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June, I9I4.7 CREDIT CONTROLS, INTEREST RATES AND MANAGEMENT OF PUBLIC DEBT t>y R. A» Musgrave The c r e d i t s t r u c t u r e of our economy has been profoundly a f f e c t e d by war finance. From I9I+O t o I9I4.6 the volume of f i x e d i n t e r e s t bearing debt, public and t p r i v a t e , rose from 215 t o i+50 b i l l i o n d o l l a r s . United States Government o b l i g a t i o n s increased from I4.O t o 260 b i l l i o n and now comprise over one-half of the t o t a l debt, j^s a r e s u l t , the y i e l d on Treasury s e c u r i t i e s has come t o dominate the general l e v e l and structure of i n t e r e s t r a t e s . Before the war, less than I4.O per cent of the earn- i n g assets of commercial banks were i n Treasury o b l i g a t i o n s ; the present r a t i o i s 70 per cent. Thus the l i n k between c r e d i t p o l i c y and debt management has been drawn more t i g h t l y and c e n t r a l banking i s confronted w i t h a net set of problems. The current dilemma of c r e d i t and debt policy may be viewed as a t r i a n g u l a i c o n f l i c t between1 ( 1 ) p u r s u i t of the t r a d i t i o n a l objectives of c r e d i t c o n t r o l , adjustments i n c r e d i t supply and i n t e r e s t involving rates; ( 2 ) maintenance of a low l e v e l of i n t e r e s t cost i n the Federal budget and of s t a b i l i t y i n the market f o r Government s e c u r i t i e s ; ( 3 ) meeting the l i q u i d i t y and earning requirements of various i n v e s t o r y groups 1 These d i f f e r e n t objectives clash i n several respects. of c r e d i t p o l i c y , during a period of i n f l a t i o n , T r a d i t i o n a l preceptf c a l l f o r the a p p l i c a t i o n of t i v e measures w h i l e debt s t a b i l i z a t i o n may require/open market purchases. restricY e t , the Central Bank cannot r e s t r i c t reserves t o check c r e d i t expansion and simultaneously purchase s e c u r i t i e s i n the open market to keep t H e i r prices frpm f a l l i n g . At other - 2 - t i m e s , economy o f i n t e r e s t payments r e q u i r e d under t h e second o b j e c t i v e may c l a s h w i t h e q u i t y c o n s i d e r a t i o n s r e q u i r e d under t h e t h i r d and b o t h may c l a s h w i t h needs f o r f l e x i b i l i t y a r i s i n g under t h e f i r s t objective. Our problem i s t o a p p r a i s e t h e s e c o n f l i c t i n g o b j e c t i v e s , t o c o n s i d e r what compromises a r e p o s s i b l e i n t h e p r e s e n t i n s t i t u t i o n a l s e t t i n g and t o i n q u i r e what i n s t i t u t i o n a l changes may p e r m i t a more c o n s t r u c t i v e I, solution. I n t e r e s t Rates and Monetary P o l i c y T h e o r i z i n g on monetary p o l i c y has been based l a r g e l y upon t h e t h a t r e a l investment ( i * e . t principle c a p i t a l f o r m a t i o n ) tends t o i n c r e a s e when t h e r a t e o f i n t e r e s t i s l o w e r e d , and v i c e v e r s a * ^ / The g e n e r a l r u l e , e x t e n d i n g from W i c k s e l l Keynes, has been t o a d j u s t t h e r a t e o f i n t e r e s t so as t o secure t h a t l e v e l o f ment w h i c h p r o v i d e s h i g h employment and o v e r a l l p r i c e to invest stability, M c k s e l l and h i s f o l l o w e r s were w e l l aware t h a t i n t e r e s t as a market phenomenon i s a p r i c e p a i d f o r t h e use o f money. This market r a t e o f i n t e r e s t was con- t r a s t e d w i t h a "natural1* or e q u i l i b r i u m rate which, i n the l a s t analysis, i s not a monetary phenomenon, b u t depends on t h e r a t e o f r e t u r n t o be expected f r o m a d d i t i o n s t o the s t o c k o f c a p i t a l . By a d j u s t i n g t h e a b i l i t y o f t h e b a n k i n g system t o l e n d , c r e d i t p o l i c y was t o be used as a d e v i c e f o r changing t h e d i f f e r e n t i a l between t h e n a t u r a l and, market r a t e s t h e r e b y c o n t r o l l i n g t h e l e v e l o f i n v e s t m e n t . The f o r m u l a was r e f i n e d s u b s e q u e n t l y , b u t t h e b a s i c c r i t e r i a f o r monetary p o l i c y remained much t h e same. The market r a t e o f i n t e r e s t , as r e d e f i n e d i n Keynesian t h e o r y , upon t h e money s u p p l y and l i q u i d i t y p r e f e r e n c e . depended The r u l e now was t o e s t a b l i s h t h a t r a t e o f i n t e r e s t w h i c h equated t h e p r i c e f o r money and t h e m a r g i n a l e f f i c i e n c y o f investment ( i t s e l f a f i r s t c o u s i n o f t h e o l d p r o d u c t i v i t y concept) a t such l e v e l as / would c a l l f o r t h a f u l l employment r a t e o f i n v e s t m e n t . W h i l e t h e t h e o r y became more comprehensive and t h e number o f v a r i a b l e s was i n c r e a s e d , t h e i n v e s t m e n t e f f e c t s of changes i n t h e r a t e o f i n t e r e s t have remained a s i g n i f i c a n t e q u i l i b r a t i n g f a c t o r in monetary and income t h e o r y . I f the r a t e of i n t e r e s t as p o t e n t a f a c t o r i n d e t e r m i n i n g t h e volume o f i n v e s t m e n t as t h e o r i s t s p o s t u l a t e , i t i s i m p o r t a n t t h a t p u b l i c p o l i c y should r e g a i n t h e freedom o f i n t e r e s t r a t e adjustment w h i c h c u r r e n t l y i s abandoned i n f a v o r o f guaranteed s t a b i l i t y i n t h e s e c u r i t y m a r k e t , and t h a t means be developed whereby t h i s can be done w i t h o u t u n s t a b i l i z i n g s e c u r i t y v a l u e s u n d u l y . hold, the c o n f l i c t l a r g e l y disappears. I f t h e premise does n o t C o n s i d e r a t i o n s o f debt management may t h e n be t a k e n as t h e d e c i s i v e f a c t o r i n i n t e r e s t p o l i c y . I n r e e x a m i n i n g t h i s premise, we s h a l l d i s t i n g u i s h t h e l o n g e r r u n r e l a t i o n s h i p between i n v e s t m e n t and t h e established l e v e l o f i n t e r e s t f r o m t h e s h o r t e r r u n e f f e c t s o f changes i n t h e l e v e l o f o r o f e x p e c t a t i o n s o f change. interest F i n a l l y , t h e investment e f f e c t s o f changes i n t h e mere a v a i l a b i l i t y o f bank c r e d i t , as d i s t i n c t f r o m changes i n t h e c o s t o f c r e d i t , w i l l be considered. I n v e s t m e n t and Long Run E f f e c t s o f Rate L e v e l ( l ) We f i r s t t u r n t o t h e l o n g e r r u n e f f e c t s o f t h e l e v e l o f i n t e r e s t on t h e volume o f i n v e s t m e n t . C o n s i d e r i n g t h e burden w h i c h t h e o r i s t s have p l a c e d upon i n - t e r e s t as a c o s t f a c t o r i n r e a l i n v e s t m e n t , t h e r e has been l i t t l e p r o o f o f i t s portance. im- Such s t a t i s t i c a l evidence as has been o b t a i n e d does n o t prima f a c i e sup- p o r t t h e premise t h a t t h e demand f o r i n v e s t m e n t funds i s h i g h l y e l a s t i c w i t h r e s p e c t to interest. P a r t l y , t h i s i m p r e s s i o n may be due t o t h e f a c t t h a t historically adjustments i n i n t e r e s t p o l i c y have c o i n c i d e d w i t h d r a s t i c changes i n p r o f i t tions ( i . e . , expecta- a c t i o n i s t a k e n near t h e t u r n i n g p o i n t s o f t h e c y c l e ) w h i c h themselves g i v e r i s e t o sharp s h i f t s i n t h e demand schedules f o r c r e d i t * It stands t o reason t h a t i n p e r i o d s o f r a p i d change i n e x p e c t a t i o n s such s h i f t s w i l l more t h a n offset movements w h i c h may occur a l o n g any one schedule i n response t o changes i n interest costs* But t h i s i s not a l l . Q u i t e a p a r t f r o m s h i f t s i n t h e demand f o r real i n v e s t m e n t f u n d s , t h e demand schedule p r e v a i l i n g a t any one t i m e i s c h a r a c t e r i z e d by a low i n t e r e s t e l a s t i c i t y . This i s e x p l a i n e d b y t h e n a t u r e o f t h e f a c t o r s w h i c h enter i n t o the planning of investment d e c i s i o n s . Investment i n a p i e c e o f equipmeni i s p r o f i t a b l e i f t h e p r e s e n t v a l u e of i t s income stream exceeds i t s c o s t * The p r o f i t a b i l i t y o f new equipment t h u s depends on i t s c o s t , t h e income stream w h i c h i s expected t o y i e l d , and t h e r a t e o f i n t e r e s t a t w h i c h t h i s income stream i s counted. it dis- The r a t e o f i n t e r e s t i s set by t h e cost o f b o r r o w i n g s a f e funds o r t h e r e t u r n a v a i l a b l e on s a f e i n v e s t m e n t s , say, i n Government s e c u r i t i e s . The i n t e r e s t f a c t o r i s t h e more i m p o r t a n t t h e l o n g e r t h e p e r i o d o f d i s c o u n t , b u t how l o n g a p l a n n i n g p e r i o d i s c o n s i d e r e d depends upon t h e c e r t a i n t y o f t h e e a r n i n g o u t l o o k . I n an u n s t a b l e economy such as o u r s , t h e t y p i c a l e a r n i n g o u t l o o k i s h i g h l y u n c e r t a i n s i n c e t h e p r o b a b l e v a l u e o f t h e income stream n o t o n l y depends upon the r e l a t i v e markets f o r s p e c i f i c p r o d u c t s b u t a l s o t h e g e n e r a l l e v e l o f income, and t h i s i s highly unpredictable. The u n c e r t a i n t y o f t h e e a r n i n g o u t l o o k i n c r e a s e s p r o g r e s s i v e l y w i t h t h e l e n g t h o f t h e p l a n n i n g p e r i o d , so t h a t i t i s customary f o r i n v e s t m e n t p l a n n i n g many l i n e s o f b u s i n e s s , c o v e r i n g a wide range o f t o t a l i n v e s t m e n t , t o e a r n i n g p r o s p e c t s beyond 5 o r 10 y e a r s . pay f o r i t s e l f " d u r i n g t h a t t i m e . in disregard An i n v e s t m e n t i s n o t made u n l e s s " i t will Since t h e e f f e c t s o f i n t e r e s t on t h e p r e s e n t v a l u e o f an a n n u i t y depend upon i t s time spread, t h e s h o r t n e s s o f t h e p l a n n i n g period, g r e a t l y reduces t h e s i g n i f i c a n c e o f t h e i n t e r e s t l e v e l . Indeed, the e f f e c t on p r o f i t s of a v e r y moderate percentage change i n cost o r e a r n i n g s i s l i k e l y t o be equivalent to that of a r e l a t i v e l y large i n t e r e s t d i f f e r e n t i a l W This e x p l a i n s why t h e l e v e l o f i n t e r e s t has l i t t l e b e a r i n g on t h e volume o f r e a l b u s i n e s s investment w i t h t h e p o s s i b l e e x c e p t i o n o f such f i e l d s as p u b l i c u t i l i t i e s or municipal public works which combine a high r a t i o of c a p i t a l cost w i t h a r e l a t i v e l y low degree of u n c e r t a i n t y and hence a longer planning period, or o f r e s i d e n t i a l construction, the demand f o r i/vhich depends l a r g e l y on f a c t o r s other than p r o f i t expectations • As f a r as the cost of c a p i t a l i s concerned, the cost of r i s k and uncert a i n t y (here r e f e r r e d t o as the r i s k premium) r a t h e r than the cost of borrowing ^safe' 1 funds, dominates the investment decision; the r e t u r n on safe funds (i.e., i n t e r e s t i n t h e economists sense of the term) i s but one element i n t h e cost of funds t o the i n v e s t o r . ^ I n %he absence of changes i n the flow of funds which are considered l a t e r , a 50 per cent reduction i n i n t e r e s t paid on safe investment such as Government bonds, f o r instance, may r e s u l t i n , say, only a 10 t o 20 per cent r e duction i n the gross ( i n t e r e s t plus r i s k ) r a t e paid on such r i s k investments as c e r t a i n mortgages and equipment expenditure f o r t h e manufacture of a new product. L i t t l e f a i t h can thus be placed i n t h e e f f e c t i v e n e s s of monetary p o l i c y i f i t i s made t o hinge on the r a t e of i n t e r e s t as a cost f a c t o r . The r a t e of r e t u r n on safe investment i s subject t o manipulation by monetary p o l i c y b u t , i n an uncertain economy, i t i s no major f a c t o r i n investment d e c i s i o n . The other component of t h e gross r a t e of i n t e r e s t - ^ i . e , , the cost of r i s k t a k i n g or r i s k premium—is of major importance i n r e a l investment decisions but i t i s l a r g e l y independent of monetary policy J j / ( 2 ) Nor i s t h e r e reason to a t t r i b u t e great s i g n i f i c a n c e as a long run f a c t o r t o the l e v e l of i n t e r e s t as a determinant of the supply of loanable funds. While i t i s agreed t h a t w i l l i n g n e s s t o p a r t w i t h cash balances i s t h e g r e a t e r a t any given l e v e l of income and money supply the higher i s the r a t e of i n t e r e s t , t h i s has h a r d l y been a s i g n i f i c a n t r e l a t i o n s h i p f o r the p r a c t i c a l range of i n t e r e s t r a t e changes, although i t may t u r n out t o bo of somewhat greater importance i n view of t h e increased r a t i o of money supply to incomc i n the post war - 6 - economy. I f income r a t h e r t h a n p r i c e e f f e c t s are c o n s i d e r e d , t h e r e s u l t may, f a c t , be t h e o p p o s i t e . J u s t as t h e r a t e o f savings may r i s e when i n t e r e s t (where t h e s a v e r ' s o b j e c t i v e i s t o r e a c h a set t o t a l o f i n t e r e s t i n c o m e ) , p r e f e r e n c e may be ment, i t lower a t t h e lower r a t e l e v e l . falls liquidity The l i q u i d i t y p r e f e r e n c e a r g u - appears, i s o f s i g n i f i c a n c e w i t h r e s p e c t t o e x p e c t a t i o n s o f r a t e change rather than w i t h reference t o a given rate level. The l e v e l of i n t e r e s t , however, may be more s i g n i f i c a n t f o r t h e b u t i o n o f funds between s a f e and r i s k i n v e s t m e n t . expected t h a t a l c w l e ^ e l o f i n t e r e s t w i l l r e s u l t or, putting i t be t h e case. distri- On g e n e r a l grounds, i t may be i n a reduced c o s t o f r i s k taking d i f f e r e n t l y , t h a t t h e gross r a t e charged on r i s k funds w i l l b y more t h a n t h e f a l l i n t h e r a t e o f i n t e r e s t . as l i f e in decline There are two reasons why t h i s I f the r a t e of i n t e r e s t i s low, i n v e s t o r s — i n s t i t u t i o n a l shoul investors such i n s u r a n c e companies i n p a r t i c u l a r — w i l l f i n d i t n e c e s s a r y t o supplement low incomes w i t h e a r n i n g s f r o m r i s k t a k i n g . of r i s k funds. T h i s income e f f e c t w i l l i n c r e a s e t h e supply Moreover, i f t h e r a t e on safe i n v e s t m e n t i s reduced w h i l e t h e risk premium remains unchanged, (and as l o n g as t h e percentage d e c l i n e i n r i s k premium remains l e s s t h a n t h a t i n i n t e r e s t ) t h e r e l e t i v e a t t r a c t i v e n e s s o f r i s k ( i . e . , t h e r a t i o o f r i s k premium t o n e t i n t e r e s t c o s t ) i s i n c r e a s e d . investment This price e f f e c t w i l l a g a i n mean an i n c r e a s e d s u p p l y o f r i s k f u n d s , w i t h t h e r e s u l t t h a t t h e r e w i l l be f u r t h e r p r e s s u r e on t h e r i s k premium. The r e d u c t i o n i n t h e r i s k premium, b r o u g h t about by t h e s e two f a c t o r s , i s l i k e l y t o be more s i g n i f i c a n t i n r e d u c i n g t h e gross r a t e on r i s k funds and i n d u c i n g r i s k investment t h a n i s t h e d e c l i n e i n interes as such* Investment and S h o r t Hun E f f e c t s o f Rate Changes S h o r t r u n e f f e c t s o f changes i n t h e l e v e l o f i n t e r e s t and e x p e c i a l l y a n t i c i p a t i o n s o f r a t e change may he more s i g n i f i c a n t t h a n t h e l o n g e r r u n e f f e c t s \ of a c t u a l changes. T h i s w i l l t e n d t o be t h e case even t h o u g h t h e p r e v i o u s l y discussed e f f e c t s o f a h i g h e r o r l o w e r r a t e are n o t c a l l e d f o r t h i n s t a n t a n e o u s l y w i t h a change i n i n t e r e s t b u t w i l l t a k e t i m e t o work o u t . A reduction i n the rate o f interest w i l l n o t be r e f l e c t e d i m m e d i a t e l y t h r o u g h o u t t h e e n t i r e s t r u c t u r e o f r a t e s i n t h e economy. The o p e r a t i o n o f income and p r i c e e f f e c t s t o reduce r i s k premium s i m i l a r ! ? i s a matter of time. To t h e e x t e n t t h a t t h e r e i s such a l a g i n t h e downward a d j u s t - ment o f gross r a t e s on r i s k f u n d s , e f f e c t s upon r e a l investment w i l l similarly delayed. More i m p o r t a n t , however, i s t h a t t h e v e r y change o f r a t e s i t s e l f may have c e r t a i n s h o r t r u n consequences w h i c h w i l l add t o t h e i r immediate effectiveness. F i r s t , t h e r e i s t h e f a m i l i a r p o i n t t h a t c e n t r a l bank a c t i o n d i r e c t e d a t a r a t e i n c r e a s e tends t o be i n t e r p r e t e d as a g e n e r a l s i g n a l o f changing economic o u t l o o k , an i n d i c a t i o n t h a t " t h e boom has r u n i t s c o u r s e " . Quite apart from the t e c h n i c a l e f f e c t o f a r a t e i n c r e a s e , t h i s p s y c h o l o g i c a l f a c t o r a l o n e may r e s u l t i n business restrictive action. A n t i c i p a t i o n o f r a t e change, moreover, may be an i m p o r t a n t f a c t o r , c i a l l y w i t h r e g a r d t o t h e s u p p l y o f funds f o r f i n a n c i a l i n v e s t m e n t . espe- As f a r as t h e demand f o r funds i n r e a l i n v e s t m e n t i s concerned, an a n t i c i p a t e d r a t e decrease w i l l t e n d t o d e l a y i n v e s t m e n t and an a n t i c i p a t e d r a t e i n c r e a s e w i l l t e n d t o accelerate 7/ i t , - * b u t t h i s i s n o t l i k e l y t o be a m a j o r f a c t o r i f , as p r e v i o u s l y concluded, t h e l e v e l o f i n t e r e s t r a t e s as such i s o f minor s i g n i f i c a n c e i n i n v e s t m e n t d e c i s i o n . As f a r as t h e s u p p l y o f funds i s concerned, e x p e c t a t i o n s o f r a t e change work i n t h e o p p o s i t e d i r e c t i o n and may w e l l be a major f a c t o r . For t h e s u p p l i e r o f f u n d s , t h e p r o s p e c t o f h i g h e r r a t e s w i l l c a l l f o r t h a f e a r of c a p i t a l l o s s and r a i s e t h e desire 8/ for liquidity. By s h i f t i n g t h e s u p p l y schedule o f f u n d s , the r e s u l t i n g i n c r e a s e in l i q u i d i t y p r e f e r e n c e may a f f e c t r e a l i n v e s t m e n t d i r e c t l y b u t i t s p r i m a r y importance - 8 i s l i k e l y t o be w i t h r e s p e c t t o f i n a n c i a l i n v e s t m e n t where i n c r e a s e d liquidity p r e f e r e n c e w i l l check t h e upward p r e s s u r e on c a p i t a l v a l u e s , s t o c k market and r e a l estate values i n p a r t i c u l a r . The s l o w i n g down o f t h e f i n a n c i a l boom i n t u r n w i l l t e n d t o s p i l l over i n t o t h e f i e l d o f r e a l investment and be somewhat o f a r e t a r d i n g f a c t o r t h e r e b y dampening p r o f i t e x p e c t a t i o n s and c h e c k i n g f u r t h e r d e c l i n e s in financing cost. E x p e c t a t i o n s o f r a t e change a c c e n t u a t e d by an exaggerated f a i t h i n t h e potency o f monetary p o l i c y on t h e p a r t o f t h e f i n a n c i a l community thus contribute what i s p r o b a b l y t h e m a j o r element o f e f f e c t i v e n e s s t o f l e x i b l e i n t e r e s t r a t e p o l i c y E x p e c t a t i o n s o f r a t e change may be e f f e c t i v e whether o r n o t t h e expected change comes t o pass. I n d e e d , e x p e c t a t i o n o f r a t e change, i n t h e s h o r t r u n , w i l l t e n d t o be more e f f e c t i v e t h a n a c t u a l r a t e changes t h a t have o c c u r r e d , and q u i t e likely t h e y w i l l be more s i g n i f i c a n t t h a n t h e l o n g e r r u n e f f e c t s o f a c t u a l r a t e changes * For these reasons, i n t e r e s t p o l i c y w i l l be more u s e f u l as a d e v i c e o f c y c l i c a l as a d e v i c e o f , s e c u l a r than policy* I n v e s t m e n t and A v a i l a b i l i t y o f Bank Credit^ So f a r we have d e a l t w i t h e f f e c t s o f changes i n i n t e r e s t upon demand and s u p p l y f a c t o r s i n the c r e d i t m a r k e t . The m a j o r c o n c l u s i o n has been t h a t t h e e f f e c - t i v e n e s s o f i n t e r e s t adjustments i s s l i g h t , m a i n l y because i n t e r e s t e l a s t i c i t y demand f o r funds i s l o w , of This must now be r e c o n c i l e d w i t h t h e c o n t e n t i o n t h a t t h e g e n e r a l e f f e c t i v e n e s s o f c r e d i t p o l i c y does n o t h i n g e p r i m a r i l y upon b o r r o w e r s ' responses t o changes i n t h e r a t e of i n t e r e s t , i n w h i c h case c r e d i t p o l i c y may be e f f e c t i v e even t h o u g h i t be g r a n t e d t h a t t h e e l a s t i c i t y o f demand f o r funds i s R a t h e r , t h e e f f e c t i v e n e s s o f c r e d i t p o l i c y i s h e l d t o r e s t on t h e " d i r e c t o f changes i n t h e a v a i l a b i l i t y o f c r e d i t " , As i t effects i s d i f f i c u l t t o f i n d a concise statement o f t h e a v a i l a b i l i t y argument, we may v e n t u r e o u r own i n t e r p r e t a t i o n * low. ( 1 ) A change i n t h e " a v a i l a b i l i t y o f c r e d i t " e v i d e n t l y means a s h i f t the c r e d i t supply schedule, Suppose t h a t t h e a v a i l a b i l i t y o f c r e d i t i s t h a t i s , t h e c r e d i t s u p p l y schedule i s s h i f t e d t o t h e l e f t * contracted, As a r e s u l t , t h e amount o f c r e d i t t a k e n i s reduced and i n t e r e s t r i s e s , depending upon t h e e l a s t i c i t i e s demand and s u p p l y i n t h e c r e d i t m a r k e t . in What t h e n i s t h e meaning o f t h e of proposition t h a t " t h e change i n i n t e r e s t i s n o t i m p o r t a n t i n d e t e r m i n i n g t h e change i n amount o f credit taken?" We i n t e r p r e t i t t o mean t h a t t h e shape o f t h e demand schedule i s considered t o be r e l a t i v e l y u n i m p o r t a n t , i * e . , t h a t t h e change i n c r e d i t t a k e n w i l l be much t h e same, whether o r n o t demand i s i n e l a s t i c * supply o f c r e d i t i s h i g h l y i n e l a s t i c , elasticity, T h i s , o f c o u r s e , i s t h e case where t h e I n t h e extreme case where t h e supply has zero t h e r e d u c t i o n i n t h e amount o f c r e d i t t a k e n (due t o t h e c o n t r a c t i o n s u p p l y ) w i l l indeed be e n t i r e l y independent o f the demand e l a s t i c i t y * in The l a t t e r w i l l t h e n be s i g n i f i c a n t o n l y i n s e t t i n g t h e new r a t e o f i n t e r e s t * i 2 / i n general t e r m s , t h e more i n e l a s t i c i s t h e s u p p l y schedule, t h e l e s s s i g n i f i c a n t w i l l be t h e e l a s t i c i t y o f demand f o r c r e d i t i n d e t e r m i n i n g t h e e f f e c t s o f a g i v e n s h i f t i n s u p p l y on changes i n t h e amount of c r e d i t t a k e n . t h e change i n amount o f c r e d i t t a k e n t h a t credit And f o r purposes o f p o l i c y , i t is counts. The a v a i l a b i l i t y argument t h u s emphasizes s h i f t a b i l i t y and i n e l a s t i c i t y credit supply. of L o o k i n g a t t h e o v e r a l l l e n d i n g and i n v e s t i n g a b i l i t y o f banks, t h e t o t a l c r e d i t s u p p l y schedule i s e n t i r e l y i n e l a s t i c when banks are l o a n e d up and ( c o n t r a r y t o t h e p r e s e n t s i t u a t i o n ) no a d d i t i o n a l funds can be o b t a i n e d t h r o u g h s a l e o f s e c u r i t i e s t o t h e F e d e r a l Reserve Banks. I f excess r e s e r v e s ( a c t u a l o r potential) are a v a i l a b l e , however, n o t even t h e t o t a l c r e d i t s u p p l y can be expected t o be entirely inelastic, s i n c e t h e r e i s a c h o i c e between h o l d i n g cash and i n v e s t i n g . Analogous t o t h e j o i n t p r o d u c t case, moreover, one s h o u l d expect t h e e l a s t i c i t y of s u p p l y t o be g r e a t e r f o r i n d i v i d u a l l i n e s o f c r e d i t than f o r t h e combined s c h e d u l e . But some a d d i t i o n a l c o n s i d e r a t i o n s , p e c u l i a r t o t h e c r e d i t b u s i n e s s , a l t e r t h e - 10 picture. Differences i n the net returns obtainable from d i f f e r e n t borrowers will u n d o u b t e d l y a f f e c t t h e a l l o c a t i o n o f f u n d s between d i f f e r e n t c l a s s e s o f loans and i n v e s t m e n t s , b u t t h e y are n o t t h e o n l y f a c t o r . To a c o n s i d e r a b l e e x t e n t , t h e c a t i o n o f funds i s guided b y t h e b a n k e r ' s d e s i r e t o a l l o c a t e quotas t o allo- different uses of funds so as t o o b t a i n t h e r i g h t combination o f r i s k and l i q u i d i t y i n h i s asset portfolio* The quota system, t h e r e b y , i n t r o d u c e s a c o n s i d e r a b l e degree o f i t y ( w i t h re.spect t o i n t e r e s t ) inelastic- i n t h e supply o f funds a v a i l a b l e f o r d i f f e r e n t u s e s , e s p e c i a l l y when t h e r e i s a change i n t o t a l c r e d i t s u p p l y . When a bank* s l e n d i n g c a p a c i t y i s c u r t a i l e d , t h e quota a v a i l a b l e f o r each group o f b o r r o w e r s w i l l be cut somewhat, b u t t h e quota f o r r i s k l o o n s w i l l t e n d t o f a l l o f f more s h a r p l y t h a n t h a t f o r c r e d i t t o prime b o r r o w e r s . P o t e n t i a l borrowers, e s p e c i a l l y i n the r i s k group, w i l l f i n d t h a t no a d d i t i o n a l funds a r e a v a i l a b l e even though t h e y may be w i l l i n g t o pay a h i g h e r r e t u r n . * ™ ^ A g a i n , t h e reason i s t h a t t h e c u r t a i l m e n t o f funds r a t i o n e d out t o a c o n s i d e r a b l e e x t e n t on t h e b a s i s o f l i q u i d i t y and r i s k t i o n s r a t h e r than w i t h regard t o is considera- earnings. R e s t r i c t i o n o f c r e d i t a v a i l a b i l i t y may t h u s be an e f f e c t i v e means o f cont r o l l i n g t h e use o f c r e d i t even t h o u g h t h e demand f o r funds i s i n e l a s t i c . The f a c t t h a t t h e s e c o n s i d e r a t i o n s have been g i v e n l i t t l e a t t e n t i o n i n monetary t h e o r y - t h o u g h a v a i l a b i l i t y c o n s i d e r a t i o n s have f o r l o n g been a f a c t o r i n C e n t r a l Banking p o l i c y - h a s l e d t o an under e v a l u a t i o n < f i t s p o s s i b l e e f f e c t i v e n e s s as a r e s t r i c tive device."--* ( 2 ) An i m p o r t a n t c o n s i d e r a t i o n i n t h i s c o n t e x t i s t h a t t h e effectiveness o f a v a i l a b i l i t y r e s t r i c t i o n ( i » e . , r e d u c t i o n i n amount o f c r e d i t t a k e n ) does n o t d e r i v e from t h e u n w i l l i n g n e s s o f borrowers t o pay a h i g h e r r a t e . Therefore, e f f e c t i v e n e s s w i l l n o t be i m p a i r e d i f means can be found t o n e u t r a l i z e i t s its impact 11 upon i n t e r e s t r a t e s ; and i f t h i s can be done, t h e c o n f l i c t between c r e d i t p o l i c y and debt management i s r e d u c e d . As l o n g as demand i s h e l d c o n s t a n t w h i l e s u p p l y i s duced, t h e r i s e i n the r a t e i s u n a v o i d a b l e , however* re- I n order to permit a o u r t a i l - inont i n supply t o be r a t i o n e d out w i t h o u t a r i s e i n p r i c e , demand must be c u r t a i l e d . W h i l e such c o n t r o l i s n o t f e a s a b l e where t h e demand f o r c r e d i t as a whole i s corned, i t i s f e a s i b l e i n c e r t a i n c r e d i t con- areas. T h i s , i n d e e d , i s e x a c t l y what i s done t h r o u g h t h e use o f f a m i l i a r forms o f s e l e c t i v e c o n t r o l s , such as s t o c k market o r consumer c r e d i t c o n t r o l s • While the c o n t r o l s o p e r a t e i n terms o f demand r a t h e r t h a n s u p p l y r e s t r i c t i o n , t h e y are n e v e r t h e l e s s o f t h e g e n e r a l c h a r a c t e r o f a v a i l a b i l i t y c o n t r o l s ; t h e i r purpose i s t o cut o f f t h e use o f funds a l o n g c e r t a i n l i n e s and t o do so d i r e c t l y and n o t t h r o u g h p r i c e adjustments. By e n f o r c i n g a r e d u c t i o n i n demand f o r c e r t a i n l i n e s o f c r e d i t , selec- t i v e c o n t r o l s , i n e f f e c t , render i t p o s s i b l e f o r t h e l e n d e r t o r a t i o n o u t a reduced s u p p l y w i t h o u t cost i n c r e a s e . They a r e e s p e c i a l l y u s e f u l i n areas—such as s t o c k market c r e d i t where a l l b o r r o w e r s may o f f e r t h e same c o l a t e r a l — i n w h i c h t h e l e n d e r alone i s n o t i n a p o s i t i o n ro r a t i o n * S p e c i f i c c r e d i t controls thus permit r e s t r i c t i o n without forcing a rise in rates. credit V^here r a t e s t a b i l i t y i s d e s i r a b l e as a m a t t e r o f debt management, v i g o r o u s use o f s e l e c t i v e r a t h e r t h a n g e n e r a l c r e d i t t r o l s seems i n con- order. W h i l e s e l e c t i v e c o n t r o l s p r o v i d e no guidance o v e r t h e secondary use o f c r e d i t , t h i s does n o t q u e s t i o n t h e i r u s e f u l n e s s 4 The a v a i l a b i l i t y argument i s not a p r o p o s i t i o n i n q u a n t i t y t h e o r y ; what i s most i m p o r t a n t i s n o t t h e t o t a l „ m o n e y s u p p l y b u t t h e a v a i l a b i l i t y o f c r e d i t t o borrowers who, by d e f i n i t i o n , are would-be spenden Where s p e c i f i c c o n t r o l s can be a p p l i e d t h e y p e r m i t b e t t e r q u a l i t a t i v e d i r e c t i o n t h a n does g e n e r a l r e s t r i c t i o n o f a v a i l a b i l i t y w h i c h may n o t be r a t i o n e d out i n t h e most d e s i r a b l e way. However, i t must a l s o be r e c o g n i z e d t h a t i n u s i n g s e l e c t i v e controls - 12 - monetary p o l i c y l o s e s the i m p e r s o n a l n a t u r e o f g e n e r a l c r e d i t r e s t r i c t i o n , a char- a c t e r i s t i c w h i c h has been c o n s i d e r e d o u t o f t h e main advantages o f monetary p o l i c y , Conclusions What may we conclude about t h e " c o r r e c t " l e v e l o f i n t e r e s t r a t e s o v e r t h e ?.jager r u n and t h e need f o r f l e x i b i l i t y o f r a t e p o l i c y i n s h o r t r u n adjustments? The t h e o r e t i c a l concept o f an optimum r a t e has l i t t l e p r a c t i c a l t o t h e average l e v e l o f r a t e s m a i n t a i n e d over a l o n g e r r u n p e r i o d . application On t h e demand ?ido f c r funds t h e r e i s no s t r o n g r e l a t i o n s h i p between r e a l i n v e s t m e n t and t h e l e v e l o f i n t e r e s t c o s t , due l a r g e l y t o t h e h i g h degree of u n c e r t a i n t y i n p r o f i t tions, expecta- On t h e supply s i d e o f f u n d s , t h e l e v e l o f i n t e r e s t r a t e s may be expected t o havo l i t t l e o r no e f f e c t on t h e r n t e o f savings and o n l y a s l u g g i s h e f f e c t on l i q u i d i t y preference. The l e v e l o f r a t e s may be more s i g n i f i c a n t as a f a c t o r i n the d i s t r i b u t i o n o f a v a i l a b l e funds between r i s k and s a f e i n v e s t m e n t , b u t t h i s i s a f a r c r y f r o m t h e t r a d i t i o n a l p o s t u l a t e o f a c l o s e and d i r e c t r e l a t i o n s h i p between i n v e s t ment and t h e r a t e o f i n t e r e s t * We are l e f t w i t h t h e c o n c l u s i o n t h a t i t i s exceed- i n g l y d i f f i c u l t , w i t h i n a reasonable range of r a t e v a r i a t i o n , t o prove t h a t a somewhat h i g h e r or a somewhat lower r a t e l e v e l i s t h e " p r o p e r " one. Due t o t h e n a t u r e o f t h e demand and s u p p l y r e l a t i o n s h i p i n v o l v e d , our a n a l y s i s l e a v e s us w i t h a wide range o f i n d e t e r m i n a n c y as t o t h e " p r o p e r " l e v e l o f i n t e r e s t ® During a period in w h i c h t h e r e i s a s e c u l a r tendency f o r investment t o f a l l s h o r t o f i n t e n d e d s a v i n g a t h i g h employment, t h e d e f l a t i o n a r y gap o r d e f i c i e n c y i n i n v e s t m e n t would be much t h e same w i t h l o n g - t e r m i n t e r e s t r a t e s a t 1 o r a t 3 per c e n t * During a period of f l a t i o n p r e s s u r e when t h e r e i s a s e c u l a r tendency f o r i n t e n d e d savings t o f a l l inshort o f i n v e s t m e n t , t h e h i g h e r l e v e l o f r a t e s as such would do l i t t l e t o l o w e r investment and c l o s e t h e i n f l a t i o n a r y gap.. I f t h i s i s t r u e , t h e d e s i r a b l e l e v e l o f r a t e s may be d e t e r m i n e d l a r g e l y on grounds o t h e r t h a n those j u s t c o n s i d e r e d , i . e * , and debt management c o n s i d e r a t i o n s become l a r g e l y controlling* distributional - 13 - The impact o f r a t e changes upon t h e gross r a t e charged on r i s k capital t a k e s t i m e t o work o u t , so t h a t t h e p r e v i o u s l y c o n s i d e r e d e f f e c t s o f r a t e changes w i l l "be f u r t h e r reduced where t h e s h o r t r u n i s concerned. Y e t , changes i n interest r a t e s may have a s i g n i f i c a n t p s y c h o l o g i c a l e f f e c t i n t h e s h o r t r u n , and t h e antici- p a t i o n o f change as such may be an i m p o r t a n t f a c t o r i n d e t e r m i n i n g t h e s u p p l y o f funds f o r f i n a n c i a l i n v e s t m e n t * I t may be u s e f u l , t h e r e f o r e , as a m a t t e r o f s t a b i l i z a t i o n t o ease o r r e s t r i c t cyclicr c r e d i t even t h o u g h l i t t l e may speak i n f a v o r o f t h e l o n g e r r u n e f f e c t s o f t h e r e s u l t i n g new r a t e l e v e l . e f f e c t s , and o t h e r c o n s i d e r a t i o n s p e r m i t t i n g , Because o f t h e s e s h o r t run i t w i l l be d e s i r a b l e t o r e t a i n some freedom i n u s i n g i n t e r e s t r a t e adjustments as an element o f c y c l e p o l i c y * In partic- u l a r , i t w i l l be d e s i r a b l e where p o s s i b l e t o a v o i d r i g i d i t i e s w h i c h exclude any p o s s i b i l i t y o f change and thus r u l e o u t e f f e c t s w h i c h may be d e r i v e d by c r e a t i n g expectation of change. S h o r t and l o n g r u n c o n s i d e r a t i o n s may, o f c o u r s e , be i n t e r d e p e n d e n t . Thu; i t has been argued t h a t a r i s e i n r a t e s i n a boom p e r i o d — a l t h o u g h i t may do some good f r o m a s h o r t r u n p o i n t o f v i e w — i s u n d e s i r a b l e , because i t may n o t be p o s s i b l e , f o r p o l i t i c a l reasons, t o r e t r a c e t h i s s t e p l a t e r on oven though over t h e l o n g e r run economic c o n d i t i o n s may prove t o be such as t o r e q u i r e a low r a t e policy. F i n a l l y i t has been p o i n t e d o u t t h a t changes i n t h e a v a i l a b i l i t y o f credi may be a u s e f u l i n s t r u m e n t o f p o l i c y and t h a t t h e e f f e c t i v e n e s s o f such change does n o t p r i m a r i l y depend upon t h e r e a c t i o n o f demand t o t h e concomitant i n c r e a s e rates. If combined w i t h d i r e c t c o n t r o l s o v e r t h e demand f o r f u n d s , r a t e may i n d e e d be a v o i d e d even though c r e d i t i s r e s t r i c t e d . in increases Where r a t e changes a r e foun^ i n c o m p a t i b l e w i t h o t h e r p o l i c y o b j e c t i v e s , t h i s suggests emphasis upon t h e use o f s e l e c t i v e r a t h e r than general c r e d i t controls. - II. Ih - I n t e r e s t Rates and Debt Management Debt p o l i c y i n coming years w i l l be p r i m a r i l y a problem o f managing t h e l a r g e body o f debt now o u t s t a n d i n g . What does t h i s i m p l y w i t h r e g a r d t o b u d g e t a r y i n t e r e s t c o s t , t h e l e v e l and s t a b i l i t y o f r a t e s and t h e m a t u r i t y c o m p o s i t i o n o f t h e tislvS? Budgetary I n t e r e s t Cost From a b u d g e t a r y p o i n t o f v i e w t h e r e i s a presumption i n f a v o r o f low i n t e r e s t payments, i . e . , a low l e v e l o f r a t e s a n d / o r s h o r t m a t u r i t i e s * Suppose t h a t i n t e r e s t payments are t o be i n c r e a s e d . T h i s may be done a t t h e c o s t o f o t h e r e x p e n d i t u r e s i n w h i c h case no q u e s t i o n o f f i n a n c i n g w i l l arise. The b u d g e t i n g c o n s i d e r a t i o n s w i l l t h e n depend upon t h e r e l a t i v e m e r i t s o f h i g h e r i n t e r e s t payments as a g a i n s t t h o s e of a l t e r n a t i v e e x p e n d i t u r e s . Where h i g h e r inter- e s t payments a r e a n e t a d d i t i o n t o t h e b u d g e t , a d d i t i o n a l f i n a n c i n g i s r e q u i r e d . 11 t h e y are t o be t a x f i n a n c e d , p o s s i b l e d e t e r r i n g e f f e c t s o f i n c r e a s e d t a x a t i o n upon consumption and p r i v a t e investment may d e v e l o p , n o t w i t h s t a n d i n g t h e p o p u l a r argument that !, no harm can be done where an i n t e r n a l t r a n s f e r o f funds o n l y i s involved. W h i l e i n c r e a s e d i n t e r e s t payments r a i s e t a x a b l e income as w e l l as revenue require- ments, t h i s w i l l n o t p r e v e n t t h e need f o r i n c r e a s i n g t h e t a x t o income r a t i o and t o t h e e x t e n t t h a t d e p r e s s i n g e f f e c t s r e s u l t t h e r e f r o m , t h e y are n o t r e l i e v e d b y t h e f a c t t h a t t h e r e c e i p t s are channeled i n t o t r a n s f e r r a t h e r t h a n r e a l expenditures. Except under i n f l a t i o n a r y c o n d i t i o n s , such d e p r e s s i n g e f f e c t s are u n d e s i r a b l e . Where t h e a d d i t i o n a l i n t e r e s t payments can be l o a n f i n a n c e d , t h e case may d i f f e r . * W i t h i n a reasonable r a n g e , d e p r e s s i n g e f f e c t s o f a d d i t i o n a l t a x a t i o n may t h e n be a v o i d e d o r o f f s e t b y f i n a n c i n g an a p p r o p r i a t e f r a c t i o n t h r o u g h b o r r o w i n g . B u t even t h e n t h e r e are l i m i t s t o t h e t o t a l l e v e l o f e x p e n d i t u r e s w h i c h may be f i n a n c e d w i t h iV out d i s t u r b i n g r e p e r c u s s i o n s , a n d h i g h e r i n t e r e s t payments are l i k e l y t o less d e s i r a b l e than a l t e r n a t i v e increases i n other expenditures• remain - 15 - The importance o f these arguments w i l l depend, o f c o u r s e , upon t h e magnit u d e o f t h e rate i n c r e a s e and t h e n a t u r e o f t h e p a r t i c u l a r s i t u a t i o n , b u t i n principl t h e b u d g e t a r y presumption f o r a l o w l e v e l o f i n t e r e s t payments i s on f a i r l y safe grounds. T h i s , we n o t e , means a presumption n o t o n l y i n f a v o r o f low r a t e s b u t a l s o of short m a t u r i t i e s t The problem i s t w o - p r o n g e d . B u t a l l t h i s i s n o t t o suggest t h a t c o s t c o n s i d e r a t i o n s s h o u l d be c o n t r o l l i n g s e s p e c i a l l y where changes i n r a t e s are n o t t o be of l o n g d u r a t i o n * the only f a c t o r . They are on$ f a c t o r i n t h e p i c t u r e , b u t b y no means The o b j e c t i v e of debt management t o keep i n t e r e s t c o s t low i s tx p a r t i a l o b j e c t i v e and must be b a l a n c e d a g a i n s t o t h e r o b j e c t i v e s w h i c h w i l l uww be c o n s i d e r e d * Debt Management and Rate S t a b i l i t y ( 1 ) I n r e c e n t d i s c u s s i o n s , much emphasis has been p l a c e d upon t h e need f o r p r i c e s t a b i l i t y o f Government s e c u r i t i e s . must m a i n t a i n p u b l i c c r e d i t w B a s i c a l l y , t h i s means t h a t debt managemen i n good s t a n d i n g " • There must be assurance t h a t t h e i n v e s t m e n t community i n t h e aggregate w i l l w i s h t o c o n t i n u e t o h o l d the" debt t o maturity; t h a t i t w i l l absorb new i s s u e s o f f e r e d i n r e f u n d i n g o f m a t u r i n g debt and t h a t i t w i l l absorb such a d d i t i o n s to^ t h e debt as may prove n e c e s s a r y * The implica-» t i o n o f t h e s e r e q u i r e m e n t s i s n o t t h a t " d e f a u l t " must be a v o i d e d ; s u f f i c i e n t demand f o r Government s e c u r i t i e s cannot f a i l t o e x i s t s i n c e t h e Government total itself c o n t r o l s t h e market f o r i t s o b l i g a t i o n s t h r o u g h the medium o f c r e d i t p o l i c y * Rather t h e i m p l i c a t i o n i s t h a t t h e debt must be p l a c e d w i t h d e s i r a b l e i n v e s t o r s and a t d e s i r a b l e terms and t h a t t h e Government i s p r o t e c t e d a g a i n s t h a v i n g t o monetize debt o r t o condone i t s m o n e t i z a t i ^ n , a t an i n o p p o r t u n e time. This p o i n t s t o t h e c e n t r a l c o n f l i c t between c r e d i t adjustments and debt stabilitya If f l u c t u a t i o n s o f s e c u r i t y p r i c e s are p r e v e n t e d i n t h e f i r s t instance b y o f f s e t t i n g c r e d i t measures, s t a b i l i t y o f s e c u r i t y p r i c e s i s assured b u t t h e use o - 16 - g e n e r a l c r e d i t r e s t r i c t i o n as a c y c l i c a l c o n t r o l d e v i c e i s s u r r e n d e r e d . o t h e r hand, i n s t a b i l i t y o f s e c u r i t y p r i c e s i s p e r m i t t e d , a danger o f If, on t h e cumulative f l u c t u a t i o n i n s e c u r i t y p r i c e s a r i s e s ; t h e o r d i n a r y course o f r e f u n d i n g o p e r a t i o n s may be i n t e r f e r e d w i t h , and t h e Governments c r e d i t s t a n d i n g may be s u b j e c t e d t o the s t r a i n o f wide p r i c e f l u c t u a t i o n s . cannot be p e r m i t t e d t o d e v e l o p . W i t h a 260 b i l l i o n d o l l a r d e b t , t h i s contingency C r e d i t p o l i c y w i l l have t o s t e p i n a t some p o i n t and f a i l u r e t o i n t e r v e n e i n i t i a l l y might r e q u i r e even g r e a t e r debt m o n e t i z a t i o n l a t e r on. B u t are t h e s e t h e o n l y possibilities? S t a b i l i t y i n s e c u r i t y p r i c e s , of course, i s a matter of degree. It i s not e v i d e n t t h a t t h e p r o t e c t i o n o f p u b l i c c r e d i t s t a n d i n g r e q u i r e s t h e maintenance o f complete p r i c e s t a b i l i t y . The q u e s t i o n a r i s e s whether t h e b a s i c s t a b i l i t y require- ment may n o t be c o m p a t i b l e w i t h such f l u c t u a t i o n s i n s e c u r i t y v a l u e s as would be occasioned b y a m o d e r a t e l y f l e x i b l e c r e d i t and i n t e r e s t p o l i c y . The i n i t i a l swings i n s e c u r i t y v a l u e s induced by such a p o l i c y i n v o l v i n g , say, changes i n t h e l e v e l o f r a t e s ( o r y i e l d s ) o f up t o 20 per c e n t , are n o t l i k e l y t o be d r a s t i c i n the sense o: endangering t h e a s s e t p o s i t i o n o f i n v e s t o r s . The r e a l problem, however, i s whether w more v i o l e n t swings m i g h t n o t r e s u l t f r o m such i n i t i a l c h a n g e s T h e effectiveness o f even s l i g h t f l u c t u a t i o n s i n i n t e r e s t , as i s f r e q u e n t l y argued, may have become s i g n i f i c a n t due t o t h e l a r g e bank h o l d i n g s o f p u b l i c d e b t ; b u t s i m i l a r l y , even s l i g h t f l u c t u a t i o n s may, f o r t h e same reason, produce major d i s t u r b a n c e s . i f moderate i n i t i a l f l u c t u a t i o n s i n s e c u r i t y p r i c e s a r e p e r m i t t e d , swings be h e l d w i t h i n reasonable I n o t h e r words, can t h e t o t a l limits? This r e t u r n s us t o t h e q u e s t i o n o f how t h e debt i s p l a c e d among v a r i o u s i n v e s t o r groups. Where t h e debt i s h e l d b y bona f i d e i n v e s t o r s , the dangers o f snowball e f f e c t s w i l l be v e r y much l e s s t h a n were i t h e l d by s p e c u l a t o r s * e x t e n t t h a t t h e debt i s h e l d by i n v e s t o r s over whose p o r t f o l i o s p u b l i c To t h e authorities - 17 - possess some c o n t r o l , t h e dangers o f sudden l i q u i d a t i o n a r e s i m i l a r l y c u r t a i l e d . p l a c e t h e debt s a f e l y , s p e c i f i c needs and preferences o f d i f f e r e n t i n v e s t o r must be t a k e n i n t o c o n s i d e r a t i o n . Thereby, i t s h o u l d be p o s s i b l e t o s t a b i l i t y i n those p a r t s o f t h e market where i t permit f l e x i b i l i t y i n other To groups establish i s most needed and g a i n freedom t o sectors* ( 2 ) The most obvious d i s t i n c t i o n i s between s e c u r i t y h o l d i n g s by commercial banks and h o l d i n g s by o t h e r g r o u p s . First, W i t h r e s p e c t t o bank h o l d i n g s , two i s s u e s arise, t h e r e i s t h e problem o f c h e c k i n g u n c a l l e d f o r c r e d i t expansion ( a n d r e s u l t i n g p r e s s u r e on r a t e s ) generated b y t h e e f f o r t s o f banks t o i n c r e a s e ( o r v e n t a d e c l i n e i n ) t h e i r e a r n i n g s f r o m Government s e c u r i t i e s • As banks s e l l pre- short- t e r m i s s u e s t o t h e F e d e r a l Reserve Banks ( w h i c h absorb t h e s e i s s u e s i n t h e process o f maintaining the rate structure) and purchase l o n g e r i s s u e s i n t h e m a r k e t , additional r e s e r v e s are o b t a i n e d , t o t a l s e c u r i t y h o l d i n g s by banks are expanded and t h e money supply i s increased. This problem has r e c e i v e d a g r e a t deal o f a t t e n t i o n and must be s o l v e d b e f o r e e f f e c t i v e monetary c o n t r o l i s r e s t o r e d . However, i t i s n o t t h e major i s s u e i n c e n t r a l b a n k i n g r e f o r m , and f r o m t h e e c o n o m i s e s p o i n t o f v i e w i t no g r e a t d i f f i c u l t y . available Barring p o l i t i c a l obstacles, quite feasible solutions presents are B l Second, and more i m p o r t a n t i s t h e problem w h i c h a r i s e s i f commercial banks want t o reduce t h e i r s e c u r i t y h o l d i n g s on b a l a n c e i n o r d e r t o o b t a i n r e s e r v e funds ( o r t o o f f s e t r e s t r i c t i v e a c t i o n b y t h e F e d e r a l Reserve) f o r purposes of expanding c r e d i t i n p r i v a t e assets* The p r o v i s i o n o f a mechanism by w h i c h t h i s can be prevented i s t h e b a s i c problem o f r e c o n s t i t u t i n g c e n t r a l b a n k i n g p o l i c y * Again, various approaches are a v a i l a b l e , some o f w h i c h a l s o h e l p t o s o l v e t h e f i r s t d i f f i c u l t y and most o f w h i c h c o n s t i t u t e a s h i f t i n t h e d i r e c t i o n o f 100 p e r cent ( o r h i g h ) reserve p r o p o s a l s . - ^ Bank h o l d i n g s o f Government s e c u r i t i e s may be r e p l a c e d i n p a r t w i t h issues n o t a t t r a c t i v e o r n o t a v a i l a b l e t o o t h e r i n v e s t o r s - a part o f present security - 18 h o l d i n g s b y benks may be i n c l u d e d i n r e s e r v e r e q u i r e m e n t s ; o r , more s i m p l y , a p a r t o f p r e s e n t s e c u r i t y h o l d i n g s may be t r a n s f o r m e d i n t o r e q u i r e d cash r e s e r v e s w h i c h , i f n e c e s s a r y , may be interest-bearing* ( 3 ) Among nonbank i n v e s t o r s , t h e major d i s t i n c t i o n i s t h a t between bona t f i d e i n v e s t o r s who purchase Government s e c u r i t i e s p r i m a r i l y f o r income and s a f e t y , and s p e c u l a t i v e i n v e s t o r s who have a m a j o r i n t e r e s t i s i n c a p i t a l g a i n s * Specula- t i o n i n l o n g - t e r m Government s e c u r i t i e s , e x t e n d i n g beyond t h a t needed f o r m a i n t a i n i n g a smooth r a t e s t r u c t u r e , b i l i z i n g long-term y i e l d s , serves l i t t l e if eny economic f u n c t i o n and, b y u n s t a - such s p e c u l a t i o n m i g h t r e n d e r i t d i f f i c u l t even f o r bona fide investors to s t a b i l i z e t h e i r holdings. The problem may be s o l v e d i n p a r t by devices ( s u c h as p r o p e r t a x p r o v i s i o n s , m a r g i n c o n t r o l s and c o n t r o l s over security l o a n s ) w h i c h w i l l reduce s p e c u l a t i o n d i r e c t l y , and p a r t l y by m e e t i n g t h e i n v e s t m e n t roquirements o f p o t e n t i a l l o n g - t e r m h o l d e r s i n c r e a s i n g l y t h r o u g h nonmarketable i s s u e s 3f t h e savings bond t y p e . By r e n d e r i n g t h e c a p i t a l v a l u e independent o f market f l u c t u a t i o n s , t h e terms o f t h e s e i s s u e s i n c r e a s e t h e i n v e s t o r ' s position. liquidity I n t h e absense o f s p e c u l a t i v e i n t e n t i o n s , t h e r e i s no p r e s s u r e t o liqui- date such h o l d i n g s due t o f e a r o f c a p i t a l l o s s e s i f a d e c l i n e i n t h e p r i c e o f market issues occurs. If, on t h e ^ t h e r hand, s a l e s a r e made, t h e y are made t o t h e Govern- ment and w i l l n o t r e s u l t i n c u m u l a t i v e p r e s s u r e upon s e c u r i t y prices® Fears m i g h t a r i s e t h a t t h e use o f nonmarketable i s s u e s m i g h t i n c r e a s e t h e i n v e s t o r ' s dependence upon p u b l i c debt p o l i c y . This i s h a r d l y t h e case* The use o f nonmarketable i s s u e s does n o t p e r m i t debt management t o d i s r e g a r d i n v e s t o r ' s prefer- ences; y i e l d s on nonmarketable i s s u e s cannot be s e t w i t h o u t r e f e r e n c e t o what t h e i n v e s t o r can earn somewhere e l s e ; investment i n nonmarketable i s s u e s i s no l e s s v o l u n t a r y t h a n i n v e s t m e n t i n m a r k e t a b l e i s s u e s and t h e freedom o f redemption i s indeed g r e a t e r . C e n t r a l b a n k i n g p o l i c y i s an i m p o r t a n t d e t e r m i n a n t o f p r i c e s and - 19 - y i e l d s , w i t h o r w i t h o u t t h e use o f nonmarket?ible d e b t . I n n e i t h e r case i s t h e l e v e l o f r a t e s e s t a b l i s h e d by a u t o m a t i c a l l y determined f o r c e s o f s u p p l y and demand, b u t b y market c o n d i t i o n s w h i c h depend, t o no s m a l l measure, on c r e d i t p o l i c y . The o n l y freedom w h i c h w o u l d be c u r t a i l e d by an i n c r e a s e d use o f nonmarketable i s s u e s i s of speculation, i . e . , t o earn a r e t u r n above t h e one p r o v i d e d f o r i n t h e coupon r a t e . For b_>na f i d e i n v e s t o r s , t h i s l o s s s h o u l d be more t h a n o f f s e t b y t h e g a i n from s t a b i l i t y . If that resulting i n s u r a n c e companies w i s h more g e n e r a l l y t o p l a c e funds i n t o g i l t - e d g e d i n v e s t m e n t o u t l e t s (and i t i s d e s i r a b l e , w i t h i n l i m i t s , such funds s h o u l d be channeled i n t o i n c r e a s e d investment i n p r i v a t e less t h a t t h e y do so) enterprise. Under c e r t a i n c o n d i t i o n s , t o be c o n s i d e r e d l a t e r , t h e s u p p l y o f a l o n g - t e r m i n v e s t ment medium migjht be r e c o g n i z e d as a p r o p e r f u n c t i o n o f debt management, b u t under no c o n d i t i o n s s h o u l d i t be t h e Government* s f u n c t i o n t o s u p p l y o p p o r t u n i t i e s for speculation, ( l l ) To t h e e x t e n t t h a t t h e s p e c u l a t i v e element i s d i s c o u r a g e d , a s u b s t a n t i a l p a r t o f t h e l o n g - t e r m h o l d i n g s o f i n s u r a n c e companies, savings institutions and s m a l l i n v e s t o r s are r e p l a c e d b y nonmarketable i s s u e s , and some c l o s e r c o n t r o l is o b t a i n e d over bank h o l d i n g s i n Government s e c u r i t i e s , t h e t a s k o f m a i n t a i n i n g s t a b i l i t y i n t h e s e c u r i t y market i s g r e a t l y s i m p l i f i e d . Given these p o l i c i e s , the danger t h a t moderate f l u c t u a t i o n s i n s e c u r i t y p r i c e s o o u l d assume s n o w b a l l p r o p o r t i o n s w i l l be g r e a t l y reduced. Thereby^ some leeway f o r t h e use o f f l e x i b l e credit p o l i c y w i l l be r e s t o r e d . Funded v s . Unfunded Debt The problem o f s t a b i l i z i n g Government s e c u r i t y h o l d i n g s as d i s c u s s e d i n t h e p r e c e d i n g s e c t i o n c a r r i e s i n t e r e s t i n g i m p l i c a t i o n s f o r t h e i s s u e o f funded v s . unfunded d e b t , ( i ) According t o t r a d i t i o n a l t h e o r y , a sound debt s t r u c t u r e i s a l o n g - t e r m 20 - debt s t r u c t u r e . This c l a s s i c a l view has been s t a t e d as follows* f, As a general p r i n c i p l e of finance i t i s unquestionable t h a t t h e f l o a t i n g ' debt should be kept w i t h i n the narrowest l i m i t s possible.--»The great e v i l of f l o a t i n g debt i s i t s u n c e r t a i n t y . To be open t o the r i s k o f a sudden demand f o r payment i s to be i n the p o s i t i o n of a banker without t h e s e c u r i t i e s w i t h which he provides h i m s e l f ; and i t i s p r e c i s e l y i n timea of commercial d i f f i c u l t i e s t h a t the c a l l i s most l i k e l y to be made."i2/ There i s good sense t o t h e main o b j e c t i v e here stated? should Debt management avoid p l a c i n g the debt w i t h investors who w i l l subject t h e Government t o the r i s k of having t o cash i n on i t s debt at an inopportune t i m e J ^ / B u t the p r i n c i 4 pie needs r e f o r m u l a t i o n i n two respects. F i r s t , the r e a l danger i s not t h e Govern- m e n t s i n a b i l i t y to r a i s e funds i n a period of economic d i s t r e s s . The need i s f o r avoiding debt monetization i n a boom period when i t i s desirable t o hold down expansion i n the degree of l i q u i d i t y t h a t p r e v a i l s i n the economy. Second, i t cannot be argued under present conditions t h a t a s h o r t - t e r m debt w i l l n e c e s s a r i l y involve a greater r i s k of forced monetization than a long-term d e b t . l e g a l i s t i c sense• This i s t r u e only i n a I f maturing debt i s presented f o r redemption i t must be p a i d , w h i l e non-matured debt present^ the Treasury w i t h no such l e g a l o b l i g a t i o n • But as we have seen, t h i s does not mean t h a t payment may not be necessary anyhow. I f non- bank i n v e s t o r s , or a l l p r i v a t e investors want t o s e l l on balance, public a u t h o r i t i e s cannot a f f o r d a hnnds-off p o l i c y , w h i l e p e r m i t t i n g prices to f a l l to any l e v e l the market may a l l o w . The vast volume of outstanding debt and possible cumulative e f f e c t s of a sharp d e c l i n e i n prices f o r b i d t h i s . The mere f a c t t h a t outstanding debt i s long-term gives no assurance t h a t the Government may not be c a l l e d t o pay such debt a t t h e wrong t i m e * ( 2 ) I f , t h e r e f o r e , long-term debt per se does not provide the s a f e t y which has been a t t r i b u t e d t o i t t r a d i t i o n a l l y , why not t u r n the e n t i r e debt i n t o short terms or* to carry the argument t o i t s conclusion, why not* t u r n the e n t i r e debt i n t o money? 21/ S h o r t - t e r m debt i s not only normally cheaper but also gives a g r e a t e r degree o f f l e x i b i l i t y t o debt management. Under t h e extreme assumption t h a t t h e y i e l d on a l l m a t u r i t i e s i s w i t h complete r i g i d i t y , t h i s i s indeed a p o w e r f u l argument* The degree o f fixed liquidity w i l l t h e n be t h e same f o r a p e r p e t u a l bond as f o r a one-day b i l l o r money and on such terms t h e r e i s no o c c a s i o n t o i s s u e l o n g e r o b l i g a t i o n s * The o n l y reason f o r p a y i n g h i g h e r r e t u r n s on one s e c u r i t y t h a n on a n o t h e r m i g h t be s o c i a l p o l i c y e r a t i o n s as d i s c u s s e d i n P a r t I I I . If it consid- i s c o n s i d e r e d necessary t o g r a n t h i g h e r e a r n i n g s t o some i n v e s t o r g r o u p s , payment o f h i g h e r r a t e s on s h o r t o b l i g a t i o n s is p r e f e r a b l e , under these c o n d i t i o n s , t o t h e issuance o f l o n g e r t e r m o b l i g a t i o n s w h i c h m e r e l y add t o t h e r i g i d i t y o f debt management w i t h o u t o f f e r i n g t h e Government any advantage i n return* Actually, t h i s extreme assumption does n o t a p p l y . Even i f t h e r e i s a g e n e r a l p o l i c y o f m a i n t a i n i n g t h e l e v e l o f r a t e s , t h e p o s s i b i l i t y o f minor changes i n t h e r a t e l e v e l o r a d j u s t m e n t s i n t h e s t r u c t u r e o f r a t e s w i l l remain, especially i f one a l l o w s f o r t h e p o s s i b i l i t y o f p o l i t i c a l change w h i c h may b r i n g r e v i s i o n s policy. of For t h i s reason t h e r e remains some l i q u i d i t y d i f f e r e n c e between s h o r t and l o n g i s s u e s and ( u n l e s s t h e r e are e x p e c t a t i o n s o f a d e c l i n i n g t r e n d o f r a t e s i n t h e f u t u r e ) t h e Government must pay h i g h e r r a t e s i f This w i l l pay o n l y i f i t i t wishes t o p l a c e l o n g e r issues. can be shown t h a t long'er i s s u e s w i l l p r o v i d e a h i g h e r degree o f " s a f e t y 1 1 — n o t because t h e Treasury i s w i t h o u t l e g a l o b l i g a t i o n s t o cash p r i o r to m a t u r i t y , b u t because t h e s e i s s u e s are l e s s l i k e l y t o be p r e s e n t e d f o r c a s h i n g . The e x t e n t t o w h i c h t h e l a t t e r i s t h e case depends l a r g e l y upon t h e degree t o w h i c h p r i c e f l u c t u a t i o n s are p e r m i t t e d , i . e . , a p o s s i b i l i t y of c a p i t a l loss e x i s t s . At b e s t , it i s a tunuous c o n d i t i o n t o r e l y o n . The case f o r p a y i n g a h i g h e r r a t e o f i n t e r e s t c e r t a i n l y i s g r e a t e r where i n exchange t h e r e i s some d i r e c t assuranco by t h e i n v e s t o r t h a t h i s s e c u r i t y h o l d i n g s "will stick". This i n v o l v e s l o n g m a t u r i t i e s as a n e c e s s a r y b u t n o t as a s u f f i c i e n t - 22 - condition. To c a r r y t h e argument t o t h e extreme, t h e Government w o u l d have t h e i n v e s t o r commit h i m s e l f t o r e t a i n h i s h o l d i n g s o f Government s e c u r i t i e s f o r a s t a t e d p e r i o d of t i m e o r t o agree t h a t p u b l i c a u t h o r i t i e s may t e m p o r a r i l y suspend t h e cashing p r i v i l e g e f o r specified periods* This m i g h t n o t be p r a c t i c a b l e , however, as it m i g h t reduce t h e l i q u i d i t y of s e c u r i t y h o l d i n g s t o a p o i n t where t h e i n v e s t o r m i g h t i n s i s t on an e x c e s s i v e l y h i g h r e t u r n » a fair compromise. The t e c h n i q u e employed i n savings bonds o f f e r s The i n v e s t o r r e t a i n s a h i g h degree o f l i q u i d i t y , y e t t h e terms o f these bonds w h i c h b y t h e i r v e r y n a t u r e must be n o n m a r k e t a b l e , impose a p e n a l t y upon e a r l y d i s i n v e s t m e n t , as t h e reward o f h i g h e r i n t e r e s t payments i s r e c e i v e d o n l y i f t h e bond i s h e l d f o r a l o n g e r p e r i o d . t h i s c o n d i t i o n have l i t t l e I n v e s t o r s who are n o t w i l l i n g t o accept claim to long-term y i e l d s . l o g i c o f our argument t h u s p o i n t s t o a debt s t r u c t u r e where t h e b u l k o f l o n g - t e r m i s s u e s i s i n nonmarketable f o r m w h i l e t h e r e m a i n i n g m a r k e t a b l e debt i s l a r g e l y s h o r t - t e r m . The y i e l d p a t t e r n on nonmarkotable d e b t , i n the framework o f such a d e b t s t r u c t u r e w o u l d , of c o u r s e , have t o be k e p t below t h a t o f t h e »e«marketable d e b t , a f t e r a l l o w i n g f o r difference in the liquidity The r e v i s e d " f u n d i n g p r i n c i p l e 1 1 thus i n v o l v e s two r e q u i r e m e n t s . First, means must be p r o v i d e d f o r c o n t r o l l i n g debt m o n e t i z a t i o n b y banks so t h a t t h e c r e a t i o n o f e x c e s s i v e money s u p p l i e s can be p r e v e n t e d . This i s n o t a m a t t e r l e n g t h e n i n g s h o r t m a t u r i t i e s b u t r e q u i r e s a d i r e c t approach. of Second, and w i t h r e g a r d t o nonbank h e l d d e b t , t h e t e r m "funding 1 1 must be r e d e f i n e d t o moan t h e replacement o f m a r k e t a b l e l o n g - t e r m debt w i t h nonmarketable i s s u e s , w i t h i n t e r e s t c o r r e l a t e d t o the period of holdings. A sound debt s t r u c t u r e , a c c o r d i n g t o t h i s p r i n c i p l e , i s one where some d i r e c t c o n t r o l o v e r bank h o l d i n g s e x i s t s , where t h e b u l k o f t h e l o n g - t e r m debt has been c o n v e r t e d i n t o nonmarketable i s s u e s and where t h e r e m a i n i n g s e c t o r o f m a r k e t a b l e debt i s l a r g e l y i n s h o r t - t e r m f o r m . - 23 - Another and more r a d i c a l p r i n c i p l e has been suggested by Henry Simons who would a b o l i s h a l l i n t e r m e d i a t e m a t u r i t i e s between cash and consols ( i . e . , various 23/ forms o f "near-money") w h i l e p e r m i t t i n g consols t o f l u c t u a t e f r e e l y . - * - * Our o f t h e t r a d i t i o n a l f u n d i n g argument a g a i n a p p l i e s . criticism Consols r e q u i r e no f o r m a l i n g b u t t h i s does n o t p r e v e n t t h e r i s k o f f o r c e d m o n e t i z a t i o n where d r a s t i c t i o n s i n t h e s e c u r i t y market must be p r e v e n t e d . fluctua- W h i l e t h e d i s t i n c t i o n between m a r k e t a b l e i s s u e s o f d i f f e r e n t m a t u r i t i e s does i n d e e d become meaningless i f y i e l d s are f r o z e n , t h i s extreme assumption does n o t a p p l y . d i s t i n c t i o n remains s i g n i f i c a n t h o l d i n g as here proposed. refund- all Moreover, t h e m a t u r i t y i f the rate of r e t u r n i s l i n k e d t o the period of On these t e r m s , t h e r e i s no reason why i n v e s t o r s " legiti- mate p r e f e r e n c e s f o r m a t u r i t i e s of v a r i o u s l e n g t h s s h o u l d n o t be met and be u t i l i z e d t o s t a b i l i z e debt h o l d i n g s , i . e . , t o "fund 1 1 t h e debt i n our sense of t h e t e r m ; t h e r e b y p e r m i t t i n g some f l e x i b i l i t y o f s e c u r i t y y i e l d s and p r i c e s w h i l e protecting t h e T r e a s u r y a g a i n s t e x c e s s i v e f l u c t u a t i o n s i n s e c u r i t y v a l u e s and f i n a n c i n g c o s t s . However, i t would be u n r e a l i s t i c n o t t o n o t e t h a t t h e s i g n i f i c a n c e o f our r e f u n d i n g p r i n c i p l e as s t a t e d i n i t s pure f o r m , i s more 'to p o i n t o u t t h e n a t u r e o f t h e problem on hand t h a n t o o f f e r an immediate s o l u t i o n . Certainly, i t s t i o n would t a k e time and i n v o l v e c o n s i d e r a b l e p r a c t i c a l d i f f i c u l t i e s . implementa- Some 20 b i l - l i o n o f m a r k e t a b l e i s s u e s are now o u t s t a n d i n g w h i c h are c a l l a b l e w i t h i n 10 y e a r s . Refunding o f these s e c u r i t i e s would have t o be a slow process u n l e s s ( 1 ) investors were tempted t o r e f u n d i n t o nonmarketable i s s u e s by t h e o f f e r o f more a t t r a c t i v e y i e l d s , o r ( 2 ) a p o l i c y was adopted o f p u r c h a s i n g f o r cash and a t market p r i c e (in most cases, above p a r ) i s s u e s w h i c h are n o t y e t c a l l a b l e , w h i l e o f f e r i n g nonmarket- 2w a b l e i s sues i n r e t u r n . A p o l i c y o f t h i s k i n d w o u l d have t o be undertaken gradually and when t h e o p p o r t u n i t y a r i s e s so as t o a v o i d e x c e s s i v e p r e s s u r e on y i e l d s . b e s t , t h e r e f u n d i n g process c o u l d be accomplished over a number o f yeans. At U n t i l then and as a more immediate s o l u t i o n t o t h e problem, p r i m a r y r e l i a n c e must be p l a c e d on - 2b - t h e o t h e r approaches, e s p e c i a l l y i n c r e a s e d c o n t r o l over bank h o l d i n g s o f securities, C o m p e t i t i o n f o r P r i v a t e Funds W h i l e debt management s h o u l d be p r e p a r e d t o i n c u r a h i g h e r c o s t where t h i s serves t o purchase i n c r e a s e d s t a b i l i t y o f debt h o l d i n g s , t h e r a t e o f return p a i d on Government bonds ( w h i c h a g a i n - i s a f u n c t i o n o f b o t h t h e coupon r a t e and the supply of various m a t u r i t i e s ) cannot be set w i t h o u t r e g a r d t o i t s e f f e c t s upon r e a l investment i n p r i v a t e ventures* From t h e l o n g e r r u n p o i n t o f v i e w , i t may be p o s t u l a t e d t h a t y i e l d s on Government s e c u r i t i e s s h o u l d n o t be m a i n t a i n e d a t a l e v e l which w i l l d i v e r t funds f r o m p r i v a t e c a p i t a l f o r m a t i o n , A h i g h r e t u r n on safe funds w i l l a l s o t e n d t o r a i s e r i s k premiums and t h e gross r a t e payable on r i s k This p l a c e s an upper l i m i t on t h e p e r m i s s a b l e r e t u r n on Government funds. securities, e s p e c i a l l y on i s s u e s w h i c h are purchased by i n v e s t o r s ( s u c h as l a r g e individual h o l d e r s ) who might o t h e r w i s e p l a c e t h e i r funds i n t o r i s k i n v e s t m e n t * Restating our previous conclusion i t investment i s n o t l i k e l y , however, t h a t t h e l e v e l o f r e a l w i l l be s e n s i t i v e t o moderate ( s a y , one p o i n t ) changes i n t h e l o n g t e r m r a t e * r e p e a t , t h e r e i s a c o n s i d e r a b l e range o f economic i n d e t e r m i n a n c y as t o t h e rate To "proper" level. Over t h e s h o r t e r r u n changes i n t h e r a t e o f i n t e r e s t may be more signifi- c a n t , b u t t h i s i s a l s o t h e p o i n t o f immediate c o n f l i c t between c r e d i t and debt policy. The use o f c r e d i t c o n t r o l as a c y c l i c a l d e v i c e has t o r e l y m a i n l y on changes i n t h e a v a i l a b i l i t y o f c r e d i t and such changes i n r a t e s as are n o t m i t t e d t h r o u g h t h e e n t i r e p u b l i c debt trans- structure. Conclusions Requirements o f debt management f o r r a t e p o l i c y may be summarized as follows: ( 1 ) From a b u d g e t a r y p o i n t o f v i e w , t h e r e i s a presumption i n f a v o r o f low i n t e r e s t payments, i n v o l v i n g s h o r t m a t u r i t i e s and a low l e v e l o f . r a t e s . - 25 - (2) D r a s t i c f l u c t u a t i o n s i n s e c u r i t y values are not permissable i n view o f t h e l a r g e p u b l i c debt b u t changes may be made i n t h e debt s t r u c t u r e w h i c h w i l l t o s t a b i l i z e s e c u r i t y h o l d i n g s and reduce t h e l i k e l i h o o d o f d r a s t i c tend fluctuations. This i n v o l v e s c o n t r o l o v e r bank h o l d i n g s o f Government s e c u r i t i e s and r e l i a n c e on s p e c i a l i s s u e s o f t h e s a v i n g s bond t y p e t o meet t h e l o n g - t e r m needs o f investors. institutional Given such a d j u s t m e n t s some f l e x i b i l i t y i n c r e d i t and i n t e r e s t policy s h o u l d be compatible w i t h a f a i r degree o f s t a b i l i t y i n t h e s e c u r i t y m a r k e t * ( 3 ) The t r a d i t i o n a l p r i n c i p l e i n f a v o r o f funded as d i s t i n c t f r o m f l o a t i n g debt does n o t a p p l y , u n l e s s " f u n d i n g " i s r e d e f i n e d t o mean t h e s t a b i l i z a t i o n o f b a n k h e l d debt and t h e p l a c i n g o f debt o u t s i d e t h e b a n k i n g system w i t h i n v e s t o r s who w i l l hold securities f o r a long period* Higher i n t e r e s t payments are w o r t h w h i l e where e f f e c t i v e i n o b t a i n i n g greater c e r t a i n t y of c o n t i n u i t y of h o l d i n g s . l o n g e r m a t u r i t i e s as a n e c e s s a r y b u t n o t a s u f f i c i e n t c o n d i t i o n . h o l d i n g s , nonmarketable i s s u e s o f t h e savings bond t y p e a r e This involves To assure s t a b l e required. ( i l ) E x c e p t i n g i n f l a t i o n p e r i o d s , t h e r e t u r n on Government o b l i g a t i o n s must n o t be p e r m i t t e d t o r i s e t o a l e v e l where funds are d i v e r t e d f r o m r e a l i n v e s t m e n t private in business. III. I n t e r e s t Rates and Income D i s t r i b u t i o n Since changes i n i n t e r e s t r a t e s i n v o l v e changes i n t h e income o f investors, c o n s i d e r a t i o n s r e l a t i n g t o income d i s t r i b u t i o n are bound t o be a s i g n i f i c a n t in rate p o l i c y . factor They are here d i s c u s s e d b u t b r i e f l y , n o t because t h e y are c o n s i d e r e d o f l e s s e r importance t h a n o t h e r aspects b u t because t h e y have been d e a l t w i t h more f u l l y by o t h e r w r i t e r s . S ' l n tions; some i n s t a n c e s , e q u i t y aspects o v e r r u l e o t h e r considera- i n most cases o t h e r c o n s i d e r a t i o n s (as those r e l a t i n g t o employment, p r i c e o r debt s t a b i l i t y ) w i l l n o t g i v e a v e r y s p e c i f i c and d e t e r m i n a t e answer. W i t h i n a con- s i d e r a b l e range t h e n , monetary and debt a u t h o r i t i e s cannot escape t h e responsibility - 26 - f o r j u d g i n g t h e "adequacy" o f investment incomes. And t h i s i s a m a t t e r o f social philosophy. The General L e v e l o f Rates Problems a r i s i n g i n t h i s c o n n e c t i o n l a r g e l y r e f e r t o e a r n i n g s o f partic- u l a r i n v e s t o r groups as d e r i v e d f r o m t h e p a r t i c u l a r i s s u e s w h i c h t h e y h o l d , b u t t h e impact o f t h e g e n e r a l r a t e l e v e l upon t h e income d i s t r i b u t i o n as a whole may be briefly considered. E s t i m a t e s suggest t h a t an i n c r e a s e i n t h e g e n e r a l l e v e l o f r a t e s p a i d on Government s e c u r i t i e s , assuming t h e p r e v a i l i n g r a t e s t r u c t u r e t o c o n t i n u e , would i n c r e a s e t h e i n e q u a l i t y o f income d i s t r i b u t i o n and t h a t a r e d u c t i o n i n t h e l e v e l would increase e q u a l i t y . rate Out o f t o t a l i n t e r e s t payments on p u b l i c l y h e l d U n i t e d S t a t e s d e b t , w h i c h amount t o about k b i l l i o n d o l l a r s , somewhat l e s s t h a n 1+0 per cent are r e c e i v e d by i n d i v i d u a l s d i r e c t l y ; and about 20 per cent by f a m i l i e s w i t h incomes under $5*000. banks and i n s t i t u t i o n a l I f we i n c l u d e such p o r t i o n s o f i n t e r e s t payments t o i n v e s t o r s as may be imputed t o t h e under #5*000 group, its e s t i m a t e d share becomes about qO p e r c e n t t ~ * Y e t , i t s share o f t o t a l F e d e r a l t a x e s r a i s e d t o f i n a n c e a d d i t i o n a l i n t e r e s t payments i s l i k e l y t o be 50 per cent o r more. I f t h e d i v i d i n g l i n e i s drawn a t a l o w e r income l e v e l , t h e spread w i l l be c o n s i d e r ably wider. A l s o , one must a l l o w f o r t h e f a c t t h a t a change i n t h e r e t u r n on p u b l i c debt w i l l be r e f l e c t e d i n a change i n i n t e r e s t charged on p r i v a t e * obligations so t h a t t h e r e s u l t i n g t o t a l change i n i n t e r e s t payments w i l l be a m u l t i p l e o f t h e change i n p u b l i c payments. Where t h e r a t e change c o n t r i b u t e s t o a h i g h e r o v e r a l l l e v e l o f r e a l t h e r e s u l t may, o f c o u r s e , be an improvement i n t h e a b s o l u t e p o s i t i o n o f a l l But i t s h o u l d a l s o be n o t e d t h a t an i n c r e a s e i n i n e q u a l i t y w i l l r a i s e t h e income, groups. propensity t o save w h i c h , i n p e r i o d s o f i n s u f f i c i e n t i n v e s t m e n t , w i l l t e n d t o make t h e m a i n t a i n ance o f h i g h employment more difficult^^ - 27 - Nonbank I n v e s t o r s A s i t u a t i o n m i g h t a r i s e where c o n s i d e r a t i o n s o f s o c i a l r a t h e r t h a n p u r e l y economic p o l i c y speak i n f a v o r o f p a y i n g a h i g h e r r a t e o f r e t u r n t o some groups o f investors than to o t h e r s . where i t For i n s t a n c e , c o n d i t i o n s m i g h t a r i s e - - a s d u r i n g a w a r - i s d e s i r a b l e t o s t r e n g t h e n t h e p o s i t i o n o f s m a l l savers- by p a y i n g a h i g h e r r e t u r n on l i m i t e d h o l d i n g s of such i n v e s t o r s , even t h o u g h such a h i g h e r r a t e m i g h t n o t be j u s t i f i e d i f c o n s i d e r e d m e r e l y as an inducement t o i n c r e a s e d bond p u r c h a s e s . A s i m i l a r problem may a r i s e w i t h r e s p e c t t o i n s t i t u t i o n a l investors. Suppose t h a t sooner o r l a t e r economic developments s h o u l d resume t h e t r e n d of t h e pre-war decade* deflationary I t m i g h t t h e n become d e s i r a b l e , on grounds o f economic p o l i c y , t o i n c r e a s e l i q u i d i t y * This i n t u r n m i g h t produce a s i t u a t i o n where p u b l i c debt c o u l d be p l a c e d w i t h i n s t i t u t i o n a l i n v e s t o r s a t r a t e s below customary s t a n d a r d s . general substantially Under such c o n d i t i o n s , s h o u l d a bonus be p a i d i n t h e f o r m o f h i g h e r r a t e s , assuming t h a t t h i s can be done w i t h o u t s e r i o u s l y diverting funds f r o m p r i v a t e i n v e s t m e n t ? Or, to add a related qudsticn, s h o u l d t h e l o n g - t e r m r a t e be m a i n t a i n e d when a v a i l a b l e funds f r o m nonbank sources are i n excess o f investment needs? » This r a i s e s b r o a d i s s u e s o f s o c i a l p o l i c y . How i m p o r t a n t i s i t , for in- s t a n c e , t o m a i n t a i n i n v e s t m e n t incomes o f endowed e d u c a t i o n a l i n s t i t u t i o n s a t a l e v e l n o t too f a r below t h e customary standard? Should t h e Government assure v e s t o r s t h a t t h e y may budget t h e i r p r i v a t e savings over a l i f e span w i t h o u t b e i n g d i s t u r b e d b y p o s s i b l e l o n g e r r u n changes i n t h e r a t e o f i n t e r e s t ? p o l i c i e s be a v o i d e d w h i c h m i g h t r e q u i r e downward a d j u s t m e n t i n l i f e a n n u i t i e s o r i n c r e a s e s i n premiums? That i s , must insurance I n t h o s e cases i n w h i c h support i s decided upon, are h i g h e r i n t e r e s t payments t h e most e f f e c t i v e approach? debated h e r e , b u t two g e n e r a l o b s e r v a t i o n s might be added. in- These i s s u e s cannot be - 28 - F i r s t , where f i x e d i n v e s t m e n t income i s needed, i t m a t t e r o f economic p o l i c y , is preferable, as a t h a t i t be p r o v i d e d t h r o u g h i n t e r e s t on Government debt rather than through f i x e d i n t e r e s t (or r i g i d dividend) payments on p r i v a t e debt. S i n c e t h e f o r m e r payments may be d e f i c i t f i n a n c e d more r e a d i l y d u r i n g d e p r e s s i o n p e r i o d s , t h e y do n o t i n v o l v e q u i t e t h e r i g i d i t i e s produced by p r i v a t e d e b t . Second, i f a special p u b l i c r e s p o n s i b i l i t y i s recognized toward t h e small saver, i t is more i m p o r t a n t t o e l i m i n a t e t h e r i s k o f l o s s i n t h e purchasing- v a l u e o f h i s capital than i t i s t o p r o v i d e p r e f e r e n t i a l i n t e r e s t payments. d i f f i c u l t o b j e c t i v e of general price l e v e l s t a b i l i t y , far S h o r t o f t h e b r o a d e r and more t h i s may be done b y making 28/ a v a i l a b l e a s t a b l e p u r c h a s i n g power b o n d . ~ * p r o b l e m s o f income adequacy o f i n t e r e s t r a t e s may be approached a l o n g two l i n e s * ^ / o n e i s t o m a i n t a i n t h e g e n e r a l l e v e l o f r a t e s on l o n g e r t e r m i s s u e s s u f f i c i e n t l y h i g h so as t o a s s u r e what i s c o n s i d e r e d an " a d e q u a t e " l e v e l o f w h i l e t a k i n g steps ( t h r o u g h r a t e subsidies or r i s k p o o l i n g ) earnings, t o lower t h e cost c a p i t a l t o p r i v a t e u s e r s i n t h o s e areas o f i n v e s t m e n t where c a p i t a l f o r m a t i o n most l i k e l y t o be s t i m u l a t e d . is A n o t h e r course i s t o a s s u r e a l o w e r o v e r - a l l l e v e l r a t e s w h i l e making s p e c i a l p r o v i s i o n f o r i n c r e a s e d e a r n i n g s where t h e s e a r e ered s o c i a l l y necessary. of The f i r s t of consid- course p r o v i d e s f o r a more i m p e r s o n a l and p e r - haps l e s s a r b i t r a r y s o l u t i o n o f t h e e a r n i n g s a s p e c t o f t h e p r o b l e m w h i l e more s p e c i f i c i n t e r v e n t i o n w i t h r e s p e c t t o i n v e s t m e n t i n d u c e m e n t s ; t h e requiring opposite h o l d s f o r t h e second c o u r s e * Commercial Bank H o l d i n g s About o n e - t h i r d o f i n t e r e s t payments on p u b l i c l y h e l d U n i t e d S t a t e s g a t i o n s a r e r e c e i v e d b y - c o m m e r c i a l banks and t h e s e payments f u r n i s h about o f commercial bank e a r n i n g s . profit, Public authorities, similarly, one-half B a n k s , w h i c h l i k e any o t h e r e n t e r p r i s e o p e r a t e c a n n o t be e x p e c t e d t o d i s r e g a r d t h e e a r n i n g a s p e c t s o f s e c u r i t y cannot a f f o r d t o d i s r e g a r d t h e e f f e c t s o f obli- for holdings* their - 29 - p o l i c i e s upon bank earnings, although the major tasks of c r e d i t and debt p o l i c y must not be Subordinated t o the minor one of preventing excessive and, p o s s i b l e , adequate bank e a r n i n g s . assuring Moving debt o u t o f bnnks, f o r i n s t a n c e , may be a way o f r e d u c i n g bank e a r n i n g s ; y e t , a p o l i c y o f d e m o n e t i z a t i o n s h o u l d be u n d e r t a k e n o n l y when t h e r e i s e x c e s s i v e l i q u i d i t y . M o n e t i z a t i o n o f d e b t , s i m i l a r l y , i s a means o f r a i s i n g bank e a r n i n g s b u t s h o u l d n o t be u n d e r t a k e n u n l e s s more g e n e r a l require i t . considerations To d i s e n t a n g l e t h e c o n t r o l o f e a r n i n g s f r o m t h e c o n t r o l o f c r e d i t , more 30/ d i r e c t approaches o f t h e p r e v i o u s l y d i s c u s s e d k i n d are needed.—* A f t e r e f f e c t i v e t e c h n i q u e s o f c o n t r o l have become a v a i l a b l e , authorities are l e f t w i t h t h e t a s k o f d e f i n i n g what c o n s t i t u t e s a "proper* 1 l e v e l o f bank e a r n ings, that i s , a l e v e l w h i c h — i n r e l a t i o n t o e a r n i n g s i n other l i n e s o f b u s i n e s s — i s 31/ s u f f i c i e n t t o c a l l f o r t h t h e necessary volume o f bank c a p i t a l A f t e r a definition o f " f a i r f t e a r n i n g s has been f o u n d , and even i n t h e absence o f any excess e a r n i n g s , a more d i f f i c u l t problem s t i l l economy i n g e n e r a l and i t s remains. The f u n c t i o n o f t h e b a n k i n g system i n t h e c o n t r i b u t i o n t o Government f i n a n c e i n p a r t i c u l a r are such t h a t a s u b s t a n t i a l share o f b a n k i n g c o s t s s h o u l d be d e f r a y e d by e a r n i n g s f r o m p u b l i c o b l i g a t i o n s r a t h e r t h a n f r o m e a r n i n g s on o t h e r i n v e s t m e n t s and l o a n s , o r f r o m s e r v i c e charges. B u t t h e r e remains t h e problem o f what c o n s t i t u t e s t h e p r o p e r share o f bank e a r n i n g s f r o m t h i s s o u r c e , and t h i s we cannot c o n s i d e r h e r e . IV. An I n t e g r a t e d I n t e r e s t Policy Regarding t h e " p r o p e r 1 ' l e v e l o f r a t e s a p p l i c a b l e under average conditions and over a l o n g e r p e r i o d , economic a n a l y s i s p r o v i d e s t h e most g e n e r a l guidance o n l y . The l e v e l o f r e a l i n v e s t m e n t as w e l l as t h e s u p p l y o f funds over t h e l o n g e r r u n are t o o i n s e n s i t i v e t o i n t e r e s t as t o render r a t e a d j u s t m e n t s an e f f e c t i v e means o f secular c o n t r o l . The " p r o p e r " l e v e l o f r a t e s over t h e l o n g e r r u n thus depends t o a c o n s i d e r a b l e degree on o t h e r c o n s i d e r a t i o n s , The amount of'lcngar t e r m Treasury bonds o u t s t a n d i n g and i n t e r e s t p a i d should n o t bo so h i g h as t o d i v e r t funds f r o m r i s k i n v e s t m e n t i n p r i v a t e business. Alsq t h e r e are f u r t h e r presumptions i n f a v o r o f low i n t e r e s t charges on b u d g e t a r y grounds and i n o r d e r t o s u s t a i n h i g h l e v e l consumption. A t t h e same t i m e , r a t e s should be h i g h enough t o p e r m i t p l a c i n g t h e debt "safely" and, under c e r t a i n c o n d i t i o n s , t o a l l o w f o r c o n s i d e r a t i o n s o f e a r n i n g adequacy. Flexible c r e d i t p o l i c y , however, may be u s e f u l as an i n s t r u m e n t r e s t r a i n t i n t h e expansion phase o f t h e c y c l e . Similarly, j u n c t i o n w i t h a s u c c e s s f u l f u l l employment p o l i c y * of i t may be u s e f u l i n con- Such a p o l i c y w i l l c r e a t e a more continuous need f o r c o n t r o l l i n g i n f l a t i o n a r y p r e s s u r e s t h a n has e x i s t e d i n t h e p a s t ; the B l o n d i n i a n s t a t e of a f f a i r s which i t i m p l i e s i s par e x c e l l e n c e t h a t i n w h i c h t h e b a l a n c i n g r o d o f c r e d i t a d j u s t m e n t s may be o f some u s e . Unless mado i m p e r a t i v e by the r e q u i r e m e n t s o f a s t a b l e debt s t r u c t u r e , t h e i r use as an i n s t r u m e n t o f re- s t r a i n t s h o u l d t h e r e f o r e n o t be d i s c a r d e d * A t t h e same t i m e , i t must be r e c o g n i z e d t h a t sharp f l u c t u a t i o n s i n t e r e s t r a t e s are i n c o m p a t i b l e w i t h t h e r e q u i r e m e n t s o f a s t a b l e debt and t h a t even moderate f l u c t u a t i o n s may r a i s e s e r i o u s p r o b l e m s . in structure W i t h i n the present s t r u c t u r e o f s e c u r i t y h o l d i n g s , o f t y p e s o f debt used and o f a v a i l a b l e c r e d i t trols, a f o r c e f u l general c r e d i t p o l i c y i s thus not p o s s i b l e . con- Y e t , as f a r as t h e e c o n o m i s t ' s b l u e p r i n t i s concerned, an i n t e g r a t e d c r e d i t and debt p o l i c y can be developed w h i c h w i l l combine t h e requirements o f a reasonable degree o f flexibility i n credit control w i t h that of s t a b i l i t y in security values. On t h e c r e d i t c o n t r o l s i d e , t h i s r e q u i r e s i n v e n t i v e and v i g o r o u s use o f e x i s t i n g s e l e c t i v e c o n t r o l s and t h e p o s s i b l e development o f s i m i l a r c o n t r o l s other areas. in On t h e debt s i d e , i t r e q u i r e s c e r t a i n a d j u s t m e n t s t o assure t h a t debt holdings w i l l " s t i c k " , i . e . , t h a t debt m o n e t i z a t i o n w i l l n o t be f o r c e d upon p u b l i c a u t h o r i t i e s a t an i n o p p o r t u n e t i m e . These adjustments i n c l u d e p r o v i s i o n f o r some d i r e c t o o n t r o l over the s e c u r i t y p o r t f o l i o s o f commercial banks and a p o l i c y o f r e f u n d i n g l o n g e r t e r m debt h e l d by bona f i d e i n v e s t o r s i n t o nonmarketable issues. Tho f i r s t p r o v i s i o n c o u l d be i n t r o d u c e d p r o m p t l y w h i l e t h e second c o u l d be i m p l e mented o n l y over a s u b s t a n t i a l p e r i o d o f t i m e . Given such s t r u c t u r a l changes, m a i n t a i n a n c e o f debt s t a b i l i t y w i l l become p o s s i b l e w i t h o u t h a v i n g t o p e r m i t bank c r e d i t expansion a t i n o p p o r t u n e t i m e s and r e s t r i c t i v e f e a s i b l e i n boom p e r i o d s w i t h o u t endangering debt c r e d i t measures w i l l become stability. I t w i l l be o b j e c t e d t h a t t h e i n t e n d e d compromise between s t a b i l i t y and f l e x i b i l i t y i s u n o b t a i n a b l e ; t h a t r e t u r n s on c a p i t a l t h r o u g h o u t t h e economy are t i g h t l y i n t e r w o v e n and t h a t s t a b i l i z i n g any one p a r t means s t a b i l i z i n g t h e w h o l e . But r a t e f l e x i b i l i t y , l i k e a l l economic m a t t e r s , i s a q u e s t i o n o f degree* Even though l o n g - t e r m p u b l i c debt i s s u e s are nonmarketable r a t h e r t h a n m a r k e t a b l e , volume and coupon r a t e s w i l l s t i l l bear upon t h e demand o f i n s t i t u t i o n a l f o r other investments. Even though banks are n o t f r e e t o y a r y t h e i r their investors Government p o r t f o l i o at w i l l , changes i n t h e i r r e s e r v e p o s i t i o n w i l l s t i l l a f f e c t t h e l e v e l o f short-term yields. The r e m a i n i n g l i n k between bank r e s e r v e s , y i e l d s on Government debt and c a p i t a l v a l u e s i n t h e economy a t l a r g e w i l l s t i l l be s u f f i c i e n t f o r s t r i c t i v e o r e x p a n s i o n a r y t e n d e n c i e s t o be t r a n s m i t t e d * t e r m p u b l i c debt w i l l be cushioned a g a i n s t market re- A t t h e same t i m e , t h e l o n g - fluctuationsr Pending i m p l e m e n t a t i o n o f these o r r e l a t e d s t r u c t u r a l changes, measures o f c r e d i t r e s t r a i n t w i l l be c o n f i n e d t o t h e n a r r o w e s t l i m i t s * Credit p o l i c y , f a r from b e i n g able t o r e n d e r a p o s i t i v e c o n t r i b u t i o n t o economic s t a b i l i z a t i o n w i l l be h a r d p u t t o p r e v e n t u n s t a b i l i z i n g c r e d i t developments. This w i l l do t h e l e s s harm t h e more e f f e c t i v e t h e use w h i c h i s made o f o t h e r and more p o w e r f u l means o f t i o n such as g e n e r a l f i s c a l p o l i c i e s o r wage and p r i c e measures* stabiliza- However, t h e p o t e n t i a l a v a i l a b i l i t y o f more p o w e r f u l approaches i s no assurance t h a t t h e y w i l l be used. I n the meantime, one cannot d i s c a r d l i g h t l y t r a d i t i o n a l approaches even though t h e y are l e s s effective* * 52 FOOTNOTES 1 . O b j o c t i v o s groupod under ( l ) aro u s u a l l y t h o u g h t o f as problems o f Podoral Reserve p o l i c y ; those groupod under (2) as a m a t t e r o f Treasury p o l i c y . Questions o f j u r i s d i c t i o n aro d i s r e g a r d e d h e r o , as a l l t h r e e a s p e c t s are m a t t e r s o f p u b l i c policy. 2 . No s p o c i f i c d o f i n i t i o n o f t h e Torm " i n t e r e s t 1 1 can bo dovolopod h o r o . S u f f i c e i t t o say t h a t t h o t o r m i s usod i n t h e o c o n o m i s t ' s sonso o f paymont f o r t h o uso o f funds whoro t h o r o i s no d e f a u l t r i s k , b u t l i q u i d i t y r i s k s aro i n c l u d o d . Similarly, wo d i s r e g a r d t h o f a c t t h a t " t h e " i n t o r o s t r a t e i s a c t u a l l y a s t r u c t u r e o f r a t o s , difforing with maturitios. I f any ono r a t o nood bo r e f o r r o d t o , t h o r e a d e r may t h i n k o f " i n t o r o s t " as t h o r e t u r n on a, say, 8 - y o a r U. S. Troasury o b l i g a t i o n . 3« Whora t h o i n v o s t o r usos h i s own f u n d s , t h o i n t e r e s t r a t o o n t o r s h i s c a l c u l a t i o n s as an o p p o r t u n i t y c o s t . Whoro ho o b t a i n s funds a g a i n s t safo c o l l a t o r c v l * i n t e r e s t r o p r o s o n t s t h o o o s t o f b o r r o w i n g . TTftoro he borrows w i t h o u t c o l l a t e r a l t h o g r o s s r a t o charged w i l l i n c l u d e a r i s k premium. U. To i l l u s t r a t e : Tho p r e s e n t v a l u o o f an a n n u i t y o f $1,000 p a i d a n n u a l l y over a 5 - y c a r p e r i o d and d i s c o u n t e d a t 2 par cent i s $i|.,713« Should tho i n t o r o s t r a t o r i s e t o 5 p o r o o n t , w h i c h would bo a 150 por c o n t i n c r e a s e , the p r e s o n t v a l u o would f a l l t o $,329. I f * p r i o r t o t h o r a t e i n c r e a s e , t h o i n v e s t m e n t was j u s t v / o r t h w h i l o , i . e . , t h o c o s t o f t h o oguipmont j u s t e q u a l l e d i t s p r o s e n t v a l u e , t h o i n v o s t m o n t a f t o r t h o 150 p o r cent r i s o i n tho r a t e o f i n t o r o s t would r o s u l t i n a loss of ^ h i s some l o s s c p u l d havo boon b r o u g h t about b y an i n c r o a s o i n t h o purchaso p r i c o of o n l y 8 por cont or an almost s i m i l a r d o c l i n o i n a n t i c i p a t e d oarnings. For dovolopmont o f t h i s argument., soo F# A. L u t z * s "Tho I n t e r e s t Rato and I n v o s t m o n t i n a Dynamic Economy", Tho Amarican Economic Reyiow, Decembor 19^5* 5. A g a i n t h i s s t a t o m o n t i s o q u a l l y a p p l i c a b l e t o t h o i n v e s t o r who uses h i s own funds and f i n d s t h a t t h o c o s t o f r i s k t a k i n g i s l a r g o r e l a t i v e t o t h e o p p o r t u n i t y oost o f safo i n v o s t m o n t o r t o the b o r r o w o r who pays a g r o s s r a t e and f i n d s t h a t i n t o r o s t i s a r o l a t i v o l y m i n o r componont i n t h e t o t a l chargo. A d i s c u s s i o n o f r i s k and u n c o r t a i n t y can n o t bo u n d e r t a k e n i n t h i s c o n t e x t ^ Tho t o r m r i s k , as usod here., i s moont t o cover b o t h t y p o s o f c o n t i n g e n c y . 6* Y o t , i t i s t h i s " g r o s s " r a t o w h i c h must bo roducod i f i n v e s t m e n t i s t o be oncouragod. Timt i s „ p o l i c i e s must be dovisod w h i c h w i l l reduce tho degree o f r i s k and u n c e r t a i n t y . Arrangements f o r r i s k p o o l i n g and Government guarantees o f r i s k s o f f e r a p r o m i s i n g and a l l t o o n o g l o c t e d approach, b u t t h o more fundamental s o l u t i o n i s t o assuro o v e r a l l s t a b i l i t y o f m a r k e t s . By s e c u r i n g such s t a b i l i t y , a s u b s t a n t i a l p a r t o f i n v e s t m e n t r i s k and u n c e r t a i n t y may be e l i m i n a t e d and r i s k t a k i n g bo roducod t o i t s p r o p e r oconomio f u n c t i o n . Tho p l a n n i n g p e r i o d can bo longthonod and tho importance o f tho i n t e r e s t f a c t o r be i n c r e a s e d . A chango i n t h o r a t o o f i n t e r e s t m i g h t t h e n becomo o f c o n s i d e r a b l e importance i n c o n t r o l l i n g tho l o v o l of p r i v a t e investment. 7. Tho i n v o s t o r who i s c o n s i d e r i n g t h o uso of h i s own funds i n r e a l i n v e s t m e n t may i n s t e a d p l a c o h i s f u n d s i n t o 2 l / 2 por aent bonds w h i l e p o s t p o n i n g t h o r e a l i n vostmont i n t h o e x p e c t a t i o n o f b o r r o w i n g l a t e r a t 1 l / 2 por c e n t . - 33 8 , This may be t h e case, even though l i q u i d i t y p r e f e r e n c e may f a l l below t h e i n i t i a l l e v e l a f t e r t h e h i g h e r r a t e i s e s t a b l i s h e d and no f u r t h e r change i s e x p e c t e d . E x p e c t a t i o n s o f r a t e i n c r e a s e are t h e more s i g n i f i c a n t t h e l o w e r t h e i n i t i a l l y p r e v a i l i n g l e v e l - o f r a t e s . The e f f e c t s o f t h e expected r a t e change on l i q u i d i t y p r e f e r e n c e , as Keynes p o i n t s o u t , depend upon t h e r e l a t i v e magnitudes o f y i e l d a t c o n s t a n t r a t e s on t h e one s i d e and t h e c a p i t a l l o s s e s and gains w i t h changing r a t e s on t h e o t h e r . The l o w e r t h e i n i t i a l r a t e l e v e l , t h e l e s s i s t h e o p p o r t u n i t y c o s t o f r e t a i n i n g cash, w h i l e t h e p o t e n t i a l c a p i t a l l o s s due t o any expected a b s o l u t e r i s e i n t h e r a t e i s t h e g r e a t e r t h e l o w e r t h e i n i t i a l r a t e l e v e l . A s i m i l a r argument h o l d s f o r expected r a t e r e d u c t i o n s , a l t h o u g h i t carries less weight. 9 . I am i n d e b t e d t o Ralph A . Young f o r most h e l p f u l s u g g e s t i o n s on t h i s section. 1 0 , V*e assume t h a t t h e demand f o r c r e d i t has some e l a s t i c i t y and t h e r e i s a p o s i t i v e r a t e o f i n t e r e s t a t w h i c h t h e v a r i o u s c r e d i t s u p p l i e s are absorbed. 11, Tfthen c r e d i t r e s t r i c t i o n i s r a t i o n e d o u t by way o f c u r t a i l i n g r i s k c r e d i t , t h e conc o m i t a n t t i g h t e n i n g o f i n t e r e s t may n o t o n l y be r e l a t i v e l y u n i m p o r t a n t b u t may indeed be h i d d e n under t h e s u r f a c e . W h i l e t h e gross i n t e r e s t charge remains t h e same, t h e r i s k i n e s s o f t h e average l o a n i s decreased* The r i s k component o f t h e gross i n t e r e s t charge a c c o r d i n g l y i s reduced, l e a v i n g an i n c r e a s e d r e s i d u a l f o r i n t e r e s t i n t h e e c o n o m i s t s sense. A quite s i m i l a r s i t u a t i o n arises i n connection w i t h d i r e c t curtailment of consumer and s t o c k market c r e d i t * Here t h e m a r g i n a l ( r i s k i e r ) b o r r o w e r s are e x c l u d e d b y c e r t a i n r e q u i r e m e n t s f o r down payment. Under c o m p e t i t i v e c o n d i t i o n s , one should e x p e c t , i n d e e d , t h a t t h e gross charge on such l o a n s w o u l d be reduced w i t h a t i g h t e n i n g o f r e q u i r e m e n t s , u n l e s s t h e s p e c i f i c r e s t r i c t i o n was accompanied by a g e n e r a l c u r t a i l m e n t o f c r e d i t , 1 2 , A v a i l a b i l i t y c o n t r o l s (as t r a d i t i o n a l l y argued w i t h r e s p e c t t o r a t e a d j u s t m e n t s ) are o f l i t t l e use f o r d e p r e s s i o n p o l i c y where t h e problem i s one o f l a c k i n g demand. 1 3 , C o n c e i v a b l y i n c r e a s e d t a x and i n t e r e s t payments may r a i s e consumption b u t , w i t h t h e g i v e n d i s t r i b u t i o n o f debt h o l d i n g and revenue s t r u c t u r e , t h i s i s u n l i k e l y . See n o t e 27* l U , I t does n o t f o l l o w t h a t , whatever t h e l e v e l o f t r a n s f e r e x p e n d i t u r e s , " F u n c t i o n a l F i n a n c e " r u l e s w i l l always p r o v i d e pome c o m b i n a t i o n o f t a x and l o a n f i n a n c e f o r w h i c h h i g h employment and p r i c e s t a b i l i t y are m a i n t a i n e d * C a r r i e d t o t h e extreme, t h e system w i l l break dowi, even i f p e r f e c t taxes a r e u s e d . (The case o f a s p e c i f i c t a x on i n t e r e s t income, i . e . , i n t e r e s t f r e e f i n a n c e , i s r u l e d o u t , ) Given an e x o r b i t a n t r a t i o o f t r a n s f e r e x p e n d i t u r e s t o earned income, t h e r a t e o f t a x r e q u i r e d t o check i n f l a t i o n m i g h t .be e x t r e m e l y h i g h and so reduce t h e f r a c t i o n o f earned income r e t a i n e d a f t e r t a x ( t o an i n f i n i t e l y s m a l l percentage i n t h e l i m i t i n g case) t h a t t h e e n t i r e process o f a u t o m a t i c a l l o c a t i o n and f a c t o r p r i c i n g , e s s e n t i a l t o a d e c e n t r a l i z e d market economy, w i l l break down, 15« Successive s h o r t e n i n g o f m a t u r i t i e s w i l l n o t n e c e s s a r i l y reduce t h e average r a t e p a i d however, The T r e a s u r y , a c t i n g as a monopsonist, w i l l " p u r c h a s e " funds o f v a r y i n g m a t u r i t i e s a t such amounts as w i l l equate m a r g i n a l costs,. The f a c t t h a t s h o r t e n i n g o f m a t u r i t i e s w i l l t e n d t o r e s u l t i n a continuous r e d u c t i o n o f f i n a n c i n g cost i s due t o t h e h i g h l y e l a s t i c s u p p l y schedule f o r s h o r t - t e r m ( l a r g e l y bank) funds t - 3b - W i t h r e g a r d t o s h o r t - r u n a d j u s t m e n t s i n r a t e s n o t e t h a t a change i n r a t e s does n o t a p p l y i m m e d i a t e l y t o t o t a l debt o u t s t a n d i n g , b u t o n l y t o t h a t p a r t o f t h e d e b t w h i c h comes up f o r r e f u n d i n g * I f t h e p r e s e n t l e v e l o f r a t e s was d o u b l e d w h i l e t h e p r e s e n t m a t u r i t y c o m p o s i t i o n o f t h e d e b t was m a i n t a i n e d , i n t e r e s t c o s t t o t h e Government w o u l d e v e n t u a l l y r i s e f r o m 5 "to 10 b i l l i o n d o l l a r s . Y e t , t h e i n c r e a s e w i t h i n one y e a r w o u l d be o n l y 350 m i l l i o n and a f t e r f i v e y e a r s , only 1 b i l l i o n . 1 6 . The a m p l i t u d e o f f l u c t u a t i o n s i n b o n d p r i c e s c o r r e s p o n d i n g t o g i v e n f l u c t u a t i o n s i n y i e l d i s a f u n c t i o n o f t h e m a t u r i t y o f t h e d e b t . Whereas a 20 p e r cent i n crease i n t h e y i e l d o f c o n s o l s w o u l d be r e f l e c t e d i n a l 6 2 / 3 p e r c e n t d e c l i n e i n t h e i r p r i c e , a s i m i l a r r i s e i n t h e p r e s e n t y i e l d o f 2 . 3 p e r c e n t on 2 l / 2 p e r c e n t , 2 0 - y e a r bonds w o u l d r e s u l t i n a p r i c e d e c l i n e f r o m 103 t o 9 6 ; f o r t h e y i e l d o f I.I4. p e r cent on a 2 p e r cent 5~year m a t u r i t y , t h e r e s u l t w o u l d b e a d e c l i n e f r o m 103 t o 101.U o n l y * 1 7 . These i m p l y some measure of d i r e c t c o n t r o l o v e r bank h o l d i n g s o f Government s e c u r i t i e s o r e a r n i n g s d e r i v e d f r o m such h o l d i n g s . A s t e p i n t h i s d i r e c t i o n has been t a k e n i n t h e course o f war f i n a n c e b y r e n d e r i n g t h e b u l k o f i s s u e s w i t h m a t u r i t i e s o v e r 10 y e a r s i n e l i g i b l e f o r bank h o l d i n g , b u t more need be done. One approach m i $ i t be t o r e q u i r e banks t o h o l d l o w i n t e r e s t b e a r i n g i s s u e s , another t o l i m i t t h e i r holdings o f longer issues* The most d i r e c t way o f m e e t i n g t h e p r o b l e m w o u l d be t h e a p p l i c a t i o n o f a t a x on bank e a r n i n g s f r o m Government s e c u r i t y h o l d i n g s i n excess of a c e r t a i n average r e t u r n on t h e i r p o r t f o l i o s . S o l u t i o n s a l o n g t h e s e l i n e s have been a d o p t e d b y o t h e r c o u n t r i e s . Canada, h a s , i n e f f e c t , a c c o m p l i s h e d t h e same k i n d o f r e s u l t b y o b t a i n i n g an agreement between t h e Government and t h e c h a r t e r e d banks t h a t e a r n i n g s b e f o r e income t a x e s on s a v i n g s d e p o s i t s w o u l d n o t exceed t h e c o s t of i n t e r e s t and o t h e r expenses o f t h e " a v e r a g e " bank b y more t h a n 3 / ^ 0 o f 1 p e r c e n t o f t h e amount o f such d e p o s i t s . I n t h e U n i t e d Kingdom, a s i m i l a r s o l u t i o n has been r e a c h e d b y i n f o r m a l agreement between t h e Government and t h e c h a r t e r e d banks f ]8. C f , A n n u a l R e p o r t f o r 19il-5* B o a r d o f Governors o f t h e F e d e r a l Reserve System, pp< 1 - 8 , where two s u g g e s t i o n s a r e made, one f o r l i m i t i n g h o l d i n g s o f l o n g t e r m s b y banks ( o v e r and above t h e r e s t r i c t i o n s imposed b y p r e s e n t e l i g i b i l i t y r u l e s ) and a n o t h e r f o r r e q u i r i n g a d d i t i o n a l r e s e r v e s t o be h e l d i n t h e f o r m o f s h o r t term securities* The f i r s t o f t h e two p l a n s seems more u s e f u l as a check t o t h e e x p a n s i o n c f bank s e c u r i t y h o l d i n g s b y s h i f t i n g i n t o l o n g e r m a t u r i t i e s and t h e second, as a more g e n e r a l d e v i c e t o r e s t o r e F e d e r a l Reserve c o n t r o l o v e r c r e d i t expansion o f a l l k i n d s . 1 9 . C. F . B a s t a b l e , P u b l i c F i n a n c e , 3 r d e d . , London, 1 9 0 3 , pp* 69U, 6 9 5 . 2 0 . The f a c t t h a t a s h o r t - t e r m d e b t i n v o l v e s more f r e q u e n t r e f u n d i n g o p e r a t i o n s i s a p a r t o f t h i s more g e n e r a l problem* I f investors are w i l l i n g to maintain t h e i r h o l d i n g s o f d e b t w h i c h has n ? t y e t m a t u r e d , . t h e y w i l l a l s o be w i l l i n g ( b a r r i n g s p e c i a l circumstances) t o r e f u n d t h e i r m a t u r i n g debt^ 2 1 . The t e r m " m o n e t i z a t i o n " w h i c h i s commonly used t o i n c l u d e s h i f t o f d e b t i n t o t h e p r i v a t e b a n k i n g system i s a v o i d e d a d v i s e d l y i n t h i s c o n n e c t i o n * W h i l e " m o n e t i z a t i o n " t u r n s d e b t h e l d b y t h e p u b l i c ' ( " e x c l u d i n g banks) i n t o money, i t does n o t w i p e o u t debt i n exchange f o r money, as does t h e no more i n f l a t i o n a r y p r o c e s s ( a s s u m i n g p r q p e r a c t i o n on bank r e s e r v e s ) o f p u r c h a s i n g o u t s t a n d i n g debt b y c r e a t i o n o f T r e a s u r y c u r r e n c y or F e d e r a l Reserve c r e d i t * - 35 - 2 2 . I f i t i s s h o r t t e r m , w h i l e t h e nonmarketable i s s u e s are l o n g - t e r m and b e a r i n c r e a s i n g y i e l d s towards m a t u r i t y , t h e r e would be l i t t l e c o n f l i c t between t h e two p a t t e r n s . 2 3 , C f . Henry Simons, n 0 n Debt P o l i c y " , J o u r n a l o f P o l i t i c a l Economy, December I 9 k k * 2k* The p o l i c y o f p u r c h a s i n g above par i s u n o r t h o d o x and would r e q u i r e s p e c i a l legislation. (The T h i r d L i b e r t y Bond A c t o f A p r i l k, 19*8 a u t h o r i z e d t h e Treasury t o make l i m i t e d market purchases, b u t n o t above par p l u s accrued i n t e r e s t . ) N o t e , however, t h a t t h e purchase o f market i s s u e s above par and t h e i r r e f u n d i n g i n new i s s u e s o f e q u a l l e n g t h t o c a l l date would n o t r e s u l t i n i n creased i n t e r e s t c o s t s ( e x c e p t t o t h e e x t e n t cthat such i n c r e a s e r e p r e s e n t e d a r a t e d i f f e r e n t i a l between m a r k e t a b l e and nonmarketable i s s u e s ) , b u t m e r e l y i n some i n c r e a s e i n t h e t o t a l o f o u t s t a n d i n g d e b t . 2 5 . See, f o r i n s t a n c e , t h e essay by H . C. W a l l i c h , P u b l i c Debt and Income Plow, Postwar Economic S t u d i e s , No. 3* Board o f Governors o f t h e F e d e r a l Reserve System, 19^5* in 2 6 . The e s t i m a t e s are based on t h e d i s t r i b u t i o n o f debt h o l d i n g s f o r December 19U6. I n a l l o c a t i n g t h e debt h e l d by i n d i v i d u a l s between f a m i l i e s w i t h incomes over and below 1 5 , 0 0 0 , i t i s e s t i m a t e d t h a t 30 b i l l i o n d o l l a r s , o u t o f a t o t a l o f 63 b i l l i o n , i s h e l d by the l o w e r g r o u p . I t i s assumed t h a t o n l y S e r i e s E bonds are h e l d b y t h e lower group and t h e d i s t r i b u t i o n o f E bond h o l d i n g s i s e s t i m a t e d on the b a s i s o f r e s u l t s f r o m t h e F e d e r a l Reserve - B . A . E . L i q u i d Asset Survey. T o t a l i n t e r e s t payments o f 1+.2 b i l l i o n ( i n c l u d i n g accrued i n t e r e s t ) t o p r i v a t e h o l d e r s are t h e n a l l o c a t e d by e s t i m a t i n g i n t e r e s t r e c e i v e d f o r each c a t e g o r y of i n v e s t o r s by i s s u e s h e l d and y i e l d s t h e r e o n * I n t e r e s t on savings bonds i s computed a t t h e r a t e o f c o r r e s p o n d i n g t o t h e average m a t u r i t y o f i s s u e s o u t s t a n d i n g , so t h a t t h i s r a t e w i l l i n c r e a s e over t i m e . I n i m p u t i n g t o the under $5*000 g r o u p , i n t e r e s t p a i d t o o t h e r t h a n i n d i v i d u a l i n v e s t o r s , i t i s assumed t h a t t h e y r e c e i v e no share i n i n t e r e s t p a i d t o commercial b a n k s . The a l l o c a t i o n o f i n t e r e s t r e c e i v e d by savings banks and i n s u r a n c e companies i s e s t i m a t e d on t h e b a s i s o f i n f o r m a t i o n r e g a r d i n g t h e s i z e d i s t r i b u t i o n o f accounts and p o l i c i e s . 2 7 . W i t h r e s p e c t t o p u b l i c i n t e r e s t payments a l o n e , t h e magnitudes i n v o l v e d are n o t l i k e l y t o be v e r y s i g n i f i c a n t . U s i n g such s k e t c h y evidence as i s a v a i l a b l e , i t may be e s t i m a t e d r o u g h l y t h a t t h e n e t i n c r e a s e i n s a v i n g s ( o u t o f a g i v e n t o t a l income) w h i c h c u r r e n t l y r e s u l t s f r o m t a x f i n a n c e d i n t e r e s t payments o f 5 b i l l i o n d o l l a r s , amounts t o about 1 . 5 b i l l i o n . On t h i s b a s i s , a f l a t 50 per c e n t i n c r e a s e i n r a t e s would reduce consumpt i o n ( o u t o f a g i v e n t o t a l income) i n i t i a l l y by about 750 m i l l i o n d o l l a r s , w i t h a l a r g e r d e c l i n e a f t e r secondary e f f e c t s are a l l o w e d f o r . (These e s t i m a t e s are based on t h o s e b y H. C. W a l l i c h , i n h i s above-mentioned s t u d y . ) I f we a l l o w f o r t h e r e s u l t i n g i n c r e a s e i n i n t e r e s t t h r o u g h o u t t h e economy, an i n c r e a s e o f p r i v a t e i n t e r e s t i n t h e magnitude o f perhaps as much as 10 b i l l i o n ( i n c l u d i n g t h e i n t e r e s t components o f p r o f i t s ) m i g h t e v e n t u a l l y have t o be added t o t h e 2 . 5 b i l l i o n i n c r e a s e i n p u b l i c i n t e r e s t payments. As t h e i n c r e a s e i n p r i v a t e i n t e r e s t payments w i l l be l a r g e l y f i n a n c e d o u t o f a " s a l e s t a x " ( i . e . , h i g h e r p r i c e s ) w h i c h w i l l be r e f l e c t e d i n s u b s t a n t i a l p a r t i n reduced consumption, - 36 - w h i l e i n c r e a s e d i n t e r e s t r e c e i p t s w i l l be r e f l e c t e d i n h i g h e r s a v i n g s , t h e n e t e f f e c t w i l l be a s u b s t a n t i a l s h i f t i n t h e d i r e c t i o n s a v i n g * However, i t must a g a i n be n o t e d t h a t t h e s e e f f e c t s w i l l work themselves o u t o n l y o v e r a s u b s t a n t i a l p e r i o d o f t i m e as o u t s t a n d i n g f i x e d i n t e r e s t o b l i g a t i o n s mature and are r e f u n d e d a t t h e new r a t e . 2 8 . This i s o f i m p o r t a n c e p a r t i c u l a r l y i n a f u l l employment economy where t h e l o n g run t r e n d f o r p r i c e s p o i n t s t o a slow i n c r e a s e , r a t h e r t h a n d e c l i n e . See t h e p r o p o s a l b y G, L * Bach and R, A , Musgrave, American Economic Review, V o l , XXXI, 1 1 Deo, 1 9 U l , p . 8 2 3 . 2 9 . These a l t e r n a t i v e s were suggested t o me by P r o f e s s o r John H* W i l l i a m s , 30. See a,bove p p . 18 and 19* 31. The v e r y concept of bank c a p i t a l i t s e l f i n v o l v e s d i f f i c u l t i e s a c c o r d i n g t o t r a d i t i o n a l t h i n k i n g t h e f u n c t i o n o f bank c a p i t a l , as d i s t i n c t f r o m c a p i t a l i n most o t h e r e n t e r p r i s e s , i s n o t t o f u r n i s h funds f o r t h e purchase o f c a p i t a l goods o r f o r o p e r a t i n g needs, b u t t o p r o v i d e some r e s e r v e f u n d f o r t h e p r o t e c t i o n of the d e p o s i t o r s claims. The amount o f c a p i t a l needed, a c c o r d i n g l y , must be r e l a t e d t o t h e c o m p o s i t i o n o f bank a s s e t s , W i t h a l a r g e volume o f Government s e c u r i t y h o l d i n g s , t h e concept o f a c a p i t a l t o r i s k a s s e t r a t i o i s more m e a n i n g f u l t h a n t h a t o f a c a p i t a l t o t o t a l asset r a t i o * A
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