A History of the Federal Reserve, Volume 2

by Allan H. Meltzer

  His first proposal was “reimpose mandatory controls for Tier I [large] firms” (ibid., 4).49 Then he proposed rolling back prices for firms that violated profit guidelines, suspending all agricultural price supports, sales of materials from government stockpiles to lower raw material prices, prohibiting foreign orders for food exports, and other measures affecting wages and imports. To reduce spending, Burns proposed compulsory savings for corporations and individuals. To meet public concerns about energy, he proposed a tax based on horsepower.

  In the last paragraph of his letter, Burns added “that the Federal Reserve has been trying hard to bring monetary policy to bear on the problem of inflation, that our efforts in this direction will continue, but that we will also try to avoid a credit crunch of the 1969 type” (ibid., 7).

  48. Shultz became Secretary of the Treasury when Connally left in 1972, and Stein replaced McCracken as chairman of the Council of Economic Advisers at the end of 1971. Shultz resigned and left the administration soon after the freeze.

  49. In April Burns had proposed “an immediate 45 days freeze over a broad range of prices.” Following the freeze, he wanted reforms “to reduce substantially the existing abuses of economic power by the labor unions and corporate giants.” He suggested other structural reforms as well (memo, Burns to John Ehrlichman, Burns papers, Box B_B89, April 13, 1973).

  This differed from Herbert Stein’s opinion. Stein (1988, 183) wrote:

  It was also part of the exercise that the revival of demand should be restrained. The Nixon team prided themselves on being alert to the error which other governments had fallen into and assured themselves and others that the controls would not seduce them into excessive expansionism.

  But they did fall into the trap. . . . The President, on the advice of his economists, decided that government expenditures should be rapidly increased during the first half of calendar 1972 . . . after which they would be restrained.

  Federal budget outlays increased almost 20 percent, from $168 billion in 1970 to $200 billion in 1973. Table 6.5 shows annual data for these years. The administration increased spending with assistance from Congress, but it did not control monetary policy. For that it required help from the Federal Reserve and particularly from Arthur Burns.50

  FEDERAL RESERVE ACTIONS, 1971–73

  The years 1971–73 are among the worst in Federal Reserve history. The Federal Reserve did not “fall into the trap” of excessive expansion under price controls. It entered by choice. Some members voted for expansion to reduce unemployment. Arthur Burns shared this objective, but he also remained committed to the reelection of President Nixon. He may have adapted monetary policy to achieve a political end. If so, he required help from other members of FOMC, and he was able to get it. There were few objections at the time from Congress or FOMC members.

  50. Phase 4 followed the brief freeze. It lasted from August 12, 1973, to April 30, 1974. The administration decontrolled wages and prices during this period. Only 44 percent of CPI prices were subject to control at the start of phase 4. This fell to 12 percent at the end (Kosters, 1975, 26–27). Controls on oil and energy prices remained until the Reagan administration. I have not found an explanation of what this phase could accomplish beyond a cosmetic showing of administration concern.

  At the last FOMC meeting before the New Economic Policy (NEP), the Board’s staff raised its estimate of GNP for 1971 by $3 billion, all in real output. They projected real growth at 3.8 percent in the second half of the year and 5.3 percent in the first half of 1972. And they expected money growth to slow in the fourth quarter, as it in fact did (Maisel diary, July 29, 1971, 72). Reported real GNP growth remained at 1 percent in the second half of 1971 but rose to 8.5 percent in the first half of 1972.

  The Board welcomed the NEP. Many of them believed that cost-push by unions and businesses caused most of the inflation. The freeze would end that and make possible a return to high employment with lower inflation. Markets interpreted the new policy as anti-inflationary. Short- and longterm interest rates fell after the announcement.

  Following the start of controls, the staff projected less reported inflation for the second half. It reduced projected inflation from 4.9 to 3.4 percent. The reported rate was 5 percent, very close to the forecast before controls. However, unit labor costs rose very little in the second half of 1971, but they rose more rapidly after controls than before. Table 6.6 shows unit labor costs during these years. In 1973, they rose rapidly.

  Maisel (diary, August 25, 1971, 85) described the August FOMC meeting as probably the longest ever. It lasted eight hours. Three topics added greatly to the discussion: the report of the Committee on the Directive, whether or how to implement new procedures, and whether to purchase federal agency issues to assist the housing market.

  The Committee on the Directive proposed that the manager should achieve a reserve target subject to a proviso clause that limited interest rate changes. The committee was unanimous, and the Board’s staff supported the proposal. All agreed that the change was a marginal adjustment that would improve control of the monetary aggregates. They did not discuss even keel, changes in Treasury deposits, or other technical issues. The manager argued that a reserve target should not be the main issue. The desk could improve control of reserves and the aggregates by permitting wider fluctuations in the federal funds rate.

  The FOMC took no action on the proposal. It agreed to have additional studies of the effect of a reserve target on interest rates and to return to the discussion after more had been learned. Nevertheless, it directed the manager to moderate growth of the monetary aggregates consistent with a floor of 5 percent for the federal funds rate. Several members expressed concern about staff projections showing a considerable slowdown in money growth during the fourth quarter.

  A few presidents, Hayes, Kimbrel, and Clay, wanted monetary policy to “reinforce the President’s move toward less inflation” by slowing growth of money (Maisel diary, August 25, 1971, 90). “Almost everyone else on the Committee agreed that the incomes policy . . . was to reduce the need for monetary restraint but that monetary policy ought not to increase restraint” (ibid.). Words like “ease,” “restraint,” and “neutral policy” continued in use without clear definition or relation to some measurable quantity.51

  The Federal Reserve came into the NEP period with high money growth. Monetary base and M1 money growth rose at 7.4 and 7.6 percent average annual rates in the first eight months. By August, twelve-month growth rates of the base and money were 8 and 7.2 percent respectively. Most members of the FOMC said they favored slower growth of the aggregates. Nevertheless, they allowed the federal funds rate to fall gradually from 5.57 percent in August to 4.91 percent in November. Free reserves rose.

  At the October 19 FOMC meeting the staff forecast M1 growth at 2.5 percent for the fourth quarter and 4.5 percent for the first quarter of 1972. They urged a reduction in the federal funds rate to 5 percent or less (Maisel diary, October 21, 1971, 2). Burns spoke first and urged no change. His concern was that if interest rates declined in 1971, they would have to rise in 1972. Rising rates in 1972 “could result in serious difficulties. That possibility worried him a great deal” (FOMC Minutes, October 19, 1971, 49–50). Burns did not explain the source of his discomfort, and no one pressed for an explanation. They probably understood that Congress and the administration would criticize rising interest rates in an election year. The members divided almost equally but later compromised on a statement calling for “moderate growth in monetary and credit aggregates” (Annual Report, 1971, 189).

  51. Under growing pressures from Congress, Burns persuaded the FOMC to purchase agency issues. A large minority opposed, as they had for the five years since Congress authorized the purchases. But Burns had soon to testify about housing. “It would be useful politically if the System were operating in agencies” (Maisel diary, August 25, 1971, 91). The staff report suggested, it would have little effect on housing. Purchases began in September. The Board an
nounced the first purchases and indicated that total purchases of five agencies issues came to $61 million and had about a two-year maturity (memo, Holland to FOMC, Board Records, September 24, 1971). This is one of several examples of failure to distinguish between mortgage credit and the real resources required to build houses.

  A week later, Paul McCracken wrote to President Nixon warning about recent slow growth in money. His memo suggested that real growth should reach 7 to 8 percent in 1972 to reduce the unemployment rate. Lower unemployment required 8 to 10 percent nominal GNP growth and 7 to 8 percent money growth (memo, McCracken to the president, Nixon papers, WHCF, Box 43, October 27, 1971).52

  Nixon and Burns

  Following the FOMC meeting, Burns met with the president for more than two hours. Paul McCracken, George Shultz, John Connally, and others were present. When the discussion turned to monetary policy, Burns repeated the views he expressed at the FOMC meeting. If he pushed interest rates down now to increase money growth, they would have the “unsavory task of just watching them go up next year. . . . What I would like to do is prevent as much as I can an increase in interest rates next year” (White House tapes, tape 1327, October 28, 1971).

  The president later responded by recalling his experience in 1960, when Burns warned in February about tight Federal Reserve policy. In the cabinet meeting, President Eisenhower sided with those who wanted a cautious policy because they feared inflation. President Nixon then explained his priority: “I don’t want the same mistake again . . . I don’t want to have a runaway inflation . . . [but many elections] have been lost on the issue of unemployment. None has been lost on the issue of inflation. . . . Unemployment is always a bigger issue than inflation” (ibid., tape 1328).

  On November 9, the Board discussed a 0.25 percentage point reduction in the discount rate to 4.75 percent and a reduction in stock market margin requirements from 65 to 55 percentage points. The latter reflected concerns about falling stock prices. At the time of the meeting, the principal stock price indexes had fallen below their August 15 level.

  52. Burns’s relations with the president continued to fluctuate over a wide range. The president told Burns at one point that he wanted his input on Federal Reserve appointments, so that Burns would have support for his proposals. William Sherrill resigned to accept the presidency of a bank in November and left in December, but Burns and others knew early in the fall that he would leave. Burns found a candidate and recommended him to the president as a person who would be “of inestimable assistance to me in the effective discharge of the Board’s functions and responsibilities” (Burns to the president, Burns papers, Box B_N1, October 8, 1971). By the time the position became open, the president was irritated and anxious about slow monetary growth. He did not take Burns’s candidate but instead appointed John E. Sheehan on December 23, 1971. Sheehan remained less than 3.5 years. He was a businessman influenced by John Connally.

  Market rates had fallen relative to the federal funds rate and the discount rate. Board members expressed concern about differences in forecast for 1972. The staff and most economists were relatively optimistic; businessmen had become relatively pessimistic.

  The Board approved the reduction in the discount rate but delayed the reduction in margin requirements. A main reason for delay was that several members argued against actions to influence stock prices or those perceived as such. By December 3, uncertainty about the international system had declined. Stock prices rose, and the Board reduced the margin requirement.53

  Nixon and Burns met frequently both before and after the OctoberNovember meetings. In the months before the Camp David meeting, the president was strongly against controls that Burns thought necessary. The president wanted faster money growth, but Burns warned him several times that if interest rates were pushed down in 1971, they would likely rise in 1972.54

  The relationship was not easy. On March 19, 1971, the two met alone. Burns complained about leaks to the press criticizing the Federal Reserve and him. The president again expressed his unhappiness about Burns’s calls for wage-price policy. But Burns cited his loyalty to Nixon and service to the country.

  I am a dedicated man to serve the health and strength of our national economy. And I have done everything in my power, as I see it, to help you as President, your reputation and standing in American life and history. (White House tapes, conversation 470-18, tape 371, March 19, 1971)

  Nixon mentioned the importance of lower inflation.

  In April and May, the president was most concerned about the dollar outflow and the Germans’ decision to stop buying dollars. At a May 4 meeting with the president, McCracken, Volcker, Connally, and Burns asked the president to publicly urge Germany not to float its currency. The president gave a political reason: “They’re going to blame us, and our political opponents at home are going to blame us” (ibid., conversation 490-24, tape 556, May 4, 1971). Connally wanted the float. He spoke of devaluation. “Even a twenty percent devaluation may not help us through 1972. You might have another crisis next year” (ibid.).

  53. As usual, Governor Robertson objected that margin requirement legislation directed the use to control of stock market credit, not prices. There was no evidence of credit expansion for carrying shares. He voted for the change, however. No one else expressed concern about the regulatory change.

  54. As early as February 19, 1971, Nixon explained his reasons for opposing price controls and urged lower interest rates (White House tapes, conversation 454-4, tape 271, February 19, 1971). Two weeks later, Burns urged the president not to give so much attention to the money supply. On June 7 and 8, the president again urged lower interest rates and stressed the importance of housing for reducing unemployment (ibid., conversations 59-4 and 60-1, June 7 and 8, 1971).

  By mid-June, public opinion surveys showed the public concerned as much about inflation as about unemployment. In May and June, consumer prices rose 6 to 7 percent at annual rates. President Nixon asked: “What do we do to make people think that we care? We need to convince people that we’re trying.” Burns’s response was a wage-price freeze from early in 1972 to July or August of that year. Then the president added: “You know I care more about unemployment than inflation. You know that . . . . ” Then, probably reflecting briefing by his advisers, he added: “But I think that perhaps the best way of getting a hold on the unemployment problem is to subdue the inflationary expectations” (ibid., conversation 519-11, tape 750, June 14, 1971).

  Two weeks later, the president was starting to consider some policy changes. Burns opposed any increase in spending and tax reduction. Then he brought up the wage-price freeze, saying he would not do it, but he would jawbone price and wage increases. “I have to do something with regard to foreign imports. I think Congress is going to pass a quota bill and if I was sitting there I’d vote for it . . .

  “Connally: I would too” (ibid., conversation 531-16, tapes 808–9, June 28, 1971).

  Nixon and Connally then criticized Burns for not supporting administration policy. Burns defended himself and predicted that events would drive the administration to adopt an incomes policy. He repeated that he supported the president. “No one has tried harder to help you” (ibid.).

  On October 28, the president discussed the negotiations with the Europeans about the dollar. They mentioned floating rates, but the IMF opposed. Connally’s main concern was Japanese trade barriers. Discussion then turned to domestic policy.

  Burns said that if the Federal Reserve pushed interest rates down, he would have the “unsavory task of just watching them go up next year. . . . [W]hat I would like to do is prevent as much as I can an increase in interest rates next year.” The conversation ended with the president reminding Burns about 1960 and the loss of the election to Kennedy over rising unemployment. “By February, we’re past the point of no return . . . let’s make sure we make our decisions” (ibid., conversation 606-2, tapes 1327–28, October 28, 1971).

  The president then addressed Burns. “Mayb
e we’re talking about an entirely different subject than was the case when McChesney Martin was running the Board.” Burns replied: “I think we are” (ibid.).

  Nixon and Burns in 1972

  The president wrote to Burns on November 4 about an article in the New York Times about slow money growth. Then he added:

  I have been flooded with calls . . . from people in Wall Street for whose judgments I have the greatest respect with regard to the Fed’s policy of holding the money supply down for too long a period. . . .

  I do want you to know that there is nothing I feel stronger on than this money supply problem and that the crescendo of complaints that I have been receiving, not only from the New York financial community but from other places . . . expressing the same concern convinces me that you owe it to yourself, as well as to our goal of getting the economy to move smartly up in the months ahead, to re-evaluate your decision with regard to holding the money supply down and to take some action to move it up” (Burns papers, Box B_N1, November 4, 1971).

  At its November meeting, the FOMC voted unanimously for “somewhat greater growth in monetary and credit aggregates over the months ahead” (Annual Report, 1971, 194). The staff remained optimistic about growth and employment, but Mitchell, Maisel, and Burns were skeptical. The forecast ended with a 5.3 percent unemployment rate in fourth quarter 1972 “which he [Burns] felt was still too high and unsatisfactory” (Maisel diary, November 17, 1971, 7). (Like others, Burns believed that 4 percent was full employment.) He added that slow money growth convinced some that Federal Reserve policy was too tight. “He thought for this reason that we ought to start getting some expansion” (ibid.). Morris (Boston), Mitchell, Maisel, Kimbrel (Atlanta), and Robertson joined Burns in advocating more expansive policy. Hayes (New York), Mayo (Chicago), Clay (Kansas City), and Daane wanted either no change or less aggressive policy action. Following the meeting, the federal funds rate fell.