A History of the Federal Reserve, Volume 2 (94 page)

After 1965, the relationship changed. Real growth slowed with the reduction in productivity growth, shown in Chart 3.1 above, in part the effect of diverting resources from private to public use for war and redistribution. Slower output growth with rising money growth increased inflation and the potential for inflation, supporting the rising anticipation of inflation in the Livingston survey.

Gold continued to flow out, but the Federal Reserve sterilized the outflow. Chart 4.5 shows that, generally, base growth continued to increase after 1964. The peak annual rate of growth for the decade, more than 7 percent, came in 1968. For the five years 1959–64, the base rose at a 3.1 percent compound average rate; in 1964–69, the compound average rose to 5.5 percent despite lower productivity growth.

A common claim is that a budget deficit increases market interest rates. Since the Federal Reserve controls a short-term rate, that rate changed only if the Federal Reserve permitted a change. To prevent a change when the deficit increased, the Federal Reserve permitted an increase in the monetary base or its growth rate.

Chart 4.6 suggests an important difference in deficit finance after 1964. In 1961–64 inclusive, the Federal Reserve increased the base enough to finance 33 percent of the annual budget deficit; in 1965–71, the percentage increased to 50 percent. Despite a small budget surplus in 1969, deficits
on average were substantially larger ($8.8 billion compared to $5.3 billion), and the Federal Reserve financed a higher percentage. Money growth rose as a result, and inflation followed.
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2. The budget had a surplus in 1969, so the rate is negative for that year. The base increased in 1969 by slightly less than in 1968, a year with a relatively large deficit.

It did not require subtle economic reasoning to know that financing deficits by injecting money was inflationary. This was a commonplace, learned from experience in most wars. Three questions arise, therefore: Why did the Federal Reserve on average finance half the deficits? Why did Chairman Martin, a strong proponent of price stability, continue the policy? And why did the professional economists on the Council of Economic Advisers hesitate to urge higher interest rates?

Experience from 1965 to 1971 suggests two broad answers to these questions. The Federal Reserve accepted its role as a junior partner by agreeing to coordinate its actions with the administration’s fiscal policy. Coordination permitted the chairman to discuss the administration’s fiscal policy with the president, but he had little effect on decisions. In practice, coordination meant that the Federal Reserve would not raise interest rates much, if at all. Martin’s reasons for accepting this role covered a wide range including (1) his definition of independence as independence within the government, (2) failure to distinguish between real and nominal interest rates, and (3) a strong commitment to consensus building within the Board and the FOMC and with the administration. By the late 1960s most of the Board agreed with the administration’s policies, not with Martin’s warnings about inflation.

Second, the Johnson administration’s principal macroeconomic concerns were economic growth and unemployment. Administration economists believed that a little more inflation was the price of permanently lower unemployment. This called for keeping interest rates from rising, a decision that President Johnson favored for populist reasons of his own. Administration economists compounded this error by believing that the main response to inflation had to be fiscal, not monetary, action. They believed that a temporary surcharge would slow inflation; their idea of coordination called for lower interest rates to soften the expected effect of the tax surcharge in 1968.

By the time policymakers recognized that the surcharge and the easier monetary policy had not slowed inflation, the public had learned a different lesson, one that would be reinforced through the 1970s. The public saw that policy responded mainly to actual or anticipated unemployment in 1966–67 in 1968, and in 1969–70. Strong words about the dangers of inflation were not matched by strong actions. They concluded, correctly, that anti-inflation actions would not persist once unemployment increased.

At the end of the decade, the members of the Council of Economic Advisers in the Nixon administration brought different ideas but no less inflation. Nixon’s economists, following Friedman (1968b), accepted that any reduction in unemployment achieved by increasing inflation would
not persist in the long run. The higher inflation rate would be learned, expected, and impounded into wages, prices, and interest rates. But they continued to believe in a reliable short-run reduction in unemployment achieved by inflating. Further, they put major stress on money growth as a short-run influence on output and long-run inflation.

These analytic changes could have served as the basis for a successful anti-inflation policy, but they were not used for that purpose. The overriding concern remained the unemployment rate. Policy continued to aim at a 4 percent unemployment rate as the attainable equilibrium. As the 1972 election approached, this concern became overwhelming both at the Federal Reserve and in the Council of Economic Advisers. No less important, Arthur Burns, whom President Nixon chose as chairman of the Board of Governors to replace Martin, became convinced that the increase in the unemployment rate required to reduce inflation would be politically unacceptable. He became the leading proponent in the administration of wage-price guidelines and later wage and price controls.

PREVAILING BELIEFS

The Johnson administration’s policy views reflected prevailing Keynesian orthodoxy. These views were widely held. To commemorate the twentieth anniversary of the signing of the Employment Act, the Joint Economic Committee invited economists and legislators closely associated with the act to a symposium. Several had served as members or chairs of the Council of Economic Advisers (CEA), which was created by the act. Their views on economic policy, and their differences, summarized the state of opinion among those actively engaged in policymaking or likely to be policy advisors. Their statements covered many issues other than macroeconomic policy, employment, inflation, and balance of payments.

No member of the Federal Reserve Board of Governors presented a statement. Although inflation was an emerging problem in 1966, there was very little attention to money and monetary policy. Most of the comments about inflation discussed fiscal policy, wage-price guideposts or controls.

The main explanations of inflation were either some version of the Phillips curve relating inflation to the unemployment rate, or systemic inflationary bias and the incompatibility of multiple objectives. Kermit Gordon, a budget director in the Kennedy administration, stressed the latter, calling it the “grand dilemma of modern mixed capitalism. As among three basic economic goals that are held in high esteem in our society—reasonably full employment, reasonably stable prices, and reasonably free economic institutions and pressures—it is widely believed that we may attain any
two together, but not all three. . . . [W]ages are determined and prices set by groups which possess a measure of discretion in these decisions; and this discretion can be used and has been used to introduce an inflationary bias into wage and price setting at levels of economic activity short of full employment” (Joint Economic Committee, 1966, 60).

Only Paul McCracken, a former member and later chair of the CEA, directly challenged this thesis. After examining non-war data for 1909 to 1929 and 1949 to 1965, he concluded that the central claim was not true. “The record does not seem to suggest that the price level now is prone to rise more rapidly during an economic expansion than in our earlier history. If anything it may be less so” (ibid., 69). Nevertheless, McCracken concluded: “There probably is an element of the market-power phenomenon in the tendency for our price-cost level to edge higher” (ibid.).
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Henry Wallich, also a former CEA member and later a Federal Reserve governor, also challenged the persistence of inflation bias, noting that it depended on some type of money illusion. Anticipating an argument soon made famous by Friedman (1968b), Wallich said, “Labor, business, consumers, investors will think in ‘real’ terms; that is in terms of constant purchasing power. To achieve the same employment effect, inflation would have to be
accelerated
beyond the expected rate, and when that new rate became expected, more acceleration would be needed. . . . I conclude that the possibility of raising employment by accepting inflation exists only in the short run, until people have caught onto the game” (Joint Economic Committee, 1966, 13–14; emphasis added).

Wallich unsuccessfully challenged the prevailing orthodoxy that full employment, price stability, and balance of payments equilibrium involved long-run tradeoffs, such as the Phillips curve tradeoff between inflation and unemployment. “Truly competing objectives are those that make demands upon resources. . . . Full employment, growth, and price stability are not of this sort . . . A rational society should have no difficulty in reconciling them, though the learning period may be painful” (ibid., 15). He criticized the emphasis on demand management in discussions of economic growth and the neglect of supply-side policies to increase productivity and capacity (ibid., 14).

Raymond Saulnier, a former CEA chairman, emphasized the role of combined monetary and fiscal expansion in generating inflation, but he expressed concern about using monetary policy to reduce inflation. “Inter
est rates are already at levels that are high by all U.S. historical standards” (ibid., 54). Because he failed to distinguish between real and nominal interest rates, he expressed concern that if monetary policy acted decisively, it would disrupt financial markets. Like many in the Federal Reserve, he argued for a more restrictive fiscal policy as the senior partner in an antiinflation policy under then current circumstances.

3. McCracken and other critics did not ask why labor unions that possessed market power did not exhaust their power in a one-time increase in the wage level and similarly for corporations.

As the discussion suggests, one main division was between those who urged fiscal restriction as the primary tool to reduce inflation and those who preferred guideposts for wage and price changes and the use of presidential power to influence individual price and wage decisions. Critics noted that not all decisions were visible, so this policy would fail, but they did not point out that, with unchanged money growth, the policy would not reduce spending unless the public held larger cash balances per unit of income.

Without making the connection to guideposts, Arthur Burns, another former CEA chairman, made the critical point. “Taking the past 20 years as a whole, the administrators of the Employment Act have concentrated on the maximization of employment” (ibid., 28). Other goals—price stability and freedom of contracting—remained secondary. Although administrations had not always succeeded, the primacy given to high employment, or avoidance of recession, was the source of the country’s inflationary bias. Although a minority criticized this ordering of goals and proposed greater weight to inflation, the payments imbalance, or poverty reduction, in the political and intellectual climate of the period, the criticisms had limited force. It would take a large and costly inflation—the Great Inflation—to change beliefs or attitudes. In the interim, economic policy put greatest emphasis on reducing unemployment or maintaining the unemployment rate near 4 percent.

Another bias noted in some of the comments was the emphasis on current problems and relative neglect of longer-term consequences. Gardner Ackley, the current CEA chair, agreed that “our horizons need lengthening” (ibid., 129). He noted especially the need for more and better information about “the future impact of Federal programs, especially the new and growing ones” (ibid., 130). Johnson’s administration did little or nothing about longer-term consequences. Within a few years, the growth of spending for Great Society programs and the unwillingness to raise tax rates enough to pay for them posed challenges.

Walter Heller emphasized both demand stimulus and, like Wallich, what later became known as supply-side policies. “The discouraging pattern of recessions every 2 or 3 years has been broken, not by simple-minded devotion to demand stimulus, but by a tight coupling of measures to boost demand with measures to boost productivity and hold costs and prices in
check—a combination designed to harmonize the demands of full utilization of our economic potential with demands of high growth, cost-price stability, and external payments equilibrium” (ibid., 37).
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