A History of the Federal Reserve, Volume 2 (104 page)

At the March 1968 meeting, Hayes and Francis pressed again for restraint. Others suggested specific actions, such as changes in the discount rate or regulation Q ceilings. Martin was cautious. He acknowledged the “unanimous view of the members today that greater monetary restraint was desirable. . . . Personally, he was not prepared at the moment to advocate an increase in the discount rate of either one-quarter or one-half of a percentage point. He would want to increase restraint gradually and unaggressively while watching developments closely” (FOMC Minutes, March 5, 1968, 117).

The federal funds rate ended the week 0.07 percentage points above the previous week, but it reversed the following week falling to the lowest weekly average in two months. Two events surrounding this meeting make Martin’s hesitation puzzling. Both events reflected the severe gold drain that followed the British devaluation in November 1967, the Federal Reserve’s failure to stop inflation, and the administration’s inability to increase taxes and unwillingness to reduce spending. First, Congress eliminated the 25 percent gold reserve requirement behind Federal Reserve notes, to free the remaining gold stock for sale but severing the last vestige of the gold reserve requirement in the 1913 Federal Reserve Act. The bill passed on the last day; on the next day, the Federal Reserve would have been forced to suspend the gold cover and impose a tax on the reserve banks (Maisel diary, March 15, 1968, 24). The president signed the bill on March 18. The Treasury had only $3.5 million of free gold left. Second, the members of the gold pool met in Washington to end the crisis in the gold market by ending the gold pool.
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Thereafter, central banks and monetary authorities would buy and sell gold to each other from their existing stocks. All other gold, including newly mined gold, would be traded at market prices without intervention by central banks. The gold exchange standard and the Bretton Woods system of fixed exchange rates was now in its last phase. Although the central bankers pledged to maintain fixed exchange rates against each other, the public could not impose discipline by demanding gold from a central bank in exchange for paper money.

Within two weeks of the FOMC meeting, Martin spoke to the Economic Club of Detroit. The speech barely mentions Federal Reserve inaction or the run on gold. The problem was fiscal profligacy, perpetual deficits, “a
very sad progression toward undermining the currency” (Martin speeches, March 18, 1968, 7). The country was “overextended and over-committed” (ibid., 8). He cited the military commitments but did not mention the expansive domestic Great Society programs except to say that “it’s time that we stopped talking about ‘guns and butter’” (ibid., 8).
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If “the central bank prints money, there’s only one answer: rising prices and continuing deficit. . . . [T]he monetary system has a responsibility at least to bring this to the attention of people” (ibid., 10).

76. France left the gold pool in the summer of 1967, so it was not represented at the meeting.

Effective on March 15, the Board approved a 0.5 percentage point increase to a 5 percent discount rate at ten of the reserve banks. New York and Philadelphia followed within a week.
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A month later, New York, Philadelphia, Minneapolis, and San Francisco increased discount rates to 5.5 percent. By April 26, all banks had the 5.5 percent rate. With the higher discount rate and a federal funds rate of 5.7 percent in mid-April, the Board raised the regulation Q ceiling rate on CDs of $100,000 or more on a schedule rising from 5.5 percent for 60 to 89 days to 6.25 percent for 180 days or more. Long-term rates remained in the range from 5.2 to 5.5 percent that they entered in early March. These rates were now above the 1966–67 peaks. In the secondary market Treasury bill rates reached 5.25 percent, close to the postwar peak. New issue Treasury bill rates and the index of stock prices continued to increase.

With consumer price inflation at 4 percent, Arthur Okun, the new chairman of the Council of Economic Advisers, explained the Federal Reserve’s actions to the president but did not criticize them.
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On this and many other occasions, he warned the president about possible serious consequences unless Congress approved the tax surcharge.
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Okun described
his “main professional concern [as] seeing that the war was financed responsibly and sensibly, and it wasn’t financed responsibly and sensibly until we got the surcharge enacted” (Okun oral history, tape II, third attachment, undated, 5).

77. Later in his speech, Martin endorsed the Great Society but added that “we don’t have the self-discipline, we don’t have the capacity to govern ourselves in such a way that we can be great” (Martin speeches, March 8, 1968, 13). Martin also recognized that a tax increase was unpopular. His mail ran 15 to 1 against (ibid., 15–16).

78. Chicago asked for 0.25; six banks asked for 0.5. St. Louis and Dallas asked for 1 percent, New York asked for 1.5 percent to show its commitment to defend the exchange rate system. New York would not accept less than 1 percent. After some discussion, Martin prevailed on the Board not to impose a lower rate.

79. Okun had been a Council member since 1964 and before that a staff member. He served as chairman from February 15, 1968, until the administration ended on January 20, 1969. He also served as a member of the new Cabinet Committee on Price Stability, established in February 1968. The committee considered price and wage controls, but Okun convinced them to reinvigorate guideposts (Hargrove and Morley, 1984, 269).

80. Almost every memo Okun wrote to the president urged a tax increase, often in detail. One memo, in May 1968, sketched the development of a possible world financial crisis including a run on gold, end of the gold-exchange system, failure to maintain a solemn pledge to pay gold, and political consequences at home including loss of employment, rapid decline in stock prices, and a conservative attack on all government spending. Okun opposed efforts
within the Council to warn the president about the economic effects of continuing the war. “I felt that he would not at all be receptive to such an obviously hortatory position . . . and that this might very severely prejudice his confidence in us” (Okun oral history, tape II, third attachment, undated, 6). Okun described his relation with President Johnson as not close.

The FOMC continued to vote for slightly firmer conditions. Free reserves turned negative in the winter and reached −$415 in April. Annual growth of the monetary base rose, however, from 6 to 6.5 percent. Bank credit growth slowed until the Board raised the regulation Q ceiling.

The FOMC gave three reasons for following a policy that it described as cautious. First was an improved prospect (in April) for fiscal action by Congress. Second, a “considerable degree of monetary restraint had already been achieved, the effects of which were still unfolding” (Annual Report, 1968, 140). Third, concern about a shift out of commercial bank time deposits would set off disruptive shifts in asset allocation and require an increase in regulation Q ceilings (which occurred soon after). It did not mention a political response but it was surely conscious after its 1966–67 experience that such a response could occur.

The
Big
Error

Through May and June, the FOMC maintained its policy stance, but it did not increase interest rates or reduce free reserves further. Finally, on June 21, almost three years after discussion started, and eighteen months after it was first proposed, Congress approved a 10 percent surtax. The final vote was not close, 268 to 150 in the House and 64 to 16 in the Senate. President Johnson signed the bill on June 28, 1968. The new law raised tax rates retroactively to January 1 for corporations and to April 1 for individuals.
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The surtax was temporary; it expired on June 30, 1969, unless renewed.

To get the surtax passed, the president had agreed to reduce spending by $6 billion in fiscal 1969.
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Congress found it much easier to agree on the principle of reduced spending than to implement it, and “Johnson declined to make any reductions above those passed on Capitol Hill”
(Califano, 2000, 288). Cuts in programs amounted to less than $4 billion. In the aggregate, spending increased by $2.7 billion in fiscal 1969 compared to $18.7 billion in 1968. Most of the reduced growth came in defense spending; spending on human resources, including most of the Great Society programs, rose $7 billion in fiscal 1969 compared to $8 billion in 1968.
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81. Unlike all other tax legislation, the surtax began in the Senate as an amendment to a revenue measure approved in the House. Chairman Mills accepted this departure from established procedure in exchange for larger reductions in spending.

82. Califano (2000, 244–46, 284–88) describes some of the difficulties encountered in getting Congress to agree to the tax increase and the president to agree to the spending reductions. By the time the bill passed, the Kennedy and King assassinations, riots in many cities, the Vietnamese Tet offensive and Johnson’s decision not to run for reelection had fostered a sense of crisis.

The surcharge set up the big error of the late 1960s. The error had two parts. As soon as the surcharge passed, Okun, the Council, Federal Reserve staff, and others began to worry about “fiscal overkill.” As in 1967, action to prevent a slowdown in real growth came promptly, in contrast to the very slow response to inflation. The contrast between the two responses, and the weights on the two concerns, was not lost on the market. This was the origin of what came to be known as “stagflation.” Anti-infl ation policies that increased unemployment could not be expected to persist, so inflation would persist. The public came to believe that any reductions in inflation induced by policy action would prove transitory. Hence prices, wages, and long-term interest rates were slow to adjust downward. Wages and many prices would seem rigid downward, or more rigid than earlier. Costs of disinflation would be large, therefore, and disinflation would be politically unpopular.

The second part of the error combined an analytic error and a forecast error. Keynesian economists at the Council and on the Federal Reserve staff believed that the temporary surcharge would have a powerful effect on consumer spending. Friedman’s (1957) analysis of consumer behavior predicted the opposite; a temporary tax increase would fall mainly on saving, not consumer spending. The Council and the Federal Reserve forecast using their Keynesian models, so they forecast a large response, hence “fiscal overkill.”
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Four days before the president signed the tax bill, Okun completely shifted his position. Instead of the dire consequences of the budget deficit, he now warned the president about the serious consequences of the ex
pected budget surplus and the swing from a prospective $10 billion deficit to a surplus at the annual rate of $5 billion in the first half of 1969.
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He offered no explanation, in the memo, or elsewhere, about why he had not mentioned his concern earlier and urged the president to reduce the size of the surtax. He told the president:

83. During Johnson’s administration, spending for human resources increased from 5.6 percent to 7.1 percent of GNP. These expenditures were programmed to continue increasing in later years. By 1985, they reached 11.9 percent of GNP.

84. A month before Congress approved the surcharge, Franco Modigliani, a leading Keynesian economist, told the Joint Economic Committee based on his own more sophisticated work:

If the people know that taxes are going to be put up for just 3 or 6 months, chances are that there will be little change in their consumption because they would look forward to being able to recoup later. Therefore, I think that attention should be given to finding measures that have the right incentives. (Testimony, Joint Economic Committee, 1968, 63)

Real growth over the coming year will probably be at only a snail’s pace, less than half as fast as in the past year. Unemployment is likely to rise above 4 percent in early 1969.

Indeed there is a risk that we will slow down too much unless the effects of fiscal restraint are cushioned by an upturn in homebuilding activity later this year. (memo, Okun to the president, WHCF, Box 2, LBJ Library, June 24, 1968)
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On July 18, Okun overstated the power of the surcharge. He projected a 1 percent increase in real GNP in the last half of 1968 and a slight decline in the first half of 1969. He forecast inflation at 3 percent in June 1969 and the unemployment rate at 5 percent instead of the 3.7 percent in June 1968. These estimates were much too pessimistic about unemployment and output growth and too optimistic about inflation. Actual values reported at the time were 5.2 percent for the deflator in second quarter 1969, 3.1 percent real growth in the first half of 1969, and a 3.5 percent unemployment rate in June of that year (Maisel diary, July 16, 1968, 9).

To assist housing, Okun wanted the Federal Reserve to reduce interest rates.
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In numerous conversations with the president in the three years of discussion about budget finance, Martin had told the president repeatedly that interest rates would be higher without the surcharge and lower with it. His statement was open to three interpretations: (1) The Federal Reserve
would act to lower interest rates; (2) it would not prevent a decline in interest rates caused by reduced government borrowing and slower economic growth; or (3) interest rates could rise but would be lower than without the surcharge.
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85. He compared the estimated $15 billion swing to the sharp change from 1959 to 1960 and reminded the president that the Democrats had campaigned against fiscal drag at the time.

86. Okun was cautious about the projected fall in inflation. He forecast 3 percent inflation by spring 1969 from the 4 percent rate at the time. In fact, consumer prices rose at about 5.3 percent in spring 1969 and the unemployment rate declined from 3.7 to 3.4 percent between June 1968 and early 1969. Real GNP growth for the four quarters ending in June 1969 was half the growth rate of the previous four quarters, as Okun forecast. One reason is that fourth quarter 1968 had negative growth. The SPF have quarterly forecasts beginning in late 1968. In fourth quarter 1968, they forecast a rise in unemployment to 4 percent by second quarter 1969.

87. Okun was moderate. He recognized that “confidence in the dollar generated by the tax bill might be dissipated by a drastic monetary easing that seemed irresponsible” (memo, Okun to the president, WHCF, Box 2, LBJ Library, June 24, 1968, 4). The Federal Advisory Council also believed that growth would slow following the surtax. They did not expect recession (Board Minutes, June 4, 1968).