Interest Rates and Their Prospect in the Recovery

JAMES L. PIERCE Staff, Board of Governorsof the Federal Reserve System

MUCH CONCERN has been expressedin the financialpress and by otherob- serversabout the prospectsfor interestrates in 1975.The particularfear is that the sharpdeclines in short-terminterest rates in 1974will be followed by sharpincreases in both short- and long-termrates in 1975 under the pressureof the massivefederal deficits expected in 1975 and 1976. This paperaddresses two questions:First, has the movementin short- andlong-term interest rates since mid-1974 been unusualin light of the slow growthof money and the collapsein economicactivity? Second, will the large volumeof deficitfinancing, induced in part by the tax cuts, lend a strongupward push on interestrates in 1975?These can be two aspectsof the samequestion, because an unexpectedand fundamentalshift in the re- lationshipsamong interest rates, income, and moneymay cloud the impli- cationsof the deficitfor interestrates.

The RecentBehavior of InterestRates andMoney Demand

As figure1 demonstrates,short-term rates peaked in the summerof 1974, andhave since fallen steeply until quite recently. Long-term rates have also Note: The views expressedin this paper are my own and do not necessarilyagree withthose of the Boardof Governors.I want to thank membersof the Brookings panel for their many constructivecomments on an earlierversion of this paper. 89 90 Brookings Papers on Economic Activity, 1:1975 Figure 1. Selected Interest Rates, Monthly Averages, January 1974-March 1975

Percent 12

90-119-day commercial paper 10 Aaa utility bondsa

% /~~~~~~~~~~~~~ 7 ' 3-month Treasury billsb

J F M A M J J A S 0 N D J F M 1974 1975

Sources: Federal Reserve Bulletin, vol. 61 (April 1975), pp. A 27, A 28; and two preceding issues. a. Recently offered series. b. Market yield. fallen from their peaks, but much more gradually; since November they have moved without a clear trend. These moveiiients were accompanied by an appreciable slowing in the growth of nominal income during 1974, which, however, remained positive until the first quarter of 1975. Real income fell throughout 1974, moving into a severe decline in the last quarter of 1974 and the first quarter of 1975. While the money stock (MI) grew fairly rapidly in the first half of 1974, after June its growth first slowed and then behaved erratically; on balance, it averaged only 1.4 percent (annual rate) from June through January, before speeding up during February and March. In light of these patterns, was the large decline in short-term interest rates and the much smaller decline in long-term rates to be expected? Was the erratic pattern of growth in Ml predictable? The answer to the first question is a qualified "yes" and to the second question a qualified "no." These answers arise from an examination of the residuals from regression James L. Pierce 91 equationsin the SMP(Social Science Research Council-M.I.T.-University of Pennsylvania)model that describethe behaviorof money demandand interestrates. If these equationsexhibit no unusualbehavior in theirpre- diction errors,one would infer that the behaviorof money and interest ratesduring the recessionwas to be expected.If, on the otherhand, the predictionerrors are unusually large, one wouldconclude that recentfinancial developmentswere unexpected. The single-periodprediction errors from the money-demand(currency plus demanddeposit) equations in the SMP model for 1973 and 1974 are shownin figure2. Theequations used to formthe predictionsof M1 wereas follows: (1) ln MC = 0.22 ln PCE - 0.005 ln RTB + 0.88 ln MC- Standarderror = 0.003; sample period: 1955:4-1971:4.

(2) ln -0.28ln MD1-0.06ln RTB-0.12ln RSD y y + 0.08 In RDIS -0.34 In N-0.05' RDIS ~ N Standarderror = 0.0068; sample period: 1955:2-1972:4. where MC = currencyheld by the nonbankpublic PCE = personal consumption expenditures RTB = interestrate on Treasurybills MD = demanddeposits held by the nonbankpublic Y= GNP RSD = interest rate on savings deposits RDIS = discountrate y/N = GNP per capitain 1958 dollars. Actual values of the exogenous variablesin these equations-real and nominalGNP and short-terminterest rates-were used to formthe predictions. As figure2 clearlyreveals, the equationsseriously overstated M1 growthin the secondhalf of 1974.1What is more, the errorswere several timesgreater than those obtainedin earlierperiods.2 1. All the equation predictionsin this paper are single-periodpredictions that have set the rho termequal to zero. As a result,the equationsexhibit serially correlated errors. When actual predictionsare made, there is less concern in distinguishingthe role of structuralvariables from informationon the errorstructure and an estimatedvalue of rho is used. 2. As will be shown below, the predictionof the demand for demand deposits was responsiblefor the large errors;the currencypredictions were quite accurate. 92 Brookings Papers on Economic Activity, 1:1975 Figure2. Actualand Predicted M1, Quarterly,1973 and 1974

Billions of dollars 300

290 Predicted -

280280 - Actual

270

260 -

250 I II III IV I II III lV 1973 1974

Sources: Actual-SMP data bank; predicted-SMP model, using money-demand equations (1) and (2) given in the text. Mi = currency plus demand deposits.

Theerrors in the money-demandrelationships give someidea of whether the declinein interestrates in 1974was smallerthan would have been ex- pectedon the basis of past relationships.The equationsimply that-given the actualvalues of other exogenousvariables-Treasury bill rates of 8.8 percentand 8.3 percentin the third and fourth quarterswould have pro- duceda 6 percentincrease in M1at an annualrate. Actualbill ratesin the two quarterswere 8.2 and 7.4 percent,respectively, which should have yieldeda greatermoney demand;yet actualM1 growthwas only 2.0 and 2.2 percentin those quarters.3Thus, according to the money-demandequations,actual bill rateswere sufficiently low to producean M1growth in excess of 6 percent. Treatingthe errorsin the equationsas reductionsin the interceptof the money-demandequations-that is, treatingthem as if the money-demand equation"shifted" downward-makes it possibleto calculatethe interest

3. The quarterlyM1 figures used in the equations are averages of the two months surroundingthe end of the quarter;for example,the figurefor the fourth quarteris the averageof Decemberand January. James L. Pierce 93 ratesrequired to achievea 6 percentM1 growth. To do this, the intercepts of the currencyand demand-depositequations in the third and fourth quarterswere adjusted by each equation'serror in each quarter.With the adjustedequations, the Treasurybill ratesrequired to obtain6 percentM1 growthin the thirdand fourthquarters were 6.2 percentand 4.1 percent, respectively. Thelarge errors in predictingmoney demand are sufficient but not neces- saryto explainthe slowgrowth in M1.The demandfor moneyprovides predictionsof themoney stock given short-term interest rates. With the interest ratesthat prevailedin the third and fourth quarters,the money-demand functionpredicted M1 growth higher than the actual. However,money growthneed not havebeen as slow as it was.If bankreserves had been supplied at a rate consistentwith more rapid growth in M1, interestrates would have fallen sufficientlyto equate money demand with the more rapidlygrowing supply and the money stock would have expandedmore rapidly.Thus, the issueis not that the declinein interestrates was so large butrather that it was not largeenough to spurmore rapid expansion in M1. Giventhe actualdecline in short-terminterest rates, the behaviorof long- termrates was not surprising.The model'sequation for the interestrate on newlyissued corporate bonds, taken as a measureof long-termrates, is 18 18 APCONQ+3~C (3) RNI = 0.76 + , b,RCP_j + E C PCON1 + 033 aRCP

bo = 0.18, bi = 0.94; co = 4.83, i = 31.18, Standarderror = 0.17; sample period: 1954:4-1971:2. where RNI = interestrate on newlyissued Aaa utilitybonds RCP = commercial paper rate PCON = consumptionprices (percent change measured at annualrate) aRCP= a measureof the standarddeviation of RCP overthe previous eight quarters. The equationdid overpredictthe rate on new issuesin late 1973and 1974 by a substantialamount, the maximumerror being 1.4 percentagepoints in the first quarterof 1974. But the patternof predictionscaptured the up- surgein long-termrates in 1973and 1974and the moderatedecline in late 1974.The errorsmade duringthe periodappear to be explainable.In the equationa distributedlag on the percentagechange in consumptionprices 94 Brookings Papers on Economic Activity, 1:1975 servesas a proxy for the expectedrate of inflation.The behaviorof this pricevariable was not an appropriatemeasure of expectedinflation because of the rapidrise in consumptionprices relative to other pricesduring the period.This variableprobably accounts for much of the overpredictionof the long-termrate in 1973and 1974.

MONEY DEMAND While the declinesin interestrates may not be surprisinglylarge, the sizableerrors in predictingmoney demand in the secondhalf of 1974remain to be explained.The searchfor explanationsis frustratingand perhaps fruitless,particularly because the errorsmay have resultedfrom largeran- dom disturbances.An effortto "explain"the errorsis alwaysan exercisein ex post theorizing,which is often difficultto distinguishfrom pure ra- tionalization.If the ex post argumentsappear to be compelling,it is crucial to test the role of thesefactors not only in the currentsituation but also at othertimes when they appearto operate. A separatelook at the model'sequations for currencyand demanddeposits, the two componentsof M1, clearlyshows that the latteris responsiblefor the overpredictionin 1974;the veryrapid currency growth during the yearwas predictedquite accurately.The errorsin the demand-deposit equationin 1974are severaltimes largerthan those obtainedat any other time, whateverthe economic conditions.The problemis to isolate any specialfactors at workin the secondhalf of 1974that couldaccount for the extremelylarge errors in predictinggrowth in demanddeposits. Manyof the possibleexplanations of the apparentcollapse in moneyde- mandare plausibleand serveto highlightsome of the problemswith conventionalmoney-demand functions.4 These functionsare of the form

(4) ln -=a -a lni-a2 Inr+a3In Ml, where M = money Y = nominal GNP

4. I have benefitedgreatly from severaldiscussions with JaredJ. Enzleron the problems of money demand.For an excellentreview of the state of the art concerningmoney demand,see StephenM. Goldfeld,"The Demand for Money Revisited,"BPEA (3:1973), pp. 577-638. James L. Pierce 95 y = real GNP N = population r = interest rates al,2,3 = coefficientsgreater than zero. The negativecoefficient on real per capita GNP, y/N, impliesa less than unitaryelasticity of moneydemand with respectto real GNP. The public economizeson money balancesas real transactions(for whichy/N is the proxy)rise. Thus, an increasein real per capitaincome will raisevelocity. Thisresult accords with the microeconomicinventory approach to money demand. A less than unitaryelasticity of demandimplies that a declinein real GNP per capita,with nominalGNP and interestrates unchanged, will in- creasethe demandfor money. This can be seen when equation(4) is re- writtento obtain (5) M = aO + (1 -a3) ln Y-a, lny +a lnN-a2 nr+a3 InM1; or, definingP as a measureof the pricelevel so that Y = Py,

(6) M= ao+( -a3)InP+(I -a3)Iny-a,lny + a ln N- a2 ln r + a3 ln M 1. Thisrearrangement of termsmakes it clearthat a 1 percentrise in P offset by a 1 percentdecline in y will leave nominalincome unchanged, but will raisethe demandfor nominalmoney balances,by a, percent. Accordingto this specification,when real income is fallingin a recession, the publicwill be less carefulin its cash management,given interestrates andnominal income. In most recessions,the movementof nominalincome is dominatedby the movementof realincome. As realincome falls, so does moneyincome, and predictedmoney demand falls withit, albeitto a lesser degree.In the currentrecession, however, nominal income continued to rise becauseprices rose fasterthan realincome fell. Thus,predicted money de- mandrose even as real incomefell. Thereis strongevidence that the public has learnedto use its money balancesmore intensively over time. Furthermore,theory suggests that the incentiveand abilityto economizeon money are relatedto real transactions and to interestrates. However, the behaviorof the publicis probably more complicatedthan is impliedin conventionalmoney-demand func- 96 Brookings Papers on Economic Activity, 1:1975 tions.The propensity to economizeon moneybalances probably cannot be capturedby the elasticityestimate on real transactions.Once individuals andfirms have economized on cashholdings, they will not unlearnall their lessonswhen interest rates and realtransactions fall. Thus,in an important sense, money demandmay not be completely"reversible." This ratchet effectshould be particularlyimportant when technologicaldevelopments, whichmay have been stimulatedby highinterest rates and large volumes of transactions,are involved. Furthermore, the upwardtrends in interestrates and real GNP in the postwarperiod make it difficultto distinguishthe effectsof thesevariables on cash managementfrom those of a time trend. It is beyondthe scope of this paperto specifya money-demandfunction that would distinguishamong the factorsthat influenceeconomizing on moneybalances. But the residualsfrom the SMPdemand-deposit equation shouldprovide some insightsinto the issue.If a ratcheteffect or a trend- determinedincrease in the technologyof cash managementis important, one might expectmoney demandto be overestimatedduring recessions. However,residuals from the demand-depositequation do not show sucha patternfor recessionsbefore the presentone. As a furthertest, new projectionswere made from the demand-deposit equation,(2), usingthe past-peakvalue of realper capitaGNP ratherthan its actual currentvalue as a crude means of capturinga ratcheteffect.5 Past-peakincome was used so thatthe declinesin realGNP wouldnot work to raisethe demandfor money relative to nominalGNP. Theestimates were reducedby $2.4 billionand $4.4 billionin the thirdand fourthquarters of 1974,respectively, thus reducing by thatamount the residualsof $6.1 billion and $10.8billion for thosequarters in the originalprojection. But the errors wereworse for previousrecessions using this new formulation.Thus, the evidenceis inconclusive.Since 1974is uniquein the numberof quartersin whichnominal and real GNP moved in oppositedirections, and the esti- mateswere improved for 1974,the evidencedoes suggestthe need for further workon the possiblenonreversibility of money demand. Therecent strange behavior of predictedmoney demand might result, in part,from the use of the Treasurybill ratein the money-demandfunction. In principle,all marketrates should be presentin one form or another;but becauseof multicollinearitythe Treasurybill ratewas chosenas a proxyfor

5. Sincethe functionwas not reestimatedusing past-peakreal income but was simply rerunapplying the coefficientfor real per capita GNP to past-peakincome, the residuals are only suggestiveof the possible misspecificationof the equations. James L. Pierce 97 other rates. Recently,the bill rate has followed a pattern considerably differentfrom that for other rates. One reasonmight be that intereston Treasurybills is not subjectto state and local incometaxes, so that as interestrates rise, bill ratesand othermarket rates increasingly diverge. The spreadshould be reducedwhen interest rates fall. This factorcould be im- portantsince some large states, including New York and California,have maximumpersonal tax ratesof 11percent or more.A secondreason may be the recentvery large increase in Treasurybill holdingsby foreigners.Some of thisunusual demand is fromforeign central banks, and some apparently fromsuddenly rich Arabs with such strongpreferences for safetythat they preferbills in spite of the largerate differential.Still anotherpossibility is that recenteconomic shocks have causeddomestic portfolio managers to attachunusually large risk premiumsto privatedebt. In orderto examinethe importanceof the relativelylow bill ratesin the demand-depositequation, the actualbill rate was increasedin 1974suffi- cientlyto returnit to a normalrelationship to the commercialpaper rate- which was probablymore typical of overall short-terminterest rates in 1974.The actual bill rates in 1974 were adjustedby the residualsin the model'sequation for the commercialpaper rate, whichtakes this rate as a functionof the bill rate.6These errors measure the unusualspread that has openedup betweenthe bill and commercialpaper rates. The errorsfor the fourquarters of 1974,expressed in percentagepoints, were 0.1, -2.4, -2.4, and 0.3, respectively.When these errorsare addedto the bill rate and fed into the demand-depositequation, its originalerrors of $6.1 billion and $10.8billion were reduced by $5.1 billionand $3.4 billionin the thirdand fourthquarters, respectively. Anotherexplanation for the collapsein moneydemand may lie in changes in compensatingbalances that commercialbanks often requireof their loan customersas a conditionfor extendingcredit or lines of credit.In the latterpart of 1974,commercial banks abandonedor modifiedtheir prime- rateformulas to keeptheir lending rates unusually far above market interest rates,expecting thereby to enhancetheir profits and to reducethe shareof loans in theirportfolios. Under this pressure,borrowers may have shifted

6. The equationrelates the commercialpaper rate to the current and one-quarter- lagged values of the Treasurybill rate: RCP = 0.54 + 0.71RTB+ 0.35RTB.1. Standarderror = 0.14; sample period: 1953:2-1969:3. 98 Brookings Papers on Economic Activity, 1:1975 theirbusiness away from banks towardother sourcesof credit-such as commercialpaper-and takentheir compensating balances with them, thus reducingmeasured money demand. Giventhe totallack of dataon compensatingbalances, the importanceof this phenomenonis uncertain.However, the reductionin compensating balanceswas probablynot verylarge. Most firmsthat borrowin the commercialpaper market must maintain credit lines at commercialbanks and, hence,compensating balances. Furthermore, the termson whichborrowers regainaccess to creditat commercialbanks will dependin part on the size of thebalances that they have maintained. Businesses would, therefore, hes- itateto reducetheir deposit balances. Thus, the restrictivelending policies of commercialbanks are unlikelyto have producedmuch reductionin compensatingbalances. Some arguethat, becausemuch of the publicalways holds minimalde- mand depositsor becauseof innovationssuch as NOWs, POWs,WOWs (negotiableorders of withdrawal,payment orders of withdrawal,written ordersof withdrawal,respectively), and money-market mutual funds, M1 is no longer an interestingvariable. If this assertion were correct, one wouldexpect to see a sizableshift into savings-and time-depositliabilities of banks and nonbankthrift institutions.Such shifts must lie behind the argumentsthat higherorders of M, such as M2 (M1 plus time depositsat commercialbanks other than certificatesof deposit)or M3 (M2 plus deposits at nonbankthrift institutions) are more reliablevariables than M1. A shiftaway from M1 to suchinterest-bearing deposits would show up as underpredictionsin the model'sequations for commercialbank savings and timedeposits (other than certificates of deposit)and the sum of liabilitiesof savings and loan associationsand mutual savings banks. However,the errorsshow little evidenceof a persistenttendency to underestimatethe growthin thesedeposits and no clearoffset to the overpredictionof money demandin the secondhalf of 1974.What does show up fromthese equations are large errorsin both directions:predicting those bank and thrift ac- countsis not easy.7

7. Recent predictionerrors do suggestthat these equationshave problems.The major difficultyin predictingthese savings and time accounts appears to lie with obtaining interest-ratevariables that adequatelymeasure the rates paid by banks and thriftinstitu- tions. For a brief discussionof the difficulties,see my commentson WilliamE. Gibson, "Deposit Demand, 'Hot Money,' and the Viability of Thrift Institutions," BPEA (3:1974), pp. 633-34. James L. Pierce 99 Manyother factors might explain the collapsein moneydemand, such as the mix of GNP, the volumeof financialtransactions, the expectedrate of inflation,the declinein real wealth,and the like. Indeed,when all the revisions are made in the GNP accounts and in the measurementof the money stock, the problemof explainingM1 in the second half of 1974 mightwell disappear. Whileits recentbehavior may be somethingof a mystery,the important lesson appearsto be that no evidenceattests to a fundamentalstructural shiftin moneydemand. While one must wait for new observationsto see if largeerrors persist, preliminary data suggestthat the predictionerrors for thefirst quarter of 1975are much smaller. Thus, the secondhalf of 1974ap- pearsto havebeen an unpleasantepisode, but conventionalmoney-demand functionscan be usedas one tool for analyzingthe futurecourse of interest rates.

The Prospectsfor InterestRates

Many observershave expressedthe concernthat the sharplyincreased governmentborrowing resulting from the large deficitsin 1975 and 1976 willput substantialupward pressure on interestrates that will tendto choke off the prospectiverecovery. Those who findthis resultinevitable argue that if the FederalReserve were to buy a substantialpart of the new debt, it wouldonly avert the risein the shortrun. Eventually, such an expansionary monetarypolicy would, it is feared,rekindle both actualand anticipated inflation,and in so doing would cause nominal interestrates to rise even higher. Leavingdirect comment on this argumentaside for the moment,a review of the historicalrelationship between interest rates and deficitsmight be useful.These two seriesare presented for 1952through 1975: 1 in figure3. It is clearthat, historically, large deficits tend to be associatedwith recession- induceddeclines in revenuesand with declinesin interestrates. This historicalrecord certainly gives no evidenceof a simplecorrelation between largedeficits and high or risinginterest rates. Perhapsduring the periods of deficitsand declininginterest rates the centralbank was pumpingin so muchmoney that the debt was effectively monetized.Again, the historicalrecord does not supportthis conjecture. Figure4 shows the annualizedrates of growthof M, quarterby quarter - - s ? L

m & & &. 8~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~...... - ch

I, ,- CO0zd

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'U~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~'~~~~~~~~~~~~~~~~~~~~...-.... , .,. ''...... ' ......

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Cd 00 ...... cd 4-4 >

4-4

...... to Cd ts > 79 C41 >. ci&.. o z cl. 00 CY 0 102 BrookingasPapers on Economic Activity. 1:1975 overthe same1952-1975: 1 period.With the exceptionof 1958and 1971-72, themost rapid M1 growth was associated with surpluses rather than deficits. This patternillustrates a frequentlyprocyclical behavior of M1 growth ratherthan a financingof deficitsthrough monetary expansion. Even in the case of the 1964tax cut, interestrates drifted up graduallywith economic activity;M1 expanded in step with the economyuntil 1966. Thissimple historical exercise is intendedonly to demonstratethat in the past deficitshave not led to the kind of immediateinterest-rate response thatsome observers seem to fearfor 1975.There is no reasonto believethat deficitsresulting from recession-induceddeclines in tax revenueswill spur increasesin interestrates. Tax cuts and expenditureincreases do tend to raise aggregatedemand and, hence, ultimatelyto raise interestrates. But whenthis happens, the riseresults from the autonomousincrease in demand and not necessarilyfrom an increasein the stock of outstandingdebt. The questionremains, however, whether a largeincrease in the stock of government debt associatedwith a deficitsuch as is now in prospectwill be an additionalfactor raising interest rates even furtherand thus retardingthe growthin privateexpenditures. Unfortunately,conventional econometric models providevery little in- sightinto the issue.They take no explicitaccount of the directeffects of the volume or compositionof debt financingon financialmarkets. Through a seriesof identities,the modelsdo provideestimates of the amountof debt raisedby varioussectors-government, business, and households.Identi- ties are also used to equatethe variousforms of savingto aggregateinvest- ment. However,the volumeof debt,as well as the demandfor it, does not directlyaffect interest rates in these models. Short-terminterest rates are determinedby the interactionof moneydemand and moneysupply. Long- term rates are determinedby term-structureequations that relatethem to shortrates. These interest rates influence total spending,which in turnfeeds back on to money demandand hence again to interestrates in a simul- taneouslydetermined system. Thus, the basicdeterminant of interestrates is the growthof the moneysupply relative to currentand laggedincome, not the volume or relativesupplies of debt. Tax cuts and expenditurein- creasestherefore will raiseincome in thesemodels, and the increasein aggregatedemand will raiseinterest rates for any given money supply.The largeprospective volume of governmentdebt qua debtwill have no impact. It is worthpointing out that thesemodels have done a fairlygood job of predictinginterest rates without explicitlyallowing for relativedemands and suppliesof credit. JamesL. Pierce 103

The Outlook throughFiscal 1976

As the foregoing discussion suggests, assessing the likely course of interest rates over the next year or so requires first some estimate of the course of aggregate demand and prices over that period. George Perry has kindly supplied me with his economic projection for 1975, and I have taken the liberty of extrapolatingit through the first half of 1976. While one may dis- agree with some features of this forecast, Perry's projections (and my extrapolations) are within the mainstream of current private forecasts. His projection has the added advantage of being very recent and of incorporat- ing the actual tax program. Perry does not assume significant "crowding out" of private expenditures in response to a deficit-induced rise in interest rates. Rather, he assumes that M1 will grow fast enough to assure constant short-terminterest rates as indexed by a 5 1/2percent Treasury bill rate over the forecast horizon. One test of the "surging interest rate" hypothesis will be to determine whether the Perry forecast is feasible given the prospective deficit and different as- sumptions concerning monetary policy.

INTEREST RATES AND MONEY DEMAND The Perry GNP projection for 1975 and my extrapolations for the first half of 1976 are shown in table 1, along with data for 1974 for purposes of comparison. The annual percentage changes of GNP, GNP in constant dollars, and the implicit deflator for half years are shown in the following tabulation: Annual percentage change

Second half First half Second half 1974 to 1975 to 1975 to first half second half first half Economic indicator 1975 1975 1976 Nominal GNP 0.25 12.3 10.4 GNP in 1958dollars -8.1 6.9 5.2 GNP implicitprice deflator 8.7 5.3 5.0 As the table shows, the projected expansion in nominal GNP is quite rapid. According to the money-demand function of the SMP model, this expansion would require an average growth in Ml in excess of 9 percent to 0 ON "t m rt m^ tn

ON :tko t N nt-NCm > .

m m m o r

ksS oo tt <>E O b e t I m N OC$> t- m? ?? oo O2 Z ON ~etm_-4 en T 00l 00 0 *

.P.* i Y ;e w s:~~~~~~~~~~~~~~~~

i~~~~t 0z "oo^-E0c

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CZe-4t t-m oo cr N ooooo O_

? a % t t t t~~~V4 N CN O0 00 XX o q ~~~~~~~~~~~~~~~~~0G

ffi .C 4 N .cr N c ON , v) o tJ Zyo~~~~~~~~~C r ? tfiv r- v, ~~~tt 00>svir

eW en, 00 00e' '!t /l- James L. Pierce 105 keep short-terminterest rates constant through 1975.8 If the sharprise in governmentdebt puts pressureon interestrates beyond that measuredby the money-demandequation, an even more rapidgrowth in M1 would be required. Manyobservers would argue that Perry'simplicit assumption about M1 growthis not realistic.It certainlydoes not accordwith the 5 to 7.5 percent rangerecently announced by the FederalReserve ;9 interest rates would ob- viouslyrise with M1 growthin this range.Thus, Perry'sGNP projection may be overly optimisticbecause rising interestrates induced by slow growthin M1relative to GNP would dampenprivate spending. To estimatethe impact on Perry'sprojected GNP of such an income- inducedrise in interestrates, the full SMP model was first adjustedto re- producePerry's GNP forecastquarter by quarter,given constantinterest rates. This simulationgenerated the M1 growth projectionmentioned above.Then M1 growth was set at 7 percentand a new simulationwas obtained.Doing this reducedGNP by about $20 billionby the fourthquarter of 1975as a resultof the slowerexpansion in M1.The simulatedTreasury bill ratestood at 6.50 percentin that quarter-a full 100basis pointsabove Perry's5.50 percentassumption.

THE DEFICIT The simulationjust describeddemonstrates how muchdifference monetary policy can make workingthrough conventionally modeled channels. The alternativeprojections for interestrates had nothingto do with the in- creasedstock of governmentdebt. The questionstill remainswhether this rise in debt will be an additionalforce contributingto a rise in interest rates:Will the prospectivenew weight of the public sector in the mix of borrowingraise interest rates? Or, will the rate increasespredicted by con- ventionaleconometric models capture the relationshipbetween rising GNP and interestrates, given M1 growth? The presentstate of analyticknowledge gives a presumptiveanswer to this question.The effortsof model buildersto find an explicitrole for the

8. In this calculation the equation was adjusted for the large error in the fourth quarterof 1974. 9. See "Statementby ArthurF. Burns,Chairman, Board of Governorsof the Federal ReserveSystem, before the SenateCommittee on Banking,Housing and Urban Affairs" (May 1, 1975; processed). 106 Brookings Papers on Economic Activity, 1:1975 relativesupplies of debt in the determinationof interestrates indicate that once term-structureeffects-which implicitlymeasure changes in the demandand supplyof credit-are allowedfor, no importantrole remainsfor changesin relativequantities of creditin the economy.10Nonetheless, in viewof the historicsize of the governmentdeficit, it is worthlooking at as a specialcase. Figure5 displaysthe amountof U.S. governmentdebt as a percentageof GNP from 1965 throughthe first half of 1976, the last three half-years representingthe Perryforecast. The percentagerises sharply in the forecast period,but onlyback to 1969-71levels, and it remainswell below thosefor earlieryears. Nothing in the behaviorof this percentagesuggests that the deficitfor 1975and 1976will lead to unusuallyhigh levels of debt relative to GNP.

FLOW OF FUNDS The nextissue is whetherthe expectedsaving and investmentflows are so unusualthat financingthe new debt of the governmentwill be difficultand thus push rateshigher. To examinethe feasibilityof Perry'sforecast from this perspectiverequired integrating government and privatefinancing re- quirementswith the Perryforecast. In a highlystylized exercise, I used an estimateof the flow of funds likely to be consistentwith the PerryGNP forecast,assuming a sustained5 1/2percent bill rate in 1975 and the first half of 1976.11If the GNP patternhad implied"strains" in financialmarkets, in the formof unusuallylarge shifts in the borrowingand lending pro- pensitiesof the privatesectors, perhaps the fearsof extremelyhigh interest rates would be justifiedo, perhapsthe GNP estimatewould be too opti-

10. See, for example, Franco Modigliani and Richard Sutch, "Innovations in In- terest Rate Policy," AmericanEconomic Review, vol. 56 (May 1966), pp. 178-97; and WilliamD. Nordhausand Henry C. Wallich,"Alternatives for Debt Management,"in Issues in Federal Debt Management,Proceedings of a Conference Sponsored by the Federal ReserveBank of Boston, June 1973 (FRBB, no date). 11. The flow-of-fundsprojection thought consistent with the assumptionsabout projected GNP and interestrates was kindly suppliedby StephenP. Taylor, of the Federal Reserve Board staff. He is in no way responsible,however, for the use to which I put his projectionor for the conclusionsthat I drawfrom it. In this connection,it should be noted that flow-of-fundsmodeling is still an infantindustry. Existing models are "rough" and analysis using them is somewhat unreliable.One of the newest and best analyses using the flow of funds for longer-termprojections can be found in BarryBosworth and James S. Duesenberry,"A Flow of Funds Model and Its Implications,"in ibid. James L. Pierce 107 Figure 5. Ratio of the Stock of U.S. GovernmentDebt to Gross National Product, 1965 throughFirst Half 1976

Percent 40

35 -

Ratio in percent 30 -

25 lI II 1965 1970 1975

Sources: Board of Governors of the Federal Reserve System, "Flow of Funds Accounts, 1965-1973" (1974; processed), pp. 1, 31; table 1 above. Government debt for 1974 was obtained directly from Federal Reserve preliminarystatistics; for 1975-76 the debt figures are projections based on data for the preceding years. mistic. If, on the other hand, there appearedto be no great difficultyin achievingthe requiredmix in the flow of funds,the fearsof surginginterest rates would probablybe without foundation,in the sense that monetary policy couldproduce Perry's projected path of constantshort-term rates. Table2 showsthe variouscomponents of grosssaving and grossinvestment that StephenTaylor has estimatedto be consistentwith the Perry forecast. While the identities requirethat saving equal investment,the mannerin whichthe balanceis struckis still instructive.The accountsare broughtinto balancein 1975 by a $45 billion rise in privatesaving and a $35 billion declinein privateinvestment. The sum of these, $80 billion, is sufficientto matchthe dissavingof the governmentsector. The expansionin privatesaving comes from severalsources. The tax cut and the generalrise in personalincome stimulates personal saving in 1975. Undistributedcorporate profits will be down; but the saving from a reduced inventoryvaluation adjustment, which measures the risingreplace- ment cost of inventories,actually raises business saving on balancein 1975. The projecteddecline in investmentis not the resultof financialcrowding out of projects-recall Perry'sassumption of constantinterest rates-but stemsrather from high excesscapacity. 108 Brookings Papers on Economic Activity, 1:1975 Table 2. Estimates of Gross Saving and Investmentfor 1975-76, and Actual for 1974, by Component Billions of dollars Half year (seasonally adjustedannual rate) Calen2daryear 1975 1975 1976 Component 1974 1975 first second first Gross private saving 213.2 258.2 254.8 261.6 267.8 Personal saving 76.7 105.4 109.4 101.4 94.1 Undistributedcorporate profits 52.5 33.2 29.6 36.8 42.3 Inventory valuation adjustment -35.5 -8.7 -10.1 -7.2 -3.9 Capital consumption allowances 119.5 128.3 126.0 130.6 135.4 U.S. governmentsurplus -7.6 -83.6 -86.2 -81.0 -71.4 State and local government surplus 1.7 -2.4 -3.1 -1.6 -0.9 Total gross saving 207.3 172.2 165.6 179.0 195.6 Gross domestic investment 208.9 179.9 169.4 190.4 213.4 Net foreign investmentand statistical discrepancy -1.6 -7.7 -3.8 -11.4 -17.9 Total gross investment 207.3 172.2 165.6 179.0 195.5 Sources: 1974 data are from Board of Governors of the Federal Reserve System, "Flow of Funds, Seasonally Adjusted, 4th Quarter, 1974, Preliminary" (February 5, 1975; processed), p. 1. Other data are projections by Stephen P. Taylor of the Federal Reserve System, consistent with the Perry forecasts in table 1. For components calculable from table 1, the results may differ slightly because of data revisions and rounding. Details may not add to totals because of rounding.

The flow-of-fundsprojection shown in table 3 tells the story in a somewhat differentway. Total fundsraised by all nonfinancialsectors in 1975 areprojected to be only $8 billionhigher than in 1974.The $80 billionrise in U.S. governmentborrowing is almosttotally offsetby a $72 billion declinein borrowingsby othernonfinancial sectors. Funds raisedby households and nonfinancialbusinesses are projectedto declineby $23 billion and $42billion, -respectively.'2 In light of Perry'sprojection of a $20 billion risein the rateof personalsaving from 1974to 1975,any sourcefor strong upwardpressure on interestrates from the householdsector is hardto find. Giventhis increase in savingand the forecastweakness of housingdemand, a sharpreduction is projectedin the volume of funds raisedon creditby households. Table4 showsthe projectionfor 1975and the firsthalf of 1976of gross investmentand gross internalfunds generatedby the corporatesector, basedon the Perryeconomy-wide forecast. Inventory investment declines sharplyfrom 1974 levels and corporatefixed investmentrises only mod- erately.Together, they implya sluggishrise in grossinvestment, which re-

12. The recentlarge volume of long-termborrowing by nonfinancialbusinesses repre- sents a restructuringof business balance sheets rather than a strong total business demand for funds. JamesL. Pierce 109 Table3. FundsRaised in CreditMarkets by NonfinancialSectors, 1972-76 Billions of dollars Half year (seasonally adjusted annual rate) Calendaryear 1975 1975 1976 Sector 1972 1973 1974 1975 first second first Nonfinancial sectors, total 169.4 187.4 175.7 184.0 179.2 188.9 211.5 U.S. government 17.3 9.7 13.0 93.7 97.1 90.3 74.5 Otherdomestic, total 147.8 170.1 147.2 84.8 77.1 92.5 130.2 Households 63.1 72.8 42.5 19.4 14.5 24.4 49.5 Nonfinancial business 70.5 85.1 88.9 47.2 43.7 50.7 57.8 State and local government 14.2 12.3 15.8 18.2 18.9 17.5 22.9 Foreign 4.3 7.5 15.5 5.5 5.0 6.1 6.9 Sources: Federal Reserve System, "Flow of Funds, Seasonally Adjusted, 4th Quarter, 1974, Prelimi- nary," p. 2; and Taylor's projections, cited in table 2. Details may not add to totals because of rounding.

Table4. GrossInvestment and GrossInternal Funds of Domestic NonfinancialCorporate Business, by Component,1974-76 Billions of dollars,except where indicated Half year (seasonally adjustedannual rate) Calendaryear 1975 1975 1976 Comnponent 1974 1975 first second first Gross investment, total 125.8 106.4 100.4 112.4 128.7 Fixed investment 115.7 116.2 114.4 118.0 123.1 Change in inventories 10.1 -9.8 -14.0 -5.6 5.6 Gross internal funds, total 81.4 96.3 89.7 102.9 114.6 Undistributed profits 34.6 18.7 14.3 23.0 28.0 Foreign profits 9.8 7.4 8.2 6.5 6.5 Inventory valuation adjustment -35.5 -8.7 -10.1 -7.2 -3.9 Capital consumption allowances 72.5 78.9 77.3 80.6 84.0 Ratio of gross internal funds to gross investment (percent) 64.7 90.5 89.7 91.5 89.0 Sources: Federal Reserve System, "Flow of Funds, Seasonally Adjusted, 4th Quarter, 1974, Prelimi- nary," pp. 1, 2; and Taylor's projections, cited in table 2. The calculations are made from data before rounding. mainsbelow the rateachieved in 1974until the firsthalf of 1976.Internally generatedfunds, on the otherhand, are expectedto rise becauseof a sub- stantialreduction in the volumeof fundsrequired for inventoryaccumula- tion as a resultof the slowingin inflation.This drop in IVA also servesto reducetaxes paid on inventoryprofits and thereforemoderates the decline in undistributedprofits. Thus, the corporatesector is expectedto be a sig- nificantlysmaller factor in capitalmarkets than it was in 1974. Over the nexteighteen months, the businesssector should be ableto financemost of its projectedinvestment expenditures from internally generated funds. 110 BrookingsPapers on EconomicActivity, 1:1975 Figure6. FundsRaised by the U.S. GovernmentSector as a Percentage of TotalFunds Raised by NonfinancialSectors, 1952-76

40 -

Ratio in percent 20

10 I

-10

-20 _ 52 54 56 58 60 62 64 66 68 70 72 74 76

Sources: Federal Reserve System, "Flow of Funds Accounts, 1945-1972," pp. 4, 5; Federal Reserve System, "1974 Supplement: Flow of Funds Accounts, 1965-1973" (September 1974; processed), p. 2; "Flow of Funds, Seasonally Adjusted, 4th Quarter, 1974, Preliminary," p. 2; and Taylor's projections, cited in table 2.

MARKET CONGESTION The evidencepresented so far suggeststhat the fears over the interest- rateimplications of the largeincrease in federaldebt are withoutfounda- tion. The sharpincrease in the savingrate combined with weakinvestment and housingdemand should leave plenty of funds for the governmentto borrow.13Another way to get at the issue is to look at the shareof federal financein total funds raised. Conceivably,if the federalshare rises fast enough,financial markets will becomecongested and interestrates on governmentdebt and substitute instruments will risesharply. Figure 6 depictsa

13. Thisconclusion is similarto one reachedindependently by John Lintner,"Savings and Investmentfor FutureGrowth, 1975-76 and Beyond"(paper prepared for the Con- ferenceon Inflationand Recession, The ConferenceBoard, New York City, April 8-9, 1975; processed). James L. Pierce 111 Figure 7. Share of U.S. GovernmentSecurities in Total Private Domestic Holdings of Credit-MarketDebt, 1952-76

Percent. 50

40-

30 -

20 -

52 54 56 58 60 62 64 66 68 70 72 74 76

Sources: Same as figure 6 (pp. 78, 27, and 3, respectively, of the published sources given). time seriesof the ratio of federaldebt to total nonfinancialfunds raised. It clearlyshows that, in 1975 and 1976,the governmentdeficit will be large relativeto the total borrowingneeds of the nonfinancialsector as the U.S. governmentmoves from its relativelyminor role in financialmarkets to a majorrole-indeed, for a time, an unprecedentedone. Whilethis shift in the weightof the public sectorin the borrowingmix maydisrupt financial markets-and one could alreadysee signsin the early monthsof 1975in the U.S. couponmarket-it does not implyany dramatic shift in the compositionof the public'sportfolio of assets.Figure 7 shows that,while the shareof U.S. governmentsecurities in total privatedomestic holdingsof credit-marketdebt is expectedto rise in 1975and 1976,it will still be verylow by postwarstandards. Althoughsome congestionmay develop in the governmentsecurities marketfrom time to time, it cannotlast long. Sincethe participantsin this markethave had ample time to preparefor the deluge of securities,the congestionis unlikelyto be severe.While interest rates on governmentse- curitiesmay rise somewhatrelative to those on privateissues, this change seemsunlikely to push up the generallevel of interestrates. The financialsituation also offersno reasonto doubt the feasibilityof 112 BrookingsPapers on EconomicActivity, 1:1975 Perry'sforecast-at leastin broadoutline. The flow of savingfrom the tax cut will directlyand indirectlyfind its way into the governmentsecurities marketand the economyshould finance the deficitwith little strain.The courseof interestrates thus will depend,as usual, on monetarypolicy and not on the deficit.If monetarypolicy provesto be much more restrictive than Perryassumes, his forecastwill be too bullish.This outcomewould resultfrom the conventionaleffects of monetaryrestriction and not from the largeincrease in governmentdebt. Commentsand Discussion

StephenM. Goldfeld:In the firstpart of his paper,Pierce looks at the 1974 behaviorof moneymarkets, and an importantpart of this exerciseis the relationbetween interest rates and money demand.In the secondpart, he looks at the likelycourse of interestrates during the next severalquarters, and againthe relationbetween interest rates and moneydemand is of central importance.However, what the past tells us about the futurefor this relationis left somewhatuncertain, and Piercemakes no specialallowance for 1974'ssurprises in his projections.Pierce also discussesthe extra im- pacts on interestrates that might arise from the large budgetdeficit that lies ahead,and finds little reason to expectany. So he endsup witha down- the-middleforecast that impliesthat interestrates will rise considerablyif the FederalReserve holds to a modest growthpath for M,. I do not dis- agreewith this assessment.But Pierceraises some provocative issues before reachingdead center and I would like to commenton some of these. The basicpuzzles in the firstpart of the paperare the largeresiduals in the thirdand fourthquarters of 1974in the money-demandequation of the SMPmodel. As Piercenotes, theselarge residuals-in whichactual money demandwas $6 billionand $11 billionbelow predictions for the thirdand fourthquarters-in no way explainthe slow growthof M, of this period. The Fed could have made money grow fasterif it had wantedto-there was not even anythingunusual in the relationbetween bank reservesand the money supply;but achievingthis faster growthwould have required pushinginterest rates down much faster.Thus, the point of the exercise cannotbe to explainthe past growthof M,, but rathermust be to under- standthe workingof the demandfunction so as to help predictthe M, requirementsfor the future. In this spirit, Pierce considersa numberof reasonswhy moneydemand may have been unusuallylow. 113 114 Brookings Papers on Economic Activity, 1:1975 Beforeconsidering these, I can reportthe residualsfrom some alternative money-demandequations that I have run for this same period. The basicequation has a structuresimilar to the one presentedby Pierce.The other two equationsadd the change in wealth and the inflationrate as explanatoryvariables. The residuals from these three equations, which were estimatedwith data through 1973, are presentedbelow for the quarters sincethen: Five- quarter Actualminus predicted M1 root (billionsof dollars) mean Equation square 1974:1 1974:2 1974:3 1974:4 1975:1 error Basic -2.5 -0.4 -4.5 -6.7 -1.2 3.8 With wealth -1.5 -0.9 -4.0 -5.5 -1.5 3.2 Withinflation -0.9 -0.1 -3.1 -4.5 -0.8 2.5 A few thingsare worthnoting in theseresiduals. The basic equationhas largeerrors, but not nearlyas largeas thosethat Piercereports for the third andfourth quarters. The wealthand inflationvariables reduce the residuals for these quarterssomewhat further, indicating that they may belongin a specificationof moneydemand. All the equationsare nearlyback on track by the firstquarter of 1975,which suggests that whateverthe mysterywas in the secondhalf of 1974, it has little importancefor the future.This is also Pierce'sconclusion. Finally, in connectionwith the secondpart of the paper,I also includedthe budget deficitin the basic equationand it did nothing,although this test has problemsbecause the equationwas in logs and the deficithad to be put in linearly. I havea fewcomments on the explanationsPierce offers for the (perhaps) unusualbehavior of money demandlast year.First, the fact that a decline in realincome gives a less thanproportional decline in moneydemand need not imply unlearningin the sense that Pierce worriesabout. On a trans- actionsview of the demandfor money,the conventionalmodel has people optimizingon money holdingsand would predictthe kind of result that Piercedescribes. Unlearning or forgettinghas nothingto do with this. To the extentthat thereis somethingelse in the empiricalresults, it may be that real incomeis not the thing to look at. Perhapsinnovations have in some sense producedshifts in money demandthat conventionalanalysis has ignored.But interestrates might be a bettercandidate than real income James L. Pierce 115 for isolatingany ratcheteffects that come from innovation. Such effects could be part of the 1974 story even if they did not show up in previous recessions-simplybecause they are new phenomena.Or it might be that, whetherreal income or interestrates is the interestingvariable, the changes are muchsteeper in the currentsituation than in past recessions.In either case, Piercehas raiseda point that deservesfurther work. Piercelooks at the savingsflows to commercialbanks and thriftinstitu- tions to see if M2 or M3 was betterpredicted than M1.Part of the problem in the poor predictivepower that he reportsfor these equationsmay lie in the interestrate that is used. I thinkthe SMP model uses a rate that has a 5 ?/:percent ceiling, and if it does, the effectmust be to understateboth the heightof effectiverates and the variationin rates over past quarters. WhenPierce turns to projecting,he makesno specialallowance for the residualsin the money-demandequations for 1974. His main messageis thatthe fairlyrapid growth in realand nominalGNP projectedby Perryon the basis of a constant5 1/2percentTreasury bill rate is unlikelyto be consistentwith a growthin the moneysupply anywhere near as slow as 6 percent. Indeed,the money supplywould probablyhave to grow fasterthan 10 percentto conformto the Perryforecast. This relationshipamong the threevariables-GNP, interestrates, and the money supply-gives Pierce his main handlefor projectinginterest rates for variousscenarios. I would use the samehandle. Piercealso addressesthe governmentdeficit as an additionalfactor that mightaffect interest rates. Here his basic approachis to examinethe flow- of-fundsanalysis provided by Tayloron the basisof the Perryforecast. But thereis probablysuch a big subjectiveelement in the flow-of-fundsbreak- down that one could expect to find crowdingout only if Taylor, in his judgment,included it. To developa satisfactoryanalysis from this kind of exercise,it wouldbe usefulto compareinterest rates and the correspondingflows from Taylor with a completeconstellation of interestrates from the GNP forecastand variousassumptions about the moneysupply. One could then see whether those two sets of rateswere roughly matched or badlymismatched. This is askinga lot fromthe presentstate of the artin flow-of-fundswork, I know, and Piercehimself makes all the properdisclaimers about the state of that art. But if this workis evergoing to convincepeople about somethingthat they now do not fundamentallybelieve in, it will have to beginby under- taking analysisof this sort. 116 Brookings Papers on Economic Activity, 1:1975 DavidI. Fand: Piercehas writtena veryinteresting paper, which takes up severalimportant macroeconomic policy issues. The firstpart of the paper analyzesmonetary developments last year and providesan understanding of the forcescurrently shaping money demandand interestrates. Pierce's analysisof the 1975-76deficits in the second part offersa thoughtfulas- sessmentof the credit-marketand interest-rateproblems that the economy may face in the next twelveto eighteenmonths. Piercefirst considersthe large decline in short-termrates, the smaller declinein long-termrates, and the sluggishgrowth in Ml in the thirdand fourthquarters of 1974. Using the money-demandfunction in the SMP model,he calculatesthat Treasurybill rates of 8.8 and 8.3 percent(in the thirdand fourthquarters, respectively) should have generateda 6 percent growthin M1in the secondhalf of 1974.The actualbill ratesin these two quarters-8.2 and 7.4 percent,respectively-were below those calculated in the SMP model for 6 percentgrowth, yet Ml growthwas only slightly above2 percentover those two quarters.The questionPierce confronts is whetherinterest rates fell too much or moneygrew too little. Pierceconcludes that the sharpdecline in short-termrates was not surprising,and that the moderatedecline in long-termrates was not out of line with the term-structureequation in the model. Since movementsin interestrates conformedto the model, the sizable 1974 errorsin Ml are viewedas the consequenceof a downwardshift in the money-demandequation. And sincethe modelpredicted the veryrapid currency growth during the yearquite accurately,Pierce associates the 1974 residualsfor M1 with a downwardshift in the demand-depositfunction. While the 1974residuals are large,it may be helpfulto test whetherthey are largeenough to reject the null hypothesisof no shift. Severalhypotheses, such as the "nonreversibility"of demand,changes in compensatingbalances, the use of a modifiedTreasury bill rate, and a shiftfrom Ml to othermonetary assets, are introducedto rationalizethis shiftin moneydemand, but those thathelp reduce the 1974residuals do not work for earlierdownturns. Pierce's ex post analysisof residualscannot satisfactorilyrationalize the assumedshift in money demand. The strategyof associatingthe largeresiduals with a shift in the deposit functionleads Pierceto a systematicanalysis of the factorsthat could ac- countfor the change.And whilethis constructiveapproach does not as yet providea satisfactoryexplanation, it may do betterwhen the reviseddata areavailable. A less ambitiousoption would treat these large 1974 residuals James L. Pierce 117 as reflectionsof a temporarydisequilibrium, following a largeand precipi- tous declinein real income. Althoughthe recentbehavior of money demandis viewedas something of a mystery,Pierce finds no evidenceof a fundamentalstructural shift from Ml towardsavings and time depositsand nonbankintermediary claims. Indeed,the preliminarydata for the first quarterof 1975 indicatesmaller predictionerrors. Pierce argues, therefore, that the Fed couldhave achieved a 6 percentgrowth in Ml in the latterhalf of 1974if it had supplieda larger volumeof reserves. Pierce'sanalysis of 1974is that, in the collapsingeconomy of 1974,the interest-ratetargets were not loweredfast enoughto avoid sluggishmoney growth.A similaranalysis of moneydemand and interestrates in a surging economywould indicate that interest-ratetargets have not kept pace with money-marketrates, and thereforeaccelerated, even explosive,monetary growth,may occur.One possibleconclusion is that interest-ratetargets are not the appropriateway to implementmonetary policy, especially when the economyis undergoingtransition. Pierce'sanalysis of the prospective1975-76 budget deficitsreveals his considerableannoyance at the tenor of recentdiscussions. He is especially concernedover some widely publicized statements that foreseelarge deficits crowdingout privateinvestment expenditures and chokingthe prospective recovery,but that give no explicitanalysis of the forcesshaping aggregate demandin the next two years. Pierceargues that thereis no simple,direct, or automaticlink between deficitsand interestrates, and that the most rapidM1 growth was typically associatedwith surplusesrather than deficits(see his figure3 on federal budgetdeficits and interestrates and figure4 on annualrates of growthin M1).The historicalrecord does not, in Pierce'sview, supportthe notion that largedeficits produce high or risinginterest rates, nor does it support the associatedfears that explosivemoney growth will inevitablyfollow the large 1975-76deficits. Thisapproach, illustrated in figures3 and 4, whichcompares contempo- raneousdeficits, interest rates, and rates of monetarygrowth is not, however, satisfactory.In assessingthe impact of deficitson interestrates one shoulddistinguish between Walter Heller's "passive" deficits and "active" deficits-that is, betweenan endogenousdeficit reflecting weakness in the economy and a discretionarydeficit reflectinga change in fiscal policy. Indeed,one would expect that the passiverecession deficits will be asso- 118 Brookings Papers on Economic Activity, 1:1975 ciated with the low interestrates. Also, while an increasein the active deficitsmay, in time, causeinterest rates to rise, this effectmay not be de- tectableeconometrically without allowance for lags. Evenif deficitsdo not exerta majorcontemporaneous influence on interestrates, they could still have a significantnet effectamong the other factorsaffecting rates. Simi- larly,in the searchfor a statisticallink betweenthe activedeficits and M1 growthrates, the lagged effectsof discretionarydeficits on money growth should be investigated,as well as their initial influence on a broader monetarytotal such as M2. Pierce'stable 1, incorporatingPerry's forecasts for realand nominal GNP and for the deflator,indicates a rise of over 11 percentin nominalGNP in the next twelvemonths. With the Fed's recentlyannounced target of 5 to 7 1/2percentgrowth in M1, the implicitspeedup in velocity from the first half of 1975 to the first half of 1976is between3 and 6 percent,and sup- ports Pierce'ssuggestion that the projectedrise in GNP relativeto the as- sumed growthin money would be associatedwith an increasein interest rates. This does not conformwith Perry'sforecast, which assumesa constant bill rate. In contrast,the flow-of-fundsevidence in table 3 indicates that the $80 billionrise in governmentborrowing in 1975is offsetby a $72 billion declinein borrowingby other sectors,and suggeststhat the projected federaldeficit can be financedwithout great pressureon interest rates. Piercepoints out that the flow-of-fundsmethodology is still being developed,and I do not see that its implicationsfor interestrates are as tellingas those availablefrom comparingthe GNP estimatespresented in table 1 with the Fed's monetarytargets. Pierce'sdiscussion of the deficitand its impacton interestrates points up the need to definethe alternativepolicies. For example,if a large budget deficitis essentialto revivethe economywithin a giventime frame,the deficit cannotvalidly be associatedwith any crowding-outeffect; indeed, there is a filling-ineffect. Alternatively, if a desiredGNP path can be achieved withouta deficit,or witha smallerdeficit, then there is somekind of crowding out. Consequently,if the focus is on a givenGNP path and if this path can be achievedwith alternativepolicies incorporatinglarger or smaller deficits,the benefitsand costs of these alternativepolicies should be considered.Determining whether a projecteddeficit-even a large one-will causeinterest rates to riseand crowdout privateinvestment expenditures is impossiblewithout specifying the alternativepolicy. James L. Pierce 119 This policyissue is verysimilar to the one facedby the Kennedyadminis- tration'sCouncil of EconomicAdvisers when it debatedthe meritsof alter- nativemethods of stimulatingthe economyin 1962. Some favoreddeficits to stimulateconsumption and werewilling to accepttighter money; others, seekingto stimulateeconomic growth, favored an easiermonetary policy and werewilling to accepttighter fiscal policy. In my opinion,discussion of the currentproblem would be improvedif, like the 1962debate, it focused more explicitlyon the relativemerits of alternativepolicies designedto achievea given GNP path. In spiteof Pierce'sexcellent presentation, I am still puzzledas to the impact of deficitson inflationand interestrates. In the last decade,and espe- ciallysince 1969,the nation has had large deficits,high rates of monetary growth,high inflation, and high interestrates. One wonderswhether some mechanismlinks these elements, or theyjust happenedto move togetherin recentyears. In my view, this conjunctureis not a happenstance.But if this interpretationof the inflationin the last decadeis accepted,and if the 1975-76deficits are not to ignitea new inflationaryspiral, policy must as- surethat these deficits do not leadto an accelerationin moneygrowth, and, indeed,that the economyreturns reasonably soon to a noninflationarypath for moneygrowth.

GeneralDiscussion

A good deal of discussioncentered on the relationbetween deficits and interestrates. William Fellner argued for analyzingthe issue of crowding out privateborrowing in the frameworkof policyalternatives. Low interest ratesreflecting rapid money growth and large deficits reflecting tax cuts and spendingincreases represent alternative ways of achievingrecovery. Choos- ing to stimulatethe economythrough a heavy relianceon deficitsmeans higherinterest rates than would otherwiseoccur. Hence, the composition of outputwill differfrom that underthe samestimulus with lower rates and a smallerdeficit. Interest-sensitive demands, such as housingand business investment,will be lowerwith the largedeficit than with the alternativepolicy. In turn,lower investment will result in less productivitygrowth. Robert Hall continuedthis line of thought,maintaining that, to the extent that contractionarymonetary policy caused the recession,it was correctto em- 120 Brookings Papers on Economic Activity, 1:1975 phasizeexpansionary monetary policy to cureit. Becausethe extent of the diminutionof the effectof fiscalpolicy through crowding out is unknown, it is difficultto know how expansionaryfiscal policy shouldbe. JamesTobin agreed that the crowding-outissue should be viewedin this frameworkof alternativepolicy mixes, as Fand had also suggestedin his remarks.But he emphasizedthat in doing this, the path of GNP and em- ploymenthad to be the same for each policy combinationthat was being considered.For a given path of GNP growth,substituting fiscal stimulus for monetarystimulus would produce higher interestrates and, in this sense,crowding out. But the publicdiscussion about deficits was not being conductedin terms of an agreed-uponGNP path. The alternativesthat werebeing argued were not all sufficientto do the samejob of recovery.In particular,if fiscalpolicy were made less expansionary,achieving the same degree of recoverywould requirea faster growth of the money supply. FrancoModigliani argued that help from both monetaryand fiscalpolicy was in order.The Pierceprojections, as well as others that he had seen, indicatedthat even with the fiscal stimulusnow in place, a very expan- sionarymonetary policy would be neededto achieveanything like the 6 to 8 percentrate of realexpansion that Perrywas projecting.The issuearising from the Piercepaper was whethereven this amountof monetarystimulus would be forthcoming.No one was contemplatingthe still fastergrowth in M1 that wouldbe neededif the GNP expansionwere to be fueledwith monetarypolicy alone. MarinaWhitman believed that any discussionof crowdingout had to take accountof the internationalfinancial market. Not only wouldinterest ratesin the United Statesaffect rates abroad, but therewould be an influ- encein the otherdirection as well.If U.S. corporationshave trouble raising funds in the U.S. market,they will borrowin the Eurodollarmarket or somewhereelse abroad.And foreignand financialcapital can be attracted to the U.S. marketif interestrates are favorableor for any otherreason, such as a changedassessment of the political climate or of the dollar's prospectivevalue. LawrenceKlein suggestedthat the simple correlationbetween deficits andinterest rates in the historicalrecord that Piercepresented was not sufficient evidenceon the relationor lack of it betweenthese two. He argued that it is the changeof interestrates that one mightexpect to be relatedto the deficit,and reportedthat he had found a weak relationshipusing an equationthat includedother interest-ratedeterminants, such as free re- James L. Pierce 121 serves,along with the deficit.Klein also notedthat the flow-of-fundsanalysis did show that big changeswere coming in the sectoralcomposition of savingand investmentbalances, and suggestedthat such big changesin themselvesmight imply greaterfrictions in achievingthe neededfinancial flows.Joseph Pechman pointed specifically to Pierce'sprojection that the ratio of federaldebt to GNP would rise by 5 percentagepoints, while in previousrecessions it had not risenat all noticeably.Pierce's analysis had not reallyaddressed the issue of how this changewould be smoothlyac- commodated.George Perry noted, however,that the real concernwas for thecourse of privateinterest rates. To the extentthat the governmentwould have to borrowexceptionally large sums, the private sector as a whole wouldhave to borrowexceptionally little. If some averageof interestrates is maintainedby monetarypolicy, this relativeshift to governmentborrowing shouldcause a declinein privateinterest rates relative to the average. Tobinadded that, on the samegrounds, one wouldwant to know whether an unusualchange were taking place in the relativeamounts of long- and short-termborrowing, since such a changewould suggesta changein the termstructure relative to its normalpattern. CharlesSchultze noted that, evenif deficitsand moneydemand (or interest rates)were not relatedhistorically, they mightbe in the comingmonths becausea significantpart of the deficitwill come fromthe one-shotrebate of taxes.This rebate may temporarilyexpand money demand to the extent thathouseholds consider it a temporaryincrement to wealththat theyplan to spendquickly. The money supply requiredto hold interestrates con- stantcould be 2 percenthigher when the rebateis firstpaid out. And this additionalrequirement-an 8 percent incrementto the annual rate of growthfor one quarter-would come on top of the rapidgrowth rates of moneydemand already projected by models such as Pierce's. Severaldiscussants commented on the 1974errors in the money-demand equationthat Piercereported. Tobin noted that these equationsassumed that money balances were in equilibrium.However, demand deposits shouldalso be viewedas a sink for unintendeddifferences between cash re- ceiptsand expenditures by individualsand businesses.A counterpartto dis- appointingsales and unintendedaccumulation of inventorieswould be dis- appointingreceipts and an unintendedfall in money balances. Pierce acknowledgedthe possibility,but noted that residualslike those of 1974 did not appearin previousrecessions when, presumably, similar sales sur- prisesand similarunintended inventory buildups occurred. Martin Feld- 122 Brookings Papers on Economic Activity, 1:1975 steinthought that the largespread between the commercialpaper rate and Treasurybill rate wouldhelp to explainthe spreadof innovationssuch as money-marketmutual funds in 1974and thusthe residualsin conventional money-demandequations. Arthur Okun repliedthat it was unlikelythat movementsinto these assets came primarilyat the expense of demand deposits. Felinerexpanded on the resultsreported by StephenGoldfeld. He rea- sonedthat inflationmay have been an especiallyimportant factor in 1974 moneymarkets. Historically, the inflationrate and interestrates may have moved togetherto such an extent that the inflationrate was not an im- portantseparable factor in the demand for money and other financial assets.But becauseof interest-rateregulations and the exceptionallyhigh rate of inflation,rates could not trackprice increases as well this time. WilliamPoole found the interest-ratedifferentials between government and privatedebt a muchmore important feature of recentexperience than the residualsin the money-demandequation for the last half of 1974. Money-demandequations are continuallybeing revised and improved and residualsbeyond the sampleperiod are not uncommon.However, the huge gap that has openedup betweenthe bill rate and privateshort-term interestrates has persistedfor a long time and is more difficultto explain. Daniel Brill emphasizedstructural elements in bank balancesheets as an importantreason for the wide discrepancyin rates.Banks were in a highly illiquidposition, partly because so muchof theircapital was tied up in bad loans to real estate investmenttrusts. This situation helps explain why banks are so reluctantto make loans and why prime lendingrates have remainedso high relativeto other money-marketrates. On the view that businessloans are the short-rundynamic factor causingchanges in M1, this reluctanceto make loans and the high bank lendingrates that result fromit makethe Treasurybill ratea particularlyinappropriate variable for explainingmoney demandat this time. The position of banks will also makeit particularlyhard for the Fed to generatean expansionin business loans. Despitethese factors, Piercecommented that the relationbetween bankreserves and the money supplywas not behavingin an unusualway.