Full text of Second Meeting on the Conduct of Monetary Policy : Hearings Before the Committee on Banking, Housing, and Urban Affairs, United States Senate, Ninety-fourth Congress, First Session, November 4 and 6, 1975

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COMMITTEE ON BANKING, HOUSING AND URBAN AFFAIRS
WILLIAM PROXMIRE , Wisconsin , Chairman
JOHN SPARKMAN , Alabama
JOHN TOWER, Texas
HARRISON A. WILLIAMS, JR ., New Jersey EDWARD W. BROOKE, Massachusetts
BOB PACKWOOD , Oregon
THOMAS J. MCINTYRE, New Hampshire
ALAN CRANSTON , California
JESSE HELMS, North Carolina
JAKE GARN, Utah
ADLAI E. STEVENSON , Illinois
JOSEPH R. BIDEN, JR. , Delaware
ROBERT MORGAN , North Carolina
KENNETH A. MCLEAN, Staff Director
ANTHONY T. CLUFF, Minority Staff Director
ROBERT E. WEINTRAUB, Professional Staff Member

( II )

1911

CONTENTS

LIST OF WITNESSES

TUESDAY, NOVEMBER 4
Arthur F. Burns, Chairman, Board of Governors of the Federal Reserve
System

2

THURSDAY, NOVEMBER 6
Prof. Milton Friedman , University of Chicago, department of economicsProf. Paul A. Samuelson , Massachusetts Institute of Technology , depart
ment of economics ..

34
49

EXHIBITS
Chart showing weekly M, against the backdrop of the Fred's planned
range - March 1975 to March 1976 - Using $ 285.0 as the base for com
puting that corridor-------Table showing rates of monetary growth , 1970–75_
( III )

25
42

SECOND MEETING ON THE CONDUCT OF
MONETARY POLICY

TUESDAY, NOVEMBER 4, 1975

U.S. SENATE ,
COMMITTEE ON BANKING, HOUSING AND URBAN AFFAIRS,
Washington, D.C.
The committee met at 10:10 a.m. , pursuant to call , in room 5302,
Dirksen Senate Office Building, Senator William Proxmire, chairman
of the committee , presiding.
Present : Senators Proxmire, Sparkman , Tower, and Garn.
The CHAIRMAN . Today we begin our second meeting on monetary
policy pursuant to the resolution Congress passed last March which
calls upon the Federal Reserve to “ consult with the Congress ... about
the Board of Governors' and the Federal Open Market Committee's
objectives and plans with respect to the ranges of growth of the mone
tary and credit aggregates in the upcoming 12 months."
There was another hearing. This is the third , in a sense, because the
House had a hearing since our hearing last May .
This morning we will hear from Dr. Burns, Chairman of the Fed
eral Reserve Board, on the ranges of growth planned for the period
upcoming. On Thursday, the committee will receive testimony from
two of our distinguished economists, Professors Paul Samuelson of
MIT and Milton Friedman of the University of Chicago. So we will
be hearing a full spectrum of views from three of the most eminent
economists with this meeting on the resolution with Dr. Burns, sand
wiched between Professors Samuelson and Friedman.
Before you begin , Dr. Burns, I want to welcome you . After your
statement of our first meeting on the resolution last May, I said :
I think we have worked out something that I hope will work well in the
future . . . I think that by disclosing the Federal Reserve Board's present views
on the appropriate ranges of growth in the monetary and credit aggregates for
the year ending next March you contributed both to the cause of informed,
intelligent government and the development of economic policy that knows where
it's going and why .
In retrospect, I think what I said then is correct. I think we have
worked out something which is proving to be a positive and construc
tive force. It lets the public, Congress and the administration know
what the basic thrust of monetary policy is. It requires the Fed there
fore to think in year- over-year terms as well as month by month . It also
should serve as a self-enforcing discipline on those who make monetary
policy by signaling unmistakeably the need for midcourse corrections
when in fact they are called for. Finally , the procedure we have worked
out requires that Congress now must do its homework in monetary

(1 )

2
economics, learn its fundamental principles and its nuances so that we
can play a constructive role in the consultative process.
Dr. Burns, go right ahead in any way you wish .
STATEMENT OF ARTHUR F. BURNS, CHAIRMAN, BOARD OF
GOVERNORS OF THE FEDERAL RESERVE SYSTEM
Dr. Burns. I am pleased to meet with this committee to report once
again on the condition of the national economy and the course of
monetary policy .
When I submitted to you the Federal Reserve's report on May 1,
the American economy was at the trough of the deepest decline in pro
duction of the entire postwar period . Since then , a l'ecovery of eco
nomic activity has gotten underway. Between April and September,
industrial production rose almost 6 percent; each month's increase ex
ceeded that of the month before , and the September increase was the
largest in over a decade. The scope of the recovery has also been
broadening. Production of durable goods has advanced strongly of late
and the increase of activity in the nondurable goods sector—which be
gan earlier — has continued. Improvement has spread beyond the Na
tion's factories, mines, and power plants, and the overall increase in
the physical volume of production during the third quarter turned out
to be one of the largest in recent years.
As real output moved upward, the demand for labor kept strengthen
ing. Since March , total employment has risen by more than 11,2 mil
lion. The average factory workweek has lengthened appreciably.
Unemployment has declined from its peak in May despite a sizable in
creaseof the laborforcethisyear. And the increaseof employment has
become more widely diffused across the economy . Of the 172 nonfarm
industries on which the Bureau of Labor Statistics reports, only 17
percent experienced an increase of employment in February. The cor
responding percentage rose with considerable regularity in succeeding
months and reached 72 percent in September.
As we look back, it is clear that the consumer led the way out of
recession and into recovery. Early this year, when price concessions
became fairly common , consumer purchases began to pick up . Con
sumer buying was further buttressed over the spring and summer
months by tax rebate checks and supplementary social security checks.
Retail sales of nondurable goods rose briskly ; and as confidence im
proved, consumers also became more willing to dip into savings or in
cur new indebtedness in order to purchase big -ticket items. This is
clearly evident in the automobile sector, where sales of new cars have
been running recently at an annual rate of around 91/2 million—a con
siderable advance from the 7 million rate of last November.
A sharp turnaround in foreign trade also helped to pave the way
for economic recovery . Our trade balance was unfavorable throughout
1974, and the deficit reached an unprecedented $9 billion annual rate
in the third quarter of last year. But a deep cutback of imports — espe
cially of fuel and industrial supplies — occurred during the recession ,
while the demand for our exports held up well . The result was a swing
in our trade position to a surplus at an annual rate of over $13 billion
in the second quarter of this year. There has been a significant rise of
imports recently, as is to be expected during a cyclical expansion .

3

Nevertheless, our trade surplus is still large, the overall balance of
payments remains favorable, and the dollar is again a highly respected
currency around the world .
Sustained buying by foreigners and American consumers enabled
business firms to make excellent progress in clearing their shelves of
excess inventories. Liquidation of inventories got underway around the
beginning of this year, and in the second quarter the rate of decline
was larger in relation to the gross national product than in any quarter
of the entire postwar period.By early summer, stocks were coming into
reasonable balance with sales in most consumer lines, and many firms
engaged in retail and wholesale trade therefore beganto rebuildinven
tories. Meanwhile, the pace of inventory liquidation slowed consider
ably in the manufacturing sector. For business firms in the aggregate,
inventory liquidation receded from an annual rate of about $ 30 billion
in the second quarter to a rate of $ 10 billion in the third. This shift
in business inventory investment has been a major factor in the recent
sharp rise of our Nation's production of goods and services.
The willingness of businessmen to move further in replenishing
depleted stockpiles, and thereby provide a continuing thrust to gen
eral business activity, will depend heavily on thestrength of consumer
demand. That in turn will be influenced materially by the real income
of consumers, their financial position , and the state of confidence - all
of which are linked to inflationary developments and prospects. In
the Board's judgment, improvement of the economy is likely to con
tinue at a satisfactory pace only if consumers and businessmen can
reasonably look forward to some further abatement of cost and price
inflation .
We as a Nation have made notable progress in reducing the rate
of inflation that prevailed during 1974. Consumer prices rose over the
first three quarters of this year at about half the pace recorded a year
earlier. The rise in wholesale prices slowed even more. These improve
ments resulted mainly from slack demand in product markets and the
competitive pressures that forced business managers to watch costs
more closely and to enhance efficiency. These efforts have begun to bear
fruit; output per man-hour turned up in the second quarter — thus
registering the first increase in over 2 years — and rose further in the
third.
Of late , however, there has been some worsening in the rate of infla
tion . Broad measures of price performance indicate a rise in the third
quarter at an annual rate of around 71/2 or 8 percent — compared with
512 percent in the second quarter. To be sure, special factors — such as
the unexpected Russian need for grain and the further rise of energy
prices — were partly responsible for this development. But price in
creases have also occurred in a number of industries — autos, steel,
aluminum , and chemicals, among others — where considerable slack
still exists . And the increase in the price of imported oil that went into
effect on October 1 may well lead to price advances over a wide range
of products in the months ahead .
Some step-up in the rate of increase in the general price level was
perhaps unavoidable, in view of the vigor of economic recovery and
the persistent rise of wages. Nevertheless, the quickening in the pace
of inflation during recent months — in the face of high unemployment
and widespread excess industrial capacity — is a clear warning that our

4
long -range problem of inflation is unsolved and remains a threat to
continuance of economic recovery.
Elimination of the long -run inflationary bias of our economy will
require progress on numerous fronts, including a marked strengthen
ing of business expenditures for new plant and equipment. Growth
and modernization of the Nation's industrial capacity are essential to
avoid a recurrence of capacity shortages in critical sectors of the econ
omy, to lay the basis for greater improvements in productivity, and
to expand job opportunities for our people.
As often happens in the early months of a cyclical upswing, busi
ness spending for fixed capital has lagged behind the recovery in other
sectors. The rise that appears to have occurred recently in the pro
duction of business equipment is as yet inconclusive. Various indica
tors suggest, however, that an upturn of business capital investment
may not be far away. Contracts for commercial and industrial con
struction have stabilized during recent months. New orders for non
defense capital goods, though edging off in the past 2 months , are now
about 8 percentabove their level in March . Moreover, the rate of for
mation of new business firms — another advance indicator of business
capital investment—is moving up again .
Further improvement in the homebuilding industry is also a vital
ingredient of a full -fledged economic recovery . Thedecline in market
rates of interest that began in the summer of 1974 bolstered the flow
of savings to mortgage lending institutions last fall , and a substantial
rise in mortgage loan commitments soon followed. Early this year ,
the volume of sales of both new and old dwellings rose, and these
sales are continuing to run well above their lows of last winter. With
better market conditions, housing starts — especially of single -family
dwellings — have been moving up again . The recovery in homebuilding
however, has been weak. Prices of new and existing houses , to say
nothing of other costs of homeownership, have risen so drastically that
many American families cannot afford to buy a home. Builders, more
over, remain very cautious in view of the overbuilding and financial
difficulties of recent years.
Mortgage lenders have also remained cautious, in part because of
fears that the enormous financing requirements of the Federal Gov
ernment would drive up market interest rates and thereby attenuate the
flow of funds to thrift institutions. The Federal budgetary deficit dur
ing the third quarter was the largest on record . In just 3 months, the
volume of Treasury bills outstanding rose by $ 14 billion . Since com
mercial banks reduced their purchase of Government securities as loan
demands strengthened , a substantial volume of Treasury bills had to
be absorbed by the general public. Borrowings by the Treasury in the
2- to 3-year maturity range were also very heavy. A series of such
note issues in August and September drove up interest rates, attracted
a sizable number of individual investors, and served to reduce the flow
of savings to banks and thrift institutions.
These developments left their mark on the residential mortgage
market. Lenders became more hesitant to commit funds, and interest
rates on new mortgage loan commitments drifted upward. Neverthe
less, mortgage rates remain below their 1974 peaks, and funds remain
readily available in nearly all areas of the country where unrealistic
interest rate ceilings do not impede the flow of credit.

5
Increases of interest rates have been particularly prominent in the
market for State and local government securities. The financial prob
lems of New York City has had widespread repercussions on the cost
and availability of credit to State and local governments. Although
yields on high -grade municipal obligations have risen about in line
with yields in other long -term markets, increased investor caution has
resulted in a marked widening of yield differentials between munici
pal issues of high quality and those of lower quality . Authorities with
relatively low credit ratings have experienced pronounced increases
in borrowing costs and, in some instances, they have been effectively
excluded from the public market. Despite these adversities the munici
pal bond market continued to function well enough to permit a record
volume of long - term issues during the third quarter. In the past few
weeks, however, the volume of new municipal issues has dropped
appreciably.
Of late, the need of business firms to borrow in the long-term capi
tal market has diminished as their liquidity generally improved, and
as the downward adjustment of business inventories and better profits
generated an enlarged flow of cash . During much of this year, how
ever, the market for long-term funds has been under pressure — first,
from corporate security issues, later from heavy Treasury borrowing
and an extraordinary volume of new municipal securities. The Fed
eral Reserve has sought to provide some assistance to the long -term
market by shifting the emphasis in its open -market operations from
Treasury bills to longer term securities. Since the beginning of the
year, the System has acquired over $6 billion of Treasury and agency
issues bearing maturities of over 1 year. Of this total , $ 2 billion was
acquired since midyear.
These purchases have been helpful in steadying the bond market
during periods of unusual tension, but they can have only an ephemeral
influence on long-term interest rates. The fundamental factor forcing
up long- term interest rates in recent years has been the high rate of
inflation which persistent deficits in the Federal budget kept fueling.
Appreciably lower long -term interest rates would, I believe, contribute
powerfully to economic expansion , butthey are unlikely to be attained
unless significant progress is made in closing the budgetary deficit and
in bringing inflation under control.
Exercise of fiscal discipline at all governmental levels is badly
needed to ease the tensions and uncertainties that have disturbed fi
nancial markets this year. The pressure of Federal financing on interest
rates during the third quarter resulted not only from the sheer mas
siveness of the Federal deficit, but also from successive upward re
visions in borrowing needs. The sharply higher yields in the market
for municipal securities have reflected the heavy borrowings by State
and local governments as well as reduced confidence in the finances of
some of these governmental units. The climate for economic expansion
would be greatly improved by clear evidence that governmental
authorities at all levels are finally willing to live within their means
and to get alongwithout financial gimmickry.
We in the Federal Reserve fully recognize that monetary policy has
an important role to play in maintaining a financial environment that
is favorable to sustained economic expansion. The strength of the eco
nomic recovery to date has been heartening, but we are still a long way
62-042-7572

6
from reasonably full employment of our labor and capital resources.
The reduction in the rate of inflation accomplished this year has also
been encouraging, but we are still a long way from reestablishing
reasonable stability in the price level. In light of these facts, the only
responsible option open to the Federal Reserve is to pursue a course
of moderation in monetary policy — a course that will provide expan
sion in supplies of money and credit adequate to facilitate further good
recovery of production and employment, but not so large as to rekindle
the fires of inflation .
To implement this course of policy, the Federal Open Market Com
mittee has projected growth ranges of the monetary aggregates that
differ little from those announced previously. For Mı , which includes
currency and demand deposits, the projected growth range for the com
ing year is again 5 to 712 percent. For M , which includes consumer
type time and savings deposits at commercial banks besides the com
ponents of M1 , the growth range has been widened by reducing the
Tower end of the range one percentage point. The growth range for
M3 , which includes deposits at thrift institutions besides the compo
nents of M2 , has been similarly widened. These adjustments were made
in view of recent experience, which suggests that pressures on market
interest rates stemming from heavy Treasury borrowing tend to
moderate inflows of savings funds to depositary institutions. The
growth range projected is thus 712 to 1012 percent for M2 , and 9 to 12
percent for M3.
These growth ranges now apply to the period extending from the
third quarter of 1975 to the third quarter of 1976 — rather than from
the second quarter of 1975 to the second quarter of 1976. This updating
of the base, I should note, implies a slightly higher level of money
balances a year from now than would be the case if the second - quarter
base were retained .
Since I last reported to this committee on May 1 , growth of the
monetary aggregates has been broadly in line with the ranges we
adopted earlier. However, month-to- month and quarter -to -quarter
changes in the aggregates have been very large , reflecting unusual fac
tors influencingthe public's demand for money.
The largest short-term variation occurred in My , the narrowly de
fined money stock . Thus , My grew at an exceptionally high annual
rate - 1.2 percent — during the second quarter , as the public's
holdings of cash bulged during May and June because of the tax
rebates and special social security payments authorized by the Con
gress. As these excess balances were subsequently drawn down,growth
of M , slowed to a 2.2 - percent annual rate from July through Septem
ber. There were similar, though smaller, variations in the growth
rates of M, and M3 .
Measured on the basis of quarterly averages, the pattern of monetary
expansion was much more stable. My increased at an annual rate of
8.6 percent between the first and second quarters, and 6.9 percent be
tween the second and third quarters. The comparable figures were
1.2 and 10.4 percent for M,, and 13.8 and 13.1 percent for M3.
Shortrun fluctuations in the rate of monetary growth are practically
unavoidable, but they also have little significance for the functioning
of the real economy . That is why we use quarterly average levels of
money balances as the base for specifying longer run objectives for

7
monetary expansion. However, we cannot ignore the short-term move
ments of money balances in the conduct of monetary policy, since it is
necessary to be alert to any large and protracted departure of monetary
growth rates from longer run objectives.
Around the middle of this year, the major monetary aggregates
were increasing at rates far above the longer run ranges the Federal
Reserve was seeking. We therefore set forces in motion which helped
to return the pace of monetary expansion to the moderate rate desired.
More recently, increases in the monetary aggregates have fallen below
our projected ranges. Once again, steps have been taken — including a
modest reduction in reserve requirements — to encourage a return to
the desired path of longrun monetary expansion .
These corrective actions have had some influence on the level of
interest rates — particularly short -term rates — which rose conspicu
ously in late June and early July, but have recently retreated on a
broad front. Temporary fluctuations such as these in short - term market
interest rates are an inevitable byproduct of efforts to keep the rate
of monetary expansion from straying too far from the desired longer
run path . It is important to recognize that the Federal Reserve's
conduct of monetary policy conforms in this respect not only to our
best judgment , but also to the spirit of House Concurrent Resolution
133 .
The longer range growth rates of the monetary aggregates we are
now seeking are , we believe, adequate to finance a vigorous further
expansion in real economic activity. Let me stress once again, how
ever, that the relation over time between money balances and the
physical volume of economic activity is rather loose , since so much
depends on the willingness of businessmen and consumers to use their
existing money holdings. Weknow from earlier history that the turn
over of the narrowly defined money stock tends to rise faster in the
recovery stage of the business cycle than does the monetary stock
itself. Recent experience has confirmed this tendency. Thus, between
the second and third quarters of this year , M , rose-as I earlier noted
at a 6.9 percent annual rate . But the income velocity of M , —that is,
the ratio of GNP to M7 - rose during that period at an annual rate
of 8.7 percent.
In deciding on the appropriate target ranges for growth of the
monetary aggregates, we at the Federal Reserve must carefully con
sider the probable movements of income velocity over the course of the
business cycle. We must also bear in mind that innovations in financial
markets can have large effects on the economy's needs for money and
other assets to finance economic expansion and to satisfy the public's
liquidity preferences.
We are living in a time of rapid changes in the public's demand
for currency, for checking accounts, for savings deposits, and for a
host of other liquid assets. Over the past 20 or 30 years, dramatic
developments in financial technology have reduced substantially the
proportion of spendable funds that is held in the form of currency and
demand deposits. More and more corporate treasurers have learned
how to get along with a minimum of deposits in their checking ac
counts. Consumers, too , have learned to keep a larger part of their
transactions and precautionary balances in the form of savings de
posits at commercial banks, or deposits in savings and loan associa

8
tions, or certificates of deposit, or Treasury bills , or shares of money
market funds, or other income-earning liquid instruments. Of late,
telephonic transfer of funds from sayings accounts to checking ac
counts is accelerating the trend toward holding transactions balances
in income-earning form .
Furthermore, as a result of recent financial innovations, liquid
assets other than currency or checking deposits are being used to an
increasing extent directly for transactions purposes. Since 1970, cus
tomers of mutual savings banks and savings and loan associations
have been able to authorize payment of regularly - scheduled household
expenditures, such as mortgage payments, directly from their savings
accounts. This year, authority for such third - party transfers was
broadened to include any payment, regardless of purpose , and per
mission was granted to commercial banks to offer similar services to
their customers. And since 1974, commercial banks and thrift institu
tions in Massachusetts and New Hamphire have been allowed to offer
so -called “ NOW ” accounts to their customers. These accounts pay a
rate of interest that practically equals the rate on regular savings
accounts, and yet they permit direct transfer of funds through a
negotiable instrument comparable to a check.
These changes are having a significant impact on the type of finan
cial assets that the public holds to meet its transactions needs, and
on the range of financial institutions that are involved in supplying
payments services. Savings and loan associations and mutual savings
banks, as well as nonmember commercial banks, are now an important
part of the Nation's payments mechanism . And yet they are not sub
ject to the reserve requirements imposed by the Federal Reserve on
member banks. As a consequence, the scope of monetary control exerted
by the Federal Reserve is being eroded.
The financial innovations that I have described so summarily are
also increasing the difficulties of determining the growth rates of the
monetary aggregates that are appropriate at any given time. Clearly,
the Federal Reserve cannot focus attention exclusively on any single
measure of money balances. We must be alert to the possibility that
our longer -run projected ranges for the monetary aggregates may
need to be altered in view of changes in financial technology as well
as more basic economic and financial developments.
Let me remind this committee , finally, that the growth rates of
money and credit presently desired by the Federal Reserve cannot be
maintained indefinitely without running a serious risk of releasing
new inflationary pressures. As the economy returns to higher rates of
resource utilization, it will eventually be necessary to reduce the rate
of monetary and credit expansion. The Federal Reserve does not be
lieve the time for such a step has yet arrived . But in view of the
economic recovery that has been underway since last spring, we are
closer to that day now than we were 6 months ago .
Our Nation is confronted today with a serious difficulty in its search
for ways to restore full employment. Highly expansionist monetary
and fiscal policies might, for a short time, provide some additional
thrust to economic activity. But, later on , the rate of inflation would
accelerate sharply — a development that would create even more diffi
cult economic problems than we have yet encountered. This committee's
report on monetary policy, issued in June, recognized this basic truth
in stating that “ if inflation is rekindled, any recovery will be short

9
lived and will end in another recession , one almost certain to be more
virulent than the present one."
Conventional tħinking about stabilization policies, as I tried to ex
plain in a recent address at the University of Georgia, is inadequate
and out of date . Stimulative financial policies have considerable merit
when unemployment is intensive and the price level is stable or declin
ing . But such policies do not work well when the price level keeps on
rising while there is considerable slack in the economy. Experience
both in our own and other industrial countries suggests that once infla
tion has come to dominate the thinking of a nation's businessmen and
consumers, highly expansionist monetary and fiscal policies do not
have their intended effect. That is , instead of fostering larger consumer
spending and business investment , they may well lead to larger pre
cautionary savings and sluggish consumer buying.
The only sound fiscal and monetary policy today is a policy of pru
dence and moderation . New ways must be found to bring unemploy
ment down without becoming engulfed in a new wave of inflation .
That is why structural policies require far more attention than they are
being accorded by academic economists or Members of the Congress.
Thank you. Mr. Chairman .
The CHAIRMAN . Dr. Burns, thank you .
You referred to the New York City difficulties as being responsible
at least in part for the increase in interest rates on State and munici
pal issues and I think that's unquestionable.
I'd like to ask you about this problem that has engaged this com
mittee, as you know , and will engage the Senate and the House in the
next few weeks. The New York City loan guarantee bill has relied
very heavily on your advice . As a matter of fact , you have been
responsible I think for greatly improving its strength and helping us
put together a responsible package that will enable us to protect the
Federal Government and ease the burden on New York if it's going to
avoid default.
You suggested, for example, that we might require the State of New
York to impose a tax equal to about one-half of its operating deficit .
We took that advice . It was protested by the New York State legisla
ture but we took your advice and incorporated it into the bill .
Then, in the second place, you suggested that New York City bond or
noteholders be required to stretch out their maturity and reduce their
rate of interest in a substantial amount. This has been a bitter pill to
swallow on the part of many noteholders but we have written that into
the bill through the Stevenson amendment, as you know , but that was
very largely — I think Senator Stevenson would agree / helped by your
advice and your encouragement that we do that.
You also suggested some reduction in the burden imposed on the
city under present pension and retirement plans. Now we met that in
two ways. First, we direct that as a condition of providing a guarantee
that the burden of pension and retirement plans be reduced and, sec
ond, we provide the three-man board on which you would serve, to
gether with the Secretary of the Treasury and the Secretary of Labor,
the authority to impose whatever additional conditions that you and
Secretary Simon and Secretary Dunlop feel to be necessary to make the
plan work . Also, the fact that you would serve on this board together
with Mr. Simon and Mr. Dunlop it seems to me would assure that
before the guarantee would be approved that you would have to be

10
satisfied that it would be practical and workable ; otherwise, no guar
antee and they have to go the default route.
Now in view of the risk which I think you have acknowledged a num
ber of times — the risk certainly to New York City, the risk to New
York State, and possibly — we don't know the extent of it, but the risk
to the United States as a whole — do you feel that we might go this
route ? Do you see that we have anything to lose by passing this
legislation ?
Dr. Burns. Let me say first of all that while I have not studied the
bill that you have written very closely, I have a strong impression that
it is an excellent bill.
In addressing myself to the New York City problem in recent months
I have found that my concern over the possible consequences of a New
York City default has become greater ; as I noted in recent testimony,
it's greater now than it was 3 months ago or even 3 weeks ago . I have
not yet reached a point, however, where I believe that it would be wise
for this country to legislate financial assistance to New York City.
It's my business to respect facts and I may change my mind. I must
tell you in all candor that I'm keeping a daily log on every financial
market in the country and if I find that the financial markets are de
teriorating I may indeed change my mind and come before this com
mittee without delay. But I'm not at that point now. If the President's
recommendation is followed and there is no financial assistance legis
lation by the Congress, and if we are lucky — it's going to take a bit of
of luck, Senator, I recognize that — we may have a turning point in
this country as far as fiscal policy is concerned — not only at the State
and local levels but also at the Federal level.
New York City's difficulties have been dramatized . New York City
has been living beyond its means, as have many communities within our
country and as has the Federal Government itself on a very large scale
the degree of attention that has been paid
in recent years . In view of
to the New York problem , I think that if the President's recommenda
tion is followed and if we are lucky - I must repeate that — it may
mark a major and most useful turning point in fiscal policy in our
country at all levels of Government.
So, while I admire the bill that your committee has drawn, and
while I think that there is a good case to be made for legislation , I am
as yet not convinced that that is the wiser course to pursue.
The CHAIRMAN . Well , I agree with almost everything you say , every
thing except your conclusion . There's no question if we're lucky this
could be an extraordinarily useful lesson. I agree that there's no
question that the lesson is just as clear as it can be. But my feeling
and I hope you will consider this — my feeling is that the lesson is
already dramaticaly clear, that New York has taken action in the last
2 or 3 months to sharply reduce their number of employees ; they have
frozen wages for 3 years. They have a plan for a balanced budget
which they are in a very good position to achieve because all the reve
nues that come in go to their financial emergency control board and
are disbursed by that board which has an absolute commitment to
proceed toward a balanced budget and it seems to me that having
taken that painful step and having to face the fact that they are going
to have to have sharp reductions in spending, that this is a lesson.
Nevertheless , I can't possibly quarrel with your conclusion that it
would also be a very good lesson to the country if New York did de

11
fault , but also the risk , if we're lucky—if we're lucky — and it's an
enormous risk. If we're lucky this could precipitate very serious eco
nomic repercussions I think , including a deeper recession, including
more unemployment, including great difficulties for our cities and this
may not happen but it's a very serious risk.
Now the second question I'd like to ask you is in connection with
the President's proposal to reduce taxes by $28 billion and to condi
tion that upon a reduction in spending, but the reduction in spending
would seem to take effect after the reduction in taxes. As I under
stand, the reduction in taxes would be effective in the coming cal
endar year . The reduction in spending would not be effective until
beginning October 1 , 1976. Therefore , there's a lag and much of what
you say here which so consistently emphasizes fiscal responsibility and
the impact of fiscal policy on monetary policy would seem to be con
ditional on what the Congress and the President finally do with re
spect to the tax reduction .
Can you give us your reaction to that proposal to reduce taxes by
$28 billion and then reduce spending later ?
Dr. BURNS. I would be in favor of such a reduction in taxes pro
vided a reduction in expenditures was made simultaneously rather
than after some lapse of time. In other words, I would want the two
reductions to become effective at precisely the same time.
The CHAIRMAN. Well, as a practical matter, then, if you're going to
reduce taxes in this present fiscal year, in view of the fact that the
budget for the current fiscal year has already been acted on. We have
already passed a number of appropriation bills. The next budget
doesn't begin to take effect until October 1 , 1976. I take it that you
would then say we shouldn't reduce taxes unless we reduce them for
the following year — that is, calendar year 1977 – because that would
be coexistent. Is that right ?
Dr. Burns. That's one possibility , and if you were to stay with the
strict procedures of the Budget Reform Act, you probably would be
driven to that conclusion. But Congress in the past has set an expendi
ture ceiling, and Congress might do that again.
The CHAIRMAN . Now , if we follow the President's proposal, how
would that affect monetary policy ? Would that make it necessary if
we did reduce taxes first and had a period in 1976 of further increased
deficit, would that make it necessary for you to follow a policy of more
stringent control of the money supply , a slower growth in money
supply ?
Dr. BURNS. That's very difficult to judge. An increased deficit would,
of course, be a matter of some concern to us, but there are psychological
factors that play on financial markets which I find very difficult to
predict. It's entirely possible that evidence that the Congress is stren
uously curbing Federal expenditures might have a beneficial effect on
expectations with regard to inflation and so forth , and therefore that
the pressures on interest rates might not be increased by the larger
deficit. Because of the difficulty of predicting these psychological fac
tors, I can't tell you what the response of monetary policy would be.
The CHAIRMAN . As a member of the Appropriations Committee,
it's very difficult for me to see how in fact we can reduce the spending
in this fiscal year. We do have a very important appropriation meas
ure still before us, the defense appropriation bill, but it's unlikely
that that would change very much with this kind of consideration in

12

mind. So that I think we really have to look forward as a practical
matter to 1977.
Supposing we keep the tax cut now due to expire and cut taxes
further, as the President has suggested , together with spending
effective next October.
Dr. BURNs. I don't take warmly to that suggestion. As I stated ,
I think the two ought to be concurrent. One should accompany the
other, and I believe
Thé CHAIRMAN . Well, if I could just interrupt, I think we have
to recognize the fact that if we don't keep the tax cut about to expire,
we'll have a de facto tax increase. Isn't that correct ?
Dr. BURNS. Let me put it this way. Whenever, after a temporary
tax cut, taxes return to their original level , you can describe that as
á tax increase or you could describe
The CHAIRMAN . That's the effect on the economy, is it not ?
Dr. BURNS. Or you can say the temporary tax cut has come to an
end and taxes are not increased at all. You can describe it either way .
The CHAIRMAN . From the standpoint of the effect on the economy,
what would concern you, it would have the same effect as a tax
increase .
Dr. BURNS. Well, I was not enthusiastic about the tax cut in the
first place . For an economy of the size of ours , I don't think its
expiration would make a great deal of difference, and evidence of
financial conservatism by the Congress might have a very salutary
effect on business and financial thinking across the country.
The CHAIRMAN . All right. Now, in the course of your very thought
ful and helpful presentation, you have to make assumptions. Can
you tell us, on the basis of the assumptions that you have made , what
you think will happen to unemployment over the coming year ?
Dr. BURNS. I'm a very poor prophet. I expect unemployment to
decline over the coming year, but I don't know by how much it will
decline. In that respect, I'm like everybody else, except that many
are inclined these days to throw numbers around more readily than
I am .
The CHAIRMAN. Well , my time is about up . I would just persist a little
on this, however, by contending that policies that we followed in
Congress, of course , depend on what assumptions we have to make,
implicit or explicit, on what unemployment and on inflation , and you
can give us expert advice. Congress has great faith in your judgment,
and this committee has shown our faith by following much of your
advice on the New York City bill recently, for example, and on many
other things.
So if you could give us some notion of whether you would expect
unemployment to decline maybe 1 percent, inflation to stay at a level
of around 6 or 7 percent or a range or something like that, it would
be very helpful. Can you do that ?
Dr. BURNS. I would go some small distance in that direction ,
Senator.
The CHAIRMAN . Well , I like that answer, but unless you say whether
you think unemployment is going to go down to 712 percent or be
in the range of 7 to 71/2 percent or something like that, I don't see
that I have much that I can find useful.

13

Dr. BURNS. Senator, I know more about the past than I do about
the future. In past recoveries, unemployment has frequently fallen by
2 percentage points within the first year. I think that if we have a
normal recovery — and it seems to me to be developing in that fashion
a year from now unemployment ought to be down to below 71/2 percent.
That would be my practical judgment, but I would want to repeat
that all such numbers must be taken with a grain of salt.
You have a different problem than we have at the Federal Reserve.
You in the Congress deal with fiscal policy, which is a very clumsy,
awkward instrument. We at the Federal Reserve deal with monetary
policy, which we can adjust within a month, within a day, and even
within an hour. For our purposes, precise forecasts are not necessary ;
if we see we are not on the track we'd like to be on , we can shift
course. That's much more difficult for you , and I therefore understand
your concern and your desire for projections and predictions.
Yet I sometimes wonder whether fiscal policy cannot be made
more flexible than it has been in the past. I wonder whether, instead
of relying on the numerical predictions, Congress might not take
inventory , say, once every 3 months, and decide whether stimulative
measures - or whatever the fiscal policies in effect at the time — have
gone far enough or have gone too far ; and depending on the conclu
sion , then either move further in the same direction or reverse course .
There might be greater possibilities of this kind than have yet been
utilized . But it would take time to work them out, so that's some
thing for the future, assuming it can be done at all .
The CHAIRMAN . My time is up . Senator Tower ?
Senator Tower. Dr. Burns, to pursue the question of Senator Prox
mire in terms of reduction of expenditure, we tend only to look at
the so-called controllables, not at the so-called uncontrollables. Don't
you think that Congress would be wise, if it's serious about reducing
projections for growth in spending, to perhaps take a hard look at
some of the so- called uncontrollables.
Dr. Burns. I couldn't agree more . Actually , I have banished the
term " uncontrollable ” from my personal vocabulary, and I would
recommend that Members of the Congress do the same.
Senator TOWER. I think that's good advice. I don't think anybody
realistically thinks that Congress can act in a timely way to prevent
default by New York City. Maybe there's some things they can do
within the State that could postpone default or prevent it, but in the
event that efforts at preventing default fail , do you hink that we
should then move in the direction the President has recommended and
restructure the Federal Bankruptcy Act to accommodate New York
and provide for some sort of emergency assistance for essential
services ?
Dr. BURNS. I would hope that no matter what happens to the legis
lation that your committee is recommending to the entire Congress,
the Congress will move on bankruptcy legislation. In the last analysis
you don't know whether the bill reported out by your committee will
be passed or not, and we ought to have a revision of chapter 9 : we
need it badly . In the absence of revision of chapter 9, there may be a
great deal of confusion and turmoil in New York City. The revision
ought to have top priority, and I don't think it has anything to do one

62--042-75-3

14
way or the other with the merits of the New York City legislation
reported out by your committee .
Senator TOWER. Would you comment on the argument that a Federal
Government guarantee of New York obligations would not cost the
taxpayers anything ? Do you subscribe to that ?
Dr."BURNS. I take it that those who argue that way assume that in
time New York City will pay off its debt completely. I think that is
gone into
a reasonable assumption ; cities in this country that have gone
default have almost invariably worked off their default very decently ,
and I would expect that a city of the stature of New York would do
that.
But the cost cannot be reckoned solely in financial terms. If we
guarantee debt for New York City , before very long we may be
guaranteeing debt for any number of other cities. While each of these
cities may in turn work off its debt in the course of time -- so that
Federal Government expenditures might not rise on that account or
might not rise appreciably — the Federal Government would still be
come involved in managing the affairs of many local governments and
the doctrine of separation of powers which has stood our country well
over the years would no longer be a part of our practice. This would
mean a further centralization of government, and the larger Federal
responsibility might have all sorts of indirect effects on Federal
expenditures.
Senator TOWER. Let me go a step further on that and ask you what
you think the impact would be on the municipal bond market if we
guarantee New York City paper but do not guarantee the paper of
other borrowing authorities at the State and local level ?
Dr. BURNS. A guarantee of New York City paper would , of course ,
improve the market for those securities. It would have a slightly ad
verse effect in the short run on securities of other municipalities, but
the market is very large and I would not expect that effect to be
either lasting or very significant.
Senator Tower. To move to another subject, the so-called Govern
ment Sunshine Act is going to be before the Senate shortly and I'm
curious as to how you feel that this act would affect the meetings of the
Open Market Committee and the Fed's ability to conduct monetary
policy.
Dr. BURNS. I must say to you that there's no piece of legislation
under consideration by the Congress that has caused me greater con
cern than the Government in the Sunshine Act. I wish I had had the
opportunity to testify on that bill. I was never accorded the oppor
tunity. No central bank in the world functions under the kinds of
restrictions that the bill would impose. The authors of the bill prob
ably had in mind agencies such as the Interstate Commerce Commis
sion , which regulates freight rates. Offhand, I would see no difficulty
at all in discussing the case for raising or lowering particular
freight rates in an open meeting. But we at the Federal Reserve Board
deal with the most sensitive issues of financial policy. We regulate
commercial banks in this country and have dealings with central banks
around the world. To discuss publicly the difficulties that individual
commercial banks face , and to discuss publicly our dealings with
other central banks, some of which come to us for assistance when in
difficulty, would cause endless embarrassment to the banks involved,
to our Government, and to our country .

15

1

1

Moreover, for the Federal Reserve to be put under the umbrella of
this type of legislation would suggest to people abroad that the Con
gress lacks confidence in its central bank. I don't think that would help
our country at this juncture of history.
It's perfectly true that the bill specifies certain exemptions under
which we could have closed meetings. However, a transcript of the
discussions at those meetings would have to be kept, and under the
Public Information Act this or that transcript might have to be made
available very shortly to the general public. As you know , the Federal
Reserve — although it's frequently accused of being a secretive organi
zation - makes all of its decisions known to the public. Some deci
sions — most of them , in fact-are made available promptly, and some
after a certain lapse of time .
I think the Government in the Sunshine Act is a very dangerous
piece of legislation and I hope that Congress will deliberate hard
before subjecting the Federal Reserve to it. For that matter, while
I'm not here to argue anyone else's case, I'm a citizen of this country
as well as Chairman of the Federal Reserve , and I don't see how you
can subject the Securities and Exchange Commission to the Govern
ment in the Sunshine Act. That could cause endless financial trouble.
The Congress obviously is seeking to improve the welfare of the
country, but I can't begin to see how the country's welfare would be
improved by bringing under this legislation financial agencies that
deal with highly sensitive matters.
In all honesty, I don't see how the Federal Reserve could function
under this legislation. We'd have a choice between living under the
law and taking great chances with this country's present and future
welfare, and breaking or circumventing the law by making our deci
sions outside of our board room . We certainly are not going to do the
latter, and I hope that you will not put me and my colleagues in the
Federal Reserve in a position where we have to injure this country ,
which is what the Government in the Sunshine Act may force us to do.
My language is plain but I'm answering your question, Senator.
Senator TOWER. I think my time is running out . One final question,
Governor Burns.
The committee voted to repeal the prohibition against the payment
of interest on demand deposits in our Financial Institutions Act. I'd
be interested in your views on the implications on monetary policy of
interest being paid on demand deposits and how it will affect current
banking practices .
Dr. Burns. I think before you legislate on that you ought to hold
hearings and this matter ought to be deliberated . I think personally
that we will , and should , go in that direction . But if I were doing it,
I'd go a little more slowly than seems to be the mood of the banking
committees of the present time. I would certainly hold hearings and
canvass the opinion of informed financial leaders of the country . Bank
ers are divided on this issue, as I think you know .
Senator Tower. Thank you , Mr. Chairman . No further questions.
The CHAIRMAX . Senator Sparkman .
Senator SPARKLIX . Mr. Chairman , I shall be very brief. Did I un
derstand you correctly as saying that we were enjoying some degree
of economic recovery ?
Dr. BURXs. At the presenttime ?
Senator SPARKMAN. Yes .

16
Dr. Burns. Yes. I think we are experiencing a good recovery, Sena
tor , at the present time.
Senator SPARKMAN . And you're optimistic that that will continue ?
Dr. Burns. Reasonably optimistic, yes.
Senator SPARKMAN. Did you say thatunemployment has come down
during the present year and you feel that it would continue to come
down ?
Dr. Burns. That's my judgment.
Senator SPARKMAN . Now I'd like to ask you to go back to this old
subject of the New York situation . If I understand correctly the
Stevenson proposal , it would require New York to do very much those
things which I understand the President feels that they should do. Is
that not correct ?
Dr. Burns. I think that that is substantially correct . The President
might go a little further than the legislation prescribes, but it certainly
goes strongly in the President's direction.
Senator SPARKMAN . I believe that's all , Mr. Chairman .
The CHAIRMAN . Senator Garn .
Senator GARN. Mr. Chairman , may I compliment you on your testi
mony today. I'd like to compliment you , too, for resisting pressures.
When you were here before there was a great deal of talk about 9, 10,
11 , 12 percent expansion. You told us at that time you felt we ought
to just sit back, take a look, see what happened , and I think that was
very wise advice at the time because we're getting a recovery as you
indicate and without going into double digit inflation as a lot of us
feared. So I compliment you on sticking with your 5 to 71/2 percent
looking at the economy rather than setting targets without looking at
what's happening in the economy, trying to prove that we can set a
particular figure . I hope some of my colleagues will look at what has
transpired since you were last here and recognize that what you told
us is pretty much what's happened and take your advice in the future.
Unfortunately , the same thing hasn't been true on the fiscal side.
We continue to spend more money. I'm not going to repeat what I
said at that time , but we haven't learned the discipline the Federal
Reserve has, so rather than continuing attempts by this body to inter
fere more and more with the Federal Reserve, maybe the Federal Re
serve could take over the Congress and see if we could get a little
more discipline on the fiscal side.
But to get to New York again, which most of us are kind of tired of
after the last 3 weeks, you seem to have come along since your first
statements feeling that it is a more serious problem than you did to
begin with . Do you feel that part of this is really a self- fulfilling
prophecy that because of so much talk and so much propaganda from
New York officials that part of what has happened in the bond market
is happening because they have said it will happen.
In my opinion, if this Congress had said no, 2 or 3 months go , I think
New York City and New York State might have come up with a solu
tion and would not be defaulting.
Dr. Burns. I think in part it is self-fulfilling prophecy, but I would
not emphasize that. Many financial observers, looking to the facts as
they see them , fear the consequences for State and local government
expenditures, the effects on the banking system , and the effects on
individual investors who hold these securities in large volume.

17

I do think that if the Congress several months ago had taken up
legislation and said flatly “ no” to New York, some of these fears would
have vanished by now, because New York City and New York State
would have taken measures which neither has yet taken . I think there's
been a belief in New York City and New York State that sooner or
later, one way or another, the Federal Government would come along
and bail New York City out. Long before either New York City or
New York State took any measures to straighten out the finances of
New York City , State and city government leaders came to Washing
ton and argued that the Federal Government would have to solve the
problem because New York City and New York State could not, and
without Federal help there would be a default which would bring dis
aster to our Nation .
Actually, as Senator Proxmire pointed out, New York State and
New York City have by now gone a considerable distance in helping
to solve their own problems. One reason they have done so is that the
Federal Government did not move in at an early stage.
Senator GARN. Well, I would agree with you completely. That's
been my analysis, that if we had said no earlier they would have solved
their problem . Because of the delay they have gonemuch further than
they intended to. If we had caved in earlier and done something for
them they would have expected a full bailout. They have weakened
their demands all along.
I mention one thing very briefly that I would like to emphasize.
One of the troubles with this bill as I see it, it is upsetting normal
intergovernmental relationships far more than I would like to see
it happen . As you well know , I have been very active in mayor circles
and municipal government. Over the past few years I have seen that
eroding with more and more power to the Federal Government and
less for the local level . If we are to send help with guarantees, you as
part of the Federal board to run the affairs of New York City I think
that distorts the normal intergovernmental relationship too much in
favor of the Federal Government and I'm afraid it would set a prece
dent in the future for other cities and more for more Federal takeovers
and dictation in cities where they're having financing difficulties.
One thing else that disturbs me about the legislation we reported
out of this committee . Do you feel we ought to be guaranteeing tax
free municipals ? We've got this legal problem of this committee not
being able to deal with taxable bonds because that isn't within our
jurisdiction, but aren't we taking bad paper then if we guarantee it
to the tune of $ 4 billion or $7 billion as in the House and making it
better than cities with AAA bond ratings and good credit who are
getting record low loans at this point ?
Dr. Burns. This would be the best paper on the market. It would
be better than that of other municipalities. It would in a sense be
better than Treasury paper. However, I would expect interest rates
to adjust to this quality differential and to reflect it. That would take
a little time . But that, in and of itself, does not trouble me very much .
I don't think that the negative consequences for other municipalities
would be serious. In fact, one could argue that taking care of New
York would improve the tone of the municipal market and that other
municipalities would benefit.

18

Senator Gary. Well , thank you. Just in closing, to get back to your
statement , I again compliment you for what you have done in the
monetary area and just don't let the politicians push you around. Just
hang tough there and don't listen to the politicians who show fiscal
irresponsibility on the fiscal side of it—don't let them push you around
on the monetary side. Thank you very much .
That's all I have, Mr. Chairman .
The CHAIRMAN . Dr. Burns, I just have a couple of questions on
New York City and then I have some other questions on monetary
problems. The monetary case that you have made is a very interesting
one.
You raise as one of your fundamental objections a strong philo
sophical objection to the guarantee , that if the Federal Government
goes down this path it's going to be deeply involved in city and State
activities and violating the Federal structure of our country and
providing a precedent would be unfortunate.
The difficulty is that I don't see that we have any option. If New
York City defaults weare going to have to go down that path anyway
in two ways : No. 1 , a Federal judge would move in and take over and
run the city, and if New York State defaults a Federal judge would
move in and run the State to a considerable extent as far as their
fiscal decisions are concerned . No. 2, once New York City defaults,
this committee after very extensive hearings has come to the conclu
sion that there would almost have to be — and Senator Brooke agreed
and other minority members — some of them at least agreed with the
majority - would have to either guarantee loans for the city or would
have to make direct loans for essential services and also to make up
the fact that New York will lose between $ 1 and $ 2 billion in revenue
that it would otherwise get absent default. Once it defaults it loses
that. It loses part of its tax revenue and it loses the payments made
by the State because the State would be in no position once New York
City defaulted to follow through with the commitments that they
have made .
So the Federal Government would be involved very heavily in a
default of New York City and if New York State defaulted it might
be involved in the default of New York State, and if New York State
defaulted , also Yonkers and possibly other cities in New York would
default and very possibly at least a few , and probably a few other
cities in the country, all involving the Federal Government becoming
engaged in lending or guaranteeing loans and in setting conditions and
so forth .
So isn't it true that there is no way under present circumstances
that we can assure the Federal Government will escape from this
involvement ?
Dr. BURNS. Your conclusion may be correct, Senator, but I'm not
entirely convinced that it is. Let me comment first on New York State.
If New York City defaults, I believe that New York State's problems
would be eased rather than made more difficult because the albatross
that New York State hung around its neck by coming to the assistance
of New York City would be cut away . New York State has various
funds which come to something like $1.5 billion that it could draw
upon and New York State , after all , has the power to raise taxes. My
judgment is that there's no real danger of a default by New York

19

State if New York State acts promptly and energetically enough to
deal with its problem .
The CHAIRMAN. You think they can protect their various State
agencies ?
Dr. BURNS. Yes.
The CHAIRMAN . The Governor was concerned about that and indi
cated in his view it would be very, very difficult, perhaps impossible, to
prevent their agencies from defaulting.
Dr. BURNs. The State has a deficit to begin with of about half a
billion dollars, maybe a little more than that. There are various State
authorities that issue moral obligation bonds and they need financial
assistance. They cannot now go to the public market. But I think that
by drawing on the pension and other funds that exist , and by using
its taxing power, New York State could work its way out of its prob
lems and be better off after a default by New York City than before.
While I'm fairly confident of that conclusion , I can't be certain that
things will go that way. Even if the Governor comes forward with a
proposal for new taxes, the State legislature might not go along. There
are many possible difficulties of that kind.
The CHAIRMAN . There are also the tough psychological problems
that Mr. Levitt suggested. He said that they have to raise something
like $3.5 to $4 billion of money in tax anticipation warranties in the
middle of next year and the private market for psychological reasons
at least could very well be closed under those circumstances, no place
to go, and if that's the case , they'll have a default in spite of the fact
that they are very sound.
Dr. BURNS. That's possible . I would be more optimistic. I would
argue that a demonstration of financial strength, of financial courage,
of the willingness to tax in order to raise the funds necessary to
straighten out the financial situation, would open up markets for
New York State .
The CHAIRMAN . There is this problem . New York State is the most
heavily taxed State in the Union .
Dr. BURNS. It is.
The CHAIRMAN. And they are in a position where taxing can be
counterproductive. If they increase their taxes they lose industry ; they
lose well-to-do individuals. They feel that they are very vulnerable
for that reason and the State legislators who have talked to me on this
problem were most responsible men who said it would be very hard to
raise half a billion dollars in taxes and to raise the larger sums they.
would have to raise under these circumstances even on a temporary
basis would be very difficult or impossible for them . Unlike Connecti
cut, which has no income tax, for example, and other well-to -do States
that are in that position. New York has gone very far in imposing taxes
on their citizens .
Dr. BURNS. New York State is one of the most heavily taxed States
in the country and perhaps the most heavily taxed. But, a special tax
levied for a limited period , a tax designed to redeem the honor of the
State, might work wonders in the financial world . Businessmen who
have been discouraged by the drift of politics in that State , the drift
of expenditures, the drift of taxation , might feel that , even though
they will go through a difficult period for a year or two , they now have
a future in New York State . So it might have a very beneficial effect .

20
The CHAIRMAN . You have to recognize that almost half the people
in the State live in the city. The city would be bankrupt under those
circumstances. The city is where a great deal of the income, the wealth
of the State resides. That would be seriously affected . So a tax under
those circumstances—I agree that that might be an alternative, but it
might not be.
Dr. BURNS. I'm puzzled by one aspect of your committee's legislation ,
Senator. Maybe you can clear this up for me. Am I right in thinking
that if New York State is in difficulty your legislation would not pro
vide any assistance to the State as such ?
The CHAIRMAN . That is correct. We have worked on this carefully
with the Governor and with the other Stateofficials and they feel that
avoiding default would preserve New York State's capacity to con
tinue to use the private markets once the guarantee is in place. They
feel this would shore them up and give them the strength they need .
Their judgment may be wrong .
Dr. BURNS. I would argue a little differently. I would argue that
with New York State being relieved of a certain responsibility for
New York City, and not needing the special tax in behalf of the city
contained in your legislation, but being willing to impose additional
taxes for a limited period for the specific purpose of setting the State's
financial house in order, the public market would open up for New
York State . It's virtually closed now, as you know. It could well, in my
judgment, go the other way . But it's a very hard question to answer
with any certainty .
The CHAIRMAN . Isn't it possible that the market might go the other
way inasmuch as the big city , New York City, would be bankrupt,
would be unable to meet its obligations, and therefore people having
been burned in New York City obligations would be very chary about
the New York State obligations ?
Dr. BURNS. Well, I'm afraid New York State made a blunder in
coming to the financial assistance of New York City in the way it did.
What the State legislature did essentially, apart from setting up the
control authority, was to borrow money to turn over to big MAC, which
then would turn the funds over to New York City. But in the process
it damaged its own credit standing. Investors in municipal bonds are a
very peculiar breed. Who are they ? First the commercial banks, which
hold about 47 percent of the State and local securities outstanding.
Next , casualty insurance companies. And then , individual investors in
the upper or middle income classes. These are conservative people , and
when conservative people find that a particular municipality or State
has made a financial mistake, they would recognize that they don't
have to buy the securities of that governmental entity. They can buy
other securities.
The CHAIRMAN . Dr. Burns, I wonder if that was a mistake . Here's
the problem for New York State. The city is their creature. The city
is their responsibility. They just can't walk away from their city. Fur
thermore, when they step in they step in with a financial emergency
control board dominated by the State—5 of the 7 members are State
people — and furthermore, they get all the revenues that go to the city.
They get all of them and then disburse them according to a plan.
I don't know how they could have a more effective system and it's
worked quite well, as we all agree. Theyhave cut down their expendi
tures. They are moving towardabalancedbudget.

21
Dr. BURNS. I understand that. But consider what they did essen
tially. They moved debt out of one pocket into another, in the process
enlarging the amount and imperiling the financial standing of the
State . If they had done that and one thing more — impose a special tax
at the same time — I think New York State's credit standing would be
high today. The mistake was not in coming to the assistance of New
York City, but in coming to the city's assistance solely by the
borrowing route instead of by a combination of borrowingand taxing.
The CHAIRMAN . It seems to me that they did impose a $300 million
additional tax burden when they moved in .
Dr. BURNS. For New York City, not New York State. We're still
discussing New York State .
The CHAIRMAN . Well , I think you may well be correct . The difficulty ,
however , is that you have a political situation. You have a Republican
State assembly and a Democratic Governor. For them to agree on some
thing like this, a burdensome tax on the people of the State to assist
New York City was something very hard to achieve .
I think under the circumstances , given the political realities, they
did a great deal . The great difficulty we're having—and even if we
go the guarantee route persuading the State to go along with the tax
increase in this very heavily taxed State , indicates how hard it would
be to go the other way. I see your point and it's a very good point.
Dr. BURNS. And I agree with you that if Governor Carey had
come forward with a tax proposal he might have had insuperable
difficulties in getting his State legislature to accept it. But if he had
made the proposal and persuaded the State legislature to adopt it
he would now be a national hero. I'll say no more .
The CHAIRMAN . Well, his difficulties were insuperable.
Just one other question . Has the Federal Reserve staff made any
estimates of the effect of a New York default on the economy ?
Dr. BURNS. If you are asking whether we think about that question
and write about it to one another and talk about it, we are at this
business constantly .
The CHAIRMAN. Well, it's one of the best staffs, perhaps the best
economic staff in Washington. You have great sources as well as great
ability there. It would be very helpful to us if the staff would make
a study of this and you give us your estimate.
Dr. BURNS. We are studying this continuously . I referred to a log
that I'm keeping on every financial market . There's been so much
rumor and so much opinion in this whole area that unless you have
a cold, factual record it's very difficult to arrive at a considered
judgment.
Take October 17, the day New York City nearly went into default .
I got reports that day from highly responsible sources about diffi
culties in the foreign exchange market ; I was told repeatedly that
the dollar was being sold in the foreign exchange market because of
fears generated by a prospective New York City default. I was not
convinced. I found those reports difficult to believe because our interest
rates were then coming down and I thought that what was happening
in the foreign exchange market could be explained in cold economic
terms—in terms of interest rate differentials alone. I therefore found
a way of placing a fair number of telephone calls to highly placed
European financiers who I thought would bring objectivity to their
62-042-75--4

22

judgment. I found that these Europeans—my sample was carefully
chosen , but might still have been a poor one — were not really con
cerned about the possible effects of a New York City default on the
value of the dollar. They noted that the dollar had risen very sharply
between March and September, and they thought that the decline
during October, which was of limited size , could be explained entirely
by the decline in short -term interest rates in this country. That was
my own explanation .
As I've said , we're studying this continually . We're keeping a log
day by day for the municipal securities market, the corporate bond
market, the money market , the Treasury market, the stock market,
and the foreign exchange market — and if conditions deteriorate, as
they may, I'm not going to be the last one to recognize that fact .
The CHAIRMAN . Well, this is — I don't know what else you can do
with respect to studying what is going on — the situation with the
present problems we have.
At the same time , I think you would agree that you cannot tell .
It's a brand new ball game once New York City has defaulted .
Dr. Burns. You can go wrong either way. We of the Federal Re
serve don't minimize the likely effect on the economy of a New York
City default. It would clearly be negative; the only uncertainty is the
magnitude. Now if the effect is larger than we— or others who are still
opposed to financial legislation
presently think, not everything will
be lost. The Congress can still act after a default.
The CHAIRMAN. Would you quarrel with the Eckstein estimates
that default would probably increase unemployment between 300,000
and 450,000 ?
Dr. BURNS. I have not studied those estimates, but how do they
know ? This is a guessing game and it can't be anything else . I would
consider such an effect very serious. I doubt that it would be that
large, but I can't really quarrel.
The CHAIRMAX . It seems to me that what they base it on is a de
cline in State and local expenditures flowing from the difficulty that
New York got into and the difficulty they would have raising money
for capital programs.
Dr. BURNS. I don't know that I would describe it as a decline ; a
retardation of growth in State and local expenditures is now under
way and will take place no matter what happens to New York City.
You could not attribute all of that to a New York City default.
The CHAIRMAN . All right, sir. Now you stay, I take it, within the
5- to 71/2- percent range that you discussed before the M, for the next
year and you made a strong case for it. Nevertheless, we still have
heavy unemployment, 8.3 percent. We are still operating far below
capacity, although there has been some recovery in the last 3 or 4
months. Housing is still in the doldrums and housing is supersensitive
to monetary policy. We are faced, as you have just said , with the prob
able contraction in city and State economic activity , at least it won't
grow as rapidly as it has, and with 14 million employees it's one of
the biggest employers in the country, and certainly very important
from any economic viewpoint.
In view of all that, don't you think there's some case for a some
what more vigorous monetary policy , an argument that it might be
7 to 9 percent or something of that kind ?

23

Dr. BURNS. There must be some case for it since so many highly in
telligent and public spirited individuals have been and are still urging
it. I would argue only that, as I read the record , we at the Federal
Reserve have been proved right.
We have argued consistently that there was no shortage of money,
that the growth path we are on is entirely sufficient to finance a good ,
strong recovery. We have argued that because we have laid heavy
stress on a factor that has been neglected, by or underestimated by
many economists — namely, the velocity factor. If you contemplate a
15 - percent rate of growth in the dollar value of GNP and a money
supply growth ratea great deal less than that, you might start won
dering whether the money supply will be sufficient to finance the kind
of expansion that we ought to have if we are to make any progress with
our unemployment problem . But what this line of reasoning neglects
is the velocity factor — the fact that the velocity of money , the turn
over of money, the willingness to use money , is much more important
in the short run than is the stock of money itself. Historically , that
has practically always been the case.
We base our projections on past history and so far we have been
right. During the third quarter velocity rose very sharply, and it will
do so again in the fourth quarter. Once you take velocity into account,
the projected rate of monetary expansion appears fully sufficient to
finance a very good recovery .
The CHAIRMAN. The recovery that we had in the last quarter was
what, in real terms, in annual rate of around 10 percent - 11 percent ?
Dr. Burns. The published figure is an annual rate of 11.2 percent .
I think the figure probably will be revised downward in time. My
guess is that the actual rise was closer to 9 or 10 percent than to 11
percent.
The CHAIRMAN . Let's assume that the rate of growth is 10 percent
and let's assume that the inflation rate is 5 percent. That means an
increase in transactions to be financed of about 15 percent. With the
money growth of between 5 and 71/2 percent, isn't it likely if the re
covery continues that vigorously -likely to require an extraordinary
increase in velocity to prevent interest rates from rising ?
Dr. Burns. Not extraordinary by historical standards.
The CHAIRMAN. How would it have to respond in order to
Dr. Burns. On the basis of your assumptions , it would have to be
8 or 9 percent and that is by no means unusual .
The CHAIRMAN. Can you tell us — you seem to be adding a new factor
in your thoughtful statement on money velocity. In addition to the
cyclical element, you seem to say there's an innovation in the markets
of various kinds. There have been changes in technology, but you don't
quantify how that may have changed the velocity of money or even
indicate specifically that it speeded it up. Has it and, if so , how much ?
Dr. BURNS. I talked about this matter because I wanted to bring it
to the attention of the committee . This is something that all of us
ought to be more aware of than we are. I wish I knew how to quantify
it and I've been after my staff on that score. All that I know is that as
a result of new developments the narrowly defined money supply no
longer means what it meant 10 years ago, and that it probably will
mean something else a year or two from now. But what all this means
quantitatively I'm unable to say.

24
The CHAIRMAN . I have a chart here but let me ask one other question .
If Mº grew faster or slower—let's say it grew faster than the 5- to 71/2
percent rate, how do you estimate that would affect unemployment and
inflation ?
Dr. BURNS. If the difference were small , I doubt that the effect
could be isolated . If the difference were large, I think it would be
interpreted by the business and financial community to mean that the
Federal Reserve had joined the inflationists and that the rate of infla
tion would be higher than it has been. I think that would have a nega
tive effect on real economic activity.
The CHAIRMAN . Well, when you say “ if the difference were great,"
what do you mean ? Supposing we had an expansion of 8 percent in
stead of the 6 or so that we might otherwise expect. Would you con
sider that to be large enough to have an adverse effect on inflationary
expectations ?
Dr. Burns. I think that could have. For example, if I came before
your committee today and indicated that our projection was for a rate
of growth in M , of 7 to 91/2 percent, I think that would have a very
significant effect on financial markets rather promptly.
The CHAIRMAN . Now I have given you this chart and the chart
shows how money , My, has grown since last March . The chart shows
that the money supply snaked through your target corridor, started
below your 5 -percent growth quarter and then rose to 71/2 quarter
before the 10-percent rate. Since early. September it's come back
sharply to the 5 -percent lower limit.
To what do you attribute the slowdown since September? Was it
deliberate and what effect would it have on the recovery in winter and
spring ?
[ The chart follows :]

AWeekly
M-1 gainst
Backdrop
The
Of
Planned
Fed's
MAs
-Using
Range
arch
to
1975
1976$2March
85.0
Base
The
Computing
for
the
Corridor

2
$ 15

3$10

$305
%1
7

3$ 00
25

grow
p%5 .a.th
2$95

2$90

8$0

sh
616

1/3

ats

12/5

2/1

26
Dr. BURNS. A part of that was deliberate , but a part I don't know
how to explain. I have found it rather puzzling. The rate of growth
of the money supply jumps around a great deal. I have never re
garded a stable rate of growth of the money supply as a virtue, but
in view of the fact that there are people in this world who do regard
it as a virtue, I have tried to measurethe Federal Reserve's perform
ance against that of other central banks around the world . I found
that the rate of growth of the money supply is far more stable in our
country than in other countries. Money growth is something that
central banks do not know how to keep on a stable course .
The important question is, does it really matter ? Studies that we
have made at the Federal Reserve Board strongly indicate that these
variations from month to month are sheer noise which have a negligi
ble effect on the real economy.
The CHAIRMAN . Well, what I'm concerned about is whether or not
this is a trend, whether or not this trend since September which
seems to be moving down is likely to continue and therefore perhaps
affect the recovery .
Dr. BURNS. Is it likely to continue ? As I think my statement makes
clear, we have taken corrective measures to try to make sure that it
does not continue .
The CHAIRMAN . Since early summer interest rates have receded from
the levels to which they rose in early June and July. I notice this
happened in conjunction with slowing of money growth . How do you
explain this ? Doesn't the interest rate drop coming as it did both
with sharply reduced money growth and a vigorously recovering
economy -- doesn't that fly in the face of economic doctrine ? It seems
to me that interest rates should be going up with the money supply
not going up and the economy recovering, and yet it's going the other
way. How do you explain it ?
Dr. BURNS. Since the middle of the year business demand for credit
in the public markets has fallen very considerably, which was un
expected . Of late, there has been some decline in the credit demands
of municipal governments ; that decline was rather notable during
the month of October. And I think the very fact that the Federal
Reserve has provided evidence to financial markets that we are con
cerned about the rate of monetary growth — that we are not going
to permit it to get out of bounds — has had a salutary influence on
current interest rates by improving expectations with regard to future
interest rates.
The CHAIRMAN. Is there any role here played by foreign central
banks that would — have they been recent buyers of Treasury
obligations ?
Dr. BURNs. I think foreign central banks have been sellers rather
than buyers on balance over recent months.
The CHAIRMAN . Now the vigor with which the real GNP grew in
the summer quarter was welcome news. I understand that many ana
lysts expected a slow market in the fall and winter. Such factsas the
retail sales gains are slowing down, some of the inventory increases
is not voluntary and inflation is again rising. What's your impression
of their analysis— your opinion ?
Dr. BURNS. In the sphere of retail trade, signs of hesitation certainly
appeared during September, but October was a very good month ; re
tail trade moved up rather vigorously during October.

27

In the sphere of production, the picture is mixed and data for Oc
tober are late in coming in. Steel production has dropped , but, pro
duction of electric power, paper board and household appliances has
risen. Automobile production was steady in October. On the other
hand, automobile sales rose rather materially during the month .
As I indicated in my statement , the Federal Reserve index of indus
trial production has shown a rise in every month since April, and each
month's rise was larger than that of the preceding month ; in Septem
ber the industrial production index rose by 1.9 percent . I expect the
index for October to show an increase, but the magnitude will not be
anything like that of September.
So, in my judgment, the expansion is continuing. The rate is uneven ,
as it always is. I don't know of any expansion that has proceeded
along a linear path or along some curvilinear path drawn by a mathe
matician . The rate of change varies. There are hesitations within indi
vidual years for example, in the years 1956 , and 1971 .
The CHAIRMAN. Now you say in your statement at the very end ,
“ The only sound fiscal and monetary policy today is a policy of pru
dence and moderation. New ways must be found to bring unemploy
ment down without becoming engulfed in a new wave of inflation .
That is why structural policies require far more attention than they
are being accorded by academic economists or Members of the
Congress."
Can you spell out briefly what some of these structural policies are
and what we could do ? Does this mean is a new incomes policy ? Does
it mean another policy with respect to unemployment? I want to get
into that, incidentally. That was a fascinating reference you made to
your Georgia speech, one that I think hasn't been given nearly suffi
cient attention. It's got a lot of potential.
But how about, in the first place, the structural changes that you
might have in mind, incomes policy, antitrust, what ?
Dr. BURNS. I'll try to spell out what I had in mind in the Georgia
speech . Letme summarize briefly what I meant by structural policies
that we ought to be thinking about.
First of all, we need to seek ways of encouraging improvements in
productivity. Larger investment in modern plant and equipment is
certainly one of the most effective waysof achieving that end and some
overhauling in our structure of Federal taxation should be helpful in
that respect.
The CHAIRMAN. Well; we followed your advice on the investment
tax credit . The President chose to make that permanent, but it's a 10
percent rate. Would you increase that ?
Dr. BURNS. Beyond 10 percent ?
The CHAIRMAN . Yes, sir.
Dr. BURNS . I must say that I'm not in the mood to give up tax
revenues. If we did give up tax revenue in this direction, which I'd
like to see , I would want to make it up in other directions.
The CHAIRMAN . Then how do we provide the incentive for greater
investment in productive equipment ?
Dr. BURNS. I think I would lower the corporate tax rate rather
than increase the investment tax credit beyond 10 percent.
The CHAIRMAN . As opposed to President Ford's 2 percent reduction ?
Is that enough ?

28
Dr. BURNS. I think that would be a move in the right direction .
Whether it's enough or not, I don't know. I'd like to see that take
place before too long.
The CHAIRMAN . I'm sorry I interrupted . You said productivity is
one area .
Dr. BURNS. A second factor that I noted in my Georgia speech was
that we ought to reexamine our environment and safety regulations .
They have been escalating costs and prices. I don't think we ought to
give up what we have been trying to do in these fields by any means, but
we could adjust our time tables to try to achieve our environmental
and safety goals over a longer period. I think that would be very
desirable .
Third , I noted the need for intensifying price competition among
our business enterprises. We ought to reassess our laws directed against
restraint of trade and we ought to reassess our governmental regula
tions affecting transportation, etc.
Next, I noted the need to take a very careful look at what we have
been doing to our labor markets. We ought to seek noninflationary
measures to reduce unemployment, and some readjustments in our
legislation governing labor markets could be helpful in that connec
tion. I mentioned the need, as I see it , of revising the Federal mini
mum wage law which is pricing many teenagers out of the job market.
I commented on the Davis- Bacon Act which is continuing to run up
costs in the construction area and which is damaging the construction
industry , one of our most depressed industries.
I think that our programs for unemployment compensation need to
be reviewed . Having unemployment compensation for a period as long
as 65 weeks may, I think, be damaging to our country and to the
need for
morale of our working people. I noted the
The CHAIRMAN . How would you reduce that ? You say 65 weeks is
too long. What limit would you put on it ?
Dr. BURNs. In the absence of the kind of program for public service
employment that I talked about in the speech , I would return to a 26
week period.
The CHAIRMAN. Well , now , if you do that, if you cut unemployment
compensation off after 26 weeks, 6 months, we have as I recall some
thing like a million and a half long-term unemployed — that's 26 weeks.
It might be a little more than that. Those people would be without any
unemployment compensation . They'd have to go on welfare , food
stamps.
Dr. Burns. They might get jobs.
The CHAIRMAN. Perhaps they could get jobs, but the difficulty, of
course, is that the evidence we have is that thejobs aren't available.
Dr. BURNS . Many jobs are available which people are unwilling to
take.
The CHAIRMAN . That's true, but the job vacancies statistics we have
suggest they fall far short of anything like the 71/2 million people who
are out of work. There may be a million and a half or there may be 2
million
Dr. BURNS. We don't have job vacancies statistics which are worth
anything. Actually, I believe we have discontinued the poor statistics
that we had . I was in favor of and I worked for a comprehensive meas
ure of job vacancies , but the Bureau of Labor Statistics never de

29
veloped such a measure they had some kind of a program that wasn't
worth very much, and when they sought my advice about discontinu
ing it I said, “Either do it right or discontinue it and save some
money ."
The CHAIRMAN . Do you have a memorandum on how it could be
done right ? I think there's sentiment in the Congress now to require
those vacancies statistics.
Dr. BURNS. Although I worked in this field extensively some years
ago, I would hesitate to prepare such a memorandum now because it
would divert me seriously from my current work . But maybe I can get
the study done by one of my old colleagues at the National Bureau.
I'll try to assist you on that one way or another.
The CHAIRMAN . All right, sir. Now I interrupted you again.
Dr. Burns. I put forward a plan that has been criticized from all
sides. I fully expected that , but I wanted to stir up some discussion .
Our present policies aren't working well . It is nonsensical to sit around
and talk about a 4 -percent unemployment rate as corresponding to
full employment and have someone say , “ Oh, no. It ought to be 3 per
cent or 212 percent ,” or have someone else say, “ It ought to be 5 per
cent or 51/2 percent because the character of the labor force has under
gone drastic changes.” I think we ought to discontinue these arithmeti
cal debates. We ought to strive for an unemployment rate literally of
zero. My plan is subject to all kinds of criticisms and I hope that other
people will improve on it , but
The CHAIRMAN . I like the philosophy of your proposal very much . I
thought the details were at best unrealistic and at worst cruel , when
you proceeded with the notion of having people on unemployment
compensation cut off after 13 weeks and required to work at less than
the minimum wage. What that will do to the economy as well as what
it would do to the individual family would be catastrophic. They say
an auto worker's unemployment compensation could be $6,000, which
might enable him to keep body and soul together. If he works for a
less than minimum wage, that means he works for less than $ 4,000 a
year. That would really torpedo him and his family . They would be
on welfare and food stamps and they'd be working but it would be in
pretty desperate shape and the country with that kind of a loss in
purchasing power, it seems to me, would be pushed down into the kind
of situation that we suffered in the 1930's, would it not ? Wouldn't

that be a danger ? I'm not saying that I don't like the idea . I think it's
a great idea , but supposing we did this. Supposing we permitted the
payment of the unemployment compensation and the cost of going to
work , transportation cost — but provided jobs on the same basis you
suggest, that everybody would be busy. There are all kinds of things
that we could do with 71/2 million people that would improve our
country, but there would be sufficient incentive for them to work in
the private sector and they wouldn't have their lives economically
torpedoed by having to work for less than $4,000 a year.
Dr. BURNS. Senator, there isn't a chance, as you indicated, that the
Congress will go in this direction this year or, in my judgment, within
5 or 10 years. Moreover, I put fences around the Congress by calling
for a constitutional amendment, and how long that would take if we
ever get it at all
The CHAIRMAN. I think there's a lot of possibilities . It may take a
couple of elections to make things , but there's a great deal of sentiment
62-042-75-5

30
from the people out of work that they're fed up with welfare and
food stamps and all these things that keep people idle and pay them
to be quiet, but instead of that we ought to require people to work if
they are going to get an income and if they're able bodied and able to
work. I think you're absolutely right on that. I disagree on the detail.
I think it is an important idea but I think it is important that you
provide an opporunity to work and they be given enough so that they
don't suffer the degradation of working for approximately the poverty
income.
Dr. BURNS. I have only two comments to make. First, I'm very
pleased to hear you speak as you just have. Any movement in this di
rection would have to be gradual, but I would hope that it would con
tinue. I'll tell you why. I think that the Government has a certain
obligation in the kind of world we live in with regard to jobs. People
are lonely. Wehave an industrialsociety. Not many people have farms
to go back to. Familyties are no longer asclose asthey once were.
But I don't think Government has an obligation to provide attrac
tive jobs. Providing a job at an unattractive wage hasmerit because it
would enable an individual to get by in some fashion for a time, while
giving him a strong incentive to find a regular job or to create a new
opportunity for himself.
This would stir people to industry. It would ignite their imagina
tion. At present, many individuals are building their life around un
employment compensation. In some of our communities they get along
well by doing very little work. Allthey need to do is work for a day
or two to supplement their unemployment benefits. Often they don't
even have to report that to the Internal Revenue Service. A fair num
berof people are getting by that way.
But the process is doing damage to the people in our country, which
is more important to me than any financial cost. So if you're inclined,
Senator, with your great influence to move away from this , you'd
be making a great contribution to this country. I would hope to see
you continuing to move in that direction and I would like to stimulate
you in that direction later on. I find what you say very encouraging:
The CHAIRMAN. Thank you very much . I thought that was one of
the most significant economic expressions that we have had in a long,
long time and it was a most helpful and useful suggestion. The fact
that Government as employer of last resort is not a far-out, radical
idea. It is a matter of doing it in a realistic way both ways, and it's a
matter of also providing strong incentive to get back into the private
sector.
Senator Garn, do you have some questions ?
Senator GARN . I don't have any more questions. I'd just like to com
ment that I, too, am encouraged by what the chairman said .When you
get liberal Democrats coming around to what we conservative Repub
licans have been preaching for years and years and I'd like you to
know that I believe in the principle of repentance and we're perfectly
willing to accept you on our side and I'll help you fight for people
who are able bodied.
The CHAIRMAN . But in my view, it was the other way around. I
thought the Federal Government as an employer of last resort was a
liberal idea , if not a radical idea. When one of the most eminent con
servative economists in the world, Dr. Burns, says that he thinks the

31
Government as an employer of last resort was something we should
work for, I was enormously encouraged and I thought we were hav
ing the great conservative community coming over to our side.
Senator GARN . I'm not going that far. I'm talking about your com
ment about able-bodied people who can work beingrequired to work
and accept all these jobs that you read about in the want ads. There's
thousands of them inthe Washington Post.
The CHAIRMAN. Well, our time is up. I want to thank you so much ,
Dr. Burns. You have been a most helpful witness as always.
The committee will stand in recess .

[Whereupon, at 12:10 p.m. , the hearing was recessed .]

SECOND MEETING ON THE CONDUCT OF
MONETARY POLICY

THURSDAY, NOVEMBER 6, 1975

U.S. SENATE ,
COMMITTEE ON BANKING , HOUSING AND URBAN AFFAIRS,
Washington, D.C.
The committee met at 10:05 a.m. , pursuant to call , in room 5302 ,
Dirksen Senate Office Building, Senator William Proxmire, chairman
of the committee , presiding.
Present : Senators Proxmire and Packwood .
The CHAIRMAN . The committee will come to order.
Today we conclude our second meeting on monetary policy pursuant
to the resolution which I introduced last February which calls for
the Federal Reserve to consult with Congress about its targets for
growth of the monetary and credit aggregates in the year ahead.
On Tuesday we heard from Chairman Burns. He told the committee
that the Fed was aiming to increase My between 5 and 71/2 percent
from the third quarter of this year to the third quarter of 1976 ; be
tween 71/2 and 1012 percent for M , and between 9 and 12 percent for
Mz. Dr. Burns stated that these " projected ,” as he put it, rates of
growth are " adequate to finance a vigorous further expansion in real
economic activity ” and although they " cannot be maintained indefi
nitely without running a serious risk of releasing new inflationary
pressures,” under current economic conditions they were “ not so large
as to rekindle the fires of inflation .”
Dr. Burns placed considerable emphasis on velocity in his testi
mony. He told us that the GNP velocity of My had risen at an annual
rate of 8.7 percent in the summer quarter, that the turnover of money
tends to rise relatively rapidly in the recovery stage of the business
cycle , and that " in deciding appropriate target ranges for growth of
the monetary aggregates, we at the Federal Reserve must carefully
consider the probable movements of income velocity over the course
of the business cycle. "
I pointed out that in the last quarter that the real growth of the
GNP, was in excess of 10 percent and assuming that we had infla
tion of 5 or 6 percent that with an M, growth of around 6 percent
that there would be a need for a very sharp growth in velocity. He
acknowledged this but indicated that he thought we'd get a 9 or 10
percent growth in velocity in the coming quarter.
Finally , Dr. Burns noted that money supply growth had gyrated
above and below the target ranges set here last spring and reiterated
last summer before the House Banking Committee . He said that
( 33 )

34

these gyrations reflected "unusual factors influencing the public's
demand for money ; " that short run fluctuations in monetary growth
“ have little significance for the functioning of the real economy, ” that
the Fed was " alert to any large and protracted departure of mone
tary growth rates from longer run objectives ;" that " corrective ac
tions ” had and would be taken to return growth rates “ to the desired
path of long -run monetary expansion ” when they departed from it;
and that such corrective actions would have “some influence on the
level of interest rates - particularly short -term rates , " and that “ tem
porary fluctuations in short-term market interest rates are an in
evitable byproducts of efforts to keep the rate of monetary expansion
from straying too far from the desired longer run path. ”.
Our witnesses today are two of the Nation's most eminent eco
nomists. Both have been constructive critics of the Federal Reserve
in the past, constantly constructive but not constantly critical , and
their views often are different from one another. Our witnesses are
Professors Milton Friedman of the University of Chicago and Paul
Samuelson of MIT. We are fortunate to have them .
Dr. Friedman, would you like to proceed ?
STATEMENT OF PROFESSOR MILTON FRIEDMAN, UNIVERSITY OF
CHICAGO, DEPARTMENT OF ECONOMICS
Dr. FIELDMAN . Thank you , Senator Proxmire.
My written testimony was prepared before I had the opportunity
to see Chairman Burns' testimony but my written testimony would
not have been very different had I seen it. [I am inserting at the end
of this testimony on additional comment on one part of Chairman
Burns' testimony .]
I believe that the Concurrent Resolution 133 which your commit
tee and the House committee were responsible for has been the most
important and the most constructive change in the structure for the
formation of monetary policy of the past four decades so I am hon
ored to testify before you.
The importance of the resolution was that for the first time in the
60-year history of the Federal Reserve it required the Federal Re
serve to specify targets for as long as a year ahead. It required the
Federal Reserve to state those targets publicly in advance and re
quired the Federal Reserve to express its targets in terms of mone
tary aggregates.
All of these were innovations. To the best of my knowledge , in the
whole 60 years of its experience prior to the resolution, the Fed had
never set itself a quantitative target for as much as a year ahead
which is rather astonishing since the Fed was established to provide
long -run continuity in monetary policy.
In my opinion, the major defect in the Federal Reserve's perform
ance over the whole of its history has been its erratic movement, the
tendency for it to move from one extreme of monetary growth to
the other, from increasing the money supply too rapidly to increasing
it too slowly. Unduly rapid increases produced or fostered the infla
tions in World War I and II. Unfortunate sharp swings in the other
direction produced the great contractions of 1920 to 1921 , 1929 to
1933, and 1937 to 1938 .

35
Chairman Burns' testimony, as you have just reported it , suggests
that that defect is still with us, despite the emphasis in your con
current resolution on steady monetary growth .
Table I of my prepared testimony shows rates of monetary growth
for the past five years. You will see that those rates of monetary
growth show wide swings from a rate of growth of over 7 percent
from January 1970 to 1973 in the narrow aggregate, down to less than
1 percent from June 1974 to January 1975 , 8.6 percent from January
1975 to July 1975 , and 0.3 percent from July 1975 to the most recent
4 weeks.
These swings have, been very undesirable from the point of view
of a stable economy. Instead of the Federal Reserve's serving as a
source of stability in the economy , it has served as a source of insta
bility. I believe that the crucial immediate question for monetary
policy and the question I would hope this committee would increas
ingly consider is why these swings have occurred. The important
point to be emphasized is that these swings have not occurred because
the Federal Reserve intended them to occur. They have represented
a deviation of actual performance from intended performance. The
general thrust of my comments here today will be that I do not
differ greatly with the objectives which the Federal Reserve has set
in response to your resolution , but I do criticize the Fed severely
for its failure to achieve those objectives. I believe it has failed to
achieve those objectives because it has continued to follow a method
ofoperation thatis not suited to its objectives.
Its procedural method is an anachronistic survival of an earlier
day. There are alternative methods of operation which would enable
it to achieve its objectives. So I propose to spend just a few minutes
discussing the objectives and then spend most of my testimony on
techniques of achieving those objectives.
With respect to the very recent performance, the question for the
coming quarter is whether the Fed does or does not alter its recent
stance . If the Federal Reserve continues for another few months the
extremely restrictive policy it has in fact followed since July, I be
lieve that the current recovery would be aborted and that we would
relapse into another recession phase . I do not believe that the Fed
will continue its restrictive policy. I fear the more serious danger
is that it will once again swing too far in the other direction ; it will
once again swing too rapid a monetary growth rate. If that happens,
then the recovery will continue in 1976 but it will be followed in 1977
or 1978 by a reemergence of inflation .
Personally, I favor slightly lower rates of monetary growth than the
5 to 712 percent for My, and the 812 to 1012 percent or more recently
the 71% to 101,2 percent rate for M , that Chairman Burns has specified.
However, my difference on this score is minor. While I would favor
slightly lower rates, I would not favor drastically lower rates in the
immediate future.
Looking farther ahead , I fully endorse Chairman Burns' comments
to the effect that continuation of monetary growth at these rates would
inevitably spell inflation at an unsatisfactory level. The rates of mone
tary growth that are incorporated in the Fed's present objectives imply
a rate of inflation in the neighborhood of 6 to 7 percent. Now that's
not bad for this year or next year, given our past experience, but it is

36
a rate of inflation that is decidedly too high for the longer period.
Therefore, I believe that it will be desirable as time passes to lower
the objective gradually. I stress gradually because I believe that we
must compromise between the desirability on the one hand of getting
to a noninflationary rate of growth , and on the other of avoiding
severe shocks to the economy.
Consequently, if I were specifying objectives for the next few
years, I would suggest that these ratesof growth should be lowered by
something like 1 to 2 percentage points a year for the next 3 to 5 years
in order to bring them down to the ultimate objective of something
like 3 to 5 percent in M, and whatever rate of M1 goes with that.
This suggestion is not inconsistent with Chairman Burns' verbal
statement. However, I believe it would be highly desirable to extend
the outlook and to have an explicit numerical timetable rather than
simply the statement that sometime in the future the rate of monetary
growth will be reduced .
as objectives are concerned , I have only one other comment
Insofar
to make. The Fed has adopted the practice of shifting the base of its
objectives each time it testifies. This meansthat you do not really have
a long-term objective for monetary growth. You have a 3 -month ob
jective and then whatever mistake is made in that 3 months is incorpo
rated in the next 3 months because each quarter the Chairman has
shifted the base to which he applies his percentages to the actual level
achieved during the prior quarter, this time during the third quarter.
I suggest that it would be far more desirable for him to specify a
long -term objective and stick to it and not simply each time validate
whatever may have been the departure , the difference between the ob
jective and the performance.
In this connection, I think it would be desirable if instead of
specifying a range of growth rates he were to specify a time path for
the level of the monetary aggregate and then add a range about it of
plus or minus 1 or 2 percent. The problem with the present procedure
is that you have a range of objectives that widens indefinitely as you
go out in the future because you start from a base point and then
you say 5 to 71,2 percent, and that gives you an increasingly wide mar
gin of tolerance the longer that you have in the future .
Senator PACKWOOD. Excuse me. Would you explain again
what you just said ? Back up about two sentences and then say it once
more.
Dr. FRIEDMAN . The Fed today , as Dr. Burns did the other day, said
we plan a 5 to 71/2 percent rate of growth from the average of the
third quarter, but the average of the third quarter is not what their
objective was in the second quarter. In this particular case it happens
to be about half a billion dollars higher for Mı .
Senator PACKWOOD . Are you saying that the Feds are saying their
objectives for 2 years is " c " and then you give them a margin of error
of 10 percent on the top or bottom side of that range ?
Dr. FRIEDMAN . Exactly, and that would be better than having this
5 to 71/2 percent which means that the margin with respect to the
level gets bigger and bigger as you go out.
Let me turn to what I think is really the much more important and
basic issue and that is the issue of performance. When Chairman
Burns testified before the House Banking Committee 3 months ago

37
both M , and M, were above the upper limit of the objectives he had
specified. When he testified here 2 days ago , both M , and M, were
below the lower limits of the objectives he had specified. Neither this
initial overshooting nor the subsequent retardation were intentional.
They were the results of mistakes, as Chairman Burns testified . Of
course, he said unforeseen contingencies entered in and caused the
money supply to increase too rapidly in the earlier period and too
slowly in the later period .
Some observers have concluded from this failure to match the target
that the Fed is a helpless giant and cannot achieve its targets and
cannot control the money supply. There is a sense in which that is
correct, but there's a more fundamental sense in which it is wrong.
The sense in which it is correct is that given the way the Fed now
operates it cannot achieve its targets. As long as it continues to use its
present procedures it will fail to achieve its monetary growth targets,
but there are alternative operating procedures that would enable it to
achieve its targets.
Let me stress that this is not a new problem . It's of long standing.
I have given in my prepared testimony a list of references on page 6
which start from 1963 with a doctoral thesis by William Dewald at
the University of Minnesota devoted exactly to this problem. I just
offer that list of references to show how extensive is the literature on
this subject.
Since before the Fed shifted to a money supply target in 1970 it
has been emphasized to the Fed by studies within the Fed, by studies
outside the Fed , that the procedure which the Federal Reserve is now
using is not a suitable procedure for controlling the money supply
and that there is an alternative procedure which would do a great deal
better job.
In addition to these problems of procedure, the Fed could modify
its current regulations and should modify its regulations about re
serves and about other features in a way which would enable it to
do a far more effective job in controlling themoney supply.
The present procedure is a carryover from the time before 1970
when the Fed had money market conditions as its objectives. The
present procedure involves setting a money supply target, the 5 to 71/2
percent, for example, that Dr. Burns set the other day, and then asking
the staff to calculate what federal funds rate would lead to that
money supply target being achieved , and then asking the New York
Federal Reserve Bank to peg the Federal funds rate at that level .
Now in principle that method could work . In principle there is a
Federal funds rate which would induce the commercial banks, the
member banks, to add to their reserves that amount which would be
necessary to produce the desired growth target . In principle , there
fore , it could work ; but unfortunately, there are two major slips be
tween that principle and the practice .
The first slip is that the Fed cannot predict what the right Federal
funds rate is. The Federal funds rate that is right depends on the
rates at which the commercial banks can lend as well as the cost of
funds to them . The Federal funds rate is the cost of the funds but it
doesn't tell you anything about the rate at which they can lend.
In order to be able to predict what the right Federal funds rate is,
you have to be able to predict the rates at which they can lend. The

38

1

Fed has a so-called money market model with which it tries to do that.
I have tested that model. It is roughly of zero value . This is a model
for predicting the Treasury bill rate and what I said is I'm going to
run a race between that model and the simplest model. I'm going to
predict next month's Treasury bill rate as the same as this. It turns
out that that gives more accurate predictions than the Federal Re
serve model does. So they cannot predict what the right rate is.
In addition, and more important, if they make a mistake the error
is cumulative and self -reinforcing. Let's suppose the Federal Reserve
picks too low a rate, as it did in the early part of this year. It picks
too low a rate at the time when market forces are tending to raise the
rates at which banks can lend. Banks then want to acquire more re
serves consistent with the desired monetary growth rate. The Fed gets
no information that it has made a mistake except from what happens
to the money supply because it's pegging the rate. It looks as if it's
doing fine . The rate is staying at say, 6 percent. Even more important ,
as the Fed feeds out more money to support the Federal funds rate,
after a brief interval, that strengthens the forces tending to raise other
interest rates because the highermonetary growth stimulates spending,
and the demand for loans , and that tends to raise interest rates.
It used to be that it took 6 months before that effect took place .
It used to be that for the first 6 months after the Fed pours out
money , that would tend to lower rates. But the markets are smart.
They have learned this lesson . If monetarists have not persuaded
anybody else, they have persuaded people who are operating in the
money market, and the result is that there's now only about a 2-month
gap between an increase in monetary growth and a tendency for that
monetary growth to raise interest rates rather than lower it . The
result of additional upward pressure on interest rates is to increase
still further the amount of funds that the Fed has to pour out to hold
the Federal funds rate. That's what happened from January to July
of this year. They kept the funds rate below the market rate and
there was a monetary explosition, a 9 - percent rate of growth in My .
The opposite happened in 1974. It was no part of the Fed's intention
to convert the minor recession of 1973 and 1974 into a major recession
from 1974 to 1975 , but they did it . Now , why did they do it ? Not on
purpose, but because they were following this obsolete procedure.
They had the Federal funds rate pegged too high . As the recession
proceeded , it tended to drive down interest rates. The Fed kept lower
ing the target Federal funds rates, but they didn't lower it fast enough.
The market rate kept falling down beneath them , and they kept
having to pull money out of the system in order to maintain their
target Federal funds rate. As a result, for a 7 -month period , they
produced nearly a zero rate of growth in M , which, in my opinion ,
was a major factor converting this mild recession into a severe
recession .
Of course , once the Fed makes a mistake it doesn't continue in
definitely down that road. It sooner or later adjusts, as I have just
described . In 1974, it kept lowering the rate, but it couldn't lower it
fast enough. In the period from January to June of this year, it kept
the rates stable. It held it constant, too low . Then it suddenly jumped
it in June with the result that it overshot the market and produced a
drastic shift in monetary growth so that from July to now you have
had essentially zero growth.

39

The Fed has gradually been waking up to this phenomenon and
has been trying to lower the rate , but it hasn't been able to lower it
fast enough. As a result ,monetary growth is not matching what the
Fed says is its objective. Sooner or later the Fed will lower the target
Federal funds rate too much. It will overshoot and then you will be
off again to the races with another explosion in the other direction.
In short, what the Fed is trying to do is the equivalent of balancing
an egg on its small end . In principle , it's possible to balance an egg
on its small end , but you will agree with me it takes extremely fine
tuning to hold that egg on its small end , and it takes extremely fine
tuning for the Fed to manipulate the money supply by the method it's
now using
There is an alternative procedure. That alternative procedure is
comparable to letting the egg rest on its side. That procedure is to
forget about the Federal funds rate, to convert the desired monetary
growth rate into an estimate of how much must be added to bank
reserves or to high - powered money or the monetary base in order to
produce the desired growth rate . This eliminates an utterly unneces
sary step in the present procedure. What I have described has to be
done now . The Fed must estimate how much reserves must grow in
order to increase the money supply by the desired level, but now it takes
an additional step — what is the Federal funds rate that will lead the
banks to be willing to increase reserves by that amounts ?
There is no disagreement on the part of the Fed or anybody else
that if the Fed forgot about the Federal funds rate, it could control
within very narrow limits the monetary base or total reserves. So the
alternative procedure is for the Fed to say, in order to produce a
5- to 71/2 -percent rate of growth in M - 1, we have to produce such
and such a rate of growth in high -powered money and they say to
the Federal Reserve Bank of New York, " Go out and buy the amount
of securities that are necessary for this purpose .”
That won't give you perfect control . There's a slip twixt that cup
and the lip , too , because there's a multiplier which connects the total
money supply with the base. That depends on such things as what
happens to the ratio of currency to deposits, how deposits are dis
tributed between demand and time, and how they are distributed
between banks with high reserve requirements and low reserve re
quirements. But all those ratios are very stable and change very slowly ,
and there is ample statistical evidence that while that introduces an
error, the error over any period of time would be less than the error
which is now introduced by the present method of operation.
More important, the error is not cumulative. It is random . From
month to month it will average out. The Fed might make just as large
an error for a 1 -month period, but it is literally inconceivable that
the Federal Reserve would have departed as far from its objectives
as it has over the past year if it had followed this alternative
procedure.
The only serious argument that has ever been made against this
alternative procedure is that it would involve more unstable interest
believe that that conclusion is the reverse of the truth . I
rates.
believe the present procedure destabilizes interest rates over periods
of more than a few days or a few weeks. I really need not stress this
issue because the argument involved is exactly the same argument

40

that you people considered or your predecessors considered — though
I think perhaps Senator Proxmire was here—back in 1951 and 1952
when
The CHAIRMAN. Thank you .
Dr. FRIEDMAN . I guess I'm making you more of a veteran than you
are , Senator Proxmire.
Senator Douglas, when he was here, was a leading figure in examin
ing the bond support program of the Federal Reserve . The fallacy in
the present procedure of trying to control the money supply is identi
cal with the fallacy in the bond support program . It's identical with
the fallacy in a fixed exchange rate system , and that is, rates are stabi
lized for days or weeks at the cost of letting discrepancies accumulate
and having big movements over the months and the years. If you look
at the actual movements of the interest rates, they have been destabi
lized by the attempt to stabilize them . In general, this is the case with
any speculative procedure which tries to peg a price. It can peg a price
over short intervals, but only at the cost of destabilizing it over long
intervals because you let the discrepancies accumulate.
This conclusion has recently been reinforced strongly by a very in
teresting paper by Prof. William Poole, who is now at Brown Uni
versity but was at the Federal Reserve Board research staff for many
years, and then at the Federal Reserve Bank of Boston, in which he,
too, has concluded that the present procedure destabilizes the interest
rate .
So I conclude that there is an overwhelming strong argument for
replacing the present operating procedure of the Federal Reserve by
an alternative operating procedure which would enable it to bring its
performance more closely in line with its objectives.
Incidently , I believe that this committee could serve a very impor
tant function in this area by setting up a series of hearings on this
technical question of methods of controlling the money supply. There
is a wide body of literature available on it. There are many people who
have studied it carefully . Your committee in the past has done this
kind of thing, brought together existing knowledge . I think it is the
most important single thing, if I may say so, that this committee could
do at the present time to foster good monetary policy.
Over and above this change in procedure, there are changes in regu
lations that would greatly improve the performance of the Fed . Some
years ago George Kaufman, who for many years was an economist with
the Federal Reserve System and most recently at the Federal Reserve
Bank of Chicago— since then he has been a professor at the Univer
sity of Oregon— some years ago he wrote and I quote
By increasing the complexity of the money multiplier, proliferating rate ceil
ings on different types of deposits, and encouraging banks, albeit unintentionally ,
to search out nondeposit sources of funds, the Federal Reserve has increased its
own difficulty in controlling the stock of money * * * To the extent the in
creased difficulty supports the long voiced contention of some Federal Reserve
officials that they are unable to control the stock of money even if they so
wished , the actions truly represent a self-fulfilling prophecy.
The major mistake of this kind, in my opinion , was the introduction
of lagged reserve requirements in 1968. I mav say that that change was
made for reasons that had nothing to do with monetary policy. It was
made fundamentally because it was believed that it would be attractive

41
to small banks and thus might reduce their tendency to leave the sys
tem . The change has not worked out that way. I do not know anybody
who has a good thing to say for the lagged reserve requirements sys
tem . The small banks don't like it . The big banks don't like it . It has
introduced variability into every dimension of Federal Reserve policy
and yet you have the standard phenomenon that you are so familiar
with , once a bureaucratic change has been made , it is the devil and all
to get it changed. But the most important single step at the moment
in the regulations the Fed could take would be to eliminate those
lagged reserve requirements.
A young man at the Federal Reserve Bank in Chicago, Bob Laurent,
has suggested a very ingenious scheme which is to reverse it . Instead

of having lagged reserve requirements , instead of having reserve re
quirements this week, depend on your deposits 2 weeks ago, have re
serve requirements depend on nextweek's deposits.
Now it turns out that that would have the effect of giving almost
perfect control to the Federal Reserve over the increase in the money
supply because they could make available the required reserves this
week which would , in turn , determine how much deposits banks could
produce next week. You now have the situation where banks can cre
ate all the deposits in the world and they don't have to scramble for
reserves for 2 weeks and 2 weeks later the Fed has to provide those
reserves. The only question , is , does the Fed provide them in the form
of unborrowed reserves or in the form of borrowed reserves ? By re
versing that relationship you would have the Fed provide the reserves
this week and then the banks could figure out on that basis how much
they were free to expand next week.
That's only one of a number of schemes that have been proposed .
I'm sure that a major change along these lines would greatly improve
the precision of Federal Reserve control.
The other change that I think most important is to eliminate the
present system under which all banks in the country have a reserve
period that ends on Wednesday . This is fundamentally an insane sys
tem . It makes no sense whatsoever because all the discrepancies pile
up on Wednesday and there are tremendous movements within a week
in Federal Reserve so -called defensive operations.
The solution is simple . Let one-fifth of the banks end on Monday,
one -fifth of the banks end on Tuesday, one - fifth of the banks on Wed
nesday , et cetera . Staggering the reserve requirements in that way
would even out this process and prevent the sharp swings within å
week that now take place.
Those are a few suggestions for the kind of reforms that could
be made. Those are the kinds of suggestions that could be explored
very well in special hearings that this committee could hold .
Let me conclude that I believe there is today a wide measure of
agreement on the part of the Congress, the Federal Reserve System
and the financial and academic community about the importance of
monetary policy for economic stability for the avoidance of inflation
and the fostering of healthy growth . There is still some disagreement
with the specific policy that will best foster these objectives. However,
I believe there has been growing support both for emphasis on mone
tary aggregates rather than interest rates as a major instrument of
monetary policy, and for a relatively steady and moderate rate of
growth in monetary aggregates as a major objective.

42

That is today the position of the Federal Reserve System itself, as
well as many of the most severe critics of earlier Federal Reserve per
formance. The major issue has shifted , I believe, from objectives to
means. The present technique of Federal Reserve operation is a sur
vival of earlier practices. It's not suited to present objectives. It has
produced a dramatic discrepancy between the Federal Reserve's an
nounced objectives and its actual performance. It's long past time that
the procedure was streamlined to accord with the change in
objectives.
The Congress and your committee in particular has played a major
role in producing a large measure of agreement on objectives. You
could now play a major role by stimulating the Fed to put its money
where its mouth is.
The CHAIRMAN . Thank you very much, Dr. Friedman .
[ Complete statement follows :]
STATEMENT ON CONDUCT OF MONETARY POLICY BY MILTON FRIEDMAN , PAUL
SNOWDEN RUSSELL DISTINGUISHED SERVICE PROFESSOR OF ECONOMICS , UNI
VERSITY OF CHICAGO
I am honored to testify before this committee on the conduct of monetary
policy. In my opinion , House Concurrent Resolution 133 has produced the most
important improvement in the institutional structure for the formation of
monetary policy of the past four decades . Though the Federal Reserve System
was established sixty -two years ago to provide long-term continuity in monetary
policy, to the best of my knowledge, it has never before set itself quantitative ob
jectives for as much as a year ahead. It never made its shorter-term objectives
public in advance. On the contrary, it kept its policy directive secret as it still
does for at least forty - five days. Finally, only in the past five years has it made
the rate of growth in monetary aggregates an explicit target of policy .
The resolution changed matters in all these respects : it requires the Federal
Reserve to state publicly its " objectives and plans" for growth in the monetary
aggregates for a year ahead. This is salutary for the Federal Reserve itself. It
should all along have been setting objectives for a considerable period in the
future - far longer than twelve months. More important, for the first time it
makes the Federal Reserve effectively accountable for its performance, which
can be judged against quantitative objectives specified in advance.
The resolution is equally notable for its emphasis on the desirability that long
run monetary growth be commensurate with the economy's increase in productive
potential—which implies steady growth, since the economy's productive capacity
grows steadily.
1. THE BACKGROUND
The major defect in Federal Reserve performance over the whole of its his
tory has been the erratic behavior of the monetary aggregates. Monetary growth
has time and again moved from one extreme to the other : from unduly rapid
growth to unduly slow growth. Periods of unduly rapid growth fueled the great
inflations of World War I and World War II, and the most recent double -digit
inflation of 1974. Periods of unduly slow growth or actual decline produced or
deepened the sharp contractions of 1920–21, 1929–33, and 1937–38, as well as the
milder recessions of the whole period.
This pattern of swinging from one extreme to the other has continued, as the
accompanying table shows :
TABLE 1.-RATES OF MONETARY GROWTH, 1970-75

Annual rate of growth of
Mi
M2
June 1970 to June 1973 .
June 1973 to June 1974.
June 1974 to January 1975 .
January 1975 to July 1975.
July 1975 to 4 weeks ending Oct. 15 .

7.3
5.6
.9
8.6
.3

10.9
8.7
5.1
12.0
4.4

43
The rates of monetary growth over the three- year period from 1970 to 1973
were higher than for any other three-year period since the end of World War
II . This rapid monetary growth undoubtedly helped produce the rapid inflation
of 1973 and 1974, and even our current inflation. A change in monetary growth
has a rapid effect on credit markets, but it generally takes some six or nine
months before it affects total spending, and then the effect at first is mainly on
physical output. In the U.S., it has generally taken some two years before a
change in monetary growth has its main effect on prices.
The mild tapering off of monetary growth from 1973 to 1974 was long overdue
and highly desirable. A reduction was essential to slow inflation . A gradual
reduction was desirable to avoid a severe economic shock. This gradual reduc
tion contributed to the mild recession that began in late 1973, but it also laid
the basis for the tapering off of inflation we have been enjoying this year. Un
fortunately, the Fed did not continue this gradual policy. In mid - 1974, it
enforced a sharp slowdown in monetary growth, which greatly deepened the
recession beginning in late 1974. That deepening in the recession was the
prelude to the concurrent resolution and no doubt did much to stimulate it.
Unfortunately , as the table shows, the concurrent resolution has not as yet
ended the propensity for the Fed to swing widely from one extreme to the
other. From January 1975 to July 1975, monetary growth jumped to an even
higher rate than during the three years from June 1970 to June 1973. That
monetary explosion helped end the recession and produce the vigorous recovery
that has been in train since April or May, but it also threatened to produce a
renewed acceleration of inflation . The slowdown in monetary growth beginning
in July was therefore appropriate, but again it has been too abrupt and threatens
to go too far. Were it to continue much longer, it would abort the current recov
ery and plunge us into renewed recession. I cannot believe that that will be
permitted to happen. Indeed , I believe that the greater danger is another mone
tary explosion, another swing from one extreme to the other.
The major current problem for monetary policy is to end these erratic swings
from one extreme to the other, and to replace them by a steady rate of monetary
growth that declines gradually over several years until it can be stabilized at a
level consistent with no inflation .
The erratic swings in monetary policy have not reflected similar swings in
the Fed's objectives, at least for the period for which the Fed has specified
objectives in terms of monetary growth and for which we know what they
were. The swings have rather reflected the failure of actual performance to
conform to the stated objectives.
After a brief examination of the stated objectives of the Fed, I shall there
fore devote most of my remarks to an examination of the reasons for the dis
crepancies between objectives and performance and for the changes in current
procedure that are required in order to reduce those discrepancies. This seems
to me the most urgent current problem in improving monetary policy so as to
foster stable and non -inflationary economic growth.
2. THE STATED OBJECTIVES
By requiring the Fed to specify objectives in terms of monetary growth
for a considerable period ahead, and by linking the desirable rate of growth
to the country's productive potential, the concurrent resolution has gone a
long way to assure that the stated objectives will be reasonably well attuned
to the economy's needs. That has certainly been the case on the two earlier
occasions on which the Fed responded to the resolution. [ This statement was
prepared without access to the latest response. ]
Personally, I have favored slightly lower rates of monetary growth than
the 5 to 712 percent rate for M and the 812 to 1042 percent rate for M,
specified by Chairman Burns on the first two occasions. However, my difference
on this score is minor. Similarly, I fully endorse Chairman Burns' repeated
emphasis that the maintenance for any long period of rates of monetary growth
at these levels would mean an undesirably high rate of inflation , and hence
that it is essential to move to sharply lower rates of monetary growth in order
to establish the basis for steady non - inflationary economic growth.
The ultimate target should be a rate of growth in M, of roughly 3 to 5 per cent
a year. That would roughly match the rate of growth in our productive poten
tial. Given the highly stable velocity of M, over more than a decade, it would
be consistent with roughly stable prices.
Our present knowledge about the short- run effects of changes in the rate of
monetary growth is too limited to yield any very precise estimate of how rapidly

44
monetary growth should be reduced to the desired long- run rate. My own judg
ment is that a transition period of something like three to five years is a reason
able compromise between ending inflation rapidly and avoiding heavy transi
tional costs. This would require the stated rates of growth for M , to be reduced
by one to two percentage points each year for the next three to five years.
This suggestion is not inconsistent with the verbal statements by Chairman
Burns. An explicit numerical timetable along these lines would however be highly
desirable. If the attainment of such a timetable can be made credible, it would
provide a basis for private economic and financial planning. The salutary effect
on inflationary anticipations would greatly ease the transition to a noninflation
ary environment.
My only other suggestion with respect to objectives is purely technical : the
desirability of expressing them in terms not of rates of growth from a changing
base, or not solely in those terms, but of a desired time path of each monetary
aggregate plus and minus a percentage band . This suggestion is linked with the
desirability of specifying a longer-range timetable. A range of monetary growth
rates tied to an initial base produces numerical limits on the aggregate that
widen indefinitely , the longer the time that elapses from the base.
3. PERFORMANCE
When Chairman Burns testified before the House Banking Committee on
July 24, 1975, both M, and M, were above both the original and revised upper
limits of the Federal Reserve objectives. Just before his current testimony before
this committee, the latest figures then available were below the lower limits,
thanks to essentially zero growth from July to mid-October in M, and a 4 per
cent rate of growth in M2.
As already noted, neither the initial overshooting nor the subsequent sharp re
tardation were intentional . Both reflected a failure of the Fed to achieve its
stated objectives. These were only the latest of such failures.
Some observers have concluded from these failures that the Federal Reserve
does not have the power to achieve its targets, that in this area it is a helpless
giant. There is a sense in which that conclusion is correct, but a more funda
mental sense in which it is wrong.
The conclusion is correct in the sense that the operating procedures now used
by the Fed to implement its policy directives tend to produce major discrepancies
between objectives and performance. So long as it continues to use those pro
cedures , it will continue to fail to achieve its monetary growth objectives . But
there are alternative operating procedures that have been extensively discussed
and explored within and without the system and that are entirely feasible that
would enable the Fed to reduce sharply the discrepancies between actual mone
tary growth and intended monetary growth .
1 A few key items in the extensive and growing literature on procedures for controlling
monetary growth are :
William G. Dewald, “ Monetary Control and the Distribution of Money,” Ph.D. disserta
tion , University of Minnesota , 1963.
Milton Friedman and Anna J. Schwartz, “ Proximate Determinants of the Nominal Stock
of Money,“ Appendix B of A Monetary History of the United States, 1867-1960 (Prince
ton , 1963 ).
Phillip Cagan, Determinants and Effects of Changes in the Stock of Money , 1875-1960
( New York, 1965 ) .
Jerry L. Jordan , “ Elements of Money Stock Determination ," Review , Federal Reserve
Bank of St. Louis (October, 1969 ).
Albert E. Burger, The Money Supply Process ( Belmont, Cal., 1971) .
Board of Governors, Federal Reserve System , Open Market Policies and Operating
Procedures, Staff Studies (Washington, 1971), especially paper by R. G. Davis.
Albert E. Burger, Lionel Kalish III, and Christopher T. Babb, “ Money Stock Control and
Its Implications for Monetary Policy ," Review, Federal Reserve Bank of St. Louis
(October 1971 ) .
Federal Reserve Bank of Boston, Controlling Monetary Aggregates II : The Implementa
tion, Proceedings of a Conference held in September, 1972, especially papers by Albert E.
Burger and by James L. Pierce and Thomas D. Thomsen .
Robert H. Rasche, " A Review of Empirical Studies of the Money Supply Mechanism ,"
Review , Federal Reserve Bank of St. Louis ( July, 1972 ).
Fred J. Levin, " Examination of the Money - Stock Control Approach of Burger, Kalish ,
and Babb ,” Journalof Money, Credit , and Banking (November, 1973 ) .
Federal Reserve Bank of New York, Monetary Aggregates and Monetary Policy ( New
York, 1974 ) , especially paper by Richard G. Davis and Frederick C. Shadrach.
Three recent items that are especially relevant to the rest of this testimony are :
William Poole , “ The Making of Monetary Policy : Description and Analysis,” Economic
Inquiry ( June, 1975 ) .
William Poole, “ Benefits and Costs of Stable Monetary Growth ” (forthcoming ) .
Albert E. Burger, “ The Relationship between Monetary Base and Money : How Close ?"
Review, Federal Reserve Bank of St. Louis ( October, 1975 ).

45
These alternative procedures would of course not enable the Fed to hit its
target on the nose day by day . There would still be sizable errors from week to
week or month to month . But by comparison with present procedures, the errors
would not be self- reinforcing. As a result the alternative procedures would en
able the Fed to avoid the wide swings from one side to the other that have long
characterized Fed performance.
The residual errors under the alternative procedure could be reduced still
further by changes in Federal Reserve regulations, particularly with respect to
required reserves, they are desirable on other grounds.
I shall elaborate these judgments by ( a ) explaining why present procedures are
defective, ( b ) outlining the alternative procedures, and ( c ) suggesting the key
changes in regulations that would be desirable to improve still further Federal
Reserve control over monetary aggregates.
( a ) Present Procedures. - Present procedures are an anachronistic survival
of an earlier day . Their persistence is an extraordinary tribute to bureaucratic
inertia . Before 1970, the Fed took as its prime objective “money market condi
tions," i.e. , a collection of market interest rates. In 1970, it shifted to money
aggregate targets. That was a major and salutary reform but it was stifled at its
birth by the failure to adjust the operating procedures to the new target. In
stead, the earlier procedures, designed to influence the “ money market,” were
retained.
The way the Fed now operates is to convert its monetary growth objective into
a Federal Funds rate which its staff estimates to be consistent with that rate of
monetary growth . It then instructs the New York desk to keep the Federal Funds
rate within a specified range. In this way, it tried to adapt the earlier procedure,
which had been developed in order to influence money market conditions, to its
new objective .
The rate of monetary growth is connected with the amount of reserves acquired
by banks through a multiplier which determines the change in the quantity of
money per dollar change in bank reserves. The amount of reserves banks wish
to acquire at any time depends in turn on the relation between the rate of inter
est that they can earn on additional loans and the cost to them of acquiring
funds. The Federal Funds rate is one measure of this cost. In principle, there
fore, there is a Federal Funds rate at each point in time which, if attained ,
would lead banks to seek to acquire the amount of reserves that would produce
any specified rate of monetary growth .
Unfortunately, there are two large slips 'twixt that principle and Federal Re
serve practice. The first slip is that the Fed cannot accurately predict the required
Federal Funds rate . In order to do so, it would have to predict the whole struc
ture of rates of interest under alternative conditions. The Fed certainly can con
trol the Federal Funds rate if it wishes to. But it cannot control the many forces
that impinge on the market for credit and that determine other interest rates ,
and it is the relation between these other interest rates and the Federal Funds
rate that is critical . Federal Reserve operations in the credit market are a minor
element in the total credit market . That is why " money market conditions” have
proved such a defective guide in the past. It is also why the Fed has such a poor
record in estimating the Federal Funds rate that will achieve a desired monetary
growth rate.
In estimating the required Federal Funds rate, the Fed uses a so - called " money
market model" which , among other things, purports to predict the Treasury bill
rate. Some years ago, I tested the model as it then was against the naive alterna
tive model of assuming that next month's rate would be the same as this. The
naive model gave more accurate predictions on the average than the Fed's sophis
ticated model . In short, its model had zero predictive power.
The second , and in some wavs even more serious, slip is that if the Fed picks
the wrong rate and sticks to it , the error cumulates and is self -reinforcing. Sup
pose, as occurred early this year, the Fed underestimates the required Federal
Funds rate, which is to say, that forces outside the control of the Fed, in this
case the rebound from the severe recession , are tending to raise interest rates
above the levels that the Fed's model predicts. At the pegged Federal Funds rate,
banks wish to add more to their reserves than is consistent with the desired rate
of monetary growth . The Fed can peg the rate only by supplying those reserves.
So long as it does so, the only sign that the rate is too low would be unduly rapid
2 As is clear from the references in the preceding note , these issues are of long standing
and the defects of the existing procedure, as well as the availability of an alternative, had
been discussed before 1970.

46
monetary growth. After an interval, the higher monetary growth will add further
to the upward pressure on interest rates by stimulating spending and thereby rais
ing the demand for loans. This interval used to be about six months. In recent
years, however, the interval has shortened drastically as the market has come
to understand the process. If the Fed continues to peg the rate, monetary growth
would accelerate without limit. It was precisely this possibilitythat finally forced
the termination of the World War II policy of pegging interest rates on govern
ment securities .
Of course the Fed will not continue down this road. Sooner or later, it will
adjust its Federal Funds target to try to get back to the desired monetary growth
path . But the length of time required to detect that the Federal Funds rate is set
at the wrong level, the cumulative and self-reinforcing nature of the errors, and
the Fed's commendable desire to change its Federal Funds peg gradually combine
to make this a difficult task , as experience has shown.
Consider just this past cyclical episode. In mid-1974, the Federal Funds rate
target was too high and produced a sharp decline in monetary growth. The Fed
moved to reduce the Federal Funds target. But the recession , and the intensifica
tion of the recession by the Fed's own mistake, kept driving market rates down.
They kept falling from under the Fed's target as it were and the Fed kept trying
to catch up. It did not do so until January 1975, but then it was not sure for a
time that it had done so and kept reducing the Federal Funds target until March,
by which time it was too low. A monetary explosion ensued . However, having held
the Federal Funds rate too high for so long, the Fed was reluctant to change.
Finally, it did so in June, and then , because of the delay, raised it by an unusually
large amount. As a result, it overshot, which brought an abrupt monetary slow
down. In the past month or so, the New York City financial crisis has increased
the demand for liquidity, by creating uncertainty, which has steepened the yield
curve, and has shifted funds from municipals to other securities, which has
driven rates on them down. These downward pressures on short-term market
rates have reinforced the delayed effects of slow monetary growth, leaving the
Federal Funds target again too high . In order to peg it, the Fed has had to pro
duce an absolute monetary contraction.
I believe, and hope, that this time the Fed will adjust its target Federal Funds
rate promptly. But even if it does, we shall have had a wholly unnecessary and
damaging swing from one extreme to the other. In principle, it is possible to bal
ance an egg on its small end — but it takes extremely fine tuning to keep it
balanced.
( b ) Alternative Procedure. There is a far better procedure — comparable to let
ting the egg rest on its side. That procedure is to convert the desired monetary
growth rate into the increase in the monetary base [ roughly , currency plus de
posits at Federal Reserve Banks ] required to produce it ; and instruct the New
York desk to purchase or sell the amount of securities required to produce the
requisite increase in monetary base. In other words, eliminate entirely the extra
step of what Federal Funds rate is required to produce the necessary increase
in reserves.
This procedure too is not perfect. The multiplier which connects the base to
the money supply is not perfectly stable . It depends on the ratio of currency
to deposits, the distribution of deposits between categories and banks subject
to different reserve requirements, and the like. But the multiplier is fairly stable.
Moreover, the ratios on which it depends tend to change slowly, so that changes
in the multiplier can to some extent be predicted . Some twelve years ago, William
Dewald demonstrated that simply assuming each ratio to be the same next month
as this would produce adequately close control of the quantity of money . Since
then , a number of careful empirical studies done within the Federal Reserve Sys
tem have demonstrated that a more sophisticated version of this method of
operation yields relatively small errors . Moreover, the residual errors could be
reduced even further by some of the regulatory changes considered in the next
sub -section .
Even if this procedure yielded as large an error for a brief period ahead as
the present procedure, it would yet have one overwhelming advantage: the
errors would not be cumulative and reinforcing ; on the contrary, errors in suc
cessive weeks would be random and offsetting. An error in this procedure does
not set in motion forces which lead to further and larger errors in the same direc
3 See references in footnote 1 .

47
tion. It is literally inconceivable that if the Fed had followed this procedure
during 1974 and 1975, it could have departed as far as it did from its own
objectives.
The one serious objection to this procedure that I have seen is the contention
that it would lead to more variability in interest rates over short periods than ,
the present procedure. I have long believed that it would have precisely, the
opposite effect except possibly for very short periods, measured in a few days or
perhaps several weeks. By delaying interest rate adjustments, the present pro
cedure permits pressures to cumulate. I believe that it thereby produces more er
ratic and unstable interest rates than the alternative procedure. This judgment
has recently been powerfully reinforced by an important paper by Professor
William Poole, until recently a member of the research staff of the Board of
Governors of the Federal Reserve, in which he reaches the same conclusion by a
very different argument .*
Under the alternative procedure, the Fed would have no need for any in
terest rate targets whatsoever. It could let the Federal Funds rate, and other
interest rates, be free market rates determined entirely by market forces. This
would have the incidental great advantage that it would help to dissipate the
mistaken belief that the Fed can or does control interest rates and the even more
mischievous notion that " tight” money is to be identified with high interest
rates rather than slow monetary growth and " easy " money , with low interest
rates rather than rapid monetary growth .
I have long said that I will believe there has been a fundamental acceptance
by the Fed of monetary growth as the appropriate target, rather than merely lip
service, when I learn that on coming into his office in the morning, Alan Holmes'
first action is something other than telephoning for interest rate quotes.
One final comment on the techniques of control. Much work has been done
inside and outside the System on a highly sophisticated level about the so-called
problem of "optimal control.” This work is important as well as intellectually
fascinating but in my opinion is concerned with effects of a second order of mag
nitude. The urgent need is to introduce as rapidly as possible the alternative
procedure to correct the first order defects of the present procedures. It will then
be desirable and possible to proceed at more leisure to refine the procedures along
the lines suggested by optimal control theory. We must not in this area as in
others let the best be the enemy of the good.
( c ) Desirable Changes in Regulations.-Over the past decade, the Federal Re
serve has introduced many changes in reserve requirements, in the classification
of deposits subject to interest ceilings and the like, that have introduced addi
tional variability into the multipliers connecting monetary aggregates with the
monetary base. In an article on this subject published some years ago, George
Kaufman, long an economist with the Federal Reserve System , concluded, "by
increasing the complexity of the money multiplier, proliferating rate ceilings on
different types of deposits, and encouraging banks, albeit unintentionally, to
search out non -deposit sources of funds, the Federal Reserve has increased its
own difficulty in controlling the stock of money . ... To the extent the increased
difficulty supports the long voiced contention of Some Federal Reserve Officials
that they are unable to control the stock of money even if they so wished , the
actions truly represent a self-fulfilling prophecy."
The major change of this kind was the introduction of lagged reserve require
ments in 1968. This change has not worked as it was expected to. Instead, it has
introduced additional delay between Federal Reserve open market operations
and their effect on the money supply , and has rendered such items as free reserves,
excess reserves, member bank borrowing, and the like more variable . Perhaps
the next most important change has been the proliferation of reserve categories.
It would be highly desirable for the Fed to reform basically the present sys
tem of reserve requirements. Three major changes are desirable : first, elimina
tion of lagged reserve requirements ; second, consolidation of reserve categories
to move toward a single reserve requirement on all kinds of bank liabilities ;
third, introduction of staggered reserve adjustment periods, so that some banks
end their reserve period on Monday, some on Tuesday, etc., instead of, as at
4 See his forthcoming paper, " Benefits and Costs of Stable Monetary Growth.”
15.For a detailed analysis, see Warren L. Coats, Jr., “ The September , 1968, Changes in
'Regulation D ' and Their Implications for Money Supply Control" (unpublished Ph.D
dissertation , University of Chicago, 1972 ) .

48
present, all ending on Wednesday. Staggering reserve periods would eliminate
a major part of the so - called “ defensive” operations of the open market desk that
arise from the intra -weekly cycle introduced as a result of all banks ending
reserve periods on the same day. This proposal could be accompanied by a length
ening of the reserve period , but need not be.
A more radical reform is to revise the reserve requirement lag by letting this
week's required reserves be satisfied by last week's vault cash plus deposits at a
Federal Reserve Bank. This ingenious proposal, suggested in an as yet unpub
lished paper by Robert Laurent of the Chicago Federal Reserve Bank, would
greatly increase the precision with which the Fed could control the money sup
ply. It deserves serious consideration ,
I have not tried to be exhaustive but rather suggestive about the kinds of
reforms needed. The issues involved are highly technical and detailed, but the
general direction in which change is needed is not.
4. CONCLUSION
There is today a wide measure of agreement on the part of the Congress, the
Federal Reserve System , and the financial and academic community, about the
importance of monetary policy for economic stability, avoidance of inflation, and
the fostering of healthy growth . There is still some disagreement about the
specific policy that will best foster these objectives. However, I believe there has
been growing support both for emphasis on monetary aggregates rather than
interest rates as the major instrument of monetary policy and for a relatively
steady and moderate rate of growth in monetary aggregates as the major ob
jective. That is today the position of the Federal Reserve System itself as well
as of many of the most severe critics of earlier Federal Reserve performance.
The major issue has shifted, I believe, from objectives to means. The present
techniques of Federal Reserve operation are a survival of earlier practices and
are not suited to present objectives. They have produced a dramatic discrepancy
between the Federal Reserve's announced objectives and its actual performance..
It is long past time that they were streamlined to accord with the change in
objectives.
The Congress has played a major role in promoting a large measure of agree
ment on objectives. It could now play a major role by stimulating the Fed to
adapt its procedures to its stated objectives.

ADDENDUM
On further consideration of Chairman Burn's testimony since the Hearings,
I wish to stress much more strongly than I did then the great importance of one
seemingly technical feature of the Chairman's testimony, namely , his shift of
the basis to which he applies the target monetary growth rates from the average
of the actual money supply in the second quarter to the corresponding average
for the third quarter. Both the shift this time, and the similar shift when Chair
man Burns testified before the House Banking Committee on July 24, 1975 , were
minor in magnitude. However, the principle involved is extremely important.
By adopting the practice of altering the basis each quarter to equal the actual
level of the money supply in the prior quarter, the Federal Reserve has done
two things :
( 1 ) Altered fundamentally one central element of joint Congressional Resolu
tion 133. That resolution asked the Fed to specify targets for one year ahead.
The Fed complies in form but, thanks to the shifting basis, it in effect gives
targets for only one quarter ahead , thereby reverting to its bad old habit of
extremely short -term planning. If the Fed continues this practice, three months
from now it will revise the basis to which it applies its stated rates of growth
to the actual average of the fourth quarter, in effect starting off again froin
scratch .
( 2 ) Adopted the policy of letting the quarterly average of the money supply be
what statisticians call a random walk with drift, which means in effect giving up
any attempt to determine its long -run course. Any discrepancy for one quarter
between its target and its performance is buried in the new basis, so that the
quarterly averages grow at the targeted rate ( the drift ) plus the cumulation of
the random errors between the target and performance. Under this system , sun
pose the target rate were constant ( say equal to 6 percent ) . Then statistical

49
theory assures that the longer this procedure is followed , the larger ( in absolute
value ) is likely to be the discrepancy between the actual money supply and a long
run 6 percent growth path .
These effects are most unfortunate . They are doubtless inadvertent con
sequences of what on the surface appears to be a purely technical adjustment to
bring matters up to date, and this appearance is reinforced by the minor quantita
tive magnitude of the adjustment on the first two occasions. But unless this
practice is altered, the fundamental aim of the joint resolution will be almost
completely frustrated.
STATEMENT OF PROF. PAUL SAMUELSON, MASSACHUSETTS
INSTITUTE OF TECHNOLOGY, DEPARTMENT OF ECONOMICS
Dr. SAMUELSON. Let me begin my remarks by addressing myself to
the problem that the economy now faces in the second quarter of the
recovery from the most serious recession in the post World War II
period. The U.S. economy seems now to be in a fairly vigorous re
covery. Probably the 11.2 percent annual growth rate reported for the
third quarter 1975 real gross national product may be a bit of an
exaggeration, attributable to temporary inventory strength that could
be spurious and in any case likely to be transient. Still, in comparison
with the slow and disappointing recoveries in Europe and in Japan the
United States seems to have been doing remarkably well, andthis in
the face of the troublesome New York City fiscal crisis.
If you will just think back to hearings before you and recall the
climate of general public opinion at the turn of the year when prudent
men of sober affairs were worried whether we were going into a great
depression like that of the 1930's, you will realize how different the
present situation is. The economic public opinion polls of the con
sumer, whether taken by the University of Michigan , by the Con
ference Board , or by private pollsters, shows that the American con
sumer in general has been following the Gross National Product
returns.
I think that the expansionary fiscal policies which Congressional
taxcutting provided for the economy at the year's turn seems to have
been vindicated by the actual pattern of events. The pattern of agree
ment with expectation is not so good as to be suspicious, but it is in
the expected general ball park . Moreover, it's a matter of some comfort
that we seem to have made slow progress on the battle against what
last year was two digit price inflation . The recent reported annualrate
of price inflation as measured by the official GNP deflater for the third
quarter, which was only about 5 percent, represents a posed short
fall from the 12 -plus percent of last year's inflation, it is something
of an understatement of what actually happened , as measured by the
chain index which does not allow for weight shifts and which shows
a 7 percent inflation rate. The fears that the public deficit would crowd
out much needed private investment spending, when we compare the
pattern of private investment spending against the current variables
and against past patterns of experience — those most extreme fears do
not seem to have been borne out.
Well, now, what has been the role of the Federal Reserve in this
period and what should its role be in the period ahead ?
1 In technical statistical terms, the standard deviation of the difference between the
actual and the target money supply increases without limit, the longer thetime forwhich
the procedure is followed .

50
The Federal Reserve was, critics think in retrospect, and many
thought at the time, insufficiently militant in its expansion of credit
and the money supply during the last half of 1975. Professor Fried
man has expressed that opinion and in some measure I would agree
with that. But if I use past patterns of timing on the relationship be
tween the money supply and the actual pattern of experience in the
last half of 1974 , I would have to conclude that the weakness then
cannot be explained by the failure of the money supply to grow at an
adequate rate in the last half of 1974.
But in any case, under the Federal Reserve's own steam and under
the goad of critics inside this committee and outside, the Fed did
become more expansionary in the first half of 1975. However, a mone
tarist cannot use this M expansion to explain the April recovery : the
log must be longer than that. Also, the sharp jump in nominal GNP
in the third quarter at something like a 15 percent annual rate took
place with the M , money supply growing only at about a 7 percent
rate, even less by some methods of calculation , in the third quarter.
The resulting sharp runup in the relocity of circulation of money can
not be adequately accounted for either by the rather minor increase in
interest rates which took place during that period or by the normal
pattern of velocity increase at the beginning of a recovery . If one does
what every scholar does do, namely benefits from the historical re
searches of Professor Friedman and Dr. Anna Schwartz , one finds
there ended cyclical patterns in the relocity of money. When the
Chairman of the Federal Reserve Board refers to such a V rise he's
referring to what every well -informed scholar now knows, thanks to
the work of Dr. Friedman and others, is a predictable pattern of ex
perience ; but much of such a V rise that takes place along with the
cyclical rise to be expected in the interest structure.
What we have had here, though, is an unusual residual error or
shift in the demand for money , one not normally associated with the
cyclical patterns of behavior. So the first thing to realize is that this
is a mystery. It's a mystery for all policymakers. It's a mystery for
scholars; and we have to ask ourselves, what does it imply with respect
to demand for money in the period ahead ?
Now if one tries to account for this increase in velocity, calling it
an increase in velocity is no explanation. It's simply another way of
describing the mystery .It's hard for me to see why the New York City
troubles should lower the demand for money rather than increase the
demand for money , but I agree with Dr. Friedman that it can explain
a drop in short-term interest rates relative to long -term . Nor do the
facts of foreign government purchases of our treasury bills work in
the right direction. Perhaps a little of the discrepancy can be attri
buted to movements in the Treasury balances, whose effects are well
understood and have some future predictive power. Still, I have to
conclude that we are left with the mystery and that, on the basis of past
patterns of evidence and the best ways that scholars have learned to
interpret evidence, one cannot prudently extrapolate the recent devia
tion in velocity from past patterns into the future.
I also want to say, and it's very relevant for anyone who wishes to
decide now what is the proper money supply 12 months from now and
who's willing to stick to that through thick and thin because there's
something worthwhile in such a rule itself, that it would also not be

51
prudent to decide now that this change in the demand for money is a
temporary thing which is going to correct itself.
There may be some hidden strength in the economic situation , so
that anyone who has a respect for evidence should have a gnawing
doubt in the back of his mind that there may be something stronger in
the economy than the Chase or other econometric forecasts have ex
pected there to be and than the monetary equations which one moni
tors and which one uses are now predicting.
The future will gradually reveal itself and this is why , in my judg
ment — and I will expand upon this latter at the end of my prepared
testimony and in questioning if somebody wants me to — why it is de
sirable for good optimal monetary policy to have a stance of flexi
bility.
Well, in order to judge whether the new targets for My and M,
announced the day before yesterday byGovernorBurns are adequate,
one must first form a judgment on the likely strength in the economy
in the quarters ahead and through the November 1976 election . That is,
the strength of the economy as it would show itself under different
monetary policies by the Federal Reserve , and then I think one may
hope to form a judgment as to what would seem to be the optimal
Federal Reserve policy.
Given the best estimates of only moderate strength in housing and
in plant and equipment spending of business, I'm using now the cur
rent data against the past patterns of experience of such data—and
given what seems to be an expansionary quirk in recent inventory
behavior, that may be a temporary condition , my best estimate is that
the U.S. economy does need a repetition for 1976 of the 1975 tax cut .
I say this quite independently of my new limits on the growth of
total public spending. In other words, I'm not agreeing with Presi
dent Ford's program that one should have a tax cut if and only if it
is matched by expenditure savings over what would otherwise have
been the pattern of growth . If the President should get from the
Congress his desired cut in the expenditures, then my desired cut in
taxes would be bigger than the one that I am now talking about.
Senator PACKWOOD. If I might ask there , if we're thinking about ex
tending the present tax cut, all you're saying is that if we cut $28
billion in spending we ought to match that with an additional $28
billion in tax cuts on top of whatever the other tax cut is that we
come up with ?
Dr. SAMUELSON. Yes, with the qualification , of course , that all
these cuts in spending are cuts in certain growth rates in spending and
are not absolute cuts from , say, the previous fiscal year level.
Senator PACKWOOD . Right.
Dr. SAMUELSON. Thus, if limitations on defense and other spending
should be decided on , a significant offset to such savings would have to
come in the form of still further tax reductions if the recovery needs of
the economyare to be taken into prudent consideration.
Well , now, turning back to monetary policy, on the supposition that
the tax reduction program will be renewed , quite apart from any
new expenditure limitations other than those which Congress will
impose upon itself, I would name as the safe goal for real growth
in GNP from the third quarter of 1974 to the third quarter of next
year to be somewhere around 7 percent. I won't quarrel with someone

52
who shades that upward ; and I wouldn't feel too terribly disappointed
if we fall a little bit short of it. I don't think that 11 percent real
growth is a healthy figure. I didn't think the numbers like that as we
were moving into the election period of 1972 were healthy. I want this
to be a long and sustained recovery. I don't want to tolerate any extra
day in which somebody is on the unemployed lines, but to rush the
process of reemployment in an attempt to get everybody back to work
this month rather than some months from now is likely to have the
effect that a couple of years from now they are going to have a worse
job situation. An unsustainable acceleration to mewould not repre
sent a prudent policy.
want to call to your attention the order in which I reveal my rec
ommendations with respect to monetary policy. I don't think that I
can arrive at a proper monetary policy until I have some ball park
feeling for what is the prudent proper real growth policy in this
period , and until I have some feeling for what is the price outlook
under different policies in the relevant period ahead — say, 4 quarters,
8 quarters, and 12 quarters ahead. Realistically, the rate of price
inflation I suspect can at best be counted on to hover around the recent
rates of 5 percent. I know there are some analysts whom I respect who
think that with the amount of slack we have in plant capacity , with
the amount of slack in the labor force, and with what they think is
going to happen to the OPEC cartel's control of its own price , that
we can hope as we move into the fourth quarter of this year and into
next year to do better than 5 percent inflation. But there are also
analysts who think that we will be back to 7 ,8 percent , and I would
also remind you that the Consumers Price Index which is what wage
contracts depend upon and which really the person in the street
rightly considers to be the important price index ,it is not now moving
at 5 percent. It is moving at something like 7 or 8 percent.
So, since I think that there are important elements in this price pre
diction that I have made which in the period of the next four or six
quarters stem from strong exogenous influences and could not be
brought down by monetary policy without having very severe effects
upon the real growth performance, it seems to me we are facing as
a prudent goal for policy something like a 12- to 14 -percent annual
rate of growth in the money GNP. I very much doubt that the recent
shift in the demand for money is so persistent that recent weak rates
of growth of M, and M, are consistent with the continued healthy
recovery, and I would like to second Professor Friedman's testimony
in that regard .
At the least, I think we shall probably have to move to the upper
limits of the recently announced target range. If I had been testifying
3 months ago before you I would have by the same reasoning said
we probably have to exceed that range ; and I may, if you call me back
to testify 2 months from now , return to that position ; but I'm left
now with the fact that the third quarter was extraordinarily strong
and it may be telling us something.
There may be elements in the situation, autocorrelated elements,
which the analysts have not yet picked up and which will become more
obvious to us and therefore I'm for the moment less dissatisfied with
the new target than I was previously .
Let me conclude my prepared testimony with a few general philo
sophic remarks on monetary policy. I believe there is widespread agree

53

ment that money does matter much and I think there is widespread
agreement among analysts that long continued rates of M growth ,
whether you use M or M, or M, or some variant, which do greatly
exceed the feasible real growth rates , that in the long run this will be
associated with rising trends of prices. But I'm afraid that there
the agreement ends.
I'm not now expressing my opinion about what I think ought to
happen, but I'm simply trying to make a roundup of what I regard to
be the trends of opinion . I do not see a converging pattern of agree
ment toward a money rule or tactic that calls for the same monetary
aggregate target in season and out. I may say that I do not believe in
such a target, but it is not that I believe that there should be an interest
rate stabilization target . I think the monetarists target would often be
better than an interest rate target , but still not as good as what I think
is the feasible optimum . The optimum stabilizing target is essentially
a leaning against the wind as best intelligence and analysis of the
pattern of evidence based against past historical experience tells you
that wind is going to be in the next 6 months and in the next 9 months.
I believe that the Federal Reserve would have a better record of per
formance if they adhered to such a general set of rules.
Now , addressing myself to the climate of opinion with respect to a
monetary rule of constant growth applied to a money aggregate, it
seems to me that the actual experiences of recent years have undercut
rather than strengthened what I would regard as never a strong case
for such a monetary rule .
Let me give some examples. Although I embrace the Clemenceau
like dictum that money is too important to leave to the monetarists ,
I never neglect help from any source. And so I monitor the money
aggregates I keep a trend chart of what's happening to the level of the
money supply because I find that a much more useful thing to do than
to keep my adrenalin running with what's happening to the rate of
growth of a very choppy series in short periods. And my chart of
that trend shows that is of mid-1974 the actual stock of money was
hugging quite close , to my eye, to the several- year trend. It's true that
if I apply a ruler to the rate of growth it's choppy around the trend ,
but the Fed — perhaps because it's been given a proper fear of mone
tarists' criticism —tends if it makes a tack in the one direction from the
trend in one period , to make a tack in the next period in the opposite
direction , cancelling out extreme deviation .
I also have great confidence in free markets and I believe that free
markets composed of intelligent people who have a lot of money rid
ing on the outcome are perfectly capable of doing the smoothing and
modulating if the Fed would continue to behave in such a fashion
and not behave in the cum -cyclical way that it so often behaved be
tween the wars, which was to create long undulations around no per
ceptible target that reinforce the business cycles.
So having these trend rates of growth, I applied various monetarists
equations to the mid-1974 data . Yet I have found no monetarists?
equation with a good prediction performance over the extended past
which came anywhere near to explaining the weakness in the economy
that revealed itself shortly after the summer of 1974, from August on.
That shows to me that the economy in the recent period has had
larger residuals of instability from nonmonetary sources and that
a money rule would have resulted, if followed , in larger than usual

54
squared errors and a squared error of deviation in this case means
thinks like human suffering and unemployment and untoward price
behavior.
Let me go on , again attempting to use what wisdom I have been able
to get from the monetarists. I cannot explain the strength of the
economy since last April on the basis of simple monetarists' equations
based upon past experience. The lags which we have learned about over
a long period of time are not so short that the upturn in the money
supply, its rate of growth in the early months of this year could have
had their action so quickly. It was like the case of the great advice
which I gave to candidate and President -elect John F. Kennedy : so
powerful was that advice that within one month after he took office
the economy was in recovery.
The CHAIRMAX . The longest recovery in our history.
Dr. SAMUELSON . Right. Yes. Well , some credit for that - less face
tiously — can be taken by some of us.
But it seems to me recent experience with monetarist models failures
to match reality in even the usual historical degree suggests that fine
tuning the money supply is not the endall of desirable economic policy.
I think M - growth -stabilization could be done better than it has
been done if it were really something that ought most to be done. But,
if you look at the smoothed out changes in the money supply , look
at annual data or use your own method of smoothing, if you consider
the cost push and exogenous price elements that impinge upon the
modern economy with stagflation and the other bad tradeoff patterns
which we have experienced, then you must conclude that the major
problem is not whether the Fed in one 6 -month period is running
ahead of some putative desirable long-run rate and in some other
period running behind . As a matter of fact, I think of those as largely
self-cancelling errors , not doubled errors. I have confidence that the
money market can adjust itself to that type of behavior.
What I object to and what I fear for the period ahead is cumcyclical
reinforcement by the Federal Reserve. I would rather have neutral
behavior than cumcyclical behavior. I think with an election year
coming up there is plenty of evidence that governments can do things
which can change the situation in 6 months, 12 months, 18 months
ahead, which will have consequences for the period thereafter. So
it seems to me that the proper behavior which I hope your committee
and similar House committees will hold the Fed to, in season and
out of season , is that they should not be deciding themselves what is
the appropriate tradeoff between price inflation and unemployment:
it is unthinkable that any governor of the Federal Reserve should
be able to decide that he is little “ Peter at the dike” deciding just
how much inflation the American Government can stand , the Ameri
can system can stand , and how much ought to be put on the backs
of the unemployed in the period in question to fight price inflation .
I think that there is no fourth branch of Government, which is
the central bank. I recognize the Judiciary and the Congress and
the Executive. I don't recognize the Federal Reserve as a fourth
independent branch of government. I think that if the Fed is not
going to be part of the Executive , it should be responsive, not, for
its day to day scratching of its ears, to the Congress. It should be
responsive to the Congress on monetary policy. "And I think that

55
its monetary policy should be a leaning against the winds as they
can be expected by past evidence to prevail of in the period ahead
when the monetary actions of the Fed have their consequences.
So I want to go beyond the steady M - growth goal that's stated here
by Professor Friedman to what seems to me to be an optimal feasible
goal . Now what I'm stating is not a fine tuning goal. It's a mistake
to try to fine tune in an engineering situation where you have prob
ability discrepancies, l'ecorded over and over again in history that
you're not able to tell about at the beginning. What you do if you're
an electrical engineering graduate student in optimal control, when
you have a stocastic or chance pattern, is to use your best judgment
in identifying this mechanism and inferring what the past historical
statistical patterns have been of the probabilistic influences. Then
you devise a filter system which is not too fast and which is not too
slow, but one designed to give you the smallest squared error
which will still be a very large squared error of performance under
many circumstances. I have tried again and again to find justifica
tions for a stable rate of growth of the money supply under realistic
circumstances. And often I do find that a stable money supply is
better than some very bad program . But it is not as good as what I
think this Congress can expect from the Federal Reserve and which
this Congress can in its instructions hold out as the proper strategies
and tactics of Fed policy.
It is right for this kind of committee when the economy is in a re
cession, as we were last December, to be critical of the Federal Reserve.
Just because it says it is lowering interest rates, that should not be
good enough for you ; when the Fed is unwilling to let interest rates
go down faster, it is keeping the monetary aggregates growing too
slowly. On such occasions themonetarists and people like myself come
before this committee in agreement . If, however, in order to have what
seems to me to be the feasible rate of real growth should require a rate
of growth of the money supply in the best judgment based upon past
patterns of experience of more than the 71/2 percent upper limit , I
think that it would be wrong, then, to crucify mankind on the
basis of a monetary rule. It's not the worst cross that the system might
have to bear, but it's not a good way of running the system .
[ Complete statement of Professor Samuelson follows :]
STATEMENT OF PAUL A. SAMUELSON, MIT
1. The U.S. economy seems now to be in a fairly vigorous recovery . Probably
11.2% annual growth rate reported for third -quarter-1975 real GNP is a bit
of an exaggeration , being attributable to temporary inventory strength that may
be spurious and is in any case all too transient. Still, in comparison with the
slow and disappointing recoveries in Europe and Japan, the U.S. has been doing
remarkably well in the face of the troublesome New York City fiscal crisis.
2. The expansionary fiscal policies that Congressional taxcutting provided for
the economy at the year's turn seems to have been vindicated by the actual pat
tern of events. Slow progress has been made on the battle against last year's
two-digit price inflation . Even if the recent reported annual rate of price infla
tion - well down from the 12 + % rates of last year—turns out to be an under
statement of what is ahead for the next year, the fears that the public deficit
would crowd out much -needed private investment spending has not been borne
out.
3. The Federal Reserve, critics think in retrospect and thought at the time,
was insufficiently militant in its expansion of credit and the money supply during
the last half of 1974. Under its own steam , and under the goad of critics, it be

56
came more expansionary in the first half of 1975. Somewhat to the surprise of
virtually all analysts, the sharp jump in nominal GNP, at 15% in the third
quarter, took place with the My money supply growing only at a 7 % rate. The
resulting sharp runup in velocity of circulation cannot seem to be adequately
accounted for either by the slight increase in interest rates or by the normal
pattern of velocity increase at the beginning of a recovery. (Why should the
New York City troubles lower the demand for money ? There seems to be nothing
in the recycling of the oil revenues of OPEC to explain the anomaly . Perhaps a
little of it can be attributed to movements in the Treasury balances. )
One cannot prudently extrapolate the recent deviation in velocity from past
patterns of experience.
4. In order to judge whether the new targets for M and M, announced the day
before yesterday by Governor Burns are adequate, one must first form a judg
ment on the likely strength in the economy in the quarters ahead and through
the November 1976 election. Given the best estimates of only moderate strength
in housing and plant and equipment spending of business, and given the quirk
in recent inventory behavior, my best estimate is that the U.S. economy does
need a repetition for 1976 of the 1975 tax cuts. This is quite independent of any
new limits on the growth of total public spending. Thus, if limitations on de
fense and other spending should be decided on , a significant fraction of such
savings would have to go into still further tax reductions if the recovery needs
of the economy are to be taken into prudent consideration.
5. On the supposition that the tax reduction program will be renewed quite
apart from any expenditure limitations , I would name as the safe goal for real
growth third quarter to third quarter to be somewhere around 7% . Realistically,
the rate of price inflation can at best hover near the recent rates of 5 % . Therefore,
we are facing as a prudent goal for policy perhaps 12-14 % annual rates of
money GNP growth. I very much whether recent weak rates of growth of M , and
M, are consistent with a continued healthy recovery . At the least we shall proba
bly have to move to the upper limit of the recently announced target range.
6. Let me conclude with some general philosophy on monetary control . There
is widespread agreement that money does matter much ; and that long- continued
rates of M growth prices. But there agreement ends. There is no converging
pattern of agreement toward a money rule or tactic that calls for the same target
in season and out. Indeed, actual experiences of recent years have undercut the
never strong case for such a monetary rule . Prior to mid-1974, my plot of M hugs
remarkable close for several years to a smooth trend : yet the worst postwar
recession followed . Similarly, the upturn in April came so soon after the weak M
growth of late 1974 as to lower confidence in over-simple M-only models .
The CHAIRMAN. Thank you , Dr. Samuelson. Thank both of you
gentlemen .
We all know, of course , that you're two of the most eminent econ
omists in the world and we are most indebted to you for your testimony.
Dr. Friedman , I intend to write to Chairman Burns and ask for a
point -by-point response to your ingenious suggestions of procedure
that would enable the Federal Reserve Board to more effectively con
trol the money supply . They seem most ingenious and when we get
his response we will make it available to you and I'd be interested in
your comments on what he's suggested .
The number of issues
Dr. FRIEDMAN. I may say , Senator Proxmire , that I have had such
responses from the Fed rather frequently over the past 6 years.
The CHAIRMAN . We'd like to get them , too.

Dr. FRIEDMAN . I appreciate it . I'm delighted that you're going to do
it.
The CHAIRMAN . Well, I take it that this last suggestion that you
had from Mr. Laurent, that perhaps hasn't been considered.
Dr. FRIEDMAN . That's a new one.
The CHAIRMAN. Now , one of the fundamental issues that we have
here, and I'd like to ask Dr. Samuelson to address himself to this

57
I think the logic of your argument is most compelling. It's very , very
hard to resist it . It makes sense that after all we put the competent
people in charge of the Fed with perhaps the best staff in Washington,
maybe the best, to use their ingenuity to have a monetary policy that
would minimize inflation and maximize growth . We do have times in
which it's clear that it's obviously desirable to restrain the economy
and other times when it's desirable to expand the economy. Your
argument against this view is that the Fed's management has been
so unsuccessful. As you know , Dr. Friedman has documented from the
beginning of the Federal Reserve Board — that the Fed has tried to
do this but the results have been counterproductive and consistently
perverse, that because they somehow can't forecast that even with the
very competent leadership they just don't seem to be going in the right
direction. Therefore , a steady increase in the money supply would let
the free market which you said you would rely on permit the kind of
adjustment that would be desirable. That is, if you have a steady
increase in the money supply and you have a tendency for the econ
omy to move ahead rapidly, then you would have the restraint that
that steady increase would exhibit with higher interest rates.
On the other hand , when you have a recession and a deflation that
that steady increase would provide an abundance of money under the
circumstances and provide for lower interest rates and therefore stim
ulation . The automatic play of the marketplace would be better than
the genius of the members of the Board .
What's your response to that ?
Dr. SAMUELSON . My response is that the inadequacies of past Fed
eral Reserve movements aren't to be explained by the fact that they
have departed from a simple monetary rule and have moved in the
direction of trying to predict that which cannot be predicted , thereby
only resulting in whipsawing themselves. Their mistakes have been of
another kind.
I think that the difficulties of their performance come from a whole
set of considerations which would not be important in a world where
money is much more neutral than the presentworld.
Let me give you an example. Suppose that you have , as you did
have in 1972 and 1973 , a worldwide boom simultaneously - Japan and
Western Europe and the United States. Suppose all over the world
you are going through a tremendous raw material boom . Every prod
uct a country like Indonesia and New Zealand can sell is selling at high
bid - up prices. You have harvest failures which add to the price pres
sure. You have a Mideast war which serves among other things to
strengthen the purely commercial OPEC cartel with a diplomatic
strengthening. The result is you have an actual inflation rate in being
which is about twice the base load inflation rate which on the basis of
past patterns of interpreting experience can be attributed to the mone
tary policy and fiscal policy of that previous period .
Now let's take that situation. If in that situation the Fed really
adhered to a fixed rule , it would succeed in fine tuning the money sup
ply but it would not succeed in keeping the pattern of output steady.
It would destabilize the pattern of output. My heart does not bleed for
the old New York Federal Reserve view that bond dealers should
have an easy time and the Nation should have stable interest rates.
I'm not interested in stabilizing that ; but I am interested in stabiliz

58
ing the approximation that we have to our full employment or high
employment potential. And I think that sticking to the monetary rule
in those circumstances, particularly not in the flexible way which Dr.
Burns does now changing the M targets anew each quarter, but stick
ing to a real rule for terminal M a year ahead - I think that that would
be very destabilizing. That's an example of what's bad about the rule
with respect to the cyclical pattern of behavior, but let me talk about
the long-term pattern .
Any sophomore who looks at the behavior of the money supply and
looks at the price level says , “ Well , the real mistake of the Federal
Reserve is not in its four -quarter movements here and its four - quarter
movements there that are sometimes too high and sometimes too low .
On the contrary, this rather stable trend around which the money sup
ply clusters is recognizable to be not a stable trend which is consistent
with long- range price stability. And so the sophomore says, “ The
whole world of the mixed economy is averaging out to 6, 8 and 10
percent annual inflation of prices.” Well, that's perfectly true, but I
don't think that the reason for the Feds making the mistake in that
chronic expansionism direction , if you regard it as a mistake, is a
matter of forecasting error. It's the fact that prices and wage rates
are now not flexible downward . With a modern welfare state, when
there is unemployment, we all have a compassionate interest in restor
ing job opportunity and we also have a political pressure to do so ,
and we all have the compassion and interest in lightening the intol
erable burdens of unemployment.
In those circumstances, when the unemployed rate goes from 51/2
percent, as it did — that's where it was just in the summer of 1974-to
around 9 percent vicinity where it was in the spring of 1975, that
does not have the downward effects upon prices and wages that it used
to have . In my opinion , the Federal Reserve is not expressing its in
dependence but is showing itself to be part of the political system
when in its deciding what the best cost-benefit policy analysis is in
each 18 months ahead, each 24 months ahead , each 36 months ahead , it
ends up deciding the thing on the up side..
I don't know a cure for stagflation . I do not know of any jury of
economists who can come together and show agreement among 12
stout jurors that there is a way of having high employment — let's say
512 or 534 percent — I won't say 4 percent — the number that was given
in an earlier period, and also having both price stability and no in
comes policy . I think that the Fed's mode of behavior, so obvious to
the sophomore and to the learned professor of economics, has nothing
to do with the question you first asked me about —what the real dif
ficulties are in departing from a stable money growth supply policy
in the direction of a stabilizing policy.
Senator PACKWOOD. Did you say that 51/2 and 534 could not be ob
tained or did you say there are not 12 good men true in the economics
profession who could agree upon a way of getting there ?
Dr. SAMUELSON. What I said was there aren't 12 representative , in
formed jurors from the economics profession who can tell you how ,
if you got there, to 512 percent, you would be able to run the system ,
the present welfare state , with price stability at those levels.
The CILARMAN . Could I ask Dr. Friedman to comment and take
into consideration the fact that the quality of the Federal Reserve

59
Board members and the quality of the staff has greatly improved,
particularly the members. We have been through the process of con
firming them and there's much less on-the-job training now . These are
skillful monetary economists, by and large, who I think are very capa
ble as I think you would acknowledge.
Given that, how about it ? Wouldn't it be wise to let them use some
discretion ? Henry Reuss once said it would take the intelligence of a
horse to operate it the way you suggest. All you'd have to do is paw the
ground. That's all.
Dr. SAMUELSON .Even a jackass could do it .
Dr. FRIEDMAN . First, I'm delighted to welcome Paul into the com
pany of monetarists. He may deny the label, but I think any careful
reading of his testimony would show that on the whole he and I are
in far greater agreement, and I may say I'm unaccustomed to that
position.
Dr. SAMUELSON . It won't last.
Dr. FRIEDMAN . However, let me point out that Paul did not in fact
reply to your question. Your question was not what an ideal group
should do. It was not what a jury of 12 men good and true of econo
mists or anybody else would agree on . Your question was , how do you
explain the fact that over 60 years men who were public spirited in
trying to promote exactly the policy that he described failed to do so ?
If you look at what the Federal Reserve says iis purpose and its ob
jectives were , it was exactly to lean against the wind. Indeed , it was
William McChesney Martin the former Chairman of the Federal Re
serve, who made that phrase famous.
They were trying to lean against the wind. Yet , as you pointed out ,
they did the opposite. Now Paul agrees with me and on this point there
is no disagreement: That in fact the simple monetary rule would have
been better over those 60 years than what the Fed actually did. What
he says is he thinks he can do still better. Maybe he can . But I say, as
I look back over the record of the Fed , the fact that they have done
worse than the rule and consistently worse than the rule, has not been
due to the fact that they have had stupid people on the staff. It is true
that the present Board members are more technically qualified, but if
you look back over the past history of the board they have always had
able people on the Board and more particularly on the staff.
So I do not believe there is any empirical reason for supposing that
by putting better men in charge you're going to get better policy. I
don't believe that is the problem .
In the second place , I agree strongly and have agreed for many
years with Paul's position that monetary policy should be determined
by Congress, that there is no room for a fourth branch of government.
I do not and have never believed in a fundamentally independent cen
tral bank . If there is to be a central bank of the kind we have it should
operate under rules which are set by Congress.
If there is to be a flexible policy ,if money supply is sometimes to go
up more rapidly and less rapidly , I agree completely with Paul , what
happens over a 2- or 3 -month period doesn't matter much . What mat
ters more is what happens over a 6- or 8- or 9 -month period . And for
this, I would rather see the Congress specify the desired rates of growth
than to have the Fed have the independent power to do it . So he and I
agres completely on that again .

60
I note that he criticizes the Fed vigorously , as I do , for their be
havior in 1974, and he agrees with me that they would have done far
better if they had followed the rule . I could go into many other
detailed points.
The CHAIRMAN. Let me just interrupt. There's a vote on the floor, and
Senator Packwood and I will have to leave . Let me point out we are
going to have to vote on an amendment by Senator Javits, which would
exempt the Federal Reserve Board completely from the so -called Sun
shine Act . We'd like to hear your advice.
Dr. FRIEDMAN . What is the Sunshine Act ?
The CHAIRMAN . The Sunshine Act would require meetings to be
open to the public by and large. There is already in the bill an exemp
tion providing that an agency such as the Federal Reserve may close
the meetings in order to avoid premature disclosure of information
which could either lead to serious financial speculation or seriously
endanger the stability of the financial institutions. They have that ex
emption, but the Fed wants complete exemption by name, and I think
your advice, if you care to give it
Dr. FRIEDMAN. I'd be glad to give it. I have long been in favor
of the Federal Reserve open market directives being made available
immediately upon the completion of their meetings . I see no justifi
cation whatsoever for the present 45 - day period of secrecy. So I
would be opposed to the amendment.
Dr. SAMUELSON. Later, I must record why my disagreements with
Dr. Friedman are much greater than his statement asserted. In con
nection with the Sunshine Act, I see no useful purpose in giving the
public the right to be present at the Open Market Committee's meet
ings or at the deliberations of the Federal Reserve , but I see no reason
why the Federal Reserve should not adopt a policy of announce
ment much sooner than 90 days.
The CHAIRMAN. As I point out , the bill does already provide that
they may close the meetings in order to avoid premature disclosure
of information which could either lead to serious financial specula
tion or seriously endanger the stability of the financial institutions.
So they have that right, but except for that they would have to
conform.
Dr. SAMUELSON. Speculation aside , there could be some problems.
If you were to have television so that nobody could interfere with
their deliberations
The CHAIRMAN. They can bar television. This is what they would
do. They have to keep a transcript of what goes on , and then that
would be open to the public later. That's the effective result .
Dr. SAMUELSON . I think that if committees like this perform their

watchdog function , it won't be important whether the full transcript
and the modes of argument at which they arrived at their decisions
are matters of public transcript record. I just don't think it's im
portant one way or the other. You will just get a lot of prepared -for
the-record ways of describing what their decisions are that they
arrive at. The important thing is that it be the practice to have dis
closure of what policies they are pursuing quicker than before, but
I think the full Sunshine Act, which is very important in many aspects
of Government, is not a useful part of the public interest in this

61

matter, and I would look with favor upon the Federal Reserve being
an exception to it .
Senator PACKWOOD. I have a quick question. You indicated a re
luctance to see these tremendous swings in employment and prices,
and you said you'd be very wary of getting a person back to work
right away and 6 to 8 months from now he's going to be in a worse
situation than now . Apart from the fact we may agree we don't
know how to keep a consistent employment or price policy, how long
should it rationally take us from today , if we follow proper economic
policies, to get to a 5- or 6 -percent unemployment and a 5- or 6-percent
annual inflation ?
Dr. SAMUELSON . Well, I think that given that we work from about
an 8 - percent amount of unemployment and many industries at only
75 to 85 percent capacity, that we can go for six quarters maybe at
112 times our growth rate, 6 percent and a little bit better than that,
which means we can do a lot better than 5 percent for a long time
six quarters. I think after about six quarters you will find yourself
reverting back gradually toward the growth rate but still something
greater. One of the very seriouscosts, in my judgment, of this last
Senator PackWOOD. I've got to stop you because if I don't make it
over there, I'll miss the vote. But at least a couple of years ?
Dr. SAMUELSON . Yes ; some regretable long time because 11 percent
growth rate is injudicious.
Senator PACKWOOD. Right.
[ Recess.]
The CHAIRMAN . The committee will come to order.
Gentlemen, I want to apologize. We had two votes in a row .
Incidentally, the Friedman viewpoint won out on the floor. By a
53 to 36 vote, the Javits amendmentwas rejected.
Dr. FRIEDMAN . I'm glad .
Dr. SAMUELSON . I was in favor of that, too.
The CHAIRMAN . The Javits amendment would have exempted the
Federal Reserve completely from the Sunshine Act, and that was
defeated .
Well, now , one of the issues that we were discussing and I want to
be sure that both you gentlemen have had an opportunity to make
adequate argument against it. I think your positions are well known
with respect to discretionary authority on the part of the Federal
Reserve Board to vary the money supply in accordance with the state
of the economy.
Now, I'd like to get into the central problem that I think we have
to confront as to whether or not the chairman is right in saying that
for the next year and through the third quarter of 1976, we should
follow this 5- to 71/2 -percent path ; is that adequate in view of the state
of the economy and the outlook for both inflation and unemployment.
Now, I understand you to say in the course of your remarks, Dr.
Friedman, that you would prefer a greater growth rate than the Fed
had had in the last few months which had been close to zero , but that
you think that it should be 3 to 5 percent.
Dr. FRIEDMAN . Not for the next year ; that the ultimate goal should
be 3 to 5 percent.
The CHAIRMAN. What should it be for the next year ?

62
Dr. FRIEDMAN. As I say, I would have made it a little lower than
5 to 71/2 percent. I would have made it 412 to 7, but it's a minor dif
ference. The main point I would emphasize is that I would like to
see those limits reduced over the next 3 to 5 years to bring them into
the
The CHAIRMAN . You’re kind of varying your fundamental position
a little bit ?
Dr. FRIEDMAN . Not at all .
The CHAIRMAN. A little bit. Now, maybe I misunderstood you. At
least you're clarifying it in my mind . I understood you to say we
should hang onto the 3 to 5 percent ad infinitum .
Dr. FRIEDMAN . Absolutely.
The CHAIRMAN . But you now indicate it should be 4 or 412 to 7.
Now I assume, in part at least , because of the state of the economy ?
Dr. FRIEDMAN. No, not because of the state of the economy.
The CHAIRMAN . Because we're up to that level and we have to adjust
downward .
Dr. FRIEDMAX. I have always argued that 3 to 5 percent is the appro
priate range and for a long time until about 1970 I was saying that
we're close enough to that that we might as well go to that immediately.
As we got increasingly far away from it and as that increasing dis
crepancy got built into the economy, I've said I want to go to 3 to 5,
but I believe it is desirable to go from where we are now to where we
want to go gradually so as not to introduce unnecessary shocks into
the economy.
The CHAIRMAN. Well , what assumptions do you make , then, with
respect to velocity ? It seems to me if you follow your argument and
assume you have a 7 - percent growth that certainly is a preferred rate
of growth, something near that in the coming year, and have 5 -percent
inflation and then have a 6 - percent growth in money supply , that's
going to take quite an increase in velocity continuing.
Dr. FRIEDMAN . First of all , incidentally, the rate of inflation you
have will not be independent of what happens in the growth in the
money supply. Now I hasten to add that the rate of inflation is a
sticky thing and it ends to have an even longer lag behind the money
supply than does output. I believe that you right now have something
likea 6-percent rateof inflation built into the economy. If you suppose
that you had something like a 6- or 7 -percent rate of My growth, the
secular velocity increase in M, growth has been about 3 percent. That
brings you up to about 9 or 10. If you now figure that during the course
of a cyclical expansion you also have a cyclical rise in velocity, you're
up to about 12 percent , and I think that a breakdown of 6 -percent real
growth and 6 -percent inflation would be tolerable. I would rather have
an 8-percent real growth and 4-percent inflation, but I think that you
can't do that and therefore I think that M , growth in the neighbor
hood of 6 percent is not inconsistent with nominal income growth in
the neighborhood of 10 to 12.
The CHAIRMAN . But you do expect to have a sharp continued in
crease in the velocity of money to make this possible without higher
interest rates ; is that right?
Dr. FRIEDMAN . No. I won't say without higher interest rates. I
believe that the cyclincal pattern of interest rates will be upward. I
believe that ordinarily during the course of a cycle interest rates have
risen during the expansion .

63
The CHAIRMAN. Looking at the straits of housing and at the enor
mous difficulties municipal obligations have , the fact that housing is
so important to the economy, that14 million people work for the cities
and States and they are in great difficulty — just yesterday there was a
decision by voters to turn down $7.5 billion in new borrowing in the
cities and States — isn't that likely to have a depressing effect on the
economy ?
Dr. FRIEDMAN. I don't believe so. I believe that this is the point of
view from which the fiscal policy that the Congress has adopted is
important. Congress has decided that it does not want any rapid ex
pansion of housing. It does not want a rapid expansion in business
investment.
The CHAIRMAN . Congress hasn't decided that.
Dr. FRIEDMAN . Implicitly, not explicitly.
The CHAIRMAN. I'm in the best position in the Congress in both the
House and Senate in this respect because I'm chairman of this com
mittee and I'm chairman of the Appropriations Committee that pro
vides the money for HUD . Other Senators and other Congressmen
also have authority and responsibility , but I think I've got as much as
anybody, more probably than anybody else , and I can tell you that both
onthe Republican side and the Democratic side we very much want to
move much closer to our housing goals. We don't want to proceed along
at 1.3 or 1.4 million housing starts. We want to go at least to 2 million
and if possible 2.6 million which is our goal.
Dr. FRIEDMAN . Excuse me, Senator Proxmire, but I'm borrowing in
this case from my colleague Paul Samuelson's famous demonstration
of revealed preference when I say Congress intends it. I don't mean
that's their implicit intent. I look at what Congress does and I ask
what does it imply ? Congress, by following a policy which has involved
a very large deficit, a deficit which has been running recently, as you
know better than I do, at the rate of nearly $100 billion a year which is
scheduled for this fiscal year to run at the rate of something like $70
billion
The CHAIRMAN . Dr. Friedman, you're really playing with me because
you know perfectly well that has far less to do with the housing — the
Housing Act — we passed an emergency housing bill that was vetoed
by the President that would have mandated an additional half million
housing starts and he vetoed it. That's the position of the Congress
overwhelmingly, the House and the Senate , both parties.
Dr. FRIEDMAN. I was speakikng about housing plus capital invest
ment and capital formation. There is a total flow of investible funds in
this country. Insofar as that flow of funds is diverted to financing
government deficits it is not available for financing capital formation.
The CHAIRMAN . What you're saying is this is a consequence of the
Congress not understanding, and I think that's correct, the implica
tions of its fiscal policy.
Dr. FRIEDMAN . Absolutely .
The CHAIRMAN. And I'm saying the emphasis is clear on the basis of
housing that we want it and we're willing to go much farther than the
administration.
Dr. FRIEDMAN. Everybody wants to have his cake and eat it too,
but you can't.
The CHAIRMAN . We could have a piece of it if the President hadn't
vetoed the housing bill .

64

Dr. FRIEDMAN . But you would have a smaller piece of capital
formation. I believe the people of this country would like to see
greaterapplication of capital to the improvement in the capital equip
ment of this country, as well as to housing. What I'm trying to say
and I'm not criticizing. I'm trying to understand. I'm saying that
the policy which has been followed of having a very large deficit has
determined the character of this expansion. It explains why this ex
pansion has been so heavily in consumption and has been so weak in
ħousing and in capital formation. From the point of view of interest
rates, there are only two things that are going to bring those interest
rates down more than temporarily. One of those is a reduction in
inflation which would bring the nominal interest rates down, and the
other is the reduction in the size of the Government deficit. An ex
pansive monetary policy , a more rapid increase in the quantity of
money, will raise interest rates and not lower them after a very brief
interval .
The CHAIRMAN . You testified the lag is now only 2 months, that if
we increase the money supply that within 2 or 3 months the interest
rates, instead of going down as you might expect with the greater
supply of funds, would go up. I'd like to ask Dr. Samuelson to com
ment on this.
Dr. SAMUELSON . Senator Proxmire, I hope that we are operating
under the following understanding : that just because I hear some
thing said in my presence and don't object does not mean that I
necessarily agree with all that I have heard .
Dr. FRIEDMAN . We know that, Paul , and it goes both ways.
Dr. SAMUELSON. And also, I hope to be able to give a clarifying
remark as to whether I think my degree of agreement with Professor
Friedman is as great as he thinks it is later, but let me now be re
sponsive to your question.
I don't think that there is a foreordained scheme of total capital
formation plus consumption, and the more that is used up in one
direction the less there is available in another direction . The size of
the cake to be eaten is affected by fiscal policy in the next 18 months
and the size of the cake to be eaten has been affected by the reces
sion. We have had less housing and less capital formation because we
have had a recession. We have not been talking about dividing up an
unchanged full employment pie in different directions. I believe it
unlikely, based on past experience, that the velocity will continue to
show increases the way that it has, and I believe that if it turns out
after 3 months and 6 months that most of the forecasts that I have are
correct and that we are not at 11 percent real growth but we are down
below what I stated to be the feasible desirable goal of 7 percent,
then I think it would be proper for the money supply to be increased
to the upper range and even possibly beyond the range. I don't
think that anybody has the knowledge now to know and stick with
the decision as to what's going to happen with respect to the velocity.
The Chairman of the Federal Reserve Board has testified his view
point. He's a man of experience. He's always worth listening to. In
1954 he believed that the recovery in 1955 would be stronger than it
actually was and he was right. The majority of the experts were
wrong and Dr. Burns was right. In 1961 he believed that the economy
in the 15 to 18 months after April 1961 was going to be much stronger

65

than the experts generally believed. He was just plain wrong. I know
he has put into the written record that he thinks it was because Presi
dent Kennedy antagonized the steel industry and the stock market
declined and so forth, but he's always worth listening to.
So when he thinks that the velocity will stretch and be compatible
with the desired rate of real growth and his own forecast given before
the House Committee was that we in fact are going to grow at 8 percent
in real terms in the next year based upon his targeted money supply
numbers , he may well be right.
I think where you divide the men from the boys and where the
policy problem becomes important is what happens if in the develop
ing pattern of revealed experience he turns out not be right. Do you
then stick with those numbers premised upon his being right. And
with the full force of my ability to testify before you , my counsel to
you is not to stick with those numbers if velocity does not stretch in
that way and be prepared to hold him to the upper range and per
haps modify his ideas and your own as to what is the proper cone
in the period that follows.
I believe we are in a vigorous recovery . That's a fact and we should
not second -guess the fact, but we should be ready to recognize that if
total gross national product growth recedes to where final gross na
tional product growth has in fact been growing and recedes even
below that, then monetary policy should be adapted to that.
Dr. FRIEDMAN . May I make one more comment ?
The CHAIRMAN. Yes, sir.
Dr. FRIEDMIN . If you will pardon me, I would like to differ with
your statement that the basic issue is whether the monetary growth
rate specified by Chairman Burns is adequate for the coming year for
the following reason : It's a basic issue only if in fact the Fed can de
liver what it says it's going to deliver.
The CHAIRMAN . What I meant to say is the basic issue before the
committee now is whether or not the range is still correct, the range
of monetary growth is correct . That's what the resolution is all about.
That's what we held our hearings on. That's all I said .
Dr. FRIEDMAN . I misunderstood. Because I believe that from a
broader perspective the basic issue is whether the Fed can deliver
within that range. What difference does it make what they say they
are going to do if in fact, as we have discovered over the past, what
they actually do deviates so far from what they say they are going to
do that their advance statements are not a reliable guide to the event.
That's why I would stress on you and urge on you the importance for
your purpose of the relation between performance and goals.
The CHAIRMAN . Dr. Samuelson, would you agree that these changes
in procedures would give the Federal Reserve more control of the
money supply and it's desirable that we proceed along that line ?
Dr. SAMUELSON . I think that some of the procedures mentioned
could enable better fine tuning of the money supply. I do not think
that it is particularly desirable to proceed along those lines. I think
it'sa very unimportant success if achievable , and if achieved
The CHAIRMAN . Well, if it's achievable , why wouldn't it be impor
tant for them to be able to do what they intend to do ? Under any cir
cumstances, shouldn't they be able to achieve their goal ? If they can't
achieve their goal, it seems to me we have a really fruitless situation.

66
Dr. SAMUELSON. I think this is an unimportant reform but I have
no objection to it.
Dr. FRIEDMAN . I don't understand you, Paul . Do you really believe
it would have been unimportant if they had achieved their goals in
the last half of 1974 ? In the last half of 1974 , month after month
they said in their directives that their target money growth rates were
in the range of 5 , 6 , 7 percent for Mı, but month after month they
were coming in at 1 percent. Do you think it would have been unimpor
tant if they had achieved what they said they were trying to achieve ?
Dr. SAMUELSON . I believe the shortfall of the performance of the
Federal Reserve in the last half of 1974 was not materially affected by
the difference between the reform now being discussed and the present
procedure.
If I may be responsive to your question , time being limited to give
you my viewpoint, Senator, let me point out to you as germane to the
question that you asked me that the Chairman of the Federal Reserve
modified slightly the range with respect to the M , and the M3
targets and he gave an explanation, which exact wording I do not
remember, but as I read it, I discerned in it an implicit prediction that
it was quite possible that the deliberate thrust of Federal Reserve
policy would turn out to result in disintermediation associated with an
increase in interest rates, and I think he's perfectly right that if that is
permitted to happen it will show a different calibration between the
M, and M, and MZ rates than if it does not happen.
Also, in response to your question about housing, I think that if
that disintermediation does take place , that one of the prime con
tractionary incidents of that process will be with respect to housing.
Now I have no firm target for the subpart of GNP which is housing
and if, because plant equipment expenditure comes back fast and con
sumption propensities are very strong, it turns out that the housing
industry is squeezed by the increase in interest rates which is incident
to that process, and if the whole economy is growing at a rate of 7
percent and we are eating into the unemployed , I would not think that
that is a bad outcome.
However, if Congress in its wisdom wishes to give a special subsidy
to housing and if it can override Presidential vetoes on that, again,
that seems to be that that's a problem which macroeconomic policy
administrators must adjust to.
But what I think would be a misfortune would be if the disinter
mediation takes place and if interest rates increase in a developing
scenario where the rate of growth of output is only 4 , 5, and 6 percent
in real terms, and the hard total of average unemployment and the
amount of long term unemployment turns out to be a very slow core
to melt. So I think as a vigilant watchdog , that your committee will
want to see whether the Federal Reserve is showing an undue pre
ocupation with what is one of our two important problems now : The
problem of inflation, as against a proper concern for the rate at which
we eat into the very amount of slack in the system now and the amount
of unemployment.
If our system does grow at a rapid rate we can have more of all
kinds of cake. In the period while you're growing beyond the long run
trend potential of the economy, which is now perhaps somewhere in
the vicinity of 4 percent, you can have an increment of consumption

67
and you can have an increment of capital formation divided between
housing and other forms — an increment which is transient but which
is verydesirable that the society have because that's the shortfall which
we did not have in the recent recession.
Although the recession became so obvious to everybody after the
summer of 1974, it was first looked on as a growth recession . The
economy since March of 1973 was proceeding below its trend rate and
we were having less of all kinds of cake. The reason for it was in order
to fight inflation , and in a measure given what the situation was there
was merit in this , but this effort did get out of hand. I think this issue
is very important, and that it should really be the main focus of your
committees with respect to witnesses like myself and Federal Reserve
officials — in order that the desired feasible amount of real recovery not
be thwarted by Federal Reserve policy which could be prevented .
The CHAIRMAN. Now along that line, Dr. Samuelson, can you explain
what has happened to interest rates over the last 3 or 4 months ? We
have had a sharp recovery. We have had a diminution in the rate of
increase in the rate of money supply and we have had interest rates
going down. Now this would seem to confirm what Dr. Friedman has
indicated, that as the money supply declines, the market somehow
adjusts and you can have a falling of interest rates in anticipation of
perhaps less inflation . What is the explanation for this ?
Dr. SAMUELSON . I do not have an explanation for the apparent shift
in the demand for money downward . Now there are many ways of de
scribing that shift in demand for money downward . You can describe
it by saving that interest rates did not grow as much as you would have
expected them to grow with the money GNP growing as much as it did
and with the money supply not growing any faster than it did , interest
rates are lower than you would have expected them to be on the basis
of the past pattern of experience .
The CHAIRMAN . What actually happened is that since July interest
rates have been falling at the same time the economy has been growing
rapidly and at the same time the money supply has not been increasing.
That's what puzzles me . Unless we accept Dr. Friedman's notion that
the money supply has been increasing at a slower rate and this fact has
been somehow adapted by the market and therefore they figure there
will be less inflation — I don't undertand the mechanism by which this
is achieved with lower interest rates.
Dr. FRIEDMAN. I wouldn't want to let that stand as the whole ex
planation I would give for the month -to -month movement in the in
terest rates.
The CHAIRMAN. This is the phenomenon that appears.
Dr. FRIEDMAN . I would like to give you an alternative explanation.
The initial decline in short term interest rates is what caused the Fed
to lower the money supply rate because the market interest rates fell
beneath what they thought it was going to be, so they were pulling re
serves out. The continuation of the decline is the result of two phenom
ena : the one you were describing, the market recognition that these
slow rates of monetary growth portend slower economic growth , slower
inflation , but also there's been a second very important factor in the
past month in particular. That has been the New York crisis. The New
York crisis, in my opinion , has lowered short term interest rates. It has
lowered short term interest rates in two ways. First, the uncertainty

68
engendered by the New York crisis has caused a great desire for li
quidity. Under thosecircumstances, you have had a widening differen
tial between rates of interest on short term securities and long term
rates. It's short term rates that have mostly gone down. You have had
a steepening of the yield curve. This also shows up in the municipal
market where the rates of interest on very high grade securities have
gone down.
The CHAIRMAN . Why is it that the New York crisis has resulted in
diminishing demand ? That sharply conflicts with precisely the ques
tion Dr. Samuelson asked. He said in his statement, “Why should the
New York City troubles lower the demand for money ?” The implica
tion is that it shouldn't . Why shouldn't it ?
Dr. FRIEDMAN . The answer to that is we have to distinguish money
from credit. It hasn't lowered the demand for money but it has low
ered the demand for certain kinds of credit.
The CHAIRMAN . Isn't that the same thing ?
Dr. FRIEDMAN. No, it's not the same thing. Money is money. Credit
is credit. And the talk of the demand for money as identical with
the demand for credit is, in my opinion , a major source of confusion
in the monetary area.
If we go to the credit market for a moment you can understand why
the uncertainty engendered by New York has caused everybody to try
to be liquid. It has therefore caused people to try to sell long term
securities and buy short term securities and this has caused an increase
in the demand for Treasury bills, let's say, versus corporate bonds.
Dr. SAMUELSON . And that's lowering interest rates ?
Dr. FRIEDMAN. This has lowered the short term interest rates rela
tive to the long term rates because it has produced a steeper yield curve .
Dr. SAMUELSON . The increased demand for Treasury bills lowers
their yield ?
Dr. FRIEDMAN . Of course. It raises the price of Treasury bills and
lowers the yield. The yield is the inverse of the price.
The CHAIRMAN . We have had a general reduction in rates of long
and short term .
Dr. FRIEDMAN . Next, the second effect of the New York crisis is
everybody has looked at the effect on the municipal bond market
and they haven't seen that the drying up of the municipal bond
market has released more funds for other things. So municipal bond
prices have gone down or yields have gone up and other yieldson
the average have gone down. So I would say that the New York crisis
has done two things. It has steepened the yield curve and it haslowered
the yield curve for all securities other than municipal and State
securities.
Now I believe this is going to be a temporary phenomenon .It won't
last, and I think you ought to reconcile yourself to the fact in a few
months, as this New York crisis passes over, interest rates are going
to resume their upward march if we have a decent expansion. If the
Fed were to keep the money supply growing at zero, then interest
rates will not start to go up again, but if the Federal Reserve does
what it should do, which is resume a moderate rate of monetary
growth , the economy will continue to recover . That will drive up
the demand for loans. It will increase the demand for credit and
interest rates will start up again in 1976 .

69
The CHAIRMAN . Dr. Samuelson ?
Dr. SAMUELSON . Yes ; it may well be that I would want to agree
with the effect of the New York crisis upon short term rates and I
thought in my testimony I stated it as a question because I started
out really with the notion that perhaps there's something in the New
York City crisis itself which might help to explain this, and then I
said it wasn't clearly obvious to me what that something was. As
go back on the airplane and benefit from Professor Friedman's sug
gestion , I may find myself agreeing with that.
[ Professor Samuelson requested the following paragraph be inserted
in the record :]
On reflection, I have to agree that the New York scare can help explain why
short term interest rates are twisted downward relative to long - term rates. But
it is not clear to me why, making people more scared and more desirious of
being liquid, should reduce the demand for money, when M is written as a func
tion of the level of money income, the level of short-term interest rates and the
level of long-term interest rates.
I would like to give another reason why, given the change in the
demand for money—and by the way, that shift in demand for money
may be less than we have been talking about because the 11 -percent
increase in the money GNP may be spurious and on revision come
down a little bit. It alsomay have to do primarily with inventory de
cisions which really don't require much money to carry them out. But,
I think , there's another explanation and this is a fact that there are a
number of people in the money market who know what monetarists
believe, and whether or not they themselves fully believe in the mone
tarists' doctrines they are under the impression that somebody else be
lieves in them , including committees like this — and I don't mean to be
facetious at all, and I don't mean to be perjorative about the process
that I'm talking about. Such individuals when they look at what's
been happening to the money supply in terms of the target say to them
selves, "Well , Dr. Burns and his colleagues are going to atone for their
shortfall in almost moving outside of the range of targeted M growth
on the downside . Hence we can be pretty sure that just ahead there's
going to be a period of renewed money growth, whatever has been the
case in the immediate past.” And since they believe that there are at
least some months during which an expansion of the money supply will
have a depressing effect upon interest rates, they are taking specula
tive and investment positions in some in the direction of getting in
upon this movement of lower interest rates, thereby reinforcing
the movement.
I don't think this is an important matter from the standpoint of a
year. I think the more important problem from the standpoint of a
year is what is happening to price inflation .
I believe that by no mysterious process but by the haggling ofthe
competitive market, that the putative rate of price inflation which is
expected for the years to come -- and this is a probability spread and
not a firm number — is very important in deciding where the equilib
rium nominal rate of interest tends to be struck between the buyers
and the sellers, between the lenders and the borrowers. We have had
some good news on the inflation front compared to earlier in the
summer when the Russian wheat deal seemed to be sending up food
prices, when there was a drought in the Middle West, when various

70

oil catchup and energy price outlooks were bad , and when the market
was getting to be scared . So there are some movements in the demand
for money which you ought not try to explain too carefully because
they are part of the regular motion of the wobble of the demand for
money as factors operate outside of the few major factors that we
pick up in our long-term patterns of experience. These patterns are
notmultiple correlations with perfect fits in the past.
The question I was addressing myself to in the testimony and in the
privacy of my study is whether this money demand or velocity has
been a little bigger than usual in this particular period, and I don't
think that one quarter makes a glacier ice age. And I don't think that
a real significant shift in demand for money can be detected from
experience no longer than this.
Dr. FRIEDMAN. I just want to make one brief comment as to long
term interest rates. I hope you recognize how low long-term interest
rates are fundamentally compared to historical experience. I happened
this summer to be working on the longterm experience of interest
rates over a 90-year period . From 1880 to 1970, the average interest
was 4.7 percent , but price inflation was only 1.1 percent. So the average
real interest rate was 3.6 percent.
Consider today a corporate bond paying 10 percent - let's make it on
the high side . If today you're in an incometax bracket in which you pay
a 30-percent marginal rate, that leaves you with a 7 percent yield. If
the inflation rate is 6 percent, you're left with a 1 percentage point
real yield compared to a 3.6 - percent yield on the average over the past
90 years. If you're going to get a 3.6-percent rate of return today with
6 percent inflation and if, to take a different example , you're in the
50 -percent bracket, you need a 19.2 -percent bond yield. So that by any
calculation compared to the past you're not going to get long -term
rates down unless you get inflation down. No use kidding yourself.
The CHAIRMAN . That may or may not be the case . I think you may
he right. But after all , it's a matter of where your money goes, where
it can go. It may be that lenders will be in the position that the best
they can do is reduce the erosion of their capital to about 2 percent a
year. There's nothing fixed or written on the wind that says you're
going to get 3.6 percent forever or even 1 percent.
Dr. FRIEDMAN . I agree with you . In that case , they can consume it
and they will. We have the evidence from a long period of history,
Senator Proxmire . And the real rate of return on capital over hundreds
of years has ranged around 3 percent.
The CHAIRMAN . Yes ; but this all depends, of course, on expectations.
Dr. FRIEDMAN . Absolutely.
The CHAIRMAN . Let me get into the final question because the hour
is late.
We are very , very concerned about this New York situation . I think
I understand where you gentlemen stand on it, but it would be most
helpful for the record if you could tell us with an understanding of
what the options are . The options are two . No. 1 , the President has
made it very clear that he wants to go the bankruptcy option , and then
it's my judgment if we go the bankruptcy option, the Federal Govern
ment is going to have to provide a guarantee for the referee in bank
ruptcy notes that he issues to provide for essential services. That was
the unanimous conclusion incidentally of the committee, all Demo

71

crats and Republicans, after listening to weeks of testimony; and al
though there's great difference on the options, that was the unanimous
conclusion.
The involvement of the Federal Government in a bankrupt New
York would be likely to last for a long time because it would be so hard
for the city of New York and the State of New York to get back into
the capital markets. Thirty States prohibit the investment by their
banks in municipal obligations within 10 years or so of a municipality
going bankrupt, including big States. Also, trust accounts are pro
hibited by law from being invested in such securities. Also, there's a
provision in the New York State constitution that would provide for a
loss of about 40 percent in property taxes for New York once it goes
bankrupt. All of that would have to be made up . Also, you have the
situation that when they are bankrupt they have to have some way ,
find a way of bridging more than a billion - dollar gap in a period of
about 7 or 8 months in their operating budget to maintain essential
services .
So the Federal Government would be involved either way . The Fed
eral Government would be involved in the first place with a Federal
court that would have to go in ; in the second place, with a Federal
loan .
The option that we provide is that we take advantage of the experi
ence New York City has had and New York State has had, too, over
the last 4 or 5 months. That experience has been , in my view, a good
experience. They have cut employment 33,000, more than 10 percent of
their work force, and it's been pretty ruthless. They have cut 18 per
cent of their classroom teachers. They have cut 17 percent of their
narcotics unit. They have closed down libraries during the evening.
They have frozen wages for 3 years.
There's more progress they can make , especially in pensions and in
other areas, but they are moving in this direction .
They also have a situation where the Emergency Financial Control
Board gets every penny that the State gets in taxes. The mayor
doesn't get it. They get it , and they only disburse it according to their
financial plan.
What we provide is a very tough board consisting of Simon, Burns,
& Dunlop who would have to be satisfied that the guarantee would
work out without any loss to the Federal Government. The financial
community, the mayor, the Governor are convinced it would work if
we gave them a $4 billion guarantee. We require the bondholders to
take a writedown. They would have to extend their maturities. They
hare to reduce their interest rates. We discussed that with the big
banks, and they have agreed to do that — not all, because we can't
reach the 160,000 lenders, but we can reach the big banks, and we have
gotten a substantial proportion , about half of the debt would be writ
ten downwards.

So we think we have put a package together which would give them
the option of following the honorable policy of paying their debts,
standing up and meeting their obligations, rather than what some peo
ple would regard as a dishonorable policy or a policy with less honor
of going bankrupt, of being on their back , being dependent.
Now , I have obviously not presented this in an objective way, but I
have given you my view , and I'm sure both you gentlemen know a

72
great deal about this and know where I have perhaps gone a little too
far in describing the situation .
So, Dr. Friedman, give me your true opinion and then Dr.
Samuelson.
Dr. FRIEDMAN . As you quite properly said, you put me in the posi
tion of “ when did you last beat your wife," and I have to say I did
beat my wife, because despite your persuasive remarks, I'm opposed to
any Federal guarantee of any securities of New York City before or
after default .
The CHAIRMAN . Before or after default ?
Dr. FRIEDMAN . Before or after.
The CHAIRMAN . Would you call out the troops?
Dr. FRIEDMAN . I believe that is a figment of the political
imagination .
The CHAIRMAN. How can that be a figment of political imagination
when you have — here's what you have
Dr. FRIEDMAN . Expenditures on policemen , and firemen in New
York City amounts to 9 percent of the New York City budget.
The CHAIRMAN. They have the police, the fire, the sanitation work
ers , the water system , the transportation system — they have to pay
their electric light bills. They have a tremendous amount of
Dr. FRIEDMAN. I believe that New York City and New York State
together are going to have to work that out.
The CHAIRMAN . Would you close the schools ?
Dr. FRIEDMAN. I'm not deciding New York City's policies. You're
asking me whether I'm in favor of a Federal guarantee. Again , you
keep on asking me when did I last beat my wife.
The CHAIRMAN . They have a priority list. Life support services
are first, but you go down the priority list and fifth only before note
and bondholders are schools. So you'd have to throw these kids who
had nothing to do with this situation out of classes, a million of them .
Dr. FRIEDMAX . Senator Proxmire, I'm not going to second -guess
what New York City does. I'm not going to try to prescribe how they
should handle it. I think that the restrictions you have introduced into
your bill are excellent , but nonetheless, I would be personally strongly
opposed to the Federal Government guaranteeing any securities of
New York City before or after default, and I realize we could take
hours to discuss it.
The CHAIRMAN . Or making any loan after default ?
Dr. FRIEDMAN. Or making any loan after default. I am in favor of
the Federal Government continuing its expenditures on those pro
grams for which it is responsible , but not making any guarantees or
any loans to New York City. Now, I recognize that that's a tough , ex
treme position. Maybe it's wrong. I'm sure we don't have the time now
to go into it in detail, but I'm trying to respond to your question as
fundamentally and as frankly as I can .
The CHAIRMAN . All right. Dr. Samuelson ?
Dr. SAMUELSON . I helieve that in the absence of Federal support in
one form or another for New York City , that it will go into default .
I believe that after it goes into default, the Federal Government will
in fact find itself in a great variety of guarantee and subsidy programs.
I think that the very occasion of default in all likelihood will leave

73
the Federal Government in the end with a much more expensive total
cost of subsidy thạn if default can be prevented.
On the other hand, in the absence of default, it will be very hard to
bring home to the effective “ real- politik ” the necessary contraction of
expenditure in New York City that would be needed if New York City
is ever again to get a loan without Federal subsidy.
So if the Federal Government in advance of default provides a guar
antee program it seems to me extremely important to scrutinize it and
reinforce it with all of the measures that can increase the pressure upon
New York City to live within what is decided to be its necessary
budget.
Now I may say — and it's a necessary part of my answer - that I
think many of the responsibilities thrown on New York are national
responsibilities. The fact that anybody can move into New York City
from Puerto Rico or from Appalachia and from the South and so forth
is part of the cause of the problem .
Second , anybody can move out of New York who has taxpayer ca
pacity and that's part of the problem . So I think Federal revenue
sharing should be more heavily involved.
On the whole, I think that the Nation would end up better off with
this rescue bill than without it ; but I do expect that there is an open
end liability involved in the bill that nobody can at this time realisti
cally assess. I don't mean that it's in the bill and it's written out in
black and white. But if it turns out that New York doesn't mend its
ways and that the fiscal gap has increased, you haven't the ability any
more than you have now, in my judgment, to walk away from the
problem .
The CHAIRMAN . We also insist in the bill that they balance their
budget in the fiscal year beginning July 1 , 1977, which they say they
can do and must do and will do .We insist on that. Wehave the guaran
tee only a 1- year guarantee and the guarantee expires if they are not
on target, if they don't stay on target .
Dr. SAMUELSON. Well, I think that those safeguards are very im
portant, but I don't know whether any person can be sure that in
the event the powers that be can live up to their agreement, because
it's a pluralistic, democratic coalition of forces you're talking about.
If what wedo is start putting chips on shoulders of civil servants'
unions and start knocking those chips off, it may be a very expensive
process, and then the solid agreement is ended and, of course
The CHAIRMAN. This control board can reject any contract. As a
matter of fact, the emergency control board rejected a teachers' con
tract which had never happened before in New York, and the control
board, as I pointed out, is about as tough — and with Dunlop on it,
about as capable and successful in this kind of thing as I think you
can be.
Dr. SAMUELSON. I applaud and recognize the importance of this, but
I think when there's a confrontation and the board has its advice
followed and the garbage is then rotting in the streets and the rats
are beginning to come out of the manholes, then the problem does not
automatically go away,
The CHAIRMAN. That's right. That's the problem , you see Dr. Fried
man. You don't have a hundred Friedmans in the Senate and 435
Friedmans in the House. You may have a Friedman as President of

74
the United States. I'm not sure . I think we may have. But under these
circumstances, the Congress of the United States and the Govern
ment isn't going to stand still when it confronts this situation of rats
coming out into the street and the children coming out of school.
We're going to move and that's all there is to it. Perhaps we can argue
theoretically that we shouldn't, but we're going to. We're going to get
involved .
Dr. FRIEDMAN. The rats aren't going to be coming out in the streets.
The CHAIRMAN . Come on .
Dr. FRIEDMAN . If I'm Mayor Beame, then this is the picture I paint.
The CHAIRMAN . They wantto do exactly what you want to do but
they want to do it over a workable period. If you try to do this in 3
months, if you try to make this cut in 3 months, the effect can really
be catastrophic. The only way you can do it probably is to close down
the schools throughout
Dr. FRIEDMAN . I dont believe it .
The CHAIRMAN . And put a million kids out of school.
Dr. FRIEDMAN . I dontbelieve it.
The CHAIRMAN . We looked at it, the arithmetic of this.
Dr. FRIEDMAN . You have much greater evidence on this than I do
and I cannot quarrel with you. Maybe if I had gone over the same
data as you have gone over I would change my view. But at the mo
ment, I havn't gone over that data and I'm of the opinion that
The CHAIRMAN. Senator Brooke, who did a very strong job oppos
ing our guarantee bill, wanted to go the default route but he was very
firm in insisting we should provide loan guarantees on the default
route . In fact, he made a strong fight for it . I think that's the view of
most of the people who oppose the guarantee. Senator Jim Allen of
Alabama said we have to give New York help, Senator Allen from
Alabama. So I think you don't represent what you would call the ma
jority in the Senate with a position of doing nothing.
Dr. FRIEDMAN . As you know , that's hardly ever been one of my
goals.
The CHAIRMAN . That's one of your most endearing qualities.
Gentlemen , thank you very , very much. I apologizefor keeping you
so late and the long recess .
Dr. SAMUELSON. May I beg your indulgence so that I may put in
the answer tothe question which because ofthe interruption I had just
started on?
The CHAIRMAN . All right. We may have some more questions for
you.
Thank you gentlemen. The hearing is now adjourned .
[Whereupon at 12:55 p.m. , the hearing was adjourned. ]
ADDENDUM
Dr. SAMUELSON . Dr. Friedman exaggerates my agreement with his
defense of the fixed -money -growth rule. Of course I think that mone
tary expansion should have been greater in the years 1929–33. But that
is in agreement with my own " lean against the wind” optimal-sto
chastic-control strategy, and only by inadvertent coincidence in trivial
agreement with Friedman's money rule. It is a false dichotomy, which
I reject , to argue in the Friedman manner : “You must choose between
the rule and discretionary policy. In the past Fed policy has often been

75
cum -cyclical rather than contracyclical , and that is the inevitable con
sequence of not binding yourself to the rule. Samuelson's discretionary
policy might for the sake of the argument be deemed to work out as a
more stabilizing procedure than the rule ; but it is a species of the
genus of discretionary Fed policy , and there is some reliable law of
politics and bureaucracy that must convince every reasonable jury
which shows that every attempt to use good discretion must result in
your actually using bad discretion. Hence the rule is our only salva
tion .” With respect, this is a tissue of logical nonsequiturs ; and it is
also a cascaded sets of speculations about the empirical likelihoods of
future politics and Fed decisionmaking. Whatever my admiration of
Dr. Friedman in the area of permanent income analysis, of penalties
that may come from pegged exchange rates , such excursions into the
field of political analysis do not encourage my agreements with him .
Here I am not trying to insist on the correctness of my views over his,
as to make clear that what he calls the great agreement between us
rests on an incorrect understanding of my position , its empirical hy
potheses and its deductive logic.
Here is just that indicative example. In my testimony I have had
to observe that recent variance in nominal GNP has a smaller part of it
explicable in terms of variance of the money aggregates. On the hypo
thetical supposition that the jury agrees on this reduction of R² of
simple monetarist regressions as applied to recent and future events,
one asks Dr. Friedman , “Would such a lowering of Rº increase or
decrease the divergence between your rule and the optimal stochastic
programming strategy ? ” Dr. Friedman replies that the worse the M fit
the more the rule is confirmed . On reflection , I do not think he will
want to make so unqualified and paradoxical a statement. There are
certainly some causes of a reduction in Rể that could justify the Fried
man answer : the case where random errors are imposed upon what was
previously a clearcut a [ PQ ] /am might be such a case ; but precisely
that case is the one in which fiscal and other policy parameters than
monetary policy will most commend themselves to the jury, in defiance
of a simplist monetarist view.
In any event, that was not the case envisaged in my testimony
Rather the jury is asked to consider a case in which long autocorrelated
waves of exogenous events — harvest failures, OPEC energy price rises,
etc. — are newly imposed on a system. In that case R’ properly registers
a fall. But with no change in the potency of M, and with the exogeneous
errors of a positively autocorrelated sort, it can be shown by the princi
ples of stochastic optimal control that the optimal policy path departs
even more from the rule than it did previously. Q.E.D.