III. The Fountainheads of Inflation

Treasury; with the governments or central banks of foreign countries, and, for the purchase and sale of federal obligations, with selected security dealers. With this position as a central bank goes the monopoly of issuing legal tender-bank notes. The federal reserve banks have the privilege of 18 THE FOUNTAINHEADS OF INFLATION makingthe money with which to pay for their own liabilities. The liabilities are created by the mem ber bank borrowing on a treasury bill or similar security and drawing out a dollar note or a dollar balance, as it chooses. The note goes into circula tion; the balance becomes the reserve. on which the member bank "pyramids" its own deposit liabilities. (The nonmembers use as their reserves mostly balances held at member institutions.) The process is further simplified if the Federal Reserve, instead of w~iting for the member banks to ask for money, pr6ceeds on its own by buying treasury paper on the open market in order to ease the money market and to lower the interest rates.

Or conversely, it may sell treasury obligations to tighten the market and to "up" the rates. All of which is as it should be. But the portfolio of the Reserve System is bulging with treasury securities in lieu of commercial paper. Treasury securities are the documentary evidence of federal deficits, past and present. Their bulk stems from the last war. The Treasury does not have to run fresh deficits every year (as it did in the fiscal year 1958-59 to the tune of a peacetime record $12.4 billion). Of its shortest term marketable debt, maturing within one year, $53 billion were at this writing in commercial banks, savings institutions, and other private portfolios. Theoretically, at least $53 billion worth of short paper could still be turned into legal tender! Nothing of the sort 19 AN INFLATION PRIMER would be possible if the central bank would stick to its function, as was originally intended, and monetize only credit instruments which represent genuinely commercial, productive transactions of the self-liquidating type.

No inflation of runaway dimensions is to be expected (as yet); but the monetization of the public debt does not have to go anywhere near the theoretical limit in order to permit a fresh out break of price boosts. Assuming an average re serve ratio of one to six, the monetization of $1 billion permits an additional credit expansion of $6 billion, or so. And the flood can rise even with out further debt monetization by the central bank, which has additional powers available to make or to break the inflation-by changing the member banks' reserve requirements. MANAGED MONEY-THE ONE-WAY ROAD The member banks, to repeat, must cover their MEMBER BANK RESERVE REQUIREMENTS Percentage of Percentage Net Demand Deposits * of Time (Savings) Central Reserve Deposits, All reserve city Country Member city banks t banks banks Banks Maximum ...... 26 20 14 6 Minimum ....... 13 10 7 3 Actual, Aug. 1, 1960 ... 18.0 16.5 11 5 -Demand deposits minus cash items in process of collection and demand balances due from domestic banks.

t New York and Chicago. 20 THE FOUNTAINHEADS OF INFLATION deposits by holding a fraction of.them in balances at their respective reserve banks. But what frac tion? This, the pertinent question, is answered in the accompanying table. Note the broad range of discretionary power in the hands of the managers (who may be under the thumbs of the politicians). Within the broad legal limits, they can cut the reserve requirements or raise them. This is called an "elastic currency." In June, 1954, to overcome a mild recession (and to strengthen Mr. Eisenhower's chances come No vember), the Board of Governors lowered the banks' reserve requirements, boosting their lend ing capacity by a hefty $9 billion. This helped to bring about an unprecedented borrowing boom, but the bank reserves were not restored to their previous levels. The performance of the Board was repeated on the eve of the next presidential election: by September, 1960, the member banks' lending capacity was boosted by another $3.6 bil lion.

This sort of elasticity pervades the whole mone tary system. Under the gold standard the mini mum gold reserve against the central banks' liabilities was permanently fixed. It used to be mandatory for the Federal Reserve to hold gold equal to at least 40 per cent of its outstanding notes and 35 per cent of its deposit liabilities. The rule has been relaxed to permit an over-all 25 per cent minimum and could be relaxed further at the 21 AN INFLATION PRIMER whim of Congress. The legal ceiling over the public debt was to be raised in a national emer gencyonly. Since 1954 it has been raised four times in less than six years. No more monetary inhibi tions! ·Floors may be lowered and ceilings raised on short notice. The power of reducing the legal' reserve re quirements is dynamite, one would think. The Congress thinks otherwise. With the blessing of the Federal Reserve authorities, it has cut the re quirements for the big banks in New York and Chicago to the level of the reserve city banks, as of 1962. Also, it permitted the banks to count the surplus cash in their tills as part of their legal reserves. This alone adds another 0.5 per cent to the big banks' potential and an estimated 3 per cent to that of the ~mall ones. To clinch it all, the political heat is put on the Federal Reserve Board to abandon the "bills only" policy-it should buy long-term bonds as weIll And the Treasury pleads for the right to sell more than the permissible $5 billion bonds direct to the central bank-to push them down its throat, as it were.

INFLATION BY "DEBT MANAGEMENT" On paper, the Reserve System has virtually every power to maintain monetary discipline and to stem the. inflation. It is under no legal obliga tion to grant credits to the member banks, still less to buy government bonds. It could skim off 22 THE FOUNTAINHEADS OF INFLATION the liquidity of the money market and force inter est rates upward. The mere refusal to grant credit to the banks in proportion to the expansion of their loans may spell the end of an ominous infla tionary boom. The March, 1951, gentlemen's agreem.ent between the Treasury and the Federal Reserve Board liberated the latter from the self assumed wartime obligation to monetize the national debt, or to hold interest rates down. Ever since, our central bank has been pursuing, sup posedly, a "flexible" policy: it commonly adjusts its discount rate-the fee it charges on its loans to the market rather than forces a rate on the market. In principle, interest rates may rise or fall without interference. In actual practice, they are not permitted to rise, nor bond prices to fall, to a level that would curb the inflation for any ap preciable length of time. The debt monetization continues, rain or shine, with interruptions few and far between.

The 1951 agreement between the Treasury and the Federal Reserve authorities woul~ have made possible a truly "flexible" policy, had the former lived up to its implicit part of the deal. There should have been no more deficits in the budget; in any case, no major deficit. The Treasury should also have proceeded to convert a substantial slice of its short-term debt into longer maturities. It did nothing of the sort; instead, the volume of short maturities has been increasing practically 23 AN INFLATION PRIMER year after year, despite the fact that there were ample occasions-recessions-when low interest rates obtained on the capital market and conver sion operations would have been perfectly feasible. There is the crux of the situation. Every stabili zation attempt undertaken by the Federal Reserve authorities is, despite their good intentions, sty mied from the outset. They are stymied for the simple reason that the Reserve System is "a crea ture of Congress" that can set down the law. In any case, the central bank cannot let the credit of the overindebted national administration go to pot, which is what would happen if the "printing press" would cease to support a prodigal Treasury.

This is called Treasury-Federal- Reserve-co-opera tion-in-managing-the-national-debt. What is being managed is a progressive inflation, imposed by the Congress. The heads of the Reserve System have no choice but to serve the fiscal interest, or resign. The latter they rarely do voluntarily. In stead, they. rationalize the inflationary policies forced upon them into a policy of maintaining an "orderly market" for federal securities and guaran teeing general "stability." "Price stability, with full employment and continued growth" is the slogan to which the monetary authorities pay un relenting lip service. How that is accomplished is illustrated by a recent statement by Mr. William McChesney Martin, Jr., Chairman of the Board of Governors, 24 THE FOUNTAINHEADS OF INFLATION before the Joint Economic Committee of Con gress. He took pride in the many devices by which the national currency had been <j.ilutedin the first nine months after the onset of the 1957-58 reces SIon: From late Fall 1957 through April 1958, there were four reductions in Federal Reserve Bank discount rates~ from 3Y2 per cent to 1% per cent. Through continuing open market operations from late Fall of 1957 to early last Summer, the Reserve System supplied the commercial banks with some $2 billion of reserve funds. Through three successive reserve requirement reductions in late Winter and early Spring of last year, the system released for the use of member banks about $1.5 billion of their req uired reserves.

The total amount of reserve funds supplied by the sys tem to commercial banks over the nine months, Novem ber 1957--.July1958, was enough to enable member banks to reduce their discounts at the Reserve Banks from $800 million to about $100 million, to offset sales of gold to foreign countries amounting to about $1.5 billion, and to finance a commercial bank credit expansion of almost $8 billion. Monetary expansion from February through July stimulated by this Federal Reserve action was at an exceptionally rapid rate-at an annual rate of 13 per cent for all deposits ..... (Italics supplied.) T~e peacetime record 13 per cent annual rate of·bank-deposit expansion coincided with a 16 per cent ($14 billion) deficit in the national budget. It was followed by a 12 per cent decline of our gold stock. Since mid-1958, the Federal Reserve has taken some easy steps to drain the "water" from under the boom, raising security margin requirements 25 AN INFLATION PRIMER from 60 to 90 per cent, reducing somewhat the credit it extends, and upping the discount rate gradually to 4 per cent. But just previously, the volume of its outstanding credits-the monetary base on which the inflation is built-had been in creased by $2.2 billion in 14 months. That helped to enlarge the money volume (cash in circulation and bank deposits) by $14 billion and to rekindle the inflationary boom.

By 1960, not only did the bill purchasing re start, but the discount rate was reduced again to 3 per cent, at a time when the European central banks were raising their rates. Also, the security margin requirements were lowered from 90 to 70 per cent and the reserve requirements of the (overlent) member banks cut by $605 million,1 as mentioned before. The Federal Reserve System's freedom of action is limited for a further reason: it has to contend with the fact that the national government is a large-scale operator on the capital market. Its borrowing, debt rolling-over, and converting operations impede time and again the policy of the central bank. Moreover, the Administration is in the business of lending money and guaran teeing credits. In 1958, the total of loans extended and underwritten amounted to $43 billion. When one arm of the government tries to restrain reck less borrowing by raising the cost and the other arm promotes such borrowing by providing cheap 26 THE FOUNTAINHEADS OF INFLATION funds, the result is irresponsibility and sheer con fusion.

1. The loans-to-demand deposits ratio of the big New York banks stood in August, 1960, at 86 per cent, just four per centage points below the 1929 high! 27 IV THE VICIOUS SPIRALS THE PARABLE OF THE HORSE AND THE TROUGH The Congress votes expenditures without reve- , nues to cover them. The Administration finances the deficit by issuing IOU's that are the equivalent of cash. The banks convert many of them into active purchasing power and draw from the Fed eral Reserve System the cash balances for legal reserves. This house of paper rests on the central bank's readiness, voluntary or otherwise, to mone tize the IOU's which represent no productive ef fort, no salable goods, no gold, not even tax reve nues-in effect, nothing but promises, not to pay but to be renewed, with more of the same to come. Come they do, be it out of the Treasury's fresh deficits and the exchange of new "shorts" (bills, certificates, and notes) for longer bonds, coming to maturity, or out of the accumulated portfolios of the public. In th~ ten months to the end of April, 1959, the bulky volume of outstanding marketable short-term treasury paper grew by no less than $23.6 billion, all but $0.2 billion avail able for monetization by the Reserve System.