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Reflections
of an Economic
Policy Maker




Reflections
of an Economic
Policy Maker
Speeches and
Congressional
Statements:
1969-1978

Arthur E
Burns

American Enterprise Institute for Public Policy Research
Washington, D.C.




Library of Congress Cataloging in Publication Data
Burns, Arthur Frank, 1904Reflections of an economic policy maker.
(AEI studies ; 217)
Includes index.
I. Inflation (Finance)—United States—Addresses, essays,
lectures. 2. Inflation (Finance) and unemployment—United States—
Addresses, essays, lectures. 3. Laissez-faire—Addresses, essays,
lectures. 4. Fiscal policy—United States—Addresses, essays, lectures.
5. United States—Economic conditions—1977—Addresses, essays,
lectures. I. Title. II. Series: American Enterprise Institute for Public
Policy Research. AEI studies; 217.
HG538.B938
332.4'973
78-21864
ISBN 0-8447-3319-9
ISBN 0-8447-3333-4 pbk.
AEI studies; 217
© 1978 by American Enterprise Institute for Public Policy Research,
Washington, D.C. Permission to quote from or to reproduce materials
in this publication is granted when due acknowledgment is made.
The views expressed in the publications of the American Enterprise
Institute are those of the authors and do not necessarily reflect the
views of the staff, advisory panels, officers, or trustees of AEI.
"American Enterprise Institute" is the registered service mark of the
American Enterprise Institute fbr Public Policy Research.
Printed in the United States o f America




The American Enterprise Institute for Public Policy Research, established in 1943,
is a publicly supported, nonpartisan, research and educational organization. Its
purpose is to assist policy makers, scholars, businessmen, the press, and the
public by providing objective analysis of national and international issues. Views
expressed in the institute's publications are those of the authors and do not neces­
sarily reflect the views of the staff, advisory panels, officers, or trustees of AEI.

Council of Academic Advisers
Paul W. McCracken, Chairman, Edmund Ezra Day University Professor of Busi­
ness Administration, University of M ichigan
Kenneth W. Dam, Harold 7. and Marion F. G reen Professor of Law, University
of Chicago Law School
Milton Friedman, Senior Research Fellow, T he Hoover Institution on War, Revo lution and Peace; N obel Laureate in Economic Science
Donald C. Hellmann, Professor of Political Science and International Studies,
University of W ashington
D. Gale Johnson, Eliakim Hastings M oore Distinguished Service Professor of
Economics and Provost, University of Chicago
Robert A. Nisbet, Resident Scholar, Am erican Enterprise Institute
G. W arren Nutter, Paul Goodloe M clntire Professor of Economics, University of
Virginia
Marina v. N. Whitman, Distinguished Public Service Professor of Economics, Uni­
versity of Pittsburgh
James Q. Wilson, Henry Lee Shattuck Professor of G overnm ent, Harvard University

Executive Committee
Herman J. Schmidt, Chairman of the Board
William J. Baroody, Jr., President
Charles T. Fisher III, Treasurer

Richard J. Farrell
Richard B. Madden
Richard D. Wood

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Administration

Edward Styles, Director of
Publications

Program Directors

Periodicals

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AEI D efense Review,
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AEI Economist, Herbert Stein,
Editor

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Governm ent Regulation Studies

Public Opinion, Seymour Martin
Lipset, Ben J. W attenberg, CoEditors; David R. Gergen,
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Policy Studies
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Regulation, Anne Brunsdale,
Editor
William J. Baroody, Sr.,
Counsellor and Chairman,
D evelopm ent Committee




CONTENTS

Preface
A rthur F. Burns
PART ONE
FREE ENTERPRISE AND ECONOMIC GROWTH

The Triumph of Free Enterprise July 2 ,1 9 7 0
Dedication and Hope July 6, 1970
The Relevance of Adam Smith to Today's Problems
June 5, 1973
The Significance of Our Productivity Lag M ay 1 4 ,1977
The Need for Better Profits O ctober 26, 1977
Investing in Physical and Human Capital
N ovem ber 29, 1977
Blessings of a Free Society February 2, 1978
The Future of the Free Enterprise System
S eptem ber 21, 1978

3
17
23
35
41
53
67
75

PART TW O
INFLATION AND UNEMPLOYMENT

Inflation: The Fundamental Challenge to Stabilization
Policies M ay 18,1970
The Basis for Lasting Prosperity D ecem ber 7 ,1 9 7 0
The Economy in Mid-1971 July 23, 1971
The New Committee on Interest and Dividends
N ovem ber 1, 1971
The Problem of Inflation D ecem ber 29, 1972
Some Problems of Central Banking June 6 ,1 9 7 3




91
103
117
129
143
155

The Menace of Inflation M ay 26,1974
Key Issues of Monetary Policy July 30, 1974
Jobs and Prices Septem ber 27, 1974
Immediate and Long-Range Economic Problems
February 7 ,1 9 7 5
The Current Recession in Perspective M ay 6, 1975
The Real Issues of Inflation and Unemployment
S ep tem b er 19,1975
Four Questions by a Student of Economics
D ecem ber 14, 1975
The Worldwide Problem of Inflation June 11, 1976
The Effects of Inflation on Homebuilding
N o v em b er 18,1976
Some Parting Thoughts January 30, 1978

161
169
181
187
201
215
225
233
241
253

PART THREE
FISCAL RESPONSIBILITY

The Control of Government Expenditures
D e cem b er 2 ,1 9 6 9
The Need for New Budgetary Procedures M arch 6,1973
Reform of the Federal Budget M ay 6, 1973
The Congressional Budget Act of 1974 A u gu st 2 1 ,1 9 7 4
The Financial Crisis of New York City O ctober 23, 1975
Moderation in Fiscal Policy M arch 23, 1976
Current Fiscal Requirements M arch 2, 1977

263
273
283
291
297
307
311

PART FOUR
SOUND MONEY AND BANKING

The Federal Reserve and the Banking System
A pril 6, 1970
The Structure of Reserve Requirements A pril 26, 1973
Objectives and Responsibilities of the Federal Reserve
System S ep tem ber 8, 1973
Maintaining the Soundness of Our Banking System
O cto ber 2 1 ,1974
Monetary Targets and Credit Allocation February 6,1975
The Independence of the Federal Reserve System
M a y 22, 1976




325
335
345
355
367
379

The Proper Limits of Openness in Government
June 1 9 ,1 9 7 6
The Condition of the Banking System M arch 10, 1977
The Importance of an Independent Central Bank
August 1 3 ,1 9 7 7
Vital Issues of Banking Legislation S eptem ber 12, 1977

387
399
415
425

PART FIVE
INTERNATIONAL FINANCE

The Par Value Modification Act February 24, 1972
Some Essentials of International Monetary Reform
M ay 1 2 ,1 9 7 2
The Need for Order in International Finance
April 1 2 ,1977
The Redirection of Financial Policies M ay 11, 1977

455
469

Index

477




439
447




PREFACE

This volume owes its existence to Dr. Thomas F. Johnson, Direc­
tor of Economic Policy Studies of the American Enterprise Insti­
tute. Soon after I took up residence at the Institute, he suggested
that various of my pronouncements during the years I presided
over the Federal Reserve System had relevance and usefulness
beyond the occasion when they were made. I welcomed the sug­
gestion and took advantage of his willingness to make a pre­
liminary selection from the multitude of my public addresses and
congressional statements.
The final selection includes all the items on Dr. Johnson's
list. It also includes some others, among them two that extend
slightly the time period he had proposed: an address of Decem­
ber 1969, delivered while I was preparing for my responsibilities
at the Federal Reserve, and one recently given, which grew out
of my experience in the System.
In making the final selection, I resisted the temptation
to include only those items that may flatter or bring honor to
their author. Much of what is contained in this volume is repe­
titious; passages here and there may appear to be, or actually are,
inconsistent with others; some of the views presented I might
now question or reject. Yet, even as they stand, these papers
convey my strong conviction that inflation has become the most
dangerous economic ailment of our times and that our country
may be headed for disaster if we ignore the lessons won through
hard experience. I trust that this collection also conveys some­
thing of my struggle to protect the integrity of the Federal Re­
serve and to wring truth from our troubled and rapidly changing




economic and political environment. Such a personal accounting
requires the suppression of editorial impulse, and I have there­
fore left the papers just as they were originally presented. They
are here arranged— rather arbitrarily in some instances— in
chronological sequence under each of five general headings.
I need hardly add that the papers were prepared in the
course of an exacting official life that left little time for niceties
of analysis or elegance in composition. Even so, they could not
have been carried out without abundant help from highly skilled
and devoted colleagues. The Federal Reserve is a collegial body
of great moral and intellectual distinction. Whatever merit this
collection of papers may have is attributable in very large part
to the passion for objectivity and decency of these erstwhile
associates of mine.




A rthur F . B urns

September 3 0 ,1 9 7 8

PART
ONE
Free Enterprise and Economic Growth







The Triumph
of Free Enterprise

It is a great pleasure for me to visit Japan again. Four years have
passed since I was here last, and while I have heard much of the
progress and prosperity you have experienced, it is good to see
the evidence with one's own eyes. My personal knowledge of
Japan goes back some ten years. During my last visit, in early
1966, the mood was not one of universal optimism because you
were then experiencing a readjustment in the rate of production
and profits. There are always those who find any economic
pause a justification for pessimism about the future. I have not
been one of those. I have long been impressed by the great
resiliency of the Japanese economy. I believe that you have
discovered a formula for economic progress that will continue to
bring excellent results in the future as it has in the past. That is
not to say that you will not encounter problems. You will. But
your resiliency lies in the skill you have developed in devising
solutions to problems and your ability to work together as a
nation to achieve your goals.
This is a particularly interesting time for an economist to
visit Japan. As I am sure all of you recall, fiscal year 1970 was
designated as a target year in the economic plan unveiled by
Prime Minister Ikeda in 1961. In what many people then thought
was a fantastically ambitious design for the future, he calmly
announced that Japan planned to double her gross national prod­
uct between the years 1960 and 1970.
It is therefore fitting, as we are gathered here today, to take
note of how the actual achievement of Japan compares with Mr.
Address in Tokyo, Japan, July 2, 1970.




3

REFLECTIONS OF AN ECONOMIC POLICY MAKER

Ikeda's bold projection of a decade ago. While his plan called for
a national output that in this fiscal year would be twice that of
I9 6 0 , it now appears that your national product will in fact be
at least 180 percent above 1960.
The Ikeda plan projected exports reaching $9.3 billion this
year, while imports would rise to $9.9 billion. It is now believed
that exports will come to nearly $20 billion and imports to nearly
$19 billion.
The Ikeda plan foresaw Japanese steel consumption rising to
45 million tons this year. It will actually be around 80 million tons.
According to the Ikeda plan, a big expansion was to occur
in automobile production. But while it was then thought that
the output of passenger cars, trucks, and buses would amount to
about 2.2 million units, it now appears that well over 4 million
vehicles will be produced this year.
I might go on with such comparisons, but it is not necessary
to do so. Virtually all indicators tell the same story. Far from
being overly optimistic, as many people then thought, Mr. Okita
and his colleagues— who drew up the ten-year plan at Prime
Minister Ikeda's request— were very conservative in their pro­
jections. However, I am sure that no one will find fault with
them for that. They would not have been believed had they
forecast the achievements that have actually come to pass.
It is interesting to recall that a few years before Japan un­
veiled its income-doubling plan, the Soviet Union had already
singled out the year 1970 as the date by which its economy
would surpass the United States in production per capita and in
the standard of living. It may be worth recalling Mr. Khrush­
chev's precise words:
The superiority of the U.S.S.R. in the speed of growth
of production will create a real basis for insuring that
within a period of, say, five years following 1965, the
level of U.S. production per capita should be equalled
and overtaken. Thus by that time, perhaps even
sooner, the U.S.S.R. will have captured first place in the
world both in absolute volume of production and per
capita production, which will insure the world's highest
standard of living.
To achieve this goal, the U.S.S.R. would have been obliged
to more than double its per capita GNP even if the United States
4



TRIUMPH OF FREE ENTERPRISE

made no further progress and simply maintained its per capita
output at the 1960 level. However, unlike Japan, the U.S.S.R.
fell far short of the goal that Khrushchev had set for 1970.
The economic contest between the U.S.S.R. and the United
States enters the year 1970 with the United States holding a
commanding lead. In 1969, total output per person in the United
States was nearly $4,600. This was two-and-a-half times the
corresponding Soviet figure. Measured in real terms, the gap
between the per capita GNP of the United States and the Soviet
Union was more than 25 percent higher in 1969 than in 1960.
While the Soviet growth rate was slightly higher than the Amer­
ican rate, the difference was so slight that if the same growth
rates were maintained over the next 50 years, the per capita GNP
of the United States would still be about double that of the
Soviet Union in the year 2020.
The wide difference between the living standards of the
Soviet Union and the United States is vividly portrayed by com­
parisons of the number of working hours required to earn
enough to buy various goods and services. It turns out, for
example, that the average worker in Moscow in April 1969 had
to work nearly seven times as long as his counterpart in New
York to earn enough to buy an identical supply of food suffi­
cient to feed a family of four for one week. The difference for
many nonfood items was even larger. The following are the
multiples by which the cost of certain goods in Moscow exceeded
the cost in New York, when cost is measured in terms of work­
ing time: for bath soap, 12.5 times; for nylon stockings, 14
times; for a man's shirt, 12 times; for a refrigerator, 12 times.
These comparisons are based on official prices in Moscow,
not black market prices, which are, in many cases, far higher.
For example, a Volga sedan costing the equivalent of $7,700
reportedly sells for 2.5 times that amount on the Moscow black
market.
Although the U.S.S.R. has failed even to come close to the
economic performance of the United States, the per capita output
of Japan has probably already overtaken that of the U.S.S.R.
The official figure for per capita GNP of Japan in 1969 is very
similar to our estimate for per capita GNP of the Soviet Union.
If the figures are adjusted to allow for differences in the purchas­
ing power of the currency that are not adequately reflected in




5

REFLECTIONS OF AN ECONOMIC POLICY MAKER

the exchange rates, Japan appears to have surpassed the Soviet
Union in 1969.
There are important lessons to be learned from Japan's
extraordinary economic success and the concomitant shortcoming
of the Soviet Union. The rather high rates of growth recorded
for the Soviet Union in the early postwar years have not been
sustained because of deficiencies inherent in the Soviet system.
In a free economy, the relative strength of the demand for goods
and services determines the allocation of productive resources.
In the Soviet system, on the other hand, the path that production
takes is basically shaped by the decisions of economic planners
in Moscow.
Important economic decisions in the Soviet Union have there­
fore not been guided by sensitive signals such as are constantly
being transmitted by costs and prices in a free market economy.
To make matters worse, until recently they were not even sub­
ject to correction by public criticism. Thus, economic success in
the Soviet system came to be measured, traditionally, in terms
of meeting targets set by the government, rather than in meeting
the wants of consumers. This sometimes led to production of
equipment that failed to work or to the output of some consumer
goods far in excess of demand, while other goods continued to
be in critically short supply. Such production might be ex­
pressed in a high rate of growth of GNP, but it did not spell
progress in the elevation of living standards. In time, the waste
involved in this process became a matter of grave concern to
Soviet officials, particularly to economists and engineers.
As early as 1959, a Soviet econometrician, L. V. Kantorovich,
pointed out that it might be advantageous if prices were allowed
to play a bigger role in guiding the allocation of resources in the
Soviet economy. Another Soviet economist, Professor Y. Liberman, proposed that profitability rather than achievement of
planned targets be used as the measure of success or failure of
productive enterprise.
Although the Soviet Union has tried some experiments with
reforms along these lines, there has been no correction of the
fundamental flaws of the Communist economic system either in
the Soviet Union or in the satellite countries. In Czechoslovakia
the frustration with the results of centralized decision making,
which reached a climax during the industrial recession of the
6



TRIUMPH OF FREE ENTERPRISE

sixties, was an important factor in the reform movement in
1967-1968, but the courageous effort to rationalize the economy
by giving greater play to individual decision making was brought
to an abrupt end by Soviet troops and tanks in the summer of
1968.
This result was no great surprise to those who recognized
that the reforms required to rationalize the Soviet-style economic
system would weaken, if not totally destroy, the political control
wielded by the Communist party. Faced with a choice between
introducing economic rationality and the maintenance of their
political power, the Russian rulers chose power. Unless and until
they are willing to change their approach, it seems likely that
their own economy and that of their satellites will continue to lag
far behind the United States and other advanced countries of the
free world.
Japan, on the other hand, has relied on the free market
system, and that system has served Japan well. The Ikeda tenyear income-doubling plan, whose goals have been so conspicu­
ously exceeded, called for basic reliance on the private sector and
on free market forces. The document which outlined the plan
stated:
In trying to achieve the economic policies contained in
this plan, it is desirable for the Government to count on
the originality and devices of private enterprises and
individuals. It should refrain, as far as possible, from
taking direct control measures for the purpose.
The authors of the plan recognized, of course, that the gov­
ernment had the responsibility of helping to create a climate
conducive to economic growth. They pointed out, in particular,
that it was the duty of the government to stabilize the value of
the currency and to minimize business fluctuations through
proper application of overall fiscal and monetary policies. But
they left no doubt about their determination that the conduct of
production and marketing was to be determined by private enter­
prises acting on their own initiative, not through state enterprises
or state controls.
Japan's faith in the free market system has paid handsome
dividends. Yet there were many economists and statesmen at the
time when Khrushchev made his extravagant predictions who
took him seriously. They argued that freedom was a luxury




7

REFLECTIONS OF AN ECONOMIC POLICY MAKER

that poor nations could ill afford, and that these countries would
therefore need to resort to authoritarian control of economic
activity, if not also to outright governmental ownership of in­
dustrial enterprises, in order to augment their income and wealth.
And, in fact, a number of countries in Asia did adopt in varying
degrees the policy of turning over to the government the decision­
making functions that are performed by private citizens in
countries that practice free enterprise.
Those who adopted this approach overlooked the fact that
Adam Smith, the father of the idea that freedom was more con­
ducive to economic growth than governmental control, had ad­
dressed himself to the problems of a nation that was then very
poor and very underdeveloped— that is, to the England of 1776.
Two hundred years ago, English peasants, living at a subsistence
level without any of the benefits of modern industry or science
to ameliorate their condition, were probably worse off than their
counterparts in most of free Asia today. And the French peasants
lived in even greater poverty than the English.
Adam Smith examined the results of governmental inter­
vention into economic activity in eighteenth century England and
France with a perceptive eye. He came to the conclusion that the
inefficient use of resources that he observed could be remedied
and that wealth could be augmented if individuals had greater
freedom to manage their economic affairs as they saw fit, instead
of being tied down by minute and exacting regulations prescribed
by bureaucrats. He saw that detailed economic regulations, often
laid down by authorities far removed from the actual operations
or needs of industry and commerce, produced undesirable results
even though they may have been, or actually were, well intentioned. In time, as the force of Smith's logic and evidence won
adherents among men of authority, his revolutionary ideas
proved instrumental in sweeping away much of the irrationality
that had retarded economic progress. This paved the way for
the extraordinary increase in living standards that has occurred
in the West in the past two centuries.
It has been said that those who will not learn from the
errors of the past are frequently doomed to repeat them. This
has been the fate of much of Asia in the period following World
W ar II. The Communists took control of all of mainland China,
and for a time the world was told in glowing terms of the great
8



TRIUMPH OF FREE ENTERPRISE

economic transformation they were effecting there. Indeed, it
was widely believed for a time that the great political contest
in the world between the advocates of democracy and the advo­
cates of dictatorship hinged on the ability of the democratic
countries in Asia to perform as well as authoritarian China. The
attention of all Asia was reported to be riveted on this contest
to demonstrate which system was economically superior.
The year 1958 was hailed as Communist China's "great leap
forward." It was claimed that food output had been doubled in
a single year, and that final victory had been achieved over hun­
ger. However, these claims were soon exposed as wild exag­
gerations, as it became evident in 1959 and 1960 that serious
food shortages had begun to reappear. Far from developing selfsufficiency in food and eliminating hunger, Communist China
experienced critical food shortages in the early 1960s and was
compelled to import huge quantities of grain from abroad to
meet her requirements. The agricultural communes which had
been so widely acclaimed as the realization of true communism
were quietly abandoned or radically modified. Agriculture in
China appears to have remained virtually stagnant throughout
the 1960s. Although production figures have been withheld, the
available evidence suggests that output may not even have kept
pace with the increase in population. In the early 1960s, the
food shortages were attributed by government officials to bad
weather, but this excuse was soon dropped as food imports con­
tinued to be required year after year.
The failures of agriculture had serious effects throughout
the Communist Chinese economy. It soon became necessary to
retrench drastically the plans for industry and transportation.
Resources were simply not available to push forward the gran­
diose schemes that were supposed to show the rest of Asia how
a country could rise from agricultural poverty to industrial af­
fluence by pursuing the Communist path. Official statistics on
economic performance of Communist China became very scarce
as the boasted "great leap forward" failed to materialize. Talk
of competition between Communist China and free Asia dropped
to a whisper once it became evident that the free countries were
well ahead in the contest.
The countries of Asia that have retained the free market
system and have avoided the centralization of economic deci­




9

REFLECTIONS OF AN ECONOMIC POLICY MAKER

sions in the hands of the government have clearly been winning
the economic contest. The countries that have done the least well
have tended to be the ones that either rejected the free market or
severely limited it by governmental controls.
The great economic success stories of Asia in the 1960s are
found in countries like Japan, the Republic of Korea, Nationalist
China, Thailand, Hong Kong, and Malaysia. These countries,
in the ten years ending in 1968, have all recorded average in­
creases in real output of 6 percent a year or more. Japan, of
course, has been one of the outstanding performers, with an
average annual growth rate of 11 percent in this period.
Rates of growth of GNP can be misleading, especially in
countries where the underlying statistical data are inadequate
and of doubtful validity. It is therefore desirable to check the
growth figures of GNP against other records. One useful indi­
cator of underlying growth is the trend of exports, since this is a
measure of a nation's ability to compete in world markets.
Export performance is a test of a country's efficiency in keeping
up with the standards being set elsewhere in the world.
Professor Ota Sik, the architect of the short-lived economic
reform in Czechoslovakia, called attention to the fact that the
Communist economies have had great difficulty in meeting the
test of economic efficiency posed by exports. As he put it: "O n
the foreign markets, Czechoslovak production is absolutely un­
able to adjust to changes in demand." This has been largely due
to the tendency to neglect quality in production. Over-priced,
shoddy goods can be sold in a market that is shielded from for­
eign competition, but they have little chance in export markets.
It is significant, therefore, that the countries in Asia that
have achieved high rates of overall economic growth have also
done very well in expanding their exports. The whole world
knows what an outstanding record Japan has piled up in export
markets. In the period 1958-1968, Japanese exports expanded at
an average annual rate of 16 percent a year. It is perhaps less
well known that the Republic of Korea, Nationalist China, and
Hong Kong have also expanded their exports at phenomenal
rates.
There are fascinating stories behind the export statistics of
free Asia. I have just come from Korea, and I am very impressed
by the remarkable change that has taken place there in just the
10



TRIUMPH OF FREE ENTERPRISE

last decade. Korea's expansion of exports from almost nothing
to over $600 million last year is a modern miracle. I am also
impressed by the fact that tiny Hong Kong, with a population of
only 4 million, exported about as much as all of India in 1969.
The experience of these Asian countries in achieving such
outstanding success in the face of what many people once
thought were overwhelming odds illustrates how difficult it is
for any economist, no matter how farsighted he may be, to chart
the future course of a nation's development. I know that many
of you could cite interesting examples from your own experience
of the achievement of what once seemed practically impossible.
Some of you may recall the pessimism that prevailed in the
years immediately after World War II about Japan's economic
future. The development of nylon obviously posed a great threat
to the future of silk, which had been one of Japan's leading
exports before the war. No one foresaw at that time that Japan
would become one of the world's great producers of synthetic
fibers and fabrics and that Japan's exports of these goods would
eventually far exceed the value of her prewar exports of silk.
Japan has demonstrated the shallowness of the belief that
latecomers in economic development are unable to compete suc­
cessfully with countries that have gotten a head start. I remem­
ber the late Prime Minister Ikeda telling me of the first tape
recorder he had ever seen. It was on one of his visits to New
York in the early 1950s. Neither he nor many of his compa­
triots then foresaw that tape recorders and other electronic
products would play a major role in the tremendous expansion
of Japanese exports that has occurred over the last decade.
One of the great strengths of a free economy is that it per­
mits the development of the unexpected. Given proper incen­
tives, the Japanese, the Chinese, and the Korean entrepreneurs
have found new uses for their land, labor, and capital. In many
cases, the raw materials, such as wood for the plywood factories
of Japan and Korea, had to be imported from distant lands.
There were failures as well as successes, but the end result has
been the rapid development of production and exports that had
not been dreamed of, much less planned.
The lesson to be learned from these experiences is an old
one. Where men are given the opportunity and the incentive
to make and sell the products of their labor in free markets,




11

REFLECTIONS OF AN ECONOMIC POLICY MAKER

they will tend to act in ways that increase productive efficiency
and thereby raise the living standards of the country as a whole.
To be sure, freedom of entrepreneurs, workers, and consumers to
make their own decisions is by no means the sole determinant
of how well a country will perform economically. A nation must
also pursue sound monetary, fiscal, and trade policies in order to
achieve its economic potential. But there cannot be the slightest
doubt, in view of the experience accumulated over centuries, that
free and competitive markets are a major determinant of eco­
nomic growth and widespread prosperity.
It is no accident that the Asian countries that experienced
the slowest rates of growth in 1958-1968 were also the countries
that leaned most heavily on centralized economic controls. The
countries at the bottom of the scale in terms of growth of real
GNP include Ceylon, Burma, India, and Indonesia. Each of these
countries has experimented extensively with government owner­
ship or control over economic activities.
Burma in particular has gone far toward economic authori­
tarianism. By exercising far-reaching controls over production,
trade, and finance, both its production and distribution have been
injured. Burma's main crop, rice, has been adversely affected by
pricing policies that have denied producers adequate incentives.
Over the past decade, neighboring Thailand has increased rice
exports by 28 percent, while Burma's exports of rice have fallen
nearly two-thirds. The result is that Burma's total exports are
now running at less than half the 1963 level. The ability to
import has fallen correspondingly.
Indonesia under President Sukarno followed economic poli­
cies that were in some respects more disastrous than those of
Burma. In addition to establishing stifling controls over produc­
tion and trade, Sukarno's government borrowed heavily abroad,
largely to build up a military machine, but partly also to finance
ambitious projects that in the end yielded little or no economic
return. The productive capital of the country was therefore
badly eroded, exports fell sharply, living standards declined, and
the country found itself saddled with huge foreign debts and
with diminished ability to produce the exports needed to service
the debt. Fortunately, Indonesia is now in the process of liber­
alizing her economy, but the country will require many years to
recuperate from the damage wrought by the Sukarno policies.
12



TRIUMPH OF FREE ENTERPRISE

The adverse impact of authoritarian economic policies has
also been felt in India, though to a much lesser degree than in
either Burma or Indonesia. India over the past decade and a half
has emphasized strong centralized control over investment,
backed by extensive restrictions on imports and foreign exchange
expenditures. Fortunately, the earlier decisions to emphasize
heavy industry at the expense of light industry and agriculture
are now being questioned. The failure to provide incentives to
exports has left India lagging far behind many other countries,
and has contributed to balance-of-payments difficulties which
necessitated even tighter import restrictions. As a result, India
has passed through a difficult period during which many of her
industrial enterprises were deprived of the supplies and equip­
ment needed to keep operating at reasonable rates.
Division of labor, territorial specialization, freedom of trade,
and decentralization of economic decision making— these were
key elements in the thinking of the founder of classical econom­
ics, Adam Smith. It is gratifying to see that the practical states­
men of the world are gradually rediscovering these essential
truths. In this rediscovery of truth, we owe a debt to countries
like Japan, the Republic of Korea, Nationalist China, Hong Kong,
and Thailand that have most recently demonstrated how na­
tions practicing economic freedom can outperform authoritarian
countries.
I see a basis for optimism about the future in the economic
experience of both the countries that have forged ahead and
those that have lagged behind. What has gone wrong, after all,
is not something immutable. A country can change its future
for the better by changing its policies. The countries that have
lagged in the economic contest have the opportunity to learn
from experience and to alter their course.
In concentrating, as I have, on the power of free markets to
spur economic growth, I am not unmindful of the responsibilities
that the advanced industrialized countries have to assist the de­
veloping nations. We have, at times, overestimated our potential
contribution. There has been a tendency to think that external
technical assistance, or external capital, could of itself provide
sufficient impetus to generate rapid growth all over the world.
We now know that the solutions are more complex. Never­
theless, technical assistance, capital flows, whether governmental




13

REFLECTIONS OF AN ECONOMIC POLICY MAKER

or private, and liberal trade policies on the part of the indus­
trialized countries can contribute significantly to the process of
economic development.
It is even more important that the advanced countries main­
tain their own economic strength if the world economy as a
whole is to prosper and international trade is to flourish.
Clearly, the prosperity and growth of the developing countries
depend heavily on the economic well-being of the advanced
countries, which provide the major export markets as well as
the principal source of the capital and technology required to
promote rapid economic development.
I am fully aware of the importance of the role of the United
States in keeping the world economy on a sound basis. At the
present time, the exercise of our responsibilities in this regard
requires that we bring an end to the inflationary pressures pres­
ent in our own economy. This is proving to be a difficult task.
As a result of restrictive monetary and fiscal policies pursued
last year, the rate of economic expansion slowed appreciably
and some slack has developed in markets for labor and other
resources. However, while we have succeeded in eliminating
excess demand in our economy, we are still experiencing rather
strong upward pressures on costs and prices. Expectations of
consumers, businesses, and workers have not yet fully adjusted
to the current balance of aggregate demand and supply.
The continuance of rising costs and prices in the face of a
sluggish economy has been deeply disturbing to many observers.
Some have concluded that success in our battle against inflation
might require so restrictive a monetary policy that a liquidity
crisis could develop. Concern about this has given rise to some
turbulence in our financial markets in recent weeks. Let me
assure you that the Federal Reserve Board is fully aware of its
responsibility to prevent anxieties of this kind from leading to
a scramble for liquidity. Any such development could harm the
world economy, as well as our own. Fortunately, we in the
United States have the legislative authority, the tools, and—
I believe— also the knowledge and wisdom to enable us to deal
quickly and effectively with any problems of this nature that
might emerge.
While the process of getting inflation under control in the
United States has been difficult, there have been scattered signs
14



TRIUMPH OF FREE ENTERPRISE

recently of moderation in the rate of advance in some major
categories of prices, and also of some improvement in the trend
of productivity in the manufacturing sector of our economy. I
believe we will be able to extend the progress that is beginning
to emerge in these areas, by pursuing stabilization policies that
prevent the reemergence of excess demand later this year or in
1971. However, we must also be careful to ensure that the eco­
nomic slowdown which began last fall does not become more
pervasive or continue much longer. On this score, I think there
is room for optimism too. Both monetary and fiscal policies have
become less restrictive in recent months, and I believe we may
look forward with reasonable confidence to a resumption of sus­
tainable economic growth in the near future, as well as to a
gradual diminution in the rate of advance in prices.
For a time, however, we must expect to see a continuation
of cost-push inflation, with increases in wage rates and prices
reflecting the excess demand that existed in the past, the effects
of which have not yet fully worked their way through the
economic system. There are some who think that, under the
circumstances, we should abandon our traditional reliance on
market forces and impose mandatory controls on wages and
prices to halt inflation. I have always been strongly opposed to
direct controls, since they are discriminatory and a source of
great inefficiency. But I think the administration has taken a
proper step in announcing the establishment of a procedure to
review the economic implications of wage and price increases in
key industries. In a transitional period of cost-push inflation,
such as we are now experiencing, the moderate incomes policy
recently announced by the President should help us to avoid
an increase in unemployment and yet hasten the return to reason­
able price stability.
The task of bringing inflation under control has caused, and
will continue to cause, some discomfort in many sectors of our
economy. The anti-inflationary program pursued in the United
States has had repercussions which have even extended as far
as Japan, I understand. However, I can assure you that our
economy is fundamentally sound and resilient. Just as I had
confidence that the lulls in Japanese growth that I observed on
some of my earlier visits were only temporary, so I have confi­
dence that economic growth and progress will be resumed in the




15

REFLECTIONS OF AN ECONOMIC POLICY MAKER

United States in the near future. We are still a long way from
having exhausted the possibilities of improving our standard of
living or increasing our productive capacity.
Man has taken a giant step forward in entering the era of
interplanetary exploration. Our technology and education will
continue to advance. How well the industrial countries or the
less developed countries use new knowledge to better man's lot
in life will depend on many things. It will depend in part on the
goals that we set for ourselves. It will depend in part on our
ability to live together in peace and to maintain the kind of
mutually beneficial relations that have existed between Japan and
the United States for nearly a quarter of a century. It will
depend in important measure on the extent to which the nations
that have lagged behind in the economic contest. But it will also
depend in important measure on the extent to which the nations
of the world recognize the great advantages of the free market
system and are willing to pursue fiscal, monetary, and commer­
cial policies that are compatible with its efficient operation.

16



Dedication and Hope

This is my third visit to Israel. I remember, just before my first
visit here in 1958, being admonished not to come by several
United States ambassadors.
The reason for the warning was plain. Israel was then in
the midst of the Lebanon crisis. With tension mounting by the
hour, even a professor ought to have enough sense to stay away
from a country about to become involved in war. The men who
told me this were seasoned diplomats; they were gravely alarmed
by the state of affairs.
But when I came here, I was struck by just the opposite—
not by the tension, not by the alarm, but by the coolness of the
Israeli people in the midst of international anxiety.
There is an ironic saying we have in America, paraphrasing
a line in a Kipling poem: " If you can keep your head while all
about you are losing theirs, perhaps you do not understand the
gravity of the situation/'
But the fact was that the Israelis I met here— some of whom
had been my students at Columbia University in years past—
fully understood the gravity of the international situation. They
kept the calm that is found in the eye of a hurricane.
I was struck then, as I am struck now, by what Ernest
Hemingway defined as the essence of courage— "grace under
pressure."
That quality of calm courage is found only in a people with
a clear sense of purpose and a firm sense of duty. This simple
fact must weigh heavily in every assessment by outsiders of the
future of Israel.
Commencement address at Hebrew University, Jerusalem, July 6, 1970.




17

REFLECTIONS OF AN ECONOMIC POLICY MAKER

On another visit, I asked David Ben-Gurion how the
Israelis were able to achieve so rapidly their advances in industry
and commerce. As you know, many economists associate eco­
nomic growth with a nation's endowment of natural resources.
England's early progress was attributed to her coal, America's
to her abundant minerals and vast agricultural resources. But
Israel was not blessed with large mineral deposits, much of its
land was barren, and even water was in short supply.
How, I therefore asked the prime minister, was Israel able
to build such a strong economy in such a short time? He an­
swered: "W e did it first by dreaming, then by doing what the
economists said was impossible."
Keeping in mind that gentle reminder of fallibility, I would
like to speak to you today about three discoveries in seemingly
different fields— in the management of economic affairs, in the
management of power, and in the achievement of ideals.
You are a part of those discoveries, and the way the young
people of Israel govern their lives will have an important impact
on the use of those discoveries in the years ahead.
The first discovery, in the field of economic management, is
this: the human element is basic in the creation of an economy
that combines full employment with high productivity and rela­
tive price stability.
The great debate you read about in economics today is be­
tween those who feel that fiscal policy is all-important and those
who believe that monetary policy is all-important. The two
schools joust in learned debate, but both are also beginning to
take account of the human element in economic affairs— that is,
the dreams, fears, and hopes that so often upset the most expert
calculations.
And so we are gradually discovering— or perhaps I should
say rediscovering— that there is more to economic policy than
the established principles of economics. When the older writers
on economics entitled their treatises "political arithmetic" or
"political economy" they were telling us something we have
forgotten: that man's hope is a crucial element in man's fate.
What is your role in this discovery? Right now, right here
in Israel, you are proving that hope is perhaps the most powerful
of all economic forces. You are proving that a spirit of purpose
can give meaning to human energy and overcome a lack of
18



DEDICATION AND HOPE

material resources. In this, you are not breaking any rules of
economics; but you are developing new rules of political
economy.
A generation ago, the only thing we had to fear was fear
itself; today, the only thing we should despair of is despair. In
nations all around the world, on both sides of the Iron Curtain,
an enervating mood of despair is becoming fashionable, espe­
cially on the part of some young people. The cultivation of
despair can do as much to undermine the strength of some
economies as the cultivation of hope can do to overcome the
apparent weaknesses of other economies.
This brings me to a second discovery that is being made, in
a related but different field— in the exercise of power in the
world.
Power traditionally has been thought of in military terms.
And, of course, as you know better than most, the survival of
freedom in the world as it is today would be impossible without
military power.
But I do not hold with those who say that power corrupts
men. Rather it is the other way around; men without morality
corrupt power. And the world is making a remarkable discovery
about the exercise of power: with nations, as with individual
men, the most effective application of power is the power of
moral example.
This, I submit, is what has made and continues to make
America great. We have a dream of freedom, of equal oppor­
tunity, and of human dignity. It is true, of course, that our reach
exceeds our grasp, but by striving to make our way of life
better and to help other nations enrich their freedom, we set a
moral example that is one of the greatest sources of our power.
We are criticized so much around the world because people
expect so much of America; I would never trade away those high
expectations for mere approval.
And this, too, is what makes Israel a "great power" in her
own right. The power of her example in dignifying life, in con­
quering disease, and in extending technical assistance to other
poor nations, can never be underestimated. I know that Presi­
dent Nixon feels this deeply. Not long ago, in discussing why
America supports Israel, he put it this way: "Americans admire
a people who can scratch a desert and produce a garden. The




19

REFLECTIONS OF AN ECONOMIC POLICY MAKER

Israelis have shown qualities that Americans identify with: guts,
patriotism, idealism, a passion for freedom. I have seen it. I
know/'
The young people of Israel, born to this noble example, have
a special responsibility both to their own nation and to the world
to preserve and enhance those qualities. You must continue to
show the world that you know the difference between bravery
and bravado. You must continue to show the world how dearly
you hold the moral precepts of brotherhood. You must continue
to show the world your readiness to seek peace and progress for
yourselves and for your neighbors.
The example of Israel is nowhere more vivid than in the
field of education. You have the privilege of being graduated
today from one of the great universities of the world. But what
impresses the world is not so much your fine educational facili­
ties or the magnificence of Mount Scopus where you began to
build this university, but the fact that education in Israel per­
meates the very existence of her people.
You do not "go to school" in Israel; in a sense, this whole
land— every home, factory, kibbutz, or even army camp— is a
school. Education is an exciting part of life. The mistake that
others sometimes make, and that I trust you will never make,
is to treat education as a chore instead of a joy; to treat gradua­
tion as an end of education rather than as a beginning.
You consider yourselves pioneers in many things, and
rightly so, but I suggest that there is a discovery you are making
that you may not be aware of: that a passion for learning dif­
fused throughout a society is the surest road to the achievement
of its ideals.
The President of the United States likes to say: "W hen
you're through learning, you're through." And he's right— the
strength of a nation, like the strength of an individual, depends
on its ability to learn how to change and to grow.
Perhaps the greatest thing that can be said about the people
of Israel is that in fighting for the life of your nation, you have
stimulated the life of the mind.
Today I have been speaking of three discoveries that are
being made in the world, and of your part in them in the years
ahead.
20



DEDICATION AND HOPE

In creating a lasting prosperity, the human element is at
last being recognized as of fundamental importance.
In exercising power in the world, the power of moral ex­
ample can be far greater than material riches or equipment.
In achieving ideals, a reverence for learning and education
is indispensable.
As you take leave of the university, as you graduate into
a new life of the mind, may each of you ask yourself this: What
am I doing to increase the sum of hope in this world? What am
I doing to nourish the sense of purpose that founded this nation
and made it strong? What am I doing to teach someone else
what I have learned?
In asking questions like these, you will come to new dis­
coveries, you will rise to new challenges, and you will justify
the faith of your fathers and the admiration of millions of free
men all around the world.
I am deeply honored to join the fellowship of this grad­
uating class and I salute you: Shalom.




21




The Relevance of Adam Smith
to Today's Problems

During the past quarter century, economists have been devoting
much of their energy to studies of the process of economic
growth. Some have concentrated on the interplay of social,
cultural, political, and economic forces that shape the destiny
of developing nations. Others have sought to determine along
empirical lines what part of the economic growth of industri­
alized countries may be attributed to improvements in education,
what part to increases in the stock of capital, what part to
scientific research, improvements of technology, and other
factors. Still other economists have developed formal mathe­
matical models to gain insight into the dynamics of a growing
economy. The formidable literature generated by this research
could be aptly assembled under the title of Adam Smith's
treatise: An Inquiry into the Nature and Causes o f the W ealth
o f Nations.
In thinking about what I might say here today, I was led
to reread passages of that celebrated work and to reflect once
again on the legacy of Adam Smith to the field of economics.
The W ealth o f Nations is universally recognized as the first
major exposition of modern economic thought. Adam Smith
himself is commonly regarded as the father of political economy.
Yet it is a striking fact that the principles underlying the growth
of national wealth and income, which was the central theme
of his book, remained for many years a subordinate issue in the
great works on economics.
Address at the Adam Smith Symposium, Kirkcaldy, Scotland, June 5, 1973.




23

REFLECTIONS OF AN ECONOMIC POLICY MAKER

Third, a pricing mechanism was needed to allocate resources
among competing uses, in accordance with the wants of con­
sumers. Free markets, Smith argued, generate price and wage
adjustments which result in a use of resources that is consistent
with the prevailing pattern of consumer and business demands,
and thus solve problems that governmental rules cannot handle.
This was an exciting new doctrine of enormous significance
for economic and social organization in the European states, and
also for the emerging nations of North America. Under the
influence of the revolution in commerce and industry that got
under way during the eighteenth century, many businessmen
and artisans had found the intricate governmental regulations of
their conduct needlessly burdensome, and they not infrequently
reacted by ignoring or circumventing them. Smith's philosophy
of free enterprise thus appeared at a time when political leaders
as well as men engaged in commerce were ready to reexamine
accepted doctrines. The lucidity and dignity of Smith's prose,
the authority of his scholarship, and the cogency of his reason­
ing hastened the appeal of his work to intellectuals and the new
merchant class. Before many years passed, T he W ealth o f N a­
tions became the most influential guide to economic reform in
his own country. Adam Smith's influence, however, did not
stop there.
If my reading of history is anywhere near the mark, de­
velopments over the past two centuries have demonstrated be­
yond serious doubt the essential validity of Smith's theory of
production. Where free enterprise has flourished, nations have
prospered and standards of living have risen— often dramati­
cally. Where detailed governmental regulation has repressed
individual initiative and stifled competition, economic growth
has been hampered and the well-being of the people has
generally suffered.
The outstanding example of economic progress under a
system of free markets is provided by the United States. The
standard of living enjoyed by the people of my country has
been, and still is, the envy of the world. The rate of economic
growth in many countries has of late exceeded that of the
United States, and thus the disparity of living standards— at
least among the industrial nations of the world— has been
shrinking. This is a heartening development. Yet, the fact is
26



RELEVANCE OF ADAM SMITH

that per capita output in the United States is still far above that
of any other country. For example, the gross national product
per person in the United States is some 20 percent higher than
in Sweden or Canada— the two closest nations in terms of per
capita output— and it is about twice as high as in the more ad­
vanced socialist countries, such as the Soviet Union and
Czechoslovakia. You may recall that Premier Khrushchev pre­
dicted in the late 1950s that the per capita output of the Soviet
Union would equal or surpass that of the United States by 1970.
This forecast proved to be an idle boast by a political leader
who had not yet arrived at a mature understanding of the main­
springs of economic progress.
The standard of living that we enjoy in the United States
reflects more than our system of economic organization. Rapid
development of the American economy was fostered also by our
rich endowment of natural resources and our vast expanse of
fertile lands. Our free institutions and opportunities for self­
advancement attracted to our shores millions of venturesome
individuals from all over the world. The people who came were
industrious and highly motivated, and they often brought with
them useful technical skills and educational accomplishments.
However, other countries also have been blessed with rich
natural resources and with people of unusual educational and
technical achievements, and yet have not managed to find the
path to rapid economic development.
The key to the economic progress of the United States, I
believe, is therefore <to be found in our institutions, which by
and large have permitted anyone in our midst to choose his
occupation freely, to work for himself or for an employer of his
choice, to produce whatever he chose, to benefit from the fruits
of his individual effort, and to spend or to save or to invest as
he deemed proper.
Under the economic system that has flourished in the
United States, the natural thing for individuals and businesses
to do is to plan for the future, so as to be in a position to take
advantage of the opportunities that continually become available
in a growing and prosperous economy. This feature of a free
enterprise system, and its crucial role in fostering economic de­
velopment, is seldom appreciated by advocates of centralized
planning. Planning for economic growth in the United States




27

REFLECTIONS OF AN ECONOMIC POLICY MAKER

and other free enterprise economies— unlike that of socialist
nations— is a mass activity pursued by literally millions of pro­
ducing and consuming units, each looking to a better future and
striving to attain it. Over the years, our business firms have
become accustomed to planning their investments in plant and
equipment, their inventories, their advertising programs, their
labor policies, their financing requirements. More important
still, they now plan on a vast scale the development of new
products and new methods of production by conducting exten­
sive research and development programs. Our families, mean­
while, have remained eager to provide for a better life in the
future, and therefore find themselves planning for a new home,
for a good education for their children, and for reasonable com­
forts in the years of their retirement. Americans work hard to
realize their goals, and they are enterprising enough to search
out or to create new opportunities.
The present condition of the economy of the United States
thus provides impressive evidence of the essential truth of
Smith's theory of production. Individual initiative, properly
compensated, has been the dynamic force behind the growth
of a mighty nation. And market forces, operating in a com­
petitive environment, have served to harmonize the plans of
millions of economic units, thereby fostering the national
welfare.
The validity of Smith's views has been reaffirmed time
and again during the past two or three decades. By the end of
World War II, for example, a large part of the industrial plant
of Germany had been destroyed and the confidence of its people
shattered by the collapse of the German nation and its division
into two separate political entities. The postwar recovery of
the economy of West Germany, operating under conditions of
free enterprise, has nevertheless been spectacular. Its per capita
output is now among the highest in the world, and its products
are exported to every corner of the globe. East Germany, on the
other hand, installed a centrally managed system, and its econ­
omy floundered for a number of years. Economic growth in
East Germany appears to have perked up of late, but its per
capita output is still well below that of West Germany.
The postwar record of economic progress in countries such
as Israel and Japan, which encourage individual initiative and
28



RELEVANCE OF ADAM SMITH

private enterprise, is even more striking. In a mere quarter of a
century, the Israelis have managed to transform a desert into
a flourishing modern nation. Japan is also poorly endowed with
natural resources and its large population is crowded into a small
area; its economy has nevertheless grown swiftly. Currently, the
production of Japan is exceeded only by that of the United States
and the Soviet Union. Since 1960, the real gross national
product of Japan has more than tripled, and it is still rising
much faster than in any other major industrial country.
The Japanese economic miracle has received universal ac­
claim. The achievements of other Asian countries that give large
scope to free enterprise— Thailand, South Korea, Taiwan, Singa­
pore, and Hong Kong— are not as widely known. Yet, all these
countries experienced average yearly increases in real per capita
output ranging from 5 to over 8 percent during the decade of
the 1960s.
The Crown Colony of Hong Kong might indeed serve as a
monument to Adam Smith, for nowhere in the modern world
have his economic principles been followed more closely. You
may recall that Smith, in his discussion of the benefits of foreign
trade, noted that a nation would be most likely to profit from
foreign commerce if its trading partners were rich, industrious,
and commercial nations. Lacking geographical neighbors that fit
this description, Hong Kong took advantage of advances in
transportation and communication that have made it possible to
trade profitably on a worldwide basis. In 1972, over three-fourths
of Hong Kong's exports— largely manufactured goods— went to
Europe and North America. And the value of its total exports
apparently exceeded that of mainland China, whose population is
perhaps 200 times as large as that of Hong Kong.
In Latin America, the highest rate of economic growth of
any nation at the present time is enjoyed by Brazil, whose eco­
nomic system has moved closer in recent years to the principles
of Adam Smith. Decisions as to the direction of investment are
now left largely to the business community; foreign investments
are encouraged; individuals are free to choose the line of work
that best suits their talents and to enjoy the rewards accorded by
the market to successful performance. This system of economic
organization, aided by the great natural and human resources of
Brazil, is producing excellent results. The rate of growth of Bra­




29

REFLECTIONS OF AN ECONOMIC POLICY MAKER

zilian production has been 9 percent or more in each of the past
five years; last year, in fact, real output in that country rose
more than 11 percent.
Lively competition, individual incentives, and a pricing
mechanism to allocate resources are as important to the growth
of national wealth now as they were in the Great Britain of the
eighteenth century. That fact, I believe, is gaining recognition
beyond the boundaries of what we loosely call the Free World.
In recent years, the socialist countries of Eastern Europe have
begun to reconsider their earlier policy of guiding the course of
their complex economies through central planning and detailed
regulation of most aspects of economic life. They have begun
to ponder whether the production of some unwanted goods or
obsolete machines might not reflect the failure of prices to signal
changes in consumer or business demands; whether more rapid
technological progress might be encouraged by providing indus­
trial managers with stronger incentives for taking risks; whether
workers would increase their productivity if more opportunities
became available to improve their own lot and that of their fami­
lies through greater individual effort.
In most of these countries, pockets of free enterprise have
indeed remained, and they have provided the socialist authorities
with some dramatic examples of the vitality of Adam Smith's
theory of production. In the Soviet Union, for example, indi­
viduals are allowed to cultivate small agricultural plots and to
retain or sell the produce they raise. Yields per acre on these
small pieces of land are typically far higher than on the huge
and highly mechanized collective farms. In 1962, for example,
small private farms constituted only 3 percent of the total acreage
cultivated in the Soviet Union, but they accounted for a decisive
part of the meats, milk, eggs, vegetables, and fruit produced and
consumed in the country— in fact, for over a third of the coun­
try's total agricultural production. The Soviet people have lit­
erally been kept alive by free enterprise in their household
agriculture, and the significance of this fact cannot have escaped
their attention entirely.
In some if not all socialist countries, doctrinaire adherence
to centralized planning and regimentation of economic life is
gradually being displaced by a more flexible administration of the
economic system. Wider scope for decision making is being
30



RELEVANCE OF ADAM SMITH

given to individual factory managers; monetary incentives re­
lated to economic performance are becoming more common;
a larger role is being assigned to prices in the allocation of re­
sources. Notable examples of this trend may be found in Yugo­
slavia and Hungary, where significant efforts have been made in
recent years to accelerate economic development by moving to­
ward a more flexible, less centrally directed form of economic
organization. In the Soviet Union, also, a reform of the indus­
trial structure is currently under way, aiming among other things
at decentralization of research and development programs.
In the developing nations, too, a trend is evident towards
wider acceptance of Adam Smith's theory of economic develop­
ment. A decade or two ago, many of these countries were
seeking to rush headlong into heavy industry, bypassing the
development of agriculture and light industry for which their
resource base and their technical skills were better suited. Bar­
riers to imports were created to speed industrial development,
while one industry after another was saddled with restrictions
and regulations that made competition in world markets ex­
tremely difficult. Political leaders in these countries had become
so fascinated with the thought of rapid industrialization that
they not infrequently ended up by creating industrial temples
rather than efficient and commercially profitable enterprises.
Some costly lessons have been learned, and some ancient
truths rediscovered, from this experience. O f late, developing
countries have been reconsidering the benefits of agriculture
and light industry as paths to economic progress. More of the
developing countries are now encouraging private foreign invest­
ment, and practically every nation is seeking ways to raise pro­
ductivity, open new markets, and foster a spirit of enterprise
among its people.
Policy makers across the world thus keep coming back to
the principles enunciated by Adam Smith some two hundred
years ago. A contemporary reader of T he W ealth o f N ations
cannot escape being impressed with the vigor of Smith's analysis
and its relevance to the world of today. Yet, he will also be
struck, I believe, by the fact that nations are nowadays concerned
with economic problems that were hardly foreseen in his great
treatise on political economy.




31

REFLECTIONS OF AN ECONOMIC POLICY MAKER

While Adam Smith was at work on T h e W ealth o f Nations,
another enterprising Scotsman, James Watt, was still struggling
to perfect the steam engine. Today we split the atom to augment
the supply of electricity, and we send men on fantastic voyages
to the moon. With the progress of science, the proliferation of
industry, and the spread of urbanization, the interdependence of
economic activities has greatly increased. Opportunities for
conflict between private and public interests have therefore
grown in importance. Adam Smith, to be sure, was not unaware
that such conflicts could occur. Contrary to a widespread im­
pression, he put fences around free enterprise— for example,
by arguing in behalf of certain restrictions on free trade, by
recognizing the need for governmental maintenance of roads,
harbors, and similar public works, and even by accepting statu­
tory ceilings on interest rates as a contribution to the general
welfare. Adam Smith, however, had no need to concern himself
with pollution of air or water, or with urban blight, or with
depletion of energy sources, or with insistent political pressures
for better education, improved health care, more recreational
facilities, and a host of other things that have led to extensive
governmental involvement in the economic life of industrialized
nations.
The business cycle of modern times, especially in nations
that practice free enterprise, has given special impetus to the
enlargement of governmental responsibilities. Experience over
many years had demonstrated that active competition serves to
coordinate individual plans and thus enables markets for specific
commodities to function, on the whole, in satisfactory fashion.
However, experience also taught us that while competition is a
good cure for overproduction in a specific market, it is a very
inadequate cure when a shortage of demand develops simul­
taneously in many markets. In such a case, business activity as
a whole will slump, the flow of incomes will be checked, and
unemployment will spread; in short, the nation will experience
a business recession. On the other hand, when demand becomes
excessive in many markets simultaneously, the general level of
prices will rise and this too will bring economic troubles.
In recent decades, therefore, governments have sought to
stimulate the general level of economic activity at certain times,
and to restrict it at other times, by a flexible use of their mone32



RELEVANCE OF ADAM SMITH

tary and fiscal policies. O f late, a new phenomenon— a discon­
certing rise in the price level even in the absence of excess
aggregate demand— has troubled various industrial countries.
This development has led some governments to intervene directly
in wage and price decisions in the hope of achieving simulta­
neously both full employment and general price stability.
We thus face problems today with which Adam Smith did
not concern himself. Economic life keeps changing, and each
generation must face anew the central problem with which he
dealt so boldly— that is, how best to draw the line between pri­
vate and governmental activities in the interest of augmenting
the general welfare. As we go about this task, we cannot be
blind to the imperfections of market processes or to the abuses
of market power by business firms or labor organizations. But
we also cannot afford to neglect Adam Smith's warning, of which
recent experience provides ample illustration, that governments
not infrequently create new problems, besides wasting resources
that could have been put to effective use by private citizens or
business firms.
In the course of my career, both as a student and as a public
official, I have found it necessary to revise my ideas about the
proper role of government in specific economic matters. Experi­
ence is a demanding teacher, and my respect for it has led me at
times to favor governmental actions that I abhorred in my youth.
My confidence in the basic advantages of free enterprise re­
mains, however, unshaken. I continue to believe, as Adam Smith
argued so cogently, that when a nation's economic activity is
organized on the basis of free enterprise, men and women will
by and large employ their talents in ways that enrich and
strengthen the nation's economy. More important still, it is only
by avoiding excessive concentration of power in the hands of
government that we can preserve our individual liberties and
have the opportunity to seek personal fulfillment with full
dignity.




33




The Significance of
Our Productivity Lag

It is a pleasure for me to join this commencement assemblage in
paying tribute to the graduating class of the University of South
Carolina.
Those of you graduating today are part of a great tradition.
The first graduate went forth from Carolina's classrooms when
Thomas Jefferson was President of the United States. And many
of the students who have followed since then— some of whose
names commemorate the buildings in which you have lived and
studied— have made notable contributions both to this region
and to the country at large. I trust that in the years ahead— in
whatever careers you pursue— you will never cease to draw
inspiration from the achievements of those in whose footsteps
you follow.
In considering what I might appropriately say to you today,
I found my thoughts turning repeatedly to the remarkable trans­
formation that our nation's economy has undergone since the
time this institution was founded. The broad outlines of that
transformation— from simple agrarianism to the complexities of
our modern industrial state— are well known to all. So, too, is
the remarkable record of material gain that has flowed to our
people in the process.
What may perhaps be less fully appreciated is that the
material progress we have made as a nation— and which has long
been the marvel of the world— was by no means an inevitable
occurrence, despite our endowment of natural resources. Nor is
it something whose extension we dare take for granted. I believe,
Commencement address at the University of South Carolina, May 14, 1977.




35

REFLECTIONS OF AN ECONOMIC POLICY MAKER

rather, that the bounty that is ours came about chiefly because
we have had the wisdom throughout most of our history to foster
an environment in which the latent energies of our people had
generous scope for realization. Ours has been a society in which
men and women, no matter what the circumstances of their birth,
have known that there were ultimately no boundaries to what
might be achieved with effort and ingenuity. That faith— and the
spirit of independence and drive it has fostered— has been the
essential dynamic force in the economic life of our nation.
In the language economists are prone to use in describing
material gains, what we have had in America is an astonishing
record of productivity achievement. Our environment of enter­
prise and the rewards it has offered have prodded us to great
effort. Historically, we have been an industrious and an inven­
tive people. We have striven for self-improvement and the
betterment of our families; and we have been willing, both
individually and collectively, to sacrifice and scrimp when invest­
ment opportunities beckoned. We have, moreover, been imagi­
native and persistent in devising better ways of doing things and
in applying new technologies in the organization of our produc­
tive activities.
The consequences of all this in terms of the efficiency of
performance of the individual American worker have been
striking. It is, indeed, our impressive historical record of upward
climb in output per hour worked that is the foundation of our
economic strength. To be sure, the aggregate income and wealth
of our nation have grown with the passage of time partly be­
cause our work force has grown in size. But that has been far
less important as a source of output gain than some of you may
realize. Overwhelmingly, what has been critical— to the extent
of accounting for about two-thirds of the rise in national output
over the span of our history— has been the advance in labor
productivity, the simple fact that an hour of labor progressively
has yielded more and more output.
I focus on this today because I think it is important for you
to have an awareness that our country's productivity growth has
exhibited a slowing in recent years, both absolutely and relative
to that of other countries. You should recognize this as a matter
of great concern to you personally and to the future of the
nation. Indeed, largely because of the slowing of the underlying
36



SIGNIFICANCE OF PRODUCTIVITY LAG

rate of productivity growth— to a pace a third less rapid in the
last ten years than in the 1950s and early 1960s— we can no
longer boast of having the highest per capita standard of living
in the world.
Far more is at stake, of course, than the issue of inter­
national prestige. As a nation, we can consume no more than
we produce, so that unless productivity growth reaccelerates,
our citizens inevitably will enjoy less rapid gains in living stan­
dards in the future than has been customary historically. It re­
quires little imagination to foresee that troublesome tensions
could arise from that situation as competing groups in our soci­
ety endeavor to secure a larger share for themselves of produc­
tion gains that are disappointing in the aggregate. Also of great
significance is the fact that without a reacceleration of produc­
tivity growth we shall find ourselves increasingly cramped in
our public life in channeling resources to the solution o f domestic
and international problems.
These are powerful reasons for trying to understand the
causes of the productivity weakening that has recently occurred.
A good deal of scholarly effort has in fact been devoted pre­
cisely to that end. However, we still cannot be sure how much
of the slowdown in productivity growth reflects transitory as
distinct from more basic causes.
One cause of slower productivity growth in recent years
that is presumably of a temporary nature has been an increase
in the proportion of relatively inexperienced workers in our
labor force. This reflects several influences: first, a greatly en­
larged stream of young people entering labor markets in the late
1960s and early 1970s as a delayed consequence of the very high
fertility rates that followed World W ar II; second, the increasing
tendency for adult women— many lacking recent w ork experi­
ence— to seek employment; and third, the prevailing trend to­
ward early retirement. As the younger workers and adult women
gain in job experience, however, the depressant effect on pro­
ductivity growth of the shift in the age and sex composition of
the labor force will no longer be operative. Indeed, a reversal
may already be in progress.
A more complicated issue to assess—but one th a t likewise
involves the potential for a favorable turn— concerns the way
in which our nation's capital stock grows in relation to the labor




37

REFLECTIONS OF AN ECONOMIC POLICY MAKER

force. In recent years, the exceptionally rapid rate of labor-force
growth has not been matched by a corresponding acceleration in
capital formation. In fact, even apart from the slump in capital
investment during the recent recession and the disappointing
recovery in capital spending since then, the growth of this coun­
try's stock of capital has tended to be slower for some time than
in the earlier postwar period. This combination of circumstances
— rapid labor-force increase and a slowing in the pace of capital
formation— has meant that progress in equipping our work force
with increasing amounts of capital equipment has proceeded
much less rapidly than in the 1950s and the 1960s. That un­
questionably has been detrimental to the maintenance of pro­
ductivity gains at their historical pace. Demographic influences,
however, are gradually becoming somewhat less awesome. Within
the next few years, the growth rate of the labor force is likely to
decline appreciably, reflecting the lower fertility rates that fol­
lowed the earlier postwar bulge. In that situation, the challenge
of achieving an accelerated pace of capital formation relative to
labor supply will become less formidable— provided, of course,
that we are successful in maintaining a climate of enterprise that
is conducive to capital spending by business firms.
Despite these two potentially favorable influences— that is,
the trend emerging toward restoration of a more experienced
work force and the definite possibility that faster growth may
resume in the capital stock per worker— complacency about
future productivity developments is by no means warranted.
I say this because the productivity slump which we have
been experiencing is only partially explained in terms of the
changing experience of our labor force and the amount of capital
our workers have been equipped with. Careful study of those
two factors still leaves a substantial part of the recent produc­
tivity slowing unexplained. Other adverse influences apparently
have been at work as well.
My own judgment is that we have been undergoing a change
in our societal values and attitudes that has contributed signifi­
cantly to poorer job performance in recent years. I advance that
as a hypothesis only, not as an established fact. It is a hypothe­
sis, however, for which there is regrettably a considerable body
of supportive evidence.
38



SIGNIFICANCE OF PRODUCTIVITY LAG

Testimony to a lessened sense of industriousness on the part
of our work force is certainly present, it seems to me, in this
country's record of job absenteeism. The number of people who
simply do not show up for work on any given day, especially
before and after weekends, has been rising in recent years and
has assumed worrisome proportions. In a typical week last year,
almost five million workers had unscheduled absences from their
jobs for a day or more either because of reported illness or for
other personal reasons. Last year's absenteeism involved the
loss of more than 100 million hours of working time per week,
giving rise, one can be sure, to a great deal of unnecessary cost
and inefficiency in the operations of our businesses— ranging
from disruption of production schedules to overstaffing by em­
ployers as a defensive measure. No one would deny, of course,
that many unscheduled absences are justified by illness or per­
sonal or family emergencies. But there is evidence that absentee­
ism has risen faster in recent years than the number of employed
individuals, and this suggests that decided changes have been
under way in our country in the basic work attitudes of
employees.
The high and rising incidence of absenteeism would be
easier to understand if workers in this country enjoyed less paid
time off than they do. Significantly, however, the average fac­
tory worker now gets nine paid holidays each year and many
workers get more. There has been an impressive liberalization
throughout the postwar period, moreover, in the amount of time
employees can take as paid vacation. Indicative of the trend is
the fact that more than two-thirds of factory workers with
twenty-five years service now get a full month's vacation,
whereas fifteen years ago only about one in five enjoyed such
generous vacations.
Employers, in short, are increasingly remunerating workers
for time during which no work is performed. At present about
7 percent of total payroll costs incurred by the average employer
in this country goes to pay for time that employees are not
explicitly on the job. And the full costs of paying for non­
working time would be much larger if there were any meaningful
way of measuring the extraordinary number of hours spent on
coffee breaks, wash-up time, retirement parties, and other social
rites that have increasingly become a part of our working lives.




39

REFLECTIONS OF AN ECONOMIC POLICY MAKER

Against this background, is there really any wonder that many
of our producers find it difficult to compete internationally and
that so many of the products in our homes and garages bear
foreign names?
These developments relating to work attitudes and the
amount of leisure time we are opting for as a society are a rela­
tively neglected aspect, I believe, of scholarly investigation into
the causes of the slowing in our productivity growth. I think
they must be brought into sharper focus to facilitate wider public
understanding of what is at stake. It is not at all clear that people
actually perceive that lessened work effort inevitably must be
reflected in the material benefits we as a people can enjoy. That
linkage was inescapably evident earlier in our history— when, to
a much greater degree than is now the case, men and women
could literally see what their individual effort yielded in con­
sumable products; but the linkage has been blurred as our pro­
ductive and distributive mechanisms have grown in complexity.
I trust it is clear that these matters are by no means of
remote concern to young people such as you who are now em­
barking on careers. Indeed, I would call your attention to the
fact that during your lifetimes the degree of productivity growth
achieved by the work force, will, if anything, be more important
than it is now, simply because of the changing ratio of the work­
ing to the nonworking portions of our population. Reflective of
the longer lifespan people are enjoying and the trend toward
lower birth rates, we are now experiencing a rapid expansion in
the elderly portion of our population. A relatively heavy burden
will thus fall on the employed portion of the population to pro­
duce goods and services not just for themselves, but also for the
swelling numbers of people who will be beyond retirement age.
That prospect emphatically underscores the importance of reachieving and maintaining strong productivity growth.
I urge you to think about the implications of that challenge
and to consider carefully the interest you have in helping to
foster a renewed spirit of industriousness in this nation. The
future is yours to do with it what you will. I hope you will
choose wisely.

40



The Need for Better Profits

It is a pleasure for me to be here on the campus of Gonzaga
University to participate in this celebration of Founder's Day.
I am also pleased to be able to join you in honoring a great
teacher of economics, Dr. Graue. It is eminently fitting that
Dr. Graue's contribution to economic understanding should be
noted today not only by festivity but also by serious economic
discussion.
In consonance with that, I would like to address a feature
of our current economic environment which, as long as it per­
sists, could well prove an insurmountable barrier to the achieve­
ment of full employment in our country. I refer to the fact that
the profits being earned by American business are at an un­
satisfactory level.
It is both striking and disturbing, I believe, that profits get
relatively little attention these days from economists. I have the
impression that the economics profession has almost forgotten
that ours is still predominantly a profit-motivated economy in
which, to a very large extent, whatever happens— or doesn't
happen— depends on perceived profit opportunities. Certainly,
the preoccupation in the nation's capital tends to be with other
matters. The slightest hint, for example, of emerging trouble
for the economy will promptly unloose a flood of fiscal and
monetary proposals, virtually all predicated on the notion that
what is crucial is governmental manipulation of aggregate de­
mand. Seldom does anyone pause to ask what should be a
Address at Gonzaga University's 1977 Founder's Day, Spokane, W ash­
ington, October 26, 1977.




41

REFLECTIONS OF AN ECONOMIC POLICY MAKER

compellingly obvious question— namely, whether lack of con­
fidence in profit opportunities on the part of our profit-oriented
businessmen and investors may not be the essential cause of
difficulty.
My own judgment is that a deep-rooted concern about
prospective profits has in fact become a critical conditioner of
economic performance in our country. If I am right in thinking
so, actions taken in Washington to enlarge the already huge
budget deficit in the interest of more consumer spending are
likely to be of little sustained benefit in reducing the level of
unemployment. That was a principal reason why I felt no
lasting benefit could flow from the fifty-dollar rebate that was
under consideration early this year.
If poor profitability is adversely affecting economic per­
formance, we should expect business firms to exercise great
caution in embarking on capital-investment projects. No busi­
nessman is likely to add to his plant or equipment if the promise
of a decent return is not present. The current expansion of the
overall economy, while otherwise generally satisfactory, has been
marked by notably weaker investment spending than was char­
acteristic of previous recoveries. In the two-and-a-half years of
this expansion, real capital outlays have increased only half as
much as they did, on average, over like periods in the previous
five expansions. The shortfall has been especially marked in
the case of major long-lived industrial construction projects, and
it has occurred even in industries— such as paper and basic
chemicals— in which the rate of utilization of industrial capacity
is well advanced.
Unless the willingness of businessmen to invest in new plant
and equipment increases decisively, the expansion of economic
activity now under way will continue to lack balance. And that,
I need hardly add, will make it more uncertain whether the
expansion is going to continue at a sufficient pace to bring un­
employment down significantly, or— for that matter— whether
the expansion itself will long continue.
The weakness of profits in recent years is not the only
cause of investment hesitancy, but it is unquestionably a very
important cause. To be sure, many people have a contrary im­
pression about the general level or the trend of profits. In fact,
the most commonly cited profits figures— the so-called book
42



NEED FOR BETTER PROFITS

profits that businesses report to their stockholders— have risen
spectacularly in the last few years, and in total are currently
running just about double their level a decade ago. But these
raw profit figures are misleading and they should never be taken
at face value.
In actuality— as the more sophisticated observers of cor­
porate finances know— raw profit numbers have become virtually
meaningless as a guide to corporate affairs because of the way
in which inflation distorts the calculation of profits. Under his­
torical cost accounting— the method used widely for inventory
valuation and universally for capital-asset valuation— the true
costs of producing goods in an ongoing business are far from
fully captured. Rather, they are significantly understated with
respect to both the drawdown of materials from inventory and
the consumption of capital assets. And when costs are under­
stated on an accounting basis, profits of course are overstated;
that is to say, the reported total of profits contains an element
of inflationary fluff that in no sense enlarges a firm's ability to
pay dividends or add to retained earnings.
The practical consequence of the inflationary fluff on a com­
pany's fortunes is decidedly negative, since taxes have to be paid
on the "phantom" portion of profits. Quite obviously, this has
lessened the ability of corporations to add to their capital invest­
ment without borrowing. The tax drain has become very large
in recent years because of the enormous understatement of costs.
For 1976, for example, the Commerce Department estimates that
the replacement cost of inventories used up by nonfinancial cor­
porations exceeded by $14 billion the materials expenses claimed
for tax purposes. More striking still is the Department's estimate
for last year of the amount by which depreciation charges based
on historical cost fell short of the replacement cost of the capital
assets consumed. That estimate came to nearly $36 billion,
making the combined understatement of costs from these two
sources $50 billion in 1976.
The huge understatement of costs that arises because of
inflation cannot be ignored by anyone seriously concerned with
corporate earnings. Once account is taken of the distortions
wrought by inflation— and when an offsetting adjustment is also
made to allow for the changes over time in Treasury depreciation
rules— we find that the level of corporate profits was overstated




43

REFLECTIONS OF AN ECONOMIC POLICY MAKER

in 1976 by about $30 billion, and that this resulted in an over­
payment of some $10 to $12 billion in income taxes. True eco­
nomic profits of corporations are thus very' different from re­
ported book profits.
Just how poor the trend of profits has recently been is
clearly indicated by the fact that in each year from 1968 through
1975 the after-tax "economic profits" of nonfinancial corpora­
tions from domestic operations were, in the aggregate, consis­
tently below the levels reached during 1965-1967. A new high
level of these profits was indeed reached during 1976, but even
that achievement is decidedly unimpressive when profits are
expressed as a rate of return on the amount of equity capital
in use. So far in the inflation-riddled 1970s, the after-tax rate
of return on stockholders' equity has averaged only about 3 a
yi
percent when the tangible assets portion of equity capital is
valued, as it should be, on a replacement cost basis. That figure
is lower by two percentage points than the average rate of return
for the 1950s and 1960s. Despite a sizable recovery from the
recent recession, the rate of return on the equity investment in
our corporations appears to be running currently at a level not
significantly different from the depressed average so far this
decade.
Anyone who wonders why capital spending has been so
halting or why stock prices have behaved so poorly for so long
would be well advised to study this dismal record of what Ameri­
can business has been earning. Historically, there has been an
impressively close correlation between the rate of return on
stockholders' equity and the rate of real investment. The linkage
between the rate of return on equity and the behavior of equity
prices is looser, but it still suggests that professional investment
managers are no longer being deceived by the inflationary fluff
in profit numbers. The stock market, by and large, has not been
behaving capriciously; instead it has been telegraphing us a
message of fundamental importance.
At any given point in time, investment activity and stock
market behavior are conditioned, of course, by much more than
current profit readings. What is ultimately decisive in determin­
ing the behavior of investors and businessmen is not the rate of
return currently earned on past investments but rather expecta­
tions about future earnings. Very often current earnings are an
44



NEED FOR BETTER PROFITS

excellent proxy for expectations about future earnings; some­
times they are not. My judgment is that businessmen and in­
vestors at present have a sense of doubt and concern about the
future that is even greater than would be justified by the low
level of true economic profits.
One telling piece of evidence that this is so is the pro­
nounced hesitancy of businessmen in going forward with capitalspending projects that involve the acquisition of long-lived
assets. The investment recovery that we have experienced so far
in this cyclical expansion has been heavily concentrated in rela­
tively short-lived capital goods that promise quick returns—
trucks, office equipment, and light machinery, for example. M ajor
investment projects that cannot be expected to provide payback
for many years encounter serious delays in getting management's
approval. Indeed, the decline of industrial construction that set
in during the recent recession continued through the first quarter
of this year— two years after general economic recovery got
under way— and has not yet turned around decisively enough to
establish a clear trend.
Many businessmen have a deep sense of uncertainty about
what the longer future holds and, as a consequence, are dis­
counting expected future earnings more heavily than they ordi­
narily would in their investment calculations. The special degree
of risk that businessmen see overhanging new undertakings
means that they often will not proceed with a project unless the
prospect exists for a higher-than-normal rate of return. This is
not only skewing investment toward short-lived assets; it is also
fostering an interest in mergers and acquisitions— something
that does not require waiting out new construction undertakings.
There has been a noticeable pickup in merger activity recently,
but such activity generates neither additional jobs nor additional
capacity for our nation's economy.
The reasons why businessmen appear to be assigning special
risk premiums to major investment undertakings are complex,
and I certainly cannot deal with them exhaustively today. But
I would like at least to touch on the conditioning influences that
seem most important— beyond, of course, the critical fact that
current corporate earnings, properly reckoned, are discouragingly low.




45

REFLECTIONS OF AN ECONOMIC POLICY MAKER

My frequent discussions with businessmen leave little doubt
in my mind that a strong residue of caution in businessmen's
thinking has carried over from the recession of 1974-1975. I
think it is fair to say that the present generation of business
managers had developed an inordinate degree of faith in govern­
ment's ability to manage and sustain economic expansion. When
they discovered that that faith was not justified, the experience
was sobering— particularly for the not inconsiderable number
of businessmen who had imprudently expanded debt in the froth
of the earlier prosperity. Moreover, the lingering sense of un­
ease produced by the severity of the recession has been deepened
by the sluggishness of the subsequent recovery in much of the
world economy outside the United States. In contrast to the
widely shared conviction of just a few years ago that the business
cycle had been mastered, a surprising number of businessmen
are now seized by concern that the world economy may have
entered a downphase of some long cycle. One factor sparking
such speculation is apprehension that the quantum jump in
energy prices may be affecting the world's growth potential to a
more serious extent than was originally thought likely.
More troublesome still, the specter of serious inflation con­
tinues to haunt the entire business community. The fear that
inflation will not be effectively controlled is indeed a key reason
for the high-risk premiums that businessmen nowadays typically
assign to major investment undertakings. Increasingly, business­
men understand the severity of the burden they are carrying on
account of the taxation of "phantom" profits. They also have
learned the hard way— from the frenetic conditions of 1973-1974
— that inflation is totally inimical to a healthy business environ­
ment. Having little basis for projecting how inflation will affect
their enterprises and fearful that government may in time resort
to direct controls once again, they feel bewildered in attempting
to judge their future costs or their future selling prices. Because
of that, they yearn for some solid piece of evidence that inflation
will be tamed. They are troubled because no such evidence is
yet at hand.
Added to these concerns is the fact that businessmen have
had great difficulty in evaluating the implications of the major
policy initiatives that are being considered this year. Business­
men cannot at this juncture confidently judge what kinds of
46



NEED FOR BETTER PROFITS

energy will be available in the years ahead. Nor do they yet
have any firm basis for assessing what kinds of tax incentives
or disincentives may apply to particular energy uses. They are
concerned that innovations in social security financing now
under consideration may end the traditional rule under which
employer and employee taxes have been the same and, as a
consequence, lead to multibillion dollar increases in the social
security levies they have to pay. They suspect, moreover— as do
many others— that the revamping of welfare programs will prove
much more expensive than is now being estimated and that still
additional taxes on businesses will be imposed as a means of
financing reform. And the daily rumors about impending tax
reform, among which ending of preferential treatment of capital
gains is frequently emphasized, have contributed to a mood of
unease in both corporate board rooms and the stock exchanges.
So too has the expectation that a serious campaign for a costly
undertaking in national health insurance may start next year.
I strongly suspect that the ability of businessmen to assimi­
late new policy proposals into their planning framework has now
been stretched pretty far. In fact, I seldom talk with a business­
man these days who does not, in one way or another, voice con­
cern about his inability to make meaningful projections of cor­
porate costs and earnings for the years immediately ahead.
The implications of the matters on which I have been dwell­
ing— the behavior of profits and the state of mind of the business
community— appear to have escaped a good many people. Eco­
nomic analysts who insist, for instance, that capital spending will
automatically catch fire as capacity margins diminish are, in my
judgment, thinking too mechanically. Much will depend on the
process by which the economy reaches more intensive utilization
of resources— especially on government's role in that process.
I also think that analysts endeavoring to assess capitalspending prospects— and indeed prospects for the economy gen­
erally— may be neglecting a sensitive cyclical development. I
refer to the fact that, whereas prices charged by business gen­
erally advanced more rapidly than did the costs incurred by
business in the early stages of this expansion, that is no longer
the case. This, of course, means that profits per unit of output
have stopped rising and may indeed have begun to fall— a devel­
opment typical of the more advanced stage of business cycle




47

REFLECTIONS OF AN ECONOMIC POLICY MAKER

expansions and one that is certainly not conducive to vigorous
capital-investment activity. I know enough about business cycle
behavior to avoid at this time the inference that a sustained
profits squeeze is emerging. We have here, nevertheless, an
incipient imbalance in the economic situation that ought to con­
cern us. And it is one more compelling reason to ask if national
policy does not need to be more explicitly oriented to the
strengthening of profitability and the encouragement of capital
formation.
The last time business investment in fixed capital was as
weak as it has been since 1973 was in the late 1950s and early
1960s. I believe there are some policy lessons we can profitably
draw from that period. There was a great deal of concern at that
time that a phase of deep-seated economic malaise had set in,
with worry voiced that sluggishness in business investment
might well prevent the economy from attaining full employment.
The parallels with today— both in objective fact and in assess­
ment— are close in many respects, the major differences being
that profit rates were not as low then, nor was inflation com­
parably troublesome.
A bold policy approach— predicated on the need for stimu­
lation of capital investment— was then developed, with one of
President Kennedy's early messages to Congress calling for
enactment of an innovative tax device, namely, the investment
tax credit. The Revenue Act of 1962 brought the tax credit into
being. That same year witnessed a reinforcement of investment
incentives in the form of significant liberalization of Treasury
depreciation rules. The investment-oriented thrust of policy was
followed, moreover, by recommendations for broadly based in­
come tax reductions for both businesses and individuals, and they
ultimately were embodied in the Revenue Act of 1964. Taken
together, those actions of the early 1960s were sensitively re­
sponsive to conditions that have many similarities to the situa­
tion in which we now find ourselves. And what is particularly
worth recalling, those actions soon had the consequence of
strengthening dramatically both investment activity and the
general economy.
If we were able to launch a policy response now that was
just as unambiguously positive in its implications for profit­
ability, I for one would have little doubt about our economy's
48



NEED FOR BETTER PROFITS

capacity to shake off its malaise. As every recent study of our
nation's investment needs has emphasized, we are confronted
with an enormous capital-formation challenge for the years
ahead. If we have the good sense to create hospitable conditions
for saving and investing, I truly believe ours could become an
age of sustained progress in employment and well-being.
The doubts and uncertainties that now prevail in the busi­
ness and investing community reflect, in large part, irritation or
annoyance at what is viewed as governmental myopia. They
must not be interpreted as being indicative of business timidity.
That enormous vitality and dynamism still exist in our business
system is attested by the extraordinary fact that, despite the
weakness of profits in recent years and the cumulating anxieties
about the future, our economy has actually generated nearly
seven million jobs since the spring of 1975— nearly all of them,
I should add, in private industry.
The practicality of so many initiatives in this administra­
tion's first year is arguable, but the President's leadership also
bespeaks a seriousness of purpose that in the end may bring
lasting benefits to our nation. We have been through a year of
animated policy debates— a year, I think, of useful growth in the
perception of how plausible but divergent objectives can be
practically blended. The basic reform this country now needs is
the creation of an environment with many new job opportunities
for our people. I expect the dust of controversy to settle and
that constructive legislation will follow.
I do not mean to suggest that encouragement of investment
through a bold tax policy is all that is needed. Such encourage­
ment is vital, to be sure, and it will undoubtedly make a differ­
ence in the willingness of businessmen to invest in new plant
and equipment. But the effort at eliminating the high risk that
now attaches to investment must be of broader reach. It must
go to the array of concerns of the business community about
energy policy, about environmental codes, about governmental
regulations at large, and— above all— about inflation.
I cannot overstate the importance of unwinding the inflation
that is continuing to plague our economy. There is a paramount
need for avoiding new cost-raising measures by government, of
which the recently legislated increase of the minimum wage is
only the most recent very troublesome example. Fiscal and




49

REFLECTIONS OF AN ECONOMIC POLICY MAKER

monetary policies need to be conducted in ways that will quiet
rather than heighten inflationary expectations. On the fiscal side,
this means that great caution will have to be observed both in
giving up tax revenues and in program initiatives entailing new
expenditures. As a practical matter, expenditures on some exist­
ing programs may therefore have to give way. We simply dare
not take steps that would result in any appreciable enlargement
of our already swollen budget deficit. That could only excite
unease in the business and financial community.
On the monetary side, I want to assure you that we at the
Federal Reserve fully appreciate the critical linkage between
money creation and inflation. We have no intention of letting
the money supply grow at a rate that will add fuel to the fires
of inflation. On the contrary, we are determined to bring about
a gradual reduction in the rate of money expansion to a pace
compatible with reasonable price stability. That cannot be done
quickly because of the powerful inflationary pressures that have
become embedded in our economic life over so many years; but
I assure you that it will be done if the Federal Reserve retains—
as I expect it will— the independence from political pressures on
which the Congress has so wisely insisted across the decades.
That does not mean that the Federal Reserve is preoccupied with
the objective of monetary firmness. Our obligation to foster
financial conditions that favor the expansion of job opportunities
is clear and I assure you this is very much on our minds. W e
constantly keep probing for that delicate balance between too
much and too little money.
The increase of short-term interest rates that has occurred
since late April has served to check what would otherwise have
been an explosion of the money supply. By taking measures to
check the growth of money, we have demonstrated that we re­
main alert to the dangers of inflation. As a consequence, long­
term interest rates, which nowadays are extremely sensitive to
expectations of inflation, have remained substantially stable.
Had we not taken steps to bring the money supply under control,
I have little doubt that fears of inflation would now be running
stronger, and that long-term interest rates, which play such a
significant role in shaping investment decisions, would therefore
now be higher than they in fact are. In that event, of course,
the continuance of economic expansion would be less secure.
50



NEED FOR BETTER PROFITS

We at the Federal Reserve always welcome advice on how
best to proceed. Ours, however, is the responsibility to act in the
monetary area, and we intend to exercise that responsibility in
ways that promote the long-run as well as the immediate inter­
ests of this nation.




51




Investing in Physical and
Human Capital

I am truly delighted to be here this morning. Back last spring
when Dick Shinn invited me to be a speaker on this occasion, I
promptly accepted. I knew, first of all, that being here would
afford me the pleasure of seeing old friends. I also knew that
I could count on an audience seriously concerned with the eco­
nomic problems that confront our nation. That, indeed, is the
strong tradition of the entities from which this council has been
formed. As a former trustee of a life insurance company and as
a former participant in the work of the National Bureau of Eco­
nomic Research, I know something firsthand of your industry's
record of sustained and generous support of scholarly research
relating to economics and finance. Against such a background
of considerations, your chairman's offer to me was one I could
hardly refuse.
I want to use my time at this rostrum today to share some
thoughts with you about the troubles our economy is experienc­
ing in reaching a satisfactory level of jobs and in purging itself
of inflation. I make no pretense of being able to advance quick
solutions for the problems we are living with. But I do have
convictions about some steps that ought to be taken— and others
that ought to be shunned— if we are eventually to extricate our­
selves from our present condition. In my judgment, inadequacy
of investment in plant and equipment— and also in human cap­
ital— is the most important reason why the ongoing economic
Address at the annual meeting of the American Council of Life Insurance,
New York City, November 29, 1977.




53

REFLECTIONS OF AN ECONOMIC POLICY MAKER

recovery has been somewhat disappointing; it also is a factor in
explaining why so little headway is now being recorded in lower­
ing the basic inflation rate.
In characterizing the present recovery as disappointing, I do
not want to be misunderstood. In view of the disabilities our
economy accumulated over a long span of years, it would have
been extremely difficult— no matter how skillful policy making
had been— to achieve a recovery that was dramatically better
than we have actually experienced. It is a statistical fact that this
recovery has been of roughly average vigor compared with pre­
vious expansions since World War II. Indeed, it has been im­
pressively better than average by the yardstick of increases in
employment.
Still, there is ample reason for the sense of disappointment
that so many people feel. Partly because of the unusual severity
of the last recession, and partly also because of the accelerated
expansion of our nation's labor force, the recovery of our econ­
omy since early 1975, while of substantial scope, has left us with
a disturbingly large total of unemployment. As you well know,
the national unemployment rate is currently about 7 percent,
and it has exhibited a stickiness at that level for the last half
year. Large segments of our work force, moreover, have been
unusually hard hit. Young people and nonwhites especially have
faced formidable difficulties in the search for jobs. The un­
employment rate for blacks— approximating 14 percent at pres­
ent— has shown no real improvement during this economic
expansion, and the unemployment rate for black teenagers has
soared to the dismaying level of nearly 40 percent. Clearly, we
are a long way from satisfactory conditions in our labor markets.
I need hardly add that recent price behavior also has been
disappointing. During the recession period, inflation did slow
considerably from its puffed-up double-digit pace. During the
last two years, however, despite considerable slack in both
product and labor markets, the basic rate of inflation appears to
have settled at an annual rate of about 6 percent. This reflects
the fact that businesses have been granting annual compensation
increments of between 8 and 9 percent on average, while expe­
riencing productivity gains that recently have not averaged much
above 2 percent.
The picture of economic performance before us is thus
54



INVESTING IN PHYSICAL AND HUMAN CAPITAL

blemished by having in it both too much unemployment and too
much inflation. I know of no one who would take exception to
that assessment. Where differences arise, of course, is with
respect to remedial action.
Throughout most of the past thirty or forty years, the dom­
inant view in this country— as in much of the rest of the world—
has been that a condition of significant slack in the economy
requires aggressive pursuit of fiscal and monetary ease; in other
words, the government would have to run a sizable budget deficit
by spending more or taxing less, and such a fiscal policy would
need to be accommodated or reinforced by liberal supplies of
money and credit. In this philosophic approach the kind of fiscal
stimulus to be employed came to be viewed as much less impor­
tant than its size. Giving the economy an adequate push and
repeating the push again and again if necessary— that was the
crucial imperative of economic policy.
This simplified Keynesian mode of thinking consistently
tended to overlook structural rigidities in our economy. It also
proceeded on the mistaken assumption that upward pressures on
the price level would come into play only when high rates of
resource utilization were achieved. Despite these blemishes of
thought, Keynesian-type remedies worked reasonably well as
long as they were applied in moderation. But their very success
led to overdoing. With caution thrown to the winds in the mid­
sixties, a relentless inflation has since then engulfed our economy.
As a result, fears or expectations of inflation have become a vital
fact that must now be reckoned with.
In this new economic environment, Keynesian-type remedies
do not work as effectively as they once did. Many people have
learned that larger governmental deficits and aggressive mone­
tary ease are often forerunners of a new wave of inflation.
Hence, when expectations of inflation mount, consumers are
nowadays apt to save more rather than less, and such behavior
obviously tends to offset the stimulating impulses that stem from
a liberal fiscal policy. The like tends to be true of business
behavior. Many, if not most, businessmen have learned that
inflation inevitably confuses the calculation of costs, that in our
present institutional setting it is generally destructive of profits,
and that it sooner or later throws the economy out of balance
and thereby leads to recession. Thus our economy is no longer




55

REFLECTIONS OF AN ECONOMIC POLICY MAKER

working as it once did, and this paramount fact is now better
understood than it was five years ago or even one year ago.
Nevertheless, mechanical Keynesianism still retains a strong
grip on the thinking of many opinion makers in our country and
abroad. Let the Federal Reserve, for example, move to restrain
a burst of money growth— as it has felt compelled to do during
the past half year— and such action triggers a torrent of protest.
Much of the protest is predicated on the simple proposition that
any rise of interest rates in the context of a less than fully
employed economy jeopardizes continuance of economic expan­
sion. The consideration that unimpeded money growth— if
allowed to proceed under recent conditions— would greatly
heighten expectations of inflation has been virtually ignored by
the critics. Yet with such a heightening of inflationary expecta­
tions, long-term interest rates— which have become extremely
sensitive to inflationary psychology— would surely have moved
upward, in contrast to their actual behavior in remaining es­
sentially stable. I need hardly add before this audience that
long-term interest rates are far more important to the proper
functioning of our economy— especially for homebuilding and
capital formation generally— than are short-term rates.
The same attitudes that trigger protest whenever interest
rates go up are also continuing to color thinking as to what
constitutes appropriate fiscal policy. Let there be, for instance,
a show of hesitancy in the expansion of the economy and pro­
posals immediately come forth in great number urging stimu­
lative governmental action. Only rarely is there any careful
effort to tailor recommendations to identified specific weaknesses
of economic performance. The overriding concern rather is with
enlarging aggregate demand for goods and services by the quick­
est possible means. That, of course, was the genesis of last
winter's fifty-dollar rebate scheme; and for a while at least, me­
chanical Keynesianism again inspired a good deal of thinking this
autumn about how to keep economic recovery going next year.
I submit that our country will not succeed in making much
headway against the problems that our economy is burdened
with until we shed such conventional thinking about stabiliza­
tion policies. Fortunately, I believe we are moving in that direc­
tion. I do not underestimate, however, the distance that yet
needs to be travelled.
56



INVESTING IN PHYSICAL AND HUMAN CAPITAL

The way in which we as a nation deal with this problem
of investment inadequacy will tell us whether policy making is
in fact evolving constructively. As you in the audience know
well, spending by American business on capital goods has been
weak in this recovery relative to that in previous expansions.
This weakness is all the more glaring when one takes into con­
sideration the fact that a significant portion of capital spending
is now devoted to governmentally mandated pollution-control
and safety equipment that in no way enlarges industrial capacity.
Moreover, recent business investment in capital goods has been
disproportionately concentrated in relatively short-lived assets
such as trucks, office equipment, and light machinery. Businesses
have shown marked reluctance to undertake major investment
projects where payback cannot be expected for many years. This
failure of investment to show greater vigor has cost our economy
many hundreds of thousands of jobs.
For a considerable while, the conventional explanation for
the weak showing of investment activity was the low rate of
utilization of industrial capacity. The counsel was not to fret,
that capital investment will be reenergized as aggregate demand
grows. However, as we moved up the scale of capacity utiliza­
tion, investment in major, long-lived investment projects has
continued to be characterized by a good deal of caution. My
own view— which I have spelled out on previous occasions— is
that businessmen's hesitancy in initiating major investment
projects is fundamentally grounded in a deep sense of uncer­
tainty about how the economic environment is likely to evolve
over the next few years. That uncertainty— coupled with what
has been a record of poor profitability in recent years— is the
real barrier, I believe, to more normal investment activity.
To the extent that is true, indiscriminate federal injections
of purchasing power into the economy would do little to end
business reluctance to invest in major projects. To achieve a
substantial lift in capital formation, specific attention to the
shortcomings of the business environment is needed— particu­
larly, to uncertainty about governmental policy concerning taxes,
inflation, energy, and environmental controls. The need to re­
duce business taxes has become especially acute: first, in order
to offset impending increases in social security and energy taxes;
and second, to neutralize the massive overpayment of income




57

REFLECTIONS OF AN ECONOMIC POLICY MAKER

taxes that stems from applying standard accounting rules to our
inflation-ridden economy. Fortunately, perception of all these
needs has been growing.
I believe that President Carter fully appreciates the impor­
tance of substantially lessening the psychological and financial
obstacles to business investment. The like is true of many influ­
ential members of the Congress. I therefore expect that economic
policy generally— and both tax and energy policy specifically—
soon will take on a more constructive character. Over the next
several months, I anticipate that decisions in Washington will
at last reduce uncertainty, improve the state of business con­
fidence, and encourage capital formation. Even now, there are
some indications that investment in heavy machinery and in
industrial construction projects is beginning to revive, and this
tendency is practically bound to be reinforced by the more con­
structive turn of economic policy that now appears to be
emerging.
The need for a stronger trend of business investment is
important both for short-range and longer-term reasons. So far,
the driving force of economic recovery has been supplied over­
whelmingly by consumer spending and homebuilding. The
outlook remains favorable for continued expansion in these
activities, but it would not be at all surprising if further gains
moderated. The consumer saving rate has become rather low
and cannot reasonably be expected to drift downward; and the
rate of housing starts has attained a level suggesting that addi­
tional gains in the coming year are likely to be modest. Thus, if
the rate of overall economic growth is to be strong enough to
reestablish a declining pattern in unemployment, it is vital that
investment activity take on new vigor.
And there are other compelling reasons for fostering an
environment favorable to capital formation. Historically, the
enrichment of our labor force with a greater quantity and
improved quality of capital goods has been a major source of
productivity gains in our country and, consequently, of advances
in "real" income per worker. One of the worrisome features of
the lag in capital spending of recent years is that it has come
at a time when growth in the labor force was accelerating. The
combination of these trends has resulted in drastically slowing
the secular updrift in the amount of fixed capital available per
58



INVESTING IN PHYSICAL AND HUMAN CAPITAL

worker. Whereas in the 1950s and 1960s the ratio of capital
stock to the work force increased by more than 2 percent a year,
it rose by only about 1 percent in the early part of this decade
and has actually slipped somewhat in the last two years. It
should not be surprising that the slowing in the growth of capital
investment has been accompanied by a slowing of productivity
gains; output per man-hour has risen a third less rapidly over
the last ten years than in the 1950s and early 1960s. By re­
vitalizing the process of capital formation, productivity gains
are likely to improve again and thus help to reduce the cost
pressures that keep driving prices upward.
The imbalance that has been developing between capital
formation and labor force growth has one other troublesome
implication that needs to be brought into sharp focus. At pres­
ent, the issue of potential capacity shortages does not arouse
much interest, since capacity margins generally are quite com­
fortable. But when one bears in mind the long lead times in
bringing major capital projects to completion, the emergence of
a serious mismatch between industrial capacity and labor supply
within the next several years is not difficult to visualize; that is
to say, the practical limits of capacity utilization could be reached
before unemployment is reduced to an acceptable level. That
may well occur if we do not generate enough growth in indus­
trial capacity to match the growth of our burgeoning labor force.
In short, the case for substantially enlarged business spending on
plant and equipment has become very powerful. Since this is
coming to be increasingly understood and since fairly clear
avenues for a governmental contribution to a better investment
climate beckon, I am optimistic that the general economic out­
look will indeed brighten.
I wish I could be equally sanguine that we will deal appro­
priately with the barriers that stand in the way of job oppor­
tunities for so many of our citizens. To the extent, of course,
that encouragement of capital formation helps to produce a
more balanced and stronger expansion of the economy, employ­
ment will be stimulated. But even with additional momentum
imparted to the expansion, it is doubtful that the unemployment
rate will drop over the next few years to a reading that would
be commonly regarded as acceptable. The reason for skepticism
is that a formidable array of structural factors is now impeding




59

REFLECTIONS OF AN ECONOMIC POLICY MAKER

the smooth functioning of our labor markets— much more so
than was the case ten or twenty years ago.
The most prominent of these is the recent upsurge in the
growth of the labor force— a phenomenon dominated by sharply
increasing participation of adult women. I mentioned earlier the
substantial increase in employment since the recession trough
of March 1975. In fact, the growth of jobs since then— totaling
almost 7 million— has been larger, in percentage as well as in
absolute terms, than during the comparable phase of any of the
economic expansions since World War II. However, the increase
in the labor force also has been exceptionally large in the course
of this expansion— amounting to more than 6 million persons.
Consequently, the reduction in overall unemployment has been
quite limited.
The greatly increased participation of women in the labor
force that has developed in recent years marks a revolution in
the role of women in our society. The pressure of inflation on
household budgets has spurred many women to seek supple­
mentary family income, but it is clear that fundamental changes
in social attitudes toward family life and careers for women have
also played a large role. In March 1975, women of age twentyfive or over participating in the labor force constituted 43 per­
cent of the adult female population. If this percentage had
remained unchanged, the adult female labor force would now
be lower by about 1.6 million. The large "extra" influx of female
job seekers has, of course, taxed the absorptive capabilities of
the labor market. So, too, have the large additions of young
people seeking gainful employment— a reflection of the high
birth rates of the 1950s and also of the rising rate of participa­
tion by young people in the labor force.
Both young people and adult women newly entering the
labor market tend to have unemployment rates higher than aver­
age, in large part because they often lack relevant work experi­
ence. Their increasing role in the labor force has thus imparted
a significant upward tilt to the overall unemployment rate com­
pared, say, with the situation twenty years ago. That upward tilt
has been reinforced by a number of other developments. The
liberalization of both unemployment insurance and welfare pro­
grams has clearly increased the potential for extended idleness.
The very fact that we have become a more affluent people also
60



INVESTING IN PHYSICAL AND HUMAN CAPITAL

has made it possible for many individuals to be more selective
in their search for work. Evidence has grown, too, that minimum
wage legislation has become an increasingly significant deterrent
to the employment of young people. And the reporting of un­
employment has been influenced to some degree by the fact that
being unemployed is sometimes a requisite in establishing eli­
gibility for welfare benefits.
The combined effect of these and lesser structural influences
cannot be gauged precisely. There is, nevertheless, fairly com­
mon agreement among careful analysts that an unemployment
rate of something like 5 or 5Vi percent would now be the eco­
nomic equivalent of a 4 percent rate, say, two decades ago. This
does not mean that we need permanently reconcile ourselves to
such a level of unemployment; but it should caution us, as we
strive to bring the unemployment rate down, that we are likely
to experience labor market tautness and resulting inflationary
stresses at a much higher level of joblessness than in the past.
In time, of course, some part of the upward bias now affect­
ing the unemployment rate should automatically lessen. Growth
in the younger-age component of the labor force can be expected
to taper off in the next few years, reflecting the decline in birth
rates that started in the 1960s. A lessened influx of young peo­
ple into the job market should ease competition for youth-type
jobs. And as the proportion of adult women with work experi­
ence increases, the incidence of unemployment among them
should also gradually diminish. Such ameliorative tendencies,
however, are likely to impinge slowly on the overall unemploy­
ment rate, and particularly stubborn obstacles to lowering black
joblessness could well persist. The rush of white adult females
into the labor force appears to have been responsible for some
crowding out of less educated black workers, both male and
female. And still another kind of competition may now be
affecting younger black workers— that stemming from the siz­
able decline in the college enrollment rate of white youths since
the late 1960s.
In view of the complex forces that have recently come into
play in our job markets, an overall unemployment rate well
above that which used to be regarded as normal remains a pros­
pect for a considerable time ahead— in the absence, that is, of
effective countering strategies. A persistently high unemploy­




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REFLECTIONS OF AN ECONOMIC POLICY MAKER

ment rate would, of course, entail great wastage of economic
potential for the nation, and—what is of greater consequence—
it would destroy all hope of a decent place in life for hundreds
of thousands of citizens. The need to address the structural
influences that overhang our labor markets has become especially
urgent for young people and black workers. The jobless rates of
about 40 percent for black teenagers and of more than 20 per­
cent for blacks between the ages of twenty and twenty-four
express a tragic failure of our economic society. Unless we deal
with that phase of unemployment constructively, whatever else
may be done by way of trying to arrest and reverse urban
deterioration is going to make little difference.
I have long argued, as some of you know, that a major
impediment to job opportunities for unskilled workers is govern­
mental interference with wage determination. However wellintentioned such action may be, our government has inflicted
grievous injury to disadvantaged members of the labor force by
mandating ever higher wage minima. An employer's decision
to hire or not hire a particular individual depends critically on
the relation between the wage of the employee and his likely
productivity. When government raises the cost of hiring work­
ers, as has just been done under a new minimum wage statute,
no compensating increase takes place in their productivity;
hence it becomes more difficult for some workers to retain their
jobs and for others, particularly young people and other lowskill workers, to find jobs.
Despite widespread infatuation with raising wage minima,
the perversity of such legislation is gradually being recognized.
It is noteworthy that a proposal for a special subminimum youth
wage lost by only one vote this year in the House of Repre­
sentatives. That is the closest we have come to a sensible depar­
ture from our mistaken course. If this whole issue is not reopened
in the next session of Congress, it would be desirable, at the very
least, to seek legislation for a pilot experiment with a youth
differential in, say, a half dozen cities with a view to demonstrat­
ing actual consequences of a lower minimum wage for young
people. At the same time, and for much the same reasons, I
would urge attention to the harmful results, especially for young
people and blacks, of the wage floors mandated by the DavisBacon Act and the Walsh-Healy Act, which deal respectively
62



INVESTING IN PHYSICAL AND HUMAN CAPITAL

with federally financed or assisted construction projects and
with work performed on manufacturing and supply contracts
of the federal government.
We need to understand that widespread access to jobs—
especially for young people— is the surest way a society has of
facilitating sound investment in human capital. Normally, the
time for learning skills is when one is young. To the extent that
meaningful work experience is blocked for young people, they
can hardly be expected to become useful, productive citizens.
Our legacy of missed training and of failure to acquire basic
work habits will plague this country for literally decades ahead.
The past cannot be undone, but that is all the more reason to
prevent further human wastage by opening more channels to
jobs that afford useful learning opportunities. Public service jobs
that fail to teach transferable skills, as is often the case, merely
disguise the problem. So, too, do income-maintenance welfare
programs. Again, I wish to avoid misunderstanding. I happen
to favor public service jobs that provide useful training, and I
certainly do not oppose thoughtfully structured income-maintenance efforts for the needy. I do believe, however, that we must
guard against social attitudes in which either course is seen—
in the case of young people especially— as a tolerably acceptable
alternative to entry into the mainstream of the job market.
Governmentally mandated wage minima are by no means
the only institutional obstacle to the assimilation of young people
and minorities into the active work force. Sooner or later—
if only as an anti-inflationary step— we will have to come to
grips with other artificial restrictions to employment opportu­
nities that have developed in our country. In particular, attention
needs to be directed to governmental licensing and certification
requirements that limit entry to various occupations. It is hard
to see, for instance, economic or social justification for the
extremely high cost of becoming an owner-operator of a taxicab
in this and other cities. Nor is it easy to justify the licensing
requirements that complicate entry to trades that range from
barbering to plumbing. Such licensing is at times merely a form
of disguised monopoly that makes it difficult for people, espe­
cially members of minorities, to enter fields that otherwise
would accommodate many additional workers.
The opening up of job opportunities for young people




63

REFLECTIONS OF AN ECONOMIC POLICY MAKER

and minorities clearly needs to be reinforced by improved ed­
ucation in primary and secondary schools. Despite the rapid
closing in recent years of the wide educational gap that used
to exist between whites and blacks, educators generally agree
that the quality of black education is still markedly inferior.
Diplomas and credentials alone mean little. What is critical on
graduation is what has been learned that is useful for job per­
formance. Too often, the knowledge acquired does not enable
the graduate to be of much value in labor markets. Too often,
habits important to employers— such as punctuality, a sense
of responsibility, and personal neatness— have not yet been
acquired. All this is an extremely important aspect of our failure
as a nation to invest wisely in human capital.
I lack the practical knowledge to comment at any length
on the enormous challenge of improving inner-city schools. But
I do know that here and there schools of excellence exist within
inner cities, thereby demonstrating— among other things— that
great financial cost is not a requisite condition for good schooling.
It is promising that a good deal of scholarly examination of
these schools is now under way, so that in time their proce­
dures can be emulated elsewhere.
The approach I have suggested for dealing with youth
and minority unemployment involves proceeding on a number
of different fronts. I am convinced that there simply is no
grandiose scheme by which our economy's complex problems
of structural unemployment are going to be solved. I realize
it is tempting to think that very rapid expansion of demand
through monetary and fiscal stimuli would pull many of those
who are now sidelined in idleness into the mainstream of the
nation's economic life. And, for a while, it is possible that
an effect of that kind would occur in some measure. But ex­
perience of recent years should by now have driven home the
truth that such policies cause inflationary pressures that are
inimical to sustained prosperity. Temporary benefits conferred
on young people and minorities would only leave a legacy of
bitterness once the distortions of inflationary stress caused the
bubble of prosperity to burst, as I have no doubt would again
be the case.
I well realize that, despite my neglect of numerous problems,
including the plight of many older citizens, I have ranged this
64



INVESTING IN PHYSICAL AND HUMAN CAPITAL

morning over a wide terrain. I hope that in so doing I have not
blurred my central thesis. That is simply that our nation urgently
needs to enlarge its investment in both physical and human
capital: first, to solidify the ongoing recovery of production and
employment; second, to put our economy on a track that will
carry us to sustainable conditions of improved economic health
in which all of our citizens will have a decent chance to share.
Among other benefits, accelerated investment in physical
and human capital will materially aid our economy in making
headway against the scourge of inflation. The prospect of re­
ducing the pressure of costs on selling prices will brighten as
improvements in productivity strengthen. A vital key to that
achievement is more and more modern capital equipment per
worker together with a better trained work force. And the act
of unblocking job avenues for workers, while politically difficult,
will in time not only serve to reduce unemployment; it will do
so without releasing inflationary waves that are bound to follow
from excessive fiscal or monetary ease.
In closing, I would like to make just one further point. You
in this audience have tremendous capability— through this coun­
cil, your companies, and as individuals— to make a difference in
the battle for a healthier economy. I well remember the im­
pressive effort your industry made years ago to counter the
insidious theory that a little inflation is a healthy thing. I know
you are continuing your educational endeavors. But I would
urge you to stretch your energies and to share even more fully
with your policyholders— a multitude almost coterminous with
the public at large— the special insights that you have accumu­
lated into the economic and social damage caused by inflation
and unemployment. Widespread understanding of economic
problems has become crucial to the vitality of our democracy.
Your industry has a proud record in improving economic
knowledge, and I am confident you will continue to build on it.




65




Blessings of a Free Society

Thank you very much, Mr. Joseph. This has been a very warm
and friendly evening. I've loved every part of it. I even found
Mr. Epstein's listing of contributors instructive. In fact, I've
told my colleagues in Washington over the years that if they
want to solve the nation's budgetary problem, or if they want
to solve the problem of prices and wages, they ought to come to
a meeting of UJA or the ADL and learn the technique of achiev­
ing real success.
I listened with a sense of humility to the kind words
spoken by your national chairman, Mr. Joseph. As I stand be­
fore you this evening, I also find myself in a mood of reverence
for the distinguished men who previously received the award
which is mine this evening. I need hardly add that I accept this
award with a feeling of some pride.
I've listened with real care to the numerous reasons that
Mr. Joseph listed why I am being honored this evening in such a
unique way. I sensed an element of exaggeration in what Mr.
Joseph had to say, and yet I cannot dismiss his words completely.
I see no way of denying that in this world of ours, I have
achieved over the years a measure of success. Therefore, if you
will permit me, I would like to reflect on the reasons for what­
ever success I have achieved in the course of my career.
I can say quite honestly a few things in my own behalf.
First, I've been lucky. I've enjoyed good health throughout my
life, and while I am approaching seventy-four, I still may have
Address at a meeting of the Anti-Defamation League of B'nai B'rith, Palm
Beach, Florida, February 2 ,1 9 7 8 .




67

REFLECTIONS OF AN ECONOMIC POLICY MAKER

more energy than most members of my staff at the Federal
Reserve. Second, I think I can fairly say that I have a moderately
good mind— and I can even say I use my mind at times. Third,
I am accustomed to working diligently— in good measure because
I enjoy working. And fourth, I can also say in my behalf that I
respect a fair number of the laws laid down in the books of
Moses, also the laws laid down by the later prophets, and even
some of the laws written by our own Congress.
To these virtues or qualities I readily confess. And yet
the qualities that I have just attributed to myself— good health,
some intellectual power, habits of industry, a respect for law
and morality— are by no means unique. Millions of people in
this world— in Latin America, the Soviet Union, on the African
continent— have all these virtues and more in abundance. Y et,
they lead lives of spiritual poverty, lives marked by fear, lives
marred by failure to express their yearning for truth or for ex­
cellence. My heart goes out to all these people— especially to
the hundreds of thousands of Jews in the Soviet Union who,
being kept in bondage, are denied the opportunity to find
spiritual peace and self-fulfillment in Israel.
It is clear to me, therefore, as I reflect on my own life,
that whatever success I have been able to achieve is due funda­
mentally to the fact that it has been my good fortune to be a
citizen of a country whose people have had the opportunity to
acquire a decent education, whose people have had the freedom
to seek truth and to express it as they see fit, whose people
have had the opportunity to put to work such special talents as
they may have and to utilize these talents for themselves, their
families, and their country.
In short, it has been my great privilege to be an American.
This is a privilege that I, along with millions of other of o u r
adopted citizens, may appreciate even more keenly than do our
native born citizens.
But as a student of history, I also know that the freedom
and opportunity with which the American people are blessed
cannot be taken for granted. The Anti-Defamation League,
under whose auspices we meet this evening, did not come into
existence because brotherly love, because respect for hum an
rights, because regard for human dignity were universal attri­
butes of the American people. On the contrary, the founders
68



BLESSINGS OF A FREE SOCIETY

of ADL, as men of experience and practical wisdom, were well
aware of the fragility of human nature. They were well aware
of the messages of bigotry and hate that from time to time
kept stirring in our land— sometimes against Jews or Catholics,
sometimes against Italians or Poles or Hungarians, and fre­
quently against people with black or yellow skins.
The founders of ADL were particularly aware of the long
and troubled history of the Jewish people, who despite their
gift of the Torah and their ancestral search for a life of holiness,
had suffered calumny, discrimination, even torture on account
of their faith. The founders of ADL understood well the weak­
ness of human nature. They knew that what had happened
before could happen again, as it indeed did on such a tragic
scale during the Nazi holocaust. The founders of ADL therefore
set for themselves the objective of communicating to their fellow
Americans a better understanding of the character of the Jewish
people. But they did not stop there. The founders of ADL went
on to declare that the ultimate purpose of the Anti-Defamation
League was to do what it can to assure justice and fair treatment
to all citizens alike.
These principles of ADL were articulated with eloquence
in the year of its founding, 1913, the very year it so happened
that my family emigrated to this blessed land. Thus, my own
life as an American and the life of ADL have been virtually
coterminous.
During these sixty-odd years that have elapsed, I have
witnessed tremendous strides in our country toward justice and
toward fair treatment of all of our citizens. When I began my
university teaching in the mid-twenties, I was one of a very tiny
group of Jews who had attained that privilege. Anti-Semitism
was still rife in our country, and it was still widespread during
the 1930s. But after the end of World War II, anti-Semitism
rapidly diminished, and it now has practically disappeared in
our universities and in our colleges.
What has happened in our colleges and universities has
also happened in many lines of business, in the professions, and
in government. Since 1946, when the Employment Act became
law, we have had eleven chairmen of the President's Council
of Economic Advisers; five of these eleven have been members
of the Jewish faith.




69

REFLECTIONS OF AN ECONOMIC POLICY MAKER

The decline of anti-Semitism in our country— also the re­
markable advance of our black people and of Mexican-Americans
in their struggle for civil rights— did not happen by accident.
These fruits of our evolving democracy are attributable to the
civilized impulses, to the generous nature, to the energy of our
nation's churchmen, legislators, and educators. Foremost among
these educators has been the Anti-Defamation League. Because
of its vision, because of its humane spirit, because of its vigilance,
because of its energy, because of its perseverance, I, among mil­
lions of others, have had the freedom and the opportunity to
achieve the professional success that has come my way.
Thus, what personal qualities I have— and I have no inten­
tion this evening to minimize my personal qualities since I may
soon be unemployed— would have counted for little had I not
had the good fortune to become a citizen of this wonderful
land of opportunity— a land whose cultivation of democratic
values has been protected and richly expanded by the courageous
leadership of the Anti-Defamation League.
What has been true in my case has been true of many
millions of others— Jews and Christians, black men and white
men, immigrants and native citizens. So, in accepting A D L's
award, I feel that I am doing so symbolically in the name o f
countless Americans, and if I may, I want to express to A D L
my gratitude for what it has done in behalf of these millions.
Let us always keep in mind, nevertheless, that the objectives
of justice and fair treatment for all our citizens which A D L
has been championing so persistently have thus far been only
approximated in our land. They certainly have not yet been fully
attained in our country, to say nothing of much of the rest o f
the world. Moreover, in view of the waywardness of human
nature, the enormous strides that we have made towards true
democracy in our land cannot safely be counted on to inform
the lives of our people in the indefinite future. To assure the
retention and enlargement of our democratic achievements, we
need to keep alive and to nourish the educational efforts in behalf
of human decency— efforts which the ADL has been conducting
with such great energy and with such unique understanding o f
the nature of man.
But that is not all. In order to extend justice and end
discrimination in our land, we need also a strong economy— an
70



BLESSINGS OF A FREE SOCIETY

economy that provides an abundance of meaningful jobs for
all those who are able, willing, and seeking gainful employment.
One of the clearest lessons of our history and that of other
countries is that bigotry, class hatred, and discrimination have
the best chance to thrive when a nation's economy becomes de­
pressed and the ranks of its unemployed multiply. A healthy and
strong economy is therefore essential to our way of life so that
justice and fair treatment to all citizens alike may be preserved
and indeed enlarged in our country.
Ours is a progressive country, but I regret to say that
persistence of a high rate of inflation during recent years has
cast a cloud on the future of our economy. Inflation, I regret
to say, is sapping our nation's strength. Inflation is causing
hardship to elderly citizens dependent on an income fixed in
dollars, but each of which is constantly shrinking in purchasing
power. Inflation is eroding the value of our bank deposits and
the life insurance we have arranged to protect our families.
Inflation is weakening the willingness of our people to save for
the future.
Also, inflation is confusing the accounts kept by our busi­
ness firms of their costs, their revenues, and their profits.
Inflation is keeping the level of interest rates far higher than
it would otherwise be, since lenders expect to be repaid in
cheaper dollars. Inflation is causing a depression in stock ex­
change values on which the fortunes of many millions of
Americans depend. Inflation is causing uncertainty in the business
and financial world, since our businessmen now have no good
way of judging what their costs of production may be in the
future, or what prices they may be able to charge, or what
profits, if any, will accrue to them when they undertake risky
investments.
And worst of all, inflation is causing doubts to spread
among the American people about themselves, about their gov­
ernment, about their country, and thus is weakening our nation's
will to improve the economy and to strengthen our democratic
way of life.
I am often asked whether it is possible to check inflation
within the constraints imposed by national politics. I have no
hesitation in answering this question in the affirmative. But what
is required first and foremost is better understanding on the




71

REFLECTIONS OF AN ECONOMIC POLICY MAKER

part of the American people of the evils of inflation, so that
their national leaders may muster their inner courage with some
assurance of popular support.
The federal government is fully capable of leading our
country out of the inflationary morass. The government could,
for example, cut back on our huge and persistent budget deficits.
Again, instead of raising the pay of federal employees by 7 per­
cent— as the government did last October and may do again
this year— the increase could be limited to 3 percent or 4 percent,
thus setting an example for American businessmen and their
employees. Again, the President might cut his own salary by
some 10 percent and invite all presidential appointees and per­
haps Congressmen to do likewise, thus dramatizing his leadership
in unwinding the inflation that is plaguing our country.
To give one more example, the federal government could
actively encourage every factory, every office, every mining
establishment, every shop to establish a productivity council
consisting of management and labor representatives, so that
ways might be devised to increase output per hour and thus
reduce the upward pressure of labor costs on prices.
The federal government can certainly check the depreciation
of the dollar that has been under way in our foreign exchange
markets, a development that is putting new upward pressure on
our price levels. Among other things, our government could
adopt, at long last, an energy policy that will encourage the
rapid development of new sources of supply, as well as lead to
some conservation of oil. And certainly our government could
adopt a tax policy that would lead to more productivity-enhanc­
ing investments in our country, not only by American businesses
but also by foreign capitalists.
In short, ladies and gentlemen, inflation is a disease that
can be conquered, but it will be conquered only when the will
to do so becomes strong enough. Contrary to a widespread
opinion, this disease could be conquered even as we expand jo b
opportunities for our people. I have in mind in particular the
main sufferers of unemployment— our young people and our
young black citizens. Not only have we neglected their educa­
tion, but we have also erected numerous impediments that stand
in the way of their job opportunities— impediments such as our
federal and state minimum wage laws, impediments such as the
72



BLESSINGS OF A FREE SOCIETY

membership limitations imposed by many of our craft unions,
impediments such as the licensing and certification requirements
for trades that range from plumbing to barbering.
Since the spring of 1975, total employment in our country
has grown at an extraordinary pace, in fact, at an unprecedented
rate. Despite the influx of millions of women into the job
market, total unemployment has dropped from a rate of about
9 percent to a current rate of about 6 1 percent. But not all
/2
citizens have shared in the expansion of jobs and incomes that
has taken place in our country.
Unemployment among black teenagers is now running at a
rate of about 40 percent; unemployment among these black
teenagers is, in fact, even higher today than it was at the bottom
of the recession. Ours is a wonderful country which has brought
blessings of freedom and opportunity to most of its people. But
as a nation with a conscience, disciplined by practical sense, we
have no greater priority in thinking of the future than to bring
young unemployed people— particularly our black brothers—
into the mainstream of our nation's economic life.
In pronouncing this basic truth, I am simply endorsing the
noble purpose of the Anti-Defamation League— to secure justice
and fair treatment to all citizens alike and to put an end forever
to unjust and unfair discrimination.
In closing these remarks, may I thank once again the
officers of ADL for thinking of me today. And may I also thank
this large and distinguished audience in joining me in expressing
gratitude to the Anti-Defamation League for remembering what
Israel has meant to our Judeo-Christian civilization and for en­
larging the freedom and the opportunity for self-advancement
of the entire American people.




73




The Future of the
Free Enterprise System

Prediction of the economic future has always been a hazardous
task. Noting this fact, a distinguished economic historian,
Werner Sombart, once remarked that "it is precisely the most
gifted men who have made the most fundamental mistakes" in
predicting the economic future. While I am by no means sure
that "gifted men" are more prone to misjudge the future than
are ordinary mortals, there is ample evidence that judgments
of the future even by the ablest economists have often been
mistaken.
Karl Marx, who revolutionized economic and political
thinking over much of the world, provides an outstanding
example.
Marx believed that certain tendencies inherent in capitalism
would ultimately lead to its destruction. In his vision, small
business firms would gradually disappear as capitalism evolved.
The concentration of production in a diminishing number of
large enterprises would be accompanied by concentration of
wealth in fewer and fewer hands. The middle class would thus
be destroyed and the masses proletarized. Inadequate consump­
tion would lead to recurring epidemics of overproduction, and
depressions of increasing severity would follow. As the misery
of the proletariat deepened, resistance to capitalist exploitation
would intensify and become more militant. With such powerful
tendencies at work, the capitalist order was bound to collapse;
Address at the Seidman Distinguished Award in Political Economy dinner,
Southwestern at Memphis, Memphis, Tennessee, September 21, 1978.




75

REFLECTIONS OF AN ECONOMIC POLICY MAKER

it was only a matter of time when the capitalists would be ex­
propriated and all instruments of production socialized.
Thus, according to Marx's theory, the failure of capitalism
in its later stages to meet even elementary economic needs of the
working masses would inevitably lead, although not without
intense struggle, to the replacement of free enterprise by a
socialistically planned regime.
In our own century, another great economist, Joseph
Schumpeter, brilliantly challenged Marx's analysis. Schumpeter
saw in capitalism a highly efficient engine of mass production
and mass consumption. In his view the capitalist spirit expresses
itself characteristically through innovation— that is, developing
new commodities, devising new technologies, harnessing new
sources of supply, devising new market strategies, forming new
types of organization. The competition of new products and
new ways of doing business against old products and customary
procedures— that is the essence of the capitalist process. This
competition of the new against the old is what really matters
in the business world; it has been continuing at a rapid pace, and
it accounts for the vast improvement in living standards wher­
ever capitalism has flourished. Indeed, not only economic im­
provement, but the major achievements of modern times in the
sciences and arts are, directly or indirectly, the products of
capitalism.
Being a student of business cycles, Schumpeter was well
aware of recurring business slumps and their spells of unemploy­
ment. But he regarded recessions as temporary phenomena that
paved the way, so to speak, to more effective utilization of re­
sources and therefore to still higher standards of living. He went
on to argue, nevertheless, that the great economic and cultural
achievements of modern capitalism did not assure its future; on
the contrary, the very success of capitalism would eventually
cause its replacement by a socialist civilization. He thus accepted
Marx's conclusion but not the analysis on which it was based.
According to Schumpeter, capitalism would be destroyed
by factors growing out of its own inner processes. As business
corporations became larger, they would become bureaucratic
and impersonal. The entrepreneurial function of innovating
would be largely assumed by trained specialists. Increasing afflu­
ence would provide both the means and the will to expand social
76



FUTURE OF FREE ENTERPRISE SYSTEM

programs and thus lead to a growing role of government. The
intellectual class created and nourished by capitalism would
become increasingly hostile to its institutions. Animosity to­
ward free enterprise would be exploited by government officials
seeking additional power for themselves. The general public
would fail to support free enterprise because the issues debated
in the public arena are much too complex and often involve
long-range considerations that go beyond popular concern. Even
businessmen would become increasingly willing to accept the
teachings of their detractors. In this social and political environ­
ment, capitalist enterprises would in time be undermined and
finally replaced by socialism.
Thus, Schumpeter arrived at precisely the same conclusion
as Karl Marx. But whereas Marx attributed the eventual com­
ing of socialism to the failure of capitalism, Schumpeter attrib­
uted it to the outstanding success of capitalism.
When we turn from the theories of Marx and Schumpeter
to recorded experience, several facts immediately stand out.
First, we find that the nations practicing socialism in Marx's and
Schumpeter's sense had either banished free enterprise under
external military pressure, as in the case of Eastern Europe, or
had undergone an internal revolution without ever developing a
significant degree of free enterprise, as in the case of the Soviet
Union and mainland China.
Second, we find that greater economic success has been
generally achieved in nations that extensively practice free enter­
prise than in nations where it is prohibited or severely limited.
The economic performance of the United States, West Germany,
and France has been more impressive than that of the Soviet
Union or East Germany or Poland. Likewise, the economic per­
formance of Japan, Taiwan, or Brazil has clearly surpassed that
of India, Sri Lanka, or Egypt.
Third, although Marx's analysis continues to appeal to many
intellectuals, his elaborate theoretical structure has been dis­
credited by experience. Instead of bringing economic misery to
the masses, capitalism has produced vast improvements in their
economic condition. True, socialism has triumphed in some
countries, but the triumph was achieved in a far different way
than Marx had envisaged. On the other hand, Schumpeter's
theory that capitalism would eventually be destroyed by its very




77

REFLECTIONS OF AN ECONOMIC POLICY MAKER

success in improving the lot of people cannot be dismissed so
readily. His prognosis may or may not turn out to be valid.
But there is no denying that much of what has happened in
recent decades in countries that boast of practicing free enter­
prise fits rather closely his theoretical model.
Let me speak more specifically about one prominent feature
of Schumpeter's analysis— namely, the expanding role of gov­
ernment in economic life. The broad trend of American eco­
nomic development has been toward increasing emphasis on the
service industries, and the government has become the channel
through which much of the public's demand for services is
satisfied. As our economy has undergone industrialization and
urbanization, there has been a steady increase in the inter­
dependence of people— that is, in their reliance on the wisdom
and enterprise, and also in their exposure to the folly and indo­
lence, of their neighbors. In such an environment, social and
economic problems often arise that cannot be adequately han­
dled by private enterprise and governmental activities therefore
tend to expand.
The spread of political democracy has accentuated the trend
toward seeking governmental solutions of economic and social
problems. With more people in the lower income groups taking
advantage of the right to vote and with advocates of all sorts
active in legislative halls, demands on the government have been
mounting— to eliminate or regulate private monopoly, to con­
serve natural resources, to strengthen trade unions, to raise
minimum wages, to protect the environment, to improve housing
conditions, to protect unwary consumers, to subsidize agricul­
ture or other industries, and so on and on.
The range of governmental activities has thus been steadily
expanding and so too has the cost. In 1929 governmental ex­
penditure— that is/the combined total of federal, state, and local
spending— amounted to 11 percent of the dollar value of our
nation's entire production of goods and services. The corre­
sponding figure rose to 20 percent in 1940, 23 percent in 1950,
30 percent in 1960, 35 percent in 1970, and 37 percent in 1977.
The sharply rising trend of governmental spending has, of
course, involved a steady increase in the fraction of the nation's
labor force that works directly or indirectly for the government.
But our government affects the economy not only by employing
78



FUTURE OF FREE ENTERPRISE SYSTEM

people or by purchasing supplies and equipment from private
industry. In addition, vast sums of money are transferred by
the government to individuals not involved in current produc­
tion— that is, beneficiaries of public retirement funds, unemploy­
ment insurance, medicare, aid to veterans, food stamps, and so
forth. And our government also affects the economy by guaran­
teeing a variety of private loans and by regulating numerous
industrial, commercial, and financial practices.
All these activities, particularly transfer payments and gov­
ernmental regulation, have grown by leaps and bounds in recent
years. Transfer payments, which were merely 3 percent as large
as the nation's total wage and salary bill in 1930, rose to 11 per­
cent by 1965 and reached 21 percent in 1977. The Federal
R egister, which records governmental regulations, ran to 3,400
pages in 1937, but swelled to about 10,000 pages in 1953 and to
65,000 pages in 1977. At least ninety federal agencies are now
involved in issuing governmental regulations. Funds allocated
for regulation in this year's federal budget amount to $4.5 bil­
lion— more than twice the expenditure in 1974. This figure, of
course, omits the expenditures on regulation by our state and
local governments. And it omits also the enormous costs of
compliance imposed on private industry. According to a recent
investigation by the Center for the Study of American Business
at Washington University, these compliance costs amounted to
$63 billion in 1976.
The proliferation and increasing cost of governmental ac­
tivities in our country have resulted in a growing burden of
taxation— higher income taxes, higher sales taxes, higher prop­
erty taxes, higher social security taxes. Even so, the willingness
of our government to raise revenue by taxation has fallen dis­
tinctly short of its propensity to spend.
Since 1950 the federal budget has been in balance in only
five years. Since 1970 a deficit has occurred in every year.
Budget deficits have thus become a chronic condition of federal
finance; they have been incurred in years when business condi­
tions were poor and also when business was booming. Not only
that, but the deficits have been mounting in size. In the fiscal
year now ending, the deficit is likely to exceed $60 billion when
"off-budget" outlays are included in the total— as they indeed




79

REFLECTIONS OF AN ECONOMIC POLICY MAKER

should be. Instead of vanishing or diminishing as the economy
improves, which was once accepted practice, the deficit has been
increasing in the course of the current economic expansion.
The persistence of substantial deficits in our federal finances
is mainly responsible for the serious inflation that got under way
in our country in the mid-sixties. Let us never forget the simple
fact that when the government runs a budget deficit, it pumps
more money into the pocketbooks of people than it takes out
of their pocketbooks. That is the way a serious inflation is
typically started and later nourished. And when the deficit
increases at a time of economic expansion, as it has been doing
lately, we should not be surprised to find the rate of inflation
quickening. O f course, other factors— particularly, money cre­
ation by our central bank and the power wielded by trade
unions— have played their part in the inflationary process.
The growing intervention of government in economic af­
fairs that has taken place in the United States has been matched
or exceeded by similar developments in other countries that we
think of as continuing to practice free enterprise. The causes
of this increasing penetration of government into the economic
life of individual countries have been broadly similar— namely,
industrialization and urbanization, increasing interdependence of
people, faster communication through radio and television, ris* ing expectations of people, wider participation of citizens in the
political arena, and increasing reliance on government for the
solution of economic and social problems.
The degree of government participation in economic life
has thus been increasing in every industrial country outside the
Socialist sphere. To cite some examples: government expendi­
ture in the United Kingdom amounted to 34 percent of the gross
domestic product in 1962 and to 44 percent in 1975. Corre­
sponding figures in the case of West Germany are 34 and 42
percent; in the case of France, 36 and 40 percent; in the case of
Canada, 29 and 41 percent; in the case of Australia, 24 and 32
percent. A similar trend appears also in Japan; but it is worth
noting that governmental spending amounted to only 23 percent
of the gross domestic product of Japan in 1975— a substantially
lower figure than in any other major industrial country.
And just as the rapid expansion of governmental activities
in the United States has been accompanied by persistent budget
80



FUTURE OF FREE ENTERPRISE SYSTEM

deficits, that too has happened in other industrial countries.
Indeed, loose governmental finance and rapid inflation have
often been practiced more intensively outside the United States,
and they have recently become characteristic features of major
economies that still boast of free enterprise.
The worldwide inflation that has been under way since the
late 1960s has become a serious threat to the free enterprise
system. The fact that inflation masks underlying economic
realities makes it all the more insidious. For example, the trend
of retail trade and housing starts began to weaken in the United
States early in 1973, but many members of the business com­
munity paid little attention to that ominous development. Nor
did they recognize that standard accounting practices, which
rely on historical costs in reckoning inventories and capital
consumption, were resulting in enormous overstatements of
their profits. Caught up in the euphoria of inflation, they built
up inventories out of all proportion to actual or prospective
sales, and thus set the stage for the subsequent sharp decline
of production and employment. What happened in the United
States was paralleled in greater or lesser degree in European
industrial countries and in Japan.
The corrosive effects of inflation go far beyond the distor­
tion of businessmen's perspective. Inflation erodes the purchas­
ing power of everyone's money income. Inflation weakens the
willingness of many people to save for the future. Inflation
drives up the level of interest rates. And once businessmen
become aware of the illusory element in profits, inflation adds
to uncertainty about the future. In an inflation-ridden environ­
ment, businessmen have no good way of judging what their
costs of production may turn out to be, or what prices they
may be able to charge, or what profits, if any, will accrue when
they undertake new investments. The risk premium that at­
taches to calculations of prospective profits from new invest­
ments therefore goes up. This discourages business capital
investment and hampers the improvement of productivity.
Nor is that all. As the effects of inflation spread across
the economy, they in time weaken the capital market. The
classical view that inflation tends to favor business profits and
therefore higher stock prices no longer fits today's world of
powerful trade unions, high interest rates, and a governmental




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REFLECTIONS OF AN ECONOMIC POLICY MAKER

bias toward consumption. Recent experience in the United States
and in other countries has demonstrated that persistent infla­
tion adversely affects stock prices as well as bond prices. Even
now, despite the recent upsurge in stock prices, the Dow-Jones
industrial average is below the level reached in 1965; and in
view of the huge rise in the general price level since then, the
stock market has obviously suffered a severe depression.
As a result of the disappointing performance of the stock
exchanges, the interest of investors in equity securities has
greatly diminished during recent years. Some wealthy indi­
viduals, seeking a refuge from inflation, have turned to investing
in works of art, or in real estate, or in foreign currencies, gold
or other commodities. Many members of the middle class, being
similarly disillusioned with equities, have sought an inflation
hedge by purchasing a home or an extra house when they
already owned one. But the many millions who lack financial
sophistication, and even some who possess it, have found no
better way to protect themselves against the ravages of inflation
than to let cash pile up in the form of bank deposits or other
liquid assets— with the result that the purchasing power of their
monetary savings has generally kept eroding.
Many professional money managers, likewise discouraged
by the behavior of common stock prices, have found solace in
the high yields that have become available on corporate and
government bonds. And they have also displayed some tendency
to shorten the maturity of their investments, so that they could
shift to higher-yield securities if faster inflation served to raise
interest rates another notch or two in the future. With institu­
tional as well as individual investors switching from common
stocks to other investments, brokerage firms and investment
advisory services have suffered reverses. Numerous firms of
this type have closed down their operations or sold out to more
enterprising members of their industry. These in turn have re­
acted to the declining interest in equities by becoming depart­
ment stores of finance— that is, by offering to their troubled
customers stock options, commodity futures, municipal bond
funds, money market funds, tax shelters, and so on, in addition
to the more traditional services. Adjustments of this type have
enabled some brokerage and advisory firms to survive and even
to prosper.
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FUTURE OF FREE ENTERPRISE SYSTEM

But what matters most for the future of our economy is
the erosion of investor interest in equity issues. In 1965 cor­
porate shares constituted over 43 percent of all financial assets
of American households; by 1977 they were down to 25 percent.
Between 1970 and 1975 the number of individual shareowners
in our country fell from about 31 million to 25 million. More
significant still, this decline was concentrated among young and
middle-aged people. Net purchases of equity issues by private
pension funds have also slumped in recent years. So-called
"equity kickers/' once a prominent feature of loans placed by
insurance firms, have practically vanished. As a result of this
declining interest in equities, the supply of venture capital has
drastically diminished in our country. Public issues by small
firms have dwindled and we rarely hear nowadays of the forma­
tion of new high-technology companies.
If the skepticism about equities that has marked recent
years continues in the future, it will become difficult even for
some well-established corporations to finance their long-term
investment projects. This difficulty will be accentuated if in­
ternally generated funds continue to provide a reduced share of
total financing needs— as has been the case during the past
decade of high inflation. Furthermore, if business firms are
forced to rely more heavily on short-term funds, the corporate
economy will become more vulnerable to financial strains in the
future. In such an environment a business recession could be
even more disruptive than the recession we recently experienced.
In short, the changes wrought by inflation have already
weakened the framework of our economic system. They threaten
to do so to a greater degree if the inflationary bias of the
economy is extended. I judge from the sluggishness of stock
exchanges in other major industrial countries during the past
decade that, with the exception of Japan, their experience has
been similar to that of the United States. If inflationary trends
should persist, the economies of these countries will also face
a very uncertain future.
Serious as these longer-range economic consequences of
inflation appear to be, there is even greater reason for concern
about its impact on social and political institutions. Inflation
has capricious effects on the distribution of income and wealth
among a nation's families and businesses. Inflation eventually




83

REFLECTIONS OF AN ECONOMIC POLICY MAKER

leads to recession and extensive unemployment, and such ad­
versities are generally followed by new measures of govern­
mental intervention. Inflation robs people who in their desire
to be self-reliant have set aside funds for the education of their
children or their own retirement. Inflation hits many of the poor
and elderly especially hard. More ominous still, by causing
disillusionment and breeding discontent, inflation excites doubts
among people about themselves, about their government, and
about the free enterprise system itself.
Such anxieties tend to spread from one country to another.
In particular, when the value of our own dollar depreciates in
foreign exchange markets, as has happened again during the
past two years, confidence in the international economy as well
as in our own tends to weaken. The ultimate consequence of
persistent inflation may therefore be a decline in both the scope
and the efficiency of free enterprise on a worldwide scale.
At the beginning of this address, I reviewed the theories of
capitalist evolution by Marx and Schumpeter. It is interesting
to observe that while Marx visualized numerous developments
that would weaken capitalism, persistent inflation was not
among them. Nor was this threat to our free enterprise system
foreseen by Schumpeter in the early editions of his Capitalism ,
Socialism and D em o cra cy . Nor, for that matter, was it foreseen
by Keynes; both he and his early followers were concerned
about vanishing investment opportunities and unemployment,
not about inflation. These failures of economic vision counsel
humility in any judgments about the future; and yet I keep
wondering whether the inflationary development that Schum­
peter had failed to foresee may not be reinforcing the very
processes on which he dwelt so provocatively.
Ours is still a dynamic and prosperous economy, but the
prosperity around us has become uneasy and even joyless to
many thoughtful citizens. Inflation is certainly our nation's
main economic problem, but it is by no means the only economic
problem. Unlike earlier times, when we were troubled either by
inflation or by unemployment, we have experienced in recent
times a disconcerting rise of the general price level even when
unemployment was extensive. And our social economy has been
beset by other problems— among them a growing burden of
taxes, excessive governmental regulation, excessive power of
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FUTURE OF FREE ENTERPRISE SYSTEM

labor, restrictive business practices, depressed business profits,
deteriorating central-city areas, decline of the work ethic, and
widespread crime. Not all of these ills can be ascribed to infla­
tion. And yet this factor has had a more ramifying influence on
our economy than may appear at first glance.
I have already observed that inflation ultimately leads to
recession. In turn, extensive unemployment creates an environ­
ment that is favorable to new or larger welfare programs and
other increases in governmental spending— increases that often
outlast the recession. Again, it is at least partly because of
inflation that workers, particularly when they are well organized,
can achieve increases in wages that far exceed improvements in
productivity. It is at least partly because of inflation that the
statutory minimum wage keeps rising— thereby causing un­
employment among young people and breeding crime. It is at
least partly because of inflation that many of our cities have
suffered physical and cultural deterioration. And, needless to
add, the poverty that persists in the midst of our plenty is in no
small degree attributable to inflation.
The burden of taxes has also risen because of inflation.
Although deficits at the federal level of government have become
our way of life, taxes have increased along with expenditures.
Indeed, federal revenues fell below 90 percent of federal ex­
penditures in only seven years since 1946. Since our individual
income tax is highly progressive, the tax burden on workers goes
up, just as if Congress had legislated higher taxes, even when
real wages remain constant— that is, when wages in dollars
simply keep pace with increases in the consumer price level.
The corporate income tax, to be sure, is essentially proportional;
but under conventional accounting techniques, inflation creates
phantom profits on which corporations have been paying many
billions of dollars in taxes. And the consequences of inflation
for the capital gains tax have been still more drastic. A recent
study by Professor Martin Feldstein of Harvard indicates that in
1973 individuals paid taxes on more than $4.5 billion of capital
gains from corporate shares; but when the costs of the shares
are adjusted for increases in the general price level, it turns out
that these individuals actually experienced a real capital loss of
nearly $1 billion.
Human nature inevitably takes its toll. If intense effort or




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REFLECTIONS OF AN ECONOMIC POLICY MAKER

large financial risks are no longer compensated by the possibility
of earning large rewards, the effort and the risks will be less
readily undertaken. That is the condition toward which we have
been generally moving. And it is precisely because a grim future
may eventually become our lot and that of other nations still
enjoying freedom that big government and the disease of infla­
tion that comes in its train must be resisted by an alert citizenry.
This need is now more widely appreciated than at any time since
World War II, but it is not yet understood widely enough.
There are some faint flickerings, however, that the Ameri­
can people are becoming less passive about the dangers facing
our nation. The recent tax revolt of California citizens may be
a symptom of a general awakening of the middle class. O f late,
many politicians have been vying with one another in proclaim­
ing inflation as our number one problem. Trade unions have
been unable to persuade Congress this year that their market
power needs strengthening. Much is heard these days in con­
gressional halls about the importance of reducing business taxes.
A move to cut back rather than increase the tax on capital gains
has won widespread support. And of late we have even wit­
nessed some minor reductions within the still swelling total of
federal expenditures.
These are interesting and promising events. As yet, they
are much too tenuous and uncertain to justify extrapolation.
They nevertheless suggest that the time may be right for a
serious attack on the inflation that has been plaguing our coun­
try. That will not be an easy task, but it will be even harder
if we hesitate or delay. Once an economy has become engulfed
by expectations of inflation, economic policy makers no longer
have very good choices. Still, much can in time be accomplished
with determined leadership.
Restrictive monetary and fiscal policies, if pushed far
enough, are always capable of bringing inflation under control;
they might, however, also unsettle the economy by bringing on
extensive unemployment. To minimize that risk, it would be
wise to supplement monetary and fiscal policies with carefully
selected structural policies. A prescription for a balanced attack
on the inflation problem might therefore run as follows in to­
day's environment: first, that the Federal Reserve continue its
present moderately restrictive monetary policy without inter­
86




FUTURE OF FREE ENTERPRISE SYSTEM

ference by the Congress or the White House; second, that the
budget for next year permit a substantial cut in the federal
deficit and that the move toward budgetary balance be completed
within the following two years; third, that this and next year's
increase in the salaries of federal employees be scaled down to
one-half the figure suggested by wage comparability studies;
fourth, that the President cut his own salary by, say, 10 percent
and call on all presidential appointees and members of Congress
to do likewise; fifth, that the President reinforce these examples
for the nation by calling on top corporate executives to refrain
from any increase in their compensation over the next two
years; sixth, that a national center be promptly established for
encouraging the organization of productivity councils across the
nation, factory by factory and shop by shop, with a view to
cooperation by management and labor in raising output per
man-hour; seventh, that we make a start towards blunting the
cost-raising measures that we have allowed to flourish— such
as tariffs, import quotas, farm price supports, and minimum
wage laws, and that we also postpone the target dates that
have been set for environmental and safety regulations.
In the course of my remarks this evening I have dwelt on
the corrosive influence of inflation because I consider this the
greatest danger to our free enterprise system. I am convinced
that inflation is a disease that can be brought under control;
but that will happen only when the will to do so becomes strong
enough. In our country there is a powerful political constitu­
ency behind each of the government's spending programs, be­
hind every tariff and import quota, behind every regulation that
protects a particular group from the pressures of competition.
We have powerful political constituencies in favor of perennially
easy credit. We have powerful political constituencies in favor
of other public or private arrangements that benefit some groups
but raise prices to everyone. Our urgent need now is for a
nationwide constituency that will fight for the paramount in­
terest that we as a people have in a dollar of stable purchasing
power.
Other nations— notably, Germany, Switzerland, and Japan
— have demonstrated that inflation can be unwound. Even Great
Britain has recently succeeded in reducing its inflation rate
sharply. If we and other inflation-ridden nations succeed in




87

REFLECTIONS OF AN ECONOMIC POLICY MAKER

curbing inflation within the framework of our basic institutions,
we may yet experience a true economic renaissance in the W est­
ern world. On the other hand, if the present worldwide inflation
continues, a command economy may eventually be the bitter
fruit of this generation's complacency and neglect. It is the duty
of each of us to do what we can to prevent this from happening.

88



PART
TWO
Inflation and Unemployment







Inflation: The Fundamental
Challenge to Stabilization Policies

We have gathered together as representatives of government
and the banking industry to discuss our problems, experiences,
and concerns about financial affairs. Each of our countries has
specific problems that are peculiar to the character of its own
economy. In nearly all of our countries, however, the funda­
mental challenge to current stabilization policies is the persis­
tence of inflationary pressures.
What I should like to convey to you today is the following
simple message: although the forces making for inflation in
modern society are strong and pervasive, these forces need not
prevail. Stabilization policies can be formulated and executed
in a way that will permit our economies to enjoy the benefits
of prosperity without inflation. I do not minimize the difficulties
of meeting this challenge, but I am convinced that success is
possible.
We are living now in an inflationary climate. In the United
States periods of strong upward price pressures over the past
quarter century have been episodic. Interspersed between them
have been years of relative price stability. But the period since
1964 has witnessed stronger and more widespread cost and price
pressures than in the previous inflationary outbreak of the mid1950s. And the current episode of inflation has lasted longer
than any other since the end of World War II.
In most other industrial countries, price performance over
the past two decades has been poorer than in the United States.
Remarks before the Seventeenth Annual M onetary Conference of the Amer­
ican Bankers Association, Hot Springs, Virginia, May 18, 1970.




91

REFLECTIONS OF AN ECONOMIC POLICY MAKER

However, after 1964 the American price level began to move up
briskly and our inflation from 1966 to 1969 tended to outpace
that in Europe. More recently, we see an acceleration of cost
and price pressures in Europe and Japan.
In these circumstances, it should not be surprising that so
many businessmen and consumers believe that inflation is in­
evitable. This has happened before. During the 1950s, the
notion that creeping inflation was endemic to a modern economy
was widely held in the United States. Yet the period from 1958
through 1964 was marked by reasonable price stability. We in
government therefore have a responsibility, I feel, to make it
convincingly clear to everyone that inflation is not an economic
necessity and that it will not be accepted as an inevitable course
of events.
I believe there are grounds for optimism about our ability
to achieve and maintain reasonable price stability, and to do so
without incurring excessive costs in terms of unemployment and
lost output. I reach that conclusion from long exposure to the
inflationary problem in the United States. The basic sources of
inflation in all of our economies are similar, however, and what
we can learn from American experience may also be applicable
elsewhere.
What are the sources of the inflationary bias that is
presently troubling us? On a first view, the root of the difficulty
seems to be the broadening of the social aspirations that have
been shaping our national economic policies, and especially the
commitment to maintain high levels of employment and rapid
economic growth. For several decades, the primary concern of
economic stabilization policies was to avoid substantial or pro­
longed declines in the level of economic activity— declines of the
sort that had plagued industrialized economies for a century or
more. As we gained experience in moderating business down­
turns, our standards of economic performance became more
exacting. Now, we are not prepared to accept more than brief
departures of our economic growth rate from its full employment
path.
Improvements in our ability to control cyclical fluctuations
in business activity have also emboldened us to search for ways
to increase the potential growth rate of our economies— through
better education and training of the labor force, through larger
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CHALLENGE TO STABILIZATION POLICIES

investment in public facilities, and through stimuli to private in­
vestment in fixed capital. In this effort, too, we have achieved
some measure of success. In the short run, however, I suspect
that these policies have added more to aggregate demand than to
aggregate supply.
Another source of inflationary pressure in recent years has
been the rise of government expenditures for social welfare. The
consequences for the federal budget in the United States have
been dramatic. Since fiscal year 1965, federal expenditures for
health, income security, veterans' benefits, education and man­
power, and community development and housing have more than
doubled. And as we look to the future, we must expect sub­
stantial further increases in the level of government expenditures
to help halt the decay of our central cities, to bring air and water
pollution under control, to provide added financial assistance to
beleaguered state and local governments, to finance basic research
in areas where private incentives are insufficient, to provide
better housing for the less privileged, better medical services to
the indigent and the aged, improved job training— in short, for
the host of things our people have come to expect their govern­
ment to provide.
The present worldwide inflationary trend may thus be
ascribed to the humanitarian impulses that have reached such full
expression in our times. This explanation, however, encompasses
only part of the truth. As every economist knows, the growth
of aggregate demand that has been generated by our social
aspirations could, in principle, have always been offset by mone­
tary and tax policies, supplemented by more selectivity in public
expenditures.
The present worldwide inflationary trend must, therefore,
also be recognized as evidence of the shortcomings of economic
stabilization policy. Serious inflationary problems are always
traceable to excessively expansionist monetary and fiscal policies
or to the failure of such policies to offset the effects of exces­
sively exuberant demand in the private sector. This, however,
is something that admits of correction.
The reason for my optimism about the prospects for longrun improvement of our price performance is a deep faith in the
learning process. True, we have made many mistakes in the
formulation and administration of our national economic policies,




93

REFLECTIONS OF AN ECONOMIC POLICY MAKER

and we will doubtless make some mistakes in the future. But
we can also learn from past experience how to distinguish the
paths that need to be taken from those that must be shunned
if we are to win the ever-recurring bouts with the threat of
inflation.
Let us consider briefly the experience with stabilization
policy in the United States, drawing on the record of the past
few years by way of illustration. These years offer, I believe,
lessons that we cannot afford to ignore.
One of the serious economic blunders of recent years was
the failure to alter the course of fiscal and monetary policies
when early warnings of inflation began to flash. Late in 1964,
signs of growing pressure on our nation's resources were al­
ready multiplying and these signs became stronger and more
widespread in the first half of 1965. With the economy moving
rapidly toward full employment, the time had come for backing
away from the stimulative policies pursued in the earlier years
of the 1960s. But precisely the opposite course was taken— both
fiscal and monetary policies became substantially more stimula­
tive during 1965.
In my judgment, the fateful policies of 1965 stemmed only
in part from the inadequacies of economic forecasting. It is
true that attention had been diverted from the problems of in­
flation by the experience of the previous five or six years, when
much slack existed both in industrial plants and the labor market
and the price level moved within a narrow range. By the late
summer of 1965, however, it was entirely clear that storm clouds
were gathering on the economic horizon. The unemployment
rate had moved close to the 4 percent target, while the rate
of utilization of industrial capacity— which was already high—
still kept rising. Yet, despite the strains under which industry
was already operating, the economy was called upon to shoulder
a much enlarged military burden in Vietnam without any change
in monetary or fiscal policy. Monetary policy continued on its
expansionist track during the latter half of 1965 and fiscal
restraints of material consequence were postponed much longer.
The mistakes of stabilization policy in 1965 reflected an
unwillingness to face up promptly to the urgent need for re­
strictive actions on the fiscal and monetary front. It was soon
found, however, that by eschewing an ounce of prevention, a
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CHALLENGE TO STABILIZATION POLICIES

pound of cure had become necessary. Inflationary forces gathered
such momentum that it took stern measures in subsequent years
to eliminate excess demand.
Another deficiency in the formulation of stabilization
policies in the United States has been our tendency to rely too
heavily on monetary restriction as a device to curb inflation,
rather than on a balanced program of fiscal and monetary re­
straints. There are several reasons why excessive reliance on
monetary restraint is unsound.
First, severely restrictive monetary policies distort the
structure of production. General monetary controls, despite
their seeming impartiality, have highly uneven effects on dif­
ferent sectors of the economy. On the one hand, monetary re­
straint has relatively slight impact on consumer spending or on
the investments of large businesses. On the other hand, the
homebuilding industry, state and local construction, real estate
firms, and other small businesses are likely to be seriously
handicapped in their operations. When restrictive monetary
policies are pursued vigorously over a prolonged period, these
sectors may be so adversely affected that the consequences be­
come socially and economically intolerable, and political pres­
sures mount to ease up on the monetary brakes.
Second, the effects of monetary restraint on spending often
occur with relatively long lags. The initial actions of a central
bank to moderate the pace of expansion in money and credit may
come at a time when liquidity positions are relatively ample in
the commercial banking system and elsewhere in the economy.
Loan commitments to businesses by banks and life insurance
companies may be sizable, and other financial institutions may
have committed large sums to the mortgage market based on
expected inflows of funds. For a time, therefore, the effects on
spending of the slower rate of expansion of bank reserves will
be cushioned. Moreover, the length of lags in the response of
spending will vary from one period of monetary stringency to
another, depending on the state of liquidity, the expectations
of the business and financial community, and a variety of other
factors.
Primary reliance on monetary policy to restrain inflation
thus places a high premium on accurate forecasting of both the
strength of private demand and the temporal effects of monetary




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REFLECTIONS OF AN ECONOMIC POLICY MAKER

restraint on spending. Because the lags tend to be long, there
are serious risks that a stabilization program emphasizing mone­
tary restraint will have its major effects on spending at a point
in time when excess demand has passed its peak. The conse­
quence may then be an excessive slowdown of total spending
and a need to move quickly and aggressively toward stimulative
policies to prevent a recession. Such a stop-and-go process may
well lead to a subsequent renewal of inflationary pressures of
yet greater intensity.
Something like this happened, I believe, in 1966 and early
1967. The monetary brakes began to be applied with consider­
able force in the spring of 1966, and they began to take their
greatest toll in spending in the fall months of that year. By that
time, the adverse structural effects of excessive monetary re­
straint had become obvious to everyone, and some modest fiscal
action was taken to help slow the economy. Just about that
time, however, the rate of consumer spending relative to income
declined rather sharply. With the expansion of total final de­
mand for goods and services tapering off, monetary policy then
moved aggressively toward ease to ward off a threat of recession.
As things turned out, the adjustment proved to be mild and
short-lived, and by the latter half of 1967 we found ourselves
in an aggravated condition of economic overheating.
W e need to recognize, of course, that there is considerable
uncertainty also about the effects of fiscal policy on the perfor­
mance of the economy. The direct effects of changes in federal
expenditures or tax rates on private incomes and spending are
themselves often difficult to predict. But the overall impact of
fiscal policy must also take into account the effects of budgetary
changes on interest rates and hence on private spending. Our
knowledge about these effects is sketchy. Much will depend, of
course, on the precise nature of the actions taken and on the
state of private expectations at the time.
In recent years, we have tended to overestimate our knowl­
edge of economic processes, and how they are influenced by
monetary and fiscal policies. We have, for example, adopted tem­
porary increases in taxes as though we knew with reasonable
certainty that the economic situation a year hence would war­
rant their removal. The economic impact of such taxes has been
considered without due regard to our limited understanding of
96



CHALLENGE TO STABILIZATION POLICIES

the effects of temporary taxes on consumer and business spend­
ing decisions. Furthermore, growth rates of the major monetary
aggregates have been permitted to vary over an extremely wide
range, notwithstanding our hazy perception of the timing and
magnitude of the economic effects of such variations. There has
been much loose talk of "fine tuning/' when the state of knowl­
edge permits us to predict only within a fairly broad band the
course of economic development and the results of policy actions.
Improvement in the formulation and implementation of
stabilization policies requires full recognition of the great un­
certainties with which we must live. This means that we need
to adopt a cautious approach to large changes in the intensity
of monetary and fiscal policies— avoiding extreme courses of
action unless the evidence clearly indicates that exceptional
policy moves are needed. Furthermore, the uncertainties in­
herent in the use of any single instrument of policy suggest that
the prudent course is to adopt a balanced program that relies on
prompt adaptations of fiscal as well as monetary policy.
Let me turn now more specifically to the current inflationary
problem in the United States, and suggest what these lessons
of recent experience seem to imply for the course of monetary
and fiscal actions.
First, I want to note that we have made much more progress
than is generally realized in getting the inflationary forces of
recent years under control. The excess demand that bedeviled
our economy during the past four or five years has been elimi­
nated. In recent months, total real output has declined some­
what. Industrial production has dropped faster and is now
about 2Vi percent below its peak last summer. Demand for
labor has moderated, the unemployment rate has increased, and
the degree of unused industrial capacity has also risen.
Throughout this phase of economic sluggishness, there has
been a risk that the decline in industrial output would intensify
and spread across the economy, with the business slowdown
taking on the characteristics of a recession. Thus far, the per­
vasive and cumulative characteristics of a recession have not
developed— largely, I believe, because of the continuing strength
of business investment in fixed capital. It seems highly probable,
moreover, that the business slowdown will not extend much
further, and that before long we will be enjoying a resumption




97

REFLECTIONS OF AN ECONOMIC POLICY MAKER

of growth in industrial output and employment. If that proves
to be the case, the success we will have had in slowing aggregate
demand without precipitating a recession will have been a
notable achievement.
W e have been less successful than we would have liked in
moderating the advance of prices, and also less successful than
we might have expected on the basis of past experience. But
there are some signs of progress in that area, too. After seasonal
adjustment, the rate of increase in consumer prices slowed in
February and again in March. The level of wholesale prices re­
mained unchanged in April for the first time in a year and a half,
as prices of some agricultural products fell sharply. The price
rise for industrial commodities in March and April was the
smallest since last July.
It is clear, nonetheless, that the average rate of price in­
crease during recent months is far too high. The question might
be raised, therefore, whether our current inflationary illness
could be cured more quickly with a shock treatment designed to
rid the patient, once and for all, of the troublesome disease.
Such a prescription would, I believe, be unsound as well
as unacceptable. The inflationary developments we are now
experiencing do not reflect the present state of balance between
aggregate demand and supply. Rather, they are the aftermath of
economic overheating that existed earlier and which is still
having lagged effects on wage rates, on other costs, and hence
on prices. We are in a transitional period of cost-push inflation,
and we therefore need to adjust our policies to the special char­
acter of the inflationary pressures that we are now experiencing.
An effort to offset, through monetary and fiscal restraints,
all of the upward push that rising costs are now exerting on
prices would be most unwise. Such an effort would restrict
aggregate demand so severely as to increase greatly the risks of
a very serious business recession. If that happened, the out­
cries of an enraged citizenry would probably soon force the
government to move rapidly and aggressively toward fiscal and
monetary ease, and our hopes for getting the inflationary prob­
lem under control would then be shattered.
It would be an equally serious mistake, however, for the
central bank to supply money and credit in sufficient quantities
to permit businesses simply to pass on all cost increases to their
98



CHALLENGE TO STABILIZATION POLICIES

customers. Readiness to validate the pressures of costs on prices,
through generous provision of money and bank credit, would
greatly increase the probability of a later resurgence of excess
demand. This, too, must be avoided.
The right course for monetary policy is, I believe, a cautious
approach that avoids both of these extremes. In recent months
the major monetary aggregates have been following a path of
moderate expansion— a path that provides added insurance that
the current economic slowdown will not cumulate, but at the
same time is consistent with avoidance of excess demand later
this year and on into 1971. The adequacy of growth in supplies
of money and credit to finance increases in real output and em­
ployment will, of course, depend heavily on the movement of
costs and prices. As I noted a moment ago, it would be inap­
propriate for the central bank simply to validate the effects of
all cost increases on prices. Consequently, the longer inflationary
wage settlements and pricing decisions continue, the larger may
be the shortfall of economic growth from its potential.
In the months ahead, we may be witnessing economic de­
velopments that will test patience— with costs and prices con­
tinuing to advance despite the slack that exists in markets for
goods and for productive services. It seems likely that we will
hear an increasing number of suggestions that additional steps
need to be taken to moderate the rise in wage rates and the
advance of prices— steps that could involve the government more
directly in the operations of the private economy.
Other countries that have depended on specific wage-price
policies— or incomes policies, as they are frequently called— have
achieved relatively little success, and the same can also be said
of our own experiment during the sixties. Nevertheless, we
should not close our minds to the possibility that an incomes
policy, provided it stopped well short of direct price and wage
controls and was used merely as a supplement to overall fiscal
and monetary measures, might speed us through this transitional
period of cost-push inflation. I recognize that an incomes policy
may not have a lasting effect on the structure of costs and prices
if its use is restricted to a transitional period of cost-push infla­
tion. Moreover, it seems clear to me that an incomes policy ap­
plied over a long period would be completely impractical. Even
with these reservations, however, there may be a useful— albeit




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REFLECTIONS OF AN ECONOMIC POLICY MAKER

a very modest— role for an incomes policy to play in shortening
the period between suppression of excess demand and restora­
tion of reasonable price stability.
O f course, primary reliance in the battle against inflation
must always be placed on policies that impinge on aggregate
demand. It is of fundamental importance that monetary and
fiscal policy work together, in this regard, in the months ahead.
If the tempo of economic activity picks up later this year, as
may now be reasonably anticipated, the task of ensuring that
this recovery does not become too brisk— thereby threatening a
reemergence of excess demand— should not fall on monetary
policy alone. Fiscal policy must do its share.
The budget set forth by the administration in January called
for a small surplus for fiscal 1971. Since January, there have
been some modifications in the projected course of federal ex­
penditures as a result of actions taken by the Congress and the
administration. Thus far, the most significant change in pro­
jected expenditures has come from the acceleration of the federal
pay raise, which added a little over $1 billion to expenditures in
the current fiscal year, and a like amount to prospective outlays
in fiscal 1971.
During prior periods of economic slack, a small change of
this kind in the outlook for federal expenditures would have
created scarcely a ripple in financial markets. In recent weeks,
however, reactions in financial markets have been dramatic. In­
terest rates have increased sharply, with yields in the long-term
markets rising above the peaks of late last year. A number of
factors have been responsible for this change in market ex­
pectations, but concern about federal expenditures appears to
have been the catalytic agent. Participants in financial markets
greeted the news of the pay raise as if it were the first in a series
of steps that would let down the bars on federal spending, and
recent developments in Indochina have intensified this feeling.
Perhaps these reactions are just one more evidence of the
strength of the inflationary fears and expectations still present
in our economy. However, the public is also mindful that
promises of fiscal restraint emanating from the Executive and
the Congress have, time and again, been unfulfilled. W e must
not permit that to happen in the year ahead.
At this juncture of history, the business and financial public
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CHALLENGE TO STABILIZATION POLICIES

is deeply concerned that the federal budgetary process may have
gotten out of hand in recent years. There is some basis for this
concern. Reforms of the federal budgetary process are, I be­
lieve, essential to long-run improvement in conducting our sta­
bilization policies and our battle against inflation.
For the long run, there are a number of budgetary reforms
that will be needed to keep federal expenditures under control.
Ultimately, I think the concept of zero-base budgeting will have
to be adopted in order to weed out expenditures on outmoded
programs whose costs have long since exceeded their benefits.
In other words, we need to have each year a careful review by
the Budget Bureau and the Congress of the total spending pro­
posed on each program, not just the proposed increases in
spending.
Progress toward this objective of zero-base budgeting might
be speeded by personnel rotation among the major divisions of
the Budget Bureau, so that a fresh point of view would be
brought to bear on the budget requests of the various depart­
ments of government. But for the immediate future, the single
most constructive step that could be taken would be a legislative
ceiling on federal expenditures for the coming fiscal year. This
ceiling should be tight enough to give reasonable assurance that
federal expenditures for fiscal 1971 do not rise appreciably above
the level projected in the budget last January. Alternatively, if
expenditures threaten to rise significantly above that level, taxes
should be provided to cover the excess.
In conclusion, I believe that the prospects for a return to
reasonable price stability are brighter than is generally recog­
nized. Excess demand in our economy has been eliminated.
After a long period of overheating, the first signs of moderation
in price behavior— though halting and slow— have begun to ap­
pear. It seems probable, moreover, that economic recovery, as
it develops, will proceed satisfactorily and yet not strain our
physical capacities.
The sources of long-run inflationary bias in the United
States, as elsewhere in the world will, of course, continue to
operate. But by applying sensible monetary and fiscal policies,
we can check the inflationary tendencies that emanate from the
pursuit of our social and economic goals. The clearest lesson of
the past few years is that delay in coping with inflationary




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REFLECTIONS OF AN ECONOMIC POLICY MAKER

pressures merely compounds the difficulties that need to be faced
later. Fortunately, this basic fact is now more widely recognized
in the United States and in other industrial countries than it was
ten or even five years ago.

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The Basis for Lasting Prosperity

Nearly three years ago, in a talk here in Los Angeles, I pointed
out that once an economy becomes engulfed by inflation, eco­
nomic policy makers no longer have any good choices. To regain
a lasting prosperity, a nation must have the good sense and
fortitude to come to grips with inflation. There is, however, no
painless way of getting rid of the injustices, inefficiency, and in­
ternational complications that normally accompany an inflation.
Events of the past several years have lent poignancy to
these simple truths. Recent experience has demonstrated once
again that the transition from an overheated economy to an
economy of stable markets is a difficult process. Elimination of
excess demand was an essential first step to the restoration of
stability, but this step has brought with it a period of sluggish
economic activity, slow income growth, and rising unemploy­
ment. And while we have made some progress in moderating
the rate of inflation, our people are still seeing the real value
of their wages and savings eroded by rising prices.
The struggle to bring inflationary forces under control, and
to return our labor and capital resources to reasonably full
employment, is still going on. I am convinced, however, that
corrective adjustments in the private sector over the past twelve
to eighteen months are creating, in conjunction with govern­
mental stabilization policies, the foundation on which a pro­
longed and stable prosperity can be constructed.
Address in the Pepperdine College Great Issues Series, Los Angeles, Cali­
fornia, December 7, 1970.




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REFLECTIONS OF AN ECONOMIC POLICY MAKER

A cardinal fact about the current economic situation, and
one that promises well for our nation's future, is that the im­
prudent policies and practices pursued by the business and
financial community during the latter half of the 1960s are
being replaced by more sober and realistic economic judgments.
In my remarks to you today, I want first to review some of the
key developments that lead me to this conclusion. Then I shall
turn to the tasks that must still be faced in order to enhance
the prospects for an early resumption of growth in production
and employment in an environment of reasonably stable prices.
The current inflation got under way in 1964. Perhaps the
best single barometer of the extent to which it served to distort
economic decisions and undermine the stability of the economy is
found in the behavior of financial markets during the late 1960s.
In 1968, well over 3 billion shares of stock exchanged hands on
the New York Stock Exchange— about two and one-half times
the volume of five years earlier. The prices of many stocks shot
upward with little reference to actual or potential earnings.
During the two years 1967 and 1968, the average price of a share
of stock listed on the New York Exchange rose 40 percent, while
earnings of the listed companies rose only 12 percent. On the
American Exchange the average share price rose during the same
two years more than 140 percent on an earnings base that in­
creased just 7 percent.
A major source of the speculative ardor came from some
parts of the mutual fund industry. Long-term investment in
stocks of companies with proven earnings records became an
outmoded concept for the new breed of "go-go" funds. The
"smart money" was to go into issues of technologically oriented
firms— no matter how they were meeting the test of profitability,
or into the corporate conglomerates— no matter how eccentric
their character.
This mood of speculative exuberance strongly reinforced
the upsurge of corporate mergers which occurred during the
middle years of the 1960s. No doubt many of these mergers
could be justified on grounds of efficiency. But the financial
history of mergers— including some of the great conglomerates—
suggests that many businessmen became so preoccupied with
acquiring new companies and promoting the conglomerate image
that they lost sight of the primary business objective of seeking
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BASIS FOR LASTING PROSPERITY

larger profits through improved technology, marketing, and
management. When talented corporate executives devote their
finest hours to arranging speculative maneuvers, the produc­
tivity of their businesses inevitably suffers and so too does the
nation's productivity.
These speculative excesses had to end, and it is fortunate
that they ended before bringing disaster to our nation. Equity
values are now being appraised more realistically than a year or
two ago. Investors are now more attentive to high quality stocks.
Indeed, many of them have discovered or rediscovered that even
bonds and time deposits are a fit use of their funds. Not a few of
those responsible for the frantic search for "performance stocks"
have shifted to other activities or joined the ranks of the un­
employed; so also have numbers of security analysts and stock
brokers. With speculation giving way to longer-term investment,
the stock market is now channeling risk capital to business firms
more efficiently.
A searching reappraisal of the economic philosophy of
mergers is also under way. Merger activity has slowed materially
since mid-1969. To some degree this is a response to the grow­
ing concern in governmental circles over the dangers that may
inhere in large concentrations of economic power. But it stems
mainly from the fact that businessmen are recognizing that time
and energy can usually be spent more productively in searching
for ways to increase the economic efficiency of their firm than in
a scramble for corporate acquisitions.
Businessmen are also reconsidering the wisdom of financial
practices that distorted their balance sheets during the late
1960s. In the manufacturing sector, the ratio of debt to equity—
which had been approximately stable during the previous decade
— began rising in 1964 and was half again as large by 1970.
Liquid asset holdings of corporate businesses were trimmed to
the bone. On the average, the ratio of prime liquid assets to
current liabilities fell by nearly half during those six years. In
permitting such a drastic decline in liquidity, many of our
corporations openly courted trouble.
Perhaps the most ominous source of instability produced by
these financial practices was the huge expansion of the commer­
cial paper market. The volume of commercial paper issued by
nonfinancial businesses increased eightfold between the end of




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REFLECTIONS OF AN ECONOMIC POLICY MAKER

1964 and mid-1970, as an increasing number of firms— some of
them with questionable credit standings— began to tap this mar­
ket. The hazards inherent in the spreading reliance on commer­
cial paper were taken much too lightly. After all, the relations
between the buyer and seller of commercial paper are by their
very nature distant and impersonal— unlike the close working
relationship that normally develops between a bank and its
business customers. The buyer— typically an industrial enter­
prise— rarely has the facilities or the experience to carry out a
full investigation of the risks attaching to commercial paper.
Moreover, the buyer regards his investment as temporary— to
be withdrawn when cash is needed or when questions arise about
the quality of the paper. The issuer, therefore, faces considerable
uncertainty as to the amount of his maturing obligations that
may be renewed on any given day. The risks facing the indi­
vidual issuer and buyer inevitably pose a problem also for
the nation's financial system, since the difficulties experienced
by any large issuer of commercial paper may quickly spread
to others.
These familiar truths were lost sight of in the inflationary
aura of the late 1960s. It took the developments of last summer,
when the threat of financial crisis hung for a time over the com­
mercial paper market, to remind the business community that
time-honored principles of sound finance are still relevant.
As a result of that experience and the testing of financial
markets generally during the past two years, corporate financial
policies are now more constructive than in the recent past. This
year, new stock issues have continued at a high level— even in the
face of unreceptive markets— as corporations have sought to stem
the rise in debt-equity ratios. O f late, borrowing by corporations
has been concentrated in long-term debt issues, and their rate of
accumulation of liquid assets has risen. Liquidity positions of
industrial and commercial firms are thus improving, though it
will take some time yet to rectify fully the mistakes of the past.
These efforts to restore sound business finances are not with­
out costs to the nation. For example, long-term interest rates,
while below their peaks at the end of last year or last spring, are
still at unusually high levels because of this year's extraordinary
volume of new capital issues. But there can be no doubt that
substantial adjustments in the financial practices of our nation's
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BASIS FOR LASTING PROSPERITY

businesses were essential if the basis for a lasting and stable
prosperity was to be reestablished.
By and large, our major financial institutions conducted
themselves with prudence during the years when lax practices
were spreading in financial markets. There were, however, some
individual institutions that overextended loan commitments rela­
tive to their resources, others that reduced liquidity to unduly low
levels, still others that permitted a gradual deterioration in the
quality of loan portfolios, and even a few that used funds of
depositors to speculate in long-term municipal securities. Fortu­
nately, such institutions were distinctly in the minority. When
the chips were down, our major financial institutions- proved
to be strong and resilient. And they are stronger today. As
monetary policy has eased, the liquidity of commercial banks
has been increasing. Even so, loan applications are being screened
with greater care. The emphasis on investment quality has also
increased at other financial institutions, as is evidenced by the
recent wide spread between the yields of high and lower grade
bonds.
These corrective adjustments in private financial practices
have materially improved the prospects for maintaining order
and stability in financial markets. But no less important to the
establishment of a solid base for a stable and lasting prosperity
have been the developments this year in the management of the
industrial and commercial aspects of business enterprise.
During the latter half of the 1960s, business profit margins
came under severe pressure. The ratio of profits after taxes to
income originating in corporations had experienced a prolonged
rise during the period of price stability in the early 1960s. But
this vital ratio declined rather steadily from the last quarter of
1965 and this year reached its lowest point of the entire postwar
period.
Until the autumn of 1969 or thereabouts, the decline in
profit margins was widely ignored. This is one of the great perils
of inflation. Underlying economic developments tend to be
masked by rising prices and the state of euphoria that comes to
pervade the business community. Though profit margins were
falling and the cost of external funds was rising to astonishing
levels, the upward surge of investment in business fixed capital
continued. True, much of this investment was undertaken in the




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REFLECTIONS OF AN ECONOMIC POLICY MAKER

interest of economizing on labor costs. Simultaneously, however,
serious efforts to bring operating costs under control became more
and more rare, labor hoarding developed on a large scale, huge
wage increases were granted with little resistance, and some busi­
ness investments were undertaken in the expectation that infla­
tionary developments would one way or another validate almost
any business judgment. While the toll in economic efficiency taken
by these loose managerial practices cannot be measured with
precision, some notion of its significance can be gained by ob­
serving changes in the growth rate of productivity.
From 1947 through 1966, the average rate of advance in
output per man-hour in the private sector of the economy was
about 3 percent per year. In 1967, the rate of advance slowed
to under 2 percent, and gains in productivity ceased altogether
from about the middle of 1968 through the first quarter of this
year. The loss of output and the erosion of savings that resulted
from this slowdown in productivity growth are frightfully high.
The elimination of excess demand, which the government's
anti-inflationary policies brought about, is now forcing business
firms to mend their ways. Decisions with regard to production
and investment are no longer being made on the assumption that
price advances will rectify all but the most imprudent business
judgments. In the present environment of intense competition
in product markets, business firms are weighing carefully the
expected rate of return on capital outlays and the costs of financ­
ing. The rate of investment in plant and equipment has there­
fore flattened out, and advance indicators suggest that business
fixed investment will remain moderate in 1971.
Business attitudes toward cost controls have of late also
changed dramatically. A cost-cutting process that is more wide­
spread and more intense than at any time in the postwar period
is now under way in the business world. Advertising expen­
ditures are being curtailed, unprofitable lines of production
discontinued, less efficient offices closed, and research and devel­
opment expenditures critically reappraised. Layers of superfluous
executive and supervisory personnel that were built up over a
long period of lax managerial practices are being eliminated.
Reductions in employment have occurred among all classes of
workers— blue collar, white collar, and professional workers
alike. Indeed, employment of so-called nonproduction workers
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BASIS FOR LASTING PROSPERITY

in manufacturing has shown a decline since March that is un­
paralleled in the postwar period.
Because of these vigorous efforts to cut costs, the growth of
productivity has resumed, after two years of stagnation. In the
second quarter of this year, output per man-hour in the private
nonfarm economy rose at a 4 percent annual rate, and the rate
advanced to 5 percent in the third quarter. These productivity
gains have served as a sharp brake on the rise in unit labor costs,
despite continued rapid increases in wage rates.
In my judgment, these widespread changes in business and
financial practices are evidence that genuine progress is being
made in the long and arduous task of bringing inflationary
forces under control. We may now look forward with some
confidence to a future when decisions in the business and finan­
cial community will be made more rationally, when managerial
talents will be concentrated more intensively on efficiency in
processes of production, and when participants in financial mar­
kets will avoid the speculative excesses of the recent past.
Let me invite your attention next to the role that govern­
ment policies have played this year in fostering these and related
adjustments in private policies and practices.
The fundamental objective of monetary and fiscal policies
this year has been to maintain a climate in which inflationary
pressures would continue to moderate, while providing sufficient
stimulus to guard against cumulative weakness in economic
activity. Inflationary expectations of businessmen and consumers
had to be dampened; the American people had to be convinced
that the government had no intention of letting inflation run
rampant. But it was equally important to follow policies that
would help to cushion declines in industrial production stemming
from cutbacks in defense and reduced output of business equip­
ment, and to set the economy on a course that would release the
latent forces of expansion in our homebuilding industry and in
state and local government construction. I believe we have found
this middle course for both fiscal and monetary policy.
A substantial reduction in the degree of fiscal restraint has
been accomplished this year with the phasing out of the income
tax surcharge and the increase in social security benefits. These
sources of stimulus provided support for consumer disposable
incomes and spending at a time when manufacturing employ­




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REFLECTIONS OF AN ECONOMIC POLICY MAKER

ment was declining and the length of the workweek was being
cut back.
I do not like, but I am also not deeply troubled by, the deficit
in the federal budget during the current fiscal year. If the deficit
had originated in a new explosion of governmental spending,
I would fear its inflationary consequences. This, however, is not
the present case. The deficit in fiscal 1971— though it will prove
appreciably larger than originally anticipated— reflects in very
large part the shortfall of revenues that has accompanied the
recent sluggishness of economic activity. The federal budget is
thus cushioning the slowdown in the economy without releasing
a new inflationary wave. The President's determination to keep
spending under control is heartening, particularly his plea last
July for a rigid legislative ceiling on expenditures that would
apply to both the Executive and the Congress. However, pres­
sures for much larger spending in fiscal 1972 are mounting and
pose a threat to present fiscal policy.
Monetary policy this year has also demonstrated, I believe,
that it could find a middle course between the policy of extreme
restraint followed in 1969 and the policies of aggressive ease
pursued in some earlier years. Interest rates have come down,
and liquidity positions of banks, other financial institutions, and
nonfinancial businesses have been rebuilt— though not by
amounts that threaten a reemergence of excess aggregate de­
mand. A more tranquil atmosphere now prevails in financial
markets. Market participants have come to realize that tem­
porary stresses and strains in financial markets could be alle­
viated without resort to excessive rates of monetary expansion.
Growth of the money supply thus far this year— averaging about
a 5x 2 percent annual rate— has been rather high by historical
/
standards. This is not, however, an excessive rate for a period
in which precautionary demands for liquidity have at times been
quite strong.
The precautionary demands for liquidity that were in evi­
dence earlier in 1970 reflected to a large degree the business and
financial uncertainties on which I have already commented. It
was the clear duty of the nation's central bank to accommodate
such demands. O f particular importance were the actions of the
Federal Reserve in connection with the commercial paper market
last June. This market, following the announcement on Sunday,
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BASIS FOR LASTING PROSPERITY

June 21, of the Penn Central's petition for relief under the Bank­
ruptcy Act, posed a serious threat to financial stability. The firm
in question had large amounts of maturing commercial paper that
could not be renewed, and it could not obtain credit elsewhere.
The danger existed that a wave of fear would pass through the
financial community, engulf other issuers of commercial paper,
and cast doubt on a wide range of other securities.
By Monday, June 22— the first business day following
announcement of the bankruptcy petition— the Federal Reserve
had already taken the virtually unprecedented step of advising
the larger banks across the country that the discount window
would be available to help the banks meet unusual borrowing
requirements of firms that could not roll over their maturing
commercial paper. In addition, the Board of Governors reviewed
its regulations governing ceiling rates of interest on certificates
of deposit, and on June 23 announced a suspension of ceilings
in the maturity range in which most large certificates of deposit
are sold. This action gave banks the freedom to bid for funds
in the market and make loans available to necessitous borrowers.
As a result of these prompt actions, a sigh of relief passed
through the financial and business communities. The actions, in
themselves, did not provide automatic solutions to the many
problems that arose in the ensuing days and weeks. But the
financial community was reassured that the Federal Reserve
understood the seriousness of the situation, and that it would
stand ready to use its intellectual and financial resources, as well
as its instruments of monetary policy, to assist the financial
markets through any period of stress. Confidence was thus bol­
stered, with the country's large banks playing their part by
mobilizing available funds to meet the needs of sound borrowers
caught temporarily in a liquidity squeeze.
The role that confidence plays as a cornerstone of the
foundation for prosperity cannot, I think, be overstressed. Much
has been done over recent months by private businesses and by
the government to strengthen this foundation. If we ask what
tasks still lie ahead, the answer I believe must be: full restoration
of confidence among consumers and businessmen that inflationary
pressures will continue to moderate, while the awaited recovery
in production and employment becomes a reality.
The implications of this answer for the general course of




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REFLECTIONS OF AN ECONOMIC POLICY MAKER

monetary and fiscal policies over the near term seem to me clear.
The thrust of monetary and fiscal policies must be sufficiently
stimulative to assure a satisfactory recovery in production and
employment. But we must be careful to avoid excessive mone­
tary expansion or unduly stimulative fiscal policies. Past experi­
ence indicates that efforts to regain our full output potential
overnight would almost surely be self-defeating. The improve­
ments in productivity that we have struggled so hard to achieve
would be lost if we found ourselves engulfed once again in the
inflationary excesses that inevitably occur in an overheated
economy.
As I look back on the latter years of the 1960s, and con­
sider the havoc wrought by the inflation of that period, I am
convinced that we as a people need to assign greater prominence
to the goal of price stability in the hierarchy of stabilization
objectives. I have recommended on earlier occasions that the
Employment Act of 1946 be amended to include explicit refer­
ence to the objective of general price stability. Such a change
in that law will not, of course, assure better economic policies.
But it would call the nation's attention dramatically to the vital
role of reasonable price stability in the maintenance of our
national economic health.
At the present time, governmental efforts to achieve price
stability continue to be thwarted by the continuance of wage
increases substantially in excess of productivity gains. Unfor­
tunately, the corrective adjustments in wage settlements that are
needed to bring inflationary forces under control have yet to
occur. The inflation that we are still experiencing is no longer
due to excess demand. It rests rather on the upward push of
costs— mainly, sharply rising wage rates.
Wage increases have not moderated. The average rate of
increase of labor compensation per hour has been about 7 percent
this year— roughly the same as last year. Moreover, wage costs
under new collective bargaining contracts have actually been
accelerating despite the rise in unemployment. In the third quar­
ter of this year, major collective bargaining agreements called
for annual increases in wage rates averaging 10 percent over the
life of the contract. Negotiated settlements in the construction
industry during the same three months provided for wage in­
creases averaging 16 percent over the life of the contract, and
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BASIS FOR LASTING PROSPERITY

22 percent in the first year of the contract. Nor is the end of this
explosive round of wage increases yet in sight. Next year, con­
tracts expire in such major industries as steel, aluminum, copper,
and cans. If contracts in those industries are patterned on recent
agreements in the construction industry— or, for that matter, in
the trucking and automobile industries— heavy upward pressures
on prices will continue.
I fully understand the frustration of workers who have seen
inflation erodp the real value of past wage increases. But it is
clearly in the interest of labor to recognize that economic re­
covery as well as the battle against inflation will be impeded by
wage settlements that greatly exceed probable productivity gains.
In a society such as ours, which rightly values full employ­
ment, monetary and fiscal tools are inadequate for dealing with
sources of price inflation such as are plaguing us now— that is,
pressures on costs arising from excessive wage increases. As the
experience of our neighbors to the north indicates, inflationary
wage settlements may continue for extended periods even in the
face of rising unemployment. In Canada, unemployment has
been moving up since early 1966. New wage settlements in
major industries, however, averaged in the 7 to 8 percent range
until the spring of 1969, then rose still further. This year, with
unemployment moving above 61 percent, negotiated settlements
/z
have been in the 8 to 9 percent range.
Many of our citizens, including some respected labor lead­
ers, are troubled by the failure of collective bargaining settle­
ments in the United States to respond to the anti-inflationary
measures adopted to date. They have come to the conclusion,
as I have, that it would be desirable to supplement our monetary
and fiscal policies with an incomes policy, in the hope of thus
shortening the period between suppression of excess demand
and the restoration of reasonable relations of wages, produc­
tivity, and prices.
To make significant progress in slowing the rise in wages
and prices, we should consider the scope of an incomes policy
quite broadly. The essence of incomes policies is that they are
market-oriented; in other words, their aim is to change the
structure and functioning of commodity and labor markets in
ways that reduce upward pressures on costs and prices.
The additional anti-inflationary measures announced by the




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REFLECTIONS OF AN ECONOMIC POLICY MAKER

President last Friday will make a constructive contribution to
that end. The actions to increase the supply of oil will dampen
the mounting cost of fuels, and the recommendations made by
the President to improve the structure of collective bargaining
in the construction industry strike at the heart of a serious source
of our current inflationary problem.
I would hope that every citizen will support the President's
stern warning to business and labor to exercise restraint in
pricing and wage demands. A full measure of success in the
effort to restore our nation's economic health is, I believe,
within our grasp, once we as a people demonstrate a greater
concern for the public interest in our private decisions.
If further steps should prove necessary to reduce upward
pressures on costs and prices, numerous other measures might
be taken to improve the functioning of our markets. For exam­
ple, liberalization of import quotas on oil and other commodities
would serve this purpose. So also would a more vigorous
enforcement of the antitrust laws, or an expansion of federal
training programs to increase the supply of skilled workers
where wages are rising with exceptional rapidity, or the creation
on a nationwide scale of local productivity councils to seek ways
of increasing efficiency, or a more aggressive pace in establishing
computerized job banks, or the liberalization of depreciation
allowances to stimulate plant modernization, or suspension of the
Davis-Bacon Act to help restore order in the construction trades,
or modification of the minimum wage laws in the interest of
improving job opportunities for teenagers, or the establishment
of national building codes to break down barriers to the adoption
of modern production techniques in the construction industry, or
compulsory arbitration of labor disputes in industries that vitally
involve the public interest, and so on. We might bring under an
incomes policy, also, the establishment of a high-level price and
wage review board which, while lacking enforcement power,
would have broad authority to investigate, advise, and recom­
mend on price and wage changes.
Such additional measures as may be required can, of course,
be determined best by the President and the Congress. W hat
I see clearly is the need for our nation to recognize that we are
dealing, practically speaking, with a new problem— namely, per­
sistent inflation in the face of substantial unemployment— and
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BASIS FOR LASTING PROSPERITY

that the classical remedies may not work well enough or fast
enough in this case. Monetary and fiscal policies can readily
cope with inflation alone or with recession alone; but, within
the limits of our national patience, they cannot by themselves
now be counted on to restore full employment, without at the
same time releasing a new wave of inflation. W e therefore need
to explore with an open mind what steps beyond monetary and
fiscal policies may need to be taken by government to strengthen
confidence of consumers and businessmen in the nation's future.
In the past two years we have come a long way, I believe,
towards the creation of a foundation for a lasting and stable
prosperity. Confidence has been restored in financial markets.
Businesses have turned away from the imprudent practices of
the past. Productivity gains have resumed. Our balance of trade
has improved. The stage has been set for a recovery in produc­
tion and employment— a recovery in which our needs for hous­
ing and public construction can be more fully met.
To make this foundation firm, however, we must find ways
to bring an end to the pressures of costs on prices. There are
no easy choices open to us to accomplish this objective. But that,
as I indicated at the outset, is the tough legacy of inflation.




115




The Economy in Mid-1971

I am pleased to meet with you again today to report the views
of the Board of Governors of the Federal Reserve System regard­
ing the state of the economy at mid-year.
Since I last appeared before this committee on February 19,
it has become evident that a cyclical recovery of our economy
has commenced. Indicators of future business activity, which
were already rising in the latter part of 1970, have strengthened
further. Comprehensive measures of current activity— such as
the physical volume of industrial production, total employment,
retail sales adjusted for price changes, and total real output of
good and services— have shown moderate improvement as the
year has progressed. We are confident that this recovery process
will continue and broaden in the months to come.
Nonetheless, some of the economic problems that have
troubled us as a people over the recent past are still much in
evidence. Large increases in wages and prices persist in the face
of extensive unemployment of labor and capital. The inter­
national balance of payments remains unsatisfactory; indeed,
our fragile export surplus has disappeared in recent months.
In financial markets, interest rates are responding to fears of
continued high rates of inflation by moving up again despite
rapid monetary expansion. And while business profits have
improved somewhat, they remain exceptionally low.
The cost-push inflation we are experiencing, and the wide­
spread concern over continued rapid inflation, are a grave obstaStatement before the Joint Economic Committee of the U.S. Congress, July
2 3,1971.




117

REFLECTIONS OF AN ECONOMIC POLICY MAKER

cle to the full economic improvement we all ardently seek. As
long as inflation persists, consumers are likely to remain rather
conservative in their spending plans, fearing the possibility of
budgetary overcommitment. As long as inflation persists, busi­
nessmen are likely to remain cautious in their investment poli­
cies, apprehensive that profit margins may erode despite higher
prices. As long as inflation persists, financial investors will
remain reluctant to commit funds to long-term securities unless
they are compensated by a higher interest rate. Expectations of
inflation thus permeate the gamut of private decisions to spend
and invest, and this is restraining the private efforts needed for
vigorous and sustained economic recovery.
A year or two ago it was generally expected that extensive
slack in resource use, such as we have been experiencing, would
lead to significant moderation in the inflationary spiral. This has
not happened, either here or abroad. The rules of economics are
not working in quite the way they used to. Despite extensive
unemployment in our country, wage rate increases have not
moderated. Despite much idle industrial capacity, commodity
prices continue to rise rapidly. And the experience of other
industrial countries, particularly Canada and Great Britain,
shouts warnings that even a long stretch of high and rising un­
employment may not suffice to check the inflationary process.
I shall return to the causes and implications of this new
rigidity in our economic structure at a later point. Let me turn
first, however, to a brief review of economic developments during
the first half of 1971, and to the supportive role that public policy
has played— and will continue to play— in the evolving economic
recovery.
The performance of the economy during the first half of
1971 is not easy to interpret because many crosscurrents are
always present in the vicinity of a cyclical turning point. In
addition, the rebound from the extended auto strike last fall,
and the accumulation of steel inventories in anticipation of a
possible strike this summer, have been distorting the underlying
trend.
Abstracting from these transitory influences, the record of
the first half of 1971 is one of gradual, but quickening, recovery.
Late last year, only the construction industry exhibited significant
strength, as the sharp recovery in residential building that began
118



THE ECONOMY IN MID-1971

in the spring was joined by renewed expansion in the construc­
tion programs of state and local governments. Early this year
consumer spending began to improve, with increases of sales
spreading to a wide variety of consumer items. The sales of
retailers other than automobile dealers rose at about a 10 percent
annual rate in the second quarter— considerably more than nor­
mal and well above the rise in consumer goods prices. Recently,
activity in our factories has also been stepped up, especially in
consumer goods lines. The index of industrial production, ad­
justed to exclude autos and steel, rose at a 6 percent annual rate
between March and June.
The improving trend of business is being supported by a
faster rate of growth in personal incomes. During the three
months from March through May, total personal income rose at
an annual rate of 8 percent, compared with a 6 percent rate over
the previous six months. Governmental transfer payments, which
have been contributing to recent income growth, were particu­
larly large during June when the retroactive increase in social
security benefits was paid. The flow of private wage and salary
payments has also quickened, in response to some gain in manhours worked as well as to continued large increases in wage
rates. And while employers have not yet reentered the labor
market for appreciable numbers of new employees, further busi­
ness improvement should soon lead to faster employment growth
also.
Inventory investment promises to supply an added source
of economic impetus in the months ahead, after allowance for a
probable rundown in steel stockpiles. Thus far in the recovery,
there has been little accumulation of inventories, apart from the
restocking by automobile dealers and strike-hedge buying by
steel merchants and users. But with business sales rising, and
the ratio of inventories to output and to sales declining in many
lines, we are coming closer to the time when needs for larger
inventories— of raw materials, work in process, and finished
goods— will begin to express themselves. The adjustment of
stocks to higher levels of activity will in turn generate further
increases in output, employment, and incomes. This is a com­
mon element in cyclical recoveries, and I judge that we are
approaching that point in the current recovery process.
There are grounds for concern, nonetheless, with regard to




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REFLECTIONS OF AN ECONOMIC POLICY MAKER

some features of the recovery now under way. First, there is
little evidence as yet of any material strengthening in consumer
or business confidence. Recent surveys of consumer attitudes
show only modest improvement, while uneasiness appears to
persist among many businessmen and investors regarding the
effects of continuing rapid increases in labor costs on future
profitability. Confidence is likely to strengthen with the passage
of time, as sales and employment conditions improve. But there
is a danger that hesitation and uncertainty will continue on an
extensive scale until significant progress is made in moderating
inflation. Greater success in the battle against inflation is prob­
ably the most important single prerequisite of more rapid and
enduring economic expansion.
Second, our international competitive position appears to
have deteriorated. In the first five months of 1971, imports
spurted and our normal trade surplus vanished. This is a dis­
tressingly poor performance in an economy experiencing sub­
stantial underutilization of its resources of labor and capital. The
problem is dramatized by the success of foreign manufacturers
in capturing a rapidly expanding share of our automobile market.
In the past six months, sales of foreign models have accounted
for 16 percent of total U.S. sales and, in addition, close to onetenth of the American models sold were produced in Canada.
It may be tempting to react to foreign competition by imposing
added restrictions and quotas on imports, but such a policy
would not serve our national interests. The constructive course
is to bring inflation under control and to stimulate our business­
men to increase their penetration of the expanding markets
abroad and to compete more effectively with foreign producers
in our domestic markets. I would favor consideration of new
government incentives toward this end.
Third, there is as yet no evidence of resurgence in business
capital spending programs. New orders for capital equipment
show little— if any— recovery from the 1970 lows when allow­
ance is made for rising prices. Construction contract footage for
commercial and industrial buildings remains far below earlier
highs. Official surveys of business spending plans for plant and
equipment show no increase, even in dollar terms, for the re­
mainder of this year. The hesitation in business investment may
reflect the sizable amounts of unused capacity that presently
120



THE ECONOMY IN MID-1971

exist. But it also results, I believe, from low business profits and
uncertainty about the profit outlook. History indicates rather
clearly that a vigorous, sustained economic recovery requires a
strengthening trend in business capital investment.
We need to encourage business firms to undertake new
capital investment; and I strongly supported, therefore, the lib­
eralization of depreciation allowances recently adopted by the
Treasury. I have also endorsed the general proposition that an
investment tax credit be adopted permanently. At the moment,
however, I am doubtful about the wisdom of restoring the invest­
ment tax credit— or of taking other stimulative fiscal actions—
in view of the state of the federal budget. In the fiscal year just
ended, the budget deficit was in excess of $20 billion. It will
remain very large in fiscal 1972. Many influential citizens in the
business and financial community view this situation with alarm,
so that these large budget deficits have become an important
psychological factor contributing both to inflationary expecta­
tions and to high interest rates.
A large part of the budget deficit is, of course, attributable
to the shortfall in tax receipts stemming from sluggishness in the
economy. Some expenditures, notably on unemployment insur­
ance and welfare, have risen for this same reason. Even taking
these factors into account, however, the federal budget is more
stimulative now than a year or two ago. The President sub­
mitted in January a moderately expansive budget for fiscal 1972,
and since then the net effect of congressional actions has been
to make it more stimulative. Social security benefits have been
liberalized, retroactive to the first of the year, and the scheduled
increase in social security taxes postponed for a year. The public
service employment bill has become law, and it appears probable
that the military pay raise bill will be larger than the budget
proposals. These and other actions, along with increases in the
so-called uncontrollable items in the budget, as Chairman Mc­
Cracken reported to you, have served to raise estimated expendi­
tures $5 billion above those originally proposed for fiscal 1972,
and to reduce estimated receipts by some $2 billion.
I would not want to rule out additional fiscal stimulus if the
recovery in the economy should prove to be well below normal
proportions, particularly if such a move were preceded or accom­
panied by a more effective incomes policy. But I would urge




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REFLECTIONS OF AN ECONOMIC POLICY MAKER

caution at the present time. Once confidence becomes stronger,
we may find that there is enough fiscal stimulus already at work.
And in any case, the fear of inflation is much too great, and its
potential effect on private behavior too negative, to run the risk
of taking new fiscal actions that would now seem imprudent.
Let me turn next to monetary policy, and to the substantial
contribution it has made to stimulating economic activity over
the past year.
The shift toward monetary expansion early in 1970 was
rather promptly followed by a resurgence in bank deposits and
in the flow of funds to other financial intermediaries. As finan­
cial institutions rebuilt their liquidity, they became more eager
lenders, the availability of credit increased greatly, and interest
rates declined. As a result, housing starts rebounded and state
and local government construction began to rise more briskly.
More receptive credit markets also enabled our business cor­
porations to issue new securities in record volume, thereby re­
building their liquidity and putting themselves in a financial
position to expand production and the capital investment that
they may wish to carry forward later on.
Late last year, as this committee knows, there was a marked
decline in the rate of expansion of the narrowly defined money
supply— that is, currency plus demand deposits. In these cir­
cumstances, a brief period of more rapid expansion in the money
supply to compensate for the fourth quarter shortfall seemed
appropriate. The System, consequently, provided bank reserves
liberally over the winter months, and interest rates— partly re­
flecting the increased supply of reserves— declined sharply fur­
ther. Expansion of the narrowly defined money supply rose to
a 9 percent annual rate during the first quarter of this year; but
the average growth rate for the fourth and first quarters com­
bined, being little more than 6 percent, remained very close to
the earlier trend in 1970.
This March and April, the Federal Reserve System faced a
dilemma. Information available at that time suggested that high
rates of monetary growth might well persist under existing con­
ditions in the money market. Interest rates, however, were
already displaying a tendency to rise, and vigorous action to
restrain monetary growth might have raised them sharply fur­
ther. In view of the delicate state of the economic recovery,
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THE ECONOMY IN MID-1971

which was just getting under way, it seemed desirable to prevent
the possible adverse effects of sharply higher interest rates on
expenditure plans and public psychology. The Federal Open
Market Committee decided, therefore, to move very cautiously
toward restraining the growth of the monetary aggregates.
With the benefit of hindsight, I now feel that stronger action
was warranted this spring. For, as matters turned out, we
experienced even faster monetary growth in the second quarter
than had been anticipated, while interest rates also moved sub­
stantially higher. Present estimates indicate that the narrowly
defined money supply rose at an annual rate of 11 percent in the
second quarter. However, growth in a more broadly defined
money supply— that is, currency, plus demand deposits, plus
commercial bank time deposits other than large denomination
CDs— receded from an annual rate of 18 percent in the first
quarter to a rate of 13 percent in the next three months. It is
worth noting also that bank credit expansion has been consider­
ably more restrained than growth in any of the measures of the
money supply. Total bank credit rose at a 12 percent annual
rate during the first quarter and then dropped to a 7 percent rate
in the second.
It may be that the recent high growth rates in money bal­
ances, besides being a lagged response to the lower interest rates
of this past winter, reflect some of the uncertainties of the gen­
eral public about the economic situation. To the extent that this
is true, the inclination to hold unusually large money balances
should subside as economic recovery becomes more evident. In
any event, it is clear that recent monetary growth rates are
higher than is necessary or desirable over any length of time to
sustain healthy economic expansion. The Federal Reserve has,
therefore, already taken some steps to reduce the growth rate of
bank reserves and thereby promote a more moderate rate of
monetary expansion.
These actions are partly responsible for the recent rise in
interest rates— particularly interest rates on very short-term
market securities. But it should be kept carefully in mind that
the rise in interest rates since March has occurred despite rapid
rates of monetary growth and continuing large flows of savings
funds to depositary institutions. Factors other than monetary
policy must therefore be primarily responsible for the upturn in




123

REFLECTIONS OF AN ECONOMIC POLICY MAKER

interest rates this spring; they include, in addition to indications
that a business recovery is developing, the prospect of very large
Treasury financing needs, deepening concern about the unrelent­
ing character of cost-push inflation, some apprehension over in­
ternational financial developments, and not a little anticipatory
borrowing in the capital market on top of that currently needed.
The fear of inflation appears to have been especially important
in the recent behavior of our money and capital markets, and a
reversal of psychology may well be required to achieve a signifi­
cant downward adjustment of interest rates.
The rise in short-term interest rates during recent months
had the effect of putting the Federal Reserve discount rate, which
had been reduced in a series of actions to 4% percent last Febru­
ary, well below the rates at which funds could be obtained by
banks in the open market. The effect of this discrepancy in rates
was to encourage member bank borrowing from the Reserve
Banks— borrowing which was rising rapidly and thereby pro­
viding reserves to support continued high rates of monetary
expansion.
Accordingly, as you know, the Board last week approved
increases in Federal Reserve Bank discount rates to 5 percent by
a unanimous vote of the five Board members present at the meet­
ing. I participated by telephone in the discussion leading to this
action, and I want you to know that I supported it fully. Our
hope is that the higher discount rate will serve to moderate the
demand for discounting at the Federal Reserve, that it will help
prevent excessive growth of the monetary aggregates, and also
impart a degree of stability to interest rate expectations.
I continue to feel that the country needs lower interest
rates, and that lower rates—especially on mortgages and state
and local government securities— would contribute to a more
vigorous economic recovery. But I am not hopeful that substan­
tially lower interest rates can be achieved— until we as a nation
make steady and meaningful progress in solving our inflation
problem.
The inflation we are confronted with has become deeply
rooted since its beginnings in 1965. The forces of excess demand
that originally led to price inflation disappeared well over a year
ago. Nevertheless, strong and stubborn inflationary forces,
emanating from rising costs, linger on. I wish I could report
124



THE ECONOMY IN MID-1971

that we are making substantial progress in dampening the infla­
tionary spiral. I cannot do so. Neither the behavior of prices
nor the pattern of wage increases as yet provides evidence of any
significant moderation in the advance of costs and prices. If
growth in productivity accelerates with a quickening economy,
some real moderation may well develop in the months ahead.
Even so, the residual rate of inflation may well run above the
characteristic level of previous cyclical upswings.
Let me cite some of the evidence that leads me to this view.
Thus far in 1971, prices of newly produced goods and services
in the private economy are still rising, on the average, at about
a 5 percent annual rate— or at essentially the same rate as in
1969 and 1970. The rate of advance of consumer prices did
diminish conspicuously during the first five months of 1971, but
most of this improvement is attributable to the decline in mort­
gage interest rates. The wholesale price index for all commodi­
ties has increased at an annual rate of 5 percent thus far this
year, or twice last year's rate. Wholesale prices of industrial
commodities, moreover, have accelerated from a 2>Vz percent
increase last year to a 4 percent rate thus far in 1971.
Much the same picture emerges from a review of changes
in wages and salaries— by far the most important component of
business costs. Wages in the private nonfarm economy, adjusted
for changes in industrial composition and for overtime work,
rose at about a 7 percent annual rate in the first half of 1971—
slightly more than in 1970 or 1969. This sustained sharp rise in
wages during a period of substantial economic slack contrasts
markedly with our experience in earlier recessions, when the rate
of advance in wages typically dropped sharply or actually ceased.
Nor is the picture more encouraging when one inspects the
trend of new agreements reached in major collective bargaining
settlements— agreements which tend to establish wage trends
throughout industry. The wage increases agreed to, for example,
in the automobile, can and aluminum settlements, and most
recently by AT&T, amount to 12 percent or more for the first
year. The full extent of the increase contracted for later years is
not yet known, since it will depend in part on the speed of
future advances in the consumer price index.
It is important to inquire into the reasons for this unusual
behavior of wages and salaries. The answer is doubtless com-




125

REFLECTIONS OF AN ECONOMIC POLICY MAKER

plex, involving a myriad of structural, psychological, and social
changes. Ironically, our national commitment to high employ­
ment and economic prosperity, and our relative success in achiev­
ing these objectives, accounts for part of the problem. For a
general expectation has developed on the part of both business
and labor that recessions, if they occur at all, will prove brief
and mild; and this expectation has influenced both the strength
of wage demands and the willingness of management to accept
them.
A second factor contributing materially to the sustained
character of wage rate increases in the current situation is the
intensity and duration of the previous phase of excess demand.
Consumer prices have been rising steadily since 1965— much of
the time at an accelerating rate. Continued substantial increases
are now widely anticipated over the months and years ahead. In
such an environment, workers naturally seek wage increases
sufficiently large to compensate for the effects of past inflation
on their real incomes, and to give some protection against future
price advances— besides providing for a measure of improve­
ment in living standards. Thoughtful employers are bound to
have some sympathy with these efforts, all the more so when
they reckon— as they now generally do— that cost increases can
probably be passed on to buyers grown accustomed to inflation.
Other factors too have been at work. The increased mili­
tancy of workers, whether union or nonunion and whether in
private or public service, has probably led to wider and faster
diffusion of excessive wage rate increases through the economy.
I cannot help but wonder, also, whether our recent experience
with wage settlements in unionized industries may not reflect a
gradual shift in the balance of power at the bargaining table.
Labor seems to have become more insistent, more vigorous,
and more confident in pursuing its demands, while resistance of
businessmen to these demands appears to have weakened— per­
haps because they fear the loss of market position that would be
caused by a long strike or because they believe that their com­
petitors too will give in to similar wage demands. More recently,
the balance of power— so important to the outcome of wage
bargaining— may have been influenced by expansion in the
public welfare programs which can be called upon to help
sustain a striking employee and his family, valid though these
126



THE ECONOMY IN MID-1971

programs may be on social grounds. And the hand of labor may
have been strengthened also by the evident success that public
sector employees have had in recent years in winning large wage
increases, frequently with the use of illegal strikes against the
government.
In my judgment, and in the judgment of the Board as a
whole, the present inflation in the midst of substantial unem­
ployment poses a problem that traditional monetary and fiscal
remedies cannot solve as quickly as the national interest de­
mands. That is what has led me, on various occasions, to urge
additional governmental actions involving wages and prices—
actions that would serve, by moderating the inflationary trend,
to free the American economy from the hestitations that are
now restraining its great energy.
There has been some progress in this area over the past
year or two. The President deserves credit for his efforts to deal
with the special supply-demand problems that had developed in
the lumber and petroleum industries, and for bringing together
labor and business leaders in the steel industry for a discussion
of basic economic issues at the outset of the current wage nego­
tiations. The Construction Industry Stabilization Committee,
formed earlier this spring, appears to be having some success in
moderating the staggering trend of wage settlements in that
industry. The periodic Inflation Alerts serve a useful function
in stimulating public discussion of areas in which wage or price
decisions do not seem to conform to economic fundamentals.
And the National Commission on Productivity may yet provide
the basis for important improvements in the cost trends of our
economy.
In the Board's judgment, these efforts need to be carried
further— perhaps much further. The problem of cost-push infla­
tion, in which escalating wages lead to escalating prices in a
never-ending circle, is the most difficult economic issue of our
time. It needs to be given top priority by our business and labor
leaders as well as by the government. There is much good will
and statesmanship in the ranks of business and labor, and it
would be wise for the government to draw upon it more fully.




127




The New Committee on
Interest and Dividends

I appreciate the opportunity to participate in your discussion of
H.R. 11309. This bill, besides extending the Economic Stabiliza­
tion Act, brings interest rates and dividends under its umbrella
of potential controls. I therefore appear before you in my capac­
ity as Chairman of the new Committee on Interest and Dividends.
Let me say, at the outset, that the most urgent economic
task facing our nation is to make a success of the stabilization
program initiated by the President on August 15.
The current price and wage freeze is a major step in break­
ing the hold of inflation on our country. The freeze must be
followed by effective restraints on the upward movement of
wages and prices, so that a solid foundation may be laid for the
early restoration of general price stability under free market
conditions.
This high objective will require unreserved, continuing sup­
port of business, labor, and the population as a whole. It will
require the support of sound fiscal and monetary measures. And
it will entail the extension and amendment of the Economic
Stabilization Act to assure continuity of the new policy.
As Phase II of the wage and price policy gets under way,
one of our major assets is the wide public acceptance of Phase I.
If this early success is sustained, which I consider likely, confi­
dence will grow that full prosperity can be attained without infla­
tion. Under those conditions, we can expect business and conStatement before the Committee on Banking and Currency, House of Rep­
resentatives, November 1, 1971.




129

REFLECTIONS OF AN ECONOMIC POLICY MAKER

sumer spending to continue to increase; we can expect wage
demands to moderate; and we can expect further reduction of
the inflation premium built into interest rates.
Before turning to the mission of the Committee on Interest
and Dividends and its relationship to Phase II, I should like to
make a few broad observations on the economic setting which
launched our nation on its stabilization policy of mid-August.
Over the past two years, strong cost and price pressures had
persisted in the face of rather sluggish demand for goods and
services, a high rate of excess plant capacity, and more extensive
unemployment than the American people will long accept. In
part, the cost pressures stemmed from efforts by workers and
their trade unions to compensate for the eroding impact of past
price increases on their real earnings. But they also reflected the
efforts of labor to anticipate future price increases. Both labor
and management came to expect that inflation would persist, and
that it might become our way of life. In this environment, labor
typically demanded large wage increases, and business firms
typically met these demands in the belief that higher costs could
be passed on in the form of higher prices.
As the pace of inflation quickened, expectations of continu­
ing inflation began to dominate economic decision making. Be­
tween mid-1970 and mid-1971, average hourly compensation
of workers in the private economy rose from 7 to 8 percent.
Major collective bargaining contracts negotiated over the same
period called for first-year increases averaging 11 percent, while
increases over the life of the contracts— without considering
future advances under cost-of-living escalators— were to average
over 8 percent per year.
Wage increases of this magnitude outstripped productivity
gains by a wide margin, and made price advances inevitable.
Even so, profit margins shrank, and during 1970 reached the
lowest level experienced in the post-World War II period. The
declining trend in profits, of course, intensified pressure on busi­
ness firms to raise their prices.
The wage-price spiral that had developed threatened our
economic recovery, which rested much too heavily on residential
building. Businessmen showed little enthusiasm for new capital
investment. Consumers were likewise cautious in their buying
and permitted their savings to mount. Moreover, foreign pro130



COMMITTEE ON INTEREST AND DIVIDENDS

ducers had become more successful, both here and abroad, in
competing against domestically produced goods. In consequence,
our balance of trade swung into a virtually unprecedented deficit,
and this too affected adversely our domestic production and
employment.
Inflationary expectations were also tending to retard declines
in long-term interest rates. The easing of monetary policy that
began in early 1970 led to a very sharp decline in short-term
interest rates. For example, the three-month Treasury bill rate
dropped from 8 percent to about 3 1 percent by March 1971, its
A
most recent low. Over roughly the same period, yields on highgrade new corporate bond issues declined from sV i percent to
only around 7 percent. The unusually wide spread that devel­
oped between long and short interest rates reflected in large part
the inflation premium that buyers of long-term securities de­
manded and borrowers were willing to pay.
Monetary and fiscal policies, meanwhile, had gone about as
far as was prudent in the circumstances. The money supply was
growing rapidly. Banks and other financial institutions were
amply supplied with funds. The deficit in the federal budget
was already large and still increasing. The liquidity of business
firms was largely restored. In this situation, additional stimula­
tive efforts would have run the serious risk of augmenting infla­
tionary fears, thereby threatening more hestitation by business
and consumers, still higher long-term interest rates, higher prices,
and further deterioration of the balance of payments.
In this state of our national economy, more and more
thoughtful citizens became convinced that an incomes policy was
temporarily needed to speed the transition from rapid inflation
to general price stability. Properly executed, such a policy could
change the psychological climate, help to rein in the wage-price
spiral, squeeze some of the inflation premium out of interest
rates, and improve the state of confidence sufficiently to lead
consumers and business firms to spend more freely out of the
income, savings, and credit available to them. Thus the nation
was in a mood to respond favorably when President Nixon
announced his new wage-price policy, as a part of a comprehen­
sive plan for orderly economic growth, embracing also taxes,
expenditures, and our international trade and payments balance.
It is, of course, too early to speak with certainty about the




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REFLECTIONS OF AN ECONOMIC POLICY MAKER

degree to which the new economic program has changed the eco­
nomic climate. But the available information suggests that dur­
ing the period of the freeze it has been working in the right
direction.
The freeze appears to have effectively halted the spiral of
prices and wages. Average hourly earnings in the private sector
of the economy leveled off in September. Wholesale prices
actually declined. And the consumer price index, which moder­
ated to an annual rate of rise of 2 V2 percent, would probably
have shown even greater improvement with more precise mea­
surement techniques.
The new mood of confidence in our nation's ability to con­
trol inflation has also led to reductions in interest rates. Since
mid-August long-term market interest rates have come down
three-fourths to one percentage point, while short-term market
rates have declined about one-half to three-fourths of a per­
centage point.
In the meantime, signs of improvement in economic activity
have been gradually gaining. Figures for September show a good
expansion in retail sales, with automobile sales particularly
strong. Industrial production rose. And employment increased
sharply, with gains widespread among various industries. Con­
tracts for commercial and industrial construction spurted. How­
ever, orders for business capital equipment have thus far re­
mained sluggish.
Once the economic recovery gathers momentum, we can
expect the nation's unemployment problem to be substantially
alleviated. To assure this outcome, we must maintain and extend
the psychological and real benefits gained during the past two or
three months.
The period of the freeze will soon be followed by a more
flexible program of wage and price restraints. The objective of
policy is to bring the rate of increase in the general price level
down to 2 to 3 percent by the end of 1972. This would represent
a cutting in half of the recent inflation rate, and would be a
major accomplishment.
This objective must not be compromised. If we succeed,
our economy will be once again on a path leading to noninflationary growth, and we may therefore look forward to a bright
economic future. If, however, we fail, our economy will suffer
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grievously— not only next year but also in later years.
The actual outcome will depend crucially on the practical
wisdom of the new Pay Board and Price Commission. They
will be subject to many pressures for wage and price adjustments
on equity grounds, for reasons of catch-up or comparability.
These may be particularly intense in the period immediately
following the outright freeze. Still, over the longer run, as the
wage-price program of Phase II takes hold, it is essential to our
nation's future that overall wage and price adjustments be con­
tained within the reasonable limits set by the President and his
Cost of Living Council.
Let me turn now more directly to the subject of interest
rates and the role of the Committee on Interest and Dividends.
Since inflation has exercised a significant influence on interest
rates in recent years, it seems clear that the future of interest
rates will depend heavily on the success of the wage and price
program. If telling progress is made in curbing advances in the
price level, as can be reasonably expected, the inflation premium
built into the interest rate structure over the past few years will
be appreciably reduced. However, this premium will not be
eliminated immediately; the inflationary attitudes that developed
over the past half-dozen years will retreat only gradually as
success in the struggle against inflation is demonstrated.
As I noted earlier, we have already experienced some re­
duction of interest rates in consequence of the initial reaction
of borrowers and lenders to the new economic program. Further
declines in the months ahead are probable if wage and price
pressures are visibly curbed. Once businessmen come to believe
that interest rates are not destined to move ever higher in the
future, long-term credit demands from corporations— which have
been very large in the past year and a half— are likely to abate.
When key market interest rates— such as corporate bond yields
— continue to decline, the downward pressure exerted on the
rate structure can be expected to work through to other, less
volatile areas, such as the rates charged by lenders on mortgage
and consumer loans.
We have to recognize, however, that as the pace of economic
recovery accelerates, new demand pressures on interest rates
will be generated. As one looks across the history of business
cycles, it is clear that interest rate movements have accompanied




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fluctuations in aggregate economic activity. Although the move­
ments of interest rates and economic activity have not corre­
sponded exactly in either timing or amplitude, it is reasonable to
expect that economic expansion will— sooner or later— begin to
generate credit demands in excess of supply, just as economic
contraction in time dampens the demand for credit relative to
the available supply.
The interest rate fluctuations that correspond to such demand-supply imbalances serve an essential economic purpose.
For example, when the demand for goods and services races
ahead of existing supplies, increases in interest rates help to
limit the expansion of credit and thus check the upward pressure
on product and labor markets.
In a period of strong economic activity, if all the credit
desired were supplied at unchanged interest rates, the overall
demand for goods and services would inevitably exceed the
nation's capacity to produce. In such conditions, inflation could
perhaps be suppressed for a time by rigid economic controls;
but— if history over the centuries is any guide— I doubt if any­
thing in the world could prevent the eventual riot of inflation.
Nor would we control interest rates in the end. Once it became
clear that inflation was footloose, higher and higher premiums
would be attached to the interest rates on which investors in­
sisted and which borrowers were willing to pay. It is no accident
that interest rates on six-month business promissory notes
have run to over 20 percent in Argentina and over 40 percent in
Brazil during the past few years.
The new economic policy, as I have already explained, is
capable of releasing powerful psychological forces that will tend
to drive interest rates to lower levels. The outlook for interest
rates over the next year or so nevertheless remains uncertain.
We cannot be sure how quickly or to what extent the inflation
premium on interest rates will be reduced. If economic recovery
gains momentum and the Phase II program succeeds in holding
down wage and price increases, opposite forces will be at work
in the money and capital markets. On the one hand, the demand
for credit on the part of the private sector will be larger, thereby
tending to raise interest rates. On the other hand, inflationary
expectations will become weaker, thereby tending to lower in­
terest rates. We are moving into a period for which there is
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no historical precedent, and little basis for gauging exactly how
credit markets will adapt to the new circumstances.
The Committee on Interest and Dividends will need to
tread cautiously in these circumstances. It cannot ignore market
conditions, for it would then run the risk of thwarting the over­
riding national objective of economic recovery and sustained
noninflationary growth. At the same time, the committee can
and should undertake surveillance of interest rates, particularly
those that most directly affect the American family, in order to
determine if they are unduly sticky— that is to say, by way of
example, whether they are adjusting appropriately to whatever
declines occur in the more flexible and competitive market in­
terest rates.
In evaluating the role of the committee, it should be
recognized that credit markets are among the most competitive
in our entire economy. Large financial institutions are, of course,
a fact of modern economic life; but no single institution, or small
group of them, is capable of dominating the market for credit,
partly because there are so many of both the large and small
institutions. Moreover, the money and capital markets in the
various parts of our country are closely connected. In this age
of the automobile and telephone, most borrowers can readily
move from one financial institution in their vicinity to another,
or— in the case of large, nationally known borrowers— from
virtually .any bank or insurance company in the nation to any
other or from any of these institutions to the open market. In
turn, many financial institutions can shift their lending from
one market to another, depending on the rate of return available
to them. The same is true of savers.
The result is that the level of interest rates is highly re­
sponsive to changes in the underlying demand-supply conditions
for credit. The structure of interest rates is also responsive.
When interest rates in one part of the market decline, interest
rates in other parts of the market generally follow along, al­
though sizable variations in interest rate spreads are not un­
common.
The price flexibility that is so characteristic of financial
markets is rarely found in product markets and practically never
occurs in labor markets. These latter markets are subject to
all sorts of rigidities. Competition is less pervasive. Some of




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our industries are dominated by a few large firms. Large seg­
ments of the labor market are fenced off from effective com­
petition by trade unions or governmental regulation. Even in
the absence of unions, employee demands derive support from
the impracticability, in most cases, of assembling a substitute
labor force. Most product and labor markets are thus less
sensitive than is the world of finance to changes in underlying
demand and supply conditions.
To illustrate these differences, we need only recall the
substantial decline in interest rates, particularly short-term
rates, that occurred from early 1970 to mid-1971. During this
period, wholesale prices, consumer prices, and wage rates con­
tinued to rise sharply, despite substantial unemployment and
sluggish demand for the products of industry. Clearly, interest
rates responded with promptness and vigor to basic market
conditions. This cannot be said of wages or most product prices.
However, it is important to recognize that not all credit
markets are equally competitive or responsive, and that some
types of interest rates move sluggishly. These rates are often
termed "administered rates" or "conventional rates," but they
are not administered in the sense of being determined by a small
group that is insensitive to the surrounding financial environ­
ment. Rather, they are rates for which a continuous, impersonal
process of bidding in the open market, such as characterizes U.S.
government securities and corporate bonds, does not exist.
The so-called administered rates— for example, on residen­
tial mortgages, for consumer credit, and on loans to businesses
and farmers— generally fluctuate over a narrower range than
market rates. These sluggish rates involve such factors as
longer-term customer relationships or substantial costs of ad­
ministration. Hence, they also generally lag behind the market;
that is, they may not move until it seems clear that market rates
have established a new trend and are not just going through an
erratic or episodic fluctuation.
It is at this point that the new committee can make its
contribution. The main role of the committee, as I see it, should
be to speed up the adjustment of traditionally sluggish interest
rates to movements in market rates. This may be especially
important in the year ahead, when we expect a further reduction
in the inflation premium on interest rates. When and as rates
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COMMITTEE ON INTEREST AND DIVIDENDS

in the open market move downward, administered rates should
move more and with shorter lags than they have in the past.
For the present, the committee intends to concentrate on
those interest rates that most directly affect the American family,
including residential mortgage and consumer credit rates. But
it is not unmindful of other areas of sluggishness, and will there­
fore watch the behavior of rates charged by a variety of in­
stitutions to a broad range of customers.
In recent years, some of the "administered" or "conven­
tional" interest rates have tended to show greater flexibility.
For example, the prime loan rate charged by banks was reduced
eleven times between March 1970 and March 1971, declining
from 8V2 to 5Va percent. It subsequently rose moderately, and
most recently, as you know, has again declined. Major banks
have been relying increasingly on the money market as a source
of funds, and interest-rate changes in the money market conse­
quently have a greater influence on key bank lending rates.
Moreover, the business customers of commercial banks have
become more and more aware of the open market as a source
of funds; this, too, has increased the flexibility of bank lending
rates. Recently, a few banks have indicated that they intend
to tie the prime rate to one or another of the open market rates.
Mortgage rates are also becoming more sensitive to com­
petitive conditions. The periodic auctions by the Federal Na­
tional Mortgage Association provide a means by which lenders
can gauge more promptly the extent to which supply and demand
pressures in the broad capital market are affecting the mortgage
market. And the information on interest rates that will be
gathered by the Committee on Interest and Dividends, once it is
disseminated throughout the country, should likewise help to
increase the sensitivity of a wide variety of sticky rates to
underlying conditions.
In evaluating interest rate developments, the committee
does not intend to try to hold particular rates at levels that are
not competitive. If, in the face of accelerating credit demands,
an attempt were made to keep some interest rates down through
the use of rate ceilings, lenders would tend to withdraw from
the affected markets. They would place their funds in other
activities where the returns that could be earned were not con­
trolled, including the equity markets. Or they would send their




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money abroad. Or some individuals, trust funds, and so forth
would lend their funds directly to borrowers within their reach,
bypassing the financial institutions and the organized security
markets that play such a major role in our economy by mobiliz­
ing capital for the use of all borrowers, small and large alike.
Let us never forget that while a legislature may impose
an interest ceiling, it has no way of compelling the owner of
investable funds to lend them out to anyone. Indeed, the threat
posed by ceilings might in itself be sufficient to keep lenders
from committing resources to areas that may eventually become
subject to rigid ceilings.
O f course, some banks or other financial institutions could
be expected, whether because of custom or legal restriction, to
continue lending in markets subject to interest ceilings that are
below the free market level. But the supply of credit to such
markets would then be reduced, so that the still active lenders
would be forced to ration their short supplies of credit by some
means other than interest rates. In such a situation, they could
also be expected to use various nonrate devices— such as com­
pensating balances, cash payments similar to points on a mort­
gage, special fees, or equity kickers— that would serve to en­
hance the return on their money. The result would surely be
an erosion of freely functioning credit markets as we now know
them, and the substitution of less efficient, less equitable proc­
esses of allocating the supplies of credit that remained available.
Arbitrary attempts to control interest rates, either in selected
areas or for the economy as a whole, must be rejected as in­
efficient, inequitable and, in the end, unworkable for all
concerned.
True, some interest rates are now legally prevented from
moving in ways that accord with underlying demand and supply
conditions. Interest-rate or usury ceilings apply, for example,
to rates on consumer and conventional mortgage loans in most
states, to rates on state and local securities in some jurisdictions,
and to rates on federally underwritten mortgages. In the past
such ceilings have limited the flow of credit to these areas in
periods of rising market interest rates; they represent a type of
impediment that it would be well to avoid in the future.
The legislation before your committee empowers the presi­
dent "to stabilize interest rates and dividends at levels consonant
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COMMITTEE ON INTEREST AND DIVIDENDS

with orderly economic growth/' This language has the great
advantage— should mandatory controls be required— of not
implying fixed ceilings; instead, it recognizes that interest-rate
levels must be appropriate to orderly economic growth, and
thus leaves room for essential flexibility.
Let me hasten to add that the President's Executive Order,
dated October 15, directs the committee to undertake a volun­
tary program; that is, to "formulate and execute a program for
obtaining voluntary restraints on interest rates and dividends."
I am confident that this objective can be achieved without
resorting to mandatory controls.
Since August 15, indeed over the past year and a half,
interest rate developments have been generally salutary. How­
ever, not all interest rates have responded fully to market de­
velopments, and some have hardly moved at all. The committee
will seek to encourage downward adjustment of these rates, and
it would certainly frown upon any premature upward move of
rates that had previously been sluggish in moving down. There
is every reason to believe that banks and other lenders will co­
operate in our program on a voluntary basis, just as business
corporations have fully accepted on a voluntary basis the need
to hold dividend payments unchanged during the period of the
freeze.
Nevertheless, the legislation before you does provide
standby authority to control interest rates and dividends in the
unlikely event that the voluntary program proves unsuccessful.
The authority is comparable to that already granted the president
with respect to prices, rents, wages, and salaries. "Stabilization"
of interest rates in the legislative context refers, of course, to
the regulation of particular interest rates. It does not relate to
general fiscal and monetary policies, which must continue to
play a vital independent role in our economic stabilization efforts.
I need add only a word here about dividends, which repre­
sent a less troublesome problem than interest rates in the con­
text of a wage-price program. In general, the committee believes
that increases in dividends during the Phase II period should
be limited in such fashion that expansion of dividend income will
be equitably related to increases in the incomes of wage earners.
Some exceptions may, of course, be necessary to facilitate the
raising of capital for expansion, particularly by small businesses.




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REFLECTIONS OF AN ECONOMIC POLICY MAKER

The details of the voluntary program with respect to dividends
have not yet been worked out. Meanwhile, the committee has
asked that dividends be maintained at levels that accord with the
guidelines of the Cost of Living Council.
As I have said earlier, success in reducing the inflation
premium built into interest rates will depend, ultimately, on
the strength of our national will. It will depend on our ability
to restrain the growth in average wage rates to a pace that is
appropriately related to national productivity gains. It also will
depend on reasonable price restraints. The full support and
cooperation of business, labor, and the general public will be
required in order to reach the objective of cutting the inflation
rate in half by the end of. 1972.
It is highly important to bear in mind that the whole
program of restraint on wages and prices represents a temporary
effort aimed at speeding the return to noninflationary conditions
in a free economy. This goal requires that we conduct fiscal
and monetary policies so as to avoid setting in motion forces
that would lead to excessive aggregate demand on our resources
and trigger still another round of inflation. Only if all of the
policy instruments available to the government are working
in harmony can the present anti-inflation policy succeed. Only
then will interest rates move down to the more normal levels
that we would all like to see.
Finally, let me say that it would be wise to use the
opportunity granted us by Phase II to ponder dispassionately
why our economy has become so prone to inflation, and why
the fires of inflation, once started, are so difficult to extinguish.
Has the structure of our economy changed so as to impart an
increasing bias toward inflation? Are business or labor groups
abusing their economic power to a larger degree than they did
ten, twenty, or thirty years ago? If so, to what degree are our
laws or regulations responsible for such abuses? Why did the
normal growth of productivity come to a virtual halt toward
the end of the 1960s? How can our governmental training
programs, on which vast sums are being expended, be made
more effective? What contribution can local productivity
councils make to improvements in industrial efficiency? How can
the advantages of computerized job banks be effectively har­
nessed? These are a few of the questions that we need to ask
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COMMITTEE ON INTEREST AND DIVIDENDS

and try to resolve in order to help assure that the controls of
Phase II, once dismantled, will not be needed again in our
lifetime.




141




The Problem of Inflation

Substantial progress has been achieved during the past several
decades in understanding the forces of economic instability and
in devising policies for coping with them. Severe depressions in
economic activity, which earlier generations knew and feared,
are no longer a serious threat. And although recessions are
still troublesome, their amplitude has diminished and they occur
less frequently than they did earlier.
Our very success in limiting declines in business activity
has become, however, a major source of the stubborn inflationary
problem of our times. As recent experience has demonstrated
once again, inflation damages the national economy. Confidence
of businessmen and consumers in the economic future is shaken;
productive efficiency falters, export trades languish, interest
rates soar, financial markets become unruly, and social and
political frictions multiply. We in the United States can have
little hope of sustaining vigorous economic growth, or using our
resources with maximum efficiency, or restoring equilibrium in
our international accounts, or attaining a more salutary distri­
bution of personal incomes unless the powerful forces that have
been pushing up costs and prices are subdued.
The current inflationary problem has no close parallel in
economic history. In the past, inflation in the United States
was associated with military outlays during wars or with in­
vestment booms in peacetime. Once these episodes passed, the
price level typically declined, and many years often elapsed
Address before the joint meeting of the American Economic Association
and the American Finance Association, Toronto, Canada, December 29, 1972.




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REFLECTIONS OF AN ECONOMIC POLICY MAKER

before prices returned to their previous peak. In the economic
environment of earlier times, business and consumer decisions
were therefore influenced far more by expectations concerning
short-term movements in prices than by their long-term trend.
Over the past quarter century, a rather different pattern of
wage and price behavior has emerged. Prices of many individual
commodities still demonstrate a capability of declining when
demand weakens. The average level of prices, however, hardly
ever declines. Wage rates have become still more inflexible.
Wage reductions are nowadays rare even in ailing businesses,
and the average level of wages seems to rise inexorably across
the industrial range.
The hard fact is that market forces no longer can be counted
on to check the upward course of wages and prices even when
the aggregate demand for goods and services declines in the
course of a business recession. During the recession of 1970
and the weak recovery of early 1971, the pace of wage increases
did not at all abate as unemployment rose, and there was only
fragmentary evidence of a slowing in price increases. The rate
of inflation was almost as high in the first half of 1971, when
unemployment averaged 6 percent of the labor force, as it was
in 1969, when the unemployment rate averaged 3 V2 percent.
The implications of these facts are not yet fully perceived.
Cost-push inflation, while a comparatively new phenomenon on
the American scene, has been altering the economic environment
in fundamental ways. For when prices are pulled up by ex­
panding demands in times of prosperity, and are also pushed up
by rising costs during slack periods, decisions of the economic*
community are apt to be dominated by expectations of inflation.
Thus, many businessmen have come to believe in recent
years that the trend of production costs will be inevitably up­
ward, and their resistance to higher prices— whether of labor,
or materials, or equipment— has therefore diminished. Labor
leaders and workers now tend to reason that in order to achieve
a gain in real income, they must bargain for wage increases that
allow for advances in the price level as well as for the expected
improvement in productivity. When individuals and families
set aside funds for the future, they tend to do so in full aware­
ness that some part of their accumulated savings is likely to
be eroded by rising prices. Lenders in their turn, expecting to
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THE PROBLEM OF INFLATION

be paid back in cheaper dollars, tend to hold out for higher
interest rates. These new patterns of thought are an ominous
development.
I do not wish to minimize the substantial progress that
has been made since August 1971 in suppressing inflationary
forces, and in altering public attitudes about the inevitability
of inflation. The shock therapy applied by the President in
the summer, of last year has had lasting benefits. The pace
of business activity strengthened almost immediately after the
announcement of the New Economic Policy, and it has gathered
momentum over the past year. Moreover, inflation has been
cut from an annual rate of about 5 percent in the first half of
1971 to about 3 percent toward the end of this year. That im­
provement reflects the widespread support by the American
public, including the trade unions, of the recent controls on
wages and prices. It must be recognized, however, that the
controls were aided by continued slack in resource and product
markets and by a pronounced rise in output per man-hour.
Next year further progress in moderating inflation will
be more difficult to achieve. The backlog of unused resources
has been gradually declining, and there is good reason to expect
less unemployment and fuller utilization of plant capacity as
1973 unfolds. Market forces may thus be exerting upward
pressure on wage rates and prices at a time when productivity
gains will probably be diminishing. If major collective bargain­
ing agreements next year call for pay increases that appreciably
exceed the growth of productivity, the upward pressure on costs
and prices will intensify.
Extension of the benefits from the recent hard-won decline
in the pace of inflation thus hangs in the balance. A further
reduction during 1973 in the rate of increase in wages and
prices is essential if the inflationary trend that has so long
plagued our economy is to be brought to a halt in the near
future. If that does not happen and cost and price pressures
intensify next year, the nation's economic future may be ad­
versely affected for a long time to come.
In fact, the outcome of our struggle with inflation is likely
to have worldwide repercussions. If we continue to make
progress in solving the inflation problem, our success will bring
new hope to other countries of the Western world where in-




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flationary trends stem in large measure from the same sources
as ours.
Almost the entire world is at present suffering from infla­
tion, and in many countries— for example, Canada, France, the
United Kingdom, West Germany, and the Netherlands— the
pace of inflation is more serious than in the United States.
In Canada, unemployment has been rising since 1966, but
it has had little visible effect on wage rates. Actually, during the
third quarter of 1972, the Canadian unemployment rate reached
6.7 percent— the highest quarterly figure in many years; yet,
new settlements in unionized industries still provided for annual
wage increases on the order of 8 percent. Prior to the recent
freeze, wages in the‘United Kingdom were rising at a rate of
10 percent or more, in defiance of an unemployment rate that
had gone up over a number of years and was still abnormally
high.
These countries have discovered, as we in the United States
have, that wage rates and prices no longer respond as they once
did to the play of market forces.
As I have already noted, a major cause of the inflationary
bias in modern industrialized nations is their relative success in
maintaining prosperity. Governments, moreover, have taken
numerous steps to relieve burdens of economic dislocation. In
the United States, for example, the unemployment insurance
system has been greatly strengthened since the end of World
War II: compensation payments have increased, their duration
has lengthened, and their coverage has been extended to a wider
range of industries. Social security benefits have also expanded
materially, thus easing the burdens of retirement or job loss for
older workers, and welfare programs have proliferated.
Protection from the hardships of economic displacement
has been extended by government to business firms as well. The
rigors of competitive enterprise are nowadays blunted by import
quotas, tariffs, price maintenance laws, and other forms of gov­
ernmental regulation; subsidy programs sustain the incomes of
farmers; small businesses and homebuilders are provided special
credit facilities and other assistance; and even large firms of
national reputation look to the federal government for sustenance
in times of trouble.
Thus, in today's economic environment, workers who be­
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THE PROBLEM OF INFLATION

come unemployed can normally look forward to being rehired
soon in the same line of activity, if not by the same firm. The
unemployment benefits to which they are entitled blunt their
incentive to seek work in an alternative line or to accept a job
at a lower wage. Similarly, business firms caught with rising
inventories when sales turn down are less likely to cut prices to
clear the shelves— as they once did. Experience has taught them
that, in all probability, demand will turn up again shortly, and
that stocks of materials and finished goods— once depleted—
nearly always have to be replaced at higher cost.
Institutional features of our labor and product markets
reinforce these wage and price tendencies. Excessive wage in­
creases tend to spread faster and more widely than they used to,
partly because workmen have become more sensitive to wage
developments elsewhere, partly also because employers have
found— or come to believe— that a stable work force can best be
maintained in a prosperous economy by emulating wage settle­
ments in unionized industries. In not a few of our businesses,
price competition has given way to rivalry through advertising,
entertaining customers, and other forms of salesmanship. Trade
unions at times place higher priority on the size of wage in­
creases than on the employment of their members, and their
strength at the bargaining table has certainly increased. The
spread in recent years of trade unions to the public sector has
occasioned some illegal strikes which ended with the union de­
mands, however extreme, being largely met. The apparent help­
lessness of governments to deal with the problem has encouraged
other trade unions to exercise their latent power more boldly.
And their ability to impose long and costly strikes has been
enhanced by the stronger financial position of American families,
besides the unemployment compensation, food stamps, and other
welfare benefits that are not infrequently available to strikers.
In view of these conditions, general price stability would
be difficult to achieve even if economic stabilization policies
could prevent altogether the emergence of excess aggregate
demand. But neither the United States nor any other Western
nation has come close to that degree of precision. In fact, excess
aggregate demand has become rather commonplace. In country
after country, stabilization efforts have been thwarted by gov­
ernmental budgets that got out of control, and central banks




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REFLECTIONS OF AN ECONOMIC POLICY MAKER

have often felt compelled to finance huge budgetary deficits by
credit creation.
There are those who believe that the hard struggle to rid
our economy of inflation is not worthwhile and that it would be
better to devise ways of adjusting to inflation than to continue
fighting it. On this view, social security payments, insurance
contracts, bank deposits, and other contractual arrangements
should be written with escalator clauses so as to minimize the
distortions and hardships that inflation causes.
This is a counsel of despair. Those who are hurt most by
inflation are nearly always the poor, the elderly, the less edu­
cated— those in our society most in need of shelter from economic
adversity. I doubt if there is any practical way of redesigning
economic contracts to deal with this problem satisfactorily. In
any event, if a nation with our traditions attempted to make it
easy to live with inflation, rather than resist its corrosive influ­
ence, we would slowly but steadily lose the sense of discipline
needed to pursue governmental policies with an eye to the per­
manent welfare of our people.
The only responsible course open to us, I believe, is to fight
inflation tenaciously and with all the weapons at our command.
Let me note, however, that there is no way to turn back the
clock and restore the environment of a bygone era. We can no
longer cope with inflation by letting recessions run their course;
or by accepting a higher average level of unemployment; or by
neglecting programs whose aim it is to halt the decay of our
central cities, or to provide better medical care for the aged, or
to create larger opportunities for the poor.
A modern democracy cannot ignore the legitimate aspira­
tions of its citizens, and there is no need to do so. The rising
aspirations of our people are consistent with general price sta­
bility if we only have the will and the good sense to pursue an
appropriate public policy. Our needs are, first, to restore order
in the federal budget and strengthen the stabilizing role of fiscal
policy; second, to pursue monetary policies that are consistent
with orderly economic expansion and return to a stable price
level; third, to continue for a while longer effective controls over
many, but by no means all, wage bargains and prices; and fourth,
to reduce or remove existing impediments to a more competitive
determination of wages and prices.
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THE PROBLEM OF INFLATION

The single most important need at the present time is to curb
the explosive growth that has marked federal spending in recent
years. Some shock therapy may be needed here, such as a freeze
or near freeze for a year or two of federal expenditures. The
President is struggling to hold budgetary outlays to $250 billion
in the current fiscal year. Even if he succeeds, as I trust he will,
federal spending will still have more than doubled during the
past eight years, and it will still exceed last year's outlays by
$18 billion.
Contrary to a widespread impression, this burst of federal
spending reflects only in small part the Vietnam war. The funda­
mental cause has been political indulgence of the theory that
most social and economic problems can be solved by quick and
large expenditures of federal money. We have tried to meet the
need for better schooling of the young, for upgrading the skills
of the labor force, for expanding the production of low-income
housing, for improving the nation's health, for ending urban
blight, for purifying our water and air, and for other national
objectives, by constantly excogitating new programs and getting
the Treasury to finance them on a liberal scale before they have
been tested. The result has been that we have hastily piled one
social program on another, so that they now literally number in
the hundreds and defy understanding— beyond the obvious fact
that they have disappointed our expectations and frustrated our
fiscal calculations. In view of this experience, a tax increase—
even if that were immediately attainable— would hardly be a
suitable alternative to tightened expenditure controls.
Significant progress in curtailing the future growth of fed­
eral spending will require major reforms of a budgetary process
that has long been badly outdated. The executive establishment
does not yet have adequate devices for evaluating the benefits of
individual programs relative to their cost, such as would be
needed in zero-base budgeting. More serious still, the Congress
continues to consider individual appropriation bills in isolation,
without regard to any controlling total. Consequently, there is
little incentive or opportunity to compare the contribution of
alternative programs to the public welfare, or to consider sys­
tematically whether the nation would be better off if the re­
sources now absorbed by government were larger or smaller.
Recognizing the need to focus on the overall budget, the




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REFLECTIONS OF AN ECONOMIC POLICY MAKER

Congress wisely decided this October to reexamine its pro­
cedures. A logical first step would be to establish a Joint Con­
gressional Committee on Expenditures and Revenues. Such a
committee would review and evaluate the budget proposed by
the administration each January for the next fiscal year. It would
seek to determine whether the proposed total of expenditures
was in keeping with the nation's needs and capabilities, whether
new sources of revenue would be required or if some taxes
could be lowered, thus returning resources to the private sector.
Determinations of this character would serve as a useful guide
to the individual committees of the Congress, and so too would
projections of the growth of revenues and expenditures over the
next three to five years, given existing federal programs and new
initiatives under consideration.
Besides such a joint committee, formal Congressional pro­
cedures for controlling total expenditures are needed. Legislative
budgets merit fuller and more careful consideration than they
have yet received. For example, the Congress might act on a
single comprehensive appropriation bill instead of the dozen
or so bills that it now handles. Another procedure might be to
legislate an overall budget total, with outlays specified for a
limited number of major categories, before turning to the appro­
priations process. Then, if any individual appropriation bill
involved expenditures exceeding the limit already established for
that category, a two-thirds vote in the House and the Senate
might be required to enact that appropriation.
Alternatively, the Congress could impose a rigid ceiling on
total expenditures, and require the Executive to adjust outlays on
individual categories so that they would be consistent with the
ceiling. Such an approach was considered by the Ninety-second
Congress, but rejected because of concern that too much power
over the purse strings would be ceded to the president. There is
some justification for that view. But it should be noted that a
ceiling also limits trie ability of the president to spend as much
as he might desire, and that restrictions might be placed on his
power to readjust spending priorities. A vigilant Congress could,
I believe, take steps to ensure that Congressional control over
the direction of spending would not be weakened by a legislative
budget ceiling.
Formal and systematic control over federal expenditures
150



THE PROBLEM OF INFLATION

would, as I have already suggested, do a good deal to eliminate
recurring bouts with excess aggregate demand. But there are
times when overheating of the economy originates in the private
sector. At such times, better fiscal tools are needed to curb pri­
vate spending. In a recent report to the Congress, the Federal
Reserve Board argued that it would be wise to enlarge the role
of fiscal policy in short-run economic stabilization, and that a
promising way of doing this would be to vary the investment tax
credit in the light of business cycle developments.
To facilitate timely adjustments, without which stabilization
policy cannot be effective, the president might be given the
authority to initiate changes in the investment tax credit. At the
same time, Congress could retain its traditional control over taxes
and act as a full partner in making the needed adjustments. For
example, the president might be permitted to change the tax
credit within a specified range, say between zero and 10 or 15
percent, subject to modification or disapproval within sixty days
by either house of Congress.
Experience since 1966 suggests that variation in the rate of
the investment tax credit would influence significantly the be­
havior of business investment over the course of the business
cycle. Such a fiscal tool would therefore reduce the burden on
monetary policy, and make possible some improvement in the
management of aggregate demand.
There has been a tendency throughout the postwar period—
both in the United States and in other countries— to rely heavily
on monetary policy to adjust to shifts in private spending pro­
pensities, and even to expect monetary policy to offset the impact
of unwanted fiscal stimulus. It is difficult, however, to maintain
adequate control over aggregate demand when primary reliance
is placed on monetary policy, first, because its effects occur with
variable lags, second, because its influence on economic activity
is disproportionately large in particular industries such as hous­
ing. If improved fiscal instruments were used side by side with
monetary policy to influence total spending, the chances of
avoiding excessive bursts of aggregate demand, with their in­
evitable inflationary consequences, would be greatly enhanced.
Furthermore, undesired effects on the structure of real output
would be reduced, greater stability could prevail in financial
markets, and the monetary managers could focus more con­




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REFLECTIONS OF AN ECONOMIC POLICY MAKER

sistently on maintaining a course conducive to sustainable eco­
nomic growth and reasonable price stability over the longer run.
This conception of the role of monetary policy has guided
our thinking at the Federal Reserve over the past several years.
During this period, more careful attention has been given to the
monetary aggregates because we recognize that excessive amounts
of money and credit might inadvertently be supplied in a period
of rising credit demands if attention were focused primarily on
interest rates. We recognize, however, that changes in the cost
and availability of credit affect the nation's economic activity, and
we therefore cannot neglect the condition of financial markets.
Monetary policy since early 1970, when judged by any of
the major monetary aggregates, has favored moderate economic
expansion. During the past three years, the narrowly defined
money stock— that is, currency plus demand deposits— has grown
at an annual rate of about 6 percent. Defined more broadly, so
as to include also consumer-type time and savings deposits of
commercial banks, the stock of money has grown at an average
annual rate of 10 percent. Between the third quarter of 1971
and the third quarter of this year, the narrowly defined money
stock increased 5.6 percent. This was well below the growth rate
of total real output, and far below the increase in the current
dollar value of output.
Monetary policy has thus provided the funds needed for a
good expansion in production and employment, and it has done
so without fostering a condition of excess aggregate demand.
We at the Federal Reserve expect to continue a policy of support­
ing economic growth, but we are firmly resolved to do this
without releasing a new wave of inflation.
Responsible monetary and fiscal policies are clearly essen­
tial for coping with the current inflationary problem. However,
as the incomes policy initiated in August of last year has demon­
strated, efforts to influence wages and prices directly can play
a constructive role when cost-push inflation reaches serious pro­
portions. The energy released by the New Economic Policy has
been abundantly evident to businessmen, workers, and con­
sumers. True, the control program did not bring inflation to a
halt, but any such expectation would have been unrealistic.
There are those who believe that the time is at hand to
abandon the experiment with controls and to rely entirely on
152



THE PROBLEM OF INFLATION

monetary and fiscal restraint to restore a stable price level. This
prescription has great intellectual appeal; unfortunately, it is
impractical.
If some form of effective control over wages and prices were
not retained in 1973, major collective bargaining settlements and
business efforts to increase profits could reinforce the pressures
on costs and prices that normally come into play when the econ­
omy is advancing briskly, and thus generate a new wave of
inflation. If monetary and fiscal policies became sufficiently
restrictive to deal with the situation by choking off growth in
aggregate demand, the cost in terms of rising unemployment, lost
output, and shattered confidence would be enormous. As a prac­
tical matter, I see no alternative but to pursue for a while longer
the experiment with direct controls. I trust, at the same time,
that reasonable steps will be taken to reduce the distortions and
inequities that are beginning to accumulate.
But the greater need in the year ahead will be to use the
breathing spell afforded by the control program to seek ways to
improve the functioning of our labor and product markets, so
that wage rates and prices become more responsive to the bal­
ance between market demand and supply.
There has been much discussion recently of the need for
structural reform— by some, because they see evidence of abuse
of economic power by large business firms; by others, because
they see trade unions forcing up wage rates well beyond produc­
tivity gains and raising costs otherwise through restrictive work
practices; by still others, because they see a multiplicity of gov­
ernmental regulations that restrict productivity and impede the
workings of competition. While opinions may differ as to which
of these several areas merits primary attention, I believe that
informed observers of the current economic scene would agree
that structural reforms are needed in all of these areas in the
interest of weakening the built-in forces of inflation. In any
event, given the realities of political life, genuine progress is
likely only if we move on all fronts simultaneously.
It will take courage for the Congress and the Executive to
deal with the issues of structural reform in forthright fashion.
The ground to be covered is difficult and enormous. W e need to
reassess the adequacy of our laws directed against monopolistic
practices of business, the enforcement of these laws, the power




153

REFLECTIONS OF AN ECONOMIC POLICY MAKER

of trade unions at the bargaining table, restrictions on entry into
business or the professions, the restrictive practices of trade
unions, the subsidies to farmers, the federal minimum wage (par­
ticularly for teenagers), restrictions on the activities of financial
institutions, the welfare system, import quotas, tariffs, and other
legislation that impedes the competitive process. We need also
to reevaluate our extensive manpower training programs and the
feeble effort to establish computerized job banks, for it is clear
that our labor market policies have thus far failed to contribute
sufficiently to the objective of expanding employment and yet
avoiding the inflationary effects that monetary and fiscal policies
so often tend to generate.
There is no quick or easy path to meaningful structural re­
form. But I see no real alternative if our national aspiration for
prosperity without inflation is to be realized, while free enter­
prise and individual choice are being preserved.
In conclusion, let me remind you that in August of last year,
confidence of our citizens was at ebb tide. The measures then
taken created hope that our government had the will to halt
inflation and move the nation's economy forward. It is time now
to take the further steps needed to consolidate the progress al­
ready achieved. In the measure that we succeed we will not only
protect our domestic prosperity, but we will also facilitate the
rebuilding of the international monetary system and the eco­
nomic growth of our sister nations around the world.

154



Some Problems of Central
Banking

The advent of the 1970s has not diminished the range or diffi­
culty of the problems that central bankers face. In the interna­
tional area, relationships among economies have been under­
going rapid change, and our governments are now actively
seeking to develop new international rules to guide their future
conduct in the spheres of money and trade. As central bankers,
we have inevitably become involved in efforts to achieve urgently
needed reforms of the international monetary system. We have
also had to wrestle anew with problems of recession, economic
overheating, and the stubborn persistence of inflation.
Today, I want to focus my remarks on the problem of
achieving greater stability in the performance of our domestic
economies. There is no more crucial need for the stability and
welfare of our economies than to find more effective methods for
dealing with inflation and its causes. Restoration of international
financial order also depends heavily on our handling of this
problem. The policies that are needed to halt inflation, without
at the same time plunging our nations into economic stagnation
or recession, extend beyond the normal province of central bank­
ing. Skillful management of monetary matters nevertheless re­
mains an indispensable ingredient in reaching the objective of
noninflationary growth that we all seek.
Since the end of World War II, our economies have de­
veloped a disconcerting bias toward inflation. A variety of in­
fluences— social, political, and institutional— have been at work
Address before the 1973 International M onetary Conference, Paris, France,
June 6, 1973.




155

REFLECTIONS OF AN ECONOMIC POLICY MAKER

here. But there can be no doubt that the speed and vigor with
which governments tend to deal with recession, their consider­
able success in this endeavor, and their reluctance to act with
similar decisiveness to curb economic booms, have contributed
materially to the worldwide upward trend of the price level and
the persistence of inflationary expectations.
Monetary and fiscal policies for managing aggregate de­
mand now bear, and must continue to bear, the main respon­
sibility for regulating the overall performance of our national
economies. At times, the level or pace of total economic activity
will continue to call for restraining policies, and at other times
there will be need for stimulus. But I must caution that experi­
ence suggests that we will need to embark on policies of active
stimulation with greater care, unless we subdue the natural incli­
nation to stay too long with such policies. The ability and the
will to make timely shifts in the thrust of fiscal and monetary
policies are of the utmost importance if these policy instruments
are to play a more constructive contracyclical role.
We need also to recognize that skillful, timely, and flexible
use of demand management policies may not suffice to achieve
satisfactory economic performance. To be sure, total spending
in the economy can be slowed through monetary and fiscal
measures. But under the institutional conditions that now pre­
vail in many of our countries, shifts in these policies have a
much stronger and more prompt effect on real output and em­
ployment than on the pace of inflation. The persistence of rapid
advances of wages and prices in the United States and other
countries, even during recent periods of recession, has led me to
conclude that governmental power to restrain directly the ad­
vance of prices and money incomes constitutes a necessary addi­
tion to our arsenal of economic stabilization weapons, to be
used occasionally— but nevertheless vigorously— when needed.
There is another difficulty in relying exclusively on broad
monetary and fiscal policies for combating cyclical fluctuations.
Overall restraint, it is true, will in time slow any exuberant
expansion. It may not, however, curb sufficiently or in timely
fashion the sectors of demand that are leading to economic im­
balance, and thereby set the stage for later economic trouble.
Overall restraints that are sufficient to curb expansion in aggre­
gate economic activity may do so by inducing sizable declines
156




SOME PROBLEMS OF CENTRAL BANKING

promptly in some areas, such as housing, and yet have slight
effect for some time in other areas, such as business investment.
This is particularly likely to be the case when reliance is placed
mainly on monetary policy, and hence on sharp changes in credit
conditions, for purposes of economic stabilization.
Throughout business cycle history, the major force making
for economic instability has been the rather large fluctuations
characteristic of business investment. At times, of course, the
spending and taxing policies of government have been a source
of economic trouble, especially in connection with wars and their
financing. On occasion, also, large changes in the spending
propensities of consumers have played their part in carrying
aggregate activity to unsustainably high, or unacceptably low,
levels. But it is in the pronounced changes of the investment
plans of business firms, with respect both to their fixed capital
and inventories, that much of the cyclical instability of advanced
industrial economies has originated.
Business investment is, of course, vital to the growth in
productivity, and the improvement in material welfare, to which
all nations aspire. Over the long run, incentives to invest there­
fore need to be enhanced. But it would be far better if a high
average level of investment could be achieved without the siz­
able fluctuations that have characterized the past. The general
economy would benefit from a reduction of this source of insta­
bility. Business enterprises would also benefit from a more reg­
ular pace of investment, since they would thus avoid a concen­
tration of expenditures at times when financing costs are high,
when the capabilities of suppliers are strained, and when deliv­
ery and installation dates become more uncertain.
In view of our continuing problems in achieving economic
stability, we must persist in the search for new and more refined
tools of stabilization policy. Ideally, these measures should be
of the kind that can be introduced or removed quickly and that
will affect private spending decisions rather promptly. Many
countries have recognized this need, and we at the Federal
Reserve have sought to profit from their experience and studies,
as well as from our own research.
Last year, for example, the Federal Reserve Board com­
pleted a study of ways in which the housing industry could be
provided a degree of insulation from the fluctuations brought on




157

REFLECTIONS OF AN ECONOMIC POLICY MAKER

by sharp changes in credit conditions. One of our major con­
clusions was that more stability in residential construction would
require less instability in business investment. Toward this end,
we proposed that consideration be given to the use of a variable
investment tax credit. When contracts or orders for new plant
and equipment are advancing too rapidly, the tax credit could be
reduced, and when such investment is lagging, the tax credit
could be raised; thus providing a direct cost incentive for mod­
erating cyclical movements in this area.
I continue to believe that the concept of a variable tax in­
centive to business investment has merit. Because of our need in
the United States to encourage greater productivity, however, I
would now recommend that the tax credit remain in effect con­
tinuously and that it at no time drop to zero. It could vary,
perhaps, between 3 or 4 percent and 15 percent, depending on
economic conditions. It would be important also to retain a
decisive role for the Congress in determining the specific rate of
tax credit. This could be done by empowering the president to
initiate changes in the investment tax credit, but making it sub­
ject to veto or approval— and perhaps also some modification—
by the Congress within a forty-five or sixty day period.
In recent months, the Federal Reserve has faced the prob­
lem of dealing with a rapidly escalating demand for bank credit,
even though the monetary aggregates, by and large, have grown
at a moderate pace. The upsurge in bank credit has been asso­
ciated mainly with the demand for business loans, and it has
been largely accommodated by the banks through the issuance
of certificates of deposit in the money market. Accordingly, the
Board in mid-May announced a new restrictive action aimed
specifically at this development. Since May 16, any further in­
crease in bank issues of large certificates of deposit or similar
money market instruments, over a base of $10 million or the
amount then outstanding, whichever is larger, is to be subject
to an additional reserve requirement, presently set at three per­
centage points. At the same time, any additional funds obtained
abroad by U.S. banks for domestic purposes became subject to
reserve requirements on a comparable basis, and the remaining
interest rate ceilings on large certificates of deposit were sus­
pended.
The new marginal reserve requirement will raise the cost
incurred by banks in obtaining additional funds through the
158



SOME PROBLEMS OF CENTRAL BANKING

money market for the financing of loan expansion. Banks doing
so will have the use of only 92 percent of the proceeds, rather
than the 95 percent that they had before. The purpose of the
marginal reserve requirement is to restrain bank lending to
business on a market-oriented basis, so that rationing of funds
by the banks to their large business customers may be accom­
plished through higher costs, rather than by the imposition of
arbitrary and inflexible interest rate controls. We expect that the
result will be to moderate the willingness of banks to accommo­
date their customers through this source of financing. If it fails
to do so sufficiently, we are prepared to consider additional ac­
tions that will limit further the availability of the funds that
banks have at their disposal.
I have urged bankers in the United States to discipline the
pace at which they are extending credit, in the interest both of
our economy's present need and of sound banking practice. I
repeat that appeal today. In doing so, I recognize that earnest
efforts by commercial banks to moderate their rate of credit
accommodation will not, by itself, be a sufficient remedy. It is
no less important that our business leaders recognize the need to
limit their investment plans for the time being, and thus restrict
their requirements for external finance, whether from the banks
or the money and securities markets. Moderation in the growth
of bank credit will be of little avail if the result is merely to
augment open-market financing of an unsustainable increase in
business spending.
In times like these, it is also necessary that public expendi­
ture in the United States be restrained to the maximum extent
feasible. It is necessary that our government seek strenuously
to achieve balance, or actual surplus, in its income relative to its
expenditure. And as far as the Federal Reserve is concerned, it
is more necessary than ever that we keep monetary expansion
down to a moderate pace, while we at the same time avoid the
kind of constriction in credit markets that could lead to recession
and the certainty of large stimulative measures later on. W e
must avoid serious overheating of the American economy now,
and we must try to curb our inflation through methods that will
not add to future economic instability. With reasonable co­
operation by all leading groups in our society, I am confident
that we can achieve these goals. This is of critical importance to
the United States and also to the world at large.




159




The Menace of Inflation

It is a pleasure to be with you today here in the heartland of
America. As graduates of this college, you are launching your
careers at a challenging but troubled time. Confidence in estab­
lished institutions, particularly in our government, is at a low
ebb. And hopes for the future of our economy have been
shaken by the debilitating effects of inflation on the nation's
businesses, workers, and consumers.
Inflation is not a new problem for the United States, nor is
it confined to our country. Inflationary forces are now rampant
in every major industrial nation of the world. Inflation is raging
also in the less developed countries, and apparently in socialist
countries as well as in those that practice free enterprise.
The gravity of our current inflationary problem can hardly
be overestimated. Except for a brief period at the end of World
War II, prices in the United States have of late been rising faster
than in any other peacetime period of our history. If past expe­
rience is any guide, the future of our country is in jeopardy. No
country that I know of has been able to maintain widespread
economic prosperity once inflation got out of hand. And the
unhappy consequences are by no means solely of an economic
character. If long continued, inflation at anything like the pres­
ent rate would threaten the very foundations of our society.
I want to discuss briefly with you today the sources of our
inflationary problem, the havoc being wrought in the economy,
Commencement address at Illinois College, Jacksonville, Illinois, M ay 26,
1974.




161

REFLECTIONS OF AN ECONOMIC POLICY MAKER

and the steps that must be taken to regain general price stability
and thus strengthen confidence in our nation's future.
A large part of the recent upsurge in prices has been due to
special factors. In most years, economic trends of individual
nations tend to diverge. But during 1973 a business cycle boom
occurred simultaneously in the United States and in every other
major industrial country. With production rising rapidly across
the world, prices of labor, materials, and finished products were
bid up everywhere.
To make matters worse, disappointing crop harvests in a
number of countries in 1972 forced a sharp run-up in the prices
of food last year. The manipulation of petroleum supplies and
prices by oil-exporting countries gave another dramatic push to
the general price level last autumn and early this year. The in­
fluence of these factors is still being felt in consumer markets.
Recently, our price level has also reacted strongly to the
removal of wage and price controls— a painful but essential
adjustment in the return to free markets.
These special factors, however, do not account for all of our
inflation. For many years, our economy and that of other nations
has had a serious underlying bias toward inflation which has
simply been magnified by the special influences that I have
mentioned.
Ironically, the roots of that bias lie chiefly in the rising
aspirations of people everywhere. We are a nation in a hurry
for more and more of what we consider the good things of life.
I do not question that yearning. Properly directed, it can be a
powerful force for human betterment. Difficulties arise, how­
ever, when people in general seek to reach their goals by means
of shortcuts; and that is what has happened.
O f late, individuals have come to depend less and less on
their own initiative, and more on government, to achieve their
economic objectives. The public nowadays expects the govern­
ment to maintain prosperous economic conditions, to limit such
declines in employment as may occasionally occur, to ease the
burden of job loss or illness or retirement, to sustain the in­
comes of farmers, homebuilders, and so on. These are laudable
objectives, and we and other nations have moved a considerable
distance toward their realization. Unfortunately, in the process
of doing so, governmental budgets have gotten out of control,
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THE MENACE OF INFLATION

wages and prices have become less responsive to the discipline
of market forces, and inflation has emerged as the most danger­
ous economic ailment of our time.
The awesome imbalance of the federal budget is probably
the contributory factor to inflation that you have heard the most
about. In the past five years, total federal expenditures have in­
creased about 50 percent. In that time span, the cumulative
budget deficit of the federal government, including governmentsponsored enterprises, has totaled more than $100 billion. In
financing this deficit, and also in meeting huge demands for
credit by businesses and consumers, tremendous pressures have
been placed on our credit mechanisms and the supply of money
has grown at a rate inconsistent with price stability.
I am sure that each of you in this graduating class is aware
of some of the troublesome consequences of inflation. The prices
of virtually everything you buy have been rising and are still
going up. For the typical American worker, the increase in
weekly earnings during the past year, while sizable in dollars,
has been wiped out by inflation. In fact, the real weekly takehome pay of the average worker is now below what it was a
year ago. Moreover, the real value of accumulated savings de­
posits has also declined, and the pressure of rising prices on
family budgets has led to a worrisome increase in delinquency
rates on home mortgages and consumer loans.
Many consumers have responded to these developments by
postponing or canceling plans for buying homes, autos, and
other big-ticket items. Sales of new autos began to decline in
the spring of 1973, and so too did sales of furniture and appli­
ances, mobile homes, and newly built dwellings. The weakness
in consumer markets, largely engendered by inflation, slowed
our economic growth rate last year some months before the
effects of the oil shortage began to be felt.
Actually, the sales of some of our nation's leading business
firms have been on the wane for a year or more. Their costs,
meanwhile, have continued to soar with increasing wage rates
and sharply rising prices of materials.
The effect on business profits was ignored for a time be­
cause accountants typically reckon the value of inventories— and
also the value of machinery and equipment used up in produc­
tion— at original cost, rather than at current inflated prices.




163

REFLECTIONS OF AN ECONOMIC POLICY MAKER

These accounting practices create an illusory element in profits—
an element that is not available for distribution to stockholders
in view of the need to replace inventories, plant, and equipment
at appreciably higher prices. Worse still, the illusory part of
profits is subject to the income tax, thus aggravating the deteri­
oration in profits. This result is especially unfortunate because
of the shortage of industrial capacity that now exists in key sec­
tors of our economy— particularly in the basic materials area.
By early this year, a confrontation with economic reality
could no longer be put off. Major business corporations found
that the volume of investable funds generated internally was not
increasing fast enough to finance the rising costs of new plant
and equipment, or of the materials and supplies needed to re­
build inventories. Businesses began to scramble for borrowed
funds at commercial banks and in the public markets for money
and capital. Our financial markets have therefore come under
severe strain. Interest rates have risen sharply; savings flows
have been diverted from mortgage lending institutions; security
dealers have experienced losses; prices of common stocks have
declined; the liquidity of some enterprises has been called into
question; and tensions of a financial nature have spilled over
into international markets.
Concerned as we all are about the economic consequences
of inflation, there is even greater reason for concern about the
impact on our social and political institutions. We must not risk
the social stresses that persistent inflation breeds. Because of its
capricious effects on the income and wealth of a nation's families
and businesses, inflation inevitably causes disillusionment and
discontent. It robs millions of citizens who in their desire to be
self-reliant have set aside funds for the education of their chil­
dren or their own retirement, and it hits many of the poor and
elderly especially hard.
In recent weeks, governments have fallen in several major
countries, in part because the citizens of those countries had lost
confidence in the ability of their leaders to cope with the prob­
lem of inflation. Among our own people, the distortions and
injustices wrought by inflation have contributed materially to
distrust of government-officials and of government policies, and
even to some loss of confidence in our free enterprise system.
Discontent bred by inflation can provoke profoundly disturbing
164



THE MENACE OF INFLATION

social and political change, as the history of other nations
teaches. I do not believe I exaggerate in saying that the ultimate
consequence of inflation could well be a significant decline of
economic and political freedom for the American people.
There are those who believe that the struggle to curb infla­
tion will not succeed and who conclude that it would be better
to adjust to inflation rather than to fight it. On this view, con­
tractual payments of all sorts— wages, salaries, social security
benefits, interest on bank loans and deposits, and so on— should
be written with escalator clauses so as to minimize the distor­
tions and injustices that inflation normally causes.
This is a well-meaning proposal, but it is neither sound nor
practical. For one thing, there are hundreds of billions of dollars
of outstanding contracts— on mortgages, public and private
bonds, insurance policies, and the like— that as a practical matter
could not be renegotiated. Even with regard to new undertak­
ings, the obstacles to achieving satisfactory escalator arrange­
ments in our free and complex economy, where people differ so
much in financial sophistication, seem insuperable. More impor­
tant still, by making it easier for many people to live with
inflation, escalator arrangements would gravely weaken the dis­
cipline that is needed to conduct business and government affairs
prudently and efficiently. Universal escalation, I am therefore
convinced, is an illusory and dangerous quest. The responsible
course is to fight inflation with all the energy we can muster and
with all the weapons at our command.
One essential ingredient in this struggle is continued re­
sistance to swift growth in money and credit. The Federal Re­
serve System, I assure you, is firmly committed to this task. We
intend to encourage sufficient growth in supplies of money and
credit to finance orderly economic expansion. But we are not
going to be a willing party to the accommodation of rampant
inflation.
As this year's experience has again indicated, a serious ef­
fort to moderate the growth of money and credit during a period
of burgeoning credit demand results in higher interest rates—
particularly on short-term loans. Troublesome though this rise
in interest rates may be, it must for a time be tolerated. For, if
monetary policy sought to prevent a rise in interest rates when
credit demands were booming, money and credit would expand




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explosively, with devastating effects on the price level. Any
such policy would in the end be futile, even as far as interest
rates are concerned, because these rates would soon reflect the
rise in the price level and therefore go up all the more. W e must
not let that happen.
But I cannot emphasize too strongly that monetary policy
alone cannot solve our stubborn inflationary problem. We must
work simultaneously at lessening the powerful underlying bias
toward inflation that stems from excessive total demands on our
limited resources. This means, among other things, that the
federal budget has to be handled more responsibly than it has
been in the past.
Incredible though it may seem, the Congress has been
operating over the years without any semblance of a rational
budget plan. The committees that consider spending operate
independently of the committees that consider taxes, and ap­
propriations themselves are treated in more than a dozen different
bills annually. All of this means that the federal budget never
really gets considered as a whole— a fact which helps explain
why it is so often in deficit.
Fortunately, after many years of advocacy by concerned
citizens and legislators, this glaring deficiency in the congres­
sional budget process is about to be remedied. Bills that would
integrate spending and taxing decisions have passed both the
House and the Senate. This is a most encouraging development,
and we may confidently expect final action soon by the Congress
on this landmark legislation.
Procedural changes, however, will mean little unless the
political will exists to exploit the changes fully. And this can
happen only if the American people understand better the nature
of the inflation we have been experiencing and demand appro­
priate action by their elected representatives.
As you leave this hall today, I urge you to give continuing
thought and study to the problem of inflation. If it persists, it
will affect your personal lives profoundly. Where possible, I
urge you to assume a leadership role in getting people every­
where interested in understanding inflation and in doing some­
thing about it. In the great "town hall" tradition of America,
much can be accomplished if people organize themselves— in
their offices, trade unions, factories, social clubs, and churches—
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THE MENACE OF INFLATION

to probe beneath the superficial explanations of inflation that are
the gossip of everyday life. Productivity councils in local com­
munities and enterprises, established for the purpose of improv­
ing efficiency and cutting costs, can be directly helpful in re­
straining inflation.
While I am on the subject of what individuals can do to be
helpful, let me note the need for rediscovery of the art of care­
ful budgeting of family expenditures. In some of our businesses,
price competition has atrophied as a mode of economic behavior,
in part because many of our families no longer exercise much
discipline in their spending. We have become a nation of im­
pulse shoppers, of gadget buyers. We give less thought than we
should to choosing among the thousands of commodities and
services available in our markets. And many of us no longer
practice comparative price shopping— not even for big-ticket
items. Careful spending habits are not only in the best interest
of every family; they could contribute powerfully to a new
emphasis on price competition in consumer markets.
I do not expect that the path back to reasonable price stabil­
ity can be traveled quickly. Indeed, our government will need to
take numerous steps to reduce the inflationary bias of our econ­
omy besides those I have emphasized. The forces of competi­
tion in labor and product markets need to be strengthened— per­
haps by establishing wage and price review boards to minimize
abuses of economic power, certainly through more vigorous en­
forcement of the antitrust laws, besides elimination of barriers to
entry in skilled occupations, reduction of barriers to imports
from abroad, and modification of minimum wage laws to im­
prove job opportunities for teenagers. Impediments to increased
production that still remain in farming, construction work, and
other industries need to be removed. And greater incentives
should be provided for enlarging our capacity to produce indus­
trial materials, energy, and other products in short supply.
But if inflation cannot be ended quickly, neither can it be
eliminated without cost. Some industries will inevitably op­
erate for a time at lower rates of production than they would
prefer. Government cannot— and should not— try to compen­
sate fully for all such occurrences. Such a policy would involve
negating with one hand what was being attempted with the
other.




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But government does have a proper ameliorative role to
play in areas, such as housing, where the incidence of credit
restraint has been disproportionately heavy. The special burden
that has fallen on homebuilding should be lightened, as is the
intent of the housing aids which the administration recently
announced. And my personal judgment is that it would be
advisable, too, for government to be prepared, if need be, to
expand the roster of public service jobs. This particular means
of easing especially troublesome situations of unemployment
will not add permanently to governmental costs. And in any
event, it would conflict much less with basic anti-inflation ob­
jectives than would the conventional alternative of general
monetary or fiscal stimulus. A cut in personal income taxes, for
instance, would serve to perpetuate budget deficits. Not only
that, it might prove of little aid to the particular industries or
localities that are now experiencing economic difficulty. Much
the same would be true of a monetary policy that permitted
rapid growth of money and credit. There is no justification for
such fateful steps at this time.
In concluding, I would simply repeat my central message:
there is no easy way out of the inflationary morass into which
we have allowed ourselves to sink through negligence and im­
perfect vision. But I am confident that we will succeed if the
American people become more alert to the challenge. I hope
that the members of this graduating class will join with other
citizens across the country in a great national crusade to put an
end to inflation and restore the conditions essential to a stable
prosperity— a prosperity whose benefits can be enjoyed by all
our people. This objective is within our means and is essential
to our nation's future.

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Key Issues of Monetary Policy

I am pleased to appear before this committee today to discuss the
six questions posed by Chairman Patman's letter of June 19,
1974. The several areas addressed by these questions are of
great interest, particularly to professional economists. My com­
ments on them convey the basic thinking of the Board of Gov­
ernors, and will— I believe— be responsive to the committee's
needs.
I must, however, go beyond a narrow or technical inter­
pretation of these questions. Rapidly rising prices, rapidly rising
wages, rapidly rising interest rates— these are the burning eco­
nomic issues of our time. My testimony today will seek to
identify the sources of this menacing inflationary problem and
to outline the course that public policy must take to restore price
stability.
The first question raised by Chairman Patman concerns the
reliability of the trade-off between inflation and unemploy­
ment— the so-called Phillips curve— as a guide for monetary
policy. The discovery some years ago of a statistical correlation
between the rate of inflation and the rate of unemployment
seemed to offer a straightforward choice to policy makers.
These early studies— using data first for the British economy,
later for the United States and other economies— suggested that
unemployment could be reduced if a nation were willing to put
up with more inflation, and that advances in the general price
Statement before the Committee on Banking and Currency, House of Rep­
resentatives, July 30, 1974.




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level could be slowed down if a higher rate of unemployment
were tolerated.
Further research and subsequent developments have indi­
cated, however, that simple statistical correlations of this kind
are misleading. The forces affecting economic activity and
prices in a modern economy are far too complex to be described
by a simple mathematical equation.
W e found in 1970 and early 1971, for example, that in­
creases in wage rates and prices may continue— and even accel­
erate— in the face of rising unemployment and declining real
output. The experience of the United States in this regard was
not unique; similar developments occurred at about the same
time in Canada and the United Kingdom.
W e have also come to recognize that public policies that
create excess aggregate demand, and thereby drive up wage rates
and prices, will not result in any lasting reduction in unemploy­
ment. On the contrary, such policies— if long continued— lead
ultimately to galloping inflation, to loss of confidence in the
future, and to economic stagnation.
The central objective of monetary and fiscal policies should
be to foster lasting prosperity— a prosperity in which men and
women looking for work are able to find work; a prosperity in
which incomes and savings are protected against inflation; a
prosperity that can be enjoyed by all. O f late, such a prosperity
has eluded us, because we have not yet found a way to bring an
end to inflation.
Let me turn to your second question, concerning the benefits
and risks involved in the Federal Reserve accommodating in­
creases of the general price level that originate in supply short­
falls and other special events.
Prices in the United States have been affected heavily in the
past several years by a variety of special factors. Disappointing
harvests in 1972— both here and abroad— caused a sharp run-up
of food prices in 1973. Beginning in the fall of last year, the
manipulation of petroleum shipments and prices by oil-exporting
countries led to huge increases in the price of gasoline, heating
oil, and related products.
Furthermore, a worldwide boom in economic activity during
1972 and 1973 led to a bidding up of prices everywhere. In the
United States, larger foreign orders for industrial materials,
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KEY ISSUES OF MONETARY POLICY

component parts, and capital equipment added to growing
domestic demands. Pressures became particularly intense in the
major materials industries— such as steel, aluminum, cement,
paper— in which expansion of capacity had been limited in
earlier years by low profits and environmental controls.
The impact of worldwide inflation was especially severe in
the United States because of the decline in the exchange value
of the dollar relative to other currencies. Besides stimulating our
export trade, and thereby reinforcing the pressures of domestic
demand on available resources, devaluation raised the dollar
prices of imported products, and these effects spread. through
our markets.
More recently, the removal of controls over wages and
prices has led to sharp upward adjustments in both our labor
and commodity markets.
It has at times been suggested that monetary policy could
have prevented these special factors from affecting significantly
the average level of wholesale and consumer prices. That may
well be true, but the cost of such a policy should not be under­
estimated. Last year, about 60 percent of the rise in consumer
prices was accounted for by food and fuel; for wholesale prices,
the proportion was even higher. To achieve stability in the
average price level, it would therefore have been necessary to
bring down very sharply the prices of other goods and services.
Prices of many commodities— particularly farm products
and industrial raw materials— are established in highly com­
petitive markets and are therefore capable of declining as well
as rising. The prices of many other commodities and services
that make up the gross national product, however, are nowadays
rather inflexible in a downward direction, in large part because
of the persistent upward push of labor costs and imperfect busi­
ness competition. For these commodities, significant price de­
clines could be achieved only by drastically restrictive policies—
policies that would lead to widespread bankruptcies and mass
unemployment. A monetary policy that sought to offset com­
pletely the effects on the average price level of the rising cost of
food, petroleum products, and other commodities whose prices
were so heavily influenced during the past two years by special
factors, would clearly have been undesirable.
Nevertheless, monetary policy must not permit sufficient




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growth in money and credit supplies to accommodate all of the
price increases that are directly or indirectly attributable to
special factors. The rise in the price of petroleum, for example,
has increased the costs of energy, plastics, petroleum-based
chemicals, and other materials. Business firms will endeavor to
pass these higher costs through to consumers. Workers, too,
will bargain for larger wage increases, in order to compensate
for declines in their real incomes. To the extent that wage in­
creases outrun gains in productivity, business costs— and ulti­
mately consumer prices— are driven up. Thus, in addition to
their direct effects on prices, special factors may have large and
widespread secondary effects on the price level.
A monetary policy that accommodated all of these price
increases could result in an endless cost-price spiral and a serious
worsening of an already grave inflationary problem. The appro­
priate course for monetary policy is the middle ground. The
price rigidities characteristic of modern industrialized economies
must be recognized, but a full pass-through of all the price effects
stemming from special factors must not be permitted.
The middle course of policy we have adopted has resulted
in a growth rate of the narrowly defined money supply— cur­
rency and demand deposits— of about 6 percent during the past
twelve months. This rate of growth is still too high for stability
of average prices over the longer term. But moderation in the
growth rate of money and credit supplies must be achieved
gradually to avoid upsetting effects on the real economy. This
is particularly true now, when price-cost relations are seriously
distorted.
I turn now to Chairman Patman's third question, which
relates to the positive elements and the risks involved in mone­
tizing deficit spending. The simple fact is that financing federal
deficits by printing money involves risks, and the risks are
grave.
Fortunately, since 1951 monetary policy in this country
has not been conducted with an eye to providing a ready market
for Treasury securities, or for financing federal deficits. Con­
siderations of this kind were an objective of Federal Reserve
policy during World War II, when Treasury borrowing pro­
ceeded on an unprecedented scale in relation to the size of our
economy. I doubt if such a policy was warranted even under
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KEY ISSUES OF MONETARY POLICY

wartime circumstances, and its continuation in the years im­
mediately after the war was a very serious mistake. It led to
excessive increases in borrowing by private firms, consumers,
and state and local governments, and thus fueled the subse­
quent inflation.
The dangers inherent in this situation became acutely evi­
dent during the Korean War, when federal deficits once again
threatened. With the aid of prodding by the Congress, par­
ticularly by Senator Douglas, the Federal Reserve and the
Treasury resolved their disagreements, and monetary policy
returned to its traditional role of regulating the supply of money
and credit in the interest of economic stability. Since then, the
Treasury has financed its deficits at prevailing market interest
rates in competition with other borrowers.
During periods of large Treasury financings, the Federal
Reserve follows the practice of maintaining "even-keel" in the
money market— that is, we refrain from taking overt actions
that market participants might interpret as a change in monetary
policy. On some occasions, therefore, the maintenance of "evenkeel" has delayed the timing of changes in monetary policy.
Treasury financing operations thus pose problems for monetary
policy, particularly when they are large and frequent.
Federal deficit financing becomes a major source of economic
and financial instability when it occurs during periods of high
economic activity, as it has in recent years. The huge federal
deficits of the past decade have added enormously to aggregate
demand for goods and services, and have thus been directly re­
sponsible for upward pressures on the price level. Heavy bor­
rowing by the federal,sector has also been an important con­
tributing factor to the persistent rise in interest rates, and to the
strains that have at times developed in money and capital mar­
kets. Worse still, continuation of budget deficits has tended to
undermine the confidence of the public in the capacity of our
government to deal with inflation.
If the present inflationary problem is to be solved, and
interest rates brought down to reasonable levels, the federal
budget must be brought into better balance. This is the most
important single step that could be taken to restore the confi­
dence of people in their own and our nation's economic future.
Let me turn, next, to the committee's fourth question, deal­




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REFLECTIONS OF AN ECONOMIC POLICY MAKER

ing with the benefits and risks of the Federal Reserve's fighting
money market fires.
As this committee well knows, the cardinal aim of monetary
policy is maintenance of a financial environment in which our
national objectives of full employment and price stability can be
realized. For the most part, this responsibility is best achieved
by striving for appropriate growth rates of the monetary aggre­
gates, and letting financial markets take care of themselves.
The appropriate monetary growth rates will vary with eco­
nomic conditions. They are apt to be higher during periods of
economic weakness, when aggregate spending is in need of
stimulus, than when the economy is booming and inflationary
tendencies threaten economic stability. Special circumstances
may, however, call for monetary growth rates that deviate from
this general rule. For example, as noted in my response to the
second question, the special factors giving rise to extraordinary
price pressures during the past year or two have required tolera­
tion of a monetary growth rate that has been relatively high by
historical standards.
There are times when responsibility for maintaining finan­
cial and economic stability requires the Federal Reserve to focus
attention primarily on factors other than growth in the money
supply or bank credit. The oldest and most traditional function
of a central bank is to act as a lender of last resort— that is, to
provide liquidity when dislocation of financial markets threatens
serious damage to the economy. Acting in this capacity, the
Federal Reserve in the summer of 1970 warded off a develop­
ing liquidity crisis in the commercial paper market. This year,
difficulties encountered by a large commercial bank led to
rumors of widespread illiquidity of the commercial banking
system. These concerns were reduced by timely Federal Reserve
action at the discount window.
It so happens that in neither of these instances did the
Federal Reserve's intervention result in a significant deviation
of the monetary aggregates from desired growth rates. But let
there be no mistake about our determination to deal with finan­
cial troubles. In the future, as in the past, we will surely not
stand aloof and permit a crisis to develop out of devotion to this
or that preconceived growth rate of the money supply.
The responsibility of the Federal Reserve for conditions in
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KEY ISSUES OF MONETARY POLICY

the money and capital markets goes beyond its historic function
to act as lender of last resort. Monetary policies need to be im­
plemented, I believe, in ways that avoid large and erratic fluctua­
tions in interest rates and money market conditions.
From one month to the next, the public's demand for money
is subject to variations that are usually of a short-run nature.
For example, a large tax refund, a retroactive increase in social
security benefit payments, or a sizable disbursement by the
Treasury of revenue-sharing funds may produce a temporary
bulge in the demand for cash balances. If the Federal Reserve
tried to maintain a rigid monetary growth rate in the face of such
developments, interest rates could fluctuate widely, and to no
good end. The costs of financial intermediation would be in­
creased, and the course of monetary policy might be misinter­
preted. To avoid these harmful effects, the Federal Reserve
seeks to achieve desired growth rates of money and credit over
relatively long periods. Experience over the past two decades
suggests that even an abnormally large or abnormally small rate
of growth of the money stock over a period of six months or so
has a negligible effect on the course of the economy— provided
it is subsequently offset.
We recognize, of course, that too much attention to pre­
venting short-run fluctuations in interest rates could inadver­
tently cause the growth rate of money or credit to drift away from
what is appropriate for the longer run. To guard against this
possibility, the Federal Reserve in early 1972 introduced a new
set of procedures for implementing monetary policy. These pro­
cedures focus more attention on provision of bank reserves
through open market operations at a pace consistent with desired
growth rates of monetary and banking aggregates.
The new procedures have been helpful, but numerous
problems of monetary control still remain. For example, a sub­
stantial part of the money supply is in the form of deposits at
nonmember banks. As a consequence of this and other factors,
there is considerable slippage between the supply of bank re­
serves controlled by the Federal Reserve and the nation's money
supply. Monetary control is therefore less precise than it could
or should be. I would once again urge the Congress to correct
this defect by extending the Federal Reserve's power over reserve
requirements to all commercial banks.




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REFLECTIONS OF AN ECONOMIC POLICY MAKER

Let me turn next to Chairman Patman's fifth question,
which deals with the relationship that interest rates, the money
supply, and the rate of inflation bear to one another.
Most interest rates in the United States are now at the high­
est levels in our history. There are some who believe that re­
strictive monetary and credit policies are responsible for this
state of affairs. This view is erroneous. The basic reason why
interest rates have risen to their present level is the accelerating
pace of price advances over the past decade, so that we now find
ourselves in the midst of a two-digit inflation.
Historical evidence— from other countries as well as our
own— indicates beyond any doubt that inflation and high interest
rates go together. The reasons are not hard to understand. In
most countries throughout the Western world, inflationary ex­
pectations have become deeply imbedded in the calculations of
lenders and borrowers. Lenders now reckon that loans will
probably be repaid in dollars of lesser value, and they therefore
hold out for nominal rates of interest high enough to assure them
a reasonable real rate of return. Borrowers, on their part, are
less resistant to rising costs of credit when they anticipate re­
payment in cheaper dollars.
Interest rates at anything like present levels are deplorable.
They cause hardships to individuals and pose a threat to the
viability of some of our industries and financial institutions. But
we cannot realistically expect any lasting decline in the level of
interest rates until inflation is brought under control.
History also indicates that high rates of inflation are
typically accompanied by high growth rates in supplies of money
and credit. But inflationary tendencies and monetary expansion
are not as closely related as is sometimes imagined. For example,
the econometric model of the St. Louis Federal Reserve Bank,
which assigns a major role to growth of the money stock in
movements of the general price level, has seriously underesti­
mated the rate of inflation since the beginning of 1973. Simula­
tions of the model, using the actual growth rates of the money
supply since the first quarter of 1972, suggest that the rate of
inflation during the past two quarters should have been a mere
3 V2 percent. Apparently, special factors— such as I mentioned
previously— have been at work.
Inflationary processes are characterized by rising turnover
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KEY ISSUES OF MONETARY POLICY

rates of the existing stock of money as well as by relatively high
rates of monetary expansion. Recent experience in the United
States illustrates this fact. Over the past ten years, the average
annual increase in the money stock has been about 6 percent—
a higher rate than in the previous decade. Since 1964, however,
the income velocity of money— that is, the ratio of gross national
product to the money stock— has risen at an average annual rate
of about 2 V2 percent, thus contributing importantly to the infla­
tionary problem.
The role of more rapid monetary turnover rates in inflation­
ary processes warns against assuming any simple causal relation
between monetary expansion and the rate of inflation either
during long or short periods. Excessive increases in money and
credit can be an initiating source of excess demand and a soaring
price level. But the initiating force may primarily lie elsewhere,
as has been the case in the inflation from which this country is
now suffering.
The current inflationary problem emerged in the middle
1960s when our government was pursuing a dangerously ex­
pansive fiscal policy. Massive tax reductions occurred in 1964
and the first half of 1965, and they were immediately followed
by an explosion of federal spending. The propensity of federal
expenditures to outrun the growth of revenues has continued
into the 1970s. In the last five fiscal years, total federal debt—
including the obligations of the federal credit agencies— has
risen by more than $100 billion, a larger increase than in the
previous twenty-four fiscal years.
Our underlying inflationary problem, I believe, stems in very
large part from loose fiscal policies, but it has been greatly aggra­
vated during the past year or two by the special factors men­
tioned earlier. From a purely theoretical point of view, it would
have been possible for monetary policy to offset the influence
that lax fiscal policies and the special factors have exerted on
the general level of prices. One may therefore argue that rela­
tively high rates of monetary expansion have been a permissive
factor in the accelerated pace of inflation. I have no quarrel with
this view. But an effort to use harsh policies of monetary re­
straint to offset the exceptionally powerful inflationary forces of
recent years would have caused serious financial disorder and




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REFLECTIONS OF AN ECONOMIC POLICY MAKER

economic dislocation. That would not have been a sensible
course for monetary policy.
The last question put to me deals with how monetary policy
should be used to check inflation and bring interest rates down
to reasonable levels.
The principal objective of monetary policy since late 1972
has been to combat the inflationary forces threatening our econ­
omy. To this end, supplies of money and credit have been
restricted at a time when credit demands were booming. Inevita­
bly, therefore, interest rates have risen. This unhappy conse­
quence has led some observers to conclude that restrictive mone­
tary policies are counterproductive— because rising interest rates
are an added cost to businesses and thus may result in still
higher prices.
There is a grain of truth in this argument, but no more than
that. For most businesses, interest costs are only a small frac­
tion of total operating expenses. The direct effects of a restrictive
monetary policy on costs and prices are therefore small. The
indirect effects of a restrictive monetary policy on prices are far
more important. When growth in supplies of money and credit
is restrained, some business firms and consumers are discour­
aged by the high cost of credit from carrying through their plans
to spend; others find it more difficult to obtain credit and there­
fore trim their spending; still others, reckoning that monetary
restraint will cool off aggregate demand, curtail their outlays for
goods and services even though they do not depend on the
credit markets for spendable funds. In all these ways, a restric­
tive monetary policy helps to moderate aggregate spending and
thus to reduce inflationary pressures.
In order to bring interest rates down to reasonable levels,
we shall need to stay with a moderately restrictive monetary pol­
icy long enough to let the fires of inflation burn themselves out.
Progress can still be made this year in slowing the rate of
price increase, and it is urgent that we do so. Inflation has been
having debilitating effects on the purchasing power of consum­
ers, on the efficiency of business enterprises, and on the condi­
tion of financial markets. The patience of the American people
is wearing thin. Our social and political institutions cannot in­
definitely withstand a continuation of the current inflationary
spiral.
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KEY ISSUES OF MONETARY POLICY

We must face squarely the magnitude of the task that lies
ahead. A return to price stability will require a national com­
mitment to fight inflation this year and in the years to come.
Monetary policy must play a key role in this endeavor, and we
in the Federal Reserve recognize that fact. We are determined
to reduce over time the rate of monetary and credit expansion to
a pace consistent with a stable price level.
Monetary policy, however, should not be relied upon ex­
clusively in the fight against inflation. Fiscal restraint is also
urgently needed. Strenuous efforts should be made to pare fed­
eral budget expenditures, thus eliminating the deficit that seems
likely in fiscal 1975. The Congress should resist any temptation
to stimulate economic activity by a general tax cut or a new
public works program. There may be justification for assistance
to particular industries— such as housing— that are especially
hard hit by a policy of monetary restraint. An expanded public
service employment program may also be needed if unemploy­
ment rises further. But government should not try to compen­
sate fully for all the inconvenience or actual hardship that may
ensue from its struggle against inflation. Public policy must not
negate with one hand what it is doing with the other.
There are other actions that may be of some help in speed­
ing the return to general price stability. For example, limited
intervention in wage and price developments in pacesetting in­
dustries may result in considerable improvement of wage and
price performance. I would urge the Congress to reestablish the
Cost of Living Council and to empower it, as the need arises, to
appoint ad hoc review boards that could delay wage and price
increases in key industries, hold hearings, make recommenda­
tions, monitor results, issue reports, and thus bring the force of
public opinion to bear on wage and price changes that appear to
involve an abuse of economic power. Encouragement to capital
investment by revising the structure of tax revenues may also
be helpful, as would other efforts to enlarge our supply potential.
For example, minimum wage laws could be modified to increase
job opportunities for teenagers, and reforms are still needed to
eliminate restrictive policies in the private sector— such as feath­
erbedding and outdated building codes.
A national effort to end inflation requires explicit recogni­
tion of general price stability as a primary objective of public




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policy. This might best be done promptly through a concurrent
resolution by the Congress, to be followed later by an appropri­
ate amendment to the Employment Act of 1946. Such actions
would heighten the resolve of the Congress and the Executive
to weigh carefully the inflationary implications of all new pro­
grams and policies, including those that add to private costs as
well as those that raise federal expenditures. And they would
signal to our people, and to nations around the world, that the
United States firmly intends to restore the conditions essential
to a stable and lasting prosperity.

180



Jobs and Prices

Thank you very much, Mr. President.
I am not going to take full advantage of the opportunity
you are giving me. If I took equal time, you and this fine audience
might have to listen to me for a full hour or two.
But, I do want to take a few minutes and comment on the
inflation problem and on the role of monetary policy.
I listened very carefully to every speaker this morning. I
was encouraged by the fact that everyone showed full under­
standing of the gravity of the inflation problem that our nation
is now facing. I learned one thing more, namely, that the Fed­
eral Reserve will not necessarily win a popularity contest.
Now, the job of the Federal Reserve System is not to be
popular. Our job is to use all of our energy, all of the ability
and knowledge that we can muster, to help protect the jobs of
American workers and the integrity of their money.
In doing our job we operate in an environment that is made
by others— by the Congress, by trade unions, by business firms,
by the general public. Now, there are some facts of life that the
Federal Reserve Board must take account of if it is to serve the
public with good conscience. The Federal Reserve has to make
some hard decisions if only because hard decisions are being
avoided by others. I want to call your attention to some hard
facts of life.
We are in the midst of an inflation which has been gathering
force over the past decade. This inflation has now reached
Remarks at the Summit Conference on Inflation, W ashington, D.C., Sep­
tember 27, 1974.




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REFLECTIONS OF AN ECONOMIC POLICY MAKER

a stage where it is endangering our economic and political
future.
As a result of this inflation, first of all, our nation's capacity
to produce has suffered a setback. Despite sluggish economic
conditions for some months now, shortages of materials, com­
ponent parts, and equipment remain acute in many of our essen­
tial industries.
Secondly, as a result of inflation, consumer purchasing
power is being eroded. During the past year, the take-home pay
of the typical worker has declined from 4 to 5 percent in what
it will buy.
In the third place, as a result of the inflation, the real value
of the savings deposits, pension reserves, and life insurance poli­
cies of the American public has diminished.
Fourth, as a result of the inflation, corporate profits derived
from domestic operations have eroded— a fact that is concealed
by accounting techniques that were devised originally for inflation-free times.
Fifth, as a result of the inflation, financial markets have been
experiencing strains and stresses. Interest rates have soared.
Some financial and industrial firms have found it more difficult
to refund maturing debt or to raise needed funds in the money
and capital markets. The savings flow to thrift institutions has
sharply diminished and stock prices have been badly depressed.
In short, as a result of the inflation, much of the planning
that American business firms and households customarily do has
been upset and the driving force of economic expansion has
been blunted.
It should not be surprising, therefore, that the physical per­
formance of the economy has stagnated in recent months, and
that unemployment is now larger than it was last fall. W e can­
not realistically expect a resurgence of economic activity until
confidence in our nation's economy is restored.
The most important requirement for rebuilding confidence,
I believe, is hard evidence that we are making progress in check­
ing the disease of inflation.
In view of the protracted character and the growing inten­
sity of inflation, the Federal Reserve has been striving for some
time to hold down the growth of money and credit.
I received a good deal of advice this morning, all of which
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JOBS AND PRICES

suggested that the monetary spigot should be opened up. I was
told to let the money supply expand more rapidly so that interest
rates could come down. If that advice were followed, the infla­
tion would become much more intense and interest rates, as they
always do in such circumstances, would go higher and higher
and soon be a good deal above their present level.
Rapid monetary expansion in the present inflationary en­
vironment would add fuel to the fires of inflation and thus
worsen our economic troubles.
Now, we at the Federal Reserve have tried to apply the
monetary brakes firmly enough to get results, but we have also
been mindful of the need to allow the supply of money and credit
to keep expanding moderately. The overall supply of money
and credit has continued to grow this year but at a slower pace
than before.
However, the demand for money and credit has been much
greater than the supply. As a result of the huge demand for
borrowed funds, credit markets have become tight and interest
rates have risen to an extraordinarily high level.
These high interest rates have imposed a heavy burden on
businesses and families across the nation. Homebuilding in par­
ticular has been hard hit by the developments in the money
market. Soaring interest rates, outflows of deposits from thrift
institutions, and the consequent decline in availability of mort­
gage credit have greatly aggravated the condition of the homebuilding industry, which was already suffering from sharply
rising construction costs, from erosion in the purchasing power
of consumer incomes, and from the overbuilding of the last two
years.
It may now be, however, that tensions in financial markets
are beginning to ease. With continued moderation in current
demands for goods and services, shortages and imbalances in our
factories and shops are diminishing. And the Federal Reserve in
recent months has been successful, as I have already suggested,
in limiting the growth of money and credit to reasonably appro­
priate dimensions.
We have, therefore, been able recently to take actions that
have reduced somewhat the pressures exerted on the banking
system. Short-term market interest rates have responded to this
relaxation and have declined from their early July peaks.




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REFLECTIONS OF AN ECONOMIC POLICY MAKER

Long-term market interest rates have stabilized, albeit at
very high levels, and they can surely be expected to fall back
once some progress is made in curbing inflation. Mortgage in­
terest rates and other institutionally determined rates tradition­
ally lag behind market rates, and they, too, will respond to
progress in curbing inflation.
The recent movements of interest rates are encouraging, but
we cannot count on any very substantial reduction until borrow­
ers and lenders in the market are convinced that the Federal
Reserve is no longer pursuing a lonely struggle against inflation.
Monetary policy is much too blunt an instrument to be
relied upon exclusively in what needs to be a national crusade
to bring inflation under control.
It is of vital importance that fiscal policy actively join in
the battle. Frugality in public expenditures, and a budget that
is tilted toward surpluses instead of deficits, can make an enor­
mous contribution to curbing inflation and to lowering interest
rates.
A policy of monitoring wages and prices, but relying on
voluntary cooperation, can also play a modest, but useful, role
in curbing inflationary excesses. I am hopeful that the newly
established Council on Wage and Price Stability will help to
point the way to anti-inflationary conduct on the part of busi­
ness, labor, and the consuming public alike.
Programs that seek to enlarge our nation's productive ca­
pacity and to intensify the forces of competition can be very
helpful in combating inflation over a longer period of time. In
this connection let me stress the need to devise effective measures
for improving the productivity of our labor force, which has been
lagging badly of late.
Greater output potential and increased productivity per
worker are essential to achieving a better life for all of our
people.
In closing, I want to assert once again and to assure you
that the Federal Reserve will persevere in pursuing monetary
policies that are necessary to curb our rampant inflation.
We also intend to keep the supply of money and credit
moving upward, so that the needs of the economy may be met.
Further, we fully recognize our responsibilities as the na­
tion's lender of last resort, and we will not hesitate to come to
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JOBS AND PRICES

the assistance of financial institutions that are caught in a tempo­
rary liquidity squeeze.
I can assure you all that there will be no credit crunch in our
country.




185




Immediate and Long-Range
Economic Problems

I am pleased to meet with the Joint Economic Committee once
again to present the views of the Board of Governors on the
condition of the national economy.
Our nation today is suffering from a serious economic reces­
sion. It is also in the midst of an inflation that is threatening the
very fabric of our society.
Public policy is thus confronted with a grave and profoundly
difficult problem. There is an immediate need for measures to
cushion the recession. Yet, we cannot ignore the longer-run
implications of our actions for the rate of inflation or for the
other adverse trends that in recent years have hampered the
nation's economic performance.
Let me turn, first, to the immediate economic situation and
then move to some of our longer-range economic problems.
Since last fall, general business activity has deteriorated.
The decline in the real gross national product in the fourth quar­
ter was unusually large. Reductions in production and employ­
ment over recent months have been about as rapid as at any
time in the postwar period. Cutbacks in activity have been
especially sharp in the auto industry, but they have been sub­
stantial also in the production of other consumer goods, business
equipment, construction products, and industrial materials.
Total employment increased during the first ten months of
1974; but there has been a marked decline in recent months, and
unemployment has risen sharply. Overtime work has also been
Statement before the Joint Economic Committee, U.S. Congress, February 7,
1975.




187

REFLECTIONS OF AN ECONOMIC POLICY MAKER

reduced and an increasing number of workers have been able
to find only part-time employment.
As so often happens in a recession, consumer demands for
autos, furniture, household appliances, and other durable goods
have declined sharply. Sales of domes tic-type autos in January—
although up from December— were at an annual rate of only
6.6 million units, nearly one-fourth below last summer's pace.
Weakness in consumer demand has extended also to clothing
and other nondurable goods. Total retail sales expressed in
current dollars fell more than 3 percent from the third to the
fourth quarter of last year, and the decline in real terms was
even larger. Actually, the physical volume of retail trade has
been moving on a downward trend since the spring of 1973.
Residential construction was notably weak throughout 1974.
New housing starts in December were at an annual rate of only
870,000 units, the lowest rate since 1966. However, conditions
in the mortgage credit markets are rapidly improving, and there
has been some tendency for new building permits to stabilize
recently. Thus, we may reasonably expect some upturn in homebuilding before very long.
Business capital spending, on the other hand, will probably
decline this year in real terms— although dollar outlays may be
rising moderately further. O f late, business firms have been
canceling or postponing plans for construction of new facilities
and for the purchase of new machinery and equipment. This has
resulted in a drop of new orders for capital equipment, and of
contracts for commercial and industrial construction.
The decline in final sales during recent months has been
unusually large— when we allow for the advance in prices— so
that inventories continued to pile up despite substantial cutbacks
in production. However, business firms are working strenuously
to cut back excess stocks— through further curtailments of out­
put, special promotions, and price concessions— and it appears
that we are now moving into a period of inventory liquidation.
This adjustment of inventories will have a temporary depressing
effect on production and employment, but it is an essential pre­
condition for an upturn in business activity later on.
As the economy weakened during the course of 1974, the
behavior of prices began to reflect it. Sensitive prices of indus­
trial raw materials started to decline in the spring of last year.
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IMMEDIATE AND LONG-RANGE PROBLEMS

Last fall, the effects of declining business activity began to show
up in wholesale prices of intermediate materials, supplies, and
components, and later on in prices of finished goods. In Decem­
ber, wholesale prices of industrial commodities were unchanged,
agricultural prices declined, and the overall wholesale price index
turned down.
The rise in consumer prices has also slowed, partly because
the run-up in prices of energy items associated with the rise in
the cost of imported crude oil has been tapering off. There have
also been substantial price concessions by automobile dealers
and other retailers to help stimulate sales and thus bring inven­
tories down.
It would be premature to conclude, however, that the menace
of inflation is, or soon will be, behind us. Agricultural products
are still in short supply, in large part because of a series of
disappointing crop harvests both here and abroad. Also, in some
sectors of the economy, such as the service area, prices are
continuing to respond to past increases in costs. A major source
of inflationary pressure now is the run-up of wage rates. Recent
increases in wages greatly exceed the long-run growth trend of
productivity. To make matters worse, productivity has declined
substantially over the past year, and unit labor costs conse­
quently rose by almost 15 percent in 1974.
Other industrial countries have also been beset by the dual
problem of recession and inflation. With the notable exception
of Germany, the rate of inflation in other industrial nations has
been about the same or higher than in the United States. Most
major countries also experienced a leveling off or decline in
employment and output last year, and these tendencies were
increasingly apparent as the year progressed.
Despite the weakening in economic activity around the
world, our export markets held up well last year. Merchandise
exports increased considerably, even after allowance for the rise
in prices. Our trade balance would have improved, had it not
been for the higher price of imported oil, which moved it into
substantial deficit. And the exchange value of the dollar has
slipped in recent months, due in some measure to capital flows
caused by the sharper decline of market interest rates here than
abroad.
Mainly because of higher oil prices, most oil-importing




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REFLECTIONS OF AN ECONOMIC POLICY MAKER

countries have had large current account deficits during the past
year, and some have experienced difficulty in obtaining needed
financing. For poorer countries, financing problems have be­
come particularly acute. Recent international understandings
to extend the oil facility of the International Monetary Fund,
to increase Fund quotas, and to create a $25 billion safety net
among member countries of the Organization for Economic Co­
operation and Development will help to cope with the inter­
national financial problems of 1975. But new strains could
develop in international financial markets. Private banking sys­
tems handled a huge volume of international financing last
year, and it is unlikely that they can repeat this performance
in 1975.
Both here and in other industrial countries, monetary policy
has responded to the weakening in economic activity by encour­
aging easier conditions in financial markets. In the United States,
that easing has proceeded somewhat faster than has generally
been the case abroad. Federal Reserve open market operations
began to be more accommodative last summer, and short-term
market interest rates began to move down from the exceptionally
high levels reached in July. As the year progressed, evidence
accumulated that economic activity was weakening and that
advances in commodity prices were beginning to moderate.
Open market operations were, therefore, steadily directed to­
wards a more ample provision of reserves to the banking system.
More recently, open market policy has been reinforced by
other monetary instruments. The discount rate was reduced on
three occasions— in early December, early January, and again
this week— from 8 percent to 6% percent. Reductions in member
bank reserve requirements were also ordered— in September,
November, and January, releasing a total of nearly
billion
of reserves and thus helping to improve the liquidity position of
the banking system.
Since last July, these policy actions— together with weaker
demands for credit by businesses and consumers— have resulted
in a sharp decline of short-term market interest rates. Downward
movements have continued in recent weeks, even though Treas­
ury financing needs have grown and market participants have
begun to anticipate massive federal deficits that, unhappily, are
now in prospect.
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IMMEDIATE AND LONG-RANGE PROBLEMS

Long-term interest rates have also declined, but much less
than short-term rates. Lenders are still demanding a sizable
inflationary premium to supply long-term funds. Moreover,
corporations have issued in recent months exceptionally large
amounts of long-term bonds— in part reflecting their need to
lengthen debt and thereby improve their liquidity position.
Demands for long-term capital by state and local governments
have also been well sustained.
The beneficial effects of easier conditions in financial mar­
kets are not all registered in the movement of interest rates.
For example, member banks responded initially to the greater
availability of reserves by repaying their borrowings from the
Federal Reserve and by taking other steps that improved their
liquidity. Banks became overextended during the 1971-1974
credit expansion, and an improvement of their financial position
was needed to lay the basis for subsequent expansion of lending.
Reductions in the prime rate of interest, therefore, have lagged
behind the decline in open-market rates, as banks encouraged
businesses to meet their credit needs in the open market.
Growth of the monetary aggregates has reflected this cau­
tious behavior on the part of banks. Despite a series of expansive
monetary actions, the narrowly defined money stock (Mi) grew
at an annual rate of only IV 2 percent in the third quarter of 1974
and 4 V4 percent in the fourth quarter. In January of this year,
moreover, a decline occurred in M i, probably because demands
for bank credit were unusually weak during the month.
Broader measures of money have shown more strength than
has Mi. With interest rates declining, net inflows of consumertype time and savings deposits at banks and at nonbank thrift
institutions have improved markedly. Growth in M 2— which
includes consumer-type time and savings deposits at commercial
banks— rose at an annual rate of about 7 percent in the fourth
quarter, compared with a 4 V2 percent rate in the third. Expan­
sion in M 3— a still broader measure of money that includes also
deposits at nonbank thrift institutions— showed similar accel­
eration. Furthermore, the volume of large denomination certifi­
cates of deposit and other liquid instruments bought by major
investors has continued to increase at a brisk pace.
Enlarged inflows of deposits to savings and loan associations
have permitted these suppliers of home mortgage funds to reduce




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REFLECTIONS OF AN ECONOMIC POLICY MAKER

their borrowing and to replenish liquid assets, thereby laying the
base for renewed expansion in mortgage lending. The full bene­
fits of these developments will not be felt for some time, but the
improved deposit inflows have already had an effect on mortgage
interest rates. Rates on new conventional home mortgages have
declined by almost a full percentage point from the peaks of
early autumn, and lenders are also more active now in seeking
out borrowers.
In short, financial conditions have eased in a variety of
ways over recent months. The liquidity of banks and other thrift
institutions has improved; short-term interest rates have dropped
sharply; a large volume of long-term securities has been suc­
cessfully marketed; uncertainties afflicting financial markets
earlier last year have diminished; and stock prices of late have
been rising again.
Despite this marked improvement in financial markets, some
further decline in economic activity has to be expected. Con­
sumer willingness to spend is likely to be held back by the effects
of widespread unemployment on personal incomes; business
spending for fixed capital and inventories will be adversely
influenced by the deterioration in sales, profits, and internal cash
flows; even residential construction activity may remain de­
pressed for a short time in view of the continuing decline in
housing starts.
Evidence is accumulating, however, that the corrective forces
needed to lay the basis for economic recovery are already under
way. Price rebates on autos and other products are helping to
stimulate sales. Consumer incomes are being sustained by en­
larged unemployment compensation as well as an expanded
public service employment program. The adjustments in finan­
cial markets to which I have referred should be of major benefit
in supplying funds for housing and for other purposes. And
the upturn in the stock market is serving to improve the state
of confidence.
For their part, businessmen have responded to declining
sales and profits by making strenuous efforts to work off exces­
sive inventories, by concentrating production in more efficient
plants, and by economizing on labor and materials. In the
manufacturing sector, productivity actually improved somewhat
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IMMEDIATE AND LONG-RANGE PROBLEMS

during the last quarter of 1974, despite a sharp decline in output.
This is a most encouraging development.
Thus, while business activity is likely to slide off further
in the months immediately ahead, there is reason to expect an
upturn later this year. The stimulative fiscal actions proposed
by the President would serve to increase the likelihood of a turn­
around in the course of the economy. The personal tax rebate,
if enacted promptly, should have a stimulative effect on spending
by late spring or summer, and the effects on business capital
expenditures of a liberalized investment tax credit should soon
follow. The resulting expansion in investment would help to
provide more jobs later this year, and would also contribute to
moderating inflation over the longer-run by improving the
capacity and efficiency of our industrial plant.
I cannot stress strongly enough the importance of measures
to increase productivity at our nation's business enterprises. This
is the first of several longer-range problems to which I want to
direct the committee's attention.
For some time now, the trend of productivity in the private
nonfarm economy has tended to flatten out. During the past
decade, the average annual increase in output per manhour was
less than 2 percent, compared with nearly 3 percent in the pre­
vious ten years. Within the past decade, the rate of improvement
in productivity has diminished also. This development has a
significant bearing on the living standards of our people, and
also on the impact that rising wage rates have on costs of pro­
duction and prices.
The unsatisfactory record of productivity improvement stems
in large part from inadequate investment by business firms in
new plant and equipment. Business profits have fallen increas­
ingly short of the amounts needed to finance the growth and
modernization of our nation's industrial plant. Environmental
and safety regulations, while desirable in their own right, have
often delayed fulfillment of capital spending plans and at times
have forced adoption of less efficient methods of production.
Productivity improvement has also been hampered by changes
in the attitude of the labor force and some laxity in management.
Workers nowadays are well trained, but many of them work
with less energy than they should, and absenteeism has become
a more serious problem.




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REFLECTIONS OF AN ECONOMIC POLICY MAKER

These changed attitudes toward work are to some degree the
outgrowth of a second disturbing trend in our economy— namely,
the fact that taxes have progressively reduced the rewards for
working, while government at the same time has increased the
share of national output going to persons who are not produc­
tively employed. Twenty-five years ago, a typical worker with
three dependents gave up about 1 percent of his gross weekly
earnings in federal income and social security taxes. Since then,
that fraction has risen steadily and reached 13 percent in 1974.
Any large increase in the absorption of private incomes by
government poses a threat to individual incentives— all the more
so when taxes are levied on persons who work and produce, and
the funds are then transferred to others who remain idle. Over
the past twenty-five years, transfer payments by all govern­
mental units— in such forms as public welfare, social security
benefits, unemployment insurance, and other public assistance—
have risen about twice as fast as total wages and salaries. These
transfer payments now amount to almost one-fifth of the aggre­
gate of wage and salary disbursements, and the fraction is
steadily increasing. A society as affluent as ours can ill afford
to neglect the poor, the elderly, the unemployed, or other dis­
advantaged persons. But neither can it afford to neglect the
fundamental precept that there must be adequate rewards to
stimulate individual effort.
Besides weakening individual enterprise, massive increases
in governmental expenditures— for social welfare, defense, and
whatnot-—have been a major cause of intensifying inflationary
pressures. This is the third of the longer-run problems that our
nation must confront. Inflation has been a problem in this
country through most of the postwar period; however, the up­
ward march of prices began to accelerate during the middle
1960s, when our government embarked on a highly expansionary
fiscal policy. Since 1965, total federal expenditures have risen
about 50 percent faster than the gross national product; budget
deficits have become chronic; interest rates have soared to un­
precedented heights; expectations of rising prices have gotten
built into wages and other contracts; and inflation has emerged
as the most dangerous economic ailment of our time.
There can be little doubt that inflation is the principal cause
of the decline in economic activity in which we now find our194



IMMEDIATE AND LONG-RANGE PROBLEMS

selves. The havoc wrought in our economy by inflation, how­
ever, goes well beyond the immediate loss of production and
employment. Because of its capricious incidence on income and
wealth, inflation has caused disillusionment and discontent
among our citizens. And because of its distorting effects on
business decisions, inflation has brought into question the li­
quidity of some major business and financial institutions.
There is no easy way out of the inflationary morass into
which we have allowed ourselves to sink. Unwinding from an
inflationary process built up over a decade will take time, and
will cause further hardships for our people. But defeat of in­
flationary forces must remain a major goal of public policy. W e
cannot realistically expect to regain lasting prosperity until
businesses and consumers glimpse some end to the inflation that
has been damaging our economy.
Lasting prosperity will also require steps to reverse the
deterioration in corporate profits that has taken place over the
past decade or more. This is another longer-run problem of
major importance.
The condition of business profits is widely misunderstood.
Profits are thought by some observers to be ample, or even
overabundant. The fact is, however, that profit margins of nonfinancial businesses have been declining rather steadily for many
years, and profits in the aggregate have been far too low in
recent years to supply the financing needed for a vigorous
expansion in capital investment.
The major source of confusion about the recent behavior
of corporate profits is not hard to find. Last year, the estimated
pre-tax profits of all nonfinancial corporations from their domes­
tic operations were 16 percent higher than in 1973 and 46 per­
cent higher than in 1972. The dominant factor in this rise,
however, was an enormous increase in inventory profits— an
element of earnings that is illusory. It stems from the fact that
the accounting practices of many corporations still do not allow
for the fact that inventories used up in production must be
replaced at higher prices during a period of inflation. As a con­
sequence, costs of operation have been understated, and fictitious
profits have been created that are being taxed by the federal
government.
Excluding this illusory inventory profit, the after-tax do-




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REFLECTIONS OF AN ECONOMIC POLICY MAKER

mestic profits of nonfinancial corporations did not rise last year.
On the contrary, they declined by 20 percent, and were smaller
than eight or ten years earlier— when the dollar value of the
output of these corporations was about half what it is today.
Last year, in fact, the after-tax profits of nonfinancial busi­
ness corporations— adjusted for inventory gains— were no larger
than the amount of dividends these firms paid to their stock­
holders. Worse still, when allowance is made for the fact that
depreciation schedules for fixed capital are also based on his­
torical costs— rather than replacement costs— and thus contribute
yet another illusory element to book profits, these firms actually
paid out more in dividends to their stockholders than they
earned from current production.
As I noted earlier, this slump in corporate profits is a
major reason why business capital investment has been impeded
and why the rate of productivity improvement has been slug­
gish. But there has been another ominous consequence of
deteriorating business profits— namely, some decline in the
financial strength of our nation's business firms. This is the
fifth long-run problem to which the committee's attention should
be directed.
Years ago, when their profit positions were more adequate,
our nation's major business corporations financed much of their
capital investment from internal sources rather than from bor­
rowed funds. However, dependence on borrowed funds has been
rising steadily for more than a decade. In the past five years,
funds borrowed in the money and capital markets by all non­
financial corporations averaged nearly 70 percent of the amount
raised internally, and in 1974 their borrowings appear to have
exceeded their internal funds.
This growing reliance on borrowed money has brought
with it a steep rise in the amount of debt owed by business firms
relative to their equity positions. In 1950, total liabilities of
manufacturing corporations amounted to less than half of the
book value of stockholders' equity. Today, the magnitudes of
debt and equity for manufacturing corporations are almost equal.
Moreover, a large parf of the indebtedness piled up by business
firms has been in the form of short-term debts, and these in turn
have grown much more rapidly than holdings of current assets.
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IMMEDIATE AND LONG-RANGE PROBLEMS

The liquidity position of nonfinancial businesses has thus been
weakened.
These are disturbing trends. The balance sheets of many of
our business corporations have become distorted by the need
to finance capital investment from external sources. Moreover,
the issuance of new stock has been inhibited by unreceptive
markets and by tax considerations. The consequence has been
that margins of equity have been significantly reduced, and many
large businesses no longer have the resiliency they once had to
resist economic and financial adversity.
The sixth longer-range problem of major concern to the
nation is the foreign exchange value of the dollar. Actually, the
dollar began weakening many years before its formal devaluation
in 1971. Earlier, there had been an enormous rise in the dollar
holdings of foreign central banks, because our balance of pay­
ments was in deficit for a prolonged period. Capital outflows—
some of them speculative— were large, and they were not offset
by surpluses in our current account because costs and prices in
the United States were rising rapidly. The devaluation of 1971
and also that of 1973 were thus a consequence of trends that
had been under way for many years.
Following the second devaluation in 1973, the foreign ex­
change value of the dollar has fluctuated fairly widely, but with­
out much net change. Such fluctuations make it more difficult
for foreign traders and investors to make rational plans for the
future. We must bear this in mind, and also the fact that any
appreciable decline in the external value of the dollar would add
to our domestic inflationary problem. The Federal Reserve and
other central banks can and occasionally do intervene to smooth
out movements in exchange rates. But a substantially greater
degree of exchange rate stability will not be achieved until under­
lying economic and financial conditions have been put in better
order.
Let me now turn, in conclusion, to the implications for
public policy of our immediate and longer-range economic
difficulties. The most urgent need at the present time is for
measures to cushion recessionary forces. But great care must be
taken to avoid aggravating the underlying inflationary forces
that have produced our present problems.
Action to reduce income taxes temporarily is an appropriate




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REFLECTIONS OF AN ECONOMIC POLICY MAKER

course at the present time. Because of inflation, many individuals
have moved into higher tax brackets, even though their real
incomes have declined or remained unchanged. Unless personal
tax rates are reduced, that trend will continue, and the automatic
budgetary stabilizers we normally count on to moderate reces­
sionary tendencies will therefore not function effectively. Also,
action is needed to reduce business taxes in view of the serious
deterioration in corporate profits and the taxing of illusory profits
by the federal government.
The President's fiscal program recognizes the need to deal
with the current recession and yet avoid releasing a new wave
of inflation. Both the tax rebate to individuals and the increase
in the investment tax credit will provide a temporary boost to
aggregate demand without adding to federal deficits over the
longer run. Moreover, increases in federal expenditures are to
be limited in several ways— by postponing new program initia­
tives apart from the energy area, by various rescissions and
deferrals of spending for existing programs, and by ceilings on
increases in social security benefits and on federal pensions and
salaries. Even so, federal expenditures should be scrutinized
with special care in an effort to hold spending well below the
levels projected in the President's budget message. Such a step
would improve the prospects for moderating the rate of inflation,
and would also bolster the confidence of our people by indi­
cating the clear intent of the Congress to stick to a course of
fiscal prudence.
These same considerations must guide the course of mone­
tary policy in the months ahead. The Federal Reserve intends
to encourage recovery by providing for an adequate expansion
in supplies of money and bank credit. Relatively soon, growth in
the monetary aggregates— including the narrowly defined money
supply— should strengthen. Let me assure this committee, how­
ever, that we have no intention of permitting an explosion in
money and credit no matter how large private or public financing
demands may become. Such a reckless course of action might
hold short-term interest rates down for a time, but it would
before long plunge our economy into deeper trouble.
This committee would be well advised to focus a large part
of its attention on the course of public policy needed to cope
with the serious longer-range problems facing the nation. The
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IMMEDIATE AND LONG-RANGE PROBLEMS

issues at stake are large and complex, and solutions will not be
readily found. Besides a major national program to deal with
the critical problem of energy— which I have not discussed— it
seems clear that efforts to gain a better measure of discipline in
federal finances have become a matter of great urgency. Ways
must be found to curb the ever increasing share of the national
income absorbed by governmental programs— especially pro­
grams that transfer funds from persons who work to those who
are not productively employed. Ways must be found also to
strengthen business profits and the state of business finances,
and to increase the incentives for expansion of productive
capacity and for modernization of our nation's industrial plant.
Above all, ways must be found to bring an end to inflation,
and thus lay the basis for a lasting prosperity at home and a
strengthening of our position in international markets. Our
people are weary of inflation; they are confused and disturbed
by the huge budget deficits that are in the making this fiscal
year and next; and they are anxiously awaiting evidence that
their government can and will take the necessary steps to restore
economic and financial stability.




199




The Current Recession
in Perspective

I am glad to meet with this distinguished group of business and
financial journalists in a leisurely setting. As a policy maker,
I feel I have much in common with the members of your pro­
fession. Both you and I must be alert to every twist and nuance
of the changing economic scene. Both you and I must keep busy
searching the business skies for some clues to the economic
future. I find this aspect of my work exciting and intriguing,
as I am sure you do. But it does involve a certain risk for
both of us.
Sharing— as we do— the problem of continually meeting
deadlines, we are in danger of becoming so preoccupied with
the very short run that we fail to see economic events in per­
spective. For that very reason, I have wanted to take advantage
of your invitation, so that we might ponder together the his­
torical developments which have brought our economy to its
present condition. This is a large and highly important subject.
I cannot hope to do full justice to it on the present occasion.
Nevertheless, I shall make a start this evening.
As you are well aware, these past few years have been trying
times for the American people. Not only have we lived through
the agony of Vietnam and Watergate, but some of us have even
begun to wonder whether our dream of full employment, a stable
price level, and a rising standard of living for all our people is
beyond fulfillment.
Address at the twelfth annual meeting of the Society of American Business
W riters, W ashington, D.C., M ay 6, 1975.




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REFLECTIONS OF AN ECONOMIC POLICY MAKER

Early last year, economic expansion began to falter in our
country, as it did in other countries around the world. At the
same time, the pace of the inflation that had been building for
more than a decade accelerated sharply further. As the year
advanced, it became increasingly clear that our economy was
moving into a recession.
During the past two quarters, the real gross national product
has declined by 5 percent, and the level of industrial production
is now 12 or 13 percent below last September. The unemploy­
ment rate has risen swiftly, and so also has the idle capacity in
our major industries. The decline in business activity since last
fall has been the steepest of the postwar period, and yet the
advance of the price level— while considerably slower than last
year— is continuing at a disconcerting pace.
No business cycle movement can be comprehended solely
in terms of the events that occur within that cycle or the one
preceding it. The economic currents of today are heavily influ­
enced by longer-range developments— such as changes in eco­
nomic and financial institutions, the course of public policy, and
the attitudes and work habits of people. By examining the
historical background of recent economic troubles, we should be
able to arrive at a better understanding of where we now are.
The current recession is best viewed, and I believe it will
be so regarded by historians, as the culminating phase of a long
economic cycle.
There have been numerous long cycles in the past— that is,
units of experience combining two or more ordinary business
cycles. One such long cycle ran its course from 1908 to 1921,
another from 1921 to 1933. And if we go back to the nineteenth
century, we encounter long cycles from 1879 to 1894 and from
1894 to 1908. These long cycles differ in innumerable ways
from one another. But they also have some features in common—
in particular, each culminates in an economic decline of more
than average intensity.
The beginning of the long cycle that now appears to be
approaching its natural end may be dated as early as 1958, but
it is perhaps best to date its start in 1961. The upward move­
ment of economic activity which began in that year was checked
briefly in 1967 and interrupted more significantly in 1970.
Although these interruptions were watched with concern and
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CURRENT RECESSION IN PERSPECTIVE

some anxiety by practicing economists and other interested
citizens, they will be passed over lightly by economic historians
concerned with large events.
The reason is not hard to see. Putting aside monthly and
quarterly data, and looking only at annual figures, we find that
total employment rose every year from 1961 through 1973. So
also did disposable personal income and personal consumption
expenditures— both viewed on a per capita basis, and in real
terms. This sustained upward trend of the economy came to an
end in 1974.
The successive phases of the long upswing from 1961 to
1974 provide a useful perspective on our current problems.
Some years ago, in my work at the National Bureau of Economic
Research, I observed a pattern in past long upswings— an initial
stage that may be called the "industrial phase" followed by
what is best described as the "speculative phase." The imbal­
ances that develop in this latter phase lead inevitably to the final
downturn. The events of the past fifteen years conform rather
closely to this pattern.
The period from 1961 through 1964 may be regarded as
the industrial phase of the long upswing. Productivity grew
rapidly— increasing in the private nonfarm sector at an annual
rate of 3.6 percent between the final quarters of 1960 and 1964,
or well above the average rate of the preceding decade. Unit
labor costs were then remarkably stable, and so too was the
general price level. Real wages and profits rose strongly. During
this period of sustained economic expansion, unemployment fell
from about 7 percent of the labor force to 5 percent, while the
rate of use of industrial capacity rose substantially.
The second— or speculative— phase of the long upswing
began around 1965 and continued through much of 1974. This
ten-year period was marked by a succession of major, inter­
related, and partly overlapping speculative waves that in varying
degrees gripped other leading industrial countries as well as the
United States.
The first speculative movement involved corporate mergers
and acquisitions. In the euphoria of what some commentators
have called the "go-go" years, rapid growth of earnings per
share of common stock became the overriding goal of many
business managers. Other yardsticks of corporate performance—




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such as the rate of return on new investments— were neglected,
and so too were the serious risks of increased leveraging of
common stock.
The aggregate volume of large corporate acquisitions, which
for some years had been running at about $2 billion per year,
jumped to $3 billion in 1965, to $8 billion in 1967, to $12V2
billion in 1968, and then tapered off. This was the great era of
conglomerates, when a variety of unrelated businesses were
brought together under a single corporate management. Entre­
preneurs who displayed special skill in such maneuvers were
hailed as financial geniuses— until their newly built empires
began to crumble. Being preoccupied with corporate acquisitions
and their conglomerate image, many businessmen lost sight of
the traditional business objective of seeking larger profits through
better technology, aggressive marketing, and improved manage­
ment. The productivity of their businesses suffered, and so too
did the nation's productivity.
The spectacular merger movement of the late 1960s was
reinforced, and to a degree made possible, by the speculative
movement that developed in the market for common stocks. The
volume of trading on the New York Stock Exchange doubled
between 1966 and 1971, and for a time trading volume on the
American Exchange rose even faster. The prices of many stocks
shot up with little regard to actual or potential earnings. During
the two years 1967 and 1968, the average price of a share of
common stock listed on the New York Exchange rose 40 percent,
while earnings per share of the listed companies rose less than
2 percent. On the American Exchange, the average price per
share rose during the same years more than 140 percent on an
earnings base that again was virtually unchanged.
Much of this speculative ardor came from a section of the
mutual fund industry. For the new breed of "performance funds/'
long-term investment in the shares of established companies with
proven earnings became an outmoded concept. In their quest
for quick capital gains, these institutions displayed a penchant
for risky investments and aggressive trading. In 1965, a typical
mutual fund turned over about one-fifth of its common stock
portfolio; by 1969, thai fraction had risen to nearly one-half.
As Wall Street then had it, the "smart money" went into issues
of technologically oriented firms or into corporate conglomerates
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CURRENT RECESSION IN PERSPECTIVE

— no matter how well or poorly they met the test of profit­
ability.
Speculation in equities was cooled for a time by the stock
market decline of 1969-1970, but then it resumed again and
took on new forms. Money managers began to channel a pre­
ponderant part of their funds into the stocks of large and wellknown firms— apparently with the thought that earnings of
those companies were impervious to the vicissitudes of economic
life. A huge disparity was thereby created between the priceearnings ratios of the "favored fifty" and those of other cor­
porations. Share prices of these "favored" companies were, of
course, especially hard hit in the subsequent shakeout of the
stock market.
Speculation in common stocks was not confined to the
United States. From the late 1960s until about 1973, nearly
every major stock exchange in the world experienced a large
run-up in share prices, only to be followed by a drastic decline.
Indeed, speculation reached a more feverish pace in some coun­
tries than in the United States. On the Tokyo stock exchange,
for example, both share prices and the trading volume actually
doubled in the twelve months between January 1972 and January
1973, and then suffered a sharp reversal.
The third speculative wave that nourished the long up­
swing of our national economy occurred in the real estate market.
Homebuilding fluctuated around a horizontal trend during the
1960s. The vacancy rate in rental housing was at a high level
from 1960 to 1965, then fell steadily until the end of the decade,
and thus helped pave the way for a new housing boom. Between
January of 1970 and January of 1973, the volume of new housing
starts doubled. Since then, homebuilding has plunged, and in
some sections of the nation it has virtually come to a halt.
Failures of construction firms and unemployment among con­
struction workers have reached depression levels. These un­
happy developments stem in large measure from the excesses
of the housing boom that got under way in 1970.
Inflationary expectations clearly played a substantial role in
bolstering the demand for houses. But the boom was fostered
also by an array of governmental policies designed to stimulate
activity in the housing sector. These governmental measures,
however well intentioned, gave little heed to basic supply con­




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REFLECTIONS OF AN ECONOMIC POLICY MAKER

ditions in the industry or to the underlying demand for
housing.
In response to easy credit and federal subsidies, merchant
builders moved ahead energetically, put up one-family homes
well ahead of demand, and thus permitted the inventory of
unsold homes to double between 1970 and 1973. Speculative
activity was even more intense in the multifamily sector— that
is, in apartments built for renting, and particularly in condomin­
iums and cooperatives, which accounted for a fourth of the
completions of multifamily structures by the first half of 1974.
The boom in housing was financed by a huge expansion of
mortgage credit and construction loans. Real estate investment
trusts played an exceptionally large role in supplying high-risk
construction loans for condominiums, recreational developments,
and other speculative activities. The growth of real estate trusts
was extraordinary by any yardstick. Their assets, amounting to
less than $700 million in 1968, soared to upwards of $20 billion
by 1973. Unsound practices accompanied this rapid growth and,
as a result, many real estate trusts now face difficult financial
problems.
The speculative boom in real estate was not confined to
residential structures. It extended to speculation in land, to
widespread building of shopping centers, and to construction
of office buildings. By 1972, the vacancy rate in office buildings
reached 13 percent, but this type of construction still kept
climbing.
The real estate boom in the United States during the early
1970s had its parallel in other countries. Speculation in land and
properties became rampant in the United Kingdom. In 1972
alone, new house prices rose 47 percent on the average. The
amount of credit absorbed in real estate ventures rose so rapidly
that the Bank of England felt forced to place special controls on
bank lending for such purposes. And in Germany, the boom in
residential construction during 1971-1973 left an inventory of
about a quarter million unsold units— more than a third of a
peak year's output— that now overhang the market.
It is in the nature of speculative movements to spread from
one country or market to another. Just as the speculative wave
in real estate was beginning to taper off in 1973, a new wave of
speculation got under way— this time in inventories. That was
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CURRENT RECESSION IN PERSPECTIVE

the fourth and final speculative episode of the long economic
upswing from 1961 to 1974. It involved massive stocking up of
raw materials, machinery, parts, and other supplies in the
United States and in other industrial countries.
The inventory speculation of 1973 and 1974 was the out­
growth of a boom in business activity that had raised its head
by 1972 in virtually every industrial country of the world. The
synchronism of economic expansion in these countries was partly
coincidental, but the expansion that stemmed from ordinary
business cycle developments was reinforced by the adoption of
stimulative economic policies almost everywhere. As a result,
production increased rapidly around the world, and led to a
burgeoning demand for raw materials, machine tools, component
parts, and capital equipment— goods for which our country is a
major source of supply. The pressure of rising world demand
was reinforced in our markets by the devaluation of the dollar,
which greatly improved our competitive position in international
trade.
By the beginning of 1973, as business firms attempted to
meet intense demands from both domestic and foreign cus­
tomers, serious bottlenecks and shortages had begun to develop
in numerous industries— especially those producing steel, nonferrous metals, paper, chemicals, and other raw materials. In
this environment of scarcities, the rise in prices of industrial
commodities quickened both here and abroad. The dramatic
advance of food prices in 1973, and later in energy prices,
greatly compounded the worldwide inflationary problem. In
our country, these price pressures were suppressed for a time
by price and wage controls, but the general price level exploded
when controls were phased out in late 1973 and early 1974.
One of the unfortunate consequences of inflation is that it
masks underlying economic realities. As early as the spring of
1973, a perceptible weakening could be detected in the trend of
consumer buying in this country. The business community,
however, paid little attention to this ominous development. The
escalating pace of inflation fostered expectations of still higher
prices and persistent shortages in the years ahead, so that inten­
sive stockpiling of commodities continued. Inventories increased
out of all proportion to actual or prospective sales. In fact, the
ratio of inventories to sales, expressed in physical terms, had




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REFLECTIONS OF AN ECONOMIC POLICY MAKER

risen by the summer of 1974 to the highest figure for any busi­
ness cycle expansion since 1957— another year when a severe
recession got under way.
In summary, the period from 1965 to 1974 was marked by
a succession of interrelated, partly overlapping, speculative
waves— first, in buying up of existing businesses; then, in the
stock market; next, in markets for real estate; and finally, in
markets for industrial materials and other commodities.
A prolonged speculative boom of this kind can seldom be
traced to a single causal factor. In this instance, however, a
dominant source of the problem appears to have been the lack
of discipline in governmental finances.
The industrial phase of the long upswing drew to a close
in late 1964 or early 1965. By then, the level of real output was
very close to the limits imposed by our nation's physical capacity
to produce. By then, the level of wholesale prices was already
moving out of its groove of stability. Nevertheless, our govern­
ment did nothing to moderate the pace of expansion of aggre­
gate monetary demand. On the contrary, it actually embarked
on a much more expansive fiscal policy. The tax reductions of
1964 were followed in 1965 by fresh tax reductions and by a
huge wave of spending both for new social programs and for the
war in Vietnam. These misadventures of fiscal policy doomed
the economy to serious trouble, but we were slow to recognize
this. Indeed, substantial tax reductions occurred again in 1969
and 1971, and they too were followed by massive increases of
expenditures.
Deficits therefore mounted, and they persisted year in and
year out. Over the last ten complete fiscal years— that is, from
1965 through 1974— the federal debt held by the public, in­
cluding obligations of federal credit agencies, rose by more than
50 percent. The large and persistent deficits added little to our
nation's capacity to produce, but they added substantially to
aggregate monetary demand for goods and services. They were
thus directly responsible for much of the accelerating inflation
of the past decade.
Monetary and credit policies were not without some fault.
As every student of economics knows, inflation cannot continue
indefinitely without an accommodating increase in supplies of
money and credit. It is very difficult, however, for a central bank
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CURRENT RECESSION IN PERSPECTIVE

to maintain good control of money and credit when heavy gov­
ernmental borrowing drives up interest rates, and when the pub­
lic is unwilling to face squarely the long-run dangers inherent
in excessively stimulative economic policies.
To make matters worse, laxity in our national economic
policies spilled over into private markets. The "new economics/'
of which less is now heard than before, held out the possibility,
if not the actual promise, of perpetual prosperity. Many busi­
nessmen and financiers came to view the business cycle as dead,
and to expect the federal government to bail out almost any
enterprise that ran into financial trouble. All too frequently,
therefore, the canons of financial prudence that had been devel­
oped through hard experience were set aside.
Many of our business corporations courted trouble by per­
mitting sharp reductions in their equity cushions or their liquid­
ity. In the manufacturing sector, the ratio of debt to equity—
which had been stable in the previous decade— began rising in
1964 and nearly doubled by the end of 1974. Moreover, a large
part of the indebtedness piled up by business firms was in the
form of short-term obligations, and these in turn grew much
more rapidly than holdings of current assets.
Similar trends developed in some segments of commercial
banking. Large money-market banks came to rely more heavily
on volatile short-term funds to finance their business customers,
and at times they increased their loan commitments to busi­
nesses beyond prudent limits. A few bank managers, too, began
to concern themselves excessively with maximizing short-run
profits, so that the prices quoted for their common stock would
move higher. Capital ratios of many banks deteriorated; ques­
tionable loans were extended at home and abroad; insufficient
attention was given here and there to the risks of dealing in
foreign exchange markets; and too much bank credit went into
the financing of speculative real estate ventures.
A variety of loose practices also crept into state and local
government finance. Faced with rapidly expanding demands for
services and limited sources of revenue, some governmental units
resorted to extensive short-term borrowing and employed dubi­
ous accounting devices to conceal their budget deficits. Statutory
debt limits were circumvented through the creation of special
public authorities to finance the construction of housing, schools,




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REFLECTIONS OF AN ECONOMIC POLICY MAKER

and health facilities. Some of these authorities issued so-called
"moral obligation" bonds, which investors in many instances
regarded as the equivalent of "full faith and credit" obligations.
The novel financial devices seemed innocuous at the time, but
they have recently become a source of serious concern to in­
vestors in municipal securities.
A nation cannot realistically expect prosperous economic
conditions to continue very long when the federal government
fails to heed the warning signs of accelerating inflation, when
many of its business leaders spend their finest hours arranging
financial maneuvers, and when aggressive trade unions push up
wage rates far beyond productivity gains. After 1965, the
strength of the American economy was gradually sapped by
these ominous trends. Productivity in the private nonfarm sec­
tor, which had grown at an annual rate of 3.6 percent from 1961
through 1964, slowed to a 2.2 percent rate of advance from 1964
to 1969, then to 1.5 percent from 1969 to 1974. Expansion in
the physical volume of national output likewise declined during
successive quinquennia. The rate of inflation, meanwhile, kept
accelerating.
With the pace of inflation quickening, seeds of the current
recession were thus sown across the economy. Rising prices
eroded the purchasing power of workers' incomes and savings.
Corporate profits diminished— a fact that businessmen were
slow to recognize because of faulty accounting techniques. New
dwellings were built on a scale that greatly exceeded the under­
lying demand. Inventories of commodities piled up, often at a
fantastic pace, as businessmen reacted to gathering fears of
shortages. Credit demands, both public and private, soared and
interest rates rose to unprecedented heights.
These basic maladjustments are now being worked out of
the economic system by recession— a process that entails enor­
mous human and financial costs. Our country has gone a con­
siderable distance in developing policies to alleviate economic
hardships, and these policies have been strengthened recently.
Nevertheless, the recession has wrought great damage to the
lives and fortunes of many of our people.
. This recession has cut deeply into economic activities. It
must not, however, be viewed as being merely a pathological
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CURRENT RECESSION IN PERSPECTIVE

phenomenon. Since we permitted inflation to get out of control,
the recession is now performing a painful— but also an unavoid­
able— function.
First, it is correcting the imbalances that developed between
the production and sales of many items, also between orders
and inventories, between capital investment and consumer
spending, and between the trend of costs and prices.
Second, business managers are responding to the recession
by moving energetically to improve efficiency— by concentrating
production in more modern and efficient installations, by elim­
inating wasteful expenditures, by stimulating employees to work
more diligently, and by working harder themselves.
Third, the recession is improving the condition of financial
markets. Interest rates have moved to lower levels as a result of
declining credit demands and of the Federal Reserve's efforts to
bolster the growth of money and credit. Commercial banks have
taken advantage of the reduced demand for loans to repay their
borrowings from Federal Reserve Banks, to reduce reliance on
volatile sources of funds, and to rebuild liquid assets. The
rapidly rising inflow of deposits to thrift institutions has like­
wise permitted a reduction of indebtedness and addition to their
liquid assets.
Fourth, the recession is wringing inflation out of the eco­
nomic system. Wholesale prices of late have moved down, and
the rise of consumer prices has also slowed. Although general
price stability is not yet in sight, a welcome element of price
competition has at long last been restored to our markets.
These and related business developments are paving the
way for recovery in economic activity. No one can foresee with
confidence when the recovery will begin. The history of our
country indicates clearly, however, that the culminating down­
ward phase of a long cycle need not be of protracted duration.
Signs are multiplying, in fact, that an upturn in economic
activity may not be far away. For example, employment rose in
April after six successive months of decline. The length of the
workweek also stabilized last month. The rate of layoffs in
manufacturing is now turning down, and some firms have been
recalling workers who formerly lost their jobs. Sales of goods
at retail— apart from autos— have risen further. Business and




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REFLECTIONS OF AN ECONOMIC POLICY MAKER

consumer confidence has been improving. And prospects for an
early upturn in economic activity have been strengthened by
passage of the Tax Reduction Act of 1975.
Our nation stands at present at a crossroads in its history.
W ith the long and costly cycle in business activity apparently
approaching its end, the critical task now is to build a solid
foundation for our nation's economic future. We will accom­
plish that only if we understand and benefit from the lessons of
recent experience.
Since World War II, a consensus has been building in this
country that the primary task of economic policy is to maintain
full employment and promote maximum economic growth. W e
have pursued these goals by being ever ready to stimulate the
economy through increased federal spending, lower taxes, or
monetary ease. Neglect of inflation, and of longer-run economic
and financial problems, has thus crept insidiously into public
policy making. Our government has become accustomed to
respond with alacrity to any hint of weakness in economic
activity, but to react sluggishly, and sometimes not at all, to
signs of excess demand and developing inflationary pressures.
The thinking of many of our prominent economists has
encouraged this bias in our economic policies. During the 1950s
and 1960s, they frequently argued that "creeping inflation" was
a small price to pay for full employment. Some even suggested
that a little inflation was a good thing— that it energized the
economic system and thus promoted rapid economic growth.
This is a dangerous doctrine. While inflation may begin
slowly in an economy operating at high pressure, it inevitably
gathers momentum. A state of euphoria then tends to develop,
economic decision making becomes distorted, managerial and
financial practices deteriorate, speculation becomes rampant, in­
dustrial and financial imbalances pile up, and the strength of the
national economy is slowly but surely sapped. That is the harsh
truth that the history of business cycles teaches.
To emphasize this truth, I should now like to offer this
distinguished group of journalists a bit of professional advice.
Since few of you are reluctant to pass along hints as to how I
should do my job, I have decided to suggest to you what the
really big economic news story of 1975 is likely to be.
The story has to do with the drama now unfolding on
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CURRENT RECESSION IN PERSPECTIVE

Capitol Hill in the implementation of the Budget Control Act
adopted last year. If I am right in thinking that our present
economic difficulties are largely traceable to the chronic bias of
the federal budget toward deficits, there can be no doubt about
the importance of what is now being attempted. No major
democracy that I know of has had a more deficient legislative
budget process than the United States— with revenue decisions
separated from spending decisions and the latter handled in
piecemeal fashion. Budgets in this country have just happened.
They certainly have not been planned.
We are now attempting to change that by adopting inte­
grated congressional decisions on revenues and expenditures.
My advice to you journalists is to follow this new effort closely.
It has a significance for our nation that may carry far into the
future. But nothing can be taken for granted here. We have
tried budgetary reform once before under the Legislative Reor­
ganization Act of 1946, and it failed. It failed partly because of
the challenge to cherished committee prerogatives, partly also
because Congress as a whole balked at accepting so much selfdiscipline. I would urge you to study the history of that earlier
effort and to watch the present undertaking for telltale signs of
similar faltering.
The potential gain for our nation from budget reform is
enormous even in this first year of "dry run/' If, in fact, the
work of the new budget committees produces in the Congress a
deeper understanding of the impossibility of safely undertaking
all the ventures being urged by individual legislators, a con­
structive beginning toward a healthier economic environment
will have been made. On the other hand, if the new budget
procedures are scuttled, or if they are used with little regard to
curbing the bias toward large-sized federal deficits, there ulti­
mately may be little anyone can do to prevent galloping inflation
and social upheaval.
I am inclined to be optimistic about the outcome. More and
more of our people are becoming concerned about the longerrange consequences of federal financial policies. Perspective on
our nation's economic problems is gradually being gained by
our citizens and their congressional representatives. A healthy
impatience with inflation is growing. You journalists are becom­
ing more actively involved in the educational process. I there-




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fore remain hopeful that we shall practice greater foresight in
dealing with our nation's economic problems than we have in
the recent past, and that we will thus build a better future for
ourselves and our children in the process.

214



The Real Issues of Inflation
and Unemployment

I am pleased to be here at the University of Georgia and to have
the opportunity to address this distinguished audience. Tomor­
row promises to be an exciting day for you, and you will need
all thfc rest you can muster. I shall therefore not waste many
words as I share with you my concern about our nation's future.
Our country is now engaged in a fateful debate. There are
many who declare that unemployment is a far more serious
problem than inflation, and that monetary and fiscal policies
must become more stimulative during the coming year even if
inflation quickens in the process. I embrace the goal of full
employment, and I shall suggest ways to achieve it. But I totally
reject the argument of those who keep urging faster creation of
money and still larger governmental deficits. Such policies would
only bring us additional trouble; they cannot take us to the
desired goal.
The American economy has recently begun to emerge from
the deepest decline of business activity in the postwar period.
During the course of the recession, which began in late 1973, the
physical volume of our total output of goods and services de­
clined by 8 percent. The production of factories, mines, and
power plants fell even more— by 14 percent. As the overall
level of economic activity receded, the demand for labor rapidly
diminished and unemployment doubled, reaching an intolerable
9 percent of the labor force this May.
Address at the Blue Key Honor Society annual awards dinner, University of
Georgia, Athens, Georgia, September 19, 1975.




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The basic cause of the recession was our nation's failure to
deal effectively with the inflation that got under way in the
mid-sixties and soon became a dominant feature of our economic
life. As wage and price increases quickened, seeds of trouble
were sown across the economy. With abundant credit readily
available, the construction of new homes, condominiums, and
office buildings proceeded on a scale that exceeded the underlying
demand. Rapidly rising prices eroded the purchasing power of
workers' incomes and savings. Managerial practices of business
enterprises became lax and productivity languished, while cor­
porate profits— properly reckoned— kept falling. Inventories of
raw materials and other supplies piled up as businessmen reacted
to fears of shortages and still higher prices. Credit demands, both
public and private, soared and interest rates rose to unprece­
dented heights. The banking system became overextended, the
quality of loans tended to deteriorate, and the capital position of
many banks was weakened.
During the past year many of these basic maladjustments
have been worked out of the economic system by a painful
process that could have been avoided if inflation had not gotten
out of control. As the demand for goods and services slackened
last winter, business managers began to focus more attention on
efficiency and cost controls. Prices of industrial materials fell
substantially, price increases at later stages of processing became
less extensive, and in many instances business firms offered
price concessions to clear their shelves. With the rate of infla­
tion moderating, confidence of the general public was bolstered,
and consumer spending strengthened. Business firms were thus
able to liquidate a good part of their excess inventories in a
rather brief period. Meanwhile, as the demand for credit dimin­
ished, tensions in financial markets were relieved, and the liquid­
ity position of both banks and business firms generally improved.
These self-corrective forces internal to the business cycle
were aided by fiscal and monetary policies that sought to cushion
the effects of economic adversity and to provide some stimulus
to economic recovery. On the fiscal side, public employment
programs were expanded, unemployment insurance was liberal­
ized, and both personal and corporate income taxes were reduced.
On the monetary side, easier credit conditions were fostered,
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REAL ISSUES OF INFLATION AND UNEMPLOYMENT

resulting in lower interest rates and a rebuilding of liquidity
across the economy.
With the base for economic recovery thus established, busi­
ness activity has recently begun to improve. Production of goods
and services turned up during the second quarter and is con­
tinuing to advance. The demand for labor has also improved.
Both the number of individuals at work and the length of the
workweek are rising again, and unemployment has declined
three months in a row. Retail sales have risen further, and of
late residential construction has joined the recovery process.
Along with these favorable developments, however, some
ominous signs have emerged. Despite an occasional pause, infla­
tion once again may be accelerating. By the second quarter of
this year, the annual rate of increase in the general price level
was down to 5 V2 percent— about half the rate of inflation regis­
tered in the same period a year earlier. But over the summer,
prices began to rise more briskly.
This behavior of prices is particularly worrisome in view of
the large degree of slack that now exists in most of our nation's
industries. Price increases in various depressed industries—
aluminum, steel, autos, industrial chemicals, among others— are
a clear warning that our long-range problem of inflation is
unsolved and therefore remains a threat to sustained economic
recovery.
History suggests that at this early stage of a business
upturn, confidence in the economic future should be strengthen­
ing steadily. A significant revival of confidence is indeed under
way, but it is being hampered by widespread concern that a
fresh outburst of double-digit inflation may before long bring
on another recession. By now, thoughtful Americans are well
aware of the profoundly disruptive consequences of inflation for
our economy. They also recognize that these consequences are
not solely of an economic character. Inflation has capricious
effects on the income and wealth of a nation's families, and this
inevitably causes disillusionment and discontent. Social and
political frictions tend to multiply, and the very foundations of
a society may be endangered. This has become evident in other
nations around the world, where governments have toppled as a
result of the social havoc wrought by inflation.
If we in the United Stales wish to enjoy the fruits of a




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REFLECTIONS OF AN ECONOMIC POLICY MAKER

prosperous economy and to preserve our democratic institutions,
we must come to grips squarely with the inflation that has been
troubling our nation throughout much of the postwar period,
and most grievously during the past decade.
A first step in this process is to recognize the true character
of the problem. Our long-run problem of inflation has its roots
in the structure of our economic institutions and in the financial
policies of our government. All too frequently, this basic fact is
clouded by external events that influence the rate of inflation—
such as a crop shortfall that results in higher farm prices, or the
action of a foreign cartel that raises oil prices. The truth is that,
for many years now, the economies of the United States and
many other countries have developed a serious underlying bias
toward inflation. This tendency has simply been magnified by
the special influences that occasionally arise.
A major cause of this inflationary bias is the relative success
that modern industrial nations have had in moderating the
swings of the business cycle. Before World War II, cyclical
declines of business activity in our country were typically longer
and more severe than they have been during the past thirty
years. In the environment then prevailing, the price level typi­
cally declined in the course of a business recession, and many
months or years elapsed before prices returned to their previous
peak.
In recent decades, a new pattern of wage and price be­
havior has emerged. Prices of many individual commodities
still demonstrate a tendency to decline when demand weakens.
The average level of prices, however, hardly ever declines. Wage
rates have become even more inflexible. Wage reductions are
nowadays rare even in severely depressed industries and the
average level of wage rates continues to rise inexorably in the
face of widespread unemployment.
These developments have profoundly altered the economic
environment. When prices are pulled up by expanding demand
in a time of prosperity, and are also pushed up by rising costs
during a slack period, the decisions of the economic community
are sure to be influenced, and may in fact be dominated, by
expectations of continuing inflation.
Thus, many businessmen have come to believe that the
trend of production costs will be inevitably upward, and their
218



REAL ISSUES OF INFLATION AND UNEMPLOYMENT

resistance to higher prices— whether of labor, or materials, or
equipment— has therefore diminished. Labor leaders and workers
now tend to reason that in order to achieve a gain in real income,
they must bargain for wage increases that allow for advances in
the price level as well as for such improvements as may occur in
productivity. Lenders in their turn expect to be paid back in
cheaper dollars, ahd therefore tend to hold out for higher interest
rates. They are able to do so because the resistance of borrowers
to high interest rates is weakened by their anticipation of rising
prices.
These patterns of thought are closely linked to the emphasis
that governments everywhere have placed on rapid economic
growth throughout the postwar period. Western democracies,
including our own, have tended to move promptly to check
economic recession, but they have moved hesitantly in checking
inflation. Western governments have also become more diligent
in seeking ways to relieve the burdens of adversity facing their
peoples. In the process they have all moved a considerable dis­
tance towards the welfare state.
In the United States, for example, the unemployment insur­
ance system has been greatly liberalized. Benefits now run to as
many as sixty-five weeks, and in some cases provide individuals
with after-tax incomes almost as large as their earnings from
prior employment. Social security benefits too have been ex­
panded materially, thus facilitating retirement or easing the
burden of job loss for older workers. Welfare programs have
been established for a large part of the population, and now
include food stamps, school lunches, medicare and medicaid,
public housing, and many other forms of assistance.
Protection from economic hardship has been extended by
our government to business firms as well. The rigors of com­
petitive enterprise are nowadays eased by import quotas, tariffs,
price maintenance laws, and other forms of governmental regu­
lation. Farmers, homebuilders, small businesses, and other
groups are provided special credit facilities and other assistance.
And even large firms of national reputation look to the federal
government for sustenance when they get into trouble.
Many, perhaps most, of these governmental programs have
highly commendable objectives, but they have been pursued
without adequate regard for their cost or method of financing.




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REFLECTIONS OF AN ECONOMIC POLICY MAKER

Governmental budgets— at the federal, state, and local levels—
have mounted and at times, as in the case of New York City,
have literally gotten out of control. In the past ten years, federal
expenditures have increased by 175 percent. Over that interval,
the fiscal deficit of the federal government, including govern­
ment-sponsored enterprises, has totalled over $200 billion. In the
current fiscal year alone, we are likely to add another $80 billion
or more to that total. In financing these large and continuing
deficits, pressure has been placed on our credit mechanisms, and
the supply of money has frequently grown at a rate inconsistent
with general price stability.
Changes in market behavior have contributed to the infla­
tionary bias of our economy. In many businesses, price com­
petition has given way to other forms of rivalry— advertising,
changes in product design, and "hard-sell" salesmanship. In
labor markets, when an excessive wage increase occurs, it is apt
to spread faster and more widely than before, partly because
workmen have become more sensitive to wage developments
elsewhere, partly also because many employers have found that
a stable work force can be best maintained by emulating wage
settlements in unionized industries. For their part, trade unions
at times seem to attach higher priority to wage increases than to
the jobs of their members. Moreover, the spread of trade unions
to the rapidly expanding public sector has fostered during recent
years numerous strikes, some of them clearly illegal, and they
have often resulted in acceptance of union demands, however
extreme. Needless to say, the apparent helplessness of govern­
ments to deal with this problem has encouraged other trade
unions to exercise their latent market power more boldly.
The growth of our foreign trade and of capital movements
to and from the United States has also increased the suscepti­
bility of the American economy to inflationary trends. National
economies around the world are now more closely interrelated,
so that inflationary developments in one country are quickly
communicated to others and become mutually reinforcing.
Moreover, the adoption of a flexible exchange rate system—
though beneficial in dealing with large-scale adjustments of
international payments,.such as those arising from the sharp
rise in oil prices— may have made the Western world more prone
to inflation by weakening the discipline of the balance of pay220



REAL ISSUES OF INFLATION AND UNEMPLOYMENT

ments. Furthermore, since prices nowadays are more flexible
upwards than downwards, any sizable decline in the foreign
exchange value of the dollar is apt to have larger and more
lasting effects on our price level than any offsetting appreciation
of the dollar.
The long-run upward trend of prices in this country thus
stems fundamentally from the financial policies of our govern­
ment and the changing character of our economic institutions.
This trend has been accentuated by new cultural values and
standards, as is evidenced by pressures for wage increases every
year, more holidays, longer vacations, and more liberal coffee
breaks. The upward trend of prices has also been accentuated
by the failure of business firms to invest sufficiently in the mod­
ernization and improvement of industrial plant. In recent years,
the United States has been devoting a smaller part of its eco­
nomic resources to business capital expenditures than any other
major industrial nation in the world. All things considered, we
should not be surprised that the rate of improvement in output
per man-hour has weakened over the past fifteen years, or that
rapidly rising money wages have overwhelmed productivity gains
and boosted unit labor costs of production.
Whatever may have been true in the past, there is no longer
a meaningful trade-off between unemployment and inflation. In
the current environment, a rapidly rising level of consumer prices
will not lead to the creation of new jobs. On the contrary, it will
lead to hesitation and sluggish buying, as the increase of the
personal savings rate in practically every industrial nation during
these recent years of rapid inflation indicates. In general, stimu­
lative financial policies have considerable merit when unemploy­
ment is extensive and inflation weak or absent; but such policies
do not work well once inflation has come to dominate the think­
ing of a nation's consumers and businessmen. To be sure, highly
expansionary monetary and fiscal policies might, for a short time,
provide some additional thrust to economic activity. But inflation
would inevitably accelerate— a development that would create
even more difficult economic problems than we have encountered
over the past year.
Conventional thinking about stabilization policies is inade­
quate and out of date. We must now seek ways of bringing
unemployment down without becoming engulfed by a new wave




221

REFLECTIONS OF AN ECONOMIC POLICY MAKER

of inflation. The areas that need to be explored are many and
difficult, and we may not find quickly the answers we seek. But
if we are to have any chance of ridding our economy of its infla­
tionary bias, we must at least be willing to reopen our economic
minds. In the time remaining this evening, I shall briefly sketch
several broad lines of attack on the dual problem of unemploy­
ment and inflation that seem promising to me.
First, governmental efforts are long overdue to encourage
improvements in productivity through larger investment in mod­
ern plant and equipment. This objective would be promoted by
overhauling the structure of federal taxation, so as to increase
incentives for business capital spending and for equity invest­
ments in American enterprises.
Second, we must face up to the fact that environmental and
safety regulations have in recent years played a troublesome role
in escalating costs and prices and in holding up industrial con­
struction across our land. I am concerned, as are all thoughtful
citizens, with the need to protect the environment and to improve
in other ways the quality of life. I am also concerned, however,
about the dampening effect of excessive governmental regula­
tions on business activity. Progress towards full employment
and price stability would be measurably improved, I believe, by
stretching out the timetables for achieving our environmental
and safety goals.
Third, a vigorous search should be made for ways to en­
hance price competition among our nation's business enterprises.
We need to gather the courage to reassess laws directed against
restraint of trade by business firms and to improve the enforce­
ment of these laws. We also need to reassess the highly complex
governmental regulations affecting transportation, the effects on
consumer prices of remaining fair trade laws, the monopoly of
first-class mail by the Postal Service, and the many other laws
and practices that impede the competitive process.
Fourth, in any serious search for noninflationary measures
to reduce unemployment, governmental policies that affect labor
markets have to be reviewed. For example, the federal minimum
wage law is still pricing many teenagers out of the job market.
The Davis-Bacon Act continues to escalate construction costs and
damage the depressed construction industry. Programs for un­
employment compensation now provide benefits on such a gen222



REAL ISSUES OF INFLATION AND UNEMPLOYMENT

erous scale that they may be blunting incentives to work. Even
in today's environment, with about 8 percent of the labor force
unemployed, there are numerous job vacancies— perhaps because
job seekers are unaware of the opportunities, or because the
skills of the unemployed are not suitable, or for other reasons.
Surely, better results could be achieved with more effective job
banks, more realistic training programs, and other labor market
policies.
I believe that the ultimate objective of labor market policies
should be to eliminate all involuntary unemployment. This is
not a radical or impractical goal. It rests on the simple but often
neglected fact that work is far better than the dole, both for the
jobless individual and for the nation. A wise government will
always strive to create an environment that is conducive to high
employment in the private sector. Nevertheless, there may be
no way to reach the goal of full employment short of making the
government an employer of last resort. This could be done by
offering public employment— for example, in hospitals, schools,
public parks, or the like— to anyone who is willing to work at
a rate of pay somewhat below the federal minimum wage.
With proper administration, these public service workers
would be engaged in productive labor, not leaf-raking or other
make-work. To be sure, such a program would not reach those
who are voluntarily unemployed, but there is also no compelling
reason why it should do so. What it would do is to make jobs
available for those who need to earn some money.
It is highly important, of course, that such a program should
not become a vehicle for expanding public jobs at the expense
of private industry. Those employed at the special public jobs
will need to be encouraged to seek more remunerative and more
attractive work. This could be accomplished by building into the
program certain safeguards— perhaps through a constitutional
amendment— that would limit upward adjustment in the rate of
pay for these special public jobs. With such safeguards, the
budgetary cost of eliminating unemployment need not be burden­
some. I say this, first, because the number of individuals accept­
ing the public service jobs would be much smaller than the
number now counted as unemployed; second, because the avail­
ability of public jobs would permit sharp reduction in the scope
of unemployment insurance and other governmental programs




223

REFLECTIONS OF AN ECONOMIC POLICY MAKER

to alleviate income loss. To permit active searching for a regular
job, however, unemployment insurance for a brief period—
perhaps thirteen weeks or so— would still serve a useful function.
Finally, we also need to rethink the appropriate role of an
incomes policy in the present environment. Lasting benefits
cannot be expected from a mandatory wage and price control
program, as recent experience indicates. It might actually be
helpful if the Congress renounced any intention to return to
mandatory controls, so that businesses and trade unions could
look forward with confidence to the continuance of free markets.
I still believe, however, that a modest form of incomes policy,
in some cases relying on quiet governmental intervention, in
others on public hearings and the mobilization of public opinion,
may yet be of significant benefit in reducing abuses of private
economic power and moving our nation towards the goal of full
employment and a stable price level.
Structural reforms of our economy, along some such lines
as I have sketched, deserve more attention this critical year from
members of the Congress and from academic students of public
policy than they are receiving. Economists in particular have
tended to concentrate excessively on overall fiscal and monetary
policies of economic stimulation. These traditional tools remain
useful and even essential; but once inflationary expectations have
become widespread, they must be used with great care and
moderation.
This, then, is the basic message that I want to leave with
you: our nation cannot now achieve the goal of full employment
by pursuing fiscal and monetary policies that rekindle inflation­
ary expectations. Inflation has weakened our economy; it is also
endangering our economic and political system based on free­
dom. America has become enmeshed in an inflationary web, and
we need to gather our moral strength and intellectual courage
to extricate ourselves from it. I hope that all of you will join in
this struggle for America's future.

224



Four Questions by a Student
of Economics

I am very pleased to join this audience in honoring the gradu­
ating class of the University of Akron. Some of you receiving
a degree today will continue with your formal education; others
will embark on business or professional careers. But whatever
your plans for the future, our nation's economic and political
condition will inevitably remain a matter of concern to you.
Recently, I received a letter from a college student named
Rebecca who posed several blunt questions concerning our
nation's economy. First, Rebecca asked, "W hat was the biggest
economic setback this year?" Second, "W hat has been the big­
gest economic boost this year?" Third, "W hat plans are being
made to get the United States out of the red?" Fourth, "W hat
can we as citizens of the United States do to help the economic
situation?"
These are thoughtful questions, and they are not easy to
answer with confidence or precision. But they undoubtedly
express the concerns of many of our citizens, and I want to take
advantage of this occasion to share with you my attempt to
answer Rebecca's earnest inquiry.
Turning to the first question, the list of candidates for the
greatest economic disappointment of 1975 is regrettably quite
long. During the past year, we experienced a severe recession.
The physical output of our national economy declined sharply
before recovery got under way. The unemployment rate rose to
Commencement address at the University of Akron, Akron, Ohio, December
14, 1975.




225

REFLECTIONS OF AN ECONOMIC POLICY MAKER

levels not seen in a long generation. Inflation continued at a
disconcerting pace. The deficit in the federal government's
budget exploded. Interest rates on municipal securities soared.
And efforts to move our nation towards independence in the field
of energy made little progress.
While all these developments have been disappointing, the
persistence of inflation at a time of such widespread unemploy­
ment of labor and of capital harbors the most troublesome
implications for our nation's future. True, the advance of the
general price level moderated significantly during the first half
of 1975. More recently, however, the upward climb of prices
has begun to accelerate again. Since mid-year, wholesale prices
have been rising at an annual rate of a little over 10 percent.
Price markups in various depressed industries— such as alumi­
num, steel, and autos— convey a clear warning that our longrange problem of inflation is unsolved.
By now, many Americans are well aware of the profoundly
disruptive consequences of inflation for our country. The infla­
tion from which we continue to suffer got under way more than
ten years ago and eventually became a dominant feature of our
economic life. As wage and price increases quickened, seeds of
trouble were sown across the economy. Rapidly rising prices
eroded the purchasing power of workers' incomes and savings.
Speculative fever mounted. The construction of new homes,
condominiums, and office buildings proceeded on a scale that
far exceeded the underlying demand. Managerial practices of
business enterprises became lax and productivity languished.
Corporate profits— properly reckoned— kept falling. And as
businessmen reacted to fears of shortages and still higher prices,
inventories of raw materials and other supplies piled up.
It is these basic maladjustments that led to the recent eco­
nomic decline— the deepest since World War II. This slump has
entailed enormous human and financial costs, and we have as yet
only partly recovered from it. The behavior of prices in recent
months is therefore very worrisome. Not only are the incomes
and savings of our people still being eroded, but revival of con­
fidence in the economic future is being hampered by fears of a
fresh outburst of double-digit inflation. If such a development
occurred, it would ultimately plunge us into an economic reces­
sion even more serious than the one we have just experienced.
226




FOUR QUESTIONS BY A STUDENT

I therefore believe that control of inflation requires a higher
priority in managing our economic policies than it is as yet
receiving. We cannot expect inflation to be brought under con­
trol if the federal government continues to run huge budget
deficits or to permit money and credit to expand unduly. We
must also face up to the hard truth that competition has become
less intense in many of our private markets. If an unemployment
rate of 8 or 9 percent is insufficient to bring inflation to a halt,
then our economic system is no longer working as we once sup­
posed. In the future, governmental efforts to achieve economic
progress will need to encompass structural reforms as well as
responsible monetary and fiscal policies.
Let me turn next to Rebecca's question concerning the most
beneficial economic development this year. Once again, there is
no shortage of plausible candidates. The recovery in business
activity since the spring has been quite vigorous. Indeed, the
rise during the third quarter in the physical volume of our na­
tional output was the largest in many a year. Since March the
number of people employed has risen by \Vz million. The re­
covery in stock prices since the beginning of the year has been
heartening to investors. The decline in interest rates from the
extraordinary heights of 1974 has brought a measure of relief
to business borrowers and home buyers. And the turnaround
in our foreign trade from a deep deficit to a large surplus has
helped to make the dollar once again a highly respected currency
around the world.
These recent shifts of economic fortune deserve, and they
are in fact receiving, much attention. But another and less widely
noticed development— namely, rediscovery of the need for pru­
dence in the conduct of financial affairs— is likely to prove of
greater and more lasting benefit to the American people.
During the past year, we have seen the consequences of
more than a decade of neglect of the principles of sound finance.
Some major business corporations and many smaller ones have
fallen into bankruptcy. A number of real estate investment
trusts and some airlines are in serious trouble. Many individuals
have lost their life's savings by making careless investments.
Not a few of our nation's commercial banks face the possibility
of large losses on dubious loans. And various state and local




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REFLECTIONS OF AN ECONOMIC POLICY MAKER

government units are now finding it difficult, if not impossible,
to raise new money through our financial markets.
More than any other single event, the agony of New York
City has made the consequences of financial mismanagement
apparent to the entire nation. A federal budget deficit in the
neighborhood of $90 billion, which is in prospect for this fiscal
year, may stagger the imagination; but few of our citizens can
grasp its impact on their daily lives. Everyone, however, can
relate to what has been happening in New York City— with
thousands of municipal workers being dismissed, the number of
policemen and garbage collectors dwindling, the subway fare
going up, taxes rising, interest on outstanding municipal securi­
ties being scaled down, pension benefits being readjusted, and
free tuition in the city's colleges placed in jeopardy.
Our country has been divided on the issue of whether, or
under what conditions, federal financial assistance to New York
City is justified. But those who favor federal assistance, as well
as those who are opposed, agree on this much: that what hap­
pened to New York must not happen in our community or in
our state. New York's dramatic encounter with bankruptcy may
therefore mark a major turning point in the management of
fiscal affairs in our country— certainly at the local and state
levels, and perhaps at the federal level as well.
State and local governments are now busy reexamining their
financial condition. Many of them are cutting back on postponable or avoidable expenditures, and raising taxes as needed.
Proposals for bond issues are being appraised by the citizenry
with a more critical eye. And recognition is growing across the
country that the New York City crisis is just one manifestation
of the lax financial practices that spread through the business,
financial, and governmental sectors over the past ten to twelve
years.
Fortunately, these unsound practices are now being cor­
rected in our business firms and banks, as well as by state and
local governments. This curative process is not without some
pain. Capital for risky ventures is harder to obtain nowadays
and it is also more costly. But this return to standards of prudent
financial management has been an essential step in rebuilding
the foundation for a durable prosperity.
I now come to Rebecca's third question: What plans are
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FOUR QUESTIONS BY A STUDENT

there for ending the persistent stream of federal budget deficits?
This concern with the need to restore order in our national fiscal
affairs is shared, I believe, by the great majority of our people.
To be sure, the swelling of the deficit this year reflects the deep
recession of economic activity— which reduced federal revenues
besides increasing outlays for unemployment benefits, welfare
payments, and related programs. But the federal deficit was
large even before the recession started; it has continued year
after year, in both good times and bad; and it has largely re­
sulted from inadequate attention to the consequences of excessive
governmental spending.
O f late, there have been some encouraging changes in the
federal budgetary process. A major reform of congressional
procedures was set in motion by the Congressional Budget Act
of 1974. In the past, revenue decisions by the Congress were
separated from its spending decisions, and the latter were han­
dled in piecemeal fashion. The result was that budgets just
happened; they were not planned. Under the new Budget Act,
Congress must assign priorities to the various outlays and set
an overall limit on spending in relation to expected revenues.
Hence, congressional decisions on expenditures will in the future
be integrated with decisions on revenues. The discipline imposed
by these new procedures offers hope, I believe, of reducing the
chronic bias toward deficits in the federal budget.
So, too, does the initiative of the President in recommending
that federal expenditures be cut next fiscal year by $28 billion
below the level that they would otherwise reach. The basic prin­
ciple underlying this expenditure proposal is sound, and I hope
Congress will support it.
Once we put an end to the rapid upward spiral of federal
spending, budget deficits are likely to run smaller or vanish
entirely. When the government no longer pours more money
into the economy than it withdraws in tax revenues, it will have
removed the single most important cause of inflation in our
times. Moreover, when the government no longer absorbs so
large a portion of private incomes, private capital investment
will tend to increase more rapidly. Improved productivity, lower
product prices, and a higher standard of living will therefore be
fostered.
Let me now turn to Rebecca's final and most challenging




229

REFLECTIONS OF AN ECONOMIC POLICY MAKER

question: What can we as citizens do to help the economic
situation? This question is so difficult because our economic situ­
ation has numerous dimensions— the level of production, the
extent of unemployment, the level of prices, the distribution of
incomes, the profitability of investment, the state of the environ­
ment, and so on. Improvement in any one of these respects
need not be accompanied by improvement in others. The ques­
tion is also difficult because what any one of us can do depends
on his personal situation— whether we work at home or in a
business, whether we are farmers or miners, journalists or sci­
entists. Moreover, as you well know, even experienced econo­
mists who have similar social objectives frequently disagree on
what can or should be done to improve economic conditions.
Nevertheless, there are some principles of life that all of us
can observe with the conviction that we will be helping our
nation's economic situation.
First of all, we can curb any latent discontent or cynicism
we may feel about the motives of our fellow citizens in business
or government. Americans, by and large, are a moral people
who have wrought economic miracles by seeking to improve
themselves, their families, and their communities. We have
demonstrated across the years that hope is perhaps the most
powerful of all economic forces, and that a spirit of purpose can
give meaning to human energy and overcome a lack of material
resources.
Second, every one of us can surely improve his understand­
ing of economic phenomena. Education is a never ending process.
The intellectual excitement of the classroom need not be lost,
and should not be lost, as we move on in life. The economic
problems of today are profoundly challenging, and there will
surely be new ones tomorrow. As citizens we need to strive
for dependable knowledge of economic realities, so that we can
make wiser decisions in the marketplace and in the voting booth.
Third, we can become more actively involved in the political
process of our nation— by electing officials at all levels of gov­
ernment who demonstrate a serious and informed awareness of
our economic problems, by communicating our thoughts on
public issues to our representatives with the clarity of conviction,
and by holding them responsible for their actions.
Fourth, we can avoid the temptation to implore the federal
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FOUR QUESTIONS BY A STUDENT

government to solve every economic and social problem through
the expenditure of public funds. We are a compassionate people,
and I trust we will remain so. It is understandable that we
attempt to muster our collective resources to aid the less fortu­
nate among us. Yet we must take great care not to weaken the
spirit of self-reliance that has been instrumental in releasing the
creative and productive energies of the American people.
Fifth, we can impose discipline on our business enterprises
through our daily decisions in the marketplace. The power of
the consumer to force business firms to price competitively and
to improve their products must never be underestimated. We as
consumers can help to keep the spirit of price competition alive
by shopping carefully and avoiding impulse buying.
Finally, every American can experience the satisfaction that
comes from honest effort— by putting in a full day's work for a
full day's pay, whether it be work in a factory, a scientific lab­
oratory, a corporate office, a governmental agency, or wherever
one may labor. "Sweet is the sleep of a laborer," so sang Eccle­
siastes. Centuries later, Carlyle reminded us that "there is a
perennial nobleness . . . in work," that indeed "a man perfects
himself by working." The rewards of work accrue, of course, to
the public at large as well as to the laborer; for the more we
produce by the day or by the hour, the more surely will the
standard of living of the American people improve.
The needs of the American economy today are large and
compelling. Some of you graduates will approach these needs
as liberals, others as conservatives. Some of you doubtless be­
lieve in free enterprise, others may aspire to a welfare state,
still others may seek the nationalization of our industries. But
whatever your philosophic or political attitudes may be, I hope
you will recognize that your dreams of a good society have no
chance of fulfillment unless our government conducts its finan­
cial affairs responsibly. This condition is essential to bringing
an end to the inflation that has been raising havoc with our
economic institutions; it is essential to the restoration of a lasting
prosperity; it is essential also to the preservation of our demo­
cratic system.




231




The Worldwide Problem
of Inflation

I am pleased to join this audience in a tribute to the members of
the graduating class, and also to their parents and teachers who
have done so much to make this day possible.
I would like to discuss with you today the dangerous disease
of inflation— which strikes me as the economic equivalent of
high blood pressure. The medical profession has recently urged
all of us to have our blood pressure checked. High blood pres­
sure damages the human body and threatens the lives of those
who suffer from it. Fortunately, when diagnosed promptly, it can
usually be treated successfully and brought under control.
I am not a physician, but I do know something about the
economic disease of inflation. The effects of inflation are per­
vasive. Persistent inflation saps the energies of a nation and
undermines economic and political institutions. In recent years,
inflation has done great damage to the economies of many coun­
tries, including our own.
Inflation is a man-made disease. If properly treated, it can
be brought under control. All of us— and especially those of you
who are embarking on a new career— have a vital interest in
bringing an end to the forces of inflation.
During your years here at the Institute, you have lived
through the worst inflation since World War II. Over the past
four years alone, consumer prices in our country have risen by
35 percent— an average increase of over 8 percent a year. O f
Commencement address at the Florida Institute of Technology, Melbourne,
Florida, June 11, 1976.




233

REFLECTIONS OF AN ECONOMIC POLICY MAKER

late, the rise has moderated— from 12 percent in 1974 to about
half that rate currently. An annual advance of 6 percent in
prices, however, is still very troublesome. If such a rate per­
sisted, the price level would double every twelve years. By 1988,
the purchasing power of each of your dollars would be cut in
half, and twelve years later— or by the year 2000— your already
shrunken dollar would be cut in half once again.
In most other countries, inflation has been proceeding at
an appreciably faster pace than in the United States. On the
average, consumer prices around the world rose by 15 percent
in 1974, and they were still increasing at a rate of 11 percent
during the past twelve months.
There is nothing inevitable about inflation, as experience
in our own and other countries indicates. The overall level of
prices in the United States remained relatively stable from 1952
through 1956, and again from 1960 through 1964. During the
latter period, wholesale prices actually declined a little, while
consumer prices increased at an average annual rate of about
1 percent. There were similar periods of relative price stability
in a number of other countries— including Canada, West Ger­
many, Belgium, Switzerland, and Japan— during the 1950s and
early 1960s.
The disease of inflation will not be cured until an aroused
citizenry demands corrective measures. The intellectual leader­
ship that you in this graduating class and your counterparts
around the country can provide to the public at large will play a
critical role in the success of this endeavor.
Let me therefore describe briefly the characteristics of infla­
tion, the havoc it creates in the economic body, and the course
that must be pursued to regain a stable price level and a healthy
economy.
The current inflation in our country began in the middle
years of the 1960s. The exuberant mood that then emerged in
the business community soon gave rise to a series of inter­
related and partly overlapping waves of speculation. The first
speculative movement involved corporate mergers and acquisi­
tions. Entrepreneurs who displayed special skill in such maneu­
vers were hailed as financial geniuses— until their newly built
empires began to crumble. Many businessmen were so pre­
occupied with corporate acquisitions that they lost sight of
234



WORLDWIDE PROBLEM OF INFLATION

traditional business objectives. The productivity of their busi­
nesses suffered, and so too did the nation's productivity.
This speculative movement was reinforced, and to a degree
made possible, by the speculation that developed during the late
1960s in the market for common stocks. The prices of many
stocks shot up with little regard to actual or potential earnings.
Speculation in common stocks, moreover, was not confined to
the United States. From the late 1960s until about 1973, nearly
every major stock exchange in the world experienced a large
run-up in share prices, only to be followed by a drastic decline.
The third speculative wave in our country occurred in the
real estate market. It involved widespread building of shopping
centers, office structures, and recreational facilities, besides land
speculation and an extraordinary boom in residential construc­
tion. Between January of 1970 and January of 1973, the volume
of new housing starts doubled and a huge inventory of unsold
homes piled up. Once a condition of overbuilding was recog­
nized, residential construction plunged and for a time virtually
came to a halt in some sections of the country.
The real estate boom in the United States also had its parallel
in other countries. For example, speculation in land and prop­
erties became rampant in the United Kingdom during the early
1970s. And in Germany, the boom in residential construction
during 1971-1973 led to an enormous increase in unsold housing
units— and to an inevitable downturn in homebuilding.
It is in the nature of speculative movements to spread from
one country or market to another. Just as the speculative wave
in real estate was beginning to taper off in 1973, a new wave of
speculation got under way— this time in inventories. It involved
massive stocking up of raw materials, machinery, parts, and
other supplies in the United States and in other industrial coun­
tries. Serious bottlenecks and shortages began to develop in
numerous industries. In the resulting environment of scarcities,
the rise in prices of industrial commodities quickened both here
and abroad.
One of the unfortunate consequences of inflation is that it
masks underlying economic realities. As early as the spring of
1973, the trend of consumer buying in this country began to
weaken. Many members of the business community, however,
paid little attention to this ominous development. Nor did they




235

REFLECTIONS OF AN ECONOMIC POLICY MAKER

recognize that standard accounting practices, which had served
well enough in an era of price stability, were now masking the
deterioration taking place in business profits. Caught up in the
euphoria of inflation, they built up inventories out of all propor­
tion to actual or prospective sales, thus setting the stage for a
subsequent sharp decline in production and employment.
The corrosive influence of inflation goes far beyond the
distortion of businessmen's perspectives. Inflation erodes the
purchasing power of wages. Inflation reduces the real value of
the savings deposits, pensions, and life insurance policies of
consumers. Inflation creates havoc in financial markets as
interest rates are driven up, funds for mortgage lending diminish,
and even some large and well-managed industrial firms en­
counter difficulty in raising funds needed for plant expansion.
In short, inflation upsets much of the planning that business
firms and households customarily do. The state of confidence
deteriorates, and the driving force of economic expansion is
blunted.
Concerned as we all are about the economic consequences
of inflation, there is even greater reason for concern about its
impact on our social and political institutions. We must not risk
the social stresses that persistent inflation breeds. Because of
its capricious effects on the income and wealth of a nation's
families and businesses, inflation inevitably causes disillusion­
ment and discontent. It robs millions of citizens who in their
desire to be self-reliant have set aside funds for the education of
their children or their own retirement. It hits many of the poor
and elderly especially hard. And it eventually leads to business
recession and extensive unemployment, such as we have just
experienced to our sorrow.
In recent years, governments have toppled in Argentina,
Chile, and other countries— in large part because the citizens of
those countries had lost confidence in the ability of their leaders
to cope with the problem of inflation. Among our own people,
the distortions, injustices, and hardships wrought by inflation
have contributed materially to distrust of government officials
and of government policies, and even to some loss of confidence
in our free enterprise system. Discontent bred by inflation can
provoke profoundly disturbing social and political change, as
the history of other nations teaches. I do not believe I exaggerate
236



WORLDWIDE PROBLEM OF INFLATION

in saying that the ultimate consequence of inflation could well
be a significant decline of economic and political freedom for the
American people.
Part of the worldwide problem of inflation in recent years
is attributable to special factors— such as the extraordinary rise
of OPEC oil prices in 1973, and the crop shortfalls of 1972 and
1974. But the fundamental source of inflation in our country and
others has been the lack of discipline in governmental finances.
The current inflation began when our government embarked
on a highly expansionist fiscal policy in the middle 1960s. Large
tax reductions occurred in 1964 and early 1965 and were imme­
diately followed by an explosion of federal spending. New and
substantial tax.reductions occurred again in 1969 and 1971, and
they too were followed by massive increases of expenditures.
Over the past ten fiscal years, the public debt— including obli­
gations of federal credit agencies— has risen by nearly $300
billion.
Deficit spending by the federal government can be justified
at a time of substantial unemployment. It becomes a source of
economic instability, however, when deficits persist in good times
as well as bad. Actually, the federal budget has been in deficit
every year but one since 1960. The huge and persistent deficits
of the past decade added enormously to aggregate demand for
goods and services, but they added little to our capacity to pro­
duce. They have thus been directly responsible for a substantial
part of the inflation problem.
It is sometimes contended that the federal deficits of recent
years have been only a minor source of economic or financial
instability, since the amounts have usually been small relative
to total borrowing by the private sector. This is a faulty argu­
ment. We must never confuse the power or responsibility of
private citizens with the power or responsibility of government.
Business firms and consumers have no way of acting in concert
to prevent an inflationary expansion of credit, and their private
actions may conflict with national objectives. The basic respon­
sibility for economic stabilization lies with the federal govern­
ment. Unless our government exercises that function better
than it has in the past, there will be little hope for restoration
of stability in the general price level.
There are some indications, I believe, that our government




237

REFLECTIONS OF AN ECONOMIC POLICY MAKER

has of late been taking its fiscal responsibilities more seriously.
Thus, the President has recommended a very small increase in
budget outlays for the forthcoming fiscal year. Moreover, the
Congress has been acting constructively in the exercise of its
responsibilities under the Congressional Budget Act of 1974.
There is therefore some reason for hope that total federal
expenditures will not continue to advance at the frightening pace
of recent years.
State and local governmental budgets are also receiving
closer scrutiny nowadays. The difficulties encountered by New
York City have had a tempering influence on the financial prac­
tices of states and their political subdivisions— as well as on
those of other economic units— across our land. The emphasis
on sound finance that is now underway enhances the chances of
achieving a lasting prosperity in our country. Governments
abroad are also more conscious of the need to brake the growth
of public expenditures in order to contain the forces of inflation.
Monetary policy too has an important role to play in the
fight against inflation, and we at the Federal Reserve are well
aware of that fact. We intend to see to it that enough money
and credit are available to finance a good rate of economic
expansion. But we firmly intend to avoid excesses that would
aggravate inflation and create trouble for the future. Many cen­
tral bankers abroad aspire to a similar course of policy, but some
of them are unable to adhere to it because of pressures from their
finance ministers or other governmental bodies. Fortunately,
under our scheme of governmental organization, the Federal
Reserve can make, and stick to, the hard decisions that are at
times avoided by decision makers subject to the day-to-day
pressures of political life.
Prudent fiscal and monetary policies are essential ingredi­
ents of a national program to restore general price stability, but
they alone may not accomplish that objective within the limits
of our national patience. Structural policies are also needed to
help restore full employment and to aid in correcting the longrun inflationary bias in our economy.
For example, governmental efforts are long overdue to
encourage improvements in productivity through larger invest­
ment in modern plant and equipment. A vigorous search should
be made for ways to enhance competition among our business
238




WORLDWIDE PROBLEM OF INFLATION

enterprises. Governmental policies that affect labor markets
should also be reviewed. The federal minimum wage law is still
pricing many teenagers out of the labor market; the Davis-Bacon
Act is still escalating costs and prices in the construction indus­
try; and governmental programs for income maintenance now
provide benefits on such a generous scale that they may be blunt­
ing incentives to work.
In some countries— for example, Canada, the United King­
dom, the Netherlands— attempts are being made to hold down
wage and price increases through ceilings or guidelines. In the
United Kingdom, the government has recently reached an agree­
ment with trade union leaders to grant tax reductions in return
for holding wage increases to an average of about 4 x 2 percent
/
during the year beginning on August 1. Such a policy would
involve some decline in real income for workers in the United
Kingdom. It offers promise, however, of cutting the inflation
rate sharply, and of relieving the downward pressures on the
pound in foreign exchange markets.
In our own country, I doubt that arrangements of that kind
would be practical. It is clear, however, that restraint on the
part of both workers and businesses would be helpful at the
present time.
The current economic recovery is now just over a year old.
In some sectors of the economy, the advance of prices has already
begun to quicken— even though unemployment remains exten­
sive and a significant part of our industrial plant is still idle.
If workers now began to demand large catch-up increases in
wage rates or greatly enlarged fringe benefits, or if business
firms began to raise prices faster than costs to increase profit
margins, prospects for a gradual further abatement of inflation
and a prolonged and stable prosperity would be endangered.
I am confident that we will succeed in curing the disease of
inflation if the American people remain alert to the challenge.
I hope that members of this graduating class will join with me
and other citizens across the country in a national crusade to
protect the integrity of the dollar. This objective is within our
means and is essential to a future of stable prosperity in our
nation.




239




The Effects of Inflation
on Homebuilding

Inflation affects every American and every form of enterprise.
But those who are engaged in the homebuilding industry have
felt the impact of inflation with especially devastating effects
in recent years. Therefore, I am truly pleased to share with this
audience of mortgage lenders my conviction that we as a nation
are entirely capable of achieving sustained, noninflationary ex­
pansion of our economy in the future.
Since the early months of last year, homebuilding has
experienced a significant revival from the drastic slump that
began in 1973. The market for single-family housing has be­
come quite active in many parts of our country, and the improve­
ment has recently spread also to the multi-family sector.
The homebuilding industry, nevertheless, continues to face
formidable problems. Extensive unemployment is retarding sales
of both new and existing homes. Builders and developers are
experiencing increased costs on account of zoning ordinances
and delays on sewer and water hookups. Other regulations de­
signed to maintain environmental quality are also proving costly.
The rising cost of fuel and utilities is causing some hesitation
among prospective homebuyers. Higher prices of gasoline, and
lingering uncertainty about its availability, are tending to dis­
courage building in outlying areas. Inflation has pushed interest
rates on home mortgages to an extremely high level. On top of
that, the cost of a new home has been soaring, so that a large
Address at the annual convention of the United States League of Savings
Associations, New York City, November 1 8 ,19 76.




241

REFLECTIONS OF AN ECONOMIC POLICY MAKER
r9(

and increasing proportion of our citizens now find it difficult— if
not impossible— to achieve the traditional American goal of
owning their own home.
Inflation is not a new problem for our nation's homebuilders.
Throughout the past century, if not longer, homebuilding has
tended to turn down when the general price level rose and credit
markets tightened. In the first two decades after World War II,
inflationary pressures were still of an episodic character, as they
had been in earlier years. Once excess demand for goods and
services was eliminated, the price level stabilized or actually
receded. At such times, interest rates generally retreated on a
broad front, and activity in the homebuilding industry soon re­
bounded strongly.
Since the mid-sixties, however, the general level of prices
has kept going up in both good times and bad. The problem of
inflation has thus taken on a new and ominous character. No
appreciable slowdown in the advance of wages and prices oc­
curred during the mild recession of 1970. During the severe
recession in late 1974 and early 1975, inflation did decline—
from an annual rate of about 13 percent to 7 percent. In part,
this slowing of inflation reflected the absence of special factors—
such as the enormous increase of OPEC oil prices and the lifting
of wage and price controls— that had caused prices to skyrocket
in 1974. But since mid-1975, despite continued high unemploy­
ment and much idle industrial capacity, there has been little
further decline in the underlying rate of inflation.
I have on other occasions discussed at length the reasons
why inflation has become chronic in our country. Large and
persistent deficits in the federal budget were directly responsible
for the accelerating inflation of the late 1960s and early 1970s.
Lack of discipline in governmental finances has thus been the
dominant source of the problem. And as often happens in human
affairs, laxity in national financial policies spilled over into pri­
vate markets.
Many businessmen and financiers came to believe that the
business cycle was dead— that governmental policies could be
relied upon to keep the economy expanding indefinitely. Canons
of prudent management that had been developed through years
of hard experience came to be regarded as old-fashioned or were
simply forgotten. Hence, many investment projects were under242



EFFECTS OF INFLATION ON HOMEBUILDING

taken carelessly; and liquidity positions and equity cushions
were allowed to deteriorate, while debts piled up at a rapid pace.
In this environment, even as the productivity of our nation's
workshops languished, the resistance of business managers to
demands for wage increases weakened, and trade unions used
their growing power to push up wage rates far above produc­
tivity gains.
With business caution giving way to exuberance, speculative
fever mounted. The first major wave of speculation, which be­
gan in 1965, resulted in numerous corporate mergers, including
the formation of all sorts of conglomerates. This merger move­
ment was reinforced, and to a degree made possible, by the
speculative movement that developed in the market for common
stocks. The volume of trading on the New York Stock Exchange
doubled within five years, prices of many stocks shot up with
little regard to actual or potential earnings, and the new breed of
"performance funds" flourished.
A little later, during the early 1970s, another speculative
wave engulfed the market for real estate. Merchant builders
moved ahead energetically in response to easy credit and federal
subsidies. Single-family homes were put up well ahead of de­
mand, and the inventory of unsold homes doubled between 1970
and 1973. Speculative activity was even more intense in the
case of apartments built for renting, and particularly in condo­
miniums and cooperatives— which accounted for a fourth of the
completions of multi-family structures by the first half of 1974.
Vacancies in rental properties therefore kept increasing after
1970.
The speculative boom in real estate was not confined to
residential structures. It extended to speculation in land, to
building of shopping centers, and to construction of office build­
ings. By 1972, the vacancy rate in office buildings across the
nation reached 13 percent, but this type of construction still
kept climbing.
As the pace of inflation quickened, seeds of serious trouble
were sown across the economy. Fearing shortages and further
price increases, business firms frantically stockpiled industrial
materials and other supplies during 1973 and early 1974. Interest
rates climbed to unprecedented heights. Many of the major
industrial corporations, and even some our nation's banks, found




243

REFLECTIONS OF AN ECONOMIC POLICY MAKER

themselves in a somewhat precarious financial condition. The
recession that inevitably followed was by far the most serious
of the postwar period, and the collapse of housing production
played a major role in the depth and severity of the general
economic decline.
In the course of the recession, many of the imbalances that
had developed among the various sectors of the economy were
reduced. Determined efforts to cut costs and improve efficiency
got under way. Inflationary tensions moderated, and the condi­
tion of financial markets improved.
These and related adjustments paved the way for a recovery
of homebuilding and other branches of production. As condi­
tions in financial markets eased and interest rates declined, the
inflow of deposits to mortgage lenders— particularly to saving
and loan associations— rose swiftly. Sales of new and existing
houses increased, inventories of unsold units gradually moved
down, and new housing starts began to rise. A full recovery of
residential building has, however, eluded us— and it will continue
to elude us until our nation makes further progress in freeing
itself from the grip of inflation.
One of the most damaging results of inflation is the persis­
tence of high interest rates. The basic reason for the high interest
rates in our times— particularly on mortgages and other long­
term debt contracts— is the relentless rise of the general price
level since 1965. Inflationary expectations have by now become
well entrenched in the calculations of both lenders and borrow­
ers. Lenders reckon that loans may be repaid in dollars of
smaller purchasing power, and they therefore tend to hold out
for nominal rates of interest that are high enough to ensure a
reasonable real rate of return. Borrowers, in their turn, are often
less resistant to rising costs of credit, because they too anticipate
repayment in cheaper currency.
The marking up of nominal rates of interest during periods
of inflation is a process that is all too familiar to economic his­
torians. Businessmen and laymen, too, have seen its recent
manifestation in Great Britain and Italy, to say nothing of some
Latin American countries. High interest rates are a companion
of inflation, and both pose perils for the housing industry.
The underlying rate of inflation now appears to be around
6 percent, and it could well increase as our economy returns to
244



EFFECTS OF INFLATION ON HOMEBUILDING

higher levels of resource utilization. Participants in financial
markets are keenly aware of this. Although fears of inflation
have lessened and long-term interest rates have fallen, they still
contain a sizable inflation premium. For example, home mort­
gage interest rates have declined by 1 to IV 2 percentage points
from their cyclical highs in 1974, but they still run close to
9 percent at present.
The effect of these high mortgage interest rates on the
ability of potential homebuyers to meet monthly payments has
been compounded by the explosion of housing prices. The
median price of a new home today is close to $45,000— nearly
double the level that prevailed in 1970. Over the past six years,
the prices of new homes have risen almost twice as fast as the
average level of consumer prices— and they are still increasing.
Other costs of homeownership have also skyrocketed. Since
late 1973, the cost of fuel and utilities has risen by roughly 50
percent. In the aggregate, property taxes and other costs of
home ownership— such as insurance, maintenance, and repairs—
have outstripped by far the average rise of family incomes.
For a time, increasing numbers of families sought to meet
their housing needs by purchasing a modestly priced mobile
home. Sales of this type of dwelling rose by almost 50 percent
between 1970 and 1972. Since then, the average retail price of
mobile homes has nearly doubled, rising to its present level of
about $13,000; the cost of buying or renting a site has also
increased. For many families, the purchase of even a mobile
home has become prohibitively expensive, and sales of these
units are now proceeding at only a third of their volume four
years ago.
The effects of inflation on homebuilding activity have been
even more severe in the multi-family sector than in the markets
for single-family homes. Starts of single-family houses— al­
though still somewhat below their 1972 level— have at least
shown a good recovery since early 1975. Starts of multi-family
units, on the other hand, did not begin to rise until this sum­
mer, and they are still running at a level less than half that of
four years ago.
Continued weakness in apartment construction partly re­
flects the overbuilding of condominiums and rental units in many
parts of the country during the speculative boom of the early




245

REFLECTIONS OF AN ECONOMIC POLICY MAKER

1970s. Over the past year and a half, the demand for rental
space has risen and the vacancy rate for rental units has gener­
ally declined. Nevertheless, the slump in constructing multi­
family buildings has continued.
Inflation has created serious difficulties for developers and
investors in the multi-family sector. In an inflationary environ­
ment, prospective construction costs are highly uncertain for a
project that takes a considerable time to complete— as is the case
with apartment buildings. Moreover, high interest rates on
construction and mortgage loans cut deeply into profits, and
investors have become apprehensive about their ability to achieve
a level of net income adequate to compensate them for the risks
they must incur. In recent years, rent increases have lagged
behind the rising costs of operation. Since mid-1973, average
rents have advanced about 15 percent, while costs of operating
apartment houses increased over 25 percent.
This lag in rents reflects the relatively long-term character
of many rental contracts, besides some concern that rising rents
may provoke angry protests from tenants. Rent controls have
also become a limiting factor. They are presently in effect in
over 200 communities in which 15 percent of our urban popu­
lation resides. Moreover, the fear of coming rent controls may
be moderating rent increases in other areas— where rent ceilings
are permitted but not yet in effect, or where rent control is
now being seriously discussed.
In view of the continuing difficulties confronting the multi­
family sector, commercial banks and other lenders are still
cautious in committing funds to builders and developers for
apartment construction, or in providing the necessary long-term
financing. Moreover, real estate investment trusts, which got
into trouble during the speculative boom in multi-family resi­
dential construction, still face very difficult financial problems.
For the past two years they have been liquidating mortgages,
and few of them are yet in any position to make sizable new
loan commitments.
Of course, progress has been made over the past two years
in dealing with the many problems surrounding multi-family
construction. That is why activity in that sector of the homebuilding industry is now moving up again. Realistically, how­
ever, we cannot expect a return to boom conditions in the
246



EFFECTS OF INFLATION ON HOMEBUILDING

construction of rental buildings or condominiums in any near
future, and that— I believe— is fortunate. A gradual and sus­
tainable rise in the volume of multi-family construction will do
far more for the health of the housing industry, and also for
the health of our national economy, than would a resurgence of
speculative exuberance.
I hope that this preference for solid and sustainable progress
will guide our governmental housing policies. When unemploy­
ment is as high as it is currently, policy makers face persistent
pressures to pump up activity in housing and other industries
through monetary and fiscal measures. Expansionist financial
policies have considerable merit as a means of reducing unem­
ployment when the price level is relatively stable or declining.
But such policies are apt to be less effective when unemployment
and inflation go together— which has become our ordeal.
In practically every industrial nation around the world, the
rapid inflation of the early 1970s led to larger precautionary
savings, sluggish consumer buying, and a weakening of business
confidence. In the present environment of deeply ingrained
inflationary expectations, the results of traditional policies of
economic stimulation are less predictable and less dependable
than they were in earlier decades. The risk is greater now that
fears of inflation will intensify and substantially weaken the
intended effects of expansionist policies on business investment
and consumer spending.
I have been asked recently whether a tax cut is desirable at
present. For the reasons I have already suggested, and also be­
cause I anticipate a resurgence of the economy, I see no advan­
tage in a tax cut at the present time. My mind on this subject,
however, is by no means closed. Later on, I will weigh the issue
carefully if economic conditions or expenditure economies seem
to warrant a tax reduction. I might add that if it appeared
desirable to attempt to stimulate the economy through a tax cut,
among other ways, I would be inclined to favor the type of
measure that President Kennedy recommended in the early 1960s
— namely, a broadly based tax reduction for both individuals and
businesses. Such a measure, on a responsible scale, would mini­
mize social conflict and have the best chance of producing lasting
economic benefits for our country.
In the case of the housing industry, as in other sectors of




247

REFLECTIONS OF AN ECONOMIC POLICY MAKER

the economy, we would be well advised to use the traditional
measures of monetary and fiscal stimulation cautiously and to
rely more on structural policies that can contribute to reduction
of unemployment without risking a new wave of price increases
or otherwise creating problems for the future. For example,
much of the construction industry activity across our land is still
subject to outmoded building codes and work rules that hamper
productivity. The wage provisions of the Davis-Bacon Act con­
tinue to escalate construction costs. And more realistic appren­
ticeship programs could certainly be developed to improve the
supply of skilled labor in the building trades.
We also need to reassess the consequences of the various
environmental regulations adopted in recent years. These regu­
lations have introduced long delays in obtaining approval for
building projects and have otherwise run up the costs of real
estate development and operation. At the federal level alone, a
dozen environmental regulations may apply to any given housing
project. Moreover, overlapping regulations at the federal, state,
and local levels, besides causing confusion and delay, sometimes
work at cross purposes.
Environmental regulations offer great promise for improving
the quality of life; they are essential to human welfare in a
modern society. But in our eagerness to improve the environ­
ment, we should try to avoid regulations that unnecessarily
impede investment in housing and in business fixed capital.
These too are essential to economic and social progress.
Structural reforms to smooth out the flow of mortgage credit
would also be in the long-run interest of homebuilding. State
usury laws are not now a major impediment to the flow of
mortgage credit to potential home buyers. They were, however,
a year or two ago, and they might again become a major obstacle
in the future. We should continue to work for their removal.
Further steps should also be taken to reduce the instability of
savings flows to saving and loan associations and other financial
institutions that supply funds for home financing.
In particular, I believe our nation would be well served
by larger use of variable-rate mortgages, with attendant safe­
guards, so that savings institutions could raise the rates they
pay on deposits during periods of rising market interest rates
and thereby sustain deposit inflows. Such a development would
248



EFFECTS OF INFLATION ON HOMEBUILDING

be beneficial to small savers as well as to the mortgage market,
and it would diminish the need for regulatory interest-rate
ceilings on savings deposits.
It has at times been suggested that the recurring financing
problems of the housing industry would be relieved, if not
actually solved, by contractual arrangements that make it easier
to live with inflation— such as mortgages whose principal is
adjusted according to the cost of living, or savings deposits
whose purchasing power is guaranteed. Such suggestions are
neither sound nor practical. For one thing, there is no feasible
way to renegotiate already outstanding mortgages or other long­
term loan contracts. But unless that were done, the institutions
that guaranteed the purchasing power of their deposits would
expose themselves to intolerable risk. More important, if a
nation with our traditions ever embarked on a systematic plan
to make it easier to live with inflation, rather than to resist its
corrosive influence, we would slowly but steadily lose the sense
of discipline needed to pursue governmental policies with an
eye to the permanent welfare of our people.
The single most important step our government could take
to improve the long-run prospects for homebuilding activity—
and for the economy at large— would be to gain better control
over the forces of inflation. Restoration of reasonable stability
of the general price level would lead to a sharp decline of in­
terest rates on home mortgages. It would certainly reduce sub­
stantially the rise of construction costs, housing prices, and home
maintenance and operating expenses. Residential builders would
then be able to project their revenues and expenditures with
greater confidence, as would also the ultimate investors providing
capital for large-scale development projects. There can be little
doubt that an environment of stable prices would assure a
brighter future for homebuilding.
Bringing an end to inflation would be equally beneficial to
other major sectors of our economy— in particular, to business
capital investment. Businessmen were unprepared for the
slump in sales and production that resulted in 1974 and early
1975 from an inflationary process that got out of control and
undermined the strength of our economy. In the aftermath of
this harsh experience, the renewal of confidence needed for a
new surge of investment activity has proceeded rather slowly.




249

REFLECTIONS OF AN ECONOMIC POLICY MAKER

But once it becomes clear that the recent gains in the struggle
against inflation are being extended, confidence in our nation's
economic future is likely to deepen, and business firms should
begin to move forward more boldly with long-term investment
projects.
Progress in reducing inflation must therefore remain a
major objective of public policy, along with reestablishment of
reasonably full employment and reasonably full utilization of
our industrial capacity. Actually, these policy objectives are
inseparable. The experience of other countries around the world,
as well as our own, indicates that lasting prosperity cannot be
attained in an environment in which expectations of inflation
remain intense.
The principal contribution that the Federal Reserve can
now make to the achievement of our nation's basic economic
objectives is to adhere to a course of moderation in monetary
policy. That principle has guided our efforts to facilitate eco­
nomic recovery and prevent a new wave of inflation. Firm
adherence to a policy of moderation has helped to build confi­
dence that inflation will taper off. And this in turn has made
it possible for interest rates to decline even as economic activity
has kept expanding.
Monetary policy alone, however, cannot solve our nation's
stubborn problem of inflation. We must work also to eliminate
its primary source— the persistent deficits in the federal budget.
And we need to give far more attention to structural measures
for lessening the powerful bias toward inflation that has been
created within our economy by imperfectly functioning markets
and a host of governmental regulations that impede the com­
petitive process and run up costs for business enterprises.
As we have learned, there is no easy way out of the in­
flationary morass into which we have strayed through negligence
and imperfect vision. But we are making progress. I am con­
fident that we will succeed if the American people, who are alert
as never before to the danger of inflation, remain steadfast. This
association has in the past played a vital role in educating our
citizens about the dangers of inflation and in encouraging gov­
ernment officials to pursue responsible financial policies. I
strongly urge you to expand your educational efforts. For in the
measure that we succeed in reducing inflation, we will restore
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EFFECTS OF INFLATION ON HOMEBUILDING

the conditions essential to a stable prosperity— for the home­
building industry and for the economy at large. Triumph over
inflation, I believe, is well within our means.




251




Some Parting Thoughts

Let me say first of all that I am most appreciative of the
invitation to appear before you. In making my final public
appearance as Chairman of the Federal Reserve Board here
at the National Press Club, I take some pride in thinking that
my relations with the press over the years have been forthright
and decent. I at least like to think that I have avoided the "u s"
and "them " mentality that so often afflicts public figures in
their dealings with the press. Certainly, the press has generally
treated both me and the Federal Reserve System fairly. For
my part, I have found the press a vigilant ally in the endless
task of contributing to public understanding of the problems
before our nation.
Having spent much of my life wrestling with the subtleties
and uncertainties of political economy, I am sensitively aware of
the pitfalls that surround coverage of economic and financial
news. I say most sincerely that I have great admiration for the
professional job that the press corps does, day after day, in
reporting and interpreting economic developments. To this
assessment I have only one qualification, namely, that broadcast
journalism still is not as effective as it might be in dealing with
economic news. I recognize, of course, that the constraint of
limited time slots presents formidable difficulties. In any event,
written journalism, as it applies to economics, has in my judg­
ment attained truly impressive maturity.
This luncheon is not a "good-bye," since I may be doing
some things in the future that will interest you professionally.
Address at the National Press Club, W ashington, D.C., January 30, 1978.




253

REFLECTIONS OF AN ECONOMIC POLICY MAKER

In fact, it's not beyond the realm of possibility that I may even
be joining your ranks in one capacity or another. Those in
town who think the time for farewell has come are mistaken.
Neither a shedding of tears— nor any special rejoicing— is yet
in order.
There are a few thoughts I would like to share with you
on this occasion. The economy is doing very well in some
respects and poorly in others. In analyzing trends, I find it
helpful to distinguish between the performance of the economy
in recovering from the recent recession and its performance
in coping with longer-run, deeply imbedded problems.
The economic expansion that began almost three years
ago still has vitality in my estimation and I see no serious risk
that it will peter out soon. The upsurge in sales with which
1977 ended caused inventories to be drawn down in numerous
businesses, thus creating a likelihood that overall economic
activity will receive a special fillip for a while from business­
men's efforts to rebuild stocks. And with consumer activity,
housing activity, and governmental activity all still exhibiting
expansionary tendencies, I believe that further gains in employ­
ment and income lie ahead.
Business investment activity, to be sure, is still not showing
decisive robustness. This reflects the uncertainties and unease
that continue to haunt our business and financial environment.
I expect, nevertheless, that the tax relief which the President
has proposed for business will lead to a strengthening of invest­
ment commitments as 1978 unfolds. In saying this, I do not
mean to embrace each and every aspect of the administration's
tax and budgetary strategy. Many of you know my views well
enough to appreciate that a tax program structured to my liking
would be tilted more decisively toward the stimulation of savings
and investment. I think you also know that I feel that tax
reduction at this stage of economic expansion should be primarily
accommodated by limiting expenditures, so that significant
shrinkage in the federal budget deficit might still be achieved.
But on the specific issue of tax reduction for business, I do be­
lieve that what has been proposed will help to relieve the low
level of corporate profitability that has prevailed in recent times
and thus constitutes an important plus for the capital-goods out­
look this year and next.
254



SOME PARTING THOUGHTS

So much for the bright side of the coin. The generally good
record of our economy in terms of recovery from recession stands
in marked contrast to a virtual absence of progress in coping
with the overlay of our longer-term economic problems. I am
thinking particularly, of course, of the dispiriting failure we
have experienced in making headway against inflation. I am
thinking also of our inability to solve the structural unemploy­
ment that is causing so many young people and blacks to be
left outside the mainstream of national progress. And while most
people probably think of our well-publicized balance-of-payments difficulties as being of recent origin, they too in fact are
the product to a considerable extent of deep-rooted ailments that
we have not dealt with effectively.
Last year witnessed no progress toward a less inflationary
environment. Rather, the basic inflation rate settled in the 6
percent area, reflecting the difference between average annual
pay increments of labor that are running above 8 percent and
productivity gains that are averaging little more than 2 percent.
While the discrepancy between wage and productivity in­
creases is tending at present to perpetuate inflation, it is im­
portant to recognize that the inflationary problem with which
this nation is burdened did not originate with an irresponsible
wage push on the part of American workers or their unions.
Rather, the tragic skein of events in which we are caught is
chiefly traceable to fundamental mistakes of governmental policy
made in the mid-1960s. Those mistakes involved overstimulation
of the economy at the very time our military involvement in
Vietnam was escalating and when we were also embarking upon
Great Society programs that were to become an increasingly
heavy drain on the federal budget. The pressures on available
resources generated in the mid-1960s started us on a path of
enormous budget deficits and rapid inflation from which we have
not been able to disengage ourselves. Indeed, we have continued
to compound our problem by seeking to fine-tune the economy
by governmental fiscal actions that, in my judgment, have weak­
ened the private sector's dynamism and efficiency.
Events of recent years, such as major crop failures and the
sharp rise in oil prices, have merely aggravated the underlying in­
flationary bias that our government, under both Republican and
Democratic administrations, has imparted to the economy. Other




255

REFLECTIONS OF AN ECONOMIC POLICY MAKER

developments— such as the escalator arrangements sought and
achieved by various economic groups— have speeded the trans­
mission of inflationary impulses across the economy. In sum,
over an extended span of time, we as a nation first created
enormous upward pressures on the price structure, and we then
devised elaborate arrangements that tend to perpetuate those
pressures even under conditions of economic slack.
The inflation plaguing our economy may not end quickly.
Government has, however, a special leadership role in the pursuit
of moderate fiscal and monetary policies, in encouraging wage
restraint by way of example, and in many other particulars.
But private actions are critical too, ranging from more deter­
mined pursuit of productivity gains to the conduct of collective
bargaining in ways that are more responsible in a broad social
sense. We see nowadays too many excessive wage settlements
entered into by managements and trade unions, who then band
together in seeking governmental protection from the market
consequences of their own actions.
The need to fight inflation is widely recognized in our
country, but the will to do so is not yet strong enough. I have
no doubt that the will to get on energetically with the job of un­
winding the inflation will be forged someday. I only hope this
will come through a growth of understanding, not from a demon­
stration that inflation is the mortal enemy of economic progress
and our political freedom.
And just as we need a more determined approach to the
challenge of inflation, so too do we need fresh initiatives for
dealing with structural rigidities in the job market. The heavy
incidence of unemployment among young people and blacks
will not be remedied by general monetary and fiscal policies.
We need, instead, specialized efforts: first, efforts to overcome
serious educational deficiencies so that individual job seekers will
possess greater marketable skills; second, efforts to eradicate im­
pediments that stand in the way of job opportunities for young
people and minorities even when the potential for effective job
performance is present. These impediments include federal and
state minimum-wage laws, restrictive practices of various craft
unions in limiting membership, unnecessary licensing and certi­
fication requirements for many jobs and business undertakings,
and— I must add to our shame— continuing racial discrimination.
256



SOME PARTING THOUGHTS

This nation can have no greater priority than to end the tragic
human wastage that we have been allowing to occur.
The disappointing aspects of economic performance are
not confined to the domestic sphere. Full prosperity in this
country can hardly be achieved in the absence of a healthy world
economy and a stable international financial system. The recent
steep decline in the value of the dollar in foreign exchange mar­
kets— precipitated in large part by our enormous trade deficit—
has become a matter of serious concern.
To be sure, there are those who argue that recent exchange
market developments are not worrisome. Indeed, much of con­
ventional wisdom holds that a depreciating currency will im­
prove a nation's trade position and, in turn, benefit its economy.
Whatever merit may attach to this theory, it would serve our
country poorly— particularly at the present time when such a
large part of the world's economy is in a semi-stagnant condition.
The dollar, we must remember, is the currency in which the
preponderance of world trade is conducted. It is also a store of
value for practically every central bank, for multinational cor­
porations, and for people of wealth and means around the world
as well as for the American people. Continued uncertainty about
the future value of the dollar could produce a disorderly, un­
settling flight from dollar assets. It could lead to hesitation about
spending or investing decisions around the world that would
be inimical to prosperity— including the expansion of our ex­
ports. If the currencies of some foreign countries, especially
those that depend heavily on exports, should experience signifi­
cant further appreciation, their economies might well suffer.
Such a development could reinforce recessionary tendencies and
add to the risk of fostering protectionist sentiment around the
world.
That the depreciation of the dollar has recently added to
economic uncertainties both here and abroad is well understood
by the administration. That is why the President has reassured
the world about our country's determination to protect the in­
tegrity of the dollar. That is why the Treasury and the Federal
Reserve have recently taken steps that have been helpful to the
functioning of foreign exchange markets. But the technical
measures so far taken cannot of themselves assure a permanently
strong dollar.




257

REFLECTIONS OF AN ECONOMIC POLICY MAKER

To protect the integrity of the dollar, we must enact without
further delay an energy policy that promises substantial reduc­
tion of our dependence on imported oil. Second, we need to in­
stitute tax policies that encourage business capital investment—
including investment in this country by foreigners. Indeed,
policies that make the United States a more attractive haven for
foreign funds are especially important, since we cannot reason­
ably expect dramatic improvement over the near term in the
trade portion of our international payments accounts. Finally,
our international payments imbalance requires an anti-inflation
strategy that promises to enhance the competitiveness of our
products in international markets.
These requirements of policy will not only serve to
strengthen the foreign-exchange value of the dollar and thus the
entire international financial system. They are equally essential
from the viewpoint of our domestic economy. An effective
energy policy, a tax policy to stimulate capital investment, and a
meaningful anti-inflation policy— all this, as the administration
recognizes, is vital to our domestic prosperity.
Before closing, I want to comment very briefly on a matter
that, to my mind, can make an enormous difference to the future
of our country. I refer to the special status of the Federal Re­
serve System within our government structure.
Throughout the ages, national governments have had a
chronic tendency to engage in activities that outstrip the taxes
they are willing or able to collect— a practice that was facilitated
in earlier times by clipping precious coins and in modern times
by excessive printing of paper money and coercion of central
banks. To afford a measure of protection against such political
abuses, the authors of the Federal Reserve Act provided for an
independent central bank, and their action— while at times
questioned— has been confirmed time and again by the Congress.
In other words, substantial independence in exercising power
over money creation is not something that Federal Reserve
officials have arrogated unto themselves, nor is it something that
others have conferred because of a belief that central bankers
have unique insight that sets them apart from other people.
Rather, the ability of the Federal Reserve to act with some in­
dependence from the executive branch, and also with immunity
from transient congressional pressures, was deliberately estab258



SOME PARTING THOUGHTS

lished and has been deliberately maintained by the Congress
in the interest of protecting the integrity of our money.
In leaving the chairmanship of the Federal Reserve Board,
I am especially pleased that President Carter has unequivocally
assured the American people of his own conviction that an in­
dependent Federal Reserve serves our national interest. On that
happy note, ladies and gentlemen, I will now end and turn to
your questions.




259







PART
THREE
Fiscal Responsibility




The Control of Government
Expenditures

This year the Congress has devoted a great deal of attention to
tax legislation. Besides aiding the fight against inflation by
extending the income tax surcharge temporarily, the Congress
has been heavily engaged in writing a tax reform bill that is of
major significance to the American public. If the bill survives
in something like its present form, some troublesome inequities
under existing law will finally be corrected. However, the rela­
tive tax burden borne by individuals and corporations will also
be changed, with corporate income tax liabilities gradually go­
ing up about $5 billion by 1975 and individual income taxes
coming down $12 billion.
This projected shift in the tax structure will favor consump­
tion at the expense of capital formation. Such a development
will be useful in the short run by helping to cool off the business
investment boom that is still under way, but it may damage
prospects for the long-term growth of our economy. We surely
cannot afford to take capital formation or economic progress for
granted. If our economy is to grow and prosper in the future,
as it both can and should, business enterprise may well need the
stimulation of an improving tax climate.
In recent times, our nation has moved rapidly towards the
welfare state, such as various European countries previously
developed. Unlike these countries, however, we also devote an
enormous part of our resources to meeting the needs of an intriAddress at the annual award dinner of the T ax Foundation, New York City,
December 2 ,1 9 6 9 .




263

REFLECTIONS OF AN ECONOMIC POLICY MAKER

cate and far-flung defense system. Thus far, the prodigious
productivity of American industry has made it possible to fi­
nance liberally both our defense needs and the social services of
government. But in order to continue to support the growing
scale of our public consumption without doing injury to private
consumption, the productivity of our factories, mines, farms,
construction enterprises, and service trades may have to improve
more rapidly than in the past. This will not be accomplished
without substantial and increasing investment in new and better
tools of production. The projected shift in the structure of taxa­
tion therefore seems undesirable to me, and I trust that the
President's Task Force on Business Taxation will soon point the
way to better balance in our tax system.
I do not know at precisely what point the burdens of taxa­
tion will materially serve to check our nation's economic prog­
ress, but I also do not think it wise to test this issue too closely.
The trend of governmental spending and taxes in the past forty
years has been sharply and inexorably upward. In 1929, govern­
ment expenditures at the federal, state, and local levels amounted
to about 10 percent of the dollar value of the nation's produc­
tion. This fraction rose to about 20 percent in 1940, to about
30 percent in 1960, and to about 35 percent this year. The
broad trend of taxation has been very similar. With over a third
of our nation's output already moving into the hands of the tax
collector, it seems hardly prudent to contemplate any further
increase in the level of taxation. And yet, unless we bring gov­
ernment expenditures under better control than we yet have, the
modest overall reduction of tax rates that the tax reform bill
projects will prove abortive and further increases in the level of
taxation may become unavoidable.
As our nation's economy has grown and as our political
democracy has widened, the responsibilities assumed by govern­
ment have kept increasing. In fiscal year 1962, the rising curve
of federal expenditures first crossed the $100 billion mark. It
now appears likely that the $200 billion mark will be crossed
the next fiscal year; so that we will be adding as much to the
federal spending rate in a mere nine years as it took nearly two
centuries to achieve previously.
The explosive increase of federal spending during this dec­
ade is commonly attributed to the defense establishment, or
264



CONTROL OF GOVERNMENT EXPENDITURES

more simply to the war in Vietnam. The fact is, however, that
civilian programs are the preponderant cause of the growth of
the federal budget. When we compare the budget of 1964 with
the estimates for this fiscal year, we find that total federal
spending shows a rise of $74 billion, while defense outlays are
larger by only $23 billion. If we go back to 1953, when the
Korean war ended, and take into account state and local ex­
penditures as well as federal, we find that defense outlays have
been responsible for only about one-sixth of the vast increase
in the cost of government that has occurred since then.
Thus, the basic fiscal fact is that spending for social pro­
grams now dominates our public budgets. Although the federal
government's direct involvement in problems of social welfare
is a recent development, it is already huge and is growing at a
fast rate. This fiscal year, programs for education, manpower;
health, income security, housing, community development, and
crime prevention will cost over $80 billion— a sum that exceeds
all the spending done by the federal government in the peak
year of the Korean war. Federal aid to the poor will alone cost
$27 billion this year, in contrast to $12 billion in 1964. Grants
in aid to states and localities will cost about $25 billion, in con­
trast to $15 billion in 1967, $10 billion in 1964, and $5 billion
in 1958.
This upsurge of federal spending is a response to the eco­
nomic and social difficulties that afflict many of our communi­
ties— witness the slums, ghettoes, racial strife, poor public
schools, teenage unemployment, drug addiction, poor health,
student disorders, inadequate transportation, traffic congestion,
air and water pollution, and unsafe streets and parks. The fed­
eral government has tried to solve these complex problems by
spending large sums of money on projects that have often been
hastily devised. Hundreds of grant-in-aid programs dealing with
health, education, welfare, and other local needs were established
in quick succession. Several regional commissions were estab­
lished to seek better balance in economic development and social
improvement. An Economic Development Administration was
established to aid local communities, both urban and rural, that
suffer from excessive unemployment or inadequate incomes.
More recently, a Model Cities Program was established, aspiring
to achieve what our best city planners can contrive. By proceed-




265

REFLECTIONS OF AN ECONOMIC POLICY MAKER

ing in all these directions, we have created a costly governmental
maze that involves much duplication and waste, that often
hampers the constructive efforts of local officials, and— perhaps
worst of all— that practically defies full understanding or
evaluation.
Nowadays, many local government officials, instead of
grappling with the most urgent needs of their communities,
devote their finest energy to maximizing and husbanding the
federal grants that happen to be available. With over 600 cate­
gorical programs of federal aid to choose from, there is plenty
to keep them busy. Many of the programs involve tedious pro­
cedural steps extending over a number of months before a
community can learn whether federal funds are to be granted
for its proposed project. Each program is equipped with its own
set of administrative requirements involving endless forms and
reports. If a local official attempts to draw upon several funding
sources to help finance a neighborhood project, he may be con­
fronted with a mass of complex application forms weighing
several pounds, with federal processing steps that may take well
over a year to elicit a "yes" or "n o " response, and with stringent
requirements for hundreds of detailed . reports. Further, this
official will usually have to work with federal representatives
scattered in a number of different cities in order to arrange the
project.
I am informed by the Bureau of the Budget that one federal
program requires over 100 different kinds of forms and reports;
that a grant involving $1,000 may require over 30 major federal
agency steps, including review by a 15-man advisory committee
and headquarters approval; that a department of one state has
counted 120 different reports that it is required to submit to a
particular federal agency, many of them on a monthly or quar­
terly basis; and that there are numerous instances in which
federal, state, and local governments make independent studies
of the same community without one agency knowing what the
other is doing, or having an opportunity to share in the results
of the other studies. The mere listing of all federal requirements
imposed on states and communities would be so voluminous
that it has never been done.
As a result of this administrative morass, various federal
programs are half smothered in paper. Employees at all levels
266



CONTROL OF GOVERNMENT EXPENDITURES

of government are required to devote time to detailed paper
work which would be better devoted to rethinking program
objectives or assessing the extent to which present objectives
are being met. More important, help may not reach the people
who need it until months— sometimes years— after it should,
with much of the money meanwhile siphoned off by the bureau­
cracy. To give only a few outstanding examples, neither the
achievements of the compensatory education program, nor of
the urban renewal and slum clearance programs, nor of the
public assistance programs have come very close to the expecta­
tions of our lawmakers.
In view of the explosive growth of federal spending and the
ineffectiveness or inefficiency of much of it, I am inclined to
think that the need for expenditure reform may be even greater
than the need for tax reform. One of the advantages of a new
administration is that it can move with energy to change the
direction of governmental policy. President Nixon responded
to this opportunity by taking major steps to win control over
federal spending. Needless to say, the rapid rise of the consumer
price level has been the most troublesome economic problem
facing the nation this year. In view of the inflationary pressures
in our markets for goods and services, it was clearly important
that the federal government curb its spending beyond the
earnest move to frugality that the previous Administration made
in its closing days. In all, reductions of $7 */2 billion from the
January budget were therefore ordered by the President for
this fiscal year. These reductions were widely distributed among
government agencies, with $4.1 billion allocated to the Defense
Department and $3.4 billion to the rest of the government.
Moreover, when Congress later passed or considered legislation
that foreshadowed an expenditure total well above the revised
budget of $192.9 billion that the President had submitted, he
firmly announced that he would try his utmost to see to it that
federal finances continue to be subject to the ceiling that he had
imposed. Later in the year, in order to deal with the special
problem of runaway construction costs, the President ordered a
cutback of 75 percent in federal construction contracts.
Administrative steps were also taken by the President to
achieve greater efficiency in government spending. In March a
carefully planned effort to cut red tape got under way. As a




267

REFLECTIONS OF AN ECONOMIC POLICY MAKER

first step, the several agencies most closely concerned with
human resources were directed to adopt common regional bound­
aries and to locate their regional offices in the same cities.
Further, a review was started of the several hundred federal
assistance programs, with the objective of simplifying procedure,
cutting down on the paper work, and shifting responsibilities to
the field so that decisions could be made both more expedi­
tiously and by officials who are in closer touch with the local
problems.
The administration has also sought legislation to correct
the deficiencies of the grant-in-aid programs. In order to give
local officials greater flexibility to meet their priority needs, the
President has requested authority to consolidate existing grantin-aid categories, subject to a congressional veto within sixty
days. Moreover, as legislation has moved through the Congress,
the administration has been alert to the opportunity of converting
narrow categorical grants into block grants for broad functional
areas. In line with this policy, proposals for grant consolidation
were advanced in connection with legislation on hospital con­
struction, on elementary and secondary school education, and on
manpower training services, as well as through the appropria­
tions route.
But by far the most important as well as the most dramatic
step that the President has taken to reform expenditure policy is
his proposal to the Congress to inaugurate a system of revenue
sharing. This proposal marks a milestone in federal-state rela­
tions. It seeks to decentralize governmental power. It seeks to
restore the balance that existed in earlier decades between the
state capitals and the national capital. Or to be more precise,
while it seeks to extend additional federal assistance to state and
local government, it insists that this be done in a manner that
will enable local officials to attend to urgent problems within
their own jurisdictions as they deem best, without being sub­
jected to rigid federal controls or requirements.
The leading features of the administration's revenue sharing
proposals are as follows: First, in view of budgetary constraints,
the revenue sharing fund will be limited in fiscal 1971 to a half
billion dollars, but will subsequently grow fairly rapidly and
reach $5 billion by the mid-seventies. Second, the distribution
of the fund among the states will be based on a simple formula
268



CONTROL OF GOVERNMENT EXPENDITURES

that assigns primary weight to population, but also gives some
weight to tax effort. Third, the distribution within each state
between the state government and the localities will be likewise
based on a formula, so that each unit of government within a
state will be assured a share that is proportionate to its own tax
revenues. Fourth, no restriction will be placed on the use of the
funds made available by the federal government; in other words,
each state, county, city, or town will rely on its own judgment
and use the money for education, health services, parks, law
enforcement, or some other way, as it deems best.
The precise details of this revenue sharing plan grew out of
detailed discussions among members of the administration, con­
gressmen, governors, mayors, and county officials. In the course
of these discussions the argument was sometimes encountered
that revenue sharing may lead to fiscal irresponsibility, since
local officials may be careless in using funds that they did not
have to raise from their own constituents. This argument can­
not be dismissed. It might in fact be decisive if the practical
choice were between levying local taxes or federal taxes. By all
indications, however, federal financial assistance to the states
and localities will continue to grow, and the only real question
is whether federal grants will lead to more or to less centralized
control. In taking a definite stand for decentralization, the ad­
ministration has enunciated a policy whose wisdom is now
widely recognized by liberals as well as conservatives within
our two major political parties.
As a result of the careful preparation of the administra­
tion's revenue sharing plan, it has already won the general ap­
proval of the Governors' Conference and also of the leading
national organizations of mayors and county officials. The
administration's own thinking on the subject is not rigid, and
it will entertain any reasonable proposal for change that would
facilitate congressional approval. In particular, the administra­
tion would welcome an enlargement of the projected revenue
sharing fund, provided categorical grants were correspondingly
curtailed. If that happened, revenue sharing would grow more
rapidly than presently contemplated, and the decentralization of
government— which has become so vital to order and efficiency
in the public economy— would be speeded.
This sketch of recent progress toward federal expenditure




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reform should be reassuring to responsible citizens, but it cer­
tainly leaves no room for complacency. Much of the needed
legislation has yet to be passed. Many of the administrative
improvements are still in an early stage and remain to be tested.
The ceiling of $192.9 billion on this year's expenditure is not en­
tirely secure. True, the curve of federal spending is now rising at a
much slower pace than in recent years, but the improvement
would be less impressive if the various government-sponsored
financial agencies were all included in the budget. And, as far
as I can judge, the growth of population, the need to improve
our social and physical environment, and the widening concept
of governmental responsibility will almost inevitably lead to
large additions to federal as well as state and local expenditures
in the future. There will therefore be a continuing need to con­
trol governmental spending, first, in order to avoid strain on our
physical resources of labor and capital, second, in order to assure
the continuance of a vigorous private sector, and third, in order
to maintain pressure for discriminating judgment on priorities
as well as for economy of execution in the public sector. These
are difficult requirements and they will not be met without fur­
ther significant expenditure reform.
One major step toward reform was taken last year and
again this year by congressional enactment of a ceiling on ex­
penditures. A legislative budget is a radical departure in budget
making, and its significance should not be minimized by the
rubbery texture of the ceiling. In the first place, the vigorous
discussion surrounding the legislative ceiling has of itself served
to dampen enthusiasm for larger spending. In the second place,
the rubbery ceiling of today can become a rigid ceiling tomorrow.
If the Congress moves in this direction, its fragmented approach
to appropriations, which will doubtless continue, need no longer
run up federal spending as it has commonly done in the past.
To be sure, the individual appropriation acts may imply a
much larger expenditure total than had previously been legis­
lated. In that event, the Congress would in effect say to the
President: "You are the manager of our national finances. We
fixed a ceiling on expenditures earlier in the year, after consider­
ing your budgetary recommendations and making our own best
judgment of what the national interest requires. But there are
several hundred of us; each of us is subject to heavy pressure
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for appropriations that seem vital to our constituents, and we
find it impossible in the time at our disposal to trim individual
appropriations so that they be consistent with the expenditure
ceiling. In view of our inability to agree on priorities, we assign
this responsibility to you; but we naturally reserve the right to
challege your actions by new legislation." Such a mandate by
the Congress would, of course, not make the President's job any
easier; it could well lead at times to uneconomical cutbacks; and
it might even mean that we will have only one-term presidents
in the future. However, by enabling the members of Congress
to satisfy both their conscience and their constituents, such a
mandate would help powerfully to assure that total expenditure
is kept under decent control.
A second reform of vital significance would be adoption of
the concept of zero-base budgeting. Customarily, the officials
in charge of an established program have to justify only the
increase which they seek above last year's appropriation. In
other words, what they are already spending is usually accepted
as necessary, without examination. Substantial savings could
undoubtedly be realized if both the Budget Bureau examiners
and the congressional appropriations committees required every
agency to make a case for its entire appropriation request each
year, just as if its program or programs were entirely new. Such
a budgeting procedure may be difficult to achieve, partly because
it will add heavily to the burdens of budget making, and partly
also because it will be resisted by those who fear that their pet
programs would be jeopardized by a system that subjects every
federal activity to annual scrutiny of its costs and results. How­
ever, this reform is so clearly necessary that I believe we will
eventually come to it. I regard President Nixon's request of
the Budget Bureau this year for a list of programs judged to be
obsolete or substantially overfunded as a first step toward zerobase budgeting.
Several other reforms that I can only mention also deserve
serious attention. First, earmarking of funds is often a dubious
practice and should be carefully reappraised by the Congress.
Second, agency heads should be subject to a presidential require­
ment that if they request additional funds— whether for new or
old programs— after the budget has been transmitted to the
Congress, they must as a rule give up an equal amount of money




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from their ongoing activites. Third, new programs should be
typically undertaken on a pilot basis and not launched on a
national scale until their promise has been reasonably tested.
Fourth, the law requiring that the cost of new programs be pro­
jected five years ahead when they are first presented to the
Congress should be strictly enforced. In addition, comprehen­
sive five-year budgetary projections should be constantly main­
tained by the Budget Bureau for the president's guidance. Fifth,
I think that it would be useful to rotate the personnel of the
Budget Bureau among its major divisions, so that the key exam­
iners can periodically shed their preconceptions or frustrations
and approach with a fresh eye the financial concerns of the
agencies that are newly assigned to their scrutiny.
In addition to institutional reforms such as these, effective
control of public expenditures will require larger reliance on
volunteer efforts for dealing with our great social ills. It will
also require thorough, realistic, and penetrating study of the
promises, costs, and achievements of individual governmental
programs. Although federal agencies, particularly the Bureau
of the Budget, need to augment their evaluative work, some
doubt will always surround research that is carried out by agen­
cies which originally advocated or subsequently supervised the
programs under study. There is a great need, therefore, for
expenditure studies by organizations that are independent of
government and have no direct stake in any of the programs.
In view of its preeminence in fiscal research and public educa­
tion, the Tax Foundation is especially well equipped to organize
teams of economists, accountants, political scientists, and man­
agement experts for the concrete study and evaluation of some
of the major branches of federal expenditure.
I hope that the trustees of the Tax Foundation will be able
to find a way of making this additional contribution to good
government. If you undertake to do so, I assure you that the
evaluation teams you send to Washington will receive a very
warm welcome.

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The Need for
New Budgetary Procedures

In a year when Congress is demonstrating a determination to
reform its procedures, your committee faces a challenge worthy
of its talents. You have the opportunity to enable Congress to
turn its power of the purse into a truly effective instrument for
stabilizing our economy. The fiscal policies of this government—
its total outlays, the priorities they reflect, and their relationship
to revenues— bear significantly on the lives of the people you
represent. Income levels, the cost of living, the balance of in­
ternational payments, and even the quality of life in this country
are directly and substantially affected by the federal budget. If
you can develop procedures that will enable members of Con­
gress to vote on an overall fiscal policy that adequately reflects
congressional priorities, you will revitalize representative gov­
ernment in this country. I am pleased to have been asked to
discuss these issues with you.
Thoughtful people everywhere are aware of the need for
more effective congressional review of the budget. A recent in­
dication of this fact is Senator Mansfield's statement on Feb­
ruary 8, 1973, disclosing that "all the new Senators of the class
of 1973" had written to him and to Senator Scott urging that
reform of the congressional budgetary process be given "top
priority." In this letter thirteen new senators, from both political
parties, fresh from election victories in states from Maine to
Idaho, unanimously and "wholeheartedly" agreed that "ConStatement before the Joint Study Committee on Budget Control, U.S. Con­
gress, March 6, 1973.




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REFLECTIONS OF AN ECONOMIC POLICY MAKER

gress has the obligation to set priorities under which expendi­
tures are to be authorized by this nation, and present procedures
of the Congress do not in fact achieve that aim/' They con­
cluded with this perceptive comment: "The first step toward
establishing priorities has to be setting a ceiling on appropria­
tions and expenditures. This must be done first, rather than
last. Unless we do this, we are not really budgeting at all."
Yet along with this awareness of the need for better bud­
getary procedures, there is concern and even cynicism about the
prospects for achieving them. We hear speculation that the
President does not really believe Congress will heed his call
for a ceiling on expenditures but expects, instead, the Congress
to overspend and thus become responsible for a tax increase
that would then be inevitable. Congress, by it own actions, has
lent some support to this pessimistic view. The early response
of the House and Senate to the President's efforts to hold
outlays for fiscal 1973 to $250 billion has been to pass bills
requiring release of some of the impounded funds. And the
Ervin bill restricting the authority to impound funds seems
likely to pass the Senate soon. Thus, people are understandably
concerned that Congress, in exercising its unquestioned right
to determine priorities among national needs, may produce
budget deficits that no one wants— not the President, not the
Congress, and not the people you represent.
The problem is too acute to allow its solution to be frus­
trated by acrimonious debate about who is to blame. Repre­
sentative Mahon recognized this in a challenging discussion of
our budget problems in Nation's Business last April. Let me
quote a few key sentences from his paper: "W ho is to blame
for this distressing record? The President? The Congress? The
American people? I think nearly all of us are. Large segments
of the population tend to demand more and more government
services, and at the same time there is a demand for lower
taxes."
I believe the American people understand that government
spending, taxes, inflation, and interest rates are all interrelated.
If they seem to favor more spending and lower taxes at the
same time, it may well be because congressional procedures
lead to votes on taxes and spending as though they were un­
related issues. Members are asked, in effect, to cast a number
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NEED FOR NEW BUDGETARY PROCEDURES

of separate votes for or against cleaner air, for or against better
schools, and for or against a host of other good things gov­
ernment can help to provide. A vote does not occur on the
question of whether expenditures for a particular category are
desired strongly enough to raise taxes, or to cut back on an­
other category. Until votes can be cast on such questions, we
cannot be sure what answers people generally would give.
At present, the decision-making process that results in a
unified budget being presented by the administration has no
counterpart in Congress. Instead, the decisions that determine
the ultimate shape of the budget are made by acting (or at times
taking no action) on a large number of separate measures—
160 for fiscal 1973, as recently reported by your committee.
Only after the results of these separate votes are determined
can we put the pieces together and discover what kind of bud­
get has emerged. In this process, members of Congress have
no opportunity to express the wishes of their constituents on
choices such as what total expenditures should be, or whether
more should be spent for housing or for education or health
care. Choices of this type are of greater importance to the
electorate as a whole than the single proposals on which con­
gressional votes actually occur.
Some of the choices that the Ninety-third Congress will
have to make can be readily anticipated. The economy is ex­
panding vigorously. We can look forward to a good increase
in physical output and further reductions in unemployment in
1973. Thus, there is no need at this stage of the expansion for
further fiscal stimulus and the administration has therefore
recommended that the budget be brought into balance at full
employment. Along with the new prosperity, however, we have
some old problems. Persistent inflation— albeit at a somewhat
diminished pace— is one of them, and the chronic deficit in our
international balance of payments is another.
The recent devaluation of the dollar, combined with the
Smithsonian realignment, have now placed us on the road
back towards equilibrium in our balance of payments. W e can­
not, however, take that improvement for granted. Indeed, con­
fidence in our own economy will be strengthened if we set a
firm and definite goal for the balance of payments— namely, to
end the deficit within a period of two to three years. And while
devaluation will help in restoring payments equilibrium, it will




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REFLECTIONS OF AN ECONOMIC POLICY MAKER

also add to upward pressures on our prices at a time when both
domestic and international considerations require a determined
effort to restore price stability. The level of federal spending,
and the way it is financed, will have an important bearing on
our ability to solve these persistent problems of inflation and
international imbalance.
Yet sizable deficits in the federal budget continue to plague
us. The administration estimates that outlays, if held to $250
billion, will exceed revenues by $25 billion for fiscal 1973. And
while the administration has recommended that the budget be
brought into a position of full-employment balance for fiscal
1974, outlays are still scheduled to rise another $19 billion and
the unified budget deficit is expected to be about $13 billion.
In addition to its implications for employment, price sta­
bility, and our international payments position, the budget is
bound to leave its mark on interest rates. With credit demands
strengthening because of the marked advance in economic
activity, interest rates have been moving up. Treasury financing
requirements, stemming from large budget deficits, have added
to the pressures on credit markets. So far the advance in in­
terest rates has been mainly confined to short-term credit. But
our chances of continuing to avoid significant increases in long­
term rates will depend heavily on whether Treasury demands
for credit can be held at moderate levels.
It is clear to me that your committee fully realizes the
pressing need to reestablish order in our federal finances. The
question is not whether it must be done, but how. A solution
requires a firm ceiling on expenditures or a tax increase, or some
combination of the two. There are several reasons, I believe, for
choosing a curb on spending in preference to a tax increase.
First, government expenditures— counting outlays by state
and local governments as well as federal— have been rising much
faster than our national production, so that an increasingly
large fraction of the wealth that our citizens produce is being
devoted to the support of government. In 1929, total govern­
ment spending amounted to about 10 percent of the dollar
value of our national output. Since then the figure has risen
to 20 percent in 1940, 30 percent in 1965, and 35 percent in
1972. It is time to call a halt.
Second, the expansion in government outlays has not pro­
duced the kind of benefits the public has a right to expect. As
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NEED FOR NEW BUDGETARY PROCEDURES

government assumes wider responsibilities, it becomes increas­
ingly apparent that we must have a better system of controls
to screen out low-priority programs and to ensure that highpriority programs operate efficiently. The best way to get effec­
tive controls of that kind is for Congress to decide that onethird of our national output is quite enough for the tax collector.
Third, I have the impression that the American people feel
that they are already carrying a sufficiently heavy tax burden
and will strongly resist any increase. If that impression is cor­
rect, raising taxes may not be a realistic alternative to a ceiling
on spending.
In its interim report of February 7, your committee has
sketched out a tentative plan to achieve better control over ex­
penditures, as a part of an overall plan for reviewing tax and
expenditure policies. You have already accomplished much in
the short time your committee has been in existence, and I find
your report most encouraging.
Under this tentative plan, Congress would establish two
overall spending ceilings early in the session. One would govern
total outlays for the ensuing fiscal year, which stem in part
from obligational authority previously enacted. The other would
limit new obligational authority, which will form the basis for
expenditures not only in the ensuing fiscal year but in later
years as well. Each of these comprehensive ceilings would be
accompanied by subceilings for major categories of expenditures,
so as to reflect congressional priorities and to assist in achieving
compliance with the overall ceilings.
Your report notes that earlier experiments with rubbery
ceilings have failed, and that procedures must therefore be
developed to assure reasonable compliance with the ceilings.
Representative Findley's proposal, H. Res. 17, which would
amend the rules of the House to require a two-thirds vote for
passage of any bill that would exceed the previously determined
ceiling for the particular category of expenditure, has much to
commend it in my view, provided it is expanded to assure
participation by the Senate in establishing the ceilings— as your
report contemplates.
Representative Reuss has suggested a somewhat different
procedure— namely, that the overall ceilings and subceilings
established early in the session be treated as tentative, so that
appropriations bills and other measures providing new obliga-




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REFLECTIONS OF AN ECONOMIC POLICY MAKER

tional authority could be passed as now by majority vote even
though they breached the ceilings. Thus, the tentative ceilings
would help to guide action on individual spending measures,
but adjustments would be made late in the session, in the form
of a Final Budget Statute. This proposal seeks to achieve
flexibility and an opportunity for late-session review, as pro­
posed by your report, without destroying the effectiveness of
the ceilings established early in the session.
I recognize that it may be too much to expect the House
and Senate to agree early in the session, on the basis of limited
information, on ceilings for major categories of expenditure that
could be overridden only by a two-thirds vote. It may there­
fore be necessary to rely, as Representative Reuss has sug­
gested, on action late in the session to set the overall ceilings
and subceilings in their final form.
For the reasons I have mentioned, I would hope that where
the tentative overall ceilings are exceeded, the late-session ad­
justment would usually take the form of reduced spending
authority rather than a tax increase. But there may be circum­
stances where Congress should consider accepting a higher
deficit than originally contemplated or financing expenditure
overruns by raising taxes. The essential point, to my mind, is
that Congress should take one of these courses deliberately, in
full awareness of its consequences.
Moreover, if reliance is placed on a Final Budget Statute
for the needed adjustments, special rules would seem to be re­
quired in order to assure that such a measure is in fact brought
to the floor and acted on. Rules such as those which speed
consideration of resolutions relating to reorganization plans
would seem to be useful in this connection.
As an alternative approach, you may wish to consider a
procedure by which Congress would adopt a joint resolution
establishing overall spending ceilings as early in the session as
possible, but in no event later than June 30. The resolution
would set firm overall ceilings on outlays and new obligational
authority for the coming year, and direct the Executive to sub­
mit within forty-five days a detailed budgetary plan for com­
plying with these ceilings. The plan would take effect within
forty-five days after its submission unless either house mean­
while passed a resolution disapproving the plan. With reason­
able cooperation between the Executive and the Congress, which
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NEED FOR NEW BUDGETARY PROCEDURES

would of course include consultation with the House and Senate
budget committees proposed in your report, such a procedure
would assure that the ceilings were effective and that they also
adequately reflected congressional priorities. Again, rules would
be needed, analogous to those for reorganization plans, to give
each house the opportunity to vote on a resolution of disapproval
if it so wished.
In developing better budgeting procedures, it may be that
the federal government could usefully adopt some of the tech­
niques of the states, where budgets are subject to a relatively
firm discipline. I have tried to learn something about state pro­
cedures through conversations with state officials and others
familiar with the subject.
It appears that state legislatures are normally subject to
a very powerful constraint— namely, elected officials of all
parties recognize a balanced budget as a prerequisite to reelec­
tion. Some states permit deficits for capital expansion but a
deficit on current account, even where permitted by law, poses
political risks that officials are reluctant to take. The general
acceptance of the need for a balanced budget enables the leader­
ship to keep the legislature in session until it is achieved. I am
not advocating that the United States Congress repair to the
banner of a balanced budget at all times. But we do need a new
sense of discipline— one that recognizes that a constantly stimu­
lative fiscal policy is more apt to produce inflation than new jobs.
One important means by which the states achieve fiscal
restraint is by granting considerably larger power to the gov­
ernors than the Congress has granted to the president. The item
veto is authorized in a number of states, and because of the
shorter legislative sessions the pocket veto is a more powerful
weapon. In some states the legislature is not permitted to in­
crease spending above the level requested in the budget unless
it also provides for a new source of revenue. And nearly all
governors impound funds frequently. However, it appears that
impounding generally involves measures such as reducing the
number of state employees or stretching out construction rather
than terminating programs.
Experience at the state level thus suggests that where over­
all outlays are subject to careful scrutiny, impounding— when
it occurs— takes a form that is consistent with spending priorities
established by the legislature. If the president and the Congress




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REFLECTIONS OF AN ECONOMIC POLICY MAKER

will work together to hold total outlays at a level reasonably
related to revenues, there should be no occasion for resort to
impounding on a broad scale.
Congress has made it clear that it does not wish to emulate
the states by strengthening the powers of the executive branch
to trim total outlays to acceptable levels. And Congress is bet­
ter equipped than are the state legislatures to play a strong role
in fiscal policy. But Congress can preserve and strengthen its
powers only by exercising them. Procedures that produce defi­
cits that the Congress itself does not desire invite corrective
actions by the Executive.
In the long run there would seem to be no political ad­
vantage to either the Executive or the Congress in battling over
budgetary prerogatives, particularly if the result is bad budgets.
Let peace be declared; let Congress play a greater role in re­
viewing the budget, and perhaps even become involved in the
preparation of the budget. Eight states have established means
for doing this, generally through a board most of whose mem­
bers are legislators. While the mechanisms established in these
states would have to be modified for application at the federal
level, perhaps some means could be found that would be
mutually satisfactory to Congress and the president.
Involving the Congress in budget preparation should help
to accomplish speedier action on budget proposals. Both the
President's Budget Message and your committee's interim report
recognize the need to reduce or eliminate the delays that have
required increasing use of continuing resolutions and have
frustrated efforts to make the budget a really useful manage­
ment tool. For programs that operate under statutory authority
that is renewed annually, enactment of the authorization bills
a year in advance, as recommended in your report, would elimi­
nate a major cause of delay in considering the related appro­
priations bills. Cooperation and consultation between the Execu­
tive and Congress in formulating the budget should also help to
expedite its enactment.
Your report recognizes the need to provide Congress with
better information about the effects of existing and proposed
legislation, not only in the current year, but up to three to
five years ahead. This would extend to the federal government
procedures already established in some states, and should prove
highly beneficial, particularly if it is buttressed by your pro280



NEED FOR NEW BUDGETARY PROCEDURES

posal for House and Senate committees on the budget, assisted
by nonpartisan, professional staffs. Indeed, the President has
already taken useful steps in this direction. Thus, in his most
recent budget message, he presents estimates, for individual
agencies and in functional detail, of the outlays for fiscal 1975
as well as for fiscal 1973 and 1974.
Finally, I feel that any discussion of better budget pro­
cedures would be incomplete without some mention of zerobase budgeting. Traditionally, officials in charge of an estab­
lished program have not been required to make a case for their
entire appropriation request each year. Instead, they have had to
justify only the increase they seek above last year's level. Sub­
stantial savings could undoubtedly be realized if both the ad­
ministration and the Congress treated each appropriation request
as if it were for a new program. Such a procedure will un­
doubtedly be difficult to achieve, not only because it will add
heavily to the burdens of budget making, but also because it
will be resisted by those who fear loss of benefits they now
enjoy. But this reform is so clearly necessary that I believe we
will eventually come to it, and I commend to your attention
Senator Brock's bill, S. 40, which provides for zero-base budget­
ing for all major expenditure programs at least once in every
three years.
The thoughts I have expressed today are my own, not
necessarily those of the Board of Governors of the Federal Re­
serve System. And, needless to say, I disclaim any special
expertise in regard to congressional procedures. But procedural
questions at times have great substantive significance, and this
is one of those occasions. I accepted your invitation because,
as a concerned citizen with some knowledge of economics, I
have believed for some time— and recent events have reinforced
the belief— that better congressional control of the budget is
absolutely essential to maintain the vitality of our economic and
political system.




281




Reform of the Federal Budget

I deeply appreciate the privilege of addressing this graduating
class, for— despite the difference in our ages— I feel that we have
much in common. Both you and I have spent some years in the
lively atmosphere of a university. Both you and I have been
concerned with problems of economics, finance, and administra­
tion. Both you and I, as residents of this fascinating city, have
had the opportunity of observing at close range the understand­
ing, selflessness, and compassion that government officials usu­
ally bring to their daily tasks; but we have also had the dis­
quieting experience of witnessing some abuses of governmental
power.
As graduates of this School of Government and Business
Administration, you are embarking on your careers at a moment
in history that is fortunate in numerous respects. Our nation is
again at peace, the economy is again prospering, the number of
good jobs is expanding rapidly, industrial strife is at a minimum,
and civil order is returning to our schools and cities. By every
reasonable criterion, so it would seem, you can— and should—
look forward with confidence to the future of our country and its
economy. And yet, if I read the nation's mood correctly, a spirit
of unease and even frustration is now widespread.
There are numerous causes of the concern and skepticism
with which many Americans, especially young men and women,
now view the contemporary scene. But I believe that most of
Commencement address at the School of Government and Business Admin­
istration, George Washington University, W ashington, D.C., May 6, 1973.




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REFLECTIONS OF AN ECONOMIC POLICY MAKER

these causes can be captured in two broad generalizations. First,
the American people have come to feel that their lives, their
fortunes, and their opportunities are increasingly beyond their
control, and that they are in large part being shaped for them by
their government. Second, more and more Americans have also
come to feel that their government lacks either the knowledge
or the competence to make good on the promises that it holds
out to the people.
It is this simultaneous dependence on government and
diminishing confidence in government that is at the heart of the
disquiet that so many Americans are experiencing. I wish I could
say that this mood will pass quickly, but I cannot do so. Building
confidence in social and political institutions is inevitably a long
process, and it can only be accomplished if thoughtful citizens
are willing to devote their minds and energy to the task.
When I was your age, the problem that particularly con­
cerned university students was the periodic recurrence of eco­
nomic depressions that wiped out business profits, caused
widespread bankruptcy, and brought mass unemployment to
wage-earners. This problem no longer afflicts our society on
anything like its earlier scale; and we have made even more
marvelous advances in conquering disease, prolonging human
life, and reducing the drudgery of physical labor. We have made
progress in these fields by diligent application of thought and
reason— this is, by identifying each problem, diagnosing its
causes, and seeking constructive solutions. It took the best
effort of many thoughtful and earnest men to solve the problems
that stirred social and political unrest in the past. And it will
likewise require much thoughtful and earnest effort to regain
the confidence in government which is so essential to our own
and our country's future.
In my own profession of economics I have seen large ad­
vances in knowledge and also substantial improvements in the
application of this knowledge to public policy. I can assure you
that those who participated in these developments have found
the experience richly rewarding. And it is precisely because you
graduates may be able to contribute to the improvement of our
political processes that I want to discuss with you today one of
the issues that has brought us much trouble and agony in recent
years— namely, the need to achieve rational control over the
federal budget.
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REFORM OF THE FEDERAL BUDGET

Those who administer the affairs of government share a
common problem with business executives: no private enterprise
and no government can do everything at once. Both must choose
among many desirable objectives, and the degree to which their
efforts prove successful depends largely on their skill in con­
centrating available resources on those objectives that matter
most. That is the very purpose of budgets. The fact that the
federal budget has in recent years gotten out of control should
therefore be a matter of concern to all of us. Indeed, I believe
that budgetary reform has become essential to the resurgence of
our democracy.
Fortunately, political leaders of every persuasion are by now
convinced that Congress must change its procedures if it is to
exercise effective control over the government's domestic and
international policies. The old debate between free-spending
"liberals" and tight-fisted "conservatives" is dying away. For'
the most part, liberals as well as conservatives realize that the
level of federal spending, and whether it is financed by taxes or
by borrowing, have a powerful effect on jobs, prices, and
interest rates.
In the Employment Act of 1946 Congress declared it to be
the responsibility of the federal government to "promote maxi­
mum employment, production, and purchasing power." The
authors of this legislation were well aware that a stimulative
fiscal policy can be useful in taking up slack in the economy,
and that a restrictive fiscal policy can help to cool an economy
that is overheating. Yet, despite the prosperity that our nation
has generally experienced since the enactment of that statute,
budget deficits have greatly outnumbered surpluses. Experience
has thus demonstrated that failure to attend properly to govern­
mental priorities leads to excessive fiscal stimulus, and that this
in turn is more apt to produce inflation than jobs.
Recognizing this fact, the Congress is now seeking a way
to determine an overall limit on federal outlays that will be
rationally related both to expected revenues and to economic
conditions. This is essential not only to achieve overall stabili­
zation objectives, but also to enable Congress to play its ex­
pected role in determining national priorities. Early in this
session of Congress, Senator Mansfield disclosed that all of the
newly elected Senators had written to him and to Senator Scott
urging reform of the budgetary process because "Congress has




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the obligation to set priorities . . . and present procedures do
not in fact achieve that aim." Their unanimous conclusion was
that the "first step toward establishing priorities has to be
setting a ceiling on appropriations and expenditures;" and that
unless this is done at an early stage of each session, the Congress
is "not really budgeting at all."
The budget that the president recommends to Congress at
the beginning of each session is the product of a systematic
process aiming to establish an overall limit on outlays and to
determine priorities within that limit. This process, however,
has no counterpart in the Congress. Instead, congressional
decisions that determine the ultimate shape of the budget are
taken by acting separately— or at times by taking no action—
on a hundred or more entirely independent measures. It is only
after separate votes have been taken on housing, education,
defense, welfare, and whatnot that we can put the pieces together
and discover what kind of a budget has emerged.
Thus, members of Congress now vote for or against
cleaner air, for or against better schools, and for or against a
host of other good things that government can help to provide.
But they have no opportunity to vote on what total outlays
should be, or whether an appropriation for a particular purpose
is needed badly enough to raise taxes or to make offsetting
reductions in other appropriations. Yet choices of this type are
far more important to the electorate as a whole than the single
proposals on which congressional voting takes place.
This fragmented consideration of the elements that make up
the budget is largely responsible for an almost uninterrupted
succession of deficits. Since 1960, we have had a deficit in every
year except 1969. Some of these deficits have occurred because
of efforts to use the federal budget as a means of stimulating a
lagging economy, but for the most part we have allowed deficits
to happen without plan or purpose.
Both the legislative and executive branches of the govern­
ment have from time to time recognized the need for reform.
In 1946, for example, Congress included provisions for better
budget control in the Legislative Reorganization Act, but the
experiment was abandoned after a brief trial. Expenditure ceil­
ings enacted for fiscal years 1969 and 1970 again proved inef­
fective since they could be readily adjusted to accommodate
increases in spending. These rubbery ceilings did, however, help
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REFORM OF THE FEDERAL BUDGET

to prepare the ground for more meaningful reform. When the
President called for a rigid limit of $250 billion on outlays for
fiscal 1973, both the House and the Senate accepted the expendi­
ture ceiling. But they were unable to agree on a method for
reducing the previously enacted spending authority so that the
$250 billion limit could in fact be realized.
Actions subsequently taken by the President to hold outlays
for fiscal 1973 to $250 billion have been criticized on the ground
that impounding of funds enables the administration to substi­
tute its priorities for those established by the Congress. Concern
over possible usurpation of congressional prerogatives is entirely
understandable. However, this controversy should not divert
our attention from the broad political consensus that has already
emerged on the need to limit outlays. If the Congress does the
job itself, there will be no occasion in the future for the admin­
istration to cut billions out of authorized outlays in order to
achieve the overall level of spending that Congress agrees is
appropriate.
Although last year's efforts to impose a legislative budget
ceiling proved disappointing, they did prompt the Congress to
ponder closely the need for budgetary reform and to create a
Joint Study Committee on Budget Control.
This committee has made excellent use of the brief time it
has been in existence. In a recently released report, it recom­
mends specific and practical procedures by which Congress could
control the level of federal outlays, the priorities among pro­
grams, and the size of any deficit or surplus. Bills to carry out
these recommendations have now been introduced in both the
House and Senate, with support from all members of the joint
committee, as well as others in the Congress.
It would seem, therefore, that prospects for meaningful
budget reform are now very good, perhaps better than at any
time since the Budget and Accounting Act of 1921. I find the
joint study committee's recommendations most encouraging, but
I also think that they need to be supplemented with systematic
and frequent review of the effectiveness of federal programs.
Traditionally, officials in charge of an established program
have not been required to make a case for their entire appro­
priation request each year. Instead, they have had to justify
only the increase they seek above last year's level. Substantial
savings could undoubtedly be realized by zero-base budgeting,




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that is, by treating each appropriation request as if it were for
a new program. Such budgeting will be difficult to achieve, not
only because of opposition from those who fear that it would
mean loss of benefits they now enjoy, but also because it would
add heavily to the burdens of budget making. It may be, there­
fore, that Congress will rely initially on procedures that ensure
reappraisal of each program only every two or three years. But
whatever form it takes, a method must be found for screening
out programs whose costs clearly exceed their benefits, while
assuring a satisfactory level of performance for programs that
contribute significantly to the general welfare.
The day is past— if indeed, it ever really existed— when
only the well-to-do need concern themselves with economy in
government. Perhaps there was a time when those who bene­
fited from the status quo could block social reform by inveighing
against governmental spending. But today Big Government is
no longer a slogan for appealing to some and frightening others.
For better or worse, it has become part of our lives. And those
who would use government as an instrument of reform have
perhaps a larger stake in eliminating wasteful programs than
those who resist change.
We have passed the point where new programs can be added
to old ones and paid for by heavier borrowing. With the econ­
omy expanding vigorously, with inflation persisting stubbornly,
with our balance of payments in serious trouble, with two
devaluations of the dollar just behind us, we clearly cannot afford
to continue large budget deficits. It is sobering to reflect that in
spite of the President's determined efforts to hold down federal
spending, the budget he originally presented for this fiscal year
called for outlays that exceeded estimated receipts by about
$25 billion.
In principle, taxes can always be raised to pay for more
public services, but the resistance to heavier taxation has become
enormous. If we count outlays by all governments, state and
local as well as federal, we find an increasingly large fraction of
the wealth our citizens produce being devoted to the support of.
government. In 1929, total government spending came to about
10 percent of the dollar value of our national output. Since then
the figure has risen to 20 percent in 1940, 30 percent in 1965,
and 35 percent in 1972. I believe that most citizens feel that
one-third of our national output is quite enough for the tax
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REFORM OF THE FEDERAL BUDGET

collector, particularly since the expansion in government outlays
has not produced the kind of benefits they have a right to expect.
The key to rebuilding confidence in government is improved
performance by government, and budgetary reform can move us
powerfully toward this goal. Rational control of the budget by
the Congress should improve our economic stabilization policies.
It should facilitate judicious choice among governmental activi­
ties. It should improve evaluation of governmental performance.
It should help us avoid abuses of power— whether they arise in
the world of business, or labor, or government itself. And it
should restore to the Congress some of the prestige that it has
lost as a result of many years of neglect.
I trust that the members of this graduating class will join
other citizens throughout the country to see to it that budgetary
reform is carried out with the promptness and on the scale that
this nation's interests require. Let us always remember that
budgets are a means for promoting national objectives. For
those of you who enter public service, better budgeting can offer
more meaningful and rewarding careers. For all Americans, it
can mean a rejuvenation of spirit as government becomes more
responsive to our aspirations and more effective in fulfilling them.




289




The Congressional Budget Act

of 1974

It is a pleasure to meet with this committee as it undertakes its
momentous responsibilities under the Congressional Budget Act
of 1974. In recent years, federal spending has risen swiftly,
deficits have become chronic, and the public debt has mounted.
Our present grave problem of inflation stems from many causes,
and inadequate fiscal discipline is prominent among them. You
and your congeners in the House of Representatives therefore
face a great challenge, but you also have a unique opportunity
to reestablish order in our nation's finances.
The budget that the president recommends to Congress at
the beginning of each session is the product of a systematic
process aiming to establish an overall limit on outlays in relation
to expected revenues, and to determine priorities within the
totality of outlays. This process, as you know, has hitherto had
no counterpart in the Congress. Instead, congressional decisions
that determine the ultimate shape of the budget have been taken
by acting separately— or at times by taking no action— on a
hundred or more entirely independent measures. It is only after
separate votes are cast on housing, education, defense, welfare,
and whatnot that we put the pieces together and discover what
kind of budget has emerged.
Thus, year after year, members of Congress have been
voting for or against larger benefits to veterans, for or against
better schools, for or against cleaner air, and for or against a
host of other good things that government can help to provide.
Statement before the Senate Budget Committee, August 21, 1974.




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REFLECTIONS OF AN ECONOMIC POLICY MAKER

But the Congress has not had the opportunity to vote on what
total outlays should be, or whether an appropriation for a par­
ticular purpose is needed badly enough to raise taxes or to make
offsetting reductions in other appropriations.
This fragmented congressional consideration of the elements
that make up the budget has contributed materially to the
almost uninterrupted succession of budget deficits. Since 1960,
we have had a deficit in every fiscal year except 1969. True,
some of these deficits occurred because of efforts to use the
federal budget as a means of stimulating a lagging economy,
but for the most part we have allowed deficits to happen with­
out plan or purpose. Machinery for putting effective ceilings on
expenditures, and for establishing priorities among alternative
uses of federal revenues, has simply not been available.
By passing the Budget Act of 1974, the Congress has estab­
lished a framework for exercising this much needed control,
and has also indicated its firm resolve to do so. The Budget Act
is a milestone in the reassertion of congressional authority and
self-discipline. There is now real hope that we can avoid the
massive increases of federal expenditure and the persistent
deficits that have plagued us in the past.
The immense importance of your committee's new respon­
sibilities may perhaps be more fully appreciated by reflecting
on what has happened to the federal budget over the long sweep
of our nation's history. Total expenditures did not reach the
$100 billion level until fiscal 1962, or nearly 200 years after the
founding of the republic. By fiscal 1971, nine years later, federal
spending had risen another $100 billion and thus passed the
$200 billion mark. In the budget as now projected, the $300
billion mark will be passed this fiscal year. Clearly, the pace of
federal spending has been accelerating rapidly, and a pause for
taking stock of where we are is overdue.
One result of the sharply rising curve of expenditures is
that government has been assuming an ever larger role in the
economic life of our people. In 1929, federal expenditures
accounted for less than 3 percent of the dollar value of our total
national output, and expenditures at all levels of government—
federal, state, and local— amounted to about 10 percent of the
national product. By 1950, the share of national output absorbed
by government had risen to 23 percent. Since that time, govern­
mental involvement in the economy has increased further; last
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CONGRESSIONAL BUDGET ACT OF 1974

year, federal expenditures alone accounted for 22 percent of our
national output, and the combined expenditures of all govern­
mental units for 35 percent.
A significant increase over the past four decades in the role
of government in economic life was inevitable. A growing popu­
lation, and the increasing complexity of modern urban life,
gave rise to new and expanded governmental activities. This
was also a period in which the United States came to occupy a
position of leadership in international political affairs and in
world economic development.
Some part of the rapid upward trend of federal spending,
however, is attributable to widespread acceptance of the theory
that social and economic problems can generally be solved by
quick and large expenditure of governmental money. We have
tried to meet the need for better schooling of the young, for
upgrading the skills of the labor force, for expanding the
production of low-income housing, for improving the nation's
health, for ending urban blight, for purifying our water and air,
and for other national objectives, by constantly excogitating
new programs and getting the Treasury to finance them on a
liberal scale before they have been tested.
The result has been a piling up of one social program on
another, so that they now literally number in the hundreds and
practically defy understanding. Not a little of our taxpayers'
money is being spent on activities of slight value, or on laudable
activities that are conducted ineffectively.
Another result of the rapid growth of federal spending has
been a larger tax burden borne by our citizens and a blunting
of economic incentives. Business capital investment in recent
years has certainly been inadequate for a nation that is eager for
rapid improvement in the general welfare. There is thus reason
to believe that governmental spending and taxing may have
gone beyond prudent limits.
Where the line should be drawn between governmental and
private use of resources is, in the final analysis, a matter of
judgment and of social values. However this question is resolved,
it should be clear to everyone that federal spending, whatever
its level, needs to be financed on a sound basis. Deficit financing
by the federal government can be justified at a time of sub­
stantial unemployment, but it becomes a source of instability
when it occurs during a period of high economic activity, such




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REFLECTIONS OF AN ECONOMIC POLICY MAKER

as we have experienced in recent years. The huge federal deficits
of the past decade added enormously to aggregate demand for
goods and services, but they added little to our capacity to
produce. They have thus been directly responsible for a sub­
stantial part of our present inflationary problem.
The current inflation began in the middle 1960s when our
government embarked on a highly expansive fiscal policy. Large
tax reductions occurred in 1964 and the first half of 1965, and
they were immediately followed by an explosion of federal
spending. New and substantial tax reductions followed in 1969
and 1971, and so too have massive increases of expenditures.
In the last five fiscal years, that is, from 1970 through 1974, the
public debt— including obligations of the federal credit agencies
— has risen by more than $100 billion, a larger increase than in
the previous twenty-four years.
In the fiscal year just concluded, the condition of the federal
budget failed to improve sufficiently. True, the reported budget
deficit declined to about $3V2 billion— a much smaller deficit
than in the three preceding years. But in a year of such power­
ful inflationary forces, the federal budget should have been in
surplus. Moreover, when off-budget outlays and the expendi­
tures of governmentally sponsored agencies are taken into ac­
count, as I believe they should be, the total federal deficit
reached $21 billion last year, which is not much lower than the
extraordinary deficits of the three previous fiscal years.
The financing of these huge federal deficits has contributed
powerfully to the upward pressure on interest rates and the
tension in financial markets, which have been so troublesome of
late. The disturbing effect of federal borrowing on the flow of
funds was illustrated dramatically earlier this month, when the
Treasury went to the market to refinance some maturing debt
obligations. Long lines of people formed at the doors of the
Treasury and the Federal Reserve Banks to bid for the new
securities offered by the Treasury. Half of the total of $4.4
billion sought by the government was obtained through non­
competitive bids— that is, from relatively small investors. A
large share of these funds undoubtedly came out of deposit
accounts, and thus further reduced the ability of our financial
institutions— particularly savings banks and savings and loan
associations— to support homebuilding activities.
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CONGRESSIONAL BUDGET ACT OF 1974

Despite such concrete evidence, it is sometimes contended
that the federal deficits of recent years have been only a minor
source of economic or financial instability, since the amounts
are small relative to total borrowing by the private sector. This
is a faulty argument. To be sure, the rate of private credit
expansion has substantially exceeded the rate of federal borrow­
ing. But we must never confuse the power or responsibility of
private citizens with the power or responsibility of government.
Business firms and consumers have no way of acting in concert
to prevent an inflationary expansion of credit, and their private
responsibilities may conflict with national objectives. The basic
responsibility for economic stabilization lies with the federal
government. Unless our government exercises that function
better than it has in the past, there will be little hope for restora­
tion of stability in the general price level.
The central purpose of the Congress, besides providing for
the nation's security, is to help find the way to a better life for
the American people— among other things, reasonably full em­
ployment, a widely shared prosperity, and a stable purchasing
power of their currency. None of these objectives will be
achieved over any length of time without far stricter fiscal dis­
cipline than we have exercised in recent years. That is why
your committee, together with the Budget Committee of the
House, has such a great and unique opportunity to serve the
nation's welfare.
I recognize that you have a good deal of preparatory work
to do before you can begin exercising fully your responsibilities
under the Congressional Budget Act of 1974. The importance
of this preparatory effort should not be underestimated. A
highly competent and thoroughly objective staff will need to be
assembled to carry out the functions of the Congressional Budget
Office. Good working relations will need to be established
between your committee and the House Budget Committee and
between both committees and the Office of Management and
Budget. Procedures will have to be worked out for implement­
ing the intricate steps in the budgetary process set forth in the
Budget Act. Some flexibility is needed in congressional manage­
ment of our enormously complex federal budget, and the Budget
Act properly provides opportunity for waiver of procedures and
deadline requirements. But unless the Congress undertakes its
new responsibility with a firm determination to reserve the




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waiver privilege for unusual circumstances, the Budget Act may
turn out to be a well-meaning but illusory gesture.
Full implementation of the new budgetary procedures, I
understand, will begin in fiscal 1977— or two years from now.
W e dare not wait two years, however, for the additional fiscal
restraint that is so urgently needed in the present inflationary
environment. Strenuous efforts should be made immediately to
pare budget expenditures in fiscal 1975 and to balance the budget
in fiscal 1976.
I recognize that this committee is not yet in a good position
to recommend to the Congress where expenditure cuts would be
most appropriate. Nevertheless, in view of the special respon­
sibility that has been assigned to you by the leadership of the
Senate, you can justly use your good offices to press for restraint
on federal spending. This is the most important single step
that can now be taken by the Executive and the Congress to
curb inflationary pressures and to restore the confidence of our
people in their own and the nation's economic future.

296



The Financial Crisis
of New York City

I am here to discuss with this committee the financial crisis of
New York City.
The difficulties now facing New York stem from the erosion
of its financial position over the past decade. During this period
the expenditures by the city's government grew rapidly while
revenues failed to keep pace. To close the gap between its
revenues and expenditures, the city relied increasingly on bor­
rowed funds. Not only capital expenditures, but also the mount­
ing deficits on current operations, were financed in this fashion.
By the end of 1974, New York City's outstanding debt amounted
to over $13 billion, much of which was in the form of short-term
notes— that is, obligations maturing in a year or less.
As poor management of New York finances persisted, at
first a few but in time more and more investors became con­
cerned about the city's financial condition. During the past
winter and spring the city began to experience very serious
difficulties in rolling over its debt— to say nothing of adding to
its outstanding indebtedness. In the absence of clear-cut remedial
measures by the city, the possibility of default on the city's
obligations became very real, and it was so portrayed almost
daily in our newspapers.
The financial crisis confronting the nation's largest city
prompted the government of New York State to offer financial
and managerial assistance. Starting in April, the state put at
Statement before the Subcommittee on Economic Stabilization, Committee
on Banking, Currency, and Housing, House of Representatives, O cto­
ber 23, 1975.




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the city's disposal substantial sums that were not scheduled for
payment until some months later. Then, around mid-June, the
state legislature created a new instrumentality— the Municipal
Assistance Corporation (MAC). This agency was empowered
to sell up to $3 billion of its debt obligations, to make the
proceeds of its borrowing available to the city, to wring some
clarity out of the city's tangled finances, and to help develop a
budgetary plan that could lead the city back to a balanced
budget.
These measures, however, proved insufficient to restore
investor confidence in the city's financial management, and even
the new securities issued by MAC soon came under a cloud.
To ward off imminent default by the City of New York, the
state adopted firmer measures on September 9. These included
creation of a state-dominated Emergency Financial Control
Board to manage the city's finances, expansion of MAC's
authority to issue securities, and a plan to arrange additional
financing of $2.3 billion for the city. This financial package
was designed to tide the city over until early December. It was
hoped that by that time a strong program of budgetary restraints
would be in place and that it would enable the city to resume
the sale of its securities to the investing public.
But the new financial plan failed to elicit any enthusiasm
on the part of investors. The financial community has remained
skeptical about the city's ability to avert default and rebuild its
financial strength. Moreover, the intertwining of the state's
finances with the city's finances has troubled investors and has
damaged the state's credit standing. The concern of market
participants was heightened this past week by the extraordinary
difficulties encountered in arranging for the city's refunding
needs on October 17, and default was averted by only an hour
or two. Thus, the stresses and strains that began to develop in
the municipal securities market in the summer have become
more acute with the passage of time.
Since the summer, and to an increasing degree in recent
weeks, the participants in the municipal market— that is, invest­
ment bankers, securities dealers, and ultimate investors— have
been attempting to reduce their exposure to the risk of loss.
This has affected not only securities bearing a New York name,
but also issues of some other state and local governments. Thus,
many securities dealers have sought to cut back on their inven298



FINANCIAL CRISIS OF NEW YORK CITY

tory of municipal securities. Underwriters of municipal issues
have generally reduced their participation in new offerings, and
some have withdrawn entirely from bidding syndicates. And
investors— the ultimate buyers of municipals— have been tend­
ing to shift to higher-quality municipal securities or to cate­
gories of investment judged to be less hazardous.
Trading in the market for outstanding tax-exempt bonds
has therefore slowed appreciably and the spread between bid
and asked quotations has widened. These developments are
characteristic of a period when investor confidence has been
shaken, and they are indicative of a weakened market.
The behavior of investors and dealers in recent months has
resulted in a rise of yields on municipal securities to the highest
level ever experienced in the tax-exempt market. Yields for
even the highest-rated borrowers have risen conspicuously, but
a part of this increase is doubtless due to the enormous volume
of municipal securities issued during the third quarter.
In the past two to three weeks, open-market interest rates
have declined somewhat. The municipal market has benefited
from this development, as well as from various indications that
the federal government is becoming more concerned about New
York's financial problems. Nevertheless, investors in municipal
securities remain highly selective. The obligations of New York
City, New York State, and certain of the state's agencies con­
tinue to be shunned by investors. And the effects of investor
uncertainty have spilled over to other governmental units as
well, some of which have not received any bids for their bonds
or have rejected bids because the interest cost was deemed
excessive.
If the weakness of the market for municipal securities were
to persist and to spread further, many soundly run, creditworthy
communities and public agencies could have difficulty— or suffer
very heavy costs— in raising needed funds. This would tend to
induce cutbacks or stretchouts in local spending programs. In
addition, holders of municipal securities, which include many
banks and other financial institutions, would to some degree be
affected, as might the attitudes of others less directly involved.
Hence, if the New York City crisis remains unresolved, and if
the fate of New York State remains tied to the city's, the process
of economic recovery now under way in our nation could be
impaired.




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In seeking ways to resolve New York City's crisis, the
suggestion has occasionally been advanced that the Federal
Reserve might serve as a source of emergency credit. No formal
application for such credit has been received by the Board or
the Federal Reserve Bank of New York. But I want to explain
why we probably would have disapproved such an application
had it been made.
As the ultimate source of financial liquidity in the economy,
the Federal Reserve has certain powers to extend emergency
credit even to institutions that are not members of the System.
But the use of that authority is tightly circumscribed. The basic
provision— contained in Section 13, paragraph 13, of the Federal
Reserve Act— states that emergency loans with maturities no
longer than ninety days may be made by the Federal Reserve
Banks on the basis of promissory notes backed by Treasury or
federal agency securities. To qualify for credit assistance under
this provision of law, a local government would have to possess
sizable amounts of unencumbered federal obligations. This
would be an unusual situation for any distressed borrower and
it obviously does not apply to New York City.
The lending authority under paragraph 3 of Section 13 of
the Federal Reserve Act is broader, permitting the Board, in
unusual and exigent circumstances, to authorize Reserve Banks
to make loans on the kinds of collateral eligible for discount by
member banks. Such paper may not have a maturity of more
than ninety days and must afford adequate security to the
Reserve Bank against the risk of loss. Furthermore, in view of
restrictions of law and congressional intent, certain conditions
must be met in order to permit the extension of emergency
credit under this authority. Among these conditions is a require­
ment that an applicant has exhausted other sources of funds
before coming to the Federal Reserve, that the borrower is basic­
ally creditworthy and possesses adequate collateral, and that the
borrower's need is solely for short-term accommodation. It does
not appear that New York City is now in a position to meet all
these requirements. Certainly, its finances would hardly permit
early repayment of emergency borrowings.
In addition to the emergency lending provisions in Section
13 of the Federal Reserve Act, the Reserve Banks have authority
under Section 14(b) to purchase short-term obligations of state
and local governments issued in anticipation of assured revenues,
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FINANCIAL CRISIS OF NEW YORK CITY

subject to regulations by the Board. Legislative history indicates
that this authority was designed to assist the Federal Reserve
Banks in meeting their operating expenditures, and also to
enable them to make the discount rate effective when little bor­
rowing took place at the discount window. There is nothing in
the Federal Reserve Act or its legislative history to suggest that
Section 14(b) contemplated the purchase of municipal securities
as a means of aiding financially distressed communities.
The Congress, of course, could amend the Federal Reserve
Act so as to relax the requirements for extending Federal Reserve
credit to financially troubled governmental units. But the Board
of Governors would have the gravest doubts about any such
action. If loans were to be made to state or local governments,
the Federal Reserve would have to involve itself in the activities
of these governmental units, including particularly their expen­
diture budgets and the adequacy of their revenues. Moreover,
since numerous demands for credit might ensue, the Federal
Reserve would have to set standards of eligibility. Being thus
placed in the position of having to allocate credit among govern­
mental units, the nation's central bank would inevitably become
subject to intense political pressures, and its ability to function
constructively in the monetary area would be undermined.
The Board fully recognizes that the Federal Reserve System
has the responsibility, subject only to restrictions under existing
law, to serve as the nation's lender of last resort. Over the
years, we have therefore developed contingency plans to deal
with possible emergency situations. As I have already indicated
in testimony before the Joint Economic Committee, our plans
have been adapted recently to cope with the financial strains
that might be associated with the default of a major municipality.
In that event, I assure you, the Board is prepared to act
promptly. The contingency plan calls for lending to commercial
banks through the Federal Reserve discount window beyond the
amounts required by normal discounting operations. Credit pro­
vided in this manner would assist banks in meeting their tem­
porary liquidity needs. Not only that, the proceeds of the special
loans made at the discount window could also be used by the
banks to assist municipalities, municipal securities dealers, and
other customers who are temporarily short of cash because of
unsettled conditions in the securities markets. In addition, the
System would, of course, be ready to use its broad power to




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REFLECTIONS OF AN ECONOMIC POLICY MAKER

stabilize markets through open market purchases of Treasury
or federal agency securities.
In the event this contingency plan has to be activated, the
Board will make funds available on whatever scale is deemed
necessary to assure an orderly financial environment. The Board
recognizes that sizable extensions of Federal Reserve credit would
run the risk of leading to a substantially larger expansion of
bank reserves and the money supply than is consistent with
longer-run monetary objectives. Clearly, therefore, any such
expansion must be only temporary. In time, any excessive growth
in bank reserves would need to be corrected through offsetting
open market operations and through repayment of bank borrow­
ing from the System.
There are also certain supervisory and examination ques­
tions that may arise with respect to banks in the event of a
major municipal default. In this connection, the Board and other
agencies have plans to revise procedures that apply to the valua­
tion of defaulted securities, so that any writedowns may be
postponed until the market has had a few months to stabilize
and thus provide more reliable indications of their value.
Even so, a default might ultimately require writedowns that
could seriously reduce the capital of some banks. In that event,
the Federal Deposit Insurance Corporation has statutory powers
to assist federally insured banks that might find their capital
impaired by a decline in the value of securities in their portfolios.
I understand that the corporation is prepared to implement, with
appropriate safeguards, its contingency plans for dealing with
insured banks that require a temporary infusion of supplemental
capital for the above reason.
I think it evident from the scope of our contingency plans
that we believe a default on debt obligations by New York City
could produce serious strains in securities markets. For a time,
it could also adversely affect municipalities that need to issue
new debt. The like is true of financial institutions that hold
such securities in significant volume, and also of individual
investors who have part of their life savings at risk in these
bonds. I still believe that the damage stemming from a default
by New York City would probably be short-lived. Indeed, the
possibility of such a default has already been discounted to a
considerable degree by the market. But I am also aware of the
uncertainty that inherently attaches to a judgment on this score;
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FINANCIAL CRISIS OF NEW YORK CITY

and I recognize that a default, besides being a very serious
matter for the city and state of New York, could have trouble­
some consequences for the nation at large.
The very fact that this committee and other committees of
the Congress are holding hearings on New York City's finances
indicates that concern is spreading that a New York default may
injure the economic recovery now in process. I have said
enough to indicate that I feel this possibility can no longer be
dismissed lightly. That, however, does not ease the task that
the Congress faces in dealing with the New York problem; for
the precise issue is whether federal financial assistance to New
York may not cause national problems over the long run that
outweigh any temporary national advantage.
As this matter is debated by the Congress, the adverse
effects of a New York City default will undoubtedly receive full
attention— as they indeed should. I would only urge that the
longer-run risks also be considered thoroughly. A program of
federal assistance to the city may well lead to demands for
similar assistance to other hard-pressed communities, even
though their distress may have been brought on by gross neg­
ligence or mismanagement. Substantial federal aid— whether
through insurance, guarantees, or direct loans— would compete
directly with the already huge amounts of federal financing
needs. Most important of all, the provision of federal credit for
local governments would necessarily inject a major federal
presence in local spending and taxing decisions.
These longer-run dangers have a vital bearing on our
nation's future; but they can be exaggerated, just as the imme­
diate consequences of a New York default can be— and perhaps
are now being— exaggerated. It is entirely clear to me that if
the federal government had previously yielded to the entreaties
for aid that New York officials kept pressing, neither the city
nor the state would have gone as far as they now have in restor­
ing some hope for eventual order in the city's finances. Earlier
intervention would have been a disservice to the people of
New York as well as to the nation at large. But it also seems
to me that the effort thus far made by both the state and the
city is still inadequate. And while I take a more serious view of
the potential economic consequences of a New York default than
I did three months ago or even three weeks ago, I am not ready




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to recommend to the Congress that financial assistance to New
York is now required in the nation's interest.
I was asked at a recent hearing what advice I would give if
Congress were inclined to legislate assistance for New York.
My reply was that stringent conditions should in that event be
laid down, so that no municipality would seek federal financial
aid unless such a request became unavoidable. I proceeded to
list a half-dozen conditions; and, if I may, I shall now restate
them somewhat more fully.
One essential condition prior to receipt of any federal assis­
tance would be that the municipality has exhausted all other
sources of funds. This would require, of course, that the munici­
pality demonstrate that it is unable to obtain credit through the
public issuance of securities, or through private placement of
securities, or direct loans from banks or other private lenders.
A second condition that seems to me essential is that the
state assume control over the finances of the municipality in
difficulty. When a local government reaches the point where
no source of funds is any longer available, its management of
finances can no longer be relied upon. State control would
mean that a local government has lost its fiscal authority, and
this should serve as a powerful deterrent to other mayors or
city councils across the nation from ever placing their munici­
pality in such a position.
A third essential condition for federal assistance, I believe,
should be that the state levy a special state-wide tax, the pro­
ceeds of which are pledged to cover one-half of the deficit faced
by the municipality. The requirement of such a tax would
materially strengthen the state's resolve to put whatever pressure
is needed on the troubled municipality to work its way toward
a balanced budget. It would thus ensure that the state will
discharge adequately its own responsibility to enforce fiscal dis­
cipline on a troubled municipality. No governor or state legisla­
ture will welcome the prospect of levying a special state-wide
tax for the benefit of a municipality that has mismanaged its
affairs. But this very reluctance would provide some assurance
that federal assistance would not be expected until an effective
city-state program of remedial action, no matter how politically
troublesome this may prove, has been developed.
Fourth, prior to receipt of federal assistance, a detailed
financial plan would need to be presented for approval by the
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FINANCIAL CRISIS OF NEW YORK CITY

federal authority charged with administering the assistance pro­
gram. Criteria for accepting a plan would have to be spelled
out— such as the use of standard accounting procedures, unre­
stricted access by the federal authority to all local financial
records, provision for retiring short-term debt other than that
required to handle seasonal discrepancies between expenditures
and receipts, and so on. Clearly, the plan should provide for
restoration of sound municipal finances within a relatively short
period and certainly within two fiscal years.
Fifth, a municipality that obtains a federal guarantee for
the payment of principal and interest on its issuance of new
securities should be required to pay an appropriate guarantee
fee. The municipal security should be taxable, but tax-exempt
bonds might be permitted in special cases— for example, if return
to nonguaranteed status were thus eased. In such cases, the
guarantee fee would naturally have to be much higher than if
the security were taxable.
Sixth, and finally, the federal guarantee program should be
of limited scope and duration. The total amount of guaranteed
debt should be set at the lowest practical figure. The debt
instruments should be of short maturity so that the guarantee
may be reconsidered periodically. In order to minimize federal
exposure to risk and to assure compliance with the approved
financial plan, the federal government should have authority to
withhold revenue-sharing funds from a delinquent municipality.
At the end of a relatively short period, say three years, all fed­
erally guaranteed debt under the program should have expired.
If conditions along the several lines I have here suggested
were included in a legislative plan for assisting troubled munici­
palities, [he number of applicants that might seek federal aid
would bd severely limited. It is highly important to recognize
that the issue of assistance to New York City goes to the very
heart of bur system of separation of powers between the federal
and stat^ governments— a system that, despite enormous eco­
nomic arid social changes, is still honored by our country. If
there is to be any legislation on assisting local governments, it
should at least be designed so that the longer-run risks to our
federal system of government are kept to a minimum.
Before bringing this testimony to a close, I want to make
two additional comments briefly.




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First, recent attention to New York City's difficulties has
brought to th£ fore certain shortcomings of our bankruptcy
laws. It is highly important that the Congress enact legislation
that would enable the judiciary to deal with a municipal default
so that reorganization of outstanding debts, service or employee
contracts, and other financial obligations may proceed in an
orderly and expeditious manner.
Second, the behavior of financial markets has recently been
disturbed by the grave uncertainties surrounding New York City
finances. A quick but well considered decision by the Congress
to assist or not to assist New York is now urgently needed.
Almost any resolution of these uncertainties may be better than
prolonged debate and controversy. Financial markets do not
thrive in such an environment.

306



Moderation in Fiscal Policy

I am pleased to appear before the Committee to Investigate a
Balanced Federal Budget of the Democratic Research Organi­
zation.
Our country is now confronted with a serious dilemma.
Over 7 million people are still unemployed, and many of them
have been seeking work for an extended period. More jobs are
clearly needed— not only for workers who are now unemployed,
but also for those who will soon be entering the labor force.
In the current inflationary environment, however, expan­
sionist policies of the traditional type cannot be counted on to
restore full employment. Recent experience in both our own
and other industrial countries suggests that once inflation has
become ingrained in the thinking of a nation's businessmen and
consumers, highly expansionist monetary and fiscal policies do
not have their intended effect. In particular, instead of fostering
larger consumer spending, they may intensify inflationary expec­
tations and lead to larger precautionary savings and sluggish
consumer buying. The only sound course for fiscal and mone­
tary policy today is one of prudence and moderation.
One of the urgent tasks facing our nation is to end the
federal deficits that have been a major and persistent source of
our inflation. Since 1960, the federal budget has been in deficit
every year but one. The cumulative deficit in the unified budget
over the past ten years, including the official estimate for the
Statement before the Committee to Investigate a Balanced Federal Budget
of the Democratic Research Organization, House of Representatives,
March 23, 1976.




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current fiscal year, comes to $217 billion. If the spending of
off-budget agencies and government-sponsored enterprises is
taken into account, the aggregate deficit for the ten years
amounts to almost $300 billion.
This sorry record of deficit financing means, of course, that
we as a people have been unwilling to tax ourselves sufficiently
to finance the recent sharp increases of governmental spending.
In this bicentennial anniversary of our nation's independence,
we would do well to reflect on the fact that it took all of 186
years for the annual total of federal expenditures to reach the
$100 billion mark. This occurred in fiscal year 1962. Only nine
years later, in fiscal 1971, expenditures already exceeded $200
billion. Four years from that date, in fiscal 1975, the $300 billion
mark was passed. And unless expenditures are held under a
very tight rein, federal spending will easily exceed the $400 bil­
lion level in fiscal 1977.
One aspect of the sharply rising curve of expenditures is
that government has been assuming an ever larger role in the
economic life of our people. In 1929, federal expenditures
amounted to less than 3 percent of the dollar value of our total
national output, and expenditures at all levels of government—
federal, state, and local— amounted to about 10 percent of the
national product. Last year, federal expenditures alone were
about 25 percent of the dollar value of our national output, and
the combined expenditures of all governmental units reached
almost 40 percent.
Much of this increase in the role of government in our
economy was made necessary by the rapid growth of population
in recent decades, the increasing complexity of modern urban
life, the explosion of military technology, and the enlarged re­
sponsibilities of the United States in world affairs. However,
the trend of federal spending has also been significantly influ­
enced by strong intellectual currents, both in our country and
elsewhere, that keep nourishing the belief that practically all
economic and social problems can be solved through the expen­
diture of public funds.
Where the line can best be drawn between governmental
and private use of resources is, in the final analysis, a matter of
social or philosophic values and of political judgment. But
regardless of how this question is resolved, it should be dear
to everyone that federal spending, whatever its level, must be
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MODERATION IN FISCAL POLICY

soundly financed. The large budgetary deficits that have per­
sisted since the mid-sixties— and in good years as well as bad
years— added little to our capacity to produce, but they added
substantially to aggregate monetary demand for goods and
services. They were thus largely responsible for the ten-year
stretch of accelerating inflation that culminated in the deep
recession from which we are now emerging.
The President's budgetary program for the coming fiscal
year, taken on an overall basis, would go far toward breaking
the spiral of federal spending and bringing order to our fiscal
affairs. The proposed budget would limit the rise of spending
in fiscal 1977 to 5 1 percent, compared with an average yearly
/2
increase of 12 percent over the previous five years. The federal
deficit is projected to decline from $76 billion in the current
fiscal year to $43 billion in the next, with a balanced budget
finally in view by fiscal 1979.
Some well-meaning citizens are now urging the Congress
to provide added fiscal stimulus in the interest of speeding the
return to full employment. I would warn this group that still
larger federal expenditures and a bigger deficit may fail of
their purpose. A deeper deficit would require the Treasury to
rely more heavily on credit markets, thus drawing on funds
badly needed for homebuilding and for business capital forma­
tion. Worse still, a significantly larger deficit would revive fears
of accelerating inflation and weaken the confidence of business­
men and consumers that is essential to the return of general
prosperity.
Moderation in monetary policy is also needed to bolster
confidence in the economic future. That is why the Federal
Reserve has been so diligently seeking to foster a financial cli­
mate conducive to a satisfactory recovery, but at the same time
to minimize the chances of rekindling inflationary fires. Since
last spring, growth rates of the major monetary aggregates—
while varying widely from month to month— have generally been
within the ranges specified by the Federal Reserve in its periodic
reports to the Banking Committees of the Congress.
The recent moderate increases in the monetary aggregates
have been accompanied, as we expected, by a sharp rise in the
turnover of money balances. The rising velocity of money has
not, however, been associated with higher rates of interest or
developing shortages of credit— as some critics of Federal Reserve




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policy had predicted. On the contrary, conditions in financial
markets have eased materially. They are more comfortable now
than at any time in the past two years, and thus remain favor­
able to continued economic expansion.
Before closing, I feel bound to say that fiscal and monetary
policies alone cannot be expected to achieve our economic goals
in the current economic and financial environment. It is not
enough to ask what further fiscal stimulation, if any, or what
further monetary stimulation, our economy requires. Nor is this
even the basic question. We should rather be asking what gov­
ernmental policies, covering as they might an enormous range
of actions and even inactions, are most likely to strengthen the
hope and confidence of our people. Let me briefly comment on
some policies outside the monetary and fiscal area that, in my
judgment, can make a significant contribution to the restoration
of full employment and also to correcting the long-run infla­
tionary bias in our economy.
First, governmental efforts are long overdue to encourage
improvements in productivity through larger investment in
modern plant and equipment.
Second, we should face up to the fact that environmental
and safety regulations have in recent years run up costs and
prices and have held up industrial construction across our land.
Third, a vigorous search should be made for ways to
enhance price competition among our business enterprises.
Fourth, governmental policies that affect labor markets cry
out for review.
Finally, we need to think through the appropriate role of
a limited incomes policy in the present environment.
Under current conditions, the return to full employment will
have to depend rather heavily on structural policies that serve
to reinvigorate competition and release the great energies of our
people. Such policies are not, however, a substitute for respon­
sible fiscal and monetary actions. In order to strengthen the
confidence of people in their own future and the future of our
country, we in government will need to work constructively on
all three policy fronts— fiscal, monetary, and structural.

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Current Fiscal Requirements

It is a particular pleasure, Mr. Chairman— and I do not say that
lightly— for me to meet with this committee. For many years,
I joined other citizens in urging a reform of the budget process,
so that tax and expenditure decisions of the Congress would
become effectively linked. Passage of the Congressional Budget
Act of 1974 was a major landmark in financial reform— com­
parable in importance, I think, to the Budget and Accounting
Act of 1921 which rationalized budgetary procedures for the
executive branch. In my judgment, the experience of the last
two years confirms the wisdom of the 1974 innovation. The
new element of order and discipline that this committee, your
counterpart in the Senate, and the Congressional Budget Office
have brought to fiscal deliberations has served the American
people well. We finally have a mechanism for determining
congressional priorities and relating expenditures to prospective
revenues.
Today, I would like to share with you my views about
evolving trends in economic and financial conditions and to spell
out the implications, as I see them, of those trends for some of
the critical economic policy questions that confront our nation.
This winter's unusual weather has, of course, greatly com­
plicated the interpretation of statistical data. For a while, jobs,
output, and sales were significantly affected by cold weather and
interruptions of fuel supplies, especially in the eastern half of
the country. And in parts of the West, drought conditions have
Statement before the Committee on the Budget, House of Representatives,
March 2, 1977.




311

REFLECTIONS OF AN ECONOMIC POLICY MAKER

necessitated the rationing of water and may later affect some
branches of agriculture and also the cost and availability of
hydroelectric power.
These vagaries of the weather have left their mark on
household budgets through their impact on incomes, fuel bills,
and food prices. The overall economic effect, however, in all
probability will prove considerably smaller than many news
accounts initially suggested. The period of acute disruption of
industrial and commercial operations was, after all, brief, and
as we meet here today, production and employment appear to
have recovered in most places. While I am sure that the hard­
ships imposed on many American families by this winter's
extraordinary weather will long be remembered, it seems most
unlikely that the disturbance we have suffered will have large
or lasting effects on the performance of our economy.
There is good reason, I think, to feel a sense of encourage­
ment about the way in which underlying economic conditions
are unfolding. Before the advent of inclement weather, the
economy was already emerging from the phase of hesitancy
that prevailed for a while last year. During the closing months
of 1976, the demand for goods and services— except for inven­
tory additions— accelerated, reflecting primarily a resurgence of
consumer buying and a further strong advance in homebuilding.
The improvement in sales volume enabled business firms to work
off a good part of the excess inventories that had accumulated
over preceding months when buying was fairly sluggish. W ith
sales and stocks coming into better balance, the pace of orders
and production began to quicken and the demand for labor
strengthened. This reacceleration of the recovery was the con­
sequence, in my judgment, of gradually cumulating strength in
key sectors of our economy and an improved financial environ­
ment. I believe that we shall see evidence before long that the
reacceleration has survived the weather disturbance, and I expect
good gains to be recorded in general economic activity this year.
Emerging trends in the consumer sector were strongly
favorable as this year began. The considerable expansion in
jobs last year, also the decline in the rate of inflation and the
enlarged liquid assets of households, served to improve con­
sumer sentiment. It seems reasonable to think that it is those
trends— rather than the transitory effects of bad weather— that
will basically condition household behavior in the months ahead.
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CURRENT FISCAL REQUIREMENTS

A quickening tempo, as I have noted, developed in late 1976
for both incomes and employment. This created the basis for
more aggressive retail buying. Indeed, reliance on instalment
credit to finance purchases of consumer durable goods increased
in late 1976; and, strikingly, the personal saving rate for the
fourth quarter fell to its lowest reading in several years.
One consequence of the buying surge was that inventories
toward the close of last year fell below levels preferred by many
business firms. In some instances further depletion of stocks
has since then occurred because of the production curtailments
occasioned by bad weather and fuel problems. Very possibly,
therefore, considerable inventory investment by businesses lies
ahead.
The major influences that affect residential construction are
also favorable. Indeed, except for January's weather-related
setback, housing activity has been in a strong upward movement
since last autumn. The swelling of new housing starts in the
fourth quarter of 1976— to a rate, incidentally, 30 percent greater
than a year earlier— assures that work on homes under con­
struction will be very active for a good many months to come.
And some further rise in starts is a reasonable expectation, in
view of the liquid condition of mortgage-lending institutions and
the progressive correction of the imbalances in the housing
market that arose during the early 1970s.
The outlook for business capital spending in 1977 is also
promising, even though serious questions can be raised as to the
likely adequacy of capital formation in our country over the
longer term. So far in the current recovery, capital spending
has been lagging; measured in constant dollars, it rose by only
3 percent through the final quarter of 1976. This contrasts with
an average rise of 15 percent during the corresponding periods
of earlier business-cycle expansions since World W ar II. How­
ever, the average rate of gain should be decidedly better during
the next year or so.
This judgment is based on a number of considerations— the
continuing improvement of product markets, the intentions of
business firms to invest as disclosed by survey data, the increas­
ing number of new firms that are starting up operations, the
comparatively favorable cash position of corporations, and an
impressive uptrend in capital-goods ordering. Contracts and
orders for plant and equipment, a leading indicator of invest­




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ment activity, spurted at an annual rate of more than 20 percent
in the fourth quarter of last year, and monthly data covering
new orders for nondefense capital goods show the rise continu­
ing in January. To be sure, the level of capital-goods production
is still far short of what we normally might expect at this stage
of cyclical expansion, but we can at least anticipate that it will
make a larger contribution to the advance of the general econ­
omy this year than it did in 1976.
It is much more difficult to reach a confident judgment
about how exports and imports will impinge on our nation's
economy this year. In 1976, both exports and imports rose
considerably, but our export trade was held back by the weak
expansion of many foreign economies. The rise in imports was
far more pronounced, reflecting in significant part our increasing
dependence on foreign sources of fuel. Some further decline in
our trade balance and also in the broader current account balance
is likely this year, but not nearly to the degree that occurred in
1976.
The challenge facing our exporters is formidable because o f
the continuation of less decisive recovery tendencies abroad than
here at home. In some instances, less vigorous economic growth
reflects actions taken by foreign officials to cope with severe
inflationary problems and the accompanying imbalances in inter­
national payments. An important drag on recovery in numerous
countries is the ongoing adjustment, as yet far from complete,
to the quantum jump of oil prices since 1973. Thus, our export
trade may be adversely affected for some time, particularly since
the external indebtedness of many nations cannot continue rising
as rapidly as it has in recent years.
But with the exception of these uncertainties relating to
foreign trade, factors on the demand side generally seem to point
to good growth in our nation's output this year. Buttressing that
expectation is the fact that overall financial conditions in this
country— an area in which the Federal Reserve System has a
major responsibility— provide a satisfactory foundation for eco­
nomic growth.
The basic objective of monetary policy in the recent past
has been to promote conditions conducive to substantial expan­
sion in economic activity, while guarding against the release of
new inflationary forces. To that end, the Federal Reserve has
fostered moderate rates of monetary growth. During the period
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CURRENT FISCAL REQUIREMENTS

extending from the cyclical trough of March 1975 to February
of this year, M i, the narrowly defined money stock— which
includes only currency and demand deposits— grew at an annual
rate of 5.6 percent. A broader monetary aggregate, M 2 which
—
includes as well savings and consumer-type time deposits at
commercial banks— increased at a 10.7 percent rate.
These increases in the stock of money have proved adequate
to finance a large gain in the physical volume of output and
employment. Indeed, the evolving stock of money could readily
have accommodated larger growth in economic activity than
actually occurred. In that connection, it is important to bear in
mind that consideration of the stock of money alone is not
sufficient for assessment of the adequacy of the economy's liquid­
ity. Money has a second dimension, namely, velocity, or— in
common parlance— the efficiency with which it is being used.
For the narrowly defined money supply, efficiency of use has
been improving with special rapidity in recent years, reflecting
numerous innovations in financial technology that serve to re­
duce reliance on demand deposits for handling monetary trans­
actions. In fact, during the span of the current recovery, the
gains recorded in the efficiency of Mi appear to have exceeded
typical gains during corresponding periods of past cyclical
upswings.
Major benefits have flowed from the Federal Reserve's
carefully fashioned monetary policy. By holding resolutely to
a course of moderation— a policy that at times has run counter
to strongly voiced urgings that we be much more expansionist—
we have helped in very significant degree, I think, to dampen
inflationary expectations. This has strengthened public con­
fidence— both here and abroad— in the value of our currency
and in the future of our economy.
Mainly as a result of the lessening of inflationary expecta­
tions, interest rates have not increased as they usually do in a
period of cyclical expansion. On occasion during the past two
years, both short- and long-term interest rates have registered
noticeable upward movements, but the general trend has been
downward in the yields on securities traded in public markets
and also in the interest charges on loans extended by financial
institutions. In general, interest rates are appreciably lower now
than they were at the beginning of the economic expansion— a
fact that augurs well for the continuation of recovery. One of




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the considerations brightening the housing outlook, for example,
is that the average rate on residential mortgage loans across the
country has come down almost 1 V2 percentage points from its
earlier high. Also important to the housing outlook is the fact
that the rates paid by mortgage-lending institutions to their
depositors remain attractive relative to money market obliga­
tions, so that no threat exists— at least for the immediate future
— of heavy shifts of funds out of such institutions.
Significantly, our nation's business enterprises have made
good use of the prevailing financial climate to improve their
liquidity. Corporations have issued a huge volume of long-term
bonds, and they have used the proceeds largely to repay short­
term debt and to acquire liquid assets. They have also greatly
increased the volume of stock flotations above the depressed
level during the recession. Supplementing these actions, busi­
ness enterprises have followed generally conservative dividend
policies, thereby retaining substantial amounts of current earn­
ings for internal use. The consequence of this combination o f
moves is that corporate balance sheets have a much healthier
look now than they did several years ago. The average maturity
of outstanding corporate debt has been lengthened appreciably,
and businesses now also have more equity relative to debt. This
clearly puts business firms in a good position to expand the
scale of their operations as opportunities arise. For a while the
improvement in liquidity occurred mainly in the case of firms
enjoying the highest credit ratings and therefore having the
easiest access to longer-term funds; but the improvement has
progressively become a generalized phenomenon.
The favorable condition of financial markets has been of
important help as well to the nation's state and local govern­
ments. Record volumes of new tax-exempt bonds were sold in
1975 and 1976, in part to pay off short-term debt. Those repay­
ments, together with progress made by many states and munici­
palities in strengthening their budgetary positions, have improved
the standing of such governments with the investment com­
munity. Testifying to that is the fact that interest rates on
municipal securities have not only declined; they have declined
more sharply than interest rates on other fixed-income obliga­
tions. In addition, the spread between yields on higher- and
lower-quality issues of municipal securities has narrowed. These
developments suggest that the demand for goods and services by
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CURRENT FISCAL REQUIREMENTS

states and municipalities— which was relatively subdued during
the past several years of difficult adjustment— will now expand
somewhat more rapidly.
During the past two years, the nation's financial institutions
have also strengthened their capability to be supportive of eco­
nomic expansion. Commercial banks have materially improved
their liquidity by doubling their holdings of Treasury securities
and reducing reliance on volatile sources of funds. They have,
moreover, retained a large share of profits to enhance capital
positions, so that the ratio of capital to risk assets, which had
declined steadily during the early 1970s, has risen appreciably.
Other depository institutions have made similar progress in
strengthening their capacity to respond to financing requests.
Savings and loan associations, for instance, have repaid large
amounts of debt besides adding heavily to their holdings of
liquid assets. With savings inflows ample, thrift institutions
have already stepped up their mortgage lending to a record level,
and they clearly are going to have considerable scope to accom­
modate further the demands for mortgage credit in 1977.
In sum, both the background of favorable financial condi­
tions prevailing at this time and the growth patterns that have
been unfolding in key sectors of our economy justify consider­
able optimism about the immediate future. Indeed, it seems
doubtful to me, as I have previously indicated, that any special
efforts to stimulate growth— at least any of a conventional char­
acter— are now needed to assure broad economic expansion this
year and on into 1978.
I realize that a majority of this committee, as well as the
able members of President Carter's economic team, feel differ­
ently. I thoroughly respect their judgment as well as yours.
In matters pertaining to the future, no sensible person can be at
all certain that he has captured the truth. As things stand, I
diagnose the condition of our economy somewhat differently,
and it is my duty to advise you as I best can.
I believe that we can all agree that, in wrestling with the
policy challenges that face our nation, no objective deserves
higher priority than that of creating job opportunities for the
millions of Americans who want to work but who nevertheless
now find themselves idle. But while the goal we seek is clear,
appropriate actions for dealing with unemployment are not easy
to devise or to carry out.




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By my diagnosis, as I have already noted, our economy
faces a serious deficiency of business investment in fixed capital,
rather than any generalized problem of demand deficiency. The
underlying difficulty is that we have done many things over a
span of years which have been damaging to the state of con­
fidence— especially the confidence of the business community.
Efforts at fiscal stimulation do not seem promising to me in
these circumstances. Indeed, they could prove inimical to real
progress, if only because they are likely to be perceived by
many people as an extension of the loose budgetary practices
from which so many of our troubles derive.
By and large, the American public is familiar with the sorry
record of federal government finances in our generation. M ore
and more of our citizens have come to appreciate the linkage
between the record of persistent deficit financing and the debili­
tating inflation of recent years. The degree to which we have
been unwilling to tax ourselves— even in good years— to finance
the programs enacted by the Congress never ceases to astonish
me, no matter how often I scan the figures. Only once since
1960 has the federal budget shown a surplus. The cumulative
deficit in the unified budget over the past fifteen years, including
the newly revised official estimate for the current fiscal year,
comes to $308 billion. If the spending of off-budget agencies is
also taken into account, as it should be, the aggregate deficit for
the period amounts of $337 billion.
We have built momentum into the rise of federal expendi­
tures by the enactment of "entitlement" programs relating to
income security and health and by extending inflation escalator
clauses to a significant range of federal programs. The merit o f
many of these responses to the needs of our citizens is indis­
putable, but the impetus thus imparted to budgetary expansion
is nevertheless very serious. It underscores the imperative need
for us to be extremely cautious in adding new programs to the
budget. In stressing this principle, President Carter deserves
your and the nation's full support. But it is equally important
that the Congress ponder carefully any abrupt surrender of
sizable amounts of tax revenue.
The inflation that has plagued the American economy since
the mid-1960s is a complex phenomenon, and it is by no means
solely the product of budgetary practices. But there can be
little doubt that the chronic reaching of the federal government
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CURRENT FISCAL REQUIREMENTS

for both financial and real resources has been a major con­
tributory element in inflation— indeed, the dominant one in my
judgment. The federal government was a party— rather than
the counterweight it should have been— to the demand pressures
that began building up in the mid-sixties and that culminated in
the speculative distortions of the 1973-1974 period. Inflation, by
my assessment, not only sowed the seeds of the recession that
ensued; it also is the basic explanation— precisely because it
became so virulent— of why the recession that followed was so
severe. Blinded by the explosive advance of prices— which for
a while swelled nominal profits— businessmen were unusually
slow in adapting their activities to the weakening pattern in
consumer markets that had actually become quite well-defined
during 1973. When businessmen finally recognized in the autumn
of 1974 that their perception of market conditions had been
mistaken, the response in scaling back operations was often
drastic— in large part because distortions had been allowed to
cumulate for such a long period.
A strong residue of caution has been evident in business
circles since then. That caution— which explains, I believe, the
relatively weak recovery in capital spending so far in this expan­
sion— is an amalgam of several things. These include the rude
discovery that the business cycle is by no means dead, a height­
ened worry about the troubles inflation can breed, apprehension
about the cost and availability of energy supplies, a lingering
fear that expansionist governmental policies could again lead to
price controls, and growing concern about the costs of complying
with existing environmental and safety regulations. In short, a
confident business mood has been slow to emerge in the aftermath of recession, in considerable part for reasons that relate to
our recent history of inflation and government's role in that
history. The consumer mood is stronger; but consumers, too,
have anxieties about inflation and inflation-inducing actions by
government.
What this analysis suggests to me is that governmental
consideration of economic policy should focus sharply on ways
and means of strengthening the confidence of our people in their
own and the nation's economic future. By focusing as we have
on the size of a "stimulative" fiscal package, we inadvertently
have been diverting attention from what I believe to be the main
problem. At this juncture of history, government actions should




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REFLECTIONS OF AN ECONOMIC POLICY MAKER

aim above all else at reassuring our citizens that the policy mis­
takes of the past will not be repeated. Indeed, from the view­
point of the responsibilities of this committee, a consideration
of what not to do again ought, I believe, to serve as the critical
point of departure for policy formulation.
Starting there, I obviously cannot feel comfortable about
the official budget for fiscal 1977, or for that matter about any
budget which moves toward enlarging the federal deficit. This
prospective enlargement comes at a time— unlike that of 1975—
when private credit demands are rising. Thus, a troubling
departure is occurring from the normal pattern of gradually
diminishing demands for credit by the federal government as
recovery proceeds.
On the basis of the revised budget proposals submitted by
the administration, it would appear that federal borrowing in
public markets in the current calendar year could be $10 billion
or so higher than in 1976. The prospect that federal demand for
credit will run considerably higher than earlier seemed likely
has stirred uneasiness among credit market participants, as is
evidenced by the decline in prices of fixed-income obligations
that followed disclosure of the administration's intentions. W hile
a "crowding out" of private borrowers from credit markets does
not seem a serious threat, at least not for 1977, the enlarged
prospective competition of the federal government with private
borrowers— with the housing sector, for instance— is most un­
welcome. It may impart some upward tendency to interest rates,
and it will also make it more difficult for the Treasury to achieve
further progress in lengthening the maturity of outstanding debt.
I have felt obligated in the course of this statement to
explain to you why, on the basis of my interpretation of the
events that have occurred during recent years, I have reserva­
tions about budget moves that do not yet have the appearance
of breaking with the past. Whatever early action is taken in
the Congress with regard to the budget, I hope that the point
I have made about the vital need for confidence-building actions
will carry some weight in your continuing deliberations as the
year goes on. To give Americans confidence that the future
will be something other than a repetition of the past, government
must demonstrate in a persuasive way that it is regaining control
of our fiscal affairs.
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CURRENT FISCAL REQUIREMENTS

The President's commendable goal of a balanced federal
budget within four years might still be within reach even if the
budget is now enlarged by the full amounts that have been
recommended. The task of holding to that timetable will, how­
ever, be made more difficult by each and every enlargement of
spending. This emphasizes the need for an especially cautious
approach to requests for program increases— both now and in
the future. In that regard, I particularly want to applaud the
President's decision to go forward with a zero-base budget sys­
tem for fiscal 1979, and also to review very critically the current
practice of allowing off-budget outlays. These steps should
serve to reduce, if not eliminate, programs that have outlived
their usefulness.
Such a budgetary approach, it seems to me, has great
potential for helping arrest the powerful upward push of federal
spending. For the record, I would note that the Federal Reserve
has for some time been conducting two pilot studies of the
feasibility of adopting zero-base budgeting ourselves. One of
those studies is going forward at the Chicago Federal Reserve
Bank and the other in a division of the Board. While evaluation
will take some time, I am inclined to think that we may be able
to move to the recommended approach fairly rapidly, even
though as an independent agency we have no formal obligation
to do so.
In closing, I would like to come back for a moment to the
workings of the new congressional budget system. I am aware,
of course, that the proposal for a Third Concurrent Resolution
for fiscal 1977 has been subjected to some fairly sharp criticism.
To the extent that such criticism has been directed at the spe­
cific content of the resolution, it seems entirely proper. Indeed,
as I have made clear here today, I take some exception myself
to its basic thrust. The legitimacy of having a third resolution,
however, does not seem to me to be open to question. If a
judgment emerges after acceptance of a particular concurrent
resolution that some significant change has occurred in national
conditions, a reopening of that resolution for revision is a
clearly proper and responsible action.
I would voice, however, one cautionary word. As a prac­
tical matter, if the Congress were to move in the direction
of very frequent revision of concurrent resolutions, the essential
discipline of the new budgetary process would be lost. It may




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REFLECTIONS OF AN ECONOMIC POLICY MAKER

be useful to recall that the only previous effort by the Congress
to operate with a formal legislative budget— under the Legisla­
tive Reorganization Act of 1946— foundered in part because
liberal supplemental appropriations made the whole exercise o f
spending ceilings by concurrent resolution somewhat pointless.
While I do not think there is great risk that we shall travel such
a route again, I mention that bit of history because it is so vital
that the new legislative budget process continue to evolve along
the lines of its promising beginnings. The last two years have
clearly demonstrated the value of the legislative budget as an
instrument for bettering fiscal discipline. This committee has
earned the nation's gratitude by its commitment to that objective.

322



PART
FOUR
Sound Money and Banking







The Federal Reserve and the
Banking System

It is a pleasure to be with you here in Boca Raton this morning.
I am particularly pleased because this meeting gives me a timely
opportunity to discuss with leading representatives of the bank­
ing community some of the concerns which have been uppermost
in my mind since February when I assumed my present position.
The principal concern of a central banker is, of course,
monetary policy. I have already expressed my views on this
subject at some length in two recent appearances before com­
mittees of the Congress, and I shall not return to it this morn­
ing. What I should like to do instead is to discuss with you the
Federal Reserve Board's administrative and regulatory policies.
Let me tell you, first, how we have altered our administra­
tive procedures. Almost all of the independent agencies of the
federal government, acting on the recommendations of the
Hoover Commission, now centralize administrative authority in
the head of the agency. In keeping with this strong trend, the
Board recently delegated the bulk of its administrative respon­
sibilities to me as chairman. I, in turn, have redelegated some
of this authority to Governor Sherrill, who in the past has
devoted considerable time and effort to this area. I expect that
centralization of administrative control will significantly improve
the efficiency of our procedures.
Other delegations of authority have been made to other
members of the Board, to directors of its divisions and to the
Remarks before the 59th annual meeting of the Association of Reserve City
Bankers, Boca Raton, Florida, April 6, 1970.




325

REFLECTIONS OF AN ECONOMIC POLICY MAKER

Reserve Banks, and still further delegations are contemplated.
The result has been that relatively minor issues involving bank­
ing structure, foreign banking, and internal personnel procedures
no longer consume much of the Board's time. We have been
able to reduce our meetings from five days a week to three.
And we can now devote these meetings largely to monetary and
regulatory policy issues, besides attending to difficult or precedent-setting banking applications.
With regard to Federal Reserve actions affecting banking
structure, we are taking steps to arrive at prompter action
where this can be done Without harm to the integrity of the
regulatory process. To further this objective, the Board recently
created the new post of program director for banking structure,
and named Mr. Brenton Leavitt, deputy director of our division
of supervision and regulation, to that post. He will be respon­
sible for marshalling staff resources so as to expedite decisions
on bank merger and holding company applications.
I should point out that progress in this area is all the more
necessary because of the increasing number of banking appli­
cations coming to us. For example, during 1969, the Board
issued decisions on 91 holding company applications, compared
with 44 in 1968 and only 17 in 1965. During the first three
months of 1970, we issued decisions in bank-holding company
cases at a rate in excess of 150 per year. Streamlined procedures
have been introduced to process this increasing flow of appli­
cations on a timely basis. Our current goal is to handle all but
the most difficult cases within ninety days of acceptance. Con­
siderable progress has already been made in this direction, and
we aim to reduce processing time below ninety days as our
procedures improve. Let me add that you can be of considerable
help to us in reaching these goals by submitting applications
which give at the outset all the factual information needed to
reach a decision.
The Federal Reserve's current emphasis on centralization
and delegation of authority has already enabled us to discharge
our responsibilities with increased efficiency and speed. Even
more important, however, than these present results, is the
improved capability these arrangements have given us to deal
with new problems flexibly and effectively.
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FEDERAL RESERVE AND THE BANKING SYSTEM

I would like to convey to you now the trend of current
thinking at the Federal Reserve on regulatory policies. There are
three basic strands in the Board's approach to regulatory issues.
First, we always aim to formulate policies that are consistent
with the safety and soundness of the banking system. Inno­
vations that significantly threaten either of these elements are
clearly undesirable in the long run, whatever their short-term
attraction may be. S eco n d , as far as practicable, we are attempt­
ing to develop policies that will be consistent with market prin­
ciples. Wherever we can, we wish to avoid introducing artificial
constraints upon the free play of market forces. In this way the
overall efficiency of our economy will be furthered. T h ird , our
efforts are being directed at building a structure of regulatory
policies that are consistent with effective monetary policy.
Regulatory policies should provide a means for furthering, not
hindering, the execution of monetary policy decisions. This is
a basic and inescapable constraint within which the Federal
Reserve must work.
These efforts to improve our administrative efficiency and
to rethink our approach to regulatory decisions have been the
result of a continuing process. This process did not suddenly
commence on February 1. And, I can assure you it is one which
will continue.
The changes within the Federal Reserve that I have been
describing are fundamentally a response to changes in the
financial environment during the past decade, especially the
latter half of the decade. I would like to review with you what
seem to me to be the major factors which have led to the new
emphasis in Federal Reserve policies.
Bankers have had to function under an extremely tight
monetary policy twice in the past five years. Though the bank­
ing industry has generally supported anti-inflationary policies in
those years, the particular means and degree of the credit re­
straint to which the industry was subjected brought forth a
stream of objections. Circumventing maneuvers by banks
occurred not infrequently, and some of these elicited an eventual
Federal Reserve response in the form of regulatory counter­
action. These episodes were not calculated to endear either of
our groups to the other. I shall explore with you a bit later




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REFLECTIONS OF AN ECONOMIC POLICY MAKER

what might be done during periods of tight money to prevent a
recurrence of such episodes.
Significant changes have also taken place in the competitive
environment of banking in the past ten years. Competition
among commercial banks has increased sharply. Savings and loan
associations, finance companies, and commercial paper issuers
have grown in both size and number. Moreover, new debt instru­
ments have proven highly successful in drawing savers directly
into the financial markets and away from such traditional inter­
mediary instruments as bank deposits. This trend toward increas­
ing competition for funds seems likely to continue. I suspect that
in the future you will have to work even harder to acquire the
funds you need. But, I am hopeful that your efforts to find new
sources of funds will not create the strains our relationship has
recently experienced.
The decade of the 1960s has also been one of remarkable
change in the structure of banking. We have seen a sharp rise
in bank mergers, an expansion of branch systems and of over­
seas banking activities, and a notable increase in the number of
bank-holding companies, especially of the one-bank variety.
These rapid structural changes have been in part a cause
and in part a result of the increasing competition of which I
have spoken. They have also been both a cause and result of
changes in the statutory and regulatory environment. Liberr
alizations as well as restrictions have occurred. But, where
limitations on structural change have been imposed— as by the
1966 amendments to the Bank Merger and Holding Company
Acts, the imposition of interest-rate ceilings, and the expansion
of the Reserve Board's regulations, especially D and Q—
increased burdens have inevitably been placed on the relation­
ship between banks and the Federal Reserve. I would hope that
these strains will in the future be eased, where this can be done
without injury to the public interest.
Another factor which has been instrumental in transforming
the banking environment has been technology. The new science
of computers and of data processing has had, and will continue
to have, striking effects upon our entire society. We have yet
to experience the full impact of this technological revolution.
The past decade contains some hints, however, of the order
of change we will be experiencing. The present check collection
328



FEDERAL RESERVE AND THE BANKING SYSTEM

system, I am told, owes its survival to the advent of automated
processing. The new technology has facilitated the growth of
banks, but it has also created problems. Corporate treasurers
have learned to manage their cash flows better through the use
of automated bookkeeping. Demand balances have suffered as
a result, placing additional pressure on banks to seek new
sources of funds. In a comparatively short time an electronic
payments mechanism will be a reality. As we move towards
such a payments system, even greater alterations can be expected
in the competitive environment and structure of the banking
industry.
At the Federal Reserve we are preparing our communica­
tions system for the payments mechanism of the future. At this
moment, we are in the final stages of installing a highly advanced
computer switching apparatus which will link all Federal Re­
serve Banks and the Reserve Board. This apparatus should be
operating by mid-year. It will provide banks and their customers
with a means of moving money and securities at a higher speed
than ever before. The computerized operation will permit the
gradual removal of limitations on the volume of transfers now
imposed on the Federal Reserve leased wire network by manual
operations and outdated equipment. This nationwide electronic
grid will also be of considerable benefit to the Federal Reserve
itself. High-speed communications with the Reserve Banks will
improve the timeliness and availability of our data. We expect
this improvement in the flow of information to aid our assess­
ment of economic and financial developments.
The changes I have been describing in the financial environ­
ment and in the Federal Reserve's efforts to meet these changes
through improvements in its equipment and its administrative
and regulatory policies must be seen against the broader eco­
nomic and social setting which encompasses them. Significant
changes in the financial environment are usually a reflection of
far-reaching economic, technological, and social developments.
Thus, the types of economic and social demands society will be
making on the financial system will condition the types of
activities in which both banks and banking regulators will be
engaging. They will, therefore, partially determine the relation­
ship between the regulators and the regulated. Within this
setting, I believe ways can be evolved to enable banks and the




329

REFLECTIONS OF AN ECONOMIC POLICY MAKER

Federal Reserve to interact more harmoniously in furtherance
of the public interest.
Let me tell you then what I think bankers might do to help
our relationship in the future. After that, I shall say a few
words about what the Federal Reserve Board can do on its part.
Please remember that these are not the official views of the Board,
but simply my personal observations. I trust that you will treat
them as such.
One way to improve our relationship would be for you
to pursue policies which are more compatible with overall eco­
nomic stabilization efforts. As you know, these efforts require
that restraints sometimes be brought to bear on credit-financed
spending. In this connection, the task of economic stabilization
might be easier if bankers considered reforming some of their
lending techniques. I am referring in particular to the practice,
which appears to have grown of late, of making binding com­
mitments for large amounts of credit tied to a conventional
"prim e" rate. Such commitments tend to insulate a sizable
sector of credit from the effects of monetary policy. If bankers
were to limit their commitments to totals they felt sure they
could finance in periods of tight money, and if they charged at
least as much for commitment takedowns as they themselves
were paying for additional funds, I suspect that some of our
nation's battles against inflation would be easier to win.
Another matter which I think deserves more attention is the
underlying trend in the quality of credit. The period since 1965
has been of the kind which historically has given rise to deteri­
oration in credit quality, sometimes with unhappy consequences.
It is hard to tell to what extent the quality of credit has suffered
in recent years, for statistics in this area are fragmentary, and
oftentimes of dubious significance. We at the Federal Reserve
are trying to press ahead with studies in this field. At this stage,
however, those of you in the very midst of the lending process
are in the best position to perceive the drift of credit quality.
I urge you to be watchful, and to share your assessment of the
situation with us.
Lastly, I would urge you to be extremely sensitive to the
importance of preserving a vigorous competitive environment
both within and outside the banking industry. If you keep this
caution in mind, you may save yourselves a good deal of grief
330



FEDERAL RESERVE AND THE BANKING SYSTEM

at the hands of the bank supervisory agencies, the Justice De­
partment, and the courts. There is much yet to be learned about
the essential ingredients and prudent limits of vigorous banking
competition, and you can help to further understanding by your
comment and example. But, progress in this area needs to be
conditioned by a deep awareness of the value that is placed
upon truly competitive banking alternatives being available to
our citizenry.
The increasing demands on banks for new and improved
services create considerable pressure for increases in the size
and diversity of banking organizations. It is vital, however,
for bankers to remember that public fears of undue concentra­
tion of economic power in banks are easy to rouse and difficult
to lay to rest. Our nation's economic, social, and political
philosophies are not congenial to the creation of monolithic
centers of power along the lines of Japan's zaibatsu. Bankers,
have done very little to allay the fears of the American public,
and of the Congress, that efforts to expand the scope of banking
are leading us in this direction. Part of the problem here has
been a seeming unwillingness on your part to have a sharp line
drawn between banking and industry. I personally believe that
a reasonable distinction can and must be made, difficult though
that task may be. The one-bank holding company bill now
before the Congress seems to me, however, to confine banks
too narrowly. That it does so is at least partly a result of a
gap in communication between the banking industry and the
American people.
This communication failure is the greatest we have seen
since the 1930s. The banking industry has simply failed to win
public understanding and acceptance of its lending practices,
its charges, and its aspirations. The result has been a rising
level of suspicion and even antagonism. I think the time has
come, indeed is past due, for making every possible effort to
correct this unfortunate state of affairs. I urge you to take
positive steps in this direction.
Now I should like to turn briefly to what I believe the
Federal Reserve can do to serve the banks and the public interest
more effectively. First, we need certainly to press forward with
current efforts to improve our administrative efficiency. Next,
I can assure you that we shall try to be sensitive to the effects




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REFLECTIONS OF AN ECONOMIC POLICY MAKER

of changes in the financial environment on the competitive
position of the commercial banking industry. In that connection,
let me remind you that in February of last year, in a statement
dealing with the proper scope of banking activities, the Board
expressed the view that "banks should be granted greater free­
dom to innovate new services and procedures . .
when these
activities are not inconsistent with the purposes of the governing
statutes. I look forward to Board action in the spirit of this
statement of principle as we consider the bank regulatory issues
ahead of us.
I have mentioned before the importance of permitting
market forces in banking as much free play as is consistent
with the protection of the public interest. This is the kind of
generality that is easier to express than to apply, for the prag­
matic considerations of the moment often press in an opposite
direction. In my view, however, banking is burdened with too
many regulatory legacies of past circumstances in which prag­
matic concerns overrode market processes. To cite a specific
example, I regard interest-rate ceilings on deposits as one device
that is overdue for serious reexamination. As a matter of per­
sonal economic philosophy, I would like to see an evolution
away from reliance upon interest rate ceilings as an ancillary
device of monetary policy, at least as far as instruments of the
money market type are concerned. When and as circumstances
permit, I believe an element of greater economic rationality
would be introduced into the financial system if interest rates
on such instruments were permitted to find their own level as a
result of market forces.
Finally, the Federal Reserve needs to explore means of
achieving a more equitable impact of monetary policy on all
segments of the economy. The strongly adverse effects of a
tight money policy on the housing industry, state and local
government financing, and small businesses need hardly be
amplified. The public, quite rightly, is especially concerned
about housing, which has borne a large portion of the burden
of tight monetary policy. Efforts to alleviate this situation
must be made.
Among the various proposals now before the Congress,
one would require the Federal Reserve to provide up to $3 billion
a year to the Federal Home Loan Bank system to support the
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FEDERAL RESERVE AND THE BANKING SYSTEM

middle-income housing market. While the underlying intent is
commendable, this proposal would undermine the Federal Re­
serve's ability to stabilize the economy and would eventually
lead to our supporting other special segments of the economy.
The consequence would be a drastic diversion of the Federal
Reserve System from its historic and essential role of protecting
the integrity of the dollar and promoting stable prosperity for
our nation. I need hardly tell you that I am doing everything
I can to promote wiser legislation.
The Federal Reserve has been accused of insensitivity to
the nation's housing needs. This is by no means true. We are
well aware of the plight of the housing industry and we have
under way at this moment a major study of housing finance
needs. Its results, I hope, will indicate what steps may depend­
ably be taken to improve the housing situation. A great deal of
study will have to be devoted also to other sectors of the
economy, particularly municipal finance. Necessary changes are
likely to be of a kind that take considerable time to put into
effect. Some of them may make the banker's job easier, and
some may make it more difficult; but, like all the ideas I have
been expressing, they will stand the test of time only if they
promote the long-run welfare of the nation as a whole.
Now seems to me a particularly apt time for us at the
Federal Reserve to be reexamining our relationship with the
commercial banking industry. At this moment financial mar­
kets and institutions are under somewhat less pressure than
earlier. Money, bank credit, and savings flows are again be­
ginning to expand moderately. There is reason to believe that
changes in the financial environment will result in a relaxation
of some of the constraints under which banks and their regu­
lators have been operating. The decade before us promises to
bring with it even greater changes in banking than the past
ten years have brought. I firmly believe that we can learn from
the hard-earned lessons of the past— that we can find ways to
discharge our responsibilities in a spirit of greater harmony and
thus bring out the best in both of our institutions. The ulti­
mate benefactor will be not the banks, nor the Federal Reserve,
but the public we both serve.




333




The Structure of Reserve
Requirements

It is a pleasure for me, both as a citizen and as a government
official, to join in the deliberations of this council. We share
many common objectives and we face common problems. O f
course, our views have not always agreed in the past, and I
doubt if the future can or will be entirely different. It is impor­
tant, nevertheless, that we make a conscientious effort to under­
stand one another's perceptions of the problems we face. If we
do so, we will generally find a path to fair and constructive
solutions.
One gratifying demonstration of that fact has taken place
in recent weeks. The Committee on Interest and Dividends
recently issued guidelines on the so-called "dual prime rate."
In response to my invitation, bankers from all over the country
met with the committee and its staff to ponder the difficulties
surrounding the prime rate in the current environment and to
seek a solution that could best serve the public interest. I am
especially grateful to two of your leaders, Eugene Adams and
Rex Morthland, for giving so generously of their time and wis­
dom to make the lending rate guidelines fair and workable.
And I also want to note that the banking industry has acted
prudently in complying with the committee's request to move
gradually and cautiously in adjusting the prime loan rate for
large businesses. Such a moderate response adds to national
confidence in the public responsibility of banking leaders.
Address before the Governing Council of the American Bankers Associa­
tion, White Sulphur Springs, W est Virginia, April 26, 1973.




335

REFLECTIONS OF AN ECONOMIC POLICY MAKER

Today, however, I shall say no more of the Committee on
Interest and Dividends, but turn instead to my responsibilities
as chairman of the Federal Reserve Board. You and I have a
number of pressing problems demanding our immediate atten­
tion. But it is also essential that we focus on longer-range
issues from time to time. I want to discuss with you one of
those issues this morning— namely, the structure of reserve
requirements.
This is a subject of substantial interest to the managers of
commercial banks. It is also a matter of considerable importance
to those of us concerned with the nation's economic and financial
policy. For reserve requirements can influence in fundamental
ways the effectiveness of monetary policy, the cost of financial
intermediation, and the allocation of savings among competing
financial institutions.
Let me begin by considering the role and purpose of reserve
requirements in the functioning of monetary and credit policies.
Before the Federal Reserve System was founded, reserve
requirements were imposed by legislation at the national and
state levels as a means of protecting bank liquidity. That philos­
ophy was retained in the original structure of reserve require­
ments established for Federal Reserve member banks. Higher
requirements were set for reserve city banks than for country
members, and still higher requirements were imposed on central
reserve city banks. Vestiges of that initial structure remain, even
today.
Required reserves, however, are not really an important
source of bank liquidity. The reserves required to back deposits
cannot be withdrawn to finance a rise in loan demand, and they
can supply only a small portion of the funds needed to accom­
modate deposit losses. The true and basic function of reserve
requirements is not to provide liquidity, but to permit the
Federal Reserve to control the supply of money and credit so
that monetary policy can effectively promote our national eco­
nomic objectives.
To achieve good management over the supply of money and
credit, reserve requirements must be met by holding assets whose
aggregate volume is under the control of the Federal Reserve.
Whatever their role may be in protecting bank liquidity, the
reserve requirements set by the various states do not meet this
336



STRUCTURE OF RESERVE REQUIREMENTS

test. This is a serious defect, since the principal reason for
reserve requirements is their contribution to effective monetary
policy.
Judged by this criterion, the present structure of reserve
requirements leaves much to be desired. Reforms are needed to
increase the precision and the certainty with which the supply of
money and credit can be controlled. Reforms are needed to
permit more variation in reserve requirements as an instrument
of monetary policy. Reforms are also needed to distribute the
burden of monetary controls more equitably among the financial
institutions that participate in the payments mechanism.
The Federal Reserve Board has been concerned for some
time with inequities in the structure of reserve requirements.
Last November, we finally used our authority under Regulation D
to carry out substantial improvements in the structure of reserves
that are required to be held against the demand deposits of mem­
ber banks.
As you know, the Federal Reserve Act specifies that the
Board must distinguish between reserve city banks and other
members in the establishment of reserve requirements. Until
November 1972, the principal determinant of a bank's reserve
status was its geographic location. Banks in principal financial
centers were generally classified as reserve city banks; those in
other locations fell into the country member category. A bank
could, however, have its classification changed by appealing for
special treatment based on the nature of its banking business.
With the passage of time, this system of reserve classifica­
tion became increasingly outmoded and inequitable. Some large
banks in cities of substantial size enjoyed the lower reserve
requirement on demand deposits applicable to country members.
At the same time, there were some small banks in major financial
centers that had to carry the higher reserve requirement imposed
on reserve city members. Over the years, exceptions had been
granted in so many cases— each of them probably justified but
different from most others— that the principles underlying the
reserve classification of member banks could no longer be
readily discerned.
The Board moved last year to eliminate these capricious
elements in reserve classification by introducing a graduated
reserve requirement— that is, by relating the reserve against




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REFLECTIONS OF AN ECONOMIC POLICY MAKER

demand deposits of each bank to the size of the bank. Under the
new system, all member banks of a given size, whatever their
location, are subject to identical reserve requirements.
This reform was a major step forward in the creation of a
more rational and equitable structure of reserve requirements.
Yet, much more remains to be done.
One of the principal steps needed is to apply equivalent
reserve requirements to member and nonmember banks. At
present, nonmember banks are not required to hold reserves in
the form of deposits at the Federal Reserve Banks, as member
banks do.
In many states, percentage reserve requirements for non­
member banks are comparable to those for Federal Reserve
members. However, the reserves required of nonmember banks
usually may be carried as correspondent balances, or even in
the form of government securities. When reserves are held as
correspondent balances at a member bank, that bank is of course
required to support these balances with reserves that consist
either of vault cash or cash at the Federal Reserve. But in such
a case the size of the cash reserve held by the member bank is
quite small relative to the initial deposit at the nonmember bank.
The consequence of these differential reserve requirements
is that shifts of deposits between member and nonmember banks
alter the quantity of deposits at all commercial banks that can be
supported by a given volume of bank reserves. Thus, the links
between bank reserves, on the one hand, and bank credit and
the money supply, on the other, are loosened, and the Federal
Reserve's control over the monetary aggregates becomes less
precise than it can or should be.
The magnitude of this problem is difficult to assess, since
nonmember banks submit statistical reports to supervisory au­
thorities infrequently. Annual data, however, suggest a sub­
stantial variability in the relative growth rates of member and
nonmember banks. Over the past decade, increases in the volume
of checking deposits at nonmember banks accounted for around
40 percent of the total rise in checking deposits. But the pro­
portion was as low as one-tenth in 1962 and as high as threefourths in 1969. Variations of this magnitude add to uncertainty
about the effects of open market operations on bank credit and
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STRUCTURE OF RESERVE REQUIREMENTS

deposits, on the cost and availability of loanable funds, and hence
also on the level of aggregate demand for goods and services.
This source of imprecision in monetary control has become
more worrisome as the proportion of bank deposits held at
member banks has declined. In 1945, 86 percent of total com­
mercial bank deposits was held by member banks. The ratio
had fallen to 80 percent by 1970 and to 78 percent by the end
of last year.
In part, this trend reflects the relatively rapid growth of
population in areas served by nonmember banks, particularly
suburban areas. The major causal factor, however, is the com­
petitive disadvantage that is imposed on member banks by
requiring them to hold reserves against deposits in the form of
vault cash or as deposits at the Federal Reserve. For nonmember
banks, required reserves are, in effect, earning assets even when
they are held as demand balances with other commercial banks,
since these balances normally also serve as a form of payment for
services rendered by city correspondents.
One consequence of this inequity is an incentive for member
banks to withdraw from the Federal Reserve System, or for
newly chartered state banks to avoid Federal Reserve member­
ship. Since 1960, about 700 banks have left the System through
withdrawal or mergers. Just over 100 state-chartered banks
have elected to join the System since 1960; nearly 1,500 others
receiving new charters chose to remain outside the System.
And the trend continues. During 1972, five banks with
deposits of $100 million or more withdrew from Federal Reserve
membership. O f the 212 new commercial banks receiving state
charters last year, only 13 elected Federal Reserve membership.
Over the years, efforts have been made to reduce the com­
petitive disadvantage faced by member banks and thereby make
System membership more attractive. Permission to count vault
cash in meeting reserve requirements clearly improved matters.
The changes made in Regulation D last November were also
helpful, because they reduced reserve requirements against
demand deposits— particularly for small member banks that
compete actively with nonmembers. Recently, a seasonal bor­
rowing privilege at the discount window was established for
member banks that have insufficient access to the national money
markets. This, too, should make membership more attractive.




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REFLECTIONS OF AN ECONOMIC POLICY MAKER

Nevertheless, there are limits to measures of this kind that can
be taken under existing legislation.
The erosion of membership in the Federal Reserve System
is therefore a serious problem. It reduces the precision of mone­
tary control, as I have already noted. It may, in time, also weaken
public confidence in the nation's central bank and in its ability
to maintain a stable currency and a sound banking system. And
it has already reduced the potential for using changes in reserve
requirements as an effective instrument of monetary policy.
When a large and increasing proportion of total bank deposits
is left untouched by changes in the reserve requirements pre­
scribed by the Board, that alone is a fact of some significance.
The greater loss, however, arises because the Board must use
changes in reserve requirements sparingly as an instrument of
monetary policy, since an increase in required reserves would
worsen the competitive disadvantage of member banks and
thereby threaten a further erosion of membership.
This inhibition has been unfortunate, for there have been
times when the prompt and pervasive impact of a higher reserve
requirement would have been the best way to signal that mone­
tary policy is moving toward added restraint on the availability
of money and credit. In view of the divergence in reserve require­
ments between member and nonmember banks, the Federal Re­
serve has sometimes had to turn to other, perhaps less effective,
measures to achieve its objectives.
These considerations argue persuasively, I believe, that
reserve requirements on demand deposits at nonmember banks
should be the same as those faced by Federal Reserve members.
Continuation of the present state of affairs is inequitable, and
it also weakens monetary control. These difficulties will become
more acute in the years to come if corrective legislative action
is not forthcoming.
The proposal to treat member and nonmember banks alike
for reserve purposes is not new. Its substance was embodied in
the recommendations of a congressional committee chaired by
Senator Douglas in 1950, repeated in 1952 in the recommenda­
tions of a congressional committee chaired by Congressman
Patman, endorsed by the Commission on Money and Credit in
1961, reaffirmed by the President's Committee on Financial
Institutions in 1963, and restated again in the 1971 report of the
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STRUCTURE OF RESERVE REQUIREMENTS

President's Commission on Financial Structure and Regulation.
Since 1964, the Federal Reserve Board has repeatedly urged the
Congress to bring all insured commercial banks under the same
reserve requirements, and to provide all these banks with equal
access to the discount window.
I am aware that this proposal is not viewed with favor by
many segments of the banking community, and that is the
major reason why this needed reform has been delayed. The
proposal would be more palatable to bankers if some part of the
Board's reserve requirement against demand deposits could be
held in the form of an earning asset, such as U.S. Government
securities. I do not want to rule out that possibility categorically.
Simple honesty, however, compels me to state that, however
attractive reserve requirements in that form may be from the
standpoint of bank earnings, they cannot serve a useful function
in monetary management. As I noted earlier, satisfactory con­
trol over the supply of money and credit requires that bank
reserves be held in the form of assets whose aggregate volume
is directly controlled by the Federal Reserve.
The principle that underlies the Board's recommendation
is simple and straightforward— namely, that equivalent reserve
requirements should apply to all deposits that effectively serve
as a part of the public's money balances. Recent efforts of nonbank depositary institutions to evolve new modes of money
transfer make adoption of this principle a matter of some
urgency. If legislative action is delayed, we may soon find a
much larger share of money transfers taking place at institutions
outside the reach of the Board's reserve requirements.
As you know, participation in third-party transfers by non­
bank financial institutions has already commenced. In Massa­
chusetts and New Hampshire, mutual savings banks have begun
to offer depositors an interest-bearing account subject to a
negotiable order of withdrawal— a "N O W account"— that re­
sembles closely an interest-bearing checking account. In Cali­
fornia, savings and loan associations are seeking direct access
to an electronic money transfer system operated by California
banks. Access to the system would enable these associations to
charge and credit the savings accounts of their customers in much
the same way that checking deposits are handled at commercial




341

REFLECTIONS OF AN ECONOMIC POLICY MAKER

banks. Other forms of third-party transfers are likely to spring
up here and there.
The Board believes, and has so indicated in testimony to
the Congress, that federal regulation should permit developments
such as these to flourish, so that the range of services of de­
positary institutions to American families may be extended. The
Board believes, however, that present trends could have signifi­
cant adverse effects on monetary control unless reserve require­
ments established by the Federal Reserve are applied to all
deposit accounts involving money transfer services. Failure to
do so would also have damaging effects on competitive relations
between commercial banks and nonbank thrift institutions.
Universal application of reserve requirements to all deposits
providing money transfer services need not mean a uniform
percentage requirement on all these deposits. There may be a
reasonable basis for lower reserve requirements on savings
accounts with third-party transfer privileges than for deposits
that carry full checking account powers. There may also be a
reasonable basis for retaining the principle of reserve require­
ments graduated by size of the depositary institution. Lack of
uniformity of reserve requirements on similar deposits does,
however, pose potential problems for monetary control.
There are other aspects of present reserve requirements that
also deserve careful and continuing review in the light of our
evolving financial structure.
The appropriateness of reserve requirements on commercial
bank time and savings deposits has been a subject of debate over
the years. It has been argued that cash reserves against time
deposits are not essential for purposes of monetary control, and
therefore should be abolished as an unnecessary impediment to
intermediation. Yet, some observers take the position that re­
serve requirements for commercial bank time deposits should
be increased to the same level as the requirements for demand
deposits, so that shifts of funds between the two deposit classes
would not alter the relation of bank reserves to bank credit and
the money supply.
The merits of these conflicting arguments are difficult to
evaluate. At present, there is no convincing evidence of frequent,
or large-scale, shifts of funds between demand and time deposits
of the sort that could be disruptive to financial markets and to
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STRUCTURE OF RESERVE REQUIREMENTS

the management of aggregate demand. Still, the potential for
such shifts may be increasing with the proliferation of new
financial services that facilitate transfers from one type of deposit
to another.
Removal of reserve requirements against time deposits
would, therefore, seem unwise at this time. And in any event,
elimination of statutory authority to impose reserve requirements
against time and savings deposits would take away a weapon of
monetary policy that is potentially useful for containing increases
in bank credit at a time when inflationary pressures are already
strong and threaten to become still stronger.
As long as commercial banks are required to hold cash
reserves against time and savings deposits, questions will persist
about the desirability of similar requirements against savings
accounts at nonbank thrift institutions. At present, extension of
reserve requirements to savings accounts at nonbank inter­
mediaries does not appear to be needed for reasons of monetary
control. There have been times when shifts of funds between
banks and nonbank intermediaries have had a disturbing influ­
ence on the mortgage market. But those shifts have not produced
serious problems for monetary control, and they would not have
been prevented by comparable reserve requirements at the two
classes of institutions.
From the viewpoint of equity, the case for equal reserve
requirements on time and savings deposits at all financial insti­
tutions is stronger. Even on this ground, however, it should be
kept in mind that the diversified services that commercial banks
offer their customers give them an advantage in bidding for
time and savings deposits— an advantage that probably still
remains after the costs of holding cash reserves are taken into
account.
However, if recent trends continue, the increasing provision
of money transfer services by nonbank thrift institutions will
blur the distinction between commercial banks and nonbank
intermediaries, just as it blurs the distinction between checking
and savings accounts. As nonbank depositary institutions be­
come more like commercial banks, the basis for differences in
reserve requirements will be weakened and so too will the
justification for differences in tax and regulatory treatment.
Public policy must take account of the competitive forces




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REFLECTIONS OF AN ECONOMIC POLICY MAKER

that are altering the structure of our nation's depositary insti­
tutions and the character of the services they supply. The need
for legislation authorizing identical reserve requirements on
demand deposits at member and nonmember banks is of long
standing. The time for bringing NOW accounts and any other
deposits offering money transfer services under the Board's
reserve requirements is clearly at hand. And if the distinctions
between commercial banks and nonbank financial institutions
gradually fade away, regulatory authority to equalize the treat­
ment of time and savings deposits for reserve purposes will also
be needed.
Enabling legislation to accomplish these ends should allow
flexibility in implementation. The transition to a new and more
appropriate system of reserve requirements should be designed
so as to minimize the adjustment problems of individual insti­
tutions, and also permit the regulatory authorities to monitor
the effects of changing reserve requirements on financial markets
and on economic activity. Abrupt changes in the structure of
reserve requirements are unnecessary and would probably be
unwise. The need, as I see it, is for a gradual transition to a
reserve structure that will accomplish two objectives: first, ensure
adequate control over the supply of money and credit in the
years to come, and second, establish an equitable sharing among
financial institutions of the costs of monetary control.

344



Objectives and Responsibilities of
the Federal Reserve System

It is a great pleasure to join you here today at the opening
ceremonies of the Federal Reserve building that now graces the
Twin Cities. The beautiful new home of your Federal Reserve
Bank, with its truly unique architectural design, is the physical
expression of the hopes and dreams of many people.
The directors of the Federal Reserve Bank of Minneapolis
were looking to the future when they chose the site for this
building. They had the courage and vision to make this new
facility an integral part of the Gateway Redevelopment Area.
In earlier times, the Gateway was known as the entrance to the
vast Western prairies. Today, this Federal Reserve Bank can be
the gateway to a brighter and better economic future for all
Americans.
The business leaders of this great metropolitan area played
a prominent role in the planning and construction of the new
building. Joyce Swan, the former publisher of the Minneapolis
Star and Tribune, was chairman of the board of directors of this
Reserve Bank through 1968. In that capacity, he directed the
early planning for the building. The late Robert Leach, a highly
respected St. Paul attorney, succeeded Mr. Swan as chairman
of the board, serving the Federal Reserve from early 1969 until
his untimely death in December 1970. The present chairman,
David Lilly, played a substantial role in bringing the project to
completion.
Address at the Federal Reserve Bank of Minneapolis, Minneapolis, Minne­
sota, September 8, 1973.




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REFLECTIONS OF AN ECONOMIC POLICY MAKER

The man chiefly responsible for the new building, however,
is the late Hugh Galusha, the former president of this bank,
whose career was cut short by a tragic accident in 1971. Hugh
Galusha was a most remarkable man. He had the inquiring
mind of a scientist, and at the same time the spirit of the
frontiersman. He was venturesome, bold, joyous, and imagina­
tive. He was not afraid of newness and challenge, as the unique
structure to which he devoted so much of his energy indicates.
His fine judgment led to the selection of the architect for the
building— Gunnar Birkerts— and to the approval of its unusual
design. He convinced skeptics at the Federal Reserve Board of
the wisdom of his plan, and he did so in a gentle but persuasive
manner.
Over the years, the Federal Reserve System has been for­
tunate in attracting outstanding men like Hugh Galusha— and his
successor Bruce MacLaury— to devote their lives to public service
at the central bank. The reason for this lies in the character of
the Federal Reserve System and the vital role it plays in national
economic policy.
The Federal Reserve was endowed by legislative mandate
with a substantial degree of independence within government.
Freedom from the daily pressures of the political process has
given the Federal Reserve the opportunity to make the hard
choices that continually confront those who are responsible for
economic and financial policies. Over the years, the Congress has
significantly enlarged the duties and responsibilities of the
Federal Reserve System. The stature of our central bank has
therefore grown within the counsels of government and in the
minds of our people. Nowadays, the people of America expect
the Federal Reserve to use its great powers to thwart— or at
least to moderate— business recessions, and they also look to
the Federal Reserve as the ultimate defender of the purchasing
power of their currency.
To earn the confidence of the American people, the mem­
bers of the Federal Reserve family have observed rules of con­
duct such as animate our great universities and our courts of
justice. We have sought to foster a spirit of freedom and objec­
tive inquiry in the field of economic analysis. Our staff in
Washington and the staffs of the individual Reserve Banks are
encouraged to analyze economic and financial problems in the
346



OBJECTIVES OF THE FEDERAL RESERVE SYSTEM

spirit of science and to express their findings freely. The direc­
tors of our Reserve Banks, who are drawn from every region
and practically every branch of business in our country, provide
a constant stream of up-to-date information on business and
financial developments. When the presidents of the individual
Reserve Banks meet with the Federal Reserve Board, as they do
at very frequent intervals in our nation's capital, they have at
their disposal a system of economic intelligence that cannot be
matched by any organization or agency in our country or, for
that matter, anywhere else in the world.
Concern for the general welfare, moral integrity, respect
for tested knowledge, independence of thought— these are the
basic assets of the Federal Reserve. They are the foundation on
which our nation's monetary policy is constructed.
The Federal Reserve must, of course, account for its
stewardship to the Congress and to the general public. We do so
through news releases, publications, public addresses, and testi­
mony before congressional committees. The information that
our central bank discloses about its myriad activities vastly
exceeds, both in promptness and detail, that of any other central
bank. We do, of course, withhold for a time information that
could cause embarrassment to a foreign government or that
might enable the more alert members of the financial community
to gain an early and unfair advantage over other citizens by
becoming privy to the precise plans that the Federal Reserve has
set in motion. Even here, once the need for delay in reporting
has passed, full disclosure is made by the Federal Reserve, so
that the Congress and the interested public may be in a position
to appraise the System's policies and actions, and so that we
ourselves may benefit from outside review and criticism.
It is precisely because of its openness and impartiality that
the Congress has resisted occasional demands to bring the
Federal Reserve under this or that administrative branch of the
federal government. Both the Congress and the informed public
have perceived the great damage that could be done to our
nation's prosperity by weakening the independent voice of the
Federal Reserve within our government. This sentiment, I
believe, has been shared by every president since Woodrow
Wilson's time, although the fervor of our presidents for the
independence of the Federal Reserve may at times have been




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REFLECTIONS OF AN ECONOMIC POLICY MAKER

greater upon leaving office than when they themselves were still
wrestling with the nation's economic problems.
Monetary policy in this country carries a heavy burden of
responsibility for the maintenance of economic stability. Actu­
ally, our nation sometimes expects more from the Federal Re­
serve than we can reasonably expect to accomplish, in view of
the imperfect tools with which we work and the complex prob­
lems that our nation faces.
During the past decade, our nation has generally experi­
enced prosperity, but the prosperity has been marred for many
of our people by persistent and rapid inflation. Many factors
are responsible for this unhappy development— among them, a
protracted and unpopular war, and abuses of market power by
some of our business firms and trade unions. But I believe that
the most important underlying cause has been the looseness
of our federal fiscal policies. Federal spending has been rising
with disconcerting speed during the past decade. Despite the
costly war in Vietnam, new governmental programs have been
enacted at a dizzy pace, almost without regard to their cost or
to the state of public revenues.
Deficits have therefore mounted in both good years and
bad. In fiscal 1965, a year of rapidly advancing prosperity,
the federal deficit came to $1.6 billion. In fiscal 1973, a simi­
larly prosperous year, the deficit amounted to $14.4 billion. In
three of the past six years, the deficit came close to— or actually
reached— $25 billion. Nor do even these figures tell the full
story of how much federal money has been paid out to the
public beyond what the government collected in taxes. Govemmentally sponsored corporations, such as the Federal National
Mortgage Association and the Federal Home Loan Banks, have
also gone heavily into debt and poured out additional billions
that are excluded from the budgetary totals. In the fiscal year
just ended, the net borrowing by federally sponsored agencies
exceeded $11 billion.
The continuance of large federal deficits at a time of rapid
resurgence of the economy has inevitably stimulated private
spending and aggravated upward pressures on the level of
prices. In fact, our economy is suffering at present from
stronger inflationary pressures than at any time since the out348



OBJECTIVES OF THE FEDERAL RESERVE SYSTEM

break of the Korean War. Prices have risen sharply since the
beginning of this year, and they are continuing to rise.
In view of the huge expansion in production and employ­
ment that we have experienced during the past year, it would
have been difficult to avoid an appreciable upward movement
of the price level even with a balanced federal budget. But as
the Fates would have it, several unusual factors combined to
impart a new dimension to our inflationary problem this year.
First, the devaluation of the dollar not only resulted in higher
prices of imported goods; it also affected our price level by
leading to some substitution of domestic for foreign products
and by imparting a sharp impetus to foreign demand for our
products. Second, our economic expansion has been accom­
panied by rapid expansion in virtually every other industrial
country. The worldwide demand for capital equipment and
industrial materials— goods for which the United States is a
major supplier— has therefore burgeoned. Third, our current
ability to expand output of basic industrial materials is nar­
rowly limited— in large part because investment by producers
of key materials has been held back in recent years by unsatis­
factory profits and new environmental controls. Fourth, bad
weather in a number of countries severely restricted agricultural
production last year— at the very time when the demand for
foodstuffs was rising rapidly in response to the worldwide
expansion of incomes and employment. The concatenation of
these special factors has played a decisive role in driving up
prices this year.
The inflationary problem we are dealing with today is
therefore quite complex, and we must be prepared for a further
rise in prices in the months ahead. The resulting damage can
be minimized, however, if aggregate monetary demand is re­
strained. The inflationary forces that now plague us will then
have a better chance to burn themselves out.
The Federal Reserve is pursuing a course of monetary
policy that is designed to minimize the threat of excess demand
by restricting the growth of the monetary and credit aggregates.
Monetary policy began to move in this direction in the spring
of 1972, but at a pace that may appear in retrospect to have
been too gradual. In any event, restrictive actions have multi­
plied both in frequency and impact in recent months. By now,




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REFLECTIONS OF AN ECONOMIC POLICY MAKER

even skeptics in the financial community should be convinced
that the Federal Reserve will not flinch in its determination to
moderate substantially the pace at which money and credit
supplies have been expanding.
A restrictive monetary policy cannot be carried out with­
out causing difficulty for some business firms or households
that seek additional credit. The homebuilding industry, in par­
ticular, is very sensitive to the level of interest rates and the
availability of mortgage money. In view of the outflow of
funds from thrift institutions into higher yielding market in­
struments, mortgage commitments have been diminishing and
this is bound to affect homebuilding adversely in the months
immediately ahead.
Early in 1970, anticipating precisely the kind of develop­
ment that is now under way in the housing field, the Federal
Reserve Board undertook a comprehensive study of the ways
in which the chronic fluctuations of housing construction may
best be moderated. Two years later, in March 1972, the Board
presented its report to the Congress. The Board's recommen­
dations for legislative action deserve more careful consideration
than they have yet received. If the needed reforms come too
late to help in the present difficulty, they can still serve the
larger purpose of stabilizing housing finance over the long
future. Meanwhile, the several housing agencies, which have
been softening the impact of credit shortages on homebuilding
activity, are in a position to continue to do so. And the Federal
Reserve System, as the lender of last resort, will, of course,
honor its obligation to provide emergency credit in the event
of need. I might add that it appears unlikely that such a need
will arise.
The time will surely come when monetary policy can again
be less restrictive, but that time has not yet arrived. At present,
there is no real alternative to a restrictive monetary policy. To
be sure, if we permitted money and credit to expand at a more
rapid pace, short-term interest rates would decline for a brief
period. But in so doing we would be adding fuel to the infla­
tionary fires now raging. Before very long, interest rates would
rise again, and probably well beyond their present level, as both
lenders and borrowers adjusted to the quickened pace of infla350



OBJECTIVES OF THE FEDERAL RESERVE SYSTEM

tion. The simple and inescapable truth is that inflation and
high nominal interest rates go together.
The Federal Reserve must therefore persevere in its present
policy. Fortunately, there are some signs that our efforts are
bearing fruit. For example, the narrowly defined money supply
— that is, currency plus demand deposits— grew at an annual
rate of 6 percent during the first half of 1973, compared with
a growth rate of 7 1 percent during 1972. In recent weeks, the
/2
growth rate has slowed further. During July and August, the
money stock rose at an annual rate of only about 2 percent.
These signs of better control over the growth of the money
supply are encouraging, but the Federal Reserve will need more
convincing evidence on moderation of the monetary and credit
aggregates before it can responsibly relax its pressure on the
monetary brake.
O f late, there have also been encouraging developments
with respect to our international balance of payments. Our
competitive position in world markets has dramatically im­
proved over the past year, and the deficit in our trade accounts
that was for some time a source of great concern has now all
but vanished. In fact, we enjoyed a modest trade surplus in the
month of July, and the outlook for our exports continues to be
very promising. These developments have not gone unnoticed
in the financial world, and the dollar has strengthened markedly
in recent weeks in foreign exchange markets. Intervention in
these markets by the Federal Reserve has helped to bring about
this turn in the dollar's value. However, a more basic factor
in the recent improvement in the value of the dollar relative to
other currencies is the increasing recognition abroad that the
American people are determined to bring inflation under control
and that they will support any reasonable policy that promotes
this objective.
Governmental efforts to stabilize the general price level
must therefore persist until the forces of inflation are fully
dissipated. Since direct controls over wages and prices in the
present environment can provide only limited benefits, primary
reliance in this struggle must be placed on monetary and fiscal
policies.
Clearly, monetary policy must play a major role in the
fight against inflation, but we should not expose the economy




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REFLECTIONS OF AN ECONOMIC POLICY MAKER

to unnecessary risks by overburdening this tool of policy.
Additional restraint through fiscal policy, in the form of reduced
government spending or increased taxes, would be helpful even
now. Particularly appropriate would be fiscal measures that
could be quickly reversed if economic activity began to weaken,
as sometimes happens after a prolonged period of economic
expansion.
We also need to improve our instruments of monetary
policy to gain better control over the monetary aggregates.
More precise management of money and credit supplies could
be achieved if the reserve requirements that apply to demand
deposits of Federal Reserve member banks were extended to all
commercial banks.
The present limitation of the reserve requirements imposed
by the Federal Reserve to the System's member banks, apart
from being inequitable, weakens monetary control. All demand
deposits are a part of the nation's money supply, and they
should be treated equally from the standpoint of reserve re­
quirements. The difficulties already imposed on monetary policy
as a result of the unequal treatment of demand deposits at
member and nonmember banks will become more acute in the
years ahead in the absence of corrective legislation. The Federal
Reserve Board must therefore urge the Congress to give this
problem its earnest consideration. The solution that we shall
propose will not infringe in any significant way on our dual
banking system, and yet it will enable the monetary authority
to achieve more precise control over the monetary aggregates.
I need hardly say, in closing my remarks, that there is
much unfinished business to attend to in our struggle to control
inflation, to manage the nation's money supply, to stabilize
housing construction, and to deal with a host of other economic
and financial problems. I am optimistic, however, about the
future of our nation's economy. Progress in moving toward
equilibrium in our international payments accounts has been
encouraging. So also has the recent evidence of moderation in
the growth of monetary aggregates. And agricultural produc­
tion in this region of our nation and elsewhere is now on the
increase, offering hope that food supplies will soon be more
plentiful.
The principal source of my optimism, however, lies not in
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OBJECTIVES OF THE FEDERAL RESERVE SYSTEM

these general indicators of progress in dealing with economic
and financial problems, but in my faith in our nation and its
good people. Our country has been blessed with rich natural
resources and our people have been endowed with the vision
and energy to strive for a better life. Let us dedicate the new
Federal Reserve building today to the brighter future that is
the hope and dream of every American.




353




Maintaining the Soundness of
Our Banking System

This year, for the first time in decades, questions have been
raised about the strength of our nation's, and indeed the
world's, banking system. It is profoundly disturbing to me, as
indeed it must be to all of you, that such questions should be
raised.
Over the past century or longer, the American people
have repeatedly demonstrated their determination to have a
sound system of banking, and they have been willing to take
whatever steps are necessary to assure it. The central role now
played by American banks in international trade and finance
imparts a new and global dimension to the need for confidence
in our banking system. This international responsibility is
made all the more compelling by the sudden and massive flows
of funds to and from the oil-exporting countries. It is clearly
of vital importance for the United States and the rest of the
world that our commercial banks continue to measure up to
the heavy obligation of financial stewardship now placed upon
them.
In the past year, we have had the two largest bank failures
in the nation's history. This fact has been widely noticed, as it
deserves to be. But it is equally important to recognize that
these failures did not cause any loss to depositors. Nor did they
have serious repercussions on other banks or businesses. The
ability of our financial system to absorb such shocks reflects
Address at the 1974 American Bankers Association Convention, Honolulu,
Hawaii, October 21, 1974.




355

REFLECTIONS OF AN ECONOMIC POLICY MAKER

credit on the safeguards that Congress has developed in re­
sponse to past experience.
One crucial element of our banking strength is federal
insurance of deposits. Another major source of banking strength
is the Federal Reserve System's ability and willingness to come
promptly to the assistance of banks facing a temporary liquidity
squeeze. The financial world understands that our banking
system can be and will be supplied with funds in whatever
amount is necessary to forestall a credit crunch.
Nonetheless, it is important to ask why, for the first time
since the Great Depression, the availability of liquidity from
the central bank has become such an essential ingredient in
maintaining confidence in the commercial banking system. The
economy is operating at a reduced, but still very high, level.
Bank profits are generally satisfactory. There is no danger of
withdrawal of deposits for purposes of hoarding. Very few of
our banks should need to count on federal support in circum­
stances such as these. It is in order, therefore, to take a close
look at recent trends in banking.
Commercial banking has been undergoing a profound evo­
lution for well over a decade. The focus of bank management
still embraces the traditional fiduciary responsibilities, but goals
of profitability and growth have been receiving more and more
attention. The recruitment and promotion policies of many
banks nowadays emphasize entrepreneurial talent. Their in­
ternal controls are elaborately designed to weed out inefficient
operations, and to stress the profits being generated by indi­
vidual departments. Innovation has become one of the prime
attributes of the pace-setting banks, and competition has sharp­
ened appreciably in the process.
In seeking growth and profitability in an increasingly com­
petitive environment, banks have generally succeeded in meeting
the needs of their business customers more effectively. Deposit
instruments have been tailored to meet the special needs of
customers. New types of lending arrangements to serve business
and institutional borrowers have proliferated. The capability
of banks to assist their customers in financial management has
also come to include "off balance-sheet" activities, such as
bookkeeping, data processing, and financial advisory services.
And as regional banks have entered national markets for loans
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MAINTAINING SOUNDNESS OF BANKING

and deposits, while local banks kept entering regional markets,
the banking alternatives available to business firms have multi­
plied and the nation's money and credit markets have become
more closely integrated.
For many years now, banks have been cultivating aggres­
sively the area of consumer finance. Besides competing inten­
sively for consumer deposits, they have been promoting install­
ment credit and increasing home mortgage lending. Where
possible, banks have expanded their branch networks to facili­
tate the quest for consumer business, and the result has been
a dramatic increase in the number of banking offices relative to
the nation's population.
The larger banking organizations have also been driving
hard to acquire foreign business— by soliciting deposits, making
loans, and conducting other financial activities through their
foreign branches or subsidiaries. Foreign exchange operations
have assumed a larger dimension in the workaday world of
banking, and this activity accelerated once exchange rates were
allowed to float and forward markets became essential for the
conduct of international business.
The quest for profits and growth has led, moreover, to sub­
stantial changes in the structure of the banking system. Bank
mergers and acquisitions of individual banks by multi-bank
holding companies have resulted in consolidation of small units
into larger organizations, which have often added financial
strength to individual banks and enabled them to provide a
broader range of services.
Nor is that all. One of the most notable manifestations of
the drive for profits and growth has been the development of
diversified bank-holding companies. These organizations now
extend substantial amounts of credit through subsidiaries en­
gaged in mortgage banking, factoring, consumer finance, leasing,
and other specialized activities. Many smaller firms in these
lines of activity have been rejuvenated through acquisition by
bank-holding companies. D e novo entry into these lines of
activity has also been widespread, thereby leading to more
vigorous competition. And since the nonbank subsidiaries of
bank-holding companies enjoy the privilege of multistate opera­
tion, the growth of their activities has played an important role
in the process of knitting together the nation's credit markets.




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REFLECTIONS OF AN ECONOMIC POLICY MAKER

Clearly, the far-flung changes I have been describing have
served the public in many ways. There is, however, another side
of the ledger. The very forces that have produced innovative,
highly competitive banking have also led to some trends that
go far to explain the uneasiness that so concerns us in 1974.
The most significant of these trends are, first, the attenuation of
the banking system's base of equity capital; second, greater
reliance on funds of a potentially volatile character; third, heavy
loan commitments in relation to resources; fourth, some deterio­
ration in the quality of assets; and fifth, increased exposure of
the larger banks to risks entailed in foreign exchange trans­
actions and other foreign operations. These developments have
increased the vulnerability of individual banks.
The first of these trends— the attenuation of the equity
capital base— is directly traceable to the recent rapid expansion
of the banking system. In the years immediately following
World War II, commercial banks were able to accommodate
increases in loan demand mainly by reducing the portfolios
of government securities accumulated during the war. Com­
mercial bank deposits therefore failed to keep pace with the
growth of the national economy. But by the early 1960s, as
loan-deposit ratios kept rising and competition became keener,
a faster rate of growth became necessary to enable banks to
expand further their lending activities. Thus, during the decade
ending in 1970, total assets of commercial banks increased at
an average annual rate of 9 percent, in contrast to a 7 percent
rate of growth in the dollar value of our gross national product.
Then, during 1971-1973, banking assets grew more than
15 percent per year. To some extent this faster growth was
linked to the pace of inflation. But banking assets increased
more than three times as fast as the price level, and about half
again as fast as nominal GNP, which itself reflects the impact
of inflation. To a large extent, therefore, the phenomenal pace
of recent bank expansion reflects neither price level changes nor
real economic growth, but an expansion of banking's share of
total financing business, both at home and abroad.
Banks provided over half of total new financing during
1971-1973 in several key domestic areas, including the markets
for consumer installment debt, corporate debt other than mort­
gages, and debt of state and local governments. Expansion in
358



MAINTAINING SOUNDNESS OF BANKING

foreign markets has been even more dramatic. During these
three years the assets of foreign branches and subsidiaries of
American banks nearly tripled, reaching $117 billion. In fact,
expansion abroad accounted for more than one-fifth of the
growth in total assets of the U.S. commercial banking system
during this period.
The diversified bank-holding company has also become an
important instrument of growth for a relatively small number
of banking organizations. Major banks or bank-holding com­
panies now account for over half of the factoring business, a
major portion of mortgage banking, and a significant part of
consumer finance and leasing.
And so I now come to my point, namely, that this enor­
mous upsurge in banking assets has far outstripped the growth
of bank capital. At the end of 1960, equity capital plus loan
loss and valuation reserves amounted to almost 9 percent of
total bank assets. By the end of 1973, this equity capital ratio
had fallen to about 6V2 percent. Furthermore, the equity capital
of banks has been leveraged in some cases at the holding com­
pany level, as parent holding companies have increased their
equity investments in subsidiary banks by using funds raised
in the debt markets. Thus, the capital cushion that plays
such a large role in maintaining confidence in banks has be­
come thinner, particularly in some of our largest banking or­
ganizations.
It has been no simple feat for banks to grow so rapidly.
A key tool of management in the drive for expansion has been
a shift in emphasis from managing assets to managing liabilities.
This is the second of the recent trends that I mentioned earlier.
Liability management requires tapping of external sources
for liquidity— that is, borrowing funds as needed to meet the
demand for loans from present customers, to accommodate new
borrowers, or to adjust to reserve drains. Asset management,
by way of contrast, involves adjusting liquid assets in response
to changes in the volume of deposits or loan demand.
The development of liability management has led the
larger banks to operate on the premise that, within wide limits,
additional funds can be acquired at any time as long as the
market rate of interest is met. The presumed ability to acquire
whatever funds might be needed has encouraged banks to seek




359

REFLECTIONS OF AN ECONOMIC POLICY MAKER

new channels for profitable investment; it has also reduced
incentives to maintain the liquidity of their assets. Recent
experience has demonstrated, however, what banking prudence
itself should have dictated; namely, that the funds on which
liability management depends can be quite volatile, especially
if the maturities are short, and that banks may therefore have
to wrestle with uncomfortable— even though they be temporary
— liquidity problems.
The shift to liability management has occurred on a vast
scale. During the 1950s, commercial banks obtained the major
portion of their new funds from increases in demand deposits or
equity capital. In more recent years, on the other hand, about
two-thirds of the new money raised by domestic offices of our
banks has come from interest-bearing time accounts or nonde­
posit liabilities. Once the concept of liability management took
hold, banks developed great ingenuity in tapping the markets
for interest-sensitive funds.
Although the beginnings of modern liability management
can be traced to the rejuvenation of the federal funds market in
the 1950s, the major breakthrough came with the introduction of
large negotiable certificates of deposit in early 1961. Private
holdings of negotiable CDs now exceed those of any other
money market instrument, including Treasury bills. Large, but
non-negotiable, time deposits have also figured significantly in
liability management. Commercial paper has become another
vehicle of liability management; some bank-holding companies
rely on it heavily to finance their nonbank subsidiaries. Still
another method by which banks have attracted interest-sensitive
funds is by borrowing Eurodollars from their foreign branches
for use in domestic banking.
Taken together, these several types of interest-sensitive
funds have assumed huge proportions. Not only have they be­
come the principal means of financing expansion at many of our
larger banking organizations, but the apparent efficiency of lia­
bility management has tempted banks to make advance com­
mitments of funds on a generous scale. This is the third of the
recent trends in banking that I previously mentioned.
Beyond question, loan commitments have a legitimate place
in the array of services offered by banks. But they should be
made with caution, since they constitute a call on bank resources
360




MAINTAINING SOUNDNESS OF BANKING

that can be exercised at an awkward time. This fact has been
driven home in recent months as banks were being called upon
with increasing frequency to meet their commitments. Excessive
commitments have raised problems for some thoroughly sound
banks, and they also have complicated the Federal Reserve's
efforts to bring aggregate demand for goods and services under
control.
A fourth disturbing trend has been a deterioration, albeit
moderate as a rule, in the quality of bank assets. During recent
years, as the role of credit in financing private spending in­
creased and as interest rates rose, the debt service requirements
of business borrowers have generally grown more rapidly than
their incomes, and the additional debt has resulted in a rise of
debt-equity ratios. These changes accompanied the efforts of
commercial banks to assume a higher proportion of the lending
done in the country. It should not be surprising, therefore, to
find some tendency toward deterioration in the quality of bank
assets.
Finally, both in this country and abroad, the freeing-up of
exchange rates has made dealing in foreign currencies both
tempting and risky. Not a few conservative bankers who pre­
viously had a strong preference for stable exchange rates sud­
denly discovered that floating exchange rates offered a new op­
portunity for profit, and some went at it with more enthusiasm
than awareness of the risks involved. The large losses that a
number of banks in Europe and the United States have experi­
enced as a result of excessive trading or unauthorized specula­
tion in foreign currencies have not only caused embarrassment
to these banks; they also have tarnished the reputation of the
banking profession.
The confluence of the closely related trends I have just
discussed— declining capital ratios, aggressive liability manage­
ment, generous commitment policies, deterioration of asset
quality, and excessive foreign exchange operations by some
banks— explains much of the recent uneasiness about banking.
Clear understanding of the current situation requires recognition
of the interrelated effects of these banking practices on the state
of confidence. An increase in doubtful loans is of consequence
because it raises questions about bank solvency. Maintenance of
solvency is closely linked, of course, to the adequacy of capital




361

REFLECTIONS OF AN ECONOMIC POLICY MAKER

and reserves for losses. Similarly, heavy reliance on potentially
volatile funds is not dangerous per se; it is dangerous only in
proportion to doubts about ability to repay the borrowed money.
Such doubts can undercut the basic premise of liability manage­
ment— that needed funds can be raised as required from short­
term sources. Extensive loan commitments are dangerous only
when too many takedowns occur at the wrong time. And losses
on foreign currency transactions have serious implications for
the public only to the extent that they bulk large relative to the
basic strength of the banks that experience them.
The developments I have sketched are in large part an out­
growth of the overheating experienced by our economy since the
mid-sixties. This was also a period in which corporate profits
failed to keep pace with expanding business activities. During
the past year, in particular, the demand for business loans grew
with extraordinary rapidity, as more and more corporations
found it necessary to borrow heavily and to do so increasingly
through the banking system. To a significant degree, many
banks— especially the larger banks— have met the recent credit
needs of hard-pressed sectors of the business community with
a fine sense of public responsibility. But that is by no means the
full story. Some carelessness also crept into our banking system,
as usually happens in a time of rapid inflation, and that is why I
have commented at such length on several disturbing trends in
modern banking.
Even so, only a very small number of banks can be justly
described as being in trouble. Despite all the strains recently
experienced in credit markets, the banking system remains
strong and sound. There is no reason to doubt the ability of our
banks to meet their commitments, even in these trying times.
But while faith in our banks is fully justified, it now rests unduly
on the fact that troubled banks can turn to a governmental
lender of last resort.
It goes without saying that the discount facility is available
for use and that it should be used when necessary; but the bank­
ing system's strength should not depend heavily on it. In our
free enterprise system, the basic strength of the banking sys­
tem should rest on the resources of individual banks. I believe
that bankers generally support this principle, and that their
policies are already reflecting renewed respect for it.
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MAINTAINING SOUNDNESS OF BANKING

It is not sufficient, however, to rely on a rethinking by
bankers of their goals and responsibilities. This country, like
others, depends on public regulation as well as private vigilance
to assure the soundness of its banking system. While the pro­
found changes that I have described were taking place, our bank
regulatory system failed to keep pace with the need. To be sure,
there has been a great deal of activity among the regulators. Ex­
aminations of America's 14,000 banks have continued to be
made methodically by the federal supervisory agencies and the
state banking authorities. And hundreds of regulatory decisions
concerning bank mergers, holding company acquisitions, and the
like have been handed down each year by hard-working regula­
tors under federal and state statutes.
But the public attention devoted to adequacy of the safe­
guards provided by the regulatory system has waned appreci­
ably since World War II. The traditionally interested parties—
legislators, bankers, financial analysts, economists, and the bank
regulators themselves— tacitly assumed that the sweeping finan­
cial reforms of the 1930s had laid the problem of soundness and
stability to rest, once and for all. They have therefore concen­
trated on other matters, such as improving bank competition and
adapting the banking system to changing needs for credit.
The stresses and doubts that have characterized recent
financial experience are, however, bringing sharply back into
focus the essential role of regulation and supervision in main­
taining a sound system of banking. The regulatory agencies are
responding to this need. At the Federal Reserve Board, concern
about the adequacy of bank capital has been increasing. Recent
decisions have also reflected a determination to slow down the
expansion of bank-holding companies. As one recent ruling
stated, "The Board believes that these are times when it would
be desirable for bank-holding companies generally to slow their
present rate of expansion and to direct their energies principally
toward strong and efficient operations within their existing
modes, rather than toward expansion into new activities." The
purpose of this pause is not only to encourage— and where neces­
sary enforce— a husbanding of resources, but also to provide a
breathing spell during which both the Board and the banking
industry can give the most serious thought to ways in which




363

REFLECTIONS OF AN ECONOMIC POLICY MAKER

commercial banks and bank-holding companies should develop
in the future.
In this connection, it is well to note the favorable action
by Congress on the legislation requested by the Federal Reserve
for authority to prevent, through cease and desist orders, un­
sound practices by bank-holding companies and their nonbank
subsidiaries. I am glad to say that the banking industry sup­
ported this needed legislation.
A number of specific projects designed to strengthen the
regulatory system are under way at the Board, including estab­
lishment of a new program of reporting and financial analysis
for bank-holding companies, a critical appraisal of the current
approach to bank examination, and concerted efforts to deal
with problems relating to bank capital, bank liquidity, and
foreign exchange operations. Similar projects, I understand, are
under way at the other federal bank supervisory agencies.
I must say to you, however, that I am inclined to think that
the most serious obstacle to improving the regulation and super­
vision of banking is the structure of the regulatory apparatus.
That structure is exceedingly complex. The widely used term
"dual banking system" is misleading.
As you know, each of the fifty states has at least one
agency with responsibilities for supervising and regulating
banks. Some states also have statutes relating to bank-holding
companies. At the federal level, every bank whose deposits are
insured is subject to supervision and regulation, but authority is
fragmented. The comptroller of the currency charters and
supervises national banks. The Federal Reserve System super­
vises state-chartered member banks, regulates activities of Edge
Act corporations, regulates all bank-holding companies, and
controls the reserves and other operating features of all its mem­
ber banks. The Federal Deposit Insurance Corporation insures
nearly all banks, but supervises only state-chartered banks that
are not members of the Federal Reserve. The FDIC also has cer­
tain regulatory powers that apply to insured nonmember banks.
Those of you who have been intimately concerned with
regulatory matters will realize that I have oversimplified, that
our system of parallel and sometimes overlapping regulatory
powers is indeed a jurisdictional tangle that boggles the mind.
There is, however, a still more serious problem. The present
364



MAINTAINING SOUNDNESS OF BANKING

regulatory system fosters what has sometimes been called "com ­
petition in laxity/' Even viewed in the most favorable light, the
present system is conducive to subtle competition among regu­
latory authorities, sometimes to relax constraints, sometimes to
delay corrective measures. I need not explain to bankers the
well-understood fact that regulatory agencies are sometimes
played off against one another. Practically speaking, this sort of
competition may have served a useful purpose for a time in
loosening overly cautious banking restrictions imposed in the
wake of the Great Depression. But at this point, the danger of
continuing as we have in the past should be apparent to all
objective observers.
I recognize that there is apprehension among bankers and
students of regulation concerning overcentralized authority.
Providing for some system of checks and balances is the tradi­
tional way of guarding against arbitrary or capricious exercise
of authority. But this principle need not mean that banks should
continue to be free to choose their regulators. And it certainly
does not mean that we should fail to face up to the difficulties
created by the diffusion of authority and accountability that
characterizes the present regulatory system. On the contrary,
it is incumbent on each of us to address these problems with the
utmost care. For its part, the Federal Reserve is now pushing
forward with its inquiries.
The range of possible solutions is broad. Some will doubt­
less conclude that the proper approach lies in improved coordina­
tion among the multiple bank regulatory agencies, together with
harmonization of divergent banking laws. My own present
thinking, however, is that building upon the existing machinery
may not be sufficient, and that a substantial reorganization will
be required to overcome the problems inherent in the existing
structural arrangement. I have no illusion that reaching agree­
ment on these matters will be easy. But I have found much wis­
dom and a strong sense of responsibility among this nation's
bankers. I therefore earnestly solicit your views. They will re­
ceive full attention as the Board searches for the best path to
progressive but still prudent bank regulation.




365




\

Monetary Targets and
Credit Allocation

The Board of Governors of the Federal Reserve System appre­
ciates the opportunity to comment on H.R. 212. This bill has
far-reaching implications for the workings of our economy. It
raises momentous issues with respect to monetary and credit
policies, the role of the Federal Reserve System, and whether
its traditional insulation from political pressures should continue.
I therefore hope that this committee will take whatever time is
needed to arrive at a full and just understanding of the proposed
legislation.
Section 2 of the proposed bill requests the Federal Reserve
Board and the Federal Open Market Committee to "direct their
efforts in the first half of 1975 toward maintaining an increase
in the money supply (demand deposits and currency outside
banks) of no less than 6 percent at an annual rate, over each
three month period.. . ." This section further requires the Board
and Open Market Committee to report to the House and Senate
Banking committees whenever the money supply deviates from
the specified target for either technical or substantive reasons.
I want to make it clear at the outset that the Board fully
supports the general objective of maintaining adequate growth
of the monetary aggregates. Indeed, the Board and the Open
Market Committee have adopted policies in recent months to
encourage greater expansion in the whole family of monetary
and credit aggregates. The Board is also well aware of its re­
statem ent before the Subcommittee on Domestic M onetary Policy of the
Committee on Banking, Currency, and Housing, House of Representatives,
February 6, 1975.




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REFLECTIONS OF AN ECONOMIC POLICY MAKER

sponsibility to the Congress, and we would welcome the op­
portunity of clarifying our actions and policies.
In our judgment, however, this purpose can be best served
through congressional hearings or other communications with
the Congress. As the members of the committee know, the
Congress has not found it easy to legislate fiscal policy. If the
Congress now sought to legislate monetary policy as well, it
would enter a vastly more intricate, highly sensitive, and rapidly
changing field— with consequences that could prove very dam­
aging to our nation's economy.
In the past few years, the Federal Reserve System has paid
more attention to the growth of monetary aggregates than it did
in earlier times. We appreciate the fact that an expanding econ­
omy requires an expanding supply of money, that any protracted
shrinkage of the money supply may well lead to shrinkage of
economic activity, and that attempts to encourage growth in
money and credit will lead to a decline of short-term interest
rates when economic activity is weak. But, while the Federal
Reserve recognizes all this, we are also mindful of the lesson
of history that rapid growth of the money supply will lay the
base for a new wave of inflation, and that interest rates on long­
term loans will tend to rise when a higher rate of inflation is
expected by the business and financial community.
As these comments indicate, the Board and the Open Mar­
ket Committee pay close attention to monetary aggregates. W e
do not, however, confine ourselves to the particular monetary
aggregate on which H.R. 212 focuses— namely, demand deposits
plus currency outside of banks. The reason is that this concept
of the money supply, however significant it may have been ten
or twenty years ago, no longer captures adequately the forms
in which liquid balances— or even just transactions balances—
are currently held. Financial technology in our country has been
changing rapidly. Corporate treasurers have learned how to get
along with a minimum of demand deposits and to achieve the
liquidity they need by acquiring interest-earning assets. For the
public at large, savings deposits at commercial banks, shares in
savings and loan associations, certificates of deposit, Treasury
bills, and other liquid instruments have become very close sub­
stitutes for demand deposits. Nowadays, a corporate treasurer
is likely to see to it that the size of his demand deposit is no
368



MONETARY TARGETS AND CREDIT ALLOCATION

larger than the working balance required by his bank. He
knows that a telephone call to his bank will suffice to convert
promptly any negotiable certificate of deposit in his possession
into a demand deposit, and he is therefore apt to keep the bulk
of his transactions and precautionary balances in the form of
interest-earning assets— that is, certificates of deposit or other
highly liquid paper.
Let me try to make what I've just said a little more concrete.
During the final quarter of 1974, the narrowly defined money
supply on which H.R. 212 focuses grew at an annual rate of 4.3
percent. Meanwhile, time and savings deposits of commercial
banks, exclusive of large certificates of deposit, grew at a rate
of 9 percent; the deposits of non-bank thrift institutions grew at
a rate of 7 percent; credit union shares grew at a rate of 9 per­
cent; large negotiable certificates of deposit issued by commer­
cial banks grew at a rate of 26 percent, and so on. We at the
Federal Reserve are concerned with all these aggregates because
the narrowly defined money supply, taken by itself, is an in­
adequate— and at times a misleading— indicator of what is hap­
pening to the stock of highly liquid assets available to American
families and business firms. Since the demands by the public
for currency, demand deposits, savings deposits, and various
liquid market instruments keep changing, monetary policy has
to concern itself with a large family of monetary aggregates.
The aggregate specified in H.R. 212 is only one of these.
Moreover, the condition of credit markets also weighs
heavily in decisions on monetary policy. There is a school of
thought that holds that the Federal Reserve need pay no atten­
tion to interest rates, that the only thing that matters is how
this or that monetary aggregate is behaving. We at the Federal
Reserve cannot afford the luxury of any such mechanical rule.
As the nation's central bank, we have a vital role to play as the
lender of last resort. It is our duty to avert liquidity or banking
crises. It is our duty to protect the integrity of both the domestic
value of the dollar and its foreign-exchange value. In discharg­
ing these functions, we at times need to set aside temporarily our
objectives with regard to the monetary aggregates.
In particular, we pay close attention to interest rates be­
cause of their profound effects on the working of the economy.
The Federal Reserve's ability to influence interest rates is far




369

REFLECTIONS OF AN ECONOMIC POLICY MAKER

more limited than is commonly believed; but in exercising what­
ever influence we do have, we must think of tomorrow as well
as of today. If, for example, we presently encouraged a sharp
decline of interest rates on top of the decline that has already
occurred in recent months, we would run the risk of seeing short­
term interest rates move back up while the economy is still
receding. There is, moreover, a very real possibility that, as a
result of such a policy, a monetary base would be established
for a new wave of inflation in the future, and that market ex­
pectations of such a development would lead rather promptly
to a rise of long-term interest rates.
It should be clear from these comments that the Board is
deeply concerned about proposals to legislate monetary targets.
Economic and financial conditions change, public preferences
for liquidity change, and what constitutes an appropriate mone­
tary response changes. Moreover, the rate of turnover of
money— that is, the rate at which the public is willing to use
the existing stock of money— is typically much more important
than the size of the stock over periods of six months, a year,
or even somewhat longer.
Changes in the public's willingness to use the existing stock
of money are a highly dynamic force in economic life. The
turnover or velocity of money depends heavily on the state of
confidence, and varies widely in the course of a business cycle.
If the public lacks confidence, increasing injections of money
will tend to be offset by a decline in the turnover of money.
The economy will not be immediately stimulated; but a large
buildup of the money stock will lay the base for an inflationary
upsurge in the demand for goods and services at a later time.
As these comments indicate, it would be unwise for the
nation's monetary authority to concentrate on just one aspect
of financial life— namely, the achievement of this or that rate
of growth of the narrowly defined money supply, as specified
by H.R. 212. There are also technical problems of importance
on which I shall not dwell, but which I must at least call to the
committee's attention. First, H.R. 212 assumes that the Federal
Reserve can control the rate of growth of demand deposits plus
currency in public circulation over periods as short as three
months. This we are unable to do. All that we can control
over such brief periods is the growth of member bank reserves;
370



MONETARY TARGETS AND CREDIT ALLOCATION

but a given rate of growth of reserves may be accompanied by
any of a wide range of growth rates of the narrowly defined
money supply. A second technical problem is that measures of
the growth of the money supply over periods as short as three
months are surrounded by very considerable uncertainty— a
fact that H.R. 212 overlooks.
In view of the formidable difficulties, both conceptual and
technical, that surround the section of H.R. 212 that I have
been discussing, it is the Board's judgment that congressional
concerns with regard to money supply behavior will be better
served by careful periodic review of the Federal Reserve's
stewardship. I can assure you that we at the Federal Reserve
are willing to report fully on the factors that have been influ­
encing growth in money— both narrowly and more broadly
defined— and also on how we evaluate monetary expansion in
relation to economic and financial circumstances. This report­
ing could be done on a periodic basis, or whenever special cir­
cumstances warrant it.
Let us turn next to Section 3(a) of the bill, which makes it
mandatory for the Board to allocate credit toward "national
priority uses" and away from "inflationary uses." Certain
broad categories of priority uses and inflationary uses are
specified. The Board is given the power to add to or subtract
from the listed categories by notifying both houses of Congress.
If,not disapproved within a sixty-day period, the Board's pro­
posals would become effective.
It is important to note that this section of the proposed
legislation amends the Credit Control Act. As the Credit Con­
trol Act now stands, the president must make a specific
determination before the Board can regulate extensions of
credit— namely, that this is necessary "fo r the purpose of
preventing or controlling inflation generated by the extension of
credit in excessive volume." This provision of law is eliminated
by the proposed legislation. As we understand it, therefore,
the proposed bill would require the Board to undertake imme­
diately and maintain in force a program of credit allocation
that may apply to any or all markets and any or all financial
institutions. In carrying out this mandate, the Board would
have available to it an extremely wide range of regulatory
options, as currently enumerated in Section 206 of the Credit




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REFLECTIONS OF AN ECONOMIC POLICY MAKER

Control Act. Supplementary reserve requirements on member
banks of the Federal Reserve System would be specifically
added to that list by Section 3(b) of H.R. 212.
Our financial markets are highly competitive and they
have served our nation well over the years. Nevertheless, the
Board recognizes that the workings of financial markets are
imperfect. We have therefore been generally sympathetic to
efforts aiming to improve the flow of credit into socially
desirable uses through special federal credit agencies— as in
the fields of housing, agriculture, and small business. In early
1972, the Board submitted to the Congress, after a thorough
inquiry, recommendations for moderating fluctuations in the
availability of housing finance. More recently, in September
1974, the Board circulated to all member banks a statement on
appropriate bank lending policies prepared by the Federal
Advisory Council— a statutory body established under the
Federal Reserve Act. The Board felt that the council's statement
could be helpful to commercial banks in shaping their lending
policies under the conditions of credit restraint then prevailing.
But as we read H.R. 212, it envisages a comprehensive
intrusion of the federal government into private credit markets,
and thus goes much further than anything that has been
seriously considered in the past. The bill delegates enormous
and virtually dictatorial power to the Federal Reserve. Imple­
mentation of the bill could undermine the market system and
wreck all chances for economic recovery. And it is even highly
doubtful whether H.R. 212 could achieve the objectives being
sought— that is, larger credit flows to certain uses, such as
essential capital investment, small businesses, and agriculture,
at low interest rates.
Decisions as to social priorities in the use of credit are
inherently political in character. If such decisions are to be
made at all, they should be made by the Congress— not by an
administrative and nonpolitical body such as the Federal Re­
serve. After all, tilting credit in favor of some borrowers
implies denying credit to someone else. Our economy has
developed by relying mainly on the market to make such
decisions. The market reflects the interaction of many thou­
sands of borrowers and lenders. If the day ever arrives when
governmental decisions are to be substituted for individual
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MONETARY TARGETS AND CREDIT ALLOCATION

preferences expressed in the marketplace, then the priorities
should be set explicitly by the Congress.
The specifications of H.R. 212 are so vague and general
that they would inevitably involve the Board in political judg­
ments— an area in which it obviously has no special competence.
For example, the bill requires the Board to allocate credit
toward "essential and productive investment." But how are
we to evaluate the credit needs of public utilities relative to the
needs of defense contractors? Are we to favor the credit needs
of "small business and agriculture," as the bill requires, even
if that means that large corporations will be denied the credit
needed to keep their employees working? Are we to favor the
automobile manufacturer who turns out cars that suit our con­
cept of what is socially desirable and punish the manufacturer
whose cars fail to pass our test of social utility? And since the
bill requires the Board to move credit away from financial
activities such as corporate acquisitions, would we have to deny
credit to finance a merger of two firms, even though such a
merger is expected to result in a strong enterprise that can
better expand job opportunities in its area? Questions such as
these may be multiplied by the hundreds and thousands.
Moreover, would it really be wise in an interdependent
world to discourage loans to foreigners? Such a policy would
handicap our exporters and importers; it would lead to retalia­
tion by other countries; it could cause goodwill towards our
nation to vanish; and it would surely diminish, as the entire bill
before us would tend to do, confidence in the dollar.
I must add that administration of the credit control pro­
gram envisaged in H.R. 212 would be enormously complex
and costly. I doubt whether it is even feasible. In view of the
variety of financial channels available to borrowers and lenders,
controls would have to be comprehensive if they were to be
at all effective. They would need to include not only the banks
but also other institutional lenders, such as the thrift institu­
tions, finance companies, insurance companies, and pension
funds. They would need to cover financing through the public
markets for debt and equity securities. They would need to
embrace the entire network of trade credit. They would have to
regulate access to lending and investing alternatives abroad.




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REFLECTIONS OF AN ECONOMIC POLICY MAKER

Such a task has not been attempted in the history of this coun­
try— not even in wartime.
The ultimate difficulty is that a comprehensive allocation
program would disrupt the orderly processes of financial mar­
kets. It could well create serious industrial imbalances and
depress sharply the economic activity of many industries and
communities. In the Board's judgment, there is no good substi­
tute for the decision-making process provided by our highly
developed, sensitive, and intensely competitive financial system.
Nevertheless, as noted earlier, the Board recognizes the
worthwhile nature of special governmental efforts to strengthen
market processes or supplement private credit flows— as in the
case of housing. The need for such special efforts varies with
economic and overall financial conditions. The need is most
evident in periods of general credit restraint,' when the supply
of credit falls short of demand. On the other hand, when credit
conditions are easing, as at present, market processes typically
assure that credit for commercially feasible projects of a pro­
ductive and socially useful character will be in reasonably
ample supply.
There is no evidence that a significant amount of credit
is being squandered on wanton or speculative enterprises. In
the latter part of January, the Board addressed an inquiry to
a sample of banks to gauge their response to the principles
suggested earlier by the Federal Advisory Council— recognizing,
of course, that credit and economic conditions change. The
inquiry covered questions on the demands by bank customers
for the kinds of loans specified by the Federal Advisory Council
as well as questions on bank policies with respect to approval
or disapproval of such loan requests.
Not all of the banks have as yet replied, but we do have
responses from about 80 percent of the sample on the ques­
tions pertaining to credit demands and credit policies. On the
basis of a preliminary tabulation of these results, about threefourths of the banks report that loan requests for purely
financial or speculative purposes, a category that figures promi­
nently in H.R. 212, were significantly fewer in December 1974
than in previous years or that none were in fact received.
Moreover, about 90 percent of the banks report that they have
become more restrictive in their attitude toward such loans.
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MONETARY TARGETS AND CREDIT ALLOCATION

Our preliminary assessment of the survey thus suggests
that bank loan policies are generally consistent with the Federal
Advisory Council's statement. I believe that even in absence
of this statement, most banks would have put in place similar
policies, in view of the limited funds available to them, their
risk exposure, and their sense of obligation to the local com­
munity and the nation. As soon as tabulation and analysis of
this special inquiry are completed, the results will be forwarded
to this committee and made available to other interested parties.
I believe that allocation of credit among competing uses
is becoming a less serious problem for our banks. For credit
demands have diminished, interest rates have declined sub­
stantially from their peaks of last summer, and many banks
and other financial institutions have recently improved their
liquidity positions.
I realize that some might argue that H.R. 212 would
increase the flow of funds to high priority areas, and perhaps
even reduce interest rates for those areas. Such an argument
would have to assume that a comprehensive, leak-proof credit
control program can be devised and enforced. That is impos­
sible in a complex economy possessing highly developed credit
and money markets. Inflation, if nothing else, will lead lenders
to seek every possible avenue to increase their yields. Gray
markets will flourish, as borrowers also attempt to protect
themselves against credit shortages. In addition, both lenders
and borrowers will inevitably turn to foreign credit markets.
The ones who would probably suffer most are small businesses
and home buyers. In short, the Board firmly believes that
credit allocation, as envisaged in the proposed legislation, will
injure our economy, besides failing to achieve the purposes it
seeks to promote.
In addition to the already substantial list of regulatory
measures available under the Credit Control Act, H.R. 212
enables the Board to impose reserve requirements on assets
with a view to rechanneling credit flows. The bill would per­
mit the Board to require a member bank to maintain, besides
the reserves required to support its deposits, a supplemental
cash reserve whose size would depend on the distribution of
the bank's loans and investments. A supplemental cash reserve
would be held against loans and investments other than the




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REFLECTIONS OF AN ECONOMIC POLICY MAKER

so-called "national priority uses/' while a reserve credit would
be given for "national priority" loans and investments. The
total of any such credit, however, could not exceed a bank's
supplemental reserve.
Suggestions for redistributing credit flows through differ­
ential reserve requirements on bank assets have been advanced
from time to time during recent years. The logic of these
proposals may seem simple and even appealing. Banks would
be encouraged to channel more funds into high priority uses,
and away from others, because the structure of reserve require­
ments would make it profitable to do so. A market device— rather
than compulsion— would thus be employed to accomplish a
desired social objective.
Careful reflection on the implications of these proposals,
however, reveals that they would seriously weaken the capacity
of the Federal Reserve to control the growth of the monetary
aggregates. Furthermore, while they would impose enormous
administrative costs on the banking system, they would be
rather ineffective in redistributing credit flows among the
various sectors of the economy.
As this committee knows, a major function of the Federal
Reserve is to control the growth of bank reserves so as to
maintain a rate of expansion of monetary aggregates that is
consistent with the economy's needs. That is what reserve
requirements are for. To exercise this function effectively,
there must be a reasonably precise relation between the volume
of bank reserves, on the one hand, and the volume of money
and bank credit on the other.
I have noted on a number of occasions that the Federal
Reserve's control over the monetary aggregates is already less
precise than it can or should be because of differences in
reserve requirements on the deposits of member and nonmember banks. The consequences of these differences is that
shifts of deposits between member and nonmember banks alter
the total quantity of commercial bank deposits that can be
supported by a given volume of bank reserves.
Differential reserve requirements on assets would introduce
yet another element of uncertainty in the link between bank
reserves and the monetary aggregates. Every shift in the com­
position of bank loans and investments between "national
376



MONETARY TARGETS AND CREDIT ALLOCATION

priority" and other uses would alter the total quantity of bank
deposits that could be supported by the existing volume of
bank reserves, and therefore lead either to a contraction or
an expansion in bank assets and liabilities. Since changes in
the structure of bank assets from one reserve period to the
next could hardly be predicted, the Federal Reserve would have
much greater difficulty in judging what additions to total
reserves were needed to achieve any desired growth rate of
the monetary aggregates. H.R. 212 would thus weaken further
the Federal Reserve's control over money and credit.
This would be a large price to pay, even if reserve require­
ments on the assets of member banks could be used effectively
to rechannel credit flows. There is every reason to believe,
however, that reliance on reserve supplements and credits for
this purpose would set off myriad adjustments in other lending
markets— adjustments that would tend to frustrate the intended
effects of the program.
Let us see how markets would react. To the extent that
member banks were induced by differential reserve require­
ments to shift funds toward certain priority uses, yields on
those assets would decline, while yields on other classes of
loans and investments would rise. The many lenders to whom
the asset reserve requirements did not apply— such as non­
member commercial banks, mutual savings banks, life insur­
ance companies, pension plans, and so on— would therefore
be encouraged to direct their loanable funds away from projects
of the priority type. Borrowers displaced at member banks,
meanwhile, would turn to other lenders or to the open market
for credit, thereby forcing up yields and thus encouraging
individuals and other lenders to supply them with funds. These
offsets would be so substantial, in my judgment, that they
would largely negate the results of the supplemental reserve
requirements. Moreover, I need hardly say that exemption of
nonmember banks from the provisions of Section 3 (b) would
induce some, perhaps many, member banks to change their
status.
Finally, this committee should consider carefully the ad­
ministrative costs and problems that would be encountered in
any serious effort to implement a supplemental reserve program
effectively and equitably. Very likely, it would be necessary




377

REFLECTIONS OF AN ECONOMIC POLICY MAKER

to require that member banks report detailed data on the struc­
ture of their assets on a daily basis, just as they now do for
deposits. Otherwise, a bank could acquire an asset eligible
for a reserve credit one day and sell it to another lender the
next— thereby benefiting from the reserve credit, but contribut­
ing nothing meaningful to expansion of credit supplies of the
desired kind. Also, it might well become necessary to attach
supplemental reserve requirements and credits to particular
loans, rather than to the dollar amount of loans in any given
category, and this would require the development of elaborate
bookkeeping systems for keeping track of many millions o f
individual loans.
In conclusion, let me state once again that the Board
recognizes that adequate expansion of money and credit is
needed to cushion recessionary forces and to encourage early
recovery in economic activity. I must warn you, however, that
the course of monetary policy cannot be guided effectively by
a single measure of the money supply, as this bill would
require. A careful weighing of the behavior of various mone­
tary and credit aggregates is essential.
The Board also recognizes that the nation's best interests
are served when credit flows are channeled into productive uses
and away from speculative channels. The market itself is a
good disciplinarian in this respect, though it often works with
a lag. Developments in credit markets of late have been
moving in a constructive direction. Banks and other business
enterprises have come to recognize that decisions made in a
euphoric inflationary environment are not always those that
contribute most to their own benefit or that of the national
economy. If inflationary pressures continue to unwind this
year, as I believe they will, managerial talent will be concen­
trated more intensively on efficiency in business enterprise,
and participants in financial markets will seek to avoid the specu­
lative excesses of the recent past.

378



The Independence of the
Federal Reserve System

It is a pleasure to be here on this beautiful campus and to join
the audience in honoring the graduating class of Bryant College.
In earlier and calmer times, it was customary for a com­
mencement orator to address the principles of life that he
thought would be most helpful to members of the graduating
class. Such pronouncements are less fitting in our turbulent
age, which has sharply narrowed the gap in knowledge— if not
also in wisdom— that once separated the generations.
Yet each of us, and here your elders may have some
advantage, has had opportunity to reflect with more than
ordinary care on his own range of responsibilities. I therefore
want to share with you today a few thoughts about the Federal
Reserve System, which serves as our nation's authority for
controlling the supply of money and credit.
Industrial nations, including our own, nowadays rely
heavily on monetary policy to promote expansion of production
and employment, to limit any decline that may occur in overall
economic activity, or to blunt the forces of inflation.
There are two major reasons for the emphasis on monetary
policy. In the first place, manipulation of governmental ex­
penditures has proved to be a rather clumsy device for dealing
with rapidly changing economic developments. Secondly, the
process of reaching a consensus on needed tax changes usually
turns out to be complex and time-consuming. Experience has
Commencement address at Bryant
May 22, 1976.




College, Smithfield, Rhode Island,

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REFLECTIONS OF AN ECONOMIC POLICY MAKER

thus taught us that alterations of fiscal policy, once undertaken,
frequently have a large part of their economic effect too late
to be of much value in moderating fluctuations in business
activity.
Even when the economy is booming, legislatures are rarely
willing to increase tax rates or to restrain the rising curve of
governmental expenditures. Such reluctance also limits the
discretionary use of fiscal measures to counter the forces of
recession that develop from time to time in a free enterprise
economy. Once reduced, tax rates cannot easily be increased
again, and new expenditure programs to stimulate a lagging
economy all too often are the source of a new inflationary prob­
lem later on.
Fortunately, monetary policy is relatively free of these
shortcomings. Flexibility is the great virtue of instruments of
monetary and credit policy. Changes in the course of monetary
policy can be made promptly and— if need be— frequently.
Under our scheme of governmental organization, the Federal
Reserve can make the hard decisions that might be avoided by
decision makers subject to the day-to-day pressures of political
life. And experience indicates that the effects of substantial
changes in the supply of money and credit are rather speedily
transmitted through financial markets to the workshops of the
economy— that is, our factories, mines, construction yards, and
the range of service establishments.
The founders of the Federal Reserve System were well
aware of the dangers that would inhere in the creation of a
monetary authority subservient to the executive branch of
government— and thus subject to political manipulation. Sen­
ator Nelson Aldrich, chairman of the National Monetary Com­
mission, whose investigations of central banking laid the basis
for establishing the Federal Reserve System, was deeply im­
pressed with the need for a strong monetary authority capable
of exercising discipline over the financial affairs of a nation.
Carter Glass, chairman of the House Banking and Currency
Committee when the Federal Reserve Act was passed in 1913,
reported that the committee regarded the Federal Reserve Board
"as a distinctly nonpartisan organization whose functions are
to be wholly divorced from politics." That view was fully
shared by President Woodrow Wilson, who was extremely
380



INDEPENDENCE OF THE FEDERAL RESERVE

careful to avoid any suggestion of interference with the newly
created monetary authority, thereby setting a precedent that
has been usually followed by succeeding presidents.
The concept of independence of the monetary authority
within the structure of government is congenial to the basic
principles of our Constitution. As Alexander Hamilton put it
in one of the Federalist Papers, our system of government is
based on the precept that partitions between the various
branches of government "ought to be so contrived as to render
the one independent of the other." Such a division of power,
according to another of the Federalist Papers, is "essential to
the preservation of liberty."
The principle of independence of the monetary authority
within the structure of our federal government was embodied
in the original Federal Reserve Act in several ways. First,
individuals appointed to the Federal Reserve Board by the presi­
dent were to have ten-year terms, and they could be removed
from office only for cause. A president could not, therefore,
remove a Board member from office simply because he dis­
agreed with his views, and the term of office was long enough
to minimize the threat of covert political pressure on Board
members. Moreover, the law provided for staggered terms in
order to avoid presidential "packing" of the monetary authority.
Second, the newly created Federal Reserve Board was
required to report on, and to account for, its actions to the
legislative branch of government, not to the administration.
Third, the operations of the Federal Reserve System were
to be financed from its own internal sources, and thus protected
from the political pressures that may be exercised through the
congressional appropriations process.
Fourth, power was to be diffused within the Federal Re­
serve System, so that the interests of borrowers, lenders, and
the general public were to be recognized and blended in the
new regional Federal Reserve Banks.
In the years that followed creation of the Federal Reserve
System, experience— particularly during the Great Depression—•
suggested that the degree of independence assigned to the
monetary authority was insufficient. The Banking Acts of 1933
and 1935 sought to rectify this and other defects in the finan­
cial structure.




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REFLECTIONS OF AN ECONOMIC POLICY MAKER

Under the new legislation, the secretary of the Treasury and
the comptroller of the currency, who originally were ex officio
members of the Board, were relieved of this responsibility.
The terms of the members of the Board were lengthened from
ten years to twelve years, and then to fourteen years, to insulate
the Board still more from political pressures. A new agency—
the Federal Open Market Committee, including representatives
of the regional Federal Reserve Banks as well as members of
the Board located in Washington— was established to conduct
open-market operations, which by the early 1930s had come to
play a major role in implementing monetary policy. Moreover,
the principle was reaffirmed that funds used by the Federal
Reserve to finance its operations were not to be construed as
government funds or as appropriated money. All of these
legislative changes strengthened the ability of the Federal
Reserve System to resist efforts by the Treasury, or the W hite
House, or any other agency in the executive branch to influence
unduly the course of monetary and credit policy.
Senator Carter Glass once stated that intelligent and fear­
less performance of the functions of the monetary authority
"involves as much of sanctity and of consequence to the Ameri­
can people as a like discharge of duty by the Supreme Court
of the United States." We at the Federal Reserve have in fact
sought to model our conduct on that of the Supreme Court.
In the exercise of our adjudicatory responsibilities, the
members of the Board scrupulously avoid any contact with
interested parties. In our deliberations on monetary and credit
policies, not the slightest consideration is given to questions of
political partisanship. Every member of the Board, and every
member of the Federal Open Market Committee, weighs the
issues of monetary and credit policy solely from the viewpoint
of the public interest and the general welfare. My colleagues at
the Federal Reserve are highly qualified individuals possessing
a diversity of skills essential to the management of the nation's
financial affairs. They live and work under a Spartan code that
avoids political entanglement, conflicts of interest, or even the
appearance of such conflicts. At the same time, the members
of the Board, particularly its chairman, maintain close contact
with members of the Executive and the Congress in order to
assure that the activities of the Federal Reserve are appropri382



INDEPENDENCE OF THE FEDERAL RESERVE

ately coordinated with what other branches of government
are doing.
Our system of monetary management, I believe, is thus
working in the way the founders of the Federal Reserve in­
tended. Nonetheless, there are now, as there have been over
the years, some well-meaning individuals in our country who
believe that the authority of the Federal Reserve to make deci­
sions about the course of monetary policy should be circum­
scribed. The specific proposals that have been put forth over
the years differ greatly, but they usually have had one feature
in common— namely, control by the executive branch of gov­
ernment over the monetary authority.
A move in this direction would be unwise and even dan­
gerous. It is encouraging to find that, despite occasional out­
bursts of temper, a majority of the Congress share this belief. I
doubt that the American people would want to see the power to
create money lodged in the presidency— which may mean that
it would in fact be exercised by political aides in the White
House. Such a step could create a potential for political mis­
chief or abuse on a larger scale than we have yet seen. Cer­
tainly, if the spending propensities of federal officials were given
freer rein, the inflationary tendency that weakened our economy
over much of the past decade would in all likelihood be
aggravated.
The need for a strong monetary authority to discipline the
inflationary tendency inherent in modern economies is evident
from the historical experience of the nations around the world.
Among the major industrial countries, West Germany and the
United States appear to have achieved the greatest success—
albeit woefully insufficient success— in resisting inflationary
pressures in the period since World War II. It is no accident
that both countries have strong central banks. In some other
countries, where the monetary authority is dominated by the
Executive or the legislature, inflationary financial policies have
brought economic chaos and even extinguished political freedom.
It is, of course, essential that the monetary authority ob­
serve the spirit as well as the letter of our laws. In our demo­
cratic society the independence of a governmental agency can
never be absolute. The Federal Reserve System is thus subject
not only to the provisions of the Federal Reserve Act, but also




383

REFLECTIONS OF AN ECONOMIC POLICY MAKER

to the Employment Act and numerous other statutes. The
original design of the Federal Reserve System recognized this
duty by requiring the Federal Reserve to account for its steward­
ship to the Congress. The oversight responsibilities of the
Congress for the conduct of the monetary authority do not,
however, require congressional involvement in the details of
implementing monetary policy. The technical complexities of
adjusting monetary or credit instruments to the needs of a
modern industrial economy are far too great to be dealt with
by a large deliberative body. At the same time, there is a
significant role for the Congress in setting forth the economic
and financial objectives that the monetary authority is expected
to observe and honor.
Over the past year, the Congress has been exercising its
vital oversight function through a new and more systematic
procedure, spelled out in House Concurrent Resolution No. 133.
That resolution requires the Federal Reserve to report to the
Congress at quarterly intervals on the course of monetary,
policy, and to project ranges of growth in the major monetary
and credit aggregates for the year ahead.
W e at the Federal Reserve regard the dialogue between
the monetary authority and the Congress stimulated by the
Concurrent Resolution as constructive. It has given the Con­
gress a better opportunity to express its views on the appro­
priateness of our actions. It has also provided us at the Federal
Reserve with an opportunity to explain fully the reasons for
our actions, and to communicate to the Congress and to the
public at large our firm intention to adhere to a course of mone­
tary policy that is consistent not only with continued economic
expansion at a satisfactory rate, but also with further gradual
unwinding of inflationary tendencies.
Such a course of policy, I believe, is the only option open
to us if we as a nation are to have any hope of regaining price
stability and maintaining a robust economy. Our country is
passing through a fateful stage in its history. Economic, social,
and political trends of the past several decades have released
powerful forces of inflation that threaten the vitality of our
economy and the freedom of our people.
Defeating the forces of inflation requires determined action.
Greater discipline is needed in our fiscal affairs, and structural
384



INDEPENDENCE OF THE FEDERAL RESERVE

reforms are required to improve the functioning of our labor
and product markets. But all such reforms would come to
naught in the absence of a prudent course of monetary policy.
At this critical time in our history, any interference with the
ability of the Federal Reserve to stick to a moderate rate of
monetary expansion could have grave consequences for the
economic and political future of our country.




385




The Proper Limits of Openness
in Government

During the past decade we have witnessed profound changes
in the attitudes of Congress, the courts, and the public gen­
erally toward "secrecy" in government. Since the passage of
the Freedom of Information Act in 1966, the public has had
broad access to government documents, and almost daily one
reads of new legislative proposals or judicial decisions that
would require agencies of government to make public some
aspects of their business that previously had been kept confi­
dential. The balance between the needs of government to carry
on certain aspects of its business in confidentiality and the right
of the public to know what is going on in government is now­
adays more frequently being struck on the side of disclosure.
At a time when antiestablishment feeling is running high, there
seems to be little inclination to consider what limits the national
interest should impose upon openness in government.
The acceleration of the trend toward greater disclosure is
unquestionably part of our nation's reaction to Vietnam and
Watergate. By 1972, a large section of the American public,
including many members of the Congress, already felt that
information vital to understanding the Vietnam war and its
proper financing had been withheld or distorted by the execu­
tive branch. The shocking revelations that soon followed of
the Watergate crimes and other excesses at the highest level of
government diminished still more the credibility of government.
Address at the 1976 International M onetary Conference, San Francisco,
California, June 19, 1976.




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REFLECTIONS OF AN ECONOMIC POLICY MAKER

The very fact that serious misconduct by high government
officials had been so recently concealed under spurious claims of
national interest has naturally resulted in widespread public
skepticism about the need for confidentiality in any phase of
government business.
It has now become a popular saying among articulate
advocates of disclosure that the government's business is the
people's business, and that the people's business should be
carried on in public. But this is a slogan, not a reasoned argu­
ment. Moreover, it is a dangerous slogan, because it obscures
the practical need to conduct some of the work of government
in private. The efforts to dispel mistrust in government by
exposing more of the process to contemporaneous public view
are undoubtedly well-meaning, but they run a serious risk of
impairing the ability of government to carry out certain of its
necessary activities effectively.
The trend toward increased openness in government should
be of special significance to the banking industry. Historically,
banking and bank supervision have been subject to a high de­
gree of confidentiality. The process of bank examination, in
particular, has been surrounded with elaborate safeguards in­
tended both to protect the privacy of bank customers and to
preserve public confidence in individual banks and the banking
system as a whole. Yet during the past ten years a number of
laws have been enacted— and a mass of regulations promulgated
under congressional mandates— requiring banks to make greater
disclosure to their customers and security holders, and in recent
months there have been several significant attempts in Congress
to breach the confidentiality of the supervisory process. These
events mark a serious departure from tradition with respect to
banking matters, and both bank regulators and bankers must
come to terms with these changing attitudes.
At the Federal Reserve we have been deeply concerned
about two disclosure issues that have confronted us recently.
One of these involves the disclosure of examination reports in
connection with a congressionally ordered study of the bank
supervisory process. The other involves disclosure of certain
aspects of our decision-making process— in particular, the
application to the Federal Reserve of one or another of the
"Government in the Sunshine" bills that may soon become law.
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LIMITS OF OPENNESS IN GOVERNMENT

I would like to discuss each of these issues in some detail,
because I believe that the positions we have taken indicate areas
in which the public interest requires some limits on openness
in government.
To be fully effective, the process of bank supervision—
and by this I mean the process by which the banking agencies
detect problems or potential problems in banks and attempt to
remedy or prevent them— depends heavily upon an atmosphere
of free communication between bank officials and examiners.
While our laws have not yet recognized an enforceable privilege
for such communications— similar to that which attaches to
the relation between a lawyer and client or a doctor and
patient— there are significant protections in this area. For
example, an examiner or some other agency employee who
makes an unauthorized disclosure of information obtained in
the examination process may be subject to criminal penalties.
Even the Freedom of Information Act expressly recognizes an
exemption for documents relating to the bank examination
process.
The banking agencies traditionally have gone to great
lengths to protect the confidentiality of examination reports.
They have done so for three principal reasons: First, public
disclosure of problems surrounding a bank could threaten such
swift erosion of public confidence in the bank that the ability of
supervisors to remedy those problems might be destroyed.
Since the main purpose of bank supervision is to prevent bank
failures, public disclosure of the results of the examination
process could run directly counter to the very objective that the
supervisors are attempting to achieve. Second, bank examina­
tion reports typically will contain confidential information
about bank customers that could damage the legitimate interests
of those customers if it were disclosed publicly. W e feel a very
deep obligation to maintain confidentiality in this area. Finally,
we believe that if examination reports were made public,
bankers would be less candid in discussing their problems with
the examiners, who in turn would be less candid in their
appraisal of bank portfolios and bank managements. The
effectiveness of the examination process itself would thus be­
come impaired.
The Federal Reserve has recently had its commitment to




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REFLECTIONS OF AN ECONOMIC POLICY MAKER

the principle of nondisclosure of examination reports tested.
You may recall that in January of this year two of the country's
largest newspapers published highly confidential information
from examination reports and internal supervisory memoranda
relating to so-called "problem" banks— that is, institutions
which had received or were receiving special supervisory atten­
tion. These disclosures set off a number of inquiries in Congress.
In January, the late Congressman Wright Patman proposed
that the General Accounting Office conduct a far-reaching study
of the bank supervisory process— a request that was subse­
quently supported by Mr. Reuss, the chairman of the House
Banking Committee, and by Mr. St Germain, an influential
subcommittee chairman. At about the same time, Mr. Proxmire,
the chairman of the Senate Banking Committee, proposed a
similar study by GAO, to be conducted under the general
direction of the committee staff. In each case the focal point
of the study was to be on the bank examination process, so that
disclosure of examination reports would be required. A sub­
committee of the House Government Operations Committee
similarly indicated its intention to conduct such a study through
its own staff, again focusing on the examination process. It
sought authority in this connection to subpoena the comptroller
of the currency to produce examination reports of more than
sixty national banks.
In response to these congressional intiatives, we at the
Federal Reserve informed the two banking committees that we
would welcome a meaningful inquiry into the performance of
our bank supervisory responsibilities, but that we strongly
opposed disclosure of bank examination reports. In order to
permit such a study to go forward, we proposed a means by
which GAO could look into the performance of our bank
supervisory functions without the need for disclosure of the
identities of individual banks or bank customers. We further
offered to work with the committee in developing a procedure
by which information on the bank supervisory process and the
health of the banking system could be supplied on a regular
basis to assist the committees in performing their oversight
responsibilities.
Our staff negotiated at length with GAO, both on the issue
of disclosure of examination reports and on the scope of the
390



LIMITS OF OPENNESS IN GOVERNMENT

study itself. We explored a number of possible ways of pro­
viding information from examination reports without disclosing
the identities of banks or their customers, but GAO would not
accept any such limitations. The negotiations finally resulted
in an agreement under which GAO will have access to exami­
nation reports of a sampling of state member banks on a care­
fully controlled basis. The security of these materials will be
closely guarded. GAO will not be permitted to remove from
our premises either the examination reports, copies or extracts
of reports, or notes or other work papers generated by GAO
itself during the study, and all such materials will be kept under
lock at the Board. When GAO completes its study it will pre­
pare a report to the Congress, but that report may not identify
any bank, bank official, or customer, and it may not be framed
in such a way as to permit such identification. Furthermore,
GAO must give us an opportunity to review its report in draft
form, so that we will be able to insure that no improper dis­
closure of examination report information is made.
I am pleased to say that both Mr. Reuss and Mr. St Ger­
main of the House Banking Committee have accepted our
agreement with GAO. More important, they have assured the
Comptroller General that no attempt will be made to compro­
mise the agreement by requiring disclosure of confidential
information. An important precedent has been established,
therefore, in support of our position that bank examination
reports should not be a subject of congressional staff study.
Indeed, the fact that the comptroller of the currency and the
FDIC had previously agreed to a GAO study, and that we too
were involved in negotiations with GAO, finally persuaded the
House Government Operations Committee not to issue a sub­
poena to the comptroller for the production of bank examination
reports in connection with the study being conducted by its staff.
We have by no means satisfied all demands for access to
examination reports. With increasing frequency other agencies
of government with investigative or law enforcement responsi­
bilities are looking to the bank examination process as a means
of obtaining information to carry out their responsibilities. It
has been our practice in the past, when access to examination
reports has been sought by other agencies in connection with
specific allegations of wrongdoing, to allow carefully limited




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REFLECTIONS OF AN ECONOMIC POLICY MAKER

access under conditions intended to protect both banks and their
customers from unwarranted invasions of privacy. Furthermore,
when our examiners uncover evidence of crime in the course
of their examinations, they regularly refer such matters to the
proper authorities. However, we do not believe it appropriate
for other agencies to use the examination process as a means
of prospecting for evidence of possible wrongdoing in areas
beyond our jurisdiction. I say this not because we want to
protect bankers or bank customers from lawful investigation
into possible misconduct, but because we firmly believe that
the principal objective of the examination process, namely,
maintenance of a safe and sound banking system, would be
injured by burdening that process heavily with other tasks.
I would now like to turn to the question of disclosure of
the Federal Reserve's internal decision-making process. This
question has received considerable public attention recently
because of a decision by a federal district judge in Washington
ordering the Federal Open Market Committee to make available
to the public, immediately after each meeting of the FOM C,
the guidelines agreed upon at that meeting for market opera­
tions by our New York bank during the succeeding month.
In addition, the court ordered that segregable factual portions
of the minutes of two FOMC meetings be made promptly
available to the plaintiff in that judicial proceeding.
W e have appealed certain aspects of the court's order,
and I am therefore limited in the extent to which I may com­
ment upon the case. But I can say that even if the district
court's interpretation of the Freedom of Information Act is up­
held, I believe the public interest would not be served by imme­
diate disclosure of FOMC strategy. Our open-market activities
are watched closely by some of the sophisticated money market
specialists. Based upon their observations they make judgments
about the current direction of monetary policy, and they shape
their strategies in the securities market on the basis of these
judgments. While their guesses are often astute, there is suffi­
cient uncertainty to cause them to temper their aggressiveness.
If FOMC plans were disclosed immediately, however, mar­
ket professionals would know at once the key determinants of
our open-market operations over the next four or five weeks.
Sophisticated and experienced market participants, equipped
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LIMITS OF OPENNESS IN GOVERNMENT

with financial resources to act quickly, would be far better
situated to interpret and trade on this information than members
of the general public. Needless to say, the Federal Reserve
has not the slightest interest in assuring profits for speculators
in stocks or bonds— the ones who would inevitably be the chief
beneficiaries of immediate disclosure. And there is still another
difficulty with premature publicity. Not only would the large
speculators gain trading advantages, but— being armed with
these new insights— they would be apt to engage in more ag­
gressive market behavior. As the response of market rates to
Federal Reserve actions was accentuated by such behavior, the
result could well be greater short-run volatility in interest rates.
Exaggerated shifts in market expectations and interest rates
caused by premature disclosure of FOMC strategy may in turn
require adjustments of policy simply to maintain orderly condi­
tions in financial markets. Our ability to control bank reserves
and to make effective use of open-market operations might
therefore be weakened.
While the case just discussed raises questions about the
timing of the release of FOMC market strategy, I am even more
deeply concerned about the prospect that Board deliberations
prior to decision may be opened to public scrutiny. One of the
principal legacies of Watergate is a deep public cynicism about
the process of government decision making. Many people seem
willing to assume that confidentiality in the decision-making
process promotes improperly motivated or even corrupt de­
cisions. The response to that attitude has been a drive to force
government agencies to conduct their deliberations in public
sessions. This movement has rallied under the banner of "G ov­
ernment in the Sunshine."
There are several versions of "Sunshine" bills presently
pending in Congress, and I am continually amazed at how little
public attention these bills have received. The basic structure
of these bills is similar: they would require multimember federal
agencies to conduct their deliberations concerning agency busi­
ness in an open forum, accessible to the public. While the bills
all recognize certain exemptions from open meetings, they re­
quire that if a meeting is to be closed pursuant to an exemption,
notice must be given of the subject matter of the meeting and a
verbatim transcript must be made and retained. Following each




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REFLECTIONS OF AN ECONOMIC POLICY MAKER

closed meeting, the agency would be required to release to the
public those portions of the transcript not covered by an exemp­
tion. Any member of the public could bring a court challenge to
the validity of the agency's action in closing a meeting, and the
court could order the entire transcript to be disclosed. This pro­
vision alone offers frightening potential for innumerable law­
suits, each of which would require individual defense.
The obstructionist dangers in this legislation do not stop
there: they extend to the greater part of the substantive business
of the Federal Reserve. Our deliberations on monetary policy
issues involve highly sensitive questions of great national con­
cern. The close scrutiny that is given our statements and actions
in this area is itself an indication of the sensitivity of the matters
with which we deal. We are keenly aware that financial markets
may react dramatically, based solely upon nuances or shades of
meaning in our decisions; and our public statements are drafted
with great care because of this.
Similar observations apply to our bank supervisory and
regulatory functions. We very often have before us detailed in­
formation about the financial and managerial condition of bankholding companies or about individual banks and their cus­
tomers. Sometimes we must deal with crisis situations that may
call for emergency action. It is unthinkable to me that the na­
tional interest would be served by discussion of these issues in
public. Indeed, the Congress has thus far concurred in this judg­
ment by delineating various exemptions from the requirement
for open meetings. But it is no answer that certain meetings
may be closed, for as long as we must keep a verbatim transcript
of such meetings the threat exists that the substance of these
meetings may be made public.
The underlying premise of the "Sunshine" legislation is
that if the public is permitted to observe the decision-making
process in action, the integrity of decision making will be as­
sured and public confidence in government will be enhanced.
This, however, is a vastly oversimplified view of the manner in
which the government works, and I believe it is a simplistic view
of the way in which government should work. The advocates of
this view ignore the fact that debate conducted on a stage is
different in tone and quality from debate conducted in private.
The simple fact is— and I think that even the supporters of
394



LIMITS OF OPENNESS IN GOVERNMENT

"Sunshine" legislation ought to concede this— that debate
carried on before a public audience tends to take on some char­
acteristics of the theater, rather than serve as a search for truth
and wisdom, and that the debaters themselves tend to become
performers pronouncing predetermined positions, rather than
participants in a deliberative process seeking to develop their
own ideas and persuade their colleagues.
The advocates of "Sunshine" also overlook the fact that
many actions of the Federal Reserve are quasi-judicial in nature.
At almost every meeting we are called upon to adjudicate the
rights of private parties seeking to engage in certain new activ­
ities or to extend the scope of their existing authority. In such
matters we conduct ourselves much as judges would. It is a firm
rule, for example, that Board members will not discuss the merits
of an application with interested parties prior to Board action on
the application. Historically, the deliberations of appellate courts
on cases coming before them have not been conducted in open
session. I see no convincing rationale for treating our adjudica­
tory deliberations differently. O f course, once decisions on ap­
plications before us have been reached, they are promptly an­
nounced and reasons for approval or denial are set forth.
There is a serious danger, I believe, that a "Sunshine" law
may have the unintended effect of diminishing the quality of
decision making in an agency such as the Federal Reserve Board.
The Board has a long tradition of free discussion. We have im­
portant decisions to make, and we have been extremely fortunate
to have Board members and staff of high intellectual competence.
Our deliberations are characterized by deep respect for one
another's opinions, and by an atmosphere that welcomes com­
pletely free expression by both Board members and staff. A
fundamental precondition to the free exchange of ideas is an
atmosphere in which new or unpopular ideas— or even wrong
ideas— can be put forth for discussion without fear of embar­
rassment or recrimination.
As we attempt to decide difficult issues, many things are
said in our Board meetings that might well not be said if we
were in public session or if each word spoken were subject to
later public disclosure. This is not to say that "ev il" views are
being expressed; it simply means that the goal of fully informed
decision making can only be achieved if the participants are free




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REFLECTIONS OF AN ECONOMIC POLICY MAKER

to bring to light all considerations that may bear upon their
actions. Were we forced to conduct our deliberations under
circumstances where highly sensitive matters could not be dis­
cussed in private, the quality of our decision making would un­
questionably deteriorate and the public interest would ultimately
be disserved.
Although the Board has at times been accused of being
overly secretive in performing its responsibilities, I believe that
charge is not based upon fact. We make far more information
available to the public about our activities than any other cen­
tral bank. Very few of the world's central banks regularly in­
form their national legislature of their plans for the future
course of monetary policy, and none does this as often as the
Federal Reserve. Not only do we appear frequently before
committees of Congress—Board members have testified twentyfive times already during 1976— but we deal constantly with in­
quiries from Congress and the public about the substance of our
work. In our responses we strive to be as forthcoming and help­
ful as we can. In the bank regulatory area, unlike many other
agencies, we have for many years published written decisions
explaining our actions in application proceedings, such as those
involving bank-holding company and merger actions.
I believe we must face the problem presented by the "Su n ­
shine" legislation realistically. Certain of the "Sunshine" bills
and associated congressional reports define the term "m eeting"
so broadly that a bare quorum of the Board— four members—
literally could not converse informally about any aspect of the
Board's business without being required first to issue notice to
the public and thereafter to conduct a public discussion or hold
a closed discussion with the tape recorder running. In certain
instances, these requirements would apply even to discussions
between only two Board members.
In conclusion, I fail to see how the national interest would
be served by circumscribing actions of the Board in an end­
less array of recording requirements. In such circumstances we
could not be expected to maintain the quality of thorough
analysis and thoughtful care that has marked our work over the
years. If the Board were exempted from the verbatim transcript
requirement, our difficulties with the "Sunshine" legislation
would be substantially reduced. However, if any of the "Su n 396



LIMITS OF OPENNESS IN GOVERNMENT

shine" bills as now written becomes law, an agency such as ours
would be in an almost impossible position. On the one hand, we
could operate under the law as enacted with the virtual certainty
that some of the destructive consequences I have indicated— and
I have not even mentioned international complications— will
occur. On the other hand, we could go through the motions of
adhering to the law's requirements but, as a practical matter,
resort to "underground" procedures that would effectively cir­
cumvent the law. That would be a cruel dilemma, but I would
have no hesitation about the choice. I must and do reject cir­
cumvention as a suitable course for the Federal Reserve. We
will have no part in any such dubious exercises.
In sharing with you my views on some of the disclosure
issues that have come before the Board recently, it has been
my purpose to question the premise that disclosure is a desirable
end in and of itself. I particularly question the premise that dis­
closure is the cure for bad government. To be sure, it is more
difficult for corruption and malfeasance to occur when the public
has easier access to the inner workings of government. But there
are legitimate and important reasons for permitting certain proc­
esses of government to operate in reasonable confidentiality.
In striving to renew the public's trust in government, we should
recognize that such trust ultimately will depend not upon the
public's observation of the process of government decision
making, but upon their perception that their government is
comprised of men and women of intelligence and integrity
making reasonable decisions in the public interest.




397




The Condition of the
Banking System

As you know, Mr. Chairman, I attach special importance to this
meeting today at which I shall report to you, on behalf of the
Board of Governors, on the condition of the banking system.
This hearing, the first of its kind for this committee, is an
outgrowth of our shared judgment— the committee's and the
Board's— that there ought to exist an official forum for objective
and systematic review of our banking system. Certainly from
the Board's standpoint, there has been a regrettable lack of bal­
ance at times in the past several years in public discussion of
banking matters. It is our hope, which I am sure you share, that
hearings of this kind will contribute to better understanding of
the performance of the nation's banking system and in so doing
will bring individual banking problems into better perspective.
A few years ago it would have been difficult to generate
broad interest in the kind of review this committee is now
initiating. The reason, obviously, is that from the standpoint
of the public the nation's banking system was adjusting well to
the general growth of the economy. During the decade of the
1960s, bankers progressively shed much of the caution that had
carried over from the great Depression and— freed, as they came
to be, of some of the restraints imposed on them— they began
to do things that were impressively creative.
That history of change during the 1960s is reasonably
well known, and I need not dwell on it. In brief, what bankers
did was to reach out for new business far more aggressively
Statement before the Committee on Banking, Housing, and Urban Affairs,
United States Senate, M arch 10, 1977.




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REFLECTIONS OF AN ECONOMIC POLICY MAKER

than they had formerly. To that end, they devised new tech­
niques— many highly ingenious— for gathering deposits and
making loans. They opened offices at a rate much more rapid
than the growth of the nation's population, and increasingly
extended their operations to new geographic areas and func­
tions. Banks that previously served only local markets sought
to become regional in scope; regional banks moved to establish
a national presence; and our nation's largest banks looked more
and more to opportunities abroad. As long as such growth was
outwardly free of signs of strain— as it generally was for more
than a decade— the development met with broad approval.
Complaints were few— except, of course, from banking's com­
petitors, who were understandably unenthusiastic about bank­
ing's new display of entrepreneurial energy and talent. Consum­
ers and businessmen could only be pleased by the enlarged range
of banking services and the more intense competition among
financial institutions.
There is, however, another side to the ledger. As often
happens with evolutionary change that is essentially constructive,
the pendulum swung too far too quickly. Excited by the profit
gains which the drive for growth yielded in the 1960s, a good
many bankers paid less heed than they should have to tradi­
tional canons of banking prudence.
Most importantly, the growth of loans and investments
in the banking system proceeded much more rapidly than did
additions to the base of equity capital. Commercial bank assets
increased at an average annual rate of 9 percent in the decade
of the 1960s and at the even more rapid rate of 15 percent in
the first three years of the 1970s. In both periods, the rate of
growth of bank assets appreciably exceeded the growth in the
dollar value of the nation's production— a fact indicative of the
determined efforts banks were making to enlarge their share of
total financing activity.
The consequences of the hard push for growth was that, by
the end of 1973, equity capital was equivalent to only about
6 1 percent of total bank assets— down sharply from 9 percent
/2
at the end of 1960. Moreover, the equity capital of banks had
been leveraged by some parent holding companies which used
funds raised in debt markets to increase equity investment in
their subsidiary banks.
400



CONDITION OF THE BANKING SYSTEM

That thinning of the capital cushion would have been
reason enough for some uneasiness about banking trends as
we moved into the 1970s. But there were other reasons as well.
O f key importance was the particular way in which asset growth
was achieved. The 1960s witnessed the birth and rapid spread
of so-called liability management by banks— a technique that
in practice involved heavy reliance on borrowed funds, often
very short-dated funds, to accommodate loan requests. Thus,
uneasiness was engendered not only by the rapid expansion of
assets relative to equity but also because that expansion rested
so heavily on volatile resources.
The unease was accentuated by the fact that, in addition
to the rapid growth of loans, commercial banks proceeded with
a rapid buildup of commitments to their customers to make
additional loans in the future. A suspicion, moreover, that
banks had to some extent compromised previous standards of
asset quality in their drive for growth added to concern in the
early 1970s. So, too, did realization that the holding company
device had carried bankers into terrain that was relatively un­
familiar. Finally, the advent of widespread floating of currencies
produced keen awareness that many of the nation's larger
banks, by virtue of their international involvement, had become
exposed to additional risks. In sum, as the decade of the 1970s
began, apprehension was emerging— and this was not confined
to banking regulators— that the innovations and developments
of the 1960s, welcome as they were in many respects, posed
some formidable challenges.
Such uneasiness as existed in the public mind with respect
to trends in banking remained relatively mild, however, until
1974. The failure of U.S. National of San Diego in October
1973, followed some months later by the well-advertised dif­
ficulties of Franklin National and Bankhaus Herstatt, both
ending in failures, transformed the incipient unease into serious
apprehension. Indeed, for the first time since the 1930s major
doubts began to be voiced here and there about the soundness
of our nation's, and indeed the world's, banking system.
The unhappy closing in our country of two large banks—
U.S. National and Franklin National— was handled by the regu­
latory authorities in a manner that caused a minimum of dis­
turbance to their customers and no loss at all to their depositors.




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REFLECTIONS OF AN ECONOMIC POLICY MAKER

Even so, public concern about banking continued. In fact, it still
lingers on in some degree, having been nurtured since 1974 by
a succession of troubling events and revelations.
Financial strains associated with the quantum jump in oil
prices— involving as they did huge borrowing by oil-deficit
nations— have contributed to unease about the health of bank­
ing. So too has the severity 6f the recent recession— itself the
product of an inflationary environment that fostered widespread
speculation. The slump in business activity triggered a number
of major business bankruptcies entailing some well-publicized
loan losses for banks. The recession, moreover, laid bare the
financial weakness of many real estate investment trusts, which,
as is well known, are heavily in debt to our nation's banks. And
the recession also played a part in exposing New York City's
financial difficulties, thus bringing to acute national conscious­
ness the risk exposure of commercial banks— particularly, but
by no means exclusively, the large New York banks— to the
vicissitudes of municipal finances.
All of these events have at times made for nervousness
about the condition of banking, and that situation may not
change quickly. A number of the problems impinging on banks
— for example, those related to international oil financing and
those having to do with New York City— are almost certain to
keep coming back into the headlines. Then, too, loan losses and
loan problems often continue months or even years after a
recession in economic activity has ended. The recent recession
illuminated the bad credits, indeed to a large extent caused
them, but considerable time will be required for troubled debtors
to work out their financial difficulties. Hence, the total amounts
of questionable loans, and the number of banks classified as
problem banks because of a sizable volume of such loans, may
not diminish rapidly even in an upbeat economy. We ought to
expect that and not be surprised by such disclosures.
On behalf of the Federal Reserve, I am pleased to report
that our analysis leads to the conclusion that the nation's bank­
ing system has passed well beyond the worst of its recent dif­
ficulties and is in fact regaining strength steadily. This is the
product of several influences— among them, corrective actions
taken by the banks on their own initiative, supervisory pres402



CONDITION OF THE BANKING SYSTEM

sure for better performance, and the recovery that is under way
in the general economy.
All of the widely used measures of bank-capital position
have shown definite improvement since 1974, reflecting a com­
bination of much slower growth in banking activity and sizable
additions to capital resources. Total loans and investments of
commercial banks have increased at an annual rate of approxi­
mately 5 V2 percent during the past two years, only about a third
of the pace that prevailed in the opening years of this decade.
A major part of the slowdown reflects, of course, the subsidence
of credit needs occasioned by the state of the economy and the
increased reliance of business firms on public debt markets. But
there also has become discernible a greater sense of caution and
selectivity on the part of bankers in extending credit. Mean­
while, in order to bolster their capital, banks have raised sub­
stantial sums in the longer-term debt market, and they have
also added to their equity base both by stepping up sales of new
stock and by continuing to pursue conservative dividend
policies.
Fortunately, our nation's banks have enjoyed relatively
good profits, in part because of a new cost-consciousness that
has manifested itself not just in go-slow policies affecting the
scope of operations but in some instances also in personnel
reductions— something that until recently was wholly unchar­
acteristic of the banking industry. Earnings of banks have been
big enough, taken in the aggregate, to absorb the large loan
losses that have occurred in lagged response to the recession and
yet permit moderate gains in net income. This performance of
profits has been a key factor, of course, in enabling banks to
strengthen their capital position by retaining a large part of
earnings. It is also worth noting that in many of the larger
banks, profits have been bolstered by exceptional income gains
growing out of international activities.
The ratio of bank equity to total assets that I mentioned
earlier as having fallen to 6 V2 percent at the end of 1973 re­
corded no significant deterioration thereafter. It tended to
stabilize in 1974, then improved modestly in 1975, and modestly
again through the middle of 1976, when it approached 7 percent.
Other available measures of the status of bank capital— those
that take debt capital into account as well as equity and which




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REFLECTIONS OF AN ECONOMIC POLICY MAKER

focus on risk assets rather than total assets— show either equal
or greater strengthening. In particular, the ratio of total capital
— that is, equity plus subordinated debt— to risk assets rose by
more than a full percentage point between the end of 1974 and
mid-1976, when it reached 10.2 percent. Significantly, this im­
provement in bank capital positions has occurred for all size
classes of banks, from the smallest to the biggest.
The growth of bank assets has not merely slowed, but—
as is typical in strength-rebuilding phases of the kind now pro­
ceeding— there has been a decided improvement in the composi­
tion of newly acquired bank assets. Between the end of 1974
and the end of 1976, commercial banks added enormously to
their holdings of U.S. government securities— in all, about
$47 billion. This emphasis on liquid assets has strengthened the
general quality of bank asset positions. Moreover, in view of
the chastening experience so many banks have had, loan officers
have typically been exercising greater care in extending new
credit.
Besides the improvement in asset composition, there has
been a diminished emphasis by banks on accommodating ex­
pansion of their portfolios by relying on short-term borrowed
funds. The total of so-called managed liabilities of large banks
declined between December 1974 and December 1976, despite
a substantial rise in the overall liabilities of these banks. The
relative dependence on borrowed funds that are potentially very
volatile has thus decreased. At present, the average ratio of
managed liabilities to the total assets of large banks is some
six percentage points below the high recorded in the summer
of 1974.
As I stated earlier, it would be unrealistic, even with the
improvement now occurring in asset quality, to expect a rapid
change in the loan-loss experience of banks. Banks for some
time will continue to wrestle with the legacy of loans that
turned sour during the recession. Complete information on
loan-loss experience is not yet available for 1976. But such
data as we do have indicate a flattening tendency in the net
loan losses of commercial banks, measured as a percentage of
loans. That is an encouraging change from 1975, when loan
losses climbed sharply. Strengthening the impression that a
turn for the better has occurred is the fact that during 1976 a
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CONDITION OF THE BANKING SYSTEM

decline was recorded in the proportion of past due loans of na­
tional banks. Moreover, preliminary data for 1976 on bank
assets classified by bank examiners as substandard or worse
also suggest that the dollar amount of classified loans is no
longer rising. Thus, some signs of improvement in bank loan
experience have appeared, and these should multiply as expan­
sion of the economy continues and gives support to the financial
position of bank customers.
Essentially the same stabilizing tendencies are evident with
regard to banks classified by banking agencies as being in the
"problem" category. When a bank is placed in such a category,
this simply means that it requires special supervisory attention.
The number of such banks increased sharply in 1974 and 1975,
but it has since then remained substantially unchanged. For
purposes of evalution, it is important to bear in mind that the
composition of these lists changes frequently as difficulties are
identified by the regulators and resolved by the institutions.
Thus, no inference of a lack of progress in overcoming specific
problems should be drawn from the recent relative stability
in the overall number of banks on such lists. In particular, the
recent stability of numbers does not mean that there is a set of
chronic "hardcore" cases that defy remedy. We should, more­
over, keep in mind the fact that the overwhelming majority of
our commercial banks do not require special supervisory
attention.
The so-called problem banks represent only a small
percentage of the total number of commercial banks in the
United States— less than 5 percent even at the worst readings
of recent years. And, of course, the number of banks that
actually fail is a small percentage of so-called problem banks.
The incidence of failure in the banking industry is, indeed,
very much smaller than in other lines of business. In the dif­
ficult period from 1973 through 1976, there were only thirtynine bank failures in the United States and most failing institu­
tions were relatively small. As a rule, the supervisory agencies
were able to arrange takeovers of the failed institutions by
healthy banks. Few were liquidated; thus services to customers
were generally uninterrupted, and losses to depositors on un­
insured balances were minimal.
The Federal Reserve Board expects the gradual improve­




405

REFLECTIONS OF AN ECONOMIC POLICY MAKER

ment that is under way in the condition of the banking system
to continue. Our anticipation that the general economy will ex­
pand at a good rate duting 1977 and on into next year is, of
course, critical to that judgment. But other important reasons
also suggest further strengthening in the banking situation.
By no means the least of these is the sobered mood of
bankers. The difficulty experienced by some banks in issuing
certificates of deposit at times during 1974 or 1975 has clearly
left its mark. So has the embarrassment that certain institutions
suffered in having to pay a premium rate on their certificates of
deposit. Fresh is the memory, also, of the cost and strain many
banks experienced in making good on liberally granted com­
mitments to extend credit. Such things as these, combined with
the shock of heavy loan losses, appear to have significantly
altered the psychological framework within which banking
decisions are made. Liability management no longer seems
quite so wondrous to many bankers, and there is clearly a new
degree of appreciation that commitments to lend ought not to
be undertaken lightly. Having learned the hard way that the
business cycle is, after all, very much alive, most bankers are
likely for a time to apply stricter standards than they did a
few years ago in making credit judgments. All in all, the bank­
ing industry is exhibiting considerable caution, which extends
both to the traditional range of banking operations and to the
nonbanking activities of holding companies. This should help
to clear up old problems and avoid new ones.
Not only bankers, but also their customers, are in a more
sober mood and this, likewise, bodes well for progress towards
a healthier banking industry. Business managers in particular—
stung by their own discovery that the business cycle is not yet
dead and that huge risks are entailed in enlarging balance-sheet
totals through short-term borrowings— have been hard at work
putting their houses in order. They have sold sizable amounts
of both long-term bonds and equity securities and have used
the proceeds of these sales largely to reduce short-term bank
debt and increase their liquid assets. Those developments, to­
gether with the continuing improvement of corporate earnings,
certainly ought to result in fewer new bad-loan problems for
banks and also should help progressively in cleaning up existing
problems.
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CONDITION OF THE BANKING SYSTEM

I can, moreover, assure this committee that the Federal
Reserve Board will make every effort to see to it that the cur­
rent trend toward a strengthened banking situation continues.
The Board in its regulatory and supervisory actions is adhering
basically to the cautionary thrust that was formally initiated in
the spring of 1973.
There has been no significant departure, for instance, in
our "go-slow" policy toward expansion of bank-holding com­
pany activities. The list of activities generally permissible for
these companies has not been expanded since early 1974, and
the Board has recently determined that two requested activities
are not to be permitted. Individual companies have been allowed
to expand into new areas only when the Board has been satisfied
with their financial condition and managerial capabilities. On
the other hand, companies whose asset composition, capital, or
liquidity raises doubts ought by now to know that the Board
will be extremely skeptical of proposals that divert financial
or managerial resources to new undertakings. Partly as a result
of pointed denial of various applications to undertake new in­
vestments— through which the Board has signalled to the
market its "go-slow" policy— the number of requests filed with
the Federal Reserve has sharply diminished in the past two
years. Moreover, in some instances in which applications for
expansion have been approved, the authority to proceed has
been made conditional on improvement of the applicant's
capital base.
The Board intends to continue using such leverage in the
interest of assuring further improvement in the condition of
the banking system. The capabilities of the Federal Reserve to
exercise a constructive influence on banker attitudes and actions
are numerous, even though our power to deal with certain prob­
lem areas is inadequate. Perhaps of greatest significance is the
fact that the examination and supervisory process is being
strengthened by expanded and more timely surveillance, thereby
enhancing our ability to identify problems and to respond to
them at an early stage. Parallel developments to strengthen
monitoring and follow-through capabilities are under way in
the office of the Comptroller of the Currency and at the Federal
Deposit Insurance Corporation. Coordination of efforts among
the three agencies is, of course, frequent.




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REFLECTIONS OF AN ECONOMIC POLICY MAKER

The conclusion of the Federal Reserve Board that the con­
dition of the banking system is improving does not mean that
we are taking anything for granted or that we see no problems.
The wiser attitude that now appears to prevail among bankers
needs to be tested as the expansion in economic activity pro­
ceeds. Memories— however painful— can sometimes be short.
Should we find that the lessons of the recent past— concerning
capital adequacy, excessive reliance on volatile funds, or expan­
sion into unfamiliar areas— are no longer generally respected
by bankers, the Board will be ready to take whatever action
seems appropriate.
Nor, even now, despite steady improvement in real estate
markets, do we have any complacency about the involvement of
banks and bank-holding companies in real estate investment
trusts (REITs). Many of these trusts have avoided bankruptcy
only because of the forbearance of creditors, and from the
strained and often touchy relationships that inevitably exist in
such a situation sudden flare-ups of trouble are always possible.
A number of REITs face a significant increase of maturing
medium-term debt later this year and in 1978. This situation
demands close attention, with the prospect that more REITrelated losses lie ahead for banks and that it will be a long while
before the messy problems in that area have been resolved.
Much the same is true of the financial difficulties of New
York City in which the New York banks have such a substantial
stake. The working assumption must be that a solution calming
to financial markets will be devised, but simple prudence de­
mands that the Federal Reserve System, because of its responsi­
bility for containing shocks to financial markets, be alert to any
sudden untoward turn in that troublesome situation.
Another area of concern with respect to the soundness of
our banking system is the continued attrition in Federal Reserve
membership. In 1976, 46 banks chose to give up membership
and 8 banks left the System as a result of mergers with non­
members. Over the past eight years a total of 427 member
banks have withdrawn from the System, and an additional 91
have left as a result of merger. These banks have left mainly
because of the high cost of the non-interest-earning reserves
that they are required to hold as members of the Federal Re­
serve. Not a few of the banks that dropped out of the Sys­
408



CONDITION OF THE BANKING SYSTEM

tem, being financially weak, faced a desperate need to cut costs
and improve profits. At present 60 percent of insured com­
mercial banks, accounting for about 25 percent of deposits, are
outside the Federal Reserve System.
Unless the trend toward nonmembership is reversed, the
soundness of the banking system will be jeopardized by the
fact that so many banks will not have direct access to the
Federal Reserve discount window. The availability of the dis­
count window— as was demonstrated dramatically in 1974—
is an important element contributing to the stability of our
banking system. There should be no assumption that corre­
spondent banks will always be able to afford assistance to non­
members. This is a problem that warrants priority attention by
this committee and the full Congress.
The Board also would like to see this committee focus as
soon as it reasonably can on gaps that continue to exist in the
supervisory powers of the agencies that regulate banks. On
January 31 of this year, the Board, as you know, forwarded to
this committee a regulatory reform bill that we believe would
contribute materially to better bank supervision.
Our draft bill proposes, among other things, the creation
of a statutory interagency bank examination council that would
establish uniform standards and procedures for federal exam­
ination of banks. The bill would also place statutory limits on
loans to insiders. As the committee is aware, problems with
insider loans have been a major contributing factor in a number
of bank failures. In addition, we see a need for change in
existing "cease and desist" authority. At present the Board
cannot remove bank or bank-holding company officers for any­
thing less than a showing of personal dishonesty. We believe
that authority for removal, with appropriate safeguards, ought
to extend as well to gross managerial negligence.
The bill we have proposed would also permit out-of-state
acquisition of large banks in danger of failure. When adverse
developments trigger deposit losses that seriously weaken a
bank, it may be necessary in the public interest to combine the
weakened institution with a larger and stronger bank. As you
know, this recently occurred in New York and California, where
large in-state banks were available to acquire the problem banks
involved. Had institutions of the size of Franklin National or




409

REFLECTIONS OF AN ECONOMIC POLICY MAKER

U.S. National failed in certain other states, no in-state bank
would have been large enough to acquire them. In such cir­
cumstances, the ability to arrange acquisitions across state
boundaries would become urgent.
These specific legislative changes would be helpful. From
a broader perspective, it is vital to make membership in the
Federal Reserve more attractive— perhaps by providing for
lower reserve requirements or allowing the System to pay in­
terest on the reserve balances that member banks maintain.
Moreover, in view of the expanding presence of foreign banks
in the United States— with assets here that now exceed $75 bil­
lion— the Board believes it important to subject foreign banks
to the same federal rules and regulations that apply to domestic
banks. To strengthen our banking system, we therefore urge
adoption by Congress of legislation on foreign banking such
as the House of Representatives passed last year.
I have dwelt thus far on the condition of the banking sys­
tem in relation to the activities that banks carry on in our
domestic markets. A proper assessment must take into account
as well the role of our banks abroad. That role has expanded
enormously, and the pace of growth has been especially fast in
the last several years. The indebtedness of foreigners to U.S.
banks and their foreign branches rose annually during the past
three years by about 20 percent. It is important to recognize in
this connection that most of the expansion in foreign lending
by our banks has been made possible by funds raised abroad.
As the world economy keeps getting bigger, some year-toyear increase in the international loan portfolios of U.S. banks
is a normal occurrence. But the recent pace of bank lending to
foreigners goes beyond anything that can be explained in terms
of the growth of either world economic activity or international
trade. In addition, it reflects three developments: first, the enor­
mous rise of financing needs around the world that was occa­
sioned by the quintupling of oil prices; second, the willingness
of American banks to respond to those financing needs; third,
the growth of multinational corporations and the international­
ization of banking through the Eurocurrency markets.
The sharp increase of oil prices did not in and of itself
give rise to a need for financing activity of the kind American
banks have been engaged in. Theoretically at least, the OPEC
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CONDITION OF THE BANKING SYSTEM

group, recognizing the severe payments imbalances they had
caused, could themselves have become bankers on a major
scale. We know, of course, that they largely avoided the route
of extending credit directly to the countries that were buyers of
their oil, but instead funneled their huge surpluses into a variety
of financial assets— chiefly bank deposits. They thereby shifted
the banking opportunity— and with it, of course, the burden
of credit evaluation— to others, which meant mainly the large
American and European banks that the OPEC group used as
depositories. The fact that things might have happened other­
wise is something we should not forget, since in the years im­
mediately ahead— if serious oil-related payments imbalances
persist— it may yet be necessary to urge upon the OPEC group
a much more active role as bankers than they have so far played.
American banks, as is well known, responded along with
other banks to the "recycling" challenge, serving since 1974 a
very substantial intermediary role between the OPEC group and
the countries whose external payments had deteriorated because
of OPEC pricing. The fact that loan demand within the United
States was relatively weak in 1975 and 1976 undoubtedly has
been a factor helping to sustain an unusuallly high rate of
foreign lending activity by our banks.
The sharp increase of oil prices, to say nothing of the
worldwide recession, caused extensive dislocations in the world
economy; but much more serious difficulties would have oc­
curred if commercial banks here and elsewhere had not acted
as they did. There simply was no official mechanism in place
in 1974 that could have coped with recycling of funds on the
vast scale that then became necessary. The supportive role that
American and other commercial banks played in this situation
thus prevented financial strains from cumulating dangerously,
and this role continues even now. Certainly, our export trade
and the general economy have been helped— and are being
helped—by banking's role in international lending.
This is not to say there have been no excesses or that ex­
pansion of international lending by American banks can con­
tinue at an undiminished pace. Even though losses on foreign
loans have been small— indeed, relatively smaller than on
domestic loans— the Federal Reserve Board is concerned about
the enlarged risk exposure of our banks. I personally have




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REFLECTIONS OF AN ECONOMIC POLICY MAKER

voiced apprehension about various aspects of these international
lending activities in both private and public discussion.
The rapid expansion of credit to the non-oil "less de­
veloped" countries (LDCs) warrants particularly close attention.
The total indebtedness of such countries to American banks
alone approximated $45 billion at the end of 1976. These
countries also owe substantial sums to foreign banks, official
institutions, and others. The fact that the aggregate external
indebtedness of these countries may run to something like $180
billion has been well publicized.
O f course, total debt figures— and more importantly the
interest charges flowing from them— need to be viewed in the
) context of the levels of production and exports of the non-oil
LDCs. Looked at in those terms, they are decidedly less wor­
risome. Nevertheless, the ratio of the external debt to exports
and also the ratio of the external interest burden to exports have
deteriorated for most non-oil LDCs in recent years, although
some stabilizing tendencies did emerge in 1976. In some
countries, such ratios have reached levels which justify serious
concern and which point to the need for determined stabilization
policies. In the absence of such policies, difficulties may be
encountered in rolling over existing debt or borrowing to meet
new requirements.
This situation demands a heightened sense of caution on
the part of our banks in managing their international loan
portfolios, and such caution does in fact appear to be emerging.
Here, too, though, the Board will be watchful of developments.
As part of a broader effort to improve knowledge of inter­
national lending activities, we are currently engaged in a joint
project with other central banks to obtain a more accurate size
and maturity profile of the indebtedness to banks of individual
countries. Such data should prove useful to bankers as they
proceed to evaluate credit requests by foreigners. The Board
has communicated its intent to be both helpful to banks and
watchful of their activities. The latter point is currently being
signalled, for example, by an informal survey of bank practices
in defining, monitoring, and controlling risk in international
lending.
The Board's judgment about the condition of the inter­
national loan portfolios of American banks is not easily sum412



CONDITION OF THE BANKING SYSTEM

marized. We have been concerned with the rapidity of the rise
in foreign lending, and we believe that here and there a slowing
must occur— to rates of growth, generally, that are consonant
with expansion of the debt-servicing capabilities of individual
borrowing countries. Such slowing, it should be appreciated,
may well involve some problems for the international economy,
since the structural payments imbalances that have occasioned
such heavy bank lending to foreign countries are not going to
disappear rapidly. The inference is clear that a strong coopera­
tive effort is more than ever necessary— involving, among
others, official international agencies, the Group of Ten coun­
tries, OPEC, the non-oil LDCs, and the private banks. Unless
we succeed in devising sound financial alternatives, serious
strains in the world economy may develop.
In closing, let me say that I am sensitive to the fact that
the statement I have made this morning— despite its length—
by no means reviews the condition of our banking system as
fully as would be desirable. Some of the matters I have touched
on are extremely complex and that inherently creates risks that
relatively brief treatment may give rise to misunderstandings.
I particularly hope that the emphasis I have placed on
the need for caution in credit extension will not be misunder­
stood. In banking, as in other pursuits, a fine line exists
between being too cautious and not being cautious enough. At
the Federal Reserve Board, we certainly do not want caution
to be overdone in the sense of having our bankers be unrespon­
sive to the needs of creditworthy borrowers, either at home or
abroad. Nor do we as supervisors, despite our obligation to be
watchful, seek to substitute our judgments for those of on-line
bankers in deciding who should get credit. W e have neither the
capacity nor the desire to play such a role.
The legitimate credit needs of our citizens and our busi­
nesses must be met if our economy— and indeed the world
economy— is to prosper. It is precisely for that reason that
the Federal Reserve is pursuing a policy of adding steadily to
our banking system's resources, and yet doing so on a scale
that will not reignite the fires of inflation. Our banks are in a
good position to serve the needs of their communities. They
have been extending impressive amounts of credit to consumers,
to farmers, and to those in need of mortgage credit. As the




413

REFLECTIONS OF AN ECONOMIC POLICY MAKER

demand for business credit strengthens, that too will be reason­
ably accommodated. I hope that in dwelling on other considera­
tions this morning, I have created no misimpressions about this
critical matter.

414



The Importance of an
Independent Central Bank

It is a pleasure for me to be here on the campus of Jacksonville
University to join in honoring this graduating class. I say that
most sincerely. Having spent the greater part of my life as a
university teacher, I always take satisfaction in the scholastic
achievement of young men and women. This is rightfully a
proud moment for you, and I very much appreciate being able
to share it.
Today, I would like to talk to you about an issue that has
been important throughout much of recorded history and which
is certain to influence your lives— for better or worse. I refer
to government's management of money— a function than in our
country is lodged by statute with the Federal Reserve System.
No nation whose history I am familiar with has succeeded
in managing the stock of money perfectly. Few, indeed, have
even managed it well. And those societies that have been least
successful have paid dearly for their ineptitude. Debasement
of the currency had a great deal to do with the destruction of
the Roman Empire. In our own times, excessive creation of
money has released powerful inflationary forces in many coun­
tries around the globe. And once a nation's money is debauched,
economic stagnation and social and political troubles usually
follow.
Each of you in this assemblage, whatever your age, has
experienced at first hand some of the consequences of monetary
Commencement address at Jacksonville University, Jacksonville, Florida,
August 13, 1977.




415

REFLECTIONS OF AN ECONOMIC POLICY MAKER

stress. For a dozen years now, our nation has been subjected
to a relentless siege of inflation that has conferred undeserved
windfall gains on some and undeserved hardships on others.
In terms of social well-being, these capricious pluses and minuses
by no means cancel out. Young people wanting to buy a home
these days know that the price of decent shelter has soared
almost out of reach. Parents across the country know the
shocking extent to which tuition costs have ballooned. And
woe to anyone who has major medical expenses and is not
adequately insured.
Those, moreover, are merely among the most readily visible
consequences of inflation. There are other less apparent effects
that are even more pernicious. Once a nation's economy has
been gripped by inflation, it becomes virtually impossible to
maintain an environment in which jobs are plentiful and secure.
The economic recession of 1974-1975, in the course of which
unemployment climbed to a level above 8 million persons, would
not have been nearly so severe— and indeed might not have
occurred at all— had it not been for the inflationary distortions
of the preceding several years.
That is clear, I think, from the sequence of events. Double­
digit inflation severely drained many family pocketbooks, re­
duced consumer confidence, and led to more cautious consumer
spending. Businessmen, however, were slow in responding to
the weakening of consumer markets. They seem to have been
blinded by the dizzying advance of prices and by the effect of
that advance on their nominal profits. They thus continued
aggressive programs of inventory expansion and capital-goods
expansion longer than was prudent, thereby causing economic
imbalances to cumulate to major proportions. By the time the
weakening of consumer markets was fully recognized by busi­
nessmen, the need to scale back had become enormous. The worst
recession in a generation ensued.
The only positive aspect of that traumatic episode is that
it finally opened the eyes of many economists and public officials
to the fact that inflation and unemployment are not alternatives
for our economy. The message is now clear that inflation in time
causes serious unemployment. Understanding of that relation­
ship is gradually tending, I believe, to make public policies more
sensible.
416



IMPORTANCE OF AN INDEPENDENT CENTRAL BANK

Some of you in this audience may be wondering, I suspect,
whether the Federal Reserve may not have something to do
with the inflation we have been experiencing. It may fairly be
asked: Has not the Federal Reserve been creating too much
money? And may not this be one of the causes of our inflation?
That question is, indeed, often put to me, and I welcome it
because of the opportunity it affords to clarify the nature of th e.
dilemma our country faces. Neither I nor, I believe, any of my
associates would quarrel with the proposition that money
creation and inflation are closely linked and that serious infla­
tion could not long proceed without monetary nourishment.
We well know— as do many others— that if the Federal Reserve
stopped creating new money, or if this activity were slowed
drastically, inflation would soon either come to an end or be
substantially checked.
Unfortunately, knowing that truth is not as helpful as one
might suppose. The catch is that nowadays there are tre­
mendous nonmonetary pressures in our economy that are
tending to drive costs and prices higher. This, I should note,
applies not only to our country, nor is it anymore just a phe­
nomenon of wars and their aftermath as tended once to be the
case. Rather, powerful upward pressures on costs and prices
have become worldwide, and they persist tenaciously through
peace-time periods as well as wars.
This inflationary bias reflects a wide range of developments
that have been evolving over a span of decades in both govern­
mental and private affairs. Foremost among these developments
is the commitment of modern governments to full employment,
to rapid economic growth, to better housing, improved health,
and other dimensions of welfare. These are certainly laudable
objectives, but they have too often caused governmental spend­
ing to outrun revenues. Other developments— such as the
escalator arrangements that various economic groups have
achieved through their efforts to escape the rigors of inflation—
have speeded the transmission of inflationary impulses across
the economy. What we as a people, along with other nations,
have been tending to do is to subject available resources to
increasingly intensive demands; but we at the same time have
sought to insure that incomes do not get eroded when excessive
pressures on resources generate inflation. This amounts, un­




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REFLECTIONS OF AN ECONOMIC POLICY MAKER

fortunately, to creating upward pressures on costs and prices,
and then arranging to perpetuate them. That is the awesome
combination that fighters against inflation have to try to counter.
Theoretically, the Federal Reserve could thwart the non­
monetary pressures that are tending to drive costs and prices
higher by providing substantially less monetary growth than
would be needed to accommodate these pressures fully. In
practice, such a course would be fraught with major difficulty
and considerable risk. Every time our government acts to
enlarge the flow of benefits to one group or another the assump­
tion is implicit that the means of financing will be available.
A similar tacit assumption is embodied in every pricing decision,
wage bargain, or escalator arrangement that is made by private
parties or government. The fact that such actions may in
combination be wholly incompatible with moderate rates of
monetary expansion is seldom considered by those who initiate
them. If the Federal Reserve then sought to create a monetary
environment that seriously fell short of accommodating the
nonmonetary pressures that have become characteristic of our
times, severe stresses could be quickly produced in our economy.
The inflation rate would probably fall in the process but so,
too, would production, jobs, and profits.
The tactics and strategy of the Federal Reserve System—
as of any central bank— must be attuned to these realities.
With sufficient courage and determination, it is nevertheless
within our capacity to affect the inflation rate significantly.
We may not, as a practical matter, be able to slow monetary
growth drastically within any given short time span, but we
do have considerable discretion in accommodating the pres­
sures of the marketplace less than fully. We are, indeed, often
engaged in probing and testing our capacity to do just that.
And, while we must be cautious about moving abruptly, my
colleagues and I in the Federal Reserve System are firmly com­
mitted to a longer-term effort of gradual reduction in the rate
of growth of money— something that is reflected in the progres­
sion of steps we have been taking to lower permissible growthranges for the money supply. Slowly undernourishing inflation
and thus weakening it seems the most realistic strategy open
to us. We believe that such an effort— especially if Congress
becomes less tolerant of budget deficits— will ultimately create
418



IMPORTANCE OF AN INDEPENDENT CENTRAL BANK

a much healthier environment for the determination of wages
and prices.
The capacity of the Federal Reserve to maintain a meaningful
anti-inflationary posture is made possible by the considerable
degree of independence it enjoys within our government. In
most countries around the world, central banks are in effect
instrumentalities of the executive branch of government—
carrying out monetary policy according to the wishes of the
head of government or the finance ministry. That is not the case
in this country because the Congress across the decades has
deliberately sought to insulate the Federal Reserve from the kind
of political control that is typical abroad. The reason for this
insulation is a very practical one, namely, recognition by the
Congress that governments throughout history have had a
tendency to engage in activities that outstrip the taxes they are
willing or able to collect. That tendency has generally led to
currency depreciation, achieved by stratagems ranging from
clipping of gold or silver coins in earlier times to excessive
printing of paper money or to coercing central banks to expand
credit unduly in more modern times.
*
With a view to insuring that the power of money creation
would not be similarly abused in our country, the Congress has
given our central bank major scope for the independent exercise
of its best judgment as to what monetary policy should be.
In fact, Congress has not only protected the Federal Reserve
System from the influence of the executive branch; it also has
seen fit to give the System a good deal of protection from
transitory political pressures emanating from Congress itself.
Probably the two most important elements making for
Federal Reserve independence are the following: First, the seven
members of the Federal Reserve Board serve long and staggered
terms and can only be removed for "cause/' This arrangement
severely limits possibilities for any "packing" of the Board and
enables members of the Board to act without special concern
about falling out of grace politically. Second, the Federal Re­
serve System finances its activities with internally generated
funds and therefore is not subject to the customary appropria­
tions process. This arrangement is intended to assure that the
congressional "power of the purse" will not be used in an




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REFLECTIONS OF AN ECONOMIC POLICY MAKER

effort to induce System officials to pursue policies that they
otherwise might consider poorly suited to the nation's needs.
The Federal Reserve has thus been able to fashion monetary
policy in an impartial and objective manner— free from any
sort of partisan or parochial influence. While the long history
of the Federal Reserve is not faultless, its policies have con­
sistently been managed by conscientious individuals seeking
the nation's permanent welfare— rather than today's fleeting
benefit. Significantly, this country's record in dealing with
inflation— albeit woefully insufficient— has been much better
generally than the record of countries with weak central banks.
Indeed, I would judge it no accident that W est Germany and
Switzerland, which in recent years also have managed their
economy better than most others, happen to have strong and
independent monetary authorities like ours.
The degree of independence which Congress has conferred
upon the Federal Reserve has been a source of frustration to
some government officials since the Federal Reserve Act first
became law. Certainly, from the standpoint of the executive
branch, it would at times— perhaps often— be more convenient
to instruct the central bank what to do than to reckon with the
System's independence. In the end, however, the country would
not be as well served. The Federal Reserve, it needs to be
emphasized, seeks earnestly to support or to reinforce gov­
ernmental policies to the maximum extent permitted by its
responsibilities. When the System's actions depart, as they
occasionally have, from the way in which the executive branch
would wish it to act, that is generally because the System tends
to take a longer-range view of the nation's welfare. Actually,
most of the time, monetary and fiscal policies are well co­
ordinated and mutually reinforcing; in other words, they are
the product of continuing and fruitful discussions between
members of the administration and Federal Reserve officials.
Not only is dialogue continuous with the executive branch
of government, but Federal Reserve officials appear frequently
before congressional committees— something that works, on
the one hand, to keep Congress informed as to System activities
and which, on the other, affords senators and congressmen an
effective means of registering approval or disapproval of Federal
Reserve policy. In practical terms, the economic policy dialogue
420



IMPORTANCE OF AN INDEPENDENT CENTRAL BANK

that is always in process within our government produces a
thorough exploration of options. It may fairly be said, I believe,
that the System's independence results in a more thorough
discussion and thrashing out of public issues than would other­
wise occur.
Despite the salutary influence that the Federal Reserve's
independence has had on our nation's economy, legislative pro­
posals that would place the System under tighter rein keep being
introduced in Congress. The proposals that have been put forth
over the years cover a wide range— for example, to enlarge the
size of the Board, to shorten the terms of its members, to enable
the president to remove board members at will, to diminish or
eliminate the role of Federal Reserve bank directors, and to
subject the System to the congressional appropriations process
or to audit by the Government Accounting Office. In recent
years, there have also been proposals calling for numerical
forecasts of interest rates or other sensitive magnitudes, which
if ever undertaken by the Federal Reserve, could unsettle finan­
cial markets, besides misleading individuals who lack sophisti­
cation in financial matters.
The shortcomings of these individual proposals matter less,
however, than what appears to be their common objective,
namely, to reduce the Federal Reserve's independence and to
restrict its scope for discretionary action. That, I believe, is the
real thrust of the diverse efforts to "reform " the Federal Reserve
System. It is perhaps of some significance that such proposals
not infrequently come from individuals who are basically dis­
satisfied with what they regard as excessive Federal Reserve
concern with battling inflation.
The element of populism in all this is strong— particularly
the preoccupation with maintaining low interest rates. It makes
no difference how often Federal Reserve officials repeat that the
System's continuing objective is the lowest level of interest rates
compatible with sound economic conditions. That is not enough.
What is desired is assurance that interest rates will be kept per­
manently down, or at least not be allowed to rise significantly.
The Federal Reserve cannot, of course, give that kind of
assurance. In a period of rising demands for funds, a deter­
mined effort by the System to keep interest rates down could
quickly turn the Federal Reserve into something akin to the




421

REFLECTIONS OF AN ECONOMIC POLICY MAKER

engine of inflation that it was during the early Korean W ar
period when the System unwisely tried to keep interest rates
down so that the cost of financing the federal debt would not
escalate. Actually, the consequences now would almost certainly
be far worse than they were a quarter century ago because the
public has become far more sensitive to inflation.
Long-term interest rates, in particular, tend to respond
quickly nowadays to changing inflationary expectations. Once
the financial community perceived that the Federal Reserve was
pumping massive reserves into commercial banks with a view
to creating monetary ease, fears of a new wave of inflation
would spread quickly. Potential suppliers of long-term funds
would then be inclined to demand higher interest rates as pro­
tection against the expected higher rate of inflation. Borrowers,
on the other hand, would be more eager to acquire additional
funds, since they would expect to repay their loans in still
cheaper dollars. In short, heightened inflationary expectations
would soon overwhelm markets in today's inflation-conscious
environment by actually causing long-term interest rates—
which are generally more important to the economy than short­
term rates— to rise. The policy of seeking lower interest rates
by flooding banks with reserves would thus be frustrated. And
I need hardly add that adverse effects on production, employ­
ment, and the dollar's purchasing power would follow.
The Federal Reserve System, I assure you, will not be
deterred by the drumbeat of dubious propositions concerning
money and interest rates. We are determined to continue on
a path of further gradual unwinding of the inflationary tenden­
cies that have become so deeply embedded in our economic life.
We are determined to continue promoting the expansion of our
economy and yet control the supply of money so as to prevent
a new wave of inflation. Such a policy, I firmly believe, is the
only responsible option open to us.
I hope that I have succeeded today in conveying some
sense of the importance to you as individuals and to the nation
generally of the Federal Reserve's role in our government.
Fortunately, despite the criticism that is not infrequently voiced
by some members of Congress, the Congress as a whole has
kept the Federal Reserve's role in a clear perspective and has
fully protected the essentials of Federal Reserve independence.
422



IMPORTANCE OF AN INDEPENDENT CENTRAL BANK

That will continue to be the case only if you who are gradu­
ating today and other citizens develop a full understanding of
what is at stake.




423




Vital Issues of Banking
Legislation

It is a great pleasure for me to be here today and to have the
privilege of addressing this gathering.
I thought I might usefully speak to you about some of the
legislation pending in the Ninety-fifth Congress. This is a busy
season for banking legislation. Bills under consideration deal
with such diverse subjects as nationwide NOW accounts, the
financial burden of Federal Reserve membership, the operation
of foreign banks in this country, the restructuring of bank
supervisory and regulatory authority, and revision of the Truth
in Lending statute. There are, moreover, various proposals in
the congressional hopper that aim in one way or another at
circumscribing the Federal Reserve's scope for independent
judgment and decision.
I cannot, of course, cover this morning all the banking
legislation that is now pending. But I welcome this opportunity
to comment on some of the major bills that have been intro­
duced, and also to indicate why we at the Board are so deeply
concerned about the character of numerous proposals that keep
being advanced under the banner of "reform ."
Let me say something first about S. 2055— the legislative
package that combines authority for nationwide NOW accounts
with measures to lighten the burden of Federal Reserve mem­
bership. As you know, this bill was voted out of the Senate
Banking Committee in early August and may soon be debated
on the Senate floor.
Address at the eighty-third annual convention of the Kentucky Bankers
Association, Louisville, Kentucky, September 12, 1977.




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REFLECTIONS OF AN ECONOMIC POLICY MAKER

I am well aware that some of you have serious reservations
about this bill. Indeed, I have heard from many bankers around
the country who object to some of its key provisions— particu­
larly the contemplated extension of NOW-account authority—
and who urge the Federal Reserve to withdraw its support of
the measure. The impact on earnings of paying interest on
transactions balances is obviously of concern— and properly
so— to commercial banks, especially those for which the check­
ing accounts of individuals make up a large portion of total
deposits.
Let me assure you that we at the Federal Reserve Board
recognize the importance of good bank earnings. W e well know
that unless earnings are reasonably satisfactory, commercial
banks will not be able to serve their communities or the national
economy in an effective manner. We also believe that bank
earnings will be adversely affected for a time during the transi­
tion to a NOW-account environment. That has certainly been
the experience with NOW accounts in New England.
Why, then, it may fairly be asked, does the Federal Reserve
support nationwide NOW-account authority?
The reason essentially is that we think it is important to
bring a sense of order to a development that has the look of
inevitability about it but which to date has proceeded in hap­
hazard fashion. The simple fact is that by one means or another
depositors have been increasingly successful in earning interest
or its equivalent on their transactions balances. Such interest
is implicit in the banking services that are provided bank cus­
tomers without charge or below cost. Beyond this, and on a
growing scale, many customers of financial institutions are
already receiving interest in cash on transactions balances—
not only in the New England states where NOW 's are au­
thorized, but throughout the country. This is the consequence,
as you well know, of recent financial innovations that enable in­
dividuals as well as corporations to move funds readily between
interest-bearing accounts and checking deposits or between
money market instruments and checking deposits. Congres­
sional inaction will not stop the spread of interest payments
on what are in effect transactions balances; it would simply
mean that the movement will go forward without guidance at
the national level, attended by inefficiency and competitive
426



VITAL ISSUES OF BANKING LEGISLATION

distortion. My colleagues and I thus see S. 2055 as a vehicle
for guiding this development in a gradual and orderly fashion
while limiting the adverse effects on bank earnings.
I well understand the displeasure that commercial bankers
feel over the fact that S. 2055 would in effect confer checkingaccount authority on thrift institutions while leaving intact their
ability to pay savings depositors a higher rate of interest than
can commercial banks. To be sure, all depository institutions
that decide to offer NOW accounts under the new authority
would do so on the same terms, so that the troublesome interestrate differential would be eliminated for that category of de­
posits. However, since N OW accounts would expand the powers
of thrift institutions to a point where they could offer depositors
the attractions of "one stop banking/' the extension of parity
should not be limited to newly created NOW accounts. Both
logic and equity suggest that thrift institutions should enjoy
either NOW-account authority or the interest-rate differential—
but hardly both.
The difficulty of overcoming opposition to any modification
of the differential must not, however, be underestimated. This
was evidenced by the failure of the Senate Banking Committee
to accept an amendment by Senator Lugar, which would have
restored the power that bank regulatory agencies had until late
1975 to adjust the differential without ratifying action by the
Congress. I have indicated to Senator McIntyre, the distin­
guished sponsor of the NOW-account legislative package, the
desirability of removing the ratification requirement because
it constitutes an impediment to timely adjustment of deposit
interest-rate ceilings as circumstances change. Even though
Senator Lugar's amendment failed in committee, this moderate
step toward less rigidity with regard to the differential deserves
sympathetic consideration by the Congress at large. Senator
McIntyre's support of the amendment was particularly encour­
aging. I hope that interested parties will continue to press the
issue.
In your continuing assessment of S. 2055, I would urge
that you weigh carefully the point I have made about the dis­
advantages inherent in letting interest payments on what are
essentially transactions balances continue to spread in hap­
hazard, piecemeal fashion. Neither individual bankers, nor




427

REFLECTIONS OF AN ECONOMIC POLICY MAKER

their nonbank competitors, nor state legislatures, nor bank
regulators, nor the Congress itself are likely to stand still.
On the contrary, actions that serve to expand the payment of
interest on transactions balances by all types of depository
institutions will continue to multiply. It is my strong conviction
that ultimately both the general interests of the nation and the
particular interests of commercial banks will be poorly served
if the changes we have been witnessing are not subjected to
orderly direction.
The transitional problems faced by financial institutions
in adapting to NOW accounts will not be easy, but they ought
to be less troublesome in most parts of the country than they
have been in New England. I say this in part because the New
England experience is available as a guide. It surely should be
possible to avoid repeating some of the mistakes— particularly
the mistakes in pricing— that were made by various institutions
in that region. Indeed, it seems clear from the statistical evi­
dence that depository institutions in Connecticut, Maine, Rhode
Island, and Vermont have generally been able to profit from
the earlier NOW-account experience in Massachusetts and New
Hampshire. Banks and thrift institutions in the New England
states that were relative latecomers to the NOW experiment
have tended to pursue more cautious marketing and pricing
strategies, and their earnings have consequently stood up better.
There are also other reasons for thinking that New Eng­
land's experience is not likely to be repeated in other regions.
For one thing, competition between commercial banks and
thrift institutions appears to be somewhat more vigorous in
New England than in most parts of the country. Then, too,
S. 2055 is deliberately structured to minimize transition costs
and protect bank earnings. It limits eligibility for N O W
accounts to individuals. It gives regulatory agencies discretion
to set a lower interest-rate ceiling for NOW 's than currently
prevails in New England. It authorizes the payment of interest
on reserve balances held at the Federal Reserve, including re­
serves against the NOW accounts. It anticipates lower reserve
requirements on NOW accounts than on demand deposits.
It allows more room for reductions in the reserves required of
member banks, especially the smaller banks. And it delays the
428



VITAL ISSUES OF BANKING LEGISLATION

effective date of nationwide NOW-account authority for one
year after the enactment of legislation.
These things in combination make it seem likely that
depository institutions across the country will be able to main­
tain their earnings reasonably well as they move to NOW
accounts. I would note especially that the one-year waiting
period will afford banks time for rational planning of their
operational systems and marketing strategies for N OW accounts.
Without this array of provisions designed to maintain earnings
strength, the Federal Reserve Board, I assure you, would not be
willing to support the NOW-account proposal.
That there will nevertheless be some net cost to many
commercial banks in making the transition to NOW 's also
seems clear. That is why we at the Board have been at such
pains to keep this cost down and that is also why we have been
so insistent on combining the NOW-account proposal with
action to lighten the financial burden of Federal Reserve
membership.
Member banks are already very sensitive to the cost dis­
advantage they suffer vis-a-vis nonmembers because of the
more onerous reserve requirements they have to meet. This
has resulted in recent years in a significant erosion of member­
ship— particularly on the part of smaller banks. There is no
question at all in my mind that this membership erosion would
accelerate if we were to go forward with nationwide NOW 's ,
without taking simultaneous action to lighten the burden of
membership. That is the reason, of course, the Board has
worked so intensely to obtain authority to pay interest on
reserve balances and to be in a position to lower reserve
requirements— particularly for the smaller banks.
A healthy, effective central bank is not a matter of paro­
chial concern— of importance only to Federal Reserve officials
and member banks. The Federal Reserve serves the entire
financial community and indeed the nation at large. It would be
in no one's interest to see its vitality sapped. Unless the erosion
of membership is arrested, a steadily diminishing portion of
commercial bank deposits will be lodged with members and the
execution of monetary policy will therefore become less and less
precise. Other things trouble me still more. Provision of
lender-of-last-resort facilities was a critical reason for establish-




429

REFLECTIONS OF AN ECONOMIC POLICY MAKER

ing the Federal Reserve System. I do not like to contemplate the
ultimate consequences for the soundness of our banking struc­
ture if fewer and fewer banks enjoy ready access to the System's
discount window.
Declining membership could also threaten the insulation of
the Federal Reserve System from day-to-day political pressures.
The System's independence from such pressures will remain
sustainable, I believe, only as long as the System continues to
have balanced representation of membership among all sizes
of banks across the country. But membership attrition has been
most acute among smaller banks— those with deposits of less
than $100 million. If the exodus continues and the remaining
members are only the larger banks, the Federal Reserve will
then be perceived by the public as a big banker's bank. This
would almost certainly generate disenchantment with the Sys­
tem. In time, the Federal Reserve's independence— which en­
ables it to base monetary policy on long-range considerations
as well as those related to the short term— would diminish if
not entirely end.
I hope that these comments on key provisions of S. 2055
may suffice to show why we at the Board view the bill on bal­
ance as a constructive and desirable piece of legislation. I said
before that I know many of you have reservations about it, and
I understand the reasons for those reservations. I nevertheless
believe that it would be the better part of wisdom to retain an
open mind toward this legislative effort and seek to improve it
rather than scuttle it.
Let me now turn to other items in the legislative mill. I
noted earlier that the banking bills under consideration this
year include the usual array of measures to "reform " the Fed­
eral Reserve System. The Federal Reserve Reform Act of 1977
recently cleared the House Banking Committee in a form greatly
different from the measure originally proposed. Fortunately,
the most troublesome features of the bill were eliminated during
the committee markup and this is an encouraging fact. One of
the defeated provisions— that dealing with so-called lobbying
communications— would have placed very broad restrictions on
the right of Federal Reserve officials to communicate with bank­
ers about legislative matters. Indeed, were it ever to become
law, there would be a serious question whether I or any of my
430



VITAL ISSUES OF BANKING LEGISLATION

colleagues would be able to address an assemblage such as this
in the manner I am doing. Other rejected provisions would have
required the Federal Reserve to publicize at quarterly intervals
numerical forecasts of interest rates and other sensitive financial
variables. Forecasts of interest rates by the nation's central bank
may seem harmless at first blush, but any such pronouncement
by the Federal Reserve would in practice carry implications for
debt markets that could generate wide and unsettling swings in
security prices.
The wish to have us make such pronouncements is some­
what puzzling. My best guess is that preoccupation with in­
terest rates— particularly with trying to influence the Federal
Reserve to keep interest rates down— often tends to blur judg­
ment. Populist emphasis on low interest rates appears to be
a key reason for the steady stream of proposals that in one way
or another would enlarge opportunities for exerting political
influence upon monetary policy. A less independent Federal
Reserve— particularly one that would be less concerned about
inflation and thus more generously accommodative of credit
demands— clearly remains an objective of many people.
A perennial favorite for the past quarter century of those
who would like to see the Federal Reserve enjoy less inde­
pendence is the proposal to subject the System to audit by the
General Accounting Office. Indeed, a bill giving the GAO
sweeping authority to audit the Federal Reserve— as well as the
Federal Deposit Insurance Corporation and the Comptroller
of the Currency— was introduced in the House last January*
In the course of the recent markup by the House Government
Operations Committee, a number of provisions were wisely
incorporated in the bill with a view to affording some protection
against disclosure of confidential information. Even so, the
measure retains major deficiencies and ambiguities, and we thus
feel compelled to oppose it. Incidentally, the bill is expected
to be on the calendar for floor action very soon, possibly this
week or next.
The bill raises serious questions of public policy. The
Federal Reserve Banks have never been subject to GAO audit.
The exempted status of the Board dates back to the Banking Act
of 1933. The complete exemption of the Federal Reserve System
from GAO audit since 1933 thus complements the original




431

REFLECTIONS OF AN ECONOMIC POLICY MAKER

exemption of the Federal Reserve from the appropriations
process. These exemptions have conferred on the Federal Re­
serve a heavy responsibility to conduct its affairs with the
highest standards of probity; they have also enabled the System
to determine its internal management free from political pres­
sures. Exemption from GAO audit is one of the main pillars
of Federal Reserve independence.
In exempting the Federal Reserve from customary appro­
priations and auditing procedures, the Congress has recognized
the special political vulnerability that a central bank tends to
develop if it in fact comports itself as it should in carrying out
its monetary function. It is simply a fact of life that whenever
a central bank imposes monetary discipline, it almost always
generates a good deal of opposition. Those displeased with
Federal Reserve performance would surely have greater leverage
in their efforts to get monetary policy changed if the System
were subject to customary appropriations and auditing pro­
cedures. I do not mean to suggest that our stewardship should
be beyond examination. Accountability by the Federal Reserve
is obviously essential, and we believe that the arrangements
Congress has fashioned across the decades achieve thorough
accountability within a framework of safeguards that take ac­
count of the special vulnerability to which central banks are
everywhere subject.
What concerns the Board most about proposals for a GAO
audit is that such auditing may become a device through which
pressure is brought to bear directly on the formulation of mone­
tary policy. To be sure, the pending GAO audit bill excludes
a broad range of monetary policy deliberations and transactions
from the proposed audit, but it does not flatly and unambigu­
ously exclude all monetary policy matters. For example, the
Committee Report indicates that the GAO would have authority
to audit and evaluate discount-window transactions to the extent
that such transactions are related to the supervisory function
of the System— as distinct from its monetary policy function.
This is an extremely fuzzy distinction, and it could easily
become a vehicle for GAO intrusion into monitoring monetary
policy— an area in which that venerable institution has neither
experience nor expertise, to say nothing of responsibility.
It is to the credit of the pending bill that it recognizes the
432



VITAL ISSUES OF BANKING LEGISLATION

need to protect sensitive and confidential information concern­
ing private parties. But I am by no means satisfied that the
bill's provisions in this regard are adequate. Except for records
pertaining to monetary policy, the GAO would be given access
to "all books, accounts, records, reports, files, memorandums,
papers, things, and property belonging to or in use by the
entities being audited, including reports of examination of banks
or bank-holding companies . . . together with workpapers and
correspondence relating to such reports . . . ." These materials
obviously include a great deal of sensitive information. And
while the bill prohibits the GAO from identifying individuals
and institutions in its public reports to Congress, all such in­
formation could still be made available to congressional com­
mittees sitting in executive session. Experience suggests that
this limitation is scant guarantee that sensitive and confidential
information about banks and their customers would not find
its way into the public domain. Great damage could thus be
caused to banks, individuals, and business enterprises. In self­
protection bankers might soon become less forthcoming to
examiners, while their work in turn might become infected
either by timidity or by zealotry because of the potential for
disclosure. The integrity of the entire bank examination process
could therefore be undermined.
Ultimately, as I have tried to suggest, the exemption of the
Federal Reserve from GAO audit can be properly understood
only in the context of the importance that congressional shapers
of the Federal Reserve System have attached to insulating this
nation's central bank from day-to-day political pressures. That
present audit arrangements for both the Board and the Federal
Reserve Banks are thorough and effective has, I believe, been
demonstrated by Federal Reserve officials in public testimony
time and time again. It is a fact, moreover, that besides the
auditing reports that go to the Congress each year, a great deal
of detailed information about Federal Reserve activities and
operations is supplied to congressional committees in response
to a steady stream of inquiries. When one also takes into
account the scope of the public oversight hearings conducted
by the House and Senate Banking Committees, the need for a
GAO oversight role is doubtful at best. If the Congress should
nevertheless want to go to the considerable expense of an




433

REFLECTIONS OF AN ECONOMIC POLICY MAKER

additional audit by the GAO, I certainly hope that such legis­
lation would not allow the GAO to involve itself in any way
with monetary policy procedures or deliberations, and that it
would also fully protect sensitive and confidential information
concerning banks and their customers.
I am mindful that my remarks have been lengthy, particu­
larly for the opening session of a working convention. Even so,
there is much in the field of banking legislation on which I have
not commented. For example, the Senate Banking Committee
will soon consider a proposal to establish a Federal Bank Com­
mission that would assume responsibility for the supervisory
and regulatory work now carried on by the three banking
agencies. In the Board's considered judgment, removal of the
Federal Reserve's supervisory and regulatory responsibilities
would at times seriously lessen the effectiveness with which
monetary policy is carried out, and that is one basic reason—
among others— why we are opposed to it. I regret that I cannot
discuss this bill fully today, but I hope that you and other
bankers in our country will make the effort to familiarize your­
selves with the issues surrounding it.
In closing, I would like to touch on one more matter. In
recent weeks, banking practices have become prominent in the
general news, and as a result are coming under special con­
gressional scrutiny. Chairman St Germain's subcommittee, for
example, has already embarked on hearings dealing with a range
of banking practices— among them, correspondent bank rela­
tions, bank policies relating to loan collateral, and bank policies
relating to overdraft facilities. Chairman Proxmire has sched­
uled hearings on similar topics toward the end of this month.
Specific legislation directed at some of the banking practices
that have recently received public attention will soon be
considered.
I deem it premature to make any kind of judgment as to
how sustained the legislative interest in such matters will be
or to what specific ends it will be directed. My hope is that a
sense of calm deliberation and balance will be maintained—
difficult though this may be at present. We cannot remind our­
selves too often that haste can easily make for bad legislation.
For several years, the Federal Reserve has been in the fore­
front of efforts to obtain added enforcement authority for fed434



VITAL ISSUES OF BANKING LEGISLATION

eral banking agencies. Our efforts in that direction in no sense
imply an unfavorable view of banking. Like other industries,
banking is not free of problems, but it is my judgment that
generally high standards of behavior prevail in banking. The
Federal Reserve's long-standing interest in greater enforcement
authority simply reflects our belief that some gaps in super­
visory authority exist and that improved enforcement powers
are appropriate.
The Ninety-fourth Congress did not give much attention
to our initiative. This year, however, after full and calm
deliberation, the Senate passed S. 71— a regulatory and super­
visory bill that embodies more stringent rules on insider loans,
strengthens cease-and-desist as well as officer-removal powers,
and provides a range of cash penalties for violations of banking
law or regulation. At present, the absence of an effective range
of penalties at times causes undue restraint on the enforcement
procedures of bank regulators.
Perhaps legislative remedies beyond those contained in
S. 71 are needed. I certainly have an open mind on this ques­
tion. But I would urge full deliberation before wider legislative
remedies are enacted. The banking legislation that I have re­
viewed with you or alluded to this morning is quite enough for
the Congress to handle in the remainder of this year.
I have talked a long time and I certainly dare not burden
you with anything else. May I just express my appreciation
once more for the privilege of visiting with you.




435







PART
FIVE
International Finance




The Par Value Modification Act

The Board of Governors of the Federal Reserve System strongly
supports enactment of the Par Value Modification Act. Prompt
passage of this bill will fulfill an important commitment under­
taken by the United States as part of the Smithsonian Agreement
reached by the Group of Ten countries on December 1 8 ,1 9 7 1 .
The Par Value Modification Act proposes a new par value
for the dollar in the International Monetary Fund. We will thus
Have a new official dollar price.of gold: an ounce of gold will
in the future be carried on the books at thirty-eight dollars
instead of thirty-five dollars as at present. The act does not
deal with the issue of convertibility, and therefore does not
affect the present suspension of convertibility of dollars into
gold or other international reserve assets.
The proposed change in the par value of the dollar will
have several financial and accounting consequences. First, the
value of the Treasury's gold and other reserve assets will be
written up by 8.57 percent, or about a billion dollars. Second,
the Treasury will be able to issue new gold certificates to the
Federal Reserve Banks for this amount, and its cash balance
will rise to the extent that it does so. Third, the dollar value
of subscriptions and contributions to several international finan­
cial organizations will need to be increased.
The net result of the various financial and accounting
adjustments, as the secretary of the Treasury has informed this
Statement before the Committee on Banking, Housing, and Urban Affairs,
United States Senate, February 24, 1972.




439

REFLECTIONS OF AN ECONOMIC POLICY MAKER

committee in detail, will somewhat improve the Treasury's cash
position and leave both budgetary expenditures and the overall
dollar assets and liabilities of the U.S. Government roughly
unchanged.
If these consequences were the sole results to be expected
from the Par Value Modification Act, there would be no need
to rush its passage. But much more than this is involved. As
this committee knows, the proposed change in the par value
of the dollar was an integral part of the Smithsonian Agreement.
Failure to pass promptly the Par Value Act could provoke a
renewal of disorderly conditions in financial markets and place
in jeopardy the Smithsonian Agreement itself. It is no exag­
geration to state that the realignment of currencies which the
Smithsonian Agreement achieved is absolutely essential to the
reinvigoration of our foreign trade and the eventual restoration
of equilibrium in our balance of payments.
The international monetary crisis we experienced in 1971
was by far the most severe since World War II. It had its roots
in events that stretch back over many years, during which a
persistent deficit developed in the U.S. balance of payments.
The crisis came to a head last summer when increasingly
unfavorable reports on our foreign trade released a wave of
speculation against the dollar that eventually engulfed foreign
exchange markets. The speculation expressed a growing belief
that there would soon have to be a substantial upward re­
valuation of at least some major currencies against the dollar—
or, what comes to the same thing, that the dollar would need
to depreciate in terms of other major currencies.
On August 15, the President announced a new policy for
dealing decisively with the domestic problems of inflation, in­
adequate productivity, and unemployment, which were weaken­
ing confidence in the American economy. Recognizing that
curbs on domestic inflation would not suffice to restore equi­
librium in the balance of payments, the President sought also
to achieve a realignment of currencies and better access to
foreign markets for American producers. To set the stage for
useful international negotiations, a temporary surcharge was
therefore imposed on imports and the convertibility of dollars
into gold or other reserve assets was suspended.
As expected, dollar prices of most of the major foreign
440



THE PAR VALUE MODIFICATION ACT

currencies rose on the exchange markets. Foreign governments,
although caught by surprise, soon sought in various ways to
adjust to the new monetary and trade conditions. Some im­
posed restrictions on inflows of funds while permitting their
exchange rates to appreciate in a controlled manner. Others
resorted to rather comprehensive financial controls in an effort
to maintain pre-August 15 exchange rates, at least for trade
transactions. Only a few countries permitted their exchange
rates to move more or less freely.
The pattern of exchange rates that evolved after August 15
thus failed to meet American objectives. Worse still, restric­
tions on international transactions were proliferating, with a
few countries even imposing restrictions or subsidies on trade
itself. Businessmen both here and abroad faced acute uncer­
tainty regarding the exchange rates and governmental restric­
tions under which trade would be carried on in the future.
This uncertainty aggravated recessionary forces already evident
in Europe and Japan. It also affected adversely the profit
expectations of American companies engaged in foreign opera­
tions or foreign trade, thereby inhibiting investment expendi­
tures and economic expansion in the United States.
In these circumstances, the dangers were growing of a
recession in world economic activity, of increasing recourse to
restrictions on international transactions, of a division of the
world economy into restrictive blocs, and of serious political
frictions among friendly nations. Prompt resolution of the
crisis was clearly necessary, and intensive international dis­
cussions therefore got under way in the autumn of 1971.
The settlement negotiated at the Smithsonian meeting of
last December provided for an average appreciation of the
currencies of the other Group of Ten countries against the
dollar of about 12 percent. Agreement was also reached on a
widening of margins for exchange rate variation. Later, a num­
ber of other countries decided to revalue their currencies upward
against the dollar, but most of the developing countries have
elected to maintain their exchange rates against the dollar at
the pre-August 15 levels.
Trade agreements were recognized by the participants in
the Smithsonian Agreement as relevant to the achievement of
lasting equilibrium in the international economy. Negotiations




441

REFLECTIONS OF AN ECONOMIC POLICY MAKER

on trade matters of immediate concern to the United States,
and which were under way at the time of the agreement, have
since been completed with Japan and the European Com­
munity— but not with Canada. The new trade measures should
improve the climate for certain U.S. exports. For the longer run,
the prospects are now promising for widespread support of
comprehensive multilateral negotiations on reducing barriers
to trade in both industrial and agricultural products.
For its part in the settlement, the United States agreed to
drop the import surcharge and related provisions of the invest­
ment tax credit, and to facilitate the realignment of exchange
rates by proposing to Congress a change in the par value of the
dollar in terms of gold.
Thus, the Par Value Modification Act is before you to
honor a critical commitment made in behalf of the U.S. Govern­
ment at the Smithsonian meeting. The American negotiators
would have preferred to achieve the desired appreciation of
foreign currencies without doing anything about the official
dollar price of gold. Other countries, however, refused to
countenance such a passive role by the United States in a
multilateral adjustment of exchange rates.
Active participation by the United States in the exchange
rate realignment was expected by other countries for various
reasons. Some countries regarded it as politically or financially
unacceptable to reduce the price of gold in terms of their own
currencies— as would have been required if the exchange rate
realignment had left the par value of the dollar in terms of gold
unchanged. And virtually all countries took the position that
no nation should be immune from changing its par value when
its balance of payments is in disequilibrium. In our judgment,
a negotiated realignment of exchange rates would have been
unattainable if the United States had refused to consider a
change in the par value of the dollar.
As already noted, the Par Value Modification Act proposes
an increase in the official dollar price of gold from thirty-five
dollars to thirty-eight dollars an ounce, that is, by 8.57 percent.
This exact increase reflects a compromise outcome of the nego­
tiations on the realignment of exchange rates. A price signifi­
cantly higher than thirty-eight dollars per ounce was never
seriously considered. An increase of less than 8V2 percent
442



THE PAR VALUE MODIFICATION ACT

would have failed to bring forth a realignment of exchange
rates as large as the readjustment that was finally accepted.
The primary objective of the U.S. negotiators at the Smithsonian
meeting was to achieve a substantial upward revaluation of the
currencies of other industrial countries against the dollar, and
this result was achieved.
It should be noted in passing that under the two-tier system
for gold, agreed to in March 1968, the official price of monetary
gold and the free market price of gold are effectively separated.
For all practical purposes, gold in official reserves is now a
different entity from gold that is bought and sold in free mar­
kets for industrial, artistic, or hoarding purposes. In particular,
the market price of gold has no bearing on the change in the
official price of gold proposed in the Par Value Modification Act.
Looking to the future, let me turn briefly to the probable
effects of the Smithsonian Agreement. Since dollar prices of
foreign currencies are now substantially higher than before,
the growth of our imports will tend to slacken and domestic
production will be stimulated. On the other hand, the lower
price of dollars abroad will make it possible for our exporters
to quote lower prices in terms of foreign currencies. Similarly,
the lower price of dollars will tend to stimulate foreign invest­
ments and travel in the United States.
There is thus every reason to expect the realignment of
exchange rates to bring about, in time, a substantial improve­
ment in our foreign trade balance and in our overall balance
of payments. Just how large the improvement will be, and how
long it will take for the full improvement to be realized, cannot
be predicted with certainty. The experience of other countries
indicates that large exchange rate changes will produce large
shifts in the balance of payments; but it also indicates that two
years or so may need to elapse before the full extent of the
favorable shift is realized.
While the Smithsonian realignment will have its largest
effects on our exports and imports, there should also be favor­
able effects on other components of the balance of payments,
including capital flows to and from the United States. Such
capital flows have already been affected. The enormous outflow
of speculative funds from the United States came to an end




443

REFLECTIONS OF AN ECONOMIC POLICY MAKER

when the Smithsonian Agreement was announced. Since De­
cember 18, there has been a small net return flow of funds.
Besides serving to reinvigorate our foreign trade and other­
wise improve the balance of payments, the Smithsonian Agree­
ment has increased confidence both at home and abroad in the
stability of the world economy. This confidence will be but­
tressed by passage of the Par Value Modification Act.
The Smithsonian Agreement provided not only for a re­
alignment of exchange rates and other measures of immediate
concern, but also "that discussions should be promptly under­
taken, particularly in the framework of the IMF, to consider
reform of the international monetary system over the longer
term." This unfinished business is most important. If we are
to avoid a repetition of crises while preserving a monetary
framework conducive to the healthy expansion of trade and
investment, we must work with other countries to build a new
and stronger international economic order.
In the area of exchange rates, the wider margins agreed to
in December should prove helpful, especially in moderating
short-term capital flows and thereby permitting somewhat
greater scope for differences in interest rates among countries.
For the longer run, procedures for changing par values will need
to be flexible enough to prevent the buildup of large and per­
sistent imbalances in trade and payments among countries.
A searching reevaluation is also needed of the roles to be
played by gold, reserve currencies, and special drawing rights
in settling international accounts. Various proposals for modi­
fying the operations of the International Monetary Fund require
study and discussion. The circumstances under which the dollar
may again be convertible into international reserve assets will
have to be reviewed carefully. And determined new efforts will
be required to reduce impediments to the international flow of
goods, services, and capital.
The issues are many and complex. It will take time to
resolve them. But the unfinished business of international
monetary reform requires that we get on with the job without
delay. Early action by the Congress on the bill before you
will set the stage for much needed progress in both the inter­
national monetary and international trade areas.
I have discussed at some length the Smithsonian Agree444



THE PAR VALUE MODIFICATION ACT

ment because it has given rise to the present hearing. But I
cannot conclude this statement without warning that neither the
Smithsonian Agreement, nor passage of the bill before you, nor
any international monetary or trade reforms that may follow,
can of themselves do more than move us toward the objectives
of renewed vigor in foreign trade and equilibrium in the balance
of payments.
To assure success in these objectives of foreign economic
policy, we must have skillful and fully responsible management
of monetary and fiscal affairs. The objectives of our foreign
economic policy and of our domestic economic policy are inter­
dependent. For the sake of both the one and the other we will
need to concentrate on stepping up sharply the productivity
of our resources and on regaining prosperity without inflation.




445




Some Essentials of
International Monetary Reform

On August 15 of last year, in the face of an unsatisfactory eco­
nomic situation, the President of the United States acted deci­
sively to alter the nation's economic course. The new policies,
especially the decision to suspend convertibility of the dollar into
gold or other reserve assets, were bound to have far-reaching
consequences for international monetary arrangements. New
choices were forced on all countries.
The next four months gave all of us a glimpse of one
possible evolution of the international economy. Since exchange
rates were no longer tied to the old par values, they were able
to float— a prescription that many economists had favored.
However, last fall's floating rates did not conform to the model
usually sketched in academic writings. Most countries were
reluctant to allow their exchange rates to move in response to
market forces. Instead, restrictions on financial transactions
proliferated, special measures with regard to trade emerged
here and there, new twists crept into the pattern of exchange
rates, serious business uncertainty about governmental policies
developed, fears of a recession in world economic activity grew,
and signs of political friction among friendly nations multiplied.
Fortunately, this dangerous trend toward competitive and
even antagonistic national economic policies was halted by the
Smithsonian Agreement. Despite recent developments in Viet­
nam, which may cause some uneasiness in financial markets
Address before the 1972 International Banking Conference, M ontreal,
Canada, May 12, 1972.




447

REFLECTIONS OF AN ECONOMIC POLICY MAKER

for a time, the Smithsonian realignment of currencies is, in my
judgment, solidly based. It was worked out with care by prac­
tical and well-informed men, and I am confident that the central
banks and governments of all the major countries will continue
to give it strong support.
Developments in the American economy since last Decem­
ber have been encouraging. Aggregate activity in the United
States has begun to show signs of vigorous resurgence. Price
increases have moderated, and our rate of inflation has recently
been below that of most other industrial countries. Moreover,
the budget deficit of the federal government will be much
smaller this fiscal year than seemed likely three or four months
ago. These developments have strengthened the confidence
with which businessmen and consumers assess the economic
outlook. International confidence in turn is being bolstered by
the passage of the Par Value Modification Act, by the con­
vergence of short-term interest rates in the United States and
abroad, and by some promising signs of improvement in the
international financial accounts of the United States.
With the Smithsonian Agreement and other indications of
progress behind us, it is necessary now to move ahead and
plan for the longer future. The Smithsonian meeting was
preeminently concerned with realigning exchange rates. It did
not attempt to deal with structural weaknesses in the old in­
ternational monetary system. Yet they must eventually be
remedied if we are to build a new and stronger international
economic order.
We all have to ponder this basic question: Given the con­
straints of past history, what evolution of the monetary system
is desirable and at the same time practically attainable? For
my part, I should like to take advantage of this gathering to
consider some of the elements that one might reasonably
expect to find in a reformed monetary system.
First of all, a reformed system will need to be characterized
by a further strengthening of international consultation and
cooperation among governments. Our national economies are
linked by a complex web of international transactions. Problems
and policies in one country inevitably affect other countries.
This simple fact of interdependence gives rise to constraints on
national policies. In a smoothly functioning system, no country
448



ESSENTIALS OF INTERNATIONAL MONETARY REFORM

can ignore the implications of its own actions for other countries
or fail to cooperate in discussing and resolving problems of
mutual concern. The task of statesmanship is to tap the great
reservoir of international goodwill that now exists and to make
sure that it remains undiminished in the future.
Sound domestic policies are a second requirement of a
better world economic order. A well-constructed international
monetary system should, it is true, be capable of absorbing the
strains caused by occasional financial mismanagement in this
or that country— such as are likely to follow from chronic
budget deficits or from abnormally large and persistent additions
to the money supply. But I doubt if any international monetary
system can long survive if the major industrial countries fail
to follow sound financial practices. In view of the huge size of
the American economy, I recognize that the economic policies
of the United States will remain an especially important influ­
ence on the operation of any international monetary system.
Third, in the calculable future any international monetary
system will have to respect the need for substantial autonomy
of domestic economic policies. A reformed monetary system
cannot be one that encourages national authorities to sacrifice
either the objective of high employment or the objective of price
stability in order to achieve balance-of-payments equilibrium.
More specifically, no country experiencing an external deficit
should have to accept sizable increases in unemployment in
order to reduce its deficit. Nor should a surplus country have
to moderate its surplus by accepting high rates of inflation.
Domestic policies of this type are poorly suited to the political
mood of our times, and it would serve no good purpose to
assume otherwise.
I come now to a fourth element that should characterize a
reformed monetary system. If I am right in thinking that the
world needs realistic and reasonably stable exchange rates,
rather than rigid exchange rates, ways must be found to ensure
that payments imbalances will be adjusted more smoothly and
promptly than under the old Bretton Woods arrangements.
The issues here are many and complex. There was a con­
sensus at the Smithsonian meeting that wider margins around
parities can help to correct payments imbalances, and should
prove especially helpful in moderating short-term capital move-




449

REFLECTIONS OF AN ECONOMIC POLICY MAKER

ments— thereby giving monetary authorities somewhat more
scope to pursue different interest-rate policies. Our experience
has not yet been extensive enough to permit a confident ap­
praisal of this innovation. It is clear, however, that no matter
how much the present wider margins may contribute to facil­
itating the adjustment of exchange rates to changing conditions,
the wider margins by themselves will prove inadequate for
that purpose.
W e may all hope that at least the major countries will
pursue sound, noninflationary policies in the future. We should
nevertheless recognize that national lapses from economic virtue
will continue to occur. In such circumstances, changes in
parities— however regrettable— may well become a practical
necessity. Moreover, even if every nation succeeded in achiev­
ing noninflationary growth, structural changes in consumption
or production will often lead to shifts in national competitive
positions over time. Such shifts will also modify the pattern
of exchange rates that is appropriate for maintaining balanceof-payments equilibrium.
In my judgment, therefore, more prompt adjustments of
parities will be needed in a reformed monetary system. Rules
of international conduct will have to be devised which, while
recognizing rights of sovereignty, establish definite guidelines
and consultative machinery for determining when parities need
to be changed. This subject is likely to become one of the
central issues, and also one of the most difficult, in the forth­
coming negotiations.
Let me turn to a fifth element that should characterize a
reformed monetary system. A major weakness of the old sys­
tem was its failure to treat in a symmetrical manner the
responsibilities of surplus and deficit countries for balance-ofpayments adjustment. With deficits equated to sin and surpluses
to virtue, moral as well as financial pressures were very much
greater on deficit countries to reduce their deficits than on sur­
plus countries to reduce surpluses. In actual practice, however,
responsibility for payments imbalances can seldom be assigned
unambiguously to individual countries. And in any event, the
adjustment process will work more efficiently if surplus coun­
tries participate actively in it. In my view, all countries have
an obligation to eliminate payments imbalances, and the rules of
450



ESSENTIALS OF INTERNATIONAL MONETARY REFORM

international conduct to which I referred earlier will therefore
need to define acceptable behavior and provide for international
monitoring of both surplus and deficit countries.
Sixth, granted improvements in the promptness with which
payments imbalances are adjusted, reserve assets and official
borrowing will still be needed to finance in an orderly manner
the imbalances that continue to arise. Looking to the long
future, it will therefore be important to develop plans so that
world reserves and official credit arrangements exist in an ap­
propriate form and can be adjusted to appropriate levels.
This brings me to the seventh feature of a reformed in­
ternational monetary system. It is sometimes argued that, as
a part of reform, gold should be demonetized. As a practical
matter, it seems doubtful to me that there is any broad support
for eliminating the monetary role of gold in the near future.
To many people, gold remains a great symbol of safety and se­
curity, and these attitudes about gold are not likely to change
quickly. Nevertheless, I would expect the monetary role of gold
to continue to diminish in the years ahead, while the role of
special drawing rights increases.
The considerations which motivated the International
Monetary Fund to establish the SDR facility in 1969 should
remain valid in a reformed system. However, revisions in the
detailed arrangements governing the creation, allocation, and
use of SDRs will probably be needed. In the future, as the SDRs
assume increasing importance, they may ultimately become the
major international reserve asset.
Next, as my eighth point, let me comment briefly on the
future role of the dollar as a reserve currency. It has often been
said that the United States had a privileged position in the old
monetary system because it could settle payments deficits by
adding to its liabilities instead of drawing down its reserve
assets. Many also argue that this asymmetry should be ex­
cluded in a reformed system. There thus seems to be significant
sentiment in favor of diminishing, or even phasing out, the role
of the dollar as a reserve currency. One conceivable way of
accomplishing this objective would be to place restraints on the
further accumulation of dollars in official reserves. If no further
accumulation at all were allowed, the United States would be




451

REFLECTIONS OF AN ECONOMIC POLICY MAKER

required to finance any deficit in its balance of payments entirely
with reserve assets.
I am not persuaded by this line of reasoning, for I see
advantages both to the United States and to other countries
from the use of the dollar as a reserve currency. But I recognize
that there are some burdens or disadvantages as well. And in
any event, this is an important issue on which national views
may well diverge in the early stages of the forthcoming ne­
gotiations.
I come now to a ninth point concerning a new monetary
system, namely, the issue of "convertibility" of the dollar. It
seems unlikely to me that the nations of the world, taken as a
whole and over the long run, will accept a system in which
convertibility of the dollar into international reserve assets—
SDRs and gold— is entirely absent. If we want to build a
strengthened monetary system along one-world lines, as I cer­
tainly do, this issue will have to be resolved. I therefore antici­
pate, as part of a total package of long-term reforms, that some
form of dollar convertibility can be reestablished in the future.
I must note, however, that this issue of convertibility has
received excessive emphasis in recent discussions. Convertibility
is important, but no more so than the other issues on which I
have touched. It is misleading, and may even prove mis­
chievous, to stress one particular aspect of reform to the ex­
clusion of others. Constructive negotiations will be possible
only if there is a general disposition to treat the whole range
of issues in balanced fashion.
We need to guard against compartmentalizing concern
with any one of the issues, if only because the various elements
of a new monetary system are bound to be interrelated. There
is a particularly important interdependence, for example, be­
tween improvements in the exchange rate regime and restoration
of some form of convertibility of the dollar into gold or other
reserve assets. Without some assurance that exchange rates of
both deficit and surplus countries will be altered over time so
as to prevent international transactions from moving into serious
imbalance, I would deem it impractical to attempt to restore
convertibility of the dollar.
My tenth and last point involves the linkage between
monetary and trading arrangements. We cannot afford to over452



ESSENTIALS OF INTERNATIONAL MONETARY REFORM

look the fact that trade practices are a major factor in deter­
mining the balance-of-payments position of individual nations.
There is now a strong feeling in the United States that restrictive
commercial policies of some countries have affected adversely
the markets of American business firms. In my judgment,
therefore, the chances of success of the forthcoming monetary
conversations will be greatly enhanced if parallel conversations
get under way on trade problems, and if those conversations
take realistic account of the current and prospective foreign
trade position of the United States.
In the course of my remarks this morning I have touched
on some of the more essential conditions and problems of in­
ternational monetary reform. Let me conclude by restating
the elements I would expect to find in a new monetary system
that met the test of both practicality and viability:
• First, a significant further strengthening of the processes
of international consultation and cooperation;
• Second, responsible domestic policies in all the major in­
dustrial countries;
• Third, a substantial degree of autonomy for domestic
policies, so that no country would feel compelled to sacrifice
high employment or price stability in order to achieve
balance-of-payments equilibrium;
• Fourth, more prompt adjustments of payments imbalances,
to be facilitated by definite guidelines and consultative
machinery for determining when parities need to be
changed;
• Fifth, a symmetrical division of responsibilities among
surplus and deficit countries for initiating and implementing
adjustments of payments imbalances;
• Sixth, systematic long-range plans for the evolution of
world reserves and official credit arrangements;
• Seventh, a continued but diminishing role for gold as a
reserve asset, with a corresponding increase in the im­
portance of SD Rs;
• Eighth, a better international consensus than exists at
present about the proper role of reserve currencies in the
new system;
• Ninth, reestablishment of some form of dollar convertibility
in the future;




453

REFLECTIONS OF AN ECONOMIC POLICY MAKER

• And finally, tenth, a significant lessening of restrictive
trading practices as the result of negotiations complement­
ing the negotiations on monetary reform.
I firmly believe that a new and stronger international
monetary system can and must be built. Indeed, I feel it is
an urgent necessity to start the rebuilding process quite
promptly. It is not pleasant to contemplate the kind of world
that may evolve if cooperative efforts to rebuild the monetary
system are long postponed. We might then find the world
economy divided into restrictive and inward-looking blocs,
with rules of international conduct concerning exchange rates
and monetary reserves altogether absent.
As we learned last fall, a world of financial manipulations,
economic restrictions, and political frictions bears no promise
for the future. It is the responsibility of financial leaders to
make sure that such a world will never come to pass.

454



The Need for Order in
International Finance

I plan to comment tonight on the need for order in international
finance. My choice of topic does not require lengthy justifica­
tion. For more than a decade now, we have been besieged by
problem after problem in the working of international financial
mechanisms. Strain and turbulence have, in fact, been so con­
stant a feature of the international financial scene in recent
years that I suspect they are coming to be widely regarded as
the normal state of affairs.
I do not share any such mood of resignation. In the first
place, governments around the world now have a better under­
standing of the troubles caused by inflation— both in their
own economies and in international dealings— than they had
only a few years ago. As a result, not a few countries have
been adjusting their economic policies with a view to curbing
inflation. In the second place, financial institutions— particularly
commercial banks— are now giving closer attention to the
volume and character of their foreign lending. And in the third
place, the International Monetary Fund has been gaining in
prestige and is already exercising a more constructive influence
than seemed likely a year or two ago. These are promising
trends, and if we build on them we can in time reattain the
financial stability that is so vital to orderly expansion of the in­
ternational economy.
Certainly, we all know of the great difficulties that plagued
financial relationships among countries during the 1930s. Those
Address at the annual dinner of the Columbia University Graduate School
of Business, New York City, April 12, 1977.




455

REFLECTIONS OF AN ECONOMIC POLICY MAKER

difficulties generated pessimism about the capacity of nations
ever again to achieve orderly arrangements for the conduct of
international finances. And that pessimism was deepened by
the frightful disruption of the world economy during the war.
Yet, it was the genius of that age to devise the structure of
Bretton Woods and to strengthen that extraordinary structure
with our own Marshall Plan. Within a framework of established
financial rules, a great liberalization of the world economy oc­
curred and world trade and output flourished. Although we
tend to forget it now, the postwar period was a time of quite
impressive stability in world finance until the early sixties.
That experience should serve to remind us that difficulties
do yield to determined effort. Our present problems in the
sphere of international finance, while different from those of a
generation ago, surely are no greater. They too can be dealt
with effectively if once again we perceive the wisdom of some
subordination of parochial interests and if nations marshal the
will to live by new rules of responsible behavior.
Quite obviously, the overriding problem confronting us
in world financial matters today is the massive and stubborn
imbalance that prevails in payments relations among nations—
a condition arising importantly, although by no means exclu­
sively, from OPEC's action in raising the price of oil so abruptly
and so steeply.
This year alone OPEC's revenues from international oil
sales are likely to total something on the order of $130 billion.
What is most significant about that figure is that it represents
an enormous explosion of revenues in such a short time. In
1972, before OPEC's aggressive pricing policy began, receipts
of the OPEC group from international oil sales totaled less than
$14 billion, with most of the rise since then representing higher
prices rather than enlarged volume. For the great majority of
OPEC's customers— both affluent and needy alike— it has been
the rapidity of the massive change that has been so trouble­
some. To be sure, OPEC members have dispensed some aid to
less developed countries, but so far the grants have been very
selective and quite small relative to the size of the international
problem that OPEC has created.
The imposition of the enormous tax that the OPEC group
has in effect levied on the world economy has been met, as you
456



NEED FOR ORDER IN INTERNATIONAL FINANCE

know, partly by transferring goods and services to OPEC
members and partly by deferring such transfers through bor­
rowing arrangements. OPEC's absorption of goods and services
for both consumption and development purposes has been ex­
panding, with the consequence that OPEC's collective currentaccount surplus has shrunk considerably from its peak level of
more than $65 billion in 1974. Only five of the thirteen OPEC
nations in fact are currently running sizable payments surpluses.
Contrary, however, to earlier widespread hopes that the aggre­
gate OPEC surplus would continue to decline— perhaps nearing
elimination by the end of this decade— it seems at present to be
eroding slowly, if at all. This year it could easily run above $40
billion, marking the fourth consecutive year that OPEC's
trading partners as a group will have to seek substantial loans
or grants to help meet their oil bills.
Continuation of a surplus for the OPEC group at such a
high level reflects several influences: first, the further increase
that occurred this January in OPEC oil prices; second, growing
demand for oil as recovery of the world economy has proceeded;
third, insufficient energy conservation by many non-OPEC
countries, including most notably the United States; and fourth,
a slowing of import absorption by the OPEC group— in some
instances because bottleneck problems of one kind or another
are being encountered, in other instances because development
plans have come to be viewed as excessively ambitious. The
apparent stickiness of the OPEC payments surplus at a high
level, buttressed by what is now a significant stream of income
from investments, implies large-scale financing requirements for
OPEC customers for a considerable period ahead. The prospect
of such persistent financing needs, year after year, is especially
worrisome.
Great as must be our attention to these OPEC-related
problems, we dare not lose sight of the fact that our interna­
tional payments mechanism is now under stress for reasons
that go beyond the extraordinarily high price of oil. The pay­
ments deficits of various nations, both industrial and less de­
veloped, can be traced to extensive social welfare and develop­
ment programs undertaken in the early 1970s and financed by
heavy governmental borrowing, often directly from central
banks. Even when the internal stresses resulting from inflation




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REFLECTIONS OF AN ECONOMIC POLICY MAKER

were aggravated by the oil burden and by weaker exports,
there was little or no adjustment of economic policies in num­
erous instances, thus causing external positions to deteriorate
sharply. There were conspicuous exceptions, of course, particu­
larly on the part of countries that historically have the greatest
sensitivity either to inflation, or payments imbalance, or both.
A wide diversity of payments imbalances thus developed around
the globe, accentuated for a time by differences in the severity
with which recession affected national economies and, more
recently, by differing inflation and recovery trends.
The current pattern of international payments imbalances,
in short, is something far more complex than an OPEC phenom­
enon alone. Essentially, what prevails is a problem within a
problem. The non-OPEC group of countries collectively not
only has a massive structural deficit vis-a-vis OPEC. In addi­
tion, serious payments imbalances exist within the non-OPEC
sector itself, with a few nations experiencing sizable surpluses
on their current account while many others suffer deficits that
reflect many factors besides the way in which the burden of
costly oil imports happens to be distributed around the globe.
A great deal of effort has been devoted by scholars to the
task of trying to estimate how long the present severe imbalance
of international payments accounts could persist in the absence
of deliberate new policy actions. The results of these exercises
generally are not reassuring. They point to the distinct pos­
sibility that huge borrowing needs— that is, needs that are un­
comfortably large in relation to the debt-servicing capabilities
of many countries— could persist at least through the remainder
of this decade.
The potential trouble in this set of circumstances should
be obvious. If OPEC surpluses on current account should con­
tinue on anything like the present scale, they would inevitably
be matched by deficits of identical magnitude on the part of
other nations. And if some countries outside OPEC should
also have sizable and persistent surpluses, as now appears to be
the case, the aggregate deficit of the remaining countries will
be still larger. Under such circumstances, many countries will be
forced to borrow heavily, and lending institutions may well
be tempted to extend credit more generously than is prudent. A
major risk in all this is that it would render the international
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credit structure especially vulnerable in the event that the world
economy were again to experience recession on the scale of the
one from which we are now emerging.
To minimize the risks that face us, there is a clear need
for a strong effort involving all major parties at interest. In
order to achieve relatively smooth expansion of the world
economy, five conditions are essential: first, the aggregate of
payments imbalances around the world needs to be reduced far
more rapidly than currently observable trends imply; second,
the divergences that now exist among countries with regard to
their balance-of-payments status need to be narrowed; third,
protectionism must be scrupulously avoided by governments;
fourth, private financial institutions need to adhere to high
standards of creditworthiness in providing whatever volume of
international financing occurs during the next few years; and
fifth, official credit facilities need to be significantly enlarged.
The realization of these conditions requires diligent pursuit
of stabilization policies by countries that have been borrowing
heavily in international markets. The obstacles to speedy adjust­
ment on the part of these countries are well known. Resistance
stems chiefly from the political difficulty of gaining broad ac­
ceptance of the painful things that must be done to restrain in­
flation and to achieve energy conservation. Countries thus find
it more attractive to borrow than to adjust their monetary and
fiscal policies; and if they can do this without having lenders
write restrictive covenants into loan agreements, so much the
better. That is why countries typically prefer to tap foreign
credit markets to the maximum extent possible rather than bor­
row from the International Monetary Fund which, in aiding
countries that experience significant payments disequilibrium,
makes credit available only after the borrower has agreed to
follow internal policies judged appropriate by the Fund. Com­
mercial banks, as a practical matter, have neither the inclination
nor the leverage to impose restrictive covenants on sovereign
governments.
In these circumstances, admonition alone is likely to ac­
complish little in prodding countries with large payments
deficits to take affirmative action. There are, however, limits
dictated by financial prudence beyond which private lenders
will be unwilling to go. More than one country has recently




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found that its ability to borrow in the private market has di­
minished. The fact is that commercial banks generally, and
particularly those which have already made extensive loans
abroad, are now evaluating country risks more closely and more
methodically. Credit standards thus appear to be firming; and
as information about borrowing countries improves, we can
reasonably expect the market to perform its function of credit
allocation more effectively.
As some of you may know, the Federal Reserve is currently
engaged in a joint project with other central banks to obtain a
much more complete size and maturity profile of bank credit
extended to foreign borrowers, country by country. That in­
formation, which is being gathered under the auspices of the
Bank for International Settlements, will be shared with private
lenders, but even so it will fill only a fraction of the existing
informational gap.
What we need is a more forthcoming attitude on the part
of borrowing countries in regularly supplying information to
lenders on the full range of economic and financial matters
relevant to creditworthiness. I realize that much of the needed
information is not even collected in some countries, but such a
condition should not be tolerated indefinitely. Logically, the
BIS— having links with the central banks of the principal lend­
ing countries— could take the lead in setting forth a list of in­
formational items that all countries borrowing in the inter­
national market would be expected to make available to present
or prospective lenders. Compliance could then become a signifi­
cant factor in the ability of countries to secure private credit,
particularly if— as I would judge essential— bank regulators in
the various lending countries explicitly took account of compli­
ance in their review of bank loan portfolios.
Imperfect or incomplete information, as I think we all
recognize, makes for inefficient markets and heightens the risk
of disruptive discontinuities if some previously unknown but
pertinent fact suddenly comes to light. In the market for bank
credit, a continuous flow of factual information will produce
gradual as distinct from abrupt changes in assessments of
creditworthiness. This should induce earlier recourse to the IMF
by countries experiencing payments difficulties than was usually
the case in the past. Even now, as lenders are becoming better
460



NEED FOR ORDER IN INTERNATIONAL FINANCE

informed and somewhat more cautious in extending foreign
credit, a tendency toward earlier recourse to the IMF appears
to be emerging. It seems likely, therefore, that more countries
that need to adjust their economic policies will henceforth do so
sooner and probably also more effectively. By so doing, the
unhappy alternative of resorting to protectionism will be more
readily avoided.
Private banks— both in this country and elsewhere— played
a very substantial role in "recycling" petrodollars between the
OPEC group and other countries, especially those whose ex­
ternal payments position was weakened by the higher oil prices.
Had the banks not done so, the recent recession would have
been more severe than it was, since there was no official
mechanism in place that could have coped with recycling of
funds on the vast scale that became necessary in 1974. But
with many countries now heavily burdened with debt, bankers
generally recognize that prudence demands moderation on their
part in providing additional financing for countries in deficit.
For that reason, they understandably wish to see an increase
in the relative volume of official financial support to countries
that continue to have large borrowing needs.
Bankers are not alone in wanting to see countries in deficit
pursue adjustment policies more diligently. This interest, in
fact, is widely shared by economists and other thoughtful
citizens who see an urgent need for healthier and more pros­
perous economic conditions around the world. The interests
of the international economy and of private lenders thus con­
verge and point to the need for a much more active role by
the Fund.
The leverage of the Fund in speeding the process of adjust­
ment would clearly be enhanced if its capacity to lend were
greater than it is now. One reason why countries often are
unwilling to submit to conditions imposed by the IMF is that
the amount of credit available to them through the Fund's regu­
lar channels— as determined by established quotas— is in many
instances small relative to their structural payments imbalance.
That will be so even after the scheduled increase in IMF quotas
becomes effective. To remedy this deficiency, the Fund is cur­
rently seeking resources of appreciable amount that could be
superimposed on the framework of the quota system. Negotia­




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REFLECTIONS OF AN ECONOMIC POLICY MAKER

tions are in progress with several countries of the OPEC group
as well as with the United States and other industrial nations
whose payments position is comparatively strong. Such a sup­
plementary Fund facility should induce more deficit countries
to submit to Fund discipline. But in no case must it become a
substitute for an adequate adjustment policy by borrowers or
serve as a bailout for private banks. If negotiations for such
a facility are completed soon, which appears possible, high
priority should be given to prompt ratification by our Congress
and the legislatures of other countries.
The ability of the Fund to act forcefully in speeding the
adjustment process will be strengthened in still another way
once the five-year effort of amending the IMF's Articles of
Agreement is completed. At present the Fund normally im­
merses itself in urging appropriate policies on a country only
when that country applies for financial assistance. Under the
revised Articles, the Fund could take the initiative in determin­
ing whether individual countries are complying with formally
prescribed obligations to foster orderly economic growth and
price stability. This authority, once available, will enable the
IMF to broaden progressively its oversight role even when a
country is not an applicant for a loan.
As the number of countries brought within the reach of
the Fund's influence increases— either because of the enticement
of enlarged lending facilities or because an IMF "certificate of
good standing" becomes essential to further borrowing from
private lenders— the outlook for correction of balance-of-payments deficits would be considerably improved. But that out­
come will also depend on full appreciation by private lenders
of the need to avoid actions that tend to undercut Fund efforts.
This does not mean that Fund judgments are to replace
those of private lenders in the determination of which countries
should be accommodated with private credit. Nor do I even
mean to suggest that the texts of the Fund's country evaluations
are to be handed around in the private banking community.
Were that to become a practice, I am sure the quality of such
reports would suffer by becoming less explicit and less frank.
But some sharing of Fund information— within the limits im­
posed by requirements of confidentiality— may still become
feasible, the most logical conduits perhaps being the central
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NEED FOR ORDER IN INTERNATIONAL FINANCE

banks of the countries in which the major private lending in­
stitutions are located.
Fund country reports are transmitted to central banks as
a matter of routine, and— as I previously indicated— new factual
information about individual countries is now being developed,
and more may well be developed later, by the BIS. Private
lenders might want to discuss with the staffs of central banks
the flow of such information, and this could be done— as would
surely be the Federal Reserve's practice— without advising
whether or on what scale a loan should be made to this or
that country. Such a consultative process, especially if it also
involved frequent interchange of information among the leading
central banks, would go quite far in preventing any inadvertent
circumvention by private banks of the efforts of the IMF to
promote financial stability.
The suggestions I am exploring with you for improving the
adjustment process obviously will not work unless broadly
shared agreement develops that international financial affairs
require a "rule of law" to guide us through the troubled cir­
cumstances that now exist. Such a rule cannot be codified in
detail, but it is essential that there be broad agreement that
parochial concerns will be subordinated to the vital objective of
working our way back to more stable conditions in international
finance. And if the IMF is to play a leadership role in pursuing
this objective, it is not only private parties that must avoid
weakening the IMF's efforts. Governments also— indeed gov­
ernments especially— must be prepared to forgo their own quite
frequent inclination to do things inconsistent with the effective
pursuit of Fund objectives. There have been too many instances
in which the government of a country negotiating a stabilization
program with the Fund's officials has attempted to circumvent
the Fund by seeking instead a loan from another government or
by exerting outside political pressure on Fund officials in an
effort to make loan conditions as lenient as possible. If the rule
of law in international monetary affairs is ultimately to prevail,
all countries— there can be no exceptions— must fully respect
the IMF's integrity.
Our first requisite, therefore, is for a new sense of com­
mitment by governments as well as private parties to a re­
sponsible code of behavior. I believe that understanding of




463

REFLECTIONS OF AN ECONOMIC POLICY MAKER

this need has been growing— certainly within our own govern­
ment. And, of course, the working of the marketplace— tending
now to make credit less readily available to some foreign bor­
rowers— is helping to foster a new set of attitudes.
As I noted earlier, the payments difficulties of countries
outside the OPEC group reflect many factors besides the way
in which the burden of oil costs happens to have been dis­
tributed. It is important that adjustment proceed along several
paths in this vast part of the world.
First, countries whose external position has been weakened
by loose financial policies are going to have to practice some
fiscal and monetary restraint, either of their own volition or
because they find it obligatory to do so in order to maintain
access to international credit facilities, including those of the
IMF. In individual instances, the adjustment process in such
countries may at times also entail allowing some depreciation
of the foreign exchange value of their currencies.
Second, since the burden of adjustment cannot and should
not rest with deficit countries alone, those non-OPEC countries
that are experiencing significant and persistent current-account
surpluses must understand that they too have adjustment obliga­
tions. In saying this, I do not mean to imply that we should urge
such countries to pursue expansionist policies that could undo or
jeopardize the hard-won progress that some of them have made
in curbing inflation. That would be both wrong and unwise.
What I mean is simply that such countries should not actively
resist tendencies toward appreciation in the value of their cur­
rencies in foreign-exchange markets. Such appreciation will aid
other countries by facilitating access to the markets of the
countries in surplus; and at the same time it will make imported
goods and services available at a lower cost to the citizens of the
surplus countries, thus reinforcing their constructive efforts to
control inflation.
Third, practically all non-OPEC countries— the deficit and
surplus countries alike— must treat energy conservation as a key
element of their economic policy. This is something to which
the United States in particular must give the closest attention.
W e are by far the largest single consumer of energy in the
world, and we have so far been notably laggard in addressing
the energy problem. This year imported oil will probably ac­
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NEED FOR ORDER IN INTERNATIONAL FINANCE

count for over 40 percent of domestic consumption of petroleum,
up from 22 percent in 1970. Our passive approach to energy
policy, besides endangering the nation's future, has aggravated
strains in the international financial system, because we are
directly responsible for a large part of the OPEC surplus. And,
of course, our huge appetite for oil has added to the leverage
of those OPEC members that have been most reckless in urging
a still higher price of oil. The energy program being prepared
by President Carter unquestionably will entail sacrifices by
many of our citizens. It is essential, however, that we at long
last recognize that a decisive conservation effort must be a
major part of our nation's economic policy.
If, in fact, we can build momentum into payments adjust­
ment by the non-OPEC group of countries along these three
paths— that is, internal discipline by countries in deficit, nonresistance to exchange rate appreciation by countries in surplus,
and determined energy conservation by all— the favorable con­
sequences will be enormous. To the extent that energy conserva­
tion is effective, the present serious imbalance of the non-OPEC
group of nations vis-a-vis OPEC will be reduced. Beyond
that, there will no longer be such extremely large differences
in the balance-of-payments status of the non-OPEC nations.
Consequently, the risk of disruption of the international financial
system would be greatly reduced, and we could have greater
confidence that progress will be realized around the world in
reducing unemployment and otherwise improving economic
conditions.
There is a critical proviso, however, to this optimistic as­
sessment— namely, that the OPEC group, seeing their surplus
decline as a result of foreign conservation efforts or their own
increasing imports, will not seek to compensate for the decline
by a new round of oil-price increases. Obviously, if they were
to do so— and if they could make the action stick— the whole
exercise of trying to reduce the massive payments imbalances
traceable to the oil shock would be rendered futile.
Effective oil conservation and the development of other
sources of energy would, of course, militate against such an
outcome to the extent that those efforts lessened OPEC's mar­
ket leverage. That is important for the longer run, but par­
ticularly in the years immediately ahead it is vital that the




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REFLECTIONS OF AN ECONOMIC POLICY MAKER

members of OPEC recognize that their economic and political
future cannot be divorced from that of the rest of the world.
Besides practicing forbearance with regard to the price of oil, it
would be very helpful if they made larger, grants of assistance
to the less developed countries and also expanded the volume
of loans and investments made directly abroad— so that the in­
termediation of American or European commercial banks may
be substantially reduced. Fortunately, there are various signs
that the more influential members of OPEC are becoming in­
creasingly aware that their self-interest requires a major con­
tribution along these lines. The OPEC group has become a large
factor in international finance, and there is some basis for
confidence that they will play a constructive role in the re­
establishment of order in the international financial structure.
In the course of my remarks tonight, I have touched on
a number of actions that either need to be taken or avoided to
achieve a new sense of order in international finance. Let me
conclude by sketching or restating the responsibilities, as I
see them, of the major participants in the international financial
system:
First, in order to contribute to a more stable international
system, the IMF must act with new assertiveness in monitoring
the economic policies of its members. To give the Fund added
leverage for such a role, its resources must be enlarged. But
those resources must be used sparingly and dispensed only
when applicant countries agree to pursue effective stabilization
policies. In view of the clear need for better financial discipline
around the world, this would be a poor time for a new alloca­
tion of SDRs— or, in plain language, printing up new inter­
national money.
Second, national governments must encourage and support
the IMF, so that it can become an effective guardian of evolving
law in the international monetary sphere. Governments need
to resist the temptation to circumvent the Fund by seeking
bilateral official loans or to embarrass the Fund by exerting
political pressure on Fund officials. Commercial and investment
bankers also need to recognize that their actions must not under­
cut IMF efforts to speed adjustment. The IMF, in its turn, will
have to equip itself to handle appropriately its new and larger
responsibilities.
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NEED FOR ORDER IN INTERNATIONAL FINANCE

Third, a better framework of knowledge for evaluating
the creditworthiness of individual countries is badly needed.
Among other things, central banks could work together through
the BIS and establish a common list of informational items that
borrowing countries will be expected to supply to lenders.
Fourth, commercial and investment bankers need to monitor
their foreign lending with great care, and bank examiners need
to be alert to excessive concentration of loans in individual
countries.
Fifth, protectionist policies need to be shunned by all
countries.
Sixth, countries with persistent payments deficits need
to adopt effective domestic stabilization policies.
Seventh, non-OPEC countries experiencing large and per­
sistent payments surpluses also need to adjust their economic
policies and they can probably best do so by allowing some
appreciation of their exchange rates.
Eighth, all countries, and especially the United States, need
to adopt stringent oil conservation policies and, wherever pos­
sible, speed the development of new energy sources.
Ninth, the members of OPEC must avoid a new round
of oil-price increases. They also need to play an increasingly
constructive role in assisting the less developed countries and
in the evolution of the international financial system.
Observance of these do's and don'ts would go a significant
distance, in my judgment, in meeting the formidable challenges
that flow confront us. But we shall undoubtedly need to be
ready to improvise in the fluid and complex area of international
finance. I have no illusions that the ideas that I have presented
here tonight can serve as a rigid blueprint. I hope, however,
that they will have some value in suggesting directions in which
governments, private lenders, and official institutions need to
move. By working together towards a rule of law in interna­
tional finance, we shall be contributing to a stable prosperity
both for our own citizens and those of our trading partners.




467




The Redirection of
Financial Policies

I am deeply honored, Mr. Chancellor, that you invited me to
join this distinguished audience in paying tribute to Karl Klasen.
This occasion has very special meaning for me, inasmuch
as Karl Klasen and I have headed our respective central banks
over almost precisely the same span of time, each of us having
begun service in early 1970.
The period since then has been one of the most eventful
in the annals of international finance, and that inevitably has
involved frequent and close contact between the two of us.
Our seven years of collaboration have left with me a deep
appreciation of the talent and the intellectual integrity which
Karl Klasen possesses. I shall miss his official counsel, and yet
I count myself fortunate in having been able so often in the
past to avail myself of the wisdom and the warm supportive
friendship of such a colleague.
I have no difficulty in singling out Karl Klasen's premier
achievement as President of the Bundesbank. That has been
his determined, unwavering endeavor to foster understanding
that there can be no durable prosperity, either in the Federal
Republic or in the world community at large, if inflation is not
controlled more effectively than it has been. Karl Klasen's skill­
ful articulation of that truth— and the bold actions he has taken
to give it meaning— place him squarely in the great tradition of
responsible financial leadership so continuously evident in your
country since Dr. Erhard's currency reform of 1948.
Remarks at Chancellor Helmut Schmidt's dinner honoring Dr. Karl Klasen,
Bonn, Germany, May 11, 1977.




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REFLECTIONS OF AN ECONOMIC POLICY MAKER

The Federal Republic's achievement— under the guidance
of men such as Dr. Klasen— in dealing with inflation more
successfully than any other major country has not been lost on
an observant world. By your example, others know what can
be done where intelligence, determination, and persistence pre­
vail. At this critical juncture in the worldwide struggle against
inflation, your achievement is a powerful counterweight to any
mood of resignation or defeatism.
Indeed, I am inclined to think that the intellectual climate
around much of the globe is slowly changing in a positive way.
Only a few short years ago expansionist convictions and policies
were in ascendancy almost everywhere, the simple creed being
that governmental budget deficits and easy money were safe
and effective stimuli whenever an economy failed to perform
at its full potential. Country after country— mine included— has
been learning the hard way that economic matters are far more
complex, and— what is especially promising— policies are begining to be modified accordingly.
The British Prime Minister has summarized the bank­
ruptcy of mechanical Keynesianism perhaps more effectively
that anyone else. "W e used to think," he said in addressing
the British Labour Party Conference in Blackpool last Sep­
tember, "that you could just spend your way out of recession . . .
I tell you in all candor," he continued, "that that option no
longer exists, and that insofar as it ever did exist, it worked by
injecting inflation into the economy. And each time that hap­
pened the average level of unemployment has risen. Higher
inflation, followed by higher unemployment. That is the history
of the last twenty years."
Those words of Mr. Callaghan's are remarkably percep­
tive. Though directed to Britain's special problems, they have
broad applicability throughout the world. They capture the
essential truth that policies for stimulating employment on
which we have relied in the past— such as budget deficits and
easy credit— do not work well in an environment that has be­
come highly sensitive to inflationary fears and expectations. In
such an environment the consuming public in its apprehension
about the future will tend to raise its saving rate and thus may
frustrate governmental policies aimed at stimulating the econ­
omy. Businessmen, too, having learned that profits can erode
470



REDIRECTION OF FINANCIAL POLICIES

quickly when inflation is not effectively contained, will tend
to become more cautious about undertaking new projects.
Mr. Callaghan thus put his finger on the vital point: inflation
is the key global problem with which we must cope if we are
to regain a lasting prosperity.
Conventional thinking about stabilization policies is in­
adequate and out of date. Our quest must be for new policies
tailored to the need for coping with inflation and unemployment
simultaneously. Our approach almost certainly must be less
aggregative in its orientation than it has been. More and more,
we need to focus on particular structural impediments to in­
creased economic activity and to work at building a social con­
sensus that leads to responsible price and wage behavior by
private parties. This does not necessarily mean that we must
forswear all use of conventional devices in dealing with unem­
ployment. But to the extent that such tools are employed, they
must be used more judiciously than has been characteristic of
the past. Policy makers everywhere must become alert to the
need for prompt reaction if signs emerge that excessive stimula­
tion is occurring. President Carter's recent decision to with­
draw his proposal for a tax rebate in the face of evidence that
the tempo of economic activity in the United States was ac­
celerating more rapidly than had been expected is illustrative of
precisely the kind of flexibility in economic policy making that
has become essential.
A very general shortcoming of the 1972-1974 period—
compounding the oil trauma of that time— was the slowness
of policy makers in many countries in appreciating just how
rapidly pressures were mounting on available resources. The
consequence was that they permitted inflation to run totally out
of control. When the distortions that arose in the process
eventually culminated in the worst recession in a generation,
the shock to the psychology of both consumers and business­
men was profound. The blow was particularly severe because
so few of the current generation of business managers had ex­
perienced an economic decline of comparable severity. They
had, indeed, been tutored to believe that the business cycle as
it once existed was dead— that any recession that might occur
would prove to be brief and mild, because of the countercyclical
weapons possessed by modern governments.




471

REFLECTIONS OF AN ECONOMIC POLICY MAKER

Here in Germany you were wise enough in 1972 and 1973
to take relatively prompt moderating action on both the fiscal
and monetary fronts, a fact that goes a long way in explaining,
I believe, the comparatively favorable price experience you are
now enjoying. But in many other countries the response was
tardy, creating extremely vulnerable conditions that continue
even now to plague recovery efforts.
Moderation in the pursuit of economic growth is partic­
ularly crucial if a much-needed revitalization of capital forma­
tion is to occur in the global economy. In the United States,
business investment, although accelerating now, has lagged con­
spicuously so far in the current cyclical expansion relative to its
behavior in earlier recoveries. And experience in the United
States appears to be representative of what is happening in
many other countries. This is a worrisome development because
it is weakening the general recovery pattern and also because
it suggests the distinct possibility that a condition of inadequate
capacity could develop at a later stage of this expansion.
The present lag in capital formation can be traced to
various causal factors, but two are of preponderant significance.
One is the substantial residue of caution that lingers on among
businessmen because of the rude discovery that the business
cycle is still very much alive. Inflation worries— more spe­
cifically, apprehension about the degree to which inflation will
be controlled— constitute the second major inhibiting influence
on capital spending in industrial countries. Forward planning
simply cannot proceed rationally in an environment in which
business managers are unable to assess cost and profit prospects
with any confidence over the long time horizons that are fre­
quently involved in new investment projects. Inflation raises the
risk premiums that businessmen attach to new undertakings;
and the higher those risk premiums become, the more likely it
is that the volume of investment will be depressed.
Fortunately, there are now numerous signs of an emerging
consensus internationally that greater price stability is a key
requisite to the achievement of sustainable economic growth and
lower unemployment. Last autumn's Communique of the In­
terim Committee of the International Monetary Fund— urging
as it did that industrial nations not only concern themselves
with inflation but actually give it priority attention in their
472



REDIRECTION OF FINANCIAL POLICIES

economic policies— provided striking testimony to the changing
attitude of policy makers. Such emphasis would have been
unthinkable in the days when the expansionist creed was in
vogue. This new understanding of causal linkage between
inflation and unemployment is reflected in the Communique
just issued upon completion of the London summit meeting.
Expressions of intent accomplish nothing of themselves, of
course, but it is of great significance that major governments
have at last come to perceive the appropriate direction in which
they should be moving.
Because excessive creation of money, historically, has al­
ways been associated with inflation, it also is of great signifi­
cance, I believe, that more countries are coming to experiment
with new techniques for achieving better control over monetary
expansion. Here, too, the Federal Republic can rightfully claim
to have played a pioneering role. The Bundesbank, acting in
December 1974, became the first central bank to announce
publicly an explicit target for monetary expansion in the coming
year. The Federal Reserve System shortly followed the Bundes­
bank in making public its monetary projections, and a number
of other countries have since then done so as well.
One key value of monetary growth targets is that they
force both central bankers and private parties to think more
systematically than they otherwise might about the amount of
inflation that is being financed at any given time. Our longerterm objective within the Federal Reserve, and I believe the like
applies to the Bundesbank, is to achieve a rate of growth in
monetary aggregates that is ultimately consistent with stability
of the general price level. In the United States, we are, of
course, a long way from that goal; and as a practical matter,
we cannot move to it rapidly because of the risk of deflecting
the economy from its present path of recovery. But it is helpful
in our continuing monetary policy deliberations in the United
States to have set our sights on what we need to achieve, and
during the past two years we have in fact adjusted our growth
ranges for monetary expansion gradually but persistently down­
ward. In short, I believe that such growth targets provide a
meaningful framework for fostering monetary discipline, and it
is my hope that more and more countries will follow the Ger­
man initiative.




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REFLECTIONS OF AN ECONOMIC POLICY MAKER

The serious inflation of recent years has had pernicious
effects not only within individual countries; beyond that, it has
greatly complicated the task of maintaining orderly international
relations.
I am aware, of course, that many people ascribe the present
condition of serious payments imbalance among countries and
the related bouts of unease in foreign-exchange markets almost
exclusively to the burden of higher oil prices. But troublesome
as the oil shock has been, it by no means fully explains the
payments stresses that presently exist. The fact is that the
troublesome payments deficits of many countries, both indus­
trial and less developed, can be traced in large measure to
extensive social-welfare and development programs undertaken
in the early 1970s and financed by heavy governmental borrow­
ing, often directly from central banks. Even when the internal
troubles resulting from inflation were aggravated by the oil
burden, there was little or no adjustment of economic policies
in numerous instances. Faced with the political difficulties of
gaining acceptance of the stringent measures required to restrain
inflation and achieve energy conservation, many countries opted
instead to borrow heavily from private external sources. Gen­
erally speaking, such borrowing entailed no obligation on the
borrower to effect adjustments in the policies that had given
rise to the need for special financing.
What is clearly required now is a financial environment
in which countries needing to borrow will have less opportunity
to do so if they are reluctant to reform their economic policies.
Adjustment efforts of many countries must be intensified, so
as to reduce their abnormally large deficits. To that end, private
lenders need to understand the importance of taking greater
initiative on their own in insisting that countries desiring to
borrow commit themselves to meaningful stabilization goals;
they must also avoid letting themselves be used as sources of
funds by countries seeking to circumvent IMF discipline. This
is a time that calls for especially close coordination of the efforts
of private lenders and the IMF in the interest of seeing to it
that international debt creation proceeds prudently and that
adjustment policies are intensified.
In particular, so that countries needing to borrow have
greater inducement to submit to Fund stabilization prescriptions,
474



REDIRECTION OF FINANCIAL POLICIES

it has become clear that the Fund's lending capacity should be
enlarged and that it should have added flexibility to make loans
whose size is not limited by the quota structure. This has been
agreed to in principle both by the IMF's Interim Committee and
the London Summit conferees, and early implementation of a
special lending facility can now be anticipated. This facility will
be established on the sound principle that loans will become
available only when an applicant country has agreed to pursue
effective economic stabilization policies.
In focusing, as I have, on the need for adjustment by coun­
tries whose external position has been weakened by loose
financial practices or by failure to adapt realistically to the
burden of higher fuel costs, I do not mean to suggest that they
alone have adjustment obligations. Countries enjoying pay­
ments surpluses have responsibilities as well, both the OPEC
group and others.
Certainly, the non-OPEC countries as a group cannot go on
indefinitely with payments deficits vis-a-vis the oil producers,
totaling $40 billion or so a year. That would entail a serious risk
of irreparable damage to the international economy. To the
extent, therefore, that non-OPEC nations find ways to cut oil
imports or to enlarge sales to oil producers, it is vitally impor­
tant that the members of OPEC not try to compensate for any
resulting slippage in their surpluses by a new round of oil-price
increases.
And, just as clearly, the non-OPEC surplus countries too
must contribute to the international adjustment process. Here,
though, I think the progress that has already been made is some­
times not fully appreciated. The rapidity with which the large
U.S. current-account surplus of two years ago has wilted away
is worth noting. And here in the Federal Republic, your currentaccount surplus has fallen from about $10 billion in 1974 to a
moderate level currently, thus reflecting a more rapid rise in
imports of goods and services than in exports. You have reason
to take pride in your record of responsibility toward your trad­
ing partners, especially in the degree of willingness you have
shown in letting the value of the mark appreciate— an apprecia­
tion that in 1976 alone totaled some 15 percent.
I recognize that the appreciation of the mark in foreign
exchange markets has entailed political risks in the Federal




475

REFLECTIONS OF AN ECONOMIC POLICY MAKER

Republic. But your policy has been enlightened in terms of
international needs, and I believe it has also been wise domes­
tically in helping to consolidate the hard-won progress you
have achieved in curbing inflation.
The Federal Republic has been fortunate indeed in having
leaders of the vision of Chancellor Schmidt and Dr. Klasen to
serve it in the troubled and turbulent times in which we live.
And it is a stroke of good fortune that a man of Otmar
Emminger's experience and character stands ready to assume
the presidency of the Bundesbank. I join you all in wishing
Dr. Emminger, whom I have had the privilege of knowing for
a quarter century, every success in continuing the Federal
Republic's struggle for a durable prosperity. And I have no
doubt that he will meet the challenge he now faces, provided
he keeps firmly in mind Dr. Klasen's great lesson to his country­
men: that monetary order is the backbone of a nation and that
an independent central bank is essential to such order.

476



INDEX

Aggregate demand, 1 4 7 ,1 7 0 ,1 9 8
management, 1 5 1 ,1 5 6 , 343
monetary policy, 152-154
Agriculture. See Crop production
American Stock Exchange, 104, 204
Anti-Defamation League, 68-70
Anti-Semitism, 6 9 -70
Argentina, government failures ef­
fe c t, 236
Asia, 12, 29
Australia, government expenditures,
80
Automation, banking, 328-329
Balance-of-payments, non-OPEC
countries, 465, 475
Bank failures, 401, 410
Bank for International Settlements,
460,
463
Bankhaus H erstatt, failure, 401
Bank holding companies, 357, 359,
364, 407
Banking

assets, 358-361, 403-404
business operations, 356-357
computers in, 328-329
consumer finance, 191, 357
equity, 358, 360, 400, 403-404
examination process, 363, 3 8 9-392
foreign exchange operations, 3 5 7 358, 361
international lending, 357, 4 1 1 412
legislation, 344, 425-435
liability management, 359-360,
362, 401, 404




loan commitments, 107, 317, 330,
358, 3 6 0 -3 6 2
mergers, 328, 357
petroleum prices effects, 402, 410
regulation, 332, 363, 388
trends, 3 5 8 -3 5 9 , 401
volatile funds, 358, 360, 362
See also Commercial banks
Banking A ct of 1933, 381, 431-433
Banking A ct of 1935, 381
Banking system
computers, use of, 328-329
and Federal Reserve Board, 3 25333, 408 -4 1 0 , 429-430
Federal
Reserve
classification,
3 3 7-338
improvements, 4 0 6 -408
review forum, 399
U.S. banks abroad, 410
Bank M erger and Holding Company
A cts, 328
Ben-Gurion, David, 18
Brazil, economic growth, 2 9 -30
Budget and Accounting Act of 1921,

311

Budget Control Act. See

Congres­
sional Budget and Impoundment
Control Act of 1974
Budget reform, 101, 273-281, 285,
286-287, 291-296, 311. See also
Congressional Budget and Im­
poundment Control A ct of 1974;
Zero-base budgeting
Burma, 12
Business
competition, 76, 167, 310

477

Business (continued)
cost controls, 108
decline in activity, 187, 202
and government regulation, 222
interest rates decline, 227
inventory liquidation, 188
investment, 3 8 ,1 5 7 , 227,254
liquidity, 131, 216
productivity increase, 157, 1 9 3 194, 227
Business cycle, 76, 92, 202, 209
capital formation lag, 472
industrial phase, 203, 208
inflationary bias, 218
speculative phase, 203, 205-208
Business profits, 107, 195
accounting
practices, 163-164,
195, 235-236
calculations, 42-43
earning levels, 41
inflationary effects, 43-44, 46, 71
opportunities, 41
California, tax revolt, 86
Canada
GNP comparisons, 27
government expenditures, 80
inflation, 146
unemployment increases, 113, 146
wage-price increase effects, 170
Capitalism, 75-77
Center for the Study of American
Business, Washington University,
79
Central bank
commercial banks, 356
credit effects, 98-99
IMF country reports, 463
and liquidity, 174, 356
monetary policy, 419
money supply effects, 98-99
See also Federal Reserve System
Certificate of deposit, 360, 369, 406
maturity range, 111
reserve requirement for, 158-159
Chile, government failures, 236
China, People's Republic of, econ­
omy, 8 -9 , 77
Code of ethics, international, 46 3 464
Collective bargaining, 145
settlements, 125-127
wage costs, 112

478




Commercial banks
apartment construction loans, 246
assets increase, 400, 404-405
cash reserves need, 343
central bank relationship, 356
competition, 328, 331
growth in, 358
liquidity, 95, 107, 216, 317
loan commitments, 401
short-term financing, 209
See also Banking
Commercial paper m arket, 105-106,
360
Federal Reserve action, 110-111
Commission on Money and Credit,
340
Committee on Interest and Divi­
dends, 129-141, 335-336
Comptroller of the Currency, 431
Congress. See U.S. Congress
Congressional Budget and Impound­
ment Control A ct of 1974, 213,
229, 238, 291-296, 311
Construction industry, 118-119. See
also Homebuilding industry
Construction Industry Stabilization
Committee, 127
Consumer markets, 163, 416
Consumer prices, rate of increase,
98, 125, 126
Consumers
attitudes, 120
buying trends, 167, 235-236
installment credit increase, 313
spending, 58, 96, 119, 182, 188
Corporate mergers
economic effects, 203-204
productivity effects, 104, 105
Corporations
capital investment financing, 1 9 6 197
liquidity, 209, 316
long-term debt, 106
short-term debt, 209
Cost of Living Council, 1 3 3 ,1 4 0 ,1 7 9
Council on W age and Price Sta­
bility, 184
Credit
adjustments,
OPEC
countries,
4 63-464, 475
control administration, 373
demand, 1 3 4 ,1 8 3
Federal Reserve Board of Gov­
ernors, 301, 373, 375

flow, 372, 374, 376
LDC indebtedness, 412
markets, 135, 138
monetary policy, 369
quality, 330
social uses, 372
Credit Control A ct, 371-372, 375
Crop production, 162, 189
erosion, 138
inclement weather, effects of, 349
price, effects of, 170
Czechoslovakia, economic reform,
6 -7 , 10, 27
Davis-Bacon A ct, 62, 114, 222, 239,
248
Deficit financing, 173, 308, 318
Deficit spending, 172, 232
Deposits insurance, 302, 356, 364,
431
Deutsche Bundesbank, 469, 473
Developing countries. See Less de­
veloped countries
Dollar
convertibility, 452-453
devaluation, 257, 275-276, 349
fluctuation, 440-441
foreign exchange market, effects
of, 84, 197, 257
par value change, 436, 442
Eastern Europe, free enterprise
banned, 77
East Germany, economy, 28
Economic Development Administra­
tion, 265
Economic recovery
in 1971, 118-120
in 1975, 192, 239
Economic Stabilization Act, 129
Emergency Financial Control Board,
298
Employment, 132, 223, 310, 384, 470
growth rate, 73
in public services, 63, 147, 168,
220, 223
restrictions on, 63
See also Unemployment
Employment Act of 1946, 112, 285
Energy policy, 4 6 -4 7 , 258, 464-465
Environmental policy, cost of, 222,
2 4 8 ,3 1 0




Escalator arrangements, 165, 256,
318, 417
Eurodollars, 360
Europe, 24, 25
Exports, 10, 189, 314
Federal Advisory Council, 3 7 2 /3 7 4 375
Federal Bank Commission, pro­
posed, 434
Federal budget
congressional review of, 166, 213,
273, 275, 280, 2 8 6 -2 8 7 , 2 9 1 -296
for 1971, 100
for 1977, 320 -3 2 1
See also Budget reform ; Federal
deficit
Federal deficit
financing, 173, 294 -2 9 5 , 318
growth of, 208, 220, 237, 276, 3 0 7 308, 320, 348
inflationary impact, 79-80, 121,
163, 173, 227, 242, 307, 309
Federal Deposit Insurance Corpora­
tion, 302, 364, 431
Federal expenditures
ceilings on, 2 7 0 -2 7 8 , 286-287
control of, 110, 2 6 7 -2 6 8
for defense, 2 6 4 -265
economic role, 308
and federal pay raise, 100
growth of, 78, 93, 149, 264-265,
267, 270, 293, 3 0 7 -3 0 8
reform, 198, 229, 2 6 9 -2 7 1 , 287
for social welfare, 47, 93, 265
and taxes, 177, 293
and Vietnam, 149
Federal grants, 2 6 5 -2 6 6 , 268
Federal Home Loan Bank, 332-333,
348
Federal National M ortgage Associa­
tion, 348
Federal Open M arket Committee,
123, 367, 368, 382, 392-393
Federal Reserve A ct, 258, 337, 372,
383
emergency lending provisions,
300-301
Federal Reserve Bank of Minne­
apolis, 345
Federal Reserve Bank of New York,
300
Federal Reserve Banks, 124, 338, 347

479

Federal Reserve Board of Governors
administrative policy, 325-333
and banking industry, 363-364,
407-408
and credit supply, 181-182, 301,
373-375
delegation of authority, 325-326
housing industry study, 157-158,
333, 350
monetary policy, 14, 50, 175, 327,
367
monitoring international lending,
412-413
and Penn Central, 111
regulatory policy, 325-333, 364
reserve requirements, 337
terms of service, 381, 382, 419
See also Federal Reserve System
Federal Reserve Reform Act of 1977,
430
Federal Reserve System
accountability, 432
bank credit demands, 158
and banking industry, 325-333
Congressional relations, 384, 420
commercial paper market, 1 1 0 111, 174
communications systems, 329
disclosures, 388, 390-392
and Federal Home Loan Bank,
332-333
foreign banks regulation, 410
foreign exchange markets, 197,
257
GAO reviews, 421, 431-433
independence of, 258, 382-383,
419-421, 430-431, 433
and interest rates, 122-124, 211,
369-370, 421-422, 431
as lender of last resort, 301-302,
350
liquidity, 174, 300, 356
membership, 339-340, 408-410,
429-430
monetary growth, 56, 122-123,
165, 176-177, 182, 183, 198,
349-350, 417, 418, 473
monetary policy, 86, 150, 152,
174-175, 250, 315, 327, 348, 379,
420
money supply, 172-173, 182-183,
368-369, 376-377

480




money transfers services control,
342
New York City crisis, 300
objectives, 345-353, 418
open market operations, 190
price increase relationship, 1 7 0 171
quality of credit, 330
reserve requirements, 158, 175,
336-3 44, 352, 370-371, 376, 377
responsibility, 174-175, 345-353,
394-395
See also Federal Reserve Board of
Governors
Feldstein, M artin, 85
Fiscal policy, 112, 131, 1 7 0 ,1 7 9
congressional-executive roles, 280,
368
cyclical fluctuations, 156
economic effects of 96, 208, 216,
310
inflation, 94, 100
moderation, 307-311
Foreign exchange rate, 361, 439-445
France, 8, 80
Franklin National
Bank,
N .Y.,
failure, 401, 410
Freedom of Information A ct, 387,
389
Free enterprise, 24 -2 6
economic success of, 1 1 -1 3 , 2 6 29, 77
effect of inflation on, 81, 87
in socialist countries, 77
in U.S.S.R., 30
Galusha, Hugh, 346
General Accounting Office
bank supervision study, 390-391
Federal Reserve reviews, 421, 4 3 1 432
Germany, Federal Republic of
construction boom, 206, 235
Deutsche Bundesbank, 469, 473
economic growth, 28, 472
government expenditures, 80
inflation, 470
monetary growth, 473
residential construction boom,
206, 235
World W ar II, effects on industry,
28
Glass, Senator Carter, 382

Gold
certificates, 439
monetary role, 451, 453
price, 439, 443
Government bonds, investment in­
crease, 82
Government expenditures, in non­
socialist countries, 80
"Government in the Sunshine" bills,
388, 393, 394-396
Government regulation, cost of, 79,
222
Great Britain. See United Kingdom
Great Society programs, 255
Gross national product (GNP)
comparisons, 27
decline, 202
growth rate, 10
Homebuilding industry
cost-price effects, 241-242, 249
economic effects, 58, 242, 244
environmental regulations, 248
Federal Reserve, 333
financing problems, 168, 244-245,
249
housing starts, 188, 313
inflation effects, 241-251
multi-family units, 245-246
unemployment, 168, 241
Hoover Commission, 325
Hong Kong, 10, 11, 29
Housing industry. See Homebuild­
ing industry
Human capital investment, 53-54
Hungary, economic development, 31
Ikeda economic plan, 3 -4 , 7
Impounded funds, 274, 279-280
Incomes policy, 9 9-100, 113, 131,
224, 310
Income tax reduction, 197-198
India, 13
Indonesia, 12
Industrial construction decline, 45,
58
Industrial production, 97, 109, 119,
132, 349
Inflation
aggregate demand, 100
capital investment, 81, 249-250
business activity, 46, 7 1 ,1 4 3 , 218
characteristics, 234-239




consumer market, 163, 182, 2 3 5 236
cost-price spiral, 172
cost-push, 15, 98, 112, 117, 1 2 4 1 2 5 ,1 2 7 ,1 4 4 ,1 7 2
double-digit effects, 217, 416
economic effects, 4, 92, 155, 1 8 1 182, 1 9 4-195, 210, 243-244, 256,
349, 416
escalator arrangements, impact on,
165, 256, 417
expectations of, 1 3 0 -1 3 2 , 212
federal budget, 80, 163, 227, 307,
309
federal expenditures, 49, 93, 194
financial m arkets, 82, 104, 182
fiscal policy, 9 4 ,1 0 0
free enterprise, 81, 87
interest rates, 81, 131, 134, 140,
169,
176, 178, 244, 315
monetary policy, 9 4 -9 5 , 100, 178,
181, 184, 208, 238, 314 -3 1 5 , 351
money growth, 50, 57, 176-177,
415, 473
Phase II, 140-141
political and social effects, 60, 7 1 72, 8 4 ,1 6 4 , 236
prosperity impact, 146, 170, 275
rate, 54, 144 -1 4 5 , 448
recession relationship, 83, 85, 2 1 0 211, 216, 319, 411, 471
reduction measures, 72, 91, 114,
310
sources, 143-144, 161-162, 218
taxes, 85, 177, 247
and unemployment, 1 4 4 ,1 6 9 , 2 2 1 222, 226, 255, 307, 416, 470
wage increases, effects of, 8 5 ,1 1 2 113, 169 -1 7 0 , 189
wage-price controls, 15, 127, 1 6 9 170
worldwide, 81, 93, 146, 171, 207,
233-239
Inflation Alerts, 127
Interest rates
control of, 111, 138-139, 328
decline, 133, 136
and Federal Reserve, 122-124,
369-370, 421-422
fluctuation, 134-135, 175
increase, 40, 123-124, 169, 3 1 5 316
and inflation, 134, 176, 244, 315

481

Interest rates ( continued )
long-term, 106, 132, 184, 315-316,
422
mortgages, 124, 136-137, 184, 245
short-term , 1 3 2 ,1 8 3 -1 8 4 ,1 9 0
International finance, 455-467
monetary crisis, 440-441
monetary reform, 444-445, 4 4 7 454
payments imbalance, 258, 4 5 7 458, 461-462, 474
International Monetary Fund, 190,
439, 444-445, 450, 451, 455, 4 6 0 463, 466, 474
Investment
in capital goods, 45, 57-58
capital market, trends in, 82-83
in construction, 45, 58
and economic expansion, 4 2 ,1 5 7
in fixed capital, 318-319
in human capital, 65
inflationary effects, 249-250
outlook, 47-48, 120-121, 188, 3 1 3 314
policy making, 57
slump in, 38, 5 9 ,1 9 6
See also Business
Investment tax credit, 4 8 ,1 5 1 ,1 9 8
Israel, 1 7 ,1 8 , 20, 28-29
Japan
economy, 3, 5 - 7 ,1 0 ,1 1 , 29
exports expansion, 10-11
free market system, 7
GNP, 5, 29
government expenditures, 80
Ikeda economic plan, 3 - 4 ,7
steel consumption, 4
zaibatsu, 331
Joint Congressional Committee on
Expenditures and Revenues, 150
Joint Economic Committee, 187
Joint Study Committee on Budget
Control, 287
Kantorovich, L.V., 6
Keynes, John Maynard, 84, 470
Klasen, Karl, 469-470, 476
Korean W ar, 173, 265, 422
Korea, Republic of, 10-11, 29
Labor, 36, 3 9 ,1 4 4
force, 38, 59-60
market, 167, 222-223
unions, 1 2 6 ,1 2 7 ,1 4 7 , 220

482




Lebanon, 17
LDC. See Less developed countries
Legislative Reorganization Act of
1946, 213, 286, 322
Less developed countries, 31, 412
Liability management, 359-360, 362,
401, 404, 406
Liberman, Y., 6
Liquidity, 1 4 ,1 0 5 -1 0 6 ,1 1 0 , 243
banks, 192
business firms, 131, 216
commercial banks, 9 5 ,1 0 7 , 216
corporate reductions, 209, 316
Federal Reserve, 174, 300, 356
Local government. See State and
local government
Malaysia, 10
Marx, Karl, 7 5 -7 7 , 84
Model Cities Program, 265
Monetary growth, 57, 122, 131, 159,
1 7 4 ,1 7 6 -1 7 7 , 314-315, 351
Federal Reserve control, 182, 183,
349-350, 417, 418, 473
See also Money supply
Monetary policy
aggregate demand, 152-154, 156
economic effects, 15, 95, 122, 170
211, 216, 310, 348
economic expansion, 99, 148, 307,
310, 314-315, 350
Federal Reserve, 8 6 ,1 5 0 , 152, 175,
250, 315, 327, 348, 379, 420
inflation, 94, 100, 178, 181, 184,
208, 238, 351
issues, 169-179
and prices, 170-171, 384
restraint, 15, 9 5 -9 6 , 110, 1 5 6-157,
178
as stimulus to economic recovery,
94, 112, 122, 216
See also Federal Reserve System
Monetary reform. See International
finance
Money supply, 110, 122, 150, 369
central bank, 98-99
Federal Reserve, 1 7 2 -1 7 3 ,1 9 8 , 367
inflationary effects, 370, 415
interest rates effects, 50, 123
Mortgages, 124, 136-137, 168, 184,
244-245, 248-249
Municipal Assistance Corp. (M A C),
298

Municipal government.
and local government

See State

National Commission on Produc­
tivity, 127
National Monetary Commission, 340
Nationalist China. Sec Taiwan
Negotiable order of withdrawal
(NOW) accounts, 341, 344, 4 2 5 429
New York City
bankruptcy, 228, 238, 297-306
New York banks involvements,
408
recession impact, 402
state help, 297-298
New York Stock Exchange, 104,
204, 243
NOW. See Negotiable order of
withdrawal
OPEC. Sec Organization of Petro­
leum Exporting Countries
Open market operations, 190, 3 9 2 393
Organization for Economic Coop­
eration and Development, 190,
237, 242
Organization of Petroleum Export­
ing Countries, 410-411, 456-459,
461, 464
Par Value Modification Act, 4 3 9 445, 448
Pay Board and Price Commission,
133
Penn Central Railroad, bankruptcy
petition, 111
Petroleum prices
balance-of-payments relationship,
220-221
banking impact, 402, 410
economic impact, 46, 189-190, 411
homebuilding industry impact,
242
inflationary factor, 170, 172, 237
OPEC action, 456-458
world economy impact, 411
Phillips curve, 169
President's Commission on Financial
Structure and Regulation, 341
President's Committee on Financial
Institutions, 340




President's Council of Economic
Advisers, 69
President's Task Force on Business
Taxation, 264
Prices
and financial policy, 169, 221, 226
and inflation relationship, 1 5 ,1 6 9 170,
218
in 1974-1975, 188-189
reasons for change, 170-171, 218
See also W age-price behavior
Price stability, 1 1 2 ,1 6 2 ,1 7 9
economic growth, 472
homebuilding industry, 249
inflation relationship, 92
monetary policy, 384
Production
costs, 144, 2 1 8-219
efficiency, 12
inflation effects, 182
See also Industrial production
Productivity
decline in growth rate, 37, 108,
193
labor, 36, 3 9 -4 0
measures to increase, 72, 157, 222
wage-price relationship, 130
Prosperity, 195
inflationary bias, 146, 275
international economic stability,
257
Real estate
investments, impact of recession,
402
investment trusts, 408
market speculation, 205-206, 235,
243
speculation in U.K., 206, 235
Recession, 96-98
causes of, 216
double-digit inflation, 217
economic effects, 144, 188, 202,
210-211, 215, 225, 244, 402
financial effects, 211, 402
inflation relationship, 83, 85, 189,
210, 216, 242, 319, 471
public policy, 197-199
world economy, 46, 441, 459
REIT. Sec Real estate, investment
trusts
Reserve requirements. See Federal
Reserve System

483

Revenue Act of 1962, 48
Revenue Act of 1964, 48
Revenue sharing, 268-269
St. Louis Federal Reserve Bank, 176
Savings and loan associations, 341
Schumpeter, Joseph, 24, 76-78, 84
SDR. See Special drawing rights
Sik, Ota, 10
Singapore, 29
Smith, Adam, 8 ,1 3 , 23-33
Smithsonian Agreement, 440, 441,
443-444, 447-449
Socialism, 77
Social security, 4 7 ,1 4 6 , 219
Social welfare programs, 219
federal expenditures for, 47, 93,
265
Soviet Union. See Union of Soviet
Socialist Republics
Special drawing rights, 451-453, 466
Speculation, 203, 205—
206
homebuilding industry, 243
inflation, impact of, 226, 234-235
international monetary crisis, 440
long-term investment relationship,
105
real estate, 235, 243
stock markets, 205, 235
Stabilization policy, 9 1 -95, 97, 130,
221-222, 237
international, 459, 471
State and local government
federal assistance to, 268, 303-305
financing, 209, 220, 227-228, 3 0 0 301, 316
securities, 124, 298-299
Stock market
economic indicator, 44
inflation effects, 82, 220
speculation, 205, 235
volume trade increase, 204
See also New York Stock Ex­
change; American Stock Exchange
Stocks of money. See Monetary
grow th; Money supply
Structural reform, 153-154, 224, 248
Sweden, GNP comparisons, 27
Taiwan, 10, 29
Taxation trends, 79, 264
Taxes, 47, 86, 96-97

484




federal spending, 293
legislation, 263
rebate, 19 3 ,1 9 8
reductions, 177, 247, 294
variable credit, 158
Tax-exempt bonds, 299, 316
Tax Foundation, 272
Tax Reduction Act of 1975, 212
Thailand, 1 0 ,1 2 , 29
Tokyo stock exchange, 205
Trade agreements, 441-442
Trade unions. See Labor, unions
Transfer payments, 7 9 ,1 1 9 , 194
Unemployment
blacks, 54, 62, 73, 256
compensation benefits, 146-147,
219
and economic recovery, 132
growth of, 182
government labor policy, 222
and inflation, 144, 221-222, 226,
255, 307, 416
minorities, 54, 256
price competition, 222
productivity incentives, 222
women, 60-61
youth, 54, 61, 73, 256
Union of Soviet Socialist Republics
economy, 5 -6
farm production, 30
free enterprise, 30, 77
GNP, 5 -6 , 27
living standards, 5, 6
production growth, 4
United Kingdom
economic development of, 24
government expenditures, 80
property speculation, 206, 235
wage-price behavior, 1 4 6 ,1 7 0 , 239
U.S. Congress
appropriation bills, 1 4 9 ,1 5 0
Joint Committee on Expenditures
and Revenues, 150
Joint Economic Committee, 187
legislative budgets, 150
tax legislation, 263
total expenditures ceilings, 150
U.S. National Bank of San Diego,
failure, 401
Usury laws, state, 248
Vietnam, 149, 387

W age-price behavior
controls, 1 5 ,1 5 3 , 162 ,1 7 1
economic effect of, 127, 218-219
free market, 26
freeze, 1 2 9 ,1 3 2
market forces, effect of, 1 4 4 ,1 4 5
Phase I program, 129
Phase II program, 129-134
productivity, 130
United Kingdom, 1 4 6 ,1 7 0 , 239
W age rates
increases in, 125-127, 130, 147,
169, 218
inflationary effects of, 112, 127,
1 4 4 ,1 8 9
minimum, 62
W alsh-Healy Act, 62




Wealth o f Nations , The, 23, 24, 3 1 32
W eather, economic effects of, 3 1 1 312, 349
W elfare programs. See Social wel­
fare programs
W est Germany. See Germany, Fed­
eral Republic of
Wholesale price index (W PI), 125
World W ar II
German industry, 28
U.S. Treasury borrowing program,
172-173
Yugoslavia, 31
Zero-base budgeting, 101, 271, 2 8 7 288, 321

485




The Author

Arthur F. Burns is Distinguished Scholar in Residence at the
American Enterprise Institute, in Washington, D.C. Also, he
is Distinguished Professorial Lecturer at Georgetown Uni­
versity, in Washington, D.C., and since 1969 John Bates Clark
Professor of Economics Emeritus at Columbia University, in
New York. He has had a long and notable career both in aca­
demic and in public life. He has been affiliated with the National
Bureau of Economic Research since 1930 and served as its
president from 1957 to 1967. From February 1970 until March
1978, he served as Chairman of the Board of Governors of the
Federal Reserve System. Prior to his Federal Reserve service, he
was Counsellor to the President (1969-1970) and Chairman of
the President's Council of Economic Advisers (1953-1956). His
principal publications include: Production T ren d s in the U nited
States S in ce 1 8 7 0 (1934); M ea su rin g Business C ycles, with
W. C. Mitchell (1946); Econom ic R esearch and the K eynesian
T h in k in g o f O u r Tim es (1946); Frontiers o f E conom ic K now l­
e d g e (1954); Prosperity W itho ut Inflation (1957); T h e M a n age­
m en t o f Prosperity (1966); Full E m p loy m ent, G uideposts, and
Econom ic Stability, with Paul A. Samuelson (1967); T h e D e fe n s e
S ector and the A m erica n E co no m y, with Jacob K. Javits and
Charles J. Hitch (1968); and T h e Business C y cle in a C h a n gin g
W o rld (1969).




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