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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 FEDERAL RESERVE BANK OF RICHMOND 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.  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.  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.  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.  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.  This ability of foreign banks to operate on a multistate basis resulted from a number of factors.  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.  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.  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 Richmond. 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