A History of the Federal Reserve, Volume 2 (41 page)

Two problems arose. First, the administration’s economists were unwilling to accept a temporary increase in unemployment to gain a permanent reduction in inflation, and the public in 1976–77 was not greatly concerned about inflation. By 1979, concern had increased. Second, administration economists underestimated the rate of inflation. Forecasts of inflation, based on the Phillips curve relating inflation to the unemployment rate, were inaccurate. Table 7.10 shows the forecasts and realizations of inflation in 1977–79. All three forecasts underestimated the inflation rate, in part because of one-time increases in food and oil prices, in part because of mistaken beliefs about the natural rate, but also because monetary base growth from 1977 to 1979 averaged 8 percent or more.

Part of the forecast error resulted from the unanticipated oil price shock. Chart 7.11 shows the two sharp increases in consumer price inflation following the two large oil price increases in the 1970s. The oil price increases in 1973 and 1979 came at a time of rising inflation. In contrast, Chart 7.12 shows the much smaller increases in nominal wage growth in 1973–74 and 1978–79. Together, the two series imply a substantial decline in real wages in both periods. Despite repeated claims by Arthur Burns and others about the role of labor unions, labor unions did not recover their losses. The oil price increases were a tax paid to foreigners that had to be borne by wages and profits. The different response of wages to demand stimulus and supply shocks suggests the importance of separating these persistent and transitory effects in discussing and responding to price increases.

At a more fundamental level, Carter’s choice of advisers
included mainly people who believed that t
he economy had to be closely managed. This fit well with Carter’s predilections. In contrast to Greenspan, Simon, and President Ford, they di
d not believe that they could rely on a robust private sector t
o restore full employment at low inflation if government adopted
non-inflationary policies. They were Keynesians with a strong belief that their task was to manage the details because without their intervention, the private sector would be unstable. A briefing paper for President-elect Carter told him: “There have been few spontaneous recoveries in the years since World War II” (quoted in Biven, 2002, 125). Advisers explained that several econometric models showed declining growth in 1977. They were wrong. The 1977 recovery is evidence against the Keynesian view.

69. President Carter’s adviser from his years as governor of Georgia warned him that wage-price guidelines were ineffective unless supplemented with general macroeconomic policy. Carter replied: “I understand from this what will not work. What will?” (quoted in Biven, 2002, 54).

To expand output and increase employment, the Carter administration proposed to reduce corporate taxes, increase depreciation allowances for small businesses, give a $50 rebate to households on 1976 income taxes, increase revenue sharing for state and local governments, and create additional public service jobs at a total cost of $15 billion. Ray Marshall, secretary of labor, proposed public employment programs. This did not appeal to Schultze, but it did to Carter. President Carter was torn between his alleged fiscal conservatism and the political pressures from the liberal side of his party (Hargrove and Morley, 1984, 463).
⁷⁰
By spring, congressional opposition, recovery, economic expansion, and the unpopularity of the $50 rebate changed the program (Hargrove and Morley, 1984, 480; Carter, 1982, 12). In April President Carter dropped the rebate and the business tax cut. Congress adopted an employment tax credit in place of public service jobs, increased the standard income tax deduction for individuals and gave assistance to state and local governments. The stimulus package transferred $6 billion in 1977 and $17 billion in 1978. The original proposal had $15 billion in each of 1977 and 1978 (Biven, 2002, 82).

Arthur Burns openly opposed the administration’s program. Burns believed that budget deficits and labor unions were major causes of inflation.
⁷¹
He wanted a lower budget deficit and stronger guidelines for wage increases. This open conflict with the administration was not forgotten
when his second four-year term as chairman of the Board of Governors expired in February 1978.

70. Charles Schultze served as budget director during the Johnson administration. He is a highly regarded economist, active in the Democratic Party. Several of Carter’s advisers described him as a fiscal conservative. In fact, budget deficits for the four years 1977–80 reached $226.8 billion. Total federal outlays rose 44 percent in nominal terms and 13 percent in real terms between 1977 and 1980. Outlays increased by one percentage point relative to GNP. This growth is not conservative compared to experience up to that time, but it is modest compared to budget and deficit increases during the Reagan administration.

71. The Shadow Open Market Committee in March warned that the new administration had shifted priorities. The committee said that this change would bring higher inflation. In September, it warned that money growth had returned to the high levels of 1968, 1972, and 1973. Government spending growth increased also. After the fact, Stuart Eizenstat said that their biggest mistake was underestimating inflation at the start of the administration and failure to act against it (Eizenstat, 1982, 79). Eizenstat was chief Domestic Policy Adviser to the president. Later, he favored price and wage controls as a short-term response to the 1979 oil price increase.

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 M
₁
growth. The Committee did not accept his recommendation for M
₁
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 nonborr
owed reserve target in 1976. The central issue was whether the System could improve operations by using a
nonborrowed reserve tar
get 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.