Kennedy’s Unheralded “Monetary Revolution” and the Triumph of the New Economics

Contrary to the fiscal doctrines of the left-wing new economists and of the politico-economic analysis of the Old Right critic of the New Deal, John Flynn, however, it was not ultimately budget deficits that allowed Kennedy to initiate the corporatist planning and militarization of the U.S. economy that bore first fruit in the emergence of the American welfare-warfare state during Johnson’s Great Society and culminated in Nixon’s fascist New Economic Policy The policy that facilitated Johnson’s simultaneous financing of extravagant expenditures on welfare programs and the military adventure in Vietnam and made conditions ripe for Nixon’s imposition of wage and price controls was not newfangled functional finance but old-fashioned monetary inflation. As the historian of macroeconomic policy, Kenneth Weiher, has pointed out, it was not the much-vaunted “fiscal revolution” but the overlooked “monetary revolution” that took place during the Kennedy administration which turned out to be the predominant influence on the economic events of the 1960s and 1970s.[111] As Weiher stated: “There was a revolution all right, but the most important change occurred at the Federal Reserve; however, 10 years passed before more than a handful of people caught on to what was happening.”[112]

In the three years of the Kennedy administration the growth of the money supply as measured by M2 averaged about 8 percent per year. If we take the eleven prior years going back to 1950, the rate of growth of M2 averaged 3.6 percent per year; if we go back four more years, to the first postwar year of 1946, the average annual rate of M2 growth over the fifteen-year period drops to 3.3 percent.[113]

There were basically two reasons why the role of monetary policy tended to be so grossly underplayed in the economic histories of this period. The first was that the new economists themselves, as unreconstructed Keynesians, uniformly denigrated the potency of monetary policy while touting the effectiveness of fiscal policy. Thus the Kennedy tax-cut bill, which did not even take effect until 1964, receives the lion’s share of the credit for stimulating the recovery from the 1960–1961 recession. Second, because most economists since the 1930s, including and especially those of Keynesian orientation, identified inflation with increases in the price level, they interpreted the 1.2 percent average annual rate of increase of the CPI during the period 1961–1963 as evidence of the absence of inflation. But in fact, the effect on the price level of the monetary expansion during the Kennedy years was blunted by two factors. The first was the rapid rate of growth in real output that began in 1962 and continued through 1966 and that was partially induced by the monetary inflation itself. The second factor was the substantial increase in the demand for money, or the decline in the “velocity of circulation of money” that occurred from 1960 to 1965. Thus the ratio of nominal GNP—that is, total current dollars spent on final goods and services in the economy per year—to the total money stock as measured by M2 fell from 1.72 in 1960 to 1.57 at the end of 1965, indicating that the public increased the average amount of dollars they held in currency and in checking and savings accounts in relation to their money incomes. These two factors taken together meant that some of the new dollars that were being injected into the economy by the Fed were being diverted from increasing the demands for goods and services in the economy at the same time that the supplies of many of these goods and services were being rapidly augmented. This explains why general prices rose at a much lower rate than the supply of money[114]

Despite the negligible increase in the CPI, however, the effects of the rapid, and initially unanticipated, monetary inflation were visible in credit markets as real interest rates trended steadily downward throughout the decade.[115] Unfortunately, both Keynesian and central bank orthodoxies of the 1960s focused on the nominal interest rate as an important indicator of the degree of ease or restraint of monetary policy, making no allowance for the effect of inflationary expectations on the nominal interest rate. Consequently, neither the new economists nor the monetary authorities believed that monetary policy was “unduly” expansionary because short-term nominal interest rates rose from 1961 to 1963.[116] Indeed, the new economists were quite pleased with monetary policy during this period, an attitude typified in Seymour Harris’s observation that “the [Federal Reserve] board provided the country with a reasonably easy money policy.”[117] Harris’s judgment was echoed by another Keynesian, George Bach, who chaired a committee of academic monetary economists that began advising the Fed in 1963 and Bach wrote, “Throughout [the Kennedy years], monetary policy was permissive if not aggressively expansionary.”[118]

Given that monetary policy was indeed grossly inflationary during the Kennedy years, what accounts for the sudden and radical shift in Federal Reserve policy from the moderate inflationism under the Eisenhower administration? The answer is Kennedy and his new economists, who conducted a relentless and incessant campaign for easy money from the very beginning of his administration. This campaign took the form of repeated public utterances on the part of the president and his economic advisers, as well as direct presidential pressure on William McChesney Martin, who was chairman of the Fed under Eisenhower and continued in that position until 1970.

Even before Kennedy was elected, he began beating the drums for a cheap-money policy. In a press conference in October 1960, then-Senator Kennedy alleged that high interest rates had induced a recession without arresting the inflation.[119] Shortly after his inauguration, in February 1961, Kennedy affirmed the need for low long-term interest rates, while allowing that short-term interest rates could not be reduced due to the balance-of-payments problems the dollar was then mired in. In a July 1963 press conference, Kennedy, while defending his platform pledge of cheap money in the face of rising short-term interest rates, boasted that “mortgage rates and other rates which affect business have dropped since this administration took office.” In an address the following day, Kennedy pointed to the contemporary economic recovery as evidence that “a determined effort can succeed in keeping long-term investments and mortgage money plentiful and cheap while boosting short-term interest rates.”[120]

Under the influence of the new economists, Kennedy also sought to obscure the link between cheap money and price inflation and to portray inflation as a consequence of the irresponsible behavior of private sectors of the economy Thus in his January 1962 State of the Union message, Kennedy argued, “Our first line of defense against inflation is the good sense and public spirit of business and labor—keeping their total increases in wages and profits in line with productivity.” Similarly, in an April 1963 meeting with newspaper editors, Kennedy contended that the economy was then threatened by deflation, not inflation. He argued that “a wage-price push inflation” could not be sustained given the prevailing levels of unused capacity and high unemployment. Even when Kennedy finally began to express fears about impending inflation, as he did in the following month, he did so in terms of “some concerns over the possibilities of a wage inflation.”[121]

Kennedy and key members of his administration also doggedly prodded the Fed, both publicly and privately, to ease monetary policy, even threatening to terminate its independent status if it did not acquiesce. As early as his campaign for the presidency, Kennedy expressed his disappointment with the Fed’s tendency to resort to restrictive monetary policy to rein in inflation and his intention to break with such a policy.[122] In April 1962, Kennedy petitioned Congress for a revision of the terms of the Fed chairmanship that would enable each president to nominate a new chairman at the beginning of his term.[123] Heller, Treasury Secretary Dillon, and Treasury Undersecretary Roosa also weighed in with calls for the Fed to ease monetary policy.[124]

Despite some initial foot-dragging and repeated caveats that the Fed would only finance real economic growth and not budget deficits, Fed Chairman Martin ultimately capitulated to the insistent demands of Kennedy and the new economists for a cheap-money policy. In fact, in February 1961, the Fed abandoned its long-standing “bills-only doctrine,” which dictated that open market operations be conducted exclusively in the market for short-term securities. In doing so, the Fed was accommodating the administration’s request to reduce long-term interest rates by buying long-term securities while simultaneously selling short-term securities in order to nudge up short-term interest rates. This attempt to artificially twist the interest-rate structure—nicknamed Operation Twist—was devised by the new economists to accomplish two goals: to stimulate domestic business investment and new housing purchases and to discourage the outflow of domestic and encourage the inflow of foreign short-term capital as a means of mitigating the U.S. balance-of-payments deficit.[125] Needless to say, this attempt to have one’s cake and eat it too—to pursue a domestic cheap-money policy and to avoid its adverse consequences for the balance of payments—was a failure. As Weiher concludes:

All involved were probably foolish to think the Fed could partition the markets so well as to accomplish this artificial “Operation Twist.” . . . In the end, investors were not tricked, and all the Fed accomplished was a significantly higher money supply growth rate.[126]

Our conclusion then is that Kennedy and the new economists succeeded in wringing from the Fed precisely the inflationary monetary policy they desired and that this policy represented a radical break with the monetary policy pursued in the 1950s. This conclusion, which is certainly reflected in the money-supply growth rates cited above, also accords with the perceptions of the new economists themselves. Seymour Harris, long-time Kennedy economic adviser and chief academic consultant to the Kennedy Treasury, made this pellucidly clear in his book on the economic policies of the Kennedy years. Harris concluded that:

In short, monetary policy under Kennedy was much more expansionist than under Eisenhower. . . .

Federal Reserve policy in 1961–1963 was not like that of 1952–1960. At the early stages of recovery in the 1950s, the Federal Reserve, overly sensitive to inflationary dangers, aborted recoveries. Whether the explanation was the growing conviction that inflation was no longer a threat, or whether it was an awareness that the Kennedy administration would not tolerate stifling monetary policies, the Federal Reserve made no serious attempts to deflate the economy after 1960. In fact, in 1963 Mr. Martin boasted of the large contributions made to expansion.

An examination of rate movements; of purchases of securities by the Federal Reserve; of reductions in reserve requirements; and of inclusion of vault cash as reserves as a means of offsetting gold losses; of financing increased currency in circulation and providing a base for more money creation; and also the high volume of free reserves of commercial banks—all of these point to a degree of cooperation of the Federal Reserve which was lacking in the 1950s.[127]

Thus, inflationary monetary policy was the sine qua non for the regime of permanent budget deficits that was initiated in the early 1960s and continued uninterrupted almost to the end of the twentieth century That private investment was able to continually expand concurrently with sharply increasing government spending on military and other programs was attributable in large measure to the fact that, during the Kennedy years, the Fed was induced to “cooperate” by routinely monetizing the cumulating budget deficits necessary to finance these programs.