A History of the Federal Reserve, Volume 2 (16 page)

Administration economists answered the critics but did not satisfy them. One reason is that they did not make their best case. Inflation, the sustained rate of increase in a broad-based price level, cannot be controlled by changing price levels of individual goods. Aggregate demand or spending is not affected. If prices are controlled, the reported price index may not rise that month, but with unchanged monetary policy, the public has as much spending power as before. They can continue to spend; they have no reason to save all or any gain from buying at controlled prices.

A common argument used by administration economists and others was that controls could lower inflation by reducing expected inflation. This argument would be strengthened if reduced government spending and money growth accompanied controls. Reduced stimulus to spending would support smaller growth of spending and eventually lower inflation; controls might possibly speed the adjustment. Not much is known about possible effects of controls on anticipations. But controls cannot lower inflation without a reduction in aggregate demand.

International issues received most attention in the first day’s discussion. The president rejected use of the 1917 Trading with the Enemy Act to impose an import surcharge.
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Congress was about to consider a surcharge, and the president wanted to move first. Connally argued that a temporary surcharge would help to get the exchange rate adjustment the United States wanted.

Arthur Burns disagreed about the decision to close the gold window and
float the currency.
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He urged delay. The action was unilateral and sacrificed the goodwill of other central banks and governments. In addition, he argued that the rest of the new program would strengthen the dollar.

10. President Nixon began the discussion saying, “[N]o one is bound by past positions.” William Safire, his speechwriter commented: “Least of all . . . himself. . . . [E]very economic speech . . . there was a boilerplate paragraph on the horrors of wage and price controls” (Safire, 1975, 519–20).

11. “I don’t want to corrupt my national security power” (Safire, 1975, 512). The current account deficit for 1971 was $1.4 billion, 0.1 percent of GDP. The merchandise trade deficit reached $2.3 billion, 0.2 percent of GDP. Compared to what came later, the size of the problem was tiny. Many in Congress favored devaluation of the dollar. Before major international meetings, Senator Jacob Javits and Congressman Henry Reuss would introduce legislation calling for devaluation. Guenther (2001) reports that Volcker would go to Javits’s office to plead for support for administration policy, to no avail.

Connally and others rejected these arguments. They did not want to appear to be forced to close the gold window. A run on gold had started. It was best, they said, to announce the whole program and present it as actions taken at their own initiative. Paul Volcker, who had previously favored fixed exchange rates, pointed out that they had little choice. The stock of gold was less than one-third of dollar liabilities to foreigners, and foreigners were demanding gold. Although Burns was not convinced, the president was.
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Burns did not give up.
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When the group met the following day, only a memo prepared by Charles Coombs supported the fixed rate. President Nixon announced that he decided to stop selling gold. The main discussion was about how to present it to the public without appearing to be defensive. The president proposed to claim that the dollar was “under assault by international speculators.” Closing the gold window protected the dollar (Ehrlichman notes, August 14, 1971).

The president then told George Shultz to assign people to work out the details of the programs. Connally and Volcker did tax policy and, with Burns, monetary affairs; McCracken and Stein worked on the details of the wage-price freeze; Shultz and his OMB staff worked on budget cuts (Safire, 1975, 517). Each group had prepared earlier, so they completed their assignments promptly.

Participants spent much of their time on Saturday going over the details of various programs or discussing what the president would say on Sunday night. One issue was control of interest and dividends. Both Connally and Burns urged the president not to include interest and dividends under the proposed ninety-day freeze of prices and wages. The law did not authorize control of interest rates and dividends, but a separate law authorized credit controls.

12. Connally warned the president never to use the word “devalue.” Devaluation required an act of Congress, but suspending gold convertibility did not (White House tapes, conversation 547-9, July 27, 1971).

13. The Quadriad met with the president to discuss Burns’s objections. “After that meeting I was told by Volcker to do my draft of the speech assuming we would close the gold window” (Safire, 1975, 518). The discussion about timing the announcement of the gold decision until after the other announcements was a reprise of a discussion between Connally, Shultz, and the president the day before. President Nixon decided to make the announcements all at one time (White House tapes, conversation 273-20, August 12, 1971).

14. His insistence is surprising. According to John Ehrlichman, Burns told the president in December 1970 that at some point he “might have to sever the link between the dollar and gold” (quoted in Wells, 1994, 66–67).

After the president announced the new program, labor union leaders and leading congressional Democrats protested exclusion of interest and dividends from the program.
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Burns did not want to put interest rates under the freeze because that would transfer authority for monetary policy to the new Cost of Living Council, in effect to John Connally, the council’s head. The Federal Reserve would be back in the position it had been in from 1942 to 1951, before the Accord.

To satisfy the critics, the administration decided on an informal program. In October, President Nixon asked Burns to chair the Committee on Interest and Dividends. Burns discussed the appointment with the Board of Governors on October 5. They agreed that Burns should serve. “The only questions raised were those of the powers of the committee related to those of the Board” (Maisel diary, October 20, 1971, 1). A main concern was that the committee would be heavily influenced by politics, since three members were cabinet officers. They expressed particular concern in this regard about Preston Martin of the Home Loan Bank Board, later vice-chairman of the Board of Governors. The Board concluded that the committee not have mandatory power to fix interest rates, and that it should avoid giving directions about open market operations and confine its attention to consumer credit and mortgage rates.

Thus, Burns became chairman of the Committee on Interest and Dividends.
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Market-determined rates remained unregulated; the committee’s responsibility applied only to dividends and so-called administered rates such as the prime rate or bank rates on consumer loans. Chairing the committee created a potential conflict of interest. If monetary policy actions raised market rates, banks expected prime rates (and others) to rise. The unions and Congressman Patman would oppose any increase in administered rates as a cost to consumers and business, so Burns might be reluctant to raise open market rates. This conflict is one explanation of expansive policy in 1972.
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15. At Secretary Connally’s briefing for reporters on Sunday evening, he answered a question about interest rates by saying, “[W]e did not do it because we didn’t know how effectively to do it” (Connally press conference, Nixon papers, Shultz Box 8, August 15, 1971, 8). In fact, the law that Congress had passed did not authorize control of interest and dividends, as he knew.

16. The other members were the Secretaries of Treasury, Commerce, and Housing and Urban Development, and the chairs of the Federal Home Loan Bank Board and the Federal Deposit Insurance Corporation. The Federal Reserve staff served as committee staff. As usual, Burns dominated the meetings so much that the others rarely attended.

17. Dewey Daane, a member of the Board of Governors at the time, objected to Burns taking the chairmanship of the Committee on Interest and Dividends. “I always thought it
very, very inappropriate for him to wear that hat and be trying to hold down interest and interest payments, when to do the Fed’s job properly, you had to be pushing interest rates up” (Hargrove and Morley, 1984, 377). Burns accepted the chairmanship so that Connally wouldn’t get it (Brimmer, 2002, 20).

The group did not decide what came after the ninety-day wage and price freeze. It left that decision to a committee headed by Herbert Stein. Stein had experience with decontrol after World War II and Korea, and he wanted to end controls “promptly and in an orderly way” (Stein, 1988, 181). He shared the view that the president repeated several times at Camp David and emphasized in his speech: controls should not become permanent. When the press asked Secretary Connally about the inconsistency between earlier statements opposing price and wage controls as unworkable, he denied that the administration had adopted controls. Nixon “put on a wage price freeze for a limited period of time, 90 days, with the idea that this would be voluntarily adhered to by the American people” (Connally press conference, Nixon papers, Shultz Box 8, August 15, 1971, 9).
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The proposed fiscal program provided a small reduction in the deficit. The proposal reduced tax rates by $6.2 billion, about half from the new investment tax credit. The planned 10 percent surtax returned $2 billion, and proposed budget cuts reduced spending by $6.6 billion. The largest proposed reductions were made in general revenue sharing and by deferring a federal pay increase. These actions required congressional approval. Most spending reductions were not realized. This did not surprise President Nixon. Burns warned him in conversation that congressional Democrats would want to increase, not decrease, spending. The president responded: “That’s always their way—to increase government spending. Our way is to increase the private sector” (White House tapes, conversation 7-152, August 15, 1971).

In the next Economic Report of the President, the Council of Economic Advisers warned about the danger of relying on controls to stop inflation. The CEA and others in the administration and the Federal Reserve ignored the warning.

If monetary and fiscal policy keep the growth of demand moderate, the price and wage controls can bring about more quickly and surely the lower rate of inflation that competitive forces would cause in such circumstances. But if demand is allowed to grow excessively, the price and wage control system
will lose its value. Correspondingly, if the presence of the price and wage control system becomes an excuse for laxity in monetary and fiscal policy, the system’s effect on controlling inflation will be negative. (Council of Economic Advisers, 1972, 96)

18. Stein later wrote, “As I look back to that weekend twenty years ago . . . I am amazed to recall how unconcerned and ignorant we were about what would happen next. . . . We did not foresee that the public would love the ninety-day freeze so much that we could not retreat from it very quickly” (Stein, 1994, 5).

There was little basis for the more optimistic possibility.

AFTER CAMP DAVID

The president drafted his own speech with revisions by his speechwriter, William Safire. On Sunday evening, he delivered the speech on television. The public accepted the new program enthusiastically. On Monday, the Dow Jones average rose 32.9 points, representing the largest one-day increase in dollar value to that time. The principal criticism came from economists,
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but labor union leaders grumbled also. George Meany, president of the AFL-CIO, wanted free collective bargaining, but he could do nothing, so he went along with the freeze at least initially (Shultz, 2003).
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The president’s address emphasized the role of speculators as the cause of dollar instability. He did not avoid the word “devaluation” but, reverting to populism, he reassured the public that the change in international policy affected only those who “want to buy a foreign car or take a trip abroad. . . . [For t]he overwhelming majority of Americans who buy American products in America, your dollar will be worth just as much tomorrow as it is today” (“The Challenge of Peace,” Nixon papers, August 15, 1971).

Connally went further. He denied devaluation. “I don’t know that it’s going to devalue at all. I think it is going to stabilize it. . . . With respect to some currencies it may go down, and with respect to others it may go up. I think it is going to change, but to say it is going to be devalued, I am not prepared to say that” (Connally press conference, Nixon papers, Shultz Box 8, August 15, 1971, 5). This was misleading. Connally also doubted that the gold price would change. He maintained this position in subsequent negotiations until he was forced to accept an increase. Since the United States did not buy or sell gold, the posted price had no economic significance.

19. Karl Brunner and I organized one group of about a dozen economists. We predicted that controls would not reduce inflation and published an op-ed in the Wall Street Journal. The public’s response differed. A public opinion poll asked, “‘Is the president doing a good job?’ Taken right after wage and price controls started, the poll showed that the percentage who thought the president was doing a good job had virtually doubled and held there” (Paul McCracken in Hargrove and Morley, 1984, 334).

20. Shultz (2003) explained that the Business Council (representing major U.S. corporations) had a rare vote on price and wage controls. The vote for controls was overwhelming. Only two voted against.

International
Negotiations

The government made a major change in policy without thought about its long-term consequences.
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No one at Camp David had a clear idea about what would happen when they closed the gold window and imposed a surtax on imports. At his August 2 meeting with the president, Connally said: “We may never go back to it [convertibility]. I suspect we never will” (White House tapes, conversations 268-6 to 269-1, August 2, 1971). But beyond this conjecture, he had no more than a loose plan to use the surtax as a bargaining chip to obtain trade concessions for exports, especially agricultural exports. And he expected to negotiate a new set of exchange rates without announcing a change in the gold price. The latter required congressional approval, which he and President Nixon wanted to avoid.

The Federal Reserve’s Board of Governors met on Sunday evening, August 15, to hear Chairman Burns’s report of the Camp David meeting, to watch the president’s speech, and to discuss the international policy change. Burns explained that Undersecretary Volcker and Governor Daane would leave that evening for London, where they would explain the president’s program to officials of principal European countries and get some preliminary views of the scope for currency realignment. Governor Daane added that he and Volcker would then travel to other European capitals to hold bilateral meetings.

Burns “said he agreed with Treasury officials who felt the dollar was overvalued, but he was not persuaded that the overvaluation was great” (Board Minutes, August 15, 1971, 4). Maisel mentioned devaluation of 10 percent. Unless that devaluation could be achieved and agreement reached on greater flexibility of exchange rates, the United States should not enter a new agreement. But Burns, Brimmer, and Robertson urged Daane to push for prompt agreement. And Robertson proposed to end the Voluntary Foreign Credit Restraint Program (ibid., 5).

Monday, August 16, was a holiday in Europe. Foreign exchange markets were closed, and they remained closed for the rest of the week. In Japan, markets remained open. The Bank of Japan purchased dollars to keep the existing exchange rate and to prevent large losses to Japanese banks that the government had urged to hold dollars (Toyoo Gyohten, in Volcker and Gyohten, 1992, 93). Also, “the Japanese were too naïve in believing President Johnson and President Nixon when they repeatedly pledged that
the United States would not devalue the dollar. . . . So we thought that the real U.S. objective was not to devalue the dollar but to free it from gold and try to stabilize its value as quickly as possible. Supporting the dollar at the parity of 360 yen, we believed, would meet the interests of the United States and be taken as an act of cooperation” (ibid.). In two weeks Japan increased its reserves by 50 percent, from $8 to $12 billion. M
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balances rose 25 percent (ibid., 94). Critics blamed the subsequent inflation in 1973–74 on this decision.

21. Looking back long after the events, Paul Volcker was critical of the program. “The inflationary pressures that helped bring down the system did not abate for long; they got much worse as the controls came off and plagued the country for a decade or more” (Volcker and Gyohten, 1992, 80).