A History of the Federal Reserve, Volume 2

by Allan H. Meltzer

  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.

  Congress did not pass the 1976 Humphrey-Hawkins bill. Instead, in 1977 it amended the Federal Reserve Act to incorporate the provisions of Resolution 133.

  The following year, Congressman Henry Reuss introduced legislation that added to the reporting requirements of Resolution 133, restricted Federal Reserve officials from encouraging banks and financial institutions to support or oppose legislation, and regulated potential conflicts of interest of reserve bank board members. The bill called for a Federal Reserve forecast of interest rates and monetary velocity for twelve months ahead and quarterly projections of the System’s portfolio composition.

  Burns testified against these new requirements and endorsed the practice under Resolution 133. The Board accepted the provisions broadening the categories of individuals being considered as directors of the reserve banks and providing for Senate confirmation of the chair and vice chair of the Board. But Burns objected strongly to prohibiting discussions of pending and proposed legislation with representatives of banks and financial institutions. And he opposed the provision putting reserve bank officers and directors under the conflict of interest provisions of the criminal code on grounds that they should not be treated distinctly (“Statement to Congress,” Federal Reserve Bulletin, August 1977, 717–21).181 The final bill reflected many of Burns’s and the Board’s objections.

  Efforts by Congress to make the Federal Reserve more accountable and to reduce unemployment and inflation continued. By 1978, the HumphreyHawkins Act had become less inflationary. The target unemployment rate was now 4 percent; government was no longer the employer of last resort, avoiding inflation received greater attention, but reducing unemployment remained the principal objective. The House passed the bill without adding a numerical inflation target. The Senate bill set the target at 3 percent or less to be achieved by 1983. Both the House and Senate bills required the Federal Reserve to set targets for monetary policy that it believed were consistent with the act.182 Administration direction or guidance for monetary policy did not remain.

  180. In May, Chairman Burns testified in the hearings under Resolution 133. Senator William Proxmire pointed to a change in the Humphrey-Hawkins bill. The goal was a 3 percent adult unemployment rate. Burns rejected the proposal or any numerical proposal (Senate Committee on Banking, Housing, and Urban Affairs, 1976a).

  181. The restriction on lobbying bankers was a response to the Banking Committee’s access to minutes of the reserve bank directors meeting where much information about lobbying appeared (House of Representatives, 1977, 15).

  In spring 1978, William Miller replaced Arthur Burns. He testified in favor of the genera
l objectives of the act. Like his predecessor, he opposed numerical targets. And he emphasized the importance of reducing unemployment and inflation (Senate Committee on Banking, Housing and Urban Affairs, 1976a, 210).

  Governor Partee testified for the Board (ibid., 215). He praised the increased attention to inflation in the 1978 House and especially Senate bills, removal of the government as employer of last resort, and elimination of the 3 percent goal for the unemployment rate, but he objected to the numerical targets that remained.

  The Board was particularly pleased that the legislation allowed greater flexibility to monetary policy. Objectives for monetary policy could change during the year as economic conditions changed. And Partee, in a break with the past, emphasized that “performance with respect to inflation has a critical bearing on the chances for actually achieving meaningful and sustainable full employment” (ibid., 214). He insisted that the improvements did not go far enough. Inflation control continued to take “a back seat” to unemployment.183

  The 1978 legislation amended section 2A of the Federal Reserve Act by requiring the Board to report in writing to Congress by February 20 on its and the FOMC’s objectives for the monetary and credit aggregates for the year ahead. In July, the Board had to report on its plans for the following year. This forced the Board to give more attention to medium-term objectives, a potentially important change. Also, the Board’s report had to relate its plans to the administration’s economic program for the year and to congressional goals.184

  182. The goals specified in the act included more than unemployment and inflation rates. They included balanced growth, productivity growth, full parity income for farmers, and other objectives. Many of these objectives were outside the competence of the Federal Reserve. The 3 percent unemployment rate for adults twenty years and over remained in the bill (Senate Committee on Banking, Housing, and Urban Affairs, 1976a, 21).

  183. One sign of change is the absence of discussion of guideposts and guidelines for wages and prices. Since the early Kennedy administration, officials and others argued that a market economy could not achieve full employment and low inflation without intervention in labor and product markets. This reasoning no longer appeared in official or congressional statements. Partee rejected it explicitly (Senate Committee on Banking . . . , 1978, 723). Partee insisted, however, that training programs would be needed to reach 4 percent unemployment rates.

  184. News reports at the time suggest the intense struggle over the provisions of the act. Republicans in Congress wanted more emphasis on reducing inflation and government spending. Union lobbyists wanted more spending (Washington Post, October 13, 1978, A2).

  By the time President Carter signed the legislation, a common belief was that the act would not achieve its stated goals. That proved to be correct. For its part, the Federal Reserve was no better at achieving announced monetary targets than before, and it continued to allow year-to-year base drift. In 2001, Congress repealed Humphrey-Hawkins, eliminated targets for money growth, but retained semiannual oversight hearings.185

  The Subcommittee on the Directive proposed several changes in response to the new mandate. It recommended eliminating two FOMC meetings, in January and June, and moving the February and July meetings earlier in the month to allow time to prepare the statement for the oversight hearings. Also, the subcommittee proposed to state short-run targets for the aggregates as three-month moving averages centered on the month of the meeting to reduce the volatility of reported growth rates and to reduce the width of specified ranges.186

  The act, like Resolution 133, explicitly absolved the Federal Reserve from responsibility for achieving its announced ranges. If it claimed that conditions had changed, it had to explain to Congress the reason for the change. In effect, this provision weakened the act. The System rarely achieved its targets for the monetary aggregates, and Congress eventually repealed the required announcement.

  At the time, the Subcommittee on the Directive proposed changes to reduce “base drift”—building the next growth rate on the excess or shortfall in the previous year—and announcing calendar year growth rates twice a year instead of moving one quarter at a time. The committee saw the new legislation as offering an opportunity for dealing more directly with problems widely believed to inhere in the existing system (Federal Reserve Bank of New York, 1978, Box 110282, FOMC, 1970–78).

  Other memos prepared at the time accepted many of the monetarists’ criticisms. One recognized that lower money growth was a necessary condition for lower inflation and that targets for monetary aggregates were a more useful measure than interest rates of the thrust of monetary policy. Another memo proposed use of a single aggregate target. Still another recognized that policy was often procyclical. “The need for serious adjustments is often deferred because of the procedure of shifting the base. The tendency for monetary growth to be procyclical is strengthened. The delayed adjustments are ultimately enlarged” (memo, “Perspectives on Controlling Monetary Aggregates over Time,” Federal Reserve Bank of New York, Box 110282, November 21, 1978, 4).

  185. Passage of the act stimulated internal discussion of changes. Presidents Baughman (Dallas) and Roos (St. Louis) proposed steps to focus on longer-term consequences of policy actions. “The economic problems we are attempting to address now require attention to the longer consequences to a degree not heretofore experienced since the 1930s” (letter, Ernest Baughman to FOMC, Board Records, April 20, 1978). Both presidents proposed a three-year horizon. The letter concluded by recognizing the procyclical thrust of Federal Reserve policy actions. “We would be hard pressed to find a persuasive rationale that monetary policy in the past three years has been countercyclical” (ibid., 2).

  Neither Burns nor many others were ready to make the needed changes in procedures to control inflation and make policy counter-cyclical.

  186. Chairman Volcker dissented because the moving averages would “convey an exaggerated impression to the public of fine-tuned precision in the setting of ranges” (Federal Reserve Bank of New York, 1978, Box 110282, FOMC, 1970–78).

  Recognition did not influence decisions. Federal Reserve actions continued to be procyclical on average until 1994. Base drift continued, as did the announcement of multiple targets for monetary aggregates and inflationary monetary growth. Recognition of excessive attention to shortrun changes was a large forward step. Unfortunately, it did not produce the required changes.

  The importance of this memo should not be underestimated. It shows that internal memos reinforced external criticisms of policy and procedures. And it established that decisions to continue the procedures and policies had to be explained some other way than by claiming misunderstanding. Most likely is the primacy given to unemployment and the misinterpretation of interest rate changes. But underlying these errors was the influence of Congress and the general public. The FOMC continued to interpret a decline in interest rates as evidence of easier monetary policy even if money and credit growth slowed in recessions. Similarly, it interpreted higher interest rates as evidence of tighter policy despite more rapid growth of money and credit. This was the main reason for procyclical policy actions and the low or negative real interest rates found during the Great Inflation.187

  REGULATION

  The 1970s were a period of active financial regulation. The Federal Reserve’s responsibilities increased under the Truth in Lending Act, the Community Reinvestment Act, and the Equal Credit Opportunity Act (non-discriminatory). These changes required rulings and interpretations to keep up with new congressional legislation and practical problems.188

  187. Tax policy became an active political issue in 1978 with the introduction of bills by Senator William Roth (Delaware) and Representative Jack Kemp (New York) that proposed large reductions in individual and corporate tax rates. Individual rates would be reduced from the prevailing 14 to 70 percent to 8 to 50 percent by 1980.

  188. The Community Reinvestment Act of 1977 (CRA) responded to complaints that some banks di
d not lend adequate amounts to meet demands of low- and moderate-income borrowers. Studies showed that the CRA reduced the spread between loans to such borrowers and other home buyers and that the loans were profitable (Laderman, 2004). Interest groups used the CRA to intervene in banks’ proposals to expand, merge, etc.

  The 1970s were a time of dissatisfaction. Truth in Lending and the diversity of banking practices raised many issues, for example disclosure of discounts for cash or surcharges for the use of credit cards (Annual Report, 1977, 132). Administration of margin requirements continued to raise issues about matters such as substitution of securities in margin accounts and the extension of margin requirements to new instruments in a rapidly changing market. These seem remote from core Federal Reserve responsibilities. Inflation required changes in nominal values. For example, in 1998 the Board permitted banks to increase the limit on credit card loans to executive officers from $1,000 to $5,000. Congress proposed or passed legislation to restrict System practices, release additional information, change the regulatory structure, and regulate the growing number of foreign banks operating in the domestic market.

  Potential default by New York City induced Congress to seek emergency loans from the Federal Reserve. The Federal Reserve Board attempted to draw a line between assistance to potential bankrupts and service as lender of last resort. It agreed to a temporary increase in bank discounts in the event of a major default, but it opposed loans to New York City. In the event of losses “that would seriously impair the capital of some banks,” it argued that the Federal Deposit Insurance Corporation had statutory responsibility (Federal Reserve Bulletin, 1975, 635–36). In 1979, the System acted as fiscal agent for Treasury loan guarantees to Chrysler Corporation.