A History of the Federal Reserve, Volume 2 (56 page)

These studies, and others done within the System, show that the principal technical reasons for poor monetary control were well understood both at the Board and several of the reserve banks. Richard Davis at the New York bank advised Paul Volcker that “nonborrowed reserves might prove a more effective means of hitting monetary targets by freeing the Committee from the burden of substantial direct responsibility for the short-run behavior of the money market” (memo, Richard Davis to Volcker, New York Reserve Bank, Box 110282, August 15, 1977, 2).

Lack of understanding cannot explain the System’s failure, and I find it implausible to believe that lack of control was inadvertent. The FOMC was unwilling to take effective action and, as we shall see, subverted efforts by Congress to improve monetary control.

The
“Missing
Money”

As noted earlier, Arthur Burns explained in testimony before the Banking Committee in 1975 that economic recovery and expansion would not require rapid money growth. He expected a rise in average growth of monetary velocity because the public’s confidence would increase, so they would reduce average money balances. Base money growth fell from about 8 percent annual rate in much of 1974 to less than 6 percent in early 1976. It remained below 6.5 percent until late in 1976. By autumn 1976, the annual rate of consumer price increase was below 5 percent, less than half the 1974 rate of increase. This was Burns’s most persistent effort to reduce inflation.

In January 1976, the staff began to inform the FOMC that money growth, particularly M
₁
, had fallen below the staff’s expectations and forecast despite their efforts to reduce the funds rate. The staff’s M 1 forecast was off by 6.25 percent at the end of 1975 (FOMC Minutes, January 18, 1976, 55). The staff made no connection to Burns’s prediction about velocity (FOMC Minutes, March 15–16, 1976, 56–57). They attributed the decline to a shift in the demand for money.

A retrospective memo showed that reported quarterly average growth of M 1 and GNP were, respectively, 4.9 and 13.6 from first quarter 1975 to first quarter 1976, so velocity growth was 8.7 percent compared to a 3 percent postwar average. In 1976 and 1977, average velocity growth was 3.7 percent. If there was a puzzle, it was limited to one year
¹⁷⁵
(memo, John Paulus to Board of Governors, Burns papers, Box B-B81, January 13, 1978, 2). Paulus gave three possible explanations. First, regulators had
changed the rules to make savings accounts closer substitutes for demand deposits. Payments could be made by drawing against saving accounts. Second, higher nominal interest rates in 1973–74 increased incentives to economize on cash balances and adopt more efficient payment systems. Third, technical changes in payment systems brought many new techniques for more efficient payments. These changes were more important for businesses than for households. Staff estimates suggested that business experienced the largest part of the decline in average cash balances (ibid., 4–5).

175. Revisions later reduced average GNP growth to 10.6 percent for the four quarters of 1975 (Department of Commerce, October 1988, 99).

At the time, the staff was most concerned by the persistent error in their estimates of the demand for money. Their estimates came from an equation, based on Goldfeld (1976), that had worked well in earlier periods but not in 1975. In retrospect, the Board’s staff misstated and overstated the problem. First, the staff acted as if their demand equation was correctly specified so errors could only mean that the world had changed. Second, their framework implied that by setting the (or an) interest rate, the FOMC determined reserves and could ignore the supply side. At times, some recognized that the multiplier connecting reserves to money changed, but changes in growth of the money stock received little attention. The staff did not consider that some of the problem came from the imprecision of their estimates of the supply of money consistent with the FOMC’s chosen federal funds rate. Or, when the staff recognized this problem, they could not convince the FOMC to change procedures. Also, the model gave little attention to anticipations.

Our interest is not in the details as perceived at the time. The incident shows the intense concentration on short-term changes, part of the reason for neglecting medium- and longer-term changes. Also, it shows the neglect of the money stock and its determinants and the conviction that staff equations correctly specified economic behavior.

Goldfeld (1976) studied the source of the error without changing the staff’s conclusion. Laumas and Spencer (1980) changed the specification of the demand equation by replacing current income with permanent income. This removed part of the problem. Lucas (1988) and Hoffman and Rasche (1991) argued that there was no evidence of instability using specifications other than Goldfeld’s. And Ball (2002, 18) concluded that the problem arose because the Board’s equation did not properly specify the opportunity cost of holding money.

Chart 7.16 suggests the importance of specifying the appropriate opportunity cost. The chart compares the logarithm of base velocity to the reciprocal of the long-term interest rate on government bonds, quarterly,
for more than forty-five years. The scatter shows a relatively stable relation. Points for the middle 1970s, the period of “missing money,” lie at the upper left and show no evidence of instability.

Striking evidence of the stability of the relation comes from comparison of the years of rising and falling interest rates and inflation. As long-term rates declined, velocity moved back along the path it followed when inflation rose.

The Board’s staff, and most outsiders, usually disregard the effect of the long-term rate on the demand for money. This neglects the public’s expectations of persistent inflation and other permanent changes except as they change the current short rate. It assumes that the short rate fully reflects expectations at longer maturities. In practice, the long rate and other relative prices affect the public’s decisions to hold money instead of bonds or real capital. This is a more general problem than the “missing money” episode, and it leads at times to misinterpretation.

Humphrey-Hawkins
Legislation

Early in 1975, Congress citing its constitutional power to coin money and regulate its value adopted Resolution 133 instructing its agent, the Federal Reserve, to

(1) pursue policies in the first half of 1975 so as to encourage lower long term interest rates and expansion in the money and credit aggregates appropriate to facilitating prompt economic recovery; and

(2) maintain long run growth of the monetary and credit aggregates commensurate with the economy’s long run potential to increase production, so as to promote effectively the goals of maximum employment, stable prices, and moderate long term interest rates.” (memo, staff to FOMC, Board Records, April 10, 1975)

The resolution was unusual in several ways. First, Congress called on its agent to do a better job. Individual’s complaints about the Federal Reserve were common; statements by the Congress were rare. Second, the resolution strengthened the role of price stability in the Federal Reserve’s mandate. Interpretations of the 1946 Employment Act usually emphasized primacy of full employment. Third, Congress instructed the Federal Reserve to avoid excessive long-term growth of its monetary aggregates, partly endorsing monetarist criticism of the Federal Reserve.

Other sections of Resolution 133 required the Board to appear before the Banking Committee semiannually to present its objectives and plans for the next twelve months. The resolution began regular oversight hearings. Regrettably, few in Congress are informed enough to enter into a useful dialogue with the Board’s chairman. The oversight hearings did not prevent the Federal Reserve from continuing to follow inflationary policies for several years. And the hearings did not get the Federal Reserve to give greater weight to the longer-term consequences of its actions.

Burns worked to weaken the resolution and succeeded in modifying it. Once the resolution passed, several members of FOMC and the Board’s staff urged cooperation with Congress, reluctantly in some cases.

Continued dissatisfaction with economic performance, the high and variable rates of inflation and unemployment, the level of interest rates, and the heightened uncertainty of economic life brought additional legislation. The FOMC undermined the intent of Resolution 133 by failing to achieve the money growth rates it announced and by setting the new growth rate without compensating for over- or underperformance. Members of the FOMC discussed their record, and some proposed procedures for correcting “base drift.” None was adopted.

Senator Hubert Humphrey and Congressman Augustus Hawkins introduced legislation that eventually became the Full Employment and Balanced Growth Act of 1978, known as the Humphrey-Hawkins Act. Humphrey began the process at a 1976 hearing on the thirtieth anniversary of
the Employment Act of 1946. He commented, “It is my judgment that that law has, from time to time, been conveniently ignored” (Joint Economic Committee, 1976, March 18 and 19,155). He left no doubt that he believed that Congress had to adopt new legislation to achieve “full employment with reasonable price stability” (ibid.).

The Speaker of the House, Carl Albert, accused the FOMC of holding a static position and ignoring evidence. “The Committee has steadfastly clung to the notion that tax cuts do not work, in spite of the success we have had with them, in the early ’twenties under Republicans, and in 1963, under President Kennedy. . . . We sorely need a fresh look at the concept of government control of the economy. We need to give up the preconceived notion that Washington knows best” (ibid., 144).

Arthur Burns and Alan Greenspan, then chairman of the Council of Economic Advisers, testified at the hearings also. Burns firmly rejected the idea that anyone could give an accurate numerical value for full employment. Any number was both unreliable and subject to change. The proper definition was that the number of people seeking jobs at prevailing wage rates is equal to the available jobs seeking workers. Then he proposed that the “[g]overnment has a responsibility of acting as an employer of last resort” (ibid., 148) at less than the minimum wage. He gave a number of reasons why, despite his usual conservative views, he believed this was necessary. The list included high tax rates that discouraged investment, environmental legislation, and archaic anti-trust laws. Burns did not consider that any lasting effect would be on real wages not employment.
¹⁷⁶
Later, he changed his statement in response to an economist’s proposal to have the government serve as “employer of last resort,” adding “of course it should” (ibid., 206). And Burns endorsed nationalization of the railroads because they have been “overregulated” by government (ibid.).
¹⁷⁷

Burns criticized the use of numerical targets for unemployment, but he avoided criticism of the 3 percent unemployment goal (to be achieved in four years) in Senator Humphrey’s bill. He criticized Humphrey’s
proposal to reduce Federal Reserve independence by putting control in the White House without directly confronting the senator. The 1976 bill had the president submit his recommendations for monetary policy. The Board would have to respond within fifteen days and explain any proposed deviation.

176. Responding to academic critics, Burns was explicit about the distinction between real and nominal interest rates, noting that short-term rates were below the current inflation rate and that long-term rates, adjusted for inflation, were about 2 or 3 percent. Burns also responded to Professor Robert Eisner’s argument that budget deficits were inflationary. Eisner said, “All you have to do is see to it that the deficit is financed exclusively by the selling of bonds” (Joint Economic Committee, 1976, 206). Burns’s response restricted or gave up independence, similar to Martin’s earlier. “If the Congress proceeds to appropriate money at such a rate, for us to fight the Congress would hardly be in conformity with the Congressional will” (ibid., 207). Burns added that, at times, the System resisted, but it had limited power to resist in practice.

177. Senator Humphrey’s bill called for prevailing wages, including Davis-Bacon wages.

Alan Greenspan endorsed full employment as a goal but agreed with Burns that full employment should not be defined as a number and certainly not 3 percent of adults as the bill specified. He argued forcefully against making the government the employer of last resort or a guarantor of jobs.
¹⁷⁸
Unlike Burns, Greenspan distinguished between productive employment and holding a job. If the job provided by government did not create value, it was like unemployment compensation. And an employer of last resort would discourage workers from looking for jobs or retraining (Senate Committee on Banking, Housing, and Urban Affairs, 1976a, 39, 51–55). Greenspan was no less forthright on the issue of planning. He did not oppose planning, but he opposed detailed numerical plans.

The approach (in the legislation) . . . relies heavily on the ability of the economics profession to plan or outline fairly precisely the path that must be followed to achieve and then maintain full employment. I find the thrust of this argument troublesome. It presumes a detailed forecasting capability which is far beyond any realistic assessment of the present or immediately foreseeable capability of the economic profession.

A modern industrial economic system based even partly on market phenomena is so complex that any model or statistical abstraction, no matter how complex, is still a gross oversimplification of the dynamics of the system. Models can never expect to achieve more than very rough approximations of the dynamics of the real world. (ibid., 33)

Greenspan added that in practice it would be difficult to separate political and planning aspects of forecasting and setting explicit numerical goals.
¹⁷⁹

The most inflationary provision in the proposed legislation was the requirement to avoid action against inflation until the unemployment rate remained at 3 percent. Several witnesses pointed out that this provision would be difficult to achieve in practice and would substantially increase
inflation. Governor Partee noted that the tradeoff between inflation and unemployment had changed. He attributed the change to structural factors, immune from monetary and fiscal policy. Burns denied the tradeoff existed.
¹⁸⁰

178. The reported unemployment rate at the time was about 7.5 percent, down from 9 percent a year earlier.

179. Governor Charles Partee made a similar statement when commenting on the section in the bill that required the Federal Reserve to commit to a twelve- to fifteen-month unalterable plan for monetary policy. Partee also voiced concern about the absence of a clear goal for inflation in the 1946 act and in Senator Humphrey’s proposal.