CHAPTER IX

WHAT IS MONETARY POLICY?

133. What is monetary policy?
Monetary policy deals with the operating instructions of the managers of our money factory. Monetary policy is what fits money into the structure of the economy. In specific terms it consists of the decisions the money managers make about the quantity of money, the price of money, and the availability of money. These are the quantities the money managers can manipulate precisely. Of course, the goal of a particular monetary policy at any one time is to steer the economy in the direction desired by the monetary authorities. In the broadest sense, monetary policy can be thought of as manipulation of the money supply in the pursuit of broad economic goals.

134. What types of broad monetary policy are there?
There are two. One is called “passive” and the other “active” monetary policy.

135. What is “passive” monetary policy?
A passive monetary policy is one which does not provide for any day-to-day or year-to-year decisions by money managers to influence the volume or kinds of economic activity. The money supply is not regulated to achieve a specific economic target. This does not mean that interest rates do not move up or down. They do. But these moves of the interest rate do not result from any deliberate action by the monetary authorities.

136. What rules guide the money supply in the passive case?
Broadly speaking, they are automatic, akin to the rules a thermostat follows in controlling a room’s temperature. For example, the system can be told to increase the money supply by, say, 8 percent a year. Or, more complicated rules can be devised.

137. What is “active” monetary policy?
Active monetary policy is the decision of the Government to give its monetary agencies the power and the responsibility to influence the economy, through deliberate and constant adjustments of the monetary mechanism. With active monetary policy, the prevailing level of the money supply and of interest rates at any time, results from a conscious choice by the central bank.

138. What kind of monetary policy has the United States followed in recent years?
An “active” policy.

139. What subtypes of active monetary policy are there?
There are two. One is “tight money policy”—a policy which restricts the money supply in order to decrease its availability and raise the general level of interest rates. The other is “easy money policy,” the opposite of a tight money policy.

140. What kind of action baa been characteristic of Federal Reserve activity?
Generally speaking a “tight money policy.”

141. Is a tight monetary policy a delicate instrument?
No. And this is the cause of much of the controversy about monetary policy. The effects of monetary policy are extremely widespread. For example, a tight money policy works by slowing down the whole economy. Sometimes this is what the Federal Reserve wishes to do. At other times, it is clear that the Federal Reserve is interested only in restricting some particular activity—as was the case with the consumer buying upsurge of 1955 when consumers were devouring autos and other drabbles. In order to restrict consumer buying of durable goods, the Federal Reserve tightened money. But there are times when the Federal Reserve is not interested in restricting consumer buying and, nevertheless, tightens money for other purposes. An example is the period from late 1961—1962. The Federal Reserve tighten money during this period in response to the balance-of-payments deficit. It had no wish to restrict consumer buying. On the contrary, there was widespread concern about sluggish demand and unemployment. But if tight money restricted demand in 1955, it follows that it should have been expected to restrict demand in 1961, and it did. Such is the shotgun effect of tight money that any attempt to use it as a precision tool must fail.

142. Must the money supply grow over the long haul?
Economists unanimously agree that the stock of money will have to grow—probably at about the same rate as the economy—if economic growth is not to be stunted. Failure to provide adequate money will spawn an era marked by deep recessions, abortive recoveries, low investment high interest rates, and chronic unemployment. This long-pull need for adequate growth in the money stock is the first commandment for monetary policy—active or passive.

143. What does the Federal Reserve mean when it says, “It can’t push on the string”?
The Federal Reserve is drawing attention to the fact that while tight money—pulling on the string—can always slow down the economy, easy money cannot always spur the economy. Their argument is that in a depression businessmen become so pessimistic that they are unwilling to borrow for investment despite rock bottom interest rates. At the same time, banks, in a depression, are very choosy about lending. With many businesses on the verge of bankruptcy, good credit risks are hard to find So though the Federal Reserve provides the banks with vast amounts of reserves, the banks, they claim, find it very difficult to place the money with prospective business investors.

144. What kind of monetary policy did the founders of the Federal Reserve think they were encouraging?
Passive. When the Federal Reserve was founded there was no thought, either in or out of Congress, that the country’s monetary policy would be anything but passive. The Federal Reserve System was established to provide automatic increases in the money supply in proportion to the need of trade and commerce. At least that was the theory.

145. What happened to the original concept?
By 1920 Federal Reserve officials were taking at least occasional steps to reduce the supply of money in order to slow down general economic expansion and to effect a reduction in prices which these officials thought desirable. This was but a first step toward an active monetary policy. After the collapse of 1929—1933, the final turn in active versus passive monetary policy came. The Banking Act of 1935 gave final form to the Open Market Committee. With this act the Federal Reserve claimed that Congress had placed responsibility for national monetary and credit policies in the Federal Reserve System. In truth, the 1935 act makes no mention of “monetary policy,” “monetary powers or “monetary controls.” Nor is there any provision suggesting changes in the original monetary policy beyond the Federal Reserve Act of 1913.

146. What were the lessons of World War II about economic policy?
The main lesson was that our country need never again suffer from a prolonged depression like that of the 1930’s. During the war we had full employment and the economy produced gigantic quantities of goods. If we could maintain full employment in wartime why not in peacetime ! Only now our economy can produce goods to eliminate poverty, ignorance, and disease rather than goods or the destructive processes of war. The second lesson was that the Great Depression resulted from the failure of Government to recognize and assume its responsible role in the economy. This included the monetary aspect of Government policy.

147. What did the 1946 Employment Act say about monetary policy?
The act says it would be the policy of the Federal Government “to coordinate and utilize all its plans, functions and resources” to promote “maximum employment, production and purchasing power. And this was to one in a manner calculated to foster and promote free competitive enterprise.” There was no question in anybody’s mind, at the time the act was passed, but that monetary policy would be coordinated with other policies of the Government in the pursuit of full employment. And so they were, until shortly before the famous Treasury-Federal Reserve “accord” of March 4,1951.

148. What was the famous Treasury-Federal Reserve “accord” of March 4, 1951?
It was the culmination of a longrun conflict between administration policy and the Federal Reserve which ended in the Federal Reserve becoming “generally independent” of the policies of the rest of the U.S. Government. From that time on the Federal Reserve undertook to go “its own way” in deciding national monetary policy.

149. What was the result of Federal Reserve “Independence”?
In practical terms the result was to commence a long decade of progressively tighter money. Given its freedom, the Federal Reserve has instinctively chosen to tighten money at every conceivable opportunity. The fact that tight money is a shotgun weapon to be used only for broad economic effects did not deter the newly independent Federal Reserve from trying to aim at specific targets.

150. What is the “bills only” policy?
“Bills only” refers to Federal Reserve Open Market Committee trading in the open market confined to very short-term Government securities, preferably 91-day Treasury bills. This was a move to affect bank reserves, and hence overall credit and the money supply, only through short-term interest rates. Long-term interest rates would be affected, but only indirectly and after a time lag. This, in effect, created a so-called free market in long-term Government securities. The Federal Reserve ceased supporting long-term U.S. Treasury bonds, except in cases where the market became “disorderly” or “threatened” to become disorderly.

151. When was the “bills only” policy abandoned?
Only in February of 1961, after repeated urgings from Congress and the newly elected President Kennedy.

152. In what way can the demise of “bills only” be taken as the end of an era?
It signaled the end of giving priority to controlling inflation and the balance of payments by tight monetary policy. President Kennedy and President Johnson chose other techniques of economic control—such as the tax cut, the accelerated depreciation schedule, operation “twist” the “interest equalization tax” to discourage oversea flows of funds.

153. What is the basic reason the Federal Reserve has continually tightened money?
Fear of inflation. The Federal Reserve has been haunted by the fear of inflation for years. There is very little evidence to justify this fear. The economy has paid heavily to ease the inflation nightmares of the independent monetary authorities. Using tight monetary policy, presumably to stop inflation, while the economy was actually stagnating, is positive proof that something is basically wrong with the theory and practice of Federal Reserve monetary policy. It indicates that Federal Reserve policy has arrived at the point where it is willing to make the economy pay a calamitous price for a dubious safeguard. If inflation indeed threatens, then one fact is clear: monetary policy is an unsatisfactory weapon with which to fight it under conditions of 1958—1963.

154. Has tight money raised the national debt?
Yes. It can be shown that if the interest rates of the early 1940’s had prevailed throughout the postwar period, the total national debt would be $40 billion less than it is now. This is just one of the terrific costs of tight money, and also proves that raising interest rates is not a simple solution to more serious economic problems. Interest will just not work in a simple fashion.