A History of the Federal Reserve, Volume 2 (56 page)

Heller “went to Washington thinking we ought to end the independence of the Federal Reserve, came out after working with the Fed under two presidents with the conviction that it isn’t too bad an arrangement, provided there is good will, competent people, and reasonably systematic consultation and presidential participation.”
³¹
He later recognized some of the difficulties he and other economists encountered in a political environment. Perhaps the most important example came early in 1966 (Friedman and Heller, 1969, 35–36). The Council advised President Johnson to reduce the budget deficit by raising tax rates. President Johnson believed that Congress would require reductions in spending; he was reluctant to reduce social spending and redistribution to pay for the Vietnam War (Goodwin, 1991). He also learned from Wilbur Mills, the chairman of the Ways and Means Committee, that a tax increase would not pass in the House (Hargrove and Morley, 1986, 251). More than two years passed before Johnson agreed to reduce spending and Congress agreed to a temporary tax surcharge. Earlier, President Johnson allowed official spending estimates to substantially understate the cost of the Vietnam War and hid the true costs from his advisers.
³²

29. Federal funds are the banks’ reserve balances, thus part of the monetary base. Chapter 2 discusses the market for these balances.

30. Council chairmen used policy coordination as a way of influencing Martin. During the Eisenhower administration, Martin met with the president or his staff to discuss economic policy thirty-four times, but twelve of the meetings were in 1958. The number of meetings increased to seventy-five in the Kennedy-Johnson years, including eight meetings in which Martin was alone with the president (Kettl, 1986, 94). Gardner Ackley, who succeeded Heller as chairman, described the meetings with President Johnson: Johnson “worked him over on more than one occasion without appreciable results” (ibid., 94). This statement would be more accurate, I believe, if it said without
immediate
result. Martin delayed raising interest rates and he permitted the monetary and credit expansion that produced inflation. Martin (1987, 4) described one such incident.

31. Martin did not mention that the meetings with the president were coercive. He described the meetings as “a very good device to make it possible for me to talk to the President at convenient intervals without being forced into it” (Martin oral history, May 8, 1987, 23).

32. Heller (Friedman and Heller, 1969, 36) treats the problem as unique. “Can you imagine a repeat of the situation in the second half of 1965 when the Council of Economic Advisers and the Treasury . . . were not aware of the Pentagon’s expenditure plans?” The precise problem has not occurred, but the Reagan administration’s “rosy scenarios” underestimated
the size of budget deficits in 1982 and 1983 and in several subsequent years, and the Bush administration refused to give cost estimates during the Iraq war in 2003. Martin (1987, 1–2) claimed that it was common to have information not shared between departments.

The main difference about monetary policy between Heller and his principal academic critics was over discretionary activism versus a rule—a consistent predictable policy.
³³
Heller’s position on this issue was shared by many of the Federal Reserve’s staff and officials, although several disagreed with the judgments, forecasts, and methods of the new Council. Heller said:

Insofar as the feasibility of discretionary monetary policy is at issue, what matters
most
is whether there is some near-term effect. If there is, then the Federal Reserve can influence the economy one quarter or two quarters from now. That there are subsequent, more pronounced, effects is not the key question. These subsequent effects get caught, as it were, in subsequent forecasts of the economic outlook, and current policy is adjusted accordingly. At least this is what happens in a . . . world where one enjoys the benefits of discretionary policy changes. (Friedman and Heller, 1969, 25; italics in the original)

Heller recognized that discretionary policy would be useful and effective only if economists’ forecasts are reasonably accurate six to nine months ahead. Friedman disagreed.

The available evidence . . . casts grave doubts on the possibility of producing any fine adjustments in economic activity by fine adjustments in monetary policy—at least in the present state of knowledge. . . . There are thus serious limitations to the possibility of discretionary monetary policy and much danger that such a policy may make matters worse rather than better. (ibid., 48)
³⁴

Heller’s focus on current or near-term events fit well with Federal Reserve practice. It too took one step at a time, based on current reports and observed what happened before taking the next step. This too was sub-optimal, as Kydland and Prescott (1977) later pointed out. Further, the Federal Reserve did not have systematic forecasts of future events until the
mid-1960s and lacked quantitative estimates of the timing and magnitude of the effects of its actions.

33. Friedman went further and recommended a fixed rate of money growth, but other rules later permitted activist response to events without discretion.

34. Friedman made clear that the same problem applied to fiscal actions. And he recognized strong political pressure to act even against modest changes. “We can avoid extreme fluctuations; we do not know enough to avoid minor fluctuations” (Friedman and Heller, 1969, 48). Frank Morris, later president of the Boston Federal Reserve bank, commented: “It will be a long time before we again have the complete confidence which we had in the early 1960s—that we knew exactly what we were doing” (qu
oted in Fuhrer 1994, 14).

Where the Federal Reserve and the Council differed most in the early 1960s was on the reasons for unemployment and the appropriate policy response. Leading Federal Reserve officials thought unemployment was structural, not cyclical. They favored industrial modernization, increased investment, job training, and other structural remedies, and they did not support policies to increase demand because they feared inflation.
³⁵
They differed also on the importance of the balance of payments and in their concern about inflation. By coordinating policy, Martin partly subordinated the Federal Reserve’s concerns to the administration’s. A principal result was that policy gave greatest weight to unemployment, reinforcing the tendencies brought by the Employment Act. But Martin continued to express concern about inflation and warned President Kennedy as early as second quarter 1961. Heller explained that they began to develop guideposts because any inflation in 1961 “surely wasn’t aggregate demand, or demand-pull inflation. . . . And if we are going to deal with cost-push, we ought to have some kind of incomes policy” (Heller oral history, II, 8).

THE COMMISSION ON MONEY AND CREDIT

The January 1957 Economic Report of the President expressed concerns about financial system operations and the system’s ability to finance growth. The report, and President Eisenhower’s State of the Union message, asked for a commission to study the operation of public and private credit agencies to assess their ability to meet future requirements in a growing economy, finance growth, and control inflation (Council of Economic Advisers, 1957, 49). The Committee for Economic Development, a private group, organized the Commission on Money and Credit. Its twenty-seven members included bankers, business executives, union leaders, consumer and farm organizations, and academic economists.
³⁶
The Commission began
its work in 1958 and issued its report in 1961 after nearly three years of meetings and considerable research by its staff, independent scholars, and the staffs of the principal financial institutions. The Commission’s report and eighteen supplementary volumes constitute the most extensive study of United States’ financial institutions since that of the 1907 Aldrich Commission, which led to the founding of the Federal Reserve.

35. Martin later told Heller that he accepted Heller’s argument for the tax cut (Kettl, 1986, 102). This was not true at the time.

36. Several of the members had served in previous administrations or at the Federal Reserve. These included Adolf Berle in the Roosevelt administration, Joseph Dodge in the Eisenhower administration, Marriner Eccles, former chairman of the Board of Governors of the Federal Reserve System, and Beardsley Ruml, a former director of the New York Federal Reserve bank and the author of the plan to withhold income tax at the source. Joseph Barr, later a Treasury Secretary, also served. Bertrand Fox of Harvard Business School and Eli Shapiro of MIT served as research director and deputy director respectively. The desirability of a commission to study financial reform had been discussed for several years following the Patman committee hearings in 1952. Showing general concern about the same set of issues, the United Kingdom organized the Radcliffe Committee, and Canada had the Porter Commission at a
bout this time.

The Commission attempted to evaluate the contribution that institutions made to the effective conduct of policy. In appraising market and non-market institutions, the Commission reflected contemporary discussion of the causes of a rising average unemployment rate, from 3.7 percent in 1951–54 to 4.9 percent in 1955–58. One view was that higher unemployment reflected insufficient stimulus and inadequate aggregate demand caused by so-called “fiscal drag” and excessively tight monetary policy. The other prominent view claimed structural features reduced employment and cited minimum wages, labor legislation, lack of proper worker training, and mismatch between openings and available skills as examples. While it found much to praise in postwar experience, the Commission noted that growth had slowed, prices had drifted upward after 1952, and balance of payments deficits continued with a loss of gold.

The Commission’s report serves as a guide to contemporary discussion of economic policy after a decade of active monetary policy. The Commission accepted that government had a role in achieving three goals: “adequate economic growth, low levels of unemployment, and reasonable price stability” (Commission on Money and Credit, 1961, 12). It accepted the common contemporary claim that “monetary, credit, and fiscal measures alone” would not achieve the three goals simultaneously if adjustment was slow or monopolists maintained wages or prices at “unduly high levels” (ibid., 12).

The Commission defined inflation as “continued increases in the general level of prices” (ibid., 14), but it then went on to describe two causes— “the pull of excessive demand in relation to supply” and cost-push (ibid., 15). The latter could arise from corporate or union market power, higher taxes, or higher import prices.
³⁷
This confused one-time price changes with the maintained positive rate of increase highlighted in the Commission’s definition. Discussions of inflation ever after were marred by failure to make this simple, but crucial, distinction.

The Commission did not propose numerical targets for inflation and
unemployment. It suggested that the economy could maintain an average annual growth rate above 4.5 percent if government policies removed impediments. This was lower than the rate the Kennedy administration considered feasible, but it reinforced their claim that policies during the 1950s had restricted growth to levels well below potential.

37. Only two members objected to the idea of cost-push inflation. They argued correctly that any increase of this kind was a one-time increase in the price level or temporary increase in inflation. The rest ignored this point (Commission on Money and Credit, 1961, n. 16).

There is little trace of earlier pessimism about the effectiveness of monetary policy. The report suggested that Federal Reserve operations affected interest rates on all classes of securities, and encouraged or discouraged bank lending, mortgage loans, and issuance of corporate bonds. The public chose to hold smaller money balances when interest rates increased, and conversely. The report noted that monetary velocity moved counter to the money stock, but that did not render monetary actions impotent. The report was less certain about the effect on investment (ibid., 52).
³⁸
It accepted criticisms that restrictive monetary policy had larger effects on housing, small business, and debtors than other groups, but it saw “no reason to object to the use of monetary policy relative to tax policy on account of its differential impact among sectors of the economy or size of business, or its indirect income distribution effects” (ibid., 59–60). But the report failed to recognize that the stronger effects on housing reflected the operation of relative prices and interest rate ceilings or that housing expanded relatively at low interest rates.

On the critical issue of deciding between commitment to domestic goals or balance of payments goals, the Commission, without dissent, agreed that the Federal Reserve should subordinate international to domestic objectives.
³⁹
It favored removing the gold reserve requirement behind Federal Reserve notes and bank reserves, a step not completed until 1968.

The Commission endorsed the conventional view that open market operations should remain the principal means of conducting monetary policy. Like the 1959 congressionally sponsored report on employment growth and price levels, it recommended that the Federal Reserve end the bills-only policy, but it claimed that the effect on long-term interest rates would be small (ibid., 63–64). The Commission favored retention of discounting at the discretion of member banks. It opposed automatic adjustment of the discount rate to market rates, but it favored a uniform
discount rate set nationally. The Commission urged the Federal Reserve to assure the banking system that it would serve as lender of last resort in times of distress (ibid., 65–66).

38. Karl Brunner’s review of the report (1961, 610–11) criticized the Commission for overstating the degree of consensus and the extent of empirically verified knowledge of the transmission mechanism. The report’s analysis contrasts favorably with the Radcliffe report in Britain done at about the same time.

39. “Federal Reserve policy should continue to consider the needs of our international balance of payments, but should be governed primarily by domestic economic needs” (Commission on Money and Cred
it, 1961, 61).