolded, both private and official sterling holders sought
to diversify into "stronger" currencies, reinforcing sterling weakness. Major
central banks helped UK authorities resist these pressures through an increasing
level of official intervention.
The government's reaction to the developing instabilities is also interesting.
In June 1976, with sterling under strong pressure-the pound had fallen some
15 percent during the previous three months--the British arranged a six month
bridging loan from the Treasury, and U.S . and European central banks agreed
to finance intervention operations. In July a mini-budget was announced which
included 2 billion pounds in expediture cuts and tax increases (in particular.
an increased surcharge on industry) and in September the minimum lending rate
was raised to 13 percent.
These measures had little effect on the economy and after an August lull
sterling came under intense pressure. Even after the MLR was raised to a record
15 percent in October, the pound remained under pressure arising from capital
outflows and speculative movements in payments leads and lags. Interest rates,
high in nominal terms, were not perceived to be high relative to the prospects
for inflation. Neither ~he exchange 1:1arke~s nor the British people believed_that
he underlving direction of economic pohcy had changed.
t B t by the end of 1976 British authorities announced measures to complement
h u rifer interest rate increases. Strict limits were placed on the level of public
t e ed3:
for both 1977 and 1978, and plans were announced to reduce the rate
~en 1ng
.
expansion.
0 f d om estic I"credit
•es were viewed as being draconian. They would not have been
These ~o ~c~eaningful moderation been accepted earlier. But they succeeded
?cesft~~Ing aexpectations of future policies as a olid J>?litical consensus in supm a f tb e policies developed. It was not an overmght development. hut as
port O
e;eturned. interest rates whi<'h under earlier exJ?ectations seemed low,
confidence d hi"gh Credit demands moderated, the financial markets stabilized
now seE>me
.
t
·
·tal flowed into the coun ry.
a.nd cap1
43-286 0 - 79 - 14
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ALTERNATIVES
I began by suggesting the basic goal of economic policy ought to be sustained
economic expansion. The obvious preconditions are domestic and international
price stability. The test of the Administration's policies is whether they contribute to this goal.
Our economy needs lower, not higher, interest rates. But lower interest rates
require stable monetary policies and controlled government spending. Through
lower spending, the Federal deficit could be eliminated: if the public sector became a net supplier of funds to the economy, then credit pressures on business
and households would ease.
This could be accomplished by an immediate across-the-board freeze of Federal
expenditures. Such a freeze could be implemented in a variety of ways. If outlays
were maintained at FY 1978 levels through the current fiscal year, the Federal
Government would be approaching balance, compared to a presently projected
$40 billion deficit. On the other hand, if expenditures were held at the level reached
at the end of the fiscal year, then the FY 1979 deficit would be on the order of $26
billion. These funds would be effectively returned to the economy, providing substantial relief to the credit markets. Most importantly, an expenditure freeze
would best be accomplished by sharply reducing the federal government deficit.
heretofore accurate assumption that there will be no signiflcnt budget restraint.
A second legislative priority should be to remove the threat of economic controls. The Congress should move quickly to prohibit the imposition of wage and
price controls and to insist on prior consultations before so-called voluntary
guidelines are announced. This is the only way that expectations of "controls''.
can be quieted and the damage caused by such expectations limited.
When these policies are implemented, the conduct of monetary policy will be
made ,s omewhat easier. Reducing the government's heavy presence in the credit
markets would facilitate moderate expansion of the monetary aggregates. A
dramatic spending freeze would demonstrate to a skeptical public the sincerity
of government's commitment to reducing inflation. This would certainly mean
greater structural economic stability and reduce perceived risks of doing business
in the United States. Capital inflows, attracted not by higher interest rates but
by the prospect of lower inflation, would strengthen the balance of payments and
the capital base of the economy.
In short, our domestic policy goals require that the United States avoid a recession. To accomplish that at the present time primarily requires a significant
change in inflationary expectations. Economic policy must induce people to believe that price increases can be reversed, that interest rates are already high.
Secondly, avoiding a recession requires a reduction in credit demands which
would best be accomplished by sharply reducting th{' federal government deficit.
The alternatives-lost real output, structurally higher inflation and less
capacity over the long term-should make the policy choice extremely easy.
CONCLUSION
My analysis of the basic condition of the U.S. economy, of the international
credit markets, and the exampl~not a guide, but rather the exampl~f the U.K.
situation, convinces me that:
Markets are behaving entirely rationally. Nothing that we can say will con•
vince the domestic borrower or the sel1er of dolJars that they have been wrong to
react as they have. They require a clear signal, such as a freeze on Federal
spending-a clear and unequivocal sign of new policy guidelines.
Wage and price guidelines cannot play this role. Rather than being a signal of a
change in policy, they are perceived as an attempt to maintain the status quo.
Domestic capacity, physical and financial, such much more strained than many
realize.
To br,eak inflationary expectations in an inflation prone economy will require a
significant departure from past policies.
Representative REUSS. Thank you very much, Mr. Yeo.
Professor Modigliani, welcome.
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STATEMENT OF FRANCO MODIGLIANI, PROFESSOR OF ECONOMICS
AND FINANCE, MASSACHUSETTS INSTITUTE OF TECHNOLOGY
Mr. MODIGLIANI. I regret that my commitments have made it impossible to turn in a prepared statement.
The purpose of the hearings, as you have announced, Mr. Reuss,
is that of examining the domestic implications of operations to rescue
the dollar.
I have pondered over these words of yours. I thought there was
something that didn't sound right to me, and finally I understood
why I disagreed with the formulation. Of course, you know I have
great respect for your thoughts, but I found in it something that
needed reformulation.
The reason is that there are two meanings to the words "rescuing
the dollar." One is rescuing the external value of the dollar and the
other is rescuing the internal value of the dollar, that is, its purchasing power. Now the way you presented the question was as though we
were going to discuss how a set of gimmicks, which were designed to
salvage the external value, were going to offset the domestic situation.
It seems to me that these two problems cannot be separated, since
the external value impinges on the internal value and the internal
value impinges on the external value. It is in fact quite clear that a
major determinant of the external value of this dollar is its internal
value, through the so-called purchasing power parity principle.
But it is also clear that the external value impinges on domestic
inflation. As a matter of fact, I understand that Mr. Schultze in his
testimony yesterday morning stated that over the last year the effect
of the IO-percent devaluation of the dollar might be assessed at
something like a 1-percent contribution to the domestic inflation.
Now, 1 percent, Mr. Reuss, as you know, is a gigantic number when
we realize that in terms of what we know about fighting inflation, the
only tool we know that works~not well, but it works nonetheless-is unemployment. And it has been estimated that it might take as
much as a 2-percent unemployment for 1 year to offset 1-percent rise
in inflation. And 2-percent unemployment is roughly a 5-percent
loss of output, which at today's $2 trillion economy is $20 billion.
These estimates, though crude, serve to give an idea of the serious
domestic costs of external depreciation.
Clearly then we must be concerned with it for its reflections on the
internal economy. I would suggest, therefore, that what we really
ought to discuss here is how the operation the administration has
launched recently is going to affect both the external and internal
value of the dollar and the relation between these two.
There is a good reason why one might want to undertake operations
to preserve the external value when there are grounds for thinking
that the extemal value might deviate appreciably from what is economically warranted. We do know, at least most of us agree, that the
market isn't always right. The market may at times overshoot the
mark, and the trouble is that in a system of floating exchanges, the overshooting may, within limits, be self-fulfilling.
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That is absolutely clear in countries in whi0h wages respond
promptly to prices, through indexation or otherwise, such as Italy,
Spain or some of the other European countries like England. It is
easy to show there that if, by mistake, the exchange rate falls 5 percent below the initially warranted level, the result would tend to be a
rise in wages and prices which· would tend to validate the lower exchange rate. This possibility justifies being concemed with the external
value per se.
When we look at the problem this way, I think we must agree that
what the administration was trying to do was primarily to rescue the
domestic value of the dollar, because I think there can be no question
in anybody's mind that today that is the real problem faoing the American economy.
We have had, unfortunately, a serious deterioration in the behavior
of inflation, in the course of 1978. This deterioration, whioh is in the
order of moving from a trend of 6-6.5 percent to something like 8-8.5
percent, unfortunately can be blamed on the administration to only
a moderate extent. I think that the administration is not blameless. I
think many people would agree that there are at least three things for
which the administration can be criticized. First, the minimum wage
legislation, which has been rather expensive in terms of inflation; second, an agricultural policy; and third, the social security policy, that
is, raising social security taxes in the face of a situation where such
a raise unavoidablv contributes to the rate of inflation. And I must
add that it isn't just the administration one should blame, but also
Congress, because all these measures were passed with approval of
Congress.
Another contributing factor has been, as noted earlier, the external
depreciation of the dollar, which perhaps might have been avoided
by more active market intervention, though that is a much more debatable question.
However, though these various factors have contributed some, they
are certainly not the whole story. So one must look at some other exogenous forces such as the behavior of food prices and the behavior of productivity, which have been mentioned by Mr. Schultze.
Perhaps there are other forces which are not fully understood. Perhaps there has been, as Mr. Yeo suggested, some rekindling of the
inflationary attitude or frame of mind. Certainly we •a re -aware of
some speculating exce~es. One can easily point to the housing market
as a place where in many regions clearly prices have been inflated
by what must be described as a speculative bubble.
In the face of these circumstances, whether they are our own doing
or an act of God, there seems to be no question but that we must take
care of bringing down that inflation.
We do not need to discuss here again the question of why inflation
is socially and economically costly. It may well be that in the mind
of the public, inflation appears worse than it really is. On the other
hand, inflation is a lot worse than most economists think or used to
~hink. So there is little question that we must act vigorously to bring
1t down.
To accomplish this task, one can think of many finesses; but, as
mentioned earlier, the one blunt tool that seems in the long run to
work more or less well, is clearly a slack in the economy.
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I think that the -administration's operation should be seen as a conscious attempt to respond to the rising inflation, of which the deteriorating exchan~e rate was a sympt~m and perhaps co~tributing cause
as well by coolmg off the economy m order to reduce mflation.
So I would see the i~crea.se in interest rates primarily -as having a
domestic goal, and not Just that of attracting foreign capital. But then
there is no point in -asking "Are these measures undesirable because
they are going to cool off the economy?"
. The answer is that we should hope they do, because if they don't
then they ~ave bee_n a failure. They were intended ~ do exactly th~
kind of pamful thmg that you, Mr. Reuss, do not hke, and I do not
like, ·b ut which we have to accept as unavoidable at this juncture.
The question still remains however: How much is the right amount
of cooling? That is a delicate question that we couldn't discuss in just
a few minutes here. But let me say that I do object to the fact that
the •a dministration, or: some of its spokesmen, are engaging in a certain
amount of doubletalk. The theme one hears is, "We want to cool the
economy, but also we want to avoid a recession, and you can be sure
there will not be a recession."
Mr. Blumenthal said yesterday, as I understand, that there will be
no recession. There will be a growth of 2 to 3 percent.
Now there -are two possibilities : First, his growth figure may refer
to the change for the whole of 1970 over 1978. If he is talking about
this, as most other people are, then he comes under serious suspicion
of double talk. For a 2 percent year-ove.r-year growth means almost
unavoidably a couple of quarters at minor contraction, or at least
stagnation, and that is what in essence we mean by recession.
On the other hand, if he talks about 2 to 3 percent from this quarter
to fourth quarter of 1979, then we are in bad trouble because that
means we are not cooling the economy. Indeed, that might mean 3.5 to
4.5 percent growth in terms of year over year, which would be excessive in my view in terms of what we are trying to achieve.
I wish the administratci.on would be more precise and I wish Congress would insist on more specific targets. Of course we can't expect
a target to be hit precisely.
But it would be important to know what the administration is aiming for and why, so that we can discuss it and see whether .it is a
sensible number.
There are, of course, other possibilities. There are temptations perhaps to rely on other tools and the usual other tool one talks abou~ is
income policies. I think there is a broad agreement among economists
and thoughtful people that there is no hope in wage and price controls and I can only say that I am very proud that in 1971, a few
months before they were ~nstituted, I testified befor~ this committee
recommending and pleadmg not to _try t hat expenment. lJnfo~unately I was preceded by Ken Galbraith who made the oppos1t.e pomt
and h~ clearly carried the day. .
The troubie with Galbraith 1s that he speaks too eloquently. It
doesn't mean that he is right, but ~e speaks well. (Laughter.]
The administration has been trymg to take a different appro~c~,
th
h O f oluntary more or less voluntary, programs. This 1s
et
athpproac
no
e approachv of prohibition, "Thou shalt not," but the approach
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of the carror·and the stick, the stick being the penalty of procurement
cancellation; and the carrot being the so-called inflation insurance.
I think that it is right for the administration to try these ways out.
They represent a tangible expression of concern and as long as they
are voluntary. I think they cannot do very much harm, and may do
a little good.
Unfortunately, I have real questions as to whether you can succeed with the so-called inflation insurance because it seems to .me the
technical problems involved are formidable. I read recently an article
of Mr. Ullman explaining those difficulties and they are exactly the
same that I have myself pointed to in some writings of mine. I think
there are formidable difficulties, but it is certainly worth trying the
best. But these measures will not do very much.
They will only help if there is slack in the economy. The more the
slack, the more they are likely to help.
The other thing that perhaps I would like to suggest to the Congress is that they keep after another angle. Let's recognize that inflation is with us and we do not know of any way that will get rid oi
it fast. Hopefully with some luck we will be able to decelerate a coupk
of points not too long from now-but it is a long process.
I suggest therefore, that Congress should still give attention to
various measures that will make inflation less painful. One has to
distinguish between two effects of inflation. One is in terms of what it
does to past contracts; the other is what it does to newly entered
contracts.
Now, there is nothing one can do in practice about past contracts.
Inflation, even though perfectly :foreseen from now on will be very
damaging to those who have, let's say, a pension written in the past
in nominal terms. But for those contracts that are newly written
there are things that can be done. As a matter of fact, the recent decision of the administration to allow the thrift institutions to issue
special certificates which carry a market rate is exactly in the direction of reducing the cost of inflation.
One of the great problems has been in the past that poor people
confronted with 7- or 8-percent inflation were only allowed to earn
5 percent on the kinds of instruments that were available to them.
They did not have the means or the sophistication to invest in instruments whose return more adequately reflected the varying course of
inflation.
I still think that stopping at what has been done so far is grossly
unfair because now we are saying if you have $10,000, you can
escape one cost of inflation, but if you are really a small holder, you
are still under the 5- or 5.5-percent ceiling. I think Congress should
give attention by now to the elimination of ceilings. I think now
it can be done with little danger because the S. & L.'s have accumulated
surpluses and are earning enormous profits on the spread between
the mortgage and the ceiling rate.
There are a few other measures which I could mention in discussion
which go in the direction of making inflation less painful: For instance, mortgage design, encouraging mortgage design appropriate
to an inflationary environment. I am not suggesting that we should,
or could, make inflation pleasant-it will never be-because there
are many past contracts and many costs that cannot be eliminated.
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But we should work toward making inflation les:::i co8tly wherever we
can.
I come finally to a couple of questions which you have raised in
your letter. First, the question of the policy mix.
Assuming that the size of the restriction is right, are we achieving
it with the right mix~
It is clear that the mix chosen so far has been leaning heavily on
the monetary policy component. We have basically gone about it by
raising interest rates and reducing the money supply. You can see
in the short run some reason for that. Such a policy does two things,
kills two birds with one stone.
On the one hand, higher intore8t rates improve the dollar situation. Making interest higher does tend to attract foreign capital
and therefore helps the support of the dollar.
Now, I would agree that in the short run, if you are trying to treat
an acute case, that policy might have justification. But in the long
run, as you have hinted, Mr. Reuss, in your statement, this is fundamentally an objectionable policy. In fact, I have been spending a lot
of effort recently complaining about the fact that over the .Jast few
years, since 1974-75, in this country and in the world we are pursuing consistently the wrong policy mix. That is, we have been restricting demand by essentially tighter monetary policy and then
offsetting that by easier fiscal policy.
P erhaps the underlying notion is that monetary policy controls
prices and fiscal policy controls output, so you have a restrictive
p8licy to kill inflation and you turn around and by fiscal policy try
to prevent it from reducing real output. That is nonsense. You cannot
reduce inflation by monetary policy as such. It is only insofar as
monetary policy produces slack that you create that effect.
The result of that policy mix has been that we have ended up by
reducing investment, and encouraging consumption because that is
exactly what that policy mix does. W e end up with a policy which,
on the one hand, reduces investment and then to compensate taxes
and expands consumption. And then, we complain that investment
has not recovered.
Of course it hasn't, and though this reflects in part another pervasion,
it has paradoxical effects of inflation; namely, that it has seriously
depressed equity values. And a depressed stock market in which
firms sell typically way below their reproduction costs discourages
investment both by raising required yields and by shutting off one
possible source of financing.
The issue of why the stock market is affected by inflation is the
subject of a study of mine which will be published soon, and which
w.ill show that the fundamental reason why this happens-against
what everybody thought should happen-is that investors are not
able to value firms correctly in a world of inflation.
The same difficulty may lead firms to raise yields required of new
investments. To conclude, I quite agree with you that we ought to
redirect our policy toward tighter fiscal policy and looser monetary
policy and that in addition ins.ide the fiscal policy we should emphasize the income taxes and reduce the social security taxes, that being
a step which for a given amount of collection does tend to reduce
inflation.
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I think I have exceeded my time and therefore I ~ill not try_ to
go into the one of intervent~on,_ but I am sure there w.1.ll be occasion
in the course of your quest10nmg.
Thank you.
. . .
Representa~ive REUSS. rhank you~ Mr. Mod1ghan~. .
Starting with the pomt you raised last, yo~ md1cated that ~he
country would do better with a .somewhat easier J?Onetary _policy
and a somewhat tighter fiscal policy because that m.1.x would mduce
toward greater capital investment, which would be a healing deterrent
o:f inflation. That view, it seems to me, is probably shared by other
members of the panel.
Mr. Pierce, you almost said the same thing. Would you agree~
Mr. PIERCE. Yes, I do with one caveat ince we ar ~i cu i!lg the
real world of policy; provided we are assured that with easmg of
monetary policy we get a tighteni~g in fiscal policies. I think th~re
is a tendency to put more emphasis on loosenmg the monetary s_1de
and then forgetting to tighten the ~cal. One o:f the reasons _I think
so is that much of the burden of pohcy .falls _on the Fe~. It 1s ID:uc_h
easier for the Fed to get away with a t.Ighenmg of pohcy than 1t 1s
for Congress and the administration.
.
.
.
It is politically easier. So the_re is a danger, I t~1nk, that m trymg
to change the mix, you don't Just change the mix, you change the
level of policy. But given that qualification, yes.
Representative REuss. For this discussion at least, changing the
mix means changing the mix.
Mr. PIERCE. That is correct, if in fact we are assured we will change
the mix. From an academic point o:f view, yes, if you change the mix,
it should be in favor o:f more tightening o:f fiscal policy and discouraging consuming, as Professor Modigliani said, I agree.
Representative REuss. Do you agree .with this general proposition,
Mr.Hymans~
Mr.HYMANS. Yes,sir,Iwould.
Representative REUSS. And Mr. Yeo~
Mr. YEO. I agree with the proposition. I would not characterize
monetary policy as tight at any time in the last 18 months-and I
am not really certain that it is tight now. Interest rates are high because it has not been tight.
Representative REuss. Let me now ask what should be done about
it~ Is the mix that emerges :from the November 1 package plus the
subsequent leaks on budget policy for fiscal 1980-should that be
changed~ Specifically, on the basis of what we now know, the administration is projecting a budget deficit of $30 billion or les for fiscal
year 1980. Should that deficit be lowered to $25 billion or something
less~ And i:f that goal is achieved, should it be an occasion for a modest
untightening of money~
Mr. HYMANS. A few comments, Mr. Reuss.
One can't, as you well know, legislate the size of the deficit. One
affects tax rates and one affects the level of Government expenditures
and t~en through _that i!1ter~ention in th economy the deficit changes.
So if we were m a s1tuat10n where we were quite certain that the
economy was overheated, we might say that we would cut Government
spending. That would, of course, slow the economy down. There would
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be a partial loss of revenue. The deficit would, of course, decrease not
by as much as the reduction in Government spending, and that would
be an appropriate measure to undertake if the purpose were to slow
the economy down.
I think, myself, that the mix of policies we have now in terms of the
tax rate structure, the level of Government spending, and monetary
policy, is for long run purposes too tight on the monetary side; though
I think that the tightness on the monetary side, as I indicated in my
testimony, is probably appropriate for a time.
But as I urged in my prepared statement, I think that by the middle of next year we ought to be concerned about that tightness of monetary policy if, in fact, it is really there. There is, as you well know, a
set of strange events going on which makes it very difficult to disentangle what is happening. There seems now to be inconsistent movements between the money stock and the monetary base. Assumig that
that is a matter of short-term perturbations, a ll of which are a part
of the underlying tightness of monetary policy as announced in early
November, then I think we are going to find that monetary policy
is a little too tight when we start to approach the middle of next year.
That is when I would urge that monetary policy become easier. I
think that would be the correct policy mix, as opposed to keeping
monetary policy where it. is and loosening fiscal policy. I think it is
the loosening of monetary policy that should be used as we get to the
middle of next year.
Representative REuss. In the event that we run into a recession or
such a slowdown in growth as to-Mr. HYMANS. Yes; there would be a number of goals, all of which
push us in the same direction. If we run into a situation similar to
what I projected and what Jim Pierce projected, that we really do have
a couple of quarters or virtually no growth or almost no growth, essentially something indistinguishable from a mild recession. Then our
goals on the international side will also be well served by that set of
events so that we would want to stop the economy from winding up
in a situation of further substantial increases in unemployment, and
at the same time we would have had a major impact in the right direction on the international value of the dollar, we would be on tr!1-Ck
toward domestic improvement of the dollar and that would be the time
to ease up on monetary policy.
Representative REuss. But that time is not now as far as you are
concerned ?
.
Mr. HYMANS. No; I think that time is not now. I think a little coolmg
.
off is important at this point.
Representative REuss. What do you have to say, Professor Modigliani?
.
.
..
· , ·
Mr. MooiGLIANI. I quite agree with this pi:oposit10n. I d~d~ t give
any measure but I think that in the present circumstances aimmg for
an increasing unemployment, which might get us somewhere not f3:r
from 7 percent, does not strike me as exagger3:ted. In ~ther_ wordsz it
might be on the hio-h side, but we ought to go m tha;t direction. With
this · policy I think we might get there, an~ so I would sa_y, on the
whole that the administration program, which means a mamtenance
of cur~ent posture for a while, is justified. .
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When the time comes to turn around in a sense that we try to prevent further slow down, then would be the time to make the decision
not to cut taxes, but to ease monetary policy.
Y oli see, on every previous occasion at the trough when we had higher
unemployment, we turned around and cut taxes. Some cut of taxes is
appropriate just to keep them constant in real terms, but only a limited
amount. But fundamentally at that point a decision should be made
that expansion should come from easing monetary policy.
Representative REuss. Mr. Pierce, would you address yourself to
the policy mix question and to the situation as we now know it in which
the administration appears to be aiming for a budget deficit of $30
billion or less, and in which monetary policy is at the stage where
short-term interest rates have gone up about 2 percentage points
this last summer; where M1 and, I guess, M2 have been flat for a month
or soi If I am misstating the way things are, correct me.
Anyway, is that all right for the moment or do you think that one
.
needle valve or the other should be changed i
Mr. PIERCE. It is a little hard to answer those questions. Given what
has happened to date, I think the policy-the short-term policy moves
that the administration and the Fed took were probably appropriate.
The Federal Reserve did announce tightening of policy and then
accomplished it. If you measure tightening of policy either in terms
of growth of monetary aggregate, which slowed markedly even though
inflation is quite high, or measured by short-term interest rates, by
either measure, I think most people would agree there has been a
tightening of policy.
Maybe it is not as tight as some people would like to see, but I
think the direction is clear.
I think the fiscal measures that the administration has announced in
terms of spending are again appropriate, but it is always hard to
translate deficits into anything that is real. But if one tries to translate that deficit projection into what the growth in Government spending would be in real terms, it would have to be really quite low, about
2 percent or less for the year. That is not rapid Government spending
at all.
So I think there has been a tightening on the fiscal side and on the
monetary side at the same time.
Now, my answer was in terms of where we are now. If I had my
druthers, I would have preferred to see a more gradual expansion in
the economy over the last year to year and a half. I think that there
was not enough concern about inflation for quite a while. There seemed
to be the belief that somehow we got the gain in production and employment for free; that it didn't cost any more inflation.
Well, we have been through that argument before. It takes a while
for inflation to accelerate again after the economy gets close to ca•
pacity. There have been some bad events, but we ought to be use to
bad events by now. We seem-to get them all the time. We might as well
assume that food prices are going to rise, oil prices are going to rise
and so on, rather than say it is nof any of our fault, "it is the dirty food
prices."
So I think that the policy now is probably appropriate given t~at
is it was not as restrictive as I would have liked to have seen in earlier
months. But ~ince it was not tight, I think appropriate action was
taken.
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In terms of where we go from here, I agree with Professor Modigliani than an ideal time to change the policy mix would be one where
it isn't necessary to raise taxes, and cut expenditures, but rather, not
to cut taxes. That is politically must easier to do; to reduce interest
rates and keep taxes higher than they would otherwise have been.
That will in and of itself change the mix. But I want to just conclude
by saying the policy mix question is a longer run matter.
For any 6-month period I don't think policy mix in terms of productive capacity change makes any difference. Over the longer term
it surely does and I think the Congress and the administration have
to worry about that mix, and forego the temptation that if the economy
does go into recession, of trying to be_stimulative from fiscal policy,
and also avoid the temptation of being too stimulative with either
·
policy.
It is unpleasant, but I think that the one way we know that works
fairly well of reducing inflation is to have excess capacity in the economy, unemployed resources, including people. That is unpleasant, but
the other measures don't seem to work at all.
I think we just have to live with .that, and not try to get back to
full employment very rapidly. I think if monetary policy is highly expansionary in 1979, inflation expectations will go very high indeed.
.
I will stop with that.
Representative REuss. So far-before we get to Mr. Ye~the consensus of those who have spoken is that if the employment production
situation worsens, get your kicks out of easier money rather than out
of reducing taxes or increasing expenditures~
Mr. MoDIGLIANI. Yes.
Mr. PIERCE. Yes.
Representative REuss. Is that it~
Mr. MomGLIANr. That is exactly the message.
Mr. PIERCE. Yes.
Representative REuss. Mr. Yeo, I want to ask you separately about
why you think that money isn't tight now. But, address yourself, first,
to the mix question. Do you agree or disagree with the proposition as
it comes to you~
Mr. YEo. I would like to formulate it a little bit differently, Mr.
Reuss. I think that in a longer run sense it would be desirable to operate with a much different budget configuration. We ought to be in
surplus now. We ought to be running a surplus, an actual surplus. Not
the full employment surplus, because I don't know who can calculate
full employment.
Representative REuss. If we ran a surplus, which would mean reducing the projected deficit by another $30 billion, could we then use
easier money than is now the case~ You say it is-Mr. YEo. Well, Mr. Reuss-Representative REuss. You say it is not tight now~
Mr. YEO. If we ran a surplus, as a matter of fact, if we even were able
to legislate actions that would appreciably reduce the deficit-not by
$3 billion-and I know from the standpoint of Congress and the executive, $3 billion is an enormous amount, I have been on that side, we
would change inflationary expectations.
The key thing about the administration's program to date is that
it isn't working in that respect. All of the evidence that we cansee in
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financial markets or in real markets suggests that inflationary expectations have not abated. Rather, they continue; and according to some
evidence, have even heightened. An appreciable reduction in the deficit
now-not in fiscal 1980, but in 1979, would lessen the price pressures
in the economy, including interest rate pressures. So that my answer
is, first, I have some question about whether the program is working.
I am concerned-there is plenty of time left-but I am concerned.
Second, longer run, I would certainly support a change in policy mix.
And now I am at your mercy, Mr. Reuss, you want to know why I
think monetary policy is not tight.
Representative REuss. Yes. Is it because the monetary aggregatesexcept during November-are still pretty frisky i
Mr. YEO. I think it-Representative REuss. I don't quarrel with the observation. I just
wonder what you based it on.
Mr. YEo. The monetary base, is one key component, but since reserve
requirements lag 2 weeks, it has to be used very carefully. Four weeks
is not a long enough period of time £or me to say monetary policy
has become tight or has not become tight. All I know is that it has not
been tight.
We have had ·a very frisky economy in November, quite spritely.
And if our interpretation of what is going on, what is producing this
rather animated character is correct, we would be very surprised if
the result aggregrates, M1, Mi-plus, M 2 , over the longer course show
a marked dooeleration.
Representative REuss. What do you and your associates-whoever
the "we" is-who is the "we," by the way?
Mr. YEo. Well, I have Alan Stoga and David Woolford here, some
of the people in our economics department.
Representative REuss. All right, fine.
What are these elements in the economy which you discerned during
November?
Mr. YEo. First of all, consumer expenditures have turned out to be
a little firmer than we had anticipated-quite firm, as a matter of fact,
You have seen the retail sales numbers for the month. It is an estimate,
as we know. The automobile market has been a little firmer than we
had anticipated.
If you are starting ot change expectations, the automobile market
is the place you look £or the first signs. Our anoodotal evidence as
bankers from retailers suggests that things really haven't changed as
much as some had imagined they would when these initiatives were
announced.
New order data suggest that business ordering continues at a very
rapid clip, so that if you take all of these little pieces of information,
and look at them as we do, we come to the conclusion that the economy
really was moving quite nicely, in a very narrow sense, in November
and into December.
Representative REuss. Along those lines, you said earlier this afternoon that you discerned tendencies toward consumer-you didn't use
the word ''hoarding"-but consumer purchasing, which looked like
a hedge a.gainst inflation.
Now, heaven know~at least every/body knows-that there has
ooen big inflation hedging in the purchase of land and homes and
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antiqu_es and jewelry. Do you discern something similar in the case
of neckties, Kleenex, handkerchiefs and stereo tapes~ You may. I am
just asking.
Mr. YEO. I think I do.
Representative REuss. What is going on i
Mr. YEO. As you suggest, Mr. Reuss, it is much easier to make the
oase for items that are finite in supply or at least are presumed to be.
But I think that there has been some acceleration elsewhere. You know,
the difficulty is that the really meaningful thing isn't whether there
aotually has been, but whether there is a desire to have accelerated
expenditures ex ante; whether people have ex ante shifted their savings
pattern. I think that they have.
Mr. HYMANS. Mr. Reuss, could I comment on the recent state of the
economy as indicated by recent evidence i Let me, if you wouldn't mind,
begin with a story told by my college professor, Tom Juster, director
of Institute of Social Research at the University of Michigan. This
involves his listening into one of the latest telephone surveys being
made to try and tap into the consumer mood.
The interviewer was asking a woman respondent over the phone
whether this is a good time to buy, and he asked first about homes, and
he said, "Tell me, is this a good time to buy a home i" And the woman
said, "A home i Prices of homes are outrageous now. They have gone
up so far so fast nobody can understand it."
And ~he interviewer said, "But is this a good time to buy a home i" .
She said, "It is a wonderful time to buy a home. Prices will be even
higher next year."
·
He said, "What about cars i" She said, "You realize my husbruid
looked all over town and we can't find a car for under $9,000. The
prices of cars are out of sight." He says, "Is this a good time to buy
a cad" She said, "It is a terrible time. Look how high the prices are."
Well, I think that indicates a good deal about what is happening.
Many consumers are totally confused about how to behave in the face
of inflation, surprises about inflation, and variations in the rate of
inflation from time to time.
So we see some buying that surely is buying ahead of anticipated
price increases and we see some evidence of resistance to high prices
and behavior reflecting the possibility that one can simply make do
without in the face of these high prices.
·
Regarding automobiles, for example, the issue ns to whether all
sales are running strong now, I contend they are not running strong.
Sales rates have come down in -the recent 10-day period and what
would one expect if the car market is about to soften, as I believe it
has i One would expect that, first, the fringe buyers decide, no, this is
not the time to buy a car.
Not the re~lar buyers, not the every-other-year-almost-like-clookwork buyers, but the fringe buyers. One does notice American Motors
doing even worse than it has recently been doing, Chrysler doing worse
than it has been recently been doing, Ford doing a little worse than
it has recently been doing and General Motors hanging in there. That
is the kind of preliminary buying pattern one typically sees, not if
car sales plummet to a 9 million car rate, nobody predicts that. But
if you say car sales will drop off from an 11.2 to 11.5 rate to something in the 10.5 million range, that is the kind of preliminary pattern
you would see.
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Further, nobody was expecting that the fourth quarter, the one we
are in now, is going to show a half percent growth rate or 1 percent
growth rate, and we are getting data which seem to be consistent with
a 2.5 to 3 percent growth rate in the fourth quarter. That is pretty
much in the standard forecasts which contain within them the further
results that the growth rate should go down in the first quarter and
down further in the second qua.r ter.
So far as I am concerned, I see the- kinds of straws in the wind that
I would expect to see. I guess that is true of all of us. Given what we
expect to see, we can easily interpret what is happening on the current
scene in a manner pretty much consistent with what we expect to see
as we go further out.
Mr. YEo. Speak for yourself.
Mr. HnrANS. I just did.
Representative REuss. These straws in the wind-if I understand
you correctly-are straws which indicate greater consumer resistance
to buying than has been true in the past~ While consumers are still
buying homes because they think they are going to rise, they are more
marginal-Mr.HYMANS. On some other things .
. Representative REuss [continuing]. On things th,t have ·a sho~ter
hfe than a home.
/
1
_
Mr. HYMANS. On some things, yes.
Representative REuss. Is there any correlation between the shortness of the life of goods and the consumer's desire to buy~
Mr. HYMANS. I am afraid I am not prepared to be that scientific
about it. The evidence is very difficult to handle.
Mr. YEo. Mr. Reuss.
Representative REuss. Yes.
Mr. YEo. In the first 10 days through December, domestic automobile sales were at an 11 million unit annual rate. I think that was the
highest rate since May.
Another straw in the wind was November's retail sales and the revision of retail sales in October. October's retail sales were revised upward and November came in at a very strong, very substantial increase. Those are the· "straws in the wind" that we see, and I think
it really is not too germane, because in responding to your question
I also said financial attitudes and expectations had not changed and
clearly in the long-range bonds market-and I think in some other
financial markets-inflationary attitudes have not changed appreciably
since the announcement of the package.
Representative REuss. Well, I resort to the attitude of one who
doesn't intend to do anything about it. It is a very fluid situation.
I don't see any reason for big policy changes based on these straws
in the wind because they certainly are straws at this point, though I
have learned a lot from hearing about them.
I want to thank you all for your very helpful contributions to our
hearing. They will be considered extensively by this committee and
we are grateful to the outstanding nature of your discussions.
Thank you.
[Whereupon, at 3 :29 p.m., the subcommittee adjourned, subject to
the call of the Chair.]
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