The Economy: The Year of Tight Money And Where It Will Lead

• Share

(2 of 9)

The trouble began late in 1965. Demand started to gallop far ahead of the nation's supply of skilled labor and its capacity to produce, setting the stage for a classic "demand-pull" inflation. Economists say that inflation occurs when prices rise 2% a year or more, which often happens when times are good, money is easy, and too many dollars chase too few goods. At such times, manufacturers borrow heavily to increase production and work forces, and output jumps unnaturally high. Prices climb ever upward. Unless the Government acts quickly and wisely to restore stability, a day of reckoning comes sooner or later. Demand drops to normal levels — perhaps because consumers become surfeited with goods or are unwilling to pay inflated prices. When demand falls, production slides, workers are laid off, and a recession begins.

To prevent just this, a tax hike was urged privately but none too effectively by Gardner Ackley, chairman of the President's Council of Economic Advisers, and publicly by such former CEA chairmen as Walter Heller, Arthur Burns and Raymond Saulnier, as well as the Federal Reserve's Chairman William McChesney Martin. Johnson rejected the advice. Administration insiders say that the President took soundings on Capitol Hill and decided that he could not persuade Congress to pass a tax increase in an election year. House Ways and Means Chairman Wilbur Mills and Senate Finance Chairman Russell Long opposed a tax rise, and Johnson did not want to fight for it and lose.

The President in January projected a small, noninflationary budget deficit for fiscal 1967, which began in July. As it turned out, the cost of Viet Nam this year was $10 billion greater than the President publicly estimated, and, says Chicago Economist John Langum, "Viet Nam was to the booming economy like too much beer to a weak bladder." Instead of raising taxes to finance the war and frustrate inflation, Johnson took the politically easy way out, left it up to Martin's Federal Reserve Board, and through it U.S. bankers, to crimp the nation's credit. The irony is that Johnson's party lost heavily in the elections anyway, and the President himself forfeited much of the faith of businessmen, who had earlier been his staunchest allies.

The Federal Reserve decried the inflationary danger long before the Administration and most businessmen did, and Bill Martin, who values his independence more than his popularity, bravely took steps that the President openly criticized. At Martin's urging late in 1965, the Fed sought to defuse demand by raising the discount rate from 4% to 4½%. The discount rate is, in effect, the interest that the Fed charges to its member banks for borrowing from the Federal Reserve System. Because it is the rate upon which all U.S. interest rates are based, the Fed's hike effectively raised the cost of borrowing.