APPENDIX E EXECUTIVE OFFICE OF THE PRESIDENT, Hon. JOSEPH C. O'MAHONEY, Chairman, Joint Committee on the Economic Report, Senate Office Building, Washington, D. C. DEAR MR. CHAIRMAN: Through the kind consideration of Mr. Lehman, the clerk of the joint committee, we have received the report of its staff entitled "Monetary Policy and Economic Mobilization," and a request for the comment and views of the members of the Council of Economic Advisers thereon. Because he is out of the city, until after the deadline set for our response, Mr. Blough has not been able to participate in the preparation of this reply. Our approach to the problem of monetary policy has never been limited to the consideration of the immediate effects of a specific measure in curbing inflationary forces or in counteracting a deflationary movement. Under the Employment Act of 1946, our responsibility, which the joint committee particularly will appreciate, is to work with others toward the coordination of all of the plans, functions, and resources of the Federal Government to promote maximum employment, production, and purchasing power on a sustained basis. The specific mandate of the Council is to appraise all of the various policies and activities of Government in the light of this principle of the Employment Act and to make recommendations to the President. Monetary policy is one of these policies. It cannot be considered apart from all others but must be integrated with them in the effort to influence, through Government programs, our enormous and complex economy, and to maintain it on the course leading to the goal of the Employment Act. Our broader point of view was presented to the joint committee in February 1950, in a special report which you requested for inclusion in the hearings upon the January 1950 Economic Report of the President. We were then discussing the monetary policy which might be appropriate if an inflationary movement were to develop under peacetime conditions. Accepting the principle that in the long run the basic solution to the shortages which initiate or aggravate inflation is to increase the supply of goods, we made these points: 1. That a vital requirement is that the credit of the Government be preserved against doubts, and that the confidence of present holders of Government bonds and of potential investors must not be shaken by the sight of falling market prices induced by raises in interest rates through Federal Reserve action. The increase in the interest burden forced upon the Treasury as it refunds billions of maturing securities or as it issues new bonds when deficit finncing is required is not the principal vice of this kind of monetary policy. We are not even greatly concerned that the increasing of interest rates increases the profits of bondholders and raises the price charged by bankers and investors for what they sell (credit) at a time when everyone else is being urged to hold down his prices and profits. The greater damage to our fiscal program lies in the fact that at a time when there would be no difficulty in supporting the Government bond market at a level permitting new issues at no change in interest rates, the price of the oustanding securities is lowered, the Government bond market is shaken, and doubts arise which if not quieted could impair the Government credit. This kind of monetary policy, at a time when the existing pattern of interest rates could easily be supported, is not justified in our opinion if its positive contribution to an anti-inflation program is as dubious and as imponderable as advocates of the policy say it is, particularly when other measures are available which act more positively and which have fewer undesirable consequences. 2. That a plan to dampen inflationary forces by increasing interest rates means to increase the cost of new capital to most borrowers indiscriminately, and to jeopardize new investment in basic productive facilities at a rate which should be encouraged rather than impeded under current conditions. Unlike selective controls, which may be directed at the very point where restraint should be imposed, the maneuvers of the central bank to manipulate interest rates affect the businessman who plans to expand his plant and facilities along lines of national need as well as the firm which wishes to speculate in large inventories. Indeed, higher interest rates are more apt to discourage worth-while new investment, which is conservatively planned, than to dampen the more speculative projects. This aspect of monetary policy has now assumed major importance, but even in the less urgent circumstances of a peacetime inflation, as we said in our February report, it raises a challenge to the policy of increasing interest rates. 3. That preferable measures, such as the tightening of credit on a selective basis need not involve increasing the cost of new capital to businessmen whose projects should be encouraged. Even though such tighter credit would mean that some desirable economic expansion would be impeded, the contribution of such a measure to the anti-inflationary program might be substantial enough to make it desirable during a temporary inflation. This judgment led the Council, as we mentioned in the February 1950 report, to support the proposal of the Federal Reserve Board in 1947 for a special bank reserve requirement, and we have continued to recommend legislation for this purpose in order that the Board might always have this power to use when need arose. For reasons which we present later, we do not believe that the power, if granted, should be used under present circumstances. Such were our general views last February. However, the inflationary problem has now assumed a very different guise from that we were considering last February, and this calls for a reconsideration. We are not dealing with a temporary situation, but with inflationary pressures arising from a Government program of very large defense expenditures which for years to come will require the extensive diversion of production from civilian demand to Government purposes. Economic stabilization under such conditions will never come until production has been enlarged impressively; and every measure proposed to curb inflation must be evaluated far more critically than in peacetime in the light of its effect in impeding the expansion of productive capacity. The process of evaluation will be but little aided by old formulas and concepts. No policy has ever been tested in the environment in which we move today. The staff of the joint committee has done well to emphasize this feature of the pattern within which the proposed hearings should proceed. Monetary policy cannot be considered solely from the standpoint of its anti-inflationary effect. Yet it is very seldom that in any article, statement, or address by an advocate of traditional anti-inflationary action by the central bank is there any reference to the need to encourage economic expansion. But when the same experts discuss anything except monetary policy, they often match the vigor of the Council of Economic Advisers in asserting that every policy must be devised with expansion in view. An example is an editorial in Business Week, November 18, 1950, in which it is said: "Production rather than regulation is the solution to our problems. Our national economy is strong because it's active and growing. It won't be made stronger by putting handcuffs on it. * * * We must convince Washington that peril lies in reliance on controls and cut-backs. The answer to our problem stui is production and more production. To get that, we need to keep on expanding our capacity. For only by industrial expansion to meet all needs fully can we prevent one control begetting another and another and another until the whole economy is throttled." We believe the proposed hearings of the joint committee will be most productive, if the focus is the role which should be played by the banking system of the country in the long effort to expand national production until it supplies the goods and services required by the defense program and at the same time meets the market demands of industry and consumers. The expansion of bank credit in recent months is treated as an unmixed evil in the communications from experts which are attached to the staff report. No one notes the heartening fact that the industrial production index was increasing from 196 in July to 212 in October. If we want industrial production to expand, we should not bewail without qualification the financial changes which inevitably accompany the process. Our banking system is a vital part of the machinery of economic activity, and ony in a temporary emergency should it be prevented from performing its function the source of business credit and of new capital for economic expansion. The tightening of bank credit, as by increasing reserve requirements, has effect as a eurb of inflationary forces only if it causes the banker to refuse loans which he would otherwise find desirable and prudent. The increasing of interest rates, if it restricts bank credit, does so by causing the businessman to desist, on account of capital cost, from a business program which he and his banker would have approved as prudent and desirable. Neither method of limiting bank credit should now be used. They are not consistent with genuine economic expansion. Our stress upon economic expansion should not be misconstrued as lack of recognition that some kinds of expansion, in commercial as well as consumer activity, must be delayed and retarded on the basis of the defense program. Further, even the achievement of necessary basic expansion in some areas will require materials and manpower which can be made available quickly only through restrictions elsewhere. Nonetheless, the net objective for the economy as a whole, and particularly for the industrial sector, must be constant expansion at the highest feasible rate. There is no other way to meet the tremendous burdens of a defense program for an indefinite number of years without disorganization and ultimate loss of our great economic power. Selective controls are available which not only apply restraint at the very points of economic activity which may well be dampened, but which also act more positively and effectively than do general credit controls. The aggressive use by the Federal Reserve Board of its power to regulate consumer credit and to regulate credit for new housing meets the requirements of what is, in our opinion, a sound policy for the restraint of credit. Monetary policy should not be expected to carry the full burden of anti-inflationary controls, but there are other selective controls, such as the restriction of credit for inventory buying, and the limiting of credit for commodity exchange trading, which can be added to those already in force. If still further types of selective credit restraints prove to be needed, legislation to authorize them should be considered. In 1948 it was shown that the bankers respond to appeals that they adopt conservative loan policies in a period of inflation. We believe that they will be influenced by the statement just issued by the Chairman of the Federal Reserve Board, particularly because they know that the Board has not exhausted all of the power to control credit selectively which has recently been used effectively in regulations W and X. There are many points in the excellent report of the staff of the joint committee and in the interesting communications from experts which require consideration, but which we shall not undertake to discuss at this time. The committee will be especially interested, we believe, in two questions which they raise. 1. What reason is there to believe that any important anti-inflationary pressure will be exerted by an increase in short-term rates, within the very limited range which is possible if it is the policy of the Federal Reserve Board to support the 21⁄2 percent long-term rate? 2. Is it a valid assumption that the alternative we actually face is between permitting destructive inflation or utilizing some power of the central bank to control inflation by raising interest rates? In considering these questions the committee should note a shift of position by some of those who advocate higher short-term interest rates. The original argument was that higher interest cost discourages the businessman borrower. Now it is that the banker (to use the phrase of one of the experts) is bought off from selling Governments if he is paid more interst and that this will tighten his disposition toward loans if he would have to add to his reserve before he could extend more credit. The new theory runs into many difficulties when it is set up against the actual financial position and attitudes of bankers. It has now been buttressed by a collateral proposal which requires continued lifting of short-term rates, because its effectiveness disappears whenever the rate is stabilized. In a candid state ment before a trade association on November 14, 1950, Lewis H. Brown, from his vantage point as a director of the Federal Reserve Bank of New York, described recent Federal Reserve policy and its rationale. After telling how the banker will make all attractive loans so long as he can secure funds by selling Governments without loss and perhaps at a profit, Mr. Brown said: "But suppose the Federal Reserve backed away now and then, suppose it said, 'Well, we'll buy the securities, but we won't pay the price you paid for them. We'll just pay a little less than we did last week, and maybe next week the price will be a little lower.' The banker is certainly not going to stop making all loans, and nobody wants him to stop completely. "But, perhaps, he'll begin to ration them a bit. Perhaps he'll cut out some of the marginal business he's been taking, such as some of the loans to finance speculative accumulation of inventory. If he does, that's as much as could be hoped for; and by just that much the operation works to restrain the expansion of credit.' If this is the meager performance as an anti-inflationary device which can be credited to the policy urged, there is little justification for asserting that our choice is between successfully curbing inflation by increasing interest rates on the one hand, or on the other hand permitting inflation with its evil effects upon defense expenditures because we stabilize interest rates at a low level. Instead of sanctioning a policy which would tend to compel the Treasury to find buyers each week |