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July 26, 1972
7:00 p.m. CDT (8:00 p.m. EDT)

Lessons to be Learned
Remarks by J. Dewey Daane
Member, Board of Governors of the Federal Reserve System
Before the School for Bank Administration
University of Wisconsin, Madison Campus
Madison, Wisconsin
Wednesday, July 26, 1972

As I thought about possible topics for my remarks this
evening, it seemed to me that it might be useful to reflect with you
on the lessons to be learned from my own experience as a central
banker, now in my 34th year with the Federal Reserve.

I have not

known Byers Miller over all of those years, but for most of them, and
have always valued his friendship and wisdom and am most appreciative
of this opportunity to be with him and all of you this evening.


holds true especially for your president, Ray Kolb, who is another old
Fed friend from many years back.
When I was in Richmond, Virginia, long ago with Byers, one
of my associates at the Fed Bank there owned an early postwar model
MG sportscar.

In those days the owners1 manuals were more complete

than they are now and one of the key passages in the MG manual read
as follows:

"If a strange noise should emanate from under the bonnet

(hood), do not proceed in the hopes that matters will right themselves.1
In some 34 years of experience dealing with problems of
monetary policy, international financial affairs, and economic
stabilization, I have come to recognize that this principle has a much
broader application than merely automobile maintenance and repair.
Time and time again the problems that have developed in the economics
sphere, though they may have seemed transitory at the outset, have in
fact proved to have great durability.

Nowhere has this been more true

than with the balance-of-payments problem of the United States, which
has persisted now for close to 15 years, and with inflation, a recurrent

and serious problem throughout this postwar period and inextricably
interwoven with our balance of payments.
What lessons have we learned over the past decade or more in
dealing with these two vital and interrelated issues?
The most recent noise under the hood of the international
monetary system--the floating of the British pound--points, in my judgment,
clearly and unequivocally to the first and most important lesson of all:
there is no substitute for sound domestic economic policies in achieving
or maintaining external equilibrium.

For the United States the principle

translates into what is now almost a truism, namely, that there are no
quick and easy solutions to our balance-of-payments problem -- yet its
resolution is essential to the restoration of a durable international
monetary system.
Over the years we have tended, with indifferent success, to
deal with our external deficits by measures designed largely to provide
temporary relief rather than correcting a structural problem.
Restrictions on capital outflows began with the Interest
Equalization Tax in 1963, when rising capital outflows were eroding
the gains that were then occurring in the trade balance.

But instead

of being temporary the restrictions had to be intensified as the trade
balance deteriorated following the peak surplus of $7 billion in 1964.
And as extended time and again, and amended, such restrictions have
become less effective and less relevant.
of the United States position.

They illustrate the paradox

Efforts by such means to shore up the


current balance-of-payments position induce a relaxation in efforts
toward the correction of a basic disequilibrium.
We have sought quotas on imports of various types of goods
to relieve pressure on particular industries, and this suggests that
pressures for quotas may again intensify if trade deficits persist.
We have negotiated financial arrangements with some countries
covering their claims on our reserves.
And we have tied economic aid to purchases in the U.S., among
many other actions of the same type.
None of these actions were successful in reversing the
deteriorating trend in our balance of payments which led to the drastic
actions of last August.

On the other hand, the realignment of exchange

rates achieved in December, through the Smithsonian Agreement, should
in time make a major contribution to improving our basic position.
Today, some people look for an easy escape in the name of
"greater flexibility" of exchange rates.

Certainly the old adage that

"steel that bends is stronger than iron that breaks" is true of the
international monetary system as well.

In the past, unnecessary rigidity

crept into the fixed rate system which had served the world so well
in the post-Bretton Woods period.

But the obvious need for prompter

moves to avert long overdue changes, with possible disruptive
consequences, does not warrant a swing of the pendulum completely in the
other direction.

And such a swing cannot, despite the wishful thinking

of many of its proponents, in truth promise to be a substitute for
sound economic policies or to provide relief from the constraints of
achieving domestic stability.


There frequently appears to be a lack of awareness among policy
makers at home and abroad that the U.S. in fact is subject to a stronger
discipline, that of the determination of the American people to enjoy
the fruits of relative price stability.

This discipline holds forth the

promise that we will in fact reap the potential advantage from the
Smithsonian Agreement.

Against the diminishing success of other palliatives

aimed at reducing our balance of payments, it points to a second and
related lesson, namely that the United States must follow effective internal
stabilization policies and win the battle of inflation.

This is not mere

For our failure to control inflation after the mid-1960's was

a key element in the rapid deterioration of our balance of payments.


would be an oversimplification to describe changes in world competitiveness
in terms of relative price changes alone, and there is no wholly satisfactory
way of comparing trends in costs and prices among countries.

But I believe

we can trace the course of events fairly well by using a measure of unit
labor costs in manufacturing.

On that yardstick, the U.S. performance in

the 1950's was better than all other industrial countries except Italy and

And from 1960 through 1964 unit labor costs in the United States

were stable while in European industrial countries, and even in Japan,
they rose sharply.

But in the period from 1965 through 1970 unit labor

costs in the United States rose nearly 4 per cent annually, against one
per cent for Japan and with other major competitors in between.


relative shift in the behavior of production costs was a major factor
accelerating the dramatic decline in our trade balance from a surplus of
almost $7 billion in 1964 to a deficit last year of nearly $3 billion.


The inflation during the latter half of the 1960's had significant
adverse effects on the U.S. domestic economy as well as on our balance of

There is no simple way of measuring the social costs that result

when costs and prices are out of control for an extended period.

But during

this period (specifically the years 1966-70) our productivity gain ran far
below its long-run growth rate«

By 1970 the cumulative shortfall was

roughly 6 per cent in the index of output per manhour -- the equivalent
of about $54 billion of annual product at today's prices.
That is the loss for just one year —
in productivity growth.

1970 —

due to the shortfall

There were also losses before 1970 -- and after.

Indeed, once a nation falls behind its potential level of productivity,
it may take years to regain that potential, and the amounts lost in the
years between can, of course, never be recovered.
It would be wrong to argue that the productivity slowdown was
attributable solely to inflation.

There were other factors —


the gradual change that has been taking place in the age structure of the
labor force.

But the renewal of productivity gains in 1971 at rates above

the long-term average suggests that factors peculiar to the 1966-70 period
rere predominantly responsible.

And I would suggest that a major identifiable

factor was our rate of inflation.
A third lesson emerges from the second, namely that the U.S. cannot
by its own policies ensure the correction of our balance of payments and
the viability of the international monetary system over the longer run.
Continuing cooperative efforts among the countries most concerned are

Other countries have assumed a relatively more important role

in the functioning of the system; they have to share, and in fact have been


sharing, in the burden of adjustment.

As we move forward in restructuring

the system, there is a clear need to take account of the underlying
economic realities and particularly the more nearly equal distribution
of economic power in the world.

It has taken us a long time to learn to

accept, or at least to recognize or acknowledge, the long-term shift in
the economic balance of power and competitiveness away from the United
States and toward other industrial countries —

most notably Japan and

That shift is the culmination of the resurgence of the Common
Market and other industrial countries following World War II from what was
virtually economic paralysis at the end of the war.

These countries —


our assistance -- worked hard to raise the real incomes of their people and
in so doing increased their importance in world trade.
rise was achieved by Japan.

Her share of world exports of manufactures

was only 1-1/2 per cent in 1950.

The most spectacular

It increased to nearly 8 per cent last

Similarly, Germany's share of world exports rose from under 4 per

cent in 1950 to 12-1/2 per cent last year.

In contrast, the U.S. share in

world trade was 18 per cent in 1950 and had declined to 14 per cent last
Looking back, then, we may have misjudged for many years the
nature of our persistent balance-of-payments deficits because we failed
to take into account the extent to which fundamental economic relationships
were changing.

Looking forward, we need to take account of the greater

economic weight of other industrial countries, both individually and in
combination, to give more voice to the less developed countries, to break


down trade barriers and avoid inward-looking economic blocs, and to provide
a more orderly process for the provision of world liquidity.

We need to

make the international monetary system more responsive to the inevitable
differences that emerge between the economies of various countries.
Prompter adjustments to avoid the build-up of large imbalances are
Let us not make the mistake, however, of assuming that achieving
the necessary somewhat greater flexibility of exchange rates would for any
length of time give us or any other country an easy escape from the external
pressures to maintain a rising productivity curve or from the internal
pressures of excess aggregate demand.

A declining exchange value of the

currency that is forced by rapid increases in domestic costs and prices
simply adds further to costs of production as import prices rise —
it still more difficult to regain control of the economy.


While we need

exchange rate adaptability to match changes in underlying economic circum­
stances, we should be wary of any tendency to believe that domestic
producers should be sheltered from competition by the help of rising
import costs, for the same exchange rate changes will also adversely
affect consumers and raise production costs even further.
The lesson that we cannot solve our balance of payments without
the cooperation of others leads to a

corollary lesson that it would be

self-destructive for us or other countries to attempt to solve external
problems by discriminatory restrictions on trade.
work to break down trade barriers.

All countries must

Transitory constraints may be required

from time to time but only to cushion the adjustments needed, not to block


off needed adjustments. For example, our 10 per cent surcharge from last
August to December could easily have led to retaliatory action abroad,
delayed necessary adjustments at home, and unnecessarily penalized a large
group of third countries«

But it was removed in time.

Another lesson to be learned is that ways and means must be
found to cope with the volatile and potentially massive flows of short­
term capital in a present world in which mobility of funds has been insured
by the improvements in communication and facilities for the transfer of

Again, the most recent crisis points out how far the international

monetary system can be subjected to unnecessary stresses and strains by
movements of speculative funds.
with such flows.

But we have not yet learned how to deal

Short-term capital flows were responsible for much of

the disorder in international markets in the 1930fs; they are now immensely
greater in size, and movements are facilitated by the greater sophistication
of market participants and technical facilities that allow nearly instantaneous
shifts between markets and from one currency to another.

The question of

how to deal with the short-term flows is not easily answered.


possibility, which we now see widely employed, is to try to dry them up
by controls -- controls against inflows and controls against outflows.
But, frankly, all experience with this instrument suggests that it is
difficult for a small country with a compact financial market, and may be
impossible for a large country rich in financial institutions and multi­
lateral corporations.

Nevertheless, I believe we need to keep searching

for more effective and concerted use of barriers to these flows when they
are serving no other purpose than to hedge against a change in exchange


rate which these very flows may artificially induce.

An alternative,

which we also need to explore, is the possibilities for an agreed procedure
among central banks which would allow for more absorption, or sterilized
financing, of such flows, possibly with some sharing of costs or losses.
Up to this point, I have been talking primarily about the
noises under the hood of the international monetary machine, especially
those reflecting our own inflation and balance-of-payments problems.


this does not mean that there have been no knocks under the hood of the
domestic economic machine and, in particular, our domestic financial

Quite the contrary.

The so-called credit crunch of 1966 and

the near crisis conditions that existed in some sectors of U.S. financial
markets during the spring and summer of 1970 are still much too vivid for
us to ignore the need for more than just a cleaner carburetor in domestic
monetary machinery.

What are the main lessons to be learned on the domestic

monetary side of things?
First of all, there is the clear lesson that more needs to be
done in the area of restructuring our financial system so that public
policies to combat inflation can work more effectively.

The Federal

Reserve's own study on housing, submitted to the Congress last year,
was one effort to make constructive proposals.

And over the years there

have been a number of studies by public (including Presidentially appointed)
and private bodies of various aspects of our financial markets.
While our financial markets could be better structured to with­
stand the variations in credit flows that may be required in the effort
to keep inflation under control, a more flexible use of fiscal policy


than in the past would reduce the extent to which financial markets may
be subject to substantial shifts in the amount and direction of savings
and credit flows.

A more flexible fiscal policy would also reduce the

likelihood that demand pressures on the economy would cumulate

to the

point where they become difficult if not impossible to control without
undesired side-effects.

Such a danger point tends to be reached when

demand pressures are so pervasive and last so long that the attitudes of
wage earners and others in society are influenced by expectations that
inflation will continue as a way of life.
A flexible fiscal policy requires a responsible attitude toward
Federal expenditures and tax policy.
budget balancing.
expand the economy.

I am not talking about continuous

There are times when we need planned deficits to help
But there also are times when we need surpluses to

help calm down the economy.

Under inflationary conditions in particular,

it is incumbent on the Executive Branch and Congress to see that Governmental
outlays are kept under control and to see that tax policy contributes to
noninflationary financing of expenditures.

What happens in the absence

of a truly responsible fiscal policy is well illustrated by the inflationary
experience since the mid-1960's.

And, against that broad background, the

recent and prospective sizable Federal deficits have exacerbated tendencies
for inflationary expectations to persist and become more pervasive.
As Chairman Burns said in testifying this morning before the
Joint Economic Committee:
We stand at a crossroads in our fiscal arrangements. Many
of our citizens are alarmed by the increasing share of their
incomes that is taken away by Federal, State, and local taxes.
Meanwhile, Federal expenditures have been rising at a rate well
above the growth rate of our national income and product. The


propensity to spend more than we are prepared to finance through
taxes is becoming deep-seated and ominous. An early end to
Federal deficits is not now in sight. Numerous Federal programs
have a huge growth of expenditures built into them and there are
proposals presently before the Congress that would raise expenditures
by vast amounts in coming years.
The fundamental problem, therefore, is how to regain control
over Federal expenditures. I do not think this can be accomplished
without departing from our traditional methods of budgetary
Among the various possible proposals, as noted by the Chairman, one that
would produce immediate beneficial results would be a legislative ceiling
on this yearfs Budget expenditures.
Again, a related lesson is that there is a need to supplement
both monetary and fiscal policy once cost-push inflationary pressures
have developed.
Once inflationary attitudes pervade the country, it becomes
very difficult to bring inflation to a halt.

Monetary policy certainly

becomes a relatively less effective instrument.

To the extent that the

inflationary forces begin to come from the cost-push side, the increasing
application of monetary restraint becomes more and more likely to lead to
unacceptably high levels of unemployment since there is no excess demand
to be curtailed.

Over time, cost-push inflationary pressures might be

contained, but that would be at the expense of high unemployment and
unutilized plant capacity.


Keeping wage increases reasonably in line with productivity
gains is the key to averting cost-push inflation.

The sharp rise in

wage rates of the past few years promoted inflationary pressures even
in a period when unemployment was running at about 6 per cent of the
labor force.

Moreover, despite rising prices, the acceleration of wage

increases led to a diminishing share of profits relative to income, with
the result that business incentives to expand were restrained.


appeared willing to invest in labor saving equipment, and to take other
measures to rationalize their organization and make it more efficient,
but the confidence required for long-term expansion of plant capacity
had been eroded.
The incomes policy announced by the Administration in August of
1971 was vital to efforts to get the economy moving while keeping
inflation under control.

From my point of view, an incomes policy should

have been put into effect earlier; its absence made the job of monetary
policy that much more difficult and--since inflationary pressures had
moved from the demand-pull to the cost-push side--placed limitations on
what could be accomplished to control inflation through public policy.
For an incomes policy to have beneficial, lasting effects, it
must help alter the attitudes of labor and business.

It must work to

remove inflationary psychology from the labor bargaining table and from
corporate pricing policy.

But over the longer run the fundamental

factors in eliminating inflationary psychology are sound fiscal and
monetary policies.

In a free society we cannot--and would not want to


if we could--rely on incomes policy as any more than a transitional
program to get us over the rough spots.

Moreover, no wage-price policy

can be long effective if demand-pull forces of inflation threaten to
A fully effective public policy program to keep inflation
under control requires not only responsible and sound fiscal and monetary
policies but also, and importantly, measures that will ensure competitive­
ness in labor and product markets.

Only with competition effective can we

have some confidence that wage increases will remain roughly in line with
productivity gains and that business pricing policies will square with
the public interest.

Under these conditions, monetary policy can more

efficiently fulfill its role of creating the financial conditions that
encourage noninflationary economic growth and reasonable equilibrium in
our balance of payments.
There is another lesson to be learned when one refers to the
efficiency of monetary policy and that is the need for flexibility and
adaptability in developing and using our policy instruments.
one of the most impressive

To me,

facets of my own experience with the Federal

Reserve System has been to observe it in action as a dynamic, changing
organism rather than a static entity.
and implementation of monetary policy.

This is true both in the formulation
We have constantly sought better

economic and financial intelligence and better ways of applying it in
the decision-making process.

We have sought, and are still seeking, ways

of improving our main policy instruments -- open market operations, the
discount mechanism and reserve requirements.


Flexibility involves, among other things, proper timing -- the
ability to change and shade policy promptly as circumstances require.
But more than timing, flexibility also requires a lack of rigidity with
respect to the financial goals of monetary policy*
In recent years, we at the Federal Reserve have placed somewhat
more emphasis than in the past on monetary aggregates in the formulation
and effectuation of monetary policy.

However, it would be wrong to

become rigid in our attitude toward monetary aggregates as a group or
to become wedded to a particular aggregate, such as the money supply.
There are many and varying definitions of money.

We can never be certain

how much money -- however defined -- the public wants to hold.

The public

is continuously shifting into and out of various kinds of assets —


as demand deposits, time deposits, and savings accounts -- which are
money-like in quality; so that we cannot be confined in our analysis to
any single definition.

And our knowledge about relationships between

money and the factors that affect decision making by individuals and
business firms -- such as credit availability and cost, prospective income
or sales, and over-all liquidity -- is subject to considerable professional
Thus, we must continuously evaluate credit conditions and
interest rates themselves to see if they are appropriate to economic
circumstances, both domestic and international.

While we cannot look

at interest rates alone because of the danger, for example, of providing
too much new credit and money to the economy if demands for goods and
services are expanding more than desired, neither can we be guided by


money alone because there is the parallel danger of providing too little
new money and credit if we have underestimated how much new cash is
required to finance desired expansion.
There is no escape from using judgment in public policy.


it is merely simplistic to base judgments about monetary policy on the
behavior of so narrow a variable as the money supply; that seems clear
from our past experience.
These and other lessons need to be applied to the full agenda
of tasks that remain to be done to curb or, even better, to avoid inflation
in the domestic economy, to restore our international competitive position,
and to create a more viable structure of international financial relation­

I do not underestimate the magnitude or the complexity of the

problems we as a nation must face over the longer run.
Not long ago at breakfast, my six-year old daughter, Whitney,
asked me, "How old are you, Daddy?t In order not to frighten her completely,
I prevaricated a bit and said, l0h, around 50."
I'm around 50, how old will you be?"

She then asked, "And when

Again, I said, "I would be near a

She persisted and asked me, "When I'm near a hundred, how old

will you be?"

To that query, I responded, "You know, Whitney, I think the

practical possibilities of either one of us living that long are not very

She thought for a moment and then looked up at me and said, "Well,

we can try, can't we, Daddy?"
As I have thought about the twin problems of balance of payments
and inflation and their integral parts in terms of improving U.S. price
performance and competitiveness, it sometimes seems to be almost as hope­
less a task as that of attaining perpetual youth.

But we can and must try.


And I am comforted somewhat by the recent comment attributes to Mrs. Alice
Roosevelt Longworth.

When congratulated on her seeming eternal youth,

she recalled a quotation from "The Spoon River Anthology1 that goes like

"Perhaps after all the secret of perpetual youth is merely arrested

This may be equally applicable to the problem we are confronted
with today, namely our search for ways to control inflation and bring about
external equilibrium and, as far as my remarks are concerned, the role of
monetary policy in that search.

For the real task of monetary policy, and

perhaps the only way it can be truly effective, is in assisting in the
arresting process -- in preventing the development of the deep-seated
inflationary expectations and spiraling cost pressures that in turn
develop a life of their own and are the principal threats to achieving
improvement in productivity and competitiveness.

Once these developments

have been allowed to become self-reinforcing, as was the case in the
latter part of the 1960's, monetary policy can play only a lesser role
in the much harder task of restoring the sort of basic noninflationary
conditions and attitudes conducive to improving our competitive position.
The final lesson, then, is that of humility with respect to the
evident limits to the contribution of monetary policy.

The job of trying

to control inflation, and to right our balance of payments cannot, and
must not, be left to monetary policy alone.

Indeed we can no longer

rely solely on general monetary and fiscal policies designed to influence
aggregate demand.

There is a constructive role to be played by more

direct measures to influence wage rates and commodity prices when costs
and prices do not respond sensitively to the balance between demand and


But in closing, I would like to make a confession
add a somewhat more optimistic note.


well a«

In selecting as my topic, ’Lessons

to be Learned,1 I confess 1 was influenced a bit by recent events in the
Peanuts comic strip in which Snoopy, after much soul-searching decides to
write a book on the subject, "Things I Have Learned After It Was Too Late,”
beginning with the first chapter on "Never Argue with the Cat Next Door.
He is Always Right," with the closing chapter, "A Whole Stack of Memories
Will Never Equal One Little Hope."

For my part I have more than a little

hope that we will win the balance-of-payments and Inflation battles.


on both fronts I believe there is room for at least cautious optimism
about the near-term outlook.
On the inflation front we do seem to be experiencing some
improvements in our record of performance on costs and prices in the U.S.

First, productivity gains are on the rise again.

Last year the

rise in output per manhour in the private non-farm economy rebounded to
a 3.7 per cent rate.

This year, with real output rising faster

an even larger increase is possible.

Labor supplies moreover should

remain relatively ample through the remainder of this year and on into
1973, given the likelihood of a rather substantial increase in the civilian
labor force.

Second, the labor cost situation seems somewhat better.


the first half of this year, for example, average hourly earnings in the
private non-farm economy rose at an annual rate of about 5-1/4 per cent,
compared with 6-3/4 per cent during the first seven months of 1971.


improvement partly reflects the results of competitive forces dampening
the rise in wage rates, but the control program has also had a salutary


Third, the price situation also appears a bit brighter.


broadest measure of price performance -- the fixed weight index of prices
of all private goods and services in the gross national product —


over the first three quarters of last year at an annual rate of about
4-1/2 per cent.

In the three most recent quarters, the rate of increase

has receded to about 3 per cent.

Consumer prices since last August have

increased at an annual rate of 2.7 per cent, compared with 3.8 per cent
in the first seven months of 1971, and in the last four months the
annual rate of increase averaged about 2 per cent.
On the balance-of-payments front, too, while our trade account
has been disappointing, especially to those who mistakenly looked for an
early benefit from the realignment of exchange rates last December,
past experience points to the fact that, while patience is necessary,
such large shifts in exchange rates do, over time, produce large favorable
shifts in trade and other current account transactions, and in capital
flows as well.

And even with our trade balance showing little improvement

to this point, beginning in mid-March the over-all balance of payments
became more favorable due principally to short-term capital inflows.
There was, in fact, a balance-of-payments surplus between mid-March and
late June when the British pound was floated.
Finally, I think the most hopeful sign of all, however, is the
evident concern of the American people with the effects of inflation.


are concerned about the impact of rising costs and prices on the purchasing
power of their incomes and on the real value of their savings.

They have

responded well to the efforts by the Federal Government to take needed


steps to halt the wage-price spiral and I am sure would support whatever
further steps might prove to be needed.

They do not intend to accept less

than a full measure of success in this struggle with inflation, nor will we
in the monetary policy arena cease trying to do our part.