Speech

Speech delivered before Sociology Club, University of Maryland College Par*, Maryland March 23. 194a. OUR PRESENT FINANCIAL SITUATION Before going into the discussion proper, I should like to spend a few moments in making a brief sketch of certain background information which will be helpful in our discussion. In 1914 the United States was a debtor nation; a substantial part national development had been and was being financed abroad. VJe were jn the process of shifting from a predominantly industrial and urban Ration. Our conventional patterns of finance drew no distinction between fiscal position of Government and that of individuals and businesses. At that time, there were about 26,000 commercial banks with total ^posits of about 17 billion dollars, compared with about H,000 banks today with deposits of 140 billion dollars. The Federal debt was only billion dollars. Today it is 257 billion. Our pre-World War I economy was a composite of regional economies, ^erhaps the heart of our central banking problem at that stage of the country'3 development was to reconcile the monetary and credit needs of major regions and to maintain a balance between these needs. It was argely with this end in view that the Federal Reserve System was established. When the Federal Reserve Act was revised substantially two decades later, between 1933 and 1935, the nation had become a great creditor country internationally and a great industrial economy domestically, ur monetary and credit problem had changed from the problem of distri- cting funds among regions—which had been solved fairly well—to the Problem of controlling the total supply of money and equating this supply 0 various national uses. In addition, the economy had gone through a fu5at war> two great "booms," and two great "busts." The war, the Dooms," end the "busts" were national in ramification. While regional -^fferences in economic organization still existed, the reality of egional interdependence was a more fully demonstrated fact than ever De*ore in our history. 0u great "bust" of 1929 had been particularly severe and its after- r atn was widespread bankruptcy, unemployment, and poverty. The economy's critical problem of that period was "idle men, idle machines, idle oney.» it determined to solve the problem on a national basis, was iscal policy and central banking policy became, more directly than ormerly, the instruments of national economic policy. Once more we find ourselves in a new period. We have again gone ^ rough a great and devastating war. The war has changed our position international affairs, and we find ourselves overwhelmingly a creditor. wh + balance power between capital and labor is different from nat it was in 1914 or 1935, and is still changing. The relationship 96 between creditor and debtor has also changed, in important part because^ better financial arrangements and techniques have been worked out. Barnes make one kind of arrangement with farmers for the repayment of loans and a different kind of arrangement with manufacturing concerns, each arrange- ment calculated to fit the operations of the borrowers. The Government is no longer merely another borrower in the market. It is by far the largest borrower. The Federal debt accounts for nearly three-fifths of the entire indebtedness of the country, and interest on the debt is a major item in the Federal budget, amounting to more than $ billion dollars a year. In this situation, special arrangements nave had to be made for selling and managing the public debt. The Treasury and the Federal Reserve work closely together in issuing, retiring, and refunding the debt. This greatly increased importance ol the public debt is one of the major factors in the present inflation. Vhy has this increase in the public debt contributed so strongly to inflation? If we'understand this point, we shall understand why some ol the problems of the Federal Reserve System are so difficult to handle. During the war, the Government spent more than twice as much as it collected in taxes, making up the difference by bonowing. Producers- workers, farmers, and business organizations-were paid for all the production of the economy, but the taxes they paid were less than hall the money spent by the Government for the goods and services needed to win the war. Producers, as consumers, therefore, were left with more money to spend or save than the value of the goods and services they could buy/ To some extent, they used these excess funds to bid up prices, bub because we were at war, and because some goods, such as automobiles, were not available, controls were effective m spreading the supply of goods and services and restraining price increases. People, therefore, saved. Some of the savings were in currency, some in bank deposits, and some in other liquid assets, particularly Gov- ernment securities. The country's aggregate money supply, as measured by currency in circulation and privately-held demand, time, and savins deposits, is two and a half times as large cs at the beginning Fram, about 170 billion dollars, compared with 66 billion in June 1940. In addition, the general public, outside of commercial bamcs, mutual savings banks, insurance companies, and Government agencies, increased its holdings of Government securities to about 90 billion dollars, or nearly six times as much as in June of 1940. These Government securi- ties in the hands of the public are practically the equivalent of money because they are readily convertible into cash. In sum t o t a f^ stock of purchasing power available to buy the current and services amounts to almost 260 billion compared with a dollars, stock of about 80 billion in 1940. It is now more than three txmes what it was in 1940. Most of this exoension in the money supply and liquid assets in the hands of the public occurred during the World War II period. However, further expansion has taiven place over the postwar period, 97 and in recent months the expansion has shown marked signs of accelera- tion. This recent acceleration of expansion largely resulted from very active bank lending to businesses and individuals. Since the war, the economy has been operating very close to capacity and the general public has shown a pronounced disposition to enjoy all the things that were in short supply during the war, from shirts and socks to automobiles and houses. The inflation is continuing for one maJor reason—people have been willing to spend tneir current incomes and dip into some of their accumulated savings. They have also supple- mented these funds by borrowing from banks and other lenders, and by buying on installment credit. As a result of these strong demands for goods and services—demands in excess of supplies—prices have risen, and we have had inflation. As long as the volume of goods and services available, valued at current prices, remains less than the amount of money being spent, inflation will persist. This condition, in fact, is the essence of inflation. Two other factors are adding to inflationary forces. First, the 'Edition of productive facilities is going on at a rapid pace. This as the effect of diverting scarce materials and labor from the produc- tion of consumer goods to the production of machines to make machines make consumer goods. This latter process is all to the good in the ong run for it is primarily in this way that we increase the productiv- ity of the nation and obtain the increasing standard of living that is oth an American tradition and a goal. In the short run, however, it adds to the bidding up of prices on scarce materials and manpower and ecause producers are paid now for turning out machinery, buildings, ^arehouses, factories and inventory which will not add to the immediate of consumer goods. Therefore, not only are the prices of scarce materials and manpower bid up by such a process but producers' income generated in the process is added to the total demand for the existing stock of consumer goods, already deficient. In addition, the supply of money i expanded because to finance this expansion in facilities, s finesses are borrowing from many sources, ana particularly from Commercial banks. Secondly, we have had a large commodity export surplus in our ;nternational trade for several years. International trade wnich results ^ a commodity balance is inherently anti-inflationary since it means j. emphasis is being placed on the production of those goods which can ^produced the most efficiently and trading these for others which are so efficiently produced. A commodity export surplus, on the other and, i essentially inflationary, for producers are paid for the produc- s !on of goods sent elsewhere in greater volume than other goods are eceived. Production of this excess of exports, moreover, may have been inanced by inflationary bank credit expansion. If the surpluses are ^a'-anced by Government loans financed out of taxes which would otherwise e-used by the fiscal and monetary authorities to reduce the excessive l>ey. SUiDP1y> or ky private lending to foreigners, the net result is ar inflationary. To the extent that export commodity surpluses ^ e paid for by imports of gold an added inflationary element is created the form of increased deposits and reserves in the commercial banking structure. 98 Both of these factors, then, expansion of productive capital and the export surpluses, have resulted in additions to the money supply through the expansion of credit, in the use of funds previously held idle, and in additions to bank reserves growing out of the payment in gold for some of our export surpluses. This brings me to the problem which confronts the banking authori- ties and about which the Federal Keserve Board is deeply concerned, for it shows clearly the changes which have taken place in the tasks o. the Federal Reserve System. Taken as a whole, the commercial banking system is fundamentally a mechanism for creating money—for allowing borrowers to spend money which no one has saved. This is in contrast to other types of lending— such as lending by building and loan associations, or savings banks, or insurance companies, or individuals. These institutions transfer savings from those who have them but do not wish to spend them to those who do wish to spend them. Limits are set to the amount of credit banks can create by the legal reouirement that they must hold cash reserves to the extent of some proportion of their deposits—which are themselves largely the result of loans and investments. Banks which are members of the Federal Reserve System, which hold 85 per cent of all commercial bank deposits in this country, must hold their reserves as deposits with the Federal Reserve Banks, and no income is derived from these reserves. On the average, recuired reserves amount to about one-sixth of commercial bank deposits. For every dollar of reserves, credit can expend sixfold. Reserves are the heart of commercial banking, and control over commercial bank credit has traditionally been exercised by control of these reserves. Three techniques have been used to exercise this control: (1) varying the rediscount rate, or the rate of interest at which member commercial banks may borrow from the Reserve Banks; U) open market operations; or the buying and selling of Government securi- ties by the Reserve System;'and (3) varying the level of reserve re- quirements, that is, the amounts which member banks deposit with Federal Reserve Banks as legally required reserves. Two of these techniaues for controlling bank reserves—discount rates and open market operations-are not so effective as they once were, while the third-drying the level of reserve requirements-was exhausted under present law as a restraining weapon early in tne recent war, except for a relatively small percentage in central reserve cities- New York and Chicago. The present limited effectiveness of available credit control technique is due almost entirely to the size ana wide distribution of the public debt largely inherited from the war. Commercial banks now hold about 70 billion dollars of Government securities, an amount equal to about 50 per cent of their total demand and time deposits, which they can sell in order to obtain additional reserves without borrowing from the Reserve Banks. The traditional open market operation to reduce excess bank re- serves is for the Federal Reserve System to sell Government securities, 99 thus drawing down private deposits at commercial tanks. In turn, this draws down the reserves of commercial hanks by reducing their deposits vith the Federal Reserve Banks. Here, however, we come up against the problem of management of our huge public debt of 257 billion dollars. If the Reserve System were to sell enough Government securities to reduce bank reserves and curb credit expansion, it would involve great dangers for the entire economy. To make possible this volume of sales, the prices of Government securities would have to be permitted to decline. With a marketable public debt held by investors other than the Federal Reserve Banks amounting to 14.0 billion dollars, no one.can say how great this decline in prices would have to be. As prices declined because of Federal Reserve sales, in- vestors would suffer capital losses and in turn would be encouraged to sell their holdings while their losses were still small, and these sales would further drive prices downward. In brief, Federal Reserve open market operations to reduce bank reserves might lead to a disruptive decline in Government security prices, which might spread to the prices other securities. This is a risk too serious to contemplate. Traditional open market policy would also have serious consequences or the Treasury. As prices of bonds decline, their yield, or effec- tive interest rate, rises, and, if Government securities were to fall seriously, all future Treasury financing would have to be done at higher interest rates, thus raising the cost of servicing the Government debt, j^iso, in o^h arket, the price at which the Treasury and other a m orrowers could sell securities would be altogether uncertain, and this uncertainty would interfere with the orderly management of the public Qebt as well as the orderly financing of private corporate investment Programs. The Federal Reserve System, in close cooperation with the Treasury, as already recognized that interest rates required an upward readjust- ment. it has recognized this through its open market and discount policy: lrst, by lowering the support price (increasing the yield) on short- erm Government securities, and second, by lowering the support price on long-term obligations (with assurance, however, that support of the -owered levels would be aggressive and continued for the foreseeable uture), and third, by the increase in discount rates from 1 to 1-1/4 Per cent. It seems much better to us to permit interest rate changes in -nis manner than to leave the economy's marketable debt to find its own interest level in a free—"bottomless"—market, dominated by Government securities. It should be apparent from what I have said that the most important ange the problem facing the central banking authorities is the increased influence of the public debt in our monetary and fiscal airs. nfter the First World War the public debt (26 billion dollars) ^ould be looked on as merely another set of obligations—to be allowed to J-nd their own price level in a completely free market. This policy, , ich vas in line with traditional attitudes, resulted in large losses 0 many individuals and businesses, but these consequences were not as serious as those which would result from a similar policy now. e Public debt today is a factor to be reckoned with in all public and 100 private decisions. Both its size and its wide distribution have given it great leverage in monetary policy and. economic conditions. Moreover, the fact that the Treasury, unlike other borrowers, must constantly refinance its debt makes stability of the market for the public debt particularly crucial. The increased importance of the public debt is also a factor in another situation whioh has received relatively less attention in public discussion. This is the shift which has taken place from the hands of the banking and fiscal authorities of a significant part of the control over the supply of money. I have already mentioned the primary differ- ence between bank, credit and credit extended by other lenders—namely, that nonbank lenders lend only savings which h&ve been accumulated by savers, while banks also make available to borrowers funds cieated by the 6 to 1 expansion of deposits to which I have referred above. It has been customary and, in the main, correct, to say that loans made by nonbank lenders add nothing to the money supply. ^ Today this is no longer true. Before we can say whether a loan by, for example, an insurance company or a savings bank or a savings and loan association adds to the money supply or not we must know where these funds were obtained. Take an insurance company for example. In the first place, of course, the insurance company obtained the funds from its policyholders in the form of insurance reserves on policies—that is, policyholders' savings. In this sense the funds were saved by the policyholders. But this is not the full answer. If the insurance company had these funds invested in Government securities, and, in order to make a loan, it sold these securities indirectly to the Federal Reserve Banks, it added to the money supply, or at least to the potential money supply. Such an addition to the money supply results because when a nonbank investor sells Government securities, their prices tend to fall, and if prices threaten to fall too far the Reserve System buys in order to pre- serve a relatively stable and orderly market for these issues. This increases private deposits at commercial banks, and the deposits of com- mercial banks at the Federal Reserve Banks, thus increasing bank reserves, and the capacity of the banks to lend. The effect, in other words, may be just as inflationary as if commercial banks had sold the securities. The insurance companies, the savings banks, and the savings and loan associations are apostles of thrift and foes of inflation and yet by selling Government securities to add to their currently available funds for investment they are contributing to inflationary pressures. In the light of all these considerations, the Federal Reserve Board has recommended to Congress the adoption of a plan which we feel would restore some of the powers over the money supply which have been lost because of the great increase in the public debt. Very simply, this plan involves a temporary increase in reserves which all banks would be re- cuired to hold, except that instead of being legally required to add to their cash reserves, banks would be permitted to hold certain income- producing assets, namely short-term Government obligations. The proposal has come to be called the Board's special reserve plan. 101 The Board has also asked Congress, as en alternative, to raise the limits to which required cash or primary reserves may be increased. To increase required cash reserves far enough to be relatively certain of effective bank; credit restriction, however, would mean reducing the earnings of banks below expenses and a reasonable return on capital. Notwithstanding this certain effect, many bankers favor this method over the Board's special reserve plan as a means of dealing with the present problem of too easy bank credit. The need for bringing the money supply more definitely under con- trol by providing additional authority for regulating the level of bank reserves has also raised the problem of appropriateness of our existing system of reserve requirements. This scheme has long been recognized as inequitable in certain respects; indeed the System has engaged in many studies of methods to improve it. Ultimately, it will be desirable to have our reserve requirements based on the type of banking business conducted by a bank rather than on the basis of location, as is now the case. But this is a complicated matter, as matters of equity invariably are> and will take time to remedy. ^Meanwhile, we confront a situation of an excessive and highly ex- pansionary money supply, and the vroblem is to find some way of regulat- growth of bank credit in the public interest with the object of pre venting recurrent outbreaks of inflation. Either the Board1s special reserve plan or authority to raise further existing reserve requirements seems to be the most feasible, available restraint for this purpose, taking into account the over-shadowing size of our public debt. There has been little need for increased reserve requirements ouring the past three months becaise of the Treasury's favorable fiscal ^svelopments, which have made possible a substantial retirement of bank- neld public debt. Such retirement has temporarily exerted pressure gainst bank credit expansion. But in the future this type of pressure ^li not be available in the same degree, and bank credit conditions may '•come unduly easy. If,this should happen, the need for some special, •^dditional restraint will be urgent. It is better to have authority to ueai with a situation as it develops than to have authority provided, if at all, too late to be used. ^he urgency for the Federal reserve Board's proposal, or some other proposal to curb credit expansion, will be especially great if we relax our current fiscal policy while inflationary dangers exist. Fiscal Policy i by far the mozt effective way to deal with the demand side of s inflation just as production and particularly more production per man- ^ °ur i the most effective way to deal with it on the supply side. This Q cans rigid Government economy and deferment of all deferable expendi- tures. It also means as large a surplus of tax receipts as possible so lat dollars are removed from the spending stream and used to retire Public debt held by the Federal Reserve System. This takes dollars out ° the money supply by an equivalent amount and is a reversal of the war- 3-iae process by which the money supply was expanded. The. classical pre- c°Pt of sound finance that debt should be paid off in. boom times has P^culiar virtue in the case of a public debt the size of ours, so much 0 vniich is held by the banking system. 102 There is still another side to the credit picture. As you know, curbing of inflationary pressures cannot be accomplished by monetary and fiscal policy alone. Among other necessary measures are appropriate private decisions, bankers, for example, must ask them- selves whether, as a group, they are extending credit on a sound basis— credit which will stand up in whatever storms are ahead of us. In this connection, I commend to your attention, as well as to the attention of bankers, the program formulated some time ago by the American Bankers association, and the joint statement on "Bank Credit Policy During the Inflation," issued Member 24, 194.7, by the Board of Governors of the Federal Reserve System, the Comptroller of the Currency, the Federal Deposit Insurance Corporation, and the Executive Committee of the Na- tional Association of Supervisors of State Banks. As you can see, I have so far spoken almost entirely about a fairly technical side of the inflation problem which confronts the monetary an! fiscal authorities, that is, about how the supply of money is being in- creased. Another, and just as important, problem is how this large and increasing supply of money is being used. Here, again, developments have removed a substantial measure of control over bank lending from the hands of the banking authorities. Banking authorities have always exercised some measure of in- fluence over the kind of loans and investments made by banks as well as over the total volume of their credit. Such influence has been exer- cised by way of statutory prohibitions or limitations, by way of varied privileges of access to Federal Reserve credit, and by way of bank supervision. Statutory prohibitions and limitations have generally been quite inflexible. Federal Reserve influence on the kind of lend- ing done by member banks has usually been accomplished, therefore, by keeping informed as to the credit policies followed by member banks and limiting the access to Reserve bank credit of those member banks found to be following unsound policies. Bank examination policy is also adapted, in cooperation with other supervisory authorities, to changing conditions. Developments over the past fifteen years, particularly in Gov- ernment programs, have modified the effectivness of the powers of the central banking authorities. This modification is particularly marked, for example, in the case of real estate loans. It would be rather difficult for the Federal Reserve Board to say that banks with large mortgage loan portfolios shall be denied the right to borrow at the Reserve Banks—even if rediscounting had any significance today—when a large part of bank real estate loans are guaranteed by the Federal Government, either in whole or in part. Similarly, in these conditions, a bank examiner might have some difficulty in convincing bankers to reduce the volume of their guaranteed real estate loans or to establish additional reserves against them. It is probably not correct to say that restraint or encourage- ment of credit expansion through central bank credit and supervisory policies ever exercised a decisive influence on the lending activities of nonbank lenders. It would be equally incorrect, however, to say that 103 such policies in the past exercised no influence. Central banking policy gradually came to exert a broad influence over national credit conditions and the prudent nonbank lender took these conditions carefully into account in shaping his own lending program. But since the middle thir- ties, financial developments, particularly those of wartime, have tended to reduce the influence of central banking policy. In addition, the link between important sectors of the credit market has been weakened at several points. In the case of mortgage credit, for example, where this change is most pronounced, programs and practices instituted since 193* have re- sulted in almost complete separation of this field of lending from gen- eral credit policy, kven mortgage lending by commercial banks has been largely sheltered from the influence of general credit conditions. Loans underwritten by the Federal Housing Administration and the Veterans Administration are obviously difficult to discourage by ordinary tech- niques of bank credit control when they are being encouraged on social grounds by other agencies. And now let me summarize and conclude my remarks on this occasion. important changes have taken place in the structure of our economy and in the financial organization of our society. As e result, central banking and fiscal policies have lost a large part of the influence they once exerted over the supply of money. The credit and monetary control thus lost has not been placed in other hands, but has been diffused knroughout all financial sectors. At the same time, national influence over the use to which the money supply is put—never as strong as control 01 the supply itself—has been weakened, partly by these same forces, partly also by the independence which particular credit programs have *ad because they are specially sanctioned and encouraged by the Govern- ment for social reasons. The Reserve Board has recommended an increase in reserve require- which it believes would restore a desirable degree of control over money supply. I suggest that the reconstruction and strengthening 0 policy controls over the use to which the credit supply is put also requires careful and conscientious study. I do not suggest that we keep reaching out for more power and more controls, but I am aware of the fact nat in honestly and sincerely seeking to promote economic stability at a high level, new effective techniques may perhaps be devised to meet the Ranging situation. For many years the Board has been able to control ^ne folow of bank credit into the securities market, and during the war was given the task of regulating consumer credit. The Board has ^contly asked Congress to renew this power, at least so far as install- ment credit is concerned. It is possible that central banking policy will find the instruments Necessary to perform its tasks under the new conditions which we face in combination of traditional controls over the supply of money and selec- 1Ve controls over the use to which credit it put. If this be so, coop- e^f-tion will be necessary between the central banking authorities and other agencies. 10k The problems vhich monetary and credit policy must face today are different from those of a few years ago. On our success in finding ways to deal with these problems will depend in no small measure our success in reaching the goal of sustained prosperity.

M.S. Szymczak (1948, March 22). Speech. Speeches, Federal Reserve. https://whenthefedspeaks.com/doc/speech_19480323_szymczak

@misc{wtfs_speech_19480323_szymczak,
  author = {M.S. Szymczak},
  title = {Speech},
  year = {1948},
  month = {Mar},
  howpublished = {Speeches, Federal Reserve},
  url = {https://whenthefedspeaks.com/doc/speech_19480323_szymczak},
  note = {Retrieved via When the Fed Speaks corpus}
}