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September 6,1974 Citing the "meat-ax, undifferenti ated" impact of monetary policy upon interest-sensitive sectors of the economy, Congressman Henry Reuss (D., Wise.) recently intro duced legislation that would make the Federal Reserve System respon sible for the allocation effects of policy. While conceding that the current "intractable inflation" will require considerable monetary restraint, the Congressman also argued that indiscriminate restraint is "irresponsible." Consequently, his bill would require the Fed to allocate member-bank credit so that less would be available for "non priority uses"— gambling casinos, conglomerate mergers, non-essen tial real estate and "inflationinducing" inventory accumulation — and more would be available for "priority" loans and investments. Priority areas could include, among others, loans to finance capital investments that increase produc tive capacity, control pollution or conserve energy; loans to finance low- and middle-income housing and small businesses; and invest ments in the obligations of state and local governments. The bill calls for member-bank credit to be allocated to "priority" areas through the use of supple mental reserve requirements and credit subsidies against various bank-asset categories. Under the legislation, the Federal Reserve could require each member bank to hold supplemental reserves against "non-priority" loans and investments, in addition to the usual reserves against deposits, and 1 could allow a bank to credit a per centage of "priority" assets against these supplemental reserves. Since these reserves (like other reserve requirements) are a form of tax, and since the credits are the equivalent of a tax reduction, their interaction would alter the relative earnings on various assets and thus provide banks with an incentive to finance priority activities. Supporters of the Reuss proposal argue that such a system involves minimal interference with the market system and would be rela tively easy to administer, and more over, that it has been employed successfully by a number of foreign central banks. This system could be seen as a logical extension of the selective-control devices used in creasingly by the Federal Reserve in recent years— Regulation Q, of course, as well as reserve require ments on a wide range of non deposit sources of funds, such as Eurodollar borrowings by American banks and the proceeds of commer cial paper sold by bank holding companies. Flaws in the proposal Critics of the Reuss proposal con cede that, initially, more funds probably would flow to the "prior ity" areas favored by the credits and fewer funds to the "non-priority" areas subject to the supplemental reserves. But this might prove to be only a short-term phenomenon. For one thing, the proposal as pres ently constituted would apply only to banks which are members of the Federal Reserve System. Because (continued on page 2) Opinions expressed in this newsletter do not necessarily reflect the views of the management of the Federal Reserve Bank of San Francisco, nor of the Board of Governors of the Federal Reserve System. the supplementary reserves are a form of tax, which increases costs, banks could be tempted to with draw from membership to avoid the "tax." To the extent that such an attrition of membership occurred, the effectiveness of supplementary reserves as an allocating device would be reduced. The problem of leakages would be aggravated by the exclusion of other institutions which participate ac tively in the loanable-funds market — nonmember banks, savings-andloan associations and insurance companies, not to mention other financial institutions and nonfinan cial corporations. Moreover, the imposition of relatively high reserve requirements on non-productive loans and investments would offer no guarantee of a reduction in the flow of credit to such uses. In all likelihood, those flows would simply shift to other sectors of the credit market, such as the commer cial-paper market, as business credit demands repeatedly have done in the past in response to only slight differentials in borrowing costs. And even if we could be sure that the proceeds of a priority loan were actually being used for the intended purpose, we could not be certain that that action would not free up other resources for "non-priority" uses. To the extent that earnings (and payouts) are adversely affected by supplemental reserve requirements, depositors and stockholders can avoid the "tax" by placing their funds elsewhere, and in an era of increasing investor sophistication and rapid technological innovation, they are likely to do so with increas ing ease. (But small savers and borrowers, who are limited in their dealings to banks subject to reserve requirements, would be penalized by having, in effect, to subsidize "priority" borrowers.) At the same time, the credit aspect of the assetreserve proposal would discriminate in reverse— against those depositors and stockholders whose institutions are not subject to any form of re serve requirement. Plugging leakages Supporters of the credit-allocation proposal recognize these potential leakages and note that to some extent they would be "plugged" by other proposed legislation, which would give the Fed power over the reserve requirements of nonmem ber banks. Some proponents, cognizant of the $300 billion avail able in inter-firm trade debt and internally generated funds, would attempt to plug these leakages also by extending credit allocation re quirements to the whole gamut of financial and non-financial institu tions. Alternatively, they would impose mandatory credit-allocation measures upon the Fed similar to those exercised over consumer, real estate and other credit during the Korean War. In rebuttal, critics argue that past efforts to plug leakages have not 2 been too successful— witness the decade-long attempt (recently abandoned) to reduce ba!ance-ofpayment deficits through controls over foreign lending and invest ment. Plugging all potential leakages of credit also would require the exercise of Federal aegis over state regulatory agencies. Moreover, what specific criteria should determine what sectors qualify for "priority" treatment? Consumers and farmers, for ex ample, might feel deserving of treatment at least equal to that afforded middle-income homebuyers, small businesses, or large firms financing additions to capac ity. Also, we cannot tell what the relative impact upon employment, incomes, savings (and prices) would be of channeling credit to homebuyers as compared with (say) large industrial firms. Then there is the question of conflicting objectives among various "priority" areas. Housing, for example, may rank high as a social need, but it does not rank high in terms of one of the other criteria adduced in support of priority treatment— namely, provid ing needed additions to the nation's productive capacity. Problems of equity Credit-allocation schemes are de signed to rectify problems of in equity, which ultimately arise from unequal market power. But critics argue that this inequity can be better rectified through fiscal policy, whose costs and benefits are visible and measurable, than through a 3 maze of portfolio regulations loaded with indirect subsidies and taxes of uncertain incidence, and riddled with leakages. This approach not only would reduce the leakage problem, but would bring into sharper focus the need for deter mining priorities and making the necessary trade-offs between pos sibly incompatible objectives— such as equity, economic growth, price stability and environmental balance. Also, priorities can change, so that assigning responsibility for their determination and implemen tation to the Fed means giving the central bank enormous power to substitute a wide range of assumed public preferences for private decisions. Finally, critics of asset-reserve pro posals question whether foreign experience effectively validates their use, as has been claimed. Sev eral recent investigations of the experience of Western European countries conclude that such con trols cannot replace, and may even undermine, efforts to control the money supply. Also, despite the use of such measures, prices have risen even faster in Europe than in the U.S. Given this country's relatively low degree of banking concentra tion, the wide availability of its nonbank lending opportunities, and the relative openness of its money and capital markets, it could be argued that selective credit controls are even less likely to succeed in the U.S. than elsewhere. Verle Johnston m o c=3 u o i S u i q s B M • qe jn • uoSaJO • epeASN . oqepi M EM B|-| . B jU J O p jE ^ . E U O Z U y • £ > |S E |V •^1|E3 '0»Sj3UBSj UBS 2SL ON IlWHSd aivd dovisod s n 1IVW SSV13 ISMIJ BANKING DATA—TWELFTH FEDERAL RESERVE DISTRICT (Dollar amounts in millions) Selected Assets and Liabilities Large Commercial Banks Amount Outstanding 8/21/74 Change from 8/14/74 Change from year ago Dollar Percent Loans (gross) adjusted and investments* Loans gross adjusted— Securities loans Commercial and industrial Real estate Consumer instalment U.S. Treasury securities Other Securities Deposits (less cash items)— total* Demand deposits adjusted U.S. Government deposits Time deposits— total* Savings Other time I.P.C. State and political subdivisions (Large negotiable CD's) 83,251 65,782 1,177 23,526 19,782 9,441 4,633 12,836 79,631 21,609 536 55,968 17,758 28,840 5,954 15,787 Weekly Averages of Daily Figures Week ended 8/21/74 Week ended 8/14/74 Comparable year-ago period - 114 413 299 - 31 226 195 11 126 -1 1 5 + 739 + 1,277 0 + 528 + - + + + — — — — + + + + + 585 94 19 52 42 3 336 155 146 777 226 429 7 292 18 428 + 8,280 + ;?,950 + 36 + 3,033 + :>,610 + 723 — 499 + 829 + c>,936 + 640 + 74 + 3,846 + 13 + r ,431 — 236 + 3,762 11.04 13.75 3.16 14.80 15,20 8.29 9.72 6.90 9.54 3.05 16.02 11.66 0.07 23.20 3.81 31.28 + + + + + + _ + + + + + + + — + Member Bank Reserve Position Excess Reserves Borrowings Net free ( + ) / Net borrowed ( —) Federal Funds— Seven Large Banks Interbank Federal funds transactions Net purchases ( + ) / Net sales ( - ) Transactions: U.S. securities dealers Net loans ( + ) / Net borrowings ( - ) 530 + 142 in clu d e s items not shown separately. Information on this and other publications can be obtained by calling or writing the Administrative Services Department, Federal Reserve Bank of San Francisco, P.O. Box 7702, San Francisco, California 94120. Phone (415) 397-1137.
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