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FEDERAL RESERVE^BANK OF RICHMOND

MONTHLY
REVIEW
The Basis for Lasting Prosperity
Farm Capital and Credit Trends
in Virginia
The Supply of Money in the
United States




The Basis For Lasting Prosperity
Remarks by

ARTHUR F. BURNS
Chairman of the Board of Governors of the Federal Reserve System
In the Pepperdine College Great Issues Series
Los Angeles, California, December 7, 1970

Nearly three years ago, in a talk here in Los
Angeles, I pointed out that once an economy be­
comes engulfed by inflation, economic policy makers
no longer have any good choices. T o regain a last­
ing prosperity, a nation must have the good sense
and fortitude to come to grips with inflation. There
is, however, no painless way of getting rid of the
injustices, inefficiency, and international complica­
tions that normally accompany an inflation.
Events of the past several years have lent poi­
gnancy to these simple truths. Recent experience
has demonstrated once again that the transition from
an overheated economy to an economy of stable
markets is a difficult process. Elimination of excess
demand was an essential first step to the restoration
of stability, but this step has brought with it a period
of sluggish economic activity, slow income growth,
and rising unemployment. And while we have made
some progress in moderating the rate of inflation,
our people are still seeing the real value of their
wages and savings eroded by rising prices.
The struggle to bring inflationary forces under
control, and to return our labor and capital resources
to reasonably full employment, is still going on. I
am convinced, however, that corrective adjustments
in the private sector over the past twelve to eighteen
months are creating, in conjunction with govern­
mental stabilization policies, the foundation on which
a prolonged and stable prosperity can be constructed.
A cardinal fact about the current economic situa­
tion, and one that promises well for our nation’s
future, is that the imprudent policies and practices
pursued by the business and financial community
during the latter half of the 1960’s are being replaced
by more sober and realistic economic judgments.
In my remarks to you today, I want first to review
some of the key developments that lead me to this
2




conclusion. Then I shall turn to the tasks that
must still be faced in order to enhance the prospects
for an early resumption of growth in production and
employment in an environment of reasonably stable
prices.
The current inflation got under way in 1964.
Perhaps the best single barometer of the extent to
which it served to distort economic decisions and
undermine the stability of the economy is found in
the behavior of financial markets during the late
1960’s. In 1968, well over 3 billion shares of stock
exchanged hands on the New Y ork Stock Exchange
— about two and one-half times the volume of five
years earlier. The prices of many stocks shot up­
ward with little reference to actual or potential earn­
ings.
During the two years 1967 and 1968, the
average price of a share of stock listed on the New
Y ork Exchange rose 40 per cent, while earnings of
the listed companies rose only 12 per cent. On the
American Exchange the average share price rose
during the same two years more than 140 per cent
on an earnings base that increased just 7 per cent.
A major source of the speculative ardor came
from some parts of the mutual fund industry. Long­
term investment in stocks of companies with proven
earnings records became an outmoded concept for
the new breed of “ go-go” funds. The “ smart money”
was to go into issues of technologically oriented
firms— no matter how they were meeting the test
of profitability, or into the corporate conglomerates
— no matter how eccentric their character.
This mood of speculative exuberance strongly re­
inforced the upsurge of corporate mergers which oc­
curred during the middle years of the 1960’s. No
doubt many of these mergers could be justified on
grounds of efficiency. But the financial history of
mergers— including some of the great conglomerates

— suggests that many businessmen became so pre­
occupied with acquiring new companies and pro­
moting the conglomerate image that they lost sight
of the primary business objective of seeking larger
profits through improved technology, marketing, and
management. W hen talented corporate executives
devote their finest hours to arranging speculative
maneuvers, the p roductivity of their businesses
inevitably suffers and so too does the n ation’s
productivity.
These speculative excesses had to end, and it is
fortunate that they ended before bringing disaster
to our nation. Equity values are now being ap­
praised more realistically than a year or two ago.
Investors are now more attentive to high quality
stocks. Indeed, many of them have discovered or
rediscovered that even bonds and time deposits are
a fit use of their funds. Not a few of those re­
sponsible for the frantic search for “ performance
stocks” have shifted to other activities or joined the
ranks of the unemployed; so also have numbers of
security analysts and stock brokers. W ith specula­
tion giving way to longer-term investment, the stock
market is now channeling risk capital to business
firms more efficiently.
A searching reappraisal of the economic philosophy
of mergers is also underway. Merger activity has
slowed materially since m id-1969. T o some degree
this is a response to the growing concern in govern­
mental circles over the dangers that may inhere in
large concentrations of economic power. But it
stems mainly from the fact that businessmen are
recognizing that time and energy can usually be
spent more productively in searching for ways to
increase the economic efficiency of their firm than
in a scramble for corporate acquisitions.

1964 and m id-1970, as an increasing number of
firms— some of them with questionable credit stand­
ings— began to tap this market. The hazards in­
herent in the spreading reliance on commercial paper
were taken much too lightly. After all, the relations
between the buyer and seller of commercial paper
are by their very nature distant and impersonal— un­
like the close working relationship that normally
develops between a bank and its business customers.
The buyer— typically an industrial enterprise—
rarely has the facilities or the experience to carry
out a full investigation of the risks attaching to com ­
mercial paper. Moreover, the buyer regards his in­
vestment as temporary— to be withdrawn when cash
is needed or when questions arise about the quality
of the paper. The issuer, therefore, faces considerable
uncertainty as to the amount of his maturing obliga­
tions that may be renewed on any given day. The
risks facing the individual issuer and buyer in­
evitably pose a problem also for the nation’s financial
system, since the difficulties experienced by any
large issuer of commercial paper may quickly spread
to others.
These familiar truths were lost sight of in the in­
flationary aura of the late 1960’s. It took the de­
velopments of last summer, when the threat of fi­
nancial crisis hung for a time over the commercial
paper market, to remind the business community
that time-honored principles of sound finance are
still relevant.
A s a result of that experience and the testing of
financial markets generally during the past two
years, corporate financial policies are now more con­
structive than in the recent past. This year, new
stock issues have continued at a high level— even
in the face of unreceptive markets— as corporations
have sought to stem the rise in debt-equity ratios.
O f late, borrowing by corporations has been con ­
centrated in long-term debt issues, and their rate
of accumulation of liquid assets has risen. Liquidity
positions of industrial and commercial firms are thus
improving, though it will take some time yet to
rectify fully the mistakes of the past.

Businessmen are also reconsidering the wisdom
of financial practices that distorted their balance
sheets during the late 1960’s. In the manufacturing
sector, the ratio of debt to equity— which had been
approximately stable during the previous decade—
began rising in 1964 and was half again as large
by 1970. Liquid asset holdings of corporate busi­
nesses were trimmed to the bone. On the average,
the ratio of prime liquid assets to current liabilities
fell by nearly half during those six years. In per­
mitting such a drastic decline in liquidity, many of
our corporations openly courted trouble.

These efforts to restore sound business finances
are not without costs to the nation. For example,
long-term interest rates, while below their peaks at
the end of last year or last spring, are still at un­
usually high levels because of this year’s extra­

Perhaps the most ominous source of instability
produced by these financial practices was the huge
expansion of the commercial paper market. The
volume of commercial paper issued by nonfinancial
businesses increased eightfold between the end of

ordinary volume of new capital issues. But there
can be no doubt that substantial adjustments in the
financial practices of our nation’s businesses were
essential if the basis for a lasting and stable pros­
perity was to be reestablished.




3

By and large, our major financial institutions con ­
ducted themselves with prudence during the years
when lax practices were spreading in financial
markets. There were, however, some individual in­
stitutions that overextended loan commitments rela­
tive to their resources, others that reduced liquidity
positions to unduly low levels, still others that per­
mitted a gradual deterioration in the quality of loan
portfolios, and even a few that used funds of de­
positors to speculate in long-term municipal se­
curities. Fortunately, such institutions were dis­
tinctly in the minority. When the chips were down,
our major financial institutions proved to be strong
and resilient. And they are stronger today. As
monetary policy has eased, the liquidity of com ­
mercial banks has been increasing. Even so, loan
applications are being screened with greater care.
The emphasis on investment quality has also in­
creased at other financial institutions, as is evidenced
by the recent wide spread between the yields of high
and lower grade bonds.
These corrective adjustments in private financial
practices have materially improved the prospects for
maintaining order and stability in financial markets.
But no less important to the establishment of a solid
base for a stable and lasting prosperity have been
the developments this year in the management of
the industrial and commercial aspects of business
enterprise.
During the latter half of the 1960’s, business
profit margins came under severe pressure.
The
ratio of profits after taxes to income originating in
corporations had experienced a prolonged rise during
the period of price stability in the early 1960’s. But
this vital ratio declined rather steadily from the last
quarter of 1965 and this year reached its lowest
point of the entire postwar period.
Until the autumn of 1969 or thereabouts, the de­
cline in profit margins was widely ignored. This is
one of the great perils of inflation. Underlying eco­
nomic developments tend to be masked by rising
prices and the state of euphoria that comes to prevade
the business community.
Though profit margins
were falling and the cost of external funds was rising
to astonishing levels, the upward surge of investment
in business fixed capital continued. True, much of
this investment was undertaken in the interest of
economizing on labor costs.

Simultaneously, how­

inflationary developments would one way or another
validate almost any business judgment. W hile the
toll in economic efficiency taken by these loose
managerial practices cannot be measured with pre­
cision, some notion of its significance can be gained
by observing changes in the growth rate of pro­
ductivity.
From 1947 through 1966, the average rate of ad­
vance in output per manhour in the private sector
of the economy was about 3 per cent per year. In
1967, the rate of advance slowed to under 2 per cent,
and gains in productivity ceased altogether from
about the middle of 1968 through the first quarter
of this year. The loss of output and the erosion
of savings that resulted from this slowdown in
productivity growth are frightfully high.
The elimination of excess demand, which the gov­
ernment’s anti-inflationary policies brought about, is
now forcing business firms to mend their ways. D e­
cisions with regard to production and investment
are no longer being made on the assumption that
price advances will rectify all but the most imprudent
business judgments. In the present environment of
intense competition in product markets, business
firms are weighing carefully the expected rate of re­
turn on capital outlays and the costs of financing.
The rate of investment in plant and equipment has
therefore flattened out. and advance indicators sug­
gest that business fixed investment will remain
moderate in 1971.
Business attitudes toward cost controls have of late
also changed dramatically. A cost-cutting process
that is more widespread and more intense than at
any time in the postwar period is now underway
in the business world. Advertising expenditures are
being curtailed, unprofitable lines of production dis­
continued, less efficient offices closed, and research
and development expenditures critically reappraised.
Layers of superfluous executive and supervisory per­
sonnel that were built up over a long period of lax
managerial practices are being eliminated. Reduc­
tions in employment have occurred among all classes
of workers— blue collar, white collar, and professional
workers alike. Indeed, employment of so-called n on­
production workers in manufacturing has shown a
decline since March that is unparalleled in the post­
war period.

ever, serious efforts to bring operating costs under

of stagnation.

developed on a large scale, huge wage increases were

output per manhour in the private nonfarm economy

granted with little resistance, and some business in­

rose at a 4 per cent annual rate, and the rate ad­

vestments were undertaken in the expectation that

vanced to 5 per cent in the third quarter.

|

Because of these vigorous efforts to cut costs, the
growth of productivity has resumed, after two years

control became more and more rare, labor hoarding

*

4




In the second quarter of this year,

These

I

productivity gains have served as a sharp brake on
the rise in unit labor costs, despite continued rapid
increases in wage rates.
In my judgment, these widespread changes in busi­
ness and financial practices are evidence that genuine
progress is being made in the long and arduous task
of bringing inflationary forces under control. W e
may now look forward with some confidence to a
future when decisions in the business and financial
community will be made more rationally, when
managerial talents will be concentrated more in­
tensively on efficiency in processes of production,
and when participants in financial markets will avoid
the speculative excesses of the recent past.
Let me invite your attention next to the role that
government policies have played this year in foster­
ing these and related adjustments in private policies
and practices.
The fundamental objective of monetary and fiscal
policies this year has been to maintain a climate in
which inflationary pressures would continue to
moderate, while providing sufficient stimulus to
guard against cumulative weakness in economic ac­
tivity. Inflationary expectations of businessmen and
consumers had to be dampened; the American people
had to be convinced that the government had no in­
tention of letting inflation run rampant. But it was
equally important to follow policies that would help
to cushion declines in industrial production stemming
from cutbacks in defense and reduced output of
business equipment, and to set the economy on a
course that would release the latent forces of ex­
pansion in our home-building industry and in state
and local government construction.
I believe we
have found this middle course for both fiscal and
monetary policy.
A substantial reduction in the degree of fiscal
restraint has been accomplished this year with the
phasing out of the income tax surcharge and the in­
crease in social security benefits. These sources of
stimulus provided support for consumer disposable
incomes and spending at a time when manufacturing
employment was declining and the length of the
work-week was being cut back.
I do not like, but I also am not deeply troubled,
by the deficit in the Federal budget during the cur­
rent fiscal year. If the deficit had originated in a new
explosion of governmental spending. I would fear
its inflationary consequences. This, however, is not
the present case. The deficit in fiscal 1971— though
it will prove appreciably larger than originally an­

ness of economic activity. The Federal budget is
thus cushioning the slowdown in the economy with­
out releasing a new inflationary wave. The Presi­
dent’s determination to keep spending under control
is heartening, particularly his plea last July for a
rigid legislative ceiling on expenditures that would
apply to both the Executive and the Congress. H ow ­
ever, pressures for much larger spending in fiscal
1972 are mounting and pose a threat to present
fiscal policy.
Monetary policy this year has also demonstrated,
I believe, that it could find a middle course between
the policy of extreme restraint followed in 1969 and
the policies of aggressive ease pursued in some earlier
years. Interest rates have come down, and liquidity
positions of banks, other financial institutions, and
nonfinancial businesses have been rebuilt— though not
by amounts that threaten a reemergence of excess
aggregate demand. A more tranquil atmosphere now
prevails in financial markets. Market participants
have come to realize that temporary stresses and
strains in financial markets could be alleviated with­
out resort to excessive rates of monetary expansion.
Growth of the money supply thus far this year—
averaging about a 5 y2 per cent annual rate— has
been rather high by historical standards. This is
not, however, an excessive rate for a period in which
precautionary demands for liquidity have at times
been quite strong.
The precautionary demands for liquidity that
were in evidence earlier in 1970 reflected to a large
degree the business and financial uncertainties on
which I have already commented. It was the clear
duty of the nation’s central bank to accommodate
such demands. O f particular importance were the
actions of the Federal Reserve in connection with
the commercial paper market last June. This market,
following the announcement on Sunday, June 21, of
the Penn Central’s petition for relief under the
Bankruptcy Act, posed a serious threat to financial
stability. The firm in question had large amounts of
maturing commercial paper that could not be re­
newed, and it could not obtain credit elsewhere. The
danger existed that a w ave of fear w ould pass
through the financial community, engulf other is­
suers of commercial paper, and cast doubt on a wide
range of other securities.
By Monday, June 22— the first business day fol­
lowing announcement of the bankruptcy petition—
the Federal Reserve had already taken the virtually
unprecedented step of advising the larger banks

ticipated— reflects in very large part the shortfall of

across the country that the discount window would

revenues that has accompanied the recent sluggish­

be available to help the banks meet unusual borrow­




5

ing requirements of firms that could not roll over
their maturing commercial paper. In addition, the
Board of Governors reviewed its regulations govern­
ing ceiling rates of interest on certificates of deposit,
and on June 23 announced a suspension of ceilings
in the maturity range in which most large certificates
of deposit are sold.
This action gave banks the
freedom to bid for funds in the market and make
loans available to necessitous borrowers.
A s a result of these prompt actions, a sigh of re­
lief passed through the financial and business com ­
munities. The actions, in themselves, did not pro­
vide automatic solutions to the many problems that
arose in the ensuing days and weeks. But the fi­
nancial community was reassured that the Federal
Reserve understood the seriousness of the situation,
and that it would stand ready to use its intellectual
and financial resources, as well as its instruments of
monetary policy, to assist the financial markets
through any period of stress. Confidence was thus
bolstered, with the country’s large banks playing
their part by mobilizing available funds to meet the
needs of sound borrowers caught temporarily in a
liquidity squeeze.
The role that confidence plays as a cornerstone
of the foundation for prosperity cannot, I think, be
overstressed.
Much has been done over recent
months by private businesses and by the government
to strengthen this foundation. If we ask what tasks
still lie ahead, the answer I believe must b e : full
restoration of confidence among consumers and
businessmen that inflationary pressures will con ­
tinue to moderate, while the awaited recovery in
production and employment becomes a reality.
The implications of this answer for the general
course of monetary and fiscal policies over the near
term seem to me clear. The thrust of monetary and
fiscal policies must be sufficiently stimulative to as­
sure a satisfactory recovery in production and em­
ployment. But we must be careful to avoid ex­
cessive monetary expansion or unduly stimulative
fiscal policies. Past experience indicates that efforts
to regain our full output potential overnight would
almost surely be self-defeating. The improvements in
productivity that we have struggled so hard to
achieve would be lost if we found ourselves engulfed
once again in the inflationary excesses that inevitably
occur in an overheated economy.

I have recommended on earlier occasions that the
Employment A ct of 1946 be amended to include
explicit reference to the objective of general price
stability. Such a change in that law will not, of
course, assure better economic policies. But it would
call the nation’s attention dramatically to the vital
role of reasonable price stability in the maintenance
of our national economic health.
A t the present time, governmental efforts to
achieve price stability continue to be thwarted by
the continuance of wage increases substantially in
excess of productivity gains. Unfortunately, the cor­
rective adjustments in wage settlements that are
needed to bring inflationary forces under control
have yet to occur. The inflation that we are still
experiencing is no longer due to excess demand.
It rests rather on the upward push of costs— mainly,
sharply rising wage rates.
W age increases have not moderated. The average
rate of increase of labor compensation per hour has
been about 7 per cent this year— roughly the same
as last year. Moreover, wage costs under new col­
lective bargaining contracts have actually been ac­
celerating despite the rise in unemployment. In the
third quarter of this year, major collective bargaining
agreements called for annual increases in wage rates
averaging 10 per cent over the life of the contract.
Negotiated settlements in the construction industry
during the same three months provided for wage in­
creases averaging 16 per cent over the life of the
contract, and 22 per cent in the first year of the
contract. N or is the end of this explosive round of
wage increases yet in sight. Next year, contracts
expire in such major industries as steel, aluminum,
copper, and cans. If contracts in those industries
are patterned on recent agreements in the construc­
tion industry— or, for that matter, in the trucking
and automobile industries— heavy upward pressures
on prices will continue.
I fully understand the frustration of workers who
have seen inflation erode the real value of past wage
increases. But it is clearly in the interest of labor
to recognize that economic recovery as well as the
battle against inflation will be impeded by wage
settlements that greatly exceed probable productivity
gains.

A s I look back on the latter years of the 1960’s,

In a society such as ours, which rightly values
full employment, monetary and fiscal tools are in­
adequate for dealing with sources of price inflation

and consider the havoc wrought by the inflation of

such as are plaguing us now— that is, pressures on

that period, I am convinced that we as a people need

costs arising from excessive wage increases.

to assign greater prominence to the goal of price

the experience of our neighbors to the north in­

stability in the hierarchy of stabilization objectives.

dicates, inflationary wage settlements may continue

6




As

for extended periods even in the face of rising un­
employment. In Canada, unemployment has been
moving up since early 1966. New wage settlements
in major industries, however, averaged in the 7 to
8 per cent range until the spring of 1969, then rose
still further. This year, with unemployment moving
above 6 y2 per cent, negotiated settlements have been
in the 8 to 9 per cent range.
Many of our citizens, including some respected
labor leaders, are troubled by the failure of collective
bargaining settlements in the United States to re­
spond to the anti-inflationary measures adopted to
date. They have come to the conclusion, as I have,
that it would be desirable to supplement our mone­
tary and fiscal policies with an incomes policy, in the
hope of thus shortening the period between suppres­
sion of excess demand and the restoration of reason­
able relations of wages, productivity, and prices.
T o make significant progress in slowing the rise
in wages and prices, we should consider the scope
of an incomes policy quite broadly. The essence of
incomes policies is that they are market-oriented; in
other words, their aim is to change the structure
and functioning of commodity and labor markets in
ways that reduce upward pressures on costs and
prices.
The additional anti-inflationary measures an­
nounced by the President last Friday will make a
constructive contribution to that end. The actions
to increase the supply of oil will dampen the mount­
ing cost of fuels, and the recommendations made by
the President to improve the structure of collective
bargaining in the construction industry strike at the
heart of a serious source of our current inflationary
problem.
I would hope that every citizen will support the
President’s stern warning to business and labor to
exercise restraint in pricing and wage demands. A
full measure of success in the effort to restore our
nation’s economic health is, I believe, within our
grasp, once we as a people demonstrate a greater
concern for the public interest in our private de­
cisions.
If further steps should prove necessary to reduce
upward pressures on costs and prices, numerous

with exceptional rapidity, or the creation on a na­
tion-wide scale of local productivity councils to seek
ways of increasing efficiency, or a more aggressive
pace in establishing computerized job banks, or the
liberalization of depreciation allowances to stimulate
plant modernization, or suspension of the DavisBacon A ct to help restore order in the construction
trades, or modification of the minimum wage laws
in the interest of improving job opportunities for
teenagers, or the establishment of national building
codes to break down barriers to the adoption of
modern production techniques in the construction
industry, or compulsory arbitration of labor dis­
putes in industries that vitally involve the public
interest, and so on. W e might bring under an in­
comes policy, also, the establishment of a high-level
Price and W age Review Board which, while lacking
enforcement power, would have broad authority to
investigate, advise, and recommend on price and
wage changes.
Such additional measures as may be required can,
of course, be determined best by the President and
the Congress. What I see clearly is the need for
our nation to recognize that we are dealing, prac­
tically speaking, with a new problem— namely, per­
sistent inflation in the face of substantial unemploy­
ment— and that the classical remedies may not work
well enough or fast enough in this case. Monetary
and fiscal policies can readily cope with inflation
alone or with recession a lon e; but, within the limits
of our national patience, they cannot by themselves
now be counted on to restore full employment, with­
out at the same time releasing a new wave of in­
flation. W e therefore need to explore with an open
mind what steps beyond monetary and fiscal policies
may need to be taken by government to strengthen
confidence of consumers and businessmen in the
nation’s future.
In the past two years we have come a long way,
I believe, towards the creation of a foundation for
a lasting and stable prosperity. Confidence has been
restored in financial markets.
Businesses have
turned away from the imprudent practices of the
past. Productivity gains have resumed. Our balance
of trade has improved. The stage has been set for
a recovery in production and employment— a re­

other measures might be taken to improve the

covery in which our needs for housing and public

functioning of our markets. For example, liberaliza­

construction can be more fully met.

tion of import quotas on oil and other commodities
would serve this purpose.

So also would a more

T o make this foundation firm, however, we must
find ways to bring an end to the pressures of costs

vigorous enforcement of the anti-trust laws, or an

on prices.

expansion of Federal training programs to increase

accomplish this objective.

the supply of skilled workers where wages are rising

at the outset, is the tough legacy of inflation.




There are no easy choices open to us to
But that, as I indicated

7

Farm Capital and Credit Trends in Virginia*
The farming sector of our economy is unusually
dynamic. Changes taking place in farming have im­
portant implications for farm operators and related
businesses including financial institutions.
This
article describes the capital and credit trends on
Virginia farms and discusses their implications for
financial institutions.
Many of the changes affecting farming increase
capital requirements. Capital investment in farming
is at an all-time high, and indications are that it will
continue to increase. Several important factors ac­
count for the increase:
1. Consolidation has created fewer and
larger farms. The number of farms in the
United States decreased from 6.1 million in
1940 to approximately 2.9 million in 1968.
Production assets per farm increased from
$6,158 in 1940 to $79,223 in 1968.1
2. Capital is a substitute for labor and land
in farming. Lower unit costs available through
newer and larger machines and other forms of
technology have forced farmers to move to
larger scale operations. Most of this mechaniza­
tion and other technology is capital intensive.
Production assets per farm worker increased
from $3,326 in 1940 to $45,872 in 1968.2
3. The use of purchased inputs such as
fertilizers and pesticides has increased. A s farms
become more mechanized and specialized, they
rely more on purchased inputs. The index of
purchased farm inputs increased from 91 in
1950 to 124 in 1967.3
4. Operating costs per dollar of farm sales
have increased because of expanding use of
purchased inputs and rising prices for these in­
puts. The index of prices paid by farmers has
risen more than one-third since 1950. Net farm
income declined from 40% of cash receipts in
1950 to 33% in 1967/
These trends are likely to continue. Thus, farmers
and others interested in agriculture are concerned
*
This article is an abridgement o f an earlier paper by the author,
“ Farm Capital Formation and Financing in V irg in ia ,” Research
Report A .E .4 , Departm ent o f Agricultural Economics, V irgin ia Poly­
technic Institute and State University (Blacksburg, V irg in ia :
Oc­
tober 1970 ).
1 U S D A , E R S, Agriculture Inform ation Bulletin 334, Balance Sheet
o f A griculture, 1968 (W ashington, January 196 9 ), p. 23.
■ Ibid., p. 24.
‘
n U S D A , Statistical Bulletin 223, Changes in Farm Production and
E fficien cy, 1968 (W ashington, June 1968 ), p. 16.
* Balance Sheet o f Agriculture, op. cit., p. 20.

8




about the availability of capital to support future ad­
justment and growth in the farm sector.
There are basically two types of capital with
which a business can be financed— equity capital and
debt capital. Traditionally, farm growth has been
financed largely with retained earnings. From 1900
to 1950, more than 85% of the new capital invested
in United States agriculture came from farm savings.5
Recently, however, farmers have financed fewer of
the increasing capital requirements from savings, and
they have turned more to debt capital for financing.
Farm debt has grown much more rapidly than in­
vestment in assets or production expenses since
1950." Total farm debt rose from $10.8 billion in
1950 to $49 billion in 1968— an increase of 350% .
Changes in Virginia Farming V irginia farm ing
has followed the national trend. The average farm
size in Virginia increased from 103.1 acres to 149.4
acres between 1950 and 1964, while the number of
farms decreased from 150,997 to 80,354. During
the same period, average value of land and buildings
per farm increased 226% — from $8,458 to $27,572.
Between 1950 and 1964, realized net farm income
in Virginia increased from $1,527 to $2,253 per
farm, an increase of only 48% in contrast to a 226%
increase in investment per farm in land and build­
ings. Thus, farmers have had to use more and more
debt capital to finance farm growth. Average out­
standing debt per farm, excluding trade credit, rose
from $728 in 1950 to $3,880 in 1964, an increase
of 443% .
W hile these data encompass farms of all sizes, the
changes are even more striking when commercial
farms— the larger, more dynamic units— are con ­
sidered separately.
Farms are classified by the
Bureau of the Census into economic classes on the
basis of the value of farm products sold as follow s:
E co n o m ic
C la s s

1
II
III
IV
V
VI

V a lu e

of

Farm

P ro d u c ts S o ld

$40,000
20,000
10,000
5,000
2,500
50

and over
to 39,999
to 19,999
to 9,999
to 4,999
to 2,499

5 Alvin S. Tostlebe, Capital in Agriculture-. Its Form ation and F i­
nancing Since 1870, A study by the National Bureau o f Economic
Research (Princeton, N ew Jersey: Princeton U niversity Press,
1 957 ), p . 146.
6 Gene L . Swackhamer and Raymond J. Doll, Financing M o d em
A griculture:
Banking’s Problems and Challenges (K ansas City,
M issouri: Federal Reserve Bank of K ansas City, 1 9 6 9 ), p. 10.

i

T a b le

of the farms with gross sales of $5,000 or less had
debts averaging $5,178.7

I

SELECTED CHARACTERISTICS OF FARMS
BY E C O N O M IC CLASS
Virginia, 1964
E con om ic

C la s s

A ll
O th e r
F a r m s1

1

I II

Percent

Percent

Percent

2.2
11.0

3.7
11.2

6.9
14.1

87.2
63.7

33.1
44.8
3.4

17.5
19.6
5.8

16.3
12.2
9.5

33.1
23.4
81.2

18.3

N u m b e r o f fa r m s
A c r e a g e in f a r m s
E x p e n d itu re s o n selected
in puts:
Feed fo r live sto ck a n d
To ta l f a r m p ro d u c ts so ld
p o u ltry
Se e d s, p la n ts, a n d rtees
Fertilizer m a te ria ls,
g a s o lin e , oil, a n d
p e tro le u m

II

Percent

Item

15.9

18.2

47.6

1 In c lu d e s C la s s IV , V , a n d V I fa r m s , p a rt-tim e f a r m s , p a rt-re tire m en t f a r m s , a n d a b n o r m a l fa r m s .
Sou rce:

U. S. C e n s u s o f A g r ic u ltu r e : 1964, V o l. 1, P art 24 ( W a s h ­
in g to n , 1967), S ta te T a b le 17.

Table I shows data for the Virginia farm sector by
economic class and permits the identification of com ­
mercial farms as defined below.
Class I and Class II farms— those generally con ­
sidered the most economically viable in the present
economic setting— contained only 5.9% of the farms
but accounted for 50.6% of the value of all products
sold and 22.2% of the land in farms. In 1964, Class
I and Class II farms accounted for 64.4% of the
feed, 59.3% of the livestock, 40.4% of the fertilizer

Capital Requirements on Virginia Farms R e­
quirements for both investment capital and operating
capital have been increasing for commercial farming
in Virginia. Moreover, this trend is likely to con­
tinue. A study by the Virginia Commission of the
Industry of Agriculture estimated that the number
of farms in the state with gross sales of $20,000 or
more will increase 58% between 1964 and 1980 and
that the average value of production assets for these
farms will increase 21% . The Commission estimated
that average production assets for Class I and Class
II farms will be $425,000 and $150,000, respectively,
in 1980.*
Loans to Virginia Farmers Increased capital
requirements have had an impact on the size of loans
and the use of credit by Virginia farmers. The ex­
perience of the Production Credit Associations re­
flects the increase in the size of loans (Table I I ) .
Only 4.8% of the volume of outstanding P C A loans
in 1960 was to borrowers with loan balances ex­
ceeding $50,000 compared to 16.3% in 1968.

Bor­

rowers with loan balances under $25,000 decreased
from 86.1% of the total in 1960 to 62.7% in 1968.
Between 1950 and 1964 debt as a percent of cash
farm income and non-real estate debt as a proportion
of production expenses more than doubled.

As

agriculture in Virginia becomes more commercial,
more debt capital will be used and loan size will
continue to increase.

materials, and 34.2% of the petroleum products pur­
T a b le

chased by all farms. Conversely, Virginia farms with
gross sales of less than $10,000 accounted for 87%
of all farms and 64% of the land in farms.

SIZE OF LOAN BALANCES FOR PCA BORROWERS

They

Virginia, June 30, 1960 and 1968

accounted for 33% of gross farm sales, 23% of feed,

I9 6 0

27% of livestock, and 41% of fertilizer materials
purchased.
Average investment in production assets in 1964
The number of acres per farm

averaged 739 and 147 for these classes, respectively.
Clearly, the capital and credit needs of the larger
commercial farms which control most of the assets
in farming and account for a large proportion of the
purchased inputs are different from those of the
smaller farms.

1968

$2 5 ,0 0 0 a n d u n d e r
25,001 to 5 0 ,0 00
50,001 to 100,000
O v e r 100,000
T o ta l

So u rc e :

T o ta l
C r e d it
O u t­
s t a n d in g

P er­
ce n tage
of
T o ta l

T o tal
C r e d it
O u t­
s t a n d in g

T o tal
P e r­
c e n ta g e
of

1,000
d o lla r s

Siz e o f
Loa n B a la n c e s

was $330,160 for Class I farms compared to $36,270
for Class V farms.

II

Percent

1,000
d o lla r s

Percent

15,421
1,621
762

86.1
9.1

105

4.3
0.5

17,909

100.0

28 ,2 34

62.7

9,475
5,58 7
1,738

21.0
12.4
3.9

45 ,0 3 4

100.0

F e d e ra l In te r m e d ia te C r e d it B a n k o f B a ltim o re .

According to the 1964 Census of

Agriculture, more than 75% of the farms in the
United States with gross sales of $20,000 or more
had debts averaging $40,425, while less than 60%




7 Bureau o f the Census, U. S. Census o f A gricu ltu re: 1964, Vol. I l l ,
Part 4, "F a r m Debt” (W ashington, 1968 ), Table 13.
s A Report by the Commission o f the Industry of Agriculture, O p­
portunities for Virginia A griculture (Richmond, V irg in ia : Com­
monwealth o f V irgin ia, 1 9 6 9 ), p. 25.

9

T a b le

III

LEGAL LENDING LIMITS OF CO M M ERCIA L BANKS
IN CLU DIN G BRANCHES IN LOCATIO NS OTHER
THAN THAT OF THE HOME BANK
Virginia, December 31, 1968
L e g a l L e n d in g
Lim it to a n
In d iv id u a l
B o rro w e r

B a n k s in T o w n s w ith P o p u la t io n of:
5,50 0 a nd u n d e r
Num ber

O v e r 5 ,50 0
Num ber

Percent

T o ta l

22
48
59
125

8.7
18.9
23.2
49.2

4
15
54
198

1.5
5.5
19.9
73.1

254

$ 2 5 ,0 0 0 a n d u n d e r
25,001 to 5 0 ,0 0 0
50,001 to 100,000
O v e r 100,000

S o u rc e :

Percent

100.0

271

100.0

S o u th e rn B a n k e rs D ire cto ry , V ir g in ia , 1969.

Availability of Credit General econ om ic con ­
ditions affect the availability of credit to farmers in
Virginia. W ith the exception of the Farm Credit
System and the Farmers Home Administration
(F m H A ), institutions that lend to farmers also lend
to other borrowers.
W hen these institutions can
make loans more advantageously to nonfarm bor­
rowers, the flow of credit to farmers may be reduced.
The Farm Credit System obtains loan funds from
the sale of bonds on the national financial markets.
Through this system, the farmer has access to the
national financial markets.
If conditions in the
capital markets and the general economy make al­
ternative investments more attractive, funds available
to the Farm Credit System will be reduced. Of
course, the Farm Credit System can make its bonds
more attractive by raising the interest rate, but this
is reflected in higher rates to borrowers.
The F m H A makes direct loans to farmers from
Congressional appropriations. It also insures loans
to farmers made by other lenders. The types of
F m H A loans and the funds available can be changed
at any time by Congress.
Characteristics of Major Farm Lending Agencies
Commercial Banks There were 233 state and na­
tional banks in Virginia in 1969 operating 998 of­
fices. A t the end of the year 189 of these banks held
some farm loans. Most banks make both real estate
and non-real estate loans to farmers. Generally, real
estate loans are those loans secured by mortgages on
farmland including improvements and used to pur­
chase farm units, additional land, or to finance capital
improvements. Non-real estate loans are all those
not secured by real estate. They may be either short
or intermediate term. Short-term loans are repay­
able within 12 months and are used to meet current
operating and living expenses.
Intermediate-term
Digitized10 FRASER
for


loans require more than 12 months to repay and
are used for investments such as livestock and ma­
chinery.
Many banks in rural America have encountered
problems because farms have grown faster than the
size of banks serving them. These banks often re­
ceive farm loan requests that exceed the amount they
can lend under legal limits. The legal limit for na­
tional banks is 10% of the bank’s capital and surplus
(except for livestock loans, which may go to an ad­
ditional 1 5 % ). State banks in Virginia can lend up
to 15% of their capital and surplus to a single
borrower.
A request for a loan exceeding the legal lending
limit is called an overline request. In 1966, a na­
tional survey of banks making agricultural loans
revealed that 14% of all banks had over line requests
from farm customers.9 This problem, however, does
not appear to be serious in Virginia. Only 4 of 259
Virginia banks reported overline requests. M ore­
over, in 1968 only 22 offices of 254 banks and
branches located in rural towns— towns with a
population less than 5,500— had legal lending limits
of less than $25,000, and 184 of these had legal lend­
ing limits of $50,000 or more (Table I I I ) . A ccording
to the 1966 survey very few bank loans to farmers
were for $25,000 or more. In 1968 all but 4 V ir ­
ginia counties had at least one banking office with
a legal lending limit of $25,000 or more, and all but
8 had at least one banking office with a legal lending
limit of $50,000 or more.
In 1962, Virginia banking law was amended to
permit limited statewide branching.1 A s a result,
0

T a b le

IV

LEGAL LENDING LIMITS OF C O M M E R C IA L BA N KS
EXCLUDING BRANCHES
Virginia, December 31, 1968
L e g a l L e n d in g
Lim it to a n
In d iv id u a l
B o rro w e r

B a n k s in T o w n s w ith P o p u la t io n o f:
5,50 0 a n d u n d e r

O v e r 5,50 0

Num ber

To ta l
S o u rc e :

Num ber

19
37
34
22

17.0
33 0
30.4
19.6

3
13
31
78

2.4
10.4
24.8
62 .4

112

$ 2 5,00 0 a n d u n d e r
25,001 to 5 0 ,0 0 0
50,001 to 100,000
O v e r 100,000

Percent

100.0

125

100.0

S o u th e rn B a n k e r s D ire cto ry , V ir g in ia ,

Percent

1969.

9 Emanuel Melichar, “ Bank Financing o f Agriculture,” Federal R e­
serve Bulletin, Board of Governors of the Federal Reserve System
(W ashington, June 1 9 6 7 ), p. 929.
10 For a detailed discussion o f Virgin ia banking laws, see Harmon
H . Haymes, A Study o f Banking in Virginia, A report prepared for
the Rural A ffa irs Study Commission (Richm ond, V irg in ia :
Com­
monwealth o f V irgin ia, n .d .).

the structure of Virginia banking changed sig­
nificantly, which is the primary reason that legal
lending limits are not a serious limitation in Virginia.
A branch office has the same legal lending limit
as its home office. Thus, one of the major advantages
of branch banking as far as rural areas are concerned
is that the legal limit on the size of a loan a bank
can make to a single borrower is increased. The
impact of branch banking on legal lending limits in
rural Virginia is suggested by a comparison of
Tables III and IV .
W hen banks and branches outside the parent
bank’s area are considered, only 8.7% of the bank­
ing offices in rural towns have a legal lending limit
of $25,000 or less and 27.6% have a legal lending
limit of $50,000 or less. When the consideration of
branches is excluded, 17% of the banks in com ­
munities with a population of 5,500 or less have legal
lending limits of $25,000 or less and 50% have legal
lending limits of $50,000 or less (Table I V ) . E x ­
cluding branches, only 22 banks in rural areas had
a legal lending limit of $100,000 or more compared
to 125 when branches were included. These data
highlight the importance of branch banking to the
growth of farm firms, especially in view of the large
average investment projected for Class I farms in
Virginia.
Production Credit Associations There are 13
Production Credit Association (P C A ) offices in V ir­
ginia.
P C A ’s are federally-sponsored credit co­
operatives owned entirely by the member borrowers.
They make both short-term (less than one year) and
intermediate-term loans (up to seven years) to
farmers for any agricultural purpose. Most PC A
loans are secured by real estate mortgages and first
mortgages on chattel property.
Any farmer is
eligible to borrow from a PC A , but he must become
a member of the association by purchasing stock
equal to 5% of the value of the loan. When the
loan is repaid, the stock may be sold back to the
association.
Federal Land Banks Like Production Credit
A ssociations, Federal Land Bank A ssociation s

Insurance Companies Insurance companies are a
major institutional supplier of farm real estate loans
in the United States. In Virginia both commercial
banks and F L B A ’s extend more real estate credit
than do insurance companies. Nine life insurance
companies accounted for approximately 80% of all
life insurance farm real estate loans in Virginia
in 1968.
Farmers H om e Administration
The Farmers
Home Administration is an agency of the U. S. De­
partment of Agriculture, which has 35 county of­
fices in Virginia, established to make a wide variety
of low cost loans to farmers and rural residents. The
Fm H A can make loans only to farmers who cannot
obtain credit from other sources on reasonable terms,
and F m H A borrowers agree to obtain credit from
other lenders when their financial situation improves.
Fm H A loans may be larger relative to security
value than loans by commercial lenders. For ex­
ample, with direct farm ownership loans, F m H A
may lend up to 100% of the normal value of the
farm.
The Farmers Home Administration has three ob­
jectives: (1 ) to strengthen the economic position
of individual family farmers, (2 ) to improve rural
communities, including towns with populations of
less than 5,500, and (3 ) to alleviate rural poverty.1
1
A s a government agency, the FmPIA has three
sources of funds to lend : (1 ) a direct loan account
appropriated by Congress, (2 ) a revolving fund
established by Congress for emergency loans, and
(3 ) funds furnished by commercial banks and other
lenders and insured by the F m H A .
five types of loans:

F m H A makes

(1 ) operating loans for cur­

rent expenses, (2 ) long-term loans to buy and
im prove farmland, including residence im prove­
ments, (3 ) em ergency loans in designated dis-

T a b le

V

SELECTED CHARACTERISTICS OF PCA A N D
BA NK BORROW ERS
Virginia, 1966

(F L B A ’s) are federally-sponsored credit coopera­
tives.

C o m m e r c ia l

In Virginia, the 13 F L B A ’s and P C A ’s are

housed together.
F L B A ’s are limited by law to making real estate
loans. Loans can be made for any constructive pur­
pose and may be for periods up to 35 years.

F L B A borrower must derive the principal part of
stock equal to 5% of the value of his loan and be­




Num ber
A ve rage
A ve rage
A ve rage

o f fa r m b o r r o w e r s
a sse ts p er fa r m
net w o r t h per fa r m
to ta l d e b t p e r fa r m

P C A 's

Banks

5,9 5 0
$8 5,36 2
6 2 ,8 59
22,503

5 1 ,3 4 5
$5 0,83 5
38 ,4 13
12,326

An

his income from farming. A farmer has to purchase
come a member of the association.

Item

So u rc e :

C o m p ile d fr o m d a t a
m in istr a tio n a n d the

p r o v id e d b y the Fa rm C r e d it A d ­
F e d e ra l R e se rv e S y ste m .

1 Aaron G. Nelson and W illiam G. M urray, Agricultural Finance,
1
Fifth Edition (A m es, Iow a: Iowa State University Press, 1967 ),
p. 320.

11

aster areas, (4 ) loans to finance recreational
enterprises as a part of operating and farm
ownership loans, and (5 ) rural housing loans.
Trade Credit While the total amount of trade
credit extended by suppliers of farm inputs in V ir­
ginia is unknown, evidence suggests that it is sub­
stantial.
Merchant credit may be short term or
intermediate term, and loans may be secured by the
item purchased or they may be unsecured, openaccount loans.
Trends in Credit Sources The proportion of
total farm real estate credit held by different financial
institutions in Virginia has changed considerably
since 1950. The F L B A ’s increased their relative
market share of such loans from 12% in 1950 to
29.5% in 1970; life insurance companies’ share de­
creased from 11.2% to 10% over this period. The
relative market share of banks declined from 37.7%
to 2 3% .
Non-real estate farm debt provided by institutions
in Virginia increased from $35.2 million in 1950 to
$152.1 million in 1970. Contrary to the situation in
real estate credit, banks have long been the major
institutional source of non-real estate credit in V ir­
ginia. Their proportion of this type of credit de­
clined from 74.4% in 1950 to 62% in 1970. The
P C A ’s held 33.5% of the non-real estate credit in
1970 compared to 15.1% in 1950.
Reliable trend data on trade credit are not avail­
able on a state basis. The 1960 Sample Survey of
Agriculture, however, indicated that merchant credit
accounted for approximately 22% of non-real estate
debt of farm operators in the United States.1 M ore­
2
over, available evidence indicates that this is a grow ­
ing source of credit.1
3
Characteristics of Bank and PCA Loans In 1966,
the Federal Reserve System and the Farm Credit
A dm inistration conducted an agricultural loan
survey. T he Federal Reserve sample survey of
44 banks indicated that Virginia banks had 81,281
loans outstanding to 51,345 farm borrowers. The
P C A ’s collected data from a 10% random sample
of their borrowers which indicated that P C A ’s had
made 7,810 loans to 5,950 borrowers.
The survey showed that the P C A ’s serviced
larger farm operations than did banks (Table V ) .
Assets per farm averaged $85,362 for PC A bor­
rowers and $50,835 for bank borrowers, and average

total debt per farm was 83% greater for P C A bor­
rowers than for bank borrowers. Average total
debt varied widely by type of farm among both
bank and P C A borrowers. General, tobacco, and
meat animal farms were the three most important
types.
Important differences in the types of farms
operated by PC A and bank borrowers help explain
borrowing differences.
One-fourth of P C A bor­
row ers operated meat animal farms, about tw ice
the proportion found among bank borrowers. Dairy
farmers accounted for 15.5% of PC A borrowers,
also a much higher proportion than at banks. Gen­
eral farmers comprised a higher proportion of bank
customers.
Approximately one-third of P C A loans and more
than two-fifths of bank loans were used for current
operating expenses other than the purchase of live­
stock.
Loans to purchase machinery and equip­
ment made up a fourth of bank loans but only 13%
of P C A loans.
The largest loans made by both institutions were
for purchasing farm real estate. Approximately 10%
of bank loans were for this purpose compared to
only 2.6% of P C A loans.
Loans with maturities of one year or less ac­
counted for approximately 60% of both bank loans
and P C A loans. The percentage of loans with a ma­
turity of over three years was considerably higher
for P C A ’s than it was for banks.
There is a marked difference in the maturity of
loans for machinery and equipment between the two
institutions. Most bank loans for this purpose were
for three years or less, compared to 61% of the
P C A loans. This comparison suggests that banks
are relatively conservative on such loans considering
that the economic life of most farm machinery is
greater than three years.
Over one-half of the farm borrowers at both banks
and P C A ’s were full ow ners o f the land they
operated.
Both institutions had about the same
proportion of tenant farmers and landlords am ong
their customers. However, part owners accounted
for almost 24% of the PC A borrowers compared
to only a tenth of the bank borrowers.
Conclusion

The capital needs of Virginia farmers

have increased dramatically in recent years, and the
evidence indicates that this trend will continue.
Lending institutions can expect to face a rising de­

12W illellyn Morelle, Leon Hesser, and Emanuel Melichar, Merchant
and Dealer Credit in Agriculture, Board of Governors o f the Federal
Reserve System (W ashington, 1966 ), p. 17.
1 John A . Hopkin and Thomas Frey, Problems Faced by Commercial
:1
Banks o f Illinois in M eeting the Financial Requirem ents o f a D y­
namic A griculture, Agricultural Economics Report 99, Departm ent of
Agricultural Economics, Agricultural Experim ent Station, U n i­
versity o f Illinois ( Urbana-Cham paign, April 1969 ), p. 9.

12




mand for credit.

A s farms continue to increase in

size, the demand for credit and the average size loan
per farm will increase.
Thomas E. Snider

The Supply of Money in the United States
Part I — The Institutional Development

“ The primary purpose of the Federal Reserve

ness venture.

Like other business activities, pros­

Sprague in 1914, “ is to make certain that there will

pecting and mining activities are equilibrated by
forces of demand and supply working through

always be an available supply of money and credit

markets.

in this country with which to meet unusual banking

the quantity of standard money in existence at any

requirements.”

given time is determined by market forces.

Act . . .,” wrote Harvard economist O. M. W .

An

article of encyclopedic length

could be written in an attempt to answer the ques­
tions prompted by this statement.

In metallic monetary systems, therefore,

The use of metallic money, however, involves real

For exam ple:

costs to society, and these costs could be and were

W hy money and

economized— but not eliminated— by the substitu­

credit? What are “ unusual” banking requirements?

tion of paper money for coin. Then, both paper and

What is an “ available supply” ?

Did a source of supply exist before the Federal R e­

metallic currency were economized by checkbook

serve System?

banking; and the prediction is now that checkbook

If so, what happened to it that a

new institution was called for ?

banking probably will be replaced by electronic ma­

Sprague gave answers to some of these questions

chinery and credit cards.

in the long article he wrote (41 pages) for the

The development of paper currency and check­

Quarterly Journal of Economics (February 1914) in

book money provoked the first social concern over

elaboration of the original topic sentence cited above.

control of the quantity of money.

Other economists, as well as bankers and central

or created demand obligations were constrained to

bankers, also have tried their hands at these ques­

redeem these notes or checks in metal—-gold or

Banks that issued

tions. The product has been an extensive literature.

silver; so bank paper simply extended or economized

Paradoxically enough, the Federal Reserve has not

the existing quantity of precious metal. Governments

emphasized strict control over the money supply

also issued paper m on ey; but this kind of act re­

during most of its 50-odd-year history.

quired political license, which was given neither

It has put

more emphasis on the cost and availability of credit.

easily nor often.

Only in recent years has the supply of money proper
come into its own as a matter for critical discussion,

political checks-and-balances between factions or
branches of the government and constitutional pro­

E ffective constraints were the

analysis, and investigation.

scriptions.
Central bank machinery took the separation of

From Metallic Standards to Central Banking In ­
attention to the money supply is more than a central
bank oversight; it has roots and precedent in mone­
tary history. Through most of the late 18th and
early 19th centuries, when central banking was in
its formative stages, the basic money commonly in
use was primarily metallic.

The earth supplies such

money and metal even further.

Central banks were

bankers’ banks, and ordinary commercial banks were
encouraged to deposit their metallic reserves in the
central bank.

This deposit served as a base on

which the banks could extend credit and create de­
posits.

The separation of media of exchange and

metal was by this time almost a full estrangement;

money at a cost, and anyone willing to give up the

and while a final decree has yet to be granted, the

necessary resources can get as much of it out of

divorce is all but complete.

the earth as he wishes.

exists; in fact, it is more important to the functioning

Precious metals are scarce

commodities, and the decision to prospect for them is

However, money still

of economic society than ever before.

not fundamentally different from the decision to ac­

At times in the past, the link between the quantity

quire them by engaging in some other kind of busi­

of gold and the quantity of money has been broken




13

temporarily.

(O n e example is the period in the

supplied in an institutional vacuum.

A gold or bi­

United States between 1862 and 1879.) Always this
phenomenon called forth principles from governing

the first place a formal framework that operates

bodies— Congress and the Executive— on how the

automatically.

quantity of money should and could be regulated

some other arrangement must be made.

until the metallic connection was reestablished. Now

banks are one such alternative arrangement.

that the relationship is forever gone, principles for

metallic standard is such a set of principles.

It is in

W hen such systems are abandoned,
Central

The function of a central bank in today’s world

regulating the quantity of money are even more com ­

is to supply money to the economy even though the

pelling. Economists have responded with intensified

original purpose of such institutions was largely to

research on various aspects of the linkages and lags

make the money stock more responsive to seasonal

of money creation, and on the question of whether

variations in the demand for money.

the creation of money begins with the central bank

bank is in a position to supply new money without

Once a central

or by indirect stimulus from the commercial banking

reference to the rules of a gold standard, some other

system and the private economy.

rules should be established to govern its operations.

In recent years, m on e­

That the supply of money should be under the

tary thought and research has examined at length

general control of government is specified in Sec­

the demand for money and, as a corollary, the defini­

tion 8 of the Constitution (Pow ers of Congress)

tion of what to include in the category of “ money.”

where it states: “ The Congress shall have power . . .

W h ile all the returns on these issues are not in,

to coin money [and] regulate the value thereof. . . .”

tw o principles have been fairly well estab lish ed :

This principle was established further by Supreme

(1 )

Court decisions, and was made even more explicit

The Definition of Money

Changes in the stock of money have been es­

tablished empirically as a fundamental factor initiat­

in the great debates on monetary affairs in Congress

ing changes in general spending; and

during the 19th century.

(2 )

The

John C. Calhoun, whose

definition of money must include currency and de­

ability as a monetary policy theorist has been over­

mand deposits subject to check, and it may include

shadowed by the drama of other social issues in

as well time deposits in commercial banks.

which he took part, stated authoritatively in 1834:

Other

principles describing and defining the behavior of
money have been conjectured and still others are
being formed— for example, the demand for money
in the framework of inflation; but the provisional
conclusions summarized above bring the status and
knowledge of the demand-for-money function to the
point where similar knowledge and principles for
the supply function are necessary and pertinent.

W h a te v e r the G overn m en t receiv es and treats as
m on ey, is m o n e y ; and if it be m on ey, then they
have the right, under the con stitu tion , to regulate it.
N ay, they are boun d, b y a high ob liga tion , to adopt
the m o st efficien t m eans, a cco rd in g to the nature o f
that w h ich they have recog n ized as m on ey , to give
to it the u tm ost stability and u n iform ity o f value.

N o present day economist or jurist could state the
matter more clearly or more logically.

Discussions of the supply of money necessarily
presume a definition of money.

For the sake of

Early Central Banking Institutions

A great deal

simplicity if nothing else, the classification adopted

of controversy developed in Congress over the con ­

here rests on a narrow definition of money, one that

stitutionality of chartering the First and Second

includes: (a ) currency outside commercial banks, the

Banks of the United States— the first institutions

central bank, and the federal government, and (b )

that came to have some central banking character­

private demand deposits subject to check, exclusive

istics.

of interbank deposits.

The principles governing the

able to the creation of these Banks, was that Con­

The W hig view, which was generally favor­

supply of this stock can be applied without much

gress could commission other institutions to assist

qualification to “ wider” stocks of money that include

it with specific duties, such as, in this case, regula­

some amount of time deposits.

tion of the monetary system.

The opposing view,

espoused by the Jacksonian Democrats during the
Central Bank Control

A n y specification of the

sensational struggle between Jackson and the Second

supply of money must be circumscribed by principles

Bank, was nowhere better given than in Jackson’s

governing the creation of money.

veto message on the bill to recharter the Second

14




Money cannot be

Bank in 1832.

The constitutional power of Con­

gress, he held, could not be delegated.

“ It was con­

correspondents.

Collectively, these larger national

banks thus had some of the characteristics of a cen­

ferred to be exercised [by Congress],” he concluded,

tral bank.

“ and not to be transferred to a corporation.”

W hile

mercial enterprises and had neither the facility nor

the charters of the First and the Second Banks were

the responsibility to behave as a central banking
system.

allowed to lapse, subsequent Congresses have never
shown much eagerness to exercise direct responsi­
bility over the supply and value of money.
practical

matter,

Congress

has been

As a

content

to

specify rules for policymaking agencies to follow and
goals for them to aspire to.
Soon after the demise of the Second Bank, Con­
gress created the Independent Treasury.

This insti­

tution was supposed to be what its name implied—
independent of banks and the monetary system.

It

However, they were fundamentally com ­

Contemporary Central Banking

T h e form ation

of the Federal Reserve System was both a reaction
to Treasury intervention in the money market and
an attempt to develop a monetary system that would
operate less erratically than it was currently operat­
ing with a national system of commercial banks.
Stability was to be achieved through the Federal
Reserve Banks’ manipulation of the discount rate.

could not remain aloof for long, however, and ulti­

Such policy was supposed to synchronize seasonal

mately grew into central banking clothes of an ad­

variations of the money supply with fluctuating

vanced order.

It was the Treasury Department ex­

seasonal demands.

tended to include enough sub-Treasury offices to

The explicit charge of the A ct itself only called

carry out all the fiscal affairs of the federal govern­

for the Federal Reserve Banks “ to furnish an elastic

ment without recourse to commercial banks or a cen­

currency, to afford means of rediscounting com ­

tral bank.

mercial paper, [and] to establish a more effective

It was under the direction of the Secre­

tary of the Treasury who, in effect, became a policy­

supervision of banking in the United States.”

making central banker.

means of furnishing an elastic currency was through

But the Secretary was and

The

His intervention into

Reserve Bank discounting of “ notes, drafts, and bills

monetary affairs, was regarded as exceeding the

of exchange arising out of actual commercial transac­

is an Executive appointee.

tions.” Discount rates charged by the Reserve Banks

prerogatives of his office.
Some 25 years after the Treasury was declared to

were to be set “ with a view of accommodating com ­

be “ independent” of banks and the monetary system,

merce and business.”

Under the original Federal

Congress attempted to reform the banking system by

Reserve Act, the rules of the gold standard, together

passing the National Bank Act. This A ct was begun

with the commercial credit doctrine for discounting

as a Civil W ar measure by the federal government

bank paper, were assumed to fix limits to the scope

but did not become fully operational until after the
W ar ended. It was designed to bring all banks under

of central bank policy.

federal charter so that the currency they issued

The early 1930’s saw the end of the gold standard
as an operational constraint on Federal Reserve

would have uniform appearance and value.

policy.

Since

By the Banking Acts of 1933 and 1935, the

not even half of all commercial banks came into this

technical controls o f the Federal Reserve System

system, a prohibitive tax on state bank note issues

over the quantity of money were greatly extended.

was added to the original Act.

The state banks

These acts formally established open market opera­

thereupon eschewed note issues, but they continued

tions in government securities and discretion over

to operate outside the national banking system by

reserve requirements for member banks (in addition

issuing demand deposits for all of their commercial

to discounting) as the legitimate province of Federal

lending activities.

Reserve action.

The national banks thereafter exclusively issued

However, precise specifications for

the use of this machinery were still lacking. Without

They also served

rules or directions, the Federal Reserve System was

as depository banks for the Treasury thus reintroduc­

extremely vulnerable to Treasury and Executive

ing some interdependence between the commercial

domination.

currency (National Bank notes).

Finally, the

The general deemphasis of monetary policy in the

national banks in the larger commercial centers came
to act as seasonal depositories for their “ country”

eral rules for its policies, saw Federal Reserve

banking system and the government.




1930’s, in conjunction with the inattention to gen­

15

policies subordinated to the Treasury’s debt-management policies. This relationship continued through
the war years and was only ended by a Congressional
resolution of 1950.
By this resolution, both the Federal Reserve Sys­
tem and the Treasury were charged with carrying
out policies that “ shall be consistent with and shall
promote the purpose of the Employment A ct of
1946.”

This resolution also led in 1951 to the

famous Accord. During the remainder of the decade,
the Federal Reserve System was allowed relative
autonomy in using its technical powers to further
the provisions of the Employment Act.

T h e C on gress shou ld advise the Federal R eserve
S ystem that variations in the rate o f in crease o f the
[n a r r o w ] m on ey stock ou g h t not to be great o r to o
sharp.
In n orm al tim es, for the present, the d e­
sirable range o f variation appears to be w ithin the
lim its o f 2 to 6 per cen t per annum , m easu red on a
qu a rter-by-q u a rter basis— a range that cen ters on the
rate o f lon g-ru n increase in the p otential g ro s s n a­
tional p rod u ct in con stant dollars.

Renewed interest in control over the quantity of
money has raised empirical questions for research
with regard to the supply of money. What basically
determines the quantity of m oney?

Another phase of central bank development became
discernible in the 1960’s.

of the Joint Economic Committee made in June
1968 states:

The quantity of money,

sured?
What

H ow is it mea­

What are the tolerances of measurement?
are the

operational

problems

of

control ?

which had been relegated to a passive role by aca­

Central to these questions is the framework in which

demic analysts, was reappraised both theoretically

the genesis of money takes place. Such a framework

and

will be presented as Part II of this article in the

empirically.

Federal

Reserve

research

and

policies, as well as Congressional discussion, reflect
this new prominence of money.

16



Another resolution

next issue of the M onthly Review.
Richard H . Timberlake, Jr.


Federal Reserve Bank of St. Louis, One Federal Reserve Bank Plaza, St. Louis, MO 63102