A History of the Federal Reserve, Volume 2 (124 page)

Excessive money growth was not Burns’s major concern. The recovery was “not robust and much higher interest rates might cut it short” (Maisel diary, June 8, 1971, 52). He favored a slow, gradual increase in rates and opposed any change in the discount rate. Burns expressed his belief that the rules had changed; “it would take much more unemployment now to hold down wages and prices than had been true in the prewar period or even in the immediate postwar period” (ibid.). He mentioned 10 percent unemployment as a possibility. This was unacceptable, so the only solution was an incomes policy.

Maisel then summarized current thinking. “It is clear that the Board as a whole agrees that monetary policy is not responsible for prices. On the other hand, a fair percentage of the presidents probably feel the opposite” (ibid., 53).

At the June 8 FOMC meeting Burns made a full statement of his own belief that “the old rules were no longer working” (FOMC Minutes, June 8, 1971, 50). He did not accept the Phillips curve tradeoff the staff used. It implied that inflation could be reduced by higher unemployment. Citing experience in the United States, Canada, and Great Britain, Burns argued that the old forces that lowered inflation during recessions remained but were dominated by new, stronger forces. He discussed three. First, expansion of public sector trade unions willing to strike against the government. Frequently, their demands had been met. “It was judged that the Government lacked the power or will to curb abuses in the market place. Hence, the trade unions have become bolder” (FOMC Minutes, June 8, 1971, 50). Second was the greater scale of welfare payments. The government allowed these payments to subsidize strikers. Third, with high inflation, union demands for cost-of-living adjustments to compensate for inflation gained
moral force. “In his view, monetary policy could do little to arrest an inflation that rested so heavily on wage-cost pressures” (ibid., 51).
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226. Stephen Axilrod on the staff made the suggestion, and Burns endorsed it. He received the same advice from Milton Friedman, who urged him to improve monetary control procedures. Friedman described efforts to control money by concentrating on interest rates as “a Central Bank delusion . . . there is no more certain route to erratic and unwise monetary policy” (letter, Friedman to Burns, Burns papers, Box B-K12, April 26, 1971). Burns replied a few days later agreeing to most of Friedman’s points. A few days later he received a letter from Senator William Proxmire, chairman of the Senate Banking Committee. Proxmire enclosed a Friedman column from
Newsweek
criticizing rapid money growth and placing responsibility on controlling interest rates and money market conditions. Burns denied Friedman’s claim. He explained rapid money growth as due mainly to “the temporary surge in demand for cash balances to accommodate enlarged transaction needs” (letter, Burns to Proxmire, Burns papers, Box B-K12, May 14, 1971). This is similar to the argument used by the German central bank during the 1920s hyperinflation.

When the FOMC met on June 29, the morning news reported that, after meeting with his advisers, the president had rejected any change in policy. Secretary Connally announced three nos: no tax reduction, no additional spending, and no wage-price review board or wage-price controls. In addition, the president intended to veto a $5.6 billion public works bill. This was a victory for George Shultz, who favored “steady as you go” and believed the economy was recovering.
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Shultz was not alone. Darryl Francis (St. Louis) reported on a meeting with twelve top executives of major companies in St. Louis. “To a man . . . the participants reported that their businesses had been strengthening rapidly in recent months, and they all expected a continuation of growth of sales through the balance of this year” (FOMC Minutes, June 29, 1971, 47). Citing rising government spending, none expected inflation to slow.

In May and June, new housing starts rose above a 2 million annual rate for the first time. The staff maintained its forecast of real growth for the year and forecast 4.1 percent real growth in 1972, rising to 5.1 percent in the second quarter. They expected unemployment to reach a peak at the end of 1971, but it would be over 6 percent at mid-year 1972.
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The FOMC turned to its decision. Governor Daane asked whether the
manager could suggest any operational measures that would encourage a decline in long-term interest rates. Mr. Holmes replied that “there was very little the Desk could do in that regard” (FOMC Minutes, June 29, 1971,58–59).

227. A striking feature of Burns’s analysis is the total absence of both inflation anticipations and the credibility of government policy as a principal determinant of anticipations. Burns’s statement is representative of a large number of others he made at about this time. This was not true of the staff. Partee, the research director, told the FOMC that “the amount of attention given to the monetary aggregates by outside observers posed a problem in terms of expectations. . . . [T]he market was simply responding to a particular theory of the monetary policy process—a theory which, incidentally, had had a relatively good forecasting record over the past few years. If that theory was wrong—and he was not sure it was—the market could be weaned from it only by a long educational process or by a clear demonstration of failure” (FOMC Minutes, June 29, 1971, 45). Burns himself argued that interest rates had increased in the spring because of inflationary expectations resulting from “very rapid expansion in M 1 ,” (ibid., 37). But he did not relate this to his explanation of inflation. Governor Daane, on the other hand, said the FOMC placed “too much emphasis on the aggregates” (ibid., 43). The market and the public generally paid attention because the FOMC did.

Minutes for the period also suggest that the belief was widely held that the administration had abandoned its anti-inflation policy and focused on unemployment to win the 1972 election. One of many examples is the February meeting of the Federal Advisory Council (Board Minutes, February 5, 1971). Less clear is whether support for wage-price policy would have been as widespread if the public believed the administration and the Federal Reserve would follow an orthodox anti-inflation policy.

228. Burns said he had been at the meeting. “He and the Council had both argued for a more activist policy” (Maisel diary, June 30, 1971, 67).

229. This forecast came from the judgmental exercise. The econometric model was less optimistic, and the staff argued for more fiscal stimulus and 8 percent money growth.

The majority agreed that they wanted to slow growth of the monetary aggregates. The issue was how much to raise interest rates and how fast. Once again, the compromise was a modest increase that left the federal funds rate in July below the annualized inflation rate for the month.
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Between meetings, the Board approved a 0.25 percentage point increase in the discount rate to 5 percent to bring it closer to market rates. Also, the Secretary announced publicly, for the first time, that the United States supported a wider band on the exchange rate. And Daane reported that at meetings in Europe, “all of the Europeans except France had agreed that a wider band would be better and . . . that occasional floats for brief periods to change rates would be all right” (Maisel diary, July 16, 1971, 69).

On July 23 Burns testified to the Joint Economic Committee. His comments offer a slightly softer version of remarks that he made at FOMC and Board meetings. Although he recognized that “expectations of inflation thus permeate the gamut of private decisions to spend and invest” (Burns, 1978, 118), he explained that interest rates had increased “despite rapid monetary expansion” (ibid., 117), and that “despite extensive unemployment, wage rate increases have not moderated” (ibid., 118). This showed that “the rules of economics are not working in quite the way they used to” (ibid.).
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After expressing concern about the budget deficit and reminding the committee about the “substantial contribution it [monetary policy] has made to stimulating economic activity” (ibid., 122), he turned again to his explanation of the reasons economic rules changed (ibid., 126–27). First was the commitment to a full employment policy. This encouraged a “general expectation on the part of both business and labor that recessions, if they occur at all, will prove brief and mild; and this expectation has influenced both the strength of wage demands and the willingness of
management to accept them.” Second was the “intensity and duration” of the previous period of excess demand.” Third was the catch-up of money wages to compensate for previous inflation. Fourth, as before, he cited increased union militancy in the public and private sectors and the growth of welfare programs used to sustain striking employees.

230. Between meetings Maisel met with the staff to get them to improve estimates of money growth. He charged them with failing “in their responsibility . . . by not putting enough resources in this area” (Maisel diary, July 1, 1971, 60). The principal tasks he proposed were: (1) improve seasonal adjustment, (2) estimate the tradeoff between reserves and interest rates for money growth, and (3) develop a better analysis of the reserve flow into various aggregates. He also met with the staff at the New York bank to get suggestions for giving instructions to the manager that would improve monetary control.

231. It seems out of character for Burns to accept the alternative—that the rules worked but he did not understand that wages, interest rates, and prices reflected concern that his policy raised the anticipated rate of inflation. He did, however, acknowledge that the FOMC permitted too much money growth in the spring (Burns, 197
8, 123).

Burns called again for a wage-price policy to control cost-push inflation. This time he did not deny that fiscal and monetary policy could reduce inflation. The problem was that these policies cannot work “as quickly as the national interest demands” (ibid., 127).

This casual empiricism is surprising, since it came from a careful empirical economic scientist. It claimed that in practice a private market economy could not reconcile price stability, full employment, and free markets. Claiming the economy had changed, it disregarded the period of high growth and low inflation prior to 1966, when unemployment remained between 4 and 5 percent with inflation below 2 percent. It dismissed, also, the substantial reduction in inflation after policy changed in 1966. And subsequently, it was falsified by the changed experience in the United States, Great Britain, and elsewhere when the public relearned that sustained inflation was neither inevitable nor likely under prevailing policies.

Burns’s testimony said little or nothing that he had not said on previous occasions. What annoyed the president and his staff most was the use made of it by congressional Democrats and the press. Senator Proxmire called the administration’s refusal to use incomes policy “inexcusable” (Wells, 1994, 72). The press picked up the dispute and spread it widely. Even Republican senators introduced bills requiring the president to stop increases in wages and prices (ibid., 73).
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232.
The
Wall
Street
Journal,
July 29, 1971, 1, described the president as “piqued,” and he complained to Haldeman and Charles Colson of his staff. Colson asked a press staff member to put out some negative commentary on Burns. The story on July 27 reported that advisers had urged the president to double the size of the Federal Reserve Board and to reject Burns’s request for a $20,000 annual pay raise. Since Burns complained regularly about excessive union wage increases, he was embarrassed by press reports claiming that he asked for a large increase. Burns told William Safire that he was “deeply offended.” The story was false. Burns had rejected a wage increase. He encouraged Senator Sparkman to hold hearings on his competence as chairman, and he told the Board that he had checked with Connally, Shultz, and Stein. All three disclaimed involvement or advance knowledge (Maisel diary, July 29, 1971, 73). Safire (1974, 442) claimed that the president was unaware of Colson’s action, but Haldeman (1994, 332) claimed the opposite. News about the budget and payments deficits and the appearance of a fight between the president and the Federal Reserve induced a sharp decline in stock prices. The president backed down, denied that Burns had asked for a raise, and praised him as “the most responsible and statesmanlike of any Chairman . . . in my memory” (quoted in Matusow, 1998, 112). Burns then wrote a letter, pledging his strong support and thanking the president for words that “were generous as well as kind” (Burns to the president,
Burns papers, Box B-N1, August 4, 1971). He told Maisel (diary, August 13, 1971, 80) that if the Board kept good relations with the White House, it would shift to an incomes policy.

The July 27 FOMC meeting was the last meeting before the president adopted what he called a New Economic Policy. Unaware of the new policy, the staff raised its forecast for the year; existing policy appeared to them capable of generating strong expansion.
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Burns’s principal concern was to slow money growth, contrary to his claim that it would not work. Despite Treasury financing and presumed even keel policy, he wanted to increase rates. He deplored the necessity of increasing rates, but rapid money growth was a bigger threat (FOMC Minutes, July 27, 1971, 47). He told the committee that “rapid rates of growth in the monetary aggregates—together with the larger Federal budget defi cit—had alarmed many people and had been widely interpreted as indicating that the Federal Reserve had joined the Administration in pursuing a highly expansionary economic policy. Interest rates had risen in large measure because of the resulting expectations of renewed rapid inflation, so that the Federal Reserve was in part responsible for their rise”
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(FOMC Minutes, July 27, 1971, 77). Hayes and Maisel opposed, citing even keel and the risk to the new issue and the market if the dealers dumped their unsold securities. But Robertson and Daane supported Burns (ibid., 69, 77).

Burns could not get support for an increase in the funds rate from 5.5 to 6 percent, so he took a vote on 5.75. The FOMC divided six to six. He then proposed a range of 5.375 to 5.75. This passed on a seven-to-five vote. The directive called for more moderate growth in the monetary aggregates and directed the manager to “achieve bank reserve and money market conditions consistent” with the FOMC’s objectives. The published vote was unanimous (Annual Report, 1971, 167).

Two weeks later, the Board received requests from Dallas and St. Louis to increase the discount rate. Dallas initially proposed a 1–percentage point increase, from 5 to 6 percent, but reduced its request to 0.5, the same as St. Louis. The Board rejected the request because it came from two banks whose presidents wanted the System to “tighten as much as possible” (Maisel diary, August 13, 1971, 77). Furthermore, the proposed change was made to strengthen the dollar, under growing pressure in the exchange markets. The five Board members present agreed that “the discount rate would not be used for balance of payments purposes. . . . The discount rate
would only be used if it were necessary for domestic policy reasons” (ibid., 77). This decision came just as the fixed exchange rate system was about to end. Clearly, the Federal Reserve was not concerned to save it. Maisel refers to the “growing belief that the dollar was overvalued” (ibid.).

233. They now projected 3.8 percent growth in second half 1971, 0.5 percentage points above their earlier forecast, and 5.3 percent in first half 1972.

234. This is a very different explanation from what he had said many times before. It may reflect his recent return from a vacation at his summer home in Vermont. Milton Friedman was his neighbor there. The argument very much reflects Friedman’s influence.