A History of the Federal Reserve, Volume 2 (87 page)

Policy coordination ensnared Martin in administration policy. He willingly sacrificed part of the Federal Reserve’s independence for the opportunity to be part of the economic “team,” make his views known to the president, and coordinate policy actions.
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Inevitably he compromised by surrendering some independence of action to coordinate policies. His offer to resign in February 1965 possibly reflected recognition that coordination with President Johnson and his advisers would be costly to Federal Reserve independence and to the country. Although he warned the country about inflation many times, he accepted reappointment in 1967 and remained until his term ended in 1970 without implementing the policy actions that he favored to achieve price stability and protect the gold stock.

President Johnson’s main argument in 1965 was that coordination required Martin to wait until he announced the 1967 budget estimates in January 1966, but he refused to give accurate estimates. In November 1965, the working estimate called for $105 billion of total spending in fiscal 1967. By mid-January estimated spending had increased to $106.4 billion for fiscal 1966 and $112.8 billion for 1967, but the 1967 estimate assumed that ordinary spending for the Vietnam War ended in December 1966. That held defense spending to $57 billion.
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Actual spending was $114.8 billion and $137.0 billion in fiscal 1966 and 1967,
and defense spending reached $58 billion and $71 billion in the two years (Recording of Telephone Conversation with Robert McNamara, December 20, 1965, 9326, Johnson tapes).

302. During the 1964 expansion without increased inflation, Martin told Heller that he had been wrong to think that the tax cut “would quickly fire up, not to say overheat the economy.” According to Heller, Martin offered to “cooperate with CEA—he a
lways has . . . , but [he] was particularly warm and insistent about it” (memo, Walter Heller to the president, July 17, 1964, WHCF, Box 282, LBJ Library).

303. Opportunities for coordination between the Treasury, the Council, and the Federal Reserve at this time included: (1) a Monday lunch at the Treasury with the secretary and Treasury staff followed by an informal meeting between Martin, the secretary, and the undersecretary for monetary affairs; (2) every other Thursday, the secretary met with Ackley, Budget Director Kermit Gordon, and a second member of the Council; (3) meetings of the Quadriad, with the president; and (4) regular meetings of the Cabinet Committee on the Balance of Payments, at which Martin and Governor Robertson participated. Minutes were kept only for the last of these.

304. This was Defense Secretary Robert McNamara’s proposal. Johnson complained that the Federal Reserve interest rate increase cost him $600 million, hardly a major item in a $112 billion budget estimate that underestimated spending by $25 billion. McNamara’s proposal financed ordinary department spending and all the long lead items for the full
fiscal year but omitted estimates for increased manpower in Vietnam and other operating expenditures.

Fourth, of lesser importance,
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the Federal Reserve staff and several of the members denied for several years that inflation had either begun or increased. They did not deny the numbers they saw. Like Gardner Ackley, they gave special explanations. The most common was a relative price theory of the general price level, in effect claiming that the rise in the price level resulted from one-time, transitory changes that they did not expect to repeat. Later, they added other explanations, especially that the cause of inflation had changed from the classic “demand pull” to the new “cost-push.” This reasoning at first claimed cost-push effects as a temporary result of slowly adjusting inflationary expectations. Later it exempted the Federal Reserve (and other central banks) from responsibility and suggested that the problem was not monetary. Governor Sherman Maisel (1973, 284), a forceful exponent of this view, presented the main idea:

In a period of general stability, a strong union or a monopolistic or oligopolistic group of companies may try to increase their income. If they have enough power, they can do so even though unemployment exists elsewhere. It is theoretically possible that other prices would fall as they raise their prices, but this is unlikely in most modern economies, where wages and prices are too rigid to react to minor increases in unemployment. In fact, the opposite occurs. Workers in industries with somewhat lower demand will strive for higher wages also . . . [S]ince profits are generally not that large, over time any increase in wages must show up in higher prices.

The economy had not acted that way in 1961–64. But even if modern economies acted as Maisel described, his discussion explains why the price level would be higher. It does not explain why prices would continue to increase or increase at a rising rate. Failure to distinguish between a change in price or wage level and a maintained rate of change hindered clear thinking about inflation. Sometimes inflation meant any price level increase. Elsewhere it meant a sustained rate of increase. Since one-time price level increases often took place over time, it was easy, but misleading,
to mix the two.

305. I regard the interpretation error as of lesser importance because I believe Chairman Martin would not have responded differently if the staff had correctly interpreted price changes. Martin was often considered an alarmist, long before 1965 and after. Despite his concerns and fears, he did not act decisively.

The sustained rate of price increase could not continue without an increase in money or its rate of use (velocity). Maisel recognized that without an increase in money, cost-push price increases were limited. He wrote (ibid., 285) that the principal reason prices continued to increase was “the unwillingness, for valid economic and political reasons, to allow the economy to suffer the necessary recession or depression which would accompany a policy of not expanding money because incomes are being pushed up from the cost side.” Then he added a critical sentence (ibid., 285): “The level of unemployment required to stabilize prices . . . is higher than that which the economy finds acceptable.”

This popular explanation worked with other features of the Federal Reserve’s approach, such as coordination, support for deficit finance, and failure to distinguish between real and nominal rates. No single person may have held all of these views. The ideas worked together to get inflation— sustained rates of price increase—started and permitted it to continue.
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FOMC met eight times during the first half of 1965. It voted twice for “slightly firmer” policy, on February 2 and March 23. Governors Mitchell and Robertson opposed both changes, joined by President Clay (Kansas City) in March. Table 3.11 shows that free reserves and the federal funds rate responded to the changes, but other interest rates declined slightly during the first half year.
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At almost every meeting, there are references to expanding activity, ris
ing prices, rapid credit expansion, or an increasing payments deficit. Difficulties in separating persistent and temporary changes, such as anticipation of rising prices or inventory building in anticipation of a steel strike, reduced the impact of the observations. The administration put on additional controls to reduce the foreign payment outflow, supporting those who wished to put responsibility for the gold loss on the administration and away from monetary policy.

306. The cost-push explanation failed to explain why inflation fell in the 1980s and remained low in the 1990s. An alternative explanation does much better. Once the public learned that policymakers would act to prevent a rise in unemployment, they anticipated, correctly as it turned out, that anti-inflation policy would cease soon after unemployment started to increase. Wages and costs became more rigid downward, necessitating a larger and more prolonged increase in unemployment to break the expectation. See Cukierman and Meltzer (1986) for a model of central banking with the appropriate features.

307. Martin described the proposed reduction of $50 million in free reserves voted at the March 23 meeting as “so slight that it was difficult to say whether such a change would have any real effect” (FOMC Minutes, March 23, 1965, 98). At the May 25 meeting, FOMC voted to maintain policy unchanged. Hayes, Balderston, Ellis, and Shephardson dissented. They wanted additional firming. Mar
tin did not support them.

The FOMC remained divided during the spring. At the May 25 meeting, Chairman Martin summarized his policy view. According to the minutes, “His own thinking probably tended in the direction of the group favoring firming, although no one could be sure about the appropriate timing. He was becoming increasingly worried about both the balance of payments and the possibility of domestic inflation. His views were not firm on either point” (FOMC Minutes, May 25, 1965, 62).

His colleagues must have been surprised when he spoke at the Columbia University commencement a week later. His speech compared the economic situation in 1965 to 1928–29. He pointed to similarities and differences. He did not claim that the country faced a serious inflation threat. His concerns were financial weakness and speculation. The press and stock market speculators emphasized the alleged similarities with 1929, not the differences. Industrial stock prices fell 5.4 percent in the next five weeks and did not pass their previous peak for four months.
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In the spring, the Treasury was concerned about a possible slowdown of economic growth.
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During the summer a new problem slowly emerged. Beginning in July 1965, President Johnson expanded the resource and financial commitment to the Vietnam War by announcing the sending of additional troops. The president did not let the members of the Council or Treasury officials know the actual size of planned spending increases.
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Martin learned from Senator Richard Russell, as early as July, that the budget deficit would be much larger than Johnson admitted to the Treasury, the Council, or the Quadriad. “I had better information than the Treasury had. . . . I went to the President, oh, I’d say four or five times and laid them out to him” (oral history, Martin papers, May 8, 1987, 1–2).
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308. In 1996, Chairman Alan Greenspan gave a speech warning about the risks in the stock market with similar effect. Like Martin, Greenspan took no action suggesting that markets should take the warning as a signal that policy would change. Some main parallels with 1928–29 that Martin criticized were proposals to devalue the dollar against gold and France’s reluctance to allow its gold inflow to raise spending and prices.

309. Bach, 1971, 121. Real GNP growth slowed from 9 to 5.9 percent between the first and second quarter! Third quarter growth was 6.5 percent. Heller reported that in June the president, the Council, and others began to discuss “whether we shouldn’t have some sort of little income tax cut at the bottom of the scale for the lower income people” (Heller Oral History, tape II, 41).

310. Ackley (Ackley Oral History, tape II, Johnson papers, March 7, 1974, 13–14) denied that President Johnson and Defense Secretary Robert McNamara knew “what it was going to cost and they just weren’t telling. It was not a plot to deceive people” (ibid., 14). Later Ackley reconsidered. “There was a period of a couple of months—six weeks maybe—in the summer in which there was, I think, a deliberate effort not to let anybody know what was going on.
But the people in Defense knew it, and the people in Budget and the Council did not know it” (Hargrove and Morley, 1984, 249). Johnson (1971, 149) explained the secrecy as an attempt to prevent Russia and China from supplying additional support to North Vietnam. The president told Senator John Stennis, “When you say it is going to cost us $10 billion there . . . the first thing Ho Chi Minh does, he takes your statement . . . and he says to Mr. Kosygin: “Look here’s what those damn Yankees are putting in . . . now how much are you going to put in?” (Recording of Telephone Conversation with John Stennis, August 18, 1965, Recording and Transcripts of Conversations, LBJ Library). Califano (2000, 34–36) confirms this explanation and adds the president’s unwillingness to open the issue of inflation and price controls when they were not needed. Secretary of Defense Robert McNamara estimated the one-year cost as $8 billion (ibid., 37).

Johnson did not want to reduce spending, raise tax rates, or have the Federal Reserve raise interest rates. Martin described the conversation.

One difficulty with this explanation is that although precise costs were hidden, much of the information about escalation was either publicly announced or known to many people. President Johnson’s account of this period (1971, 141–53) describes a press conference in July 1965 at which he announced that, on the recommendation of General William Westmoreland, he was increasing troops in Vietnam to 125,000 (ibid., 153). In April, the authorized number was 40,000 (ibid., 141). Also, in July he met with eleven members of the congressional leadership in both parties and discussed his options in Vietnam and his decision. He told them that costs would increase, although he did not report an amount.

Budget Director Charles Schultze made a determined effort to keep Federal Reserve officials from knowing planned spending and the deficit. “I have instructed my staff
not
to discuss the budgetary outlook with the Fed. Quite apart from security considerations I am afraid that
the
budgetary outlook would be used as an excuse to tighten up on monetary policy” (memo, Schultze to the president, October 4, 1965, WHCF, Box 22, LBJ Library; emphasis in the original). This is a striking example of why “coordination” became a one-way influence on the Federal Reserve to reduce its independence.

311. Senator Richard Russell was chairman of the Senate Armed Services Committee. Martin suggests in his oral history that Russell learned it from the Defense Department. Other sources suggest that Undersecretary of Defense David Packard informed Martin. Both may be correct. Dewey Daane reported, “There was uneasiness [in July]. Martin had some sort of pipeline to undersecretary David Packard. I had a gut feeling that the figures were going to accelerate a lot more and said so at the meeting. Martin called me into his office and said, ‘You know, I’ve been talking to David Packard and you’re right . . . These things are going to go way beyond what the administration has admitted’” (Hargrove and Morley, 1984, 249). At about this time, Ackley warned President Johnson that only if defense spending increased by $10 billion should they consider higher tax rates. He described this as “remote” and assured the president that Defense Secretary McNamara assured him that he planned “a gradual and moderate build-up of expenditures and manpower.” He concluded: “It is now less likely that you will want to recommend a tax cut next year. But it remains a possibility that shouldn’t be ruled out” (memo, Ackley to the president, July 30, 1965, WHCF, Box 23, LBJ Library, 3, 4). A month later, he reported a 1.9% annual rate of increase in consumer prices, but “the evidence does not point to any real inflation in the months ahead” (ibid., August 25, 1965, 3).