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SHADOW OPEN MARKET COMMITTEE
(SOMC)
Policy Statement and Position Papers

March 8-9,1992

PPS 92-01

BRADLEY POLICY
RESEARCH
CENTER

Public Policy Studies
Working Paper Series

W I L L I A M

SIMON
GRADUATE SCHOOL
OF BUSINESS ADMINISTRATION

U>WERSlTYOFR<XHESrER
ROCHESTER,

NEW

YORK

14627

Shadow Open Market Committee

TABLE OF CONTENTS

Page
Table of Contents

SOMC Members

SOMC Policy Statement Summary

Policy Statement

Structual Shifts Amid a Cyclical Fluctuation: A Tricky Environment for
Countercyclical Macroeconomic Policies
Mickey D. Levy

Memo to the Shadow Open Market Committee
H. Erich Heinemann

Where Do We Stand in the Battle Against Inflation?
WilliamPoole

Some Issues in the Interpretation of Recent Monetary Policies
RobertH. Rasche

Foreign Exchange Market Intervention
Anna J. Schwartz

How to Help Russia
Allan H. Meltzer.

March 8-9,1992

SHADOW OPEN MARKET COMMITTEE

The Shadow Open Market Committee met on Sunday, March 8,1992from2:00 PM to 6:00 PM
in Washington, D.C.

Members of the SOMC:

Professor Allan H. Meltzer, Graduate School of Industrial Administration, Carnegie Mellon
University, Pittsburgh, Pennsylvania 15213 (412/268-2283,412/268-6837 FAX); and Visiting
Scholar, American Enterprise Institute, Washington, DC (202/862-7150)
Mr. H. Erich Heinemann, Chief Economist, Ladenburg, Thalmann & Co., Inc., New York,
New York 10022 (212/940-0250,212/751-3788 FAX)
Dr. Mickey D. Levy, Chief Economist, CRT Government Securities, Ltd., New York, New
York 10004 (212/858-5545,212/858-5741 FAX)
Professor Charles I. Plosser, William E. Simon Graduate School of Business Administration
and Department of Economics, University of Rochester, Rochester, New York 14627
(716/275-3754,716/461-3309 FAX)
Professor William Poole, Department of Economics, Brown University, Providence, Rhode
Island 02912 (401/863-2697,401/863-3700 FAX)
Professor Robert H. Rasche, Department of Economics, Michigan State University, East Lansing, Michigan 48823 (517/355-7755,517/336-1068 FAX)
Dr. Anna J. Schwartz, National Bureau of Economic Research, New York, New York 10003
(212/995-3451,212/995-4040 FAX)

ii.

Shadow Open Market Committee

SOMC POLICY STATEMENT SUMMARY

Washington, March 9—The Shadow Open Market Committee today called on the
Administration and Congress to "take actions that will maximize the durability and sustainability
of the expansion with declining inflation."
In a policy statement, the Shadow Committee, a group of academic and business economists
who regularly comment on economic issues, recommended the following actions:
First, the Federal Reserve should reduce the growth of the monetary base to a range of 5 to
6 percent. Even if this move leads to a temporary rise in short-term interest rates, it would establish
a foundation for sustainable growth and lower rates in the future.
Second, the Administration and Congress should limit the growth of mandatory federal
spending (excluding net interest) to the sum of the rate of inflation and the growth rate of the
population. Such action would reduce federal spending by $390 billion over the next five years.
President Bush should withdraw his proposed changes infiscalpolicy on March 20 if, as we hope,
Congress fails to enact them into law by that date.
Third, Senator Paul Sarbanes and Representative Lee Hamilton should withdraw their proposal to remove the presidents of the Federal Reserve banks from the Federal Open Market
Committee. This proposal is a shameful assault on the independence of the central bank.
Fourth, Congress should move with deliberate speed to deal with structural problems in the
banking system.
Fifth, the U.S. should reject proposals to provide large sums to stabilize the currency of the
former Soviet Union. Such aid, if provided, would be ineffective and would waste scarce resources
in donor nations.
The Shadow Open Market Committee meets in March and September. It was founded in
1973 by Professor Allan H. Meltzer of Carnegie Mellon University and the late Professor Karl
Brunner of the University of Rochester.

March 8-9,1992

In its statement, the SOMC warned that "Rapid money growth has raised fears of future
inflation which, in turn, has played a role in the recent rise of long-term rates. The longer rapid
money growth continues, the more rates will eventually rise and the shorter will be the current
economic expansion."
The Committee said that faster rates of growth require changes in tax law. "Productivity will
increase if tax changes (1) favor growth instead of redistribution, (2) favor long-term instead of
short-term improvements and (3) eliminate the bias that currently favors consumption over
investment and saving . . . It is irresponsible to propose credits for home purchases, reduced
withholding taxes, or increased family allowances as solutions to the long-term problems of
middle-class voters and taxpayers."

Shadow Open Market Committee

SHADOW OPEN MARKET COMMITTEE
Policy Statement
March 9, 1992

Contrary to popular perceptions, the economy has expanded since spring 1991, albeit at a
mild 13 percent pace. The rate of recovery accelerated in January and February. We expect the
pace of the rebound to pick up through the year. The primary objective of economy policy makers
now should be to take actions that will maximize the durability and sustainability of this expansion
with declining inflation. To accomplish this goal, we recommend the following actions:
First, the Federal Reserve should reduce the growth of the monetary base to a range of 5 to
6 percent. Even if this move leads to a temporaryrisein short-term interest rates, it would establish
a foundation for sustainable growth.
Second, the Administration and Congress should limit the growth of mandatory federal
spending excluding net interest to the sum of the rate of inflation and the growthrate of the population.
Such action would reduce federal spending by $390 billion over the next five years. President Bush
should withdraw his proposed changes in fiscal policy on March 20, if, as we hope, Congress fails
to enact them into law by that date.
Third, Senator Paul Sarbanes and Representative Lee Hamilton should withdraw their proposal to remove the presidents of the Federal Reserve banks from the Federal Open Market
Committee. This proposal is a shameful assault on the independence of the central bank.
Fourth, congress should move with deliberate speed to deal with structural problems in the
banking system.
Fifth, the U.S. should reject proposals to provide large sums to stabilize the currency of the
former Soviet Union. Such aid, if provided, would be ineffective and would waste scarce resources
in donar nations.

March 8-9,1992

The Outlook for the Economy
Although the 1.6 percent decline in real GDP in 1990-91 was mild, the economy has languished
since spring 1989. This reflects the lengthy period of slow money growth from 1987 through
mid-1991. In addition to the cyclical slowdown, significant structural shifts have altered the mix
of economic output and generated large declines in industries that attract public attention. While
exports have continued to grow robustly, some domestic industries have contracted. Firms have
cut costs and restructured their operations. Restructuring, while painful in the short run, should
yield sizeable, permanent gains in productivity.
The cyclical recovery since last spring has been muted by declining defense spending. Federal
defense expenditures went from a 14 percent annual rate of increase in the two quarters ending in
March 1991 to an 8.5 percent annual rate of decline in the last three quarters. The pace of decline
in defense spending increased as the year progressed, reaching a 13.6 percent annual rate in fourth
quarter 1991.
The decline in defense spending helps to explain in part the sluggish recovery and some of
the differences between the states. Several of the states with the largest increases in unemployment
Massachusetts, California, New Hampshire, Connecticut, and Missouri, for example are
states that relied most heavily on defense procurement (see Figure).
Monetary Policy
We have often criticized Federal Reserve policy makers for knowing only two speeds for
money growth too slow and too fast. In the late 1980s, central bank officials appeared to have
learned from past mistakes. Since mid-1991, they have forgotten these lessons.
Monetary expansion is now too rapid. Growth of bank reserves, monetary base and money
currency plus checkable deposits was between 8 and 9 percent in 1991. These growth rates
increased markedly in the first two months of 1992.
Rapid money growth has raised fears of future inflation which, in turn, has played a role in
the recent rise of long-term rates. The longer rapid money growth continues, the more rates will
eventually rise and the shorter will be the current economic expansion.

Shadow Open Market Committee

Recent Federal Reserve statements to Congress send two messages. The first says that there
is now sufficient monetary stimulus for the recovery to proceed at a more rapid pace. The second
says that faster money growth will be provided so that the Federal Reserve cannot be blamed for
the electoral defeat of the President or current members of Congress.
Many observers urge the Fed to seek faster money growth by forcing short-term rates to lower
levels. We reject this advice. One popular reason for advocating easier money is that the growth
of broad measures of money—M2 particularly—was near the lower bound of the Federal
Reserve's target in 1991. While M2 has accelerated recently, the growth of this aggregate remains
moderate. We believe that the reported growth rate of M2 understates current monetary stimulus.
The slow growth reflects declines in only one component of M2 small time deposits. These
deposits are term deposits. The holder pays a penalty for early withdrawal. As the deposits made
in earlier years become available for withdrawal without penalty, holders are reluctant to renew
them at current rates of interest.
This behavior is entirely consistent with other observed behavior such as the rush to refinance
home mortgages and the funding of corporate debt. Each of these actions suggests that the public
believes that short-term interest rates will not fall further. When interest rates rise, the spread
between short- and long-term rates should close, and the shift out of small time deposits should
reverse.
Efforts to boost M2 growth to a 6 percent annual rate (as some have suggested) would produce
two unfortunate results that would threaten the durability of the expansion. First, inflation will rise,
not immediately but more likely in 1993. The nation paid a high price to lower inflation particularly the slow average economic growth of the past three years. We must not waste these efforts.
Second, current policy is a return to stop and go. At some point, money growth will have to
slow to reduce inflation. Slowing money growth often produces a wrenching adjustment, particularly when high money growth has been maintained too long.
The shift to slower money growth causes slower growth of output or a new recession. We
urge the Federal Reserve to begin now to slow the growth of the monetary base from the current 8
percent annual rate to a 5 to 6 percent range, even at the cost of a temporary rise in short-term
interest rates.
We believe that 5 to 6 percent base growth will provide sufficient monetary stimulus for a
durable expansion. Stable monetary policy can contribute to stable growth and stable prices. Money
growth that is consistent with low inflation will increase economic efficiency.

March 8-9,1992

Also, under current law, depreciation and capital gains are not indexed for inflation. Inflation,
therefore, taxes capital. This has slowed the expansion of capital intensive industries. Price stability
ends this tax on capital, thereby strengthening the industrial sector.
Fiscal Policy
The Administrations' tax and transfer program and its rebuttal from Congressional Democrats
call for short-term stimulus and income redistribution. These proposals will not meet their immediate
objectives and divert attention from meaningful reform. Congress should reject these proposals.
President Bush should withdraw his proposed changes in fiscal policy on March 20, if, as we
recommend, Congress fails to enact them into law.
Faster rates of economic growth, higher productivity and improved standards of living require
changes in tax law. Since the early 1970s real wages, real compensation and real income have
grown slowly, reflecting the sluggish growth of labor productivity.
Short-term tax changes that increase spending cannot solve the problem of lagging productivity growth. It is irresponsible to propose credits for home purchases, reduced withholding taxes,
or increased family allowances as solutions to the long-term problems of middle class voters and
taxpayers.
Middle class and other incomes can be increased permanently only by increasing productivity.
Taxing upper-income groups to benefit middle-income groups will neither restore prosperity nor
promote long-term growth. Tax changes that encourage productivity will raise standards of living
and improve our ability to produce high value-added products.
Productivity will increase if tax changes (1) favor growth instead of redistribution, (2) favor
long-term instead of short-term improvements and (3) eliminate the bias that currently favors
consumption over investment and saving. If a tax policy meeting these criteria cannot be adopted
in an election year, the best course would be to defer action.
Last fall, the Treasury released a study on integration of personal and corporate taxes that
highlighted the double (sometimes triple) taxation of income from capital. This study focused
attention on the bias in the current tax system against investment, productivity and growth.
The study pointed out that the U.S. lags behind its trading partners in the treatment of taxes
on capital. The President should endorse a proposal to deal with the problems described in the
Treasury analysis.

Shadow Open Market Committee

In his annual message, the Director of the Office and Management and Budget (OMB) called
attention to the growth of spending for so-called mandatory programs. Such outlays amount to
$767 billion, excluding net interest. They make up more than half of total spending and are likely
to increase by more than 7 percent a year for the nextfiveyears and beyond.
OMB noted that if these programs were constrained to grow at the rate of growth of population
plus the rate of inflation, the saving over five years would be $390 billion. This would lower the
budget deficit and, most importantly, encourage a shift of resources toward investment.
We urge the Administration and the Congress to limit the growth of mandated benefits to
encourage growth and productivity by shifting resources from consumption to investment Cutting
defense spending is not a substitute for reforming non-means-tested entitlement programs.
Reform of the Financial System
Congress has failed to act on the Treasury's 1991 proposals to improve the stability and
efficiency of ourfinancialsystem. The weaknesses in thefinancialsystem persist. Timely reforms
are required to prevent another debacle similar in magnitude to the S&L crisis. Present law allows
the Administration to make needed changes while Congress debates more basic actions.
The regulatory agencies should repudiate their "too big to fail" policy. The Fed should (1)
amend its Regulation A to eliminate its extended credit facility, (2) reduce required reserve ratios
on net transactions deposits to the legislated minimum of 8 percent, and (3) request legislation to
authorize reserve requirements as low as zero.
Such administrative changes would eliminate the subsidization of large bank profits resulting
from the exemption of defacto insured deposit liabilities from Federal deposit insurance premiums.
These changes would reduce the discriminatory taxation of depository institutions relative to other
types of intermediaries.
The Sarbanes-Hamilton Proposal
Senator Paul Sarbanes and Representative Lee Hamilton have proposed removing Reserve
Bank presidents from the Federal Open Market Committee (FOMC). This proposal is shameful;
it is a direct assault on the independence of the monetary authority.
The proposal seeks to remove the influence of those members of the committee who have
been among the most outspoken proponents of price stability and higher growth. Since depreciation
is not indexed for inflation, as noted earlier, higher inflation is a tax on capital that reduces the
capital stock and lowers productivity growth.

March 8-9,1992

The Sarbanes-Hamilton proposal may never become law, but it is damaging nevertheless. It
increases doubts about the commitment of the federal government to long-term price stability, and
it pressures the Federal Reserve to pursue inflationary policies. We urge the sponsors to withdraw
their proposal.
International Trade
Public perceptions are incorrect: The U.S. is the largest exporter in the world. Real exports
have grown at a compound rate of more than 10 percent over the past six years. In real terms, the
U.S. trade deficits has declined from over $155 billion in 1986 to just $20 billion in 1991. Continuation of this trend will result in a trade surplus in the near future. The U.S. has clearly achieved
a dramatic improvement in its international competitiveness.
Recent calls for increased protectionist policies in response to America's bilateral trade deficit
with Japan are dangerous and misguided. Currency market intervention to prevent a decline in the
yen makes no sense. Current disputes with Canada over the domestic content of automobiles and
lumber subsidies threaten to scuttle the free trade agreement at great cost to the U.S. economy. The
Administration should, instead, continue to pressure governments in Europe and Japan to complete
the Uruguay Round of Trade negotiations.
Aiding Russia and Other Former Soviet Republics
The Administration may soon propose financial aid to Russia and other former Soviet
republics. Proponents of aid raise fears of a return to totalitarianism or military adventurism to
make their case. Some urge afive-yearcommitment of $30 billion per year of which the U.S. would
contribute as much as $5 to $6 billion annually.
We in the West cannot determine the fate of the Soviet peoples. Grants of $30 billion would
provide about $100 for each former Soviet citizen. The survival of democracy and freedom will
not be ensured by this, or any other, sum. The fate of Soviet citizens must depend on their decisions
and actions, not ours.
Calls for a new Marshall Plan suggest that we should give the former Soviets the type of
support we gave to western Europe in the early postwar years. This, too, would be a mistake. The
Marshall Plan provided capital to market economies in which competition was the norm. All of
these economies had legal, financial and accounting systems, property rights and enforceable
contracts.

Shadow Open Market Committee

None of these institutions is present in the former Soviet republics. Economic development
cannot be expected until these economies introduce private property and the institutions that permit
markets to function effectively and honor and enforce contracts. Freeing prices is not enough. Nor
can the former Soviets' problems be solved by grants or loans to stabilize the ruble.
A popular argument presents these loans as costless because we give the Russians paper
dollars that the Russian state bank would hold as backing for the ruble. If the plan works, the ruble
will be convertible at a stable value, and the dollars will not be spent. If the plan fails, as many
have in Latin America and Africa, the grants will be dissipated. A safe thing for Russians to do is
hold dollars instead of rubles. The dollars we lend or give would quickly disappear from the central
bank.
This would be certain to happen if Russia fails to close its enormous budget deficit. The
deficit is currently financed by printing rubles as fast as the presses can run. Inflation is rampant,
and lifetime savings are destroyed.
Dollars we give are a claim against U.S. wealth. If the International Monetary Fund (IMF)
advances the dollars, the only difference to U.S. taxpayers is that they will share the cost with other
countries. The U.S. has the largest share. The advance would be paidfromthe money American
taxpayers have given to the IMF. The IMF would soon ask for more money. As always in the past,
our government would make our taxpayers contribute.
There are better ways to help the Russian economy. First, we should remove all tariff and
non-tariff barriers to trade and urge the Europeans to do the same. If Eastern Europe can sell goods,
including food, to Western Europe and the U.S., they will earn hard currency to pay for Russian
oil, coal and minerals. The Russians will earn foreign exchange which they can use to stabilize and
develop their economy.
Second, Russia is rich in mineral resources. It lacks management skills and technology to
exploit many of these resources. These will not come from government-to-government loans or
the IMF. The most effective way to develop the Russian economy is to let foreign investors buy
participations in assets. The new owners will bring technology and management skills. But not
much will happen until the Russians establish the institutions and economic structure which permit
markets to function efficiently.
Russia has decontrolled many prices. This was an important step; it took courage to make
it. But it is not enough. With the present budget deficit and no clear rules for ownership and
contract, the economy will at best limp ahead. Foreign aid will be wasted.

March 8-9,1992

The mark of successful reform will be a flow of private capital to Russia and its neighbors.
Private capital from loans or asset sales can be used to stabilize the ruble and, if the budget is
balanced, bring down inflation and put the economy on a positive, sustainable growth path. Protecting U.S. taxpayers' interests will do more to help the Russians than the well-intentioned schemes
now on their way.

Direct Defense Procurement Purchases and
Unemployment by State

0
500
1000
1500
2000
2500
Direct Defense Procurement in 1989 per Person Employed in State (1988 dollars)
Source: Department of Defense and Bureau of Labor Statistics

March 8-9,1992

Shadow Open Market Committee

STRUCTURAL SHIFTS AMID A CYCLICAL FLUCTUATION:
A TRICKY ENVIRONMENT FOR COUNTERCYCLICAL
MACROECONOMIC POLICIES
Mickey D. LEVY
CRT Government Securities, Ltd.

The cyclical aspects of recent economic performance are well-known and disappointing: after
falling 1.6 percent from third quarter 1990 through first quarter 1991, real GDP has risen very
gradually for three quarters and, aided by the recent monetary easing, the economy is mounting a
stronger recovery from recession. However, this cyclical fluctuation masks deeper, structural shifts
in demand and supply that began before the recession took hold and will continue to distinguish
themselves well beyond the recovery. These non-cyclical adjustments, which underlie the
uniqueness of this cycle, are generating a significantly different pattern of output. Economic policy
makers, however, seem unable to discern these shifts and non-cyclical adjustments from previous
cyclical fluctuations, and so they continue to pursue traditional countercyclical macroeconomic
policies. Such policies would produce phantom, short-term gains for consumers and businesses at
the expense of sustainable long-term increases in living standards, and only postpone needed
economic reforms.
Recessionary conditions merged in Spring 1989, more than a year before real
GDP began to decline, and those conditions have persisted for nearly three years.
This elongated period of subdued economic activity is attributable both to the
cyclical slowdown in aggregate demand generated by the Fed's gradualist
monetary policy despite the significant decline in short-term interest rates
since Spring 1989, money supply grown was stingy from 1987 through most of
1991 and to ongoing structural shifts in the economy. These structural shifts,
which involve shifts in certain production processes and changes in sectoral
demand in response to changing relative prices and government incentives, have
been as important as the cyclical slump in shaping economic performance.
The resulting significant shifts in the shares of GDP have generated highly
variable economic performance across industries and regions. Exports have
continued toriseas a share of GDP, while the shares of investment in residential
housing and business structures, consumption of durable and non-durable goods,
and federal defense purchases have receded. Associated with this uneven pattern,

March S-9,1992

the Midwest has outperformed the national economy and its banks have generally
remained sound, in sharp contrast with the declining economies and widespread
banking problems on the eastern seaboard.
With the recent aggressive monetary easing, real GDP is projected to accelerate
gradually to 2-3 percent in the second half of 1992 and slightly over 3 percent in
1993, while inflation in projected to recede gradually in the next year. However,
uneven performance will persist as healthier aggregate economic growth unfolds.
Accordingly, certain industries will continue to consolidate, and certain regions
will continue to struggle with recovery.
In light of the nature of these non-cyclical adjustments, traditional countercyclical
macroeconomic policy prescriptions that attempt to manage aggregate demand
may be ineffective, inappropriate, and counterproductive. Excessive stimulus
may raise short-term activity, but it does not lift productivity or long-run growth,
and only weakens the durability of the expansion.
Cyclical Slump and Shifting Mix
Although the 1.6 percent decline in real GDP was far less than the average 2.5 percent decline
in the previous eight recessions, aggregate declines in selected variables have been in line with
recent recessions episodes. A number of recessionary-type conditions have gripped the economy
and financial markets for nearly three years: markedly weaker product demand in domestic
industries; squeezed profit margins and declining corporate profits; business efforts to reduce
operating costs, including payroll layoffs and inventory control; declining real estate activity and
prices; deterioration in credit quality, rising bankruptcies and sharp increases in bank loan loss
reserves; and declining short-term interest rates.
Meanwhile, amid this elongated slump in the aggregate economy, performance has continued
to be very uneven by industry and by region. Since first quarter 1989, real exports have risen 25
percent, compared to 1.2 percent in real GDP. While the slumping auto industry has received the
most attention, exports of capital goods, excluding autos, have risen 37 percent and exports of
consumers goods are up 27 percent. As a consequences, the changing mix of GDP that began in
mid-1985 has continued. Exports, which had fallen to 7.1 percent of GDP, have rebounded to 11.6
percent. Real consumption of durable and non-durable goods has fallen since early 1989, and has
declined as a share of GDP. New construction—both residential and business structures—has
fallen sharply in real terms and as a share of output, while federal defense purchases have also
receded by both measures. At the same time, businesses have reduced inventories relative to sales
and national output.

Shadow Open Market Committee

In light of this unevenness, it is no wonder that the real estate and retail trade industries have
incurred the bulk of the bankruptcies in the non-financial sector. Nor is it surprising that the
anecdotal evidence supporting the allegation of a credit crunch is largely concentrated in these
underperforming industries; clearly the supply of credit is being reallocated from declining to rising
industries, and the unevenness of performance is accentuating the reallocation. The banking
industry, whose portfolios were overweighted in assets of underperforming industries (particularly
real estate) and has been suffering from slumping loan demand, has experienced huge losses and
must deal with it excess capacity through restructuring and consolidation.
The unevenness by industrial sector has had a direct bearing on performance in different
geographic regions. The eastern seaboard, particularly the New York and New England areas, has
experienced economic hardship and significant readjustment because of its heavy reliance on the
weakest industries financial services, retail trade and real estate. This is also the region that has
been the most severely affected by the stingy bank lending environment. The cutbacks in bank
lending has occurred primarily as a consequence of declining loan demand and deteriorating
economic performance and credit quality, rather than a cause of these conditions. The Midwest,
with its heavy reliance on export-related manufacturers, has significantly outperformed the national
averages; depository institutions have remained stronger, and bank credit generally has been more
readily available. Within that region, areas relying on domestic automobile production have suffered, while certain other manufacturing centers have actually registered employment gains and
very few businesses bankruptcies. The Northwest has continued to outperform, with its strong
manufacturing and agricultural bases. California has been suffering from declining real estate
activity and prices. Contraction of the federal defense industry is having its largest negative impacts
on the economies in states that receive the highest per capita defense contracts including California,
Massachusetts, Connnecticut, Florida, Virginia and Texas.
Non-cyclical Economic Adjustments
This shifting mix of GDP has occurred both independently and as part of the cyclical slump.
It has involved both a change in the mix of aggregate demand that is, a change in the types of
goods and services demanded—and a shift in aggregate supply that is, a change in certain
production processes. These changes have occurred in response to changes in relative prices and/or
government policies that have encouraged or discouraged certain types of economic activity, as
well as rapidly changing technologies and demographics:

March 8-9,1992

The five-year surge in exports (10.5 percent average annualized growth) reflects
the lower U.S. dollar; the restructuring of production processes by U.S. manufacturers, including cuts in operating costs that have significantly increased
productivity and lowered unit labor costs relative to foreign competitors; and the
increased international demand for certain U.S. exports, particularly capital
goods, industrial materials and manufactured consumer goods.
Investment in residential real estate reached a peak in 1986 and began slumping
well before the cyclical downturn. The declines in real estate activity and prices
reflect gradually slower new family formation and the earlier reduction in the tax
advantages of home ownership and investment in multifamily dwellings, as well
as the sluggish economy.
Business investment in structures, which peaked in 1985 has fallen sharply, as
have real estate prices, partly in response to the significant oversupply generated
by the earlier tax advantages to build, and more recently by the subdued demand
for office space as financial and business service industries restructure and
consolidate.
Consumption of durable and non-durable goods has been sluggish—and has
declined as a share of GDP—as the earlier tax advantages of debt-financed
consumption (the deductibility of sales taxes and personal interest expenses) have
been eliminated, and high levels of indebtedness as well as declining real estate
values and demographic trends have dampened propensities to consume.
Businesses have reduced their desired level of inventories partly as an effort to
reduce operating costs and partly due to rapidly evolving inventory control
technology. As a result, certain production processes have been altered.
Federal defense purchases have declined in real terms since 1988. As a result
of the end of the cold war this trend is expected to accelerate. Although state and
local government purchases have risen, total government purchases have been
flat in real terms and receding as a share of total output.
While it is difficult to quantify the distinction between cyclical characteristics in the economy
and non-cyclical adjustments, much of what has been occurring has been non-cyclical. Typically,
excesses that emerge during expansions, fueled by stimulative macroeconomic policies (particularly
accommodative monetary policy), are eliminated during recessions by shifts toward restrictive
policies that squeeze aggregate demand. In contrast, many recent adjustments in the economy have
been in response to non-cyclical factors that change incentives and relative financial advantages of
certain types of activity, including tax policy, demographics, and exchange rates and international
economic trends.
Businesses have been actively restructuring their production processes throughout the 1980s,
and efforts have intensified since 1988. Attempts to cut operating costs have involved a permanent
reduction in the desired level of inventories, reduced payrolls in response to the high costs of labor
relative to capital, plant closings, and more investment in productivity-enhancing computer

Shadow Open Market Committee

equipment. While the cyclical downturn certainly has contributed to the weakness in the industries
involved, the declines in product demand and profit squeeze that forced many of the recently
announced restructurings unfolded well before the recession—in fact, it is unfortunate that many
of the announced restructurings were delayed until the recession (witness General Motors).
Throughout the 1980s, these restructurings generated significant productivity gains in manufacturing (2.6 percent annualized rise from 1980-1990 and 2.9 percent during 1983-1990), lifting the
competitiveness of U.S. exporters. More recently, the restructuring has spread to wholesale and
retail trade (both department stores and autos), real estate, banking, finance, business services and
other service industries like airlines.
Also, in the foreseeable future, the reductions in defense spending will transfer some of the
nations' most productive resources to private uses. This reallocative process will alter the mix of
demand for goods and services and have a significant impact on production processes and productivity in the private sector. In the near term, however, it will have a dampening impact.
These non-cyclical adjustments have generated the impression that the cyclical downturn was
much more severe than the actual statistics indicate. Many of these trends will supersede the cyclical
downturn and will significantly influence performance as the economy rebounds. Moreover, while
most attention focuses on the pain and short-run implications of these non-cyclical adjustments,
they form the bases for long-run productivity gains.
Foundations for Economic Growth
Contrary to popular impressions, the aggregate economy has stabilized and has been
expanding ever-so-gradually since second quarter 1991. Given the widespread restructuring, what
has lifted the economy? Exports have risen dramatically at a 14 percent annualized rate. Businesses
have increased investment spending on producer durable goods, more than offsetting declining
investment in structures. The bulk of this investment has been in information processing and related
equipment, while investment in transportation equipment has declined. The level of inventories
has stabilized following sharp decline during the cyclical downturn; the shift from inventory liquidation in the first half of 1991 to stability in the second half contributed positively to real GDP
growth. Investment in residential housing has begun to grow. Personal consumption expenditures,
which recovered immediately following their sharp decline in early 1991, but slumped again in
fourth quarter 1991, have shown renewed signs of life.

March 8-9,1992

The economy has been effectively chopping across an elongated trough. Real GDP is projected to grow at a very modest 1-2 percent annualized rate in the first half of 1992, accelerate to
the 2-3 percent range in the second half and 3 percent plus in 1993. However, the recent unevenness
of performance will persist, as strong growth in exports and producer durable goods equipment,
and a modest pickup in housing are expected to lead the recovery. In contrast to recent recoveries,
demand for consumer goods, including automobiles, will remain sluggish. Also lagging behind
will be business investment in structures, banking and business services, and national defense-related
industries. In other words, continued restructuring and selective downsizing is expected. The lack
of full participation of every industry in the recovery will continue to support negative impressions
about the economy.
The Federal Reserve has more than sufficiently eased monetary policy to accommodate an
acceleration in nominal GDP and real growth; lack of liquidity is not a factor that is inhibiting
sustained economic expansion. Bank reserve growth has been rapid and is accelerating: 10 percent
year-over-year, 16 percent annualized in the last six months and 21 percent in the last three months.
Rates of growth in the monetary base and Ml have risen sharply in response to the Fed easing: 12
percent and 9 percent, respectively, in the last six months. Growth rates in the broader monetary
aggregates have lagged behind. Six month annualized growth in M2 and M3 has been 3 percent
and 1 percent, respectively. This divergence reflects the shift of non-Mi components of M2
(particularly small time deposits) into Ml transaction deposits, plus bank purchases of U.S. Treasury
debt, while private loan demand continues to decline. These portfolio adjustments change the
composition of financial assets, but they do not alter the fact that the Fed has pumped up both
currency and bank reserves, and is maintaining a policy of monetary accommodation. In the last
three months, M2 growth has accelerated significantly to an approximate 4 percent annualized pace,
and the gap between growth rates of Ml and M2 has narrowed.
The increased liquidity provided by monetary accommodation is a necessary but not a sufficient condition for increased short-run spending. Recently, the confluence of non-cyclical
adjustments and structural shifts in many sectors have inhibited the growth of spending.
Consequently, the Fed's infusion of bank reserves has had the effect of pumping up prices of certain
financial assets. Yet, as these non-cyclical adjustments continue, certain factors create the basis
for a stronger economic rebounds. The lower interest rates ease household and business debt
burdens, raise real discretionary income and corporate cash flows, and lower the cost of debt-

Shadow Open Market Committee

financed spending; they help stabilize the market values of real estate and improve the quality of
bank assets; and will gradually lift aggregate demand. With business inventories low, any pickup
in product demand will elicit expanding production.
Exports are projected to grow approximately 6-9 percent per year in 1992-1993, despite
economic weakness overseas, providing a major source of product demand. The need to rebuild
infrastructure in Germany and throughout Europe, even as consumption and domestic demand in
certain European nations subsides, raises the demand for U.S. capital goods, industrial materials,
and electronic equipment. In the Asia Pacific nations, a major market for U.S. exports, economic
growth continues to outpace the industrialized world, and selected Latin American countries continue their strong turnaround (Mexico leads the pack, with Chile, Brazil and Argentina not far
behind), stimulating rapid growth in trade with the U.S.
Business investment in producer durable equipment will continue to rise as firms strive to
increase productivity. Investment in equipment is forecast toriserapidly, but total growth in business
fixed investments will be suppressed by continued weakness in business investment in structures.
Meanwhile, the rebound in employment, which typically lags the cycle, may be slower than usual,
as businesses that are expanding continue to focus on controlling operating costs, while businesses
that face further consolidation will shed excess human capital.
Given these foundations, a gradual recovery is unfolding, despite only modest participation
by domestic consumers. Real consumption is projected to grow slower than real GDP, reflecting
subdued growth in employment and real disposable income, and continued efforts by households
to restructure their balance sheets.
U.S. trade deficit will fall further, as exports grow strongly while imports are muted by the
slow rebound in consumption. The real trade deficit has shrunk from a peak of $164 billion in third
quarter 1986 to $18 billion in fourth quarter 1991. Absent misguided efforts to stimulate short-term
domestic consumption, the ongoing shift in the mix of output is projected to generate a trade surplus
by 1993.
The sustainability of the expansion depends crucially on the avoidance of macroeconomic
policy mistakes and government efforts to disrupt either the adjustment of relative prices (i.e. real
wages, interest rates, exchange rates) or free functioning of the goods sector. Persistent excessive
monetary easing that generates undesired rapid growth in nominal GDP and inflation pressures
would require a monetary tightening that would jar economic expansion. The recent rapid growth

March 8-9,1992

in bank reserves and the narrow monetary aggregates would be dangerous if sustained; although
inflation is projected to recede gradually in 1992, the continued rapid monthly growth would
eventually be inflationary and economically disruptive.
The Federal Reserve must recognize that the cyclical weakness in aggregate demand has been
relatively mild, requiring only mildly stimulative countercyclical policy. Aggressive monetary
easing that attempts to overcome what in reality have been structural and non-cyclical adjustments
would be a mistake, generating a temporary boost to the economy that weakens the durability of
the expansion. At issue is whether the Fed will take the politically unpopular step to lift the funds
rate and slow money growth even when inflation seems under control. This may prove difficult
during the election season.
In addition to low inflation, the ongoing adjustments of relative prices, without government
interruptions, are also a necessary ingredient to sustained economic expansion. Foreign exchange
intervention and attempts to manage the U.S. dollar are disruptive, may directly or indirectly lead
to policies that inhibit international trade, or may be inconsistent with domestic policy objectives.
Similarly, attempts to offset other private sector price adjustments (real wages), or to otherwise
mitigate the impact of non-cyclical adjustments on certain sectors, reduces economic performance.
Also, attempts to provide fiscal stimulus may also threaten the durability of the expansion by
temporarily shifting the timing and mix of aggregate demand growth and/or indirectly eliciting
undesired monetary policy.
Financial Market Implications
Short-term rates have bounced off their lows, the yield curve has begun to flatten, and the
U.S. dollar has begun to appreciate in anticipation of a sustained rebound in U.S. economic activity.
Prices of certain commodities such as lumber and copper have risen sharply, and the sizeable stock
market rotation from growth stocks to cyclical stocks is similarly anticipating rebound in economic
activity and profits.
The previous inflection point in interest and exchange rates occurred in Spring 1989, the last
time economic performance shifted gears. Short-term interest rates and the U.S. dollar peaked and
the yield curve achieved its most inverted point coincident with the last quarter of 4 percent plus
real GDP growth. As economic performance deteriorated into recession, short-term interest rates
fell more than one half (the federal funds rate declined from 9 7/8 percent to 4 percent), long-term

Shadow Open Market Committee

rates receded from 9.3 percent to 7.8 percent and the yield curve shifted to sharply positive, and
the trade-weighted U.S. dollar fell 11 percent, despite mounting economic weakness in most
industrialized nations.
The magnitude of the changes in interest rates around inflection points in economic performance tends to depend on how rapidly the economy shifts gears and the Federal Reserve response.
Around most previous economic peaks and troughs, economic decelerations and accelerations have
been fairly sharp, reflecting the abrupt changes in monetary and fiscal policies; consequently,
changes in short-term rates and the yield curve have been significant. On average, real GDP has
growth over 6 percent during thefirstyear of previous postwar economic recoveries, generating a
significantrisein short-term rates and flattening curve. The pattern of rates of this cycle is expected
to be different: if real GDP grows 2-3 percent—not significantly different than the Federal
Reserve's "central tendency" forecast of 1 3/4- 2 1/2 percent then short-term rates should stay
in a relatively narrow range andriseonly gradually beginning in late 1992. With inflation projected
to recede gradually, the yield curve is projected to flatten further, although the magnitude of the
decline in long-term rates may be inhibited by excessive monetary easing.
The U.S. dollar is projected to appreciate further as improving economic performance in the
U.S. relative to other industrialized nations and the associated shift in relative short-term interest
rates raise the demand for dollar-denominated assets. Economic performance in Japan continues
to weaken, Japanese asset prices continue to decline, and money growth is slowing, placing pressure
on the Bank of Japan (BoJ) to ease short-term interest rates. Economic growth in Germany is also
slowing, but heightened inflation pressure deters the Bundesbank from easing monetary policy.
This policy constrains other European central banks from lowering short-term interest rates and
thus limits domestic demand growth in those nations. Recently, the dollar has appreciated
approximately 7 percent versus the D-mark and most continental currencies, but only 3 percent
versus the yen due to coordinated intervention by the U.S. Treasury and BoJ. Such intervention
can only temporarily inhibit the fundamental trend; thus, look for more U.S. dollar appreciation,
particularly versus the yen.
More Misguided Fiscal Policy
President Bush and Democratic leaders propose traditional countercyclical stimulative
packages aimed primarily at lifting the economy from recession and reducing the impact of those
already hurt by recession (extension of unemployment insurance benefits). They pay lip service to
the need to raise investment and productivity, but recommend more deficit spending to provide a
short-term boost to consumption and housing activity. The President proposes a higher share of

March 8-9,1992

federal spending for entitlement programs, and no material cuts in the non-means-tested entitlements. The President's package, even if enacted immediately, would not have as large of a
broad-based, short-run stimulative impact as the Administration expects, in part because of its design
and in part because its traditional countercyclical (demand management) thrust would be ineffective
in overcoming some of the non-cyclical factors that have been inhibiting expansion. The leading
Democratic tax cut initiative is directed almost exclusively at redistributing income and stimulating
short-term consumption at the expense of long-term investment and growth. The current fiscal
debate sidesteps mounting long-term problems whose solutions involve microeconomic policy
adjustments and a reallocation of national resources designed to raise productivity and standards
of living.
The Administration asserts that enactment of its proposal will lift real GDP growth over its
baseline projection by 0.6 percent in 1992 and an average of 0.5 percent per year in 1993-1997. I
question this assertion. Lower withholding taxes will lift real disposable income by approximately
$25 billion in 1992 but it does so effectively by allowing taxpayers to "borrow" from next year's
expected tax refunds. This one-time shift may raise consumption now at the expense of consumption
later, but it certainly will not permanently raise spending growth. Moreover, it may have less impact
than expected due to the extent of households use the additional disposable income to reduce debt
burdens (save). The proposed 15 percent temporary additional first year depreciation allowance
will change thetimingof business investment but will not permanently raise investment growth.
All else equal, some other provisions of the President's proposal would have their announced
impacts. The proposed $500 increase in the personal exemption for certain households would raise
consumption, although a portion of the increase in after-tax incomes would be saved. The tax credit
for certain first-time home buyers would modestly increase new housing starts, but probably not
beyond a 1.4 million annual pace on a sustainable basis. The proposed permanent extension of the
tax credit for research and development as well as the President's already rejected capital gains tax
cut would raise investment and output. However, the positive permanent impact on investment and
jobs of the latter may fall short of the President's expectations, particularly if the savings from lower
capital gains taxes are added as a preference item to the Alternative Minimum Tax (AMT) base, as
is now proposed. In contrast, the short-run impact of cuts in defense purchases is contractionary.
In fact, a cut in defense purchases offset by a rise in government transfer payments lowers national
output. How defense resources are reallocated through the budget process and into the private
sector is key to long-run productivity and economic performance.

Shadow Open Market Committee

The negative financial market response to the President's budget package, the Administration's separate $100 billion health insurance plan that was proposed without a clear method of how
to pay for it, and the substantially higher deficit projections, have pushed up interest rates. This
constrains the potential impact of the budget proposal on aggregate output. Accordingly, if enacted,
the President'sfiscalinitiative may raise consumption spending and housing starts, and temporarily
lift businessfixedinvestment in 1992, but these gains would be achieved at the expense of future
investment, productivity, and output.
The pending Democratic initiatives would generate similar outcomes, only more accentuated,
through an aggresive redistributive tax scheme. The latest bill, passed by the U.S. House of Representatives includes a 20 percent credit on FICA taxes, up to $200 per year for individuals and
$400 for couples (cost, $45.3 billion), and several provisions to subsidize real estate, all to be paid
for by and increase from 31 percent to 35 percent in the top marginal tax bracket on individual
income, a 10 percent surcharge on the highest income taxpayers, and an increase in the AMT rate
to 25 percent. While not likely to be enacted, this legislation shows the misdirection of the fiscal
debate.
The fiscal debate ignores the failures of traditional countercyclical fiscal policies since the
1960s and why they failed. Countercyclical policies primarily aimed atincreasing aggregate demand
fail to permanently lift output because they do nothing to remove factors inhibiting supply. At most
they can have a temporary impact. Moreover, the tradeoffs they imply between short-run and
long-run growth and between investment (saving) and consumption are undesirable. Presendy,
they are particularly inappropriate remedies to the widespread non-cyclical adjustments underway
in the private economy. There is also a glaring gap in the debate about what should be the government's role in effectively reallocating valuable resources from national defense into productive
private sector uses.
The economy would be better served, even in the near term, if policy makers focussed more
on efforts to lift productive capacity and long-term growth, particularly in light of the demographic
trend of slower labor force growth. Raising productivity is the best way to lift real earnings and
living standards. The bases for these efforts should center on microeconomic adjustments that
provide more resources and incentives to invest in productivity-enhancing capital (physical and
human) and to save; to eliminate barriers to growth (including economic and non-economic regulations, breaking down trade barriers, etc.); and to consider the federal spending budget within the
context of how to best allocate national resources in order to create an environment conducive to
long-term growth, as well as achieve redistributive objectives.

March 8-9,1992

This requires less emphasis on the size of the deficit and whether it is in conflict with the
Budget Enforcement Act of 1990, and more on what we are deficit spending for, the incentives
created by the mix of spending and the structure of taxes, and the implications for long-run economic
performance. In recent years, the budget has been allocating a smaller share of resources into
programs where more resources are needed, like education and skill training, research and development, investment and infrastructure, but increasing outlays into non-means-tested entitlement
programs, which add to national debt but not productive capacity. In fact, this spending bias has
been institutionalized by the budget process: first by Gramm-Rudman-Hollings, which excluded
from sequestration many entitlements programs including social security, and now by the Budget
Enforcement Act, which places absolute dollar caps on so-called discretionary programs, which
include most productivity-enhancing investment programs, but allows spending increases in the
so-called mandatory (entitlement) programs. Certainly, these entitlement programs are well
intended and necessary. But many are inefficiently structured, costly economically, and generate
significant intragenerational and intergenerational inequities.
Two changes are desirable:first,institute the opposite set of constraints in the budget process,
placing absolute caps on the entitlements, but allow more spending for investment-oriented discretionary programs, and secondly, restructuring some of the entitlement programs to improve their
fairness and efficiency, ensure their long-runfinancialviability, and provide more resources for the
truly needy and other national needs.
Cuts in projected defense spending are not a substitute for these needed reforms.

Shadow Open Market Committee

CHART 1
I
1991
I
5589.0
Nominal GDP
i 4824.0
GDP
i
4843.7
GNP
48426
Domestic Demand
4875.4
"Final Sales
3241.1
170.7
Residential Investment
519.1
inventory Investment
1 -32.8
Government Spending
9445
Exports
512.5
Imports
531.1
GDP Deflator
1153
Employment Costs (Private)
111.4
1315
Unit Labor Costs (Non-Farm)
107J9
Productivity (Non-Farm)
142.0
Compensation (Non-Farm)
189.7
Corporate Profits A/T
w
Operating Profits A/T
182 J
«
418.4
Net Cash Flow
w
1 Current Account
10.5
JcjJ
QUARTERLY DATA

Levels

Yr-to-Yr% Change
% Change (annualized^
II
1991
1991
i
I
ll
II
111
Jll
IV I I
jv
L I
3.1
2.7
5746.7 |
2.3
4.6
4.1
2.7 !
2.5
3.4
48722 | -2.5
1.4
1.8
-1.2 -0.8
0.8 ! -1.2
0.4 |
NA | -2.8
NA i -1.0 - 1 1 -0.8
0.3
2.0
NA I
4889.8 I -3.5
-2.0 -1.5
0.9
3.4 -0.3 I -1.9
0.1
4878.9 I -3.4
0.7
0 5 -1.2 I -1.3
-1.0 -1.2 -0.8 |
-0.2 -0.3
3269.5 | -1.3
1.4
2.3 -0.2 | -0.5
0.5
182.0 -24.8
3.1
10.9
13.1 i -18.0 -13.8 -7.5 -0.7
504.1 -17.4 - 3 . 3
-3.7 - 4 . 5 j -5.7
-5.4 -8.2 -7.4
N/A
N/A
N/A
10.9
N/A
N/A
N/A
N/A
N/A j
9232
2.8 -0.1
-3.4 -5.4 I
2.3
1.7
0.9 -1.6 S
5622
-7.4
19.4
7.3
13.1
3.3
6.7
8.7
7.6 I
579.8 -15.4
13.3
22.3
2.5
-3.8
-1.2
1.6
4.7 I
117.0
2.8
1.4
2.4
3.8
3.0
2.1 I
2.5
2.2 1
116.7 J
5.6
6.6
6.9
5.7
5.9
6.1
6.3
6.2 1
1335
2.8
2.8
1.8
1.2 |
5.4
4.6
3.0
2.1 1
1085
0.0
1.9
0.7
1.1
-0.2
-0.2
0.6
0.9 1
145.4
2.8
4.7
2.6
2.3
5.2
4.4
3.7
3.1 1
2918.5
-4.7 - 3 . 7
3.8 1439.3 I -4.7
-5.7 -3.4 1366.6 1
2919.2
8.1 -1.5 -1.4 1544.6 I - 9 . 9 -10.8
10.2 1627.4 I
31653
- 1 . 9 -0.4
2.9 638.4
-4.1
-2.7
0.3 6415 I
NA
NA
135.6 -30.1 - 9 3 5
132.7 100.6
13.9
NA j
Monthly % Change
I
12 Month % Change>
1991
1992
1991
1992
Dec
Jan
Nov
Feb
Feb
Nov
Dec
Jan
I"eb
j
52.4
0.0
-5.5 - 5 . 8
10.5
20.6
15.0
22.5
34.0 J
-230
3
-91
NA
NA
-0.8
- 0 . 7 -0.6
NA I
-40
-47
-52
NA
NA
-2.5
-2.4 -2.3
NA I
0.22
0.01
NA j
NA -0.02
NA
0.87
0.95
0.86
0.4
0.4
-0.1
NA {
NA
NA
3.1
3.0
2.8
1.9 - 3 . 8
-0.9
NA I
NA
NA | -2.6
-8.8
0.3
NA
-0.3 -0.5
-0.8
NA
0.1
NA 1
-0.2
0.4
-1.0
NA
-0.6 • -0.6
NA
NA |
-2.8
- 2 . 2 -2.5
0.0 -0.1
-0.3
NA |
NA
NA
-0.4
- 0 . 2 -0.7
NA
0.2
0.2
0.3
NA I
NA
3.1
3.1
2.5
0.4
0.2
0.1
NA I
NA
NA
3.1
3.0
2.7
NA
0.3
0.2
0.3
NA
3.9
NA J
4.6
4.4
NA I
0.0
0.1
0.6
NA |
NA
-0.1
1.6
3.9
NA
1.9
5.5
0.0
NA
NA
-4.1
15.0
38.3
NA
-3.4
6.2
6.0
NA
NA
39.4
8.4
23.5
4.9 -17.4
NA
3.1
NA I
NA , - 2 7 0 - 2 6 5 -283
NA &
1.5
NA I
0.6 -5.1
NA I
1.5
6.8
-2.0
NA
NA
0.4 -3.7
NA 1
NA
NA
1.6
-1.7
NA J
0.7
NA
NA
-0.3
NA
-0.4
-0.1
NA
0.0
NA
NA
0.1
NA 1
NA
0.4
0.4
NA
0.75 -0.42
NA -0.52
NA J
NA -0.23
0.12 -0.42
0.9
NA
-0.2 - 0 . 2
NA
4.0
4.0
5.5
NA I
NA
0.1
0.4
NA
NA 1
NA
-2.0
-1.0
NA
0.03
NA
NA
0.00
NA -0.02 -0.01
NA
NA I
42.3
NA
NA -34.0
NA -56.3
NA
NA i
-6.1
-30
3.95 1 ^45** - 4 9
1
- 2 5 7 - 2 7 8 -255 -217
-53
-7
5.21
-35
25
-204 - 2 2 8 -217 -166 1
7.34
-11
-33
-6
31
-97
- 9 9 -106
-51
-22
-12
7.85
-1
-18 j
27
-69
-62
-54
3257.3
-1.1 - 0 . 9
9.1
0.9
247
13.6 I
18.6
13.3
41256
-0.2
0.7
7.1 - 0 . 8
27.8
13.7 I
22.4
18.2
88.0
0.5
-3.0 -2.6
2.3
7.1
2.8
3.1
72 I
-2.0
128
-0.9 - 1 . 2
1.8
0.3
-4.4 -6.2 -2.2 I
1.62
-4.1 -3.6
1.0
2.5
4.6
9.1
4.3
9.3 1
0.8
1.4
NA
NA
1.2
NA 1
10.2
8.2
8.7
NA
0.4
0.2
0.3
NA
NA 1
3.5
3.2
3.3
NA
0.1
0.1
NA
0.2
NA 1
1.3
1.3
1.5
NA
NA
NA
NA
0.5
NA 1
NA
NA
NA
NA
NA 1
NA I -0.0 -0.2
NA l - 0 . 9
NA
-0.9
i( Quarterly

II
III
56526
5709.2
4840.7
48627
4847.8
48720
4853.1
4893.8
4883.5
4893.7
32524
3271.2
172.0
1765
514.8
510.0
-30.4
0.1
9445
936.1
535.7
5452
548.0
5765
116.4
115.7
1132
115.1
1325
133.1
108.4
108.6
1435
1445
182.7
189.6
180.0
1775
416.6
428.7
3.0
-20.4
Levels
1992
1991
MONTHLY DATA
Nov
Dec
Jan
47.4
47.4
50.3
1 Purchasing Managers Index
I Non-Farm Payrolls
(b) 108.843 108546 108.755
18.290
18.337
18.238
Manufacturing Payrolls
W
7.1
7.1
6.9
I Unemployment Rate
(c)
| Avg. Hourly Earnings (sa)
10.47
10.48
10.44
| Domestic Unit Auto Sales
5.9
5.9
6.2
107.6
108.1
106.7
I industrial Production
78.8
79.3
78.0
Capacity Utilization
121.1
1215
121.6
PR
1332
133.6
132.9
PPt Ex. Food & Energy
1385
1382
1375
JCPI
144.7
144.4
145.1
CPI Ex. Food cV Energy
152.7
1535
1525
Retail Sales
1106
1167
1085
1 Housing Starts
1055
993
1118
Permits
-2.4
-15.7
-445
J Federal Budget
(d)
1175
119.6
124.0
I Durable Goods Orders
234.1
NA
I
243.1
I Manufacturing Orders
4075.3
NA
4046.9
Personal Income ($82)
32635
NA
3263.0
| Consumption ($82)
5.7
5.3
5.0
| Personal Saving Rate
(c)
| Leading Economic Indicators
1452
1465
1455
8 Total Business Inventories
817.4
NA
8135
1.53
NA
1.50
Inventory/Totai Sales
(c)
-5.9
NA
-4.2
Merchandise Trade
4.24
3.94
1 3 Month Bill
1
473"
T)(c)
5.03
4.96
5.56
2 Year Note
7.09
7.03
7.42
10 Year Note
(c)
7.92
7.70
7.58
30 Year Bond
W
2958.6
3227.1
2986.1
I DJIA
38851
416.08
38552
I SAP 500
85.7
86.1
88.0
I U.S. Dollar (FR8)
130
128
125
f Yen/$
1.56
1.58
1.62
8 DM/$
898.1
910.4
891.4
S M1
34423
34521
3434.4
|M2
4175.2
4180.5
4170.8
|M3
NA
NA
757.1
I C&l Loans & Non-Financial CP
728.4
NA
I
730.1
| Consumer CrecSt
' (a) Quarterly % changes are not airmuaJized
(b) Monthly changes are in levels
(c) All changes are in levels or baais points
Annual: sum of past 12 mc>nths
(d) Monthly: change from same month last yetir;

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Shadow Open Market Committee

03^ar-92

CHART 3

Growth of Real GDP and Its Components From 89:Q1 to 91:Q4
(Annualized Growth Rates)
Gross Domestic Product
Personal Consumption Expenditures
Structural Investment

-7.2%

Producers' Durable Equipment
Residential Investment

-7.2%

Exports

8.0%

Imports (minus)

-3.1%

Federal Government Purchases
State And Local Purchases

Mix of GDP
1986 vs 1991
Consumption: Durables

9.6%
8.5%

\mmmmmmm

Consumption: Nondurables

'mmmmMmmz/MMmmmm

Consumption: Services
3.8%
3.0%

Structural Investment

7.3%

Producers* Durable Equipment

7.4%
5.2%

Residential Investment

3.7%
7.5%

Exports

—

'5%

Imports (minus)
8.7%
7.6%

Federal Government Purchases

11.0%
11.4%

State And Local Purchases

1986

1991

35.8%
37.4%

March 8-9,1992

CHART 4

Real Consumption

I \ I ' I ^M'' i I
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Real Business Fixed Investment

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Real Residential Investment

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Real Exports of Goods and Services

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Shadow Open Market Committee

CHART 5

Real Inventory investment

-7
-6 -5 -4
Quarters Preceeding Trough

-3

-2

- 1 Trough 1
This Cycle

5
6 7
8
9
10
Quarters Following Trough
Post War Average

March 8-9,1992

CHART 6

02-Mar-92

Money Growth vs. the Fed's Target Ranges
Weekly M2
3650

3250

12/31/90
02/25/91
1992 Targets: Low-2.5% High-6.5%
1991 Targets: Low-2.5% High - 6.5%

04/22/91

06/17/91

08/12/91

10/D7/91

12/02/91

10/07/91

12/D2/91

01/27/92

03/23/92

Weekly M3
4400

4050

12/31/90
02/25/91
04/22/91
1992 and 1991 Targets: Low - 1.0% High - 5.0%

06/17/91

08/12/91

01/27/92

03/23/92

Weekly Ml
960
940
920

900

—

»
I

880

_
860
840
820

10/37/91

800
12/31/90
• 02/25/91
04/22/91
06/17/91
08/12/91
Note: The Fed does not currentty maintain target ranges for Ml.
Data Through 2/17/92
For comparison with M2 growth the range shown above is the M2 target 2.5V6 5%.

12/02/91

01/27/92

03/23/92

Shadow Open Market Committee
28-Feb-92

CHART 7

Currency

Bank Reserves

15.0%

Bank ReeervM (Adj.. SA.)
_

90
_

— Money Slock: Currency (S«)
— Red Currency (St) Yr/Yr

Bask Reaen*e (Adj.. SA.) Yr/Yr

Real Reaervw of Depository Inetmaiona (Ad

Monetary Base

0.0%

— Money Stock: Currency (Sa) Yr/Yr

M1
20.0*

10.0%

. Monetary Baae (Adj., SA) Yr/Yr

Mooetary Base (Adj., SA)

— Ml(SA)

Real Mooetary Baae (Adjufted. SA, MU.S)

— M1 (SA) Yr/Yr

— Real M1 (sa) Yr/Yr

M3
15.0%

3600

10.0%

3500
3400

L
10.0%

3300
3200
_ 3100
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2400

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o

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87

_M2(SA)
_ Real M2 (sa) Yr/Yr

_M2(SA)Yr/Yr

5.0%

M3 (SA)

Real M3 (sa) Yr/Yr

90
_

M3 (SA) Yr/Yr

CHART 8

02-Mar-92

M1 Velocity

Monetary Base Velocity
i

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M2 Velocity

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89^90

91 ' 92

TABLE 1

Trends in Selected Inflation Measures
(Annualized % Changes)
INFLATION MEASURES

1989

1990

1991

1991
'

III

CPI

4.8%

5.4%

4.2%

3.5%

2.1%

3.0%

3.2%

CPI EXCLUDING FOOD & ENERGY

4.5%

5.0%

4.9%

6.8%

3.3%

4.2%

3.5%

PPI

5.1%

4.9%

2.1%

-2.2%

-0.3%

-0.5%

3.7%

PPI EXCLUDING FOOD & ENERGY

4.4%

3.7%

3.5%

5.5%

2.4%

1.6%

3.4%

GDP DEFLATOR

4.4%

4.1%

3.7%

5.0%

3.1%

2.1%

1.7%

AVERAGE HOURLY EARNINGS

4.0%

3.7%

3.3%

2.9%

4.7%

2.6%

2.1%

UNIT LABOR COSTS

4.3%

5.2%

2.8%

2.5%

1.8

March 8-9,1992

Shadow Open Market Committee

MEMO TO THE SHADOW OPEN MARKET COMMITTEE
H. Erich HEINEMANN
Ladenburg, Thalmann & Company, Inc.

The trashing of the economy by national news organizations is a disgrace to American
journalism. News people wrap their craft in the flag of the First Amendment to the Constitution.
Cantankerous news persons, they say, are trustees of the institutions of freedom. However, that
trust will erode if its custodians abuse their role.
Reporting of economic news is a complex affair. To track the daily activity of more than 250
million souls in the world's richest economy requires abstract measurements often far removed
from the realities of daily life. As on example, the alchemy of seasonal adjustment routinely
transforms ups into downs and vice versa.
In such a setting, opportunities for bias and distortion are endless. A slanted story may be
hard to detect, even by specialists who spend full time crunching economic numbers. That said,
the negative spin on current economic news is obvious to even a casual reader or viewer.
News people have used real and imagined signs of weakness to attack the White House. The
message is plain. With the economy in trouble, the President should leave town. By sending a
garbled message, journalists have helped ensure an inappropriate and misdirected policy response.
Wall Street Journal publisher Peter R. Kann warned recently that when pack journalism
preempts a story, common sense and fairness are the losers. "Standards drop to the lowest common
denominator," he said. "... The larger the pack, the poorer the performance." Mr. Kann charged
that "there is a tendency toward exaggerated pessimism in much of what we read and hear. The
point isn't to dispense 'good news.* The press has obligation to tell the truth, which involves
problems, failings, promises unkept. Pessimism, however, is a mind-set that assumes the worst and
bends reality to fit"
Not long ago, the cover of a national magazine asked, "How Do We Get Back to Prosperity?"
The picture, hardly surprising, was a wrecked automobile, with Uncle Sam sitting to one side holding
his injured head.

March 8-9,1992

The U.S. has many problems, short- and long-term. Growth is slow. Real income per worker
has shown little change in recent years. Debt is high. Net investment and productivity are low.
Living standards are under pressure. However, the economy now close to $5 trillion a year—is
neither bankrupt nor in a recession. Neither manufacturing in general, nor autos in particular, are
wrecked.
To the contrary, the U.S. is recovering, albeit slowly. Gross domestic product rose $17 billion
in the second quarter of 1991, $22 billion in the third and $9.5 billion in the fourth. Jobs have begun
to rebound, after dropping 1.5 percent during the recession. A Total of 93.7 million people had full
time jobs in February. This was the third consecutive monthly gain for a total jump of 784,000.
The drop in jobs during the recession was well below the average postwar downturn.
Personal income after tax, adjusted for inflation, came to $3.5 trillion last year, little changed
from the second set in 1990. The net worth of the U.S. "household sector" is more than $17 trillion,
including $2 trillion in residential real estate.
U.S. exports have risen 80 percent in the past six years. Trade in goods and services is close
to balance; exclusive of oil imports (which reflect geography, not economics); the nation has a
substantial payments surplus. The much-maligned auto industry represents a slightly larger share
of the economy today than in the 1960s, when firms such as General Motors were highly profitable.
Don't Give Up The Myth
The national news pack has been reluctant to abandon the myth that activity is in a sharp
decline. For instance, network news organizations routinely report weekly data on initial claims
for unemployment insurance. Few bother to put such data in context. In the last year, approximately
23 million Americans filed unemployment claims. Yet over the same span, total employment was
unchanged.
This means that over the past year 23 million workers were either recalled to their former
jobs or found new ones. Reporters properly include news of layoffs in their dispatches. However,
they rarely include reports of the route hiring that is essential to the normal working of the economy.
In fact, the U.S. has a labor market that is as big as it is diverse and dynamic. The flows of workers
through the market are huge. Jobs are tough to getrightnow, but let's not invent difficulties.
Many of the sins are of commission, no omission. Malodorous material is pouring out of the
information sewer. The New York Time said that "payrolls fell by 2.3 million jobs between July,

Shadow Open Market Committee

1990and April, 199L That's almost as manyjobs as were lost in the 1981-82recession." According
to The Washington Post, "between June, 1990 and December, 1991, total employment dropped
nationwide by more the 3 million jobs."
These assertions were false, as a quick check of standard government data would have shown.
The facts are as follows:
Non-farm payroll employment was 110,269,000 in July, 1990; it was 108,736,000 in
April, 1991, a decline of 1,533,000. Duringthe 1981-82 recession, payrolls went down
2,823,000. Moreover, the 1990-91 slump was a drop of 1.5 percent; a decade earlier,
with a smaller work force, the decline was 3.1 percent. Total employment—which
measures the number of people who have jobs rather than the number of jobs—came
to 116,728,000 in December, 1991, down 1,539,000 from the June, 1990 total of
118,267,000.
According to ABC News and Money Magazine, "public confidence in the economy dropped
another notch to a new all time low" this winter. Look at what actually happened. Retail sales rose
across the board. Sales of new homes exploded. Cancellation rates on new home contracts fell
sharply. Total vehicle sales rose to an annual rate of 12.5 million units in February, up 800,000
units from a month earlier.
Who Gets What?
Democratic presidential candidates have been trying hard to transform alleged inequities in
the distribution of income into a campaign issue. Their task will be easier because of spurious
reporting in The New York Times. The Times asserted that "an outsize 60 percent of the growth in
aftertax income of all American families between 1977 and 1989 and an even heftier three-fourths
of the gain in pretax income—went to the wealthiest 660,000 families." That was one percent of
the 66.3 million families in the U.S.
However plausible that claim might appear, it was absurd on its face. During the 12-year
period 1977 through 1989, real after tax income rose by $960 billion to a total of $3.5 trillion. (The
Times reported this gain as $740 billion in itsfirstedition and $583 billion in its second. There was
no explanation about what happened to the missing $157 billion.) If one percent of all families had
really accounted for $576 billion of the $960 billion gain, that would have left only $384 billion
for everybody else.
Yet in the same span, real consumer spending went up $926 billion to a total of $3.2 trillion.
Where did all that money come from? The increase in consumer debt was nowhere near big enough,
even without an inflation adjustment Moreover, that's only part of the story.

March 8-9,1992

In current dollars, the net worth of the household sector rose $10 trillion to $17.3 trillion in
this period. That included a $2.4 trillion jump in home equity and a $ 1 trillion rise in net investment
in consumer durables. In additional, there was a whopping $5.9 trillion gain in net financial assets.
What The Times was actually trying to account for was not the change in TOTAL incomes
(what the headline and the illustration with the piece said in all editions of the paper), but rather the
change in AVERAGE incomes, which is very different. Michael Milken's outlandish $500 million
bonus probably accounts for most of the anomaly.
If The Times' initial report had been accurate (it was not), this would mean that it would be
irrational for national firms to spend billions of dollars every year to reach mass markets through
advertising on network television. In such an event, presumably, the only truly valuable advertising
media would be publications such as The Times, with their narrow, affluent, upper-crust readerships.
Teenage Recession
Among many important stories that news organizations have ignored is the impact of the
increase in the minimum wage on teenage employment. Teenagers (people aged 16 to 19) are
typically hit hard during a business downturn. They have few skills, little or no seniority and weak
attachment to the labor force. When business slows down, they are always among the first to be
laid off.
Because teenage jobs are far more volatile than the adult work force, shifts in teen employment
are a leading indicator. Teenage jobs were unusually weak in the 1990-91 downturn. Changes in
teenage employment usually account for about one-third of the variance in total employment. By
contrast, during the 1990-91 downturn, the number of employed teens fell by 950,000, or 66 percent
of the drop in total jobs.
Teenage unemployment rose far less. Most of the young people who lost their jobs simply
dropped out of the labor force and did not look for work. More recently, teenage employment has
started to rise once again, a further sign that an accelerated recovery is now underway.
The Labor Department regularly publishes data that track the reasons why individuals are not
in the work force. During the fourth quarter, 65 million people were neither working nor looking
for work. Of this total, 91 percent were out of the labor force by choice. They were keeping house,
retired, going to school, or were ill or disabled.

Shadow Open Market Committee

Some 5.8 million individuals who said they would like a job did not look for work. They
cited a variety of reasons: school, ill health, home responsibilities, plus about 1.1 million "discouraged workers." These are individuals who stopped looking for a job/work because they thought
they could not get one. Government statisticians break thesefiguresdown by sex, race, age and
prior work experience.
It is hard to separate the impact of the recession on teenage jobs from these other factors.
However, the 27 percent increase in the minimum wage from $3.35 a hour to $4.25 in 1990 and
1991 plainly played a role in reducing jobs available to low-skill, inexperienced and poorlymotivated workers. In an effort to head off such a result, current law provides for a special, subminimum "training wage" for young people. Unfortunately, the red tape in this program has
discouraged employers from using it.
Debate about the minimum wage is usually framed in terms of social equity. Such issues
play well, but they are irrelevant. The facts are simple: the minimum wage is an inefficient and
inequitable method to give a subsidy to low income workers. It gives benefits to people who don't
need them (for example, teenagers from upper income families) and it reduces employment
opportunities. The increase in the minimum wage made the performance of the job market appear
bleaker than it really was.
Flash Point For Inflation
In an environment of near-hysteria about the economic outlook, the Federal Reserve's easy
money policy is now out of control. Preliminary data indicate that total bank reserves the raw
material for the money supply rose at a compound annual rate of about 60 percent in February.
Money growth has passed the flash point for inflation. While price changes are subdued at
present, that reflects tight money from 1987 through 1990. Easy money in 1991,1992 and beyond
will eventually result in higher prices, higher rates and another slump. Assuming George Bush
wins in November, he may regret his victory.
The value of financial assets equity and debt is likely to ride a wild roller coaster in
1990s. For the immediate future, prices should continue to rise as the Fed floods the market with
high powered money. Talk of a new era in Wall Street will likely become commonplace. However,
easy money always gives way to tight money. The only question is when.

March 8-9,1992

The growth of total bank reserves in 1991-92 has retraced the near-vertical pattern it traced
in 1986. The massive surge of fresh liquidity in 1985 and 1986 was followed in 1987 by an abrupt
reversal. Reverse growth dropped from 25 percent to zero, thus setting the stage for the stock market
meltdown on Monday, October 19, 1987. The spike in reserve growth this winter is an obvious
warning for investors. Too fast leads to too slow, which leads to too fast, which leads to...
Fed chairman Alan Greenspan has painted himself into a corner. He is pegging the price of
bank reserves, the Fed funds rate, at 4 percent. This is far below market equilibrium. He must
pump huge amounts of high powered money into the credit market to keep the funds rate from
rising.
Attempts to hold down credit costs in an expansion always boomerang. Holding rates down
forces the Fed to print money. The more money Mr. Greenspan prints, the more the expected rate
of inflation will rise. As a result, interest rates will go up at an accelerating pace as investors seek
to maintain the real return on their assets.
The Federal Reserve's dilemma is likely to become more difficult in months to come. The
White House and Capital Hill are flailing around trying to jump start the economy in time for the
election. Mr. Greenspan would be lynched if he allowed short-term rates to rise.
Last month, with the economy still moving in very slow motion, the Fed had to pump out
funds at a pace more appropriate in Latin America than the U.S. As the recovery gathers momentum,
the equilibrium rate will also go up. The longer Mr. Greenspan holds rates down, the more money
he will have to print, and the further rates will ultimately rise.
According to The Wall Street Journal, "bond investors" havefrustratedthe Federal Reserve's
"grand plan" to lower interest rates. Editors of the paper seemed puzzled why long rates should be
rising, in face of the Fed's determination to hold short rates down. There is no mystery why long-term
rates have gone up, and why they will likely continue torise.By pegging the funds rate at 4 percent,
the Fed is in effect offering to sell reserves at a bargain price.
A simple model will illustrate. To hold Fed funds at 4 percent, the Fed must supply whatever
quantity of reserves banks desire to hold at that price. It cannot control the demand for reserves in
the short run. Clearly the demand for reserves is very large at a rate of 4 percent.
Investors (bond or otherwise) were not "responsible" for higher rates. In fact, Fed officials
themselves were primarily to "blame." Bond buyers simply responded rationally to the inflationary
signals from the central bank. Rates rose because investors wanted to protect the real value of their
principle.

Shadow Open Market Committee

Meanwhile, Washington is alive with talk about schemes to manipulate long interest rates by
reducing Treasury sales of long-term bonds or by having the Fed peg long bond prices. Such efforts
will fail. Investors set bond prices and interest rates by judging the expected value of debt already
outstanding not by watching changes in the supply of new issues.
If the Fed wanted to influence long-term rates direcdy, it would have to buy bonds, which
would add to an already swollen money supply. That would fan fears of future inflation even more,
which would lead to higher, not lower, rates.
Were the Fed to offset its purchases of long bonds with sales of short-term paper, that would
put upward pressure on short rates. The Fed attempted to twist the yield curve in this fashion during
the 1960s, with poor results. They never learn.
Moreover, as Mr. Greenspan pointed out in a recent letter to the chairman of the Senate
Banking Committee, Donald W. Riegle, Jr. (D-MI), the Treasury scope for cutting back its security
sales in one or another maturity sector is limited by "the huge size of the deficit. Considerable sales
will likely be needed in all maturities.
"Large shifts toward the short end could distort (read boost) yields, thereby dissipating any
advantage to the Treasury. A major shortening of Treasury debt would also alter the liquidity profile
of the economy, with possible implications for the stance of monetary policy."
Mr. Greenspan did not say so, but a significant drop in the maturity of the debt would also
expose taxpayers to an immediate increase in interest coasts when the Fed tightens, as it inevitably
will.
Get America Moving
Growth, or the lack of it, will surely dominate the election campaign this fall. Ironically, the
economy's current difficulties are nowhere near as bad as commentators on the nightly news
maintain. Despite its sluggish aftermath, the recession was short and shallow.
Business should be expanding at a good clip well before election day, driven by strong exports,
capital spending, housing as well as moderate gains in consumer spending. The long-run story is
more discouraging. The economy has moved in slow motion for almost 20 years. The long-term
trend of real growth is now 2.5 percent or lower, a full percentage point below where it was during
the first 25 years after World War DL

March 8-9,1992

This difference adds up. For example, last year real disposable income per employed worker
was $30,240 in constant 1987 dollars. If the nation had maintained its early post-war trend, the
average real income per worker (wages, salaries, benefits and income from investments) would
have been 41 percent higher, or $42,574.
The chief culprit is an equally long-term slump in the profitability of American corporations,
which led to a parallel drop in net investment and productivity. What America needs, and what
Washington has failed to provide, is a strategy to reverse this trend and get the economy moving.
Voters elected Presidents Reagan and Bush in part because of their pro-growth rhetoric.
However, neither President tried to implement the radical shift in financing of U.S. health, safety
and environmental regulation needed to reinvigorate the economy
The pending overhaul of the health care system may be the litmus test for future performance.
If Congress decided to finance national medical insurance with explicit or implicit corporate taxes,
the result will be less investment, less productivity and even lower rates of growth.
The economic virus that has infected the nation is easy to identify. As a share of the economy,
saving and investment have eroded far below the standard of the last 50 years. In effect, U.S.
workers have lacked the tools they needed to maintain their productivity, or output per hour. As
productivity has lagged, so too have real incomes, growth and living standards especially in
relation to other industrial nations.
Saving and investment declined because the return on investment went down, which dulled
the incentive for firms to spend for new facilities. Profits as a share of national income are now a
fraction of their postwar norm. Corporate cash pays for the bulk of productive investment Thus,
growth in the capital stock has stalled.
U.S. workers have gained a progressively larger share of the economic pie over the last 30
years. In the jargon, labor income has accounted for a larger part of national income; the share of
income from property has gone down. Even though the share has gone up, living standards are
under pressure because total income has grown at slower rates.
There were many reasons for the erosion in profits. Congress boosted EXPLICIT corporate
taxes $ 120 billion in 1986 by repealing investment incentives. Substandard returns created a setting
where financial engineers were more important than product engineers. While merger mania made
Wall Street rich, it backfired horribly, leaving companies with little else but crushing burdens of
debt and interest.

Shadow Open Market Committee

More fundamental over the long run was the huge, largely uncharted, increase in IMPLICIT
corporate taxes to pay for federal health, safety and environmental regulation. The nation must
shift the burden of such taxes toward income from labor and away from income from property to
resume its former growth rate. If voters refuse to act, they will pay the price in lower living standards
in relation to other advanced industrial countries.
Americans want clear air, clean water and safe places to work. They want to protect
endangered species and have comprehensive medical care. They are less clear how to pay for such
benefits. Enter the mandated environmental expenditure, the politician's dream and the economist's
nightmare. Such laws require companies to use the "best available" technology to reach environmental and/or social goals.
Raising taxes would produce an immediate response from voters. However, mandating
corporate outlays, at whatever cost, effectively masks the expenditure. It is almost impossible to
trace who pays for such regulations or find out precisely what the costs are.
According to Robert Crandall, a senior fellow at the Brookings Institution, a Washington
think tank, "federal environment policy is absurdly inefficient The cost of environmental policy
has been rising steadily and draining valuable resources from other productive uses. Much of this
cost is unnecessary the result of poorly designed legislation."
Mr. Crandall argues that Congress has ignored "years of research into marketed-based
approaches to solving environmental problems. . . We continue to spend far too much for the
environmental results we obtain." He speculated that "it is possible for this inefficiency is deliberate"
aimed at keeping the lid on growth.
"There are many Americans," he added, "who believe that economic progress is necessarily
associated with environmental degradation. . . These largely populist groups see environmental
policy as a means to rein in untrammeled economic progress." In other words, slow growth (no
growth?) is an objective of regulation rather than an unintended consequence.
Whatever the motivation, the growth slowdown is real. Average Americans are working
harder and earning less. This pattern will not reverse without more investment and more productivity. In turn, that requires a higher rate of return. Corporate profits are too low!

PEOPLE ARE GOING BACK TO WORK
1
2
N
0
N
T
H

C
H
A
N
G
E
S

Full Tine
EMploynent

1965 1968 1971 1974 1977 1980 1983 1986 1989 1992
Notes: The chart shows annual changes in full-tiMe eMployMent in nonfarM
occupations. Data are Millions of eMployees. seasonally adjusted.
Household survey. Total nonfarM eMployMent less voluntary and
involuntary part tiMers. Vertical lines show recessions.
Sources: Haver Analytics; HeineMann EconoMic Research

EASY HONEY
T
H
R
E
E

22.5X-I
15,8X

N
0
N
T
H
C
H
A
N
G
E
S

Total Bank Reserves
7.5K-I
0
-7.5'/J

1988
1989
1990
1991
1992
Notes: The chart shows the three-Month rate of change in a threeMonth Moving average of totar bank reserves adjusted for
shifts in legal reserve requirenents. Data at seasonally
adjusted annual rates. The vertical lines show the recession.
Sources: Haver Analytics; HeineHann EconoMic Research

TOTAL BANK RESERVES (FR8)
(MillionaofDoJiara)
Compound Annual Rate* of Change

05-Mar-02

initial Monm

I ]F so 90

Mar

Apr

May

Jun

Jul

Aug

Sep

Oct

Nov

Dec

Jan 91

Feo

Mar

Apr

May

Jun

Jul

Aug

Sep

Oct

Nov

Pec

Jan 02

Feb

Terminal
Momn

48048

48112

48202

47962

47806

47636

47973

48262

47942

48245

49104

49459

49590

49530

40344

50000

50345

50410

50666

51147

51818

52695

53752

Mar 90

181

Apr

1.94

2.27

May

-071

-186

481

I Jun

•0.05

178

•3.75

•164

Jul

•205

-2.04

•461

•401

•6.32

Aug

-0.31

-0.60

•1.42

0.00

0.07

Sap

0.76

0.62

0.30

1.60

3.00

8.15

747

Oct

•0.33

-0.60

•1.08

-0.10

0.29

250

-0.30

•7.87

Nov

055

0.41

0.15

1.18

1.78

3.88

229

-0.21

785

Dec

£64

276

282

4.12

5.11

7.56

724

7.18

15.45

23.59

Jan 01

3.21

3.37

3.40

4.72

5.66

7.80

7.60

7.83

13.27

1608

9.03

Fat>

3.21

3.36

3.47

4.55

5.35

7.13

6.65

6,73

10.67

11.63

6.00

323

Mar

284

205

3.01

3.04

4.57

6.02

5.63

532

8.13

8.21

3.52

086

-1.44

Apr

231

236

237

3.15

3.64

4.81

4.32

3.87

5.03

5.55

1.47

•0.93

-204

-4.41

May

124

135

a 44

4 25

4.80

508

5.87

5.45

7.47

7.41

4.44

3.32

3.35

5.83

17.17

3.56

3.70

3.80

4.58

5.11

6.22

506

5.80

7.61

7.58

5.12

4.35

4.64

675

1261

8.80

Jul

145

3 56

165

4.36

4.84

5.82

5.55

5.36

6.02

6.81

4.60

3.88

4.01

5.43

603

502

1.58

Aug

3.00

4.04

4.15

4 85

5.33

6.28

6.07

5.05

7.41

7.36

5.40

5.00

5.30

8.70

0.87

7.28

562

Sap

4.03

4.16

4.27

4.04

5.30

629

6.00

5.06

7.31

7.26

5.50

516

5.44

6.64

8.90

7.04

553

210

6.33

Oct

4.63

4.80

4.04

561

6.06

6.83

6.78

8.08

610

666

640

6.81

8.04

10.27

8.04

202

11.83

11.48

16.86

Nov

542

5.81

5.70

6.48

6.07

7.86

7.80

7.82

0.12

0.22

8.00

790

643

274

11.02

11.07

11.57

14.22

15.00

10.50

Oec

6.31

8.54

8.76

7.46

7.00

600

8.01

0.00

10.30

10.40

0.47

0.51

10.15

11.52

13.60

13.21

1200

1666

17.87

21.08

24.62

28.01

Jan 02

6.66

6.00

7.12

7.81

8.33

0.21

9.24

0.35

10.50

10.78

0.86

0.03

10.56

11.83

13.80

1230

14.00

1532

17.22

20.11

21.20

20.63

14.65

Fad

636

8.66

a oe

0.72

10.32

11.28

11.41

11.65

1298

13.34

1264

1202

13.77

15.28

17.44

17.47

1663

21.20

2202

20.54

20.07

31.30

33.60

Jun

Source: Helnemann Economic Reeearcfi

54368

8.83

11.04

2237

55.88

56417

b a w b N b b ^ b M - * w ^ ( o

o ) w o i b l o u i - - b y » i o ' * . - i b D -

i u u b b b - b b b * ^ b * - * N O - 6 i u b f o b N O M b N > 4 » a ) b

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83SHM2HMIMB83SBMS88B88SS5S

S s o o u > u i N s i o s o ^ i o ^ S S o i | y } S S G u N o S o » N 0 < * t t
i f o a M a ^ b a i b i a b t b i > b c » b i & N b 6 b D U N ^ - > b u i b N

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mi&!£fc&f*fmfmfc&f{fmfgfifc

Shadow Open Market Committee

Table 1 «Part 2
Federal Reserve Action and Monetary Growth

(in

(13)

(12)

Savings
4 Small
Adjusted
Reserve
Ratio

Date
(3/10)
Jul 1988
Aug

Mar
Apr
May
Jun
Jul
Aug
Sep
Oct

Nov

o.om

Dec
Jan 1992
FebPE

0.0170
0.0171
0.0177

Sep

Feb
00

Mar
Apr

May
Jun
Jul

Aug
Sep
Oct
Nov

Dec
Jan 1991

Feb

(5/4)

(2/4)
0.0147
0.0147
0.0148
0.0149
0.0149
0.0131
0.0191
0.0131
0.0131
0.0132
0.0131
0.0131
0.0150
0.0150
0.0150
0.0150
0.0152
0.0153
0.0158
0.0158
0.0180
0.0157
0.0180
0.0180
0.0181
0.0182
0.0183
0.0184

Oct
Nov
Dec
Jan 1090

Currency
Ratio

0.3931
0.3948
0.3947
0.3924
0.3930
0.3940
03983
0.3997
04018
0.4042
0.4084
0.4100
0.4155
0.4182
0.4225
0.4288
0.4305
0.4322
0.4440
0.4440
0.4428
0.4430
0.4378
0.4354
0.4373
0.4374
0.4373
0.4353
0.4309
0.4293
0.4257
0.4178

3.5909
38135
3.8181
3.5990
38152
3.8107
38221
3.6114
3.6149
3.6208
3.8374
3.6293
3.6540
3.6430
3.6423
3.6616
3.6621
3.6592
3.6928
3.8832
3.6457
3.6509
3.6120
3.3783
3.5682
3.5402
3.5153
3.4697
3.4166
3.3848
3.3284
3.2400

1.0372
1.0310
1.0229
10100
10077
0.9993
09940
09788
0.9859
09542
0.9519
0.9439
0.9431
0.9283
0.8933
0.8978
0.8896
0.8823
0.8738
0.8861
0.8642
0.8517
0.8321
0.8171
0.8067
0.7888
0.7743
0.7537
0.7290
0.7101
0.6908
0.6573

0.3358
0.5170
0.4980
0.4734
0.4713
04558
0.4489
04431
04343
04263
04396
0.4368
04383
0.4434
0.4331
0.4337
0.4228
0.4081
0.4057
0.3957
0.3821
0.3750
0.3602
0.3514
0.3461
0.3504
0.3403
0.3419
0.3391
0.3294
0.3259
0.3202

(2+4/1)

(9/4)
0.0211
0.0190
0.0198
00205
0.0193
0.0197
0.0201
0.0187
0.0186
0.0188
0.0193
0.0188
0.0183
0.0193
0.0204
0.0181
0.0188
0.0184
0.0192
0.0171
0.0166
0.0173
00166
0.0154
0.0160
0.0157
0.0155
0.0151
0.0152
0.0157
0.0158
0.0141

Money
Multiplier

Treasury
Deposit
_B§tto

Foreign
Deposit
__Rado
(8/4)

(7/4)

(8/4)

(18)

(17)

Nondeposit
Llabil.
Ratio

Large
Time
Deposit
Ratio

Time
Deposit
Ratio

(16)

(15)

(1*)

0.0415
0.0285
0.0448
0.0369
0.0262
0.0348
0.0412
0.0388
0.0294
0.0351
0.0444
0.0367
0.0270
0.0412
0.0343
0.0369
0.0337
0.0405
0.0519
0.0685
0.0491
0.0353
0.0338
0.0399
0.0351
0.0286
0.0447
0.0470
0.0463
0.0406
0.0026
0.0406

2.8743
2.8710
2.6686
2.8772
2 8732
2.8672
2.8495
2.8478
2.8408
2.8309
2.8161
2.8125
27938
2.7833
2.7723
2.7502
27404
Z728Q
2.6606
2-6801
2.6627
2.6913
27073
27180
27121
27115
27131
27205
27335
27366
27531
27738

Table 2
Federal flwrw Action and Monetary Growth

(Compound Annual Rates of Change)

P«ta

Monetary
Growth
(M-1)
(M-M

Jul I860
Aug
Sep
Oct
Nov
Dec
Jan 1990
Feb
Mar
Apr

8.79
123
129
2.99
0
9 770
1.39
7 330
0
2.78
8.87
9.96
4.61
•0.60
-0.60
6.17
-1.04
-104
8 94
54
9.28
-0.88
2
23
2.23
3.99
0.19
19.87
9.21
1.16
11.81
9.81
4.18
4.16
9.59
7.81
13.24
14.96
9.49
17.79
17.75
28.60
1968
9.02
1969
0.92
1990
4.09

May
Jun
Jul

Aug
O
y
£
^
§
<§•

Federal
Reserve
Actions
(Monetary
Base
Growth)

Sep
Oct
Nov
Dec
Jan 1991
Feb
Mar
Apr
May
Jun

Jul
Aug
Sep
Oct
Nov
Dec
Ja/> 1992
Feb PE

1991-IH

4.21
2.64
4 001
1
9.63
310
10.03
1003
10
74
10.74
9.72
8 77
896
9 669
9
7.62
7.20
13.46
14.73
9.09
6.74
6.38
9.38
23.45
16.21
7.96
•2.69
-2.65
4.09
4.79
4.75
6.92
9.84
7.09
9.96
8.96
6.04
9.93
17.98
17.96
1988
7.00
1989
4.09
1990
9.37
1991-IH

8.00
1991-IIH

Ad|utted
Reserve
Ratio

4 56
139
-1.02
3 87
-171
-2 73
-7 99
-0 89
3 19
-4 33

-0.94
0 78
-1.46
-2.28
-078
-178
-0 17
-0 12
-108
-039

-6 49

161

-169
-6.24

-010
107

4 02
-2.89
0.16
3.86
-101
-179
-7 94
-220
-3 23
-429

0 41
-087
-017
0 73
-081
016
-0 47
049
-014
-023

-6 79
-264
-866

NonOepostt
Liability
Ratig

0.36
0.24
0 31
049
009
0 34
0 22
0 63
0 92
047

0.49
0.73
0.80
0.79
0.19
0 64
0 28
0.24
0 39
0.32

-0 69

009

-092

032
-0.99

032
003

011
-0.10

-4 92

-0 66

-4 93

0.44

0.80

-0.16

0.93
-0.23
-2.30
-3 78
-2.83
-140
-3.12
3.10
-2.48
-0.42

-7.31
-9 53
-3.08
-2.79
-18.97
0.02
2.06
-0.17
7 53
3.99

0 03
-0 73
-0.02
0.11
-1.49
0.93
0.78
-0.16
1.37
122

1.46
-0.17
0.32
0.29
0.37
0.24
0.08
0.39
0.69
0.94

0.43
-0.02
0.43
0.98
0.10
0.31
0.99
0.22
0.92
0.32

-2.74

-0.55

-3.44

0.46

0.47

0.14

-0.29
0 72
3.68
6.39
1.49
6.22
1102
1988
•1.98
1989
-3.17
1990
•9.28

2.44
-0.29
-137
-3.07
-2.34
-027
-7 80
1988
0.47
1969
0.11
1990
-0.45

0.12
0.10
2.80
6.46
1.86
9.67
12.98
1988
-1.94
1989
-Z92
1990
-9.21

-1.58
0.64
1.64
1.96
0.99
2.36
366
1988
- a 18
1989
-0.52
1990
-0.19

-101
0.37
0.74
0.91
0.55
0.82
1.37
1968
-0.21
1989
4X19
1990
0.40

0.13
0.26
-0.06
0.11
0.28
0.19
0.23
1968
-a 13
1969
0.29
1990
a 16

1991-IH
•0.97

199MIM
6.33
•0.64

This it accounted tor by changes in the:
.
Savings
A Small
Urge
Time
Time
Currency
Deposit
Deposit
Ratio
Ratio
Ratio

-949
-9 97
-4 50
-5 79
-23.31
-0.34
1.23
3.81
7.71
907

1991-IH
8.97

1991-IIH
9.87
1.87

Contrlbutton
of the
Money
Multl*
plier

1991-IH
-1.19

1991-ilH
194
2.91

199HH
-0.99

199HIH
-086
0.34

199HH
0.44

199MIH
1.32
2.30

1991-IH
0.39

199MIH
0.68
023

Treasury
Deposit

0.01
0.06
•0.03
•003
0.09
-002
-0.02
0.06
0.00
-0.01
-0.03
004
000
-0.03
-005
0.09
0.01
0.02
-0.04
0.07
0.02
•0.02
0.03
0.04
-0.03
-0.02
0.01
0.01
-0.00
-0.01
-0.00
0.07
1988
0.00
1969
0.00
1990
0.00

0.23
0.90
-0.62
0.30
041
-0.39
-0.26
0.10
0.36
•0 23
•0.36
0.30
0.38
-097
•0.54
0.87
0.12
-0.27
-0.90
•0.92
-0.92
0.84
0.44
0.09
-0.22
0.21
•0.36
-0.41
-0.06
0.03
0.17
-0.50
0.49
1968
-0.00
1969
0.02
1990
•0.02

199MH
0.34

1991-IIH
0.34
-0.09

Foreign
Deposit
Ratio

1991-IH
0.02

0.02
1991-IIH

a 14
-0.20

P»0<?

1991-IIH
-0.01
-0.02

•0.08
-0.09

os
^

p
u (r io6ui *uaaMN^' Q
D iQSg&>o~ i -u» cv &> o* -i »o 4X pu ui
( iai oi 6b s^ >a Jb S
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- p 6 p - p p p p 6 6 6 6 6 6 6 6 6 6 o 6 o 6 o 6 6 6 6 6

p p p p p p p p p p p p p p p p p p p p p p p p p p p o p p p a
8 o » a » a N l o S t t f S u ^ a S u u S ^ o s a N N M M 8 S * M s

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0 6 6 0 0 6 6 0 0 0 0 0 0 6 0 0 6 6 0 0 0 6 0 0 0 0 0 6 0 0 0 6

J S £ r o i : s ^ 8 8 t S b 8 ^ b a i S S 8 ^ 8 8^«i^S2SS^9^ks

0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 6 6 6 0 0 0 0 0 0 0 0 0 0 0

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ro — —

a « u b ) ^ l o ^ u u o a i s » o i o s a u a ' i i 6 i ( ) u o - o o « u

P ~ i o ~ p p p ~ p 6 6 i b f o « b f b 6 6 p p p p o 6 6 6 6 ~ ~ 6 6 6 o

^ 9 » l » B N N U I ^ p S U ( I U 0 p N ^ C ( » N N e i ) O s a » » U U U

a » ^ N O S N B N N 0 a O - > ' « U O i U « - U U ( I U a U O « « » M < '

March 8-9.1992

o > jj* -n

1*1
IS

fell*

s i is

If I

is 5 I

It III it
§

§ 5

a- o

• Z

15 S 5 3 1 S

I ffIi\\

Ell

I*
s
i

Tabic*

Oata

a
a-

Fadaral Ratarva Action and Monetary Growth
(Compound Annual R a t a of Changa)
(Mamo)
Ratarva
Ratarva
Growth Rati
Growth Rata
Thraa-month
Month to Month
Moving Avaraoa
784
•7 24
990
1188
458
11.85
0.83
104
3 75
285
5 74
-028
•7 58
818
•3 52
-3 68
8.88
20.82
14.72
17.88
13.88
-18.70
17.74
4.58
1.01
10.70
4.71
12.11
23.73

Jul 1988
Aug
Sap
Oct
Nov
Oec
Jan 1960
Fab
Mar
Apr
May
Jun
Jul
Aug
Sap
Oct
Nov
Dae
Jan 1881
Fab
Mar
Apr
May
Jun
Jul
Aug
Sap
Oct
Nov
Oac
Jan 1982

17.88
8.07
80.48
1988
4.56
1868
0.67
1880
222
199MH

6.16
1991-JIH
11.68
3.53
Sourca: Fadaral Ratarva Board; HaJnamann Economic Rataarch

-037
-0 18
3.40
4.72
886
9.37

5 72
454
191
248
022
1 12

-4 53
0.11
4>87
033
0.93
8.07
15.21
17.87
19.45

3.96
3.90
0.68
7.78

543
5.47
9.17
13.52
17.91
18 57
28.81

March 8-9,1992

Shadow Open Market Committee

WHERE DO WE STAND IN THE BATTLE
AGAINST INFLATION?
William POOLE1
Brown University

My bottom line in answering the question that makes up the title of this paper is: 1) Disciplined
monetary policy over the last few years has reduced U.S. inflation another notch, leaving two to
three percentage points to go to achieve price stability; 2) However, the current situation is fraught
with peril for the Federal Reserve; further progress in reducing inflation in the near future, or even
in sustaining gains already achieved, will be difficult to achieve, in part because of uncertainties
over the economic impacts of reductions in defense spending.
The paper has two major sections. Thefirstcontains an analysis of recent inflation experience
and an argument that we should consider the battle won when broad indexes of goods prices, rather
than price indexes covering both goods and services, are stable. The second section contains an
analysis of the current business situation with an emphasis on the importance of reductions in defense
spending for the slow recovery so far from the 1990-91 recession. I'll argue that we run ariskof
an excessively expansionary monetary policy because of a misinterpretation of the proper policy
response to defense cuts.
The Inflation Situation Today
Figure shows that CPI inflation rate since 1980 as measured by 12-month changes continuously compounded. Fve shown Consumer Price Indexes for All Items and for All Items less food
and energy. The change in the latter index is sometimes said to measure "core inflation." This term
is somewhat misleading in that it seems to imply that increases in food and energy prices are
somehow less important than increases in other prices, but I'll stick with it anyway. The reason

1 thank Data Resources, Inc. for providing access to its data bank, from which I drew much of the
data used in this paper. I also thank David McNicol and Paul Dickins of the Department of Defense,
Office of the Assistant Secretary of Defense (Program Analysis and Evaluation), who sent me the
material on defense impacts by state that I use in the second part of this paper.

March 8-9,1992

for examining this index is that food and energy prices are often volatile in the short run; excluding
them provides a measure of underlying inflation that is less subject to temporary aberrations than
is the full index.
The average rate of core inflation from January 1983 to January 1992 was 4.4 percent; the
rate over the 12 months ending January 1992 was slightly lower—3.9 percent. From past experience in the neighborhood of business cycle troughs, we might expect core inflation to fall a bit
further in the months ahead. Table 1 shows how inflation has behaved just before and just after
cycle troughs since World War EL Not counting the most recent recession, core inflation is 1.6
percentage points lower on the average over the twelve months following a recession than over the
twelve months ending with the trough. Over the subsequent twelve months that is, from 12 to
24 months after the trough—core inflation fell on the average by another 0.6 percentage point.
We should not make too much of these averages; for core inflation data, the sample is small only
six troughs—and the table makes clear the variability around the averages due to special circumstances such as the two back-to-back recessions in the early 1980s. Nevertheless, if we take
the averages at face value and assume that the most recent recession trough was May, 1991, which
seems to me likely, then we cannot expect much additional decline in inflation in the months ahead
as we are already through most of thefirst12 months following the trough. If, however, the trough
has not yet been reached, then we might expect some further easing of core inflation over the months
ahead.
What Does Zero Inflation Mean? At the beginning of this paper I said that the U.S. economy
was 2-3 percentage points away from achieving price stability, and I made this statement even
though CPI core inflation over the 12 months ending January, 1992 was 3.9 percent. I now want
to argue that the goal of price stability should be stated in terms of goods prices, putting services
prices aside.
Changes in the quality of services makes services price indexes suspect. The problems of
adjusting services prices are severe both conceptually and practically. The case of medical care
prices, which account for 6.9 percent of the CPI at present, nicely illustrate the nature of the problem.
On the one hand, rapid improvements in medical care technology have led to large unmeasured
quality improvements for many medical services. On the other hand, prices of medical care are
increasingly subject to distortionfromthe continuously growth involvement of government. Cost
containment in medicine involves price control to some extent, and we know that price control
generally leads to quality deterioration. At the conceptual level, it is hard to say exactly what service
is being performed, and therefore what is being priced,frommany extreme medical interventions

Shadow Open Market Committee

to extend life. If we cannot define the service in the first place, we cannot make any sense of the
question of whether quality is improving or deteriorating and we do not really know what the prices
indexes are measuring.
The necessity of thinking through the meaning of the price indexes, and especially the services
component, has become more and more important Services are growing as a proportion of the
total economy, and the differential between indexes of services prices and goods prices is also
growing. Table 2, which reports the three major components of the implicit price deflator for
personal consumption expenditures in the National Income and Product Accounts, provides some
numbers relevant to this issue.
Theright-handside of Table 2 reports differences in the inflation rates in the left-hand side
of the table. We can see that the difference between services inflation and durables inflation, and
between services inflation and non-durables inflation, have both tended to grow. The differential
between services and durables inflation was 0.8 percentage point in the 1960s and 3.0 percentage
points in the 1980s, and the non-durables differential was 0.4 and 1.9 percentage points for the
1960s and 1980s, respectively. If the total PCE deflatorrisesat a rate of about 2 percent, the durables
and non-durables components will probably show little or no inflation.
Figure 2 shows the story of the Producers Price Index for finished goods since 1980. Core
PPI inflation was just above 2 percent over the four quarters ending 1991:4. Reducing inflation by
a further 2 percentage points will leave the PPI at about 0 inflation, on the average. Over the entire
period from January 1947 to January 1992, the PPI for finished goods increased at an annual rate
of 3.46 percent whereas the All Items CPI increased at a rate of 4.14 percent. For January 1983 to
January 1992, the average rates for the PPI and CPI were 1.59 percent and 3.84 percent, respectively.
Over this same period, these indexes excluding food and energy rose at rates of 2.05 percent for
the PPI and 4.39 percent of the CPI. Thus, over the postwar period as a whole the gap between the
CPI and PPI is about 0.7 percentage point but the gap may have now risen to about 2 percentage
points, or even a little more.
A Possible Danger in Falling Goods Prices. If monetary policy were to achieve 0 increase,
on the average, in the total CPI or the total PCE deflator, then we can reasonably expect that price
indexes for durable and non-durable goods would be falling, perhaps at a rate of around 2 percent
per year. The danger in a situation of declining goods prices is that the rate of decline might exceed
the real rate of interest consistent with full-employment equilibrium. Because the nominal rate of
interest on money cannot fall below zero, declining goods prices might yield a higher real rate of
return from holding money than from holding physical capital or inventories of goods. U.S.

March 8-9,1992

experience suggesting that the riskless real rate of interest is in the neighborhood of 2-3 percent on
the average. Thus, achieving stability in broad price indexes that include services might put the
U.S. economy quite' close to the point at which the prices of goods are declining at a rate about
equal to the real rate of interest. Many goods—certainly durable goods by definition—are
storable; their purchases can be either accelerated or delayed by changes in expectations of their
future prices relative to current prices.
Just as expectation of rising inflation can stimulate the economy, so also can expectations of
falling goods prices depress the economy. The process is self-limiting during an inflationary period,
provided the central bank does not accommodate the inflation by increasing money growth, because
nominal interest rates rise, which increases the real rate of interest on interest-bearing assets
denominated in money. However, this same process cannot work in reverse to limit the depressing
effects of falling prices when the rate of deflation exceeds the real rate of interest. When the nominal
rate of interest reaches zero, further deflation increases the expected real rate of return on assets
denominated in money and by holding it above the real rate of return on goods reduces the demand
for goods, further depressing economic activity. Economic activity is likely to be more stable if
monetary policy yields stable goods prices rather than falling goods, prices. Price indexes including
services prices will then be rising.
The Inflation Outlook
Given past experience immediately following cyclical troughs, given that the economy has
developed a degree of slack, and given the lack of economic momentum in recent months, it seems
safe to forecast that inflation in unlikely to become a problem over the next year or so. The issue
is whether inflation is likely to rise starting one or two years from now. That is above all an issue
of what king of monetary policy the Federal Reserve will follow over the next several years. In
addressing that issue, we need to focus on the role of defense cuts and public understanding of the
implications of the cuts, and on the current and future stance of monetary policy. With regard to
defense cuts, it would be unfortunate indeed if today's cuts led to monetary policy mistakes that
caused more inflation. And it would be ironic, too, given that the Vietnam War build-up led to
monetary policy mistakes that caused the beginning of the inflation that we are now in sight of
vanquishing. With regard to monetary policy, a key issue today is the divergent behavior of M2
and other monetary aggregates.

Shadow Open Market Committee

Defense Cuts. Reductions in defense procurement spending started before 1989, but that was
the last "normal" cold war year. The revolutions in Eastern Europe in 1989 and the collapse of the
Soviet Union in 1990-91 have created a completely different environment for defense spending.
Every worker in a defense industry now feels at risk even though, when the dust settles, many will
in fact remain employed. These workers and their industries have begun to adjust to the changed
situation. Declines in defense employment and output are not immediately offset by increases in
non-defense employment and output because defense workers and capital cannot be instantaneously
transferred to new uses. Declines in defense output and the indirect effects from lost personal
income are part of the explanation fo the slow (perhaps temporarily aborted) recovery from the
recession.
To gain a feel for the role of defense cuts in causing increased unemployment, I have examined
estimates of defense spending by state in 1989.2 The case for using the level of defense spending
in 1989 rather than estimates of defense cuts is that many of the effects of likely future cuts are
already appearing as affected industries and workers react. Current defense oudays reflects past
commitments; we should not expect that changes in outlays to date would have much explanatory
power. Moreover, because future defense budgets are still being debated in the Congress and
administration, it is not possible to come up with accurate estimates of planned defense cuts by
state. My working assumption is simply that the largest dollar cuts will occur where the largest
spending was in 1989.
I have examined estimates of defense spending in 1988 dollars by state for three major
categories of spending shown in Section I of the reference cited in footnote 2. One is defense
procurement and research, development, test, and evaluation (hereafter, simply "procurement").
The second is total direct defense purchases and pay excluding procurement. The third is indirect
defense purchases resulting from direct defense purchases. The indirect purchases arise as defense
contractors buy parts and materials from other firms. For example, Electric Boat's payroll for its
workers building subs in its Groton, Connecticut shipyard appear in the procurement category; pay
for Navy personnel on subs at Electric Boat in Groton appear in the second category; Electric Boat's
purchases of steel and other inputsfromfirms all over the United States appear in the third category.

The data source is Department of Defense, "Projected Defense Purchases, Detail by Industry and
State, Calendar Years 1989 through 1994," Directorate for Inflation, Operations and Reports
(DIOR), the Pentagon, Washington, D.C., November 1989.

March 8-9,1992

The Defense Department estimates of this third category are developed using the U.S. input-output
tables and estimates of the distribution of industry by state. I have converted the data in dollars
by state to per capita dollars by dividing by state employment in 1989.3
Figure 3 relates the increase in state unemployment rates between August, 1989 and August,
1991 to the per capita level of defense spending for procurement by state in 1989.4 The correlation
coefficient is 0.37. I am not sure what correlation I expected before making the calculation and
looking at the figure, but I do find the figure revealing. We would not expect the correlation to be
extremely high; state unemployment is obviously affected by much more than defense spending.
Rhode Island, for example, sits between two high-defense states and experiences spill-over effects
from those states. Rhode Island has also had a banking crisis that had nothing to do with defense
and its large yacht-building industry was hit hard by the luxury tax on yachts. States such as
Michigan with above-average concentrations of durables manufacturing always experience larger
effects from recessions than other states.
The second category of defense expenditures is direct defense expenditures excluding procurement. These expenditures are largely payroll and other expenses of armed forces stationed at
various bases in the United States. The correlation direct defense excluding procurement in 1989
and the change in state unemployment is 0.06, or essentially zero. This result is not really surprising;
cuts in armed services personnel have been small, and have mostly comefromreducing personnel
at bases abroad. However, we should expect to see effects form this source in coming years as
bases are closed.
The third category is indirect expenditures arising from direct expenditures. Indirect
expenditures in 1989 have a correlation of 0.37 with the change in unemployment rate by state.
This result suggests that effects from indirect expenditures are just as important as thosefromdirect
expenditures for procurement. However, the indirect expenditures result may be entirely spurious.
The distribution of manufactured inputs purchased by defense contractors by state is necessarily
highly correlated with durable goods manufacturing in general. Therefore, estimates of indirect
defense expenditures may simply be picking up the usual effects of recession on durable manufacturing. In fact, the input-output methodology used by the Defense Department to estimate

State employment data source: 1991 Statistical Abstract of the United States, Table 636.
4
Unemployment rate by state from Monthly Labor Review, November, 1991, Table 11 and
November, 1990, Table 11.

Shadow Open Market Committee

indirect defense expenditures does not explicitly identify firms supplying defense contractors but
instead assumes that the indirect defense expenditures are distributed by state in the same way as
total indirect expenditures are distributed by state in the input-output tables.
From Figure 3 we can see that the recession left many state untouched. Between August of
1989 and August of 1991, unemployment actually remained unchanged or fell in nine states and
rose by 0.5 percentage point or less in another six states. Only four states experienced unemployment
rate increases of 3.0 percentage points or more; New Hampshire, 3.4 percentage points; Delaware,
3.6 percentage points; Rhode Island, 4.7 percentage points; and Massachusetts, 4.9 percentage
points. Federal Reserve efforts to use monetary policy to stimulate employment in depressed states
would almost certainly create inflationary pressure for the economy as a whole. Despite the distress
in certain states, the recession has been mild on the average—the national unemployment rate has
been about 7 percent in recent months. The unemployment rate was about the same or above 7
percent for every year from 1980 through 1986.
Many analysts are unduly pessimistic about the speed with which the economy can adjust to
defense cuts. Table 3 provides some perspective by comparing projected defense cuts out to 1997
with prior experience after the Korean and Vietnam wars. This is not the place to argue about
whether the recessions following these wars were caused by defense cuts; contractionary monetary
policy certainly played a role in both episodes. My point is simply that however the recessions are
explained, the economy recovered quickly even though substantial defense cuts were being made.
During the Korean War, defense spending reached a high of 13.2 percent of GNP in 1953,
and then fell rapidly over the next two years, to 9.6 percent of GNP in 1955. The recession of
1953-54 was followed by a boom in 1955 despite the defense cuts. The economy also went through
a mild recession in 1969-70 as defense cuts began with the Vietnam War tapering down, but this
recession was followed by a boom in 1972.
The estimates shown in the right-hand block of Table 3 are based on defense outlays projected
in the FY 1993 Budget and fiscal year GDP projected by the Congressional Budget Office. Defense
cuts may be somewhat larger than administration proposal in the Budget, but such cuts would still
be smaller as a percentage of GDP than were the cuts after the Korean War. Certain communities
will be heavily affected by cuts, but the economy as a whole should have little difficulty in digesting
them.

March 8-9,1992

In sum, defense cuts and anticipations of future cuts may explain part of the recent recession
and slow recovery. However, adjustments to those cuts are now well underway. The transfer of
resources from defense to non-defense uses requires real adjustments that monetary policy can do
little to affect. Policy makers should understand this fact and the fact that experience shows that
the economy can handle large adjustments relatively smoothly. Policy makers must resist the
temptation to follow expansionary policy; doing so will have little effect on the adjustment to smaller
defense expenditures but will run the risk of delaying once again achievement of price stability.
Recent Money Growth. At the last SOMC meeting, I examined the behavior of the monetary
aggregates and documented the fact that slow growth of M2 in 1990-91 was due to its small CD
component. I argued that we should emphasize a definition of money that excluded small CDs.
After the meeting, I learned that Brian Motley had published a paper in 1988 making roughly the
same argument.5 Motley's work and additional study on my park has led me to modify my preferred
money definition by adding institution-only money market mutual funds, which are currently in
M3. Thus, what I call "MZM' for "money zero maturity" equals present M2 plus institution-only
MMMFs less small CDs. Figure 4 shows the behavior of MZM, Ml, and M2 over the last few
years.
Small CDs continue to run off at a rapid pace for the reasons I discussed at the last SOMC
meeting. In the twelve months ending January, 1992, small CDs fell at a continuously compounded
annual rate of 10.6 percent. Institution-only MMMFs have been growing rapidly and totaled $ 182.4
billion in January, 1992, which reflects a 12-month growth rate of 27.7 percent continuously
compounded. The well-known problems in the commercial banking and thrift industries are leading
to changed flows of funds institutionally; we need to be sure that our definitions of monetary
aggregates reflect the economic functions of various types of accounts infinancialinstitutions rather
than institutional patterns that have prevailed historically. We cannot yet be absolutely sure that
M2 "ain't what she used to be," but I believe the case for adjusting our definitions is strong.
Inmy examination of the aggregates last fall, I used data ending with July, 1991. The 12-month
growthrate for Ml was 5.9 percent; now the most recentfigureis 9.7 percent. The 12-month growth
rate for M2 was 2.9 percent; now the most recentfigureis 3.4 percent. By every measure, monetary
policy is more expansionary than it was six months ago. If I am right that M2 should be deemphasized, then monetary policy is not only more expansionary than it was but also quite expansionary
on an absolute scale. If this monetary expansion has the usual, and intended, effect, then the economy

"Should M2 be Redefined?," Federal Reserve Bank of San Francisco, Review, Winter 1988.

Shadow Open Market Committee

will start to grow vigorously very soon, which will put upward pressure on interest rates. To keep
inflation from rising next year, the Fed will have to let interest rates rise as much as necessary to
reduce money growth from current rates.

March 8-9,1992

Figure 1
CPI,
•Jan.

12-Month
1980

Change

Jan.

1992
1

'' A

- *

V /A

vV r/ \*\
\\JUL1 i t « m i

1 + s * F o o d and E n e r g y

•

\ A
*

v \\
H.

—6

/ v

/-^"^""v.

* KJJ

V">v

\
2

r
L

\r i

A l l It«ms((

—2

l i iM it tt it t l i i n II t i i i l l it MI I I i i i i l tit tt i n I I i l l ii i l l it if i j i i n t n t i l i l i i i t t i n II i l l ti i l l t i t ti Mttt i l l ii t n it i M I I I I I i l l II t n I I ii« l l l l l l t i l l t l l

19t0

19*1

19S2

1593

190-4

1965

19*C

1907

19*S

1969

1990

1991

Shadow Open Market

Committee

Table 1
CPI Inflation Rate at NBER Reference Cycle Troughs
(continuously compounded percentage annual rate)

All items less food and energy

All Items
Trough
Month
1949:10

12 Mo.
Before

-2.7

12 Mo.
After

3.41

Change

Next
12 mo.

Change J

12 Mo.
Before

12 Mo.
After

Change

Next
12 mo.

Change

6.1

6.6

3.1

NA|

11954:5

0.9

-0.6

-1.5

1.0

1.6

1 1958:4

3.6

0.1

-3.4

1.9

1.8

2.4

1.7

-0.7

2.0

0.3 I

11961:2

1.5

0.9

-0.6

1.2

0.3

0.7

1.3

0.6

1.0

-0.3 I

5.4

3.5

-2.0

3.4

-0.1

6.4

3.3

-3.1

3.0

-0.3 1

11975:3

9.9

5.9

-4.1

6.2

0.3

10.8

6.4

-4.4

6.0

-0.4 1

1 1980:7

12.4

10.2

-2.1

6.4

-3.9

11.7

10.5

-1.1

7.3

-3.31

1 1982:11

4.4

3.1

-1.3

4.1

1.0

5.2

4.2

-0.9

4.5

0.31

1970:11

11991:5 ?

4.9

-1.6

0.5

-1.1

Average

5.0

2.6*

-0.61

3.9*

NA: Not available
* 12 months ending 1992:1
Note: Due to rounding error, differences in inflation rates may not match table's entries,
which are calculated from unrounded data.

March 8-9,1992

Table 2
Implicit Price Deflator for Personal Consumption Expenditures
Selected Periods

Inflation DifferentiaT
Services less:

Average Inflation
Percent Annual Rate
Nondurables

Nondurables 1

Services

Total

4.4

5.1

0.5

1.9

0.71

1.9

2.4

2.7

0.3

0.8

0.4 I

6.6

5.1

7.1

6.7

0.1

1.6

-0.31

79:4-91:4

4.9

3.0

4.1

6.0

1.1

3.0

1.91

90:4-91:4

2.9

1.8

1.2

4.0

1.1

2.2

2.71

Total

Durables

159:1-91:4

4.6

3.3

J 59:1-69:4

2.4

1 69:4-79:4

Durables

* Entries may not match differences in table entries for inflation rates due to
rounding error.

Shadow Open Market Committee

[Figure 2
PPI F i n i s h e d Goods # 12-Month. Change
Jan.

19 8 0

Jan.

19 9 2

l€

14 H

-a
-4
19*0

1511

1512

19*3

15*4

19*5

19*€

19*7

19**

13*9

1990

1991

March 8-9,1992

Figure 3
D i r e c t D e f e n s e Procurement Purcliases
Unemployment b y S t a t e

and

81
U

a
c

C
©

u
n.

3
0
5»

*
MET

g
« 3
6
C

IA*

- l

-3

0
Direct

Defense

S00
Procurement

1000

1SOO

i n 19S3 p e r

P e r e o n Employed. I n S t a t e

• O U Z M I D«p«xtaM&t cC p*£«n»« mad. *ux««u o f L*boc g t * t : l » t l o »

2000

250O
(198S

dollar*)

Shadow Open Market Committee

Table 3
Defense and the Economy, 1950-56, 1969-74, and 1989-97 (1992-97 Projected)
Defense Purchases as Percentage of GNP or GDP

% of GNP* |

% of GDPC 1

% of GDI* |

5.0 |

1 1969

8.2 1

1 1989

5.9 I

10.1 1

1 1970

7.6 |

1 1990

5.5 I

I 1952

13.1

1971

6.7 |

| 1991

4.9 |

11953

13.2 1

| 1972

6.4 |

| 1992

4.8 1

1954

11.2 1

| 1973

5.7 1

| 1993

4.4 J

1 1950

1951

I 1955
I 1956

9.6 1
9.5 1

1994

4.1

| 1995

3.8 1

1 1996

3.7 I

| 1997

3.5 J

* Calculated from NIPA calendar year data, 1989 Economic Report of the President, Table Bl.
b
Calculated from NIPA calendar year data, 1992 Economic Report of the President, Table Bl.
e
Fiscal year basis; national defense budget outlays as percentage of GDP; actual, 1989-91, from 1992 Economic Report of the President, Tables B-74, B-75; projected,
1992-97, from Budget of the United States, FY 1993, Table 11-4 and Congressional
|
Budget Office, The Economic and Budget Outlook: Fiscal Years 1993-1997, Table 1-5. |

March 8-9,1992

Figure 4

Monetary A g g r e g a t e s ,
1985:1 --

Monthly,

1992:1

_^-—

3 000

MZM

(rati*

2000

1 H

1 **1 0 0 0
Mllioni

Small

CDe

^ ^ ^
^Z-^"^

^^>~~~

—

"^—\

—

Growth r a c e , J a n . 9 1 t o «Tan. 921 Ml
M2
MZM

500

9.7 %
3.4 %
11.3 %

1 i i i i i i t t t i 1 1 i i 1 1 i i i i i i 1 1 1 1 1 1 1 i i i 1 1 11 i 1 1 1 i i 11 i i i 1 i i i i i i i i i i i 1 i i i 1 1 i i 1 1 1 1 1 i i i i i i i i i i i 1

1**5

19S6

19*7

1988

1989

1990

1991

Shadow Open Market Committee

SOME ISSUES IN THE INTERPRETATION
OF RECENT MONETARY POLICIES
Robert H. RASCHE
Michigan State University

Two articles have appeared in the Wall Street Journal in recent months which allege that the
Federal Reserve's practice of targeting the Fed funds rate, in conjunction with the actions of the
RTC, OTC and/or other bank regulators, has wiped out any monetary stimulus during the recent
recession. In particular, Paul L. Kasriel argues that "although the Fed has been pushing down on
the monetary throttle, the forward thrust has been overwhelmed by the activities of the FDIC and
the RTC (Wall Street Journal, December 23,1991). In a subsequent letter to the editor, James L.
Grauer argues that "what appears to be a respectable buildup of reserves in the past few months can
inauspiciously be ascribed to the conscription of surplus reserves to accounting recognition by the
Fed as depositors shifted money out of accounts not requiring reserves into those Ml categories
still requiring reserves." Both writers advocate that the Fed abandon funds rate targeting.
I certainly do not wish to quarrel with the policy position of these authors that Fed funds
targets are, in general, not the best way to operationalize monetary policy. However, I believe that
their interpretation of the monetary history of the recent recession is contradicted by the available
evidence. Indeed, my interpretation is that in spite of its devotion to Fed funds targets, during the
past year the Fed has avoided the pit into which it traditionally has plunged during recessions with
its interest rate targets.
Consider first Mr. Kasriel's argument about the interaction of the FDIC and RTC actions
with the Fed's interest rate targeting policy. The key assumption in his argument is that the actions
of the RTC and the FDIC have generated conditions under which the actual excess reserves in the
banking system exceed desired excess reserves at the funds rate target. If such a situation materialized, and if the Fed maintains its funds rate target, there is no doubt that reserves would be
withdrawn from the banking system. The key here is that it does not follow that closing of insolvent
depository institutions automatically generates excess reserves that exceed desired reserves at the
established funds rate targets. If loan demand remains strong, all reserves that find their way into

March 8-9,1992

the remaining depository institutions will be loaned out If loan demand weakens, regardless of
whether the RTC or FDIC is closing insolvent institutions, actual excess reserves will exceed desired
excess reserves at the fund rate target and the Fed will withdraw reserves from the banking system
if it tries to maintain the fund rate target. The necessary and sufficient condition for the Kasriel
scenario to occur is that the rate of interest that banks can earn on loans and investments falls relative
to the funds rate maintained by the Fed. Under these conditions, there is a net excess supply of Fed
funds, to which the Fed must react either by changing the funds rate target or conducting open
market sales.
The data do not support the case that the Fed has tried to prop up the funds rate in the face of
weakening loan demand over the past year. From February, 1991 through December, 1991 the St.
Louis Adjusted Monetary Base has grown at an annual rate of 8.4 percent. Adjusted Bank Reserves
as measured by St. Louis have grown at an annual rate of 8.7 percent; the currency component of
the money stock has grown at an annual rate of 8.3 percent; Ml has grown at an annual rate of 8.6
percent and Bill Poole's measure of M2, Small Time Deposits, has grown at an annual rate of 8.9
percent. Since the peak on the late expansion in July, 1990, through December, 1991, Adjusted
Bank Reserves as measured by St. Louis have grown at an annual rate of 8.1 percent. This represents
a substantial increase in the growth rate of adjusted reserves over that of the three years prior to the
cyclical peak (see attached graph), as Erich Heinemann regularly reminds his readers. This is hardly
a picture of a Fed that is steadily withdrawing reserves from the banking system to stem the fall of
the funds rate during the contraction phase of the cycle.
The weakness in M2 and M3 growth in the second and third quarters of 1991 is concentrated
totally in the Small and Large Certificate of Deposits components of those aggregates. From the
second to the third quarter of 1991 when M2 stood still, Ml grew at an annual rate of 7.0 percent,
the Adjusted Base at an annual rate of 5.7 percent, and Adjusted Reserves as defined by St. Louis
grew at an annual rate of 4.7 percent. The lack of growth of M2 during this period is the next result
of a decline in the ratio of the non-Mi components of M2 (primarily small CDs) and the increase
in the monetary base or adjusted reserves. It does not result from negative growth, or a decline in
the growth rate of either the base or adjust reserves that is required to support he Kasriel hypothesis.
Mr. Grauer argues that there is a "black hole" from which reserves are emerging as portfolio
shifts occur from nonreservable deposits to reservable transactions deposits. The argument for the
existence of this "black hole" rests on the definition used by the Board of Governors for bank

Shadow Open Market Committee

reserves. The current definition of such reserves excludes so called "surplus vault cash" of "nonbound depository institutions;" those depository institutions whose vault cash holdings exceed their
required reserves.
The first important thing to note is that "surplus vault cash" is excluded only from the Board
of Governors definition of bank reserves. It is included in the Board of Governors measure of the
Monetary Base, and it is included in both the Adjusted Monetary Base and Adjusted Reserve
Measures of the St. Louis Fed. (An excellent discussion of the measurement of the current Monetary
Base concepts is "alternative Measures of the Monetary Base: What are the Differences and Are
they Important," by Michelle R. Garfinkel and Daniel L. Thornton, Federal Reserve Bank of St.
Louis, Review, November/December, 1991, pp. 19-35.) Since the latter three measures include all
vault cash and deposits at the Fed they are invariant to shifts between nonreservable and reservable
deposits, and their growth rates would not be artificially inflated by such shifts. Such shifts, if they
were to occur could produce misleading signals from the Board of Governors measure of bank
reserves. However, there is not evidence that surplus vault cash is mergingfromthe "black hole"
to confuse monetary signals. Table 1 shows monthly data for both surplus vault cash and excess
reserves as measured by the Board of Governors for 1990-91. These data arefromTable 1.12 in
the Federal Reserve Bulletin and are not seasonally adjusted. Surplus Vault cash jumped after the
reduction in required reserve ratios in December, 1990 and January, 1991. However, since April,
1991 it has remained quite constant in the range of 3.7-3.9 billion dollars, approximately 1.3-1.5
billion larger than during the corresponding months of 1990. Excess reserves, as measured by the
Board of Governors have averaged close to 1.0 billion since April, 1991, around .1 billion higher
than during the corresponding months of 1990. The sum of these two measures, which is probably
the best available measure of "surplus reserves" in the banking system, has been quite steady in the
range of 4.7-5.0 billion since April, 1991. Thus the data do not support the contention that reserves
have emerged, or are emerging from the "black hole" of surplus vault cash to be captured in the
measurement of required reserves and total reserves by the Board of Governors.
To the contrary, the important issue surrounding the surplus vault cash is not that posed by
Mr. Grauer, but the question of measuring the impact of the reduction of reserve requirements when
depository institutions are not effectively constrained in their portfolio decisions by such requirements. This is the issue that we discussed at our meeting in March, 1990.

March 8-9,1992

Table 1
Surplus Vault Cash and Excess
Month

Surplus Vault Cash

s Reserves

Reserves
Surplus Vault Cash •
Excess Reserves

Jan 1990
Feb 1990
Mar 1990

2.461
2.795
2.330

1.016
.989
.861

3.477
3.784
3.191

Apr 1990
May 1990
Jun 1990

2.179
2.351
2.314

.897
.962
.774

3.075
3.313
3.088

Jul 1990
Aug 1990
Sep 1990

2.460
2.563
2.473

.862
.868
.909

3.322
3.431
3.382

Oct 1990
Nov 1990
Dec 1990

2.590
2.433
2.893

.847
.947
1.665

3.437
3.380
4.558

Jan 1991
Feb 1991
Mar 1991

4.250
4.753
4.043

2.168
1.809
1.179

6.418
6.562
5.222

Apr 1991
May 1991
Jun 1991

3.764
3.944
3.801

1.030
1.030
1.00B

4.794
4.974
4.809

Jul 1991
Aug 1991
Sep 1991

3.993
3.981
3.869

.906
1.086
.929

4.899
5.067
4.798

Oct 1991
Nov 1991

3.919
3.663

1.083
.893

5.002
4.556

Adjusted Reserves
Monthly Averages of Daily Figures
Seasonally Adjusted

Billions of Dollars

80
8.7x
-1.6x

ir\ /U

3.0%

2.5? !

JVM7.2X
60

e
nOU

11.7%
JO^

1985

1 ' 1

1986

1987

• 1 ' 1 ' 1 ' 1
1988

1989

•

l •
1990

1 ' 1

1991

Adjusted reserves is the difference between adjusted monetary base and currency component of M l .
Percentages are annual rates of change for periods indicated.

Prepared by Federal Reserve Bank of St. Louis

March 8-9,1992

Shadow Open Market Committee

FOREIGN EXCHANGE MARKET INTERVENTION
Anna J. SCHWARTZ
National Bureau of Economic Research

The Federal Reserve and the Treasury are reversing the policies of 1988-90 that increased
authority of the Federal Reserve to warehouse holdings of foreign currency for the Treasury to $25
billion. Warehousing is a term that refers to loans, not appropriated by Congress,fromthe Federal
Reserve to the Treasury General Fund as well as the Exchange Stabilization Fund. The Treasury
has used these loans to acquire foreign currencies. Apparently a decision has been reached by the
two agencies for the Treasury gradually to repay the loans, and for the Fed not to eliminate its
authority to warehouse but to reduce it to $5 billion.
At the end of 1990 the combined portfolio of foreign exchange assets of the Treasury and
Federal Reserve totaled $52 billion. They sold off about $8 billion in marks during the first seven
months of 1991, reducing the portfolio to $44 billion. In the three months, August-October 1991,
the latest period reported by the Fed, there was no intervention. By the end of 1991, however, the
authorities had increased their holdings by $2 billion to $46 billion.
In recent weeks there have been newspaper reports of interventions to purchase yen, but the
magnitudes are not yet known. It is ironic that, according to written responses to questions from
the Senate Banking Committee, released on February 11,1992, Chairman Greenspan said, a policy
that "seeks to depreciate the dollar against the yen . . . is not an appropriate way to stimulate the
economy" (Wall Street Journal, February 12,1992). Contrary to economists who advocated such
a policy to spur U.S. exports, Chairman Greenspan said it could be counterproductive.

March 8-9,1992

Shadow Open Market Committee

HOW TO HELP RUSSIA
Allan H. MELTZER
John M. Olin University Professor
Carnegie Mellon University
Visiting Scholar, American Enterprise Institute

U.S. taxpayers are being urged to givefinancialaid to Russia and other states of the former
U.S.S.R. The impetus comes from many sides, including Harvard professors, international organizations, and some of our European allies. The administration seems to share this view. Secretary
Baker has promised aid once a reform plan is in place.
The reasoning of some of these groups differs, but their end is the same—-subsidized loans
and financial aid to supplement the humanitarian aid that many countries have sent. The short-term
aim is to stabilize the ruble and contribute to the success of reform. The broader objective is to
assure the transition to afreesociety.
Although there is reason to doubt that the Russians need more food, shipments of food and
medicine should be sent if needed to prevent hunger and disease. Our long tradition of disaster
relief and humanitarian aid is ample reason to provide relief.
Financial aid is very different. Whether it is $30 billion a year for five years, as some now
urge, or a lesser amount to stabilize the currency, the arguments made forfinancialassistance are
weak. Often they are little more than threats that we must pay now or face chaos, disorder, and a
return to communism.
It is hardly credible that people freed from a brutal totalitarian system would welcome its
return or support a coup when faced with their first crisis. No one can know with certainty, but
many of the fears seem overblown.
Even if the threats and fears are correct, they are not a reason for government loans. We in
the west cannot determine the fate of the Soviet people. Grants of $30 billion provide about $100
for each former Soviet citizen. The survival of democracy andfreedomwill not be determined by
this modest sum. The fate of Soviet citizens must depend on their decisions and actions, not ours.

March 8-9,1992

Some propose a new Marshall plan to give the former Soviets the type of support we gave to
western Europe in the early postwar years. This, too, is a mistake. The Marshall plan provided
capital to market economies in which competition was the norm. All of these economies had legal,
financial and accounting systems, property rights and enforceable contracts.
None of these institutions are present in the former Soviet states. Economic development
cannot be expected until these economies introduce the institutions that permit markets to function
effectively and the tradition of honoring or enforcing contracts. If prices arefreeto change, markets
will function, but the response of output to price changes will remain modest Production will be
held back by uncertainty. Producers will not know whether raw materials will be delivered at the
right time, with the right specifications, or at the contract price.
Nor can the former Soviets' problems be solved by grants or loans to stabilize the ruble. A
popular argument presents these loans as costless because we give the Russians paper dollars that
the Russian state bank would hold as backing for the ruble. If the plan works, the ruble will be
convertible at a stable value, and the dollars will not be spent.
More likely the stabilization plan will fail as so many have in Latin America and Africa. A
safe thing for Russians to do is hold dollars instead of rubles. The dollars we lend or give would
quickly disappear from the central bank. This would be certain to happen if Russia fails to close
its enormous budget deficit. The deficit is currentlyfinancedby printing rubles as fast as the presses
can run. Inflation is rampant, and lifetime savings are destroyed.
Any dollars we give are a claim against U.S. wealth. If instead we let the International
Monetary Fund (IMF) advance the dollars, the only difference to U.S. taxpayers is that we share
the cost with other countries. Ours is the largest share, and it would be paid from the money U.S.
taxpayers have given to the IMF. But the IMF would soon ask for new money and, as always in
the past, our government will contribute.
There are better ways to help the Russian economy. First, we should remove barriers to trade
and urge the Europeans to do the same, if Eastern Europe can sell goods, including food, to Western
Europe and the U.S., they will earn hard currency to pay for Russian oil, coal and minerals. The
Russians will earn foreign exchange which they can use to stabilize and develop their economy.
Second, Russia is rich in mineral resources. It lacks the management skills and technology
to exploit many of these resources. These will not comefromgovernment to government loans or
from the IMF. The most effective way to develop the Russian economy is to let foreign investors

Shadow Open Market Committee

buy assets. The new owners will bring technology and managements skills. But not much will
happen until the Russians establish the institutions and economic structure under which markets
function efficiently.
Russia has decontrolled many prices. This is a first step; it took courage to make it. But it
is not enough. With the present budget deficit and no clear rules for ownership and contract, the
economy will at best limp ahead. Foreign aid will be wasted.
The mark of successful reform will be a flow of private capital to Russia and its neighbors.
Private capital from loans or assets sales can be used to stabilize the ruble and, if the budget is
balanced, bring down inflation and put the economy on a positive, sustainable growth path. Protecting U.S. taxpayers interests will do more to help the Russians than the well-intentioned schemes
of some Harvard professors.

Full text of Policy Statement and Position Papers : March 9, 1992

FRASER