The Year of Tight Money And Where It Will Lead

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Paradoxically, 1966 has been by far the most prosperous year in U.S. history, yet has produced considerable concern about the future of business. Though production, profits and personal income jumped impressively, the economy developed some bothersome growing pains. And money was the root of many of these evils.

During the year, interest rates climbed by one-fifth or more, and many would-be borrowers could not get credit at any price. For lack of money, scores of communities put off plans for needed schools, parks and highways. Thousands of prospective home buyers were compelled to postpone their dreams to another year; the cost of mortgage loans climbed to 6 1/2% or more, and construction of housing plunged 19% to a postwar nadir. Tens of thousands of investors shifted their money out of stocks and into higher-yielding bonds, Government securities and savings accounts; the stock market skidded 25% from February to October and, despite a recent rally, is still 20% below its early-year high.

The essential reason for these problems was that the U.S. tried to accomplish an uncommon amount and strained its resources of manpower, materials, machines and money. In 1966, the nation simultaneously expanded the war in Viet Nam, extended a host of domestic programs, and escalated its standard of living. Considering all the demands put upon it, the economy performed remarkably well. The output of goods and services, growing by well over $1 billion a week, swelled from $681 billion to $739 billion; the number of jobs rose by 2,200,000 and 75 million Americans were at work; the average income for a family of four rose from $9,772 to $10,304. But if the nation's cup ran over, that was simply another way of saying that it ran out of capacity.

The inevitable result was that, after six years of healthy, balanced growth, the pleasures of expansion turned into the pangs of inflation. Consumer prices pushed up 3.6% and industrial production expanded by an unsustainably high 8%. Striving for stability, the Government put its reliance largely on one weapon: the manipulation of monetary policy. Money became costlier and harder to borrow than at any time in 40 years.

Opportunity Lost. It is now clear that a chance was missed in 1966. It was a year when the transitory requirements of politics prevailed over the laws of economics. Early in the year, before inflation became acute, President Johnson might have used all three basic tools that have been popularized by the Keynesian new economics -- tax and budget policy as well as monetary policy -- to curb the economy's overexuberance. He did not. Says a top official of the U.S. Federal Reserve: "There was a wonder ful opportunity to show that the new economics works both ways, and that with proper tax measures we can not only promote growth but preserve a reasonable balance. A golden opportunity was lost in 1966."

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 4 1/2%. 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.

The Fed can be faulted, though to a much lesser degree than the Administration, for being slow in using another of its regulatory tools -- the money supply -- and later on for overusing it. Despite their waning hopes that Johnson would raise taxes, the Fed's governors kept rapidly increasing the supply of money during the first part of 1966. Businessmen, eager to expand their overworked plants, hired more employees and built inventories, went on a borrowing spree and were willing to pay a premium price for money. Loans to business -- which usually flatten out during the first half -- actually jumped by $7.5 billion, or almost 10%.

Sequence of Squeeze. With inflation becoming a reality as prices jumped, the Federal Reserve at midyear made a hairpin turn. It shifted from expanding the money supply at a 6% annual rate to contracting it by a 2% rate, doing so by selling Government bonds to sop up cash. From April to August, the money supply -- currency in circulation and demand deposits in banks -- dropped from $171.6 billion to $166.9 billion. The reverse was particularly jarring because, simultaneously, loan demands were greatly stepped up as a result of two moves by the U.S. Treasury -- which does not always coordinate too well with the Fed.

First, as part of a long-term program to put corporate collections on a pay-as-you-go basis, the Treasury in April speeded up taxes -- increasing by hundreds of millions of dollars the quarterly amounts that corporations had to ante up in 1966. Second, in June, the Treasury ordered corporations to pay their withholding taxes for employees twice a month instead of only at each month's end. While these two actions did not really boost taxes but simply made for earlier payment, they had the cosmetic effect of temporarily making the budget deficit appear smaller than it was. Corporations borrowed billions from the banks to pay for the speedup. In effect, the banks had been obliged to finance the narrowing of Johnson's budget deficit.

Day by day the money shortage worsened, and at one point the nation came uncomfortably close to a money panic. Prime interest rates went up four different times, shooting from 4 1/2% in late 1965 to 6% in mid-1966 -- equal to an increase of 33% in twelve months. A wave of hedge-borrowing and money hoarding swept the country. Figuring that money would become steadily scarcer and costlier, corporate treasurers borrowed more than they needed. In June, the Chase Manhattan Bank raised interest rates on most consumer loans for the first time since 1959, to 5 1/2% "discounted" (in effect 10 1/2%), and other banks quickly followed. Bargain-hunting consumers rushed to borrow at 5% on their insurance policies, and insurance executives appealed to banks for new reserves -- putting more pressure on the banks.

Crisis loomed over one big segment of the money market: the savings and loan associations. Tempted by higher yields elsewhere, depositors withdrew $1.5 billion from the S & Ls in July. Government money managers were so worried that dangerously nonliquid S & Ls would go under that the Federal Home Loan Bank Board, which regulates the associations, arranged a $4 billion stand-by loan with the Treasury and hoped to get $5 billion more from the Federal Reserve -- if needed. Says one high U.S. Treasury official: "The withdrawals scared the hell out of us. The savings and loan people were hysterical."

To the Precipice. August saw the worst banking squeeze since Franklin Roosevelt's bank holiday of 1933. Though the supply of available money had fallen about $2 billion from the end of June to the end of July, a record high $3.7 billion in new issues of bonds and stocks hit the money market in August. Meanwhile, the U.S. Treasury was corning to the banks for billions more to finance the budget deficit. Under longstanding moral and legal commitments that they could not ignore, the banks were also shelling out corporate loans faster than they were taking in deposits. In New York City banks, the ratio of loans climbed to well over 70% of deposits, a 45-year peak.

Moreover, many banks had lent long but had borrowed short -- a classic formula for financial woe. Altogether $18.6 billion of their $194.4 billion total deposits were in the form of short-term certificates of deposit, and many holders of "C.D.s" were cashing them in to draw fatter interest elsewhere. The dismal prospect was that deposits would continue to decline, while in mid-September the banks would be hit by corporations for more loans to finance quarterly tax payments. If the banks turned them down, the corporations would start a run on their deposits.

Though they could scarcely believe that the Fed would let any such disaster occur, bankers could not be certain. To raise money, they sold off billions of dollars in municipal bonds from their portfolios at great loss. Bond prices crashed and bond yields soared. A year before, long-term municipal bonds had been selling at $1,000 and paying $40 in annual interest; in late 1966, the same bonds were down to $800 but still paying $40 -- in effect, yields rose from 4% to 5%. New York State had to pay 5.7% to float one tax-free issue; Baltimore, Louisville, Tulsa and Arlington, Va., canceled others. So queasy and depressed was the bond market that several corporations called off bond issues. Moneymen tossed in their sleep, worrying that if companies could get money no other way, they would begin wholesale withdrawals from banks. Says Chase Manhattan President David Rockefeller, 51: "This was certainly the most difficult period of my career."

Rescue with a Catch. During the six weeks when the squeeze was at its worst, Bill Martin was in a hospital after surgery, and Fed policy was being framed by his vice chairman, James Robertson, and the vice chairman of the Fed's Manhattan-based Open Market Committee, Alfred Hayes. On Sept. 1, just after Martin returned to his desk and grasped the situation, the Fed came to the aid of the bankers. It informed them that it was willing to lend them more than before, and at longer terms. But there was a hooker: in a major expansion of its powers, the Fed made clear that it would begin to scrutinize big bank loans on a one-by-one basis, and bankers would have to justify their loans to the federal agency. It was just a step or two short of outright credit control.

Still, the move helped, and the Fed has since taken further action. In the past five weeks it has increased the money supply by $500 million, and interest on 90-day Treasury bills has dropped from 5.5% to 4.8%. Nobody is certain whether this represents a long-term policy change or merely the Fed's usual pre-Christmas easing to accommodate loans during the big-buying season. Demand for money will remain intense next year. The Government will have to borrow heavily in 1967 to finance its budget deficit, and corporations will borrow earlier in the year because the pay-as-you-go tax scheme will step up their payments in the first half, while slightly reducing them in the second half.

The worst of the credit squeeze is over, but the days of 5% mortgages and personal loans are gone, at least for the foreseeable future. Rudolph Peterson, president of California's Bank of America (see box, next page), notes that money rates have drifted upward since 1950 in a pattern of sharp rises followed by drops to levels steeper than before. "Interest rates will ease down over the next year or two," he predicts, "but will end up a bit higher than they were at the start of the current move."

Taxing Their Powers. Throughout 1966, money managers have been trying to cool the economy's real growth to a sustainable, noninflationary rate between 4% and 4 1/2% -- compared with this year's 5.5%. Historically, business slows down about six months after the Federal Reserve begins to reduce the money supply -- and that is what is presently happening. As 1967 begins, corporate profits and order backlogs are slipping and the boom is less explosive than before. Most businessmen are un certain about the year ahead. What worries them is that the future will be determined largely by factors they cannot control: tax policy, money policy, Viet Nam and labor's wage demands.

Economist Beryl Sprinkel, vice president of Chicago's Harris Trust and Savings Bank, warns that the economy will soon reach a no-return point where recession will be inevitable unless the Federal Reserve steadily eases up on money. The Fed is in a quandary. Its seven governors are concerned about the danger of overcure -- too much money tightness contributed to both the 1957 and 1960 recessions, when industrial production dropped. But Bill Martin's men are equally worried that total demand is still too strong, and the nation's balance of payments is too weak to permit any significant easing.

The balance of payments is particularly nettlesome because this year the U.S. ran a deficit of about $1.5 billion; the Viet Nam war alone caused a drain of $1 billion, and nobody expects the U.S. to get even until the war is over. The trade surplus shrank from $6.9 billion in 1964 to $4.8 billion, and the picture would have been much darker ex cept that U.S. bankers brought back $3 billion from their overseas branches.

The Fed still leans to higher taxes. Treasury Secretary Henry Fowler argues for a "change in mix"-- a moderate tax boost and an equivalent easing of money, which would reduce capital and consumer spending but help out the housing industry and credit-starved small business. Economist Walter Heller, who still exercises strong influence on President Johnson, urges a strictly temporary and quickly reversible 5% surcharge on personal and corporate taxes in order to close the inflationary budget deficit and permit an easing of money. While most corporation chiefs oppose a tax increase, Banker Peterson supports Heller, believes that a 5% surcharge in exchange for easier money would be a good bargain.

Prices & Wages. As Government and non-Government economists, and as bankers and other businessmen assess 1967's prospects, they conclude that forecasting is much more difficult than usual. But out of the mass of facts and figures before them, it is possible to arrive at a consensus of likelihoods.

Inflation will continue in 1967 -- but at a slower pace, and with a difference. Prices will probably rise something less than 3%, going up not so much because of swelling demand but because of increased labor costs. Labor contracts in an unusually large number of basic industries will be up for renegotiation, almost twice as many as in 1966 (see following story), and even moderate labor leaders expect trouble in controlling their truculent rank and file. The most explosive situation is in the auto industry, where the minority of electricians, tool-and-die makers and other skilled craftsmen in the United Auto Workers recently won power to veto any proposed contract, are demanding hourly raises of $1 or more, and are cockily talking strike. If the nation's most influential industry is forced into a prolonged stoppage after contracts expire on Sept. 6, that could gravely damage the whole economy.

Barring major strikes, unemployment will remain close to 4% -- it is now 3.7% -- and whenever it holds that low, prices tend to rise and productivity slackens. One reason for the economy's strength from 1961 through 1965 was that productivity (output per man-hour) gained an average 3.6% annually; this year, it rose only 2.8%. Meanwhile, wages went up by an inflationary 4%, partly because President Johnson, in a political bind, unwisely went along with a 5% increase for airline workers. Says former U.S. Budget Director Kermit Gordon, an author of the shattered but ostensibly still guiding 3.2% guidelines: "If we get through 1967 with no more than a general 5% wage increase, we'll be damn lucky."

Spending & Housing. The wage rises will spur consumer spending because the wage earner is, after all, a consumer. For years, the consumer spent about 94-c- of every dollar he earned, and saved the rest. Lately he has been spending even more, and some experts believe that Americans may adopt a new pattern of still lower savings because they feel confident that Medicare and Social Security will provide for their old age. The Commerce Department expects personal income in 1967 to go up 5% to 7% and spending to increase at least that much.

But consumers may well change the way that they spend their money. Best estimates are that durable goods will be down somewhat, while spending for nondurables will continue to rise and that services will follow their 8.5% advance of this year, taking just over 35-c- of every consumer dollar. Appliance sales will stay flat, except for color TV, which will rise from around 4,700,000 sets to 7,500,000. Car sales are likely to slip from just under 9,000,000 to 8,700,000 -- making 1967 the third best year in Detroit history -- but consumer insistence on costlier cars and more options will keep dollar volume close to 1966's. Though housing remains the softest spot, it will start to harden in the next few months, become stronger at midyear because money will ease a bit and the recent slump has created a big backlog of demand, especially among the millions of newlyweds of the "war baby" generation born in the mid-'40s. The Commerce Department expects housing starts to climb 20%, to 1,500,000.

Investment & Inventories. Businessmen boosted their capital spending in 1966 by 17% to $61 billion. Next year's gain may be only half as great, partly because so many new plants will become operative as a result of the capital-investment splurge of the '60s. Though next year's wage rises will give businessmen reason to spend more for labor-saving machines, wage increases will also pinch profits and give businessmen less capital for investment. The suspension of the 7% investment credit will take about $3 billion out of capital budgets. Commerce Department surveyors were surprised to find that businessmen plan to increase their annual rate of capital spending by only 7% in next year's first half. If they do no better than that, the Administration will seriously consider restoring the investment-tax credit.

Businessmen will probably thin out their stockpiles of supplies. One year-end result of tight money has been that in many areas production has begun to move faster than sales, meaning that inventories have been rising too much. They are now at a four-year high of 1.52 times monthly sales, but a downturn has begun in appliance, auto, and steel stockpiling and production. Managers added $10.5 billion to inventories in 1966; the Government expects them to add only $7 billion in 1967.

Budgets & Bullets. Government spending will provide a brisk stimulant to the economy next year. Just how much is anybody's guess, but while President Johnson leaked that his ad ministrative budget will rise from $125 billion or so to $140 billion in fiscal 1968, it will in fact be closer to $130 billion -- barring an unexpected step-up in Viet Nam. The combination of higher Government spending and leveling corporate profits, which will hold down tax revenues, will raise the budget deficit. By June, the comprehensive "national incomes account budget" is likely to be running in the red by an annual rate of $5 billion -- less than the expected deficit in the popular administrative budget, but still inflationary.

Defense spending will go up, though not nearly as much as this year's increase, which accounted for one-third of the rise in national production. According to current Pentagon plans, as many men will be mustered out of the armed services as taken into them by fall. Johnson will be under consider able pressure from the new Congress and from business to pare nondefense spending, to moderate either the war on poverty or other domestic programs so long as a more important war is going on overseas. Says Jack Straus, chairman of R. H. Macy & Co.: "What the President has to do is pick priorities, just as we do in the retail business. We realize that we cannot do everything, and so we simply allocate money for those projects which are the most important."

Under these circumstances, real recession appears to be only an abstract possibility for 1967. Manhattan Economist J. Carvel Lange believes that the recent slowdowns in housing, appliances, autos and other sectors are building an $8 billion to $12 billion backlog in private demand, which will provide "a strong cushion" for the economy if an end or easing of the Viet Nam war significantly scales down Government spending. Government economists, whose estimates have been on the low side in recent years, predict that the G.N.P. will advance about 6 1/2% to $790 billion. The Bank of America's Peterson expects a 6% gain, with just over half of that reflecting real growth. Pessimists may call that a slump, but, says George Moore, president of Manhattan's First National City Bank, "it's like a Japanese recession -- the growth rate gets cut and they call it a recession." Americans may well have been spoiled by all those years of 5 1/2% plus, but if growth calms down to a noninflationary pace, they should relax and enjoy it.

Businessmen are concerned about the future, but they are also remarkably confident. Among the most confident is Banker Peterson, who believes that with intelligent and courageous policy actions, men can make prosperity perpetual, create great societies at home and grand designs abroad. In the next five years, he observes, the number of U.S. families will grow by 5,000,000, or 10%, providing a tremendous expansive force and placing many new demands upon the nation's banks and businesses. "The next big thrust in the economy," he says, "will come from urban development -- new concepts of housing, transportation, pollution control. All these things are sitting on the shelf, ready to go, and when the war in Viet Nam ends, domestic development will move fast." America's economy need never run down, because, says Rudy Peterson, "there are so many things that need to be done."

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