Expressed concern about the budget deficit had little influence on the size of the actual deficit compared to President Ford’s budgets. Chart 7.13 shows that deficits in 1977 and 1978 are about the same as in 1975. The 1979 deficit fell to about $40 billion, in part because of stronger growth. Compared to the deficits that came in the Reagan presidency, these deficits though historically large, seem modest.72
Burns’s opposition to the administration program did not go as far as tightening monetary policy enough to bring down inflation.73 Although the federal funds rate rose during the rest of his term as chairman, the rise was gradual and often less than the increase in inflation. As noted earlier, monetary base growth remained historically high. Between December 1976 and February 1978, the twelve-month average base growth rose from 6.7 to 8.7 percent. Despite Burns’s frequent strong statements about the evils of inflation, his policies continued to finance inflation and fostered inflationary expectations. When Burns took office in February 1970, the Society of Professional Forecasters predicted 3 percent inflation for the next four quarters; when he left in March 1978, the forecast had doubled to 5.9 percent.
72. Critics of budget deficits often claim that deficits increase real interest rates. This claim is hard to accept as a major influence for the United States given the United States’ experience since 1980. Large deficits of the Reagan years, surpluses in the late years of Clinton’s presidency, and renewed deficits in the Bush presidency from 2001 leave little visible effect on real interest rates. One possible reason is Ricardian equivalence. A more likely reason is that many countries manage their exchange rates by buying the debt issued by the U.S. to finance its budget deficits.
73. Burns believed that monetary velocity would rise rapidly during the early months of a cyclical recovery. In an exchange with Congressman Henry Reuss on February 3, 1977, about the Carter fiscal program, he denied the need to increase the money growth rate. Unlike Martin in 1968, he did not blindly accept coordinated action.
Dr. Burns. I cannot overemphasize the point that no matter how you define the money supply . . . for periods of intermediate duration, such as a year or a little longer, the dynamic factor is not so much the rate of growth of the money supply as the rapidity of its turnover.
Just before the election, FOMC members and staff forecast sluggish growth in the world economy. They were uncertain about what to do and did not think that the private sector could produce a revival unaided. Burns said that classical liberal financial policy “may no longer work in [an] environment in which inflation coexists with recession or sluggish economic expansion” (Burns papers, FOMC, October 19, 1976, tape 4, 7–8). Not everyone shared the pessimism, but it was widespread.74 The sluggish economy with continued inflation would be called “stagflation,” a term that, perhaps inadvertently, covered up the role of anticipations of future inflation. Burns explained stagflation as a result of an unanticipated, large, worldwide recession in 1973–75. This increased uncertainty and pessimism everywhere (ibid., tape 4, 8). He thought “a cut in taxes accompanied by a cut in expenditures, . . . concentrated in large part in a reduction of business taxes . . . would help to restore confidence,” (ibid., tape 6,5). He was less confident about the benefit of monetary ease.
The Chairman [Reuss]. That is precisely why I put to you at the start of the discussion the assumption that velocity would increase at approximately the same rate, around 3 percent that it has in the post-World War II period. . . .
Dr. Burns. But I can not accept your assumption, and I do not accept it. I am assuming that the increase in velocity will be appreciably larger than that. (Hearing before the House Committee on Banking, Federal Reserve Bank of New York, Archives Box 110282)
The testimony is one example of Burns’s allegedly uncooperative attitude. In the event, velocity increased about as he forecast. In November 1976, an international group of sixteen economists called for coordinated expansion by the United States, West Germany, and Japan. Paul McCracken and Arthur Okun represented the United States. Despite inflation the concern was mainly unemployment.
74. At about the same time, U.K. Prime Minister Callaghan moved toward more liberal policies. “We used to think that you could just spend your way out of recession. . . . I’ll tell you in all candor that that opinion no longer exists. And that insofar as it ever did exist, it worked by injecting inflation into the economy and each time that happened the average level of unemployment has risen” (quoted by Burns, Burns papers, FOMC, December 21, 1976, tape 5,1). Burns’s opinion was that Keynesian views still dominated in the United States and had misled Carter.
The FOMC had learned about the cost of policy coordination. Several expressed the point more or less explicitly. The general view was that they must avoid inflation. Volcker expressed concern about the pessimism in statements by members of FOMC. He blamed the election campaign (not the candidates) and suggested the election result would reduce uncertainty and pessimism. He did not favor fiscal expansion and criticized Eastburn and Gramley for endorsing a political program to reduce tax rates (ibid., 5, 5).
In November, Burns proposed reducing the upper bound and midpoint of the federal funds target while also reducing the lower limit on M1 growth. The Committee did not accept his recommendation for M1 growth. Instead of Burns’s proposed 3 to 7 percent, the FOMC chose 5 to 9 percent unanimously, the same range as in October. The difference showed a shifting concern toward moderate stimulus and Burns’s expressed concern to continue reducing the inflation rate. President Baughman (Dallas) urged restraint. He thought the Carter administration would ask for fiscal stimulus, followed by price-wage restraint. Kimbrel (Atlanta) reported that businessmen had started to increase list prices in anticipation of price controls.
Several members urged the Board to agree to proposed reductions in the discount rate. The Board soon afterward accepted the recommendations. Volcker stated the FOMC’s position in December. “Some stimulus could be productive, but [he] preferred to see it in a mild fiscal package” (ibid., tape 8). As usual, most of the discussion was about a difference of 0.12 or at most 0.25 in the funds rate. Wallich was the most vocal about the risk of inflation.
Burns looked back at policy in 1976. He claimed that the FOMC had performed “admirably,” citing the continued expansion and decline in interest rates (ibid., tape 4, 1–2).75 He agreed with a subcommittee report that suggested that control of monetary aggregates required a longer term program. Again, Burns did not propose or undertake steps to improve control of money growth.76
A subcommittee chaired by Governor Partee reported on the results of using a nonborrowed reserve target in 1976. The central issue was whether the System could improve operations by using a nonborrowed reserve target with less emphasis on the federal funds rate. The subcommittee concluded that a nonborrowed reserve (NBR) target was more likely to be hit than a reserves against private deposits (RPD) target used earlier, but that control of short-term money growth would not improve. To hit the money stock target, NBR was no better than the federal funds rate target (ibid, December 21, 1976, tape 3, 1–9).
75. In fact, the monthly average federal funds rate began the year at 4.87 percent, rose to 5.4 in June, then declined to 4.65 in December.
76. The FOMC voted to extend the authorization for direct purchases of securities from the Treasury.
The subcommittee opined that adopting an NBR target gained little if the FOMC continued to seek control of money for a two-month period. It proposed to abandon the NBR target.
President Balles (San Francisco) drew a more appropriate conclusion. The committee should seek balance between short-run interest rate stability and keeping monetary aggregates within a twelve-month growth range chosen once a quarter. He wanted to let interest rates fluctuate more than in the past to improve control of money growth and inflation (ibid., tape 3, 16–18).
The subcommittee report and subsequent discussion again failed to get the FOMC to look ahead far enough to control money growth and inflation. Eve
n after it gave up tight control of the funds rate in 1979–82, it did not act on the information learned from the Partee committee study or on Balles’s conclusion. The focus remained on the short-term. Another missed opportunity!
President Carter’s first budget director was a Georgia banker, Bert Lance. Lance was a fiscal conservative who opposed the proposed 1977 stimulus package. An alleged scandal about his banking practices before he joined the administration forced him to resign in summer 1977.77 He was exonerated later. President Carter (1982, 12) believed that Lance knew less about economics than other advisers but was better able to deliver information because of their long relationship.
Other members of the economic advisory group were Treasury Secretary Michael Blumenthal, a businessman; Stuart Eizenstat, a Georgia lawyer who served as Chief Domestic Policy Adviser; and Council chairman Charles Schultze. These four became part of the Economic Policy Group (EPG). Carter added others to the group, so it became unwieldy and ineffective. He blamed Blumenthal for its ineffectiveness. This contributed to his decision in 1979 to replace Blumenthal as treasury secretary with G. William Miller (Carter, 1982, 19–22). One part of his concern was the inability to get a uniform recommendation. He often had to decide between alternatives. For this, too, Carter blamed Blumenthal’s lack of leadership. He thought the EPG was ineffective under Blumenthal, but it improved when Miller became treasury secretary (Carter, 1982, 19–22). Miller liked the change to Treasury and did an effective job of managing the financial transaction that released the hostages held by Iran.
77. At the Shadow Committee meeting in March 1977, Beryl Sprinkel and I expressed concern about the end of the disinflation policy. Sprinkel, a bank officer, knew Lance and arranged a meeting with him in May 1977. The argument that got Lance’s attention was that a stimulus policy in 1977 would likely require an anti-inflation policy that would increase unemployment in 1979–80, when President Carter would run for reelection. Lance asked us to stay in touch and come back, but he left soon after.
Before the inauguration, the economists responsible for international economic policy expressed concern about the effect of the stimulus package and a larger fiscal deficit on net national saving and the exchange rate. Shortly after the inauguration, the new president sent Vice-President Walter Mondale and some economists to talk to the principal countries with payments surpluses—West Germany and Japan—about coordinating policies. The main idea was that if all three expanded spending, relative positions would remain about the same and the dollar would not devalue.
All three countries had excessive unemployment. The response by Japan was cautious but generally positive (Biven, 2002, 103). The response in Germany was negative. Chancellor Helmut Schmidt pointed out that although exchange rates might remain stable, worldwide inflation would be the “inevitable result” (ibid., 99; Volcker and Gyohten, 1992, 145–48).78 Nevertheless, Germany’s efforts to reduce its budget deficit stopped in 1977–78, and the Bundesbank allowed money growth to exceed its preannounced targets. But the German official position remained opposed to greater policy coordination with the United States. It attributed the “high current account deficits in the United States . . . not to any low level of demand, but to massive public sector debt as well as to the consequent low level of savings in the country” (Kitterer, 1999, 199).
President Carter’s personal style influenced policymaking also. He thought it was his responsibility to be fully informed about details of all policy positions, so that he did not require the assistance of an aide (Carter, 1982, 17). He recognized also that he sent too many recommendations to Congress at one time (ibid., 23). And he felt very much the outsider in Washington and believed that leaders of Congress had not campaigned for him. As a “southerner, born-again Christian, a Baptist, and newcomer,” he believed he had no obligation to major lobbying groups and former Democratic leaders (ibid., 6–7). He described his economic aims as a balanced budget, lower inflation, and deregulation of trucking, airlines, communication, banking, finance, and oil and gas prices (ibid., 45). These aims did not please many congressional Democrats (ibid., 66). And he blamed his failures also on the oil price shock.
78. Schmidt asked for the estimated effect of the stimulus package on inflation in the United States. “When [Fred] Bergsten replied it was expected to raise the inflation rate by only 0.3 percent Schmidt is reported to have been ‘incredulous’” (Biven, 2002, 99).
FEDERAL RESERVE ACTIONS, 1977–78
The election removed a government that gave much attention to reducing inflation and brought in a government that gave priority to reducing unemployment. See Table 7.10 and Charts 7.1 and 7.7 above.
Actual and expected inflation rose. The unemployment rate remained unchanged. The 1979 oil price increase was a one-time increase that overstates the underlying inflation rate. The Federal Reserve responded by increasing the federal funds rate. By December 1978, federal funds adjusted for expected inflation exerted disinflationary pressure.
At the start of the period, several reserve banks requested discount rate reductions. The Board rejected six requests in December 1976 and three in January 1977. It pointed to evidence of a strengthening economy.
Early in December 1978, President Carter announced that he chose a businessman, G. William Miller, to replace Arthur Burns as chairman of the Federal Reserve. Burns, who had done much to sustain and increase the Great Inflation, was replaced in part because he was considered too much an anti-inflationist. Schultze also complained that Burns was more than willing to comment on administration policy at Quadriad meetings with the president but unwilling to tell the president what the Federal Reserve would do (Schultze, 2005). Schultze wanted more policy coordination; Burns guarded Federal Reserve, and his own, independence as a principle he insisted upon despite often yielding to administration pressure. This created an unsatisfactory outcome. He did not control inflation and did not gain the trust and confidence of the Carter team. Most of all, Carter did not get along well with Burns, as he later said.
Table 7.11 shows planned and actual federal funds and short-term money growth targets during the rest of Burns’s term as chairman. The minutes give M1 growth and the funds rate as ranges, usually one-half percentage point for the funds rate and four to six percentage points for M 1 growth.
As before, the manager always came close to the federal funds target, although usually modestly below. The manager and the FOMC did not respond forcefully to the much wider discrepancies between actual and planned money growth. Particularly in April, July, and October, money growth was highly inflationary. Reactions remained mild.79
79. The New York bank staff compared the use of the federal funds rate and nonborrowed reserves as operating targets. The main conclusions were that (1) either could be used to control monetary aggregates, (2) neither target was better than the other, (3) the federal funds rate target permitted greater money market stability, and (4) market interest rates would be more variable, if nonborrowed reserves became the principal target. The memo questioned whether money market stability was advantageous (Richard Davis to Paul Volcker, Federal Reserve Bank of New York, Archives Box 110282, August 15, 1977). The memo does not say how the comparison was made, but it does not suggest that the variability of interest rates under a nonborrowed reserve target and interest rate targeting achieved the same monetary growth. A reserve target required an increase in interest rate volatility compared to past practice. The memo shows also that Volcker had considered some of the issues that arose in 1979–82 years before he changed procedures. The memo does not discuss the effects on the maintained rate of money growth or how to lower inflation.
In 1977, the Board also approved two increases in the discount rate; one on August 29 raised the rate to 5.75 percent; the other on October 25 set a 6 percent rate.80 On January 6, 1978, the Board approved a 6.5 percent discount rate. The rise in interest rates shown in Table 7.11 suggests, and the Board’s announcement stated, that the adjustments recognized market actions that ha
d occurred previously. Beginning in May, the Board rejected discount rate increases ten times before the August increase and three additional requests before the October increase.
The reserve banks were ahead of the Board in seeking to slow inflation. As the Board noted: “In proposing those increases the directors of the Federal Reserve Banks in question stressed the outlook for rising prices and the desirability of providing a signal of the System’s determination to continue pursuing an anti-inflationary monetary policy” (Annual Report, 1977, 142). The Board expressed concern that an increase in the discount rate would be “misconstrued as an indication of a major shift in monetary policy” (ibid.). The underlying reason was that despite an average increase of consumer prices of more than 6.5 percent (annual rate) per month between May and August, the unemployment rate remained between 6.9 and 7.2 percent. Despite his anti-inflationary rhetoric, Burns again failed to respond effectively to inflation. In the meetings, he often proposed less expansive policies, but he did not fight for them. The FOMC responded weakly to monthly money growth rates as high as 18 percent annual rate. Burns was not alone. Dissents from FOMC decisions remained rare in this period. John Balles (San Francisco) expressed concern in January about rapid growth of M2, but did not follow through. Phillip Coldwell dissented in June because he wanted a 0.25 percentage point reduction in the lower bound on the funds rate. Coldwell dissented again in July, joined by Jackson and Roos (St. Louis). Each favored a less expansive policy. But Governors Lilly and Wallich dissented in September because they believed monetary policy was too restrictive. At the time, growth of M1 for the year ending in third quarter 1977 “had exceeded by a considerable margin the upper limit of the range set at its meeting in early November 1976” (ibid., 292). However, at the same meeting Frank Morris (Boston) and Larry Roos (St. Louis) dissented for the opposite reason. They regarded as inadequate the policy response to the money growth rates reported at recent meetings. Morris and Wallich also dissented in October, one again favoring faster money growth, the other slower. Roos dissented again in December, and Lilly, Morris, and Partee dissented in early January from a decision to raise the upper limit on the funds rate by 0.25 to 7 percent principally to strengthen the dollar.
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