A History of the Federal Reserve, Volume 2

by Allan H. Meltzer

  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 12.7 The plan called for no action until September, when Congress returned, but the start of a run on the dollar forced earlier actio
n.

  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.8

  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).9

  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.

  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.11 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.12 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.13

  Burns did not give up.14 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).