Case Scenario: MONETARY POLICY ERRORS OF THE 1970S

It is sometimes claimed that the Fed cannot set interest rates by fiat, and hence cannot be accused of contributing materially to business cycle fluctuations. That is not entirely true, though, because the Fed can move the Federal funds rate far away from its equilibrium value for extended periods of time. Even more to the point, the Fed could set money supply growth by fiat in the period before banking deregulation in 1982. Thus in 1972 and 1979, Fed Chairmen Arthur F. Burns and G. William Miller bowed to political pressure and permitted the money supply to grow much faster than was commensurate with non-inflationary policy. As a result, inflation zoomed the next year, and the economy went into recession shortly thereafter. During the first half of 1970, the growth rate in M2 had declined to 2%. As soon as the recession got underway, that pattern was abruptly reversed, and by the end of 1971, M2 was rising at a 14% annual rate. Nonetheless, the recovery in 1971 was unusually sluggish.

As already described, Nixon imposed price controls on August 15, 1971,16 devalued the dollar, instituted an expansionary fiscal program - and demanded that the Fed keep interest rates low. The increase in inflation that would have otherwise occurred during 1972 was suppressed by wage and price controls, but inflation then started to rise sharply during 1973 even though controls remained in place, and then burst into flame in 1974, rising to 12%. Eventually Burns reduced growth in the money supply and boosted the Federal funds rate to 13%, which intensified the recession. While the real growth rate would have diminished because of the first energy crisis in any case, the inaccurate policies of the Fed - including the support for controls by the Chairman - made the downturn much more severe. Burns was reappointed Fed Chairman in 1974, but when his four-year term as Chairman ended in 1978, he was not reappointed by Jimmy Carter - ironically, because his monetary policy was viewed as too restrictive by the economists who advised Carter. In his place, G. William Miller was appointed to the post as Fed Chairman. In his first year, Miller did not make any unusual moves in either direction. In early 1979, however, the economy started to slow down, and Miller decided he did not want a recession to start on his watch. As a result, he boosted money supply (M2) growth from 61 2% to 91 2%.

That may not seem like a very large swing relative to the fluctuations earlier in the decade, but that increase was accompanied by a statement from Miller to the effect that he did not want Jimmy Carter to run for reelection in a recession year, and was boosting the growth in the money supply now to boost the real growth rate two to three quarters later - i.e., during the 1980 election campaign. This time, investors did not wait so long to react, possibly because they trusted Carter less than Nixon. In any case, the core inflation rate (excluding food and energy) zoomed from 9% to 13%. Soon it became clear that Miller would have to be replaced. Carter first asked David Rockefeller, who declined the position but recommended Paul Volcker. Shortly after taking over at the Fed, Volcker instituted what became known as the monetary version of the ‘‘Saturday night massacre,'' boosting the Federal funds rate by an unprecedented 3%. Because inflationary expectations had become so thoroughly imbedded in the minds of investors, though, the inflation rate did not budge until Volcker also imposed credit controls. The economy went into a very brief recession in 1980, recovered for a year, and then plunged into a more prolonged downturn in 1981-2. It is clear that the mistakes made by Burns and Miller during the 1970s were the principal reason that real GDP was actually lower at the end of 1982 than it had been in 1979.3, before Volcker was appointed Fed Chairman.