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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.