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November 10, 1978
N ew Economic Policy
The policy events of October-November 1978 are the most dramatic
that have occurred in the national
economy since the New Economic
Policy was unveiled in August 1971.
The background was similar in the two
cases, with inflation undermining the
strength of the national economy and
permitting a worldwide attack on the
world's leading currency. Considerable
dissimilarities can be seen in the policy
actions taken to meet these problems,
however, with the actions of 1978 being more market-oriented and more
appropriate to the inflationary circumstances than those taken in 1971. This
is a hopeful sign for those who prefer
textbook solutions to textbook economic problems.
The first phase of the New Economic
Policy (1978 version) began in late October, when the Administration announced a set of wage and price
guidelines, designed to put a 7-percent
lid on annual wage increases and (essentially) a 6-to-6 1/2 percent lid on annual price increases. The Administration also reiterated its earlier plan to
cut the Federal budget deficit to about
$39 billion in fiscal 1979 and about $30
billion in fiscal 1980. The new program
failed to win any plaudits in Wall Street
or in overseas markets, judging from
the continued declines in stock prices
and in the value of the dollar. Thus,
the other shoe had to be dropped on
November 1, with a $30-billion package of dollar-propping measures and a
tighter anti-inflation credit policy.
What happened
In announcing these moves, the Treasury and the Federal Reserve said that
the fall in the value of the dollar
exceeded any decline related to fundamental factors, is hampering progress
toward price stability, and is damaging
the climate for investment and
growth.* The wide range of policy
actions included:
* A rise in the Federal Reserve's discount rate from an already high 8 Y2
percent to a record 9 Y2percent;
* An additional 2-percent reserve requirement on large time certificates,
forcing banks to post about $3 billion
more in required reserves;
* An expansion of credit lines (swap
arrangements) with foreign central
banks, giving the U.s. as much as $15
billion worth of marks, yen and Swiss
francs for use in buying dollars in the
open market;
* The sale of $2 billion worth of International Monetary Fund special drawing rights (SDR's) to the governments
or central banks of Germany, Japan
and Switzerland;
* A temporary withdrawal of $3 billion
worth of marks, yen and francs from
the U.s. reserve account at the International Monetary Fund;
* The sale in overseas markets of up to
$10 billion worth of Treasury securities denominated in foreign currencies;
and
* An increase in Treasury gold'sales
henceforth to at least 1.5 million
ounces a month.
The Fed's supplementary reserve requirement on large CD's should make
it more costly for banks to raise funds
through that medium, and should induce them to go to the Eurodollar
market instead. The higher level of domestic interest rates should attract an
(continued on page 2)
inflow af fcn:;ign funds <1nd<1bJ.ckf!c'l.'
of U.5. funds. Again, the tighter reserve position and the higher level of
interest rates should make it more difficult for banks to participate in covered-interest arbitrage through
forward sales of dollars, either on their
own account or by providing funds to
their overseas branches or foreign
commercia! banks. The other actions
should also have significant effects. For
example, the new level of gold sales,
which amounts to roughly 60 percent
of all newly-mined production, could
boost
exports by about $4 billion a
year.
u.s.
·dgmreU'e!rnu
COYilUU'OH§
Substantial differences are evident between the economic environment of
mid-1971 and the environment of late
1978. Then, the economy was in the
early and still uncertain stage of a
cyclical recovery; today, it is in the advanced stage of the longest and
strongest peacetime expansion of the
past generation. Then, consumer
prices were rising at about a 4-to-S
percent annual rate; today, prices are
rising at about twice that rate. And in
1971, the attack on the dollar oc- .
curred within a framework of fixed exchange rates, whereas the 1978 crisis
occurred within a system of flexible
rates, with the dollar (on a tradeweighted basis) already 23 percent below its early 1970's value and weaker
by far against the stronger currencies.
The policy mix differed substantially
between 1971 and 1978, partly reflecting the different economic environments, but also reflecting policymakers' determination not to repeat
2
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Administration in 1971 imposed a rigid
set of wage and price controls, and
meantime stimulated the economy
with a broadly expansionary set of
policies. This time the Administration
opted for voluntary wage/price
lines - without the bureaucracy and
(above all) without the rigidities implicit
in mandatory controls - and meantime moved to restrict rather than stim. ulate the economy.
There are precedents for both types of
approaches. The mandatory approach has been tried frequently
throughout human history, dating at
least as far back as Hammurabi in 1750
B.C. In 20th century America, controls
were imposed in three wartime episodes - \!Vorld War I, World \iVar II
and Korea - and in the first two of
those periods the control period ended in an infiationary blow-off. The closest parallel to the present set of
guidelines,· however, is the set of measures developed in the early 1960's to
restrain cost-push inflation. Those
measures eventually came to be
based upon a specific standard for
average wage increases - 3.2 percent, or the five-year moving average
of output per hour. The present wage
guideline of 7 percent, however, compares with a much lower level of productivity, which has risen in the past
decade at only about half the rate of
the preceding period. This suggests
that cost inflation could continue to be
severe in the absence of a nationwide
drive to boost productivity.
fiscal, monetary differences
Fiscal policy now promises to take a
different direction from the path taken
in 1971. Back then, policy had already
turned stimulative when controls vvere
imposed, with a rise in the Federal
budget deficit from $3 billion in fiscal
1970 to $23 billion in fiscal 1971. Policy
then remained stimulative in the following fiscal year, with another $23billion deficit, which created a great
deal of inflationary tinder whose presence was masked by the existence of
price controls. But this time an upsurge of inflation has already occurred,
abetted by a series of massive deficits.
The Administration has tried to combat
that problem, however, by reducing
the deficit from $49 billion in fiscal 1978
to $39 billion in fiscal 1979, and then
to $30 billion or less in the following fiscal year.
Monetary policy was stimulative in the
year prior to the August 1971 imposition of controls, with an 8-percent increase in the M 1 money supplyreflecting the upsurge in deficit financing during that period. Over the following year, M 1 increased only about
5 percent, but the rise in real terms
was greater than the year-before increase, because of the slowdown in
prices during that price-control period.
In 1978, the M1 money supply again
has shown an 8-percent year-to-year
increase, matching the sharp rise of
the 1970-71 period: (Still, that represents a relatively smaller increase, given the fact that prices recently have
been rising at double that earlier
pace.) The Fed's attempt to lower the
recent rate of money growth should
be strengthened by the latest tightening moves, which in the context of rising credit demands have helped boost
interest rates to record levels. For example, the prime business-loan rate, at
10% percent, is now 4 V2percentage
points above its 1977 low.
3
On the international front, strong differences can be found between the
1971-style and 1978-style actions.
Policymakers in the former case accepted a 10-percent dollar depreciation, but then tried to maintain a
jerry-built structure of fixed exchange
rates for another year or more, until
this effort to maintain the Bretton
Woods system finally collapsed. That
period exhibited all of the hallmarks of
a fixed-rate system at its worst. But the
1978 period, at least to some observers, has exhibited some serious failings
of a flexible-rate system, with the dollar
appearing to be in a free fall and with
an old-style financial pank:threatening
to erupt. Also, in the Administration's
view, the problem has been aggravated by the existence of roughly $500
billion in foreign hands, compared to
the $360 billion in the U.s. (M1) money
supply.
Policymakers realize that market
vention is no final solution to the problems of the dollar, but such a policy
permits the line to be held while basic
measures are undertaken to cure the
inflation that underlies all our problems, domestic and international alike.
Again, there is no evidence of any attempt to prop up a failing system, as
happened in 1971. On balance, then,
the policymakers of today deserve a
reasonably good grade for addressing
real problems with realistic solutions
- unlike their counterparts of 1971,
who swept problems under the rug or
even adopted counterproductive solutions whose effects still bedevil our
lives.
William Burke
"
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lFlElDrERAl
RrESrEiRVlE
DISTRaCT
(Dollar amounts in millions)
Seiected
ami iUabi!ities
lali'ge Commeli'dau
Loans (gross, adjusted) and investments*
Loans (gross, adjusted) - total
Security loans
Commercial and industrial
Real estate
Consumer instalment
U.s. Treasury securities
Other securities
Deposits (less cash items) - total*
Demand deposits (adjusted)
U.s. Government deposits
Time deposits - total*
States and political subdivisions
Savings deposits
Other time deposits:j:
Large negoriabie CO'S
Weekly A.verages
of Daily figi!Jli"es
Member Banl( fReserveiPosition
ExcessReserves(+)/Deficiency (-)
Borrowings
Net free( +)/Net borrowed (-)
federal funds-Seven large Banks
Interbank Federal fund transactions
Net purchases (+ )/Net sales(-)
Transactions with u.s.security dealers
Net loans (+)/Net borrowings (-)
Amount
Outstanding
10125178
119,152
96,206
1 J22
28,037
33,738
17,975
8,559
14)87
114,294
30,683
959
80,786
6,564
31 J69
39,540
-19,090
Week ended
10125178
+
Change
from
10/18178
Change from
year ago
Dollar
Percent
+
+
+
+
+ 1 7)91
+ 16,812
- 220
+ 3,919
189
164
186
139
107
53
32
57
394
- \395
+ 531
+ 1,196
+ 73
- 115
+ 1,038
+ 945
17.09
21.18
11.33
,16.25
28.50
28.27
+ 9.65
1.19
+ 15.57
+ 6.50
+ 236.49
+ 18.95
+ 22.92
+ 0.02
+ 37.21
+ 79.47
+
+
+
+
+
+ 7A82
+ 3,962
+ 753
-
+
+
+
+
+
+
+
+
Week ended
10/18178
27
25
52
+
74
36
38
+
455
+
1,629
371
+
93
174
15,400
1,874
674
12,869
1,224
7
10,722
8,453.
. Comparable
year-ago period
+
+
26
8
18
+ 1,315
+
416
*Includes items not shown separately. :j:lndividuals, partnerships and corporations.
Editorial "Comments may be addressed to the editor (William Burke) or to the author ••••
Fli'ee
of this and other federal Resente publications can be obtained by caning or writing the Public
u!I1lformaiiol1
Section, !Fedell'aiReserve Bank ot Scmfll'al'u:i§co, P. O. BOl{ 7702, San fl/'OiliUds(O 94120. Phone
(415) 544-2184.
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