A History of the Federal Reserve, Volume 2 (52 page)

the gold loss in the 1950s. Much of this reflects the substitution of domestic for foreign sources. This effect is not significant in the 1920s, where the computed response is zero. As in the 1920s, discounts have a brief significant negative effect on the base. In the 1920s, the Federal Reserve countered changes in discounts by changing government securities.

Operating on a free reserve or interest rate target, the Federal Reserve offset discounts and gold movements by changing government securities. The last row of Chart 2.A1 shows these responses. The policy of controlling free reserves surrendered control of the base to the market.

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The Early Keynesian Era:

A Low-Inflation Interlude, 1961–65

They don’t really know what the money supply is now, even today. They print some figures ... but a lot of it is just about superstition.

—William McChesney Martin Jr. (1985)

The 1960s started and ended with the economy in recession. In between, the country had almost nine years of growth, the longest sustained economic expansion up to that time. Industrial production rose 6.4 percent and real GNP 4.3 percent compound average rates. Real per capita consumption increased more than 30 percent. Annualized increases in consumer prices remained below 1.5 percent until the middle of 1965. After five years of recovery, growth, and low inflation, inflation reached 5.5 percent in 1969. The Great Inflation was under way, sustained by rapid money growth to finance the government budget and pay for the Great Society and the war in Vietnam.

This chapter and the next two are a bloc. They discuss the long expansion, the emerging and rising inflation that culminated in peacetime wage and price controls and the August 1971 decision to end convertibility of the dollar into gold. Although not intended to end the Bretton Woods system of fixed exchange rates permanently, efforts at restoration failed. In retrospect, the major policy changes that President Nixon announced at that time ended an era.

The years 1961–71 were a part of the Keynesian interlude dominated by a strong belief that government was responsible for stabilizing an unruly private sector. The distinguishing characteristics were two related beliefs: (1) that policymakers could adjust their actions in a timely way to smooth
fluctuations, and achieve full employment with high growth and low inflation, and (2) that policymakers could choose and achieve the right, possibly optimal, combination of inflation and full employment. Keynesian economists called their program “the new economics” to signify the departure from prevailing orthodoxies. They did not concern themselves with the way their prescriptions would work in a political system.

The new economics was not an issue in the 1960 election, but economic growth was. The Democrats criticized the Eisenhower administration’s record, three recessions in eight years, and a 2.5 percent growth rate during its term in office.
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Their platform promised to “put an end to the present high-interest, tight-money policy” (quoted in Kettl, 1986, 97) and to double the growth rate to 5 percent, increase social security payments, raise the minimum wage to $1.25 per hour, and increase housing starts to two million a year using government loans if needed.
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When the new administration took office in late January 1961, the unemployment rate was close to 7 percent, near the upper limit of postwar experience to that time. Although the recession soon ended, the unemployment rate lagged behind. In office, the new administration made a determined effort to apply Keynesian economic policies including the relatively new Phillips curve, relating inflation and unemployment.
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As understood at the time, the Phillips curve implied incorrectly that policy could permanently reduce unemployment by increasing inflation. Instead of aiming for price stability, the government would choose where to set the tradeoff.

1. Per capita GNP from 1956 to 1960 (in 1954 prices) rose 0.6 percent for the United States compared to the following per capita growth rates: Italy, 6.0; Germany, 4.4; France, 3.0; United Kingdom, 1.9 (Knipe, 1965, 149). The comparison suggests one main reason for rising foreign investment by U.S. companies. Soviet growth was also a concern. Stein (1988, 90–92) discusses the campaign’s economic issues.

2. The best year for housing in the 1960s was 1963, with 1.6 million starts. Real GDP growth reached 5 percent or more in four years, 1962 and 1964–66. The first of these was a year of recovery. Congressman Reuss later said: “Democrats generally have been quite critical of the Federal Reserve System’s performance in the second half of the fifties, and we made a great campaign issue” (Subcommittee on Domestic Finance, 1964, 1206).

3. The Phillips curve was an empirical relation with no formal foundation, but it had great appeal and moved with remarkable speed from the economic journals to the policy process. Samuelson and Solow (1960) estimated the Phillips curve on data for the United States. Both worked with the new administration before the election and in its early years, Samuelson as an informal, personal adviser to President Kennedy and Solow as a senior staff member at the Council of Economic Advisers. Their paper contained a phrase about the relation of inflation to unemployment that they and others chose to ignore: “A first look at the scatter is discouraging; there are points all over the place” (ibid., 188). They recognized, however, that the shape of the curve, hence the tradeoff, depended on the policies pursued. Almost all discussion ignored the fact that most of the data which Phillips used came when the gold standard tied down expected inflation.

The administration soon proposed faster depreciation schedules to increase investment and later reductions in business and personal tax rates as a conscious effort to create a budget deficit to stimulate the economy. During the campaign, John F. Kennedy and his economic advisers promised to end the restrictive monetary policies, especially bills-only, that Democrats had criticized through most of the 1950s. The new presidential advisers wanted closer coordination of monetary and fiscal actions. Some had expressed publicly their desire to replace Martin as chairman of the Board of Governors. Walter Heller, soon to be chairman of the Council of Economic Advisers, spoke to Martin a week before the inauguration. He found Martin “cooperative, open-minded and cordial. He obviously had no intention of resigning” (Oral History Interview, 1964, Heller, August 1 and 2, 186).
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To show that he intended to cooperate with the new administration, he proposed regular luncheons with the Council of Economic Advisers every two or three weeks (ibid., 186).
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The main events of the 1960s that dominated politics and monetary policy were the Vietnam War and the expansion of the welfare state. The last half of the 1960s was a time of major social change. President Lyndon B. Johnson succeeded in passing the landmark “Great Society” legislation that reversed the government’s role from enforcing racial laws and restrictions to enforcing equality before the law and, later, giving preference in hiring to groups that had suffered from discrimination. The Great Society
also initiated and expanded programs in health, education, and welfare that redistributed income, increased social spending, and brought the welfare state to the United States.

4. The oral history interview took place at Fort Ritchie, Maryland. Heller and other participants read from or used notes and memos made at the time of the event. Paul Samuelson explained that “Kennedy himself was a very cautious temperament and I couldn’t imagine him having a showdown on an issue like this [firing Martin]” (letter, Paul A. Samuelson to the author, January 24, 2001). As noted in Chapter 2, Martin considered resigning but did not complete the letter.

5. Martin took up the issue of resigning again at a meeting in 1961 with James Tobin and Walter Heller. He explained that he was a registered Democrat and had voted for Stevenson in 1952. Since coming to the Federal Reserve, he had remained out of politics. In a reference to a January 1961 article by Tobin very critical of Federal Reserve policy, he explained also that he had seen stories in the press that said the new administration wanted him to go. He had been appointed by President Truman. He had offered to resign in 1953 when President Eisenhower took office, but he was asked to stay. “During the [1960] campaign monetary policy was an issue, with the Democrats criticizing tight money. For these reasons Martin felt that a matter of principle was involved, and he decided he should not offer his resignation to President Kennedy” (memo, Tobin to Files, Luncheon Conversation with Chairman William McC. Martin, Heller papers, May 30, 1961, 1). Looking back, Heller said the relation between Martin and the principals in the Treasury, Council, Budget Bureau, and the president was harmonious. He recognized, however, that coordination did not work as he had hoped. He had less influence than he wished. “The Treasury captured . . . control of monetary policy to a very considerable extent by the relationships between [Douglas] Dillon and Roosa on the one hand and Martin on the other” (Oral History Interview, 1964, Heller, August 2, 329). This changed after Dillon resigned.

Between 1960 and 1970 government outlays doubled in nominal terms and rose 50 percent in real terms. All of the increase in defense expenditure came after the middle of the decade. Its increase, $30 billion between 1962 and 1969, was 60 percent of 1962 expenditure. Spending for education and health and human services other than social security increased five- or sixfold.
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President Johnson did not want to choose between war and social programs. In his words, “I was determined to be a leader of war and a leader of peace. I refused to let my critics push me into choosing one or the other. I wanted both” (Goodwin, 1991, 283). Believing that Congress would reduce spending for social programs if he proposed a tax increase, Johnson was slow to raise tax rates to pay for the spending programs and, for a time, hid the true rise in defense spending to mislead the public, Congress, and the Federal Reserve.
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Budget deficits increased the debt held by the public. Federal Reserve holdings more than doubled.

Financing the war and the president’s Great Society by increasing money growth created inflation. Under the Bretton Woods system, foreigners could choose to share the inflation or revalue their currencies. Almost all chose inflation. Although many governments grumbled about “imported inflation,” only Germany and the Netherlands agreed to revalue their currencies to reduce the dollar inflow, and their changes were relatively small.

The first half of the decade in the United States was a period of recovery and rapid growth with low inflation. The administration worried about gold losses and the continued international payments deficit, in part a result of strong productivity growth and a high level of employment that pulled in imports, in part a result of foreign loans, grants, and defense spending. In the second half, the problems became more serious. Productivity growth declined after 1965, spending for the Vietnam War and budget deficits increased, inflation rose, and the international payments deficit continued. At first the administration relied on selective controls and ad hoc measures
to manage the gold loss. Later it avoided gold sales by restricting sales to other than foreign official holders and discouraging purchases by foreign governments and central banks.
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6. Adjusted for inflation, defense and war expenditures in 1968 were larger than in any year of the defense buildup in the 1980s.

7. Stockwell (1989, 37) wrote: “For both strategic and political reasons, however, this escalation was kept a closely held secret. Along with numerous other government offices, the Federal Reserve was given no information on this buildup [1965] or its likely economic impact.” President Johnson apparently believed policy coordination should go one way only. Chairman Martin learned about the 1965 increase independently.

Chart 3.1 shows the decline in productivity growth in the business sector beginning in 1966. Productivity rose at a compound annual rate of 4.45 percent from 1961 to second quarter 1966 and 2.40 percent for the remaining quarters. These growth rates include both cyclical and structural changes, so they may overstate the magnitude of the slowdown, but there is no mistaking the change in trend. As always, observers could not at first distinguish between persistent and transitory change. In fact, there was no way to know how long the slowdown would persist, but its persistence presented a problem for monetary policy just at the time that government spending and budget deficits increased markedly. Failure to recognize the persistent reduction in productivity growth was one of the reasons for the major policy errors of the period.

Federal Reserve actions raised the growth rate of the monetary base during the decade from a 4.3 percent average for the first four years to 6.0 percent for 1964 to 1968. By mid-1971 base growth had increased to 7 percent or more. With increased money growth and slower productivity growth, inflation began to rise. Increased money growth was a second
policy error. By the end of the decade, the inflation rate reached 5 percent. The rise continued. Charts 3.2 and 3.3 show these data.

8. This chapter ends in 1965. To compare the earlier and later experience with Keynesian policies, charts in this introduction to the chapter cover the full 1961–71 period up to third
quarter 1971.