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CHAPTER IX / Continue to Chapter X
WHAT IS MONETARY POLICY?
Throughout the preceding chapters, the phrase âtight (or easy) money policyâ was used liberally. Most people understand the phrase-in broad terms; but monetary policy is too important to be left to âbroad terms.â For it deals with the operating instructions of he managers of our monetary plant. Monetary policy is what fits the money industry into the structure of the economy.
But in specific terms, âmonetary policyâ has many definitions. Sometimes, although rarely in this book, it means the pattern the Government uses to erect a money system, and particularly the goals the Government has in mind as it monitors the moneymaking machinery.
This is why monetary economists occasionally speak of âpassiveâ or âactiveâ monetary policy.
A government pursues a passive monetary policy by constructing a system which does not provide for any day-to-day or year-to-year decisions about influencing the volume or kinds of economic activity by monetary managers. The money supply is not manipulated to reach a specified economic target.. This does not mean that interest rates do not move up or down in response to the rise and fall of demand for credit. They do. But the monetary managers pursuing a passive monetary policy do not cause these moves or modulate them by any deliberate action on their part.
What rules guide the monetary system in providing the money supply in this case?
Broadly speaking, they are Automatic, akin to the rules a thermostat follows in controlling a roomâs temperature. For example, the system can be told to increase the money supply by, say, 3 percent a year -- the actual figure to be decided upon after considering the long-term growth rate of the economy and the associated monetary needs. Other, more complicated rules can be devised. An active monetary policy is, obviously, the opposite. The Government grants the monetary agency both the power and the liberty to influence the economy, through deliberate and rather constant adjustments of the money supply valve. With an active monetary policy, the prevailing level of interest rates at any time results from a conscious choice by the central bank.
The United States has followed an active monetary policy for years -- with activity reaching a peak after 1953, particularly during President Eisenhowerâs administration. Indeed, the economic ideology of that administration generally repudiated the use of any mechanism but the monetary for steering the economy. Almost exclusively, monetary policy was relied on to prevent inflation, regulate business activity, and promote other desirable ends. Despite its ideological precepts, however, the Eisenhower administration ,vas compelled be- cause of the tight money policies and their restrictive effect on the economy, to go into budgetary deficits in order to prevent an economic tailspin. Since 1960, active monetary policy has been used, but less exclusively .
Whatever the degree of activity, an active monetary policy, in the U.S. case, leads the Federal Reserve to reduce the money supply during certain periods-or to refuse to allow it to expand-in order to bring pressure on interest rates. In other periods, it does the opposite. In general, the Federal Reserve tries to restrain the economy when it operates at high levels and to stimulate business when recession grips. Or, to be precise, the Federal Reserve attempts to anticipate an economic upturn or downturn and react accordingly. âActiveâ and âpassiveâ describe the overall type of monetary policy. More common are the terms âtight money policyâ and âeasy money policy.â And these terms, clearly, are the interesting ones once a government has opted for an active central bank. âTight moneyâ as a reminder-refers to a policy of restricting the money supply in order to decrease the availability and raise the price of money. âEasy moneyâ is the opposite.
One further general point, touched on in chapter I, is worth repeating. Active monetary policy only offers the choice of easier or tighter money. But the effects of monetary policy are so widespread that the same policy can be and is used for different purposes at different times with the fallout drifting where it will. For example, the Federal Reserve turned toward tighter monetary policy during the consumer buying upsurge of 1955 with the express purpose of cooling consumer demand for autos and other durables. The valve was turned tighter in the spring and summer of 1957 to restrain business investment in new productive capacity which the money managers feared, was outstripping sluggish consumer demand. The result was a recession which lasted from July 1957 to August 1958. Again in late 1959 and early 1960 a tight money policy was pursued and interest rates rose. Again the result was a recession. This one began in May 1960 and lasted until February 1961. Finally interest rates began climbing in late 1961 and continued their rise to early 1962. Yet consumer demand has far from strained productive capacity during this period, and the low rate of business investment was an object of national concern. The new reason for the tighter monetary policy. The flow of dollars into foreign deposits and securities.
It is interesting to note that the steady rise in interest rates that began in 1961, has stabilized in recent months, probably due to the fact that the money supply was increased beginning in late 1962 -- an increase which may have been a âhappy accident.
Enough was said in chapter I to indicate how a change in the money supply influences business activity. Here, again, there are some general observations to be made about the stock of money and the economy.
First, since our economy is growing and dynamic, economists almost unanimously agree that over long haul the stock of money will have to grow-probably at about the same rate as the economy-if economic growth is not to be stunted. Failure to provide the money will spawn an era marked by deep recessions, abortive recoveries, low investment, high interest rates and chronic unemployment. This ]ongterm need for adequate growth in the money stock is the first commandment for monetary policy-active or passive.
Second, the effects of an easy money policy are not necessarily the exact opposite of those of a tight money policy. As economists put it, monetary policy is not âsymmetricalâ in its effect. Tight money, it is easy enough to see, can chill practically any boom. By making money tight enough investment can always be choked off. But easy money will not always kindle a burnt-out economy, as the 1930âs cruelly illustrated. There has been some controversy among economists about this point in recent years. Still the generally accepted view is that an economy in a full-fledged depression such as that of the early thirties will not respond vigorously to cheap and plentiful money. (Note the qualification: full-fledged depression; a recession is another matter.)
The Federal Reserve authorities, who by and large agree with this view, sometimes use the analogy of the string. The Federal Reserve can pull on the purse strings but it cannot push them. Why canât it push on the string First, money may be generally available and cheap, but borrowers must be willing to borrow for investment and banks must be willing to lend to those particular borrowers who apply for loans. But, during a depression, the prospects for business are so dismal and the weight of productive capacity so enormous that business firms are unwilling to borrow for equipment or inventory despite rock bottom interest rates. At the same time, banks are reluctant to lend to many of the would-be borrowers. With business after business on the verge of bankruptcy, everyone is a poor credit risk. And the banks must, of course, consider their own survival. After these generalizations, the question can be asked, âWhat type of monetary policy has marked the Federal Reserveâs actions over the years? Though it will come as a surprise to anyone under 40, active monetary policies have not always been with us.
Indeed, just when monetary policies became active and where the Federal Reserve obtained its legal authority to engage in active monetary policies, is anything but clear.
Certainly when the Federal Reserve Act was passed in 1918 there was no thought, either in or out of Congress, that the countryâs monetary policy would be anything but passive. The main monetary problem the country had encountered was the periodic shortages of money. The Federal Reserve System was established largely to eliminate money shortages. The theory of the Federal legislation was that the ideal system would bring prompt, orderly, and automatic increases in the money supply in proportion to the need of trade and commerce. The economic activity of the country was not to be limited by the money supply; instead the volume of economic activity was to determine the money supply. A member bank of the Federal Reserve which lent all of its available funds and then needed additional funds to meet the credit requirements of trade and industry could automatically obtain the additional funds from the nearest Federal Reserve bank by posting eligible paper.
But by 1920, however, officials of the Federal Reserve were taking at least occasional steps to reduce the supply of money and credit in order to encourage general economic contraction and the reduction in prices which these officials thought desirable. At the time, the Federal Reserve had no formal machinery for reducing the money supply. In 1920, therefore, they simply called the class A directors (themselves bankers) of the Federal Reserve banks to a meeting where they agreed that the Nationâs important banks should be persuaded to call in outstanding loans and refuse to make new loans, thus producing a countrywide contraction of credit. This âvoluntaryâ or conspiratorial contraction of credit greatly aggravated if it did not initiate the 1920-21 depression.
The largest volume of credit extended by the Federal Reserve to the banking system, before World War II, was reached in 1920. Thereafter, the Federal Reserve banks began to limit the amount of credit they extended to the banking system. Full active monetary policies, of the type we know today, were not then in evidence. Rather, from the recovery of the depression in 1921 through 1926, the Federal Reserve permitted a general expansion of the money supply, though with interest rates somewhat high by :present standards. Then, in 1927, 1928, and 1929, a policy of restraint was followed, resulting in virtually no change in the money supply between August 1927 and August 1929. As mentioned earlier, the so-called credit excess which fed the wild speculations in the stock market in the late twenties was not an excess of credit relative to the needs of the whole economy. It was an excess because this credit was fed into the economy by way of loans to brokers, dealers in securities and the banking system, resulting, when the speculative bubble burst, in the start of a credit squeeze. The credit squeeze was followed by some extraordinary actions on the part of the Federal Reserve in the early thirties which resulted in the unbelievable-a one-third decrease in the money supply during the collapse of 1929-33.
Then the final turn in active versus passive monetary policy came with the Banking Act of 1935 which gave final form to the Open Market Committee.
The first annual report of the Federal Reserve System issued after passage of the 1935 act proclaimed that this act placed âresponsibility for national monetary and credit policies on the Board of Governors and on the Federal Open Market Committee.â
In truth, the 1935 act makes no mention of âmonetary policy,â âmonetary powers,â or âmonetary controls.â Nor does it contain any provision suggesting a change in the monetary policy that underlay the original Federal Reserve Act of 1913.
In short, after passage of the 1935 act, the Federal Reserve authorities of that day simply claimed responsibility for âmonetary policiesâ- without explaining what they thought âmonetary policiesâ meant.
In the period between passage of the 1935 act and the beginning of World War II, an active monetary policy was, on occasion, in evidence- in the sense that the Federal Reserve took certain deliberate actions to counteract or offset other events of the day. The best illustration of this involves a legislative action with which the writer was personally concerned. It has to do with the so-called soldiersâ bonus. Let me explain.
During World War I there was a great increase in wages and, of course many âwar millionairesâ were made. Those who served in the Armed. Forces, however, continued to receive a low rate of pay, appropriate to, if anything, the 1915 wage scale. Specifically, soldiers in the trenches in France were paid $1 per day. In a fit of conscience following the war, Congress decided to adjust the pay of the World War I veterans, retroactively. Instead of giving the soldiers their overdue pay in cash, however, the Congress provided for it in what was called a delayed compensation certificate. These certificates were to be paid off in cash when the veterans reached a certain age.
Now, during the great depression, many of these same veterans were, of course, standing in breadlines, selling apples on street corners, and otherwise suffering the fate of others in the great army of the unemployed. It occurred to me that under these circumstances, the compensation certificates should be paid in cash, without delay, not at whatever time the veterans reached the age specified in the certificates. Further, it seemed to me that the release of such a large amount of cash by the Government would be generally beneficial, providing (or releasing) added purchasing power over the whole country and thus helping to bring about economic recovery. After a prolonged controversy, which involved several Presidential vetoes, this proposal was finally successfully enacted in 1936. The delayed compensation certificates were paid in August of 1936, putting several billion dollarsâ purchasing power into the cities, towns, villages, and farms of the country.
To add a personal note, it was my experience with this legislation which made me a ware of money and banking matters and caused me to begin seeking an education on the subject, both from the monetary authorities in the Government and the written works on the subject. Even so, I was for several years puzzled as to why the release of these several billion dollars of purchasing power did not cause any big splash in the economic pond as I had expected, but indeed seemed to have no effect on the economy. In time, I learned that in June of 1936, the Federal Reserve raised reserve requirements of the member banks, in anticipation of the âinflationaryâ effects of the soldiersâ âbonusâ and, in fact, reduced the money supply of the country by almost the exact amount of the payments which the veterans received. The Federal Reserve prevented âinflation,â to its way of thinking, but it proceeded to hobble the economy which had 17 percent of its workers already unemployed-and subsequently plunged the economy into the deadening relapse of 1937 - 38.
It would not be correct to suggest that because of the 1936 episode the Federal Reserve simply followed a tight money policy between 1935 and the beginning of economic recovery in late 1939. Actually, throughout this period, except for the 1937 blunder, member banks had large amounts of excess reserves-that is, reserves which they did not utilize to create deposits. In fact, this became the classic example of the limits to an easy money policy during a depression-lithe push on a stringâ analogy mentioned earlier.
On the other hand, interest rates were maintained at a substantially higher level during this period than during the World War II years. During World War II, the Government followed a variety of credit policies. One policy -- a new departure -- was direct restriction of consumer credit. This was provided by the so-called regulation âWâ which prescribed minimum down payments and maximum terms of payment on consumer purchases of automobiles and other consumer durables. At other times, the Federal Reserve issued other regulations, imposing selective credit controls under wartime authorities enacted by Congress. In the main, however, the policy of this period was to provide whatever amounts of money and credit were needed by the economy, which was turning out the largest possible amount of weapons and other supplies needed to fight the war and meet essential civilian needs at home. In this period, and indeed during the postwar years -- up until March of 1951 -- the Federal Reserve maintained a market yield on Government bonds at less than 2% percent. And all other interest rates were kept correspondingly low. For example, through a good part of this period, the market rate on 91-day Treasury bills was maintained below one-half of 1 percent.
World War II taught us many lessons. One was that our country need never again suffer from a prolonged depression like that of the 1930âs. A conclusion almost unanimously reached was that if we could have full employment and have our economy produce the gigantic quantities of goods for the destructive processes of war, then we could likewise, in peacetime, maintain full employment and produce enough goods to eliminate poverty, ignorance, and disease in this country.
The Great Depression had been brought on, not by bad management in the private economy, but by the failure of Government to manage its affairs correctly, and most particularly the failure of Government to recognize and assume its role in the economy. If there were the right utilization and coordination of its resources and policies by the Government, then, no one then doubted, the private enterprise economy could and would provide full employment, maximum production, and maximum purchasing power.
This lesson which we learned from World War II, or at least thought we had learned, was much in the minds of the American people at the end of the war. Most of us were then highly resolved that never again would we permit any Government neglect or failure to deprive us of the benefits of our great potential for economic well-being. This high resolve was set down, furthermore, as declared national policy, in the Employment Act of 1946:
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Henceforth it would be the policy of the Federal Government -- to coordinate and utilize all its plans, functions, and resources for the purpose of creating and maintaining, in a manner calculated to foster and promote free competitive enterprise and the general welfare, conditions under which there will be afforded useful employment opportunities, including self-employment, for those able, willing, and seeking to work, and to promote maximum employment, production, and purchasing power.
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Let us note that this declaration of policy does not say that Government shall replace free competitive enterprise. It says that the Government will coordinate and utilize its plans, functions, and resources in a manner to foster and promote free competitive enterprise, and in this way maintain maximum employment, production, and purchasing power.
When the Employment Act of 1946 was being debated and enacted into law, policies of the Federal Reserve had then been closely coordinated with those of the rest of the Government for a period of some 7 years. I happen to have been the House author of the Employment Act of 1946, and I appeared as a witness before the committees of both the Senate and the House handling the legislation. I believe, therefore, that I heard, both in Congress and in the general public arena, every question and every point of view which was then expressed concerning this legislation. I think that I have some basis for saying that when the act was passed, there was then no question in anybodyâs mind but that monetary policies would continue to be coordinated with the other policies and resources of Government. And so they were, until shortly before the famous Treasury-Federal Reserve âaccordâ of March 4, 1951.
Notwithstanding the clear language of the Employment Act of 1946, and notwithstanding the fact that the Nation was at war in Korea in the fall of 1950, top officials of the Federal Reserve began a revolt against the policies of the President and the Secretary of the Treasury. As we have already noted, the Federal Reserve had held all interest rates at relatively low levels from late 1939 on. The rate on long-term Government bonds had been set at a maximum of 2112 percent, and actual interest yields throughout the period had been somewhat below 21;2 percent. The rate on 91-day Treasury bills had been held at less than one-half of 1 percent until mid-1947, after which they fluctuated around 1 percent. Low rates on both short- and long-term Government securities meant, of course, low rates on bank loans to business and other borrowers.
In mid-August of 1950, however, the Federal Reserve raised the discount rate and short-term Treasury bills jumped toward 11;2 percent, although there were requests from the Secretary of the Treasury and the President for the System to continue a low-rate policy. It was later revealed by testimony of some of the Federal Reserve officials to committees of Congress that the Open Market Committee had held a meeting on August 18 and decided not only to raise the discount rate, but to âgo their own wayâ on the Government longer term bond rate as well, despite what the President, the Secretary of the Treasury, and the head of the
Office of Defense Mobilization might do.
The disagreements between the Federal Reserve and the Treasury, and the efforts of the President of the United States to obtain the Federal Reserveâs cooperation, were known to the public only in a general way at the time. The exact events were not made known until early 1952 when a Subcommittee on Monetary Policy and Management of the Public Debt (a subcommittee of which the writer was chairman) made a lengthy investigation and called the Secretary of the Treasury, the Chairman of the Federal Reserve Board, and other officials to testify.
According to the record, the main events were as follows: Disagreements between the Treasury and the Federal Reserve in the late fall and winter of 1950 had several unsettling effects in the Government securities market. Indeed, they had resulted in âfailuresâ of several Treasury issues of new securities made in an effort to finance the Korean war. In view of these conditions, the President of the United States called the Chairman of the Federal Reserve Board and the Secretary of the Treasury to the White House in early January 1951, and asked the Federal Reserve to continue holding the then existing interest on Government bonds. This official, according to later testimony of the Secretary of the Treasury, gave assurances that this would be done.
Following the meeting, the Secretary of the Treasury made a speech, on ,January 18, announcing the policy which had been agreed upon. This speech strengthened the Government securities market, but several officials of the Federal Reserve promptly made public statements disagreeing with the policy. Further, on January 29, the Open Market Committee reduced its buying of long-term bonds, thus raising the interest rate somewhat.
As a result of these events, the President called the Chairman of the Board of Governors and the entire Open Market Committee to meet with him on January 31 to clarify the situation.
The results of the meeting were again announced to the press and the Government securities market settled down once more.
Then there began a series of meetings between the Federal Reserve, Treasury officials, and the chairman of several committees of Congress who were, it seemed, anxious to give support to the Federal Reserveâs
position in this squabble. Following these meetings, the Chairman of the Federal Reserve Board informed the Treasury, notwithstanding the assurances given at the January 31 meeting with the President, that the Federal Reserve was no longer willing to maintain the existing situation in the Government securities market.
After this development, the President asked the Federal Reserve and the Treasury to designate officials from the two agencies to try to work out the differences between the two agencies. On February 26, 1951, the President also appointed a four-man committee made up of the Director of Defense Mobilization, the Secretary of the Treasury, the Chairman of the Board of Governors of the Federal Reserve System, and the Chairman of the Council of Economic Advisers, asking this Committee to study ways and means of providing restraints on private credit expansion, while at the same time providing stability III the Government securities market. At this meeting the President expressed his hope that the Federal Reserve would maintain existing interest rates until this Committee had reported. The Chairman of the Committee, the Director of Defense Mobilization, expressed a belief that the Committee could make its report in about 10 days, i.e., March 8.
Before 10 days passed, however, the officials of the Treasury and the Federal Reserve who had been given the task of trying to work out differences reached an âaccord.â This so-called accord was signed and given to the press on March 3, for public release on the following day. March 4,1951.
The names of the cast in this drama may be of interest. Mr. Truman was, of course, President. Up until January of 1951, Mr. Marriner Eccles was Chairman of the Board of Governors of the Federal Reserve System, and, by reason of this position, also Chairman of the Open Market Committee. Mr. Ecclesâ term as Chairman of the Board of Governors expired on January 31, and President Truman refused to appoint him to a new term as Chairman because of his disagreement with the policy Mr. Eccles was urging, and most particularly with Mr. Ecclesâ part in raising short-term rates during the previous 6 months. Instead, Mr. Truman appointed as Chairman another member of the Board of Governors, Mr. Thomas B. McCabe. Mr. McCabe, incidentally, was one of the Republican members of the Board.
Here it should be remembered the term of a member of the Board of Governors is 14 years, Once appointed to membership on the Board, and confirmed by the Senate, a man cannot be removed by the President except in the case of misbehavior. The Chairman of the Board of Governors is chosen, of course, from among the seven members of the Board. The President designates a Chairman, and the memberâs term as Chairman is 4 years. Thus at the expiration of 4 years, the President may refuse to reappoint a member as Chairman, although that member may, if he chooses, continue as a member of the Board until the expiration of his 14-year term.
Mr. John Snyder was Secretary of the Treasury. Mr. Snyder was in the hospital during February and early March, with It serious eye operation, and did not participate in the meetings with the congressional committee chairmen or in the signing of the accord. Mr. William McChesney Martin was then Under Secretary of the Treasury and acted in Mr. Snyderâs place in these matters. Following the signing of the accord, Mr. McCabe resigned from the Federal Reserve Board; President Truman promptly appointed Mr. Martin to the Board and designated him as Chairman. Since the signing of the so-called accord, in March of 1951, this event has been widely interpreted as an understanding, reached between the Treasury and the Federal Reserve, that the Federal Reserve would henceforth be âindependent.â It would no longer âpegâ Government bond prices. It would raise or lower interest rates as it might see fit, as a means of trying to prevent inflation or deflation.
These are understandings which have been grafted onto the accord over the years. Certainly, no such understandings were universal at the time the accord was signed. Indeed, at that time the President and the Secretary of the Treasury, at least, appeared to have thought that the accord signified a settlement fairly close to the position the Treasury held, rather than an agreement that henceforth the country would have a freewheeling Federal Reserve which would spend the next 10 years sending interest rates into orbit.
Indeed, in the first month following the signing of the accord, the long-term rate on Government bonds rose imperceptibly. And, in fact, by December 1952, just prior to a change of administration, the longterm rate still had not been raised above 2-3/4 percent. (It was 2.47 percent in March 1951.)
For years now, both Federal Reserve officials and others, have created the impression that money and credit run wild in the pre-accord years. The postwar policies of the President and the Treasury, it is claimed, were totally misguided and,; if continued would have led to an inflationary disaster. Just how bad were those policies (For background purposes, it should be remembered that, until the accord, the Federal Reserve stood ready to prevent the rate on Government long-term securities from rising above 2-1/2 percent. This meant that if the private banking system wished to raise reserves, it could start selling Government bonds. As the price of bonds dropped, raising the market rate of interest on these securities, the Federal Reserve would eventually begin buying bonds and creating the desired reserves which would then allow the banks to expand the money supply. Of course, the System could always raise the reserve requirement behind the old money supply, canceling out the money-creating power of the new reserves.)
Professor Emeritus Alvin Hansen of Harvard University, one of the most influential American economists of the past 35 years, supported the accord in principle. Yet he wrote in 1957, referring to the Board of Governorsâ views presented at hearings held by a subcommittee of the Joint Committee on the Economic Report, December 6 and 7, 1954:
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âThe reader gets a picture of a flood of sales to the Federal Reserve and a rapidly mounting money supply. The result, we are told, was a âspiral of costs and prices.â And again: âThis inflationary process was stopped early in 1951 when the Federal Open Market Committee discontinued pegging the prices of U.S. Government securities.â [âPegging the priceâ refers to the Reserveâs purchasing of Government securities to prevent the market rate of interest on them exceeding 2% percent.] 1 Finally, the following: âThe facts are --- the country suffered a serious inflation until the Federal Open :Market Committee abandoned the pegs.â
Now, the facts are, however, quite otherwise than here stated --- Federal Reserve holdings [of Government securities] were $5.1 billion less in June 1950, than December 1946 --- The money supply did not increase. Currency plus demand deposits stood at $110.2 billion in June 1950, and at $110 billion in December 1946. We did not have continuous inflation in the pre-accord period.
Wholesale prices in June 1950, stood at the same level as in September 1947, a period of nearly 3 years. Loans and investments of commercial banks remained stationary from 1946 to 1948 but rose moderately before Korea --- Money and bank credit were not running wild --- It would be difficult to find statements more misleading than those cited above --- The reader is lead to believe that there was a continued spiral of rising costs and prices all through this period. Nor is the reader informed that the price spurt following Korea was stopped a month before the accord [italic mine] -- the weekly index reaching the peak figure on February 13, 1951.2
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Notwithstanding these facts, the Federal Reserve people were quite sure that they could do a better job of running the country than the President, and with only slight increases in interest rates.
In the early part of 1952, a subcommittee appointed by Senator OâMahoney, then chairman of the Joint Economic Committee, made a complete investigation of the circumstances of the so-called accord, the events leading to it, and the conflicting views on monetary theories which were then being urged. This subcommittee, of which I was privileged to be chairman, not only conducted hearings at which principal Government witnesses and leading economists were heard; we also surveyed Government witnesses and economists by questionnaire, in advance, allowing plenty of time for answers. All of these expert views were published in compendiums and hearings under the title âMonetary Policy and the Management of the Public Debt.â I believe there was no doubt at that time that the Federal Reserve was contending for only very slight increases in interest rates. Indeed, I believe I correctly summarized the issue, as it was then drawn, in the foreword to part I of the volume of replies to questions which the subcommittee had posed, as follows:
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The Federal Reserve System has recently sought to lessen the availability and attractiveness of credit by making bank reserves more costly and more difficult to obtain. It sought to do this by raising the rediscount rate and conducting its open-market operations in a manner bringing about a small rise in short-term interest rates on Government securities. It is contended that fractional interest rate changes increase banksâ needs for liquidity because of uncertainty as to whether additional reserves will be available, and at what cost.
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1 Comments within brackets are the authorâs and not Professor Hansenâs.
2 Hansen, Alvin. âThe American Economy,â McGraw-Hill, New York. 1957. pp. 74-77.
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At the same time the market price of assets on hand is reduced and their sale thus made less attractive to the commercial banks. The objective is to force commercial banks to restrain credit expansion by rationing limited credit among potential borrowers. The Treasury meanwhile is attempting to follow a debt-management policy aimed at maintaining stable and low interest rates on Government securities, in the belief that a fractional increase in interest rates has no noticeable effect on the volume of credit and hence on inflation generally.
Monetary economists disagree as to the effectiveness and wisdom of attempts to dampen inflationary pressures by general credit control measures. Evidence based upon our own staffâs study of the recent attempts in that direction has Dot been conclusive. The fact is that bank loans have continued to increase; what the increase might have been without the Federal Reserve Systemâs efforts cannot be said.
If it can be demonstrated that increases in interest rates resulting In a rise in the service charges on the public debt have a measurable effect in reducing the volume of credit and in fact are responsible for holding down prices, Including the prices of goods and services purchased by the Government, do not interfere with needed economic expansion, and do not unnecessarily increase the amount of cost of carrying the national debt, such facts would be arguments for allowing Government obligations to find their level in the open market (âMonetary Policy and the Management of the Public Debt,â S. Doc. 123, pt. 1,8241 Oong., 241 sess., pp. ix, x).
At the end of 1951, then, the Federal Reserve had both self-proclaimed independence, as a result of the accord, and an operational policy which aimed at maximum credit effects through minimum changes in interest rates. It then added another string to its bow the âbills onlyâ policy.
During the hearings held by the Subcommittee on General Credit Control and Debt Management in early 1952, at which Federal Reserve officials appeared, several members of the Committee enthusiastically offered the notion that the Government bond market should be âfree.â Since the Federal Reserve operates under congressional powers and is considered to be an arm of Congress, its officials are, to some extent, amenable to suggestions from prominent Members of Congress, particularly if these suggestions happen to be in accord with the thinking of the financial community.
In any event, the Open Market Committee appointed an ad hoc committee, composed of certain of its own members, to study the Committeeâs general credit policy. Further, the ad hoc committee was asked to comment on changes in the content or method of the then established policy. The committee made a report in November 1952, containing its recommendations, the most famous of which became known as the bills-only policy. Although this policy was only revealed to Congress and the public in 1954, it had by then become an established practice of the Open Market Committee, and was to continue as almost sacred ritual for the next 8 years.
The bills-only policy declared that henceforth the Open Market Committee, when trading in the so-called open market, would confine its activity to very short-term Government securities, preferably 91- day Treasury bills. Buying or selling Treasury bills in the open market means, of course, that the Federal Reserve adds to or subtracts from bank reserves, just as would be the case if it bought Government securities of any other maturity. In other words, the Open Market Committee intended to ease or tighten credit as it saw fit, as before, but its actions were to have a direct effect only on short-term interest rates.
Long-term rates would almost inevitably be affected, but only in an indirect way, and after an indefinite time lag. This was to be the so-called free market in long-term Government securities. No longer was the Federal Reserve to give any support to the Treasury. Henceforth when the Treasury Issued bonds or medium-term securities, it was to dump these issues on the market and watch the natural consequences- first a drop in bond prices, then a gradual recovery as the market absorbed the bonds. Any private rigging or manipulations of the market were to go without interference from the Federal Reserve, as were any speculative booms or panics short of a âdisorderlyâ market. The bills-only policy had only one reservation: The Federal Reserve would buy long-term bonds in the event that the Open Market Committee made a findings that the market was disorderly. It would not be correct to suggest that there were no good arguments in support of the bills-only policy. On the contrary, some very astute and well-intentioned people worked out good theoretical arguments for the policy. These arguments had validity however, only if the Federal Reserve was to be neither a part of government nor a performer of any of the functions of Government -- other than to issue the money in some automatic way.
If the Federal Reserve had played the role simply of adding to the money supply at some constant rate, leaving it up to the rest of the Government to handle the problem of general regulation, counteracting the business cycle, and so on, the bills-only policy might possibly have been appropriate. But the Federal Reserve did not adopt such a role. It assumed more -- not less -- responsibility for economic regulation, particularly after President Eisenhower took office in 1953.
Indeed, the Eisenhower administration, as mentioned earlier, ushered in a new era for monetary policy. The administration announced at the outset that it would rely on monetary policy exclusively for its economic regulation and would respect the complete independence of the Federal Reserve to carry out these policies as it saw fit. The more direct arrangements which had been adopted during the Korean war for restraining inflationary forces were promptly dropped. The Governmentâs fiscal policy-its tax and expenditure policy-was to be aimed simply at balancing the budget, or at least talking about balancing the budget, rather than counteracting inflationary and deflationary forces.
But the new era found the Federal Reserve moving light-years away from its original idea that imperceptible increases in interest rates were the sure-fire antidotes for the countryâs economic ills. As the years ,vent on, continued doses of higher interest were doled out and not in small capsules either. The result of the first small increases in rates left the Federal Reserve authorities unsatisfied. They obviously concluded, not that they had tried the wrong medicine, but that they had not used enough of it.
While the Federal Reserve has grown increasingly active in economic regulations over the past decade, it has also been aiming its fire to an increasing extent at specific targets, as compared to the economy in general. This is in sharp contrast to its theories of a decade ago, when it felt that a shot of credit restraint aimed at the economy in general would produce such universal results that nothing more would be needed. Its specific targets, furthermore, have been for the most part those which could be hit âonly by changes in long-term interest rates, not by changes in short-term rates. In other words, while the specific economic effects the Federal Reserve wanted to bring about could, by its own reckoning, be brought about only by changing longterm rates, it has nevertheless clung to the âbills onlyâ policy by which it was able to change long-term rates only in the most ineffective and unreliable way imaginable. To put the matter another way, the âbills onlyâ policy tied the Federal Reserveâs hands as to changing the longterm rate with any precision, and at the time when it thought this rate should be changed.
For example, in the first 11 months of 1957, the object of the Federal Reserve monetary policy was to dampen what it considered to be an âinvestment boom.â These officials hindered by âbills onlyâ proceeded to make credit tighter throughout the whole economy. Consumer interest rates rose. Thousands of small firms were bankrupted, being unable to obtain the credit necessary to carry inventories. Yet all that the Federal Reserve claimed it wanted to do was slow down the building of new plants. Well, the investment boom, which was already staggering by early 1957, did crumple-with an assist from the Federal Reserve. And the economy slid into the stagnant bog, from which it has only recently emerged.
In the early part of 1958, the object of monetary policy was to stimulate more investment. This meant setting the long-term rate down. Still clinging to the âbills onlyâ policy, the Federal Reserve gave the commercial banks repeated injections of reserves. In consequence, short-term interest rates promptly came down, but long-term rates stayed up. In fact, long-term rates declined so slowly and bond prices rose so gently that there developed a great speculative binge in the Government bond market. Elevator boys, used car dealers, and professional bond brokers were all borrowing directly or indirectly from the plentiful supplies of short-term funds to purchase Government bonds. They thought the Federal Reserve would not rest until it had driven bond prices up (and, thus, market yields down).
Actually, by the time the easy-money policy of the first half of 1958 began to exert a substantial effect on long-term rates, the Federal Reserve people thought, that economic conditions had changed and called for a turnabout in credit policy. The brakes were put on. In mid-1958, speculators realized Government bond prices were headed down, and the big debate in the Government bond market resulted. Billions of high-riding dollars were lost in that infamous affair. As we have said, the âbills onlyâ policy permitted the Federal Reserve to come into the long-term market, on occasion, when it found the market to be âdisorderlyââ In mid-1958, the Government bond market became âdisorderlyâ -it seems to me extremely disorderly and the Open Market Committee finally stepped in and lent some support.
Even after these experiences, however, when the Open Market Committee met in the early spring of 1959 to consider a policy for the year, it readopted the same old tried-and-found-wanting âbills onlyâ policy. There was one dissenting vote. Mr. Hayes, the president of the New York Federal Reserve Bank, dissented, as he had done the previous year.
Only in February of 1961 did the Open Market Committee finally abandon its âbills onlyâ policy. This was after repeated urgings from Congress and the newly elected President Kennedy. Then, too, new circumstances had arisen.
In early 1961, the United States was in an unenviable position. The country was both in a recession and suffering from a balance-of-payments deficit, deepened by a flow of dollars going abroad, seeking short-term investment at the higher oversea interest rates. The recession called for Prompt reduction in the level of interest rates, to be achieved under âbills onlyâ -- by first driving down the short-term rate. But if the System energetically lowered short-term rates, it would simultaneously open the floodgates wider to the dollar flow abroad.
One sensible solution was to abandon âbills only.â After all, business and State and local government borrowing for new equipment and new construction is at long-term rates. The same is true for home mortgage borrowing. If the long-term rate-quite high by postwar standards, especially for a recession period-could be brought down directly, without much effect on the short-term rate, most of the effect of easier money would be achieved. And with a stable, short-term rate, the Payments deficit would not be intensified. The dogma of âbills onlyâ was finally refuted by the logic of hard fact, and long-term Government bonds were purchased by the Federal Reserve. Since then the System has not hesitated to enter the long-term market when the situation warranted.
The demise of âbills only;â can be taken as the end of an era. For the new administration; Presidents Kennedy and Johnson lifted the monopoly of the economic control center held by monetary policy. It had become painfully clear that the monetary policy carried out by the Fed was not sufficiently expansionist to keep the country moving at a rate justified by the increase in the working force and industrial capacity. The two Presidents, with Congress voting the needed measures when necessary, began to apply the tremendous economic leverage the Government possesses as it taxes and spends.
The prime example, of course, is the $11 billion tax cut of 1964 aimed directly at spurring economic growth. There are others. The Treasury drafted a more favorable depreciation schedule for business, in effect increasing the after-tax return from capital goods investment. The Congress voted an investment âtax creditâ doing more of the same. These two fiscal measures of 1962, it is widely agreed, gave a strong push to the sharp gain in business investment during 1963.
Then there is the most enlightening-because the most ingenious-measure of all, the âinterest equalization tax.â The very word âinterestâ spells monetary policy, but the tax is a fiscal measure: a substitute for an otherwise disastrous monetary move. Briefly, the United States, already coping with a large foreign payments deficit in 1963, was being overwhelmed by a flood of foreign long-term borrowing of dollars. Every extra dollar loaned to an oversea borrower would increase the payments deficit. What was to be done ~ The traditional monetary policy answer was: raise long-term interest rates. This would make all borrowing-foreign and domestic-more expensive. And at some rate, the flood could be stemmed.
Of course, anyone concerned about high unemployment and the waste of unused resources could not walk the monetary route, given the less than fully employed economy of 1963. Instead the administration proposed to place a tax on long-term investment in foreign securities, with some exceptions. And this alternative to higher interest rates, though not law at the time of writing, has cut foreign borrowing sharply. The economy consequently has not had to lose one extra dollar of investment or income, thanks to this fiscal initiative. Has the new look affected monetary policy ~ Not at all. Leaning heavily on the balance-of-payments deficit, and warning ominously about inflation once again, the Federal Reserve still kept long-term Government interest rates at a higher level during the 1960-61 recession than their peak during the 1955-57 boom-=--despite the end of âbills only.â As the recovery proceeded interest rates were kept fairly stable-and relatively high-until the last half of 1963 when the long-term rate was permitted to climb. By 1964, it was close to its postwar high -- 4.37 percent. Why the need for a higher restraining rate, especially since it directly contradicted administration policy? Judging from the public statements of the Chairman of the Board of Governors, inflation-even though the central bankâs seismograph alone registered rumbles from this volcano.
Thirteen years have now passed since the accord and the liberation of the Federal Reserve. What have been the results? The major result is shockingly obvious. Interest rates have climbed steadily, with slight interruptions, during the entire post accord period. (See table 3.) The period has been marked, then, by a continual shift of income to the banks, other major financial institutions, and individuals with significant interest income. The rest of the country provided this income.
TABLE 3. --Yields on long-term Government bonds 1919 to present
Original chart shows the month by month percentages. See them at (to be filled in later - mrc)
Year [Percent per annum]
1919 / 4. 73 ..... l920 / 5. 32 .....
1921 / 5.09 ..... 1922 / 4.30 ..... 1923 / 4.36 ..... 1924 / 4.00 ..... 1925 / 3.86
1926 / 3.68 ..... 1927 / 3.34 ...... 1928 / 3.33 ..... 1929 / 3.60 ..... 1930 / 3.29
1931 / 3.34 ..... 1932 / 3.68 ..... 1933 / 3.31 ..... 1934 / 3.12 ..... 1935 / 2.79 .....
1936 / 2.65 ..... 1937 / 2.68 ..... 1938 / 2.56 ..... 1939 / 2.36 ..... 1940 / 2.21 .....
1941 / 1. 95 .... 1942 / 2.46 ..... 1943 / 2.47 ..... 1944 / 2.48 ..... 1945 / 2.37 .....
1946 / 2.19 ..... 1947 / 2.25 ..... 1948 / 2.44 ..... 1949 / 2.31 ..... 1950 / 2.32 .....
1951 / 2.57 ..... 1952 / 2.68 ..... 1953 / 2.94 ..... 1954 / 2.56 ..... 1955 / 2.84 .....
1956 / 3.08 ..... 1957 / 3.47 ..... 1958 / 3.43 ..... 1959 / 4.08 ..... 1960 / 4.02 .....
1961 / 3.00 ..... 1962 / 3.95 ..... 1963 / 4.00 ..... 1964 / 4.16 (first 3 months)
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NOTE. - Long·term Government yields from January 1919 through Oct. 14, 1925, are unweighted averages of yields of all outstanding partially tax·exempt Government bonds, due or callable alter 8 years, and those from Oct. 15, 1925, through December 1941 of all such bonds due or callable alter 12 years. Averages (or the 2 sets of bonds were identical from Oct. I?, 1925, through July 16, 1928. Beginning January 1942 through Mar. 31, 1952, yields are based on taxable bonds neither due nor callable for 15 years; beginning Apr. 1, 1952.through Mar. 31, 1953, on bonds neither due nor callable for 12 years. From Apr. 1, 1953, to present, series based on bonds maturing in 10 years or more.
Source: Board of Governors of the Federal Reserve System, âBanking and Monetary Statistics,â 1953; Annual Report of the Secretary of the Treasury, 1958; and Treasury Bulletins.
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The continued rise in interest rates, with its accompanying costs, could perhaps be defended as necessary if the economy had worked close to the limit of its resources most of these past 13 years, or had exhibited a recurrent tendency to sharp, steep price increases, But this was not the case. True, it could be argued that the resource criterion was met during 1951-53, and possibly the price criterion during 1956--57. (See table 4.) But after 1957, as the mounting unemployment percentage and the trendless wholesale price index show, neither criterIon for another shot of high interest was fulfilled. The irony of the situation is that long-term interest rates remained close to the old 2-1/2 percent ceiling during most of the first period -- favorable to high interest -- and started their steep climb only in late 1955.
TABLE 4. -- Unemployment and industrial wholesale prices, 1949-63
Year..................................1949 - 50.... 51.... 52.... 53.... 54.... 55,,,, 56,,,, 57.... 58.... 59.... 60.... 61.... 62....63....
Unemployment
as percent of
civilian labor force ..............5.9....5.3... 3.3.... 3.1.... 2.9...5.6....4.4...4.2 ...4.2.... 6.8.... 5.5...5.6... 6.7...5.6...5.7
Industrial wholesale
price index (2) ..
1957 - 59 = 100 ............80.0 ....82.9.. 91.5.. 89.4 ...90.1 ...90.4 ..92.4 ..96.5 .99.2 .99.5 ..101.3 101.3 100.8 100.8 100.7
(1) New definitions; after 1900 Includes Alaska and HawaII.
(2) All commodities other than farm products and foods
Source: Economic Report of the President, January 1964;
How does the Federal Reserve justify this Alice-in-Wonderland policy? Inflation. After 1957? Yes.
What inflation? it might well be asked. And that is exactly the point. As the industrial wholesale price index shows there has been nothing which even hints of inflation in the price of industrial goods since 1958. By crying inflation these past years, as in their justification for the accord, the Federal Reserve is indulging in public mythmaking. There has been no inflation, either during the depressive stagnation of 1958-61 or during the hesitant recovery of 1961-64. Surely if the economy were as inflation prone as the Federal Reserve solemnly reiterates, some evidence of it would have appeared these past 6 years.
Perhaps, it can be argued, as some Federal Reserve authorities have done recently, that the price record is a testimony to their high interest policy. Without it, inflation would have occurred. What can be said? In the first place, the argument is irrefutable but worthless. Who knows what would have happened if ... ? Second, if the statement is true, the monetary authorities are indirectly saying that monetary policy can only keep prices stable by crippling economic growth and saddling the economy with widespread unemployment and idle capacity. For these were the conditions under which the economy operated the last 6 years -- with the Federal Reserve throwing its weight toward restraint. Is this the price the economy must pay to stop inflation? It seems the Federal Reserve thinks so.
The argument, then, simply confirms the sour lesson of our 13-year monetary experiment. Small doses of higher interest or even a mild recession will not stop price rises in the modern economy (1). Whatever the variety of ways rising prices may be stopped, there is one sure-fire method: a protracted period of underemployment for men and machines.
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(1) It is necessary to distinguish between âdemand-pullâ Inflation and âcost·push.â The latter occurs when several groups can push up prices even when general demand is not high enough to take all the goods the economy could produce.
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And, since monetary policy can do only two things -- stimulate or repress the economy -- it is obvious what the monetary authorities will do if they think they sense inflationary tremors. They will slam the brakes and slow the economy to a prolonged crawl.
The inflation argument has had help from the balance-of-payments deficit the past 3 years in justifying monetary policy. The interest rate the system is mainly concerned with, for foreign payments purposes, is the short-term rate. But by keeping that rate high, they have also automatically kept the long rate higher than otherwise called for. The reason is that except under unusual circumstances, the bond market will keep long-term rates higher than short term. Therefore, even though the Federal Reserve adopted a policy of keeping long-term rates as stable as possible in 1961-62, it could not go further and bring these rates down without threatening to drive short term rates down as well -- an event which would have nullified its payments deficit policy. And, when the System raised short-term rates in mid-1963 to 3% percent, publicly giving the payments deficit as the reason, the long-term rate also moved up in normal sequence. Just what has the Federal Reserve tried to accomplish with its high short-term interest policy? Well, the short-term capital outflow, generously defined, ran at approximately $2 billion in 1960, $2.4 billion in 1961, $1.5 billion in 1962 and $1.1 billion in 1963. Thus the Reserve authorities tied their hands with regard to the long-term rate during the 1960-61 recession and the high unemployment years subsequently to keep $2 billion annually, at the most, from flowing overseas. How much did it cost the economy to use monetary policy for this purpose? No one knows. But it would not be farfetched to think that over a 4-year period many billions of dollars worth of investment, and even more billions of dollars worth of production and income were forgone.
Add in, as well, the very real personal tragedy of unemployment. Once again the bitter lesson of the post-accord period is drawn, this time with respect to the balance of payments. Was there no other way to prune a $2 billion outflow -- a comparatively small amount considering our $600 bi1lion economy -- than by first cutting domestic business investment and output by many billions of dollars while the economy was running at less than full speed? This is really letting the tail wag the dog. But it is exactly what will result if monetary policy is used as a jack-of-all-trades. Monetary policy is most inefficient. It produces much costly fallout. And there is the counterexample of the âinterest equalization taxâ to show what can be done to control capital outflows at minimum social and economic cost. Another result of post-accord monetary policy is that the U.S. economy has unwittingly become a low investment economy. This point is extremely important. Because if we operate our economy with perpetually high interest· rates -- and this seems to be the outlook unless something is changed -- then, even though we manage to have full employment, say, because of fiscal measures, the economy will invest less than it otherwise would with low interest rates. This implies slower growth of output because of lower efficiency gains and smaller additions to capacity. In other words, by instituting a high interest policy a country chooses to grow more slowly than it otherwise could. Clearly, such a choice is a critical one for a country to make. And, for the past 7 years, the Federal Reserve has chosen the high interest, slower growth option for this country. (See table 5.)
TABLE 5 -- Rate of investment and long-term interest rates, 1946-63 / See on page# xx--- to be filled in later (mrc)
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1 First Issued in 1941. Series Includes bonds which are neither due nor callable before a given number of years as follows: April 1953 to date, 10 years / April 1952 to March 1953. 12 years / October 1941 to March 1952, 15 years.
Source: Economic Report of the President, January 19?? (to be corrected -- mrc).
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The purpose of the table is not to show that the drop in business investment as a percentage of gross national product is mainly the result of the high-interest policy of recent years. It is to show that the economy has been devotlllg a smaller proportion of its resources to investment than it had previously (with no evidence that the previous proportion was âtoo high,â by any reasonable standard for âtoo highâ) .
And, throughout this period, Federal Reserve policy has been in the direction of smaller investment.
Is a low-investment economy (in percentage terms) what the American people want ?
Certainly it is not what their last two Presidents have wanted, judging from the emphasis on economic growth in their public statements. It is also not what Congress has voted for. Quite the contrary. But it is what the country now has as a byproduct of the Federal Reserveâs unhindered ministering to the countryâs health. Finally, a third result of post-accord monetary policy should be mentioned here. It illustrates in a quite unexpected way how far the consequences of recent monetary policy reach.
In fiscal year 1963, the U.S. Government paid out approximately $10 billion as interest on the national debt. The budget deficit for the same year was $8.8 billion. Much political hay was made with the deficit. It was potential inflationary dynamite, ran the âno deficitâ claim. And these same people strongly supported tighter money and higher interest rates to prevent the otherwise inevitable inflationary explosion. Yet if these people were really worried about the deficit, they should have been rabid partisans of a low-interest policy. For it can be shown that last yearâs deficit would have been $5 billIon less if the Government had not been forced by Federal Reserve policy to pay increasingly more on its outstanding debt. In fact, the total national debt would now be $40 billion less If the interest rates of the early 1940âs held prevailed in the postwar period.
This is what table 6 shows. In 1946, the Government paid an average rate of 1.8 percent on its debt. In 1947, interest rates went up. The Government paid out $5 billion in interest. At the 1946 rates It would have: paid out $0.4 billion less. This mean the deficit in 1948 was $0.4 billIon higher than it need be. The Government could have used the $0.4 billion paid out in extra interest in 1947 to reduce the debt carried over into 1948. In 1948, then, the debt at 1946 interest rates would have been $251.9 billion (col. 4) rather than the actual $252.3 billion (col. 3).
TABLE 6 -- Higher interest and U.S. Government debt / See on page xxx ( to be added later -- mrc)
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