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FEDERAL RESERVE BANK OF RICH M ON D MONTHLY REVIEW Antitrust and the New Bank Holding Company Act Forecasts 1971 The Supply of Money in the United States FEBRUARY 1971 Antitrust and the New Bank Holding Company Act: Part I Until 1956, the regulation of bank holding com trust and administrative techniques. The first part of controlling traces the separate development of antitrust and bank holding company regulation along their different monopolies and monopolistic tendencies commercial paths until 1956 and reviews the milestones that led banking was considered a special case not subject to to their recent integration. federal antitrust laws. pear in the next tw o issues, survey current bank panies remained substantially independent of anti trust enforcement. For purposes A s a matter of fact, the Subsequent parts, to ap Banking Acts of 1933 and 1935 did much to dis holding com pany regulations as they apply to courage competition in commercial banking, deny acquisitions of com m ercial banks and entry into ing to commercial banks many forms of competitive nonbank businesses. conduct encouraged in other lines. W ith the enactment of the Bank Holding Company The Antitrust Approach to Business Regulation A ct of 1956, however, the competitive criterion be came explicitly relevant to acquisitions of commercial banks by bank holding companies controlling 25 per cent or more of the stock, or the election of a ma jority of the directors, of each of two or more banks. Thereafter, antitrust principles— themselves in pro cess of rapid change— became increasingly important in the regulation of bank holding companies. This trend was due in part to judicial decisions applying the antitrust laws to banking generally and in part to amendments to the banking and bank holding company laws themselves. Now, with the passage in December 1970 of farreaching amendments to the Bank H olding Company Act, a substantial integration of traditional antitrust policy and bank holding company regulation in the commercial banking industry has occurred. All types of bank holding companies, whether they control a single bank or more than one, and all forms of bank holding company expansion, as regards both bank ing and permissible nonbanking functions, are now subject to the administrative authority of the Board of Governors of the Federal Reserve System acting under general guidelines embodying the substance of antitrust doctrine, as modified to conform to the particular conditions of the commmercial banking industry. This article discusses the background and present status of bank holding company regulation by anti 2 Comprehensive antitrust regulation in the United States dates from the Sherman A ct of 1890. This short statute declares unlawful (1 ) every combina tion, contract, or conspiracy in restraint of trade or commerce, (2 ) every monopolization of trade or commerce or any part thereof, and (3 ) every at tempted monopolization or combination or con spiracy to monopolize such trade or commerce. As the Supreme Court has noted, it was • .. enacted in the era of “ trusts” and of “ combina tions” of businesses and of capital organized and directed to control of the market by suppression of competition in the marketing of goods and services the monopolistic tendency of which had become a matter of public concern. The end sought was the prevention of restraints to free competition in business and commercial transactions which tended to restrict production, raise prices or otherwise control the market to the detriment of purchasers, or consumers of goods and services, all of which had come to be regarded as a special form of public injury.1 Congress, however, failed to define the character istics of illegal restraint of trade and monopolization, thus leaving to the courts the task of interpreting the statute in the light of its legislative history and the particular practices at which it was aimed. The vague and general nature of the Sherman A ct’s prohibitions was not the only difficulty confront ing Federal courts called upon to construe and ap 1 A p e x H osiery Co. v. Leader, 310 U .S . 469, 492-493 ( 1 9 4 0 ). ply them. There was little common law precedent to guide the courts in shaping the new antitrust policy, century Supreme Court decisions that fostered a widespread belief among lawyers that money trans and as the Supreme Court soon came to realize, even this body of law was not relevant to the public issues raised by Federal antitrust policy. Faced with the reality that all contracts and com actions in and of themselves were not “ commerce” subject to Federal jurisdiction under the commerce clause of the Constitution. These 19th century de cisions relied upon an entirely different constitutional binations among businessmen necessarily restrain the basis to justify Federal regulation in the areas of trade of the contracting or combining parties to some banking and currency. extent, even if only by restricting their power to deal with others, and that most such arrangements are essential to the functioning of a free enterprise economy, the Supreme Court concluded in 1911 in its epochal Standard Oil and American Tobacco de cisions2 that it had no alternative but to be guided by the “ rule of reason” in adjudicating alleged anti trust violations. Not all restraints of trade would be regarded as illegal. Only restraints deemed “ un reasonable” by the courts would be proscribed. From these beginnings antitrust jurisprudence evolved gradually on a case-by-case basis over a period of 60 years, although from time to time the Sherman A ct has been supplemented by legislation defining particular forms of illegal practices. Am ong this legislation was the Clayton Act of 1914,3 focus ing particularly upon price discrimination, tying con tracts, exclusive dealing, full line forcing, corporate stock acquisitions, and interlocking directorates; the Robinson-Patman A ct of 1936,4 replacing the inef fectual price discrimination provisions of the Clayton A ct with complex provisions applicable to differential pricing and other discriminatory practices in dis tribution arrangements; and the Celler-Kefauver Antimerger Act of 1950,5 designed to prevent eco nomic concentration by means of corporate mergers, consolidations, and acquisitions of assets. Even as regards these last three Acts, however, the substance of illegal conduct today is largely the result of judicial interpretation and application of the law and not of the statutory language itself. But the body of unique national antitrust law that emerged gradually between 1890 and 1960 was not applied to commercial banking generally until the past decade (although one ill-fated proceeding, dis cussed later, was undertaken in 1948). Partly re Commerce, Banking, and Antitrust Legal au thority for Federal antitrust legislation is found in the commerce clause of the Constitution, investing Congress with power to “ regulate Commerce with foreign Nations and among the several States, and with the Indian tribes. . . .” Some of the first Su preme Court antitrust decisions after 1890 limited the scope of Federal jurisdiction to cases involving actual transportation of physical commodities across state lines. This approach was soon abandoned, how ever, and by the end of W orld W ar II it was clear that any significant effect upon interstate or foreign commerce attributable to challenged conduct would sustain antitrust jurisdiction.6 Nevertheless, this turnabout in judicial thinking did not affect the application of antitrust legislation to the commercial banking industry, as it (along with the insurance industry) continued to occupy a unique, immune status under such legislation. As noted, the Supreme Court had ruled on several o c casions in the 19th century that transactions in money did not constitute “ trade or commerce” for con stitutional purposes. In Paid v. Virginia/ an 1867 decision, the Court concluded that writing a contract of insurance was not “ commerce,” relying heavily on its earlier 1850 decision in Nathan v. Louisiana.8 There the Court stated that the “ individual who uses his money and credit in buying and selling bills of exchange . . . is not engaged in commerce but in supplying an instrument of commerce.” These decisions, which predated the Sherman A ct by many years, continued in full force and effect until the 1944 decision in United States v. SouthEastern Underwriters Association ,9 Moreover, they were supported by a line of decisions dating back to McCullough v. Maryland,10 which had affirmed sponsible for the long delay was a succession of 19th 2 Standard Oil Co. v. U .S ., 221 U .S . 1 (1 9 1 1 ); U.S. v. A m erican To bacco Com pany, 221 U .S . 106 (1 9 1 1 ). 3 A c t o f October 15, 1914, 38 Stat. 730. 6 See, for example, Mandeville Islands Farm s v. A m erican Crystal Sugar Co., 334 U .S . 996 (1 9 4 7 ). 7 8 W all. 168 (1 8 6 8 ). 8 8 Howard 73 (1 8 5 0 ). 4 A ct o f June 19, 1936, 49 Stat. 1526. 9 322 U . S. 533 (1 9 4 4 ). 5 A c t o f December 29, 1950, 64 Stat. 1125. 10 4 W heat. 316 (1 8 1 9 ). 3 United States. In that landmark case, as well as in subsequent decisions upholding the National Bank enactment of the Bank Holding Company A ct of 1956.12 Prior to this legislation, bank holding com panies cou ld acquire banks both within the ing Act of 1864, the Court had not relied upon the state in which the holding company itself was in power of Congress over interstate commerce to sup corporated and in other states as well. port Federal regulation. Instead, it had grounded of nonbanking businesses were equally free from its decision on the Constitutional power of Congress It Federal regulation. A s of December 31, 1950, 20 known bank holding companies owned various kinds was therefore generally assumed that Congress did of businesses including life insurance, home finance, not intend commercial banking to be subject to anti automobile insurance, fire and marine insurance, and the constitutionality of the Second Bank of the to “ coin money and regulate the value thereof.” trust control. This assumption found support in the real estate. Acquisitions Although South-Eastern Underwriters much more detailed, specific legislation applicable to and Transamerica had clearly established the ap commercial banks as represented by the National plicability of the Sherman and Clayton Acts to bank Banking Act, the Federal Reserve Act, and existing holding company acquisitions, in reality not one anti state legislation. trust proceeding had been brought against a bank W h atever jurisdictional questions m ight have holding company by the Antitrust Division of the existed regarding applicability of the Sherman Act Department of Justice in the entire history of the to commercial banking were swept away with the antitrust laws. 1944 South-Eastern This to bring its proceeding under the Clayton A ct after decision reversed the earlier position and indicated . . the trans receiving advice from the Department of Justice that there was inadequate evidence of abuse of power by mission of great quantities of money, documents and Transamerica to support a Sherman A ct charge.13 Underwriters decision. clearly the Court’s conclusion that communications across . . . state lines” is interstate commerce for antitrust purposes. Beginning as early as 1927, rising concern over the growth of bank holding companies led to nu Soon thereafter, in 1948, the first antitrust pro ceeding directed against corporate acquisitions of stock in commercial banks was instituted under the Clayton Act by the Board of Governors of the Fed eral Reserve System. In fact, the Board had only decided The defendant was Trans- america Corporation, a large diversified bank hold ing company based on the W est Coast. The Board’s complaint alleged that Transamerica controlled 41 percent of all commercial banking offices, 39 percent of total commercial bank deposits, and about 50 per cent of commercial bank loans in the states of A ri zona, California, Oregon, Nevada, and Washington, as a result of systematic and continuous acquisitions of bank stocks. Although Transamerica successfully defended the action, the opinion of the United States Court of Appeals for the Third Circuit held that merous legislative proposals for their direct regula tion. A t first, the principal thrust of these pro posals was to restrict acquisitions of banks by hold ing companies. This emphasis was closely related to the bitter struggle over branch banking that raged in Congress throughout the decade of the 1920’s. The Banking A ct of 1933 settled this issue, at least for a time, by restricting branching by national banks to the same geographical limits permitted to statechartered banks. A s a result, no national bank could branch across state lines. Even within the state where its head office was located, a national bank could establish branches only if state banks within such state were authorized to have branches, and then only within the same geographic areas per mitted to the state banks. commercial banking was, indeed, interstate com merce subject to antitrust regulation.11 Neverthe less, the failure of the Board’s antitrust proceeding in this factual context raised serious questions as to the probable effectiveness of the antitrust laws in controlling acquisitions by bank holding companies. Regulatory Approach of the Bank Holding Com pany Act The Transamerica case led directly to 11 Transamerica Corporation v. Board o f G overnors o f the Federal R eserve S ystem , 206 F.2d 163 (3rd Cir. 1953 ). 4 FRASER Digitized for 12 12 U .S .C . 1841 et seq., as amended. 13 Fischer, A m erican Banking Structure ( 1 9 6 8 ), p. 279. The Board’s action was brought under “ old” Section 7 o f the Clayton A c t, as originally enacted in 1914. W hile the Board’s case was pending, Section 7 was extensively revised in 1950 to prohibit any form of corporate merger, acquisition or consolidation which m ight sub stantially lessen competition or tend to create a monopoly in any line o f commerce in any section o f the country. The amended statute is entirely different from the earlier revision, which had been largely emasculated by hostile Supreme Court interpretations in the 1920’s and 1930's, long before the Transamerica proceeding. Especially notorious were the decisions in S w ift & Co. v. F .T .C ., 272 U .S . 554 (1 9 2 6 ), and A rrow -H a rt and H egem an Electric Co. v. F .T .C ., 291 U .S . 587 (1 9 3 4 ). A changed antitrust environment and a receptive Supreme Court have made amended Section 7 into an extrem ely effective deterrent to corporate concentration by mer gers or by corporate acquisitions involving competitors and com panies standing in the relationship o f actual or potential customer and supplier, as discussed in Part II o f this article. But bank holding com panies were under no similar restrictions and could lawfully acquire banks — at least insofar as Federal law was concerned— both within the states where they were located and in other states as w ell; and they continued to do so throughout the 1930’s and 1940’s. In addition, Transamerica and certain other bank holding com panies began broadening their penetration into non banking areas by means of acquisitions, thus bring ing extensive banking and nonbanking businesses under common control. industrial and manufacturing concerns. It is axiomatic that the lender and borrower or potential borrower should not be dominated or controlled by the same management. In the exceptional case the corporate device has been used to gather under one management many different and varied enterprises wholly unallied and wholly unrelated to the con duct of a banking business. . . . The Board believes, therefore, that it is necessary in the public interest and in keeping with sound banking principles that the activities of bank holding companies be re stricted solely to the banking business and that their activities be regulated, as are the activities of the banks themselves.16 In 1938, President R oose Between 1945 and 1956 a number of bills to bring velt sent a special message to Congress calling for bank holding companies under direct Federal con creation of a Temporary National Economic Com trol were introduced in Congress. mittee to undertake flected the Board’s recommendations; others took . a thorough study of the Some of these re concentration of economic power in American in different approaches. dustry and the effect of that concentration upon the sion and debate the position of the Board on the decline of competition.” question of permissible activities of bank holding The measure included the following recommendation: companies moderated somewhat. . . . that the Congress enact at this session legisla tion that will effectively control the operation of bank holding companies; prevent holding companies from acquiring control of any more banks, directly or indirectly; prevent banks controlled by holding companies from establishing any more branches; and make it illegal for a holding company, or any corporation or enterprise in which it is financially interested, to borrow from or sell securities to a bank in which it holds stock. Roosevelt also recommended that the proposed legis lation include a provision “ for the gradual separation of banks from holding company control or owner ship____ ” 14 Congress never seriously considered this so-called “ death sentence.” Only two bills to regulate bank holding companies were introduced between the 1938 special message and the end of W orld W ar II, and no hearings were held on either of them.15 The Federal Reserve System and Bank Holding Companies During these years of discus Then in 1943, a new factor was in Whereas in 1943 it had advocated that “ the activities of bank holding companies be restricted solely to the banking busi ness,” in 1952 the Board advised the House Com mittee on Banking and Currency as follow s: . . . the Board believes that the principal problems in the bank holding company field arise from two circumstances: (1) The unrestricted ability of a bank holding company group to add to the number of its banking units, thus making possible the con centration of a large portion of the commercial banking facilities in a particular area under single control and management; and (2) the combination under single control of both banks and nonbanking enterprises, thus permitting departure from the principle that banking institutions should not en gage in businesses w holly unrelated to banking because of the incompatibility between the business of banking which involves the lending of other people’s money and other types of business enter prises.17 By 1952, therefore, the Board had moved away from the view that bank holding companies should be restricted “ solely” to the business of banking and The Annual Report of had adopted the position that banking institutions the Board of Governors to Congress called attention to the use of the bank holding company device as a should not engage in businesses “ wholly unrelated to banking.” A s will be seen, this was a subtle change, means of evading restrictions on branch banking, but an important one, for the future evolution of and for the first time the Board expressed concern bank holding company legislation. troduced into the situation. over the possible growth of conglomerate bank hold ing companies with extensive ownership of nonbank businesses. The report stated, in relevant p art: The Bank Holding Company Act of 1956 As finally enacted, the Bank Holding Company Act of 1956 accomplished the two objectives sought by the Accepted rules of law confine the business of banks to banking and prohibit them from engaging in ex traneous businesses such as owning and operating 16 Annual R eport o f the Board o f Governors o f the Federal R eserve S ystem (1 9 4 3 ), pp. 34-36 (emphasis added). 14 Senate Document N o. 173, 75th Cong., 3rd Sess. (1 9 3 8 ), pp. 8-9. 15 Fischer, Bank Holding Companies (1 9 6 1 ), p . 65. 17 “ Control and Regulation o f Bank Holding Companies,” Hearings Before the Committee on Banking and Currency, House o f Rep resentatives, 82nd Cong., 2d Sess., on H .R . 6504 (1 9 5 2 ), pp. 9-10 (emphasis added). 5 Board. A “ bank holding company” was defined as any corporation, business trust, association or similar organization controlling 25 percent or more of the voting shares or the election of a majority of di rectors of each of two or more banks. Any com pany meeting this definition was required to divest its interest in every business other than that of In determining whether to approve any acquisition . . . consideration shall be given to the financial history and condition of the applicant and the banks concerned; their prospects; the character of their management; the convenience, needs, and welfare of the communities and the area concerned, and the national policy against restra in t o f trade and undue concentration o f econom ic p ow er and in fa v o r o f the m aintenance o f com petition in the field o f banking.™ managing or controlling banks, with certain limited In addition, every such company was Although the Senate Banking and Currency Com required to register with the Board and to obtain mittee reported the 1947 bill out favorably, no fur its prior approval before acquiring control of more ther action was taken. than five percent of the voting shares of any bank.18 “ Declaration of Policy” was introduced in 1950, and The Federal and state branch banking statutes the italicized portion quoted above referring to na were supplemented by a provision written into the tional antitrust policy was omitted. In its place were exceptions. A similar bill without the Act prohibiting the Board from approving any ac substituted the words “ . . . whether or not the effect quisition of any interest in any bank outside of the of such acquisition may be to expand the size and state in which the acquiring bank holding company extent of a bank holding company system beyond maintains its principal place of business or conducts limits consistent with adequate and sound banking its principal operations unless specifically authorized by statute in the acquired bank’s home state.19 Ten and the public interest. . . years later this provision was further restricted by an amendment limiting an acquiring bank holding guide the Board in ruling upon proposed acquisitions company to acquisitions within the state in which same ones incorporated into the 1947 bill, as modi the operations fied in 1950. of its banking subsidiaries were The criteria finally selected in the 1956 A ct to of banks by holding companies were substantially the It turned out, however, that this sub principally conducted on the date on which it be stitute was unsatisfactory and unworkable in practice, came a bank holding company or on the date of the as the Board recognized in a report to Congress in 1958 only two years after the A ct went into effect. amendment, whichever is later.20 Criteria for Approving Bank Acquisitions P re facing a proposed 1947 bank holding company bill was a “ Declaration of Policy” asserting, among other things, that . . . all of the provisions of this Act shall be in terpreted to control the creation and expansion of bank holding companies; to separate their business of managing and controlling banks from unrelated businesses; and g en erally to maintain com petition am ong banks and to minimize the d anger inherent in concentration o f econom ic pow er through cen tralized control o f banks . . . . T o further the objectives of this policy declaration, the following standards were written into the Act to guide the Board of Governors in considering pro posed acquisitions of banks by bank holding com panies : 18 Exceptions to this prohibition were written into the A ct for voting shares of banks held by a bank (1 ) in a fiduciary capacity, unless held for the benefit of the shareholders o f the fiduciary bank, (2 ) to collect a debt previously contracted in good faith, provided the shares were disposed of within two years from the date on which they were acquired, and (3 ) for additional shares acquired by a bank holding company in a bank in which such bank holding com pany owned or controlled a m ajority o f voting shares prior to such acquisition. 19 70 Stat. 115 (1 9 5 6 ). 20 80 Stat. 237 (1 9 6 6 ). 6 Commenting on its experience in attempting to dis tinguish permissible from prohibited acquisitions during the first two years, the Board told Con gress, in p art: As guides for the exercise of the Board’s judg ment in passing on applications, the first three of these statutory factors present little difficulty . . . . To a large extent this is also true of the fourth factor, relating to the convenience, needs and welfare of the communities and area con cerned. The factor which has given rise to the greatest difficulty is the fifth— that relating to whether the proposed transaction would expend the “ size or extent” of the holding company system “ beyond limits consistent with adequate and sound banking, the public interest, and the preservation of competition in the field of banking.” The major problem has been the difficulty of balancing considerations affecting competition and the public interest under the fifth factor and those affecting convenience and needs under the fourth factor. Even so, and although they were substantially re placed in 1966, the 1956 standards at least provided an interim statutory framework for regulating bank 21 “ Providing for Control and Regulation o f Bank Holding Com panies,” Hearings Before the Committee on Banking and Currency, United States Senate, 80th Cong., 1st Sess. on S. 829 (1 9 4 7 ), p. 9 (em phasis added). holding company growth during a decade of rapid relationship and profound antitrust change. mercial banking. N o one, except per to the traditional business of com haps the Supreme Court, could have said with any confidence just how much lessening of competition Congress reacted in 1970 with important new legislation brin gin g one-bank h olding com panies would be required for a bank acquisition to violate under regulation. In addition, antitrust prohibitions applicable to reciprocity and tying arrangements either the Sherman or the Clayton Act prior to the As for conglomerate acquisitions of were specifically applied to all insured banks and to nonbank businesses by bank holding companies, bank holding companies. A t the same time, the pro early 1960’s. antitrust tests simply did not exist at that time. But by 1966, as a result of a series of Supreme visions of the Bank Holding Company Act govern ing entry by all types of such companies into new Court decisions beginning with the Philadelphia areas were substantially changed. Bank22 opinion in 1963, a different antitrust environ 1966, antitrust principles governing corporate mer Meanwhile, in ment had come into being. And by 1968, a changed gers and acquisitions had been substituted for the economic environment caused hundreds of leading original five “ banking factor” criteria for approving commercial banks with billions of dollars in deposits bank acquisitions written into the Act in 1956. These or The 1966 and 1970 amendments, which have had the restrictions of the the effect of substantially merging antitrust and bank Bank Holding Company Act, immediately began holding company methods of regulation in the com mercial banking industry, will be discussed in the to organize one-bank holding companies. ganizations, exempt from entering or announcing plans to enter a variety of new business areas, some having little direct next two parts of the article, to appear in the March 2- U .S . v. Philadelphia National Bank, 374 U .S . 321 and April issues of the Monthly Review. William F. Upshaw (1 9 6 3 ). 7 FORECASTS 1971 Recovery in Sight? Forecasting the economy’s performance for the coming year is a difficult task, and all too often the forecasts prove to be less accurate than the predictor may have desired. For example, in the waning months of 1969, few if any of the seers incorporated a protracted automobile strike in their projections. But, as is well known, the strike had widespread and significant effects upon the economy. The estimates of the quarter-by-quarter change in G N P had been reasonably accurate until effects of the General Motors strike began to appear, but then the fore casting error began to mount. In general, last year’s forecasts might be summed up as having been accurate with respect to the di rection of the economy, if not to the magnitude of its changes. The only exception to this evaluation is the rate of price increase, which was expected to slow. The forecasters thought that slackening con ditions in labor and product markets would be re flected in a smaller rate of increase in prices. Some slowing of price inflation did occur in the second half of 1970, but the implicit price deflator— the price index for G N P — in 1970 ended up showing a higher growth rate than in 1969. This year forecasters are aware of the possibility of some major strikes during 1971, and most note that the threat of a steel strike will affect the economy even if the strike does not materialize. Many expect an abatement of inflationary forces during 1971 notwithstanding the continuation of strong cost-push pressures. Also, 1971 is expected to be a year of significant recovery for the construc tion industry. The impetus to general economic re covery is expected to come from that industry, from state and local government spending, and from con sumer spending. Capital outlays and Federal Gov ernment expenditures are expected to contribute little to economic growth in 1971. The consensus of forecasts examined in this article indicates a 1971 G N P of around $1,050 billion. Based upon current Department of Commerce esti mates for 1970 G N P, this figure would represent a gain of approximately 7.5% , which is greater than the 4.9% rate in 1970. Economists are predicting a rather large jump in current dollar G N P during the first quarter of 1971. This gain is expected to result partly from consumer purchases of durable goods deferred from the last quarter of 1970 because of the automobile strike. Also, adding to the gain will be business inventory accumulation because of a re plenishment of automobile dealer stocks and a build up of steel stocks in anticipation of a possible strike in that industry. None of the forecasters expects an end to inflation in 1971, but many think that its rate of growth will be slightly less in the fourth quarter than in the first. The 1971 forecasts summarized here represent the best efforts of business and academic economists during the autumn and winter of 1970 to predict the performance of the U. S. economy in 1971. This article attempts to convey the general tone and pat tern of some 50 forecasts reviewed by the Research Department of this Bank. Not all of them are com prehensive forecasts, and some incorporate estimates of the future behavior of only a few key economic indicators. Several represent group rather than in dividual efforts. The views and opinions set forth in this article are those of the various forecasters. ATo agreement or endorsement by this Bank is implied. 1970 Forecasts in Perspective A year ago m ost projections of current dollar G N P for 1970 centered around $986.5 billion, an increase of 5.8% over 1969. The forecasts ranged from a low of $966 billion to a high of $990 billion. After allowing for expected price increases, the growth of real G N P was pre dicted to account for about one-third of the 5.8% rise. Latest estimates by the Department of Com merce indicate a 1970 G N P total of $976.8 billion, which is well within the range of our forecasters. Compared to 1969, wrhen the seers had predicted a G N P of around $912 to $915 billion and the eco nomic aggregate actually totaled $931.4 billion, 1970 was a banner year for forecasters. The most fre quent estimates for 1970 G N P, however, were a good deal larger than the actual G N P recorded; so 1970 could only be called a “ banner year” when compared RESULTS FOR 1970 A N D TYPICAL FORECAST FOR 1971 Unit or Base Estimated Forecast 1971* 1970 Percentage Change 1969/ 1970/ 1971 1970 Gross national product _________________________ Personal consumption expenditures _________ Government purchases of goods and services .... Gross private domestic investment ___________ Net exports of goods and services ___________ $ $ $ $ $ billions billions billions billions billions 976.8 617.2 220.5 135.4 3.7 1,049.6 663.4 233.9 145.0 4.5 6.9 6.9 3.9 — 3.1 7.4 7.5 6.1 7.1 .... .... New plant and equipment expenditures _________ Change in business inventories ________________ Corporate profits before taxes __________________ New construction put in place _________________ $ $ $ $ billions billions billions billions 80.4 3.2 82.6 91.4 80.8 5.2 89.2 98.7 6.6 0.5 — 9.4 0.5 8.0 8.0 Private housing starts _________________________ Domestic automobile sales _____________________ Rate of unemployment _________________________ millions millions per cent 1.43 7.2 5.0 1.70 8.5 5.5 — 2.7 — 14.9 19.0 18.0 Industrial production index _____________________ Wholesale price index __________________________ Consumer price index _________________________ Implicit price deflator __________________________ 1957-1959 1957-1959 1957-1959 1958 167.6 117.1 135.3 134.8 173.5 119.4 140.5 139.6 — 3.0 3.6 6.0 5.3 _ — — 3.6 2.0 4.0 3.6 * F igures are con stru cted from the typical percentage ch ange foreca sted for 1971. with the poor 1969 performance. If there had been no automobile strike during the fall, 1970 might indeed have been a memorable forecasting year. The consensus of the quarter-by-quarter forecasts for 1970 was that G N P was expected to rise by ap proximately $10 billion during the first quarter. $10.5 billion in the second, $14 billion in the third, and $16 billion in the fourth. G N P actually in creased $7.8 billion in the first quarter, $11.6 billion in the second, $14.4 billion in the third, and between $5 billion and $6 billion in the fourth. The average predicted increase for the first three quarters of 1970 was $11.5 billion, compared to an actual average increase of $11.3 billion. Compared to past per formances, therefore, their estimates for current dol lar G N P were close indeed. Unfortunately, the forecasts for G N P measured in 1958 dollars were less accurate. The predictors thought that prices would rise from 4 % to 4.5% over the year. In fact, the implicit price deflator for G N P rose 5.3% over the course of the year. In contrast to the predicted moderate slowing from the 4.7% increase during 1969, the inflation rate for the year was moderately higher than in 1969. In any event, G N P measured in 1958 dollars is now expected to total $724.7 billion for 1970. This figure represents a decrease of 0.4% from the 1969 total. It might be noted that the forecasters have rather substantially underestimated the rate of price increase in each of the last three years. The estimates of the various components of G N P, as well as other important economic indicators which were projected for 1970, generally reflected a ten dency to underestimate the slowing of the economy from its 1969 pace. The rate of unemployment, pre dicted to average 4.3% to 4.5% for the year, was actually 5.5% . Gross private domestic investment was expected to increase by 4 % to about $145 or $146 billion ; it actually fell by approximately 3% to $135.4 billion. The estimators’ over-optimism with respect to the 1970 performance of construction and inventory investment accounted for most of their error in the investment sector. On the consumer side, 1970 personal consumption expenditures were expected to be around $614 bil lion, but they appear now to have totaled $617.2 billion. Personal consumption was one of the few aggregate series that was underestim ated. T he 9 underestimate cannot be easily rationalized since d o mestic automobile sales, which account for a signi ficant proportion of consumer expenditures, were substantially overestimated. They were expected to total around 8 million units in 1970, but current indications are that they will total 7.2 million. The consumer price index rose over 6 % from its 1969 average, which was higher than the average forecast of a 5% rise. The forecasters also tended to underestimate the slowing of the business sector of the economy. The index of industrial production, which was predicted to average between 172 and 173 for the year, actually dropped to an average of 167.6. Corporate profits before taxes dropped 9.4% to $82.6 billion in 1970— again well below the estimated range of $90 to $91 billion. Apparently, almost all of last year’s forecasters underestimated the extent of the downturn in the economy and expected inflation to subside more than it did. W ith respect to the two economic goals of price stability and full employment, it is un fortunate that the predictions were not realized. THE 1971 FORECASTS IN BRIEF G ro ss N ation al Product Forecasts for 1971 G N P are concentrated around $1,050 billion. This esti mate represents an approximate 7.4% yearly gain, somewhat more than the 4.9% advance registered for 1970. The forecasts range from a low of $1,031 billion to a high of $1,059 billion. Price rises are expected to account for about half of the anticipated increase in current dollar G N P. Most of those who made quarterly forecasts expect G N P, measured at seasonally adjusted rates, to increase by almost $30 billion during the first quarter, $20 billion in the second, $17 billion in the third, and $18 billion in the fourth quarter. As a rule, personal consumption expenditures are estimated around $663.5 billion. This represents an increase of 7.5% , which is somewhat more than the 6.9% increase registered during 1970. Government purchases of goods and services are expected to total $234 billion. This increase of approximately 6 % is again projected to be larger than the 1970 gain of 3.9% . The forecasters expect a further decline in defense spending, but they think that other Federal Government expenditures will rise enough to offset the decline. State and local government expendi tures, on the other hand, are predicted to be one of the strongest sectors of the economy in the coming year, mainly because of anticipated improvements in the capital markets. Gross private domestic investment is expected to rise by about 7.1% to $145 billion, which is a sub10FRASER Digitized for TYPICAL* QUARTERLY FORECAST FOR 1971 Q u a rte r-b y -Q u a rte r Ch anges in B illio n s U n le s s O t h e r w is e of D o lla r s N o te d I II III IV G ross N ational P rod u ct 29.5 20.0 17.0 18.2 P erson a l C on su m p tion E xp end itu res 18.5 10.9 12.0 11.0 G ross Private D om estic In vestm en t 7.1 3.4 0.0 4.0 N et E x p orts 0.0 0.0 0.0 0.2 G overn m en t P u rch ases 3.2 3.0 3.5 3.3 3.9 3.5 3.4 3.1 Im p licit P rice D e fla t o r f * M edian. f P ercen ta ge ch anges at annual rates. stantial improvement over the 3.1% decline during 1970. Plant and equipment spending is projected to remain almost unchanged, but the overwhelming ma jority of forecasters expect construction spending to show a rapid recovery from the depressed conditions of the past two years. Construction, therefore, will combine with increased business inventory invest ment to offset the rather lackluster spending pace predicted for producers’ durable goods. It should be mentioned that no clear consensus emerged for investment spending. In the case of gross private domestic investment, the estimates most often clustered between 6.6% and 7.4% , but the median estimate was that it would rise by 7.4% . Moreover, the estimates ranged widely from a 4.3% to an 11.4% rate of increase. Likewise, even though more plant and equipment spending forecasts fell in the zero to 1% range than in any other range of equal magnitude, the median estimate called for an increase of 2 % . The predictions ranged widely, from a decline of 4% to an increase of 7.7% . Esti mates for inventory investment show even less of a consensus. It was most often estimated to be be tween $5 and $5.5 billion. The median estimate was $6 billion, however, and the figures cited by our group of forecasters ranged between $3 billion and $11.1 billion. In d u strial Production M ost predictions call for the Federal Reserve index of industrial production (19 57 -5 9= 10 0) during 1971. to average around 173 or 174 This estimate represents a 3.5% in crease in the index, compared to the actual decline of 3% on record for 1970. The forecasters expect a recovery in automobile production from the strikeaffected conditions of 1970 as well as an expansion in the production of other consumer durables. Several of the forecasters think that the threat of a steel strike will cause forward building of steel inventories during the first half of 1971. Many of them, however, seemed to believe that a major work stoppage in that industry would be avoided. Construction The value of new construction put in place is expected to total $98 to $99 billion in 1971, an increase of around 8 % over 1970. Both residential and nonresidential construction outlays are expected to show the effects of the recovery in the construction industry. Private housing starts are commonly expected to rise almost 20% to a total of 1.7 million units. Forecasters usually base their pre dictions for a recovery in the construction industry upon greater availability of funds in the mortgage market combined with pent-up demands engendered during the last couple of years. New Plant and Equipment M ost of the fore casts indicate that firms will spend $80.8 billion for plant and equipment during 1971. This forecast is for almost no increase in expenditures over the $80.4 billion totaled in 1970 and represents a substantially smaller growth rate than the 6.6% recorded during 1970. The low estimate for 1971 seems to stem from the generally bearish investment plans of private businesses. Corporate Profits Forecasters are far from unanimous about the future for corporate profits, and the predictions for the growth of profits before taxes range from 5% to 15%. Most of the esti mates, however, are in the neighborhood of 8 % growth, which would raise the total to $89.2 billion for the year. Such a growth of corporate profits would suggest a sizeable increase over the 9.4% de cline which corporate profits recorded in 1970. Profits after taxes are also expected to show an 8 % growth rate to $48 billion. Since most forecasters estimate either before-tax profits or after-tax profits, very little can be inferred about their assessment of corporate tax liabilities in 1971. Unemployment T h e unem ploym ent rate is pro jected to average 5.5% by most of the observers of the 1971 scene, and the forecasts range between 4.8% and 6.1% . Since the unemployment rate reached a high of 6 % in December to average 5% for the year, our forecasters are predicting some downward move ment in the unemployment rate during 1971. Prices This year nearly all o f our forecasters are predicting some moderation in the rate of in flation. The most common prediction is that the implicit price deflator for G N P will increase by only 3.6% — well below the 5.2% increase of last year. The most pessimistic of our forecasters predicts an an increase of only 4 % . The consumer price index is generally expected to rise by almost 4 % during the year. Estimates for the increase in this index ranged from 3% to 4.6% . Wholesale prices are ex pected to increase by a smaller amount, approxi mately 2 % , during the year. Quarterly Forecasts Eleven of our forecasters made quarter-by-quarter predictions for the 1971 econ om y; the details of their forecasts are sum marized in the quarterly table. They call for a relatively rapid rate of growth for G N P during the first quarter attributable mainly to recovery from the automobile strike, some slight tapering off during the second and third, and a slight acceleration again during the fourth quarter. Prices are expected to rise somewhat less in the fourth quarter than in the other three, but always at a more moderate annual rate than in 1970. Summary The econ om y slow ed considerably more than anticipated during 1970. This slowing, however, was accompanied by a faster rate of infla tion than had been anticipated. Prices actually ac counted for the entire increase in current dollar G N P during 1970. The 1971 consensus is for a resumption of growth in real G N P, some abatement of inflation, and a decline in the unemployment rate from its fourth quarter 1970 level. This year the forecasts might be called “ cautiously optimistic,” and most of the experts think that 1971 will be a better year for business than 1970, but not startlingly so. William E. Cullison A compilation of forecasts in booklet form, with names and details of estimates, may be obtained from the Federal Reserve Bank of Richmond. 11 The Supply of Money in the United States Part II — The Monetary Framework Part I of this essay sum m arized som e o f the principal institutions and events that have been in strumental in shaping control over the money supply in the United States. This section examines the more important technical factors and processes that generate change in the U. S. money stock at the present time.1 High-Powered Money T h e units of m oney in common use are the final products of a refined technical operation. Tw o different industries com bine and coordinate resources and raw materials to generate the dollars that compose this product. The primary industry is the central bank. It produces what is sometimes known as high-powered money ( H P M ) , which consists of (1 ) currency and (2 ) commercial bank reserve accounts in the central bank. These components make up the base on which the actual money supply of hand-to-hand currency and demand deposits is formed. Most currency is a part of the actual money supply, but it also may be held by banks as reserves on which demand de posits are expanded.2 Tw o institutions, other than the gold and silver industries, have furnished the monetary system with H P M in the past. First, the Treasury Department at various times printed paper currency (e.g., U. S. notes, Treasury notes, and silver certificates) when authorized to do so by Congress. During the late nineteeth and early twentieth centuries it also ma nipulated its deposit balances in national banks as a part of deliberate policy to increase and decrease bank reserves at different seasons of the year. Since 1914, the Federal Reserve System has been the more prominent institution for furnishing H P M . It issues Federal Reserve notes and maintains the reserve (or deposit) accounts of member banks. The Treasury still has some outstanding currency in the 1 Much o f the following discussion on high-powered money and the two determining ratios are presented in greater depth in Philip Cagan, D eterm inants and E ffe c ts o f Changes in the Stock o f M oney, 1875-1960, N B E R , Columbia U niversity Press, 1965. 2 The total stock of H PM as of June 30, 1970 was $80.0 billion. This total consisted of (1 ) member bank reserve accounts with Fed eral Reserve Banks— $22.2 billion; (2) Federal Reserve notes out standing— $50.6 billion; and (3 ) Treasury currency outstanding-— $7.2 billion. The defined narrow stock o f money was $222 billion, consisting of $172 billion private demand deposits adjusted for inter bank holdings and $50 billion o f currency held outside commercial banks and the Federal government. 12 form of silver certificates and fractional coin, and it still has substantial balances (tax and loan accounts) with commercial banks. However, the Federal R e serve System has taken over most of the currencyissuing job, and member bank deposits in Federal Reserve Banks have been substituted for the specie reserves that used to be held by the banks themselves. Both the central bank and the Treasury may carry out seasonal policies with H P M but only the central bank can provide year-to-year (secular) in creases in this basic stock. W here the Treasury must rely on bank reserves already in existence to change its balances at commercial banks, the Federal Reserve System creates H P M from scratch by buy ing government securities or acquiring other assets. The final payment for the securities takes the form either of an issue of Federal Reserve notes or of a new credit to the reserve accounts of member banks. Both of these items are counted as liabilities of Fed eral Reserve Banks, and both of them are H P M . Once H P M has been created by the central bank, its final monetary effect depends on its route through the second of the two money-generating industries — the commercial banking system. Most Federal Reserve notes are channeled through commercial banks to become a part of hand-to-hand currency. However, commercial banks keep about 10 percent of these notes as reserves in addition to their deposit reserve accounts in the central bank. The Currency-Deposit Ratio In addition to the quantity of H P M , two ratios have an important influence in determining the ultimate quantity of money. One is the ratio of currency to demand deposits expressed as that households and business firms wish to maintain. This ratio is a function of technical factors, such as checking facilities available to the nonbank public. It also depends on such behavioral factors as trust or mistrust of banks, desire to avoid inflation or evade taxes, black market activities, and the extent of personal travel. Given the total amount of the H P M base, the narrow money supply (defined in footnote 2 ) is larger when the currency-deposit ratio is smaller, and vice versa. For example, let this ratio be one-to-five at some point in time. Then assume that households and business firms experience some change in preferences that prompts them to main tain a ratio of only one dollar in currency to six dollars in checkbook balances, and let them deposit some of their currency in commercial banks in order to achieve this new ratio. The net effect of currency deposited in the banks is to give the banks excess reserves. If the central bank holds constant the stock of H P M , that is, if it does nothing to offset the additional currency in the commercial banks, these banks now have the means to expand credit on the asset side and deposits on the liability side. The volume of deposits then increases by the amount of excess reserves times the inverse of the average ratio of reserves to demand deposits maintained by the commercial banking system. Thus, a unit of H P M held as hand-to-hand currency by the nonbank public has much less monetary influence than the same dollar held as a reserve unit in a commercial bank. The Reserve-Deposit Ratio T h e second of the two determining ratios is largely a function of central bank policy. It is the ratio of all banks’ reserves to their total demand deposits. It may be expressed as where R is the dollar volume of commercial bank reserves held against demand deposits and Da is the dollar value of demand deposits. Generally, the banks make loans and investments until the actual ratio is reduced to the legal minimum ratio required by law. By increasing earning assets and thereby re ducing this ratio, banks maximize the earnings po tential of their portfolios. The minimum required ratio varies from one bank classification to another and between state banks and member banks of the Federal Reserve System. R e serve requirements for state chartered banks are subject to state laws. W hile these laws may be very different one from another, they generally specify reserve requirements in terms of vault cash (cur rency), deposits in “ other” banks— usually member banks of the Federal Reserve System— and “ ap proved” government securities. The “ approved” se curities are limited issues of state or Federal govern imposed by the Federal Reserve System on member banks indirectly restrict creation of state bank de posits as well. For the commercial banking system as a whole, some ratio of total reserves to total deposits exists at any given moment. If the quantity of H P M and the value of the currency-deposit ratio mentioned above are already determined, the volume of demand deposits (and also the total stock of money) is greater when the reserve-deposit ratio is lower and smaller when this ratio is higher. These three basic parameters define an unadjusted money stock. However, several factors involving monetary accounting and classification must be disposed of before the narrow stock of money is obtained. Accounting Issues in Classifying the Stock of Money One item to be considered is interbank demand deposits— deposits to the credit of one bank and accounted as a liability by another bank. A c cording to current Federal Reserve regulation, a commercial member bank that makes such a deposit in another member bank may deduct this amount from the total of its own demand deposits subject to reserve requirements. Even though the recipient bank must keep reserves against these deposits, the net effect is to exempt the member banking system as a whole from maintaining reserves against inter bank deposits. If this allowance were not made— if reserve requirements were in full force against inter bank deposits— an increase in this item would di minish the measured narrow money supply even though gross demand deposits remained constant. A s it is, the reserve allowance permits an increase in interbank deposits with no corresponding decrease required in deposits held by the nonbank public, foreigners, or the government. Member interbank deposits, therefore, neither absorb reserves nor are a part of a classified money stock. Another difficulty, one which cannot be handled so readily, is the fact that both time and demand deposits require reserves. Therefore, reserves held against time deposits in commercial banks must be deducted from total reserves in order to count the amount of reserves that can be used to expand de mand deposits. Time deposits raise yet another problem. Since interest is paid on them, they are in competition with a whole complex of interest-earning assets in fi ment securities bearing relatively low rates of in nancial markets. terest. mercial banks is subject to interest rate effects and Most of the reserves maintained by these Therefore, their creation by com banks, however, are interbank deposits with mem interactions of demands and supplies of other fi ber banks; so the reserve requirement limitations nancial assets. These feedbacks may alter the re 13 serves available for demand deposit creation, so that interest rates on financial assets may have some in direct bearing on the volume of demand deposits. This influence is so roundabout that it is difficult to measure. The opinion here is that it is visible but of low significance. Dollar demand deposits held by foreigners in U. S. commercial banks also require an accounting pigeon hole. These deposits absorb reserves just as any other deposits do. Since they may be used to buy goods and services produced in the United States and are largely behavioral, they are included in the narrowly defined money supply. The Federal government also has demand de posit balances in commercial banks, as well as vault cash (currency) in government offices, and deposit accounts with Federal Reserve Banks. The latter two of these three items remain relatively constant, but the tax and loan accounts at commercial banks are another matter. W hile subject to reserve re quirements, they are not usually counted as a part of the narrowly defined stock of money. The gov ernment is assumed to carry out policies and make decisions that require spending without regard to its cash balance holdings. Only money held by private households and business firms can influence (or be influenced b y ) individual behavior. H ow ever, classifying the money supply to include or exclude government balances is purely arbitrary. It can be done either way. The way it is done should depend on the function of the money supply so classified. Short-Run Effects of Treasury Balances T he ability of the Treasury to create H P M has become GENESIS OF THE M O N EY SUPPLY TOTAL D E M A N D DEPOSITS H A N D -T O -H A N D CURRENCY Demand deposits held by households and business firms r "'1 i i i Seasonal fiscal policies ii ii i i i r~ i i*' *i i 1 i i i i Currency deposit ratio i i— Treasury deposits Currency held by households and business firms Foreign deposits I Interbank deposits <&:**_ j TIME DEPOSITS Member bank reserves (deposits) with Federal Reserve Banks Currency issued by Treasury and Federal Reserve System Other reserves of nonmember banks ALL C O M M ERCIA L BA N KS 7 Interest rate complex \ Mem ber bank deposits in Federal Reserve Banks Treasury currency outstanding Federal Reserve notes outstanding HIGH-PO W ERED M O N E Y 14 negligible. Its fiscal powers of taxing and spending, however, cause the balances it keeps in commercial banks to fluctuate widely. These balances average about $6 billion, but their month-to-month variation is often $2 billion and is sometimes more than $4 billion due to a lack of synchronization between federal tax receipts and disbursements. Since none of the government’s cash holdings is created by the Treasury, increases and decreases in government balances must be reciprocated by corresponding de creases and increases in the money holdings of house holds and business firms in the private economy. Sometimes, the change of the month-to-month money supply in the private economy from this source is larger than the annual secular change due to Federal Reserve policy effects either on H P M or on the reserve-deposit ratio. This datum emphasizes that the Treasury’s short-run influence on the private money stock is frequently massive. Figure 1, in which some nonmonetary details are condensed, gives a schematic view of the whole money-generating process. H P M originating in the Federal Reserve System (and to some extent in the Treasury) is channeled through commercial banks to become either hand-to-hand currency or bank re serves. The currency-deposit and reserve-deposit ratios establish the ultimate amounts of deposits and currency that will be generated as well as the total of both. Offstage, a complex of interest rates in the money market has some possible effects on total time deposits created, and thus on the total of de mand deposits. Seasonal fiscal policies, finally, are seen defining the short-run volume of Treasury de posits held in the aggregate of total demand deposits. Richard H . Timberlake, Jr. 15
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