View original document

The full text on this page is automatically extracted from the file linked above and may contain errors and inconsistencies.

Federal Reserve Bank of Philadelphia




Review

The Metropolitan Money Gap

About This Issue
The urban crisis now facing Americans has many facets—
jobs, transportation, welfare assistance, education, air and
water pollution, recreational facilities, housing of the poor,
fire and police protection . . . and the list goes on. While
many cities and other local governments are attempting to
meet soaring demands for improved public services, difficult
problems arise in financing these services and the facilities
they require.
This issue of the Business Review is devoted to three articles
dealing with two fundamental problems of municipal finance:
borrowing during periods of tight money and urban-subur­
ban distribution of financial burdens in the Philadelphia
area. We hope that these studies may be of value to private
citizens as well as to policymakers concerned with municipal
finance.

BUSINESS REVIEW is p ro d u c e d in th e D e p a r tm e n t o f R e s e a rc h . E van B. A ld e rfe r is E d ito r ia l C o n s u lta n t;
D o n a ld R. H u lm e s p re p a re d th e la y o u t a n d a rtw o r k . T h e a u th o r s w ill be g la d to re c e iv e c o m m e n ts on th e ir a r tic le s .
R e q u e s ts fo r a d d itio n a l c o p ie s s h o u ld b e a d d re s s e d to P u b lic In fo r m a tio n , F e d e ra l R e s e rv e B a n k o f P h ila d e lp h ia , P h ila d e lp h ia ,
P e n n s y lv a n ia 1 9 1 0 1 .




The Municipal Bond
Market and Tight Money
by William F. Staats
Because it is now necessary to use monetary

state and local government bonds would fare

policy to dampen inflationary pressures in our

during a prolonged period of restrictive mone­

economy, tight money is here again. Although

tary policy. We have some new data (see box)

1968 may not witness a credit crunch of the

on the 1966 experience which give clues to what

severity experienced in 1966, one question of

happens in that market during tight money.

current concern is how the secondary market for

Two major forces in the market
ABOUT THE DATA
Much of this analysis is based upon data sup­
plied by the J. J. Kenny Company, a major
municipal bond brokerage house in New York
City. We are grateful for the cooperation of Mr.
John J. Kenny and his staff. Neither Mr. Kenny
nor any member of his staff is responsible for
the interpretations or statements in this article.
The J. J. Kenny Company provided no informa­
tion regarding identity of dealers participating in
the market.
Data on individual trades for two one-month
periods in 1966 were used. The first period was
from August 15 to September 15, and the sec­
ond from December 1 to December 31. During
the first period, the municipal bond market was
in a highly demoralized state as financial pres­
sures had pushed money and capital markets
to the brink of crisis. By December, monetary
policy had eased and the market for municipals
was strong.
Of course, these data do not represent a ran­
dom sample of all municipal bond transactions
during two periods because bonds were also
sold through media other than the J. J. Kenny
Company. However, operations of the company
are so large that a reasonably good cross-section
of transactions was represented. We were unable
to secure complete data on trades involving 25
bonds or less; therefore, this segment of the
market is not sufficiently represented in our
sample.




As shown in Chart 1, yields on municipals
climbed sharply in 1966, reaching a peak in late
August and early September, and then dropped
during the remainder of the year after monetary
policy eased a bit.1 Of course, during periods of
restrictive monetary policy, market yields on all
types of debt— whether issued by corporations,
the Government, state and local governments, or
other debtors— move up. But yields on munici­
pals tend to rise faster than yields on other
types of issues largely because of the activities of
banks and bond dealers, the two major institu­
tional forces in the market.
Commercial banks. The secondary market for
state and local government bonds has come to
be dominated by commercial banks. Bankers
have begun to view municipal bonds, particularly
short-maturity issues, as a type of secondary re­
serve in which they can invest temporarily funds
not needed to meet loan demand. When loan
demand slackens, commercial banks having an
adequate supply of reserves aggressively buy
municipal bonds. But when loan demand builds
up, banks simply quit adding to their municipal1
1 “ M unicipal” is used as a synonym for state and local.

3

busin e ss re v ie w

largest holders of tax-exempt securities. In con­
trast with 1960, when they owned just over onefourth of state and local government securities
outstanding, banks now hold about 40 per cent.
More importantly, only in recent years have
many bankers begun to view municipals as a type
of secondary reserve subject to liquidation when
funds are needed for other purposes.
Some banks, after taking substantial capital
losses upon liquidation of state and local bonds
in 1966, may have avoided building up large
holdings of municipals, but evidence indicates
that the 1966 episode left most banks unshaken.
As monetary conditions eased late in 1966 and
early 1967, commercial banks returned to the
market with a large appetite for municipals and
vigorously expanded their tax-exempt portfolios.2
In recent weeks, banks apparently have again
begun to curtail purchases of tax-exempts as
monetary policy impedes growth of bank re­
serves and as demand for business loans builds.
It is too early to tell how severe pressures in the
municipal market may be, but some participants
foresee developments similar to those of two
years ago.
Bank domination of the secondary market for
state and local bonds— and the effects of such
portfolio and, in the face of tight money, may
liquidate portions of their holdings.
In contrast with 1965, when commercial banks

dominance during periods of tight money— are
not just temporary phenomena. Other market
participants will have to continue adjusting their

bought an amount of state and local bonds equal

expectations and plans to a market highly subject

to about 75 per cent of new municipal issues, in

to cyclical swings.

1966 banks absorbed an amount equal to less

Municipal bond dealers. Because bond deal­

than 33 per cent of new issues. Moreover, some

ers may be net buyers or sellers of municipals

banks did not replace maturing municipals and

at any particular time, their actions also affect

others dumped large amounts in the secondary

prices of bonds. Dealers vary the size of their

market. One or two large banks slashed their
municipal investments by as much as 35 per cent.
The influence of banks in the municipal bond
market has increased as banks have become the

4




2 For a more com plete discussion of the importance of
banks in this market, see William F . Staats, “ Com m ercial
Banks and the Municipal Bond M a r k e t Business Re­
view, Federal R eserve Bank of Philadelphia, February,
1967.

busin e ss review

inventories over time, depending on several fac­

In contrast, in December when money was

tors. Perhaps the most important is their expec­

easier, the same dealers increased their inventor­

tation of future market conditions. For example,

ies by one-third. Half of the dealers increased

if dealers expect higher prices at some specific

inventories, and two-fifths of them decreased their

time in the future, they will build up inventories

holdings.

now in order to realize capital gains. Of course

Effects on yields. Because of the way banks

other factors of an institutional and professional

change their investments and the way dealers

nature also help determine the desired level of

manage their inventories, yields on municipal

inventory.3

bonds tend to fluctuate more widely than those

The planning horizon is rather short and flex­

of other securities of comparable maturity. In

ible for most firms. Inventory decisions are sub­

times of restrictive monetary policy, yields on tax-

ject to almost constant review as market condi­

exempt securities climb faster than yields on

tions change. Inventory data secured from forty-

other types of securities, and during periods of

seven of the nation’s leading municipal bond

monetary ease they decline faster. In dollar terms,

dealers confirm statements of market participants

price movements are even more pronounced. Be­

and indicate that dealers’ investment behavior

cause municipal bonds sell at lower yields than

tends to be pro-cyclical— that is, dealers tend to

taxable bonds, percentage declines in municipal

reduce inventories when prices are falling and

bond prices would be greater than those of cor­

increase inventories when prices are rising. Such
behavior reinforces both the direction and pace
of price movements. From mid-August to midSeptember of 1966— at the height of the credit

porate or U.S. Government bonds even if the

crunch— the aggregate inventory of dealers sur­

tight money.4 Actually, the yield differential does

veyed declined by more than 10 per cent. Some

not remain unchanged during periods of tight

dealers slashed their inventories by as much as

money; rather, it tends to narrow— that is, yields

absolute yield differentials among types of secu­
rities remained unchanged during a period of

75 per cent. About half of the dealers reduced

on tax-exempt bonds move up faster than yields

them and only a little over one-fourth increased

on Governments or corporates— and widen in

inventories. One-sixth held them unchanged. Most

easy money, as shown in Chart 2.

of the larger dealers decreased their inventories.

Bond characteristics and price

3 For som e dealers the cost o f carrying municipal in­
ventory may be a determinant of inventory siz e; however,
for larger dealers the costs of holding tax-exem pt secu­
rities frequen tly may be negative because of tax factors.

Prices of municipal bonds having different char­
acteristics such as maturity, coupon rate, and

4 The follow ing illustrates price changes of a municipal bond and a corporate issue when the market yield on
each security increases and the same absolute differential betw een yields remains.

Y ield
Yield

P rice*

Percentage
change
in price

8%

$375

-6 2 .5

-$ 6 2 5

-5 0

-

Initial

N ew
P rice*

M unicipal

3%

Corporate

5

A bsolu te yield differential

2%

$1,000
1,000

10

500

A bsolute
change
in price

500

2%

* Disregarding yield to maturity.




5

b usin e ss re v ie w

other words, a bond carrying a coupon rate of 3

Chart 2
YIELD DIFFERENTIALS FOR LONG-TERM
SECURITIES— U.S. GOVERNMENTS VERSUS
MUNICIPALS DURING 1966

per cent sold, say, for $910 in August-September
while another bond, identical in all respects ex­
cept that it had a coupon rate of 3.01 per cent,

The difference between yields on long-term (10-year and long­

sold for $910.64. In December, however, prices

er) Government securities and municipal bonds decreased
sharply from April to September, 1966. As monetary condi­
tions eased after mid-September, the differential widened

of the two bonds differed by $1.56.

again.

compensate for capital gains taxes. While interest
income (coupon rate times par value) on munici­

These differentials reflect investors’ attempts to

Basi s Poi nt s

pal bonds is tax-free, realized capital gains on
them are not. For bonds selling at discounts from
par, yield consists of the two elements— interest
income and capital gains. As far as an investor
is concerned there is a substantial difference in
after-tax yield between one bond having its yield
comprised entirely of interest income (market
yield equals coupon rate)

and another bond

where capital gains provide nearly all of the yield
(market yield is greater than coupon rate).5

Maturity.

As shown in Chart 1, yields on
municipal bonds having different maturities did
n i l I i 11 t i u

l i I 1111

11 11 11 111 I l.i i

J
F M
A
M
J
J
A
S
O
Source: Federal Reserve Bulletin and The Weekly Bond Buyer.

1 1 1 i > i 11 i l l i u

N

i

O

11 i 1111 i i -

not move up equally during the summer of 1966.
For example, yields on bonds with two-year ma­

rating are affected differently by market forces
during tight money than during monetary ease.

Coupon rate. As may be expected, the dollar
price of a bond is most importantly related to
coupon rate and time to maturity. Given any
market yield, coupon rate is directly related to
price— the higher the coupon, the higher the
price. Preliminary regression analysis indicates
that the relationship between these variables may
be different in periods of tight money than dur­
ing times of monetary ease. For example, in
August-September, 1966, a one basis point (.01
per cent) difference in coupon rate was asso­
ciated with a price difference of 64^ per thousand-dollar bond; the same differential in coupon
rate during December was related to a price dif­
ference of $1.56 per thousand-dollar bond. In

6




turities jumped about 95 basis points from the
first of April to the late summer peak, while yields
on 20-year maturities climbed only 70 basis
points during the same time. And as monetary
policy eased late in 1966, yields on shorter-maturity municipals fell faster than those on longermaturity issues.
During tight money, yields on short-maturity
securities are about equal to those on bonds hav­
ing long maturities. In contrast, during monetary
ease short-maturity issues usually carry lower
5 For exam ple, the net yield after tax on a bond having
a 3.1 per cent coupon rate and sold at par is 3.1 per cent.
But the net yield after tax on a 15-year bond with a
1.5 per cent coupon and priced to yield 3.1 per cent is
fust 2.81 per cent ( assuming the maximum capital gains
rate o f 25 per cen t). Therefore, an investor would not be
willing to pay the same price for each bond but would
bid low enough on the second bond to secure the same
3.1 per cent after-tax yield available on the first bond.

b usin ess review

yields than longer-maturities. This is not unique

Changing demand and supply factors account

to the municipal bond market. The same phe­

for the narrowing price differential among bonds

nomenon is experienced in the corporate as well

of different ratings during tight money.0 As mone­

as in Government bond markets. Several factors

tary conditions ease, the differential widens again.

are at work. Investors expecting interest rates to

Smaller relative yield (price) swings in lower­

fall like to invest in longer-term securities to lock

rated municipals may offset quality factors, mak­

up high yields for a number of years; so they

ing these issues useful in tax-exempt portfolios

tend to put upward pressure on prices of long-

requiring the highest possible degree of price

maturity issues. Often, investors switch out of

stability over interest-rate cycles.

short-term securities when long-term rates appear
attractive compared with expected future short­

Market characteristics

term rates. By selling short-maturity issues, in­

The impact of tight money on participants in the

vestors increase the supply and help push prices

secondary market for municipal bonds is reflected

down (and yields up) on such securities. Short­
term rates are also boosted when debtors, ex­

in some of the market characteristics.
Price continuity. A good market is able to

pecting lower rates, borrow for shorter periods
so as to avoid committing themselves to high
rates too far into the future. In addition, in the
spring and summer of 1966, commercial bankers
put considerable pressure on the short end of the
maturity spectrum by liquidating huge volumes
of low-coupon issues having from one to five
years to maturity.
As shown in Chart 3, over 38 per cent of the
bonds included in our data and traded in AugustSeptember were in the shortest-maturity category.
This compares with only 14 per cent of those
traded in December. In contrast, nearly 53 per
cent of the municipals sold in the secondary
market in December, but only 28 per cent of
those in August-September, had maturities of 15
years or more.

Rating.

Our data also show that investors

shift their preferences for bonds of a given rat­
ing during periods of tight money. For example,
an AA-rated bond commanded a price of about
$13 more than an A-rated security during the
peak of the credit crunch. However, the same dif­
ference in rating was associated with a $25 price
differential in December.




0
There are two reasons for the narrowing differential
during tight m oney. The first— a segm ented market view
— is that the effect o f investm ent behavior of banks is
concentrated in high-grade bonds. W hen, for example,
banks liquidate municipals in tight m oney, usually
higher-rated issues are dum ped. Therefore the supply of
high-grade municipals in the market increases more than
the supply o f lower-rated issu es; so, the prices o f the
form er drop relatively further than those of the latter.
The second reason, based upon a risk-premium con­
cept, suggests that investors are m ore eager to buy lower­
rated municipals during tight m on ey because o f interestrate considerations. Y ield consists o f two pa rts: the pure
cost o f m oney and the risk prem ium . (S ee Harry Sauvain, Investment Management, second edition, PrenticeHall, Inc., 1959, p. 115.) F or high-grade issues, nearly all
o f the yield represents the pure cost of m oney. But for
lower-quality bonds risk factors account for a large pro­
portion o f total yield. The risk prem ium remains prac­
tically unchanged regardless o f monetary conditions.
Increased interest rates during tight m oney will cause a
relatively greater increase in those yields where the pure
cost o f m oney is the larger proportion o f total yield.
For exam ple, assume the pure cost o f m oney ( the pre­
vailing interest rate on a p erfectly riskless security) is
4 per cent, and that a high-grade municipal yields 4.50
per cent and a lower-grade issue yields 6 per cent. The
risk prem ium , then, is .50 per cent and 2 per cent, respec­
tively. If, because o f a restrictive monetary policy, the
pure cost o f m oney rises to 5 per cent the high-grade
bond would yield 5.50 per cent and the lower-rated one
would carry a 7 per cent yield (assuming, o f course, no
change in the risk prem iu m ). Thus, the yield on the
high-grade security increased 22 per cent and that on the
lower-grade bond rose only 17 per cent. E xp ressed in
terms of prices, the price o f higher-rated municipals
would drop relatively further than those o f lower-grade
bonds, so that the differential betw een the two prices
would narrow.

7

busin e ss rev iew

adjust readily to disturbances in the normal

of lower quality, so dealers expected to chalk up

supply-demand relationship so that there is little

large profits when interest rates declined.

change in price from one trade to the next in a

By December 1966, however, dealers had be­

given security. Evidence indicates that during

come more venturesome in the wake of a less

periods of a restrictive monetary policy, price

restrictive monetary policy. They were willing to

continuity in the tax-exempt bond market may be

bid more frequently on lower-quality issues and

disrupted. During August-September of 1966 the

on larger blocks of bonds. In December, larger
block sizes attracted larger numbers of bids; and

difference in prices of two consecutive trades in
the same bond averaged about 1.6 times the
December average.

Number

of

bids.

bonds with lower ratings and coupon rates re­
ceived more bids than did high-quality, high-

banks

coupon issues. Moreover, by December, dealers’

dumped huge volumes of municipals on the sec­

proclivity to hid more frequently on bonds hav­
ing short maturities had apparently disappeared.

As

commercial

ondary market in late summer of 1966, market
conditions deteriorated and many dealers essenti­

Increased bidding on lower coupon issues as

ally stopped making markets in tax-exempt bonds.
Some dealers were wary of even entering bids

monetary conditions ease reflects increased in­

for fear of acquiring bonds whose value was de­

ital gains factors mentioned earlier. As market

vestor interest in these issues stemming from cap­

preciating hourly. The extent of dealer chariness

yields fall, prices rise faster the deeper the dis­

is revealed in the average number of bids sub­

count from par value.7 Perhaps as more specu­

mitted on each block of municipals offered for

lators discover opportunities for capital gains in

sale. During August-September, the average num­

price swings of municipals, discount bond prices

ber of bids per transaction amounted to only

will become less depresssed during tight money.
Bid spreads. The uncertainty which haunts

four-fifths of the December average.
In August-September, the number of bids
seemed to be significantly related to the maturity
and rating of bonds being offered. The longer the
time to maturity, the smaller the number of bids.
Also, higher-quality bonds attracted more bids
than did lower-rated obligations. The number of
bonds offered in each transaction had no rela­
tionship to number of bids.

1
For example, assume there are two bonds both with
15-year maturities. O ne o f the issues carries a 2 per cent
coupon and the other a 3.5 per cent coupon. In order to
achieve an after-capital-gains tax yield o f 4.25 per cent,
the first bond must be priced at a 4.675 per cent yield
basis (or $713.90 per thousand-dollar bond) and the sec­
ond at a 4.375 per cent basis (or $ 9 0 9 .6 0 ), as shown in
the table. If market yields fall to, say, 3 .60 per cent, the
price o f the deeper discount issue w ould jum p 10.07 per
cent and the other bond’s price would increase ju st 8.52
per cent.
2 per cent
coupon

3 .75 p er cent
coupon

To yield a net
4.25 per cent,
price must b e :

4 .675 per cent
basis before
capital gains
or
$713.90

4 .375 per cent
basis before
capital gains
or
$909.60

To yield a net
3.60 per cent,
price must b e :

3.90 per cent
basis before
capital gains
or
$785.80

3.6125 per cent
basis before
capital gains
or
$987.10

10.07

8.52

Perhaps the relationship among number of
bids, rating, and maturity in this period can he
explained by the high degree of uncertainty which
prevailed during late summer of 1966. Dealers
who got up enough nerve to enter bids concentra­
ted on high-quality issues with short maturities
because of the greater potential for profit on these
bonds. As indicated earlier, prices of higherquality bonds fluctuate more widely than those

8




Percentage
change in p rice:

b usin e ss rev iew

Chart 3
MATURITY DISTRIBUTION OF BONDS TRADED
During the period of tight money, municipals having short
maturities dominated trading; but in December, under easier
m onetary conditions, longer-term municipals were pre­
dominant.
Years to M aturity

tax-exempt market. Because of bank behavior,
pressures were intensified; dealers became de­
moralized as each summer day two years ago
brought a new wave of municipals offered for
sale by banks. So, the 1966 tight money experi­
ence was different from those which preceded it.
But what about the future?

Having been

through the experience once, market participants
know better what to expect when tight-money
pressures again grip the municipal market.
Banks remain dominant in the market, and they
may again dump huge volumes of municipals
during a prolonged period of tight money. But
the disruptive impact of heavy bank liquidation
Per Cent o f Total

the municipal market during tight money causes
increased bid spreads (dollar difference between
the highest and lowest bids). For example, in
late summer of 1966 the average spread was
$27.74 but in December it had eased to $26.01.
Moreover, December bids were more concentra­
ted around the average than those in AugustSeptember.8 During the tight-money period, one
or two dealers frequently entered very low bids,
either bidding to lose or perhaps hoping to snare
real bargains in the depressed market.

of tax-exempt bonds could be ameliorated if other
investors were waiting in the wings to buy muni­
cipals when banks unload. Recent reports of ris­
ing “ odd lot” or individual investor interest in
municipals are encouraging. Certainly, the lofty
yields currently available on tax-exempt issues
should whet the appetite of individuals who have
never bought municipals before. At least some
dealers have decided to invest greater resources
in attempts to sell municipals to individuals.
Speculative investors in municipals may be­
come a more stabilizing force in the tax-exempt
market. Demand and supply factors for different

Implications for 1968 and the future

types of municipals shift from tight money to

The secondary market for state and local govern­

ease. And as these shifts become apparent, specu­

ment bonds, along with other financial markets,

lators may be more willing to take advantage of

was under stress during the late summer of 1966.

opportunities as they arise. For example, as more

Investors, dealers, brokers, issuers, and monetary

speculators discover the wide price fluctuations

authorities will long remember their experience.

of state and local government issues, they may be

Tight money was not invented in 1966. Financial

more willing to invest in a depresed market, thus

markets, including the municipal market, had ex­

moderating the range of price swings. Or, as they

perienced restrictive monetary policy before. But

understand the changing price gaps among muni­

what made the 1966 episode unique was the in­

cipals of different ratings, they may find potential

creased importance of commercial banks in the

profit opportunities. More speculative interest in
the municipal market could help to make it a

8 The standard deviation was $27.89 for A ugust-Septem ber and $22.58 in D ecem ber.




stronger market during tight money.

9

b usin e ss re v ie w

Monetary authorities, too, have learned from

Investors, dealers, speculators, issuers, and

the 1966 episode. Clearly, the link between the

monetary authorities affect conditions in the

banking system and the market for tax-exempt

municipal market. As they have learned in 1966

bonds is stronger than ever before. And, as banks

what to expect during tight money, they may

use the municipal market for a significant portion

discover opportunities to benefit themselves and

of their asset adjustments the Federal Reserve

at the same time moderate the impact of tight

System will maintain a keen interest in the sec­

money on the secondary market for state and

ondary tax-exempt market.

local government bonds.

A survey of larger state and local governments shows that most governments in the Third
Federal Reserve District were able to borrow about as much as they planned in 1966, and
that their capital spending barely felt the impact of tight money at all.

Municipal Borrowing
Experience in 1966
by Susan R. Robinson
It is widely thought among financial analysts that

hibit sale of new debt, curtailed borrowing is

state and local governments bear much of the

significant only in that spending is influenced as

burden of monetary restraint principally because

a result.

commercial banks, the major institutional in­
vestors in municipal securities, shift funds away

What happened in 1966?

from municipals and into business loans to ac­

Financing plans of large governments in the

commodate

when

Third District were not heavily affected by mone­

money becomes tight. Also, borrowing by local

tary policy in 1966. Fifty-four per cent of the

governments may be constrained when interest

56 governments surveyed in the Third District

rates rise above legal limits

had no plans to raise long-term funds during the

their

corporate

customers

often

imposed

by various states, city charters, or bond refer­

year, so that conditions in the capital market pre­

enda. For these reasons, some economists believe

sumably were irrelevant to their spending plans.

that municipalities may be unable to sell as many

Of the 22 entities which did borrow, only four

bonds as they want, and consequently are unable

decided to postpone a 1966 bond offering tempo­

to spend as much as planned. The real effective­

rarily (until a later date within 1966) or to accept

ness of monetary policy is reflected in spending.

a financing operation smaller than originally

Although a restrictive monetary policy may in­

planned, and five governments said they aban­

10




b usin e ss re v ie w

doned a bond issue or postponed borrowing be­

on equipment or on projects for which contracts

yond 1966. Of these nine, two cited factors other

had already been awarded.1 Only four large gov­

than credit conditions as the main reason for

ernments in the country had such a curtailment.

not borrowing as planned. Thus only seven— or

One government in the District plus 17 elsewhere

14 per cent of all governments, and 32 per cent

in the United States indicated that borrowing

of borrowing governments— changed their plans

difficulties in 1966 caused postponement or can­

because of high interest rates and market condi­

cellation of contract awards during the first part

tions.

of 1967. This illustrates problems caused by lags

In dollar terms the problem of municipalities

in monetary policy— some of the impact of re­

and therefore the effectiveness of monetary re­

straint was felt after the need for restrictiveness

straint appears somewhat greater. The Third Dis­

was past.

trict accounted for almost 10 per cent ($607
million) of the dollar volume of municipal bond
offerings in the United States in 1966. However,
bond offerings totaling $319,606,000 were aban­
doned or postponed into 1967 in the District.
This represents almost one-fourth of all aban­
donments and long postponements in the United
States, and is the highest of all Federal Reserve
Districts. A large issue abandoned by a turnpike
authority accounted for the District’s lopsided
share of the total. Reductions in offerings in the
District totaled $1,107,000, or nearly one-tenth
of all reductions, and shorter postponements
equal to $13,428,000 were only 3.6 per cent of
the United States total.
To be effective, monetary restraint must slow
the rate of increase in expenditures. How did
tight money affect capital spending? Of the units
which reduced, postponed or abandoned bond
financing, only two reported that new contract
awards were postponed or cancelled as a result.
Total awards in the District were only $3.4
million less than planned. For the United States
as a whole, actual awards fell short of planned
awards by $120 million. The volume of construc­
tion awards postponed or cancelled seems rather
small when compared with the total general ex­
penditures during fiscal 1966. No Third District
government reported lower spending during 1966




How did governments adjust?
One reason why contract awards and capital
outlays were less affected than borrowing is that
pressing needs do not necessarily coincide with
availability of funds. Municipal authorities find
that some outlays cannot be delayed if there is
any possible way of financing them.
Higher interest rates and scarcity of funds
had a greater impact on the ability of large gov­
ernments to borrow than on their ability to spend.
The six governmental entities in the District
which did not borrow as planned in 1966 but did
not cancel construction contract awards relied on
a variety of adjustments. The most important
1 Our evidence seem s to indicate that the tight m oney
did not significantly affect capital spending b y large
governm ents in our District, but it requires a qualifica­
tion. The questionnaire asked about cancellation and
postponem ent o f those issues which municipalities had
“ contem plated” making— meaning issues which were
under serious consideration. H ow ever, because of the
difficulty o f obtaining reliable data, w e have no informa­
tion about projects— and bond offerings to finance them
— which m ay have been in the early planning or formula­
tion stage and were dropped because o f anticipatory
credit conditions. A lso , comparisons o f spending and
borrowing in 1966 with that o f earlier and later years,
either planned or actual was beyond the scope o f the
questionnaire. Thus, possible variations in the rate of
growth of expenditures have not been considered. Finally,
the questionnaire was not able to focus on the problem of
curtailed capital spending excep t in relation to borrow­
ing. That is, only governm ents which experienced some
difficulty in borrowing answered questions about spend­
ing plans.

11

b usin e ss re v ie w

were postponement of cash disbursements, re­

townships. The average population for all non­

duction of current expenditures, short-term bor­

borrowing units was 174,830, while for all po­

rowing, and use of cash and liquid assets. For

tential borrowers it was 267,604.

the U.S. as a whole, many governments used long­

Some entities such as special local districts

term funds which had been borrowed in advance

were included in the survey on the basis of

and kept as a buffer. Several of these measures

bonded debt because population was inapplic­

show a decrease in the level of total spending as

able. The same relationship is true here— potential

a result of tight money. And, since these alterna­
tive sources are all temporary in nature, the evi­

borrowing units had more bonded debt than
those which didn’t borrow— $218.7 million as

dence suggests that, had the period of monetary

opposed to $64.6 million.2

restraint been prolonged, there would have been

Therefore, if population and debt are used as

a more appreciable decrease in outlays from de­

indicators of size, the smaller of the “ large” units

sired levels. On the other hand, if we assume

did not come to the market place in 1966. It is

governmental entities have some level of desired

possible that smaller governments

liquidity, they would have had to replace liquidity
later. In this way the impact of tight money would

couraged because of expectations of tight money

be transferred into later periods.

of the large governments didn’t plan to borrow

were dis­

conditions, although it is likely that the smallest
for reasons unrelated to conditions in the finan­

What were the characteristics
of governments involved?
There is no way to tell on the basis of our infor­

cial market.
The survey also sheds some light on what sort
of governments had difficulty arranging bond

mation why thirty of the large governments in the

financing during tight money. Those which re­

District had no plans to borrow at all during

ported postponement, reduction, or cancellation

calendar 1966. Presumably, the decision not to

of bond offerings had a slightly and, perhaps, in­

make capital expenditures financed by bonds was

significantly lower average rating than those

made before 1966, prior to the period of mone­

which

tary stringency, and was not influenced by mone­

(where 3.00 = A A and 2.00 = A ) . Although not

tary policy. We can, however, make a few com­

all smaller governments had difficulties, the eight

parisons between governments without plans to

governments (with the exception of two state

borrow and those which had plans. For example,

authorities) which experienced some difficulty

the average M oody’s rating for potential bor­

in financing were generally smaller than average

rowers and those without borrowing plans were

in population or debt.

borrowed

successfully— 2.13

vs.

2.54

virtually identical, midway between AA and A
(with a number of cities being unrated).
The survey results show that cities and town­
ships which had no borrowing plans in 1966 were
smaller in population on the average than those

How costly was borrowing in 1966?
One major concern of municipal managers is
the net interest cost of borrowed funds. Borrow­
ing governments did “ pay” extra to borrow in

which borrowed (or tried to do s o ). The reverse
was true for counties, although most of the
counties had higher population than cities and

12




2
To som e extent, this divergence may represent a d if­
ference in policies toward borrowing rather than a d if­
ference in size of the borrowing unit.

busin e ss re v ie w

1966, as net interest costs were higher than in

Social consequences

previous years. Costs reflect the general move­

If monetary stringency results in spending cut­

ment of rates during 1966, especially the major

backs by state and local governments, the question

municipal bond yield indices. Two-thirds of the

of social consequences should also be considered.

borrowing by large Third District governments

To what extent must public services, as provided

( including one of two issues which had been

by municipalities, be sacrificed in order to

postponed earlier in the year) took place in the

achieve the goal of economic stability, the advan­

second and third quarters when interest rates
were highest. For the U.S. as a whole, however,

tages of which are felt more indirectly? Because
monetary policy may have an uneven impact,

borrowing was evenly spread throughout the

does the municipal sector suffer more through

year. This points up the difficulty which munici­

curtailed expenditures and higher interest costs

pal authorities have in timing their bond offerings

than do others during tight money? And, if so, is

to take advantage of more favorable capital mar­

this an unnecessary social cost of monetary policy

ket conditions. Inclination of municipalities to

and economic stability? These questions obvious­

pay more interest in order to borrow during

ly cannot be answered simply on the basis of the

periods of tight money rather than postpone ex­

survey, but the results suggest that the social costs

penditures serves to blunt some of the effects of

of tight money— at least in the Third Federal

a restrictive monetary policy.

Reserve District— in 1966 were small.

SURVEY
This analysis is based on responses of govern­
mental units in the Third Federal Reserve District
to the Federal Reserve Survey of State and Local

Government Financing and Capital Outlays in
Calendar 1966. The survey dealt with plans for
bond issues in 1966, the experience with long­
term financing during that year, and the effects
of this experience on capital spending. The sur­
vey sample included only state governments;
larger counties, cities, and townships as deter­
mined by population data; and special local
districts, state agencies and educational insti­
tutions which were designated “ large” on the
basis of their outstanding debt or other criteria.
(A survey of smaller entities is currently in
process.) The minimum size limitations by type
of entity were:
County ............... 250,000 population
City ..................... 50,000 population




Township .......... 50,000 population
Special local
district .......... $5 million debt outstanding
Local school
district ........... 25,000 enrollees
States .................All
State agencies
and state and
local institutions
of higher
learning ........ All except very small
The response rate in the Third District was
better than 90 per cent, as 53 local governments
and the state governments of Pennsylvania, New
Jersey, and Delaware answered the question­
naire. The U.S. total includes replies from 983
governmental units. These results are analyzed
in the June 1968 issue of the Federal Reserve

Bulletin.

13

The Metropolitan
Money Gap
by Richard W . Epps
In the late forties when suburbia was gaining its
current size, cities, often, were better off finan­

region’s low-income population, providing them
with needed public services like education, and

cially than the suburbs. Fortunes have turned in

health and police protection. Nearly one-fifth of

the past 20 years. Suburbia has matured, filled

Philadelphia’s families fell below the $3,000
poverty line at the time of the last Census, while

out its stock of public facilities, and begun to en­
joy the benefits of a high-income population. Left

only one-tenth of suburban families were in the

with a largely low-income population and aging

low-income classification. Traditionally, responsi­

physical plant, central cities have incurred in­

bility for paying for services to the low-income

creased costs while resources have relatively

population has been with the middle- and high-

dwindled. The result is an expenditure differential
— city expenditures are relatively higher than

suburban residents have escaped, in part, this

suburban— and a consequent heavy load on the

social responsibility by moving to the suburbs

resources of city dwellers.

where they do not share in the heavy city govern­
ment tax bills.

Some observers suggest that suburban resi­

income population. Many observers argue that

dents should share part of the city’s burden, and

How appropriate are these arguments to the

for two reasons.1 First, suburban residents de­

Philadelphia area? This article reports on ex­

pend, in part, upon the city for jobs. And since

penditures by local governments in the Phila­

both employers and suburban commuters require

delphia area and the distribution of the public bill

government services, these jobs for suburbanites

among the region’s residents. Summarized, the

cost the city money. In the Philadelphia area,
nearly one out of three suburban workers com­

findings are:

mutes to the city for employment.1 Since subur­
2

1. In 1965, the City of Philadelphia spent 12
per cent more than did the governments of sur­

ban residents benefit from these jobs, some

rounding suburban areas.3 This differential was

observers say suburban residents should help

less than that in the nation’s other large metro­

pay the public bill which results.

politan areas.

Second, and more important in the estimation

2. The two expenditure bundles that make up

of some, the city houses a large share of the

total government spending— education and gen­
eral government— have strongly contrasting pat­

1 Interdependence betw een city and suburbs was dis­
cussed in the D ecem b er 1967 edition o f this R eview in
an article entitled “Foundation o f Interdependence .”
2 The analysis in this article concerns the eight-county
Philadelphia M etropolitan A rea with Philadelphia as the
central city and Bucks, Chester, Delaware and M o n t­
gom ery counties in Pennsylvania and Burlington, Cam­
den and G loucester counties in N e w Jersey as suburbs.

14




terns. The City of Philadelphia spends only
two-thirds as much per capita as suburban gov­
ernments on public education whereas the city
3
G overnm ent, as used in this article, includes county,
municipal and school district governm ents.

b usin e ss review

spends twice as much as suburban governments
for general government purposes (such things

4.

However, state and federal aid, taxes paid

by commuters, and taxes paid by business all

act to reduce the tax bill of non-business residents
Three factors are particularly important in of the City of Philadelphia, leaving it in 1965

as fire protection and police protection).
3.

determining the differential in spending for gen­

slightly lower than the tax bill of suburban resi­

eral government purposes: the concentration of

dents. The suburbs, in effect, are carrying a part

business and industry, relative size of the low-

of the city’s financial burden.

income population, and relative size of the highincome population, in descending order of im­
portance. Combined, the three may account for
more than half of the spending differential, and
in large part support the two arguments posed
above.

Government spending
Spending by the city and the suburbs in the
Philadelphia area is compared with that by gov­
ernments in the nation’s 36 other largest metro­
politan areas in Chart l .4 In total, Philadelphia
government spends more per capita than subur­

LIMITATIONS OF THE STATISTICS
The Philadelphia Metropolitan Area, the subject
of this article, includes more than 800 units of
local government in its eight counties. In each
of the counties the menu of public services is
divided up somewhat differently among the
levels of government although the total menu is
much the same from county to county. For
example, in Chester County essentially all road
maintenance is carried out by municipal govern­
ments, but in Delaware County a large share of
road maintenance is carried out by the county
government. Thus, to compare counties, we
must use total figures for all the governmental
units within each county. Use of these totals
has a drawback. They probably are not repre­
sentative of any one of the multiple local gov­
ernments. Thus, the conclusions of this article
cannot be applied arbitrarily to any single local
government— only to the total.
The statistics have a second limitation. Serv­
ices provided by government in one area may
be provided privately in another area. For ex­
ample, the City of Philadelphia pays for most
refuse collection, but suburban communities
often rely heavily upon contractural agreements
between haulers and residents.
While the service is provided in both areas
and residents of both areas pay for the service,
it shows up in the public budget in only one
area. The extent of such substitution of private
for public spending cannot be consistently de­
termined, but is probably greater in the suburbs.




ban government— by about 12 per cent. However,
the spending differential is not as severe as that in
most of the nation’s other large metropolitan
areas.
The total hides two differing patterns in Phila­
delphia, however. For general government, the
city spends substantially more per capita than
the suburbs, and this local differential is about
in line with the differential in other areas (second
set of bars in Chart 1 ). For education, on the
other hand, the city-suburbs differential in Phila­
delphia is both substantial, and substantially
worse than that in other areas (third set of bars
in Chart 1).

Buying education.

Although suburban gov­

ernments spend relatively more on public edu­
cation than does Philadelphia, spending levels*
* The thirty-six areas includ e: Los A n geles-L on g Beach,
San Bernardino-Riverside-Ontario, San D iego, San Fran­
cisco-Oakland, D enver, W ashington, D .C ., M iam i, TampaSt. P etersburg, Atlanta, Chicago, Indianapolis, Louisville
( Kentucky-Indiana), N e w Orleans, Baltim ore, Boston,
Detroit, M inneapolis-St. Paul, Kansas C ity (M issouriKan sas), St. Louis ( M issou ri-Illinois), Newark, PatersonClifton-Passaic, Buffalo, N e w York C ity, R ochester, Cin­
cinnati ( O hio-K en tu cky-lndiana), Cleveland, Columbus,
Dayton, Portland ( O rego n -W a sh in gto n )P ittsb u rgh , Prov­
idence, Dallas, H ouston, San A ntonio, Seattle, M ilw au­
kee.

15

b usin ess re v ie w

are not uniform in the suburbs (Chart 2) .5 Bucks

police

County residents spend most for public education

street and highway maintenance, parks, recrea­

protection,

sanitation,

health

services,

— $125 per capita. Delaware County comes in last

tion, and urban renewal). These are government

among the suburbs with $85 per capita; Philadel­

services provided to residents, businesses, com­

phia is below all the suburban counties with $75

muters and transients.

per capita.
What do these spending differences mean?
Spending for education on a per capita basis
gives an indication of the relative financial load
upon the community. To get an idea of the mean­
ing of spending for educational quality, we turn
to spending on a per student basis. Expenditures

Chart 1
PHILADELPHIA’S SPENDING DIFFERENTIAL
IS LESS THAN THAT OF OTHER
LARGE METROPOLITAN AREAS
Indexes of per capita spending by city and suburban govern­
ments are presented in the bars below for the Philadelphia

of the New Jersey counties. The reason for this

region and for the nation’s 3 6 other largest metropolitan
areas. On total government spending, Philadelphia’s citysuburban differential is less than the metropolitan area aver­
age. However, the two components of total spending— educa­
tion and general government— both display larger contrasts
in the Philadelphia area than in the metropolitan average.

improved appearance for Philadelphia is that the

P e rc e n t (Central CityUOO)

in the City of Philadelphia appear decidedly
higher on a per student basis— only slightly be­
low the suburban average— and higher than some

PER CAPITA TOTAL EXPENDITURES, 1964 1965

city has relatively fewer public school students
than do the suburbs, in part because the city
population is the most elderly of the region’s
counties and in part because the city’s non-public
school population is large relative to that in
suburban areas.
Still, Philadelphia does rank below the subur­

City

Suburbs

City

Suburbs

PER CAPITA PUBLIC EDUCATION EXPENDITURES
P erCent (Central C ity: 100)

ban average. This is an example of the spread
between needs and expenditures. With many of
the city’s students coming from poverty back­
grounds, the city’s educational needs are likely
greater than those of the suburbs.

General government expenditures. In

con­
trast to education, Philadelphia spends consider­
ably more for general government purposes than
do the suburbs (see Chart 3 ). General expendi­
tures include all of the noneducational functions

City

Suburbs

City

Suburbs

PER CAPITA GENERAL GOVERNMENT EXPENDITURES, 19641965
Per Cent (Central City-100)

of local government, except water (e.g., fire and
5 M o n e y spent for public education is, of course, only
part o f the total education bill. To compare total educa­
tion spending, expenditures for private education must
be added to the public spending. Such a comparison
would still leave a large gap betw een city and suburb
because m ost private education in Philadelphia is paro­
chial, a system that depends heavily on volunteers for
its staff, thus having low per-student costs.

16



City

Suburbs
Philadelphia

Source: United States Bureau of the Census.

C ity
Suburbs
Average of 36
Largest M etropolitan Areas

busin e ss review

Why does the city spend more than the sub­

Chart 2
PHILADELPHIA SPENDS LESS THAN
THE SUBURBS ON EDUCATION

urbs? A complete explanation is difficult for two
reasons. First, the City of Philadelphia provides
some services that suburban governments often do
not provide. Fire protection is an example. Sec­
ond, Philadelphia provides some services that are
only partially provided, either publicly or pri­
vately, in the suburbs. Airports are an example.

The differential in spending for education can be viewed in
two ways— per capita (upper bars) or per student (lower
bars). The first represents the load on the community, with a
wide spread between the city and suburban values. The
second is an indication of quality of education, and makes
Philadelphia look substantially better. Still, the city lags the
suburbs.

Still, three factors may be singled out as impor­
Dollars

PER CAPITA CURRENT EXPENDITURES, 1964-65

tant in causing the differential.0
Among them are two often mentioned as rea­
sons for the suburbs to share part of the city’s
burden.
1. Business generally requires more public
services than do residents. Thus, the City of
Philadelphia, with its heavy concentration of

PER STUDENT CURRENT EXPENDITURES, 1964-65
Dollars

business and industry, spends relatively more
than the largely residential suburbs. A 1 percent
increase in business concentration, measured by
the proportion of assessed real estate in business
use, leads to between a $2 and a $5 increase in
per capita expenditure.

Source: Pennsylvania Department of Public Instruction and New Jersey Taxpayers
Association.

2. Low-income residents also increase local

a $1 to $4 increase in per capita spending with

expenditures. The rate of increase is probably

each percentage point increase in the proportion
of families with income below $4,000.

somewhat less than that with business, however—
0 The importance o f various factors was measured via
regression analysis upon a sample o f 46 Pennsylvania
municipalities. O nly Pennsylvania municipalities were
included in the sample in order to avoid problem s result­
ing from differing legal structures. The dependent vari­
able was general governm ent expenditures per capita,
and independent variables experim ented with were
median incom e, business and residential density, owner
occupancy, per cent o f assessed value in commercial use,
population in each o f 12 incom e classes, percent non­
white population, and em ploym ent. The results should
be interpreted as only indicative of the relative im por­
tance and impact o f the factors studied, since data are
for 1960 and 1962 and county expenditures were not in­
cluded in the observations. Partial correlations between
spending and families under $4,000 incom e, percent of
assessed value in commercial use, and families over
$10,000 incom e were respectively, .56, .40, and .49.
A num ber of these and other factors were investigated
in a study carried out b y Williams, Herman, Liebman
and D ye entitled Suburban Differences and Metropolitan
Policies, 1965, University o f Pennsylvania P ress, Phila­
delphia.




3. Finally, families at the other end of the

17

b usin e ss re v ie w

income scale increase the public spending bill,

Chart 4
HOW SPENDING IS SUPPORTED

though not so much as either business or lowincome population. A one percentage point in­
crease in the proportion of families with over
$10,000 income leads to a rise in public expendi­

State and Federal aid are greater in Philadelphia than in the
suburbs, relieving some of the city’s financial burden. Still,
about half of the difference in spending is supported by
higher city taxes.

tures of between 40^ and $1.20.

PER CAPITA REVENUE STRUCTURE, 1964 X965

Combined, these three factors could account

Dollars

for the majority of the differential in spending.7
Philadelphia has relatively more business and
low-income population than the suburbs, with
both tending to increase the differential. Partially
offsetting these two factors, Philadelphia has less
high-income population.

Revenues

Philadelphia
Source: United States Bureau o f the Census.

Suburban Average

How is the financial burden of supporting these
public expenditures distributed across the reg­
ion? Philadelphia raised about 12 percent, or
$35, more money per capita than did the suburbs
in 1965. Neither Philadelphia nor the suburbs,
however, collect all their revenues from their own
constituents.
Chart 4 shows the distribution of the revenue
load among three types of revenue— fees and user
charges, state and federal aid, and local taxes.
Fees and charges are mostly local revenues, col­
lected from local businesses and constituents of
each government. Their level is nearly the same
in city and suburb, thus leaving the distribution
of the revenue load unaffected.

State and federal aid is more complex. The
actual redistributional effect of the aid is the dif­
ference between the pattern of state and federal
tax collections and the pattern of aid. In fact,
state and federal taxes are not tabulated by
county, and so a comparison of tax and aid pat­
terns is not possible. All we know is that Phila­
delphia receives nearly 50 percent more aid than
do the suburbs. Just how much of this is a redis­
tribution of the revenue burden is not clear.
After state and federal aid, a $20 difference
remains between Philadelphia and suburban rev­
enues— a $20 difference in per capita taxes. The
tax-level difference is actually less than it appears

7 Due to the p ossibility o f errors in measurement, the

on the surface, however. Two factors act to de­

effect of each factor must be stated as a range. W ith the
ranges noted in the text, and using measures from the
last census, the effects o f the three factors are:

crease it. First, more than one-third of the Phila­

A m oun t of differential accounted fo r :

which is in part paid by suburban residents.

Concentration o f business
Low -incom e population
H igh-incom e population
Other factors
Total Philadelphia-Suburbs
differential

18




L ow
Estimate
$24
$10
— $ 2
$48
$80

delphia tax revenue comes from the wage tax,

High
Estimate
$60
$40
— $ 7
— $13

live in the suburbs and pay the wage tax. Thus,

$80

residents is higher. Second, the heavy industrial

Nearly one-fourth of the workers in Philadelphia
per capita local tax actually paid by Philadelphia
residents is lower, and that paid by suburban

b u sin e ss re v ie w

Chart 5
THE TAX BILL
The upper set of bars represents the per capita tax bill in
Philadelphia and the suburbs, with Philadelphia having the
heavier load. This high Philadelphia burden is substantially

The result of these two adjustments— that is,
the distribution of Philadelphia wage tax and re­
moval from each area of the tax paid by business
establishments— is dramatic. The lower set of
bars in Chart 5 represents the per capita tax bill

reduced, however, when taxes paid by business are removed,
and non-resident tax payments are redistributed. The result

on non-business residents after adjustment. The

is the tax paid directly by residents, the lower set of bars, in

load, after adjustment, is about the same in city

which the city load is slightly lower than the suburban load.
UNADJUSTED

and suburbs.

Per Capita Tax in Dollars

Disparities reconsidered
Expenditures are high in the City of Philadel­
phia, partly because of the services Philadelphia
provides to the rest of the region— jobs and
housing of the low-income population. However,
within the current revenue structure, Philadelphia
non-business residents pay no more in taxes than
do suburban residents, in part because employers
pay taxes and in part because of revenue sharing
through the wage tax.
Philadelphia
Source: United States Bureau of the Census.

What of the future? The expenditure differen­
tial will increase. Pressures within the Philadel­

and commercial development in Philadelphia

phia school system to raise the per student ex­

gives the city an added tax base.8 The tax con­
trast must be adjusted for this also, yielding for

penditure are great. Moreover, the increasing
voice and militancy of the low-income population

each area the tax actually paid by non-business

to raise the level of city services will have an im­

residents.

pact on city spending. Revenues of the city will
have to increase, probably at a higher rate than

8 The taxes paid by business offset, to some extent, the
increased public spending to which business gives rise.
W hether the offset is com plete is difficult to determine
since m easurement o f the added public costs is neces­
sarily uncertain.




suburban revenues. Where the increased load will
fall— city or suburbs— will be one of the major
fiscal questions for the region.

19

FOR THE RECORD ...
BILLIONS $

INDEX

Manufacturing

Third Federal
Reserve D istrict

Per cent change

A pril 1968
from

A pril 1968
from

4

mos.
1968
from
year
ago

year
ago

mo.
ago

LO C A L
CH A N G ES

4

mos.
1968

mo.
ago

year
ago

from
year
ago

Metropolitan
Statistical
Areas*

+

4

+

—

2

+

2

+

2

-

3

+

3

+

5

+

2

+

17

+

2

+

3

-1 0

+

-

-

— 1

2

7

+

Per cent
change
April 1968
from

Per cent
change
April 1968
from

Per cent
change
April 1968
from

year
ago

0

mo.
ago

year
ago

mo.
ago

year
ago

mo.
ago

year
ago

-

+

-

+ 7

3

15
0

Trenton

............

0

-

3

-

0

2

+27

— 4

-1 0

2

A tla ntic City ....

+22
2

Per cent
change
April 1968
from

Total
D e p o s its '"

3

0

3

0

-

Payrolls

Wilmington ..... + 2

0

Check
Paym ents"

Employment

mo.
ago

MANUFACTURING
Production ..........................
Electric power consumed
Man-hours, to ta l* .........
Employment, total ............
Wage in c o m e *....................
CONSTRUCTION" ................
COAL PRODUCTION ...........

Banking

United States

Per cent change
SUMMARY

MEMBER BANKS. 3RD. F.R.B.

+

+

-1 7

+ 13

1

7

1

+ 2

+ 4

+ 10

Altoona ..............
(All member banks)
Deposits ..............................
Loans ....................................
Investments ........................
U.S. Govt, securities ....
Other ..................................
Check p a y m e n ts '" .........

0

+ 2

— 2

7

+24

+29

+ 2

+ 9

Harrisburg .......

BANKING

0

+ 2

0

+ 6

+ 6

+

+

1

+ 11
+ 7

+

5

Johnstown ....... + 3
+

1

+

2

—

2

— 4
+ 1
+ 4f

8
+ 8
+ 15
+ 6
+24
+ io t
+

+11
+ 8
+ 19
+ 10
+28
+ io t

0
+

2

—
—
+
+

1
3
1
4

8
+ 8
+ 11
+ 5
+ 17
+ 14
+

10
+ 8
+ 15
+ 8
+21
+ 15
+

0

+ 13

+ 14

+ 6

+ 14

+

3

Lancaster .........

0

0

-

4

+ 2

+ 5

+ 12

+

2

+ 8

Lehigh Valley ..

0

0

+

1

+ 5

0

+

+

1

+ 11

1

8

Wholesale ............................
Consumer ............................

'Production workers only
"V a lu e of contracts
'"A d ju s te d for seasonal variation




+ 4t

+ 4t

0
0

+ 3
+ 4

+ 2
+ 4

115 SMSA’s
^Philadelphia

— 1

— 4

0

+ 7

+ 6

+

+ 2

— 6

+ 4

+ 10

+28

+ 2

0

0

— 3

+

8

— 8

+ 2

+

Wilkes-Barre .... ot

0
0

Scranton ............
PRICES

Philadelphia .....
Reading ...........

1

-

2

— 6

-

3

+ 3

+

7

York ..................

0

+

1

-

+ 4

+ 8

+13

3

+ 9
-2 6

1

+ 13

+

1

+12

-

2

+ 2

'N o t restricted to corporate lim its of citie s but covers areas of one
or more counties.
" A l l commercial banks. Adjusted fo r seasonal variation.
'"M e m b e r banks only. Last Wednesday of the month.

Remarks
By
Andrew F. Brimmer

Member
Board of Governors of the
Federal Reserve System

Statutory Interest Rate Ceilings
and the
Availability of Mortgage Funds

Supplement to Business Review, June 1968
Federal Reserve Bank of
Philadelphia






Statutory Interest Rate Ceilings and the
Availability of Mortgage Funds
By
A n d re w F. B rim m e r*
As frequently happens when market processes

suspended temporarily, and in a number of States

are subjected to statutory regulation, the attempts

maximum rates have been raised. Nevertheless,

by the Federal and State governments to fix the

as market interest rates (including rates on resi­

maximum rates of interest which lenders can

dential mortgages) have continued to rise under

charge on residential mortgages have produced

the impact of growing credit demands during the

effects the reverse of those intended: usury laws,

current period of monetary restraint, usury ceil­

originally designed to protect individual bor­

ings remain a serious obstacle to the flow of

rowers, have increasingly prevented these poten­
tial borrowers from obtaining mortgage funds.

mortgage funds in some States. Moreover, in
some geographical segments of the mortgage

While most public attention has been focused on

market, maximum rates are still generally frozen

the adverse effects of statutory ceilings on Fed­

at the extremely unrealistic ceiling of 6 per cent.

erally

State-

Thus, the task of coming to grips with the prob­

imposed ceilings also severely limit the access of

lems posed for housing finance by outdated stat­

homebuyers to mortgage funds in a number of

utory interest rate ceilings are still before us.

areas.

The principal points of these remarks can be
summarized briefly:

underwritten

mortgages,

many

In the last few years, and especially in the
wake of the severe difficulties experienced by the
homebuilding and financing industries during

— The inherent deficiencies of the residential

the period of monetary restraint in 1966, a major

mortgage as a capital market instrument are
compounded by rigid statutory ceilings on inter­

effort has been launched, on both the Federal and

est rates which lenders can charge.

State level, to moderate the rigidities of statutory

— Statutory interest rate ceilings, whose roots

ceilings on mortgage interest rates. This effort

are deeply imbedded in historical experience, are

has achieved varying degrees of success. Statu­

so low in a number of States that they pose a

tory limits on FHA and VA mortgages have been

serious obstacle to the functioning of their mort­

* M em b er, Board of Governors of the Federal R eserve
System . This paper was presented before the 74th Annual
Convention o f the Pennsylvania Bankers Association at
Atlantic C ity, N ew Jersey, on M a y 29, 1968. It was re­
vised on June 4, 1968 prior to publication by the Federal
R eserve Bank o f Philadelphia. I wish to express m y
appreciation to M r. R ob ert M . Fisher and M iss M a ry A nn
Graves o f the Board’s staff for assistance in the prepara­
tion o f the paper.
N o t e : M o re arguments and data presented in this paper
refer to home mortgages, and multifam ily mortgages in­
volving borrowers other than corporations, which are
usually excep ted from State usury ceilings, but not
Federal ceilings.




gage markets.
— The adverse effects of usury ceilings— while
most evident in the behavior of lenders— are par­
ticularly harsh on builders of new houses and on
owners of existing homes. These effects can be
seen most clearly in the case of FHA and VA
underwritten mortgages, where discounts pro­
vide a sharp and readily measurable indicator of
the impact of inflexible rate ceilings.

3

— The recent moves to suspend statutory ceil­

in so many ways— by maturity, credit worthiness

ings on FHA and VA mortgages and to raise ceil­

of the borrower, legal requirements of the State

ings in several States have been only partially

in which the property is located, etc.— that they

successful. Discounts are again sizable on FHA

clearly are not interchangeable. Federal guar­

and VA mortgages, and newly raised ceilings in

antees and insurance tend to add homogeneity.

a number of States are again interfering with the

However, while less than one-fifth of all residen­

flow of mortgage funds.

tial mortgages on new homes in the period 1963-

— Thus, there is still a major job ahead if we

66 had such protection, the proportion has de­

are to develop a mortgage market capable of

clined further in 1967-68. Moreover, additional

meeting the expanding demands for residential

fees and rate limitations have also tended to

finance.

reduce the effectiveness of efforts to create a
genuinely competitive, nationwide financial asset

— Finally, when the Truth In Lending Act be­
comes effective in mid-1969, the lender will be

out of the residential mortgage.

required to supply a complete statement of the

The institutional structure of mortgage markets

finance charges involved on home mortgages.
Consequently, the argument for usury ceilings as

has also limited the ability of the mortgage to
compete with other financial assets. Undoubtedly,

a “ protection” for the borrower will be further

one of the most serious obstacles is posed by

weakened.

Federal and State statutory ceilings. Interest rate
limitations on mortgages established by such

Structural defect in mortgage financing

statutes inevitably make mortgages non-competi­

The deficiencies in mortgages generally— and in

tive in periods when generally rising interest rates

residential mortgages particularly— which make

force yields on market securities up to or beyond

them a special type of financial asset are widely

the statutory ceilings. While discounts can in­

known. However, it may be well to remind our­

crease the yield on mortgages, many lenders find

selves again that a substantial part of the obstacle

the use of discounts a difficult procedure for tech­

to the development of a truly viable mortgage
market arises from the characteristic of the in­

nical and other reasons. Moreover, both laws and
administrative regulations inhibit their use, and

strument itself. Furthermore, some policies and

the impact on the cash position of the seller or

regulations affecting Federally underwritten mort­

builder is often so large that it further reduces the

gages have also helped to give mortgages a special

use of discounts.

standing (not always beneficial) in the capital
market.
Most varieties of debt instruments other than
mortgages are relatively homogeneous within

Origins and scope of statutory
interest rate ceilings
Interest charges have been made since ancient

broad categories. For example, investors nor­

times, and the efforts to regulate such charges are

mally accept corporate bonds of the same ma­

equally

turity and quality rating as reasonably close

charging interest on loans fell into disrepute

substitutes— with

quite early after it began; undoubtedly this was

relatively

small changes

in

ancient.

Apparently

the

practice

of

yield differentials required to encourage substi­

partly because interest rates were high and

tution. In contrast, mortgages are differentiated

penalties for default were heavy.

4




The historical record (from ancient Greece,

as of midyear.

through the Jews, to the Christian Church, to the

As one examines the geographical pattern of

secular authorities in Europe and to the American

mortgage rate ceilings, it is easy to discern the

States today) is replete with efforts to prohibit or

broad outlines of a mechanism designed to attract

regulate interest charges— which almost from the

funds from surplus savings areas to capital deficit

very beginning became known as “ usury.” Over

regions. Leaving aside New England

time, however, the authorities began to distinguish

apparently steps to free the mortgage market

between low interest rates and high interest rates

were undertaken years ago), it is evident that

— with the concept of usury being reserved for

State statutory ceilings were set in the East at a

the description and condemnation of high interest

fairly low 6 per cent, reflecting the sizable volume

(where

rates. On the basis of this distinction, England in

of savings generated in this area over the years.

1545 eliminated the prohibition on usury and

The advanced degree of industrial development,

established a legal maximum interest rate. Other

the high ratio of savings to personal income, and

countries followed this example. Over the years,

the growing stock of wealth of households— all

however, Great Britain ceased fixing legal inter­

supported the evolution of strong financial insti­

est rates, and left it to the courts to determine

tutions. The latter in turn were able to mobilize

whether a rate is usurious.

savings in substantial volume to be invested in

In this country, it was the States— not the Fed­

their immediate areas or channelled into distant

eral Government—-that followed the legacy stem­

regions where the demand for funds greatly ex­

ming from the English action of the sixteenth

ceeded the supply. The regions facing the greatest
capital shortage were the South and West, with

century. In general, States fix a legal rate at
which debts may be assessed after they have
become due and remain unpaid, and they also

the Midwest falling between the two extremes.
Thus, again leaving aside New England, as one

fix the maximum rate permitted in a contract.

generally fans out from the Middle Atlantic region,

With the advent of the Federally underwritten

the contours of mortgages rate ceilings rise in a

FHA and VA mortgages, the Federal Government

fairly regular pattern. While valleys appear in sev­

did become involved in the making and adminis­

eral instances, the average of the maximum rates

tering statutory ceilings on mortgage rates.

is definitely higher the farther out one travels.

Today, 46 of the 50 States have established stat­

Unfortunately, the older Eastern regions are no

utory ceilings on mortgage interest rates. As

longer blessed with as large a volume of excess

shown in the table on the following page, if we

savings as they were in the past. With the strong

put aside the four States which permit any rate

demands for funds— demands arising from the

to be charged, the vast majority of the States have

large and persistent deficit in the Federal budget,

set ceilings in the range of 7-8 per cent and 10-12

from State and local governments, from corporate

per cent. However, at the beginning of the year,

borrowers, from foreign borrowers, as well as

nine States (Delaware, Maryland, New Jersey,

from households competing for mortgage funds

New York. Pennsylvania, Tennessee, Vermont,

— savings intermediaries in these older regions

Virginia, and West Virginia) still limited the

of the country are behaving in exactly the way

maximum rate to 6 per cent. Moreover, at least

one would expect them to behave: they are in­

two of those States had not yet raised the rate

vesting their funds where they can obtain the




5

highest returns. In the process, mortgage bor­

demand for credit as well as the supply of funds.

rowers in a number of States are attracting a

This in turn means reduced activity in homebuild-

declining share of the total savings flows.

Adverse impact of statutory rate
ceilings

ing and in the transfer of existing dwellings.
These adverse effects can be traced in the be­
havior of lenders, of builders, and of households.

Lenders:

The principal reaction of lenders

Low statutory interest rate ceilings affect the

to low rate ceilings is to reduce the supply of new

home mortgage market adversely by reducing the

commitments. As one would expect, as market

STATE STATUTORY CEILINGS ON CONTRACT INTEREST RATES ON HOME MORTGAGES
JUNE 4, 1968
Rate Ceiling
(Per cent)

Number of
States

Names of States

Any rate

4

Connecticut,1 Maine, Massachusetts,
New Hampshire.

21

1

Rhode Island.

12

4

10

12

9

1

8

16 and D.C.

Colorado, Hawaii, Nevada, Washington.
Arkansas, California, Florida, Kansas, Montana,
New Mexico, Oklahoma, Oregon, Texas, Utah,
Wisconsin,1 Wyoming.
Nebraska.
Alabama, Alaska, Arizona, Delaware,2
District of Columbia, Georgia, Idaho, Indiana,
Louisiana, Maryland,3 Minnesota, Mississippi,
Missouri, New Jersey,4 Ohio, South Dakota,
Virginia.

1

New York.5

7

8

Illinois, Iowa, Kentucky, Michigan, North Carolina,
North Dakota, Pennsylvania, South Carolina.

61/2

1

Vermont.

2

Tennessee," West Virginia. (In Tenn. and W. Va.,
S & Ls may charge a premium above the lim it.)

7 i/2- 5

6

1 On loans of $5,000 or less, the maximum rate is 12 per cent.
2 The State legislature on May 23 passed a bill for the rate to go from 6 per cent to 8 per cent.
3 As of July 1, 1968.
4 The State assembly on June 3 passed a bill fo r the rate to go from 6 per cent to 8 per cent.
5 The State legislature on May 21 passed a bill, which the Governor signed on June 3, to give the
State Banking Board the discretion to set the rate between 5 per cent and iy 2 per cent.
1 On loans exceeding $50,000, the maximum rate is 7 i/2 per cent.
1
Note: In many States with ceilings, FHA-insured and VA-guaranteed mortgages are excepted.

6




interest rates (including those on mortgages)

Where legal, lenders charge discounts or adopt

converge on statutory ceilings within a given

other means of raising the effective yield. Ex­

State, domestic lenders tend to reduce in-State

pressed in the form of “ points” (i.e., a given per­

lending and to expand the investment of funds

centage of the principal amount involved), such

out of State. At the same time, low rate ceilings

discounts on FHA-insured loans provide an indi­

discourage in-State lending by out-of-State insti­

cation of the market’s changing evaluation of the

tutions. In general, such ceilings divert funds to

effective rate on mortgages in excess of the statu­

investments whose yields are more free to move

tory ceiling. For example, on 6 per cent FHA-

in response to market forces.

insured loans, the market yield in April, 1967,

by the behavior of New York City savings banks.

was 6.29 per cent and the discount was 2.5 points.
Over the following twelve months, as interest rates

In view of the 6 per cent ceiling (which had been

rose generally, the same category of 6 per cent

This pattern of reaction was amply illustrated

in effect until midyear) in New York State, sav­

FHA-insured loans in April of this year were

ings hanks were investing an increasing propor­

yielding 6.94 per cent in the secondary market,

tion of the funds in properties in other States and

and the discount had risen to 7.9 points. However,

in high-grade corporate bonds. This is clearly

for public relations reasons, lenders are often

understandable when the maximum of 6 per cent

reluctant to make loans subject to substantial

generally obtainable on mortgages secured by

discounts. Instead, many lenders prefer to with­

properties located in New York was set against

draw from the market.

market yields in the first four months of this year

Home builders: Other adverse effects of low
statutory ceilings during periods of rising market

in the neighborhood of 6 % per cent on out-ofState conventional mortgages and against slightly
higher secondary market yields on mortgages

yields can be seen in the behavior of builders.
The first place to look is the interaction between

underwritten by the Federal Government. Also

lenders and builders. During such periods, banks

during the first four months of this year, newly

and other short-term lenders reduce construction

issued high-grade corporate bonds have offered
yields well over 6y» per cent. The magnitude of

loan commitments to builders as the volume of

out-of-State mortgage investing that the New

lenders is cut back and as the stiffening terms of

York savings banks were doing was indicated in

such permanent commitments shift more of the

early March by the Superintendent of Banks

risk to construction lenders.

permanent takeout commitments from long-term

while testifying in support of a bill that would

As market rates press against statutory ceilings,

empower the State Banking Board to fix mortgage
rate ceilings in line with current market yields.

homebuilders may have to absorb an increasing
share of mortgage discounts in their profits, thus

He reported that in 1967, savings banks in New

weakening incentives to build. Whenever possible,

York State had invested $916 million in mort­

however, builders try to pass discounts along to

gages within the State and $1.1 billion in out-of-

buyers in higher prices or lower quality construc­

State mortgages. He also reported that there was

tion.

a rising trend toward out-of-State mortgages

margins are probably smaller than in higher-

throughout

priced dwellings, may be hit the hardest. When

1967, and that no

occurred so far this year.




reversal had

Lower-priced construction, where profit

mortgage discounts become “ excessive,” builders

7

may withdraw from home construction and tem­

ance applications climbed steadily to around

porarily go out of business or into other lines of

650,000 at an annual rate. With the maintenance

construction activity where discounts are less of

of a fairly easy monetary policy through the fall

a problem.

of 1965, discounts remained in the neighborhood
The impact of statutory mort­

of 2 points, and loan applications on existing

gage interest rate ceilings on individual house­

homes rose further to a peak of almost 900,000

holds can be seen in the behavior of both buyers

units. However, with the adoption of a policy of

and sellers of homes. Homebuyers, presumably
the party for whose benefit maximum mortgage

sued until the fall of 1966—discounts rose sharply

Households:

monetary restraint in late 1965— which was pur­

ber of ways: the availability of funds is reduced,

and reached nearly 7 ^ points in the third quarter
of 1966. Under the market pressures implied by

and housing prices are inflated by discounts.

such deep discounts, loan applications were cut

Many borrowers would be better off financially
by paying market interest rates rather than higher

by more than half, dropping below some 400,000

housing prices, involving large down payments
and about the same monthly housing outlays. The

tary policy of 1967 brought a noticeable decline

range of choice of available housing is restricted

loan applications recovered to an annual rate of

rates are set, are discriminated against in a num­

units at an annual rate. The relatively easy mone­
in discounts to about 2.5 points by April, and

by reductions in new construction and the with­

about 700,000., But this respite was short-lived.

drawal of some existing homes from the market.

The strong competition

for long-term

funds

And whatever volume of credit is provided by

(particularly from corporations) put new pres­

mortgage lenders is extended on more restrictive

sure on market yields as the year progressed,

non-rate terms than would otherwise prevail.

and discounts on FHA-insured mortgages again

In circumstances where statutory ceilings gen­

rose steeply. By April 1968, such discounts had

erate discounts, home sellers, whenever possible,

reached about 7.9 points, and loan applications

try to pass such discounts in higher prices, rather

on existing houses had fallen below 600,000 at an

than absorb the amount in reduced capital gains.

annual rate as sellers progressively withdrew

Otherwise they may temporarily withdraw their

their homes from the market.

homes from the market, or seek to finance the

In many cases, rather than withdrawing their

sale through possibly higher-cost (to buyers)

homes, sellers try to bury the discount in a

financing involving the use of take-back second

higher price. Actually, he gains little by such an

mortgages. The propensity of sellers to withdraw

effort, because any real-estate brokerage fee is

their homes from the market can be seen dramat­

calculated on the total price. In fact, the seller’s

ically in the behavior of applications for FHA

net proceeds would be somewhat lower under

insurance on used dwellings. For example, in late

these circumstances than would be the case if no

1961, FHA-insured mortgages were carrying dis­

discount were involved and capitalized.

counts of about 4 points, and insurance applica­
approximately 560,000. For almost two years,

Recent developments in ceilings
on mortgage rates

discounts fell steadily and leveled out close to 2

The types of behavior examined above were re­

points in mid-1963. Over the same period, insur­

sponsible for much of the frustration-—on the

tions were at a seasonally adjusted annual rate of

8




part of lenders, builders, and households— which

would apparently prohibit the charging of any

stimulated the recent efforts to modify mortgage

discounts, points, or similar fees on all mort­

statutory ceiling laws at both the Federal and

gages, presumably including FHA and VA loans.

State levels. Federal action involved Congres­

It is reported that the Maryland Attorney General

sional passage of PL 90-301— and Presidential

is preparing an opinion on the precise application

approval on May 7— which suspends temporarily

of this unusual feature. If all FHA and VA mort­

(until October 1, 1969) statutory limits appli­

gages were included, of course, no lender could

cable to interest rates on all FHA and V A market

make a Government underwritten loan at a dis­

rate mortgage programs. The limits had been 6

count in Maryland, and funds for this type of

per cent on home loans and from 5)4 to 6 per

investment could become scarce indeed. In fact,

cent on multi-family loans. In addition, the legis­

much of the benefit of the move to a higher ceil­

lation raised the permanent ceiling on all market

ing on mortgages would be erased.

rate multi-family programs to 6 per cent.

In Pennsylvania, the Governor on May 17

The same law authorized a regulatory rate ceil­

signed a bill permitting a lender to charge a

ing on Federally underwritten loans adequate “ to

premium of 1 percentage point above the existing

meet the mortgage market.” Acting under this

6 per cent usury ceiling. Formerly, only savings

authority, FHA and VA specified an across-the-

and loan associations could charge up to 7 per

board limit of 6 % per cent for all market-rate

cent. Permission to charge the premium, which

programs within States permitting this level of

expires five years from the effective date, applies

rates on Government underwritten loans. The
effect was to bring about some reduction in dis­

only to newly made mortgages. No existing mort­
gage, according to the law, may be renegotiated

counts. However, since market yields on FHA

at the premium.

and VA mortgages currently exceed 7 per cent,

It is reported that many long-term mortgages

discounts remain fairly substantial. At present
such discounts probably range between 4 and 6

in Pennsylvania were made under a provision
calling for renegotiation of the rate after each

points nationwide, compared with more than 8

successive 3-year period. Apparently, the new

points at the time the law became effective.

law would prohibit renegotiation of such loans

At the State level, several liberalizing moves
were made recently. North Carolina raised its

at the premium rate, although the courts may
have to resolve the uncertainty. In the meantime,

ceiling on mortgage loans to 7 per cent from 6 per

while the new law in Pennsylvania is definitely a

cent, effective in June, 1967. Effective March 1

step forward, on closer examination, the stride

this year, Virginia adopted a ceiling of 8 per cent,

seems not to have been as long as one originally

compared with the previous 6 per cent maximum.

thought.

On May 7, the Governor of Maryland signed a

Efforts in other States, notably New Jersey

bill raising the usury ceiling to 8 per cent from 6

and New York, to liberalize the 6 per cent usury

per cent, effective July 1. In the interim, appar­

ceiling also met with some success this year. But

ently some FHA and VA mortgages were closed

the outcome of these efforts assumes even more

under terms calling for 6 per cent interest payable

critical importance in light of the trend of mort­

through June 30 and 6 % per cent thereafter. A

gage rates. From spring to midyear, home mort­

special (and unusual) feature of the legislation

gage yields rose above 7 per cent for the first time




9

in the postwar period. If further increases should

presented to the President in 1963. This commit­

occur, investment in home mortgages will come

tee recommended that “ Government credit pro­

under increasing restraint within an additional

grams should, in principle, supplement or stimu­

8 States with 7 per cent usury ceilings. Last year,

late private lending, rather than substitute for it.”

these 8 States (Illinois, Iowa, Kentucky, Michigan,

Personally, I am not aware of any reports

North Carolina, North Dakota, South Carolina—

showing that mortgage borrowers in such States

and Pennsylvania which just moved to 7 per cent)

as Massachusetts, Maine, and Connecticut— where

accounted for 18 per cent of all housing units for

any mortgage rate may be charged— have been

which building permits were issued within the

forced to borrow at exorbitant rates of interest,

nation’s 3,014 permit-issuing places.

even on junior financing. On the other hand, we

Concluding observations

have learned from informal sources that since

Thus, a significant task remains ahead of us, if

going market yields (rates) tend to prevail in

we are to develop a truly viable mortgage market.

these States, lenders have been more willing to

A critical ingredient in the process is the early

make new commitments on local properties there

abolition of statutory rate ceilings.

than they have been in adjacent or nearby States

The public policy objective of usury ceilings is

such as New York, Vermont, or Pennsylvania,

to protect mortgage borrowers in unfavorable

where usury ceilings are (or were) 6 per cent and

bargaining positions from “ excessive” charges on

discounts may or may not be charged.

loans extended by private lenders. But when going

Finally, the need for any usury “ protection”

yields exceed usury ceilings substantially, this

will also be substantially lessened, if not elimi­

objective becomes increasingly difficult to achieve.

nated, when the truth-in-lending legislation that

Meanwhile, other unintended and unfavorable

has been passed by Congress and signed by the

are pro­

President is in force (July 1, 1969). The Con­

duced. The anomalous outcome may be that bor­

sumer Credit Cost Disclosure provisions of the

consequences

(as mentioned above)

rowers in States with quite high usury ceilings, or

Consumer Credit Protection Act (cited as the

with no usury ceilings, are more successful in

Truth In Lending Act) require that the borrower

their quest for adequate credit from private

be given a complete statement of all charges in­

sources on more reasonable overall terms than

volved. Those charges that are defined to be part

are borrowers in low-rate States. Retention of

of the finance charge are to be computed in

below-market usury ceilings thus inevitably in­

terms of an annual interest rate. In the case of

hibits lending in the private sector, giving rise to

real estate, the computation of the annual interest

demands for greater lending from public sources.

rate includes any points which may be involved

To the extent that more Government agency

on the mortgage. Because of this required state­

credit is forthcoming, public credit tends to be

ment, the borrower should have a more accurate

substituted for private credit, and when subsidies

idea of the actual costs involved with any particu­

are involved they are granted at the expense of all

lar mortgage and also a more useful basis for

taxpayers. The substitution of public for private

comparison in his choice of mortgage contracts.

credit runs exactly counter to the settled position

In the meantime, the efforts to remove State

of public policy as set forth in an interagency

usury ceilings on mortgage interest rates are still

committee report on “ Federal Credit Programs”

worth pursuing.

10




The'Budget,
'Regulation Q ,

and Gold:
Three Issues forToday and Tomorrow

By
K a rl R. Bopp
President, Federal Reserve Bank of Philadelphia
65th Annual Convention of the New Jersey Bankers Association
M ay 23, 1968




Supplement to Business Review, June, 1968




The Budget Regulation Q, and Gold:
Three Issues for Today and Tomorrow
by
Karl R. Bopp
So much has happened in banking and finance

My view is that neither central bankers nor

since we last met that it is difficult to choose

observers should measure policy or the need for a

which of many current events to talk about.

change in policy by movements in a single or

Meanwhile, critics of the Federal Reserve System,

even a few financial variables. The System has

whatever their leaning, have had a field day. By

been and is continuing to invest large efforts in

choosing the measure that supports his view, the

order to develop a better grasp of the relation­

critic can prove almost anything— to his own

ships among financial variables and developments

satisfaction— but not to the satisfaction of other

in the real economy— which, after all, is the ulti­

critics who choose another measure.

mate objective of policy. I am a member of a

For example, those who believe simply that

so-called Steering Committee which has devoted

the Federal Reserve controls the money supply

several years with first-class staff assistance to

and that the money supply controls everything
else in the economy insist that the Federal Reserve

studying possible benefits from a redesigned dis­
count window which, among other things, might

began a disastrously easy money policy about the

reduce

time we met here last year. They conclude we

changes in the rate more meaningful.

administrative

surveillance

and make

followed an easy money policy because last spring

We now publish our policy record approxi­

and summer the money stock was increasing at a

mately 90 days after each meeting of the Federal

near-record rate of 9 per cent and total member

Open Market Committee. The record and our
reasoning are there for all to see.

bank deposits at a rate of almost 12 per cent.
On the other hand, those who believe simply

I shall not, therefore, go into that record in

that the Federal Reserve fixes interest rates and
that interest rates fix the rest of the economy de­

detail today. Instead, I shall concentrate on three
interrelated developments— each of which could

scribe that same period as one of extremely tight

be a speech in itself. The first might be entitled

money because interest rates rose even faster than

“ The Failure of Fiscal Policy” ; the second, “ The

in 1966 and to the highest levels in decades.
Incidentally, it is a bit— well— disconcerting to

light of Gold.” These titles, though over-dramatic,

learn that in some cases the same individuals who

sum up three basic issues of the past year and—

a few years back criticized us severely for not pay­

more important— of the long run as well. Indeed,

ing enough attention to rates are now criticizing

the thrust of my remarks is that in all three cases

us for paying any attention to rates at all, but

we are confronted with presssing problems that

such is the life of any banker— central or com­

not only call for immediate solutions, but have

mercial !

important implications for the longer run.




Dilemma of Regulation Q” ; and third, “ The Twi­

3

The Budget
Most— if not all— of our current financial prob­
lems stem from the failure to get timely changes
in fiscal policy. Substantial and continuous budg­
etary deficits, in an economy utilizing nearly all
of its resources, have been heavily responsible for
recent price increases. This renewed burst of in­
flation, in turn, has contributed to a further
deterioration in our balance of payments and
further weakening of the prestige of the dollar.
The need for restraint in the fiscal program of
the Federal Government has been obvious for
many months. Whether one is a New Economist
or an Old Economist, the combination of a budget
deficit of over $20 billion, which is what it will

stalemate indicates once again that two-way flex­
ibility— use of fiscal policy to restrain as well as
to stimulate— remains to be mastered. As a re­
sult, some observers of economic developments
have become disenchanted and are moving to
the view that the best that can be hoped for is to
establish a stable fiscal policy and leave respon­
sibility for counteracting swings in the economy
to monetary policy. The disadvantages of such
a course are obvious when we observe the level
of interest rates today. A more flexible fiscal
policy remains worth striving for, and I haven’t
lost hope.

Regulation Q

amount to in the fiscal year 1968, and a price
level rising at an annual rate of 4 per cent spells

The second issue with important short- as well as

bad economics.

tion Q. The Federal Reserve’s experience in

long-run implications is the dilemma of Regula­

It also spells bad politics. A tragedy is that dif­

changing ceiling rates on time and savings de­

ferences of political views as to how to close the

posits is brief and inconclusive. When ceilings

budgetary gap have stalemated action on both

were raised in December 1965, they helped make

spending and taxes for so long. Because of parti­

possible a rapid growth of money and credit in

san political considerations, as well as more

early 1966. When they were not raised in the

fundamental philosophical disagreements, law­

summer and fall of 1966, they helped to produce

makers and administration officials are clinging

the credit crunch.

to their respective concepts of the ideal solution

As credit tightens and interest rates rise to

to the budgetary problem and are unwilling to

historically high levels, commercial bankers find

make concessions in spite of the urgency of the

it increasingly difficult to compete at existing

situation. This is the short-run failure of fiscal

ceilings. If, however, commercial bank ceilings

policy.

are set too high, other financial institutions, sub­

Perhaps even more serious is the implication

ject to various restrictions, may find it difficult

for the longer run. Are we to face such grave
situations again and again as time rolls on? Al­

to compete with commercial banks. If open mar­

though the theory of flexible fiscal policy is just

investors— principally large investors but increas­

as sound as it ever was, the possibility of it being

ingly even ones having smaller portfolios—

put to practical use has been dealt a severe blow.

channel funds out of financial institutions and

ket rates rise above the ceiling rates, many

This is a great disappointment, particularly inas­

into marketable securities. This disintermediation

much as the tax cut of 1964 had led many to be­

can have far-ranging effects upon financial insti­

lieve that the principles of flexibility were finally

tutions and the particular markets which they

taking hold as a working proposition. The current

serve.

4



The Federal Reserve has just recently raised
the ceilings for large-denomination CD’s. This

charge on loans.
Institutional and statutory rigidities which

indicates clearly a desire to avoid the kind of

impair efficient functioning

crunch that occurred in 1966 without precipi­

structure are man-made problems; so it would

of

our financial

tating the kind of disintermediation that drained

seem that they could be removed readily. As you

funds out of the housing and municipal markets

know, however, artificial and arbitrary market

during the same period. Whether these new ceil­

impediments are difficult to eliminate, mainly

ings will be adequate only time will tell.

because of the support they receive from special-

The problems with interest rate ceilings stem
largely from efforts of monetary policy to keep

interest groups in legislative halls throughout
the nation.

the rate of economic growth within sustainable

Longer-run solutions to the problems of in­

limits. To the extent that appropriate fiscal meas­

terest rate ceilings are possible. I do not give up

ures are carried out, the burden upon monetary

on this as an ultimate goal. First, it is desirable to

policy is decreased and the pressure on interest

broaden opportunities for the various kinds of

rates is reduced. Therefore, a short-run solution

financial institutions to compete with each other.

to the problem of interest rate ceilings under

This would mean that arbitrary

Regulation Q is a timely and appropriate fiscal

among types of institutions would be reduced.

policy to supplement a restrictive monetary pol­
icy.

more efficient secondary markets for mortgages

The dilemma posed by Regulation Q points up
a longer-run problem which gives rise to it. Prin­

and other debt instruments. Improved flows of
funds among markets make it easier and more

cipally, this is the imperfection of competition

efficient for banks to adjust their asset positions.

in financial markets. Personally, I would prefer

For example, the better the secondary market for

not to be in the business of setting ceiling rates

municipal bonds, the easier and less costly it is

on time and savings deposits. I would rather

for banks to use them as a type of secondary

operate in an economy in which institutions

reserve.

distinctions

Second, it is desirable to develop broader and

would be free to compete against each other for

I believe that usury restrictions deserve special

existing supplies of funds; and price would regu­
late the allocation of funds.

attention now. Originally, usury legislation was
adopted to protect the public from unscrupulous

Unfortunately, the various kinds of financial

money lenders— a goal which is still in favor in

institutions have special restrictions that govern

this era of concern over consumer protection. I

their activities. Savings and loan associations, for

am sympathetic with the principle of aiding con­

example, cannot invest in corporate bonds. Mu­

sumers; but there is a difference between consu­

tual savings banks can operate only in certain

mer protection and interest rate ceilings estab­

geographical areas. Secondary markets for mort­

lished by usury laws.

gages are not as fluid as some other kinds of

Usury ceilings were established in relation to

markets. Federal agencies regulate the rate of

interest rate levels prevailing at the time. Perhaps

interest which savings institutions can pay for

framers of usury provisions thought that the

funds. Furthermore, many states impose usury

ceilings were set high enough to present no sub­

ceilings on the rates which these institutions can

stantial future problem to borrowers or to lenders.




5

However, as rates have climbed to historically

Federal Housing Administration raised the ceil­

high levels, the usury limitations have become a

ing on interest rates on mortgages which it in­

problem. They may protect the borrower from

sures. Also, Fannie Mae has instituted an auction

paying high rates; but in today’s markets they

process for determining prices of mortgages it

are more likely to prevent him from getting the

buys. These actions are a step toward removing

funds at all.

some of the impediments to funds flowing into

I am reminded of a story from the days of

the mortgage market. More such actions are

wartime rationing.
A woman went into a store to buy pork chops.

needed if we are not to be faced periodically with
financial disruptions in periods of high interest

The butcher told her the price was a dollar a
pound.

rates.

“ Why your competitor across the street is
charging only 75^.”

Gold

“ Please, madam, why don’t you go there to
get them ? ”
“ Oh! he doesn’t have any to sell.”

I use the word “ twilight” advisedly because the
question of gold still sets off a great deal of pyro­
technics. Nevertheless, it seems clear that the

“ Well, when I don’t have any to sell, my price
is only 50^.”
Because interest rate ceilings vary

The third issue before us is the twilight of gold.

role of gold as well as that of the dollar has been
weakened by recent events.

among

In the short run, gold has occupied the center

states, lenders often find it advantageous to shift

of the stage. The decline of over $2.5 billion in

funds to other geographical areas. The shift may

United States gold reserves since your meeting a

not coincide with the relative need for funds

year ago is an indication of the difficult state of

among the areas. Now, roughly four-fifths of the

the U.S. dollar in the world economy.

states have more lenient usury laws than do
Pennsylvania, Delaware, and New Jersey.
As you know, new truth-in-lending legislation

The liquidity considerations of the United
States should not be confused with questions of
solvency. Each year our nation grows wealthier

passed Congress and was sent to the White House

in relation to the rest of the world. During the

yesterday. Knowledge of costs can give real pro­

ten years ended in 1966, U.S. investments and

tection to the consumer-borrower. Companion

assets abroad jumped by 126 per cent to $112

legislation on the state level to remove or sub­

billion, while foreign assets and investments in

stantially revise usury provisions would be timely

the U.S. increased by 91 per cent to $60 billion.

and appropriate. Recently the Pennsylvania Leg­

So, the United States with net investments of over

islature has raised the interest limitation on mort­

$50 billion in the rest of the world is an economi­

gage loans in the state. The action may not be

cally sound nation— and it has grown stronger

adequate, but is a step in the right direction.
I would hope that in the months and years

year by year. But, we do have a liquidity problem
that demands solution.

ahead substantial efforts could be devoted toward

The gold problem has been caused by a failure

eliminating the arbitrary, man-made impediments

of the United States to achieve reasonable equi­

to free competition within and among various

librium in its balance of payments with other

financial institutions and markets. Recently, the

countries. Over the past ten years the aggregate

6



deficit in balance of payments has approached

can producers to export to foreign markets and

$27 billion. These deficits have resulted from a

will entice foreign businesses to increase sales in

number of factors. The United States has poured

American markets. Military outlays overseas can

billions of dollars into economic assistance pro­

be expected to continue at a substantial level even

grams, helping war-ravaged nations back to their

if shooting stops in South Vietnam. And it re­

feet. American corporations, alert to expanding

mains to be seen how much over-all reduction in

overseas opportunities, have boosted investments

the balance-of-payments deficit will be achieved

in foreign lands. Our rising income levels have

by the President’s program announced on Jan­

enabled more individuals to travel and spend

uary 1.

abroad. Our military commitments around the

The most important step in bringing the bal­

world and particularly in Southeast Asia have

ance of payments closer to equilibrium has not

been a large drain on dollars. Moreover, foreign

yet been taken. That step is a move toward fiscal

nations have stepped up competition with Ameri­

restraint. A reduced Federal deficit should help

can firms for important markets both in the

restrain domestic demand, thereby slowing down

United States and elsewhere. Domestically, in­

imports; it should help to hold down domestic

flationary pressures have encouraged foreign

prices and thus stimulate exports. Furthermore,

businesses to sell goods in United States markets,

it should pay handsome dividends in improved

thereby putting pressure on our favorable balance

psychology around the world with respect to the

of trade. All of these factors have been operating

health of the dollar.

for a number of years.
Our Government has taken a number of short-

Looking to the longer run, progress toward
establishing special drawing rights is an en­

run, stop-gap measures to stem the outflow of

couraging development. The supply of gold is

dollars and gold. There is the voluntary foreign
credit restraint program with which you are co­

too uncertain to provide a base for a growing
world economy, and it is clear from recent ex­

operating splendidly. Also, we have the interest
equalization tax levied against foreign invest­

perience that there are limits to how far dollar
liabilities can be expanded through balance-of-

ments by United States citizens. We have the

payments deficits.

foreign investment restraint program which asks

The new “ paper gold” is another step in the

businesses not to ship dollars overseas for invest­

evolution of a more viable international mone­

ment purposes. The Government has cut the value

tary system begun with the creation of the In­

of items tourists can bring back duty-free in an

ternational Monetary Fund. As this system has

attempt to curtail tourists’ spending abroad.

evolved, gold has been a declining portion of

Restrictions on overseas travel by individuals

world monetary reserves— from 72 per cent in

have been proposed. And the list goes on.

1948 to 56 per cent in 1967. The “ paper gold”

In spite of these stop-gap measures, the near-

will be a further supplement to gold, enabling

term outlook for the balance of payments is far

world trade to grow in a more orderly way. It

from good. Tbe likely increase in economic activ­

is, however, no less vital to pursue other policies

ity during the rest of the year will continue to

which will encourage economic growth through­

produce a large demand for imports. Further

out the world, and not restrain it. Recourse to

increases in prices will make it harder for Ameri­

quotas and other restrictions on trade would




7

frustrate these very promising efforts.

In the case of the Federal budget, efforts should

The long-run goal of a more viable interna­

go forward to prevent recurrence of the kind of

tional monetary system cannot be achieved, how­
ever, unless we bring our international payments

fiscal impasses that we are now experiencing. In
the case of Regulation Q, the Fed will be faced

closer to equilibrium.

with a dilemma every time interest rates get high

Conclusions

and money gets tight. Efforts to make financial

There are many lessons to be drawn from recent

markets freer and more competitive are essential

experience. The one I want to emphasize is the

if we are not to be confronted with recurring

importance of working toward long-run solutions

problems of disintermediation and adverse allo­

to current and persistent problems. The danger

cation of credit. Finally, in the case of gold,

in resorting to ad hoc expedients which at best

action to put the world’s financial system on a

only postpone a showdown is that fundamental
solutions may be made even more difficult to at­

more flexible footing should proceed as rapidly

tain. I am fully sympathetic to the view that

solution is for the United States to get its bal­

today’s fast-moving world calls for great flexi­

ance of payments closer to equilibrium.

as possible. The first step to assure this long-run

bility. Actions of the Federal Reserve System in

We cannot let the house burn down while we

recent years, in fact, have exhibited more flexi­

design the most efficient water system. But with­

bility than in any other period of the Fed’s
history.

out such a system, we shall be in grave danger

8




each time a fire breaks out.