A History of the Federal Reserve, Volume 2 (31 page)

Arthur Burns remained chairman of the Board of Governors until replaced by G. William Miller in April 1978. Miller had little experience with monetary policy. He had served as a director of the Boston Federal Reserve bank. His appointment owed much to his work in the presidential campaign and his friendship with Vice President Walter Mondale. He left the Federal Reserve to become Secretary of the Treasury in August 1979. Table 7.2 shows the personnel changes during 1973–79.

Two notable appointments, Henry C. Wallich and Paul A. Volcker, joined the FOMC during this period. Wallich was a Yale professor at the time of his appointment with years of practical and academic experience. He had worked as an international economist at the New York Federal Reserve bank and served as a member of the Council of Economic Advisers in the Eisenhower administration. In 1958, he joined the Treasury as head of tax analysis. In March 1974, he joined the Board of Governors, replacing Dewey Daane. He strongly opposed inflation but did not always favor control of money growth.

Paul A. Volcker became president of the New York bank in August 1975. He had a long experience in the System, beginning in 1949 at the New York bank and later in the bank’s research division under the direction of Robert Roosa. Roosa brought Volcker to the Treasury in 1962. He worked in both Democratic and Republican administrations, rising to Undersecretary of Monetary Affairs in the Nixon administration. Volcker was always an anti-inflationist.

Turnover of Board members increased during the period. Some complained that Board salaries did not adjust for inflation, so their real incomes fell. One seat, occupied by Governors Robertson, Holland, Lilly, Miller, and Volcker, changed four times during the six-year period. For the first time, two of the new governors, Holland and Partee, came from
the senior staff, and one governor, Coldwell, was a reserve bank president at the time of his appointment. Many of the appointees were professional economists or experienced in financial markets.

Miller claimed that the president accepted his suggestions for appointments to the Board while he was chairman. He recommended Nancy Teeters, the first female member, Emmett Rice, the second black, and, just before leaving, Frederick Schultz, a Florida banker. Schultz became vice chairman of the Board.

Congress made several changes in financial regulation that broadened the Federal Reserve’s regulatory and supervisory activities and enlarged its staff by about 50 percent. Bank holding companies expanded by acquiring non-banking subsidiaries. The Board in 1970 assumed responsibility for one-bank holding companies. Truth-in-lending legislation and consumer credit protection became main activities. The Freedom of Information Act and other programs required increased transparency and information. To house the expanded staff, the Board supervised construction of the new Martin building, which opened in 1974.

Of the changes Congress authorized in this decade some altered the banking and financial systems permanently. By the end of 1979, nearly 2,500 bank holding companies held 70.6 percent of banking assets
(O’Brien, 1989, 51). Growth of non-bank financial institutions and inflation eroded regulation Q and restrictions that separated banking and other financial firms. By the end of the 1970s, the burden of several costly regulations became apparent. Deregulation began.

THE ECONOMY IN 1973–79

Rising inflation was the main economic event of the period. Chart 7.1 shows the percentage change in the deflator for private consumption during the 1970s. The two peaks roughly coincide with increases in oil prices, but it is less clear that oil price increase caused most of the price increase properly measured. Unlike the consumer price index, the deflator is much less affected directly by oil prices, and its peak rates of inflation remained well below the rates recorded by the consumer price index. The consumer price index, however, was widely used to adjust wages and other contracts and it was widely quoted at the time.

It is true, nevertheless, that the peaks in oil price increases shown in Chart 7.2 correspond to the peaks in general measures of the price change. Part of the increase resulted from the world increase in aggregate demand in 1973 stimulated by expansive policies in several countries.

Real growth in the United States made a large contribution to robust world growth in 1972. Chart 7.3 shows this surge and the recession that followed. It was the deepest recession of the postwar years to that time. Inflation continued at a high level during the recession, so there was much talk about “stagflation,” inflation at a time of high persistent unemployment. By this time producers and consumers had learned that anti-inflation policies did not persist once unemployment rose, so they were hesitant to change their beliefs about long-term inflation. Measures of anticipated inflation remained at about a 5 percent annual rate, and ten-year Treasury bond yields remained about 7 percent.

Chart 7.3 also shows the real interest rate computed from the ten-year Treasury bond and the anticipated rate of inflation from the Society of Professional Forecasters. The rate moves in a very narrow range. In contrast, growth of the monetary base, especially the real value of the monetary base, fluctuated over a wide range. Real base growth rose during the boom in 1972, fell in advance of the recession in 1973–74, and rose during most of the expansion during the middle of the decade. Chart 7.4 shows these data.

Chart 7.5 shows the surge in the base growth compared to output growth in 1973–
74, its subsequent collapse in 1974–75 and the new surge at the end of the 1970s. Inflation rose, pushed by excessive monetary stimulus and lax monetary and fiscal policies. By contra
st, inflation remained low in 1963–64, when the base and real GDP rose at abou
t the same rate.

Productivity growth declined during the 1970s as shown in Chart 7.6. The relatively high nominal base growth maintained through the decade and falling productivity growth contributed to average inflation over the decade. As in Nordhaus (2004), slower productivity growth was in part the result of the oil shocks during the decade. Variable inflation contributed
also by making it difficult for producers to make long-range plans and by focusing their attention on short-term gains. Federal Reserve actions reinforced these tendencies.

The civilian unemployment rate in Chart 7.7 follows the same general path (with opposite dips) as productivity growth. The unemployment rate fell as productivity and real growth rose, and it rose during recessions, when growth of productivity and real output fell. Chart 7.7 shows the peak in the postwar unemployment rate at 9 percent. In 1982, the unemployment rate reached a higher peak, 10.8 percent, near the end of the recession that ended the high inflation period.

Much economic theory of the cost of inflation discusses the cost of a fully indexed inflation. All prices adjust fully to the anticipated inflation rate. The 1970s inflation was far from that theoretical construct. Congress did not index personal income tax rates until the 1980s. Interest rates on time and demand deposits remained controlled. The government controlled energy prices. The controlled rates and prices did not adjust to inflation.

One consequence was that it was privately profitable to use talent and personnel to develop alternatives that avoided regulation. These innovations introduced variability into monetary aggregates and eventually their
redefinition. A second consequence was that savings and loan institutions faced long periods in which the yield on their portfolios remained far below the interest rates permitted to be paid on their liabilities even though these rates remained below open market rates. The savings and loans suffered loss of income and deposits. Inflation and their decisions about risk taking eventually destroyed many of them at substantial cost to taxpayers.

Finally, Chart 7.8 points out a major change in the use of resources. Beginning with the start of President Johnson’s Great Society spending in 1965–66, transfer payments as a percentage of personal income doubled in less than a decade. The change in administration in 1969–70 slowed the growth rate for a short time. The rate of increase rose following the slowdown until the proportion reached more than 12 percent of personal income. This surge reflects the introduction and growth of many so-called poverty programs but also transfer programs for health care. These programs shifted resource use from production to consumption and probably contributed to slower productivity growth as resources were drawn to the new federal programs. The small changes in the last half of the 1970s reflect mainly changes in income. A new, smaller surge in transfer payments occurred at the end of the 1980s.

The data summarized here, particularly data on the Great Inflation,
encouraged an extensive literature on the causes of the inflation by both political scientists and economists. Before turning to the details of the period, we examine some of these explanations.
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