A History of the Federal Reserve, Volume 2 (117 page)

Stock market margin requirements had remained at 80 percent since June 1968. Board members reached general agreement that only initial margin requirements should be lowered, but timing was a problem. Brimmer and Robertson thought the move was inflationary and would undercut their efforts. Mitchell and Maisel did not want to suggest that the Board feared a stock market panic. Burns pointed out that many stock exchange firms faced insolvency as their assets declined in value. Poor psychology dominated sound economics four to three, so the Board did not act on May 4. It decided to wait for the FOMC meeting the following day.

The presidents divided also. Burns wanted to make the change. After the FOMC meeting, the Board met to lower stock margin requirements to 65 percent. The stock price index continued to fall on average until July, but the major move had occurred.

The stock market and the economy were the main topics of discussion when the Board had its regular luncheon meeting with the CEA. Two CEA members wanted faster money growth and lower interest rates, but Hendrik Houthakker disagreed. The meeting also discussed Chairman Burns’s speech urging voluntary wage and price controls. He received no support from the CEA members, but some suggested that the president could do more to hold down wages and prices in specific sectors, especially construction and energy (Maisel diary, May 21, 1970, 56–57). Whatever Burns meant by cost-push inflation, his speech claimed that voluntary controls could reduce this source of inflation.

Faced with the many problems and uncertainties, the System ignored targets for money and credit, supplying reserves to assist the Treasury financing (even keel) and satisfy the increased demand for money. The main issue at the May 26 FOMC meeting was whether to remove the bulge in bank reserves and money and, if so, how soon. “Burns spoke up in a very emotional manner” warning of a financial crisis and urging attention to the liquidity problem and the possible crisis (Maisel diary, May 27, 1970, 61). “It was necessary temporarily to put aside the objective of moderate growth in the monetary aggregates and to undertake the classical func
tions of a central bank when a crisis existed—or was near at hand” (FOMC Minutes, May 26, 1970, 28).

180. The forecast is from the SPF for second quarter 1970. The Board’s staff forecast 5 percent inflation for the year with recovery starting
in third quarter 1970.

Not all of the members agreed that a crisis was near or on the policy action to be taken if one were. The committee went back to doing what it had done before. It granted discretion to the manager to moderate pressures in financial markets. It made one change, mainly cosmetic, by instructing the manager to recognize the committee’s longer run objectives for money and credit growth. On the central issue of what should be done about the bulge in reserves during the May Treasury financing, there were many opinions but the only firm decision came from the manager’s statement that the sense of the meeting was to do nothing at the time. The issue of how to deal with temporary (positive and negative) deviations from a projected path was a critical part of achieving long-run objectives.
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The System had not decided how to treat these bulges in reserves, and again it did not consider auctioning securities to avoid the problems arising from even keel operations to support the Treasury market.

Between December 1969 and June 1970, the unemployment rate rose from 3.5 to 4.9 percent. The staff predicted a continued rise to 5.6 percent in fourth quarter 1970 and 5.9 percent in first half 1971. The actual rate was 5.8 for the fourth quarter, and 6.1 in December 1970. The rate remained between 5.9 and 6.0 percent in the first half of 1971. “Burns felt this unemployment rate was not satisfactory—it was too high—and he wanted to get greater monetary ease” (Maisel diary, June 12, 1970, 64).

At Burns’s request the staff proposed to reduce reserve requirement ratios for time deposits but to offset some of the reserves released by putting reserve requirements on bank-issued commercial paper. Mitchell proposed to remove regulation Q ceilings on CDs over $100,000. Only Burns supported him. Neither proposal could overcome opposition from those concerned about the unsettled state of the money market and those who did not want any increase in ease.
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181. Much of the bulge came as discounts and advances. Between May 1 and 20, discounts increased $405 million to $1.27 billion. This seems an appropriate response to a temporary increase in demand that would reverse when market conditions improved.

182. Maisel’s diary (June 12, 1970, 67) concluded that the Board would have voted to put reserve requirements on bank-issued commercial paper but hesitated because of concern about the announcement effect. Maisel reported on the views expressed at the academic consultants meeting on June 19. The prevailing view was that once the unemployment rate rose above the full employment rate of 4 percent, inflation would fall. Gardner Ackley and Herb Stein agreed that with unemployment at 5 percent at the time, “there was no advantage in any increase in unemployment with respect to future price decreases. . . . [P]rices would come down just as rapidly with a minimum excess of unemployment as they would with a much higher unemployment rate” (ibid., June 19, 1970, 70–71). This seems a peculiar version of a Phillips curve, but Maisel reported it was widely accepted. In fact, inflation increased from
5.43 to 5.97 percent between October 1969, before the recession, and May 1970. During the same months, the unemployment rate rose from 3.7 to 4.8 percent.

Reflecting on its experience in the spring, the Board asked for a staff report on the use of even keel in a monetary targeting regime. The staff report, “Even Keel and the Monetary Aggregates” (Board Records, July 17, 1970), recognized that dealers and other market participants would have to distinguish between policy changes in interest rates and changes resulting from the new operating procedure. Also, the manager would have to learn how quickly or slowly to adjust the money stock back to its target. The fact that the FOMC used more than one aggregate target raised additional issues; they often moved in different directions in weekly or monthly data.

The staff recognized a divergence between current and longer-term consequences. Inflation or aggregate demand depended on trend growth in the aggregates, but dealers held large volumes of debt during Treasury financings. Debt prices would fluctuate with short-term interest rate changes. The rationale for even keel was to prevent (or minimize) these fluctuations. This problem could not be avoided, but it could be reduced if the Treasury used more auctions for longer-term debt (ibid., 11).

The staff concluded that the FOMC should continue even keel operations. At later meetings, it would have to adjust the growth paths of the monetary aggregates by adjusting money market conditions. During discussion at the July 21, 1970, FOMC meeting, Axilrod proposed permitting greater flexibility in the use of even keel. Some members agreed, but Burns was cautious. There was a risk that a Treasury financing would fail.

The FOMC did not make a decision and did not change policy. The Treasury gradually shifted to auctioning medium- and long-term maturities in 1972. Auctions let the market choose a market clearing rate. Gradually even keel operations ended (Garbade, 2004).

THE PENN CENTRAL FAILURE

Events intervened to change positions on regulation Q and the Federal Reserve’s role as lender of last resort. The System’s responsibility as lender of last resort had led in December 1969 to an agreement on the use of emergency credit to assist mutual savings banks and savings and loan associations that were not members of either the Federal Reserve or the Federal Home Loan Bank System. For members of the Home Loan Bank System, the Reserve Board limited its responsibility to “conduit loans”— loans to Home Loan Banks that these banks would relend to “individual savings and loan associations when the inability of those associations to meet . . . withdrawals appeared to threaten a run that might have more gen
eral spillover effects on the financial system” (Board Minutes, January 8, 1970, 6). The Home Loan Banks would secure the loans with government or federal agency obligations. The agreement was temporary but the Board renewed it several times.

The agreement anticipated failure of some large thrift institutions. That didn’t happen at the time. However, the discussion created a general understanding that the Federal Reserve had a broad responsibility in a crisis to sustain solvent but illiquid financial institutions, not just its members. It was not about to repeat the errors made in the banking crises of 1929 to 1933.
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It was also not yet ready to accept much risk. The first test came as a mixed package early in June. The Penn Central Railroad, then the seventhlargest corporation in the United States and a principal means of transport in the northeast and midwest, was unable to rollover its outstanding commercial paper liabilities. The Federal Reserve did not feel obligated to support non-financial institutions; its concern was the $40 billion commercial paper market. Bank affiliates had issued $7.5 billion, enough to threaten the solvency of major banks if there were many defaults.

The government’s first effort was to stretch the authorization in the Defense Production Act of 1950 to make loans to defense contractors unable to obtain commercial credit. The railroad did not have a defense contract, but it moved military equipment, supplies, and personnel. A consortium of banks would make a short-term loan of $250 million, if the Federal Reserve guaranteed the loan. The System would in turn get a guarantee from the Navy Department. Later, this loan would be replaced by a longer-term loan arranged by the Department of Transportation. The effort failed when the Defense Department decided not to issue the guarantee.

On June 21, the Penn Central filed for reorganization under the Bankruptcy Act. It had paid off $100 million of its $200 million in outstanding commercial paper, but it could not obtain credit without a guarantee, and none was forthcoming.

The New York bank anticipated two main consequences. First, as commercial paper matured, banks would be pressed to lend directly to corporations and issuers of commercial paper. Since there were no reserves against commercial paper, substitution of loans would increase the demand for reserves, tightening the market. Second, some borrowers would not find loans. The bank estimated that replacing commercial paper with

183. Pierce (1998, 1–2) recalled meeting with the discount officers of the reserve banks at the time. “The fascinating part of it was that I discovered the real bills doctrine lived. The discount officers did not want to lend to the banks because . . . if they couldn’t borrow they would be bankrupt. . . . Burns was there. He had to yell at them and tell them lend. Just lend.”

bank loans required as much as $7 to $10 billion of additional reserves, as much as 16 percent of the monetary base. New York had told the large banks that the discount window would be open for temporary loans to assist banks during the adjustment. It suggested that the Board suspend indefinitely ceiling rates of interest on large certificates of deposit and supply the reserves required by the increase in CDs.

Chairman Burns noted that Penn Central had also borrowed heavily in the euro-dollar market. He feared that the firm’s failure would reduce the willingness of foreigners to lend or invest in dollar assets. To keep them from selling required confidence. He was uncertain how to do that.
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He reminded the FOMC on June 23 that financial crises followed major financial failures in the past, citing the Baring Bank, Knickerbocker Trust, and the First and Second Banks of the United States as examples. Burns “was the prime mover in the administration to try to get the government to guarantee Penn Central’s cash needs” (Maisel diary, June 24, 1970, 73). He had the support of the Treasury but not the Council of Economic Advisers or George Shultz, newly appointed as director of the Office of Management and Budget.
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At the Board, Robertson and Brimmer “saw no reason to save the Penn Central” (ibid.). Congressman Patman disliked what he regarded as a close relationship between the Penn Central and the Pennsylvania Republican Party.
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Burns had only modest support for removing regulation Q on large CDs at the June 22 Board meeting. Mitchell was the only one who fully shared his view. He had always favored removing regulation Q ceilings. As often happens, members gave ample reasons for delay. Robertson and Brimmer
favored waiting to see if a crisis occurred. Acting hastily might suggest a crisis when none was imminent. Sherrill could agree to a temporary change. Daane expressed concern about the effects on the exchange rate, and Maisel wanted to coordinate any action with the FDIC and the Home Loan Bank. Burns’s strong case for restoring confidence had a four-tothree majority, but the Board waited to act until they coordinated decisions with other agencies (Board Minutes, June 22, 1970, 23).

184. The
Wall
Street
Journal
printed a front-page article on June 12 discussing the spreading liquidity crisis. In addition to Penn Central, it mentioned two industrial corporations, LTV and Lockheed, and cited statistics showing a relatively low ratio of cash and government securities to current liabilities of corporations. The article cited the decline in growth of reserve bank credit at a time of rising demands for credit.

185. George Shultz moved from Secretary of Labor to become first director of the new Office of Management and Budget (OMB). He became a principal presidential adviser with an office in the White House west wing instead of at OMB. Shultz described the president as wanting “to be sure that I knew what he was thinking” (interview with George P. Shultz, November 10, 2003). “The previous budget director acted as though it was his budget, not the president’s budget” (ibid.). Shultz opposed Burns’s policy of bailing out Penn Central. “It sends a wrong signal for people who mismanage. They should fail” (ibid.). Of course, Burns received staff memos and pleading from the financial markets about the risks of a spreading financial crisis (memo, Effects of a possible default by a major corporation, Burns papers, Box B-20, June 3, 1970).

186. Congress was asked to vote a $500 million loan as part of the defense loan. Maisel and Shultz claim that the loan collapsed because Penn Central hired President Nixon’s former law firm as special counsel who had been active in the Republican Party (Maisel diary, June 24, 1970, 74 and June 26, 1970, 88; Shultz Interview, Nov
ember 10, 2003).