A History of the Federal Reserve, Volume 2 (46 page)

EMPLOYMENT, GROWTH, AND PRICE LEVELS

Economic growth averaged 2.7 percent a year for the six years 1954–59, and the deflator rose an average of 2.2 percent. Growth seemed modest compared to Germany, Japan, and other recovering economies. Concerns about growth, productivity, inflation, gold losses, and rising interest rates led Congress to authorize the Joint Economic Committee to undertake one of the most extensive studies of the economy ever done and to hold hearings throughout 1959. Senator Paul Douglas served as the committee’s chairman, and Professor Otto Eckstein, a fiscal expert at Harvard, served as technical director.
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The staff report shows mainstream academic opinion at the time, mainly Keynesian in its origin. A principal concern was “the slow growth of the American economy of the last six years, which coincided with a rise in the price level” (Joint Economic Committee, 59, Staff Report, xxi). The fault lay in using fiscal and monetary policies to stabilize the price level. “[T]he amount of growth that was surrendered for what at best was a small gain toward stabilizing the price level, was very large” (ibid., xxi).
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It attacked the administration’s concern for avoiding inflation and suggested a permanent increase in inflation would sustain a permanently higher growth rate. “The theory that, in an environment of stable prices the economy will experience sustainable healthy growth is fallacious. The severe, restrictive application of present monetary and fiscal tools which would be necessary to halt the increase of prices would keep the economy in a perennial state of slack” (ibid., 10). In the staff’s view, private industry made large investments in 1956 and 1957 to meet high future levels of output, but “[g]overnment stepped too hard on the fiscal and monetary brakes” (ibid., xxv).

The report claimed that lost output in recessions was not made up in subsequent recoveries. If the government chose a policy of facilitating growth and maintaining aggregate demand, the economy could grow at 3.9 percent to 4.5 percent, far above the historic average of 3 percent or
the lower 1954–59 average (ibid., 8). The report expressed concern about inflation but downplayed the role of monetary policy. Instead, the report highlighted three causes of inflation: instability of output, market “power to raise prices in the absence of excess demand,” and rising service prices (ibid., xxii).

314. The text concentrates on issues related to Federal Reserve actions and policies. The project included studies of pricing, investment, agriculture, taxation, etc.

315. As these quotations suggest, the staff report is highly critical of the Eisenhower administration’s emphasis on balanced budgets and the Federal Reserve’s concerns about inflation. Less clear is the extent to which the report is a political document prepared for the 1960 election campaign or the mistaken view that policy can increase growth by accepting more inflation.

Senator Douglas, the committee chair, did not entirely share the staff’s view. He frequently expressed annoyance at the emphasis the Federal Reserve, and others, gave to inflation when the reported annual rate of change in the consumer price index remained about 1 percent. As the discussion showed, failure to adjust fully for quality changes gave an upward bias to the index,
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so true inflation was below 1 percent and probably slightly negative. Douglas’s exchanges with some of the witnesses suggest that, although inflation was low or zero, anticipated inflation had increased during the decade. The Eisenhower administration’s very large, peacetime deficit in fiscal 1959 (2.5 percent of GNP) aroused concerns. Large budget deficits that had previously occurred only in wartime had now occurred in peacetime.
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316. The bias was recognized at the time. Many years later, in the 1990s, economists and officials discussed the bias again and, soon after, the Bureau of Labor Statistics adjusted the index for quality changes and new product introductions.

317. The main argument, made by those who raised concerns about inflation, was that the budget deficit was inflationary. The argument was formalized later as the fiscal theory of inflation. See Woodford (2001). The following exchange between Senator Douglas and Alfred H. Hauser, vice president of the investment division of Chemical Bank, illustrates Senator Douglas’s irritation. After Hauser’s agreement that principal price indexes showed no evidence of current inflation, Douglas asked: “Do you think that people ought to be more restrained in their talk about how we are being devoured by inflation when as a matter of fact we have had stability in the price level during the last year or perhaps 13 months? . . .

Mr. Hauser. This is a matter of opinion, but I feel it is necessary for all of us to
holler our heads off about inflation all the time.

The Chairman. Even though it doesn’t occur?

Mr. Hauser. Even though it doesn’t occur, because the potential is so great that it could explode at any time if we relax in our diligence and in our efforts to hold it down.

The Chairman. Do you think we should holler our heads off on the reality of inflation in the last year?

Mr. Hauser. No, sir. I don’t believe in saying anything that is not in accordance with the facts. . . .

The Chairman. If these hearings have done nothing more than this, to have the eminent financiers of the City of New York say there has been no inflation in the past year, and prices have been steady, we will have served our purpose. . . .

Would that the newspapers of the city could hear these winged words. Would that the life insurance industry could take these words to heart and cease putting in full-page ads in the newspapers shouting about the horrors of inflation. . . .

Mr. Hauser. Sir, I do not draw the same conclusions that you do from the concern we have about inflation. . . .

The staff report’s principal recommendation for monetary policy was greater reliance on selective controls. “General credit controls have proved to be selective in their effects; in fact generality in stabilization is an illusion” (ibid., xxiv). This claim is based on the more powerful effects on housing, state and local government spending, and small business. The staff’s solution was selective controls on consumer credit, inventory investment, residential construction, and fixed investment, although the report recognizes that the last of these would prove difficult to regulate with selective controls. General controls should continue with some changes. To reduce uncertainty, the discount rate should be tied to market rates, reserve requirement ratios should remain fixed, and the Federal Reserve “should abandon the ‘bills-only’ policy in its present rather doctrinaire form and be prepared to deal in long-term securities whenever the economy would benefit” (ibid., xxxv). The staff favored “turning over the entire administration of monetary policy to a Board of Governors reduced in size” (ibid., xxxv).

Recommendations for debt management included some of the best recommendations in the report: auctioning long-term debt, advance refunding, and purchasing power saving bonds for small investors. Although the staff recognized that the 4.25 percent interest rate ceiling was arbitrary and complicated debt management, the staff took a political position: “modification of the policies that led to the present situation is a matter of much more pressing importance” (ibid., xxxvi–xxxvii). Congress should decide whether it wished to lift the ceiling before other reforms were made. The debt management section repeated the importance of abandoning billsonly. This would permit the Federal Reserve to smooth erratic fluctuations in long-term bond prices.

Two of these recommendations satisfied some of the more active Democratic members, notably Senator Douglas and Congressman Reuss, who wanted an end to bills-only and no further reduction in reserve requirement ratios. They favored holding hostage repeal of the 4.25 percent interest ceiling until the Federal Reserve gave up bills-only.

The staff failed to recommend elimination of regulation Q ceiling rates on deposits or payment of interest on demand deposits. It did not distin
guish between real and nominal interest rates when it discussed rising interest rates. As noted above, it claimed that monetary expansion could raise the economy’s long-term growth rate.

The Chairman. In other words, there is an accumulation of toxic poisons underneath the surface . . . which will undermine the health of the body politic in the future. . . .

Mr. Hauser. The principal one is the deficit which we experienced in the past fiscal year.

The Chairman. That you know is over. Curiously enough it was not accompanied by any increase in prices. The biggest peacetime deficit in history was accompanied with stability in prices. (Joint Economic Committee, Hearings, 1959, August 6, 1959, 1634–37)

Pessimism about the effectiveness of general monetary policy for preventing inflation dominated the recommendations about monetary policy. The main reasons advanced for reduced effectiveness were movements in monetary velocity that offset changes in the money stock. Among the causes of offsetting behavior the staff listed were growth of financial intermediaries—savings and loans, mutual savings banks, pension funds, etc.—that remained “outside the reach of Federal Reserve actions” (Joint Economic Committee, 1959, Staff Report, 351). Also, the report described banks as relatively immune to the effects of Federal Reserve policy. “The deposits extinguished by the [Federal Reserve] security sales will largely be idle deposits” (ibid., 348).
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No basis for any of these claims followed.

The monetary policy chapter was by far the longest and most detailed of the eleven chapters. It occupied nearly one-quarter of the volume, and its main theme could not have been pleasant reading for Chairman Martin and his colleagues. The report repeated several times that monetary policy had slowed the growth of the economy without preventing inflation.

The report did not try to establish that easier monetary policy, perhaps supplemented by selective controls, could achieve the substantially higher growth rates it proclaimed as feasible. It simply asserted this claim. It treated losses of output in recession as permanent losses, never made up in recoveries. Therefore, if recessions could be avoided, the growth rate would increase. The report did not discuss why it rejected the standard view that in the long run money is neutral so that the economy’s long-term growth rate is independent of its monetary growth rate.

Fortunately, the importance of this section and its conclusions does not depend on the quality of its analysis. It provided one of the earliest full statements of the prevailing Keynesian policy position that rose to influence in the 1960s—that there is a permanent tradeoff between inflation and unemployment or growth, that the Federal Reserve’s concern about preventing inflation permanently lowered either the growth rate or level of output, and well into the 1970s, that the economy could not achieve simultaneously full employment and price stability without government action affecting wage and price changes.
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A similar claim appears in the 1962 Economic Report.

318. The staff report was written by Warren Smith, who had published similar views about offsetting changes in Smith (1956).

319. The report discusses, and for the most part dismisses, the earlier claim that a large debt makes interest rate changes, especially increases, destabilizing. Long-term interest
rates had almost doubled during the decade without major bankruptcies caused by creditors’ losses.

Perhaps the report’s lasting influence on policy was to raise concerns at the Federal Reserve about the possible political consequences of reducing inflation. The temporary decline in real growth during the transition to lower inflation raised congressional interest in monetary policy and threatened independence. I have found no direct evidence that Martin or his colleagues held this view. There is, however, a distinct difference between the Federal Reserve’s response to inflation in 1958–60 and its response the next time inflation rose, after 1965.

The
Balance
of
Payments

Persistent balance of payments deficits had become a policy concern. The chapter on balance of payments problems was both much shorter and made fewer recommendations than the monetary chapter, perhaps because the authors did not favor more restrictive policies. It concluded that the problem was not inability to compete, later called loss of competitiveness. Instability in monetary policy was made partly responsible for the swings in the payments deficit. The report recommended greater reliance on multilateral aid to developing countries to reduce the burden on the United States. It found that non-repetitive, adverse factors contributed to the loss of gold. On the brighter side, it noted that the gold outflow had improved the world distribution of the monetary gold stock.

The
Federal
Reserve’s
Response

The 1959 hearings were the first large-scale inquiry into policy procedures in a decade. They came at a time when the Board’s staff and its analysis were in transition from the 1920s traditions to the more Keynesian approach of the 1960s. Emanuel Goldenweiser and especially Winfield Riefler had retired, and a new group of economists, trained during the postwar years, occupied many of the junior staff position where drafts of official responses began. Several soon after rose to senior positions

Four main topics interested the Joint Economic Committee’s leadership. Their common element was the rise in interest rates. First, reductions in reserve requirement ratios in the 1950s had reduced these ratios for demand deposits from 23, 19, and 13 at the time of the Accord to 18, 16.5, and 11 at the 1959 hearings. The reductions transferred earning assets to banks and deprived government of the additional revenue it would have received had the Federal Reserve bought securities in the open market instead of reducing reserve requirement ratios. Allowing vault cash
to count as part of reserves (approved by Congress) further benefited the banks. Second, the committee’s leadership blamed the System’s bills-only policy for making long-term rates higher than necessary. The report did not mention higher expected inflation or higher productivity growth in the world economy. Average long-term rates had increased from 2.5 percent at the time of the Accord to between 4 and 4.25 percent in 1959. Rates on five-year notes reached 5 percent or more. Among the public and their representatives in Congress, only those with memories of the 1920s could recall a prevailing 5 percent interest rate. Third, the Treasury wanted to lengthen the average maturity of the public debt, but the 4.25 percent ceiling prevented it from doing so. Fourth, proposals to auction long-term securities did not appeal to the Board or the Treasury. Auctions would have made even-keel unnecessary, because the market, not the Treasury, would set the price. The Federal Reserve would have gained increased opportunity to adjust policy.