April 28, 2004,
Rising inflation and interest rates, although still low by historical standards, are starting to get the attention of economists. It is becoming harder and harder to find an economist who doesn’t think the Federal Reserve needs to tighten monetary policy soon. However, Fed officials continue to say that unemployment, low capacity utilization, and strong productivity growth argue against tightening at this time. They may be right. But one cannot help but suspect that politics is also playing a role.
The classic case of the Fed subordinating good policy to politics was in 1972. Richard Nixon was acutely aware that Fed tightening in late 1959 brought on a recession that began in April 1960. As the nominee of the incumbent party, Nixon took the blame for slow growth. In his book Six Crises, he complained bitterly that the Fed had, in effect, thrown the election to John F. Kennedy, whose most potent campaign pledge was that he would get the economy moving again.
When Nixon became president in 1968, he vowed that he would not let the Fed do it to him again. At his earliest opportunity, he appointed a trusted aide, Arthur Burns, to the chairmanship of the Federal Reserve. His job was to make sure that money and credit stayed easy through the 1972 election.
However, Nixon did not want to take any chances. He ordered White House staffers to keep an eye on Burns and push him to err on the side of monetary ease. According to William Safire, a White House aide at the time (in his book Before the Fall), when Burns resisted pressure to guarantee full employment in time for the election, negative press stories about Burns were planted in newspapers. A plan to dilute the Federal Reserve Board’s power was also floated. In his book Secrets of the Temple, William Greider says the tactics were crude, but successful.
The problem was inflation. It jumped to 6.2 percent in 1969 after having been in the 1 to 2 percent range for many years. In essence, the inflation rate had tripled in a very short period of time. The recession, which began in December 1969 and ended in November 1970, brought it down only very little to 5.6 percent in 1970.
Under normal circumstances, the Fed would have tightened monetary policy to bring down inflation. But Nixon wanted to keep monetary policy loose in order to make sure the economy was robust going into the election. This led to the imposition of wage and price controls in August 1971. While everyone knew they would not work for long, the controls reduced inflation enough to keep monetary policy expansive through November 1972, which was all that mattered.
In his book Nixon's Economy, historian Allen Matusow wrote, “Burns had offered Nixon an implicit bargain. In 1971 Nixon controlled prices, and in 1972 Burns supplied money by the bushel. The policy helped reelect the president but also assured the next cycle of boom and bust.”
Once past the election, the price controls began to break down. Inflation jumped to 8.7 percent in 1973 and 12.3 percent in 1974. Another recession began in November 1973 and didn’t end until March 1975. These poor economic conditions created fertile soil for Nixon’s enemies when the Watergate scandal broke. Had the economy been stronger, Nixon probably would have survived it, just as a strong economy unquestionably helped Bill Clinton weather the Monica Lewinski scandal.
With Nixon gone, analysts began to focus on Burns. In July 1974, Fortune magazine ran a long article putting most of the responsibility for stagflation at his door. Since then, it has become the conventional wisdom among economists that the Fed erred drastically by not tightening in 1972 and thereby allowing the inflation genie out of the bottle.
Burns took most of the blame because he had been a renowned economist before joining the Fed. This made it impossible to believe that he simply didn’t know better. Therefore, one is left with the inescapable conclusion that Burns used the Fed to help Nixon with full knowledge of the disastrous consequences for the economy. The only alternative is to believe he was incompetent, which no economist believes was the case.
The reason this history is relevant today is because the Fed is under increasing pressure to tighten monetary policy. While there is no evidence of White House pressure to keep monetary policy easy, one can assume that it will not be displeased if the Fed avoids tightening before Election Day.
Fed Chairman Alan Greenspan is well respected and no one believes he would knowingly use monetary policy for political purposes. However, the longer he waits to tighten monetary policy, the more people are going to ask whether politics is playing a role.