A History of the Federal Reserve, Volume 2 (86 page)

Once again, the problem remained because cooperation tried to stabilize a nominal exchange rate without recognizing that the real exchange rate was misaligned. The choice for Britain was deflation or devaluation. As expected in these circumstances, success was temporary. The pound experienced repeated runs until Britain devalued in 1967.
²⁹¹

In early December 1964 Martin met with Prime Minister Wilson, Secretary Dillon, and President Johnson at the White House. Martin criticized both British and American balance of payments policies, telling President Johnson that overseas commitments would eventually force devaluation of the dollar. He urged the president “to declare yourself [against devaluation] . . . It is important that the whole world know where you stand on this basic question” (quoted in Bremner, 2004, 159). Secretary Dillon surprised the president by agreeing that the United States had not done enough.

The loans and interest rate increases gave the pound a brief period of calm. Some of the November loans came due in May, so speculation resumed in March. Secretary Dillon told the president that speculators believed the Wilson government would not have a contractive budget in April and that the pound would be devalued. Dillon wanted to avoid a British devaluation out of concern for a subsequent attack on the dollar, but he could accept a reduction to $2.50 (from $2.80) because of recent improvements in the U.S. balance (memo, Douglas Dillon to the president, March 27, 1965, Confidential Files, Box 49, LBJ Library).
²⁹²
Ackley opposed devalu
ation, “It can be avoided. But I see serious danger in telling that it cannot under any circumstances be permitted” (memo, Ackley to the president, July 29, 1965, National Security Files, Box 215, LBJ Library). The danger was that the United States would have to offer “unilateral support of the pound” (ibid., 2). The State Department favored support.

291. Less than ten months later, August 5, 1965, Johnson again discussed British problems with Martin. Johnson feared that a British devaluation would put pressure on the United States to devalue.

Martin: We don’t want them to devalue, but we simply can’t go on bailing them out if they are not going to actively take steps to help themselves. . . . We have to put all the pressure we can on them, but if they say they can’t do it, there is no point in our going to underwrite them without anything to back it up. . . .

Johnson: . . . we have to ask how we can protect the dollar because it became clear some time ago that they are not going to protect the pound.

Johnson, Recordings of Telephone Conversation with William McC. Martin, August 5, 1965. Between 1959 and 1964, prices in the U.K. (GNP deflator) increased by 28 percent, in the United States by 7.7 percent. If the nominal exchange rate was appropriate in 1958–59, it was overvalued in 1964 (data from Federal Reserve Bank of St. Louis, 1978). Consumer prices for 1957 to 1964 show an increase of 18.9 percent for the U.K. and 9.2 percent for the U.S. (Council of Economic Advisers 1971, 306).

292. The U.S. estimated that about this time, the U.K. had $2.5 billion in reserves plus $1.25 billion in dollar securities and a $300 million IMF drawing balance. Against this $4 billion, it had monetary liabilities equal to more than $11 billion. The balance of payments
remained in deficit. The Wilson budget in April 1965 imposed taxes on consumer spending and relied mainly on incomes policy to reduce inflation (memo, the U.K. Balance of Payments Crisis,
March 27, 1965, National Security File, Box 215, LBJ Library).

Early in 1965, Dillon resigned. The president appointed Undersecretary Henry Fowler as his replacement.
²⁹³
Dillon’s departure was a blow to Martin. The two held similar views about inflation and the balance of payments. Both had worked well with President Kennedy, who accepted much of their advice. Dillon’s departure and Johnson’s manner and attitudes may have made Martin consider his own status. Moreover, Gardner Ackley was a very strict Keynesian who did not approve of central bank independence. On February 8, 1965, Martin prepared a handwritten letter tendering his resignation, but he did not submit it (Martin papers, February 8, 1965). A month later, he told the president that he wanted to leave, but the president said he had lost Douglas Dillon and could not lose him also (Bremner, 2004, 161–62).

End
of
Non-inflationary
Growth

The year 1965 was the transition from one of the best four-year periods in U.S. experience to years of inflation and slow growth. It was the last year of strong productivity growth and the first year of rising inflation. See charts 3.1 and 3.3 above. The four-quarter average rate of increase in the GNP deflator rose from 1.5 to 3 percent. The consumer price index began the year rising at a 1 percent annual rate. It ended at 2 percent: a twelve-month moving average of the CPI rate of increase did not fall below 2 percent in the next twenty years.
²⁹⁴
The unemployment rate fell from 5 percent at the start of the year to 4 percent at the end.

To administration economists with their firm belief in the Phillips curve, the increase in inflation was the price paid for lower unemployment. They were willing to pay the price, reluctant to tighten policy. Martin and several of his colleagues on the FOMC held a very different view. They were more concerned about inflation and the balance of payments.

Until 1965, the United States balance of payments had improved and
not just because of the visible capital controls and military purchases at home. Chart 3.11 (above) shows the increase in the current account surplus. Part of the improvement was a response to the lower inflation rate at home compared to inflation abroad (Chart 3.12). The beginning of domestic inflation coincides with the decline in the current account surplus.
²⁹⁵

293. Fowler had played an important role in organizing business support for the tax cut. He had served in government in the Roosevelt and Truman administrations.

294. Chart 3.4 above shows that change in the federal funds rate is much smaller than the change in the inflation rate for the next several years. Real short-term rates fell.

The administration made the first of several errors. Early in 1965 the president’s Economic Report and his other messages announced the need for further expansion and proposed a reduction in excise taxes and a “budget that will once again contribute expansionary force rather than restrictive pressure” (Council of Economic Advisers, 1965, 9). This was part of an ambitious program to achieve “the Great Society” by increasing funds for poverty programs, welfare, and training.
²⁹⁶
Monetary policy could contribute by continuing to hold up short-term interest rates to stem a capital outflow, while lowering long-term rates to encourage expansion (ibid., 105–6).
²⁹⁷
The president also asked for repeal of the 25 percent gold reserve requirement against deposit liabilities of reserve banks (ibid., 12).

The administration’s concern for fiscal stimulus came despite a decline in unemployment to 4.8 percent in January 1965 and a reported 7.5 percent annual increase in industrial production in 1964, a year with a major automobile strike. These and other signs of strength should have
suggested that additional stimulus was unnecessary, but administration economists did not interpret them that way.
²⁹⁸
Reports of a large increase in the payments deficit at the end of 1964 gave evidence that the interest equalization tax had shifted a large part of foreign borrowing to banking markets not subject to the tax. The first quarter increase in the deflator, 4.9 percent at annual rate, gave a second warning. This was the largest quarterly increase in eight years. The gold outflow in January gave an additional warning. At $263 million, it was twice the amount of gold sales for the entire year of 1964. Outflows continued in February and March, reaching a record $832 million for the first quarter and $1.664 billion for the calendar year.
²⁹⁹
About half the outflow went to France.

295. In December 1964, Secretary Dillon sent the president the most positive report on the balance of payments in several years. After reporting about $1 billion smaller deficit in 1964, Dillon wrote: “Our technical experts foresee further limited gains in 1965, bringing the deficit on regular transactions slightly under $2 billion. If realized, that would be the smallest deficit since the balance of payments became a problem in 1958” (memo, Douglas Dillon to the president, December 9, 1964, Confidential Files, Box 49, LBJ Library). Dillon noted that about $1 billion had come from restrictions on purchases—$500 million from tying aid, $300 million from reduced defense spending abroad, and $200 million from reduced purchases by the Atomic Energy Commission. He recommended renewal of the interest equalization tax, continuation of limits on duty-free tourist expenditures, and, as possible further steps, a tax on tourists’ foreign expenditures and restrictions on bank lending.

296. Johnson thought of the Great Society as an effort to restructure society “more concerned with the quality of their goals than with the quantity of their goods” (quoted in Goodwin, 1991, 211). President Johnson’s ambitions for the Great Society went beyond growth of output or redistribution. Goodwin (ibid., 218) contrasts this elevated aim with the actual accomplishments. “There seemed to be few among the principal officers of government who were trying to determine how the programs could be made actually to work. The standard of success was the passage of the law—and not only within the administration, but in the press and among the public.” Goodwin (ibid., 220) added that President Johnson was “unable to foresee the possibility of resentment based, not on objection to his social goals . . . , but on hostility to the implicit assertion of increased central authority to define the general welfare and confer benevolences which . . . should not be imposed by presidential will.” Between 1965 and 1968, the government created five hundred new social programs (ibid., 287).

297. The Board’s Annual Report gave data on purchases of long-term securities in 1964 as $1 billion. It estimated that this was 2 percent of purchases of long-term securities by all market participants.

If the push for additional stimulus was the first mistake made that year, it was not the last. More consequential were the effort in midsummer to hide the increase in military spending to support the Vietnam War and, late in the year, public pressure on the Federal Reserve to prevent any increase in interest rates.
³⁰⁰
The Federal Reserve chafed under administration pressure, but it permitted annual growth of the monetary base to reach 5.9 percent by December, the highest twelve-month growth rate since early 1952. Chart 3.16 shows the surge in real output and money. A policy that gave attention to the sustained rate of money growth would have seen the pressure for inflation after 1967.

The Federal Reserve did very little during the first half of the year. Treasury borrowing required “even keel” operations much of the time. That contributed to, but it cannot alone explain, the cautious, hesitant response. Four reasons stand out.

First, Martin wanted the FOMC to reach a consensus before it acted. He often waited, thinking that discussion, events, and perhaps collegiality would help form the consensus. But Governors Mitchell and Robertson persistently opposed tighter policy. On April 30 Sherman Maisel, an economics professor from the University of California at Berkeley, joined the Board, replacing Mills.
³⁰¹
Maisel usually voted with Mitchell and Rob
ertson. Later, after the president appointed Andrew Brimmer to replace Canby Balderston, Martin was never certain when he would have a majority of the Board. He hesitated to act with a majority of FOMC if it did not include a majority of the Board.

298. A memo from Ackley to Johnson acknowledged the rapid advance, “but
the
current
strength
is
partly
temporary,
reflecting accumulation of steel inventories and the catch-up in autos. . . .
There
is
room—In
fact,
urgent
need—for
rapid
expansion
throughout
this
year
(memo, Ackley to the president, Background for Thursday “Quadriad”: the Case Against Tight Money,” February 9, 1965, Confidential Files, Box 49, LBJ Library; emphasis in the original).

299. The gold outflow includes an additional subscription to the IMF.

300. Charles Schultze wrote a memo to his staff instructing them not to discuss the budget with Federal Reserve officials. He told the president, “I am afraid that
the
budgetary
outlook
would
be
used
as
an
excuse
to
tighten
up
on
monetary
policy”
(memo, Schultze to the president, Schultze Papers, WHCF, October 4, 1965).

301. Maisel was the first academic economist appointed to the Board since Adolph Miller, who served from 1914 to 1936. Maisel was an expert on housing finance. He remained until
1972, when he returned to Berkeley. I am greatly indebted to Governor Maisel for giving me use of the private diary that he maintained throughout his tenure at the Board. Other changes at about this time were the appointment of Frederick Deming as Treasury Undersecretary for Monetary Affairs. Hugh Galusha replaced Deming as president of the Minneapolis federal reserve bank. Robert Stone resigned as manager of the System Open Market Account to become an officer of a commercial bank. His successor was Alan R. Holmes, who had worked as his deputy.

Second, and most important, Martin believed he had a duty to prevent inflation and maintain the dollar’s value. This belief clashed with his firm belief that the Federal Reserve was independent within government. If an elected administration proposed and Congress approved budget deficits, the Federal Reserve had to help finance part of them. He did not choose to undermine decisions of elected officials and legislators. Instead, he sacrificed independence.

Third, “policy coordination” added to the problem. Independence “within the government” suggested that monetary, fiscal, and other administration policies should seek the same objectives and attach similar weights to employment, price stability, and the payments deficit. This did not happen. Martin did not accept the mistaken idea that policymakers
could maintain a welfare-maximizing inflation rate that lowered unemployment to the socially desirable minimum. He expressed much greater concern about inflation and the balance of payments than President Johnson or his advisers.
³⁰²
When Douglas Dillon left the administration, Martin lost a powerful ally inside. He had earlier lost a president who paid attention to his warnings and acquired one with entrenched populist views who hated “high” interest rates (Bernstein, 1996, 364).