William: Hello.
This is William Clark, financial editor
of the Chicago Tribune,
welcoming you to this weekly series of commentaries
on current economic development.
Reporting to you will be one of the nation's
leading economists, Professor Milton Freedman,
of the University of Chicago.
Milton: I am delighted to welcome you
to this series, Mr. Clark.
I am sure that your participation in it
will make it much more valuable to our subscribers.
William: Well, thank you.
I'm very pleased to be here, and I'm looking forward
to these discussions.
I'm sure it'll help my own education.
That'll be worthwhile (laughs).
You have some correspondence from subscribers.
I noticed that some of it comes from the academic world,
and some of it comes from the business world with questions
suggesting subjects they'd like you to comment on.
May I read this one in part which is
from a professor at a mid-western university?
Professor: "Will you please answer this question?"
William: I am quoting from the letter.
Professor: "What is the effect of our present,
"fixed exchange rate system on our foreign trade?
"By holding the dollar at an artificially high value
"in terms of foreign money,
"are we not loading the dice in favor
"of the American importer and against the exporter?
"If so, why don't our industries such as steel,
"which are complaining of imports, take a stand
"for free exchange rates?"
Milton: The subscriber is entirely right,
and we are loading the dice.
By maintaining the dollar at a rate which overvalues it,
that is to say, making the dollar more expensive
in terms of foreign currencies
than it would be in a free market,
we are, in effect, making American goods expensive
to foreign purchasers and foreign goods cheap to Americans,
and thus stimulating imports and retarding exports.
That's why we've been forced-- we have not been forced to--
but have decided to put on a large measure
of direct controls to reduce imports.
At the same time it's perfectly understandable
why the import industries like steel
don't proceed to argue for free exchange rates.
As they see it, they see it as it affects themselves,
as each one of us tends to see
what affects him most personally.
And if we look, for example, at steel,
while steel would benefit from a policy
of free exchange rates,
which would lead to a lower market value of the dollar,
and hence to less competition from other countries' steel,
they would benefit from that,
but they would benefit still more, as they see it,
from an import quota on steel.
That's directed immediately at their own needs.
All of the benefit of that goes to them.
Moreover, they would argue that
from a political point of view,
once you start talking about exchange rates in general,
you're taking on a much larger range of interest,
you're taking on the banks and the financial interests
that may have a different point of view.
So that I think in the first instance,
the reason why the import industries don't
talk about exchange rates is
because they feel that they can get more by concentrating
their political power on a narrower sector.
In the second instance, the reason why they don't talk
about it is because I am sure there is not
a full understanding of the situation.
Most people do not recognize that we have been
following a policy which has been discriminating
against our own export industries
or against the industries competing with imports.
William: I suppose the most effective way to get
an industry to campaign for something
like free exchange rates or something of that order,
would be through an association, wouldn't it?
You'd almost have to approach it through
the American Manufacturer's Association or
the American Banker's Association,
rather than on a one-industry basis.
Milton: I suppose so.
But once you start doing that, you get the--
as you always do in these areas of conflict
between the importers and the exporters
and between different domestic industries--
so that, in fact, unless you have
a narrowly-defined industrial group,
like the steel people,
like the Iron and Steel Institute,
and then from their point of view,
they will see a bigger payoff in going
for import quotas on steel,
which will solve their problem regardless
of what else happened.
I say will solve their problem.
I don't mean that.
I'm using it as an example.
In fact, I think import quotas on steel
will not solve the steel industry's problem.
I'm firmly opposed to 'em.
I think it would be most undesirable.
In fact, I think that the steel industry in the long run,
would be better off in a world
with freer exchange rates and less import quotas.
But, as I've emphasized before, one of the things
that fascinates me is how short-sighted industries are
when it comes to looking at such broader issues.
In terms of as they see it, they would benefit much more
from steel quotas.
William: Doctor, here is a question from a banker.
Banker: "You have expressed the belief--"
William: And again I'm quoting.
Banker: "You have expressed the belief
"that federal tax policy, specifically as related
"to the surcharge, but as a comment on all tax policy,
"has no economic impact in and of itself.
"It all depends, you say,
"on what associated monetary policy is doing.
"But doesn't the reverse also hold true?
"Would not the effects of a given monetary policy
"be reinforced or diminished as the case might be
"by a shift in tax policy?
"Given, for example, a constant five percent
"money supply expansion, which you recommend,
"would not a higher tax rate at a specified level
"of federal spending produce a slower rate
"of economic expansion than that achieved
"with a substantially lower tax rate?"
Milton: If I were to answer this question
in one word, it would be no.
But I am sure that the subscriber
wants a much fuller answer than that.
Part of the answer
is to
make sure what we mean
when we talk about an economic impact.
The subscriber says that I've urged that the surtax
has no economic impact in and of itself.
That's true and it's also false,
because we have to distinguish different kinds
of economic impacts.
Particularly, the main kind of economic impact
I have been speaking of is the impact on total spending,
on GNP movements, on inflation, on deflation.
I believe that tax policy has no significant impact
on that for a given monetary policy.
That it only has an impact if it changes a monetary policy.
It's not-- and this is a major source of misunderstanding
in this area.
Here are two different statements one can make:
The first statement is that tax policy has some effect.
Monetary policy has some effect.
What the aggregate effect will be depends
on the particular mixture of tax policy
and monetary policy you adopt.
That's really the viewpoint expressed by the subscriber.
The viewpoint I am taking in this area is
a very different one.
I am saying that it's the monetary policy that matters.
The tax policy might have an effect
if it changed the monetary policy.
It's not that the mix matters.
It's what tax policy does to monetary policy.
Now that's so far as inflation, deflation is concerned.
If in the case the subscriber suggests,
a constant five percent money supply expansion,
then I would say, if you really can take that for granted,
then what taxes are in relation to spending
will not in any way affect whether GNP rises
at four percent, five percent, or six percent.
In fact, under those circumstances,
GNP would tend to be rising somewhere
around four to six percent.
Somewhere in that neighborhood.
But that still doesn't mean that the tax policy
wouldn't have an economic impact.
But it would have an economic impact
of a very different kind.
It would have an economic impact
on what fraction of our income we would be spending
through the government.
It would have an economic impact
on interest rates and capital markets.
And interestingly enough, that second economic impact
is precisely the opposite
of that which the subscriber suggests.
Let me see if I can make that clear.
Suppose that with a constant five percent
money supply expansion, a higher tax rate were imposed.
Federal spending is not changed.
Let's suppose that goes so far
that the federal government is running a surplus.
It's taking in more than it's paying out.
What does it do with that surplus?
It retires bonds.
What does that do?
It provides funds to the capital market.
In effect,
that fiscal policy involves
forcing the taxpayers to save the excess
of tax payments over expenditures,
and therefore it adds to the funds available for saving.
As these funds available for saving
come on the capital markets,
they would tend to drive down interest rates,
which would tend to induce business enterprises
to expand capital formation.
As they expanded capital formation,
we would have more and more factories,
more and more machines.
We would have greater productivity of labor.
We would have a greater, a more rapid rate
of economic expansion in real terms.
GNP in nominal terms, in dollar terms,
might still be rising at, let's say, five percent.
But instead of that being say four percent,
or let's say three percent real rate of rise
and two percent price rise,
the effect of a higher tax relative to expenditure
might be a negative four percent rate of rise
instead of at a one percent tax rise.
That is, it would stimulate investment
and capital formation.
Indeed, one of the fascinating things
about the history of the last ten years
is that when Mr. Kennedy first came in as president,
the economic advisors who came in at that time,
Walter Heller came in as chairman
of the Council of Economic Advisers,
were for exactly the reasons I've been citing
in favor of what they called a tight fiscal policy
and an easy money policy.
That is, they wanted high taxes relative to expenditure,
because they thought this would enable interest rates
to stay relatively low.
And they wanted interest rates to stay relatively low,
because they were very, very strongly
oriented toward growth.
They were talking about getting the economy
moving again, you remember.
William: Right.
Yes, indeed.
Milton: What happened was that they were forced
to drop this policy by the pressure
of the balance of payments.
They discovered that we were having
a balance of payments outflow.
Low interest rates would discourage
inflows of capital and encourage outflows of capital.
And so they were led to shift from a tight fiscal policy
to an easy fiscal policy, to recommend the tax cut of '64.
Not really in order to stimulate the economy,
but in order to enable high interest rates
to be associated with the full employment at home
and to solve the balance of payments problem.
I think this is a great mistake to mix up these things.
In my opinion, the sensible thing to do,
as I indicated in the answer to the first question,
is to allow free exchange rates,
movements in exchange rates to solve the
balance of payments problem.
Then to use monetary policy to give you
a stable internal economy,
that is to keep income rising at a steady rate
to avoid inflation.
And then use tax policy for the other objectives
for which tax policy is appropriate.
Namely, for deciding what we want to do
through government rather than privately.
And indeed I can understand people who might think
that the rate of private saving is too low
and who might want to have a large volume
of government savings.
And that seems to me to be a very, very
effective and efficient way of organizing our economy.
We've got three tools as it were.
We've got three kinds of objectives.
Why not use each tool for that objective
for which it's best suited?
Exchange rates for foreign balance of payments,
monetary policy for inflation, deflation,
taxes for deciding how to use our resources.
William: Now you referred to the policies of the advisors
and monetary authorities during the Kennedy's
and the Johnson administrations, Doctor.
How do you read, and I know you're pretty close
to the current team in Washington, the new team.
What is your reading on the views of the new group
of advisors to President Nixon?
Milton: Well there is no doubt that that new group
of advisors has a very different slant
and a very different view than the new economists
who have just left.
The new group of advisors include, of course,
Paul McCracken as chairman
of the Council of Economic Advisers.
Bob Mayo as new Budget Director,
David Kennedy as new Secretary of Treasury.
And more recently, three more individuals
who have been named.
Charlie Walker who has been named as the
Under Secretary.
William: Charls without the "e" at the end of Charles.
The poor fellow gets his name wrong in print
more than anybody I know of (laughs).
Milton: And, interestingly enough,
he's very sensitive about it.
William: Yes, I know (laughs).
Milton: Charls Walker is Under Secretary
to the Treasurer.
Paul Volcker--
Folker. I'm not sure how he pronounces it.
It's V-O-L-K-E-R.
I met him, but I don't know him well.
As Under Secretary to the Treasury for Monetary Affairs.
And most recently of all, President Nixon has just named
Arthur F. Burns, who was the Chairman of the Council
of Economic Advisers under Eisenhower,
as his Special Counselor.
Now all of these gentlemen have views that differ
sharply from the former team in two respects.
First place, all of 'em will feel
that fine-tuning has been carried too far.
They all feel that when the government tries to intervene
very sensitively from day to day and week to week,
it's likely to cause more trouble than it cures,
that it's far better for the government
to maintain a longer period stance,
try to influence the general environment,
and allow the private enterprise economy
and the private markets to adjust
within that general environment.
In the second place, all of them, without exception,
I think, would give greater weight to monetary policy
as opposed to fiscal policy
as a tool for short-term economic adjustment
than would the outgoing set.
Now that doesn't mean necessarily that they would to
as far as I would in attributing essentially no influence
on this area in respect of aggregate demand,
no influence to fiscal policy,
and dominant influence to monetary policy.
But all of them would go much farther
than the former administration did
and the former economists did in this respect.
William: How would their feelings, do you think,
be translated to the Federal Reserve Board,
or can they be or will they be?
Milton: Well that's a very interesting problem,
because of course, if monetary policy is the key,
as I think it is, to whether we're going to have
a stepping up of inflation in the next six months
or next year, or whether we're going to be able
to taper it off.
If it is a key, then the Federal Reserve Board
becomes critical, and of course,
constitutionally the Federal Reserve is independent.
Now the interesting thing about that problem
is the problem is not one of willingness
or anything like that.
President Nixon will, of course, be talking
with the members of the Board,
and the members of the Board will be listening.
Moreover, I believe the basic objectives
of the members of the Federal Reserve Board
and of President Nixon are exactly the same.
Both of 'em would like to see a tapering off of inflation.
I think the problem is a very different one.
I think the problem is, in a sense,
within the Federal Reserve Board.
Whether the Federal Reserve Board can achieve,
has itself organized in such a way as to achieve
the objectives it would like to achieve.
Here we have the evidence of the past six months.
During the past six months, the Federal Reserve Board
has been extraordinarily expansionary.
Quantity of money measured by currency,
demand deposits, and commercial bank time deposits
has been rising at a rate
of about 12 percent a year.
What the Federal Reserve Board looks at
is sometimes called the Bank Credit Proxy,
which is essentially in its essence,
the deposits of commercial banks,
who rose in the last six months of 1968
at an annual rate of 12.9 percent.
Close to 13 percent a year.
Now suppose you asked a
Federal Reserve Board member,
did you plan it that way?
Did bank credit rise at 13 percent a year
because you intended it to?
I am sure.
I have asked similar questions to Federal Reserve
Board members in the past.
And I am sure that each and every one of them
would say to you, no, we didn't plan it that way.
We would really have preferred it if bank credit
had risen let us say at seven percent
instead of thirteen percent.
William: Well couldn't they have done something about it?
Milton: Yes, indeed.
In my opinion, they could.
They have the power to do something about it,
if they wish to exercise their power that way.
Well, then you'll ask me the question,
which I've asked them.
Why didn't they?
William: Why didn't they?
Exactly.
Milton: Well I have been repeatedly frustrated
over the years and asking that question.
And the reason seems to be that they have a mechanism
of operation, of adjustment,
a way of exerting their influence,
which is not very well suited to achieving
specified money supply or credit growth targets.
Their method of operating grew up during a period
when the Federal Reserve Board emphasized interest rates,
not money supply, not quantity of money as a major factor.
And it's a method of operation that is pretty well suited
to controlling short-term movements and interest rates.
You see, part of the big problem is that you've
got a creature whose head is in Washington
and whose hands are in New York, and it's not always clear
that the head and the hands are the same.
William: What do you mean by that, Doctor?
Milton: Well, the policy-making body
in the Federal Reserve system
is the Open Market Investment Committee.
The Open Market Investment Committee,
that's the most important single policy-making body.
It consists, as a technical matter,
of the seven members of the Federal Reserve Board
plus five selected Federal Reserve Board bank presidents.
New York Bank president is always a member of that group.
I think the Chicago Bank president is.
Some of the others rotate.
Technical matter, it's those twelve.
As a matter of fact, not what's true on paper,
all Federal Reserve Bank presidents
come to those meetings, and as a matter of fact,
what you really have is a group of nineteen,
seven board members and twelve presidents,
although only of those nineteen, only twelve of them,
the seven board members and five presidents, have a vote.
Now this Open Market Investment Committee,
it makes policy once every three weeks
when it meets in Washington.
It passes that policy on.
That's what I call the head.
On the other hand, the people who execute that policy
are in New York.
They are what the Fed refers to as the people at the desk.
The man in New York who buys and sells.
The man in New York who every morning at 10:00,
or whenever he opens for business, I don't know exactly.
He picks up the telephone and calls, I don't know,
seven or ten dealers and asks them what their
situation is today.
By dealers I mean dealers in U.S. government bonds.
And then he will call banks.
[Inaudible] The man at the desk is in New York.
The instructions are transmitted from Washington
to New York in the form of the so-called directive,
the Open Market directive.
If you read that, it's like reading a coded message,
because there are words in there that seem
to have no meaning.
You look at it week after week,
and it seems to be saying the same thing.
But every slight change has some significance.
However, the instructions are not very precise
in money supply terms.
They are expressed in terms like keeping credit conditions
as they were last week,
provided that bank reserves don't expand too rapidly,
or don't expand by more than x dollars.
That's the way it's written.
And in fact, the way in which the Board--
the desk has always operated
is through this so-called feel of the market.
Through saying, well, if the market looks tight,
we have to provide a little reserves,
if it looks easy, as they see it.
But what looks tight or easy in New York
in terms of interest rates,
may have very little relationship to what's happening
to the total quantity of money.
Take this last six months.
As I say, I have no doubt that the Fed
would have preferred the quantity of money
to go up less rapidly.
Why did it go up so rapidly?
Well, I have no full explanation, because, as I say,
I've been baffled by this process.
But I think that there are two factors that explain
why they made, what I regard
and what they would regard, as a mistake.
The first factor is that whenever interest rates
are tending to rise as they--
You will remember the initial impact
of the surcharge was a decline
in interest rates as you would expect.
But subsequently interest rates started to rise,
and they continue to rise.
Whenever they start to rise, it looks to the people
in New York as if conditions are "tight" as they seem,
because people are trying to borrow
at lower interest rates, and they can't do it.
And so they have a tendency to try
to keep interest rates from rising quite as fast.
And in the short run, for a brief period,
they can do it by buying more on the open market.
And so you will observe that in those periods
when interest rates have tended to be rising,
the banks have been tending to--
the Federal Reserve system has been expanding
the quantity of money.
Now I may say this is not a new phenomenon.
Exactly the same phenomenon helps to explain
the disastrous policy of the Federal Reserve
from '29 to '33.
At that time interest rates were tending to fall.
And they were acting in such ways
to keep 'em from falling, which meant that they
were pulling money out of the system and contracting it.
So coming back here, I think that this tendency
to operate in terms of what's happening to interest rates,
is a major factor that makes their--
Well, within the system, they call this a linkage.
Well, you can see what it means.
A linkage between the [inaudible].
And it's one of the major factors that makes this linkage
a very ineffective one.
A second factor, which I should mention,
is that the Federal Reserve Board economists,
like most other economists,
have grossly overestimated the importance
of fiscal policy relevant to monetary policy.
They have been taken in by the general line of thought.
And so when the surtax was passed,
the Federal Reserve Board economists
thought that there was danger,
that there would be a slow-down in the economy;
and as a result, wherever they were in doubt,
they leaned in the direction of pouring in money.
And the combination of these two factors
has led to a very large deviation
in this past six months between what the Fed
would have liked to achieve and what it, in fact, achieved.
And that's why, as I see it, the real problem in this area
is not how do you get the Federal Reserve
to want to do the right thing?
But how does the Federal Reserve reorganize
its own operating procedures
so as to be able to do the right thing?
Let me emphasize that what I'm saying is more true today
than it would have been three or four years ago.
As of three or four years, or five years ago,
and certainly the farther back the more,
the greater the extent to which the Federal Reserve
would have denied completely that the money supply
had anything to do with anything, and to which they
would have deliberately defended the interest rate target.
But the thing that has fascinated me
as the years have gone on,
is that the Fed has begun to shift on this area.
William: This was what I was going to ask, Doctor.
You do see some little indications of a shift.
Milton: Oh, I think there are very large indications.
But you know, this is a large organization,
it's slow for it to move, and it takes a long time
between shifts in the head of it to get down
to the hands and the feet.
William: The personnel of the board
itself changes slowly.
I suppose there's a very large staff,
a rather permanent staff that may [crosstalk] on this.
Milton: Oh yes.
There's a large staff of economic research.
But most of those are not really concerned
with this problem.
The largest part of their staff is concerned with things
like computing the Federal Reserve Board
Index of Industrial Production,
what's happening to consumer purchases.
The interesting thing to me has been that over the years,
if you look at the Federal Reserve Board
staff in Washington, in addition there are staffs
at each of the 12 Federal Reserve banks.
But if you look at the Federal Reserve staff
in Washington, most of them are concerned with things
other than monetary policy.
If you look at the Federal Reserve staffs over the country,
most of the economists who could be regarded
as working on money, have been in the Federal Reserve system
for the last 10 years.
In fact, I would say that if you took the number
of man-hours available for research
on monetary economics and banking economics
of a general kind,
most of them, ninety percent of them,
would have been in the Federal Reserve system somewhere.
But unfortunately, their productivity
has not been proportional.
If you look at the significant literature
on monetary economics,
I think two percent would be a high estimate
for the fraction which has come from the ninety percent
who are in the [Inaudible].
Maybe I'm being biased, because I'm in an academic,
in a university environment.
William: Doctor, I'm looking at the Wall Street Journal,
which every week has a regular story on, well,
this one this week is headed
Federal Reserve Keeps Firm Hold on Credit Reins.
And the first paragraph, the Federal Reserve system
maintained its firm hold on the nation's credit range
in the weekend [and Wednesday?] pressing the bank's
net reserve position to the tightest level
in more than nine years.
According to figures released yesterday
by the New York Federal Reserve Bank.
What is the significance of that?
How significant is it?
Milton: Well most of that weekly article is boiler plate.
That has some numbers and words changed from week to week,
and is almost utterly meaningless.
I think it does more harm than good to try
to follow what it does.
The reason for that is, that they concentrate
on the wrong criteria, and we're back again
on the position we were looking at before.
They keep looking at--
The thing they cite week after week
is net borrowed reserves.
That's not a very meaningful figure.
It's not a very meaningful total.
Now, we're in a complicated area,
which I think it's worth going into to some extent,
but I'm not sure we have the time today--
William: Well, we are getting a little close on time.
What would it be more meaningful for them to treat
in an article like this, Milton?
Milton: It would be much more meaningful for them
if they dropped all the references to net borrowed reserves,
and concentrated their article on what was happening
to monetary totals.
In particular, what was happening to the quantity
of reserves, base money, and the amount of money
that's available for banks to use as reserves.
What was happening to the money as narrowly-defined
currency plus demand deposits,
what is happening to money as broadly-defined currency
plus demand plus time deposits.
They ought to present these figures, and then it would be
perfectly appropriate for them also to present
figures on interest rates and what interest rates are doing.
But the particular magic numbers of net borrowed reserves
that they have concentrated on, are,
as I say, extremely misleading.
William: Well, that suggests something
we can discuss another time, perhaps.
Thank you very much, Dr. Freedman.
If you subscribers have questions, or comments,
or suggestions for topics you would like discussed
in this series, please send them to
Instructional Dynamics Incorporated,
166 East Superior Street,
Chicago, 60611.
This is William Clark.
Dr. Freedman and I will be talking to you again next week.