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THE INTEREST COST-PUSH CONTROVERSY
Thomas M. Humphrey

In business circles, and even in political discussions,
the question is very often raised, how the rate of
interest affects the prices of commodities.
The
practical business man is perhaps most often inclined to believe that an increase in the rate of
interest is bound to increase the cost of all products
and therefore to enhance prices, and he finds it
very confusing when he hears a scientific economist
or a representative of a central bank proclaim that
the rate is increased in order to force prices down.
It is obviously the duty of economic science to remove this confusion . . . .

GUSTAV CASSEL [l, p. 329]
Whenever
the Fed seeks to fight inflation with
restrictive monetary policy, a debate erupts between
tight-money proponents and members of the so-called
interest cost-push school. The former group argues
that higher interest rates associated with tight money
are necessarily
anti-inflationary
because they help
choke off the excess aggregate demand that puts
The latter contingent,
upward pressure on prices,
however, insists that higher interest rates are inherently inflationary
because they raise the interest
component of business costs, costs that must be
passed on in the form of higher prices. According to
the latter view, lower, not higher, interest rates are
consistent with lower prices. Low interest rates, the
argument goes, would lead to lower interest costs
and therefore to lower prices of final products. Longtime Congressman
Wright Patman of Texas was
perhaps the best-known proponent of this view.l
Missing from the debate is a careful and systematic
attempt to refute the interest cost-push doctrine.
Few economists today regard the doctrine as important enough to warrant rebuttal,
As Professors
Lawrence Ritter and William Silber note in their
widely-used textbook Money [5, p. 100],
most professional economists today simply refuse to take the
doctrine seriously and therefore typically tend to
dismiss it out of hand.
1 The pure interest cost-push doctrine should not be confused with the related argument that low interest rates
help restrain inflation by encouraging capital formation
that enhances labor productivity, lowers unit labor costs,
and increases potential output. Unlike the interest costpush doctrine, which asserts that interest rates affect
prices directly through costs, this latter argument holds
that interest rates affect prices indirectly through their
prior impact on capital formation.
Both arguments, of
course, are advanced by modern proponents of low interest rate easy-money policies.

For the definitive refutation of the interest costpush doctrine, it is necessary to go to the late 19thand early 20th-century writings of the great Swedish
economist Knut Wicksell, particularly his critique of
the monetary doctrines of Thomas Tooke.
Tooke, a
formidable British monetary controversialist,
leader
of the so-called Banking school, author of the monumental six volume History of Prices (1838-57),
and
foremost collector of price and monetary data in the
19th century, had advanced the interest cost-push
argument that high interest rates cause high prices
and low rates low prices.
Wicksell responded by
exposing the fallacies in Tooke’s argument and by
demonstrating
with the aid of a simple macroeconomic model that, contrary to Tooke’s contention,
high interest rate tight-money policies are inherently
anti-inflationary
whereas
low interest
rate easymoney policies are inflationary.
In so doing, Wicksell established the theoretical
foundations of the
tight-money view.
This article examines the Tooke-Wicksell
controversy and shows how Wicksell’s analysis effectively
answers the contentions raised by the interest costpush school.
The Tooke-Wicksell
controversy
is
important not only because it produced the first clear
statement of the interest cost-push doctrine as well
as the first rigorous and systematic attempt to disprove it, but also because it helped establish the case
for tight money and because it introduced the prototype of the analytical macroeconomic model that most
monetary authorities use today in designing antiinflationary monetary policies.
Thomas Tooke and the Emergence
of the Interest
Cost-Push
Doctrine
The controversy
began with
Tooke’s 1844 attack on what he called “the commonly
received opinion” that low money rates of interest
raise prices and high rates depress them. [8, p. 77]
Tooke emphatically rejected this conventional view,
arguing instead that a lowering of loan rates tends to
reduce, not raise, prices. Focusing solely on the cost
aspects of interest and ignoring the influence on
prices of interest-induced
increases in borrowing,
lending, the money stock, and spending, he asserted
that a reduced loan rate “has no . . . tendency to raise
the prices of commodities.
On the contrary, it is a

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3

cause of diminished cost of production, and consequently of cheapness.”
[8, p. 123]
He then proceeded to elaborate this point in a passage that
Representative
Wright Patman would have heartily
endorsed.
A general reduction in the rate of interest is
equivalent to or rather constitutes a diminution of
the cost of production . . . . in all cases where an
outlay of capital is required . . . [T]he diminished
cost of production hence arising would, by the
competition of producers, inevitably cause a fall of
prices of all the articles into the cost of which the
interest of money entered as an ingredient. [8, p.
81]
Written

in 1844, these passages are virtually

iden-

tical to Patman’s 1952 assertion that “the more interest that business must pay for the capital it uses
the more it adds to the cost of doing business.
To
that extent, increases in interest rates are inflationary.”
[3, p. 735]
Tooke’s statements, like those of
Patman, embody all the essentials of the interest
cost-push doctrine, namely (1) the notion that interest rates influence prices chiefly through costs, (2)
the idea that movements of interest rates and prices
are positively correlated,
(3) the denial that low
interest rates are inflationary, and (4) the contrary
assertion that low rates in fact tend to reduce prices
rather than to raise them. Tooke believed that these
propositions, particularly the last, were amply confirmed by the facts.
And the presumption
accordingly
is [he writes]
that the very reduced rate of interest which has
prevailed within the last two years must have
operated as one of the contributing
causes of the
great reduction of prices . . . which has occurred
coincidentally with reduction in the rate of interest.
[8, p. 81]

To Tooke, at least, it was obvious that a policy of
pegging interest rates at arbitrarily low levels would
not produce inflation.
Wicksell’s
Critique of
the Interest
Cost-Push
Doctrine
Tooke’s
interest
cost-push
doctrine
went largely unnoticed for more than 50 years until
Knut Wicksell challenged it in the closing years of
the century.
Wicksell’s extensive comments on the
doctrine--comments
that Arthur Marget described
as “the clearest statement we have on the subject”
[2, p. 248] -may
be found in his Interest and Prices
(1898) and in the second volume of his Lectures on
Political Economy (1905).
In these works he criticized the doctrine on several grounds.
Confusion of Relative Prices and Absolute Prices
First, he argued that the interest cost-push proposition confuses relative prices with the general level of
prices.
4

ECONOMIC

the proposition that prices of commodities depend on their costs of production and rise and fall
with them, has a meaning only in connection with
relative prices. To apply this proposition to the
general level of money prices involves a generaliza
tion which is not only fallacious but of which it is
in fact impossible to give any clear account. It can
be concluded then that . . . Tooke’s proposition must
be regarded as false, both in theory and in practice,
[9, pp. 99-100]
In particular, Tooke fails to perceive that interest
rate movements cannot possibly influence the price
level if, as he assumes, total spending and real output
remain unchanged.
With these magnitudes fixed.
interest rate changes will affect only relative prices
but not the absolute level of prices. The latter variable, Wicksell argued, is determined by aggregate
demand and supply. Therefore interest rate movements cannot affect it unless they alter either aggregate demand or aggregate supply. In terms of the
equation of exchange P = MV/Y, where P is the
price level, M the money stock, V its velocity of
circulation, and Y real output, interest rate movements will not affect P unless they alter MV (i.e.,
total spending) or Y (i.e., real output).
If these
aggregates remain unchanged, the price level also will
remain unchanged.
Interest rate movements in this
case will affect relative prices, to be sure.
Some
prices will rise and some will fall, but the average of
all prices will remain unchanged.
For example, a
rise in the market rate of interest would tend to raise
the particular prices of interest-intensive
goods, i.e.,
goods in which interest accounts for a significant
portion of total costs. Confronted with the price increases, purchasers would demand fewer of these
goods, thereby leading producers to cut back output
and lay off labor and other factor resources.
The
resources released from the interest-intensive
industries would seek employment in the noninterestintensive industries tending to drive down wages and
prices there. The net result would be a change in the
structure, but not the overall level, of prices.
To summarize, Wicksell held that, given the level
of total spending and real output, interest-induced
changes in the prices of specific commodities would
be offset by compensating changes in the prices of
others, leaving the aggregate price level stable:. In
this regard he noted that a fall in the rate of interest
would tend to lower the specific prices of capitalintensive goods, thereby reducing the outlay required
to purchase those items and increasing the amount
available for spending on other goods. The resulting
increased spending on these latter items would bid up
their prices enough to offset the drop in the prices
of the former items, thereby leaving the average of
prices unaltered. As Wicksell put it

REVIEW, JANUARY/FEBRUARY

1979

A fall in the rate of interest . . . thus causes fluctuations in the relative prices of both these groups
of commodities, but cannot exercise a depressing
influence on the general price-level except in so far
as it increases the actual volume of goods. the
[quantity] of money remaining stable, and possibly
gives rise to a slower circulation of money. [10,
p. 180]
Since Tooke says nothing about the monetary, output, or velocity effects of interest rate changes he
cannot explain how such changes affect general
prices.
Behavior of Noninterest
Elements of Cost Wicksell also criticized the interest cost-push doctrine’s
tendency to assume that all noninterest components
of costs remain unchanged
when interest
rates
If this assumption were true, costs and
change.
prices would, as Tooke asserts, fully register underlying changes in the interest rate. Wicksell, however,
denied the validity of this assumption.
Noninterest
cost elements, he argued, would not remain fixed in
the face of interest rate changes. Instead they would
vary and in so doing would offset or nullify the impact of interest rate changes on total costs.
More
precisely, a fall in the rate of interest would tend to
result in compensating
rises in wages and rents,
leaving total costs unchanged.
As Wicksell
expressed it:
[Tooke’s] argument is based on the inadmissible,
not to say impossible, assumption that wages and
rent would at the same time remain constant,
whereas in reality a lowering of the rate of interest
is equivalent to a raising of the shares of the other
factors of production in the product. [10, p. 183]
The mechanism whereby a fall in the interest rate
raises the relative shares of the other factors is as
follows: The fall in the interest rate initially reduces
costs relative to prices, thus giving profit-seeking
entrepreneurs
an incentive to expand their operations.
To expand operations, however, entrepreneurs must hire more land and labor.
Assuming
those resources are already fully employed, the resulting increased competition for them only serves to
bid up their prices, thereby raising the rent and wage
components of total costs. In this manner the fall in
the interest component of business costs is counterbalanced by rises in the wage and rent components
with the aggregate level of costs and prices remaining
unchanged.
Interest
Rates, the Balance
of Payments,
and
Gold Flows
Wicksell’s
third criticism
of the
high-interest-rates-cause-high-prices
argument is that
it is in apparent “conflict with the well-accredited
fact that a rise in the rate of interest has always

shown itself to be the appropriate

method of checking

an unfavorable balance of payments and of instigating
a flow of bullion from abroad.” In other words, the
doctrine cannot explain why rises in the bank rate
tend to correct trade balance deficits and reverse gold
outflows. For according to the interest cost doctrine,
such rises should, by pushing up domestic prices
relative to foreign ones, worsen the trade balance
instead of improving it.
If Tooke’s view were correct we should be confronted by the curious situation . . . that in order
to improve the discount rate and the balance of
trade, the banks would take steps which, on his
theory? would lead to higher costs of production
and higher prices and to a further restriction of
the already too limited export of goods. [10, p.
186]
Conversely,
the opposite case of a favorable balance of payments leads to equally absurd consequences. A
favorable balance would cause an inflow of bullion,
and this clearly would . . . bring about a lowering
of the rate of interest. The result according to
Tooke would be a still further fall in domestic
prices . . . so that the balance of payments would
become more and more favorable and money would
flow in on an ever-increasing scale. [9, p. 99]
In short, the interest cost-push doctrine implies, contrary to fact, that the foreign trade balance is perpetually in unstable equilibrium, with trade deficits
or surpluses
becoming
progressively
larger and
larger in a monotonic explosive sequence.
Credit Market Instability
Wicksell
also pointed
out that Tooke’s doctrine implies that money and
credit markets are likewise in a state of dynamic instability.
For if it were true that a fall in interest
rates produces a drop in prices, then a lower money
rate of interest would lead to reductions in borrowing, lending, and money creation and thus to further
downward pressure on money rates.
That is, with
lower prices, less money and credit would be required
to finance the same level of real transactions.
The
demand for loans would therefore contract and money
would flow into the banks.
In an effort to expand
loans and reduce excess reserves, banks would lower
the rate of interest still further causing a further
drop in prices and a further decline in the demand
for loans.
Via this sequence the rate of interest
would eventually fall to zero. Conversely, a rise in
the interest rate would, according to Tooke’s theory,
produce a rise in prices that leads, via a rising demand for loans, to further increases in the interest
rate and prices and so on in an explosive upward
spiral. “In other words, the money rate of interest
would be in a state of unstable equilibrium, every

FEDERAL RESERVE BANK OF RICHMOND

5

move away from the proper rate would be accelerated
in a perpetual vicious circle.”
[10, p. 187]

ence between the natural and the market rates of
interest. As previously mentioned, the natural rate is

In actuality, however, money and credit markets
are not in unstable equilibrium.
This fact, Wicksell

the rate that equilibrates real investment and real
saving. As long as the market rate is equal to the
natural rate, saving will equal investment and the
economy will be in equilibrium.
But if the market
rate should fall below the natural rate there will be

writes, is clearly a stumbling block for Tooke’s theory
and is sufficient reason for rejecting it. [10, p. 186]
Natural
Finally,

Rate Versus
Market Rate of Interest
Wicksell
criticized the interest cost-push

doctrine for failing to distinguish between the market
and natural or equilibrium rate of interest.
The
former of course is the loan rate or cost of money.
The latter, however, is the expected marginal yield
or internal rate of return on newly-created units of
physical capital.
It is also the rate that equilibrates
desired real saving with intended real investment at
the economy’s full-capacity level of output. Or what
amounts to the same thing, it is the rate that equates
aggregate demand for real output with the available
supply. This latter definition implies that the natural
rate is also the interest rate that is neutral with respect to general prices, tending neither to raise nor
to lower them.
In other words, if the market rate
were at the level of the natural rate, price stability
would prevail.
On the basis of the foregoing analysis Wicksell
held that price movements are generated by the
differential between the two rates and not, as Tooke
claimed, by the absolute level of the market rate
alone. In other words, the level of the market rate
per se is irrelevant, contrary to Tooke’s theory. The
market rate, whether high or low, rising or falling,
cannot affect general prices as long as it remains
equal to the natural rate. For if the two rates are
equal, intended capital formation equals intended real
saving, aggregate real demand therefore equals aggregate real supply, and price stability results. Only
if the market rate deviates from the natural rate
would price changes occur.
Wicksell’s
Model
The
foregoing
summarizes
Wicksell’s purely negative criticism of the interest
His positive contribution
concost-push doctrine.
sists of a theory of how interest rate movements
influence prices not through costs but rather through
excess aggregate demand supported and financed by
money growth. His theory concludes, contrary to the
interest cost-push doctrine, that high interest rate
tight-money policies are anti-inflationary
while low
interest rate easy-money policies are inflationary.
He
reached these conclusions via the following route.
First, he argued that the excess of investment over
saving at full employment is determined by the differ6

ECONOMIC

an excess of desired investment over desired saving.
The explanation is straightforward.
Given the natural rate, a fall in the market rate lowers the cost of
capital relative to its yield thereby stimulating investment.
At the same time, the fall in the market
rate lowers the reward to thrift thereby discouraging
saving.
Investment expands and saving contracts
producing an excess of the former over the latter.2
The opposite happens when the market rate is raised
above the natural rate, i.e., desired saving exceeds
desired investment.
The relationship between the
investment-saving
gap and the natural-market interest rate differential may be expressed as
(1)

I-S

= a( -R)

where I is investment, S saving,
the exogenouslydetermined natural rate of interest, R the market
rate, and a is a constant coefficient relating the interest rate differential

to the investment-saving

gap.

Second, Wicksell assumed that the gap between
investment and saving generates a corresponding expansion in the demand for bank loans, i.e.,

where
is the change in the demand for bank loans,
the dot signifying the rate of change (time derivative) of the attached loan demand variable.
This
equation states that when the investment demand for
loanable funds exceeds the funds supplied by voluntary saving, there will be an expansion in the demand
for bank loans to cover the difference.
Third, Wicksell assumed that the banking system
accommodates the extra loan demand with a corresponding expansion of loan supply, i.e.,

where
is the expansion in the supply of bank
loans. This equation implies a perfectly elastic supply
of loans and thus corresponds to Wicksell’s statement
that
2 “If the banks lend their money at materially lower rates
than the normal [i.e., natural] rate . . . then in the first
place saving will be discouraged . . . . In the second
place, the profit opportunities of entrepreneurs will thus
be increased and the demand for [investment] goods . . .
will evidently increase . . . ." [10, p. 194]

REVIEW, JANUARY/FEBRUARY

1979

With a pure credit system [in which the money
stock consists entirely of demand deposits and no
reserve constraint exists to limit loan expansion as
when the central bank stands ready to provide
unlimited reserves to the banking system in order
to prevent market rates from rising] the banks
can always satisfy any demand whatever for loans
and at rates of interest however low . . . . [10, p.
194]
Fourth,

he maintained

that money growth

relationship between the rate of price change and the
level of excess demand can be expressed as
(6)

exactly

matches bank loan expansion dollar for dollar.
In
his own words, “bank deposits and bank loans must
[10, p. 86] This condition
always march together.”
can be expressed as

where

is the expansion

money stock expands
new loans are granted
checking deposits of
are part of the money

of the money stock.

The

identically with loans because
in the form of increases in the
borrowers and these deposits
supply.

Fifth, he held that growth in the money stock is
accompanied by corresponding increases in aggregate
demand (total spending) for an exogenously-given
full capacity level of real output. Given this level of
real output- which
Wicksell treats as a fixed constant throughout his analysis3 -the increased spending manifests itself in the form of excess demand in
the commodity market.
In this way money growth
converts the excess desired demand implicit in the
investment-saving
discrepancy of Equation
1 into
The relationship between
excess effective demand.
money growth and excess demand may be expressed
as
(5)

E=

where E is excess demand. This equation states that
excess demand cannot occur without an identical
amount of money growth to support and finance

it.

Finally, he argued that prices are bid up by excess
demand, with the rate of price rise being roughly
proportional to the level of excess demand.4
The
3 Regarding the full employment assumption Wicksell
states that "we are entitled to assume that all production
forces are already fully employed, so that the increased
monetary demand . . . leads to an . . . increased demand
for commodities, [and] to a rise in the price of all . . .
goods . .. .” [10, p. 195] Note also that he dismisses as
unimportant the possibility that an interest-induced rise
in capacity output might work to lower prices.
This
price-reducing output effect, he said, would be “very
small.” More important, it would “occur only once and
for all” and thus would be swamped by the cumulative
(i.e., continuous) rise in prices stemming from the interest rate differential.
[9. pp. 142-3]
4 Note his
necessarily
is simplest
demand.”

assertion that “This increased demand . . .
results in a rise in all prices -a rise which it
to regard as proportional to the increase in
[9, p. 144]

=

bE

where
is the rate of price rise, the dot signifying
the rate of change (time derivative) of the attached
price level variable, and b is a constant coefficient
relating excess demand to price changes. According
to the equation, prices will rise when excess demand
is positive, fall when excess demand is negative, and
stabilize at a constant level when excess demand is
zero.
Taken together Equations l-6 constitute a simple
macrodynamic model in which a decline in the market
rate of interest below the natural rate results in
excess demand that bids up prices with the money
stock simultaneously expanding to accommodate and
validate the price increases.
The model can be condensed to a single reduced form equation by substituting Equations 1-5 into Equation 6 to yield

which says that the ultimate cause of price level
changes is the differential between the natural and
market rates of interest. According to the equation,
prices rise if the market rate is below the natural
rate, fall if the market rate is above the natural rate,
and remain stable-i.e.,
neither rise nor fall-if
the
market rate equals the natural rate.
Similar equations can be derived for the money growth and excess
demand variables showing that they too are determined solely by the interest rate differential.
On the basis of Equation 7 Wicksell reached several conclusions contradicting Tooke’s interest costpush doctrine. First, given the natural rate, a policy
of pegging the market rate at arbitrarily low levels
will produce a cumulative rise in prices. As Wicksell
himself put it, if the banks “were to lower their rate
of interest, say 1 percent below its ordinary [i.e.,
natural] level, and keep it so for some years, then
the prices of all commodities would rise and rise and
rise without any limit whatever.” [ll, p. 547]
In
other words, contrary to Tooke’s doctrine, a low
interest rate cheap-money policy is inflationary.
Second, if prices are rising, the market rate is too
low and must be raised to slow and ultimately stop
the inflation.
This will require a reduction and
eventually a cessation of money growth. Therefore
a higher interest rate tight-money policy is inherently
anti-inflationary,
contrary to the interest cost-push
doctrine.
Third, a rise in the market rate above the natural
rate will produce an absolute decrease
in the price

FEDERAL RESERVE BANK OF RICHMOND

7

level.
In Wicksell’s
interest is maintained

own words, if “the rate of
no matter how little above the

current level of the natural rate, prices will fall continuously and without limit.”
[9, p. 120] Thus, far
from being inflationary
as Tooke claimed, higher
interest rates may well be exactly the opposite, i.e.,
deflationary.
To summarize, given the natural rate of interest,
the rate of price increase varies inversely, not directly, with changes in the market rate. Thus lower
rates are inflationary
ary, contrary

and higher rates anti-inflation-

to Tooke’s

interest

cost-push

doctrine.

Tooke Versus Wicksell
on the Gibson Paradox
Finally, Wicksell used his model to counter Tooke's
claim
that the statistical data offered strong empirical
support for the interest cost-push doctrine.
Tooke’s
own empirical studies had established that historically
interest rates and prices tend to move up and down
together-a
phenomenon that Keynes was later to
On the basis of these
call the Gibson paradox.
studies, Tooke had argued that the coincidental movements of interest rates and prices constituted strong
empirical proof that high interest rates cause high
prices and low rates low prices. Wicksell, however,
disagreed.
He denied that the positive correlation
between movements in interest rates and prices implied that the former caused the latter.
Instead, he
argued that both rising interest rates and rising prices
stemmed from a common cause, namely exogenous
shifts in the natural
rate-due
to technological
change, innovation, and other external developments
-followed
by corresponding
lagged adjustments in
the market rate.5 He explained how the lag in the
adjustment of the passive market rate to the active
natural rate could result in coincidental rises in interest rates and prices. The lag, he said, meant that
while the market
the natural rate,

rate was rising it was still below
thereby causing excess aggregate

demand and hence a continuous rise in prices.
The price rise itself he held to be the key component of the process by which the market rate adjusts
itself to the natural rate. Specifically he maintained
that under a metallic monetary system a rising price
level affects market interest rates through its prior
impact on bank reserves.
He explained that rising
prices produce two kinds of gold drains that threaten
One is an
the depletion of banks’ gold reserves.
external drain to cover an adverse trade balance
stemming from the domestic inflation.
The other is
an internal drain of gold into hand-to-hand circula5 What follows relies heavily on Patinkin’s analysis of
Wicksell’s cumulative process.
See [4, pp. 587-97].

8

ECONOMIC

tion and into nonmonetary industrial uses. To halt
these drains and protect their reserves banks are
forced to raise the loan rate until it eventually equals
the natural rate. In this way rising prices serve as
the connecting link between the natural and market
rates of interest. This link may be expressed by the
relationship

where
is the rate of change of the market rate of
interest and c is a coefficient relating price changes
to changes in the market rate.
The foregoing

equation,

which states that interest
level proportional to
rate changes arechanges,
reconciles Wicksell’s theoretical model with Tooke’s
empirical findings of a positive correlation between
movements in interest rates and prices. The equation
shows that interest rates and prices rise and fall together.
Yet, within the context of Wicksell’s entire
model, the equation does not imply that higher interest rates produce higher prices. On the contrary,
the model states that both the rise in prices and the
rise in the interest rate are caused by that interest
rate being too low relative to the natural rate.
In
sum, Wicksell held that an initial rise in the natural
rate relative to the market rate generates the price
increases that feed back into the market rate causing
it to rise toward the natural rate.6 Thus, contrary to
Tooke’s contention, a positive correlation
between
interest rates and prices constitutes no disproof of
the proposition that low interest rate easy-money
policies are inflationary and high interest rate tightmoney policies are deflationary.
To disprove these
propositions
one would have to demonstrate
that
price movements are positively correlated not with
the market rate alone but rather with the differential
between that rate and the natural rate. Tooke did not
do this. Hence his empirical correlations constitute
no proof of the interest cost-push doctrine.
Nor do
they constitute disproof of the rival tight-money view.
6 Wicksell assumed that the market rate in a metallic
monetary system would converge smoothIy on the natural rate without overshooting.
In terms of his model, the
convergent behavior of the market rate can be described
by substituting Equation 7 into Equation 8 to obtain
and then solving this differential equation for the time path of the market rate. The resulting
expression for the time path of the market rate is

where t is time. e is the base of the natural logarithm
system, and Ro is the initial disequilibrium level of the
market rate. This expression states that the market rate
will converge smoothly on the natural rate providing that
the product of the coefficients a, b, and c (i.e., the multiplicative term abc) is positive, i.e., larger than zero.

REVIEW, JANUARY/FEBRUARY 1979

The Current

Relevance

of Wicksell’s

Model

The

preceding sections have described Wicksell’s model
of price level movements.
It remains to show how
his analysis helps answer current and recent complaints that high interest rates cause high prices.
According to Professors Ritter and Silber, the best
answer to these complaints is that high interest rates
accompanied by monetary expansion are indeed inflationary whereas high rates associated with tight
money-defined
by them as zero or negative money
growth-are
not. High rates, they claim, are incapable of producing inflation without an accommodative
expansion of the money stock. Without this monetary expansion, further increases in the price level
At that point the
would be difficult to finance..
higher interest

rates would prevent further spending

and the inflationary process would grind to a halt.
In short, higher interest rates are not inflationary
unless ratified by monetary growth. The key factor,
they conclude, is the behavior of the money stock
and not the high interest rates themselves.
[5, pp.
102-3]
The Ritter-Silber
conclusion is fully consistent
In his model too the bewith Wicksell’s analysis.
havior of the money stock distinguishes cases where
high interest rates are inflationary from cases where
they are not.
This can be shown by substituting
Equations 1-3 into Equation 4 to yield

which states that money growth is directly related to
the natural rate-market rate differential.
Taken together, Equations 9 and 7 state that if the money
stock is growing, then high market rates are indeed
producing higher prices. For the positive growth of
the money stock indicates that the market rate, no
matter how high, is nevertheless below the natural
rate and is thus generating the monetary expansion
that supports a continuous rise in prices. Contrariwise, if the money stock is constant or falling, then
the market rate of interest, no matter how high, is
noninflationary
or deflationary.
For when money
growth is zero or negative the market rate is equal to
or above the natural rate and is thereby tending
either to stabilize prices or to reduce them. Thus,

contrary to the contentions of the interest cost-push
school, high interest rates associated
with tight
money are noninflationary.
Conclusion

This

article

has reviewed

the Tooke-

Wicksell
controversy
concerning
the influence of
The article shows that
interest rates on prices.
neither the anti-inflationary
tight-money view nor its
rival, the interest cost-push doctrine, are new.
In
particular, the article disproves the recent claim that
“one of the first economists to concern himself with
the cost-push effect of interest rate changes was John
Kenneth Galbraith.“ [6, p. 1049 n. l]
Contrary to
the foregoing assertion, the interest cost-push doctrine long predates Galbraith’s 1957 version, having
been enunciated
years earlier.

by Thomas

Tooke

more than 100

The article also disproves the allegation that professional economists are not even interested in answering the interest cost-push doctrine, i.e., that they
simply “refuse to take it seriously and typically dismiss it out of hand.”
[5, p. 100]
Whether or not
this charge applies to modern economists, it certainly
does not apply to Knut Wicksell.
For, as documented in the article, Wicksell took the doctrine
seriously enough to attempt to refute it rigorously
In so doing, he provided the
and systematically.
definitive critique of the doctrine. He also developed
an analytical model that established the theoretical
foundations of the tight-money view and that provided a framework for anti-inflationary
monetary
policy. His model supports the current case for tight
money just as Tooke’s
views constitute a key argument underlying the opposite case for easier money
and lower interest rates.
In short, the ideas and
arguments advanced in the Tooke-Wicksell
debate
continue to survive and flourish in current discussions of monetary policy. For better or worse, the
interest cost-push doctrine refuses to die, thereby
supporting George Stigler’s contention that economic
theories- no
matter how fallacious-never
perish.
The survival of the doctrine in the face of Wicksell’s
criticism aptly illustrates Stigler’s dictum that “there
is no obvious method by which a science can wholly
rid itself of once popular theories.”
[7, p. 201]

FEDERAL RESERVE BANK OF RICHMOND

9

References
1. Cassel, G. “The Rate of Interest, the Bank Rate,
and the Stabilization of Prices.” Quarterly Journal
of Economics, 42 (1927-28),
511-29.
Reprinted
in Readings in
Monetary Theory.
Edited by F.
Homewood, Illinois:
R. D.
Lutz and L. Mints.
Irwin, 1951, pp. 319-33.
2. Marget, A. The Theory of Prices.
York : Prentice-Hall,
1938.

Vol. I.

New

3. Monetary Policy and the Management of the Public
Debt. Hearings before the Subcommittee on General Credit Control and Debt Management of the
Joint Committee on the Economic Report.
82nd
Congress, 2nd session, March 1952.
Money, Interest,
and Prices.
4. Patinkin, D.
edition. New York:
Harper and Row, 1965.
5. Ritter, L., and Silber,
Basic Books, 1970.
6. Seelig, S.
Inflation.”
ber 1974),

10

W.

Money.

2nd

New York:

“Rising Interest Rates and Cost Push
The Journal of Finance, 29 (Septem1049-1061.

ECONOMIC

7. Stigler, G.
“The Literature of Economics:
The
Case of the Kinked Oligopolv Demand Curve.”
Economic Inquiry, 16 (April l978), 185-204.
8. Tooke, T. An Inquiry Into the Currency Principle.
Second edition. London: Longman, Brown, Green,
and Longmans, 1844. Reprinted as No. 15 in Series
of Reprints of Scarce Works on Political Economy.
London:
The London School of Economics
and
Political Science, 1964.
Trans9. Wicksell, K. Interest and Prices (1898).
lated by R. F. Kahn.
London : Macmillan, 1936.
Reprinted New York: A. M. Kelley, 1965.
10.

Lectures on Political Economy.
Vol.
II: Money
(1905)
Translated
by E. Classen.
Edited by L. Robbins.
London : Routledge and
Kegan Paul, 1956.

11.

“The Influence of the Rate of Interest
on Prices.”
Economic Journal, 17 (1907) 213-20.
Reprinted in Economic Thought: A Historical Anthology. Edited by J. Gherity. New York: Random
House, 1965, pp. 547-54.

REVIEW, JANUARY/FEBRUARY 1979

FORECASTS 1979
SLOW

GROWTH,

CONTINUED

INFLATION,

BUT

NO RECESSION

William E. Cullison

The

views

and

opinions

set forth

in

this

article are those of the various forecasters.
No
agreement
or endorsement
By this Bank is
implied.

Most of them think that inventories, having been
accumulated cautiously during the current expansion,
will not be subject to large swings in 1979.
These elements led the forecasters
real GNP

The economy in 1979 will be plagued with slow
growth, increased unemployment,
and continuing
high rates of inflation. This gloomy prognostication
is not the woeful wailing of some modern day Cassandra, but the general conclusion reached by the
leading business and academic economists who have
published forecasts for the 1979 economy. While the
consensus forecast provides little to cheer about, it
does have a favorable side.
The group offering
quarter-by-quarter
forecasts thinks that the rate of
inflation will subside modestly during the year.
Moreover, the consensus of this group is that there
will be no recession (using the casual definition of a
recession,
two consecutive
quarters
of negative
growth in real GNP).
According to the consensus
of forecasts received by this Bank, real GNP growth
(measured in constant 1972 dollars) will decline to
zero in the third quarter of 1979 before beginning a
slow advance in the fourth quarter.
The major areas of concern to the forecasters this
year include the homebuilding industry and the prospects for consumer spending in general. Heavy borrowings by consumers in 1978 imply heavy repayment burdens in 1979.
Moreover, slower economic
growth coupled with continuing high rates of price
increase are expected to erode consumer purchasing
power.
The current high levels of mortgage and
other interest rates, even if they rise no further, are
expected to have a slowing effect on the housing
industry and on other consumer purchases in 1979.
Far fewer consumers than in 1978 are expected to
re-finance their homes in order to finance current
consumption expenditures.
Reduced income taxes
are seen as helping to sustain consumer spending,
although higher social security taxes will offset some
of this effect.
On the other hand, the forecasters generally expect
nonresidential
construction,
and business fixed investment in general, to remain relatively
strong.

1978, the 1979 Consumer
8.2 percent

to conclude that

will be 2.4 percent higher in 1979 than in
higher,

Price

Index

will average

and the unemployment

rate will

average 6.6 percent compared to 6.0 percent in 1978.
Last year, the consensus

prediction

for real GNP

growth, 4.3 percent, was close to the actual increase
for the year as a whole, 3.9 percent.
forecasters
rapidly

expected

in the first

growth tapering

real
quarter

GNP

off after that.

tended coal strike

to

of 1978,

and adverse

Last

year’s

increase

most

with rates of

Because

of the ex-

weather

conditions,

however, the economy actually had slightly negative
real growth in the first quarter with a resurgence

in

the second. Then the economy experienced a general
slowing in the third quarter, followed by what appears to be a growth resurgence in the fourth.
Many of last year’s forecasters had expected an
improvement in the foreign trade deficit, measured
They were
on a National Income Accounts basis.
basing their predictions upon expectations of recovery
abroad, as they are to some extent this year. Their
predictions were, of course, not fulfilled.
This year,
the forecasters expect U. S. exports to benefit from
the depreciation in the exchange value of the dollar
that took place in 1978 and they expect imports to
be dampened by slower growth in the U. S. economy
as well as by the price effects of the dollar’s decline.
This article attempts to convey the general tone
and pattern of some 40 forecasts received by the
Research Department of this Bank.
Not all of these
forecasts are comprehensive,
and some incorporate
estimates of future behavior of only a few key economic indicators.
Some are made in terms of annual
averages while others are made on a quarter-byquarter basis, and a consensus drawn from one of
these groups may differ from that drawn from the
other. Moreover, the individual forecasts are based
on varying assumptions and this should be taken into
account in interpreting the consensus.

FEDERAL RESERVE BANK OF RICHMOND

11

This Bank also publishes the booklet Business
Forecasts 1979, which is a compilation of representative business forecasts with names and details of

only

the various estimates.

of error, was relatively accurate. The consensus expected inventory investment to remain constant.
It
actually rose $0.1 billion from the revised $15.6
billion averaged for 1977.

be as informative

No summary

article can ever

as the actual forecasts

themselves.

Serious readers are urged to look at the individual
forecasts in more detail in Business Forecasts 1979.

11.8 percent-a

forecasting

error

Net exports, which the forecasters
1978

FORECASTS

IN

PERSPECTIVE

of 3.9 per-

centage points. By contrast, the consensus prediction
for inventory investment, which is a common source

often find diffi-

cult to estimate accurately, was overestimated
by
$3.8 billion last year, although the actual figure,
-$11.8
billion, was well within the range of fore-

The consensus forecast for 1978 current dollar
GNP, published in last year’s January/February
Economic
Review,
predicted an increase of 10.4

casts.
The range was, as it often is, quite large,
from +$1.7 to -$14.0
billion.

percent over 1977.
The rates of increase forecast
ranged from 9.0 percent to 11.3 percent.
Using the
revised 1977 GNP total of $1,887.2 billion, the consensus forecast for 1978 GNP would have been
$2,083.5 billion and the range from $2,057.0 billion
to $2,100.4 billion.
Increasing prices were expected
to account for 5.9 percent of the gain in GNP, so
GNP measured in constant dollars, or real GNP,
was expected to rise 4.3 percent.

The forecasts of the last major component of GNP,
government purchases of goods and services, centered
Actual
around a rate of increase of 12.1 percent.
government spending is now thought to have risen
10.2 percent.
All in all, the last year’s forecasters did well in
predicting changes in real GNP, but because they
underestimated the rate of price increase, they underestimated current dollar GNP and its components.

Current estimates by the U. S. Department
of
Commerce indicate that GNP in 1978 actually increased 11.7 percent.
Prices, however, increased
more than anticipated, so preliminary estimates put
the increase in real GNP around 3.9 percent-less
than the 4.3 percent increase predicted by the consensus of last year’s forecasters.

Regarding profits and industrial production, the
forecasts for 1978 underestimated
profits but predicted industrial production accurately.
Before-tax
corporate profits were predicted to rise 6.3 percent;
most observers now think they increased about 14.1
percent. The index of industrial production rose 5.5

The forecasters
expected the unemployment rate
At present,
to average 6.7 percent for the year.
preliminary estimates indicate an average of 6.0 percent.
As with the aggregate GNP figure, the forecasters
also under-predicted the components of GNP.
Most
of the under-prediction, however, can be attributed to
underestimating the rate of inflation.
Personal consumption spending was forecast to increase 9.3 percent, but it actually rose 11.0 percent.
Consumer purchases of durable goods, estimated
to increase 6.7 percent, actually rose 10.8 percent.
Consistent with the underestimate of consumer durables, purchases of nondurables were estimated to
increase 8.6 percent, whereas the actual rate of increase was 9.8 percent.
Consumption spending for
services was forecast to increase 11.0 percent, so its
actual 12.2 percent increase came in closer to the
mark than the other component forecasts.
The forecasters expected a more moderate rate of
increase in gross private domestic investment than
the 21 percent rate of growth registered in 1977.
Although the growth rate did, in fact, moderate to
15.7 percent, the forecasters had expected it to be
12

ECONOMIC

percent, exactly as predicted.
As with the implicit price deflator, the forecasters
underestimated the rise in the Consumer Price Index.
Consumer prices were expected to rise 6.1 percent,
but current figures indicate a rise of 7.7 percent.
The consensus of the quarter-by-quarter
forecasts
for 1978 had current dollar GNP rising 10.7 percent
in the first quarter, 9.8 percent in the second quarter,
10.2 percent in the third quarter, and 9.9 percent in
the fourth, measured at annual rates.
The realized
quarterly increases, measured at annual rates, were
7.1 percent, 20.6 percent, 10.7 percent, and 14.7
percent. For real GNP, the consensus forecast called
for annual rates of increase of 4.8 percent, 4.5 percent, 3.9 percent, and 3.5 percent for the four quarters, respectively.
The realized increases for the
first three quarters, were -0.1
percent, 8.7 percent,
and 2.6 percent, while the preliminary number for
the fourth quarter is now placed at 6.1 percent.
The forecasters, then, exhibited considerably less
prescience about the quarterly path of the economy
than they did about average figures for the year as a
They expected relatively greater growth
whole.
during the first quarter of the year, with the growth
rates tapering off throughout the year. Instead, the

REVIEW, JANUARY/FEBRUARY 1979

economy experienced

its slowest growth

in the first

quarter, with the rate fluctuating about throughout
the year. It is true, however, that the slowness in the
first quarter resulted from unforeseen circumstances
-the
coal strike and the unusually severe winter
weather. The forecasters did rather well for the first
half, taken as a whole.
The limits of forecasting
apparent in the discrepancy
dicted quarter-by-quarter
ment rate.

prescience were equally
between actual and pre-

behavior

The unemployment

of the unemploy-

rate was expected to

average 6.8 percent in the first quarter and to decline
only to 6.6 percent
the unemployment

by the fourth quarter.

Instead,

rate surprised almost everyone by

dropping sharply in the first quarter-from

6.6 per-

cent in the fourth quarter of 1977 to 6.2 percent;
fluctuating

around

and

5.9 percent for the remainder

of

the year.

RESULTS

1979

FORECASTS

IN

BRIEF

Gross National Product
Forecasts
for 1979 current dollar GNP center around $2,322 billion. This
consensus forecast indicates an approximate
10.2
percent yearly gain, less than the 11.7 percent increase apparently registered in 1978.
Prices, as
measured by the implicit deflator for GNP, are expected to increase 7.6 percent, about the same as the
7.4 percent rate of increase registered last year. As a
result, GNP measured in constant dollars, or real
GNP,

is projected

to rise only 2.4 percent, compared

to 3.9 percent in 1978.
Estimates for increases in
current dollar GNP range from 9.0 percent to 11.0
percent.
The consensus of quarterly estimates indicates a slowing of the economy during the year. It
calls for increases of 10.5 percent in the first quarter
of 1979, 7.8 percent in the second, 7.1 percent in the
third, and 6.8 percent in the fourth.

FOR 1978 AND TYPICAL

FORECASTS

FOR 1979
Percentage
Change

Unit or
Base

Gross national

product

Preliminary
1978*

_________________________ $ billions

2107.0

2322

1339.7
197.6
525.8
616.3
344.6
222.1
106.8
15.7
434.2
-11.8
1385.0

1471
210
577
686
369
249
109
14
482
-5.5
1418
171
204
1.71
8.58
6.6
149.9
211.2
163.6

Personal consumption expenditures ____________$ billions
Durables ________________________________
$ billions
Nondurables
____________________________
$ billions
Services ________________________________
$ billions
Gross private domestic investment _____________ $ billions
Business fixed____________________________
$ billions
Residential structures _____________________
$ billions
Change in business inxentories ______________ $ billions
Government purchases ______________________
$ billions
Net exports_________________________________
$ billions
Gross national product (1972 dollars) _____________ billions
$
Plant and equipment expenditures______________
$ billions
Corporate profits before taxes___________________
$ billions
Private housing starts _______________________
millions
Automobile sales (domestic)
___________________
millions
percent
Rate of unemployment _______________________
Industrial production index ____________________
1967=100
Consumer price index _________________________
1967=100
Implicit price deflator ________________________
1972=100
* Data

available

** Figures

as of January

are constructed

from

Forecast
1979**

152.5e
198.5e
1.98
9.25
6.0
145.0
195.4
152.0

1977/ 1978/
1978 1979

11.7
11.0
10.8
9.8
12.2
15.7
16.6
16.2
10.2
3.9
12.3
14.1
-0.3
2.0
5.5
7.7
7.4

10.2
9.8
6.5
9.7
11.3
7.1
12.2
1.7
11.0
2.4
12.0
2.6
-13.9
-7.2
3.4
8.2
7.6

18, 1979.
the

typical

percentage

change

forecast.

e Estimated.

FEDERAL RESERVE BANK OF RICHMOND

13

Personal consumption expenditures are expected
to total $1,471 billion for 1979, up 9.8 percent from
1978. The estimates for consumption spending range
from an increase of 9.1 percent to an increase of 10.5
percent.
Forecasters
estimate that expenditures for
durable goods will rise 6.5 percent for the year, while
expenditures for nondurables and services are projected to advance 9.7 percent and 11.3 percent, respectively.
The slowdown in durable goods expenditures is expected to be felt primarily in sales of
appliances, furniture, and automobiles as a result of
generally

heightened

Government

consumer

purchases

caution.

of goods and services

are

projected to total $482 billion. This estimate represents a 11.0 percent increase over 1978, somewhat
more than the 10.2 percent gain of the previous year,
The 1979 forcasts for government purchases range
from increases of 9.2 percent to 11.4 percent.
Gross private domestic investment is expected to
rise by 7.1 percent in 1979, following a 15.7 percent
increase in 1978.
Inventory investment is expected
to be at a somewhat lower leve1 than in 1978, indicating a continuation of the cautious inventory policies seen in recent years.
Residential construction,
of course, is expected to be the weakest sector of the
economy, increasing only 1.7 percent, compared to
16.2 percent in 1978.
Business fixed investment
spending will hold up reasonably well, if the forecasts are correct.
That sector is expected to register
a 12.2 percent gain compared to 16.6 percent last
year. The array of forecasts this year, as is usually
the case, diverge more from the consensus in the
investment area than in any other. Expectations for
residential construction range from decreases of 5.3
percent to increases of 3.2 percent.
For business
fixed investment, estimated increases range between
9.2 percent and 14.9 percent.
Forecasts for investment in business inventories, for which the consensus
was $14.0 billion, range from $2.0 billion to $20.0
billion.
Industrial
Production
The typical forecast
for
the Federal Reserve index of industrial production
(1967 =
100) in 1979 is 149.9, an increase of 3.4
percent.
This prediction calls for more moderate
expansion than in 1978, when the index increased
5.5 percent.
Housing
The construction
industry is expected
to feel the effects of high mortgage rates and rising
construction materials costs in 1979. Activity in this
sector is expected to be almost 14 percent below the
1978 pace.
Private housing starts-which
totaled
almost 2 million in 1978- are
expected to total only
14

ECONOMIC

TYPICAL*

QUARTERLY

FORECASTS

FOR 1979

Percentage Quarter-to-Quarter Annual Rates
Unless Otherwise Indicated
Forecast
I
Gross

national

product

inventories†
exports†

Rate

GNP

8.5
1.9
7.6
10.3

8.6
1.4
8.2
9.6

14.4

5.7

12.8

10.9

-2.2

-10.5
15.0

9.6

9.4
-1.5

-5.9

-0.5

8.3
-12.5

7.1
-5.8

11.7

6.4

8.3 10.2
1.4

1.8

0.4

1.2

10.1

8.0

6.5

-3.3

-5.1

-33.8 -28.4
index 2.5

of unemployment‡

price

1.4

12.5

starts

production

implicit

8.9
4.7
9.2
10.5

3.1

housing

Consumer

6.8

product

Corporate
profits
before taxes

Industrial

7.1

-2.2

Plant and equipment
expenditures

Private

7.8

17.9

purchases

Gross national
(1972 dollars)

IV

9.9
5.3
10.5
11.1

Gross private domestic
investment
Business
fixed
investment
Residential
construction
Change in business

Net

1979
III

10.5

Personal
consumption
expenditures
Durables
Nondurables
Services

Government

II

index

deflator

-14.9

-0.5

-22.9
1.6

15.6

-3.1

0.0

6.1

6.4

6.6

6.8

8.7

7.6

6.8

6.9

7.7

7.2

6.5

7.0

* Median
† Levels,

billions

‡ Levels,

of dollars

percent

1.7 million units in 1979. According to preliminary
estimates, housing starts ran at average annual rates
of 2.1 million in October and November of 1978, so
the predicted number for 1979 represents a considerable decline from the year-end 1978 rate. Still, forecasters expect the downturn in construction
to be
relatively mild.
Credit is expected to be available,
although at high cost to home builders and buyers.
Corporate Profits
All the forecasters
expect little
increase in pretax profits this year. The most pessimistic forecaster
expects no increase in corporate
profits.
The most optimistic predicts a 9.0 percent
rise. The consensus forecast calls for an increase in

REVIEW, JANUARY/FEBRUARY

1979

pretax profits of 2.6 percent, to $204 billion.
This
would follow a gain of approximately 14.1 percent in

Quarter-By-Quarter
Forecasts
Fifteen forecasters made quarter-by-quarter
forecasts for 1979. As

1978. Hence, corporate profits are expected to reflect
the slower growth of the economy, but they are not
expected to decline precipitously as they normally do
in recession years.

indicated by the accompanying table, the forecasters
expect generally slow rates of growth in each quarter
of the year. Translated into percentages and annualized, the expected median growth rates of real GNP
are 3.1 percent, 1.4 percent, 0.4 percent, and 1.2 percent for the four quarters, respectively.

Unemployment
Most forecasters
are predicting
an increase in the rate of unemployment during 1979.
The typical forecast for the year’s average is around
6.6 percent. This will be only 0.6 percentage points
above the 1978 average, but considering that the
unemployment rate at year-end 1978 stood around 6.0
percent, a 6.6 percent average for 1979 indicates that
the unemployment rate will be considerably higher
by year-end.
The quarterly consensus forecast, in
fact, puts the unemployment rate at 6.9 percent in
the fourth quarter.
Prices
This year the forecast indicates that the
rate of price increase will remain at about last year’s
rate.
The implicit GNP deflator, which rose 7.4
percent in 1978, is expected to increase 7.6 percent
in 1979.
The Consumer Price Index, however, is
expected to rise 8.2 percent, slightly higher than the
1978 average increase of 7.7 percent.
Net Exports
The nation’s trade position, measured on a National Income Accounts basis, was
approximately $11.8 billion in deficit in 1978 and is
expected to improve moderately in 1979 to show an
average deficit of only $5.5 billion for the year. The
forecasters expect import growth to moderate as the
economy slows, and they also foresee an increase in
exports from the continuing recovery abroad and as a
result of more competitive export prices.
The estimates for net exports varied between -$8.5
billion
and +$5.6 billion.

These rates are median forecasts, however, and
there is considerable variation among the forecasters.
The forecasts for increases in real GNP in the first
quarter range from 0.3 percent to 5.3 percent ; second
quarter expectations
range from decreases of 2.0
percent to increases of 3.0 percent; third quarter
from -2.1
percent to +4.8 percent; and the fourth
from -3.0
percent to +3.0 percent.
If the median forecasts are realized, the 6.8 percent unemployment rate for the fourth quarter will
represent a considerable worsening of the current
With a civilian labor force of
employment picture.
around 97 million persons, an increase of 0.8 percentage points in the average unemployment rate means
an increase in unemployment of 776 thousand persons.
Several of the forecasters expect the unemployment rate to be as high as 7.2 percent by year-end
1979.
The forecasters expect the rate of increase in the
prices of items included in GNP to move somewhat
erratically during the year. The consensus forecasts
were for increases of 7.7 percent, 7.2 percent, 6.5
percent, and 7.0 percent for the four quarters, meaPrice
sured at seasonally adjusted annual rates.
increases forecast ranged from 7.2 percent to 7.7
percent in the first quarter, 6.1 percent to 8.0 percent
in the second, 5.2 percent to 7.1 percent in the third,
and 4.8 percent to 7.4 percent in the last quarter
1979.

of

BUSINESS FORECASTS 1979
The Federal Reserve Bank of Richmond is pleased to announce the publication
of Business Forecasts 1979, a compilation of representative business forecasts for
the coming year. Copies may be obtained free of charge by writing to Bank and
Public Relations, Federal Reserve Bank of Richmond, P. O. Box 27622, Richmond,
Virginia 23261.

FEDERAL RESERVE BANK OF RICHMOND

15

A SUMMARY
INTERNATIONAL

OF THE

BANKING ACT OF 1978
John P. Segala

The International

Banking

Act of 1978 is a land-

mark piece of legislation which, for the first time,
establishes a framework for Federal regulation of
foreign banking activities in the U. S. [1]
Discussion of such legislation dates back to at least 1966
when a study by the Joint Economic
Committee
showed that because they were not subject to Federal
law, foreign banks experienced certain advantages
and disadvantages vis-a-vis their domestic counterparts. [3]
For example, foreign-owned banks had
the unique opportunity to branch interstate, but were
hampered in competing for “retail” deposits because
they could not obtain FDIC insurance.
Although a
number of bills addressing these issues were introduced before Congress in the years following the
JEC study, none was enacted until 1978.
During the 1970’s, pressure for foreign banking
legislation mounted as the number and size of foreign
banking operations in the U. S. grew rapidly. [2]
In 1973 there were about 60 foreign banks operating
banking offices in the United States with combined
assets of about $37 billion.
By April 1978, there
were 122 such offices with combined assets of approximately $90 billion. Moreover, the involvement

in the U. S. to engage in as wide a range of activities
and geographical areas as permitted by its home
country to U. S. banks operating there. Since U. S.
banks operating in many foreign countries face fewer
regulatory constraints than in the U. S., it was suggested that only minor changes in existing legislation
were warranted. While the question of international
reciprocity in the regulation of foreign banks is addressed in the new legislation, the major emphasis
of the Act is on national treatment of foreign banks.
The reasons why this policy was favored should become clear below.
Foreign
banks in the
Organizational
Forms
United States operate under four major forms of
organization : agencies, branches, investment companies, and commercial bank subsidiaries.

of these institutions in U. S. credit markets had risen
to the point where, by April 1978, they held over $26
billion in commercial and industrial loans. [5] This
is equal to about 20 percent of business loans of the
300 large weekly reporting banks.
Thus, foreign
banks operating in the U. S. could no longer be
viewed strictly as specialized institutions primarily
engaged in financing foreign trade.
Rather, they
are significant participants in a wide range of markets for banking services in this country.

Agencies are primarily engaged in financing trade
and investment between the United States and their
home country. The major sources of funds for agencies are balances placed with them by parent or sister
institutions and borrowings in the interbank and
Federal funds markets.
While agencies are prohibited from accepting conventional deposits, they
can maintain “credit balances,”
which represent,
among other things, undispursed amounts of loans
made to their customers and receipts from international trade transactions.
Thus, credit balances are
sometimes analagous to the unused portion of a loan
held by a customer on deposit with his commercial
bank. But there are limits on the types of payments
that can be made from such accounts. For example,
payrolls and utility bills typically cannot be met from
credit balances.

In discussions of the major thrust of foreign bank
regulation, two divergent views emerged.
One view
argued for strong Federal regulation to be based
upon the principle of “nondiscrimination”
or national
treatment.
This policy sought to place foreign banks
on an equal competitive footing with domestic banks,
making both groups subject to the same rules and
regulations.
A different position argued for a policy
of “reciprocity”
which would allow a foreign bank

The branch form of organization allows foreign
banks a broad scope of banking activities, including
provision of a range of services approaching “full
Unlike
agencies,
service”
commercial
banking.
branches are able to solicit demand and time deposits.
Traditionally,
branches have focused their lending
operations on the U. S. subsidiaries of home based
corporate customers,
although they have become
increasingly involved in the U. S. corporate banking

16

ECONOMIC

REVIEW, JANUARY/FEBRUARY 1979

market.

Although

U.

S.

and

foreign

corporate

deposits and interbank borrowings still represent the
primary sources of funds for branches, the importance of retail deposits
Investment
ment activities

has been growing.

companies

engage in loan and invest-

and have many of the same banking

powers as agencies.

Like agencies,

they cannot ac-

cept deposits but can maintain credit balances.
advantage

of investment

the only organizational

companies

One

is that they are

form allowed to deal in se-

curities.
Foreign

banks may also establish commercial bank
These subsidiaries are
subsidiaries in the U. S.
identical to banks owned by U. S. residents and are
subject to identical regulatory restrictions.
Through
this form, foreign banking corporations can provide
a full range of banking services in the United States.
Prior to the 1978 legislation, subsidiaries were the
only organizational
form of foreign bank that fell
under Federal
regulatory
authority,
although in
practice and for a variety of reasons Federal chartering was rarely favored. One reason was that Federal
law required that all directors of a National bank be
U. S. citizens, while some states allowed up to half
of the directors of a state bank to be non-U. S.
citizens.
It should be noted that foreign banks may simultaneously operate a variety of organizational forms.
Though state laws prohibit foreign banks from operating both an agency and a branch in a single state,
they may operate either of these forms with any or
all of the other entities. For example, a foreign bank
may simultaneously operate agencies, representative
offices, investment companies, and state-chartered
bank subsidiaries.
Its choice in this connection is
dependent upon the kind of banking business it
wishes to conduct and the laws of the individual
states in which it seeks to operate.
The Multistate
Banking Issue As of April 1978,
there were 63 foreign banks operating facilities in
more than one state with 31 of these operating
in three or more states. [4] This ability of foreign
banks to operate on a multistate basis resulted
from a number of factors. [6]
First, Federal law
did not prohibit multistate branching by foreign
banks.
Since foreign banks were not eligible for
Federal Reserve membership, imposition of McFadden Act restrictions on multistate branching was not
possible.
Moreover, because branches and agencies
of foreign banks were not defined as “bank subsidiaries” under the Bank Holding Company Act, they
were not subject to the multistate banking prohibi-

tions of that legislation.
acted specific legislation

Finally, certain states enpermitting
foreign bank

entry regardless of whether the bank had facilities
in other states.
Thus, given the legal opportunity,
foreign banks expanded their multistate operations in
not only international banking and finance, but also
in domestic commercial and industrial loans, money
market operations, and in some cases, retail banking.
The

effect

on the competitive

equality

between

foreign and domestic banks due to the ability of the
former to conduct multistate
controversial
Banking
state

topic

Act.

foreign

over their

view, supported
Supervisors

domestic

and the Institute
foreign

International

if any, did multi-

banks

a competitive

counterparts

by the Conference

that any advantage

was the most

in the

To what degree,

branching give

advantage

operations

addressed

?

of State

of Foreign

One
Bank

Banks, held

banks appear to have is

largely illusory because domestic banks have already
established their own multistate presence through the
operation

of loan production

porations

and nonbanking

Also, since foreign
international

offices,

affiliates

Edge

in other

banks are primarily

banking

operations,

Act corstates.

engaged

their major

in

com-

petitors are not domestic banks but rather Edge Act
corporations
to operate

which, like foreign banks, are permitted
in more than one state.

Finally,

it was

argued that restricting foreign banks to one state
would give California and New York, which contain
the nation’s important centers for financing foreign
trade, a virtual monopoly of these activities to the
detriment of other states wishing to increase their
role in international banking.
Therefore, the argument ran, Federal
restrictions
on foreign
bank
branching was both unnecessary and undesirable.
The Federal Reserve and the Department of the
Treasury
believed otherwise.
While admitting a
multistate presence of domestic banks, they argued
that the taking of deposits was the essence of banking, and it was in that activity that domestic banks
The multistate privilege, it
were at a disadvantage.
was argued, gave to foreign banks a potentially
broader and more diversified base from which to
solicit deposits than was available to domestic institutions.
Moreover, foreign banks operating on a
multistate basis could provide a full line of services
to large corporate customers with operations in various states and various foreign nations.
The opportunity for a corporation to transact its entire banking
business both at home and abroad with one bank was
seen as an important reason that foreign banks were
attracting such customers. [5]

FEDERAL RESERVE BANK OF RICHMOND

17

To this argument was added the issue of the effect
of multistate foreign bank operations on the structure
of the U. S. domestic banking system. In his testimony

before

Congress,

Chairman

Miller

of

the

Federal Reserve System warned of the dangers of
allowing a third tier of privileged foreign chartered
banks to develop over state and Federally chartered
banks. [4] By permitting the world’s largest foreign
banks to establish full service facilities throughout
the U. S. and at the same time continuing to prohibit
multistate operation of domestic banks, a situation
could arise where only a handful of the largest domestic banks would be competitive with these foreign
institutions.

den Act to the present financial, banking, and economic environment.
The McFadden Act, passed in
1927, prohibits
domestic
banks from interstate
branching.
Modification or repeal of this legislation
could lead to the establishment
networks by domestic banks.

of multistate

branch

To summarize, by focusing on the key advantage
to foreign banks, namely the ability to accept deposits on a multistate basis, the International Banking Act significantly
improves
the competitive
equality between foreign and domestic financial institutions with respect to the taking of deposits. While
foreign banks will still be able, with proper state
approval, to make both domestic and international
commercial loans throughout the country, this does

The 1978 Settlement
The International
Banking
Act of 1978 attempts to settle the multistate banking
issue by establishing rules that promote competitive
equality between domestic and foreign banks while
preserving the ability of states to attract foreign
capital and develop international
banking centers.
Specifically, the Act allows foreign banks to establish
branches or agencies in any state where permitted by
state law, as was previously the case. However, the
foreign institution is required to designate a particular state as its “home state” and its deposits from
outside that state are limited to those foreign-source
and international
banking and finance related deposits permissible for Edge Act corporations.
Thus,

National
Licensing
and Chartering
As noted,
until enactment of the International
Banking Act all
foreign bank branches and agencies operating in the
U. S. did so under state authority.
However, passage of the Act has given these institutions for the

branches outside

first time, the option

the home state are to accept only

the type of credit balances allowable to agencies.
Foreign banks are also prohibited from acquiring
subsidiary banks outside the home state.
Finally, a “grandfather” clause in the Act exempts
from these limitations all foreign bank operations
existing on or before July 27, 1978. This feature of
the Act has been criticized on grounds that it maintains domestic banks at a competitive disadvantage
relative to grandfathered
institutions
and likewise
places foreign banks entering the United States for
the first time at a similar disadvantage.
Failure to
include

such

against

U.

a clause,
S.

banks

operating

governments.

Another

father

was

clause

businesses established

however,

risked
abroad

justification

fairness.

It

by foreign

for the grand-

was

under a particular

should be allowed to continue

retaliation

argued

that

set of rules

under those rules.

The Act, it might be noted, contains a brief section that has the potential for altering the structure
of U. S. banking. This section requires the President,
in consultation with the bank regulatory agencies, to
submit a report to Congress containing recommendations with respect to the applicability of the McFad18

ECONOMIC

not appear to give them a significant advantage vis-avis their domestic counterparts
since U. S. banks
also have ways of competing for domestic loan business.
Thus, the 1978 legislation leaves intact the
right of states to determine the extent of foreign
bank activity within their own borders while at the
same time ensuring that this does not give foreign
banks a competitive edge.

of obtaining

either

a state or

Federal license. Specifically, the Act allows foreignowned banks to establish Federal branches or agencies in any state where it does not already have a
state licensed branch or agency, provided that state
law does not prohibit such institutions.
In conjunction with this provision, foreign banks electing Federal branch or agency licenses gain access to Federal
Reserve System services such as check collection and
wire transfers.
Although foreign-owned
bank subsidiaries
have
historically
been allowed the dual charter option,
The reason
only a handful have made this choice.
was that Federal law required all directors of NaTherefore,
to
tional banks to be U. S. citizens.
encourage Federal chartering
of subsidiaries,
the
International Banking Act permits a minority of the
directors of a National bank to be non-U. S. citizens,
subject to approval by the Comptroller of the Currency.
To ensure that Federal
foreign
over

their

visions

branches

and agencies

banks do not have a competitive
state

counterparts,

were included

REVIEW, JANUARY/FEBRUARY

1979

several

in the Act.

of

advantage
special

These

are:

pro(1)

Federally
licensed agencies of foreign banks, like
state licensed agencies, cannot accept deposits but
can maintain credit balances arising from their lending activities;
(2) a foreign bank cannot maintain
both Federally licensed branches and agencies in the

Investment
and Nonbanking
Activities
The
Glass-Steagall
Act of 1933 made it illegal for a company to engage in both commercial and investment
banking activities in the U. S. This prohibition was
subsequently reinforced by the Bank Holding Com-

same state,
organization
within states
strictions of

pany Act of 1956 and by rulings

since states permit only one form of
; and (3) Federal branches and agencies
are made subject to the branching rethe McFadden Act.

Regulatory
and Supervisory
Authority
An important provision of the new legislation establishes a
comprehensive
framework
for the regulation and
supervision of foreign banking in the U. S. In the
past, almost all of this authority has rested with the
states, but passage of the Act has shifted major
responsibility to the Federal level. Thus, the Federal
Reserve Board, in consultation with the states, is
given the power to set reserve requirements for all
Federal and state licensed foreign bank branches and
agencies whose parent organizations
have over $1
billion in total worldwide assets. Almost all foreign
banking organizations with U. S. offices meet this
The power to set reserve requirements
criterion.
was deemed necessary for Federal Reserve control
over inflows and outflows of funds, as well as over
domestic deposits.
Regarding supervision, the Act provides authority
for the Comptroller of the Currency, the FDIC, the
Federal Reserve Board, and the states, to examine
the foreign banking organizations
within their respective regulatory jurisdictions.
Specifically, Federally licensed branches and agencies will be examined by the Comptroller’s
office;
state licensed
branches insured by the FDIC will be examined by
the FDIC
and the states; and, all state licensed
agencies and branches not insured by the FDIC will
be examined by the states.
In order to ensure full
compliance with the Act, the Federal Reserve Board
is provided with “residual examining authority” over
all the banking operations of foreign banks.
This
authority permits the Federal Reserve to make independent examinations of any and all foreign bank
operations

in the U. S.

It was granted

to the Fed

Governors.

These

necessarily
tions.
S.

were not

banking

organiza-

a branch or an agency and

acquiring

broker/dealer,

a controlling

foreign

interest

banks

were

engage in both commercial

regarding

mestic

existed

from nonbanking

banks

are

unable

activities.

business

is not closely

related

One argument
foreign

banks

Steagall

used to justify

from

Act and the Bank

was one of reciprocity.
ating

in a certain

the

the prohibitions

Company

nation

the same in the U. S.
structure

activities there,

The counter argument

within its borders.

Moreover,

The approach of the 1978 legislation
the issue of nonbanking
ing issue.
promote

In both
competitive

domestic

financial

interests

of national

the International

activities

instances
equality

ing and anti-tying

of foreign banks is
the objective
without

importance.

comprehensive
otherwise

review of these operations than would

be possible.

is to

foreign

and

sacrificing

Toward

this end,

Act applies the nonbank-

provisions

of the Bank

Holding

Company Act to all foreign financial institutions.
undue burden on a foreign

gives the Federal

the Fed

nations.

to addressing

between

institutions
Banking

and a Federal

allows a more

discrimina-

similar to the one used to settle the multistate branch-

from

Providing

is that

the banking

sets of rules apply to banks from different

activities

authority

to

tion within a given market is created when different

fathered

regulator.

Act

are permitted

each country has the right to determine

banking

vised by a different

of

That is, if U. S. banks oper-

foreign

engage in investment and nonbanking

bank may simulta-

with this special examining

exclusion

then banks from that nation should be allowed to do

neously operate a state licensed agency in one state
each being super-

foreign

of the Glass-

Holding

prevent

branch in another,

5

sitions.

tution as a result of these restrictions,

a foreign

do-

than

to banking,

multistate

example,

While
more

banks were, in practice, allowed to make such acqui-

the examination

For

banking.

percent of the voting shares of any company whose

as a tool to be used in consolidating
ations.

to

the separation

to acquire

of what in many cases are complex

oper-

in a

able

and investment

A similar situation
of banking

of

however,

to foreign

By establishing

simultaneously
U.

prohibitions,

applicable

of the Board

of such

July

26,

are

However,

the power

the grandfathered

status of any company
if this status

1985,

undue concentration
competition,

of resources,

nongrand-

the Act

to terminate

cember

31,

insti-

existing

institutions

1978.

Reserve

financial

To

after De-

has contributed

to

decreased or unfair

conflicts of interest, or unsound banking

FEDERAL RESERVE BANK OF RICHMOND

19

practices.

It is vital to note that foreign institutions’

nonbanking

activities

conducted

Bank

Holding

principally

outside

from the restrictions

the U. S. are exempt

of the

banking markets.
been subject

to restrictions
To

redress

tages, the International
FDIC

Regarding

Insurance

FDIC

insurance

issues were involved.
equality.
foreign

Prior

provision

to enactment

This

of

two basic

The first concerns competitive

bank branches

insurance.

the

to foreign bank branches,

of the 1978 legislation,

were not eligible

created

for FDIC

both a competitive

advan-

The advantage and a competitive disadvantage.
tage arose because foreign branches did not incur
FDIC insurance
premium assessments and thereby
realized a cost savings not available to domestic
banks. But because foreign banks were not insured
they faced a disadvantage in competing for deposits,
especially at the retail level.
The second issue involved the lack of regulatory jurisdiction
over the
The FDIC
non-U. S. portions of foreign banks.
not only insures deposits, it also attempts to minimize bank failures via bank examinations and other
means.
But, since U. S. authorities have no jurisdiction over the non-U.
S. operations of foreign
banks, the FDIC is hampered in such efforts.
The

International

issues

by making

foreign

banks

(defined,
than

Banking
FDIC

that

do not

for practical
FDIC

those

FDIC

inequalities
from

are

risks

reduced.

surety

deposits

as deposits
that

of less
accept

are protected and com-

associated

deposit

retail

these
for all

is made mandatory.
To

protect

with insuring

banks that cannot be monitored,
such banks

optional

branches

insurance

In this way, small depositors
petitive

addresses

accept

purposes,

For

$100,000).

retail deposits,

Act

insurance

the

foreign

the Act requires that

bonds

or assets

at the

Edge corporations

these apparent

Banking

First,

restriction

limiting outstanding

liabilities

statutory
original

limit

disadvan-

Act revises several

of the Edge Act.
and surplus

to

relative to their foreign

provisions
the capital

have

that some consider

place them at a disadvantage
competitors.

Company Act.

However,

it removes

to ten times

of these institutions.

on liabilities

was

the
This

included

Edge Act to prevent insolvency.

in the

However,

because neither domestic nor foreign banks face such
a limitation,

and since Edge corporations

to examination

and reports

are subject

of condition

in the same

manner as member banks, the restriction

was deemed

discriminatory.

The second major revision abolishes

the mandatory

10 percent

posed on the liabilities
places

Yet another

the first time, majority
corporations

reserve

control of Edge corporations

banking

to the four

The

control

original

resulted

U. S. companies

that

in the Edge Act allows, for

may become

article.

and re-

requirements

institutions.
another

Thus,

major

tional form for foreign bank operations
in addition

im-

banks.

revision

by foreign-owned

requirement

of Edge institutions

it with the same

apply to member

reserve

from

mentioned
prohibition

Congressional

Edge

organiza-

in the U. S.
earlier

in the

against

foreign

concerns

lacked the sophistication

that

to compete

with the great banking and trading houses of Europe.
Clearly,

such fears no longer exist.

sion of the Act requires

the Federal

Another

provi-

Reserve

Board

to revise any other regulatory restrictions that discriminate against foreign-owned banking institutions
or that disadvantage or limit Edge Act corporations
in competing with foreign banking institutions.

FDIC.
Edge

Act

Although

Revisions

the new legisla-

tion seeks mainly a revision of regulations
to foreign bank operations
tains an important
the specialized
Edge

section revising

U. S. financial

in international
are restricted

their international

with
20

foreign

of

known as

corporations

engage
and

that are closely related to

and foreign

Edge corporations
domestic

the regulation

institutions

banking and financial operations
to activities

lation that originally
allow

Edge

Act corporations.

that apply

in the U. S., it also con-

provided

business.

The legis-

for the chartering

of

was enacted in 1919 in order to

banks

to compete

financial

institutions

more

effectively

in international

Summary
and Conclusion
The
International
Banking Act of 1978 is the first comprehensive legislation that brings foreign-owned banking operations
in the U. S. under Federal regulations comparable to
Its
those faced by domestic financial institutions.
major objectives are to promote competitive equality
between foreign and domestic banks, to improve Federal control over monetary policy and to provide a
Federal presence in the regulation and supervision
of foreign bank activities in the U. S. Under the
Act, the deposits of foreign-owned
bank branches
operating outside of their home state are limited to
the international
finance related credit balances alThus, while such branches may
lowed agencies.
make loans, they are restricted in their ability to

ECONOMIC REVIEW, JANUARY/FEBRUARY 1979

compete with local domestic
retail

deposits.

In

directs the Federal
encumber
The

Act

also

banks

Federal

the

in competing

foreign

National

welcome

banks

a comprehensive

Finally,

for the U.

with

to

obtain
and a

bank under liberalized

that in states where forthey

will have

regulatory
S. offices

the U. S. nonbanking

a

State-

to that of domestic

In providing these alternatives,

framework

that

and agencies

option which is similar

banks.

new legislation

to revise regulations

branches

This ensures
are

or

institutions.

allows
for

chartered

regulations.

lishes

banking

licenses

Federally
eign

addition,

Reserve

Edge Act corporations

foreign-owned
Federal

banks for wholesale

the Act estab-

and supervisory
of foreign

activities

banks.

of foreign

banks operating

in the U. S. are placed under the

same restrictions

as their domestic counterparts,

FDIC

and

insurance is made available to foreign branches

desiring

such coverage.

References
1. International
Banking
95th Cong., 2nd sess.

Act

of 1978, Pub.

L. 369,

2. Summers, Bruce J. “Foreign Banking in the United
States : Movement Toward
Federal
Regulation.”
Economic Review, Federal Reserve Bank of Richmond, (January/February
1976) pp. 2-7.
For3. U. S. Congress.
Joint Economic Committee.
eign Banking in the United States. Economic Policies and Practices Paper No. 9, Washington, D. C.
1966
4. U. S. Congress.
Senate.
Committee on Banking,
Statement
by G.
Housing, and Urban Affairs.
William Miller before the Subcommittee on Financial Institutions
of the Committee on Banking,
Housing, and Urban Affairs
on H.R. 10899, 95th
Cong., 2nd sess., 1978.
5. U. S. Congress.
Senate. Report of the Committee
on Banking, Housing, and Urban Affairs.
Report
No. 95-1073, 95th Cong., 2nd sess., 1978.
6. Welsh, Gary M. “A Case for Federal Regulation of
Foreign Bank Organizations in the United States.”
The Columbia Journal of World Business, Vol. X,
No. 9 (Winter 1975).

The ECONOMIC
REVIEW produced by the Research Department of the Federal Reserve Bank of
is
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