A History of the Federal Reserve, Volume 2 (15 page)

By 1971, Germany accepted that appreciation of the mark was the best way to prevent domestic inflation. The German government tried to get agreement from other European countries for a joint float against the dollar, but France and Italy opposed. They disliked inflation but were unwilling to accept the cost of adjustment. Once again coordination failed. Germany especially had less aversion to exchange rate adjustment than to continued inflation.

One of the lessons of 1965–71, known as the policy trilemma, is that independent monetary policy, fixed exchange rates, and capital mobility are incompatible. As long as low unemployment was the principal policy objective on both sides of the Atlantic, the choices for the Europeans were inflation, greater exchange rate flexibility, or rigid capital controls. The experience of 1965–71 taught many about the choices they had to make; President Nixon’s decisions at Camp David forced them to take the first steps to greater exchange rate flexibility.

SIX

Under Controls: Camp David and Beyond

The frequently heard argument that “needed” fiscal and monetary stimulation will be possible if there is an “adequate incomes policy” is proof enough of the most pernicious aspect of controls. It suggests why controls or any reasonably formal incomes policy are likely to lead to more inflation and not to less.

—Shultz, 1975, 4

On August 15, 1971, President Nixon announced the New Economic Policy to the nation and the world. Consumer price inflation was at a 3.6 percent average rate for the eight months of 1971 before controls began. In the eight months after controls ended in April 1974, the average inflation rate was 12.2 percent. Inflation rose, as Schultze suggested it would. Of course, the reason inflation rose may be unrelated to the control program.
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Part of the increase resulted from the oil price increase. This raised the price level. Since the increase occurred over time, the rate of price change increased also. But that increase was temporary, unlike the price level change. Once oil prices reached a new level, the rate of price change declined.

This chapter tells a story of failure: failure of ideas that in one form or another had dominated policy analysis and professional economic opinion since the 1940s, failure also in the narrow sense that policy did not reduce inflation or restore price stability, and failure of the Federal Reserve and the government to maintain the internal and external value of money. No single reason explains these failures. The two principal reasons were: (1) the simple Keynesian model, augmented by price and wage controls to
reduce inflation with lower social cost, was flawed, based on faulty reasoning; and (2) Federal Reserve independence proved inadequate. Political concerns dominated economic policy both in the decision to impose price and wage controls and in the unwillingness to raise interest rates high enough to stop inflation.
²

I. Using service prices that are less influenced by oil prices, for the same two periods, the data show 4.5 and 12.5 percent (Kosters, 1975, table 9, 40–41).

Arthur Burns and the Federal Reserve were central to both failures. Burns had earlier opposed Keynesian reasoning, but in office he accepted large parts. The president’s decision to adopt price and wage controls was a victory for Burns’s mistaken view that direct intervention in price and wage decisions was necessary to control inflation. And he sacrificed Federal Reserve independence and credibility for political reasons to a degree not seen since Marriner Eccles in the 1930s or perhaps never before.

Dependence on a simple Keynesian framework such as the model of Ackley’s (1961) textbook was not the only analytic mistake. Freezing prices and wages did not reduce aggregate demand. The individual’s nominal budget remained unchanged. Individual prices could be constrained, but spending was not. Controls could prevent some price level increases, but at best spending and inflation—the rate of price change—would be reduced temporarily. Chart 6.1 shows the brief temporary success in 1972. Measured rates of price change fell slightly after controls, but inflation surged once controls became voluntary or ended in 1973. Although the measured rate of price change rose and fell during the 1970s, it did not return to the range just prior to controls. Of course, the large surges in measured rates of inflation in 1973 and 1979 include the one-time effects of dollar devaluation and oil price increases as well as inflation properly measured.
³

Also, the Federal Reserve and administration economists repeated an old error—they failed to distinguish real and nominal values. In part for that reason, the Federal Reserve remained reluctant to raise interest rates high enough to end inflation. This behavior reinforced the widespread belief, based mainly on its response to unemployment, that the Federal Reserve would not persist in a policy to end or substantially reduce inflation. The belief grew that any reduction in inflation would be temporary.

There is no evidence showing that inflation was lower after controls than before. Four-quarter forecasts for the GNP deflator rose from 3.1 percent before to 5.6 percent after controls. Twelve-month growth of average
hourly earnings is much less affected by special factors like the 1973–74 oil shock. This measure declined only from 6.8 to 6.4 percent. Chart 6.2 shows the earnings data. Earnings decelerated slightly during the early months of controls but rose in 1972 to the highest rates of increase up to that time.

2. Even President Nixon described the decision to control prices and wages as political. “The August 15, 1971 decision to impose them was
politically
necessary and immensely popular in the short run. But in the long run I believe it was wrong” (Nixon, 1978, 521; emphasis added).

3. The administration and Congress raised social security benefits in 1971 and restored the investment tax credit to increase spending.

Those responsible for administering price and wage controls made, at most, modest claims for their success in lowering inflation. The budget director at the time, George Shultz, claimed a small, transient effect (Shultz and Dam, 1998, 71–72, 80–81). But Shultz also recognized that controls encouraged an easier monetary policy. He noted that West Germany had lower inflation and avoided controls (ibid., 80). And Arnold Weber, administrator of the Cost of Living Council and a member of the Pay Board set up to control wages, concluded that “wage controls . . . will not slay the inflationary dragon” (Weber and Mitchell, 1978, 406), although he credited wage controls for stabilizing wage increases. Elsewhere, his study claimed that the “Pay Board’s program was aimed largely at the union sector” (ibid., 311). Only 30 percent of private non-farm employment was unionized at the time, so the Pay Board did not expect to control aggregate wage growth.
⁴
Paul McCracken denied any long-term affect. “Did our wage
and price effort leave us with a better performance in terms of inflation? I would say ‘no, it did not’” (Hargrove and Morley, 1984, 348).
⁵

4. Econometric studies produced mostly negative results. See McGuire (1976), Oi (1976), and Gordon (1973). For example Gordon (ibid., 778) concluded that “controls will have no long-run effect on inflation” but consumed real resources and caused shortages.

Though controls failed as economic policy, they succeeded as political policy, at least until the election.
⁶
The administration claimed that controls would prevent inflation from rising during a period in which “fiscal and monetary policy [would] exert a more expansive thrust than was prudent
earlier where the inflation objective was more vulnerable” (Council of Economic Advisers, 1972, 101–2). The other parts of the program included: (1) an embargo on gold sales, (2) a 10 percent surtax on imports, (3) reinstatement of the investment tax credit, (4) reductions in government spending, (5) elimination of excise taxes on purchases of domestically produced cars, and (6) acceleration of planned income tax reductions. The investment tax credit and the temporary elimination of excise taxes on cars stimulated investment and consumption. The 10 percent surcharge on imports shifted purchases from imports to domestic production and gave an advantage when bargaining for exchange rate changes. Price and wage controls were intended to prevent a surge in prices from the devaluation of the dollar and increased spending.

5. The main proponent within government, Arthur Burns, claimed more than political expediency. He cited effects on public psychology. “Properly executed, such a policy could change the psychological climate, help to rein in the wage-price spiral, squeeze some of the inflation premium out of interest rates, and improve the state of confidence sufficiently to lead consumers and business firms to spend more freely out of the income, savings, and credit available to them” (Burns, 1978, 131). Burns did not reconcile spending “more freely” with lower inflation.

6. The program was mainly a political act. “In political terms, . . . he knew it would stun his critics and befog the issue that could best be used against him. Nixon hated to do it, but he loved doing it” (Safire, 1975, 527). McCracken described the program as mainly a political decision pressed by John Connally. “It was very clear that the President’s popularity rating was low, in part because there was this almost tidal wave of demand for wage and price control. . . . I could see how a good political leader, not being excessively concerned with economic matters, would think that was the right way to go” (Hargrove and Morley, 1984, 350). Matusow (1998, 112) cites Haldeman’s notes for July 23 to show that President Nixon told Connally the time had come to act on a wage-price freeze.

The stimulus program worked. Industrial production had started to increase before the new program, but the rate of increase rose to a 10 percent annual rate by the election. Housing starts increased, and real GNP growth surged to 7 percent in the first three quarters of 1972. President Nixon’s favorite benchmark, the unemployment rate, fell to 5.5 percent just before the election. And, most important for the president, he won the 1972 election.

AT CAMP DAVID

On August 13, 1971, the president took fifteen principal advisers to the presidential retreat at Camp David. He had made all the main decisions in meetings with Treasury Secretary John Connally, Peter Peterson, and George Shultz on August 2 and 12.
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The plan called for no action until September, when Congress returned, but the start of a run on the dollar forced earlier action.

There were signs of improvement ahead, but patience had worn thin, and we ran out of time. Demands for action poured down on the White House from all sides. Media criticism of our policies became intense. . . . Most of
the critics and many of the economists hammered away on one theme: the need to have some program of mandatory government control of prices and wages. (Nixon, 1978, 517)

7. Connally, Peterson, and Shultz were at Camp David along with Arthur Burns, Paul McCracken, and Herbert Stein from the CEA, Paul Volcker from Treasury, and H. R. Haldeman, John Ehrlichman, and William Safire from the president’s staff. Safire was there to write the president’s speech. Arnold Weber, Caspar Weinberger, Kenneth Dam, Michael Bradfield, and Larry Higby from the Office of Management and Budget, Treasury, and the White House staff participated also. Although the meeting made a major change in foreign economic policy, the president did not invite Secretary of State William Rogers or National Security Adviser Henry Kissinger. Neither knew about the program in advance, although the president made an effort to inform Rogers on August 14. Burns’s involvement shows his involvement as a presidential adviser, despite Federal Reserve independence. It is similar to Eccles’s role in the Roosevelt administration.

The group met from 3:15 to 7. The president cautioned them against leaks and told them not to make telephone calls. They were told not to tell anyone, even family, where they were. Paul Volcker briefed the group on gold losses that day. Then he told the group that action was needed on both international and domestic policy (Haldeman, 1994, 341). The president let Connally outline the proposed actions.
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Some of the economists opposed the import surcharge without much effect. The main dispute was over the decision to close the gold window. Arthur Burns urged the president to adopt the rest of the program but leave the gold price unchanged. He proposed that the president negotiate a cooperative agreement to depreciate the dollar but received no support. “He warned that I would take the blame if the dollar were devalued.
‘Pravda
would write that this was a sign of the collapse of capitalism’ . . . [H]e worried that the negative results would be unpredictable; the stock market would go down; the risk to world trade would be greater. . . . As events unfolded, this decision turned out to be the best thing that came out of the whole economic program I announced on August 15, 1971” (Nixon, 1978, 510–20).
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The meeting was to decide how to implement the new policy, not whether to do it. Burns’s argument did not change the proposal. For the rest of the meeting, small groups worked out some details of how the program would be implemented and how it would be announced; William Safire and President Nixon prepared the president’s speech to the public with some assistance from Herbert Stein.

President Nixon’s main concern was to lower the unemployment rate
before the election.
¹⁰
As Stein noted, the public and the president identified full employment with a 4 percent unemployment rate (Stein, 1988, 158). Before controls and devaluation, the administration had to fight off criticism that only obstinacy and slavish devotion to free markets prevented use of some type of wage-price policy. Before August 1971, the administration took some actions to respond to the critics, especially in the construction industry, where large local wage increases became troublesome.

8. Nixon (1978, 519) described “strong, skeptical, support among those present for the freeze and other domestic actions.” Shultz (2003) opposed wage and price controls when he learned about the program in early August. “President Nixon said, ‘I want to do it.’ He had decided, so the argument was over.” McCracken had also opposed controls publicly just before the Camp David meeting.

9. James (1996, 212–15) notes that the participants did not discuss floating rates as a practical solution to the payments problem. As late as May 1971, James reports that PierrePaul Schweitzer, the IMF managing director, told Secretary Connally to devalue the dollar to a new parity. Connally opposed and urged Schweitzer to get Japan to revalue. Connally’s attitude at this time is suggested by his widely quoted statement to foreign governments: “The dollar is our currency, but it’s your problem.” James (1996, 218) attributes the change in Connally’s position to the issuance on August 6 of a statement by the Joint Economic Committee calling for devaluation of the dollar. Earlier President Nixon had agreed to suspend convertibility on Connally’s recommendation based on Volcker’s proposal.