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THE FEDERAL RESERVE SYSTEM
AFTER FIFTY YEARS
HEARINGS
BEFORE T H E
SUBCOMMITTEE ON DOMESTIC FINANCE
OF THE
COMMITTEE ON BANKING AND CURRENCY
HOUSE OE REPRESENTATIVES
EIGHTY-EIGHTH CONGKESS
SECOND SESSION
ON
H.R. 3783
A B I L L TO P R O V I D E FOR T H E R E T I R E M E N T O F F E D E R A L R E S E R V E
BANK STOCK, AND F O R O T H E R P U R P O S E S
H.R. 9631
A B I L L TO INCREASE TO 12 T H E NUMBER O F M E M B E R S OF T H E
F E D E R A L R E S E R V E BOARD, AND FOR O T H E R P U R P O S E S
H.R. 9685
A B I L L TO AMEND T H E F E D E R A L R E S E R V E ACT TO P R O V I D E T H A T
I N T E R E S T R E C E I V E D BY F E D E R A L R E S E R V E BANKS ON OBLIGAT I O N S O F T H E U N I T E D STATES SHALL B E COVERED INTO T H E
TREASURY AS MISCELLANEOUS R E C E I P T S , TO A U T H O R I Z E A P P R O P R I A T I O N S F O R T H E E X P E N S E S O F T H E F E D E R A L R E S E R V E BANKS
AND T H E BOARD O F GOVERNORS O F T H E F E D E R A L R E S E R V E
SYSTEM, AND F O R O T H E R P U R P O S E S
BLR. 9686
A B I L L TO R E Q U I R E T H E PAYMENT O F I N T E R E S T ON C E R T A I N
F U N D S O F T H E UNITJED STATES H E L D ON D E P O S I T IN COMMERCIAL
BANKS, TO P R O V I D E F O R R E I M B U R S E M E N T O F COMMERCIAL BANKS
F O R S E R V I C E S P E R F O R M E D F O R T H E U N I T E D STATES, AND F O R
OTHER PURPOSES
H.R. 9687
A B I L L TO AMEND T H E F E D E R A L R E S E R V E ACT AND T H E F E D E R A L
D E P O S I T INSURANCE ACT BY E L I M I N A T I N G T H E P R O H I B I T I O N
AGAINST T H E PAYMENT O F I N T E R E S T ON DEMAND D E P O S I T S
H.R. 9749
A B I L L TO AMEND T H E F E D E R A L R E S E R V E ACT TO P R O V I D E F O R
F E D E R A L R E S E R V E S U P P O R T O F GOVERNMENT BONDS W H E N
M A R K E T Y I E L D S EQUAL OR E X C E E D 4 % P E R C E N T
VOLUME 2
FEBRUARY 11, 25, 26, 27; MARCH 3, 4, 5, 9, 10, 11, 12 AND 25, 1964
Printed for the use of the Committee on Banking and Currency
28-680
U.S. GOVERNMENT P R I N T I N G O F F I C E
WASHINGTON : 1964
COMMITTEE ON BANKING AND CURRENCY
W R I G H T PATMAN, Texas, Chairman
A L B E R T RAINS, Alabama
CLARENCE E . K I L B U R N , New York
ABRAHAM J . MULTER, New York
W I L L I A M B. WIDNALL, New J e r s e y
W I L L I A M A. B A R R E T T , P e n n s y l v a n i a
E U G E N E SILER, Kentucky
L E O N O R K. SULLIVAN, Missouri
P A U L A. F I N O , New York
H E N R Y S. R E U S S , Wisconsin
F L O R E N C E P . DWYER, New J e r s e y
THOMAS L. ASHLEY, Ohio
SEYMOUR H A L P E R N , New York
C H A R L E S A. VANIK, Ohio
J A M E S HARVEY, Michigan
W I L L I A M S. MOORHEAD, P e n n s y l v a n i a
OLIVER P . BOLTON, Ohio
R O B E R T G. S T E P H E N S , J R . , Georgia
W. E . ( B I L L ) BROCK, Tennessee
F E R N A N D J . ST GERMAIN, Rhode I s l a n d
R O B E R T T A F T , J E . , Ohio
H E N R Y B . GONZALEZ, Texas
J O S E P H M. McDADE, P e n n s y l v a n i a
CLAUDE P E P P E R , F l o r i d a
SHERMAN P . LLOYD, U t a h
J O S E P H G. M I N I S H , New Jersey
B U R T L. TALCOTT, California
C H A R L E S L. W E L T N E R , Georgia
D E L CLAWSON, California
R I C H A R D T. HANNA, California
B E R N A R D F . GRABOWSKI, Connecticut
C H A R L E S H . WILSON, California
COMPTON I . W H I T E , Jfi., I d a h o
J O H N R. STARK, Clerk and Staff
Director
J O H N E . BAEEIEEE, Professional
Staff
Member
ALVIN L E E MORSE,
ORMAN S. F I N K , Minority
SUBCOMMITTEE
Counsel
Staff
ON DOMESTIC
Member
FINANCE
W R I G H T PATMAN, Texas, Chairman
H E N R Y S. R E U S S , Wisconsin
W I L L I A M B . WIDNALL, New J e r s e y
C H A R L E S A. VANIK, Ohio
J A M E S HARVEY, Michigan
CLAUDE P E P P E R , F l o r i d a
O L I V E R P . BOLTON, Ohio
J O S E P H G. M I N I S H , New J e r s e y
W. E . ( B I L L ) BROCK, Tennessee
C H A R L E S L. W E L T N E R , Georgia
R O B E R T T A F T , J R . , Ohio
R I C H A R D T. HANNA, California
C H A R L E S H . WILSON, California
ROBERT E . WEINTRAUB, Senior
Economist
R O B E R T A. S C H R E M P ,
HARVEY W. G E I S T ,
Investigator
Investigator
S T E P H E N D. KENNEDY, Research
n
Assistant
CONTENTS
Statement of—
Bach, Prof. G. L., Stanford University and Carnegie Institute of ***£•
Technology
1387
Barger, Prof. Harold, chairman, Department of Economics, Columbia
University
1353
Brownlee, Prof. O. H., University of Minnesota
1061
Brunner, Prof. Karl, University of California, Los Angeles
1047, 1050
Daane, Hon. J. Dewey, member of the Board of Governors, Federal
Reserve System
1191
Dillon, Hon. Douglas, Secretary of the Treasury
1230, 1236
Friedman, Prof. Milton, University of Chicago, Chicago, 111
1133
Goldfinger, Nathaniel, director, Department of Research, American
Federation of Labor & Congress of Industrial Organizations
1471
Gordon, Prof. H. Scott, Carleton University, Ottawa, Canada
943
Gurley, Prof. John, Stanford University
1309
Johnson, Prof. Dudley W., University of Washington
1433
Johnson, Prof. Harry G., University of Chicago, Chicago, 111
970
Lerner, Prof. Abba P., Michigan State University
1398
Meltzer, Prof. Allan H., Carnegie Institute of Technology, Pittsburgh,
Pa
926, 938
Mitchell, Hon. George W., member of the Board of Governors,
Federal Reserve System
1179
Robertson, Prof. Ross M., business economics and public policy,
Graduate School of Business, Indiana University
1357
Samuelson, Prof. Paul A., Massachusetts Institute of Technology
1114
Shapiro, Prof. Eli, Harvard University, Cambridge, Mass
1098
Strotz, Prof. Robert H., Department of Economics, Northwestern
Universitv
1451
Villard, Prof. Henry H., College of the City of New York
1020
Warburton, Dr. Clark, Federal Deposit Insurance Corporation
1314
Additional statements and information submitted to the subcommittee
byBach, Prof. G. L., Stanford University: Federal Reserve organization
and policymaking
1393
Brock, Hon. W. E.: * 'Johnson and Martin—Varied Forces Could
Propel Them Toward a Conflict," article from the Wall Street
Journal, March 9, 1964
1426
Brunner, Prof. Karl, University of California:
Chart 1. Percentage change of money supply between corresponding months of adjacent years
1059
Chart 2. A B + AL corresponding months (adjacent years)
1060
Comments on Governor Mitchell's testimony
1223
Daane, Gov. J. Dewey: Supplemental statement
1213
Dillon, Hon. Douglas, Secretary of the Treasury:
Information concerning central banking policies
1246
Proposal regarding Federal Reserve action to prevent market
yields on Government securities from rising above 4% percent. _ 1251
Comparison of usable space by 12 Federal Reserve banks and
space in U.S. Government buildings in the Federal Triangle in
Washington
1268
Special advantage of the tax and loan account system
1269
Letter with answers to questions submitted to the Secretary by
the chairman, Mr. Patman, dated March 17, 1964
1273
Statement of the public debt, February 29, 1964 (table)
1274
Tax policy
1293
3U
IV
CONTENTS
Additional statements and information, etc.—Continued
Friedman, Prof. Milton, University of Chicago:
Chart 1. Comparison of changes in money and production, Page
1957-63
1136
Comments on testimony of Gov. George W. Mitchell and Gov.
J. Dewey Daane
1220
Should there be an independent monetary authority?
1165
Goldfinger, Nathaniel, director, AFL-CIO:
Statement of executive council on the balance of payments
1484
"City School Board Borrows $1.25 Million in Investment Scheme
To Gain Interest," article from the Gazette and Daily, York,
Pa., dated March 20, 1964
1496
Ourley, Prof. John, Stanford University: Tables 1 and 2. Money
supply
1313
Johnson, Prof. Dudley W., University of Washington:
Table I. The money supply, 1962-63
1438
Table II. Changes in the holdings of Government securities
1439
Table III. Excess reserves for all member banks, 1960-63
1440
Table IV. Behavior of "free reserves/' 1960-63
1440
Johnson, Prof. Harry G., University of Chicago: Alternative guiding
principles for the use of monetary policy, essays in international
finance
975
Kilburn, Hon. Clarence E.: Letters to Hon. Wright Patman, chairman, dated March 5 and 13, 1964
1510
Meltzer, Prof. Allan H., Carnegie Institute of Technology:
Chart I. National income and predicted income
929
Chart II. Average monthly changes in money and bank credit in
postwar cycles
931
Chart III. Annual changes in currency between corresponding
months
933
Charts Ilia, Illb, IIIc
934-936
Mitchell, Hon. George W., Board of Governors, Federal Reserve
System:
Percent change over corresponding month of preceding year,
1949-63
1187
Selected earnings data for member banks, by class of bank,
1954-63, tables I - I X
1188-1191
Supplemental statement
1213
Patman, Hon. Wright, chairman, House Banking and Currency
Committee:
Letter from Wm. McC. Martin, Jr., Board of Governors of the
Federal Reserve System, to Hon. Paul H. Douglas, chairman,
Joint Economic Committee, dated November 5, 1963, with
attachments
1381
Letter to Hon. Clarence E. Kilburn, dated March 14, 1964
1511
Wide variances in top salaries received by Federal Reserve bank
employees and those of other U.S. Government employees
1093
Annual salaries of the principal Federal officials
1095
Yields on long-term Government bonds, by months, 1919 to
present
1416
Robertson, Prof. Ross M., Indiana University:
"The Mysterious World of the Fed"
1519
"Credit Policy at the Discount Window"
1525
Samuelson, Prof. Paul A., Massachusetts Institute of Technology:
"How To Be a Central Banker," article from the Washington
Post, November 24, 1963
1124
"Money Machinations," article from the Washington Post,
August 25, 1963
1126
Warburton, Dr. Clark, Federal Deposit Insurance Corporation:
Guid elines for Federal Reserve operations
1320
Capital stock of Federal Reserve banks
1328
Extension of reserve requirements to commercial banks not now
members of the Federal Reserve System
1332
Proposals for change in the membership and terms of office of the
Board of Governors of the Federal Reserve System and in the
relation of the System to other financial agencies of the Federal
Government
1333
CONTENTS
V
APPENDIX
Supplemental statement of Gov. George W. Mitchell and Gov. J. Dewey p W
Daane
1213,1515
Comment by Gov. George W. Mitchell on Prof. Milton Friedman's
comments
1517
"The Mysterious World of the Fed," by D. C. Hastings and R. M. Robertson
1519
"Credit Policy at the Discount Window," by C. R. Whittlesey
1525
THE FEDERAL RESERVE SYSTEM AFTER 50 YEARS
TUESDAY, PEBBUARY 11, 1964
HOUSE OF REPRESENTATIVES,
SUBCOMMITTEE ON DOMESTIC F I N A N C E OF THE
COMMITTEE ON BANKING AND CURRENCY,
Washington, D.C.
The subcommittee met, pursuant to recess, at 10 a.m., in room
3101, Longworth House Office Building, Hon. W r i g h t Patman
(chairman) presiding.
Present: Representatives Patman, Reu^s, Kilburn, and Widnall.
The CHAIRMAN. The committee will please come to order.
A t these hearings on the first 50 years of the Federal Reserve
System, officials of the System have testified, as one, t h a t the Federal
Eeserve has done a fine jdb with the monetary powers Congress has
entrusted to it, and is in need of little, if any, reform.
I have doubts about this. As Al Smith said, "Let's look, at the
record." Almost everyone will agree the Federal Reserve's record
in the 1929-33 depression was bad. This is not a partisan opinion.
President Hoover wrote in his memoirs (page 212) that the Federal
Eeserve "was indeed a weak reed for a nation to lean on in time of
trouble."
Since Hoover's time we haven't had a great depression. B u t we
have had five recessions and two inflations in the 30 years since
1933, and this is not a record anybody ought to brag about.
Of course, the Federal Reserve's officials will tell you these episodes
weren't its fault, but reflect the failure of other policies. This is at
best a half-truth. Recognizing that other policies, especially fiscal
policy, influenced past economic trends and turns in no way whatever
absolves the Federal Reserve from responsibility for these trends and
turns.
Let's look at the five recessions and two inflations we've had since
1933. Between the summer of 1936 and the spring of 1937 the
Federal Reserve doubled bank reserve requirements. The price we
paid for this was t h e sharp 1937-38 business and employment
decline.
Inflation was unavoidable during the Second World W a r and
immediately thereafter. B u t the Federal Reserve was not completely blameless in this episode. I n 1942 reserve requirements at
central city banks were reduced from 26 to 20 percent. I t was 1948
before this inflationary action was reversed and reserve requirements
at central city banks increased back to 26 percent.
During the 1948^10 recession the Federal Reserve reduced its
holdings of Government securities by $5 billion. These sales
decreased bank lending and investing power, and thereby aggravated
the 1948^9 recession.
925
926
T H E FEDERAL RESERVE SYSTEM AFTER FIFTY YEARS
During the sharp inflation that followed the invasion of South
Korea, the Federal Reserve did nothing until J a n u a r y - F e b r u a r y
1951 when reserve requirements on demand deposits were raised by 2
percent and on time deposits by 1 percent. The Korean war inflation slowed down almost to zero immediately.
From the spring of 1951 until now our great and essentially healthy
and venturesome free enterprise economy has three times been
throttled by the Open Market Committee of the Federal Eeserve
System. The Open Market Committee's decisions affect the money
supply and interest rates. I will let the facts speak for themselves.
The recession of 1953-54 began in July 1953. Interest rates on
Government securities began to rise early in 1953. The growth of
the money supply fell steadily beginning in January 1953, and
by July was at an annual rate of less than 1 percent.
The next recession began in July 1957 and lasted until April 1958.
Interest rates started to rise in the middle of 1956. The growth
of the money supply fell below 2 percent during 1956 and by the
spring of 1957 the money stock was actually decreasing. I t continued to decrease until the beginning of 1958, long after the recession
began.
The most recent recession began in May 1960 and lasted until F e b ruary 1961. Once again we find interest rates rising and the growth
of the money supply falling just before the downturn. The money
supply fell from $142.8 bSlion at the end of September 1959 t o
$139.4 billion in J u n e 1960.
Beginning today we are going to hear from some outstanding economists who are expert in monetary matters. I am sure we will all
benefit from their discussions and answers to our questions on the
Federal Reserve's past and present policies, and on how much
independence it needs.
Today we have Prof. Allan Meltzer, and I believe I will ask you
to put your statement in the record at this point and then summarize
it, if you please.
J u s t bring out the main points and then, after you get through, we
have with us Prof. H . Scott Gordon, of Carleton University, Ottawa,
Canada, and his statement is not long, so it will be all right for
him to read it, and then we will ask both of you gentlemen questions after you have concluded.
(Mr. Meltzer's statement referred to follows:)
STATEMENT OF ALLAN H . MELTZER, GRADUATE SCHOOL OF INDUSTRIAL
ADMINISTRATION, CARNEGIE INSTITUTE OF TECHNOLOGY
SOME SUGGESTED CHANGES I N MONETARY ARRANGEMENTS*
Two separable questions underlie the changes that this committee
is considering. Both have to do with a primary concern in the monetary area; viz, the effectiveness of arrangements connecting monetary
*A statement prepared for the hearings before the Committee on Banking and Currency,
U.S. Honse of Representatives, Feb. 11, 1964. The analysis supporting the following
statement has been conducted jointly by the author and Karl Brunner, of UCLA, in a series
of papers and in a report prepared for this committee entitled "An Analysis of Federal
Reserve Monetary Policymaking."
THE FEDERAL RESERVE SYSTEM AFTER FIFTY YEARS
927
policy with the behavior of prices and output in the economy. One
question involves the effectiveness of the Federal Keserve as an agency
for carrying out the congressional mandate imposed by the Federal
Reserve Act, the Employment Act, and other legislative expressions
of public policy. This question is summarized by asking: Does the
Federal Reserve have effective operating control of the money supply? The other question involves the connection between the money
supply and the pace of economic activity. I t asks: Do changes in the
stock of money alter the level of income in the short run? Unless
both of these questions can be answered affirmatively, we must either
look for new arrangements or abandon the hope of improving our
policies.
A considerable amount of evidence is available that helps to provide answers to both questions. The evidence comes from the United
States and a variety of countries and from detailed study of Federal
Reserve policymaking procedures. I t suggests that the relation of
the money supply to economic activity is sufficiently close that we
can count on a reasonably reliable and predictable effect, provided
that we have adequate control of the supply of money. Unfortunately, our study of Federal Reserve policymaking uncovered very
little evidence that their understanding of the monetary process or
their procedures for controlling it are at all adequate for the important task delegated by the Congress.
Again, there are two issues. The first concerns the adequacy of
Federal Reserve procedures for deciding on the present and near
term future outlook for the economy. Here we find that the record
since 1951 has been excellent. The Federal Reserve has made correct
and timely judgments at turning points. They have shown judicious
prescience. I n the current state of knowledge, there is little reason
to expect a performance superior to the record achieved.
But there is the second part of the problem. This involves knowing what to do when turning points are predicted or are judged to
have occurred. An adequate understanding of the money supply
process, of the factors governing the response of the stock of money
to Federal Reserve policy, is required for this purpose. Our detailed
study of the Federal Reserve's procedures reveals that their knowledge of the monetary process is woefully inadequate, unverified,
and incapable of bearing the heavy burden that is placed upon it.
After 50 years, the Federal Reserve has little verified knowledge to
form the basis for its policy actions. Equally important, the dominant views expressed by Federal Reserve officials are founded on
notions that were responsible for major errors in 1929-33, 1936-37,
and at other crucial points.
I would like to expand briefly on some of the points raised before
suggesting some changes in policymaking arrangements. A more
detailed discussion of many of the questions involved and a more
adequate analysis of the weaknesses in the Federal Reserve conception is contained in the Study that we are preparing at the request
of this committee. 1
1
Karl Brunner and Allan H. Meltzer, "An Analysis of Federal Reserve Monetary Policymaking," House Committee on Banking and Currency, Washington, D.C., 1964.
928
THE FEDERAL RESERVE SYSTEM AFTER FIFTY YEARS
THE RELATION OF MONEY TO INCOME
Monetary policy is predicated on the notion that there is a reliable
connection between the quantity of money and money ^ income.
If there is no connection between the two; monetary policy is useless
as a device for carrying out the goals of maximum employment and
purchasing power embodied in the Employment Act.^ Evidence
from a large number of countries and many different time periods
suggests that money and money national income are closely associated.
The observed association can be explained in a number of ways;
that is, by means of alternative theories.
One explanation emphasizes the casual importance of money in
generating greater utilization of our human and physical resources.
Predictions of annual values of money national income from the
factors influencing the demand for and supply of money have been
able to indicate all of the turning points in economic activity since
1925.
For the years 1951-58, annual values of national income have been
predicted with an error of 2.5 percent. This is but one piece of
evidence supporting the contention that monetary
policy plays an
important role in determining the level of income.2
Some additional evidence on this point is presented in chart I.
We have used the factors determining the demand for and supply
of money to forecast quarterly values of income from the fourth
quarter of 1954 through 1959. The results of some preliminary efforts
shown in the chart, once again suggests the importance of monetary
factors. Our forecasts have an average error of 1.5 percent for the
period. Moreover, the forecasts are reasonably reliable at turning
points in economic activity. While the stock of money (currency
and demand deposits) is not the only factor that is used in making
these predictions, our analysis suggests that periods of decline or
little growth in the money supply are followed by periods of slow
growth or decline in economic activity.
As I indicated in my testimony before the Joint Economic Committee last year,3 the very slow rate of growth in the money supply
from 1959-62 was a factor of paramount importance in the slow
rate of utilization of resources and the high rate of unemployment
in those years. I urged then that the rate of monetary expansion
be increased and argued that if this were done, we could reach higher
levels of economic activity while reducing our gold outflow. The
record for 1963 amply supports these contentions. The average rate
of growth of the money supply (currency and demand deposits) was
above 4 percent for the first time in many years. Economic activity
expanded while the gold outflow slowed.
These facts are indicated to emphasize the importance of the issues
that this committee is considering and the great power that has been
entrusted to the Federal Eeserve Board. Monetary policy is not a
matter of "pushing on strings" as the Board and others have so often
suggested. It is a powerful force in our economy, as you are well
* Karl Brunner and Allan H. Meltzer, "Predicting Velocity: Implications for Theory and
Policy,"
Journal of Finance, May 1963.
8
"Monetary Policy for 1963/' hearings before the Joint Economic Committee, Feb. 6,
1963. See also the similar statement of Beryl Sprinkel at this committee's hearings on
the balance of payments, July 1963.
OHABT I
450
440
National Income and Predicted Income
Quarterly 1954-IV to 1959-IV
430
3
420
410
6
400
390
CO
^Predicted
Income
380
37o
i
i
36o
550
340
330
320
4-54 1-55 2-55 3-55 4-55 1-56 2-56 3-56 4-56 1-57 2-57 3-57 4-57 1-58 2-58 3-58 4-58 1-59 2-59 3-59 H-*l
to
CD
930
THE FEDERAL RESERVE SYSTEM AFTER FIFTY YEARS
a w a r e . L e t u s consider, t h e r e f o r e , h o w t h e F e d e r a l E e s e r v e h a s used
t h e p o w e r d e l e g a t e d t o it.
THE FEDERAL RESERVE'S UNDERSTANDING OF THE MONETARY PROCESS
I have already indicated that the Federal Eeserve has an excellent
record in judging turning points in the period since 1951. But correct judgment at turning points is not enough. Appropriate action
must be taken, or the advantage of making correct judgments about
the state of the economy is of little value.
Two issues are chosen from the many available to illustrate the importance of careful analysis and the absence of a validated, systematic understanding of monetary processes by the Federal Eeserve.
One concerns the perennial confusion between money and "credit"
that is a prominent feature of Federal Eeserve discussions. The other
suggests the importance of some elements that play a dominant role
in the monetary process and have no role at all in Federal Eeserve
discussions. The cyclical behavior of the public's demand for currency is the issue chosen for this purpose.
A major failure of the Federal Eeserve is the failure to understand the importance of money in the economy. When asked by the
Joint Economic Committee to distinguish between monetary expansion and credit expansion, the Board submitted the following written
reply:
No difference was meant by the two terms "bank credit expansion" * * *
and "monetary expansion" * * *
* * * * * 'bank credit expansion* and 'monetary expansion* are essentially two
sides of the same coin." 4
Chart I I reveals that this statement is totally incorrect. The rate
of monetary expansion in the postwar period has been slower during
periods of economic expansion than during periods of recession.
Federal Eeserve policy has been perverse. They have permitted
larger rates of growth in the money supply during periods of expansion than during periods of contraction. This is the direct opposite
of a policy designed to expand economic activity during recession
and to control inflation.
I do not wish to suggest that the Federal Eeserve desires to add
to our unemployment or to promote inflation. When we look at this
stock of "bank credit" for the same periods, we note "credit expansion" has behaved in a countercyclical way. The rate of "credit
expansion" has been greater during periods when unemployment and
recession were our national concerns. And the rate of "credit expansion" slowed during periods of expanding economic activity.
Thus, if monetary and credit expansion were "two sides of the same
coin" and both behaved in a countercyclical way, our confidence
in the Federal Eeserve's operations would be greatly increased.
But the two are not the same. Therefore, we must conclude that
Federal Eeserve policy with respect to the money stock has been
perverse on the average in the postwar years. They have not understood the basic process that they have been entrusted to control.
* Review of the Annual Report of the Board of Governors of the Federal Reserve System
for the Year 1960, hearings before the Joint Economic Committee (Washington, GPO,
1961), p. 147.
8
e
$*
5 u
1
4 4
\N1 5 2 f c m O d
sNomtvy
Nt savmod
2
<4
1
8
I
o
o
THE FEDERAL RESERVE SYSTEM AFTER FIFTY YEARS
a
o
931
I
932
THE FEDERAL RESERVE STSTEM AFTER FIFTT YEARS
This has hindered them in their ability to carry out the mandate of
the Congress.
Let us turn briefly to another issue, the Federal Eeserve's understanding of the behavior of the stock of currency. This is an issue of
great importance. The Federal Eeserve apparently failed to recognize and clearly failed to offset the severe contractive effects occasioned by the public's demand for currency at several times during
1929-33. Have they learned to appreciate the importance of understanding cyclical behavior of the demand for currency as a factor in
the cyclical behavior of the stock of money and the economy? Our
conclusion is that they have not. Their statement to Congress in 1952
denies any important effect of the demand for currency on "the adequacy of the money supply." 5 To be sure that this view continues to
represent the state of their analysis they were asked to discuss the
problem of currency in a questionnaire to be published as a p a r t of
our report to this committee. Neither the Board of Governors nor the
12 Eeserve bank presidents mentioned the cyclical problem of currency demand, although the seasonal and longer run problems were
discussed. We can only conclude that the Federal Eeserve has not yet
recognized the cyclical nature of the demand for currency.
Chart I I I clearly reveals that cyclical fluctuations in currency demand have played an important role in the postwar period. Currency patterns dominated the behavior of the money supply in the
immediate postwar period, they exercised a severely negative effect on
the money supply in the early months of 1962 and contributed to the
totally inappropriate reduction in the money supply in that year; they
offset a severely contractive Federal Eeserve policy during the recession of 1954 and eventually led to monetary growth despite perverse
Federal Eeserve policy.
This evidence of lack of basic understanding of the monetary process
can be illustrated by a number of additional examples. Many of these
are contained in the committee report to which I have referred. All of
our examples lead to the same conclusion: The Federal Eeserve does
not have a rational foundation for policymaking.
SOME SUGGESTED CHANGES
Two features of the Federal Eeserve System seem to account for
their failure to analyze and test their conception of the monetary
process. First, their analysis and their approach to monetary policy
is dominated by extremely short-run week-to-week, day-to-day, or
hour-to-hour events in the money and credit markets. Second, their
viewpoint is frequently that of a banker rather than that of a regulating authority for the monetary system and the economy. This should
not be construed as an attack on the motives of the men involved. Our
point is simply that they are accustomed to consider their problems in
much the same way that a banker considers his. But the questions that
they have to decide are quite different from those that face an individual banker. Their concern with extremely short-run details inhibits careful analysis and the development ox a tested frame of reference capable of providing answers to questions such as those discussed in the previous section.
""Monetary Policy and the Management of the Public Debt" (Washington: Joint
Committee on the Economic Report, 1952), pt. I, p. 338.
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THE FEDERAL RESERVE SYSTEM AFTER FIFTY YEARS
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Changes in the legal and internal framework of the Federal Reserve
System should attempt to remove the causes of present weakness.
This requires elimination of the problems and procedures that have
dominated Federal Reserve thinking and action.
One important step in that direction would be the requirement that
the Federal "Reserve report publicly on their detailed analysis, and
the evidence supporting their analysis, of the monetary process aiid
of the link between policy actions and the money supply. Such reporting would permit an audit of their analysis by outsiders and would
lead to helpful communication between the Federal Reserve, the Congress, the academic community, and the public. I can think of no
more important first step to eliminate the errors that continue to pervade their thinking, nor can I suggest a part of their responsibility
that they have been more reluctant to carry out.
A second suggested, change would remove from consideration many
of the short-Tuii problems that seem to dominate Federal Reserve
thinking. To accomplish this, the discount window at the Reserve
banks should be left open. Borrowing should be a right, not a privilege of membership in the System. A penalty rate should be charged
for discounting or borrowing at the Reserve banks. Under the proposed arrangement, the Federal Reserve would control the base for
monetary expansion, bank reserves plus currency. Banks could use
the discount window to obtain reserves for their settlements, but such
borrowing operations would be offset by open market operations. The
Federal Reserve would have responsibility for controlling the quantity of money; the individual banks would be responsible for their own
daily and weekly reserve adjustments to float, redistribution of deposits from Reserve city to country banks, and other extremely short
run problems.
Third, the Federal Reserve would be left with the principal task of
deciding on the quantity of money that should be available at the end
of 6 months or a year. With adequate analysis of the relation of monetary policy to the stcok of money and the observed ability of the Federal Reserve to judge turning points, direct concern with and concentration on this question would greatly improve policy operations.
Policy should not be decided for a 3-week period only, as it is under
the present arrangements that are dominated by concern about movements of tax and loan balances, float, Treasury borrowing, and so
forth.
Fourth, the Federal Open Market Committee should be abolished
and the power transferred to a Board of Governors that has been reduced in size. Two major postwar studies of Federal Reserve policymaking reached the same conclusion. 6 Although the analysis supporting my conclusion differs from that of the earlier studies, I concur in
the conclusion of the earlier reports. The suggestion that Chairman
Martin made earlier in these hearings indicates a willingness to accept
a smaller Board.
^ The detailed nature of the findings that suggest these recommendations and many others cannot be presented in this statement. But they
«G. L. Bach, "Federal Reserve Policy Making," (New York: Alfred Knopf, 1950). The
author of the study was Chairman of the Hoover Commission task force that studied the
Federal Reserve. .See pp. 222-22)6. 233-237. "Money and Credit, the Report of the
Commission on Money and Credit." (Englewood Cliffs: Prentice-Hall, Inc., 1961), pp.
938
THE FEDERAL RESERVE SYSTEM AFTER FIFTY YEARS
are based on analysis, supported by evidence, that will be available in
the near future. A relevant conclusion drawn from that analysis is
that discretionary monetary policy can do a better job of carrying out
the congressional mandate than it has done in the past 50 years, if
monetary policy is based on a validated and coherent framework. The
proposals made are designed as a first step toward that end.
T h e CHAIRMAN. Therefore, if you will summarize it, Dr. Meltzer,
it will be appreciated.
STATEMENT OF ALLAN H. MELTZER, PROFESSOR OF ECONOMICS,
CARNEGIE INSTITUTE OF TECHNOLOGY, PITTSBURGH, PA.
Mr. MELTZER. Thank you very much, Mr. Patman, members of
the committee.
I do not plan, in my remarks, to make reference to particular bills.
I wish to provide some background information, and I will be happy
to answer any questions about the bills or about the history of the
Federal Reserve System to the extent that I know it.
T h e question to which I want to direct attention is the minimum
requirements for an effective monetary policy. There are really two.
One is that there be a close predictable relation between money and
income, that is, that changes m the growth rate of the money supply
have some reflection in the pace of economic activity.
The second requirement is t h a t there be a relation between Federal
Reserve policy and changes in the rate of growth of the stock of money.
Unless we can answer both of these questions affirmatively we can
neither hope to control inflation, reduce unemployment, or carry out
any of the mandates that Congress has entrusted to the Federal Reserve
System.
The CHAIRMAN. NOW, money and income is the first one. W h a t is
the second one ?
Mr. MELTZER. The second one is the relation of the Federal Reserve's policy to the supply of money.
Now, on both of these questions we have accumulated a large
amount of evidence in recent years. F o r one, the relation of money
to income, I have prepared a chart that represents just a part of the
findings that come from a variety of different countries and from many
different time periods.
Monetary factions have been shown capable of predicting every
turning point since 1925 on an annual basis and predicting almost all
the turning points in economic activity during the century.
These predictions are based not only upon changes in the money
supply but also some other variables that determine velocity. But
the primary variable that we are interested in, and one of great importance in making these predictions, is the stock of money.
K a r l Brunner and I have attempted to do some preliminary studies
for this committee to compare quarterly predictions with actual
changes in national income from the fourth quarter of 1954 to 1959.
This should read "billions'* over here and not "millions."
And we find again
The CHAIRMAN. Without objection we will place the chart in the
record at this point.
(The chart referred to will be found in Mr. Meltzer's prepared statement on pp. 926-938.)
THE FEDERAL RESERVE SYSTEM AFTER FIFTY YEARS
939
Mr. MELTZER. Thank you.
We find again that there is a close and predictable relation
between the rate of growth in the stock of money and the rate of growth
of income.
Monetary policy is not simply a matter of pushing on strings,
as the Federal Reserve has at times maintained. I t is a most
important part of the procedure by which we attempt to control inflation and promote full employment in our society.
The CHAIRMAN. What are the years there ?
Mr. MELTZER. This starts in the fourth quarter of 1954 and goes
quarterly along to the end of 1959.
And here we find that the relationship is very close. As a matter
of fact, the average error that we make is about 1% percent of income
at an annual rate.
Mr. REUSS. Mr. Chairman, may I ask a question at this point?
The CHAIRMAN. GO ahead.
Mr. REUSS. The black line is
Mr. MELTZER. The actual income, and this
Mr. REUSS. W h a t do you mean by "actual income" ?
Mr. MELTZER. That is the national income that we had in a particular
quarter. F o r example, let's take one of these. This period is the
third quarter of 1959. The level of national income, at that time,
was somewhere in the neighborhood of 425 or 430.
The red line is our prediction.
Mr. REUSS. W h a t do you mean by your prediction?
Mr. MELTZER. I t is a forecast. F o r example, to predict the third
quarter of 1959 we used information only available up through the
second quarter of 1959. These predictions are based upon the demand
and supply for money or factors influencing the demand for and supply of money.
Mr. REUSS. Well, will you tell me a little more about the formula
which you used for deriving your red line ? Otherwise, the chart will
not mean much to me.
Mr. MELTZER. Yes. The red line is produced by taking the stock
of money. Essentially, that depends upon Federal Reserve policy,
changes in the public's desire to hold currency and time deposits, and
we make our predictions from that.
That is for the supply of money. The demand of money is represented in this case by velocity. I t is dependent largely upon interest
rates and wealth and some other variables that are rather technical,
and I prefer not to go into them, but essentially it is based on interest
rates and some other factors.
Mr. WIDNALL. W h y does your chart end with 1959 ?
Mr. MELTZER. Because one of the variables that we used here is the
total wealth available in the economy, and that variable is only
available to make predictions up to the end of 1959.
Mr. Goldsmith and the national bureau compiled that series up
through 1958, and some other people extended it through 1959. B u t
there is no more available data from which to make forther predictions. So we cannot go beyond that year.
But we do have a very strong relationship between changes in
the stock of money and the level of income.
Although we cannot make these predictions because we do not have
all of the elements to put into them, we do observe that after 1959, as
940
THE FEDERAL RESERVE SYSTEM AFTER FIFTY YEARS
the chairman just indicated, the rate of growth of money supply
slowed down. From 1959 until late 1962 the rate of growth of money
supply was extremely low, one of the slowest periods in recent history.
Mr. WIDNALL. The Federal Reserve System has to predict things
3 weeks in advance. You say you cannot do it because you do not
have any figures since 1959 ?
Mr. MELTZER. That is correct. We are not using the chart to indicate Federal Reserve policy, sir.
We simply want to show that for a long period of time money
has had a very, very close relation to income and, therefore, the first
condition for an effective Federal Reserve policy is being met; namely,
that there is a relation between money and income. We know that
for the period following 1959, when the rate of growth of the money
supply slowed down and the rate of growth of income also slowea
down. I n late 1962 and early 1963, when the rate of growth of money
supply increased again, the rate of growth of income increased again.
So the basic features that are revealed by the chart are also revealed
by our contemporary history.
Mr. RETTSS. I have another question. I gather that this is not simply
a chart of the national income for a particular period, compared with
the money supply for that same period.
Mr. MELTZER. N O , it is compared with a prediction of income
based upon the money supply and some other factors.
Mr. REUSS.
Yes.
Mr. MELTZER. I n other words
Mr. RETTSS. Are we being told what those other factors are, because
otherwise I do not get much
Mr. MELTZER. The other factor is velocity, that is the rate of turnover of the stock of money. T h a t factor is predicted by interest rates
and some other things, the ratio of income to permanent income, the
transitory component of income and a measure of the return on real
capital.
The CHAIRMAN. Are you saying that as the interest rate increases
the velocity of money decreases ?
Mr. MELTZER. ISTO, as the interest rate increases velocity increases,
and we multiply money times, velocity to get income; that is, money
times our prediction of velocity gives us a prediction of income.
Mr. RETTSS. A couple more questions. You talked about predicted
income. Were you and your associate, during these years, actually
sitting there with a crystal ball, or is this an ex post facto reconstruction ?
Mr. MELTZER. E X post, but to make this prediction, or any one of
these, we used only information we would have had had we been
sitting there forecasting at the time.
We used information on what had happened up to one quarter before
the prediction we wanted to make.
So we could have made these predictions at the time just as well
as at the present time.
Mr. REUSS. Let me ask this question: I have long observed the
correspondence between the money supply, properly defined as demand
deposits and currency outside banks, and national income and also
gross national product. Does your chart tell us anything more than
that?
THE FEDERAL RESERVE SYSTEM AFTER FIFTY YEARS
941
Mr. MELTZER. Yes, I think a little bit more.
The other factor that enters into the determination of income with
money is velocity, that is, the rate of turnover.
^ If we take the stock of money and multiply it by the number of
times that money turns over to generate income, we have a prediction
of the level of income itself.
Now, velocity can change. We take interest rates and we include
some other things that our theory tells us are important, for example,
the ratio of income to permanent income, and some other technical
things. That way we get not simply a gross association between
money and income but we get a prediction of what level of income
should be from monetary factors, and this tells us a great deal more,
I think, about the confidence that we can place in the relationship of
money to income.
^ I t tells us, for example, that we can use this procedure if we continue to collect information on stock of wealth, to predict income
ahead of time.
The CHAIRMAN. Suppose, Doctor, you go ahead and briefly
cover your charts and your testimony, so that we can have Dr.
Gordon, and we will ask each of you questions then.
Mr. MELTZER. NOW, the second question that comes u p is how well
does the Federal Eeserve control the money supply.
If money is important as a predicter of income, how well is the
Federal Reserve's control over the stock of money. Here again we
have broken that question down into two parts.
One is the question: Do they recognize the turning points in economic activity? Do they know when it is that recession occur? As
I have indicated in my statement and as Dr. Bruner and I have indicated in the report, the record in the postwar period is excellent. We
do not believe that very many people in the current state of knowledge, could have done better in recognizing turning points, than the
Federal Eeserve has done. But judging turns is not enough.
They have to know what to do when the turning points occur.
Now, this, we think, is their greatest weakness, not knowing what to
do. They do not have a valid, appropriate understanding of the
money supply process. I n 50 years they have not developed one.
Now, one or two statements will develop this point in more detail.
One has to do with their discussion of credit rather than money.
F o r example, Chairman Martin, of the Federal Eeserve System in
response to a question asked bj the Joint Economic Committee, submitted a written statement saying that monetary and credit expansion
are two sides of the same coin. I n these hearings many Federal
Eeserve people have talked about credit expansion.
Now, we observe the following. These black areas represent average monthly changes in money or in credit during periods of recovery.
These are periods in which we are moving from the bottom to the
top. The problem becomes one of preventing inflation.
W h a t we find is that the Federal Eeserve permits a larger rate of
growth in the money supply during the periods when they should be
controlling inflation, and a smaller rate of growth in the money supply
during periods when they should be preventing unemployment.
Their policy is in terms of bank credit not money. W e see that they
allow bank credit to increase very rapidly during periods of unem
942
THE FEDERAL RESERVE SYSTEM AFTER FIFTY YEARS
ployment. That is because the banks are acquiring Government securities in place of loans or there is a spillover from money into time
deposits. However, we find that the rate of growth of the money
supply is slow when it should be fast and fast when it should be slow.
I t is not countercyclical.
Therefore, many of the problems that we have had, such as the
sluggish rate of growth, an.d the slow decline in unemployment, as
well as the problems of rising prices, are due to the Federal Keserve's
policy. They increased the money supply too quickly when they
should retard it and too slowly when they should accelerate it.
And this, we think, is the major weakness. This weakness emerges
from their lack of understanding of the process t h a t they have been
entrusted to control.
They have never made any detailed studies about monetary and
credit expansion or they would not say that the two rates are the
same. Their statement that the two rates are the same is totally
incorrect. I t is a factual question and it can be observed in the chart
that it is factually incorrect.
Now, the third chart that I would like to present deals with currency. They have been asked several times, by this committee, and in
a questionnaire that this committee sent to the Federal Reserve people
for us, this question: Do they believe that swings in the public's
currency behavior are important? They deny that these are of importance cyclically. Yet all we have to do is look at the evidence and
we observe that cyclical changes in currency are very important.
F o r exampile, they help us to explain some very puzzling things.
I n 1946 the public's demand for currency decreased very rapidly.
This permitted an expansion of the money supply that was inflationary during that period despite the fact that the Federal Reserve
was making lots of statements to the effect that they were trying to
control inflation. They ignored the currency behavior of the public
and they misjudged the situation.
I n 1953-54, during the recession, the Federal Reserve was pursuing an inappropriate policy. They were consistently compressing
the policy variables and reducing the money supply, thereby fostering
further unemployment.
But the public's currency behavior came to our rescue. I t declined
so steeply in the 1953-54 recession that it reversed the incorrect
policy action taken by the Federal Reserve and thereby permitted
growth of the money supply and helped us recover from that recession.
I n early 1962 the public's currency demand was strong. As currency rose, it caused a fall in the money supply. During the early
part of 1962 the money supply was allowed to decline despite rising
unemployment.
Now, the Federal Reserve has announced that they moved to slightly
less easy policies in 1962. That is the statement published by the manager of the System Open Market Account. But the public's currency behavior reversed, and the money supply grew rapidly during
the period in which they claimed t o be less easy.
I n fact, it went from a negative rate to one of the highest positive
rates of growth in the postwar period.
Again we can observe the facts and conclude that the Federal Reserve has misjudged the behavior of the stock of money. This occurs
THE FEDERAL RESERVE SYSTEM AFTER FIFTY YEARS
943
because they do not have a validated understanding of what it is that
they have been entrusted to control; namely, the stock of money.
So, to very briefly conclude my remarks, I would like to say that
while we have a number of detailed recommendations about how the
System could be improved, we think that there is no more important
thing that could be done than to have them submit annually on the
public record, not only a statement of the actions that they have taken
but a statement which tells us what their analysis is, how did they
incorporate all of these monetary factors, what is their analysis of the
factors governing the money supply, and what is their evidence to
support it.
And I think that if we begin to do t h a t the next 10 years will
show an improvement in policy over the poor record that the Federal
Reserve has achieved in the past.
I would like to make one last remark which, I think, is of some
consequence; namely, that their failure to analyze the currency demand
is of great importance, because it is one of the primary elements that
they have misinterpreted or ignored.
From their statements and from their behavior in the postwar
period we have no reason to believe that they would not make the
same mistake with respect to currency in 1964 that they made in 1932
or 1933.
Thank you.
The CHAIRMAK. Thank you, sir.
All right, Mr. Gordon, we are glad to have you, sir, and you may
proceed in your own way.
STATEMENT OF H. SCOTT GORDON, PROFESSOR OF ECONOMICS,
CARLETON UNIVERSITY, OTTAWA, CANADA
Mr. GORDON. Thank you, Mr. Chairman.
These brief comments will be directed at H . E . 9631, which is
one of those before the committee.
I n considering the proper form of organization of a modern central bank it is above all necessary to appreciate the fact that a central
bank is an instrument of government, and its acts are acts of governing. The generic term "Central Bank" and specific names such as
"Federal Reserve Bank," "Bank of Canada," "Bank of England"
convey the impression that central banks are similar to commercial
banks and other types of private banks. Central banks and private
banks both deal in money and financial instruments, but their
similarities end just about at that point. The differences between
them are much more profound than these similarities. Private
banks are business institutions, they enter the financial markets as
primary participants; in effect offering their various services for
sale, just as any other business does. Central banks enter the same
markets, but in the role of controllers and regulators; they do not
produce and exchange, they govern.
I t is almost platitudinous to say that it is desirable that the regulatory activities of a central bank should be in harmony with the
other regulatory activities pursued by the government of the country. I n the case of monetary regulation, however, we see a very
complex application in practice of this simple point. Different countries have tried to assure this harmony of policy in different ways.
944
THE FEDERAL RESERVE SYSTEM AFTER FIFTY YEARS
A t one extreme, there are central banks that are established as
independent entities, with autonomous financial power and legal
rights of regulation, and with legal protection of their senior officers
against governmental pressure. I n such cases, harmony of central
banking with other governmental policies may depend on nothing
more concrete than a statement in the statute establishing the bank
that it should strive to promote the general econmic good and avoid
economic evil. The Bank of Canada is an illustration of such an
approach.
A t the other end of the spectrum, a central bank may be established as a fully integrated part of the executive branch of the
Government—subject to executive authority in all matters relating to
its policy and operations. My interpretation of H.R. 9631 is that
it would make the Federal Reserve System into such an agency.
There are a large number of intermediate constructs in the world
of central banking today. These consist of central banks which are
formally autonomous and independent of government, but which may
be brought under the Government's influence in various ways. F o r
example, in Great Britain, the chancellor of the exchequer is legally
empowered to issue specific directives to the Bank of England,
which the latter is required to follow.
The object of much central banking legislation seems to be
to assure that the bank's policies will be in harmony with those of
the Government, while leaving the bank free of governmental control and influence in the pursuit of its day-to-day operations. The
•view that operating independence is desirable springs largely
from the fear that the executive branch may be tempted to misuse
the great financial power of the central bank by perverting it to
partisan or even personal ends. To my mind, such evils are possible
in all spheres of governmental operations, and the real guarantee
against them is the light of public knowledge. The sphere of
finance does not inherently contain greater dangers of this sort than
those of, say, defense or public works. The Federal Reserve already
has an enviable record for furnishing information which permits
searching public discussion and criticism of its practices.
I t furnishes a great deal more information on these deliberations,
practices, and discussions within the System than we have in
Canada.
No doubt this coxjld be extended and thereby provide even greater
guarantees against the misuse of financial power by the executive
branch.
Some authorities argue for central bank independence on the
ground that governments are inclined to be inflation prone, and an
independent central bank will check this tendency. Without examining the validity of this contention here, I would point out that this
view is a plea for the independence of the central bank in setting
its basic policy, not merely in its day-to-day operations. Such a view
cannot be logically held by anyone who believes that the policies
of the central bank and the Government should be harmonious.
I n Canada we have had some direct experience with the undesirable consequences of central bank independence. The events preceding the attempted dismissal of the governor of the Bank of Canada
in 1961 showed that central bank independence can degenerate into
irresponsibility, and that the Government itself can make use of the
THE FEDERAL RESERVE SYSTEM AFTER FIFTY YEARS
945
autonomous position of the central bank t o deny its own responsibility for what it conceives to be politically unpopular policies. W e
have not yet fully recovered, in Oanada, from the consequences of the
acrimonious controversy between the Bank of Canada and the Government in 1960-61, and we have not yet resolved, by appropriate
statutory changes, the formal weaknesses in our central banking legislation that permitted those unfortunate events to occur.
I have myself argued, in my own country, t h a t central bank independence is an anomaly in the modern world, and that the Bank of
Oanada should be reconstituted with the status of an ordinary department of government. Since this is the effective status that, as
I interpret it, H . E . 9631 would give to the Federal Keserve System,
I am not therefore inclined to be critical of this bill on general
grounds.
I would add, however, that the Canadian political system calls
for such a charge in the status of the central bank more clearly than
does that of the United States. I n Canada, the full integration of
the central bank into the executive branch of government is demanded both by the requirements of good economic policy and by
the basic constitutional theory which underlies parliamentary government; in the United States it would seem t h a t only the economic
argument is fully applicable, though that alone is a very strong one
in the light of the important role we expect monetary management
to play in the modern econoimic world.
The CHAIRMAN. NOW, Mr. Gordon you mentioned the question of
whether or not the Government and the monetary authorities should
act in harmony.
Is it the general rule in the other central banks of the world, in
major countries, that the monetary authorities, the money managers,
and the government do work in harmony or not ?
Mr. GORDON. I think it is the general experience that they do work
in harmony, and the informal arrangements that one usually discovers between the monetary managers and the government, represented usually by a minister of finance or treasury are much more
important than the formal ones.
F o r example, in the British case no directive has ever been issued
by the chancellor of the exchequer, and such a directive would be
a public acknowledgement that the real mechanism had broken
down, which is the mechanism of informal discussion. And I think
that our own experience
The CHAIRMAN. Wait just a minute though. You state here, for
example, that "for example, in Great Britain, the chancellor of the
exchequer is legally empowered to issue specific directives to the
Bank of England, whfeh the latter is required to follow."
But you now state that no directive has ever been issued ?
Mr. GORDON. NO directive has ever been issued.
The CHAIRMAN. Yet, he has the power, if he desires to do so ?
Mr. GORDON. Yes.
The CHAIRMAN. NOW,
be a little bit more specific with my question, if you please, in reply.
I have here as an example, Belgium, and in that country the Government owns 50 percent of the central bank, and I understand the stock
of the bank is traded on the exchange, but the Government controls the
Central Bank of Belgium.
946
THE FEDERAL RESERVE SYSTEM AFTER FIFTY YEARS
Is that correct ?
Mr. GORDON. Yes; I believe so.
The CHAIRMAN. And in Canada, of course, the central bank has been
100-percent Government controlled since 1938; France, 100-percent
Government owned since 1946; and Germany 100-percent Government
owned since 1957, since their incorporation.
I n Italy a majority of shares are held by savings banks and
are managed by several large commercial banks and insurance companies and social security institutions.
Well, is it controlled by the Government or does it work in harmony
with the Government or does it not in Italy ?
Mr. GORDON. I cannot speak for the Italian case, Mr. Chairman,
but the Canadian case demonstrated most clearly that ownership
of the bank is no guarantee of control, in any sense.
The Minister of Finance, in right of the Crown, holds 100 percent of the shares of the Bank of Canada and yet he was powerless
to intervene in the policy of the bank and, indeed, he was even
powerless to require the Governor of the Bank to meet with him to
discuss banking policy.
There was
The CHAIRMAN. I n other words, they had, gotten* off and considered
themselves somewhat independent ?
Mr. GORDON. More than somewhat independent.
The CHAIRMAN. NOW, I will take Japan. Japan, since the central
bank was established in 1882, the Minister of Finance has owned 55
percent of the stock.
Generally, do the monetary authorities and the Government of
J a p a n work in harmony or not?
Mr. GORDON. I cannot say, sir. I do not know.
The CHAIRMAN. W h a t about the Netherlands ? Of course, that is
like Canada. I t has been a 100-percent Government owned bank since
1948.
Sweden has been a 100-percent government-owned bank since
1668, and Switzerland is a joint stock company 55 percent owned
by Cantons and managed by a large number of private shareholders.
I t generally works in harmony with the Government, is that not
correct?
Mr. GORDON. Yes. However, the degree of ownership does not
again correspond with the degree of independence of the bank.
The CHAIRMAN. Well, that is true here in this country, Mr.
Gordon.
You see, the Federal Reserve banks are 100-percent Government
owned, by the U.S. Government.
Of course, this so-called stock that they try to make out causes
this ownership to be in the private banks; we have an awful time
getting over the true f&cts concerning that but, generally, now, anyone who knows anything about it at all knows that the word "stock"
is a misnomer—that the "stock" does not carry any proprietry ownership of any type or nature.
Mr. WIDNALL. Mr. Chairman, will you yield ait that point ?
The CHAIRMAN.
Yes.
Mr. WIDNALL. What was the Government's investment in the
Federal Reserve System?
THE FEDERAL RESERVE SYSTEM AFTER FIFTY YEARS
947
The CHAIRMAN. The credit of the Nation. T h a t is the best investment on earth. I t is 100 percent. I t is everything.
I t is a mortgage on everything that you have, the income of all
the people, and the taxing authority carries it out.
Mr. WIDNALL. As evidenced by stock?
The CHAIRMAN. A S evidenced by the fact that Congress has given
that power. There is no stock held by anyone except the private
banks. T h a t is where the misapprehension came about, about the
ownership of the banks.
Mr. WIDNALL. Well, these other countries, are they not judging
the credit of a nation by buying stock ?
The CHAIRMAN. Well, we could buy stocks here but it would be
meaningless. There is no stock really owned. That stock that is
outstanding is not stock.
Mr. WIDNALL. Well, are you saying that in these other countries
then it is meaningless for the government to buy stock in the banks?
The CHAIRMAN. Yes, of course, as long as they control it that is
all they need because they operate on the credit of the nation and
they should control it.
Now, the United Kingdom, the entire capital stock of the Bank of
England has been held in the treasury since 1946.
As Mr. Gordon says, it does not always mean that because the government owns all of the stock, it does not necessarily mean that it is
government controlled.
Just like Canada, they had a very sad experience in 1960 and 1961;
did you not, Mr. Gordon?
Mr. GORDON. Yes, indeed, sir.
The CHAIRMAN. I n which the bank was getting off to itself. Like
I have often said, our Federal Reserve System attempted to secede
from the Government in 1951 by getting off to themselves and
running the whole show.
That is what we are fighting against and what we have been fighting against ever since that time or at least what I have been fighting
against.
Now, I will ask a question of Dr. Meltzer
Mr. WIDNALL. Mr. Chairman, at that point, did not Dr. Meltzer
say that their record since 1951 was unassailable ?
The CHAIRMAN. I did not understand it that way.
Mr. MELTZER. N O , that was not my statement. I said their record
in predicting or observing turning points was unassailable, but their
record in taking appropriate action was very poor after they had seen
them.
Mr. WIDNALL. Well, can you predict what will happen internationally ?
You have been very dogmatic and absolute in your criticism
of the Federal Reserve*
Mr. MELTZER. That is quite correct. We have a report that will be
presented to this committee. W e have evaluated in great detail the
Federal Reserve's record of control of the supply of money in the
United States.
We find that record to be very poor, largely because they have
a very inadequate understanding of the factors governing or controlling the supply of money.
948
THE FEDERAL RESERVE SYSTEM AFTER FIFTY YEARS
Partly because the record is so poor—we then raised the question,
maybe control of the money supply is impossible. Maybe our control
over the money supply is so bad that Federal Reserve policy is the best
as we could do under the circumstances.
So we present our own ideas and our own conception about how
the monetary system works. I am not exactly sure of the figures, but
the results are something like this, sir—the very best that we can find
for the Federal Eeserve is a control over approximately 40 percent of
the monthly change in the money supply.
The worst that we can find, for our conception, is a control over
about 85 or 90 percent. So we conclude that their record is very poor
because they have not understood the process. They have not analyzed the determinants. We give them great credit and we say their
record is unassailable in judging turning points. But they do not
know what to do thereafter.
Mr. WIDNALL. Are you not, in your evaluation, looking back all
the time and the Fed has to look forward?
Mr. MELTZER. T h a t is an element in the process. We have based
our findings on an analysis of events that have occurred. But that is
not the ma j or point.
They have to look forward, but what we are asking is when they
take their actions—in which they apparently have confidence—that
they base their actions on a theory or framework that has been shown
to work in the past.
All we have to do is look at the chart, the chart No. 2 that is
in the statement that I prepared for the committee and observe that
the rate of credit expansion has been countercyclical in the postwar
whereas the rate of monetary expansion has not been countercyclical.
Mr. WIDNALL. May I ask one more question? I do not want to
impinge on your time, Mr. Chairman.
The CHAIRMAN. Surely.
Mr. WIDNALL. Dr. Meltzer, would not restrictions on the growth
of credit in the times of good business drive interest rates higher and
have very adverse effects on the percentage of unemployment ?
Mr. MELTZER. N O , sir. W h a t we want to achieve, I think, is very
well stated in the Employment Act.
W h a t we want to do is have maximum employment and maximum purchasing power. Now, to do that, through discretionary
monetary policy, means that we are going to have a faster rate of
growth in the money supply during periods of unemployment and a
slower rate of growth in the money supply during periods of inflation,
and that is the opposite of what we observe the Federal Reserve has
been doing in the postwar period.
Mr. WIDNALL. Well, I still do not understand that as an answer
to my other question.
Would not restriction on the growth of credit in times of good
business drive interest rates higher, and then have an adverse
effect on the percentage of unemployment ? W h y would it not drive
interest rates higher ?
Mr. MELTZER. Oh, the restriction of monetary growth does drive
interest rates higher given the demand. That is absolutely correct.
But that is the process by which we control inflation.
Mr. WIDNALL. But does not that have an adverse effect on unemployment?
THE FEDERAL RESERVE SYSTEM AFTER FIFTY YEARS
949
Mr. MELTZER. N O , sir. When inflation threatens, we want, in effect,
to ration loans through the interest mechanism by having high interest rates. We want to deter some borrowers, to get them to postpone
their expenditure to some period when we have less demand. T h a t is
how we even out some cyclical u p and down swings.
I s that responsive to your question?
The CHAIRMAN. I n other words, Dr. Meltzer, you Stated the Federal Reserve's record in the past 50 years is unsatisfactory on predicting the amount of money or the volume of money that should be in
circulation?
Mr. MELTZER. Not in predicting it, sir, but in controlling it. I t is
the relationship between the policies that they pursue and the money
supply that they do not understand.
Now, the basis of our position with respect to that is—I think can
be simply stated in the following way:
If credit were the most important thing then their policy would
be quite appropriate, but they have provided no evidence that credit
is the most important thing, and we have been able to find none.
W h a t we have found is that money is very important and their
record is very poor because they confuse money and credit.
The CHAIRMAN. During the last 50 years then, since 1913, when
the Federal Eeserve Act became law, by decades has there been a
real decade of good, you might say, conduct—which is not a good
word to use—but, in other words, has the record of the Federal
Eeserve System been good in any decade during the last 50 years?
Mr. MELTZER. Well, let me just run through them.
I n the first decade, of course, they ran into World W a r I and there,
of course, they provided an extremely rapid rate of increase and an
inflationary increase in the money supply.
I n 1921 they did a very poor job in handling the recession of that
year.
The CHAIRMAN. We had a cruel recession that year.
Mr. MELTZER. Yes, very serious. And I would say, in general, the
answer is that there has been no complete decade in which their
policy has been very adequate.
The CHAIRMAN. During the entire 50 years ?
Mr. MELTZER. T h a t is right.
The CHAIRMAN. All right. Mr. Widnall?
Mr. WIDNALL. Dr. Meltzer, I would like to have a little bit better
knowledge of your own background.
Where did you study and what work have you done since?
Mr. MELTZER. I was an undergraduate student at Duke University
in Durham, N.C.
I then became, for a number of years, a self-employed businessman. I worked at that for about 4 or 5 years until I returned to
graduate school at the University of California, in Los Angeles, I
think, in 1953, and I stayed there until 1955.
I then went to France, wrote a thesis on French inflation, and the
problems of the central bank, and of quite some relevance here went
into the reasons why the central bank was largely responsible for that
inflation through their inappropriate policies. I returned and I
taught by the University of Pennsylvania for a year, and since that
time I have been at the Carnegie Institute of Technology in Pitts
950
THE FEDERAL RESERVE SYSTEM AFTER FIFTY YEARS
burgh, and I have been working on monetary, primarily on monetary
problems. I have been a consultant to congressional committees, the
Treasury, and commercial banks.
Mr. WIDNALL. Are you presently on the staff of the committee?
Mr. MELTZER. Yes, I am, sir. I am a part-time member of the
staff.
Mr. WIDNALL. Are you appearing today as a staff member?
Mr. MELTZER. I believe
The CHAIRMAN. H e is appearing as an economist, as a witness.
We felt that he is so well known in the type of work that he is
doing that he could make a great contribution to this committee
in starting off the series of hearings that we are now conducting.
And he is only part time on the committee.
Mr. WIDNALL. D O you have any charts, Dr. Meltzer, that would
show the relationship of the price level in this country to the fluctuations that you show ?
Mr. MELTZER. F o r this period ?
Mr. WIDNALL. With respect to velocity and with respect to money
and credit?
Mr. MELTZER. Yes. I have a chart here dittoed, and I will be
happy to bring it up to you, sir, showing the price level during
this period.
Mr. WIDNALL. I S it not true that there has been considerable
price stability in the postwar years ?
Mr. MELTZER. Yes, there has been a reasonable amount of price
stability particularly in recent years, although, I might add that I
think we have to be very careful with the price indexes.
I think there is a Joint Economic Committee report indicating they
have something of a bias in them, and we have to be very, very careful
about concluding that a stable price level is really not a declining price
level, and that a rising price level is not really a stable price level.
Small changes in one direction or the other are not terribly meaningful.
Mr. WIDNALL. I S it not true that pressures are being exerted
against them
Mr. MELTZER. Indeed, it is.
Mr. WIDNALL. Is it not true the price level or the stability of
prices is one of the most important things for the low-income people
of the countiy ?
Mr. MELTZER. Yes, it is. I have written to some extent on the problems of controlling inflation and the answer is "Yes," particularly for
those on pensions, but it is also very important for creditors.
Mr. WIDNALL. NOW I would think, from what I have seen in recent
years, that the record has not been too bad on keeping price stability in this country.
Mr. MELTZER. I would say that my judgment of that record is
that prices have probably declined; that is, actual prices have probably declined during the period and that policy was somewhat deflationary from 1959 to 1962. As a result unemployment rates rose.
So^ that on that ground I would conclude that policy has not been
bad in the last year. But we also have to ask the question to what
extent is the Federal Eeserve responsible for the growth of the money
supply last year and to what extent is it simply a fortuitous event that
THE FEDERAL RESERVE SYSTEM AFTER FIFTY YEARS
951
they have not fully understood ? I think we can make a very strong
case for the fact that it is largely a fortuitous event.
May I elaborate on that, sir?
Mr. WIDNALL. Surely.
Mr. MELTZER. 1963 is a very good year to discuss, 1962-63.
I mentioned in my statement, in my earlier remarks, that it was precisely at the time that the Federal Reserve indicated that they had
moved to a policy of slightly less ease that the money supply began
to grow at a much more rapid rate. Their indication of a change in
policy toward less ease was published in the Federal Reserve Bulletin
by the manager of the account, Mr. Stone. Slightly less ease should
mean that the money supply is going to be compressed, that growth
in the money supply is going to slow down. But it is just at that time
that the money supply began to grow faster.
Judged by free reserves that Mr. Hayes at these hearings and that
Mr. Martin and others have used over and over again as the indicator
of their policy—their policy has been tight. But judged by appropriate indicators, that adequately summarize Fed policy operations on the
money supply, their policy has been easier since late 1962. So they
misjudged the meaning or content of their policy, and I think there is
a strong case to suggest that they do not understand, in any reasonable
detail, the operations that they are conducting or their effect.
Mr. WIDNALL. Why is it that the most or most of the other large
countries in the world, their interest rates and the rediscount rates
are higher than in the United States?
Mr. MELTZER. That is a rather complicated question, but in part it
is certainly due to the functioning of our financial system in this
country, the absence of certain risk elements, the very well developed
capital markets that we have in this country. We have a very active
and efficient capital market and that is one reason that leads to a lower
interest rate. The degree of risk and other factors enter into the interest rate level along with the demand and supply for money and
other assets.
Mr. WIDNALL. Now, if the Federal Open Market Committee is so
woefully lacking in understanding, the money process after years of
close and careful study, do you believe that a board which has a tenure
of no more than 4 years and an advisory board of 50 who are not
schooled in monetary policy and have a term of only 1 year, can do a
better job?
Mr. MELTZER. My own judgment, and this I think is the judgment
of the Hoover Commission report or Mr. Bach, who prepared the
Hoover Commission report, probably would be that the best arrangement might very well be a single man charged with the responsibility
for this in much the same way that we deal with other administrative
problems of the Government.
Mr. WmNALL. Well, you do not find t h a t in any of the bills that
are presently pending before this committee, do you ?
Mr. MELTZER. N O , sir; I do
Mr. WIDNALL. W h a t I just
not.
read to you is the monetary organization
provided in H.R. 9631, on which you commented before, Mr. Gordon.
Mr. MELTZER. My comment ?
Mr. WIDNALL. N O ; I said on which Mr. Gordon commented before.
Mr. MELTZER.
Yes.
28-680—64—Vol. 2
3
952
THE FEDERAL RESERVE SYSTEM AFTER FIFTY YEARS
Mr. WIDNALL. That is all at this moment.
The CHAIRMAN. Mr. Reuss ?
Mr. REUSS. Thank you, Mr. Chairman.
I am more interested in the policies of the Fed than in whether
1 or 5 or 7 or 14 can do it better. I applaud both of you gentlemen,
Dr. Meltzer and Dr. Gordon, for getting into some of the fundamental
problems of Federal policy.
What do you mean, Dr. Meltzer, by the "demand for currency"?
Mr. MELTZER. As you know, in what I think we both regard
as the appropriate definition of money, currency, and demand deposits, the public is free to choose how it wants to hold its money.
The Federal Eeserve makes available to the public, through the
banking system, any amount of currency that it wants to have in
exchange for deposits. So, generally the supply of currency is whatever the public wants it to be.
The supply of currency responds to the demand. But the public
has at times desired to convert deposits into currency in great volume.
The most outstanding example of this is, of course, the banking crisis
of 1929-33 when the public en masse came into the banks and said,
"We don't want demand deposits any more. W e want currency."
Fortunately, we do not often have quite such dramatic events as
that and we have not had one since 1933. But we have had bank runs
in other periods of our history, and we have cyclical fluctuations in
currency demand. These swings, on the order of $2 to $3 billion over
the course of some years, are approximately 10 percent of the supply
of currency.
Mr. EEUSS. Let's just take the last 10 years because that seems
to be when you did most of your work.
Is there any rhyme or reason for these variations in the demand
for currency ?
Mr. MELTZER. Oh, yes. They respond to
Mr. RETJSS. Name them.
Mr. MELTZER. They respond to income, the public's monetary wealth
and various cost elements, the kinds of transactions to be made.
There is a well-known seasonal problem here——
Mr. REUSS. Oh, of course, at Christmastime and all of that
Mr. MELTZER. This is also a cyclical problem, responding to the
public's monetary wealth, costs and yields.
Mr. REUSS. Well, what are the factors that increase the propensity
to demand currency instead of a demand deposit ?
Mr. MELTZER. Well, among the factors, I think, several are well
known.
The location of banks in shopping centers would, for example,
be a factor affecting—a longrun cost factor affecting the currency
demands of the public.
Now, superimposed upon that
Mr. REUSS. Let's stop there and take them up one by one. Yes, but
that is very long run indeed; is it not ?
Mr. MELTZER. Yes.
Mr. REUSS. I n 19th
century society, there was a great propensity, I
suppose, to demand hard cash because it was such a long trip to go to
the bank to cash a check. But talking about just the last 10 years,
there have not been any gigantic historical movements in this field,
have there ?
THE FEDERAL RESERVE SYSTEM AFTER FIFTY YEARS
953
Mr. MELTZER. N O , sir, that is right. T h e longrun movement is a
minor influence in the whole problem, not of great significance for
present purposes.
Mr. EEUSS. G O on, if you will, then, but understand my position: I
am sort of from Missouri on this, and I am not impressed, really, so
far, with the proposition that there are great variations in demand by
the American public for currency.
Mr. MELTZER. That, we can demonstrate. T h a t is a fact.
Mr. EEUSS. The whole line wiggles, but
Mr. MELTZER. All right. Now, you would like to know
Mr. EEUSS. W h a t rationale
Mr. MELTZER. Fine. Let's go back to 1946.
Mr. EEUSS. All right.
Mr. MELTZER. There we had a large decrease in the public's desired
holdings of currency. Now that decrease was not wholly but partly
associated with the end of the war.
Two factors during the war had a lot to do with the public's demand for currency. One was the much greater mobility of the population, servicemen, and wives traveling around.
That gave rise to a demand for currency.
Secondly, an unfortunately but probably quite important reason was
the amount of black-market activity that was taking place and the
number of transactions that were carried out in currency. Now,
with the end of the war we see that there was a very sharp decline,
something in the neighborhood of $2 to $3 billion over the course of
a year and half.
All right. Now, thereafter the line wiggled around slightly, of no
great consequence for this sort of analysis
Mr. EEUSS. I f I may interrupt you, I suppose the demand for currency went down in postwar Germany even more markedly, because
nobody in his right mind wanted currency. W h a t you wanted was
cigarettes or some better medium of exchange.
So when you deal with wartime or postwartime, I have no trouble
following you, but in the last 10 years I cannot see anything but an
undecipherable wiggle there. I cannot derive any great sociological
laws from it.
Mr. MELTZER. May we take the swing here which, I think, is
observable?
Mr. EEUSS. From what year to what year, please ?
Mr. MELTZER. This is from approximately the beginning of 1953
to somewhere in the neighborhood, I would judge, of August of
1954. All right?
That is within these years. Now, there we have a swing on the
order of $1.5 billion. That is a fairly large swing.
Mr. EEUSS. Of people who
Mr. MELTZER. Are reducing their holdings of currency.
Mr. EEUSS. And putting them into demand deposits?
Mr. MELTZER. Into demand deposits, that is right.
Initially into demand deposits. They may ultimately go into other
assets, but this had great or decisive influence.
The reason for that is that the Federal Eeserve controls two
elements; one, the reserves of banks and, two, the stock of currency.
954
THE FEDERAL RESERVE SYSTEM AFTER FIFTY YEARS
Now, what they really control is the sum of these two because the
public can switch deposits into currency. But when the currency goes
back into the banks reserves it supports a larger amount of money than
it does if the public holds it as currency, and it is for this reason,
not because of the movements on here, but because of what happens
that those movements take place that currency is of great importance.
A swing of $1.5 billion into the commercial banking system gives the
banking system $1.5 billion larger reserves. There is a multiple
expansion of bank deposits based upon that.
Mr. REUSS. And is one of your complaints that the Federal Reserve
has little or no control over swings in preference from demand deposits
to currency ?
Mr. MELTZER. N O , sir. Our complaint is that they deny that they
exist. They do not recognize them.
When they are asked a question, " I s this a problem for monetary
-control?"
Their answer is, "No problem at all." That is the answer that they
gave to, I believe, the Joint Economic Committee, and that is the
answer they gave to us.
But let's go to a more recent period, if I may, sir. Right here.
Now, that looks like a small change but, given the scale that we
have here, again we have a swing in this short period of 1 year of about
$1 billion in the public's currency holding.
T h a t is a fairly large swing. The public only holds something in
the neighborhood of $30 to $35 billion in currency. So that is a
relatively large percentage change.
I t also permits a much larger expansion in bank deposits. I t was
this swing—in this case an increase in currency and a contraction of
bank deposits—that helped to produce a reduction in the money supply. I t is one reason why the money supply fell in early 1962.
Although the Federal Reserve said at that time that its policy
was easy, the money supply declined. We observed the same thing in
1949, incidentally.
Mr. REUSS. And what would you do about it? I take it that in
Mr. MELTZER. 1961-62, yes.
Mr. RUESS.
any period like 1961-62, your view must have been
that the money supply should be expanded
Mr. MELTZER. Absolutely.
Mr. REUSS.
because our growth rate was insufficient and we had
large reservoirs of unemployment demand power—just as we do today
I take it you would have increased the money supply faster to counteract the diminution that was taking place because people were, for some
reason, drawing on their bank deposits and getting the cash ?
Mr. MELTZER. That is right, I certainly would. This is just one
example. We could provide others.
W e could provide evidence from the Federal Reserve's analysis or
failure to analyze the swing into time deposits or any one of the many
factors that determine the money supply.
I just chose two. The report that we prepared for the committee
will contain others.
F o r many of these variables we find that at any particular time,
they may be a small factor, but others may be important at that time.
I t is the combination of currency and time deposit demand with policy
variables that determines money supply, and it is the failure of the
THE FEDERAL RESERVE SYSTEM AFTER FIFTY YEARS
955
Federal Reserve to recognize most or, in fact, at times any of them
as an influence in determining the money supply that we have discussed
in our report.
Mr. REUSS. Isn't the major trouble with the Federal Reserve monetary policy in the last 10 years—I would not put it further back than
thatr—that they simply have not given the economy sufficient increases
in the money supply to support the higher level of economic activity
that was necessary if we were to grow sufficiently and to find enough
jobs to take care of those who emerged on the labor market for the
first time or were displaced by automation? Is that not the real sin?
Mr. MELTZER. This has certainly been the problem from 1959
through 1962 or mid-1962.
I n late 1962 they permitted a more rapid rate of expansion in the
money supply, and in 1963 at times the money supply was growing at
a rate of 6 or 7 percent.
Mr. REUSS. Yes, it is true that at times in the last year they have
been inadvertently purged of sin for a while, but even then about
all they were doing for that short period was to do what they ought
to have been doing all along. I s that not so ?
Mr. MELTZER. Well
Mr. REUSS. The countries of Europe have generally increased their
money supply in the last 10 years at a rate of 8, 9, or 10 percent a
year, and they have increased their G N P at a similar rate.
We have increased ours at a rate of 1 or 2 percent of our money
supply, and our G N P at about the same niggardly rate. I s that not
the major fault of our policy, compounded along the edges by insufficient observation of what was happening as between demand deposits
and cash and term deposits ?
Mr. MELTZER. N O , sir. I think that the problem really is the one
that we are pointing to.
I n order to control a process you have to understand it.
You have to know what are the basic elemental features that
go into determining the money supply.
Otherwise, I do not see how you can hope to control it. J u s t as
in the case of a corporation officer, he must know what is going
on in his business in order to give instructions to other people so
that they will know what to do. The problem that the Federal
Reserve faces is that they really do not understand this process and,
consequently, they think at times that they are being tight when,
in fact, they are being easy and they think they are being easy when
they are, in fact, being tight. They simply do not understand this
process.
I t is not that they have, I think, any desire to be restrictive when
they should not be. The problem is that they do not understand what
they are doing.
Mr. REUSS. Yes, but I am not interested so much in psychoanalyzing the Federal Reserve as I am in having a sensible monetary
policy. And, in the past 10 years, in those instances, due to not knowing what they were doing, they created a more expansionary money
supply than they thought they were creating.
Mr. MELTZER. Absolutely, at times this was true.
Mr. REUSS. This has been error, but it has been great for the
country, has it not ?
956
THE FEDERAL RESERVE SYSTEM AFTER FIFTY YEARS
Mr. MELTZER. Yes, but we ought to be careful before we get too
happy about such errors because they can reverse on us quickly.
There can be a change in the public's currency behavior, a change
in the time deposit behavior, or any one of these other factors affecting
the money supply and suddenly the money supply will decline.
I n 1949—let me elaborate on that. I n 1949 they consistently
maintained that their policy was an antirecession policy, and yet the
money supply was shrinking during the recession.
Now, why was the money suppply shrinking during that period
while the Federal Reserve was maintaining what they call a "posture
of ease?"
The answer is that they did not understand what they were doing,
and I think the same thing can happen now because I do not think
their understanding has improved since then.
Mr. EEUSS. Of course, one reason that the money supply could
have been shrinking in 1949 when we were getting into a recession
is that the monetary authorities can create money until it, figuratively
speaking, runs out of the economy's ears, but if business expectations
are bad or if the tax system or fiscal policy is wrong and nonexpansionary, monetary policy alone is not going to produce the required lift,
and, therefore, businessmen are not going to go to banks and ask for
loans and are not going to expand and buy inventory even though
there is plenty of money around.
T o that extent they are "pushing on a string."
Mr. MELTZER. N O , we find no evidence to support that. The one
period, and the period that gave rise to that metaphor was during
Chairman Eccles tenure during the depression.
I t was during the late 1930's that they kept arguing that they could
not push on strings. But, in fact, it had nothing to do with pushing
on strings.
I t was their very inappropriate behavior that the chairman referred to at the opening of this meeting. They doubled the reserve
requirements in 1936 and 1937. Mr. Goldenweiser's statement in 1941,
published in Banking Studies, gives very adequate testimony to that.
They described the doubling of reserve requirements as no change
in their policy. The fact that they had doubled reserve requirements
seemed to them to make no difference. The reason for that is developed in some detail in our report. But the simple reason is that they
did not understand the role of excess reserves in the banking system,
and they did not understand what the effect of their operation would
be. So they made an error and compounded it. And this is the most
serious weakness in the system, that they do not understand the operation that they have been entrusted to control.
If I may add to that, I agree with your opening statement that it
is not so much a matter of administrative arrangements as it is a
question of their having a thorough understanding of the process
that the Congress has given them to control.
And I just do not find very much evidence that they have that
understanding.
Mr. EEUSS. Well, I hope your study, Dr. Meltzer, will help me on
the point with which I have the most difficulty which is: How do you
sort out the effects of the monetary policy which the Federal Eeserve
does not now control because they fail to recognize them?
THE FEDERAL RESERVE SYSTEM AFTER FIFTY YEARS
957
You mentioned two of those, namely, the interplay between demand
deposits and time deposits and the interplay between demand deposits
and currency.
How do you sort out the total effect of these monetary changes to
which you say the Federal Eeserve has been blind and the total
effect of the changes in monetary policy to which the Federal Eeserve
has not been blind.
W h a t is their quantitative measure? You certainly are not suggesting that the Federal Eeserve has no effect on the money supply ?
Mr. MELTZER. I would suggest
Mr. EETJSS. I n many cases the results may be different from what
they are trying to do, but it does affect them.
Mr. MELTZER. Let me try to answer that. That is a multipart
question. Let me answer it in several stages.
First, the Federal Eeserve certainly does affect the money supply.
Their primary influence is exerted through the monetary base, bank
reserves plus currency. Their policy actions change the base and
thus change the money supply. Our theory tells us that a 1 percent
change in the base should cause a 3 percent change in the money
supply. That means that a dollar of new reserves or currency should
add $3 to the money supply. We have tested that and found that it
holds for many different time periods.
Second, our theory incorporates factors like time deposit demand
and currency demand by the public. I t tells us what the effect of
changes in the public's desire for currency or time deposits will do to
the money supply. An exchange of currency for demand deposits
should have a smaller effect on the money supply than an increase
in bank reserves through open market operations. A switch of demand deposits into time deposits should have a smaller effect still,
according to our theory.
Now, we have tested these implications. And we find that they
generally hold. So we have confidence in the theory. We have evidence to support the theory. That is what gives us our confidence
in it.
Our point is not that the Federal Eeserve does not have any effect
on the money supply. Their policy operations are of very great
importance. "But they do not understand how their policy operations
affect the money supply. They do not have an adequate theory, and
they have not developed and tested one.
That is why I say that they do not know what they are doing.
Their theory is inadequate and has not been verified.
We have also tested our theory in France, in Great Britain and we
have started to test and develop a theory for Canada. Generally the
theory works quite well.
I t is on the basis of these tests that we believe that we can sort out
the effects of the various factors. We do not say that our theory is
absolutely correct in every detail. W h a t we are saying is that it is
possible to analyze the factors determining the money supply and put
them together in a coherent, consistent, and validated way. Then you
can understand their effect and control them or at least do much better
than has been done.
Nor do we claim that our theory is correct in every way and theirs
is totally incorrect. All we say is that we have compared the two
and have seen which one of the two is better.
958
THE FEDERAL RESERVE SYSTEM AFTER FIFTY YEARS
Someone will come along with a better one than ours. Then control
can improve further.
The CHAIRMAN. The Federal Reserve, of course, has the power to
determine the volume of money. H a s it not erred more times during
the past 50 years by failing to provide sufficient money rather than by
providing sufficient money or more than sufficient?
Mr. MELTZER. If we take the great wartime experiences, of course,
the general policy has been on the side of being much too easy during
wartime periods. Some Members of the Congress, I believe, ana
others were anxious to see a larger part of our war effort paid for by
taxes. The Federal Eeserve provided the money to finance that and
overproduced money.
A t other times I think—let me summarize my views on this by
saying that they have gone too far at various times, in both directions,
and it would be very difficult to conclude as to which times they did
worse.
The CHAIRMAN. Doctor, some of the Members of the committee and
the House are contemplating a campaign with the Members of the
House of Representatives by organizing a Steering Committee, composed of all who are interested in it, to make sure that we do not
increase the 4*4 percent interest rate ceiling on long term bonds.
Efforts have been made in the recent past to raise the ceiling, and a
few of us have led the campaign against it, and at one time it almost
passed before we knew about it.
But we succeeded in stopping it with a group of about 60 or 70
Members of the House.
Now, it occurs to me that all signs point to an effort to be made
in the reasonably foreseeable future to take that 4*4 percent ceiling off.
Are you not impressed that there is something brewing in that
direction ?
Mr. MELTZER. I haven't been watching that, sir, in recent months.
The CHAIRMAN. NOW, if we are going to peg the prices of those
bonds, should we rely upon the traditional and well known method of
raising the reserve requirements of banks in order to prevent an excess
amount of money and credit, or should we have a different system,
like immobilizing reserves in order to do it ? Which would you suggest would be the better?
Mr. MELTZER. I would say that I am a strong partisan of open market operations. And I think the record bears out that the Federal
Reserve has not fully understood the way in which reserve requirements fit into the System.
I am strongly in favor of seeing that power, the power to alter reserve requirements, taken away from them. That would force concentration on open market operations.
The CHAIRMAN. NOW, would you have the open market operations
conducted as they have been in the past almost as a secondary way,
used, that is, after lowering reserve requirements as a measure of providing reserves for the commercial banks, or would you change the law
or the regulations and make it possible for the Open Market Committee
to acquire more bonds in their portfolio, and let the interest flow over
into the Treasury ?
H a d you given that consideration?
Mr. MELTZER. Yes. I would see no harm in having the interest
flow back into the Treasury.
THE FEDERAL RESERVE SYSTEM AFTER FIFTY YEARS
959
The CHAIRMAN. I t occurs to me that the Federal Reserve System
could, without any danger of inflation or deteriorating the dollar,,
could, over a period of years—not quickly or suddenly—but finally
fully acquire and own as much as, say, half of the national debt,
which would be about $150 billion. Naturally, that would have to
be done slowly.
But when accomplished it would, of course, save the taxpayers
about $5 billion or more a year.
How would you look upon a proposal like that ?
Mr. MELTZER. Well, I am in favor of saving the taxpayers' money.
As far as the proposal—may I ask a question about the proposal,,
sir?
You would have the Federal Eeserve buy up the debt, is that right £
The CHAIRMAN. Well, when other people don't want it, that is as
the economy grows.
Mr. MELTZER. When it is appropriate, say, to increase the
quantity of money, that they would do it through open market
operations.
The CHAIRMAN. That is right.
Mr. MELTZER. Oh, absolutely. I think that open market operations
should be their primary tool. One of the recommendations I would
like to make is thaJt the discount window be left open, and at a penalty
rate, so that the banks can borrow and make their own reserve adjustments. That would remove a problem that has consistently plagued
the Federal Eeserve, and focused their attention on all of the shortrun
money market changes. Such problems should be removed from the
concern of the Open Market Committee. Instead of concentrating on
the 3-week or 1-week period, or hourly or daily operation, the Federal
Eeserve Open Market Committee should be asked and forced, perhaps,,
to concentrate on the 6-month problem, or the 1-year problem, to pro*vide the requisite growth in the money supply, and to leave these very
shortrun problems to the bankers. And under those circumstances, I
would want them to deal in open market operations exclusively.
The CHAIRMAN. Mr. Gordon, I would like to ask you this question:
I n 1960 and 1961 I believe is when you discovered in Canada that
you did not actually have control of your Central Bank. Is t h a t
not right?
Mr. GORDON. The problem originally began, sir, in 1956-57. On
that occasion, the Central Bank was pursuing a tight money policy.
The Minister of Finance was questioned in the House concerning
the policy, and he denied that he had anything to do with the
policy, or was responsible for it.
Subsequent to these events, it became common for the Minister to
deny on the one hand that he was responsible for the Bank, and the*
Bank to deny, on the other, that it was subservient to the Minister,
which finally produced a crisis in the money market in 1959, and then
was brought to a head by the insertion of the Governor into the field
of public controversy in 1960-61.
Mr. WIDNALL. Mr. Chairman, would you yield at that point?
Wasn't that basically a clash of personalities, and not something
wrong in the structure ?
Mr. GORDON. Well, I believe, myself, sir, that a structure should
always be designed to provide for the existence in positions of authority of inappropriate personalities.
960
THE FEDERAL RESERVE SYSTEM AFTER FIFTY YEARS
The first Governor of the bank was a man of unimpeachable
integrity and sense of the proper position of a public servant. The
second Governor was not. But we cannot tell beforehand which
personality will occupy the post.
Mr. WIDNALL. Does the Bank have to get annual appropriations
to run its business ?
Mr. GORDON. N O ; it does not. Indeed, it did not even furnish an
operating statement until a few years ago.
The CHAIRMAN. But they do furnish operating statements now
annually ?
Mr. GORDON. They do. The statements are so restricted, however,
t h a t it is quite impoissible for an outsider to analyze them as one
would the operating statement of a business.
The CHAIRMAN. NOW, from time to time various officials of the Fed
have suggested that the independence of the Federal Reserve actually
serves a good purpose, actually helps the Congress. The idea is that
when something unpopular is done, something like tight money, we can
say, "the Fed did it; we didn't do it." And they would be a sort of
scapegoat, and we would be off the hook. It's supposed to be tempting, to us, to evade that responsibility.
But we would get ourselves in a position like you were in in Canada. The people would not know who to blame, they would not
know—and, of course, they have no way of voting against the money
managers, they have no way of reaching them, unless they are subservient to the elected officials there is no way for the people to reach
them at all. And that is what you got into in Canada, wasn't it?
Mr. GORDON. Yes, sir. I t was a situation which, of course, was
not sustainable for very long.
But at one time during the history of it, the central bank inserted
itself into an election campaign. I t s annual report was published in
the middle of an election campaign, and the report was deliberately
written to influence the state of opinion.
The CHAIRMAN. Well, we had just in a minor way something like
that in our country one time, when Mr. Eisenhower was wanting to
get all the money he could to apply on the budget. The Fed came
to his rescue by turning over $266 million at one time at the end of
the year—just out of the clear blue. And that is somewhat of a
political gesture, it was thought at the time by the people. Of
course other people did not take that view.
The argument is made in this country that the Fed should be insulated against the electorate—the political angle.
Isn't it true in most countries of the world the central banks are
more or less tied in, their monetary policies, with the central government—the central bank with the central government? And that
is for the obvious purpose of the people being able to blame somebody that they have something to do with putting into office. Isn't
t h a t correct?
Mr. GORDON. Yes, I believe this is the heart of the issue.
We mistake the question of responsibility very often. W e think
of the responsibility of a public official in terms of his personal
integrity. However, responsibility really means being responsible
t o some other body and eventually to the people at large.
The CHAIRMAN.
Yes.
THE FEDERAL RESERVE SYSTEM AFTER FIFTY YEARS
961
The insincerity, I think—of course that is just my opinion—of
the contentions of people that the central bank should be insulated
against the electorate is due to the fact, not only that they have
nobody to actually blame, but it is hurtful to the economy—in the
case of our Federal Eeserve System in particular—because although
they are insulated and have the type independence they claim they
are entitled to have and insist upon having, if they have that
type independence, they are insulated against the people all right,
and the people cannot reach them.
But they make no effort to insulate themselves against the bankers
who profit the most by what they do.
I t is rather almost on the side of hypocrisy, the way I view it, for
us to say that there should be a small number of people to act as our
monetary managers. The Constitution gives that power to the
Congress. The Congress delegates it in this case to the Federal
Eeserve. And if we just let them run the show, independent of
everybody, the people don't get the consideration.
But now they are not trying to insulate themselves against the
bankers, not at all. The bankers are on the boards.
Now, Mr. Wilson, President of the United States when the Federal
Eeserve Act was passed, wanted 12 autonomous banks, just like were
adopted in the 1913 act—no Central Bank at all. H e was opposed to
it.
Well, of course, the big bankers all fought it. They didn't like
it at all. They wanted a central board, like the present Open Market
Committee, where they could have a voice and help determine the
volume of money and the cost of that money.
Well, Mr. Wilson said that was against the public interest. And
when certain big bankers visited him one time, Mr. Glass insisted
that he see them, because they insisted they knew more about money
than anybody else, and they wanted to be on those boards.
And when they came in his office, and he was asked that question—
"Mr. Wilson, we believe we know all about the monetary matters of
our Nation, and we know more about it than the people in politics,
and we want this Federal Eeserve fixed so we can serve on these
boards," Mr. Wilson said, "Which one of you gentlemen would ask
me to put presidents of railroads on the Interstate Commerce Commission, to fix passenger rates and freight rates?" They didn't attempt to answer that. They began to talk about the weather, and
they slunk out, and they didn't come back any more.
But Mr. Wilson went ahead with his insistence, and he got it
fixed up just like it was.
Well, now, that was fine—no central bank, but just each region to
look after the finances of that region—a wonderful theory.
And then in order to get eligible paper to create reserves, they
had to make loans to little businessmen and farmers, and people like
that locally. And they were pursuing t h a t type of thing all the
time because they wanted that eligible paper. They could put it in
their bank and lend money. I t was wonderfuL
But they began to get away from that. Then they got the Open
Market Committee and through that a central bank. And they are
on these committees that Mr. Wilson didn't want to exist at all and
certainly wouldn't have wanted them to be on.
962
THE FEDERAL RESERVE SYSTEM AFTER FIFTY YEARS
I think it is almost on the side of hypocrisy for people to say they
believe that we should do everything in the interests of all the people,
equal rights to all and special privileges to none—an J yet advocate
that we have an independent board to determine our monetary policies,
which is the most important policy any government on earth will ever
be called upon to execute and administer—to let it be executed and
administered by people who are selfishly interested. And that is what
we are doing here.
They want an independent board, independent of the people, independent of those who are elected by the people, but not independent
from those who would profit by their operations—but insist that
they be allowed to serve on the board. That is the part that I think
that our committee should give a lot of consideration to and endeavor
to get something done that will be fair to everybody.
Have a board, have monetary managers—but who will not be
catering to any particular group that is benefiting from the decisions
of the operating managers. And that is what you have been trying
to do in Canada, is it not, Mr. Gordon ?
Mr. GORDON. Yes. We haven't done anything specific yet, Mr.
Chairman, because a Royal Commission is now sitting. But it is
expected that the Royal Commission will make proposals of this
sort.
The CHAIRMAN. Yes,
sir.
Any other questions, Mr. Widnall ?
Mr. WIDNALL. Yes, I have some questions, Mr. Chairman.
The CHAIRMAN. All right.
Mr. WIDNALL. Dr. Meltzer, you have evidently made a very
thorough study of the 50 years of the Federal Reserve System. You
are not just highly critical of the last decade, but all five decades.
A n d these have been under different Federal Reserve heads, different
Federal Reserve boards.
Now, in your study, was it complete enough to tell and place in
the record any criticism of lack of rapport between Government
and the Federal Reserve System made by a President of the United
States or a Secretary of the Treasury?
Mr. MELTZER. Let me answer that first by sa}^ng that we have
gone into great detail about the postwar period. We have not gone
into great detail about the earlier period, although we have studied it.
Professor Friedman, who will be here, I think, later this week has gone
into a study of periods before and after the Federal Reserve was
chartered. He has done more detailed studies of the earlier years.
But I would say "Yes," there have been periods in which the
Federal Reserve at least has claimed to us and I think publicly that it
did operate by so-called leaning against the wind.
One of these, I believe, had to do with the rise in the discount rate
in 1957, if I am not mistaken.
The CHAIRMAN. That was Mr. Martin's statement. We were in a
recession, and I told him at the time that he was leaning against the
wind of the people, but not leaning against the wind of the banks.
Mr. WIDNALL. A S I recall that, Mr. Chairman, it was leaning
against the economic wind, and not against the President or the
Secretary of the Treasury or the Government. The essence of the
main bill before us has to do with a complete revision of the
System, emasculating what we have today and starting out prac
THE FEDERAL RESERVE SYSTEM AFTER FIFTY YEARS
963
tically anew. And, as I understand, the chief allegation that has been
made is there is no real communication with Government, and that
this is operating completely in a secret chamber, without any such
communication, and independent decisions are made that are not
in the interests of the people of the United States.
And I think it is extremely important for the record to have
documented what Presidents of the United States in 50 years have
criticized this, what Secretaries of the Treasury have criticized
it, and what recommendations have been made to change it.
We have had Democrat and Eepublican Presidents. W e have had
many changes on the Federal Reserve Board.
I think it is extremely important when we are evaluating the 50
years.
Mr. MELTZER. May I give you one example that comes to mind?
F o r the most part, we do not know what goes on in the detailed
meetings of the Board of Governors, or the Open Market Committee.
We do know a little bit now, perhaps more than we have before,
because the diaries of President Harrison, former President of the
New York Federal Reserve Bank, have now been deposited at Columbia University.
I understand that at one very critical juncture in monetary policy,
and in the state of the economy, the Congress was—during the great
depression—the Congress was clamoring for some Federal Reserve
action. And I think Mr. Patman read and quoted President Hoover's
statement to that effect. Yet during that period the Federal Reserve
was doing very little.
Now, there was one very brief period in which they engaged in
large scale open market operations. The Congress had been clamoring
quite loudly, and Members of the Congress had been making statements which would lead many in the Federal Reserve to believe that
there might be serious changes in the act. A t that time, they had a
meeting of the Open Market Committee at which they voted to have
open market operations to expand reserves. They determined, in
order to meet the criticism of Congress, that the managers could
go out and buy these open market securities on the following day so
that they would appear in the record of their actions for that week.
And so that they could then say to the Congress
Mr. WTONALL. Isn't it true the Secretary of the Treasury was a
member of the Board at that time as well as the Comptroller of the
Currency ?
Mr. MELTZER. Yes, that is correct. The Secretary and the Comptroller were both members of the Board at that time.
Mr. WIDNALL. The circumstances were different than they are
today.
Mr. MELTZER. Different in what respect, sir ?
Different in terms of the composition of the Board—perhaps yes.
Different in terms of the fact that they did not really understand the
nature of the events that were occurring and the correct or appropriate responses to them—I would say by and large I see no evidence
to conclude that things are different in that respect.
Mr. WIDNALL. A t that time, the Federal Reserve System and
Board was much closer to the Government than it is now; isn't that so ?
Mr. MELTZER. I am not sure "closer." You mean by the presence
of these two gentlemen ?
964
THE FEDERAL RESERVE SYSTEM AFTER FIFTY YEARS
Mr. WIDNALL. I think this can be documented, as to the complexion
of the Board.
Mr. MELTZER. That the Secretary of the Treasury and the Comptroller were members of the Board. T h a t is certainly true in that
sense the Government's policy
Mr. WIDNALL. You said there was a great clamor in Congress then
for change.
Mr. MELTZER. Yes, sir; that is my understanding of the record of
the Harrison diaries.
Mr. WIDNALL. I would like to ask another question.
You are rather critical of the policy in that early 1930 period.
Now, in 1935 and 1936, what was our situation with respect to other
countries with respect to gold and currency flow ?
Mr. MELTZER. YOU mean were we experiencing an inflow in 1935 ?
Mr. WIDNALL. I n 1935 and 1936.
Mr. MELTZER. I am not sure of the
precise dates.
But during that—somewhere in that period, we were experiencing
a substantial inflow of gold—what I suppose we can refer to as saberrattling gold because of events in Europe.
Mr. WIDNALL. Don't you feel that defensive measures had to be
taken at that time ?
Mr. MELTZER. N O , sir; I did not believe that defensive measures
had to be taken. And certainly I could not find myself in any
sense supporting measures such as doubling reserve requirements.
T h a t is a very drastic action in the midst of a depression.
Mr. WIDNALL. Well, it is certainly necessary to increase reserves
when you are experiencing that type of flow.
Mr. MELTZER. A t times. If we read Mr. Goldenweiser's statement,
which is perhaps much more knowledgeable than mine about the reason for doing this, the Federal Reserve did not take that action as
a device for tightening the money supply. A t least that is his statement. H e was the director of their division of research and their
adviser. H e said, "We did not envisage that as any major change in
our policy of ease. We did that because we were out of touch with
the market," I think that was his phrase.
Mr. WIDNALL. Now currently, isn't Switzerland putting the brakes
on their money supply, despite unemployment in Switzerland?
Mr. MELTZER. I have not studied the current Swiss situation.
Mr. WIDNALL. Germany is, also.
Mr. MELTZER. Germany is attempting to control, yes. I do know
a little bit about that. Germany is attempting to control the rate
of price increases.
Mr. WIDNALL. Isn't a lot of that due to the influx of funds from
abroad, which is exerting pressures on prices and starting inflation?
Mr. MELTZER. I think my own analysis of the German situation
would take as a very important factor the decline in the number of
workers that they have been able to recruit from places like East
Germany. That has put pressure on wages and prices in West Germany, and has let to a more rapid rate of price increase. Prior to
the building of the wall, they were able to expand their economy by
attracting workers from East Germany, without putting a great deal
of pressure on prices.
Mr. WIDNALL. So you feel the funds coming in from abroad to
Germany and Switzerland exert no pressures?
THE FEDERAL RESERVE SYSTEM AFTER FIFTY YEARS
965
Mr. MELTZER. No. Gold flowing into the country has an expansive effect on the money supply.
Mr. KILBTJRN. I was much interested in your first question which
I understand has not been answered.
I presume the professor here has made a study of the Federal
Eeserve for 50 years.
Have you ever known of a President or a Secretary of the Treasury
that has criticized the operations of the Federal Eeserve System?
Mr. MELTZER. Yes. I think President Hoover—President Hoover's
statement was that the Federal Eeserve—in periods of great crisis the
Federal Eeserve was a weak reed. That is a paraphrase.
Mr. KILBURN. Will you please put it in the record ?
Mr. MELTZER. Certainly.
(The quotation appears on p. 212 of Hoover's "Memoirs.")
The CHAIRMAN. Didn't Mr. Truman—Mr. Truman criticized the
Federal Eeserve Board—he had the whole Board come to see him. I t
never happened before. Not only the Board, but the Open Market
Committee members.
And isn't it a fact, Doctor, that the Federal Eeserve's operations
had not been as important—were not important until, you might say,
after the commencement of World W a r I I . The national debt was
small before that time, comparatively small. I t s operations were in
proportion. Isn't that correct ?
Mr. MELTZER. I n terms of the volue of their purchases or sales, yes.
I n terms of their impact, sir, no.
Their behavior—again, to return to the period 1931, 1932, 1933—
was very, very significant from the standpoint of converting what at
least in my judgment and the judgment of other experts—not all
other experts, I might add—might have been a minor recession into
a major depression.
Their action in 1936 and 1937 was largely responsible for the
recession that occurred in 1937,1938, in my judgment.
The CHAIRMAN. NOW, the early 1920's—that was a time when the
Federal Eeserve did not rise to the occasion, and actually caused
things to be done that were disastrous to the economy. I s that
correct ?
Mr. MELTZER. That is correct. I n the period 1920, 1921, that recession was largely a Federal Eeserve recession.
Mr. WIDNALL. Mr. Gordon, in June of 1962, there was a crisis in
Canada, and the United States came to the rescue at that time. Do
you believe that the deliberations within the United States at that
time, the decisions that were made, should be exposed to public
view word for word ?
Mr. GORDON. That is a very difficult question, Mr. Widnall.
Mr. WIDNALL. This committee is asking right now the Federal
Eeserve System, the Open Market Committee, produce the minutes
of all of their meetings, so that they can be evaluated by the committee. We just know from experience once they are here, everybody in the United States is gping to know, and everybody in the
world. There is some disposition on the part of some of us to say
that many of these transactions are transactions that could be harmful in our relations with other nations if they are exposed to public
view.
966
THE FEDERAL RESERVE SYSTEM AFTER FIFTY YEARS
Mr. GORDON. Well, I would say that, let us say, a year after
the event, more harm is likely to come from permitting groundless
speculation as to the nature of the agreements that were made,
because it is the responsibility of independent economists, for
example, to analyze the circumstances. I n the absence of hard information they must speculate. And more harm is likely to come
from permitting groundless speculation than by disclosing.
I thought when you asked the question you had in mind immediate disclosure of the agreements.
Mr. WIDNALL. Well, we have asked for the minutes for 1960, 1961,
1962 and 1963. And 1963 would certainly be the same as immediate
disclosure.
Mr. GORDON. I would think that the monetary authorities should
have some right to hold information for as much as 6 months,
or perhaps a year, and probably it would have to be at their discretion which to hold, because some information might be damaging
to an on-going program.
But I do not think that information held more than a year is really
justified.
Mr. WIDNALL. I s there any means of public information in Canada
as to the deliberations within the central bank with respect to the
monetary policy ?
Mr. GORDON. None.
Mr. WIDNALL. Do you know of the release of public information
in any of the other central banks—deliberations between members
with respect to decisions on interest rates and exchange with other
countries ?
Mr. GORDON. I believe, as a matter of fact, that the United States
furnishes more information of this sort than any other central
bank in the world. I may be wrong in that there may be a particular
small central bank which furnishes more, but certainly the Federal
Reserve furnishes more than any other major central bank at the
moment.
Mr. WIDNALL. Mr. Gordon, I don't really want to put you on the
spot. You are a foreign visitor. But you are a witness before this
committee.
Would you care to express an opinion as to whether or not you
believe the Federal Reserve System knows what it is doing?
Dr. Meltzer evidently doesn't believe it does.
Mr. GORDON. Well, as a foreigner, I read statements that are made
in the press from time to time by officials of the Federal Reserve, such
as the Chairman of the Board of Governors. And to speak frankly,
I am not surprised at the bad record of the Federal Reserve because I
could not imagine that a good record could emerge from the place
from which such statements emerged—if I am making myself clear.
That is to say, it seems to me that there is so much muddiness in
the analysis of monetary processes displayed by the public statements
that it is very difficult to believe that the actual practice could somehow resolve itself and be clearer.
Now, I must say that our own central bank in Canada is no less
muddy in its public statements than the Federal Reserve has been.
And I would ascribe a good deal of our bad performance to exactly
the same sources as Professor Meltzer has. I n fact, I wonder at
THE FEDERAL RESERVE SYSTEM AFTER FIFTY YEARS
967
times whether we are not experiencing a North American phenomenon, rather than a peculiarly Canadian or American one, since there
seems to be an extraordinary disposition in the two countries in
northern North America to make the same mistakes.
But I just add that this is the result, not of the intensive analysis
such as Professor Meltzer has done, but of the layman's reading of
press reports concerning monetary events in the United States.
Mr. WIDNALL. Well, you have just testified on H . E . 9631, which
would enable a great change in the composition of the Federal Reserve
Board.
Do you believe that putting on that Board a lot of uninformed
people for a very short term is going to give you a better system
than you have right now.
Mr. GORDON. N O , I do not, sir. The part of Professor Meltzer's
testimony that would worry me is that it seemed to me to be largely
an argument that the quality of the work was poor, and, therefore,
should be replaced by better work. And this does not necessarily
call for a reorganization of the System. I t calls for a replacement
of personnel, perhaps.
Now, as I read the bill, if it was taken literally, it would produce
a very short-term Board, which is not likely to result in an improvement in the technical work which the Board would perform. But
I think that if one reads the bill with some idea as to what would
evolve from it, I take it to mean that what would evolve from it is
that it would in fact be the Treasury that was the monetary authority
in the United States.
Now, again, this is based on very little knowledge of the way the
American system of government works.
But I cannot conceive that a very short term Board of the sort
that is proposed in the bill would actually end up being the important operating agency of monetary policy.
Mr. WIDNALL. Mr. Gordon, in other words, what you are saying
is that the Treasury would dominate under the new bill.
Mr. GORDON. Yes,
sir.
Mr. WIDNALL. Now, I believe you are familiar with the fact that
there is a rapport between the Federal Reserve System and the National Security Council, the President's Economic Committee, and
the Treasury at the present time, an exchange of information all the
time.
Mr. GORDON.
Yes.
Mr. WIDNALL. So that actually in practice here, we are doing better
than the central bank of Canada with respect to rapport with the
Government.
Mr. GORDON. Yes, sir.
Mr. WIDNALL. Do you
know enough about the other central banks
in the world to know how our present setup or rapport would compare with those—say the Bank of England?
Mr. GORDON. I would judge that if we were to rank central banks
in a spectrum, running from those which in fact had very close relations with their governments to those who had verv distant and arm'slength relations with their governments, we would have to rank the
United States on the latter side, as I expressed it just now—that is,
by and large, among those that had rather distant relations with their
governments.
,28-680 0—^64—vol. 2
4
968
THE FEDERAL RESERVE SYSTEM AFTER FIFTY YEARS
Mr. WIDNALL. I think that is all.
Thank you both.
The CHAIRMAN. Thank you, gentlemen, very much, for your
appearance and your testimony.
Will it be satisfactory if any members of the committee—some
could not be here this morning—would send you a question through
the chairman in writing, and you will be willing to answer it when
you look over your transcript ?
You will probably have some questions—not many—that way.
We were intending to have these other witnesses this week, but on
account of the fact that the members will be out of town, we are
canceling the hearings on Thursday and Friday, and we will
resume again after the week of the 17th. That will be the 24th.
And so, without objection, we will stand in recess subject to the
call of the Chair.
Again, thank you, gentlemen.
(Whereupon, at 11:55 a.m., the committee recessed, subject to the
call of the Chair.)
THE FEDERAL RESERVE SYSTEM AFTER 50 YEARS
TUESDAY, FEBRUARY 25, 1964
HOUSE OF REPRESENTATIVES,
SUBCOMMITTEE ON DOMESTIC F I N A N C E OF THE
COMMITTEE ON BANKING AND CURRENCY,
Washington, D.C.
The subcommittee met, pursuant to call, at 10 a.m., in room 1301,
Longworth House Office Building, Hon. Wright Patman (chairman)
presiding.
Present: Representatives Patman, Reuss, Hanna, Kilburn, Widnall,
and Brock.
The CHAIRMAN. The committee will please come to order.
Today we resume hearings on the first 50 years of the Federal
Reserve.
This week we will hear from six outstanding economists. Every
one of these men is a recognized authority on monetary economics.
They represent universities from California to Cambridge, Mass. I
am sure that by the time they have finished presenting their testimony
and answering our questions we will have heard many shades of opinion and points of view.
We have not stacked the deck. We have tried to get the broadest
possible range of opinion on how our monetary system operates, on
the effectiveness of monetary policy, and on the independence of the
Federal Reserve.
During the first 2 weeks in March we will hear from still more economists and from Government witnesses including Secretary Dillon.
Now, this morning we have Prof. H a r r y Johnson and Prof. Henry
Villard.
You gentlemen have prepared statements, I believe. They have
been furnished to the members of the committee, and we appreciate
them, gentlemen.
Now, if it is all right, each one of you may summarize your statements any way that you would like to so as to use the minimum time to
present the main points, and then the members of the committee will
interrogate you and probably bring out everything you desire to anyway. We are indebted to you gentlemen for coming here this morning.
Professor Johnson, you may proceed, sir.
969
970
THE FEDERAL RESERVE SYSTEM AFTER FIFTY YEARS
STATEMENT OF PROF. HARRY G. JOHNSON, UNIVERSITY OF
CHICAGO, CHICAGO, ILL.
Mr. JOHNSON. Thank you, Mr. Chairman. I want to begin with
the argument for an independent monetary authority which is, I think,
the key
The CHAIRMAN. Will you identify yourself, please, for the record
first?
Mr. JOHNSON. I am Prof. H a r r y Johnson, of the University of
Chicago.
I want to begin with the argument for an independent monetary
authority, which is the crux of the issues facing the committee, in my
judgment.
The argument for an independent monetary authority has two
facets to it. One is the political argument that an independent monetary authority is desirable to prevent Government from being able to
indulge in its natural propensity to resort to inflation. The other,
which is less explicitly political, is that a stable monetary environment is essential to the proper functioning of a predominantly free
enterprise society, and that an independent monetary authority is
essential to maintain such a monetary environment.
The first argument seems to me utterly unacceptable in a democratic
country. Indirectly, it is an argument for establishing the monetary
authority as a fourth branch of the Constitution, charged with the
function of forcing the Legislature and the Executive to follow conservative economic policies involving the balancing of the budget and
restraint on Government expenditures. I n other words, it involves
the establishment of a special position in Government for the owners
of one form of property—owners of money and of assets fixed in terms
of money—a position which is inconsistent with the principles of democratic equality and the presumption of democracy that the purpose of
government is to serve the social good.
Turning to the second argument, granted that a stable monetary environment is desirable, the question arises whether an independent
monetary authority as presently understood is sufficient to provide
such stability. The argument that it is assumes that, if free of control by the Executive and Legislature, the monetary authority will
govern monetary policy in the light of the longrun best interests
of the economy, and wrill conduct its policy flexibility and efficiency
in the short run. This assumption is not consistent with the historical
evidence of the behavior of monetary authorities; the evidence is
rather that central banks have done little if anything to restrain
inflationary policies in wartime—'and war and its aftermath have been
the almost exclusive source of serious inflation in the major countries in the 20th century—while in peacetime they have displayed a
pronounced tendency to allow deflationary policies on the average.
Moreover—I refer here particularly to the behavior of the United
States and Canadian central banks in the past decade—in the shortrun conduct of policy they have tended to overreact to changes in
the economy and to reverse their policy with a substantial delay,
thereby contributing to the economic instability that their policies are
intended to combat.
These defects are in my judgment inherent in the conception, constitution, and operating responsibilities and methods of an independ
THE FEDERAL RESERVE SYSTEM AFTER FIFTY YEARS
971
ent monetary authority, and are unlikely to be modified greatly by
gradual improvement of the techniques of central banking on the
basis of accumulated experience and research. For one thing, freedom of a central bank from direct political control does not suffice
to render it insensitive to contemporary political opinion. On the
contrary, its position as the one agency of economy policy formation outside the normal political structure both exposes it to subtle
and sustained political pressures and forces it to become a political
animal on its own behalf, devoting considerable effort either to justifying its policies" by reference to popularity-esteemed objectives or
to denying responsibility for economic conditions and passing the
buck on to the Executive or the Legislature, the result being to
obfuscate the policy choices that have to be made. Secondly, the
position of the central bank as controller of the money supply inevitably must bias the monetary authority—except in times of national emergency such as war—toward emphasizing the pursuit of
objectives connected with the value of money—resistance to domestic
inflation, and preservation of the international value of the currency—to the underemphasis or neglect of other objectives such as
high employment and economic growth. Thirdly, the methods of
monetary management, which involve the central bank concentrating
its attention on money market conditions and interest rates, and on
member bank reserve positions and lending, rather than on the performance of the economy in general, are extremely conducive to the
behavior pattern of overreaction and delayed correction of error already mentioned.
Because it concentrates on money market and banking phenomena,
rather than the effects of its policies on the quantity of money and
economic activity, and because the effect of monetary policy on the
economy operates with a substantial lag, the central bank is extremely
likely to push its policy too far and too fast before it realizes that
the policy has taken effect and begins to consider moderating it; and
because the realization of effectiveness comes late, it is likely to reverse
its policy too sharply. I n addition, the fact that the central bank
stands in a special relation to its Government and domestic economy
fosters the existence of an international fellow club member relationship among central banks, a relationship congenial to the formation and propagation of policy fads in central banking. I t is only
on the basis of fads in central banking opinion, I believe, that one
can understand the emergence of the fear of runaway inflation as a
dominant motif in central bank policy statements in 1957-58 and
the belief at that time in the need to reduce bank liquidity by debtfunding, or the widespread belief that the dollar would soon be devalued that emerged in 1958-59 and persisted thereafter in spite of
reiterated statement of the U.S. determination not to devalue.
Eecognition of the undemocratic nature of the political argument
for an independent monetary authority, together with scholarly documentation of the inadequacies of the historical performance of the
Federal Keserve System, has led a number of economists—including
my distinguished colleague, Milton Friedman, who will appear before
this committee at a later date—to recommend that the goal of providing a stable monetary environment should be implemented, not by
entrusting discretionary monetary management to an independent
972
THE FEDERAL RESERVE SYSTEM AFTER FIFTY YEARS
monetary authority, but by legislating that the monetary agency be
required to increase the quantity of money at a fixed rate determined
from historical experience. I have a certain sympathy with this
recommendation, as an alternative to discretionary management as
it has been conducted in the past, but there are, in my opinion, some
overriding objections to it. I n the first place, the proposal is essentially a component of a much broader program for transforming the
country into a working model of an ideal competitive system, which
system it is assumed would require no deliberate economic management; since the majority of public opinion seems in fact committed
to the belief that economic management can improve on unfettered
competition, adoption of the proposal would entail accepting a selfdenying ordinance in a crucial area of policy, an inconsistency which
I doubt would prove acceptable for long. I n the second place, the
proposal depends on the empirical assumption that the demand for
money depends primarily on income and is relatively insensitive to
changes in interest rates, an assumed fact concerning which the results of empirical research are in substantial conflict; if the demand
for money is not a stable function of income only, the proposal mightlead to more instability than discretionary management. Thirdly,
the proposal abstracts from the complications of international competition. To be feasible, the proposal would have to be accompanied
by the adoption of floating exchange rates, and even in that case
might aggravate instability associated with international movements
of capital in response to interest-rate differentials between countries;
alternatively, it would have to be accompanied by policies of direct
intervention in international trade and payments inconsistent with
the efficient operation of a competitive economy.
My own view is that the pursuit of monetary stability through the
separation of monetary management from other economic policy, and
its placement under either an independent authority or a strict rule
of increase, is an illusory solution to the problem. Instead, I believe
that monetary policy should be brought under the control of the
Executive and legislature in the same way as other aspects of economic
policy, with the administration bearing the ultimate responsibility
for monetary policy as part of economic policy in general. I n making
this recommendation, I must admit that there is a danger of monetary
mismanagement in the pursuit of political objectives; but I consider it preferable for such mismanagement to be a clear responsibility
of the administration, and accountable to the electorate.
I would also point to a danger emphasized by the British economist,
Sir Roy Harrod, at the time of the nationalization of the Bank of
England, and confirmed, in my judgment, to some extent by subsequent British experience; namely, that bringing the monetary authority within the fold of Government may give more rather than less
weight in policymaking to its definitions of, arid opinions on, policy
problems. I n this connection, though, I would like to point out that
the monetary authority can only too easily be cast as a scapegoat to
conceal the unwillingness of public opinion and the administration
to recognize and resolve genuine policy conflicts. I n particular, in
THE FEDERAL RESERVE SYSTEM AFTER FIFTY YEARS
973
this country in recent years the fundamental policy problem has been
the conflict between equilibrium in the balance of payments and a
sat ; sfactory level of domestic activity, imposed by the overvaluation
of the dollar relative to the major European currencies; and I do not
believe that an administration armed with complete control of monetary policy, but committed to preserving the international value of the
dollar, would have conducted a monetary policy very different from
what the Federal Eeserve has in fact conducted. I t might, of course,
have taken the bold step of raising foreign loans on the order of $15
to $25 billion to tide over the years of waiting for European prices to
inflate up to the American level, but there is no evidence that the administration has been prepared to contemplate such a policy. Given
the commitment to a fixed exchange rate, domestic monetary policy
must necessarily be subordinated to the balance-of-payments position;
the burden of achieving a satisfactory level of employment and activity must be borne by fiscal policy rather than monetary policy, which,
in recent circumstances, has meant a substantial tax cut; and it is the
reluctance of public opinion, the Congress, and the administration to
resort to a tax cut, rather than the policy of the Federal Reserve System, that is ultimately responsible for the unsatisfactory levels of employment and activity that have characterized the economy during
the recent years.
While I believe that the monetary authority should be made part
of the regular machinery of governmental economic policy making and
policy execution, I am not too hopeful about the possibility that this
change would result in a significant improvement in the efficiency of
monetary policy as an instrument of shortrun economic stabilization.
My reasons for skepticism stem from the analysis of the influence of
the monetary authority's position and responsibilities in the economy
on its methods of conducting monetary policy that I have already
sketched. This analysis leads me to a conclusion basically similar to
that of the proponents of a fixed rule of monetary expansion: that
the monetary policy instrument is not well adapted to the pursuit of
shortrun stabilization policy, and that it should instead be devoted,
so far as possible, to the goal of providing a stable longrun monetary
environment. I differ from the advocates of an expansion rule, however, in recommending that this goal should be established as a priority
objective of discretionary monetary policy, operating as one of a group
of instruments of economic policy rather than legislated as a rigid
obligation on the monetary authority. I have developed the analysis
underlying this recommendation in a lengthy document prepared for
the Canadian Eoyal Commission on Banking and Finance, which is
attached to this statement.
The CHAIRMAN. I t may be inserted in the record at this point.
(The document referred to follows:)
E S S A Y S IN I N T E R N A T I O N A L
FINANCE
No. 44, November 1963
ALTERNATIVE GUIDING PRINCIPLES
FOR THE USE OF
MONETARY POLICY
HARRY G. JOHNSON
INTERNATIONAL FINANCE SECTION
DEPARTMENT OF ECONOMICS
PRINCETON UNIVERSITY
Princeton, New Jersey
975
976
THE FEDERAL RESERVE SYSTEM AFTER FIFTY YEARS
This is the forty-fourth in the series ESSAYS IN INTERpublished from time to time by the
International Finance Section of the Department of Economics in Princeton University,
This essay is based on a Staff Paper prepared for the
Canadian Royal Commission on Banking and Finance in
October 1962, and is published in this series with the permission of the Royal Commission. Permission to publish
in no way implies that the Commission agrees with any or
all of the views expressed. The International Finance
Section has previously published, as ESSAY NO. 42, the
Memorandum submitted to the Royal Commission by the
late Sir Dennis Robertson, with a foreword containing a
description of the mandate of the Royal Commission and
of the project of this Section to publish some of the Memoranda of Evidence. The Memorandum submitted by Dr.
Marius Wilhelm Holtrop was published as ESSAY NO. 43.
The present essay is here published with only a few minor
revisions of the original paper.
The author, Harry G. Johnson, was formerly Professor
of Economic Theory at the University of Manchester and
is now Professor of Economics at the University of Chicago and Editor of the JOURNAL OF POLITICAL ECONOMY.
He has written several important books, perhaps the bestknown being INTERNATIONAL TRADE AND ECONOMIC
NATION AL FINANCE
GROWTH and MONEY, TRADE, AND ECONOMIC GROWTH.
The Section sponsors the essays in this series but takes
no further responsibility for the opinions expressed in
them. The writers are free to develop their topics as they
will. Their ideas may or may not be shared by the editorial
committee of the Section or the members of the Department.
The submission of manuscripts for this series is welcomed.
Director
International Finance Section
FRITZ MACHLUP,
THE FEDERAL RESERVE SYSTEM AFTER FIFTY YEARS
E S S A Y S IN I N T E R N A T I O N A L
977
FINANCE
No. 44, November 1963
ALTERNATIVE GUIDING PRINCIPLES
FOR THE USE OF
MONETARY POLICY
HARRY G. JOHNSON
INTERNATIONAL FINANCE SECTION
DEPARTMENT OF ECONOMICS
PRINCETON UNIVERSITY
Princeton, New Jersey
978
T H E FEDERAL RESERVE SYSTEM AFTER FIFTY YEARS
ALTERNATIVE GUIDING PRINCIPLES
FOR THE USE OF
MONETARY POLICY
Introduction
This paper is directed to the specific question: what should monetary
policy seek to do in the Canadian economy ?
Monetary policy as traditionally conceived is concerned with shortrun economic stabilization, the damping of the business cycle. This function has come to be expressed customarily in terms of the pursuit of
the two objectives of price stability and high employment. Insofar as
prices and general economic activity tend to move upwards or downwards together, these two objectives do not conflict, but are essentially
the same: a monetary policy directed at stabilizing either one of the
price level or the level of unemployment would tend to stabilize both.
The two objectives may, however, conflict if the level of unemployment
considered desirable itself implies a rising trend of prices, or if the price
level is rising for some reason other than an excessively low level of
unemployment.* In recent years a third objective has been added to
the list, the objective of economic growth; but for reasons that are too
complex to be developed here, the objective of growth can in practice
also be identified with the general goal of economic stabilization.**
In addition to the general objective of economic stabilization, expressed in the three goals of high employment, price stability, and economic growth, monetary policy has in practice another objective,
resulting from the role of the central bank as fiscal agent for the government, the objective of assisting the government to borrow in the financial
markets on the most advantageous terms obtainable. This objective,
which becomes paramount in wartime, may conflict and in the past has
in fact seriously conflicted with the use of monetary control for pur* This statement is phrased to avoid a final judgment on the issue of cost-push versus
demand-pull inflation, and also to allow for the influence, important in Canada, of foreign price trends on the trend of domestic prices.
** This is not to say that a government pursuing the obj ective of growth would
necessarily conduct monetary policy on traditional lines; rather, the point is that the
scope for monetary policy alone to stimulate growth seems limited to whatever contribution economic stabilization can make to growth. This point is implicit in the
rather unsatisfying discussion of objectives contained in the Report of the Commission
on Money and Credit.
THE FEDERAL RESERVE SYSTEM AFTER FIFTY YEARS
979
poses of economic stabilization. The problems raised by the conflict between the objectives of economic stabilization and cheap governmental
financing, however, were most acute in the period before that with
which the Commission is immediately concerned, and will accordingly
be ignored for the most part in this paper.
More generally, this paper will ignore the possibilities of conflict between the objectives of monetary policy, important as they are to both
the explanation of past policy and the formulation of future policy, and
will instead be concerned with the use of monetary policy for the purpose of economic stabilization, defined in the very broad sense of damping cyclical fluctuations in the economy. The starting point of the
argument is the assumption, presumed to be generally accepted, that
the performance of monetary policy as an instrument for short-run economic stabilization in Canada in recent years has been definitely unsatisfactory.
It is not the purpose of this paper, however, to attempt to assign
responsibility for the unsatisfactory record of Canadian economic policy
with respect to economic stabilization in recent years. Instead, its purpose
is to examine the merits and drawbacks of the alternative lines of action
with respect to the guiding principles of future monetary policy that
might be pursued by the Commission, in the light of the unsatisfactoriness of recent experience. For this purpose, it is sufficient to assume that
the unsatisfactory record is the outcome of a combination of causal factors, which may include confusion in the minds of the government and
the public with respect to the priorities of policy, insufficient coordination between the government and the Bank of Canada, errors on the
part of the management of the Bank, and inadequate knowledge of the
powers and limitations of monetary control of the economy on the part
of all concerned.
Given the unsatisfactory nature of the record of the past, there are
three main alternative positions that can be taken as to the conduct of
monetary policy in the future. The first is to accept the record of the
past as establishing that in practice monetary policy cannot achieve the
degree of economic stabilization that has been expected of it, and to
recommend that this fact be recognized by a corresponding writing-down
of the standards for monetary performance to make them accord with
what is achievable by monetary policy as operated in the past. The
second is to take the record of the past as establishing that the performance of monetary policy with respect to economic stabilization could be
improved by eliminating sources of error, and to recommend changes
in the philosophy, institutional setting, and methods of monetary management that would help to improve performance. The third alternative
980
THE FEDERAL RESERVE SYSTEM AFTER FIFTY YEARS
is to take the record of the past as establishing that monetary policy
should not be entrusted with major responsibility for short-run economic
stabilization, but should instead be directed to providing a stable longrun monetary environment, the responsibility for short-run stabilization
being transferred to other instruments of economic policy. Broadly
speaking, the second alternative corresponds to the approach of the
American Commission on Money and Credit, and the third to the approach of the British Radcliffe Committee.
The main part of this paper is devoted to discussion of the arguments
for and against these three approaches, and exploration of their implications for the reform of the Canadian monetary system. As a prerequisite
to examination of these approaches, however, it is necessary to make
explicit certain assumptions about the nature of central banking, the
way in which monetary policy operates, and the philosophy of economic
policy, since these assumptions are important to the argument. In addition, it is relevant to point out that the arguments concerning the various
alternatives depend crucially on whether it is assumed that the country
is on a fixed exchange rate or a floating rate, since the choice of a fixedrate system imposes definite limitations on the freedom to use monetary policy for economic stabilization. Finally, whatever the approach
adopted, it is necessary to consider the merits of various suggestions
that have been made to give the monetary authority special powers
of selective control over certain types of credit or certain kinds of credit
institutions that are considered to play an especially destabilizing role
in economic fluctuations. Accordingly, the paper begins with a statement of fundamental assumptions, goes on to comment on the relevance
of the choice between fixed and floating exchange rates, discusses the
three alternative approaches to future monetary policy, considers the
case for and against various specific types of selective controls, and
concludes with a summary section containing the author's personal
judgments on some of the major issues.
Fundamental
Assumptions
In order to discuss alternative approaches to the future conduct of
monetary policy in a practically relevant way, it is necessary to take
a position on three fundamental matters, all of which can be considered
"practical" questions, though in different ways. These matters are the
nature of a central bank as an institution, the way in which monetary
policy affects the economy, and the philosophy of economic policy.
The importance of the institutional nature of a central bank derives
from the fact that monetary policy is entrusted to its day-to-day man-
THE FEDERAL RESERVE SYSTEM AFTER FIFTY YEARS
981
agement and influenced by its advice, rather than being managed directly by the government as an integral part of its general economic
policy. The central bank is an independent corporation, not a government department; its personnel is selected by a different procedure
than the Civil Service; and its routine activities bring it into intimate
contact with one special sector of the economy, the financial system.
It is only to be expected, therefore, that it will develop its own views
on monetary policy, views that will be influenced in general by the
habits of thinking about economic affairs prevalent in the financial community, especially by that community's concepts of "soundness" and
of "financial morality," and in particular by the financial community's
assessments of the nature of contemporary national economic problems
and the policies appropriate to deal with them, whether these assessments are grounded in thorough economic analysis or not. Further,
since the central bank is a national institution part of whose work
brings it into contact with its opposite numbers in other countries, the
central bank's thinking on domestic policy problems will be influenced
by the thinking of other central banks about their own and its policy
problems. Finally, since the central bank in its day-to-day operations
must establish and maintain working relationships with the financial
system of the country, and since its effectiveness depends on its ability
to manipulate that system, it will naturally seek to conduct its operations
so as to avoid disrupting the functioning of the financial system.
In these respects, the central bank is not of course uniquely differentiated from government departments; departments of labor and agriculture, in particular, typically share the attitudes of their clients and
in part serve to represent the interests of those clients to the government.
The difference, however, lies in the fact that the central bank is at
least partially independent, and is entrusted to formulate and carry out
national policies that may be in direct conflict with the interests of the
financial institutions with which it is normally in close contact.
The institutional nature of the central bank imposes two important
limitations on the possibilities for improvement of the conduct of monetary policy, so long as monetary policy is entrusted to the management
of a quasi-independent central bank. In the first place, there are narrow
limits on the extent to which a central bank can be converted into an
institution that controls the monetary system according to principles
and methods of analysis that are radically different from those understood and accepted by the financial community. Secondly, the central
bank itself will inevitably generate strong resistances to the pursuit of
a monetary policy that threatens to disrupt established financial rela-
982
THE FEDERAL RESERVE SYSTEM AFTER FIFTY YEARS
tionships or expectations.* In short, if monetary policy continues to
to be entrusted to the management of a central bank—an assumption
that is axiomatic—this itself imposes limits both on how far and in
what ways the management of monetary policy can be improved, and
on how vigorous monetary policy can be made to be. Recognition of
these limits, however, may lead to any one of the three alternatives
previously mentioned: it may be argued that, given the institutional
character of a central bank, one should not expect monetary policy
to achieve a very high standard of economic stabilization; or that there
is still a wide gap between the attainable and the attained, that could
be significantly narrowed by feasible changes in central-bank management and operating procedures; or that the central bank could contribute more efficiently to the prosperity and growth of the economy
if it were relieved of the responsibility for short-run economic stabilization.
To discuss alternative approaches to the conduct of monetary policy
fruitfully, it is necessary to take a position not only on what can reasonably be expected of a central bank, but also on what monetary control
can be expected to achieve. This necessitates a general view of how
monetary policy affects the economy. The view that seems to emerge
from the research and thinking underlying the Reports of the Radcliffe
Committee and the Commission on Money and Credit can be summarized very broadly as follows. Monetary policy has a direct and
observable influence on interest rates and credit conditions, and through
changes in these variables has an observable effect on the flows of
credit through certain markets, and notably on the volume of bank
loans and on the demand for mortgage financing of new residential construction. But what matters for short-run economic stabilization is not
control over interest rates and credit conditions, or even over the
volume of particular types of lending, but control over the volume of
expenditures. And except in the case of housing, where the situation
is complicated by the large-scale intervention of the government as a
guarantor of mortgages the terms of which make their attractiveness
to institutional lenders vary countercyclical^, it is virtually impossible
to establish that monetary policy has a reliable, speedy, and quantitatively significant influence on final expenditure.
This difficulty has led some experts to conclude that monetary policy
has no influence on the economy. On the other hand, the weight of
* Cf. Bank of Canada Submission II, §E, "Some Practical Considerations in MonetaryPolicy." This section amounts to the assertion that it is better to endure economic
fluctuations than to counter them by a monetary policy that disturbs the financial system.
T H E FEDERAL RESERVE SYSTEM AFTER FIFTY YEARS
983
economic theorizing suggests that monetary policy ought to have some
influence on economic activity; fragmentary evidence of such influence
exists; and various well-known dramatic historical episodes testify that
the influence of monetary factors can be significant, at least over the
long run. Caution would therefore suggest the view that monetary
policy does have an influence on economic activity, but that this influence varies with circumstances, with respect to both its magnitude
and the time required for it to take effect. This view in turn suggests
that the use of monetary policy for short-run stabilization is a difficult
and hazardous enterprise.
This position, again, does not prejudge the issue between the three
alternative approaches to the future conduct of policy. It can be argued
with equal freedom that the central bank has done as well as could be
expected, given the inherent difficulties of the task, and that there is no
obvious way of improving its performance; or that the difficulties are
a challenge to be overcome by more determined effort, requiring reform of the central bank to equip it better for an assault on the problems;
or that the difficulties and risks of error are so great that the central
bank would be better occupied with more modest responsibilities.
Finally, discussion of the alternatives requires a position to be taken
on the general philosophy of control in a predominantly free-enterprise
economy. Much of the discussion of monetary policy in the postwar
period, and especially of "selective" techniques of control extending
beyond the traditional "general" instruments of bank rate and openmarket operations, has been concerned with questions of equity and
consistency with the basic principles of a free-enterprise economy.*
The position taken in this paper is the pragmatic one that the use of
monetary policy, or for that matter any other "general" policy instrument, for the purpose of economic stabilization necessarily involves
frustrating the plans of some sectors or individuals in the economy
for the general good, and that in the economic world as it is this
necessarily involves some inequity. Accordingly, the decision as to
whether to supplement or substitute for traditional monetary policy
by more selective methods of credit control should be taken on a balance
of considerations of equity and effectiveness, rather than by reference
to the pure principles of a competitive economy.
* These questions have even been raised with regard to the traditional instruments;
in the United States it has been argued that control of the rediscounting privilege gives
the central bank an undesirable degree of arbitrary authority; and both there and
elsewhere the advocacy of "bills only" in open-market operations has been fundamentally
a demand for fair competitive conditions for government-bond dealers.
28-680 0—64—vol. 2
5
984
THE FEDERAL RESERVE SYSTEM AFTER FIFTY YEARS
The Relevance of the Exchange-Rate
System
As previously mentioned, it makes a considerable difference to the
argument concerning the three alternative approaches to the future
conduct of monetary policy whether the country is assumed to be on a
fixed or a floating exchange rate. A discussion of the issues involved
in the choice between the two alternative exchange-rate systems is beyond the scope of this paper: this section is confined to the implications
of that choice for what it is possible for monetary policy to attempt or
attain. These implications are, however, relevant to the discussion of
which exchange-rate system is preferable.
The point of most importance is the familiar one that a country on a
fixed exchange rate is obliged to conduct its economic policy so as to
keep its balance of payments balanced. More precisely, a fixed exchange
rate obliges a country to keep fluctuations in its balance of payments
within the limits set by its available international reserves, supplemented
by its international borrowing power. Given the importance of shortterm capital movements in the contemporary world, and their volatility
in responding to interest-rate differentials or speculative sentiments,
a country on a fixed exchange rate is likely to be obliged to conduct its
monetary policy primarily by reference to the effects of domestic interest
rates on international capital movements, and this may well necessitate
the pursuit of a monetary policy contrary to that indicated by the objective of domestic economic stabilization.* In addition, the need to command international confidence, imposed by the presence of a large volume
of internationally mobile short-term capital, may restrict the freedom of
the monetary authority to use all the elbow-room potentially available
to it, since confidence is inspired and maintained by conformity to what
is regarded as orthodox financial behavior by other central banks and
the owners of internationally mobile capital. Finally, the adoption of a
fixed exchange rate may aggravate the task of economic stabilization
because it provides maximum scope for the transmission of expan* In principle, the effect of international capital movements on the country's international reserve position could be overcome by operations in the forward-exchange
market aimed at eliminating the covered interest differential between domestic and
foreign capital markets. This technique was recommended to the Radcliffe Committee
but rejected for what seem to be largely institutional reasons. The workability of the
technique has been the subject of a continuing controversy among the experts; the
United States monetary authorities claim some success in using it in the past two years.
Whether it could be an adequately effective insulator for Canadian monetary policy
is a question beyond the scope of this paper; suffice it to remark that exploitation of
the technique in support of a monetary policy aimed at short-run stabilization would
involve a higher degree of sophistication in monetary policy than has been customary
in the past, and possibly a greater chance of error.
THE FEDERAL RESERVE SYSTEM AFTER FIFTY YEARS
985
sionary and contractionary developments in foreign economies to the
domestic economy.
A fixed exchange rate, in short, introduces the likelihood that a
country will have to endure internal instability, either as an automatic
result of the link with conditions in the rest of the world forged by the
fixing of the exchange rate or as a consequence of pursuing the monetary policy required to balance the balance of payments by inducing
appropriate movements of international short-term capital. A floating
exchange rate, by contrast, provides more scope for the pursuit of an independent monetary policy. It does not of course insulate the economy
from the influence of favorable or unfavorable developments in foreign
markets, or from the impact of short or long-term capital movements;
but it does permit the economic authorities to attempt to prevent such
developments from giving rise to fluctuations in the level of economic
activity.*
The implications of the difference between the two exchange-rate
systems for the choice between the three alternatives would seem to be
as follows. First, since a fixed-rate system obliges monetary policy to
be conducted primarily by reference to the state of the balance of payments, it necessarily lowers the standard of stabilization that can
reasonably be expected either from monetary policy as practised in
the past or from an improved system of monetary management, by
comparison with a floating-exchange-rate system. Second, insofar as
adherence to a fixed-rate system obliges a country to practice orthodox
central banking, both in order to command foreign confidence and because the fixed-rate system as currently operated involves a considerable
amount of cooperation among central bankers, such adherence tilts
the balance in favor of accepting the limitations of economic stabilization by traditional methods of central banking, rather than attempting
to improve the performance of monetary policy by radical reform of
the constitution and operating methods of the central bank, whereas
adherence to a floating-rate system would tend to tilt the balance in the
opposite direction. In addition, as already mentioned, adherence to a
fixed-rate system greatly complicates the question of how, in fact, a
better performance with respect to stabilization could be secured in
practice. Thirdly, adherence to a fixed-rate system reinforces the argument for relieving monetary policy of the responsibility for economic
stabilization, since it automatically imposes on monetary policy the
* The extent to which a floating exchange rate provides this extra freedom of
manoeuvre depends on the degree to which wages and prices in the economy are
"sticky," so that relative domestic and foreign costs can be altered more easily by
exchange-rate changes than by inflation or deflation of demand.
986
THE FEDERAL RESERVE SYSTEM AFTER FIFTY YEARS
prior responsibility of controlling international capital movements. But
this additional responsibility undermines the case for directing monetary policy toward the creation of a stable long-run monetary environment, since if monetary policy is not directed at the control of international capital movements some other means has to be found to control either capital movements or the balance of trade, and the most
direct means of doing this—exchange controls and trade controls
(which include such devices as temporary tariff surcharges)—may well
be either impossible to operate efficiently enough to be worth the effort,
or, if efficient, more disruptive than the use of monetary policy for the
same purpose. Under a floating-exchange-rate system, on the other
hand, the problem of balancing the balance of payments does not
exist;* the choice between the three alternatives is more definitely
arguable in terms of strictly economic considerations; and the balance
is tilted somewhat in favor of the third alternative by the fact that to
some extent movements of the exchange rate will serve as an automatic
stabilizer insulating the economy from changes in world markets.
Alternative
Guiding Principles for Future
Policy
The preceding sections have outlined certain fundamental assumptions concerning the nature of central banking, the influence of monetary policy on the economy, and the philosophy of economic policy, and
indicated the relevance of the choice between a fixed and a floatingexchange-rate system to the potentialities of monetary policy. The following sections discuss the three alternative approaches to the future
conduct of monetary policy outlined in the introduction. In each case,
the relevant section outlines the rationale of the approach under discussion, and describes briefly the kinds of recommendations for change
in the conduct of monetary policy that adoption of the approach might
suggest.
(a) Lowering the Expected Standard of Performance of Monetary
Stabilization Policy
There are several grounds for arguing that the unsatisfactory record
of monetary stabilization in Canada in recent years represents about
as good a performance as can reasonably be expected, and that the inference to be drawn from this experience is that expectations of per* The balancing of the balance of payments may be secured by an inflow of foreign
capital which is regarded as undesirable on some extraneous ground such as the
dislike of American ownership of Canadian assets. The solution to this problem, if
it is regarded as a problem, is clearly to increase Canadian savings and provide more
incentive to Canadians to hold equities; both objectives would be served by a combination of surplus budgeting and easy money.
THE FEDERAL RESERVE SYSTEM AFTER FIFTY YEARS
987
formance have been set impossibly high and should be revised
downward.
In the first place, it can be argued that the openness of the Canadian
economy to the world economy, and particularly the dependence of the
Canadian economy on the American industrial complex for markets
for Canadian resource products and on the American capital market
for capital for Canadian economic development, makes the Canadian
economy respond sensitively to fluctuations in the rest of the world, and
particularly in the United States, and narrowly restricts the possibilities
of economic stabilization by domestic economic policy. On this argument, the unsatisfactory record of stabilization in Canada in recent
years predominantly reflects the effects on the Canadian economy of the
slowing down of American economic growth, and the balance-of-payments difficulties under which the United States has labored in the
same period; there is little that the Canadian policy-makers could do,
or can be expected to be able to do in the future, to offset destabilizing
influences emanating from the world economy. It can further be argued
that over the long run Canadian prosperity and growth is best fostered
by active participation in a liberal system of world trade and payments,
and that the consequential exposure to economic fluctuations emanating
from the world economy is a necessary price of long-run economic
gains.
Secondly, it can be argued that the task of economic stabilization is
inherently an extremely difficult one, and that there is no obvious way
of effecting a significant improvement in its performance. The effects
of monetary policy on the economy, in particular, are diffuse and far
from predictable, and it is extremely doubtful how far monetary policy
can successfully offset the effects of economic disturbances. Nor, it
may be added, does the existing state of economic knowledge, whatever
it may have to say about the theoretical possibility of efficient economic
stabilization, hold out much prospect of significant improvement in the
practical achievement of stabilization in the near future. At the present
time, economic theory for the most part can contribute only a description of intricate economic relationships that must be better understood
before stabilization policy can be made more efficient. That being so,
the most that can be expected is a gradual improvement of performance
as knowledge and experience accumulate.
Finally, it can be argued that the unsatisfactory performance of
monetary policy in the past cannot be reasonably attributed to any
easily remediable defects in the institutional arrangements for the conduct of monetary policy. A central bank, it can be argued, has been
found by historical experience in the Western world to be the most
988
T H E FEDERAL RESERVE SYSTEM AFTER FIFTY YEARS
appropriate institution for the conduct of monetary policy. Its partial
independence of the government is essential to the role it has to play
in relation to the domestic financial community and the international
financial world. As a responsible institution, it can be trusted to seek
the knowledge it needs to operate effectively, to exercise the best judgment of which it is capable in formulating monetary policy, and to
learn from experience. Like any institution or individual entrusted
with the exercise of judgment, it may make mistakes, either because
the situations in which it must act are complicated, or because it is
influenced by a transient climate of public opinion, or because the exercise of its powers and responsibilities affect its judgment. But the
probability of mistakes is inherent in the process of entrusting decisions
to the judgment of responsible institutions or individuals, and the risk
of mistakes is the price that must be paid by a nation for attempting
to improve its economic management by centralizing the control of
economic decisions in the hands of responsible public servants. If on
the average the record of economic management is not very satisfactory,
the correct inference is that the possibilities of achieving economic improvement by entrusting important decisions to the judgment of
responsible institutions are more limited than had been thought.
If these arguments are accepted, and the position is taken that the
unsatisfactory record of the past implies a need to write down expectations concerning the degree of economic stabilization attainable in the
future, the main positive recommendation that emerges is that the
public, the government, and the central bank should neither expect very
much from monetary policy nor attach too much causal importance to
it. This recommendation could be implemented in part by explicit incorporation in the Bank of Canada Act of the principle that the Minister
of Finance, or the Government, is ultimately responsible for monetary
policy, together with revisions of the wording of the Preamble to the
Act designed to convey the sense that the objectives of policy listed
are objectives of the Government's economic policy, and that the
responsibility of the Bank is to conduct the day-to-day management
of monetary policy so as to implement these objectives so far as is possible
by monetary means. The purpose of both amendments would be to
make the language of the Act reflect the view of the potentialities of
monetary stabilization to which the arguments outlined above lead,
while at the same time giving legal expression to the instrumental conception of the central bank on which the analysis of this paper is based.
The position that the degree of stabilization attainable by monetary
policy is lower than has generally been regarded as satisfactory carries
some other implications. If the standard of performance that can be
THE FEDERAL RESERVE SYSTEM AFTER FIFTY YEARS
989
expected of monetary policy is revised downward, there is still a choice
open between accepting a lower standard for stabilization policy, and
attempting to achieve some of the ultimate objectives of stabilization
policy by other means. Three alternative forms of action along the
latter line are conceivable and could be recommended. The first is to
develop instruments of stabilization alternative to monetary policy of
the traditional kind; such instruments could be either fiscal devices,
or selective instruments of credit control—the latter are discussed in a
subsequent section. The second is to develop or improve the means of
compensating or offsetting the social consequences of instability, particularly of unemployment on the one hand and inflation on the other,
and to recognize that if a socially undesirable degree of instability is
regarded as economically unavoidable its effects could be mitigated by
greater generosity toward the victims. The third alternative is to attempt to improve the capacity of the economy to absorb and adjust to
instability with less damage; this would require more determined efforts
to make management and labor more flexible and mobile than they
are now.
(b) Improving the Performance of Monetary Stabilization Policy
In order to argue that the performance of monetary stabilization
policy could be substantially improved, it is not sufficient to point to
the unsatisfactory record of the past and claim in the light of hindsight
that the monetary authority should have been able to do better. Nor is
it enough, to ensure improvement, to recommend that the Bank should
become generally more alert, intelligent, and flexible. A serious argument must rest on a demonstration that monetary policy in the past
has made errors that would, at least on a balance of probabilities, have
been avoided had the system of monetary management been different,
and different in certain definable ways.
Such a demonstration is extremely difficult; not only does it require
a detailed examination of the past, and specifically of the state of opinion
and the economic knowledge available at the time when various key
decisions were taken, but it also requires a hazardous exercise in
analysis of the might-have-been. What follows is not intended as an
expression of the author's own views on these questions, but simply as
an outline of a position to which an assessment of the evidence might
lead and an exploration of its implications.
It can be argued that the performance of monetary stabilization in
Canada in the recent past has fallen seriously short of an attainable
standard for one or both of two major reasons, both of which reflect
defects in the Canadian system of monetary control that could be
990
THE FEDERAL RESERVE SYSTEM AFTER FIFTY YEARS
remedied by changing the present arrangements for monetary management.
The first argument is that, either because the democratic governmental
process failed to reflect accurately the preferences of the public, or because the ambiguity of the Bank of Canada Act with respect to the
ultimate responsibility for monetary policy allowed the Governor of
the Bank to impose his own preferences, the priorities according to
which monetary policy was conducted were at variance with the
priorities that public opinion would have approved. Specifically, monetary policy attached unduly heavy weight to the objective of preventing
or restraining inflation, and unduly little weight to the objective of
maintaining high employment.* Accordingly, it can be argued, the performance of monetary policy would have been better had the objectives
of policy conformed to the preferences of the public; and performance
in future could be substantially improved by ensuring that the objectives
of policy pursued by the Bank do conform to the preferences of the
public.
The specific recommendations to which a position based on this
argument would lead depend crucially on whether it is maintained that
failure in the past was the result of the Bank taking a different view
on objectives than the Government, or of the democratic system failing
to generate an accurate indication of the public's preferences.
If it is maintained that the failures of the past were due to the
excessive exercise of independence by the Bank, the logical recommendation would be for reforms of the Bank's constitution designed
to give the Government control over its actions. A minimal step in this
direction would be to revise the Bank Act to assert explicitly that the
Government is ultimately responsible for monetary policy, and that
the Bank functions as the Government's monetary agent. This step,
however, might accomplish little by itself. It would oblige the Bank
to exert itself to discover the Government's policy intentions and
priorities, at least in general terms, and to ensure that the Government
regarded the monetary policy being pursued as consistent with its
general economic objectives; but it would not oblige the Government
to assume an active responsibility for the conduct of monetary policy,
in the sense of laying down the lines to be pursued by monetary policy.
* This argument is admittedly a difficult one to substantiate, since it depends on
positing the existence of an ascertainable public opinion on the priorities of policy,
and runs the danger of arguing from hindsight or of confusing personal preference
with public opinion. Its plausibility must rest heavily on the facts that a large proportion of the country's academic economists disapproved of the Governor's monetary
policy and expressed that disapproval publicly, and that the Government found it
necessary eventually to remove the Governor of the Bank from his office.
THE FEDERAL RESERVE SYSTEM AFTER FIFTY YEARS
991
To ensure that the Bank's conduct of monetary management did in
practice conform to the Government's policies closely enough for the
Government to be actively responsible for monetary policy, it would
probably be necessary to oblige the Bank to look to the Government,
not merely for general directions concerning the objectives to be pursued and the relative priorities attached to them, but for specific directions concerning the concrete monetary operations that the Government
considered to be required by its general economic policy. A formal
method of doing this would be to oblige the Government, acting
through the Minister of Finance, regularly to communicate to the
Governor of the Bank its views on what monetary policy should be.
An alternative would be to strengthen the influence of the regular government departments primarily concerned with economic policy on the
formulation of monetary policy, perhaps by setting up an interdepartmental committee to advise the Governor of the Bank.
If past policy failure is attributed to failure of the democratic governmental system to reflect public preferences with adequate accuracy,
the problem of securing a substantially improved performance is much
more difficult. There are two not necessarily mutually exclusive lines
on which improvement could be sought. The first would aim at improving the expression of public opinion through Parliament. On this line
of approach, the basic problem is the general one of securing effective
democratic government by improving the quality of public understanding and discussion of issues so that public opinion is brought to bear
on governmental decisions while they are being formulated, rather than
left to be expressed in electoral approval or disapproval of the results
of these decisions. This is a problem in public education—in the present
context, of education of the public in the economics of policy choices—
and it is doubtful how far such education can be promoted by changes
in the institutional arrangements for the conduct of monetary policy.
It is, however, arguable that the quality of public discussion and understanding of the issues involved in the use of monetary policy would
be substantially improved if the Bank were obliged to publish regularly
its own account of the actions it had taken, the purpose of these actions,
and the results expected to follow from them, all in terms sufficiently
concrete to permit informed discussion and appraisal.
The line of action just described assumes that Parliament is the
proper body for the expression of public opinion and its translation into
policy, and that it is the responsibility of the Bank to be guided by
public opinion as represented by the Government in office. The alternative line of action rests on the different assumption—one that is more
in keeping with the tradition of central banking—that elected govern-
992
THE FEDERAL RESERVE SYSTEM AFTER FIFTY YEARS
ments are fallible and not entirely to be trusted, especially in matters
of monetary management, and that it is the responsibility of central
banks to formulate their own view of the public interest and pursue
it, as the phrase goes, to the point of "nagging" the Government. On
this assumption, the failure of the past is attributable to inadequate
or biased representation of public opinion in the management of the
Bank, and the indicated line of reform would be to strengthen the
representation of public opinion on the Bank's Board of Directors.
Specifically, it can be argued that by the very nature of central banking financial opinion is likely to have an excessive influence on the
Bank's thinking, and that this influence should be counterbalanced by
functional representation of other sectors of the economy on the Board.
In addition, it could be argued that since monetary policy affects the
whole economy in a variety of complex ways, special representation
should be given to professional economists, whose business it is to
understand and study how the economy works.
The foregoing discussion is concerned with the contention that the
past failures of monetary policy are in large part attributable to a
failure of monetary policy to reflect the public's preferences with respect
to the priorities of economic policy, a failure that could be remedied by
improving the arrangements for monetary management. The second
argument attributes past failure, not to the pursuit of objectives different from those preferred by public opinion, but to failure of the
Bank to understand the economic relationships on which monetary
policy was seeking to operate, or to make use of the available economic
knowledge concerning those relationships, let alone attempt to improve
on that knowledge. This attribution is much easier to support than the
other, inasmuch as the economic analysis and assumptions employed
in formulating the Bank's policy are on public record in the Annual
Reports of the Bank and the speeches delivered by the Governor, and
can be shown—in fact, have frequently been shown—to be illogical,
inconsistent, inadequate, or factually wrong in a variety of respects
crucial to efficient policy formation.
Given that the Bank in the past has displayed an alarming ignorance
of elementary economic principles, not to speak of the results of scientific economic research, it can be argued that the performance of the
Bank would have been much better had it possessed and applied an
up-to-date knowledge of economics, and that its future performance
could be substantially improved if it were made to realize the importance
of economic science and research to its work, and obliged to base its
policy actions on a thorough economic analysis of policy alternatives
THE FEDERAL RESERVE SYSTEM AFTER FIFTY YEARS
993
and consequences, and to improve its economic knowledge by a continuing large-scale research effort.
This prescription could be implemented by a variety of changes. The
relevant recommendations could include the appointment of senior
economists to the Board of Directors; a program of exchanges between the Bank's staff of economists and economists in the universities;
regular informal conferences of Bank officials and academic economists
to discuss technical problems of monetary management or the bearing
of general economic problems on monetary policy; regular publication
of the results of the Bank's own research in a journal open to contributions from outside economists.
Many of such changes could easily be effected by the Bank itself;
that the Bank has not chosen to introduce them points to the main
source of doubt concerning the probable effectiveness of this prescription, since it indicates that the Bank itself does not consider that more
extensive and intensive use of economics and economists would help it
to perform its duties. For the prescription to work, it would not
necessarily suffice for the Bank to have to employ and argue with
economists; the language of economics, like the language of the law,
can be used to conceal the truth as well as to discover it, and the employment of an economist, like the employment of a lawyer, is not
necessarily a guarantee of honest intentions. What the prescription
aims at is to convert the Bank, as an institution, from the banker's
habits of thought to those of the economist. Whether this could be
done, and whether if it could be done the Bank could still function
effectively in its relations with the financial system, are difficult questions whose answers depend on the institutional character of central
banking. So far as the first question is concerned, it seems clear that
the Bank's personnel would have to be persuaded of the value of the
scientific approach to its problems. This would have to be achieved by
experience; probably the most effective ways of making the bank undergo the experience would be to appoint senior professional economists
to the Board of Directors, and to oblige the Bank to publish detailed
economic analyses of its policy choices and their results, preferably with
a commentary by independent economists. So far as the second question
is concerned, avoidance of possibly serious disturbance of the traditional understanding between the Bank and the domestic and international financial communities might require an improvement in these
groups' understanding of the economics of policy, highly desirable in
itself but unattainable in practice. Nevertheless, the effort and risks
involved in converting the Bank to a more economically oriented in-
994
THE FEDERAL RESERVE SYSTEM AFTER FIFTY YEARS
stitution might well be considered worth undertaking, if the result
promised to be a substantial improvement in the performance of monetary stabilization policy.
(c) Abandoning Short-Run Stabilization in Favor of a Stable
Monetary Environment
The preceding two subsections have been concerned with the alternative positions that past experience indicates that a lower standard of
achievement should be expected of monetary stabilization policy, and
that an appreciably better performance could be ensured in future by
revising present arrangements for monetary management either to make
the central bank's actions conform more closely to public preferences,
or to make its operations more scientific, or both. This subsection is
concerned with the third alternative, that the attempt to achieve shortrun economic stabilization by monetary policy should be abandoned,
and that instead monetary policy should be directed to creating a stable
monetary environment in the economy.
There are three main arguments for the abandonment of short-run
stabilization as a primary objective of monetary policy. The first starts
from the observation that while in principle it should be possible to
operate monetary stabilization policy efficiently, because monetary
action can be taken swiftly and can be finely adjusted, in practice the
use of monetary policy for stabilization purposes has been laggard and
clumsy in its recognition of and reaction to both short-run changes in
the contemporary economic situation and long-run changes in the
economic environment. More specifically, monetary-policy changes
have consistently lagged significantly behind changes in phase of the
business cycle. What is more important, changes in the priorities among
objectives expressed in monetary policy have lagged long behind
changes in the economic environment or conjuncture: monetary policy
in the period from the end of the war to the early 'so's—a period of
economic euphoria—was preoccupied with the danger of a deep recession, with the result that it contributed to inflation; it then became
preoccupied with the dangers of inflation, about the same time as the
economic climate changed toward one of chronic depression, with the
result that it contributed to unemployment and slow growth. Delay in
the recognition of economic changes and adjustment to them, it can
be argued, is inherent in the nature of policy-making institutions in a
democratic society; but it is especially ingrained in the nature of the
central bank, which lacks the mandate of an elected government to
act speedily in emergencies. That being so, the central bank should
not be entrusted with the responsibility for stabilization policy, since
THE FEDERAL RESERVE SYSTEM AFTER FIFTY YEARS
995
effective performance of that responsibility would require it to act with
a speed and foresight, and a willingness to court unpopularity, that is
contrary to its institutional nature and the political framework within
which it must operate.
The foregoing argument derives from consideration of the position
of the central bank in the system of government. The second argument
derives from consideration of the institutional nature of the central
bank and its position in the economy. The central bank, it can be
argued, is primarily a banking institution, and its main business is with
commercial banks and other financial institutions. Its organization and
traditions are adapted to that role; they are not designed specifically
for the purpose of control of the economy by manipulation of the money
supply, and the degree to which they can be adapted to that purpose
is severely limited. On the one hand, the position of the central bank
in relation to the economy is not such as to encourage or force it to
think continually of the requirements of the economy as a whole, but
rather such as to concentrate its thinking on the requirements and
interests of the financial sector. On the other hand, pursuit of a vigorous monetary policy directed at economic stabilization necessarily
brings it into conflict with the interests of the financial institutions with
which it normally works, a conflict it will naturally wish to evade or
avoid. In short, reliance on monetary policy for short-run stabilization
involves entrusting the job to an institution that is neither well equipped
for nor single-mindedly enthusiastic about the responsibility. It can
be argued that the prospective degree of stabilization attainable is not
worth the difficulty of attaining it, and that it would be better to try
to achieve economic stabilization by some other means.
The third argument is concerned with the economic possibility of
stabilization by monetary means. As has been mentioned in an earlier
section, economists have had little difficulty in verifying that monetary
policy can influence interest rates and credit conditions, and great difficulty in detecting the influence of the latter, or of the quantity of money
itself, on economic activity. Nevertheless, very few economists would
be prepared to assert, and certainly none has ever attempted to prove,
that monetary policy has no influence whatever on the economy. The
most plausible view, on the basis of research to date, is that monetary
policy has an influence on the economy that varies in magnitude and in
timing and is by no means easily predictable. This in itself would suggest that the use of monetary policy for short-run stabilization might do
more harm than good, the disturbance resulting from unintended or
unanticipated effects of monetary-policy actions outweighing the intended beneficial effects. Further, recent theorizing on these matters sug-
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T H E FEDERAL RESERVE SYSTEM AFTER FIFTY YEARS
gests that one reason why the influence of monetary policy is difficult to
detect is that enterprises and individuals make their plans on the basis of
expectations about the normal state of the economy, including the normal state of credit conditions, and that these expectations adjust only
slowly to changes in the way monetary policy is conducted. This line of
thought readily leads to the conclusion that the vigorous pursuit of
monetary stabilization policy may be not only not very effective in the
short run but of decreasing effectiveness over time, since the economic
decision-units at which monetary policy is directed will learn to manage
their affairs so as to avoid being disturbed by changes in monetary
policy; and to the further conclusion that vigorous use of monetary
policy may impede the long-run growth of the economy, by adding to
the uncertainties of economic decision-making and reinforcing speculative pressures that tend to keep long-term interest rates high.
All three of these arguments lead to the conclusion that the attempt
to achieve economic stabilization by traditional monetary means should
be abandoned, and that the objective of stabilization should be approached in some other way; none of them, however, excludes the
possibility, explored in the next section, that a useful improvement in
stabilization might be attainable by the use of selective credit controls.
All three also imply, though with varying emphasis, that monetary
policy ought to be directed toward the creation and maintenance of a
stable long-run monetary environment for the economy. The first argument would suggest that since the monetary authority is likely to be a
bad judge of what the current state of the economy requires in the way
of monetary policy, it should be given the simpler task of concentrating
on the long-run monetary requirements of a growing economy. The
second argument would suggest that the central bank is especially
equipped by tradition, experience, and institutional role to promote and
police the development of the country's financial institutions and to
maintain orderly conditions in its security markets—particularly to
cushion the disturbing effects of governmental fiscal and debt operations. The third argument would suggest that the central bank can contribute most effectively to both short-run stabilization and long-run
growth by following a definite, well-understood and publicized, consistent policy in its monetary operations, one to which it is committed
sufficiently long ahead for borrowers and investors to be able to plan
with confidence.
The difficulty with recommending that monetary policy be directed
to creating and maintaining a stable long-run monetary environment
is to give this recommendation a concrete content. Two concrete proposals have been advanced and canvassed in recent years. One is the
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997
Radcliffe Committee's proposal that monetary policy should seek to
stabilize long-term interest rates at a level appropriate to the long-run
balancing of savings and investment at a high employment level. The
other is the proposal advanced by various American economists, that
the money supply should be expanded at a constant rate based on the
long-run growth rate of demand for money. The difference between
the two proposals reflects partly a difference between the British and
American institutional systems of monetary control—the British system
concentrating on changing interest rates and the American on changing bank reserves and the quantity of money—and partly a difference
in basic monetary theory, which resolves essentially into a difference
over empirical facts. The Radcliffe proposal assumes either that fluctuations in the economy originate predominantly in changes in the demand
for money that could be counteracted by changes in the amount of it
supplied, or that the demand for output is insensitive in the short run
to changes in interest rates; the alternative proposal assumes that
fluctuations in the economy originate predominantly in changes in the
demand for output that do not alter the demand for money, and that
interest rates have a negligible influence on the quantity of money demanded. Since fluctuations may originate in both monetary and real
disturbances, and both the demand for output and the demand for
money are likely to be responsive to changes in interest rates to some
extent, adoption of either proposal would entail some possibility of destabilization by comparison with an ideal stabilization policy. In the
case of real disturbances, the Radcliffe proposal would eliminate both
the stabilizing effects on expenditure of automatic increases in interest
rates in booms and decreases in interest rates in depressions and the
further stabilization that could be effected by countercyclical monetary
contraction and expansion. The alternative proposal would eliminate
the possibility of counteracting monetary disturbances, and in the case of
real disturbances would allow fluctuations in interest rates to induce
increases in velocity in booms and decreases in velocity in depressions,
these changes in velocity serving to accommodate a fixed stock of money
to a varying level of output and activity. The destabilizing effects of
either alternative, it can be argued, would be small by comparison with
the destabilizing effects of active monetary stabilization policy as conducted in the past, and by comparison with the gains from a more
stable monetary environment.*
The Radcliffe proposal was a recommendation to the central bank
and the economic policy authorities; the American proposal is some* The last half of this paragraph has been revised as a result of discussion with
Alvin Marty.
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T H E FEDERAL RESERVE SYSTEM AFTER FIFTY YEARS
times intended to be translated into legislation binding the central bank
to expand the money supply at a specified rate. Such a statutory restriction on the central bank's freedom of action is alien to the tradition
of British central banking, and presumably could not be contemplated;
nor is the state of knowledge concerning monetary behavior sufficiently
advanced to permit the devising of a rule that would not run the risk
of becoming inappropriate. The spirit of the two proposals could, however, be expressed in a recommendation to revise the Bank Act to
make the Bank's primary responsibilities those of fostering the growth
of the country's monetary and financial system, and maintaining a
stable monetary environment in Canada, and to impose on the Bank
the obligation not only to devise its policy with reference to those
objectives, but to announce and explain publicly what its monetary
policy is and will be for some reasonable time into the future. Whether
the policy was to be expressed in terms of interest rates on certain government securities, or in terms of the rate of expansion of the money
supply, could either be specified statutorily, or left to the Bank's discretion.*
New Controls Over Credit
The preceding section dealt with three alternative approaches to the
future use of monetary policy—acceptance of a lower expected standard
of performance with respect to economic stabilization, determination
to improve that performance in the future by reform of the system of
monetary management, and alteration of the objective from economic
stabilization to the creation of a stable monetary environment. Each
of these approaches is consistent with the recommendation that the
traditional techniques of monetary management be reinforced by the
introduction of various kinds of selective controls over the granting
and use of credit. It can be argued that even though the degree of
stability achievable by monetary policy is not high, it would be higher
if the monetary authority had the power to strike more directly at
sources of instability, or that a more determinedly scientific approach
to stabilization should be empowered to use techniques that analysis
of the sources of instability suggests might be more effective than
orthodox techniques; or that the use of selective credit controls could
contribute significantly to stabilization without disturbing expectations
* The recently revived technique of a fixed Bank rate is a device for committing
the Bank to pursuing a stable policy in the very short run, and changing it only at
intervals and by degrees to which the money market is accustomed. The position discussed in this subsection is essentially that a technique of this kind should be developed on a time-scale appropriate to the financial planning of the productive sector
of the economy.
T H E FEDERAL RESERVE SYSTEM AFTER FIFTY YEARS
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and increasing uncertainty as much as would the use of orthodox monetary policy.*
The purpose of this section is to explore the merits and drawbacks
of various types of selective control over credit. Such selective controls
can be divided for discussion into four types—"moral suasion,'' controls over bank behavior, controls over other credit institutions, and
controls over particular types of borrower. Since the use of selective
controls in any form raises some issues of a general nature, and since
this paper cannot embrace a discussion of all the specific kinds of selective control that might possibly be considered, discussion of the four
types of selective control just mentioned is preceded by a brief statement of some of the general issues.
(a) Some General Issues
Any attempt to use control of the money supply and credit conditions to stabilize the economy, whether the method employed is "general" or "selective," must necessarily operate indirectly. What matters
for economic activity is the level of spending, not of borrowing in
general or in certain specific forms, and monetary or credit control
must operate through whatever influence the quantity of money, interest rates, or the availability of credit in general or in certain selected
forms has on the level of spending. This means that selective credit
control can only be effective to the extent that would-be spenders cannot resort to alternative financial institutions or alternative sources of
finance than those over which control is exercised; and a primary question about any proposed device of selective, credit control is the extent
to which it can control actual spending, as distinct from merely altering the form in which spending is financed. The answer to this question
obviously depends not only on the particular device under consideration, but also on the length of time over which the device is intended or
required to be effective. Over the course of time, would-be borrowers
deprived of access to their customary sources of finance will learn to
resort to alternative sources, or to manage their affairs so as not to
be dependent on their previous sources; similarly, competition among
lenders will in the course of time develop substitutes for institutions and
types of lending resort to which is restricted by selective control.** Thus
* The argument here would be that the use of selective methods explicitly recognizes
that the circumstances are abnormal, and therefore minimizes the disturbance to longrun expectations. The validity of this argument clearly depends on selective controls
being used infrequently and for short periods; if they became a permanent feature
of the economic environment, their use for economic stabilization could raise the
same problems as the use of monetary policy.
** For example, the pressure of rising interest rates against legal limits on the interest
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THE FEDERAL RESERVE SYSTEM AFTER FIFTY YEARS
heavy and sustained reliance on selective controls may be self-defeating,
and may have the long-run consequence of reducing the efficiency of the
financial system and the economy by fostering the substitution of inherently less efficient for inherently more efficient financial institutions
and practices.
Because the efficiency of selective controls depends on their frustrating the plans of would-be spenders who are dependent for finance on
the specific credit institutions or forms of credit subjected to control,
selective controls are inherently discriminatory between spending units.
Should this consideration be a matter for serious concern? It can
be argued—the contention that "general" monetary control is nondiscriminatory to the contrary—that "general" monetary policy is
equally discriminatory, since it in fact operates in part through the
rationing of credit among borrowers by banks and other lenders. It
can also be argued that any policy of economic stabilization is inherently discriminatory in the sense that it will entail frustrating the
plans of some economic units (consumers or firms), and that the distribution of frustration among the units will necessarily be to some
extent fortuitous. The practical question therefore is whether the
inequity involved in any particular device of selective control is tolerable, in conjunction with the contribution to stabilization it makes.
To put the argument of the two preceding paragraphs a rather
different way, the important economic fact is not so much that selective
controls discriminate against some types of economic units, as that
they discriminate against established efficient methods of financing. And
the important economic question is not so much whether they are effective enough to justify their inequity, as whether the leverage gained
by discriminating occasionally against efficient financing methods is
worth the possible long-run loss of economic efficiency that this discrimination may produce.*
The possible long-run distorting effects of the discrimination implied
by selective controls are particularly important in the case of selective
rates payable on deposits and chargeable on loans has led the chartered banks to
develop new deposit instruments and loan forms that enable them in fact to exceed
these limits. At the same time, these and other restrictions on the banks' freedom
to compete in the deposit and loan market have fostered the growth of other deposit-taking and loan-making institutions, such as the trust companies and the finance
companies.
* There is a close analogy between the use of selective controls on credit and the
intermittent use of specific taxes such as capital levies or tariff surcharges. Both raise
questions of equity, which have to be resolved by reference to established standards
of equity, and both, if frequently resorted to or prolonged, may distort the economy
into an inefficient structure.
THE FEDERAL RESERVE SYSTEM AFTER FIFTY YEARS
1Q01
methods of control applied to the operations of the chartered banks.
In effect, the obligation imposed on chartered banks to maintain a
minimum non-interest-yielding cash reserve in the form of Bank of
Canada notes and deposits constitutes a tax on the chartered banks,
levied in return for the privilege of conducting a banking business.
Other restrictions on the chartered banks' freedom to determine the
composition of their assets, such as the minimum liquidity ratio and
other proposed devices to force chartered banks to hold government
debt, constitute additional taxes—as do legal restrictions on the rates
banks may charge. The use of such restrictions and variations in them
to assist stabilization policy may in the long run retard the development of the banking system and foster the development of other less
efficient institutional arrangements for conducting business the banks
are best equipped to handle. In a concentrated banking system like the
Canadian one, the use of selective controls directed at the banks may
also encourage the banks to develop arrangements among themselves
similar to those of cartels and combines, and oblige the central bank to
accept such arrangements, as compensation for the loss of profit opportunities resulting from selective controls. Thus the distortions resulting from discriminatory treatment of banks may be aggravated by the
distortions resulting from monopolistic practices.
One further comment is in order. Since discrimination is generally
regarded as ethically undesirable, there is a natural tendency to condone or recommend it particularly in cases where the activities or economic units against which it is directed can also be considered as
ethically or morally undesirable. Specifically, there is a strong tendency
in discussions of selective credit controls to favor controls on the finance
of speculation in stocks and real estate, on the grounds that speculation
is a morally reprehensible activity, and on consumer finance, on the
grounds that it is immoral for wage and salary earners to pledge their
future earning power. Both types of financing can in fact be defended
as rational activities which can contribute to the improvement of
economic efficiency and welfare in the same way as any other kind of
borrowing—speculation by leading to a more efficient allocation of
assets among uses, instalment buying by leading to a more efficient
allocation of consumption over time. If nevertheless it is considered
that they should be restricted on moral grounds, the presumption should
be that they are equally immoral whether the economy is booming or
slumping, and should be dealt with by permanent measures.* The only
* One important reason for the condemnation of speculation, in addition to the
usual sober citizen's dislike of seeing someone else get something apparently for nothing, may be the realization that present tax laws give the speculator an enormous
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THE FEDERAL RESERVE SYSTEM AFTER FIFTY YEARS
possible economic argument for countercyclical selective control of them
is that they contribute extraordinarily to economic instability. This cannot be readily demonstrated for speculation in stocks and real estate,
which involves trading in existing assets; though it can be argued in
the case of consumer credit, which finances the purchase of goods.
(b) Moral Suasion
For the purposes of this paper moral suasion has been classified as
a type of selective credit control. Actually it occupies an awkward
middle ground between the unobjectionable straightforward provision
of information by the central bank about its own analysis of the economic situation and the best interests of private enterprises, and the
use of explicit selective controls on credit, since it attempts to persuade
economic decision-takers by one means or another voluntarily to take
actions that the central bank wants them to take but cannot force
them to take. Since the actions involved generally amount to some
form of rationing of credit, and since the persuasiveness of the central
bank ultimately derives from its powers of control over the money supply, moral suasion can however be assimilated more closely to selective
credit control than to the proffering of disinterested objective advice.
The use of moral suasion by the central bank inevitably involves some
conflict with the immediate economic self-interest of the institutions at
which it is directed, which institutions must be persuaded to comply
either on the general ground of responsibility to the community at
large or on the narrower ground of good relations with the central
bank. The extent to which institutions can be persuaded to act against
their immediate self interest on these grounds obviously depends on a
variety of factors, including the extent to which they can afford the
loss of profits or of goodwill (in the first case) and the extent to which
the central bank has power to discipline them (in the second case). It
follows that moral suasion is more likely to be effective when directed
at the chartered banks and other heavily concentrated sectors of the
financial system and the economy than when it is directed at sectors
characterized by keen competition among a large number of small firms.
The more monopolized a sector is, the more dependent it is on governmental goodwill, and the more its activities are prominent in or open
to public discussion, the more amenable it will be to control by moral
suasion.
differential advantage over the citizen who earns his income by regular work.
The appropriate remedy is not to try to hamper the speculator, but instead to remove
the tax advantage by treating speculative capital gains as income.
THE FEDERAL RESERVE SYSTEM AFTER FIFTY YEARS
1003
These considerations suggest the first reservation about the use of
moral suasion. Its effectiveness depends on the extent to which economic
decisions are concentrated in the hands of a few units, which consequently can afford to allow what are essentially political considerations
to override economic calculation. Correspondingly, reliance on it implies at least tacit approval of concentration of economic activity in a
few decision-taking units, and assumption of some governmental responsibility for rewarding compliance with moral suasion by favors of
some kind. The recognition of responsibility is usually a reciprocal
relationship. It may be considered only realistic to recognize that
economic control in Canada is concentrated; and it may even be argued
that such concentration is desirable on various economic grounds. But
it should be recognized that the use of moral suasion does raise the
question of whether economic concentration is desirable, and that this
question is a controversial one.
A second question relates to the objectives at which moral suasion
is likely to be directed. Judging by past experience in Canada and elsewhere, moral suasion is likely to be directed at or canalized into restraining types of lending or spending that according to conventional
financial thinking are unsound or morally somewhat shady, such as
loans for speculative purposes or for consumer spending. Restraint of
this kind may have little effect in controlling the true sources of instability, which often are simply excessive spending on thoroughly
respectable projects. More generally, moral suasion raises the question
of how far the monetary authority, in collaboration with responsible
financial institutions and leading corporations, is competent to judge
better than the competitive market process (or possibly an economic
planning agency) what types of expenditures are in the national interest
and what types are not.
A third question relates to the time lag inevitable in the use of moral
suasion. For moral suasion to work, not only must the monetary
authority and the government be persuaded that the economy is getting
out of hand, but the financial and business community to which moral
suasion appeals must also be persuaded. This presupposes that the need
for action is apparent to all concerned; and this in turn ensures that
action will only be taken with an appreciable lag.
On the other hand, there are two considerations favoring the use of
moral suasion. One is based on the assumption that private enterprises,
both financial and nonfinancial, are poor forecasters and poor interpreters of their own economic interests, and moreover react to economic
changes with considerable inertia. Consequently, it can be argued, the
adoption by the monetary authority of a definite simple line on the
1004
THE FEDERAL RESERVE SYSTEM AFTER FIFTY YEARS
nature of the contemporary economic situation and what action it calls
for will be welcomed by the financial and business communities, and
will speed up the change to policies that private-enterprise institutions
would willingly follow if they were better informed and more flexible.
This consideration amounts to accepting the proposition that in a complicated world, salesmanship has to substitute for perfect knowledge
and wisdom, and assumes that imperfect guidance is better than none.
The second consideration is based on the assumption that financial
institutions are involved in intricate professional-client relationships
with their customers, and that corporation management is built on a
delicate balance of power among different departments, so that the
application of the correct economic decisions is greatly facilitated if
reference can be made to the overriding authority of the central bank's
opinion. For example, it is frequently asserted that a directive or policy
statement from the central bank makes it easier for commercial banks
to refuse their customers loans while retaining their goodwill; and it
is conceivable that the financial-planning departments of big corporations may be similarly strengthened in their resistance to overoptimistic
expansion plans emanating from the production and sales departments.
These considerations, of course, implicitly assume that the judgment
of the monetary authority is both reasonably reliable, and expressed
in terms that both are plausible and can readily be translated into action
by the relevant private-enterprise institutions. Clearly, these assumptions limit the extent to which moral suasion can be relied on to improve the performance of economic-stabilization policy.
(c) Control Over Chartered Banks
One of the reasons why orthodox monetary policy operates slowly
and imperfectly in restraining a boom is that at the start of the upswing
the chartered banks are typically holding a relatively high proportion of
government debt and a relatively low proportion of loans. As the upswing proceeds, and the demand for loans grows, the banks can satisfy
this demand even though monetary policy is restraining the growth of
their total assets, by running off their holdings of government debt in
order to finance the expansion of loans. In effect, this process transforms idle bank deposits into active deposits, owners of idle balances
being persuaded by a rise in interest rates to surrender these balances
to the banks in exchange for government securities formerly held by
the banks, and the banks relending the balances to borrowers who wish
to spend them. In a different terminology, restriction of the money supply by monetary policy is partially offset by an induced increase in the
velocity of circulation.
THE FEDERAL RESERVE SYSTEM AFTER FIFTY YEARS
1005
It can be argued that the effectiveness of monetary policy would be
significantly increased if the central bank had the power to prevent the
banks from running off their holdings of government securities, for
example by being empowered to impose a variable minimum ratio of
"more liquid assets" to deposits, or a variable maximum ratio of general loans to deposits. Since the use of such powers would involve
obliging the banks to hold more government securities than they would
otherwise choose to hold, it could be argued that the granting of them
would have the additional advantage of helping to keep down the cost
of the public debt by partially insulating the government-securities market from the effects of restrictive monetary policy.
The quantitative magnitude of the influence on both aggregate spending and interest rates achievable by use of such powers depends on the
extent to which spenders who normally finance themselves by bank
loans have access to other sources of finance, or possess assets that can
be sold or pledged to finance spending. The restraining effect on expenditures (and interest rates) would be greatest if everyone refused
a bank loan had no alternative but to cancel his spending plans; even
in this case some of the effect would be offset by the influence of lower
interest rates in inducing larger expenditures by spenders not dependent
on bank loans. The restraint on expenditures (and interest rates) would
be virtually zero if all potential borrowers from banks had the alternative of financing expenditures by selling off holdings of government
bonds. In general, the restraint achievable depends on the deterrent
effect on would-be borrowers from banks of the higher cost of alternative means of finance. It is generally agreed that some groups of wouldbe spenders—notably small businesses and consumers—are sufficiently
dependent on bank finance for the denial of bank loans to force them
to cancel or curtail their spending plans. Thus, providing the banks
do not channel their loans to such groups at the expense of other groups
having access to alternative sources of finance, the powers of control
under discussion could increase the effectiveness of stabilization policy
to some significant extent.
Assuming that this kind of selective control of chartered-bank lending
could contribute to stabilization, whether it should be employed depends on three sets of considerations. First, its use is an alternative
to more vigorous and alert use of monetary restraint; instead of preventing the banks from lending as large a proportion of their total
assets as they wish, the monetary authority could achieve the same
effect on loans by restricting total bank assets more severely. Preference
for the selective over the general method of control of bank loans must
therefore be derived from an empirical judgment that the central bank
1006
THE FEDERAL RESERVE SYSTEM AFTER FIFTY YEARS
cannot or will not apply general monetary restraint quickly and subtly
enough—that is, it cannot anticipate the banks' switch from government securities to loans—or from the view that a more active monetary
policy would have undesirable destabilizing effects on the economy, or
from the judgment that the government-debt market should be protected so far as possible from the impact of monetary restraint. In the
second place, the concentration of the restrictive effect on spenders
who are dependent on bank finance may be regarded as both unfair and
economically undesirable. In particular, it is frequently argued that
restriction of bank loans bears unduly heavily on small businesses,
with effects deleterious to economic growth and favorable to economic
concentration and monopoly and the control of Canadian enterprise by
American capital. These effects, so far as they can be demonstrated to
exist and to be avoidable by other methods of stabilization, have to be
weighed against the improvement in stabilization achieved by selective
control of bank lending. Finally, forcing the banks to hold more government securities and less loans than they would like amounts to imposing
a special kind of tax on bank earnings; whether this tax amounts to a
net burden or not depends on whether it is assumed that total bank
assets would be the same with or without the selective controls, or that
in the absence of controls the central bank would restrict total bank
assets more severely. In either case, some intricate questions about
the effects on the banks' earnings and competitive position are involved.
Essentially similar considerations to those last mentioned are involved in proposals to supplement existing methods of control over
bank deposits by giving the central bank power to alter the reserve ratio
the chartered banks are obliged to maintain, either by direct variation
of the required ratio or by requiring the banks occasionally to hold
additional reserves in the form of "special deposits/' on which interest
may or may not be paid.
In a modern central-banking system, the required reserve ratio serves
two functions. First, it fixes the "expansion multiplier"—the number
of dollars by which the commercial-banking system can expand deposits
on the basis of a dollar increment to reserves. Second, it imposes a tax
on the commercial banks, equal to the loss of interest on the portion of
reserves they would not hold if they were not obliged to. This tax,
whose burden rises and falls with the general level of interest rates,
can be regarded as the price the banks must pay to the central bank, and
indirectly to the government, for the services of the central bank and
the privilege of operating a banking business. Its level influences in
the short run the division of bank earnings between the banks and the
THE FEDERAL RESERVE SYSTEM AFTER FIFTY YEARS
1007
government, and in the long run the allocation of resources to the
provision of banking services.
The use of variable reserve ratios rather than open-market operations with a fixed ratio to control the volume of bank credit can accordingly be recommended on two grounds. The first is that the central
bank's control over bank deposits is closer, the higher the reserve
ratio; and that close control is more desirable, and the burden of a
higher reserve ratio on the banks more bearable, in the boom than in
the slump. This argument assumes, plausibly, that banks will work
closer to the minimum reserve ratio the higher that ratio is. The second
argument is that raising required reserves in a boom will tend to
restrain the growth of bank loans and the rise of interest rates in the
same way as would requiring the banks to hold government debt
directly, since reserves are an indirect form of public-debt holding. The
factual assumption here is questionable, since taxing the banks by
forcing them to hold larger reserves may increase their desire to hold
loans rather than securities. On either argument acceptance of the
recommendation involves the same considerations as before, a balancing
of likely effectiveness in stabilization against considerations of equity
and economic efficiency.
There is, however, a special set of circumstances in which the power
to vary reserve requirements or to require the banks to hold special
deposits may have particular advantages. A country on a fixed exchange
rate may easily experience a rapid inflow of short-term capital; if the
monetary authority wishes to prevent such a capital inflow from
generating a multiple expansion of the domestic money supply, it may
have considerable difficulty in doing so by open-market sales of securities, since the sales required may be extremely large. The desired
insulation of the domestic monetary system could be secured more
readily by requiring the banks to hold additional deposits at the central
bank as reserves against the increase in foreign-owned deposits—in
effect, the multiple-expansionary effect of an acquisition of foreign
assets by the central bank would be offset by an increase in reserve
requirements.
(d) Control over Other Credit Institutions
In the past seven or eight years the argument has commonly been
advanced that monetary control of the economy has been weakened by
the development of financial intermediaries which offer the asset-owner
assets which are close substitutes for bank deposits. The presence of
these intermediaries, it is argued, means that an effort to tighten credit
conditions simply leads asset owners to transfer their assets from the
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T H E FEDERAL RESERVE SYSTEM AFTER FIFTY YEARS
form of bank deposits into the form of substitutes for bank deposits;
since the liabilities of financial intermediaries are backed by a fractional
reserve of bank deposits, the effect is an increase in the total of money
and close money substitutes that can be provided on the basis of a given
amount of chartered-bank reserves provided by the central bank, so
that the intentions of monetary control are frustrated, whether monetary control is conceived of as working through the total amount of
money or through the amount of credit extended by financial institutions. Consequently, it is argued, effective monetary control requires
that these financial intermediaries should be subjected to the same kind
of cash-reserve requirement as are the commercial banks.
The importance of this argument depends on how far in fact monetary restriction leads to a transfer from bank deposits to the liabilities
of financial intermediaries rival to banks. The empirical evidence produced so far does not suggest that such shifts are an important cause
of frustration of monetary policy, or that the presence of financial intermediaries is a source of instability. To this proposition there is one
important exception: the finance companies. In boom times the demand
for instalment credit is so great, and so insensitive to the cost of instalment credit, that finance companies can offer very high yields to attract
funds from alternative forms of liquid investment; by so doing, they
provide finance for consumer purchases that add to the pressure of
demand on available productive resources and so contribute to economic
instability. Finance companies, however, are not generally considered
to be close rivals to commercial banks in the same sense as other savings
and deposit-accepting institutions; and proposals for controlling their
activities are usually directed at controlling the terms of instalment
finance, rather than the lending capacity of the companies. For this
reason, such proposals are dealt with in the following subsection, on
control of specific types of borrowing.
So far as other financial intermediaries are concerned, there would
seem to be no empirical case for empowering the central bank to exercise control over their activities similar to that exercised over the
chartered banks. There may, however, be a case on grounds of equity
or financial efficiency for subjecting near-bank institutions to reserve
requirements similar to those now imposed on chartered banks. The
purpose of such a change would not be to improve the central bank's
power to pursue economic stabilization—as already mentioned, there
is little reason for believing that the central bank's control is weakened
by the presence of financial intermediaries, and indeed so long as the
public does not switch easily from bank deposits into close substitutes
the presence of intermediaries may on the contrary increase the leverage
THE FEDERAL RESERVE SYSTEM AFTER FIFTY YEARS
1009
of the central bank on economic activity.* On the contrary, the purpose
would be to burden the intermediaries with the same taxation as the
minimum cash-reserve requirement now places on the chartered banks.
Whether this would constitute an improvement in equity and efficiency
is a controversial question. As already mentioned, in return for this
taxation the chartered banks receive certain services from the central
bank, and enjoy the privilege of conducting a banking business. How
far the services and the privilege are worth the tax paid for them is an
extremely intricate question, as is the question of what equal conditions of competition between banks and near-banks would entail.
(e) Controls over Specific Types of Borrowing
The foregoing subsections have been concerned with controls over
specific types of lending institutions. This subsection is concerned with
the alternative type of selective credit control, which is directed at
specific types of borrowing, rather than at lending by particular institutions. The argument for controls of this type is that certain kinds of
borrowing finance types of expenditure that are of especial importance
in the causation of economic instability; and the case for such controls
must rest on demonstration that instability can be reduced—that is that
instability of the relevant types of expenditure can be reduced—by controls on the financing of such expenditure. Given that certain types of
expenditure can be identified as contributing to instability, the problem
raised by such proposals is how far control of the finance of such expenditure can mitigate instability. This problem is a serious one, because on the one hand there is no sure way of identifying a dollar of
borrowing with a dollar of expenditure, and on the other hand the
same expenditure can be financed in a variety of ways, some of which
may be difficult to control. Specifically, an individual or enterprise with
a wide enough variety of assets or activities can always find a legitimate way of raising borrowed funds, regardless of the purpose for
which the borrowing is intended; and similarly, if the demand for
credit for some purpose is keen enough, the financial system can, given
some time, always find a legitimate way of satisfying the demand.
* The presence of financial intermediaries supplying assets very similar to bank deposits and holding a fractional reserve in the form of bank deposits means that the
economy's total stock of "liquidity" or "money services" rests on a smaller fractional
base of central-bank liabilities than it would if these intermediaries were not present.
Consequently, so long as the public's division of its monetary assets between the various alternative forms, and the cash ratios observed by banks and competitive financial
intermediaries, are reasonably stable, a given change in the central bank's liabilities
will produce a larger absolute change in the public's stock of monetary assets when
financial intermediaries are present than when they are not.
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THE FEDERAL RESERVE SYSTEM AFTER FIFTY YEARS
Three main types of borrowing are commonly assigned a special role
in the generation of economic instability: instalment borrowing, particularly consumer instalment finance; borrowing for new capital investment; and borrowing for stock-market and real-estate speculation.
Accordingly, it may be argued that economic stabilization could be more
efficiently secured by empowering the central bank, or some other governmental agency, to control the terms on which consumer instalment
credit is available, to license borrowing for new capital investment,
and (or) to prohibit borrowing for speculative purposes or to control
the terms of such borrowing.
So far as consumer instalment credit is concerned, it can be argued on
the basis of the evidence that consumer purchases financed by such credit
have been a destabilizing factor in recent economic fluctuations. It can
also be plausibly argued that consumer instalment buying is relatively
insensitive to changes in the rate of interest incorporated in instalment-credit terms, but is sensitive to the down payment required and
the period over which repayment is spread (as incorporated in the
amounts of the instalment payments). Finally, it can be argued that
the inequity and economic inefficiency involved in curtailing consumers' ability to pledge their future earning power are of a lesser
order of importance than the inequity and inefficiency of similar
restrictions applied to productive enterprises. Consequently, it can be
argued, control of the down-payment and maturity terms of consumer
instalment credit offers the prospect of a significant contribution to
economic stabilization at a relatively small cost in terms of inequity
and inefficiency.
On the opposite side, it can be argued that the use of controls over
the terms of instalment finance places an inequitably heavy burden on
the members of the community who are dependent on the earning power
of their labor, as contrasted with those who possess property on which
they can borrow, or whose prospective earning power is sufficiently
high and certain to enable them to borrow on their personal credit from
a bank. It can also be argued that any substantive use of such powers
of control will foster evasion either directly or through the development of techniques for renting the services of consumer durables rather
than selling the goods themselves on credit; this has in fact been the
American and English experience with controls on instalment finance.
Finally, there is the possibility that the control of purchases of consumer durables through control of the terms of instalment credit will
set up replacement or "echo" cycles in the purchase of such goods,
which will aggravate the problems of the authorities concerned with
economic stabilization in future.
THE FEDERAL RESERVE SYSTEM AFTER FIFTY YEARS
1011
According to accepted economic theory, the main source of fluctuation in economic activity is fluctuations in the volume of business investment, and one promising way of promoting economic stabilization
is to stabilize the level of business investment. A possible approach to
stabilizing business investment is to try to stabilize the amount of new
borrowing for the purpose of business investment, by controlling access
to the new capital market by the licensing of new capital issues, as was
done in the United Kingdom for a long period.
Capital-issues control as a means of controlling new investment is
however severely limited, especially in a country like Canada where
firms have ready access to foreign capital markets. From a broad economic point of view, of course, the effect of control over access to the
domestic capital market in inducing would-be borrowers to borrow
abroad is not in itself objectionable, since restraint on new domestic
capital issues would usually be introduced when the supply of domestic
savings fell short of the demand for them, and foreign borrowing would
tap foreign supplies of savings; still, the need to resort to foreign borrowing might unduly favor foreign control of Canadian enterprises. If,
on the contrary, capital-issues control comprised both domestic and foreign flotations, it would raise problems both of interference with the activities of subsidiaries of foreign companies and of handicapping Canadian enterprises competing with foreign enterprises in the domestic and
world markets. The main problem with capital-issues control, however,
is that control of new capital issues is a remote and doubtfully effective
way of controlling investment expenditure: the modern corporation
can both finance itself by appropriations of current earnings, and plan
its external financing to maximize its freedom with respect to the timing of its investment expenditures. It is probably safe to say that
capital-issues control in the United Kingdom had little substantive influence on investment once physical controls over materials were
abandoned, and that in fact it was never a major influence on investment, but only a device for ensuring orderly queuing of new issues in
the capital market. More generally, capital-issues control is not a very
promising device for control of investment, though it can be a useful
financial adjunct of investment planning enforced by other means.
The third type of control over specific types of borrowing commonly
recommended is control over borrowing for speculative purposes,
especially stock-market and real-estate speculation. As previously
argued, it is extremely difficult to establish that such speculative borrowing contributes to economic instability, since it involves the purchase of existing assets and not of currently produced goods. The most
that can be argued is that the expenditure of speculative profits by
1012
THE FEDERAL RESERVE SYSTEM AFTER FIFTY YEARS
speculators who sell out to more optimistic speculators contributes to
aggregate demand, and that a bull market for equities may cheapen the
cost of new capital to corporate enterprises and stimulate new investment. How far the excessive optimism of the boom is fostered by increases in stock and real-estate prices caused by purchases financed
on credit is an unresolved question; so is the question of how far it is
possible to restrain increases in aggregate demand by impeding speculation through restricting the availability of credit to finance it. Anyone
with assets can speculate without the assistance of loans from a bank
or a broker, and anyone with personal credit can obtain funds that can
in fact be used for speculation. There is therefore considerable doubt
whether control of loans for stock or real-estate speculation can either
prevent speculation or, even if it can do so, contribute much to economic stabilization.
The case is different with speculation in stocks of physical goods,
and a somewhat better case could be made out for selective control of
loans to finance the accumulation of inventories. Unfortunately, speculative inventory accumulation is difficult to distinguish from the increases in inventories necessary to efficient production at a higher level;
and in any case inventories can be financed by other means than
borrowing.
Concluding
Observations
This paper has had two major purposes: to survey the alternative
positions that may be taken with respect to the future conduct of
monetary policy and the types of recommendations to which they lead,
and to examine the possibility of increasing the power of monetary
stabilization policy by the adoption of various types of selective credit
control. Three alternative positions on future monetary policy have been
distinguished: acceptance of a lower standard of performance, recommendation of changes designed to make monetary stabilization policy
more effective, and recommendation of abandonment of short-run
monetary stabilization policy in favor of creation of a stable monetary
environment. In the author's own judgment, the third alternative has
the most to commend it; however, if Canada remains on a fixed exchange rate the limitations on the freedom of domestic monetary policy
which that entails probably will necessitate the adoption of the first
alternative, or at best a mixture of the first and second alternatives.
A variety of selective credit controls has been examined. Given the
concentration of control in the Canadian financial system and economy,
more intensive use of moral suasion might help stabilization policy,
and the granting of powers to the central bank to control the more
THE FEDERAL RESERVE SYSTEM AFTER FIFTY YEARS
1013
liquid assets or loans ratio of the chartered banks might also be useful
and defensible. The author, however, has a prejudice against extension
of the central bank's authority in these directions, on the grounds that
it involves increased dependence on the central bank's judgment of complex economic problems, and tends to support economic concentration
and monopolistic practices in the financial sector and in the economy
generally. Turning to controls over specific types of borrowing, a
reasonably good case can be made out for empowering the central bank
to fix the down-payment and repayment terms of consumer instalmentcredit contracts. While an even better case could be made out for
regularizing the flow of private-investment expenditure, it is extremely
doubtful that capital-issues control could be used effectively for this
purpose. Finally, it is in the author's judgment highly questionable
whether controls on borrowing for stock-market and real-estate speculation could contribute anything significant to economic stabilization.
1014
T H E FEDERAL RESERVE SYSTEM AFTER FIFTY YEARS
PUBLICATIONS OF T H E
INTERNATIONAL FINANCE SECTION
The International Finance Section publishes at irregular intervals
papers in three series: ESSAYS IN INTERNATIONAL FINANCE, PRINCETON
STUDIES IN INTERNATIONAL FINANCE, and SPECIAL PAPERS IN INTERNATIONAL ECONOMICS. All three of these may be ordered directly from
the Section.
Single copies of the ESSAYS are distributed without charge to all
interested persons, both here and abroad. Additional copies of any one
issue may be obtained from the Section at a charge of $0.25 a copy,
payable in advance. This charge may be waived to foreign institutions
of education or research.
For the STUDIES and SPECIAL PAPERS there will be a charge of $1.00
a copy. This charge will be waived on single copies requested by persons
residing abroad who find it difficult to make remittance, and on copies
distributed to college and university libraries here and abroad.
Standing requests to receive new ESSAYS as they are issued and
notices of the publication of new STUDIES and SPECIAL PAPERS will
be honored. Because of frequent changes of address and the resulting
waste, students will not be placed on the permanent mailing list.
The following is a complete list of the publications of the International
Finance Section. The issues of the three series that are still available
from the Section are marked by asterisks. Those marked by daggers are
out of stock at the International Finance Section but may be obtained in
zerographic reproductions (that is, looking like the originals) from
University Microfilms, Inc., 313 N. First Street, Ann Arbor, Michigan.
ESSAYS
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INTERNATIONAL
FINANCE
Friedrich A. Lutz, International Monetary Mechanisms: The Keynes
and White Proposals. (July 1943)
Frank D. Graham, Fundamentals of International Monetary Policy.
(Autumn 1943)
Richard A. Lester, International Aspects of Wartime Monetary E x perience. (Aug. 1944)
Ragnar Nurkse, Conditions of International Monetary Equilibrium.
(Spring 1945)
Howard S. Ellis, Bilateralism and the Future of International Trade.
(Summer 1945)
Arthur I. Bloomfield, The British Balance-of-Payments Problem. (Autumn
1945)
THE FEDERAL RESERVE SYSTEM AFTER FIFTY YEARS
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Frank A. Southard, Jr., Some European Currency and Exchange E x periences. (Summer 1946)
8. Miroslav A. Kriz, Postwar International Lending. (Spring 1947)
9- Friedrich A. Lutz, The Marshall Plan and European Economic Policy.
(Spring 1948)
10. Frank D. Graham, The Cause and Cure of "Dollar Shortage." (Jan.
1949)
11. Horst Mendershausen, Dollar Shortage and Oil Surplus in 1949-1950.
(Nov. 1950)
12. Sir Arthur Salter, Foreign Investment. (Feb. 1951)
13. Sir Roy Harrod, The Pound Sterling. (Feb. 1952)
14. S. Herbert Frankel, Some Conceptual Aspects of International Economic
Development of Underdeveloped Territories. (May 1952)
15. Miroslav A. Kriz, The Price of Gold. (July 1952)
16. William Diebold, Jr., The End of the I.T.O. (Oct. 1952)
17. Sir Douglas Copland, Problems of the Sterling Area: With Special
Reference to Australia. (Sept. 1953)
18. Raymond F. Mikesell, The Emerging Pattern of International Payments.
(April 1954)
19. D. Gale Johnson, Agricultural Price Policy and International Trade. (June
1954)
20. Ida Greaves, "The Colonial Sterling Balances." (Sept. 1954)
21. Raymond Vernon, America's Foreign Trade Policy and the GATT. (Oct.
1954)
22. Roger Auboin, The Bank for International Settlements, 1930-1955. (May
1955)
23. Wytze Gorter, United States Merchant Marine Policies: Some International Implications. (June 1955)
24. Thomas C. Schelling, International Cost-Sharing Arrangements. (Sept.
1955)
25. James E. Meade, The Belgium-Luxembourg Economic Union, 1921-1939.
(March 1956)
26. Samuel I. Katz, Two Approaches to the Exchange-Rate Problem: The
United Kingdom and Canada. (Aug. 1956)
27. A. R. Conan, The Changing Pattern of International Investment in
Selected Sterling Countries. (Dec. 1956)
28. Fred H. Klopstock, The International Status of the Dollar. (May 1957)
29. Raymond Vernon, Trade Policy in Crisis. (March 1958)
30. Sir Roy Harrod, The Pound Sterling, 1951-1958. (Aug. 1958)
31. Randall Hinshaw, Toward European Convertibility. (Nov. 1958)
32. Francis H. Schott, The Evolution of Latin American Exchange-Rate
Policies since World W a r II. (Jan. 1959)
33. Alec Cairncross, The International Bank for Reconstruction and Development. (March 1959)
34. Miroslav A. Kriz, Gold in World Monetary Affairs Today. (June 1959)
35- Sir Donald MacDougall, The Dollar Problem: A Reappraisal. (Nov. i960)
36. Brian Tew, The International Monetary Fund: Its Present Role and
Future Prospects. (March 1961)
37. Samuel I. Katz, Sterling Speculation and European Convertibility: 19551958. (Oct. 1961)
38. Boris C. Swerling, Current Issues in International Commodity Policy.
(June 1962)
39. Pieter Lieftinck, Recent Trends in International Monetary Policies. (Sept.
1962)
2 8 - 6 8 0 O—64—vol. 2
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THE FEDERAL RESERVE SYSTEM AFTER FIFTY YEARS
40. Jerome L. Stein, The Nature and Efficiency of the Foreign Exchange
Market. (Oct. 1962)
41. Friedrich A. Lutz, The Problem of International Liquidity and the
Multiple-Currency Standard. (March 1963)
42. Sir Dennis Robertson, A Memorandum Submitted to the Canadian Royal
Commission on Banking and Finance. (May 1963)
43. Marius W. Holtrop, Monetary Policy in an Open Economy: Its Objections, Instruments, Limitations, and Dilemmas. (Sept. 1963)
PRINCETON
STUDIES I N
INTERNATIONAL
FINANCE
f No. 1. Friedrich A. and Vera C. Lutz, Monetary and Foreign Exchange Policy
in Italy. (Jan. 1950)
t
2. Eugene A. Schlesinger, Multiple Exchange Rates and Economic Development. (May 1952)
t
3. Arthur I. Bloomfield, Speculative and Flight Movements of Capital in
Postwar International Finance. (Feb. 1954)
t
4- Merlyn N. Trued and Raymond F. Mikesell, Postwar Bilateral Payments
Agreements. (April 1955)
t
5- Derek Curtis Bok, The First Three Years of the Schuman Plan. (Dec.
1955)
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6. James E. Meade, Negotiations for Benelux: An Annotated Chronicle,
1943-1956. (March 1957)
t
7. H. H. Liesner, The Import Dependence of Britain and Western Germany:
A Comparative Study. (Dec. 1957)
t
8. Raymond F. Mikesell and Jack N. Behrman, Financing Free World Trade
with the Sino-Soviet Bloc. (Sept. 1958)
Marina von Neumann Whitman, The United States Investment Guaranty
Program and Private Foreign Investment. (Dec. 1959)
Peter B. Kenen, Reserve-Asset Preferences of Central Banks and Stability
of the Gold-Exchange Standard. (June 1963)
Arthur I. Bloomfield, Short-Term Capital Movements under the Pre-1914
Gold Standard. (July 1963)
SPECIAL PAPERS I N INTERNATIONAL
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Gottfried Haberler, A Survey of International Trade Theory. (Revised
edition, July 1961)
Oskar Morgenstern, The Validity of International Gold Movement
Statistics. (Nov. 1955)
Fritz Machlup, Plans for Reform of the International Monetary System.
(Aug. 1962)
Egon Sohmen, International Monetary Problems and the Foreign E x changes. (April 1963)
Walther Lederer, The Balance on Foreign Transactions: Problems of
Definition and Measurement. (Sept. 1963)
THE FEDERAL RESERVE SYSTEM AFTER FIFTY YEARS
1017
Mr. JOHNSON. F o r purposes of discussion, the five bills I have read
can be divided into two groups: H.R. 9686 and H.E. 9687, respectively,
to provide for the payment of interest on U.S. Government deposits and
reimbursement of commercial banks for services performed and to
eliminate the prohibition of interest on demand deposits; and H.R.
3873, H.R. 9631, and H.R. 9685, respectively, to provide for the retirement of Federal Reserve Bank stock, to increase to 12 the number of
members of the Federal Reserve Board and introduce other constitutional changes, to provide that interest received by the Federal Reserve
Banks on U.S. Government obligations be covered into the Treasury
as miscellaneous receipts, and to authorize appropriations for the expenses of the Federal Reserve Banks and the Board of Governors.
I approve of both groups of bills in principle, because I believe that
the banking system ought to operate on competitive principles and that
monetary policy should be coordinated with other economic policies
under the responsibility of the elected government of the country.
The first two bills, as I understand them, are intended to restore the
influence of competition in two areas of commercial banking operations
in which heretofore arbitrary governmental price fixing has been the
rule, in the one case to the disadvantage of the Treasury as a large depositor and in the other to the disadvantage of the private bank customer. Both changes are, in my opinion, desirable. The prohibition
of interest on demand deposits was incorporated in the Banking Acts
of 1933 and 1935 with the intention of inhibiting banks from engaging
in as risky business as they might be tempted to do by the necessity
of competing for deposist by paying interest on them. There is no a
priori reason to assume that prohibition of payment of deposit interest
will make banks more cautious in their lending and investment policies,
nor does an exhaustive analysis of the empirical evidence bearing on
this question, conducted by George J. Benston, of the University of
Chicago, substantiate the claim. Moreover, the language of the Federal Reserve Act on this point—
No member bank shall, directly or indirectly, by any device whatsoever, pay
any interest on any deposit which is payable on demand—
is virtually unenforceable and evidently not enforced; the effect of the
prohibition has been to lead banks to compete by other devices ranging
from free checking and other services through variable compensating
balance requirements on bank loans to the offer of various gifts,
methods of competition which are socially wasteful and likely to have
regressive effects on the distribution of income. Not only should the
prohibition of interest payments on demand deposits be terminated,
but so should the powers of the Reserve Board and the F D I C to control
interest rates on time deposits, which equally serve no useful social
purpose. According to the same logic of efficiency in a competitive
economy, the Treasury should receive the market rate of interest on
its deposits with the banks, and pay reasonable service charges to the
banks to cover the costs to the latter of managing the deposits, rather
than simply canceling the one against the other as is the present practice.
The three bills in the other group aim at fundamental constitutional
changes. H.R. 3783 would recognize that the original conception of
the Federal Reserve System as an institution for reserve pooling by
members has long been a mere fiction, the function of the system now
1018
THE FEDERAL RESERVE SYSTEM AFTER FIFTY YEARS
being largely to control the volume of deposits in pursuit of economic
policy objectives. I t would also facilitate monetary control by somewhat reducing the burden of membership on member banks and so
encouraging widespread membership in the system. This conclusion
assumes that 6 percent is below the normal yield in bank capital.
H.R. 9685 would have the effect of subjecting the Federal Keserve
System's expenditures to congressional control, by obliging the system
to seek appropriations instead of expending as much as it sees fit of
the healthy profits earned from the interest-free issue of notes and reserve deposits against interest-bearing Government debt before turning
the residue over to the Treasury. I must confess to mixed feelings
about this proposal. On the one hand, one senses a certain atmosphere
of freedom from financial restraint in the way the Federal Reserve
System staffs itself and issues its publications; and there is the remote
possibility, exemplified by the 1961 dispute in Canada between the
Governor of the Bank of Canada and the Minister of Finance, that the
Federal Reserve might use the funds at its disposal to propagandize
the public on its own behalf in a policy dispute.
On the other hand, there is a strong tendency, here and elsewhere,
for legislators to insist on underpaying their top civil servants, to the
detriment of the quality of the service and the efficient performance of
public business; while congressional control of appropriations sometimes permit the hounding of public officials and inquisition into the
detailed conduct of public business to no apparently useful purpose.
H.R. 9631 is obviously the most important of the five bills, since its
effect would be to transfer control of monetary policy to the Administration, provide constitutionally for the coordination of monetary,
fiscal, and debt-management policy, and render the Federal Reserve
System financially accountable to Congress. As indicated by the general argument of the preceding section, I am in favor of the objectives
of this legislation, and particularly of the coordination of monetary,
fiscal, and debt-management policy through the appointment of the
Secretary of the Treasury as ex officio Chairman of the Federal Reserve
Board.
The past history of the relations between the Treasury and the
Federal Reserve contains numerous examples of conflicts between these
facets of economic policy, conflicts of which it cannot be said that
either party wTas always espousing policies consistent with economic
stability; and it would contribute to the efficiency of economic policy
for these conflicts to be reconciled in the formulation of policy rather
than erupt in the execution of inconsistent policies. Such provision
for the coordination of monetary and fiscal policy is especially necessary under present circumstances, when the pursuit of domestic objectives must be reconciled with restoring equilibrium in the balance of
payments.
The bill does, however, contain a variety of detailed provisions
which may or may not constitute the best method of achieving the
general objective of the legislation, but on wThose merits I am not
competent to judge. I might mention, however, that I have some
reservations about the usefulness and functions of the Federal Advisory Committee: it seems to me that a body of 50 assorted members,
appointed for a term of 1 year and meeting only occasionally, might
constitute a helpful source of information about the various sectors of
the economy and a sounding board for ideas originating in the Federal
THE FEDERAL RESERVE SYSTEM AFTER FIFTY YEARS
1019
Eeserve Board, but could hardly acquire the knowledge of policy problems and the internal cohesion required to fulfill tne initiatory role
envisaged for it in the bill.
I shall confine my comments on recent monetary policy to a few
brief remarks.
Monetary policy since 1957 displays the pattern of overreaction
followed by excessively sharp reversal to which I have referred in
a previous section; in addition, it displays the increasing subordination of domestic objectives to balance-of-payments objectives that
is the necessary consequence of the weak international position of
the dollar. I shall not document this assertion by a detailed chronicle of monetary policy, since other presentations before this committee will have done so or will do so; but I would like to call attention to the contractions of the money supply—currency plus demand
deposits, seasonally adjusted—from July 1959 to June 1960 and from
January to August 1962, whose severity, given the prevailing conditions of undesirably high unemployment, was undoubtedly motivated by concern about outflows of gold, and to the slow rate of
increase of the money supply—in relation to the longrun historical
average—in the first half of 1963 and the slight contraction in the
period June to August, which were associated with an adverse turn
of the balance of payments and the danger of a capital outflow.
These restrictive episodes in each case were followed by recession or
a slowing down of the rate of expansion, in which they undoubtedly
played some casual role.
Over the period from December 1960 to December 1963 the money
supply has increased at an annual average rate of 2.9 percent, a
rate well below the longrun historical average for the economy, and
this low rate of increase, which must I think be attributed ultimately
to concern over the balance-of-payments problem, has clearly played
a part in inhibiting the achievement of satisfactory levels of activity
and employment. Since August 1963 the money supply has been
increasing at a much faster rate—a 6.2-percent annual rate for the
month ending December 15. This change to a more expansionary
policy I interpret as having been made possible by the elbowroom
provided by the rise in short rates in mid-1963, the influence of the
proposed interest equalization tax on foreign borrowing in the United
States, and, I suspect, agreement on the part of the European countries to help to support the dollar through several more years of
deficit and their acquiescence in a U.S. policy of domestic expansion:
but the expansion that has actually occurred I would attribute to
a policy of attempting to prevent interest rates from increasing further, at a time when demand was expanding, in part under the influence of past and prospective tax reductions.
The change to a higher level of short-term interest rates, made necessary by the danger of capital flight, was accompanied by a renewed
announcement of the policy of tilting the yield curve so as to prevent
or inhibit increases in long-term rates. The possibility of achieving
divergent movements of short and long rates by monetary policy seems
to me, on the evidence of recent economic research on the term structure of the public debt and its sensitivity to changes in the maturity
composition, extremely limited; and long rates have in fact been
following short rates upward.
1020
THE FEDERAL RESERVE SYSTEM AFTER FIFTY YEARS
Some analysts would regard the upward movement of long rates as
portending a slackening or decline of economic activity. I am not sure
on this point. F o r one thing, the investment credits and provision for
accelerated depreciation will have increased the private rate of return
on investment projects to which they apply, and so made a given level
of long rates less restrictive than it would have been before these tax
changes; for another, the expansionary effect of the impending tax cut,
combined with continued monetary expansion, would permit long rates
to rise consistently with economic expansion. The balance-of-payments situation and the commitment to the present value of the dollar
in fact oblige the economic policy authorities to adopt a policy combination that expands domestic demand and activity while raising interest rates sufficiently to improve, or at least prevent a serious deterioration of, the capital accounts of the balance of payments.
As I have mentioned, recent monetary policy exemplifies not only
the growing subordination of monetary policy to the balance of payments problem but the pattern of overreaction to economic change
followed by excessively sharp reversal of policy characteristic of discretionary monetary policy as currently practiced. This pattern is, in
my judgment, attributable to the concentration of the Federal Reserve
on money market conditions, interest rates, and member bank reserve
positions as the objects of monetary rates, and member bank reserve
positions as the objects of monetary control.
While I have expressed reservations about the desirability of a rigid
rule of monetary expansion as a specification of a proper monetary
policy, it seems to me that the performance of the Federal Reserve as
an agency of economic stabilization would be considerably improved
if it were to devote less attention to monetary and banking conditions
and more to the effects of its policy actions on the quantity of money
and its rate of change. Thank you.
The CHAIRMAN. Thank you, Professor Johnson. Now we will hear
from Professor Villard. You may proceed in your own way.
STATEMENT OF PROP. HENRY H. VILLARD, COLLEGE OF THE CITY
OF NEW YORK
Mr. VILLARD. Thank you, Mr. Chairman. I am Henry H . Villard,
chairman of the Department of Economics of City College.
As I see it, the basic problem that we face is that when the economy
is close to full employment, we are faced with the necessity of choosing
among alternatives. I t is this which we have not yet learned to do.
The alternatives I have primarily in mind are employment and
growth on the one hand, and inflation and balance-of-payment difficulties on the other. I n my opinion, as the level of total spending in
the economy is increased to reduce unemployment, we will typically
increase the rate at which additional compensation is likely to be
demanded by the factors of production and the resulting increase
in prices can usually be expected to increase our balance-of-payment
difficulties.
For, as I see the matter, if I may be permitted to reduce a by-nomeans-simple problem to its barest essentials, we have fundamentally
to determine what it is now fashionable to call the proper "trade off"
between employment and inflation. On this matter I happen to have
some rather strong opinions. F o r my guess is that a more expansion
THE FEDERAL RESERVE SYSTEM AFTER FIFTY YEARS
10M
ary monetary and fiscal policy might well reduce unemployment by
not less than 2 percent of the labor force, or one-third of the present
level, and that the resulting increase in output—because of the concomitant reduction in on-the-job unemployment—might well increase the national income by not less than 5 or 6 percent—or by at
least $25 billion. On the other hand, because I believe that recent increases in prices stem mainly from the administered character of much
of our present pricing of the factors of production—often referred
to as the "cost push"—and are, therefore, substantially independent
of the "demand pull" induced by additional spending, I rather doubt
that a 5- or 6-percent increase in the national income would raise the
rate of increase in consumer prices from the 1.25 percent that we have
averaged over the last 5 years to much over 2 percent. Once again to
put a quite complicated matter in the baldest possible terms, as I see
it, in order to reduce the rate of increase in prices by hardly more
than 1 percent a year we have recently been wasting perhaps 5 percent
of our productive potential. When I take into account that continuing unemployment has caused labor leaders to question seriously the
value of automation and is turning many of the unemployed into unemployables, I find what I estimate to be the recent "trade off" between
unemployment and inflation a very poor bargain indeed.
What I have just presented are guesses with which many able
economists will strongly disagree. I am least interested in trying to
persuade you to accept my particular estimate of the "trade off," which
may or may not be right. What I am very much interested in stressing is that a decision is currentlv being made—and being made more
by omission than commission. For at present the overall decision is
the result of an unplanned amalgam of substantially independent decisions by the Federal Reserve System in regard to monetary policy, by
the Treasury and the Congress in regard to fiscal policy, by the Council
of Economic Advisers when it suggests guidelines on desirable price
increases—and by everyone in the economy in a position to administer
prices. Thus, as I see the matter, we are in regard to overall economic
policy in a situation quite similar to w^here we were in regard to security
policv not so long ago, and I offer the thought that the solution may
well be similar: the establishment of a National Economic Council to
include representatives of the Federal Reserve System, the Treasury,
the Council of Economic Advisers, and other interested Government
agencies.
This is obviously not the place to spell out in detail the way in
which a National Economic Council should operate, but there are two
thoughts I would like to offer. First, I conceive of the Council, in
relation to the President, as having a primary advisorv and coordinating role. For in my judgment—paraphrasing Clemenceau—•
overall economic policy is too important a matter to be left to economists or bankers, to the extent that the Congress can be persuaded to
delegate its constitutional powers, they should be delegated to no one
less than the President.
Second, I urge in the strongest possible terms that the Congress delegate more operating responsibility for economic policy to the President. Under the Constitution, power over both the monev supply—
or monetary policv—and taxes and expenditures—which together
constitute fiscal policy—is vested in the Congress. Fifty years ago
operating control over monetary policy was wisely delegated by the
1022
THE FEDERAL RESERVE SYSTEM AFTER FIFTY YEARS
Congress to the Federal Eeserve System. But thus far the Congress
has been completely unwilling to make any significant delegation of
its powers over expenditures and taxes. I believe what is most needed
today—and is far more important than any possible change in the
Federal Reserve arrangements—is for the Congress to delegate to the
President, and through him to the Council, the power to vary, within
limits carefully specified by the Congress, rates of expenditures and
taxation. For the Congress cannot effectively concern itself with
the day-to-day operation of the economy.
I take it that the immedate concern of this committee is how well
the 50-year-old delegation of short-term control over monetary policy
to an independent Federal Reserve System is working. I have two
somewhat contradictory thoughts on the matter. On the one hand,
I think there is likely to be general agreement that arrangements to
isolate the Reserve System from undue influence by bankers or by the
Secretary of the Treasury in pursuit of low interest rates are both
desirable and have by and large been successful. Thus I am not in
favor of efforts to increase the influence of the Secretary of the Treasury over the system or, for that matter, the influence of the Congress.
On the other hand, I am strongly in favor of arrangements which would
insure the coordination of monetary policy with general economic
policy as determined by a National Economic Council. This means
that, in the event of irreconcilable conflict, I would favor subordinating
the System to the President, operating through a council such as I have
proposed.
If, under such delegation, the President were to abuse his powers,
say to obtain low interest rates for the Treasury, the electorate
would then know whom to hold accountable for any subsequent inflation. I n short, I am prepared to compromise the independence of
the Reserve System in order to achieve overall coordination of economic policy. But my regard for the quality of those heading the
System is snch that I would be inclined, before making drastic changes,
to see whether the coordination of monetary policy with general economic policy could not be achieved by persuasion rather than compulsion.
On the specific bills I find mvself in close agreement with Professor
Harold Barger. of Columbia University, who is scheduled to appear
before you on March 10.
I have seen his statement although he has not yet appeared before
you.
First, I share his conclusion that, because of the importance of membership in the Reserve System, H.R. 3783 should not be enacted unless
coupled with a measure to require all commercial banks to become
members of the system. Again I share with Professor Barger his conclusion that it would be undesirable to increase the size of the Board,
include the Secretary of the Treasury, or expand the size of the Federal
Advisory Committee.
I further agree with him on the desirability of abolishing the Open
Market Committee and obviously on the need to achieve coordination
of monetary and general economic policy though I am less certain
than he is as to how best this can be done in the absence of a National
Economic Council. Finally, I feel as does he that audit by the General
Accounting Office is not needed. I am not clear as to whether the pur
THE FEDERAL RESERVE SYSTEM AFTER FIFTY YEARS
1023
pose of the proposed audit is to uncover possible waste or subject the
system to more congressional pressure. I feel certain the waste, if
any, is trivial, so that I would oppose an audit for this purpose unless
perhaps GAO audits are applied uniformly to all Government expenditures, including those of congressional committees. As I have
already made clear that I do not believe that the Congress is well
equipped to make short-run decisions on economic policy in general or
monetary policy in particular, I am also opposed to more congressional
pressure on the system either indirectly through a GAO audit or directly by insisting on annual appropriations, as is provided in H.R.
9685.
On the remaining bills before you I continue to find myself in agreement with Professor Barger. I approve in principle of H . E . 9686,
providing for the payment of interest on Treasury deposits with offsetting compensation for banking services rendered the Treasury;
my only reservation is whether enough is involved to justify the bookkeeping that would be required. I see no reason why, if economically
justified on a competitive basis, interest should not be paid on demand
deposits, as permitted by H.R. 9687. And I support the KilburnRobertson bill—H.R. 8505—to eliminate the penalty rate on discounts
secured by ineligible paper, as proposed by the Reserve System.
I have saved H.R. 9749, which requires the Reserve System to make
sure that the yield on Federal bonds does not rise above 4.25 percent,
for final comment because it seems to me to epitomize the problems we
face. For we are all in favor of the Government borrowing at reasonable cost and we are all opposed to inflation. But, most unfortunately,
there are times when these two objectives are contradictory: should
market conditions cause the price of Federal bonds to decline to the
point at which they yield more than 4.25 percent, all that the Reserve
System can do to support bond prices is to create additional money,
which will in turn typically add to inflationary pressures. I t seems to
me that the choice between higher interest costs and inflation can only
be made as a part of overall economic policy—which is something that,
within the delegated range, I believe the President should decide with
the help council I have proposed. I n my judgment for the Congress
to mandate by statute a particular interest rate regardless of all other
considerations makes no sense whatsoever. Thank you.
The CHAIRMAN. Thank you, Professor Villard. I would like to
ask you specifically about these bills and these will just be a few
questions in order to make the questioning short.
Now, about the one to retire the so-called Federal Reserve Bank
stock, would you favor that, Professor Johnson ?
Mr. JOHNSON. Yes, sir; I would.
The CHAIRMAN. YOU would favor that ?
Mr. JOHNSON. Yes.
The CHAIRMAN. What
Mr. VILLARD. Only if
about you, Professor Villard ?
it were accompanied by some effort to compensate the banks for the loss of profitability. I would not like to
see the attractiveness of the Reserve System reduced by the measure.
Otherwise, I have no objection to it.
The CHAIRMAN. D O you not think the fact that they get their checks
cleared free of charge would be a sufficient attraction to stay in the
system? You know that costs the Government about $125 millionplus a year.
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THE FEDERAL RESERVE SYSTEM AFTER FIFTY YEARS
Mr. VILLARD. Well, it does not seem to have been an adequate attraction to bring all banks into the system.
The CHAIRMAN. Nonmembers get it through their corresponding
banks, you know.
Mr. VILLARD. I realize that
The CHAIRMAN. Suppose we were to change the law, so that they
could get their checks cleared only if they belonged to the system ?
Mr. VILLARD. Well, any device which gives us a coordinated monetary system is one that I favor.
I do not strongly object to the repealing of—the retiring of the
stock. I t does seem to me though it should be viewed as part of the
overall organization of the system.
The CHAIRMAN. YOU look upon it as an attraction ?
Mr. VILLARD. This is what I understood from, I believe, Mr. Martin's testimony, that he felt it was an attraction. I do not really
know which way it is.
The CHAIRMAN. NOW, do you believe, Professor Johnson, that we
should take the representatives of the banks off of the Open Market
Committee ? I n other words, make it strictly a committee or a board
composed of people who are public servants representing the public
only?
Mr. JOHNSON. My answer to that question, sir, is "Yes."
The CHAIRMAN. You favor that ?
Mr. JOHNSON. Yes.
The CHAIRMAN. What do you think about
Mr. VILLARD. I also favor it, sir.
The CHAIRMAN. Yes, sir. Now, the next
it, Professor Villard ?
one is about having the
Federal Reserve turn over to the Treasury the interest on its holdings
of Government securities and get its appropriation from Congress.
Would you favor that, Professor Johnson ?
Mr. JOHNSON. I would be in favor of it, sir, though I do not know
qu^te how much there is in it.
The CHAIRMAN. What about you, Professor Villard ?
Mr. VILLARD. I would have some reservations. I n fact, I think I
am opposed to it.
Let us say that I do not think it is desirable for the Reserve System
to have to come to the Congress for annual appropriations. This is
simply part of my feeling that the Congress should not be in a position
to apply pressure on day-to-day decisions of the monetary authority.
The CHAIRMAN. Yes, sir. Now, I would like to ask each of you
gentlemen this: when the Open Market Committee buys Government
bonds, and it now has approximately $34 billion worth, the Open
Market Committee, in effect, trades Federal Reserve notes, currency,
money, for these Government obligations. I n other words, it transfers one Government obligation for another Government obligation.
Do you think that those obligations that are bought with Government money should remain outstanding and the taxpayers should be
compelled to pay interest on them when they, in effect, have been paid
for once by the transfer? What do you think about that, Professor
Johnson ?
Mr. JOHNSON. I have a little difficulty getting used to that way of
looking at it, sir.
THE FEDERAL RESERVE SYSTEM AFTER FIFTY YEARS
1025
The point of open market operations is to influence the economy by
changing the proportions of interest-bearing debts, and deposits of
the Federal Reserve and currency, in the hands of the public.
If the amount of money outstanding increases and the amount of
debt in the hands of the public decreases this means that the Government (taking the Federal Reserve and the Treasury together) has less
interest to pay. My understanding is present arrangements do provide for the return of surplus
The CHAIRMAN. Yes, sir, that is correct.
Mr. JOHNSON (continuing). To the Treasury.
The CHAIRMAN. Yes. I will not pursue that point because it would
involve quite a bit of discussion and more time than I am allowed at
this time. So if I want to pursue it I will do it later on. I see your
point all right.
But I think the point is reached where these outstanding bonds are
not needed; $34 billion certainly is not needed for open market operations. A much smaller percentage could be used that would suffice
for the reasons that you just stated which, of course, are valid reasons,
I recognize that.
Mr. JOHNSON. Well, I would like to put this point, Mr. Chairman:
In fact, we create a lot of technical difficulties with monetary management by having the Treasury issue the debt as a gross total and then
have the Federal Reserve buy and hold some of it in order to alter the
composition outstanding among the public.
If we look at the Government operations as a whole, it might facilitate matters if the Federal Reserve was able to issue interest-bearing
obligations instead of having to buy and sell Government bonds.
The CHAIRMAN. I see. Do you favor, Professor Johnson, the General Accounting Office auditing the Federal Reserve System ?
Mr. JOHNSON. Sir, that is a matter on which I do not have an opinion because I do not know the details of the organization.
The CHAIRMAN. Would you favor that, Professor Villard?
Mr. VILLARD. N O , I do not believe I would, sir. I do not think it
would serve any particularly useful purpose.
The CHAIRMAN. NOW, how do you gentlemen feel about eliminating
the prohibition against the payment of interest on demand deposits?
Professor Johnson, how do you feel about that ?
Mr. JOHNSON. I am all in favor of that, sir, and I would like to
extend it to the elimination of all restrictions on time deposits.
The CHAIRMAN. H O W do you feel about that, Professor Villard ?
Mr. VILLARD. I feel exactly the same way.
The CHAIRMAN. NOW, how do you feel about these funds going
into the banks, private banks, and what is known as the tax and
loan accounts?
First, do you believe it is necessary to have those tax and loan accounts at all ? You know, the bankers are putting up an awful fight,
claiming that they are losing money all the time.
I have never known people to fight so hard to keep on losing money,
but they claim they are losing money. Do you feel that they should
pay interest on the difference between what it actually costs them
and what the account is worth to them, Professor Johnson ?
Mr. JOHNSON. Well, in my statement I argue in favor of the payment of interest and the payment of compensation for services.
1026
THE FEDERAL RESERVE SYSTEM AFTER FIFTY YEARS
However, Professor Villard has raised one question as to how far
this amount of accounting is worthwhile, and that is obviously a
factual question.
I n principle I am in favor of interest being paid on loans and
charges being made for bank services rather than mixing them up
together in one bundle in the hope that one will compensate the
other.
The CHAIRMAN. I will yield to Mr. Brock.
Mr. BROCK. Thank you, Mr. Chairman.
Mr. Johnson, I did not quite understand this. Would you say once
again what your feeling was to 9749, which would amend the Federal Reserve Act to provide for a ceiling on Government bonds ?
Mr. JOHNSON. I am sorry, Mr. Brock, but I was not given a copy
of that bill and unless you press me on it I had rather not express a
judgment on it. If you press me, I will.
Mr. BROCK. Well, in general, could we put it this way: Do you think
it is wise for the Congress to enact legislation putting a limit on the
amount of interest or the yield of Federal Government bonds?
Mr. JOHNSON. N O , I do not think that would be wise because what
constitutes a high interest rate or a low interest rate varies from time
to time and, under present circumstances, as I mentioned indirectly
in my paper, the current interest rates may well be low.
Given the tax incentive to business investment and so forth they
may be low, whereas in the past they would have been extremely high.
I do not feel that we can predict what a reasonable level of interest
rates will be. I agree with the intention of helping to minimize the
cost of public finance, but I do not think that it is appropriate to try
to do that by fixing a ceiling on the interest rate on Government debt.
Mr. BROCK. I n other words, if I follow you through with this
thought, it is possible, as Professor Villard has stated or has indicated
at least, that if you put a ceiling on Government bonds then you
could increase the inflationary tendencies which were already inherent
in the rising market ?
Mr. JOHNSON. Suppose we have a situation like this: Suppose that
for one reason or other the profitability of investment gets extremely
high. We then find that interest rates tend to drift up to that 4.25
percent ceiling because of the pressure of the demand for funds.
To legislate that the Federal Reserve must keep the interest rate
at that level means, in effect, that it is obliged to buy all the bonds
offered to it.
Now, this would involve the creation of money which might contribute greatly to inflationary pressure, and I feel that if you want to
make a choice between low interest costs on the Government debt and
resisting inflation you should be free to do that in light of the circumstances at the time.
Since this legislation is intended to be a permanent feature of the
system we cannot tell whether it will prove a serious obstacle to the
policy or whether, conversely, it might prove completely ineffective.
Suppose, for example, the opposite situation existed, where interest
rates were low, this restriction would be meaningless and contribute
nothing to cheap Government financing which, I understand, is the
main motive of the bill.
THE FEDERAL RESERVE SYSTEM AFTER FIFTY YEARS
1027
Mr. BROOK. Well, the main motive of the bill is cheap Government
financing, perhaps, but also it is, as I understand it, to insure that the
people in the country get a reasonable rate of interest
The CHAIRMAN. A reasonable rate of what?
Mr. BROCK. Cheaper money.
The CHAIRMAN. I think there is a difference between the cost that
the Government should pay for interest and what the economy in
general should pay for interest.
I do not think the Government should pay as much because it is
the Government's credit that is used to create money, and I think the
Government's interest rate, if it was left up to me, that is, I would
make it around 3 percent and hold it there.
Mr. BROOK. Well, what
Mr. CHAIRMAN. And the Fed can do that if they want to. They
can make it 2.99 or 3.01, and hold it right there if they want to, and
they have.
Mr. BROCK. That is right.
Is it not true ? Mr. Johnson, that if we were to adopt such a policy
of a fixed maximum on the yield that—let's take your initial illustration, where we had a strong inflationary tendency within the country, and we were trying to save the Government money on this, we
could raise the cost to the individual American citizen quite considerably through inflation not only in its borrowing but in all prices, and
thereby create a situation where you would have done quite a lot
of damage to the economy as a whole. I s that not true?
Mr. JOHNSON. I find it difficult to sort out the different ideas involved in your statement, sir.
The effect of a ceiling of this kind under inflationary conditions
would be that the Federal Reserve System would be involved in buying Government debt in exchange for the creation of money. I n
effect, what would happen would be that the Government would be
saving not so much because it was getting low interest rates but because interest-bearing debt was being turned into currency by people who did not want to hold it at that low interest rate.
This, in turn, would mean inflationary conditions. I t would not
necessarily be effective at all in holding down interest costs on private borrowing.
Mr. BROCK. I t might be the reverse, might it not ?
Mr. JOHNSON. Initially, yes. I t would depend on how fast the
Federal Reserve bought the debt, but it would mean, in effect, that
you were depriving yourself of the use of monetary policy to help
to curb the inflation.
And this would seem to me undesirable in principle. So far as
the Government financing costs are concerned the Government does
get a better rate than people in general precisely because it is the
Government.
If one wants to reduce the cost of public debt to the Government
then one might think of all sorts of ways of doing this, for example,
jraising reserve requirements on banks which would mean automatically that they would have to hold larger reserve deposits
which, m turn, would mean that the Federal Reserve would hold
the Government debt and the interest on that would go back to the
Treasury.
1028
THE FEDERAL RESERVE SYSTEM AFTER FIFTY YEARS
There are many ways of doing this if that is what you want to
do, but I would not like to see the hands of the monetary policymakers tied by an obligation to maintain an interest rate which
was chosen without any regard to the circumstances in which they
might find themselves.
Mr. BROCK. If we had adopted a national policy of stable prices
and economic growth and full employment, which are all admirable goals, and we had this interest ceiling at the same time that
we had inflationary pressures, might it not be required for the Congress to enact legislation to hold prices at a certain level, in other
words, price and wage controls, in order to
Mr. JOHNSON. Well, this is carrying the argument a step further.
First of all, you debar yourself from using monetary policy to
stop the inflation and then you try to stop it by controlling prices,
but attempting to stop an inflation by controlling prices, while you
continue to expand the money supply, is an attempt to doctor the
symptoms and not the disease itself, and it is very likely if that went
on very long people would find ways of dodging and you would get all
the problems you get when money ceases to be trusted.
People resort to other means of exchange and generally the economy becomes very inefficient.
Mr. BROCK. I S not this really—although I think the conditions
justify the situation, but is it not true that this basically is what
happened during World W a r I I , when we had tremendous demands, tremendous money, and yet we had price controls?
Is it not illustrated by, or the problems involved illustrated by,
what happened after World W a r I I , when we took off the wage and
price controls and we left the ceiling on the Government bonds and
we had a tremendous surge in prices, some 70 percent, in
Mr. JOHNSON. That is right, but you have to be careful there because to some extent the manifestations of higher prices were already present but obscured by the controls.
I t was not simply that everything was going nicely and then
you took off the price ceilings and trouble began. The trouble was
piling up behind those price controls.
But this illustrates a point I made in my statement, incidentally,
that at the time when a restrictive monetary policy is desirable to stop
the inflation in fact you did not have such a policy. You had a lowinterest-rate policy during the war which did contribute to the subsequent inflation.
Mr. BROCK. Both of you commented on, to a limited degree, the provisions which would authorize the appropriations process rather than
the present procedure of a Fed taking interest from Government
obligations.
Would you comment, Mr. Villard, or Professor Villard, on what
effect it would have on our money supply if the Federal Reserve were
prohibited from taking these Government bonds ?
I n other words, if these $33 or $34 billion were not held by the Fed
but had to be sold to the general public what effect would that have ?
Mr. VILLARD. Well, it is a bit hard to answer in the abstract, in the
sense that it is conceivable that one could change arrangements so that
the effect would depend on the arrangements that one made to compensate for the sale.
THE FEDERAL RESERVE SYSTEM AFTER FIFTY YEARS
1029
But is your question in terms of general sale or recapture of the interest on these bonds ? I t seems to me
Mr. BROCK. N O , it is not related to the interest so much as it is to the
money supply.
In other words, when these bonds are purchased by the Federal
Reserve they are put in actually—actually, they are credited—a deposit
is credited from which you can expand the money and
Mr. VILLARD. Obviously they could not be sold to the general public
without decreasing the money supply.
An open-market operation consists of buying or selling Government
bonds and an open-market sale means decreasing the money supply.
Any program of just selling bonds to the general public would cause
a drastic decline in the money supply.
Mr. JOHNSON. May I comment on that, sir ?
Mr. BROCK. Yes.
Mr. JOHNSON. The
question is whether you think of getting rid of
these Government bonds, retaining the present reserve ratio or not.
If you assume the reserve ratio to be stable and you sell the bonds,
it would involve a drastic contraction of the money supply and increase
the interest rates on Government debt and, in general, would have adverse effects on both the economy and the Treasury.
However, you could contemplate, in going about this, another
way which would be to combine the sale of the bonds with a reduction
in reserve ratios. This, in effect, has been the general trend of Federal
Reserve policy in the postwar period, to expand the money supply
to meet the needs of growth by reducing reserve requirements.
The effect of this has been that the public has held the bonds rather
than the Federal Reserve. And one might argue that this is desirable.
Certainly, the banks would argue that it is desirable to have lower
reserve ratios and let them hold the bonds. But the consequences
for the cost of the debt would tend to be to raise it because the fact
that the Federal Reserve holds only Government bonds, or mostly
Government bonds, means that when money or assets are held by them
it goes into the Government debt, whereas when the banks have the
disposal of the money the Government debt must compete with private
debt.
I cannot quite see the objective from which you are exploring this
particular proposal. One could, if one were worried about the interest
cost only, simply convert a large block of Federal Reserve holdings of
interest-paying debt into non-interest-bearing debt.
This would be a perfectly feasible change and would involve no
monetary consequences. I t would only affect the allocation of the
interest received on Government debt between two branches of
Government.
Mr. VILLARD. But might I comment that inasmuch as the earning
of the Federal Reserve System, over and above its expenses, go back
to the Government it does not make too much difference what one
does at the margin in regard to the $33 billion that the System holds.
If it holds more it simply means it will return more to the Government so long as the amount of its expenditures are set. So it does not
seem to me that converting the debt one way or the other is of any
particular significance.
Mr. BROCK. Well, may I proceed with this for 1 more second?
1030
The
THE FEDERAL RESERVE SYSTEM AFTER FIFTY YEARS
CHAIRMAN.
Yes.
Mr. BROCK. Well, if this is the case then you, I think, Professor
Villard, argued against the appropriation process, but if we were to
not pay interest to the Fed on this $33 billion, in effect, do you not
have to go to the appropriation process?
Mr. VILLARD. YOU very definitely do, but what I am really saying
is that it does not make any difference what you do over and above
that portion of the debt which compensates for the cost of operating
the Federal Eeserve System. That goes back to the Treasury in any
event, so that making, for example, part of the debt held by the
Federal Eeserve System noninterest bearing would not change the
picture.
The appropriation matter is, of course, the same question as to
whether you believe the monetary authority should have to come in
annually for an appropriation from the Congress.
There is a case for it, but I do not feel that this is a desirable change,
or that they have in fact misused the money even though it is substantially without any close control, or that they have used it in an
inappropriate fashion.
Mr. BROCK. My time has expired. Thank you.
The CHAIRMAN. Mr. Eeuss.
Mr. EEUSS. Thank you, Mr. Chairman.
Pursuing just briefly the point that you have been discussing with
Mr. Brock, you gentlemen have suggested that if Congress, by law,
required paying off the bond at 4*4 percent or at any other fixed percentage, if we then got to full employment or something near it, there
would be an increase in the money supply unrelated to the needs of
the economy which might well be inflationary.
Could not that evil day be somewhat postponed at least by taking
compensatory action with respect to the legal bank reserve requirements—that is to say, if Congress passed such a law?
I have some reservation at the moment as to whether it should, but
could not the possible inflationary effects of that be deadened, or at
least postponed, by Federal Eeserve policy of raising the reserve requirements of the banking system?
Would you not be able to peg the price somewhat longer without
getting into inflationary problems?
Mr. JOHNSON. I would comment as follows, that it is obviously
possible to reduce the cost of the Government debt by obliging the
Federal Eeserve or the banking system as a whole to hold more of it.
I n fact, that was one of the arguments for secondary reserve requirements that have been with us since the war.
That, I think, would be a more feasible way of pursuing the objective of lowering Government interest cost; that is, requiring a part of
the market to hold the debt even though it involves a lower return
on their money than they could get elsewhere without imposing an
interest rate ceiling.
I think, if that is the objective, it would be better to pursue it by
creating an artificial market.
I t is true that if you fixed the price you could mop up some of the
inflationary consequences at least in the short run by forcing the banks
to hold a larger and larger portion of it or, as you suggest
Mr. EEUSS. Or the Federal Eeserve?
THE FEDERAL RESERVE SYSTEM AFTER FIFTY YEARS
1031
Mr. JOHNSON. Or the Federal Eeserve—increase the reserve requirements so that banks have to hold more deposits in the Federal
Eeserve and thereby enable the Federal Eeserve to hold more of the
public debt without having a general expansion of credit to the public.
That is true.
But it would involve, in effect, imposing a tax on the banks. The
obligation to hold higher reserves is an obligation on the banks to
forgo yielding assets
Mr. EETJSS. By sterilizing some of their bank assets ?
Mr. JOHNSON. Yes; and in the longer run this might mean that
banks were seriously impeded in competition with other financial
institutions so that you would be eroding the base of monetary control
by forcing the economy to develop alternatives to banking as a means
of providing the banking services.
If you reduce the profits of banking, obviously you tend to make
banking services be provided in some other way.
Mr. VILLARD. Might I comment that I think that the strongest
objection that I would have is to the inflexibility involved in it.
I do not dispute the point that you have raised, that there is a range
over which—as Professor Johnson just stated—it is possible to offset
inflationary effects.
But I would think it would be most undesirable to mandate a
matter of this sort by congressional action once and for all; it should
be something that is possible to vary as conditions vary.
Mr. EETJSS. Going on to a related point, what do you gentlemen
have to say about the present ability of the Federal Eeserve money
managers to control the money and credit of the country?
What the Federal does control, is, if I am not mistaken, a very much
smaller figure than the total of savings and loan deposit certificates
and various other pieces of paper put out by financial intermediaries.
Do either of you have anything to say on the general question of
whether the Federal Eeserve may not, in fact, and with the best will
in the world be kidding itself and the public about its ability to
Mr. JOHNSON. Well, Congressman, the fact that the Federal Eeserve directly controls only bank credit is not essential because as long
as the rest of the system responds to the changes in the base of bank
credit the existence of other institutions gives more leverage, rather
than less, over the economy.
Now, there has been a great deal of dispute among economists in
the past 7 or 8 years over whether the presence of these other intermediaries makes a difference or not, and so far as my best judgment
goes, there is not that much change in the economy or substitution of
one type of liability for another, and so forth, so that the Federal
Eeserve does not have all the power it needs through its control of
money supply.
Mr. VILLARD. This would also be my opinion.
I would say that there have been changes but they are not of the
magnitude or sort that significantly reduce the power of the Federal
Eeserve to control monetary matters.
Mr. EETJSS. Another question: Can you gentlemen think of any way
in which we could differentiate between the uses to which credit is put?
I will give you an example of what I mean. I n the present state
of the economy, with 5-plus percent unemployment, underuse of re28-680—.64—Vol. 2
8
1032
THE FEDERAL RESERVE SYSTEM AFTER FIFTY YEARS
sources, and so on, we obviously need credit, bank credit and other
forms of credit, to enable businessmen to erect new plants, buy equipment, and other capital goods the very creation of which will itself
make jobs.
Therefore, if a bank loan is made for that purpose that is fine. If,
however, a bank loan is made for the purpose of enabling me to bid up
the price on a piece of downtown real estate over here in one of the
suburbs I would not think that was particularly good. That does not
put anybody to work. I t simply adds to the cost of the economy,
makes somebody a windfall profit, and so on. Is there any way known
to man in which we can steer things in one direction or the other ?
What I am getting at, really, is that I would like lots of credit at
low interest rates for productive purposes, but I wish there was some
way of providing that without at the same time creating too much
speculative activity in the stock market, in real estate, and so on.
Mr. JOHNSON. Well, Congressman, I have dealt with these issues at
considerate length in the document I have circulated, which I prepared for the Canadian Royal Commission.
The answer that I arrived at is that money is an anonymous material
and nobody can tell what it will be used for, so that efforts to prevent
lending for one purpose and to favor lending for another purpose are
very easily evaded.
So they tend to be pretty useless.
Also it is very difficult to tell just what is a productive purpose and
w^hat is not. Take the real estate transaction that you are talking
about: I t is quite possible that a purchase of a piece of land may be
preliminary to the development of a subdivision, and it is impossible,
in my judgment, to tell whether such things are speculative or not.
They are speculative in one sense, that they look toward future
profits, but they may be looking toward employment and
Mr. REUSS. If I may interrupt you; of course, if it is the first step
in the production of a development of a subdivision, that is fine. If,
however, it is merely a change in a 1926 Florida land transaction, then
it is bad and not good. As you say, you cannot tell the difference,
but
Mr. JOHNSON. Well, I do not think it is possible to tell the difference,
at least until afterwards, which is too late.
I do not think you can devise legislative rules or operating rules
which will enable you to discriminate in this fashion. We do have,
in our society, a bias against speculators.
Everybody resents seeing somebody make money apparently for
nothing.
On the other hand, an exercise of judgment about the future often involves just this kind of activity. I t may be also that our tax system
gives an unfair advantage to those who operate in that kind of transaction by enabling them to get capital gains treatment, and so forth,
but this seems to me to be a question for the tax system rather than
the credit mechanism.
Where taxes create incentives for people to play for capital gains
or take advantage of the special laws, that is a fault of the tax system,
and I do not think it is possible to combat that by the way you conduct credit policy.
Mr. VILLARD. May I comment that it seems to me that it is not
merely a question of the distinction between speculation and productive credit. I t seems to me that the real problem is more fundamental.
THE FEDERAL RESERVE SYSTEM AFTER FIFTY YEARS
1038
As I suggested in my statement, if one wants to obtain full utilization of resources, then there is almost certainly going to be greater
pressure on prices. This is a characteristic of our economy, it seenif
to me.
And there is no way that I can see that, on the credit side or even
adding fiscal policy, that you can avoid the necessity of having to
choose between a higher level of spending which, in turn, is essential
for a higher level of employment, on the one hand, and the pressure,
that it leads to for the prices of the factors of production to rise mortrapidly.
W h a t I mean concretely, to take the most important factor of production—labor—is that as the economy moves toward full employment, and profits become high, the labor movement feels that it should
push harder for wage increases which, in turn, means more rapid
price increases.
I t is because of the need to choose between these that I urge J he
establishment of some mechanism for the coordination of overall economic policy.
Mr. EETTSS. Thank you.
The CHAIRMAN. Mr. Hanna.
Mr. H A N N A . Thank you, Mr. Chairman.
As I gather from your statements, gentlemen, both of you would
agree that the functions now carried on by the Open Market Committee could be carried on through some other mechanism. Is that true?
Mr.
JOHNSON.
Yes.
Mr. VILLARD. That is correct; yes.
Mr. H A N N A . I t is now equally your view that we might continue i c
utilize the public debt in the sense directly connected with the suppi}
of money. I s that correct?
Mr. JOHNSON. That is not only correct but it is essential in the waj
a modern central bank operates* that it must operate in public debt.
The existence of the public debt enables it to operate much more
flexibly and impartially than if it had to operate in private debt. ab
was the case in the old days before the public debt got so large.
I t penetrates into every segment of the economy, and is much less
concentrated in one p a r t of the economy.
Mr. H A N N A . I take it that p a r t of your criticism about the operation of the Open Market Committee is related to the whole idea of the
separation per se of the Federal Eeserve System as the monetary
policy decided.
If we made some other mechanism, and I suspect that, Professoi
Villard, your suggestion is that there ought to be some kind of a mix—
I took it from Professor Johnson that you felt that there ought to be
a strong relationship to the Executive.
Mr.
JOHNSON. Yes,
sir.
Mr. H A N N A . Would you agree with that?
Mr. VILLARD. I agree completely. As I tried to state, I think the
only person to whom power can appropriately be delegated is no one
less than the President.
Mr. H A N N A . T O the decree that we make changes, it would be
making a separate agency directly related to the President or the mix,
suggested by yourself, of using the agencies now involved but having
1034
THE FEDERAL RESERVE SYSTEM AFTER FIFTY YEARS
them coordinated and responsible directly to the Executive. Is that
correct?
Mr. VILLARD. Correct; yes, sir.
Mr. H A N N A . All right. Now, on looking at some of the problems
that we have in terms of today's operation, the way we are doing it
now, it seems to me that you gentlemen were saying that, in a sense,
we are trying to solve our problems of bringing together some warring
and, sometimes, let's say, incompatible changes by a kind of jousting,
it appears to me.
I n other words, Mr. Martin is on one horse—and you can call his
white or black, depending on how you want to run the television
show—and he seems to be jousting against inflation and for a balance
of payments and trying to keep the international monetary situation
where we will have a certain position with the dollar.
The Council of Economic Advisers, with their orientation, seem to
go for growth and employment and, incidentally, try to get price
stability and make a bow toward the balance of payments.
I s it your feeling that out of this jousting we really are not getting
as good an answer to these things as we might get if we went at it in
some other way ?
Mr. JOHKSON. That is certainly my opinion. I n effect, we are in
the position of attempting to drive a car by putting one person in
charge of the steering, another in charge of the rate of engine turnover, and another in charge of the brakes and saying, "Now, fellow,
that is your responsibility; you look after the brakes."
Well, naturally, he is going to concentrate on the brakes, and he
is going to be disturbed from time to time by changes in engine speed
or changes in the steering.
And, in effect, we have a problem facing us of combining full employment, growth, and the balance of payments; we have different people in charge of different pieces of this, and it is wider than just the
monetary policy.
F o r example, the Labor Department has a concern with unemployment. I t tends to think of it in terms of the solving of labor problems : more time in school, better training, shorter workweeks, and so
forth.
So that we have all these people looking at what is essentially an
indivisible problem from a particular point of view, and working at
their own policies on it in terms of what they control and what their
responsibilities lead them to think are important.
Monetary authority concerns itself with price stability, stopping inflation, and balancing the balance of payments. The Executive, as
far as it can, is trying to pursue all of these problems, but it is working with different agencies which are not well coordinated and which
take different views of things.
I n my judgment, the problems have to be looked at as a related set
of problems, and you have to balance these different tools and you
have to balance the specific concerns of the particular agencies with
their own problems.
Mr. VILLARD. I am in complete agreement. I think it is a question
of what I referred to as the tradeoff between objectives which are desirable but contradictory.
One has to decide how much employment one wants to create, given
the fact that a very high level of employment undoubtedly puts
THE FEDERAL RESERVE SYSTEM AFTER FIFTY YEARS
1035
greater pressure on prices and causes increases in our balance-of-payments difficulties.
I t seems to me that what is urgently needed is an agency where these
tradeoffs can be worked out, where the President can decide what the
tradeoff is to be in terms of his grand economic strategy. I might add
that I think some of the problems that the monetary authority is
being asked to do something about are well beyond their competence.
I do not mean beyond their technical competence but rather beyond
their powers.
I have in mind specifically that, in my judgment, the balance of payments is probably going to be a serious restraint on the level of activity
of the country so long as we do not change the arrangements that we
have in the directtion of providing greater international liquidity, on
the one hand, and also, in my judgment, to permit some variation in
exchange rates.
Well, that is well beyond the power of the Federal Reserve, and to
ask them to cope with the matter, given present arrangements, is going
to inevitably ask them to undertake a level of restraint which may not
be desirable in terms of other objectives.
Mr. H A N N A . I think, from what you gentlemen said, it kind of
bears out the basic feeling that I have had; that, in this area, as in
many others, there is a basic dependence on what happens. If you do
one thing something else happens.
I t has also been my view that the relationships are much more important today than the independent units and that, therefore, the thing
that has not been encompassed is who is responsible for the relationships. People have been responsible for the components but nobody
is responsible for the relationships.
Now, I noticed that, when our industrial complex was faced with
this kind of a problem, in the development of the missiles, they developed what they called the "systems analysis" type of approach, in
which somebody was responsible for the relationships of the various
units and had their eye on the coordination or inner actions. I s it
your suggestion that, whereas you really think we ought to be moving
in terms of
Mr. VILLARD. I would even be broader than that and say it seems to
me that the analogy should be with the security problem, where a
great many agencies of Government were involved with what added
up to our national security, and out of that need came the National
Security Council. I offered that as a valid analogy. I t seems to me
that we need an economic council which would coordinate our policies.
There is no doubt in my mind that the rate of increase in wages is
a, factor which influences the rate of increase in prices which, in turn,
influences the degree of overall employment that it is possible to
achieve without upsetting the tradeoff ratio between price increases
and employment that the Federal Reserve can be expected to accept.
Now, therefore, it seems to me that one has to look at the problem as a
whole because, perhaps, the key thing in achieving more employment,
which I am sure we are all for, is to devise techniques to prevent this
being accompanied by rapid increases in prices and balance-of-payments difficulties—and this is something which needs a very broadly
coordinated approach rather than something which is handled piecemeal where it cannot be handled effectively.
L036
THE FEDERAL RESERVE SYSTEM AFTER FIFTY YEARS
Mr. HANNA. Mr. Johnson, you would then say, in terms of what
Mr. Villard says, that you agree with him and that coordination is not
possible so long as the Fed's or the Federal Eeserve is the one place
where we have a very important unit which does not have any responsibility now to the President and, therefore, could not be coordinated
by the person who reasonably has to do the coordinating, and that is
die Executive. Is that correct ?
Mr. JOHNSON. That is correct; yes, sir.
Mr. HANNA. Thank you, Mr. Chairman.
The CHAIRMAN. Yes, sir. I would like to ask you gentlemen to
comment on this statement: The Open Market Committee has now
about $34 billion in bonds. Suppose we should fix a 4^4-percent rate
as the maximum yield for Government obligations, and then suppose
bond prices dropped to where someone would have to buy these bonds
to keep them at 4^4 percent, as was done, of course, during World War
IT. And suppose the Federal Reserve should buy those bonds, and
suppose the Federal Reserve should increase their holdings from $34
billion to $100 billion, or maybe $150 billion—a half of the national
debt.
If proper corrections were made along with these acquisitions, how
could that be detrimental to the public interest when, instead of the
debt costing $11 billion a year to service, it would only cost one-half
that much? What would be your comment on that, Professor
Johnson?
Mr. JOHNSON. Sir, I think you are defining the public interest only
in terms of the interest cost to the debt. I think it would be against
the public interest if this process involved inflationary development in
the economy, which
The CHAIRMAN. Well, I would agree with you if it involved inflation, but, you see, when you have a car that can go 100 miles an hour,
that does not mean that you will not put on the brake, and the same
way here.
xis you began to acquire these bonds, and if there was danger of
inflation, you could increase the reserve requirements of banks, which
is a most effective method, I believe. Would you not think that would
offset the possible inflationary effect of the acquisition of the bonds?
Mr. JOHNSON. I would agree that it is an effective method, but I
have already argued this morning that the consequences of it would
be, in effect, to place a tax on the banks and, therefore, on the customers.
The CHAIRMAN . Place a tax on banks ?
Mr. JOHNSON. In effect, yes. You would be forcing them to hold no
interest-paying deposits
The CHAIRMAN. NO, that is just the Federal Reserve banks.
Mr. JOHNSON. The member banks, yes.
The CHAIRMAN. NO, the Federal Reserve banks.
In other words, I am saying that if the Open Market Committee acquired up to half of the national debt, of course, the reserves would be
increased in the banks, and it could cause inflation, but you can offset
that by increasing the reserve requirements of the banks.
Mr. JOHNSON. That is exactly the point I am making, sir.
If you increase the reserve requirements, you are, in effect, forcing
the banks to hold a higher proportion of their assets in the form of
non-interest-paying deposits.
THE FEDERAL RESERVE SYSTEM AFTER FIFTY YEARS
1037
Therefore, indirectly what you are doing is taxing the banks in the
sense that you are reducing their profits by making them hold these
deposits which, in turn, indirectly are Federal Eesarve holdings of
public debt.
So that the essence of the matter is that the banks are being forced
to hold noninterest bearing assets which match the absorption of
public debt by the Reserve banks.
Now, one might well believe that banking in the country should not
be conducted as it is, mainly that banks should be simply cloakrooms
which hold money and charge their customers the full cost of any
banking services they get.
A t present the customers get services which they do not pay for because the bank makes money on its loans, and these earnings, in part,
go to finance services provided to the customers.
Now, that would involve a change in the whole nature of banking
which we could argue, but if we do not want to contemplate that kind
of a fundamental change in the nature of banking in this country then
we have to realize that the effect of this policy would be to tax banks.
To force them either to contract their activities or to pass more of
the cost on to the depositors, would be the results, and there are issues
of public policy involved in this that would have to be debated.
The CHAIRMAN. I believe your argument is very similar to one that
Mr. Eccles made, and you are familiar with his argument on that, that,
in other words, we have got to have the banks' services some way and
they have got to have profits.
And, of course, I agree that they must be profitable institutions and
if they are not allowed to profit this way we would have to subsidize
them because we have got to have them, and he used the word "subsidize" one time.
Mr. JOHNSON. Well, I am not prepared to argue that we should
subsidize the services
The CHAIRMAN. N O , he was not either, but he said we had to provide
the service and if we did not allow them to make it this way that they
would have to be subsidized or taken care of in some way. W h a t is
your comment on that, Professor Villard ?
Mr. VILLARD. Well, I think it is exactly along the lines of what
Professor Johnson has said.
I t is perfectly true that you can offset the inflationary effects of increased purchases of Government bonds by raising the reserve requirements but to do so reduces bank holding of such assets.
Now, it is conceivable, to run a banking system, for example, in
which the banks have no earning assets whatsoever—in other words,
the so-called 100-percent reserve approach. B u t then the banks, in
order to be able to provide the services which they are now compensated for out of their earnings, in part on Government bonds but to
some extent in other forms, if they were not compensated out of their
earnings they would have to pass these charges directly to their depositors.
I do not see any net benefit coming out of this that would be significant.
The CHAIRMAN. The hearings have developed the fact that the Federal Reserve System lias almost gone out of business, the way I see it,
except the Federal Reserve Bank of New York through its open market operations.
1038
THE FEDERAL RESERVE SYSTEM AFTER FIFTY YEARS
The other 11 banks do very, very little business. A t one time a
major part of their earnings came from the discount window, but the
discount window is not used much now.
The number of transactions in each Federal Reserve district is very
low over an entire year, probably not enough to justify the employment of more than three people.
So the question naturally arises of what should be done about this.
The check clearings represent a large part of the business of these other
11 Reserve banks.
So, should we consider turning the check clearings over to the banks
and let them do it at a price which would probably be greatly reduced
from the cost to the Federal Reserve System ?
Do you think that the banks could service these checks at a much
lower cost, Professor Johnson, than it is costing now through the
Federal Reserve ?
Mr. JOHNSON. I am really in no position to judge what the cost
would be through private enterprise as compared with the Federal
Reserve System. But I would agree with the general tenor of your
question, which, as I see it, is this, that we now provide a system
through which the public gets free clearance of checks between the
different parts of the country, the cost of which is borne by the members of the Federal Reserve System through the Federal Reserve check
clearing operations.
And it seems to me that the check clearing is not a necessary part at
all of a central bank's business. I n other countries, they do not provide these services, at least not to the same extent, and there is much
to be said for allowing competition to operate in what is essentially a
private service.
I n other words, it seems to me that the desirability of having free
clearance of checks between remote parts of the country is very moot.
I n some ways it promotes economic inefficiency because if you can
transfer money without cost over great distances this tends to disperse
the economy and offset other advantages of concentration of economic
activity.
So I think I would be in favor of transferring the check clearing
functions and letting the banks set up whatever arrangements would
be efficient.
The CHAIRMAN. Even though the Government pays the cost, as it
does now, it would probably be out more money ?
Mr. JOHNSON. That might well be true.
The CHAIRMAN. Before I ask Dr. Villard to comment on this, would
you please extend your remarks in the record on what other central
banks do concerning clearing checks and rendering services which, of
course, you said is something that we are doing for the banks ?
Mr. JOHNSON. Well, the banking systems that I am most familiar
with are those of the United Kingdom and Canada, and there is the
point that their banking systems are heavily concentrated so that you
have branch banks, very many branches, and they do their own internal
clearing through the branches.
They also have a clearinghouse which does the clearing between the
banks.
So that what their central bank mostly does is to transfer deposits
on its books between these banks, but most of the check clearing goes
THE FEDERAL RESERVE SYSTEM AFTER FIFTY YEARS
1039
on outside and is organized by the bankers through their clearinghouses.
The CHAIRMAN. Professor Villard, would you comment on this:
Do you consider check clearing a private matter that should be conducted by the private banks themselves or is it a public function that
the Government should do through the Federal Reserve and pay for
at the taxpayers' expense ?
Mr. VILLARD. Well, I would like to pick uj> the point that Professor
Johnson was just making, that there are quite significant differences
between a large number of small banks and the banking systems of
Great Britain and Canada.
I t seems, therefore, that we have got to have some system of overall
clearing, and I must admit that I am not clear that private enterprise
could clear significantly less expensively.
Certainly, I would not like to see us return to a situation in which,
when accepting a check we had to worry about whether the bank was
going to honor the check—the sort of thing that occurred in the 19th
century
Mr. H A N N A . Mr. Chairman, will you yield right here, because I
would like to get this point across to the gentleman.
I s it not true that the check clearing is directly related to the velocity of money in the society, and is it not in our best interest to keep
that velocity as high as we can so that no matter what we do we certainly need a very efficient kind of check clearing if we are going to
get more velocity ?
I t seems to me that there are two things that function here: one,
the amount of money you have got and how fast it will operate because you can do more with less money if you have velocity. Is that
a germane point, sir ?
Mr. JOHNSON. I think it is germane in the sense that the argument
for returning this function to private enterprise, is that it might well
be carried on cheaper and therefore would facilitate more efficient
use of money. I t is certainly germane to the issues.
Mr. VILLARD. But there may be times when you do not want high
velocity, if such velocity creates inflation.
I t is very hard to know whether it is desirable to increase velocity
until you know what the conditions are. But let me make clear that
I am all for the efficient clearing of checks.
I am just not at all clear in my mind about how it can best be done.
I have not thought about the matter very much, but I am not at all
clear that it can be done better by private enterprise than it can in a
system in which each member bank has to hold deposits in one of the
12 Reserve banks. This seems to me in many ways to be an arrangement which facilitates the whole clearing operation.
Now, maybe private enterprise could come up with better alternatives, but it is not immediately obvious to me that this is the case.
Mr. JOHNSON. Well, if I might make a historical comment, the
emergence of bankers' clearinghouses and the very origin of them was
out of a realization by banks that they did not have to keep trading
deposits back and forth with each other but could add them up and
cancel them out against each other.
I t seems to me, in the argument that you presented against returning the clearance of checks to private enterprise, you are mixing u p
1040
THE FEDERAL RESERVE SYSTEM AFTER FIFTY YEARS
very different things because you mentioned the question of whether
the check would be honored and so forth.
Now, it seems to me that this is a question of the integrity of the
bank ? which is handled in other ways. I do not really see t h a t the
clearing process does anything about that.
I t also seems to me that if the banks were left to themselves they
would very quickly come to police each other and make sure t h a t they
perform properly. The performance of this function by Government
doesn't seem to me to have any particular justification.
I t may well use more resources than would be required if it were run
on business lines, and it does not seem to be any part of a central bank's
function. That function is to control the total reserves available
to the banks.
The clearing function does not have anything to do with that. I t is
simply a question of clearing all transfers between banks down to a
net figure, and it is a bookkeeping operation which, I think, could be
handled quite efficiently without the Federal Reserve being responsible for it.
The CHAIRMAN. The Federal Reserve banks earn about 1 percent of
their cost. How can you justify continuing an organization of 20,000
people, like it is now, with not only presidents being paid from $70,000
and $40,000 or in that range, but vice presidents galore, and every
one of them being paid somewhere among those figures?
How can you justify continuing that type of service with such a
large overhead and with so little in the form of meaningful results?
Would you comment on that, Professor Johnson ?
Mr. JOHNSON. Sir, I do not regard myself as being here to pass
judgment on the justification or otherwise of this kind of thing.
The CHAIRMAN. That is all right. If you do not want to answer it,
it is perfectly all right.
Mr. JOHNSON. But I would remark that I think the initial plan for
the 12 Reserve banks was a compromise which belonged to a much
earlier stage of the country's history, and that there is now really no
scope for 12 central banks because, in effect, the market is so well
integrated that 1 operating bank is enough.
If the others have developed these other functions, in a sense I
would think the purpose was to justify their existence, and I certainly
think the question of whether it is worthwhile having this widespread
organization with duplication of departments in different parts of
the country is justified—I feel, as I say, in my statement, that the
Federal Reserve does staff itself rather lavishly for the task that it
actually performs and the question as to whether this is justified is
well worth raising.
The CHAIRMAN. W h a t are your comments, Professor Villard?
Mr. VILLARD. I must admit that I am less clear that the level of
staffing is undesirable. I t is certainly something on which I do not
feel I am an authority, but I would raise the question, going back to
the matter of check clearing, as to whether a privately operated system
would be significantly less costly.
If it could be demonstrated that this was the case, and there were
real economies to be realized, then I would obviously be inclined to
go to a private system, but it is certainly not something on which I
am immediately clear and, therefore, I would not want to suggest
that it is certain that if we took this function away, or broke it out—
THE FEDERAL RESERVE SYSTEM AFTER FIFTY YEARS
1041
and I agree that it could be broken out, as it is certainly not an essential part of central banking—but I do not know, if it were broken out,
that it would save us a great deal.
I t seems to me that this is a subject for careful investigation.
The CHAIRMAN. I will read a couple of questions here, and I will
shorten my questioning.
The regional Federal Reserve banks spend money on such things
as adult community education, advice on manpower retraining, research on mass transit problems, research on regional economic development, and so forth.
Is it possible that the Federal Reserve, its entire building and so
on, is duplicating the spending and efforts of other Government
agencies ?
More important, is it possible that some spending by the Reservebanks gets the Government into activities and areas where Congress
has not yet authorized the Government to go and which, when and
if Congress decides to appropriate money for these activities, would
not necessarily be assigned to the Federal Reserve ?
What do you think about that, Professor Johnson ?
Mr. JOHNSON. I agree, sir. I think the Federal Reserve banks in
various parts of the country do do a lot of things for which there is
no obvious reason that they should be responsible.
I feel this is in part the result of an urge on the part of the Federal
Reserve System to build itself a political base by performing useful
services for its clients in order to encourage a favorable attitude.
Once you set up an institution of this kind and give it funds on a
large scale it will attempt to do something which will justify the existence of the institution and so it will get into these things.
The CHAIRMAN. I t is perfectly natural that they will; yes. May
I suggest, Professor Johnson, that I agree with you, that it is natural
that they will reach out and try to justify their existence and they do
that largely by insisting and contending that they are carrying out
the Full Employment Act.
You know, up until the Full Employment Act passed they did not
have too much to hold to about getting out into certain activities that
they are now engaged in, but in the Employment Act I think their
activities are supposed to be restricted in cooperation and in coordination with other Government agencies. Is that not your understanding ?
Mr. JOHNSON.
Yes.
The CHAIRMAN. SO, they are going out on their own, doing something alone under the Full Employment Act that the Full Employment Act says that they shall do only in coordination with other
Government agencies. Is that not your understanding ?
Mr. JOHNSON. I had rather let Professor Villard answer that.
The CHAIRMAN. W h a t about that, Professor Villard ?
Mr. VILLARD. I t seems to me that some of the things may well be
desirable. While some people may well want to transfer them from
the Federal Reserve System to some other Government agency, I
would want to be certain that this would be desirable. I am not, for
the minute, commenting on your point that the Congress may not have
authorized some of the activities. But the Federal Reserve has a
long record of giving us a great deal of useful economic information.
1042
THE FEDERAL RESERVE SYSTEM AFTER FIFTY YEARS
I do not know whether that was something they should have done
or not, but I know it is something that I am awfully glad they did.
Now, maybe some other agency should pick up and carry on the
index of production, but in the absence of some other agency providing
us with this type of information, I would think it would be wholly
desirable for the Reserve to continue.
The CHAIRMAN. That is done by the Board and not the banks; is
it not?
Mr. VILLARD. That is correct. I was not for the minute distinguishing between the Board and the banks.
I , in general, do not feel too well qualified, as I have not analyzed
the operations of the individual banks to see whether they include
things which are either not particularly necessary or duplicate what
others do. But I will admit that my general impression is that they
do not, but it is a question which I do not have a strong basis for
answering.
The CHAIRMAN. When minimum bank earnings, after taxes, are
about 10 percent of the average bank capital account, this being so,
does not the requirement that a member bank of the Federal Reserve
must subscribe capital, which pays only 6 percent before taxes, deter
banks from joining the Federal Reserve System? W h a t do you say
about that, Professor Johnson ?
Mr. JOHNSON. Well, in my paper, sir, I made that very point, and
it is for that reason that I support the bill, to end this provision.
One might argue that the bank makes much less than 6 percent on
other assets; but this particular element of their assets is a part of their
equity and the yield on it should be compared with their equity in
general and not with the lowest yielding assets which they have.
The CHAIRMAN. I s that your view, Professor Villard?
Mr. VILLARD. Well, I was basing my reaction to this in large part
on Mr. Martin's testimony in which he implied that the banks did find
that the return on the stock they owned was attractive.
I f this is not the case, and the banks would prefer not to own the
stock, then I would modify my opinion.
Actually, I do not think that the particular issue of stock ownership
can be divorced from the broader problem of the way in which we
organize our banking system; I certainly would not like to see anything move us in the direction of making the appeal of State banks
greater.
The CHAIRMAN. Would it be all right with you gentlemen if any
members of our subcommittee should want to ask you a question, for
them to submit it in writing, then you can answer it when you have
the transcript?
Mr. JOHNSON. Yes.
Mr. VILLARD. Yes, sir.
The CHAIRMAN. Mr. Brock
wanted to ask you some more questions;
did you not?
Mr. BROCK. Yes, sir. Professor Villard, I am interested in your
statement in which you recommend not the adoption of the bills that
are under consideration but a somewhat different approach in which
we create, in effect, an overall coordinating policy committee subject
to the President.
Now, I noted in your statement here on page 6, that you say this—
if under such delegation the President were to abuse his powers, say,
THE FEDERAL RESERVE SYSTEM AFTER FIFTY YEARS
1043
to obtain low interest rates for the Treasury the electorate would then
know whom to hold accountable for any subsequent inflation.
This is an interesting theory; but it is not true that, for example,
if a President were running for his second term he could create certain
policies which, over the short range, would not prove detrimental to
the economy, at least in his immediate applications or its immediate
applications, but which would be detrimental, say, in 3 or 4 years ot
even 1 or 2 years, but immediately after an election ?
I s it not true that you would create more political pressures for
changes in monetary policy overall, economic policy, with the change
in the administration, with the advent of some new pressure on the
President ?
Are you not subjecting yourself to some rather drastic shift according to the winds if you take this position ?
Mr. VILLARD. Well, I do not believe so, because it seems to me that—
perhaps I should answer it the other way around and say that obviously the President will be subject to political pressures, but what
I am concerned with is that he should be the one who makes the basic
economic decisions.
Now, in making these decisions he will undoubtedly be subjected to
pressures, pressures on the one hand, for example, to reduce the
level of unemployment, pressures on the other hand, to prevent an
increase in prices.
I think both of these alternatives generate political pressures. I
sometimes worry about the fact that the pressure on the President to
prevent an increase in prices may be more powerful politically because everybody is subjected to price increases but there are only a
relatively small percentage of the population who are unemployed,
so that it may well be that he will give too much weight from my point
of view to preventing price increases.
But I do not see, in a democracy, any alternative except to give
the power to make decisions on basic economic policy to the Executive.
This does not guarantee that he will make the right decisions all the
time, but I do not think there is any possibility of setting up a group
of experts who should have this power.
I n fact, I agree with Professor Johnson's point that you would
really have to have a fourth arm of the Government composed of
experts if you do not want to give the power ot the President.
I n short, it seems to me that, to the extent that power can be appropriately delegated by the Congress, it must be given to the President.
The CHAIRMAN. Mr. Brock, will you yield for just one other observation, please ?
I would like to ask you to consider that in a democracy, as the witness just brought out, elected officials are held accountable.
Now, in your facts as you stated in your hypothetical case, it is true
that the Executive would have lots of power and he could create certain conditions, but he has something to lose. He is an elected official.
If he does not do the right thing, the people have a recourse. They
can defeat him. They can defeat his party for years to come. There
is a great penalty, but if you put it off and let the bankers run it and
people who cannot be reached by the electorate, why, they have nothing
to lose.
I hope you have cont You have no way of getting back at them.
sidered that, Mr. Brock.
1044
THE FEDERAL RESERVE SYSTEM AFTER FIFTY YEARS
Mr. BROCK. I have considered it, Mr. Chairman, and I have also
considered that a President, in his second term, is subject to the whims
of nobody, because he cannot be reelected and, therefore, is in a position to make decisions which perhaps are not in the best interest of
the American people or even preferred by the American people.
The CHAIRMAN. But he would have his own party involved, whether
if, be Republican or Democrat, and he would have their future at stake.
Mr. BROCK. That is possible, but it perhaps is not the overriding
consideration.
Mr. JOHNSON. May I make an observation ?
The whole democratic political system rests on the assumption that
the political leaders will be responsible to a bigger conception than
their own interest, and the two-term limif ation has been with us only
for a limited time, but I do not think the evidence is that it has made
Presidents sacrifice the interest of their country to their own, just because they will not be elected.
It is a continuing thing even though the individual is going to be
eligible for reelection or not eligible.
H e will still have others around him who will be seeking reelection,
and he will have to retain their loyalty by pursuing the interest of
the party as a whole.
If we were to act on the assumption that as soon as you elect a man,
and he gets into a position where he knows his political future will be
bmited, he will immediately start to pursue his own interest to the
neglect of the longer run continuity, I think you are finished, because
everybody is mortal.
Each individual sooner or later comes to the point where his remaining life is going to be short enough where he can do incalculable damage to the country without paying any penalty.
But this will not happen if people who get to be leaders recognize
their obligations.
Mr. BROCK. I think we are getting into a broad philosophical area,
and I will get away from it as quickly as we can resolve it, which may
be 10 or 20 years, but this country was not set up to give weight to
your idea that we have to depend on the best possible people in office.
It was set up on a principle of checks and balances, believing that
ail men are human, and we set up this check-and-balance system in
order to insure ourselves against such an abuse.
N"ow, you are completely falling away from that theory when you
say we do not need any controls upon an elected official. Now, my
point is that when you have an economic system you need a stable
monetary supply.
The purpose of the Federal is not a political purpose. I t is a purpose which is designed to insure constitutionality within the same context—the Congress and the Executive, of balance in their responsibilities. I do not think we need to pursue the point.
Mr. VILLARD. Would it be useful for me to comment on the direct
points that you are raising ?
Mr. BROCK. Surely; go ahead.
Mr. VILLARD. YOU are thinking that monetary policy or a stable
money supply or whatever is something that can be decided in isolation.
THE FEDERAL RESERVE SYSTEM AFTER FIFTY YEARS
1045
I think there was a time when this made a considerable amount of
sense, but I think what has happened is that there is today no real
role for monetary policy except as a part of overall economic policy.
The real question is whether it is better to give ultimate responsibility for monetary policy to a separate organization or to devise some
way of coordinating overall monetary policy with overall economic
policy.
Mr. BROCK. I do not think, in the sense of what you are saying, that
we are actually arguing.
Perhaps we are oversimplifying each other, because I would not at
all advocate that the Federal Reserve be an island unto itself.
I t certainly has to operate within the context of an overall economic
policy, and I do not object to any effort to increase the coordination.
W h a t I object to is the placing of our monetary system under direct
absolute control of the Secretary of the Treasury or the President,
either one, when he has authority, as he does under this bill, to lire
any member at any time just at his whim.
Mr. VILLARD. Well, as I indicated, I have a high regard for the
members of the Federal Reserve System, and they are doing what they
think is right. So, therefore, I would prefer to see us work through
cooperation rather than compulsion.
But I must admit that, if it were to be an irreconcilable conflict, if
the Federal Reserve were to come to the conclusion that certain policies had to be followed which were felt by the President to impede
the pursuit of what the country needed in the w^ay of an overall economic policy, then I must admit that I believe that some way should
be found to enable the President to achieve his objectives.
Mr. BROCK. I do not think we have reached that situation, though.
Mr. VIIJLARD. But I must admit that I do not think we are so terribly far from it—in the sense that there could be disagreements of a
sort which could lead to serious problems unless, in fact, it is understood that the Reserve System is not to pursue goals which are in
conflict with those of the Chief Executive.
Mr. BROCK. Let me take this into a specific context, if I may. Mr.
Johnson, you mentioned, in commenting on Mr. Patman's statement,
that the Fed does have to justify its existence. That it, perhaps, would
tend to become a political entity.
Would you compare for me the justification that the Federal Reserve has to make for its existence with the justification that the Postmaster General has to make for his existence as an appointed official by
the President ?
Mr. JOHNSON. Well, I suspect there is more to that question than I
quite grasped.
The CHAIRMAN. Pardon me, Mr. Brock, but we have a bill up on the
floor at 12 o'clock and we are first up. We will have to go soon. Would
you ask him to answer this in writing for the record ?
Mr. BROCK. All right. The question was, if I can repeat it—some
of the members have been comparing the Federal Reserve with the
Post Office Department. I do not think there is any compr -'son
possible, but my point is that the Post Office or any appointive head
of an agency is certainly more prone to try to spend his time justifying
his existence because he can be fired immediately if he does not. He
has to be political.
1046
THE FEDERAL RESERVE SYSTEM AFTER FIFTY YEARS
Certainly an agency head, appointed at a whim, could be fired by
the Executive and he would be more subject to an attempt to try to
reconcile his political entity, to t r y to justify his existence, than a
political entity such as the Federal Keserve.
Mr. JOHNSON. I think it justifies itself in a different way, because
it tries to devote a great deal of effort in trying to persuade the public
that it follows the policies t h a t they have approved and
(The written answer by Prof. H a r r y G. Johnson to question by
Eepresentative Brock is as follows:)
As I understand the record of the hearings, Representative Brock has asked
me to compare the justification for its existence that (in my view) the Federal
Reserve must make, with the justification for his existence that must be made
by an appointive official such as the Postmaster General. Strictly speaking, the
comparison should run between the Chairman of the Board of Governors and
the Postmaster General. The members of the Board are appointed for a term
of years longer than that of the President, and the Chairman for a 4-year period
not coterminous with the Presidency. The Chairman cannot be removed at the
will of the Executive, whereas the Postmaster General is appointed by and holds
office at the will of the Executive; the Chairman is therefore politically independent of the administration whereas the Postmaster General is a political
appointee.
The arrangements just outlined make the Federal Reserve System an "independent" monetary authority. The point I sought to emphasize in my statement
is that, even though the System is not subject to political control by the
Executive, it is nevertheless responsible to public opinion, since its representatives can be summoned to testify before Congress and can be subjected to
questioning of its policies, and the Federal Reserve Act can be amended by
Congress if the performance of the System causes sufficient dissatisfaction.
The Federal Reserve System and its Chairman are therefore obliged to justify
their existence in a different and more indirect way than is the Postmaster
General. On the one hand, the System seeks continually to justify its existence
to the general public through the performance of research and other services
aimed at satisfying regional needs, and through explanation of its policies in
terms of economic objectives generally regarded as desirable, such as price
stability, employment, and the like. On the other hand, it is frequently found
defending itself from criticism by stressing those effects of its policies that cast
it in the most favorable light—at one time the rate of increase of the money
supply, at another the level and trend of interest rates, at still another the
volume of "free" reserves—or by arguing that monetary policy has done all
that can be reasonably expected of it and that it is the responsibility of some
other instrument of policy—debt management, or fiscal policy—to produce
further improvement of the economy's performance. As I argued in my statement, the need of the System to justify itself in these ways helps to obscure the
real choices between policy objectives that have to be resolved in some fashion
or other.
The CHAIRMAN. W e will have to conclude because we have gotten
word that we are first up and we will just have to go.
Thank you, gentlemen, for everything that you have said. I t has
certainly been very helpful to us. Thank you.
W e will stand in recess until 10 o'clock in the morning.
(Whereupon, at 11:50 a.m., the committee was recessed, to reconvene
at 10 a.m., Wednesday, February 26,1964.)
THE FEDERAL RESERVE SYSTEM AFTER 50 YEARS
WEDNESDAY, FEBRUABY 26, 1964
HOUSE OF KEPRESENTATTVES,
SUBCOMMITTEE ON DOMESTIC F I N A N C E OF THE
COMMITTEE ON BANKING AND CURRENCY,
Washington, D.C.
The subcommittee met, pursuant to recess, at 10 a.m., in room 1301,
Longworth House Office Building, Hon. Wright Patman (chairman)
presiding.
Present: Representatives Patman, Eeuss, Pepper, Minish, Hanna,
Harvey, and Brock.
The CHAIRMAN. The committee will please come to order. Today
we are going to hear from two more outstanding economists: Professors Karl Brunner, of the University of California at Los Angeles,
and O. H. Brownlee, of the University of Minnesota.
Professor Brunner's prepared statement, which will be put into the
record in full, is based on a study he made as a member of this committee's staff on the Federal Reserve's operating procedures and policy
criteria and the effectiveness of its policies. His findings and conclusions are, of course, his own. H e was not guided by any one of us, and
none of us are bound to accept his conclusions. But I am sure we can
learn much from Professor Brunner. I am also sure that we will
learn a great deal from Professor Brownlee.
Gentlemen, we are glad to have you. You may proceed in your own
way. I t is my suggestion you put your statements in the record at this
point. Then if you want to summarize them—because the more time
you give us to interrogate you, the better opportunity we will have to
bring out the main points we are interested in.
Before starting, I would like to say that a statement of the salaries
of other Government officials in the United States compared with the
Federal Reserve salaries will be ready tomorrow, and I will put it in
at that time. I t is rather an amazing statement. I t shows the Members of Congress rather low on the totem pole. But the full statement
will be put in tomorrow. All right, Professor Br miner, you may
proceed.
STATEMENT OF PROP. KARL BRUNNER, UNIVERSITY OF
CALIFORNIA AT LOS ANGELES
Mr. BRUNNER. Thank you very much, Mr. Chairman, gentlemen of
the committee. I shall summarize my written statement in order to
emphasize the major points.
My written statement covers some fundamental aspects of our policy arrangements in the monetary field. I t deals, therefore, only
1047
28-680—64—Vol. 2
9
1048
THE FEDERAL RESERVE SYSTEM AFTER FIFTY YEARS
indirectly with the specific bills before this committee. But I shall
be very happy to answer any questions which bear directly on these
bills.
I t should be acknowledged at this point that my statement is based
on research performed together with Prof. Allan Meltzer. I n particular, it is founded on a study which we prepared for this committee. A chapter of this study has already been published and other
chapters are currently submitted to this committee.
Rational monetary policy involves several ingredients. The first ingredient covers the effective control of the money supply by the
Federal Reserve authorities. The second ingredient subsumes the
existences of a systematic relation between the money supply on the
one side and the behavior of economic activity and the price level on
the other.
Moreover, if we grant discretionary power to the Federal Reserve
authorities, a power actually provided by the Federal Reserve Act,
a third ingredient must be recognized; namely, the rapid and correct
recognition by the monetary authorities of evolving economic situations.
I t should be acknowledged quite immediately that the Federal Reserve performed most laudably on this point over the postwar period.
I t spotted turning points quickly and effectively. I would submit that
improvements on this performance are quite difficult to achieve.
Of course, such improvements are not impossible. But I would contend that an allocation of resources designed to improve the performance on this score would yield very small returns indeed when compared with the returns to be expected from an allocation of resources
designed to improve the Federal Reserve's performance on the first
ingredient mentioned before. W h a t I mean is the following:
Our investigations indicate that the control exercised by the Federal
Reserve authorities is quite ineffective and could be substantially improved by a suitable exploitation of the resources already available to
the Board. An effective control over the money supply involves two
elements: First, we note the existence of a systematic effect of policy
actions on the money supply; and secondly, that the Federal Reserve
authorities recognize the nature of the process on which they operate.
As a result of our studies we came to the conclusion that the Federal
Reserve authorities lack a coherently formulated, carefully assessed
and validated conception of this process. The monetary authorities
are consequently often led into erroneous assessments of evolving monetary situations. Moreover, they are frequently misinterpreting their
own policy behavior.
I n order to substantiate this point a number of cases were assembled
in my written statement. I shall select one single case for my oral
summary:
Two charts were constructed for this purpose. Both charts have
been appended to the written statement which was submitted to the
committee.
Chart 1 indicates the percentage changes of the money supply between corresponding months in adjacent years. The second chart depicts the growth rate of a magnitude of fundamental importance. I n
order to give this magnitude a name, we have labeled it the "extended
base." I t is the sum of two components. The first component is the
THE FEDERAL RESERVE SYSTEM AFTER FIFTY YEARS
1049
monetary base. The monetary base is simply the governmental money
directly issued by the authorities. I t forms the base on which the
banking system has erected a superstructure of assets and deposits
liabilities. Furthermore, it is completely determined by Federal Reserve credit, gold stock, Treasury currency, and some minor items.
The second component of the extended base is the cumulated sum of
reserves liberated from required reserves, or impounded into required
reserves, by changes in legal reserve ratios.
Two reasons explain the fundamental significance of the extended
base:
First, it is the most important single determinant of the money
supply. I t is not the only determinant, but it is the most important
one.
If you compare the two charts appended to the written statement
you will notice the common sweep of the two magnitudes which clearly
reflect their close association. Detailed statistical investigations summarized in our report submitted to the committee confirm this close
association and also confirm the dependence of the money supply on
the extended base.
Secondly, the monetary authorities completely control this magnitude. I t is effectively manipulated by the monetary authorities and
effectively summarizes actual policy behavior. I t is a useful indicator
revealing the actual policy behavior of the Federal Reserve authorities.
Having introduced to you the extended base as a policy indicator
of crucial significance and described it as a fundamental determinant
of the money supply, I wish to draw your attention to one case listed
in my written statement, which exemplifies the fallacious policy assessments frequently advanced by the Board.
The Federal Reserve authorities typically assert that they moved
to an antirecessionary policy or engaged in a stimulative policy during
all the deflationary phases of the postwar period. Let me confront this
assertion with the record of actual behavior.
The first recession began in late 1948 and terminated during the
second half of 1949.
Chart 1 indicates that the annual growth rate of the extended base
collapsed in 1948 to a negative value and remained negative over the
whole recession. The Federal Reserve authorities thus engaged
throughout the first deflationary phase of the postwar period in an
active deflationary policy.
The second postwar recession began in the middle of 1953 and
reached bottom 1 year later. During this period the growth rate of
the extended base collapsed by more than $1 billion p.a., from $1.4
billion to $200 million. The Federal Reserve authorities thus moved
throughout the recession in a deflationary direction. The growth
rate of the base remained at least positive and to this extent policy
was less deflationary than in the previous recession.
A more pronounced deflationary policy occurs again in the subsequent recessions of 1957-58 and in 1960-61. During a substantial
part of the downswing, even after professing a change in policy
toward more ease, policy remained actively deflationary. This fact is
clearly revealed by the negative growth rates of the extended base
observed in 1957 and 1960.
1050
THE FEDERAL RESERVE SYSTEM AFTER FIFTY YEARS
I n summary, we find no evidence to support the contention made by
the Federal Reserve authorities that they engaged in a stimulative
policy during recessions. On the contrary, we find that during deflationary phases they had either a deflationary policy or were moving
in a deflationary direction.
Other examples could be adduced from the postwar period, from
last year for instance, or from the interwar period, to reveal the
strange discrepancies between professed and actual policy.
This discrepancy results from the absence of a clearly formulated
and validated conception. I n the absence of such a conception, we
cannot expect monetary policy to contribute systematically to
monetary stabilization.
Thank you.
The CHAIRMAN. Thank you, Dr. Brunner.
(The statement referred to follows:)
STATEMENT OF KARL BRUNNER, UNIVERSITY OF CALIFORNIA AT LOS
ANGELES
AN APPRAISAL OF FEDERAL RESERVE POLICY AND SOME PROPOSALS BEARING
ON POLICYMAKING PROCEDURES 1
A number of changes in our monetary arrangements have been submitted to the committee's attention. These and similar proposals
deal essentially with a fundamental issue; viz, the efficacy of the institutional arrangements guiding policy decisions and transmitting the
resulting impulses to the pace of economic activity. This problem
may be usefully divided for our purposes into two distinct aspects.
One aspect covers the relation between the money supply and the behavior of economic activity, expressed by national income. The other
aspect pertains to the connection between the beheavior of the money
supply and monetary policy, exercised via open-market operations,
changes in legal reserve ratios, modifications of the discount rate, and
conceivably adjustments in the administration of the "discount window." Two conditions are thus sufficient and necessary for monetary
policy to form an efficacious instrument: (1) The existence of a systematic connection from the money supply to the rate of economic
activity, and (2) the exercise of a firm control over the money supply
by the Federal Eeserve authorities.
Monetary policy would barely deserve much consideration in case
economic activity were not affected by the behavior of the money supply or the Federal Eeserve had little control over this magnitude.
The position of the Federal Reserve authorities on these issues has
been strangely inchoate and ambivalent. One wonders whether they
recognize existence and nature of the relation between money supply
and national income. But I question even more, whether the Federal
Reserve authorities possess a clear and validated conception about the
nature of the process which determines the money supply. A firm
control over this magnitude requires both the existence of a reliable
relation connecting it with policy action and the proper recognition
of this relation.
1
T h e analysis supporting the following statement has been conducted jointly by the
author and Allan H. Meltzer at Carnegie Institute of Technology in a series of papers and
in a report for this committee, entitled: "An Analysis of Federal Reserve Monetary PolicyMaking."
THE FEDERAL RESERVE SYSTEM AFTER FIFTY YEARS
1051
THE RELATION BETWEEN MONEY SUPPLY AND ECONOMIC ACTIVITY
On numerous occasions spokesmen of the System refer vaguely to
the Federal Reserve's responsibility to keep "credit flowing" and to
adjust the "availability of credit." These formulations are usually
quite elliptical and replete with shadowy ambiguities. Whatever
their meaning may be, however, they suggest a conception which denies
the relevant operation of the money supply on prices and economic
activity. These suggestions are reinforced by an explicit assertion
recently made by a member of the Board, who denounced "the assumption" of a "close coordination between growth in the money supply
and growth in gross national product" to be "erroneous." 2
If this assertion were correct, monetary policy would be an exercise
of small significance and monetary arrangements barely worth our
detailed attention. On the other hand, if the money supply does contribute to shape the behavior of prices and activity levels, then the
nature of effective monetary institutions rationally designed to stabilize the economy deserves a careful investigation. Most particularly,
the Federal Reserve's overt attitude bearing on this issue would appear
to require serious reconsideration. What do we, therefore, know about
the relation between money supply, prices, and output?
There is no room in this statement beyond a suggestive and selective
outline of the wealth of evidence attesting to the influence of monetary forces. We note, for instance, that substantial increases in the
money supply are typically associated with every major inflation
ever observed. Whenever we recognize a large rise in prices, we also
note a concomitant increase in the money supply. And so long as
prices move rapidly, the money stock also expands. The converse
applies with equal regularity. Whenever the money stock increases
at a sufficient rate, prices rise and continue to rise unless the money
stock is stabilized. The hyperinflations observed yield excellent evidence in support of this contention, and so do the more or less intermittent inflations of numerous Latin American countries. 3
The behavior of prices and money stock in the Confederacy during
the Civil W a r offers a particularly incisive piece of evidence. The
Confederate governments had financed the war to an even greater
extent than the Union by issues of new paper notes. I n the earlier
part of 1864 a determined attempt was made to change the financial
arrangements and to hold the money stock in line. Within a very
short interval the inflationary momentum was broken and prices even
declined. But a few months later, political and administrative convenience overcame financial prudence. The money stock resumed an
accelerated growth with a consequent rise in prices. 4 One may also
note that receding activity levels typically occurred after the growth
rate of the money stock fell below a barrier of 3 percent per annum.
Chart I appended to this statement exhibits the relevant observations
2
49th Annual Report of the Board of Governors of the Federal Reserve System, 1962.
The assertion occurs on p. 71 under the "Record of Policy Action." The assertion was
made
at the session of the FOMC, Mar. 27, 1962.
8
The reader may usefully consult the excellent study hy Philipp Cagan on "The Monetary
Dynamics of Hyperinflation," i n : "Studies in the Quantity Theory of Money," Chicago,
1956, edited by Milton Friedman.
*The events have been excellently described by Eugene M. Lerner, "Inflation in the
Confederacy, 1861-1865"; op. cit.
1052
THE FEDERAL RESERVE SYSTEM AFTER FIFTY YEARS
for the postwar period. Other studies have investigated this pattern
over many decades.5
Some revealing contours emerge fr@m a comparison of several postwar cycles with respect to the behavior of money stock and unemployment rates. The half-cycle beginning with the trough of 1949 and
terminated with the peak of 1953 was accompanied by a growth rate of
the money stock which persisted for a lengthy period at a high level.
The unemployment rate dropped very rapidly from 7.6 percent in
February 1950 to a range between 3 and 4 percent at the end
of the year. The average rate of decline slowed subsequently, but the
decline continued to a low of 1.3 percent in October 1953. The momentum of the persistently high growth rate exhibited by the money
stock in 1950,1951, and 1952 contributed to absorb the available labor
resources into current activity. The half-cycle beginning with the
trough of 1954 and ending with the peak of 1957 shows a radically
different pattern. The growth rate of the money stock expanded to a
high rate reached in June 1955, then it faltered, decelerated gradually toward the end of the year and abruptly collapsed at the beginning of 1956. I t oscillated during the remaining phase of the u p swing around a low level of 1 percent per annum. This pattern is
strongly reflected in the behavior of the unemployment rate. This
rate moved again sharply downward with the onsetting recovery from
around 5% percent to a range of &y2 or 4 percent in the last quarter of
1955. From this point on, however, contrary to the previous upswing,
and in accordance with the behavior of the growth rate of the money
stock the decline in the rate of unemployment is suddenly stalled.
There followed a period of oscillations around a slightly rising trend
of unemployment, eventually aggravated by the downswing of 1957-58.
The half-cycle beginning with the trough of 1958 and terminated
with the peak of 1960 supplies further information for our purposes.
The growth rate of the money stock increased rapidly from the onset
of the recovery to a high level of 4.8 percent per annum in J a n u a r y
1959. I t decelerated slowly until June to 4 percent, whereupon it collapsed to a negative growth rate in February 1960. The rate of unemployment, on the other hand, began its decline from a high plateau
of 7.7 percent and moved steeply to around 5.7 percent in the last
quarter of 1958. The downward trend, strongly attenuated, however,
continued to the middle of 1959. Around this time, when the growth
rate of the money stock fell away to a negative value, the downward
trend in the rate of unemployment vanished.
The above discussion indicates the broad association between thebehavior of the money supply and the behavior of the unemployment
rate. An accelerating growth rate of the mony stock has been typically
associated with declining levels of unemployment. Gradual retardations in this growTth rate were reflected in the appearance of slower
and more hesitant absorption of unemployment, expressed by comparatively larger oscillations of the unemployment percentage around
an attenuated trend. Moreover, low or abruptly collapsing growth
rates tended to be associated with a stationary or even slightty increasing unemployment trend, accompanied by rapid and comparatively
substantial short-run fluctuations.
5
The reader is referred to Beryl Sprinkle's "Monetary Growth as a Cycle Predictor,"
Journal of Finance, September 1959.
THE FEDERAL RESERVE SYSTEM AFTER FIFTY YEARS
1053
These patterns also hold for our most recent experience. The growth
rate of the money stock reached a provisional peak of 4 percent in
December 1961 and gradually dropped in subsequent months to a low
of 1 percent in October 1962. The motion was accelerated in November which brought it to a 4-percent level in November 1963. And the
percentage of unemployment? Similar to the previous cases we observe a rapid decline until February 1962. The rate of fall then decelerated quickly and in July 1962 the trend was reversed. The unemployment rate oscillated around a slightly rising trend. A week
downward trend was thereupon resumed in the early months of 1963,
thus reflecting the impact of the accelerated growth rate of the money
stock.
Other studies may be adducted in support of the contention that the
money stock does exert a substantial effect on the behavior of economic
activity and the rate of utilization of our resources. 6 Lest there be
a misconception as to the meaning of the relation between money
and income, it should be emphasized that the behavior of economic
activity and prices is not solely determined by the behavior of the
money stock. I n the context of our economic organization both monetary and nonmonetary forces jointly operate to shape the behavior of
national income. The peculiar interaction of these sets of forces determines the appropriate range for the growth rate of the money supply. Beyond this range inflation becomes likely and below it deflation threatens, revealed by either falling prices or curtailed output.
Control over the money supply yields thus no assurance of paradise.
I n particular, control over the money supply is not sufficient to eliminate all fluctuations in aggregate activity. But intelligent control
over the money supply can be sufficient to eliminate destablizing impulses generated by the montary system and maintain the remaining
fluctuations in a comparatively narrow range.
THE FEDERAL RESERVE AND CONTROL OVER THE MONET SUPPLY
I n 1952 the Joint Committee on the Economic Report published a
study which contained, according to a spokesman of the System, the
best statement made by the Federal Reserve authorities. The Board
acknowledged at the time that its "most important functions" are
"those affecting the money supply." 7 On the same occasion the Board
acknowledged an obligation to convey pertinent knowledge about
monetary events to a larger public. The obligation presupposes, of
course, that the Board has systematically acquired a validated knowledge about the monetary process. I submit that the Board has not
performed this task. The resulting situation seriously impairs the
quality of monetary policy.
«The reader may consult Allan H. Meltzer's statement presented to the Committee on
Feb. 11, 1964, for some additional material. He is also referred to the following papers:
Karl Brunner and Anatol Balbach, "An Evaluation of Alternative Monetary Theories," in
Proceedings of the Western Economic Association, 1960, and Karl Brunner and Allan H.
Meltzer, "Predicting Velocity; Implications for Theory and Policy," Journal of Finance,
May
7 1963.
"Monetary Policy and the Management of the Debt. Their Role in Achieving Price
Stability and High Level Employment." Part I, Washington, D.C., 1952, p. 246. This
report is subsequently referred to as the Patman report. A different view has recently
been stated by the presidents of the 12 Federal Reserve banks. They asserted that
monetary policy is essentially concerned with the "overall availability of credit." Part I
of their answer to question I in the questionnaire appended to the study mentioned in the
star footnote.
1054
THE FEDERAL RESERVE SYSTEM AFTER FIFTY YEARS
The existence of a systematic and reliable connection between policy
actions and the behavior of the money stock is not sufficient for the
execution of a useful policy, even with the explicit recognition that
money does affect the pace of activity and the price level. Useful
policy also requires a validated knowledge about the nature of the
money supply process.
The remainder of this section presents a sequence of exemplifying
cases to support my contention that the Federal Reserve authorities
lack a coherent notion of the process operated on, that they are frequently guided by fallacious assessments of evolving situations, and
even misconstrue the meaning of their own policy behavior. The argument is based on a detailed empirical analysis of the U.S. monetary
system to be published in some other context. 8 This analysis guided
the selection of the two charts appended to this statement. Chart 1
exhibits the percentage change in the money stock (i.e., currency outside banks and demand deposits adjusted) between corresponding
months of adjacent years. The change is located at the terminal
month. A 4-percent increase noted for November 1963 thus means
that the money stock rose from November 1962 to November 1963 by
4 percent. The second chart (denoted by A B + A L ) presents the
growth rate of the extended monetary base. The monetary base consists approximately of the money directly issued by the Federal Reserve banks and the Treasury. Its volume is determined by Federal
Eeserve credit, the gold stock, Treasury currency issued and a few
comparatively minor items in the balance sheet of Federal Eeserve
banks. The base effectively summarizes the Federal Reserve's posture
bearing on open market and discount policy. I n order to obtain a
magnitude which completely summarizes the total policy actions, the
base is extended by adding the cumulated sum of reserves "liberated"
from required reserves (or impounded into required reserves) through
changes in the requirement ratios. 9 I t can be shown that the extended
base forms a unique index reflecting the Federal Reserve's actual
policy behavior. I n particular, the Federal Eeserve authorities can
modify this magnitude with the aid of discount policy, open market
transactions and changes in legal reserve ratios. Furthermore, the
behavior of the extended base dominates the behavior of the money
supply. Detailed analysis and evidence supporting this contention
have been published elsewhere.10
Still, the reader may usefully compare the broad contours of the
two charts appended. Changes in the extended base between corresponding months of adjacent years are plotted in the second chart.
The changes are again located with the terminal month. The reader
will immediately notice the close similarity of the broad contours.
As a matter of fact, a more detailed inspection reveals to the reader
that the similarity goes beyond these broad contours to some detailed
features. The gross correlation between monthly data of annual
8
Work performed jointly with Allan H. Meltzer at the Carnegie Institute of Technology
will be published in a monograph on "Money Supply and Money Demand." The reader
may also consult ch. VI of our study, "An Analysis of Federal Reserve Monetary PolicyMaking."
This chapter will be available in a few weeks.
9
No justification can be developed at this point for the procedure indicated. The reader
will find this justification in the material mentioned under the previous footnote. The
reader may also consult Karl Brunner, "A Scheme for the Supply Theory of Money,"
International
Economic Review, January 1961.
10
See footnotes 8 and 9 and the forthcoming paper by Karl Brunner and Allan H.
Meltzer on "Some Further Investigations of Demand and Supply Functions for Money,"
Journal of Finance, 1964.
THE FEDERAL RESERVE SYSTEM AFTER FIFTY YEARS
1055
changes in the money stock and monthly data of annual changes in
the extended base actually measures 0.82. This means that approximately 67 percent of the observed variability in the annual changes
of the money supply can be explained by variations in annual changes
of the extended base. This magnitude is not the only determinant of
the money stock, but it is the single most important one. Moreover,
it is effectively manipulated by the Federal Eeserve authorities.
At this point, the stage has been set for an inspection of a sample
culled from a large collection of policy statements offered or actions
performed by Federal Eeserve authorities. The limitations imposed
renders this inspection unavoidably sketchy. But it will be sufficient
to bring out the major point in sharp focus.
(1) The support policy in the period after World War II until the
peak of 191$
Until the "Accord of March 1951" between the Board and the Treasury, the Board was obliged to maintain a fixed yield pattern on the
market for Government securities. This obligation has frequently
been deplored by spokesmen of the System. I n particular, more or less
serious inflationary consequences were attributed to the support
policy. We read thus:
In view of the recurrent heavy demands for funds during the period, these
purchases had the effect of monetizing substantial amounts of Government securities, creating bank reserves and laying the basis for excessive credit expansion.11
Similar statements were made on other occasions. One may also
observe that such statements effectively conveyed the impression to
an outside public that the Federal Eeserve was forced into inflationary
actions under the support policy.12
What are the facts? Chart 2 supplies an incisive answer. From
October 1945 until June 1947, the growth rate of the extended base
collapsed from above $7 billion per annum to below $300 million
per annum. I t rose subsequently and hovered around $700 million.
During 1948, it fell rapidly and crossed to negative magnitudes in
the middle of 1948. I n the postwar period the Federal Reserve thus
actually moved very rapidly in a deflationary direction. This posture
is clearly reflected on chart 1 by the behavior of the money stock.
Thus, irrespective of serious demerits inherent in a policy of support, it did not, contrary to impressions created by Federal Reserve
descriptions, unleash inflationary impulses over the period considered.
When Congress granted emergency powers to raise reserve requirements in August 1948, the growth rate had already crossed over into
negative values and had been for more than 16 months below the
long-run required rate. 13
11
12
Patman report, p. 346.
We note in a recently published book covering Federal Reserve policy: * * * "pegging
Government security prices and yields not only prevented the Federal Reserve from using
its powers to limit inflation but actually became a substantial inflationary force itself."
Daniel S. Ahearn, Federal Reserve Policy Reappraised, 1951-59, New York 1963, p. 16.
Emphasis
supplied.
13
It should be noted that among the answers to the questions submitted to the presidents
of the 12 Federal Reserve banks and to be published in the study mentioned under the
star footnote, the following acknowledgement can be found: "From the end of World
War II to the time of the accord, open market operations on balance withdrew reserves
(in several steps in 1949) from the banking system in an attempt to reduce excessive
liquidity." But there is still no explicit acknowledgement that Federal Reserve policy
had actually reached a deflationary posture in early 1947. It was the momentum of the
reviously accumulated money stock which carried the economy further to a peak in
ovember 1948.
S
1056
THE FEDERAL RESERVE SYSTEM AFTER FIFTY YEARS
{2) Federal Reserve policy during the recession of 19If£/191$
Economic activity reached a peak in November 1948 and the subsequent downswing continued until October 1949. Spokesmen for
the System asserted that policy "shifted gears" in a direction to
stimulate the economy. The System was described to have "acted
promptly to adjust monetary and credit policy to the changed conditions of early 1949." 14
How do the facts compare with the asserted "active countercyclical"
policy ? Once more, the reader is invited to ponder first chart 2 and
then chart 1. I n November 1948, the growth rate of the extended
bases was around minus $500 million per annum. I t dropped even
further to minus $900 million in February 1949, rose slightly thereafter
and oscillated around minus $600 million until the end of the year.
A decisive deflationary policy was the dominant mark for the whole
downswing. There is no shred of evidence for any "active countercyclical policy." Chart 1 also shows that the money supply closely
followed the behavior of the base. The operation of the currency
factor, one of the other determinants of the money stock, decelerated
its negative growth and led to an earlier upturn than for the extended
base.
{3) The monetary expansion of 1950
The bottom was reached in October 1949. With the onset of recovery
the Federal Reserve's evaluation shifted again. Open market transactions over the period beginning February 1950 and ending with J u n e
1950 "were conducted so as to remove some of the stimulus to credit
growth." Moreover, "the volume of bank credit and the money supply
had continued to increase despite restraining action by the System".
These statements, quoted from the annual report covering the year
1950, clearly convey the impression that Federal Reserve policy wras
more "restraining" in 1950 than in 1949, when policy was allegedly
easy.
W h a t happened actually? The growth-rate of the extended base
accelerated over the first 6 months of 1950 by approximately $850 million. I n particular, it crossed the line into a positive range. I t hovered
and oscillated thereafter until nearly the yearend around $250' million.
I n December 1950, it jumped by more than $1 billion, initiating a pronounced and lengthy acceleration. W e thus conclude that policy in
the first 6 months was not restraining, it moved on the contrary in an
expansive direction. Over the second half of the year, there are definite
indications of an attempt "to hold the line."
(4) The raise of legal reserve ratios in Jcmuary 1951 and associated
policy-assessments
The outbreak of the Korean W a r imparted a considerable momentum
to the U.S. economy and the Federal Reserve authorities became concerned about the inflationary potentialities. I n late 1950 and early
1951, reserves became available to banks from various sources. I n order to counter their expansive effect, the Federal Reserve raised the
14
Annual Report of the Board of Governors for 1949. Even quite recently the Board
still maintained that an "active countercyclical monetary policy" prevailed in 1949, "as
would be appropriate under the Employment Act of 1946." The reader may find these
statements among the answers to our questionnaire previously mentioned. The Federal
Reserve authorities also asserted in the Patman report that the dominant policy of "ease"
was at worst only "modified" by simultaneously occurring open market sales, p. 292.
THE FEDERAL RESERVE SYSTEM AFTER FIFTY YEARS
1057
legal reserve ratios. 15 Moreover, the Federal Eeserve indicated that
policy became increasingly "less easy" or "tighter" during 1951. Bank
reserves were alleged to become "less readily available than they had
been previously". "Eeserve positions of commercial banks" were seen
to be "under greater pressure in 1951 than in other postwar years." I n
short, the Federal Eeserve's policy was described to be more "restraining" than in previous years. And the facts? Once more, the
reader is invited to consult chart I I . The growth-rate of the extended
base moved around $1 billion at the beginning of 1951 and accelerated
to approximately $2.2 billion per annum at the end of the year. There
occurred thus a tremendous expansion which carried the growth-rate
of the extended base to levels not experienced since the middle of 1946.
This highly expansive posture mirrored by the growth-rate of the
extended base, was effectively transmitted to the money supply.
(5) Federal Reserve policy during the recession of 1953/195Jf
According to the counting of the National Bureau of Economic [Research, a peak was reached in July 1953. The lower turning point
was passed in the following summer. Looking back over 1953, the
Federal Eeserve authorities described their own action in the following terms:
In recognition of the change in the economic * * * situation, the Federal
Reserve modified its credit policy with a view to avoiding deflationary tendencies.
* * * The System began early in May to increase the availability of credit by
enlarging the supply of reserve funds.18
The Federal Eeserve had successfully convinced itself that its policies were actively engaged "to avoid deflationary tendencies." Our
observations determine a radically different situation. The growth
rate of the extended base moved in January 1953 at a level of $2.1
billion per annum and dropped throughout the year, with a hesitation
in July, to a precarious low of only $500 million per annum. Whereas the Federal Eeserve thought to have "eased policy," the relevant
policy indicator and major determinant of the money stock fell by
more than 75 percent. The deflationary trend continued in 1954,
somewhat attenuated, well into the summer. The actual movement
of the policy indicator is again reflected by the behavior of the money
stock (chart 1). We notice a persistent and sharp contraction in
1953 continued until April 1954. Once more, some other determinants
contributed to accelerate the growth rate of the money stock while
the policy indicator was still moving downward.
(6) Federal Reserve policy during the recession initiated in 1960
The momentum of the upswing beginning in April 1958 was soon
smothered by an increasingly restrictive monetary policy. A peak
was eventually reached in May 1960. According to the Federal Eeserve's account the "policy of restraint on expansion of bank credit and
money which carried over from 1959 was progressively moderated over
the first half of I960." 1 7
is "These increases absorbed the additional reserves being made available at the time by a
return flow of currency, a decline of Treasury deposits at Reserve banks, and Federal
Reserve purchases of long-term Treasury bonds from nonbank investors * * *." Annual
Report
for 1951.
16
Annual report for 1953. The report also asserts that "The System in late summer
iind early autumn * * * actively promoted credit ease with a view to avoid deflationary
tendencies."
A similar statement is repeated for 1954 in the annual report covering 1954.
17
Annual report for 1960. The report also says about the period following the "early
months" of 1960 that "monetary policy began actively to stimulate expansion."
1058
THE FEDERAL RESERVE SYSTEM AFTER FIFTY YEARS
A stimulative policy was thus perceived to hold for 1960. But the
reader will notice, wThen inspecting the appended charts, that the collapse in the growth rate of the extended base, proceeding since February 1959 continued until April 1960. A t this point, the growth rate
was even negative and below any reasonable approximation to the
desired long-run rate of growth. Until September 1960, the growth
rate held around minus $100 million. Policy shifted actually into an
expansive gear only in October 1960. The growth rate of the money
supply fell with the base throughout 1959. B u t it reached a nadir
in May 1960, thus revealing the operation of other determinants (viz.
currency factor) of the money supply, which offset the deflationary
behavior of the policy dominated magnitude. An inspection of the
actual circumstances thus indicates that the Federal Reserve authorities were pushing on the brakes while claiming to apply judicious
pressure on the accelerator.
(7) The pattern in postwar recessions
Some general statements were made by spokesmen of the Federal
Reserve System bearing on the relation between policy and cyclic
phases. We may read, for instance, that in periods of recession "System policy is more likely to become positively stimulative rather than
to remain the same." "At such times," it is asserted, the System
shifts "to an active antirecessionary policy." 18
W h a t do the facts actually show? The following listing summarizes the relevant information for each postwar recession. The
reader may check by inspection of chart 2.
(a) November 1948 to October 1949: Throughout this period
the growth rate of the extended base is negative.
(h) J u l y 1953 to August 1954: The growth rate of the extended
bases collapsed from approximately $1.4 billion per annum to
around $200 million per annum.
(c) July 1957 to April 1958: The growth rate of the base fell
below zero until November and stayed around zero until February
1959.
(d) May 1960 to February 1961: The growth rate of the extended base remained negative for the first 3 months of the recession. Even at the end of the year the rate was still more than 50
percent below the desired long-run rate of growth.
These facts yield little support for the contention advanced by the
Federal Reserve authorities. Actual policy was either actively deflationary or moving in a deflationary direction, or, as toward the end of
1960 insufficiently expansive.
AN EXPLANATION OF ACTUAL POLICY BEHAVIOR
The astonishing discrepancy between actual and professed policy
attitudes discussed in the previous sections requires an explanation.
Such an explanation has been provided in the study prepared for this
committee. I t is argued there, that the peculiar circumstances shaping
the Board's procedures have channeled attention to the very shortest
run evolutions of the credit markets. The Board's conceptions have
been decisively influenced by the daily and weekly fluctuations on the
38
Part 2 of answer to question V supplied by presidents of the 12 Federal Reserve banks.
THE FEDERAL RESERVE SYSTEM AFTER FIFTY YEARS
1059
"money markets." This short horizon made it very difficult to detect
the pattern of systematic associations working in the process. These
patterns are drowned by the "random noises," which typically dominate the shortest-run fluctuations on the markets continuously watched
by the Federal Keserve officials. On the other hand, an attention span
extending beyond a few weeks and covering at least a month already
permits us to focus more sharply on the systematic structure underlying the whole process. But the Board's routine tends to limit the
time span of the attention. This situation entails that substantially
greater discretionary power is actually delegated to the Account Manager than is formally acknowledged. Our detailed investigation, summarized in the study indicated above, led us, moreover, to the conclusion that policy changes have frequently been initiated by the Account
Manager and were subsequently supported by a suitable consensus of
the Federal Open Market Committee.
CHABTI
SOME PROPOSALS
1. Continue the growth rate of the money supply achieved by the
end of 1963. There are still unutilized resources which could be
absorbed into current activity by monetary expansion. This requires a
1060
T H E FEDERAL RESERVE SYSTEM AFTER FIFTY YEARS
CHART 2
growth rate at a comparatively higher level to be maintained over some
time period. I t should also be emphasized that expansive monetary
policy could not be expected to absorb a major portion of total existing
unemployment.
2. Stabilize the growth rate of the (extended) base. The gyrations
observed in the past have no rationale. They may be anachronistic residues of confused notions bearing on "needs of trade" and "elasticity."
Actually, they only amplify economic fluctuations.
3. Variations in the growth rate of the base should take account of
other major determinants of the money supply, in particular, the currency flows between public and banks.
4. More effective utilization of the Board's research facilities. The
Board's research division has performed excellently in the collection
and preparation of data. But these data were not effectively exploited
by the Board. I n particular, major policy decisions should not be
founded on anecdotal impressions, but on carefuly executed and validated pieces of analysis. The Board has potentially the facilities available to broaden its systematic knowledge about the structure of monetary processes.
THE FEDERAL RESERVE SYSTEM AFTER FIFTY YEARS
1061
5. Annual report should carefully explain the effect of policy actions
on money supply and credit markets. This requirement would
be designed to aid in channeling the Board's attention beyond the
"random noises" of the shortest horizon.
6. Abolish the Federal Open Market Committee. This Committee
is too cumbersome and unwieldy. There is no indication that it operates to supply decisive guidelines to the Account Manager.
7. Consolidation of policy in the Board and smaller size of Board.
The Board should be reduced to at most four members. All policy
decisions are to be made by the Board. Furthermore, most of the
routine wrork currently to be dealt with by members of the Board
should be delegated to administration officials in the higher echelons.
Such delegation would enable the Board to allocate more time to basic
policy issues.
8. Adjust length of membership tenure to presidential term with
possibility of repeated reappointment.
9. Either abolish discounting or make it a right to be granted every
member bank for any desired amount and frequency of occurrence,
willing to meet the collateral conditions and the discount rate.
Under the second choice, the discount rate would have to be a
"penalty rate." Suitable manipulation of the discount rate, relative
to market rates, can effectively modify the Federal Reserve's portfolio of discounts and advances without application of administrative pressures and discretionary procedures.
The CHAIRMAN. NOW, Professor Brownlee, you may proceed, sir.
STATEMENT OF 0. H. BROWNLEE, PK0FESS0R OF ECONOMICS,
UNIVERSITY OF MINNESOTA
Mr. BROWNLEE. Thank you. I will direct my comments more directly to the specific bills which are being considered at the present
time.
The CHAIRMAN. Yes, sir; we wish you would.
Mr. BROWNLEE. I n general, I am enthusiastic about the proposal to
eliminate the prohibition against paying interest on demand deposits.
And, of course, I wish you would go further and also remove the
ceilings on interest rates to be paid on time deposits as well. I think
this is the most important of the five proposals. I also feel that it is
desirable for banks to be permitted to treat Government as it treats
any other depositor, that is to pay interest on its deposits and also to
levy charges for service.
I believe that it is desirable to grant banks membership in the Federal Eeserve without requiring that they hold stock. However, I
don't consider the difference between this and present arrangements
to be very important.
The other two proposals, I take it, are designed primarily to reduce
the independence of the Federal Eeserve System; that is, you want
to take away their independent income so they will have to come
directly to Congress for appropriations, and you also wish to make the
Chairman of the Board the Secretary of the Treasury.
I assume the latter proposal is designed to try to introduce more
coordination between monetary policy and fiscal policy.
1062
THE FEDERAL RESERVE SYSTEM AFTER FIFTY YEARS
I don't think that spectacular changes would necessarily result if
these proposals were accepted. I think it is a basic change in our concept of monetary policy rather than an organizational change which is
required in order to achieve the results which I think you are seeking.
While I agree that the Open Market Committee has performed
much in the way in which Professor Brunner has just described, in
general I find it quite difficult to understand what the Open Market
Committee is trying to do, meaning what instructions it gives to the
New York desk and what procedures it uses to see whether or not its
instructions are being carried out.
I also believe that using as targets free reserves can result in exactly
the kind of behavior of our monetary supply which Professor Brunner has just described; that is, one can have many different levels of
total reserves for any given amount of free reserves, and the first
change that ought to be made is to forget about free reserves as a
target and look at the total of bank reserves.
I don't think necessarily that making the Secretary of the Treasury
the chairman of the board is going to bring about this difference.
I also happen to be among a group led, I believe, by Professor Friedman, of the University of Chicago, and Professor Shaw, of Stanford
University, who believes that it would be desirable to follow a policy
of increasing our money supply at a constant rate, say 3 % to 4 percent
per year, in which case not only should the Open Market Committee
be changed, but its function as such could be abolished. We would not
need a committee to perform the functions such as the Open Market
Committee is supposed to be performing.
I will terminate my oral statement here and permit you more time
for questioning.
The CHAIRMAN. All right, sir. I notice you didn't pass on the
other bills.
Mr. BROWNLEE. Well, I don't consider myself to be an expert in
these areas.
(The prepared statement is as follows:)
STATEMENT OF O. H . BROWNLEE, PROFESSOR OF ECONOMICS, UNIVERSITY
OF MINNESOTA
I have been requested to offer my opinions with respect to five bills
affecting the organizational structure of the Federal Reserve System
and to comment on the desired level of interest rates and money supply
at this juncture in economic activity.
I n general, I support the proposals to (1) grant banks membership
in the System without requiring them to hold Federal Reserve stock ;
(2) eliminate the prohibition against the payment of interest on demand deposits; and (3) permit banks to pay interest on deposits made
by the Treasury and charge for services rendered to the Treasury. I
have no strong opinions on the proposals to return interest received by
the Federal Reserve banks on obligations of the United States to the
U.S. Treasury nor on the proposal to enlarge the membership of the
Federal Reserve Board, make the Secretary of the Treasury its Chairman, abolish the Open Market Committee, create a Federal Advisory
Committee, and so forth. The latter appear to be designed to make
Federal Reserve operations more effective as devices for economic
stability, but I believe that reforms in basic policy rather than only
THE FEDERAL RESERVE SYSTEM AFTER FIFTY YEARS
1063
in organization are needed, if the system is to maximize its contribution to the economy.
I n order for a central bank to perform its primary functions of
(1) providing a market for bank assets, particularly in the event of
an increase in the public's demand for cash, therefey avoiding such
decreases in the money supply as occurred during the early 1930's;
and (2) buying or selling certain assets in accordance with some predetermined rule in order to alter banks' reserves which in turn will
alter the money supply, it is not necessary for the member banks to
have any financial interest in the central bank. Rediscounting was
performed by large banks in central cities prior to the creation of the
Federal Keserve System, and this may be responsible for the conception of a central bank along the lines of a private bank. The requirement that member banks hold stock and share in the profits or losses
of the Federal Reserve appears to me to be a silly one.
Many analysts of monetary policy have been critical of the degree
of independence of the Federal Reserve banks from the President and
Congress, and I assume that the proposals in H.R. 9631 and H.R.
9685 are designed to reduce this independence. Requiring that interest received by Federal Reserve banks on U.S. obligations be returned to the Treasury would eliminate the Federal Reserve's financial
independence and force it to obtain congressional appropriations. I
see no overriding objections to this providing that the activities of the
System rather than its actions are scrutinized in determining appropriations. I t would be highly undesirable for a tight-money Congress
to approve the budget of the Board and the banks if interest rates
happened to be high or to cut it if rates were low, for example.
This change, as well as making the Secretary of the Treasury the
Board's Chairman, abolishing the Open Market Committee and creating a large Advisory Committee, will not bring fundamentally improved performance to monetary management. When monetary policy has been tailored to the desires of the Treasury, as it apparently
was in World Wars I and I I , during the depression of the thirties and
in the post-World W a r I I period, it has been basically more expansionary than when the Board has had control. This is not necessarily
good, unless we consider inflation to be a good thing. Our principal
difficulties, however, have been with the variability of the rate of
change in the supply of money. Some of this may have been planned.
There are many persons who believe that changes in the money supply
can be used to reduce fluctuations in economic activity. However,
some of it appears to me to be unplanned. I confess that I cannot
determine from the record what the Open Market Committee was
attempting to achieve, the directions which it gave to those who were
charged with gaining the objectives nor the criteria used to determine
if what was obtained was approximately the same as that which was
sought. Nevertheless, I am certain that many different levels of total
reserves, and hence of the potential money supply, can exist with a
given amount of "free reserves"—the target variable used by the Committee. An increase in free reserves can be compatible with an increase or a decrease in the potential money supply. Regardless of its
composition, the body in charge of open market operations should operate on total reserve rather than free reserves.
I also believe that trying to smooth out business fluctuations by
changing the rate of change in the money supply leads to greater
28-680—64—Vol. 2
10
1064
THE FEDERAL RESERVE SYSTEM AFTER FIFTY YEARS
fluctuations than otherwise would occur. Stated another way, our
monetary activities have contributed to economic instability not only
because of using the wrong targets but also because of acting as if the
future could be known more accurately than we can now predict it.
Direct evidence in support of this belief is hard to obtain. But, so is
evidence against it. And, the indirect evidence combined with accepted theory favors a policy of increasing the money supply at a constant rate. This permits setting clearly targets for total bank reserves
relatively far into the future. The Open Market Committee not only
can be abolished; its function can be abolished as well.
I am unreservedly in favor of abolishing the prohibition against
the payment of interest on demand deposits, and I also favor eliminating the ceilings on interest rates payable by commercial banks on time
deposits, although the latter is not now being considered. These regulations hark back to the depression of the thirties when it was believed
that the way to make "safe" banks was to reduce bank competition
for deposits and thereby induce banks to make less risky loans. The
wholesale failure of banks during the thirties was due more to the
irresponsibility or bad judgment of the monetary authorities than to
the risks of the investments. This, however, is irrelevant. I would
expect no more risks under free interest rate than with rates that are
controlled for several reasons.
First of all, a bank interested in maximizing expected profit subject
to such portfolio restrictions as are imposed by laws and bank examiners would allocate a given amount of loanable funds among various
opportunities in a given way regardless of what it had to pay to secure
these funds, just as a profit maximizing business would choose the
same bundle of goods to produce from a given bundle of resources
independently of the cost of the resource bundle.
Secondly, because interest ceilings prevent the commercial banks
from using interest rates in competing with other banks for funds, the
commercial banks loan less than otherwise would be the case. More
funds are loaned by other types of financial institutions. I do not believe that the loans made by these other institutions are less risky than
those that would have been made by the commercial banks.
Finally, although commercial banks are denied the right to use
interest rates to compete with each other and with other financial institutions, they can compete in other ways. Advertising, premiums for
opening or augmenting accounts and services offered to depositors at
fees below their costs are the principal forms of such competition. If
it were true that the riskiness of loans were related to the costs of obtaining funds, risk would not be significantly affected by the interest
ceilings if cost were not significantly affected.
The social losses which result from the interest rate ceilings imposed
on deposits probably are not very large. However, there is little point
in incurring them. Present arrangements result in (1) lower service
charges on small deposits than otherwise would be the case, (2) higher
costs to larger deposits, and (3) a larger component of services in lieu
of interest payments. This latter category represents income that is
not subject to income tax. Converting some of it to income subject to
tax represents an important byproduct of removing the prohibition.
Even though it may discredit the sensible things I have said about
interest ceilings, let me conclude my remarks on this subject by saying
THE FEDERAL RESERVE SYSTEM AFTER FIFTY YEARS
1065
t h a t I believe that commercial banks have been permitted to take too
few risks and that there have been too few bank failures. The control
of commercial banking has made it into an industry comparable in
stodginess to the railways (the responsibility for the status of the latter probably can be traced to the I C C ) .
More failures probably would raise F D I C rates—a feature which
would not be welcomed by all bankers. However, just as it is nonsense
to grant all auto drivers insurance at the same rates regardless of differences in their abilities to handle cars or to make life insurance rates
independent of the states of health of the insured, it is not optimal to
charge the same deposit insurance rates to all banks. Rates on deposit
insurance could be classified according to risk and the status of the
bank be made known to all potential depositors. No subsidy given by
"saf e" banks to risky ones—as can be the case under existing arrangements—need result.
An unregulated insurance company which was a monopoly would
find it in its interest to grade its rates according to risk. I n a competitive industry, such gradation would be virtually inevitable. The
F D I C appears to be an unimaginative monopoly, partially because it
is not interested in maximizing profit, but more important because for
most banks insurance with the F D I C is compulsory. Perhaps other
insurers should be permitted to enter the field of deposit insurance to
help keep the F D I C on its toes.
IS THE MONEY SUPPLY SUFFICIENTLY LARGE?
Since the "accord" between the Treasury and the Federal Reserve
(1951), the average annual rate of growth in the money supply has
been about 2 percent. Percentage increases were considerably larger
than this average during the last 3 years as a result of augmenting
bank reserves through permitting banks to count vault cash as a part
of their reserves and as a consequence of reduced reserve requirements for time deposits. If increases in the money supply were the
only demand expanding device, an annual average rate of increase of
2 percent is too small to keep the price level constant with real output
growing at 3 percent or more per year (or to keep output growing at
3 percent per year at a price level which cannot be reduced). Federal
cash payments to the public exceeded receipts, thereby increasing the
Federal debt and adding to aggregate demand. State and local borrowing also increased substantially. The result is a level of interest
rates higher than would have prevailed had there been smaller increases in debt and larger increases in the money supply.
I believe that the money supply could have been expanded faster
than it was, given the fiscal situations of the various governmental
units, without significant price increases. Many persons believe that
the real gross national product has been from 3 to 5 percent below that
which could be produced without inflation for nearly 7 years. However, I do not hold the Federal Reserve wholly responsible for our
monetary policy. The outflow of gold from the United States—as a
result of foreign economic aid, military assistance, private U.S. investment abroad particularly in common market countries where it was
expected that U.S. produced goods could enter under increasingly less
favorable terms, and prices for the dollar that have been too high in
1066
THE FEDERAL RESERVE SYSTEM AFTER FIFTY YEARS
terms of foreign currencies—was given undue weight in determining
the desired interest rate levels.
The U.S. economy could function without impairment on much
smaller gold reserves than we have. However, steps have been taken
to try to diminish the outflow of gold. The most important of these
has been toward maintaining sufficiently high rates of interest to induce foreigners not to convert their claims against us into gold rather
than adjustments in the fundamental factors. I n fact, it has been
argued that the short-term rate can be pushed up and the long-term
rate down, thereby reducing gold outflows and encouraging domestic
investment. Although it is not of relevance to the present discussion,
I believe that the spread between long- and short-term rates cannot be
altered significantly within the range of action available to the Treasury. Reductions in long-term accompanied by increases in short-term
Government debt will be approximately countered by relative increases
in long-term and decreases m short-term private debt (including that
issued by foreigners).
The cut in Federal taxes will make both the gross national product
and the level of interest rates higher than would have been the case
had no action been taken. Although I do not know precisely at what
level of gross national product the Federal budget will balance, my
guess is that it is near the desired value and that increasing the money
supply at a rate in excess of 3 percent per year to reduce interest rates
would now be inflationary.
F o r a given desired gross national product, we have a choice between easy money and a tight budget (a surplus) or tight money and
an easy budget (a deficit). We have chosen the latter policy. I do not
know how important the difference between the two policies would be
in terms of economic growth. The course we have chosen pushes
consumption and Government spending at the expense of private investment. An easy-money policy—if it is not to be inflationary—
pushes private investment at the expense of consumption. Such fundamental choices should be made by the Congress. I hope that it
knows what kind of choice it has made.
The CHAIRMAN. Very well. Now, first, I want to ask Dr. Brunner a
question.
Suppose, Dr. Brunner, that in the years since 1953 the Fed had used
open-market purchases to raise the quantity of money instead of having lowered reserve requirements. Would we have had substantially
more inflation, less unemployment, and less economic growth than
we did have these past 11 years? I n answering you may assume that
the money supply's behavior would have been the same as it was.
Mr. BRUNNER. Some of the results accumulated in our research
project bear quite immediately on this question, Mr. Chairman. We
investigated in particular the response of the money supply to variations in the legal reserve ratios and to open-market operations. The
comparatively frequent changes in the legal ratios which occurred in
the postwar period fortunately permitted a careful examination of
both requirement policy and open-market policy. We found that the
money supply responded by essentially the same order to open-market
operations of a given volume or to changes in the same volume of
required reserves resulting from variations in legal reserve ratios.
THE FEDERAL RESERVE SYSTEM AFTER FIFTY YEARS
1067
I n particular, according to the statistical investigations performed,
open-market purchases of $1 billion or a reduction in requirement
ratios which liberates $1 billion of reserves from required reserves,
generate essentially the same response of the money supply. I t follows, therefore, that the behavior of the money supply actually observed since 1953 could have been obtained under unchanged requirement ratios with suitably chosen open-market operations. Moreover,
under the circumstances specified in your question, Mr. Chairman, the
substitution of open-market operations for changes in legal reserve
ratios would have induced no significantly different experience in
either unemployment, inflation, or economic growth.
Open-market operations can thus effectively substitute for changes
in requirement ratios. The appropriate future growth of the money
supply requires, therefore, no discretionary powers by the Federal
Reserve authorities over the requirement ratios. Once the authorities
understand the structure of the money supply process, open-market
operations supplemented with suitable adjustments of the discount
rate are sufficient to assure an adequate control over the money supply
and to generate its required long-run growth.
The CHAIRMAN. I will ask you another question. Then I will want
the comments of Professor Brownlee.
If we had used open-market purchases to expand the money supply,
wouldn't the debt held by the Federal Eeserve be much higher today
than it is, and so the actual interest paid by taxpayers much less ?
Mr. BRUNNER. I didn't quite understand.
Did you address it to me or Dr. Brownlee ?
The CHAIRMAN. Well, let me read it again. I am anxious for you
to answer this.
If we had used open-market purchases to expand the money supply,
wouldn't the debt held by the Federal Reserve be much higher today
than it is, and so the actual interest paid by the taxpayers much less ?
Mr. BRUNNER. The answer is "Yes." I n case the Federal Reserve
authorities maintain the legal reserve ratios at a constant level, the
required long-run growth of the money supply would have to be
achieved by suitable open-market purchases. Such purchases undoubtedly lower the outstanding effective debt, that is, the interestbearing debt held outside the economy's Government sector.
Under a system of fixed requirement ratios monetary policy would
thus unavoidably operate as a built-in retirement process which contributes to reduce gradually the effective debt of the U.S. Government.
The order of magnitude of this built-in retirement process can be
usefully specified. If the Federal Reserve authorities had maintained
the legal reserve ratios since January 1953 at a constant level, approximately $5 billion more open-market purchases would have been necessary to generate the growth-behavior of the money supply which we
actually experienced.
I t should be noted in this context, however, that both average growth
rate and cyclic behavior of the money supply were inadequate in the
postwar period. I n particular, the average growth rate was too small
from 1953 to 1962. I would contend that the rising rate of unemployment and the retardation of economic growth were associated with this
unnecessarily constraining monetary policy. An appropriate policy
will have to assure for the next 10 years a growth rate of the money
supply averaging 3 to 4 percent per annum. Such a policy would
1068
THE FEDERAL RESERVE SYSTEM AFTER FIFTY YEARS
imply a growth rate of the monetary base between 3 and 4 percent per
annum, provided the other determinants of the money supply remain
unchanged. The open-market purchases necessary to yield such a
growth rate would lower the effective interest-bearing debt of the
U.S. Government by approximately $20 billion over a 10-year period.
However, if the currency patterns observed over the postwar years
persist, then a larger growth rate of the monetary base may very
likely be necessary to generate the required long-run growth of the
money supply.
The CHAIRMAN. Would you like to comment, Professor Brownlee,
on those questions ?
Mr. BROWNLEE. Well, let me see if I understood the first question.
Did you ask, Does it make any difference as far as economic activity
is concerned, whether we get the desired money supply through
changes in reserve requirements or through open-market operations ?
The CHAIRMAN. That is right.
Mr. BROWNLEE. The answer, is no, it doesn't, as far as I can see.
The CHAIRMAN. And the second one now.
Mr. BROWNLEE. Well, it depends on what you mean by much. I t
is true the total debt in the hands of the public would be smaller, and
that in the hands of the Federal Reserve would be larger if the money
supply could be expanded by open-market purchases. Open-market
operations are a way by which we can convert the debt which is interest bearing to debt which is noninterest bearing.
The CHAIRMAN. Let me bring u p an entirely new question.
I f you gentlemen have not given consideration to it, you may say so.
I t occurs to me that when the Open Market Committee takes Federal Reserve notes, and buys U.S. Government bonds they take
Federal Reserve notes, which is one Government obligation, and
trade them for another Government obligation, an interest-bearing
obligation and it it occurs to me t h a t that cancels that debt, when it is
acquired. Of course I know the Committee does it for the purpose
of having open-market operations. B u t if we take Professor Brownlee's suggestion, we wouldn't have the type of operation that we have
now. We would do it probably a different way.
I t occurs to me that that cancels that debt. And if we say it should
still be kept alive for open-market operations, should the taxpayers
be compelled to continue to pay interest on it? I t has been paid once.
W h a t do you think about that, Dr. Brunner ?
Mr. BRUNNER. Your question, Mr. Chairman, seems to bear on the
issue whether or not the Federal Reserve's open-market purchases effectively lower the volume of interest-bearing debt and thus lower the
volume of tax receipts required to finance interest payments.
The CHAIRMAN. T h a t is right.
Mr. BRUNNER. The Federal Reserve banks currently receive interest on their portfolio of Government securities. These earnings
appeared usually more than sufficient to cover the Federal Reserve's
costs of operation. A major part of the emerging profits seems to
have been transferred to the Treasury. This transfer effectively reduced the volume of tax receipts required to finance interest payments
on the national debt. The tax receipts still necessary to finance the
remaining net payments on the Federal Reserve's portfolio of Government securities must, therefore, be understood as the taxpayers'
contribution designed to finance the operations of the Federal Re
THE FEDERAL RESERVE SYSTEM AFTER FIFTY YEARS
1069
serve banks. The taxpayer thus finances in this manner a Government agency outside the usual budgetary controls provided by our
constitutional processes.
The effect of different types of monetary policy on the use of tax
receipts for interest payments on the effective debt may be further
clarified. If the Federal Reserve authorities had expanded the money
supply since 1953 to the extent actually observed by relying solely on
open-market operations, the interest payment on the effective debt
would currently be lower by approximately $150 to $200 million.
Moreover, should the monetary base expand over the next 10 years in
accordance with the longrun growth requirements of the money supply, the interest payment on the effective debt at the present level
could be reduced by approximately $800 million until 1974. This
computation presupposes, however, that the Federal Reserve's operational costs are not expanding pari passu with the increase in its
portfolio of Government's securities. A p a r t from salary increases
and in the absence of wide-flung ramifications of new activities engaged in by the Federal Reserve System, only a very small p a r t of
the $800 million could be reasonably expected to cover increased operational costs. A n appropriate growth policy under constant requirement ratios could, therefore, be expected to lower significantly
the volume of tax receipts necessary to cover interest payment on the
effective debt.
The CHAIRMAN. Let me change it just a little bit.
Do you believe that the amount that is acquired in the manner I
have indicated should be considered a part of the national debt?
W h y shouldn't we say that the amount of bonds in the Federal Reserve open-market portfolio should not be considered in arriving at
the total amount of the national debt ?
Mr. BRUNNER. The combination of the Federal Reserve's portfolio
of Government securities with the total volume of such securities held
outside the Government sector is rather arbitrary and can also be
quite misleading. The decisive amount is the volume of U.S. debt
held outside the Government sector of the economy. F o r proper information the debt held by the Federal Reserve System should be
listed separately. Such presentation would make it more explicit
that the U.S. debt held by the Federal Reserve is either a mere bookkeeping device without economic significance or a device to coerce
taxpayers to share the operational costs of our monetary authorities.
The CHAIRMAN. Professor Brownlee, would you like to comment on
that question?
Mr. BROWNLEE. I think your statement is essentially correct. T h a t
is, when we trade non-interest-bearing Federal debt—Federal Reserve
debt—for interest-bearing Federal debt, we are in effect canceling that
portion of the debt. But what we include as debt, I think, is somewhat arbitrary.
I suppose we actually should include money. B u t for the most part,
we call debt only that portion which bears interest. And it is in this
sense that under your proposal, if the Federal Reserve were to turn
its earnings over to the Treasury, open-market operations will effectively cancel a portion of the interest-bearing Federal debt.
The CHAIRMAN. I considered a bill at one time—I am not sure I
introduced it—to require that in determining the amount of the public
1070
THE FEDERAL RESERVE SYSTEM AFTER FIFTY YEARS
debt, the national debt, the amount of bonds held by the Open Market
Committee in the Federal Reserve banks would not be considered.
Now, of course, that would mean if they have $34 billion now, there
would be $34 billion less national debt on the books.
But if for any reason they would sell $4 billion, the debt would
go up by that amount. I n other words, just the amount in the openmarket portfolio would be considered not part of the debt.
Would that be reasonable enough, Mr. Brownlee ?
Mr. BROWNLEE. Well, why are you interested in knowing the total
amount of the debt anyway ?
The CHAIRMAN. Well, that has become very important. I t is psychological, I know.
Mr. BROWNLEE. Yes. As far as the debt ceiling that is imposed by
Congress is concerned, I think you are correct.
One should not include in this the amounts which are held by the
Federal Reserve. But I think the important thing is to know where
the debt is—that is, how much debt is in the hands of the public, how
much is in the hands of the Federal Reserve, and how much is in the
hands of other Government agencies.
We speak of a total debt of approximately $300 billion. Actually, only about half of this is really in the hands of the public.
The CHAIRMAN. Would you like to comment, Dr. Brunner, on the
last statement I made about having a debt policy written into the law,
that in arriving at the national debt that the amounts of bonds held
by the Open Market Committee would not be made a part of the
national debt?
Mr. BRUNNER. A clear separation of the Federal Reserve System's
portfolio of Government securities from any specification of the national debt may actually contribute to a clearer understanding of
monetary problems.
Government securities held outside the Government sector by commercial banks and the public play a radically different role in the
monetary processes than the Federal Reserve's portfolio of Government securities. Some of the tables occurring in Federal Reserve publications combine U.S. debt held by commercial banks and Federal
Reserve banks as elements of a uniform category. This procedure
unavoidably generates serious misconceptions about the role of U.S.
debt in the monetary process and beclouds the proper interpretation
of the Federal Reserve's portfolio of Government securities. I submit, therefore, that a specification of "national debt" in terms of U.S.
debt held outside the economy's government sector would be useful.
The CHAIRMAN. Mr. Brock ?
Mr. BROCK. Thank you, Mr. Chairman.
Mr. Brownlee, if I might just cover a couple of points on the specific
bills involved.
On the bill which would place the Federal Reserve under the Secretary of Treasury, in effect, as I understand it, you say this will bring
no fundamental improvement in performance. I n other words, I am
interpreting—I would say that you are not particularly in favor of
this bill.
Mr. BROWNLEE. Well, I am neither opposed to it nor in favor of
it. I am essentially indifferent to it.
THE FEDERAL RESERVE SYSTEM AFTER FIFTY YEARS
1071
That is, I don't think that a Secretary of the Treasury unnamed
is necessarily a wiser man than a Chairman of the Federal Reserve
Board unnamed because we can find some Secretaries of the Treasury
who have been wiser than certain chairmen of Federal Reserve Boards,
but one cannot be assured that this will essentially be the case.
And it is a fundamental change in the nature of monetary policy,
rather than a change in the organization, which is required, I think,
to achieve the objectives which we have in mind.
Mr. BROOK. Well, one of the points you raised here, on this second
pageit would be highly undesirable for a tight money Congress to approve the budget
of the Board and the banks if interest rates happened to be high or to cut it if
rates were low, for example.
What you are saying is that you are concerned over the political
impact it might have on monetary policy.
Mr. BROWNLEE. Exactly. I think it is not the actions as such of
the Federal Reserve which ought to determine the size of its appropriation. I t is its function as such. And, on this score, I am a little
bit wary about requiring the Federal Reserve to come to Congress for
an appropriation.
Mr. BROCK. Wouldn't the same thing be true—would it not be subject to political pleasures and whims in the changes of the political
climate? F o r example, if a tight money administration were supplanted by a loose money administrator, or vice versa—would it not
be in opposition to your approach to monetary affairs ? You want a
stable approach. If he were subject to the Treasury, wouldn't this
defeat your purpose, when you had a change ?
Mr. BROWNLEE. Administratively it certainly appears the way to do
this. You know more about what kinds of pressures are brought to
bear and are more of an expert on this question than I am.
Mr. BROCK. Well, I am raising the question because I think there
are these pressures, and under a situation where there were, don't you
think it would be undesirable ?
Mr. BROWNLEE. If I were forced to commit myself, I think the answer would be yes.
Mr. BROCK. Professor Brunner, if I may ask you a couple of questions on these charts, please, sir.
You say that the first page, on 1948-49
Mr. BRUNNER. Pardon me, sir. Are you referring to chart 1 appended there ?
Mr. BROCK. Yes.
Mr. BRUNNER. Yes, sir.
Mr. BROCK. YOU say that
this period from 1948 to 1949 reflects
active deflationary policies on the part of the Fed.
Mr. BRUNNER. That is what I said, yes.
Mr. BROCK. All right.
Now, would you explain to me what you mean by the peak—the
peak of what ? This first line, in the latter part of 1948, about November of 1948. I t shows a period which you label as a peak.
Mr. BRUNNER. The graph appended to the written statement before
you contains also the same vertical line centered on November 1948.
Mr. BROCK. This vertical line here ?
Mr. BRUNNER. The vertical line centered on November 1948 and
labeled "peak" indicates that aggregate economic activity has reached
1072
THE FEDERAL RESERVE SYSTEM AFTER FIFTY YEARS
a peak at the month specified. The National Bureau of Economic
Research has developed an intricate routine to determine the turning
oints in the pace of economic activity. The specifications worked u p
y the National Bureau are quite generally used in our profession to
locate the upswings and downswings of our economic fluctuations.
These very specifications were used to locate the peaks and troughs
in the graphs appended to the statement. According to the timetable
charted by the National Bureau, economic activity began to decline
in November 1948 and reached bottom in October 1949.
Mr. BROCK. NOW, following through, the second line is the trough of
economic activity.
S
Mr. BRUNNER. Yes, sir.
Mr. BROCK. NOW, you say
that the Fed, looking at the trend of your
jagged line here—the trend line
Mr. BRUNNER.
Yes.
Mr. BROCK (continuing). Shows a deflationary policy.
Mr. BRUNNER. T h a t is right.
Mr. BROCK. F r o m the peak to the trough.
Mr. BRUNNER. I beg your pardon ?
Mr. BROCK. F r o m the peak to the trough.
Mr. BRUNNER. T h a t is right.
Mr. BROCK. I n other words, while we were going down we were
still exercising deflationary policy.
Mr. BRUNNER. T h a t is right. The Federal Reserve pursued an
actively deflationary policy throughout the downswing in economic
activity.
Mr. BROCK. All right.
Now, taking the last two pages of the 1960 to 1961 peak and
trough
Mr.
BRUNNER.
Yes.
Mr. BROCK (continuing). You have from the peak to the trough a
fairly substantial increase in the trend line.
Mr. BRTXNNER. Chart 1 or chart 2 ?
Mr. BROCK. This is still the same chart 1.
Going from the peak of economic activity to the trough, you have
an expansionary monetary policy.
Mr. BRUNNER. YOU refer to the growth rate of the money supply
depicted on chart 1. This growth rate reached a nadir immediately
following the peak of economic activity. But you should notice, sir,
t h a t the growth rate was negative, and while it accelerated throughout the downswing, remained negative for a portion of the recession.
After the unnecessary collapse of the money supply's growth rate in
1959 and early 1960, it moved at least in the right direction throughout
the deflationary phase of 1960-61. Unfortunately, this increase in
the growth rate of the money supply was not achieved by courtesy of
the Federal Reserve authorities. Inspection of chart 2, which depicts
the growth rate of the extended base, clearly reveals that Federal
Reserve policy remained substantially deflationary for a major portion
of the recession. The growth rate of the extended base, which effectively summarizes the actual policy behavior of the Federal Reserve
authorities, remained negative until late in 1960 and was still much
lower than the required longrun growth rate at the close of 1960.
The accelerated movement of the money supply initiated in late
spring of 1960, and persisting during the downswing, was caused by
THE FEDERAL RESERVE SYSTEM AFTER FIFTY YEARS
1073
the behavior of the other determinants of the money supply. I n particular, the reallocation of the public's money balances between currency and checking deposits contributed to retard the decline in the
money supply and offset partly the deflationary impulses imparted on
the monetary system by Federal Reserve policy. During every recession we note a backflow of currency from the public, a relative decline
in the allocation of the public's money balances to currency. This
behavior on the part of the public initiated together with some other
forces the increase in the growth rate of the money supply in 1960,
months before the growth rate of the extended base (on chart 2)
reveals a reversal of Federal Reserve policy in an expansionary
direction.
Mr. BROCK. All right. Then your statement that the chart reflects
deflationary activity in one area, and expansion activity in the other,
is not a reflection of the policy of the Fed, but is a reflection of the
actual money supply, which has no relationship to the policy ?
Mr. BRUNNER. I am not quite sure that I understood your question
correctly; I am sorry.
Mr. BROCK. Well, you said during your testimony that the first
chart showed a deflationary policy of the Fed.
Mr. BRTJNNER. T h a t is right.
Mr. BROCK. B u t the last chart—which is the same chart, but 14
years later—you say it doesn't reflect any policy at all, that it reflects
the actual conditions in the money supply. Now, you are talking
apples and oranges, Professor.
Mr. BRUNNER. Are you referring to this period again, sir? To this
period in 1960-61?
Mr. BROCK. T h a t is right.
Mr. BRUNNER. I n order to clarify this issue, I wish to emphasize
once more that chart 2 describes the growth rate of the extended base,
summarizing the actual policy behavior of the Federal Eeserve. I t is
also the most important determinant of the money supply's growth
rate depicted in chart 1. But you will note, sir, that, while the extended base is the most important, it is not the only determinant of the
money supply. A few other factors contribute to shape the behavior
of the latter magnitude. Foremost among these other factors is the
partition of the public's money balances between currency and checking deposits.
An inspection of chart 2 clearly reveals that, over the first 4 or 5
months of the recession initiated in 1960, the growth rate of the extended base was negative. During this phase, the Federal Eeserve
authorities engaged in an actively deflationary policy. Later in the
downswing, the growth rate of the base became at least positive. During 1961, policy became decisively expansionary, hesitated seriously
for some months in 1962, and moved further to generate a growth rate
of the base in the late fall of 1963 not achieved since 1952. This prolonged and decisively expansionary policy is quite likely one of the
single most important reasons explaining the length and vitality of
the current upswing in economic activity.
You indicated correctly that the money supply behaved somewhat
differently than the base during the recession of 1960-61. I t s growth
rate hit a nadir immediately after the peak in economic activity, and
many months before the growth rate of the base revealed an attenuation of the Federal Reserve's deflationary policy. The other deter
1074
THE FEDERAL RESERVE SYSTEM AFTER FIFTY YEARS
minants of the money supply worked to offset the Federal Reserve's
policy behavior. I n particular the public's currency behavior modified
the Federal Reserve's deflationary posture. This modification is effectively revealed by the comparatively early turning point in 1960
for the growth rate in the money supply. A comparison of the two
charts clearly exhibits this point.
Mr. BROCK. I appreciate that. I was just trying to clear up a false
impression I got.
Mr. BRTJNNER. I hope I was responsive to your question, sir.
Mr. BROCK. Yes; I think you were responsive. '
Let me follow through, then. W h a t do you think constitutes Federal Reserve monetary policy ? I s it the rediscount rate ? W h a t particular actions are you using as an index of their inflationary-deflationary activities ?
Mr. BRXJNNER. Your question involves several parts, and bears on
the description of the policy indicator labeled as the extended base
and whose growth rate is depicted on chart 2.
Monetary policy is exercised by the Federal Reserve authorities
through open-market operations, changes in legal reserve ratios,
and variations of the discount rate posted by the Federal Reserve
banks. The index used to summarize Federal Reserve policy effectively
combines all the policy actions of the Federal Reserve authorities into
a single magnitude—namely, the extended base. Open-market operations, changes in required reserves attributable strictly to fiat
changes in legal reserve ratios, and changes in the Federal
Reserve's portfolio of discounts and advances, are reflected dollar
for dollar in matching changes of the extended base. I n particular,
this crucial determinant of the money supply can be manipulated
and completely controlled by the Federal Reserve authorities by means
of the three policy instruments mentioned above.
The contribution of these three instruments to the observed behavior of the extended base varied considerably under different circumstances. A few illustrating cases may be selected to exemplify
this point. During the recession of 1948-49, the Board lowered the
legal reserve ratios in successive steps. This action was effectively
designed to raise the extended base by a substantial amount, and was
thus properly planned to increase the money supply and counteract
the prevailing deflation. Unfortunately, the Federal Reserve authorities also engaged in ]arge-scale open-market sales which lowered the
extended base. These sales dominated the effect of the changes in
the legal reserve ratios, a fact clearly revealed by the growth rate of
the extended base. Contrary to the Federal Reserve's assertions, the
open-market sales did not modify a prevailing "policy of ease"; neither
did the Federal Reserve actually exert a "countercyclically stimulative" policy. Policy was deflationary at the time, because the positive
effect of lower requirement ratios was overwhelmed by the negative
effect of open-market sales.
A somewhat different constellation was observed in the recession
of 1953-54. Once more, the release in required reserves, accomplished by the reductions in legal reserve ratios, contributed to raise
the extended base. But, this effect was again offset by a contraction
of Federal Reserve credit. This contraction was reflected simultaneously in the Federal Reserve's portfolio of discounts and advances,
and its portfolio of Government securities. Thus, both discount policy
THE FEDERAL RESERVE SYSTEM AFTER FIFTY YEARS
1075
and open-market policy explain the deflationary direction in the movement of the extended base during the recession of 1953-54. Inspection of pertinent data for 1957-58 and 1960-61 would again reveal
that both open-market and discount policy shaped the deflationary
trend of the extended base for a good part of the recession.
Mr. BROCK. My time has expired.
Mr. BRUNNER. D O you wish me to elaborate further ?
Mr. BROCK. I would like very much to follow through, but my time
has expired.
The CHAIRMAN. Mr. Pepper ?
Mr. PEPPER. I notice on page 3 of the statement of Dr. Brownlee
the statement that "the Open Market Committee not only can be
abolished, its functions can be abolished as well."
And Dr. Brownlee seems to be of the opinion that it is better to
have a constant increase in the money supply rather than have it
flucuating as the Open Market Committee has done with it.
Is that correct ?
Mr. BROWNLEE. Yes, that is correct.
Mr. PEPPER. NOW, does Dr. Brunner differ from Dr. Brownlee in
that matter?
Mr. BRUNNER. Not fundamentally, sir. However, I would reformulate the issue in the following manner. The development by the
Federal Reserve authorities of a validated conception about the structure of the monetary process forms the most urgent and primary problem facing us. I n this context, the choice between a rule laying down
the target growth of the money supply or a framework of discretionary power appears to be of secondary importance. Whether we prefer a rule, or continue the exercise of discretionary powers, intelligent
action must be based on relevant knowledge of the monetary process,
in the absence of such knowledge, the Federal Eeserve would have no
reliable information how to achieve a given target growth of the
money supply, neither possess any standards to appraise the soundness of its judgments evolving in the context of discretionary powers.
I wish to emphasize that I strongly agree with the stabilization of
the growth rate of the money supply implicit in the proposal formulated by Professor Brownlee. Proposals 2 and 3, in the last section
of my written statement, yield essentially a similar result. They provide that the growth rate of the base should be stabilized around a
constant-trend line. Deviations from this trend should only occur
to compensate the effect on the money supply of substantial variations
in the public's allocation of money balances between currency and
checking deposits.
Mr. PEPPER. May I ask both of you gentlemen if you will comment
briefly on these two questions: One, assuming there is to be an agency
that will have the power to enlarge and to contract the money supply
of the country—now, one, should that agency be governed by some
sort of rules or some sort of principles that are laid down by law, let
us say; and, two, should that agency have a closer relationship to the
Government, be more directly responsible to the Government than
the Federal Eeserve Board is at the present time?
Will each of you gentlemen comment briefly on those two questions,
if you will.
Mr. BRUNNER. Yes, sir, I submit that it would be very useful to
formulate some more specific goals guiding the monetary policy of the
1076
THE FEDERAL RESERVE SYSTEM AFTER FIFTY YEARS
Federal Reserve authorities. You will have noticed the gyrations of
the growth rate of both money supply and extended base depicted on
the appended graphs. I t is difficult to see any rationale in these gyrations and simultaneously admit the relevant operation of monetary
processes in our economy. Our analysis leads me to contend that such
gyrations only contribute to amplify economic fluctuations. A more
definite mandate addressed to the Federal Eeserve authorities could in
my judgment substantially improve the performance of our monetary
system. The gyrations in the growth rate of the money supply were
dominantly caused by unnecessary variations in the growth rate of
the extended base. Removal of the variations in the latter magnitude
can be accomplished by an appropriate mandate to our monetary
authorities.
You covered also a second point in your question, bearing on the
proper relation between an agency controlling the money supply and
the Government. I feel that the so-called independence of the Federal Reserve System has been overemphasized on occasion. Monetary
policy was subjected to serious political constraints in 1917-20 and
^tlso in 1941-47. The control of the money supply is an essential function of Government and should be explicitly faced as a responsibility
of our Government. This obligation should be discharged in accordance with the particular function of the branch of government
involved: Congress could formulate a more explicit mandate in order
to eliminate the gyrations noted on chart I I . Moreover, congressional
hearings may develop a searching investigation of policy assessments
typically made b ^ the Federal Reserve authorities. Such investigations could effectively contribute to force the Federal Reserve authorities to base their judgments more on substantiated analysis and
less on personal impressions. The administration, on the other hand,
would discharge its peculiar function through appropriate choices
of members for the Board.
Mr. PEPPER. Doctor, I am going to have to ask you if you will discontinue your reply, because my time is limited.
I must not trespass upon my colleagues. I think we get your general
view. Thank you very much.
Now, Dr. Brownlee, would you comment briefly on those two questions, please, sir ?
Mr. BROWNLEE. Well, yes. I think there should be more definite
guidelines for the Federal Reserve or for whatever other agency would
take over the control of the money supply. And a definite guideline
such as increase the money supply this year by 3 percent is something
everybody can see. We know whether or not we have 3 percent, 5 percent, or 1 percent.
W i t h respect to the relationship of the monetary authority to the
Government, certainly it should not be independent. That is, if Congress wants inflation, it ought to be able to get inflation, or if it wants
deflation it should be able to get it. However, I don't think the Federal
Reserve has been completely independent.
W e talk about the independence of the Federal Reserve, but the
administration has exerted a good deal of control over the Federal
Reserve; that is, there are periods in which the monetary policy of the
Federal Reserve was completely subordinated to the Treasury, and
1945 to 1951 is an example where the monetary policy was to stabilize
THE FEDERAL RESERVE SYSTEM AFTER FIFTY YEARS
1077
interest rates. When you have stable interest rates, you cannot choose
any money supply that you want.
However, we are now faced with a situation where if the tax cut
goes through we will be faced, I think, with a rather substantial deficit.
This implies, in general, a tighter monetary policy than we should be
pursuing if we were faced with a budget surplus or with a balanced
budget.
I t is in this sense that there certainly ought to be coordination
between Treasury, or tax and expenditure policy, and monetary policy.
Mr. PEPPER. Thank you very much.
Mr. REUSS. Gentleman, I would like to ask you both a question. But
before I do, I would like to clear up one minor item. Professor Brownlee, the second from the last sentence on page 6 of your paper says:
An easy money policy, if it is not to be inflationary, pushes private investment at the expense of consumption.
I wonder if you really mean that—an easy money policy would not
push private investment at the expense of consumption in the case of
a substantially underemployed economy.
Mr. BROWNLEE. YOU are correct—in that case. I am visualizing
the following case: Let's imagine we wanted the gross national product
this year to be $630 billion. We can achieve the $630 billion gross
national product, we will say, with a 5-percent, long-term rate of interest and a budget deficit of $20 billion.
We might also achieve it with a 3-percent rate of interest and a
budget surplus of $10 billion. Both these situations lead on a gross
national product of $630 billion, which is what we want.
The first, the high interest rate combined with the budget deficit,
will result in more consumption and less investment than the second,
a budget surplus combined with a low interest rate.
Mr. REUSS. The difference of policy between the two is that, in the
second case, you tax very rigorously.
Mr. BROWNLEE. I n a sense, we have a support price program for
bonds.
Mr. REUSS. I think we have cleared up our difference. So for practical purposes of February 1964, a policy of relatively easy money
would simply expand production, using the production gap that now
goes to waste because we don't produce the goods and services that
we could, rather than require a cutting down of consumption.
Mr. BROWNLEE. Well, that depends on what happens to the tax bill.
I f the tax bill goes through, I don't think we can pursue an easier
money policy than we are pursuing at the present time without some
increase in prices.
Mr. REUSS. An easier money policy, perhaps, but we can avoid going
from our present policy to a tighter money policy.
Mr. BROWNLEE. Yes, I think that is right.
Mr. REUSS. Which brings me now to the point I wanted to ask
both you gentlemen.
You both seem to be saying—and if that is what you are saying, I
agree with you—that we would be better off if we increased our money
supply year after year at something approximating the rate at which
we would like to increase our gross national product.
I n other words, instead of the niggardly increases in the money
supply of 1 or 2 percent which we have had in the last decade, both of
1078
THE FEDERAL RESERVE SYSTEM AFTER FIFTY YEARS
you gentlemen would like to see increases in the money supply and
in the gross national product on the order of 4 or 5 or 6 percent each
year.
Does that do violent injustice to the position of either of you?
Mr. BROWNLEE. If we don't use these particular numbers—if we are
not forced to use these particular numbers, 4, 5 or 6 percent—I think
the answer is yes.
You are describing my position correctly.
Mr. BETTSS. Well, what numbers would you use?
Mr. BROWNLEE. I don't know. I think 6 percent is probably a bit
large.
Mr. REUSS. Four percent, however, is fair enough, is it not ?
Mr. BROWNLEE. Four percent might be close. I might settle for
something smaller.
Mr. REUSS. H O W small ?
Mr. BROWNLEE. Maybe 3 percent.
Mr. REUSS. But not the 2 percent that we have been stumbling along
with?
Mr. BROWNLEE. N O , we don't have to settle for 2 percent. s
However, I would like to qualify the statement which you have
made as an interpretation of my position to take into consideration
what is happening to the fiscal situation at the same time. That is,
we ought to pursue in general a tighter monetary policy when we
have a loose fiscal policy, and a looser monetary policy when we have
a tight fiscal policy.
We cannot formulate monetary policy independently of our knowledge of fiscal policy.
Mr. REUSS. I recognize that. W h a t I understand you to say, Professor Brownlee, is that you would not go for such a loose, sloppy,
slatternly fiscal policy as would require a tightening of our money
supply beyond a roughly 3 percent increase rate a year. Isn't that
what you are saying?
Mr. BROWNLEE. I would hope that would be the situation. However,
if we should by chance achieve a slatternly fiscal policy, then I would
want to compensate as much as I could for this by the appropriate
monetary policy.
Mr. REUSS. Well, do you think that it's good for the country to have
a policy of fiscal slovenliness—cut taxes all the way and spend money
like a drunken sailor, and then fix it all up by having tight money ?
You are not for that ?
Mr. BROWNLEE. NO, decidedly not.
Mr. REUSS. H O W about you, Professor Brunner ?
Mr. BRUNNER. Thank you, sir. I would certainly agree with Professor Brown! ee's concern to achieve a comparatively stable growth
rate of the money supply. Monetary policy should be designed to
maintain the growth rate of the base within a 3 percent to 4 percent
band. Deviations from this band should only occur in response to unexpected variations of the public's partition of money balances between
currency and checking deposits. Sustained periods with growth rates
beyond the band indicated should be carefully avoided.
Moreover, variations in fiscal policy tend to exert a somewhat attenuated effect on the economy if monetary policy is effectively operating to stabilize the growth rate of the base in order to assure a stable
growth rate of the money supply. Our investigations strongly sug
THE FEDERAL RESERVE SYSTEM AFTER FIFTY YEARS
1079
gest that variations in fiscal policy, occurring in the context of a constant monetary policy, induce comparatively small responses in national income over the longer run. An increase in the deficit
accompanied by a simultaneous increase of the base resulting from
an accommodating Federal Reserve policy has a radically different
effect from a deficit financed by borrowing from outside the Government sector. A stable growth rate of the base would imply that variations in the deficit can only change the rate of borrowing through issues
on the open market. While variations in fiscal policy must reasonably
be expected to affect the level of activity, the repercussions will remain
relatively muted under the circumstances specified.
There is no doubt that we should carefully watch the trade off between monetary and fiscal policy. But I would also contend that a
more intelligent arrangement of our monetary policy procedures yield
some measure of leeway in our fiscal policy.
Mr. REUSS. Did either of you gentlemen see the recent statement
by Chancellor E r h a r d of Germany ? And did either of you, if you
saw it, chuckle as I did, when you read that Chancellor E r h a r d was
describing the proposed German economic policy for the year 1964,
and after observing that Germany had full employment, no unemployment, and considerable inflationary pressures, concluded that it
would therefore be necessary to restrain increases in the money supply.
The Chancellor then went on to say that he was quite caught up
with the need for prudence, and that Germany should consequently
restrain increases in the money supply for this year to 6 percent,
so that they would be roughly equal with the anticipated 6 percent
increase in the gross national product. Did either of you happen to
see that ?
Mr. BROWNLEE. I did not see the statement.
Mr. REUSS. Doesn't this suggest that if the prudent and cautious
and fiscally admirable West Germans can talk about the kind of increase in their money supply in order to underwrite and validate
a similar increase in their gross national product for 1964, a year in
which they have full employment and inflationary dangers, that this
country could well take a leaf from that book and make much greater
additions to the money supply than we have made on the average in
the last 10 years ? If this were done, and were accompanied by sensible
fiscal policies, there would be a much better chance that this country
would enjoy a larger annual increase in its gross national product.
Would either of you care to comment on that ?
Mr. BRUNNER. A growth rate of 6 percent in the money supply is of
course, mild when compared with some previous growth rates. I
looked it up in the last days.
Mr. REUSS. I t has been greater—10 percent ?
Mr. BRUNNER. I t was 6.8 percent from 1959 to 1960 and 14.3 percent
from 1960 to 1961. The growth rates appear to be substantially smaller
for 1962 and 1963.
Mr. REUSS. But doesn't it indicate that our money managers, with
their niggardly penny ante 1- or 1-plus-percent increase in the money
supply have to bear some part of the responsibility for the fact that
we have lagged lamentably behind our West European friends and
allies in economic growth in recent years.
Mr. BRUNNER. The comparatively restrictive policies pursued from
1955 until 1962 contributed—according to my judgment—substan28-680—64—vol. 2
11
1080
THE FEDERAL RESERVE SYSTEM AFTER FIFTY YEARS
tially to the retardation of our economic growth and to the rising
levels of unemployment. Suitable monetary expansion could reasonably be expected to absorb some of the prevailing unemployment. On
the other hand, any attempt to accelerate the money supply until unemployment has reached negligible levels would release serious inflationary pressures. But an admission of such limitations or constraints on the effective use of monetary policy does not remove a
range of monetary expansion appropriately designed to lower unemployment without generating inflationary problems.
Mr. REUSS. Dr. Brownlee, you took what I thought was a refreshing view of the function of bankers, as people who are supposed to
make loans to keep business moving.
Do you have some specific recommendations, other than that there
be adequate increases in the money supply each year, for making
our banking community somewhat more dynamic? One thing you
seem to suggest is to take the interest ceilings off time deposits.
And did you also suggest that we permit the payment of interest on
demand deposits?
Mr. BROWNLEE. Yes; I am decidedly in favor of removing ceilings
on interest rates paid by banks.
I f you mean, do I favor specific allocations of credit for specific
sectors of the economy, my answer is "No," because I think we should
use the interest rate as much as we can as a device for allocating credit.
I spent a considerable amount of time recently in South America,
where I find that they do ration credit, and the outcome, I find, highly
unsatisfactory.
I n general, credit rationing is used to keep the dying sectors of
the economy alive, and the live sectors of the economy from growing.
I think we ought to avoid this as much as possible, as we have. May I
make one comment with respect to comparisons of growth rates?
I think we look at the 6-percent figure in some Western European
countries, an 8-percent figure in Japan, and 3 percent or less here, and
we are inclined to say, "Well, why can't we achieve this 6- or 8-percent
growth rate?"
First of all, I think there are quite a few large errors in these
measurements, and we shouldn't take them seriously, particularly on a
year-to-year basis. If we are going to look at comparative growth
rates, they should be over a relatively long period of time, say 20 or 25
years, in which case our rates are probably not going to look as unfavorable as they have in the immediate postwar period. I think the
rapid growth rates in Western Europe are partially accounted for by
being able to put back into use with relatively little additional capital,
capital which was unused before.
Let's take the case of a string of freight cars but no locomotive.
We can make the whole thing operative by simply putting in a locomotive, giving a very high rate of return on investment.
This situation no longer exists in Western Europe. And our growth
rates, I think, will compare more favorably with theirs in the future.
Mr. REUSS. Thank you.
Mr. Minish ?
Mr. M I N I S H . No questions.
Mr. REUSS. Mr. Harvey ?
Mr.
HARVEY. N O
questions.
THE FEDERAL RESERVE SYSTEM AFTER FIFTY YEARS
1081
Mr.REUss. Mr.Brock?
Mr. BROCK. Professor Brownlee, would you explain to me what you
mean by money supply ? W h a t consists of the money supply, as you
are referring to it in this discussion ?
Mr. BROWNLEE. The total currency, plus demand deposits, if there
are no restrictions on interest rates that can be paid by banks.
However, given our current restrictions, I would add in some portion of time and savings deposits.
But, generally, currency and demand deposits—the things against
which we can write checks, or use to pay our bills at the A. & P .
Mr. BROCK. NOW, you suggest that perhaps 3- to 4-percent increase
in the money supply would be a figure which we might adopt as something of a goal, overall monetary policy goal; is that correct ?
Mr. BROWNLEE. Yes.
Mr. BROCK. Would you
explain to me how you intend to go about
increasing this money supply ?
Mr. BROWNLEE. I could do it by open market operations. This is
my preferred procedure. That is in line with the Chairman's suggestion—or in line with the outcome which the Chairman wants to
achieve.
At the same time, we are reducing the amount of the interest-bearing
debt.
Mr. BROCK. You would do it by open market rather than other
techniques?
Mr. BROWNLEE. Primarily open market operations.
Mr. BROCK. H O W would you handle the reserve requirements of
banks if you were using open market operations ?
Mr. BROWNLEE. How would I handle the reserve requirements?
Mr. BROCK. Would you have a completely stable reserve requirement?
Mr. BROWNLE^. Yes.
Mr. BROCK. And you would not fluctuate that ?
Mr. BROWNLEE. N O .
Mr. BROCK. Your rediscount rate would be the same?
Mr. BROWNLEE. The rediscount rate would be the
same. Rediscounting is used primarily as a means of permitting banks to borrow
temporarily to obtain reserves.
Mr. BROCK. Well, it does give some discouragement, and thereby
affects the monetary supply.
Mr. BROWNLEE. Yes. But, again, if I understand correctly the way
the Federal Reserve operates, it doesn't permit the banks to rediscount
as much as they wish at the given rediscount rate, because at the
rediscount window, banks in general are discouraged from rediscounting.
Mr. BROCK. But you would fix a rediscount rate permanently, would
you?
Mr. BROWNLEE. Would I fix a rediscount rate permanently ? I don't
think I am really in a position to answer this question without giving
it some additional thought.
Mr. BROCK. Well, let's look at it this way. You defined monetary
supply in fairly restrictive terms, with which I would agree. But the
volume of loans is certainly a part of the overall supply of money. I t
affects it.
1082
THE FEDERAL RESERVE SYSTEM AFTER FIFTY YEARS
Mr. BROWNLEE. Well, it shows up in demand deposits primarily.
Mr. BROCK. S O either you are going to have a fixed rediscount rate,,
and use solely open market operations, or you are not, and you are
going to counterbalance open market operations with a change in the
rediscount rate.
Mr. BROWNLEE. Well, I think rediscounting is sufficiently small at
the present time so we can more or less neglect it. I think you are
asking me what kind of a role would I like rediscounting to play in
the monetary system.
And I don't think I am able, at the present time, to give you a satisfactory answer, because I have not thought about it sufficiently.
Mr. BROCK. Given a consistent fiscal policy, would a monetary policy, envisioning a 4-percent expansion annually—would it fairly well
insure a stable economy ?
Mr. BROWNLEE. Well, we cannot be sure of a stable economy. B u t
we probably get more stability this way than we do under existing
procedures, whereby we try to guess what is going to happen in the
future, miss frequently on such guesses, adopt anti-inflationary policies
in anticipation of inflation, when deflation actually is the outcome, or
adopt anti-deflationary policies in anticipation of deflation when
inflation is the outcome. We cannot expect perfect stability. But
it is my guess that we get more stability this way than with any other
procedure that I can think of.
Mr. BROCK. All right. Let's take the problem we face with financing of the Federal debt. One of the bills we have before us—I have
forgotten the number—provides for the amendment of the Federal
Reserve Act to provide for Federal Reserve support of Government
bonds when market yields equal or exceed 4 ^ percent. Would you
be in favor of a bill of that type ?
Mr. BROWNLEE. Would you repeat that ?
Mr. BROCK. What, in effect, the bill does is put a limit on the cost
of Government borrowing—it places a limit of 4 % percent.
Mr. BROWNLEE. I am opposed to this.
Mr. BROCK. May I ask Professor Brunner—are you in favor of this ?
Mr. BRUNNER. N O ; I could not support this bill.
Mr. BROCK. All right. Professor Brownlee, going back to your
statement, you were, as I understood it, actually in favor of monetizing
the debt. You made some statement to that effect.
Mr. BROWNLEE. I am in favor of monetizing it as rapidly as we can.
through such things as open-market operations; yes.
Mr. BROCK. How would you do it ?
Mr. BROWNLEE. Well, I think the chairman has already described it
for us. We are increasing the money supply annually, we say by
3 or 4 percent through open-market operations.
My guess is that this would involve purchases of Federal securities
on the order of a billion and a half dollars per year at the present
time. This is not a very rapid rate of monetization of the debt when
we consider there is about $150 billion of it to monetize.
Mr. BROCK. Well, in other words, it could take a hundred years.
Mr. BROWNLEE. T h a t is correct.
Mr. BROCK. W h a t would be the effect—let's say we have no increases,
no deficit spending, should the day ever come—if we had no more
deficit financing, and we are able to have strictly balanced budgets,
no excess of income over expenses or vice versa, at the end of 150
THE FEDERAL RESERVE SYSTEM AFTER FIFTY YEARS
1083
years, and you have succeeded in monetizing the debt, what would be
your monetary structure ?
Mr. BROWNLEE. Then we can start buying private debt. Open-market operations can consist of buying private bonds in place of Government bonds.
Mr. BROCK. I see. And your controls would consist at that point
then strictly dealing in private debt.
Mr. BROWNLEE. Yes, if there is no Government debt to buy. You
might wish to buy foreign debt. But I prefer General Motors bonds
to the bonds of Colombia or Bolivia.
Mr. BROCK. Well, in the meantime, say 20 years hence, what would
be the situation if your Federal Eeserve Open Market Committee had,
say, $40 billion in its portfolio ? Then let's take a situation in which
we had strong inflationary pressures on the economy.
Mr. BROWNLEE. Strong inflationary ?
Mr. BROCK. Yes. W h a t tools would they use to control the inflationary pressures ?
Mr. BROWKT.EE. Well
Mr. BROCK. Would you ask that they try to have any effect on inflation by price control ?
Mr. BROWNLEE. Will you repeat? Certainly they should be able
to sell securities as well as purchase them.
However, I think situations in which security sales would be called
for are relatively infrequent except in cases of large budget deficits.
Mr. BROCK. Should we get into a situation in which we may be
approaching, in which the United States is losing its markets overseas, and have a balance-of-payments problem—now, are you going to,
under your proposal—would you have the Federal Reserve take that
into consideration in its monetary policy ?
Mr. BROWNLEE. Well, I think it depends on the cause of this balance-of-payments deficit.
Mr. BROCK. Well, let's take the current situation.
Mr. BROWNLEE. Well, I think the current situation is one in which
the dollar is priced too high.
The dollar is relatively overvalued, and we should have some devaluation in order to cure the exchange problem. We can't use monetary
policy to do everything, and it is not appropriate to use monetary
policy to try to cure the exchange situation. We ought to have a more
flexible exchange rate.
Mr. BROCK. Then in relation to gold or in relation to what standard?
Mr. BROWNLEE. Well, the price of the dollar certainly is too high
in comparison with the price of the mark. Perhaps it is too high in
terms of the pound. These two are the principal Western European
currencies.
Mr. BROCK. I t would be difficult to change the price of the dollar
unless we took it off the gold standard, would it not ?
Mr. BROWNLEE. We are not on the gold standard at the present time.
We are willing to sell gold to foreigners, but not to natives.
Mr. BROCK. I remember Professor Heller, when he was before the
committee, suggested that if our situation continues to deteriorate, we
might have the situation where we would have to go off the gold standard, or at least remove gold as a reserve requirement behind our cur
1084
THE FEDERAL RESERVE SYSTEM AFTER FIFTY YEARS
rency within this country, and still maintain it for international payments. Is this a logical step ?
Mr. BROWNLEE. I see no logic to maintaining our current gold requirements for currency, because we really make no use of them, except
to sterilize a fairly good percentage of our total gold.
Mr. BROCK. B u t if we use it to pajr our international obligations,
and we guarantee a certain price relationship between the dollar and
gold, then when you say a more flexible exchange rate, you are asking
the other countries to make their currency more flexible in relation to
ours.
You are not asking us to take the difficult step of making ours flexible, are you?
Mr. BROWNLEE. Yes, I am asking us to take the difficult step of
making our currency more flexible.
The current price of $35 per ounce is to low for gold.
Mr. BROCK. The Federal Keserve would have no concern over this
balance-of-payments problem. Who should be concerned with fiscal
policy, Treasury ?
Mr. BROWNLEE. I t should not be the concern of the monetary authority, Federal Reserve.
Mr. BROCK. If we were as a matter of fiscal policy to change the
value of the dollar, would it not in effect have quite an effect on
monetary policy ?
Mr. BROWNLEE. If we were to change the value of the dollar ?
Mr. BROCK. Yes.
Mr. BROWNLEE. Well,
it will change the ratio of internal prices to
foreign prices.
Mr. BROCK. I t makes the dollar relatively more or less attractive,
doesn't it?
Mr. BROWNLEE. Yes, but it won't change the internal price level in
terms of dollars.
Mr. BROCK. B u t it could change the value of the dollar as related
to international circles. I n other words, there could be a great demand for the dollar overseas. Or we would have an outflux of dollars,
or influx—depending upon the fiscal policy of the Federal Government, which is not related to the monetary policy.
Mr. BROWNLEE. Well, it depends upon the price we set for the dollar relative to other currencies.
Mr. BROCK. I f we had a substantial change, you would have a substantial change in attitude toward the dollar ?
Mr. BROWNLEE. Our goods would become more attractive in foreign
markets, foreign goods would become less attractive in our markets,
and our balance of payments would become more favorable.
Mr. BROCK. And the attitude toward the dollar would change ?
Mr. BROWNLEE. Eight. The attitude toward the dollar in foreign
countries will change—but for purposes of acquiring U.S. goods.
Mr. BROCK. I f there were a substantial change in the attitude toward the dollar, and let's sajr we had an influx of a tremendous amount
of foreign currency, or foreign investments and so forth, if they like
our rate of interest, for example, over here, it would have a definite
effect upon the monetary supply in this country, would it not ?
Mr. BROWNLEE. Well, it will have a definite effect certainly upon
total purchases of goods and services in the country.
Mr. BROCK. Which is related to money supply ?
THE FEDERAL RESERVE SYSTEM AFTER FIFTY YEARS
1085
Mr. BROWNLEE. Well, it is true this is related to the money supply.
But the causal relationship runs the other way; that is, the money
supply effects primarily total purchases rather than the other way
around.
Mr. BROCK. W h a t I am getting at, and what seems to be a little
inconsistent to me about your theory—and I am not disagreeing, but
I am just trying to find out—it seems to me we might be trying to
operate in a vacuum, if we try to disassociate monetary policy from
fiscal policy. There has to be a causal relationship. And if we get
into a situation as you have just described, where there is a change
in the value of the dollar, and its appeal to other people, and we have
a built-in increase of 4 percent in this country, if we had at the same
time that that occurred strong inflationary tendencies in this country,
and if we had a strong influx from oversea currencies, we could have
a very difficult economic situation, because of inflation.
Mr. BROWNLEE. May I try to rephrase the situation as I think you
p u t it?
Imagine there is a strong increase in demand on the part of foreigners for U.S. goods. This is an inflationary disturbance, so to
speak.
Should we not offset this by appropriate monetary change ? I s that
your question?
Mr. BROCK. I am just asking, isn't there a cause and effect relationship which they should take into consideration ?
Mr. BROWNLEE. Well, I think it depends on whether or not this is
a permanent change in the demand on the part of foreigners or a
temporary change. If it were a permanent change, then certainly
we should and could take it into account. I f it is a temporary change,
I would be willing to ignore i t ; that is, this kind of thing one year is
offset by the opposite kind of thing the next.
Mr. BROCK. Thank you very much.
The CHAIRMAN. Mr. Hanna?
Mr. H A N N A . Thank you, Mr. Chairman.
I would like to welcome Professor Brunner here as a graduate from
UCLA. I am delighted to see my alma mater being represented in
these hearings.
I should like to ask both of the gentlemen this question.
I s it not true that neither the Federal Reserve System nor any of
the administrative agencies of the Government who have a responsibility in terms of, say, things like wages, prices, or employment, or
growth, can really operate isolated one from the other. I n other
words, do not these things have some interrelationship. Do not these
things interrelate ?
Mr. BRUNNER. Your question raises an issue which occurs implicitly
in statements frequently made by spokesmen of the Federal Reserve
System. Distinct agencies of the Government are seen to be responsible for different aspects of our economy. One agency is concerned
with monetary policy and monetary phenomena, another agency deals
with employment policy, a third one with price-wage policy, et cetera.
I n this manner a combination of policies are offered in separate comartments. Association of such diverse policy responsibilities with
ifferent agencies unavoidably raises a quest for coordination of the
separated and apparently independent policies.
S
1086
THE FEDERAL RESERVE SYSTEM AFTER FIFTY YEARS
This conception, frequently encountered, requires a careful clarification. Foremost, monetary policy affects via the monetary processes the pace of economic activity and the behavior of the price level.
Monetary policy is thus not directed at a monetary aspect of the economy, requiring complementation with an employment policy and
price-wage policy. Monetary policy generates impulses which are
transmitted to the behavior of employment, prices, and wages. I t is,
therefore, of crucial importance that monetary policy be framed in a
context which acknowledges this effect of monetary processes on the
economy. To this extent wTe require not an interrelation of diverse
policies, but an explicit recognition that monetary policy has systematic consequences on the volume of unemployment and the behavior
of prices and wages.
But there remains another aspect to your question which does bear
on coordinated policies of different agencies. Changes in demand
and production conditions continuously generate a reallocation of
our human and nonhuman resources. Unemployed resources are an
unavoidable byproduct of this reallocation process. The volume of
these unemployed resources depends on the reallocation pressures generated by changing demand and supply conditions on the one side
and the absorptive capacity of the market process on the other. This
kind of unemployment is not insensitive to, monetary expansion. B u t
a substantial absorption of such unemployment would very likely
require a rate of inflation we prefer to avoid. Other policies supply
probably more efficacious instruments to induce an appropriate absorption of reallocative unemployment. Such policies would operate to
improve the absorptive capacity of the market process. A variety of
institutional arrangements involving retraining, social mobility, information distribution, and so forth, could still be introduced to improve
our labor markets. Lastly, a sharp vigil against practices involving
restraint of trade would also raise the absorptive capacity of the
market process. I conclude thus that employment policy and pricewage policy may be properly listed as separate or independent
prongs of our general economic policy, provided they are specifically
concerned with the quality of the markets' absorptive capacity. To
this extent coordination or interrelation of policies meaningfully
exists.
Mr. H A N N A . Well, I would take it, then, you would say there is
a greater effect flowing from monetary policy into some of these other
fields than there is flowing back the other w^ay. But they are not
without some effect in the other flow.
Mr. BRTJNNER. Our investigations indicate a strongly marked
asymmetry. Monetary processes exert a substantially stronger influence on economic activity and prices than the later magnitude exert
on the monetary processes. I wish to emphasize this asymmetry because I wonder on occasion whether the Federal Reserve authorities
fully recognize the effect exerted by monetary policy on levels of
unemployment and the price level. I n particular, I wish to assure
myself that we do explicitly recognize that monetary policy reaches
beyond monetary phenomena and the credit markets.
On the other hand, it should also be acknowledged that monetary
policy yields no cure for all problems. Other kinds of policies have
to supplement monetary policy. Such policies can effectively improve
THE FEDERAL RESERVE SYSTEM AFTER FIFTY YEARS
1087
the efficiency of the market process and lower unemployment barely
responsive to monetary policy without substantial inflation.
Mr. H A N N A . Well, then, I think that from what you said I might
very well feel assured that to the degree that monetary policy is
treated as though it were looking down a tube at our economy, as
though it had had a totality all of its own, independent of anything
else, that would be incorrect—if we looked—if we have set our monetary policy with the idea that we didn't have to be too much concerned in these other fields, that it would be a mistake. And it would
seem to me that if you set one goal in terms of wages and another goal
in terms of employment, and then these found themselves up against
a conflict with monetary policy, you might be canceling out in some
degrees policies that are made by the same government, because
they didn't include their own interrelationships.
Couldn't we possibly have a monetary policy that would be exactly
contrary to some other policies within these other areas ?
Mr. BRUNNER. Such possibilities could certainly arise. I remember a classic case within the realm of monetary-fiscal policy which
occurred in Switzerland during the early postwar years. The Central
Bank was engaged in an anti-inflationary policy, while the treasury,
social security administration, and postal checking system proceeded
on a line which tended to offset the Central Bank's policy. But this
very possibility of conflict once more induces me to stress the urgency
of a carefully assessed and explicit conception concerning the nature
of the processes operated upon. Without a validated knowledge about
these processes and a relevant interpretation of the different policy
actions, it would be impossible to coordinate intelligently the various
policies.
Mr. B A N N A . I think we had a witness yesterday who suggested
that perhaps we need to coordinate in this field similarly as we have
done in the military field, in a sense of bringing together under one
command these people who necessarily must have policies and move
out into the same field of action. Would you feel that this might be
a productive move ?
Mr. BRTTNTNER. May I clarify your question, sir? Are you saying
that we should combine under one command, for instance, fiscal policy
and monetary policy ?
Mr. H A N N A . Well, there was suggested that there would be under
one, if you want to call it command—I think the analogy was made to
the military—that at least the policies be clarified through the Executive, since he would be the one person responsible for the state of the
economy on all of its fronts, and that there ought to be some kind of
central coordination, so that the movement of the economy would have
some total relationship, and that we would all be fighting in the same
war—they would not find themselves fighting each other.
Mr. BRUNNER. Coordination of policy does not require a single
agency concerned with the whole spectrum of economic policy. Such
coordination can be usefully achieved by means of a general frame laid
out by Congress. This frame may appear in form of a more explicit
mandate addressed to the Federal Reserve authorities. This mandate
should be specific enough to prohibit the gyrations observed in the
growth rate of the money supply, and to maintain this growth rate
within a limited ran^e—say, 3 to 4 percent. If this monetary
policy were clearly understood, other agencies would possess clear and
1088
THE FEDERAL RESERVE SYSTEM AFTER FIFTY YEARS
reliable expectations concerning the trends in monetary policy, and
proceed accordingly to discharge their own policy function.
Coordination of policy in the context under discussion is not so
much an organizational-institutional problem as a problem of reliable information based on relevant knowledge. This information
and knowledge could be most satisfactorily induced with the aid of
suitably explicit frameworks, or guidelines, formulated by Congress.
I would contend that coordination of policy achieved in this manner
can be expected to work adequately enough. I see no advantage in a
single administrative agency covering the whole of economic policy.
On the contrary, serious problems are likely to arise under such a
concentration of administrative functions.
Mr. H A N N A . YOU think we could do this and still have the flexibility
that we need to adjust to the changes ?
Mr. BRUNNER. I beg your pardon?
Mr. H A N N A . D O you think we could maintain a flexible posture, and
still carry out such coordination ?
Mr. BRUNNER. Yes, I think so.
Mr. H A N N A . That is all, Mr. Chairman.
The CHAIRMAN. Mr. Harvey ?
Mr. HARVEY. I have no questions, Mr. Chairman.
Mr. BROCK.. I would like to follow up one point.
The CHAIRMAN. YOU may proceed, sir.
Mr. BROCK. Professor Brunner, in Mr. Hanna's question—I think
what you were seeking is that, if we got into a period of, say, economic
distress, would we by this approach limit the ability of the monetary
policy to respond to need by pumping more money into the economy ?
Mr. H A N N A . T h a t was in my question about would we impair the
flexibility.
I n other words, I am sure if anybody suggested such an
idea that the most obvious defense would be that you would lose this
flexibility.
Now, I am not convinced that you would. That is why I would
like to have these experts' testimony whether you would or not. If we
would, this would be certainly a very strong defense.
Mr. BROCK. Well, I would like either one of you to answer what
would be the response of either our fiscal or monetary policy if a situation of deflation and depression were to occur. Are we still under the
philosophy that we use pump priming, for example? Would we,
rather than increase the money supply, substitute Federal spending for
that increase in the money supply ? W h a t tools would be used to slow
down a recession ?
Mr. BROWNLEE. I think that it depends on what caused the recession. Many of the fluctuations that have taken place, particularly in
the postwar period, are the responsibility of the Government. If, for
example, the recessions were brought about by declines in Federal
spending without declines in taxes, or if we maintained the current
or proposed tax schedule with no increases in Federal spending over
the next few years, then, of course, while this could be compensated
for by monetary policy—we are really not tackling the cause when we
use monetary policy to try to solve this particular problem.
We were talking about this kind of case when Mr. Keuss was in
the chair. We were postulating essentially a sane-type fiscal policy,
in which case I think we don't need this overall military-type
organization.
THE FEDERAL RESERVE SYSTEM AFTER FIFTY YEARS
1089
To comment on Mr. Hanna's question, I don't think any one person,
or any one agency, ought to be responsible for the state of the economy.
I don't think we ought to have a wage policy other than we ought to
have wages flexible enough so that labor can shift from one sector
of the economy to the other.
And the monetary authorities should not have an employment goal,
but a gross-national-product goal, in money terms; and this should
be translated into a quantity-of-money goal, nothing more. I n this
sense, the overall military-type organization, I don't think, is really
appropriate.
Mr. BROCK. Well, in your proposal of having a fixed rate of increase,
somewhere between 3 and 4 percent increase in the monetary supply,
you are eliminating monetary policy as a factor in determining the
actions we take in a recession or inflation.
Mr. BROWNLEE. Well, I would consider this 3 or 4 percent something like the Constitution. Obviously, it is something that could be
amended. First of all, we don't know whether it should be 3, 4, or 5
percent. We will have to do some experimenting to know what goes
on.
Secondly, if a situation should come up, where it was obviously appropriate to have a larger or smaller increase, we ought to make it.
Mr. BROCK. Well, let me ask you this: I n a recession, obviously—or
at least it is obvious to me—but obviously, to me, the demand for loans,
the demand for money, decreases in a recession.
Mr. BROWNLEE. Sometimes a recession can be caused by an increase
in the demand for money.
Mr. BROCK. "Which came first, the hen or the egg?" is not the
point. The point is that during a recession you have a lessening of
demand for money. Is this a fair statement ?
Mr. BROWNLEE. Well, insofar as income falls, and the demand for
money depends upon income, the answer is correct.
Mr. BRUNNER. May I ask a clarifying question, sir? You were
referring simultaneously to the demand for money and the demand
for loans. I t is very important to distinguish sharply these two
demand patterns. The demand for money summarizes the response
of the public's money balances to changes in market conditions, and
the public's wealth position, and the demand for loans describes the
response of the public's indebtedness—or rate of indebtedness—to
banks to changes the same magnitudes. They play a radically different
role in our economy's monetary process.
Mr. BROCK. YOU are entirely correct. I meant the demand for
loans, because
Mr. BRTJNNER. I thought so. Thank you.
Mr. BROCK. The velocity of money also would fall, would it not?
Mr. BRUNNER. Yes.
Mr. BROCK. Isn't this
a prime factor in the money supply in the
country ?
Mr. BRTJNNER. N O , sir. Velocity has no direct effect on the money
supply. Both have one determinant in common—namely, the prevailing interest rates. But this common determinant plays a very asymmetric role. Interest rates decisively shape the behavior of velocity.
Some other factors also contribute systematically to affect velocity
behavior. Money supply, on the other hand, is only marginally influenced by interest rates. The money supply is dominated by the
1090
THE FEDERAL RESERVE SYSTEM AFTER FIFTY YEARS
extended base, a magnitude emerging from the policy actions of the
Federal Eeserve authorities.
Mr. BROCK. Well, in the depression days, was the velocity of money
high?
Mr. BRUNNER. N O , sir. Velocity moves with the cycle. Moreover,
the data reveal that the cyclic changes of velocity exhibit, in the average, an order of magnitude similar to the cyclic changes in the money
supply.
Mr. BROCK. Well, in other words, in good times your velocity increases.
Mr. BRUNNER. T h a t is right.
Mr. BROCK. I n bad times, it decreases.
Mr. BRUNNER. That is right.
Mr. BROCK. SO, if you had a stable rate of influx of money—increase
in the monetary supply—it would have no positive effect, really, in a
depression, because the demand for loans would be nonexistent, the
psychology of the Nation would be poor, and the economy would be
falling.
Mr. BRTTNNER. N O , that is not correct, sir.
Mr. BROCK. Well, you just said that it was true
Mr. BRUNNER. N O , sir. There is no doubt about the cyclic behavior
of changes in velocity and the money supply, and in particular, also of
velocity itself. The evidence is clear on this point. But nothing
whatever can be inferred from this observation with respect to the
effectiveness of monetary policy. As a matter of fact, these observations are consistent with our hypotheses explaining the behavior of
velocity and the money supply, hypotheses implying the continued effectiveness of monetary policy.
Our detailed investigations covering both interwar and postwar
periods strongly suggest that the deflationary phase of the thirties
did not render monetary policy impotent. I n particular, the demand
for loans remained sensitive to variations in interest rates.
Monetary policy was not powerless, it was simply not used. The
tremendous expansion of the money supply, initiated in 1933, was
perhaps the single most important factor contributing to the recovery.
I t is noteworthy, however, that this expansion was not due to policy
actions but resulted from the inflow of gold. Monetary policy contributed nothing to the upswing, but was very likely a major cause of
its termination in 1937.
Mr. BROCK. Let me pursue that from a different tack. I n the depression days, what if you had a fixed input of money, and as Professor Brownlee has suggested, we used the Open Market Committee
Mr. BROWNLEE. Open market operations.
Mr. BROCK. Yes, the operations of the Open Market Committee.
If there isn't a demand for loans, Professor Brownlee, what effect
would it have, if you had an expansionary policy ?
Mr. BROWNLEE. If there isn't a demand for loans ?
Mr. BROCK.
Yes.
THE FEDERAL RESERVE SYSTEM AFTER FIFTY YEARS
1091
Mr. BROWNLEE. Let's go back to your first question. You asked
essentially should we use, or should we try to use, monetary policy to
offset depressions, or inflation. My answer is "No"—I want to stick
to this 3- to 4-percent rate of increase in the money supply, although
if there were some really disastrous disturbance of an inflationary or
deflationary nature, I would alter this.
I n general, if there is a reduction in the demand for loans, this
shows up in a reduction in interest rates, and some larger quantity
of loans at this lower rate of interest than would have been taken out at
higher interest rates. That is, the interest rates adjust the demand
and supply for loans. And I would expect relatively small fluctuations
in this under the kind of policy which I am proposing.
I n answer to your question, obviously you cannot force people to
take loans if they don't want to borrow money. But you can induce
them to take loans—borrow money—to make purchases at lower rates
of interest.
Mr. BROCK. Logically, those that have money would be competing
to put it to work, and they would cut their rates of interest in order
to attract more borrowers.
Mr. BROWNLEE, Yes.
Mr. BROCK. But if we
are going to eliminate—you almost are eliminating monetary policy as a factor
Mr. BROWNLEE. I am proposing that we eliminate discretion in
monetary policy.
Mr. BROCK. That is right. So you would not change your policy to
take into account one year, a change in the economic situation.
Mr. BROWNLEE. That is right.
Mr. BROCK. Would you tell me what policy you would use ?
Mr. BROWNXEE. First of all, I would not expect drastic year-to-year
changes. But in the event we did have a large inflationary shock, I
might follow on a tighter monetary policy. However, I would not
change my policy, noting that the cost of living index had gone up,
say, one-tenth of a point or gone down one-tenth of a point, or perhaps
even 1 point.
Mr. BROCK. Well, you are not going to use monetary policy over the
short range, then you are going to use fiscal policv.
W h a t fiscal policv would you suggest ? A sliding tax rate ?
Mr. BROWNLEE. N O . Essentially having the tax system such that the
budget would balance at the gross national product which is desired.
That is, if we want a $630 billion gross national product, we want the
tax system set up so that budget would approximately balance at $630
billion gross national product.
Mr. BROCK. All right.
If we set out these goals—of course, the function of this committee
is to try to determine what procedures are necessary—if we were to set
certain basic goals for monetary policy, should we define them by law at
a fixed percentage, give them a range from 3 to 4, or should we say
that the goal of monetary policy is to provide a fairly consistent rate
of increase in the money supply ?
1092
THE FEDERAL RESERVE SYSTEM AFTER FIFTY YEARS
Mr. BROWNLEE. I think I would start with the latter. But if I
found that the monetary authorities were not following this, then I
might legislate a number, such as 3 or 4 percent.
The CHAIRMAN. Mr. Brock, may I interrupt just a minute, please'?
Our bill comes up first thing, at 12 o'clock, and we have been notified.
I f it is all right with you gentlemen, we will ask you in writing any
additional questions after you look over your transcript. Will that t>e
all right?
Mr. BROOK. Yes,
sir.
The CHAIRMAN. Thank you very much. We will recess until 10
o'clock in the morning. Thank you, gentlemen, very much.
(Whereupon, at 11:50 a.m., the committee recessed, to reconvene at
10 a.m., Thursday, February 27,1964.)
THE FEDERAL RESERVE SYSTEM AFTER 50 YEARS
THURSDAY, FEBRUARY 27, 1964
HOUSE OF REPRESENTATIVES,
SUBCOMMITTEE ON DOMESTIC F I N A N C E OF THE
COMMITTEE ON BANKING AND CURRENCY,
Washington, D.C.
The subcommittee met, pursuant to recess, at 10 a.m., in room 1301,
Longworth House Office Building, Hon. Wright Patman (chairman)
presiding.
Present: Representatives Patman, Eeuss, Hanna, and Widnall.
The CHAIRMAN. The committee will please come to order.
A t this point I would like to put in the record the statement I mentioned yesterday comparing the salaries of high-ranking Government
officials and the salaries of other Government officials working for the
Federal Reserve, commencing with the President of the United States,
$100,000. Next is the President of the Federal Reserve Bank of New
York, $70,000, and then the President of the Federal Reserve Bank of
Chicago, $55,000. I t gives several pages of the higher salaries in Government. I t will be placed in the record at this point.
(The statement referred to follows:)
W I D E VARIANCES I N T O P SALARIES RECEIVED BY FEDERAL RESERVE B A N K
EMPLOYEES AND THOSE OF OTHER U.S. GOVERNMENT EMPLOYEES
I n our system of government, why do we have an appropriations
process ? Why do we have authorization hearings, authorization bills,
appropriation hearings, appropriation bills, and all the rest of it?
I s it because we do not trust the specific individuals who are put in
charge of the agencies in question ? Of course not. I s it because the
Congress sees fit to interfere with the petty, day-to-day matters that
occupy so much of the energy of the agencies and departments? Of
course it is not.
We have the appropriations process, with all its cumbersome machinery and sometimes irritating delays, because it safeguards the fundamental right of the people to be governed by their elected representatives.
What happens when an independent agency like the Federal Reserve
System gets away from the tried and true American system of checks
and balances and proper auditing is pointed up by the list of top salaries of our principal Government officials, including Federal Reserve
topkicks.
The inequities are so glaring that I am certain the Congress will
want to do something aoout them. When the American people learn
1093
1094
THE FEDERAL RESERVE SYSTEM AFTER FIFTY YEARS
about these absurd inequities, I am certain that they will insist that
the Congress do something about them.
Our staff made a comparative analysis of the highest paid officials
on the public payroll of the United States and the Federal Reserve
banking system. Just as Government officials are paid by the American taxpayer, so, too, are the officials of the Federal Reserve System.
I t is interesting to see how many of these high-bracket individuals
come from the Federal Reserve banks. I t is convincing evidence that
the officials of the Federal Reserve System are rather generous in setting salaries for themselves, because, as I have indicated, the ordinary
checks and balances do not affect the Federal Reserve people and they
do not submit to an audit by the General Accounting Office, as do
other Government and semigovernmental agencies.
Let us look at some of these absurd inequities. I t will come as a
shock to most Americans that the second highest paid salary paid
for by the taxpayers, the one right next to the President, goes to the
President of the New York Federal Reserve Bank. How absurd that
he receives twice as much as the Chief Justice of the United States;
twice as much as the Speaker of the House of Representatives; how
utterly ridiculous that he receives twice as much as the Vice President
of the United States.
How absurd that the Presidents of the Federal Reserve Banks of
Atlanta, Cleveland, and Richmond get $40,000—$15,000 more than
the Secretary of State of the United States, and $15,000 more than
the Secretary of the Treasury of the United States.
The appropriations process is one of the basic and most important
tools for the protection of the principles of our American system.
Now, you don't have to have appropriations, because there is an
alternative. You can have back-door financing instead, where an
agency gets its money through the "back door," as it were, and spends
the money without accounting to anyone, and without an independent
audit by any other Government agency.
But where is the protection in tliat li Where is the Congress control
over public policy ? Where is the people's control over how and where
their tax dollars are spent ?
I t is just like in the old days, when a farmer sent his sons to town
for feed and supplies, and he would toss them his purse full of money,
without counting it, and he would tell them what to go and buy.
And they would go and buy it, and come back, and they would toss the
purse back to their father, and he would put it in his pocket without
opening it and without counting it to see what was inside and what
they had spent.
H e was entirely at their mercy, and if they were honest, all right,
and if they were not, he had no way of knowing and no protection.
And he had no way of knowing how they spent the money, even if
they were honest and didn't steal, he had no way of knowing whether
they spent it wisely, and paid the lowest price for what they got,
and didn't waste it.
Now, that is precisely how the Federal Reserve System, which spent
about $200 million of the people's money last year, that is how the
Federal Reserve operates.
How does the Fed get its money? Do they come up here for authorizations and appropriations ? They do not. Ninety-nine percent
of the Federal Reserve's income last year came from the interest on
THE FEDERAL RESERVE SYSTEM AFTER FIFTY YEARS
1095
their portfolio of Government securities, and that interest, of course,
is paid by the taxpayers of the United States. I t is Government
money and the people's money.
And they take that money—about a billion dollars a year—and
they spend what they want, how they want it—last year they spent
about $200 million—and then they turn the rest back to their father.
And in 50 years they have never had an independent audit of any
kind.
Now, that is back-door financing at its very worst—no appropriations hearings, no safeguards, no congressional control over public
policy decisions, no control by the people over how their money is
spent, no safeguards against theft, no safeguards against waste.
During the hearings we are holding on the Federal Reserve, witnesses from the Fed have repeatedly made statements that they were
insulted that anyone was impugning their individual honesty and
competence by suggesting they should have an audit, or come under
the appropriations process.
That line of argument misses the point entirely. I am not, never
have, and I hope, never will accuse these men individually or collectively of dishonesty and incompetence. No one is making such a
charge. The point is that ours is a government of laws not men
and we built in safeguards like the appropriations process so that no
matter what kind of men run the system, there are still safeguards
against misuse of funds and misuse of authority.
If you give a man the authority to make some vital decision like
determining the interest rate that will be charged on any loan or
debt in the United States, including the public debt, it isn't enough
to say, "Well, that's an honest man, I know him, he's a good man and
he would never steal a dime." I t isn't enough. You've got to say,
"Well, I know it's all right, because every year he has to come before
the Congress and justify his salary and his expenses to the appropriations committees, and he only spends what they allow him to spend,
so we have those safeguards over how he behaves."
So I think this is very bad business, and I think that we should all
look very carefully at how the Fed spends its money, which they get
from the taxpayers without appropriations from anybody.
Annual salaries of the principal Federal officials including the highest paid
officials of the Federal Reserve System, January 5,1964
President of the United States
President, Federal Reserve Bank, New York
President, Federal Reserve Bank, Chicago
President, Federal Reserve Bank, Philadelphia
President, Federal Reserve Bank, Cleveland
President, Federal Reserve Bank, Richmond
President, Federal Reserve Bank, Atlanta
President, Federal Reserve Bank, Minneapolis
President, Federal Reserve Bank, Dallas
President, Federal Reserve Bank, San Francisco
First Vice President, Federal Reserve Bank, New York
President, Federal Reserve Bank, Kansas City
Vice President and Senior Adviser, Federal Reserve Bank, New York
Chief Justice of the United States
President, Federal Reserve Bank, Boston
President, Federal Reserve Bank, St. Louis
Vice President, Federal Reserve Bank, New York
Vice President of the United States
28-680—64—vol. 2
12
$100,000
70,000
55, 000
40,000
40.000
40,000
40,000
40,000
40,000
40,000
40,000
37,500
37, 500
35,500
35,000
35,000
35, 000
35,000
1096
THE FEDERAL RESERVE SYSTEM AFTER FIFTY YEARS
Annual salaries of the principal Federal officials including the highest paid
officials of the Federal Reserve System, January 5, 1964—Continued
President of the Senate pro tempore, when there is no Vice President
of the United States
$35, 000
Speaker of the House of Representatives
35,000
Associate Justices of the Supreme Court
35, 000
Vice President, Federal Reserve Bank, New York
32, 500
Vice President, Federal Reserve Bank, New York
31, 500
First Vice President, Federal Reserve Bank, Kansas City
30, 000
Vice President, Federal Reserve Bank, New York
29, 000
Vice President and General Counsel, Federal Reserve Bank, New York. 28, 500
Vice President, Federal Reserve Bank, New York
28, 000
Adviser to the Board, Board of Governors of the Federal Reserve System
27,50O
First Vice Presidents, Federal Reserve Banks of Boston, Philadelphia,
Richmond, Chicago, St. Louis, and San Francisco
27, 500
First Vice President and General Counsel, Federal Reserve Bank,
Atlanta
27,500
Vice Presidents (2), Federal Reserve Bank, New York
27, 500
U.S. Representative to the United Nations and Representative in the
Security Council
27, 50O
U.S. Permanent Representative to the North Atlantic Treaty Organization
27,500
Ambassador at Large
27, 500
Chiefs of Mission, class 1, Foreign Service
27, 500
Vice President, Federal Reserve Bank, San Francisco
26, 500
Adviser to the Board, Board of Governors of the Federal Reserve System
26,000
Secretary of the Board, Board of Governors of the Federal Reserve System
26,000
General Counsel, Board of Governors of the Federal Reserve System
26, 000
Vice President, Federal Reserve Bank, New York
26, 000
Assistant Vice President, Federal Reserve Bank, New York
25, 500
Circuit judges, U.S. courts of appeals
25, 500
Chief Judge and Associate Judges, U.S. Court of Claims
25, 500
Chief Judge and Associate Judges, U.S. Court of Customs and Patent
Appeals
25, 500
Judges, U.S. Court of Military Appeals
25, 500
Director, Division of Research and Statistics, Board of Governors of
the Federal Reserve System
25, 000
Director, Division of Examinations, Board of Governors of the Federal
Reserve System
25, 000
First Vice Presidents, Federal Reserve Banks of Cleveland, Minneapolis, and Dallas
25, 000
Vice President and Senior Adviser, Federal Reserve Bank, Richmond
25, 000
Vice President and Cashier, Federal Reserve Bank, Philadelphia
25', 000
Assistant General Counsel, Federal Reserve Bank, New York
25, 000
Secretary of State
25, 000
Secretary of the Treasury
25,000
Secretary of Defense
25, 000
Attorney General
25, 000
Postmaster General
25, 000
Secretary of the Interior
25,000
Secretary of Agriculture
25, 000
Secretary of Commerce
25, 000
Secretary of Labor
25, 000
Secretary of Health, Education, and Welfare
25,000
Deputy U.S. Representative to the United Nations and Deputy Representative in the Security Council
25, 000
Deputy U.S. Representative in the Security Council, United Nations
25, 000
Chiefs of Missions, class 2, Foreign Service
25, 000
U.S. Representative to the Organization for Economic Cooperation and
Development
25,000
U.S. Representative, European Communities
25, 000
U.S. Representative on the Council of the Organization of American
States
25,000
Special Representative for Trade Negotiations
25,000'
T H E FEDERAL RESERVE SYSTEM AFTER FIFTY YEARS
1097
Annual salaries of the principal Federal officials including the highest
paid
officials of the Federal Reserve System, January 5,
1964—Continued
Director, Office of Emergency P l a n n i n g
Associate Directors ( 2 ) , Division of Research a n d Statistics, B o a r d of
Governors of t h e F e d e r a l Reserve System
Senior Vice President, Economic Research, F e d e r a l Reserve Bank,
K a n s a s City
Vice President, F e d e r a l Reserve Bank, D a l l a s
Assistant Vice President, F e d e r a l Reserve Bank, New York
Adviser, I n t e r n a t i o n a l Finance, B o a r d of Governors of t h e F e d e r a l
(Reserve System
Director, Division of B a n k Operations, B o a r d of Governors of t h e
F e d e r a l Reserve System
Vice President, General Counsel, and Secretary, F e d e r a l Reserve Bank,
Chicago
Vice Presidents, F e d e r a l Reserve B a n k s of New York a n d Chicago
Assistant to t h e Board, B o a r d of Governors of t h e F e d e r a l Reserve
System
Adviser, Research a n d Statistics, B o a r d of Governors of t h e F e d e r a l
Reserve System
Assistant General Counsel, B o a r d of Governors of t h e F e d e r a l Reserve
System
Vice President a n d Secretary, F e d e r a l Reserve Bank, St. Louis
Vice President a n d Cashier, F e d e r a l Reserve Bank, Chicago
Vice Presidents, F e d e r a l Reserve B a n k s of Cleveland (2) a n d ChicagoGeneral Auditor, F e d e r a l Reserve Bank, Chicago
Medical Director, F e d e r a l Reserve Bank, New York
Economic Advisor, F e d e r a l Reserve Bank, New York
Chief J u d g e of t h e U.S. District Court for t h e D i s t r i c t of C o l u m b i a —
Legislative Counsel, B o a r d of Governors of t h e F e d e r a l Reserve
System
Vice President a n d Secretary, F e d e r a l Reserve Bank, Minneapolis
Vice President a n d Secretary, F e d e r a l Reserve Bank, Dallas
Vice Presidents, F e d e r a l Reserve B a n k s of Cleveland and St. Louis—
District judges, U.S. district courts
Judges, T a x Court of t h e United States
Judges, U.S. Customs Court
Director of the B u r e a u of t h e Budget
Comptroller General of t h e United States
Under Secretary of S t a t e
Deputy Secretary of Defense
U.S. Representative in t h e Economic and Social Council, United
Nations
U.S. Representative in t h e Trusteeship Council, United Nations
Chiefs of Missions, class 3, Foreign Service
Director, Office of Science a n d Technology
Deputy Special Representative for T r a d e Negotiations
Administrator, Agency for I n t e r n a t i o n a l Development
Chairman, Atomic Energy Commission
Administrator, F e d e r a l Aviation Agency
Administrator, National Aeronautics and Space Administration
Director, U.S. A r m s Control a n d D i s a r m a m e n t Agency
Members of Congress
Postmaster, San Francisco
Postmaster, Dallas
Postmaster, Minneapolis
Postmaster, New York
Postmaster, Chicago
Postmaster, Philadelphia
Postmaster, Cleveland
Postmaster, Boston
Postmaster, St. Louis
Postmaster, K a n s a s City
Postmaster, A t l a n t a
Postmaster, Richmond
$25, 000
24,500
24, 500
24, 500
24,250
24^ 000
24, 000
24,000
24,000
23,500
23, 500
23,000
23,000
23, 000
23,000
23,000
23, 000
23, 000
23, 000
22,500
22, 500
22, 500
22, 500
22, 500
22, 500
22,500
22, 500
22, 500
22, 500
22, 500
22,500
22, 500
22, 500
22, 500
22, 500
22, 500
22, 500
22, 500
22, 500
22, 500
22, 500
18, 500
18, 465
18,465
18, 250
17,750
17, 500
17, 000
17, 500
17,500
15, 990
15, 000
14,075
1098
THE FEDERAL RESERVE SYSTEM AFTER FIFTY YEARS
I n looking over the listing of salaries, bear in mind that those of
officers and employees of the Federal Reserve banks are fixed by their
respective boards of directors, subject to the approval of the Board of
Governors of the Federal Eeserve System. Salaries of members of the
Board's staff are fixed by the Board. All other salaries listed are
fixed by law. This includes the Governors.
The CHAIRMAN. Today, we are going to hear from two more outstanding economists, Prof. E l i Shapiro, of the Graduate School of
Business of H a r v a r d University; and Prof. Paul A. Samuelson, of
MIT.
Professor Shapiro was a Deputy Director of Research for the Commission on Money and Credit.
Professor Samuelson is the author of the most widely read text on
economics and many other works. I am sure we will benefit greatly
from today's testimony.
Professor Samuelson, I notice you have a prepared statement and
Professor Shapiro, too. They have been submitted to the committee
and we have passed them out.
This committee is divided up into eight subcommittees and three of
those subcommittees are meeting today, which takes some of our people
away, but they are following this testimony rather closely.
W e get the benefit of it the next morning. This morning we received
yesterday's testimony and tomorrow morning we will receive today's
testimony.
The members are very much interested in this and they are giving
it careful consideration.
W e appreciate your coming down, gentlemen. We appreciate hearing from you and, Professor Shapiro, you may start first. If you
would like to just put your statement in the record at the point where
you commence, and not read it unless you desire to do so, but emphasize
the points that you would like to emphasize, please do so.
Professor Shapiro.
STATEMENT OF PROF. E U SHAPIRO, HARVARD TTNIVERSITY,
CAMBRIDGE, MASS.
Mr. SHAPIRO. Thank you very much, Mr. Chairman.
The CHAIRMAN. All right, Professor Shapiro, you may proceed.
Mr. SHAPIRO. Mr. Chairman, I am pleased to testify this morning
on the question of measures affecting the organizational structure of
the Federal Eeserve System. To be present with an old friend and
former colleague merely adds to this pleasure. As I understand from
my correspondence with your able clerk and staff director, the committee is also interested in the "tenor of monetary policy" at the
present time.
I would like to state at the outset that I regard an examination of
possible changes in monetary arrangements in the United States
as a desirable and necessary continuous surveillance of the central
bank by the Congress to which it is responsible. I firmly believe
that structural reforms in our monetary system should be undertaken when the need for such reforms is demonstrated.
THE FEDERAL RESERVE SYSTEM AFTER FIFTY YEARS
1099
I do regret, however, the intrusion of consideration of the ''tenor of
monetary policy" into these proceedings. I say this because even
if the present course of monetary policy were letter perfect, it should
not preclude the discussion and enactment of necessary structural
changes which might improve the effective discharge of monetary
policy in this country in the future.
I t is my fond hope and expectation that the stabilization authorities
in our society will learn to disassociate permanent, structural changes
from short-run cyclical stabilization tactics. F o r if there is one
lesson to be learned from past stabilization experience, it is that many
proposals for cyclical stabilization, which by their nature require
speedy action, are often bogged down in procedural questions on
the assumption that the short-run change is in fact a permanent
feature of our legislative code. If our stabilization record in the
future is to show improvement over past performance, I believe we
must learn this lesson well.
One of the basic proposals before this committee is the need for
and desirability of changing the institutional arrangements prevailing
in the central banking system in this country. I t is regrettable that
discussion pertaining to such changes often degenerates into name
calling and bandying about of cliches. These tend to obscure the fact
that the underlying changes which have taken place in our explicit
economic goals, in the array of policy instruments available to attain
these goals as well as the changes in the political setting, require that
we reexamine the organization of the Government's stabilization
agencies.
And let me try to give some examples of what I have in mind.
As an example of the changes to which I refer, when the Federal
Reserve Act was passed in 1913, the only explicit goal of economic
policy was price stabilization. Since this was the only goal and the
only widely accepted instrument for achieving this goal was monetary
policy, there was no conflict of agencies and no need for integrating
policy objectives.
With the passage of years, however, another major objective of
policy; namely, full employment, was introduced into the body politic.
During this same period, fiscal policy or the relationship between
Federal expenditures and revenues was recognized as a major contributor to the attainment of these goals. As the desire for economic
growth was added to the array of goals, both sets of instruments were
seen to be useful in achieving these goals. However, the increase in
the number of goals gave rise to the possibility of conflicts among
them. There thereby arose the need to make choices.
Since policy decisions are made by different agencies and since these
decisions require trade-offs to be made among the various goals, our
stabilization strategy requires coordination among the agencies to
insure the pursuit of a common end. F o r if one agency takes price
stability to be the critical goal and pursues policies appropriate to the
attainment of that goal, while other agencies deem full employment
or economic growth to be the more important objective of policy, we
will observe conflicting policies which may indeed prevent the attainment of any of these goals.
For example, if the central bank, in its interest in price stability,
maintains a monetary policy which dampens demand, the fiscal
1100
THE FEDERAL RESERVE SYSTEM AFTER FIFTY YEARS
policy of the Government in attempting to offset this policy will be
forced to run larger deficits. W i t h a deficit of sufficient size, it may
be possible to offset this restrictive monetary policy.
However, we get a larger deficit than would otherwise be necessary
to achieve and maintain full employment and thereby reduce national
saving. I n addition, the restrictive monetary policy results in higher
interest rates and by lessening investment results in a lower growth
rate at that full employment level. I cite this example simply to
make clear the fact that the independent pursuit of different goals
may make more costly the attainment of any one of them.
j u s t as these goals and instruments have changed over time, so too
have our notions of the appropriate structure of the central bank
in this country. I t is well to recall that the Aldrich Commission proposed a central banking system to be called the National Reserve
Association, a corporation with capital subscribed by its member
banks and controlled by them. Among the issues fought in the 1912
campaign was the question of the form which central banking was t o
take in this country.
W i t h their victory in that election, the Democrats pushed vigorously by President Wilson, passed the Federal Reserve Act- The
party in power denied the regional Reserve banks the right to be
represented on the Board and were responsible for making the Secretary of the Treasury the Chairman of the Federal Reserve Board,
thus establishing the principle that the monetary authority was a
public body.
I n the inevitable compromises attendant on this conflict, a complex
structure called the Federal Reserve System was created. Commercial banks were represented as owners of the regional banks. The
officers of the latter, in turn, while elected by the commercial banks,
were subject to approval by the Federal Reserve Board. Thus banking representation was assured and concessions to the regional needs
of the country were incorporated in the 1913 act.
I n 1935, the only major overhaul of the Federal Reserve System
was enacted. In general the 1935 act centralized power in the Federal
Reserve Board. At the same time, Treasury representation on the
Board was terminated. The Federal Reserve Board was given explicit power to change rediscount rates recommended by the regional
banks and the Board was given sole control over the variable reserve
requirement that was enacted. The Open Market Committee, the most
influential body of the Federal Reserve System, was to be composed
of the regional Reserve banks, of which the New York bank was to
hp, a nermarierit member.
I should add, in addition, that prior to 1935 the Open Market Committee was constituted, as I recall, exclusively of the regional bank
officers, as was pointed out to me earlier this morning. So that in
point of fact the 1935 act may be interpreted
The CHAIRMAN. May I interrupt you there ?
Mr. SHAPIRO. Yes, sir.
The CHAIRMAN. I t is my
understanding that the Open Market Committee, under the act of 1933, was composed of the designated Governors of each of the 12 Federal Reserve banks. It remained that wav
until the 1935 act.
THE FEDERAL RESERVE SYSTEM AFTER FIFTY YEARS
1101
I believe that is correct.
Mr. SHAPIRO. I believe you are correct, Mr. Chairman. I was referring earlier to
•
The CHAIRMAN. Preceding that, they had informal meetings of a
group that they referred to as the Open Market Committee—an official group—but recognized by the Board, as I understand it.
Is that your understanding, Professor Samuelson ?
Mr. SAMUELSON. I think so.
The CHAIRMAN. All right; fine. Thank you.
Mr. SHAPIRO. While further centralization of central banking was
reflected in the 1935 legislation, the regional banks were still left with
an important participation in the policymaking role. My review of
the evolution of the central bank in this country is meant to suggest
that we have no idee fixe on what is the "perfect" structure for a central bank.
Control over the money supply of the Nation is a vital operating
responsibility for stabilization in our economy. As such it is desirable that the central bank's activities should be harmonious with the
other stabilization activities of the Government. How this is done
is perhaps less important than that it should be done. At one extreme
it has been suggested that the central bank should be a part of the
Treasury.
On the other hand, there are those who would preserve the autonomy
of the central bank from any Government pressure. Our own central
bank occupies a position midway between these extremes. I t operates under a congressional mandate which can be charged should the
Congress be dissatisfied with the Fed's conduct of policy.
Since the congressional act is broad in scope and provides wide
discretion to the monetary authority, there remains a great deal of
latitude within which the Reserve System can operate. I t is precisely
because of this degree of freedom open to the central bank that we
must strive to eradicate any elements of doubt about its responsiveness to the public will and the discharge of its obligations as a Government agency.
Because of historical anachronisms, the present structure of our
Federal Reserve System contains many vestigial remains which positively do it no good and, in point of fact, lead to suspicion as to its
ultimate motivations. Precisely because I am interested in maintaining the presence of a central bank midway between these polar
positions, I tend to support the following recommendations on Federal
Reserve structure which were put forth by the Commission on Money
and Credit.
The F R B Chairman and Vice Chairman should be designated by
the President from among the Board's membership, to serve for 4-year
terms coterminous with the President's.
The F R B should consist of five members, with overlapping 10-year
terms, one expiring each odd-numbered year; members should be
eligible for reappointment.
Occupational and geographical qualifications for Board members
should be eliminated. Instead, the statute should stipulate that members shall be positively qualified by experience or education, competence, independence, and objectivity commensurate with their responsibilities. Salaries of top officials throughout the Government
1102
THE FEDERAL RESERVE SYSTEM AFTER FIFTY YEARS
should be sharply increased, and in view of the gravity of their responsibilities, F R B members should be compensated at the highest
salary level available for appointive offices in the Government.
The present statutory Federal Advisory Council should be replaced
by an advisory council of 12 members appointed by the Board from
nominees presented by the boards of directors of the regional banks.
A t least two nominations, not more than one of them from any single
sector of the economy, should be presented by each bank. The Board
should make its selection, one from each district, in such a manner
as to secure a council broadly representative of all aspects of the
American economy. Council members should serve for 3-year terms,
not immediately renewable. The council should meet with the Federal
Reserve Board at least twice a year.
A n important internal source of advice should be further recognized and strengthened. The law should formally constitute the 12
Federal Reserve bank presidents as a conference of Federal Reserve
bank presidents, to meet at least four times a year with the Board,
and oftener as the Board finds necessary.
The determination of open market policies should be vested in the
Board. I n establishing its open market policy the Board should be
required to consult with the 12 Federal Reserve bank presidents.
The determination of reserve requirements should continue to be
vested in the Board. I n establishing these requirements the Board
should be required to consult with the 12 Federal Reserve bank presidents.
The present form of capital stock of the Federal Reserve banks
should be retired. Instead, membership in the System should be evidenced by a nonearning certificate for each member bank.
As I envisage the outcome of incorporating the aforementioned
changes in the structure of the Federal Reserve System, we would
confine voting on the open market committee to the same publicly
appointed members who have the only votes when reserve requirements
or rediscount rates are at issue. P u t differently, the five presidents
with present votes would be in an identical position as the seven
presidents who attend, offer expert advice, but do not vote.
I would urge a word of caution with regard to this suggestion because I am impressed by the quality of the bank presidents in the
regional banks.
There are a remarkable number of trained professional people who
have come up through the Federal Reserve System whose judgments
and training, I regard as a valuable national asset.
I t has been suggested by many thoughtful officials of the Reserve
System that the removal of voting responsibility from the Reserve
bank presidents might result in their resignation from the System.
The cost of such an outcome could be very high since the training
and stature of many of these officials is extremely valuable.
Therefore I would urge a very deliberate evaluation of the likelihood of such a prospect before I would enact legislation incorporating
recommendations to change the present structure of the open market
committee.
I n order to free the Federal Reserve Board members from the
numerous demands made on their time, thereby enabling them to concentrate on the proper determination of monetary policy, I would
urge consideration of a suggestion made by Governor Robertson.
THE FEDERAL RESERVE SYSTEM AFTER FIFTY YEARS
1103
Bank examination and supervision, as well as issues pertaining to
bank structure, should be removed from the Board, and given to a
newly formed Federal Banking Commission which would perform
the functions now done by the Federal Reserve Board, the Comptroller of the Currency, and the F D I C . The latter organizations
presumably would disappear.
I n addition to these recommendations concerning the Federal Reserve System, I would like to conclude my comments with some suggestions concerning the execution of the policy decisions by the Federal Reserve Board.
The provision of reserves available to the banking system should be
determined in a longer run context than appears to be the case at the
present time. Preoccupation with the minute variations in the
financial markets tends to cause erratic behavior on the part of the
Fed, and subjects these markets to uncertainties which, in my opinion,
are not helpful either to the outcome of monetary policy or to the
effective functioning of these markets.
I believe that the bond market is more viable than is suggested by
the Fed's almost minute concern with it. Moreover, the concern with
the state of the bond market appears to me to constrain the Fed in
pursuing monetary policies which might substantially affect bond
prices.
I n this sense, I agree with the Commission on Money and Credit
report, when it states:
The monetary authorities should make full use of the fact that monetary
measures can be varied continually in either direction and reversed quickly at
their discretion.
If, in fact, our economic system contains more rigidities than was
true in the past, I believe a more active response to projections in the
rate of change of economic activity may be desirable. For, if the Fed
delays its action in the face of an increasing number of signs of recession, and then later reacts with an overactive policy of increasing
reserves, it tends to get the worst of two worlds. That is to say, unemployment is larger than it need be, and the subsequent increase in
economic activity tends to be associated with more price rise than is
necessary. The latter need not occur but, as I view the postwar
record, it has in fact occurred because of the caution exercised by the
Fed in putting on the breaks during the upswing. I n my judgment,
this hesitancy to tighten the reserve positions of the banking system
stems from their concern about the response of the bond market to
such action.
As I see it, the primary function of the Federal Reserve System is
to determine the appropriate level of bank reserves. However, in a
banking system with 14,000 institutions, many of which are small unit
banks, there should be a mechanism to assure their liquidity.
If the discount window were made a right instead of a privilege,
this liquidity would be assured to the individual bank and, in my
judgment, the following two advantages would result. By allowing
each bank the right to rediscount, the Fed need no longer be concerned
about temporary losses of liquidity for individual banks as it pursues
a policy of reducing the reserve base. The right to secure reserves
might also have the effect of encouraging more venturesome lending
on the part of commercial banks, as they would now be protected from
1104
THE FEDERAL RESERVE SYSTEM AFTER FIFTY YEARS
a reduction in liquidity in the event that some of these loans are not
payable at maturity for cyclical, local, or regional causes. Insofar as
this policy shifted the lending practices of commercial banks toward
more venturesome loans, it may contribute to more rapid economic
growth.
However, as it is the responsibility of the Federal Reserve System to
control the reserve base, any increment to reserves over the target
established by the central bank would have to be offset by corresponding open-market sales.
I n return for the right to rediscount, a penalty rate, conceivably progressing with the extent of the rediscounting, would be exacted. An
alternative mechanism to maintain the control over rediscounting, and
to assure control over total reserves to the monetary authorities would
be to provide the right of rediscount to a bank only if its assets do not
increase while it remains in debt to the Reserve bank.
Finally, while the Fed has an enviable record of providing information to the public, compared with most other central banks, I believe
much more could be done in this area. Subject to the constraint that
information should be revealed only when it would not compromise
the effectiveness of changes in monetary policy, the Board should be
encouraged to report in full on its reasons for changes in policy, and on
the evidence which was available to it in arriving at its decisions. I
am persuaded that such material would enable scholars to examine in
detail, and insulated from policy needs, the rich body of data on the
operations of monetary policy. The present long lag between action
and reporting, and the sketchy nature of reporting, tends to generate
rumor, misinformation, and confusion. Thank you very much, M r .
Chairman.
The CHAIRMAN. Thank you, sir. Professor Samuelson, you may
proceed, sir; and, after you gentlemen have concluded your statements^
then the members of the committee will question you.
STATEMENT OF PAUL A. SAMUELSON, OF MASSACHUSETTS
INSTITUTE OF TECHNOLOGY
Mr. SAMUELSON. Mr. Chairman, I am pleased to testify here this
morning particularly, along with my old friend, Professor Shapiro.
I should warn you t h a t academic people, like us, disagree. I used to
be at Harvard, and I am now at M I T . Professor Shapiro used to be
at M I T , and he is now at Harvard. I cannot help but think that one
of us has made a mistake in judgment, although possibly two of us have.
I shall merely summarize the highlights of my submission on the
assumption that it will be entered into the record in its entirety.
The CHAIRMAN. Yes,
sir.
(Professor Samuelson's complete statement follows:)
TESTIMONY SUBMITTED BY PROF. P A U L A. SAMUELSON, OF
MASSACHUSETTS INSTITUTE OF TECHNOLOGY
EVOLUTIONARY FEDERAL RESERVE REFORM
Consideration of the economic principles of money and credit, the
American constitutional system of pluralistic checks and balances, and
the experience with central-bank operations in the history of the major
free nations, leads me to the following conclusions.
THE FEDERAL RESERVE SYSTEM AFTER FIFTY YEARS
1105
(1) The present Federal Reserve System, the Board of Governors
in Washington, and the 12 regional Federal Reserve banks, has evolved
toward becoming a tolerably effective central bank—from beginnings
in 1913 which, while understandably defective in many important
respects, did represent a major reform.
(2) Further evolution is both inevitable and desirable, particularly
in making the Federal Reserve at responsible institution in the American political structure. Whatever may have been true in a few countries for a few decades in the 19th century, there can never be a place
in American life for a central bank that is like a Supreme Court, or
1831 House of Lords—truly independent, dedicated to the public weal
but answerable for its decisions and conduct only to its own discretion,
and to the consciences of its men in authority as they each envisage
their duty.
(3) Lack of coordination between monetary, fiscal, and debt policies,
as determined by the Executive and Congress, with monetary credit,
interest, and debt-management policies, as determined by Federal
Reserve policy, can lead to short-run crises and to costly longrun ineffectiveness. Yet, at this stage of Federal Reserve evolution, there
is nothing to prevent tragic recurrence of such undesirable conflicts.
I t has been more of a lucky accident than an inherent feature of present legislation and practice that the United States has been able to
avoid costly friction; but, not even with our lucky combination of
personalities and events has our economy been spared some cost attributable to lack of unified monetary policy.
(4) A central bank that is not responsible is irresponsible, rather
than independent. To be responsible means to be responsive. I t need
not mean being responsive to each month's 50.001 percent of democratic opinion; or being responsive to the articulate minority wThich
at the moment seems stronger than any other minority.
But it does mean being responsive to the changing values, views,
moods, and even fads of the American citizenry. I t does mean a
definite relinquishment of an adherence to certain thought-to-beeternally sound doctrines, dogmas, and principles. Neither Governor
Strong, nor Montagu Norman, nor even Chairman Martin can perform the role of Peter, holding a thumb in the dike against the floods
of what is considered to be temporary unreason. The days when
continental central bankers could encourage capital flight and even
engineer a run against the currency in order to bring an accredited
goverment to heel and to fiscal probity were not good old days. I n
any case they are not our days.
A clique of discrete, prudent, self-restrained central bankers never
had the power or the ability to run international finance well, despite
tall tales and romantic legends. W h a t is true is that international
cooperation has often been somewhat effective in the past, often for
good and occasionally for definite evil (although never consciously
for evil).^
(5) A jury of competent economic experts, drawn from the principal nations of the free world, would probably counsel the following:
The central bank (i.e., the Federal Reserve) should in the last
analysis, but not in its day-to-day operations, be responsible to the
Executive. The head people in the central bank can always protest;
indeed it is their duty to nag w^hen policies seem wrong. They can
resign with a public blast. But when the Executive has lost confidence
1106
THE FEDERAL RESERVE SYSTEM AFTER FIFTY YEARS
in the top people in the central bank, he should have the power to
ask for their resignations, with the opportunity for both sides to state
their divergent views. The executive branch, in turn, being but one
of our three major branches—Congress, the judiciary, and the executive^—is subject to all the continuing checks and balances of our pluralistic Republic.
M Y RECOMMENDATIONS
Speaking as an American economist, cognizant of our peculiar evolution of institutions and practice, I do not now recommend such a
drastic change. Perhaps in the coming decades, we may evolve toward
a similar system. The most important changes needed now seem to me
to be the following:
(a) The 14-year terms of the Board members are too long. Staggered 6-year terms would seem none too short. Perhaps 4 years would
be better.
(&) The Chairman of the Board of Governors should definitely be
appointed by each new President, and should serve at the pleasure of
the President. (Whether he should have to be selected from the
Board members is not, I should guess, an important issue one way or
the other.)
(c) The present Open-Market Committee gives too much representation to the regional banks, too little to the executive branch. A t
the most, there should be the President of the New York Federal
Eeserve Bank and 1 rotating President from the other 11 banks on it.
A t the least one member designated by the Executive should be on
the Open-Market Committee if a committee with its functions, distinct
from the Board of Governors itself, is retained.
(d) If an irreconcilable conflict between the Executive and the
Federal Eeserve were to ensue, it should be made clear that the Federal
Eeserve must yield, albeit with the right to full protest to both Congress and the public. The sole exception to this ultimate yielding
should be in the case that Congress by explicit resolution of both
Houses releases the Federal Eeserve from its showdown subordination.
I have not tried to spell out the legislative details of the above
recommendations and have deliberately left my wording general. The
above recommendation, I believe, preserves the proper kind of independence of the central bank. Like the House of Lords, it should be
able to delay innovations, to smooth down the volatile changes of
public opinion and of thin majorities. But the central bank should
never be thought of as an island of isolated power, as a Saint George
defending the economy against the dragon of inflation and frenzied
finance. As Edmund Burke said nearly two centuries ago:
The age of chivalry is dead—that of responsible, democratic government has
succeeded.
Mr. SAMUELSON. First, the present Federal Eeserve System—the
Board of Governors in Washington and the 12 regional Federal
Eeserve banks—has evolved toward becoming a tolerably effective
central bank, from beginnings in 1913 which, while understandably
defective in many important respects, did represent a major reform.
2. Further evolution is both inevitable and desirable, particularly
in making the Federal Eeserve a responsible institution in the American political structure. Whatever may have been true in a few countries for a few decades in the 19th century, there can never be a place
THE FEDERAL RESERVE SYSTEM AFTER FIFTY YEARS
1107
in American life for a central bank that is like a Supreme Court or
1831 House of Lords—truly independent, dedicated to the public weal
but answerable for its decisions and conduct only to its own discretion
and to the consciences of its men in authority as they each envisage
their duty.
I think that is an alien notion to our traditions and I think it is
particularly an inappropriate notion for the present day.
3. Lack of coordination between monetary, fiscal, and debt policies
as determined by the Executive and Congress with monetary credit,
interest, and debt-management policies as determined by Federal
Eeserve policy can lead to short-run crises and to costly longrun
ineffectiveness.
This has happened in many countries. I dare to think that we have
not escaped from it in the United States, and it is germane to the
present time.
Yet, at this stage of Federal Eeserve evolution, there is nothing to
prevent tragic recurrence of such undesirable conflicts. I t has been
more of a lucky accident than an inherent feature of present legislation and practice that the United States has been able to avoid costly
friction; but not even with our lucky combination of personalities and
events has our economy been spared some cost attributable to lack
of unified monetary policy.
These costs are still with us. They go on all the time, and they are
not to be recorded in the newspaper and are not to be measured by
crises nor by changes in the legislative structure.
Fourth. A central bank that is not responsible is irresponsible, rather than independent. To be responsible means to be responsive. I t
need not mean being responsive to each month's 50.001 percent of
democratic opinion; or being responsive to the articulate minority
which at the moment seems stronger than any other minority.
But it does means being responsive to the changing values, views,
moods, and even fads of the American citizenry.
I t occurs to me to quote E. B. White's definition of "democracy."
As I remember it, he said, "Democracy is the recurring suspicion that
more than half the people are right more than half the time."
And it is an illusion that we can create a body for all time which
will protect us from our own mistakes—as Ulysses lashed himself to
the mast and put wax in the ears of his shipmates so that he could, at
the beginning, act as a trustee for himself when going through the
Islands of the Sirens, protecting himself against the temptation when
he heard the beautiful music, imploring the men to untie him and let
him go on to his destruction.
I think that such a trustee notion was a delusion in every century
but is peculiarly so today, and much of what is called the polar view
on one side, that Professor Shapiro referred to, stems from a romantic
belief in that illusion.
Specifically, real life does mean a definite relinquishment of an adherence to certain thought-to-be-eternally-sound doctrines, dogmas,
and principles.
I want to warn you against some of my colleagues who I see will
be testifying later. Many of them in their infinite wisdom, and their
wisdom would have to be infinite to justify their position, will tell
you there can be established once and for all certain sound principles
1108
THE FEDERAL RESERVE SYSTEM AFTER FIFTY YEARS
which can be set down and which can be followed and which ought
not to be deviated from except in the greatest of emergencies.
I should like to say, in my fallible ignorance, that for 30 years I
have been studying that philosopher's stone of sound principle and
every morning, when I have worked hard and thought I have discovered it, by sundown I have discovered its flaws.
Neither Governor Strong nor Montagu Norman, nor even Chairman
Martin can perform the role of Peter, holding a thumb in the dike
against the floods of what is considered to be temporary unreason.
I emphasize the words "considered to be." Often such diagnoses
are correct and often they are not, and when they are not the Nation
suffers tremendously.
I do not know who the heroes are of central bank history but if you
examine each one who was nominated in turn the results is disillusioning. When I began as a student, Montagu Norman was considered to
be the hero. But any review of Montagu Norman must debit against
bis undoubted successes in the 1920's, his undoubted tragic errors in the
1930's.
Fortunately for the reputation of Governor Strong, but sadly for
him, he died before the 1929 crash; the complete record is not there,
but it seems doubtful that he could have avoided history.
The days when continental central bankers could encourage capital
flight and even engineer a run against the currency in order to bring
an accredited government to heel and to fiscal probity were not good
old days. I n any case they are not our days.
A clique of discreet, prudent, self-restrained central bankers, never
had the power or the ability to run international finance well, despite
tall tales and romantic legends. W h a t is true is that international
cooperation has often been somewhat effective in the past, often for
good and occasionally for definite evil, although never consciously foi
evil.
Let me turn to what a jury of competent economic experts, drawn
from the principal nations of the free world, would probably counsel
the following:
Now, there would be no uniform consensus among them but, as you
look for the central tendency, I think you will find an agreement
around the following paragraph. I t is not my recommendation to
you at this time, I should say.
They would probably say that the central bank, that is, the Federal
Reserve, should in the last analysis, but not in its day-to-day operations, be responsible to the Executive. The head people in the central
bank can always protest.
That is too weak. They sit on the councils making the decisions.
They have the right to formulate policy. They have the right to
protest.
I think I am quoting Montagu Norman back in the 1930's, that it
is the duty as Governor of the central bank to nag when policies to
him seem wrong.
H e can always resign with a public blast. Indeed, in a well-running
system the finest hour of the Governor of the central bank is often the
hour in which he resigns with a full protest, perhaps bringing down
a house of cards or a more solid house about him.
But when the Executive has lost confidence in the top people in
the central bank, he should have the powder to ask for their resignation,
THE FEDERAL RESERVE SYSTEM AFTER FIFTY YEARS
1109
with the opportunity for both sides to state their divergent views.
T h e executive branch, in turn, being but one of our three major
branches—Congress, the judiciary, and the executive—is subject to
all the continuing checks and balances of our pluralistic Eepublic.
Now, that would be the consensus of responsible economic opinion
in a random country in the free world.
But I am now speaking as an American economist, cognizant of our
peculiar evolution of institutions and practice, and so I do not now
recommend such a drastic change. Perhaps in the coming decades,
we may evolve toward a similar system.
I would like to stress the evolution of the Federal Reserve though.
F o r even without changes in charter, this has been a pragmatic fumbling procedure of trial and error and correction. Open market operations which we commonly regard as the most powerful tool of the
Federal Eeserve were not envisaged by the creators of the Federal
Reserve System.
And it was more or less in the state of absentmindedness that we
stumbled upon them in Governor Strong's era.
The general tenor of my recommendations would be something like
the following:
(a) The 14-year terms of the Board members are too long. Staggered 6-year terms would seem none too short. Perhaps 4 years would
be better.
I have no strong feelings on the exact details of the change.
(b) The Chairman of the Board of Governors should definitely
be appointed by each new President, and should serve at the pleasure
of the President. Whether he should have to be selected from the
Board members is not, I should guess, an important issue one way or
the other, particularly after you shorten the terms of the other
members.
May I interject here the unwritten constitutional law of the American system ? I can speak as authoritatively on it as anyone, because
nobody can speak with any authority on it at all.
According to the unwritten constitutional law, if one had been
testifying here 5 years ago or 10 years ago or 15 years ago or 25 years
ago he would have said that the Chairman of the Federal Reserve
Board does serve at the pleasure of the President because he would
have said, "As everyone knows, the Chairman hands in his resignation to the incoming President."
Actually I do not think anybody knows anything about that subject. I t is not written in the records anywhere.
I t has, as far as I know, never been put to a test and the unwritten
constitution is not a constitution that you can depend on. I t is not
only unwritten but it is unformulated, unlike some parts of the British
Constitution.
(c) The present Open Market Committee gives too much representation to the regional banks, too little to the executive branch.
A t the most, there should be the president of the New York Federal
Reserve Bank and one rotating president from the other 11 banks on
it. At the least one member designated by the Executive, perhaps
the Secretary or Treasurer, should be on the Open Market Committee
if a committee with its functions, distinct from the Board of Governors itself 3 is retained.
1110
THE FEDERAL RESERVE SYSTEM AFTER FIFTY YEARS
If a separate committee of the Board of Governors is not retained
then there will have to be created, according to my view, some new
committee which has some representation of the executive branch
on it.
(d) If an irreconcilable conflict between the Executive and the
Federal Reserve were to ensue, and this would happen very rarely,
it should be made clear that the Federal Reserve must yield, albeit
with the right to full protest to both Congress and the public. The
sole exception to this ultimate yielding, and this is what I venture as
a possibility, should be in the case that Congress by explicit resolution
oi both Houses releases t h e . Federal Reserve from its showdown
subordination; only in that case would the Executive not prevail in
the case of an irreconcilable conflict.
I mention this explicitly because I think no responsible or irresponsible member of the Federal Reserve System would claim that the
Federal Reserve System is independent in this caricature sense that
I have described "independent." Most representatives of that agency
and historians of that agency would feel that the Federal Reserve is
responsible ultimately to Congress. And I believe that to be the case,
but I think the nature of that responsibility has to be spelled out.
I have not tried to spell out the legislative details of the above recommendations and have deliberately left my wording general. The
above recommendations, I believe, preserve the proper kind of independence of the central bank: like the House of Lords, it should be
able to delay innovations, to smooth down the volatile changes of public opinion and of thin majorities. But the central bank should never
be thought of as an island of isolated power, as a St. George defending
the economy against the "dragon" of inflation and frenzied finance.
As Edmund Burke said nearly two centuries ago:
The age of chivalry is dead—that of responsible, democratic government has
succeeded.
Thank you.
The CHAIRMAN. Thank you, sir.
I would like to comment just briefly before asking questions.
You gentlemen have covered these subjects very fully, more fully
than the witnesses I believe that we have had so far, and the members
of the committee and I certainly appreciate what you have said. Even
if I do not agree with you 100 percent I still value your testimony and
I value your statements.
The question on the terms of office is this: Last year Mr. Kennedy,
President of the United States, was privileged to select the Chairman
of the Federal Keserve Board which, I think, is one of the most
important positions in the free world, more important in many ways
than the Presidency. H e can do more to veto things than the Congress of the United States.
The President was in a strait jacket. H e did not have freedom
of choice because of the law passed way back in 1935 specifying 14year terms, and there are only about two selected during a President's
first 4 years and then during the first 2 years of the second term, the
limit allowed by the Constitution, he can select two more.
I n other words, it would be in the last 2 years of a President's second
term of 4 years in office that he would be allowed to select a majority of
that Board. Now, of course, in his last 2 years in office the President's power in influence declines a lot, we all know that.
THE FEDERAL RESERVE SYSTEM AFTER FIFTY YEARS
1111
So, during the effective term of the President, during the first 6
years, he has a majority that can work against him. Now, when
Mr. Kennedy was permitted to select this Chairman of the Board, if
he had been given the choice to select anyone in the United States
that he wanted, I think it would have been much better, but under
the present law he was compelled to take one of those seven members.
Therefore, he did not have freedom of choice. H e only had one
person on that Board who was selected by him. I believe that was
Mr. Mitchell, from Chicago.
And, of course, there was Mr. Martin and all of these other people,
but he had to take one of the seven. I do not look upon that as a
healthy situation.
Would you comment briefly on that, Professor Samuelson?
Do you think that is a healthy situation? I believe your paper
indicates it is not.
Mr. SAMUELSON. A S indicated in my submission, I believe that the
Chairman of the Federal Keserve Board should be chosen at the
pleasure of the President.
The CHAIRMAN. Yes, I noticed that. That is good.
How do you feel about that, Professor Shapiro ?
Mr. SHAPIRO. I t seems to me I said a similar thing. I do think
that there are differences, however, between Professor Samuelson and
myself, although I would hardly regard them as substantative differences, for he suggests, as I understand it, a 4-year term for the Board
members which presumably means that the incoming President could,
in fact, appoint an entirely new Board
The CHAIRMAN. T h a t is right.
Mr. SHAPIRO (continuing). Upon his arrival.
The CHAIRMAN. That is right. T h a t makes a difference.
Mr. SAMUELSON. Excuse me, but just to correct the record, I spoke
of staggered 6-year terms or 4-year terms and did not spell out details.
I did not spell them out because I have no strong opinion
The CHAIRMAN. But you mentioned 4 years.
Mr. SAMUELSON. Yes, but it does not mean though that you would
have to have a new Board on Inaugural Day.
The CHAIRMAN. T h a t is right. Now, really, the basic question here,
gentlemen, is whether we are going to have a Board that is independent from Congress and the President, insulated against what they
call politics and the electorate or whether we will have a Board that
is under the supervision of the Government of the United States.
And they are trying to get over to the country now, "Keep the
Federal Eeserve out of politics; we don't want politics in the Federal
Reserve."
The way I construe that, that is contrary to our form of government. Who put the Federal Eeserve and monetary matters in
politics ?
The f ramers of our Constitution did it when they said that the Con*
gress shall coin money and regulate its value. Of course, the Supreme
Court has held that to coin money means to print money, too.
So, since the framers of the Constitution wrote that into the Constitution, to make it the duty of Congress, I construe that to mean that
the monetary power, which is a very important power in any country,
should be conducted and administered and supervised by the elected
representatives of the people.
28-680—64—vol. 2
13
1112
THE FEDERAL RESERVE SYSTEM AFTER FIFTY YEARS
Then if a mistake is made or if they go against the public interest
they have something to lose. They can lose their seats in Congress.
They can be disgraced for life, be ruined in politics.
They have something to lose if they act against the public interest.
But if you are going to have a Board that is insulated from politics,
they have nothing to lose.
There is no way for the people, who vote, to vote against these people. They are off by themselves.
Do you agree with that statement on politics, Professor Samuelson ?
Mr. SAMUELSON. I do essentially. If somebody said that we ought
to divorce government from politics and have the executive branch
removed from politics, the connotation is that we want to get away
from graft, from petty intrigue, and all of those things.
But if somebody said that the Government should be divorced from
statesmanship, it would have an entirely different ring. I cannot
imagine having a city-manager-type of executive in this country, a
man who makes decisions about public expenditures, recommendations
about taxation, and so forth.
Similarly, I cannot imagine a city manager, a hired professional—
I presume he would turn out to be a banker under those circumstances—given a subcontract to run the monetary affairs of the
Government.
This is not a matter of politics statesmanship. I t is a matter of
responsible responsiveness to the wishes of the people in our Republic,
as done with due process of law.
The CHAIRMAN. Do you believe that the Federal Reserve has assumed too much power now ?
Mr. SAMUELSON. NO ; I do not know what the question means.
The CHAIRMAN. Well, here is what it means. They will not pay
any attention to the President unless they want to. They feel like they
are away from the Government. They feel like they are independent.
Independence to them, if I can interpret what they say correctly,
means that the President cannot tell them what to do and the Congress
cannot either, unless Congress by a specific law instructs them.
They have bankers around them all the time. They should look
after the general welfare of all the people, and they should be insulated from any special-interest group that could profit from their
actions.
So it appears to me that it is dangerous to permit those who can
profit most from the manipulation of the volume of money and the
interest rates, to participate in the proceedings that make monetary
policy.
W h a t do you say to that, Professor Samuelson ?
Mr. SAMUELSON. W i t h all respect, Mr. Chairman, I should like
to disassociate myself from the general line of that reasoning. I
think I can put my position in the following way, that I give two
cheers for the Federal Reserve.
I do not recognize two full cheers for them in your remarks. I do
not give three cheers to the Federal Reserve because I think there are
certain correctable deficiencies in their behavior.
But I think that my criticisms are perhaps less strong than yours,
sir.
The CHAIRMAN. Would you like to comment on that, Professor
Shapiro ?
THE FEDERAL RESERVE SYSTEM AFTER FIFTY YEARS
1113
Mr. SHAPIRO. Well, I would like to comment in several ways on
that.
I n the first instance, it seems to me that the notion of an independent
Fed, that is to say, independent of everybody but their own
willful desires, I would regard as technically inaccurate, for the
Congress of the United States indeed can change this by legislation
and the Congress of the United States is responsive to the will of
the public under the circumstances.
And I would submit that in the event that the Fed indeed did an
outrageous thing, outrageous so that a hue and cry was reflected in
the mail and correspondence to the congressional Members, that
action indeed would be undertaken.
This is one line of argument.
On the other hand, I do believe that by virtue of the broad mandate
which the Federal Reserve Board does have, it is in point of fact
trying to kid some of us as well by talking about independence about
which I think they imply independence of the Executive and for a
broad range of problems I regard them as really pretty independent—
period.
On the other hand, I do not believe that the Federal Eeserve authorities are indeed people with malevolent intent. I think on some
issues there are indeed differences in the primacy of goals, and until
such a time as we could in point of fact stabilize the primacy of goals,
I would regard individual judgments or individual actions as a consequence of a lack of consensus on a particular order of goals.
I t is for this reason that I would regard the structural revisions
which I suggested as making quite clear that the Federal Eeserve
authorities are indeed responsible to the public will and, indeed, for
the most part, I would regard them as responsive to it.
So I, too, would disassociate myself from the line of argument which
is implied by your comments.
I would say one further thing in this regard. I think Professor
Samuelson was explicit about in the long run the central bank would
be responsive to either the Executive or to the Legislature.
I would subscribe to this position wholeheartedly. I think both of
us commented on the evolution of the Federal Eeserve System, indicating that in point of fact this direction of movement has indeed
taken place.
To revise legislation which starts on the assumption that there is
indeed an antipublic desire on the part of the central bank,, I would
regard as insulting to the central bankers, and I would regard as
destabilizing to our body politic at the present time, and therefore
the character of the recommendations suggested by me, I think, are
in effect much less radical. Despite the fact that I regard them as
simply a continuation of that which has already gone on I suspect
you will find newspaper accounts of the domination of the Federal
Eeserve System as a consequence of what I regard as relatively simple
and straightforward structural reforms, designed to minimize any
suspicion whatever of banker domination by our central bank, one
of the most important stabilization bodies in our Government.
The CHAIRMAN. I want to make two comments, and then I will
yield to other members.
One is on legislative changes. You know, in a democracy such as
our own, there are a lot of people who have bottleneck positions, any
1114
THE FEDERAL RESERVE SYSTEM AFTER FIFTY YEARS
one of whom can say "No" and make it stick, but there is not one
person in the United States who can say "Yes" and be absolutely
sure. They just cannot do it.
Now, when you go to making legislative changes you first introduce
a bill that is referred to a subcommittee. The subcommittee chairman can stop it if he wants to.
Then it passes out and it goes to the whole committee, and the whole
committee chairman can have a lot of influence on it, and it can stop
there.
Then it has to go through the leadership of the House and then the
Rules Committee and those four bottlenecks—that is not all—just
those four we see every day.
And then in the Senate it is the same way. So the chances of getting
something really meaningful but opposed by an intrenched interest
in this country, that is profiting so much by occupying a position that
gives them special privileges, are rather remote because it takes only
a few to stop things while a majority cannot always actually accomplish things.
So we have those deterrents to changes. So we should not speak of
them glibly in that we can just go to Congress and get something
done right quick. We just cannot do that.
I t is too difficult in a democracy, as it should be. I am not saying
that a change should be made. I think it is all right.
Another point is that the people, who handle the money, control
the supply to a great extent and interest rates, perform the most
important functions of our Government. The people who do that
can veto the wishes of the President if they wish to.
They can veto the will of Congress if they want to. They can veto
the program of the administration in power regardless of the politics.
They have a lot of power and certainly if you are going to have
a board, it occurs to me, to channel these great problems and make
good judgments for all of the people, they should be insulated from
this special interest group like the bankers lining their own pockets
with gold so easily, if they can influence the right decisions and they
have not done badly in the past.
And if we are going to say that it is right to do that for the banks,
let them have such a tremendous influence on the volume of money
and the cost of money, why should we not do the same thing for the
railroads, the truckowners, and the people in interstate commerce ?
Let them be on the Interstate Commerce Commission or have representation there to fix rates, freight rates, and passenger rates ?
W h y should we not have the broadcasters on the Federal Communications Commission or have the Commissioners compelled to confer
with the broadcasting industry before they can make any change and
let them be heard in all important decisions and even vote?
I t occurs to me that one would be just as logical as the other.
I will not pursue that because my time is up, but I will yield to
Mr. Reuss.
Mr. REUSS. Thank you, Mr. Chairman.
I, too, am very grateful to both of you gentlemen for giving us
your help and testimony this morning. I wish you were here for 2
years, as I would like to examine you at length. I will do the best
I can with the time that is at our disposal.
THE FEDERAL RESERVE SYSTEM AFTER FIFTY YEARS
1115
Professor Samuelson, would the following be a fair paraphrase
of your view of central banking and governmental relationships in
the free world today: I n most countries which have central banks, a
dispute between the chairman of the central bank and the chief of
state would require the resignation of the chairman of the central
bank. I n this country, if there is a dispute between the Chairman of
the Federal Reserve and the President, about the only thing the
President can do is to resign ?
Mr. SAMUELSON. I do not think this has ever been put to the test,
sir, but I think it is a fact of structure that in almost every nation
of the free world it is beyond constitutional question that, when there
is a pitched battle and difference, that the head of the central bank
resigns.
I think there are some exceptions, but they are very few. And if
you take a candid look at the trend, the changes in legislation in the
last quarter of the century and the previous quarters of this century,
it cannot be questioned at all that the trend is against the 19th centurv notion of an insulated central bank with unilateral power as
against the Executive.
Mr. REUSS. With respect to our Federal Reserve Board of Governors, as you know, the President must soon appoint someone to
one of the seven seats on the Board.
Would it be a good idea to have at least one member of the sevenman Federal Reserve Board of Governors who could discuss Board
decisions publicly, whether by dissent or by making known the present thought of the Federal Reserve Board of Governors, much as
the late Mr. Justice Brandeis and Mr. Justice Holmes did on Supreme
Court decisions of another generation ?
Would this be useful ?
Mr. SAMUELSON. I think that there would be some usefulness in
such a procedure, and I think that under the general recommendations that I have made we would be more likely to have it.
We do learn, late, the minutes of the meetings of the Open Market
Committee. These are illuminating to scholars who have waited
avidly for their publication. I t is remarkable how close to one's surmises they turn out to be, but there are occasional surprises.
I think if you had a member of the executive branch on such a committee, and there was a real problem which the Nation should know
about, it would come out very soon.
I do not think that under my recommended reform structure it
would be desirable or necessary to try to create or recreate the Chamber of Deputies in the Federal Reserve Board, to have a labor spokesman, an agricultural spokesman, a female spokesman
Mr. REUSS. YOU agree with Professor Shapiro that it would be not
only necessary but desirable, to have an even more itemized
Mr. SAMUELSON. Yes.
Mr. REUSS (continuing). List of
Mr. SAMUELSON. Yes, but if you
representation that we have now?
went to one of Professor Shapiro's
poles—the one that never existed, of a truly independent monetary
authority—I think you would then have to have on the Board a
representation of every significant interest group in the Nation, and
you would be creating kind of a dual governmental system.
Mr. SHAPIRO. Could I interject, Paul, that simply at that pole I
would say the people who support that view would disagree with you
1116
THE FEDERAL RESERVE SYSTEM AFTER FIFTY YEARS
on the grounds that they want, in effect, to have a body which has
some eternal wisdom which ought to be imposed on the body politic.
So that I think for anybody who would support that view, and I
find it very hard to conjure up any such representative at the moment,
I think that they would argue that they do not want
Mr. SAMUELSON. But that is precisely my point, that the only conditions under which you could possibly let anyone get away with
such a system would be to re-create a Congress wTithin that which you
call the independent central bank.
Mr. REUSS. But, getting back to the proposition which I put,
taking the Federal Reserve System as it is today, would it be, in
your opinion, a useful thing if there were at least one person out of
seven who could publicly dissent and debate monetary policies with
the majority of six ?
Mr. SAMUELSON. May I answer that in this indirect way.
I do not like to comment on absolutely current matters, but let's
take the situation as it existed before President Kennedy's election
in November 1960.
The Federal Reserve Board then—and it was not a very different
Board from what it is now—represented some very able people,
drawn from various walks of life, and certainly no competent person would have reason to criticize the motives and abilities of a
single member of that Board.
Nevertheless, it was definitely not representative of the central
tendency and the dispersion of the middle-of-the-road economic
thinking of this country.
Now, there have been only limited changes in that Board in the 4
years that have passed——
Mr. REUSS. Not such as to produce any difference
Mr. SAMUELSON. I do not think that the difference has been great.
I n that sense, if you ask me would the addition of such a dissenter
such as you described make it a Board more representative of the
middle-of-the-road thinking and the dispersion around that middleof-the-road economic thinking, my answer would be very positively
"yes."
Mr. REUSS. W h a t wTould you think of that, Professor Shapiro I
Mr. SHAPIRO. Well, I would not start with the notion that the
President ought to appoint a dissenter. I start with the basic proposition that the President ought to have an opportunity to appoint a
member to the Board and, more important, he ought to have the
right within his term, at the beginning of his term, to designate the
Chairman.
Now, the President may want a dissenter or he may not want a
dissenter. Presumably he wants a man with whom he is compatible,,
presumably whose views are compatible with his as well.
And I would certainly favor that proposition by modifying the
inclusion of "dissenter."
I do not care whether he is an assenter or dissenter but at least
the President has a channel to that Committee
Mr. REUSS. I do not believe I made my question clear.
I am asking both of you gentlemen to focus upon the Federal Reserve Board, as it now exists and as it has existed for some time.
I t has not changed in outlook very much, and I ask you to bear in
mind what you have both suggested, that it is a pretty monolithic
THE FEDERAL RESERVE SYSTEM AFTER FIFTY YEARS
1117
board. There is no disagreement within the Board, apparent to the
public, at the time decisions are made. Yet on the outside a great
many very respected and, by no means, radical economists and financiers, may differ very deeply with the Fed.
My question is, in the light of this would it not be a good thing for
the country if one member of the Fed turned out to be a maker of
public dialogue on monetary policy?
There is not now such a member of the Fed. Oh, 15 months after
the event we may find in the very turgid English of the annual report, that there was dissent but we have no notion of the kind of debate which occurred.
Mr. SHAPIRO. Mr. Reuss, I would say my notion that a full and
complete record of both the reasons and the evidence for open market
policy decisions, made available and made available quickly rather
than latently, with a lag of something like 15 months and then really
a report of brief comments would be very helpful in this regard.
And this is indeed why I make the suggestion that I do.
I suppose, being an eternal pacifist at heart, I would respond to
your question by saying would it not be wonderful if we had a Board
which really had common interests with the President so that you
did not have dissenters and the need for dissent, but I appreciate
that that is an unrealistic expectation.
Under the circumstances I would like to have a provision made so
that the President does have some vehicle to this Board either by an
appointment during his term or certainly, at the very minimum, the
right to choose the Chairman, so that for any seven or five that were
there, when he came into power, he could presumably discuss matters
with them and try to choose from among them one whose views are
compatible with his own views.
And I certainly see no reason for the secrecy surrounding policy
questions with respect to the Federal Reserve System.
I think basically what you are concerned about is that there are
understandable differences of opinion, and there ought to be a vehicle
for a responsible party on the Board to make known his differences
so the public is informed about differences that exist on the Board
on any specific issue.
I do not know whether it is inherent in the Board or inherent in
the selection process, but it seems to me that we have had some very
strong Chairmen on the Federal Reserve Board in its history, and
somehow or other one does not find an awful lot of direct information which would suggest the character of dispute or differences.
This would be, I think, extremely helpful for at the moment I am
only subject to the availability of rumor, sometimes assertions on the
part of people in the regional banks, who are trying to indicate that
they are fighting. But it is hard for me to learn what they are fighting about and how valid their arguments are.
Well now, this ought to be available so one could check the points
of view and the evidence on which different points of view are made
for I think we do have lots of talent in the regional banks who, I
am told, are causing more and more difficulty at the Board meetings.
But I do not know this to be a fact.
Mr. RETTSS (presiding). Thank you.
Mr. SAMUELSON. May I interject a brief caveat there?
1118
THE FEDERAL RESERVE SYSTEM AFTER FIFTY YEARS
Mr. REUSS.
Yes.
Mr. SAMUELSON. There are certain needs for privacy in the decisionmaking process when you are operating an open market operation on Government bonds.
And while I think that 15 months, as the maximum delay, is too
long, I do not think that good policy requires that there be a televised version of each meeting of the Federal Reserve Board.
Mr. REUSS. Well, of course, nobody was suggesting that and
actually my question involved an area broader than just open market
operations.
For example, we have had hearings here for weeks and every representative of the Federal Reserve in Washington comes up here and
sings exactly the same song.
Sow, this suggests that this thing is a monolith, that members of
this organization somehow lose their individual personality.
And my question is: Would it not be a useful thing if somebody
in the Fed publicly disagreed with others in the Fed on these fundamental questions of economic policy ?
Would not we be a better country if this happened ? Your answer
to that question was, Professor Shapiro, I gathered, yes.
Mr. SHAPIRO. Yes, except that let me repeat my concern, that I just
do not want to appoint dissenters for the sake of dissenting.
There are differences of a point of view and perhaps it might be
interesting to appoint one of the academicians that you bring down
here who is peculiarly free with his advice in terms of not having to
pay the price for seeing that advice executed, put on the Board, and
see—study him experimentally in terms of his behavior patterns.
I s there something in the central banking process that does this
or is it that the process is really very complicated and that the issues
are not at all as simply and straightforward as some of us would
have you believe ?
Mr. REUSS. I agree that my proposal for public dissents would increase the number of public utterances, but I think that would be
better than the "me tooism" that engrosses the organization today.
Professor Samuelson ?
Mr. SAMUELSON. Mr. Chairman, I do not know how much time you
want to use up on this particular question
Mr. REUSS. Mr. Hanna, this is largely out of your time. Would
you bear with me?
Mr. H A N N A . Yes.
Mr. SAMUELSON. I
think, to get a man which is or who is essentially
associated with one strong policy which is entirely different from
that of the majority so that you can predict that he will dissent
on every vote would be an absolutely futile procedure.
^ I t might bring some publicity to bear upon the matter, but Justice Brandeis was not a great dissenter because he often dissented,
but rather because he dissented in a certain way and on certain issues
and because he dissented early in a direction that history decided was
the correct side.
Mr. REUSS. My complaint though is that almost nobody dissents
on anything.
Mr. SAMUELSON. Yes. Now, may I go to the problem of the unanimity of the Board when confronted by the enemy, the family toward
the parent?
THE FEDERAL RESERVE SYSTEM AFTER FIFTY YEARS
1119
The Board is responsible to Congress, so naturally, as we must
all feel toward our parents, there is a certain element of fear
involved.
I t is not feasible even within the executive branch
Mr. RETTSS. Fear of the parent or fear of reprisals by the other
children ?
Mr. SAMTTELSON. Well, that is my point. I t is not feasible within
the executive branch or at least it does not make for a good way to
run a railroad to have each general and admiral completely a free
wheeler on his own in the Defense Department testimony.
Now, if I may comment on the problem within the Board—and
now I cannot stand on the grounds of solid fact, documented, but will
merely say things that every schoolboy knows—there was an issue
in the Board at the time of 1952 and for some time afterward of "bills
only" or "bills preferably." For once, there did develop a cleavage of
opinion within the System on this issue.
That was healed gradually over time. I t would be only human
nature and only in accord with the nature of every institution if, at
some point in that conflict, the people involved who were on the losing
side should suddenly discover that it is not expedient to continue bj
be on the losing side; and so then, against their own convictions, they
began to change their opinion.
Now, I cannot document this with microfilms or pumpkins, but I
am sure that there were such people in the Reserve System who felt
themselves silenced because of feared reprisals from the other children and also from some of the older children in the family.
My image of the real politic within the Federal Reserve System
is somewhat different from that of Chairman Patman who has left
the room.
I think there have been many times when the provinces have been
more nearly right than the center, but that the focus of power h a s
been going toward the center, toward Washington, rather than
toward the 12 regional banks; and that sometimes the people out in
the provinces have been more on the side of the angels, as I interpret
the side of the angels, than the people in the center.
Mr. REUSS. Thank you very much. Mr. Hanna ?
Mr. H A N N A . Thank you, Mr. Chairman. I could not help but
recall, when I listened to your testimony, Professor Samuelson, a
comment that dogma is deadly and truth is illusive.
To that I have tended to graft on that at times of rapid change
dogma is more surely to be deadly and illusiveness of truth is
bound to be more intense.
I t seems to me that the more protected an institution is and the
more important its functions are the higher the probability is that
there will emerge some kind of dogma and that the justification of
whatever actions they take will be against the framework of that
dogma, as perhaps a choice against the illusive chase of truth.
And there is going to be less patience with the judgments that are
admitted to be unsure and subject to admission of error, and I think
perhaps we are as much to blame for that as the people we put in
these kinds of institutions for these rather awesome duties, because
they can be sure that our judgments or their judgments are going
to be pretty harsh, too.
1120
THE FEDERAL RESERVE SYSTEM AFTER FIFTY YEARS
So I think that perhaps we participate in this sort of thing and,
therefore, I think that the critical analysis should be directed toward
the kind of institution we have made, in its essence, and I think that
is the kind of critical approach that you gentlemen are making as
against what the Chairman's position seems to be.
But I wondered, looking at that, is it not basic here that one of the
reasons that we cannot have the members of the Board too independent is that their actions are in no sense independent of politics %
I n other words, let's say that we try to make the members of the
institutions separate from politics but we cannot separate decisions
they make from politics; can we?
Mr. SAMTJELSOIST. You cannot separate your policy from politics,
in my opinion, but there is one thing that is true and let me illustrate
by a problem that has come up again and again.
If you read brokerage letters, the financial page, and the political
pages, you will read—in a year like 1956 or a year like 1960—that
interest rates will not tighten because this is an election year and
the party in power wants to be reelected and, naturally, the Federal
Reserve which was thought in those years on the whole to favor the
party in power, will do something about it and politics will enter in
and that will change the betting odds on the bond market. That is
rot. That just is not factually the case.
I thought this rot in advance of the time when this was a matter
of discussion. The Federal Reserve, if you fully examine what it
did, if anything, tightened money—which is supposed to be bad politics for the administration in question, both in the 1960 election and
the 1956 election period.
I think that it did this because, in its fallible judgment of the
business cycle situation, leaning against the wind called for a continuing tightening, or countenancing of natural tightening.
So, in that sense, there is a divorce of Fed practice from petty
politics.
Mr. H A N N A . I was not speaking of politics in a petty sense because
I am rather sensitive about doing that, as a politician, but I was
thinking of politics more in the fact that no matter for what reason
they did what they did it would have an effect upon the political
situation.
That is what I am talking about. I am not talking about their
motives or anything about that.
F o r instance, supposing, as Dr. Shapiro suggests, that perhaps by
looking at the bond market they make a decision to do something
that they think, looking at the bond market, seems to be dictated.
Well, the effect of what they do does not flow back strictly to the
hond market, if that happened to have been their point of reference.
What I am suggesting is that the effect of that decision has a much
broader spectrum of cause and effect, involving the position of the
President who might be running for office, the position of the Labor
Department and that may be trying to effect the policy of employment, and the position of the Treasurer in terms of his trying to
effect some policy there.
Now, am I wrong about that?
Mr. SAMUELSON. NO ; I agree completely with you.
One of the problems, for example, that the central bank has to
wrestle with in any country is what is the proper compromise if a
THE FEDERAL RESERVE SYSTEM AFTER FIFTY YEARS
1121
compromise is necessary between complete stability of the price level
and the complete attainment of 96 percent of the labor force employed.
Now, that is a policy issue. I think it is ridiculous to think that this
could be jobbed out on a subcontract to some independent group to
make a decision.
By the way, they do no make a decision about the whole thing,
but they make a decision about one part that impinges very importantly on the outcome. The result has been that we have gone along
with the image of an adversary procedure, where it is the business
of the Federal Reserve, the central bank, to worry about the price
level, as if that was its brief, and its mandate; while it is supposed
to be the business of somebody else, I suppose the executive branch—
you cannot call it the Treasury because the Treasury does not decide
these things—to determine what the unemployment rate will be and
what the rate of growth will be.
You cannot divorce these two.
But if you try to, you will get something like what we have had
in recent years; namely, a biasing of policy toward fiscal ease which
means a low-capital-formation economy, because we keep tighter
money and we offset it by a looser fiscal policy.
I am here leaving the international balance-of-payments problem
aside for a moment, even though you can leave it aside only for a
moment.
W h a t we see in the tax bill is an example of that. We are encouraging the use of resources by tax reduction in the direction of current consumption, even though it is true that there are aspects of the
tax bill which have a bearing upon capital formation. And the
Federal Reserve is prepared to—in fact, it has warned us that it
is prepared to—mop up any inflation that may result from that by
tightening money and credit, which means putting the tourniquet
around capital formation.
Well now, under such a procedure, where I can only move the white
man in chess and you can only respond with the black man in chess,
you are not going to get the optimum from anybody's point of view.
Mr. H A N N A . Let me say that all I can do is be astounded by your
brilliance since yesterday that was the same analysis I made except
I was talking about jousting between knights.
Mr. SAMUELSOK. If I may say so, I am not a bit astounded by your
brilliance.
Mr. H A N N A . Well, Professor Shapiro, would you comment on the
other aspect of the same thing, about our getting in a position of a
buyoff between one policy as against another ?
I n other words, that is really what it seems to me that it amounts
to, is it not, that we get to a point where we have to—I mean,
how much growth are we going to get as against how much risk
of inflation ?
Are we not put in that kind of a position ?
Mr. SHAPIRO. Mr. Hanna, I will respond to your very pertinent
question in just a moment.
I would like, however, for the record, to clarify a statement made
in my earlier presentation which might, indeed, have been misinterpreted.
1122
THE FEDERAL RESERVE SYSTEM AFTER FIFTY YEARS
When I commented on the present occupation of the Fed with the
state of the bond market I did not mean to imply that the Federal
Reserve authorities were concerned with the income and wealth of
commercial banks or bond dealers, I think in
Mr. H A N N A . Oh, I understand that.
Mr. SHAPIRO. I think, in complete integrity, they regard this market as one which needs minute care, a view which I do not share for
precisely the reason that I believe an enterprise society has very
large elements of strength, and it is only in that context that m y
earlier remark ought to be interpreted.
With respect to the tradeoffs, the question that you posed earlier,.
I think my response to your comments would be, as fairly as I can
do it—I would think that the Federal Reserve authorities are preoccupied with stability of the price level in such a way that when
compelled to make a choice they tend to err in the direction of pricestability, whereas I would personally regard getting to the utilization
of our full capacity as a primary goal in our society.
Now, these are reasonable differences. I would assume that they
would argue that they really are interested in the same end as I, and
they regard changes in the price level as deleterious to the accomplishment of what we would regard as single goals.
However, I do think it makes a difference in terms of the ultimate 1
outcome for I am not as panic stricken by the prospect of a pricerise and, indeed, many of the cliches that we have heard in recent
years, namely, that the Congress would move with great rapidity t o
cut taxes but would not move with respect to raising them, is hardly
a description of either of the late President's initiative with regard
to a tax cut or the Congress response to that.
So that, moreover, I think that we have enjoyed a remarkable*
period of price stability under the circumstances with widespread
unutilized capacity.
I am much less fearful of the policy of ease, designed to insure
that we arrive at a higher level of capacity of utilization, than we
have thus far succeeded in doing.
Now, on the other hand, there is an issue on which Paul and I
sometimes have had differences and I think they are honorable
differences.
One thing that does worry me about the outbreak of inflation, if it
should occur which I deem unlikely in the calendar year 1964, is
t h a t it will be associated in the minds of the public with a large
debt or the tax reduction associated with the tax cut bill.
A n d from this I infer a public confirmation of a suspicion which
does not have a bit of accuracy, as it has been used, that Government's
debts are inflationary.
And I am fearful, therefore, that if we do have an outburst of
price inflation, particularly of the character of that in 1955-56 in
this country, that we may set back fiscal policy, as a stabilization
tool, for half a century which I would regard as a great tragedy
from the point of view of our future stabilization tools.
A n d it is this sort of problem which I think lends somewhat more
urgency to our ability to maintain price stability in the near term
future than I would otherwise feel, but this would not compel me
to, in point of fact, lead to a policy on the part of the Fed which
THE FEDERAL RESERVE SYSTEM AFTER FIFTY YEARS
1123
would cause a sharp rise in interest rates, in order to avert a rise in
the price level, as we indeed do shift to higher levels of employment
^nd output.
Moreover, I am not at all sure that the issue of price inflation,
versus employment is put forth very well. I n terms of the 2 percent
per annum price increase, which is widely regarded as a sign of inflation, I would say it is simply a measure of the mappropriateness
of our price indexes.
So that it seems to me that we are losing employment for the very
wrong reason or for a very wrong reason, if the choice was between
the 2 percent price increase and higher levels of employment and
output.
Mr. H A N N A . Well, I take it that my time has expired.
I would simply like to ask that both of you gentlemen might submit
comments for the record or your statements relative to these two
questions: Do you think that by having the incoming President, whoever he might be, have the right to determine who shall be Chairman
of the Board and a lessening of the present stretch of service, the
term, would in any way impair the powers of the Board and its flexibility and the utilization of that power; and (b) would it deteriorate
in any way the quality of the men who might be available for these
positions ?
That is all, Mr. Chairman.
Mr. EEUSS. Professor Shapiro, you make a number of very fundamental suggestions with regard to the F e d ; first, in the seven changes
recommended by the Commission on Money and Credit Report and
then, in your additional suggestions, including the recommendation
of Governor Robertson on bank supervisory functions.
I would like to explore with you what the adoption of these changes
would involve. I should like, in particular, to discuss two of these
changes.
If we took the Fed out of the business of bank examination and
supervision and formed a Federal Banking Commission to take over
those functions, plus those now exercised by the Comptroller of the
Currency and F D I C , would not the functions of each of the 12
regional Federal Reserve banks then consist largely of two things:
One, of having its President act as an adviser to the Board in
Washington on monetary policies—open-market policy, reserverequirement policy, and rediscount policy—and, two, of carrying out
its present responsibility with respect to check clearance? Would it
not about boil down to that?
Mr. SHAPIRO. Well, Mr. Reuss
Mr. REUSS. Not that that is not plenty.
Mr. SHAPIRO. I think, in point of fact, that the regional banks at
the moment have two functions, really the housekeeping functions
including check clearance, bank examinations, and so on, and then
the regional intelligence for the Board in Washington are necessities
appropriate to providing that intelligence to the Board in Washington.
Now, currently there is a third feature, namely, that this intelligence is required for the four non-New York bank Presidents who
will serve on the open-market committee, and I envisage my proposal
or let me say my confirmation of the Commission's proposal as
1124
THE FEDERAL RESERVE SYSTEM AFTER FIFTY YEARS
really giving that policymaking function as much importance under
this scheme as it does under the present scheme.
Fourth, the Presidents would be indeed the important advisers to
the Board but they would not have a vote, and the economic intelligence function, which is currently performed, would still be performed and would still be required in a country as large as this,
with as much regional diversity as it now has.
So that one of the issues really turns on whether, in fact, you
think the high quality of the personnel in the Reserve bank presidencies that we have acquired in recent years would cease when their
vote was taken away.
As I commented to you a moment ago, I have a kind of an experimental turn of mind. I would like to see whether, if these men were
given votes on the Board and were given salaries commensurate with
the Board's salaries, not their current salaries, whether this would be
more of a deterrent to their staying than the present system, where
five of them have the right to vote but there are also associated with
this, salaries which in point of fact are higher than most of the
Government salaries and mostly for commensurate responsibilities.
Mr. REUSS. "Most" is an understatement. While the President
of the United States receives a salary of $100,000, the President of the
New York Federal Reserve, with a salary of $70,000 a year, receives
compensation three times that of the Secretary of the Treasury.
Mr. SHAPIRO. Excuse me, but let me answer your question very
directly. I fear that this was a very circuitous response.
I would say that under the proposal as I envisage it, the responsibilities to the public, that the Reserve bank presidents now have,
would still be maintained for they would participate as advisers in
Open Market Committee deliberations.
Mr. SAMUELSON. May I put in the record a recommendation about
salaries at some stage ?
Mr. REUSS. YOU certainly may. Without objection it will be
received.
(The recommendation referred to follows:)
The top salaries of Board members are woefully low and should be raised
substantially by Congress. The following inserts from my regular end-of-themonth articles for the Washington Post give some of my views on monetary
policy.
[From the Washington Post, Nov. 24, 1963]
How To B E A CENTRAL BANKER
Lord Chesterfield wrote letters of wisdom to his son, and F. Scott Fitzgerald
wrote similar letters to his daughter. In my children's house are many bedrooms. And, who knows, someday I may be able to speak of my son, the central
banker.
This then is a most appropriate time for a letter of wisdom from an academic
Polonius like me to a new member of the Board of Governors of the Federal
Reserve. Here are my five commandments.
I. Thou shalt vote immediately to raise your own salary.—This is no jest. A
Board member now receives a salary that was too low 20 years ago. Today
you can't even get a dean for such wages, much less a Presidential naval aide.
To be sure the job has 14-year tenure, with possible reappointment for not too
outstandingly good behavior. The pace is not frenzied; the pressure not great.
The cafeteria and tennis courts are among the best in Washington, and it is not
a bad post to retire to.
Still, as Adam Smith pointed out, it is poor economy to underpay people who
handle a great deal of money. And it is a fact that technical experts in any
organization have their pay held down by the pay scale of the bosses. The
THE FEDERAL RESERVE SYSTEM AFTER FIFTY YEARS
1125
excellent staff of economists and statisticians at the Fed will decline in quality
and, what is not the same thing, will increase in average age if the anomalous
situation continues to prevail in which college professors receive higher salaries
than public servants.
Since the Reserve System claims to be independent of the Executive, strike
a blow for freedom and do not wait for the long-delayed rise in Executive
salaries. Set the pace for once. Better still, legislate a sliding scale with a
General Motors yearly "improvement factor" in the salary level. What's good
for General Motors sometimes is good for the country. The profession of central
banking, like that of teachers and philosophers generally, is one of those sectors
with slow productivity growth: if the wives of its practitioners are to share in
the rising trend of living standards, hourly wages must rise there; this need not
involve any overall inflation—or what might be equally sinful—any violation
of the Kennedy-Heller wage-guide formulas.
Where is the money coming from to finance these increases? Are you kidding? Anyone who asks that question is thereby disqualifying himself for
the job of central banker.
II. On taking office do not divest yourself of your common stocks.—Remain
a member of the human race and invest your assets in a mediocre balanced
mutual fund, which holds the conventional one-third of bonds and two-thirds of
equities. (I needn't recommend a particular mediocre fund; serious scientific
investigation shows there is no other kind.)
These recommendations on petty personal finance are not trivial. Just as
Gibbon was said to have often confused himself with the Roman Empire, so<
there is an anthropomorphic fallacy that money managers fall prey to—of confusing the well-being of a steadily employed 55-year-old man with the interests
of a great and diverse country- Please no conflicts of interest!
III. Shake up the "Old Lady of Constitution Avenue'' a bit.—The place is
getting a little stale. Remember you have tenure and 14 years from now
most of the present Board will be retired.
Let me be specific. Everyone knows that the principal economists at the Federal Reserve in recent years have been Winfield Riefler, Woodlief Thomas,
Arthur Marget, and Ralph Young. Ask any jury drawn at random from the
15,000 members of the American Economic Association, and you will learn
that these have been gifted and respected experts.
But that jury will also report that they never represented four essentially
different points of view. Nor three different points of view. Nor, as far as
textual exegesis can determine, as many as 2.00 points of view. Granted this
is better than a similar evaluation, which finds that Bank of England economists
do not add up to even 1.00 points of view; still it is not good enough for a
country of 190 million people.
IV. Thou must do something about the public image of the Federal Reserve.—
An index number of scholar's confidence in the Fed, using 1928 as a base of 100,
showed a steady postwar rise from 3 in 1945 to 73 in late 1952. The incompetent handling of matters in early 1953 sent this index confidence plunging
down toward 50; there followed what technical chartists call a head-andshoulders topping out, until the disastrously biassed tight-money capers of
1956-60 created a crash in the index. Since then the index of confidence in the
probity of the Federal Reserve has been painfully climbing back toward the
level of 50.
How to improve the image? Sending Board members' speeches to the complete mailing list of the American Economic Association is perhaps not the most
constructive move possible at this time. Institutional advertisers in the leading economic journals is probably too crude. You can't buy love; you have
to earn it. The therapy must be fundamental and drastic.
V. Stop being jockeyed into the underdog position of last defender of the
stability of the price index.—The universe was not created with a basic division
of powers; the Government being under obligation to use its fiscal policies to
produce high and growing real output; the Federal Reserve being under obligation to use its monetary policy to insure stability of the price level.
Such logic leads—indeed it did lead, even in the days before gold was a problem—to credit policies that are too tight and fiscal policies that have thereby
to be so much the looser. The result, even at full employment, will be a bias
against capital formation and a bias toward present consumption.
1126
THE FEDERAL RESERVE SYSTEM AFTER FIFTY YEARS
The founders of the Federal Reserve really didn't know what they were
doing. But surely none of them thought they were designing an engine that
would be a bulwark against growth.
Son, do something about it.
PAUL A. SAMUELSON.
MASSACHUSETTS INSTITUTE OF TECHNOLOGY, November 1963.
[From the Washington Post, Aug. 25, 1963]
MONEY MACHINATIONS
I
A mysterious absence has been haunting the American economy these last
half dozen years. What in the world has happened to our money supply?
How is it that the total of currency in circulation and demand bank deposits
subject to checking, which is what economists call the money supply, has
failed to grow much since 1958?
President Kennedy fought his campaign on the promise to get America moving again. But all the President's horses and all of his men have apparently
not been able to put the money supply back on its century-old trend of at
least 3 percent growth each average year. Since the beginning of 1959, money
has grown scarcely 1% percent per year. There is a strong school of economists who think that, just as a teenage boy needs plenty of bread and ice cream
to grow on, so does an expanding economy need its full ration of new money
to grow on.
Money. Money. Money. That is their chant. Control it and you control
the stability and growth of the system. Mismanage it, or let it mismanage
itself, and you bring upon yourself boom and bust.
n
Bluntly, these economists blame the Federal Reserve for domestic stagnation
since 1959. Most of them favored Richard Nixon in the 1960 campaign; then,
and now, they attribute Kennedy's vistory to the Fed's stranglehold over the
money supply.
Chairman William McChesney Martin, Jr., of the Federal Reserve Board, is
their scapegoat. While many of us have been rather pleasantly surprised by
the flexibility of the independent Federal Reserve System in its cooperation with
the Kennedy administration, the monetary theorists indict the Reserve System
for currently contriving the tightest of tight money. They are scornful of the
claim that interest rates have been kept from rising much in the present recovery. They point to the chart of "M," the money supply. Never before has
it grown so little in 2y2 years of recovery; and that, they insist, is the only valid
criterion of whether money is too tight.
They regard the recent rise in the official discount rate as just the latest twist
of the tourniquet, and an omen of more to come. Mr. Martin, Secretary Dillon,
Under Secretary Rosa, and President Kennedy, they believe to be deceiving
themselves. There is no way to tighten money for balance-of-payments purposes without having it clamp down on domestic recovery.
ni
Suppose they are right. How would they handle the gold and international
problem? Here the M-men divide into at least three camps:
1. Some simply dismiss the gold problem. Let us pay out what we have
until we have no more and can then suspend gold payments and the gold standard. Or better still, they argue, simply let the dollar fluctuate in free exchange
markets according to supply and demand. While this may sound irresponsible
to lay people, this group presents elaborate argumentation to show we would
have been better off since World War I on a free-exchange-rate rather than
a fixed-exchange-rate system.
2. Others believe that free rates are undesirable or politically unfeasible.
If domestic prosperity should create a gold problem, they favor direct interventions—like the interest-rate equalization tax on purchase by Americans of foreign securities, export subsidies, or capital controls. Better still, they favor
THE FEDERAL RESERVE SYSTEM AFTER FIFTY YEARS
1127
a n eventual multilateral devaluation if prosperity and existing parities prove
£o be incompatible.
S. A final group expect that after prosperity has been achieved here by monetary expansion, interest rates will naturally rise enough to terminate shortterm capital and gold outflows. After chanting "Money, money," they chant
"Twist, twist." To keep money for domestic investment cheap they advocate the
following.
(a) Mr. Roosa should stop fumbling around with lengthening the maturity
of the public debt. He should float only short-term debt from now on, and buy
up fdr the trust funds all long-term bonds whose yields compete with interest
rates charged for plant and equipment financing.
(&) The Fed's Open-Market Committee should buy in long-term Government
bonds: eschewing short-term bills, it can help keep their yields competitive
with rates abroad. So far, "Operation Nudge or Twist," they believe, has been
pursued only on a token scale.
IV
Here is my brief evaluation of these issues. Actually, money has not been
quite so tight as this view alleges. Saving deposits which pay interest have
been growing rapidly while checkable deposits have languished. Undoubtedly
saving deposits are quite a substitute for demand deposits. If we broaden
the definition of the money supply to include such deposits, we have been
living in a very easy money period. The truth lies somewhere between the
definitions which either completely include or exclude saving deposits.
Nevertheless if it had not been for the balance-of-payments problem it would
have been optimal policy in this era of unemployment and steady prices for the
Federal Reserve to have made itself unpopular with the New York banking community by making money much easier than it has been. Some of the load
could then have been taken off the politically burdened shoulders of fiscal
policy. Private investment in plant, equipment, and housing could have been
stimulated to accelerate the growth of our full-employment potential GNP.
Even if one is an agnostic about the great potency of monetary policy a
five-and-a-half-percent unemployment rate requires that all such remedies be
given their trial.
Looking ahead, I agree that the Treasury and the Federal Reserve must do
more than they have been doing to prevent the tightening of long-term capital
funds that is developing as a result of the program to defend the dollar through
the elevation of short-term interest rates.
The heat will grow. While economics is too serious a business to be put in
the hands of the young Lochinvars from the West, even from the mouths of
zealots come cautions worth pondering.
PAUL A. SAMTJELSON.
MASSACHUSETTS INSTITUTE OF TECHNOLOGY, August 28, 1963.
Mr. REUSS. I t seems to me that these advisers are going to be
about the most expensive advisers in the world. F i r s t of all, they
are paid up to $70,000 per year.
Secondly, to help them in their advisory role, they have well-paid,
well-staffed research establishments.
I wish the Banking and Currency Committee had the research
establishment of at least one of the Federal Reserve regional banks.
Yet their primary function would be check clearance, that which
is performed for many a city by an affiliate of the banks known as a
clearinghouse. I have observed both. These institutions and their
work look very similar.
Because the clearing functions of the regional banks do not require
high-priced experts, you would in effect be paying astronomical sums
for advice from the 12 regional banks. You see
Mr. SHAPIRO. Yes, I
j Mr. REUSS (continuing).
tralize* policy functions in
appointed seven members
many you would appoint.
28-680—64—vol. 2
14
W h a t you have done here is, first, to cenWashington, vesting these in the publicly
of the Board of Governors, or however
I agree with this recommendation.
1128
THE FEDERAL RESERVE SYSTEM AFTER FIFTY YEARS
Secondly, you would be taking the nonmonetary policymaking
functions out of the Fed and putting these under the control of a
Federal Banking Commission which, I think, is also an appealing
proposition.
This would leave the 12 regional banks with one highly paid President and a highly paid set of officers to run a glorified clearinghouse
and a research establishment.
I am thinking now of the rather mundane subject of cost to the
people, because the taxpayers foot the bill of the Federal Eeserve
in the end. To the extent that the Fed spends money, it cannot get
back to the Treasury.
To ask my final question, could you not get the kind of regional
advice needed without paying so frightfully much money for it?
I t seems to me we could get honest and intelligent men from each
of the 12 present districts to come in and advise the Board. But
I do not see why you would have to pay the advisers three times
the salary of Board members, besides giving them staffs which are
the envy of the duly constituted monetary committees of Congress.
While we are at it, why could we not save a few hundred million?
Mr. SHAPIRO. Mr. Reuss, I think this is a very serious question, and
I do not wish to be trivial in responding to it, but I cannot avoid
the opportunity, however, of saying under our present system we are
paying all of that for five minority votes or a conceivable five
minority votes.
So I think that conceivably even if we maintain the present system
I think your question is a relevant one to which I wish I had a
handy answer.
Mr. REUSS. If I may interrupt you, under the present system, the
12 banks do some bank supervision, that is to say, they deal with
State banks which are Federal Reserve members for roughly the same
purposes as does the Comptroller of the Currency in dealing with the
national banks.
Mr. SHAPIRO.
Yes.
Mr. REUSS. But if you are going to take this supervisory function from them—and I must say it seems to me to be an irrelevant
function for the Federal Reserve System—what you have left are
these enormously expensive clearinghouses. A t one address on Wall
Street, you will have Mr. Hayes getting $70,000 a year with a multimillion-dollar research service, running a clearinghouse, although he
has in addition his Government securities business and his responsibilities in the foreign exchange area.
We will take Chicago. You would have in the Chicago Federal
Bank a President getting $50,000 or $60,000 a year with a huge
research establishment. But, unlike the New York Reserve banks,
all in the world the Chicago bank would be doing would be an
operation very similar to the Chicago clearinghouse down the street,
whose manager is doing a highly competent job with a far smaller
budget, particularly now that computers and electronic equipment
reduce money operations to button pressing.
Mr. SHAPIRO. Well, I would say, for one thing, the multimilliondollar research staffs in the regional banks, as you described them,
ought to be carefully examined in terms of what do we get for what
we pay, and I am not an expert, I do not know enough about what
they do to make glib judgments that they are either good or bad
THE FEDERAL RESERVE SYSTEM AFTER FIFTY YEARS
1129
Mr. KETJSS. If I may interrupt at this point, should not their
research output be shared by other governmental agencies ?
The Treasury and the Department of Commerce, for instance, are
interested in the state of the Union.
Mr. SHAPIRO. Yes, I think one possibility again, of course, would
arise from the fact that conceivably, as a result of adoption of the
plan I put forth, that the regional banks are regional economic intelligences of the Federal Eeserve Board, and it may well be that vou
could save a substantial amount of money in terms of duplication
which is done, which is unnecessary, and thereby free up resources
to either be returned to the Treasury or the
Mr. REUSS. F o r example, right now you have 13 congeries of people
in the Fed who get out reports and essays on our international balance
of payments.
We have 1 here in Washington and 1 in each of the 12 banks. They
are wonderful people, but with the shortage of good people in the
world could not just 1 of those 13 outfits contribute on the balance of
payments, free up some of these others to do more useful work?
Mr. SHAPIRO. Oh, these national issues on which, as I agree with
you, you look at the letters put out by the banks and there is a tremendous amount of overlap and duplication, I would expect, therefore, that you could either make a decision that you want to cut the
total amount of resources devoted to the research function within the
combined Federal Reserve System or, alternatively, say that you are
going to do other things, that you are not now doing, with the manpower that you have on hand, on the assumption that these are substittitable men, which is not always the case.
So that I would think there would be an improvement in efficiency
as a consequence of recognizing a delegation of responsibility, namely,,
the regional banks being a part of the Federal Reserve System's research and intelligence or research intelligence, thus the regional
research staffs would be concerned with a careful and detailed knowledge of regional matters, and would free up those portions of the
personnel in the regional banks that are duplicating what is being
done in the other Reserve banks and in the Board itself.
I think there are economies to be gained from that.
W i t h respect to the salaries paid to the Presidents of these banks,,
it seems to me that frequently, when people are perturbed about
suggestions that the open market committee be revised to preclude
voting rights to these reserve bank presidents, somewhere in their
testimony later on they will talk about the need for paying these*
salaries to attract commercial bankers or people who have alternatives
in commercial banks.
Well now, this tends to cause people who read these two pieces of
testimony to be quite concerned about giving the voting right to these
bank presidents. Whether the inferences are correct or incorrect is
beside the point.
I think, in point of fact, you are raising the question of: Are these
governmental officials? Never minct all the compromises that were
made in order to overcome the concern about domination of the financial power in Washington in 1913, and it is quite conceivable that
you would* indeed, get able men for less money, but I %m not in a
position to make such a judgment for partly i n teaching I argue*
that there is a relationship between returns and productivity.
1130
THE FEDERAL RESERVE SYSTEM AFTER FIFTY YEARS
Mr. REUSS. Let me ask one final question: Let's suppose we, the
Congress, adopted the overall Shapiro package here, after extensive
consideration in the committee.
Mr. SHAPIRO. Long delays
Mr. REUSS. The 12 regional Feds would become glorified check
clearinghouses except for retaining an advisory function. Let's
assume that the Presidents of these regional Feds should continue to
get a very, very handsome salary, $50,000 a year or more, double or
triple what scientists and Cabinet officials get.
Let's suppose further that they are given a research budget which
allows them to hire at top going prices a dozen crackerjack economists and a suitable complement of other stall.
And let us assume, furthermore, that they give high-level advice
to the Board of Governors in Washington. They would be^ wise men
on economic policy for their own regions, and their function would
be to present this expertise to the Federal Board.
Now, I come to my question: Do you not think you would get pretty
good people as candidates for those jobs?
Mr. SHAPIRO. I have not a single reservation in the world, and I
deem it inappropriate to offer my services, even at substantially below
$50,000. You will have to make a judgment as to whether I am competent, but on those financial terms I suspect that you could get able
people indeed.
Mr. REUSS. W h a t do you think ?
Mr. SAMTJELSONT. Well, my general viewpoint on salaries is one that
the Board members' salaries should be very considerably increased.
If I may enter into the record somewhat frivolous writings of
financial journalistics, I did speak to that issue.
I do not think that the total amount spent on salaries of the 12
Federal Reserve bank top officials is a great amount.
Now, admittedly, we should turn off the lights in the White House
and in the halls of this building when they serve no useful purpose,
and you will want to save money everywhere; but the consequences
of a good Federal Reserve System and a bad Federal Reserve System or a very good one and less-good one are so much greater than
the sums of money that we are talking about that I would leave that
to a separate survey of where one could economize.
Mr. SHAPIRO. Excuse me, Paul. I would certainly concur in that
and, as I understand it, by the way, the C E D is looking into this
whole salary question.
There is, however, one point t h a t I would like to make just as I
think one requires the compensation to get able people in the central
bank I think it is equally important that we able to recruit able
people in every other walk of Government enterprise, and I would
not single out the central bank as a peculiar group of people who
deserve more than the going rate on the assumption that at less thaii
these rates we attract very competent people in other parts of the
Government.
Mr. SAMUELSON*. I think that top Government salaries are much
too low for the responsibility that is exercised, with the result that
very poor people or very rich people are much more available for
those positions on a career basis than most of us in-between.
I have tried to
THE FEDERAL RESERVE SYSTEM AFTER FIFTY YEARS
1131
Mr. KETJSS. I agree with that. My question was whether $50;000 a
year, plus the availability of a topnotch staff of economists, is n o t
likely to attract good people.
Mr. SAMUELSON. I think that you will get good people for those
posts.
I think that the people in the past have been very good but not
beyond the expected range of excellence.
My own proposal has been very modest with respect to evolution.
Change as little as possible. Just correct the small things that need
change.
Now, to the very notion that you turn the 12 regional banks into
glorified clearinghouses, if that were the effect of Professor Shapiro's
recommendation I would consider that a debit against it.
There is an honorific function that is involved there. Even austere
socialistic countries, when they send ambassadors abroad, make sure
that their expense accounts are adequate to the station.
Mr. KETJSS. I do think you are flaying a dead horse here because
there was not a suggestion that the President of this bank be the
alpaca for his glorified clerk.
The suggestion was that the President of the 12 regional banks be
a person of very high stature, paid at least as well as he is now and
better than some of them now are, and with a staff adequate to his
function. He would be a regional pro consul who came to advise
Washington, just as he does now unless he happens to be a member of
the Open Market Committee. Both of you gentlemen, or at least
Professor Shapiro, would divest him of that.
Mr. SAMUELSON. I do not think you will save hundreds of millions
of dollars though if you confine your discussion to reducing the research staffs somewhat in the regional offices.
Mr. EEUSS. Well, a great part of the savings would come in amalgamating the bank-examining functions which are now spread over
three agencies.
That was the essence of the Shapiro-Eobertson suggestion. But I
do not purport to know how much it would save.
Well, thank you very much, gentlemen, for your great help. We
appreciate your appearing here, and the subcommittee now stands in
recess until Tuesday morning at 10 o'clock.
(Whereupon, at 12:05 p.m., the committee was adjourned, to reconvene at 10 a.m., Tuesday, March 3,1964.)
THE FEDERAL RESERVE SYSTEM AFTER 50 YEARS
TUESDAY, MARCH 3, 1964
HOUSE OF REPRESENTATIVES,
SUBCOMMITTEE ON DOMESTIC FINANCE OF THE
COMMITTEE ON BANKING AND CURRENCY,
Washington, D.C.
The subcommittee met, pursuant to recess, at 10 a.m., in room 1301,
Longworth House Office Building, Hon. Wright Patman (chairman)
presiding.
Present: Representatives Patman, Reuss, Vanik, Minish, Weltner,
Wilson, Kilburn, Widnall, Mrs. Dwyer, Harvey, Bolton, Brock, McDade, Talcott, and Clawson.
The CHAIRMAN. The committee will please come to order. Today
we are going to hear from Prof. Milton Friedman, the Paul Snowden
Russell distinguished service professor of economics at the University of Chicago. Professor Friedman is perhaps today's outstanding
expert in monetary economics. He is the author of many books and
articles, including "A Monetary History of the United States, 18671960," which he wrote with Mrs. Anna Schwartz,
I t is noteworthy that several of our earlier witnesses have alluded
to Professor Friedman's theories and policies. Some have indicated
his criticism of past Federal Eeserve policies is too strong, others have
said it is too weak. Some have told us his rule for conducting monetary policy is too rigid, others have said it is just what we need for a
well-run economy. Now, we will have a chance to hear from Professor Friedman himself on these matters, and I know that we will all
learn a great deal from his testimony.
STATEMENT OF PROP. MILTON FRIEDMAN, TUnVERSITY OF
CHICAGO, CHICAGO, ILL.
The CHAIRMAN. Professor Friedman, we are certainly glad to have
you, sir. I believe you have a prepared statement, and you may proceed in your own way, sir.
Mr. FRIEDMAN. Thank you very much for those kind introductory
comments, Representative Patman.
In these introductory comments, I shall discuss briefly three issues:
1. The desirability of an "independent" monetary authority.
2. The prohibition of interest payments on demand deposits.
3. Current monetary policy.
1. The desirability of a/n "independent" monetary authority
Should there be a truly "independent" monetary authority? A
fourth branch of the constitutional structure coordinate with the legislature, the executive, and the judiciary? That is the central issue
1133
1134
THE FEDERAL RESERVE SYSTEM AFTER FIFTY YEARS
involved in judging the present organizational structure of the Federal Reserve System.
I t is an issue that has recurrently been a subject of political controversy in the United States and that has been decided sometimes
one way and sometimes the opposite. I t was decided in the affirmative
when the first Bank of the United States was established in 1791;
in the negative after a bitter battle when the bank's charter was allowed to expire in 1811; again in the affirmative when the second bank
was chartered in 1816; again in the negative when the second bank's
charter was allowed to expire in 1836 after the bank war between Andrew Jackson and Nicholas Biddle.
The pendulum swung again in the Civil W a r when the National
Banking System was created but that time only part way. The next
50 years saw frequent debate over the issue but no major change until
the enactment of the Federal Reserve Act in 1913. That act completed
the swing by establishing again an "independent" monetary authority.
This time, the independent power was lodged primarily in the regional Reserve banks.
Until Benjamin Strong's death in 1928, the power was in fact
exercised primarily by New York. Strong's death unleased a struggle for power that produced a transfer from New York to the other
banks, a transfer that had tragic consequences for the Nation.
The mistakes of the Reserve System in 1919-21 and the even more
disastrous mistakes of 1929 to 1933 led to a swing part way back, away
from independence. Though the Banking Acts of 1933 and 1935
broadened the range of monetary instruments that could be used by
the System, they also transferred effective power from the banks to
the Reserve Board.
I n principle, the Board is independent, and, in practice, it has displayed some measure of independence. Yet it is clearly subject, far
more than the banks were, to political pressure, direct and indirect.
I t is hardly conceivable that the Board could today defy political pressure to anything like the extent and for anything like the length of
time that the banks did in the early 1930's.
Should this residual degree of independence be increased or decreased ? I n an article that I am submitting herewith for your consideration and for the record, I have discussed the issues of principle
involved in some detail. I shall therefore simply state my major conclusions :
(1) Proponents of an independent monetary authority seek a stable
monetary structure that is free from day-to-day political pressures.
This aim is eminently desirable.
(2) However, a truly "independent" monetary authority is most
unlikely to achieve this aim. Experience shows that independent,
monetary authorities have introduced major elements of monetary
instability, and analysis suggests that they can be expected to continue
to do so. I n addition, it is most undesirable politically to give so much
power to individuals not subject to close control by the elect orate.
(3) The surest way to achieve the aim of a stable monetary structure is, in my opinion, to legislate a rule specifying the behavior
of the quantity of money. The rule that I favor is one which specifies
t h a t the quantity of money shall grow at a steady rate from week to
week, month to month, and year t o year.
THE FEDERAL RESERVE SYSTEM AFTER FIFTY YEA&S
1135
Z. The prohibition of interest payments on demand deposits and control over interest rates payable on time deposits
The prohibition of interest payments on demand deposits, enacted
in the Banking Acts of 1933, for member banks, and of 1935, for
other insured banks, was not then desirable and is not now. I t is a
straightforward example of governmental price-fixing, of a governmentally enforced price cartel. The price that a bank can explicitly
pay to borrow funds from depositors is fixed at zero, and this fixed
price is enforced by the Government.
The fixed price of zero serves no public purpose and runs directly
counter to our general objective of fostering free markets and free
enterprise.
Insofar as it serves any private purpose, that purpose is simply to
inhibit competition among banks and thereby enable them to pay less
than the competitive price for the funds they borrow and to earn
more than the competitive rate of return on their capital.
I t has always seemed to me a remarkable example of how hard it is
to be objective about one's own problems that the banking community, which is so strong an advocate of free markets and free prices
in almost all other respects, should believe it to be in the public interest
for the Government to fix the price of the major resource purchased
by the industry.
The prohibition should be repealed at once.
Similarly, the powers which the Reserve Board and the F D I C now
have to control the rates of interest that commercial banks may pay
on time deposits should also be repealed. They have no more justification than the prohibition of interest payments on demand deposits.
3. Current monetary policy
I turn now to current monetary policy partly because it illustrates,
in my view, the difficulties with an independent monetary policy.
The chief defect in Federal Reserve policy has been a tendency
to go too far in one direction or the other, and then to be slow to recognize its mistake and correct it. Contrary to widely held views, the
major mistakes of this kind in peacetime have all been in a deflationary
direction (if 1919 is excluded as still part of the wartime experience) :
These major mistakes include the sharp deflation enforced on the
country in 1920-21; the contraction in the quantity of money by
one-third from 1929 to 1933; the doubling of reserve requirements in
1936-37 and the subsequent shift from a rapidly rising to a declining
quantity of money; and, most recently, the decline in the quantity
of money from 1959 to 1960. That decline certainly contributed to
bringing the expansion which began in 1958 to an untimely end; and
may, indeed, have been the primary reason for the brevity of the
expansion.
Current policy again reveals the tendency for the System to go too
far, though at the moment in the opposite direction; namely, in the
direction of an unduly rapid expansion in the quantity of money.
For the background of the present situation, it is perhaps desirable
to start with early 1958, when the quantity of money started to rise at
a rapid rate as a result of a belated but vigorous response by the Reserve System to the recession that began in mid-1957. During the
rest of 1958, the quantity of money rose at a very rapid rate. The
1136
THE FEDERAL RESERVE SYSTEM AFTER FIFTY YEARS
recession, which had aroused wide concern that it would prove deep
and long, ended in April 1958. The rest of 1958 was characterised
by vigorous expansion.
Chart 1
Comparison of Changes in Money and Production, 1957-1963
Panel A.
Billion dollars
280
260!
Seasonally Adjusted Data
Ratio scales
Index (1957-59 = 100)
Money stock
240
220
200
180J
Currency plus demand
deposits adjusted
160
140
Panel B.
Month-to-Month Rate of Change
+2
Money stock
Index of industrial production (FRB)
•1957
1958
•1959
1960
1961
The horizontal broken lines represent high and low steps in the rate of change.
T and P show reference cycle turning points.
1963
THE FEDEKAL RESERVE SYSTEM AFTER FIFTY YEARS
1137
I have here a chart which presents some of the same evidence in a
visual form and which may help to bring home to us some of the particular points I am making.
The chart covers the period, as you will see, from 1957 to 1963 and
shows in the top panel, at the very top, what we have called the money
stock, which includes currency, demand deposits, and time deposits at
commercial banks.
The next line down is what the Federal Eeserve System calls the
money supply, currency plus demand deposits adjusted.
The bottom curve in panel A is the index of industrial production
and is some indication of what has happened to general business.
You can see the episode that I am now speaking of by the sharp decline in business from 1957 to 1958, which was the recession of that
year.
I t is difficult to see what is happening in the series on the stock of
money, because it is such a steady series with a rapid upward trend.
A much better idea can be obtained from the series in the bottom
panel showing month to month changes in the stock of money. The
scale for the series is in percent per month. The top series in panel^B
is for the money stock defined to include time deposits in commercial
banks. The next series is for the more narrowly defined money
stock—currency plus demand deposits only.
You can see that the recession in 1957 had been preceded by a rather
slow rate of growth in the money stock.
This jump in the series at the end of 1957 was the Federal Eeserve
Board's reaction to the recession. As you can see, the reaction came
late. I t came at the end of 1957, although the recession had been in
progress for some time. I t was followed, a few months later, by the
beginning of an upturn in industrial production.
The next step is the rapid rate of increase in the quantity of money
in 1958 which I was speaking of a moment ago. I t was associated
with or brought to an end or helped bring to an end the contraction
and to launch the subsequent expansion.
I n 1959 the Eeserve System again reversed course, as is reflected in
the sharp drop in the rate of change in the money stock. I t reversed
course partly because it concluded, and correctly, that it had shifted
too far in an expansionary direction partly because of concern over
gold losses.
Once again, unfortunately, it shifted too far, this time in a contractionary direction. The quantity of money not only ceased growing, it actually declined from J u l y 1959 to June 1960. The rate of
change was negative, as can be seen in the two top series in panel
B of the chart.
The monetary decline was followed by economic recession.
As can be seen in panel A of the chart, the index of industrial
production reached its peak in early 1960. The P on the bottom line
of panel A marks the date that the National Bureau has designated
as a reference peak. I t is when they estimate that business in general
reached its peak. I t came on this occasion later than the peak in
industrial production, and both came some months after the downward shift in the rate of change of the money stock.
I n mid-1960, there was another shift, this time to a higher rate.
F r o m June 1960, the quantity of money rose at a fairly rapid rate to
the end of January 1962.
1138
THE FEDERAL RESERVE SYSTEM AFTER FIFTY YEARS
The monetary expansion was followed by economic expansion beginning in early 1961. Once economic expansion was clearly underway, the System again reversed—presumably because of continued
concern with gold. From January 1962 to August 1962, the money
stock, defined narrowly, to include currency and demand deposits—
that is, the second one of the lines in each panel—actually fell at an
annual rate of about 1 percent; defined more broadly, to include
commercial bank time deposits as well, it rose at a fairly rapid rate—
about 5!/2 percent per year—though more slowly than in the prior
year.
This discrepancy between the rates of growth of the two definitions
of money is far wider than usual. I t was itself produced by Federal
Reserve action, raising the maximum rate of interest commercial
banks could pay on time deposits.
Taken altogether, the period from 1957 to mid-1962 was characterized by unduly wide swings in the rate of growth of the money stock
and also by a somewhat lower average rate of rise in the money stock
than in earlier postwar years. The swings in the money stock contributed to the too-frequent ups and downs in the economy. The
low rate of rise in the money stock contributed to the generally high
level of unemployment but also, on the favorable side, to relative
stability in wTages and prices.
September 1962 saw another change of course. The change was
in a desirable direction, but too great in magnitude. Since then, the
quantity of money, defined narrowly, has risen at a rate of nearly
iy2 percent a year; and defined more broadly at over 8 percent a year.
These are rates of rise that cannot be long maintained without producing a substantial increase in prices.
Over the some 90 years for which we have data, the average rate
of rise of the money stock, broadly defined, the top line, was about
5y2 percent, and even this was larger than was consistent with stable
prices. Prices at the end of the period were higher than at the beginning by an amount which, averaged over the nine decades, equaled
a rise of 1 percent a year. Over these nine decades, there is no instance in which the stock of money, broadly defined, grew as rapidly
as in the past 15 months for as long as a year and a half without being
accompanied or followed by an appreciable price rise.
I t is worth noting how closely the shifts that I have listed in the
rates of growth of money have been followed by changes in economic
activity. Each time the quantity of money has risen at a more rapid
rate, economic activity has some months later accelerated, and conversely.
That is the connection I have been pointing out on the chart where
it comes out very clearly.
The connection is particularly close and impressive in the current
expansion. A faster rate of growth in the quantity of money beginning in mid-1960 was followed by the end of the recession in early
1961 and a rather rapid recovery during the rest of the year.
The slowing down in the rate of growth of the quantity of money
in early 1962 was followed a few months later by a slowing down
in the rate of recovery that caused so much concern and that produced
a level of income for the year 1962 appreciably below the early forecasts o i t h e Council of Economic Advisers.
THE FEDERAL RESERVE SYSTEM AFTER FIFTY YEARS
1139
The increase in the rate of growth of the quantity of money in September 1962 was followed around January or February 1963 by an
acceleration in economic activity and a rapid growth in income despite the absence of the tax cut that had been advertised as a sine qua
non of continued recovery.
Why has the Reserve System been so erratic? Why has it shifted
back and forth and tended to go too far in each direction ?
There are, I believe, two main reasons. The first is the use by the
Eeserve System of the wrong criterion of policy. The Reserve System,
and so also most people who discuss monetary policy, tend to state
the objectives of policy in terms of what are called money market conditions. The most popular current variant stresses interest rates and
judges performance by the behavior of interest rates.
Other variants stress availability of credit, free reserves, borrowings by banks, and the like. Now, the fact is that the Reserve System
is only one of many forces affecting credit conditions; it can affect
interest rates only to a limited extent; and it can do even that only by
giving up control over the quantity of money.
On the other hand, the Reserve System can, if it wishes to, control
the quantity of money. By altering the volume of reserves available
for banks to hold, it can determine the quantity of money within very
narrow limits and with very brief delay. No other agency in the
economy can exercise anything like a corresponding degree of control
over the quantity of money. The behavior of the quantity of money
should be the primary criterion of monetary policy.
The second reason why the Reserve System has tended to go too far
in its swings is because of the time it takes for its actions to have effects. The effects of monetary expansion occur only several months,
and sometimes many months, after the expansion. The result is to
blur the connection and to lead to overreaction when the effects finally
become manifest. At the present moment, for example, there is already built into the economy considerable monetary steam.
If the Reserve System waits until the inflationary effects of its present policies become clearly manifest and only then curtails the rate
of monetary expansion, it will be months thereafter or perhaps a year
or more before the inflation is stemmed. I n the interim, it will understandably be tempted to step on the brake too hard.
This delay is very clearly seen in the chart which shows how each
of the shifts in the rate of change of the money stock has been followed some months later by the corresponding movements in economic
activity.
To summarize briefly this discussion of current policy: the Reserve
System moved in the right direction when it speeded up the rate of
growth of the quantity of money in mid-1962, but it went too far;
it has since then produced a faster rise in the quantity of money than
can be maintained for long; the danger is that when this becomes
painfully apparent, the Reserve System will again, as so often in the
past, swing too far in the opposite direction and force unnecessary
deflation on the country; if this outcome is to be avoided, it is essential that the System promptly moderate the rate of growth in the
stock of money and shift to a rate that it can maintain indefinitely.
Finally, the major requisite for a continuing improvement in monetary policy under the present organizational structure is that the System use the quantity of money as the magnitude in terms of which it
1140
THE FEDERAL RESERVE SYSTEM AFTER FIFTY YEARS
states its proximate objectives, and adapt its day-to-day instruments
of policy to control the quantity of money in accordance with stated
objectives. I t should permit interest rates to adjust in the light of
market forces to whatever levels are consistent with the resulting
quantity of money.
Thank you.
The CHAIRMAN. Thank you, Dr. Friedman.
Mr. Eeuss, would you like to question Dr. Friedman ?
Mr. REUSS. Thank you, Mr. Chairman.
Welcome, Mr. Friedman. When you speak of the ability of the central bank to control the money supply, they do that, do they not, by
making available bank reserves and deposits which are the crucial part
of the money supply here, but are only created if businessmen and
others utilize that lending capacity of the banks ? Is that not so ?
I n a time of real depression, the monetary authorities can create
tremendous bank lending powers through increasing reserves, yet the
money supply may not be much increased if businessmen are absolutely
hopeless and do not borrow money at any price. Is that not so ?
Mr. FRIEDMAN. I do not believe so. I t has often been alleged to be
true and one can conceive of a kind of world in which it would be true.
However, in the course of many years of American history it has never
been true, so far as I can judge from the evidence.
The fact of the matter has always been that if banks get additional
reserves they can, at their own volition, use those to increase the monetary supply. If businesses were not willing to borrow, which again
has, so far as I know, never been the case, then banks can buy investments.
They can buy Government securities, State and local securities, and
soon.
Mr. REUSS. And in either case there is an addition to the money
supply ?
Mr. FRIEDMAN. There is an addition to the money supply. To the
best of my knowledge, as I say, there is no case in at least the 90 years
of American history for which I have examined the evidence in detail
in which the situation you describe has existed.
Mr. REUSS. Fine. You have answered that question very clearly.
You believe that this country would be better off if Congress simply
legislated a rule of conduct for the monetary authorities which said,
"Increase the money supply defined, as currency outside banks and time
and demand deposits at the annual rate of 4 percent a year" ? You say
3 to 5 percent.
Mr. FRIEDMAN. The percentage I have used has been for the broader
concept of the money supply. On the experience of the past 90 years
you would want to use a slightly smaller percentage for the narrower
concept you referred to.
Mr. REUSS. YOU suggest in your article some number between 3 and
5 percent for the narrower
Mr. FRIEDMAN. N O , I believe it is for the broadly defined monetary
stock.
Mr. REUSS. Well, you say, "For this purpose I have defined the stock
of money as including currency outside commercial banks plus all
deposits of commercial banks.
" I would specify that this should rise by x percent or some number
between 3 and 5"
THE FEDERAL RESERVE SYSTEM AFTER FIFTY YEARS
1141
T h a t is the narrow definition ?
Mr. FRIEDMAN. N O . I t is the broader of the two which I referred
to in my testimony and which are depicted on the chart.
There are still oroader definitions that one can use, but the broader
of these two precisely corresponds to what you mentioned.
I t includes both demand deposits of commercial banks and time
deposits of commercial banks, whereas the narrower definition would
include only the demand deposits of commercial banks.
Mr. EEUSS. I see.
Mr. FRIEDMAN. NOW, you can have still broader definitions by including the time deposits of mutual savings banks, mutual savings
and loan associations, and so on.
Mr. EEUSS. D O you ever recommend a percentage increase for the
narrower definition just including currency outside banks a n d — Mr. FRIEDMAN. Yes, 3 to 5 is about right for the broader definition.
Somewhere between 2 and 4 is about right for the narrow definition.
Mr. KEUSS. NOW, which of the two would you select if we were
writing the statute here ?
Would you take the broader or the narrower or an average of
both?
Mr. FRIEDMAN. I would take the broader subject to the proviso
that the present control over rates of interest on both demand deposits
and time deposits is eliminated. The control of the rate of interest
has been a major source of erratic shifts between the totals defined
by the two definitions.
Mr. EEUSS. We had a recent example of that within the last 2 years
when the Fed allowed a higher rate of interest on time deposits, and
then at a time when they had been, as they frequently do, creating
very niggardly inadequate additions to the money supply, and they
pointed to the broader definitipn and said, "Look, we have been creating money like a drunken sailor here.
"Look at the way the money supply, broadly defined, has moved
up."
Mr. FRIEDMAN. That is this difference right here on the chart at
the beginning of 1960.
Mr. EEUSS. But this would be an illusory way of looking at it, would
it not?
Mr. FRIEDMAN. Eight.
Mr. EEUSS. Further, with this model statute we are constructing,
I will recapitulate as follows: Congress says to the Fed make additions to the money supply at an annual rate of 4 percent, "money"
being defined as currency outside banks and both time and demand
deposits.
What instruments of monetary policy would you let the Fed use?
Certainly, open market policy ?
Mr. FRIEDMAN.
Yes.
Mr. EEUSS. Would you keep the rediscount window open ?
Mr. FRIEDMAN. There are different levels on which one can discuss
this.
My own preference, if you really were altering the powers as well
as the rule, would be to eliminate discounting completely.
Mr. EEUSS. But let banks borrow where they can ?
Mr. FRIEDMAN. Eight, and have open market operations. I would
also eliminate the ability to change reserve requirements so that I
1142
THE FEDERAL RESERVE SYSTEM AFTER FIFTY YEARS
would leave the Fed with the one tool which is the most potent they
have; namely, open market operations.
Mr. EEUSS. If we do that, and I approach this with an open mind
and I am certainly not saying we should not, we can then save some
money on salaries of the Board of Governors and we can get a computer to do all this ?
Mr. FRIEDMAN. Under present circumstances, we do need a computer, because there is a sizable slip between the open market operation and the final money supply, first because part of the total money
stock is held as currency and the public may change the proportion in
which it wants to hold currency and deposits and, secondy because
the banks may change the ratio of reserves they want to hold.
Mr. EEUSS. YOU could give us the program for that computer so
that
Mr. FRIEDMAN. Well, the Federal Eeserve now could give that program to you very well and much better than I can.
They have such a program, of course. And, do not misunderstand
me, I think the Federal Eeserve would operate such a program very
well. I think they are very good at these kinds of technical operations. The problem is not their technical capacity but what rule they
follow, what criterion they use.
Mr. EEUSS. Back to your percentage again, should it be 3, 4, or 5 ?
Have you considered anything like a formula-timing arrangement
such as stock market operators use, whereby you could relate th^t
percentage to such things as unemployment, degree of unused industrial capacity, so that in a year or a month or a week, at which we were
running at 6 percent unemployed and 15 percent of the industrial
capacity unused, maybe that week the money supply ought to be increased at a rate of 5 percent, whereas in a week when we get closer
to capacity you ought to go down to 3 percent? Would that not be
feasible ? Is there anything wrong with considering that ?
Mr. FRIEDMAN. There is obviously nothing wrong with considering it and, of course, it is feasible to have such a formula, but I do
not think it is desirable at the present state of our knowledge.
The reason it is not desirable is because I do not think we could have
reasonable confidence that such a formula would do good rather than
harm.
The reason at the moment we cannot have such confidence is precisely the point I have emphasized earlier; namely, the time which it
takes for monetary changes to have their effect.
We cannot even measure what unemployment is now. W e can
measure only what unemployment was a month or more back. More
important, what we do now will affect not the unemployment of today
or 3 months ago, but maybe the unemployment of 5 months from now
or 6 months from now or a vear from now.
So, in point of fact, I do not believe that we know enough now to
set up a formula of this kind which would do more good than harm.
Mr. EEUSS. Strangely enough, I have more fears about your ingenious proposal on the inflationary side than I do on the deflationary
side. Strangely enough, you know what side I am worried about.
That is so for this reason. If you set your percentage figure of
money increase each year at, say, 5 percent, I would really have no
fears about it being inadequate. I n years of terrible depression—God
THE FEDERAL RESERVE SYSTEM AFTER FIFTY YEARS
1143
forbid we have them—there still probably would be enough money
available to get the economy moving forward, because banks could sell
their earning assets to make loans any time anybody really wanted
them.
However, on the inflationary side, if you speak in terms of the Continent of Europe, of the full employment of men and factories, I tend
to shy away a bit from creating 4 percent additions to the money
supply in the year.
I will let you get by without putting an accelerator on this, but
could you not put a brake on it ?
Mr. FRIEDMAN. I think it would be very undesirable to do so. I n
point of fact, I personally do not know of any inflationary episode
in any country in which the money supply has increased as little as
4 or 5 percent a year.
The only way, I believe, that you could get the kind of dangerous
inflationary conditions that you are conceiving of would be by having
a more rapid rate of increase in the money supply than would be
specified in the rule.
This is certainly true of American experience. I have not examined equally carefully the experience of all other countries, but I do
not know offhand of any example in which there has been substantial inflation without a substantial rate of rise in the money supply,
by which I mean a rise of more than 4 or 5 percent a year.
Mr. KEUSS. S O your answer to my question would be, in the first
place, you think the Friedman type of formula would prevent the
overflow of employment which raises this problem in the first place.
Secondly, if you should prove to be wrong, you would be the first
man to come in here and confess error and say change the law tomorrow so as to put on this brake
Mr. FRIEDMAN.
Yes.
Mr. REUSS (continuing). Which could be done in a great hurry,
could it not ?
Mr. FRIEDMAN. Yes; it could; and I think it would.
And I may say, on this score, Mr. Reuss, I prefer very much the
rule over alternatives that I know, but as between two other alternatives, which is congressional control of monetary supply and central
bank control of monetary policy, I would personally prefer to trust
the Congress.
Mr. RETTSS. I am deeply touched
Mr. FRIEDMAN. I hasten to add, Mr. Reuss, that high as is my regard
for the Congress and its Members, my preference for having Congress
in control is not because I believe the Members of Congress are personally able or more devoted than the members of the Board.
I think the members of the Board and the System are devoted
public servants and able people. That is also true of Members of the
Congress, and I do not mean to make a distinction between them.
The difference is in the pressures under which they operate. I t is a
natural human quality of every one of us that the hardest thing in the
world is to do what you just generously suggested I would do, and
that is to admit error.
If any one of us can possibly avoid it, we will.
If a person is a member of a board which is in a so-called independent position, so that he is not subject to being unseated at the next
28-680—64—vol. 2
15
1144
THE FEDERAL RESERVE SYSTEM AFTER FIFTY YEARS
election, it is very, very tempting for him, once he has made a mistake,
to be slow to recognize that it is a mistake. I t will have to be shown
to be a real and glaring mistake before he will come to the conclusion
that it was a mistake.
On the other hand, if he is a Member of Congress, he does not have
t h a t much leeway. Under circumstances when Congress is making a
terrible mistake, the Congressman will hear from the voters back home.
I look at our own monetary experience and history. I am personally
convinced that, in the great depression from 1929 to 1933, this country
would have been far better off if the Congress had been followed
than it was with the Reserve System sitting in the saddle.
If you read the records of the Reserve System, what do you find ?
You find that after an initial mistake everybody's opinions congeal.
"Oh, it is not our fault. Other people are responsible and we have
to maintain our position."
Why did the System ever engage in the open market operation of
1932 which was the one occasion, during the depression, in which it
engaged in large-scale expansionary action? Under threat of a congressional investigation.
The open market operation was ended a week or 2 weeks after
Congress adjourned.
So I think that the record is very clear that our performance in
the 1930's in the monetary area would have been very much better if
Congress had had control over it than the way it was.
Mr. REUSS. Thank you.
The CHAIRMAN. Mr. Widnall ?
Mr. WIDNALL. Thank you, Mr. Chairman.
Professor Friedman, you have offered some very interesting testimony and certainly some stimulating thought.
I n studying the Federal Reserve System and its actions through the
period of years have you, in any way, contrasted that with the action
of foreign central banks during the same period ?
Mr. FRIEDMAN. Only to a very limited extent, Mr. Widnall. I
know, of course, of the actions of the Bank of England during the
1920's and the Bank of France during that same period, because that
was the period in which our central bank, the Bank of England and
the Bank of France, were working very closely together in cooperation.
I am not sure what phases of their operation you would like me to
comment on.
Mr. WIDNALL. Well, I am thinking right now: The Bank of England has just raised the rate from 4 to 5 percent.
If you were advising the Bank of England, the central bank, do you
think they are operating in a correct way to meet the changes of
economy over there ?
Mr. FRIEDMAN. I have not followed in detail the current circumstances of the British economy, so I cannot answer the question about
this particular rise.
I n general, of course, the situation of England and the situation of
the United States have one very important point of difference, and
that is that foreign trade is much more important to Britain than to
the United States. Hence, monetary policy in Britain, under present
international arrangements, namely with fixed rates of exchange, has
THE FEDERAL RESERVE SYSTEM AFTER FIFTY YEARS
1145
to be much more sensitive, to adapt much more rapidly to its international financial position than does the monetary policy in the United
States.
Mr. WIDNALL. Is not one of the most important things we are
facing today our balance-of-payments situation and does not that involve foreign trade ?
Mr. FRIEDMAN. Yes, indeed, it is.
Mr. WIDNALL. So that the action of the Federal Reserve cannot be
taken just predicated on what is happening in the domestic economy.
I t also must relate itself to the entire world ?
Mr. FRIEDMAN. Unfortunately, you are right. T h a t is because we
are following what, in my view, is a most undesirable policy with
respect to our balance of payments.
As I have testified before the Joint Economic Committee, I personally am in favor of a free market solution to the problem of the
balance of payments by setting exchange rates free to fluctuate and
to be determined in the open market. That would make it possible
to have a domestic monetary policy that does not have to be wagged
by the 5-percent tail of our economy which consists of foreign trade.
Mr. WIDNALL. On page 5 of your testimony you said:
The swings in the money stock contributed to the too frequent ups and downs
in the economy. The low rate of rise in the money stock contributed to the
generally high level of unemployment but also, on the favorable side, to relative
stability in wages and prices.
Now, do you think that a change in the money stock would have
helped those who do not have the skills in today's unemployed ?
Do you think it would help those who are frozen out of employment
because of age today ?
Mr. FRIEDMAN. Well, obviously
Mr. WIDNALL. Federal reserves have nothing to do with those
Mr. FRIEDMAN. I would like to emphasize that, while the money
stock and monetary policy are extremely important, they are not
everything, by any manner of means.
What determines the real wealth of the Nation is not its monetary
institutions or policy. W h a t determines the wealth of a nation are
the qualities and capacities of the human beings, of the kind that you
have been referring to, the kind of economic system under which we
operate, the resources we have available, and so on.
Monetary policy operates mainly to affect, on the one hand, the level
of prices and, on the other hand, the fluctuations.
If you had not had the sharp decline in the rate of growth of money
from 1959 to 1960 I believe that the 1958-60 expansion would have
continued for a longer period.
I believe that that would have meant more jobs for people, including the people who are low in skill and including the people who are
at advanced ages.
The circumstances under which a man of 60 can get a job depend
on the general buoyancy of the market. I n a boom, at a time when
there are many job opportunities, he will get a job more easily than
at the time of a recession.
So I think the answer I would make is, "Yes." A more stable, steady
monetary policy during that period would have meant that fewer
people would have been unemployed and among them would have been
some of the people you mentioned.
1146
THE FEDERAL RESERVE SYSTEM AFTER FIFTY YEARS
Mr. WIDNALL. Does not Government action in many other fields
affect unemployment, for instance, that you cannot go out and earn
anything over a certain amount if you are on social security, yet social
security may not support you and your family ?
H a s not the fact that today many people do not want part-time jobs
contributed to moonlighting and if the person who is unemployed
wants a full-time job they cannot get people for part-time jobs, so
the people who work all week take part-time jobs over the weekend?
Now, part of this has been frozen in by Government action.
Mr. FRIEDMAN. Of course, I quite agree.
I think a considerable fraction of our present unemployment may
well be attributable to Government action in other fields. I am only
speaking about monetary policy and monetaiy policy is not a panacea
that will cure everything, and we must not suppose it to be that.
Mr. WIDNALL. Well, what I was just trying to get at is this: I took
it from your statement that you were emphasizing that the Federal
Reserve had a great deal to do with the high rate of unemployment
continuing through the years.
What I was trying to point out is that they may have had something
to do with it but there were many, many other factors involved in it
that contributed to it that they had no control over.
Mr. FRIEDMAN. That is entirely right and, as I say, in that same
statement, their policy contributed to the generally high level of unemployment but also, on the favorable side, to relative stability and
wages and prices.
So that there are two sides to the picture. I n addition, I quite agree
that there are many other factors that affect the level of unemployment.
Mr. WIDNALL. Professor Friedman, to go back to page 2 you said:
Even more disastrous mistakes of 1929 to 1933 led to a swing part way back,
away from independence.
As I recall it, during that period the Secretary of the Treasury had
an active role with respect to Federal Reserve decisions. Is that not
so?
Was not he part of the setup at that time ?
Mr. FRIEDMAN. H e was an ex officio member of the Federal Keserve
Board but at that period Federal Reserve policy in the United States
was being determined by the Federal Reserve banks and not by the
Board. The fact of the matter is that, during the period you were
speaking of 1929 to 1933, the Under Secretary of the Treasury, Ogden
Mills, was one of the few voices in Washington that was consistently
taking what I, in retrospect, regard as a sensible position at that time.
Ogden Mills was consistently in favor of the Federal Reserve following a more expansionary policy.
After 1930, late 1930, when Eugene Meyer became Chairman of the
Federal Reserve Board, the Federal Reserve Board as a whole, consistently along with the New York bank, was in favor of an expansionary policy and the Board plus the New York bank were overruled
by the outlying banks: Chicago, Boston, Philadelphia and so on.
So that while you are quite right, that the Secretary of the Treasury
was a member of the Board, you are, if I may say so, viewing that
situation in the light of the present powers of the Board and not in
light of the fact that as of that time effective power was being exercised by the Federal Reserve banks and not the Board.
THE FEDERAL RESERVE SYSTEM AFTER FIFTY YEARS
1147
Mr. WIDNALL. I t is not clear to me what you mean, as you read
further on that same page, where you say:
Though the banking acts of 1933 and 1935 broadened the range of monetary
instruments that could be used by the System, they also transferred effective
power from the banks to the Reserve Board.
In principle, the Board is independent and, in practice, it has displayed some
measure of independence.
Yet it is clearly subject, far more than the banks were, to political pressure,
direct and indirect.
Now, I understood the purposes of these hearings, in evaluating
the 50 years of the Federal Reserve System, were to also consider a
bill that would place the Federal Eeserve System in an operation
where they would be directly subject to political pressure.
Have you any comments to make on the pending bill which would
change the composition of the Federal Eeserve Board ?
Mr. FRIEDMAN. Well, now, let me comment not on the details of that
bill but on the general aim.
I n my view it would be desirable to make it clear and explicit that
the Board and the Eeserve System are subject to direct political control by the administration and the Congress. I n my view, the present pseudoindependence is not a real independence and is, as in the
past, likely to do harm rather than good.
As to the specific measures which are taken to achieve this object, I
do not myself feel competent to judge those in detail. W h a t I am
trying to do in those sentences, Mr. Widnall, is to separate the substance of what is really the case from the mere form.
I n practice, the most important thing that was involved in theBanking Act of 1933 to 1935 was shifting the focus of power from
a dozen cities spread around the country to Washington.
The Board in Washington is very much subject to a kind of
political pressure which the banks spread around the country are not.
I n addition, the Board in Washington, the members of it are appointed by the President. They are directly connected with the political activities in the Capitol.
They are sensitive to the currents of opinion. I t is literally incredible to me that our present Board could maintain a policy as
much in variance with the policy desired by Congress as the System
maintained from 1932 to 1933. I just do not believe that this would
be conceivable.
And I wonder, Mr. Widnall, whether you think it would be conceivable to have such a situation ?
Mr. WIDNALL. I think the present system is working pretty well,
and I would differ with you in my own analysis of the situation. I
just do not see the consistency of your saying that this present setup is
far more subject to political pressures direct and indirect, when the
charge is made day after day about the Federal Eeserve System, that
they are not responsive to the President or to the administration.
I t does not seem to go together.
Mr. FRIEDMAN. The question is: Should this residual independence
be increased or decreased ?
The Board does have a measure of independence. The question
is does it still have too much or too little and, in my own view, it still
has too much.
Mr. WIDNALL. That is all for the time being. Thank you.
1148
THE FEDERAL RESERVE SYSTEM AFTER FIFTY YEARS
The CHAIRMAN. Mr. Vanik?
Mr. V A N I K . I just have a couple of questions here.
Your statement deals broadly with the relationship of money supply in prosperity. Now, is it your theory that the rising interest rates
are brought about by the inadequate money supply ? That seems to
be the substance of it, is it not ?
Mr. FRIEDMAN. N O .
Mr. V A N I K . Well, I misunderstood you then.
Mr. FRIEDMAN. I am sorry. I am undoubtedly responsible for the
misunderstanding.
I have tried to emphasize that interest rates are largely determined
by a wide range of forces of which the quantity of money is only one.
The Federal Reserve System, or any other central bank, cannot
determine the structure of interest rates. A t most, it can manipulate
a small corner of it a little bit.
The fact is that rising business, increasing income, expansion, tends
to bring about, in general, rising interest rates and not the other way
around.
Mr. V A N I K . Well, you then believe in this doctrine of the free
marketplace for the financing of home level and where everybody has
to accommodate themselves to that situation.
I s that not about it?
Mr. FRIEDMAN. There is no alternative
Mr. V A N I K . There are some alternatives now. Is there not another
way to stabilize interest rates simply by the establishment of national
usury laws?
There seems to be a little morality in the past in which usually it
was a violation of the law. And this is not price control. I t is a
matter of putting a ceiling on what money can bring from those people
who have to pay for the use of it.
I t goes to our very heritage. I t is fundamental in our law and why
is it that that approach cannot have some place in this discussion ?
Mr. FRIEDMAN. Mr. Vanik, I believe that that is price control. I
find it hard to know how else you would define "price control."
Mr. V A N I K . I t is a ceiling
Mr. FRIEDMAN. Yes, indeed
Mr. V A N I K (continuing). But it has its roots in morality.
Mr. FRIEDMAN. N O .
Mr. V A N I K . YOU think this
Mr. FRIEDMAN. N O , I hope
has no foundation
that Jeremy Bentham did not write in
vain.
Mr. V A N I K . YOU think there is no reason to have any ceiling limitation put on
Mr. FRIEDMAN. None whatsoever.
Mr. V A N I K . There is not any relationship between interest rates
and human decency?
Mr. FRIEDMAN. There may be a relation between a market in which
interest rates are free to move and human decency. You and I would
be alike in wanting to promote human decency.
Where we disagree is that you believe an artificial
Mr. V A N I K . I believe we just pause in talking about human
decency
Mr. FRIEDMAN. Whereas you think that a legislative ceiling on
interest rates would promote human decency I think, and I believe
THE FEDERAL RESERVE SYSTEM AFTER FIFTY YEARS
1149
there is much evidence to support this belief, that such a limit will
reduce it.
To put a usury law on, which limits interest rates to a level which is
below the market level, is to deny people credit who most need it.
No doubt people who urge usury laws think they are helping the
borrowers. Actually, they are hurting them. W h a t happens, when
you put on a usury law in any country, is that the borrowers who most
need loans are driven to get the loans at much higher rates of interest
than they otherwise would have to pay by going through a black market of one kind or another.
Mr. V A N I K . Does not a usury law have the effect of stabilizing the
cost of money and the cost of the use of it ?
Mr. FRIEDMAN. N O , its only effect is to make loans unavailable.
Consider price control in general. The effect of price control, if
you set the price too low, is to create a shortage. If you want to
create a shortage of loanable funds, establish a ceiling on interest rates
below the market, and then you will surely do it.
Mr. V A N I K . There are some areas today where we fixed the price
of money.
W h a t are they?
Mr. FRIEDMAN. We have fixed the price of money by establishing a
ceiling of zero
Mr. V A N I K . N O , no, with respect to Federal bonds we do it in
certain areas.
Would you mind enumerating those?
Mr. FRIEDMAN. I n connection with the bills before this committee
we have fixed a ceiling at zero on the rate of interest that commercial
banks may pay on demand deposits.
Mr. V A N I K . Yes.
Mr. FRIEDMAN. I t
is very hard for me to see that that is promoting
any kind of human decency. T h a t is just preventing depositors from
getting income they otherwise would get.
We have fixed a ceiling rate on interest on time deposits.
Both of these, I think, are bad and should be repealed. We have
a Federal law saying that the interest rate on Government securities
shall be—what is it ? F o u r and a quarter percent ?
I think that is bad and ought to be repealed.
Mr. V A N I K . You think we ought to pay more than that ?
Mr. FRIEDMAN. N O ; I think we ought to pay less.
Mr. V A N I K . H O W much less do you think
Mr. FRIEDMAN. A S much as we have to pay
Mr. V A N I K . If we repeal it won't we be likely to pay less?
Mr. FRIEDMAN. I t will not affect how much we pay. T h a t law has
no effect on how much we pay.
I t is a piece of paper
Mr. V A N I K . Well, we get around that by the discountii^g.
Mr. FRIEDMAN. Of course.
Mr. V A N I K . NOW, you assume that there is a free market and free
competition in money supply.
That is the basis of the supposition on which you operate ?
Mr. FRIEDMAN. N O ; it is not. I assume that there is a market which
has a large measure of freedom, and in which undoubtedly there are
interferences with freedom. I believe that this Congress and this
1150
THE FEDERAL RESERVE SYSTEM AFTER FIFTY YEARS
committee ought to be considering ways in which it can make the
market freer and not ways in which it will make it less free.
Mr. V A N I K . Well, I think the whole thing is concerned with the
economy, the way it is going to move along and expand, without the
drag that high interest rates might impose upon it. That is our basic
concern right now.
Mr. FRIEDMAN. I wonder if you would mind citing the evidence that
high interest rates are a drag ?
Mr. V A N I K . Well, I am not here answering the questions. I will
put that to you.
Mr. FRIEDMAN. I do believe an assertion like this needs to be examined.
I t is asserted that high interest rates are a drag
Mr. V A N I K . I think this committee, as a matter of fact, has put out
a number of documents to just prove that very point, and I think the
Joint Economic Committee has and they have labored very extensively to come around to that kind of a conclusion.
I am among those here who feel right now that high interest rates
drag our economy and wash out the gains that might be brought about
through the stimulation of the tax cut.
I think, for example, if the automobile interest rate went u p and
consumer purchases went up that it ought to prevent automobile purchases because people ought to realize that a great part of their purchasing money is going to be interest rate.
I think that as this word gets around consumers might back off from
making purchases. If housing loans go up any higher, why, I think
that it might discourage housing investments.
I can see all kinds of dangers and possibilities that can result from
the uninhibited interest rates.
People who have the capital seem to want a free market and those
who do not have it seem to want more competition and some assurance
that the prices are going to be reasonable.
Now, I believe in this: that this creation of a surplus of anything,
whether it is wheat or beef or money, will serve to depress the price
providing w^e can insure that balance can be maintained.
Now, you advocate surplus or at least a sufficiency of the money
supply but you have given us no assurance that it is going to be available through your plan or through your system, and that is any reasonable price.
Now, I think money, and this use of money, differs from anything
else—this is not wheat. This is not bread. This is not meat. This is
not automobiles.
This is something a little bit different.
I t is a limitation on what we should—when I think about the
nbandonment of usury laws I feel that wre have stepped a long step
away from—I think we ought to review the reasons for which the
usury laws were originally put on the books in most of the States.
W h a t w^as the motivating factor ? Was it not something that was
unrelated to money supply or anything else ?
And is it not worth while reviewing again?
Mr. FRIEDMAN. Let me make two comments, Mr. Vanik.
The first of those is that considering any high price or rise in price,
whether it be high interest rates or anything else, we have to distinguish between two cases which are quite different in their effects.
THE FEDERAL RESERVE SYSTEM AFTER FIFTY YEARS
1151
One case is where someone artificially pushes the price up. An example is the wheat market where the Government establishes a high
support price for wheat and artificially makes it high or another might
be in the money market, if the Federal Eeserve System or some other
monetary authority restricts the money supply and in the process
forces up the rate of interest. Such forced-up high prices are adverse
to the economic system and very undesirable.
The second case is one in which, in a free market, the price rises
because there is an increase in demand.
If people are better off and want to buy more wheat or more meat
and this raises the price then such a rise in price is a good thing because it encourages production in order to meet the demand, and the
same thing is true on the market for loans.
If an increased demand for loans forces up or drives up the interest
rate then this is the signal that produces an expansion in the quantity
of loans available and is a very good thing.
So we cannot say whether high interest rates are good or bad. W e
have to distinguish between high interest rates that are pushed up
by some action of government or the monetary authorities and high
interest rates which are a natural result of an increased demand.
The second comment I would like to make is that one of the difficulties in our discussion is the use of the word "money" in two very
different senses.
I n one sense, we use "money" to mean the green paper we carry
around in our pockets or the deposits in the banks.
I n another sense, we use "money" to mean "credit" as when we refer
to the money market. Now, "money" and "credit" are not the same
thing. Monetary policy ought to be concerned with the quantity of
money and not with the credit market. The confusion between
"money" and "credit" has a long history and has been a major source
of difficulty in monetary management. Similarly, I am afraid that
part of the difficulty in our discussion has been the use of the term
in these two senses.
Mr. V A N I K . My time has expired.
The CHAIRMAN. Yes. Mr. Harvey?
Mr. HARVEY. Mr. Friedman, in your statement you are very critical
of the actions of the Federal Eeserve Board, particularly from the
period 1958 on. I n fact, you cite several instances to indicate that those
actions have been very erratic. I will call your attention to the fact
that hindsight is a wonderful thing, indeed, for all of us as human
beings.
I see nothing in your statement, however, which would lead me to
believe that subjecting these very questions to a politically motivated
administration would call for any better result whatever.
On the contrary, to me it would be the reverse. You would have
the Congress reporting out accelerated public works measures in times
of peak prosperity, for example, most unresponsive to the unemployment figures and demonstrated need.
So, I just cannot agree with your conclusions whatsoever. I will
agree that perhaps by way of hindsight the Federal Reserve did err,
but I cannot believe that either the administration or either party,
being politically motivated as they would be, would come up with
better results but only poorer ones.
1152
THE FEDERAL RESERVE SYSTEM AFTER FIFTY YEARS
Mr. FRIEDMAN. I do not disagree with you, Mr. Harvey. As a matter of fact, as I say in my statement, my preference is for an arrangement which would prevent such close day-to-day control and such
erratic behavior on the part of either Congress or the Eeserve Board.
W h a t I would like is to have Congress enact a rule which would
provide a stable basis for monetary policy and protect it alike from the
arbitrary actions of either Congress or the Board.
Furthermore, I do not mean to suggest that this period was particularly erratic. I considered this period in detail because it is recent
history and hence the period we are most familiar with.
As a matter of fact, if I look back over the 50 years of Federal
Eeserve history, I would say that their performance in this period is,
on the whole, better than the average, not worse than average. Yet,
even in such a period where it is better than average it has been less
satisfactory than would have been achieved by a stable rule.
So far as the minor short-term movements are concerned, you may
well be right that Congress would have been worse. I do not know,
it might have been better or worse.
My preference for Congress derives from a different consideration.
As I see it, the major problem of monetary policy is to have a system
which is not subject to major mistakes. W h a t I am convinced of, on
the basis of the record, is that Congress is less likely to make a major
mistake than a Reserve Board is, although it may make more minor
mistakes.
You may be right that in terms of the minor fluctuations Congress
would have been worse. W h a t I am impressed with is that Congress
would never have permitted the decade of the thirties to develop as it
did and would not do so again in the future.
Mr. HARVEY. Thank you.
I have no further questions, Mr. Chairman.
Mr.RETJSS (presiding). Mr. Minish?
Mr. M I N I S H . Mr. Friedman, you mentioned earlier that you feel that
the interest on Government bonds is too high. Do you have -any suggestion as to what you think it ought to be ?
Mr. FRIEDMAN. I'm sorry, I did not mean to say the interest on
Government bonds is too high. The interest on Government bonds
ought to be whatever rate you have to pay in the market to get people to be willing to buy Government bonds.
Mr. M I N I S H . Do you have any suggestions on it ?
Mr. FRIEDMAN. On the rate of interest ?
Mr. M I N I S H .
Yes.
Mr. FRIEDMAN. I am not sure I understand your question. Are you
asking me what suggestions I have for Government debt management?
Mr. ]\fiNiSH. Yes.
Mr. FRIEDMAN. Well, my suggestions for that are very simple. I
would reduce the range of securities offered by the Treasury very
much.
I would replace our present rag-bag mixture of all sorts and kinds
and sizes and assortments with two Kinds of securities, a short bill
and a long bond, one of each.
Second, I would distribute all such securities by auction alone. I
would not have prices set in advance. I would have an open auction
at which the bills or the bonds were sold at whatever price was offered
for them.
THE FEDERAL RESERVE SYSTEM AFTER FIFTY YEARS
1153
Mr. M I N I S H . Thank you.
The CHAIRMAN (presiding). Mr. Bolton?
Mr. BOLTON. Thank you, Mr. Chairman.
Professor, I , too, have enjoyed very much being here and listening
to your testimony.
I notice on page 3 and in the pages that follow that you would permit banks to pay interest on demand deposits. Some of us are exceedingly interested in seeing to it that there are as many people in
the banking business and the credit business of the United States as
possible and to prevent an undue concentration of economic power. I
wonder if you would comment on what effect the payment of interest on demand deposits would have on the size of institutions and
eventual domination of the banking business by certain large institutions ?
Mr. FRIEDMAN. I believe it would not have much effect in either
direction on that particular problem because the fact, of course, is that
commercial banks now pay interest on demand deposits in indirect
ways.
By making the payment of interest open and above board, making
it explicit, the people who would benefit would be largely the small
depositors.
Mr. BOLTON. I wonder if you would go a little further in the indirect
method ?
Mr. FRIEDMAN. Oh, of course. One indirect method is the provision
of services without charge. If you have a deposit in a bank and the
bank clears your checks, accepts your deposits without charging you
specifically for those activities, that is a way of paying interest to you
in the form of services.
F o r example, if you consider some of our large concerns, General
Motors, Ford and others, and ask them what determines the amount
of deposits they hold in small banks throughout the country, they will
tell you that they hold such deposits in order to compensate the banks
for the services which the banks are rendering to them.
Equally, you can look at that the other way around. They are receiving interest on those deposits in the form of the services which the
banks are rendering to them.
Another way in which interest is paid on deposits implicitly and
indirectly is by the fact that a depositor will be in a position to" get a
loan more readily and at a lower rate of interest than a nondepositor.
A third way in which interest is paid on deposits is by the banks
encouraging people who borrow from them to use the products of firms
which keep deposits with them.
I have known and talked with treasurers of very large enterprises
that keep very large deposits all over the country for no other purpose
than to induce the banks with whom they have deposits to say a good
word for their products to the people who are borrowing from the
banks.
And I am sure t h a t there are many other ways which I do not know
of whereby banks pay such indirect interest.
W h o are the people who are in the best position to get indirect interest payments of this kind?
There are those whose deposits are large enough to make it worth
while to have special arrangements and who are worth dealing with.
1154
THE FEDERAL RESERVE SYSTEM AFTER FIFTY YEARS
As always, almost every time you interfere with the free market you
tend to work against the interest of the ordinary fellow in the market.
Mr. BOLTON. Would you feel that the payment of interest on top
of these would merely expand the leverage which the large institution
has?
Mr. FRIEDMAN. Oh, no, no, you would substitute interest for many
of these.
If you had interest rates some of these other things would disappear. Whenever you interfere with the market operation what do
you do ?
You encourage people to get around the interference or the blockage.
So I believe that a direct open payment of interest would reduce
these indirect devices.
As to the size and number of banks, that is largely a question of the
terms on which a license can be obtained to open a bank rather than
of the payment of the interest.
Mr. BOLTON. I n a subcommittee of this committee we are wrestling
with the question of the services offered by banks particularly centering around computers, and the question has been asked as to whether
or not a law, which would require banks to charge on an equal basis
for all the services that they offer, regardless of the size, on the basis
of cost or cost-plus or some other basis, would be right.
What would be your reaction to that ?
Mr. FRIEDMAN. I would think that that would be a case of adding
an undesirable law in order to offset the effect of another undesirable
law.
I t would be far better, in my view, to repeal the prohibition of the
payment of interest on demand deposits. If you did that this would
establish an incentive for the banks to charge for services which they
render.
Mr. BOLTON. Of course, with a computer, this is not due to a law
but this is due to a physical aspect which produces leverage just because of its own being and type of operation such as the freezing of
accounts
Mr. FRIEDMAN. But so far as not charging for the services, one of
the reasons for that is because this offers still another way in which
a bank can indirectly pay interest on deposits.
Mr. BOLTON. Referring to another part of your testimony, sir, I
think you made the point that there are many things which affect the
monetary market and the economy generally, particularly this was
brought up I thought in your colloquy with Mr. Vanik and Mr. Eeuss,
and, therefore, it puzzled me to hear you recommend a steady increase
in the amount of money each year because I think you would agree
that the amount of money is only one of the factors which affects the
economy and, therefore, under a steady legislated growth would you
not feel that there was or there would be a time when this would be too
little and another time when this would be too much for the economy
as of that point in its development or retrogression?
Mr. FRIEDMAN. Of course, but would we know it?
T h e problem is that the actual variations in the quantity of money
in the past, as you examine them over a long period, seem to me to
have been destabilizing. They seem to me to have been bad. Now,
if you look at the record——
Mr. BOLTON. I do not follow you there.
THE FEDERAL RESERVE SYSTEM AFTER FIFTY YEARS
1155
Mr. FRIEDMAN. W h a t I am saying is, consider the actual changes
that have occurred in the quantity of money. Is it true that when,
in retrospect, it would have been desirable to have had a faster increase
in the quantity of money, such a faster increase occurred, and when,
in retrospect it would have been desirable to have a slower increase
in the quantity of money, such a slower increase occurred ?
The answer is "No." If you look over the record of the past what
you find is that more often than not the money supply increased
when it should have decreased and vice versa; that instead of changes
in the money supply offsetting other forces they have themselves been
another source of instability. F o r example, in the period covered
by the chart, suppose instead of the ups and downs that you had in
the rate of change of the money stock, you had had a perfectly steady
movement. I n retrospect, it seems clear the steady movement would
have been preferable most of the time.
Mr. BOLTON. If you are only looking at it from the standpoint of
the source of the money supply
Mr. FRIEDMAN. N O .
Mr. BOLTON (continuing). But those charts do not take into account
any of the other factors which influenced the economy such as the
international situation, such as the international financial situation,
such as the general confidence of the public, et cetera.
Would you not have the same ups and downs, whether you had a
steady monetary supply or not, and would you not, in effect, by a
steady increase touch off just what Mr. Reuss was worrying about,
which was a gradual impetus and push toward inflation ?
Mr. FRIEDMAN. Quite the opposite. Undoubtedly, if you had had
a steady increase in the money supply you would have had some fluctuations in economic activity, of course. We cannot solve all problems by any single solution.
What I am saying is that industrial production or economic activity, which reflects all of these forces you are speaking of, would have
fluctuated less if the money supply had increased at a steady rate
than it actually did. W h y ?
Because the changes in the rate of growth of the money supply came
at the wrong time and were in the wrong direction. F o r example,
in early 1960, monetary growth was sharply contracted when it should
have been maintained at a relatively steady rate.
I s there any body here who would not agree that we would have been
better off during this time to have had a slightly easier money policy ?
Mr. BOLTON. I do not know, sir, because I do not remember in sufficient detail the other factors which were affecting it, among them, if
nothing else, the psychology of the business community.
Mr. FRIEDMAN. But, you see, Mr. Bolton, I think we are saying
the same thing. We are really in agreement.
What you are saying is, consider this period of early 1960. That
is a period when some other forces were maybe producing a decline.
Then we should have tried to offset those other forces by a more rapid
increase in the money supply.
I agree, if we had known it. What did we do ? We intensified the
other forces by a slower increase.
Consider another period when we were having a rapid expansion,
say late 1958, What are you saying? The monetary authorities
1156
THE FEDERAL RESERVE SYSTEM AFTER FIFTY YEARS
should have been holding it down. They were not. Instead they were
boosting it.
And so what we observe, if we look at the record, is that, in fact,
instead of using monetary fluctuations as a balance wheel, instead of
using them to <^et other forces, we have used them to intensify other
forces.
Why have wc dc^ie this? We have done this because we simply do
not know enough, we are not smart enough, we have not analyzed sufficiently and understood sufficiently the operation of the world so we
know how to use monetary policy as a balance wheel.
Therefore, what I am saying is that the first step we ought to take
is to convert monetary policy from being a destabilizing force into
at least being a neutral factor.
Mr. BOLTON. Thank you, sir.
My time has expired, Mr. Chairman.
The CHAIRMAN. Yes. Mr. Weltner?
Mr. WELTNER. Thank you, Mr. Chairman.
Professor Friedman, you said that there are two main reasons why
the Federal Eeserve System has been erratic. One, I believe, you
state is because it stresses the wrong thing.
You say it should stress the quantity of money and not the interest
rates. Then, secondly, you state that adjustments in the quantity of
money take their effect only over a period of several months. Although the quantity can be increased or contracted within a very short
time, the effect of that is a long-range proposition.
Now, if the answer to our monetary problem is by stressing the
quantity of money, how is it that we are going to solve the problem
that you set forth as your second main complaint against the Reserve
System, to wit, that the effect of monetary expansion is not of immediate effect but one which has caused substantial difficulties in regulation.
Mr. FRIEDMAN. Not by that step alone; that is to say, that the
problem of the lag in reaction and the fact that the effects are spread
over a period is not a problem that can be solved by just looking at
the quantity of money.
In order to solve that problem or in order to eliminate that difficulty
it would be necessary to forecast what is going to happen much better
than we now can.
The Federal Eeserve Chairman, Mr. Martin, has often used the
phrase that the Federal Reserve System should lean against the wind,
and that is what Mr. Bolton was arguing a moment ago.
The fact is that the wind he should lean against is next year's wind,
and it is hard now to know which way the wind is going to be blowing
a year from now.
So I do not think that, under present circumstances, there is any
way that I know of fully to eliminate the effect of the lag. That is
one of the reasons why I am in favor of trying to have a steady policy
which does not require trying to do the forecasting which we cannot
do; that we ought to adjust our behavior to the present state of our
knowledge and to have some humility about what we know and what
we do not know.
Mr. WELTNER. Would you go so far as to say that the Federal Reserve System is incompetent to adjust against the difficulties created
by the lag?
THE FEDERAL RESERVE SYSTEM AFTER FIFTY YEARS
1157
Mr. FRIEDMAN. Yes, indeed, but this is not because of incompetency
of any particular people at the Federal Keserve. I would say that
economic science today is incompetent to do it.
I am not making any criticisms of particular people. I am saying
that in the present state of our knowledge—my knowledge, your
knowledge, the knowledge that economists in general have—we simply
do not know enough to be able to know what way the wind is going to
blow next year sufficiently to be able to adjust to it.
Mr. WELTNER. YOU feel that we can control the volume and the
direction of the wind itself by a stated rule concerning the expansion
of money supply ? I s that right ?
Mr. FRIEDMAN. The analogy is, I am afraid, getting us involved in
knots.
The winds that we are speaking of are the kind of other forces that
Mr. Bolton was talking about, international forces, changes in profitability in different industries, changes in the supply of goods.
There are those winds. I n addition, by its changes in the money
supply the Federal Keserve is creating another wind which might
either counter the others or reinforce the others. W h a t I have been
saying is that in practice the Federal Reserve's wind has been reinforcing the others rather than countering them.
I t has been going with them rather than against them most of the
time. We do not at the present time know how to make it counter
them.
Mr. WEJLTNER. Thank you.
The CHAIRMAN. Mr. Brock?
Mr. BROCK. Professor Friedman, following the point raised by Mr.
Bolton—following that point up—when you have a period of inflationary depression it could exist with our current situation, 6 percent
unemployed and 15 percent unused industrial capacity, could it not ?
Mr. FRIEDMAN. The reason why I am hesitating is because any short
answer to that question is going to be misleading. There is a sense in
which it could.
But there is another sense in which I think it could not.
Mr. BROCK. Well, what I am getting at is, the inflationary pressures
could be caused, for example, by the inordinate ability of some segment of the economy to force prices u p ; for example, monopolistic
powers by management
Mr. FRIEDMAN. I do not believe so. The only case I know of which
remotely can be described in those terms is 1933-37. I t is hypothetically possible that you could have the kind of a world in which some
groups could force up prices and produce either unemployment or inflation. I do not think, as a factual matter, that is a correct description of the American economy at any time except, as I said, during the
early New Deal period when NRA, trade union legislation, and so on,
did produce something of an autonomous cost push.
The rest of the time I think you would have to say that inflationary
pressure is a consequence of unduly rapid rates of rise in the money
supply.
Mr. BROCK. We had Professor Brunner and Professor Brownlee
here, who related the state of the economy solely to interest rates.
Is this your approach? I mean, are you trying, without saying so,
or are you saying t h a t interest rates are the predominant
1158
THE FEDERAL RESERVE SYSTEM AFTER FIFTY YEARS
Mr. FRIEDMAN. N O , I do not believe so. I would not want to comment on what they did say without seeing their full papers. Speaking
only for myself, I think that the state of the economy depends on
many things.
So far as price inflation is concerned, the immediate proximate
source of price inflation is almost always, so far as I know, an unduly
rapid increase in the quantity of money. This is true not only for
the United States but for every other country. I know of no
exception.
I know of no case on the record where you have had price inflation
without monetary expansion at a rapid rate.
Mr. BROCK. Could I say this then, in summary of what you are
proposing: I t is that we have a number of variables and your approach
would be just to eliminate possibly one of the variables?
Mr. FRIEDMAN. That is quite right, in monetary policy. I might
have suggestions on other areas of economic policy.
Mr. BROCK. That is right.
Mr. FRIEDMAN. But monetary policy has one thing that it really
controls, and that is the quantity of money. Our question is, How
should we make it behave ?
Mr. BROCK. I am not quite sure I am clear on what would happen to
the money stock in some cases of your proposal.
Let's say that we had a standard increase of 4 percent in the money
stock. This is the larger approach with the time deposits included.
Now, if we had a period of expansion with this fixed input of 4 percent, how would you control the demand for money which would
cause the expansion ?
I n other words, you would have in a period of expansion a greater
demand, obviously, for money; and people would go down to the
banks and deposit their money because the banks would be seeking
more funds, and they would raise their rates of interest on demand
deposits and on time deposits, and this would increase the money
supply.
What would be the reaction to that ?
Mr. FRIEDMAN. N O , this would not increase the money supply.
Where do people get the money which they deposit? They get it
by somebody transferring it to them.
Perhaps the easiest way to think of this is to think in terms not of
deposits but, for the moment, these pieces of paper [indicating].
Suppose there are a fixed number of these bills around. Then each
individual separately thinks he can determine how much he has, but
all people together cannot.
The only way I can get more is by somebody transferring it to me.
Well, that is exactly the same situation in time of expansion or of
contraction.
If the Keserve System controls the total amounts of money there
is
Mr. BROCK. There is a great deal of difference in the velocity with
which that changes hands ?
Mr. FRIEDMAN. That has to do with the ratio of the income to the
money stock. There are some differences in velocity. Over ordinary
periods there is not a great deal of difference, however.
Velocity is relatively stable except for great disturbances. I n a
period like 1929-33, when the Keserve System permitted a third of
THE FEDERAL RESERVE SYSTEM AFTER FIFTY YEARS
1159
the money supply in the United States to be destroyed, then there
was a very sharp change in velocity.
I t went down very sharply and reinforced the effect of the decline
in the quantity of money. If you had a big inflation there would
be a sharp change in velocity. I t would increase and again reinforce
the effect of the increase in the quantity of money.
But if you keep the money supply fairly steady, the historical records suggest that the changes in velocity are rather moderate.
Mr. BROCK. Could we take the current situation ? You have mentioned the tremendous increase in the money supply in the last 15 to
18 months.
What would be your reaction to the current situation? W h a t
should we do ?
Mr. FRIEDMAN. The Federal Keserve Board, in my view, should
immediately shift to a lower rate of increase in the stock of money
and that can be sustained indefinitely.
Mr. BROCK. Through its open market operations ?
Mr. FRIEDMAN. Through its open market operations it should shift
to a point at which the quantity of money is increasing at something
like 4 percent a year and hold it there. If it does not do that; if it
keeps on increasing the quantity of money as rapidly as in the past 15
months, it is going to have to take another one of these steps which
will go too far and force deflation on the economy.
Wnat I am urging is a policy of trying to have a moderate, steady,
stable policy that you can live with indefinitely instead of having a
world in which you go from one side to the other each time thinking
you are going to offset something that is going on, but in practice,
more often than not intensifying it.
Mr. BROCK. I am looking at your chart. As you say that, I am looking at your chart and looking at the period from May 1957—or the
year, actually, of 1958—where you had a fairly rapid decrease in the
index of industrial production.
A t the same time the Federal Reserve obviously or, at least the way
I read your chart, was taking steps to correct it. The money stocks
were going up.
They reduced the rate. Some action was being taken. I s that
correct ?
Mr. FRIEDMAN. Well, that depends on how you interpret this period. You see, this little bump over here is another one of those consequences of the change in the rate of interest that could be paid on
time deposits.
Mr. BROCK. That occurred right about at the low point of the
recession ?
Mr. FRIEDMAN. A S you will see, there is at this period a sizable difference between the behavior of the rate of change of the broader
total of money and the narrower total because of the immediate rush
into time deposits which then tapered off.
If you correct for this, I would say that during 1958 to the middle
of 1959 the Federal Reserve was rather feeding the expansion.
And that was all right. I t should have been, but not quite at such
a high rate. W h a t I am saying that suppose it had been between
these two and it just held that steady
Mr. BROCK. Well, the rate is almost zero or somewhere between
zero and 1 percent, which is less than the figure that you recommend
28-680—64—vol. 2
16
1160
THE FEDERAL RESERVE SYSTEM AFTER FIFTY YEARS
Mr. FRIEDMAN. N O , I am sorry, but these percents are per months
and they need to be multiplied by 12. That is perhaps a defect of the
chart. So, you see, this 1 on the chart is 12 percent per year and this
minus 1 is minus 12 percent per year.
Mr. BROCK. But you would try to have as the index of industrial
production is going up too fast, you would have the other one going
down. Is that correct ?
Mr. FRIEDMAN. N O , I would not.
Mr. BROCK. N O , I see. Then under our current situation before we
adopted the fixed rate of, say 4 percent—I mean, this is what you
would say the Fed should have done if they had exercised foresight?
Mr. FRIEDMAN. I n a sense, yes, that is right. W h a t I am going
on to say is I do not believe the Fed could have exercised that kind
of foresight. If I had been at the Fed I would have been urging
them not to try to second-guess these things.
I would urge instead to keep the policy at a level at which it can
be maintained indefinitely and at which it does not do any harm.
This is really what it seems to me is the lesson of experience.
Mr. BROCK. Fine. Can we get to the specific bills then ?
Mr. FRIEDMAN. Surely.
Mr. BROCK. Without passing a fixed rate of growth in the money
stock as you propose, should we pass the bills that are before us, to
fix a maximum u p of 4 ^ or 4 % percent on the yield of Government
bonds?
Should we pass those too ?
Mr. FRIEDMAN. Let's separate them then. I would not like to judge
or to argue about the precise details of the first bill, but I think a bill
which would place the Federal Eeserve under the direct control of
the administration and the Congress would be a good thing, a bill
which would reduce its degree of independence.
Mr. BROCK. May I follow that up just for a second ?
A t this period, when we have had this very large increase in money
supply and there are inflationary pressures and the administration
obviously would not take a restrictive policy at this time, would this
still be true because with the tax cut and the debts we envision over
the year, would you still say that we should have it under the Secretary of the Treasury ?
Mr. FRIEDMAN. Yes, indeed, because I fear that the Federal Eeserve
may not take the restrictive action until it is too late, and until it
overdoes it.
I think the Treasury is at least as likely to take what you call
restrictive action at any earlier date. Maybe it is not.
Again I really do not want to try to second-guess individual episodes.
I am trying to look at the structure as a whole.
You are now considering a bill, not in terms of what it will do
in the year 1964, but in the decades ahead. W h a t I am saying is that
if you look at a long stretch of experience, I think that you will
join me in the conclusion that major mistakes are less likely if the
Eeserve System and the monetary authorities are more closely controlled by Congress and the administration.
As to minor mistakes, we are going to have them either way. I t
is human to err. The Eeserve System is going to err.
THE FEDERAL RESERVE SYSTEM AFTER FIFTY YEARS
1161
The Treasury is going to err. The crucial question you have to
ask is, "Over the long pull, which is less likely to make a major
mistake?"
On the second bill, I think it would be a mistake to legislate a limit
on the yield of Government securities. The rates of interest ought to
be determined in the free market like other prices.
I think it is most undesirable for Congress to fix prices and ? therefore, I myself would oppose a bill to fix the price or the yield on
Government bonds.
Mr. BROCK. W h a t would be the effect of such a bill ?
Mr. FRIEDMAN. Such a bill would be evaded and would not have
any significant effect on the price the Government had to pay to
borrow.
You cannot force people to lend. If the Government needs to
borrow how does it get the funds ?
I t either prints pieces of paper, in which case you have inflation, or
it pays what it has to pay to borrow the funds. Not only are private
people ingenious in getting around obstacles, but I think governmental
officials are ingenious in getting around legal obstacles.
Mr. BROCK. Thank you, my time has expired.
The CHAIRMAN. Mr. Wilson ?
Mr. WILSON. I have no questions.
The CHAIRMAN. Professor, you stated that we should have a moderate, steady, stable policy we can live with indefinitely.
Can you have that kind of a policy without the Federal Reserve
System ?
Mr. FRIEDMAN. Yes. indeed.
The CHAIRMAN. W h a t changes would you make? Now, I believe
that I am summing up the testimony before this committee in a few
short sentences:
No. 1,1 believe we have, most of us, been convinced that the Federal
Reserve at the end of 50 years is not the same Federal Reserve that
started out in 1913. I n 1913 the policy was to give the people an adequate money supply, available to all of the people under reasonable
conditions and terms and at a reasonable cost. They established what
was known as eligible paper so as to encourage the banks to seek this
kind of paper from farmers, small businessmen, and others. The
banks could take eligible paper and put it up with the Federal Reserve
and so it could be used as high-powered dollars upon which the banking system could create $10 or more of credit dollars for every dollar
obtained at the discount window.
Of course, that made it very profitable to the banks 3 which is as it
should have been, because we must have a profitable banking system
in order to have a good economic system.
Now, after a few years the Open Market Committee was established.
Until that time each of the 12 banks were operating in opposition to
one another. Some would be in the market selling bonds and some
buying, and there was no coordination.
That is correct, is it not, Professor ?
Mr. FRIEDMAN. Yes.
The CHAIRMAN. S O they
organized what was known as the unofficial
Open Market Committee. They had no power to do this under the law.
1162
THE FEDERAL RESERVE SYSTEM AFTER FIFTY YEARS
Each bank was autonomous because that is the only way that President Wilson would permit it at the time, 12 separate regional banks,
but this committee was organized and it was pretty effective because
the Federal Reserve Board gave it its blessing and they operated as
though they w^ere an official open market committee.
Well, in the beginning certain groups in this country only wanted
a Federal Reserve if the bankers could be on the Board and have influence in determining the volume of money, its availability, and its
cost.
Others believed that the bankers should not be on the board.
Now, in 1913 when President Wilson took a firm stand against the
bankers being on the boards he said that you might just as well put
railroad owners on the Interstate Commerce Commission to fix freight
rates as to put bankers on the Board to regulate money. You recall
that story, I am sure.
So we did not have bankers on the Board. But they were represented on each one of these 12 Federal Reserve banks. And as time
went on and this unofficial committee of the Reserve banks, the Open
Market Committee, began to operate the banks who had always opposed the Federal Reserve began to look sympathetically upon it.
And in 1926 or 1927, in that period of time when the Federal Reserve
banks were going to expire—you see, they had 25- or 20-year charters.
Which was it, 20 or 25 ?
Mr. FRIEDMAN. I am sorry, but I
The CHAIRMAN. I t was either 20 or 25, just like the old two banks
in the past.
Mr. FRIEDMAN. The two banks in the past were 20 years but
The CHAIRMAN. Yes, sir. So there was going to be an expiration
time. But the Federal Reserve was pleasing the big banks more and
more all the time, and the big money interests became more interested
in it and they took the initiative years before the expiration of the
charter to get the charter continued indefinitely, as it is today. They
felt that the Fed would be in the hands of this Open Market Committee and so of men that this particular group wanted to control the monetary system.
I n 1933 this group started trying to legalize the Open Market Committee. But the Committee was made up of the Presidents of each
of the 12 banks. So the Committee represented the private bankers
because the 12 Presidents were selected by boards of directors twothirds of whose members were selected by the private banks and business. That did not look too good to anybody, just having the banking
interests completely in control of that great power.
So, 2 years later, in 1935, it was changed and when the bill came
before this committee, this committee stood firm. I t didn't want any
bankers on the Board. I t wanted an Open Market Committee composed of people selected by the President and confirmed by the Senate,
dedicated public servants, to operate our monetary system, and that
is the way the bill left this committee.
I t went through the House. The people who opposed the original
Federal Reserve Act, for the reasons I have stated, also opposed this
House bill.
They would not have any part of it when the bankers were not
represented but when it went to the Senate, the Senate put the bankers
back on the Open Market Committee, and then of course they all em
THE FEDERAL RESERVE SYSTEM AFTER FIFTY YEARS
1163
braced it. I t came back over here and it was passed unanimously. I
mean, the conference report was passed practically unanimously, if
not unanimously.
There was no opposition any more because the bankers were on the
Board.
Now, the question is, Professor, Do you believe that because of
people who are subjected to the bankers' influence all the time, people
like the 12 Federal Reserve bank Presidents, and all of these advisory
groups who are always conferring with our money managers, that the
views of the bankers have a special influence on our money policies and
this is not good because if it is handled right one way the bankers
gain a lot and if it is not handled that way they do not make as much
money ?
Mr. FRIEDMAN. Well, I think that this is a very difficult and complicated question.
My impression, on reading the evidence and looking over the history, is that the bankers who have been associated with the Reserve
System in all capacities have been, in the main, public-spirited citizens
who have been trying to promote the interests of the public.
To this extent I would not agree that they have, in any deliberate
way, used their position of influence on the system to promote their
private interests.
On the other hand, there is no doubt that each of us is very much
affected by the environment in which we are and know best those
things which we are familiar with. And there is no doubt that from
the point of view of the bankers, what they are individually familiar
with is the credit and investment market.
To them it seemed perfectly natural and understandable in trying
to serve the public interest to place major emphasis on interest rates
and credit conditions rather than on the aggregate quantity of money.
From this point of view, I think it has been an unfortunate thing
that we have had a Reserve bank which has been as closely linked to
the banking community and to the lending and investment process
as it has, not at all because the individuals are trying to feather their
own nests, not for that reason, but because they naturally interpreted
the instrument they were dealing with in terms of the environment
they knew best and were most familiar with.
And this was a wrong interpretation, as I see it, from the point of
view of the public interest.
The CHAIRMAN. Substantially I agree with you, Professor. I do
not impugn the motives of these people.
I think they are in an environment where they just naturally think
that way and they think, honestly, to serve the public interest you
have to serve the bankers and by serving the bankers you have to serve
the public interest.
Mr. FRIEDMAN. Pardon me, but I do not believe that is the case
either, because I think I can name times in history where bankers
did things that they thought were against the
The CHAIRMAN. Oh, I will agree with you; there have been times.
Mr. FRIEDMAN. S O I do not think it is because they thought they
were trying to serve the banks' interest.
The CHAIRMAN. I did not go that far. I said where they honestly
believed
Mr. FRIEDMAN. Oh,
yes.
1164
THE FEDERAL RESERVE SYSTEM AFTER FIFTY YEARS
The CHAIRMAN. NOW, we have these 12 great regional banks. We
have enormous buildings, ivory towers, some people call them, superbuildings
Mr. KILBURN. Will the chairman yield for just a question ?
The CHAIRMAN. You see. I have not asked any questions at all.
You see, I yielded
Mr. KILBTJRN. You did not yield to me and I am an ex officio member
The CHAIRMAN. Well, you will be next after me. Since I am the
author of the bill I think I ought to ask some questions. I haven't
asked all I want to ask yet because I yielded to the other members.
I did that when I was chairman of the Joint Economic Committee.
I yielded to the other members first. I started it, and I think it's a
pretty good plan. But I do want to ask a few questions on this.
Now we have all of these buildings all over the United States,
and there is only one building that really operates the Federal Reserve
System, and that is the Federal Reserve bank in New York.
The other business that is done in all of these dozens and dozens of
big buildings over the Nation you could probably do in space no larger
than this room.
I am referring to the business that is directly related to the administration of the Federal Reserve Act and nothing else.
Now, I know that they have largely engaged in clearing checks and
things like that. T h a t is the biggest item, of course. They employ
20,000 people. They draw good salaries, as I would expect them to
draw.
I do not have any kick on that particular thing except some minor
ones or some minor cases, where it seems like they are out of line.
Now these 20,000 people, what are they doing ? They are clearing
checks for the commercial banks.
I think this committee should consider hiring some management—
Mr. Reuss suggested that one time, and I think it is an excellent idea—
some management firm, experts in their line, to find out how much it
would cost to clear all of these checks for all banks without reference
to the Federal Reserve and maybe if it is the Government's duty to pay
it we could pay it.
I t might be a lot less than it is now. We are spending about $200
million on the Federal Reserve now and about $125 million of it is
directly related to just paying for the clearing of checks that, under
the law, the banks themselves are supposed to pay.
But since the Federal Reserve banks became so rich from buying
Government bonds, which cost them nothing, collecting $1 billion a
year of interest on them, of course they are glad to pay all of these
bills. Now, if we separated out this clearing of checks function, we
would not have much left for the Federal Reserve banks to do.
Do you agree? How would you recommend that we liquidate the
remainder of the Federal Reserve System? Would you set up an
independent board responsive, as you have said, to the President of the
United States and the administration in power ?
How many many members would you recommend? How long a
term?
Mr. FRIEDMAN. Well, let me go back, if I may, because there is no
reason that I can see why the Government should subsidize the clearing of checks.
THE FEDERAL RESERVE SYSTEM AFTER FIFTY YEARS
1165
I see no reason why the clearing of checks should be a nationalized
industry any more than why any other line of production should
be nationalized. I t seems to me that it would be desirable to require the
private banking industry to do its own clearing of checks and to pay
whatever costs are involved in that.
The clearing of checks does not seem to me to be anything that
justifies a subsidy. So I would go beyond what you have suggested
and say that check clearing should be done by private industry.
Beyond that, my major difficulty in answering your question is on
what assumptions I answer them.
If I were to suppose that you passed the rule that was suggested,
then the problem of the Federal Reserve System becomes primarily a
straightforward administrative problem which should be handled by
having a separate administrative body like any one of the operating
agencies
The CHAIRMAN. Like the F T C or ICC ?
Mr. FRIEDMAN. Yes, only I think it would be preferable probably
to have it as a branch of the Treasury, that it should be a bureau
within the Treasury that has the special responsibility of seeing to it
that the supply of money goes up at a steady rate.
If you do not want to go so far as that, if you want simply to eliminate the present independence of the board but leave it with discretion
about how much it should change the quantity of money, what movements it should make, then I find it somewhat more difficult to answer
the question. The function then becomes much more important and
it is not clear that you would want to set it up as a bureau within the
Treasury rather than as a separate, independent agency under the
Executive Office of the President.
However, I hasten to say that you gentlemen are far more familiar
with these problems of appropriate political organization than I am.
I would only want to stress that the objective should be to have an
administrative organization which is subject to the control of the
President and of the Congress in the same way as the Treasury Department, the Commerce Department, and the other departments
are.
(Article by Milton Friedman is inserted at this point in the
record:)
SHOULD THERE B E AN INDEPENDENT MONETARY AUTHORITY? 1
(Milton Friedman)
The text for this paper, to paraphrase the famous remark attributed to
Poincare, is, "Money is too important to be left to the central bankers." The
problem that suggests this text is the one of what kind of arrangements to set
up in a free society for the control of monetary policy. The believer in a
free society—a "liberal" in the original meaning of the word, but unfortunately
not in the meaning that is now current in this country—is fundamentally fearful of concentrated power. His objective is to preserve the maximum degree
of freedom for each individual separately that is compatible with one man's
freedom not interfering with other men's freedom. He believes that this objective requires power to be dispersed, that it be prevented from accumulating in
any one person or group of people.
The need for dispersal of power raises an especially difficult problem in the
field of money. There is widespread agreement that government must have
some responsibility for monetary matters. There is also widespread recogni1
From Leland B. Yeager (ed.)t "In Search of a Monetary Constitution" (Cambridge,
Mass.: Harvard University Press, 1962).
1166
THE FEDERAL RESERVE SYSTEM AFTER FIFTY YEARS
tion that control over money can be a potent tool for controlling and shaping
the economy. Its potency is dramatized in Lenin's famous dictum that the
most effective way to destroy a society is to destroy its money. It is exemplified in more pedestrian fashion by the extent to which control over money has
always been a potent means of exacting taxes from the populace at large, very
often without the explicit agreement of the legislature. This has been true
from early times, when monarchs clipped coins and adopted similar expedients,
to the present, with our more subtle and sophisticated modern techniques for
turning the printing press or simply altering book entries.
The problem is to establish institutional arrangements that will enable government to exercise responsibility for money, yet will at the same time limit
the power thereby given to government and prevent the power from being used
in ways that will tend to weaken rather than strengthen a free society. Three
kinds of solutions have developed or have been suggested. One is an automatic
commodity standard, a monetary standard which in principle requires no governmental control. A second is the control of monetary policies by an "independent" central bank. A third is the control of monetary policies by rules that
are legislated in advance by the legislature, are binding upon the monetary authority, and greatly limit its initiative. This paper discusses these three alternatives with rather more attention to the solution through a central bank.
A COMMODITY
STANDARD
Historically, the device that has evolved most frequently in many different
places and over the course of centuries is a commodity standard; that is, the
use as money of some physical commodity such as gold, silver, brass, or tin, or
cigarettes, cognac, or various other commodities. If money consisted wholly
of a physical commodity of this type, in principle there would be no need for
control by the government at all. The amount of money in society would depend
on the cost of producing the monetary commodity rather than on other things.
Changes in the amount of money would depend on changes in the technical conditions of producing the monetary commodity and on changes in the demand for
money.
This is an ideal that animates many believers in an automatic gold standard.
In point of fact, however, as the system developed it deviated very far from
this simple pattern, which required no governmental intervention. Historically,
a commodity standard—such as a gold standard or a silver standard—was accompanied by the development of alternative forms of money as well; of fiduciary
money of one kind or another, ostensibly convertible into the monetary commodity on fixed terms. There was a very good reason for this development.
The fundamental defect of a commodity standard, from the point of view of the
society as a whole, is that it requires the use of real resources to add to the
stock of money. People must work hard to dig something out of the ground in
one place—to dig gold out of the ground in South Africa—in order to rebury it
in Fort Knox, or some similar place. The necessity of using real resources for
the operation of a commodity standard establishes a strong incentive for people
to find ways to achieve the same result without employing these resources. If
people will accept as money pieces of paper on which is printed "I promise to
pay so much of the standard commodity," these pieces of paper can perform
the same functions as the physical pieces of gold or silver, and they require very
much less in resources to produce.
This point, which I have discussed at somewhat greater length elsewhere,2 seems to me the fundamental difficulty of a
commodity standard.
If an automatic commodity standard were feasible, it would provide an excellent solution to the liberal dilemma of how to get a stable monetary framework
without the danger of irresponsible exercise of monetary powers. A full commodity standard, for example, an honest-to-goodness gold standard in which 100
percent of the money consisted literally of gold, widely supported by a public
imbued with the mythology of a gold standard and the belief that it is immoral
and improper for government to interfere with its operation, would provide an
effective control against governmental tinkering with the currency and against
irresponsible monetary action. Under such a standard, any monetary powers
of government would be very minor in scope.
2
"A Program for Monetary Stability" (New York: Fordham University Press, 1959),
pp. 4-8.
THE FEDERAL RESERVE SYSTEM AFTER FIFTY YEARS
1167
But such an automatic system has historically never proved feasible. It has
always tended to develop in the direction of a mixed system containing fiduciary
elements such as bank notes, bank deposits, or government notes in addition to
the monetary commodity. And once fiduciary elements have been introduced,
it has proved difficult to avoid government control over them, even when they
were initially issued by private individuals. The reason is basically the difficulty of preventing counterfeiting or its economic equivalent. Fiduciary money
consists of a contract to pay standard money. It so happens that there tends
to be a long interval between the making of such a contract and its realization,
which enhances the difficulty of enforcing the contract to pay the standard money
and hence also the temptation to issue fraudulent contracts. In addition, once
fiduciary elements have been introduced, the temptation for government itself
to issue fiduciary money is almost irresistible. As a result of these forces,
commodity standards have tended in practice to become mixed standards involving extensive intervention by the state, which leaves the problem of how
intervention is to be controlled.
Despite the great amount of talk by many people in favor of the gold standard,
almost no one today literally desires to see an honest-to-goodness full gold
standard in operation. People who say they want a gold standard are almost
invariably talking about the present kind of standard, or the kind of standard
that was maintained in the 1930's, in which there is a small amount of gold in
existence, held by the central monetary authority as "backing"—to use that very
misleading term—for fiduciary money, and with the same authority, a central
bank or other government bureau, managing the gold standard. Even during
the so-called "great days" of the gold standard of the 19th century, when the
Bank of England was supposedly running the gold standard skillfully, the
monetary system was far from a fully automatic gold standard. It was even
then a highly managed standard. And certainly the situation is now more
extreme. Country after country has adopted the view that government has responsibility for internal stability. This development, plus the invention by
Schacht of the widespread direct control of foireign exchange transactions, has
meant that few, if any, countries are willing today to let the gold standard
operate even as quasi-automatically as it did in the 19th century.
Most countries in the world currently behave asymmetrically with respect to
the gold standard. They are willing to allow gold to flow in and even to inflate
somewhat in response, but almost none is willing either to let gold flow out to any
large extent or to adjust to the outflow by allowing or forcing internal prices
to decline. Instead, they are very likely to take measures such as exchange
controls, import restrictions, and the like.
My conclusion is that an automatic commodity standard is neither a feasible
nor a desirable solution to the problem of establishing monetary arrangements
for a free society. It is not desirable because it would involve a large cost in
the form of resources used to produce the monetary commodity. It is not feasible
because the mythology and beliefs required to make it effective do not exist.
A N I N D E P E N D E N T CENTRAL B A N K
A second device that has evolved and for which there is considerable support
is a so-called independent monetary authority—a central bank—to control monetary policy and to keep it from being the football of political manipulation. The
widespread belief in an independent central bank clearly rests on the acceptance—in some cases the highly reluctant acceptance—of the view I have just
been expressing about a commodity standard, namely, that a fully automatic
commodity standard is not a feasible way to achieve the objective of a monetary
structure that is both stable and free from irresponsible governmental tinkering.
The device of an independent central bank embodies the very appealing idea
that it is essential to prevent monetary policy from being a day-to-day plaything
at the mercy of every whim of the current political authorities. The device
is rationalized by assimilating it to a species of constitutionalism. The argument that is implicit in the views of proponents of an independent central bank—
so far as I know, these views have never been fully spelled out—is that control
over money is an essential function of a government comparable to the exercise
of legislative or judicial or administrative powers. In all of these, it is important to distinguish between the basic structure and day-to-day operation within
that structure. In our form of government, this distinction is made between the
constitutional rules which set down a series of basic prescriptions and proscrip-
1168
THE FEDERAL RESERVE SYSTEM AFTER FIFTY YEARS
tions for the legislative, judicial, and executive authorities and the detailed
operation of the several authorities under these general rules. Similarly, the
argument implicit in the defense of an independent central bank is that the
monetary structure needs a kind of a monetary constitution, which takes the
form of rules establishing and limiting the central bank as to the powers that it
is given, its reserve requirements, and so on. Beyond this, the argument goes,
it is desirable to let the central bank have authority largely coordinate with
that of the legislature, the executive, and the judiciary to carry out the general
constitutional mandate on a day-to-day basis.
In recent times, the threat of extension of government control into widening
areas of economic activity has often come through proposals involving monetary
expansion. Central bankers have generally been "sound money men," at least
verbally, which is to say, they have tended to attach great importance to stability of the exchange rate, maintenance of convertibility of the Nation's currency into other currencies and into gold, and prevention of inflation. They
have therefore tended to oppose many of the proposals for extending the scope of
government. This coincidence of their views in these respects with those of
people like myself, who regard narrowly limited government as a requisite for a
Ifree society, is the source of much of the sympathy on the part of this group,
whom I shall call "new liberals," for the notion of an independent central bank.
As a practical matter, the central bankers seem more likely to impose restrictions on irresponsible monetary power than the legislative authority itself.
A first step in discussing this notion critically is to examine the meaning of the
"independence" of a central bank. There is a trivial meaning that cannot be
the source of dispute about the desirability of independence. In any kind of
a bureaucracy, it is desirable to delegate particular functions to particular
agencies. The Bureau of Internal Revenue can be described as an independent
bureau within the Treasury Department. Outside the regular Government departments, there are separate administrative organizations, such as the Bureau
of the Budget. This kind of independence of monetary policy would exist if,
within the central administrative heirarchy, there were a separate organization
charged with moentary policy which was subordinate to the chief executive or
officer, though it might be more or less independent in routine decisions. For our
purposes, this seems to me a trivial meaning of independence, and not the meaning fundamentally involved in the argument for or against an independent
central bank. This is simply a question of expediency and of the best way to
organize an administrative hierarchy.
A more basic meaning is the one suggested above—that a central bank should
be an independent branch of government coordinate with the legislative, executive, and judicial branches, and with its actions subject to interpretation by
the judiciary. Perhaps the most extreme form of this kind of independence
in practice, and the form that comes closest to the ideal type envisaged by proponents of an independent central bank, has been achieved in those historical instances where an organization that was initially entirely private and not formally part of the government at all has served as a central bank. The leading
example, of course, is the Bank of England, which developed out of a strictly
private bank and was not owned by or formally a part of the Government until
after World War II. If such a private organization strictly outside the regular
political channels could not function as a central monetary authority, this form
of independence would call for the establishment of a central bank through
a constitutional provision which would be subject to change only by constitutional amendment. The bank would accordingly not be subject to direct control
by the legislature. This is the meaning I shall assign to independence in discussing further whether an independent central bank is a desirable resolution of
the problem of achieving responsible control over monetary policy.
It seems to me highly dubious that the United States, or for that matter any
other country, has in practice ever had an independent central bank in this
fullest sense of the term. Even when central banks have supposedly been fully
independent, they have exercised their independence only so long as there has
been no real conflict between them and the rest of the government. Whenever
there has been a serious conflict, as in time of war, between the interests of the
fiscal authorities in raising funds and of the monetary authorities in maintaining convertibility into species, the bank has almost invariably given way, rather
than the fiscal authority. To judge by experience, even those central banks that
have been nominally independent in the fullest sense of the term have in fact
been closely linked to the executive authority.
THE FEDERAL RESERVE SYSTEM AFTER FIFTY YEARS
1169
B u t of course t h i s does not dispose of the m a t t e r . T h e ideal is seldom fully
realized. Suppose we could have a n independent central b a n k in t h e sense
of a coordinate, constitutionally established, s e p a r a t e organization. Would it
be desirable to do so? I t h i n k not, for both political a n d economic reasons.
T h e political objections a r e p e r h a p s more obvious t h a n the economic ones.
I s it really tolerable in a democracy to h a v e so much power concentrated in a
body free from a n y kind of direct, effective political control? W h a t I h a v e called
t h e "new liberal" often characterizes his position a s involving belief in t h e rule
of law r a t h e r t h a n of men. I t is h a r d to reconcile such a view w i t h t h e approval
of a n independent central b a n k in any meaningful way. True, it is impossible
to dispense fully w i t h t h e rule of men. No law c a n be specified so precisely
a s to avoid problems of i n t e r p r e t a t i o n or to cover explicitly every possible case.
B u t the kind of limited discretion left by even the best of laws in t h e h a n d s of
those administering t h e m is a f a r cry indeed from t h e kind of far-reaching
powers t h a t the l a w s establishing central b a n k s generally place in t h e h a n d s of
a small number of men.
I w a s myself most fully persuaded t h a t it would be politically intolerable to
h a v e an "independent" central bank by t h e memoirs of Emile Moreau, t h e governor of the B a n k of F r a n c e during t h e period from about 1926 t o 1928, t h e
period when F r a n c e established a new p a r i t y for t h e f r a n c a n d r e t u r n e d to gold.
Moreau w a s appointed governor of t h e B a n k of F r a n c e in 1926, not long before
PoincarS became P r e m i e r after violent fluctuations in t h e exchange value of
t h e franc and serious accompanying i n t e r n a l disturbances a n d governmental
financial difficulties. Moreau's memoirs w e r e edited a n d brought out in book
form some years ago by Jacques Rueff, who w a s t h e leading figure in t h e recent
F r e n c h m o n e t a r y reform. 8
T h e book is fascinating on m a n y counts. T h e p a r t i c u l a r respect t h a t is most
relevant for our present purpose is t h e picture t h a t Moreau p a i n t s of Montagu
Norman, governor of t h e B a n k of England, on t h e one h a n d , a n d of H j a l m a r
Schacht, a t t h a t time governor of t h e B a n k of Germany, on the o t h e r ; they w e r e
unquestionably two of t h e t h r e e outstanding central bankers of t h e modern e r a ,
Benjamin Strong of t h e United S t a t e s being t h e third. Moreau describes t h e views
t h a t these two European central b a n k e r s h a d of t h e i r functions a n d their roles,
a n d implies their a t t i t u d e t o w a r d other groups. T h e impression left w i t h me—
though i t is by no means clear t h a t Moreau drew t h e same conclusions from w h a t
he wrote, a n d it is certain t h a t he would have expressed himself more temperately—is t h a t Norman a n d Schacht were contemptuous both of t h e masses—
of "vulgar" democracy—and of t h e classes—of the, to them, equally vulgar
plutocracy. They viewed themselves as exercising control in t h e interests of both
groups but free from t h e pressures of either. I n N o r m a n ' s view, if t h e major
central bankers of the world would only cooperate with one another—and h e h a d
in mind not only himself a n d Schacht b u t also Moreau a n d Benjamin Strong—
they could jointly wield enough power to control t h e basic economic destinies of
t h e Western World in accordance w i t h rational ends and objectives r a t h e r t h a n
w i t h t h e i r r a t i o n a l processes of either p a r l i a m e n t a r y democracy or laissez-faire
capitalism. Though of course stated in obviously benevolent terms of doing t h e
"right t h i n g " and avoiding d i s t r u s t a n d uncertainty, t h e implicit doctrine is
clearly thoroughly dictatorial a n d t o t a l i t a r i a n .
I t is not h a r d to see how Schacht could l a t e r be one of the major c r e a t o r s of
t h e kind of far-reaching economic planning and control t h a t developed in Germany. Schacht's creation of extensive direct control of foreign exchange t r a n s actions i s one of the few really new economic inventions of modern times. I n
t h e older literature, when people spoke of a currency as being inconvertible, they
m e a n t t h a t it w a s not convertible into< gold or silver or some other money a t a
fixed r a t e . To t h e best of my knowledge, it is only after 1934 t h a t inconvertibility came to mean w h a t we currently t a k e it to m e a n ; t h a t it is illegal for one
m a n to convert paper money of one country i n t o paper money of another country
a t any t e r m s h e can a r r a n g e w i t h another person. 4
3
Emile Moreau, "Souvenirs d'un Gouverneur de la Banque de France" (Paris: G6nin
[1954]).
* Another feature of Moreau's book that is most fascinating but rather off the main track
of the present discussion is the story it tells of the changing relations between the French
and British central banks. At the beginning, with France in desperate straits seeking to
stabilize its currency, Norman was contemptuous of France and regarded it as very much
of a junior partner. Through the accident that the French currency was revalued at a
level that stimulated gold imports, France started to accumulate gold reserves and sterling
reserves and gradually came into the position where at any time Moreau could have forced
the British off gold by withdrawing the funds he had on deposit at the Bank of England.
1170
THE FEDERAL RESERVE SYSTEM AFTER FIFTY YEARS
I turn now to the economic or technical aspects of an independent central
bank. Clearly there are political objections to giving the group in charge of a
central bank so much power independent of direct political controls, but, it has
been argued, there are economic or technical grounds why it is nevertheless
essential to do so. In judging this statement, much depends on the amount of
leeway that the general rule governing the central bank gives to it. I have
been describing an independent central bank as if it could or would be given a
good deal of separate power, as clearly is currently the case. Of course, the
whole notion of independence could be rendered merely a matter of words if in
fact the constitutional provision setting up the bank established the limits of its
authority very narrowly and controlled very closely the policies that it could
follow.
In the 19th century, when wide support for independent central banks developed, the governing objective of the central bank was the maintenance of exchange stability. Central banks tended to develop in countries that professed to
have commodity currencies, which is to say had a fixed price for the commodity
serving as the monetary standard in terms of the nominal money of the country.
For two countries on the same standard, this meant a fixed rate of exchange
between the corresponding national currencies. In consequence, the maintenance of such fixed rates had to be the proximate aim of the central bank if it
was to achieve its major aim of keeping its currency convertible into standard
money. The Bank of England, for example, was narrowly limited in what it
could do by the necessity of keeping England on gold.
In the same way, in the United States when the Federal Reserve System was
established in 1913, it never entered into the minds of the people who were establishing it that the System would really have much effective control internally
in ordinary times. The Reserve System was established when the gold standard
ruled supreme, and when it was taken for granted that the major factor determining the policy of the System, and hence the behavior of the stock of money
in this country, would be the necessity of maintaining external equilibrium with
the currencies of other countries. So long as the maintenance of a fixed exchange rate between one country's currency and the currencies of other countries was the overriding objective of policy, the amount of leeway available to
the central bank was narrowly limited. It had some leeway with respect to
minor movements of a short-term character, but it ultimately had to respond
to the balance of payments.
The situation has changed drastically in this respect in the course of the past
few decades. In the United States, which is of most immediate concern to us,
the Reserve System had hardly started operations before the fundamental conditions taken for granted when it was established had changed radically. During World War I, most of the countries of the world went off gold. The United
States technically remained on gold, but the gold standard on which it remained
was very different from the one that had prevailed earlier. After the end of
World War I, although other countries of the world gradually reestablished
something they called the gold standard, the gold standard never again played
the role which it had before. Prior to World War I, the United States was
effectively a minor factor in the total world economy, and the necessity of maintaining external stability dominated our behavior. After the war, we had become
a major factor to which other countries had to adjust. We held a very large
fraction of the world's gold. Many countries never went back on gold, and those
that did went back in a much diluted form. So never again has there been anything like the close domination of day-to-day policy by the gold standard that
prevailed prior to 1914. Under these circumstances, "independence" of the
central bank has become something meaningful, and not merely a technicality.
One defect of an independent central bank in such a situation is that it almost
inevitably involves dispersal of responsibility. If we examine the monetary
system in terms not of nominal institutional organization but of the economic
functions performed, we find that the central bank is hardly ever the only
authority in the Government that has essential monetary powers. Before the
The result was that Norman changed from being a proud boss and very much the senior
partner to being almost a suppliant at the mercy of Moreau. Aside from the human drama,
it emphasizes how important it is whether the rate of exchange is fixed 5 percent too low
or 5 percent too high. Britain went back on gold in 1925 at a price of gold in terms of
the pound that was probably something like 5 or 10 percent too low, and France went back
de facto at the end of 1926 and de jure in mid^l928 at a price of gold in terms of francs
that was 5 or 10 percent too high. This difference meant the difference between the
French being at the mercy of the British and the British being at the mercy of the French.
THE FEDERAL RESERVE SYSTEM AFTER FIFTY YEARS
1171
Federal Reserve System was established, the Treasury exercised essential monetary powers. It operated like a central bank, and at times a very effective
central bank. More recently, from 1933 to 1941, the Federal Reserve System was
almost entirely passive. Such monetary action as were taken were taken predominantly by the Treasury. The Treasury engaged in open-market operations
in its debt-management operations of buying and selling securities. It created
and destroyed money in its gold and silver purchases and sales. The Exchange
Stabilization Fund was established and gave the Treasury yet another device for
engaging in open-market operations. When the Treasury sterilized and desterilized gold, it was engaging in monetary actions. In practice, therefore, even if
something called an independent central bank is established and given exclusive
power over a limited range of monetary matters, in particular over the printing
of pieces of paper or the making of book entries called money (Federal Reserve
notes and Federal Reserve deposits), there remain other governmental authorities, particularly the fiscal authority collecting taxes and dispersing funds and
managing the debt, which also have a good deal of monetary power.
If one wanted to have the substance and not merely the form of an independent
monetary authority, it would be necessary to concentrate all debt-management
powers as well as all powers to create and destroy governmentally issued money
in the central bank. As a matter of technical efficiency, this might well be desirable. Our present division of responsibility for debt management between the
Federal Reserve and the Treasury is very inefficient. It would be much more
efficient if the Federal Reserve did all of the borrowing and all of the managing
of the debt, and the Treasury, when it had a deficit, financed it by getting money
from the Federal Reserve System, and when it had a surplus, handed the excess
over to the Federal Reserve System. Rut while such an arrangement might
be tolerable if the Federal Reserve System were part of the same administrative
hierarchy as the Treasury, it is almost inconceivable that it would be if the central bank were thoroughly independent. Certainly no government to date has
been willing to put that much power in the hands of a central bank even when
the bank has been only partly independent. But so long as these powers are
separated, there is dispersal of responsibility, with each group separately regarding the other group as responsible for what is happening and with no one willing
to accept responsibility.
In the past few years, I have read through the annual reports of the Federal
Reserve System from 1913 to date, seriatim. One of the few amusing dividends
from that ordeal was seeing the cyclical pattern that shows up in the potency
that the authorities attribute to monetary policy. In years when things are
going well, the reports emphasize that monetary policy is an exceedingly potent
weapon and that the favorable course of events is largely a result of the skillful
handling of this delicate instrument by the monetary authority. In years of
depresssion, on the other hand, the reports emphasize that monetary policy is
but one of many tools of economic policy, that its power is highly limited, and
that it was only the skillful handling of such limited powers as were available
that averted disaster. This is an example of the effect of the dispersal of responsibility among different authorities, with the likely result that no one assumes
or is assigned the final responsibility.
iAnother defect of the conduct of monetary policy through an independent
central bank that has a good deal of leeway and power is the extent to which
policy is thereby made highly dependent on personalities. In studying the history of American monetary policy, I have been struck by the extraordinary
importance of accidents of personality.
At the end of World War I, the Governor of the Federal Reserve System was
W. P. G. Harding. Governor Harding was, I am sure, a thoroughly reputable
and competent citizen, but he had a very limited understanding of monetary
affairs, and even less backbone. Almost every student of the period is agreed
that the great mistake of the Reserve System in postwar monetary policy was to
permit the money stock to expand very rapidly in 1919 and then to step very
hard on the brakes in 1920. This policy was almost surely responsible for both
the sharp postwar rise in prices and the sharp subsequent decline. It is amusing to read Harding's answer in his memoirs to criticism that was later made
of the policies followed. He does not question that alternative policies might
well have been preferable for the economy as a whole, but emphasizes the Treasury's desire to float securities at a reasonable rate of interest, and calls attention
to a then-existing law under which the Treasury could replace the head of the
Reserve System. Essentially he was saying the same thing that I heard another
member of the Reserve Board say shortly after World War II when the bond
1172
THE FEDERAL RESERVE SYSTEM AFTER FIFTY YEARS
support program was in question. In response to the view expressed by some of
my colleagues and myself that the bond-support program should be dropped, he
largely agreed but said, "Do you want us to lose our jobs?"
The importance of personality is strikingly revealed by the contrast between
Harding's behavior and that of Emile Moreau in France under much more
difficult circumstances. Moreau formally had no independence whatsoever from
the central government. He was named by the Premier, and could be discharged
at any time by the Premier. But when he was asked by the Premier to provide
the Treasury with funds in a manner that he considered inappropriate and
undesirable, he flatly refused to do so. Of course, what happened was that
Moreau was not discharged, that he did not do what the Premier had asked him
to, and that stabilization was rather more successful. I cite this contrast neither
to praise Moreau nor to blame Harding, but simply to illustrate my main point,
namely, the extent to which a system of this kind is really a system of rule by
men and not by law and is extraordinarily dependent on the particular personalities involved.
Another occasion in U.S. history which strikingly illustrates this point is our
experience from 1929 to 1933. Without doubt, the most serious mistake in the
history of the Reserve System was its mismanagement of monetary T matters
during those years. And this mismanagement, like that after World W ar I, can
very largely be attributed to accidents of personality. Benjamin Strong, Governor of the Federal Reserve Bank of New York from its inception, was the dominant figure in the Reserve System until his death at a rather early age in 1928.
His death was followed by a shift of power in the System from New York to
Washington. The people in Washington at the time happened to be fairly mediocre. Moreover, they had always played a secondary role, were not in intimate
touch with the financial world, and had no background of long experience in
meeting day-to-day emergencies. Further, the chairmanship changed hands just
prior to the shift of power and again in mid-1931. Consequently, in the emergencies that came in 1929, 1930, and 1931, particularly in the fall of 1930, when
the Bank of United States failed in New York as part of a dramatic series
of bank failures, the Federal Reserve System acted timorously and passively.
There is little doubt that Strong would have acted very differently. If he had
still been Governor, the result would almost surely have been to nip the wave of
bank failures in the bud and to prevent the drastic monetary deflation that
followed.
A similar situation prevails today. The actions of the Reserve System
depend on whether there are a few persons in the System who exert intellectual
leadership, and on who these people a r e ; its actions depend not only on the
people who are nominally the heads of the System but also on such matters as
the fate of particular economic advisers.
So far, I have listed two main technical defects of an independent central bank
from an economic point of view; first, dispersal of responsibility, which promotes shirking responsibility in times of uncertainty and difficulty, and second,
an extraordinary dependence on personalities, which fosters instability arising
from accidental shifts in the particular people and the character of the people
who are in charge of the system.
A third technical defect is that an independent central bank will almost
inevitably give undue emphasis to the point of view of bankers. It is exceedingly important to distinguish two quite different problems that tend to be confused : the problem of credit policy and the problem of monetary policy. In our
kind of monetary or banking system, money tends to be created as an incident in
the extension of credit, yet conceptually the creation of money and the extension
of credit are quite distinct. A monetary system could be utterly unrelated to
any credit instruments whatsoever; for example, this would be true of a completely automatic commodity standard, using only the monetary commodity itself
or warehouse receipts for the commodity as money. Historically, the connection
between money and credit has varied widely from time to time and from place
to place. It is therefore essential to distinguish policy issues connected with
interest rates and conditions on the credit market from policy issues connected
with changes in the aggregate stock of money, while recognizing, of course, that
measures taken to affect the one set of variables may also affect the other, and
that monetary measures may have credit effects as well as monetary effects
proper.
It so happens that central bank action is but one of many forces affecting the
credit market. As we and other countries have seen time and again, a central
bank may be able to determine the rate of interest on a narrow range of securities, such as the rate of interest on a particular category of Government
THE FEDERAL RESERVE SYSTEM AFTER FIFTY YEARS
1173
bonds, though even that only within limits and only at the expense of completely
giving up control over the total stock of money. A central bank has never been
able to determine, at all closely, rates of interest in any broader or more fundamental sense. Postwar experience in country after country that has embarked
on a cheap-money policy has strikingly demonstrated that the forces which determine rates of interest broadly conceived—rates of return on equities, on real
property, on corporate securities—are far too strong and widespread for the
central bank to dominate. It must sooner or later yield to them, and generally
rather soon.
The central bank is in a very different position in determining the quantity of
money. Under systems such as that in the United States today, the central
bank can make the amount of money anything it wishes. It may, of course,
choose to accept some other objective and give up its power over the money
supply in order to try to keep "the" or "a" rate of interest fixed, to keep "free
reserves" at a particular level, or to achieve some other objective. But if it
wishes, it can exercise complete control over the stock of money.
This difference between the position of the central bank in the credit markets
and in determining the money supply tends to be obfuscated by the close connection between the central bank and the banking community. In the United States,
for example, the Reserve banks technically are owned by their member banks.
One result is that the general views of the banking community exercise a strong
influence on the central bank and, since the banking community is concerned
primarily with the credit market, central banks are led to put altogether too
much emphasis on the credit effects of their policies and too little emphasis on
the monetary effects of their policies.
In recent times, this emphasis has been attributed to the effects of the Keynesian
revolution and its treatment of changes in the stock of money as operating
primarily through the liquidity preference function on the interest rate. But
this is only a particular form of a more general and ancient tendency. The
real-bills doctrine, which dates back a century and more, exemplifies the same
kind of confusion between the credit and the monetary effects of monetary
policy. The banking and currency controversy in Britain in the early 19th
century is a related example. The central bank emphasized its concern with
conditions in the credit market. It denied that the quantity of money it was
creating was in any way an important consideration in determining price levels
or the like, or that it had any discretion about how much money to create. Much
the same arguments are heard today.
The three defects I have outlined constitute a strong technical argument against
an independent central bank. Combined with the political argument, the case
against a fully independent central bank is strong indeed.
LEGISLATED RULES
If this conclusion is valid, if we cannot achieve our objectives by giving wide
discretion to independent experts, how else can we establish a monetary system
that is stable, free from irresponsible governmental tinkering, and incapable of
being used as a source of power to threaten economic and political freedom? A
third possibility is to try to achieve a government of law instead of men literally
by legislating rules for the conduct of monetary policy. The enactment of such
rules would enable the public to exercise control over monetary policy through its
political authorities, while at the same time preventing monetary policy from
being subject to the day-to-day whim of political authorities.
The argument for legislating rules for monetary policy has much in common
with a topic that seems at first altogether different, namely, the Bill of Rights to
the Constitution. Whenever anyone suggests the desirability of a legislative rule
for control over money, the stereotyped answer is that it makes little sense to tie
the monetary authority's hands in this way because the authority, if it wants to,
can always do of its own volition what the rule would require it to do, and, in
addition, has other alternatives; hence "surely," it is said, it can do better than
the rule. An alternative version of the same argument applies to the legislature.
If the legislature is willing to adopt the rule, it is said, surely it will also be willing to legislate the "right" policy in each specific case. How then, it is said, does
the adoption of the rule provide any protection against irresponsible political
action?
The same argument could apply with only minor verbal changes to the first
amendment to the Constitution and, equally, to the entire Bill of Rights. Is
it not absurd, one might say, to have a general proscription of interference with
free speech ? Why not take up each case separately and treat it on its own merits ?
1174
THE FEDERAL RESERVE SYSTEM AFTER FIFTY YEARS
Is this not the counterpart to the usual argument in monetary policy that it is
undesirable to tie the hands of the monetary authority in advance; that it
should be left free to treat each case on its merits as it comes up? Why is not
the argument equally valid for speech? One man wants to stand up on a street
corner and advocate birth control; another, communism; a third, vegetarianism;
and so on, ad infinitum. Why not enact a law anirming or denying each the right
to spread his particular views? Or, alternatively, why not give the power to
decide the issue to an administrative agency? It is immediately clear that if we
were to take up each case separately, a majority would almost surely vote to deny
free speech in most cases and perhaps even in every case. A vote on whether
Mr. X should spread birth control propaganda would almost surely yield a majority saying "no"; and so would one on communism. The vegetarian might perhaps get by, although even that is by no means a foregone conclusion.
But now suppose all these cases were grouped together in one bundle, and the
populace at large was asked to vote for them as a whole: to vote whether free
speech should be denied in all cases or permitted in all alike. It is perfectly
conceivable, if not highly probable, that an overwhelming majority would vote
for free speech; that, acting on the bundle as a whole, the people would vote
exactly the opposite to the way they would have voted on each case separately.
Why? One reason is that each person feels much more strongly about being
deprived of his right to free speech when he is in a minority than he feels about
depriving somebody else of the right to free speech when he is in the majority.
In consequence, when he votes on the bundle as a whole, he gives much more
weight to the infrequent denial of free speech to himself when he is in the minority than to the frequent denial of free speech to others. Another reason, and
one that is more directly relevant to monetary policy, is that if the bundle is
viewed as a whole, it becomes clear that the policy followed has cumulative effects
that tend neither to be recognized nor taken into account when each case is voted
on separately. When a vote is taken on whether Mr. Jones may speak on the
corner, it is not clearly affected by favorable effects of an announced general
policy of free speech, and an affirmative vote will not produce these effects.
In voting on the specific case, it is only peripherally relevant that a society in
which people are not free to speak on the corner without special legislation is
a society in which the development of new ideas, experimentation, change, and
the like are all hampered in a great variety of ways. That these ways are
obvious to all is due to our good fortune of having lived in a society that did
adopt the self-denying ordinance of not considering each case of speech separately.
Exactly the same considerations apply in the monetary area. If each case is
considered on its merits, the wrong decision is likely to be made in a large fraction of cases because the decisionmakers are examining only a limited area and
are not taking into account the cumulative consequences of the policy as a whole.
On the other hand, if a general rule is adopted for a group of cases as a bundle,
the existence of that rule has favorable effects on people's attitudes and beliefs
and expectations that would not follow even from the discretionary adoption of
precisely the same policy on a series of separate occasions.
Of course, the general rule need not be explicitly written down or legislated.
Unwritten constitutional limitations supported unthinkingly by the bulk of the
people may be as effective in determining decisions in individual cases as a
written constitution. The analogy in monetary affairs is the mythology of gold,
referred to earlier as a necessary ingredient of a gold standard if it is to serve
as an effective bulwark against discretionary authority.
If a rule is to be legislated, what rule should it be? The rule that has most
frequently been suggested by people of a generally "new liberal" persuasion is a
price-level rule; namely, a legislative direction to the monetary authorities that
they maintain a stable price level. I think this is the wrong kind of rule. It is
the wrong kind of rule because the objectives it specifies are ones that the monetary authorities do not have the clear and direct power to achieve by their own
actions. It consequently raises the earlier problem of dispersing responsibilities
and leaving the authorities too much leeway. There is unquestionably a close
connection between monetary actions and the price level. But the connection is
not so close, so invariable, or so direct that the objective of achieving a stable
price level is an appropriate guide to the day-to-day activities of the authorities.
The issue of what rule to adopt is one that I have considered at some length
elsewhere.5 Accordingly, I will limit myself here to stating my conclusion. In
6
"A Program for Monetary Stability," pp. 77-99.
THE FEDERAL RESERVE SYSTEM AFTER FIFTY YEARS
1175
the present state of our knowledge, it seems to me desirable to state the rule
in terms of the behavior of the stock of money. My choice at the moment would
be a legislated rule instructing the monetary authority to achieve a specified rate
of growth in the stock of money. For this purpose, I would define the stock of
money as including currency outside commercial banks plus all deposits of commercial banks. I would specify that the Reserve System should see to it that
the total stock of money so defined rises month by month, and indeed, so far as
possible, day by day, at an annual rate of x percent, where x is some number
between 3 and 5. The precise definition of money adopted and the precise rate
of growth chosen make far less difference than the definite choice of a particular
definition and a particular rate of growth.
I should like to emphasize that I do not regard this proposal as a be-all and
end-all of monetary management, as a rule which is somehow to be written in
tablets of gold and enshrined for all future time. It seems to me to be the rule
that offers the greatest promise of achieving a reasonable degree of monetary
stability in the light of our present knowledge. I would hope that as we operated
with it, as we learned more about monetary matters, we might be able to devise
still better rules which would achieve still better results. However, the main
point of this paper is not so much to discuss the content of these or alternative
rules as to suggest that the device of legislating a rule about the stock of money
can effectively achieve what an independent central bank is designed to achieve
but cannot. Such a rule seems to me the only feasible device currently available
for converting monetary policy into a pillar of a free society rather than a
threat to its foundations.
The CHAIRMAN. Professor Friedman, do you know any justification
for such an important part of our Government as the monetary
authority, which determines the volume of money, the availability of
credit, and the cost of both, to be in the hands of people who feel like
they are away from the Government to the extent where they can
have a secret meeting every 3 weeks here in Washington, telling no
one what happened, telling no one what is going to happen ? Do you
find any justification for that sort of conduct in a democracy or in a
republic ?
Mr. FRIEDMAN. I do not find any justification for giving such large
powers to a small number of individuals regardless of whether they
exercise them in secret meetings or open meetings.
The CHAIRMAN. I t is doubly bad because of the secrecy, though, is
it not?
Mr. HARVEY. Mr. Chairman, now that the bell has rung I would like
to ask a question of the chairman as to when we can expect the full
committee to have an executive meeting?
I know that that is what Mr. Kilburn wanted to ask you.
The CHAIRMAN. I do not know. We wanted to get the hearings
finished. We feel like they are important.
Two Governors of the Federal Reserve Board are witnesses tomorrow. We have heard all of them except these two, and you gentlemen
have been wanting Mr. Dillon here and he will be here day after
tomorrow, and then we have some other witnesses.
We want to make a credible package out of this, if we can, by having
full and complete testimony from both sides, something that we will
be proud of, and I believe that we can be.
We are getting a record here that I think all the members are going
to be proud of, especially the committee members, and I believe that
there is great interest in this particular hearing, and I would not like
to just disband it until we are really through. I think in a couple of
weeks we will be through enough
Mr. HARVEY. I would like to ask you this, that we have an executive
meeting of the full committee before that time because I think the
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T H E FEDERAL RESERVE SYSTEM AFTER FIFTY YEARS
chairman is aware, as all of us are who receive mail on the matters
that come up—and I think that we should have one before that
The CHAIRMAN. Well, I am sorry that Mr. Kilburn left, and I will
not discuss it on that account. I have no comment on that.
I have nothing to hide on that
Mr. HARVEY. I am sure the chairman does not, but I merely mention
it because I am sure all of the members are interested in it, and the
things
The CHAIRMAN. Well, what would be the object of a meeting?
Mr. HARVEY. I think, to discuss the policy of the committee.
The CHAIRMAN. Well, we have discussed the policy of the committee, and the chairman has certain powers
Mr. WIDNALL. That is just the question, Mr. Chairman, whether or
not the chairman has the powers
The CHAIRMAN. Well, get up a statement and give it to me and whatever charges are made will certainly get consideration. You will get
consideration quickly, but let's have some charges now.
Mr. WIDNALL. Mr. Chairman, nobody has made any charges. Information has been requested and that is what Mr. Kilburn wanted to
discuss before the full committee, and it seemed to me like a reasonable
request.
Mr. HARVEY. I do not think we should have to—I did not make my
request clear
The CHAIRMAN. Let's do not
Mr. HARVEY. I n the light of making any charges other than the fact
that I was aware of the situation, I thought it would behoove the committee if we are going to live together and get along together, to sit
down and discuss it. I t seems to me that we should.
The CHAIRMAN. Well, I do not know of a thing that the chairman
has done that any chairman cannot do under the rules of the House.
I f I have done anything wrong I am willing to listen to anybody
who wants
Mr. HARVEY. I respect the chairman a great deal, and I think he
knows that, and I also respect the gentleman from New York, but
The CHAIRMAN. Well, get me up a statement. Get me a memo.
Let's have something so that we will know what we are meeting about.
If there is any constructive reason to have a meeting we will have
one right away, but if there is no constructive reason I do not want
to interrupt these hearings.
W e are going pretty well on these hearings. W e certainly had one
of the most important witnesses that we could have in the entire world
here with us this morning, and he has given us wonderful testimony.
His contribution here is going to be great, and this record will be of
great importance.
Mr. WIDNALL. Mr. Chairman, do I understand you to say that you
have no desire or intention of having an executive meeting for discussing the problem posed by Mr. Kilburn unless somebody makes
charges against you, Mr. Chairman ?
The CHAIRMAN. N O , I did not say it that way. I said if anyone
wants a meeting of the committee, like the minority, that they should
state what they want it for and if they want it for a constructive reason,
within the rules, it will be granted. I have no desire to keep the
minority from having a meeting when they want it. I t is perfectly all
THE FEDERAL RESERVE SYSTEM AFTER FIFTY YEARS
1177
right. B u t I do not want to interrupt good hearings, constructive
hearings.
Incidentally, you gentlemen have never favored—you have been
against it. You started in fighting it when we started our hearings
Mr. WIDNALL. Mr. Chairman, we did not fight having hearings in
connection with evaluating the Federal Eeserve System.
I would like to see documented in the record any minority statement saying we should not have a look at 50 years of operation of the
Federal Eeserve System.
We did not fight that. And, for the record, and it should be in
the record right now once again—is that not true, Mr. Harvey ?
Mr. HARVEY. T h a t is certainly true.
The CHAIRMAN. Well, I think you will find right in the beginning
of the record some statement that you did not look with pleasure on it
at all.
Mr. HARVEY. Let me say this, Mr. Chairman, and I think right now
there are a great many members—I do not know how those on the
majority side feel—but on the minority side there is considerable feeling about the direction we have been pursuing and that is why I suggested, meaning no offense to the chairman whatsoever, that I thought
also to sit down in executive session, if onlj for a few minutes.
The CHAIRMAN. Well, I will ask the minority member to prepare
any statement or memo for my information that would justify me in
calling an executive session of the whole committee now, and the
reasons for it, and if it will serve a constructive purpose you can rest
assured it will be done.
We will set these hearings aside and have the meeting, but unless it
is compelling in some way I would be very reluctant to set these hearings aside.
We have gone to a lot of trouble to arrange with witnesses to come
here, and you cannot get a time that is suitable to everybody. You
have to have one that is mutually satisfactory, and you cannot always
do that.
We have had great difficulty with some witnesses and even with
Professor Friedman. We have had him scheduled for about 2 weeks
and postponed from time to time. We just cannot get things done like
we want to.
Mr. WIDNALL. May I make a further observation, Mr. Chairman?
The CHAIRMAN. Yes,
sir.
Mr. WIDNALL. There has been no hesitancy to call meetings prior
to 10 o'clock for consideration of a matter, where it was thought necessary, by the chairman, and I certainly think that the point that has
been made by Mr. Kilburn in his letter to you, and his own request to
you, would be something that could be settled very quickly in the
committee, and it seems to me a reasonable request, as I understand it.
This is the whole point that I have been making.
The CHAIRMAN. Well, I will just ask Mr. Kilburn to prepare a
memo to me setting forth why he would like to have a hearing. I
think this committee is the one that should have the executive session
because we are conducting the hearings on it and at the same time
I would not be adverse to having one of the whole committee, if reasons
are given to justify quitting what we are doing, to take it up. That is
all I want, just a statement.
1178
THE FEDERAL RESERVE SYSTEM AFTER FIFTY YEARS
Mr. WIDNALL. Mr. Chairman, one further statement: I think you
just said that Mr. Dillon will be coming up on Thursday, as we have
wanted. I s it my understanding that you do not want Mr. Dillon
to appear before the committee ?
The CHAIRMAN. Oh, no. I said that is one reason why we do not
want to interrupt the hearings. We have been trying to get him but
he has been busy in the tax fight and other matters, and with the
Joint Economic Committee, and we could not agree on the time, and
I tried to explain it to you gentlemen. H e did not want to do it,
and I did not want him to interrupt his schedule, but you gentlemen
seemed to be displeased.
You wanted him up quickly and now then, since we could not get
him up quickly we are going to have him the day after tomorrow and
for that reason I thought especially you would want to go ahead without any interruptions. T h a t is the reason I brought that up.
We will stand recessed until 10 o'clock in the morning.
(Whereupon, at 12:10 p.m., the committee was recessed, to reconvene at 10 a.m., Wednesday, March 4, 1964.)
THE FEDERAL RESERVE SYSTEM AFTER 50 YEARS
WEDNESDAY, MABCH 4, 1964
HOUSE or REPRESENTATIVES,
SUBCOMMITTEE ON DOMESTIC F I N A N C E OF THE
COMMITTEE ON BANKING AND CURRENCY,
Washington, D.C.
The subcommittee met, pursuant to recess, at 10 a.m., in room 1301,
Longworth House Office Building, Hon. Wright Patman (chairman)
presiding.
Present: Representatives Patman, Reuss, Vanik, Moorhead, Weltner, Hanna, Kilburn, Widnall, Bolton, and Brock.
The CHAIRMAN. The committee will please come to order.
We are glad to have the other two members of the Board of Governors here, and when I say "other two" I mean the two that we have
not heard from. We have heard from the other five.
We are glad to have Mr. George W. Mitchell and Mr. J. Dewey
Daane.
Mr. Daane is the most recent addition to the Board of Governors'
team.
Mr. Mitchell, you have a prepared statement and so does Mr.
Daane. You may proceed in your own way.
We will place the statements in the record, as you appear, and then
if you want to summarize them and bring out the high points, that
will be fine, with the understanding, of course, that we look over this
record very carefully and give your full statement consideration
anyway. After you have finished, the members of the committee will
interrogate you.
So, Mr. Mitchell, you may proceed in your own way.
STATEMENT OF HON. GEORGE W. MITCHELL, MEMBER OF THE
BOARD OF GOVERNORS, FEDERAL RESERVE SYSTEM
Mr. MITCHELL. Well, Mr. Chairman, I think perhaps the most
expeditious thing for me to do will be to read the statement.
The CHAIRMAN. That will be perfectly all right.
Mr. MITCHELL. And it is really divided into three parts.
At the outset I have some comments on the proposals incorporated
in the bills dealing with changes and the structure of the Federal
Reserve System
The CHAIRMAN. Yes,
sir.
Mr. MITCHELL (continuing). And then I have a middle section
which contains some material on bank earnings over the past 10 years
that you requested and, finally, I have a section dealing with some
of the money supply theories that the committee has been hearing
about.
1179
1180
THE FEDERAL RESERVE SYSTEM AFTER FIFTY YEARS
Now, the statement does include some tables and appendix material . I do not plan to read those, but
The CHAIRMAN. We will place them in the record, but if you can
get through well within an hour it will be appreciated.
Mr. MITCHELL. I t will not take me that long. Very good.
The CHAIRMAN.
Yes.
Mr. MITCHELL. I n my judgment there are no significant benefits
or losses to be realized by changing the number of persons on the
Board from seven to five, or nine. A board larger than nine would
tend to become progressively more cumbersome and needlessly duplicative of points of view. A board smaller than five would diminish
the potential advantages of differing points of view and delegate
more policy-type decisions to staff.
As for the length of term for Board members, it seems to me a 4year term would have the unfortunate selective effect of eliminating
many well qualified individuals who could not consider appointment
to the Board for that length of time at prevailing salaries. Business,
banking and academic employment today are far more attractive than
Government posts, especially for men in the prime of their careers with
limited independent means. Perhaps an even more important deterrent to recruiting qualified candidates is the fact that a Board member
must, and quite properly so, sever business and financial connections
on which his future economic prospects and security had theretofore depended. Unless a man has substantial independent personal
or family means or unless he expects to complete his working career
within the period for which he is appointed to the Board, the length
of the term he can look forward to is a significant consideration in
determining his availability. I t is my opinion that a term longer than
4 years is needed to provide the President with a suitable panel of
competent men whose independence of judgment is least exposed to
considerations of personal or family necessity. On the other hand,
I doubt that a 14-year term is needed to achieve whatever contribution job security can make to quality and independence of Board members ; my suggestion would be a minimum of 6 or 7 years and a maximum of 10 to 12.
ABOLITION OF FEDERAL O P E N M A R K E T C O M M I T T E E
During the period since I became a member of the Board of Governors—September 1961—it has consistently been plain to me that the
members of the Federal Open Market Committee, whether from the
Board of Governors or from the Federal Reserve banks, have made
open market policy decisions on the basis of their individual evaluations of the public interest. This statement does not rest on the fact
that I admire their independence of judgment because they tend to
reach the same conclusions I do—most of them don't—but rather on
my observation that on any given public policy the views and reasoning expressed in committee deliberations reflect the man, whether he
lives in Washington or not.
The committee's policy record supports this judgment. Looking
at the voting record on the policy directives from September 1961
through the end of 1963, there were 55 dissenting votes cast on directives relating to current policy. Abstracting the dissenting votes castby me and one of my colleagues at a time during this period when
THE FEDERAL RESERVE SYSTEM AFTER FIFTY YEARS
1181
we concluded that a policy of greater monetary ease than the one described in the directive would have been desirable, the record shows
that 17 dissenting votes were cast by members of the committee who
were members of the Board of Governors, and that 16 dissenting votes
were cast by members of the committee who were from the Federal
Reserve banks. Within the latter group, eight of the dissenting votes
reflected a view that a policy of lesser ease would have been desirable,
while an equal number of dissenting votes reflected a view that a policy
of greater ease would have been desirable. These dissenting votes
were cast by six different Presidents who sat on the committee at one
time or another during the period. Dissents by members of the Board
were also to the right and left of the majority—for less ease—for
greater ease. Looking at individual voting records, President Hayes,
Governors Balderston, Shepardson, and Mills have at times over this
period voted against the majority in favor of less ease. Presidents
Bopp, Clay, Scanlon, Bryan, Deming, and Governors Robertson, Mills,
King, and I at times voted against the majority in favor of more ease.
From this record I detect no more bias in one direction or another
among the Presidents than can be found on the Board.
My reason for favoring a continuation of the Open Market Committee more or less as presently constituted is not primarily negative,
however. I think that regional representation from men whose dayto-day business activities keep them in touch with industrial, commercial and banking developments in the major centers of the Nation
brings to the committee qualitative judgments and insights that aggregative statistics will always lack.
AUDIT
The word "audit" automatically claims the support and endorsement
of everyone who has nothing to hide. But there should be a recognition that from a practical standpoint we cannot afford audit, audit,
and reaudit. Verifying the existence and accuracy of the assets and
liabilities shown on Federal Reserve balance sheets and determining
if expenditures at the Federal Reserve banks are consonant with
legal requirements and guidelines laid down by the Federal
Reserve Board is achieved by internal auditing procedures at
each Reserve bank and by the Board of Governors independent examinations. I believe these are ample guarantees that the Reserve
banks' accounts and spending are fully policed. So far as I am aware,
the examination of several thousand vouchers by the Committee staff
did not uncover either any falsification of the balance sheet statements or any deviation from statutory requirements or from Board
guidelines. This is corroborative evidence that a third verification
and audit at the Reserve banks would waste resources that could be
better employed elsewhere. Moreover, I believe it unwise to so constrain management decisions that the business of Government is operated not with a view to getting the job done, but with a view to what
a third set of auditors may say about how it was done. Compared
with Federal agencies, the Federal Reserve System is not very large
but I believe it gains in operating efficiency from the decentralization
of management responsibility to administrators on the site.
The term "auditing" is also used to refer to a review of management
policies, procedures, and standards. This is a type of audit to be used
1182
THE FEDERAL RESERVE SYSTEM AFTER FIFTY YEARS
with special expertise lest there be a tendency to substitute the auditor's judgment for that of the operating officer whe bears the responsibility for performance as well as costs. An illustration can be found
in the cost of providing security in Reserve banks where vast sums
of currency, coin, and securities are handled daily. The expenditure
for protection must be reasonably related to the exposure to possible
loss. An auditor might criticize an expenditure for guards as excessive but his judgment does not assume any responsibility if a loss is
actually incurred.
This is not to say that I believe it inappropriate for the GAO, or
any officially designated agency, to review the operational standards
and techniques in the Federal Reserve System to see if they conform
to the best in present day management practices. On the contrary,
I would welcome such an examination. I n fact, within the organization of the Board of Governors there is such a unit continuously
screening technical operations at the Reserve banks with a view to
achieving the most economical and expeditious manner of processing
securities, checks, currency, coin, or just facts.
Some criticism has been made of the president of the Reserve banks
for expenditures on employee welfare, community activities, employee
education, and the entertainment of visitors and guests. If any criticism is made I believe it should be of the Board of Governors for
guidelines it has prescribed. However, I believe the guidelines as they
stand are satisfactory. I t is true they provide for considerable discretion on the part of the presidents and their boards of directors
but I see no evidence this discretion has been abused. I t should be
borne in mind that the Federal Reserve banks provide many people
with their first job and education on the job is needed to develop the
new worker's potential. Average salaries at the Reserve banks are
low—about $5,000—and welfare-educational programs are especially
appropriate.
FEDERAL
RESERVE
ACCOUNTING
Over the years some students of central banking have suggested
that it would aid public understanding and approval of sound monetary policies if the financial statements and reporting of the Federal
Reserve did not follow conventional accounting lines but were made
uniquely applicable to central bank operations.
I believe the System has done better to follow conventional business
accounting practices on its operating statements and balance sheets.
The magic of monetary creation may thereby be blurred but at least
the present system has the virtue of requiring the System to show
sources of receipts to cover expenses and payments to the Treasury
and it also establishes the principle that for every investment expenditure there be an equivalent balance sheet asset. These accounting
conventions have more than a fictitious value in setting the rules
by which the central bank operates and they are safeguards against
at least some abuses of monetary power.
I n this context it seems to me that the size of the Federal Reserve
surplus is not particularly significant, even if it were regarded as a
"sinking* fund" for the retirement of the public debt. Whether or not
member banks should be permitted to own stock in the Reserve banks
should be decided on other grounds, namely on the grounds of encouraging System membership.
THE FEDERAL RESERVE SYSTEM AFTER FIFTY YEARS
1183
The main reason that more banks do not belong to the Federal Eeserve System is that it is more profitable to stay out. The nonmembers
usually benefit from having lower reserve requirements, or none at all,
and some of them benefit by collecting fees for clearing checks. Both
of these advantages to the nonmember banks are really disadvantageous to the public interest. Among the member banks there are
many that would become nonmembers if the advantages of membership were to become slightly less—one of these marginal advantages is
the dividend on Federal Eeserve stock. I believe it would be unwise to
make membership in the System any more costly from a competitive
standpoint than it is now.
MEMBER BANK EARNINGS, 19 5 4 - 6 3
Now, gentlemen, this section on member bank earnings contains
reference to attached tables 1-9, which you might want to be following
as I read my discussion.
What I have attempted to do here is to show what has happened to
the gross income of the member banks in the United States, over the
past 10 years, and the impact of the changes in the interest rates, the
changes in the capital accounts, the changes in expenses, and then the
net of all of this on the earnings of these banks.
The data are set up by Eeserve city and country banks to provide
you with a look at the differences that can be attributable to differences
in the size of the banks.
The Eeserve city banks would tend to be banks of over $100 million,
and the country banks would, of course, be very much smaller.
Over the past 10 years, gross revenues of member banks have increased by 130 percent. Member bank operating expenses, however,
have risen even faster, or more than 160 percent. Eeflecting the more
rapid growth in operating expenses than in revenues, net current earnings before income taxes grew by 77 percent and net income after taxes
by 66 percent. The ratio of net income to capital fluctuated from year
to year, but showed no marked change over the period.
Data are shown separately for Eeserve city and country banks, a
breakdown which also provides a rough indication of the differences
in operating experience between large banks and those of smaller size.
Eates of growth in net current earnings (table I I ) over the 10-year
period were identical at Eeserve city and country banks, but country
banks experienced a somewhat slower rise than city banks in net income after taxes (table I I I ) . The somewhat slower growth in net
income after taxes than in net current earnings before taxes reflects
in part the relatively large additions to income in the base year from
profits on the sale of securities. Such profits, which are included in
net income but not in net current earnings, were particularly large
in 1954, a recession year, when interest rates were depressed and market values of fixed-income securities relatively high.
The rate of return on bank capital (table V ) , as measured by the
ratio of net income to total capital accounts, has fluctuated somewhat
from year to year, mainly because of the erratic behavior of nonoperating adjustments, particularly profits and losses on the sale of securities.
Over the period, Eeserve city banks earned a slightly higher average
return on capital than country banks, 9 percent compared with 8.7
percent. A t each class of banks, this rate exhibited a slight uptrend,
1184
THE FEDERAL RESERVE SYSTEM AFTER FIFTY YEARS
averaging about one-half of 1 percentage point higher in the last 5
years than in the first 5. This small rise relative to the increase in net
income reflects the substantial growth in member bank capital accounts
(table I V ) since 1954, mostly from retained earnings. The increase
in capital accounts at Reserve city banks was 67 percent, or nearly as
much as the growth in net income, while the increase at country banks,
82 percent, substantially exceeded the rise in net income.
REVENUES
An important factor contributing to the growth in member bank
revenues (table I ) over the past decade was the rise in interest return
on both loans and investments associated with the general advance in
market rates of interest. Of even greater significance, however, was
the growth in total earning assets as commercial bank loans and investments were expanded to accommodate growth of the domestic
economy. Assets shifts and increases in service charges and trust
department fees also made significant contributions to bank revenues
over this period.
The average rate of return on loans outstanding (table V I ) at
Reserve city banks rose between 1954 and 1962 from 4.27 to 5.56 percent, or less than one-third. A t country banks, where the average
size of loan is relatively small and loan rates tend to be higher and
less responsive to changes in credit conditions than at city banks, the
increase was considerably less—from 5.36 to 6.21 percent, or a little
under one-sixth. Although these increases reflect mainly the advance
in market rates of interest over the period, they also stem in p a r t from
shifts within the loan portfolio toward higher yielding types, including consumer loans.
Returns on loans have not shown any appreciable advance during
the current business upswing such as occurred in the two previous
expansions of this 10-year period. I n fact, at Reserve city banks,
earning rates were appreciably lower in 1961 and 1962 than they had
been in 1960, when they reflected the relatively high interest rate structure which had developed late in the previous business upswing. However, country bank rates, which also receded in 1961, rose in 1962 to a
level slightly above the 1960 average.
Net interest and dividend return on investments (table V I I ) , while
fluctuating considerably from year to year mainly in reflection of capital gains and losses on securities transactions, also has moved upward
over the period. The increase between 1954 and 1962 was about onethird at Reserve city banks and two-fifths at country banks, with
the raee at country banks averaging slightly higher over the period
than at city banks.
Total earning assets of both Reserve city and country banks showed
larger relative increases between 1954 and 1963 than the average interest return on assets, and hence were a more importance factor in
the growth in revenues. During this period, total loans and investments rose 53 percent at Reserve city banks and 72 percent at country
banks.
Additional gains in revenues were realized as a result of the rise
in the proportion of these assets held in the form of loans, which
yield a much higher interest return than investments. Over the
10-year period, the ratio of loans to total loans and investments rose
THE FEDERAL RESERVE SYSTEM AFTER FIFTY YEARS
1185
from 48 to 65 percent at Reserve city banks and from 42 to 56 percent
at country banks. This shift reflected in part the working down of
holdings of U.S. Government securities to more normal levels after
the unusually large acquisitions during World W a r I I . Finally, banks
added slightly to revenues over the period by increasing earning assets
at the expense of their holdings of cash assets.
EXPENSES
Almost half of the $5 billion increase in member bank operating
expenses over the 1954-63 period was accounted for by interest paid
on time deposits (table V I I I ) . This item, which was relatively unimportant in 1954, had increased nearly sixfold by 1963, from $494 to
$2,847 million. The rise was somewhat larger at Reserve city than
at country banks, and reflected both an upward movement in rates
paid on these deposits and rapid growth in total time and savings
deposits.
Eates paid on time and savings deposits rose continuously over the
period, with particularly large increases in 1957 and 1962 after the
Federal Reserve had raised the ceilings on rates that member banks
were permitted to pay on these deposits. City banks paid higher
rates than country banks and they also raised there rates a little
more than country banks between 1954 and 1963. The increase in
average rates paid by both groups of banks, however, was between
150 and 160 percent, considerably more than the rise in average rate
of return on earning assets.
Time and savings desposits rose much more rapidly during this
period than demand deposits (table I X ) . Consequently, the ratio
of time to total deposits increased substantially. Country banks
have normally had a higher percentage of time to total deposits than
city banks, but this margin narrowed considerably after 1961, when
large city banks began to compete for corporate funds by issuing
negotiable time certificates of deposit. Thus, the ratio of time to
total deposits at Reserve city banks increased much more than at
country banks between 1954 and 1963. I n 1963, time and savings
deposits accounted for 35 percent of all desposits at Reserve city banks
and 44 percent at country banks.
Increased wages and salaries accounted for most of the remainder
of the $5 billion operating expense rise at member banks between
1954 and 1963. Mainly, this reflected the rise in wage and salary
scales in industry generally.
THE MONEY SUPPLY GUIDELINE
I welcome the vigor with which an increasing number of academic
economists, including two who have been serving on your staff, are now
analyzing the statistical behavior of monetary magnitudes. The laudable aim of these investigations is to establish linkages, and stable relationships between the past behavior of monetary action and productive activity in the economy. I, myself, have recently tried to suggest
ways in which the effects of monetary action on spending can be
traced. The measurement problems are formidable and I regret to say
that, in my judgment, we have not come nearly as close to achieving
usable results as some of the academic people believe. Very little work
1186
THE FEDERAL RESERVE SYSTEM AFTER FIFTY YEARS
has been done on cyclical changes in the structure of money ownership
or on the role of turnover as it affects the demand for money. Another
major avenue for tracing the course of monetary action, changes in
interest rates and credit conditions, has had even less professional
quantitative analysis. Happily, there seems to be a growing interest
among professional economists in extending our knowledge along
both of these lines.
The money supply school of thought has been strongly influenced
by the writing and teaching of Professor Friedman, whose views are
familiar to you. A great deal of the empirical investigation has been
inspired by his teaching but I would counsel against accepting the
recommendations for action advanced by this school of thought.
Specifically, I don't believe that the way in which changes in money
supply generate changes in economic activity has been sufficiently
thought through and empirically tested to warrant the adoption of a
fixed monetary policy rule based on the past behavior of the money
supply. I n fact, it has not even been established, in times like these,
whether changes in money supply precede changes in economic activity, or vice versa, or whether money supply and economic activity
move coincidentally. However helpful historical money supply patterns are to our understanding of past economic developments, converting this understanding into a rigid operating rule without the benefit of modifications that human judgment can provide to take account
of the changing environment would be a hazardous step.
F o r example, had we at the beginning of 1961 adopted the Friedman proposal for a constant 4-percent rate of expansion in money
supply, defined to include coin, currency, and privately held time and
demand deposits in commercial banks, we would have added some $14
billion less to credit supplies than actually was provided by the monetary policies followed by the Federal Reserve in these years. I n contrast, the Federal Reserve could formulate monetary policy during
the last 3 years by looking not only at the Friedman definition of the
money supply, but also at the more logically defined money supply,
at interest rate and credit conditions, and at the unfolding balanceof-payments situation.
I would like to return for a moment to some testimony that you have
heard that changes in the money supply systematically precede fluctuations in general economic activity. A casual connection is imputed to this association; namely, that changes in the money supply
cause the level of activity to change. From this imputation a policy
prescription is derived which provides for continuous increases in the
money supply at some optimal but invariant rate. I invite your attention to the attached chart which is presented to give you an opportunity to test Professor Brunner's technique for determining what
causes what. I n particular, you might want to guess which one of
these series is the best predictor and, therefore, causal in Professor
Brunner's analysis, of the others. 1
1
5 Economic Time Series.
The chart of year-over-year percent changes contains the following series, although not
in this sequence:
On chart
1. Demand deposits adjusted and currency
D
2. Industrial production
B
3. Nonagricultural employment
A
4. Private nonfarm residential construction
C
5. New order® for durable goods
B
Shaded areas are recession periods as dated by National Bureau of Economic Research.
THE FEDERAL RESERVE SYSTEM AFTER FIFTY YEARS
1187
Petcent Change over Ccrespnndmg Month
oi Preceding Year
1949-63
5 Economic Time Series
1949
1950
1951
1952
1953
1954
1955
1956
1957
1958
1959
1960
1961
1962
1963
1964
There is nothing in this type of statistical exercise that proves that
money supply changes are truly leading economic activity and, of
course, there is nothing in such a bare statistical exercise that proves
or even argues persuasively that changes in the money supply cause
fluctuations in economic activity. 2 I don't mean to deny that such a
2
There is one other more or less technical qualification that should be observed in
the presentation of cyclical lead and lag analysis. It is possible to create by simple arithmetic manipulations, leads and lags where none exist, except in terms of arithmetic relations having nothing to do with economic substance. One must always be very wary,
therefore, in drawing conclusions produced by these manipulations where there is no
satisfactory explanation given of the economic and institutional mechanics by which the
leading series is supposed to influence the lagging series and no satisfactory explanation
of the economic rationale of using the particular arithmetic manipulations.
To be more explicit. In any series that has a roughly cyclical movement, the movement
of the rate of change of that series (that is to say the percentage change from one month
or one quarter to the next) will also be cyclical—but with different timing—so that movements of the rate of change will lead the series itself. The exact amount of the lead and
whether it is a constant lead or varies in different parts of the cycles—i.e., as between
the upswing and the downswing—will depend on the particular pattern of movement of
the original series, but the lead will average about one quarter the length of the cyclical
movement. This means that if we have two series that have, say, the identical cyclical
movement, then we can always show that either one of them leads the other by plotting
the rate of change of the one it is desired to show leading against the original series of
the other. Not only can either of two coincident series be converted to lead but by the
same operation a slight lag can be converted to a lead. Therefore, unless very specific
economic and institutional rationale are to be given for the particular arithmetic operations, they remain essentially primitive arithmetic exercises rather than economic analyses.
Just as the arithmetic operations of taking rates of change can shift the cyclical timing
and change the impression of leads and lags, the arithmetic operation that Professor
Brunner uses, of recording each month of a series in terms of its percentage change from
the corresponding month of the previous year, can also change timing. The arithmetic
relations in this case are somewhat more complicated than in the case of the rate-ofchange calculations—depending on the length of the cycle, the existence of a trend, etc.
But in series with rising trends, which is the case in the charts presented by Professor
Brunner, the arithmetic operation itself can produce the appearance of leads. This, too,
is a case where the ability to manipulate series arithmetically in such a way as to arrive
1188
THE FEDERAL RESERVE SYSTEM AFTER FIFTY YEARS
causal relationship exists. If it didn't there would be no argument
for the existence of any type of monetary authority. I do argue, however, that the nature of the causal process is important, and that it has
not been delineated and that I have seen nothing to demonstrate that
the causal relationship is constant in degree and timing over economic
cycles or over long periods when basic structural relationships in the
economy have changed.
I t appears to me that the arguments for abandoning discretionary
money management in favor of a rigid formula is a surrender of the
intellect and abandonment of the objectives of scientific inquiry. We
are asked to cease grappling with the complexities of the modern economic world because the all too human minds of investigators seem
inadequate to cope with the problems of such a world. Without in
any way denigrating the importance of the credit and monetary-creation powers vested by the Congress in our present monetary authorities, I must disassociate myself from those who feel these powers can
be employed without thought, judgment, discretion, and concern for
the world as it is.
SELECTED EABNINGS
D A T A FOR MEMBER B A N K S , BY CLASS OF B A N K , 1 1954-63,
INCLUSIVE
[Reserve city category includes aU Reserve city banks and prior to 1962, New
York and Chicago central Reserve city banks]
TABLE I.—Gross
revenue
[Millions of dollars]
Year
1954
1955
1956
1957
1958
1
Reserve Country
city
2,857
3,170
3,659
4,074
4,271
1, 969
2, 173
2, 419
2, 697
2, 856
Year
1959
1960
1961
1962 1
1963
Reserve Country
city
.-.
4,819
5,298
5,429
5,952
6,504
3,256
3, 630
3,788
4,202
4, 630
Data for 1963 partly estimated.
at leads cannot by itself be used to establish even a presumption of the nature of the
economic relationship involved.
I might say parenthetically that Professor Brunner nowhere indicates the economic
rationale for working in terms of year-over-year changes, the movements and magnitudes
of which depend not only on what is happening currently but also on what happened a
year ago. It is, therefore, a quite awkward technique to use in evaluation of current
happenings.
Professor Brunner, I am sure, would not take exception to this raising of the question
of the logic and relevance of certain aspects of his procedures, he himself applies the
most rigorous standards of logic and relevance to his evaluation of other economists'
work. I have recently heard him express himself as astonished at some of his academic
colleagues for presenting arithmetic relationships without demonstrating their relevance
to economic and policy issues through an analysis of the economic and institutional
mechanisms involved.
THE FEDERAL RESERVE SYSTEM AFTER FIFTY YEARS
1189
TABLE II.—Net current earnings before income taxes
[Millions of dollars]
Year
1954
1955
1956
1957
1958
1
__-__
Reserve
city
Country
1, 153
1,313
1,558
1,679
1,670
674
764 1
840
870
840
Year
Reserve
city
1,922
2,162
2,058
1,984
2,040
1959
1960
1961
1962
1963 1
Country
1, 013
1, 111
1,085
1, 128
1, 192
Data for 1963 partly estimated.
TABLE III.—Net income after taxes
[Millions of dollars]
Year
1954
1955
1956
1957
1958
1
__
Reserve
city
Country
669
629
662
750
933
427
357
364
419
524
Year
1959
1960
1961
1962
1963 i
Reserve
city
Country
805
1,061
1,083
1,035
1, 142
452
628
629
660
677
Reserve
city
Country
9,993
10, 455
11,071
11, 694
12, 325
5, 905
6,366
6,846
7,372
7, 941
Data for 1963 partly estimated.
TABLE IV.—Total capital accounts
[Millions of dollars]
Year
1954
1955
1956
1957
1958
1
Reserve
city
_.
7,362
7,838
8,325
8,851
9,503
4,
4,
4,
5,
5,
362
661
946
256
583
Data for 1963 partly estimated.
Year
Country
1959
1960
1961
1962
1963
l
1190
THE FEDERAL RESERVE SYSTEM AFTER FIFTY YEARS
TABLE V.—Net income as a percentage of total capital accounts
[Millions of dollars]
Year
1954
1955
1956
1957 _.
1958
1
_
Reserve
city
Country
9. 1
8.0
8.0
8.5
9.8
9.8
7.7
7.4
8.0
9.4
Year
Reserve Country
city
8. 1
10.2
9.8
8.9
9.3
1959
1960
1961
1962
1963 1
7. 7
9. 9
9. 2
8. 9
8. 5
Data for 1963 partly estimated.
TABLE VI.—Net interest return on loans as a percentage of total loansx
[Millions of dollars]
Year
1954
1955._
1956.__
1957
1958 .
Reserve
city
4.27
4.30
4.57
4.96
5.00
Country
5.36
5.47
5.54
5.80
5.83 j
Year
1959
1960
1961
1962.
1963
___
Reserve Country
city
__ _ _
5.35
5.93
5.44
5.56
(2)
6.
6.
6.
6.
(2)
06
13
10
21
1
After nonoperating losses and chargeoffs, recoveries, and profits, but not
including
transfers to and from valuation reserves.
2
Not available.
TABLE VII.—Net interest and dividend return on securities as a percentage of
total securitiesx
[Millions of dollars]
Year
1954
1955
1956
1957
1958
Reserve
city
Country
2.50
1.76
1.65
2.09
3.48
2.40
1.90
1.93
2.27
3.04
Year
1959.
1960
1961
1962
1963
. _
Reserve Country
city
1. 18
3. 13
3.67
3.35
(2)
2.
3.
3.
3.
(2)
05
21
36
34
1
After nonoperating losses and chargeoffs, recoveries, and profits, but not
including
transfers to and from valuation reserves.
2
Not available.
THE FEDERAL RESERVE SYSTEM AFTER FIFTY YEARS
1191
T A B L E VIII.—Interest paid on time deposits as a percentage of total time
deposits
Year
1954
1955
1956
1957
1958
1
Reserve
city
Country
1.34
1.39
1.62
2. 18
2. 26
1. 25
1.33
1. 53
1. 97
2. 14
Year
1959-I960.
1961
1962
1963 i
.
Reserve
city
Country
2.44
2.63
2.80
3.39
3.45
2.
2.
2.
3.
3.
28
53
65
04
18
D a t a for 1963 p a r t l y estimated.
T A B L E I X . — T i m e deposits as a percentage of total deposits
Year
1954
1955
1956
1957
1958
1
Reserve
city
Country
21. 4
21.8
22.0
23.5
25. 9
32. 6
32. 5
32. 7
34.4
36. 5
Year
1959
I960- _
1961
1962.__
1963 l
Reserve
city
Country
26. 4
26. 2
28.7
31.7
35.3
37. 3
38.7
40. 0
41. 6
43.5
D a t a for 1963 p a r t l y estimated.
The CHAIRMAN. Thank you very much, Governor Mitchell.
Now, Governor Daane, you may proceed in your own way, sir.
STATEMENT OF HON. J. DEWEY DAANE, MEMBER OF THE, BOARD
OF GOVERNORS, FEDERAL RESERVE SYSTEM
Mr. DAANE. Mr. Chairman and members of the committee, as you
stated, Mr. Chairman, I am the newest member of the Board of Governors, having been appointed by President Kennedy shortly before his
death and having been sworn in last November 29. I am, however, not
new in terms of intimate acquaintance with the Federal Reserve; in
fact, excepting a relatively short period in the Treasury Department,
I will this spring be rounding out 25 years of continuous service in the
System. Nor am I exactly a stranger to inquiries such as this into the
workings of the Federal Reserve System. I well remember one of my
earliest substantive tasks after joining the Research Department of
the Federal Reserve Bank of Richmond in early 1939 was to try to
assist the President of that bank in preparing his replies to questions
addressed to him, and to other System officials, by Senator Wagner,
28-680—64—vol. 2 — 1 8
1192
T H E FEDERAL RESERVE SYSTEM AFTER FIFTY YEARS
then chairman of the Senate Banking and Currency Committee.
These questions were concerned with many of the same issues, such
as that of the most appropriate role of the Secretary of the Treasury
in relation to our central banking system, as are again raised by the
proposed bills being considered by this committee. I also participated
in the appraisals conducted within the Federal Reserve as j>art of the
more recent congressional inquiries—in 1949 under the chairmanship
of Senator Douglas, and in 1952 the even more extensive review conducted under your chairmanship.
I t is my sincere hope that the careful review and findings in your
1952 committee report will not be passed over in a desire to make
change in the Federal Reserve System for the sake of change. Over
the past 25 years I have at firsthand watched the System adapt, as it
should always be ready to do, to the constantly changing financial environment in which it operates, but in the past decade certainly nothing has changed the basic principles of central bank action nor its need
for some sort of insulation from partisan political pressures in order
to serve most effectively the public interest—principles and needs
which were so well recognized and underscored in what is known as
the Patman committee report.
From the background of this experience and in order to avoid repeating testimony you have received from other Federal Reserve witnesses concerning the bills before you, let me comment generally about
four of them: H.R. 3783, to retire Federal Reserve bank stock; H.R.
9631, to revamp the structure of the Federal Reserve System; H.R.
9685, to require the System to pay over to the Treasury its earnings
on Government obligations and seek appropriations to meet its expenses; and H.R. 9749, to require the Federal Reserve to use open
market operations to support prices on Government obligations so as
to assure yields of not more than 4 % percent.
Taken together, these bills would, I believe, tend to decrease the
contribution that monetary policy can make toward achievement of a
stronger economy. I n part, the bills would run the risk of diverting
monetary policy from its primary goal of meeting the needs of the
economy as a w^hole to one of simply facilitating the management of
the public debt. They would take from the presidents of the Federal
Reserve banks their most important function—participation in the
formulation of monetary policy. And they w^ould weaken the capacity
of the System to maintain, year in and year out, the degree of independence from the budget and appropriations process which is needed
to assure the long lasting value of the dollar against the short-lived
pressures of budgetary developments. I n my judgment these steps
would inevitably reduce the strength and ability of the System to serve
the public interest.
To the extent that I have been able to follow these hearings, I
gather that these steps are advocated partly from fears of some that
the Federal Reserve might one day attempt to block Government programs approved by the electorate, partly from a suspicion that Federal Reserve bank presidents are banker dominated, and partly from
dissatisfaction with the process of monetary policy formulation.
Taking a closer look at these three main threads in the current
inquiry, namely, the relationship and role of the Federal Reserve
\s ithin the framework of Government, the allegation of banker domi
T H E FEDERAL RESERVE SYSTEM AFTER FIFTY YEARS
1193
nation, and the monetary policy process, it will come as no surprise
to you that I do not find much to agree with in these bills.
First of all, whatever the theoretical possibilities may be of a basic
conflict between the Federal Reserve and the administration, the fact
is that the relationship lias been and is a harmonious one. I n announcing his decision to reappoint Mr. Martin as Chairman of the
Board of Governors, President Kennedy described the relationship in
these terms:
As C h a i r m a n of the B o a r d of Governors, Mr. Martin has cooperated effectively
in t h e economic policies of this administration a n d I look f o r w a r d to a constructive working relationship in the years ahead.
As you know, t h e F e d e r a l Reserve System is a fully independent agency of t h e
U.S. Government but it is essential t h a t there exist a relationship of m u t u a l
confidence and cooperation between the F e d e r a l Reserve, the economic agencies
of the administration, including especially the Secretary of t h e Treasury, and
t h e President.
Mr. Martin h a s my full confidence and I look forward to continuing to work
with him and his colleagues on the Board in the interest of a strong U.S.
economy.
The Federal Reserve System, after all, is a public institution. I t s
policies evolve within the framework of general Government policies.
The primary g^ais of monetary policy are identical to those of Government economic policy; v*e, too, are governed by the Employment
Act of 1946. Thus the principal objective of monetary policy is to
make a maximum contriBution to the attainment of the national economic goals of an adequate rate of growth, sustained high levels of
production and employment, and reasonable price stability. We, too,
are seeking maximum employment, production, and purchasing*
power.
I n recent years I have been in the administration as a part of the
Treasury Department and its policies, and I have also previously
been on the other side of the fence as a part of the Federal Reserve
and its policies. Both institutions clearly have been working toward
the same dual objectives, namely, the attainment of a satisfactory rate
of growth with maximum employment, and the elimination of a serious balance-of-payments problem.
From my experience both at the Treasury and the Federal Reserve
it may be helpful to you if I comment somewhat further on the effective working relationships which now exist between these two agencies.
There are, of course, shades of difference in view betiveen the Federal
Reserve System and the Treasury from time to time, but the same
thing may be said within either the Federal Reserve or the Treasury,
and in my judgment these differences are healthy. The fact of the
matter is, that in the formulation of monetary policy, the Federal
Reserve is as responsive to the needs of Government finance as it
either should be or can be, and the Treasury, in turn, is acutely conscious of the problems which its debt management operations create
for the monetary authorities. I am quite certain from my experience
on both sides of the fence that it would be unreasonable to hope for
any significant improvement in the technical coordination of monetary policy and debt management through the consolidation of these
functions under a single head.
This then leaves as the only significant question whether the public
interest would be better served by placing the formulation of monetary
1194
THE FEDERAL RESERVE SYSTEM AFTER FIFTY YEARS
policy under the domination or the detailed direction of the Secretary
of the Treasury. I am convinced that this would be most unfortunate—not just for the Federal Reserve and for the Treasury in
the first instance, but more importantly for the Government and
the people of the country in the longer run. Both the Treasury and
Federal Eeserve naturally reflect two different viewpoints related to
their own particular responsibilities which need to be fully reflected
in their respective spheres. These responsibilities should not be centralized. I n my view, it is greatly to the advantage of the Treasury
that it is able to make its debt management decisions in the light
of a monetary policy which is determined independently by men of
high qualifications, rather than place itself in the dilemma of having
to generate both monetary and debt management policies simultaneously, which would require it somehow to insulate its thinking on
monetary policy in some way from its obvious and desirable zeal to
finance the debt as economically as possible. I have seen at first hand
in other countries the dangers involved in downgrading or subordinating monetary policy.
Again, from my own experience in serving two Secretaries of the
Treasury, both of whom were able and conscientious public servants
but already overburdened in terms of the tremendous responsibilities
thrust upon them, I question whether as a practical matter it would
be feasible for the Secretary of the Treasury to participate fully in
the formulation of monetary policy. Some alternative involving
delegation of authority would have to be developed and I do not
believe this would be desirable.
The present arrangements for the coordination of monetary policy
with the other economic policies of Government are, in fact, very
effective. The changes that are proposed in these bills seem to me to
offer little hope for improvement and to run the risk of serious
mischief.
A second main thread in the current inquiry both puzzles and, I
must confess, saddens me. I t is the implication regarding the public
service motivation of System officials, and specifically of the Presidents and Directors of the Eeserve banks. To me the Federal Eeserve,
no less than the Treasury, stands for all that is best in purposeful
public service. I n fact, I believe that much of the underlying strength
of the System derives from the sense of constructive purpose, and the
spirit of public service, which permeates all parts of the System. I n
my judgment anything that is destructive of that purpose and spirit,
by innuendo or outright action, would be inimical to the public interest.
I speak with feeling on this point because in my lifetime I have
never known a more selfless public servant than the President of the
Federal Eeserve Bank of Eichmond, Mr. Hugh Leach, with whom I
worked for 20 years, and who I believe was typical of the Federal
Eeserve Presidents in terms of his objectivity and dedication to the
public interest, and complete freedom from any banker influence. His
devotion to public duty was recognized not only in the immediate
financial community but throughout the State of Virginia and the
Fifth District. I thus find that any charge of banker domination is
inconceivable—I also find it difficult to visualize the System obtaining the services of men of this quality if they are prohibited from
sharing the responsibility for the formulation of policy.
THE FEDERAL RESERVE SYSTEM AFTER FIFTY YEARS
1195
The third and final thread in the inquiry on which I would like to
comment briefly is the apparent criticism of the System, on the one
hand, for not adopting the single criterion of the stock of money as its
sole objective and measure, and, on the other hand, for being guided
in the formulation of policy too much by short-run money market
factors, rather than more basic longer term economic and financial
developments. Neither criticism is justified. As to those who would
put money stock rigidly above all else, I think one of your preceding
academic witnesses, Professor Samuelson, gave eloquent answer. Making the stock of money paramount and the sole objective and measure
of monetary policy would be indeed a retrogression. I t would ignore
the fact that there is no optimum money supply nor sacrosanct rate
of money supply growth—that money supply, in fact, may be permissive rather than causative.
The other charge, that of money market myopia, displays a lack of
understanding of the policy formulation process and of the System's
operations in the market. The policy formulation process does not
simply focus on the day-to-day money market developments, and there
has certainly been no overemphasis on such short-term factors in the
setting of monetary policy. Let me illustrate my point by describing
the economic intelligence we currently receive before and at a typical
Open Market Committee meeting. I t includes a 30- to 40-page written
document and a total of about 2 hours of oral briefing, both of which
concern such subjects as production and employment, incomes, trade,
wages, costs, prices, construction, agriculture, credit, capital, money,
savings, taxes, and the balance of payments. This list of briefing
subjects certainly does not suggest an overemphasis on short-term
money-market factors in the discussions underlying the process of
arriving at a decision regarding an appropriate monetary policy at
any specific time.
Nor is one single guide to operations adopted in the policy process
as has been alleged—the weaknesses of the various operational guides,
such as free reserves, member bank borrowings, and various shortterm interest rates are well recognized throughout the System. Those
who criticize use of any of these operational guides fail to understand
the distinction between the System's defensive and dynamic operations in the market. Because the purpose of defensive operations is
to offset the effect on the level of reserves of various market factors
they do not ipso facto constitute changes in the reserve level or in monetary policy. On the contrary, they simply neutralize the effects on
reserves of these other factors, thereby keeping the road clear for those
dynamic operations which are designed to achieve changes in the level
of reserves in the light of longer run economic and financial objectives.
Two concluding observations relating to the main threads of this
inquiry may be relevant.
First, as to the underlying question of the System's sense of responsibility within the Government there is obviously a clear need for the
Federal Eeserve to be closely attuned to the economic thinking of
Government, and this is being accomplished by various arrangements
at the technical and policy levels. Each President of the United
States can be expected to develop informally his own particular method of communication within the Government, but whatever the variation in method the System's awareness and sensitivity in its relations
1196
THE FEDERAL RESERVE SYSTEM AFTER FIFTY YEARS
with the executive branch are assured. Correspondingly, continuing
inquiries of the sort being undertaken by this committee assures that
the System is at all times closely attuned to, and responsible to, the
Congress as well.
Finally, coordinated monetary and debt-management policies in
t h e recent past have succeeded in assisting our balance of payments
while accommodating record levels of borrowings at home—with an
interest rate pattern not that suggested by bankers but one unique for
a sustained expansion period. The impressive results seem to me to
provide significant commentary on all three issues posed in this current
inquiry.
Thank you, Mr. Chairman.
The CHAIRMAN. Thank you, sir.
I will forgo asking questions myself at this time until the other
members have had an opportunity.
Mr. Reuss?
Mr. REUSS. Thank you, Mr. Chairman.
Our Republican colleagues on the committee must be laughing this
morning, because they will remember, as I do, the election of 1960
when we Democrats attacked the existing Federal Reserve for its
monetary policy, and attacked it with such vigor that foreign central
bankers started a run on our gold supply in September and October
of 1960, and here we have the two Democratic appointed members of
the Federal Reserve System who have out-Martined Bill Martin in
their testimony this morning. I think the laugh is on us.
Mr. WIDNALL. Will the gentleman yield ?
Mr. REUSS. Sure.
Mr. WIDNALL. I am not laughing. I am just pleased that it is now
being brought to the attention of the American public what bipartisan
appointments can mean as far as the Federal Reserve System is concerned, and also that people with a background that goes far beyond
a banking background can contribute their own evaluation of the circumstances before them. And one further thing:
I do not recall that the then Senator Kennedy campaigned for the
Presidency on this issue. Some Democrats may have made these statements in the course of the campaign, but I do not believe this was a
campaign issue.
Mr. REUSS. Oh, yes, he was properly critical of Federal Reserve
policy in the recent past and thought it played quite a role, as I did,
in contributing to the recessions of 1957 and 1960.
But, to ask some questions: Mr. Mitchell, you indicate in your testimony that you would not change the present composition of the Open
Market Committee, and you give as a reason that regional representation from the five presidents of the Federal Reserve banks is a constructive contribution to the present Open Market Committee.
Could not the Open Market Committee, if it were reconstituted to
consist of the seven publicly appointed members of the Federal Reserve Board, get that regional advice if it set up as an advisory committee all or part of the 12 Federal Reserve bank presidents ?
Mr. MITCHELL. Yes, it could get the advice. I think there is a little
difference between receiving advice from somebody else and being able
to implement your judgment and advice by having the power to vote
on a policy issue.
Mr. DAANE. Could I add a comment on that, Mr. Chairman ?
THE FEDERAL RESERVE SYSTEM AFTER FIFTY YEARS
The CHAIRMAN. Yes.
Mr. DAANE. I would just
1197
like to say that in my own experience, as I
indicated, I worked closely with the president of one of the Reserve
Thanks, for over 20 years actually, and was constantly advising him with
respect to monetary policy formulation.
But I find in even the very short period of time that I have been at
the Board there is a considerable difference between the degree of
responsibility that you share when you simply are advising someone
and when you are actually on the firing line with a vote involved in the
policy process.
Mr. REUSS. I S that the president of the Federal Reserve bank ? He
was appointed by the bank rather than the President of the United
States; was he not?
Mr. DAANE. H e was appointed by the bank's directors, but he was
approved by the Board of Governors, and, of course, he took an oath
when he served on a rotating basis as a member of the Open Market
Committee.
Mr. REUSS. Until and unless he became a member of the Federal
Open Market Committee; if, in short, he were one of the seven regional
T>ank presidents who was not a member of the Federal Reserve Open
Market Committee, he did not take an oath of office to the United
States; did he?
Mr. DAANE. He did not, Mr. Reuss. On the other hand, as I tried
to say in my statement, the sense of public service was still present
in the interim periods, when he was not taking an oath. He was kept
abreast of and a part of the policy process.
Mr. REUSS. Well, I just brought this out because you seemed to make
a great point of the effect of taking an oath, and I wished the record to
show that 7 of the 12 regional bank presidents do not take an oath at
all until and unless they are appointed as members of the Open Market
Committee.
Mr. DAANE. I do not think that the oath taking per se is the really
significant difference. His sense of purpose would have been the same
but his sense of responsibility would have differed if he were excluded
from the direct responsibility from time to time for the policy formulation itself.
Mr. REUSS. Mr. Mitchell, you come to grips with your fellow
Chicagoan, Professor Friedman, who testified here yesterday along the
lines that he has advanced in recent years, that he cannot make head
nor tail out of Federal Reserve policy; that while he does not know
t h a t you always hurt the economy very much; he thinks that when you
do it good it is accidental; and that it would be much better if you set
as your target the creation of annual increments to the money supply
of around 4 percent, which would suit him fine, and let it go at that.
You attempt to refute this by setting forth a chart which, as I look
at it, shows that the wobbles in the money supply do seem to wobble in
some sort of harmony with the wobbles in industrial production and
^employment and various other factors, and I think your point is
which causes which.
Does the money supply adjust to changes in gross national product,
o r is it vice versa?
Mr. MITCHELL. Yes, precisely; and, actually, there are other series
that are better indicators than the money supply.
1198
THE FEDERAL RESERVE SYSTEM AFTER FIFTY YEARS
Mr. REUSS. Well, while I want to make it clear that I am by no
means a "Friedmanite" and am not prepared to buy lock, stock, and
barrel his proposition, nevertheless, I am not persuaded that you refuted him this morning, and I would like to pursue this a bit with you.
I t is a fact, is it not, that the Federal Eeserve System can control the
money supply whereas it cannot, nor can any other governmental
agency except very, very indirectly, control industrial production and
employment and gross national product?
Mr. MITCHELL. Well
Mr. REUSS. That is true; is it not?
Mr. MITCHELL. The point
Mr. REUSS. I hear "No" from the minority side. W h a t about this,
Mr. Mitchell?
You can't control the money supply?
Mr. MITCHELL. Well, let me say first that the purpose or the objective of both fiscal and monetary policy is to effect the growth of the
economy and try to moderate economic fluctuations. The whole discussion of public policy, as it relates to monetary policy and fiscal
policy, is to effect the rate of growth and to minimize cyclical
fluctuation.
So we are trying to effect the thing you say we cannot effect with
our policies.
Mr. REUSS. Yes, in your wildest, most euphoric moment, you do not
claim that you can, all by yourself, bring about full employment without inflation ?
Mr. MITCHELL. All I am saying, Mr. Reuss, is that the point about
fiscal and monetary policy is that it is attempting to do the very thing
t h a t you say it cannot do.
Mr. REUSS. Well, you are misconstruing what I said.
I am not talking about fiscal policy, taxes, and spending. I was
talking about monetary policy.
Mr. MITCHELL. Well, I think monetary policy can make a contribution in this direction; yes.
Mr. REUSS. Agreed. Is it not also true that monetary policy can
control the money supply ?
Whether that, in turn, will produce the beneficent results on employment and production that we all want is another matter, but you
can control the money supply, can you not ?
Mr. MITCHELL. Well, it is at times difficult. The money supply
grows in a very lumpy fashion, and this is because the initial action
which we take, in providing reserves, does require a response from the
banking system and from individuals
Mr. REUSS. But the banking system is either going to make loans
or buy investments
Mr. MITCHELL. YOU can eventually do something with the money
supply but in the course of doing this you may cause some things to
happen that you believe are undesirable and, therefore, the goal of
just making the money supply move, if followed relentlessly, could
have an impact upon credit conditions and expectations that might be
totally undesirable.
Mr. REUSS. Yes, but you must answer my question, which was not
whether it is good to make the
Mr. MITCHELL. Oh, I think I am answering your question.
THE FEDERAL RESERVE SYSTEM AFTER FIFTY YEARS
1199
Mr. REUSS (continuing). Not whether it is good to make changes in
the money supply the sole goal of monetary policy. There you have
indicated you disagreed with Friedman, who sayis it is, but my question is whether you can
Mr. MITCHELL. Ignoring all other consequences, absolutely.
Mr. REUSS (continuing). Change the money supply. No doubt
about that?
Mr. MITCHELL. Ignoring all other consequences.
Mr. REUSS. Well, Mr. Chairman, I did have one more question, but
my time has expired.
The CHAIRMAN. Suppose we bear with him to ask that other question, Mr. Widnall ?
Mr. REUSS. Well, thank you very much, but I can wait.
The CHAIRMAN. Mr. Widnall?
Mr. WIDNALL. Thank you, Mr. Chairman.
Mr. Daane—is that the way you pronounce it ?
Mr. DAANE. Yes, "Dane," as if it were one "a."
Mr. WIDNALL. I particularly concur with the statement that you
made at the top of page 7 as to the implication regarding the public
service motivation of system officials in this investigation. I am very
pleased that you brought that out.
Would you, for the record, give your own background before you
took this present position, by way of education and business and
experience ?
Mr. DAANE. Yes. I joined the Federal Reserve bank at Richmond,
in the Research Department, in June of 1939 and after being with
them for roughly 8 years—I graduated prior to joining the bank,
incidentally, from Duke University, with an A.B. degree.
After working at the Federal Reserve bank at Richmond for
roughly 8 years, on leave of absence for 15 months I obtained my
master's, and subsequently my doctor's degrees at Harvard, returning
to the Federal Reserve Bank of Richmond as their monetary economist, on J a n u a r y 1, 1947, becoming subsequently an assistant vice
president and vice president and director of their Research Department.
I transferred in 1960 to the Federal Reserve Bank of Minneapolis,
as vice president and economic adviser to that bank and its president,
and was then loaned by that bank to the Treasury Department to be
Assistant to the Secretary in June of 1960, Assistant to the Secretary
for debt management.
I continued on in that capacity until the fall of 1961 when I was
appointed Deputy Under Secretary for Monetary Affairs, and at that
point terminated my leave of absence with the Federal Reserve Bank
of Minneapolis.
I was in that position until the end of this past November when I
was appointed a member of the Board.
Mr. WIDNALL. Thank you, Mr. Daane.
Now, earlier in the hearings there was a great deal of emphasis
placed on the obligation of the Federal Reserve System to keep in
mind the full obligation to observe what was in the full Employment
Act of 1946 in making their decisions.
As I understand from your testimony, your ability to meet that
obligation will be seriously circumscribed if the pending legislation
is enacted. I s that not so ?
1200
THE FEDERAL RESERVE SYSTEM AFTER FIFTY YEARS
Mr. DAANE. Yes, I believe that is so particularly with respect to the
very unique contribution in the formulation of policy that comes about
from regional representation and, more importantly, perhaps, from
the submerging of the monetary policy process to the exigencies of
Government finance which could result from the bills that are before
you.
Mr. WIDNALL. NOW, one further question to y o u :
On page 6, you said: " I have seen at first hand in other countries the
dangers involved in downgrading or subordinating monetary policy."
Could you amplify that further by giving an
Mr. DAANE. A n illustration ?
Mr.WiDNALL (continuing). An illustration of your own experience ?
Mr. DAANE. Yes, I certainly could.
I went down in 1950 as the head of a fiscal mission to the Republic
of Paraguay.
I was loaned at that point by the Federal Reserve Bank of Richmond
to the International Monetary Fund. I was supposed to work primarily on Paraguay's budget problems.
When I arrived in Paraguay I sat down with their comptroller and
budget director and I noticed that they had a budget that was almost
in balance, about, I would say a 5-percent deficit or something less, but
t h a t about a third or more of their revenues were coming from recursos
varios, "miscellaneous taxes."
I recall I asked the comptroller what are these miscellaneous taxes
t h a t produce so much revenue, and bring the budget back into balance ?
We were looking at the budget for the next fiscal year. A n d he
laughed and he said, "This is simply central bank credit from the
Bank of Paraguay," and so their deficit was not in the neighborhood
of 5 percent but something in the neighborhood of 50 percent because
they had this direct access to central bank credit.
The effect of this, which is the point of my reference in the statement,
is that they had at the time that I went down there in 1950 an official
rate of exchange of about 8 guaranies to the dollar. The guarani was
worth roughly 12.5 cents.
While I was there the effective rate in the black market went up to
some 25 guaranies to the dollar or about 4 cents and in the very close
intervening period after that it slipped to something like, I believe,
just a fraction of 1 cent, and the real reason for this was very simple.
A t the close of a day, when the Minister of Finance wanted to pay
his bills, he could resort directly to a draft on the Bank of Paraguay.
Well, this is an extreme case, admittedly, of a small country in Latin
America.
But the principle is precisely the same, and it has happened in other
countries as well.
Mr. WIDNALL. Thank you.
Mr. Mitchell, what effect do you anticipate the recent act of the Bank
of England, in raising its discount rate to 5 percent, will have on the
American monetary market ?
Mr. MITCHELL. Well, I think the preliminary indication is that the
rate effect will not be very significant but at this time I think it is impossible to say what might happen.
Mr. WIDNALL. I s there a potential difference between the shortterm effect and the long-term effect ?
THE FEDERAL RESERVE SYSTEM AFTER FIFTY YEARS
1201
Mr. MITCHELL. Well, I would not characterize it that way. I would
say that at the moment the people whose behavior will be altered by
this change in bank rate have not decided which way or in what way
to change their investment policies.
Until they do, we will not really know what the effect is.
Mr. WIDNALL. I t could lead to a flight of funds from the United
States to England, though, could it not ?
Mr. MITCHELL. Well, it could lead to some short-term flows inspired by interest differentials to England, yes, although I think that
this is not going to happen on a very large scale.
Mr. WIDNALL. Mr. Mitchell, would you also, for the record, give
your own background just as Mr. Daane has done ?
Mr. MITCHELL. Before I worked for the Federal Reserve System
I was a tax administrator in the State of Illinois, from 1932 to 1944.
I n 1944 I came with the Federal Reserve System and I was with the
Federal Reserve Bank of Chicago until I came down here 2y2 years
ago. But during the period I was connected with the Federal Reserve
Bank of Chicago, I wTas on leave of absence to work for Governor
Stevenson, as his director of finance.
That was for 2y2 years.
Mr. WIDNALL. I would like a specific answer from both of you as
to whether or not you feel that the composition of the Federal Reserve
Board of Directors is such that it is banker dominated.
Mr. Daane ?
Mr. DAANE. I am sorry, Mr. Widnall, does your question relate to
the boards of directors of the Federal Reserve banks, the Board of
Governors ?
Mr. WIDNALL. The Board of Governors.
Mr. DAANE. N O ; I certainly do not believe that it is banker-dominated in any sense whatsoever.
1 feel that this is a charge that is not true in any way, shape, form
or fashion. I try to point this out in my statement with respect to
the presidents of the Reserve banks, but it is equally applicable to the
members of the Board of Governors.
Mr. WIDNALL. Would you care to comment on that, Mr. Mitchell?
Mr. MITCHELL. I do not think it is banker dominated. I think
there are lots of relationships between the Federal Reserve and bankers because they are both in essentially the same business and as so
they speak a common language in a great many respects, and the Federal Reserve engages in supervisory operations which bring them in
close contact with the bankers.
And I think this gives rise to some speculation that the banks tend
to dominate the Federal Reserve, but I do not think this is so.
Mr. WIDNALL. Well, do you believe that the Board itself is dominated by the Chairman?
Mr. MITCHELL. Well, I think the Chairman is more than just one
member of the Board, yes, but when you say "dominated" I do not
think he dominates me and I do not think he wants to.
Mr. WIDNALL. Mr. Daane ?
Mr. DAANE. I will comment again simply supporting Governor
Mitchell's comment, in the negative to your question, that the Chairman has made it very clear that he expects us to, and in fact we do,
vote our own convictions in the interest of the some 200 million people
in this country. Even in the short time that I have been on the Board
1202
THE FEDERAL RESERVE SYSTEM AFTER FIFTY YEARS
I have in, I believe, at least two instances involving bank mergers publicly dissented from a majority opinion of the Board in which the
Chairman concurred.
Mr. WIDNALL. Thank you very much.
The CHAIRMAN. Mr. Hanna ?
Mr. H A N N A . Thank you, Mr. Chairman.
As one member of this committee, I certainly want it to be clear
t h a t as far as my participation here is concerned I have the feeling,
and I hope it is correct, that the inquiry is directed more to the structure and organization of the Federal Keserve than it is to any personalities or individuals.
Certainly, I have not felt, and perhaps I am not as sensitive as some,
that the inquiry is directed toward the personalities or their abilities
or their character, and I hope that that feeling I have is true.
However, talking in terms of specific structure, I think that maybe
your situation is not different from mine. I came here as a new member of Congress, just as you gentlemen have been new members of the
Board.
I do not find myself dominated by the chairman of this committee,
but I do find myself dominated by the structure of Congress.
And I wish to heaven something could be done to change the structure, and I think that is what we are trying to talk to you gentlemen
about.
Now, I do not know whether you want to comment on whether you
are not dominated by the structure of the body in which you serve, but
I suspect you are. Talking about that then, and keeping our eye on
the doughnut and not on the hole, I would ask you this question: Do
either of you feel that the Board would be seriously impaired in its
quality or ability to operate if the terms of the Board members were
made to be 6 years, the existing term ?
Mr. Mitchell, would you care to comment on that ?
Mr. MITCHELL. I n my statement I suggested that as a lower limit.
Mr. H A N N A . Mr. Daane, would you care to comment on that?
Mr. DAANE. I would, I believe, go along with Governor Mitchell,
that perhaps a 6-year term as a lower limit with eligibility for
Mr. H A N N A . A second term?
Mr.DAANE. Pardon?
Mr. H A N N A . With eligibility for reappointment ?
Mr. DAANE. With eligibility for reappointment. I rather feel from
observation over many years that the experience acquired with an
institution such as the Federal Reserve is an invaluable asset, but I
don't see anything sacrosanct about that experience having to be in the
form of a fixed term of 14 years. I would like to see the people that
are experienced and capable and contributing have an opportunity
to have their services retained within the system.
Mr. H A N N A . However, I don't know whether I would be correct in
assuming that you would not take a position that the pool of resources
of the United States is so limited that we couldn't get highly qualified
persons for this Board, in the event that we did place it at 6 years with
the right to reappointment.
Mr. DAANE. NO. All I am saying is, I think there would be considerable advantage in retaining the option for reappointment to
make use of valuable experience.
Mr. H A N N A .
Yes.
THE FEDERAL RESERVE SYSTEM AFTER FIFTY YEARS
1203
Mr. DAANE. I may be a little biased on this, since I had most of
my working lifetime in the System.
Mr. H A N N A . Yes, I had rather felt that, and I noted that both of
you gentlemen have come up through the System, and I am taking
that into account as I evaluate what you have to say.
Would either of you care to comment on this? Do you think that
it would in any way seriously impair the operation of the Board, if
each incoming President had the power to appoint the Chairman
either from members of the Board or from some other place in society,
if he felt the man qualified to operate as Chairman? Do you think
this would seriously impair the operation, Mr. Mitchell?
Mr. MITCHELL. N O , I do not.
Mr. HANNA. Mr. Daane?
Mr. DAANE. N O , nor do I. I believe in fact that the Chairman has
testified favorably toward this and I find it difficult to conceive of
the President's hands being tied in the appointment of the Chairman
of the Federal Reserve.
Mr. H A N N A . Thank you.
The CHAIRMAN. Mr. Hanna, will you yield briefly, please ?
Mr. HANNA. Yes, Mr. Chairman.
The CHAIRMAN. Mr. Martin testified that he would be in favor of
the 4 years being served along with the President, that is correct,
but he did not say that he would be willing to give the President of
the United States freedom of choice to appoint anyone that he wanted
to appoint.
UndeT- existing law he is compelled to appoint one of seven members
to the Federal Reserve Board under a statute. But Mr. Martin—
do you ever remember him having said that he would give the President freedom cf choice?
Mr. DAANE. I assumed that when he called for a coterminous term
of the Chairman and the President, he in effect was thinking that
this would free the President's hands to appoint the man that he
wished.
The CHAIRMAN. If the law would remain on the statute books, he
would have to appoint one of seven. Excuse me.
Mr. H A N N A . That is all right, Mr. Chairman. I hope the record
will show that I wasn't dominated by your request to yield. I t would
have been granted to any other member.
Speaking in terms of the interest rates on deposits, do you think
that we would in any way seriously impair the monetary policy of
the United States in the operation of the banks if we allowed interest
rates to be paid on demand deposits, Mr. Daane ?
Mr. DAANE. Yes, I would like to address myself to this question.
This I do feel would be a disadvantageous step from the standpoint
of the economy, from the standpoint of the system and the strength
of our whole monetary mechanism.
I believe the best answer on this perhaps is that of the President's
Committee on Financial Institutions, which pointed out the two principal problems involved, if we were to move over to a payment of
interest on demand deposits. First, this would inevitably put the
smaller banks at a definite disadvantage. I t would accelerate whatever disadvantage the small banks now have, and would tend to cause
the deposits to gravitate to the larger banks.
1204
THE FEDERAL RESERVE SYSTEM AFTER FIFTY YEARS
Secondly, as this Committee report points out, a report signed by
all of the presidentially appointed members, including the Secretary
of the Treasury and the Chairman of the President's Council, the
probability is very high that this would result in banks reaching out
for unsound assets in order to support the additional costs.
I think Governor Mitchell has amply demonstrated what is happening to earnings and expenses over the past decade, and if you threw
this cost in on top, my conclusion is that it would first of all be a
definite detriment to the smaller banks and second, would be a threat
to the soundness of our banking system.
Mr. H A N N A . Mr. Mitchell, do you care to comment on that?
Mr. MITCHELL. Well, I think I would go pretty slow in making a
change of this kind. I tend to agree with what Governor Daane
says about payment of interest on demand deposits as a competitive
weapon.
I think that it could be used in a predatory manner, and for a bank
with imperialistic designs, this could be a frightfully powerful weapon
to attract deposits. So I can't help but feel that should this come
about the smaller banks would be the ones that would be hurt the most.
Mr. H A N N A . D O you think that we could not safeguard that by
any other moves that we could make under existing supervisory
powers ?
Mr. MITCHELL. Well, no; because if you did get into this sort of a
situation, the small bank would have to pay the same return or lose
the deposits, and this means that their earning potential would go
down and down.
Mr. H A N N A . D O you feel any differently about regulation Q, as to
time deposits ? Do you think we should or should not have a ceiling
on interest rates on time deposits ?
Mr. MITCHELL. Well, it is easy to give you an answer here, that I
might, you know, at some time regret.
I t seems to me that philosophically I would like to see all such
constraints removed, but I think one has to be extremely careful in
timing the removal. My conviction is that if it were removed, it
ought to be removed on a standby basis, so that the power to reimpose
it is there.
Mr. BOLTON. Would the gentleman yield for a clarification ?
Mr. H A N N A .
Yes.
Mr. BOLTON. A S I understand your original question, did it have
to do with the demand deposits or with Government deposits?
Mr. H A N N A . Demand deposits. I was talking in the latter sense
about time deposits.
Mr. BOLTON. Eight.
Mr. H A N N A . NOW, let me ask you about the operation of the discount window of Federal Eeserve banks. Do either of you gentlemen
feel that an invigorating of the use of the discount window in terms
of making a wide arrangement of paper qualified for discount and
actually making this a matter of right for the member banks would
be bad for the system ? Mr. Mitchell ?
Mr. MITCHELL. Well, I think in view of the changing portfolio of
banks, it would be desirable to make it possible for them to rediscount
all kinds of good paper.
As far as the discount window management is concerned, the second
part of your question, whether borrowing should be a right or not,
T H E FEDERAL RESERVE SYSTEM AFTER FIFTY YEARS
1205
depends on whether you want to use changes in the discount rate to
restrict the use of the window.
I n recent years since regulation A, which is the regulation controlling borrowing, was revised, borrowing is not regarded as a right, and
the discount window is primarily used to make short-term adjustments.
Mr. H A N N A . I t isn't used very much actually, is it?
Mr. MITCHELL. Well, it is used quite a bit; I think borrowings
currently are running around $200 million. The discount window is
an extremely good safety valve, while banks are adjusting their investment position. They can only use the discount window temporarily,
especially the larger banks. The smaller banks do use the discount
window to some degree for seasonal reasons.
Mr. H A N N A . Mr. Daane, would you care to comment ?
Mr. DAANE. Well, I would go right along with Governor Mitchell,
that I think the archaic definitions of eligible paper should be dropped
so that a wider range of paper can be used without penalty.
I served on the discount committee of the Federal Reserve Bank
of Richmond, and I think that this would help mechanically in
enabling banks, particularly some of the smaller banks, to make better
use of the discount window without penalty.
I don't believe that it should be a right. I think the steps taken to
modernize the discontinuing mechanism were steps in the right direction. I would not wish to see loss of all control over the use of discounts from an administrative standpoint.
Mr. H A N N A . Thank you very much. My time is up. Mr. Chairman, I am delighted to find in this exchange that the gentlemen do not
believe that the Federal Reserve is a perfect organization, and that
some improvements can be made.
The CHAIRMAN. Mr. Bolton ?
Mr. BOLTON. Mr. Chairman, first of all I would like to address a
question to my colleague, Mr. Reuss. Did I understand you to say, in
asking your question, that you felt that no Government agency can
have a direct effect on either the gross national product or on jobs?
Mr. RETJSS. That is right. I think the effect is indirect through
monetary policy, fiscal policy, or tax policy, but it can't have a turn-onthe-faucet effect as our Federal Reserve System can with the money
supply.
If the Federal Reserve System were to have as its members seven
Professor Friedmans, they would then control the money supply to a
pinpoint or finer. I t is easy to do that.
Mr. BOLTON. I was interested in the gentleman's comment, and I
doubly appreciate it in view of his position, the rather strong position
on that side with respect to not only defense spending but also with
respect to A R A and A P W , and I appreciate your comment.
Mr. RETJSS. I think those things are only indirect in effect. They
need to be done. But would that mortal man could control our gross
national product and our employment and unemployment by as direct
a method as we can control our money supply.
Controlling our money supply is extremely easy to do, and it can be
done directly. Whether a given move is wise or not is something that
there is much room to argue. But certainly we can control it.
As a start in the analysis of the problem, I think wTe ought to recognize that.
1206
THE FEDERAL RESERVE SYSTEM AFTER FIFTY YEARS
Mr. BOLTON. I am glad to see that the gentleman's point was merely
a relative control, because I was sure I must have misunderstood the
fact that he did not feel that there were any Government agencies or
programs that had an effect on either the gross national product or on
jobs.
Secondly, I would just like to say for the record that I have approached this whole hearing and sets of hearings and these bills on
an individual position as a member of the committee, and certainly not
on a partisan basis. I was startled by the gentleman's reference to
the position of the majority and the minority and would like to ask
whether in view of his comment this means that this series of bills are
an administration and a majority position.
Mr. REUSS. Certainly the bills that we are considering, which I
consider only as a very small part of the scope of this investigation
really, these bills are as I understand it, not administration bills. They
are bills introduced largely by the chairman and largely so that the
witnesses may have something to sink their teeth into.
My comment was simply this: that Democrats generally have been
quite critical of the Federal Reserve System's performance in the
second half of the fifties, and we made that a great campaign issue
and came to power, and then the two Democratic appointees, very fine
and sincere and knowledgeable gentlemen, I hasten to add, the two
Democratic appointees come up here and outdo the very people that we
were criticizing.
Mr. BOLTON. I think it illustrates the
Mr. REUSS. And let the record show that the members of the
minority are again chuckling, as well they might at this.
Mr. V A N I K . Mr. Chairman, will the gentleman yield ?
Mr. BOLTON. Gladly.
Mr. V A N I K . I might say at this point if the interest goes up, I am.
going to be one of the first to jump all over the Federal Reserve.
Mr. BOLTON. The gentleman has made his position quite clear on
that, and I thought he received a very clear answer to his position
yesterday.
If I may turn to the witnesses just for a moment, referring to the
colloquy with the gentleman from California, Mr. Hanna, I was very
interested in your answer regarding the interest rate on demand deposits. Yesterday the position was taken by a witness to the effect that
presently there is an evasion of this by the submission of services and
other benefits to those who have demand deposits which, were banks
permitted to pay interest, would disappear.
And secondly, that by the avoidance through services and other
benefits today to those with large demand deposits, that actually there
is more leverage and more benefit in competitive structure given to
the large banks as contrasted to the smaller banks, and that therefore
the smaller banks are worse off under the present regulation of nonpayment of interest than they otherwise would be. Would you care to
comment on that ?
Mr. MITCHELL. Yes, I will be very glad to comment on that. The
point of the payment of interest on demand deposits is that if it were
permitted, as I understand the proposal, it would operate a good deal
like the payment of interest on negotiable certificates of deposit.
Negotiable C.D.'s can be issued now and are being issued now with
very small differentials in their offering price, and so they are ex
THE FEDERAL RESERVE SYSTEM AFTER FIFTY YEARS
1207
tremely competitive. If a bank wants to get additional funds in this
fashion, it will change its offering price by as little as perhaps five
basis points and get results in terms of inflow. This suggests that with
a few basis points change, given the kind of a banking system we have,
you could drain deposits, demand deposits, quickly from one bank to
another.
Now the payment of interest you referred to in the form of service
charges is not susceptible to this type of manipulation on a day-to-day
basis. I t tends to get woven into the compeitive fabric, and I don't
think it is a serious problem.
I t is also true that a great many banks are now substituting service
charges for compensating balances. You might as a large corporation
go to a bank and be told: "Well, you can either keep a compensating
balance of x hundred thousand dollars or you can pay so much per
transaction."
Some customers prefer to pay by the transaction, and if the bank
has a good cost accounting system, of course they are able to do this and
do it profitably.
Mr. BOLTON. Would you like to comment on that, Mr. Daane ?
Mr. DAANE. N O . I think Mr. Mitchell is exactly right. There is
some implicit interest payment built in now under the present framework, but nothing like the competitive aspect that would occur if
you make an explicit interest payment.
Again going back to the President's Special Committee Report on
Financial Institutions, it brings this out and adds the point that the
committee doesn't feel that explicit interest payment on our medium
of exchange is appropriate, and demand deposits, of course, are our
principal medium of exchange.
Mr. H A N N A . Will the gentleman yield for a moment at that point ?
Mr. BOLTON. I will.
Mr. H A N N A . Am I correct in assuming that since you made the
change in the regulation Q in the use of these C.D.'s, that there has
been an observable flow from demand deposits into time deposits that
did not exist before this change ?
Mr. MITCHELL. Oh, I think that is true, yes, and even more than
that, of course, there have been people who formerly held securities
directly who now prefer to hold a deposit and let the bank hold the securities.
Mr. H A N N A . I n other words, we have made a more vibrant tool out
of the time deposits.
Mr. MITCHELL. Very much SO.
Mr.HANNA. Yes.
Mr. MITCHELL. Negotiable certificates of deposit have grown from
nothing to about $10% billion now.
The CHAIRMAN. Mr. Vanik?
Mr. V A N I K . I have no questions.
The CHAIRMAN. Mr. Brock ?
Mr. BROCK. Thank you, Mr. Chairman.
I n the nonpartisan spirit we have been observing recently, I want
to express my appreciation to Mr. Reuss for his acquiescence in the
fact that criticism in the 1960 campaign did create some fiscal problems for this country.
Mr. REUSS. If the gentleman will yield
Mr. BROCK. Certainly.
28-680—64—-vol. 2
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THE FEDERAL RESERVE SYSTEM AFTER FIFTY YEARS
Mr. REUSS (continuing). I think there is no doubt that the European central bankers initiated and fueled the very damaging October
1960 run on gold. They did not bring this country to its knees, but
they came pretty close to it. However, my point simply was that
their threats and fears were, as it turned out, utterly baseless. The
Federal Reserve today is just as congenial to them as it was in the
late fifties.
Mr. BROCK. I hope they have that same feeling when we get through
whipping up the Federal Reserve in these hearings.
Let me get into this problem if I may with either one of you gentlemen of the money supply, brought up perhaps more forcefully by
Professor Friedman than any of the witnesses we have had. Under
his approach we would eliminate the rediscount, we would eliminate
the Federal control over reserve requirements, and use solely the
operation of the Open Market Committee to maintain a stable input
into the money supply of say 4 percent per year.
Now this would be accomplished through some small department
within the Treasury Department, and we would have no Federal Reserve in effect. I would like to ask either of you this question.
Let me say further that he also brought out that the purpose of this
was to eliminate one of the variables in our economic structure. I n
other words, he said the ups and downs are aided by and exaggerated
by some of the variables, and one of the variables that he would eliminate is the money stock.
Now, is it possible, in your opinion, if we eliminate rediscount
money, if we eliminate your control over reserve requirements and
use solely open-market operations, is it possible for these operations
to guarantee that we have a fixed input into the money stock of 4
percent on a weekly basis throughout a period of years ?
Mr. MITCHELL. In my prepared statement I said something about
this, but I think Professor Friedman's prescription is defective.
I n the first place the objective of monetary policy is to effect a better climate for the private enterprise economy, so it will grow more
rapidly and so it will grow without as much in the way of fluctuations. He has never demonstrated to my satisfaction, and I think to
the satisfaction of most of the people in his profession, that the changes
in the money supply that he says cause changes in economic activity
actually do so.
The point is he doesn't know which comes first, the chicken or the
eg£, and he has not been able to prove this. Yet he says, "Let's abandon
all monetary judgment and just take this simple formula, and then w^e
can forget about discounting, we can forget about changes in reserve
requirements and everything will come out fine."
Now as I said in my statement, had we taken this course at the beginning of 1961, we would now have had $14 billion less credit than
we presently have. I happen to be of the school of thought that thinks
that we would have a more viable domestic economy if we had a little
more credit rather than a little less. Mr. Friedman apparently following his own prescription here, would have interest rates much
higher than they are at the present time, and less credit and less economic activity and less employment.
Mr. DAANE. Mr. Brock, could I just add that certainly if you geared
up your open market operations to his formula, you could add x number percentage to the reserve base of the banking system every year.
THE FEDERAL RESERVE SYSTEM AFTER FIFTY YEARS
1209
But as Governor Mitchell has said, this would be far more devastating
with respect to the possible impact on the economy. And I'm just
wondering, Mr. Reuss, since in your recent book you said, " I have heard
no one suggest that we should go back to the chaos that prevailed
before 1913," would you say that after yesterday's testimony ?
Mr. RETJSS. I am not quite sure I understand the question.
Mr. DAANE. I n your book you simply said that you had heard no
one suggest that we go back to the chaos in our monetary system that
prevailed prior to 1913. I wondered whether you would repeat this
after Professor Friedman's testimony, where he clearly, by the rigidity
in his limits as Governor Mitchell has pointed out, would have had
us supply $14 billion less over these recent years.
Mr. RETJSS. Yes. My book, of course, went to the publishers before
I heard Mr. Friedman testify. But in defense of Mr. Friedman, who,
as you perhaps know, is the financial and monetary adviser to Senator
Barry Goldwater, and not me, in defense of Dr. Friedman, he did not
really suggest yesterday that we go back to the pre-1913 chaos, a
chaos in which there was no regular method of adding to the money
supply.
That was the gravamen of the pre-1913 difficulty, and Professor
Friedman at least suggests that we should add to it on an annual basis
roughly corresponding to the increase in the gross national product
which the Employment Act of 1946 requires us to adopt.
Mr. DAANE. But the effects of a rigid addition, rather than having
the demands and needs met by the best monetary management, not perfect admittedly, but the best judgment that we can make, is quite a step
back toward that pre-1913 rigidity.
Mr. RETJSS. I am afraid I am impinging on Mr. Brock's time, but I
will be back.
Mr. DAANE. I am sorry.
Mr. BROCK. I happen to agree with the colloquy which has gone on,
Mr. Daane, but I would like to clarify one point. You could with
open market operations affect the money reserve, but is this the same
thing as the money stock or the money supply in existence in the
country ?
Mr. DAANE. Mr. Reuss was trying to point out I believe earlier in
the colloquy with Governor Mitchell that this was a fairly invariant
relationship. Actually over the years, of course, it hasn't been. If
you want to assume an invariant relationship, you have to assume a
banking system that is fully loaned up, or invested up, so that every
dollar of reserves does in effect get used. I n the kind of expanding,
dynamic, growing economy that Ave have at the present, this is a fair
assumption. But there have been periods in the past when this would
not hold.
Mr. BROOK. I t has been stated that should we have this fixed input
and say that people in a psychologically depressed mood as you have
during a depression did not have the demand for money
Mr. DAANE. That is right.
Mr. BROCK. This would of course reduce your monev supply no
matter what you do with your reserve requirements. The rebuttal
is that we can just lower interest rates and so on, until we have reached
the point at which they would. Is this a logical philosophy?
Mr. DAANE. Continuing on with vou j n ^ a moment, certainly you
could flood the economy with reserves, not on the Friedman thesis,
1210
THE FEDERAL RESERVE SYSTEM AFTER FIFTY YEARS
because there you would be feeding it in just on a mechanical formula
basis, but on the present basis you could flood the economy with reserves and reduce interest rates to a fairly irreducible minimum, as
we did in the thirties. But this in and of itself certainly did not
produce the expansion in the money supply or the economy that was
desired at that time. I think you have a pretty good case illustration.
Mr. BROCK. Professor Brunner, as I recall, said it did have that effect. H e said we put a tremendous quantity of money in. I am not
arguing with you, but I am simply trying to bring out some of these
inconsistencies. H e said we did have a tremendous input up until 1936,
at which time the Fed adopted a highly restrictive policy and doubled
reserve requirements, and therefore we caused a recession in
Mr. DAANE. There are a lot of other things than the money stock
that enter into the factors accounting for aggregate economic activity.
A t times the role of money stock is simply a permissive one. As
Governor Mitchell has pointed out, there is no proof of a line of
causation.
My own view is quite skeptical of this line of causation, so that
I would dissent from this conclusion that Professor Brunner has
reached, and I think Governor Mitchell has demonstrated in his
charts some of the fallacy in it.
Mr. MITCHELL. Could I make a comment here ?
Mr. BROCK. Certainly.
Mr. MITCHELL. Because I think that it hasn't been brought out
yet. When the Federal Reserve conducts open market operations, it
provides the person from whom it is buying securities with a deposit
in a bank. Now these deposits add to that bank's reserves.
Now the question is what will a bank do with unused reserves. The
small country banks typically carry unused reserves because it is
uneconomical for them to put them to work. But a large bank, typically a reserve city bank, has a man who runs what is called the
money position. His job is to keep excess reserves in the bank at
a minimum. I n other words, his job is to put every dollar's worth
of reserves to work to the fullest extent of his ability.
Now this is the point. To the extent he and his counterparts succeed in doing this, you will have additions to the money supply
proportionate to the Federal Reserve's open market operations.
Mr. BROCK. I n that one sense.
Mr. MITCHELL. Yes, in this case. Now the point is that this means
you get more money, but it may mean that the turnover of money tends
to decline if you are in a slack period. And so when you put turnover
and money supply together, which Professor Friedman does not do,
you get an entirely different effect than he implies in just his money
stock analysis.
Mr. BROCK. My time has expired, but I appreciate that. Thank you.
The CHAIRMAN. I t is my plan to summarize what you gentlemen
have said, without asking you questions, in the interest of time. Mr.
Reuss had some other questions when his time expired a while ago,
and I want to yield to him after I summarize. If you gentlemen desire
to comment on what I have said in the record when you examine your
transcript of testimony, you may do so.
No. 1,1 would like to comment on the Presidents of these 12 Federal
Reserve banks not taking an oath of office. They do not take an oath
THE FEDERAL RESERVE SYSTEM AFTER FIFTY YEARS
1211
of office. They should take an oath of office, but they never take any
kind of an oath until they become official members of the Open Market
Committee.
They don't take an oath as Presidents of the Federal Reserve bank
t h a t they represent. They take an oath as members of the Open
Market Committee. But this is an entirely separate and distinct
thing. I think this omission should be corrected.
Also, although the Directors do take an oath, the oath is very limited.
I t is not a constitutional oath. They just take an oath that they will
not discriminate against banks as though it were strictly a banking deal
that they were looking after as directors of the Federal Reserve banks,
haying no reference to the public interest at all. I think that this
omisvsion should be corrected too because the public interest doesn't
oeem to be represented.
Now, about Mr. Martin's statement and possible testimony that the
Chairman of the Board's term should be coterminous with the President. I t is my understanding that he did not say that the President
would be allowed real freedom of choice. If he had said so, he would
have recommended that the statute be changed in some way, because
if you are going to give the President an opportunity to have real
freedom of choice, and the Board is fully filled, if the President goes
out and gets someone to be Chairman, that will either make eight
members of the Board or one of the Board members will be required
to resign. If Mr. Martin really wants the President to have freedom
of choice and make the Chairman's term coterminous with the President's term, he'll have to resign as Chairman and as Governor too—or
else persuade one of the other Governors to resign.
Another thing that attracted my attention in the testimony was
Mr. Mitchell saying the Fed looks upon this 6-percent dividend which
is paid to the member banks on their so-called stock as an inducement
for banks to join and stay in the System. I do not see how this can
mean too much, because last year the banks made nearly 10 percent
after taxes on their capital. What inducement is there for them to
hold a capital investment paying 6 percent when they are making
nearly 10 percent on capital right now, and made over 9 percent during
the last 10 years, as brought out by you gentlemen in your testimony.
I also find the statement that Mr. Daane made about the briefing you
receive before Open Market Committee meetings a little curious. The
briefing includes a 30- to 40-page written document and about 2 hours
of oral briefings, both of which concern such subjects as production and
employment, incomes, trade, wages, cost, prices, construction, agriculture, credit, capital, money, savings, taxes, and the balance of payments.
But evidently the briefing does not cover the rate of interest. I consider this item to be very important.
Interest is one of the most important costs paid by consumers and
taxpayers. I think it should be in every briefing that is held, and I am
surprised that the Federal Reserve does not recognize the importance
of interest rates. I'd like your comments on this.
The hearings also have brought out some points about the operating
procedure of our monetary authority, which I don't think anybody can
possibly tolerate as a national policy. One point is that there are really
19 members of the Open Market Committee, although the legal limit
is 12. I t is my belief that the Open Market Committee is operating in
violation of the law and has for sometime.
1212
T H E FEDERAL RESERVE SYSTEM AFTER FIFTY YEARS
Mr. Martin himself said that there are 19 participants at Open Market Committee sessions. But Congress passed a la\v saying there would
be only 12. The Open Market Committee meets in secret session. The
Committee allows seven men to come in, although they are not members. They are presidents of district Reserve banks but not Committee members. They haven't taken any oath because the oath
doesn't apply to them unless they are Committee members. Now there
are also 30 or 40 other people acting in advisory capacities in that
room when the Open Market Committee meets. W h a t all these people
say and do determines the volume of money and interest costs.
Now, for all we know, the nonmembers may have as much to say in
determining the money supply and interest as the 12 lawful participants. They don't tell Congress anything about what happens.
They refuse to tell Congress anything that happens. They don't
tell anybody. The President has nobody there. He doesn't have any
representative. So even the President cannot know what goes on
unless someone is kind enough to tell him.
But commercial banks are represented, and the banks are the ones
who can profit the most by open market operations. I don't believe
that this kind of operating procedure can be tolerated in a democracy,
in a republic. If you gentlemen would like to comment on that when
you see this transcript, it will be all right.
Still another matter of real concern is that for 50 years you have had
no audit, no Government audit, no independent audit, just an audit
of your own, a self audit. When you handle hundreds of billions of
dollars a year of Government money, of Government credit, nobody
looks over your shoulder except some of your own people. I don't
think that should be tolerated in a democracy and a republic. I would
like to have the comments of you gentlemen on that particular point,
too.
Another thing that I am concerned about is that during the last
several years, if instead of lowering reserve requirements to let the
banks have high power dollars upon which the banking system could
issue $10 in making investments or loans for every one high-powered
dollar, if instead of lowering the reserve requirements you had gone
into the market and bought Government bonds, the Government bonds
that the Fed would hold today would be at least $10 or $15 billion more
than the $33 billion it now holds. This would be a tremendous help
to the taxpayers because the interest on those bonds would have come
back, all of it, directly into the Treasury, and today that would mean
a saving to the taxpayer of $350 to $550 billion a year. You might
comment on that, too.
Finally I'd like your comments on one other matter. You both have1
indicated, and everyone else at the Fod seems to agree with you, that
we don't know very much about the link between the volume of money
and the economy. Xow what I don't understand is why the Fed spends
money on research into things like the wheat problem and manpower
retraining, which are the legitimate concern of the Departments of
Agriculture and Labor, when there's so much to be learned about the
role money plays in our economy. Why haven't you studied what
changes in the volume of money and interest rates do to employment,
profits, prices, investment, and our economy's growth? W h y do Ave
have to depend on economists outside the Fed to advance our knowledge of the link between money and economic activity? And why do
THE FEDERAL RESERVE SYSTEM AFTER FIFTY YEARS
1213
you spend so much effort trying to tear down their work when it would
be far more beneficial if you did some constructive research with part
of all that money you get without having to come to Congress for it
and can spend without the GAO checking on how you spend it? A t
this time I yield to Mr. Eeuss.
(The additional information requested by the chairman follows:)
SUPPLEMENTAL STATEMENT OF GOVERNOR MITCHELL AND GOVERNOR DAANE
In response to Chairman Patman's request, we submit the following comments
on questions he raised that were not previously covered in our testimony.
Chairman Martin's support for legislation authorizing a new President to
appoint a Chairman of the Board of Governors of his own choice is a matter
of public record. President Kennedy submitted such a proposal to the Congress
on April 17, 1962. It provided that the terms of the Chairman and Vice Chairman should expire on January 31 of the year in which the President's term
expires, and that all Board members' terms should expire in odd-numbered years,
rather than even-numbered years as is now the case. The President's message
transmitting this proposal stated explicitly the reason for this change: "In
order that the President may be able to appoint a Chairman of his own choice
shortly after his inauguration, he must have an opening on the Board of Governors to fill at the same time." The bill was introduced by Senator Robertson
as S. 3202 of the last Congress. In response to Senator Robertson's request for
his views, Chairman Martin wrote the Senator a letter supporting the bill.
The full text of the letter may be found at page 7100 of the Congressional Record for April 25, 1962.
At another point in his statement, Chairman Patman observed that he did not
see how a 6-percent dividend on capital stock in a Federal Reserve bank could
be much of an inducement to membership in the System when member banks,
in recent years, have been making net profits of 9 to 10 percent. This comparison is inappropriate; the 9 percent is a net return on capital and the 6 percent is
a gross return on an asset. A commercial bank operates with assets of 10 or
more times its capital. Therefore, a return of 6 percent on an asset normally
converts into a substantially larger return on its capital, even after deducting
for expenses. A more appropriate comparison, therefore, would be with the
average return on bank assets, which is well below 6 percent. On this basis.
Federal Reserve bank stock is an attractive investment.
The description of Open Market Committee briefings was not intended to be
all-inclusive, but it did include "costs" and "prices" (which includes the cost of
living index) and the Federal Reserve does, of course, follow interest rate developments closely.
As to the question of secrecy on the part of the Federal Open Market Committee concerning its operations, it should be borne in mind that the results of the
policy decisions made by the Committee are reported promptly and regularly
to the public. The immediate results of the Committee's deliberations are decisions to buy or sell securities; each week, on Thursday, the System makes
public a statement of the securities it held as of the preceding day, showing
changes in its holdings during the past week and during the past year. This
statement also shows total member bank reserves, excess reserves, and free
reserves and describes the factors affecting bank reserves during the week.
Current figures on the money supply and interest rates are published in a variety
of forms by the System, as well as other sources. So whether monetary policy
is evaluated by its impact on the money supply, or its impact on bank reserves,
or its impact on the money market, or a combination of these factors, the relevant facts are made available for all. The annual report by the Board to
the Congress contains a detailed record of policy decisions by the Open Market
Committee, including (1) a record, by name, of all votes cast by each member of
the Committee in connection with the determination of open market policies;
(2) summaries of the economic and financial developments and conditions taken
into account in arriving at policy actions; (3) statements of the reasons underlying the actions of the Committee; and (4) statements of the reasons underlying
dissents, when there are dissents. A copy of this policy record for 1963 was
furnished your committee early this year, in advance of the filing of the full
annual report.
1214
THE FEDERAL RESERVE SYSTEM AFTER FIFTY YEARS
Mr. RETTSS. I want to pursue with you gentlemen the theme that we
were discussing, which had to do not with whether we should substitute a mechanical formula like Dr. Friedman's for existing monetary
policy, but whether the money supply was an important factor in economic growth. I think it is.
Mr. Mitchell says, quoting from page 13:
It has not even been established in times like these whether changes in money
supply precede change in economic activity or vice versa.
I gather Mr. Daane agrees with that, and I emphatically disagree.
I think that this philosophy is what is wrong with Federal Reserve
policy today, so this is an important question to explore.
Let me ask Mr. Mitchell this. I n the year from February 1957 to
February 1958 the Federal Eeserve actually decreased the narrowly
defined money supply. I t decreased it from $137 to $136 billion. I n
the middle of this 1-year period, in July 1957, there was the start of a
serious recession and enhanced unemployment.
Again in the year following July 1959 the Fed again decreased the
money supply from $143 to $139 billion by June 1960, and again at
the midpoint of this adventure, in February 1960, a serious recession
started with much unemployment and suffering.
My question is this: I n saying as I do that the Federal Reserve's
decrease in the money supply had something, and an unfortunate
something, to do with the unemployment and recession that followed,
am I guilty of McCarthyism, of guilt by association, or is there not a
causal connection between this strangulation of the money supply and
the unemployment and recession which followed ?
Mr. MITCHELL. I think you put it beautifully. This is guilt by association; yes.
Mr. RETTSS. I am guilty of monetary McCarthyism ?
Mr. MITCHELL. Yes; that is right, because we don't know which
comes first. If you have a decline in business activity, it will of itself
result in a decline in velocity and/or a decline in the money supply.
Free reserves rise.
Mr. RETJSS. Let's get that again. A falloff in business activity
necessarily involves a decline in the money supply ?
Mr. MITCHELL. I n money use. You have to look at turnover as well
as money supply.
Mr. RETTSS. Let's go a little slower now. You have just testified
that nowadays the boys with the sharp pencil in the big city banks
who control most of the credit of this country, when they can't make
loans make investments, and that is my experince as to how they
operate.
Mr. MITCHELL. That is true, but
Mr. REUSS. Well, then why, when the loan window atrophies
through a moderation of business activity, aren't these same money
boys at the banks going to increase their portfolio of investments?
Mr. MITCHELL. Yes, but you have a big range of these sharp-pencil
boys. Some of their pencils are not very sharp and some don't even
have a pencil, so that in between here you have people who are not
responding because of the change in interest rates and the fact that
it is not as profitable to be a sharp-pencil fellow at one time as it is at
another. I n other words, the rate of interest has something to do
with the strength of the effort to minimize excess reserves.
THE FEDERAL RESERVE SYSTEM AFTER FIFTY YEARS
1215
Mr. REUSS. I would like both of you gentlemen to file for the record
a study, which I am sure has been made by the Fed, of the last 10
years, let's restrict it to that, of the banking system's use of its Reserve
power to create earning assets, either by loans or by investments.
Mr. BROCK. Will the gentleman yield ?
Mr. REUSS. Yes, but I cannot yield at this moment. I will be very
surprised to find that city banks were letting possible earning assets
die aborning because they never used their reserve power, but this is
an important question, and obviously it would not be fair for me to
ask you to answer it offhand, but I would appreciate at this point in
the record in your filing your findings on that.
Mr. DAANE. Could I just interrupt with one comment, Mr. Reuss.
Mr. REUSS. Surely.
Mr. DAANE. Y O U did have a substantial increase in excess reserves
in the hands of those banks that don't have the sharp pencils or the
opportunity to exercise them.
Mr. REUSS. Yes. Well, I would like to see those, because this all
bears on the question of this relationship.
Mr. BROCK. Can I ask him to include one other thing.
Mr. REUSS. Surely.
Mr. BROCK. Would you also include the difference between the addition to the money supply, when you have additional reserves from loans
and when it is put into investments, they have two different effects
upon the money supply. Would you give us your opinion as to the
relationship between the addition to the money supply through loans
and through investments, when they do shift from one to the other,
when they can't make loans, in other words there is no demand, and
they shift into investment.
Mr. REUSS. T O continue, having established that I think that the
Federal Reserve money supply policy of 1957 and 1960 respectively,
had something to do with the ensuing recessions and increases in
unemployment, and you gentlemen having established that you don't
think it had anything to do with that, let me go on to another point.
Mr. Mitchell, you take Professor Friedman to task because you say
that if we have followed Professor Friedman and his 4-percent money
supply expansion formula, we would have increased money supply less
since 1961 than we, in fact, have increased it. That is the point you
make.
Mr. MITCHELL. T h a t is right.
Mr. REUSS. Again in fairness to Dr. Friedman, I think it should be
stated that he professed concern, a concern which I don't feel, he professed concern at the fact that we have exceeded his formula in the
last few years, and thinks that we have created money at too rapid a
rate.
However, would it not be fairer to look at say the whole 10-year
period from 1953 to the present date, and if you do that, denning the
money supply precisely as Mr. Friedman does to include time as well
as demand deposits, the increase per year of the money supply has
been at a 3-percent rate or less, so that wouldn't you agree with Professor Friedman's criticism that in the last 10 years the Federal Reserve has allowed, on the average, for increases in the money supply
1216
T H E FEDERAL RESERVE SYSTEM AFTER FIFTY YEARS
which are inadequate for the kind of maximum employment and
production which the Employment Act of 1946 enjoins upon us?
Would you agree or disagree with that ?
Mr. MITCHELL. I wouldn't want to make a statement without reviewing the specific period that you are referring to. A lot depends upon
w^here you begin to examine or make a comparison.
I was just referring to this one economic upturn, which began about
that time, and saying that he would provide less to finance this upturn
than I think is desirable.
Mr. REUSS. S O that
Mr. MITCHELL. Or that the Federal Reserve has thought was desirable as a group.
Mr. REUSS. YOU, however, did pick the period, 1961 to date, the
most rapid period of Federal Reserve money creation in recent years,
and then proceeded to
Mr. MITCHELL. I did this for a very specific additional reason. One
is that he uses a definition of the money supply, which includes time
deposits. If you ask him why he includes time deposits, he says, " I
only include them because they work better."
]STowT when the Federal Reserve changed regulation Q, time deposits
of commercial banks became more competitive wdth direct holding of
Government securities than they ever had before, and they became
much more competitive with savings and loan associations, and as a
result time deposits went up very sharply. This illustrates the trouble
with using a fixed inflexible rule, because a change in environment
took place that he never anticipated, and his rule just won't work
under these conditions.
Mr. REUSS. This is one of the reasons why I am not dominated by
Professor Friedman. But let me see if we can't find one area of agreement here. I n that same paragraph on page 13, when you were talking about Professor Friedman, you talk about the Federal Reserve
formulating monetary policy with "a more logically defined money
supply."
Mr. MITCHELL. Narrowly defined.
Mr. REUSS. Good for you. You think that currency outside banks
and demand deposits is a more sensible view of the money supply.
Mr. MITCHELL. That is right.
Mr. REUSS. S O do I. Using that more sensible and logical view of
the money supply, is it not a fact that the Federal Reserve System in
the last 10 years since 1953 has produced expansions of the money
supply which have been inadequate to the maintenance of the maximum employment and production goals of the Employment Act of
1946?
Mr. MITCHELL. The way you put this question makes it extremely
difficult to answer, because it is just like Professor Friedman's monetary history. I t is a money supply interpretation of history, and this
is the kind of box you are placing me in, in asking this question in this
form. I happen to think that there were times when we should have
bee^ pushing the money supply harder.
Mr. REUSS. Will you agree that our decreasing of the money supply
in the 1957 and 1960 periods that I have referred to, followed in each
case by severe recession and unemployment, was not the Federal Reserve's finest hour ?
THE FEDERAL RESERVE SYSTEM AFTER FIFTY YEARS
1217
Mr. MITCHELL. Well, the period of the 1957 experience—my vote is
not recorded any place, so this is just free information—my feeling
was that the Federal Reserve did not switch policy early enough in
1957, and I think the facts warranted an earlier switch, and if I had
been a member of the Board, I would have voted for an earlier switch
than the one which occurred.
But I don't think that you can expect the Federal Reserve's performance to be perfect. If you look at the policy record, I think you
will find—and I thought you were going to give me a chance to read
from the policy record—where the Federal Open Market Committee
expressed a concern about what was happening to the money supply.
Mr. RETISS. Instead of just expressing concern, why didn't they do
something about it until after
Mr. MITCHELL (interrupting). They were attempting to do something.
Mr. REUSS (continuing). Until after unemployment went up ?
Mr. MITCHELL. Well, the point is that the money supply, if you just
focus your attention on the money supply to the exclusion of what
happens to interest rates and credit conditions
Mr. RETJSS. Which I do not suggest doing.
Mr. MITCHELL. But you don't suggest doing. B u t you see the Federal Reserve is looking at all of these other factors, too, and not just
to the money supply. That is the reason it can't make the money supply respond at the moment it wants to, and in the way that Professor
Friedman recommends.
This is the point at which we started. I said yes, we could make the
money supply follow the Friedman prescription if we forget about all
other considerations, but not unless.
Mr. REUSS. Mr. Daane, on page 4 of your report you purport to
recite the objectives of the Employment Act of 1946, and you there
refer to "sustained high levels of production and employment." This
is the way the Fed constantly reads the Employment Act of 1946, but
I can assure you that isn't what Congress said.
Mr. DAANE. N O , Mr. Reuss
Mr. RETJSS, If I may finish; what the Congress said was "maximum
employment and production," and this "sustained" talk has been used
constantly by the Fed to choke off an expansion on the ground of "we
had better put on the brakes here because if this economy gets going
too good, we won't be able to sustain it," and this I think has been very
harmful in 1957 and 1960 and at other times.
Therefore won't you take a look at the actual wording of this act,
and put in "maximum employment and production" instead of this
"sustained" stuff.
Mr. DAANE. When you get the stenographic record, Mr. Reuss, you
will see that at that point I reiterated that we are concerned with
"maximum employment, production and purchasing power," if you
would like the reporting gentleman to go back to it, you will find that
I added the specific words from the Employment Act.
Mr. REUSS. Yes, except if you and your colleagues keep putting in
this "sustained" stuff, you get into a frame of mind where you think
you are doing your duty when you put on the brakes the minute things
get going reasonably well on the ground that if you don't, it can't be
sustained.
1218
THE FEDERAL RESERVE SYSTEM AFTER FIFTY YEARS
Mr. BOLTON. Will the gentleman yield ?
Mr. KETTSS. I hope that in future presentations, and not only in t h e
stenographic record but in your mimeographed format, you will observe the Biblical admonition that in the beginning was the word, a n d
the word is really "maximum employment and production," not "sustained high levels of employment."
Mr. DAANE. I would be glad to assure you, Mr. Eeuss, I have that
in my mind.
Mr. EEUSS. I will be glad to yield to Mr. Bolton.
Mr. BOLTON. Doesn't the gentleman agree that the word "sustained"
does have some real bearing in view of the comment, the added language that the chairman called our attention to was also in the act,,
which is maximum purchasing power.
Mr. REUSS. On that I have no quarrel with Mr. Daane's formulation. I did not read it, but he has in there "reasonable price stability, 5r
which is, I think, a completely fair rendering of maximum purchasing
power, and I do not criticize the Fed for those aspects of its activities
which are devoted to reasonable price stability. They operate there
about as I would operate.
What I do criticize them for is their slamming on the brakes and
keeping us thereby from reaching maximum employment and production. We haven't reached that for the last 10 years.
Mr. BOLTON. That is the very point I am trying to pick up the
gentleman on, because in judging the balance, they have, in addition
to making every effort to create an ever-expanding economy—to create
maximum employment—they also must take into consideration the
question of whether or not inflation with the reduction in purchasing
power is going to accompany it.
The fact that their judgment and yours or mine or anybody else's
may differ as of a given moment—and this is the question that Professor Friedman, I think, made best of all the points he made yesterday—
to the effect that the major reason that he was for the static injection
of a greater money supply was because this took out of the human
judgment field, which had according to the way he figured it proven to
be fallible over the past history of the monetary transactions.
But I don't see how you could criticize the gentleman for making
a judgment when that judgment must take into effect not only maximum employment, but must also take in the question of purchasing
power, and therefore of inflation and the value of the dollar.
Mr. REUSS. Let me state why I was critical. The goals of the Employment Act of 1946 are threefold: maximum employment, maximum
production, and maximum purchasing power. I want all those goals
pursued, including the third one.
Mr. BOLTON. Of course.
Mr. REUSS. But I don't want the first two diluted by putting in little
words like "sustained," which in the nast have been used, quite apart
from maximum purchasing power, to justify, incredible though it may
seem, activity by the money managers to moderate upward economic
activity before maximum employment and production, accompanied
by maximum price stability, is attained. This I think is wrong.
Well, just let me say that if Mr. Daane or Mr. Mitchell on reading
this^ record find a comma or a syllable in what I have just said on this
subject with which they disagree, let them spread their disagreement
on the record on that point.
THE FEDERAL RESERVE SYSTEM AFTER FIFTY YEARS
1219
Mr. DAANE. I t is a matter of semantics, I am sure, Mr. Eeuss. We
are interested, you and I, in exactly the same thing; namely, the objectives of the employment act. But I do happen to believe that a
sustainable expansion—sustained over longer periods, and we have
had one right now—will overtime produce maximum production, employment, and purchasing power. I think this is semantic matter.
We don't disagree.
Mr. EEUSS. I must resist this embrace, because when you put in
"sustainable" you are getting aw^ay from maximum, and this isn't just
quibbling. I yield to the chairman.
The CHAIRMAN. May I suggest to you gentlemen that Mr. Martin—
T brought that to his attention, and he changed it and added maximum
purchasing power. But I think over the years the Fed has insisted
on leaving maximum purchasing power out.
I was the author of the employment act, we called it the Full Employment Act when it was started. The only change we made in it
was to make it maximum instead of full. I was the first witness before
the committee that considered and recommended the bill. I believe
that I know something about what the purposes were.
I think you will find in there the three maximums that have been
discussed here, but nothing is said about the Federal Reserve at all.
The Federal Reserve is just embraced in the Employment Act of 1946;
it is given no special assignment. Moreover, the act does say, I know,
because it was discussed a long time in the committee, it does say that
all the agencies of the Government, and this includes the Fed, will
in coordination carry out these policies.
Nowhere does it say that the Federal Reserve will do this by itself.
The Federal Reserve is not even mentioned in the act. But the Federal Reserve's policies and instructions and guidance from Congress
have been very limited, and I think the Federal Reserve looks upon
this vacuum as a great opportunity and so it took on the goals of the
Full Employment Act as additional responsibilities. I will admit
the Fed should try to achieve these goals but not by yourself but in
coordination with other agencies. Do you agree with me on that
coordination ?
Mr. MITCHELL. Certainly.
Mr. DAANE. We have certainly had coordination with other
agencies.
The CHAIRMAN. I haven't heard about any coordinating efforts and
meetings.
Mr. DAANE. We certainly have coordination, Mr. Chairman, with
other agencies, as I tried to point out in my statement, toward the
same objectives as the rest of government.
The CHAIRMAN. Yes, but the Fed in discussing its functions invariably leaves out it is supposed to achieve the goals of the Full Employment Act in coordination with other agencies. So I think that
some consideration should be given to that in the future.
Mr. REUSS. Thank you, Mr. Chairman.
The CHAIRMAN. Will it be all right to submit questions of any members, including members of the full committee, to you gentlemen, and
you may answer them when you look over the transcript?
Mr. DAANE. Certainly, Mr. Chairman. May I just add one word
on Mr. WidnalFs question as to the Bank of England changing the
1220
THE FEDERAL RESERVE SYSTEM AFTER FIFTY YEARS
bank rate, because I think it is an important question that has implications in terms of markets both here and abroad.
The only addition I would like to make for the record is simply
that there was an unprecedented degree of consultation between the
United Kingdom authorities and our authorities before this move
was taken, which I believe augers for no disturbing competitive flows
of funds as a result of this change in the bank rate. And in fact we
still have in our markets on the basis of a comparison of our bill rate
and the United Kingdom rate, on a covered basis, a slight advantage
our way.
So I guess all I am trying to be sure to get in the record is that this
move, just like our move last July, was not intended to attract funds
competitively, but rather to deter an outflow, an interest induced
outflow.
The CHAIRMAN. Yes, sir. Thank you very much, gentlemen.
Mr. MITCHELL. Thank you, sir.
Mr. DAANE. Thank you, sir.
The CHAIRMAN. Thank you. If you desire to make comments as
you go along in the transcript, you may be privileged to do so.
(Eeplies of Milton Friedman and K a r l Brumier on testimony of
Governors Mitchell and Daane are as follows:)
COMMENTS BY MILTON FRIEDMAN ON TESTIMONY OF GEOEGE W. MITCHELL AND
J. DEWEY DAANE
I am grateful to Chairman Patman for giving me an opportunity to comment
for the record on remarks by the witnesses that refer to my work and to my
testimony before this committee. For ease in cross-reference, I shall comment
on the various points raised in the order in which they occur in the testimony,
and for brevity, I shall restrict myself to the more controversial and immediately
relevant comments.
1. Mr. Mitchell: "Had we at the beginning of 1961 adopted the Friedman
proposal for a constant 4 percent rate of expansion in money supply * * * we
would have added some $14 billion less to credit supplies than actually was
provided by the monetary policies followed by the Federal Reserve in these
years."
This is arithmetically true but extremely misleading. In the first place, as
Mr. Reuss brought out later in the testimony, the results depend very much
on the starting point. I would never want to argue that a constant rate of
growth would be better for every conceivable pair of dates but only that on
the average over considerable periods, it will provide a stabler and preferable
monetary policy. In this particular case, Mr. Mitchell has chosen as his
starting point a date preceded by an unduly slow rate of growth in the money
supply. Given the prior mistake, it was desirable to have a somewhat more
rapid rate of rise over this period than the rule would have given, if we start
it at the point Mr. Mitchell chooses.
In the second place, Mr. Mitchell neglects to point out that during these years
the money supply to which I would apply the 4 percent rule (currency outside
banks plus demand and time deposits of commercial banks) not only grew
much faster than the narrower money supply of currency plus demand deposits
but that the difference in rates of growth is much larger than it has been at
any earlier time. The reason it is larger is because of Federal Reserve action
in changing discontinuously the rate of interest banks may pay on time deposits.
As a consequence, part of the growth in the broader money supply was at the
expense of other assets. Under my proposals of both a steady rate of growth
and no legal ceiling on interest rates paid by banks, the two money supply
totals would have grown at more nearly the same rate, and a smaller rate of
growth in a broader money supply would have been as expansionary as the
actual rate of growth. Hence, even for this particular period since 1961, I
believe that the rule, correctly applied, would have been superior to actual
policy.
THE FEDERAL RESERVE SYSTEM AFTER FIFTY YEARS
1221
In the third place, even neglecting these qualifications, as I pointed out in
my testimony, the money supply has for the past 15 months or so, been growing
at a faster rate than can be maintained indefinitely. Hence, it would have been
desirable to have had a somewhat smaller growth. As I pointed out in my
testimony, while the Reserve System moved in the right direction in late 1962,
it moved too far in that direction.
2. Mr. Mitchell: "The nature of the causal process [whereby changes in the
money supply causes fluctuations in economic activity] is important * * * it
has not been delineated, and * * * I have seen nothing to demonstrate that
the causal relationship is constant in degree or timing over economic cycles or
over long periods when basic structural relationships in the economy have
changed."
Except for the final statement (about long periods), I am in entire agreement.
We need more knowledge about the nature of the causal process, we need a
fuller delineation of it. I have no doubt that the causal relation is not constant
in degree or timing over economic cycles. Indeed, I have argued elsewhere that
there is much evidence it is variable. Where I disagree is with the conclusion
Mr. Mitchell draws from these observations. He concludes that therefore there
is no argument "for abandoning discretionary money management in favor of a
rigid formula."
Surely, this conclusion is a non sequitur. If Mr. Mitchell does not know the
nature of the causal process; if it is not constant in degree or timing, how can
he know what monetary action to take at his discretion? How does he get
knowledge out of ignorance? I would have supposed that much more precise
and accurate knowledge would be required to know what delicate jugglings of
the monetary supply would have the desired effect in each instance than to
know that a constant rate of growth of the money supply would not be an
independent source of disturbance. Perhaps this is wrong, but is not some
evidence required before the opposite conclusion can be accepted? What evidence
do Mr. Mitchell and his colleagues offer? Some of us have tried to examine the
evidence for the past and have concluded that the Reserve System has not had
the knowledge required. If the Reserve System rejects our conclusion, ought
it not provide some counterevidence and not simply content itself with irrelevant
homilies about "thought, judgment, discretion, and concern for the world as
it is"?
As to the long-period stability of the average relation between money and
business, I should like to refer Mr. Mitchell to two publications he has apparently
not seen, which provide a good deal of evidence, both by Anna J. Schwartz and
myself: "Money and Business Cycles," published in a Supplement to the Review
of Economics and Statistics, XLV, No. 1 (Feb. 1963), part 2, 32-64; "A Monetary
History of the United States, 1867-1960" (Princeton University Press for
National Bureau of Economic Research, 1963).
3. Mr. Daane: "Mr. Reuss, in your recent book you said 'I have heard no one
suggest that we should go back to the chaos that prevailed before 1913/ I wonder
whether you would repeat this after Professor Friedman's testimony?"
As Mr. Reuss subsequently pointed out, I am not in favor of going back to the
situation as it existed before 1913; I am in favor of substituting a steady rate
of growth of the money supply for the unsteady, erratic growth we then had.
However, it is worth pointing out that the alleged "chaos" that preceded the
enactment of the Federal Reserve Act seems to have produced a higher degree
of monetary and economic stability than the period since. If one compares the
50 years before the Federal Reserve System with the 50 years since, the quantity of money apparently fluctuated less in the earlier period than in the later,
and so did economic activity in general. I say "apparently" because the statistical evidence is much less adequate for the earlier than for the later period.
However, the evidence is certainly sufficient to justify the milder conclusion
that the later period was not distinctly stabler than the earlier.
One immediate objection to this comparison is that the later period contained
two major wars. However, the result is the same even if all war years are
omitted from the later comparison: The money supply and economic activity
were apparently less stable in the later peacetime years, when money was supposedly being managed by men who were applying "thought, judgment, discretion, and concern for the world as it is," to quote Mr. Mitchell, than in the
earlier years of "chaos," to quote Mr. Daane, when the money supply was
largely at the mercy of the unfettered gold standard.
Perhaps there is some satisfactory explanation why money managers were,
not able to improve on chaos. Perhaps they faced harder problems of adjust
1222
THE FEDERAL RESERVE SYSTEM AFTER FIFTY YEARS
jnent. Or, perhaps even if they were not able to improve on chaos in the past,
they now know enough to do so in the future. Surely, it is about time that the
System provided some evidence on these points—or at the very least, criticized
the evidence others of us have tried to provide. It is disappointing to see
them instead retreat behind what they present as platitudes about rigidity
versus judgment and discretion but what are in fact illogical evasions of the
substantive issues. I can understand how this position could be expressed in
the 10th Annual Report of the System, where incidentally it was stated with
rather more subtlety and sophistication than it is currently being stated. But
it is now some four decades of rather informative experience later, and by now
I believe the Congress and the people of the United States deserve a less superficial justification for assigning large and potentially dangerous powers to the
unfettered discretion of a few men.
4. Mr. Mitchell: "The point is that this means you get more money, but it
means that the turnover of money tends to decline if you are in a slack period.
And so when you put turnover and money supply together, which Professor
Friedman never does, you get an entirely different effect than he implies in
just his money stock analysis."
Apparently, Mr. Mitchell has neither read my work nor examined the empirical
evidence which is presented in it. If he had done so, he would have found that
I have examined intensively the behavior of the velocity of circulation of money
(what he calls turnover), that I have studied its secular and cyclical behavior,
and have tried to present some theoretical explanation of why velocity behaves
as it does. He would find also that the facts are the very opposite of what he
asserts them to be. On the average, velocity tends to move in the same direction
as the quantity of money and not in the opposite direction, though a full statement of the relation would require some minor qualification. For the period of
the Reserve System, perhaps money supply and velocity have moved in the same
direction because the System has reinforced the forces making for instability
rather than offset them. Once again, perhaps the future can and will be different,
but Mr. Mitchell says nothing in his testimony to suggest that it will be.
In my opinion, taking into account the actual relation between money supply
and turnover strengthens, rather than weakens, the case for a fixed rule of a
constant rate of growth instead of discretionary monetary management of the
kind we have experienced.
5. Mr. Mitchell: "He [Friedman] happened to fumble into a definition of the
money supply, which includes time deposits * * *. Now when the Federal
Reserve changed the regulation Q, time deposits of commercial banks became
more competitive with direct holdings of Government securities * * * and * * *
with savings and loan associations, and as a result time deposits went up very
sharply. This illustrates the trouble using a fixed inflexible rule, because the
change in environment took place that he never anticipated, and means that
his rule just won't work under these conditions."
As to definition, I regard the choice as a matter of convenience, not principle,
as I have repeatedly written. Neither definition can be regarded as more
logical than the other. I have examined a very wide range of evidence and the
bulk of it favors the broader total. However, perhaps that is the wrong choice,
and I am certainly anxious to see any evidence Mr. Mitchell may have which
indicates that it is the wrong choice. I am not so far aware of any which has
been published by the Reserve System.
In any event, in my testimony before your committee, I presented data for
both totals. Whenever feasible, I have used both in the statistical analyses I
have made. I know of no significant empirical finding or policy conclusion that
would have been changed by the use of one definition rather than the other,
provided numerical magnitudes relevant to one definition are not treated as
applying to the other. For example, the rule of a steady growth could be
applied to either. However, the desirable numerical rate of growth must be
adapted to the definition used. Historical evidence suggests that a rate of
growth between 3 and 5 percent for the broader total (currency outside banks
plus all privately held deposits of commercial banks) would be consistent with
roughly stable prices; while for the narrower total (currency plus demand
deposits only), the corresponding range is about 2 to 4 percent.
More important is the rather extraordinary statement by Mr. Mitchell about
the alleged trouble in using a fixed inflexible rule. The trouble, he says, is that
the rule cannot deal with erratic changes in the environment caused by Federal
Reserve discretionary action. The automatic pilot won't work when
the live
pilot jiggles it. Hence, he says, dispense with the automatic pilot.1
1
A response by Governor Mitchell to the foregoing comments appears in the appendix
p. 1517.
Digitized foratFRASER
THE FEDERAL RESERVE SYSTEM AFTER FIFTY YEARS
1223
COMMENTS ON GOVERNOR MITCHELL'S TESTIMONY
(By Karl Brunner)
I appreciate the opportunity offered me by Chairman Patman to comment in
some detail on Governor Mitchell's testimony presented before this committee.
Governor Mitchell criticizes my testimony given to this committee on February
26 in the context of a reference to some remarks made in my lecture
to the Research Division of the Board of Governors on February 27, 1964.1 He particularly notes the importance I attached to the existence of a highly competitive
market for ideas. The operation of such a market provides the critical examination of ideas so necessary for the growth in our systematic knowledge. I also
emphasized however the importance of the rules guiding the competitive process.
The critical examination applied to our ideas should be based on relevant logical
considerations; i.e., considerations related to the logical status of the propositions made. Such rules are not a sufficient condition to maximize the accrual
of reliable knowledge, but they definitely provide a necessary condition. The
statement prepared by Governor Mitchell is thus a welcome contribution to our
mutual appraisal. However, its appearance in the public domain also exposes
it to a searching inquiry bearing on the state of knowledge and analytic procedures of the Federal Reserve authorities. Such inquiry is the purpose of my
comments, which concentrate on the last section of Governor Mitchell's opening
statement.
The objections raised by Governor Mitchell may be usefully divided into three
groups, one dealing with some observational references made in my testimony,
another with the policy recommendation attributed to me, and the last with his
arguments bearing on the choice between discretionary management and a rule
guiding policy actions.
1. According to the statement read by Governor Mitchell my contention concerning the general nature of the causal process linking money and economic
activity was based on a juxtaposition of the growth rate in the money supply with
turning points in economic activity. It is argued that such "bare statistical exercises" cannot "demonstrate" or "prove" the lines of causation. This argument
fails on several points.
(i) Chart I of my statement, which exhibits the annual percentage changes in
the money supply between corresponding months, was primarily used to discuss
the Federal Reserve's misconceived assessment of its policy action. It occurred
in the context of a discussion attending to the nature of the money supply process
and the Federal Reserve's conception of this process. This problem is not even
mentioned in Governor Mitchell's statement, which deals only with the issue
posed by the choice between "rules and authority."
It is noteworthy that Governor Mitchell bypasses the fundamental issue raised
in my testimony. I contended that Federal Reserve policy is mostly guided by
some vague unspecified ideas and inchoate notions which often conflict with each
other. More specifically, the Federal Reserve's policymaking lacks the rational
foundation which a coherently formulated and validated conception would supply.
There is no evidence indicating that the Federal Reserve authorities have seriously attempted to systematically explore the structure of the monetary processes and thus supply the substantiated analysis necessary for rational policy
decisions. It is therefore most encouraging to notice Governor Mitchell's ap1
A correction in Governor Mitchell's report of my lecture appears necessary. I did not
express my astonishment about "some of my academic colleagues for presenting: arithmetical relationships without demonstrating their relevance to economic and policy issues.*'
My lecture was entitled "Fashions or Knowledge," and dealt with the changes in our
opinions concerning the efficacy of monetary policy. In particular, I considered whether
or not the long cycles observed in our opinions are the result of substantiated analysis.
The fundamental contention of the lecture denied this surmise and I asserted particularly
that we usually moved in a fashionlike manner prone to psychological suggestive but
logically irrelevant impressionisms. Three specific cases were developed: (i) The accrual
of excess reserves in the thirties' and the assertion of a breakdown in monetary policy,
(ii) the apparent decline in the relative importance of banks and the lowered effectiveness
of monetary policy, and (ill) the comparative variability of velocity and the resulting
impairment of monetary policy. It was then shown that in all cases some observations
were adduced as evidence in support of a proposition denying the effectiveness of monetary
policy or asserting a decline in its effectiveness. Moreover, in all cases a logical analysis
reveals that these observations have no evidential value. Hypotheses can be constructed
(some of them published in our work) which imply the denial of the propositions under
considerations which are also consistent with the observations adduced. It follows that
the observations listed have no relevant application, by themselves, to the appraisal of an
effective monetary policy. My lecture dealt with proposition and their relation to
discriminating observations and not with "arithmetical relationships."
28-680—64—vol. 2
SO
1224
THE FEDERAL RESERVE SYSTEM AFTER FIFTY YEAR&
proval of investigations designed to extend our systematic knowledge about the*
structure of monetary mechanisms. But the very proposals advanced by Governor Mitchell suggest to show that the Federal Reserve authorities do not know
how to exploit the facilities at their disposal in a manner conducive to enlarging
their relevant knowledge. He advocates more detailed investigations concerning
"cyclical changes in the structure of money ownership or on the role of turnover
as it affects the demand for money."
The Federal Reserve has on major occasions been prone to collect data without
any guiding, purposeful idea. The collection of data exhibiting the ownership distribution of deposits supplies a good example. In order to establish, the relevance
of such costly collections, the resulting data should be shown to bear immediately
on a hypothesis concerning the structure of monetary processes. Such hypotheses
may conceivably be formulated and excellent results could conceivably be
achieved. This remains to be seen. However, in view of the limited resources,
available and the lack of reliable knowledge stressed by Governor Mitchell, it
would appear rational to adjust the collection and preparation of data according
to a plan designed to cover the most urgent gaps in our policy foundations. This
procedure requires that the range of phenomena bearing, most directly on important policy issues be delineated, that several hypotheses covering this range o r
various subranges be carefully and explicitly formulated, and ultimately, that
these hypotheses be patiently assessed by repeated and competitive exposure to
observations.
It should be noted that the second proposal points to potentially relevant material. Unfortunately, its formulation is dangerously misleading and could'
serious vitiate the construction of suitable hypotheses. But I welcome the
Federal Reserve's growing awareness of a demand behavior for money and the
recognition that extensive investigations promise to yield important information
applicable to rational policymaking. I particularly hope that Governor Mitchell
will launch a detailed investigation into the structure of velocity and demand
behavior which will be successfully implemented by the Board's Research
Division.
One important range of problems, however, is missing among Governor
Mitchell's suggestions. More than 10 years ago the Federal Reserve authorities
acknowledged in a report to a congressional committee that its basic functions
center on the control of the money supply. Effective control presupposes the
possession of relevant knowledge concerning the structure of the process generating the observed behavior of the money supply. There is little evidence that
the Federal Reserve authorities have acquired the reliable knowledge necessary for an effective control over the money supply. On the contrary, there is
considerable evidence that they are still enmeshed in serious misconceptions.
I find the absence of any suggestions indicating the urgency of better founded
conceptions about the money supply process somewhat disturbing, most particularly when the chart discussed by Governor Mitchell in a lengthy footnote
occurred, with the exception of a single sentence, in the context of considerations applied to the money supply process.
(ii) However, even a single sentence is sufficient to justify critical attention.
Governor Mitchell's statement appears to suggest that I engaged in some arithmetical legerdemain. But his elaborations miss some essential points.
(a) It is perfectly legitimate to advance an empirical hypothesis asserting a
causal connection leading from the growth rate of the money supply to the
pace of economic activity represented by turning points located independently
of the money supply. Such a hypothesis has been formulated by the sentence
alluded to. I would not wish to argue the richness of its detailed informative
range, but I do acknowledge
its usefulness as an explanation for the economy's
broadest contours.2 The observations adduced do bear on this hypothesis and
are not an artifact with respect to this hypothesis. The assertion that they
are an artifact can only mean that an alternative hypothesis implying the denial
of the systematic character of the asserted regularity is better confirmed. But
Governor Mitchell presents no case yielding such a result even approximately.
(6) Moreover, Governor Mitchell's criticism is subject to various interpretations: (1) He possibly means that the observations adduced, while relevant,
possess very little discriminating power, or (2) he mav wish to suggest that
discriminating observations sharply differentiating rival ideas could only be
2
1 used the hypothesis for the first time at a forecasting seminar in November 1956
organized by the School of Business Administration at UCLA. The hypothesis was used'
to predict the occurrance of a turning point located in the middle of 1957.
THE FEDERAL RESERVE SYSTEM AFTER FIFTY YEARS
1225
specified with the aid of a theory which explains the empirical hypothesis
postulated.
The table appended to Governor Mitchell's statement suggests the first interpretation. The table exhibits the annual percentage changes of five different
magnitudes (industrial production, money supply, nonagricultural employment,
private nonfarm residential construction, and new orders for durable goods).
If Governor Mitchell wishes to have any meaning attached to this procedure,
he must implicitly wish to draw attention to alternative hypotheses explaining
turning points in economic activity in terms of one or more of the series on
nonagricultural employment, private nonfarm residential construction, or new
orders for durable goods. These alternative specifications might assert that
the money supply's behavior observed in the same chart results directly or
indirectly from the gyrations in the chosen nonmonetary causal entity. But
the major portion of my written statement bears on this very point. I summarized some results of the money supply theories investigated by Professor
Meltzer and myself. We have shown that under the base hypothesis the extended base (monetary base plus cumulated sum of reserves liberated from or
impounded into required reserves by changes in legal ratios) dominates the
money supply. Moreover, the extended base is controlled by a set of circumstances not systematically dependent on current economic activity. In particular, under present arrangements it is determined by policy actions. Thus an
explanation of the money supply by means of a money supply theory extends the
range of observation bearing the causal direction of monetary processes.
Several money supply theories with radically different structure have been
investigated in our project. The major implications coincide and emphasize
the decisive role of the extended base. These theories have also been sufficiently
tested to reveal their empirical relevance. These results have been published
and presented at professional meetings for public exposure. Moreover, these
results were summarized partly in my written statement and the underiying
studies referred to in the footnotes. This analytical underpinning and the
associated evidence is disregarded by Governor Mitchell. This analysis and
evidence support the empirical hypothesis mentioned above as against the alternatives implicitly submitted to the committee for consideration. We do
not contend that our money supply theories are in any sense final and conclusive. We do hope that improvements emerge from mutual appraisal of one's
hypotheses. But the Federal Reserve authorities still have to show an awareness of the very problem involved.
The second interpretation leads us to an important problem. It is quite true
"that the way in which changes in money supply generate changes in economic
activity has (not) been sufficiently thought through and empirically tested."
The detailed nature of the so-called transmission mechanism has not been reliably traced and still poses a challenge to our searching inquiry. An appropriate theory of this mechanism might explain the comparatively simple hypothesis indicated above. Such explanation would occur in a context which
assigns more discriminating power to the observations adduced. We thoroughly
agree with the request for a clearly articulated conception of the transmission
mechanism. It should be noted, therefore, that we have formulated a detailed
theory and also presented one of its implication bearing on Governor Mitchell's
objection.8 In view of the analytical underpinning actually provided, the objection becomes groundless. Such underpinning does not "establish" the causal
structure of the monetary mechanism, but it does supply an interpretation and
provides a frame which guides our evaluations.
Lastly I wish to emphasize another point related to Governor Mitchell's objection concerning my discussion of a causal relation linking money and economic
activity. His comments fail to mention that I supplemented the observation he
discussed with other evidence. As a matter of fact, I referred explicitly to
detailed analysis and evidence emanating from our research project. Both the
3
I mentioned this point explicitly in the discussion following my lecture in the Fed's
Research Division. Somebody raised a well-taken point concerning the significance of
simple hypotheses of the type discussed. I indicated that a searching evaluation would
require the formulation of a higher level theory which enables us to squeeze more relevant
information bearing on the casual structure out of a given sample of observations. I also
indicated that this reason led Professor Meltzer and myself to formulate a higher level
theory which implied the regularity asserted by the simple hypothesis. I also referred to
the paper summarizing our theory: "The Place of Financial Intermediaries in the Transmission of Monetary Policy." American Economic Association, May 1963. The implication referred to and the appropriate regression occur in footnote 12.
1226
THE FEDERAL RESERVE SYSTEM AFTER FIFTY YEARS
evidence and the analysis strongly support the contention of a causal relation
from the money supply to the behavior of economic activity.*
(iii) Two more comments remain to be clarified at this point. Governor
Mitchell finds that I provided no "proof" or "demonstration" for the causal relation under consideration. Such requests can never be satisfied. No empirical
theory can be "proved" or "demonstrated," but we can assess its comparative
performance and thus its measure of confirmation.5
Moreover, footnote 2 of Governor Mitchell's opening statement asserts that I
"nowhere indicate the economic rationale for working in terms of year-over-year
changes." The reader should note that these annual increments of monthly data
exhibited in charts I and II of my written statement were used to discuss the
dependence of the money supply on the extended base. Annual first differences
between corresponding months have desirable statistical properties. They effectively remove multicollinearity between the determinants of the money supply
while remaining sufficiently large relative to the unavoidable chance variations
east up by the process. Furthermore, they partly avoid serious problems associated with potential distortions introduced by many seasonal adjustment procedures. Lastly, annual increments of monthly data usefully describe the relative
shift in the Federal Reserve's policy between corresponding months. These
shifts are sufficiently sharp and thus permit a more decisive evaluation of the
Federal Reserve's policy assessments.
2. The criticism addressed to my alleged championship of an "invariant rule"
occurs in the context of a section which "counsels against the recommendation"
of a definite and constant growth rate of the money supply. I regret that Governor Mitchell seriously misread my testimony.
First, I did not propose a constant or even invariant growth rate of the
money supply. I did propose however the growth rate of the extended base be
stabilized. In particular, I contended that there exists no rationale, founded
on any systematic knowledge that we currently possess, which yields a justification for the wild gyrations in the growth rate of the extended base. Moreover,
no rationale has ever been provided by the Federal Reserve authorities beyond
useless metaphors (leaning against the wind, proceed on an even keel etc.).
Three points were specifically emphasized in my written and oral testimony.
(a) Monetary policy should be designed to remove the unnecessary and harmful gyrations in the growth rate of the money supply which were mostly due to
the Federal Reserve's policy behavior.
(b) In particular, monetary policy should avoid the occurrence of sustained
growth rates in the money supply below 3 percent per annum.
(o) My position was further elaborated in my answers to one of the questions
posed by Congressman Pepper. I indicated that I considered the choice between
a rule on the one side and discretionary management on the other to form an
issue of secondary importance. The dominant and primary issue must be recognized in the misconceptions about the money supply process guiding the Federal
Reserve's policy evaluations. I cannot attach much importance to the choice
discussed by Governor Mitchell under the prevailing circumstances. The primary
problem remains the Federal Reserve's overt preference for basing policy decisions on vague, unsubstantiated, and conflicting notions and justifying them
with the aid of metaphors. Contrary to Governor Mitchell's contention, I neither
advocated an invariant growth rate nor am I very much interested in this issue
at the present stage.
The oral response to Congressman Pepper's question also presented the reason
for my relative disinterest in this problem. I noted that under both regimes
appropriate and validated knowledge about the structure of the monetary process
was required. I doubt that a rule will be very useful if the Federal Reserve
authorities do not know how the money supply process operates. They are still
guided by a conception which leads them to believe that they are "stimulative"
when they are actually deflationary. Under these conditions the imposition of
a rule might very likely yield a situation where the Federal Reserve authorities
would feel justified to assert that the money supply is uncontrollable. The
4
Governor Mitchell does not deny the existence of a causal relation from money supply
to economic activity. This acknowledgement of the causal relation occurs in the context
of his criticisms of my chart I. I fully agree that this chart provides only weak evidence
indeed concerning the causal relation discussed. But where is Governor Mitchell's
evidence?
Or what is his hypothesis explicating the nature of this causal relation?
5
This point was also emphasized in the discussion following my lecture in response to
some question raised.
THE FEDERAL RESERVE SYSTEM AFTER FIFTY YEARS
1227
Federal Reserve would still have to know how to behave in order to manage the
money supply in accordance with the rule. Such knowledge can only be provided by a carefully constructed and validated theory.
A similar argument applies to discretionary management. Judgment must
also be relevant, and this relevance can only be obtained from a validated theory.
Thus before the issue between "rules and discretion" can be fruitfully considered,
the problem of relevant knowledge must be faced by the Federal Reserve authorities. I regret that this question, the fundamental issue, has been avoided
by Governor Mitchell and replaced by an issue I had explicitly assigned a
secondary and derivative position. I venture to assert that this secondary problem will not continue in the presently polarized form, once the Federal Reserve
authorities have acknowledged their responsibility and learned to exploit their
Research Division effectively in order to obtain the systematic knowledge required for their policy decision®.
3. Even with the assignment of a second order relevance to the issue "rules
versus discretion," the argument used by Governor Mitchell to dispose of a
'rigid rule" is worth same examination.
(a) He argues that a policy following the Friedman rule would have led to
a smaller expansion in "credit" (?) since 1961 than actually occurred in subsequent years. Governor Mitchell chose, as it happens, the bottom of a downswing for his base period. It would be easy to select numerous other periods
and obtain the opposite result. The crucial point is that Governor Mitchell
selects an upswing from a total pattern of instability in growth rates of bank
credit and money supply created by the Federal Reserve's policy. Having made
this selection he suggests that Friedman's rule would have been inadequate to
assure the recovery observed.
The choice between rules or discretionary management rationally depends on
our evaluation of the consequences to be expected under the alternative monetary
arrangements. The Federal Reserve's established behavior yields sufficient information to constrain the actual choice available under prevailing circumstances between some rules on the one side and the procyclic movement of the
growth rate in the money supply on the other. Such procyclic movement is
difficult to justify without denying the causal relation from money to economic
activity. These patterns were essentially generated by the inherited behavior
of a well-established organization. It is therefore only reasonable to expect
that an acknowledgment by this organization of the causal relation discussed
previously must be inherently difficult even in the face of mounting evidence.
Among the contributions of a more rationally founded conception of the money
supply process we could expect a radical modification of the substance involved
in a choice between "rules" or "discretionary management." The force of a
coherent and validated conception might alter "discretionary management" so
that it would perform according to some modified rule characterized by some
measure of "built-in" flexibility. Under these new conditions the rules advanced
whether "invariant" or "flexible" would center on the common requirement of
a comparatively stable growth rate in the money supply and specifically remove
the inherited procyclic pattern. It should also be noted in this context that the
differential movements in the exclusive and inclusive money supply so sharply
focused in recent years would become negligible, if the prohibition or regulation
of interest payments to owners of checking and time deposits is terminated.
(&) Governor Mitchell also adduces the nature of our imperfect knowledge,
and particularly the absence of any "demonstrated constancy" in "degree and
timing" of the causal relation as another reason counseling rejection of a "rigid
rule" concerning the growth rate- of the money supply. There is no doubt concerning the imperfect nature of our knowledge, an imperfection extending to "degree
and timing" of the causal relations. But such acknowledgment does not yield
the result suggested by Governor Mitchell. In particular, the deplored uncertainty of our knowledge provides no rationale for "judgment and thought." Such
judgment is no more reliable than the uncertain knowledge used in its support.
Or does Governor Mitchell seriously contend that the gyrations in the growth
rate of the money supply produced under a regime of "judgment and thought"
is better than a growth rate maintained within a narrower range? However,
this suggestion would not be compatible with the admission that there exists a
causal connection leading from monetary processes to economic activity. Such
a causal connection implies that prevailing Federal Reserve policy is essentially
destabilizing.
Moreover, the Federal Reserve authorities convey an impression that they
continuously adjust in policy to evolving circumstances. Such a conception
1228
THE FEDERAL RESERVE SYSTEM AFTER FIFTY YEARS
makes eminent sense if there exists reliable knowledge concerning the structure
of the process operated upon by policy. But Governor Mitchell emphasizes the
highly imperfect nature of our knowledge about the transmission mechanism.
The exercise of fine judgment has thus simply no basis, at least no cognitively
relevant basis. Continuous application of fine judgment can only be rationalized
in a context where the detailed structure of the transmission mechanism is
reliably known. In the absence of such detailed and validated knowledge it
seems doubly important to avoid the gyrations of the money supply observed in
the past. I submit that the stabilization of the growth rate of the money supply
is quite feasible. This feasibility depends on the expectation that our competition is likely to yield an adequate conception of the money supply process in the
near future. This conception will be expressed by a theory sufficiently confirmed
and relevant to provide a rational foundation for policy, and particularly for
comparatively fine and continuous adjustments of policy bearing on the money
supply.
In view of the knowledge situation just described, Governor Mitchell's last
paragraph is somewhat surprising. Arguments in favor of a "rigid rule" are
equated with a "surrender of the intellect and abandonment of the objectives of
scientific inquiry." Moreover, proponents of a rule are described to advocate
employment of the Federal Reserve's vast powers "without thought, judgment,
discretion, and concern for the world as it is."
Little need be said with respect to the emotively appealing but otherwise unsupportable assertion that a rule implies "a surrender of the intellect and abandonment of the objective of scientific inquiry." The short analysis presented
above summarizing my position with respect to the issue "rules versus discretion" indicated the importance of appropriate knowledge under either arrangement. The assertion quoted is strange indeed when we consider that it is made
by a representative of an institution whose policies are not the results of scientific inquiry—at least until March 1964. And with respect to the other objection addressed to proponents of a rule, I wonder what the Federal Reserve's evidence of thoughtlessness, absence of any judgment, discretion, and concern for
the world actually is. Professor Meltzer and I are convinced that the Federal
Reserve authorities are deeply concerned with the world, that they continuously
apply earnest judgment, discretion, and thought. We have no doubts on this
score. But we doubt most emphatically the relevance of this judgment and
thought. In particular, we submit that it is not based on any validated conception of the monetary process. In short, we ask, What is the conception guiding
the Federal Reserve's policy? Where has it been coherently and explicitly formulated, and where has it been stated in a manner conducive to the "objective of
scientific inquiry" and thus in a form permitting systematic appraisal by competitive exposure to observations? And lastly, where and when has it been
actually appraised by more than subjective "personal experience"? Only when
these questions can be successfully answered with clearly formulated statements
and supporting evidence can we intelligently choose between alternative conceptions and provide the foundations for a national policy.
(Whereupon, at 12:20 p.m., the subcommittee was in recess, to
reconvene at 10 a.m., Thursday, March 5,1964.)
THE FEDERAL RESERVE SYSTEM AFTER 50 YEARS
THTJBSDAY, MARCH 5, 1964
HOUSE OF REPRESENTATIVES,
SUBCOMMITTEE ON DOMESTIC F I N A N C E OF THE
COMMITTEE ON BANKING AND CURRENCY,
Washington, D.G.
The subcommittee met, pursuant to recess, at 10 a.m., in room 1301,
Xiongworth House Office Building, Hon. W r i g h t Patman (chairman)
presiding.
Present: Representatives Patman, Reuss, Vanik, Moorhead, Minish,
H a n n a , Kilburn, Widnall, Harvey, Bolton, Brock, and Taft.
The CHAIRMAN. The committee will please come to order.
Today we are going to hear from Secretary Dillon. I had hoped
we would have had the benefit of his comments in January, right after
we heard from Chairman Martin. The Secretary was unable to testify at that time because of the tax bill, and other pressing matters, but
I am glad he is here today.
Secretary Dillon was not scheduled to be our last witness in January,
and he will not be our last witness in March. We want to hear from
as many experts on our Nation's money system as we possibly can, so
that in deciding on the merits of the bills before us, we will have the
benefit of a complete and comprehensive record. So next week we
bave scheduled more economists, including:
Dean George Bach, of Carnegie Tech, who is also a director of the
Pittsburgh Federal Reserve Branch Bank, and Clark Warburton, who
has had many years of experience in pne of the greatest of our banking
institutions, the F D I C , and is one of the most knowledgeable public
servants in the Federal Reserve System.
But today we will hear from Secretary Dillon. Before we do,
however, I would like to take a moment to comment briefly on certain
remarks by Governor Daane yesterday, on the likelihood of abuses
when you combine the monetary and fiscal powers under a single
authority. Governor Daane recounted his experience in Paraguay,
and I think there is a crucial lesson for us to learn from this that goes
to the heart of the issues before the subcommittee regarding our own
need for having our monetary authorities more responsive to the
electorate.
The point is simply that these grave abuses in the State of Paraguay, described by Governor Daane, occurred under one of the toughest little dictatorships ever known in this hemisphere, where the money
managers are not responsible nor accountable to the electorate. There
simply is no electorate.
Xow here in America, by contrast, we do have an electorate. But
:are we really fulfilling the promise of our wonderful free society?
1229
1230
THE FEDERAL RESERVE SYSTEM AFTER FIFTY YEARS
How can this be if those controlling our money supply are not clearly
responsible to the people, if not directly then through their duly elected
representatives ?
I would like the record to show that this episode in Paraguay supports the stand that where there is less political accountability, then
monetary policy is more subject to abuse and the long-run public and
national interests are poorly served. I am sure that more will be said
on this subject as the hearings progress.
Mr. Secretary, we will place in the record at this point your statement, and if you will summarize it over, s&y 10 or 15 minutes, we will
have more time to ask questions, it will be appreciated.
The request is made in view of the fact that we must get through
here by noon. Surely, you do not want to come back if you can
help it. You are a very busy man. We do not want to come back
if we can help it.
We must go to the floor to take u p the interest equalization bill
which has been reported out by the Ways and Means Committee,
which you are interested in, too, of course.
If you will just proceed in your own way, sir, we will appreciate
it very much.
(The complete statement of Secretary Dillon referred to follows:)
STATEMENT OF H O N . DOUGLAS DILLON, SECRETARY OF THE TREASURY
Mr. Chairman, my testimony today will be limited to what I have
experienced during my 3 years as Secretary of the Treasury. T h a t is
the only period in which I have had any close contact with the Federal
Reserve System or with the operations of our commercial banking
system.
FEDERAL RESERVE-TREASURY
COOPERATION
I t is difficult for me to conceive of any closer working relationships
between two coordinate agencies of Government than those that have
characterized the Treasury and the Federal Reserve during the past
3 years. That does not mean that our policy judgments always coincide any more than do, for instance, the policy judgments of the individual (xovernors who sit on the Federal Eeserve Board. But I believe
that each agency has been fully informed at all times on the problems
and policies of the other, and worked closely together in coordinating
their separate actions.
I have always found the officials of the Federal Reserve eager to
learn of our special problems and quick to cooperate within the bounds
set by their own primary responsibility for regulating the supply
of money and bank credit according to their own best appraisal of
prevailing economic circumstances. This common understanding and
cooperation has been of great help to me as the chief fiscal and financial
office of the Government and in my direction of our international
financial relationships.
Cooperation has been reflected in a number of informal relationships that, by their presence through several administrations, are now
a matter of course. Every Monday, for instance, the Chairman of
the Board of Governors visits the Treasury to discuss current issues
and problems with me, and my associates. Every Wednesday, the
Chairman, together with other Governors and members of his staff,
THE FEDERAL RESERVE SYSTEM AFTER FIFTY YEARS
1231
meet at lunch with the Under Secretary for Monetary Affairs and
his associates to discuss matters of mutual interest. More formally,
certain aspects of international policy are cleared through the National
Advisory Council under my chairmanship. These relationships have
been further bolstered by free and continuous exchange of information between the staffs of the Treasury and the Federal Reserve.
I n addition, Presidents Kennedy and Johnson have continued the
practice of meeting from time to time with the top financial officials
of the administration. Chairman Martin has participated fully in
these discussions. He cannot, of course, bind the Federal Reserve to
a decision that is within the province of his Board or of the Open
Market Committee. But he is always willing to convey his own appraisals and judgments to us. These conferences also enable him to
interpret accurately and sympathetically the administration's objectives and policies to his own Board and to the Open Market Committee, so that those groups may have the benefit of this information
in arriving at their own decisions.
This process of close consultation and cooperation cannot be attributed entirely to a happy accident of congenial personalities or to
a fortuitous coincidence of objectives. Its foundation rests solidly
upon the fact that the Federal Reserve is bound by the same broad
objectives, cited in the Employment Act of 1946, that govern the operations of other Government agencies.
FEDERAL RESERVE
INDEPENDENCE
From time to time, suggestions have been made that coordination of
financial policy should be enforced by various devices. Such a proposal is contained in one of the bills before you—H.R. 9631—which
would make the Secretary of the Treasury ex officio Chairman of the
Federal Reserve Board.
This proposal seems to me to raise most important questions of public policy, for inevitably the implication is that the stature of the
Federal Reserve—independent not of the Government, but of the
Treasury—would be, to some degree, diminished.
Demands on the time of any Secretary of the Treasury are already
heavy. Added responsibilities for the formulation and execution
of monetary policy would compete with his responsibilities in other
areas. Delegation of a large portion of these new responsibilities to
his subordinates—and that could hardly be avoided—would in turn
raise further questions about whether the critical and complex issues
of monetary policy were receiving the attention they deserve. I t is
one thing for the Secretary of the Treasury to be continually aware of
the general nature and direction of monetary policy, and to keep in
close touch with the Chairman of the Board of Governors on the issues
that seem most significant—as I now do. I t is quite another to be
responsible for the vast and complex activities of a very intricate
operating organization.
Proposals of this kind also raise the possibility that decisions on
monetary policy, directed toward the overall health of the economy,
will at times, consciously or unconsciously, be biased by the constant
pressures on the Secretary of the Treasury to assure the economical
financing of the dominant borrower in our economy—the Federal
Government itself. This does not mean that the Federal Reserve
1232
THE FEDERAL RESERVE SYSTEM AFTER FIFTY YEARS
should not or does not properly take into account the financing needsof the Federal Government in determining its own policy. These
Treasury -financing operations have important implications for financial markets generally, and in their common pursuit of a vigorous and
healthy economy the Federal Reserve and the Treasury share a common interest in the orderly financing of Government. But occasions
could, of course, arise in which almost any Secretary of the Treasury
would feel a conflict between his immediate interest in insuring a
successful financing and the broader objective of maintaining a supply of money and credit in tune with the needs of the economy as a
whole.
Finally, and perhaps most fundamental to a resolution of this issue,
experience over many years and in many countries has taught t h e
wisdom of shielding those who make decisions on monetary policy
from day-to-day pressures. The day of private central banks operating without regard to Government policy is long since gone, and quite
properly so. But around the world, almost all countries still find it
useful to maintain independence for their central banks within the
Government.
Independence naturally implies the right to disagree; and not only
to disagree, but to act on the basis of different judgments. Some differences between the Treasury and the Federal Reserve may from time?
to time be a fact of life. But this need not be distressing. The necessity to test policy proposals against the views of an independent
Federal Reserve is, I believe, the best insurance we can have that theclaims of financial stability will never be neglected.
I n considering this problem of acheiving a proper balance, I share*
the view of the present Chairman of the Board of Governors that the
Chairman's term of office should be made coterminous, or more nearly
coterminous, with that of the President. With a President free t o
choose a new Chairman upon taking office, or shortly thereafter, there
will be firm institutional basis for expecting that the kind of cooperative relationship that has characterized the past 3 years will continue
in the future, and that the viewpoints and aims of an incoming administration will be sympathetically reflected in the councils of the Federal
Reserve. Two years ago, President Kennedy made precisely such a
proposal to the Congress. I t was valid then and it remains valid t o day. I commend it to your attention.
T H E I N T E R N A L STRUCTURE OF T H E FEDERx\U RESERVE
The bills before you raise a number of other specific issues concerning the internal structure of the Federal Reserve, including the composition of the Board, the usefulness of the Federal Open Market
Committee, arrangements for appropriate audits, and the methods
of covering its necessary expenditures. I will not dwell upon these
issues at length for they raise a number of detailed questions of organization upon which I have no special competence.
I n approaching questions of this kind, however, I do feel strongly
that we should remain mindful of the relevance of one of President
Wilson's remarks at the time the Federal Reserve System was established 50 years ago. He noted then that the sponsors of that legislation
were dealing "with our economic system as it is and as it might be
THE FEDERAL RESERVE SYSTEM AFTER FIFTY YEARS
1233
modified, not as it might be if we had a clean sheet of paper to write
upon."
This Committee is dealing with a living institution—an institution
that has demonstrated its capacity to innovate, to experiment, and to
adapt itself to a very wide range of circumstances. But in this process
of change, it has never lost certain characteristics—an established
tradition of independent judgment; a mixture of regional participation in policymaking with ultimate central control that is unique
in our Government; an ability to attract highly qualified officials and
staff; and a reputation for operating efficiently and impartially.
The structure that has resulted does not fit easily into the framework
of standard tables of organization. Policy responsibility is widely
dispersed and coordination depends in part on informal working relationships built up over the years. Vestigal elements of an earlier conception of private participation in central banking policies—elements
that are more symbolic than real today—are still visible.
But change without clear purpose can be dangerous too. If there
are persuasive reasons for particular proposals—if it can be shown
that ownership of Federal Reserve bank stock by member banks has
biased Federal Reserve policy decisions, or if budgetary or auditing
practices have been loose, to take two examples—by all means, this
committee should act. But I doubt the advisability of taking action
simply for the sake of achieving symmetry with other Government
agencies, particularly if there was danger that such action might impair a long tradition of regional participation and efficient service of
which I believe the country can be proud.
Personally, I would be inclined to the view t h a t if any change is
made in the composition of the Board itself, it might better be made
smaller rather than larger. I would also think that consideration
might usefully be given to some shortening in the present 14-year
term for Board members, as well as to the elimination both of the current special geographical restrictions on Board membership and of indications that members should be representative of particular interests.
I n the same vein, I should also express my firm support for the
efforts now underway to lift the salaries of Board members along
with those of other Government officials. This is the appropriate
path toward reducing the present anomalies—so evident within the
Federal Reserve System itself—that have left Board members with
salaries far below the more competitive rates paid not only in industry
but within the Federal Reserve System itself.
OTHER ISSUES
Three of the bills before your committee—H.R. 9686, H.R. 9687, and
H.R. 9749—raise issues of general financial policy rather than of the
administrative structure and independence of the Federal Reserve
itself.
The first of these, which would require the pavment of interest on
treasury tax and loan accounts, is the most limited in scope. This matter, as you know, has been carefully reviewed at intervals by the
Treasury Department. W e now have underway a new and comprehensive study of the facts both on bnnk earnings that can be attribu
1234
THE FEDERAL RESERVE SYSTEM AFTER FIFTY YEARS
table to these accounts and on bank expenses in handling transactions
of the Government. This study, which I hope will be completed by
July, will shed further light on this matter.
However, in appraising the tax and loan account system, I think it
is vital to keep in mind that these arrangements were basically designed not as a method to reimburse banks for services performed but
to fill a special need in our decentralized financial system, characterized
by a large number of independent banks. These arrangements perform a twofold function. First, the use of tax and loan accounts
avoids abrupt flows of deposits from one section of the country to another, as well as disturbing contractions or expansions in the total
of bank reserves, that would otherwise be an unfortunate byproduct
of the large, day to day cash and borrowing operations of the
Treasury. Second, the tax and loan account system makes it possible
for commercial banks to underwrite and distribute new Treasury
securities—an indispensable element in the smooth market absorption
of many new cash offerings.
I know of no arrangements in foreign countries that have been more
successful in minimizing and cushioning the effects of Treasury operations on the money markets, even though in many of those countries a
highly centralized banking system makes simpler the task of forestalling disturbing flows.
Any effort to seek a precise balancing of costs and earnings that
emerge from the mutual relationships of the Treasury and the banks
that would directly or indirectly impede these basis functions of the
tax and loan account system would be self-defeating.
T would be happy to have Mr. John Carlock, who as Fiscal Assistant Secretary is directly in charge of the Treasury depository arrangements, provide you with a more detailed review of these matters at
your convenience.
Much broader issues of monetary theory and practice are raised by
the proposal of H.R. 9687 that we reverse the Banking Acts of 1938
and 1935 and permit banks to resume payment of interest on demand
deposits. This approach was fully explored by the President's Committee on Financial Institutions. However, the majority of the committee concluded in its report filed last year that the dangers and difficulties posed by such a change, particularly for smaller banks outside of the financial centers, outweighed any potential advantages.
I joined in that majority finding.
The final bill, H.R. 9749, would commit the Federal Eeserve to support the yields of all Government securities at rates no higher than
4!/4 percent. This would, in my judgment, represent a departure
from the principles of flexible and vigorous monetary and credit
policies.
In my judgment, efforts to peg interest rates by governmental decree,
or to hold them below a predetermined level, represent an unrealistic
simplification of what can in fact be done, or properly attempted by
any governmental authority. We want interest rates to be as low as
possible. We want to remove any props that artificially hold rales
above the levels that supply and demand in competitive markets would
produce. We want the influence of Government constructively used,
wherever there is room for choice, on the side of lower rates. But
I think that to make a fixed level of interest rates the sole objective in
any circumstances would prevent the Federal Reserve from doing
THE FEDERAL RESERVE SYSTEM AFTER FIFTY YEARS
1235
most of the other things that we expect it to do—in avoiding inflation, or averting boom-bust cycles, or assisting sustained growth. The
contribution that flexible interest rates and monetary policies can
make to growth without inflation are so great that we must place no
artificial restrictions of this kind on Federal Reserve operations.
Before closing, I would like to suggest to the committee two areas in
which outmoded restrictions in the Federal Reserve Act have clearly
outlived any usefulness they might once have had, and today unnecessarily constrict the flexibility with which the Federal Reserve
can discharge its domestic and international responsibilities.
The first of these areas concerns the archaic requirements defining
the paper eligible for securing advances to member banks.
A t the present time, as you know, the Federal Reserve can freely
lend to member banks at the prevailing discount rate only on the basis
of Government securities or commercial paper meeting certain rigid
legal requirements in its maturity, purpose, and "self-liquidating"
character. I n recent years, a much larger proposition of the Government security holdings of many banks has been needed to secure
public deposits or for other purposes that effectively forestall their use
in borrowing from the Federal Reserve. The supply of other paper
meeting the technical eligibility requirements of the Federal Reserve
Act has also declined as the character of bank lending has changed
over the decades, and in any event the use of this paper for borrowing would require awkward and cumbersome procedures by both
commercial banks and the Federal Reserve.
The necessity for banks to maintain assets that meet these restrictive
eligibility requirements in a volume adequate to provide a reasonable
margin over foreseeable needs could become an impediment in the
flexible distribution of bank credit among competing uses. Moreover,
shortages of eligible paper could potentially affect the ability of the
Federal Reserve to make credit promptly available at reasonable terms
to its members when required. Unless these eligibility requirements
are relaxed, the time could come that the flow of credit from banks to
consumers, homebuyers, and businesses requiring medium-term credit
would be unnaturally constrained. Doubts might unnecessarily arise
over the ability of the Federal Reserve to relieve any sudden pressures
effectively and expeditiously. I urge that you give your early attention to removing this anachronism from law.
A somewhat parallel rigidity in the law is beginning to affect the
ability of the Federal Reserve to meet its growing responsibilities in
the international financial area. The Federal Reserve banks, as they
acquire foreign currencies, can place these funds abroad only in bank
deposits or in commercial paper of limited classes and restricted availability. F o r years, these restrictions were of no practical import, in
view of the limited amount of foreign currencies held by the System.
But, the Federal Reserve is now resuming operations in a variety of
foreign currencies on a larger scale and participating widely in the
network of reciprocal currency agreements and other arrangements
that have emerged from the increasing cooperation among monetary
authorities in recent years. Consequently, the need for greater flexibility is apparent.
By permitting the foreign currencies acquired to be held in a wider
variety of safe and liquid money market instruments—including, in
particular, foreign treasury bills—the Congress would be taking an
1236
THE FEDERAL RESERVE SYSTEM AFTER FIFTY YEARS
important new step to further strengthen the international monetary
system and the position of the dollar.
Clearly, perfection cannot be claimed for either the Federal Reserve
Act, which became law more than 50 years ago, or the Federal Reserve
System as it has evolved within the framework of that law. As in the
past, the effective adaptation of the Federal Reserve to the needs of
today and tomorrow will require that the Congress be willing to
search out and eliminate faults and anachronisms that hamper effective performance. But, I would also urge this committee, in undertaking that necessary task, to protect and preserve those elements in
the structure of the Federal Reserve that underlie its special strength
and stature at the center of our banking system.
STATEMENT OF HON. DOUGLAS DILLON, SECRETARY OF THE
TREASURY
Secretary DILLON. I will be glad to, Mr. Chairman.
I wanted to open my statement by saying that my testimony is based
on my experience as Secretary of the Treasury only, in the last 3
years, because prior to that time I had had no close contact with the
Federal Reserve System or with commercial banking practices in any
detail. My previous experience had been in the investment banking
business, which is something quite different.
I n my statement I point out, in the opening parts of it, that in the
3 years that I have been in the Treasury the cooperation and understanding between the Treasury and the Federal Reserve have been very
close.
This does not mean necessarily, that our ideas coincide at every
moment, but we have always fully informed each other of what
policies there are and the differences have not been at all major. I n
fact, there have probably been stronger differences within the Federal
Reserve System, between individuals, than may be between the Treasury and the Federal Reserve as a whole.
The Federal Reserve, during this 3-year period, has always been
attentive to Treasury policies and needs and to the desires of the
administration.
This cooperation was carried out by regular weekly meetings that I
have had every Monday with the Chairman of the Board of Governors
and my staff, headed by the Under Secretary for Monetary Affairs,
who goes over to the Federal Reserve one other day every week, and
they meet together and talk in considerable detail.
I n addition, both Presidents Kennedy and Johnson have met with
top financial officials of the administration, including the Chairman
of the Federal Reserve Board, from time to time, and this has afforded
yerj useful opportunities for the President to make his views known
and to elicit the thinking of the Chairman.
While the Chairman cannot bind the Board, because the actions of
the Board are by majority vote—as are also the actions of the Open
Market Committee—certainly it has been very useful to have him
informed closely on administration policy, and I am sure he has
carried that back and given it to the Open Market Committee and the
Board and it has been reflected in their actions.
I think that the main reason for this is that, as we see it, the Federal Reserve is bound, just as much as we are, by the broad objectives
of the Employment Act of 1946.
THE FEDERAL RESERVE SYSTEM AFTER FIFTY YEARS
1237
Now we come to the more specific things, which is the question of
^"independence" and particularly the bill, H.R. 9631, which would
make the Secretary of the Treasury the ex officio Chairman of the
Federal Reserve Board.
This proposal seems to me to raise very serious questions of public
policy, for inevitably the implication is that the stature of the Federal
Reserve, independent not of the Government but of the Treasury,
would be to some degree diminished.
Also, demands on my time are already very heavy and if I had, in
addition, the responsibility for both the formulation and the execution
of monetary policy it would be impossible for me to carry these
responsibilities out without fairly extensive delegation, and I do not
"know whether that would be proper, to turn the complex and critical
problems of monetary policy over to subordinates.
I t is one thing for me to be continually aware, as Secretary of the
Treasury, of the general nature and direction of monetary policy and
t o keep in close touch with the Chairman of the Board of Governors,
as I now do.
I t would be quite another thing for me to be responsible for the vast
a n d complex activities of a very intricate operating organization.
Also, I think there is the very real possibility that, in making
decisions on monetary policy, the Secretary of the Treasury would
a t times, consciously or unconsciously, be biased by the constant pressures upon him to assure the most economical financing of the Federal
Government.
The Federal Reserve pays attention to this, of course, but they fit
it into their own policy. I t is as important to them as it is to us that
*our financing operations are successful. But if the control of both
financing and overall monetary policies rested in one person, I think
there would undoubtedly be times when any Secretary would have
a feeling of conflict between his immediate interest in insuring a successful financing and the broader objectives of monetary policy.
Finally, and perhaps most fundamental to a resolution of this
issue, experience over many years and in many countries has taught
the wisdom of shielding those who make decisions on monetary policy
from day-to-day pressures. The day of private central banks operating without regard to Government policy is long since gone, and
quite properly so. B u t around the world, almost all countries still
find it useful to maintain independence for their central banks within
the government.
Independence naturally implies the right to disagree; and not only
to disagree, but to act on the basis of different judgments. Some
differences between the Treasury and the Federal Reserve may from
time to time be a fact of life. But this need not be distressing.
The necessity to test policy proposals against the views of an independent Federal Reserve is, I believe, the best insurance we can have
that the claims of financial stability will never be neglected.
I n considering this problem of achieving a proper balance, however,
I think improvements can be made, and I share the view of the present
Chairman of the Board of Governors that the Chairman's term of
office should be made coterminous, or more nearly coterminous, with
that of the President. W i t h a President free to choose a new Chairman upon taking office, or shortly thereafter, there will be firm institutional basis f orexpecting that the kind of cooperative relationship
1238
THE FEDERAL RESERVE SYSTEM AFTER FIFTY YEARS
that has characterized the past 3 years will continue in the future,
and that the viewpoints and aims of an incoming administration will
be sympathetically reflected in the councils of the Federal Reserve.
Two years ago, President Kennedy made precisely such a proposal
to the Congress. I t was valid then and it remains valid today. I
commend it to your attention.
The other bills before you raise specific issues concerning the internal structure of the Federal Reserve, including the composition
of the Board, the usefulness of the Federal Open Market Committee,
arrangements for appropriate audits, and the methods of covering
its necessary expenditures. I will not dwell upon these issues at
length for they raise a number of detailed questions of organization
upon which I have no special competence.
However, I do think that we should bear in mind, in dealing with
this, that this is a living institution that has demonstrated its capacity
to innovate and to change, and which has maintained an established
tradition of independent judgment, a mixture of regional participation
and policymaking, with the ultimate central control here in Washington, which is unique in our Government, and it has shown an ability
to attract highly qualified officials and staff and has had the reputation
for operating impartially and efficiently.
So I think, in making changes, the burden of proof is more or less
on those who wish to make this change to show that something worthwhile will be accomplished.
Policy responsibility is widely dispersed and coordination depends
in part on informal working relationships built up over the years.
Vestigal elements of an earlier conception of private participation in
central banking policies—elements that are more symbolic than real
today—are still visible.
As I said, a change without clear purpose can be dangerous too.
If there are persuasive reasons for particular proposals—if it can
be shown that ownership of Federal Reserve bank stock by member
banks has biased Federal Reserve policy decisions, or if budgetary
or auditing practices have been loose, to take two examples—by all
means, this committee should act. But I doubt the advisability of
taking action simply for the sake of achieving symmetry with other
Government agencies, particularly if there was danger that such
action might impair a long tradition of regional participation and
efficient service of which I believe the country can be proud.
Personally, I would be inclined to the view that if any change is
made in the composition of the board itself, it might better be made
smaller rather than larger. I would also think that consideration
might usefully be given to some shortenings in the present 14-year
term for board members, as well as to the restrictions on board membership and of indications that members should be representative of
particular interests.
This is because I think you might get higher and more able people,
and these restrictions may somewhat inhibit the search for such
people.
I n the same vein, I should also express my firm support for the
efforts now underway to lift the salaries of Board members along with
those of other Government officials. This is the appropriate path
toward reducing the present anomalies—so evident within the Federal Reserve System itself—that have left Board members with sal
THE FEDERAL RESERVE SYSTEM AFTER FIFTY YEARS
1239
aries far below the more competitive rates paid not only in industry
but within the Federal Reserve System itself.
I noted, in passing, that on the list that was made public the other
day there were 14 employees of the Federal Reserve Board in Washington listed there with salaries that are higher than either the Chairman or the members of the Board, and there are probably many more,
because this stopped at the level some $2,000 above the salary paid
1~ne TiOJirrl TnPTYihpr^
Three of the bills before your committee—H.R. 9686, H.R. 9687,
and H.R. 9749—raise issues of general financial policy rather than
of the administrative structure and independence of the Federal
Reserve itself.
The first of these, which would require the payment of interest on
Treasury tax and loan accounts, is the most limited in scope. This
matter, as you know, has been carefully reviewed at intervals by the
Treasury Department. A t the suggestion of Senator Douglas, we
now have underway a new and comprehensive study of the facts both
on bank earnings that can be attributable to these accounts and on
bank expenses in handling transactions of the Government. This
study, which I hope will be completed by July, will shed further
light on this matter.
However, in appraising the tax and loan account system, I think
it is vital to keep in mind that these arrangements were basically
designed not as a method to reimburse banks for services performed
but to fill a special need in our decentralized financial system, characterized by a large number of independent banks. These arrangements perform a twofold function.
First, the use of tax and loan accounts avoids abrupt flows of
deposits from one section of the country to another, as well as disturbing contractions or expansions in the total of bank reserves, that
would otherwise be an unfortunate byproduct of the large, day-to-day
cash and borrowing operations of the Treasury. Second, the tax
and loan account system makes it possible for commercial banks to
underwrite and distribute new Treasury securities—an indispensable
element in the smooth market absorption of many new cash offerings.
I know of no arrangements in foreign countries that have been
more successful in minimizing and cushioning the effects of Treasury
operations on the money markets, even though in many of those countries a highly centralized banking system makes simpler the task of
forestalling disturbing flows.
Any effort to seek a precise balancing of costs and earnings that
emerge from the mutual relationships of the Treasury and the banks
that would directly or indirectly impede these basic functions of the
tax and loan account system would be self-defeating.
Now, Mr. Chairman, if you desire, later in your hearings, to go
into this in greater detail, I would be happy to have Mr. John Carlock,
our fiscal Assistant Secretary who is directly in charge of the Treasury
depository arrangements, provide you with a more detailed review of
these maters at your convenience.
Much broader issues of monetary theory and practice are raised by
the proposal of H.R. 9687 that we reverse the Banking Acts of 1933
and 1935 and permit banks to resume payment of interest on demand
deposits. This approach was fully explored by the President's Committee on Financial Institutions.
28-680—64—vol. 2
21
1240
THE FEDERAL RESERVE SYSTEM AFTER FIFTY YEARS
However, the majority of the Committee concluded in its report
filed last year that the dangers and difficulties posed by such a change,
particularly for smaller banks outside of the financial centers, outweighed any potential advantages. I joined in that majority finding.
The final bill, H.R. 9749, would commit the Federal Reserve to support the yields of all Government securities at rates no higher than 4^/2
percent. This would in my judgment represent a departure from the
principles of flexible and vigorous monetary and credit policies.
I n my judgment, efforts to peg interest rates by governmental decree,
or to hold them below a predetermined level, represent an unrealistic
simplification of what can in fact be done, or properly attempted by
any governmental authority. We want interest rates to be as low as
possible. We want to remove any props that artificially hold rates
above the levels that supply and demand in competitive markets would
produce.
We want the influence of Government constructively used, wherever
there is room for choice, on the side of lower rates. But I think that
to make a fixed level of interest rates the sole objective in any circumstances would prevent the Federal Reserve from doing most of the
other things that we expect it to do—in avoiding inflation, or averting
boom-bust cycles, or assisting sustained growth.
The contribution that flexible interest rates and monetary policies
can make to growth without inflation are so great that we must place
no artificial restrictions of this kind on Federal Reserve operations.
Finally, I would like to suggest to the committee two areas in which
outmoded restrictions in the Federal Reserve Act have clearly outlived
any usefulness they might once have had, and today unnecessarily constrict the flexibility with which the Federal Reserve can discharge its
domestic and international responsibilities.
The first of these areas concerns the archaic requirements defining
the paper eligible for securing advances to member banks.
A t the present time, as you know, the Federal Reserve can freely
lend to member banks at the prevailing discoimt rate only on the basis
of Government securities or commercial paper meeting certain rigid
legal requirements in its maturity, purpose, and "self-liquidating"
character. I n recent years, a much larger proportion of the Government security holdings of many banks has been needed to secure public
deposits or for other purposes that effectively forestall their use in
borrowing from the Federal Reserve.
The supply of other paper meeting the technical eligibility requirements of the Federal Reserve Act has also declined as the character
of bank lending has changed over the decades, and in any event the
use of this paper for borrowing would require awkward and cumbersome procedures by both commercial banks and the Federal Reserve.
The necessity for banks to maintain assets that meet these restrictive
"eligibility" requirements in a volume adequate to provide a reasonable margin over foreseeable needs could become an impediment in the
flexible distribution of bank credit among competing uses. Moreover,
shortages of eligible paper could potentially affect the ability of the
Federal Reserve to make credit promptly available at reasonable terms
to its members when required. Unless these eligibility requirements
are relaxed, the time could come that the flow of credit from banks to
consumers, homebuyers, and businesses requiring medium-term credit
THE FEDERAL RESERVE SYSTEM AFTER FIFTY YEARS
1241
would be unnaturally constrained. Doubts might unnecessarily arise
over the ability of the Federal Reserve to relieve any sudden pressures
effectively and expeditiously. I urge that you give your early attention to removing this anachronism from law.
A somewhat parallel rigidity in the law is beginning to affect the
ability of the Federal Reserve to meet its growing responsibilities in
the international financial area. The Federal Reserve banks, as they
acquire foreign currencies, can place these funds abroad only in bank
deposits or in commercial paper of limited classes and restricted
availability.
For years, these restrictions were of no practical import, in view of
the limited amount of foreign currencies held by the System. But,
the Federal Reserve is now resuming operations in a variety of foreign
currencies on a larger scale and participating widely in the network
of reciprocal currency agreements and other arrangements that have
•emerged from the increasing cooperation among monetary authorities
in recent years. Consequently, the need for greater flexibility is
apparent.
By permitting the foreign currencies acquired to be held in a wider
variety of safe and liquid money market instruments—including, in
particular, foreign Treasury bills—the Congress would be taking an
important new step to further strengthen the international monetary
system and the position of the dollar.
Finally, I just want to say that perfection cannot be claimed for
either the Federal Reserve Act, which became law more than 50 years
ago, or the Federal Reserve System as it has evolved within the framework of that law. As in the past, the effective adaptation of the Federal Reserve to the needs of today and tomorrow will require that
the Congress be willing to search out and eliminate faults and anachronisms that hamper effective performance. But, I would also
urge this committee, in undertaking that necessary task, to protect and
preserve those elements in the structure of the Federal Reserve that
underlie its special strength and stature at the center of our banking
system.
Thank you.
The CHAIRMAN. Thank you, Mr. Dillon. Mr. Reuss ?
Mr. REUSS. Thank you, Mr. Chairman.
Mr. Secretary, in your paper this morning, you referred to our balance-of-payments problems which, as you know, has been a longtime
interest of mine.
I have noticed in the press in recent weeks that you have indicated
your concern that European countries, by unnecessarily increasing
their own domestic interest rate structure, could embarrass our balanceof-payments picture by affecting U.S. capital movements.
I want to congratulate you for speaking out on that subject. I
think that is very much in the public interest.
Despite what you said, I know that some of the countries did raise
their interest rates. However, at least in the case of the United Kingdom my understanding is that the Bank of England is now purchasing Treasury bills, which are particularly the instrument that is bought
by Americans and others who might want to get out of dollars and get
into pound sterling. Because of that, I gather that the effects of the
interest rate increase in the United Kingdom are not likely to be
1242
THE FEDERAL RESERVE SYSTEM AFTER FIFTY YEARS
very heavily felt on our balance of payments and our short-term capital outflow. I s that too optimistic a view ?
Secretary DILLON. N O , we would hope not.
We had the opportunity to discuss this thoroughly with the British
and make available to them our views on the dangers of an interest
rate structure that would disturb the international monetary system by
drawing funds out of the United States, and I think they full agreed
with that.
Indeed, in the announcement of the Bank of England, when they
raised this discount rate, they said it was not intended to draw foreign
funds into the United Kingdom and, through a variety of means, they
can certainly minimize those movements and I think you have pointed
to one of them.
The fact remains that the week after that change the covered cost
of investment in Treasury bills still favors the United States over
London by a very small fraction.
Before this change it favored our market by about one quarter of
1 percent or slightly more, and now it is practically level except for
a slight three or four basis points, or five basis points, in favor of
New York.
But there is no pull the other way, and I think that is the general
objective, to try and maintain that sort of situation.
If they can maintain that sort of a situation then I do not think
there will be any real problem.
Mr. EEUSS. And by not presenting any real problem I take it, and
I hope that you mean there will be no movement here to raise our own
interest rates ?
Secretary DILLON. Yes. That is what I stated in the statement
which the Treasury made on this action of the Bank of England, that
there was nothing to change our present policies in that respect.
Mr. EEUSS. Yes. As I say, I think you all did an excellent job on
that.
Turning to another aspect of our balance of payments, the EuroDollar market and particularly the European banks which now hold
large numbers of dollars. Would it not be a good thing for this
country and for our balance of payments if those foreign banks would
use, their Euro-Dollar resources to a much greater extent than they
now do, to make loans to U.S. corporations and other borrowers? By
so using their dollars, they would prevent them from falling into the
hands of the central bank which can demand gold for them.
They might also be induced to acquire additional dollars and sell
francs or marks or whatever they have for that purpose.
I t would serve the further purpose of tending to keep interest rates
in this country somewhat lower than they would be without this additional supply of capital.
I t is not, therefore, altogether a good thing for this country wThen
foreign banks make dollar loans within the United States?
Secretary DILLON. Well, certainly, one of the chief benefits of the
Euro-Dollar system is that it has made funds available at lower interest rates than might otherwise be the case. That market operates
on a very small margin—a smaller margin than our own banks have
been used to operating on.
To the extent that our own companies could borrow in that market
cheaper than they could borrow m New York or elsewhere in the
United States, I would agree with you. I think it would be very fine.
THE FEDERAL RESERVE SYSTEM AFTER FIFTY YEARS
Mr.
RELTSS.
1243
Particularly for the balance of payments ?
Secretary DILLON. Yes.
Mr. RETJSS. I understand that London Euro-Dollar brokers, who
constitute a fairly large proportion of the total, need to obtain permission from the Bank of England before they may operate in the United
States. Is that your understanding, too ?
Secretary DILLON. I am not aware of that, but it may well be so. I
can answer that for the record.
Mr. RETJSS. I would appreciate your doing that.
If it turns out to be so, would it not be a good idea to make a remonstrance to
Secretary DILLON (interrupting). I will be glad to look into that.
Mr. REUSS (continuing). To some of the people in the Bank of
England'(
Secretary DILLON. I will be glad to look into that.
Mr. REUSS. That is, to see if they could not open that up a little
bit more?
(The information referred to follows:)
The information available to us here, which we have informally confirmed
with the Bank of England, indicates that that Bank does not require lenders of
Euro-dollars in London to obtain permission from it before making loans to U.S.
concerns. In fact, when Euro-dollar interest rates are sufficiently attractive,
U.S. concerns here, and their subsidiaries abroad, do avail themselves of the
facilities of the Euro-dollar market. They may do this both directly and through
American banks which hold Euro-dollar deposits of their branches. The Eurodollar market does, therefore, now exert an influence on U.S. rates and the availability of capital from this source competes with U.S. sources of capital. It must
be remembered, however, that the United States is also a lender in the Euro-dollar
market and this market can, therefore, both attract and supply capital in competition with U.S. sources.
Mr. REUSS. The final question I have concerns the negotiations now
going on looking toward the development of a more effective international monetary system, which negotiations stem from the decisions
taken at the International Monetary Fund meeting in Washington in
last October.
I am not asking you to say in public the exact status of these negotiations, but I would ask you this: Is there a United States position
which we are now putting forward ?
Secretary DILLON. There is a general United States position that has
been established by consultation within the administration. Whether
we have fully put it forward in the group yet, I am not certain because
conversations have been exploratory in nature within the group up to
this date. I think that that exploratory stage has now about been
finished.
I think probably at the next meeting they will really get down to
cases on what they are going to recommend, and at that time, most
certainly, our basic position will be available and will be put forward.
Mr. REUSS. I certainly would like to communicate to you again, as
I have before, my sense of urgency about this because I think so many
of our interest rate problems, so many of our balance-of-payments
problems, stem from the fact that here in a world in which capital
among the free nations happily can move freely from country to country, we have allowed this pleasant situation to construct what individual countries can do about dealing wTith unemployment and inadequate growth. So3 I cannot think of a more important item.
1244
THE FEDERAL RESERVE SYSTEM AFTER FIFTY YEARS
I recognize the delicacy of negotiations when you have 10 or more
countries that you are sitting down with. However, the Congress will
ultimately have to approve whatever is arrived at.
I would like to ask you this: I n accordance with the Vandenberg
formula, by being in on the takeoff as well as the landing, would it be
possible for you to communicate in private, if you prefer, to such
members of this committee as are interested, and the chairman
Secretary DILLON. I think the
Mr. REUSS (continuing). What the United States position is?
Secretary DILLON. I think we could certainly do that in confidence,
as you say.
How successful we will be in accomplishing our objectives, I do not
know. The program that was set forth originally was to t r y to have
a report by the deputies—who are working on this problem and who
have been working very hard on it ever since last fall—in proper form
for the ministers to meet on, and either to agree on or to agree on in
part for their governments, by some time in the early summer. I
think, when we get into the position of coming up to that firm agreement, it would be very appropriate and proper for us to consult with
the appropriate committees, including this one.
So far as the more immediate and preliminary United States position is concerned, I do not think there is any reason why we could not
have confidential discussions on a limited basis, but it is very important
obviously, from a negotiating point of view, to keep those confidential..
Mr. REUSS. Of course, and I very much approve the course you
are taking. My time is about to expire, but in these negotiations it is
my view, at least, that we ought to put forth a wholehearted United
States position which will, as far as we are concerned, do the job that
needs to be done; if we cannot get any votes for it, well, that is too bad,
but I do not think w^e should
Secretary DILLON. Well
Mr. REUSS (continuing). Aim at the lowest common denominator
right at the start.
Secretary DILLON. Well that, of course, raises a basic question—
whether it is best to aim at perfection and to get nothing or whether
it is best, knowing what you want is perfection, to be willing to accept
something less than that, but which is a substantial improvement in
the system. There have been very few- times in history—maybe
Bretton Woods, right after the war, which is the only time that 1
know of—when there was a really major sort of change in the system.
Otherwise, international payments mechanisms have tended, I think,
rather naturally because of the many countries involved, to evolve
rather gradually. I think we want a favorable outcome. I think it
will be through a sort of evolution that we will get definite progress
in the system and that, at this time, we will not reach a totally new and
perfect system.
Mr. REUSS. Well, I w^ould leave with you my hope that we will at
least aim for a whole loaf, and if we have to settle for a half a loaf,
take the half a loaf.
I would hope, however, that we would not aim for a half a loaf
and have to take an eighth of a loaf. Thank you, Mr. Chairman.
The CHAIRMAN. Mr. Widnall ?
Mr. WIDNALL. Thank you, Mr. Chairman.
THE FEDERAL RESERVE SYSTEM AFTER FIFTY YEARS
1245
Mr. Secretary, I have listened very carefully to your testimony.
Now, am I correct in understanding that none of the bills, pending
before the committee right now, that we are considering are administration proposals?
Secretary DILLON. That is correct. I think the Bureau of the
Budget stated that they had no position, no administration position,
on any of these bills.
Mr. WIDNALL. I am very pleased
Secretary DILLON. I think the only one that would be an administration position—and it is a carryover from the previous Congress—
is the recommendation of President Kennedy providing for appointment of the Chairman of the Federal Reserve Board coterminous with
the President.
I understood that yesterday
Mr. WIDNALL. That is not before us at this time, Mr. Secretary.
Secretary DILLON. N O ; it is not before you at this time. I t was
introduced by Mr. Spence in the last Congress. I t has never been
introduced in this Congress.
Mr. WIDNALL. And, incidentally, as you pointed out in your own
testimony, Mr. Martin, the Chairman of the Board, said he agreed to
the coterminous feature.
Secretary DILLON. Yes; he supports that, including the provision
for a vacancy to occur on the Federal Reserve Board with each presidential election; so the coterminous feature would not be limited to
the President choosing among the particular members of the Board,
but would also give him the right to appoint a new member.
There has been a bill introduced in this session of the Congress
which carries out only half of that. I t was introduced by Mr. Multer,
and allows the President to choose among the current members of the
Board. But that was not President Kennedy's proposal, which went
beyond that.
Mr. WIDNALL. Mr. Secretary, I think it has been fine for the record
to have your statement displaying the fine cooperation and coordination of effort that has taken place between the Federal Reserve and
the President of the United States and the Secretary of the Treasury.
I t seems to me that constantly through the hearings there has been
the thread of a charge that everything is done in secret and the President of the United States has no knowledge of what is going on and
the public has no knowledge of what is going on, the administration
had no knowledge of what is going on, and that that is a little oligarchy that is doing everything just the way they want to do it.
Now, on the contrary, as I understand your views, you say that there
has been a continuous flow of information back and forth and the
seeking of information on the p a r t of all involved that has worked out
very well during the past years?
Secretary DILLON. Yes. We have these weekly meetings, as I say,
as well as continual staff contacts; I meet with the chairman on Monday, which, it just so happens, is always the day before a meeting of
the Open Market Committee, so he can discuss with me, and he does
discuss with me, the problems that he thinks will come before that
meeting the next day.
And then we are informed of the general tenor of what happened at
the Open Market Committee immediately after it is finished.
1246
THE FEDERAL RESERVE SYSTEM AFTER FIFTY YEARS
Mr. WIDNALL. During the course of Mr. Daane's testimony yesterday he stated:
I have seen at first band in otber countries the dangers involved in downgrading or subordinating monetary policy.
I t was after that statement that he mentioned Paraguay as an
instance that he thought of off-hand which he admitted himself might
be a little bit in the extreme, but I wondered if you might have any
illustrations in connection with that that would be helpful to the
committee or if you felt that you could submit some information
later
Secretary DILLON. I think I had rather try to submit some.
I t is generally now accepted that central banks should operate with
a considerable measure of autonomy. That is the case in Great Britain.
I t is even more so in Germany, where the central bank has at least as
much autonomy as the Federal Reserve System here.
I t is the case in Italy. I t is the case, to a somewhat less extent, in
France. And so it seems to be a generally accepted practice in the
world, but I would like to take a look and see if there are good cases
that can be made to show that a lack of autonomy resulted in central
banks being utilized strictly to help finance the government, and that
inflation has resulted.
Of course, we have had that sort of thing in past history much
more. I think generally the world has come to the point where it is
now recognized that stability and the fight against inflation is very
important, and that is the reason for this independence within a government.
Now, I do not say that central banks should be independent of the
Government, and I feel very strongly that they should not be, and are
not. I know that the Federal Reserve considers itself part of the
Government. I t was created by Congress. The members of the Board
are Government officials.
And they are bound by the laws of the country, by the Employment
Act, and so forth.
So I do not think that there is room for a central bank outside of
the Government, as was originally the case in our early history with
the Bank of the United States when we had a private central bank—
totally private. I think we have passed way beyond that. Such things
do not exist in any leading country any more, and I do not think they
should here.
(The following statement was supplied for the record:)
War periods in most countries have illustrated the predominance of considerations of government finance over considerations of monetary and price stability
in the determination of central bank policies. Central banking systems, under
war conditions when governments have been unable to raise the revenues needed,
have often provided for government requirements through expanded note issue,
the creation of deposit liabilities for the government, or an expansion of bank
reserves. This monetary expansion occassioned by fiscal requirements has
sometimes also entailed the expansion of credit to the private economy with the
result of an added pressure on prices. In this sense we have had an undue
monetary expansion in the United States related to the exigencies of Government
finance and the consequent central bank accommodation of the Government, and
there have been similar experiences with the European governments.
Perhaps more significant are instances when, under peacetime conditions,
governments have put pressure on central banks to finance government deficits,
with a consequent undue increase in the supply of money and inflationary repercussions. The classic example is Germany. Inflation in Germany began in
THE FEDERAL RESERVE SYSTEM AFTER FIFTY YEARS
1247
3914, as a result of war financing, continued throughout World War I, and then
accelerated, especially from 1921 on, as a result both of fiscal policy and the
expansionary monetary policy of the Reichsbank. At the height of the inflation,
the 12-month period, from July 1922 through June 1923, domestic prices rose
approximately 18,000 percent. At the same time, and as an explanation of
the phenomenal rise in prices, money in circulation rose almost 9,000 percent,
mostly attributable to an increase of 7,000 percent in the floating debt. During
this same period, budgetary expenditures exceeded receipts by approximately
2,800 million gold marks, and the Reichsbank continued to discount an everincreasing volume of Treasury bills. Six successive increases in the discount
rate—from 6 to 18 percent—were not sufficient to offset the inflationary consequences of these purchases of Government debt, as the Reichsbank went through
the forms of monetary restaint but not the substance.
There are also more recent European cases; for example, France and Greece
in the period following the Second World War. The method of financing the
heavy state expenditures during the years immediately following the war contributed greatly to inflationary pressures in France, and made it difficult for the
Bank of France to control the course of inflation. In 1952, for example, when
the Government budget amounted to nearly 35 percent of the national income,
41 percent of the total increase in the money supply was created by direct
advances to the Government by the Bank of France and the acquisition of Government securities by the central bank and the commercial banks.
In the postwar period up to 1953 the Bank of Greece expanded the note
issue to meet the demands of the Government to finance its budgetary deficit.
The note issue increased from 104 billion drachmas at the end of 1945 to a high
point of 2,971 billion drachmas. In this period loans from the Bank of Greece
to the Government increased from 85 billion drachmas to 8,766 billion drachmas.
Along with the expansion of credit to the Government there was an expansion
of credit to private entities to bring the total note issue in September 1953 to
6,401 billion drachmas and the total loans of the Bank of Greece to 12,244 billion
drachmas. Symptomatic of increased prices was the fall in the external value of
the drachma from 502 to the dollar to 30,100 drachmas to the dollar.
There are a number of illustrations in Latin America. Government and central bank relationships in Paraguay in 1950 were discussed in Governor's Daane's
testimony on March 4, 1964. That experience predated the present Government. In Brazil, the Government's cash deficit has grown annually until in
recent years it has amounted to half of revenue receipts, and this deficit has been
covered in substantial part through currency issued by a Government board
through the Bank of Brazil, which is not a central bank with independent powers
of control. Within the existing arrangements it has been practically impossible
to control either public or private credit, with the result that the inflation in
Brazil was 50 percent in 1962 and 80 percent in 1963.
Earlier postwar experience in Argentina, similarly illustrates the danger of
excessive Government borrowing from the central bank, which had been made
an instrument of the Finance Ministry. Between 1945 and 1955, there was a
deficit each year and the cumulative deficit came to 35 billion pesos, of which
20 billion pesos were financed by bank credits. Total bank credits increased
;from 12 to 89 billion pesos and cash in the hands of the public from 8 to 52
billion pesos. In this period of time the cost of living increased more than 500
percent.
In September 1960, the new government in Ecuador initiated an extremely
expansionary policy. Within 9 months central bank credit increased 50 percent, with the bulk of the increase occasioned by lending to the Government.
This resulted in the only major price increase in 10 years. The central bank
lost most of its foreign exchange reserve and there was a massive flight of
capital from the country. In November of 1961, a new government permitted
the central bank to undertake the necessary credit measures and after a time
price stability was achieved and public confidence revived.
The New Zealand Central Bank was originally established as an independent
central bank in 1933. In 1936 the bank's functions were redefined to place more
emphasis on assistance to government financing, and beginning in 1938, the bank
began to make large direct advances to the government to finance government
deficit expenditures. The rise in these advances was paralleled by an outflow of
private capital, necessitating the establishment of the tight import and exchange
controls. Since the bank was made responsible to the Minster of Finance in
1939, its legal status has not been changed. In practice, however, there has
been a gradual increase in the bank's use of a flexible monetary policy.
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THE FEDERAL RESERVE SYSTEM AFTER FIFTY YEARS
The examples, which have been cited, do not emerge uniformly from differences
in the formal legal status of central banks. Monetary policy, whatever the
precise institutional framework, should be and, in greater or lesser degree has
been, responsive to national goals and policies of various countries. However,
most governments have, in practice, concluded that a degree of independence
for the central bank can contribute to developing and strengthening national
attitudes and traditions regarding the importance of monetary stability. This
practice and tradition in the United States is formally reflected in the legal
framework of the Federal Reserve System.
Mr. WIDNALL. I think the members of the committee appreciate
your constructive suggestion with respect to eliminating what you
call the archaic requirements defining paper eligible for securing advances to member banks.
I believe a similar suggestion had been made earlier in the testimony by others who have testified.
Secretary DILLON. That bill was submitted by the Federal Eeserve
last August and my statement here can be taken as administration support for the general principles in that request.
Mr. WIDNALL. That is all at this time, Mr. Secretary.
The CHAIRMAN. Yes. Mr. Vanik?
Mr. V A N I K . Mr. Secretary, carrying through with the question that
Mr. Widnall had directed to you, concerning the reaction of the
Bureau of the Budget, would you say that the position of the Bureau
of the Budget was in opposition to this legislation or would you say
that it is a position of indifference ?
Secretary DILLON. I would say it is neither. I t is simply that
there has not been developed a detailed administration position on any
of these bills. This requires a long and fairly detailed procedure on
complicated matters of this kind in which they seek the views of all
of the interested agencies and then try to work out a unified position.
They just have not had the time to do that, and they have not really
been asked to do that. So, therefore, they have just stated the plain
fact that they have no position.
I did submit my statement to the Bureau of the Budget, and they
did clear it, but I do not think that should or was meant to indicate the
position I took on these individual things necessarily would be a final
position if they were asked to develop one. But they found no objection to those positions.
Mr. V A N I K . Then we may expect that the administration position
will be forthcoming?
Secretary DILLON. If we are asked. If we are asked.
If I understand that the committee wants that, I will try to get it.
Mr. V A N I K . Well, I want it. I do not have the authority to demand
your position, I suppose that would be up to the committee, but I
would like to have it.
Secretary DILLON. I should think it is up to the committee.
Mr. V A N I K . I would like to be guided by the administration position, and I would like to know what the arguments are pro and con.
Now, in your concept of the Federal Eeserve Board you reaffirm
its independent status.
As an administrative agency it makes a private appraisal of facts,
as I understand it, and then makes decisions; which have a far-reaching effect upon the economy of the Nation.
Now, what concerns me is the system under which the facts are
privately gathered and assessed and in which enormous decisions are
secretely arrived at.
THE FEDERAL RESERVE SYSTEM AFTER FIFTY YEARS
1249
I wonder if we have not approached the point where the gathering
and the assessment of the facts by the Fed should not be made more
of a public matter and that its decisions should not be determined
by clear-cut guidelines or criteria which should be developed by regulations in the administrative process, so that Congress, the administration, and so that your office and the public could test from time
to time the validity of these guidelines as well as their objectivity.
Secretary DILLON". Well, I think the basic guidelines are laid down
by the Employment Act
Mr. V A N I K . I am talking about the Fed now, before they are motivated into an alteration of the rediscount rates. Shouldn't this kind
of a decision result from a process which dictates action when certain
conditions are reached. We can test these conditions, so that it just
is not an arbitrary thing. Decisions should emerge by rule of law
or an established regulatory process which indicates that when certain conditions are met a certain action will result by the Fed, so that
there is less discretion and more certainty in its action and when it
will come?
Secretary DILLON. I think there are two problems there, Mr. Vanik.
One is that it is very hard to foresee every particular time when
some action, either up or down, should be taken with respect to the
discount rate, for instance, or in open market policy. I think it is
essential to have full freedom and flexibility of operations and not
be hampered in that by any rigid guidelines.
The other problem, which is a market problem, is that any system
which would give advance—clear-cut advance—information that action was likely to be taken on such and such a date would cause very
substantial perturbations in the market. This is not the case now
because the market can react only after action is taken.
Mr. V A N I K . D O you not agree, Mr. Secretary, that most of the
people know just about what is going to happen ?
Tliere seem to be people in the trade who know the fluctuations of
the economy and can almost anticipate to the hour when action will
be taken by the Fed. Only those not familiar with its history and its
processes are caught by surprise.
I would say that within the trade and in the finance circles the movements of the Fed, and almost all of its actions, are almost pretty well
anticipated.
Secretary DILLON. I am not sure of that. I think there are times
when you are quite right, but not always.
I think many of those in the banking business, particularly in the
commercial banking business in New York, have felt for some time
t h a t there was a clear case from their point of view for a more restrictive policy on the part of the Fed, and the Fed hasn't seen it that way
and has operated the other way.
So I do not think they have foreseen the policy of the Fed very
successfully.
Mr. V A N I K . Let me ask you: Suppose there was a situation which
would arise in which you would violently disagree with some action
that the Fed was taking or was about to take. W h a t would you do
a/bout it?
Secretary DILLON. Well, under the present law, if they feel they
want to go ahead, there is nothing to be done.
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THE FEDERAL RESERVE SYSTEM AFTER FIFTY YEARS
I think the only way of assuring that that would not happen is to
insure that you have a Chairman of the Federal Reserve Board who
is sympathetic to the aims of the administration and does work with
that administration.
And I think that the bill making the term of the Chairman coterminous and giving a new President the right to appoint a new member
of the Board who could be Chairman either immediately or shortly
after—and by "shortly" I mean within a matter of 2 or 3 months after
his inauguration—would greatly lessen the possibility of anything like
that happening.
If such a thing happened nevertheless, of course there is always a
chance that the Secretary of the Treasury might be the one that was
wrong.
Mr. V A N I K . Well, is that Chairman enough ? He just has one voteSecretary DILLON. That is right, but he has a strong influence, and
I think that all the members of the Board do feel—and I have talked
to some of them, not all of them because I do not personally work intimately with the whole Board—that it is very important for the monetary authority to work with and not against the basic policies of the
administration in office, whatever that administration may be.
And I think, in a way, that the actions of the Federal Reserve System in these last 3 years, as compared to its actions in the years before,
are partly a reflection of that.
Mr. V A N I K . Well, it seems to have a capacity to blend or to accommodate the administration.
Secretary DILLON. That is right.
Mr. V A N I K . That seems to be one of its characteristics.
Secretary DILLON. Whichever administration may be in
Mr. V A N I K . But can you conceive of a situation where the Fed may
take some very, very tremendous action and the barn would burn down,
and we would be pretty powerless to do anything about it except to try
to correct it on the next go-around ?
Secretary DILLON. I t is theoretically possible, yes.
Mr. V A N I K . Supposing Congress passed a law, requiring the Federal Reserve Board to support Government securities at prices so that
no yield would go above 4 ^ percent, and we would also, in the same
legislation, require banks to hold a reserve at a fixed percentage of
demand deposits.
The reserve would consist of variable proportions of cash and Government securities.
Would this stabilize the price of the Government securities at a
decent interest rate without contributing to inflation or without impeding the power of the Fed to control inflation or the ups and downs
in the economy ?
Secretary DILLON. Well, I think most of the time the Fed certainly
could operate adequately within such a limit, and it would not be in
effect. There would not have to be any stabilization because that is a
reasonably elevated rate of interest ove
@FedFRASER