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THIRD MEETING ON THE CONDUCT OF
MONETARY POLICY
HEARINGS
BEFORE THE
COMMITTEE ON
BANKING, HOUSING, A.ND URBAN AFFAIRS
UNITED STATES SENA'fE
NINETY-FIFTH CONGRESS
SECOND SESSION
ON
OVERSIGHT ON THE CONDUCT OF l\IONE'I'ARY POLICY
PURSUANT TO PUBLIC LAW 95---188
NOVEMBER 15 AND 16, 1978
Printed for the use of the Committee on Banking,
Housing, and l'rban Affairs
U.S. GOVERNMENT PRINTING OFFICE
36--066 0
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Federal Reserve Bank of St. Louis
WASHINGTON : 1978
COMMITTEE ON BANKING, HOUSING, AND URBAN .A.FFAIRS
WILLIAM PROXMIRE, Wisconsin, Chairman
JOHN SPARKMAN, Alabama
EDWARD W. BROOKE, Massachusetts
HARRISON A. WILLIAMS, JR., New Jersey JOHN TOWER, Texas
THOMAS J. McINTYRE, New Hampshire
JAKE GARN, Utah
ALAN CRANSTON, California
H. JOHN HEINZ III, Pennsylvania
ADLAI E. STEVENSON, Illinois
RICHARD G. LUGAR, Indiana
ROBERT MORGAN, North Carolina
HARRISON SCHMITT, New Mexico
DONALD W. RIEGLE, JR., Michigan
PAULS. SARBANES, Maryland
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Federal Reserve Bank of St. Louis
KENNETH A. MCLEAN, Staff Dwector
JEREMIAH
BUCKLEY, Minority Staff Director
STEVEN M. ROBERTS, Chief Economist
s.
(II)
CONTENTS
LIST
OF
WITNESSES
WEDNESDAY, NOVEMBER
15
Paire
Phillip D. Cagan, Columbia University, Department of Economics ______ _
Leif Olsen, chairman, Economic Policy Committee, Citibank ___________ _
George Perry, senior fellow, The Brookings Institution ________________ _
Albert T. Sommers, senior vice president and chief economist, The Conference Board __________________________________________________ _
THURSDAY, NOVEMBER
3
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G. William Miller, Chairman, Board of Governors, Federal Reserve
System__________________________________________________________
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ADDITIONAL STATEMENTS AND DATA SUPPLIED FOR THE RECORD
"Flexible Exchange Rates and Macroeconomic Performance: The United
States Since 1973," paper by Rudiger Dornbusch, Massachusetts Institute of Technology_______________________________________________
National City Bank of Minneapolis, "U.S. Economic Outlook and Policy,"
article written by Walter W. Heller and George L. Perry_____________
Newsweek, article "Money Watchers Beware," by Milton Friedman_____
The Conference Board:
"A Collision of Ethics and Economics," article by Albert T. Sommers__
"The Balanced Federal Budget: An Orthodoxy in Trouble," article
by Albert T. Sommers_______________________________________
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TABLES, CHARTS, AND EXHIBITS SUPPLIIilD FOR THE RECORD
Budget position, growth and inflation, 5-year averages_________________
Budget position, 9-year moving averages_____________________________
Budget surplus or deficit as a percent of gross national product, selected
countries_______________________________________________________
Charts t.o accompany testimony of G. William Miller, Chairman, Board
of Governors of the Federal Reserve System:
Real GNP____________________________________________________
Components of final sales_______________________________________
Income and consumption_______________________________________
Saving rate___________________________________________________
Private housing starts__________________________________________
Homes sold___________________________________________________
Deposit growth at thrift institutions_____________________________
Outstanding commitments at savings and loan associations__________
Nonresidential fixed investment_________________________________
Nonresidential construction_____________________________________
Producer's durable equipment___________________________________
Ave~age l!-Ilnual g:owth of the capital stock_______________________
Busmess mventor1es_ _ _ _ _ __ __ __ ____ ____ __ __ __ __ __ __ __ __ __ __ __ __
Real government purchases of goods and services__________________
Federal unified budget deficit___________________________________
Civilian labor force and employment_____________________________
Unemployment rate ____ --------------------------------------Unit cost indicators, nonfarm business sector_____________________
GNP price indexes_____________________________________________
U.S. merchandise trade balance_________________________________
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Federal Reserve Bank of St. Louis
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IV
TABLES, CHARTS, AND EXHIBITS SUPPLIED FOR THE RECORD-Con.
Charts to accompany testimony of G. William Miller, Chairman, Board
of Governors of the Federal Reserve System-Continued
Trade-weighted average exchange value of U.S. dollar against 10
major currencies _______________________ ----------____________
Funds raised by nonfinancial sectors_____________________________
Short- and long-term interest rates______________________________
Short-term interest rates and inflation____________________________
Household borrowing ___ --------------------------------------Mortgage rate and inflation_____________________________________
Total automobile credit________________________________________
Index of GNP and money_stock M 1______________________________
Money supply indexes-M 1_____________________________________
Recently established M1 growth ranges and actual M1-------------Recently established M 2 growth ranges and actual M 2______________
Recently established M 3 growth ranges and actual M 3______________
Money stock M1 and Mi+--------------------------------------Real GNP (percent change from previous quarter, annual rate)_____
Unemployment rate (percent)___________________________________
GNP prices (percent change from previous quarter), annual rate_____
Business capital spending for pollution abatement_________________
Business capital spending for health and safety____________________
Index of real GNP and money stock Mi+------------------------Money stock-Mi+ growth rates--~-----------------------------Composition of total Federal outlay__________________________________
Consumer installment credit________________________________________
Corporate debt and its relationship to GNP__________________________
Deteriorating tendency of budget deficits to be self-correcting____________
Distribution of Federal purchases of goods and services_________________
Expenditure velocity and the commercial paper rate___________________
Federal budget surplus or deficit_____________________________________
Federal purchases of goods and structures as a percent of gross national
product________________________________________________________
Gross Federal debt and its relationships to gross national product_________
Gross Federal debt in current and constant dollars_____________________
Inflows into thrift institutions_______________________________________
Interest rates_____________________________________________________
Output and expenditures of the Government sector____________________
Percent changes at annual rates for selected economic indicators, 1978--79__
Percentage distribution of total debt_________________________________
Personal debt and its relationship to GNP _________ ~-----------------Projections of the Federal budget____________________________________
Real money supply and growth_____________________________________
Saving-investment balance__________________________________________
Share of goods and structures in total Federal outlay___________________
State and local debt and its relationship to GNP______________________
The money supply_________________________________________________
Three levels of good prices__________________________________________
Three views of the budget position___________________________________
Total gross debt and its relationship to GNP_________________________
Total gross public debt_____________________________________________
Total private debt and its relationship to GNP________________________
Unit money supply_-----------------------------------------------
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THIRD MEETING ON THE CONDUCT OF MONETARY
POLICY
WEDNESDAY, NOVEMBER 15, 1978
U.S.SENATE,
CoMMITTEE ON BANKING, HousING, AND URBAN .AFFAms,
W (U/hington, D.O.
The committee met at 10 a.m. in room 5302, Dirksen Senate Office
Building, Senator William Proxmire, chairman of the committee,
presiding.
Present: Senators Proxmire, Garn, Lugar, and Schmitt.
OPENING STATEMENT OF CHAIRMAN PROXMIRE
The CHAIRMAN. The committee will come to order.
Today we begin 2 days of hearings on the conduct of monetary
policy. These hearings come at a very difficult time for our economy.
Many economists are now forecasting that we will have a recession
in 1979. At the same time, inflation is our No. 1 economic problem.
Tomorrow we have the Chairman of the Federal Reserve Board testifying. We wanted to get outstanding independent experts-you
gentlemen represent that-to give us your views so that we would
have a framework for questioning the Chairman of the Federal Reserve Board on what his policies are.
Monetary policy has become increasingly tighter as the year has
progressed, with interest rates now at levels 40 percent or more above
what they were at the beginning of the year.
On November 1 the Federal Reserve increased the discount rate
from 8½ to 9½ percent, a dramatic and unprecedented rise. Mortgage
rates have risen to levels that press legal ceilings in an increasing
number of States. The prime rate has been raised to 11 percent at
some large banks. High interest rates and slower economic growth in
1979 may lead to difficult times for the housing market and increased
unemployment.
Now in recent days the actions of the Federal Reserve Board have
seemed more mixed. This morning's papers, for instance, report that
the Federal Reserve Board pumped some reserves into the banking
system yesterday, heightening speculation that the monetary authorities are not pushing interest rates quite as high as many thought
earlier this month. The action kept the Federal funds rate below 10
percent and certainly if we have learned anything in the years we
have been observin_g this we have learned that a 1-day action doesn't
indicate a long-range policy. Nevertheless, yesterday's actions may be
significant and they do indicate that Fed policies are not as singlemmded or decisive or clear-cut in attackin_g inflation as some had expected.
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(1)
2
We certainly want to get into what our monetary policies are and
what they ought to be this morning. But also we ought to consider
how we can best evaluate those policies. M 1 has a diffe'rent status
now than it had a short time ago. Also, in a breakthrough in congressional oversight of monetary policies we persuaded the Fed a couple
of years ago to report to us quarterly on their monetary performance.
That's the reason we're here this morning. We anchored much of that
report to the Fed's goals for M 1-the narrowly defined money supply.
Because M1 consists of currency and demand deposits and because
demand deposits are likely to decline perhaps very sharply owing to
the new permission to commercial banks to transfer funds automatically from savings accounts to checking accounts M1 has a different
context now and it's hard to evaluate what a decline in M 1 may mean
i£ we get that decline as we did a couple weeks ago.
In addition, we have another serious problem, this relating to the
potency of monetary policy. In the past we have been aware that monetary policy worked principally through a prompt and decisive reaction by the bellwether housing industry to a credit crunch. In 1967,
for instance, a Fed study showed that 70 percent of the economic restraint :following the credit crunch was suffered by the housing industry. Without the housing reaction the restraint would have been very
limited indeed.
But now we have protected savings institutions from an abrupt loss
of deposit inflows that are needed :for mortgage credit and the result
is that the industry may be able to continue at a relatively high rate of
housing production in spite of credit restraint and a high level of
interest rates and the restraint necessary to slow the rest of the economy may be much more severe and interest rates far higher.
We would be very interested in any comments you may have on this
new situation, what it means for our monetary authorities, and what
it means for congressional economic and housing policy generally.
We are fortunate to have with us today a group o:f distinguished
economists with widely varied backgrounds: Prof. Phillip Cagan of
Columbia University and the National Bureau o:f Economic Research;
Mr. Lei:f Olsen, chairman, economic policy committee o:f Citibank;
Dr. George Perry of the Brookings Institution; and Mr. Albert Sommers, senior vice president and chief economist of the Conference
Board.
You gentlemen are eminent economists. We are honored by your
presence. As I'm sure you appreciate, this is an interim recess period
for the Senate. Elections were just held a week ago and most Senators
are out of town. Senator Schmitt I understand is going to be here a
little later this morning, but we are delighted to have you and the
record that you make is going to be extremly important in our
questioning of Mr. Miller and in our understanding of monetary policy
and, of course, in the influence that we can have on the Fed's monetary
policy.
So with that, Professor Cagan, whv rlon't yon begin and then we will
go right down the line in order before we begin the questioning. I
would appreciate it if you could confine your remarks to about 10
minutes if that's possible and your :full statement will be printed in the
record.
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STATEMENT OF PHILLIP CAGAN, PROFESSOR OF ECONOMICS,
COLUMBIA UNIVERSITY
Mr. CAGAN. I welcome the opportunity this morning to discuss with
this committee the effect of new financial developments on the conduct
of monetary policy.
[ Complete statement follows:]
THE EROSION OF MONETARY CONTROLS AND THE CONDUOT OF MONETARY POLICY
INTRODUCTION
Monetary policy is used to stabilize aggregate output and the price level It is
the most flexible policy instrument we have for this purpose, and stabilization is
its main function. There is general agreement that we are highly dependent upon
its effective use for the achievement of our major macroeconomic goals. Monetary policy involves the control of the money supply and is primarily the responsibility of the Federal Reserve. There have always been difficulties and
problems in pursuing an effective monetary policy, both in terms of determining
policy targets and of implementing them. In the past several years the means of
implementation have been affected by financial developments which are providing a growing quantity of transactions balances not subject to direct control
by the Federal Reserve, and it has become essential that we prevent this erosion
of monetary policy. The monetary controls of the Federal Reserve have not been
substantially changed since its foundinig in 1913. It is not surprising tha.t after
65 years certain changes are needed.
My remarks will first discuss the monetary controls we have and the justification for them, and second the changes that I see as necessary to prevent their
erosion and to improve their operation. At a time when the nation is struggling
to control and subdue a persistent inflation, it is imperative that we maintain
our major means of controlling aggregate spending in top working condition.
My recommendations, summarized in the concludipg section, are in line with
Senate bill 3485 introduced earlier this year by Senator Proxmire. I propose that
we go further, however, in reforming reserve requirements. Current proposals
to stem the loss of membership in the Federal Reserve System are much too limited to deal adequately with the erosion of monetary controls that is presently
underway.
THE JUSTIFICATION FOR MONETARY CONTROLS
As participants in the national economy, all of us benefit when aggregate
spending and the flow of payments follow a steady path consistent with the
potential full-employment growth of aggregate output. Major variations in aggregate spending are disruptive to a full and efficient use of our resources and
to the restoration and preservation of price stability. The main objective of
monetary policy, in cooperation with government fiscal policies, is to achieve
,the level of aggregate spending consistent with national goals and to keep the
economy moving steadily along the desired growth path. This requires the capability of controlling the supply of the means of payment, traditionally designated
the money supply but also referred to here as currency plus transactions balances
and close substitutes.
As individuals we all want to have the maximum flexibility to determine the
goods and services we purchase and to vary our total expenditures over time.
For this purpose we want, as the occasion arises, to borrow and lend and to
allow our holdings of money balances to absorb changes in our rate of payments
which do not match our incoming receipts. This desired flexibility on an individual level can be in conflict with stability of the natonal economy. While
aggregate stability can be maintained so long as considerable variations over
time in spending by individual units offset one another, business cycln: and increased inflationary pressures can be an indication that the preponderance of
changes in individual spending decisions arc bunching together and not offsetting. We accept the need for monetary actions to counteract major deviations
in aggregate spending from a stable growth path, despite the resulting pressures
on us to alter our individual spending and borrowing decisions.
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When institutional developments in the financial system undermine our monetary controls, it is well accepted that the controls can and should be changed to
maintain their effectiveness. In the monetary area the pursuit of the public interest has always been recognized as justifying some limitation, insofar as it is
judged beneficial, on the private interests of individual financial institutions.
We have now reached a time when such changes are needed.
THE TOOLS OF MONETARY STABILIZATION POLICIES
In our free economy we do not control individual spending decisions directly.
To do so would require controls on individuals of a kind that are undesirable
and probably unworkable. Monetary controls are an accepted indirect means of
influencing aggregate spending. Through variations in the rate of growth of
the money supply, monetary policy is able to influence the volume of borrowing
in financial markets and the decisions of individual businesses and households on
how much to spend or save.
A desired increase in aggregate expenditures in the private economy is financed
by increased borrowing and a willingness to reduce holdings of money balances
in relation to the volume of transactions. The increased demand for credit tends
to raise the cost of borrowing (interest rates) if monetary growth does not
increase, and raises interest rates even more if the Federal Reserve reduces
monetary growth. Although higher interest rates discourage some originally
planned increases in borrowing, they also draw forth an increased volume of
lending. Insofar as the increased lending is supplied through greater household
saving und reduced consumption, there is a shift in the composition of spending
in the economy but no increase in the total. Insofar as the increased lending
occurs through funds supplied by money creation or a willingness of lenders to
reduce their money balances, however, aggregate spending increases. Thus increases in aggregate spending can be traced ultimately to corresponding increases
in monetary growth and to a willingness to reduce holdings of money balances.
The willingness to reduce holdings of money balances does not mean that the
total quantity of money outstanding is reduced; rather, the existing quantity
is redistributed from the initial holders who reduce their balances to those who
want to spend more and from them to the recipients of the increased spending
who, because their sales and incomes are thus higher, also spend more. The process is sometimes referred to as an increase in the "velocity of circulation of
money", whereby a given quantity of money is used to transact a higher volume
of expenditures. The same is true, in reverse, for decreases in aggregate spending.
Well-timed changes in monetary growth produced by monetary policy can in
principle offset changes in aggregate spending which reflect the public's willingness to increase or reduce its holdings of money balances. In practice, however,
such offsets are virtually impossible to time well, because of lags in the effect of
monetary policy actions and of the difficulty of forecasting accurately and setting
the correct policy in motion ahead of time. This has long been recognized ; despite
appreciable improvements in forecasting capabilities, the Federal Reserve is a
long way from being able to act effectively to prevent fluctuations in aggregate
spending. Further improvements in monetary policy are possible. In addition, it
is important to help monetary policy with institutional reforms which work to
contain the short-run, difficult-to-offset effects on aggregate spending of the
public's willingness to vary its holdings of money balances.
There is, of course, no way to prevent people from increasing or reducing their
money holdings, with consequent changes in aggregate spending. But most of the
large fluctuations in aggregate spending are associated with changes in the aggregate volume of borrowing and corresponding changes in interest rates. Changes
in interest rates induce changes in the volume of bank lending (in part through
changes in the quantity of money) and changes in lending by households and
businesses largely via banks and other financial intermediaries as a result of
changes in the public's willingness to vary its holdings of money balances. The
magnitude of this response depends upon how readily the financial system can
supply assets which the public can substitute conveniently for part of its money
balances. The more inconvenient or difficult the substitution, the less readily will
attempted changes in aggregate borrowing and spending be financed.
An unmet increase in the demand to borrow funds raises interest rates and
elicits an increase in the supply of funds. But the increase in interest rates indicates that the supply is not forth coming to the extent demanded and the higher
rates price the least insistent borrowers out of the market. In this way a bunching
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Federal Reserve Bank of St. Louis
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of desired increases in borrowing at the same time is counteracted, and the desired spending increase is spread out over a longer period, thus smoothing the
fluctuations in aggregate spending and utilization of resources.
The role of changes in intere&t rates in monetary policy is sometimes mistakenly deplored. Barring changes in the demand for credit and aggregate spending which the economy cannot satisfy at current levels of prices and incomes,
policy can pursue a path of steady monetary growth, and interest rates will
remain fairly steady. But when aggregate borrowing and spending fluctuate
widely and exert pressures on interest rates, the rate should be allowed to rise
(to hold down an excess) or to fall (to reduce a deficiency) in the demand for
credit. For monetary policy to attempt to hold interest rates constant in the
face of fluctuations in aggregate demand requires changes in the supply of money
which would reinforce the fluctuations in spending. The changes in interest rates
transmit a signal through financial markets that the demand for credit is out of
line with the initial supply. Adjustments are needed to equalize demand and
supply consistent with as little fluctuation in aggregate spending as is possible.
Of course, interest rates might tend to change for other reasons which are
inconsistent with economic stability; it is the task of monetary policy to assess
the underlying situation and act accordingly to keep aggregate spending on a
stable growth path.
Changes in interest rates are therefore often a reflection, and seldom the cause,
of instability in the economy. However disruptive changes in interest rates may
be to financial markets and certain sectors of the economy, attempts to stabilize
the rates will only intensify instability in the rest of the economy. Xevertheless,
if monetary policy is effectiYe in promoting stable economic growth, it can remove
the underlying causes for many of the large fluctuations in interest rates.
It is unfortunately the case that, even with large changes in interest rates,
monetary policy is unable to offset completely the short-run destabilizing changes
in bank credit and in the public's willingness to hold money balance. Xew developments in the financial system will make the task of monetary policy considerably
more difficult.
FINANCIAL DEVELOPMENTS AND THE EFFECTIVENESS OF MONETARY CONTROLS
What are these developments and why do they make monetary policy more
difficult? A variety of balances which can be used to conduct transactions or
otherwise serve as very good substitutes for demand deposits have been developed
and are growing in quantity and importance. These comprise savings deposits at
banks and thrift institutions which holders can transfer directly to third parties,
and accounts at these institutions as well as money market mutual funds which
can be transferred into checking accounts by telephone, automatic overdrafts, and
repurchase agreements. Savings deposits of commercial banks can be automatically transferred into checking accounts as needed beginning November 1st,
according to a new ruling of the Federal Reserve. The coming use of an electronic
transfer system will enhance these developments though not fundamentally
change them.
The advantage to the public of these substitute arrangements is that they pay
interest and can be held in lieu of demand deposits for handling transactions,
because they can be transferred to third parties by check or can be indirectly
transferred by first briefly passing through a demand deposit on which checks are
written. The advantage to issuers is their attractiveness to the public and the
lower or zero reserve requirements. So far repurchase agreements appear to be
the most important in quantity of these new developments, but all have the potentiality of considerable growth. We are at the threshold of a radical transformation
of the payments system.
It is important to emphasize that it is not so much the permanent substitution
of these financial innovations for demand deposits that creates a problem for
monetary policy. Indeed, so long as the total quantity of these balances maintains
a reasonably predictable relationship to the volume of spending that can be undertaken with them, monetary policy can proceed to stabilize aggregate spending as
usual by producing variations in the demand deposit component of the total. The
Federal Reserve could control the total of such balances by operating to control
demand deposits as it does now. This assumes, however, that changes in demand
deposits will not be completely offset by shifts by the public between them and
other transactions balances. While the Federal Reserve could in principle change
demand deposits by sufficient magnitude to produce the targeted change in the
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Federal Reserve Bank of St. Louis
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total of transactions balances and allow for any substitutions that occurred as a
result of the operation, the magnitude of offsetting operations would, given
increases in substitutability, lrnve to be commensurately larger. This can create
problems, and is discussed further below.
The more serious problem for policy is that tile supply of these new transactions balances and substitutes is highly elastic to the demand for them and can
expand and contract readily to reinforce fluctuations in aggregate spending.
Shifts between demand deposits and other transactions lJalances will increase
the magnitude of short-run cyclical changes in aggregate spending. In addition,
such shifts will lJe very difficult for monetary policy to monitor and offset, because
the extent to which these new transactions balances are used for transactions and
thus influence aggregate expenditures differs from that of the demand deposits
they substitute for and will vary over time as competitiYe pressures evolve. We
must remember that these balances are now held for a variety of purposes. (My
proposal below is designed to reduce the behavioral differences between demand
deposits and other transactions balances.) Even if we had current measures of
the total quantity of such balances (which at present we do not), the information
,vould not tell us what the influence on aggregate expenditures is or will be and
therefore what is the effectiYe size of countermeasures that policy should undertake to offset them.
Consider what happens, for example, when the demand for credit begins to rise
to finance a bunching of desired increases in spending in the economy. Interest
rates will begin to rise also. Households and businesses induced to lend more at
the higher rates and those wanting to spend more will find it convenient to do so
by exchanging their demand deposits for interest-bearing transactions balances
or by spending their demand deposits and relying on other transactions balances
they already hold to handle their transactiom; needs. The financial institutions
which supply the transactions balances in exchange for demiand deposits will be
able to lend the demand deposits to others. In this way the existing quantity of
demand deposits can finance an increased volume of lending and spending. The
quantity of the new transactions balances and substitutes can expand to satisfy
the public's desire to hold more, because they require little or no backing in the
form of currencJ' or reserve balances controlled by the Federal Reserve. Even
though the Federal Reserve can control the quantity of demand deposits through
the quantity of reserves. it has no comparalJle control over the quantity of the
new transactions balances and sulistitutes.
One should not make the mistake of supposing that the issuers of these new
transactions balances can expand the quantity entirely at their own initiath-e,
any more than an individual commercial bank can expand its demand deposits.
An institution which lends transactions Jmlances to lJorrowers finds that the loan
is quickly spent by the borrowers, and the withdrawal of the balances must be
covered with federal funds through the clearing mechanism. Since without excess
reserves the withdra,Yal cannot be covered, the institution is dependent upon
access to federal funds or a deposit of funds to supply a transactions balance.
Institutions can and do take the initiath-e. of course, in attracting such deposits.
The deposited funds are then lent, because little or no resen-e is held behind the
new account. The public thus sets in motion yariations in the supply of transactions lJalances and sulJstitutes through shifts between them and demand deposits
which intensify the instability of aggregate spendng.
Two decades ago in the Hl50's economists lJecame concerned over the possible
erosion of monetary controls resulting from growth in financial intermediaries
which issued highly lir1uid, low-risk substitutes for bank deposits. The major
substitutes then were savings shares of sadngs and loan associatious and commercial paper issued hy corporations. In a study of those develo11ments published
in Hl75, Anna ,I. Schwartz and I concluded that, while such substitutes had led
to a secular decline in holdings of demand devosits relative to aggregate expenditures, the short-run variations in holdings had not increased and had not impaired
the conduct of monetary policy. ("Has the Growth of :\Ioney Substitutes Hindered
l\Ionetary Policy'/", Journal of l\Ioney, Credit, and Banking, May 1975.) Those
developments did not involve the growth of assets that could be directly transferred to third parties. Recent developments do, and for that reason I believe
that they are, uulike previous developments. a serious impairment of monetary
policy. There is already evidence that desired holdings of demand deposits hav~
lieen appreciably redne<'d by the availability of these new transactions balances.
Because of their cnvahility of effecting third-party payments, they are a supply
of money that, if lllll'Dl11ToJlpd, can seriously impair the short-run conduct of
monetary policy.
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NEEDED CONTROL OF NEW TRANSACTIONS BALANCES AND SUBSTITUTES
The reason why the public is ir:.duced to shift from demand deposits to substitute financial assets when interest rates rise is that interest is prohibited on
dPmand deposits and the differential return varies. If banks could pay interest
on demand deposits and Yaried the payment in lir:.e with changes in interest paid
on competitiye financial instruments, inducements for the public to shift between
demand deposits and other assets owing to changes in ir..terest rates would disappear. For this rPason repeal of the prohibition of interest on demand deposits
is widely recommended. Part of the financial deyelopments which are eroding
monetary effectiveness can be traced to the grndual response of the financial system to the competitive pressures to circumvent this prohibition. Those developments have accelerated as interest rates lrnYe risen to higher and higher average
levels.
Although it is desirable to rescind this prohibition and thm; to remove the
financial innovatiorn, to circnmvent it, it is importar:.t to recognize that it would
mitigate but not solve the problem of the declining effectiveness of monetary
policy in the short and long run. In the short run, it is unlikely that bar:.ks would
yary the interest paid on demand deposits as rapidly as interest rates Yaried on
many competitive assets, particularly money market mntual funds and repurchase
ag-reements. Consequently, incentives to shift between demand deposits and substitutes would continue to fluctuate oYer time. Even over the long run, interest
on demand deposits could r:.ever match interest paid on other transactions
balances that have lower or no reserve requirements. Given this difference in
noninterest-earning reserves, demand deposits are more expensive to provide
than other transactions balar:.ces. Banks could vary the interest on demand
deposits by only a fraction of any changes in interPst rates on finaneial assetK
For this rl'ason, payml'nt of interPst by the Federal Reserve on bank reserves
mig-ht be desirable for eqnity, !mt the problem is not solvl'd unless the interPst
paid equals the market rate. (The proposals made here do not require interest on
reserves.) J\foreovl'r, given their competitive disadvantage, dl'mand depmdts
wonld continue to decline rPlative to the total qtiantity of transactions balances.
As the fraction of demand deposits in the total became small, stabilization of the
growth of the total would require mor:.etary policy to produce large percentage
changes in demand deposits to offset small percpntag-e changes in the other components. The ability of commercial hanks to respond quickly to Federal Reserve
policy actions to expand or contract total demand deposits by a large percentage
would he limited. It is not clPar what the consequences of operatir..g monetary
policy under surh conditions would be, but it is certain to be less advantageous
and probably quite difficult.
The obvious and necessary solution to this problem is to subject all transactions
balances and substitutes to the same requirement of reserve balances at the Federal Reserve. The result would he to tie the r111tstanding- quantity of those assets
which most closely influence the aggregate volum,! of sr,ending to the quanity of
reserve halancPs over which the Federal Rf'sene has immediate control. This
would apply to the large and growing quantity of nonmember bank demand
deposits which do not require reserves in the form of balances at Federal
Reserve Banks. Nonmember reserve requirements are g-enerally lower than those
for member hanks and are held in other forms ovE'r which thf' Federal Reserve
has much less control. ·with universal reserve r!'qnirements, shifts between one
kind of transactions balance and another wonld not affect the total outstanding.
This would tighten the relationship hetwerm aggregate expenditures and the
outstanding quantity of total transactions halances. Monetary policy ,vm always
be a far from perfect means of stabilizing- the economy. But the more nl'arly the
total quantity of transactions balances and rnbstitutes were controlled by monetary policy, certainly the more effective that policy could he and the lf'SS likely
would it he for wide deviations to occur in the volume of expenditures from
policy targets.
A requirement of ten percent on all transactions balances :md close ~uhstitutes
would be reasonable and equitable among all issuing institutions and would
maintain the effectiveness of monetary 11olicy. Transitional disruptions due
to any change in total required reserves can he smoothed by open market
operations. Changes in the percentage over time are not needed for policy
purr,oses.
Although it is necessary to apply reserve reqnirf'ments to all assets which are
largely used as transactions balances or closely substitute for them, broader
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coverage would be undesirable. For example, bond.'! or the cash surrender value
of.life insurance are not used as transactions balances. If they were nonetheless
subject to reserve requirements, they would absorb reserves, and changes in the
quantity of these assets for a given supply of reserves would affect the total
quantity of transactions balances that could be supplied. Such a change would
thus influence aggregate expenditures in a way that was inconsistent with the
stabilization objectives of monetary policy. Reserve requirements should therefore apply uniformly but exclusively to those assets that can be used to ma],ce
payments to third parties or can be transferred into transactions accounts, antomatically or by telephonic orders with several days or a ,business week for
purposes of covering check clearings. This would include all time and savings
deposits in the economy subject to such transfers, repurchase agreements, overdrafts to the limits allowed and instant credit lines, brokerage balances and
money market mutual funds invested in short-term securities which are subject
to practically no variation in dollar value and which are transferable by pho_ne
orders within a business week, and certificates of deposit with an initial
maturity of a business week or less. Eurodollars of domestic parent banks,
which have maturities of a business week or less at inception, should also be
include\l, though they present legal and reciprocity obstacles. These various
assets, though traditionally not called money, are provided the services of a
means of payment and are, in effect, money.
Reserve requirements under this provision would not be applied to ass,!!ts
which, even though they can be sold and the funds made available for transfer
within -a business week, do not maintain a virtually fixed market dollar value,
such as most financial market credit instruments. Treasury bills might meet
the definition but, being an issue of the government, need not be subject to
monetary control. Reserves would therefore be required for all financial institutions in proportion to the money balances they provide to the public in one
form or another, where money is understood to be a transactions balance or a
close substitute for it.
Passbook savings accounts of individuals pose a special problem, because they
are traditionally withdrawable on demand and this privilege has been consecrated by historical practice. Yet individuals have not usually used passbook
savings as significant substitutes for transactions balances. Therefore, it seems
to me that we could waive the reserve requirement for them and still allow
individual savings accounts to be withdrawn on demand upon presentation of
the passbook at banking offices, not however by written or telephonic orders or at
remote terminals. Delay of withdrawal would have to apply to all other time and
savings deposits, else they could be effectively utilized as transactions accounts.
It is true that many other balances that meet the above definition of a transactions balance are not at present used primarily for transactions purposes.
Many savings deposits which have privileges of third-party payment are still
held largely as investments and not to make payments, and therefore do not
reduce the holders' use of demand deposits for transactions purposes. But the
use of savings deposits and other new transactions balances to conduct transactions will undoubtedly develop further, and until fully developed will exert
and uncertain and confusing influence on aggregate expenditures to the detriment
of an effective conduct of monetary policy. The important advantage of subjecting all such assets to reserve requirements, and of creating a sharp distinction
between them and all other assets so far as speed of transfer is concerned, is
that this will tend to homogenize the attractiveness of assets so designated
as transactions balances and equalize their use for that purpose. Reserve
requirements reduce the amount of interest and services that issuing institutions
can afford to provide on such balances; consequently, the holders have an incentive to use them largely for transactions or, if they are not needed for that
purpose, to shift into other assets which have no transactions advantages but
pay a higher rate of interest. To maximize the difference between transactions
balances and other assets, no reserves requirements should be imposed on the
others. Given the wide access to the federal funds market, there is no longer
any important reason to impose reserve requirements for safety on any depoJ'!itS
other than those that we want to control as transactions balances.
Sharpening the distinction between a more homogenous amount of transactions
balances ( a revitalized M,) and other assets should tighten the link between the
quantity of transactions balances and aggregate expenditures, and thus contribute
significantly to the attainment of log-run policy goals and short-run monetary stability. A sharp distinction between money and other assets, one with reserve
requirements and the other without any, should help make a uniform requirement
acceptable to financial institutions.
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It was once thought that reserve requirements might beneficially vary with
the turnover of each deposit category with the purpose of stabilizing the aggregate
velocity of circulation of deposits in the face of shifts among different categories. But this was subsequently found to be an impractical objective. There is no
firm knowledge on which to base such differences in reserve requirements. While
differences in reserve requirements among transactions accounts may unfortunately result for political reasons, they cannot be justified on economic welfare
grounds and tend to defeat the purpose or reserve requirements of stabilizing the
total supply against shifts in the components.
Reserve requirements may well drive some of the items on which they are
imposed out of the transactions business but that would only occur for those which
are less efficient or less attracti're to the public for handling transactions. Money
market mutual funds would lose much of their attractiveness if they were subject
to reserve requirements. To avoid being covered they would have to delay the
transfer of customers' funds for a designated time period, say a business week.
This could be accomplished by a requirement that a definite order to transfer
funds to a cus,tomer's transactions balance be held in a special unusable account
without interest for a full business week. The definition of transactions balances
and substitutes subject to reserve requirements must be specified in terms of the
time and cost of transfer, rather than in terms of the characteristics of existing
assets, because the cost of maintaining reserves will induce issuers to devise new
kind of accounts to circumvent the legal requirements.
,Such a requirement may at first sight appear to be an arbitrary hindrance to the
efficient operation of financial institutions. But the "efficiency" which reserve
requirements interfere with only involves the issue of transactions servicesessentially what we have always meant by money-the total quantity of which is a
legitimate governmental responsibility. If a private institution ,vants to issue
money, it should be free to do so, but only under the same reserve requirements
and safety standards imposed on all other issuers. Commercial banks, which
were originally delegated to share a monopoly of money issue with the government, have the most to gain from restrictions on the issue of competitive transactions services.
The beneficial developments in the efficiency of our financial institutions and
markets will not be hindered by these restrictions on transactions balances and
substitutes. The inno,·ations in electronic transfers, management of funds, and
new financial instruments can continue to bring benefits to the public and will not
be obstructed by the provision that those which provide transactions services will
be subject to the same limitations and costs of reserve requirements as are demand deposits and all other such assets.
CONCLUSION
Monetary policy is an accepteci and necessary means of controlling aggregate
spending. The effectiveness of monetary policy depends upon its capability of controlling the quantity of transactions balances. The number of assets used as
transactions balances or close substitutes is growing, and this reduces the capability of monetary polic.v to offset variations in exnenditures over time. When a
large part of the public wants to change its expenditures in the same direction at
the same time, the social welfare is reduced by the resulting instability of aggregate expenditures. Reserve requirements on transactions balances and close
substitutes for them will increase the capability of monetary policy to control
fluctuations in aggregate expenditures. In order to keep aggregate expenditures
linked as closely as po,:i-ihle to thP available quantity of trani-actions balances,
we should reduce the extent to which assets not subject to reserve requirements
can be used as convenient substitutes for transactions balances.
The proposal here is that all transactions balances and close substitutes he subject to a uniform requirement that 10 percent of the balances be matched by a
deposit with Federal Reserve Banks on a current basis. Transactions balances
and close substitutes are defined as a financial account that is largely fixed in
dollar amount and can he transferred to third parties or into such a transferable
balance within a business week by written or phone orders. Reserve requirements
on all other deposits should be zero. Economic stability will he greatly improved
by s_harpening the distinction between transactions balances and all other assets.
An Important reason for enacting reform legislation now is to prevent developments which will be more costly to undo later.
The CHAIRMAN. Thank you very much, Mr. Cagan.
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STATEMENT OF LEIF OLSEN, CHAIRMAN, ECONOMIC POLICY
COMMITTEE, CITIBANK
Mr. OLSEN. Thank you, Mr. Chairman. I'm going to present some
excerpts from my longer statement which I understand will be introduced in its entirety.
The CHAIRMAN. Very good. Without objection, your statement w~ll
be yrinted in full in the record. We appreciate your abbreviating it.
LComplete statement follows:]
TESTIMONY OF LEIF
H.
OLSEN, CHAIRMAN, ECONOMIC POLICY COMMITTEE, CITIBANK
One of the critical assumptions which seemed to guide economic policies as
1978 began was that the economy still contained sufficient slack so that stimulative monetary and fiscal policies could be applied without great risk that inflation
wourrd accelerate. This assumption was incorrect. The Council of Economic
Advisors, for example, in their report released earlier this year estimated the
GNP gap-the difference between the actual level of the economy and its potentia-to be about $74 billion.
Since that report was put together nearly a year ago, there has, of course,
been reason to revise that estimate. It appears now that early this year the
economy reached its potential-that point at which it can grow only as fast as
permitted by new entrants into the labor foo-ce and new output capacity added
to our capital stock. This potential rate of physical growth of the economy,
excluding inflation is currently estimated to be about 3 percent to 3½ percent
per annum over time. Historical evidence demonstrates that once •the economy
has reached the physical limit of its potential, inflation will equal the difference
between the nation's nominal income growth and 3 percent to 3½ percent. Since
nominal national income, which is determined by the rate of growth of money
plus velocity, this year seems to be growing at about a 10---11 percent annual
rat&---as it did both in 1976 and 1977-the warranted rate of inflation should
be about 8 percent and that appears to be the case.
Unfortunately, we have failed to reduce the rate of growth of nominal GNP
early enough to avoid an increase in inflation. The market has experienced a
sufficient number of such episodes that it no longer believes the implicit assurance
that accelerating inflation will be avoided by a timely reduction in the rate
of growth of nominal national income before the economy reaches its potential.
That is why business and labor do not slow down price-wage increases as much
as might seem warranted when the economy is coming out of a recession with
substantial excess capacity and high unemployment.
The pure logic of the arithmetic leads neople to anticipate the ultimate effects
of running the economy at a 10 to 11 percent rate of increase when it can grow
in physical terms at only 3 to 3½ percent once all the silack has been removed.
Asking business and labor to limit :price and wage increases is futile when
monetary and fl 1scal policies have overstimulated the economy and when nominal
national income is rising at an annual rate of 10 to 11 percent. It will only
lead to distortions and inequities.
To reduce inflation requires a reduction in the rate of growth of money and,
thus, in the rate of growth of nominal national income. Such a policy now
clearly carries the risk of recession. The alternative would be at best to maintain inflation at a 7 to 9 percent rate or at worst to see it rise higher as inflationary expectations increase. Uultimately a re<>ession would occur.
Monetary policy has not yet become restrictive. Monetary policy is restrictive
when the Federal Re,ierve acts to slow the growth of the monetary bas&--bank reserves and currency-and, in tnl'n, hl'oadh' df'fined money supr.1ly. More
to the point, a restrictive monetary policy is one which produ<>es a reduction in
the rate of growth of nominal national income. Since nominal national income
is well on its way toward an 11 percent increaRe this year, monetary policy
cannot be Raid to have been restrictive relative to 1977 and 1976.
The monetary base has been growing at 11n anmrnl rate of 11pnroximately !l½
percent thro11ghout this year as agflinst rates of R!'i percent in 1976 11nd R!l
percent in 1977. Snowing the growth of the monetary bmie to, sfly, 6 oil' 7
percent would also cause a sharp slowdown in the growth of the money stock-
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currency and commercial bank time and demand deposits held by the public.
A sharp slowdown in the growth of money supply has been characteristic in
the Federal Reserve's past battles with inflation-for example in 1900, in 1969~
70, and again in 1973-74. In all these cases, the inflation was the result of
overly expansionary monetary policies which continued to stimulate the economy
beyond its potential growth rate after that limit had been reached. The severity
of the monetary restraint which was needed caused the rate of increase in the
nation's income and output to slow down so markedly as to precipitate a recession.
Restraint comparable to these past efforts to curb inflation has not taken place
yet this year. The increase in interest rates is noit the result of a restrictive
monetary policy with its attendant squeeze on the availability of credit. Instead
it reflects the strengthening in the demand for credit in an economy which is
now significantly more inflationary than it was a year ago and in which real
growth has continued at about a 4 percent annual rate.
Levels of interest rate reflect inflation. A glance around the world reveals
that countries with high inflation have high interest rates. Those with low
inflation have low interest rates. The reason is that market rates of interest
comprise two components-the real rate and the inflation premium which
compensates lenders for the loss of purchasing power over the term of the
loan.
Short-term market rates, such as the 00-day commercial paper rate, in the
United States are recovering from the deep recession of 1974--75. They are moving tO'Ward a normal level at which they should approximately equal the sum
of the inflation over the past year plus a real rate of about 2½ percent. With
an 8 percent rate of inflation, a 10½ percent 90-day commercial paper rate would
not be extraordinary. It would have been extraordinary had short-term market
rates continued to run below the rate of inflation in an economy now effectively
at full employment.
Long-term interest rates are also heading toward a higher level because of the
acceleration in inflation this year. Long-term bond rates-in thrs case I am
using: the Aa-corporate utility bond rate as a benchmark-norma~ly equal approximately the sum of the actual average inflation over the past 4 years
with some weighting for the most recent year plus a 3½ percent real rate.
Inflation average about 7.2 percent in the last 4 years and by the end of
next year, if our forecast proves correct, the average will be 8.4 percent. Thus
a Aa-corporate bond rate of 10 percent or more would not be out of line by
that ,ume. Except for intermittent rallies such as occurried this summer, interest rates will not decline significantlly unless the economy contracts in a
recession or some near-miracle produces a substantial reduction in the rate of
inflati-On.
Now back to monetary policy. Changes in ta,rgets for the Federa,l funds rate
get a lot of attention in the financial press. But its significance is not generally
understood as attested by accounts of the tightening monetary 'policy each time
the funds target is raised. Rises in the fedeml funds rate-the rate that banks
pay when they borrow excess reserves, principally though no,t exclusiveUy from
other banks-do not occur because the Federal Reserve has slowed the growth
of the monetary base. Rather, the funds rate rises because of strong loan demand
which presses banks to become more agg;ressive bidders for available federa,l
funds.
The Federal funds rate target is simply the point at which the Federal Reserve decides to intervene, to either supply reserves to the banking system or
to withdraw them. If the actual rate threatens to move above the Federal Reserve's target because the banks, faced with strong loan demand, continue to bid
aggressively for the excess reserves of other banks, the Fed will supply reserves.
This bidding steadily and continuously pushes the Federal funds rate higher than
expected by the central bank authorities. As a result the Federal Reserve puts
more and more reserves into the banking system. Subsequently, when it is
evident from the excessive infusion of reserves into the system that the Federal
funds target is too low, the monetary authorities move it higher. Then it tests
the higher level for a time to see if at this level the supply of reserves will be
neither too much nor too little. 'l'hus, through a kind of trial and error, the monetary authorities move the funds rate target higher and higher, but the underlying
demand for credit has been stronger than expetced. The very fact the Federal
Open Market Committee, which determines monetary policy, has steadily moved
the Federal funds target higher is evidence that it, too, believes the nation's
money supply has been growing faster than it would prefer.
So far those members of the Federal Open Market Committee who favor a
more restrictive monetary policy have in part at least been mollified by the
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upward ratcheting of the Federal funds rate in the search for that point at
which it begins to arrest the rate of increase in the monetary base and the
stock of money.
And those members of the FOMC group who favor a cautious approach, one
that seeks to avoid a credit crunch and a recession, may take comfort since
policy has so far avoided just that.
So, as long as the search for the right Federal funds target continued and as
long as the monetary base continued to rise at an unabated rate, differences over
monetary policy have not been very pronounced.
But, obviously, this cannot continue. At some point the Federal funds target
will begin to slow the growth of bank reserves. And at some point the monetary
authorities must decide (a) to become so restrictive as to risk a recession, or
(b) to continue indefinitely to finance 7-9 percent inflation and 3-4 percent
real growth.
Now, it may be that the Federal Reserve's target has only recently begun to
reach the point where it has overtaken the strength of the demand for credit and
Federal funds particularly with the moves taken two weeks ago in defense of
the dollar-the increase in the Federal funds target, the discount rate and reserve requirements.
An interesting dilemma now exists. On the one hand the market-particularly
the foreign exchange market-reads the Federal Reserve action as the promise
of monetary restraint. The kind of restraint that the market expects would cause
a recession. On the other hand officials insist a recission is out of the question.
,vill policymakers seek to avoid the recession? If monetary and fiscal policies
stay that stimulatiYe then inflationary expectations will accelerate, and the
dollar will nosediYe again in foreign exchange markets.
Now the general perception in the credit markets is that reserves are ample
and that, except for higher interest rates, credit is as generally available as it
was a year ago. It is a perception that cuts across both domestic and international markets. And it is a perception that it fostered in a highly deceptive
environment.
In the second quarter of 1975-just at the beginning of the upturn-the external borrowing of nonfinancial corporations as a percent of total borrowing
was 19 percent. In the first half of this year it ran at about 40 percent. Short
and intermediate borrowing by these corporations increased 4.5 percent in
1976, 15 percent in 1977 and in the first half of this year by 20 percent at an
annual rate. Business borrowing from commercial banks in the first nine
months of this year has increased at an annual rate of 15.1 percent. The rate in
the first half was 17.3 percent. While it slowed down in the third quarter, there is
no reason to believe it will not continue at around a 15 percent annual rate as long
as the economy continues to grow at a 10-11 percent annual rate in nominal terms.
In addition, borrowing by households in relation to personal income has fully
recovered from the recession of 1974--75 and is now at a record high. And the
U.S. Treasury borrowing as a percent of total funds raised by all borrowers
is running at an unusually high level with the economy as fully employed and
as inflationary as it now is.
The liquid "feel" of the credit markets is due to the rapid and unabated growth
of the monetary base-bank reserves and currency. If the growth rate of the base
should slow down significantly as it has in past periods of severe monetary restraint. the money markets could congeal very quickly.
In this context, the task of the monetary authorities is unusually difficult as
compared with earlier battles against surging inflation largely because their
policy actions have become so much more visible and better understood. While
the Federal Reserve has long published the minutes of the Open Market Committee, it now releases them 30 days after the meeting, rather than after 90
days as previously, and there is currently a court test that could require the
Federal Reserve to publish the minutes immediately after the conclusion of the
Open Market Committee meetings. Furthermore, the minutes of the Open Market
Committee are now followed more closely by more economists and financial
market participants than ever before. Analyzing monetary policy has, in fact,
become a major preoccupation of the country's financial markets and the financial press.
The Chairman of the Federal Reserve Hoard must now report four times a
year to Congress on the conduct of monetary policy. This was not the case prior
to 1975. (Beginning January 1, 1979, he will report twice a year.) In addition to
the accumulating record of the chairman's testimony, the greater interest of
Congress in the influence of monetary policy was pointed up in a study prepared in 1976 by Robert Weintraug, staff director of a House Banking Sub
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committee that was chaired by Stephen L. Neal, Congressman from North Carolina. It concluded that the money supply and velocity-the turnover of moneyplay important parts in recessions and recoveries. Specifically it pointed out
that:
Slowing money growth sharply for any prolonged period weakens the economy and increases the risk of recession. Ifor a time, however, velucity jii'creases sustain expansions even after money growth slows. But inevitably, if
money growth is retarded sharply for very long, confidence is undermined, the
trend in velocity turns down, and recession follows. Once underway, recessions
are aggravated by continuing to retard money growth.
The Neal Committee study also opined that "monetary policy remains a
mystery to most Americans." This is much less true now than it was in 1976.
Widespread attention is now focused on monetary policy and its effects on
the economy. Today there is open talk by economists, both in and out of government, about the power of monetary policy t-o precipitate a recession as it becomes
restrictive in fighting inflation. Such comments were seldom heard prior to the
1974-75 recession. In fact, that recession was noteworthy for having progressed
for nearly a year before it was even recognized. But while inflation is now the
number one economic problem, the idea of pushing anti-inflation policies to the
point of incurring a recession-even though that is now difficult to avoid-is
not likely to have universal support.
Last month J. Dewey Daane, former member of the Federal Reserve Board of
Governors, speaking as a professor of Banking at Vanderbilt University, said:
My ... general exhortation to the monetary authorites would be to go ahead
and use monetary policy in the inflation fight, avoid the limitation imposed by
fear of provoking recession by being too aggressive, and accept the limitation
that monetary policy alone cannot prevent an inflation that could trigger even
more serious recession or depression.
What former Governor Daane said is likely to be the center of policy debate
now unfolding. There will be those who will agree with him that if policy is
timorous in slowing the growth of reserves, inflation is likely to accelerate and
the ultimate recession could be much deeper than one which could occur earlier
as a result of more timely restraint. In the past, monetary policy was anything
but timid when inflation became a serious problem. ·witness the severe monetary
crunch that occurred in 1969 and another in 1974.
Opposing the advocates of timely monetary restraint are those who argue
that precipating a recession does not cure inflation. This point of view is
espoused by the administration. It holds that a recession exacts the high social
cost of unemployment and lost output while achieving an insufficient and brief
cooling of inflation. This argument is not new. It has emerged intermittently since
at least as far back as the 1930s. But it is now more pervasive and intense as a
result of the experiences in the last two recessions.
What everybody knows is that the credit crunch of 1969 and the consequent
recession of 1970 were followed rather quickly by inflation that accelerated so
markedly in 1971 as to induce President Nixon's administration to impose pricewage controls.
The next downturn, to some, seems to have provided lesf' relief from inflation.
The recession of 1974-75 was the most severe since the late 1930s. It pushed
the unemployment rate to over 9 percent and idled a substantial proportion of
our industrial capacity. And while inflation did cool, it never fell much below
5 percent for an appreciable time-a rate which is still regarded as exceptionally
high by historical standards. The irony is that 5 percent-the lowest rate achieved
in this cycle-was the rate prevailing in the summer of 1971 when controls
were imposed.
The inability to achieve a greater subsidence of inflation through th<' idling
of both capacity and workers is not due to some diabolically monopolistic plot
by labor and business, but rather reflects the learning experience of these two
groups as well as investors and others who have lived through recessions and
recoveries. They do not necessarily have to understand the technical workings
of monetary and fiscal policies. What they know from experience is that once
the economy plunges into recession, something happens to reverse the downturn,
to revive aggregate demand and-once that is achieved-to accelerate inflation.
Consequently, there are no inducements to labor or business to alter their wage
and price expectations. They assume, in short, that inflation will continue into
an indefinite future. The economic slack that prevails in the early stages of
cyclical recoveries is acknowledged by everyone, particularly the government,
to be transitory.
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Putting it more crudely, business and labor-implicitly and explicitly-expect
that government policies will revive inflation before it dies from lack of fiscal
and monetary nournishment. Consequently, labor will not reduce wage demands
so that employers can afford to employ idled workers. And employen will not
reduce prices sufficiently to increase the demand for output and re-employ idled
factory capacity. Instead, government in expected to make such adjustments
unnecessary with stimulative monetary and fiscal policies, and so far it has not
disappointed those expectations. In fact, "getting the economy moving again" bas
become a trite political slogan for getting out the vote by assuring business and
labor that monetary and fiscal stimulus will be forthcoming.
Government action to stimulate the economy has been given widespread publicity, but responsibility for pushing the economy into a recession has generally been
obscured. This is now changing as the link between monetary policy and economic
conditions has become more widely understood. This public acknowledgement of
the power of policy to induce a recession also makes the monetary authorities
more subject to intimidation. Policymakers may be urged to reject effective
monetary restraint and to avoid a credit squeeze. It is argued that a recession
will not only cause the pain of unemployment but will also require higher government benefit payments to the unemployed, cause a sharp dropoff in revenues and
a ballooning Federal deficit, probably in excess of $100 billion. And if there is a
recession, monetary policy, in classic countercycliral fashion, will become highly
expansionary so as to speed economic recovery, and in achieving that goal it will
set the stage for still higher inflation.
But if the monetary authorities relax their resistance to inflation and try to
avoid a recession by continuing an accommodative policy, they will be embarking
on a policy course markedly different from the past. At best, inflation will remain
high and it might well accelerate. And inflation expectations will not diminish
even for the short run as they do during recessions. More than likely policymakers
will find it impossible to avoid that ultimate confrontation with rising inflation
expectations that eventually results in a recession.
The longer policy leans with the wind instead of "against it," as former Federal
Reserve Chairman William McChesney Martin usPd to say, inflation and interest
rates will stay high or go higher, and the dollar will remain weak or grow weaker
in the foreign exchange markets.
So the choices open to the Federal Reserve authorities are anything but heartening. And their task will not be made any easier by the introduction of stiffer
price-wage guidelines or "voluntary" controls. The experience with price-wage
controls during President Nixon's administration suggests that such direct intervention undertaken to influence wage-price decisions only confuses matters for
the monetary authorities. Should they avoid a reduction in nominal GNP pending
the outcome of voluntary controls? That would simply result in higher inflation
and controls would dh,tort the pffectR of inflation. Should they tighten concurrently with the imposition of controls? Then a recession will occur and why would
controls be needed.
Although it may do little good to say so, the time to have avoided the present
predicament was probably 2 years ago. Greater modernation, greater patience
then would have averted today's painful choices. But there will be a lot of
hindsight advice that will be most constructive during recovery from the next
recession. And the words of the Council of Economic Advisors in the Ford
Administration's Economic Report (January 1976) can serve as a blueprint for
that future recovery :
There is a lesson to be drawn from past policy mistakes. The history of monetary and fiscal policies demonstrates that we have a great deal to learn about
implementing discretionary policy changes ... We should set policies broadly
consistent with sustainable long-tPrm noninflationary growth and'try to limit the
size and duration of any policy deviations that promise short-tPrm benefits but
risk interfering with our long-run goals. If we do· not commit ourselves to a
gradual recovery over a period of years, we may increase economic instability
and lose our chance for sustainable 11:rowth, which we believe offers the safest
and surest route to full employment in future years.
This advice should have been put to a test at least in 1976 and 1977. Instead
policies have been dedicated to stimulating the economy in pursuit of full employment as quickly as possible. As a result, inflation accelerated this year to rates far
above the expectations of nearly everyone. And now, once again, we have lost "our
chance for sustainable growth."
Monetary authorities are in a hind. No mattPr what they do, they face sharp
public criticism. Their discomfiture is echoPd in the plaintive cry that "monetary
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policy alone cannot prevent ... inflation." If monetary policy needs help, what
can be done?
The proposition that inflation is a monetary phenomenon is an oversimplification insofar as it presumes the absolute independence of the Federal Reserve in
setting monetary policy. Yet this has never been true. The Federal Reserve is a
creature of Congress and subject to the will of Congress.
Nevertheless, the extent to which the Federal Reserve is responsible to Congress
in the conduct of policy and the extent to which it is expected to be free from
governmental influence have always been shrouded by ambiguity. A cynic might
conclude that this is the most comfortable arrangement since no one in government is explicitly responsible. The Federal Reserve blames excessive federal
pending for inflation and it, in turn, is blamed for tight money and high interest
rates.
Ideally, in the kind of check-and-balance process that is inherent to our overall
structure of government, the Federal Reserve is supposed to introduce an element
of discipline into the policy dialogue as well as the government actions that
influence the economy. But the Federal Reserve is also expected to be accommodative, to provide monetary stimulus, especially in efforts to achieve prompt recovery
from recessions.
Yet when the going gets rough, when inflation surges ahead, the Federal Reserve
is expected to assert its independence, and clamp do"'n on the growth of money
and credit. In the past the ensuing recessions were seldom pinned on monetary
policy. As recently as 1973-74, there were relatively few economists who focused
on the relationship between changes in the money supply and changes in economic
growth. Today such analyses are the foundations on which most economic forecasts rest.
'J:n recent years (a) the rise in government spending, (b) the huge borrowing
undertaken by the Treasury on behalf of favored segments of the private sector,
(c) the vast and costly intrusion of federal and state regulations into the private
sector, (d) the large and growing role of government in allocating income and (e)
the escalation of inflation expectations with each recovery from recession, have
made the accommodation of the ]'ederal Reserve authorities more and more inflationary as it increased the nation's money supply to try to finance the cost effects
of all these activities.
And now, as another wave of inflation engulfs the nation, the Federal Reserve
is once again expected to restrict the rate of growth of money and credit and
risk a recession. But this time, in sharp contrast to the past, the role of monetary
policy in precipitating the recession is not obscure. It is not likely this time to
be sheltered from criticism. The private sector is being warned that if inflation
does not cool off-if the President's voluntary price-wage guidelines do not
work-there will have to ·be a tight monetary policy and an induced recession.
It may appear that this is no more than a fair warning. But once the economy
is in recession, will Congress and the administration take a benign view of the
Federal Reserve?
(]'he improved understanding of monetary policy will be a blessing in the long
run as the public learns that in the final analysis inflation is a monetary phenomenon-the result of excessive money growth. It may then insist that the
Federal Reserve no longer accommodate imprudent government policies. Jt may
also demand greater restraint on federal spending and it may demand +· tt the
Federal Reserve be given greater freedom from political influence an consequently greater responsibility for keeping inflation low. It should be c' .i.r from
the experience of the past decade that the more the Federal Reser , tries to
satisfy political demands for financing the government's programs and its interventions into private markets, the more remote is the likelihood of - ~i,ieving its
other goals, "maximum employment, stable prices, and moder - long-term
interest rates" as directed by the Federal Reserve Reform Act of 1977.
/If that becomes the case then the monetary authorities will have public support f9r adopting another goal of the Federal Reserve Reform Act of 1977 to
"maintain long-run growth of the monetary aggregates comi· ,isurate with the
economy's long-run potential to increase production ... " ·· .., should rule out
large increases in the monetary aggregates (including
f. effect of velocity)
when the economy is recovering from recessions. We _,_,Gld have learned by
now that such major compensatory swings in the m0:1dary aggregates are not
compatible with longer run price stability, maximum employment and moderate
interest rates.
This means running the economy following the next recession at less than full
employment until expectations no longer prevail that monetary and fiscal policies
will continue to finance higher and rising inflation. Exhortations alone cannot
accomplish this. The marketplace has been disappointed too many times.
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The CHAIRMAN. Thank you, Mr. Olsen.
STATEMENT OF GEORGE PERRY, SENIOR FELLOW, THE BROOKINGS
INSTITUTION
Mr. PERRY. My written statement is very brief and I can cover it in
the time you have asked us to.
[Complete statement follows:]
STATEMENT BY GEORGE
L.
PERRY,' SENIOR FELLOW, BROOKINGS INSTITUTION
It is hard to conduct monetary policy today. And it is hard to evaluate it fairly.
In recent weeks, a speculative slide in the foreign exchange value of the dollar
became a prime concern of policymakers. To help stop that slide, the Federal
Reserve, in a move endorsed by the President, moved interest rates abruptly
higher on November 1. That rise of 100 basis points in the discount rate dramaticaHy signaled a change in •policy : it is now widely believed that maintaining the domestic expansion is no longer the top priority of policy. What I would
add is that the expansion was in trouble before November 1.
Mon,etary policy has been under conflicting pressures all year both to sustain
the ec!momic expansion and to slow inflation. These conflicting pressures arise
from our legitimate national interest in both price stability and low unemployment. We have not devised a way to combine the two, or in recent years, even
to come acceptably close. Confronted with that inability, policy has osciUated
between fighting inflation and fighting unemployment. We have already had two
recessions in the 1970's when concern over inflation got top priority; and I believe
we were headed for a third even before this month's dramatic jump in interest
rates.
I projected a 1979 recession in my own forecast of October 1, which is summarized in table 1. That forecast was based on the expectation that monetary
policy, which had raised interest rates substantially during the summer, would
raise them substantially further during the fall and winter. That expectation, in
turn, was based on the evidence that monetary policy would not accommodate
the prevailing rate of inflation. The interest rate increases since Otcober 1 came
sooner than I had expected they would, and increased further the probability of
a recession next year. I expect the unemployment rate will peak at around 7
percent in late-1979 if the downturn in the economy is kept mild and brief as in
the forecast of table 1. In that view of the outlook, 1980 is a recovery year. If
fiscal 1md monetary policies get much tighter and stay tight in the face of a
weak economy, the recession could ,become much worse. That is a risk, but it is
not my present forecast.
How do we end up creating a recession that nobody wants? Inflation is deeply
entrenched in our economy. It responds only very gradually to weak demand
and economic slack. Consequently, s'1owing aggregate demand results mainly in
slowing the growth of real output and employment. To put the matter directly
in terms of monetary policy, if policy slows the growth of the monetary aggre\gates, the 5.rst and principal effect is to raise interest rates and slow the real
economy. Weaker demand and increased slack in labor and product markets then
gradually slow the inflation rate, but the effect is disappointingly small. Statistical estimates indicate that we give up perhaps three million jobs to take one
percentage point off the inflation rate by that route.
TABLE !.-PERCENT CHANGES AT ANNUAL RATES FOR SELECTED ECONOMIC INDICATORS, 197S-79
Quarterly percent changes at annual rates
GNP _________________________________
Real GNP ____________________________
GNP price deflator ____________________
Industrial production __________________
1Q78
to
2Q78
2Q78
to
3Q78
3Q78
to
4Q78
4Q78
to
1Q79
1Q79
to
2Q79
2Q79
to
3Q79
3Q79
20.6
8.6
11. 0
13. 2
11. 3
3.6
7.3
7.4
9.2
2.6
6.4
4.2
9.1
1. 9
7.1
2.5
6.3
-.4
6. 7
-2.5
4.1
-1.4
5.6
-8.2
5.2
-.2
5.5
-2.5
to
4Q76
1 The views expressed are my, own and are not necessarily those of the officers, trustees,
or other stair members of The Brookings Institution.
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The same real restraint occurs if policy maintains a prevailing growth rate
in the aggregates while prices rise more than before. Average prices this year
have accelerated for a number of reasons. Lower unemployment rates stepped
up the base rate of wage inflation by perhaps ½ point. Legislated increases in
payroll taxes and minimum wages added nearly another point. Exceptional
price increases in food, energy and housing, which are largely unrelated to wage
costs, are adding 2 points more. And the decline in the exchange value of the
dollar (over and above the decline that would be expected from differential rates
of price increase here and abroad) added several tenths more. Altogether,
prices have been rising at near a ten percent rate this year, an acceleration of
several percentage points. Unless the Federal Reserve was prepared to accommodate with a corresponding acceleration of the monetary aggregates, monetary
policy was automatically going to tighten.
Tighter money will not re,peal the rise in the payroll tax on minimum wage,
it will not improve the weather for growing vegetables or put more cattle into
feed lots, and it will add to the CPI through higher interest rates before it has
any effect on the CPI through weakening demand. Nonetheless, ·because price
increases from whatever source speed up the whole wage-price spiral, a tight
monetary policy now may be the best of a bad lot of choices. But we should
recognize its costs. And we should try to have better choices available in the
future.
I have expressed the issues for demand management in terms of monetary
policy because that is the immediate subject of this hearing. But the same
points apply to fiscal policy. Cutting expenditures in an attempt to reduce the deficit will reduce aggregate demand. Beyond this, deficits have no special or additional consequences for inflation. And as for the effects of demand on inflation,
the same disappointing trade-off of losses in jobs and output in exchange for
gains in price moderation applies whether the slowdown is accomplished through
fiscal restraint or monetary restraint or both. The additional point to remember
about attempts to reduce the deficit is that if they lead to recession, they will
swell the deficit instead.
If we want to fight inflation with remedies that are less painful and more
effective than putting people out of work, we have to look beyond restrictive
fiscal and monetary policies. The government is responsible for a great number
of laws, regulations and procedures that add to costs and prices; by repealing,
reversing and desisting it can reduce them. The benefits of social and economic
regulations, import quotas, price supports, payroll taxes and higher energy
prices should all be weighed against their inflationary costs. In addition to reducing costs and prices imposed on the private sector, the government can try
to influence the price- and wage-setting process in the private economy. The administration's new guidelines program attempts to do this. The real wage insurance that it has proposed is a major innovation in anti-inflation policy. I
believe that proposal, or some variant of it, deserves support.
By their actions in the areas I have just described, the Administration and the
Congress have the power to influence importantly the rate of price increase in
1979. The appropriate goals for monetary policy depend on how much the government does in these areas, as well as on how severe an economic slowdown the
government is prepared to accept. It seems proper to leave that decision to elected
officials rather than to the Federal Reserve Board.
The CHAIRMAN. Thank you, sir.
STATEMENT OF ALBERT T. SOMMERS, SENIOR VICE PRESIDENT
AND CHIEF ECONOMIST, THE CONFERENCE BOARD
Mr. SOMMERS. Thank you, Mr. Chairman. I submitted a very short
paper which I will summarize. My summary may be somewhat longer than the paper.
The CHAIRMAN. We will have the paper printed in full.
[Complete statement follows:]
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OPENING REMARKS
· of
ALBERT T. SOMMERS
Senior Vice President and Chief Economist
THE CONFERENCE BOARD
I'm grateful for this opportunity to offer the committee some
judgments on monetary conditions in the United States and their bearing on
the economic outlook, and with particular reference to the management of
inflation.
The conclusions I have to offer you are uncomfortably large.
They are stated here generally; I would be happy tO"pursue them with you
further in discussion.
Submitted with these rema"d<.s are copies of two
articles that have a bearing on our general economic situation and the
pressures on monetary policy, and a set of a few charts describing monetary
performance in recent years.
The American economic experience of the past dozen years has been
strikingly cyclical; peaks in business conditions, accompanied by peaks in
interest rates, the inflation rate, and real growth have occurred at a more
or less regular four-year .interval, in 1966, 1969-1970, 1973-1974,
and now, probably, in early 1979.
Each of these peaks has been followed by
declines in economic activity, notably in housing, consumer demand for durable
goods, and business demand for fixed investment and inventory, and they have,
of course, been accompanied by declines in employment and rises in unemployment.
These experiences with the business cycle have been prpgressively more
intense, in general producing higher peaks in interest rates and inflation,
followed by progressively more serious recession.
The unstable behavior of
the economic system over the past dozen years -- about three times more un-
stable than in the comparable preceding period -- has carried substantial
cost; human cost, of course, and also periodic interruptions of the growth
of investment, with an associated long-term loss in productivity and growth
of living standards.
The record of the past decade doubtless reflects a large number of
destabilizing influences
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from outside the system -- the Viet Nam War, the
19
crop failures of 1973, the extremely advanced state of the business cycle
throughout the West in 1973, the explosion of oil prices.
There would
probably also be much agreement on the proposition that economic policy has
contributed to the instability, through alternating waves of fiscal stimulus,
followed by monetary restraint.
If we were to leave the diagnosis here, we
would be left simply with the prescription that we avoid accidents, and avoid
mistakes in fiscal and monetary policy.
Unfortunately, the causes of the
instability of the past decade are more systematic and more deeply rooted,
particularly with respect to the inflation that has been such a prominent
feature of recent history.
The United States -- and in fact all Western
economies -- have for much more than a decade been caught in a dilemma of
ends and means for which nobody -- not the Congress, not the Administration,
and not the Federal Reserve -- is ultimately responsible.
If the problem
of our instability were to be capsuled in a single sentence, it would be that
we have been experiencing rapid and cumulating changes in our economic institu-
tions, in the goals we seek as a· nation, and in our technological structure;
while we have experienced little or no change in the policy equipment available
to government for the management of the system.
The social costs entering
into each unit of our output have risen dramatically; we have struggled to
provide security guarantees for an increasing proportion of the population;
we have encouraged widespread indexation of incomes to protect parts of the
system against inflation; institutional changes, technological changes and
marketing changes have reduced the intensity of price competition on both
the wage and price side of markets.
The resulting elevation in the level
and durability of inflation has been experienced all over the West; in the
United States, the rate of change has been strikingly rapid in the last
fifteen years, and it has been associated with a strikingly rapid increase
in the domestic inflation rate, both in terms of U.S. history itself, and
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relatively to the inflation rate in the rest of the West.
It is now fairly widely accepted that the inflation confronting
the United States in recent years is a new kind of inflation, incorporating
an "underlying" institutional inflation on which cyclical inflation is superimposed.
In the presence of modern economic institutions, the suppression
of prices to any given level of general inflation now requires a much higher
degree of unemployed resources of capital and labor than was true two decades
ago; the U.S. Phillips curve has been drifting up and to the right,
not just a short-term cyclical condition.
This is
In West Germany, the prolonged
effort to suppress inflation has been associated with prolonged high unemployment, slow growth and a deep suppression of new investment,
The record of the Federal Reserve System in these turbulent years,
as it has struggled with an environment acquiring an increasing inflation bias,
should be viewed sympathetically.
The powers of the Federal Reserve are
limited almost exclusively to the supply side of the credit market.
Apart
from its variable control over securities margin credit, (which it has not
altered for five years) and its Regulation Q controls over certain interest
rates (which were partly vacated by the new savings certificates) it has little
or nothing to say about the direction of credit.
Its powers on the supply side
resemble a nuclear deterrent that can pay scant attention to the priorities
and values established by legislation.
It cannot distinguish between non-
productive and consumption uses of credit, on the one hand, and credit to support
business investment, or meet the requirements of government, on the other
hand.
Its nuclear deterrent does not lend itself to gradualist application
even at the aggregate level; the effects of gradualism are deferred or dissipated by floating rates, offshore accumulations of dollars, inflationary
expectations, the ingenuity of the banks themselves, a wide and unpredictable
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21
cycle in velocity, and such inventions as the savings certificates.
With its present equipment, the Federal Reserve is incapable of
focusing its response on inflation itself; in the end, when it brings to bear
its ultimate, blunt power to make credit not only expensive but scarce, it
strikes at the real world of employment, output, living standards and real
investment, as well as the nominal world of prices and inflation.
In fact,
the evidence of the past dozen years suggests that its effects on the real
world are vastly greater than its effects on the inflation itself.
The accumulation of evidence on this point has not escaped-the_
attention of the Federal Reserve itself.
More than six years ago, a conservative
chairman of the Federal Reserve, after a series of speeches making many of
the points suggested here, came finally to a recommendation of a mandatory
incomes policy, as an ally for monetary policy in the struggle against modern
inflation.
On the basis of this description of a decade of highly cyclical
and inflationary experience, I would offer the following observations,
1.
There are no easily identified "bad guys" in the record.
I
don't see any evidence that the Federal Reserve, given the character of its
powers, and given its responsibilities toward the real world as well as toward
inflation, could have behaved sufficiently differently to produce a very
different historical record.
The argument that inflation has forced the
Federal Reserve to provide funds at a rate that consistently exceeds its own
targets is as good as the argument that it has been the provision of the funds
that has caused the inflation in the first place.
In 1978, the real money
supply (M1 , divided by a general price index) is no higher than it was almost
a decade ago.
In almost all the intervening years, money growth among other
Western eountries wasalmost consistently faster than it has been in the United
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22
States.
This is by no means the same as saying that money doesn't matter; but
I find no gross negligence on the part of the Federal Reserve in the application
of its limited powers to the trade-off between growth and inflation.
2.
Given the very serious nature of the inflation we confront,
consideration should be given to enlarging the powers of the Federal Reserve
on the demand side of the credit market (as well as to providing a more
effective alliance between the Federal Reserve and other arms of policy; see
below).
Sensible credit restraint powers, far short of absolute direction of
credit,would help to moderate the business cycle, preserve a steadier course
for private investment, permit more effective response on the part of the
Federal Reserve's supply-side powers, and produce interest rates both less
volatile and, on average, lower.
The United States banking system is the most
aggressive in the world; it competes violently for consumer credit in all
forms, and produces far and away the highest use of credit for consumption
purposes.
3.
Virtually all modern mixed economie~ run federal budget deficits
most of the time; their spending seeks to achieve social objectives and maintenence
of infrastructure (and in our case,.a.lsrge defense effort) while.revenues
are constrained by the need to preserve incentives in the private sector.
Big
budget deficits are inflationary if they must be financed by monetary authorities,
less inflationary to the extent that they are financed by real saving.
The
personal saving rate is strikingly low in the United States, partly because of
the uninhibited use of credit in consumption.
I am not very confident that the
U.S. budget will be balanced in the near future; credit restraint in the private
sector. (particularly in consumption) can help to reduce the inflationary implications of whatever budget deficit we encounter.
4,
In times such as these, an incomes policy, if it were to be
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23
effective, is a natural temporary ally of monetary policy, in that it promises
to slow the destruction of liquidity by inflation.
No one would suggest that
an incomes policy is an alternative to monetary policy (or fiscal policy); but
it can provide an environment of slow inflation, and falling inflationary
expectations, during which the growth of money can be slowed to a sustainable,
relatively non-inflationary rate.
5.
For many of these proposals, it is already late this time
around in our repititive four-year cycle, and in any event the special urgencies
of our international financial situation are compelling a drastic response of
·monetary policy.
I don't think there is any real alternative now, but the
experience in 1979 will be better, or less worse, to the extent that the
President's incomes policy receives national support, to the extent.that
the Congress refrains from adding independently to the burdens on the Federal
Reserve, and to the extent that moderation can be achieved in the use of
credit for consumption.
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amerlca at
!ffl!
A collision
of ethics
and economics
Democracy is egalitarian, seeking a
more equal distribution of income. Capitalism is
organized on dominance and leadership, and depends
on an unequal distribution for saving,
investment and growth. The two are by now
very uncomfortable bedfellows.
by Albert T. Sommers
tially free-market systems. But we are learning-the
CBOfloeottNCl!WEGonomlll
lesson has been driven home by the persistent failures of
Western systems, particularly in the put decade-that
the mixture is by no means benign and stable. The
changed composition or the GNP between private and
public demand now appears to be only the surface manifestation of a profound social tide, driven by a powerful
dynamic that is reshaping Wes tern economic history. The
mixed economy is not inert; instead. it is a witches' brew
of intensely interactive principles of social organization.
What is at work in Western mixed economies" is a
genuine collision of ethics and economiCl-<lf ethical
principles and market principles.• This is not the first
such collision. Long ago. the victory of a religious ethic
over the mechanics or self-interest produced an "age of
faith," in which a transcendental ethic dominated much
or economic activity for a thousand years~ even into
American Colonial times. In turn, the religious ethic was
ultimately challenged and unseated by the immense energies of the early Industrial Revolution. In Religion and
T
he term .. mixed economy.. has achieved general
acceptance u a description of the institutional
conditiona that now prevail without exception
among the developed economic systems of the West. As a
grudging acknowledgment of the fact that the old
economic order no longer prevails in the West, the term
marks some progress in understanding. though really not
much. All it suggests is that free-market economic
systems now coexist with large. planned government
sectors; it leaves open and even encourages the comfortable possibility that the "mixture•• is a stable sociological
compound: that the society is in deliberate and conacious
control of the proportions of public and private entering
into the mix; and that the full implications of its appearance and growth arc revealed by the percentage share of
the gross national product taken by government. The
system buys a little compassion-perhaps at the expense
of a litlle efficienc:y---&nd that"s about it.
This is, indeed, the way it all looked only two decades
ago, when economists in the United States, u well u in
Europe, were congratulating themselves on the apparently successful grafting of social programs onto essen-
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06
•1t should be clear that the term ..ethical principles.. docs not
mean that such principlca are necessarily valid. nor docs it imply
that market principles arc ..unethical ... The distinction runs to
source. not validity or respectability.
25
,,.. Ria of c,,pitallsm, Tawney provided a magnificent
descriptioa of the inemrablc victory of capitalism over
religion, and its eventual capture of the reliaioua citadel
itself. Out of the victory of self-interest came Adam
Smith, and economic man.
cw ethic, born in democracy and nurtured by an
uncertain and equiYOCII revolution in the social
life sciences, is now taking on Adam Smith.
Economics without reference to the fon:ea of democracy-without comideration of the awesome ethical front
that has been advancing on the free market for decadessimply cannot comprehend a modem socioeconomic
structure. In particular, comentional economic:s cannot
understand or prescribe for the centnl failures of Western economic systems-their inability to conuol inflation
and to provide a level of new private investment compatible with their ethically imposed employment and distributive objectives. Not the least evidence of the struggle
and the failures is the remarkable current growth of the
literature. mainly by economists, on the impac:t of social
and political forces on economic systems. The Brookings
Institution has recently funded a large study in this area;
even Milton Friedman, whose dedication to formal
economics is not in dispute, has conceded that a full
understanding of the Phillips curve of a modern society
will require the entry of social and political variables.
It seems incontestable now that democracy and the free
market are no longer in the simple, cooperative relationship that prevailed in earlier days, when they represented
mutually supportive reactions to the power of religion,
monarchy and historically entrenched class. Democracy
and the free market are now very uncomfortable bedfellows; the marriage has been, and doubtless will continue to be, a stormy one. Stormy marriages are ssid to have
their compensations, and this one certainly has; it is difficult to imqine a more monumental achievement than the
reconciliation of the enormous energies of the free market
with the striving for compassion, for equal opportunity
and for social justiJ that is associated with democracy.
But nobody should expect it to be easy.
F
or the democratic- ethic turns out to be basically
distributive, cgali~, oriented to consumption.
unimpressed with incentive, and concerned with the
"average man" and eager to believe in his perfectibility.
The free market, on the other hand, is basically cumulative, organized on dominance and leadenhip, a machine
driven by incentive and reward, anti-egalitarian, and
darkly suspicious of altruism. Capitalism fuses risk and
reward in a rigid gel of market logic; democracy treats
them as partly independent variables. Democracy seeks a
more equal distribution of income; capitalism depends on
an unequal distribution for saving, investment and
16
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ifowth.
Democracy legislates values. arrays priorities.
praises and condemns. The free market offers no priorities. no values. no end, no purpose; it makes do with man
as it found him. 111 refusing to bend to purpose, the free
market protects us from the purposes of others, and it
liberates the enormous energies contained within self•
interest. Democracy struggles to direct the energies
toward its own purposes; in so doing. it often treads on the
incentives that are responsible for the energy in the ftnt
place.
Democracy treats ..economic man" and ..scareity•· as
cultural artifacts; capitalism treats them as ultimate
truths. Democracy is a dynamic, progressive, teleological
process in search of a just world. The free market is an
austerely beautiful intellectual structure; its Euclidian
geometry of self-interest is repellently fleshless to all but
the strongest minds.
Democracy expects and evokes changes in economic
institutio111; the only change the free market seeks is the
retum of an errant world to its eternal principlea-a
defensive posture similar to the posture of religion when
it was driven from the field by the free market in the last
encounter between an ethic and a social tide. Democracy
enlists government as its ally and uses it freely, even
brutally, in its pursuit of equality. The free market understands perfectly well that government, which was its ally
in its last encounter with an ethic, is its mortal enemy in
this one.
The description suggests, properly, an unequal struggle. All over the West, the free market has been on the
defensive and in retreat. Democracy has invaded the
marketplace, altering its institutions, breaking down its
natural defenses against inflation, and forcing outcomes
that are all but unrecognizable by conventional economic
reasoning.
It should be added that the democratic ethic working
its way through domestic economies does not stop at the
water's edge. However ambiguous in terms of its origin
and ultimate rationale, the instantaneous ethical "ought"
of its moral imperatives is not constrained by geography
or national boundaries. Its distributive justice is at work
in the North-South issue (and even in the oil issue),
imposing inflationary outcomes for the prices of materials
produced in the developing world, as it produces infla•
tionary outcomes at home.
In the complex, circular relationship in which history
abounds, tbe democratic ethic has been associated with a
humanistic tide in the social sciences (other than economics) and in the proliferating life sciences-uthropology, biology, genetics, zoology, ethology and the evolutionary sciences. At least one of the motivations driving
today's immense research effort into the nature of man
and his biological heritage is a search for valueo-for an
ethical system that is immanent in natu~ requiring no
26
appeal to religious authority; an ethic that is not a temporary cultural fashion or an accommodation to free-market
materialism, but rooted in man himself. The life scientists, especially aware of the ecological risks of unrestrained competition, seek a natural base for the coopera•
lion they consider essential to the future of man. Th~
Ethical Animal is the title of a book by a distinguished
Scottish zoologist; ...evolutionary ethics'" is now a stan•
dard library classification. Virtually all popular works on
evolution conclude with an uneasy but determinedly
liberal chapter on its ethical implications. The chapters
arc not ftattering to the free market; it is cooperative
behavior-a natural base for altruism-rather than self•
interest that draws the attention of the evolutionists,
becau.,e it is in cooperation that an ethic suitable for an
advan~ complex, interdependent SOC:ial system is likely
to be found.
What the economist sees as a .. mixed economy" is,
from the point of view of the life sciences, a heightened
cultural form of a conflict traceable all through evolutionary history: the struggle of a social species to reconcile
the individuality of the member with the society.wide
need for species survival-that is, with altruistic behavior.
With the guidance of natural .selection, the natural world
evolved effective balances of individual aggression and
social responsibility that represent behavioral mixed
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economies-partly free and aggressively competitive.
po.rtly socially imposed and cooperative. But in the human paradig~ the tension between a free market and a
social ethic has been compounded by the furious pace of
technology. The contradictions of the mixed economy are
traceable, in the end. to a profound and widely accepted
anthropological fact. Cumulative cultural transmission
bas exploded into a technological revolution requiring for
its support a high degree of cooperation, specialization
and interdependency, and into a democratic distribution
of political power that has no counterpart in nature; while
evolution. proceeding at the deliberate, noncumulative
pace of natural selection, has provided an incompletely
sociaJized. still competitive and aggressive animal to oper•
ate the culture.
If inequality is the critical issue of democracy , and
altruism of the life sciences, .. externalities" and ••dependencies" are the critical issues raised by technology. The
gravest threat to the free market, and the greatest voltage
available to ethics, is the enormous social implication of
technology. Increasing complexity and specialization
deepen the dependence of the individual on the aggregate
as they increase his productivity. They reduce his
influence on his own future, expose him to risks (and
rarely, rewards) over which he has no control, and therefore press him to seek protection and redress from those
27
who presume to control the system-that is, from government. The humanistic trend of the social sciences has
provided the ethical mandate for his effort, and a democratic political system has provided the vehicle. The
growth of the economic role of governments in the West
is a profound and probably irreversible consequence of
democracy, humanism and technology.
Viewed this way, the .. mixed economy'" is not a
mixture, but a process, inimical to its free-market component, in which ethical principles advance on and absorb
parts of the institutional structure. The recognizable
tendency of government bureaucracies to grow, to divide,
and to proliferate, the tendency of legal interventions into
markets to progress to further interventions, are commonly observed illustrations of ethical displacements of market phenomena; they reflect the laws of motion of modern
social systems. The process is visible enough in the spread
of command-type (as distinguished from incentive-type)
regulation, particularly in such newly legislated areas as
occupational safety, fair employment practices and environmental controls, as well as in the now traditional areas
of antitrust and regulatory matters. But more general and
important evidence of the ethical impact reaches into the
conventional major areas of macroeconomic policy, and
their bearing on stabilization and control of inflation.
E
And similarly with budgetary outcomes. In the last half
of this decade the United States will evidently run an
accumulated Federal deficit of nearly $300 billion. A
substantial portion of these deficits reflects the rising tide
of transfer payments, which now dominate Federal
outlays. as a reflection of governmental efforts to fulfill
the distributive ethic of democracy. The phenomenon is
available for study cross-sectionally, as well as over time
in the United States; virtually every member country of
Organization for Economic Cooperation and Development is running a budgetary deficit (relative to its GNP)
equal to ours. The bureaucratic instincts that lead to such
deficits are essentially conciHatory. The rise in social
spending accommodates the egalitarian ethic, while the
shortfall in revenues avoids the still higher progressivity
of the tax structure that would be required to balance the
budget, and thereby restrains or defers the impact on
"What we might hope for is
a
structure that will provide a suitable home
for the complex, partly competitive. partly
cooperative, enormously diverse animal
that is man."
thical interventions into the marketplace have
released a torrent of general inflation throughout
the democratic West. By their reformation of the
relationship of the government to the private sector, and private incentives. In effect, the budget deficit helps to
by the alterations they have induced in private-sector keep the social pesce at the troubled border between
institutions-by the radical alteration and Hhumaniza- democracy and capitalism. In the same way, the rapid
tion .. of conditions in labor markets. the imposition of creation of money finances social spending (that is, it
politically validated full-employment commitments on finances the budget deficit) and suppresses the financial
top of "labor markets" that no longer at all resemble consequences in the private sector.
markets, by the spread of indexation (not simply in wage
contracts but, by implication, for all wages, and increasn modem societies, fiscal arid monetary policies may
be enabling conditions of inflation, but they do not
ingly for purchase-sale contracts in the private sector, and
"cause" inflation, and they cannot stop inflation. In
most particularly with respect to sales to government),
and by the enormous growth of distributive social costs fact, it is truer now to say that inflation causes budget
entering into each unit of output-the social develop- deficits and rapid money growth than to put it the other,
ments of the past two decades have greatly increased the conventional, way. All three phenomena-inflation, budget deficits and rapid money growth-are coordinate
level and durability of inflation.
In turn, this inflation, upstream from the economic reflections of the ethical invasion of free markets.
system itself, has outflanked, neutralized, and then
In these circumstances, virtually every Western econosubverted the traditional restraints on inflation provided my (and for somewhat different reasons all developing
by fiscal and monetary policy. All throughout the West, economies as well) have resorted to incomes policies
conservative central bankers are tolerating, albeit irrita- intended to slow the destruction of liquidity by inflation.
bly, a rate of growth in monetary aggregates that flatly Incomes policies and their inherent resort to numerical
defies their own orthodoxy; failure to create the nominal calculations of "fair" (or "equitable" or "just") prices,
liquidity, in the presence of a source of inflation indepen- wages and profits, are an ethical response to an ethically
dent of money itself, would result in shrinking real induced inflation; they invoke the ••public interest"
liquidity. rising interest rates, recession, and violation of against private market determination, particularly where
(as in wages) ethically oriented institutional change has
social commitments to high employment.
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I
28
americaat
left a heavy deposit of inflationary market power.
Besides incomes policies. two other additions to the
equipment of macroeconomic policy have been applied in
most other Wcstem economies and are certainly possible
developments in the United States within a few years.
The democratic ethic. in the course of its effort to achieve
a more equal distribution of income, tends to enhance
consumption at the expense of investment, and hence at
the expense of growth, and hence. ultimately, at the
expense of employment. Its egalitarian goal thus ultimately collides with its employment goal. In European
countries whose cultural and political conditions permit
it, this confrontation has led to direct public investment in
productive facilities. In the United States, where public
ownership of investment assets still appears to be ruled
out by public attitudes, the urgent practical need to maintain investment has resulted in a proliferation of offbudget agencies whose funding, in effect, extends to
private activities the privileged status of the Treasury in
capital markets. Thus far such activities have been largely
but not exclusively limited to the housing market; it
would hardly be surprising to find a growth of such' agencies channeling credit under quasi-public terms to other
investment-type activities (and, perhaps imminently, to
the financial requirements of state and local governments). Supplementary to such devices are investmentoriented tax credits, such as the investment tax credit or
accelerated amortization on new facilities; these devices
retain a market orientation, but of course they involve
revenue losses that will be reflected in future budget
deficits. whose management may well require still more
progressive (or, in the case of payroll taxes, less regressive) general taxation. Despite credible arguments that
the fungibility of money limits their usefulness, most
Wes tern economies have equipped their central banks
with a battery of selective credit controls, frequently on
installment credit, to constrain the consumption consequences of their income-distribution efforts and to preserve resources for public and private investment.
Finally, it does not seem likely that the humanization of
the workplace has yet reached its maturity--even in
Europe, where it is more advanced than in the United
States. On both sides of the Atlantic, labor is in a long
transition from a variable cost to an overhead cost. No one
would question the past and impending loss of crude efficiency in this translation, but it appears to be inevitable,
and in the end it may have impressive benefits as well as
costs.
T
o look beyond these near-term and medium-term
possibilities into the longer future course of American economic institutions as they respond to the
internal frictions of the mixed economy is, obviously,
hazardous in the extreme; all that can be offered are some
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~f!!
humble speculations.
There is not much reason to think that the process
described here has reached an end; its historical roots are
deep, well watered by the intellectual support of the social
and life sciences. But it is at least a reasonable guess, on
the evidence in Europe and the United States, that
beyond the near term the pace of change may slow to a
more settled, more manageable and perhaps less inflationary rate.
A considerable portion of the energy of the democratic
ethic has been used up in the massive institutional transformation of the past 40 years, and particularly the accelerated rate of change of the past decade or two. The
rhetoric of the attack. on the free market and its cruelties
has assuredly been blunted by rapid growth of nonmarket
distributive and social efforts. The further pursuit of
ethical ends seems to carry a clearly rising marginal cost,
in efficiency and perhaps also in public irritation. It is far
more widely recognized today than it was five years ago
that, barring fundamental changes in the legal status of
property (and surveys suggest no desire for such changes
in the United States), much of any incremental ethical
effort will be dissipated by inflation, and that there is no
truly effective way of controlling inftation other than
simply slowing the rate at which we do inflationary
things. In the great trade-off between ethically imposed
institutions and market institutions, as in all the other
more conventional trade•off's in economics, there is no
free lunch; indeed, the price of the lunch is rising. While
they have properly and importantly directed the attention
of economists to the ethical implications of democracy
and technology, the social and life sciences have thus far
failed to dislodge self-interest as a fact of life, and a principal motivation to efficient activity; the evidence accumulates that this useful, dependable. and candid, if not
inspiring, motivation has been profoundly weakened by
the costs of ethical goals. And there remain large opportunities to improve the material well-being of all, especially
those in lower levels of the income distribution, by
preserving efficiency. incentives, investment and growth.
I
t is not too much to hope that democratic systemsgrown more aware of the challenge they face, recog•
nizing the dangers in asking more of man than he is
yet able to deliver, and confronted with the evidence (so
obvious outside the West) that predominantly socialized,
nonmarket economies have their own desperate problems
-will settle into a long•tenn compromise, at least as to
rate of change. What we might hope for is an institutional
structure that will preserve a vigorous competitive arena
at the same time that it accommodates technology and
seeks social justice-a structure that will provide a suitable home for the complex, partly competitive, partly
cooperative, enormously diverse animal that is man. ■
29
February, 1978
Information Bulletin No. 36
THECONIEREIICE BOARD
0
THE BALANCED FEDERAL BUDGET: AN ORTHODOXY
IN TROUBLE
By Albert T. Sommers
Introduction
The American people, and their elected representatives in Washington, have always subscribed to the
principle that governments should operate with
balanced budgets. The principle has simple but deep
moral roots in our history and cultural traditions. A
government, no less than an individual, should live
prudently within its means; the habit of debt incurrence is an indication of profligate living. Moreover,
a balanced budget accords with American views of
the proper limits of government; it imposes constraints on government spending, and hence on its
size and power. To permit government to incur grow-
ing debts impairs its responsiveness to the people,
since it detaches spending, in some degree, from the
willingness of the electorate to provide the funds for
government through taxation.
These essentially moralistic views of appropriate
budgetary outcomes have survived for decades in the
presence of an increasing recognition that the role of
government has grown to a point where its operations have an important influence on general
economic activity, and thus might require broader
and more flexible criteria, external to the budget
itself, by which its performance is to be judged.
In the past ten years, the United States and virtually all developed western economies have experienced
abnormally high rates of Inflation and money growth, as well as continuing large budget deficits, all in the
presence of relatively severe business-cycle fluctuations, and slower long-term growth. Conventional
forecasting has not been effective In warning against these outcomes, and conventional mathematical
simulations of the past do not reproduce them very well. Moreover, the conventional reasoning on which
economic policy rests does not seem to prescribe a clear c9urse out of "stagflation" and back to more
vigorous and less inflationary performance.
After a decade of such puzzling and uncomfortable experience, it no longer seems presumptuous to suggest that some of the conventional propositions of economics be reviewed to assure that our ways of looking at precisely such variables as inflation rates, budget outcomes and rates of money growth are still relevant to an economic system that has undergone substantial Institutional change. There seems to be a growIng conviction among practicing economists that such-a reappraisal is now In order.
This article on federal budgetary concepts Is the first of a series by Albert T. Sommers, the Board's chief
economist, on economic policies and their consequences in a modern mixed economy. The material Is
frankly exploratory-intended to pose issues and stimulate discussion, rather than to advance formal conclusions. Ensuing articles will deal with monetary policy, the sources of inflation in modern economies, and
some proposals for new approaches to the problems of inflation, budgetary deficits, and monetary growth.
KENNETH A. RANDALL
President
36-066 0 - 79 - 3
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30
Respect for a balanced budget has persisted even
among Keynesian economis1s; and the monetarists'
counterpoint to Keynes. which elevates 1he growth of
money to the principal determinant of activity and
stable, even in dollars, in recent years); and they are
not clearly related to short-term cyclical recessio n
(the fisca l 1979 deficit would lie fully four years
beyond the end of the last recession).
prices, has seemed to demand prudent fiscal behavior
as a precondition to prudent management of
monetary conditions.
In the light of this apparent near•unanimity among
the general public and the professionals, both
American political parties have traditionally incorporated a balanced budget in their platforms,
election after election, through decades of growing
government and changing social and technological
conditions. And in the past 20 years they have maintained this position in the face of very nearly continuous budget deficits, run pragmatically by administration after administration that took office
with a balanced budget among its specified economic
goals.
A s long as the deficits were small, or clearly related
to war, or clearly a temporary accompaniment of
general recession, the gap between the normative rule
and the actual performance of the budget provided
nothing more than minor occasions for political skirmishing. But the budgetary outcomes of the past few
years, and the prospective outcomes of the next few
years, are something else again. In the two and onequarter years comprising fiscal 1975, fiscal 1976, and
the so-called transition quarter (the third quarter of
calendar I 976) the cumulative budget deficit totaled
about $125 billion. The deficit of fiscal 1977 has
evidently brought the accumulated total to about
$170 billion. Both Congress and the Administration
expect a deficit of about $60 billion in fiscal I 978,
even in the absence of tax reduction; a reduction of
$20 billion (the proposed amount has evidently
drifted up to or above this figure), if it were to beeffective in the fall of calendar 1978, wou ld add
perhaps $5 billion to the fiscal 1978 deficit, and it
would seem to assure a deficit of about $60 billion in
fiscal I 979, even assuming a relatively strong
recovery of business in that year. 1 In the five calendar
years from 1975 to 1979, the aggregate deficit is thus
likely to be about $280 billion, give or lake a dozen
billion. The public debt outs tanding at the end of
fiscal 1979 is likely to be about double its level in
1971. Such deficits can hardly be described as small;
they are certainly not related to defense outlay, much
less to war (spending for defense has been very nearly
'The es1ima1es for 1978 and 1979 do not renect changes in ~cial
security taxes, or the net budgetary impact of proposed energy
taxes and rebates. .
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Chart
O
Federal Budget Surplus or Deficit
20
11 I 11111 1111 I I 11 I 11
'55
'60
'65
'70
I 11 I I
'75 '77
Sources: U.S. i)eplrtmffll of Com"""ct; The Conf......ce B<N,rd
We are not, of course, alone in this bewildering
fiscal experience. The deficit of recent years has
amounted to about 3 percent of our gross national
product; similar relative deficits are being run all
over the W.est, among nations whose traditions with
respect to the role of government are, at least in some
cases, as conservative as our own.
Such spectacular departures from intended
budgetary outcomes certainly invite a careful appraisal of the circumstances that have produced
them, and of their real meaning in modern
economies. What conditions have brought us to a
situation in which pragmatic management produces
suc h stunningly unorthodox outcomes? Are we
mismanagi ng ourselves? Have Western economies
suffered a runaway loss of prudence? Or has the
budget orthodoxy grown less and less realistic in the
real wor ld? Have our views of Federal budgets, and
31
perhaps even the accounting conventions by which
we measure the oUlcome, grown anachronistic during
decades or rapid change in th e social and economic
Chon
O
conditions of the system, and or the role or government in the system? Budget deficit s of their recent
size mean something; ir they d id not, the re wou ld be
rea so n neither to fear them no r 10 see k them. Effecti ve economic policy (measured by crit eria wh ich
relate to 1he performance of 1he entire system , not
just the budget outcome) would seem 10 require a
practical consideration of th e causes and co nsequen ces o f la rge and co ntinuing deficit s.
Budget Surplus or Deficit
as a Percent of Gross National Product,
Selected Countries
Canada
Sorplus
0....0000
D
D□
-5 ..
DD
Deficit
Italy
D
D
,.
--
France
LJ
I I
D
The Budget as an Instrument of Policy
Budgetary reasoning, and budgetary policy, might
well start with a recognition that a budgetary outcome is a n inst rument o f polic y, not an end in itself.
Illustrations of ends in them selves are high employment , vigorous growth in total outpul and living
standards, a low and stable rat e of in nation, equality
or economic opportunity. These might be called the
general or macroeconomic ends of the system. The
distingui shing characteristic of these ends is that they
are a t the surface of the economic sys tem , not inside
it s complicated, compensating machinery. Their
justification is not economic, but social and ethical,
connected with considerations or the good lire, personal freedom , justice. They are goals that might be
common to economic sys tem s whose interna l structures a re widely different. We would not be con-
cerned particularly ir a budget deficit persisted over
the lon g term in the presence of very sati sfacto ry
achievement with respect to these general ends. But
we would be di sa ppointed, and properly so, if we
achieved a continuing budget balance in the prese nce
of persistent unemployment and slow growth in living standards. In an array of policy targets by order
of real impo rtance, th e budget o utcome is ultimately
and inevitably subordinated to the other goals-the
Japan
□ Li □ □
□
0
=0 0
rai sing taxes. But in a longer-term context, the goal
or a balanced budget seems to retain its high priority
in the minds or the public as well as or the legislators
and admini strators who establish the budget outcomes. The high priority renect s morali zing on a
point that is not at the interface of economics and
morals, but deep within the technical structure or the
economic system.
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n~ _:
~
Netherland•
00
0000 ° 0
-5.
United Kingdom
I ■
0000
s ··
00
uu ~uo:
··· ·· ····· ·· .. ········· ·················· ..................... _,o
Weat Germany
true e nd s.
In practice, of course, we instinctively grasp thi s
difference. Because o f the obvious risk to the real
ends, nobody proposes to close next year's prospective $60-billion deficit by reducing spending and/o r
□
5·
D
DDD
.~u-_:
United States
Surµlu:.
·71
·73
" Fir51t>111fo l 1977
N.A. Not avai llble
SourCl'I : lntem at ional Moneta ry Fu nd; The Con '-<ence Bo¥d
·is
. -,~
·n
32
One reason why moralistic considerations are applied to this essentially amoral, technical concern is
that the terminology of federal budgeting is, by and
large, drawn from the accounting terminology used
in the private sector, and this permits and encourages
moral analogies to private behavior. For a family, a
balanced budget is better than an unbalanced budget;
a family should "live within its income," and
therefore so should a government; "surplus" does
not carry the moral stigma of "deficit"; and with
respect to "debt" "less" is better than "more" for
businesses and families alike.
These analogies, resting on the common
vocabulary of governmental and private accounting,
are highly imperfect; and they may be expensively
misleading. A sovereign government is not a family
owing its debt to other families or businesses; its expenditures are not in its own interest, but presumably
in the interests of the nation as a whole; its receipts
are not an income from sales to others, but a levy on
itself for common purposes. The debt of a sovereign
nation, equipped with its own central bank capable
of creating the funds necessary to meet the debt, is
very different from the debt of a family or a business
not so equipped.' The public debt is embodied in
risk-free financial instruments which appear as assets
on the balance sheets of holders. For the nation as a
whole, the public debt is largely equivalent to public
holdings of these risk-free financial assets. The extinguishing of public debt by repayment extinguishes
the asset as well.
Attitudes toward federal debt and the deficits that
result in the debt are thus colored by accounting terminology and the analogies to which it leads. There
are other, more substamive objections to an un-
balanced budget, of course. Conservatives respond
favorably to a commitment to a budget balance,
partly because they believe it to be a constraint on
government spending, and hence a protection of the
relative size of the private sector; and also because
they think of a budget deficit (that is, a departure
from a zero balance) as being inherently and inevitably inflationary, in direct and linear proportion
to the size of the deficit (the departure from zero
balance). Even liberals, studying prospects for
private capital formation over the longer term, have
argued for a balanced budget (or even a surplus) at
full employment, because they consider the financing
lThis is true even of federal debt held by foreign individuals and
banks, and in1erna1ional institutions, so long as the debt is
denominated in the national currency.
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of the deficit to be an invasion of a fixed supply of
long-term capital available for investment and
growth. These propositions are by no means foolish
analogies; there are doubtless deficits of a size (and
composed of a structure of spending and taxing) that
might well be inflationary, and might well impair
prospects for private capital formation. But it is not
at all clear a priori that a zero position in the
budget-that is, a close approximation to a perfect
balance-is inevitably and under all conditions the
proper or most desirable point in the spectrum of
budget outcomes for purposes of either price stability
or private capital formation. Nor is it at all clear,
given the present structure of the U.S. economy, that
a zero balance would be associated with the very important goal of sustained high employment and
minimal unemployment. This does not mean that a
balanced budget (or a surplus) is inherently
undesirable, or that a deficit is inherently desirable.
It simply means that "desirability" can be measured
only by economic consequences, in the long run, as
well as in the short run.
In all respects but one, a zero budget deficit (that
is, a zero position in the surplus-deficit scale)
resembles. zero on a Fahrenheit scale. It is simply a
point in a continuum, halfway between a $1 billion
surplus and a $1 billion deficit in much the same way
that a $3-billion surplus is halfway between a $4billion surplus and a $2-billion surplus. The one
respect in which it is distinguishable from other
budget outcomes (and in which it may be thought to
resemble zero on the Celsius scale) is that it connotes
a zero change in public debt. The question of whether
a balanced budget is desirable in the long run can
thus be translated, without any loss of meaning or
significance, into the question of whether zero
change in the federal debt is a desirable or stable condition for the system. (For some purposes, it may
even be useful to treat the level of the public debt as
the primary statistic, and the budget outcome as the
derived, first-difference result.) This question is examined in a later section. It is raised here because it
may help to dispel some of the strictly doctrinaire appeal of a "balanced budget."
We do not ask of a business that it never increase
its debt as it grows-nor do we ask of a growing
family that it fix its debt in absolute terms, despite an
increase in its income and living standards. Apart
from public debt, we are accustomed to looking at
debt relatively-relatively, that is, to the income flow
or asset base from which it is serviced. A family or
business may well be experiencing rising debt, and yet
33
be ''living within its means''-even if it is not ''living
within its income."
The history of economic reasoning about the
budget position has been moving for decades toward
this more general but less familiar view. For most of
our history, public policy sought simply to collect the
revenues to meet expenditures; on the eve of World
War I, the public debt was little changed from what it
had been 20 years earlier, and was actually lower
than the level that prevailed at the end of the Civil
War. Apart from the elevations of federal debt
associated with war, surpluses appear to have been
the rule rather than the exception. Prior to the
Depression of the 1930's, the Federal Government
was small (federal expenditures, exclusive of
statutory retirements of debt, amounted to only 3
percent of GNP in 1929) and severely limited in its
domestic functions and responsibilities.
ci.t
8 Total G,- Public Debt
-~------------------,,
800
100>,--------------~-----el
60
10 --------+-------------,
5
The Great Depression enormously enlarged the
role of government, and the wide acceptance of
Keynesian macroeconomics allocated to government
a major responsibility for the level of employment.'
After an ensuing further growth of government in-
tervention and of the size of the federal debt during
World War II, the nation emerged into the postwar
era prepared to commit itself, through the Full
Employment Act of 1946, to an aggressive
macroeconomic role. While we remained committed
in principle to a balanced budget, we gradually ac'The .. L-ompensatory" economic polides advoca1ed by Marriner
Eccles during those years supported the applications of Keynesianism in the United State~.
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cepted the realities of cyclical behavior of the budget.
In the presence of the so-called "automatic
stabilizers" (and together with the very high
dependence of the Federal Government on income
taxes whose base fluctuates with economic activity)
the system tended to run deficits in years of recession. Throughout the 19S0's, it became acceptable
budgetary practice to run a deficit in poor business
years, presumably to be at least partly offset by
surpluses in better years. This stage of evolution in
budgetary thinking might be called "cyclical
budgeting."
In the course of the l 950's, the extraordinarily liquid condition of the system-generated by a combination of massive federal budget deficits and
restraints on the price level during World War IIwas gradually neutralized; what could properly be
called a "postwar boom" appears to have ended
around 1957. In the years from 1957 to 1962, the
growth rate of the system subsided seriously. A deep
recession struck in 1958, followed surprisingly quickly by renewed recession in 1960. Even in 1962, only a
year after the onset of recovery, the growth rate appeared to be faltering again.
The response of budgetary thinking to this emerging stagnation of the system took the form of "fullemployment budgeting," a principle that had not
been unknown even before World War II, but suddenly appeared to be an appropriate application of
Keynesian reasoning to align budgeting practice with
the substantial macroeconomic role of government.
The "new economics" of the Kennedy years
established full-employment budgeting-in which
budgets are calculated to balance at the receipts constructively available at full-employment, and to
generate stimulative deficits in proportion to the
shortfall from full employment-as the accepted
wisdom among the great majority of practicing and
academic economists. Since then, the full- employment income of the Federal Government has provided a guide to the presumably noninflationary limits
of federal spending. While full-employment
budgeting represents a substantial departure from
earlier practice (or at least a new rationale for the
pragmatism that had characterized federal fiscal
policy even in the I950's), it retained a balanced
budget as a significant event. (Full-employment
budgeting tacitly accepts long-term growth of the
federal debt, since it does not specifically argue for
surpluses at full employment to offset deficits in
years of less-than-full employment.) Its general propositions are still widely accepted, although two minor
34
elaborations have recently appeared, in response to
conditions and problems in the performance of the
system as a whole.
The first of these would tolerate a departure from
full-employment budgeting-in the direction of a
full-employment deficit-as a temporary device
under severely depressed economic conditions, in
order to accelerate recovery. At a later point in the
recovery, fiscal policy would presumably make a
kind of midcourse correction to restore the fullemployment balance. This reasoning arose in
response to the severe recession of 1974-197S. In the
same years-from about 1973 to the presentanother variation of the general principle has arisen
in connection with a threatened inadequacy of
private capital formation. This variation proposes
that the budget achieve a surplus of at least moderate
dimensions at full employment, to provide a margin
of federal saving to contribute to a presumed very
high (but perhaps temporary) need for private investment. Such a budget surplus would, it is argued, provide a flow of real saving into the capital market for
the use of private investment.
This woefully oversimplified history of the evolution of views on budgetary targets may be enough to
indicate that the changes in views have arisen not so
much from elaborations of theory but, rather, from
responses to demonstrated needs, as exposed by actual performance of the whole system with respect to
its true ends. Indeed, all of the changes in theoretical
formulation were preceded by entirely pragmatic
adaptation to necessities, dictated by the evolution of
the system, and particularly of the role of government.
The experience of the past three years, in which the
actual budget deficit has been far larger than any
projections at the start of the period would have
envisioned-and more persistent than the currently
accepted formulation of budgeting objectives would
have approved- raises the question whether even the
evolved views of budgetary objectives now meet the
needs of the system (including the private sector of
the system) and whether they offer budgetary criteria
that are coherently related to the other objectivesthe true ends-of economic policy.
a-e TIie - - Paeltlon, Growth and Inflation,
Five- Veer AVWll!lff
Surplue or Detlclt
Percent of GNP
_,L..._________________
u■
J
J@rirubrnl
hrirl:@JOO
01848-
1952-
1956-
1960-
1964-
1968-
1972-
1973-
1952
1956
1960
1984
1968
1972
1978
197,7
of civilian goods had restrained the price level and accumulated record volumes both of savings and of unsatisfied real demands. The "real" liquidity of the
system-that is, nominal asset holdings in relation to
the price level-was dramatically high. Abnormally
liquid, and hungry for output, the private sector of
the U.S. economy emerged from the Depression and
World War II with violent energy in its balance
sheet-enough in even the very earliest postwar
years, while reconversion to civilian production was
still in progress, to drive the budget position into a
modest surplus in 1946, and then a surplus amounting almost to 6 percent of GNP in 1947.' Excepting,
significantly, only the recession year of 1949, the
budget was in surplus in every year until 19S1.
Modest deficits were run in 19S2 and 1953, as Korean
War expenditures reached their peak, and a second
cyclical deficit appeared in the recession year 1954. In
the years 1955 to 1957, in what might be described as
the final flowering of' a true postwar boom, modest
surpluses appeared in each year. Small deficits then
Budgetary Outcomes: The Postwar Record
At the end of World War II, the American
economy was altogether abnormally liquid. For live
years, public holdings of public debt had grown enormously, while price controls and controls over output
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Federal Reserve Bank of St. Louis
~Budget data in ths section are on a national-income-accounts
(NIA) basis, which offers quarterly data at seasonally adjusted annual rates, and calendar-year 101als. The NIA data differ from
budget data in timing and coverage, but the typical aggregate dif-
ferences are small.
35
predominated from 1958 to 1962, as the energies of
the postwar boom subsided, and were gradually
replaced by the stimulative policies of "the new
economics." From 1963 to 1965, the budget was
close to balance. Deficits were experienced in 1966 to
1968, as expenditures for the Vietnam War rose to a
peak; and the budget position returned briefly tci a
moderate surplus in 1969, thanks both to vigorous
economic experience and a short-lived surtax. Starting in 1970, the budget has been in continuous
deficit, reduced nearly to a balance by the boom in
1973, and then vastly augmented by recession in 1975
and 1976.
Chart
8
The Budget Position, Nine-Year
Moving Averages
%
1.5~------------------,
1.0
Average Surplue or DeflcH
>¼------••
a Percent of GNID-------1
0.5
come, from an average surplus of 1.3 percent of
GNP in the earliest period to an average deficit of 2.6
percent of GNP in the latest period. (In the later
periods shown in the chart, the deepening deficit is
associated, not necessarily causally, with a falling
real-growth rate, and a rising rate of inflation.) If
nine-year averages are used (beginning with the
period 1947-1955 and ending with the period
1969-1977), the number of quarters in which the
budget was in surplus likewise declines almost
without interruption from twenty (out of thirty-six)
in the earliest period to four in the latest period; and
the average surplus or deficit also subsides almost
perfectly smoothly from a 1.1 percent surplus in the
earliest period to a 2.0 percent deficit in the latest
period. The evidence is suggestive of a secular trend
toward deficit throughout the postwar years, briefly
interrupted in the first half of the l960's by the innovations of the ''new economics.''
It is part of accepted reasoning about the budget
position that deficits are a form of public investment,
and hence stimulative to the private sector and to the
private income flows that form the tax base-and,
hence, at least partly self-liquidating in time. Conversely, budget surpluses are thought to be a restraint
on the private sector, and are considered anti- inflationary and, perhaps, deflationary.
The postwar history of the budget position suggests that budget deficits have grown somewhat less
stimulative to the private sector over time, and, as a
Soun:n: U.S. Department of Commen:e; Th• COnference Board
If this long postwar experience is summarized in
five-year period averages, beginning with the period
1948-1952 and ending with the period 1973-1977, at
least some of the cyclical and war-induced influences
on the budget are smoothed. Such period averages
disclose a gradual subsidence of the budgetary out-
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Federal Reserve Bank of St. Louis
corollary, that budget surpluses (or even close approaches to surplus, as in 1973) have grown more
restrictive, and more likely to produce recession. In
the early postwar years ending in 1955, the two
cyclical deficits (in 1949 and 1954) were followed by
surpluses in the two following years (1950-1951, and
1955-1956). In the II years, from 1955 to 1965, the
cyclical recovery of deficits is still visible, but
somewhat less so; and in the period from 1965 to
1976 (in which only two surplus years occurred) the
cyclical recovery of the deficit gradually disappears:
deficits have been followed by deficits.
The cyclical deficit of 1949 was followed by two
years of surpluses; the cyclical deficit of 1954 was
followed by three years of surpluses; the cyclical
deficit of 1958 was followed by only a gradual
recovery that did not reach a surplus until the second
year. The fiscal deficit of 1971 was followed by continuing deficits; and the near approach to budgetary
balance during the boom of 1973 has been followed
by the deepest peacetime deficits on record. Judging
from the present expectations for 1977 and 1978, the
36
a.,r1
G
The Deteriorating Tendency of Budget Deficits to be Self-Correcting
EMlllons ol Dollars
1ۤ@FMOi
(calendar Year Basis)
itMOWEt¼i
11
ID
,. ___,.c--•'5'
SUrpLIBFallowad
-II
brDeflctt
-11
'74
Note:Scalloompreaed
Sources:U.S.Oepertm,antofCommerce;Th&ConfereneeBoerd
ll= Actual Budget Surplus or Deficit
huge deficits of 1975 and 1976 have not themselves
produced any visible potential for a recovery to
budgetary balance. In the first of the three periods
under discussion here (1947-1955), there were four
years in which a surplus was followed by an average
surplus in the ensuing two years. In the second of the
two periods (1955-1965), there was only one such
observat,ion; in the final period ( 1965-1976), there are
no such observations; virtually all of the years fall in
the quadrant indicating deficit followed by deficit,
and the circular pattern of self-correction so visible
for 1947-1955 has disintegrated into continuous
deficit. (See Chart 6.)
ensuing sections. Here, it is appropriate to note an internal feature of budgetary behavior that may well
explain a significant portion of the subsidence of the
deficit position. This feature is the change in the
nature of federal outlays.
A first obvious trend within federal outlays is the
pronounced decline of direct purchases of goods and
services as a percentage of total outlay, and the rise in
Chor10
...
y: Averag1Surpluaor Deficit cwerthll Next Two Y•R
The Composition of Total Federal Outlay
80.-----------------~
70
The Changed Nature of Federal Outlays
The internal evidence simply within the time series
for budgetary outcomes in the postwar years carries
the suggestion of a secular decline in the budgetary
position, and a reduced response of the tax base to
the stimulative effects of increased federal outlay, or
of tax reduction. A number of trends visible in the
postwar record of the U.S. economy could account
for this result. It may be the effect of offsetting anticyclical and/ or anti-inflationary monetary policy; it
may be a consequence of the rising rate of inflation
itself (which reduces the real significance of nominal
liquidity, including the federal-debt component of liquidity); ii may be the result of a declining
autonomous growth potential in the non-federal sector, and particularly a decline in the energy of private
investment. Or it may be the result of international
developments affecting the behavior of the domestic
· economy. Some of these possibilities are explored in
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Federal Reserve Bank of St. Louis
50
1
Trlllllfer PaJIIIINlle /""""'
.....w-...
30
\l,
20 ,__
___...,_
.................
..,_ -.. ...,../
___,~-··-··_·_ _ _ _ _ _ _ _ _ _ ___,
··'
10
OL.L...........LIU....L..L-'-'...LIU....L..L-'-'...LIU.......................L.L.L-'-'--'-'
1947 '50
'55
'65
'75 '77
'70
'80
Note:
Exdudas"NctlnbrfflP■id':"Sublidi•lmCumntSurplusofGcwemll'IIIIII
Enta,priM," and ''Wage Aca\11111 ... Dilbcnementt"
~ : U.S. D11p11rtmel'ltof Commeroa; Thll Conlarm Baad
37
the share of transfers to individuals and to state and
local governments. In the early postwar years,
transfers temporarily constituted an abnormally high
share of total outlays (in the years 1947 to 1950 they
averaged about 34.5 percent). This high share was a
reflection of the post-World War JI veterans' readjustment programs. Thereafter, the share of purchases of goods and services rose from about 43 percent in 1947 to over 74 percent in 1953 (the last year
of the Korean War). From 1953 on, transfer
payments have persistently taken a larger share of
total outlay, and goods and services purchases a
smaller share. In 1974, the relationships crossed over;
transfer payments to persons exceeded purchases of
goods and services. In 1977, transfer payments accounted for almost 41 percent of all spending, and
purchases of goods and services only 34 percent.
Grants-in-aid to state and local governments, expressed as a share of total federal outlay, hit a trough
of 3. 7 percent in the early 1950's, and have since risen
almost without interruption; they now account for
more than 15 percent of total federal outlay. In 1977,
the combined total of transfer payments to persons
and grants-in-aid to state and local governments was
65 percent greater than outlays for goods and services, and comprised 57 percent of total federal
outlay.
Even within the total of purchases of goods and
Chart
O
The Distribution of Federal
of Goode and Services
'I,
Purchase■
Chart
.
Soun:es: U.S. ~ o f Commaree;TheConferenca Board
services, significant trends in the composition of
spending appear. In 1955, purchases of goods constituted 38 percent of total purchases of goods and
services; in I 965, they accounted for 27 percent, and,
in I 977, for 20 percent. Purchases of structures by
the Federal Government were 5.4 percent of total
purchases in 1965, and4_3 percent in 1977. Purchases
of goods and structures, taken together, have fallen
more or less steadily from over 43 percent of all purchases in 1955 to 33 percent in 1965, and 24.0 percent
90
Compensation of Employeu
The Shara of Goode and Structuraa In
Total Federal Outlay
~---------------------------------------------------------·------·--------
Chart 4!)
100
80
O
Federal Purchaaea of Goode and
Structuraa as a Percant of
Gro88 National Product
%
w----------------------------------------··-----··------------------------·-
70
9----------------------------------------------------------------------------
Source,,: U.S. 09partmant of Commarce; The Confarance
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Federal Reserve Bank of St. Louis
Board
Source.: U.S. Department of Commerce; The Conm'811ce Board
38
in 1977. In the same 2()..year period, purchases of services have risen from about 15 percent of all purchases to 30 percent, and compensation of employees
from about 41 percent to about 46 percent. In terms
of total federal spending, purchases of goods and
structures have fallen from about 28 percent of all
spending in I 955 to about I9 percent in I 966, and to
about 8 percent in 1977.
This is an altogether dramatic inversion of spending patterns within aggregate federal outlays. It is
difficult to believe that it has no significance for the
budgetary outcome. In terms of total federal spending, the compensation of federal employees, together
with transfer payments to persons and transfers to
state and local government, now account for over 80
percent of all federal outlay. The general impression
that the Federal Government is a stimulative, and
perhaps an oppressive, inflationary presence in the
real markets for the output of American industry is
unwarranted. On the contrary, this component has
been shrinking dramatically as a component of
federal outlay, and just as dramatically as a percentage of total national output. Payroll and transfers
are now the overwhelming costs of the Federal
Government. In I 975, the combined purchases of
goods (including defense goods, of course) and construction by the Federal Government amounted to 2
percent of gross national product.
Another insight into the changing relationship of
the Federal Government to the rest of the system is
provided by the national-accounts measure of the
"output" of the Federal Government, and its contrast with the much more familiar measure of the
purchases of the Federal Government. As a share of
Chart
CP
the nation's total gross product, federal purchase of
goods and services in the years I947 to 1977 ranged
from about 5.5 percent (in 1947) to a peak of 15.7
percent (in 1953, the last year of the Korean War).
The "output" of goods and services by the Federal
Government in the same years has ranged from a low
of 3.4 percent (in 1948) to a high of 5.4 percent (in
1952). Without exception in every postwar year, the
expenditures of the Federal Government have exceeded its own output; it is thus characteristically a
net importer of goods and services from the other
sectors of the economy, the significance of the. net
importation being measured by the difference between its output and its purchases. This net importation gap reached a peak of 10.6 percent of GNP in
1953; it declined irregularly thereafter, rose briefly in
the years of the Vietnam War, and since then has
subsided strikingly, to 4.2 percent of the GNP in
1977. (The output of the Federal Government is
predominantly service, including, of course, the ser-
vices of its own employees.) The Federal Government's net demand on the rest of the system-that is,
the excess of its purchases over its own output-is
now lower than at any time since 1948, about onethird lower than in the early 1960's, and half its
relative importance in the early 1950's. State and
local governments, on the other hand, have grown as
a net importing sector, from about 3.5 percent of
GNP in the middle J950's to 4.5 percent in the middle
1960's, and to about 6 percent currently. What might
be called the net buying function of government in
the United States has been gradually shifting from
the federal to the state-local level.
As a final note on this subject, it is difficult to
Output and Expandlturaa of tha Government Sector
Percent
Percent
~ - - - - - - - - - - - - . , a .--------------,1• .--------------,
StateandLocat
Nettmport•
~=~~~~=~~~~~-~o
1947 '50
'55
'60
'65
'70
'75'77 1947 '50
SOllrces: U.S. Dep..-trnent of Comm&n:11; The Conference Boan:!
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Federal Reserve Bank of St. Louis
'55
'60
'65
'70
~~~~~~=~~~~==
'75 '77 1947 '50
'55
'60
'85
'70
'75 '77
39
believe that the rapid growth of grants-in-aid to state
and local governments has no bearing on budgetary
outcomes. The share of grants-in-aid in total federal
outlays reached a trough of 4.2 percent in 1954; the
share has ri5en, almost without interruption, to 16.0
percent in f977. Since 1970 , grants-in-aid have increased at ibOut 16 percent per annum. Jr such
outlays we,; excluded from federal budget expenditures, the budgetary outcome would have been a
surplus in every year since 1968, with the exception of
I 975. The accumulated deficits of the years 1974 10
1977 amounted to over $185 billion; excluding
gra nt s-in-aid, the aggregate outcome for these four
years would ha ve bee n a surplus of about $40
billion. 1 The transfers of federal funds 10 state and
local governments represen t, in a sense, 1he
monetization of a portion of 1he financial requirements of these governments, which lack 1he
convenience of 1heir own Federal Reserve system.
These points themselves say nothing about the virtues of tran sfers or grants-in-aid, nor do they argue
for or against a restructuring of the spending pallerns
of the Federal Government. But if it were to be accepted that direct purchases of goods and structures
from the business sec tor exert a larger multiplier on
private economic activity (and hence on the tax base)
than compensation of employees and transfers, 1hen
it should be concluded that aggrega1e federal outlays
are no longer as stimulative as 1hey were one or two
decades ago, and, as a corollary, that budget deficit s
1hem selves are no longer as stimulative, and hence no
longer as self-correcting, as 1hey were. Unless the
composition of federal outlay is substa ntially altered
from it s present composition, 1here is a case for arguin g that the effort 10 see k a balanced budget wi ll be
more denationary than il was 10 or 20 years ago.
There is a suggestion in these arguments 1hat under
presenl accounting, and given the prese nt composi1ion of outlay, a sustained deficit (considerably
lower, one can hope, than th e $60-billion average of
fi scal 1976-1978) may be required to avoid recession
and maintain economic growth. Al the least, they
emphatically suggest 1ha1 the 1reatment of a zero
balance as intrinsically appropria1e ma y be a serious
co nstraint on the freedom of fiscal policy to see k 1he
goals of growth and stability under the present
distribution of government outlay. The road to a
balanced budget see ms 10 run partly through some
very difficult social terrain, where transfer programs
originate.
The Federal Debt in Perspective
Total federal debt outstanding can be thought of
as the accumulated total of past surpluses and
deficit s. There are several different statistical concepts of the federal debt, and the year-to-year change
Chart
CD
Grou Federal Debt and Its Relationship
to Gross National Product
2.500 ~ - -- - - - - - - - - - - - - ~
Billions of Dollars
R•tio~
2.000 >--- - - - - --
- - - - - - - -~ ;
...···'········
__
..
....···
..·····
1.000 f--- - - - - - - -- - _..~-- _-...,C....~-.,;..;
9()()f--- - - - - - - - - -.T.- /c'"-~ -- , , --i
~
: =======__=
____=___=__:=::·=
.-:_
=
:::=
: ~-i":::_--:._
::··_:.., .- :_.. - -- --,
400
200>-o-'~ - ~ - - - - - - - -- -+-- - --i
.·••·
,_:///
;r-}f·· . . .·······
1:~~=========~==
- -:·:================--,
-1
80
'' ''
110
f--- -- - ~70 f--- -...~_..,..-~··_···_ __
Groas Federal Debt as a
90
80>--- . , . - - - - 50 ....,,~--~ - - - - 50
40 t - -- - - - -
'Thi ~ i~. of l·our~e. an ovl."r~imrlifil·ation. The expendit ure of 1he
grant~ (IOgclh('r with macd1ing fund s) by ~late and IOl·al governllll'lll S douh1k,~ l'nlarged 1he fcdl·ral ia,. ba ~e; without 1hem,
frdl."ral revenue~ "ould haw hCl'll k ~s than they were. Alternaci vl'·
ly, d 'fon ., <lf ~•atl' and lol.'.al governmrn1 ., 10 raiw thi: equivalent
ca., rl'H'nucs 1hl' lll\l'l\ l'~ "ould ha ve- dl'rre"ed the federal tax hasl'.
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Federal Reserve Bank of St. Louis
30 >--- - - - - - •47 ·so
25
·ss '60 ·55
70
30
75·77
~~~~~~~~~~~~~~~~~~
1947
'50
·55
"60
"65
"70
hcludetFedefally•sponso,edcredita,gencin
Sources: U.S. T,easurv Dep1nment; U.S. [)ep1fl!T>"11 of Commerce;
TheConferenceBotrd
'75 '77
40
in any of them will not be identical with the budget
measures of surplus or deficit owing to differences in
concept and liming, changes in Treasury cash
balances, inclusion or exclusion of the debts of certain agencies and of nonmarketable debt , and inclu-
sion or exclusion of holdings of federal debt instruments by federal agencies. In general , however,
we can expect that a balanced budget produces little
change in the outstanding debt ; significant surpluses
will reduce the outstanding debt; and significant
deficits will increase it .
In the past history of the deficit, spectacular
deficits have been inevitably associated with war.
doubtless reflect political and social decisions that
gave a great deal of weight to considerations other
than their budgetary impact, and these decisions can
be fairly questioned-indeed, they should be.• But
the record of the growth of public debt over the
longer term in the United States does not itself provide grqunds for intense moral criticism or fear,
which rest on an excessively simple reading of the
word "debt" in its application to federal credit instruments.
Unlike debt instruments of the private sector, or
even of state and local governments, federal debt
obligations are backed by the full faith and credit of
From 1861 to 1865, the total public debt rose from
under $l00 million to about $2.7 billion. (See Chart
3.) In the I 880's and the early I 890' s, the deficit was
reduced by continuous surpluses, to a point below $1
billion; and it remained in a low $I-billion range,
a sovereign nation entirely capable of creating the
with alternations of surpluses and deficits, until the
solvency risk. (Depending on their maturity, their
current value may fluctuate less or more widely. of
course, as prevailing current interest rates may determine.) The interes t rate applicable to such securities
is a function of the rates available on alternative investments, and the risk preferences of investors.
Viewed this way, the credit instruments that are the
beginning of World War I. By 1919, the debt exceeded $25 billion. Thereafter, throughout the boom of
the 1920's, the debt fell , reaching $16 billion in fi scal
1930. (During the l920' s, debt reduction was requi rsed by statute.) Starting in 1932, countercyclical
defi~its of $2 billion to $4 billion elevated the public
debt to about $40 billion in 1939.
At the end of World War II , the gross debt was
about $270 billion. Offsetting surpluses and deficits
in the first postwar decade left the debt virtually unchanged in 1957. Thereafter, deficits have far outrun
the occasional small surpluses; by 1965 the debt had
reached $325 billion, and by 1970 about $400 billion .
At the end of I 977, the gross federal debt was
estimated at $715 billion; in I 977 , interest charges on
the debt were higher than the outstanding debt in
1939.
In the 30 years following the Civil War, the debt
was reduced by almost two-thirds. In the 10 years
following the end of World War I, the debt was
reduced by about one-third; in the decade following
the end of World War II, the debt was not reduced at
all, and in the three decades following the end of
World War II it had increased roughly two and onehalf times.
The public perception of this record of debt
growth in the postwar years takes it to be an indica-
funds required to meet its obligations. While holding
them involves an intervening inflation risk, as does
the holding of all credit instruments and even the
holding of cash itself, federal obligations carry no
mirror image of the federal debt are a part
(distinguishable, of course, from other parts) of the
liquidity of the economic system as a whole. A
system can be " too liquid ," in the sense that the liquidity imparts an inflationary thrust to the system;
and it can also be " too illiquid," with resulting deflationary pressures. The growth of the holdings of
federal debt instruments may be related to inflation
or deflation, but not to bankruptcy.
Viewed against this backgro und of the behavior of
the economic system as a whole, and the trend in the
real and nominal size of the flows through it s
operating statement (as summarized by the GNP),
the elevation of federal debt in the postwar years is
hardly conclusive evidence of overt mismanagement
and growing " risk"; on the contrary, the growth of
private debt has been vastly more rapid (and perhaps
more "risky" ), in actual terms as well as relatively to
other appropriate dimensions of the economy . 1
Between 1947 and 1974, the relationship of the
federal debt to national output declined persistently,
tion of improvident government, in violation of the
most elementary rules of prudent stewardship, a
principal cause of the inflation of the price of
everything, and , ultimately, a threat to national
solvency. The enormous deficits of recent years (and
the large prospective deficits of this and next year)
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Federal Reserve Bank of St. Louis
•One such set of dedsions- 1he combined "guns and butler"
programs of the Viemam War years- has been the subj ect of ;ippropriate cri ticism.
' The growth of corpora1e debt in particular may renect, in part ,
an in sufficiently fa vorable environment for net new equit y issuance.
41
except in the presence of extraordinary cyclical conditions or military demands. Cyclical interruption occurred in 1949; the decline leveled off during the
Korean War; it was reversed briefly during the recession of 1958; •it was ·reversed again in one year of the
Vietnam War. The decline leveled off in the
1970-1971 recession, and resumed in the expansion
from 1972 to 1974. The relative debt has since risen
sharply, under the recession conditions of 1975-1976.
Viewed against a backdrop of percentages of GNP,
the debt fell from slightly over 100 percent of GNP in
1947 to about 40 percent in the late I 960's. In the early 1970's, it fell below 40 percent, and has ·been
restored 10 40 percent by the very large deficits of
1975-1977. These figures carry the suggestion that,
given the present structure of federal spending and
the autonomous strength and debt-carrying capacity
oT the non-federal sector, a level of public debt
significantly below 40 percent of gross national product may be deflationary and unsustainable- that is,
it may so constrain activity and the tax base as to produce recession and a decline of the tax base, and
hence a new contracyclical expansion of federal debt.
This observation should , of course, be treated as
highly tentative, because its implications are so large.
Given the present level of federal debt, growth of the
debt in proportion to the recent growth of nominal
GNP would connote annual budget deficits of
perhaps $70 billion; that is, at a 10 percent growth
rate of nominal GNP (which would imply about the6
percent in nation rate of recenl years) a $70 billion increase in federal debt would leave the relationship of
the debt 10 GNP unchanged. Formulated in this admittedly unfamiliar bu1 revealing way, the rela1ionship suggests 1hat a reduction in the rate of innation
would be associated with an improvement in the
budgetary outcome-a reversal of the conventional
causality.
Another accompanying chart calculates the public
debt in real terms-a statistical process that leaves
something to be desired in the way of conceptual
clarity. but nevertheless appears to be revealing. The
real value of the debt (shown in the chart at several
different price levels) declined until 1957, and was
about unchanged from 1957 10 1965. It rose and subsided with the Vietnam War in the late 1960' s, and
again in the recessio n and recovery of the early
I 970's. As late as 1974, the real equivalent of the debt
was about as low as at any time in the postwar years,
and substantially below its levels of the early postwar
years. In 1975-1977, the real debt rose sharply (that
is, the debt rose at a faster percentage rate than the
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Federal Reserve Bank of St. Louis
"""" '9
Groaa Fede rel Debt In Current and
Constant Dollars
aoo~----------------~
Billions of Dollars
·._
600
...---·····-..
___________
...-·-....-·········-....·--···...______...······-..
r-- - - - ~ ~ -- -- - - - - - - . . - - 1
1977 Dollars
··--..________ ....... --··
1972 Dollars
1950 Dollars
Sou rces : U. S. Treasurv D-,1men1; U.S. D~tment of Commerce; The Confer.- Board
ongoing rate of innation). The elevation of the actual
debt, shown on the same chart in current dollars, is in
considerable measure a reflection of the same
postwar in nation that characterizes virtually all other
value series. The growth of the public debt appears to
be intricately related 10 the behavior of the system as
a whole, particularly its price behavior. Much of the
abnormal rise in the debt relationships 10 GNP and
to prices since 197S reveals the impact of severely abnormal domestic and international conditions on a
budget struct ure that had acquired vastly augmented
social functions and responsibilities, and necessarily
42
Cl>anG) Total Gl'OIIS Debt and Its Relatlonahlp
to Gl'OIIS National Product
5000,-----------------~
Billions of Dollars
4000
'
230
-
Total Gross Oebt asa
Percent of GNP
220
3000
state and local debt appears to have slowed around
the middle 1960's; since then, the rise has been
roughly equivalent to the advance of nat io nal o utput .
(This outcome is doubtless influenced by the rapid
grow th of federal transfers 10 state and local governments.) Nol so wit h private debt , wh ich rose from
about 80 percent of GNP in the ea rly postwar yea rs
to JOO percent by 1953, 120percent by 1959, l40percent by 1964, 160 percent by I 970, a nd 170 percent by
1974. Significantl y, the percentages fell in 1975
th roug h 1977. Corporate debt, relative to national
outp ut, rose above 100 percent of GNP in the early
1970's a nd fell in 1975-1977; personal debt leveled
off at about 65 percent of GNP in I 972. The servicing burden of private debt (that is, the corporate interest payments relati ve to corporate earnings, and
personal interest payments rela ti ve to personal income) reached postwar pea ks aro und 1973; the ascent of the corporate int erest burden in the late
1960's and early 1970's-the go-go yea rs of debt
leverage-was spectacular.
Continuous growth of aggregate debt (including
public a nd private) in correspondence wit h (in fact
Chon
CD State and Local Debt and Its Relationship
to Groaa National Product
500 ~ - - - - - - - - - - - - - - - - ~
Billions of Dollars
400
R ffioScM
, - - - - - ----;
20
State and Local Debt asa
Percent of GNP
300
200
-
-
'',7 '50 ' ·55
- ---"60
'65
••·••••••
Stata and Local
15
-
Debt
.·••·
,o
'70'
300~~~~~~~~~~~~~~~~~~
1947 '50
'55
'60
'65
'70
'75 '77
Sou tCfl: U.S. Oe,»n ment of ComrMKll; The ConfHence Board
responded to the same rise in costs and prices that affected the private sector. In this sense. it would be as
unreasonable to expect public debt to remain constant in the presence of inflation as it would be to expect the debt of a growing corporation to remain
constant under such conditions.
Unlike the federal debt, both state-local debt and
private debt have risen much faster than total national output in the postwar years, with the result
that the tota l debt (federal, state-local and private)
has risen from about 190 percent of GNP in the middle 1950's to about 205 percent in the middle I 960' s,
and to 225 percent in recent years. The relative rise of
https://fraser.stlouisfed.org
Federal Reserve Bank of St. Louis
100 1-- - - - -,,-r"-'-----~ ,__- - , - " - - - --j
: 1-- - - 1'!.~'! ....
70
..... ····:~~~.~~
••.,c··,11
··~·- - - . - ' - - - - - •••"'
·· ~··•_' ----j
60 l - - - ~ 50
40
30
20
••
••• /:..~-.~~·~
. ···_··_· - - - -.~···_· - ---<
~ - - --#--,.~ - - - - - -··-···_···_·- - ---<
...•·····
1-- H,__ _ _ _ _7 " - -- - - - --1
~.... <J-_rt:····....
1->----~=•·_··_··_··__________- i
....-·_............•······
Sourcn , U.S. Department of ~ c e; The Conftunce Eloard
43
Charte
Total Private Debt and Its Relationship
to Gro88 National Product
4.000 ~ - - - - - - - - - - - - - - - - - - ,
Billions ol Dollars
deb, was being liquida1ed; in mos, of 1he 1930' s,
private debt fell even in absolute amount, through
default , repossession a nd bankruptcy, while 1he
public debt rose sha rp ly in a co uni ercydica l
response. The pronounced decline of 1he fed era l deb,
in the firs1 postwar decade, relative to gross national
product, was associated with extremely rapid growth,
bolh abso lu1 ely and rela1ively, in non-federal deb1.
Viewed this way, the recent very sharp acceleration
of publ ic deb1 is partly a r·e sponse to 1he lessened propensities to in cur debt in 1he private sec1or, and an
actua l decline of re lative debt of s1a1 e- local government s. In the presence of a now nea rl y ex plicit co mChart ~
1.000
900
Corporate Debt and Its Relationship
to Gro88 National Product
2,500 , - - - - - - - - - - - - - - - - - - ,
Billions of Dollars
800
700
2.000
600
500
400
1.000
300
900
800>-- - - - - - - - - ~ - , - - -, -s - - ~ -~
100
5QOf--- - - - - - T
..............•
'55
'60
'65
'70
'75 ' 77
400 l ----7"~-.T,•
..···•··
100~~~~~~~~~~~~~~~~~~
1947 '50
·55
·so
·55
·70
'75 '77
Sources: U.S . l>epart=t of Comme<ce: TM Confen,nce Board
slighlly fasler than) 1he grow1h of the nominal va lue
of output appears to be a fundamental condition of
the system if it is to remain near full employment.
Taking the 1wo componenls of federal deb1 and nonfederal debt (including state-local as well as private
debt), the record suggests tha1 1he sysiem produces
systematic offsetting changes in the two debt components. In periods of rapid formation of private
deb1, the federal debt is rela1ively remained; when
private debt is restrained , the system falls away from
full employment, and 1he resulling budge1ary defici1 s
maintain the grow1h rale of aggregate debl. In 1he
1920's, private debt rose very rapidly, while federal
https://fraser.stlouisfed.org
Federal Reserve Bank of St. Louis
.......... /.
300i---,-- - , - ~ - ~,._,...__ _- - - - - - -,
......... /
/.·
,..,,/.>./'
100f--+-- - - - - - - - - - - - - - - -,
90 '-'-"-'--'-'-"-'-'-~~........~~~~~~~~~j
1947
'50
•55
·so
·es
Sources: U.S. e>ep.,tmenl o l ComrM<ce; TM Confe<..-..:e Board
'70
'75 '77
44
Chart
CD
Personal Debt and Its Relationship
to Gross National Product
2,000 . - - - - - - - - - - - - - - - - - ~
Billions of Dollars
1,500
>-·- - "-· - - - - - -- ~ - - - - - - - - - - - '
Personal Debt as a
Percel'ltof GNP
Per90nal Debt •••-···
__
...
•
1,000
900
800
700
800
500
>-- -- -- - - ----+- ~ ~- ---+------<
...····
__
excessive money growth produce inflation, or, in the
presence of a high-employment commitment, does
inflation periodically demand rapid growth in
money?) ls the conventional view of the causal relation between deficits and inflation still effective?
These questions are crucial to the setting of fiscal
and monetary policies for a mixed economy; they are
crucial to a determination of whether an economy
constructed the way this one is can stay at high
employment without growth in aggregate debt (and
in money supply) proportionate to the growt h of
nomi nal output. If nominal output is being elevated
by an inflation originating outside these va riables,
3001-- - ~- --
-17---~--·_·_ ..,,,,.,__~---~ -,,c..-·_/ __. _-··_·_ . .
____ ..----
200r."-=--~
....
____
....-------·
...:::--~-1.-----
Chart
CD
The Percentage Distribution of
Total Debt
"
ao~----------------~
•~r-·_,,____=~------- - ------<
80 H,_- ...-..c-_,~•·-- · - - - - - - - - -- ----l
70 fl-- --~
.....-.' - - - - - - - - - - -- - - - - -----1
60 r - - - - - - - - - - -- -- - - ----<
50
r,--~--.'..- - -- - - - - -- - -- - --1
Note: lncludelu nincorponted ente,priNI
Sources: U.S. o,,p.,tmen l of Commerce; The Conference B011 rd
mitment to high employment, the falling away of the
propensity to enlarge debt in the non-federal sector
has become a causal element in the rapid growth of
debt in the federal sector. In terms of the distribution
of total (public and private) debt, federal debt fell
from 55 percent of the total in 1947 to 16 percent in
1974; it had recovered to 18 percent of the total by
1976_
This perspective on federal debt leaves open an important question. Since federal obligations are the
nearest eqivalent to cash, it can be argued that budget
deficits and the resulting growth of the public debt
are inherently inflationary; and that the inflation appears in the value of national output, which accounts
for the declining or stable relat ionship of the debt to
national output. Viewed this way, the stability of the
real (deflated) debt would seem to result from the
fact that the inflation caused by the rise of the debt
elevates the very price index used to deflate it. Does
the federal debt cause inflation, or (in the presence of
a high-employment commitment) does inflation
periodically demand a rise in the federal debt? (There
is a monetary parallel to this fiscal uncertainty_ Does
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Federal Reserve Bank of St. Louis
,..........................
401----.,.__----- -~··'''--...~_·l_. - - - ---l
\
.,...................•••••••····~rporate O.bt
.•~...........•·····~,
301-----,,:.-----~.--7"-,ca-------:=-~
••••.,,,ll
10
" - - - - - -- - - - - - - - - - -__J
....................
,.,,.,,,.,,...,,.,......
State and Local Debt
. ............... .
0 '--'--'-'--'-'-'--'--'--'--'...LI'--'--'-'--'-'-'--'--'--'--'...LI'--'--'-'-...Liw...J
...-•es
1947 '50
'55
'60
'75 '77
'70
•1ncludlluninoor,,ontld.-iterpritn
Soun:es: U.S. Dlp9rtrnent of
eomn-o.: n- Con..,_ lloerd
45
then both fiscal and monetary policy are under irresistible pressure to incorporate it. If they resist,
recession will compel them to do it anyway. In this
process, they give the impression of collaborating
with inflation, and even of causing it. If labor costs
rise rapidly, producing unemployment and then in-
creased federal spending (or tax reduction) and hence
a budget deficit, it is hard to argue that the deficit has
caused the inflation. In the presence of institutional
cost-push and a high-employment commitment,
budget deficits (and their associated money growth)
would seem to be more properly described as enabling conditions of the inflation, rather than its cause.•
Budget Outcomes
Budget Projections
and
actual receipts, expenditures and surplus or deficit.
The two sets of series together produce a third set.
The difference in the two receipts figures represents
the shortfall of government revenue attributable to
the system's operation below full employment. The
difference in the two spending series is the excess
spending (mainly unemployment benefits) resulting
from the excess of unemployment. And subtraction
of the full-employment surplus or deficit from the actual produces a measure of the deficit resulting from
a condition of less-than-full employment. (See Chart
20.)
The calculations served a strikingly useful purpose
in the early 1960's: They revealed that the system was
Full-Employment
In the hectic years of the Korean War, the Council
of Economic Advisers, alerted to the inflationary
consequences of war by the violent behavior of the
price level only a few years earlier, invented a calculation for measuring the inflationary potential of the
future called the "inflationary gap." The calculation
measured prospective demand, including the
demands of the growing war effort, and compared it
with a measure of the probable supply, both
measures being computed at then prevailing prices.
In those innocent and vigorous days, made more
vigorous by a renewed surge of wartime spending,
the prospective demand of course exceeded the prospective supply; the extent of the excess measured the
probable inflation pressure, and provided an indication of the tax increases necessary to remove the excess.
This procedure was a special case of what is now
called "full-employment" budget analysis. The case
was special in the sense that an actual condition of
full employment could safely be assumed. Interestingly, the present practice, for which the concepts were developed in the early 1960's, is directed
not to the inflation potential, but rather to the
budgetary outcome on the specific assumption of a
condition of full employment. The calculations pro-
Chart~ Three Views of the Budget Position
20~--------------~
Billions of Dollars
s.-.llyA,tum,l'A,mua/R-
-30
-40
10
-50
\
-70
-BO
Cyclical Budget
Position*
duce a continuous set of retrospective measures of
-90
full-employment budget receipts, expenditures and
surplus or deficit, which can be compared with the
-100
.,
-10
\
I
I
"'
'\ .rI
-20
-30
-40
I
"
"The high-employmem commitment is only one of a host of
social commitments of modern governmems that affect their
policies and their budget ouicomes. Certainly, the effort to
mitigate income inequality, by elevating transfers, has elevated
spending, and the consequent deficits.
36-066 0 - 79 https://fraser.stlouisfed.org
Federal Reserve Bank of St. Louis
4
1965 '66 '67 '68 '89 '70 '71 '72 '73 '74 '75 '76 '77
*Ai:tu■I-Hi9h-Employment SurplUIIJl"oeflcit
Stlurces; U.S. O■p■rtmm,1ofCommtn:11;St. Louis Flldar■ I R - ;
ThaConferel'lceBoard
-50
46
experiencing a very large structural budget surplus, a
non-federal sector, which must be vigorous enough
consequence of the persistence of wartime tax rates,
to drive the system toward full employment while absorbing the "fiscal drag" inherent in a falling budget
deficit.
In the 1970's, economic advisers to federal administrations and, in the past few years, the Congressional Budget Office that advises the Congress, have
projected the future of the budget and of the
economy several years into the future, making use of
the techniques of full-employment analysis. In effect,
the revenue side of the budget is projected by assuming (I) an economic growth path leading to full
employment; (2) the course of the general price level;
and (3) the existing tax rates, which are applied to the
taxable income !lows to reach the constructive
revenue total. The expenditure side of the budget is
even though the economic thrust provided by war
had long since subsided. At prevailing tax rates, the
Federal Government would have run a massive
surplus; the development of the surplus constituted a
"fiscal drag" on the private sector so severe as to
forestall the very rise to full employment on which
the receipts estimate was based. The tax rates that
called for such a surplus were thus inappropriate and
self-defeating; they condemned the system to
underemployment, and perhaps a budget deficit as
well.
After a brief interlude of guilt at the thought of
legislating tax reduction in the presence of a budget
deficit, the nation treated itself to a whole sinful feast
of tax reduction-personal rate reductions, a corporate reduction, an improvement in depreciation
allowances, and an investment tax credit, all within the years I 962 to I964. The results roundly confirmed the analysis. The system rose rapidly to full
employment, and the federal budget, benefiting from
the surge of taxable private revenues, reached
balance at the lower statutory rates.
The proposals for tax reduction that set this process in motion implied an immediate enlargement of
the budget deficit, deliberately induced; they depended upon the response of private markets to drive the
system back to full employment, and hence to higher
taxable revenues, and hence to a budget balance. The
fact that they worked demonstrated that a condition
of their working was satisfied. The private markets
were indeed responsive; that is, they were
characterized by considerable autonomous
strength-enough, at any rate, to produce full
employment without the help of any budget deficit at
all.
The dependence of the process on this condition
was more or less obscured in the general celebration
of the middle-1960's, and for a long time thereafter
full-employment budgeting lost sight of the condition. But it is nevertheless inherent in the customary
goals of full-employment accounting. Full employment itself can perhaps be achieved without reference
to the condition (by an overwhelmingly stimulative
deficit); and a balanced budget can perhaps be
achieved without reference to the condition (by
highly restrictive spending and tax policies). But the
simultaneous achievement of both objectives, starting from a position in which neither full employment nor a balanced budget prevails, must depend
upon some degree of autonomous strength in the
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Federal Reserve Bank of St. Louis
then projected on the basis of "current services" -
that is, assuming no new federal programs beyond
those mandated by present law. The procedure requires an assumption with respect to the inllation
rate affecting both sides of the budget, since inllation
interacts with the progressive personal tax structure.
(It interacts differentially with the real accounts in
other ways as well, in amounts and timing, but these
other interactions are usually ignored.) Both parties
in the 1976 election developed full-employment
budget projections for the next five years, and both
showed a budget surplus developing by 1980, and
reaching altogether boggling proportions in the early
years of the I 980's.
Such exercises incorporate several logical !laws
that vitiate their meaning, and make it risky to use
them as guides to prospective actual outcomes. The
projections simply assume away the uncertainty with
regard to the autonomous strength of the system;
that is, they assume the strength is there sufficiently
to produce both full employment and a balanced
budget-indeed, even full employment and a large
surplus. The favorable results of the projections also
hang on the progressive nature of the personal tax
structure. In the absence of reductions in the
statutory personal rate schedule, the growth in
employment assumed in the rise to full employment,
combined with the inllation assumption, tends to
elevate personal tax receipts faster than GNP, and
faster than personal income; the implicit effective
personal tax rate thus rises dramatically. In the most
widely publicized of these exercises, the effective
federal rate advances from about I I percent of
before-tax incomes in 1976 to about 15 percent in
1981. This is, of course, far higher than the level ever
reached by the effective personal rate. Moreover, the
47
price assumption is not related to any of the other
assumptions used in the process. It is derived from
nowhere as an exogenous element, independent of
the real world of the future, and not affected by
whatever decisions may be made with respect to the
spending and taxing outcomes.
The logic of such full-employment projections
treats the theoretical outcomes several years from
now as a potential real outcome, and assumes that
adjustment to alter the outcome is feasible and meaningful. The rise in the effective personal tax rate
means that the statutory rates can be reduced 10
reduce the constructive surplus, and the remainder of
the surplus can be used to fund additional federal
programs. The outcome is thus refitted to assure the
full employment that was assumed at the outset,
while reducing the constructive budget surplus to a
budget balance. (All of this, incidentally, without
altering the price outcome.)
In fact, the constructive full-employment economy
found by this process is not a part of a spectrum of
possible outcomes, and adjustment of its parts
crosses a logical divide that separates the impossible
from the possible. It is simply inconceivable that the
real economy, in the real world, would reach full
employment while generating an enormous federal
surplus; it is having trouble enough maintaining itself
at 7 percent unemployment while generating a $50billion deficit. It is likewise inconceivable that the
assumed inflation rate under conditions of an $80billion surplus would not be a lot higher if the surplus
were deliberately reduced by tax reduction and incremental government outlay.
The projection of the full-employment series into
the future may well be a useful exercise, and any
budget officer would be inclined to engage in it. But
conditions entirely outside the scope of the fullemployment projections permitted the simultaneous
achievement of the two goals of full employment and
a balanced budget. These conditions included a fullemployment surplus that could be liquidated; a near
balance in the actual budget; a low rate of inflation,
in the presence of reasonably effective wage and price
guidelines; a net export surplus; a still-high relationship of purchases to transfers in the mix of federal
spending; and a considerably lower relationship of
private debt to GNP, and a higher relationship of
public debt to CNP, than prevails today. Taken
together, these conditions were such as to encourage
a vigorous response of private activity to the tax
reductions of the early 1960's; that is, they permitted
and encouraged a vigorous state of autonomous
strength in the private sector, and hence a vigorous
response to the tax reductions. Moreover, there was
very little fiscal drag to be overcome in the early
Chart 0,
Projections of the Federal Budget
BIiiions of Dollars
its inherent structure of assumptions, some of them
not revealed in the process itself, drives the system inevitably into mysteriously favorable outcomesmysteriously, because they almost never eventuate.
They must inevitably hold out the promise of both
full employment and a balanced budget several years
out; but the promise simply _amounts to assuming
favorable outcomes to the disagreeable conditions
that are now maintaining the system very far from
full employment, and very far from a balanced
budget.
The good news provided by the projections is thus
largely an anifact of the methodology. What might
be deduced from the fact that the methodology appeared to work in the I 960's is not that the technique
is infallible, by any means, but rather that certain
https://fraser.stlouisfed.org
Federal Reserve Bank of St. Louis
.._
._
orDollolt
300
250
125
100
75
50
25
a
......,_....
-""'
"""""--
_
48
l 960's; the actual budget deficit fell only about $5
billion from fiscal 1962 to fiscal 1965, when it was
virtually in balance. To achieve an actual balance
now would involve a fiscal drag of as much as $60
billion. With respect to the autonomous strength of
the non-federal sector, it might be noted that in 1962
the system was able to maintain itself at 5.5 percent
unemployment, with a $?-billion deficit; it is now at
6.5 percent unemployment, with a $60-billion deficit.
Under present conditions, it may well turn out to be
necessary to forego the expectations raised by the
Cllort
e
full-employment projections, and to choose between
(or optimize) the goals of high employment and a
balanced budget.
Revelations of the Saving-Investment Balance
The uncertainties surrounding the happy outcomes
of full-employment projections are exposed more
systematically in the accounting of investment and
saving. In national accounting, aggregate saving is
the same quantity as aggregate investment, in any ac•
counting period, regardless of the level of activity, of
The Sevlng·lnvestment Balance
Bllions of Ool~s
so~-----------
80.------------
801----------~--I
7 0 > - - - - - - - - - - -........
Govemrnent Sector
Federal
0,-,-----------~
701------------1----1 8 0 > - - - - - - - - - - - . . . . . . ,
80 ....._ _ _ _ _ _ _ _ _ _ _,____.,
50>-----------__,
50>----------
401-------------.i
401----------
301------------
20
10
0
20
10
0
20
10
-·-
-•ndLocal
10
'55
'80
"65
'70
'75'77
20
Sources: U.S. Depanmem of Commerce: The Conter.nca Board
https://fraser.stlouisfed.org
Federal Reserve Bank of St. Louis
'55
'80
'65
·10
'75 ·n
49
inflation, or of interest rates. At the start of an accounting period, the ex ante intentions of savers and
investors may differ widely; at the end of the period,
the ex post identity will be found to have prevailed.
The translation of the ex ante differences into the
ex post identity is associated with a business-cycle
movement of the aggregate; if investment intentions
exceed saving intentions, expansion of employment
and income will proceed until the saving generated
equals the investment intentions. Conversely, if saving intentions exceed investment intentions, the contraction of activity and incomes will proceed until the
identity is restoi;ed. •
·
The identity of saving and investment that prevails
for the aggregate economy does not prevail in all the
sectors. The personal sector is typically a very large
net saver; the business sector is typically a very large
net investor; the international sector may be an area
of net investment (if it is running a surplus in its current account) or of net saving (if it is running a deficit
in its current account); and the government is a net
investor when running a deficit and a net saver when
running a surplus. The terminology of savinginvestment accounting is awkward for the government and international sectors; it strains ordinary
language a little to speak of a government deficit as
an investment, and an international deficit as a form
of saving. But the accounting nevertheless works,
and provides a useful test of the feasibility and consequences of projected changes in budget position."
In the context of the saving-investment balance, a
reduction of a budget deficit is a shift of the government sector from investment toward saving. The
closing of a deficit gap of, let us say, the approximate
$60-billion rate that is a reasonable expectation for
'While business-cycle movemems are consequences of differences in the ex ante intentions, the identity of actual saving and
invescment prevails a1 all times. High investment intentions in the
presence of low saving intentions are associated initially with temporary unintended inventory liquidation (unintended disinvestment), as well as unexpectedly high profics and corporate saving.
An extreme example of this process is provided by the reaction of
inventory and profits during the two scare-buying periods of very
low saving intentions following the start of the Korean War in the
last half of 1950.
"A possibly helpful clarification: when government spends less
than its rc<:eipts, it is saving; when it spends more than its rc<:eipts,
it is engaged in dis-saving, or net investing. When a nation in its international transactions, is exporting more than it is importing, ii
is investing: when it is importing more than it is exporting, it is disinvesting, or saving. A government deficit is stimulative, like an investment; a-trade deficit is suppressive, like saving. A government
deficit raises the relationship of income to supply in the other sectors; a trade deficit reduces the relationship, since che income
generation involved in imports occurs overseas.
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Federal Reserve Bank of St. Louis
early 1978, would, by virtue of the saving-investment
analysis, require a simultaneous shift of $60 billion
toward investment, on balance, among the other
three sectors.
The opportunities for such a shift toward investment in the non-federal sector include a reduction of
the net personal saving rate, an increase in net
business investment, and/or a shift toward balance in
the current-account international deficit. The net
personal saving rate is already quite low; a rise would
appear to be more likely than a decline. The international deficit is enormous. of course, but an important improvement in it is difficult to forecast. since it
hangs heavily on the management of the energy
deficit, and future changes in the price of oil. In fact,
the very high volume of net saving in the international current account since the unprecedented surge
in oil imports and oil prices obviously explains part
of the high investment deficit in the federal sector.
Under these conditions, the hope for a substantial
upward thrust in aggregate investment for the nonfederal sector lies largely in a pronounced rise in net
business investment-that is, a much sharper rise in
investment than in retained earnings and depreciation in the business sector. Barring improbably
favorable trends in the U.S. export position, the
autonomous thrust of the private sector required to
offset the fiscal drag of the federal sector's movement toward saving depends upon business outlays
for plant, equipment and inventory. The cheerful
full-employment projections inevitably incorporate
this hope. They are, in fact, nothing more than a
mathematical expression of the hope. The projection
now in use by the Council of Economic Advisers, and
by the Congressional Budget Office, calls for an improbable (but not impossible) expansion of business
investment.''
Progress toward high employment and reduced
deficits will, at the least, require accommodative
monetary policy to restrain the rise in the cost of
capital, and improvement in the incentives (including
tax incentives) for private investment. But the considerable secular changes in the system since the
l960's, as described elsewhere in this paper, suggest
that it is unlikely to reach full employment in the near
foreseeable future in the absence of a continuing
budget deficit, and, hence, that policies directed
''The Congressional Budget Office has recently published a
much le~s optimistic set of budgetary outcomes for the next five
years, in which it in effect subordinates the budget outcome to a
target for real growth, and adds a rapidly rising contribution of incremental outlay and tax reduction to offset fiscal drag.
50
specifically to reduction of the deficit will require
broad, pragmatic review to assure that they do not
militate against the achievement of real growth and
rising employment. 12
Conclusion
Federal budget outcomes, it appears, incorporate
and reflect social and economic conditions far wider
than those contemplated in the conventional budget
orthodoxy. Like any other part of so integrated a
system, they are not truly controllable within the
federal budgeting arena in which they arise; they rest
on the non-federal economy and the inherent
strength of its parts.
In a real sense, the budget deficits run throughout
the West in recent years are a social as much as they
are an economic phenomenon. They reflect the
distinguishing socio-economic condition of the
1970's; the friction between democratic ethical prinuSomc of the wayi. or relating the federal deficit and 1he federal
dcb1 offered here have a bearing on the .. crowding-Olli" thesis, in
which it b arguL-d 1ha1 1hc financing or a budge1 deficit preempts a
portion of a fixed supply or capital fund!-., and thui. di!>places
priva1c borrowing. While there may be time!> when "crowding-
om" may look like a real danger, it i!> revealing that the
phenomenon itself did not develop even under the condition!> of
1975, when ii was widely cxpcc1cd. In fact, it is ROI likely ever to be
an inevitable and unavoidable development, or more 1han a tran-
,icnt a:,.pcct or conditions in capital market!\, The .. invotment"
rcprcscmcd by lhe ddicil i" incvi1ably mirrored by "aving in the
mm-kdcral scc1or; in 1975, Ihc aL-iual liquidity of 1he non-federal
"-CClor wa" cnormou"ly increa"-L-d by 1he federal delici1. The L"Ydkal
component of 1he federal dcficil develop" because of slack marke1s
(and oflcn inventory liquida1ion) and hence depresM:d incentive" to
borrow and invo1 in the priva1e"cc1or. At lea"' 1his portion or1he
delici1 i" mainly a renL"Clion of weak credit demand in the private
"-L"Ctor. A" private ncdit demand begin" to grow, the assoda1cd rise
in private busine"s ac1ivily begin:,, 1u eleva1e 1he 1a" base, and
reduce Trea1-ury borrowing rL'QUirement!<t. Thb "-I ill leaves open !he
(1(1i-1-ibili1y llf a 1ransi1ional period in which private demand for
money accelcratci. in 1he l"rc,cnce nf i.till large federal demand;
under i-uch condi1ion!<. lhe 1-\-dcral Rc,-crve i!<t under con"iderablc
l"rL"?..,urc IU Iolcra1e 1he implied relatively rapid growth rate of
money and crL-di1. Such condition" may well l"revail in 1978.
https://fraser.stlouisfed.org
Federal Reserve Bank of St. Louis
ciples, on the one hand, and free markets and their
incentive needs on the other. The rapid rise of
government spending on social programs accommodates ethical principles; the suppression of
revenues below what would be required to balance
the budget avoids the still greater pressure of taxes on
the markets and incentives on which the private sector depends. Deficits are run pragmatically, in defiance of orthodoxy, because they help to keep the
social peace at the troubled border between
democracy and capitalism. In the I 960's, there was
just less trouble at the border.
Much the same thing could be said about the violation of monetary orthodoxy. The rapid creation of
money finances the social spending of government,
and suppresses (or diffuses) the financial consequences to the private sector. In so reacting,
pragmatic fiscal and monetary policies provide liquidity faster than output can grow, and hence are
associated with inflation. But all three phenomenabudget deficits, rapid growth of money, and inflation
itself-are inseparable reflections of the friction between ethical principles and market principles being
experienced throughout the democratic West.
If these propositions are correct, then the achievement of the true ends of economic policy-reduced
unemployment; more stable, less cyclical economic
performance; a lower and more stable rate of inflation; vigorous long-term economic growth associated
with a high rate of private investment-all of these
worthy objectives depend upon pragmatic, rather
than doctrinaire, management of fiscal and monetary
policy, innovation in the equipment and powers
available to fiscal and monetary institutions, and
then innovative approaches to the social and structural causes of inflation. The important thing our
budget experience is telling us is not that deficits are
good, or that they are inevitable, but rather that we
are in need of a new concordance between ends and
means.
51
$
CONSUMER INSTALLMENT CREDIT
400 r------,,-----.---,---,----,----.---.----,--..------.,------,
Billions of Dollars
Seasonally Adjusted Annual Rates
300 ·
AotloScai. - 1 - - - 1 - - - 1 - - - 1 - - - 1 - - - 1 - - - 1 - - - 1 - - - 1 - - - 1 - - - 1 - - - 1 - - - 1
100
90
80 "'8~1-----1-----1-----1----1----+----1---170 Wll!WWWWWWIWW!llllllllWJJllllllllllll.LWll!JlllWJJJJU.IIWJJll!llillllll.LWIIIJlllW.llllJJilllWIIIW!lllllllll.lJ.ll.WlllllllllllllllllllWl.ll!ll
1967 '68 '69 '70 '71 '72 '73 '74 '75 '76 '77 '78 '79 'ao
$
60
7
7
Net Change
50
l l l
I l
'-- (Excess of Extensions Over Liquidations)
Billions of Dollars
~
Seasonally Adjusted Annual Ratu
40
~
Arittwnetk: Seate
t\ ,/
30
V
\
20
10
0
-10
V
fi
,\I\
~~N'.J """''
,. ,..,....
1967
I "'
VY
I
v~
AM
Al
I
A
,V
1.. , .. ,,
'68
~
N
.J\
'\I]
'69
'""
'70
1.... ,1 .... 1.... .1 .... 111111 .... 1.. ,11111,,. ""11lt111 1111l1n• ln,11111111 1!111111111 11,,11111 1111il11111
'71
'72
'73
'74
'75
'76
'77
'78
'79
'80
Sources, Federal Reserve Boord; The Conference Boord
https://fraser.stlouisfed.org
Federal Reserve Bank of St. Louis
ATS/OCE:-'78
52
INFLOWS INTO THRIFT INSTITUTIONS
$
Policy Loans of Life Insurance Companies
0.---.......- .......- .......- .......- .......- .......- .......- .......-...---,--...--...--...----,
400
IWIIIWIIIWWJ.WJIIWIIWJ.IJIIWW.IWILW.W.LWIIJIWW.WW.W.W.WIW.WW.UlW.W.W.W1W.WW.UlW.WJ.11;UWJ.IIWIIWWJw.lllllWIIW.W
Savings Capital of Savings
$
7",000
a Loan Associations
Mnlions of Dollors
-
5,000
_ ----- Manth·IO·Malth Changes
Three· Month Moving Avcages
Seasonally Adjusted
I
0
-1,000
-1,500
1/
"'"'""
,,,,,1, .... 1.. ,,,1,,·, ""'''"'
1
Millions of Doll~
-
Seasanally Adjusted
,.
1,000
0
;;1
'""''"" """" '"'"""' ""'""" """'"" ,,,,,1,,,' 111!1' I "'"'"'" lr111il111 1
Deposits of Mutual Savings Banks
1,500
500
'
~
""''""
2}00
2,000
\l
I
I
I'
~9 ti
~-
i-:
·~
'
rf'l
.J(
I
"
A
/"
r L·y qr~
~ ~1''
2,000
"
IL
'
i·ti'fV1I \,I
;
:-..
3,000
!
.
I
4,000
1,000 -I:-.......
.
•
I
6,000
""
.--,
j
,!.
~1 ~ 'l' ur
;
~,
~~
l
"\.Jt
I
~
ft
';\A-' \1V'
,J
'Yrt
.
l
"
,\Ai!
l""""l.i
~·
~
:Jl
uV
fI
!:f
'I
'"''"""
-500
1 .... 1.,.,,
.. ,,,1, .. .,
'"'"'" "'"'""
-750 ""'h"" """'"" """'""
"'"'""' ,,,1111111, ""''""' 1.. qt\11tJ
1951 68 69 '10
'71 '72 '73 '74 '75 '76 'n
Sources: American Council of Life Insurance; Feden,\ Home Loan Bank Board;
Nalional Association of Mutual Savings Bonks; The Ccnference Board
https://fraser.stlouisfed.org
Federal Reserve Bank of St. Louis
'
·~
.. .,,11111 '""'""'
'79
'so
ATS/0CE-'78
53
THREE LEVELS OF GOODS PRICES
270
260
-I
I
_1967•100
lndexNumbers
250
240
o ll•v.,
I
I
,.
I
I
II
230
Raw Mo1erials Prices •i;;.:
\
<Nonfarml
220
-
I
I
I
210'
h ..i
\
\
200
,v
I
~I
'
I
I
I
I
'
''
I
I
140
/
\JI
Producer ,
Prices /
v
I
I
I
150'
!/
Ill A J /.
I
160
\)
I
I
170
I
I
I
I
180
I
I''I
iY
I
I
II
I
I
· 190
;'
·1 I
7/
/
(Nalfarm) /
,,
.,.,ti
,I
/'
/Consumer Prices
(Commodities Less f'ood l
·7
I
'
I
130
,'
I
/V
I
120
",
,N
/'
110
,- (/
I\I
I
l00
90
I
,,1-~ ~
\
'
•
~
I
I
I
,..........
1967
.,.
I
f
Ratio of:
1.6
1.4
I\
I
Raw Materials Prices ro
P,ducar Prices
·t::.~
~
12
•
iJ
'68
1.8
10={
I
1. ... ,11111·
1/·'i
I
\ Jv,
V
,.. [ ? ,
P'\.'
. ./
/
Producer Prices
,,'°~:':ii"'"
08 1973 '74
,.......... ,.......
69
1
'70
I
I
'7s '76 '77
..1.. .........1.. .... ,....1.. .........
I
I
I
'78 '79
'ao
L. . ,. . l..... ,...,.L ........,
'71
Sources: us. Oepor!ment of Lobar; The Conference Boon:!
https://fraser.stlouisfed.org
Federal Reserve Bank of St. Louis
ATS/OC£·'78
54
THE MONEY SUPPLY
Money Stock,
Excluding Time Oeposits(M 1)
$
600
500
Billions of Dollars
I
I
Seasonally Adjusted
I
I
I
1200
I
1100
Ratto Scale
Money Stock,
1ncluding Time Deposi1s (M
$
1000,
Ratio Scale
I
I
900
400
800
I
I
1 ·~
I
I
I
I
Billions of Dollars :
·Seascnatly Adjusted
I
I
I
I
' 'I
I
I
I
'
I
I
I
'I
I
I
I
I
I
I
I
I
·,
I
I
I
I
I
'
I
I
I
I
I
I
I
I
I
I
I
I
I
I
I
' '
I
I
I
700
600
I
I
'I
I
I
I
I
I
I
I
'
500
I
I
I
I
I
'I
I
'I
I
I
'
I
I
I
I
I
I
I
I
I
I
I
I
I
I
I
I
I
400
I
I
l
I
I
I
I
I
I
I
I
I
I
I
I
I
I
I
I
I
I
I
I
I
150 .......................................................................................... 3oou.w·................................................................"""".....,_,.a.u.u
1967 169 171 17'3 175 177 179
1967 169 171 173 17!5 177 179
%
Annual Rates· af Change
20
~Pe-rcen--t--:-:-----:-:-,---~
1!5
1--.'--,,,--,-,-r--,'r-r-'-r-:-r-'-r'--.-...--i
1-
I
I
I
Three-Period
I
,
o/o
Annual Rates of Change
20..-------------Percent
:
I
I
,
I~
I
l
I
I
I
15 t--r1--;1-r-'---ilh-rl-,
-5--~--.. . --~---= -5-----~. . . . . . . . . . . . . . .
1967
1
69
71 . 173
1
75
1
1
77
1
79
Sources: Federal Reserve Board; The Conference Boord
https://fraser.stlouisfed.org
Federal Reserve Bank of St. Louis
1967
1
69
1
71
1
73 175
~1
77 '79
https://fraser.stlouisfed.org
Federal Reserve Bank of St. Louis
EXPENDITURE VELOCITY AND THE COMMERCIAL PAPER RATE
7.5
I
I
I
I
I
I
I
I
I
I
6.5
I
I
'
I
'
'
I
: M1 VELOCITY
-,
I
I
I
I
I
I
I
I
I
2.6
I
I
I
I
I
I
I
I
: (Current-dollar GNP
, ,
, divided by M\
: Money Stock
: :
I
'
I
I
I
I
I
I
I
I
I
2.5
Percent per Alllllllll :
I
I
I
I
I
I
I
I
I
I
I
I
I
I
I
I
I
: M2 VELOCITY :
I
I
'
I
12%
I
I
I
I
I
I
I
I
I
I
I
I
I
I
I
I
I
'
I
I
I
I
I
I
10
I
:<current-dollar GNP;
, divided by M2 , , ,
: Money Stock) : : :
I
I
I
I
I
I
I
I
I
I
I
I
I
I
I
I
I
I
I
I
I
I
I
I
I
I
I
I
I
I
I
I
'
Commercial
Poper Rate
I
,·
I
5.5
2.4
8
C.l"1
C.l"1
I
I.
6
2.3
4.5
I
3.5
1967 '69 '71
'73 '75 '77 '79
Sources; fedeml Reserve Boordi US. Deportment
2.2
I
1967 '69
I
I
I
I
I·
I
I
I
I
'71
of Convnerce; Standard
I
I
I
'
I
I
I
'73 '75 '77 '79
a ~or's
C0tp.i The Conference Boord
ATS/OCE • 078
56
UNIT MONEY SUPPLY
I
Index Nwnben, 1972a 100
R-
Seascnally Adjusted I
Scale
I
I
I
I
I
I
I
I
I
I
I
I
I
I
1
I
175.
Annual Rates of Change
o/a
15020
1
Implicit Price Deflator
I
I -
I
I
I
I
I
I
,. .: .-..Pefelf't
I
I
I
I
I
I
15
I
10
I
I
I
I
5
I
i
I
I
I
I
I
100
, Implicit Price
0
1-;--,......,.._,_,_ Deflator ..,1,_,1,--,,-,---, 90
.80
I
I
.70
I
.60
I
I
I
I
I
I
I
I
I
I
I
I
I
I
I
I
I
I
I
I
I
I
I
I
I
I
I
I
I
I
I
I
I
I
I
1967 169
I
I
I
80 %
20
I
I
I
I
I
I
I
I
I
I
I
I
I
, Three-P9riod
ovin Average'.;;:
I
I
'77
'79
M2 Money Stock Divided
by Real (1972) GNP
15
I
I
'n '75
'71
I
I
I
I
I
I
I
I
I
I
Pe:-C:.nt
I
I
I
I
I
I
I
I
10
I
I
5
.50
0
-5
.40
I
I
I
1
.~O
I
I
I
I
-10
1967
: M Money Stock• D vided
: by Real (1972) GNP
I
I
I
I
I
I
I
I
I
I
I
I
,.
I
I
I
I
I
I
I
I
I
I
I
I
I
I
·,
I
I
I
I
1
I
I
I
15
I
I
I
I
'73 '75
I
I
I
I
I
I
I
77 '79
1
M1 Money Stock Divided
by Real (1972) GNP
%
zo
69 '71
I
I
I
I
I
'p,~
I
I
I
I
I
I
I
10
I
5
.20
0
-5
.J 5 U.U.U.U.0.0..WLU.1.W.U.U.U.j.i.lJ.WJ.JU.W,UJ.1.1.W.UWW.O..U
1967 '69 '71
'73 '75
1
77
1
79
-10 .
1967
I
69
1
'71
Sources: Federal. Reserve Board_; U.S. Department of Commerca; The Conference Boord
https://fraser.stlouisfed.org
Federal Reserve Bank of St. Louis
73
1
75 '77 '79
1
___ ,,,..,.,,,. ,_
57
THE REAL MONEY SUPPLY AND GROWTH
1/oo
~
Bil lions of 1972 Dollars :
s«,,cna11y AdjusNd
I
I
I
I
I
I
I
I
I
I
I
I
I
Annual Rates of Change
. o/a
15
Real GNP
Percent
1,400
I
I
10
1,300
1,200
1,100
I
I
I
I
I
I
1,000
I
I
' '
700
I
I
I
I
I
I
I
600
I
'
I
I
I
'' '
I
I
I
I
I
I
I
I
I
I
I
I
I
I
I
I
I
I
I
I
I
I
'
I
I
I
I
I
I
-~
'
I
-5
-10
1967 '69
I
I
I
I
I
I
I
I
P9rcent
10
'
'73 '75
'71
'77
'79
Deflated M2 Money Stock
15
I
500
I
I
%
I
I
I
0
I
I
I
I
I
I
I
I
I
I
I
I
I
I
I
I
I
I
I
I
'
5
I
I
I
I
I
I
I
I
I
I
I
I
I
I
I
I
I
I
I
I
I
I
Three-Period
Movin9-.ige
I
I
I
I
5
.0
400
I
I
I
I
I
I
I
'I
I
r ·'
I
I
I
'
300
.,
I
I
I
I
'
I
I
I
I
I
I
I
I
I
I
I
I
I
'
I
I
'I
-5
-10
I
I
I
I
1967
%
I
10
I
I
I
I
I
'
I
69
1
1
71
'79
'73 '75
Deflated M1 Money Stock
I
'
I
'
I
I
5
0
-5
-10
200
1967
69
71
1
'73 '75
'77
'79
-15
1967
I
'69
1
71
Sources: U.S. Department of c«nmerce; Federal Reserve Board; The Conference Board
https://fraser.stlouisfed.org
Federal Reserve Bank of St. Louis
'73
'75
'77
'79
58
INTEREST RATES
16
I
I
I
Percent Per Annum
14
..
Inflation Rate
12.
10
Treasury B!!.'_ Rate
-,
II
8
.
I
;:i~
6
4
2.
0
I\
~
I\.
I\
"'I
,,.,I'-.
J
r-#
I
I
11
'69
1967 168
'70
1
7(
'72
I I I
73
1
'74
'75
'76
'77 '78- '79
I 11
80
1
16
Percent Per Annum
14
12.
IQ
1967 169
71
1
'73
'75
'77 '79
Sources: U.S. Oepartment of Commerce; Department of the Treasury; Federal Reserve; Moody's; s1andard
Ccrporatian; The Conference Boord
https://fraser.stlouisfed.org
Federal Reserve Bank of St. Louis
a Pear's
ATS/OCE'78
59
The CHAmMAN. Well, thank you, Mr. Sommers.
I would like to have each of you gentlemen comment on Mr. Sommers' rather shocking and unusual statement that there's no recourse
left but full use of the powers of the Fed, No. 1; and No. 2, there's
no escape from recession in 1979; it's just a matter of how deep it will
be and how long it will be.
Mr. PERRY. Well, I share the forecast that we are headed for recession
in 1979. I don't think anything is ever certain, but the odds are getting
good.
The CHAIRMAN. You said good or bad?
Mr. PERRY. Well, that's a statistical term, not a value term, sir.
The CHAIRMAN. OK.
Mr. PERRY. As to no recourse. I'd stop a little short of that. I think
that realistically we are not going to do anything that will give us an
alternative, though I still believe that if we were to directly attack
the inflation problem in ways besides slowing demands, we could
muddle through. We might begin to decelerate the rate of inflation
and avoid an actual downturn.
The CHAmMAN. So your advice for the Fed is that we tell the Fed
that we think that they should follow as tough and stiff an antiinflation policy as possible, including' continuing to tighten up on
the availability of credit?
Mr. PERRY. I'm sorry. Did I say that?
The CHAmMAN. I'm asking you whether you're saying that or not.
You say that there may be no alternative-there may be an alternative,
but we're unlikely to use the alternative. To be realistic about it, if
we're going to really mean business on inflation, we have to follow the
tough prescription that I understood that Mr. Sommers gave us.
Mr. PERRY. I think it's appropriate for a congressional committee
toThe CHAIRMAN. This is a banking committee. We have primary
responsibility in the economic area and monetary area, not so much in
the spending or taxing area which other committees are responsible
for.
Mr. PERRY. I think it is a responsibility of the Congress to instruct
the Fed to restrict credit to whatever extent it deems necessary to
slow the present rate of inflation, realizing the implication of a very
restrictive course is probably to create a recession next year. It that
responsive to your question?
The CHAIRMAN. Yes; itis.
Mr. PERRY. I just want to emphasize that to criticize the Fed at this
time next year for having brought about a recession when it is in effect
following the mandate that's being given by the Congress would be
unfair to the Fed. If that is the implication of what they are doing,
the mandate ought to be clear on that point.
The CHAmMAN. All right. Mr. Cagan.
Mr. CAGAN. If we look ahead to a time when the inflation rate would
be much lower than it is, the rate of monetary growth simply has
to be lower than it is now. We can't permanently have a lower inflation
rate and not reduce the rate of monetarv ~rowth. I believe the proper
proposal is for the Federal Reserve to· slowly and consistently, year
by year, reduce the rate of growth of the money supply until it's consistent with a very low rate of inflation that we would be willing to
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live with. Somehow we have to get from where we are to that distant
goal. I don't see why now is not as good !l. time to start as any.
I would have preferred that they had started a couple years ago.
They let the present situation get out of hand by accommodating the
late expansion phase of a business cycle; monetary growth should
have been gradually coming down earlier.
The CHAIRMAN. Do you agree with the forecast of Mr. Sommers
that we are going to have a recession in 1979 i
Mr. CAGAN. I don't know whether we will have a recession or not.
I would say there's a good chance of it, given the fact that economic
activity is strong. If you now begin to restrain activity, the chance of
a mild recession exists. Yet, it's conceivable that, if policy moves
gradually, we could have a period of leveling off without what's
called a recession.
The CHAIRMAN. At best, a stagnation, if not stagflation period j
Mr. OLSEN. Well, I'd say, first, directly, that we are forecasting a
recession in 1979 but policies which ,.vould precipitate that recession
are not yet visible in the pipeline. It is our assumpton that monetary
policy will become sufficiently restrictive so as to cause a recession.
Now, having said that, let me add very quickly that I don't want to
convey the impression that the.tmonetary authorities are conducting
policy with the specific goal of producing a recession next year. The
outcome of the economy will in large part be due to the difficulties that
the Federal Reserve has in fine-tuning monetary policy, the relatiye
crudeness of the tools they are emplr>ying, and the methodology m
which they execute policies, some of which both I and Professor
Cagan have touched on.
What we expect will happen next year is that if policy does not
lean sufficiently in the direction of tightness to cool off inflation, then
I find the prospect more frightening than a recession next year
because we will be embarking on uncharted waters.
The CHAIRMAN. So really what you're saying, if we're lucky, we will
have a recession next yead
Mr. OLSEN. Yes; I would say that because if policy remains excessively expansive we would have a worse recession very probably
after worse inflation at some later date.
The CHAIRMAN. Of course, as was pointed out by one of you gentlemen-I think Mr. Sommers-we have the freest economy in the
world and that's one of the commitments of a free economy. You don't
always expand. It's never a straight line upwards. w·e always have
periods where we don't grow and where we recede a little bit. We're
lucky it's only a brief recession and not a depression. I do_n't think
anybody has said we can expect to have a system that's gomg to go
on forever expanding. Isn't that right i
Mr. OLSEN. Except I would hasten to add that the magnitudes of
the swings we are experiencing, particularly on the inflationary side,
are much greater than they were 15 or 20 years ago and the inflation
that precedes the recessions now is of considerable magnitude und that
creates very severe distortions in the economy and certainly a redistribution of income at the very least.
The CHAIRMAN. Let me ask you another question.
Mr. PERRY. I would like to say that the easy acceptance of downturns
in this economy is not my view of where our freedom leads us. This
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is not an exceptionally long expansion and it need not inevitably end
because of any excesses in the private sector. If it ends it will end
becawie we take policy steJ?S to slow down economic growth and that
slowdown becomes a recession. I don't think that the fact that we have
a very free market economy implies a downturn next year or even in
1980.
The CHAIRMAN. Now you're an economic historian. Can you give
us any period in the last 90 years or so when we didn't have a recession
within a 10-year period~ We had, the longest expansion we ever had,
was from 1961 to 1969.
Mr. PERRY. That's correct, but we are now discussing recession
within a 3- or 4-year period.
The CHAIRMAN. That would be almost the second longest period
of expansions, one of the longest.
Mr. PERRY. We ought to get better and better at this.
The CHAIRMAN. Well, you're an optimist.
Mr. PERRY. I don't think the 1960's were an accident and I think
that it is :possible to sustain expansion. We don't really have excesses
in the private sector at the present time. Indeed we have a lot of
unfinished business.
The CHAIRMAN. We don't have excesses in the private sector with
the settlement with the coal miners and with the coming Teamster
settlement, with all the other elements that you gentlemen have
indicated contribute to inflation~ Don't you think we have excesses 1
Mr. PERRY. We have an inflationary problem. The excesses are there
in the way the system is working to set wages and prices in this
economy. I don't think we have excesses in the real system in the sens~
we have overstrained our capacity, or in the sense that we have made
labor or materials scarce. Those are the excesses that we usually think
of as inevitably leading to a real downturn.
The CHAIRMAN. Tomorrow Chairman Miller will announce the Open
Market Committee's monetary growth rate target for the year 1978
third quarter to 1979 third quarter when he appears before our committee. How meaningful are those targets for M1 , M2, and Ma 1 Let's
start with Mr. Olsen. In view of what you have warned us about, we
are prepared to expect it's a little different now than it was.
Mr. OLSEN. The Federal Reserve, as it well knows itself, has not had
outstanding success in hitting the targets that it's established, so the
targets when they announce them suffer from some lack of credibility.
I know that in our own view, and we follow monetary policy very
closely, when we hear those targets we lay them alongside what's
actuaily happened over the last 6 or 12 months. Then we judgmentally
try to arrive at a probability that they will be able to achieve them,
and we are not helped by the lack of credibility in the ability of
policymakers hitting the targets.
The CHAIRMAN. I'm glad you make that point because, after all, the
Federal Reserve people don't run for office. I don't understand why
they can't set a range. At first what we tried to get initially when we
put this into effect a few years ago was a specific number. I pointed to
the Bundesbank which at that point had an 8-percent goal, a very
high goal. They figure 8 percent, not a range of 5 to 9 percent. Now
the Federal Reserve gives us this range where the lower end is ridiculous. Nobody expects them to be at 4 percent growth in the M1, but
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they give that as the range, and they give a top range which, as you
say, they miss completely and lose their credibility on. I think we
ought to hit them very hard on that. I can't understand how they can
possibly justify having missed the upper range of a very, very wide
spectrum they have given themselves.
It's a political thing, I suppose. I suppose when they give the upper
range they are afraid to make it too high and realistic because if they
do I think they may be telling people they are in for monetary policy
which is inflationary.
Mr. OLSEN. Well, that may well be. Certainly when they exceed the
upper end of the target they do tend to raise inflationary expectations.
The CHAIRMAN. My time is up, but if the other members will permit
I would appreciate it if you could answer that question, each of you
answer it.
Mr. CAGAN. As my remarks indicated, we are experiencing changes
in the meaning of the monetary aggregates, and therefore we are going
through a period when it's becoming increasingly difficult to interpret
them. My best guess would be that M1 is going to grow less rapidly
than it has in the past, whereas the true money supply will grow more
rapidly than the recorded M1 • Some cross between M1 and M 2 will
have to serve as our indicator for the time being.
The CHA.JRMAN. What do you mean by the true money supplyi
Mr. CAGAN. Total balances in the economy that are used for transactions purposes. The problem is that, while we have figures on NOW
accounts, not all those accounts are being used by the holders as transactions balances. We are in a period of change which makes it very
difficult to know what the proper figure should be. If we could have
the reforms I was talking about, I believe we could then define and
measure a concept of money that would be the appropriate one for
Federal Reserve policy. Then I would hope that they would set a
target for about a year ahead. I believe anything shorter than a year
is difficult for them to hit. They might then announce that policy will
be directed toward reducing the rate of change of this quantity by,
say, 1 percentage point from year to year. I believe such an announcement would be very salutary for the foreign exchange markets and
the domestic economy. It would be an announcement that people could
use to guide private economic plans. I would expect, then, that on the
average inflation would decelerate 1 percentage point a year. Wage
rates and other plans could be based on this guide. I think this would
bring down expectations in a way tJ,at ,vould help to ameliorate some
of the effects on output that the gentlemen at this table have been very
concerned about.
Mr. PERRY. I don't believe there's a monetary aggregate available
to us that has a sufficiently close relationship to our economic targets
that we can use it to define policy and feel comfortable with it. I think
at a time like this and at any time really, the Federal Reserve must
concern itself with many things-with what's happening to the economy, what's happening to the interest rates over which it does have
a direct control, and "·hat's happening to monetary aggregates. If it
were to take the position that interest rates were as high as it wants
them for now, at least until it gets some fresh evidence on the economy,
then it would put more of the responsibility for both inflation and
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recession next year on the Government and on the policies that the
Government conducts.
I just don't think you can turn that question around and make it
entirely the responsibility of the Fetl or how fast M-something grows.
The CHAIRMAN. How meaningful are these targets £or M 1 , M 2 and
Ma?
Mr. SOMMERS. I think they are reasonably meaningful given th~
qualifications that you've heard. There may well be longer term ways of
resolving through gradualism the problems relating to the ongoing
rate of inflation, but we're not living through a long term and I think
Mr. Miller will very likely tell you that tomorrow. We are living in
a very critical short term in which the rate of inflation almost predictably i~ in an uptrend fr?m a level tp.at's already seriously high. The
behav10r of raw materials prices and of markets themselves have
actually strengthened such an expectation. In those circumstances, and
given the international responsibilities confronting the Federal Reserve, I think the Federal Reserve likely may well conclude that a
negative M 1 real growth rate is now urgently needed and it's compatible with both its domestic and its international responsibilities.
So I would expect, without knowing of course, that the growth
rate of the M 1 aggregate which as everybody knows is going to be
a little difficult to measure closely any longer, is going to have to be
below the rate of inflation. Anything less than that, I'm afraid will
begin to liquidate what progress has been made on the dollar overseas
and I think the Federal Reserve will take that view.
Now there's further opportunity here for at least informal credit
restraint on the part of the Federal Reserve and its relations with
individual major banks that would not set :a precedent by any means.
The effocts would be supplementary to the gradual withdrawal of the
rate of growth of reserves and I think would help to smooth and accommodate our progress into 1979.
I know this committee is folly aware that the techniques of economic
forecasting still lack totial perfection. The forecast of recession I gave
you is I think a very high probability, but it-even if it occurs, it's
not the end of the world. "\:Ve will survive a recession. We will come
out and grow again. It woul<l be a shame to go through the next one,
the fourth one of these mountains and vaHeys, and not learn from
it that the structure we're dealing with is crapable of and inclined to
produce these very serious waves in interest rates, economic activity,
housing, in the automobile market, capital investment perhaps most
importantly of all. I think we are at a point where we should use
the time ,av,ailable in the future, whether in recession or not, to ~ake
progress in reducing the amplitude, of that cycle.
The CHAIRMAN. Thank you very much.
Senator Lugar.
Senator LuGAR. Mr. Chairman, in Mr. Olsen's testimony he recounts
on page 11 of the text that the downturns have be come I?rogr~ssively
more severe or, to say it another way, th_at t~e l~vel of mHat~on has
remained higher after each cycle. The osc1llahon 1s more volatile, and
he suo-o-ests that one reason for this is that labor and business have a
learn~IY curve. He savs what they know from experience is that once
the ecoifomy plunges into recession, something hapnens. to re:7erse the
downturn, to revive aggregate demand and once that 1s achieved, to
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accelerate inflation. Consequently, there are no inducements to labor
or business to alter their wage and price expectations. They assume,
that inflation will continue indefinitely. The economic slack that previails in the early stages of cyclical recoveries is acknowledged by
everyone, particularly the Government, to be transitory.
Then he says,
Putting it more crudely, business and labor-implicitly and explicitly-expect
that Government policies will revive inflation before it dies from lack of fiscal
and monetary nourishment. Consequently, labor will uot reduce wage demands
so that employers can afford to employ idled workers. And employers will not
reduce prices sufficiently to increase the demand for output and re-employ idled
factory capacity. Instead, Government is expected to make such adjustments
unnecessary with stimulative monetary and fiscal policies, and so far it has not
disappointed those expectations.
Now I want to supplement that with a comment in Mr. Perry's
testimony, in which he says,
If you want to fight inflation with remedies that are less painful and more
effective than putting people out of work, we have to look beyond restrictive
fiscal and monetary policies. The Government is responsible for a great number of ~aws, regulations and procedures that add ,to costs and prices; by repealing, reversing and desisting it can reduce them.
What I would suggest at the outset, and what I want your comments on, gentlemen, is that-quite apart from anything the Federal
Reserve Board might do or Chairman Miller might announce tomorrow-what is being suggested here-and I believe to be trueris that there is an expectation on the part of business ,and labor that
regardless of what happens with regard to a recession, the Federal
Government will come to the rescue. Therefore, if one can have a
temporary holding policy on both the levels of wages and prices, essentially all this means is that the next level or round of inflation will
be at 'a higher point.
There are no very good reasons, either tactica.lly or strategically,
to change course in terms of policies. These is no reason, to lower
wages rates, lower prices, or in essence to become any more flexible.
Furthermore, although the President has suggested that regulators begin thinking about dismantling a good number of regulations,
already we see resistance to this. The thought is that this would violate
a good number of pledges with regard to social goals. It will be very
difficult to eliminate very much of anything. Many regulations will
remain in place.
Given ,ill of thiat, an interesting dilemma exists. On the one hand,
the market-particularly the foreign exchange market-reads the
Federal Reserve action as the promise of monetary restraint. The kind
of restraint the market expects would cause a recession. On the other
hand, officials insist a recession is out of the question. Will policymakers seek to ,avoid the recession i If monetary and fiS{)al policies
remain stimulative, then inflationary expectations will accelerate and
the doUar will nosedive again in foreign exchange markets.
The expectation of foreign observers is that we are serious about
restrictive policies. The President means business and ·apparently the
Federal Reserve Board, working hand-in-glove, means business also.
On the other hand, the Secretary of the Treasury is suggesting there
will not be a recession. You on this panel today think that the~e
probablv will be a recPssion. But it is an intriguing thought that business will continue :as usual.
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For example, we already find many suggestions that even at high
mortgage rates, homeowners are still buying houses and taking the
higher rate; and that many businesseii-the Wall Street ,Journal had
an article on this yesterday-are saying that although the rate is very
high, only most marginal building projects might be set aside. In
essence, money may be borrowed right now at a zero cost if inflation is
10 percent and the :interest rate is 10 percent. We may in £act not have a
recession simply because people have decided once again to stay in
goods as oppose'd to money, to bet against the dollar at home as well as
abroad. I£ so, this is a more scary scenario than a mild recession in a
conventional sense.
Have we built into our economy such structures and expectations
with regard to inflation, that whatever targets are announced, they may
not have much effect, simply because people take a look at their experiences, recalculate what their self-interest appears to be, and proceed~
Mr. Olsen, would you comment on that to begin with~
Mr. OLSEN. Yes, I would be happy to. One of the reasons why
policies have become sufficiently restrictive in the past to induce a
recession when we have had a great deal of inflation is because of the
strong demands that something be done to reduce the inflationary
expectations and because the Federal Reserve £eels keenly at that
particular time their responsibility to not continue to finance higher
and higher inflation.
Now there's another element present and powerfully present at this
particular time, and that is that policy is to a certain degree a captive
of the market. I believe next year it will become even more a captive
of the market. The action which was undertaken by the Federal Reserve 2 weeks ago, £or example, in raising the discount rate and the
reserve requirements was not an action which was contemplated with
great care some weeks or months prior to its undertaking. It was dictated by conditions in the marketplace which had become so extreme
that the authorities had literally no other choice. H they lean on the
other side toward expansiveness in an C'fl'ort to avoid a recession, £or
example, as we move through 1979, the consequences of such a policy
are difficult to predict, but in the very least they would tend to feed
greater inflationary expectations, recognizing it's going to be a year,
very probably, of turbulent labor negotiations .
. So as we move through the year, policy is very likely to become
mcreasingly a captive of the market where the choices open to them
are just clear that they have to lean against the wind and become more
restrictive.
. Senator LuGAR. Following up on that briefly, when you say "captive of the market," are you speaking of an international market of
expectations~
Mr. OLSEN. In this case, in the case of 2 weeks ago, it was the international markets, but also with some ramifications as far as domestic
markets are concerned, but I think this will also become true of the
domestic market as inflation continues to run high and particularly
when it accelerates above the expected trend. I think that is a very
important point to emphasize. You can read all the literature as last
year ended and 1978 opened, including testimony given before this
committee earlier this year, and the inflationary expectations were
significantly lower than the actual inflation which we have incurred.
And while inflation forecasts are being made for next year may prove
to be no better and inflation could be worse and when you have infla
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tion running higher than expected, i,t has a major effect on decisionmaking, on people's behavior in the marketplace, and it also of course
affects and surprises policymakers as well.
Senator LUGAR. Is it not a fact that the rooent administration action
followed reports of significant exchanges of dollars for foreign currencies abroad? In other words, was there not some feeling there might
be a run on a bank? If this is the case, how are we going to continue
to talk about business as usual in this economy and no recession without feeding the same fires that almost caused the panic? The $30 billion
and the other measures were required to stave that off for the present.
Mr. OLSEN. I don't quite understand your question in the sense you
think if there's talk about recession that this will feed pessimism in
the foreign exchange.
Senator LUGAR.No; it probably would feed optimism.
Mr. OLSEN. That's probably true. I think it's noteworthy following
the President's announcement on the wage-price guidelines the exchange rates on the dollar continued to decline and the stock market
continued to decline, but after the announcement that implied a more
restrictive monetary policy we had a strong rebound in the dollar and
exchange markets and also in the stock market; but in addition to that,
even bond prices moved up and bond rates moved down in the hopes
that now we were going to get a bona fide anti-inflation monetary
policy.
Senator LUGAR. Mr. Chairman, my time is up but maybe one of the
other panelists may have a comment.
Mr. CAGAN. I would also like to emphasize the role of expectations
in the inflationary process. I think they are crucial. But I would also
like to point out that expectations are not based only on whether we
are going to have a recession or not. It's clear from past experience that
we can go through a recession with some temporary decline in the rate
of inflation and, then, after it speeds up again, come out on the other
side of the recession without any reduction of the long-run inflation
rate. Financial markets are looking further down the line and will be
very much influenced by whether, in the long run, there will be a commitment to slowing down the inflationary process. That requires some
statement or stance on the part of the monetary authorities that there
will be a continuing policy of gradually slowing the inflation rate.
Now expectations are very difficult to get a grip on. The only way I
see of influencing expectations is to tell the market that gradually the
rate of monetary growth is going to be reduced. This means avoiding
past policies in which we let the expansion get out of hand, react to it
and produce a recession, then in the recession expand monetary growth
to get out of the recession, and finally, as we enter the later stages of
recovery, continue to overexpand monetary growth because we are
afraid of the next recession. I'm not opposed to a monetary policy
which varies over the business cycle appropriately, but policy should
still adopt an overall trend in which it is clear to the market and ,to
foreigners that gradually the rate of monetary growth is coming down.
Then you will see the dollar recover.
Mr. PERRY. I agree with the other people on this panel that the inflation problem is very serious. I think I'm emphasizing a different aspect
of that. Once we all agree it's very serious, we then stop to ask what
can we do about it? I don't believe that it's either an effective cure or
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a convincing cure to tighten money and go into a recession. We did
that before and it didn't stop inflation. Now if we're saying we're going
to do much more of that-we're not going just to take recession; we are
prepared to take something more, we'll call it depression, or we're
prepared to take a severe recession every 2 years--if we are P:epared
to somehow go through this process long enough, then I beheve we
probably would, through that means, cure the inflation problem that
we have. I think that any realistic estimate of what it would take going
that route,, its consequences to the economy, would horrify most people.
Therefore, I am suggesting that we get on with the very long overdue
business of trying to deal directly with the price-wage problem by
influencing the way the price and wage setting mechanisms in this
country work and by doing something about things the Government
does that add to prices and costs.
I think the urgency of the inflation problem is something we all
share. I'm just very dubious of the cost-benefit ratio for the oldfashioned medicine, and the record I think is on my side.
Mr. SOMMERS. Senator, I think you're addressing yourself to a very
real question of the role of psychology in perpetuating business
expansion. My own impression is that policymakers live in an environment which as it has proceeded along the course of the last year has
gradually reduced its degrees of freedom. I'm not sure there's much
degree of freedom left. This is why I gave you such a high probability
on recession. The psychological state that is required for continued
economic growth is beginning clearly to deteriorate in the United
States. The decline in the stock market I think is often underestimated. You know, there's $100 billion of lost liquidity-it's not in M1
or any of the Ms but from the point of view of the whole, it's a significant element of this liquidity. That deterioration is the beginning
of the deterioration of the automobile market, no matter what the Federal Reserve does any longer. The commitments to construction activity are gradually being eroded away now.
There are rates which, regardless of what the real interest rate may
be-that is, the rate less the rate of inflation-induce a withdrawal of
activity in the production of long-lived assets, particularly as the fear
of recession arises. There's a strong possibility that what you borrow
the money to build may not be filled or self-liquidating or generating
the income you expected.
So we are already, in a sense, in the gravitational field of a recession
now. Now the issue is really how to keep it moderate.
Mr. Perry just said some things that I'd like to agree with too. We
haven't said much about the President's wage-price program. I don't
imagine any of us here thinks of the wage-price program as a thing
of beauty by any means, nor would we want to live with it over the
long term, but as a way of alleviating the erosions of liquidity that lie
ahead I think we should hope that it would get very widespread support. That would help too, But the psychological structure you were
speaking of and inquiring about, whether it was sustainable through
1979, I don't think it is.
The CHAIRMAN. Senator Schmitt.
Senator ScHMI'IT. Thank you, Mr. Chairman.
Gentlemen, I have been listening now for over an hour. Gradually,
I think each of you in your own way, and sometimes using the specific
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word "gradualism" or "gradually," have indicated that had we been
over the last 2 or 3 years gradually taking steps other than the ones
we really are discussing today, and will discuss tomorrow, we probably
would have the inflationary problem together. Thus we would not be
on the verge or having had to take precipitous steps such as an increase
in the discount rate, that may push us into a recession, however mild
or deep it may be.
Would you generally agree with that; that we missed an opportunity
over the last 2 or 3 years to institute gradual deflationary forces?
Mr. PERRY. No.
Senator SCHMITT. I think we had three heads shake yes and one no.
Mr. PERRY. I do not.
Senator SCHMITT. Would you explain why yon do not think we
could have done that?
Mr. PERRY. I think the expansion has been gradual. Policy has been
gradual.
Senator ScHMITT. But what I'm referring to is policies that would
have been deflationary in nature, gradual deflationary policies, and I
can list those for you.
Mr. PERRY. The problem, sir, is I don't think we have those in our
collection of tolls unless by "gradual" you mean had we not permitted
any recovery from the 1975 recession for instance. But I don't think by
normal standards of how rapid that recovery was or how policy was
conducted during that time, we pursued anything but a gradual
course.
What we failed to do during this time is grapple with the wage-price
spiral directly.
Senator SCHMITT. Let me sutrgest, taking I believe from your own
testimony, some gradual techniques that might have been applied. I
would also submit they should still be applied if we are ever going to
get out 0£ this thing. One is a gradual decrease in the Federal deficit.
The first decrease we have seen, at least on paper, was during the 95th
Cong-ress, $22 billion. The reality of that will come when we see the
supplementals and how they are handled for fiscal 1979, but a gradual,
$10, $15, $20 billion decrease in the Federal deficit. Wouldn't that create a deftationarv force?
Mr. PERRY. The decrease in the deficit that's occurred has been
along the lines you have described. Indeed, it's progressed a little
better than that, if we measure it from its peak of about $100 billion,
to its present level. But I don't think that would have made much
difference, had we altered the rate at which we varied that deficit. It
would not have left us with a different problem today than we have.
Senator SCHMITT. It would have left us with a decreased demand
£or increased money supply, if that had been combined with a real
gradual decrease in the money supply by the Federal Reserve System,
which we have not had-if those two things are moving simultaneously, wouldn't that have been a deflationary force?
Mr. PERRY. As I have been able to analyze the inflation problem,
Senator, unless we were prepared to make the real economy grow a
good deal slower, unless we were prepared to have much smaller gains
in employment than we in fact achieved over this period, it would not
have mattered f?r where we are today in terms of the inflation problem. Nor would 1t have mattered if we had gotten to today's economy
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with a slightly different deficit or a somewhat different growth in the
money supply.
Senator SCHMITT. Well, let me indicate some other things that, again
taken simultaneously, my information from the private sector and
certainly from my constituents would have maintained an expansion
even in a time of decreasing deficit and hopefully also a decreasing
share of the GNP spent by the Federal Government. Decreased reguJatory cost, the private sector has continually said over the last few
years that if we had decreased the cost of regulations that they would
have been expanding. Decreased payroll cost. They say exactly the
same thing. And those are two things we have had control over if we
were willing to exercise it. A decrease in energy cost through domestic
production rather than imports of higher cost foreign supply. And
maybe as important as any of these, the increase in the availability of
new goods and services by this time with increased investments and
new technologies and innovations that would come from those technologies.
Now I have listed four other areas. Now taken simultaneously with
good fiscal policy and a compatible monetary policy, I don't see how
anybody can argue they would not have been major deflationary forces
in our society.
Mr. PERRY. I agree entirely with that list of items you mentioned,
Senator. But I do want to distinguish those from the deficit itself
which is a different matter altogether. I think the regulatory area
directly affects cost and prices. Payroll prices directly affect costs and
prices.
Senator SCHMITT. But the deficit directly affects the money supply.
That is the basic forcing function for increases in the money supply.
Mr. PERRY. No.
Mr. SOMMERS. May I offer you a variation i
Senator SCHMITT. You may differ or offer a variation.
Mr. SOMMERS. That isn't entirely clear to me any longer. There are
deficits of a size that are overpoweringly inflationary and should be
ruled out, but the dimensions of the deficit that we are now experiencing may not quite be the Achilles heel of the whole system that it's
commonly supposed to be.
Almost every Western country is running a budget deficit. It turns
out to be something very close to the nature of a mixed economy that
it will run a budget deficit. The German deficit is considerably bigger
than ours and widening. The ,Japanese budget deficit is widening at
the response of the requests of businessmen to maintain a higher level
of activity and support it with increased government spending.
I think a point Mr. Perry was on the edge of making-and I would
agree with him if he were to make it-is that we should distinguish
between the size and power of government, which everybody agrees
needs to be kept under control in the lTnitf,d States, measured in terms
of its relative size, which is its share of GNP, and its power to achieve
the objectives of the system. This is the power of the Federal Reserve,
the powers of the Congress and the administration to control and
legislate.
In this latter sense, the United States is a relatively weak government. Its central bank is weaker than most other central banks. The
division of power between the executive branch and the legislative
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branch, which is unfamiliar to most of our trading partners, produces
terribly dilatory consequences when action is needed. Denmark raised
their value added tax about 3 or 4 weeks ago. There was no mention
in the paper before the night on which the President and his equivalent of our Congress decided to do that. Here it takes a year at least;
often by the time we get the legislation it's inappropriate.
I think what Mr. Perl'}7 is saying is we don't have much of a toolbox here to manage the kinds of problems that we have encountered
and I do think we are reaching a point in time when we should
seriously turn to the examination of the toolbox.
Senator SCHMITT. But I thought we agreed that-I went through
a list of fairly reasonable tools that are certainly within the toolbox
of the Congress.
Mr. SoMMERS. Well, by tools, you mean reduction of social security
taxi
Senator SCHMITT. Payroll costs in general, that being one of the
major ones. Regulatory costs, the energy costs, increased investments
in new technologies either through tax policy or through Federal investment itself. Those are deflationary tools and they are particularly
deflationary if you're doing something disciplined with respect to the
total money supply.
Mr. Sol\'Il\J:ERS. I can't disagree with that formulation but I would
stay with my description of the tie that we face and most of the rest
of the developed world now faces that is generally responsible for the
shape of our inflation experience over the past 10 years. I really don't
think, unless we substantially alter the kinds of commitments that
we have undertaken-noneconomic ethical types of efforts to reshape
the character of the system-that individual efforts of the type you
have described would have greatly altered the experience we have
had.
Senator SCHMITT. Gentlemen, would you care to comment i
Mr. CAGAN. As I see the problem, it's important to control the rate
of change of policy measures and to look further down the road. When
a recession first comes, Congress will want to put some stimulative
policies in place, and that will be appropriate given the degree of unemployment and excess capacity which occurs at that time. But shortly thereafter, as the economy begins to recover, it is time to begin
thinking of reversing those policies, not waiting until we have reached
full employment to do so. Gradually, as we approach full employment,
we should slow the economy down. In our experience so far, the economy, instead of stopping at the stop sign, goes right through it. It's
like docking a boat. You have to slow down as you approach or
you're going to go right through the dock. And this requires gradually
reducing the rate of monetary growth and the deficit as well.
The problem with the deficit is not so much the size of the deficit
itself. I imagine the economy can adjust to any size deficit if it becomes permanent although I would hate to see a deficit become permanent. Many people are very concerned about the rise in interest rates
that occurs as the economy recovers. ,vhen a deficit increases because
of an inability to balance the budget, that contributes to rising interest
rates. The Federal Reserve, in an e:ffort to hold down the rise in
interest rates but not knowing exactly how much and always being
cautious, allows the overexpansion that we have had in the last
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several business cycles. The rate 0£ growth 0£ the money supply expands as we come out 0£ the recession rather than declining and that's
the problem we seem to have every tinie.
Senator ScHMITI. Exactly. But that is controllable i£ we have the
discipline and patience to control it.
Mr. CAGAN. It certainly is technically controllable i£ we would
turn our sights away from the next 2 months and look further down
the road.
Senator SCHMITT. I agree.
Mr. OLSEN. The bulk 0£ my prepared remarks really answered your
question. I made the point that we should have begun slowing down
earlier. There was even talk about this, 0£ course, in the midst 0£ the
recovery period, that we should be much more cautious. That has been
our problem in the past because the time to be cautious is the time the
unemployment rate still seems to be unacceptably high and recovery
doesn't seem to ,be full. So again, the consensus required to get that
slowdown is sometimes very difficult to achieve. A brief review last
year 0£ the literature on the forecasts £or this year, the strategy 0£ the
administration, and so forth-you can see that it simply miscalculated
on the amount 0£ slack and decided we could go ahead with the same
kind 0£ policies we had in 1976 and 1977 and it's been disastrous £rom
the standpoint 0£ inflation.
The other final point I would make is it's somewhat ironic that
now you hear talk about gradualism for the next year in trying to
avoid recession-Senator ScHMITT. We have had quite bit 0£ talk about that in this
committee, including statements by the Chairman 0£ the Federal Reserve Board.
Mr. Olsen, a final question. Do you think that the specific short-term
effects 0£ the increase in the discount rate is inflationary because 0£
an increased cost in money and increased competitiveness 0£ £oreign goods i
Mr. OLSEN. The discount rate increase itsel£ does not have as significant effect on the other interest rates. It's taken more as a symbolic
measure. The proportion 0£ borrowing by member banks, £or example, from the Federal Reserve is relatively small so that the interest
rate effect on the cost 0£ borrowing by the member bank isn't that
great and, in addition to that, it's still below market rates. It's not
a penalty rate for banks which borrow from the Federal Reserve. So
it doesn't have any effect in raising interest rates.
Senator SCHMITT. But the interest rates are going up.
Mr. OLSEN. The interest rates have gone up.
Senator ScHMI'IT. Directly or indirectly because 0£ it.
Mr. OLSEN. The interest rates have gone up and, as I mentioned
in my text, primarily because 0£ strong demand for credit in a highly
inflationary economy. The way to get interest rates down is to decrease
the demand for credit and you do that through a restrictive monetary
policy.
Senator SCHMITT. Thank you.
The CHAIRMAN. I want to follow up on what Senator Schmitt was
talking about with respect to the deficit and spending and its relationship to monetary policy and inflation. Either the whole country is
wrong or you gentlemen are wrong because i£ we ever got a message
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clearly in an election it was that the electorate felt very strongly that
Government spending was a big issue and was a fundamental reason
for our inflation. Maybe everybody is wrong, everybody is out of step;
but that is the view. I submit if they are wrong, the psychological benefit of balancing the budget next year, for example, would be enormously helpful in achieving an atmosphere in which we could make the
President's guidelines work, make it possible to have a monetary
policy that would both reduce the incre,ase in the money supply and do
so with moderated interest rates and I'm rather shocked that you
realistic, able, intelligent economists seem to feel that-in response to
Senator Schmitt-perhaps I misunderstood you-that reducing the
deficit and perhaps eliminating the deficit would not be of No. 1 importance in getting a grip on inflation, No. 1; and No. 2, on making the
President's policies work more effectively and is a very, very imJ?ortant
element in making it possible to have a monetary policy which can
function.
I think perhaps Mr. Olsen would tend to agree with that view,
perhaps not. I noticed, for instance, Mr. Kauffman, whom we all respect as a brilliant economist as well as a respected banker in New
York has argued very strongly that this is one of the fundamental
reasons for our inflation and until we recognize that we're going to be
in very deep trouble. He testified before the Joint Economic Committee this year to that effect and I'm sure he feels that very strongly.
Mr. OLSEN. I think cutting the budget deficit down is important and
reducing Government spending is important, but I would point out
that that alone will not guarantee that you will reduce the rate of inflation unless the rate of growth of the money supply also diminishes
along with it.
The CHAIRMAN. Yes, I would agree with that. What I'm saying, if
you're going to reduce the rate of growth in money you need as a
partner in that and a full partner a really austere fiscal policy and one
much more austere than the administration has called for-not a $30
billion deficit next year, but a whale of a lot less than that-a balanced budget.
Mr. OLSEN. There's no question about it. But to some degree the
size of the deficit-and I might ndd to that-the proportion of borrowing by the Treasury as a proportion of the Federal funds in the
credit market at this stage in recovery has been extraordinarily high
and the size of deficit and the size of the financing required by the
Treasury is intimidating to the monetary authorities.
The CHAIRMAN. Isn't the Federal Government into the credit markets for $30 billion and could that make a great difference if that could
be eliminated~
Mr. OLSEN. It would certainly help the monetary authorities in
their task. I wouldn't want to overstate that if we got the budget
down lower that that alone would cure the inflation problem.
The CHAIRMAN. I agree with you wholeheartedly on that. Certainly
no one of these things will do it.
Mr. CAGAN. I think the emphasis should be on the change in the
budget. At the same time that you slightly reduce monetary growth
which tends to put an upward pressure on interest rates, if the Government's demand for credit were reduced, then the private sector
would be able to borrow more or less the same amount it had before,
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and the effects o:f disintermediation on the housing industry and small
business would not occur, even though monetary policy were tightening and had the effect in the long run o:f reducing the inflation rate.
We wouldn't have to go through this very painful period o:f having
interest rates rise very high because o:f the first impact o:f changing
the rate o:f monetary growth. So there the budget is paying a very
crucial role.
However, this wild inflationary world that we live in may make it
very difficult for the Congress to exert the kind o:f control over the
budget that would allow them to balance it. Expenditures and taxes
are much more difficult to predict in this inflationary environment and
much more difficult to bring into balance. When you set your sights
a year ahead, you may not be quite sure how it's going to come out,
and you may end up with a deficit that perhaps no one really wanted.
Mr. OLSEN. I just want to make one quick point that Mr. Sommers
mentioned before, that Germany has a relatively larger domestic
deficit than -the United States has, yet they have siwiificantly less inflation. That should tell us something about the effect o:f fiscal policy
alone on inflation.
The CHAIRMAN. Mr. Perry.
Mr. PERRY. Senator, the public opinion polls may say a lot o:f things
and i:f the one you read tells you what you just said, and I'm sure it
does, it's wrong. I think it's wrong on all counts.
In the first place, there is no connection between the size o:f the deficit
and the money supply. Those are two unrelated matters. They are
unrelated in principle.
The CHAIRMAN. I don't claim there's any connection between the
size o:f deficit and the money supply, but there's a connection between
the size o:f the deficit and the demand :for money and therefore the
price o:f money and therefore the level o:f interest which is the price
of money.
Mr. PERRY. I couldn't agree with that. I would not agree with that
argument.
The CHAIRMAN. Let's make it extreme. Supposing we had a $100
billion deficit and the Federal Government is borrowing $100 billion
in the market. You don't think that would have an effect in driving
up interest rates i
Mr. PERRY. No. The reason is the following: let's imagine that we
chose to eliminate this deficit by raising taxes by $100 billion. Then
to keep the same level of activity in the economy-The CHAIRMAN. That's a big "if."
Mr. PERRY. The private sector would have to borrow the $100
billion instead o:f the Government. You're not changing that basic
proposition simply by making me borrow instead of you. That's the
rea<:on that there is no connection with interest rates.
The CHAIRMAN. I don't understand. Did vou say you could meet that
by having a $100 billion increase in taxes i Maybe you could, but my
statement is keeping everything the same. If you increase spending to
a point where you have a $100 billion deficit, that has a tendency to
increase the interest rates i:f you have the same monetary policy.
Mr. PERRY. Well, I don't know how that is keeping everything the
same, Senator. You just increased spending on me.
Mr. CHAIRMAN. You keep everything the same except spending.
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Mr. PERRY. I was keeping everything the same. I was just trying to
make it simpler by keeping everything the same except taxes, since it
was easier to visualize the fact that if you raised your taxes you
would have to borrow more in order to conduct your affairs at their
previous level. But the same is true with spending except one has to
realize that the recipient of that spending now has to borrow since the
Government is not borrowing. That's the reason there is no necessary
connection. The Government's deficit corresponds to a surplus somewhere else. So long as you keep the level of GNP what it is, it's just a
question of who has the deficit. If the Government has less, the private
sector will have more.
Consequently, there's no effect on the demand on credit markets.
The CHAIRMAN. You're making assumptions that are unrealistic.
I think if you're going to have a $100 billion deficit you don't keep the
same level of GNP.
Mr. PERRY. Then I think we agree, if we're talking about a different
level of activity.
The CHAIRMAN. Well, you have a different level of activity if you're
going to increase Federal spending by 25 percent in 1 year. You're
going to have a different level of activity.
Mr. PERRY. My impression was that the public opinion poll you
referred to was not asking if we caused a major recession would we
have less inflation; but rather, given the present level of employment
that we have in this economy, would it make a difference if we had a
smaller or larger deficit. We are holding a fixed level of activity.
The CHAIRMAN. The public perception is that the present level of
spending and the present level of the deficit is one of the elements contributing to inflation, and I think that's a very broadly supported view.
!1,-s I say, it may be wrong, and you apparently think it is, but I think
it's a very broadly supported view.
Mr. PERRY. I was trying to tell you why. I was also trying to addr~ss
the question of the correlation between monetary growth and deficits
which, in principle, could be anything and historically is, in £act, a
negative correlation. The reason again is because we get large deficits
when we slow down the economy and that also corresponds with
periods when we slow down the money supply. So I'm afraid that a
lot of these various slogans don't really help ti.s on that.
Mr. OLSEN. I didn't want to leave the impression that I suggested
there's any correlation or any quantitative measurement between rates
of change of money supply and size of deficit. It's something more
qualitative. In past years-we don't hear it so often now, but in past
years we used to hear the reference of "even keeling" on the part of
Federal Reserve policy by which the Federal Reserve would seek to
maintain stable conditions in the credit markets during Treasury
financing operations and it did so often by putting reserves in and
didn't take as much out so there was some expansionary bias there.
It might also be reflected in the kind of statements that former
Federal Reserve Chairman William MacChei;mey Martin made back
in the 1960's when he said £or the Federal Reserve to pass judgment
on congressional appropriations and spending decisions and therefore
withhold the financing bills if it came to that would be preposterous.
He said the Federal Reserve must act in concert with the Treasury's
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requirements and so on. It's an attitude on the part of the Federal
Reserve. It's something that's qualitative.
I would agree there's no quantitative between the two. It's something
that intimidates the monetary authorities.
The CHAIRMAN. Let me see if I can formulate the question 'a little
different because I follow up on Senator Schmitt and I would agree
with the view here that there's no connection between the deficit and
the money supply. I think there is a definite connection between the
amount of Federal spending, the deficit, and both interest rates and
inflation. I'd like to get your view on whether or not a sharp reduction
in the increase in spending would have a favorable effect in permitting
the President's anti-inflation program to work and in making it possible for monetary policy to proceed with a small gradual reduction in
the increase in the money supply without seeing adverse effects on
interest rates.
Mr. SOMMERS. You're getting the general opinion from this group
that the relationship is much looser than is widely held by the public,
both with respect to the deficit and the money supply, the deficit and
the rates of interest, and the deficit and the rate of inflation. May I
make just a couple of points in connection with that?
First of all, the deficit is falling strikingly rapidly now and it will
probably continue to do so. On a seasonally adjusted basis that the
national accounts provide us with, the Federal deficit was down to $25
billion by the second quarter of 1978. It doubtless fell further in the
third quarter and will probably fall further in the fourth quarter. So
we are ending 1978 with an ongoing deficit-from the NIA accounting system which is not so different from the budget which we customarily deal with-probably below the $20 billion rate. The State
and local surplus is probably that big, at least until all the Proposition
13's work their way through. The government sector in the United
States is very nearly in balance. And when you look around, the demand for credit is rising extremely rapidly, pressing very heavily on
the supply, and hence on the interest rates. It's the explosion in private credit much more than in public credit that accounts for most of
the post-war experience. I offered you a publication that I did about a
year ago at the Conference Board that bears on the relative importance
of public and private debt. The crowding out argument that we hear
frequently has simply never been observed in the real world. I doubt
very much that it ever will.
Now this does not mean that budget deficits are good or bad. We run
a budget deficit, as everybody else does, for very simple reasons related
to the historical positions of all of these systems. We are all pursuing
a new range of objectives for the economy. Some like them, some don't.
But that's what we have done. That's elevated spending at the same
time we cherish, particularly in the United States, a private market
economy. There are tax rates that would simply foreclose the private
market economy, so the tax rates are set in the hopes of preserving the
kind of incentive that a private economy needs.
These are independent calculations and it shouldn't be surprising
that they don't balance. We have the 10 highest tax structure among
13 Western developed nations. We have taken better care of the pri-
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vate sector than most other economies, but it has left us with a considerable gap.
The real question is whether the last dollar of Federal spending at
the margin is something that we would prefer to alternative spending
elsewhere. That's a very difficult weighing effort to do. At the extreme
it's easy enough. There's not much sense in having private cars out
there if you don't have public roads to run them on, and you could
make the reverse comparison. It's much more nearly that fundamental
question of what it is that we want out of this system and how much
insistence, and properly so, on protecting the private sector that explains the general deficit.
Now apart from fluctuations in economic activity, one other point
that bears on this deficit and that helps explain the difference in the
German experience and the Japanese experience from our own, is the
propensity to save in the consumer sector. The German saving rate is
more than three times as high as the U.S. saving rate. The Japanese
personal saving rate is four times as high. The Germans are financing
a budget deficit with real saving in the personal sector and we are not.
One of the reasons we are not is that our monetary system markets
money to consumers for consumption purposes the way we market
toothpaste. It's an intensive, aggressive continuing effort with no restraints on it. There's a difficulty here. One of the principal ones is
the ease with which we make it possible for the personal sector to take
on immense volumes of credit and therefore experience a low saving
rate and add to the demand for funds on top of the Federal Government.
Just as a last point, right now the growth of installment credit outstanding is far more rapid than the growth of the Federal debt-at
this point in time, 50 percent more rapid and on a smaller base. On a
percentage the growth rate in installment credit is probably double
what it is in Federal debt.
The CHAIRMAN. My time is up. I've got some more questions.
Senator LUGAR. Go ahead.
The CHAIRMAN. I find myself in pretty sharp disagreement with you
with gentlemen and I'm not persuaded, but I will certainly review
your remarks and see if I can correct some misimpressions on my part;
but you do seem to come down pretty hard on the notion that if the
monetary policy isn't the only game in town, it's about the only game
we can use right now and use very effectively. Now I come to the point
that I raised in my opening statement but I haven't asked questions
a:bout it and nobody has discussed it and I'm interested that there
hasn't been any concern about it.
Monetary policy in the past has worked, if not entirely, very largely
through the housing sector. An analysis by Sherman Mais~ll of the
Federal Reserve, as you recall, in 1967 showed a 1967 credit crunch
that, although the housing industry constituted about 3.5 percent of
the GNP it suffered 70 percent of the effect of that crunch. We all
know how supersensitive the housing market is to changes in interest
rates.
Now we have a different ballgame. Now we have a situation in which
the housing industry is somewhat insulated. It's possible for savings
an_d loans to raise money by paying above the Treasury bill rate, somethrng they couldn't do before; and therefore they have money avail-
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able and it looks as if housing is going to be able to move along fairly
well. There's going to be some reduction but it may not be anything
like the reduction that took place in previous credit crunches.
My question therefore is, what does this do to monetary policy i Are
we dealing with something that's becoming a paper tiger? Does it
mean that the credit crunch will have to have an effect throughout industry and what level of interest rates do we have to get to before you
have a bite in the business sector that you had before in the housing
sector on the assumption that housing isn't going to suffer the kind of
decline it has in the past? Would you like to kick that off, Mr. Olsen i
Mr. OLSEN. Yes. I think that the insulation that you speak of isn't
going to be sufficient, that we will have a housing decline. The reason
why is because when you have a rapidly accelerating inflation it alters
the way in which the marketplace allocates credit. This is a mirror
image of what's happening in the economy.
As inflation accelerates, those who demand and require credit for
short-term purposes-and one illustration I could use is someone who's
rolling over inventory several times a year, for example-his ability
and need to bid for short-term credit is very strong so that he will bid
and push short-term rates up. If the inflation is rising rapidly enough
he will push those rates up above the long-term rates. The long-term
bidder for funds who's discounting a long-term stream of income
doesn't have nearly as high inflationary expectations and is not likely
to outbid the short-term bidder for funds.
The CHAIRMAN. An argument you hear over and over again is that
home buyers anticipate as much as a 20-percent increase in the value
of their home. They feel that's one investment they can make that's
likely to ride with inflation.
Mr. OLSEN. That's as long as they expect that policies will continue
to pursue those inflationary policies.
The CHAIRMAN. They have seen it happen. All of us have had that
experience. We know our neighbors that have bought houses for $50,000
that are now worth $100,000.
Mr. OLSEN. We're already beginning to see, that savings banks are
not able to continue. to bid for funds even where they have freedom
to do so at rates above 10 percent and offer those funds out at mortgage
rates somewhat higher than that. So it's already beginning to bite.
Let me add that it's something of an illusion to say that the transmission of a restrictive monetary policy moves through the housing
market only. The housing market is very visible and very conspicuous,
though there are other sectors of the economy also that pull back from
bidding for long-term funds, including the State municipal area and
corporations; they all pull back from bidding for long-term funds
when inflation strengthens the bidding for short-term credit.
The CHAIRMAN. No question. You're rig-ht about that. My point was,
they pull back in aggregate overall in the economy at a somewhat
higher rate than they have in the past.
Mr. OLSEN. That may be, but additionally what happens is that as
monetary policy reduces the Nation's nominal income, it squeezes real
income. The dramatic event of 1973-74, for example, was the fact that
real consumption snending and real retail sales began to decline as
early as March 1973 and continued to proceed all through 1974. Because total consumer spending is not something that is as vocally
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represented in Washington, and you don't have organized representation for this area, nobody pays that much attention to it. But housing,
which is so conspicuous, receives more attention. But the recession of
1974-75 began in the total consumption sector.
Mr. CAGAN. In a boom, when demands for credit are becoming
excessively high, various sectors of the economy are trying to borrow
more resources than we actually have. Someone has to cut back. Previously it was the housing industry, for one.
Which industries should cut back under those circumstances are
those that can easily cut back and then recover very quickly. Housing,
as a matter of fact, has been able to do this in the past.
The CHAIRMAN. I can tell you, because this is the Banking, Housing,
and Urban Affairs Committee, they are unhappy about it. They feel
it's the most inefficient, cruel, ruthless operation. They say again and
again marginal firms have failed. They can't operate efficiently because they have to operate at peak capacity and then drop to very low
capacity. The labor people are very unhappy with it. You have a high
level of unemployment. One of the reasons you have construction wages
which are inflationary is because they say they work not the 2,000
hours a year that people ordinarily work but about 1,400 hours a year,
and therefore they have got to have higher hourly pay. It has a very
disruptive effect. If we could stabilize housing, as they have in other
countries, it would be a better situation.
Mr. CAGAN. I was on the staff of the Council of Economic Advisers
in 1969, and those complaints were coming into the Council when we
had a period of rising interest rates and considerably more disintermediation than we have had recently. They complained quit loudly,
and I'm sure most of their complaints should be tnken quite seriously.
On the other hand, they said at that time that the housing industry
was never going to recover from the effects of what was happening
in 1969. Yet, if you remember, very quickly honsin,<r came back during
the recession and reached new levels of building that we hadn't seen
before.
I agree that one industry should not have to bear the brunt of
monetary restraint. As you pointed out, through the borrowing of
the savings and loans and other institutions, the effect on this industry
is less, which means the effect is going to be transferred to other industries, to some extent to small business, which is unfortunately not in
a position to bear it.
One thing that could be done, as was said before, is for the Government to step out of the market at the time that this happens. If Government demands for credit were not so insistent, more credit could go
to the private sector. But some demands for credit have to be cut back.
The more evenly cutbacks fall across the economy, in general, the
better.
The CHAIRMAN. That's one of the reasons why I feel it would be
helpful if we could reduce the deficit, so the Government demand £or
funds would not be so great.
Mr. OLSEN. I just wanted to add this point. The time for the housing
industry to express its concern is not this year when interest rates are
rising as they are, but it should have been in 1976 and 1977 when
policies were overly expansionary and were heading for the kind of
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inflation we are encountering this year. I have told people in the housing industry this repeatedly. Their problems are born in excessively
expansionary monetary policies and not in periods of restrictive monetary policies.
The CHAIRMAN. It's hard to expect them to do that when in no year
do they come close to the goals we set in 1968 on the basis of studies
in Government and business who felt we should have 26 million
housing starts. So 2.4 million was the peak year and we have been well
below that. In 1976-77, we were well below that. It averaged about 2
million. So in their view we were not up to what the economy seemed
to need.
Mr. OLSEN. But it would be better to seek those goals in a more
stable growth for housing.
The CHAIRMAN. They thought they were still on the up rather
than at a peak and about to fall. ,
Dr. Perry?
Mr. PERRY. I have nothing to add.
The CHAIRMAN. Mr. Sommers?
Mr. SOMMERS. I think the protection is wearing thin. It will be
interesting to see how many banks will now be eager to offer them.
They are a terrible drain on the thrift institutions. Moreover, the life
insurance companies don't carry this protection, and there's been a
gradual deterioration in the position of life insurance companies in
this respect. I would expect it to get 1t lot worse over the next 4 or 5
months. There will be, I think, a considerable decline in the housing
market.
The CHAIRMAN. Let me ask you gentlemen, as experts, to see if you
can help us on what other indications of monetary policy should we
look at in view of the prospect that over the next few months, perhaps
over the next few years, M1 will not be as satisfactory as it has in
the past because of the changes in the transaction accounts.
What other indications should we look aH Monetary base i Nonborrowed reserves? Total credit demands? What do you think would
be the best indication we could work ont with the Federal Reserve for
observing monetary policy more precisely?
Mr. SOMMERS. I only have a brief comment. We will begin to ~t
a statistical base on the new arrangements, and at least we will be
able to do some more measurement. For the time being, the monetary
base is one recourse that we can take i.n this interim, lmt there may be
other more professiona1 opinions down the way here.
The CHAIRMAN. Any disagreement with that?
Mr. CAGAN. I would like to point out the monetary base alone is not
going to be sufficient, because the ratio between transactions balances
and the monetary base is undergoing change during this period. I
would encourage the Federal Reserve and their expert staff to devote
resources to this problem. I know they have been doing some internal
work. but I don't have the impression they are giving this top priority
as I think they should. A lot of estimates and new data could be collected to shed further light on the extent to which the public is using
these new transactions balances and to which shifts are occurring
from demand deposits to these new transaetions balances. With their
resources they can gain insights into this question. I think we are
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going to need a lot of help over the coming years until we have some
such reforms of the kind I suggested.
The CHAIRMAN. I agree with that bnt do you see any specific statistic we could use as a guide from quarter to quarter to determine the
conduct of monetary policy? We'd like to get to a situation where
M1 may decline but that decline may be a deception. It may not be a
real decline because people aren't using demand deposits as much as
they were. They were keeping their money in the time deposits.
Mr. CAGAN. I would continue to look at M 1 and try to supplement
that with information on major shifts that are occurring. Some data
are available on repurchase agreements which are a large quantity.
I£ any new development comes along that implies that corporations
or other large holders are shifting from demand deposits into savings
deposits, there should be supplemental data acquired on that. I would
urge you not to stick with what you have. I don't think the present
aggregates are sufficient for this purpose.
The CHAIRMAN. Mr. Perry.
Mr. PERRY. Professor Cagan's suggestions in his formal testimony
are very useful ones and might be pursued further. Within the aggregates we look at, it's my impression that M 2 has a closer relationship
to economic activity than M 1 even on a historical basis, and consequently we shouldn't be terribly distressed if we can no longer
read M 1 at all.
More importantly, I would hope that the Fed would look both at
what's going on in the financial markets and what's happening to
interest rates as well as what's happening to some of its aggregates.
This is something that requires a lot of judgment, a lot of careful
examination of the economy, not a simple rule.
The CHAIRMAN. Now in the rush in the lust Congress we passed the
Humphrey-Hawkins bill and a lot of people have mixed feeling about
that, but the Humphrey-Hawkins bill did provide for new responsibilities for the Fed in reporting to the Congress and reporting to
the country and also it provided for an attempt on our part to try
to coordinate monetary policy and other economic policy generally,
including fiscal policy. ·what we need as a base for that is some sort
of forecasting of what the expectations are for the eeonomic growth,
unemployment, inflation, or so forth.
I'd like to ask you, because it woul<l contribute very much to our
evaluatiun of the wisdom or lack of it of the Federal Reserve Board's
targets for monetary policy, if you could gi,Te us your estimates on the
outlook. You did indicate the likelihood of a recession, particularly
Mr. Sommers, and most of you seem to agree that that's likely. The
administration is :forecasting no recession for next year, real economic
growth of between 3 and 3.5 percent. Chairman Miller is :forecasting
no recession and economic growth around 2.5 percent, I understand.
They may be right.
Those don't square with the :forecasts Wt are now getting, not only
from you but from the private sector generally. Where do you see ~he
differences in the economic outlook coming from? ·what are the ma1or
problem areas? Where do yon see the recession likely to develop?
You have indicated that inflation is the fundamental cause, but
looking at the consumption, investments. exports and so forth, can you·
jnst give us a quick notion of where you think the administration is off?
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Mr. OLSEN. Well, recession normally follows a sequence of events
moving through various industries. Consumer spending particularly
for durable goods, which also includes the housing area, would be one
of the early areas in which a downturn would manifest itself and it
would emanate from lower increase in nominal national income in
which inflation would not yield immediately and you would have
decline in real income and with it a decline in consumption spending.
The capital investment area tends to lag and is the last segment
of the economy hit and that is very briefly the kind of sequence of
events we have seen happen in past recessions and I would expect
it would happen in the year ahead.
Also, on the restrictive monetary policy, may I make a comment on
the earlier question you had on monetary aggregates because the monetary base which we do follow isn't entirely a reliable guide at all times:
In fact, the base did not decline in the prerecession period of 1974-75
and again it's ,a point that Professor Cagan made that you can have
marked changes in the multiplier of the base to money and the Federal
Reserve clearly needs to do more analyses on this and does indeed
need to make some improvements in its definitions and its targets. I
would also urge that the Federal Reserve should review once again
the 2-week lag in the reserve adjustment as well, which may also be
a problem in the execution of policy.
The CHAIRMAN. My question is, where do you see the administration's forecast and the Federal Reserve's foreeast going wrong? Maybe they haven't been sufficiently detailed indicating precisely where
they expect the economy to grow, but do you have 'any thoughts on
that?
Mr. SoMMERS. I think you will probably find the whole panel agreeing on this. Our own projections call for an absolute decline in units
of consumer spending for durable goods, as much as 10 percent or
more in automobiles. and less than that outside of automobiles.
The CHAIRMAN. Less than that for housing, for instance?
Mr. SOMMERS. No. More than that, about an 18-percent decline in
units, which would produce 7 or 8 percent decline in actual dollars
since there's a considerable inflation rate we expect to be maintained
there.
We think the growth rate of plant and equipment spending will
still be positive but just barely so, as distinguished from a 5- or 6-percent real rise this year.
The CHAIRMAN. ,Just barely positive in real terms?
Mr. SoMMERS. In real terms, yes. About 10 percent in dollar terms
with most of the loss being the kind of off-the-shelf quick order capital
goods. Trucks and buses would be part of that.
Finally, we think inventory is a?cumulating rig-ht n?w at an i:ncreasing rate. The fourth quarter mventory accumulation rate will
be very high and we expect that to fall verv, very sharply so there
will be a loss of inventory demand. These would be offset by what may
be a considerable improvement in exports and an increase in both the
defpnse and nonde,fense imPnding of the Fe<lPr::tl Government.
The CHAIRMAN. Mr. Olsen, you indicated that you expected there
may be a recession next year.but you also indicated-and I think
others did too-that there's been a continuous big demand for credit.
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Why isn't this rather severe action taken by the Federal Reserve Board
begun to have a bite~ Where is the slippage~
~fr. 0LSE~• .B~cause I don't think they have actually reduced the rate
of mcrease first m the monetary base and-The CHAIRMAN. Why hasn't the sharp increase in interest rates begun to have an e:tfect i
Mr. _OLSEN. ~ecause the real rate has only recently increased. Again,
t~e pomt tha,t Senator Lugar made, that when you have inflation running at 8 or 9 percent and you have interest rates running at about
8 or 9 percent, the real rate is virtually zero and it's only been in the
last 6 months that the real rate has increased, and our estimate is
when the economy is fully employed an equilibrium rate £or short rates
would be the inflation over the past year with ,about 2.5 percent real
rate over the top of tha,t. With the real inflation rate running at 8
a 10.5-percent interest rate would be what we regard as equilibrium:
The CHAIRMAN. There have been some rumor that business demands are high because businesses are borrowing on credit lines high
because of credit controls this spring. Have you seen any evidence of
thati
Mr. OLSEN. Some.
The CHAIRMAN. That would be artificial and it would be likely to
show up later on.
~r. OLSEN. But what's happening is you're getting increasing commitments requested from the banks, not so much drawdown. The
sharp increase in short and intermediate borrowing is typical at this
stage in recovery where you have reached potential GNP with inflation ,accelerating.
The CHAIRMAN. Dr. Perry, historically the economy has never
experienced, as I understand it, a soft landing where economic growth
is slowed by tight money but no recession takes place. Given the lags
in monetary policy effects in the economy, the difficulty in forecasting turning points in the economy, and the Federal Reserve's reluctance in the past to shift gears quickly and forcefully, what are the
chances it will be different this time and we will have continuing
growthi
Mr. PERRY. Well, my testimony did include my most recent forecast
and I'm on the side of those who expect a recession, as you can see
there. We did have a soft landing once before and that was 1967. The
special circumstances then were very strong demands, predictably
strong demands, from some sectors other than housing. So although
you killed the housing industry during 1966 and into 1967, you had
these very strong demands holding up the overall economy. We don't
have a repeat of that this time and that's why I expect we will see a
recession next year. There isn't any clear strength to offset the predictable weaknesses.
By the way, I think that the present level of interest rates will be
perceived to be very high by the private sector within several mo~ths,
because I think the rate of price inflatio_n that we ~ave ~een experie~cing very recently exaggerates the basic rate of mflat10n that .we ~
o-oing to be living with in a few months. In view of the moderat10n m
those inflation numbers that I expect, it's going to turn out that we're
looking at a very high real interest rate.
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The CHAIRMAN. Dr. Perry, do you think that the program to support
the dollar has been successful so far and do you think that there's indications that it will continue to be successful 1 Do you think it's basically
sound1
Mr. PERRY. Yes. Certainly so far I believe it has been successful.
Intervention is generally a game that's very hard for us to play
properly. Traditionally governments have intervened in currencies
unsuccessfully. Nonetheless, that doesn't say that you shouldn't try to
when you believe you've reached excesses. All of our trading partners
think the speculation has been excessive. They all joined in wanting to
support the dollar and I think that's an indication.
What bothers me is that we may find ourselves pursuing policies that
we would not want to pursue in terms of domestic objectives simply
because we're responding to speculation by foreigners in the foreign
exchange markets. I don't think we ever want to be in a position of
having the "gnomes of Zurich" dictate our social priorities at home.
We can come close to that if we gear our policies too much toward
what's happening to the dollar abroad.
The CHAIRMAN. Mr. Olsen do you agree with that, that the support
of the dollar program that the President announced has been successful
and is likely to continue to be 1
Mr. OLSEN. Well, I think it's been successful in the 2 weeks that
it's been out, in the sense that the dollar improved in the exchange
markets and it's holding relatively well. But whether the program
succeeds over the longer run remains to be seen. I don't think the program as it stands will be sufficient.
The CHAIRMAN. What do you need in addition to that?
Mr. OLSEN. You have to adopt a less expansive monetary policy.
You have to demonstrate that you're absolutely intent on reducing the
rate of inflation, particularly the rate of inflation relative to other
countries, and convince the marketplace that the intent will be carried
out.
The CHAIRMAN. Well, gentlemen, I want to thank you very much.
I think you have given us a very, very helpful analysis of our economic
problems and what we can do about those economic problems from a
monetary policy standpoint. You have given us a g:ood basis for questioning the Chairman of the Federal Reserve Board tomorrow.
One more question because it's one that's concerned us a lot, the staff
and I in talking about this, and we'cl like to get your views as outsiders who are more objective perhaps. We would like to get thP other
members of the Federal Reserve Board and the presidents of the Federal Reserve Banks who also serve on the Open Market Committee to
testify before this committee from time to time on monetary policy.
We think it would be helpful to get their views, although we recognize
only the Chairman can and should speak for the Board as a whole. We
think there's a lot of talent there and a lot of ability and a lack of
understanding on the part of the Congress and the public of our monetary policy. We would like to get the broadest and most interesting
kind of debate so we can get a better understanding on the part of
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Congress and this committee and the public generally. We think that
would be constructive.
There are problems involved, however, in getting more than one
voice speaking for the Federal Reserve Board and I'd like to get your
views on whether you think it would be proper policy for us to invite
to testify not only the Chairman of the Federal Reserve but the six
other members and perhaps some of the Federal Reserve presidents
who also have the same vote he has in determining what the course of
monetary policy should be.
Let's start off with Mr. Sommers.
Mr. SOMMERS. I guess we all recognize some difficulties in that. The
members of the Board of Governors, many of them, carry specialization and I might suggest one way of achieving this and yet preserving
the sense of one overall voice on the part of the Chairman would be to
invite them to address themselves to their specialization. Invite Henry
Wallich to speak on the international views of the Federal Reserve,
and so on down the line. I think it might be somewhat awkward if the
procedure were to appear to be being used to uncover differences of
opinion within the Board. I think that might be awkward, but specialization may be a route in which you could get most of what you want
done.
The CHAIRMAN. Dr. Perry.
Mr. PERRY. I really haven't given this any thought. Board members
should not be muzzled. They should be free to express views when they
differ from the Chairman. But there's 80me risk in making the whole
process of formulating monetary policy appear even -more divisive
than it is from time to time by causing disagreements to be aired very
publicly rather than resolved within the Board itself. I can see some
problems in going very far in inviting everyone to air his particular
disagreements, but I really haven't given it enough thought to have a
view on where to strike a balance.
The CHAIRMAN. You see, right now we have a situation where monetary policy does seem to be so important and somewhat complicated
by all the factors we have discussed this morning. It would be especially helpful to get all the insight we could get and there's a lot
of talent there, a lot of very able people, and by and large, in the past
the people think of the Federal Reserve Board as the chairman and
that's all. It's not that. It's not the way it functions and it seems
unfortunate that the other members aren't heard and I think it would
enlighten us occasionally. Of course, there might be a little difference
that might be embarrassing for a short time, but I can't see any objection to it. But I'd like to get your views. Dr. Cagan.
Mr. CAGAN. My first response to it, not having thought about it
much before, is that it would be unfortunate if it produced any posturing on the part of the different members. We can only have one monetary policy at a time; that group has somehow to compromise and be
able to talk to one another. If they get hardened into a position because
of public exposure, that, of course, would be unfortunate.
On the other hand, they do occasionally in the FOMC reports
disagree, and I suppose it would be possible for them to come here
and explain what their position is if it's already been made public.
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The CHAIBMAN. Just a couple months ago we had the Chairman voting the minority along with Charles Partee at one point, so it's not as if
he does speak with one voice.
Mr. OLSEN. My initial response would be that I would not do it. I
think the reason why is because the members of the Open Market
Committee-I have in mind particularly the district presidents conduct extensive discussions and I think that if you have many voices
being represented, particularly before Congress here, that will alter
possibly the roles played in the committee function itself. It certainly would create a great deal of difficulty for the chairman to represent that committee.
Additionally, the members of the Open Market Committee now do
at times publicly make their opinions known.
My initial reaction is I would be very cautious about it. I'd look at
it very hard before moving ahead on such a proposal.
The CHAIBMAN. Well, I appreciate that caution. I'm hopeful that
we can develop something, yet I want to do it in a way that wouldn't
injure the effectiveness of the Federal Reserve Board and our monetary policy.
Gentlemen, thank you very much. You have been most helpful.
The committee will stand adjourned until tomorrow morning.
[Whereupon, at 12 :30 p.m., the hearing was recessed, to be reconvened at 10 a.m., Thursday, November 16, 1978.]
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Federal Reserve Bank of St. Louis
THIRD MEETING ON THE CONDUCT OF MONETARY
POLICY
THURSDAY, NOVEMBER 16, 1978
U.S. SENATE,
COMMITTEE ON BANKING, HOUSING, AND URBAN AFFAIRS,
W(J,8hington,D.O.
The committee met at 10 a.m. in room 5302, Dirksen Senate Office
Building, Senator William Proxmire ( chairman of the committee)
presiding.
Present: Senators Proxmire, Sarbanes, Tower, Garn, and Schmitt.
STATEMENT OF CHAIRMAN PROXMIRE
The CHAIRMAN. The committee will come to order.
This is the second day of our hearings on the conduct of monetary
policy. We are honored to have with us today Chairman Miller of
the Federal Reserve Board.
This is the final hearing on monetary policy that have followed from
H. Con. Res. 133 which the committee approved and was passed in
1975. The next hearing on the conduct of monetary policy will be held
under the requirements of the Humphrey-Hawkins bill, which is
now law-it passed the Congress a month or so ago---and, of course,
that will be next February. Those requirements will expand the
dialog between the Federal Reserve and the Congress because the
Federal Reserve will be required to state in more precise terms the relationship between their monetary policy plans and objectives and the
numerical goals for employment, unemployment, production, and
prices established by the President in his Economic Report.
This change is particuarly important coming at this time because
of the serious inflation problem and the possibility of recession. Moreover, the monetary aggregates as an indicator of monetary policy
have become somewhat less useful than they were before and the meaning of changes in M1 may be seriously distorted because of the establishment of automatic transfer accounts. Right now everyone would
agree that M 1 , the conventional money supply measurement, is growing
too rapidly, but by this time next year M1 may be declining because
of shifts of funds from consumer checking accounts into savings accounts, not because of tighter monetary policy or changes in real
economic activity. M 2 may become a more appropriate measure for
policy purposes or it may be that more attention will need to be focused
on bank reserves and interest rates because none of the monetary aggregates will provide the information necessary to relate monetary policy
to production and employment.
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Three of our four witnesses yesterday predicted a recession next
year, in part because rates have risen more than most people would
have expected. The housing sector, although partly insulated from
rising interest rates, is likely to come under increasing pressure as will
consumption and thus inventory growth.
The Fed faces a very tough challenge in designing a policy that will
reduce inflation without precipitating a recession. You obviously need
all the help you can get. Last April when you appeared before this
committee, Chairman Miller, you said the Congress should look at
reducing spending and you would be personally satisfied with a deficit
of $50 billion by 1979. We have done better than that by a big margin,
but the economy is continuing to grow more strongly than expected
and interest rates are far higher than anybody would have guessed
last spring. A sharp cut in the increase in Federal spending would help.
In my judgment, a balanced budget in 1980 is within our grasp and
would greatly help the Federal Reserve to hold down interest rates.
e would like to know how the Federal Reserve plans to pursue
recowry without either recession or higher inflation. We'd like to
hear you explain the Federal Reserve's plans relative to that dilemma.
Senator Tower.
Senator TowER. I have no statement right now, Mr. Chairman. I
may make a comment after the Chairman gives his testimony.
The CHAIRMAN. Senator Garn.
Senator GARN. I have no opening statement, Mr. Chairman.
The CHAIRMAN. Senator Schmitt.
,v
STATEMENT OF SENATOR SCHMITT
Senator ScHMITr. Mr. Chairman, these hearings on monetary policy,
as everybody knows, come at a very critical time. It seems that we
make that statement every time we have this particular set of hearings,
but in this case inflation has risen to over 10 percent on an annual
basis, doubling since the begining of the 95th Congress. The dollar has
fallen to postwar lows, and individuals and institutions here and
abroad have bid the price of gold and other currencies to alltime
highs apparently in search of a safe haven for inflated U.S. currency.
Since the recent Fed actions which everybody is familiar with
investors and economists seem all of a sudden convinced that a recession is pending. We have heard a variety of charges of why all this
havoc exists. Labor blames business; business blames Government;
Government blames business and labor. Everybody is passing the
buck and, unfortunately, and most conspicuously, the White House is
passing the buck. The Carter administration has, unfortunately, laid
the blame for our economic crisis on previous administrations and
more unfortunately on the public and business at large, while ignoring
the discomforting :fact that inflation was only 4.8 percent when the
present administration took over the reins of Government.
Having allowed our economic health to deteriorate to a dangerous
point, the administration took what they would have us call bold action, but as Shakespeare said, "Delay has dangerous ends." ~he fea_rs
and uncertainties induced by the continuing inflationary spiral will
not be as easily dispersed as they were created, and if we look at those
indicators of what inflation will be doing over the majority of next
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year, when we look at prices of raw materials and so forth, it's awful
hard to see this 10-percent inflation decreasing under present policy.
The rapid tightening of credit will certainly have serious long-term
effects and many economists are predicting a recession in the coming
year. The only question seems to be in their minds how deep that recession will be.
Now, I'm not personally convinced that we have to have a recession,
but that certainly seems to be the prevailing opinion that we heard
yesterday and are hearing from other quarters. All of this could have
been avoided. I believe, had the Carter administration exercised
some caution in the first 18 months of its tenure and done what the
chairman, Chairman Miller of the Federal Reserve Board, and others
asked to be done, and that is establish certain gradual trends in
economic policy that would be basically deflationary in their nature.
There might still be time to avoid a recession if we undertook an attack at the root causes of inflation rather than its symptoms. At the
very least, if we undertook such an attack we would establish confidence I think within the business community, labor community, and
the public at large that would have a deflationary effect in its own right.
There's little consolation to me that the President now recognizes
what many of us in the electorate have been telling him for the last
2 years, that at the peak of the business cycle, a peak of recovery, the
Federal deficit and Federal spending in general must be brought under control. It is the deficit that creates pressure for increases in
money supply to finance the borrowing that that deficit requires.
Let us hope that the President also recognizes that excessive regulatory costs, excessive payroll costs, excessive energy imports of expensive energy, and inadequate investment in new research and technology are also major inflationary forces and these excesses must
be changed if we are going to begin to deflate the economy.
Now we find the economic indiscretions of the past 1½ years have
come home to roost, and strong action to halt the economy's decline
was clearly necessary. Hopefully, the President will follow through on
his pledge to hold the line on the budget and give more careful scrutiny
to regulatory programs and hopefully to realize that there are some
very positive actions that the Government can take of a deflationary
character. He will certainly have this Senator's support for all wellconceived initiatives along those lines.
Unless he does follow through, however, in these and other areas,
the underlying causes of inflation will continue to exist. The recent
program which he announced will only be a prelude to more stringent
program of wage and price controls, and possibly even tighter credit
if the indicators that come from the administration are to be believed.
In each of these cases-that is, wage and price controls and tighter
credit-the people who will suffer are the victims of inflation and,
unfortunately, very few of the root causes of inflation will come into
play.
Now, in these hearings we will have a chance to probe into some of
the implications of the actions recently announced by the President;
but along with examining the content of that policy, I hope we will also
address the manner in which that policy was formulated and announced. And having the President make the announcement of this
nature at the ,i\Thite House, the strong impression has been given to
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the American public that it was in fact the President and not the
Federal Reserve Board that had made these important decisions affecting the monetary policy of our Nation.
Now, the Chairman and I have talked about this, and I am reassured
by his attitude. However, this impression is still prevalent out among
the public. The impression is so pervasive that even Henry Reuss, the
chairman of the House Banking Committee, put out a statement to
the press praising the President for raising the discount rate. Well,
everybody knows that that is the job of the Federal Reserve Board,
not the job of the President. It doesn't mean there cannot be discussions, but it is not the President's prerogative.
If the President and the Fed have misled the chairman of the
House Banking Committee who has dealt with monetary policy for
years, you can be certain that the public has also been confused. The
apparent subordination of the Board's rule in the conduct of monetary
policy to that of the President, particularly at a time so near the
election, raised serious questions about the basic independence of the
Federal Reserve Board.
During Chairman Miller's confirmation hearings before the Senate
Banking Committee, as you may recall, I personally, as others, made
strenuous efforts to maintain the focus of the hearings on two fundamental issues: Mr. Miller's philosophy in the conduct of monetary
policy and the sincerety of his commitment to maintain the independence of the Federal Reserve Board from the dictates of the executive
branch.
In the first few months of his service, to a great extent he put to rest
any doubts with regard to the first of these issues; namely, his belief
in the proper conduct of monetary policy and the importance of
money supply with respect to inflation.
The second concern, however, the independence of the Fed, has
grown to be a matter of even greater concern in recent weeks and
months. During the confirmation hearings in February, the Banking
Committee heard repeated assurances of Chairman Miller's commitment to the independence of the Board. Recent weeks have opened
these assurances to question, and I hope that we will improve our
feelings today as a result of his testimony. The continued independence
of the Federal Reserve Board is of vital importance to the economic
stability of the United States and the confidence that others have in
that economic stability.
Monetary policy must be conducted in an atmosphere that is not
clouded with political partisanship, and I'm encouraged by private
conversations, as I said, with the chairman since the President's recent announcement, and I hope the White House also has been informed by him of his view of his position, his roles, and, more importantly, his independence.
I'm also very hopeful and I feel sure that other members of the
Banking Committees of the House and Senate will agree, that in the
future the Federal Reserve Board will make announcements of this
nature in a manner that enhances rather than reduces the independence
of the Federal Reserve System in the eyes of the public.
Thank you, Mr. Chairman.
The CHAIRMAN. Thank you, Senator Schmitt.
Mr. Chairman,_go right ahead.
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STATEMENT OF G. WILLIAM MILLER, CHAIRMAN, :BOARD OF
GOVERNORS, FEDERAL RESERVE SYSTEM
Mr. MILLER. Thank you very much, Mr. Chairman. I hope to address some of these issues you have raised as we go through our discussions today.
As you know, Mr. Chairman, I have, with the assistance of Federal
Reserve staff, prepared a statement which reflects our usual report
on the state of the economy and on the establishment of ranges for
growth of the monetary aggregates during the coming four quarters.
This statement is available and, with your permission, I would like
to have it included in the record. Perhaps I will depart from the
prepared text and briefly review the charts on the economy and the
outlook for the monetary policy which I have made available to you.
The CHAIRMAN. Without objection, the statement will be printed
in full in the record.
[ Complete statement follows: J
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SEMI-ANNUAL REPORT ON MONETARY POUCY
Statement by
G. William Miller
Chairman, Board of Governors of the Federal Reserve System
Mr. Chairman, members of this distinguished Comnittee,
events in recent months have presented a formidable challenge to
our nation.
While sustained economic expansion has led to higher
levels of output and employment, continuing domestic inflation and
a sharp decline in the value of the dollar on foreign exchange markets have posed growing threats to the vitality of the U.S. and
world economies.
Monetary policy is being directed forcefully toward
helping to resolve these urgent problems.
The objective of the Federal Reserve has, for some time
now, been to foster monetary and financial conditions that would lead
to a reduction of inflationary pressures, while encouraging continued
moderate economic growth.
Real gross national product rose at a 4 per
cent annual rate, on average, during the first three quarters of this
year, as compared with 5-1/2 per cent over the course of 1977.
This
slower pace in the expansion has been sufficient to achieve substantial
further gains in employment, but at the same time it has avoided a
significant overshoot of general levels of resource utilization that
would have intensified inflationary demand pressures in labor and product
markets.
Even so, there has been a marked pick-up in the rate of inflation.
For example, consumer prices have climbed at an annual rate of
9-1/2 per cent so far this year.
to this development.
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Federal Reserve Bank of St. Louis
A number of factors have contributed
Reduced supplies of some agricultural cdmnodities--
93
especially meats--have caused sharply higher food prices.
Legislated
increases in the Federal minimum wage and in employer contributions for
social security and unemployment compensation have boosted labor costs.
Wage gains have been somewhat larger this year than last, on average,
while our productivity performance has been lagging.
And the depre-
ciation of the dollar in international exchange has raised the prices
of imports and weakened competitive restraints on the prices of domestically produced goods.
With a heavy calendar of collective bargaining in prospect
for 1979, and with wage demands likely to be intensified by recent
price advances, the threat of a further escalation of labor costs is
very real.
Furthermore, scheduled increases next year in the minimum
wage and social security taxes will again provide a significant inflationary impulse to costs.
President Carter has announced a major program to break the
self-destructive cycle of wages chasing prices and prices chasing wages.
The program includes quantitative guidelines that establish standards
for constructive behavior on the parts of labor and management.
In
addition, the President has indicated that he will seek to eliminate
needlessly costly and anti-competitive regulation.
He has also conmitted
his Administration to the contaimnent of Federal spending and greater
fiscal restraint.
On November 1, the Administration's anti-inflation program
was fortified by the joint actions of the Federal Reserve and Treasury
36·066 0 - 79 - 7
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Federal Reserve Bank of St. Louis
94
to strengthen the dollar in exchange markets.
The Federal Reserve
discount rate was raised by one percentage point, and reserve requirements on large denomination time deposits were increased.
In addition,
$30 billion in key foreign currencies were mobilized for exchange
market intervention.
The speculative assault on the dollar in inter-
national currency markets had depressed its exchange value well below
what could be justified on the basis of fundamental economic considerations.
The psychological momentum of the markets, if ·not broken,
threatened to worsen our inflation problem and to undermine confidence
at home and abroad.
The clear willingness of the United States to
intervene actively in exchange markets and the monetary actions of the
Federal Reserve have led to a rebound in the exchange value of the
dollar and a more stable market enviromnent.
This should be beneficial
for domestic pri~e performance in the period ahead and bolster confidence
in the nation's economic policies.
If the cooperation of business !!Pd labor that is so essential
to the success of the Administration's anti-inflation program is to be
obtained and if we are to gain the fullest benefit of the recent dollarsupport initiatives, it is absolutely essential that monetary and fiscal
policies demonstrate prudent restraint.
If inflation is to be gradually
slowed, aggregate demand must not be permitted to expand to the point
where it presses excessively on available supplies of labor and industrial
resources.
This means that real GNP at this juncture probably should not
grow at an annualized rate much above 3 per cent, in line witfi the
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Federal Reserve Bank of St. Louis
95
prospective growth of potential output.
Nor, of course, do we
want to see a protracted shortfall fran that pace. that would bring
on recession and underutilization of labor and productive capacity.
Recent trends in the econany and in financial markets
suggest that expansion likely will be sustained, but at a more moderate
pace over the next year or so.
One noteworthy development has been
the leas robust pattern of spending by households following exceptional strength earlier in the cyclical recovery.
Personal consump-
tion expenditures rose at an estimated annual rate of less than 3 per
cent in real terms during the first three quarters of this year, after
having advanced at an average rate of 5-1/2 per cent in the preceding
2-3/4 years.
Rising costs of foods and other necessities have put
substantial pressure on the budgets of many families, and the proportion of disposable income spent has been unusually high.
Record levels
of borrowing have played an important role in supporting consumer outlays, and the heavy repayment burdens households face are likely to be
an increasing constraint on spending in the forthcoming year.
As a
consequence, personal consumption expenditures probably will no more
than keep pace with increases in personal income,
In addition, financial factors should induce some tapering
off in homebuilding
in 1979.
To date housing starts have remained
on a high plateau, but the effects of recent increases in interest rates
will soon begin to show through.
The new 6-month certificates, intro-
duced in June, have enabled thrift institutions to avoid the disinter-
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Federal Reserve Bank of St. Louis
96
mediation that has curtailed mortgage credit availability in the past,
but they have not sheltered the housing market from the effects of
higher interest rates.
Builders already are experiencing steeper
rates on construction loans, for which charges tend to move in step
with the bank prime business loan rate, and the stock of loan c011111it·ments for permanent mortgage financing made earlier at lower rates is
being depleted.
The combined effects of higher mortgage rates and
inflated house prices on the cost of home ownership is likely to bring
about some decline in building--although nothing approaching the disastrous drops we've seen in the past seems in store.
Business investment meanwhile should remain supportive of
economic expansion.
Inventories by and large are quite lean in relation
to current sales levels, and even with a continuation of cautious inventory policies, businessmen likely will wish ~o expand their stocks in
line with rising sales.
As for spending on plant and equipment, a
recent private survey of investment intentions suggests only a modest
increase next year in real terms.
On
the other hand, contracts and
orde~a for new plant and equipment have been running well ahead of
year-earlier levels--even after adjustment for inflation.
In general,
the willingness of businessmen to c011111it funds for major investment
projects will hinge in large part on the success of efforts to control
inflation, and thereby provide the basis for greater confidence in the
future health of the economy.
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Federal Reserve Bank of St. Louis
97
The foreign trade sector represents an element of strength
in the economic outlook.
The U.S. trade deficit should continue to
shrink as a result of the stronger growth in prospect for some of our
major trading partners and as a result of the effects of past exchange
rate changes on our competitive position.
In all, it is my expectation that real GNP will increase by
roughly 2-1/2 to 3 per cent in the year ending with the third quarter
of 1979.
With labor force growth unlikely to be so rapid as in the
past couple of years, this rise in activity should be enough to keep
the unemployment rate in the 5-3/4 to 6-1/4 per cent area.
In this projection I have assumed that inflatiOll will slow
into the 6-3/4 to 7-1/2 per cent range.
There are as always many
uncertainties on the- price front--the effects of weather on crop harvests
and the decisions of the OPEC cartel, for example, are factors beyond
the sphere of economic analysis.
What is clear is that the cost increases
already in train will be placing continued pressure on the price structure, so that it will be difficult to break the momentum of inflation.
However, if there is general compliance with the Adminiatration'a guidelines, the advance of prices next year could be held to around the low
end of the range I've projected.
This would repreaent a substantial
deceleration fran the 8-1/4 per cent increase in the GNP deflator
expected for this year, and would be a good start in the difficult
process of restoring price stability.
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Federal Reserve Bank of St. Louis
98
The recent credit-restraining actions of the Federal Reserve
have aroused fears in some quarters that an overly restrictive monetary
policy might precipitate an economic downturn.
There is no doubt that
domestic credit markets are tauter than they were 6 months ago.
None-
theless, current financial conditions appear consistent with the moderate economic expansion that is desirable at this juncture.
The Federal Reserve has been moving its policies in a progressively less accommodative direction this year in an effort to prevent excessively rapid growth in money and credit.
In an enviromnent
of inflation and heightened inflationary expectations, borrowers have
become willing to pay higher rates of interest in order to obtain credit
to finance acquisition of assets whose values they anticipate wi11 be
rising more rapidly.
This phenomenon is most clearly seen in the real
estate market, but the behavior is camnon in other sectors as well.
To
hold down nominal rates of interest in such a circmnstance is to invite
a credit-financed surge in aggregate demand that would add further to
inflationary pressures.
Consequently, the Federal Reserve has pursued
policies that have permitted market rates to rise appreciably this year.
Yields on Federal funds and other short-term instrmnents have increased
more than 3 percentage points since the beginning of 1978, while interest
rates on long-term bonds and mortgages have risen about one percentage
point.
These are sizable movements, to be sure, but the fact is that,
even at current levels, real rates of interest--that is, actual rates
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Federal Reserve Bank of St. Louis
99
adjusted for inflationary expectations--are not very high and credit
remains in adequate supply to finance a volume of spending that is
appropriate in light of the availability of real resources in the
econmny.
Usury ceilings, which are unrealistic in relation to present
market interest rates in many states, are cutting into credit availability in some local markets, and it would be desirable if these
obstacles to the efficient operation of our financial system were
eliminated.
But there has been nothing like a general "credit crunch,"
and we do not foresee one.
It is the intention of the Federal Reserve to work toward a
gradual deceleration of monetary and credit expansion to a pace consistent with price stability.
The speed with which we can move in that
direction without severely disrupting economic activity is limited by
the degree to which inflation has become embedded in our economy.
some progress has been made in the past year.
But
While M-1 growth over
the past four quarters--at 8 per cent--was about the same as in the
previous year, growth in M-2 and M-3 decelerated to rates of 8-1/4 and
9-1/4 per cent, respectively.
Growth in these broader aggregates was
3 to 3-1/2 percentage points slower than in the previous year.
The
actual growth in M-1 over the past four quarters was well above the
4 to 6-1/2 per cent range set for this aggregate, but growth in the
broader aggregates was within their ranges.
To have achieved sig-
nificantly lower growth rates for the monetary aggregates than actually
developed would have required substantially higher market rates of
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Federal Reserve Bank of St. Louis
100
interest and a sharper curtailment in credit supply, which in our
judgment would have run an unacceptably high risk of wrenching
financial markets so severely as to lead to an economic recession.
Growth in the monetary aggregates has to be evaluated in
·relation to basic economic and financial forces affecting the public's
preferences for money in its various forms.
During the past four
quarters growth in nominal GNP remained very rapid as moderate expansion in real output was accompanied by an accelerated rate of price
increase, generating a substantial demand for money--particularly
M-1--to finance transactions.
Federal Reserve policy did not
fully acc01mDodate these strong demands, and, in fact, the rate,of
growth in real money balances actually slowed.
The pattern of growth in the broader aggregates has been
strongly influenced by the introduction at banks and thrift institutions in June of this year of the 6-month money market certificate
whose ceiling varies weekly with changes in the auction yield on 6-month
Treasury bills.
Growth in savings and small-denomination time deposits
subject to Federally regulated interest-rate ceilings had slowed markedly in the fall of 1977 and in the first half of this year as higher
yields on market securities increasingly attracted funds that would
otherwise have been held in accounts at banks or thrift institutions.
In order to enable these institutions to compete more effectively for
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Federal Reserve Bank of St. Louis
101
lendable funds, the Federal Reserve and other regulatory agencies
created two new deposit categories--an 8 per cent, 8 year certificate
and the money market certificate.
The money market certificates have proven especially successful.
They have been widely offered, most frequently at the ceiling rates,
and have resulted in a marked pick-up in consumer-type deposit growth.
Growth in deposits at savings and loan associations and mutual savings
banks, which averaged 6-3/4 per cent at an annual rate in the first
5 months of 1978, has averaged 13 per cent since the introduction of
the new accounts.
This growth has pennitted thrift institutions to
increase their commitments for mortgage loans while reducing their
dependence on borrowed funds and stenming the decline in their liquidity
positions.
At commercial banks, which are at a quarter percentage point
rate disadvantage relative to the thrift institutions, there has been a
less marked, but still noticeable gain in growth of the combined total
of savings and small time deposits--from 3-3/4 per cent through M~y, to
6-1/2 per cent in the past 5 months.
Nonetheless, with bank credit
demands remaining strong, banks continued to liquidate Treasury securities and to increase short-tenn borrowings through such instruments as
large CD's and Federal funds in financing these demands.
At its October meeting, the F<MC updated its longer-tenn
ranges for the monetary aggregates.
Its task was complicated by new
uncertainties associated with the introduction on November 1 of automatic transfer services (ATS) which pennit consumers to authorize their
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Federal Reserve Bank of St. Louis
102
banks to shift funds fran savings to demand deposit accounts as needed
to cover checks written.
The major impact of this innovation should
be on M-1, as consumers take advantage of the opportunity to reduce
their holdings of non-earning demand deposits, but the size of this
effect cannot be projected with any real precision.
M-2 and M-3
will be less affected because shifts of funds fran thrift institutions
to banks, and also fran market instruments to deposits, are likely to
be canparatively modest.
Against that background, the continuity in the FOMC's objectives with respect to the monetary aggregates for the one-year period
from QIII:1978 to QIII:1979 is more clearly indicated by the broader
aggregates M-2 and M-3.
The C0111Dittee re-established the ranges for
these two aggregates at 6-1/2 to 9 per cent and 7-1/2 to 10 per cent,
respectively.
It is expected that growth in these aggregates will be
well within these ranges as monetary policy pursues a course of responsible restraint to complement the Administration's program to combat
inflation through fiscal discipline, wage and price moderation, and
regulatory reform.
The Comnittee anticipates growth in bank credit
at an 8-1/2 to 11-1/2 per cent rate to be associated with the ranges
adopted for the monetary aggregates.
With regard to M-1, the FOMC
expects growth within a range of 2 to 6 per cent over the QIII:1978
to QIII:1979 period.
The existing 4 to 6-1/2 per cent range has been
lowered because the public can .be expected to shift funds to take
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Federal Reserve Bank of St. Louis
103
advantage of the ATS service, and the range has been widened because
of uncertainties about the speed and extent to which the public may
undertake such shifts.
Because of uncertainties about the relationship between M-1
and the transactions demand for money during the transition to the new
ATS service, and in view of the widening role in financing transactions
played by savings accounts, the C011111ittee also indicated a growth range
for M~l+
(M-1 plus savings accounts at commercial banks, N<Ji' accounts,
demand deposits at mutual savings banks, and credit union share drafts)
that it expected to be generally consistent with ranges of growth in
the other aggregates.
This range
has been set at 5 to 7-1/2 per cent
over the one year period ending in QIII:1979.
The structure of the domestic payments system has been
changing considerably over the past several years as a result of
regulatory changes and financial innovations.
Deposits in thrift insti-
tutions have been increasingly used for third-party payments.
At banks,
liquidity reserves of the public, as well as funds held against expected
transactions needs, have come to be held more and more outside of demand
accounts.
On
the other hand, banks and particularly thrift institutions
have also lengthened the maturity of consumer-type time deposit liabilities, so that some deposits have be~ome less money-like.
And, in general,
distinctions among depository institutions with respect to their deposits
have become increasingly blurred.
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Federal Reserve Bank of St. Louis
Existing measures of the monetary
104
aggregates are, as a result, becoming outdated.
The Federal Reserve
is studying possible adjustments to these measures to reflect the
changing institutional environment.
The measure of M-1+ represents
an interim step in this process, while a more comprehensive revision
is underway.
It should be noted that one consequence of these ongoing
changes is a need for more timely and broader reporting of deposit
data--not only from nonmember canmercial banks, but also from thrift
institutions.
While monetary aggregates are useful indicators of financial
conditions, the continuing change in the institutional enviroment and
in public preferenc,s for different deposits indicates that any single
monetary measure, or even a set of several measures, can by no means
be the sole focus of policy.
Thus, a broad range of financial indi•
cators--including nominal and real interest rates, credit flows, and
liquidity conditions--necessarily must be considered in assessing the
stance of monetary policy.
Looking beyond these relatively technical questions about how
best to characterize monetary policy, it is clear that in the present
environnent we cannot rely solely on monetary management to contain
inflationary pressures.
It is essential to obtain public cooperation
in the Administration's anti-inflationary program and to exercise
restraint in fiscal policy, if the nation is to achieve a gradual,
'orderly reduction in the rate of inflation.
You can be assured that
monetary policy will do its part in achieving that objective.
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Federal Reserve Bank of St. Louis
105
November 16, 1978
Charts to Accompany Testimony
Of G. William Miller
Chairman, Board of Governors of the Federal Reserve System
Change from previous period,
annual rate, per cent
REAL GNP
15
1972 Dollars
10
5
-l_
,____ _.J.....,.._
_.,l__ _...,L__
___J_ _-1.._ ___J
H1 03
1974
1975
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Federal Reserve Bank of St. Louis
1976
______j
1977
1978
:
5
106
COMPONE.NTS OF FltfAL SALES
Trough. 117501=100-
1972 DoHars
1975
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Federal Reserve Bank of St. Louis
1976
1977
1978
107
INCOME AND CONSUMPTION
Percentage change
8
Real Consumption
4
t---"""T"""T
TTTTT_....__...........__.............._...._____._--ULUU&l'--.L.LLl..__._..,__---i +
0
Real Disposable Income
4
H1 Q3
1974
1975
1976
1977
SAVING RATE
1978
Per cent
10
8
2
1974
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Federal Reserve Bank of St. Louis
1975
1976
1977
1978
108
PRIVATE HOUSING STARTS
Annual rate, millions of units
2.5
Multi-Family
1970
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Federal Reserve Bank of St. Louis
1972
1974
1976
1-978-
109
HOMES SOLD
MIHIDna of units
5.0
4.0
New and Existing
1974
1975
1976
DEPOSIT GROWTH AT
THRIFT INSTITUTIONS
1977
3.0
1978
1979
Change from previous period, annual rate, per cent
20
15
10
5
1-974
1975
1976
1977
1978
1979
OUTSTANDING COMMITMENTS AT
SAVINGS AND LOAN ASSOCIATIONS
BIiiions of dollars
30
20
1974
36-066 0 • 79
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Federal Reserve Bank of St. Louis
1975
- 8
1976
i977
1978
1979
110
NONRESIDENTIAL FIXED INVESTMENT
Ind••• trough quarter =100
1972 Dollars
Average of Five
Previous Cycles
120
110
100
1974
1975
NONRESIDENTIAL
CONSTRUCTION
1972 Dollars
1977
1976
Trough, 117501=100
1978
PRODUCERS'
DURABLE EQUIPMENT
1972 Dollars
Trough, 117501=100
120
100
1974
1975
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Federal Reserve Bank of St. Louis
1976
1977
1978
1974
1975
1976
1977
1978
111
Average Annual Growth of the Capital Stock*
--
-
Per cent
6
-
-
5
-
-
4
-
-
3
-
-
2
-
-
1
I
1962-1967
I
1967-1972
0
1972-1977
* Private nonresidential net capital stock measured In constant dollars.
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Federal Reserve Bank of St. Louis
112
BUSINESS INVENTORIES
Annual rate, bllllons of dollars
80
Change In Book Value
40
20
i-----------,----------------1
+
0
20
1974
1975
1976
1977
1978
Ratio
1.8
Inventories Relative To Sales
1.5
1.4
1974
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Federal Reserve Bank of St. Louis
1975
1976
1977
1978
113
REAL GOVERNMENT PURCHASES
OF GOODS AND SERVICES
Billions of 19?2 dollars
280
240
200
160
STATE AND LOCAL
FEDERAL UNIFIED BUDGET DEFICIT*
Billions of current dollars
+
0
20
40
60
.
1974
* Fiscal years
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Federal Reserve Bank of St. Louis
1975
1976
1977
1978
1979
114
1!11 CIVILIAN LABOR FORCE
Change from prewloua period,
annual rate, mllllona
■ EMPLOYMENT
•
4
2
+
'---"'--------------1 0
H1
1974
1975
1976
1977
03
1978
UNEMPLOYMENT RATE
Per
cent
•
7
•
5
1974
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Federal Reserve Bank of St. Louis
1975
1976
1977
1978
115
UNIT COST INDICATORS Non farm Business Sector
Percentage change
Compensation Per Hour
10
+
0
1974
1975
1976
1977
H1 03
1978
Percentage change
Output Per Hour
10
5
+
0
5
H1 03
1974
1975
1976
1977
1978
Percentage change
Unit Labor Costs
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Federal Reserve Bank of St. Louis
15
10
5
+
0
Hl 03
1974
1975
1976
1977
1978
116
GNP PRICE INDEXES
Change from previous period,
annuel l'llle, per cent
10
5
10
5
+
D
Total Less Food
to
5
H1
1974
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Federal Reserve Bank of St. Louis
1975
1976
H2
1977
H1
Q3
1978
117
U.S. MERCHANDISE TRADE BALANCE
'
50
Annual rates, seasonally adjusted, bllllons of dollars
lntemaUonal Accounts Basis
40
30
20
10
+
0
10
20
30
40
L..---L---.L----.L----.L----.L------------.150
. 1971
1972
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Federal Reserve Bank of St. Louis
1973
1974
1975
1976
1977
1976
118
TRADE-WEIGHTED AVERAGE EXCHANGE VALUE OF
_U.S. DOLLAR AGAINST 10 MAJOR CURRENCIES
March 1973•100
10
130
.
120
110
100
; 90
1971
1972
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Federal Reserve Bank of St. Louis
1973
1974
1975
1978
1977
1978
80
119
FUNDS RAISED BY
NONFINANCIAL SECTORS
Billions of dollars
au.s. Government
IDDPrivate
400
300
200
100
1974
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Federal Reserve Bank of St. Louis
1975
1976
1977
1978
120
Short and Long Term ln18reat Rates
SHORT-TERM INTEREST RATES
Per can~
11
9
4-6 MONTH PRIME
,COMMERCIAL PAPER
7
5
L--....IL---L--..L.--J..--'--...1---L---'---.&..---a....-....a 3
Per cent
LONG-TERM INTEREST RATES
11
-,
I
.. I
I .,
'
,_ .. .,,I
,
1-o._
9
Aas UTlUTY BOND
' ... ...... ., ,'
New 188118
7
5
L..-...JL---'---'---.A---....-...JL--~--~-----'--....13
1968
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Federal Reserve Bank of St. Louis
1970
1972
1974
1976
1978
121
Short-T•rm Interest Rates and Inflation
Per cant
14
✓ .-1 CONSUMER PRICE INDEX*
"
I
I
I
I .,
I
I
I'
1I
I
I
I
I
12
10
I
I
I
\
,,
"I
8
I
V \
\
8
4
_ _ _ _ _ _ _ _..,___ _..,__ __..___ _.__ _..,___ _. . _ _ _ _ _ _ _ _ _ 2
1968
1970
• Annual rate of cttenge from prevloul qlllll'lllr.
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Federal Reserve Bank of St. Louis
1972
1974
1976
1978
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Federal Reserve Bank of St. Louis
122
Household Borrowing
Annual rate of change, billions of dollars
180
20
11170
1872
1874
11178
1878
123
Mortgage Rate and Inflation
Percent
14
" , ...,
I •
HOME MORT~GE INTEREST RATE
I'- I
I 'I
I
I
I
I
'
\ l1
\II
'II
\
II
'
,,
8
I
\I \
\
Averaa• '7&•'78
I
I
' ,,,
10
I
'
\
12
I
I
I
I
" ,,
I\/ \
I "
I
I
I
I
I
I
I
CONSUMER PRICE INDEX*
I
I
\
I
I
\
,. I
\ i' \ I
-
'4
I
I
I
I I
I I
8
..J
'
4
I 4' r I
\IV
,,
•
1988
1970
*Annual rate or change from prwtoua quarter.
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Federal Reserve Bank of St. Louis
1972
2
1974
1978
11178
124
Total Automoblle Credit
VOLUME EXTENDED
Annual rate, billions of dolara
100
90
80
70
eo
50
40
FINANCE RATES
Per cent, average rate
14
13
Finance Companies
12
11
10
9
1972
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Federal Reserve Bank of St. Louis
1974
1978
1979
125
Index of GNP and Money Stock M•1
1970 QIV•100
2.2
2.0
1.8
,
__ , ,
;,
,,.,,. ,,.
1970
36-066 0 - 79 - 9
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Federal Reserve Bank of St. Louis
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1974
126
MONEY SUPPLY INDICES-M-1
Merell 1973=100
200
180
180
140
120
100
1973
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Federal Reserve Bank of St. Louis
1974
1976
1977
1978
127
Recently Established M-1 Growth Ranges and Actual M-1
Biliona of dollara
,,_.1%
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,,
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385
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375
355
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1977
1978
1979
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128
Recently Establlshed M-2 Growth Ranges and Actual M-2
Billions of dollars
,
,,,,
...
945
930
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1977
1978
1979
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129
Recently Established M-3 Growth Ranges And Actual M-3
Billions of dollars
1640
...
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1977
1978
1979
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130
Money Slllck M-1 and M-1+
Bllllon8 of dollars
1970
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1972
1974
1978
1978
131
REAL GNP
Per cent change from previous quarter, annual rate
1972 Dollars
1974
1975
1976
1977
1978
1979
UNEMPLOYMENT RATE
Per cent
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1974
1975
1976
GNP PRICES
1977
1978
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1979
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1974
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Federal Reserve Bank of St. Louis
1975
1976
1977
1978
1979
132
Mr. MrLL'ER. I have now been in office as Chairman o:f the Federal
Reserve a little over 8 months. My prediction before this committee
at my confirmation hearings and in subsequent hearings of difficult
times :for the Federal Reserve certainly has proved to be accurate.
During these 8 months the difficulties we have :faced with continuing domestic inflation and a sharp decline of the dollar have increased
the threats to the stability and the growth o:f our economy.
During this period, the objective o:f the Federal Reserve has, however, been to foster monetary and financial conditions that will lead to
a reduction o:f inflationary pressures while encouraging continued
1noderate economic growth.
I:f you will bear with me, let us :follow together the charts that have
been provided-I think they have been made available to everyone
here-and perhaps we can see the application o:f this overall policy
and some of the consequences and the conditions that now exist.
The first chart indicates performance in terms o:f real growth o:f
the gross national product. From the trough of the very sharp and
deep recession o:f 1974-with a negative growth rate in GNP o:f 3.5
percent in real terms, the worst we had seen in 40 years-we have seen
the steady progression up to rather high rates of growth in 1976 and
1977, reaching 5.5 percent in real terms in 1977. Our conscious objective, with the acceleration of inflation, has been to lower that growth
rate, to bring it down nearer to the longer term capacity o:f our economy, and to do that on an orderly basis so as to avoid disruptions,
maintain balance within the economy, and slow down growth and slow
down inflationary pressures without triggering a recession.
On the second chart, you wiU see some of the components which are
reflected in the GNP, and you will see that there has been rather a good
balance. The chart shows the relative growth o:f residential construction, personal consumption and business fixed investment since the
1975 period. The steep incline in residential construction might cause
you to question the balance, but it appears because residential construction was in a deep depression in 1975 and therefore would be
expected to return to a more normal level of performance. What we
see is a topping out in these particular components and a slowing
down in their g-rowth rates, so that while residential construction has
been maintained at a high level, it has not been continuing to expand.
We have seen a rather balanced leveling off in economic growth.
On the next chart, you will see that during this period we have had
very strong patterns of consumption in relation to real incomes and in
relation to real disposable incomes, and that the savings rate has been
going down as people have used their resources to buy more and more
goods and services. One of our objectives, of course, is to dampen any
tendency toward overconsumption and to improve conditions for more
savings and investment.
On the next chart you will see, over a period starting in 1970, the performance of the economv in the privnte housing sector. Whnt's very
important to notice on that chart is that from the end of 1972 until
the end of 1974 there was a dramatic drop in housing. Housing starts
reached an annual rate of 2.5 mi11ion at the end of 1972; in a very short
time, because of the condition of financial markets and the inflation in
1973-1974, housing tumbled from 2./5 mi11ion starts to an annual rate
of 900,000. That's not a recession; that's a dramatic depression in the
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housing industry. It pulled down the whole economy because it immediately affected the acquisition o:f other durables-home :furnishings, and many materials and other things that go into housing. Notice
that there was a particularly rapid drop in multi:family housing and
also a very steep drop in single :family homes.
There was a recovery in housing :from the period o:f economic recover starting at the trough and moving through 1976-77. But notice
the "V" shaped performance in early 1978. What happened was that
early in this year it was apparent that housing, under the ?onditions
that then existed, was perhaps headed :for another sharp declme. There
was the threat at that time-because o:f inflationary pressures leading
to higher interest rates-o:f renewed disintermediation which could
haye clobbered the housing market. What happened, o:f course, was
that the Federal Reserve and other bank regulatory agencies moved to
establish the new money market certificates that have allowed the continued flow o:f :funds-allowed the thri:fts to match other market rates
in competing :for :funds-to the thri:ft institutions and thereby prevented a decline. The key here is that one o:f the monetary policies
o:f the Federal Reserve was to maintain financial conditions that
avoided an undue burden o:f restraint on any sector of the economy.
The next chart illustrates this point another way. Housing salestotal housing sales shown in the upper panel-after beginning to head
downward a:fter the first part o:f the year, have continued rather stable
at a 4.6 to 4.8 million level. This fi~nre includes both new housing and
the turnover in existing housing. But the middle panel o:f the chart
shows what was happening to the flow o:f :funds into thri:ft institutions-a rather sharp decline :from the mid-1977 period. With the introduction o:f the new money market certificates, there was a recovery
in that flow o:f :funds, and that saved the housing industry.
In the bottom panel yon see the sharp decline in commitments :for
new mortgages which affects new housing starts and construction.
Again, this was stabilized and turned up, thereby preserving the
housing market during this period.
Turning to the next chart, let's take a look at nonresidential fixed
investment. We have compared the current cycle-the heavy linewith the average o:f five previous business cycles. What is apparent
here is, o:f course, that this cycle has shown a deeper decline because of
the very serious recession, but that it has also shown a lag in recovery.
You will notice that it was the end of 1977 before nonresidential fixed
investment even came back to its prior peak in real terms. There was
a much sharper recovery in prior cycles when investment reached prior
peaks much earlier and then achieved :further growth. Here we see
both a slow recovery and a.gap in the recovery from prior cycles.
This is a positive :factor, because over expansion would have put
pressures on our economic system and would have created an imbalance
which could affect later recessionary tendencies. So, by and large, we
must look at this as a positive :factor, showing the additional capacity
and ability o:f our economy to continue nonresidential fixed investment
to meet our :future needs. The strPngth in this sector continues to
sho~ up, particularly in construction and in production o:f durable
eqmpmrnt.
On the next chart, howeyer, is something of deep concern to me and,
I know, to you, and that is the continuing decline of the capital stock
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134
in constant terms over the years. From 1962 to 1967 there was an annual
average growth in capital stock of 5 percent; from 1967 to 1972, only
4.2 percent; and over the last 5 years, only 2.8 percent. That's a very
alarming occurrence. It is, in my opinion, one of the reasons that we
have had such a poor performance in productivity and, therefore, such
a poor performance in trying to break the cycle of wages chasing prices
and prices chasing wages.
Having looked at business fixed investment, let's look at business
inventory investment. Look particularly at the end of 1974--the upper
panel-and the dramatic decline in inventory accumulation that took
place as the recession hit. That was, I believe, the steepest decline on
record in terms of inventory shifts. The annual rate of change was
dramatic and production came down rather rapidly in order to liquidate inventories and contributed to the severity of that recession. That
dramatic liquidation is compared here with the gradual recovery and
accumulation of inventory in relation to the needs of business. The
bottom panel is particularly encouraging as regard the question of
balance because it shows that inventories relative to sales are still very
healthy and that we have in fact a lower ratio of inventories to sales
than we have seen for a long time.
So this sector of the economy also is in good shape and doesn't create
an expectation of major change.
Let's move on to the government sector. Here, of course, we know
that government spending and Federal budget deficits have been contributors to economic activity but ha.ve also caused severe concern
because-as you pointed out just a moment ago, Mr. Chairman-the
heavy Federal deficits that have been generated in recent years do
themselves contribute to the current inflationary pressures. I won't
dwell on the upper panel, but you see the continued upward drift in
government purchases of goods and services ; these are in real terms.
I want to call particular attention to the bottom panel. Notice that
there was almost a $5 billion deficit in 1974. But look at the dramatic
deficits that came about because of the recession and look at how large
those deficits have continued to be, despite the recovery. Just look at
the 5 years from 1974 through 1978; look at the estimate of about a
$49 billion deficit this year. Over those 5 years, the aggregate deficitstarting with the very modest one in 1974--is $210 billion. That's not
including the a.gencies' borrowing. With the expected defic,it in 1979,
we're talking about adding $300 billion to the Federal debt over this
period of time. This is one of the concerns that we have all had and
that we share in looking at the mesh of monetary and fiscal policies
in inflationary times.
Turning now to the employment aspects of our economy, we see
some rather dramatic shifts in recent years. Obviously, there was a
very severe decline in employment and a very rapid increase in unemployment in the recession of 1974---75, with unemployment levels reaching the highest that I have experienced in my adult lifetime or that
any of us has experienced. This was very alarming. But there was also
a very rapid recovery, and in the face of rather large gains in the
civilian labor force there were very large gains in employment.
The growth of employment in 1977 was an unprecedented accomplishment; over 4 million jobs were added in 1 year, and that's very
encouraging. In the first half of this year, the annual rate of job
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Federal Reserve Bank of St. Louis
135
increases was at 5.6 million, a really dramatic contribution to bringing
our American workers back into productive employment. And, of
course, there has been as the year progressed, some slowing down after
those large increases. The point is, however, that there has been very
good recovery on the employment front from the disastrous levels of
1974-75. And while none of us is entirely satisfied, the 5.8 percent current level of employment is one that is not a cause for immediate alarm.
As a matter of fact, on the other hand, we take considerable comfort
from the fact that we now have a record employment in this country
of almost 59 percent of the adult population. That is an encouraging
aspect.
However, if you turn to the question of the application of labor a.nd
unit labor costs on the next series of charts, you will see some area for
continued concern. Compensation gr~wth just hasn't moderated. We
continue to have high increases in compensation, which is to be expected in the face of individuals facing continuing price increases.
These compensation increases ha.ve been particularly large in the first
quarter of recent years. The first part of this year they were quite large
because of the social security tax increase and the minimum wage
increase: In the first half of the year compensation per 'hour increased
10 percent; in the third quarter, 9 percent. So we still see high levels of
compensation increases.
Output per hour was actually negative the first half of the year.
This is quite alarming and another indication of our poor productivity position. Output has improved in the third quarter, but unit
labor costs as a result of the interaction of the two top factors increased ,at 11 percent-an 11 percent increase in unit labor cost in the
first half of the year. Fortunately, that's improved in the third quarter with increases at 5 percent. That's a little bit of encouragement,
but doesn't yet represent a long-term trend.
Senator ScI-11\IITT. Mr. Chairman, excuse me for interrupting, but
how is the output per hour measured? What is output?
Mr. MrLLER. Output per hour is the physical output of goods and
services.
Senator SCHMITT. By dollar costs?
Mr. MILLER. No; by hour of labor input.
Senator ScHMITT. But how is the output measured? By the value
of the goods?
Mr. MILLER. Not exactly. Output is measured in real terms by what
the mines and factories produce in pounds and tons ,and units measured
in 1972 doUars.
Senator SCHMITT. OK.
Mr. MILLER. Senator Schmitt, the top panel is in terms of money.
The middle one-Senator SCHMITT. I understand that, but output is output, and it can
be measured in various ways.
Mr. MILLER. Turning to the question of inflation, this is, of course,
our most serious problem and we cannot take any great comfort in
what's happened this year. If you look •at the top panel of the next
chart, the total inflation rate in the first half of 8.1 percent is quite
alarming; and even the slowdown in the third quarter to 7.5 perc~nt
is still not very much progress. We know that the first half was mfluenced by very high rates of increase in food prices of almost 15
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Federal Reserve Bank of St. Louis
136
percent, as we see in the center panel. But even if you take out food,
as we have done in the bottom panel, you can see that the first half
of the year shows a 6. 7-percent increase in the inflation rate; and the
third quarter shows 7.8 percent. So we don't find any comfort when
we make some progress in food prices because other sectors are now
beginning to reflect a general passthrough and the upward bias of
prices. So inflation is our most important problem.
Turning to the international sector, the U.S. merchandise trade
balance has been one of our severe problems in the value of the dollar.
And the decline of the value of the dollar has created considerable
inflation itself and has contributed to inflationary expectations.
We have made improvement, both because of the general change
in relative growth rates between the United States and major trading partners, and also because the price level of U.S. goods has made
us more competitive. So, as you see in the bottom panel, the trade
bal,ance, which was at a very high level in the first quarter, has improved and is expected to continue to improve. But just to make a
point which we all know, the upper line shows the balance if we exclude petroleum, and if we exclude petroleum we know that we would
have a very favorable balance of trade. So petroleum is very much
the issue here as to how to solve this problem.
The next chart shows the trade-weighted average exchange value
of the dollar from 1971, the time of the move from the fixed exchange
rate era into the floating exchange rate era. The dollar declined during that period, rebounded somewhat and recovered particularly in
and after the recession of 1975, but has been drifting downward for
some time. The substantial decline in the past year of about 15 percent
is of great concern.
The insert panel shows the recovery in the dollar that has taken
place since actions taken on November 1, to correct the disorderly
markets that had resulted in an overdiscounting of the value of the
dollar. There has been a 7.5-percent improvement in the value of the
dollar since November 1. So, to date, th~ actions have been successful
in turning that situation around-although, as we know, the final
solution to the value of the dollar depends upon our correcting the
fundamental difficulties of inflation and current account deficits.
Senator ScHMrrr. Mr. Chairman, could VO'U in one or two sentences
relate the value of the dollar to inflation itself i
Mr. MILLER. Yes; the decline in the value of the dollar in the last
year has added about 1 percent to inflation. I would say that through
the first three quarters of this year we have added about three quarters of 1 percent to inflation from that, and we will realize more.
Perhaps, before it runs its course, we may even be impacted as much
as 1.5 percent because of additional inflation from the decline of the
dollar since last year.
Senator ScHMI'IT. Could you give us an example of how 1
Mr. MILLER. It happens for two reasons. One, because a lower valued
doUar means it takes more dollars to buy the same amount of physical
imports and we have many essential imports which we must pav for
in dollars. Also, the higher cost of imports reduces the comoetitive
pressure of imported goods on domestically produced goods. So there
are two reasons why inflation is affected adversely by a decline in the
value of the dollar.
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Federal Reserve Bank of St. Louis
137
S~nator ScHMITr. Now as the dollar increases, however, will not
foreign goods become more competitive?
Mr.. MILLER. As the dollar increases in value, or is stabilized, the
effect 1s reversed. If the dollar should appreciate in value that would,
for example, lessen pressures for increased petroleum prices, and we
would be the beneficiaries-just as many of our other nations have
benefited from paying lower prices. Japan, for example, with an appreciated yen while oil is priced in dollars, is paying less for oil
this year than last year, while we are paying more.
Senator ScHMITr. But the trade balance figures may show, at least
in the short term, an adverse effect to an improved dollar; is that
correct?
Mr. MILLER. It depends. Once you have made the adjustments in
supply relationships and when you consider that our trade balance
includes large components of agricultural products, we sti11 have the
potential to improve our trade balance even with a stable or appreciated dollar.
The CHAIRMAN. Senator Schmitt, I appreciate your thoughtful and
intelligent questions, but I do think, however, unless it's a matter of
clarifying some technical statement that the Chairman is making while
he's making his presentation, I would hope you could defer your
questioning.
Senator ScHMITr. I'm only trying to establish the significance of
the charts.
The CHAIRMAN. I understand that, but we can go back to the charts
in the questioning and I would prefer to defer questioning until after
the Chairman has finished his statement.
Senator ScHMITr. Thank you, Mr. Chairman.
Mr. MILLER. Let's turn to the next chart which deals with funds
raised by non.financial entities. The point is to illustrate the tremendous
growth in demand for credit over the last 5 years, both because of the
expansion of the economy from the recession and because of the high
level of demand generally in the economy, which I will talk about in a
moment.
What's interesting to note is the very high relative demand from the
governmental sector-the gray area on the chart-during the period
of recession and postrecession, and the continued high level of Government demand for funds even though the private sector now has a
larger share.
Let ns look at some of the background. Turn to the next chart and
let me just, for a moment, review the situation as to intereRt rates. The
upper panel deals with short-term interest rates, the solid line being
commercial paper and the dotted line being 3-month Treasury bills.
Yon can see the cyclical nature of interest rates, which were affected
hv economic activity, demand for fonds. The long-term rates show less
volatilitv but also show the cyclical pattern as in the lower panel
which shows mortgage rates, 1itility issues, and municipal bonds.
Turning to the next chart, it's important for us all to realize that
interest rates are related verv closelv to inflation. Here we have
replotted the Rhort-term rate for commercial paper-the solid lineagainst the Consumer Price Index. It's anparent from this chart that
interest rates follow right along with inflation. This is to be expected,
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Federal Reserve Bank of St. Louis
138
because those who lend :funds must get back, in their view, enough to
maintain the purchasing power o:f their loaned :funds plus a return on
their loan.
This is a very misunderstood :factor in our economy. There seems
to be some lack o:f appreciation :for the :fact that it is inflation that
causes high interest rates, not some deliberate policy o:f the Federal
Reserve or o:f Government.
To remind ourselves about the relation between interest rates and
inflation, let me illustrate one o:f the very important sources o:f demand
:for credit. This next chart shows the demand :from households, :from
people, to borrow money. Look at the dramatic growth in the annual
rate o:f additional debt assumed by households. From the more austere
demands o:f the recession period o:f 1974 and 1975, we've seen an explosion in the demand :for credit by households; installment debt has
escalated rapidly. The shaded area shows housing mortgages. Look
how rapidly and unprecedentedly high that demand has grown. The
"other" area shows other kinds o:f personal borrowings.
Households have been a major source o:f demand :for credit. The
total household debt now is $306 billion, so we have a heavy burden
o:f debt. The repayment required o:f households to service this debt
now amounts to almost 21 percent o:f disposable personal income,
which is a very high burden and something we want to watch carefully as we look at maintaining balance and moderate growth in our
economy.
I:£ you turn to the next page, I would like to point out something
that I think is important. The solid line represents the rate charged
:for home mortgages. You will see that over the last 10 years there have
been somewhat higher mortgage interest rates, as we all know, than
was characteristic in earlier times. But i:f you look to the le:ft part of
this chart, at the years 1968 through 1972, the upper o:f the two
straight lines going across indicates the average mortgage interest
rate during that period. It was 7.8 percent. The bottom straight line
is the average inflation during that period-represented by the Consumer Price Index-which was 4.6 percent. So individuals who bought
homes during that period paid 3.2 percent in real terms: they paid
the inflation rate plus 3.2 percent to buy homes. Look at the right
side o:f the chart, 1975 through 1978. The average mortgage interest
rate has been 9.1 percent. The average inflation has been 6.8 percent.
The average individual has paid only 2.3 percent in real terms. He
paid less interest rate to buy a house in real terms during this period
than in the prior period.
So when we talk about interest rates and about mortgage rates, I
hope you will bear in mind that in terms o:f the real cost, it actually
has been lower in recent years, which accounts :for why households have
been willing to and anxious to buv houses as a store o:f value and as a
reasonable purchase in the :face o:f what appeared to be high nominal
interest rates, although lower real interest rates.
Look at the next chart. The upper panel shows the rapid expansion
iii the volume o:f automobile credit. People are buying automobiles,
nnd they are paving higher prices :for automobiles, so that it takes
more monev to financ·e the purchase o:f automobiles. Rut look at the
lower panel. There has been a level interest rate :from finance compa-
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Federal Reserve Bank of St. Louis
139
nies to finance automobiles since 1975 and a slightly declining interest
rate-going up a bit recently but basically stable-from commercial
banks.
·
Individuals have not been paying higher interest rates, in real
terms, to buy houses in recent years; they have not been paying higher
interest rates in nominal terms-and less in real terms-to buy automobiles in recent years.
'The point I want to make is that it is not interest rates that are the
main problem for consumers. It is inflation which adds to the fundamental cost of houses and automobiles and durables. It's not the interest rate that is the culprit.
In terms of monetary aggregates Jve have the problems that Chairman Proxmire has just indicated: the shift by individuals and businesses in preferences for the kinds of money that we try to measure.
e are perfecting our payments mechanism with new techniques.
Because of a number of £actors, what use to be considered to be savings or investment has become more and more like conventional money,
and we have to deal with the monetary aggregates bearing this in mind.
The next chart plots the relationship of M 1-the basic, narrow measure which includes currency in circulation plus demand deposits- to
nominal GNP, just as a reference point. This chart shows that the
amount of money necessary to support growth in nominal activity in
the economy-the turnover of goods and services-has been shrinking. M 1 growth has been much less rapid than the growth of GNP.
The following chart also corrects a misapprehension or misconception in this country: The growth of money in the United States as
measured by M 1 has been lower than in major foreign countries,
many of which have lower •inflation rates. The growth of money, M1,
on a relative basis, since 1973, has been lower in the United States than
in Germany, ,Ta pan, or the United Kingdom. So I hope we will bear in
mind, when we sometimes hear the statement that we have inflation
beca11se the growth of our money is so much faster than that in other
countries, that that just isn't borne out by the facts. I hope ,ve can
correct that misperception.
But we do need to deal with establishing and achieving a monetary
policy with the objective of slowing growth, of restraining inflationary
pressures, and yet continuing conditions for a moderate growth rate
in the economy.
Mr. Chairman, because of the features you mentioned, including the
introduction on November 1 of a service whereby banks now may offer
the opportunity to individuals-not to businesses but to individualsto arrange for automatic transfer from their savings accounts into
their checking accounts, M1 is going to be distorted. e don't know
by how much in the future. So the Federal Open Market Committee,
for the coming four quarters, has established a range for M 1 of 2 percent to 6 percent.
Our prior range, as shown on tlrn chart, was 4 to 6.5 percent. We
have done two things that yon will notice. We have lowered the range,
but we have also widenerl it. vVe <lid so, frankly, because we don't know
to what degree there will be a shift such as you mentioned. We are
anxious to learn more, and we will be collecting data to track that
shift and making it available to you so we will be able to assess what's
,v
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really happening. But, in the meantime, we are continuing a policy of
trying to restrain the growth of the monetary aggregates, of trying to
bend them downward. While we have had disappointments during
the second quarter of this year because of the over 20 percent nominal
activity in the economy, and while we have had disappointments in
September for reasons we can't yet really explain, we are seeing a
slower rate of growth in October and, so far, in November.
In October, M1 grew at a rate of about 3.5 percent, which is an
encouraging trend, although it's been too short a period of time to
know if we have made a lasting impact.
By widening the range of M1 we are not trying to duck the issue of
our responsibility in this regard. We want to inform you later by reconstructing M1 as it might have been and comparing that to what's really
happened.
For M1, as shown on the next chart, we have reestablished the same
rate of growth as in prior meetings: 6.5 to 9 percent. I might mention
that both M2 and Ma have stayed within their growth ranges in recent
times, even though M1 has been stubbornly growing too rapidly. As in
the case of M1, these other aggregates have been slowing recently; their
rates of growth are much slower than they were last year. So we have
made real progress with these two. But you will see that they have been
in their upper ranges recently, and that's because of these new 6-month
money market certificates. The money market certificates, which were
introduced to avoid disintermediation, have resulted in $45 billion
being held in Ma and M2 rather than flowing out of these money aggregates into some other form of market instrument or investment. In
that sense, we have a new factor here that we didn't have in prior
cycles.
Look at the next chart for a moment. You will see that M3 follows
much the pattern that I mentioned. It's growing at a rate about 3 percent less than last year. We are maintaming a range for the coming
four quarters of 7.5 to 10 percent, which we believe to be consistent
with the objective of monetary policy to achieve the economic pattern
I will mention in a moment.
The bank credit that would be associated with these aggregate
growth ranges would be 8.5 to 11.5 percent. But there's one new
measure that we want to publish today and that we want to begin to
explore, and that is an alternative to M1 that we can use as a means
of tracking the growth of spendable money, of M1 type money. That
is shown on the next chart.
We are going to publish today a money aggregate called M1 plus.
M1 plus constists of M1 plus those savings accounts with banks which
are more and more used like checking accounts because they are so
easily accessible, plus NOW accounts, plus demand deposits at mutual
savings banks, and plus credit union share drafts. In other words,
we're taking M1, plus savings accounts at banks, plus those transactions accounts in thrift institutions which are more appropriately
associated with M1.
The relationship of M1 to M1 Plus is shown in this next chart. We
have established a range for the next four quarters of 5 to 7.5 percent
for this particular aggregate, and we wi11 be reporting to you as
whether this could be a substitute in tracking narrowly based money
in the future. However, I want to say to you that we are going to
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continue to study this and we are going to come to you-we hope in
the not too distant future-with some additional suggestions for
redefinitions to perfect our ability-all of our abilities-to track
what's really happening with the monetary aggregates.
It is my view, however, that monetary policy must not be limited
to a look at aggregates. We must also consider other £actors such as
interest rates, the conditions of liquidity, the performance of the real
economy. As has been my practice and your request, the next chart, the
final one, shows you my views of the performance of the economy in
the coming four quarters.
It is my view that the real growth of GNP over the next 12 months
will be in the range of 2.5 to 3 percent. This means a slowing rate of
growth, perhaps even slightly below the long-term trend, but it also
means that I do not see conditions that will bring about a recession
unless new £actors are introduced or unless some economic policy
decisions yet to be made affect this.
My view for the unemployment rate under these conditions is that
it will range, at the end of this period, between 5¾ and 6¼ percent,
not much different from what it has been-not an improvement, but
at least not deterioration-as we try to deal with this problem of very
virulent inflation.
My expectations £or prices would be in the range of 6¾ to 7½
percent, coming down from the very rapid rate of inflation in the
second quarter, and more in line with recent experiences-not tremendous progress, but at least the beginning of improvement.
Thank you very much.
The CHAIRMAN. Thank you very much, Mr. Chairman, and I want
to congratulate you on your presentation. It's a novel presentation. We
have had these presentations from both Chairman Burns and yourself.
This in many ways is one of the best I have heard. I think you show
a remarkable understanding of all the elements that confront us in
our economy and this is most helpful in putting it into a perspective
we can understand.
Having said that, however, I must say that I'm deeply disappointed
at the ranges you give us. After all, the fundamental purpose for your
appearing is to tell us what monetary policy is going to be: what increase in the money supply you expect; and here you give us a range.
I can understand why your range for M1 has to be difficult, but to tell
us it's going to be between 2 and 6 percent is giving us such a wide
spectrum that it's meaningless in my view. I don't say it's an insult to
the committee, but it doesn't mean anything in my view.
Now in the second place, for M2 and Ms, you also give us very, very
broad ranges. That been done in the past and I have complained about
it. If you, as chairman of Textron, had n. division manager come in and
1
say,
Our goal for sales in the next year-last year we sold $50 million
and next year we're going to sell between $50 and $75 million.
You would say,
Come on now. Give me a goal. I don't want a prediction. I don't
want a wide range. That doesn't mean anything. Tell me where you
want to go.
I have that difficulty here. When you give us this broad range I just
feel as if we havt~ no real notion of where the Federal Reserve Board is
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aiming. There's some feeling that you think there are enormous possibilities here, you can range all over the place, but no chart that
would indicate not where you were going to end up, because nobody
can predict the future, but where you're trying to end up. And that,
in my view, has been the principal objectfre of these hearings.
Mr. MILLER. Mr. Chairman, with 'lll due respect, I don't think it's
possible, with so many variables, to set a narrow goal for M 2 or Ma.
Take, for example, the decision made earlier this year to introduce
new kinds of savings instruments to avoid disintermediation. It would
have been very nice to give you some narrowly targeted figures, but
that would have encouraged us not to make the decision we did and
therefore to impact the housing industry unfairly and unnece5sarily.
We would look good only in the numbers.
I would rather have the leeway to take action that is related to the
real performance of the economy and to what we are trying to accomplish in maintaining balance and avoiding undue burdens on any
sector than to be motivated to bring in some figures that look good
but that have done irreparable damage to the economy.
The CHAIRMAN. What I'm talkin,g about is having a precise goal
that you're trying to end up with. When we started this discussion
with Chairman Burns, he finally decided he would agree to come in
with this provided we would permit him to work within ranges and
not a specific goal. West Germany had a monetary goal of that year
of 8 percent. They were going to try to hit 8 percent and I could understand how you could have perhaps 1½ percent or 1 percent difference,
but to have this-after all, on growth, you say growth will be between
2½ and 3 percent for the whole economy. You say unemployment will
be between 5¾ and 63/4. Prices will be between 63/4 and 7½. Those
are predictions not under our control but what you expect. Then when
it comes to monetary aggregates which are very largely under the control of the Federal Reserve Board, you give us a range which doesn't
really tell us what you're trying to do. I don't mean what you can
accomplish, but what you think would be the best level for you to
achieve in order to achieve your economic ends.
Mr. MILLER. Other countries that have single targets miss them
widely,soThe CHAIRMAN. You have a range and you miss that very widely.
Mr. MILLER. Not in M 2 and. Ma.
The CHAIRMAN. Well, in M 1 •
Mr. MILLER. M 1 is a changing aggregate. You know, I don't want in
any way to detract from the purpose of your discussion, but if you
look at these charts and look at the size of the figures you're talking
about, I don't think that, going out four quarters, the band that is
shown is a very wide target. I apologize to you for the wide range on
M1 and I told you frankly why that exists.
The CHAIRMAN. I understand that, but it seems to me it might have
even been better simply to say that because of the automatic transfer
that M 1 is simply not any longer a viable goal and you're going to
come up and tell us what your goals are on M 2 and M 3 • Other members
of the commitee might not agree with that, but as far as I'm concerned
that might be a more helpful thing.
Mr. MILLER. Mr. Chairman, we deal with an economy subject to so
many variables. For example, we had a zero growth rate in the first
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quarter and M1 was within its target range. The nominal growth of
GNP in the second quarter was over 20 percent because of catchups
from the first quarter and because of pull-forward activity as people
became concerned about inflation and changed their buying patterns
well after the decision had been made as to monetary aggregates. For
us to be locked in from a decision made in January to what people
were doing in April with so many changes taking place--because of
weather, unexpected growth of inflation, and a rather unsustainable
nominal level of activity and the consequent need for money to carry
on these transactions-would not have contributed to long-range policy, which I think has been rather appropriate.
When I came to Washington the expectation of growth, of real
growth for this year was 4¾ percent. The outlook now :for growth
this calendar year in real terms is 3¾ percent. That's been reduced
without penalizing the social goals of our economy: people have been
employed; housing has been maintained. And yet we have dampened
by a s11bstantial amount the growth rate as a result o:f much tighter policies. That's the progress you should be interested in; I don't think any
of us should get too locked in to mechanical, numerical-The CHAIRMAN. It's a tighter policy in a way perhaps. Interest rates
are going higher, but it's not a tighter policy in that the rate of increase in the money supply is greater than it has been in the past.
Mr. MILLER. We're likely to see that we have made real progress in
holding down the growth o:f the money aggregates. We have a lag effect. The aggregates are slowing down and, in my opinion, you will see
the money supply continue to slow.
The CHAIRMAN. Now you have given us a very good economic background here on the housing particularly and other elements o:f our
economy that are especially sensitive to interest rates. You have also
indicated that- and I think it's very constructive-I say that because
of the fact this is the Banking, Housing and Urban Affairs Committee
and we all concerned with housing-you follow policies, i:f not insulating housing completely, help housing be cushioned from the sharp
increase in interest rates. The question arises, there's no gain without
pain. Here we have a situation in which housing may have been protected somewhat but in protecting housing monetary policy is not as
potent as it's been in the past, not as potent inasmuch as it doesn't
really slow the economy with the same decisiveness and bite as it did
when your monetary policy made less funds available for housing,
slowed the economy through slowing housing, and had the effect of
brin,g-ing interest rates and inflation under control somewhat more
quickly.
Are you concerned with that and what will be the effect with the
:funds still available :for housing, albeit at a higher rate o:f interesH
Mr. MILLER. Senator, I'm not convinced that any o:f us-any of usshould sit in judgment and decide what part o:f onr economy should
suffer the brunt. ,Vhy should we deny credit to housing as compared
to automobiles?
The CHAIRMAN. I agree with that. I'm not nrguinQ' that at all. I'm
just saying, what will be the effect of that? What will it mean? We'll
have to suffer somewhat higher interest rates and somewhat higher
prices.
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Mr. MnL'ER. If you maintain the same amount of credit availability,
there will be some sector that will bear more burden; housing will bear
less. The effect on housing, in my opinion, from the actions we have
already taken, is that housing will slow along with the whole economy. I would expect that housing starts next year will be more like
1.7 million instead of the 2 million this year, which is the consequence
of the necessary tightening that we need to dampen inflationary forces.
But it means that the housing industry can stay intact, free of the
dismantling that took place in prior cycles, and in a vital position to
maintain the housing stock needed for the future. I think that's the
consequence. ·whether or not inte,rest rates will have to be somewhat
higher in order to get the same restraint, I don't really know yet. If
so, I think it will be a marginal difference. We're talking a half of a
percent difference, if any, to achieve the same kind of restraint. That
1s a penalty, but I do not think it is a severe one.
The CHAIRMAN. Now, the witnesses who testified yesterday indicated that if monetary policy wasn't the only game in town, it would
still, inspite of what we have just discussed, be the most potent and
effective instrument we now have to cope with inflation. With tight
monetary policy, we can begin to bring prices down. Without it,
there's no way yon can.
Do you concur in that view? What other policies would be helpful?
In the past, Chairman Burns spoke of the importance of fiscal policy
that was conservative and restrictive. There have been other suggestions with respect to regulation policy and so forth. Can you give
us any suggestions as to how important (a) you think that monetary
policy is, and (b) what else we can do to attack inflation?
Mr. MrLLER. Monetary policy cannot do the job alone, but it is a
potent and essential weapon in the arsenal for combating inflation.
The two most important weapons are monetary policy and fiscal policy.
We certinly need to have the discipline in fiscal policy that allows
monetary policy to accomplish its goals with less damage to the system-or 'less potential damage. But one would have to say that putting
in place those two key elements, there are still other things that
properly can contribute to slowing inflation. One is a coincident incomes policy which is a part of the wage and price moderation program that has been announced recently. Such a policy, without responsible and sound monetary and fiscal policy, is useless; but with
sound fi;;cal and monetary policy, it can make a contribution to working through this period of change toward more stable conditions.
The same is true of regulatory policies which, as you know have contributed significantly to cost increases and therefore to price increases.
That, too, has a role to play-of reducing burden-but it will operate
more slowly, because impact on the economy of a regulatory change
does have a considerable lag. We should not lessen our enthusiasm for
action on this front because we will benefit from such changes later.
We mu~t run such a program not only to stop inflation now-to begin
to turn 1t down-but to work it out permanently.
As you know, my view is that it will take us 5 to 7 years to bring
inflation down to the rate it should be-below 2 percent. All of our
capacities-monetary policy, fiscal policies, changing some of our
legislated and regulated cost increii,ses--are going to be tested. Certainly we're going to want to use an incomes policy, at least as support.
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The CHAIRMAN. My time is up. I just want to say how interested
I am in your last remark that it will take 5 to 7 years to bring inflation down to 2 percent. The Humphrey-Hawkins bill that we passed
provided for 3 percent inflation in 5 years. So you're more optimistic
than that was and we were attacked in that.
Mr. MILLER. I put 7 years in just in case.
The CHAIRMAN. Senator Tower.
Senator TowER. Mr. Chairman, I think you have made a very fine
presentation, and I think the chairman has preempted some of the
questions that I intended to ask.
Let me pursue just a little further on the matter of the monetary
targets. Wouldn't it have been more effective if you had reduced the
targets for M 2 and Ma ?
Mr. MILLER. Senator Tower, we considered that, and there would
be some advantage to reducing those ranges. Certainly there would be
an announcement value and a public relations value in showing our
commitment to fighting inflation. But I don't really think we need to be
defensive 'about our commitment. We really are sincere about it, and
we have demonstrated that.
The ranges are such that I believe we would be just as well served
by moving toward the bottom of the ranges as by lowering them simply
to augment our commitment to a lower rate of inflation. Perhaps we
should have lowered them, but I believe we have more room here to be
more moderate in monetary growth.
Quite frankly, we have been a little uncertain because we do not
know to what e"xtent these money market certificates will continue to
bring funds in that would otherwise flow out of these aggregates.
Senator TowER. Mr. Chairman, I think you have done a pretty good
job without minmizing the impact of monetary policy on inflation of
bringing it into proper perspective. I think there are perhaps some
slightly exaggerated notions of the impact of monetary policy on inflation insofar as it's related to other causes which you have alluded
to.
One that I'm particularly concerned about is productivity, and I
think really that's one of the principal key issues in the inflationary
battle. How do we get our productivity up? I think ultimately that's
the answer to the slide of the dollar, not the total answer, but at
least would partially contribute to the enhancement of the dollar. And
you note in your charts the alarming lack of adequate capital growth
and that investment spending will be a factor in sustaining the economy, but can we really expect investment to continue to rise in the
face of higher interest rates?
Mr. MILLER. Senator Tower, higher interest rates are an impediment
to investment, and therefore we have that kind of contradiction in
terms which always troubles us in trying to control inflationary pressures. It's rather interesting, however, to observe that as we have continued to exercise monetary restraint-and we have said all year
we would continue to do so to the extent necessary to bring down the
growth of the aggregates and dampen inflationary pressure-and after
we have done so-particularly following the November 1 action,
which was quite a substantial increased tightening on the monetarv
side-long-term interest rates have behaved very well. Actually, the
immediate effect of the November 1 announcement was for long-term
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interest rates to drop. Even though they have to come back up somewhat, they are lower now than they were in the middle 0£ October.
So, in a sense, as there is evidence 0£ our progress in combating inflation, the financial markets create conditions £or the lower long-term
rates that are the rates we need to deal with investment. Now, in the
meantime, as this committee knows-and I want to just elaborate a
little on this point-it is critical that we. deal with his productivity
issue. It's critical that we deal with the inadequate business fixed investment that we have had £or so long.
Japan spends about 20 percent 0£ its gross national product on
business fixed investment; Germany, 15 percent. ,ve have been spending 8 or 9 percent. We can't go on decade after decade spending so
much lower than other industrial and modern nations without falling
behind in our productivity, in our technology, in everything. It's very
critical that we reverse that trend.
One can see the effects 0£ our declining investment just by looking
back over the last 30 years. For the first 20 years after ,vorld ,var II,
productivity gains were about 3 to 3.5 percent a year, really quite
good; in the last 10 years, they have been down to less than 2 percent;
and in the last 5 years, to 1.3 11ercent. That is the trend that, as you
point out, we cannot continue. e are headed £or disaster.
So I think we not only have to take the actions to combat inflation
and thereby bring about conditions £or more favorable interest ratesbecause interest rates would not have so high a component 0£ inflation
in them-but we also have to adopt policies that will incentivize investment. One 0£ my £avorites is a program to allow £or more liberalized depreciation which would compensate £or higher interest rates
by returning a higher cash flow £or investment. That policy, which
I realize isn't in the jurisdiction 0£ this committee but which is relevant to this committee, would be very important in trying to stimulate the investment side 0£ our economy as we are holding down some
0£ the demand side which makes the problem worse.
Senator TowER. Have you all at the Fed made an attempt to determine what the impact is on capital growth 0£ what we call the regulatory burden, compliance 0£ certain regulations, which result in
investment 0£ capital in compliance that would otherwise go into
improving productivity 1
.
Mr. MILLER. Yes. There's been some work on that, but I'm not sure
I'm prepared to quote any figures at the moment. Quite a bit 0£ investment in recent times, 0£ course, has gone into areas which do not contribute to productivity gains but contribute to social improvements.
I can send you a report on this, Senator, i£ yon like.
Senator TOWER. I think it would be a matter 0£ great interest.
Mr. MILLER. I'm sorry I don't have that right at my fingertips.
[Chairman Miller subsequently submitted the £allowing £or the
record:]
,v
In order to comply with more stringent Government reimlations, businesses
havP had to devote a substantial portion of their capitaf spending in recent
years to pollution abatement and to promotion of worker health and safety.
The following is a summary of the available data on such Government mandated
capital spending; a concluding section discusses some recently published estimates of the impact of these regulations on productivity.
CAPITAL SPENDING FOR POLLUTION ABATEMENT
The Commerce Department has been publishing data on businei-s capital
spending for air, water, and solid waste pollution abatement since 1973. As can
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be seen in Table 1, such spending now accounts for about $7 billion or approximately 5 percent of total business capital spending. As might be expected, the
share of spending devoted to abatement efforts appears to have been edging
down i_n recent years after an initial period in which many existing as well as
new facilities had to be brought into compliance with the new laws.
The burdeh of anti-pollution capital spending has been concentrated in six
industries: electric utilities, petroleum, paper, chemicals, steel, and nonferrous
metals. These six industries have accounted for about ¾ of all such spending
since 1973. Moreover, each of these industries has devoted 10 percent or more
of the!!" capital spending budgets to poll:u.tion abatement.
CAPITAL SPENDING FOR HEALTH AND SAFETY
McGraw-Hill has been collecting data on business capital spending for health
and safety since 1972. As is shown in Table 2, mandated capital spending for
this function totaled around $3 billion in 1977 or just over 2 per cent of total
business capital outlays. Similar to the case of pollution abatement spending,
capitaI outlays for health and safety as a share of the total were largest in
the period soon after the adoption of the more stringent regulations.
IMPACTS ON PRODUCTIVITY
Estimates of the impact on productivity of the more stringent pollution
abatement and health and safety regulatio"ns were published in a recent article
by Edward Denison.' His study, which covered the period from 1967 to 1975, concludes that these regulations have been responsible for an increasingly large
loss ii! productivity. He estimated that by 1975 pollution abatement was responsible for ¼ percentage point loss in annual total factor productivity growth and
that health and safety regulations accounted for another 1/s of a percentage
point ioss. Since the postwar trend of such productivity growth is only about
2 per cent, as of 1975, these regulations together appear to be absorbing approximately ½ of the underlying growth in output per unit of input.
TABLE !.-BUSINESS CAPITAL SPENDING FOR POLLUTION ABATEMENT
Year
Billions
1973 ____________________________________________________________ _
1974____________________________________________________________ _
1975 ____________________________________________________________ _
1976____________________________________________________________ _
1977 ____________________________________________________________ _
1978 1_ - - - - --- - --- -- - - -- -- - - -- - - -- -- - - -- -- - - -- - --- - -- - -- - --- -- - - 1
Percent
change
$5. 238 -------------5. 617
7.2
6. 549
16. 6
6. 762
3. 3
6. 939
2. 6
7.154
3.1
Percent o
total capita
outlay
5. 3
5. 0
5. 8
5.6
5.1
4. 7
Anticipated spending as reported in a BEA survey conducted in November and December of 1977.
Source: BEA, U.S. Department of Commerce.
TABLE 2.-BUSINESS CAPITAL SPENDING FOR HEALTH AND SAFETY
Year
1972 ____________________________________________________________ _
1973____________________________________________________________ _
1974 ____________________________________________________________ _
1975 ____________________________________________________________ _
1976 ____________________________________________________________ _
1977 ____________________________________________________________ _
1978 1_ - - - - - - -- -- - - -- -- -- - --- - - - --- - - - - -- - - - - -- -- - - - - - --- -- - - -- --
Billions
Percent Percent of total
change capital outlays
$2. 509 -------------2. 569
2. 4
3. 074
19. 7
2.714
-11.7
2. 376
-12. 5
2.884
21.4
3. 386
17. 4
2•.8
2.6
2. 7
2.4
2.0
2.1
2.1
Anticipated spending as reported in a McGraw-Hill survey taken in the spring of 1978.
Source: Economics Department, McGraw-Hill Publications Co.
1
Senator TowER. Thank you very much, Mr. Chairman.
The CHAIRMAN. Senator Sarbanes.
' Edward F. Denison, "Ell'ects of Selected Changes In the Institutional and Human
Environment Upon Output per Unit of Input," Survey of Current Business, January 1978,
vol. 58, No. 1, pp. 21-44.
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Senator SARB.\XES. Chairman l\filler, what real GNP growth would
we have to keep the unemployment rate at least where it is, if not
moving downward?
l\Ir. l\IILLER. Three to 3½ percent I would think, Senator Sarbanes;
that order of magnitude.
Senator SARBANES. Now is it your view that we should have as an
objectiYe only a 2½- to 3-percent growth in the GNP, or that that's
simply what's going to happen?
l\Ir. l\IJLLER. That's my prediction of what's going to happen in 1979
because of other forces.
Senator SARBANES. Is your monetary policy designed, to help make
that happen or is it designed to the extent you think possible, to give
us a somewhat better GNP growth and therefore a better unemployment rate?
l\Ir. l\f1LLER. The monetary policy that we're looking at now is
consistent with real growth in the range of 2½ to 3 percent. If I had
been speaking before this committee in July, I would have been talking
of a growth rate more like 3 to 3½ percent, which is consistent with
maintaining or improving labor utilization. The factors that have
impacted negatively since then are the acceleration of inflation, the
dollar situation which contributes to it, and the necessity of countering
those actions which are at conflict with our other objectives. The
fundamental thing we need to accomplish is to find that degree of
dampening of inflation which would a1low us, for a period of time, to
have a more moderate rate of growth than a 3 to 4 percent range
rather than to have a policy of recession followed by recovery.
Senator SARBANES. I don't quarrel with the desire to try to get a
a steadier pattern rather than a roller coaster.-The thing that concerns
me and what I would like vou to explain a hit is why a rate of 2½
to 3-percent growth as an objectiYe in real GNP which would give us
a rising unemployment rate as opposed to a somewhat not significantly
large growth rate of GNP ,Yhich would give us a steady unemployment
rate and perhaps ewn a continning decline in the unemployment rate,
makes such a critical difference on the inflation question.
Let me add a conple of points. It's my own view that one of
the difficulties in achieYing productfrity increases is resistance to
changes that stem out of a fear of unemployment, that in an economy in which employment opportunities continue to dewlop there's
less resistance to changes in how we do business which may cost
people jobs because they enYision there may be other jobs available to
them. But what they perceiYe to be a declining employment situation
causes enormous resistance to changes which woukl result in improYing productivity, any number of labor disputes obviously reflect
that.
Mr. MILLER. I think your latter point is true. ·we have an inflation
which has been built up oyer 12 years. It started with an unwillingness
to pay for the war in Vietnam and continued through an nn"-illin.~ness to make the adjustments necess:iry to re-estnblish stability. We
let the whole thing get out of hand. The price we have to pay now, in
order to get our house in order, is to suffer some periods of slower
growth than "'e would like, because that slower growth rate is essential if w·e are to reduce our demand for imported goods, restnbilize
the dollar, lessen the inflationary pressures of consumption and demand
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at a time when we haven't put enough into the supply side. So we're
paying the price of past policies.
Senator SARBANES. Do you assert-Mr. MrLLER. The sooner we pay the price with a policy of moderation
instead of a roller coaster approach, as you put it-the sooner we
are willing to saw wood for a few years and work our way out of itthe £aster we are going to enjoy the opportunity to reestablish growth
rates that will absorb recent increases in the labor force and achieve
th,~ level of unemployment we all want.
Senator SARBANES. Now if your policy moves the economy into a
recession, clearly the Federal deficit will increase markedly. Is that not
the case?
Mr. Mn..LER. There's no question, in my view, that recession is not a
good policy. There are people who would advise that recession is a
good response to the present condition. I don't agree with that; it is
not a good response because it would immediately and automatically
increase the Federal deficit, increase the stimulus from the fiscal side,
take away what we are trying to accomplish by restraint and change it
to another form which would be less attractive because it would add to
the Federal debt and the permanent cost of carrying the economy
which I don't think would contribute anything. So my view is that a
recession is neither necessary-there's nothing out of balance in the
economy that requires there be a recession-nor reasonable as a matter
of policy because it isn't effective.
Look at what happened in 1974-75: It was the worst recession in
40 years, and we did not make real progress in eliminating inflation.
We will eliminate inflation by being slower and surer and steadier and
having more persistence.
Senator SARBANEs. I think the line that yon cross that I am very concerned with beca11se I think it has significant psychological impacts in
another area, is the line when the unemployment starts going back up.
In other words, I think you can keep it moving down even at a decelerated pace in order to accommodate this more moderate growth and
then you're moving in a positive fashion on both fronts. I£ you allow it
to start going back np you're going to start developing a shift in attitude and a growing concern, which are going to affect a lot of policies
that would otherwise contribute to the effort to get a more stable and
balanced economy.
Let me ask this question: You have been one of those who have continually raised the social security tax issue as a contribution to inflation, the forthcoming increase. I don't understand the argument unless
you're prepared to reduce the benefits. Wouldn't eliminating the tax
increase result in a contribution to inflation because you would have
higher payouts to maintain the benefit levels but lower receipts to
balance the trust fund ?
Mr. MILLER. Senator SarbanPs, next ye'ar's increase in social security
taxes on January 1 would probably add a half a percent to inflation
next year. But my comment that that be deferred has always been
conditioned upon a commitment by Congress to make changes in
social security which would reduce its long-term costs and thereby
avoid the consequence yon mentioned.
What is the purpose of social security? It is to provide a basic pension upon retirement. We can reduce costs by not giving as much bene•
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fits to those who have other sources of income in their later years. For
example, we could tax social security benefits which are now tax free
when paid to people after they retire. We could tax benefits to those
who have other income and thereby feed back funds into the social
security system. That's one possibility.
A new law about mandatory retirement has been passed. If we extend
the retirement age for social security by 1 or 2 years, that would reduce
its costs substantially. If we look at the disability features-how they
should be funded and from where they should be funded-that could
be improved. There are many things we could do.
If we can't make those tradeoffs, we shouldn't change the tax; we
should collect the money, I agree. But when you face the $10 billion
tax on all Americans next year from adding a half a percent to inflation-that is, a $10 billion tax in the form of lost purchasing poweryou have to look at alternatives.
Senator SARBANEs. I'm glad to draw this out, though, because it never
appears in any reports on your assertions that we ought to defer the
tax increase. Implicit in that, if the reason for proposing it is as
an anti-inflation measure, is a commensurate reduction in the benefits. In the way it's been presented, which of course becomes very
appealing politically, the taxes ought not to be increased, but the fact
is, if you take that route-for the reasons you advance at least-you
would then have to cut benefits which of course reflects the basic
question of balancing the benefits and the tax burden. There is no
free lunch, as we are constantly reminded.
Mr. MrLLER. I'm glad yon cleared that up because my statement has
always been conditioned on reducing the net benefits.
Senator SARBANES. Let me ask one final question. When you and
Secretary of the Treasury Blumenthal took the stabilizing actions with
respect to the dollar, or made the announcement and issued your statement, that statement was very forceful in stating that what was being
done to the dollar was not a fair accurate reflection of the health of the
American <>conomy, and that the economy was in fact stronger than
suggested by what was happening to the dollar in the international
markets.
'\Vhy is that going on in the international markets? ,vhat's at work,
and why isn't the underlying strength of the American economy, which
although we have some problems is nevertheless quite strong, being
reflected intemationally? ,vhat is it that enables this preying upon the
dollar to take place?
Mr. MILLER. We have to be honest with ourselves. It's a question of
confidence. Whatever may have been the performance or the outlook
for the economv, those who deal in currencies in world markets feel a
declining confidence in either the capacity or the will or the desire of
those who manage the American economy to combat inflation and to
deal with the trade deficits in a way that would correct the dollar
decline in the future.
For that reason, there were both shifts in portfolios out of dollars
and anticipatory buying of other currencies that were expected to
appreciate. There was pressure on the dollar and there was speculation, and all these factors combined to create a disorderly market
that was not really appropriate to the true condition.
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For that reason, we had to take forceful action to correct the situation. In the process, I hope to establish credibility for the fact that
the Federal Reserve, the Treasury, the Congress, and the President
have joined together and are committed to Government policies that
will be effective and will address the issues and will correct the problems and will introduce the fiscal discipline and the monetary discipline
necessary.
Senator SARBANES. Well, I see my time is up. Thank you, Mr.
Chairman.
The CHAIRMAN. Senator Garn.
Senator GARN. Thank you, Mr. Chairman.
Mr. Chairman, since the programs announced by the President of
voluntary wage and price restraints a couple weeks ago, there have
been a lot of economists who have daily predicted that his proposals
for strengthening the dollar would contribute to or lead to a recession
in 1979, and there aren't too many views to the contrary. However,
William Bowman in the current issue of Business Week disputes that,
suggesting that the steps announced on November 1 may be the beginning of a chain of events that will stimulate long-term capital
investment.
I'm wondering if you consider such an assessment accurate. There
are not too many who have said that. As I have mentioned, most of
them feel just the opposite.
Mr. MILLER. Senator Garn, I would make a couple of comments.
The actions taken on November 1 lessen the chance of recession rather
than increase it. I would have said, in July, that there was no reason
for a recession. But if the instability in the exchange markets in
August, which accelerated in October to become a cause of deep concern, had been allowed to continue, the disorderliness not only in
domestic markets but in international markets would definitely have
Jed to recessionary pressures, to holding back on economic activity.
Therefore, the action to correct the dollar situation was one that
will lessen the probability of a recession. It is therefore consistent with
that article to say that, if it is now perceived that for the first time all
of the weapons are being mobilized to combat inflation and there's a
will and determination to do so, then long-term interest rates-rates
for long-term capital-will, if anything, stabilize or go lower which
will bring about the conditions for businesses to make longer term
capital investments which they are not doing now. That's the point
of that article, as I recall; that does make sense.
Businesses became very liquid after the last recession. Prior to that,
with the credit crunch in 1974, businesses were caught short and so
afterwards they borrowed heavily in long-term markets and they
became liquid. Under recent economic conditions, most businesses
have been reluctant to borrow in the long-term markets and there's
been a light corporate debt issue calendar. Instead, businesses are once
again covering their needs with short-term borrowings, which means
they are very reluctant to make commitments to long-term investm~nt.
As they see a change, there is no question that there's an underlymg
probability that more businesses will be willing to commit to longterm investment.
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Senator GARN. Well, I understand the philosophy behind the article.
It said that they would lead to a chain of events, not an immediate
thing, and you're reiterating the same thing. But in looking at wage
and price restraints, voluntary or involuntary, it disturbed me last
night on the news where Mr. Kahn said that if these did not work it
would necessitate mandatory wage and price controls.
In light of what you have said, at least in my experience, wage and
price controls primarily function by squeezing profits; increased costs
are normally absorbed by squeezing profits rather than by higher
prices where you have controls, whether they are voluntarily adhered
to or whether they are mandatory.
It seems to me that it's contrary to long-term capital growth. Everybody has talked about it. I have heard you talk about it. Most everybody says we're not having enough venture capital, and we're not
having enough investment in new plant and equipment, and that
seems to be shared by most everybody; and yet here with these restraints it seems to me that squeezing profit margins from which
investment capital has to come-I really don't see how we are not
endangering the economy. Wage and price controls also inaccurately
cast business and labor as the originators of inflation, and I don't
share that view either. I think it's government.
But how, in the light of either voluntary or mandatory wage and
price controls that are going to squeeze profits-where is this investment capital going to come from?
Mr. MILLER. I don't see the voluntary wage and price controls putting that squeeze on. I would think that mandatory controls might,
and I would personally not be in favor of mandatory wage and price
controls under any conditions that I see. I don't see how that's a
solution.
Senator GARN. Do you agree with Mr. Kahn that if the voluntary
wage and price controls fail, mandatory controls will become necessary? Is that a policy of the administration?
Mr. MILLER. No; I don't think they become necessary. I think they
would be very unwise, because they are inequitable and they don't
work, and they just result in putting off the day of reckoning, as I
believe you're pointing out.
What happened the last time we had mandatory wage and price
controls? We held the lid on, and then we reinflated the economy and
made plenty of funds available and low cost, and stimulated the
economy, and then took the lid off and went to double-digit inflation.
That's an unwise policy, and putting controls on and starving everybody is an unwise policy.
In the meantime, having a speed limit in the form of voluntary
wage and price restraints will mean more normal behavior as we take
account of the flows of cash and profits that are necessary to sustain
growth. HI were running a busfoPss under the voluntary wage and
price controls, I would put my salesmen to work harder to increase
my volume, to increase my turnover, and to keep my profits up. In
that sense, motivations may change.
Senator GARN. I'm glad you don't favor mandatory wage-and-price
controls. I would hope we would have learned from the mistakes of
Richard Nixon who yielded to political pressure, and I think we have
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all seen the results, as you outlined, o:£ what happened in the early
1970's.
To get back to the profit squeeze under yoluntary wage-and-price
controls, according to press reports yesterday, the administration may
relax the 7-percent wage standard under the guidelines without relaxing the price standard. I:£ we're going to sell out to labor on the one
side because George Meany won't support the President and w~'ve got
to somehow paci:fy him and we relax that and keep the lid tight on
prices, obviously it's going to squeeze profits. You can't relax one and
not relax the other. You're really going to have to stimulate that turnover and push your salesmen to work harder to overcome that. So I
think he's already causing a problem i:£ he yields to that political pressure :from labor. I think he's going to doom the voluntary controls :from
working because the profit squeeze will be extremely more difficult, and
I just don't see how it can work.
Mr. MILLER. I had understood that the alternative to a fixed allowance :for price increases would be a "margin test" so that businesses
would be protected. But perhaps I didn't hear correctly what was said
yesterday. I had understood there would be an alternative: If costs that
couldn't be controlled by business did go up more than the allowance
in a base period, that a test to maintain profit margin would be allowed
as an alternative. I:£ so, I would think there wouldn't be the kind o:£
pressure on profits that you mentioned.
Senator GARN. I:£ that's true, we're not moderating the price o:£
goods, and how are we solving inflation? That's how I get in trouble
on the other side o:£ the coin, too. I:£ we're going to have those who do
restrain themselves to 7 percent and we're going to have a subsidy to
make up the difference to labor-maybe I'm just naive and don't
understand the fiscal policy o:£ this country or the economy very well,
but I don't see how it's less inflationary when we have talked so much
about the deficit and the need to reduce the deficit, and then we say,
"All right, business, you restrain and, labor, you restrain, but i:£ you
really can't make it, we're going to take dollars out o:£ the Treasury
and re:fund to you," increasing the deficit. I would appreciate it i:£ you
could explain to me how that is cutting the inflation rate i:£ we're
going to say voluntary wage-and-price controls but i:£ you can't really
cut it we'll make some adjustments and we'll pump more taxpayers'
dollars in to buck up the wages by the difference o:£ what you think you
needed and what the 7 percent aHowed.
Mr. MILLER. I don't know the details yet. I don't think the details
on the wage insurance program have been presented. But I presume
that the tradeoff between avoiding direct cost and price increases and
the cost o:£ wage insurance will result in a tax credit that will not be
the economic equivalent o:£ foregone real income. There would be a
cap ~m insurance; it wouldn't set up a runaway situation; it would be
realized only by those sectors o:£ the economy which had complied with
the rules and held down wages and thereby contributed to the slowing
o:£ inflation. We'll have to wait to see just what is proposed-I'm not
familiar with how the program would be administered as to groups o:£
complying workers-whether there would be a dollar limitation or
whether there would be a blank check. I:£ the program were a blank
check, one would be concerned. But i:£ it is insurance in which all have
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to share one could make a case that in the interim we would be holding
down inflation and that the credit for taxes would come later and
would merely make up for some of the foregone real income to
individuals.
Senator GARN. My time is up, but one more question. Aren't we
really playing games with a lot of complex economic policy in trying
to transfer the blame to labor and management when the No. 1 culprit
is Government? You have talked about deficits. If you were setting
fiscal policy in light of the present economic problems, what target
level would you set for a budget deficit in fiscal 1980?
Mr. MILLER. Senator Garn, there's no question, as I mentioned, that
the inflation buildup started 12 years ago, and that it started as a result
of Government policies. There's no question that Government has been
a principal, and perhaps the principal contributor, to the rate of
growth of inflation. There's no question but what sound fiscal and
monetary policy would reduce inflation. But there's nothing to be
gained by not also recognizing that an incomes policy and other kinds
of policies to improve productivity and investment could be supportive
of fundamentally sound fiscal and monetary policy.
As far as what I would set as a target, I have said before that we
should move over several years toward reducing Federal experrditures
from 22 percent of GNP to 20 percent, and that we should balance the
budget by 1981. I notice that Senator Proxmire has indicated the
budget should be balanced in 1980. I'm skeptical of whether or not
certain legislative mandates could be dismantled in time to balance it
by 1980, but we should be shooting near a $20 billion or $30 billion
deficit and move in two steps to balance the budget by 1981. If we're
at $38 billion this year, we can cut it in half the next year and eliminate
it the next, for a balanced budget. But I'm skeptical about it being
balanced in one step.
Senator GARN. Well, I think you would agree that it certainly would
be easier for you to use monetary policy effectively as Chairman of
the Federal Reserve Board if the fiscal policy were more stable in the
Congress.
Mr. MILLER. If the budget could be balanced in 1980, my life would
be easier and my testimony before this committee would be far more
interesting.
The CHAIRMAN. I want to follow up on that and before I do I want
to say how delighted I am that you are completely, emphatically
against mandatory wage and price controls. The President of the
United States, the Chairman of the Federal Reserve Board and as far
as I know every member of this committee-we took a little informal
poll and all are against it-I don't know anybody on the committee
who is for mandatory controls, and I hope the signal goes out loud
and clear that the likelihood is that this Congress is not going to
approve it and I hope the next Congress will not approve it. I think
that will help make the present program work.
One other point Senator Garn raised, the question on profit margins being squeezed by the increase in pay. As I understand it, the
employer can take the best two out of three of the preceding years'
profit margin and he can maintain that if he has to increase wages.
Senator Garn is right in saying that would tend to be inflationary, but
you've got to do what you can do under these circumstances.
Then the final point was the argument that the wage rate insurance
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of 7 percent could be very costly. Of course, the point that Mr. Schultze
has made before us very emphatically is if you're going to get labor
to agree to this kind of a sacrifice you have to have some kind of carrot, and if enough agree you won't get inflation exceeding 7 percent.
The whole point is to get enough people in it. If you can get most of
the work force in it or most of the big unions in it, then it will work.
Now I'd like to follow up what Senator Garn talked about and be a
little more precise if I can. I'd like to see if we can establish a tradeoff, as close a tradeoff as we can, between fiscal restraint and monetary
policy and what the consequences will be.
Could you give me some notion of what effect it would have, for
example, if we reduced spending, say, $30 billion below what it otherwise would be? ·what effect would that have on short-term interest
rates? Maybe it's asking too much to ask you that.
Mr. MILLER. Just off the top of my head, that's about an 8-percent
reduction in demand for credit. To the extent that it had both aspects
of the reduction in demand for credit and a convincing show of Government actions to restrain inflation, my guess is that there would be a
fairly prompt reduction in long-term rates.
I'm afraid I couldn't tell you how much of a reduction because I'm
not sure of how it would interact with other policies-perhaps I could
do a little work on that.
The CHAIRMAN. I wish you would. If you could have your staff
people put this in your computers and see if they can come out with
some kind of notion I think it would be extremely helpful for us up on
the Hill, for Senator Garn and others who are very anxious to hold
down spending. If we can point to a definite consequence of lower
interest rates, I think that would be a big boost to us.
Mr. MILLER. e'll do that.
[Chairman Miller subsequently submitted the following for the
record:]
,v-
In response to your question, I asked my staff to use the Board's econometric
model to simulate the effects of a $30 billion cut in Federal spending. The results
of such an exercise must, of course, be viewed as no more than suggestive, for they
will reflect a rather mechanical translation of the average responses of the economy in the past and will be critically dependent on particular assumptions and
initial conditions. The model indicated that, with a given rate of money stock
growth, a Federal spending reduction of $30 billion (at an annual rate) throughout 1979 would leave short-term market interest rates roughly 1 percentage point
lower by year end than would otherwise be the case. The reduction in Federal
spending, besides having a direct impact on government borrowing req11irements,
would tend to dampen aggregate demand in the economy and thereby also ease
privute demands on credit markets.
In reality, any number of factors might substantially alter the interest rate
effect. More rapid monetary expansion would tend, for a time, to further lower
interest rates while bolstering aggregate demand. A cut in Federal taxes would
tend to offset the interest rate reduction while bolstering aggregate demand.
There is also the possibility that, in the circumstances we face today with widespread concern about the destabilizing impact of Federal spending, private investment might respond very positively to greater fiscal restraint so that the effects
on interest rates and aggregate demand would be appreciably offset.
Conjecture about the precise interest rate effects aside, the basic and important
point is clear: reduced government spending would help to relieve inflationary
pressures in the economy and would free financial and real resources for use in
private productiYity-expanding investment. This is one of the reasons I've advocated a reduction over the next few years in Federal outlays as a percentage of
gross national product from the 22 per cent area to 20 per cent.
The CHAIRMAN. Today you're announcing the birth of your new
baby. You're the proud daddy of M1 +, a new monster.
Mr. M1LI,ER. I'm not going to claim it yet. If it works out, it will be
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the Miller aggregate. If it doesn't work out it will be the Axilrod
aggregate.
The CHAIRMAN. It will be whose?
Mr. MILLER. My associate, Steve Axilrod, who's our staff director
for monetary policy.
The CHAIRJ\IAX. Axilrod has a nice euphonious sound. Maybe you're
the daddy and heis the mother. I think Ws important for us to find out
as much about this as possible so we know exactly what we're dealing
with.
For example, you claim that savings accounts have played a widening role in financing transactions and that's true, but certainly not all
savings desposits have transactional characteristics. ,,niat are your
estimates 0£ the percentage 0£ savings deposits through transactions to
jnsti£y including all sayings account which you do here in the monetary aggregate where all other components are transactional in
nature?
Mr. MILLER. Mr. Chairman, that's one 0£ the things we're not sure
about. 1£ we had our druthers, we would define Mi+ as being currency,
true demand deposits-which may disappear some day-but those
kinds 0£ savings accounts at banks which can be accessed £or third
party payments. Some 0£ them are accessed by cardi some by telephone,
and now 0£ course some are automatic. 1£ we could distinguish those
kinds 0£ accounts from those which are true savings-true savings that
are subject to notification for withdrawal-we could answer that question. w·e haven't been able to do that, but M1+ has to be looked upon
as being imperfect because obviously by including all savings accounts
of banks it's including too big a universe.
However, by including No,v accounts-which are really transactions accounts-and share draft accounts, and that sort of thing, we
are getting close to what "money" in a narrow sense should be. So I
apologize, but we are doing surveys and trying to find out the answer
to your question and we will be giving you information on that.
The CHAIRMAN. 1£ you could give us the results 0£ those studies we
would appreciate it.
Mr. MILLER. We are going to keep giving them to you. ,ve are going
to get the results from time to time and see what shifts have occurred.
The CHAIRMAN. This past summer you requested the Congress to
approve transactions accounts for thrift institutions, yet you're not
including thrift institution transactions accounts in this Mi+•
Mr. MILLER. Yes; we are.
The CHAIRMAN. Not savings deposits.
Mr. MILLER. Not savings deposits.
The CHAIRMAN. Why not?
Mr. MILLER. Because at the moment they are not readily accessed
£or transactions. There are maybe a few that are tied in with-The CHAIRMAN. They have telephone transfers, don't they?
Mr. MILLER. Yes; there are some that have access either by telephone or in conjunction with a bank or an affiliated organization, but
as far as we can tell, those are fairly minor. But you're correct, to the
extent these grow, we are going to have to find out how to measure
them.
The CHAIRMAN. Now I realize it's very hard to start with something
new and give us a guide that's helpful, but you have told us that your
target range for Mi+ is set at 5 to 7.5, as I understand it.
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Mr. MILLER. Yes, sir.
The CHAIR::liAN. It's hard to know whether those growth rates mean
anything. I just don't know how to evaluate them. I don't know how
the press can or anybody else can. So let's sec if we can find out what
the historical growth of these aggregate components have been, how
stable the relationship between M1 + has been or ,:an be expected to be,
and what the growth rate in the past year and previous years has
been. I presume you may have had some of that when you put this
together and decided to include a new aggregate. So can you give us
as much detail on that as possible?
Mr. MILLER. Let me make a comment on it, Mr. Chairman, and I will
send you a schedule on it too. Look at the chart that shows M 1 and Mi+.
Let me show you one of the imperfections of 1\L+- Yon will notice that
M 1 + goes along a trend until about 1975 and then seems to bend up
rather rapidly. During a period of recession, savings increase, and
therefore more people were saving their money instead of marshalling
it for spending. That's the imperfection of Mi+ at the moment; we
haven't segregated out those funds that are being held to be spent as
distinguished from those being saved.
Bearing in mind that impedection, and that we want to work more
on it, if you look back M 1 + grew at a rate of 11 percent from mid-1976
to mi~l-1977. During the year 1977, it grew at only a 9-percent rate.
And m the last four quarters, it has grown 6 percent.
Perhaps it would help if for the record I give you a table of the
growth rates behind this chart.
The CHAm::11AN. ·wen, that's very helpful and it would be helpful
to have that. vVe didn't have the growth rates docnmented here. vVe
had the chart but not the rates. That's very helpful.
Mr. MILLER. Let us give you the table. One of the reasons we're not
sure it's the ideal aggregate is because it's still not as pure as we would
like it to measure funds which are being held for immediate purchases.
[Chairman Miller subsequently submitted the following table for
the record :J
Money Stock-JI,+ Growth Rates
(Annual rates of growth, compounded quarterly)
Annual:
1975 ------------------------------- ----------------------------- 8.8
1976 ------------------------------- ----------------------------- 12.6
1977 _
_ ------------------------------- -------------- 9.3
Quarterly:
1975:
I ------------------------------- ---------------------------II ------------------------------- --------------------------III ------------------------------- --------------------------
IV----------------------------------------------------------
1976:
5.3
5.3
11. 3
6.9
14.1
l¥- --=-----==============- -===----=====================-----
1977:
-
--------------------------------------
,.Jr_ _: : : : : :-: : : : .·:
::::::a____ ::__::::::::::____ _
Iir.----========·====· =-===------==-==========================
36-066 0 • 79 • 11
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13.8
7.7
15.1
13;2
8.9
8.2
7.0
5.0
7.0
5.4
158
The CHAIRMAN. I have some more questions but my time is up.
Senator Garn.
Senator GARN. What about Senator Schmitt?
The CHAIRMAN. Senator Schmitt is coming back.
Senator GARN. I just wanted to pursue :further what I was talking about when my time ended before, and that's a discussion I suppose that went on continuously between Chairman Burns and me,
and I suppose will continue between you and me :for some time into
the :future. That's the point I was trying to make about these voluntary
wage and price guidelines. And I understand, as the chairman has
pointed out, that there are obviously offsets.
The point I was trying to make is they are very technical. They are
going to be very hard to administer, particularly with small businesses.
You can look at the giants. You can go to General Motors and so on.
But the complexity o:f trying to deal with the vast number o:f businesses and industries across this country-I have never seen those programs work very well just :from the technical complexities alone. So
there may be offsets as :far as the inflationary impact, but the difficulty
o:f trying to administer imd decide who gets the credits and who does
not and how they are pa.id seems to me to be missing the point once
again, that you have got to look at the primary cause o:f inflation as
government.
Certainly I agree with you that we need to go ahead and do everything in the private sector to supplement that effort,. My point is we
are not doing nearly enough in the public sector. We are saying, "Do
as I say, not as I do." We are talking about restraints. Why should
labor and business cooperate when we're raising our budgets at 20-25
percent a year, when we're having these huge deficits? We had token
cuts-I laup:h at the 95th Congress saying we cut the budget after we
increased it 18-20 percent in many areas. We had 2 percent across-theboard cuts on the floor. So we were taking little tiny nibbles at the
increase. The budget was not cut in the Congress this year. Fiscal policy was not cut back, despite Proposition 13.
When I read the Washington Post saying that this wias a con~rvati ve Congress, my goodness, it may be to them; but a half a trillion
dollar budget-and I just really don't understand how they can say
that there was any great emphasis on the private sector. I don't disagree with what you said, Mr. Chairman, but we are still running rampant in the way we spend money, and we are kidding ourselves when
we say we are not. The increases are big. We are not re,straining
ourselves.
And when you talk about the inflationary impact o:f the increases o:f
social security, I ,agree with you, they are there. I agree with your
philosophy on social security as well. We are :funding a lot o:f rich
people that shouldn't have to be on social security. It's gone :far beyond
its original intention. But when we plug another $40 or $50 billion o:f
deficit in and you figure that here is 1 percent :from the social security
increase alone, then why was the President unwilling to accept~not
the Roth-Kemp-but the Nunn-Bellmon, the son o:f Roth-Kemp, which
was tied to exactly what you were savinP.', regulating- taxes and growth
in spending as a percentan'e o:f the GNP? To me this proposal would
have shown some real progress in fig-hting inflation, but it was passed
by the Senate and it was passed by the House and it was kicked out in
conference because the President ohi-ected to it. But then we have
this big program to get brisiness and labor.
Again, I don't ohjl'ct to the voluntary program, but until we start
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as an admi!1istration and as a Congress really responding to the basic
ca.uses, whic~ are defi?it spending, wild, foolish spending, which is
still unrestrarned despite the mood of the people of this country, and
the overwhelming regulatory burden, the economic costs of which
are estimated ras high ,as $130 billion a year or $2,000 per family,
promulgated without any regard whatsoever for the cost of regulation-there's no cost-benefit analysis that we do when we pass themand much greater attention to the importiation of energy, what you're
talking about is a very small part, at least in my opinion, to those
three causes that are all under the control of Government. And we're
not doing it.
That's hardly a question. It's a speech. But I didn't get to fl.nigh
it in the other round. I have no other questions other than I'm glad
you disagree with mandatory wage ,and price controls, but I think
we've got to have emphasis on Government and quit pushing the
blame to the private sector, either labor or management.
Mr. MILLER. Senator Garn, I have been in my assignment for a
little over 8 months, and I came in, I hope, with a realistic attitude.
Therefore, I suppose my feeling of more comfort is because I'm willing to be satisfied with some progress. When I crame to Washington
the outlook for fiscal year 1979 was for a deficit of $60 billion; now
the outlook is for a deficit of $38 billion. I admit that is still large, but
from my point of view at least it was a step in the right direction.
When I came to Washington there was certainly resistance, if not
hostility, to monetary policy dealing with the issue. Now it seems
we have support from Congress and from the President for a monetary
policy tougher than we have seen in many a year. I take comfort in
that, and I take comfort in the :fiact that we have been able to slow
the economy down 1 percent and have that accepted by everybody as
necessary medicine. I take comfort from the fact that we have really
seen some minor miracles in shifting fiscal policy, in shifting the
attitude of Government toward monetary policy, in dealing- with the
condition of the dollar that didn't exist 8 months ago, and in trying
to bring the economy down in a balanced fashion and wash out the
inflationary pressure without the necessity of recession.
The progress so far, I would have to say, makes me feel better
about coming- to Washington than I expected to feel. While it's been
tough and the problems haven't been addressed with as much vigor
as any of us would like, the progress has been much greater than we
might have expected given the climate when I arrived in March.
Senator GARN. I feel slightly better, but you didn't have to listen
to -all the speeches of the politicians during election. There wasn't a
Liberal in this country, Democrat or Republican. All of them we1:'e
fiscal conservatives. They certainly ran that ~ay and I hope their
constituents around the country try to see durmg the 96th Congress
that they vote the wav they t,alked during their campaigns an<l then
we might be 'able to give
a great dearmore help if they will vote
like thev talk. Thank you, Mr. Chairman.
The CHAffiMAN. Sei,ator Schmitt.
Senator ScHMTTT. Thank you, Mr. Chairman.
Chairman Miller, do yo11 have any chart to show the real growth
of the GNP compared with the growth of M1 over the last several
years; that is, the inflation compensated GNP growth~ The chart you
gave us indexes GNP and M1.
Mr. MILLER. I don't have a chart. I can provide you with one if you
like.
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Chairman Miller subsequently submitted the following
chart for inclusion in the record of the hearing:
INDEX OF REAL GNP AND MONEY STOCK M-1+
1970 QIV=t.0
1.9
1.8
1.7
1.6
1.5
1.4
1.3
Real
--
_.,,
1970
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.,,.
,, .,,
,, ✓,---
1 .2
- - ..-
GNP,--
..... -
..... ,
... ,,, ,, ✓-
1. 1
1 .0
1972
1974
1976
1978
161
Senator ScHMITl'. Do you have an estimate of what the relative
growth rates have been¥
Mr. MlLLER. Of M1 plus, yes. If you look at the second from the
last chart, you will see, as I was mentioning a moment ago, that
M1 plus shows an acceleration in growth in the period 1975-76.
Senator ScHMITT. I made a rough calculation. It looked like that
was probably about a 12 or 13.
Mr. MILLER. It was running about 11 percent. M 1 plus as we define
it now is imperfect beoause it does include pure savings and during
a recession people save more.
Senator ScHMITl'. Then you would estimate 11 percent¥
Mr. MILLER. Since that time it's been about 7 or 8 percent.
Senator ScHMITl'. The M1 plus i
Mr. MILLER. M1 plus.
Senator ScHMITl'. The M1 has been 6 or 7.
Mr. MILLER. M1 was 8 percent last year and this year.
Senator ScHMITl'. What i
Mr. MILLER. M 1 was 8 percent last year and this year.
Senator SCHMITT. Then why would M 1 plus be less i
Mr. MILLER. M 1 plus has been 6.1 percent over the past year as
against 8 percent for M1. M1 plus has been less, of course, because
savings rates have gone down; we have put in M1 plus all the
transactions kind of accounts and savings have actually dropped off.
It's an imperfect substitute for M1, although it's getting closer to
what we want.
Senator ScHMITT. But over the last 2 years M1 plus has been growing
at about what rate i
Mr. MILLER. About 9 percent in 1977; so far this year, about 6
percent.
Senator SCHMITT. What is the real growth in GNP in that same
period of time i
Mr. MILLER. The real growth of GNP was 4.6 percent in 1976 and
5.5 percent in 1977; over the past four quarters, it was about 3.75
percent in real terms.
Senator SCHMITT. Do you think that the rough difference in those
figures is the true measure of the contribution that excess money
growth gives to the inflation rate, somewhere around 2 or 3 i
Mr. MILLER. You can look at it the other way around. Nominal
GNP has been growing at about 11 or 12 percent, and M1 plus is declining in its relation to nominal activity of the economy. Therefore, the
money available to carry on that level of nominal activity is declining.
We included the chart showing that M1 has been declining in its
relation to nominal GNP-its growth rate is lower than nominal
activity.
Senator ScHMITr. But isn't the partial measure of the contribution
of excess money supply growth to inflation roughly the difference between the real GNP growth rate and the money supply growth rate i
Mr. MILLER. It certainly is a contributing factor and we should
get the rate down, no question.
Senator SCHMITT. Isn't that a rough quantitative measure i
Mr. MILLER. I personally don't believe it's that closely related, no.
For example, you had 20 percent nominal activity in the second quarter, and M1 grew at 10 percent, and I don't believe-
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Senator ScHMITr. I don't think you can look at it on a quarterly
basis. I think you have to look at it over a year.
Mr. MILLER. Over many years; I think it would be more apt to be
true over a long time.
Senator SCHMITT. Because again, just on the back of the envelope
here and from what you said, it sounds like the contribution of excess
money growth over the last 2 years may be really adding 2 or 3 percent to the inflation rate which is now at about 10 percent. Would
you agree with that?
Mr. MILLER. No, I don't think so. Even if you believe in the longterm relationship, you have to consider the length of the lag effect. You
have to look at the growth 2 years ago. At that time the growth of M 1
was much lower. I think the lag effect is such that-Senator SCHMITT. Then why have we had a doubling of the inflation rate over the last 2 years?
Mr. MILLER. One reason, of course, is that we had a doubling or
quadrupling of the price of oil that's worked its way into the economy.
,¥e have also had famines and shortages of food throughout the world.
Supply and demand does work in pricing, and the shortage of grain
and the Humboldt current that moved out We•st causing the anchovy
crop to fail all contributed to a shortage of goods and the driving up
of prices. This has been true throughout history; supply and demand
is a factor.
Senator SCHMITT. And you think the doubling in the last 2 years
is a result of forces external to the United States?
Mr. MILLER. I think it's a combination of factors. As I say, it
started with the failure to pay for the Vietnam war and the inflationary impact created by too large a growth of money, but other, exogenous factors have also contributed.
Senator SCHMITT, We have passed the inflationary pulse as a result
of the Vietnam war.
Mr. MILLER. Sure, but once you start it and build it in, you have
an automatic, structural inflation with cost-of-living increases on wage
contracts, and-Senator SCHMITT. I agree with all that, Mr. Chairman, but the
point is, 2 years ago the inflation rate had been coming down and had
reached a 4.8-percent level, and then started up again. And what I'm
asking you is what caused that upswing?
Mr. MILLER. In my opinion, it was caused by a decline in the
demand for goods and services because of a major recession; we had 9percent unemployment.
Senator ScHMITT. So the recession is what built in the inflation rate,
the new inflation rate, the reason we have 10 percent now?
Mr. MILLER. The higher demand for goods and services without an
increase in the capacity to supply has added to pressures on prices, as
has the supplying of credit to allow-Senator SCHMITT. So you're saving no matter what the administration might have done or the Congress might have done 2 years
ago, had we been smart enough and wise enough, we couldn't have
avoided the increase in the inflation rate over the last 2 years?
Mr. MILLER. Over the last 2 years we have been operating much
nearer our capacity level. Exper1ence shows us that when we get up
to 85 percent of industrial capacity we get to uneconomic capacity
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which contributes to inflationary pressures because of the higher costs
that go with higher resource utilization. We have had high unemployment much of which consisted of inexperienced workers, but we also
have had high employment and high utilization of-Senator SCHMITT. That's been roughly the same for several years.
There's not been a major change in the structural unemployed.
Mr. MILLER. There's been a major change in the number of employed in the last several years-the highest increase possible-thereby putting pressure on the purchasing of labor. More money has been
paid to acquire labor because it has, in terms of experien_ce and skills,
been in short supply.
Senator SCHMITT. Well, somehow I find it-Mr. MILLER. Unskilled labor and inexperienced labor have been
in plentiful supply. Skilled and experienced labor has been in short
supply.
Senator ScH1\UTT. Do you have any feeling for what contribution
that's made to the inflation?
Mr. MILLER. As I said, I would not single out any one factor; it's
been the interaction of many factors; 1 percent of inflation has come
from the decline of the dollar; 1 percent has come :from minimum
wages, social security taxes, and unemployment taxes. You can account
for the whole 2 percent increase without ever counting the money
supply effect.
Senator ScHMITT. That's 2 percent out of 5.
Mr. MILLER. Two percent out of 8; we had 6 percent before. The
marginal difference of 2 percent can be accounted for by other things.
Senator SCHMITT. What about the rate of increase in regulatory
costs? Senator Garn mentioned an approximate figure.
Mr. MILLER. One might argue that the underlying rate of inflation
has declined, but that despite the decline in the underlying rate of
inflation we have added inflationary components by legislating themsocial security taxes, minimum wage, unemployment insurance taxes;
by failing to solve our energy problem, bringing in more oil, and
thereby contributing to a weak dollar due to deficits in foreign trade;
and by imposing regulatory burdens that have resulted in costs to the
system without commensurate output. All of those have contributed
to inflation, as has excess money, as has excess Government spending.
Senator SCHMITT. So are you saying that had the Congress and the
administration jointly refrained :from the increase in payroll costs,
primarily minimum wage, and social security, had we somehow developed our own productive capacity in energy rather than depending
on higher cost foreign supply, had we resisted the increases in regulatory authority, that we could have at least held our own against that
inflation rate that was inherited by the 95th Congress and the Carter
administration?
Mr. MILLER. It would appear so.
Senator SCHMITT. Do you think we ought to try to do those things
in the 96th Congress?
Mr. MILLER. Yes, sir.
Senator SCHMITT. At least to try not to make it any worse?
Mr. MILLER. I sure do.
Senator SCHMITT. Thank you, Mr. Chairman.
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The CHAIRMAN. Chairman Miller, I think your chart 12 which you
discussed so well explains a lot of that colloquy you just had with
Senator Schmitt. You recognize that food in 1976 dropped in cost and
in 1978 in the first half it skyrocketed up to almost 14 percent. It's
clear that a very, very large share of the increase in prices has been
the food increase.
Mr. MILLER. That's correct, and you can go back quite a while, Mr.
Chairman, to some of the causes. A lot of that increase has been in
meat, as you know, and that goes back to policies of the past which
resulted in liquidation of herds and a shortage of supply. A restriction
on the importation of meat has also added to the shortage of supply,
and the operation of supply and demand has driven prices up.
The CHAIRMAN. You have given your estimates on GNP growth,
unemployment, inflation, and so forth. I'd like to know what type of
fiscal policy assumptions you have made to get those expectations.
What do you expect the size of the deficit to be in this current fiscal
year and next fiscal year?
Mr. MILLER. For fiscal year 1979, we have assumed a Federal deficit
of $39 billion and an agency deficit, I believe, of $11 or $12 billion.
The CHAIRMAN. $39 billion for fiscal 1979. Did you make any
assumptions for 1980?
Mr. MILLER. For 1980, of course, we haven't seen the administration's
proposal, and therefore we have not done any more than go on an
assumption of $30 billion.
The CHAIRMAN. How much do you expect the Federal or do you
think Federal spending should rise in real terms in fiscal year 1980?
Would it be practical in your view to keep Federal spending stable in
real terms?
Mr. MILLER. In real terms, I would hope so. In fact, one could argue
for a decline because if the amount of inflation is increased we still
would not make much progress.
The CHAIRMAN. The President has indicated or newspaper reporters
have indicated that the administration plans a 3-percent real increase
in defense spending. So if you're going to hold overall spending stable,
that means you're going to have to have some cut in domestic spending.
Mr. MILLER. You're going to have to have a cut in other spending,
yes.
The CHAIRMAN. Do you think that's realistic to expect to have a
stable real spending overall?
Mr. MILLER. It would be the minimum expectation. I would hope
that some inroads could be made. After all, in terms of getting Federal
expenditures down as a percent of GNP, you're not only going to have
to hold the rise to the inflation rate, but also to begin to eat into it if at
all possible. If you hold it to the inflation rate, in a number of years
you will have reduced it down to 20 percent, I realize; but the sooner,
the better.
The CHAIRMAN. The administration has said that the President's
anti-inflation program should reduce the rate of inflation between 6
and 6.5 percent. You forecast 63/4 and 7½ percent. Why do you think
the administration is wrong and too optimistic ?
Mr. MILLER. I really can't say, in terms of their analysis, because
I have not had the benefit of it. But we have done an independent
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estimate and based upon built-in increases-based upon the outlook for
food which is improved but not good, and based upon the continued
high prices of meat, and based upon the expectation of an oil price
increase-we just come to a different conclusion. We built our estimate
from scratch, so I don't know how we could compare it with the
administration's.
The CHAIRMAN. Yesterday Leif Olsen from Citibank told the committee that loan commitment growth has accelerated and there's some
indication of anticipatory borrowing because of fear of credit controls.
Now as you know, that authority is on the books. The Wall Street
Journal on Monday indicated the same thing. President Nixon set up
a Committee on Interest and Dividends in Phase II which was supposed to moderate interest. President Carter hasn't included banks in
the anti-inflation program but said that banks and other financial
institutions are expected to follow the wage standards and profit
margin test.
What role will the Federal Reserve play in seeing that monitoring
profit margin and interest rate increases in the anti-inflation program?
Mr. MILLER. We haven't been called upon to play any role.
The CHAIRMAN. Would it mean anything if you don't monitor it?
Nobody will.
Mr. MILLER. I£ we are asked to, we would be pleased to do it; we
have not been asked.
The CHAIRMAN. Well, what does it mean then when the President
said the banks and other financial institutions are expected to follow
the wage standards and profit margin test? Just hope they will and
nobody checks it?
Mr. MILLER. I expect Chairman Kahn's organization will be pursuing this with banks, just as they will with other organizations.
The CHAIRMAN. But they have always looked to you, the Federal
Reserve Board, to be the instrument to carry out that policy. I don't
know how Mr. Kahn can do it. He will have, at most, 150 people with
the whole economy and the Federal Government to monitor, and obviously the Federal Reserve Board has the personnel and the expertise.
Mr. MILLER. Yes, we do have. It's a decision that is up to the administration.
The CHAIRMAN. But if the President should call on you to do it, you
would?
Mr. MILLER. We would be pleased to cooperate.
The CHAIRMAN. Now on· Monday, the Mellon Bank announced it
·was establishing a special prime rate for small business loans at a base
rate one quarter percen~age below the bank's prime rate. The dual
prime rate was encouraged by the Committee on Interest and Dividends in 1972. Would you encourage other banks to follow the Mellon
Bank?
Mr. MILLER. I was very pleased to see that, and I certainly would
encourage it. Our structure for checking small businesses would indicate that by and large there has not been any differential lack of credit
for small business ns compared to other businesses, but we are now in
a zone where I think that could be a problem. You're correct in indi-
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eating that a dual rate might be desirable until we get back to a more
normal rate structure.
The CHAIRl\L\N. As you know, there's been some disc1t:,f<ion in the
press and also an allegation by a bank official of one of the biggest
hanks in the country that our large banks may have speculated against
the dollar and contributed to its downfall. I'm very suspicious of any
conspiracy theory because I have seen so few work out, and I recognize
that conspiring to reduce the yalue of the dollar seems to be about as
speculative an activity as yon can get into. But I ·wonder if the Federal
Reserrn has any evidence that the banks have clone this. A number of
constituents have asked me about this and I think many people in the
country are concerned about it.
Mr. MILLER. ,Ve have no evidence, Mr. Chairman. ,ve would be concerned and, as a matter of fact. because of the growth of the international exchange markets, I think we plan to take a critical look at their
structure and learn more about them so that if any such characteristics
are developing we can determine what action, if any, should be taken
before a crisis is created by an imperfect market. "\Ye do not, however,
ha rn evidence of that.
The CHAIRMAN. Now apropos of the same subject, the Eurodollar
market, yon have been quoted as saying this:
The Eurodollar market is of deep concern to us because a very large amount
of dollar denominated money is out there over which the central bank has very
little control. A lot of money is created in the international market outside the
control of any central bank and this is one of the &"reatest worries in this period
of time.
My question relating to this is, first, how much money is out there?
I understand it's approaching a half a trillion dollars. ·what effect is
this uncontrolled money creation having on the U.S. money supply and
interest rates?
Mr. MILLER. There are various estimates of Eurodollar deposits. As
best ·we can determine they may run from $400 to $600 billion. Perhaps
one would assume that $400 or $500 billion would be reasonable. We are
not sure of the net position; that's one of the worries.
This kind of dollar denominated resource has to be of concern
because in times of shifts there's just no way to cushion or deal with it
unless we have some concerted central bank effort.
The CHAIRUAX. ·wen, are you trying to do this?
Mr. MILLER. Yes. indeed. This is one of the areas the Bank of International Settlements has been looking into and gathering data on. It
is trying to determine Eurocurrency positions. At the moment the
debate is about data and facts; beyond that, one mons to policies that
would allow for an orderly system for dealing with that money base.
The CHAIRl\IAX. So you would negotiate with other central banks to
try to establish reserve requirements or other restraints in Eurodollar
creation? Can that be done?
Mr. MILLER. It seems to me, both with regard to exchange markets
and Eurocurrency, cooperation with the other major central banks is
required to get an effective policy. Everybody has to work together on a
common base and establish a willingness to apply, the same rules.
Money always goes to wherever it is treated the best and markets can
pop up anywhere-in Singapore, Hong Kong, anywhere. Therefore,
the central banks that control the banking institutions which have
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those deposits have got to take fundamental coordinative action. I
hope over the coming years that we can develop some constructive
actions along these lines that ,vould give greater stability to the international money market and the flow bf funds.
The CnAIRJ\fAN. I have a couple more questions. My time is up. Senator Schmitt.
Senator ScRMTIT. Thank you, Mr. Chairman.
Chairman Miller, I received a mailogram from Frank Moore, Assistant to the President for Congressional Liaison, on November 2, 1978.
In thatmailogram there are statements such as the following:
I want to explain to you the actions taken today by the President in support
of the dollar.
At the request of the President, the follpwing actions have been taken ,by the
Secretary of Treasury and the Federal Reserve.
Two of the actions listed are as follows :
A one percent increase in the discount rate by the Federal Reserve effective
immediately, and an increase of two percent by the Federal Reserve in reserve
requirements against certificates of deposit.
Now as you know from our phone conversation and correspondence,
I'm very disturbed by the White House taking credit £or things that
or actions that are entirely within the purview of the Federal Reserve System. Would you care to explain how this happened and your
feelings about this 1 ·
Mr. MILLER. There are two aspects to the policies and the decisions
announced on November 1. Those dealing with intervention involve
areas of responsibility that are primarily the Treasury's.
Senator ScHMI'IT. I understand that.
Mr. MILLER. The Treasury is the Government's arm that is represented on the IMF, and it draws from the IMF and sells SDR's and
can issue bonds £or foreign currencies. It's necessary to coordinate
that action with the Federal Reserve because as the central bank, we
maintain the Swap lines with other central banks-even though that
is an international monetary matter of concern to the Treasury-and
we do implement, through the Federal Reserve Bank of New York,
the actual intervention £or our account and £or the account of the
Treasury. So it has to be coordinated.
The monetary actions that were taken by the Federal Reserve were
complete!Y. independent. They were not requested by anyone. They
were policies that had been under discussion because of the general
economic conditions and because of the disorderly markets that were
evidenced in August and h&d worsened in October.
The President, as you know, announced in August that he had requested Secretary Blumenthal and me to counsel him on actions that
might be appropriate to deal with the dollar. In that counseling, he
did request us to give him advice and to take those actions that are
the responsibility of the Treasury and the administration, with the
support of the central bank. But at no time did the President or anybody else request monetary actions, domestic monetary actions, by
the Federal Reserve. ThO!!!e were taken independently, and they were
tak~n based on discussions that predate the President's speech on inflat10n on October 24. The discussions predate the decisions taken,
but they were obviously coordinated so as to be well timed as part of
any effort to deal with the dollar. They were announced by the Fed
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eral Resr,rve in a separate document and, as you know, the Federal
Reserve was not represented at that press conference on November 10.
I cannot say anything more than that we announced jointly with the
Treasury the international actions and announced separatedly our
own domestic monetary actions.
Senator ScHMITr. Why do you think the President-let's just say
the White House has chosen to make a contrary statement to the
Members 0£ the Senate and I presume the House~
Mr. MILLER. Maybe the semantics are causing confusion. The President had requested us to take action to deal with the dollar which is a
matter within his proper authority. It may be too much was covered
in one press release. I must say it's a happy day for the Federal Reserve when, instead 0£ being criticized for monetary policy, the White
House is commending it for responsible policy.
Senator ScHMITT. I have no problem with that. I do have some questions about whether it was a wise action, but nevertheless, that isn't
what bothers me. What bothers me is that the White House either
doesn't understand or has chosen to mislead us on their control or apparent control over the Federal Reserve System and I think your
statement has clarified that situation today and I hope that, once
again, as we said in your confirmation hearings, that the independence
0£ the Federal Reserve is something you will continue to protect.
Mr. MILLER. Senator Schmitt, there were two kinds 0£ actions by
the Federal Reserve. First, a series 0£ decisions by the Federal Open
Market Committee, which is the forum £or dealing with the international Swaps with operating interventions. That Committee was involved in the decision to increase the Swap lines with Germany and
Switzerland and Japan and to activate the Swap line with ,Japarn The
decision 0£ the Committee was unanimous. Except for myself and Governor Teeters, the members have been on that Committee for a long
time, predating the President. I don't see how the President could
control them since my calling them and bringing them to Washington
was not within his knowledge.
,
Second, the action on the discount rate and the reserve ,requirements was taken by the Board 0£ Governors. It was unanin;ious, and
it involves Governors with lonf! service who cannot be inflHPnced by
the President. So I think our independence is well established.
I want to repeat those things because I want to reassure you of-Senator ScHMITr. It may be well established in vour mind and in
mine and others, but it certainly was not well established in the mind
of Frank Moore or in the press conference that the President called.
Mr. MILLF.R. Don't forget, I have written on mv mirror at home
that "The Federal Reserve is a creature of the Congress." I don't
think the Chairman was listening; he's supposed to listen when I say
that.
Senator SCHMITT. There's some question down on Pennsylvania
Avenue about that.
Chairman Miller, do you think that it's really possible by sometime
next year to see a 3- or 4--nercent decline in the inflation rate~
Mr. M1LL'ER. Three or four, no.
Senator SCHMITT. Well, you said 6½ to 7.
Mr. MILLER. I said 63/4 to 7½ against an inflation rate this year of
about 8 percent.
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Senator ScHMITr. Against the average inflation rate for this year j
Mr. MILLER. Yes.
Senator ScHMITr. But the inflation rate of the last month or two
is over 10 percent, is it not?
Mr. MILLER. The inflation rate overaU for the third Quarter using
the inflator is '7½ percent. Don't mix that up with the CPI. The Consumer Price Index in the third quarter was 9 percent, as I recall. But
looking at the total economy, not just consumer spending, the-Senator SCHMITT. Let's take the Consumer Price Index, which is
what most consumers have to look at at the grocery store and elsewhere.
That is rising. Do you think that that can be reduced over the next 12
months1
Mr. MILLER, It can be reduced, but I don't think it can be reduced
3 percent. In the first quarter, the CPI was up 9.3 percent; in the second quarter, 11.4 percent; and in the third quarter, 7.8 percent. So
the third quarter is the latest data we have. It's 7.8 percent. I don't
think it will be reduced more than-Senator ScHMITI. I think you're going to find many shoppers have
not seen any decrease. At least they don't perceive to have seen it. I
think that was a :factor in the election. I think it's going to be a
factor next year in the actions of the Congress. From what I hear, the
inflation rate of raw materials and other preprocessed components of
consumer goods are going up at a much higher rate than the Consumer
Price Index and that means another pulse of inflation in the Consumer
Price Index somewhere downstream.
Mr. MILLER. One of our charts-"Short Term Interest Rates and
Inflation"-compares the commercial paper rate with the Consumer
Price Index. You will notice how the CPI bounced up in late 1976
and 1977, and the steep increase of the Consumer Price Index in 1978,
with the dropoff in the third quarter. Part of that, as you know, is the
dropofl' in food prices as the harvest came and some of the shortages
cleared up. But other factors, as you point out, are continuing to rise.
I would not want to mislead you. I don't think any index of inflation
is going to come down by large amounts in 1979. I have said that if you
start with an inflation rate measured at about 8 percent on the inflator,
you're talking of 5 to 7 years to get it down to 2 percent. I have no
thought that we could bring it down instantaneously. I wish there
were a simple way.
Senator ScHMITI. I just want to be sure we are not misleading people about what's going to happen in the grocery store. You talk about
an inflation rate of 6 or '7 percent. That isn't what the homeowner has
seen or the shopper has seen, and I think it has to be very clear that
it's not going to be easy-it's not going to be easy at all over the next
12 months to see any significant decrease in the inflation rate in the
Consumer Price Index.
·
Chairman Miller, the President has proposed a concept of wage
insurance. Has the Federal Reserve begun to look at that in terms of
its economic impact and particularly its impact on inflation?
Mr. MILLER. We have just begun to study it. We don't know the
details yet, and until we know how it will be capped, how widely it
will apply, and what its conditions will be, w_e are a little at a disadvantage in trying to evaluate it. But as soon as we have the details of
the proposal we will see what we think the impact will be.
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170
Senator SCHMITT. As soon as you feel comfortable in doing so, would
you inform the committee of your analysis on that?
Mr. MILLER. I would be delighted to. Going back to the CPI, I was
showing you all items. Let me break out food, just to show you the
problem. Food was up 16 percent in the first quarter; 20 percent in the
second quarter; but only 3 percent in the third quarter.
Senator ScHMIT.r. Aren't you concerned that that's an artifact based
on the trends that we have seen?
Mr. MILLER. The high meat prices in the first and second quarters
were offset somewhat by the more plentiful supply of other foods, including fruits and vegetables. I just want to confirm that when you
talk about grocery prices you're talking a component that's rising
faster than the overall CPI. Gasoline and fuel oil prices were also quite
heavy in the third quarter, 12.5 percent. I give you the overall rate of
7.8 percent; some of the components are very volatile and move among
quarters very rapidly.
Senator ScHMITT. I realize that, but I just want to be sure, as I
said, that we don't mislead-that the apparent inflation rate is going
to look very high until we do take some positive, longer-term actions
and see the effect of those longer-term actions. The short-term things
that we're talking about really is 1 percent maybe.
Mr. MrLLER. There's no one basic inflation rate; that's correct.
Senator SCHMITT. Thank you.
The CHAIRMAN. Chairman Miller, you will be joined I understand
by a new member of the Federal Reserve Board shortly. We have a
vacancy with the resignation of Governor Jackson, a man whom we
all respect and admire. I think he's done a fine job. I do hope that you
will do your best to see that you get an expert in monetary policy. I
think that that's the name of the game as you know now so well, and a
top flight economist who can add to the expertise of your distinguished
board. Can you give us any hint or any indication of who you're
looking for, what decision you may have made, who it might be?
Mr. MILLER. It will be a decision made bv the President, but I certainly hope we will have a highly qualified Governor, and I will point
out that we need to have full strength in these difficult times. It will
be hard to replace Governor Jackson, but we will do our best.
The CHAIRMAN. Chairman Miller, economists at Chase Manhattan
Bank have done a statistical study of the currency composition of the
extern:i l portfolios of European banks, which shows that diversification of foreign currency holdings out of dollars and into German
marks, Swiss francs, and other nondollar assets is "a major force
behind the dollar's current decline." They point out that the huge
dollar holdings abroad plus the trend toward diversified currency
portfolios in times of dollar instability imply that "when the dollar
gets into trouble, the trouble is going to be serious. International investors are going to diversify away from dollars as soon as there is a
hint of trouble and, to the extent this occurs, the dollar problem may be
magnified and the role of the dollar in international finance reduced."
What concerns me most is that the response at Treasury and the
Federal Reserve to this problem is all too likely to be to push interest
rates still higher and pile up more and more foreign currency debts.
w·e are :falling into the trap of letting the asset preference of foreign
bankers determine the health of our economy. Foreign bankers love
1
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171
to see the United States have high interest rates so their dollar holdings will earn more.
How oan we prevent foreign hankers from holding the doHar
~ostage, pressuring it at will by diversifying their assets or threaten~ng to do so, thereby pressuring the Federal Reserve to raise U.S.
mterest rates and depress our economy? You have climbed on that
merry-go-round already. How do you propose to get off? Are you content to let foreign bankers set U.S. interest rates?
Mr. MILLER. The problem, of course, of excess dollar holdings in
~he world comes from a long stretch of years of running deficits. Dur~ng a certain period of time when we had a trade surplus, a deficit
m certain of our accounts helped to recapitalize Europe and other
parts of the world. But the continuation for ,a generation of excess
dollars in the world has resulted in the "chicken coming home to
roost." We are faced with the long-term difficulty of reducing the
number of dollars, and when we do so I don't think we can control
the probability that some holders of dollars will want t;o diversify
their assets.
The CHAIRMAN. So the situation might get worse in the future than
it already is?
Mr. MILLER. No. We have seen some shifts, but as we demonstrate
our progress with the fundamentals of inflation and the current account deficit-which will be reduced next year-we will make it
through this period and see stability.
What we must do is commit ourselves to 5 to 7 years of proven
policies which don't generate a new set of problems by throwing out
a whole new flood of dollars.
The CHAIRMAN. Well, my question is, how big a role would high
interest rates have to play in that? Can we do that without having
interest rates that are close to historic highs?
Mr. MILLER. Interest rates, in my opinion, are influenced mainly
by t:he rate o-f inflation. Are they hig-h or are they not? One of my
charts illustrates that in real terms the rate for mortgages is lower
now. If you have an 8-percent inflation rate, it's not unusual to expect
something like 11 percent as the price o-f money. The real rate of
interest o-f 3 percent today is rather consistent with the past.
The CHAIRMAN. You made me a little hypnotized on that. As you
recall, ,after World War II we ha:d a period in which inflation
was serious and in which interest mtes were extremely low. This
can happen. After all, vou say an invPstor will insist on some kind of
a premium plns inflation. lle mav not have a choice. If you're sittill'g
there with $100 in cash or $100,000 in cash and interest rates are lower
than the inflia,tion rate, what do you <lo with it? You ,don't have much
o-f a choice. Mavbe you can put it in gold and mavbe that will go
down. Maybe you crin put it in real estate rind what will happen to
that? It's not as if the investor can command higher intPrPst mtes.
Mr. Mu,LF.R. Mr. Chairmrin, historv shows that if there's not an
adequate retnrn on capital for a significant period of time holders
of canital hide it in rPal goods of one form or another. At the time
of the French Reviolntion the French currencv was debased. The result,
of course, was complete destruction of the monetary system with
enormous consequences.
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172
We could h~ve the same thing here. We could get lower interest
rates by floodmg the country with dollars and by paying the piper
later, to the great detriment of all of us. None of us must be tempted
by that solut10n. Interest rates, in the meantime, will continue to be
nominally high as long as infliation is high.
The 9HAIRMAN. I_ thin~ you're_ right. There undoubtedly is some
connection between mflat10n and mterest rates. I just don't think it's
so absolute and complete and I'm just hopeful that the efforts to improve the dollar will not result in interest rate policies that will tend
to slow the economy excessively.
Now let me as~ you about another issue. During the past 4 years
the Federal ~efic1t has been over $200 _billion, but 3:s you said earlier
that does not mclude all agency borrowmg nor does 1t include borrowing back the Federal loan guarantee. So the Government's effect on
the credit market is understated if you just look ,at the deficit.
Should we have a total Federal aggregate and an actual credit budget
so we can better control the Federal Government $hare of borrowing
in the credit market or at loost have a better idea of what's going
on and recognize what influence we are having?
Mr. MILLER. Yes, I think so. I think Congress should be looking at
the other figures and not just look at the deficit.
The CHAIRMAN. We haven't been looking at this. We primarily look
at the Federal debt and the deficit grows out of the budget and not all
the other elements.
Mr. MILLER. I think it's important. There's just as much effect from
demand for Government credit through agencies as there is from
the Treasury.
The CHAIRMAN. In all this discussion there's been very little questioning about what I think puzzles many people about our current
situation. We still have manufacturing capacity utilization rates far
below the peaks reached in previous expanf)ions. We have 5.8 unemployment which is far above what it has been in the past when _we
had serious inflation as 'a result of shortages. We have had no sign
that I know of of labor shortages. Real GNP is growing at 3 or
3½ percent rate.
So there's still plenty of slack in the economy. ~iven ~hose _conditions, why is inflation getting worse and where 1s the mflationary
.
pressure coming from?
Mr. MILLER. The inflationary pressure has com{\ from a series of
elements, in my opinion. I do think go,:ernment deficits have helped
increase demand, to my mind to the pomt where we are _at_ the _level
of relatively full utilization of economic resources as d1stmgmshed
from physical resources.
The CHAIRMAN. Your own Federal Reserve figures show about 85
percent for utilization.
Mr. MILLER. I said economic as distinguished from physical. The 85
percent figure is the physical capacity output, but m~ny of the_ currently unused facilities in the TTnite<l States are marcnna~ and ~i.~?er
costs come into play as any business begins to use up all of its fac:hties.
The CHAIRMAN. Why doesn't the_ Federal Reserve Boar1 give us
capacity utilization figures then which measure the economic factors
here and give us a better picture?
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173
. Mr, ;MILLER. I wish we could. I don't think we have the basis yet for
obtammg data on the cost of capacity.
Mr. Chairman, you also must realize that in some industries we
have high utilization. The steel industry is being very highly utilized
right now, at well above 90 percent of capacity. At that level, that
industry is up against considerable limits on its economic capacity.
The CHAIRMAN. Mr. Chairman, you know perfectly well the way
steel has done their prices. They have raised their prices when they
have been operating at 60 percent capacity. They don't seem to pay
attention to supply and demand in that industry. One firm will raise
the price and within 24 hours they all go to the same price or within
1 percentage point.
Mr. MILLER. Commodities always sell at the same price; it's true.
The CHAIRMAN. They move in remarkable concert.
Mr. MILLER. All commodities tend to. But you know the factors that
have led to inflation. Once you start on a course of inflation you create
structural inflation. Fifty percent of the income recipients in the
United States are tied directly or indirectly to inflation. As inflation
goes up, compensation costs go up. We know we have legislated in
costs, some of which we talked about today. We know the decline of
the dollar has added to inflation. We know the OPEC cartel that is
able to impose higher petroleum prices adds to inflation. And we know
that the fact that we have poor productivity gains with high compensation increases adds to prices and costs and inflation. We know
that government spending has added to inflation. We know money
has been growing more rapidly than we like.
We dampen the economy as we have been doing in order to wring
out these inflationary forces. Inflation is a combination of factors and
it's going to take a combination of policies to wring it out. Monetary
policy cannot do it alone, but we can do it if we continue to get
cooperation. I think many of the things you advocated, Mr. Chairman, are becoming more and more recognized in Congress; there certainly has been a trend in the right direction, a different fiscal policy.
Senator Garn mentioned that every politician this year, Democrat or
Republican, was a fiscal conservative. That can't be bad; and if they
vote that way next session that will help.
I would like for us in this country to believe in ourselves a little
more. It's been a trying time; it's bPen II difficult time. When I came
here the problem looked insurmountable. We have made some progress.
We have done so with less discord and disharmony than might have
been exnected. I believe if we keep at it and show our determination
and willingness and persistence and stick-to-it-iveness, we will wring
inflation out. But it's going to take a while. It's going to take courage,
and it's going to take persistence, and it's going to take understanding.
I hope these charts help us to get a better view of the total picture
and to realize it isn't just monetary policy-it isn't just any one
sector-it's what we can do in total.
The CHAIRMAN. Well, Mr. Chairman, several times today you have
said we have made progress and I think in some areas not related to
inflation we have. but in the inflation area I think you're very, very
hard put to show that we are making any real progress. Mavbe in the
last couple of months it's a little better, but that's because of the volatil-
36-066 0 - 79 - 12
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174
ity of food increas~s. At J.w,: ritt~ the point of my question is that I
hope ;you recognite th~t {ij 'iliity have something aside from demand
inflation. We nave a..cmrls-tiij~:li H:iflation, wage increases exceeding productivity inc~e9:se.s bt6i;ij,~11dpu~ amount, poor pr?dlictivity performancei plus mcreRfl~ ' fbdi;l prices and energy prices.
Mr. MrttER. You're a~
right. Until fairly recently the inflation of the last few. yearij, ··~·,.~ eep. more cost-push than demand-pull.
Only recently hav~ we.
~; ntp demand-pull factors.
The CHAIRMA~. ~d\t . tiff; cdnclude by saying once again that I
think you have done It'
jbb here. You have a very impressive
grasp of all the ec0Mmr1 lttfors involved. I think we have all been
very _im. pressed, btit.riie,, :.t: k,. ohce again? these ~anges are excessive.
Particularly'when)tou:f. ,,, ti your·own child I thmk y~m should have
a much more precise rtili ,J, ltn the range you have given us for M1.
You at.e establishing ~lli- ·.
;tot giving projections. I would hope that
you coulcj. narrow t,hat; , ij: hitlf' of 1 percent range at the most and
maybe you earl giv.e us ·I J>Mlflc target for something that's your own
baby.
. . ·i ..
Mr. MiLLlliR, Mr, dh~li'!Hit:h, we need to get into the range first, and
then we cil.n narrow·it, ·, •·• .· ; , .
The CH.AIRMAN; :Tha~·.titl :very much.
The committee ~'ill st·. ~ajourned.
[Whereupon, at 12 :ff ,Hi,; the hearing was adjourned.]
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~t,iy
~ii ~'.·ataI
':i,
175
ADDITIONAL STATEMENTg AND lliTA
FLEXIBLE EXCHANGE l'l&TES llliD lftC
. . Vi ■ 11d
Octobet 1978
Ta: U.S. SI~
Massach~Mttt Institute of
1ncpe.rienc111
This paper sets out the background
c:011r8ll made
The evaluation of
with floating rates.
It ill
difficult by the fact that there i~ no obvious
for this reason that the lllOSt practical way of
···•~ :\uk is
to
/J1:\·1' .'·
I would include among these k
look at key issues.
Ji \r;l)e· foll.owing:
., ,,
exchange rates and the
'
J ,'
~.
~1)!fll••
1
.rtttli
anli
i'i,·
account
international patterns
adjustment, predictability and stability of exchanae
11f ~p,~1jtic
Part I of this paper reviews in some detail the
economic scene in the reference period.
Here we
IJII\ICro-
lQDJi··~~·:th~· cpuri~ ot
'I-' '!'
economic activity and at policy initiatives in the
policy.
U~H ·,Qf iatiillHis .. tion
riJ-r,.11
Part II deals with the behavior of exchaqga
accounts and reviews key issues.
llnd
Part III p~·opose$ ' ~~l~py
the aii:ternd
ll)ill
for
the medium term.
I.
THE
us
HACROECONOMIC E.WERIENC~
HH:..,l~
'
,
'
~
The period since 1973 has been marked by aver)( HMppi;i:\nting macroeconomic performance.
Inflation has been high anli, ~P,~~
rf\er the .l>oom yea-r
of 1973, the economy moved into the sharpest rece,i;i,J\ ~I) fPi:ty years,
covery from the recession has been steady but v11ry
between inflation and unemployment remains ve-ry
remains de~ressed, and productivity growth has
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fl~,ll'f fft118,·
fhe tr11de-off
UllfJVf:IJl1~te,. fnvestment
dce}iP,jtg/
Re-
176
1.
An Overview
Chart I summarizes the macroeconomic performance in terms of two key
indicators -- Okun's discomfort index and the real value of the stock market.
The real value of the stock market shown here is the Standard & Poor
composite stock price index deflated by the GNP deflator.
It thus expresses
the real value in terms of output of the nations' capital stock.
That value
has sharply declined since 1973 -- a decline of almost fifty percent by the
time the economy had reached the 1975 recession bottom. While there has been
some recovery in 1975/76 it has not been lasting.
In summary the real value
of the stock market is much below its level of the early seventies or the
1960's.
This is of course a striking fact since the capital stock has been
growing and technology has improved.
It is more than anything else an in-
dicator of an unpromising outlook for the economy.
Okun's discomfort index is calculated as the sum of inflation and
unemployment.
The Chart shows the sharp deterioration of macroeconomic
performance (and comfort) in 1974/75 as inflation and ~nemployment both
increased sharply.
There has been an unquestionable increase in the under-
lying rate of inflation.
Nevertheless much of the rcn-up of 1974/75 proved
temporary and has since subsided.
The same is true for unemployment.
Even
so, however, we find ourselves at present with an uncomfortably high rate
of inflation, the possibility of acceleration and a rate of unemployment
that is too high -- although it may be "normal" -- to undertake deflationary
policies.
The change in economic outlook is shown in Table 1 by a comparison of
subperiods during the last twenty years.
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177
%
105 t - - - \ - - - - - - - - - - - - - - - - - - - - - - - - l 1 8
/'-.,
I
/
'
\
\
t---~---+---_;____________-J16
95
/
1
I
\
'
I
Okun's Discomfort Index
(Right Scale)
I
~:--__________jl4
i-----:..;--,...----__;,
85
I
I
Real Stock Harket Prices
(Left Scale 1973=100)
I
55
i--..--------- -------------~
I
1973
1974
1975
1976
1977
1978
Note: The Okun Discomfort index is the sum of the rate of
CPI inflation a.d the unemployment rate for males 20 years
and over.
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CHART 1 INDICATORS OF ECONOMIC PERFORMANCE
8
GNP Growth
1957-j?
~.1
1~61-11
197:1-71
ll,1
1.2
Productivity Growth
4.2
4.0
2.9
3.9
2.9
1.5
5.0
2.0
1.3
rates. The unemployment rates
20 and over respectively.
-:t:
',, .J.t-:J
trl tlllli
and ittiW
l~~
consider the experience in more detail
thi -~1ative
...
macroeconomic policies and external shocks •
~
2.
irhe 1~tli 1
~i
wit~
:ij~rij~tt_up_·•, -
:r1~•7·d2_·,i,:.¢~\;~~-•,
ur
,
3
~
e
ii
t ~:ning
.... ·. i: 'f;.ti,\~
and deficit iinance of the Vietnam
~rought the economy Leyond full employment.
the revised and more conservative estimates of
the l::EA, hill~ \'"liijliided and 011erutilization ran to half a percent of potential
outpUj:,
1iit!h~,:L6t'·,rose from only 3.3% in 1972 to ,;.2% in 1973 and thus
;iiiji~ili½ib1 change in the policy priorities.
poil~f ~b~~ toward a tightening stance.
mark~ e
fiscal
Both monetary and
'· i. ~. -: ~ '.:~
Tablia 2
t:lil\t~i\tti) of monetary and fiscal policies in 1973/74 is shown in
,nJ j ~h~~~ ri review indicators of monetary and fiscal policy.
Monetar)'
·•i:-olilb
'rite
in thil.rllicoli'•k-~
:
~kit
ha_d been ample during the period of price controls
~~b~ .thie
i ·;' . :· ,:,-
~ ••
69/70 recession tightened substantially.
Short-
term :l.ntei'ul \'ttte!i increased by more than two hundred basis points.
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TABLE 2:
Nominal Monetary Growtp
Ml
M2
K3
7.1
6.2
5.0
4.4
10.6
a.a
!!Ill!
lnterest Rates
l(TB
RAAA
12.i
.• ~.Q
7.5
9,1
p
7.4
7. 7
7.~
?,9
ll,1
s.~
5.7
8.3
10,9
12,8
5,0
1977
7.9
9.8
5.6
6,9
8.3
11, 7
7, 7
p
1978/I
1978/II
6,5
8,6
8.8
8,4
8,0
8.7
9,0
7,4
8,7
1970-72
1973
1974
1975
1976
9.5
I
6,4
8,P
1978/III
Note:
All numbers are average annual pfrc1111t111111 f11.f11 8 ,
Fiscal policy behaved much in the eame llll!ll!llll:,
After a fisc&l expansion
with a widening full-employment deficit in ?117~·wp find a reduction in the
full-employme»t deficit and, indeed, an act411t ~11rpl11s
tor
the consolidated
public sector.
TABLE 3:
GNP~
(%)
1970-72
Fiscal ~~He~
~
ljudg!!t~
Actual (BiH $) · H,li;,
., ,p
QovAment Budget Sur,>lus
4as % of GNP)
1973
1.5
-.6
-17.1
-6. 7
1974
4.2
1975
1976
8.7
6.5
5.3
-10.7
-70,6
.. 2.,3
-4.2
-)3.8
.. ~p.6
-48.1
.. a~.s.
-2.0
-1.1
1977
I
•
,.1
-4,6
.-1.0
.5
-.2
Note: Gap is the GNP gap using the Council o,f ·~po~ppiic Mvisors' estimate.
The Federal Budget Surplus is measured on·a qaflpn,l income accounts basis
(actual) and a high employment basis (H,E,),'. f~p Govsrlllll"nt budget surplus
in the last column measures the consot;l,daUd ;Civeril!llent, see tor surplus; including state and local governments,
·
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180
Given the sharp increase in inflation in 1973 and the fact that the
economy was at full-employment, if not beyond, one can hardly take issue
with a move toward more restrictive policies.
Furthermore the fact that
both monetary and fiscal policy turned to a restrictive stance was a notable
exception to the historical record.
If it had not been for the supply
shocks of the year that reduced external demand, raised inflation and
disrupted economic activity we might now take the view that the policy mix was
altogether appropriate.
As it turned out, of course, the external supply shocks in commodity
markets and the OPEC oil-shock brought about a sharp reduction in real
aggregate demand along with an adverse shift of the aggregate supply schedule.
Real aggregate demand declined because fiscal policy failed to offset
the "overtaxation" that inflation brought about in the presence of progress-
ive taxation on nominal income and inappropriate accounting techniques in
the corporate sector.
At the same time monetary growth was insufficient
to make up for the high inflation so that the real money stock declined
sharply.
Table 4 summarizes the facts about inflation, GNP growth ~nd real
money growth for the period.
TABLE 4:
There is no need to allocate the cause of the
Inflation, Real Growth and Money Growth
GNP Growth
Inflation
Real Money Growth
1973
5.5
6.2
1.2
1974
-1.4
11.0
-4.9
1975
-1.3
9.1
-4.5
1976
6.0
5.8
-0.7
1977
4.9
6.5
0.7
Note: Inflation is measured in terms of the CPI. Real money growth is
the growth rate of M1 deflated by the CPI, 1972 = 100.
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181
subsequent steep decline in economic activity to fiscal policy, monetary
policy or the external shocks.
The fact is that the economy moved rapidly
into a deep recession without policy makers being particularly aware or
responsive to the deterioration.
3.
Recession and Recovery
The peak of the expansion of the early 70 1 s is dated November 1973.
The
slide into the recession took up the period from November 73 to the trough
in March 1975.
Unemployment increased sharply reaching an extraordinary 9%.
Inflation continued to increase in 1974/75.
through 1975.
Monetary policy remained tight
Fiscal policy in 1974 moved to a further tightenin~ in the
failure to offset the inflation effect on real tax burdens.
the recession while it was well underway.
move toward fiscal expansion.
It thus deepened
Only in 1975 do we see a decided
On a full-employment basis the federal deficit
swinga by 25 billion, while the actual deficit increases by as much as 60
bill.!,:,n.
The large actual deficit of the government sector
4.2 as a per-
cent of GNP -- of course signals to a significant extent the slack in
economic activity rather than discretionary fiscal policy.
The fiscal expansion in 1975 no doubt helped the recovery.
a substantial, unanticipated decline in velocity.
So did
The demand for money
[M1 ] declined relative to money income more than can be accounted for by
the normal cyclical movement of velocity.
The traditional money demand
equations overpredicted money demand and the economy had the benefit of what
Okun has called the "velocity bonus",
Even though monetary growth was
deliberately kept low -- below the rate of inflation as Table 4 shows
economic activity recovered along with declining interest rates.
The velo-
city bonus was an essential aspect of the recovery and brought about a
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182
precarious reconciliation between the monetarist in~istence for low nominal
1110ney growth and the need for an expansion in real economic activity.
The
bonus was so timely that it has been suggested that the Fed deliberately
and consciously instituted a host of M1 saving regulations so as to reduce
M1 demand and foster an expansion even with low M1 growth rates.
In 1976 and early 1977 the real expansion continued, along with a decline in both unemployment and inflation.
The real stock market picked up.
Economic management was in the pleasant position of charting a recovery
course with sufficient scope for expansion before the inflation unemployment
trade-off came to dominate. That issue was reserved for 1977/78.
slightly increased, unemployment had declined very substantially.
now surfaced in the discussion:
Inflation
Two issues
First, would continuing fiscal ease bring
about crowding out and impinge on an already poor record of private investment?
Second, what ~as the level of full-employment and what rate of
unemployment should policy makers set as a target?
The discussion over the natural rate of unemployment was widely shared
and led to a considerable consensus.
The 4% natural rate that the CEA had
targeted in the 60's was no longer appropriate.
It could no longer be
reached in view of a slow down in productivity growth, in part due to the
oil shock, and a changed composition of the labor force.
of unemployment increased to a range of 5-6%.
The natural rate
The great uncertainty that
surrounds the estimate of the natural rate, of course, could not fail to make
expansion policies more timid.
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183
The question of fiscal policy continues to be very active.
The incoming
Carter administration had scheduled substantial tax cuts amounting to a two
year$ 31 billion package.The continuing strong expansion in early 1977 and
the desire of a budget balanced around 1980 led to a reconsideration and a
much more modest tax package in 1977.
out.
For 1978 much the same prospects stand
Ambitious tax reform is gone and the preferred tax package -- roll-
backs of social security taxes and other price increasing measures -- seems
barred.
All the administration can hope for is that the tax package is either
so wild that it can be vetoed or else so modest that it maintains revenues
for anti-inflation policies next year.
Much of the economic policy action has been in the field of monetary
policy.
In 1975 the Fed, under congressional direction, adopted monetary
growth targets.
Table 5 summarizes the targets and the performance to date.
While in the early part of the recovery monetary policy was broadly in the
target ranges this has ceased to be the case.
Monetary growth since the
second half of 1977 has been increasing [for~] while the monetary growth
targets have, of course, been kept down so as not to add fuel to inflationary
expectations.
The Fed is once more facing the cyclical dilemma of rapidly
rising interest rates and rapidly increasing monetary growth.
TABLE 5:
PERIOD
Monetary Growth Targets
Ml
Actual
Target
M2
Target
Actual
76/2 - 77/2
6.6
4½-7
10.7
7½-9½
76/3 - 77/3
7.8
4½-6½
11.0
7½-10
76/4 - 77/4
77/1 - 78/1
7.8
4½-6½
9.8
7-10
1.s·
4½-6
8.8
1-9½
4-6
8.6
q~
77/2 - 78/2
77/3 - 78/3
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7.9
4-6.5
6.5-9
184
Since early 1977 we have seen rising interest rates.
rates increased by nearly
three hundred basis points.
have increased by more than fifty
basis points.
Short-term interest
Long-term rates
While the Fed has
allowed substantial monetary expansion, it certainly has done so along with
sharply rising interest rates.
The traditional bite of interest rates,
through disintermediation, is alleviated through special funding arrangements for S
&
L's, but also through the baby boom and inflationary expecta-
tions in the housing market.
TABLE 6:
1977/1
Interest Rates in 1977 /78
1977 /2
1977 /3
1977 /4
1978/1
1978/2
1978/3
Fed. Funds
4.66
5.16
5.82
6.51
6. 76
7.28
8.02
Aaa Utility
8.17
8.21
8.09
8.27
8.70
8.98
B. 71
4.
The Outlook:
The stance of monetary policy is so essential in the current phase of
the :.,1siness cycle because the right monetary/fiscal policy mix is important
for a continuing expansion with high investment and a deceleration of infla-
tion.
Briefly, the key issue is whether fiscal initiatives can be used to
slow inflation -
along with a good performance of food prices -- so that
monetary policy need not tighten further and become a m>re serious impediment
to investment.
Unfortunately the outlook for a favorable monetary-fiscal
policy mix are entirely dim at present.
The "official" economic outlook for 1978/79 is summarized below:1
1 s,e Survey of Current Business, July 1978. The current account forecast comes
from Morgan Guaranty Trust Co. World Financial Markets, September 1978.-
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185
TABLE 7:
The Outlook
1978
1979
Real GNP
4.1%
Inflation ~Pn
6.8%
4.3%
6.4%
6.6%
6.5%
Unemployment
Current Account Deficit
19.0
10-11.0
($Billion)
There is of course considerable disagreement that surrounds this
forecast.
The brunt of the disagreement runs to the effect that inflation is
likely to be higher, in the 7 to 7½ range perhaps. 1 Real growth prospects are
viewed with skepticism and many will argue that growth in the 2 to 4 percent
range is quite likely. Unemployment in 1978 will be around 6-6.2 percent but may
fise more than the forecast allows for if growth turns out to be low.
Finally as to the current account there is a very substantial range of
forecasts.
The broad consensus is of course to see an improvement, both as
a consequ~r.ce of reduced domestic growth and perhaps increased growth abroad.
More importantly, the sharp real depreciation of the dollar in the last year
is expected to bring its fruits over the next year and contribute toward an
improved external balance.
1The Wall Street Journal reported on October 3,1978 that the Council on Wage
and Price Stability perceives an underlying rate of inflation that is accelerating
with non-food inflation thus far at over 8%.
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II.
THE BALANCE OF PAYMENTS AND THE EXCHANGE RATE
In this part we study the external developments and attempt an explanation
of the evolution of the balance of payments accounts and of the exchange rate.
In a first section we summarize facts about developments in the nominal
and real exchange rate.
accounts.
The next section reviews the balance of payments
The analysis is combined in section 3 where we explain the
evolution of net exports in terms of growth patterns and changes in
competitiveness.
1.
Exchange Rate Developments
Chart 2 shows the evolution of the real exchange rate. The numbers
shown there are multilateral effective exchange rates for the dollar adjusted
for divergent movements in wholesale prices.for manufactured goods. The Chart
suggests two important facts.
First, we observe the major real depreciation of the dollar in 1973.
Next it is important to recognize the subsequent appreciation of the dollar
in real terms on several occasions but in particular the sustained appreciation
from late 1975 until early 1977.
Table 8 summarizes the movements in effective nominal and real exchange
rates.
It documents a substantial nominal and real appreciation of the
dollar for 1973/III to 1976 and a subsequent rate has had a very moderate
nominal depreciation of about 1.5 percent.
however, continued to depreciate.
The real exchange rate has
The precise estimate of the real depre-
ciation differs, of course, depending on the price adjustments.
The range,
as shown in Table 8 is between 3 and 9 percent respectively for adjustments
with the WPI and the deflater.
The movement in effective nominal rates on
an annual basis conceals, of course, the very substantial fluctuations and
trend changes in the key rates of the DM and the Yen,
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187
105
Real Exchange Rate
(1975
=
100)
100
95
1973
1974
1975
1976
1977
1978
Source: International Monetary F•ond
CHART 2
Table 9
THE REAL EXCHANGE P.ATE
indicates that for the entire period 1973/74 to 1978/II the
nominal effective exchange rate of the US dollar has shown much less
movement (-3.1) than the corresponding appreciation of the OM (23.6) and
the Yen (27.4).
This of course indicates that the OM and the YEN were
at one end of the currency spectrum while the
us
occupied an intermediate
position with currencies like the Canadian dollar or the Pound Sterling
depreciating relative to the US while others, including the Yen and the
OM appreciated.
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188
TABLE 8 $- EXCHANGE RATE INDICES
(1975=100)
Effective Rate
Real Rate
Real Rate
(Nominal)
(WPI-Adjusted)·
(Def. Adjusted)
Indices (1975=100)
1973
98.6
98.2
104.8
1974
100.8
99.9
102.9
1975
100.0
100.0
100.0
1976
105.0
103.2
104.0
1977
103.8
100.9
102.4
1978/I
98.1
96.l
96.3
1978/II
96.6
n.a.
n.a.
1973/III-1976
10.6
' Changes
9.3
1976-1978/I
-6.6
-6.9
-7.4
1973/74-1978/I
-1.6
-3.0
-7.3
Source:
n.a.
International Monetary Fund
TABLE 9
COMPARATIVE NOMINAL EXCHANGE RATE MOVEMENTS (\ CHANGES)
DM
DM/$
YEN
YEN/S
1973/III-76
10.6
3.4
-4.9
-6.1
-10.6
1976 - 1978/II
-8.0
14.4
21.2
31.4
34.4
1973/4 - 1978/II
-3.1
23.6
26.1
27.4
27.4
$
Note: Colwnns one, two and four show multilateral effective exchange
rate movements. Columns three and five show bilateral exchange rate
changes. A minus sign indicates a depreciation.
~ : International Monetary Fund
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189
TABLE 10
Cl!l\NGES IN NOMINAL AND REAL EXCHANGE RATES:
us
GERMANY
1973/74 - 1978/I
JAPAN
Nominal
-1.6
24.7
18.l
Real Rate (WPI)
-3.0
3.6
-1.6
Real Rate (DEF)
-7.3
1.6
4.2
Source:
International Monetary Fund.
The striking comparison is of course that between nominal and real
exchange rate changes.
Table 10 shows the comparatively minor changes in
real exchange rates that accompanied the large appreciation of the Yen and
the DM.
This large discrepancy reflects the differentials in inflation rates.
Each of the countries shown had comparatively lower inflation rates than
partner countries and accordingly their relatively favorable inflation
perfo'='llance reinforced nominal depreciation or substantially offset nominal
appreci~tion.
The most striking instance is that of Japan where the real
excharge rate on a wholesale price basis actually depreciated despite the
substantial appreciation of the nominal rate.
2.
The Balance of Payments:
The balance of payments accounts for the last five years are shown in
Table 11.
Chart 3 supplements the table with details of the current account
evolution since 1970.
We note the growing tendency toward a merchandise
trade deficit and, an increasingly positive balance for services, mainly
as a consequence of a sharp increase in the dollar value of investment income.
The current account mirrors the major swings in the merchandise balance
and accordingly is in surplus in 1973-75 and has deteriorated since,
Net capital flows have been outward throughout the period.
The magnitude
of these flows has increased substantially as has the item "statistical
discrepancy."
36-066 0 • 79 • 13
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190
TABLE II
THE U.S. BALANCE OF PAYMENTS
(Billion
1973
$)
1974
1978
1977
1975
I
Merchandise Trade:
II
.9
-5.3
9.0
-9.4
-31.1
-11.2
-7.8
6.9
l. 7
18.4
4.3
-15.2
-
6.9
-3.3
Net Private ca2ital:
-8.0
-9.9
-26.8
-30.0
-17.0
-12.1
1.0
Statistical DiscreEan~:
-2.7
-1.7
5.4
9.3
-1.0
3.8
8.0
5.3
8.8
4.7
10.6
35.2
18.3
-4.6
Current Account:
Official Settlements:
Source:
Survey of Current Business, June 1978 and Economic Indicators,Sept. 1978
Note: Quarterly data are seasonally adjusted. Capital flows do not include government
capital flows.
-IOt------,l----t----+---+---+----+------,l---...+-1----1
Source: Economic Indicators,Sept. 1978
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CHART 3
THE US BALANCE OF PAYMENTS
191
The official settlements balance is a measure of the extent of
official intervention or managed floating.
over tqe period there has been
a substantial increase in liabilities to foreign official holders.
The
extent of intervention, of course, reached its peak in 1977/78 with the
UK, Germany and Japan all attempting to stem the appreciation of their
currencies.
There was no semblance of intervention to counter "disorderly
markets" but rather an outright leaning against the wind or trend.
The changing pattern of the trade balance reflects in part, of course,
the fact of higher oil prices.
Beyond that, however, there are no major
changes in regional balances.
Table 12 looks at this question and shows a
deteriorating balance with the OPEC countries.
The merchandise
balance
with Europe remains favorable, that with Japan continues to show a deficit.
A surprising development is the deterioration of the merchandise balance
with non-oil LDC~.
As we will comment below this reflects their growing
importance as suppliers of manufactures and as a new competitive force in
the world economy.
OPEC
Western Europe
Japan
1970
2.9
-1.2
.1
1.4
2.6
1973
1.4
-1.3
-1. 7
1.6
0.9
1975
9.1
-1. 7
-8.9
s.o
9.0
1977
5.9
-8.0
-22.9
-6.8
-31.1
Note:
NON-OPEC LDC
Rows may not add due to rounding.
Source:
Survey of Current Business
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TABLE 12
June 1978, Part II.
REGIONAL MERCHANDISE BALANCE
TOTAL
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Foods, Feeds
Beverages
&
Industrial Supplies
Materials
&
Capital Goods
Consumer Goods
Other
3.5
ExEorts:
1970
13.8
32.5
(5.2)
43.6
6.6
1973
21.3
27.8
(3.6)
40.4
6.7
3.7
1975
18.0
27.9
(5. 3)
44.2
6.1
3.8
1977
16.3
28.6
(5.0)
43.8
7.4
3.8
1978/I
17.6
27.5
(3.2)
43.8
7.4
4.2
1970
15.4
38.6
(8.0)
24.5
18.6
2.8
Im12orts:
1973
12.9
39.9 (12.7)
26.7
18.3
2.1
1975
9.9
52.3 (29.1)
22.6
13.5
1.8
1977
9.3
53.4 (31.5)
21.7
14.4
1.2
1978/I
9.5
49.3 (25. 7)
23.8
15.8
1.8
Note:
The third column, in brackets, shows the category fuels, lubricants, petroleum and products.
The category capital goods in the third column includes automotive vehicles, parts and engines.
Data for 1978/I are seasonally adjusterl.
Percentages may not add to 100% due to rounding.
Source: Survey of Current Business, June 1978, Part II.
TABLE 13
PERCENTAGE COMPOSITION OF US TRADE.
~
tO
t-:i
193
In Table 13 we review the connnodity composition of trade.
The major
change is again the large increase in the import share of oil products.
Their share rose from less than ten percent before 1973 to more than 251
after the oil shock.
For the remaining product groups the time period is
too short to observe any significant shifts in the connnodity c0111position
of trade.
There appears to be however a change in the group of foods,
feeds and beverages which have declined as importables and grown as
exportables.
3.
Explaining the Balance on Goods and Services:
A key question in the analysis of the US external accounts and in
the evolution of the exchange rate is the balance on goods and services.
We saw above in Chart 3 the goods and services balance near zero through 1972,
showing a surplus in 1973-76 and then moving into a very substantial deficit.
~-0
4.9
4.G
4.7
Log
Relati e Incomes
(Left
cale)
4.5
4.4
1
1
1
1961
1965
1969
CHART 4
1
1973
1
1S77'7
1
1081
RELATIVE INCOMES AND COMPETITIVENESS
Note: COlllpetitiveness is a 2-year moving average of relative wholesale
prices adjusted for exchange rates. Relative Inc0111es are measured
by the ratio of US to foreign manufacturing output indices.
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194
The main explanations for this pattern of the goods and service
balance derives from three factors:
i.
The development of the US competitive position in world trade.
ii. The relative rates of income expansion in the US and abroad.
iii. The real prrce of agricultural products which are a net export
good.
Appendix I sets out equations for imports and exports of goods and services.
These equations suggest the following points:
First, both exports and imports
are sensitive to the US competitive position, but in both cases the lags
are very pronounced with very little effect occurring in the first year.
There is thus clearly a J-curve.
Second, an expansion in US income, given
potential output, raises import demand in the same proportion.
An expansion
of income and capacity at the same ra~e implies a substantially higher income
elasticity of 2.5.
Third, a foreign income expansion raises our exports
by one half the rate of foreign expan~ion.
If both actual and potential
output rise abroad the export expansion is still only .85 times the
foreign rate of growth.
There is accordingly a very pronounced asymmetry
in the real income response of our imports and exports.
If domestic and
foreign income, actual and potential, expand at the same rate our goods
and service balance worsens substantially.
Table 14 and Chart 4 show the
services balance.
data for an analysis of the goods and
We show here indices for domestic and foreign income,
US competitiveness and the real price of agricultural products.
Competitiveness,
because of the adjustment lags, is shown as a two-year moving average.
Consider first the period to 1973.
Here the main effect is the very
substantial real depreciation of the US dollar since 1971.
From 1970 to
1973 the real dollar had depreciated by 17 percent and that depreciation
progressively showed
up in an increase in net exports.
At the same time
1973 shows a high real price of agricultural products and fast growth aborad
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195
YROW
YUS
(1967=100)
COMP
(1975=100)
RPA
(1972=100)
Net Exports
(Billion $)
1973
I
122.9
155.0
107.1
121.6
3.0
II
123.5
160.5
102.5
139.5
11.4
1974
I
118.8
161.7
100.2
lJl.9
6.8
II
114.4
154.2
99.l
122.3
5.3
1975
I
102.5
144.2
98.0
111.9
19.9
II
112.8
146.4
100.0
118.5
20.9
I
118.9
156.7
101.5
114.0
10.1
II
121.2
161.6
101.6
110.4
4.9
I
124.8
164.6
102.9
112.4
-7.2
II
128.8
162.9
102.0
101.3
-15.1
n.a.
n.a.
n.a.
109.1
-19.0
1976
1977
1978
I
Note:
YUS and YROW are output indices for the
us
and the rest of the world.
For YROW we have formed an index with the following weights: Japan 29.0%,
Germany 23.3%; France 18.0%, UK 11.3%, Canada 9.8%, Italy 8.9%. The underlying
data are compiled by the IMF. COMP is a 2 year moving average of the US
real exchange rate using the IMF multilateral, price adjusted effective rates.
The adjustment uses wholesale prices. RAP is the real price of agricultural
products.
TABLE
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14
DETERMINANTS OF THE US TRADE POSITION
196
relative to the US.
1973 is thus clearly the year where everything works
toward an external surplus.
Consider next the very substantial surplus in 1975.
Here we have to
look to the large decline in US output (17% since the second half of 1973)
with only a 10% decline abroad.
We also have to look to a continuing gain
in competitiveness as measured by the moving average which shows a 4 percent
gain since the second half of 1973.
Thus both the relative growth rates and
the change in competitiveness help explain the large 1975 surplus.
Finally we want to look at the sharp reversal of the goods 'IJ}d service
deficit in 1977,
First, looking at relative output growth we find for
the US an expansion of 26% for the period 1975/I to 1977/II,
expansion amounts to only 13 percent.
Abroad the
Second, we observe a deterioration
in the competitive position since the first half of 1975 of four percent.
Finally we observe a decline in the real price of agricultural goods.
All
three factors combine, therefore to give us a very substantial deficit.
1977 in that sense is precisely the opposite of 1973,
What are the prospects for the goods and services balance?
The
depreciation of the dollar since last year has reversed the loss of competitiveness that arose in the 1973/4-1976 period.
Real exchange rates constructed
by Morgan Guaranty suggest that from Sept 1977 to October 1978 the dollar
depreciated in real terms by almost seven percent,
There is thus a very
substantial further gain in competitiveness in the pipeline that should
make itself felt over the next two years,
The second important consideration
is the relative slowdown in economic expansion anticipated in the US and
the prospect for increased growth abroad.
The promise of substantially
higher growth abroad strikes me as unrealistic.
therefore stem from reduced growth at home,
The main effects must
Given the high value of our
income elasticity of import demand such a reduction in the rate of expansion
to the level of capacity growth may
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stop a further deterioration in the
197
external balance and perhaps help reduce the deficit.
A
word of caution, however is needed. The
difference in income
elasticities is so pronounced, and unfavorable to the us, that the growth
patterns which we are likely to observe -- three to four percent here and
abroad for actual output--, cannot make too much of a dent if any.
The
fact that the rest of the world, in particular Gerr:tany and Japan have set
lower medium term growth targets than their average in the sixties and
early seventies will prove a major constraint on US policies.
Table 14 shows that in the period 1967-73 growth abroad was more than
twice as high than in the us.
For the entire period 1960-73 the rest of
the world real income (using the weights described in the appendix) grew
at a rate of 6 percent compared to only 4.2 in the us.
For the period to
come growth of potential output abroad is estimated at 4.2 percent and
that seems a high estimate of growth performance abroad.
Accordingly there is
little prospect for a substantial divergence in growth rates given US
intentions or constraints to sustain growth at about 3.5 percent or above.
One must conclude, therefore, that an improvement in the US competitiveness
is required not only to close the present trade gap but in fact to prevent
it from widening.
I would go further to argue that the similarity of the
growth path in the near future requires quite possibly a continuing real
depreciation of the dollar.
4.
Exchange Rates, Inflation and the Adjustment Process:
Flexible exchange rates have changed
and unemployment.
the trade-off between inflation
Expansionary aggregate demand policies through monetary
or fiscal ease cause the exchange rate to depreciate thereby raising import
prices.
Import price inflation in turn affects domestic inflation rates
of the CPI through a variety of channels which we consider in more detail
below.
Flexible rates thus accelerate the inflationary impact of expansionary
policies before any expansion in aggregate demand can actually take place.
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198
They modify the inflation process from one that is governed by the level of
aggregate demand relative to potential output to one where import prices and
therefore the CPI become considerably more flexible and inflation can occur
even at high levels of economic slack.
There is a further complication that
arises from the possibility of shortrun J-curve effects on aggregate demand.
If in the shortrun an exchange depreciation worsens the current account so
that nominal spending on net imports increases, does this spending increase
occur at the expense of domestic output?
Is it thus possible that expansionary
aggregate demand policies have little direct effect on demand for
domestic goods but do have a substantial inflationary impact?
If so the
traditional case for stabilization policy-- sticky prices in the shortrun and
aggregate demand that is policy responsive--is exactly reversed.
Clearly the scope for stabilization policy under flexible rates is now
an empirical question.
We have to know by how much a depreciation of the
exchange rate by say ten percent raises import prices and by how much the
increase in import prices raises domestic inflation.
Secon~ ~e need to know
by how much the depreciation changes competitiveness and to what extent the
change in competitiveness affects net export demand.
In Appendix III we report some results for price equations of the US
economy.
We show there that a ten percent increase in import prices would
raise domestic prices--CPI or GNP deflator--in the current quarter by 1.5
percent and in the longrun by about 3 percent.
There is thus a quite sub-
stantial effect from import prices to domestic inflation.
To complete the
links we need to know the transmission from exchange rates to import prices.
Here a_reasonable estimate is a 2:1 transmission:
a ten percent depreciation
would raise import prices by about five percent.
These numbers clearly bear out the idea of an important inflationary
impact of depreciation.
They show also, however, that depreciation is still
a powerful way of changing relative prices.
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A depreciation changes import
199
prices relative to domestic prices and thus changes our competitive position.
SCllle of that gain in competitiveness from increased import prices is lost
through the spill-over into domestic inflation.
Most of it, though, is
preserved and helps achieve a longrun improvement in net exports.
The extent to which a change in competitiveness affects net exports
has been reviewed in the previous section.
We noted there that both exports
and imports are substantially responsive to changes in competitiveness and
that accordingly depreciation in the longrun helps improve the current
account.
In the shortrun, of course, the responsiveness of trade flows to
relative price changes remains small.
We conclude from a review of the relevant facts that for the US economy
exchange rate adjustment has an inflationary impact, that the inflationary
impact is not sufficient to to impair a substantial gain in competitiveness
and that the gain in competitiveness will in time yield an improvement in
net exports.
The US therefore can use exchange depreciation as a means to
increase aggregate demand and restore external balance simultaneously.
There
remains, of course, the question about the proper monetary/fiscal policy
mix that accompanies a depreciation.
To get some perspective on the inflationary or deflationary impact of
import price movements a comparison with the appreciating countries-Germany, Switzerland and Japan--is helpful.
Table 15 shows how in these
countries the absolute decline in import prices due to appreciation has
made inflation stabilization possible and certainly much less costly than
it would be in a depreciating country.
The strong asymmetry has suggested
the idea of a virtuous and vicious circle where appreciating countries
succeed in reducing inflation which in turn favorably affects their exchange
rate performance while the converse is the case for depreciating countries.
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200
TABLE 15:
DOMESTIC AND IMPORT PRICE INFLATION
GERMANY
Domestic
Import
SWITZERLAND
Import
Domestic
JAPAN
Domestic
Import
1975
5.9
-1. 7
6.7
-9.8
11.9
7.6
1976
4.5
6.7
1.7
0.4
9.3
6.0
1977
3.9
2.7
1.5
1.3
1.2
8.1
-4.2
-6.5
1.4
-10.0
3.6
-17.0
1977/78
Note: Domestic inflation is measured by the CPI. Inflation for 1977/78 refers
refers to the rates from 1977/II to 1978/II.
Source: Federal Reserve Bank of St.Louis and International Financial Statistics
The substantial impact -0f falling import prices on domestic prices
and export prices implies that in these smaller, open economies
exchange appreciation works mainly as an anti-inflationary device and
only to a lesser extent as a means to changing relative prices and
competitiveness.
This observation is reinforced by our review of
changes in real exchange rates in section 1.
III TOWARD A POLICY MIX
In this concluding part I will briefly make a case for a policy mix
that involves fiscal tightness, low real interest rates and a real exchange
rate that generates a full employment current account surplus.
If that
case is accepted then there is a strong case for allowing continuing real
depreciation of the dollar to achieve the gain in competitiveness that is
implied by the policy mix.
In Figure 1 we plot two schedules along which we achieve respectively
fullemployment goods market equilibrium, II, and a specified current
account surplus, EE.
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On the vertical axis we have the longterms real
201
interest rate and on the horizontal axis the real exchange rate which
serves as a measure of US competitiveness.
The II schedule is positively
sloped since higher interest rates reduce aggregate demand below fullemployment and therefore require a compensating improvement in our
competitiveness to maintain internal balance,
Along EE a decline in the
interest rate raises real aggregate demand and therefore generates a current
account deficit.
To restore the current account to the target level we
require a gain in competitiveness so that the external balance schedule
is negatively sloped.
The schedules are drawn for a given stance of fiscal
policy (say a full employment balanced budget) and given foreign incomes,
tastes and technology.
The equilibrium that reconciles the targets of internal and external
balance is at point A with interest rate R0 and the real exchange rate Q0 •
The real interest rate will in turn affect the compositL,n of aggregate
demand between investment and consumption and thus the grn,th prospects.
This is shown in the left hand panel where the growth rate of output is
shown as an inverse function of the real interest rate.
Corresponding to
the equilibrium at point A we have a real growth rate TI 0 •
The formalism of our model is deliberate.
It serves to remind us of
the key role played by interest rates and real exchange rates in determining
the longrun real structure of the economy.
Indeed, these two variables,
along with fiscal policy fully determine the allocation of resources
between goods, between sectors and across time.
It is thus a useful
framework to set out a medium term program for us policies.
As a starting point we look at Figure 1 where we show the current
equilibrium at point A' with economic slack, and a deficit in the external
balance.
Real interest rates are high.
Because of economic slack and
because of high real interest rates investment and real growth of potential
output and productivity are low.
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202
FIGURE l
THE POLICY MIX
Real Interest
Rate
E
Real Exchange
Rate
Growth
1T
0
0
Where is the problem?
The problem is an impr .:,per policy mix and an
inappropriate set of relative prices.
Fiscal policy is too easy and,
given overall 'fiscal policy, it has been favoring consumption at the
expense of investment.
Given the ease of fiscal policy monetary policy
has been relatively tight thus maintaining high real ·interest rates.
Finally there is a good chance that the real exchange rate has not
depreciated sufficently.
The proper policy mix then is to pursue an overall tightening of
fiscal policy and to redistribute fiscal revenue in a manner that will
favor investment, productivity growth and will tend to reduce inflation.
At the same time monetary policy should ease and the real exchange rate should
be allowed to remain at its present level or even deprE!!ciate.
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In terms
203
of figure l the policy mix should move us to point A.
Why is investment and growth in capital and productivity important?
I have argued above that the important change in foreign growth patterns
implies a structural deficit for the US current account unless we are
prepared to accept a trend depreciation in the real exchange rate and,
of course, the implied reduction in our real income.
A
second factor works in the same direction.
Foreign producers,
particularly in LDCs continue to adopt and imitate US products and processes.
They have been gaining in competitive advantage 1productivity gaps are
shrinking and the product cycle may well be accelerating.
For the US this
implies continuing loss of competitiveness and, once more, the need for
continuing real depreciation to maintain a market for our output.
The alternative strategy that is advocated here takes a longrun view.
An effective remedy to break the pattern of what Kindleberger so perceptively
has called the "aging
of America" is a move toward an investment,
innovation and trade oriented-pattern of the economy. 1 Such a policy would
allow maintenance of the real exchange rate not through overvaluation and
stagnation but rather through the introduction of new products in the
export sector and through cost saving innovations in traditional industries.
IV
CONCLUDING REMARKS
The paper has reviewed our experience with flexible exchange rates
since 1973.
The question of exchange rate flexibility as an adjustment
process has been addressed and the following conclusions emerge:
1see C.P. Kindleberger "
·
The Aging
forthcoming.
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Economy." Weltwirtschaftliches Archiv,
204
(1)
Exchange rate changes have been substantially larger in nominal terms
than in real terms.
Real exchange rates, until the end of the first quarter
of 1978, have been quite moderate.
The magnitude of nominal rate fluctuations
must be seen in the fact that Japan and Germany have substantial flexibility
in their traded goods price structure and that accordingly very large
changes in nominal exchange rates are required to bring about a given change
in real exchange rates.
(2)
The U.S. current account does not present a puzzle.
Changes in
competitiveness and relative rates of expansion in the U.S. and abroad account
well for the surpluses of 1973 and 1975 and the deficit of 1977.
In a longer
term perspective there is the serious possibility of a structural deficit
because of the Houthakker-Magee law:
The U.S. has a very high income
ela1c1ticity of dema•:·1 for imports but faces a low world elasticity of demand
for her exports.
AcG~rdingly, with a decline in the growth rates in the
rest of the world :~ncreased innovation or a trend real depreciation are
required to avoid a widening of the current account gap.
This conclusion
is reinforced by the fact of growing competition from LDC manufactures in
the U.S. market.
(3)
The medium term policy mix in the U.S. can either attempt to stabilize
the financial dollar for the benefit of external holders of dollar
denominated assets or it can stabilize the real dollar for the benefit of
internal balance, current account improvement and growth.
A
reasonable policy
mix that stabilizes the real dollar involves a shift toward fiscal tightness
and increased use of fiscal resources for the promotion of innovation,
investment and productivity.
The move toward fiscal tightness should
be accompanied by easy money so as to keep real interest rates low and to
permit a depreciation of the real exchange rate.
The policy mix will ensure
a move toward external balance and a reallocation of resources toward growth.
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205
APPENDIX
I:
Trade Equations
This appendix briefly reviews equations for exports and imports of
goods and services for the US economy.
The equations were estimated with
half-yearly observations and are designed to cast light on the role of real
exchange rates or competitiveness and real income expansion on the current
account.
The competitiveness variable we use is the IMF multilateral exchange
rate adjusted for wholesale price changes.
"Rest of the World" actual and
potential output are indices of manufacturing output for six industrialized
countries using the following weights:
Japan 28.8%, Germany 23.3%, France
18.0%, UK 11.3%, Canada 9.8%, Italy 8.9%.
Potential output indices are
obtained from the series constructed by Artus and Turner. 1
On the export side we use as a category exports of goods and services
in the national income accounts measured in 1972 prices,X. The equation
is estimated for the period 1963-1977, using half-yearly data:
A-1
log X = 5.15
(.86)
-
.20loq (Y*/Y'*)
(.15)
p
+
.82 log Y*
(.03)
-1.03 log (P/P*)
(.16)
SER= .022, Rho= .32
Standard errors are given in parenthesis.
DW= 1.88
The equation is estimated with a
correction for first order serial correlation.
Y* and Y; are foreign actual
and potential output indices, P and P* are us and foreign dollar prices and their
ratio is thus a measure of US competitiveness.
The competitiveness variable
is entered as a second order unconstrained polynominal allowing for effects
in the current and three lagged quarters.
The equation does show some
response to a change in competitiveness.
Increased us competitiveness will raise exports.
The elasticity is about one.
The lag in adjustment, though, is very pronounced; in the first year the
elasticity is close to zero.
1 J. Artus and A. Turner "Measures for Potential Output in Manufacturing
for Ten Industrialized Countries, 1955-80. Unpublished Manuscript,
International Monetary Fund, May 1978.
36-066 0 - 79 - 14
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206
Consider next the implications of foreign changes in income.
A one
percent rise in foreign income, given potential output, raises exports by
about half a percent.
effect on our exports.
There is thus an extraordinarily low cyclical
If foreign income expands along with potential
output the elasticity rises to .82.
This would suggest that there is an
import bias in the pattern of foreign capacity expansion.
Of course .85
is still very low indeed as an income elasticity of demand for us goods.
On the import side we have an equation for the category imports of
goods and services in the national income accounts measured in 1972 pr¾ces,
M.
A-2
The equation is estimated for the period 1964-77:
Log M = -14.4
(1.00)
- 1.71 log (Y/Y)
(0.1)
p
+ 2.64 log Y + 1.3 log (P/P*)
(.08)
(.15)
SER= .025
Here Y and Yp are US actual and potential output.
DW= 1.90
The competitiveness
variable is entered again a& an unconstrained second order polynominal
allowing for the effects :•1 the current half-year and an additional three
years lagged.
The lag is thus considerably longer than on the export side.
The import equation shows a substantial response to changes in competitiveness.
The longrun elasticity here is 1.3.
the lag is very pronounced.
Again we find, however, that
The elasticity for the first year is only
.5 and thus confirms the idea of a J-curve.
The level of imports is highly responsive to our income.
Given
potential output an income expansion of one percent raises imports in real
terms by nearly one percent.
When actual and potential output expand to-
gether the income elasticity rises to as much as 2.64 thus showing a very
large import bias in the trend composition of U.S. output and demand.
The estimation methods used here are quite unsophisticated and the
data are not without problems.
Accordingly one should take the elasticity
estimates primarily as representative evidence rather than as very tight
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207
and exact estimates.
Even so there is a striking implication of the equations:
on a full employment path in the world our imports would rise faster than
our exports unless in the rest of the world real income grows three times
as fast as it does in the US.Failing such a
substantial differential
in growth patterns changes in the terms of trade would have to come about
to raise our competitiveness and thus restore balance to a growing trade
gap.
The change in the real effective exchange rate that has taken place
since last year is about 6%.
Such a change will raise exports by about
4.25 percent once the full adjustment has taken place and, assuming of·
course, that the change in competitiveness is sustained.
On the import side
the change in competitiveness would imply a reduction in imports of almost
8 percent.
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208
APPENDIX II:
EXCHANGE RATE EQUATIONS
In this appendix we set out a theory of exchange rate determination
and provide some evidence on the limited success of monetarist models of
the exchange rate.
The longrun equilibrium exchange rate, E, is determined so as to
set relative prices compatible with external balance:
E
A-1
= O(P/P'')
where o is the longrun equilibrium real exchange rate and P and P* are
the longrun price levels here and abroad.
Today's equilibrium spot rate
Eis related to the expected future equilibrium rate,
The current rate is
the present discounted value of the anticipated future rate, the discount
factor being the international nominal interest differential.
E = --'E=--~-~--
A-2
1 + r(M/P,Y)- r*
where r is our shortterm interest rate which is a function of the real
money stock,M/P,and real income.The foreign interest rate is r*.
Combining
A-1 and A-2 yields:
A-3
E
a
P/P*
l + r(M/P,Y)-r*
The determinants of the equilibrium exchange rate according to A-3 are:
i.
Shortterm interest rates:
An increase in our shortterm interest
rate causes an appreciation of the exchange rate, and conversely
for an increase in foreign rates.
ii.
The average future path of prices:
if prices here are expected to
increase relative to those abroad, and there is no offsetting increase
in the interest differential, then the spot rate will depreciate.
In this respect the ratio of expected price levels, P/P*, can be
proxied by the differential in longterm interest rates which
indicate the longterm inflation differential.
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209
iii.
The longrun equilibrium real exchange rate, cr:
a depreciation
in the equilibrium real exchange rate, because of a loss in
competitive advantage, shifts in demand,. adverse oil price
changes or the like will lead to an immediate depreciation in
the terms of trade.
Most empirical single equation models of the exchange rate use a simple
monetary approach.
The equilibrium exchange rate is determined by the
relative supplies of nominal monies and the relative demands for real
balances:
A-4
E
~
M*
L*(r*,Y*)
L(r,Y)
E(M,M*,r,r*,Y,Y*)
In the accompanying table we show loglinear versions of equation A-4
specified to include long and short interest rates as well as an
adjustment lag in money demand.
The equations show a substantial standard
error which no doubt is due to the lack of a real exchange rate term which
serves as a vehicle for expectations. 1
1For a more detailed treatment see R.Dornbusch "Real and Monetary Determinants
of Exchange Rates." Unpublished Manuscript,MIT,1978.
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MONTHLY DM/S EXCHANGE RATE EQUATIONS:
(y-y*)
(r-r*)
1
-.41
(.20)
.87
(1.61)
2.
1
-.38
(.20)
.14
(1.61)
3.
1
-.23
(.17)
-1.05
(1.49)
!t
m-m*
1.
, (e+m*-m)_ 1
.67
(.11)
1974/3 - 1978/5
const,
Rho
SE)'!.
1 13
c:10>
,97
.021
1.28
9.12
(4.38)
1.24
(.09)
.97
.021
1.41
10.27
(3.18)
.46
(.20)
.53
.018
1.94
(,rL.,. :rfl
DW
\
~
.....
4.
1
-.45
(.21)
3.23
(3.14)
5.
1
-.61
( .33)
8.01
(6.65)
6.
1
-.26
(.27)
-1.51
(5.56)
.57
(.21)
1.13
(.12)
.97
.022
1.36
29.55
(3.52)
1.44
(.03)
.65
.029
1.79
13.37
(6. 33)
.60
(.31)
.58
.018
1.90
*
+ a (e+m*-m)
+ al (y-y*) + a2<rs-rs) + a 3 (rL - ri,)
0
-1
Equations 1-3 were estimated using a correction for first order serial correlation. Equations 4-6
were estimated using Fair's method with production, the lagged right and left hand variables and time
as instruments. Standard errors in parentheses.
Notes:
The estimated equation is:
e+m*-m
= const
0
211
APPENDIX III.
Import Prices and Domestic Inflation
This appendix briefly reviews the channels through which import
prices enter the domestic inflation process.
An equation for the US
summarizes these channels and gives some quantitative idea of the
importance of depreciation as a source of increased inflation.
Consider a depreciation of the exchange rate.
We should expect such a
depreciation to lower foreign prices and to raise domestic prices of
imports.
A rough approximation is that import prices rise by about half
the depreciation.
Now given such an increase in import prices how will it
spread through the economy and lead to increased consumer prices?
The most immediate effect of a depreciation is to raise the prices of
commodities, and in particular food •. This is a direct effect on consumer
prices that we would expect to occur without substantial lags.
A second effect is from increased import prices on the prices of
competing domestic products.
This "sympathetic price increases" again
should ari•, with relatively little lag.
The extent to which we would
observe them depends largely on the extent to which markets are competitive
and on the extent to which there are unemployed resources and capacity.
In the us the perhaps most obvious example of this process is the automobile
industry where small car prices are market up along with import prices.
A third channel arises from any impact that import prices have directly
on wages.
Such a direct effect, given the rate of domestic inflation and
unemployment, would arise primarily as an expectational response to the
extent that import price inflation leads domestic inflation.
believe, no evidence yet of this channel in the US.
There is, I
It is more important in
relatively open economies where import price inflation sets domestic inflation
and where monetary policy fully validates the ongoing inflation process.
Finally there is an indirect response of wages to increased import
price inflation.
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This arises in one of two forms.
First the adjustment of
212
wage inflation to increased price inflation that is brought about by the
other channels discussed above.
Two parallel sources are increased wages
arising from the reduction in umemployment and/or the gain in profit margins
that arise from the gain in competitiveness.
to some lag, but there empirical relevance
These responses are subject
can certainly not be discounted.
Given these various channels we have to ask whether a depreciation does
not in fact get ultimately passed on fully into increased price inflation
so that relative prices remain invariant.
A summary of these different channels for the US is provided in the
equations reported below:
canst
P_l
1/u
p
R2
PCPI
.002
(.003)
.43
(.14)
.007
(.005)
.15
(.03)
_,;4
1.92
PDEF
.004
(.002)
.40
(.10)
.004
(.003)
.15
.7'i,
1.96
(.02)
Price Index
m
DW
PDEF'' PCPI and Pm are respectively the inflation rates for the
GNP deflater, the CPI and import price.
The prime male unemployment rate
is u.
The equations were estimated for the period 1965-1977 with quarterly
data.
The import price inflation was entered as a one year moving average.
The equations show a shortrun impact of import price on domestic
inflation of .15 and a longrun impact of about twice that magnitude.
This
suggests that depreciation is quite effective in changing relative prices
but that it does certainly have an inflationary impact.
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213
APPENDIX IV;
REAL EXCHANGE RATES
(lndeus of Rclalive Coats and Prices
m+wis Ocher Industrial Coururia. 197S= 100)
.,,.
Jt76
lf7I
1972
1973
1t1•
1975
1976
lffl
Ill
u
IV
lffl
Ill
1971
IV
I
100.0
96.4
112.9
IOU
99.5
101.5
92.0
102.9
92.8
102.1
104.6
101.4
96.7
97.6
99.i
91.7
109.5
107.8
100.8
108.1
87.7
105.0
92.8
105.9
106.3
101.7
103.3
101.2
United States
102.8
950
120.3
1070
98.9
91.4
921
108.5
82.8
98.8
102.0
91.1
100.5
92.2
100.8
92.0
120.J
110.0
102.6
94.6
90.6
109.2
79.9
100.6
100.9
90.7
107.8
95.6
United States
Canada
Japan
100.2
94.2
117.5
102.8
100.8
96.9
90.9
102.B
89.0
107 0
9B.5
B9.6
100.4
96.3
93.5
116.6
105.I
102.2
100.5
88.7
105 7
86.5
110.4
968
89.5
104.6
United States
97 5
111.3
103.2
1024
98.3
9l.3
102.I
90.3
108.1
101.0
96.7
97.0
100.7
97.I
107.3
102.B
101.2
99.1
90B
103.5
95.l
1062
99.7
96.8
95.4
100.0
990
93.6
112.2
102.4
99.0
976
90.5
1040
95.0
105.0
96.6
89.9
101.0
1033
96.0
92.2
110.8
1048
99.5
1003
B8.2
106 7
93.3
107.7
94.8
89.9
107.7
107.4
United States
103.l
97.l
100.0
950
102 3
1026
92.5
1033
98.7
1024
97.1
9S6
IOI.I
93.6
949
89 5
938
101.6
10B.5
99B
91.6
104.5
96.8
104.2
99.0
94 9
?014
-..Und'--Casts/65umdJJOJ
15'0
99.I
JG.3
...o
96.9
104.9
93.I
tl.9
97.8
19.5
16.0
911
19.9
103.6
UI.I
100.5
7U
86.8
97.2
97.3
89.2
96.2
100.7
90.1
87.4
93.9
83.1
105.7
12U
102.0
86.8
88.7
98.3
94.8
91.0
98.9
100.2
92.2
87.4
96.l
848
101.6
111.3
990
938
96.5
96.3
101.8
93.3
110.6
95.6
96.6
915
92.6
91.5
90.8
1110
100.2
100.5
970
98.5
102.8
89.4
108.3
89.6
97.5
93.4
90.4
95.1
96.3
100.0
1000
100.0
100.0
100.0
1000
100.0
100.0
100.0
1000
1000
100.0
100.0
100.0
104.5
111.2
101.0
100.0
102.0
IOI.I
95.4
99.5
89.4
101.0
105.5
113.2
100.6
95.2
103.I
101.0
107.7
104.8
102.5
105.2
91.3
102.2
89.8
104.4
108.1
111.4
92.7
94.2
136.9
101.3
86.6
81.7
91.4
96.0
92.4
88.7
103.6
90.7
85.3
98.8
90.7
104.1
123.5
101.4
96.4
83.3
95.0
92.6
94.3
90.4
103.2
91.8
85.2
JOI.I
90.2
102.6
109.9
98.4
1055
89.2
93.9
96.6
95.6
100.3
101.7
97.4
89.8
97.4
97.0
91.3
105.J
103.7
108.3
92.I
96.4
96.5
90.7
1026
95.2
102.3
93.3
93.0
98.6
97.6
100.0
100.0
100.0
100.0
100.0
100.0
100.0
100.0
100.0
100.0
100.0
100.0
100.0
100.0
105.7
107.5
103.1
100.7
100.4
97.4
97.5
100.6
87 9
100.7
102.3
105.7
102.6
92.9
105.3
99.8
112.9
106.3
ICl.3
94.8
93.2
106.7
824
101.2
106.5
99.4
968
89.3
133.8
94.5
87.8
89.1
102.7
94.7
<J0.8
96.9
97.0
67.8
83.7
8B.O
102.9
120.2
96.8
97.9
89.2
105.4
94.4
93.5
96.4
98.8
92.0
85.2
90.3
100.7
104.8
96.7
Ill.I
95.3
1039
100.0
95.8
104.1
96.0
95.0
88.3
92.3
91.7
102.9
101.5
112.7
99.4
106.0
93.8
88.3
103.9
93.6
97.6
89.3
97.7
97.6
100.0
100.0
100.0
100.0
100.0
100.0
1000
100.0
100.0
100.0
100.0
100.0
100.0
104.0
104.6
!OH
100.5
101.9
101.6
968
99.7
91.5
102.7
97.6
103.2
93.4
1024
98.0
111.2
1037
103 2
994
90.7
102.3
90.l
107.8
101.l
98.8
96.5
115.3
102.7
94.3
90.2
96.4
88.4
93.8
93.6
1065
96.8
89.7
90.4
83.3
110.4
106.9
1033
100.5
91.4
98.2
IOI 4
111.3
94.S
104.3
100.3
97.0
102.7
99.l
101.4
93.7
93.0
92.4
100.0
104.0
113.9
95.2
106.1
98.7
88.6
1032
98.8
99.2
101.4
96.9
96.4
95.0
100.0
1000
100.0
1000
100.0
1000
!000
1000
100.0
100.0
1000
100.0
100.0
1000
103.2
104.8
103.9
100.4
1019
102.2
91.9
101.7
92.7
101.9
1015
102.5
IOU
93.1
100.9
97.S
107.3
IOJ.3
102.4
100.1
90.2
103.7
94.9
105 7
100.5
99 5
96.3
99.0
109.9
117.9
99.3
93.9
97.3
91.9
92.3
96.5
103.4
94.5
8U
87.8
87.5
105.9
!03.7
114.6
103.4
920
99.7
92.7
93.9
96.7
102 7
97.5
810
908
B9.4
101.5
96.I
106.9
115.1
99.6
99.9
995
97.1
100.7
100.0
100.0
100.0
1000
100.0
1000
1000
l000
100.0
100.0
106.0
104.6
96.2
98.I
101.0
100.9
98 7
100.l
93 I
99.6
948
104.0
1041
96.9
102.5
986
101.8
97 3
!02.3
996
95 7
1006
958
96.2
926
1007
1000
103.5
1044
112.5
101.4
99.1
100.7
101.2
93.2
99.2
952
99.5
1066
1109
100.0
9U
104.8
111.7
100.3
102.9
104.9
104 2
91.8
103.7
88.7
104 7
1120
118.6
993
87.1
107.1
103.7
103.4
102.5
105.8
111.2
89.8
101.0
86.0
105.3
110.4
119.5
91.8
92.5
103.9
101.6
106.3
105.6
102 2
1082
91.7
102.8
86 7
104.5
110.7
114.0
90.6
93.6
101.3
1021
108.3
1068
101.3
99.9
91.8
102.l
937
105.7
106.5
110.6
91.7
93.1
Caiada
Japan
Austna
Belgium
Denmark
France
Gennany
Italy
Netherla'lds
No,way
Sweden
Switzerland
United Kingdom
--UndL-Casts(65r,nc,fJJOJ
144.5
11.7
18.2
19.1
910
104.2
95.4
15.3
IOI.I
115
I0.6
100.5
11.5
101.5
-
1?:.,
910
19.1
11.0
104.0
97.3
9d
9;,i;;.
9U
16.5
12.8
92.6
99.1
106.i
108.8
104.8
98.8
99.5
97 3
95 5
100.4
90.~
99.6
1027
104.1
103.2
91.9
106.0
107.2
104.6
105.0
103.I
98.8
93.4
105.1
86.2
104.3
107.4
108.3
102.6
84.9
1068
103.5
107.1
102.8
102.7
97.7
93.6
105.3
81.3
103.2
109.0
107.8
96.3
88.7
106.2
101.2
110.6
108.l
102.0
95.6
93.3
107.0
80.9
102.3
108.7
101.5
95.0
88.2
105.5
99.3
113.6
107 2
101.5
94.6
93.8
106.0
846
1005
106.3
97.1
95.5
88.2
Vaue Added l),!tmrs/99by dJJOJ
IOU !03 5 103.3 102.5
104.0
105.8
109.1
101.0
101.8
IOI.I
941
99.3
92.4
102.4
96.9
1031
92.8
103.2
106.4
104.3
105.9
104.1
91.B
103.0
91.5
107.5
:009
106.9
B6.8
100.9
107.1
104 3
105.3
102.1
90.3
102.4
90.4
101.,
102.3
106 7
93.4
99.2
109.0
IOU
104.4
100.4
904
101.9
90.7
108.5
102.5
102.0
95.1
Austria
Belgium
Denmark
France
Germany
Italy
Netherlands
No,way
Sweden
Sw1tzerta-,d
United Kingdom
Caiada
Japan
Austria
8Ptg1um
Denmark
France
Germany
ftaiy
Netherlands
Norv.ay
Sweden
United Kingdom
-.,_,Pncn/63,FJJOI
118.5
100.9
97.9
17.1
101.4
19.5
95.6
89.9
107.2
95.2
93.6
92.0
80.6
105.2
99.l
90 7
97.2
94.3
106.2
99.7
B8.6
90.5
842
107.7
94.3
103.1
105.6
106.8
1007
101.5
101.8
93_;
1015
94.8
IOl.2
1020
102.3
1024
92.3
102.4
103.7
104.0
103.9
105.3
104.7
91.0
104 9
94.9
1060
104.7
105.9
101.0
87.9
102.0
100.7
104.1
103.9
105.3
102.s
896
1039
,4.3
105.4
103.7
105.9
956
95.2
101.9
9B.6
105.S
104.1
1040
101.l
898
1033
95.0
106.2
102.1
101.5
93 3
97.5
Canada
Japan
Austria
Belg1ur.,
Denmark
France
Germany
Italy
Netherlands
Norw.:y
Swede-,
Switzerland
Umted Kingdom
-E,pan/Jn,t ,-.iu,s{U,y,FJJO)
112.2
122.7
98.7
95.1
99.4
91.0
92.5
94.5
102.7
96.1
141
17.0
82.2
104.6
95.5
111.6
107.B
95.4
998
98 0
989
IOU
958
974
82.5
926
96.3
99 3
961
103.8
91.2
932
928
98.1
:oo.o
1000
100.0
100.0
105.1
105.0
97.5
979
998
1009
97 2
1000
96.J
98.9
98.2
102 7
1030
97.0
106.2
992
~8.9
101.6
102.4
10~ 2
94 2
102.4
946
102.7
954
107.3
101.6
92.5
102.2
103.6
10!.7
97.1
101.6
101.6
91.7
101..i.
95.5
97.1
94 2
107 0
98.8
98.7
1021
101.3
102.0
97 3
102 B
100.2
948
100 I
964
97.3
91.8
102.9
9B.5
102.6
gs.,
966
1007
97.8
95.4
91.0
989
97.0
104.3
916
956
680
932
111.0
111.7
United States
Canada
Ja!lan
Austria
S.!1g1um
Denmark
France
German)
ltaiy
Netherlands
Norway
Sweden
Switzerland
United Kingdom
Source: International Monetary Fund, International Financial Statistics,
October 1978.
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Federal Reserve Bank of St. Louis
214
Cost and Price Comparisons for Mfg.
The five indicators of relative costs and prices in manufacturing shown in this
table for each of the industrial countries are calculated by the Current Studies
Division. IMF Research Department. Each of the indexes represent the ratio
trcbucd to 197S = 100) of the relevant indicator for the country listed in the
stub to a weighted geometric average of conespondin1 indicators for the other
thirteen industrial countries. after expression of all of the national indicators in
tcnns of a common cuncncy. The indi~ators thus take account of changes in
ac:hangc rates.
These index.es should be interpreted with considerable caution. While e,tCry
effort is made to use national data that are as nearly mtemationally comparable as
possible. the degree to v.-·h1ch it is practicable to assure comparability is limited by
the character or the available data. For this reason. the table provides a wide array
af available indicators.
Several or the indicators arc subject to frequent and sometimes substantial
revisions. To an important extent. these revisions stem from the procedures used
IO estimate several or the indicators. Thus, the national data underlying the two
unit labor cost series and the ,,alue-added deOator series ue cakulatcd by
benchmarking the be!iot a-.ailable monthly or quarterly senes on reasonably
comprehensive and comparable. but penodically revised. annual data fri>m the
national accounts. While such benchmarking makes these sencs partu:ularly
susceptible to rc-.·ision. it· also perm us the calculation of up-to,.datc: quarterly sencs
•·hich. on an annual basis. are also reasonably comprehenswc and comparable.
The latter two charactenstics could not be assured on the basis of quarterly data
alone without a considerable narrowing of the theoretical concept subjected to
measurement.
The weights used to construct the partner-or compctitor~ountry index. are
desi&ncd to make the indicators pamcularly rcle-.·ant v1;ith respect to mo-.·ements in
\.-OSts and pri.:es affecting exports of manufactures. The v.·eights. which are built up
From disaggregated (i.e .. four-digit SITC) trade data for manufactures in 1975. take
account at the disag_g!"c,ated lc-.el of the relati-.·e importance of a country's trading
partners in its direct bilateral rela1ions "'·1th them. oi competitive relations •·1th
"lhird countries" in paru1o;ular markets, and of differences among counmcs in the
importance or foreign trade to the manufacturing sector.
The nature and scope of the 1warious national indicaton entering into the
comparisons arc brie-Jly described below. \\"hJle menrion is made of specjfic
dc-ficiencies in some of the indicators. the emchasis is on what the indicaton
purport to measure.
I. L"nit labor ,·..lsrs. These 3rc defined as compensation of employees. per unit or
,n,I 01.nput (in the value adJcd ~nse) in the m3nufactunng sector. At.:count 1s
1alcn uf emplo)·er-pa:d S<X:1al m!lourance prem1a •nd other em..,lo)ment taus as
well as waaes and saiancs. For tnc most recent quarters. ho"" . '!'r. 1he unn iabor
\."Oil index.cs typically refer more narrowly to wages or wages and salaries per w11t
of IGlal output of manufactured prodUC'&s (rather than of value Nldcd in lhe
1Mnul'1<:lurin1 sector).
1 2. Normalized unit labor ,-asts.. These dala arc in1cnded to abstracl from ,he
cyclical swings in com·cntionally.measurcd producc1vity that Aten dis1on the
actual unit labor cost series (mainly because q·c\ical ch3•,s.cs in reponcd
employment do not correspond closely to those in effective inp:..1s of labor). The
normalized series are calculated by dividing an inde:-1. of actual houri)·
compensation per worker by an mdeJ. of output per manhour adjusted so as lo
eliminale estimated cyclical swings.
J. Valu~ddttl fkflators. These represent the quoti(:nt or the current and
constant pri..:c estimates of value added in manufacturir.g-!dji sted. howe"'cr. for
changes in indirect ta~es. Such indicators, ,.-hich share tnc propcr,ies of the
corresponding GNP dctlator series for the overall ei:onomy. arc bcsr -.·ic,.·ed in the
present contcu as comP1-,sitl! indicators of the co-.t (per unit oi ;cal -.·alue addcj)
or all primary factors of production (including capual anJ ·cntrcrrencursh1p." !'\
well as labor). These indicators differ from final product pn~es m chat they
abstract rrom the costs of intermediate inpu:s obtained by th!! manufacll.:.r.r:.g
sector from other st-clors. The c.ltr3pol3rion beyond 1he mosr rccenl bem:nm-1:k
year is ba.~ on 1ai:holcsale prices for manufactures adJusteJ to c:tcludc t:"lc
influence of changes in raw matenal prices.
4. \l'lwlcwle pn'"f.-c.'S. In pnnciplc. 1hcsc inde"es are intended to measure final
product prices (ududin@ mdircct taJ.CS. which are not generally im;,oscd on
exponed aoods). Howev~r. the various national indexes tend to lack comparab1hh"
in both concept and commodily composition. Whert:ver possible. USC IS made here
of' indeacs which appro,.im,ue final product prices 1c.,-.. "industry selling pni:cs' or
"finished" goods prices). For France. the manufactures component of the consumer
pria: index is used.
5. E.tport unit •alues. These series. which serve as proxies ror data on linal
product prices for traded goods. !ioutTer from some of the same compostUonal
drawbacks as the wholesale prices. In addition. because of the less-than-complete
homogeneity of lhe commodi1y classes upon ""·hich the unit \.alucs are calculated.
the national series arc often some•·hat erratic. On the other hand. the relall\ cs
(each computed as the ratio of one counuy·s mde" to that of its compcuto~) tend
to be much less ._.ariablc than those for the ether indicators bccau!iC of the dc~rec
of competition charactensuc of international trade and the resultant sclec.:ti-.ity in
the composition of a country's exports. lntrmationa.i compc:htzon often places
severe limits on how far an cx.poner·s prices may d1"crg.e from thaw charged oy
competitors. so that goods not compeUtively priced lend to Jisappear from the
tndc flows for which unit values arc computed. Consequently. the capon unit
Yllucs ~ 'undcrlyina COIi dcvclopmcnlS 1mpcrfcc1ly.
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Federal Reserve Bank of St. Louis
215
By Milton Friedman
Money Watchers
Beware
•Thereleased
figures on the quantity of money
by the Federal Reserve
System each Thursday afternoon are
awaited on Wall Street with bated
breath. The bond and sh ort-term-money markets slow down until they appear. The weekly monetary change is
h eadlined the next day by the financial
press to explain movements in market
interest rates. Indeed, this moneywatching game has been carried to
nearly ludicrous extremes, in view of
the large margin of statistical error in
the week-to-week figures.
Different money watchers rely on
different monetary aggregates, but
the favorite is doubtless the aggregate
termed M1, the total of currency outside banks plus demand deposits at
commercial banks.
GOODBYE M,
The Fed has adopted a change in
regulations for member banks effective on Nov. 1, 1978, that will, at least
for a time, render M1 a nearly useless
aggregate in judging economic or financial conditions, or in interpreting
monetary policy.
The new regulation will "permit
banks that are members of the Federal
Reserve System to arrange with their
[individual, not corporate] depositors
for the automatic transfer of funds
from depositors' savings acounts to
demand deposit and other accounts to
cover checks drawn or to maintain a
minimum balance."
The immediate effect will be a massive transfer of deposits from demand
to savings deposits in order to earn
interest. Why should anyone who
qualifies continue to maintain more
than a minimum balance in a demand
deposit? Changes in M, will be dominated by such transfers rather than by
Fed policy. Past relations between
changes in M 1 and in other economic
magnitudes will cease to hold.
There will be less effect on broader
monetary aggregates, such as M2,
which is M1 plus time and savings
deposits at commercial banks other
·than large negotiable certificates of
deposit; or M3, which includes also
deposits at mutual savings banks. savings-and-loan shares, and credit-union shares. Transfers between components of these broader aggregates will
cancel out. But there will be secondorder effects. By making deposits at
member banks more attractive relative to other assets, the · new regula-
Neweweek, October 30, 1978
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Federal Reserve Bank of St. Louis
lion will tend to
increase M2 relative to M3 and
broader aggregates. Perhaps more important, reserve requirements on savings deposits are lower than on demand deposits. Hence, the transfer of
deposits will release reserves that
could generate a Sharp growth in M2.
To counter this potential inflationary
development, the Fed will doubtless
engage in offsetting open-market operations, introducing different and
hard-to-predict perturbations into the
figures. Money watching will become
a most uncertain sport.
END INTEREST LIMITATIONS
There is a good reason for the
change: the development of close
substitutes for checking accounts by
mutual savings banks and other thrift
institutions (NOW, POW, COW accounts; telephonic fund transfer, etc.).
The right response would not be
piecemeal tinkering but removal of
the present prohibition on the direct
payment of interest on demand deposits. Unfortunately, the Fed cannot
of its own accord remove that prohibi~
tion; that requires an Act of Congress.
I wish.that. instead of, or in addition
to, promulgating its new regulatiofl,
the Fed had forthrightly asked Congress to repeal the whole o( Regulation Q-not only that part which
prohibits the payment of inte rest on
demand deposits but also the part
which gives the Fed power to limit
the interest rates that member banks
may pay on time and savings deposits.
Needless to say, any legal provisions
which limit the interest rates that may
be paid by nonmember banks and
thrift institutions should be repealed
at the same time.
We should end once and for all the
attempted, and to some extent successful, exploitation of depositors for
the benefit of banks and the government. Had limitations on interest
rates never been introduced or had
they been repealed years ago, the
present proliferation of ingenious devices for evading Regulation Q would
not have arisen; the ugly word •·disintermediation" would never have entered the financial lingo; the financial
structure would have developed in a
more rational and efficient way; and
monetary policy would have been
freed of a major source of confusion
and disturbance.
75
216
FOR RELEASE TUESDAY Ul.'S OCTOBER 17, 1978
NATIONAL CITY
BANK
OF MINNEAPOLIS
October 17, 1978
U.S. ECONOMIC OUTLOOK AND POLICY
by
WALTBR W. HBLLBR AND GBORGB L. PBRRY
The next twelve months will provide a new t.est of the "soft landing" thesis. Can a programmed
slowdown of the economy, designed to ease presaures on prices and the do1Iar, find happiness in a pause
that rebesbes - say a two to three percent growth rate for several quarters? Or will an inventory
drawdown (or perhaps an abrupt end of the housing boom) convert slowdown into recession?
Economic and political development.a of the past several months have raised the odds, if not on
a crash landing, at least on running off the end of the expansion runway. Under the impact of the
Fed's doaes of tighter money and the "Proposition 13 effect" on state-local spending, a recession in
1979 has gone from being a possibility last spring to an even money bet today.
The recession risk could be reduced by policy a<:tions here and development.a abroad. The Fed
could ease up somewhat. A successful launching of the Administration's new program of wage-price
moderation would relieve some of the pressure on the Fed and also reassure consumers. Economic
expansion in Europe, Japan and Canada might be stronger than currently forecast.
The authors of this Letter, while not differing on either the qualitative factors at work or the
downward push they are exerting on the economy, do differ on whether present trends will stop short
of, or end up in, a recession in 1979. So for the first time in the 12-year history of the Bank Letter,
we have agreed to disagree - mildly.
Heller is betting against history and assuming that the deceleration of the economy will not
inevitably feed on itself, i.e., that the slower advances in consumer and government spending won't
necessarily trigger an inventory recession or crippling cutbacks in housing and business investment.
Lending some credence to this position is that the current expansion, in spite of it.a advancing
age, has considerably less than the usual quota of imbalances, speculative excesses, and shortages
that presage a recession. In this setting, given a sizeable tax cut - and given even a mild letup in
inBationary preasu.res and monetary tightening - the economy could dip to a 2% growth rate or even
below, without falling through the floor.
Perry has history on his side. Slowdowns to a growth rate of 2% or less have typically turned
into recessions. So our quantitative assessment.a below are based on Perry's slightly more pessimistic
outlook for 1979, one which foresees a mild recession by next spring. _
For 1978, the rise in GNP will be about $220 billion, representing 3.8% real growth and 7.3%
inBation (as measured by the GNP de:8ator). But by the end of this year, the growth rate will decline
to_ 3% or less. Further slowdown (including two or three quarters of slightly negative growth) will
limit the yea,r-over-year rise in GNP to about $180 billion for 1979, with real GNP up only 1.6% and
the price de:8ator rising by about 7%.
THE POLICY SETTING
Past recessions have almost invariably been associated with a tightening of fiscal or monetary
policy, or both. Monetary policy is the major restraining force in the economy today:
• The Federal Reserve has raised the federal funds rate by 200 basis point.a during the past nine
months. And over the past year, it has allowed less than 1% growth in the real value of the
monetary aggregates.
• The Fed has been pushed in this direction by continued stubbom inflation, by the weakness of
the dollar, by the monetarist convictions of some members of the Federal Open Market Committee, and finally, by the hope that new aavinga instrument.a will largely insulate housing
activities from sharply rising short-term rates. These factors are still at work to push rates somewhat higher.
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Federal Reserve Bank of St. Louis
217
Fiscal _policy will also swing toward restraint once the stimulUB of January's income tax cuts is
behind UB. Federal budget expenditures, which rose to about $450 billion in the fiscal year just ended,
will rise about 9% in both FY 1979 and FY 1980. Trend revenue growth over this period would be
around 12% in the absence of any tax changes. Even a $20 billion income tax cut will not keep the
high-employment surplUB from growing by fiscal .1980 in the face of a near-$10 billion payroll tax
increase next January and the unrelenting ''inflation tax."
Although the marked slowdown or even receBBion we foresee for 1979 will increase some expenditures like unemployment compensation and decrease tax revenues, thUB temporarily deepening the
deficit, it is the comparative trend growth rate of 9% in spending versus 12% in revenues that defines
the fiscal pressure that the Federal budget will be exerting on the economy.
DETAILS OF THE OUTLOOK
As already suggested, the receBBion risk for 1979 does not grow out of imbalances and excesses in
the private sector. The expansion has been balanced and demand bas not outstripped supply capabilities in any significant sector of the economy. Inventories are modest relative to sales, and bUBiness
additions to plant and equipment are not outstripping the growth in markets for their products.
Although bank liquidity has declined, it is not in the danger zone. The cash position of business
( especially big bUBiness) is not being squeezed.
However, the following assessment of demand prospects by sectors will expose weaknesses in the
short-term outlook for several sectors. The danger is that these weaknesses will be contagious and
spread to other sectors.
Consumption
The good performance of consumption during the past year is closely associated with the surprisingly sharp growth in payrolls during this period. The combination of nearly 4 million new jobs in the
non-farm sector and hefty wage increases kept personal incomes rising strongly. By mid-year, wages
and salaries were 12% above year-earlier levels, and consumer spending rose almost in proportion.
Disposable income was up 11.5% and consumption spending, 11.3%. Personal saving, at a rate below
6% of disposable income for this period, stayed well below the average rate of 7.4% in the years
1970-75. Spending on durable goods, especially automobiles, remained high and led to a corresponding
increase in installment debt. But the burden of total consumer debt, in terms of repayments as a percentage of disposable income, rose only slightly above its long-term average of 20%.
As the level of spending on durable goods tapers off during the second half of 1978, it will pull the
increase in_consumer .spendlng for 1978 as a whole down to about 10½%. Income tax cuts will help
support consumer demand, but some two-thirds of their impact will be offset by payroll taxes. The
combinati01;, of higher prices for 1979 models and the recent history of strong sales will dull consumer
appetites for automobiles in 1979. Sales of some 11.4 million units this year are likely to shrink to
10.6 million units next year. Consumer savings rates will be moving up again, to something like 6½%
in 1979. Overall, therefore, we expect consumer spending to rise only 7¼% next year.
Business Investment
BUBiness investment in plant and equipment and inventories will reflect the slowdown in consumer
spending. The "accelerator process" will be at work: the slowdown in overall demand will lead bUBiness
to scale down its inventories and its spending for new plant and equipment.
The weakening of final sales will be reflected rather promptly in bUBiness inventories. If the
pattern of previous business cycles repeats itself, the slower pace of consumer spending would translate
mto a decline of $15 to $20 billion in inventory-building between 1978 and 1979. If this inventory
swing materializes, it would be the major force in converting the 1979 slowdown into a recession.
Business fixed investment will respond more slowly:
The gradualness of the recovery of such investment from the deep receBBion bas masked the
fact that investment is near its historical peak as a ratio to GNP. By virtue of a 17% advance
over 1977, bUBiness fixed investment will average about 10½% of GNP in 1978.
Even after combing out the investment outlays that are being made to meet pollution standards, one finds bUBiness fixed investment running above 10% of GNP and adding over 3½%
to the bUBiness capital stock this year.
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• A further positive factor in 1978 is that business spending on structures bas been growing
somewhat more rapidly after being depressed by excess capacity for most of the current
expansion.
Fi'"
The 1978 performance of plant and equipment
usures some momentum in this sector
in 1979. But with the growth rate of the economy
· short of the growth rate of capacity in
coming quarters, the strength of business investment · ebb before the year is out. Investment
outlays will still rise by 1~ to 14%, year-over-year, but the pace of such spending will slacken 88 the
year progresses.
Reslc:lentlal Construction
Except for an interruption during the unusually cold winter of 1978, housing starts have remained
at a robust annual rate of just over 2 million units during the past year. A variety of measures, notably
the new 6-monthe saving certificates with interest rates geared to Treasury billa, kept the sharp rise
in market interest rates from draining funds from the thrift institutions. So housing starts have i:olled
along at higher rates than most forecaatera had anticipated.
Even now, with low vacancy rates and the amall stock of unsold homes, housing demand remains
strong. But housing starts will not be totally immune to tighter money.
•
Past experience suggests that rising mortgage interest rates, already up 50 basis points during
1978, will be somewhat of a damper on the demand for new housing.
Further incressea in short-term interest rates propelled by Federal Reserve policy will teat the
ability of thrift institutiona to pay for further funils and trigger some diaintermediation in spite
of the buffer provided by the new 6-monthe certificates.
• As against the unexpectedly strong housing performance in 1978, when starts will tota!J~
under 2 million units and residential construction outlays will be up by 15%, next year is likely
to see no change in construction spending 88 starts fall to about 1% million units.
Net Exports
One of the brightest sectors on the 1979 horizon is that of net exports. In 1977-78, disappointing
growth rates among our trading partners have contributed to the large U.S. net export deficit and,
with it, to the weakness of the dollar. In the year ended June 30, industrial production in the other
major OECD countries rose only half 88 fast 88 in the United States: 2l!t% agsmst 5%. The ensuing 12
months will see a virtual reversal of that performance, with the rise in industrial J?roduetion abroad
approximating 5% 88 against a rise of perliaps 3% in the United States. This shift m relative growth
rates will boost U.S. exports and curb U.S. imports.
The trade balance will also be helped by the decline that bas already occurred in the dollar. On
a trade-weighted basis, the dollar's value on foreign exchange markets is down about 10% from a year
ago (with much larger slippage, of course, against the mark, the Swiss franc, and the yen). Net
exports in the national income accounts, which are likely to run at about the same $11 billion deficit
in 1978 88 they did in 1977, should approach a balance for 1979 as a whole. If foreign economies grow
considerably faster than we now expect - 88 their high unemployment and exceaa capacity would
readily permit them to do - it would step up our net exports and possibly ward oft a U.S. recession.
Government Purchases
Federal purchasea of goods and services have moved erratically in recent quarters as agricultural
support buying rose during 1977 and then declined during the first half of 1978. But this decline in
purchasea is being reversed even in the face of budget stringency. The back-pressure on the budget is
being exerted mainly on Federal pay increases and grants to state-local governments. Real purchaaea,
eepecia]ly for defense purposes, continue to rise at a good clip. We anticipate that total Federal
purchases will rise by 6% this year and 8l!t% in 1979.
At the state-local level, we find a different story. In 1977, state and local governments ran an
aggregate surplus of $29¥.t billion. Of this total, $18 billion was a surplus in retirement funds, with the
remaining $11 l!t billion representing a general fund surplus. This year, the combination of rising revenues, expanding federal grants, and the cushion of accumulated surpluses will boost state-local
government purchasea by more than 12%. But the general fund surplus is being sharply eroded in the
second half of 1978, partly as a result of slower growth ;n the revenue base but mainly as a result of
California's Proposition 13:
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Federal Reserve Bank of St. Louis
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• Taken by itself, the California action will have little net direct effect on total demand as state
and local taxes are cut by more than expenditures while Federal taxes on Californians rise
somewhat.
However, the Proposition 13 fever will hold down spending plans in general. Federal grants,
which roee by $11 billion in the most recent four quarters, will rise only half as much in coming
quart.era. Revenues will grow more slowly as the rise in incomes tapers off.
• As a result, purchases by state-local governments will rise only 9% in 1979.
PRICES, PROFITS AND EMPLOYMENT
Prices: Although the basic inflation rate has worsened during the past year, some modest improvement is in sight. As unemployment declined during the expansion, the average rate of wage increases
roee by 1 to 1½ percentage points. But the increase in wages in recent months has been tapering off,
and the prospects of a weakening economy- together with the Administration's new initiatives for
slowing inflation - provide some insurance against a further speedup in prices. Although meat prices
will continue to rise, the food component as a whole will not be as strong an inflationary factor m the
year ahead as it has been this year. Overall, therefore, we foresee a rise of just under 7% in the GNP
deflator in 1979 against a rise of 7.3% in 1978.
Profits: With increases in sales volume tapering off, profit margins and profits will not perform
very well in 1979. As against a rise of 14½% in profits in 1978, we anticipate only a small further rise
in 1979. On a year-over-year basis, profits comparisons will look rather favorable early in the year but
will deteriorate as the year progresses.
Unemployment: The unemployment rate declined to near 6% last winter and has stayed 'there
through the spring and summer months. A falling rate of real expansion will now translate into rising
unemployment. From an average of 6% this year, unemployment is expected to rise to 6½% in 1979 and
may well approach 7% by the end of the year.
CONCLUSION
The shadow of chronic inflation continues to fell over the U.S. economy's prospects of full employment at home and a stronger dollar abroad. By now, surely, thoughtful observers must be aware that
there is no easy way out of the inflation thicket:
Putting the economy through the wringer of recession (by tighter money and leaner budgets)
would offer us something like a 1% cutback in the inflation rate at a cost of about $200 billion
in lost GNP.
• Putting the economy in a straightjacket of wage and price controls would temporarily suppress
inflation at the cost of curtailing our economic freedom of choice, distorting resource flows, and
inviting widespread chicanery.
• That leaves us the undramatic alternative of combining monetary and fiscsl moderation with
wage and price moderation and unrelenting efforts by government to minimize its own costand price-propping and competition-stifling actions.
It is the third route that the Carter Administration has chosen. Belatedly, it is initiating a program of wage-price jawboning with teeth - a program that will use procurement, regulatory, and
other indirect levers to induce business to decelerate its wage and price boosts. If it works - if it carries both clout and conviction - it can ease cost-push forces, strengthen the dollar, and keep Federal
Reserve policy from saddling us with a 1979 or 1980 recession.
So the American people - as consumers, as workers, as employees, and as stockholders - have an
enormous stake in the success of the new Carter offensive against inflation. If the program fails either because the White House bungles it or because business and labor sabotage it - the country
may well face the Hobson'• choice of recession versus controls, or heaven forbid, both.
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