A History of the Federal Reserve, Volume 2 (54 page)

In several ways, the 1960s international monetary system repeated some mistakes of the 1920s. In both decades, central banks and governments did nothing to solve the adjustment problem. In the 1920s, after restoring convertibility and fixing the exchange rate, the French franc was undervalued and the British pound overvalued. To restore equilibrium at prevailing exchange rates, France and the United States had to inflate and Britain had to deflate. None of them would do as required. In the 1960s, the dollar and the pound had to depreciate to restore equilibrium, or Britain and the United States had to deflate. Neither country was willing to deflate prices, and the Kennedy and Johnson administrations would not devalue the dollar against gold and other currencies.
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Again, as in the 1920s, the French government resented the central role of the dollar and the pound as key currencies. It began to convert its dollar and pound holdings into gold, just as it did after 1927.
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In both periods, failure to solve the adjustment problem by realigning real exchange rates caused the breakdown that central banks and governments wanted to avoid.

The flaws of a gold exchange system, evident in the 1920s, returned in the 1960s. Each country had an interest in claiming gold in exchange for dollars. To weaken this claim, the United States had to either raise interest rates enough to maintain foreign dollar balances, appeal to other countries to cooperate to maintain the system by limiting gold outflows, or use capital controls. As in the 1920s, cooperation faced two problems: (1) national policies limited its extent; and (2) it did not go far enough to address the problem of real exchange rate misalignment.

A new problem arose in the Johnson administration. Policymakers in the United States were much less concerned about international coordination than coordination of domestic fiscal and monetary policies. They believed that domestic policy coordination could harmonize domestic and international concerns while maintaining high domestic employment and economic growth. Unlike the 1920s, the United States had to deflate rela
tive to foreign countries. But foreign governments objected to the inflationary consequences of the U.S. policy mix for them, particularly after es
calation of the Vietnam conflict. As Undersecretary of State George Ball predicted in 1962, international policy cooperation to maintain the fixed exchange rate system and the $35 gold price would not survive “a situation

13. Great Britain devalued the pound twice in the Bretton Woods years. The pound was a second reserve currency.

14. See volume 1, chapter 4. Jacques Rueff, an advocate of the gold standard, was an active policy adviser in both periods. France devalued in 1958 and 1969. Between 1961 and 1968 France bought $3.3 billion, half of the $6.7 billion that the U.S. sold.

where we should become more heavily involved in Southeast Asia. . . . [O]ur European friends would walk away from us . . . [saying] they don’t want to have any part of [financing] it” (Gold and the Dollar Crisis, Kennedy tapes, Transcript, August 20, 1962, 8). Ball did not anticipate that the war would raise pressures on the system by increasing the size of the dollar outflow, especially in 1970–71.

A basic conflict underlay the failure of United States policy to sustain the fixed exchange rate system. Congress gave two instructions. It ratified the Bretton Woods Agreement, committing the United States to a fixed exchange rate and the policies to support it. But Congress soon afterward approved the Employment Act with a loose commitment to full employment and stable prices or purchasing power. Policymakers did not discuss or even mention the possibility that maintaining the fixed nominal exchange rate might require deflation relative to foreigners if not absolute deflation. No one mentioned that the price level adjusted (real) exchange rate would have to be consistent with real rates of growth and price changes at home and abroad or that these rates of change might require a temporary increase in unemployment to lower the domestic price level and restore the equilibrium real exchange rate.

In practice, United States’ policymakers put domestic concerns ahead of international obligations. They told foreign governments and central banks that they should revalue their currencies. Foreigners, in turn, urged the United States to stop the flow of dollars that caused “imported inflation.” This dialogue, sometimes called the “dialogue of the deaf,” continued sporadically until the Bretton Woods system ended in 1971.
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The Federal Reserve responded to inflation by repeatedly raising the federal funds rate and reducing free reserves. As Chart 3.4 above shows, the increase in the interest rate was often less than the increase in the inflation rate. Taylor (1999) shows that this was true, on average, for the 1960s
and 1970s.
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Real interest rates declined or remained low, except in 1969. Table 3.2 shows December values for the nominal and ex post real federal funds rate. Although there are occasional comments to the contrary, in the 1960s and some subsequent years, the Board and the FOMC usually failed to distinguish between real and nominal rates. They described their policy as “tight money” and thought themselves bold for raising nominal interest rates as high as they did. This too repeated earlier experience.

15. There were many public and private meetings to discuss what could or should be done. At one meeting in the Treasury, at which I was present, probably in 1970, Treasury Secretary David Kennedy was briefed on the balance of payments and the dollar. The meeting lasted most of the day and Kennedy did not get a clear answer about what he should do. Finally, he told the group that he would soon meet the European finance ministers, and they would be sure to ask him what he planned to do. No one ventured an answer until Professor Fritz Machlup said, “ask them what they would do.” Kennedy’s eyes lit up, and his expression changed. “Yes, what would you d
o?” he said.

Regulations enacted in the 1930s did not work well in the 1960s. Economic growth, rising inflation, and increased wealth and financial sophistication encouraged financial innovation both to increase opportunities and circumvent regulation. The Federal Reserve was slow to respond to the challenge. The Office of the Comptroller of the Currency, in the Treasury Department, endorsed or encouraged reforms by the national banks that it supervised, forcing attention to regulatory changes at the Federal Reserve and other agencies. But interest rate regulation, regulation Q, remained, and its effects on allocation of financial assets began the process that culminated in the massive losses by the savings and loan insurance systems in the 1980s.

The 1960s saw growing professionalization of monetary policy. Economists assumed a larger role, not just as staff members but as Board members and reserve bank presidents. The main factors driving professionalization were the increased demands that governments and the public placed on economic policy, the growing sophistication of financial services and economic analysis, the widespread use of these services, and the frequent crises in the international monetary system. Not to be overlooked
was the presence of a new generation of economists who had developed Keynesian economics and were eager to use their tools to improve the country’s economic performance. President Kennedy brought them into his government, and gradually they or their students rose to positions of influence in the government and the Federal Reserve System.

16. Orphanides (2001) challenged Taylor’s finding and showed that the marginal response of the federal funds rate to inflation remained about the same, and about 1.5, throughout the Great Inflation.

The Great Inflation caused a significant loss in economic well being. The conclusion to the chapter considers why inflation started and how the Federal Reserve contributed to its start.

KEYNESIAN POLICIES

In 1960, economic policy did not have an explicit framework relating policy decisions or actions to output, prices, balance of payments, and the like. The Employment Act and the Bretton Woods Agreement stated policy goals but did not connect these goals to each other or to policy operations.

Truman administration economists relied mainly on controls and regulation, and the president favored a balanced budget even in wartime. Fiscal discipline and budget balance dominated fiscal discussions in the Eisenhower administration. The president’s chief economic advisors, Arthur Burns and Raymond Saulnier, and President Eisenhower himself, favored modest counter-cyclical policy including budget deficits in recession offset by surpluses in prosperous periods. Both economists were pioneers of National Bureau methods of business cycle analysis, which they used in government. This framework tried to isolate statistical regularities based on history. It lacked formal, analytic structure and depended on stability of often tenuous bivariate associations, eschewing attempts to relate the associations to economic theory.

At the Federal Reserve, the only comprehensive efforts to develop a policy framework to that time came in the Board’s 1923 Annual Report, in the writings of Winfield Riefler and W. Randolph Burgess, and in Benjamin Strong’s speeches and testimony during the 1920s. Vestiges of these efforts remained. Important as they were at the time they were written, they had faded along with the real bills doctrine. They said nothing about the effect of policy actions on output, employment, or prices.
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The 1962 Economic Report of the President (Council of Economic Advisers, 1962) introduced a new policy framework based on the Keynesian economics of that time. The “new economics,” as it was called, differed markedly from earlier approaches. It proposed activist, discretionary policies aimed not just at smoothing business cycles but at fostering economic
growth.
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With growth would come resources for reducing poverty, improving health care and education, expanding social programs, and redistributing income. President Kennedy’s advisers persuaded him to reduce tax rates in part by explaining that he would eventually have more revenues to finance increased spending (Heller oral history, tape I, 24).

17. See volume 1, chapter 4 for discussion of the Riefl er-Burgess framework, the real bills doctrine, and the Board’s Tenth Annual Report.

Emphasis on growth was not new. Arthur Burns had worked with a cabinet committee to develop strategies to increase the growth rate (Hargrove and Morley, 1984, 102–3). These efforts were not part of an overall policy plan or tied to the business cycle or a theory of economic policy. Burns did not have a numerical growth target, believing that the growth rate resulted from private decisions to save and invest that he could not forecast. The Democrats’ 1960 platform proposed 5 percent growth as a target, although Heller doubted that economic potential could sustain that rate (Hargrove and Morley, 1984, 273–74).

Heller and his colleagues changed the Council and the policy process in several ways. Heller, especially, became a public advocate of the administration’s programs. Unlike his predecessors, he appeared on television, gave public speeches, and testified in Congress to advocate administration programs. The Council developed models or frameworks that guided proposed actions and forecast their consequences, particularly fiscal actions. Their early proposals included a request that Congress grant the president limited, discretionary authority to spend for capital improvements and reduce individual tax rates temporarily “to meet the stabilization objectives of the Employment Act” (Council of Economic Advisers, 1962, 72–74). These proposals were bold. They asked Congress to replace some of its constitutional authority to decide spending and tax rates with a veto over presidential discretionary actions. Congress did not take up the proposals.

Discretionary fiscal policy was at the center of the Council’s analysis. The 1962 Report introduced the full employment budget surplus as “a numerical measure of the expansionary or restrictive impact of a budget program on the economy” (ibid., 77). In a recession, the current budget might show a deficit, while the full employment budget showed a surplus. The report pointed out that, in this condition, the current deficit should be increased to stimulate growth and a return to full employment. The report used experience from 1958 to 1960 to illustrate the concept. The
Eisenhower administration permitted the deficit to increase during the 1958 recession. It rejected tax reduction during the recession because of its long-term budget effects, and it strove to eliminate the deficit once the recession ended. It succeeded in balancing the 1960 budget, but the economy was far from the 4 percent unemployment rate that the Kennedy advisers regarded as full employment. This, the report said, showed that fiscal policy was restrictive because the budget should reach balance at full employment, not before. The Kennedy advisers wanted to increase the current deficit to reduce “fiscal drag” on the economy.

18. Walter W. Heller (1966, 28) who served as chairman of the Council of Economic Advisers from 1961 to 1964, described the change in policy. “The patterns of professional thought and practice that prevailed in previous economic policy making had not given full scope to the concepts and techniques of modern economics. Policy thinking had been centered more on minimizing the fluctuations of the business cycle than on realizing the economy’s great and growing potential.”