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SHADOW OPEN MARKET COMMITTEE
Policy Statement and Position Papers

September 18-19, 1983

PPS-83-5

CENTER FOR
RESEARCH IN
GOVERNMENT
POLICY
& BUSINESS

Graduate School of Management
University of Rochester

SHADOW OPEN MARKET COMMITTEE
Policy Statement and Position Papers

September 18-19, 1983

PPS-83-5

Shadow Open Market Committee Members - September 1983
SOMC Policy Statement, September 19, 1983
Position Papers prepared for the September 1983 meeting:
The Politics of Myopia and Its Ideology, Karl Brunner, University of Rochester
Recent Behavior of Base Velocity, Allan H. Meltzer, Carnegie-Mellon University
Oops, Another Money Demand Shift, Jerry L. Jordan, University of New Mexico
Monetary Policy Options and the Economic Outlook, Jerry L. Jordan, University of
New Mexico
Analysis and Forecasts of Money Multiplier Behavior 1982-*, James M. Johannes and
Robert H. Rasche, Michigan State University
Federal Budget Outlook — A Report to the SOMC, Mickey D. Levy, Fidelity Bank
Economic Projections, Burton Zwick, Prudential Insurance Company of America
Statement on Protectionism to SOMC, Jan Tumiir, GATT, Geneva, Switzerland




Shadow Open Market Committee
The Committee met from 2:00 p.m. to 7:30 p.m. on Sunday, September 18, 1983.
Members of SOMC:
PROFESSOR KARL BRUNNER, Director of the Center for Research in Government
Policy and Business, Graduate School of Management, University of Rochester,
Rochester, New York.
PROFESSOR ALLAN H. MELTZER, Graduate School of Industrial Administration,
Carnegie-Mellon University, Pittsburgh, Pennsylvania.
DR. HOMER JONES, Retired Senior Vice President and Director of Research, Federal
Reserve Bank of St. Louis, St. Louis, Missouri.
PROFESSOR JERRY L. JORDAN, Anderson Schools of Management, University of
New Mexico, Albuquerque, New Mexico.
DR. MICKEY D. LEVY, Fidelity Bank, Philadelphia, Pennsylvania.
PROFESSOR ROBERT H. RASCHE, Department of Economics, Michigan State
University, East Lansing, Michigan.
DR. ANNA J. SCHWARTZ, National Bureau of Economic Research, New York, New
York.
DR. BERYL SPRINKEL, Executive Vice President and Economist, Harris Trust and
Savings Bank, Chicago, Illinois.*
DR. JAN TUMLIR, Research Director, GATT, Geneva, Switzerland.
DR. BURTON ZWICK, Vice President, Economic Research, Prudential Insurance
Company of America, Newark, New Jersey.

•On leave from the SOMC; currently Under Secretary of the Treasury for Monetary
Affairs.




Policy Statement
Shadow Open Market Committee
September 19, 1983

At our first meeting, ten years ago, we offered a medium-term Strategy for
ending inflation and restoring productive growth to its long-term average. The rate of
inflation for the previous three years was, then, about 5Yz%. The average rate of
money growth ~ currency and checkable deposits — for the previous three years was
then reported as 6h%. Currently, the corresponding numbers are, respectively, Sh%
and 9%.
We warned, then, that unless the Federal Reserve adopted a disciplined, mediumterm strategy to end inflation, inflation would rise and economic instability and
unemployment would increase. Looking back, we see a record of failed policies, fiscal
and monetary indiscipline and growing trade restrictions in many countries. Recent
mismanagement of the international debt problem has led governments and central
banks to seek short-term stopgaps to delay, but not avoid, the consequences of
mistaken policies.
For the past year, money growth in the United States, Canada, Germany,
Holland, France, Italy and the United Kingdom has been between 10% and 15%. These
policies are short-sighted. There is no reason to doubt that the combination of these
monetary policies, accompanied by contractive trade and debt policies, will produce
renewed inflation, slow growth and low investment. They will fail to produce sustained
real growth with low or falling inflation.
Discretionary monetary policy has failed in the United States and in most other
countries. Most central banks and governments have shown themselves incapable of
maintaining financial discipline long enough to restore economic growth with low
inflation. The lack of discipline is, currently, a cause of the short-sighted policies that
are a major reason why the world economy faces severe problems.
Currently, the world's largest economy, ours, pursues policies that drain an
extraordinary share of the world's savings to finance domestic budget deficits and to
maintain domestic consumption. At the same time, the U.S. government and the
International Monetary Fund urge less developed countries to tighten their belts,
reduce their consumption and export capital.




1

The International Monetary Fund urges debtor countries to adopt policies that —
however, sensible or successful when applied by one single, small country — make little
little sense when applied by several relatively large debtors simultaneously. These
policies, requiring reductions in imports and expansion of exports by all the debtor
countries, are mistaken. They fail to recognize that the economies of the principal
debtor countries are interrelated and related to the United States and the world
economy.
Each country's effort to reduce imports and expand exports forces
contraction on others. The effect is a contractionary policy made more severe by
growing import restrictions in the United States and Western Europe.
Inflation, trade restrictions, and IMF loans are not a solution to the international
debt problem. That problem cannot be solved unless international trade increases,
protectionism is reduced, and debtors and creditors adopt a medium- or long-term
program that distinguishes loans that are likely to be repaid from loans that are, de
facto, in default.
Monetary Policy
Most forecasters now expect a modest increase in the rate of inflation in 1984.
Others, including members of the Federal Open Market Committee, project an
inflation rate of 6% to 7% in 1984. Higher rates of inflation are highly probable if
money growth in 1984 were to remain at the 1983 rate.
No one can be very certain about these forecasts of inflation as long as monetary
growth swings over the wide range experienced in recent years, as the accompanying
table shows.
Quarterly
Periods
Q4/77-Q4/78
Ql/79
Q1/79-Q3/79
Q3/79-Q2/80
Q2/80-Q4/80
Q4/80-Q2/8I
Q2/81-Q4/81
Ql/82
Q1/82-Q3/82
Q3/82-Q2/83
Q3/83?
Averages




Mi
8.2%
5.6
10.3
2.2
13.3
7.1
J/ • £.

n.o

4.7

li?*5

Monetary
Base
9.3%
7.1
8.6
7.4
9.5
7.2
4.4
10.1
7.4
J. ijl * -3

8.0

Policy
GO
SLOW
GO
STOP
GO
SLOW
STOP
GO
SLOW
GO
SLOW

Current policy procedures expose the economy to the continuing risk of alternating
periods of excessive expansion of money followed by excessive contraction. These
procedures contribute to uncertainty and thus to high interest rates, low investment
and stagnation.
The annual growth rate of the monetary base — currency and bank reserves ~
has been over 9% over the past year. This is one of the highest rates of growth in the
ten years that this committee has been meeting. It is imperative that this rate of
increase be reduced. Fortunately, Federal Reserve actions have resulted in somewhat
slower grwoth of the base during the third quarter.
We urge the Federal Reserve to hold the growth rate of the monetary base to 6%
from fourth quarter 1983 to fourth quarter 1984. This will be consistent with a growth
rate of Ml of 6-7%, and if followed by further deceleration, would prevent a renewed
burst of inflation and would help the economy to return to stable real growth with
falling inflation in subsequent years.
Medium-Term Monetary Strategy
The present period of comparable rates of inflation in the major countries offers
an opportunity to increase the stability of the world economy, reduce world inflation,
and increase the stability of exchange rates. These desirable goals can be achieved
without fixing exchange rates if principal countries agree to consistent monetary
policies.
We urge the governments of the United States, Germany, Japan and the United
Kingdom to agree to set the growth rate of the monetary base euqal to a moving
average rate of growth of real output with adjustment for a moving average growth of
base velocity. Such a policy would bring relatively stable prices in all countries and
would increase the stability of exchange rates. Further, it would provide a disciplined
approach that is easily monitored. It would provide targets that even incompetent
central banks could achieve and facilitate a gradual adjustment to changes in relative
rates of financial intermediation. A transition period is required to move from present
rates of inflation to this stabilizing policy.
Targets for nominal GNP growth have been proposed as an alternative to
monetary targets. The idea is that the Federal Reserve would adjust the growth of
money to achieve targets for GNP growth.
We find no merit in proposals of this kind. They would increase economic
instability and make money growth even more unstable than under current procedures.
Further, they are based on incorrect interpretations of the recent behavior of velocity.




3

There is no evidence that velocity is now more volatile, once allowance is made for the
effects of increased variability of monetary policy and the decline in inflation.
Other Medium-Term Policies
We repeat some of our earlier recommendations for fiscal policy, trade and
international debt.
Fiscal Policy
Based on our current economic forecasts, we continue to project deficits in the
range of $175-200 billion in fiscal years 1984 and 1985. These deficits reflect the
continued high level of government spending. The path of total government spending
for the remainder of the decade will be largely determined by spending for defense,
pensions (mostly social security), and health care services. Together with interest on
the debt, outlays on these programs will account for about 80% of total government
spending in the future. Congress and the Administration should reduce the growth rate
of real Federal outlays on these programs below the rate of sustainable GNP growth.
This would require a re-examination of the defense spending path, and significant
structural reforms in retirement and health programs.
Current deficit projections constitute a policy of deindustrialization. Financing
the U.S. deficit absorbs savings from the rest of the world. The other side of this
capital transfer is an enormous U.S. trade deficit. Business and political leaders
conclude wrongly that U.S. goods cannot compete in world markets. They urge
protection to slow imports and subsidies to encourage exports.
These
recommendations are based on an incorrect diagnosis of the problem. Tariffs and
protection will not eliminate the problem but will reduce efficiency and further
misallocate resources and lower standards of living.
Reversing the current
deindustrialization requires reducing government spending. That is the proper solution
to the budget deficit and the trade deficit.
We strongly oppose repeal of tax indexation. Increasing taxes through inflation
does not solve any real problem.
International Indebtedness
The international debt problem requires a temporary (self-liquidating), not a
permanent, increase in the lending capacity of the International Monetary Fund. We
oppose a permanent increase in the IMF quota.




4

International loans should be valued on the books of the lenders to reflect their
real economic value. Outstanding loans that are unlikely to be repaid in full should be
written down, over time, to current economic value.
Central banks and governments should announce in advance that they will accept
the responsibility to serve as lender of last resort to banks or branches operating in
their countries, regardless of the nationality of the owners. Central banks of major
countries bear the responsibility to prevent a financial panic stemming from failures of
banks that they control.
Trade Policy
Growing restrictions on international trade in agricultural and manufactured
goods reduce opportunities for debtor countries to earn foreign exchange. These
restrictions lower standards of living in debtor and creditor countries alike and prevent
debtors from earning the resources for investment in growth.
The United States should take the leadership in international economic policy by
calling for another round of phased reductions in barriers to capital movements and
reductions of quotas, tariffs and other restrictions affecting trade in agricultural and
manufactured goods.




5




THE POLITICS OF MYOPIA AND ITS IDEOLOGY
Karl BRUNNER
University of Rochester

I.

The Politics of Myopia as Usual

The last twenty years offer remarkable evidence about the irrelevance of some
political labels.
The drift into permanent inflation, initiated by a "liberal"
Administration under President Johnson, was continued under three "conservative"
Administrations. The drift in our budget "policies" even gained momentum under the
current conservative Administration.
President Reagan was elected on his promise to cope with inflation and the
increasing burden of government. We may reasonably believe that PresidentialCandidate Reagan understood the basic economic nature of both problems. We may
also reasonably believe that his understanding was matched by a sincere conviction
about the required course of our monetary and budget policies. Still, two and a half
years after the President's inauguration his program vanished in a limbo of political
oblivion. It actually died, after some successes, already last year.
There occurred one outstanding success. The reduction of inflation from a rate
above 10% p.a. to about 4% p.a. in the first half of 1983 was a noteworthy
achievement. The Federal Reserve Authorities deserve full recognition on this count.
They managed to lower monetary growth from 1979 to 1982 by more than half. By
July 1982 monetary growth measured year over year sank to 4.5% p.a. Few observers
expected in the early months of 1981 such a rapid response of inflation to monetary
retardation.
A major inflation battle had been won. But the war on inflation had meanwhile
been lost. The Administration, Congress and the Fed all decided in the late summer
(or early fall) of 1982 to abandon the anti-inflationary concept pursued since 1980.
The change was marked by the Fed's shift from a policy of "monetary control", to the
old pattern of explicit interest rate targeting. There ensued beyond July 1982 one of
the largest accelerations in monetary growth observed in the postwar period.
Monetary growth, measured year over year, expanded almost three-fold from July 1982
to July 1983. It rose from about 4.5% p.a. to about 12% - 13%p.a.




7

The reversal to the Fed's accustomed pattern unavoidably produced a serious
dilemma. Persistent monetary growth of 14% p.a. observed from 3uly 1982 into the
spring of 1983 would revive inflation over the next two years and bring it back to
double-digit levels. Interest rates would move to corresponding levels and their variability approach the magnitudes experienced in 1980-1982. On the other hand, any
substantial correction of the course pursued since the second half of 1982 induces most
likely another recession in 1984. The Administration thus became confronted this
summer with a difficult question: How should it shape monetary policy in order to hold
the revival of inflation to a modest level and simultaneously avoid a recession in 1984.
A substantial retardation has already been initiated in June. Monetary growth,
measured year over year, already dropped by 2 percentage points over the past three
or four months.
The phase of retardation seems unlikely to continue beyond this fall. But nobody
really knows. Even the members of the FOMC hardly know what they will do in three
or six months. This uncertainty is the necessary consequence of the policymaking
procedure favored by the Fed's bureaucracy. The choice of procedure reveals the
bureaucracy's total opposition to any pre-committing policy expressing a generally
understood long-range strategic conception. The bureaucracy appreciates quite well
that any pre-commitment, expressed for instance by a constant monetary growth rule,
lowers its status in the political market and its attractiveness to a potential clientele.
The political commitment to discretionary policymaking with its inherent uncertainties
serves the bureaucratic interests much better. Thus emerges a "politics of myopia"
confined to tactical manipulation for the day, dominated by reactions to immediate
states and events with little thought or attention to longer-run consequences.
Discretionary management concentrates thus on specific actions addressed to at most
a few weeks.
The Fed's policy conception is not, per se, a sufficient condition for an
inflationary bias. It actually explains the behavior of the Fed in the 1930's and the
deflationary momentum produced by the Fed at the time. Our Central Bank
effectively contributed to the debacle of 1929-1933 and the second recession in
1937/38. Once inflation has been set in motion however, the politics of myopia built
into discretionary management lowers the liklihood of a non-inflationary state to a
very low level. The politics of myopia thus converts monetary policymaking to a
"random walk through history".




8

The social cost associated with a politics of myopia is quite substantial. It
produces unnecessary short-run loses in output and lowers incentives for long-range
investments. But the political process creates no feedback from these costs to the
bureaucratic agency responsible for their occurrence. The effect produced by this
absence of a useful "feedback control" is reinforced by the approval generally
encountered by discretionary management on the media and political market. The
media market thrives on the frequent appearance of "fresh and new" events. This
demand is satisfied by discretionary management, but not by a pre-committing
strategy. The operators on the political market understand on the other hand that a
politics of myopia offers opportunities to exploit the government's monetary powers
for purposes of wealth redistribution closed off by pre-committing strategies.
Several strands in the nature of the political process explain the absence of a
political feedback. The ideological defenses erected on behalf of discretionary
policymaking should be especially noted at this stage. The Fed naturally contributed
over the past decades a major portion to the ruling ideology. It has been supported
time and again, and most particularly over the recent past, by an array of professional
articulators in Wall Street, the media or political market. Some strands of this
ideology shaping recent attitudes will be further examined.
II.
1.

Strands of the Current Ideology
The Cost of Anti-Inflationary Politics are Too High

The successful reduction of inflation imposed its social costs on our society. The
recession of 1981/82, predicted by the Shadow in early 1981, was the consequence of
the monetary retardation observed at the time. Complaints about the social cost
associated with an anti-inflationary policy increased as the recession unfolded. One
heard more and more that the social cost of anti-inflationary monetary policies are
"simply too high".
Several issues involved in this context need our attention. We just note in
passing that such arguments frequently cover an essentially inflationist bias
occasionally associated with some massive economic or political interests.
A prevalent fallacy requires more explicit consideration. A Keynesian tradition
suggests that monetary policy can only lower inflation by setting off a recession. A
recession appears thus as a sufficient and necessary condition of declining inflation.
This view is usually supported by the notion that the economy, and particularly




9

movements of the price-level, are controlled by strong exogenous inertial forces.
These forces are supposed to distribute the effects of monetary retardation over a long
series of years.
Monetary analysis emphasizes that men operating on the market place are
motivated to learn about new events and grope for adequate interpretations. This
analysis emphasizes thus that monetary retardation is a sufficient and necessary
condition for declining inflation. Whether or not a recession emerges depends on the
credibility of the anti-inflationary policy. With a highly credible policy strong motives
operate to adjust price movements rapidly to the new environment. The recession will
be small and short under the circumstances. With low credibility agents require
convincing information before they modify their price setting behavior. But the
accrual of such information requires time. The recession will be comparatively deep
and long in this case. The social cost of an anti-inflationary policy is thus not simply a
function of magnitude and speed of monetary deceleration. The credibility of the
policy regime crucially affects the outcome, and this credibility is shaped by the
history of inflationary policies and agents' knowledge of policymaking procedures.
Two additional aspects need our attention. The argument advanced to justify a
policy of permanent inflation often attributes the full rate of unemployment (say
10.8% in the USA) to the anti-inflationary policy. This practice appears most
particularly in the media. Associated with this practice is the claim that the recent
recession was the largest since the 1930's. This view is however quite false and
thoroughly misses important aspects of the unemployment problem. My last position
paper prepared for the meeting of March 6-7, 1983 (PPS-83-2) presented data showing
that the last recession was smaller than the recessions of 1953/54 and 1957/58 but
larger than those of 1960/61 and 1970/71. Its magnitude occurred thus well within the
range of postwar recessions. The dramatic exaggerations perpetuated on the media
market resulted of course as an immediate impressionistic response to the high rate of
unemployment observed in 1982. This rate was certainly the highest since the 1930's.
But its nature hardly compared relevantly with the unemployment experience of the
Great Depression from 1929 to 1933. Episodes beyond 1933 associated with the NIRA
and the new labor market legislation contained some elements similar to those
conditioning unemployment in the 70's. The cyclic component reflecting monetary
retardation measured probably at most 3 percentage points of the 10.8% reached in
1982. The large remainder expresses the normal rate of unemployment determined by
"real conditions" independent of monetary events. The evolving pattern of welfare




10

arrangements affecting the relative (private) cost of unemployment supplemented by
union and other government policies determined the trend in the more permanent
component of normal unemployment. Pervasive structural changes in all Western
economies requiring large reallocations of human and non-human resources add a more
transitory component to the basic normal rate of unemployment. An array of rigidities
introduced by government or unions which prevent the necessary adjustment transform
a potentially transitory event into a permanent feature of the economy. A crucial
consequence of this analysis is the fact that a dominant portion of current
unemployment in the Western democracies cannot be lowered by exercises in monetary
expansionism.
Lastly, are the social costs of anti-inflationary policy "too high"? In order to
answer the question we need to know what "too high" means. In particular, we need to
know what is the relevant comparison? No relevant explanation is usually offered and
it is simply contended that "it is too high" without ever considering the social costs
associated with the relevant alternative rarely explicitly mentioned, viz. a policy of
permanent inflation. Some contend that a policy of stable and anticipated permanent
inflation invokes much lower social costs than an anti-inflationary policy. This could
indeed be the case. But the comparison is quite irrelevant. A policy of stable and
fully antiticpated inflation belongs to the Never-Never Land of romantic illusions. The
reality is controlled by a politics of myopia and discretionary management. The
monetary authorities operating in our reality staunchly oppose the pre-commitment
required for a stabilized and fully anticipated policy of permanent inflation. A policy
of permanent inflation thus imposes in fact a series of real shocks and most
particularly intermittent declines in output. This aspect was developed in greater
detail in previous position papers. These papers argued that the social costs associated
with a once-and-for-all anti-inflationary policy were probably substantially lower than
the present value of the social costs built into a policy of permanent inflation.
Advocates of permanent inflation should at this stage seriously consider this issue
before we grant them any intellectual respectability.
2.

The Slack (or Gap) Makes Monetary Expansion Innocuous and Even Desirable

The current state of the economy seems to justify, so we hear, a large increase
of monetary growth. The high level of unemployment and a comparatively low level of
output defuses apparently any potentially inflationary dangers associated with a
massive monetary acceleration. The pervasive slack in the economy controls the price
movements and monetary acceleration will be absorbed by a corresponding expansion




11

of output with negligible inflationary effect. We are assured moreover that at some
indefinite point in the future monetary growth need be lowered. Advocates of this
policy never experience any doubts that they will know when to apply the monetary
brakes in time to prevent the resurgence of inflationary drift.
We note that this argument was forcefully advanced in the summer of 1975 and
1976. It justified the abandonment of the anti-inflationary episode introduced in 1974
and supported the monetary expansion of 1977 and 1978. The consequences became
clearly visible on the international currency and the domestic financial markets in the
second half of 1978 and 1979. These events, produced by the policymaking of previous
years, prompted the change in policy introduced in October 1979.
The argument, plausible as it may sound, must be recognized as an expression of
the politics of myopia. Little attention is directed to the state expected beyond the
immediate monetary acceleration. But the acceleration imposes a dilemma. Sustained
acceleration revives inflation and a subsequent retardation lowers the momentum of
economic activity. The argument thus supports the yo-yo game typically fostered by
the politics of myopia. It is a game which confronts agents operating in the market
place with great uncertainty about the course of monetary affairs. Monetary evolution
contributes under the circumstances to substantial variations in output. It also raises
the level of real interest rates and increases the variability of nominal rates. The
dominant political concern addressed to recessions and rising unemployment whenever
inflation receded produces moreover under this policymaking procedure a systematic
inflationary bias. An inflation rate (say 4% p.a.), low compared to the prior peak
(above 10% p.a.), tends to divert political attention to the "gap and slack" in the
economy. The inflation issue lost political significance at this stage and "moving the
economy again" is the new key word. As this process unfolds over time the critical
level of comparatively low inflation tends to drift higher. A politics of myopia is
basically incapable to cope with the long-run requirement of a non-inflationary policy
minimizing destablizing monetary shocks on the economy.
3.

The KKM Syndrome

The assertion that "nobody knows what money is" emerged as the simplest and
most radical expression of the politics of myopia. This extreme position has been
propagated by Irving Kristol on the intelligentsia market, by Henry Kaufman on Wall
Street, and Frank Morris (President of the Boston Fed) in the banking community.
The protagonists of the "death of money" hardly bother to develop an argument
or even an approach to an analysis. Their cogitations remain at an impressionistic




12

media level.

None has ever produced, even approximately, an articulated piece

acceptable by any professional standards. But one wonders whether any contribution
to knowledge or any relevant information is really intended by the protagonists.

It

would appear that some of these verbal exercises are mostly motivated to discredit
"monetarism", understood to mean a view advancing the idea of a long-range precommitting strategy of monetary control. It certainly offers a useful excuse for the
politics of myopia.
The assertion that "nobody knows what money is" is well designed to tickle the
media market's attention. The political market can usefully exploit this line to justify
essentially inflationary policies. But some simple reflections should alert us that the
statement makes little sense.
A general pattern characterizes all trading economies beyond the most primitive
level. Among all the assets (or resources) of the economy occurs without exception a
small subset with a very distinctive property. The items of this subset are typically
used as a general medium of exchange. Transactions are typically settled by a transfer
of such items. Transactions are thus not settled by random transfers of assets. This
distinctive occurrence of general media of exchange constitutes the characteristic
feature of a monetary economy and "money" consists of all items typically and
generally used as a medium of exchange.
So much should really be quite clear but obviously needs to be reemphasized.
With this as our background what is the meaning of the assertion that "nobody knows
what money is"? Consider the implication of such an assertion. If nobody knows what
money is, then nobody knows about the existence of any generally used media of
exchange.

This means however that no such distinctive assets will exist.

When

"nobody knows what money is" transactions are settled by random transfers of assets.
But we do not observe this pattern. Most agents, including even Kristol, Kaufman and
Morris, exhibit little difficulty in distinguishing between the majority of items in the
small monetary subset and all other non-monetary assets. Kristol should, according to
his own assertion, be indifferent between receiving currency, a check on a deposit
account, a car load of eggs or cucumbers for his learned contribution to the Wall
Street 3ournal. His actual behavior hardly reveals such indifference, i.e. he knows, as
most everybody else, what is money and what is not money.
Some elaborations occasionally made by the protagonists of the "death of money"
suggests that they do not really mean what they say. Morris exemplifies for instance
his point with a reference to money market fund accounts.

He refers especially to

some prevailing uncertainty about the behavior of such accounts.




13

Such uncertainty

indeed exists and will frequently exist around the boundary line between two classes of
phenomena. But this kind of uncertainty offers no rational basis whatsoever for the
sweeping assertion so cavalierly and repetitively offered to the media market.
The inference from a degree of uncertainty about the boundary line to the
assertion of total ignorance may satisfy the standards of the intelligentsia market.
But its general application would yield some weird results. The boundary line between
Canada and the USA is hardly specified to the last millimeter. The KKM inference
thus assures us that nobody knows really about Canada and the USA. The political
undertone implicitly justifying a politics of myopia is further revealed by the
remarkable fact that this inference is suspended on many occasions involving
comparatively substantial uncertainties about the boundary line (e.g. inflation rate,
components of national income accounts, current account deficits, etc.).
4.

Velocity, the Demise of Monetarism and Flexible Action

T n e relevant issue obscured by the choice of language expressed by the KKM
syndrome is the magnitude and behavior of the measurement error.
The
impressionistic hyperbole suggests at best that "something" happened to this
measurement error over the past few years. But we obtain no clear indication about
the precise content of the vague suggestions made. A very similar situation can be
observed with the confused discussion about velocity. Somehow the behavior of
velocity was radically changed in such a manner as to spell the "demise of monetarism"
(Robert 3. Gordon). But the nature of the assertion, while conveying an emotionally
satisfying ring reinforced by a small number of observations, remains quite obscure.
We are not really told what has changed, what properties of the stochastic process
governing velocity were modified in which way. It is not possible to infer from the
vague allusions whether the level of velocity suffered a once-and-for-all permanent
change, or whether the trend growth increased (or decreased), or possibly the variance
of the stochastic term increased. In a similar vein we do not learn what the contention
about the measurement error really is. Has its average increased, or its variability, or
both? Interestingly enough, no evidence has so far been presented by the protagonists
bearing on any of the aspects. "Eyeball" observations covering just a few quarters
offer simply no relevant information for our purposes. There is, so far, no evidence
that the variance of the stochastic term increased or the trend growth substantially
shifted. Allan H. Meitzer's position paper suggests however the possibility of a onceand-for-all drop in the level of the base velocity. It is noteworthy that the estimated
variance of the base velocity was lower for the I970»s than for the 1950's (excluding
the Korean war experience).




14

Much attention was directed to the apparently peculiar behavior and large
decline in velocity observed over the past six quarters. Robert J. Gordon detected in
this behavior the "demise of monetarism". An editorial writer of the Wall Street
Journal attributed moreover to "monetarists" all kinds of propositions apparently
inconsistent with the observed behavior of velocity or the monetary multiplier. The
significant aspect of all this contentious dispute is the simple fact that the
propositions occasionally attributed to monetarists (e.g. predictable velocity and stable
multiplier) are just the opposite of what has been said (most particularly by the
Shadow). The statistical record repeatedly surveyed over the past years by the Shadow
essentially emphasized two facts: first, that the monetary multiplier is "not stable"
(i.e. not constant) but effectively predictable, whereas secondly, velocity is neither
stable nor predictable. The pattern traced by velocity is best approximated by a
random walk. On other occasions, as in the case of Robert J. Gordon, there occurs no
reference to any "monetarist proposition" apparently invalidated by the "velocity
recession." The whole verbal exercise exhibits consequently no relevant intellectual
content, whatever its media or political value may be.
Professor Gordon's critique could possibly be interpreted to be addressed to the
monetarist policy rule without however any bearing on monetary analysis. He may
convey a frequent impression that large unexpected movements in velocity require a
flexible and "non-dogmatic" response by the Central Bank. Such flexibility in response
is suggestively offered as a strategy necessary to cope with the velocity problem.
Gordon pleads in particular, as some others, for a nominal GNP rule. We may explore
the implication of this strategy with the aid of the following formulation. Let m stand
for the rate of monetary growth, g a target rate of increase in nominal GNP, v the
rate of change in velocity, g the adjustment coefficient to target deviations, c a
constant representing desired "average" monetary growth, and lastly e a random shock
modifying the monetary control process; we write then
m t = c + 8 (g - m j - v j) + e t

(1)

We proceed moreover under the best assumption about velocity. This means that v is
controlled approximately by a white noise process. Monetary growth moves under the
circumstances according to the following pattern
1TK =




C+Bg

-iff

I
i=0

(-B)1 e t-r e Vi-i

15

The variance of monetary growth can be lastly derived
(2)
V(e)+ B V(v)
1-3
L
where V(x) indicates the variance of x. A positive contemporaneous covariance
between e and V adds a positive term on the right side raising V(m). A negative
contemporaneous covariance lowers on the other hand V(m).
Expression (2) shows that flexible adjustment expressed by a positive 8 converts
velocity shocks into monetary shocks. The variance V(m) rises with the variance V(v).
This dependence of V(m) increases moreover with 0 . The larger the response of the
monetary authorities to a target deviation, the greater is the variance of monetary
growth. Advocates of "flexible action" may argue that this result is quite irrelevant.
The larger variance of m is designed to offset the variance of v in order to produce a
smaller variance on the growth rate of nominal GNP. This contention is easily demonstrated to be false. The growth rate of nominal GNP, indicated by gnp, is given by
V(m)

gnp = m t + v t
or

I

(-B)1 e t - i " B

Vi-i + v,
i=0
This expression implies that the variance of gnp, disregarding covariances between e
and v, is given by

"TIT

V(gnp)

=

1

V(e) + V(v)

1-0'

The lowest variance is achieved under the circumstances with 0 = 0, i.e. with a
strategy of constant monetary growth.
It could be argued that a complex structure of serially correlated e's and
correlated e' and v's could conceivably Justify the choice of a positive 3 . Such
arguments typically overlook the information level required for their case. Indeed, if
such complex structure prevailed with all the proper covariances and serial
correlations necessary to yield a positive optimal 0 -value, the policymakers would
have to possess reliable knowledge about this structure. This knowledge assumption is




16

hardly tenable. But an optimal choice of 3 made relative to a false specification of
the relevant stochastic processes yields little expectation of true optimality. We have
no basis under the circumstances to expect an improvement over a constant monetary
rule.
This point can be elaborated in the context of a modified Gordon rule. Suppose
planned monetary growth mp depends on the deviation of expected gnp instead of the
last observed gnp, from target, i.e.
mP t = c + 3 (g - mp t - E*vt)

(3)

The magnitude E*v describes the perceived expectation of v for the current quarter on
the basis of information available at the beginning of quarter t. This perceived
expectation diverges in the context of very incomplete information about the
stochastic processes from the true expectation. This happens in particular whenever
one wishes to impose a systematic pattern on a serially uncorrelated v. The magnitude
E*v should be considered as a random term in this case. It is not a constant
maintained over time. Actual monetary growth can be written as
m t = mp t + e t

(4)

where e signifies against the random component in monetary control. The growth rate
of nominal GNP satisfies thus

The variance of gnp is given by
2
V(gnp) = ( j ^ g )

V(E*v) + V(e ) + V(v)

(6)

The first term expresses the increment in the variance of gnp attributable to
incomplete and risky information about the expectation of v in the context of flexible
adjustment policies. A random walk of v (even with drift) clearly implies that g be
set equal to zero. Once again the underlying velocity problem determines a constant
monetary growth rule as an optimal strategy. The much advertised velocity problem
yields no case for a "policy of flexible action" which usually produces the reality
characterized by the politics of myopia.




17




RECENT BEHAVIOR OF BASE VELOCITY
Allan H. MELTZER*
Carnegie-Mellon University

The Federal Reserve is back with its usual claim that the demand for money
shifted in 1982. The alleged shift is used to justify a return to the money growth rates
typical of the middle, and late seventies, the Burns and Miller years of highly
inflationary monetary policy. This time the claim seems more substantial, or at least
is more obvious to the naked eye, so it has been treated as an established fact by Wall
Street and Washington.
A common explanation of the shift is that deregulation of the banking system
reduced the demand for time deposits relative to the new, interest earning demand
deposits. This answer may be correct, as far as it goes, but it is surely incomplete.
Most of the observed decline in velocity in 1982 and early 1983 cannot be explained in
that way.
The reason is that the velocity of the monetary base — currency and total bank
reserves — declined relative to trend also. The Federal Reserve Bank of St. Louis
adjusts the base by the amount of reserves released or impounded by changes in
reserve requirements, so the recent regulatory changes that lowered the banks'
average reserve requirement are treated by St. Louis as a release of reserves and a
reduction in the demand for base money. The reduced demand for base money taken
alone, has the effect of increasing measured base velocity. This effect of regulation
takes us in the wrong direction. The introduction of super-Now accounts raises the
demand for base but has too little effect on required reserves to explain the decline in
base velocity.
Deregulation and other institutional changes may have increased the demand for
currency to be used as vault cash (reserves) of depository institutions. Much of the
recent decline in base velocity (relative to trend) is concentrated in the first quarter
of 1982, well before major regulatory changes took effect, however. This timing of
the drop in velocity would seem to rule out a major effect on deregulation, although
deregulation may have contributed to the decline in velocity in the fourth quarter of
1982 and the first quarter of 1983.
*I am grateful to David Santucci for his assistance with the computations.




19

Other proposed explanations include the decline in expected inflation and the
variability of monetary growth and of expenditure. A drop in the expected rate of
inflation lowers the cost of holding cash balances, so cash balances per unit of output
rise and velocity falls. Rapid accelerations and decelerations of money (or spending)
introduce unanticipated changes into the growth of money and economic activity.
Some of these unanticipated, transitory changes are held as cash balances. In addition,
increases in the unanticipated components of money and spending increase uncertainty
and, thus, lower velocity relative to trend.
Deviations from Trend: First Results
In "Strategies and Tactics for Monetary Control", Karl Brunner and I report
estimates of the trend in base velocity computed from quarterly data, using time
series analysis, for the period 1951-2 to 1981-3. The computed trend is .0061 per
quarter or approximately 2.5% per year. For a more recent period, 1971-1 to 1981-3,
the estimated trend is very similar, .0059 per quarter. I have used the trend computed
for the longer period (.0061) to obtain trend values for velocity and extended the time
period to include the first quarter of 1983. The observations we seek to explain are
deviations from the computed trend of base velocity.
Let DV denote these
deviations.
As a first effort to test whether there has been a systematic change in base
velocity, I estimated (t-values in parentheses),
DV = -0.0* - 0.02 DB + 0.02 p
(0.22) (4.08)
(3.04)

(1)
p r 0.94, R 2 = 0.19
(31.31)

where DB is the acceleration of the base, computed as the difference between the
current rate of change and a moving twelve quarter average rate of change, p is the
current (actual) rate of price change, and p measures first order serial correlation of
the residuals.

1.

The hypothesis is:
EV = V e * 0 0 6 1 t
with EV denoting the expected (trend) value of velocity, and
V - EV = DV.
DV = f(DB, w) where w is the expected rate of inflation and EV is independent of
the expected rate of inflation. Changes in the expected rate of inflation induce
one-time changes in the demand for money and in velocity.




20

The first effort produced findings broadly consistent with all subsequent efforts.
The estimates suggest that accelerations of the base and reductions in the rate of
inflation reduce velocity relative to trend; decelerations of the base and increases in
inflation raise velocity relative to trend. These findings are consistent with a very
large literature. Further, there is strong first-order serial correlation, a finding
consistent with the often stated view that there is a lag before changes in money
growth are fully reflected in the growth rate of spending. The coefficient of firstorder serial correlation is close to unity, in this and most other estimates, suggesting
that the equation could be estimated by taking first differences of the deviation from
trend, DV, and other variables. 2) Finally, the equation suggests that most of quarterly
DV is random, or at least not explained by DB, p and the lagged error.
The purpose of the estimates is to judge whether the trend of velocity has
changed in recent quarters, after taking account of the factors included in (1). The
answer given by the regression is that there is at most a one-time decline in the le\el
of velocity. Two estimates of the size of the decline are shown in Table 1. The first is
the error from equation (1) computed for the full period, 1952-1 to 1983-1. The second
is the error computed from the same equation estimated for the shorter period, 1971-2
to 1983-1, inclusive. In both columns, the error in estimating DV becomes negative in
1981-4 and remains negative through 1983-1. Table 1 shows these residual errors.
Table 1
Residual Error in DV Computed from
Equation 1
Quarter
1981-4
1982-1
-2

1951-2 to 1983-1
-.114
-.333
-.233

1971-2 to 1983-1
-.072
-.189
-.253

-3

-.218

-.282

-4

-.305

-.349

1983-1

-.270

-.334

The columns are essentially the same. Both suggest that the residual remained in
a narrow range and has not increased. These data suggest that a one-time drop in the
level of velocity of about -0.3 may have occurred early in 1982.

2.

The value of p suggests that DV is a random walk (hence not stationary) but
A DV is likely to be stationary.




21

Even this conclusion is much less than a certainty. The standard errors of
estimate for the two equations are 0.13 for the longer period and 0.17 for the shorter,
so the residual error is within a range that can arise from sampling error. The
conclusion that the level of velocity has changed is an interpretation of the persistence
of the error, not the size.
To gain some perspective about size, note that the average level of base velocity
is about 17.15 for the five quarters ending in 1983-1. The average residual error (0.28)
is about 1.6% of the level for this period, but it is nearly three times the trend
increase in velocity at recent levels. In 1983-1, base velocity is 1.36 (almost 8%)
below its previous trend, but most of the decline is predicted by the variability of
monetary policy, the decline in inflation, and the lagged residual (including effects of
lagged responses to inflation and monetary policy.)
Some Further Results
The measurement of DB and inflation are open to obvious criticisms. To see
whether these criticisms affect the result, I replace DB and p, in equation (1), with
DMBA2 and T in equation (2). DBMA2 is the residual from an ARIMA (0, 1, 2) model
T
for Jln B and T is the expected rate of inflation computed from an ARIMA (0, 1, 1)
T
model estimated on computed quarterly rates of price change of the GNP deflator.
DV = -0.23 - 0.016DBMA2 - O.OlOtr
(0.67) (3.70)
(0.«9)

(2)

p = 0.94, R 2 = 0.21
(16.85)
The measure of current expected inflation has no significant effect on DV. In
other respects the equation is "similar to equation (1) in its implications.
A further step permits unanticipated changes in spending to affect DV. DYAR1
is the difference between actual £ n GNP and the value predicted using an AR1 time
series model,
DV = ~0.t*5 - 0.017DBMA2 + 0.005DYAR1 + 0.018w
(1.20) (*.*2)
(3M)
(0.88)




p= 0.96, R 2 = 0.38
(21.06)

22

(3)

The residuals from equation (2) and (3) and the standard errors of estimate for
the two equations is shown in Table 2. These are not substantially different from the
residuals reported in Table 1. They suggest, at most, that there may have been a onetime drop in the level of base velocity of about 1.5%. The inference is a bit weaker,
given the possible tendency of the residual to decline. There is no evidence of a
substantial change in the behavior of velocity once allowance is made for the effects
of unstable monetary policies, the decline in inflation, and lagged effects.
Table 2
Residuals from Equations (2) and (3)
Quarter
81-4
82-1
82-2
82-3
82-4
83-1
ard Error

Equation ([2)
-0.09
-0.29
-0.29
-0.22
-0.28
-0.16

Equation (3)
-0.03
-0.28
-0.32
-0.19
-0.23
-0.16

+0.17

+0.15

A Change in Trend?
The persistence of the negative error, and the relative large decline in measured
velocity may be the start of a lower "trend" in velocity. A lower trend rate of
increase could occur, for example, if the instability of monetary policy encourages
people to hold more money (here mainly currency) per dollar of GNP. My previous
estimates are based on the assumption that the trend has remained unchanged. Is
there evidence of a change in trend?
Table 3 presents some data for earlier (old) more recent (current) estimates for
the ARIMA 011 model, with a constant, used to compute the trend.
Table 3
Old
1951-2
1961-1
1971-1
1971-1

to
to
to
to

1961-1
1971-1
1981-3
1983-1

.0073
.0055
.0059 + .0012

Current
.0067
.0051
.0044

+.0018

The hypothesis that the trend has changed is rejected for the sample observations.
Measuring "trends" always depends on starting and ending points chosen, so a different
sample may give a different result.




23

Conclusion
There is no doubt that base velocity declined in 1982 and early 1983 and is lower
than the value expected from its prior trend. The issue is whether the trend of base
velocity has changed, or whether there has been a one-time drop in base velocity, or
whether the recent behavior of base velocity is consistent with its past behavior when
account is taken of the factors determining that behavior.
There is, as yet, no reliable evidence of a change in trend. Arguments that base
growth can be raised to offset the faster trend rate of increase in base velocity appear
to rest on a weak foundation, or no foundation at all.
There is slightly more evidence suggesting a one-time decline in the level of
velocity in the first quarter of 1982. The evidence is weak and consists mainly of a
persistent residual equal to about -0.3, 1.5% of the recent value of base velocity. If
true, this finding might have been used to justify a one-time increase in the level of
the monetary base in early 1982, but it cannot serve as the reason for faster base
growth now.
Most of the decline in base velocity appears to be the result of the variability of
monetary policy, a decline in the expected and actual rates of inflation and the
delayed effect of past changes in these and possibly other factors. The analysis
suggests that a more reliable consistent monetary policy that reduced the variability
of the base would also reduce the variability of base velocity.




2h

OOPS, ANOTHER MONEY DEMAND SHIFT
Jerry L. JORDAN
University of New Mexico

Late in 1982, the growth of the money supply (Ml) accelerated sharply while
nominal GNP growth declined. The ratio of GNP to Ml is refereed to as the "income
velocity of money" and the inverse of velocity is the "demand for money." So when
income growth slowed while money growth increased, it was said that the demand for
money increased "causing" a decline in the velocity.
In the first quarter of 1983 the growth of income increased, but money growth
was faster, so the ratio continued to decline and it was asserted that the "demand for
money" was still increasing. However, in the second quarter of 1983 nominal income
growth was very rapid while money growth slowed somewhat, so the ratio increased
slightly. Now, in the second half of 1983, money growth is supposed to be sharply
reduced, while GNP is expected to continue rising at a rapid rate. Presumably, the
implied increase in the velocity of money will be "caused by" a decline in the demand
for money balances.
Or is it? Maybe the whole episode reflects not much more than the fact that
there are lags between changes in the rate of change of money growth and nominal
income growth. Let's look at the recent record.
Following the imposition of a pervasive set of credit controls early in 1980, the
level of Ml declined in the second quarter of that year. However, GNP declined by
even more, so the ratio of GNP to Ml also declined. Some observers, including Federal
Reserve Board staff members, said the decline in the money stock was caused by a
decline in the demand for money balances, but the decline of velocity implied an
increase in the demand for money! Which was it? Trying to explain what is happening
to the money supply by making assumptions about what is happening to money demand
is a tricky business.
During the first quarter of 1981, nominal income growth was almost 20%, while
Ml growth slowed to only about one-third that rate. Since the ratio of income to
money went up, the apparent rise in velocity meant the demand for money declined,
right? Not necessarily. Interest rates also fell in the first quarter of 1981, which




25

might imply a greater demand for money balances. Those who "explain" what
happened in the first quarter of 1981 by references to "shifts in the demand for money"
have a problem in reconciling their argument with what happened in the spring of 1980.
The alternative explanation for what happened in early 1981 is quite straight
forward. In the second half of 1980, money growth accelerated to a 13% annual rate.
After the normal lags, income growth also accelerated. Meanwhile, money growth was
reduced, so the ratio of the two increased. The apparent increases and decreases in
velocity reflect nothing more than the presence of lags.
For all of 1981, money growth was sharply reudced compared to the previous
year, while nominal income growth did not slow as rapidly. The result was an apparent
increase in velocity, since the ratio GNP/M1 rose about 4.5%. Then, 1982 was the
mirror image of 1981. Money growth reaccelerated, while income growth declined in
lagged response to the sharply slower money growth in mid-1981. Once again, Fed
staff members concluded that the observed decline in the ratio GNP/M1 reflected an
increase in the demand for money balances, and they "explained" the rapid growth of
money supply as being appropriate because of the assumed increase in money demand.
Following similar logic, the central bank in Germany observed that even during
the hyperinflation of the early 1920*s, the people always demanded more money than
was being printed. Central bank officials concluded that they would have to buy bigger
and faster printing presses if they were going to be able to create new money as fast
as the demand was growing.
During the past few years, U.S. monetary growth has been more volatile than at
any other time in recent history. The "explanations" offered by the Fed for this
increased volatility have been couched in terms of "money demand shifts," and an
effort has been made to convince outside observers that these accelerations and decelerations of monetary growth have little economic significance. In 1981, it was argued
that more attention should be paid to broader measures of money or credit because of
the declining importance of Ml-type money. Then in 1982 and 1983, it has been argued
that the public's increased preference for Ml-type money meant that its rapid growth
rate could not be taken as a reliable indicator of the thrust of money policy actions.
Again, which story are we supposed to believe - - M l is not reliable because people
don't want to hold it, or Ml is not reliable because people do want to hold it. The Fed
has tried to have it both ways.
The logic of these ad hoc arguments is that as long as accelerations and decelerations in money growth are attributed to shifts in money demand, it is impossible to
conclude that there is either an excess supply of or excess demand for money balances.




Consequently, there can be neither expansionary nor contractionary impulses arising
from the monetary growth fluctuations. Consistent with past behavior, continued
rapid growth of GNP in the second half of 1983 (around 12%), while Ml growth is
supposed to be slower (about 7%), will be atrributed to an increase in the velocity of
money "caused by" a decline in the demand for money. Early in 1983, they said rapid
Ml growth did not suggest a vigorous recovery. Soon we can expect them to be saying
that slow Ml growth doesn't suggest slower economic growth.
As long as the extreme volatility of money continues and there are lags between
monetary growth and income growth, there must be considerable short-run volatility in
observed velocity. For illustration, suppose the lag from changes in monetary growth
to changes in income growth was exactly two quarters. Suppose further that monetary
accelerations and decelerations lasted exactly six months. A chart of money growth in
income growth would look something like the following:

[M r e f e r s t o money growth and GNP r e f e r s t o income growth.]

If one computed the ratio of GNP/M for each quarter, the series would rise and fall
very sharply every other six-month interval. A naive interpretation would be that
"velocity is unstable" (because the "demand for money" is unstable) while actually the
volatility in the data series was produced by a highly stable relationship between
money and income in the presence of lags and volatile monetary growth.
The lesson from recent experinece is that the monetary authorities are simply
unwilling to produce stable monetary growth and they do not want outside observers to
conclude that the volatility of monetary growth reflects stop-and-go policy actions.
Two years ago the Reagan Administration advocated a monetary policy consisting of a
slow, steady, and predictable growth of the money supply. It has not been slow, it has
not been steady, and it has not been predictable. Worst of all, there is absolutely no
reason to assume the future will be any different than the past.




27




MONETARY POLICY OPTIONS AND THE ECONOMIC OUTLOOK
3erry L. JORDAN
University of New Mexico
There are no good monetary policy options. Since policymakers must choose
between alternative policies with undesirable consequences, there is no reason to
assume that a single option will be selected and adhered to. Rather, policies will
continue to alternate between "spurts" of monetary growth for six to twelve months,
followed by restrained monetary growth for another six months or more. Such a
pattern has been observed since late 1978, and is a "best guess" about what the future
will be like.
Some observers have concluded that sustained monetary expansion, lasting for
two years or more, is now underway. Previous periods of sustained rapid monetary
growth were 1963-65, 1967-68, 1971-72 and 1977-78. Each of those periods ended in a
major "credit crunch" and a recession,* and I would assume that continued rapid
monetary growth in 1983 and through 1984 would result in another severe credit crunch
and recession in 1985. Some sectors and industries would be prudent to incorporate
such an assumption into their strategic plans, but I do not believe it is the most likely
course of policy actions.
Recent Developments
Quarterly average data for the past few years reveal the following growth rates
for M1 and the monetary base:

Q4/77-Q4/78
Ql/79
Q1/79-Q3/79
Q3/79-Q2/80
Q2/80-Q4/80
Q4/80-Q2/81
Q2/81-Q4/81
Ql/82
Q1/82-Q3/82
Q3/82-Q2/83
Q3/83-?
AVERAGES

Ml
8.2%
5.6
10.3
2.2
13.3
7.1
3.2
11.0
4.7
13.8

MB
9.3%
7.1
8.6
7.4
9.5
7.2
4.4
10.1
7.4
10.3

7.9

POLICY
GO
SLOW
GO
STOP
GO
SLOW
STOP
GO
SLOW
GO
SLOW

8.0

•The first credit crunch in 1966 was followed by an unofficial "mini-recession."




29

After an approximate two-quarter lag, nominal and real GNP growth rates have
undergone similar accelerations and decelerations. Over the period since Q3/79 when
the Fed allegedly adopted a more strict monetary control procedure, the following
average rates of increase have prevailed:
Mi
Q3/79-Q2/83

M§

INFLATION*

7.6%

7.6%

7.3%

Using the rough rule of thumb that inflation reflects monetary growth two years
earlier, there is not much to be optimistic about. Prior to 1982, the highest rate of
monetary growth occurred in 1978. Two years later, the rate of inflation hit a historic
peak. Somewhat slower average monetary growth on average in 1979 and 1980 was
reflected in slower average inflation in 1981 and 1982, and the sharply slower
monetary growth in 1981 provides a leading indicator of the slower inflation we are
experiencing in 1983. Unfortunately, the sharp acceleration of monetary growth
beginning in the second half of 1982 serves as a warning that inflation is going to begin
accelerating sometime in the next year. Even if we are now in or we enter another
"stop" cycle for monetary growth, the seeds of increasing prices in 1984 have been
sown.
The behavior of "money-income velocity" has played a significant role in
discussions about monetary policy in the past few years. Interpretations of observed
movements in velocity and arguments about alleged "money demand shifts" have been
presented by SOMC members at previous meetings and on other occasions. Our
conclusion, and that of others such as the economists at the St. Louis Fed and Milton
Friedman, has been that conjectures about shifts in "money demand" do not justify the
sharp accelerations and decelerations of monetary growth that we continue to observe.
To the extent that the most recent explosion of monetary growth has been rationalized
on the basis of an alleged shift in the demand for money, the monetary authorities
have taken a very large gamble. If they are wrong, they will have thrown away all the
progress made against inflation and inflationary psychology and the cost will be
another recession and further upward ratcheting of unemployment.

+GNP implicit price deflator.




30

Assumptions for 1983-84
The range of forecasts for the next 15 months is not exceptionally great
compared to the past few years. However, it would be a mistake to be sanguine about
the outlook. There is almost no dissent from the view that real output growth in 1984
will be less than in 1983, and inflation next year will be higher than this year. How
much less output and how much more inflation is influenced by assumptions about
policies as well as potential shocks.
A.

Underlying assumptions;
1.
world oil prices change very little;
2.
no significant crop failures;
3.
no significant changes in the Federal budget prospects;
4.
no wage and price nor credit controls;
5.
no disruptive defaults on international debt.

B.

Variable assumptions:
1.
monetary growth in the second half of 1983 and in 1984 is steady at
the mid-point of the Fecfs announced target ranges;
2.
alternatively, monetary growth continues to fluctuate over a wide
range;
3.
4.
5.

historic M1 velocity growth rates are resumed;
alternatively, the level of velocity returns to historic trend;
alternatively, MJ_ velocity grows at rates similar to historic M2
velocity trend rates;

6.

alternatively, monetary base velocity growth rates follow the historic
cyclical pattern, but a permanent shift in the level of the multiplier
is associated with a permanent shift in the Ml velocity level (but not
its growth rate).

Economic Projections
At the March 1983 meeting of the SOMC, the following table was presented:
GNP
Q4/82-Q4/83
Q4/83-Q4/84




11.2%
8.7

OUTPUT
5.9%
2.5

PRICES
5.0%
6.0

31

Ml.

VI

5.5%
4.9

5.4%
3.6

BASE
6.1%
5.4

VB
4.9%
3.1

At that time it was projected that "at least two quarters of 7% plus real growth
would occur in 1983." It was also projected that the rate of inflation in the first half
of 1983 would be the low for the cycle and that the rate of inflation would rise in the
second half of 1983 and further in 1984.
Monetary growth has been considerably higher than the SOMC assumed as well as
much faster than the FOMC had set as a target. However, during such an acceleration
phase of monetary growth it is typical that the contemporaneously measured velocity
growth declines below trend. The growth rates of GNP, output and prices in 1983 have
been similar to what was projected by the SOMC in March. It now appears that
nominal income and output growth will be somewhat greater and prices about the same
as we thought six months ago.
Because of the lagged effects of the sustained acceleration in monetary growth
and the typical cyclical increase in velocity, it now seems likely that nominal income
growth and inflation in 1984 will be greater than projected last March.
1.

Variable assumptions 1 and 3 would imply the following optimistic outcome:
GNP
Q4/82-Q4/83
Q4/83-Q4/84

2.

11.4%
9.2

OUTPUT

PRICES

6.1%
3.7

5.3%
5.5

Ml
10.2%
6.0

VI

MB

VB

1.2%
3.2

9.3%
6.5

2.1%
2.7

Alternativey, if Ml velocity were to grow at rates similar to historic M2 velocity,
the projections for 1984 would be:

Q4/83-Q4/84

3.

GNP
8.0%

OUTPUT
2.0%

PRICES
6.0%

MJ_
6.0%

VJ_
2.0%

Another alternative would be that by Q4/84 the historic trend of velocity for Ml
is re-established, which would imply:
GNP
Q4/83-Q4/84

OUTPUT

PRICES

Ml

VI

18.0%

?

?

6.0%

12.0%

A recession in 1985 would be almost a certainty.




32

4.

Continuation of the stop-go pattern of monetary growth of the past several years
would mean Ml growth rates of:
Q4/83 = 3.0%
Ql/84 = 3.0%
Q2/84 = 8.0%
Q3/84 = 8.0%
Q4/84 = 3.0%
Such a pattern would imply:

Q4/83-Q4/84

GNP
10.0%

OUTPUT
3.0%

PRICES
7.0%

MJ_
5.5%

VI
4.5%

However, such a stop-go monetary policy would produce one or two quarters of
zero or negative real growth next spring or summer. Interest rates would
continue to be highly volatile, and domestic investment spending would continue
to be anemic.
5.

The acceleration of money growth in the past year was too much for too long
even if Ml velocity declined to a trend rate similar to historic M2 velocity.
Inflation in 1984 will be faster than in 1983. The range for inflation next year is
6% to 8%, with some probability that a quarter or two may exceed 8%.

6.

Real output growth next year is not likely to exceed 4% even if the very rapid
Ml growth of the past year were to be continued through 1984. Sustained rapid
monetary growth has never produced sustained rapid real growth. The most
likely range for real growth next year is 2-4%.

7.

If variable assumption 4) is accepted (historic velocity trend is re-established),
the monetary growth range the Fed has announced for 1984 would be much too
high. A sharper reduction in monetary growth would be necessary to avoid a
return to double-digit inflation in the next two years. Unfortunately, sharp
reduction in monetary growth has an adverse short-run impact on output and
employment. Given what the Fed has done in the past year, they must choose for
the next year between accelerating inflation or a return to recession.

8.

If the level of the monetary base velocity in Q4/84 is such that the growth of
base velocity for the period Q4/80 to Q4/84 is about the historic trend (about
2%), the implied growth of GNP from Q2/83 to Q4/84would be about 11.6% a.r.
This implies a pro-cyclical acceleration of VB growth to about a 5% rate over the
six quarter period, which would not be unusually high by historical standards. For
1984, the following would be implied:




33

Q4/83-Q4/84

GNP
10.8%

OUTPUT
4.3%

PRICES
6.5%

MB
6.0%

VB
4.8%

If Ml growth continues to be somewhat faster than Base growth, Ml velocity
growth would be somewhat less than Base velocity growth, and VI would not
return to historical trend by the end of 1984.
Policy Recommendations
Sorting through all the alternative assumptions, the relationship between
monetary base growth and GNP growth over the four-year period is most likely to
prove to be reliable. As reported at the March 1983 meeting, the pro-cyclical
movements in Base velocity have tended to average out over four-year cycles, and
there is no evidence to support the view that such will not be the case this time.
Average growth of the Base of 6.5% in the second half of 1983 and about 6% in 1984
would minimize the risk of either a sharp acceleration of inflation or a return to
recession.




34

ANALYSIS AND FORECASTS OF MONEY MULTIPLIER
BEHAVIOR 1982-4
James M. JOHANNES
and
Robert H. RASCHE
Michigan State University

In our last report to this committee, we noted that we had changed our forecasting methodology, and were updating our data set each month to reflect the data
that existed at that time, and then constructed truly ex-ante forecasts based on these
data sets. Our analysis of the behavior of autocorrelation functions of these updated
estimations indicated that the estimated residuals of some of the component models
were not behaving as white noise. As a result, we have specified most of our
component models (the exceptions are those for t_ and r+iUv). The revised models,
which are the basis for the forecasts below, are given in Table 1. At first glance it
appears that these models are considerably different and in some cases more
complicated than the previous specifications. However, if we invert the moving
average portions of the new models so that they are written in the form of infinite
autoregressive models, and compare these with the equivalent form of our earlier
models, the differences between the old and new specifications can be seen to be
relatively minor.
The forecasts based on data through July 1983, for the twelve month period
August 1983 through July 1984, for the M.-adjusted monetary base multiplier are given
in Table 2. For the remainder of this year, the difference between the forecast value
for each month and the actual value for the corresponding month of 1982 is quite
large, on the order of 2-3 percent. However, it is important to note that these
differences are declining as the end of 1983 approaches. In large part these
differences represent the impact of the rapid increase in the M.-adjusted monetary
base multiplier that occurred in the last several months of 1982, and do not reflect
forecasts of any major changes in the multiplier in the near future. By the second
quarter of 1984, the forecast year over year change in the multiplier is on the order of
one percent. It should be remembered, of course, that forecasts nine to twelve months




35

into the future using these time series models have considerably less precision than one
to two month forecasts from the same models. However, it seems appropriate to
interpret these forecasts as suggesting that the M.-adjusted monetary base multiplier
behavior in the next twelve months will show a slight upward trend.
Analysis of Recent Behavior of the M. -Adjusted Monetary Base Multiplier
In our last report to this committee, we provided an extensive analysis of multiplier forecasts for various money stock concepts and various reserve aggregates.
From that analysis we concluded that any distortion in the behavior of M. growth over
the period October through December 1982 that was uniquely and hence upredictably
associated with "parking" of All Savers funds, introduction of MMDA accounts, or the
introduction of "Super NOW" accounts was minimal. This analysis is extended in
condensed form in Table 3. The first three lines reproduce the one month forecasts of
the M.-adjusted monetary base multiplier for the period October-December 1982 from
our previous report. It can be seen from those results that subsequent data revisions
have not substantially changed our earlier conclusions. The multiplier was somewhat
underestimated in October and November, but the forecast errors were not highly
unusual by historical standards. The fourth rows of the table reproduces the forecasts
that we prepared for the last meeting of this committee through July 1983. Over the
seven month forecast period for which data have become available since the last
meeting, the largest forecast error that we have observed is .97 percent, and the mean
error averaged over the entire forecast period has been close to zero. The remaining
row of the table give the one month ahead forecasts updated each month since the last
committee meeting. The experience here is consistent with that of the OctoberDecember 1982 period: none of the errors appears to be highly unusual by historical
standards. The root-mean-squared forecast error for the ten one month ahead
forecasts in Table 3 measured as a percent of the actual multiplier is .11 and the mean
forecast error measured as a percent of the actual multiplier is .25. The largest
absolute forecast error occurred in May 1983, by which time it is generally agreed that
any distortions to M. behavior from the introduction of new financial instruments had
long since disappeared.




36

TABLE 1
Revised Time Series Models for MultipllerComponents
July, 1983
(l-B)U-B 12 ) Ink -

(1 + .1786B + .14789)(1 - .0992B4 - .5863B12)a
(.0601) (.0634)
(.0535) (.0523)

(l-B)U-B 12 ) Int. -

(1 + .2263B)(1 + .1508B3 + .1954B6 + .1785B9 - .5074B12)a
(.0606)
(.0549)
(.0553)
(.0563) (.0571)

(1-B)(1-B12) lng -

(1 - .4288B - .1248B2 - .1645B4)(1 - .6696B12)a
(.1246) (.0638)
(.0569)
(.0481)

$
(1-B)(1-B12) lnr+i

-

(1 - .1157B + .0839B6 - .1813B9 + .6909B12)(1 - .3565B)afc
(.0838) (.0620)
(.0925)
(.0652)
(.1072)

(1-B)(1-B12) lnz -

(1 + .2722B + .1362B2 + .1411B3)(1 - .7560B12)at
(.0606) (.0301)
(.0614)
(.0420)

(1-B)(1-B12) lntc

(1 - .5315B)(1 - .6250B12)at
(.0681)
(.0663)

-

Note: Models for k, tj, g, and z are estimated with an intervention for the introduction of
nationwide NOW accounts over the period Jan-Apr, 1981. For a description of this intervention see
Johannes & Rasche, "Forecasting Multipliers for the 'New-New' Monetary Aggregates", September, 1981,




TABLE 2
Mj-Adjusted Monetary Base Multiplier
(Not Seasonally Adjusted)
Actual 1982-3

cast 1983-4

Year Over Year
Percent Difference

August
Sept.
Oct.
Nov.
Dec.

2.5339
2.5663
2.5990
2.6098
2.6251

2.6251
2.6486
2.6655
2.6669
2.6829

3.54
3.16
2.53
2.16
2.18

Jan.
Feb.
March
April
May
June
July

2.6253
2.5956
2.6100
2.6499
2.6060
2.6224
2.6255

2.6834
2.6449
2.6530
2.7023
2.6366
2.6533
2.6553

2.19
1.89
1.63
1.96
1.17
1.17
1.13




38

TABLE 3
Summary of Recent Ex-Ante Forecasts of M^-Adjusted Monetary
Base Multipliers (Not Seasonally Adjusted)
(Percent Errors in Parentheses)
Oct
1982

Actual (July 1983)

Forecast
Data

9/82

Forecast 10/82
Data
vo

Forecast 11/82
Data
Forecast 12/82
Data *
Forecast
Data

Apr
1983

May
1983

June
19B3

July
1983

2 .5990

2 .6098

2.6251

2.6253

2.5956

2.6100

2.6499

2.6060

2.6224

2.6255

2.6408
(-.59)

2.5902
(-21)

2.5999
(.39)

2.6542
(-.16)

2.6261
(-.77)

2.5972
(.97)

2.6086
(.65)

2 .5778
(.82)
2 .5775
(1 .24)
2.6230
(.08)

5/83

Forecast
Data

Mar
1983

4/83

Forecast
Data

Feb
1983

3/83

Forecast
Data

Jan
1983

.2/83

Forecast
Data

Dec
1982

1/83

Forecast
Data

Nov
1982

6/83

*Forecasts prepared for March, 1983 Shadow Meeting.



2.5754
(.78)
2.6070
(.11)
2.6731
(-.87)
2.5708
(1.36)
2.6339
(-.44)
2.6234
(.08)




FEDERAL BUDGET OUTLOOK-- A REPORT TO THE SOMC
Mickey D. LEVY
Fidelity Bank

The federal budget deficit for fiscal year 1983, which is drawing to a close, will
be approximately $207 billion, nearly double the record-setting $110.6 billion deficit in
1982. (The total rise in publicly-held debt, including deficits incurred by off-budget
entities, will exceed $225 billion.)
Projections of the FY 1984 budget deficit have been revised downward, to $179.7
billion by the Administration in its Mid-Session Review of the 1984 Budget, and to a
range of $183-$192 billion by the Congressional Budget Office (The Economic and
Budget Outlook: An Update, August 1983). The Administration also forecasts deficits
to decline to $129 billion in FY 1986, while the CBO forecasts slightly higher budget
imbalances in future years:
Projected Unified Budget Deficits ($Bil)

1983
Administration
CBO

1984

210
207

Fiscal Year
1985

180
183-192

170
176-180

1986
129
143-146

Any optimism about these forecasts of declining deficits, however, must be
tempered. Both forecasts assume the enactment of substantial deficit-cutting
legislation, and such action may not be politically feasible, at least on the short-term
horizon. Also, although there is much uncertainty about the economic outlook, some
of the assumptions underlying these projected budget outcomes may be too optimistic.
Consequently, budget deficits may be higher than these projections indicate.
Budget Proposals and Current Services Budget Outcomes
Unless proposed legislation is enacted, unified budget deficts are projected to
remain above $200 billion for years to come, even if a strong economic expansion is




41

sustained, inflation remains modest, and interest rates decline. The Reagan Administration's budget calls for deficit-reducing legislation of $21 billion in FY1984, $36
billion in 1985 and $90 billion in 1986:
The Reagan Administration's
Current Services and Proposed Deficits ($Bil)

1984

Fiscal Year
1985

1986

866
848
-18

948
918
-30

1032
991
-41

666
668
3

742
748
6

813
862
49

200
180
-21

206
170
-36

219
129
-90

Expenditures
Current Services
Proposed
Difference
venues
Current Services
Proposed
Difference
Eicits (-)
Current Services
Proposed
Difference
•Figures may not add due to rounding

The Congressional budget plan, as adopted in the First Concurrent Resolution on the
Budget for Fiscal Year 1984, also includes significant deficit-cutting legislation.
However, the proposals by the Administration and Congress involve major differences
in policy mix that will be difficult to reconcile. The Administration's budget calls for
large reductions from current services in non-defense expenditures, slight increases in
defense outlays, and only modest rises in tax revenues.
(For FY 1986, the
Administration's proposed $129 billion deficit hinges critically on its contingency tax
plan, which will generate $46 billion in additional revenues.) In contrast, the
Congressional budget plan relies very heavily on legislated tax increases, and it would
cut scheduled defense spending. The first Concurrent Resolution also would set up a
"reserve fund" for new spending initiatives in domestic programs.
Passage of $21 billion worth of deficit-cutting legislation for FY1984 seems
unlikely given the conflicting composition of the proposed cuts and the fact that 1984
is an election year. The beginning of FY 1984 is rapidly approaching and little effort
has been made to reconcile the conflicting policy approaches. The Administration's
proposed outlay cutbacks in Medicare, Medicaid, farm price supports, and other nondefense expenditure programs require Congressional approval. Moreover, one-quarter




42

($4.5 billion) of the Administration's proposed $17.9 billion in outlay cuts in FY 1984 is
in a category entitled "All other-mostly non-defense discretionary", which is less-thanencouraging (over one-third of the proposed $88.7 billion outlay cuts in fiscal years
1984-86 is in this category). While many of the Administration's proposals represent
sound public policy, it is uncertain whether Congress will have any appetite for such
legislation during the election season. Even more uncertainty surrounds Congress's
plans to cut defense spending (by $29.5 billion in fiscal years 1984 to 1986) and to
increase tax receipts (by $12 billion in 1984 and $15 billion in 1985), particularly since
the First Concurrent Resolution did not specify how these changes would be
accomplished.
Economic Outlook and Budget Outcomes
Budget outcomes depend heavily on economic performance and, in this regard,
the budgets of the Administration and CBO are based on economic performance that in
certain aspects is more optimistic than the SOMC forecasts. The Administration
forecasts a strong, sustained economic expansion, accompanied by only modest rises in
inflation, and continuous declines in interest rates through 1986 (the CBO is only
slightly more pessimistic, with marginally lower real growth and modestly higher
inflation and interest rates):
Economic Assumptions Underlying Budget Forecast
Fiscal Year
1983
GNP (%chg. 4th Qtrto-4th Qtr)
Real $
Current $
CPI (%chg. 4th Qtrto-4th Qtr)
Unemployment Rate
(% 4th Qtr)
Interest Rates
(% annual average)
91-day Treasury Bill
10-Year Treasury Note

1984

1985

1986

5.5
10.4

4.5
9.7

4.0
9.0

4.0
8.7

3.1

4.4

4.7

4.5

9.6

8.6

8.0

7.3

8.6
10.6

8.5
10.1

7.8
9.3

7.2
%.7

Source: Mid-Session Review of the 1984 Budget




43

These patterns of inflation and interest rates would be different than the climbing
rates that have accompanied previous post-war expansions; additionally, they are
seemingly inconsistent with the expansive monetary and fiscal policies that have been
in place since mid-1982.
The SOMC forecasts 4% real GNP growth from the fourth quarter of 1983 to the
fourth quarter of 1984 (slightly lower than the Administration's 4.5% and the CBO's
4.3%), but anticipates higher inflation and interest rates in 1984 and beyond. A halfpercentage point slower economic growth, if sustained into 1985, would raise the
deficit by approximately $2 billion in FY 1984 and $7 billion in FY 1985. Higher
inflation would partially mitigate this impact in FY 1984 by raising tax collections by
more than outlays. However, beginning in 1985, when personal income taxes are
indexed for inflation, the deficit-reducing characteristics of higher inflation will be
diminished.
The Administration's forecast of $103.5 billion in net interest payments in
FY 1984 (12.2% of total budget outlays) also may be too low, according to the SOMC
forecast of higher interest rates. Budget deficits are increasingly sensitive to interest
rates, given the magnitude of deficits and the rapidly mounting outstanding debt, a
large portion of which must be refinanced in each of the next several years. The CBO
estimates that one-percentage point higher-than-forecasted interest rates beginning in
October 1983 would increase the deficit by $3 billion in 1984, $8 billion in 1985, and
$11 billion in 1986. (Since early July, interest rate yields have averaged 9)4% on 91day Treasury bills and 11H% on the 10-year notes, both well above their respective
forecasted levels for 1984.)
There is a strong need to narrow the current and projected budget imbalance, but
skepticism that a consensus on constructive budget policy can be reached prior to the
election is warranted. Only partial legislative success, combined with forecasted
economic growth and slightly higher-than-projected inflation and interest rates would
result in a deficit in the $190 to $200 billion range for FY 1984. Slower economic
growth or continued modest inflation but persistently high real interest rates would
push the deficit closer to the $200 billion level.
Slowing the growth of government outlays clearly is the wisest policy
alternative, but it may be the most difficult politically. In FY 1984, a scheduled 83.8%
of total outlays are for income security and health (42.9%), defense (29.1%), and net
interest (11.8%). Congress will be slow to cut payments-for-individuals, particularly
on the heels of the enactment of earlier non-defense spending cuts and the Social




#4

Security Amendments of 1983, and the Reagan Administration likely will be just as
unyielding in its opposition to cutting scheduled defense spending. On the other hand,
while raising taxes would temporarily reduce deficits and ease financial market
pressures, it would have undesirable economic consequences. Any effort to raise taxes
must take a back seat to slowing spending growth and, above all, must not involve
tampering with legislation that indexes personal income taxes for inflation, even
though such action would reduce the structural budget imbalance.
The silver lining in the budget outlook is that with the proposed legislation,
deficits would begin to recede, absorb less saving, and reduce upward pressure on
interest rates. The need to do so is immediate, in light of anticipated increases in
capital spending and renewed rises in business loan demand. However, the dark clouds
of reality are ominous: legislative inaction would prevent deficits from declining
below $200 billion annually, and the various consequences of that for any extended
period could only be negative.




k5




ECONOMIC PROJECTIONS
Burton ZWICK*
Prudential Insurance Company of America

The annual growth of real output exceeded 9% in the second quarter of 1983, and
the most recent statistics suggest very strong growth in the current quarter as well.
Though the inflation rate has bottomed out, it does not yet show any major
reacceleration. With unemployment declining in line with rapid output growth, the
sum of the unemployment and inflation rates — the late Arthur Okun's misery index —
should continue to decline over the next six to twelve months.
Economic cycles -- including those periods of declining misery — strongly reflect
the actions of the Federal Reserve. In earlier cycles, the Federal Reserve remained
too tight for too long, causing needlessly severe and prolonged recessions of the
economy. Declining misery phases occurred when the Fed stimulated to hasten the
economy's return toward full employment. Unfortunately, the Fed allowed their
stimulus to become excessive, causing inflation to accelerate and ultimately creating
the need for another round of restraint.
Insofar as the economy and monetary policy are different this time, the Fed
remained tighter for longer during the last phase of restraint — causing an even
sharper downturn — and has moved toward rapid stimulus earlier in the recovery. As
summarized in Table 1, Ml has grown about 13% in the last year. Many analysts
believe that 1983 M1 growth may be overstated by 2 or 3 percentage points because of
the introduction of Super Now accounts in January 1983. An Ml Divisia measure —
designed to reflect the effects of Super Nows and any offsetting effects of MMDAs on
Ml — shows twelve month growth of 11.0%. This is close to those estimates including
a 2-3% adjustment in Ml, and it is also closer than reported Ml growth to the 9.4
growth rate of the monetary base. Even after adjustment via the Divisia measure, the
past year's growth in Ml raises annual MI growth since the fourth quarter of 1980 to
the 7Yz% area, offsetting the bulk of the decline in Ml growth that occurred in 1981
and early 1982.
•The views expressed here are mine alone and should not be interpreted as the official
forecast of Prudential. I gratefully acknowledge the helpful comments of Jason
Benderly and Michael Hamburger.




47

While the monetary expansion has almost certainly contributed to the rapid
improvement in the economy in recent quarters, it again places the Fed in a no win
situation. On the one hand, Federal Reserve efforts to offset the recent growth in
money run the risk of sharply slower output growth, possibly including a recession
before the end of 1984. On the other hand, continued monetary expansion at anywhere
near the level of the past year — even Ml growth in the upper half of the 5-9% target
recently announced for the second half of 1983 — will result in 1983 growth of 9-10%
for both Divisia Ml and the monetary base. Following growth of about 8% in 1982, this
1983 growth will leave longer run money growth at a rate that has historically been
associated with 10-12% growth in nominal GNP and 7-9% growth in inflation. When
combined with enormous fiscal policy imbalance whether measured by expenditures or
budget deficits, this monetary expansion is likely to heighten concern about inflation
and encourage investors to shift their wealth from financial assets back into real
estate and commodities.
Given these alternatives, it is difficult to predict which way the Fed will turn.
Recent votes show unusual division within the FOMC, and the recent reserve statistics
make near term monetary policy extremely difficult to interpret. Reserve growth has
slowed to the 5% area over the last three months, and both the St. Louis and Board of
Governors' measures of the monetary base have slowed to the 6-7% area over this
period. At the same time, the yield curve has a pronounced upward slope, and Ml
growth — though slower than in early 1983 — still remains above 8% for the past three
months. The one unambiguous feature of monetary policy is the Fed's careful
management of the federal funds rate. The Federal Reserve seems determined to
resist any upward pressure on the funds rate for fear of aborting the recovery. They
also seem unlikely to allow any major downward move in the funds rate for fear of
adding to the bond market's concern that the Fed is unwilling to curb inflation.
The most probable forecast as reported in Table 2 assumes 7-9% growth in Ml
and the monetary base for the second half of 1983 and 6-8% growth in 1984. In this
scenario, annual output growth runs about 7% in late 1983, slows to the 5% area in
early 1984, and falls to the 4% area In late 1984. The inflation rate gradually
accelerates — to over 5% in late 1983, to 6-6&% in early 1984, and to over 7% by late
1984. The federal funds rate remains in the 9-11% range, while government bonds
trade between 11% and 13%. The dollar declines but not dramatically over the period.




48

Since Ml velocity declined by about 5% in 1982, the velocity numbers in the most
probable senario -- between 0% and 1% in 1983 and slightly over 4% in 1984 — imply
zero velocity growth over the 1982-84 period. Even with adjustments for the effects
of Nows and Super Nows introduced over the 1982-84 period, predicted velocity (198284) is below the 3-3.5% post World War II trend in Ml velocity. (Corresponding
monetary base velocity growth, 1982-84, is about 0.5% per year compared with post
World War II trend growth of about 2%.) The low level of predicted velocity, relative
to trend, suggests that the greatest risk to this forecast is that the economy will grow
faster than in the most probable scenario. Particularly if the Federal Reserve resists
the upward rate pressure likely to arise under this scenario with faster growth,
monetary growth will reaccelerate. The bond market will weaken further and the
dollar will decline sharply. The Fed will then be forced toward extreme monetary
restraint — possibly before the end of 1984.
A lesser risk, but one that cannot be ignored so long as the Fed continues to
target the funds rate, is that the economy and associated credit demand will run
weaker in late 1983 and early 1984 than generally expected. In this case, the 9-11%
range on the funds rate (or even a funds rate as low as 8%) could be associated with 36% money growth. With policy much tighter than intended by the Fed, the economy
will weaken — possibly falling into recession before the 1984 election. Given the
political pressures from both the President and Congress, we view this scenario as less
likely than either our most probable scenario or the scenario with more rapid expansion
over the next twelve months.




49

WEEKLY StMMARY OF MONETARY STATISTICS
FOR THE WEEK ENDED AUGUST 31, 1983

Annual Growth Rates
Aggregate (SA)

26 Week

52 Week

8.6
C10.0)

11.1
C9.8J

12.9
(11.0)

6.4

8.7

9.4

FRB Monetary Base
fAd justed! *

6.8
(6.2)

8.9
(9.1)

8.7
(10.1)

"total Reserves
(Adjusted) *

5.8
13.2)

6.9
(7.7)

6.5
(12.6)

-0.3
(-2.7)

2.1
(4.1)

3.8
(10.9)

Ml
Ml:Divisia)
S t . Louis Monetary Base

Km

o

ffonborrowed iteserves
(Adjusted) *

J j
t

wDCK

NOTES:

••3

o*
•Figures in parentheses represent the growth rates of the FRB monetary base and
reserves adjusted for our estimate of the ongoing net release of reserves result
ing from the shifting of deposits into the new MMDAs and Super NOW accounts. We
estimate that a total of approximately $2.4 billion of reserves have been released
since November 1982. Additionally, adjusted nonborrowed reserves include extended
credit of about $0.5 billion.
Prudential Economic Research
September 6, 1983



BOONOOC PROJBCT1CNS
11972$, Seasonally Adjusted Annual Rates of Change Except Where Noted)
1982

1983
Q2A

1984

a»

2**

035

Q«

Real (WP
-1.0
G > Deflator
W
3.7
Nominal GKP
2.7
Final Sales
-1.5
Honey Supply 0411
Velocity of Ml
Monetary Base
vel. Monetary Base

-1.3
3.8
2.5
4.5

2.6
5.5
8.2
0.6

9.2
3.5
13.0
5.9

7.0
5.0
12.4
4.5

6.0
5.5
11.9
5.5

5.3
6.0
11.6
4.4

4.6
6.5
11.4
3.7

4.0
7.0
11.3
4.0

4.0
7.5
11.8
3.7

-1.7
4.4
2.6
0.2
8.5
-5.4
7.9
-4.8

6.2
4.9
11.4
4.1
11.0
0.4
9.5
1.7

4.5
6.7
11.5
4.0
7.0
4.2
7.0
4.2

Real QJP Components:
Conswption
0.9
Durables
-3.7
Nondurables
1.3
Services
2.1

3.6
15.2
1.5
1.9

2.9
7.6
3.2
1.4

9.7
32.0
5.8
6.5

6.3
10.0
5.4
5.9

5.8
12.0
4.9
4.6

4.7
7.0
4.6
4.0

4.6
7.0
4.5
3.8

3.9
5.0
3.8
3.7

3.7
3.8
3.8
3.7

2.5
6.2
0.6
2.9

6.2
15.0
4.8
4.6

3.5
4.7
3.4
3.2

-9.B
-7.2
-9.5

-6.7
-5.5
-7.1

-1.5
-13.9
4.9

6.1
-15.1
16.6

10.9
0.8
15.7

13.0
5.6
16.2

10.6
8.8
11.4

10.1
7.8
11.1

9.6
9.3
9.7

8.7
9.1
8.5

-9.0
-4.2
-11.1

7.0
-6.1
13.2

9.7
8.7
10.2

-13.1

53.1

57.7

75.9

13.0

8.5

4.5

1.5

0.0

0.0

3.0

35.8

1.5

Federal
State i Local

26.2
-0.2

28.2
-0.2

-17.9
-1.6

-2.7
-0.5

8.5
-1.1

8.3
-2.3

4.5
0.0

4.1
-1.1

4.3
-0.5

4.0
-0.7

8.6
0.1

-1.6
-1.4

4.2
-0.6

Net Exp (B1.72S)
Invent (Bi.72S)

24.0
-1.3

23.0
-22.7

20.5
-15.4

11.0
-4.0

4.5
5.0

3.0
7.0

1.5
10.5

-1.0
14.0

-1.0
14.2

-1.0
15.5

_
_

—
—

—
—

Addenda:
Unatp Rate ft)
Funds Rate (%)
30-¥r Gov't. (•)
tad. Prod.
Captltil Mfg. (»|
DW72$
PretxProf WVfiea
Auto Sales*
Housing**

9.8
11.0
12.8
-3.4
71.1
-0.3
4.1
5.6
1.12

10.5
9.3
10.8
-8.1
69.0
2.6
-14.8
6.0
1.26

10.0
8.8
10.6
17.9
73.7
3.3
94.5
6.9
1.69

9.5
9.5
11.5
16.0
76.5
8.1
45.0
7.2
1.75

9.0
10.0
11.5
11.0
78.5
5.8
30.0
7.6
1.80

8.6

8.2
(9--11)
(11-•13)
9.0
9.0
80.0
81.0
4.5
4.5
24.9
22.0
7.8
8.0
(1.7--1.9)

8.0

—
_
—.

—
—
—

—
_
—

Business Inv.
Structures
Bquipjnent
Residential

•Millions of domestic u n i t s .
••Millions of s t a r t s .
Prudential Eoononiic Research
Septenter 6, 1983




10.2
8.7
10.7
9.9
70.7
2.9
59.0
6.1
1.69

Q1E

Q?£

Q3E

Q4E

Annual: 4th Qtr. bo 4th Otr.
1982A
1983E
1984E

Q1A

8.0
(9-11)
01--13)
7.0
5.0
80.0
82.0
4.5
3.5
19.3
13.9
8.2
8.3
0.7- -1.9)

-7.5

13.7

—

—

7.5

—

0.2
-15.7

5.0
55.4

4.3
20.0

_
—

—
—

—
—




STATEMENT ON PROTECTIONISM TO SOMC
Jan TUMLIR
GATT (Geneva, Switzerland)

There is an illusion fostered by governments (whether they want to believe it
themselves or want us to believe it I don't know; probably both) that the contemporary
and still growing protectionism has been a pragmatic — or at any rate inevitable -response to the high unemployment levels prevailing since 1974. This is factually
uncorrect for the protectionist pressures have been growing, and governments yielding
to them, since the late 1960s. A much stronger case could be made to the effect that
the origins of contemporary protectionism have been ideological; but I do not want to
argue that case now. It is more important to point out the dangers of the illusion. It
implies that, as recovery proceeds, protectionism will begin to wane and eventually
disappear by itself. To believe that is foolhardy and dangerous. The main force behind
protectionism today is the formidable force of precedent. The more groups have
already obtained protection, the stronger case can be made by any new claimant for
"equal treatment". Democratic societies are not notable for their tolerance of
privilege. To arrest and reverse the protectionist trend, will require great political
effort and, above all, courage. The governments revealed preference for illusions does
not suggest that the requisite courage is there. The Western governments do not seem
so much protectionist as helpless.
We in the GATT have been arguing that the causal relations run the other way:
not that recovery will, by itself, dispel protectionism but that we shall not have an
enduring recovery until something is done first to secure and liberalize the conditions
of international trade. The argument is that by now the whole price system of our
economies is distorted and rigid, that the pervasive influence of governments throughout national economies has led not only to a decline in savings but to a misallocation
and waste of such investment as can be financed without inflation, and that these
rigidifying distortions can exist only because national economies are protected against
external competition. Rehabilitation of the price system cannot be expected under
present conditions of international trade. This is why arresting protectionism, and
dismantling the barriers put into place in the last, say, 15 years, is so important.




53

But we cannot make much headway with this argument because people think that
trade restrictions, though they have multiplied in recent years, are still largely
exceptional. So this requires some measurement of the levels of protection, and here
is the economist's dilemma. Strictly speaking, such a measurement is impossible for
the index number problem is essentially involved here. For several reasons, to be given
immediately, what you can have is a very rough estimate and even that must be
qualified in several respects, if you have any professional self-respect, that is. Even
so, journalists invariably make a mess of such estimated figures as are provided. Given
the caution with which one has to argue this point, there is little left in the end in the
way of an effective political argument.
There is, first of all, the problem of definition. What is it we are going to
measure? Even with respect to tariffs and quotas, the simplest of trade barriers, there
is no simple way of measurement and comparison. Yet this is only the beginning of the
difficulty.
What about subsidies, and subsidy-countervailing and anti-dumping
measures?
Bilateral agreements?
Intra-industry agreements and international
industry agreements, in other words, national and international cartels? Tolerated and
supported by governments they can represent as effective a restriction of trade as
anything a government can impose on the border. But this is not all: a government
can promulgate internal regulations of production which are more or less perfect
substitutes for protective measures imposed at the border. And how does one agree
on, and measure, bureaucratic chicanery and intimidation of potential importers?
What to include in the measure of protectionism is a problem prior to any difficulty of
measurement. There is a simple reason why GATT cannot provide an authoritative
indication of the existing levels of protection, or how they have increased over some
recent period. The representatives of member countries would never agree on what
was to be considered protection for the purposes of such measurement.
Second is the problem of knowledge. Not all trade restrictive measures come to
out attention, in fact the ones we know of are likely to be only a small fraction of
those actually in force. Bilateral agreements — voluntary export restraints and
orderly marketing arrangements — are the most frequent and most rapidly multiplying
forms of restriction. They are the exact equivalent in international trade law of the
problem that extortion by threat of violence poses in criminal law. They are
negotiated in the following way. A large importing country says to the smaller
exporting country; "We are having a difficulty in our widget industry, we think you are
a part of the difficulty, and there are two possibilities. We can enact a quota which
will halve your export of widgets to us, Alternatively, you can restrict, from your own




54

side, your exports to us to two-thirds of the present volume — we can live with that,
provided you don't complain." Which is like the Mafia soldier saying to the shopkeeper
or restaurant owner: this is a very rough neighbourhood, I strongly recommend you buy
yourself some protection. Both transactions are clearly illegal but they do have an
undeniable aspect of voluntariness: where there is no complaint, the law cannot be
enforced. And most restrained countries do keep their restraints secret.
The third difficulty is that even where we know which trade flows are subject to
which kind of restriction, we do not know the degree of restrictiveness. A good
example here is the Multi-Fibre Agreement: it subjects to quantitative restrictions all
exports of textiles and clothing from developing to developed countries. Without its
coverage changing, it has been renegotiated twice, becoming each time much more
restrictive. Another example may be the arrangements the US and various European
countries have made with Japan concerning automobile imports. The quantitative
limits set in 1981 were above what could be sold in the 1982 declining market. So one
might say they were not restrictive; but in fact their very existence changed the
behaviour of both buyers and sellers.
It is here that the index number problem enters. Because of the problem of
weighting we cannot calculate even a meaningful tariff average, let alone the average
restrictive effect of many different kinds of non-tariff barriers. The only proper
weighting system would be one in which each tariff rate, or each restriction, was
weighted by the amount of imports it keeps out. That we cannot know and weighting
by the amount of imports that actually come in subject to these barriers is strictly
speaking meaningless. Normally you would expect that when world trade is growing,
the proportion of imports under quantitative restrictions would be falling. In the mid1970s, however, I looked at imports under some forty plus officially notified Japanese
restrictions, and over the preceding decade they had been growing as total imports,
their share was constant — which does not mean, of course, that there was no
restrictive effect.
Still, even by these crude measures one could show that the extent of restriction
in international trade has been growing in the last fifteen years or so, and at an
accelerated pace since the mid-1970s. For this meeting, I could prepare only a point
estimate, the whole thing being — as you may appreciate from the appended tables —
extremely laborious.
In this case we set out to measure "imports under non-liberal arrangements",
"liberal" defined as imports transacted among independent firms and encountering no
worse obstacle than a tariff. Thus we include imports from centrally planned




55

economies and imports of OPEC oil in "non-liberal trade", but no imports from or to
various known cartel arrangements in the industrial countries. The definition captures
quantitative restrictions on the export side but subsidies are wholly ignored. Note that
the table does not give estimates; it tabulates trade under known restrictions, which
means the minimum of what can be considered non-liberal trade.
The proportion, in the three main trading powers, of total imports under some
kind of restriction is horrifying, even though OPEC oil accounts for the bulk of these
figures. But even the proportion of restricted imports of manufactures is pretty bad,
if you consider what these restrictions do to the price system of the importing
economies. And — to be emphasized all the time — keep in mind that subsidies to
export and import-competing industries, and their distorting effects, are not
considered here. From the viewpoint of overall distortions, the fact that Japan has a
lower proportion of manufactured imports under restriction means little, for Japan
also has a higher proportion of exports under restraint. The distortion of the price
mechanism in Japan is at least comparable in extent to that in the other two large
economies.
There exists a range of (even more tenuous) independent estimates of the
proportion of total world trade that is conducted under various restrictions or nonliberal arrangements. At the upper end are Francois David, a high official of the
French Ministry of Trade, who puts this figure at 60% (Le commerce modial a la
derive, Paris, Caiman-Levy, 1982, p. 225) and S. Page (UK National Institute for
Economic and Social Research) with an estimate of 48% ("The Revival of
Protectionism and its Consequences for Europe", Journal of Common Market Studies,
September 19SI, p. 29). My own estimate is in the range of 41-44%. Note that
virtually nothing can be said at this time about international trade in services and the
degree of restrictions here.
Whatever the value and shortcomings of estimates of this kind, they are useful at
least for the education of economists. American economists in particular, accustomed
to think in terms of a vast national market in which competition is vigorous and
commodity imports account for only 7-8% of GNP (an exaggerated fraction to boot,
for trade is measured in gross values, GNP is value added), tend to underestimate the
importance of trade restriction. Yet trade is what combines the national price
systems into the international price system without which we could not speak of
economic rationality. It is what makes the national price systems function; and the
information conveyed by the international system is the most important part of all the
information that the national price systems process.




56

From the extent of trade restrictions we can therefore guess at the degree of
impairment of the price system. And the proportions suggested here appear to be
roughly confirmed when we enumerate the industries in which pricing is either strongly
influenced or fully determined by trade and other policy measures, officially tolerated
cartels and so forth, and when we think of the relative importance of these industries
in the GNP. The count is drearily familiar; crude oil (which influences the pricing of
other sources of energy), virtually all of agriculture, textiles and clothing, several
branches of petrochemicals, iron and steel, ballbearings, automobiles, television sets
and components, many high technology industries (especially those with military
application), and armaments in general. Industrial machine tools remain perhaps the
only major industry under unimpeded world-wide competition. For how long?
« # * * •

What can a group like ours propose in the way of remedies?
There is, I am convinced, only one solution to the problem of protectionism but it
will take at least another decade before the political conditions will be ripe for it. The
essence of the problem is this. The international trade policy rules which for some two
decades held protectionism at bay and made trade liberalization possible have been
both negotiated and subsequently administered by diplomats. In the last fifteen years
or so, so many breaches have been made in these rules that today we can say that the
liberal trade system is eroding mainly by the cumulative force of precedent. The only
stable, long-term solution is that, eventually, these international rules will be accepted
by governments in a legal form which will establish private rights in or to the
conditions of trade specified by the international agreement. That would mean that
the international treaties on which the trade system would rest would be interpreted,
no longer by diplomacy (i.e. the executive branch of government), but by national
courts.
In the present conditions, this ultimate solution cannot but appear visionary and
Utopian. While pointing to it, we should also propose some more practical measures.
Since no government can arrest protectionism on its own, the only hope for the near
and intermediate future lies in a new trade negotiation through which at least the
governments of industrial countries could support each other in their resistance to
protectionist pressures. My suggestion is to combine the urgency of a policy action on
trade with the urgency of articulating and negotiating a real solution to the problem of
international indebtedness.




57

By a real solution I mean one that does not consist of financial gimmicks. The
real problem here is a declining availability of, or increased competition for, real
savings, due in large part to the high level of inefficiency which has crept into the
economies of both the creditor and the debtor countries in the 1970s. The innumerable
inefficiency-causing national arrangements are the ultimate cause of protectionism;
they now require a rising level of trade barriers to be sustained at the national level.
In other words, both the creditor and the debtor countries need, almost equally, a trade
liberalization to restore to them a degree of economic efficiency sufficient for the
existing debt burdens to be carried and serviced without a political disruption on the
debtor, or a new wave of inflation on the creditor side.
It is unlikely that a new full-scale round of GATT negotiations could be arranged
to produce useful results in the time available for mere "management" of the debt
problem. The present situation demands prompt action. Is it possible to think in terms
of a trade negotiation limited to a maximum of 15-20 countries, main creditor and
debtor countries, exchanging trade concessions on an MFN basis?




58

VT/jf
13/9/83
IMPORT RESTRICTIONS BY TYPE OF MEASURE" IN SELECTED INDUSTRIAL COUNTRIES

United
States

EC(9)'

109.4

TOTAL IMPORTS UNDER RESTRICTION
(billion dollars in 1980)

Japan

87.9

154.4

(Percentage shares)
TYPE OF MEASURE
Prohibitions
Quotas
Licences
Voluntary Export Restraints
State trading
Cartels
Non-specified

a

12
70
12
0
5
1

25*5

1
0
2*5
67
4

lh
16
3
16*5

45
12

Import restrictions as at the end of 1981. Trade figures refer to 1980.
Excluding internal trade.

c

Mainly imports of fuels from OPEC.

Sources:

WLAD/y



IMF, Exchange Arrangements and Exchange Restrictions, International
Financial Statistics, Direction of Trade Yearbook; UN, Yearbook of
International Trade Statistics, Commodity Trade Statistics, trade data
tapes; GATT, Inventories on non-Tariff measures, International Trade;
National trade returns and presB clipings.

59

WT/j f
13/9/83
COMMODITY PATTERN OF IMPORT RESTRICTIONS8 IN SELECTED INDUSTRIAL COUNTRIES

(Billion dollars)
Total
Imports
in 1980

Imports found to be under restriction

Food

Fuels

Iron
Other
"'"-'
j
"
" y steel

United States

o

4.8

76.4

-

Japan
OS

253.0
139.9

5.9

11.1

371.7

3.0

54.5

1.2

Other
manufactures

All
commodities

Other fuels

Manufactures

Import restrictions as at the end of 1981.

10.3

5.8

109.4

43

. 18

3.2

58.9

87.9

63

14

9.8

6.7

6.9
0.3

8.5

EC(9)S

5.2V

Textiles
4
clothing

Imports assumed Total Imports
to be under
under
restrictions
restriction

( Percentages)
Share of Imports
under restriction
In total Imports

9.6

69.6

154.4

42

18

Trade figures refer to 1980.

Fuels not found to be under any specific restriction in importing countries but "restricted" from the export side
(unilateral price fixing by a cartel of oil-exporting countries).
Excluding internal trade.
d

Including restrictions introduced during 1982.

Note: - "Other Primary" refer to products such as: Hides and skins, wood, crude fertilizers and metal scrap.
- "Other Manufactures" refer to products such as: certain chemicals (mainly ethyl alcohol, medicinal products,
essential oils and manufactured fertilizers), leather, ball bearings, passenger cars and motor cycles, ships and
boats, radio and television receivers, thermionic etc. valves and tubes, photocells etc., footwear, travel goods.
Sources:

WLAD/ya



IMF, Exchange Arrangements and Exchange Restrictions, International Financial Statistics, Direction of trade
Yearbook; UN, Yearbook of International Trade Statistics, Commodity Trade Statistics, trade data tapes;
GATT, Inventories on non-tariff measures, International Trade; national trade returns and press clipings.


Federal Reserve Bank of St. Louis, One Federal Reserve Bank Plaza, St. Louis, MO 63102