Posts Tagged 'Richard Nixon'

Cleaning Up After Burns’s Mess

In my two recent posts (here and here) about Arthur Burns’s lamentable tenure as Chairman of the Federal Reserve System from 1970 to 1978, my main criticism of Burns has been that, apart from his willingness to subordinate monetary policy to the political interests of he who appointed him, Burns failed to understand that an incomes policy to restrain wages, thereby minimizing the tendency of disinflation to reduce employment, could not, in principle, reduce inflation if monetary restraint did not correspondingly reduce the growth of total spending and income. Inflationary (or employment-reducing) wage increases can’t be prevented by an incomes policy if the rate of increase in total spending, and hence total income,  isn’t controlled. King Canute couldn’t prevent the tide from coming in, and neither Arthur Burns nor the Wage and Price Council could slow the increase in wages when total spending was increasing at rate faster than was consistent with the 3% inflation rate that Burns was aiming for.

In this post, I’m going to discuss how the mess Burns left behind him upon leaving the Fed in 1978 had to be cleaned up. The mess got even worse under Burns’s successor, G. William Miller. The clean up did not begin until Carter appointed Paul Volcker in 1979 when it became obvious that the monetary policy of the Fed had failed to cope with problems left behind by Burns. After unleashing powerful inflationary forces under the cover of the wage-and-price controls he had persuaded Nixon to impose in 1971 as a precondition for delivering the monetary stimulus so desperately desired by Nixon to ensure his reelection, Burns continued providing that stimulus even after Nixon’s reelection, when it might still have been possible to taper off the stimulus before inflation flared up, and without aborting the expansion then under way. In his arrogance or ignorance, Burns chose not to adjust the policy that had so splendidly accomplished its intended result.

Not until the end of 1973, after crude oil prices quadrupled owing to a cutback in OPEC oil output, driving inflation above 10% in 1974, did Burns withdraw the monetary stimulus that had been administered in increasing doses since early 1971. Shocked out of his complacency by the outcry against 10% inflation, Burns shifted monetary policy toward restraint, bringing down the growth in nominal spending and income from over 11% in Q4 1973 to only 8% in Q1 1974.

After prolonging monetary stimulus unnecessarily for a year, Burn erred grievously by applying monetary restraint in response to the rise in oil prices. The largely exogenous rise in oil prices would most likely have caused a recession even with no change in monetary policy. By subjecting the economy to the added shock of reducing aggregate demand, Burns turned a mild recession into the worst recession since 1937-38 recession at the end of the Great Depression, with unemployment peaking at 8.8% in Q2 1975.. Nor did the reduction in aggregate demand have much anti-inflationary effect, because the incremental reduction in total spending occasioned by the monetary tightening was reflected mainly in reduced output and employment rather than in reduced inflation.

But even with unemployment reaching the highest level in almost 40 years, inflation did not fall below 5% – and then only briefly – until a year after the bottom of the recession. When President Carter took office in 1977, Burns, hoping to be reappointed to another term, provided Carter with a monetary expansion to hasten the reduction in unemployment that Carter has promised in his Presidential campaign. However, Burns’s accommodative policy did not sufficiently endear him to Carter to secure the coveted reappointment.

The short and unhappy tenure of Carter’s first appointee, G. William Miller, during which inflation rose from 6.5% to 10%, ended abruptly when Carter, with his Administration in crisis, sacked his Treasury Secretary, replacing him with Miller. Under pressure from the financial community to address the seemingly intractable inflation that seemed to be accelerating in the wake of a second oil shock following the Iranian Revolution and hostage taking, Carter felt constrained to appoint Volcker, formerly a high official in the Treasury in both the Kennedy and Nixon administrations, then serving as President of the New York Federal Reserve Bank, who was known to be the favored choice of the financial community.

A year after leaving the Fed, Burns gave the annual Per Jacobson Lecture to the International Monetary Fund. Calling his lecture “The Anguish of Central Banking,” Burns offered a defense of his tenure, by arguing, in effect, that he should not be blamed for his poor performance, because the job of central banking is so very hard. Central bankers could control inflation, but only by inflicting unacceptably high unemployment. The political authorities and the public to whom central bankers are ultimately accountable would simply not tolerate the high unemployment that would be necessary for inflation to be controlled.

Viewed in the abstract, the Federal Reserve System had the power to abort the inflation at its incipient stage fifteen years ago or at any later point, and it has the power to end it today. At any time within that period, it could have restricted money supply and created sufficient strains in the financial and industrial markets to terminate inflation with little delay. It did not do so because the Federal Reserve was itself caught up in the philosophic and political currents that were transforming American life and culture.

Burns’s framing of the choices facing a central bank was tendentious; no policy maker had suggested that, after years of inflation had convinced the public to expect inflation to continue indefinitely, the Fed should “terminate inflation with little delay.” And Burns was hardly a disinterested actor as Fed chairman, having orchestrated a monetary expansion to promote the re-election chances of his benefactor Richard Nixon after securing, in return for that service, Nixon’s agreement to implement an incomes policy to limit the growth of wages, a policy that Burns believed would contain the inflationary consequences of the monetary expansion.

However, as I explained in my post on Hawtrey and Burns, the conceptual rationale for an incomes policy was not to allow monetary expansion to increase total spending, output and employment without causing increased inflation, but to allow the monetary restraint to be administered without increasing unemployment. But under the circumstances in the summer of 1971, when a recovery from the 1970 recession was just starting, and unemployment was still high, monetary expansion might have hastened a recovery in output and employment the resulting increase in total spending and income might still increase output and employment rather than being absorbed in higher wages and prices.

But using controls over wages and prices to speed the return to full employment could succeed only while substantial unemployment and unused capacity allowed output and employment to increase; the faster the recovery, the sooner increased spending would show up in rising prices and wages, or in supply shortages, rather than in increased output. So an incomes policy to enable monetary expansion to speed the recovery from recession and restore full employment might theoretically be successful, but, only if the monetary stimulus were promptly tapered off before driving up inflation.

Thus, if Burns wanted an incomes policy to be able to hasten the recovery through monetary expansion and maximize the political benefit to Nixon in time for the 1972 election, he ought to have recognized the need to withdraw the stimulus after the election. But for a year after Nixon’s reelection, Burns continued the monetary expansion without let up. Burns’s expression of anguish at the dilemma foisted upon him by circumstances beyond his control hardly evokes sympathy, sounding more like an attempt to deflect responsibility for his own mistakes or malfeasance in serving as an instrument of the criminal Campaign to Re-elect the President without bothering to alter that politically motivated policy after accomplishing his dishonorable mission.

But it was not until Burns’s successor, G. William Miller, was succeeded by Paul Volcker in August 1979 that the Fed was willing to adopt — and maintain — an anti-inflationary policy. In his recently published memoir Volcker recounts how, responding to President Carter’s request in July 1979 that he accept appointment as Fed chairman, he told Mr. Carter that, to bring down inflation, he would adopt a tighter monetary policy than had been followed by his predecessor. He also writes that, although he did not regard himself as a Friedmanite Monetarist, he had become convinced that to control inflation it was necessary to control the quantity of money, though he did not agree with Friedman that a rigid rule was required to keep the quantity of money growing at a constant rate. To what extent the Fed would set its policy in terms of a fixed target rate of growth in the quantity of money became the dominant issue in Fed policy during Volcker’s first term as Fed chairman.

In a review of Volcker’s memoir widely cited in the econ blogosphere, Tim Barker decried Volcker’s tenure, especially his determination to control inflation even at the cost of spilling blood — other people’s blood – if that was necessary to eradicate the inflationary psychology of the 1970s, which become a seemingly permanent feature of the economic environment at the time of Volcker’s appointment.

If someone were to make a movie about neoliberalism, there would need to be a starring role for the character of Paul Volcker. As chair of the Federal Reserve from 1979 to 1987, Volcker was the most powerful central banker in the world. These were the years when the industrial workers movement was defeated in the United States and United Kingdom, and third world debt crises exploded. Both of these owe something to Volcker. On October 6, 1979, after an unscheduled meeting of the Fed’s Open Market Committee, Volcker announced that he would start limiting the growth of the nation’s money supply. This would be accomplished by limiting the growth of bank reserves, which the Fed influenced by buying and selling government securities to member banks. As money became more scarce, banks would raise interest rates, limiting the amount of liquidity available in the overall economy. Though the interest rates were a result of Fed policy, the money supply target let Volcker avoid the politically explosive appearance of directly raising rates himself. The experiment—known as the Volcker Shock—lasted until 1982, inducing what remains the worst unemployment since the Great Depression and finally ending the inflation that had troubled the world economy since the late 1960s. To catalog all the results of the Volcker Shock—shuttered factories, broken unions, dizzying financialization—is to describe the whirlwind we are still reaping in 2019. . . .

Barker is correct that Volcker had been persuaded that to tighten monetary policy the quantity of reserves that the Fed was providing to the banking system had to be controlled. But making the quantity of bank reserves the policy instrument was a technical change. Monetary policy had been — and could still have been — conducted using an interest-rate instrument, and it would have been entirely possible for Volcker to tighten monetary policy using the traditional interest-rate instrument. It is possible that, as Barker asserts, it was politically easier to tighten policy using a quantity instrument than an interest-rate instrument.

But even if so, the real difficulty was not the instrument used, but the economic and political consequences of a tight monetary policy. The choice of the instrument to carry out the policy could hardly have made more than a marginal difference on the balance of political forces favoring or opposing that policy. The real issue was whether a tight monetary policy aimed at reducing inflation was more effectively conducted using the traditional interest-rate instrument or the quantity-instrument that Volcker adopted. More on this point below.

Those who praise Volcker like to say he “broke the back” of inflation. Nancy Teeters, the lone dissenter on the Fed Board of Governors, had a different metaphor: “I told them, ‘You are pulling the financial fabric of this country so tight that it’s going to rip. You should understand that once you tear a piece of fabric, it’s very difficult, almost impossible, to put it back together again.” (Teeters, also the first woman on the Fed board, told journalist William Greider that “None of these guys has ever sewn anything in his life.”) Fabric or backbone: both images convey violence. In any case, a price index doesn’t have a spine or a seam; the broken bodies and rent garments of the early 1980s belonged to people. Reagan economic adviser Michael Mussa was nearer the truth when he said that “to establish its credibility, the Federal Reserve had to demonstrate its willingness to spill blood, lots of blood, other people’s blood.”

Did Volcker consciously see unemployment as the instrument of price stability? A Rhode Island representative asked him “Is it a necessary result to have a large increase in unemployment?” Volcker responded, “I don’t know what policies you would have to follow to avoid that result in the short run . . . We can’t undertake a policy now that will cure that problem [unemployment] in 1981.” Call this the necessary byproduct view: defeating inflation is the number one priority, and any action to put people back to work would raise inflationary expectations. Growth and full employment could be pursued once inflation was licked. But there was more to it than that. Even after prices stabilized, full employment would not mean what it once had. As late as 1986, unemployment was still 6.6 percent, the Reagan boom notwithstanding. This was the practical embodiment of Milton Friedman’s idea that there was a natural rate of unemployment, and attempts to go below it would always cause inflation (for this reason, the concept is known as NAIRU or non-accelerating inflation rate of unemployment). The logic here is plain: there need to be millions of unemployed workers for the economy to work as it should.

I want to make two points about Volcker’s policy. The first, which I made in my book Free Banking and Monetary Reform over 30 years ago, and which I have reiterated in several posts on this blog and which I discussed in my recent paper “Rules versus Discretion in Monetary Policy Historically Contemplated” (for an ungated version click here) is that using a quantity instrument to tighten monetary policy, as advocated by Milton Friedman, and acquiesced in by Volcker, induces expectations about the future actions of the monetary authority that undermine the policy and render it untenable. Volcker eventually realized the perverse expectational consequences of trying to implement a monetary policy using a fixed rule for the quantity instrument, but his learning experience in following Friedman’s advice needlessly exacerbated and prolonged the agony of the 1982 downturn for months after inflationary expectations had been broken.

The problem was well-known in the nineteenth century thanks to British experience under the Bank Charter Act that imposed a fixed quantity limit on the total quantity of banknotes issued by the Bank of England. When the total of banknotes approached the legal maximum, a precautionary demand for banknotes was immediately induced by those who feared that they might not later be able to obtain credit if it were needed because the Bank of England would be barred from making additional credit available.

Here is how I described Volcker’s Monetarist experiment in my book.

The danger lurking in any Monetarist rule has been perhaps best summarized by F. A. Hayek, who wrote:

As regards Professor Friedman’s proposal of a legal limit on the rate at which a monopolistic issuer of money was to be allowed to increase the quantity in circulation, I can only say that I would not like to see what would happen if under such a provision it ever became known that the amount of cash in circulation was approaching the upper limit and therefore a need for increased liquidity could not be met.

Hayek’s warnings were subsequently borne out after the Federal Reserve Board shifted its policy from targeting interest rates to targeting the monetary aggregates. The apparent shift toward a less inflationary monetary policy, reinforced by the election of a conservative, antiinflationary president in 1980, induced an international shift from other currencies into the dollar. That shift caused the dollar to appreciate by almost 30 percent against other major currencies.

At the same time the domestic demand for deposits was increasing as deregulation of the banking system reduced the cost of holding deposits. But instead of accommodating the increase in the foreign and domestic demands for dollars, the Fed tightened monetary policy. . . . The deflationary impact of that tightening overwhelmed the fiscal stimulus of tax cuts and defense buildup, which, many had predicted, would cause inflation to speed up. Instead the economy fell into the deepest recession since the 1930s, while inflation, by 1982, was brought down to the lowest levels since the early 1960s. The contraction, which began in July 1981, accelerated in the fourth quarter of 1981 and the first quarter of 1982.

The rapid disinflation was bringing interest rates down from the record high levels of mid-1981 and the economy seemed to bottom out in the second quarter, showing a slight rise in real GNP over the first quarter. Sticking to its Monetarist strategy, the Fed reduced its targets for monetary growth in 1982 to between 2.5 and 5.5 percent. But in January and February, the money supply increased at a rapid rate, perhaps in anticipation of an incipient expansion. Whatever its cause, the early burst of the money supply pushed M-1 way over its target range.

For the next several months, as M-1 remained above its target, financial and commodity markets were preoccupied with what the Fed was going to do next. The fear that the Fed would tighten further to bring M-1 back within its target range reversed the slide in interest rates that began in the fall of 1981. A striking feature of the behavior of interest rates at that time was that credit markets seemed to be heavily influenced by the announcements every week of the change in M-1 during the previous week. Unexpectedly large increases in the money supply put upward pressure on interest rates.

The Monetarist explanation was that the announcements caused people to raise their expectations of inflation. But if the increase in interest rates had been associated with a rising inflation premium, the announcements should have been associated with weakness in the dollar on foreign exchange markets and rising commodities prices. In fact, the dollar was rising and commodities prices were falling consistently throughout this period – even immediately after an unexpectedly large jump in M-1 was announced. . . . (pp. 218-19)

I pause in my own earlier narrative to add the further comment that the increase in interest rates in early 1982 clearly reflected an increasing liquidity premium, caused by the reduced availability of bank reserves, making cash desirable to hold than real assets thereby inducing further declines in asset values.

However, increases in M-1 during July turned out to be far smaller than anticipated, relieving some of the pressure on credit and commodities markets and allowing interest rates to begin to fall again. The decline in interest rates may have been eased slightly by . . . Volcker’s statement to Congress on July 20 that monetary growth at the upper range of the Fed’s targets would be acceptable. More important, he added that he Fed was willing to let M-1 remain above its target range for a while if the reason seemed to be a precautionary demand for liquidity. By August, M-1 had actually fallen back within its target range. As fears of further tightening by the Fed subsided, the stage was set for the decline in interest rates to accelerate, [and] the great stock market rally began on August 17, when the Dow . . . rose over 38 points [almost 5%].

But anticipation of an incipient recovery again fed monetary growth. From the middle of August through the end of September, M-1 grew at an annual rate of over 15 percent. Fears that rapid monetary growth would induce the Fed to tighten monetary policy slowed down the decline in interest rates and led to renewed declines in commodities price and the stock market, while pushing up the dollar to new highs. On October 5 . . . the Wall Street Journal reported that bond prices had fallen amid fears that the Fed might tighten credit conditions to slow the recent strong growth in the money supply. But on the very next day it was reported that the Fed expected inflation to stay low and would therefore allow M-1 to exceed its targets. The report sparked a major decline in interest rates and the Dow . . . soared another 37 points. (pp. 219-20)

The subsequent recovery, which began at the end of 1982, quickly became very powerful, but persistent fears that the Fed would backslide, at the urging of Milton Friedman and his Monetarist followers, into its bad old Monetarist habits periodically caused interest-rate spikes reflecting rising liquidity premiums as the public built up precautionary cash balances. Luckily, Volcker was astute enough to shrug off the overwrought warnings of Friedman and other Monetarists that rapid increases in the monetary aggregates foreshadowed the imminent return of double-digit inflation.

Thus, the Monetarist obsession with controlling the monetary aggregates senselessly prolonged an already deep recession that, by Q1 1982, had already slain the inflationary dragon, inflation having fallen to less than half its 1981 peak while GDP actually contracted in nominal terms. But because the money supply was expanding at a faster rate than was acceptable to Monetarist ideology, the Fed continued in its futile but destructive campaign to keep the monetary aggregates from overshooting their arbitrary Monetarist target range. It was not until Volcker in summer of 1982 finally and belatedly decided that enough was enough and announced that the Fed would declare victory over inflation and call off its Monetarist campaign even if doing so meant incurring Friedman’s wrath and condemnation for abandoning the true Monetarist doctrine.

Which brings me to my second point about Volcker’s policy. While it’s clear that Volcker’s decision to adopt control over the monetary aggregates as the focus of monetary policy was disastrously misguided, monetary policy can’t be conducted without some target. Although the Fed’s interest rate can serve as a policy instrument, it is not a plausible policy target. The preferred policy target is generally thought to be the rate of inflation. The Fed after all is mandated to achieve price stability, which is usually understood to mean targeting a rate of inflation of about 2%. A more sophisticated alternative would be to aim at a suitable price level, thereby allowing some upward movement, say, at a 2% annual rate, the difference between an inflation target and a moving price level target being that an inflation target is unaffected by past deviations of actual from targeted inflation while a moving price level target would require some catch up inflation to make up for past below-target inflation and reduced inflation to compensate for past above-target inflation.

However, the 1981-82 recession shows exactly why an inflation target and even a moving price level target is a bad idea. By almost any comprehensive measure, inflation was still positive throughout the 1981-82 recession, though the producer price index was nearly flat. Thus, inflation targeting during the 1981-82 recession would have been almost as bad a target for monetary policy as the monetary aggregates, with most measures of inflation showing that inflation was then between 3 and 5 percent even at the depth of the recession. Inflation targeting is thus, on its face, an unreliable basis for conducting monetary policy.

But the deeper problem with targeting inflation is that seeking to achieve an inflation target during a recession, when the very existence of a recession is presumptive evidence of the need for monetary stimulus, is actually a recipe for disaster, or, at the very least, for needlessly prolonging a recession. In a recession, the goal of monetary policy should be to stabilize the rate of increase in nominal spending along a time path consistent with the desired rate of inflation. Thus, as long as output is contracting or increasing very slowly, the desired rate of inflation should be higher than the desired rate over the long-term. The appropriate strategy for achieving an inflation target ought to be to let inflation be reduced by the accelerating expansion of output and employment characteristic of most recoveries relative to a stable expansion of nominal spending.

The true goal of monetary policy should always be to maintain a time path of total spending consistent with a desired price-level path over time. But it should not be the objective of the monetary policy to always be as close as possible to the desired path, because trying to stay on that path would likely destabilize the real economy. Market monetarists argue that the goal of monetary policy ought to be to keep nominal GDP expanding at that whatever rate is consistent with maintaining the desired long-run price-level path. That is certainly a reasonable practical rule for monetary policy, but the policy criterion I have discussed here would, at least in principle, be consistent with a more activist approach in which the monetary authority would seek to hasten the restoration of full employment during recessions by temporarily increasing the rate of monetary expansion and in nominal GDP as long as real output and employment remained below the maximum levels consistent with desired price level path over time. But such a strategy would require the monetary authority to be able to fine tune its monetary expansion so that it was tapered off just as the economy was reaching its maximum sustainable output and employment path. Whether such fine-tuning would be possible in practice is a question to which I don’t think we now know the answer.

 

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Ralph Hawtrey Wrote the Book that Arthur Burns Should Have Read — but Didn’t

In my previous post I wrote about the mistakes made by Arthur Burns after Nixon appointed him Chairman of the Federal Reserve Board. Here are the critical missteps of Burns’s unfortunate tenure.

1 Upon becoming chairman in January 1970, with inflation running at over 5% despite a modest tightening by his predecessor in 1969, Burns further tightened monetary policy, causing a downturn and a recession lasting the whole of 1970. The recession was politically damaging to Nixon, leading to sizable Republican losses in the November midterm elections, and causing Nixon to panic about losing his re-election bid in 1972. In his agitation, Nixon then began badgering Burns to loosen monetary policy.

2 Yielding to Nixon’s demands for an easing of monetary policy, Burns eased monetary policy sufficiently to allow a modest recovery to get under way in 1971. But the recovery was too tepid to suit Nixon. Fearing the inflationary implications of a further monetary loosening, Burns began publicly lobbying for the adoption of an incomes policy to limit the increase of wages set by collective bargaining between labor unions and major businesses.

3 Burns’s unwillingness to provide the powerful stimulus desired by Nixon until an incomes policy was in place to hold down inflation led Nixon to abandon his earlier opposition to wage-and-price controls. On August 15, 1971 Nixon imposed a 90-day freeze on all wages and prices to be followed by comprehensive wage-and-price controls. With controls in place, Burns felt secure in accelerating the rate of monetary expansion, leaving it to those controlling wages and prices to keep inflation within acceptable bounds.

4 With controls in place, monetary expansion at first fueled rapid growth of output, but as time passed, the increase in spending was increasingly reflected in inflation rather than output growth. By Q4 1973, inflation rose to 7%, a rate only marginally affected by the Arab oil embargo on oil shipments to the United States and a general reduction in oil output, which led to a quadrupling of oil prices by early 1974.

5 The sharp oil-price increase simultaneously caused inflation to rise sharply above the 7% rate it had reached at the end of 1973 even as it caused a deep downturn and recession in the first quarter of 1974. Rather than accommodate the increase in oil prices by tolerating a temporary increase in inflation, Burns sharply tightened monetary policy reducing the rate of monetary expansion so that the rate of growth of total spending dropped precipitously. Given the increase in oil prices, the drop in total spending caused a major contraction in output and employment, resulting in the deepest recession since 1937-38.

These mistakes all stemmed from a failure by Burns to understand the rationale of an incomes policy. Burns was not alone in that failure, which was actually widespread at the time. But the rationale for such a policy and the key to its implementation had already been spelled out cogently by Ralph Hawtrey in his 1967 diagnosis of the persistent failures of British monetary policy and macroeconomic performance in the post World War II period, failures that had also been deeply tied up in the misunderstanding of the rationale for – and the implementation of — an incomes policy. Unlike Burns, Hawtrey did not view an incomes policy as a substitute for, or an alternative to, monetary policy to reduce inflation. Rather, an incomes policy was precisely the use of monetary policy to achieve a rate of growth in total spending and income that could be compatible with full employment, provided the rate of growth of wages was consistent with full employment.

In Burns’s understanding, the role of an incomes policy was to prevent wage increases from driving up production costs so high that businesses could not operate profitably at maximum capacity without a further increase in inflation by the Federal Reserve. If the wage increases negotiated by the unions exceeded the level compatible with full employment at the targeted rate of inflation, businesses would reduce output and lay off workers. Faced with that choice, the Fed or any monetary authority would be caught in the dreaded straits of Scylla and Charybdis (aka between a rock and a hard place).

What Burns evidently didn’t understand, or chose to ignore, was that adopting an incomes policy to restrain wage increases did not allow the monetary authority to implement a monetary policy that would cause nominal GDP to rise at a rate faster than was consistent with full employment at the target rate of inflation. If, for example, the growth of the labor force and the expected increase in productivity was consistent with a 4% rate of real GDP growth over time and the monetary authority was aiming for an inflation rate no greater than 3%, the monetary authority could not allow nominal GDP to grow at a rate above 7%.

This conclusion is subject to the following qualification. During a transition from high unemployment to full employment, a faster rate of nominal GDP growth than the posited 7% rate could hasten the restoration of full employment. But temporarily speeding nominal GDP growth would also require that, as a state of full employment was approached, the growth of nominal GDP be tapered off and brought down to a sustainable rate.

But what if an incomes policy does keep the rate of increase in wages below the rate consistent with 3% inflation? Could the monetary authority then safely conduct a monetary policy that increased the rate of nominal GDP growth in order to accelerate real economic growth without breaching the 3% inflation target? Once again, the answer is that real GDP growth can be accelerated only as long as sufficient slack remains in an economy with less than full employment so that accelerating spending growth does not result in shortages of labor or intermediate products. Once shortages emerge, wages or prices of products in short supply must be raised to allocate resources efficiently and to prevent shortages from causing production breakdowns.

Burns might have pulled off a remarkable feat by ensuring Nixon’s re-election in 1972 with a massive monetary stimulus causing the fastest increase in nominal real GDP since the Korean War in Q4 of 1972, while wage-and-price controls ensured that the monetary stimulus would be channeled into increased output rather than accelerating inflation. But that strategy was viable only while sufficient slack remained to allow additional spending to call forth further increases in output rather than cause either price increases, or, if wages and prices are subject to binding controls, shortages of supply. Early in 1973, as inflation began to increase and real GDP growth began to diminish, the time to slow down monetary expansion had arrived. But Burns was insensible to the obvious change in conditions.

Here is where we need to focus the discussion directly on Hawtrey’s book Incomes and Money. By the time Hawtrey wrote this book – his last — at the age of 87, he had long been eclipsed not only in the public eye, but in the economics profession, by his slightly younger contemporary and fellow Cambridge graduate, J. M. Keynes. For a while in the 1920s, Hawtrey might have been the more influential of the two, but after The General Theory was published, Hawtrey was increasingly marginalized as new students no longer studied Hawtrey’s writing, while older economists, who still remembered Hawtrey and were familiar with his work, gradually left the scene. Moreover, as a civil servant for most of his career, Hawtrey never collected around himself a group disciples who, because they themselves had a personal stake in the ideas of their mentor, would carry on and propagate those ideas. By the end of World War II, Hawtrey was largely unknown to younger economists.

As a graduate student in the early 1970s, Hawtrey’s name came only occasionally to my attention, mostly in the context of his having been a notable pre-Keynesian monetary theorist whose ideas were of interest mainly to historians of thought. My most notable recollection relating to Hawtrey was that in a conversation with Hayek, whose specific context I no longer recall, Hayek mentioned Hawtrey to me as an economist whose work had been unduly neglected and whose importance was insufficiently recognized, even while acknowledging that he himself had written critically about what he regarded as Hawtrey’s overemphasis on changes in the value of money as the chief cause of business-cycle fluctuations.

It was probably because I remembered that recommendation that when I was in Manhattan years later and happened upon a brand new copy of Incomes and Money on sale in a Barnes and Noble bookstore, I picked it up and bought it. But buying it on the strength of Hayek’s recommendation didn’t lead me to actually read it. I actually can’t remember when I finally did read the book, but it was likely not until after I discovered that Hawtrey had anticipated the gold-appreciation theory of the Great Depression that I had first heard, as a graduate student, from Earl Thompson.

In Incomes and Money, Hawtrey focused not on the Great Depression, which he notably had discussed in earlier books like The Gold Standard and The Art of Central Banking, but on the experience of Great Britain after World War II. That experience was conditioned on the transition from the wartime controls under which Britain had operated in World War II to the partial peacetime decontrol under the Labour government that assumed power at the close of World War II. One feature of wartime controls was that, owing to the shortages and rationing caused by price controls, substantial unwanted holdings of cash were accumulating in the hands of individuals unable to use their cash to purchase desired goods and services.

The US dollar and the British pound were then the two primary currencies used in international trade, but as long as products were in short supply because of price controls, neither currency could serve as an effective medium of exchange for international transactions, which were largely conducted via managed exchange or barter between governments. After the war, the US moved quickly to decontrol prices, allowing prices to rise sufficiently to eliminate excess cash, thereby enabling the dollar to again function as an international medium of exchange and creating a ready demand to hold dollar balances outside the US. The Labour government being ideologically unwilling to scrap price controls, excess holdings of pounds within Britain could only be disposed of insofar as they could be exchanged for dollars with which products could be procured from abroad.

There was therefore intense British demand for dollars but little or no American demand for pounds, an imbalance reflected in a mounting balance-of-payments deficit. The balance-of-payments deficit was misunderstood and misinterpreted as an indication that British products were uncompetitive, British production costs (owing to excessive British wages) supposedly being too high to allow the British products to be competitive in international markets. If British production costs were excessive, then the appropriate remedy was either to cut British wages or to devalue the pound to reduce the real wages paid to British workers. But Hawtrey maintained that the balance-of-payments deficit was a purely monetary phenomenon — an excess supply of pounds and an excess demand for dollars — that could properly be remedied either by withdrawing excess pounds from the holdings of the British public or by decontrolling prices so that excess pounds could be used to buy desired goods and services at market-clearing prices.

Thus, almost two decades before the Monetary Approach to the Balance of Payments was developed by Harry Johnson, Robert Mundell and associates, Hawtrey had already in the 1940s anticipated its principal conclusion that a chronic balance-of-payments disequilibrium results from a monetary policy that creates either more or less cash than the public wishes to hold rather than a disequilibrium in its exchange rate. If so, the remedy for the disequilibrium is not a change in the exchange rate, but a change in monetary policy.

In his preface to Incomes and Money, Hawtrey set forth the main outlines of his argument.

This book is primarily a criticism of British monetary policy since 1945, along with an application of the criticism to questions of future policy.

The aims of policy were indicated to the Radcliffe Committee in 1957 in a paper on Monetary Policy and the Control of Economic Conditions: “The primary object of policy has been to combine a high and stable level of employment with a satisfactory state of the balance of payments”. When Sir Robert Hall was giving oral evidence on behalf of the Treasury, Lord Radcliffe asked, ”Where does sound money as an objective stand?” The reply was that “there may well be a conflict between the objective of high employment and the objective of sound money”, a dilemma which Treasury did not claim to have solved.

Sound money here meant price stability, and Sir Robert Hall admitted that “there has been a practically continuous rise in the price level. The rise in prices of manufactures since 1949 had in fact been 40 percent. The wage level had risen 70 percent.

Government pronouncements ever since 1944 had repeatedly insisted that wages ought not to rise more than in proportion to productivity. This formula meaning in effect price level of home production, embodies the incomes policy which is now professed by all parties. But it has never been enforced through monetary policy. It has only been enjoined by exhortation and persuasion. (p. ix)

The lack of commitment to a policy of stabilizing the price level was the key point for Hawtrey. If policy makers desired to control the rise in the price level by controlling the increase in incomes, they could, in Hawtrey’s view, only do so by way of a monetary policy whose goal was to keep total spending (and hence total income) at a level – or on a path – that was consistent with the price-level objective that policy-makers were aiming for. If there was also a goal of full employment, then the full-employment goal could be achieved only insofar as the wage rates arrived at in bargaining between labor and management were consistent with the targeted level of spending and income.

Incomes policy and monetary policy cannot be separated. Monetary policy includes all those measures by which the flow of money can be accelerated or retarded, and it is by them that the money value of a given structure of incomes is determined. If monetary policy is directed by some other criterion than the desired incomes policy, the income policy gives way to the other criterion. In particular, if monetary policy is directed to maintaining the money unit at a prescribed exchange rate parity, the level of incomes will adapt itself to this parity and not to the desired policy.

When the exchange parity of sterling was fixed in 1949 at $2.80, the pound had already been undervalued at the previous rate of $4.03. The British wage level was tied by the rate of exchange to the American. The level of incomes was predetermined, and there was no way for an incomes policy to depart from it. Economic forces came into operation to correct the undervaluation by an increase in the wage level. . . .

It was a paradox that the devaluation, which had been intended as a remedy for an adverse balance of payments, induced an inflation which was liable itself to cause an adverse balance. The undervaluation did indeed swell the demand for British exports, but when production passed the limit of capacity, and output could not be further increased, the monetary expansion continued by its own momentum. Demand expanded beyond output and attracted an excess of imports. There was no dilemma, because the employment situation and the balance of payments situation both required the same treatment, a monetary contraction. The contraction would not cause unemployment, provided it went no further than to eliminate over-employment.

The White Paper of 1956 on the Economic Implications of Full Employment, while confirming the Incomes Policy of price stabilization, placed definitely on the Government the responsibility for regulating the pressure of demand through “fiscal, monetary and social policies”. The Radcliffe Committee obtained from the Treasury the admission that this was not being done. No measures other than persuasion and exhortation were being taken to give effect to the incomes policy. Reluctant as the authorities were to resort to deflation, they nevertheless imposed a Bank rate of 7 per cent and other contractive measures to cope with a balance of payments crisis at the very moment when the Treasury representative were appearing before the Committee. But that did not mean that they were prepared to pursue a contractive policy in support of the incomes policy. The crises of 1957 and 1961 were no more than episodes, temporarily interfering with the policy of easy credit and expansion. The crisis of 1964-6 has been more than an episode, only because the deflationary measures were long delayed, and when taken, were half-hearted.

It would be unfair to impute the entire responsibility for these faults of policy to Ministers. They are guided by their advisers, and they can plead in their defence that their misconceptions have been shared by the vast majority of economists. . . .

The fault of traditional monetary theory has been that it is static, and that is still true of Keynes’s theory. But a peculiarity of monetary policy is that, whenever practical measures have to be taken, the situation is always one of transition, when the conditions of static equilibrium have been departed from. The task of policy is to decide the best way to get back to equilibrium, and very likely to choose which of several alternative equilibrium positions to aim at. . . .

An incomes policy, or a wages policy, is the indispensable means of stabilizing the money unit when an independent metallic standard has failed us. Such a policy can only be given effect by a regulation of credit. The world has had long experience of the regulation of credit for the maintenance of a metallic standard. Maintenance of a wages standard requires the same instruments but will be more exacting because it will be guided by many symptoms instead of exclusively by movements of gold, and because it will require unremitting vigilance instead of occasional interference. (pp. ix-xii)

The confusion identified by Hawtrey between an incomes policy aiming at achieving a level of income consistent with full employment at a given level of wages by the appropriate conduct of monetary policy and an incomes policy aiming at the direct control of wages was precisely the confusion that led to the consistent failure of British monetary policy after World War II and to the failure of Arthur Burns. The essence of an incomes policy was to control total spending by way of monetary policy while gaining the cooperation of labor unions and business to prevent wage increases that would be inconsistent with full employment at the targeted level of income. Only monetary policy could determine the level of income, and the only role of exhortation and persuasion or direct controls was to prevent excessive wage increases that would prevent full employment from being achieved at the targeted income level.

After the 1949 devaluation, the Labour government appealed to the labour unions, its chief constituency, not to demand wage increases larger than productivity increases, so that British exporters could maintain the competitive advantage provided them by devaluation. Understanding the protectionist motive for devaluation was to undervalue the pound with a view to promoting exports and discouraging imports, Hawtrey also explained why the protectionist goal had been subverted by the low interest-rate, expansionary monetary policy of the Labour government to keep unemployment well below 2 percent.

British wages rose therefore not only because the pound was undervalued, but because monetary expansion increased aggregate demand faster than the British productive capacity was increasing, adding further upward pressure on British wages and labor costs. Excess aggregate demand in Britain also meant that domestic output that might have been exported was instead sold to domestic customers, while drawing imports to satisfy the unmet demands of domestic consumers, so that the British trade balance showed little improvement notwithstanding a 40% devaluation.

In this analysis, Hawtrey anticipated Max Corden’s theory of exchange-rate protection in identifying the essential mechanism by which to manipulate a nominal exchange rate so as to subsidize the tradable-goods sector (domestic export industries and domestic import-competing industries) as a tight-money policy that creates an excess demand for cash, thereby forcing the public to reduce spending as they try to accumulate the desired increases in cash holdings. The reduced demand for home production as spending is reduced results in a shift of productive resources from the non-tradable- to the tradable-goods sector.

To sum up, what Burns might have learned from Hawtrey was that even if some form of control of wages was essential for maintaining full employment in an economic environment in which strong labor unions could bargain effectively with employers, that control over wages did not — and could not — free the central bank from its responsibility to control aggregate demand and the growth of total spending and income.


About Me

David Glasner
Washington, DC

I am an economist in the Washington DC area. My research and writing has been mostly on monetary economics and policy and the history of economics. In my book Free Banking and Monetary Reform, I argued for a non-Monetarist non-Keynesian approach to monetary policy, based on a theory of a competitive supply of money. Over the years, I have become increasingly impressed by the similarities between my approach and that of R. G. Hawtrey and hope to bring Hawtrey's unduly neglected contributions to the attention of a wider audience.

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