A History of the Federal Reserve, Volume 2 (84 page)

The staff introduced a proposed new directive at the April 14 meeting, offering two choices, one more explicit and quantitative than the other. Those who expressed opinions divided seven to five in favor of the less explicit instructions to the manager. The committee adopted a directive without quantitative targets.
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The Ellis-Mitchell-Swan memo, and the lengthy discussion that followed, brought out several perennial, basic problems. One was the prob
lem of knowledge. What should the FOMC know to carry out its mandate? What could it know? How important was consensus? Was it better to use vague statements that everyone could accept or to be more precise and report differences of opinion? Underlying much of the discussion was the relative weight attached to public relations and operating instructions to guide the manager.

Following our report, Congressman Patman held hearings on proposals for changes in the Federal Reserve Act to retire reserve bank stock, retire government debt at the reserve banks, require annual appropriations, increase the Board of Governors to twelve members, eliminate the open market committee, and restore the Secretary of the Treasury to the Board. The more than twenty days of hearings did not support Patman’s bills. Many witnesses were critical of the Federal Reserve, but they did not agree on what should be done. One response to the academic criticism was a regular meeting at the Board between Federal Reserve governors and leading academic economists known as the Federal Reserve Consultants meeting. Also, the Board voted to reduce the surplus accounts of the reserve banks from twice paid-in capital to 100 percent of paid-in capital. It voted to return the excess, about $500 million, to the Treasury (Board Minutes, December 16, 1964, 3–9). Mills dissented, and Governor Robertson noted in discussion with the bank presidents that this was a defensive action taken to prevent congressional action that would “diminish the System’s independence” (ibid., December 15, 1964, 5).

275. Governor Mills and Presidents Hayes, Irons, Deming, Wayne, and Hickman were particularly critical of the staff proposal. Governor Balderston asked the staff to comment on holding meetings once a month instead of every three weeks. By the 15th or 20th, most data became available. A longer interval might require a more conditional statement. The staff added, “More frequent meetings may tend to focus the attention of the Committee too much on short-run, transitory developments” (Brill to Balderston, Board Records, July 24, 196
4, 3).

Ellis, Mitchell, and Swan recognized that the System did not have much knowledge of the linkage between its actions and its objectives. They were less explicit and seem less clear about differences in objectives. Some, like Hayes, placed great weight on the payments deficit and often seemed willing to sacrifice domestic employment for a smaller payments deficit. Mitchell and Robertson took the opposite position. The discussion did not consider this problem.

The memo described the FOMC’s solution and its weaknesses. “The Committee does not avoid responsibility for making decisions in the face of uncertainty when it takes this easy road of not specifying its intentions and its instructions in complete, clear, and consistent terms. It does, however, reduce its ability to make the best decisions of which it is capable” (Revised memo, Ellis, Mitchell, and Swan to FOMC, Board Records, June 2, 1964, 13).
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Hayes opposed the new directive because the members lacked sufficient knowledge about financial processes and linkage with real activity. He did not suggest steps to improve that knowledge. He did not “share the feeling of serious dissatisfaction with existing directives that underlies these new programs” (FOMC Minutes, July 28, 1964, 58). He doubted that the manager could hit a precise target for growth in reserves. Irons (Dallas) thought it was a mistake to avoid “tone and feel” and insist on quantitative targets (ibid., 65). Tow (Kansas City) pointed out the lack of agreement. Some members preferred “a credit and interest rate approach, while others preferred some variant of a money supply approach” (ibid., 71).

Malcolm Bryan, referring to the 1964 hearings, noted the “criticism of the directive by Congress and nearly everyone who testified in front of the Banking and Currency subcommittee” (FOMC Minutes, September 9, 1964, 60). He added that the System could not avoid making the decision that Ellis, Mitchell, and Swan proposed. “Those judgments are already being made. If we are fearful in expressing them as a Committee,
then the Manager, whose actions
must
and
do
result in reserve numbers, has to make his decision for us. . . . [H]ave we not delegated, vested, or abdicated—choose the word you prefer—our responsibility?” (ibid., 61).

276. The memo recognized problems of using free reserves including that “changes in free reserves can be associated with more or less specific degrees, or changes in degree, of ‘ease’ and ‘restraint’” (Revised Memo, Ellis, Mitchell, and Swan to FOMC, Board Records, June 2, 1964, 7). The memo defended free reserves as specific and subject to close control, and because use of free reserves leaves interest rates to market determin
ation (ibid., 2).

The committee could not agree because the members could not overcome five obstacles.
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First, the directive and accompanying material served several purposes ranging from public relations to managerial direction. Explicit instructions, or precise statements about current and future conditions, helped one but hurt the other. Explicit instructions opened the FOMC to criticism. Second, the FOMC did not agree on weights placed on specific objectives or on the way to reach them. Several members recognized that it would be difficult and time consuming to reach agreement on precise quantitative targets. Third, some went further, arguing that no one had sufficient understanding of economic dynamics either to give precise quantitative instructions or to develop side conditions (provisions) that would remain relevant.
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Fourth, some members saw their task as one of responding to hourly or daily market changes and resetting objectives every three weeks. Hayes was the strong proponent of this view, but he was not alone. Others wanted to set a path for monetary policy to achieve longer-term objectives. Although Bryan and Mitchell did not express this view explicitly, that appeared to be one of their objectives. Fifth, several members recognized that a more quantitative directive would of necessity shift considerable responsibility to the Board’s staff. They would not accept the counterargument that an imprecise directive and conflicting statements shifted responsibility to the account manager. Governor Mills rejected interest rate targets as a form of pegging, although that was not part of the proposal.

President Hayes defended the manager’s discretionary adjustments, arguing that precise instructions with proviso clauses would lead to less desirable outcomes. “The new instruction would be far narrower than the existing type of instructions, and would necessarily introduce important new constraints . . . [I]n a market that is dynamic and changeable in frequently unpredictable ways, I believe those new constraints would redound to the disadvantage of the Committee in the achievement of its central objectives” (Hayes to FOMC, Board Records, October 15, 1964,
8–9).
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Hayes did not believe it was desirable or useful to develop a longterm path. He favored period-by-period reassessment, a procedure later shown to be sub-optimal.

277. Martin presided but did not contribute much substance to the discussion. He may have recognized that the members would not reach agreement.

278. Hickman (Cleveland) praised the recommendation to adopt a range for free reserves. Opponents either feared that the manager would embarrass the FOMC by missing the range frequently or preferred to allow the manager to use his judgment (FOMC Minutes, September 29, 1964, 63). Bopp pointed to lack of knowledge and difference of judgment as the source of differences between FOMC members (ibid., 56). Elsewhere, Bopp (1965) criticized the critics for claiming more useful knowledg
e than they had.

Several members agreed that the first two proposals, describing the economy and financial conditions, should not be part of the directive. Robertson summarized some of the problems. “When do trends begin and when do they end? What changes are temporary and what are permanent? How far ahead do today’s actions have an impact?” (Robertson to FOMC, Board Records, October 20, 1964, 4).
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These issues remain central to a careful analysis. The problem of distinguishing between permanent and transitory changes in trends or levels was usually neglected and has not been resolved.
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Tax
Cut

On February 26, 1964, President Johnson signed the bill reducing tax rates that President Kennedy had first considered after the stock market break in May 1962. The bill passed the House in September 1963, but the Senate Finance Committee refused to act until satisfied that spending reductions would hold total spending in fiscal 1965 below $100 billion. Johnson brought proposed spending down to $97.9 billion.
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Actual spending
for fiscal 1964 was $96.5 billion, below the budget estimate.
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The final bill reduced tax rates from the range 20 to 91 percent to 14 to 65 percent in 1965. Corporate tax rates declined from 52 to 48 percent.

279. Hayes criticized other parts of the Ellis-Mitchell-Swan proposal also. He doubted that the FOMC could agree on a single long-term target and dismissed reserves against private deposits as inadequate. He saw no advantage in trying to agree on a common assessment of the economic outlook and doubted it could be done.

280. The manager noted some additional problems. During the first thirty-eight weeks of 1964, the first published free reserve figure differed from the final figure by $40 million in fifteen weeks, by $60 million in nine weeks, and twice by more than $80 million. He estimated that “75 percent of the time, the range [for a free reserve target] should be well over $100 million—perhaps more like $150 million” (Stone to FOMC, Board Records, October 16, 1964). Robertson’s mention of permanent and transitory disturbances opened an important issue that was never studied by the staff. Muth (1960) gave a general answer.

281. Bremner (2004, 155) reports that Martin was sufficiently concerned about the Patman bills that he asked President Johnson for help. Johnson called the Speaker of the House, John W. McCormick. The hearings ended two weeks later; none of Patman’s proposals passed the committee. As part of the hearings, Congressman Patman asked Chairman Martin to release FOMC minutes for 1960–63. The FOMC discussed the request at several meetings before rejecting the specific request. It agreed only to establish procedures that would make available minutes prior to 1961, including the 1960 minutes that the subcommittee had obtained once before. Martin’s letter referred Patman to the record reported in the Board’s Annual Report. He argued that release would reveal confidential information including plans of foreign governments and restrict discussion at FOMC meetings (FOMC Minutes, April 14, 1964, 68). This is the beginning of the program to make records available to scholars and others that the Board instituted in the 1970s.

282. Johnson should have been aware of congressional demands for spending control when he sought a surtax a few years later. Early in the 1963–64 discussions, Secretary Dillon warned President Kennedy, referring to Senator Byrd: “We do believe you have to put on a
performance that looks like you’re being careful with expenditures” (Kennedy, 2001a, October 2, 1962, 334). Heller’s original proposal reduced taxes by $6 to $7 billion and put most tax reduction at lower income
levels. The final bill shifted reductions toward corporations and higher income levels to gain business support and Republican votes in Congress, (ibid., 339). The original bill included substantial tax reform that was later eliminated.

A year earlier, Dillon told Kennedy that Martin would be helpful in getting the tax cut adopted (Dillon papers, Box 34, January 16, 1963). Martin did not defend Heller’s argument that the tax cut would expand consumer spending, and his support for the policy was modest. He made few references to the administration’s proposal and, when he did, it was mainly to the problem of financing the deficit. He did not follow his claim that the Federal Reserve had to help with deficit finance if the Congress approved the budget. Instead, he told the Joint Economic Committee that the Federal Reserve “would be derelict in its responsibilities were it—in the light of a large defi cit—to add to bank reserves and to bring about substantial credit expansion solely to facilitate the financing of the deficit. . . . [I]t would be ill-advised to generate the danger of inflation, either long-run or short, by creating redundant dollars, in order to make easier the financing of a deficit” (Martin testimony, Joint Economic Committee, February 1, 1963, 10–11). But he agreed to finance any increase in real output that resulted from the tax cut.

The last quote reflects Martin’s non-Keynesian views and his continuing concern that the Federal Reserve would have to inflate to finance the deficits that Congress created. He presumed that interest rates would rise, but they would not increase enough to prevent inflation. His testimony showed him aware of the problem he faced later; his conflict between supporting the tax cut and financing it arose because he believed that the Federal Reserve could not refuse to finance a deficit that Congress adopted. The Kennedy-Johnson tax cut brought this concern to the fore because the administration argued that the deficit was both desirable and temporary. By approving the tax cut, Congress knew that the resulting deficit was not an accident.

283. Heller estimated the total tax reduction as $12 billion. Reductions became effective on January 1, 1964 and 1965 (Stein 1990, 431; Hargrove and Morley, 1984, 200–201). Barro and Sahasakul (1986, Table 2) show a reduction in the average marginal tax rate from 0.247 to 0.212 (14 percent) between 1963 and 1965. Heller had originally emphasized the need to eliminate fiscal drag by reducing the full employment budget surplus. In the first half of 1965, with the tax cut fully in effect, the calculated full employment budget surplus was $7 billion, only $2 billion less than in the latter part of 1962, when Kennedy proposed the tax cut (Stein 1990, 436).