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Comments by
WILBUR D. F1JLTON, PRESIDENT
FEDERAL RESERVE BANK OF CLEVELAND
in response to the questions of
THE SENATE FINANCE COMMITTEE
March 31, 1958
CONTENTS
Page
Foreword
PART I.
PART II.
PART I II.
MONETARY POLICY SINCE 1941
(a) Graphic Summarization •
(b) Textual Description • •
............
.....
..
ASPECTS OF INFLATION AND DEFLATION
Definitions • . • • • . • . . • • •
Cyclical Fluctuations and Growth
Crosscurrents in 1957 . . .
s\UIIIna.ry'" •
PART V.
39
45
48
OBJECTIVES OF ECONOMIC POLICY
II
•
•
1111
..
•
•
•
•
Interrelation of Objectives
Relative Importance of Objectives .
PART IV.
3
21
.
..
..
FISCAL AND DEBT MANAGEMENT POLICY
Fiscal Policy . . . . . . . . .
Present Fiscal System . • • • •
State and Local Government Finance
. . . •
Debt Management Policy
ADEQUACY OF THE MONETARY sYSTEM
Stability of Value • • • • . . • . • •
Responsiveness of the Monetary System
Allocation of Credit . • . • . • .
Adaptability of the J.Y onetary System •
53
53
59
63
65
69
71
......
75
76
78
81
Appendix
Letter Request from Senate Finance Committee
List of Questions . • • • • . . • • • • • • • •
87
89
Foreword
The material in this report constitutes my comments in
response to the seventeen questions submitted by Senator Harry F. Byrd
as Chairman of the Senate Finance Committee, as of
Feb~
17, 1958.
The questions are not taken up in the order of their listing
(see Appendix) but are considered under five general headings, as indicated in the table of contents.
To a considerable degree, these comments are an adaptation of
a draft document which had been prepared through the collaboration of
all twelve Federal Reserve Banks.
Certain portions of this report,
however, represent this bank's own contribution to the general subject.
I wish to refer particularly to pages 3 to 19 which contain a graphic
summarization of monetary policy since 1941.
Also, on page 53 will be
found a brief summary of my own judgment of the relative importance of
•
price stability, maximum employment, and economic growth as objectives
in the pursuit of the highest attainable rate of national growth and
development.
Wilbur D. Fulton, President
Federal Reserve Bank of Cleveland
-3-
Part I. MONETARY POLICY SINCE 1941
(a). Graphic Summarization
Monetary history from 1942 to 1957 falls readily into eight
successive phases, each of which differed quite significantly
from its predecessor in terms of the prevailing economic environment.
The eight phases are discussed in chronological order in
the following eight pairs of pages. On the left page t here is
indicated the type of monetary action which was theoretically
appropriate in view of the concurrent behavior of average prices
and of the general trend of economic activity. On the right
page there is a review of the developments which actually
occurred in the realm of monetary affairs.
It will be noted that the type of monetary policy suggested
by the movement of prices was not always compatible with that
suggested by contemporary trends in economic activity (production and employment).
-4-
Period Covered
1942--mid-1945
Appropriate Monetary Policy suggested by:
Trend of PRICES
Trend of ECONOMIC ACTIVITY
RESTRAINT
(In the face of rapidly
rising incomes, prices
were relentlessly moving
upward, either by reluctant sanction, or by
threat of black markets.)
RESTRAINT
(Pressure of demand was
almost continuously in
excess of capacity to
produce.)
J
T
J
-5-
The Historical Record
Monetary restraint, however desirable theoretically throughout
the war period, was almost totally foreclosed by the following announcement shortly after Pearl Harbor:
The Federal Reserve System is prepared to use its powers
to assure that an ample supply of funds is available at
all times for financing the war effort; and to exert its
influence toward maintaining conditions in the U. S.
Government security market that are satisfactory from
the standpoint of the Government's requirements.tt
11
In the face of the national emergency, a commitment of this type
seemed almost inescapable. It proved unfortunate, however, that so
large a part of the war's cost was financed by means of an inflationary expansion of bank credit.
Pursuant to the foregoing commitment, over the period the Federal
Reserve System purchased $19 billion of U. S. Government securities.
It is true that most of this acquisition ($18 billion) served merely
to offset the concurrent drain on member bank reserves caused by the
outflow of currency (into circulation) and gold. Nevertheless, in view
of the $3~ billion excess reserves already in existence at the time
of Pearl Harbor, combined with some further additions of new central
bank credit during the war, member banks were able to expand their
holdings of U. S. Government securities by nearly $53 billion. Accordingly, the nation's money supply (checking account balances and currency) more than d~mbled during the 3~ year period.
-6-
Period Covered
Mid 1945--Mid 1946
Appropriate Monetary Policy suggested by:
Trend of PRICES
Trend of ECONOMIC ACTIVITY
RESTRAINT
(Prices rose sharply
as war-accumulated purchasing power pushed
against a continuing
shortage of many
civilian goods.)
EASE
(Considerable unemployment
developed while readjustment to civilian economy was
taking place. )
-7-
The Historical Record
In view of the subsequent boom it is a matter of some curiosity
that bank credit expanded only very moderately during the reconversion phase. The expansion occurred in the form of bank loans (not
investments), where ~ 10 percent expansion presumably expedited
conversion to civilian production.
The wartime commitment regarding interest rates on U. S. Government securities presented no problem to the System during this 12-month
period. Long-term money rates in particular reached record low levels
without active intervention by the System. System purc hases of U. S.
Government securities ($1.9 billion, net) were only enough to offset
a concurrent further outflow of currency.
During this interval margin requirements on stock exchange collateral were increased in two steps from 50 percent to 100 percent.
Also, somewhat later, the t percent preferential discount rate on
short-term Government securities was discontinued.
-8-
Period Covered
Mid 1946 to late 1948
Appropriate Monetary Policy suggested by:
Trend of PRICES
Trend of ECONOMIC ACTIVITY
RESTRAI NT
(Removal of wartime controls
permitted the full force of
war-accumulated purchasing
power to push prices to
record high levels.)
RESTRAI NT
(Under conditions of
relatively full utilization of all economic
resources, enlargement of
the credit base merely accentuated upward pressure
on prices.)
-9-
The Historical Record
The System was virtually powerless to counteract the inflationary
potential of a $4 billion influx of gold, because it was still committed
to support the pattern of interest rates established in 1942. The
money supply increased only moderately (albeit to a new all-time high),
but a significant expansion (55 percent) occurred in bank loans. This
active use of bank credit contributed greatly to inflationary pressures.
Fortunately, (in view of the inflexibility of monetary policy) inflationary
influences were being dampened by the continuously large cash surplus of
the U. S. Treasury.
During this interval, the discount rate was raised from 1 percent to 1! percent in two steps. The System also was freed from the
wartime commitment of having to peg the 91-day Treasury bill rate
at 3/8 percent. Likewise, war loan accounts (at member banks) were
made subject to reserve requirements. Finally, the percentage of required legal reserves was raised by approximately $3 billion by action
of the Board of Governors. The potentially restrictive effect of
this last named action was largely neutralized, however, by concurrent purchases of an almost equivalent quantity of U.S. Government
securities.
The cost of money and credit did rise appreciably (from a low
level) during this interval, but not enough to exercise any significant restraint on credit expansiono The Treasury surpluses exerted
some restrictive influence, but the System itself was limited to
fringe action by the pattern-of-rates cornmitmento
In terminating the 100 percent margin requirements in January
1947 (to 75 percent) after a sharp reaction in stock prices, the System recognized that the boom was no longer being supplemented by
speculative activity in securities.
-10-
Period Covered
Late 1948--Early 1950
Appropriate Monetary Policy suggested by:
Trend of PRICES
Trend of ECONOMIC ACTIVITY
EASE
(Average prices began to
recede after mid 1948. By
late 1949, wholesale
commodity prices reached
a two-year low. )
EASE
(The unemployment situation
indicated the existence of
considerable unused capacity
and idle resources which
might be activated by easier
credit conditions.)
-11-
The Historical Record
In response to the softening of commodity prices and the
diminished rate of industrial activity, the System pursued a
policy of monetary ease throughout 1949.
The major move was represented by two series of reductions
in the percentage of required reserves of all three classes of
member banks, and covering time as well as demand deposits.
The reduction in requirements was equivalent to the creation
of nearly $4 billion of excess reserves.
Since; in the absence of any contravening measures, that
reduction could have become the base for an excessive expansion
of the money supply, the System concurrently undertook to reduce
its record-size pQrtfolio of Government securities to the lowest
level in the postwar period--in fact, since 1944. Enough liquidity
was permitted to remain in the banking system, however, to accommodate a $6 billion expansion in member bank holdings of u. S.
Government securities.
Quantitatively, the supply of money did not change much on
balance during 1949, but the cost of money declined noticeably,
not only in the capital markets but also with respect to bank
loans to businesso The wartime commitment to support prices
of U. S. Government securities presented no immediate problem
while the bull market in such securities lasted.
The discount rate remained unchanged at the comparatively
low level of 1! percent.
In March, margin requirements for stock exchange collateral
were reduced to 50 percent (from 75 percent).
-12-
Period Covered
Early
1950-~id
1953
Appropriate Monetary Policy suggested by :
Trend of PRICES
Trend of ECONOMIC ACTIVITY
RESTRAINT
(A vigorous upthrust in
prices was precipitated by
the Korean War. The
Consumer Price Index
shortly broke into new
high ground and was nudging
u~ward during most of this
22 yea~ period, despite
some retreat of wholesale
prices from speculative
peaks reached early in the
War.)
RESTRAINT
(In tenns of industrial production, recovery from the 1949
contraction was full and complete before the Korean invasion. Except for some months
of hesitation during late 151
and early 1 52, there was no
cushion of idle resources or
capacity. Inflation of bank
credit would merely accentuate
the upward pressure· on prices.)
-13-
The Historical Record
Upon the outbreak of the Korean War, the still-standing commitment to support Government security prices (which had been of
only nominal significance in the recessionary year 1949) suddenly
re-emerged as a roadblock to the application of effective monetary restraint against a surging inflationary wave. During the
first eight months of the Korean outbreak, the System created
$6 billion of member bank reserves, in the course of purchasing
Government securities from sellers who wished to obtain funds
for other purposes.
During those eight months, the System had at its disposal
(to combat inflation) only such measures as increasing the discount rate (to 1-3/4 percent), invoking controls over consumer
instalment credit, and promulgating the new ~gulation X to curb
real estate credit expansion. Margin requirements were upped
to 7S percent (from SO percent). Reserve requirements also
were increased $2 billion (Jan. 19Sl) •
All of these measures combined, however, were relatively
powerless in the face of the rapid rate at which new central
bank credits were being created. Fortunately, from the point
of view of monetary management, a considerable portion of these
credits were being offset by a strong outflow of gold.
Following the Accord between the Treasury and the Federal
Reserve System (March 19Sl) credit policy was designed lito limit
bank credit expansion to amounts consistent with the requirements
of a growing eccnomy at a high level without inflation."
The continuing demand for long-term capital as well as bank
credit eventually pushed money rates to a 20-year high (May-J une
19S3). The discount rate had been upped to 2 percent in January
of that yearo In February, margin requirements were reduced
to SO percent since no substantial increase had occurred in the
use of credit in the stock market.
-14-
Period Covered
Mid 1953--late 1954
Appropriate Monetary Policy suggested by:
Trend of PRICES
Trend of ECONOMIC ACTIVITY
NEUTRALITY
(Prices did not decline but
remained relatively stable-at virtually the all-time
high.)
EASE
(Official end of hostilities
in Korea was followed by a
substantial cut in defense
requirements. Readjustment
from ttwar economyn was
accompanied by contraction
in employment and production.)
-15-
The Historical Record
Beginning in May 1953, the System embarked first on a
policy of relieving the tension in the money markets and
then of actively promoting credit ease.
Reserve requirements were reduced in July 1953 and
again about a year later. The amount of excess reserves
created in the two actions was estimated at $2.8 billion.
The striking consequence of the reductions was a record
increase in the loans and investments of member banks .
The $16 billion expansion (in 18 months) caused the nation's
money supply to expand by a record peacetime amount and
induced a high degree of liquidity in the economy as a
means of stimulating industrial recovery.
The cost of short-term money fell to a seven-year low
in 1954. Early that year the discount rate was lowered
in two steps to 1~ percent (from 2 percent). The cost of
long-term funds also declined to the lowest in several years.
-16-
Period Covered
Late 1954 to late 1957
Appropriate Monetary Policy suggested by:
Trend of PRICES
Trend of ECONOMIC ACTIVITY
RESTRAINT
(Early in 1956, consumer
prices began to break out
on the upside into new alltime high ground. Wholesale
prices had begun a renewed
climb almost a year earlier.)
RESTRAINT
(By late 1954, the economy was
back on an "overtime" basis.
Many materials also seemed to
be in short supply. Airy undue
expansion of the credit base
would merely have aggravated the
upward pressure in prices, and
would not have resulted in any
more employment or production.)
-17-
The Historical Record
Fairly early in 1955 it became the policy of the System to
permit no fUrther cyclical expansion of member bank reserves.
Temporary additions for normal seasonal purposes were not allowed
to become a permanent part of the credit base but were largely
withdrawn after each need had passed.
As a consequence of this policys the $20 billion increase
in member bank loans was financed largely by a concurrent liquidation of member bank holdings o£ U.S. Government securities-at almost constantly declining prices. (Member banks also increased their borrowings somewhat in order to meet the extraordinary demand for business, instalment, real estate, and other
loans.) Accordingly, the contemporary expansion in demand
deposits was held to the smallest proportions recorded in any
business boom for at least thirty years. Only the less-volatile
time deposits expanded appreciably.
The continuing strong demand for credit and capital, in
the face of a nearly static credit base, produced a steady rise
in the cost of money. In order to keep the discount rate in
reasonable relationship with open market money rates, the rate
was increased from 1! percent to 3~ percent in a series of steps
be ginning in April 1955 and ending in August 1957. Margin requirements against stock exchange collateral also were increased (from
50 percent to 70 percent) during the early months of this period.
COMMENT: If the System had capitulated to all of the pleas
for nmore credit," the boom presumably would have risen to greater
and more untenable heights, and the ensuing readjustment might
have been much more drastic and difficult.
-18-
Period Covered
Appropriate Monetary Policy suggested by:
Trend of PRICES
Trend of ECONOMIC ACTIVITY
Late 1957 to date (Mar. 31, RESTRAINT
1958)
(Despite the industrial
recession, prices continued
to creep upward thereby
further depreciating the
purchasing power of current
income as well as of savings.)
EASE
(Industrial activity declined
sharply in the fall of 1957.
Thus, without reference to
the price situation, a policy of
credit relaxation was clearly
appropriate.)
-19-
The Historical Record
The complete history of the current period cannot be written
until the next phase has taken over. Yet it may be recorded here
that the System has used all three major instruments of general
credit control for the purpose of mitigating recessionary tendencies and of establishing a sound base for a renewed expansion
in industrial activity.
The discount rate was brought down in several stages from
the long-time high of 3! percent, to
percent. Legal reserve
requirements of member banks also were reduced by roughly $1 billion. Meanwhile, purchases and sales of U.S. Government securities were of such a nature as to permit member banks to reduce
their indebtedness to the reserve banks from a level of nearly
$1 billion (Sept.-Oct. 1957) to almost zero.
2i
Changes in the supply of money have been somewhat slow in
reflecting these several developments, but there has been a
vigorous expansion in membe~ bank ~loans and investments" in
recent weeks, with possibly much more to come as a result of
the latest cut in reserve requirements.
The decline in the cost of money has been one of the sharpest
on record.
Margin requirements on stock exchange collateral were reduced
to 50 percent (from 70 percent) in January 1958.
The remainder of the historical record
depend not only upon the course of economic
during the coming months, but also upon the
effects of actions already taken are yet to
of this period will
activity and prices
extent to which the
be felt in full.
-21-
PART I. MONETARY POLICY SINCE 1941
(b) Textual Description
The purpose of the following discussion is to review monetary
policy since 1941 in somewhat greater detail than in the preceding pages,
emphasizing the inflationary characteristic of the period as a whole as
well as the relationship of monetary policy to t he rise in
prices~
Policy in Wartime
At the outbreak of war 3 the Board of Governors of the Federal
Reserve System announced that the primary ob jective of the System during
the
Ha.r
would be "to assure t hat an ampl e supply of funds is available
at all t imes for financing t he war effort and to exert its influence
toward maintaining conditions in the
o
••
Government security market
that are satisfactory f rom the standpoi nt of the Government ' s r equirements."
Notwithstanding t he urgency of the situation, and the need for
a r eassuring posture 3 t he decision (to assure an ample supply of funds for
war finance, and to finance the war at low and stable rates of interest)
in effec t r elegated cont rol of inflati on to a p osition secondary to the
objective of facilitating war financec
Inflationary forces, it was hoped
could be kept vrithin reasonable bounds by rationing, direct controls over
rices, wages 3 and output, together with selective control of consumer
credit.
That this hope was substantially realized is indicated by the
relatively mild increase (11 percent) in consumer prices be tween mid-1942,
'1'1hen the machinery of direct control was becoming effective , and t he end
of t he war.
The mere statistical increase in the price index, however,
understates the de gree of inflati on, in view of the growth of black markets and the substitution of nonst andard and inferior products.
-22-
Two major operating policies were adopted early in 1942 pursuant
to the System 1 s wartime financial object ive..
They were:
(1) an official
commitment on the part of the Federal Reserve Banks to purchase all United
States Treasury bills that might be offered at a rate of 3/8 of 1 percent,
coupled with an agreerrent to resell the bills to the vendor any time before
maturity at the same rate; and (2) purchases in the open market to prevent
yields on longer-term Government securities (certificates, notes, and bonds)
from rising above predetermined levelso
Successful implementation of these
policies result ed in t he establishment of a patterh of rates on Government
securi t ies, ranging f rom 3/8 of 1 percent on 91-day Treasury bills to
2-1/2 percent on t he longest-term bonds (at that time, 30-year maturity) ..
To facilitate further the financing of the war, two additional operating
policies were adopted.
They were the establishment of a preferential
discount rate of 1/2 of 1 percent for advances secured by short~term
Governments, and reductions in reserve requirements of central reserve
city banks ..
Once investors and other market participants became convinced
that rates would not be permitted to rise above the levels selected early
in the war, the a ttainment of the primary objective of monetary policy
during the war was assured.
In a sense, the maintenance of a low and
stable structure of interest rates produced some highly desirable results:
(1) it encouraged prompt buying of securities b y investors, who might
otherwise have awaited higher rates; (2) it assured a strong and steady
market for out st anding securities; (3) it kept down the int erest cost on
a given volume of war debt; and (4) it limited the yield on bank and
other investors' earnings on any gi ven type of Treasury security ..
-23-
Unfortunately, however, the failure to raise a greater proportion
of the funds required for financing the war through taxes and sales of securities to genuine nonbank investors, and the resulting rapid expansion of
bank credit and the money supply, contributed to inflationary pressures,
both current and latent.
Only
40
percent of the funds obtained to finance
the war were raised through taxation.
The lar Loan drives, vmile appearing
on the surface to have resulted in the sale of l arge amounts of securities to genuine nonbank investors , actually relied significantly on baruc
credit expansion for their success.
After the Third War Loan, the Treasury
offered nothing but short-term securities for subscription by commercial
banks.
Consequently , banks subscribed to the short-term securities, sold
considerable amounts to the Reserve Banks, and then bought the longer
bank-eligible securities in the market above par, thus permitting speculatively-inclined, nonbank subscribers to make quick profits arid again subscribe to large amounts in the next Loan.
In addition, the relatively
low yields on bills and certificates exerted strong pressures on banks
and other investors to liquidate these instruments (which the Federal
Reserve had to purchase in order to maintain the rate pattern) using the
funds thus acquired to purchase longer-term, higher-yielding securitieso
While most of the reserves supplied in this manner were absorbed by an increase in currency in circulation and an outflow of gold, a substantial
volume was used to support the expansion of bank investments and, consequently, promoted inflationary growth of the money supply.
Although the shifting process could have been discouraged and
perhaps eliminated by permitting short-te rm r ates to rise relative to
longer-term yields, Treasury officials were reluctant to agree to any
breach of the rate pattern.
Even though the shifting process gained
L
-2hmomentum in the later stages of the war and did not cease until about
mid-1946, it was not until the summer of 1947 that yields on Treasury
bills and certificates were permitted to move higher.
In the meantime,
'
the over-all technique of war finance and the resulting excessive monetary
expansion, together with wartime shortages and accumulated demands, laid
the basis for a sharp increase in prices of goods and services when price
controls and rationing were suspended in 1946o
Postwar f olicy up to the Accord
Throughout most of the period from mid-1946 until the consummation of the Treasury-Federal Reserve Accord in early 1951, Federal
Reserve Authorities l-rere confronted with the task of reconciling two
conflicting responsibilities.
Briefly stated, these responsibilities
were, on the one hand, to utilize general instruments of credit control
in an orthodox manner to restrain inflationary pressures and, on the
other hand, to maintain stable and orderly conditions in the Government
securities market.
The importance of. the first responsibility is emphasized by
the fact that from the beginning of the period until the latter part of
1948, and again in the l atter part of 1950 and in early 1951, inflationary
pressures were severe.
In the earlier period, the pressures resulted
primarily from the huge volume of liquid assets built up during the war
and the accompanying shortages of goods and deferred demands.
In the
l a tter period, the outbreak of fi ghting in Korea, which followed closely
upon recovery from t he mild rece ssion of 1948-1949, stimulated business
and consumer spending in expectation of greatly expanded military expenditures and in fear of renewed shorta ge s of goods.
Under each of these
circumstances, orthodox principles of central banking would have called
for a re strictive credit policy.
While some inflation was no doubt
-25-
inevitable in each instance, an effective restrictive policy would have
limited inflation by reducing the attractiveness of liquidating Government
securities in order t o purchase goods and services or, in the case of
banks and other financial institutions, in order to engage in credit
extension to private borrowers at higher yields o
Adoption of an orthodox restrictive policy would, of course,
have necessitated the abandonment of the policy of maintaining a stable
market for Governm.ent securities o
Flexible credit policies require
flexible interest rate s, which in turn mean that prices of debt instruments, including Governm.ent securities, must be free to fluctuate with
market forces and those emanating from the actions of the central banko
So long as prices of Government securities were supported at relatively
high prices, holders of the instruments had the opportunity of liquidating
their Governments at attractive priceso
In essence, the Federal Reserve
acted as a passive buyer of Governments and, in the process, supplied additional reserves to the market on the initiative of holders of Government
obligationso
There was, on the other hand, wide concern as to the probable
effect of abandonment of par support on the market for existing Goverrunent
securities,
in generalo
em
the Treasury's refunding operations, and on the state of business
Such action, it was believed, might precipitate disorderly
conditions in the Government securities ma.rketo
Lower and fluctuating
prices for Government securities would lead to complications in Treasury
refunding operations, and hi gher interest rates would increase the cost to
the Treasury of servicing the Federal debto
In the early postwar period,
it was feared that abandonment of par support might precipitate a crisis
in the security markets generally and interfere seriously with the xeconversion and expansion of industryo
-26-
These l atter arguments, while perhaps appearing less convincing
today in view of the relative ease with which the par support program was
finally terminated in 1951, were of considerable significance in the early
postwar years.
It should be recalled that at the time large amounts of
Government securities
~re
in the hands of financial institutions and other
investors who had purchased t he securities for patriotic and other reasons
during the war, and who were anxious to liquidate the securities to obtain
funds for other purposes.
It is, therefore, quite possible that chaotic
conditions in the market for Government securities would have developed
had the System attempted to abandon the par support program much earlier.
In view of these considerations, the System attempted to reconcile the conflicting objectives by combatting inflation through actions
that did not necessitate the abandonment of the support program.
Thus
despite purchases of $10 billion of Treasury bonds in the twelve months
ended October 1948, total Federal Reserve holdings of Government securities increased only $1 billion (the $1 billion of net purchases was more
t han offset qy an increase in reserve requirements in September 1948).
The difference of
~~9
billion resulted partly from System sales of shorter-
term Governments, which took place during the rise within the
patte~
of yields on these securities; another offset was the Treasury's program
of debt retirement out of surplus funds, which was concentrated in maturing securities held by the Reserve Banks.
Other actions taken by the System to limit inflation included:
(1) an increase in Reserve Bank discount rates from 1 to 1-1/4 percent in
January 1948 and to 1-1/2 percent in August;
(2) appeals to bankers to
exercise caution in lending policies, to curtail speculative
loan~,
and
to guard against overextension of consumer credit (Regulation W was inoperative from November 1947 to November 1948);
and (3) requests for
-27-
additional powers over member bank reserves, including authority to raise
existing requirements to higher levels and to prescribe secondary reserve
requirements for
memb~r
posals had much effect.
banks.
It is doubtful that these actions or pro-
The discount mechanism was in a state of disuse
inasmuch as banks could easily adjust reserve positions cheaply and efficiently in the Government securities market.
Appeals to bankers were inef-
fective in offsetting customer pressure and a strong profit pull toward
private credit extension, not to mention the difficulty confronting bankers
of distinguishing essential
~rom
nonessential credit demands.
Requests for
additional le gislative authority received no action until the summer of
1948, when Congress renewed the authority for Regulation Wand granted
the Board of Governors temporary authority to raise member bank reserve
requirements above existing statutory limits.
The Board promptly raised
reserve requirements and reinstituted consumer credit control.
As it
turned out, inflationary pressures bad begun to sUbside in the summer of
1948.
With the changed economic situation that became apparent in
early 1949, System authorities took action to ease credit, including reductions in margin requirements, instalment credit terms, and member
bank reserve requirements.
However, concern regarding the rise of prices
of Government securities led to substantial System sales between January
and June 1949 as market demands for Governments increased.
In late June,
the Federal Open Market Committee announced that, after consultation with
the Treasury, it had been decided that purchases, sales, and exchanges of
Government securities would be undertaken wi. th primary regard to the
general business and credit situation.
It was pointed out that the
policy of maintaining orderly conditions in the Government securities
-28-
market would be continued but that, under
con~tions
existing at t he time
"the maintenance of a relatively fixed pattern of rates has the undesirable
effect of absorbing reserves from the market at a time when the availability
of credit should be increased."
The statement was widely hailed as marking
the return of the System to flexible monetary policies.
Support operations were again undertaken, however, following the
outbreak of fighting in Korea in the summer of 1950.
Although the System
attempted to restore flexibility to monetary poticy in August, when discount rates were raised, t he Treasury opposed such action.
The necessity
for supporting Treasury refunding operations in August and during succeeding
months forced the Federal Reserve to absorb large amounts of shorter-term
securities and to support long-term bond prices.
Banks, insurance companies,
and other financial institutions began to liquidate Governments in large
volume in order to obtain funds to support private credit extension.
Later,
other holders began to sell Governments, particularly longer-term issues,
because of fear t hat their prices would later decline.
In supporting the
market, the Federal Reserve between August 1950 and the end of the year
purchased $8 billion of maturing Governments, $1 billion of restricted
bonds, and $1.4 billion of short-term securities.
Sales of short-term
Governments in the amount of $7 billion partially offset these purchases.
In January 1951, as support purchases continued in large amount and as
seasonal factors were adding substantially to bank reserves, member bank
reserve requirements were increased.
It was clear that net System purchases were contributing to inflationary pressures by keeping interest rates low and credit readily available, and by adding to the reserves of the banking system.
Loans of commer-
cial banks increased $7.5 billion during the latter half of 1950 alone.
-29-
Prices of goods and services rose r~pidly, reflecting heavy buying by
individuals and businesses in fear of war-induced shortages.
Moreover,
there was considerable public discussion of disagreement between the
Treasury and the Federal Reserve.
The need became imperative for an
understanding between them which woul.d pe'rmi t the System to pursue flexible
monetary policies suited to 'the general business and credit situation.
result
~as
The
the Treasury-Federal Re serve Accord, announced jointly by the
Secretary of the Treasury and the Chairman of t he Board of Governors and
of the Federal Open Market Committee on March
4; 1951.
The terms of the Accord, which provided the basis for restoration
of flexible monetary policies, were as follows:
(1) In order to remove a substantial portion of the
long-term Government bonds that were overhanging the market,
t he Treasury agreed to offer in exchange for certain longterm marketable issues a long-term, nonmarketable bond that
would be convertible at the holder's option into a marketable
Treasury note.
(2) The Open Market Committee pledged that it would, in
effect, support the exchange operation by mald.ng limited
purchases of any long-term bonds that private holders might try
to sell after the terms of t he exchange offering '~ere annonncedo
It was specified, however, t hat "the situation would be assessed
daily," that 11 the market would be kept orderly, 11 and that "open
market purchases, if any, would be made on a scale-down of
prices."
(3) It was agreed that in order to hold to a minimum the
reserve-creating purchases of short-term Governments, the
Federal Reserve "would immediately reduce or discontinue purchases of s hort-term securities and permit the short-term
market to adjust to a position at which banks would depend upon
borrowing at the Federal Re serve to make needed adjustments in
their reserveso 11 It was thought that this action would result
in renewed use of the "discount window11 as an avenue for obtaining Federal Reserve credit and, as a consequence, greater
reliance on discount policy as a device of credit controlo
Short-term interest rates would, it was believed, tend to
fluctuate around the discount rate. The Federal Reserve agreed,
however, not to raise the discount rate (then 1-3/4 percent)
during the r emainder of 1951.
-30-
(4) Federal Reserve authorities pledged that their
operations l-70uld be designed "to assure a satisfactory
volume of exchanges in the refunding of maturing Treasury
issues." The Open Market Connnittee would, in other words,
support Treasury refunding operations to ease the readjustment.
The Federal Reserve continued to purchase substantial amounts of
Treasury bonds for a short time following the Accord, but on a gradually
declining scale of prices.
Following the Accord, purchases of short-terms
were promptly discontinued.
Short-term rates, reflecting the termination
of System purchases, rose sharply at first, but thereafter tended to move
with market forces.
reserve positions.
Banks began to use the discount facility to adjust
Under these conditions it was possible to pursue flex-
ible monetary policies, even though support for Treasury financing operations was afforded from time to time until late 1952.
In evaluating Federal Reserve credit policies during the years
1946-1951, it is important to note that
early
po~twar
by far the lar ger portion of the
inflation (in the period 1946-1948) occurred before the
problem of par support became acute in late 1947.
Between early 1946 and
the end of 1948 consumer prices rose 32 percent.
However, four fifths of
the increase took place before the final quarter of 1947, reflecting the
removal of direct controls in 1946, and it was not until late 1947 that
the System began large-scale purchases of long-term Governments in order
to support their prices.
Thus most of the inflation that occurred in
1946-1948 resulted from earlier actions--namely, the manner in which the
war was financed, and the resulting monetary expansion--and the huge
accumulated demands for goods and services both here and abroad.
Nevertheless, hindsight supports the judgment that an earlier
return to more flexible monetary policies would have been desirable.
-31-
Had it not been for the substantial Treasury surpluses in 1947 and 1948,
totaling almost $14 billion, and the use of a large portion of the surplus
£unds to retire maturing securities at the Federal Reserve Banks, control
over the Reserve position of the banking system would have been still more
d.ifficul t.
The willingness of the System to monetize longer-term Govern-
ment securities by creating Federal Reserve credit at relatively low rates
of interest undoubtedly interfered greatly with efforts to restrain inflationary pressures.
The success of the offsetting policies should not, how-
ever, be underestimated.
Despite the support operations, the volume of bank
credit and the money supply actually changed little in 1948o
Even more important is the judgment that failure to restore
flexible monetary policies earlier in the postwar period led inevitably
to reliance on support techniques following the outbreak of fighting in
Korea.
While much of the earlier postwar inflation was beyond the practi-
cable influence of monetary policy, the same was less true in l ate 1950
and early 1951.
The post-Korean inflation resulted not only from a more
active use of the money supply as consumers and businesses rushed to buy
in expectation of shortages and higher prices, but was also supported
strongly by credit expansiono
The credit expansion was facilitated by
Federal Reserve creation of reserves as an adjunct to the support program.
Policy Since the Accord
Monetary policy during most of the period since the Accord has
been directed primarily toward restraining inflation.
Pressures on the
supply of labor and other resources, arising from a high level of defense
expenditures and strong consumption and investment demands (except for a
brief period in 1953-54 and again recently), tended to push prices higher.
Between mid-1951 and the end of 1957, consumer prices rose 10 percent,
with more than half of the increase occurring in 195'6 and 1957.
-32-
Balance between aggregate demand for and supply of goods and
services was reasonably well maintained in 1951 and 1952, even though
consumer prices advanced during the period.
This increase stemmed pri-
marily from rising rent and transportation costs and largely reflected
the culmination of inflationary pressures that had been built up before
the establishment of price and wage controls in early 1951, and before
the Accord.,
Flexible administration of general credit controls, coupled with
other important factors, helped promote stable growth in 1951 and 1952.
Among the other factors were the various selective and direct controls,
including regulation of consumer and real estate credit, the voluntary
credit restraint program, and price ceilings and allocation of scarce commodities; increases in taxes which offset, in part, rising Government expenditures; and, by mid-1952, a retardation in the rate of growth of defense expenditures.,
Following the Accord, and throughout most of 1951 and 1952,
Federal Reserve actions were designed to minimize inflationary credit expansion while at the same time facilitating the readjustment of the Government securities market to termination of support.
ing
1~th
In addition, and in keep-
the terms of the Accord, the System afforded direct support to
Treasury refunding operations.
Although purchases of Governments during
such periods were substantial, the System was able to offset most of the
acquisitions by sales or redemptions of short-term Governments.
Thus be-
tween mid-April and November 1951, purchases of $300 million of long-term
bonds and $1.5 billion of short-term issues were almost wholly offset by
liquidation of $1.7 billion of short-term Governments.
The same technique,
which was possible only because the System was no longer pledged to maintain
-33-
stable prices for Government securities and could therefore operate flexibly in the mar ket, was used in February, June, August , and September
1952. Reflecting the effects of t he termination of the support program,
sustained demands for funds in the market, and the generally restrictive
monetary policies, interest rates rose irregularly through 1951 on Government securitie s, corporate issue s, and other debt instruments.
In 1952,
bond yields tended to level out, but short-term Government rates continued
to increase.
By the end of the year, interest rates generally were at the
highest levels since the I930 1 s.
Inflationary pressures began to mount in late 1952 and early
l953 3 as defense expenditures rose further while consumer and business
demand expanded.
With credit demands strong and the economy operating
close to capacity levels, the System exercised restraint in order to prevent excessive use of bank credit and inflationary expansion of the money
supplya
Member bank borrowing from the Federal Reserve Banks rose, inter-
est rates increased and, in January 1953, the Reserve Banks increased their
discount rates by 1/4 point, to 2 percent, in confirmation of the rate
structure t hat had developed and to increase the cost of borrowing to
member banksa
With the development of strains in the money and capital. markets
in the late spring of
1953, System credit policy was reversed, as manifested
by substantial purchases of Treasury bills in May and June and by a reduction in member bank r eserve requirements in July.
At the same time,
business a ctivity leveled out, and then declined, primarily as a result of
sharp cutbacks in defense expenditures and an accompanying shift by businesses from accumulation to liquidation of
inventories~
Throughout the
remainder of 1953 and during all of 1954, monetary policy wa s directed
toward ease in order to cushion recessionary tendencies and to provide a
-34-
monetary and credit atmosphere conducive to recovery.
The recession was both mild and short-lived, partly because
basic forces of demand remained strong, and partly because easy availability of credit at low interest rates provided the basis for rising construction activity and, in late
1954 and early 1955, for a resurgence of
consumer spending for automobiles and other durable items.
to note that actions taken by the monetary authorities in
It is important
1954, including
open market operations designed to make bank reserves freely available,
contributed significantly to t he liquidity of the economy generally and of
the banking system in particular.
Confronted with reduced demands for
loans, banks used the additional reserves made available through Federal
Reserve action to increase sharply their holdings of Government and other
securities.
Between May
1953 and November 1954, total inves tments of com-
mercial banks rose more than
almost
$14 billion, with Governments accounting for
$12 billion of the increase.
As the first signs of economic recovery emerged in late
1954,
the System permitted bank reserve positions to firm slightly in response
to rising credit demands.
Reflecting the widening of the recovery move-
ment, credit demands continued t o rise in early
1955. The System permitted
bank reserve positions to tighten further and, in April, the Reserve Banks
raised their discount rates
1/4 point to 1-3/4 percent, increasing the
cost of borrowing to member banks and bringing discmmt rates into better
alignment with market rates.
This rate increase 1.ras a straightforward
indication to the business and financial community that monetary policy
had been shifted toward restraint as contrasted with the policy of ease
that had been followed in the second half of
1953 and
in
1954o Meanwhile,
there had been a rapid increase in the use of credit for purchasing and
-35-
carrying securities, and margin requirements were increased in January
and again in Aprilo
By the time of the discount rate increase in April
the slack that had developed in the economy in
1955, most of
1953-54, as reflected
in
ready availability of labor and other economic resources, had been eliminated.
Pressures on costs and prices intensified as aggregate spending continued
to rise.
The accompanying demands for credit , in the face of inadequate
savings and the gradually increasing restrictiveness of monetary policy,
forced interest rates highero
The Federal Reserve Banks increased their
di sec unt rates in six steps, reaching a uniform level of 3-1/2 percent in
August
~957a
Despite these policies, wholesale prices began to rise in
the latter part of
1955 and consumer prices in early 1956. The rise in
consumer prices continued almo st without interruption through
1957 o
Monetary policy was once again shifted tovTard ease in the final
quarter of 1957. With the abatement of inflationary pressures and the accompanying decline in loan demand in the fall, bank reserve positions were
~owed
to ease slightly in the latter part of October and early November.
Then, as additional economic and financial data confirmed that the peak of
business activity had been passed and that recessionary forces were developing, the Reserve Banks reduced their discount rates by 1/2 point t o a level
of 3 percent.
Financial markets responded dramatically to this clear signal
that monetary policy had been altered in view of the changing business situation and, by the year end , pressures on bank reserves had been eased considerably and yields on Government and other debt obligations had declined
markedly from earlier peaksc
Easing actions were continued in early 1958,
as business continued to decline, and were reflected in significant easing
in reserve positions of member banks and reductions in margin requirements,
-36-
discount rates, and member bank reserve requirements.
The preceding review indicates that monetary policy has been
flexibly administered in the seven years since the Accord.
A major
question of interest, houever, is whether the price inflation that oc curred in 1956 and 1957 could have been wholly or partly avoided had
Federal economic policy, including monetary policy, been designed to be
still more restrictive.
It is reasonable to assume that fiscal policies
resulting in larger cash surpluses in fiscal years 1956 and 1957 would have
helped restrain inflationary pressures.
These surpluses could have been
used in such manner as to limit the spending power of the private sector
of the economy.
In addition, the Treasury's financing problems would
have been reduced, thereby facilitating the administration of a restrictive monetary policy.
In retrospect, there is little doubt that the direction of
monetary policy was generally correct through the seven-year period.
There
is some question, however, whether the policy of ease was carried too far
in
1954, when a combination of open market operations and reductions in
discount rates and reserve requirements pushed available reserves of member banks to high levels and short-term interest rates to exceedingly low
levels.
As noted earlier, commercial banks utilized a large portion of
the available reserves to purchase Government and other securities.
While
this action cushioned the 1954 recession and provided a basis for recovery
by promoting growth in the money supply, it also contributed to the growth
of liquidity in the banking system.
Consequently, when policy was shifted
toward restraint in 1955, and gradually became more restrictive through
1955 and 1956, commercial banks were
in a position to meet demands of
consumer and business borrowers by liquidating Governments and extending
loan credit o
-37-
There also is some question whether the System moved fast
enou,gh in exercising restraint in the early and intermediate stages of
the boom.
Granted t hat a somewhat less easy policy in 1954 would have
reduced commercial bank purchases of securities at that time, even the
excessive liquidity existing at the begirming of 1955 might have been
absorbed more quickly, and credit expansion thereby restrained further,
had policy been tightened earlier and faster in 1955.
That the record bank loan expansion that occurred in 1955 and
1956 was an important factor in the inflationary push is indicc. ted by continued expansion in business activity and rising
~ri ces,
s trained growth of the money supply during the periodo
despite the reThe active money
supply, consisting of adjusted demand deposit s and currency outside banks,
increased only 3 percent in 1955 and about 1 percent in l956o
The
rate of use of the existing money supply, however, increased markedly
during the periodc
The increase in velocity was facilitated by the liqui-
dation of bank investments, particularly Government securities, the concurrent extension of private credit to business and consumer borrowers, and
rising market rates of interesta. This type of shift, within the framework
of a stable or slowly expanding money supply, tended to be accompanied by
an increase in money velocity as the recipients of the bank loans used the
funds to spend for goods and serviceso
Duri.ng 1955 and 1956, a more re-
strict ive credit policy mi ght have curtailed the shift from bank investmeots
to loans and restrained total spendingo
These judgments, 2t should be strongly emphasized, are possible
only on the basis of hindsighto
It should be recalled that, in 1953-54,
there was concern lest the recession deepen and lead to large-scale reductions in output and employmento
that monetary policy
l~TRS
At the time, there was little protest
being carried too far in the direction of easeo
-38-
It is even more important to recall developments in late
The recovery from the recession of
1953-54
and in
1955.
moved much faster than was
generally expected; there were still doubts in early
v1as
1954
1955
that the recovery
firmly established, and there was considerable apprehension that a
move toward tighter credit at a faster pace might halt the recovery short
of its full potential.
Moreover, it should be recalled that at various
times during the boom period, forces emerged that seemed to indicate a
leveling off in business activity, or even an imminent decline.
It is
mainly in retrospect that the need for a more restrictive policy in the
early stages of the boom seems clear.
- 39-
PART II.
ASPECTS OF INFLATION AND DEFLATION
Definitions
Few concepts in the field of economics have been subject to such
a wide variety of interpretations as the terms inflation and deflation.
The variation in usage is revealed by noting some characteristics of four familiar definitions of inflation, all of which
~be
found,
either explicitly or implicitly, in a wide range of economic writings:
1. Inflation is a general rise in prices produced by expansion
of money and credit supplies at a more rapid rate than growth of the
economy's output potential.
2. Inflation is a general rise in prices created by excessive
Government spending and deficit financing.
3. Inflation is a general rise in prices elicited by an expansion of aggregate demands beyond the capabilities of the econ~ to supply
goods and services at existing price levels.
4. Inflation is a general rise in prices fostered by wage increases in excess of productivity gains.
Each of the above definitions has the property of defining inflation in terms of an alleged cause of rising price levels.
The first three
find the core of the difficulty in factors affecting total spending, although the precise factors are not necessarily identical, whil e the fourth
points to forces affecting production costs.
Each regards inflation as a
kind of economic disorder or disturbance, while considering the price movement largely as symptomatic of an underlying problem.
None of the above definitions may be regarded as "correct" or
"incorrect."
The question may be raised, however, whether a definition
couched in terms of a specific cause of rising prices ever is likely to
COllml.a.Ild universal support.
It is preferable perhaps to choose a definition
of inflation which is entirely neutral as to the source of advancing prices,
a solution to which professional usage has turned increasinglyo Inflation,
,!!!
~
view, is regarded simply
~ ~
upward movenent of
.!:!:!! general
price
level, irrespective of the originating f orces .
As a corollary, inflation
may be identified as a reduction in the purchasing power of money, which
varies inversely with prices.
This definition leaves unanswered the important questions of
causal factors and appropriate remedial actions but, by virtue of that
fact, the air is cleared for meaningful discussion on these critical matters.
Customarily, inflation develops during the expansionary phase of
cyclical movements about the growth trend of the
econ~ .
On the other
hand, an expansion in business activity may create enlarged empl oyment and
production without being classified as inflationary.
In similar fashion, a comparably neutral definition of deflation
i s one which refers to ! situation where there is ! generally falling trend
of prices, i . e., an appreciation in the purchasing power of the monetary
unit.
Thus, this view of deflation recognizes that periods of moderate
contraction in economic activity need not always be accompanied by deflation, or a general reduction of prices.
It is true that contractionary
tendencies in the economy, in the past, nearly always have elicited a
downward price readjustment .
Nevertheless, it is evident from the behav-
ior of prices during the mild recession of 1953-54--when selective price
adjustments had comparatively little impact on the general price level-and again in the current recessionary period of 1957-58, that moderate
contractions in business activity may produce little or no direct response
in prices.
It is well to recall that inflationary or deflationary tendencies may operate for many months before accumulating sufficient strength
to generate "open11 inflation or deflation.
And with respect to upward
pressures on the price level, it may be noted that inflationary forces,
having gathered strength, may be partially repressed over extended periods
- 41-
by conventional industry pricing practices or governmental regulations
and controls.
In many industries, price adjustments are made at discrete
intervals, and a considerable amount of time may elapse before the pressure of rising costs or the pull of rising demands is reflected in pricing
decisions.
The celebrated ninflationary gap 11 of the World War II and im-
mediate postwar years exemplifies the repression of inflationary forces
with Government controls.
Factors Affecting the Price Level
The relative importance of various sources of change in general
prices has been a subject of continuing dispute over many years of economic
observation and analysis.
Manifestly, since the issue cannot be readily
resolved, it is the purpose of this discussion to cite some major elements
affecting price levels, to outline broadly the interrelationships among
these elements, and to indicate the combined influence of these forces in
producing inflation.
It is a matter of general economic intelligence that periods of
rapid inflation have been characterized by especially heav,y demands for
goods and services.
Postwar experience evidences three distinct periods
in which the inflation problem has been thrust to the forefront of the
economic scene--from about mid-1946 to mdd-1948 , the year beginning in
June 1950, and the period from mid-1955 onward.
In the first two of these
three episodes are seen the inevitable aftermath of global war and the
reflection of abnormal strains accompanying defense production and mobilization, while the third represents the effects of an extraordinarily
vigorous capital goods boom, following a residential construction and
consumer durable goods boom.
That war periods produce serious inflationary tensions no one
seems to question, or to regard as unusual.
It appears to be understood
less readily'J on the other hand, that peacetime booms give birth to a
-42multiplicity of price-boosting forces .
The statement that supplies of
goods and services are relatively inflexible in an economy running close
to full-capacity production, so that further increases in demand encourage advancing prices, is but a partial expression of the potent inflationary forces inherent in a major industrial boom.
The encouragement of industries to ration short supplies of
goods through price increases during boom periods is accompanied by a
forceful push from advancing costs.
These stem not only from the in-
creased bargaining strength of organized labor as industry profits expand,
but from the declining resistance of firms to wage demands as it becomes
easier to shift cost increases to customers.
Competitive bidding for
scarce labor resources is another essential ingredient in the growth of
money wage rates, and in the encouragement of wives, teenagers, and older
workers to offer their services in the labor market.
Significantly, these
cost pressures are at their maximum when productivity gains are least
likely to offer an offsetting influence.
During recovery from a condition
of underemployed resources, the initial phase of the upswing normally is
accompanied by exceptional increases in efficiency, but these gains do not
continue with further growth of output in relation to capacity.
A well-
established feature of cyclical experience is that productivity increases
much less rapidly as the economy moves into the region of full-capacity
production. Utilization of stand-by capacity, lack of experience with
newly installed equipment, fewer shutdowns for routine maintenance, and
the employment of less skilled and less productive workers are probably
among the factors hampering the growth of efficiency in the late stages
of industrial expansion.
It is because these cost pressures at the peak of a boom are
intimately connected with the strains placed upon the nation ' s basic
resources that traditional analysis of inflati onary pressures has focused
-43-
upon the growth of aggregate demand in relation to aggregate supply.
It
should be noted, in this regard, that the expansion of demand need not
have its origin in rapidly growing money stocks or in Government spending
and deficit financing.
The major sources of growth in spending during the
recent boom scarcely can be attributed to such factors.
For example, total
spending on final output of goods and services advanced 20 percent between
1954 and 1957, while the money supply (demand deposits adjusted plus
rency outside banks) rose a little more than
cur~
5 percent between these years.
Moreover, the growth of total output in physical terms between 1954 and
1957, somewhat more than 11 percent, clearly outdistanced the expansion
money stocks.
of
Federal purchases of goods and services, meanwhile, declined
from 13.5 percent of Gross National Product in 1954 to 11.6 percent in 1957.
Gash payments to the public by the Federal Goverrunent rose $13.6 billion
between calendar 1954 and calendar 1957.
Although the growth of cash re-
ceipts from the public was more than $2 bi llion larger than the rise in
payments, the sharp increase in payments from an already high level may
have had a mildly expansive effect on total spending.
Such an effect would
have been at a minimwn in calendar 1956, when a $5.5 billion surplus occurred in the Federal cash budget.
To recognize the importance of demand in "pulling up 11 prices,
and to cite the close relationship between cost pressures and the current
state of demand, is not to deny that cost increases-- or attempts by producers to widen profit margins- -may have an independent 11 pushing 11 influence
on prices.
Although firms necessarily must consider demand in establishing
prices, it is evident that the r e are few areas in the econo:ti'.\V in which
prices are completely beyond the
influen~ e
of the individual seller.
Thus,
a firm faced with rising costs or desiring t o expand profit margins per
unit of sales may, even in the face of constant demand for its output,
elect to increase prices even though that may involve a decline in salese
-44In this connection, a few remarks are appropriate concerning the
alleged
noninflationa~
productivity gains .
character of wage increases which do not exceed
It can be conceded that i.f wage increases in
eve~
firm were at the same rate as productivity gains in that firm, there should
be no upward force on prices arising from this source.
But widespread ap-
plication of this rule is difficult to imagine when there are marked differences in productivity gains among firms in a given industry and among the
various industries.
Wage concessions granted to labor in those firms where
productivity gains are largest tend to spread quickly to other firms in the
industry, and to other industries, a process facilitated by the keen competition among individual labor organizations and by competition among
employers.
Also~
the rule may be difficult to maintain when the structure
of demand tends to shift to those industries where productivity gains are
comparatively low.
Transfers of resources from one industry to another
are not costless, and attraction of adequate labor supplies to those industries where demand is rising may necessitate a rise in wage rates beyond that permitted by efficiency increases.
In this case, price stability
is threatened unless downward price adjustrrents in industries experiencing
slackening demands match upward price movements in industries which are
expanding output.
The price structure , however, does not appear to be suf-
ficiently flexible to ensure that these offsetting variations always will
occur.
Y~ntion
of price inflexibilities suggests another line of reason-
ing whose implications have an important bearing on lang-run price trends.
For a variety of reasons, downward flexibility of many prices is comparatively small.
the story.
The resistance of wage earners to wage cuts is only part of
Heavy contractual payments clearly undermine the willingness
to reduce prices, as do Governmental controls- - excise taxes, tariffs, minimum wage laws, and regulated prices, for example .
Indeed, Governmental
-45policies are sometimes designed deliberately to prevent downward adjustments in specific prices.
The support of agricultural prices, the eleva-
tion of tariff barriers to protect injured industries and retail price
maintenance codes are specific examples .
The extent of these downward price rigidities militates against
price declines in periods of moderate business contractions.
Since infla-
tion in periods of booming economic activity tends to become "built-in, 11
price behavior in periods of cyclical expansion and contraction tends to
be asynunetrical .
Obviously, it might be possible to break down many of
these price rigidities by permitting massive contractions of demands for
goods and services, and corollary movements of production and employment,
but such a solution is unacceptable in terms of the Employment Act of 1946.
Cyclical Fluctuations and Growth- -The General Postwar Experience
During the postwar decade, the t otal real output of the
has increased by an average rate of about J . J percent a year.
econo~
Mild fluc -
tuations in the growth rate have occurred, with annual changes ranging
from an increase of nearly 10 percent to declines of slightly more than
l percent .
Total industrial production, covering the output of the
nation ' s factories and mines, has grown more rapidly, averaging
cent a year.
4.5 per-
Annual changes in this broad sector of the economy also
have been somewhat more pronounced, ranging from a gain of more than
15 percent to declines of nearly 7 percent.
increase has been about
1.5 percent
a year .
In agriculture, the rate of
On the whole, these figures
indicate more rapid growth in real output during the years since World
War II than during the last half century.
Growth in employment over the period has paralleled the expansion in real output.
The rate of increase, however, has been much less
and has averaged somewhat more than 1 percent a year .
With the number
of hours worked continuing downward, the r ate of increase in man-hours
-46has been even less.
For the private sector of the
the average
econ~,
annual gain in man-hour employment has been about 1 percent over the period
since 1947.
clined.
In agriculture, both employment and hours of work have de-
The differential rates of growth between real output and man-hours
worked point up the enhanced productivity during the period .
During the postwar contractions, as has been true historically,
aggregate unemployment increased more than employment declined.
This re-
flects the tendency of the labor force to grow with the increased numbers
of persons of working age in the population.
economic
activi~
and job opportunities,
Cyclical fluctuations in
however~
do cause the rate of gain
to vary over short-run periods.
In dollar terms, the gain in output during the postwar period is
more pronounced than the increase in physical production.
ing flow of income likewise has risen more rapidly .
The correspond-
For example, national
income (total net income earned in production of goods and services) rose by
more than
6.5
percent a year on the average .
The differential between the
two measures--money and real value- -reflects the rising prices of goods,
services, and the factors of production.
Prices of the goods and services in the Consumer Price Index have
risen about
44
percent since 1946.
MeanwhileJ annual average prices of
wholesale commodities increased nearly
50 percent. Average hourly and
weekly earnings of manufacturing production workers, which provide a rough
indication of the advance in price of an important kind of labor, have almost doubled over the period.
During the period since the end of World War II, there have been
three distinct inflationar,y movements .
in the late BUJIUTler of
In the first, prices reached a peak
1948. Wholesale prices during the interval from
beginning of 1946 to their high point in August 1948 shot up
and consumer prices rose by more than one third.
the
53 percent
Prices declined during
47the recession of 1949, reaching a low point at the beginning of 1950.
Wholesale prices declined 8 percent and consumer prices
4 percent during
the interval "
A revival in wholesale prices had already started by the time
the Korean War broke out in June 1950 but the rise was more rapid thereafter.
In the early months of 1951, prices in wholesale markets were
19 percent higher than at the beginning of 1950 .
During the remainder of
1951 and 1952, wholesale prices declined slightly and subsequently remained
stable in 1953, 1954, and the first half of 1955.
During this period--1951 through
1954 -~wholesale
price movements
did not parallel general economic activity, which continued to expand until
mid-1953.
This divergence between the movements of wholesale prices and
over-all economic performance after early 1951 probably reflected in part
a reaction from speculative buying and hoarding in both U.
So
and world
commodity markets that followed the outbreak of the Korean War.
When sup-
plies of raw materials and other commodities proved to be more than sufficient to meet demands, prices receded.
Later, wholesale prices failed to
move with general activity in 1953 and 1954, when they held steady in the
face of reduced production, employment, and income.
The 1ndex of consumer prices also increased rapidly during the
early phase of the second postwar inf'lationary period initiated in 1950.
The swift pace of the advance was slowed somewhat during 1951, and .a fter
mid-1952 the index leveled off.
At its peak, the Conawrer Price Index was
15 percent higher than it had been in February 1950.
During the subse-
quent decline of business, consll.ller prices held steady with only a minor
tendency to decline o
The third postwar wave of price inflation began in mid-1955,
when wholesale prices began to advance rapidly .
Following its customary
time lag, the index of consumer prices started to rise in the spring of 1956.
-48By Januar,y of this year, the increase amounted to about
wholesale index and about
6.5
7.5
percent in the
percent in consumer prices, with recent ad-
vances generally being rather small.
This description of price movements throughout the past 12 years
underscores the view that inflation has been a major postwar problem.
The
evidence shows both that periods of rising prices have been longerj and
that the effects of these advances have been additive in that deflation
has failed to reduce prices to the levels preceding inflation.
Furthermore,
the rate of inflation has been very uneven as prices proceeded on their upward course at an irregular pace.
Crosscurrents in 1957
Total real output during the first three quarters of 1957 was
generally stable at the advanced levels attained in late 1956.
During the
last months of 1957, however, economic growth ceased and business activity
began to decline.
In an immediate sense, the decline may be related to
changes in the volume of demand for goods and services.
The rate of inven-
tory accumulation had been reduced early in the year and in the fourth
quarter liquidation occurred.
The rising level of national security out-
lays ended in the second quarter and exports fell.
Business outlays for
new plant and equipinent also began to decline in the final quarter of 1957.
Gradually changing supply conditions also were important.
Adjust-
ments made in basic resource supplies had significant impacts upon the demand for new business expansion and upon productivit.y and prices.
By
ear~
1957, pressure on the nation's industrial capacity was eased. Record volumes of spending for new plant and equipment had enlarged industrial facilities significantly.
While the output capacity of major industrial
materials was increased by an additional 9 percent or more during 1956 and
1957, production rates failed to exceed the levels attained early in 1956.
Accordingly, the margins of unused capacity widened during 1957.
-49Capital expansion programs during the last boom undoubtedly were
founded in part upon such considerations as anticipated demands in the
1960s and upon the presumption of continued rise in producers ' goods prices,
as well as upon current demand.
Nevertheless, the lack of continued growth
in current production posed a serious deterrent to sustained high levels of
capital investment.
The adjustment in the capital-output relation in major
industries was thus an important factor in the slackening of business
investment demand.
In the labor market, conditions changed gradually.
As indicated
earlier, the tightest period appears to have been during the latter half
of 1956.
During the first three quarters of 1957, total employment was
generally above the level of the previous year, but the margin of gain diminished as 1957 progressed.
Labor force participation rates--proportions
of the adult population in the labor force --steadily fell below those in
1956.
The length of the workweek also declined.
These developments indi-
cated that human resources were under considerably less pressure than they
had been earlier.
The slowdown in production during 1957 was associated in part
with the lack of significant growth in real conswnption .
Personal con-
sumption in real terms recorded one of the smaJ.lest increases of the postwar period.
Constant dollar expendit ures for durable goods did not grow,
while increases in nondurable goods and service consumption were small.
The moderate increase in consumer demand apparently was in keeping with
the very slight gain in real disposable personal income during the year.
After tax deductions and adjustment for rising prices, the relative rise
in personal income was the smallest in the post war period.
In addition,
the increase in consumer credit outstanding was among the smallest during
the last 12 years .
With the pressures on the nation as resources r educed in 1957,
-50productivity gains were again more favorable.
The indicated gain for 1957
was still small, although appreciably larger than the gain in the previous
year.
In comparison with the increases in wage rates, the small magnitude
of productivity gain caused a continuation of the upward pressure on unit
costs and on prices during the year, although in reduced magnitude.
Wholesale prices rose much less in 1957 than in 1956.
in industrial prices in particular was quite small.
The rise
The average for the
year rose only 1 percent and the increase after February was very
slight~
Prices of producers' finished goods continued to rise but at a slower pace
than during the previous year and a half .
Similarly, wholesale prices of
consumer finished goods increased only slightly, except for new model auto
prices.
Semifabricated materials and components rose moderately and crude
material prices dropped significantly.
Farm product and processed food
prices continued to increase but at a lesser rate than in 1956.
In general, wholesale prices are more responsive than retail
prices to changes in aggregate demand and supply conditions.
The modest
gains in such prices last year, particularly in industrial prices, is
directly associated with the slackened rate of growth in demand and the
generally easier situation in resource supplies.
In the consumer market, on the other hand, several circwnstances-unrelated to current production--loomed strongly in the upward trend of
prices during 1957.
For example, the decline in meat supplies, due pri-
marily to drought and its aftermath in widespread areas of the country,
played an important role in advancing food costs during the last 2 years.
More recently; freezing weather reduced the output of other food items
which have resulted in price advances.
Many service prices are subject
to the approval of public commissions and therefore tend to adjust slowly
to changed economic conditions.
Much of the increase in rents, after re-
lease from control, reflects delayed adjustments to market conditions.
-51The significance of such special conditions in the consumer
market may be realized by noting that service and food prices were primarily responsible for the rise in the Consumer Price Index last year.
In
no small measure, special circumatances such as those described above-together with the time lag in consumer prices- -explain the overlapping of
inflation and slackening demands during 1957.
-53Part III.
OBJECTIVES OF ECONOMIC POLICY
The questi on calls for our judgment of the relative importance of
objectives of economic policy.
The reply bel ow begins with a brief
summary of our position and follows with a more detailed consider ati on
of Question 6.
(See appendix.)
Swranary
l o The three objectives should be considered as of broadly equal
importance. (Price stability, empl oyment stability, sustained economic
growth.)
2o None of the three should be interpreted in terms of a target
of 100 percent fulfillment--all can be taken in a relative sense.
3. By its very nature, objective number 3 (growth) does not require
a st ipulated quota of performance each year.
4. Such general objectives in relative terms can be posited, even
in the absence of specifi c arithmetic criteria (i.e., allowable percentage of unempl oyment or toler able creep of prices).
5. From a theoretical standpoint, we believe that the three objectives are generally compatible. Furthermore, we see no empirical evidence
in the historical r ecor d which compels the conclusion that the three
ob jectives must be considered mutual ly incompatible, although the practi cal
difficulties of reconciliation are painfully obvious. There has as yet
been little experience in a full-scale testing of monetary- fiscal policies,
applied in a sustained and determined manner, to achieve price stability
without sacrifice of the other two objectives.
6. As a practical or political matter, price stability is often
relegated to a junior order of pr ecedence. We bel ieve that its relative
rank could be elevated to a position of approximate equality with the
other objectives.
Interrel ation of Objectives
Price stability, business stability, and economic growth are closely
interrelated.
In principle, stable prices, business stability at high levels of
employment, and economic growth are mutually consi stent.
i nconsi stencies may at times develop.
In practice,
Excessive expansion or contrac-
tion in major sectors of the economy tendsto be accompanied by inflationary
-54or deflationary tendencies; too much emphasis on one objective may impair
ability to achieve the others.
Rising prices usually lead to waste, inefficiency, misdirected use
of resources, and eventually to a boom which ends in depression.
On the
other hand, falling prices (when caused by shrinking demand) tend to be
accompanied by declining production, idle plants, and unemployed labor.
Price stability, therefore, appears to be essential, although not necessarily sufficient, for achieving business stability and steady economic
growth.
High level employment is also consistent with achieving sustained
long-term growth.
Unemployment and idle facilities represent a waste
of economic resourceso
On the other hand, attempts to maintain employ-
ment at a maximum level without regard to price stability may inhibit
economic growth.
In a dynamic economy, resources are continually being
shifted from declining to expanding industries; improved machinery and
techniques replace the old and obsolete.
Such changes are essential
for increasing efficiency and promoting economic growth, but they may
also result in temporary unemployment.
Efforts to prop up declining
industries or to delay the introduction of improved techniques as a
means of preventing unemployment prolong relatively inefficient methods
of production and retard the rate of economic growth.
primarily
t~ard
Attempts directed
maintaining employment at a maximum level also create
an economic climate which is not conducive to the most efficient use of
productive resources.
When demand is pressing against capacity, the
emphasis is on getting more output.
Costs and prices are a secondary
considerationo
Inflation, formerly considered predominantly a wartime problem in
this country, has become a threat in peacetimeo
have contributed toward this wider danger.
Several developments
Governments have assumed
-55responsibility for maintaining llmaxiJnumH enployment.
Collective bargain-
ing has become a powerful force in determining wage rates.
Several
important industries are dominated by a few large conpanies, and the
prices of their products do not respond readily to the free play of
supply and demand.
Fear of "creeping" inflation has led to protective
devices such as escalator clauses which by their nature tend to perpetuate it.
It is extremely difficult, if not impossible, to keep aggregate
demand strong enough to maintain full enployment without spilling over
into rising prices, especially with the close interrelationship between
wages and prices under the present institutional structure.
An increase
in prices generates intense pressure for higher wage rates.
Under con-
ditions of full enployment a wage increase can more easily be passed
along in the form of higher prices.
Thus an increase in either prices
or wage rates ~nds to initiate a rising price- wage or wage-price spiral.
Fear of inflation has led to devices to protect real income from
the erosion of rising prices.
Some wage contracts tie wage rates to
the index of consumer prices.
Once prices begin to rise, regardless of
the initial cause, wage rates increase automatically.
If wage increases
were limited to cost-of- living adjustments of modest proportions, so
that they could readily be absorbed by increased efficiency of production,
no further impetus to the price increases should result.
And, as further
efficiencies were achieved, costs would be lowered, so that real wages
could be increased through price reductions.
But when cost-of- living
wage increases are added to basic wage increases that fully match or
exceed increases in productivity, the tendency is to set in motion an
upward spiral of costs and prices.
In fact, as the experience of a
number of countries has demonstrated, escalator provisions in wage arrangements can perpetuate a wage- price spiral of ever-increasing intensity,
-56with the result that the currency approaches worthlessness at an accelerating ratea
Although the wage 'lescalator 11 clause is best known, other devices
have a similar effectG
Some countries have issued 11 purchasing power"
bonds, whereby the amount of interest and sometimes the principal are
tied to the price indexa
income to priceso
Cost- plus contracts also tie contractual
With no incentive to cut costsj rising prices are
likely to be fully reflected in higher costs and in a larger fee as
wello
Escalator clauses and similar devices j because of the accelera-
ting effect once prices begin to rise j make it more difficult to achieve
price stabilitya
The fact that the present economic environment facilitates operation of the wage-price spiral does not mean that inflation is inevitableo
Wage increases are inherently inflationary when in excess of the rise in
productivity for the economy as a whole; it is problematical whether,
under all circumstances , action to limit credit and the money supply and
thus to make more difficult the financing of business at the higher price
level can prevent a wage - price spiral from continuing to push prices upwarda
However , credit restraint , properly timed, can be of great value
in minimizing and possibly preventing or halting an upward spiralo
The
longer a spiral is permitted to continue , the more difficult it becomes
to halt it without precipitating a decline in production and employmento
Policies directed toward maintaining maximum employment may result
in long-run inflation even though a continual rise in prices is avoided.
Recurrent booms may push prices upwardo
On the other hand, because of
prompt actions to stimulate production and restore full employment,
periods of recession may be accompanied by a halt to the rise of prices
but little, if any, declineo
With prices moving upward from a higher
base following each recession the long-run trend would be a ratcheting
-57upward movement in the price level.
Too much emphasis on full employment
may prevent the effective restraint necessary to maintain price stability.
Success in promoting stability of prices and in avoiding wide fluctuations in production, employment, and income, however, will in general
provide an economic atmosphere conducive to maximum economic growth--the
third objective of economic policy.
In a market
econo~,
the forces that
promote economic progress on the part of the individual are in
genera~
the same forces that foster a rising standard of living for society as
a whole. While this view does not deny that government policies may accelerate economic growth, it does recognize that the major impetus for
growth stems primarily from the efforts of individuals to promote their
own well- being, within the i'ramework of a stable econom,y, rather than
concerted efforts of the government to elevate growth to a major objective
of public policy.
Aside from the promoti on of stability in prices and business activity, the contribution of public policy to economic growth lies mainly
in fostering competition in the
lant to growtho
econo~.
Competition is a strong stimu-
It sharpens interest in reducing costs , in searching
out more efficient methods of production, and in discovering and applying new techniques and products.
and skills.
It places a premium on entrepreneurship
It promotes business investment, both as a means of reduc-
ing production costs by introducing more efficient equipment and as a
means of increasing capacity to capture a larger share of the market.
Competition is, in short, the major stimulant to economical use of resources, both human and material, through technological progress and
the elimination of waste and inefficiency in productive processes.
Given the pace of technological advance , the rate of economic growth
tends to vary directly with the proportion of economic resources devoted
to capital formation.
While monetary and fiscal policies inevitably
-58affect the pace of capital formation, the precise allocation of resources
in a market economy between production for consumption and production
for investment is determined largely by the free choice of consumers and
businesseso
Experience indicates that the maintenance of reasonable
stability in the value of money and prosperous economic conditions provides an atmosphere conducive to a sustained and satisfactory rate of
economic growth.
~
If this view is correct, stability of prices and busi-
activity must be
economic growth
~ ~
accepted~
the primary goal of policy, with
natural and desirable consequence of their· success-
ful attainment.
Moreover, it is important to recognize that, under conditions of
relatively full use of economic resources, a faster rate of growth can
be achieved only at the expense of current consumption.
Such a choice
should generally, in our opinion, be a reflection of individual preferences rather than a government decisiono
These longer-run problems of harmonizing economic policy objectives
have their counterpart in the short runo
an illustration.
The current situation affords
The index of consumer prices has continued to rise
even though production, employment, and income has been declining for
a number of months, and recently the index of wholesale prices also has
been rising.
Sole emphasis on price stability would call for continued
restraint to check the rise.
A restrictive policy, however, would tend
to intensify the decline in production and the rise in unemployment.
Thus, policies directed solely toward price stability would be somewhat
inconsistent with maintaining business stability and a full utilization
of labor and productive facilities.
When such conflicts occur, monetary and fiscal authorities should
reappraise the relative significance of the various objectives and select
that combination which is most appropriate under the circumstances.
-59Relative Importance of Objectives
The relative importance of economic objectives varies with economic
conditionso
No specific ranking is appropriate under all circumstances.
The particular combination that should be pursued at a given time depencts
on existing conditions and a careful appraisal of the probable consequences of the policies that would be necessary to achieve each objective.
Wide acceptance of the view that chronic inflation will be present
in peacetime does not appear to be based on the conclusion that it is
desirable per
adequateo
~
or that economic instruments for preventing it are in-
Rather it seems to rest primarily on the premise that maximum
employment is the goal of paramount importance, even though it involves
the threat of long-run inflation.
This premise tends to block the use
of monetary and fiscal policies with whatever vigor is required to check
rising prices and to prevent a decline in the purchasing power of the
dollar.
Such an emphasis on the employment goal, however, is subject
to change, in the event of an increased realization of the economic and
social damage which is wrought by inflation.
In any event, the pursuit of policies to achieve either of these
objectives (full employment and stable prices) will inflict sacrifices
and hardships on someone.
Emphasis on the employment objective even
though it results in recurrent inflation, may temporarily minimize unemployment but there is a price for ' someone to pay.
is like a termite.
Creeping inflation
Working underneath a surface of prosperity, it con-
stantly nibbles away the buying power of the dollar, favors speculative
rather than constructive investment and so
unde~mines
the foundations
of growth, and eventually may lead to runaway inflation.
A price increase of 3 percent annually, although small in itself,
would in 20 years reduce the buying power of the dollar by nearly onehalf.
One effect would be to wipe out a substantial part of the real
-60-
value of money savings and fixed incomes.
It would inflict heavy losses
on millions of people with savings deposits in banks, shares in savings
and loan associations, and life insurance; and impose a sharp reduction
in the standard of living of those with fixed incomes, such as recipients
of annuities, pension, and other forms of retirement income.
The hard-
ship is just as real, although not so obvious, as the loss of income
resulting from unemployment; and to a large extent the burden falls on
those least able to bear it.
Secondly, as it became clear that money
savings were faced with progressive shrinkage in purchasing power, the
flow of savings into savings institutions would tend to decline, there
would be a shift from money and fixed-income obligations to equities and
real property, speculation and waste would be
enc c ~aged,
and maladjust-
ments would be created among different types of economic activity.
developments would accelerate the pace
of ~_inflation
the hardships imposed on much of the population.
These
and thus intensify
If carried far enough,
it could eventually lead to chaotic conditions in the economy.
But even
in the absence of such a culminating phase, the consequences of substantial inflation are damaging enough to warrant very strong efforts to
prevent it.
Likewise, an effective use of monetar.r and fiscal policies to help
maintain price and business stability cannot be entirely painless.
In
essence, a restrictive monetary policy designed to prevent spendable funds
from rising more rapidly than the output of goods and services available
for .people to buy, limits the total quantity of credit available to borrowers.
Some would-be borrowers are deprived of credit which otherwise
would be available.
But the limited supply is allocated among borrowers
by market forces instead of by the decisions of some
regulato~y
agency.
It is well to note that using direct controls as a means of maintaining maximum employment without inflation also has its price.
-61-
Experience demonstrates that a harness of' direct controls over prices
.and wages creates rigidities and distortions, makes adjustment to change
slow and more difficult, infringes upon individual freedom, and stifles
private initiative.
The long-run effect is to inhibit not only the
mobility of resources, but growth itself.
In addition, direct controls
are inconsistent with the principles laid down in the Employment Act
that maximum employment, production and purchasing power should be promoted in ways that would foster and promote free competitive enterprise.
Even more important, perhaps, is the fundamental weakness inherent
in direct controls.
The fact that they are needed is conclusive evidence
that aggregate demand is in excess of the amount which is consistent with
price stability.
Their purpose is to suppress the effect of excessive
purchasing power on priceso
With prices controlled and supplies limited,
however, money accumulates which cannot be spent for the goods people
want to buy.
Experience suggests that before long, workers may decide
that greater satisfaction can be derived from more leisure rather than
more worko
Inability to convert income into goods dulls the incentive
to work, spawns inefficiency, and leads to conditions inimical to economic
growth.
Furthermore, i f long continued, the accumulation of pent-up pur-
chasing power is almost certain to lead to violations, the growth of black
markets, and eventual price inflation.
Selecting the most appropriate goals of economic policy is a difficult and complicated task.
General economic welfare can best be promoted,
i t seems, by carefully weighing the advantages, and the sacrifices and
hardships involved in pursuing policies designed to achieve alternative
objecti ves.
The l ong-run as well as the short-run effects should also
be consideredo
Only in this way can men of judgment reach a sound
decision as to the particular combination which seems most appropriate
for a particular situationo
-63-
PART IV.
FISCAL AND DEBT MANAGEMENT POLICY
The comments that follow are submitted in an effort to be
responsive to the Committee's questions concerning fiscal and debt
management policies, even though such policies are not within the area
of responsibility of the Federal Reserve System.
The discussion is
intended to be theoretical and analytical, rather than to recommend any
specific policies or courses of action.
Fiscal policy
In principle, the view is widely held that fiscal policy should
be conducted in an anticyclical manner, with Government revenue·s exceed·
ing expenditures in boom periods, and expenditures exceeding revenues in
periods of recession, so as to help compensate for major swings in
private spending.
To some extent this now tends to occur automatically
under the present fiscal structure, as most of the major types of taxes
tend to produce greater revenues in periods of expanding activity, income,
and private spending, and considerably smaller revenues in periods of
declining activity.
Furthermore, under continuing programs some types
of expenditures tend to contract in prosperous times and to increase in
periods of recession.
For example, disbursements from unemployment trust
funds, grants-in-aid to the states for public assistance, and to some
extent old-age benefits decline in periods of expanding business activity,
and increase in periods of recession and rising unemployment.
To be most effective as an anticyclical infiuence, however, the
automatic variability of receipts and e:xpendi tures in response to changes
in economic condi ti.ons may need to be re-enforced by' active efforts to
restrain Government expenditures when private (business and consumer)
spending is high and to accelerate governmental projects when private
spending is declining.
Similarly, to the extent that tax reduction is
-64possi ble within the framework of a budget balanced (on a cash basis)
over the full cycle, the reductions would be most conducive to economic
stabi l i ty if effected when recessionary tendencies prevail.
And if
increased taxation is required to achieve over- all budgetary balance,
the tax increases would best be effected in periods when expansive and
inflationary tendencies prevail.
Furthermore, different types of expenditures and receipts have
different economic effects. Government expenditures that require large
amounts of materials and labor, such as public works, public housing,
and highway construction, and of course, direct or indirect subsidies,
would be most useful in promoting steady growth of the economy if they
could be concentrated in per iods of recession.
In the field of taxation, sim.i larly, some types of taxes are
believed to bear more heavily on consumer spending, while others are
believed to bear more heavily on saving and investment.
For example,
broadly based taxes such as excise taxes (especially retail sales taxes)
and the "normal" income tax are considered to have greater impact bn
consumer spending than on saving, whereas the progressive surtaxes are
consi dered t o have gr eater effects on saving.
The actual effects of
such taxes on spending and savifll:, however, are not measurable.
The
economic effects of corporation taxes also are very difficult to measure.
The corporation inoome tax is commonly considered nonregressive.
There
is generally a strong tendency, when tax r eduction is oonsidered desirable
in order to exert a stimulating effect on the economy, to place primary
emphasis on reductions in personal income and excise taxes .
But it is
questionable to what extent the corporation income tax is actually
nonregressive.
The fact that the average ratio of net income after
taxes to invested capital in recent years has been much the same as in
earlier periods of high activity, when tax rates were much lower, would
-65seem to suggest that corporations in general have been able in fixing
selling prices to treat the tax on profits as an item of cost and so to
pass the tax along to customerso*
The present fiscal system
The current l evel s of expenditures and receipts have made the
fiscal policy of the Federal Government a far more important influence
on the economy than in ear lier days.
between 20 and
25
Government receipts have taken
percent of total national income in recent year s, and
Government purchases of goods and services have accounted for 11 to 15
percent of total gross national product, in addition to which l arge
amounts have been returned to the public through transfer payment s and
interest on the public debt.
Sizable variations in Government expendi-
tures or in Government r eceipts, therefore, can have profound effects on
the economy.
In the recession of 1953-54, for example, the curtailment
of Government expenditures following the end of the war in Korea accounted
for a much larger part of the decline in gross national product than the
net decline in private expenditureso
On the other hand, the substantial
tax reductions of 1954 undoubtedly helped to promote early recovery from
the recession.
And in 1949, the increase in Government defense and
other expenditures, together with a reduction in tax collections , went
far toward offsetting the decline in business inventory and other investment and stimulating consumer spending.
Over the postwar period as a whole, the budgetary position of
the Government--in the sense of the over-all balance between total
payments and total r eceipts--does not appear to have been a major
*
It is sometimes argued that, to the extent that accelerated depreciation on plant and equipment has been permitted for tax purposes,
corporation profits in recent years have been understated. On the
other hand, it is argued with at least equal force that f ar more
generally the practice of basing depreciation on historical cost,
rather than reproduction cost, has r esulted in serious overstatement
of corporation profits.
-66-
inflationary influence.
The delayed effects of the huge wartime deficits,
together with the shortages of civilian goods that accumulated during
the war, were probably the most important inflationary forces in the early
postwar years, 1946-48.
In fact, the large cash surpluses of the Treasury
in calendar years 1947, 1948, and 1956 were helpful in restraining the
inflationary tendencies of those years, and the smaller surpluses in
1951 and 1957 were at least on the right side of the line. On the other
hand, the deficits of 1952 and 1953 contributed to the inflationary
influence of real or anticipated shortages of goods (actually more anticipated than real) during the Korean war period.
But the net budgetary position, even on a cash basis, does not
tell the whole story.
The very magnitude of Government expenditures,
and the levels of taxation required to meet them, have effects independent of the balance of receipts or payments.
The current high levels
of Government expenditures, and their tendency to follow a long-term
upward trend, have made them a much more important element in the
economy than in earlier years, and a fairly stable one.
But even within
a fairly steady total volume, shifts among the various types of expenditures can have substantial effects on particular industries or areas of
the economy.
For example, the shift of emphasis from military air craft
to guided missiles during the past six months or so has had a depressing
effect on aircraft production and employment, with the eventual effects
in terms of manpower and material requirements still uncertain.
Furthermore, even with a balanced budget, Government expenditures and taxes at current high levels can exert inflationary influences.
For exa.11ple, the corporation tax rate is so high that the effect of
higher interest rates in restraining borrowing in a boom period is
diluted, since it is said that "the Government. pays more than half the
cost".
Also, incentives to efficiency and avoidance of wasteful or
-67-
unnecessary expenses are greatly weakened, with inflationar y effects.
Quite aside from such tax aspects, i t becomes extremely difficult to
achieve economy and avoid inflationary influences in Government operations and procurement when the aggregate vol ume of expenditures is so
huge.
Another major weakness of fiscal policy as an instrument of
national economic policy is the difficulty in obtaining timely public
support and Congressional action for the fiscal measures that would be
most conducive to economic stability in the sense of steady, sustainable
growth without inflation.
It is usually difficult, except in periods
of national emergency to get public support for increased t axation,
expecially of the kinds that would be most effective in restraining
inflationary tendencies; and curtailment of Government spending finds
more favor in the generality than in the specifics.
On the other hand,
when tax reduction or accelerated expenditure appears to be appropriate
to exert a sustaining influence on producti on and employment, it is
usually a time - consuming process to reach agreement on the types of tax
reduction or of increased expenditure that will be most appropriate to
the circumstances.
And even if the initiation of changes is well timed,
the expenditure programs adopted may attain their greatest momentum
when they are no longer needed, and so give rise to new unstabilizing
forces.
Similarly, new taxes levied to meet the needs of a particular
situation are frequently retained long after the particular circumstances
'
that led to their adoption ·have passed; and tax reductions also are hard
to reverse except in emergency situations.
One great difficulty is that of appraising the extent of the
need for a specific fiscal policy and how long it will be needed.
Despite all the improvements that have been made in economic data, forecasting remains a decidedly imperfect art.
The current situation may be
-68-
used to illustrate the point.
In so far as the current recession repre-
sents an inventory adjustment, it should provide its own remedy within
a few months .
Another and more important factor, especially from the
viewpoint of duration, however, is the decline in business investment
in plant and equipment, fol lowing the development of excess capacity
in a number of industries.
Planned expansion of national defense expen-
ditures, together with the rising trend of state and local government
capital projects and a possible acceleration of residential construct ion,
should go far toward offsetting the decline in business investment, but
the relative timing and momentum of the various factors are uncertain.
Meanwhile, major questions are how well consumer spending-the largest single element in the national economy--will be sustained,
and how far the curtailment of business investment will go.
Recent
data on consumer spending have been difficult to interpret because of
the complicating infl uence of unusually severe winter weather in much
of the country.
Developments in this area, probably more than any
other, will determine whether Government intervention, in the form of
tax reduction or a large incr ease in public works, is needed to count eract the r ecessionary tendencies.
If there is a normal seasonal pick-up
in such things as automobile sales and residential building during the
spring months, and consumer spending generally is well sustained, and
if the contraction in business investment is not accelerated, quite
moderate action on the part of the Federal Government might be sufficient.
On the other hand, if it should appear that consumer spending
is being substantially curtailed as a result of unemployment and apprehensiveness concerning future prospects-- and perhaps also by the burden
of existing consumer debts--vigorous steps in the form of prompt acting governmental measur es would be indicated.
In the tax field, probably a substantial but temporary reduction
-69-
in broadly based taxes would be most effective and appropriate (temporary,
in view of the prospect of a rising trend of Government expenditures and
probably sizable deficits ahead)o
This does not necessarily mean, how-
ever, that tax reductions should be limited to personal income and excise
taxeso
Some forms of corporation tax reduction might also be expected
to have stimulating effects on business activity and employment.
For
example, some countries have used variable depreciation allowances to
stimulate business spending on plant and equipment in periods of reduced
activity and to restrain such expenditures in periods of high activity.*
And, in the expenditure field, the preferable emphasis would be on projects that have been started and can readily be accelerated, or on
projects that are past the planning stage and can be put into motion
rapidlyo
The great danger in a public works program is that it will
only attain substantial momentum after the greatest need has passed, and
may t hen accentuate inflationary tendencies by competing with other
active demands for materials and manpower- -especially the latter
unl~ss
care is taken to select projects that are clearly needed and are of such
types and so located as to provide employment for the unemployedo
At
best, public works cannot be expected to make effective use of the particular skills of many of those who are out of work.
State and local government finance
Major parts of state and local government expenditures, such as
expenditures for education, police and fire protection, maintenance of
pUblic institutions, street and highway maintenance, and other public
services are not greatly influenced by economic conditionso
But there
* In the present situation, with excess capacity in many industries,
more liberal depreciation allowance on new investments in plant might
not have much effect in inducing acceleration of expansion plans, but
might accelerate replacement of inefficient or obsolete equipment wit h
a view to achieving cost savings and relieving the squeeze on profits.
-70-
are other parts, such as the construction and improvement of public
institutions and highways which ideally might be accelerated or retarded
to help compensate for the wider swings in private spending, and thus
exert a countercyclical influence on the economy.
Practically, however,
such countercyclical timing of cons truction projects appears to be very
difficult to achieve, even though it might result in appreciable savings
in costs .
The principal types of state and local expenditures which
tend to rise in periods of recession and to contract in periods of
expansion are unemployment benefits and other forms of public assistance
to the needy, much of the financing of which is done by the Federal
Government.
Major capital expenditures of state and local governments
are usually financed by the sale of securi ties, rather than by current
taxation, but frequently require the approval of the voters before the
additional indebtedness can be assumed.
And even though savings might
be achieved by moving forward or postponing such projects to periods of
recession, t he tendency frequently is to delay them unti l the need is
clearly urgent, and then to proceed regardless of economic conditions
and costs .
In f act, projects involving large expenditures are more
likely to be voted down in periods of r e cession, since taxpayers are
particularly reluctant to assume new burdens at such times, although
projects previously approved are carried forward.
On the other hand,
shortages of materials and unfavorable conditions in the capital market s
may retard such project s in boom periods.
The net result has been a
generally rising trend of state and local expenditures through prosperity
and recession during the postwar period.
Since t he fields of progressive taxation of personal income
and taxation of corporation profits are so largely pre-empted by the
Federal Government, state and local government r evenues are derived
largely from r eal property taxes, general and specific sales taxes, and
certain basic business taxes which frequently are independent of profits
earned.
Consequently, while they have shown a generally upward trend,
they have varied only to a minor extent in response to changes in business conditions.
As a result, they have tended to become more burdensome
i n periods of business recession, and less burdensome in periods of
prosperity.
Debt management policy
For some years economist s rather generally have urged that the
management of the public debt be conducted in such a manner as to reenforce countercycl ical fiscal and monetary policies .
More specifically,
the general pol i cy advocated is that the Treasury place particular
emphasis on the sale of long-term securities duri ng periods of high
activity and inflationary pressures, and on the sale of short-terms during
periods of recession.
A primary purpose would be to divert investment
funds from private investment and thus restrain tendencies toward overexpansion in prosperous times, and to avoid competition for the available
supply of investment funds in periods of reduced business activity and
unemployment.
Furthermore, in a period of expansion the use of the proceeds
of sales of long-term securities, togetrer with the surplus r evenues which
an appropriate fiscal policy should provide, would be used to retire
short-term debt held by the banks and others, thus reducing the liquidity
of the banking system and helping to make restrictive monetary pol icies
of the central banking system more effective.
In a period of recession,
the proceeds of Treasury sales of short-term securities (presumably
largely to the cormnercial banks) would be used to meet Government deficits,
ani perhaps to retire long- term securi.ties.
A result could be to off-
set, or more than offset, the decline in bank loans characteristic of a
period of recession, thus maintaining or increasing total bank credit and
- 72-
the money supply, and at the same time increasing bank liquidity and
re - enforcing an "easy'' monetary policy o
The experience of recent years, however, has raised questions
concerning the feasibility and, to some extent, the desirabil ity of such
a debt management pol icy.
In the first place , the heavy demands for
capital in a period of high activity tend to make the financial markets
unreceptive to long-term Treasury securities and to require the Treasury
to bid up interest rates progressively if it is to be successful in
diverting funds fran other uses.
The Treasury is likely to be severely
criticized by potential borrowers (such as builders and municipalities)
who find it most di.fficul t to compete, and by others in the role of
taxpayers who object to the increased service charges on the public debt.
Furthermore, the increased l iquidity of the banking system
that results from large sales of short-term Treasury securities to the
banks in a period of recession (such as 1953-54) delays and limits t he
effectiveness of restrictive monetary policies when inflationary t endencies again become a problem.
These difficulties have led some
observers to conclude that the Treasury should abandon any attempt to
use debt management policy as an instrument of national economic pol icy,
and should be guided by market conditions in deciding upon the type and
maturity of securities to be offered at any given time.
In the l ong
run, presumabl y the Treasury would dir ect its efforts primarily toward
achieving wide diversification in the maturity structure of the public
debt, and avoiding excessive concentration in short maturities.
This
would reduce the amount and frequency of refUnding operations r equir ed,
and thus would r educe to a minimum the interference of debt operations
.•
with the execution of monetary policy.
The Treasury would not try to
force long-term issues on an unreceptive market, but would ordinarily
limit its offerings to short or intermediate maturities under tight
- 73-
money marke t conditionso
That, of course, would mean that the Treasury
would have to do most of its long-tenn financing in periods of easy
money conditions, when funds for l ong- term investment tend to be
~ore
readily available and other demands on the capital markets tend to become
less pressing.
A third alternative woul d be to follow an intermediate course.
While avoiding attempt s to float large amounts of long- term securities,
and thus to withdraw funds from the private capital market in important
amounts during periods of expansion, the Treasury might try to sell
limited amounts from time to time at competitive rates.
If this proved
successful, there would be less need for large offerings of long- term
securi ties, designed to maintain satisfactory maturity distribution of
the public debt, in periods of reduced business activity and employment e But moderate amounts of l ong- term financing might be done even
then, at least after the initial recession phase, to provide an outlet
f or savings in excess of other current demands in the capital mar kets.
(The amounts, per haps, would depend upon the general vulnerability of
busi ness conditions and the extent of other current demands in the
capital market for availabl e savings-- although this would not preclude
some modest competition for savings by the Treasury against other demands .)
And to the extent that there was need fo r the financing of sizable
budgetary deficits, securities designed for commercial bank subscription
mi ght well be issued in diversified matur ities up to ten years.
This
would facil i tate an appropriate distribution of bank portfolios, and
help to avoid the development of excessive liquidity in the banking
system which would be l ikely to result from heavy emphasis on shortterm financing dur ing a period of recessiono While such a compromise
debt management program would be of limited use as an instrument of
anticyclical economic policy, i t would at l east involve a minimum of
-74-
interference with anticyclical fiscal and monetary policies, and should
involve less difficulty than an attempt to carry out a thorough-going
ant icyclical policy--a poliey which has not yet been found feasible for
any extended period.
-75Part V. ADEQUACY OF THE MONETARY SYSTEM
There is probably no unanimity of opinion about the adequacy
of any monetary system, but most observers would include in any j udgment
the following criteria:
(1) stability of value; (2) responsiveness to
economic change in accommodating orderly economic growth; (3) allocation
of the credit created by the banks in such a way that the nation's resources are used effectively; and (4) adaptability of the money-creation
process to accord with the objectives of public policy.
Stability of Value
The term stability of value is generally used to signify some
constancy in purchasing power over goods.
The limits of tolerance exclude
both a rapid and continuous rise of the price level and a severe fall in
the price level.
At times this coUl'l,try has experienced some instability
in t he value of money in terms of price change, but thus far the severe
losses of purchasing power have been confined to periods of adjustment to
the financial and other consequences of war emergencies.
The extreme
upward surges of the price level like those of 1914-20 and 1946-51, and
similarly the violent collapses such as that of 1929- 33, in fact, appr oached
highly undesirable extremities .
Monetary developments played a role in
those fluctuations, but they cannot be said to have been an originating
cause.
Another connotation of stability of value is constancy of purchasing power in tenns of gold and foreign currencies conver tible into
gold.
In this sense, the dollar has been dependable and stable for many
years except for a brief period in the early 1thirties.
The United States
today provides a fixed point of reference for national currencies, and
this reference point is the dollar and the dollar price of gold.
The
dollar continues to be t he most generally acceptable currency in the world
·- 76today.
The integrity of the dollar depends in the final analysis on the
productive power of the American economy in conjunction with successful
handling of fiscal and monetary problems .
Responsiveness of the Monetar y System to Economic Change
Congress endowed the Federal Reserve System vrith the power to
provide a flexible supply of money and credit, recognizing that elasticity
in the money supply can facilitate economic change and growth and that a
rigid or arbitrarily limited volume can stifle development .
The present
financial institutional arrangements within the monetary system facilitate
an allocation of resources among different regions, industries, and firms.
The system permits funds, and the resources these funds represent, to be
channeled to those areas or businesses which are able to use them most
efficiently.
The present monetary system provides fluidity of funds in a
free market economy.
Organized and interrelated as it is, it represents
a cohesive whole which makes possible intensive utilization of available
funds.
This flexibility has generally worked well and has assured satisfactory handling of the changing transactiaurrequirements of an economy
whose population and labor for ce have increased
since the Federal Reserve was established.
75 percent in the 44 years
During those four decades, the
sheer physical output of goods and services has expanded to a volume scarely
imaginable in
1914. Many undreamed- of products and services have entered
into the composition of the gross national product, with accompanying basic
shifts in regional distribution of productive capaci ty and population.
Moreover, at various times in that half- century the economy passed through
serious depressions and at recurring intervals became involved in prqblems
of war finance .
Each successive phase brought to light new needs, which
have been recognized by Congress, not only in monetary and credit institutions and in the policy instruments available to the Federal Reserve System,
-77but also over a much broader r ange of public policy and responsibility.
The adaptability of the monetary system is more specifically
illustr ated over the period since World War II and, in particular, with
the return to a flexible monetary policy beginning in 1951.
During the
years 1952-1957 as a whole , the economy experienced a substantial rise in
economic activity.
Despite the '53-' 54 setback, the average rate of in-
crease in physical production over the five- year period, '52- '57, was in
excess of the long-term growth trend.
Savings and new bank credit facili-
tated shifts in production and allowed basic productive capacity to be
expanded at a rapid pace .
Recurrent inflationary price developments, how-
ever, posed a serious probl em .
The ideal role of bank credit is t hat of meeting the r eal needs
of the economy without contributing to inflationary developments, as competing demands for raw mater ials and finished products tend t o press
against available supplies .
role.
By and large, bank credit has filled this
The postwar decade brought a rapid r at e of technological as well
as organizat ional improvement reflected in a high output increment per
unit of capital formation.
Through this period of major change , with its
inherent potential for t emporary distortion of the economy and strain on
many prices, monetary poli cy has oper ated to limit excessive demand in
the money mar ket and in the economy in gener al .
The less constructive aspects of financial history s i nce 1951
are reflected in the price rises which have occurred in t he period since
the 1954 recession.
The generally strong demands for both consumer and
capital goods permitted price advances of sufficient size and persistence
t o r aise questions as to the future value of the curr ency.
The
pric~
advances
have r eflected primarily nonmonetary f orces rather t han excessive expansion
- 78of the money supply, and raised questions as to the feasibility of restraining such forces by monetary policy alone .
Allocation of Credit
The varying forces of supply and demand in different sectors of
the freely functioning money and capital markets allocate available credit
and capital among the myriad seekers of funds through variations with.i n the
structure of interest rates, taken in the context of differences in risk,
maturities, etc .
The heart of the allocative process lies, of course, in
arrangements that assure each borrower the possibility of access to competing sources of funds, and each investor the possibility of choosing among
competing borrowers or types of investment.
The power to limit or influence the total volume of money, and
the additions to the total supply of credit which are derived from changes
in bank credit and the money supply, is the responsibility of the Federal
Reserve System.
The use of this credit by specific borrowers and sectors
of the economy is influenced by the cost of the credit and the ability and
willingness of the lenders to extend it.
This willingness is influenced
by the balance between reserves which are freely available and reserves
that must be obtained through borrowing at the Reserve Banks at the discount rate.
The Federal Reserve Banks are the principal suppliers of
reserves, and they may add to or subtract from the reserve base as they
create (or extinguish) their own credit through open market purchases (or
sales) of securities or advances to member banks.
Changes in the availa-
bility of reserves may also be effected through changes in the level of
reserve requirements.
An increase or decrease in the reserve base exerts
pressure toward increased or reduced availability of credit and a larger
or smaller money supply, with an accompanying tendency for rates to rise
or fall and lending tenns to ease or tighten .
Changes in interest rates
-79are the means by which market forces effect a balance between supplies
of funds and demands for funds at any given timeo
Since the banking system
and the credit and capital markets of the nation are closely interconnected,
interest rate changes quickly affect a wide range of credit instruments.
Furthennore, uncertainty created by changes in rates affects the whole
complex of lenders' and borrowers' decisions.
And under conditions where
the System has limited the availability of credit, lenders are inclined
to r ation the available supply among various userso
Federal Reserve monetary policies thus function through the commercial banking system, and regardless of the instrument of policy used
to influence credit, the supply of bank reserves is affected.
Although non-
bank lenders and investors may be affected directly or indirectly by
Federal Reserve operations, the most signi ficant result is change in the
money supply and corresponding change in the credit structure.
Role of financial intermediaries .
One aspect of developments
in the monetary system in recent years has been the significant growth of
such financial intermediaries as mutual savings banks, savings and loan
associations, and life insurance companies.
The claims on such financial
intermediaries (including savings deposits, savings and loan shares, policy
reserves, and other financial assets) differ in essential fashion and function from demand deposits .
In contrast to other financial institutions, the commercial banking system can, if additional reserves are made available, expand its deposits by several times the added reserves as banks make new loans or
purchase securities .
Bank deposits are expanded as a result of the mone-
tization of the debts of borrower s.
In the case of the financial intermediaries,
acquisition of debt instruments involves the exchange of one asset (demand
deposits in a commercial bank) for another (the investment acquired) .
Total
assets cannot be increased by setting up demand liabilities in favor of
the borrowers .
Thus, it can be said that commercial banks create the effective
money supply in the form of demand deposits, which are an independent variable at the margin of the credit supply.
The financial intermediaries
cannot on theiT own initiative, either individually or as a system, enlarge
the money supply of the public by expanding their liabilities. Most of the
increases in the total of claims against the financial intermediaries depend
upon an act of saving by individuals .
The rise in savings, instead of
representing an addition to spending power, generally reflects the diver sion
of a part of personal income from spending on consumer goods to the financ ing of productive facilities, homes, and other capital uses.
It is true that demand balances at the commercial banks may be
activated as funds are recirculated by the intermediaries through their
investment operation, and that the velocity of deposits may thus be increased.
Many other types of transactions, however, are reflected in changes
in the velocity of money.
Velocity will undoubtedly continue to reflect
the effect of changes in business activity and in interest rates, and will
need to be continuously taken into account in assessment of the credit
situation.
But that is not a new development, and present institutional
arrangements in the United States seem adequate to prevent serious interference with credit policy arising from changes in velocity.
Position-of commercial banks .
bank financial intermediaries,
In evaluating the growth of non-
co~~ideration
should be accorded the fact
that commercial banks have maintained their position of relative importance
in the economy during the past forty years .
In 1916-17 the nation's com-
mercial bank demand deposits were equivalent to about
24 percent of gross
-81national product; currently they amount to about 26 percent.
Thus, for as
l ong a period as there are reliable statistics, commercial banks have shown
no decline in importance.
The ratio of the money supply to gross national
product declined during the postwar boom, but the decline followed a rapid
wartime rise, and the r atio is not lower now than it was in the 1920s .
Adaptability of the Monetary System
~ven
as late as the decade prior to the establishment of the
Federal Reserve System, predominant attention was directed to money in the
form of circulating currency, when considering the monetary and credit
relationships to economic activity.
During the depression of the 1930s ,
the tendency was to turn to fiscal policy as the predominant instrument
of economic policy.
Through World War II and into the postwar period the
operations of the national Government, and at times those of other instrumentalities, became highly important in their effects on economic developments .
After the early postwar years , however, t here
~as
a widespread
tendency here (and abroad) to turn again to monetary poli cy as an important
instrument of economic policy.
Thus, in the last decade, it has become
customary to view monetary and credit policy, fiscal policy, and public
debt management as essential complementary parts of any program working
toward the objectives of economic policy--realization of the potential
for growth, avoidance of serious instability of production, employment,
and prices.
Monetary policy deals most di rectly with the sources of changes
in the money supply.
Fiscal and debt management policies cannot of them-
selves create or extinguish money.
They can only take such action as may
lead to changes in credit conditions and economic activity within t he
framework of contemporary monetary policy.
Since changes in credit and
capital markets have a large influence on the general state of expectations of business and consumers, it is important that balance be maintained
between the supply of reserves and bank credit, and the physical growth
of the economy.
Fiscal policy, which concerns Government expenditures and
receipts, can have direct effects upon demands for goods and services and
on spendable incomes.
Effective co-ordination of monetary policy, fiscal policy, and
debt management depends upon sympathetic comprehension and treatment of
mutual problems by the Federal Reserve and by the legislative and the
executive branches of the Government.
Fiscal policy as determined by
Congress must be based on many considerations, but one important factor
should be its impact on economic stability.
The real problem is not a
selection of either fiscal or monetary instruments of economic policy in
preference to the other, but to co- ordinate them in such a way as to gain
the particular advantages and mutually reinforcing action of each in pursuit of .economic policy objectives.
Monetary policy has the advantage of being an impersonal, flexible, and adaptable instrument .
Monetary measures can be taken with a
minimum of delay; their immediate effects can be measured with some accuracy.
visible.
Reasonable adjustments can be made quickly to changes currently
The instruments used in policy decisions make possible continuous
contact with the banking system and the money market.
Even though dis-
counting is done at the initiative of individual member banks, open market
operations are undertaken solely at the initiative of the Federal Reserve.
The Federal Reserve, because of the interrelationship of these two instruments, is able to retain control of the reserve position of member banks
and thus influence their credit policies.
Fiscal policies and debt manage-
ment policies, on the other hand, are less flexible and adaptable.
-83Fiscal policy, like monetary policy, suffers from imperfect visibility as to the economic conditions to be encountered.
In addition, it
entails a sizable lag betNeen the considerations of measures to be taken,
definite decisions, and their execution; and by its nature involves rigidities .
These factors hamper satisfactory design of the revenue structure so
that tax revenues at given rates increase or decrease in a higher proportion
than fluctuating national income, thus tending to produce budget balance
over the cycle of economic activity with alternating deficits and surplus.
The
auto~atic
features, however, which have been incorporated in postwar
Federal budgets exert a stabilizing influence, and their f orce may affect
both upward and downward movements of business since revenues rise in a
higher proportion than output when output rises , i.e., spendable private
income rises less than output.
This influence, however, may not be realized
i f surpluses occurring in periods of prosperity are used to finance addi-
tional or expanded programs rather than to retire debt.
Avoidance of a
continuously rising debt and resulting inflationary pressure calls for fis cal discipline of a high order.
So long as the budget is dominated by defense and related expenditures, and so long as obligations of earlier wars and transfer payments
are relatively large, it will continue to be difficult to distribute
Federal expenditures on the basis of positive goals and to vary the size
of the Federal budget in relation to private spending.
In periods of underemployment, fiscal and debt management policies have certain advant ages over some Federal Reserve acti ons .
They may
have a more direct effect on the demand for goods and services.
Monetary
policy, however, can be made ef£ective more quickly and may be sufficient
during a moderate recession.
It counters declining business activity through
lowering the cost of credit and increasing its availability as well as by
-84reducing pressures for forced liquidation of inventories or other goods .
Given a st rong underlying demand, growing population, expanding wants , and
r apidly changing technology, an increased availability and lower cost of
funds tend to induce increased expenditures by individuals, state and local
units, and by business.
Terms and conditions for the purchase of a wide
range of goods are brought within reach of an increased number of cr edit
users .
Many t ypes of business and municipal capital e:xpendi tures react t o
favorable prices and a ready availability of funds for financing .
This
situation is encouraged when the banking system is strong and liquid.
On
the other hand, when the overriding problem is one of inflation, monetary
policy may play a more effective and central role than in a recession.
The large public debt in the postwar per iod has emphasized the
need f or a close understanding between those r esponsible for debt management and monetary policy.
The Federal Reserve must take adequate account
of fiscal and debt problems in effecting credit policy;
to take account of credit policy in managing the debt .
the Treasury needs
At times , debt
oper ations have tended to inter fere with the execution of restrictive
monetary policies as well as of fiscal policy.
Largely, this has come
about through the influence of the maturity structure of the debt--on
interest rates and in altering the liquidity of the banking system and the
economy at large.
Debt management decisions as they affect the maturity
structur e of assets held by private investor s, including the commerci al
banks and nonbank financial intermediaries, have a pervasive effect.
The
significance of liquidity is found partl y in its effect on the willingness
and ability of individuals and business to dispose of assets for the purpose
of acquiring other assets or to incur debt for the same purpose .
A holder
of cash or shor t - term marketable debt which may be sold or easily redeemed
-85with little sacrifice is able to generate a demand for goods by spending
or lending.
Time moves faster than debt management decisions and, without
continuous effort and some leadership of the market, excessive liquidity
is injected into the economy through large floating debt.
This factor
also bears upon the technical problem of management of the debt and the
latitude for effective monetary policy.
If it were practicable to establish
and equalize quarterly maturities, vdth a relatively small floating debt,
and thereby develop a roughly uniform term structure of the debt, adminis trative and technical pr oblems would be greatly simplified a.nd monetary
policy probably made more effective.
Liquidity needs in a significant
sense could then be better adjusted by the Federal Reserve.
Such a general
framework would seem best to provide a successful operating atmosphere in
which the joint obligations of debt management and monetary policy can be
met with the best results.
On the whole, policies designed to deal satisfactorily with
inflation and deflation must continue to evolve programs for action which
will produce the best end product.
The question of what regulates the
relationship between goods and money, causing prices to rise and fall, is
one of fundamental importance in any society and becomes increasingly
significant in t he degree to which the division of labor and capitalistic
organization of production separate producer from consumer .
In pursuing
various economic objectives, monetary policy to be most effective must be
accompanied by other appropriate measures of public policy.
APPEND I X
HARRY JPLOOD ftRD, VA., CHAtltMAH
.....ERT a. KERR, OKLA.
J. ALL&N P'lt£AJit.. JR., DEL.
RUU.n.L a.. LONCI, LA..
G EORO:E A. • MATHERS, FLA.
CLINTON P . AND£R.OH, N. M EX.
PAUL. H . DOUGLAS, ILL.
AL8EWT GORE, TENN.
ELIZABETH
EDWAJilD MARTIN, PA •
J OHN J. WILLIAMS, D£L .
RALPH E. ~DE.IIta, Vf.
GEOftQ£ W. MAl.DHE'. NEV.
P1'tAHK CAitLSON, KAN ••
WALLACE F. 8ENNETT, UTAH
WILLIAM E. J ENN ER• IND.
a. 8~1 NG EJl, c:HIIEI" ct.ltRK
Mr. W. D. Fulton
Pres i dent , Federal Reserve Bank of Cle veland
Clevela nd , Ohio
Dear Mr. Fulton:
As you know the Senate Finan c e Committee has undertaken an inquiry
entitled "Investigation of the Financial Condition of the United States. " We
have had testimony from three witnesses so far: former Secretary of the
Treasury, George M. Humphrey; form er Under-Secretary of the Treasu r y,
W. Randolph Burgess; and Federal Reserve Board Chairman, William
McChesney Martin, Jr. Under separ ate cover I am sending t o you a copy
of these hearings.
I am anxious that the Finance Committee hav e available for study
and guidance your thoughts and opinions about vital matters affecting our
economy. In preparing your reply it is suggested that you use the attached
list of questions merely as a guide. Please feel free to answer part or all
of the questions and make any furth e r comments you deem desirable or
appropriate.
For your information I am also addressing a similar letter to the
individuals shown on the attached list. It is m y present intention to recommend to the Finance Committee that the answers to this letter be compiled
into a compendium for use by the members of Congress.
We must have a strong and sound economy to undergird our continued
progress as a free nation . Your cooperation in answering these questions
and adding your further comments will be a valuable contribution. I will
appreciate your getting your answ ers and c omments to me by April 1, 1958
if at all possible. In the e v ent you will not be a ble to furnish your answers
by that date, it would be most helpful if you would k i ndly indi c ate an approximate date when you could c onv eniently furnish your answers and
comments.
Chairman
1.
Give a definition in your own words of deflation and inflation.
2.
Explain how you believe the economy of the United States can best avoid
eithe r inflation or deflation . If you think present laws should be changed
or new laws are required, then make specific suggestions.
3.
Comment generally on the monetary control policies of the Federal
Reserve System as exercised within the following years: 1942 to 1957.
(You may wish to divide the period into two parts, 1942-1950 prior to
the accord, and 1951-1957 . )
4.
Beginning in August 1 9 56 there was an increase in the Consumer Price
Index each month through September 1957 , thereby causing a decline in
the value of the dollar. What factors contributed most to this decline in
the value of the dollar .
5.
What effect does the management of the current Public Debt have upon
the national credit structure and the economy of the United States?
6.
(a) Discuss in their relationship to one another and according to your
judgment of their relative importance , the following three objectives
of economic policy in the United States:
1. Pr ice Stability
2 . Stability of production, d emand, and employment
3. Economic growth in produc t ion, d e mand, and employment
{b) With respect to these three objectives , discuss and appraise the
significance of what you consider to be the most important trends
since World War II- - during the most re ce nt two or three years- - and
especially during 1957 .
7.
Give your opinion of the effect on our economy of current Federal ,
State, and loc al Government spending .
8.
Give y our opinion of the effect on our economy of current Federal,
State and local taxation.
9.
Will you distinguish between fiscal policy (embracing expenditures,
taxes and debt) and monetary and. c redit policy, and then relate
them. one to the other. Please discuss these policies stating how
they may be used to restrain inflationary trends and otherwise aid in
preserving a stable economy.
10. (a) Comment generally on the adequacy or inadequacy of the United States
Monetary System. (For the purpose of this question consider that the
monetary system includes bank deposits and bank credits). Also please
furnish your ideas for the correction of any inadequacies that you feel
now exist in our monetary system.
(b) Comment briefly on the adequacy or inadequacy of the United States
fiscal system.
11 . (a) What is the explanation of the seeming paradox that at times inflation
and unemploy;ment exist side by side in our economy.
(b) Shall we accept, as some have suggested, a gradual inflationary
trend as desirable (or necessary) to achieve and maintain full employment goals?
12. To what extent and in what way do you believe that the growth of private
debt in rec ent years may have become a threat to the stability and
vitality of the American economy .
13 . Considering the financial condition of the United States, at what point,
if any, in terms of unemployment, production, and consumer demand,
should the Federal Government move in major ways, such as a tax
cut and/ or large increases in public works, to counteract a downturn
in the economy.
14. How muc h of a factor in your opinion has deficit spending by the
F ede ral Government since the end of World War II been in contributing
to or producing inflation?
15. Can full employment goals be attained while maintaining a dollar that
has relative stable purchasing power?
16. Are escalator provisions in wage or other contracts compatible with
achieving economic stability?
17 . List and briefly discuss what you consider the causes of the present
recession, and what should be done to terminate it.
@FedFRASER