business men have indicated plans to step up plant and equipment outlays by 14 per cent; and finally because banks continue to increase their loans to business. I might add, businesses of all sizes. This impatient desire to achieve fairly antiinflationary results within a matter of months from a policy of monetary restraint is totally unrealistic considering that the inflation was powerfully stimulated for at least two full years and longer.

It appears to some officials that the current boom in plant and equipment spending smacks of direct defiance of the government's anti-inflation program. This, however, overlooks the classic behavior of capital investment. Following the strong general demands in the economy over the past two years, which have increased incomes and profits, businessmen are, in the terminology of today's youth, simply doing their thing. It would be contrary to all we know about capital investment to find businessmen planning smaller outlays this year than last. Commercial banks for their part do not have the ability to cause or continue inflation. That ability rests exclusively with the monetary authorities. The continued rise in loans, particularly to business, is a customary phenomenon accompanying continued expansion and continued inventory accumulation following the kind of economic growth we experienced last year. Commercial banks are primarily lenders and secondarily investors in securities-governments and municipals. In our whole financial structure and in our regulatory approach, this is the primary function assigned to the commercial banks. This is their contribution to economic growth. In performing that function in an orderly fashion, they cannot overnight refuse to fulfill earlier commitments to customers. There are long lags in such commitments; but as pressures have mounted, banks have been scrutinizing new loan requests closely and turning down many that they might otherwise have made if their money positions were more comfortable. In my opinion, it is a mistake to focus such close attention on loans to business and to measure the success or failure of an anti-inflationary monetary policy on this one variable. The more pervasive effects of monetary restraint should not be overlooked. Banks, on balance, have reduced their security holdings this year. In selling securities to other investors they have, in effect, preempted the ability of those investors to hold other financial assets so that the policy of restraint has effects on liquidity and on monetary growth which, in time, will slow the growth of income and spending. Monetary restraint probably will achieve a slowdown in the economy generally before we see the effects on capital investment. The concern about the high interest rates of today should be cushioned by the realization that the sharp slowdown in monetary expansion is the best promise we have that a reduction in interest rates is somewhere on the horizon. For by slowing down the growth of money and credit, we limit the growth of incomes, and this will produce a slowdown in the economy and lower rates. Indeed, the tendency in the past decade has been for interest rates to peak out before the slowdown in the economy becomes pervasive.

There is now a chance that mortgage rates will not move much higher. This would not have been the case if the Federal Reserve had not begun a policy of restraint last December. The traditional spread between high-grade corporate bonds and mortgages has recently disappeared. When this occurred late in 1967, it resulted in a sharp spurt in mortgage rates in the spring and summer of 1968. However, if high-grade corporate bond rates now begin to ease off in response to the early (but not yet clearly evident) slowdown effects of a restrictive monetary policy, then mortgage rates may not move much higher.

One final point I would like to make. When interest rates on long-term bonds, both government and corporate, are high and rising, we express concern for borrowers. But I would also suggest that we should have at least equal concern for lenders if we wish to preserve our traditional long-term capital markets. When rates are as high as they are today, it means that the market values of securities bought at an earlier date and now held in the portfolios of individuals and institutions are deeply depressed. Some of these institutions are pension funds. Some of them are small commercial banks. Some of them are savings institutions acting in a fiduciary capacity for depositors. Such bond holdings, deeply depressed by unfortunate fiscal and monetary policies, in effect, are locked in. To sell them would mean realizing very sizeable losses. Furthermore, such a destruction of the value of fixed income obligations cannot help but cut deeply into the confidence of long-term investors and savers.

The widespread tendency of institutional investors and pension fund managers to reduce the percentage of funds invested in fixed income obligations and to increase the proportion invested in equities has accelerated in recent years. This new investment posture will not change easily, even with a material slowdown

in the economy. The expectations of a quick move by the authorities to reinflate the economy will provide something of a floor under interest rates as many investors will take advantage of improvements in bond markets to sell long-term securities which they have been locked into in recent years. In short, we have already significantly altered the flow of savings in our capital markets, which have long been the envy of the rest of the world.

In conclusion, I would like to point out that it is unreasonable to think that inflationary expectations must first end before the economy will slow down. The reverse is true. Inflationary expectations are not the cause of inflation. It takes money and credit to validate those expectations, and the Federal Reserve has the power to permit or prevent people from fulfilling their expansive plans.

MONETARY POLICY & INTEREST RATES

'52 '54 '56 '58 '60 '62 '64 '66 '68 NOTE: Shaded areas represent periods of slowdown in the growth of money supply.

Senator PROXMIRE. Our last witness is Mr. Warren L. Smith, Department of Economics, University of Michigan.

Mr. Smith.

STATEMENT OF WARREN L. SMITH, DEPARTMENT OF ECONOMICS, UNIVERSITY OF MICHIGAN

Mr. SMITH. Thank you, Senator Proxmire.

Senator PROXMIRE. Oh, yes, I should say—and a former member of the Council of Economic Advisers.

I. INTRODUCTION

Mr. SMITH. The secular upward drift of interest rates in the United States since World War II is, in my judgment, a cause for concern and even apprehension. Starting from levels that were artificially low at the end of the war, interest rates have risen to successively higher peaks in 1953, 1957, 1959, 1966, 1968, and early 1969, at which time many rates had reached their highest levels for a century or more. Moreover, this trend toward higher interest rates is likely to continue in the years ahead unless deliberate and substantial policy actions are taken to bring it to an end.

If we are to accomplish in the coming years the improvements in our urban environment that nearly everyone agrees are crucial for social stability, tremendous amounts of capital investment will be needed. The Housing and Urban Development Act of 1968 set as a target the construction of 26 million new housing units-including 6 million for low- and moderate-income families-during the next decade. This is nearly double the rate of housing construction during the 1960's to date. I believe this target is unrealistically high, but if we are to move even part way toward its achievement, vast amount of funds will have to be mobilized to finance housing construction. Moreover, tremendous amounts of investment in streets, highways, water and sewer facilities, parks, and so on, will be needed to support the housing program. Huge amounts will also need to be spent on the reconstruction of our cities, the establishment of adequate urban transportation systems, and the abatement of air and water pollution. The heavy demands that will be placed on our capital markets in connection with the financing of these programs in housing and urban development seem certain to maintain strong upward pressure on interest rates in the years ahead unless major compensating adjustments in economic policy are made. Indeed, the high interest rates resulting from these ambitious programs may well prevent the programs from achieving their objectives.

II. CAUSES OF RECENT HIGH INTEREST RATES

Our present inflationary problem which has led to a ratcheting up of interest rates since 1965 can be traced back to the rise of $20 billion (at annual rate) in defense spending between the third quarter of 1965 and the first quarter of 1967. Superimposed on an unsustainable investment boom, this rapid rise in defense spending turned an orderly and gradual expansion into a disorderly and excessively rapid one.

In retrospect, if seems clear to nearly everyone that taxes should have been raised in early 1966 at the time of the rapid buildup in Vietnam. But taxes were not raised, and the burden of checking the inflationary boom fell on the Federal Reserve. Monetary policy became drastically restrictive in 1966, and interest rates rose sharply. Although I would not defend every detail of Federal Reserve policy during the "credit crunch" of 1966, I believe the system basically did the right thing in using its powers vigorously to check inflation, although its policies did create financial difficulties and impose a disproportionate share of the burden of stabilization on homebuilding.

Monetary restraint, with an assist from some moderate fiscal meas ures, notably the suspension of the investment tax credit, did slow the pace of expansion sharply by early 1967. If we had followed through with a tax increase in the fall of 1967, as President Johnson proposed, I believe we would have succeeded in reestablishing a pattern of orderly economic growth and avoided some of the inflation that we have recently experienced. But no action was taken on this proposal until nearly a year later; as a result inflationary tendencies became so firmly entrenched that the tax surcharge-even when supplemented by the expenditure restraint also contained in the Revenue and Expenditure Control Act of 1968-has not been as successful as had been anticipated in cooling our overheated economy. Consequently it has proved to be necessary to supplement fiscal restraints with additional monetary restraint, and interest rates have taken another jump.

Basically, I believe the sharp rise is interest rates that has occurred since 1965 is attributable to our failure to make timely adjustments in fiscal policy. We failed to raise taxes in early 1966 as we should have. Monetary restraint slowed the expansion temporarily in early 1967. giving us another chance to impose needed fiscal restraint, but we waited too long to act, with the result that fiscal restraint had to be supplemented with another dose of monetary restraint, pushing interest rates up another notch. In the absence of responsible fiscal policy, the Federal Reserve could have prevented the rises in interest rates that have occurred in the last 3 years only by further feeding the fires of inflation.

I believe there is a lesson for the future in the experience of the last 3 years. If we want to reverse the alarming upward trend in interest rates and avoid the kind of sharp gyrations in monetary policy that we have experienced in the last 3 years, we will have to be prepared to follow a more flexible fiscal policy. In particular, this will require a willingness to raise taxes promptly when the pressures of demand become excessive. Monetary policy has had to bear more than its share of the burden of economic stabilization recently as a result of inaction. or excessive delays in adjusting fiscal policy. Furthermore, if we are to be able to finance at reasonable interest rates large programs in housing and urban development involving heavy borrowing by home buyers and by State and local governments, compensatory fiscal adjustments of a more permanent nature will be requred. Taxes will have to be raised relative to expenditures, thereby freeing resources for use in these programs and enabling the Federal Reserve to follow

a more expansionary monetary policy to facilitate their financing. Without some such adjustment in the mix of fiscal and monetary policy, our plans for urban reconstruction will either be thwarted by high interest rates or generate serious inflationary pressures.

III. CURRENT PROBLEMS OF MONETARY POLICY

The primary task of monetary policy at the present time is to exert effective restraint on the business sector of the economy. The surtax seems to be restraining consumption spending. This is evidenced by the fact that retail sales have risen very little since last August, while personal consumption expenditures, after jumping by $13.2 billion the third quarter, rose only $5.7 billion in the fourth quarter, with all but $1 billion of this increase in expenditures for services which are generally much less affected by income changes than are purchases of goods. Despite the leveling off in consumer spending, however, industrial production increased at an annual rate of 6 percent from August to February, while nonagricultural payroll employment rose by 1.7 million during the same period. As a result of increasing employment and rising money wages, personal income has continued to rise vigorously, cushioning the impact on consumption of the surtax and the increased social security taxes that became effective on January 1.

Thus, the business sector has continued to increase production, thereby expanding employment and income. In addition, business has stepped up its investment plans sharply the recent OBE-SEC survey indicates that investment spending planned for 1969 exceeds 1968 spending by 14 percent. It appears that the failure of the economy to slow down as rapidly as many observers expected it to has generated inflationary expectations in the business sector, and that these expectations have created a pattern of business behavior that has kept the expansion going vigorously.

Under these conditions, the effect of monetary restriction need to be focused on the business sector. But there are several reasons why it is difficult for monetary policy to influence the business sector very substantially.

First. It is doubtful whether business investment spending is very much affected by rising interest rates, particularly in the short run.1 In part, this is due to the fact that a large part of investment is financed from internal sources-retained earnings and depreciation allowances. In addition, the large element of risk that is inherent in investment decisions weakens the impact of interest rates on such decisions. Furthermore, the fact that interest is a deductible expense for income tax purposes greatly reduces the signficance of changes in interest rates. In the presence of the inflationary expectations that now seem to prevail, it might take an especially large increase in interest rates to produce a significant effect on investment.

Second. It is often argued that the Federal Reserve can affect business spending substantially, apart from its effects on interest rates,

1 For an analysis of the effects of monetary policy on business investment in 1966, see Jean Crockett, Irwin Friend, and Henry Shavel, "The Impact of Monetary Stringency on Business Investment," Survey of Current Business, August 1967, pp. 10-27. This study concludes that the effects were quite limited.