of 5- to 10-year securities has increased from 10.1 percent to 12.2 percent and of securities of more than 10 years from 5.7 percent to 7 percent.

While the Fed has performed well in the longrun management of the money supply, shortrun management, and the performance of short-term interest rates, has been another story.

Month-to-month growth rates have fluctuated wildly, ranging as high as 19.4 percent in April of this year, down to a rate of less than 1 percent in May. Such fluctuations cause turmoil in financial markets, periodically drive interest rates up unnecessarily, and play havoc with investor confidence. The way the Fed manages the money supply-basing reserve requirements on bank deposits that existed 2 weeks earlier rather than on those of the current week-undoubtedly contributes to these undesirable fluctuations. The Fed offset the April 19.4 percent bulge in the money supply, caused by such transient factors as the monthly deposit of $6 billion in social security payments, by allowing the Federal funds rate to rise rapidly and to remain at higher levels for a number of weeks. This gave some of the large commercial banks an excuse to raise their prime rate even though demand for business loans at their banks was poor.

This technique of basing reserves on 2-week-old deposits, known as "lagged reserve requirements," has been condemned by a large number of economists, including the leading monetarist and Nobel laureate, Dr. Milton Friedman. In testimony to the Senate Banking Committee on November 4, 1975, he said he "does not know anybody who has a good thing to say for the lagged requirements system." Öthers who have condemned the lagged reserve requirement include George G. Kaufman, former assistant vice president and economist at the Chicago Federal Reserve Bank and now professor of banking and finance at the University of Oregon and author of "Money, the Financial System and Economic Activity"; Albert E. Burger, assistant vice president of the Federal Reserve Bank of St. Louis and author of "The Money Supply Process"; Warren L. Coats, Jr., economist at the International Monetary Fund, formerly of the Chicago Fed, whose doctoral dissertation spells out the case against lagged reserve requirements; R. Alton Gilbert, economist at the St. Louis Fed; Daniel E. Laufenberg, an economist at the Federal Reserve Board; and William Poole, former senior economist at the Board of Governors and assistant vice president of the Boston Fed who is now professor of economics at Brown University.

It has also been suggested that the use of seasonal adjustment for computing monetary growth may be causing the Fed to react unnecessarily and erratically.

I hope that our July dialog can inquire into both the "lagged reserve" and the "seasonal adjustment" questions. The pain they engender for the economy may not be worth the pleasure they give to their votaries.

Most of all, we shall be interested in the Federal Reserve's monetary plans for the next year. We look for enlightenment not only in the monetary aggregates beloved of the monetarists, but in estimates of future interest rates, velocity, and portfolio composition-as they bear upon our ultimate goals of jobs, production, and prices.

We are fortunate enough this morning to have before us two of the Nation's truly great economic leaders, both widely respected in their profession, both with some experience in government, and, happily, the best of personal friends despite the fact that one of them is usually found in what is called the progressive camp and the other in what is called the conservative camp; and I love them both and thank them for being here.

Without objection and pursuant to our rule, both of their statements will be received in full into the record. I am going to call first on Dr. Heller, and then on Dr. Fellner, to proceed with their testimony.

Let me say that it is the Chair's hope and intention that we will finish with our witnesses in ample time to let them both make engagements later this morning. I think if we stick to the 5-minute rule, that will be possible.

Dr. Heller, would you start out?

STATEMENT OF DR. WALTER W. HELLER, REGENTS' PROFESSOR OF ECONOMICS, UNIVERSITY OF MINNESOTA

Dr. HELLER. Thank you, Mr. Chairman.

What I would like to do is work from my prepared statement, but skip parts of it.

The CHAIRMAN. Proceed in any way that you like.

Dr. HELLER. In appraising the Federal Reserve's economic performance, I want to begin with some left-handed compliments.

Now, the record of the past 212 years, except for the annual spring offensives the Fed's overreaction to the tax cut in 1975 and the April runups in the money supply in 1976 and 1977-is certainly a great improvement over the excesses of 1972-74, over the swing from excessive openhandedness in 1972 to excessive tightfistedness in 1974.

Second, while one can quarrel with the norms or targets of monetary policy over those 211⁄2 years-and I will-one can also compliment the Fed on the relative stability and serenity of policy during those years: First, its success at staying within the bounds, albeit at the low end, of its target ranges; second, its willingness to back off from premature tightening in June 1975 and May 1976; and, third, to the surprise of most everyone but Chairman Burns, money velocity, the rate of turnover of money balances, has obligingly speed up enough during this period to bridge the gap between an average rise of about 6 percent a year in M1, and nearly 12 percent in normal GNP.

Yet, in terms of a reasonable cost-benefit test, the cost in jobs and output set off against the benefits in reduced inflation, the restrictiveor at best, grudgingly expansionary-tilt of monetary policy in 1975 to 1977, has been a poor bargain for the country.

As to benefits, Federal Reserve policies and fiscal policy-relying on the harsh discipline of weak labor markets and weak product markets has given up precious little relief from inflation in the past 21⁄2 years.

Throughout the recovery, since March 1975, basic inflation—that is, excluding food and fuel-has orbited in a 52- to 612-percent range, with no decisive movement either way, while the annual advance in

hourly compensation has held stubbornly at or above 8 percent for the past 30 months; and neither price inflation nor wage inflation has been responsive to this rather grudging monetary policy.

In other words, once the excess demand pressures of 1972-73 and the external shocks of 1973-74 worked their way through the system, the residual inflation boiled down to hardcore, Burns-resistant, cost-push pressures. Triggered by the fierce double-digit inflation of 1973-74, wage advance moved into an obit about 5 to 6 percent above productivity advances.

And, meanwhile, conditioned by the cost passthrough philosophy of the 1971-74 price controls, the business practice of pricing via markup over costs became more and more firmly entrenched, even in the face of weak markets.

Now, the upshot is that the self-propelled cost-price merry-goround-I don't call it a spiral, because we are orbiting in a fairly stable inflationary merry-go-around-is largely imprevious to macroeconomic policies. Now, it may be that such inflation would slowly succumb to the sadomasochism of sustained tight money and tight fiscal policy and I call it masochism because the financial community which suffers from it seems to be the most vocal in calling for it—but even that is doubtful. It defies both the weight of the evidence and the dictates of commonsense to assume that structural inflation arising out of market rigidities and excess market power is going to yield to aggregative policies and overall economic slack.

Now, that bring me to the costs of restrictive Federal Reserve policies. Can one get beyond casual observations about unnecessary losses in jobs and output and the fits and starts of recovery that are in part generated by monetary policy? Can we get beyond that and identify fairly reliably a causal relationship between monetary restriction and retarded expansion?

Well, I turn here to Allen Sinai, of Data Resources, who has really done this rather persuasively with respect to the stall in U.S. economic recovery last year. His study concludes and I quote:

*** that low monetary growth is a primary cause of the stall in economic activity during the last three quarters of 1976.

An interesting sidelight, Mr. Chairman, is that almost halfway through the slowdown, the Fed did not recognize that it was taking place.

Now, I didn't have any testimony from Dr. Burns to work from, since he is not appearing until tomorrow. So, I went back to what he said to you on July 27 of last year. And when he appeared here, he expressed his belief that "a resumption of the upward trend in retail sales is already underway," that "a larger and more basic source of stimulus to economic activity can be expected from business outlays for new plants, machinery, and other equipment," that "the outlook for our export trade is also brightening."

He concluded that "activity in all major sectors of the private economy thus seems poised for further advances."

Well, now, I cite his testimony of a year ago partly because, as I say, I don't have tomorrow's testimony to address myself to, but more pointedly to suggest that Dr. Burns, like the rest of us, is fallible

and perhaps given to see the brighter side of his stingy monetary policies.

Now, in reckoning the cost of unduly restrictive or insufficiently expansionary policy, one really has to go beyond just the gross loss of jobs and GNP. When the Fed runs too tight a monetary policy and holds interest rates unduly high, it inhibits private capital spending in three ways.

First, the higher cost of money undoubtedly tips the balance against some marginal investment decisions.

Second, to the extent that common stock prices fall in response to rising interest rates, price-earnings ratios also fall, and the costs of capital investment to business rises.

Now, let me interpolate there. If anyone doubt the impact of raising interest rates on the stock market, one need only to look at the neurotic kneejerk reaction of Wall Street to the money supply numbers each week; and yesterday's drop in the stockmarket, for example, is attributed in part to the inference that the Federal Reserve is somehow or another turning the monetary screw up another notch.

Let me add parenthetically that I'm sure that Chairman Burns and the FOMC deplore this monetary myopia in the financial community just as much as I do. A good way to scotch this obsessive preoccupation with weekly ups and downs of M1 and M2 would be, first, to let the financial world know that the Fed is as concerned with interest rates and in a slack economy presumably with low and stable interest rates as it is with money supply; second, not to give credence to the money switch-doctors by its own quick markup of the Fed funds rate in response, for example, to the annual April showers of money supply; and third, perhaps not to publish the money supply figures so often or publish them with an economic health warning that would say "dangerous if inhaled or swallowed."

I suppose it is not very realistic to assume that this will come about because if they don't have the money supply figures, they will infer them, but that preoccupation certainly does the economy no good in any discernible way.

Well, let me return to my main theme and say, it is most important, third, that, to the extent that monetary and fiscal restraint keeps aggregate demand under wraps and therefore holds sales volumes well below capacity, the major ingredient for vigorous growth in plant and equipment spending is missing. Since business liquidity today is high and profit margins have made a substantial comeback, this lack of strong markets and the consequent damage to business confidence stands out as the chief culprit for the poor performance of business fixed investment in the recovery so far.

Now, the repercussions of this lag in plant and equipment spending are really very serious. Without robust investment, the stepup in productivity and the avoidance of bottlenecks which are our best defense in the long-run battle against inflation will be harder to come by.

Further, President Carter's battle for a balanced budget by fiscal 1981 rests heavily-even crucially-on a strong investment performance in the private sector. If the cost of money is high, if the demand for products is weak, if the stockmarket prices are eroded, the pros

pects that the current upswing in private capital spending will turn into the robust and sustained boom we need will be dim indeed.

If, instead, the Fed runs an easier monetary policy, it will facilitate not only vigorous capital expansion, but it will also facilitate the running of a tighter fiscal policy and the achievement of budget balance.

Now, let me turn to today's setting. I am again at a bit of a disadvtange, not knowing what Chairman Burns will say, but, given his long-stated long-term monetary goal, and given the inflationary smog that continues to foul the air that the FOMC breathes, one can venture a guess or two.

Against the background of two quarters of virgorous economic expansion the Fed might well be tempted to shave off a thin slice of monetary salami somewhere from its target ranges and possibly snug up policy just a bit.

But it is fair to ask Dr. Burns what in present economic circumstances or prospects would justify doing anything less than evenkneeling or even, better yet, drawing back a bit from the spring runup in rates, as they did in 1975 and 1976.

The facts lend very little if any support for further tightening. Inflation is dropping back into its hardcore range. I doubt that Dr. Burns and his colleagues expect more than 6-percent inflation in the coming year. I don't say that with any satisfaction. All I am saying is that there doesn't seem to be any acceleration of inflation in the works. Second, there is no sign that the economy is about to exceed its speed limits. Indeed, the economic patterns of the second quarter suggest that there has been some slowing of both output gains and the inflation rate during those 3 months, and the $20-billion rate of inventory accumulation in the second quarter even suggests the possibility of a miniinventory cycle.

As for the economic landscape ahead, most forecasts for the next 12 months fall in the range of 42 to 512 percent real growth, and I would agree that that is the right range.

But most important, there are still no signs that the economy is nearing its capacity, nor that it is about to be bedeviled by bottlenecks. And I cite the usual evidence here. I particularly note that in the materials industries, we are running 10 percentage points below the levels of capacity utilization that we hit in 1973.

And then, when you turn to the broadest measure of available capacity namely, our GNP potential at full employment--and I use the modest definition of 5-percent unemployment as full employment— actual output in the second quarter was running $116 billion a year below potential, if one accepts Alan Greenspan's conservative formula, and $148 billion if one uses George Perry's formula as a guide.

And, by the way, I asked the people who developed those formulas to give me those numbers. Those are their numbers, not mine.

Now, to get from here to there, from today's high unemployment to 5-percent unemployment by 1980, will require somewhere between 514percent and 534-percent annual growth from now until 1980.

Now, to avoid rekindling demand inflation calls for gliding, not crashing, into the 5-percent unemployment range. So, if we are serious about full employment by 1980-and Lord knows that is a modest