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iP d w t e w SEPTEMBER 1965 IN THIS ISSUE D ebt a nd the E c o n o m y .. . •8? ■; 3 •' Som e Perspective on Foreign Exc h a ng e Rates 2 4 FEDERAL RESERVE BANK OF CLEVELAND Additional copies of the E C O N O M IC REVIEW m ay be obtained from the Research Department, Federal Reserve Bank of Cleveland, Cleveland, O hio 44 1 0 1 . Permission is granted to reproduce any material in this publication. SEPTEMBER 1965 DEBT This article is concerned with an area about which nearly everyone has something to say, and usually from a fairly fixed and passionate point of view. At the same time, it is an area, unfortunately, about which economists and econom ic literature have provided relatively little that can be taken as authoritative and definitive. Over and above the fact that the economy needs debt to func tion —on this point there is virtually no dis agreement —there is little in the way of benchmarks or yardsticks suggesting how m u ch d eb t the econom y o u g h t to have or can have. Because of the lack of standards or benchmarks, there is wide disagreement as to how debt can be meaningfully measured or evaluated, for example, regarding its growth and composition. The confusion and diverse opinions that sprout whenever debt announced with rage and shock, 'the debts of the American people today are higher than ever before in our history I' It is an effective point and he delivered it w ell—as he should. He has been saying it for years. It is a line that suggests evil doings in high places and has the special political advantage that it is almost al ways true. It is virtually an econom ic law and its corollary is that we are almost always upset about it. A few years ago we were shocked by the rapid growth of farm debt, then we were dismayed by the expansion of business debt, then Congress got worried about housing debt, and the President became concerned about consumer debt. Meanwhile, when things became slack, we all fussed about the national debt. But why? Why do we continue to accumu late debts when they cause us so much concern?1 is discussed are suggested by the following quotation: Not long ago one of our elder statesmen made a campaign speech in which he 1 See Marshall A. Robinson, D eb t and the A m erican Econom y, The Brookings Institution, Washington, D. C., 1959, p. 1. AND THE ECONOMY THE ECONOMICS OF DEBT This s e c tio n a tte m p ts , p erh a p s h e r o ic p o w er fro m th ose sp en d in g u n its —in a lly , to c o m e to grips w ith th e q u estio n dividuals, fa m ilies, p o se d in th e fo reg o in g q u o ta tio n . The g o v e r n m e n t bod ies, e tc . — th a t save a p a rt bu sin ess con cern s, crea tio n o f d eb t is p a rt o f a p ro c e s s by o f th eir cu r re n t in co m es to th ose sp en d w h ich th e su rplu s p u rch a sin g p o w er o f ing u n its desiring to m a k e ou tla ys in savers is p la ced in th e hands o f d eficit excess o f th eir c u r r e n t in co m es. Such spen d ers. In o th e r w ords, th e crea tio n tran sfers o f p u rch a sin g p o w er involve o f d eb t in volves a tra n sfer o f p u rch a sin g th e in cu rren ce o f d eb t, th a t is, an oblig a - 3 ECONOMIC REVIEW tion on th e p a rt o f a borrow er to m a k e p la ce. The levels o f savings and in v e s t repa y m erit a t s o m e fu tu r e tim e. B u t, m e n t, h ow ever, w ou ld a lm o st certa in ly sim u lta n eo u sly , su ch transfers o f p r e s e n t be less than o p tim u m . S om e sp en d in g p u rch a sin g p o w er also involve th e c r e a u n its th a t fo re se e p rofita b le in v e s tm en t tion o f a financial a sset h eld by th e le n d o p p o rtu n itie s w ou ld be restra in ed b y a er, th a t is, a claim to fu tu r e p u rch a sin g lack o f p u rch a sin g p ow er. O th er un its, p ow er. Thus, th e crea tio n o f d e b t involves th e s im u lta n eo u s crea tio n o f o ffs e ttin g having n o su ch desirable o p p o rtu n ities , w ou ld have to ch o o se b etw ee n co n su m in g assets an d liabilities. all th eir c u rr en t in c o m e , h oard in g a p o r D eb t is cr e a te d (an d a ccu m u la ted ) b e ca u se it is essen tia l to th e p ro p e r fu n c tion in g o f an e c o n o m y su ch as th a t o f th e U.S. E co n o m ic g row th , w h ich is o n e im p o r ta n t m ea su re o f e c o n o m ic p e r fo rm a n ce, d epen d s to a large e x te n t on a n a tio n ’ s w illin gn ess to fo r e g o th e im m ed ia te c o n s u m p tio n o f p a r t o f its c u r r e n t o u tp u t in favor o f a cq u irin g th e m ea n s o f p ro d u cin g a larger o u tp u t fo r fu tu r e c o n s u m p tio n . S ta ted so m ew h a t d ifferen tly , sa tisfa cto ry e c o n o m ic g row th dep en d s on a d eq u a te levels o f savings and ca p ita l fo r m a tio n . A n o th er, th ou g h less m ea su ra b le, in d ex o f e c o n o m ic p e r fo rm a n c e is th e e x te n t to w h ich scarce resou rces are a llo ca ted to th e m o s t p r o d u ctiv e uses. O p tim u m savings an d in v e s tm e n t levels an d an e ffic ien t red is trib u tio n of savings, w h ich involves sh iftin g c o n tr o l over reso u rces to th ose b e s t able to d e te rm in e th eir use, are fa c il ita te d b y th e p ro c e s s o f d e b t crea tio n . C onsider, fo r exam p le, an e c o n o m y in tion o f su ch in c o m e in th e fo r m o f g e n eralized p u rch a sin g p ow er, or m a k in g less p r o d u ctiv e in v e stm en ts. In any ev en t, a less than o p tim u m share o f scarce resou rces w ou ld be d ev o ted to ca p ita l fo rm a tio n . S u pp ose now th a t d e b t crea tio n b e co m es p ossib le. p rofita b le S pending in v e s tm en t u n its w ith o p p o rtu n ities w ou ld c o m p e te w ith ea ch o th e r to a c qu ire n ecessa ry p u rch a sin g p o w er fro m saving u n its. The la tter, as a g en era l m a tter, m ig h t be in clin ed to transfer p u rch a sin g p o w er to th ese u n its for an y o f several reason s. First, b eca u se th ey e x p e c t to share in th e retu rn s ea rn ed on th e in v e s tm en t, su ch u n its sta n d ready to receive a larger a m o u n t o f fu tu r e p u r ch asin g p o w er —an a m o u n t, p erh a p s, su fficien t to cau se individuals to fo reg o so m e p r e s e n t c o n su m p tio n . S econd, th e o p p o r tu n ity c o s t o f hoarding rises c o n siderably as excess fu n d s can earn an in te r e s t r etu rn . Finally, by len d in g to w h ich a d e b t p ro c e s s does n o t e x is t; th a t th ose p erh a p s m o re qualified to m a k e is, con sid er an e c o n o m y in w h ich n o in v es tm en ts , savers now have o p p o r tu n i sp en d in g u n it is able to sp en d m o r e than ties to earn b e tte r retu rn s than th e r e th e su m o f its c u r r e n t in c o m e an d fin an turns fo rm e rly ea rn ed on ca p ita l th ey cial savings. S urely, so m e saving and, th em selves had acqu ired . In su m m a r y , th er e fo r e , ca p ita l a ccu m u la tio n w ill take th en , th e e c o n o m y b en efits by e n c o u r a g 4 SEPTEMBER 1965 ing, th rou g h th e p ro cess o f d eb t crea tio n , a sep a ra tion b e tw e e n ity crises are minimized. . . . O n the borrowing side, the intermediary with a large number of depositors can normally rely on a predictable schedule of claims for repayment and so can get along with a portfolio that is relatively illiquid. The advantages of large-scale borrowing and lending with numerous creditors (i.e., holders of claims on the intermediary) and debtors (those whose debt instru ments are held by the intermediary) can be distributed to the intermediary's debt ors in the form of favorable terms of lend ing, to its creditors in the form of interest payments and other benefits, and to its stockholders in the form of sufficient divi dends to attract additional capital funds.2 th e fu n c tio n o f saving an d th e fu n c tio n o f in v e s tm en t. The tra n sfer o f fu n d s fr o m savers to in vestors is fa cilita ted by th e ex is te n c e o f financial in s titu tio n s and fin ancial m a rk ets. The p rin cip a l fu n c tio n o f fin an cial in s titu tio n s su ch as c o m m e r c ia l banks, m u tu a l savings banks, in su ra n ce com p a n ies, an d savings an d loan a ssocia tions, a m o n g o th ers, is to p e r fo r m as in term ed ia ries in th e tra n sfer o f p u r chasin g p o w er b e tw e e n u ltim a te len d ers and u ltim a te borrow ers. M ore sp ecifi cally, th e p rin cip a l fu n c tio n o f financial in term ed ia ries is to p u rch a se th e d eb t in stru m e n ts o f u ltim a te b orrow ers and Individual len d ers and borrow ers are to issu e th eir ow n d eb t in s tr u m e n ts for less lik ely to agree easily u pon th e p o r tfo lio s o f u ltim a te len d ers. I n ( co n cern in g th e typ e o f d e b t secu rity, term s dividual savers, th erefo re, have a c h o ice d u ra tion o f loan, r e p a y m e n t p roced u re, o f a cq u irin g claim s e ith e r on th e u lti e tc .) th a t are su ita b le for b o th p a rties. m a te borrow er or on an in term ed ia ry This, to g eth e r w ith th e risks a tta c h ed in s titu tio n . .As im p lied , th e ex is te n c e and d ev elo p to w ou ld lik ely resu lt in low er rates o f sav m e n t o f fin ancial in term ed ia ries ten d to ing and ca p ita l fo rm a tio n . raise th e level o f savings an d in v e s tm e n t ation by financial in s titu tio n s, h ow ever, and, at th e sa m e tim e, to in crea se th e “ g ive(s) len d ers a wide va riety o f financial efficien cy o f r eso u rce a lloca tion . a lack o f p o r tfo lio diversification, In te rm e d i C on assets p a rticu la rly s u ite d to th eir need s, sider, in this c o n n e c tio n , th e follow in g an d . . . also m a k e(s ) it less n ecessa ry for s ta te m e n t p erta in in g to in te r m e d ia tio n : borrow ers to issu e th ese typ es o f s ec u ri Financial intermediaries exploit econo mies of scale in lending and borrowing. On the lending side, the intermediary can invest and manage investments in primary securities (i.e., debt instruments issued by ultimate borrowers) at unit costs far below the experience of most individual lenders. The sheer size of its portfolio permits a significant reduction in risks through diversification. It can schedule maturities so chances of liquid ties, w hich are ill-a d a p ted to th eir ow n b u sin esses.” z M o st observers w ou ld agree, a t lea st in p rin cip le, th a t d eb t pla ys a p a r tic u larly im p o r ta n t an d b en eficia l role in ou r econ om y. In con sid erin g specific 2 See J. G. Gurley and E. S. Shaw, M o n e y in a T heory o f Finance, The Brookings Institution, Washington, D. C „ 1960, p. 194. 3 Ibid. p. 197. 5 ECONOMIC REVIEW DEBT and E C O N O M IC A C T I V IT Y End of Year Billions of dollars 2,000 '47 '51 '49 '57 '55 '53 '59 '61 '63 '65 Ratio 3.0 RATIO of TOTAL DEBT to GNP 2.0 1 '47 1 1 '49 1 '51 1 1 '53 1 1 '55 1 1 '57 ............................... 1 '59 '61 '63 '65 U. S. D e p a r t m e n t o f C o m m e r c e a sp ects o f d eb t, h ow ever, all sem b la n ce THE BIG PICTURE o f a g r e e m e n t vanishes. Thus, an a ctive As indicated in Chart 1, at the end of 1964, and co n tin u o u s d ebate rages regarding total debt in the economy had reached nearly su ch q u estio n s as how m u c h d eb t th e $1.3 trillion, which admittedly is an astro e c o n o m y o u g h t to have, and h ow this nomical figure. Total debt had thus doubled d eb t sh o u ld be d istrib u ted a m o n g d iffer since 1953, and had increased nearly three e n t sectors o f th e e c o n o m y . times since the end of W orld War II (the aver U n fo rtu n a tely , e c o n o m is ts have y e t to provid e age annual rate of growth during 1947-1964, a d eq u a te answ ers inclusive, amounted to 6.06 percent). In the to th ese im p o r ta n t way of historical comparison, total debt had p u b lic p o lic y q u estion s. To gain so m e p ersp ectiv e on th e m a g amounted to $228 billion in 1941, $179 n itu d es and relation sh ips a ssocia ted w ith billion in 1932 (the low level during the d eb t, th e follow in g pages are d ev o ted to 1930's) and $196 billion in 1929. Admittedly, th e “ n u m b e r s ” and so m e o f th eir im p li magnitudes such as these—outside of sheer cations. U n fortu n ately, th ere are n o a n size —do not mean very much by themselves; sw ers p rovid ed —if th ere are “ a n sw ers.” they should be compared with or contrasted The to other relevant magnitudes. discu ssion cen ters on aggrega te data —th e broad or global sta tistics —as A comparison often made is that with the w ell as d isaggregated d a ta —th e m a jor Gross National Product in order to get an secto rs o f th e e co n o m y . impression of the magnitude of debt in terms SEPTEMBER 1965 of the total value of the nation's current out put as well as the nation's ability to service declined drastically) and 1.8 in 1941. There is implicit in these figures an important phe debt out of current production. As Chart 1 nomenon. As has been pointed out elsewhere, shows, the movements of total debt and GNP, in a somewhat different context, the rapid although characterized by some unevenness, expansion in total debt since W orld War II have been largely parallel, especially in really has not represented "a breakthrough recent years. This is confirmed by the ratio to unprecedentedly high levels relative either of total debt to GNP, shown in the bottom to GNP or to after-tax income. Rather, this panel of the chart. In 1964, the total debt/GNP expansion has represented a process of catch- ratio was 2.04, not much higher than during ing-up."4 In other words, rising d eb t—and, most of the postwar period, and actually as will be seen, this applies only to private below 1946. (The annual growth rate of GNP, d e b t—has been making up ground lost dur in current dollars, during 1947-1964, in ing the depression of the 1930's and the war clusive, was 5.92 percent.) As the ratio line years. (All of the net increase in total debt indicates, the debt/GNP ratio has tended to decline, or increase less, during recession from 1930-1945 was accounted for by the Federal Government.) periods (1948, 1953, 1957), as debt has in creased less, or has fallen more, than GNP. Again for historical interest, and as shown 4 See C. Canby Balderston, "Borrowing Short and Lending Long/' Address before the Fiftieth Annual Fall Conference of the Robert Morris Associates, in the left-hand panel, the debt/GNP ratio Montreal, Canada, September 28, 1964, p. 5. (Mimeo was 1.9 in 1929, 3.1 in 1932 (when GNP had graphed.) 2 PUBLIC and PRIVAT E DEBT End of Year Billions of dollars Ratio S o u r c e of d a ta : U. S. D e p a r t m e n t o f C o m m e r c e 7 ECONOMIC REVIEW PUBLIC AND PRIVATE DEBT not increased anywhere as fast as that of state and local governments (during 1947- One way to analyze total debt is to separate 1964, inclusive, Federal debt increased at public and private debt. As Chart 2 shows, an average annual rate of 1.65 percent and private debt clearly accounts for a larger that of state and local governments at 10.56 proportion of total debt; since private debt percent). This is revealed by the widening has been increasing faster than public debt, gap between Federal debt and total public the proportion has risen in each year of the debt in Chart 2. At the end of 1964, gross postwar period. (Since 1947, private debt Federal debt amounted to $356 billion, and has increased at an average annual rate of was 20 percent larger than in 1955 (private 9.34 percent and public debt at 2.67 percent.) debt had doubled over the same period) and At the end of 1964, private debt amounted to was about one-third higher than in 1947 $819 billion, or about 65 percent of total debt. (private debt had increased more than four Private debt more than doubled from 1955 times). State and local debt amounted to $92 through 1964, and increased more than four billion in 1964, and had more than doubled times during 1947-1964, inclusive. While since 1955 and had increased more than private debt as a ratio of total debt was 0.65 five times since 1947. in 1964, it had been 0.50 in 1952, and about 0.40 in 1947. In connection with this increase, the catching-up of private debt referred to PRIVATE DEBT, LIQUIDITY, AND INCOME earlier should be recalled. As a ratio of total On the basis of the foregoing numbers, it debt, private debt amounted to 0.60 in 1941 would seem not unreasonable to suggest that — which was the prewar l o w —and 0.82 in if debt in the economy is a matter of concern 1929. As indicated earlier, total private debt — as to problems of servicing it, or as to qual actually began to decline in 1929; there was ity or rates of grow th—the area to be con no increase again until the very late 1930's, cerned with is private debt. In Chart 3, the and private debt did not regain its 1929 level following series are plotted: (1) total private until 1947. From Chart 2, some observations about debt, (2) liquid assets held by the nonbank public debt are readily apparent. First, public debt as a ratio of total debt amounted to 0.35 and the like, and (3) private GNP.5 The relationship of private debt to private at the end of 1964. (See lower panel of Chart GNP provides an indication of the private 2.) In comparison with private debt, public sector's ability to service debt out of current debt has increased moderately since W orld income. Private debt in relation to liquid as War II, becom ing a much smaller proportion sets provides some indication of the private of total d e b t—and GNP. In the case of the sector's ability to adjust to an unexpected latter, it means that public debt is presently adverse turn of econom ic events. If income less of a burden for the economy than earlier. 5 Total GNP less Government purchases of goods and Within total public debt, Federal debt has services. 8 p u b lic—money, savings deposits and shares, SEPTEMBER 1965 PRIVATE DEBT, LIQUID ASSETS, and IN CO M E End of Year Billions of dollars 1,000 800 RATIO Sele<ted Years '47 * '49 '53 '51 '55 '57 '59 '61 '63 '65 Ratio 2.0 .-------------------- _ 1.5 1.0 0.5 - 0 RATIO of PRIVATE DEBT to PRIVATE GNP i ..................................... : ! , '4 7 '49 '51 '53 '55 '57 1 1 I '61 '59 1 1 '63 1 '65 Ratio 2.0 RATIO of PRIVATE DEBT to LIQUID ASSETS 1.5 1.0 I I I '2 9 '3 2 ’41 S o u rc e s of d ata: 0.5 0 l '4 7 1 1 '4 9 1 1 '51 1 '5 3 U .S . D e p a r t m e n t o f C o m m e r c e a n d 1 '5 5 Board 1 1 '5 7 1 1 '5 9 1 1 1 '61 1 1 ’63 1 '6 5 of G o v e r n o r s of the F e d e r a l Reserve System is maintained at high and growing levels, problems, they would be concealed or de the ability to handle debt out of current in ferred. come is obviously enhanced; this ability is With reference to the numbers, private importantly backstopped by the accumula debt, on balance, has been obviously out tion of liquid assets, which by definition are stripping both private GNP and liquid assets, readily convertible into cash. a pattern that has pretty much characterized If one looks at the numbers, some casu al the postwar period. However, in recent years, observations can be made. The word "casual" increases in the ratio of private debt to liquid is emphasized because it is in this connection ity have slackened, as indicated in Chart 3. that existing knowledge is probably most This suggests that the private sector of the deficient. For example, it is not known what economy is nearly holding its own in building relationship between income and debt is a cushion against its debt, which cannot help appropriate or desirable or sustainable, and but be a favorable thing. On the other hand, what volume of liquid assets is sufficient. It the ratio of private debt to private GNP has is generally agreed among most observers continued to increase throughout the postwar that if income continues to advance strongly, period. As Chart 3 shows, that ratio has al the likelihood of problems emerging from most doubled in the postwar period, rising debt is considerably reduced —or if there are from 0.87 in 1947 to 1.66 in 1964. W hile the 9 ECONOMIC REVIEW HOUSEHOLD DEBT ratio for 1964 was virtually the same as that Private debt is the sum of corporate debt for 1929, it was more than one-third lower than for 1932, which was the peak year dur and of individual and noncorporate debt. The ing the 1930's. The ratio declined appreci latter, in turn, includes consumer debt and ably during W orld War II, reflecting sharp residential nonfarm mortgages —here refer increases in income. red to jointly as "household debt" —along with several categories that are not dealt If historical comparisons mean anything — with in this article, such as farm debt and and they may not —the current ratio of private debt to private GNP is relatively low. More other noncorporate business debt. Currently, about one-half of total private over, the transformation of the econom y —the debt is owed by corporations, while house built-in correction factors and the improved hold d e b t—as defined here —represents one- institutional third of the total (see Chart 4). Household arrangements—would suggest that the economy can handle more debt than debt, however, has grown faster than corpor it could earlier. At least this would appear ate debt during the postwar years, with an to be the case when considering the broad accompanying shift in the proportions of total aggregates. What the case is within or be private debt accounted for by the two major hind the broad statistics on private debt may segments. A sevenfold rise in household debt or may not be another matter. The rest of this to $264 billion during 1947-1964, inclusive, article is concerned with the major com po contrasted to a less than fourfold advance in nents of private debt. corporate debt to $402 billion. TOTAL P R IV A T E D EB T-N et End of Year Bil li ons of dollars 1,000 r - ’ ercent C0RP0RATE DEBT FARM and OTHER DEBT 61 % 23% 9% CONSUMER DEBT '4 9 S o u r c e s of data: '51 '5 3 '5 5 '5 7 '59 U .S . D e p a r t m e n t o f C o m m e r c e 10 '61 and '63 '6 5 Board - 80 - 60 - 40 - 20 18% RESIDENTIAL MORTGAGES '4 7 100 49% 19% u - 1947 of G o v e r n e r s of the F e d e r a l R e s e r v e S y s t e m 1964 0 SEPTEMBER 1965 Nonfarxn residential mortgages, the long on debt than might be warranted by its size, term portion of household debt, account for which is less than one-tenth of total private about seven out of every ten dollars of house debt. Its growth from $11.6 billion to $76.8 hold indebtedness, or about the same propor billion during 1947-1964, inclusive, was ac tion as in 1947. The growth of residential companied by shifts in the relative shares of mortgage debt during the postwar period its two major components, instalment and from close to $27 billion in 1947 to $187 noninstalment credit, as well as among the billion in 1964 has been steady and virtually several types of instalment credit. (See Table I.) uninterrupted, reflecting a fairly steady in From Chart 5, it is apparent that the use of crease in private home ownership. W hile instalment credit by consumers has increased residential mortgage debt has contributed a during the postwar period at a much faster large share of the growth of total household rate than the use of noninstalment credit (see debt, its rise appears to have created less also Table I). In part, this reflects the catching concern than has the expansion of consumer up of instalment debt for consumer items that debt, except perhaps for the growing prac had been in limited supply during the war. tice of refinancing mortgages for purposes For example, the large rise in automobile other than the financing of home ownership. loans —a nearly thirteenfold increase between Anticipated acceleration in the rate of family 1947 and 1 9 6 4 —was partly the result of a formations over the next few years can be rapid recovery in automobile loans from a expected to speed up the growth in residen very low base during the early postwar years tial mortgage debt. as production began to catch up with pent-up C on su m er C redit. Consumer credit, demand for cars. But even after the readjust which represents the short- and medium-term ment, automobile credit has been a major portion of household debt and contributes force in the continued rise in the volume of three out of every ten dollars to the total, instalment credit, sharing that role with per tends to occupy a larger place in discussions sonal loans, which have expanded even TABLE I Consum er Credit O utstanding, 1947 and 1964 (end of year) 1964 19 47 TOTAL .................................................. 1964 as a Amount Percent Amount Percent Multiple (billions) o f total (billions) of total of 1947 $1 1.6 1 0 0 .0 % $76.8 1 0 0 .0 % 6.7 N O N IN S T A L M E N T ................................ . . . 4.9 42.3 17.4 22.7 IN STA LM EN T ....................................... . . . 6.7 57.7 59.4 77.3 8.9 Automobile p a p e r ............................. . . . 1.9 16.6 24.5 31.9 12.9 Other consumer go od s p ap er . Repair and modernization loans 3.6 2.2 18.5 15.3 19.9 7.0 . . . . . . 0.7 6.2 3.5 4.6 5.0 . . . 1.9 16.4 16.1 20.9 8.5 . . . . Personal lo a n s.................................... Source: Board of Governors o f the Federal Reserve System 11 ECONOMIC REVIEW 5 cost items, for which instalment credit is C O M P O N E N T S of C O N S U M E R CR E D IT O U T S T A N D I N G generally used, reflects consumers' confi dence in current and future income levels. The slowdown or reduction in instalment End of Yeor credit, notably for automobile and other con sumer goods, that occurs during periods of business d eclin e—for example, 1954, 1958, 1961 —can be seen in Chart 5.6 Conversely, the increase, or acceleration, in the same series during recovery periods, as consumer confidence is restored, is also suggested in the chart. At the same time, it is significant that the volume of personal loans has con tinued to rise virtually uninterrupted even during periods of business recession. The growing use of instalment credit has been facilitated by a generally favorable econom ic climate during much of the postwar period, particularly by rising consumer in come and its discretionary portion, which has served to augment the debt-carrying capacity of consumers. An adequate supply of lendable funds, offered by a growing num ber of financial institutions on terms accept able to consumers, has been an important '4 7 '4 9 '51 '5 3 '5 5 '5 7 '5 9 '61 '6 3 '6 5 contributing factor. Undoubtedly, also, the adoption of highly alluring methods designed S o u r c e of d a t a : B o a r d of G o v e r n o r s of the F e d e r a l R eserve System to put consumers into a buying mood has helped to carry the "buy now, pay later" way faster than automobile debt due largely to of life into new territory, in some cases per the growing variety of purposes for which haps beyond limits of prudence. personal loans have come to be used. On the other hand, the creation of addi Instalment credit is sensitive to changes in tional consumer buying power by means of business conditions, as the data in Chart 5 credit has tended to stimulate econom ic illustrate. The strength of consumer demand activity by increasing current demand for is closely related to the general level of econ o many types of consumer goods and services. mic activity; the willingness of consumers to It may well be questioned, for example, commit a portion of expected future income 6 This relationship would, of course, be more precisely for the purchase of automobiles or other high- demonstrated by the use of monthly data. 12 SEPTEMBER 1965 6 reflect the ability of consumers to carry and/ CO NSUMER DEBT, IN COME , and LIQUID ASSETS or liquidate their debts. As Chart 6 indicates, consumer credit outstanding amounts to only a fraction of End of Year total annual disposable income. The size of that fraction, however, has grown from onefifteenth to more than one-sixth of disposable income during the postwar period, a reminder of the rising popularity of consumer credit as a method of financing large purchases. Instalment credit, which, as previously stated, has grown faster than noninstalment credit, has accounted for the major share of the in road of consumer credit upon disposable income. (See Table II.) TABLE II '4 7 '49 '51 '53 '55 '57 '59 '61 '63 '65 * Data not available prior to 1950 S o u r c e s of d a t a : C on sum er Credit an d Com ponents a s Percentages of D isp o sa b le Personal Incom e U.S . D e p a r t m e n t of C o m m e r c e ; S e c u r i t i e s and E x c h a n g e C om m issio n ; B o a r d G overnors of Total of the F e d e r a l R e s e r v e S y s t e m Consumer Instalment Instalment Noninstalment Credit whether the production and sale of seven or Y ear eight million automobiles per year —including 1 9 47 6 .8 % 3 .9 % 2 .9 % 6 .0 % the beneficial effects reaching far beyond the 1948 7.6 4.8 2.9 7.0 8.2 automotive industry —would be feasible, or possible, without extensive use of consumer Credita Credita Credita Repayment 19 49 9.2 6.1 3.0 1 9 50 10.3 7.1 3.3 8.9 1951 10.0 6.7 3.3 10.1 1952 1 1.5 8.1 3.4 10.7 1953 12.4 9.1 3.3 11.0 whether consumer debt is growing too fast 19 54 12.6 9.2 3.5 1 1.8 in relation to the general growth of the econ 1955 14.2 10.5 3.6 12.3 19 56 14.5 10.8 3.6 12.7 19 57 14.6 1 1.0 3.6 12.9 1958 14.2 10.6 3.6 12.7 credit. Nevertheless, it is legitimate to ask omy and whether corrective or preventive measures should be considered to forestall 1959 15.3 1 1.6 3.6 12.6 19 60 16.0 12.2 3.8 13.1 Too M u ch C on su m er D e b t? Due to the 1961 15.8 1 1.9 3.9 13.1 lack of generally accepted standards by 1962 16.4 12.5 3.9 13.2 possible econom ic dislocations. 1963 17.4 13.4 which current levels of consumer credit 4.0 13.7 1964 17.8 13.8 4.0 14.0 could be measured, and tagged either "safe" a Outstanding at end of period. or "dangerous," there are no clear-cut an b Annual totals. swers to those questions. However, it is per NOTE: Due to rounding, percentages for instalment and non- haps helpful to consider consumer credit along with econom ic variables —personal income after taxes and liquid assets—that instalment credit do not in all cases a d d up to total consumer credit. Sources: Board of Governors of the Federal Reserve System; U. S. Department of Commerce 13 ECONOMIC REVIEW Since the terms of maturity vary for con that the expected rise in the number of young sumer credit, especially for the instalment families, who commonly rely heavily upon in portion, debt repayments, rather than the stalment credit, will not cause a further in amount of debt outstanding, offer a better crease in that ratio in the years to come. measure of the proportion of current spend The making of repayments causes an in able income that is required to pay for past dividual borrower to suffer an actual reduc purchases and is thus unavailable as current tion in his personal current spending power. consumer purchasing power. As shown in A proportionate restraint, however, does not Table II, the increase in repayments as a proportion of disposable income, while some necessarily apply to all spending units, taken what less than the increase in total instalment instalment credit. as a whole, since not all families are using credit outstanding as related to income, has In times of declining incomes, consumers been steady. This development has been can, if necessary, fall back upon their reserves viewed with alarm by some observers at to meet loan repayments. As shown in Chart different times. No convincing reason has as 6, liquid assets held by individuals have been yet been presented for considering the pres increasing virtually p a ri pa ssu with income. ent ratio of about 14 percent —or the previous Of special importance is the fact — shown 12 percent or 13 percent —as an absolute up by the data in Table III—that consumers in per limit. There is, furthermore, no assurance the aggregate have added a larger amount TABLE III Debts an d Liquid A sse ts of Consum ers (In Billions o f Dollars) Y e a r-e n d D a ta Net Ch an ge Liquid Assets Y ear Consumer Debt Household Debt Liquid Assets Outstanding Outstanding * against Consumer Debt Liquid Assets against Household Debt </* 1 Annual Increase .............. $ 6.5 $1.2 $ 7.4 $+ 5.3 1952 .................. .............. 10.6 4.8 11.3 + 5.8 — 0.7 1953 .................. .............. 9.0 4.0 1 1.2 + 5.0 — 2.2 1954 .................. .............. 8.6 1.1 10.2 + 7.5 — 1.6 1955 .................. .............. 10.7 6.4 18.3 + 4.3 — 7.6 2.7 o 1 9 5 1 .................. 1956 .................. .............. 11.2 3.6 13.9 + 7.6 — 1957 .................. .............. 11.7 2.3 10.4 + 9.4 + 1.3 19 58 .................. .............. 12.7 0.3 9.9 + 12.4 + 2.8 1959 .................. .............. 19.4 6.4 18.9 + 13.0 + 0.5 1 9 60 .................. .............. 8.0 4.5 14.4 + 3.5 — 6.4 1 9 6 1 .................. .............. 17.5 1.7 12.6 + 15.8 + 4.9 1962 .................. .............. 28.8 5.5 17.6 + 23.3 + 11.2 1963 .................. .............. 30.9 6.7 21.0 + 2 4 .2 + 1964 .................. .............. 33.0 6.9 22.4 + 26.1 + 10.6 in clu d e s consumer credit and nonfarm residential m ortgages. Sources: U. S. Securities and Exchange Commission; U. S. Department of Commerce; Board of Governors o f the Federal Reserve System 14 9.9 SEPTEMBER 1965 to their liquid assets than to their total debt ARE AGGREGATES M ISLEADING? in each of the 14 years since 1950 (see the The broad aggregates —debt, income, as "net change'' column of liquid assets against sets—do not necessarily portray potential consumer debt). If comparison is made be weaknesses in the debt structure. For ex tween liquid assets and total household debt ample, in the absence of specific knowledge (mortgages plus consumer debt), the result as to who owes the debt and who owns the shows that debt has outpaced liquid assets liquid assets or earns the income, it might be in seven of the ten years from 1951 to 1960. erroneously assumed that the sum total of After 1960, however, asset accumulation accelerated to produce an excess of liquid liquid assets could be made to serve as a asset growth over growth in household debt, those assets might be owned largely by con averaging over $10 billion annually for the sumers without any debt at all. backstop for debt repayments, when in reality last three years. This development serves to The use of instalment credit is less than demonstrate the ability of consumers —at universal. Furthermore, as revealed in periodic least during a period of sustained high in polls by the University of Michigan's Survey co m e —to step up accumulation of liquid Research Center, the proportion of all families reserves despite a growing level of debt and that do use it, and the percentages of spend a 14 percent toll on current incomes for in able income tied up in instalment debt re stalment credit repayments. payments, vary considerably among different income classes. (See upper panel of Chart 7.) DETERIORATION OF Q UALITY? About 60 percent of middle-income families The increasing use and growing amount reported using instalment credit in early of household debt, in the opinion of some, tend by definition to lower its quality. Length 1964, but less than 40 percent of the families in the highest income group and only about ening of terms of maturity, lower downpay one-fourth of the lowest income families were ments, and lower standards in the screening doing so, albeit for different reasons. of applicants for loans are generally cited as As Chart 7 further indicates, families in evidence of deterioration that will lead to the lower income brackets carried the heavi growth in delinquencies. The recent record est debt burdens relative to income. For on this point is not conclusive. While the fore example, 12 percent of all families in the closure has lowest income class and 17 percent of all doubled during the last ten years, delinquency families with $3,000-$4,999 in com e—rep rates on instalment credit held by banks have resenting a large proportion of the debt- moved horizontally during that interval. The carrying families in those two income brackets rate on nonfarm mortgages growing number of personal bankruptcies, — were committed to annual payments equal on the other hand, suggests that—aside from to at least 20 percent of disposable income. cases of misfortune or fraud —some borrowers, The higher absolute amounts of repayment, as well as their lenders, may have failed to of course, were concentrated in the higher exercise prudence. income groups, where they represented a 15 ECONOMIC REVIEW INSTALMENT A previous survey had also shown that DEBT three out of four families in 1963 held some Percent Distribution of Family Units by Amount of Annu al Payments as a % of Di sposable Income 1964, BY INCOME GROUPS 100 % liquid assets, thus reinforcing their debtcarrying ability (see Table IV). As would be expected, the proportion of families with 80 4 NO DEBT ings per family increase with the size of 60 40 | LESS THAN 1 0 % 20 4 4 __ 0 UNDER 3,0 0 0 5,000 7 ,5 0 010,00015,000 D o l la r 100 % s 3,000 2 0 % or MORE of DISPOSABLE INCOME ALL ALL INCOME GROUPS, Selected Y e a r s * 4 spendable income. From the data in Table V, it appears that both the proportion of families 1 0 % - 19% 4,9 9 9 7,499 9,999 14,9998,OVERGROUPS 80 with assets and, to a smaller extent, the amount of liquid reserves per family (if not necessarily the rates of reserves to incomes) have tended to grow during the postwar period, which is consistent with the rise in NO DEBT 60 aggregate totals discussed previously. A direct comparison of specific amounts of liquid as 4 40 20 ~ i i ~ i— '5 5 * liquid assets and the size of individual hold '5 8 '60 '61 '62 I I '63 LESS THAN 10 % 4 10 % mgA 2 0 % '6 4 - 19% or MORE of DISPOSABLE INCOME D a t a p r i o r to 1 9 6 4 a r e b a s e d on s p e n d i n g u n i t s r a t h e r t h a n f a m i l y u n i t s S o u r c e of d a t a : S u r v e y R e s e a r c h C e n t e r , U n i v e r s i t y of M ic h iga n sets with specific instalment debt burdens carried by individual families, however, is not possible on the basis of the data. Thus, the possibility that families holding assets are the ones with little or no instalment debt and those without assets carry the heaviest debt burdens relative to income, remains strong. It is further strengthened by statistical smaller percentage of income and, presum inferences indicating that a family with low ably, a lighter burden. financial reserves is more likely than a more The general picture of the use and distribu affluent family to owe instalment debt and, tion of instalment credit does not appear to if so, to carry a heavier relative debt burden. have changed appreciably over the past ten W hile some of the individual data may years, if results of previous surveys are com appear to be cause for concern, particularly pared with the most recent one. As the data in the event of a decline in income levels, it in the lower panel of Chart 7 indicate, the should be remembered that important institu average percentage of all spending units tional changes have occurred in the economy reporting use of instalment credit—47 per that affect debt-income-liquid assets relation cent in 1 9 6 4 —has remained fairly constant ships and the debt-carrying capacity of con while the proportion of families with a debt sumers in general. Auxiliary assets (such as burden of at least 20 percent of disposable pension funds, unemployment compensation, income —one 1964 —is including supplemental benefits under private slightly lower than in most earlier surveys. agreements, and health and other insurance family Digitized for16 FRASER in ten in SEPTEMBER 1965 TABLE IV Liquid A sse ts of Consum ers, 1963 By Incom e Groups and b y A m o u n t of A sse ts (Percent Distribution of Sp e n d in g Units W ithin Income G roup s) Spending Units with Annual Income of: Liquid Assets Under $3,000- $5 ,000- $7,500- $ 1 0 ,0 0 0 All $3,000 $4,999 $7 ,499 $9,999 and O ve r Spending Units 1% 16 29 N o n e ............................. . . . . 49% 28% 27% .............. . . . 24 33 30 7% 29 $ 5 00-$ 1,999 .................. . . . . 13 17 21 34 24 21 $2 ,000 -$4,9 99 . . . . 8 12 12 15 23 13 . . . . 6 10 10 15 36 13 Less than $ 5 0 0 .............. $5 ,000 and over . . . . 24% Source: Survey Research Center, University of Michigan TABLE V Liquid A sse ts of Consum ers in Selected Years (Percent Distribution of Sp e nd in g Units b y Size of Assets) Liquid Assets 1 9 4 7 -1 9 4 9 1 9 5 1 -1 9 5 3 1 9 5 5 -1 9 5 7 1 9 5 8 -1 9 6 0 A v e rag e A v e ra g e A v e ra g e A v e ra g e 1963 N o n e ...................................................... ......... 2 7 % 29% 27% 25% 24% Less than $ 5 0 0 ................................................. 27 29 29 30 29 $ 5 0 0 -$ l,9 9 9 ........................................... ......... 25 22 22 22 21 $ 2 ,000 -$4,9 99 11 12 12 13 9 10 11 13 ................................................. 13 $5 ,000 and o v e r .................................... ......... 8 Source: Survey Research Center, University of Michigan plans) have built in some protection, albeit small, for income maintenance, and have proportion of total debt, as indicated earlier, it has constituted a steadily declining share perhaps lessened the need for the same meas of private debt — falling from three-fifths to ure of liquid assets as protection in case of less than one-half of the total. retirement, loss of employment, or prolonged The trend of corporate debt is depicted in illness. Growth of auxiliary assets helps to Chart 8, with totals for the short- and long release liquid reserves for other purposes, term components shown separately. Although including the repayment of consumer debt the two components have represented fairly when necessary. consistent shares of the total, the long-term portion has grown steadily while the short CORPORATE DEBT term portion has moved upward more ir Total debt of nonfinancial corporations has regularly—a pattern largely associated with increased without interruption in every year reductions in borrowing requirements during in the postwar period, reaching a total of periods of business recession, for example, $402 billion at the end of 1964. W hile cor 1949, 1954, 1958. The recent relationship porate debt has accounted for an increasing between short- and long-term corporate debt 17 ECONOMIC REVIEW CORP ORATE DEBT and CORPORATE GROSS P RO DU CT Nonfinancial Corporations — End of Year Billions of dollars Ratio 1.3 RATIO of CORPORATE DEBT to CORPORATE GROSS PRODUCT 0.9 0.7 J ___ I____I____I___ I____I___ I____l____I___ I____I____l____l____i___ i '4 7 '4 9 '51 '5 3 ’55 '57 '5 9 i '61 i '63 i '65 S o u r c e o f d a t a : U.S. D e p a r t m e n t o f C o m m e r c e is the reverse of the pattern that prevailed in prewar years, when long-term borrowing age ratio of 1.20 in the 1938-1946 period.7 Before reviewing other corporate debt consistently exceeded short-term debt, and reflects the changing character of corporate relationships, some comment should be made needs for funds. was mentioned earlier in connection with concerning the "catching-up process" that A comparison of corporate debt with Cor total private debt. As a result of a number of porate Gross Product (a proxy for corporate income) shows that, during 1947-1957, the factors, nonfinancial corporations emerged from the war years in a hyperliquid condition, total of corporate product, although slowed with debt levels low in relation to output, and twice by business recessions, was consistently with a need for funds to finance both the re larger than the volume of corporate debt, placement of badly worn plant and equipment with the debt/corporate product ratio averag and the new expenditures required to gear ing about 0.9. Since 1957, however, corporate operations to rising levels of econom ic activ debt has risen considerably faster than cor ity. Increasing needs for funds, coupled with porate product, with the result that the ratio growing corporate preference for borrowed averaged 1.11 d u rin g funds, have undergirded the steady rise in 1 9 5 8 -1 9 6 4 , and reached a high of 1.16 in 1964. The 1964 corporate debt since the end of the war. figure, while a high for the postwar period, 7 The earliest year for which Corporate Gross Product does not compare unfavorably with an aver estimates are available is 1938. 18FRASER Digitized for SEPTEMBER 1965 9 SOURCES and USES of CO RPORATE FUNDS Annui '4 7 '4 9 '51 '5 3 '55 '5 7 '59 '61 '63 '65 Totals '47 '4 9 '51 '53 '55 '5 7 '5 9 '61 '63 '65 S o u r c e o f d a t a : U.S. D e p a r t m e n t o f C o m m e r c e SOURCES AND USES OF FUNDS ciation allowances, investment tax credit, and reduction in corporate income taxes, have The postwar trend in corporate indebted augmented the internal flow of funds. The ness is probably best explained by the chang rising flow of internally generated funds has ing composition of both sources and uses of been almost exactly matched by the need for corporate funds (see Chart 9). As is clearly funds to finance plant and equipment. evident, corporate demands for funds are strongly influenced by the business cycle, Periods of business expansion have been sharply during characterized by sharply enlarged demands early stages of business expansion and con for funds for inventory accumulation and for tracting noticeably prior to and during re additions to financial assets —principally ac cessions. Of importance is the steadily grow counts ing volume of funds generated internally. usually slackened as the pace of expansion Since the end of the war, three-fifths of total slowed, receding to low levels during reces with demands increasing receivable. These demands have corporate requirements have com e from in sions, as additions to inventories and financial ternal sources, that is, retained earnings and assets are curtailed. It has been, in fact, the depreciation charges. In recent years, tax volatile changes in current assets (principally concessions, in the form of liberalized depre inventories and accounts receivable) that 19 ECONOMIC REVIEW have accounted for most of the swings in with an average of about one-fourth in the corporate demands for funds during the post entire postwar period. war period. Despite this volatility, however, In recent years, growing need for current total demands for funds have trended upward financing has further stimulated demands (especially after 1954), and the demand for for external funds, and corporations have met external financing has continued to grow. these requirements almost entirely through W hile funds from external sources supplied the use of borrowed monies. Additions to only two-fifths of total requirements during corporate debt during 1961-1964 accounted 1947-1964, 85 percent of external funds have for nine-tenths of the volume of funds raised represented additions to corporate debt.8 externally, compared with an average of 85 Furthermore, 56 percent of the addition to percent in the entire postwar period. corporate indebtedness was accounted for by Marked corporate preference for debt has short-term obligations, with the remainder of reflected both the availability of large amounts course coming from long-term sources. of internally generated funds, part of which The period since 1961 has been character adds to the corporate equity base, and the ized by continuous business expansion — lower costs associated with borrowed funds, already the longest peacetime expansion on as compared with equity financing. Moreover, record. With a sustained rise in levels of out a higher proportion of borrowed funds usu put, corporate demands for funds have also ally exerts favorable leverage on a corpora risen continuously, reaching a record level tion's net income, especially during periods in 1964. The volume of internally generated when total income is rising steadily. funds has continued to satisfy about threefifths of total requirements, and has almost Recent growth in corporate debt, therefore, matched the volume of funds allocated to additions to physical assets (plant, equipment, has been associated in large part with the and inventories). More importantly, however, accumulation of inventories and an unusually the volume of funds required for additions to large buildup in financial assets. The bulk of financial assets has been sizable in each year, the increase in financial assets has been in contrast to the pattern in earlier expansions. centered in accounts receivable, while hold Funds allocated to the increase in financial ings of cash, U. S. Government securities, assets in 1961-1964 constituted slightly more and other financial assets (including an un than one-third of total funds used, compared determined amount of other types of negotiable steady, although not necessarily excessive, securities) have expanded more moderately. 8 Since external sources of funds include the net new A major part of growing working capital stock issues of investment companies (totaling about requirements has been satisfied by an increase $2 billion annually in recent years), debt as a propor in short-term borrowing —principally notes tion of external funds of nonfinancial corporations is understated. The total for other current assets as a use and accounts payable and bank loan s—but of funds is correspondingly overstated, due to the inclu increasing amounts of long-term borrowing sion of the net new investments of these companies. have been used in recent years. 0 Digitized for 2 FRASER SEPTEMBER 1965 ACCOUNTS RECEIVABLE calendar days' sales outstanding has risen As a result of the increasing proportion of steadily, from about 34 days in early 1961 to corporate funds allocated to investment in nearly 38 days in March 1965. Despite this accounts receivable in the postwar period, trend toward more liberal terms, however, the volume of accounts receivable outstanding the percentage of manufacturers' receivables has expanded nearly five times, accounting that are current, that is, within terms, was for nearly one-half of total current assets at actually somewhat higher during the past the end of 1964, compared with only 31 per year (averaging 84 percent) than in earlier cent in 1946. This large expansion in the years of the expansion. Looking at the repay volume of trade credit is reflected in the ment record in another way, the proportion current liabilities section of the corporate of accounts receivable volume that is over 90 balance sheet in the nearly fourfold increase days past due has averaged only 2.8 percent in notes and accounts payable. The slower during the past year, which is slightly below rate of growth in accounts payable would the average for the entire expansion. seem to indicate, however, that nonfinancial These comparisons bring into sharper focus corporations have been extending larger the growing role of corporations in providing amounts of credit to their customers than they current financing to their customers, indicat have been receiving from their suppliers. ing that more liberal credit terms are becom The ratio of accounts receivable to accounts ing standard practice, and are being accepted payable has risen steadily (from 102 percent by corporations as an added cost of doing in 1946 to 124 percent in 1964). The sharp business. expansion in trade credit is a natural conse quence of the increasingly competitive busi CORPORATE DEBT AND ASSET SIZE ness climate, with the availability of larger The growth in debt of nonfinancial corpora amounts of interim financing serving as an tions can be broken down by asset size of additional incentive to corporate customers. borrower.10 This is done on the premise that increased use of debt by corporations would The sustained rise in the volume of trade be potentially more dangerous if a dispropor credit extended has raised questions in some tionate amount of the increase were accounted quarters about possible deterioration in the for by smaller firms, among which the like quality of such credit. Data collected by the lihood of failure is considerably higher. The Credit Research Foundation indicate that the record of the 1951-1961 period indicates average collection period for the accounts that the increase in debt of nonfinancial cor receivable of manufacturing corporations has porations was centered most heavily in small lengthened considerably during the current and large firms. W hile debt of all corporations business expansion.9 The average number of 10 Data were taken from S tatistics o f Incom e, Internal 9 See N a tion al Summary o f D om estic Trade R e Revenue Service, U. S. Treasury Department. Most c e iv a b le s , published quarterly by the Credit Research recent data available are for corporations with account Foundation, Inc. ing periods ended July 1961-June 1962. 21 ECONOMIC REVIEW increased by 146 percent during the period, represented a steadily increasing proportion small firms (under $1 million in assets) re of both items. Although completely compar ported an increase in debt of 187 percent, able historical data are not available, reason and large firms (over $100 million in assets) ably reliable estimates indicate that the ratios an increase of 162 percent. Corporations in of debt to assets and net worth are currently the intermediate size classes added debt at a at record levels, exceeding even those that more moderate rate. As a result of the faster prevailed in the 1929-1933 period. rates of growth in debt of corporations at the While such comparisons serve to place the two extremes of the size range, corporate debt upward spiral of corporate debt in somewhat in was more heavily concentrated better perspective, they do not provide con among large and small firms than in 1951. clusive evidence that such debt has reached 1961 Percentage Distribution of Corporate Debt B y A sse t Size C lass, 1951 and 1961 excessive or unmanageable proportions. The record of business failures during the present expansion has improved steadily, with the $1 $10 Under million million O ver $1 to $ 1 0 to $ 1 0 0 $100 million million number of failures and the rate of failure per Y e ar million million 1951 1 7 .8 % 1 5 .7 % 1 9 .1 % 4 7 .4 % 1 0 0 .0 % Total 1961 20.8 14.3 14.5 50.4 100.0 W hile comparable data for recent years are not available, it is unlikely that these relation ships have changed significantly.11 T O T A L CORPORATE DE BT in RELATION to T O T A L ASSETS and N E T W O R T H Nonfinancial Corporations — End of Year Billions of dollars 1,000 Growing corporate preference for debt as 80 0 the principal source of external funds has 60 0 brought pronounced changes in the relation 40 0 ships between corporate debt and other items 300 in the corporate balance sheet. Chart 10 200 shows the postwar growth in corporate debt, compared with the increases in both total assets and net worth of nonfinancial corpora 100 80 tions. The increase in corporate debt has outpaced gains in both assets and net worth, and, as the bottom panel indicates, debt has Ratio 1.1 0.9 11 This assumption is supported by analysis of recent 0.7 trends in the increase of debt of manufacturing cor porations. Although the distribution of debt among man ufacturing firms is not the same as for all nonfinancial 0.5 0.3 corporations, debt increases of manufacturing com panies in recent years (1961-1964) have followed the same pattern as during earlier postwar years. 22 Sources o f d a t a : U.S . D e p a r t m e n t o f C o m m e r c e a n d U .S . D e p a r t m e n t o f th e T r e a s u r y SEPTEMBER 1965 10,000 concerns in 1964 at the lowest levels borrowed funds from reaching unmanageable in five years. The sustained rise of corporate proportions. W hile a protracted period of profits during the current business expansion business recession would probably strain the is further evidence that corporations have capacity of corporations to service debt, the encountered little difficulty in servicing a continued exercise of public and private growing volume of debt. In addition, a sub initiative to promote a sustainable and suffi stantial increase in the volume of internally cient rate of econom ic growth is good insur generated funds (which reached a record ance against such an eventuality in the cor annual rate of $51 billion in the first quarter porate sector, as well as in the household of this year) is working to keep the inflow of sector and in the economy at large. 23 ECONOM IC REVIEW SOME PERSPECTIVE ON FOREIGN EXCHANGE RATES In recent months, much attention has been outspoken, they clearly are not united in focused on the existing international mone presenting an alternative scheme. Rather, tary system. This attention essentially involves their suggestions reflect a diversity of value inquiry into the adequacy of international systems and analytical frames of reference. liquidity, and the relationship of the present This article discusses one proposal, which international payments mechanism to the role involves the establishment of an international and status of the U. S. dollar and the British payments system based upon freely fluctuat pound sterling. ing rates of exchange between national mone By and large, national monetary authorities tary units.1 The proposal is discussed in an and the financial community in general have attempt to improve understanding so that expressed confidence in the present inter sound evaluation can be made by those inter national monetary system, which is commonly ested in the area. called a gold exchange system. These parties THE M EANING, IMPORTANCE, AND DETERMINATION OF EXCHANGE RATES recognize imperfections in the system, but believe that a more satisfactory scheme, if one is needed, can best be built upon the existing structure. Thus, their proposals usually take the form of modifications of pres Before considering an international mone tary system based upon flexible exchange rates as opposed to one based upon relatively ent arrangements. Others, including a num fixed rates of exchange, it might be helpful ber of academ ic economists and some foreign to set the stage with a general discussion of observers, believe more far-reaching changes are necessary. A ccording to some individ 1 Students of international finance generally distinguish uals, the gold exchange standard, with its between freely fluctuating exchange rates and floating dependence on the dollar and the pound, exchange rates. The first, and the one discussed in this is alleged both to be built upon an unsound foundation and to be incompatible with cer article, refers to exchange rates arrived at entirely through the market mechanism; put otherwise, govern ment intervention in the foreign exchange market is tain domestic g oa ls—full employment, stable completely absent. The second, which is not discussed prices, and an acceptable rate of econom ic in this article, is a variant of the first with the notable growth. In other words, if a different system were in effect, smoother adjustments could be made and domestic econom ic goals could more easily be achieved. Though the critics of the existing inter national monetary mechanism are often quite http://fraser.stlouisfed.org/ 24 Federal Reserve Bank of St. Louis exception that the financial authorities intervene in the foreign exchange market, with sales or purchases to keep fluctuations in exchange rates "orderly." The system that is discussed in this article is offered only for pedagogical reasons; this is done because a system of freely fluctuating exchange rates presents some clear-cut distinctions from the existing system and is useful for illustration. SEPTEMBER 1965 exchange rates. What are exchange rates? he quickly calculates that the price, in dollars, Why are they important? How are they of the British-made garment is $50.40 (18 x determined? $2.80). With transportation and other charges Essentially, an exchange rate is a price assumed negligible and with no tariff charges, paid for a unit of one nation's currency in the agent would probably make his company's terms of the currency of another. Thus, for purchase from the British manufacturer. example, the prevailing U. S. dollar-pound Knowledge of exchange rates thus is essen sterling exchange rate may be expressed as tial to international trade by enabling traders approximately £1 = $2.80; that is, it costs to compare, in terms of their own country's $2.80 to acquire one British pound. Similarly, currency, the effective prices of foreign the prevailing dollar —D eu tsch e m ark ex goods and services. Because commerce be change rate may be expressed as DM1 = tween nations is a substitute for mobility of $0.25; that is, it costs $0.25 to acquire one productive German the explanation physical resources) across national bound around, it follows that the price of a dollar in aries, it is essential to overall econom ic ef terms of pounds is just a trifle over seven ficiency.3 And because exchange rates are shillings,2 and four marks will exchange for essential to trade, they therefore play an one dollar. important part in promoting a dynamic and m ark. Turning v Since exchange rates express the price of factors (natural, human, and expanding world economy. one currency unit in terms of others, they In addition to the broad function of enab provide a direct link between the prices of ling international commerce, exchange rates goods and services in different parts of the serve two additional specific functions. First, world. Consider, for example, a men's cloth the value and volume of a nation's imports ing chain in the United States choosing be and exports are related to the exchange rate tween purchasing a line of suits from a domes between its currency and the currencies of other nations. Second, the composition of tic manufacturer or a similar line from a manufacturer in England. Assume, further, that the decision rests largely upon price, trade (that is, the makeup of imports and exports) is related to the exchange rate be with delivery periods and quality being tween the home currency and those of other essentially the same, and tariffs nonexistent. nations. The U. S. manufacturer obviously states his 3 This statement is clarified by an understanding of the price in terms of dollars. Suppose the whole principle of comparative advantage. For a complete sale price of suits is set at $52.00 each. The British manufacturer sets a price for his gar discussion of this, see any basic economics textbook. In essence, the principle states that, because of the diversity in resources and means of production between ments in terms of pounds. Suppose he is countries, the world would be economically better off willing to sell the suits at £1 8 each. W here if each country were to specialize in the production of should the U. S. clothing chain make its pur those goods and services in which it is relatively more chase? First the purchasing agent must efficient, and were to trade with nations who are rela tively less efficient. Even if one nation were a b solu tely determine the dollar equivalent of the price more efficient in the production of every commodity in pounds. At approximately $2.80 per pound, than the others, it would still be beneficial for this nation to specialize in those fields in which it possesses a com 2 One pound = 20 shillings. At £1 = $2.80, one shilling = 14 cents. parative advantage. In this way world resources may be utilized most efficiently. 25 ECONOMIC REVIEW Consider first the relationship between American-made goods than before, since the exchange rates and the value and volume of absolute pound price has declined, and since imports and exports. To make matters simple the price of American goods has fallen rela (though at the cost of introducing an element tive to the price of alternate goods produced unreality), in Britain. Thus, the dollar value of American assume that prices of goods manufactured — hopefully not too la rg e —of exports to Britain would almost certainly in the U. S. (as expressed in dollars) and goods manufactured in Britain (as expressed increase.5 What of imports from Britain? The dollar in pounds) remain stable despite exchange price in the U. S. of such imports will rise in rate movements. Assume further that initially proportion to the increase in the dollar price £ 1 = $2.80. At this rate of exchange between of the pound. Thus, for example, prior to the the dollar and pound, traders in the U. S. change, a purchase of an automobile selling will import some dollar amount of goods and for £985 in England would have cost a U. S. services from Britain, say $280 million worth. importer (exclusive of transportation and Also, at this rate traders in the United States other charges) $2,758 (985 x $2.80). A will export a certain dollar amount of goods doubling of the dollar price of the pound now and services to Britain, say $280 million doubles the import price of the automobile worth. to $5,516 (985 x $5.60). Because the dollar Suppose now the exchange rate becom es price of goods imported from Britain would £1 = $5.60.4 Everything else the same, what increase both absolutely and in relation to could happen to U. S. exports to and imports from Britain? Because the dollar price of prices of substitute goods produced at home, American-made goods does not change, and Americans would likely purchase fewer British goods. But, though possible and per because the pound can now command more haps likely, it does not necessarily follow that dollars ($5.60 as against $2.80), the British the dollar value of American imports would would find American-made goods and ser decrease. Prior to the increase in the value vices more attractive (in terms of price) than of the pound, Americans were spending in previously. For example, an American cam total, say, £100 million on British goods. era, which formerly sold in Britain at £8 Suppose now they decided to purchase fewer ($22.40), would now sell for £4. Britain can British goods and to spend only £80 million thus acquire the same dollar volume of im on imports. In terms of dollars, however, the ports from the U. S. for one-half of what it outlay increases to $448 million (80 million formerly cost in terms of pounds. In terms of x $5.60). dollars, this country would receive the same The preceding paragraphs have attempted amount as before. Almost certainly, however, to clarify the role of exchange rates in in the British would seek to acquire more fluencing the value and volume of a nation's 4 Under present arrangements this can happen in one total imports from and exports to other nations. of two ways: Britain cou ld revalu e th e pound upward, 5 The amount of increase, of course, depends on the in terms of the dollar, or the U. S. cou ld d ev a lu e the price elasticity, or degree of responsiveness, of British dollar, in terms of the pound. demand for American-made goods. 26 SEPTEMBER 1965 The following brief discussion deals with the The distribution between what a nation additional role played by exchange rates in imports and what it exports becom es explicit influencing the product composition of a only when an exchange rate is introduced. country's exports and imports. Consider, in From a consideration of columns 1 and 2 this connection, the hypothetical table below. above, one could hardly tell what commodities each country would export and import. C ol P RICES A N D E X C H A N G E R A T ES (1) Cost in U.S. in $ Commodity (2) (3) In ^"ost 'n umns 3 through 5 translate costs in Britain, (4) (5) United Kingdom Shillings _______ IN D O LLA RS_______ and @ £ Pence 1=$5 @ £ 1=$4 @ £ 1 = $ 2 .8 0 $0.56 expressed in terms of shillings and pence, into their dollar equivalents. It can be ob served that, at an exchange rate of £1 = $5.00, the first arbitrary exchange rate level, M a rga rin e $1 4 /- $1.00 $0.80 W o o l cloth 1 4 /3 1.06 0.85 0.60 Britain would not be able to export to the U. S. Cotton cloth 1 4 /8 1.16 0.93 0.65 an y of the commodities in the table. With the Cigarettes 1 5 /- 1.25 1.00 0.70 Linoleum 1 5 /6 1.38 1.10 0.77 P ap e r 1 6 /- 1.50 1.20 0.84 be able to purchase American-made goods G la ss bottles 1 71- 1.75 1.40 0.98 Radio tubes 1 8 /- 2.00 1.60 1.12 at lower prices than those of equivalent exception of margarine, U. S. buyers would Pig iron 1 9 /- 2.25 1.80 1.26 Tin cans 1 1 0 /- 2.50 2.00 1.40 British-made goods. (The British may still produce these goods for domestic sale, how Source: P. T. Ellsworth, The International Economy, Revised, ever, because purchase in the United States The Macm illan Com pany, New York, 1958, p. 262 would involve additional costs —transporta The table provides a sample of commodities tion, tariffs, e t c .—which could offset their produced both in the U. S. and Great Britain. production cost disadvantage.) As the pound The unit of each commodity is that amount becom es cheaper in terms of the dollar, costing $1 to produce in the United States British goods becom e more and more com (column 1). Column 2 shows the cost in petitive with equivalent American-made prod Britain, in terms of British currency units, to ucts. Thus, at £1 produce the same amount of product.6Though start exporting cotton cloth, wool cloth, and all commodities appearing in the table are cigarettes. At £1 = $2.80 the list of exported = $4.00 the British may produced in both countries, it is likely that products would extend to linoleum, paper, the real costs7 of some commodities are rela and glass bottles. Thus, the exchange rate tively less in one country than in the other. markedly affects the distribution of products And, as explained by the law of comparative traded between nations.9 advantage, it is these commodities which will generally constitute a nation's exports.8 Having briefly explored the meaning of exchange rates and their importance, con 9 The latter effect is closely associated with the role 6 The notation 4 /-, for example, reads four shillings, no pence; likewise, 4 /3 reads four shillings, three pence. played by exchange rates in influencing the value and volume of a country's imports and exports. Thus, it is 7 Real costs refer to opportunity costs —the amount of one good that must be forfeited to produce a unit of another. traded goods are purchased or sold when exchange 8See footnote 3. and import goods into a country's trade. not simply a matter where more or less of previously rates vary; such changes may introduce new export 27 ECONOMIC REVIEW sideration may now be turned to how exchange chosen for illustrative purposes because they rates are determined. As mentioned earlier, are multiples of the present rate of exchange.) the discussion is limited to exchange rate The horizontal axis measures the amount of determination under free market conditions.10 pounds supplied and demanded. The red In such a situation the prevailing exchange line sloping downward to the right shows a rate would reflect basic supply and demand hypothetical relationship between the ex conditions. Consider, by way of illustration, change rate and the demand by Americans the exchange rate between the U. S. dollar for pound sterling. With British prices (fixed and the British pound. In any period the rate in terms of pounds) given, it is reasonable to of exchange between the two currencies assume would reflect the relationship between the pounds as the price of the pound increases that Americans will want fewer supply of dollars made available to Britishers in terms of dollars. The black line sloping by Americans and the demand for dollars by upward to the right shows a hypothetical Britishers. Alternatively, it could be said that relationship between the exchange rate and the exchange rate between the two currencies the supply of pounds made available by would reflect the relationship between the Britishers to Americans. With American supply of pounds made available by Britishers prices (set in terms of dollars) given, it is to Americans and the demand for pounds hypothesized that, as the dollar becom es by Americans. cheaper in terms of pounds (or put otherwise, The matter can, perhaps, be made clearer as the pound becom es dearer in terms of and more precise with the aid of the accom dollars), the volume of pounds made avail panying chart. The vertical axis measures able to Americans, in the course of business the price of the pound in terms of dollars. dealings, will increase. It should be recalled (The prices above and below $2.80 were from earlier discussion that this latter result may not always occur. Suppose now that the exchange rate were set at £1 = $5.60. Could this rate be long maintained, given the hypothesized supplydemand relationships? Probably not, for at this price the supply of pounds would exceed the demand for pounds; not all sellers of ster ling will be able to find buyers. The price of the pound would therefore tend to fall. Sup pose the exchange rate were set at £1 = $1.40. Could this rate be long maintained in a free market? Probably not, for at this price the demand for pounds, to purchase goods and services or investments in Britain, would 10 For a summary discussion of how the present system exceed the supply of pounds made available. actually works, see page 29. The price of the pound would therefore tend 28 SEPTEMBER 1965 to rise. Only at £1 = $2.80 is there an exact coincidence between supply and demand. Thus, £1 = $2.80 becom es an "equilibrium " rate of exchange. This rate of ex ch a n ge—£1 SOME ASPECTS OF THE EXISTING INTERNATIONAL MONETARY SYSTEM Under present international monetary ar = $2.80 — rangements, exchange rates are allowed to would be an equilibrium rate only so long vary only slightly in response to temporary as changes do not occur in the hypothe changes in supply and demand factors; mem sized supply and demand relationships. Shifts ber countries of the International Monetary in these relationships would make the exist Fund ing equilibrium rate unmaintainable and, hence, necessitate a new equilibrium rate. through buying and selling as needed in the foreign exchange market —stable rates of (IMF) are required to maintain — Suppose, for some reason, Americans be exchange between their internal currency come more willing to spend dollars in Britain, units and a specified weight of gold .11 This for example, as a result of the recent popular requirement effectively establishes stable rates ity in this country of a British singing group of exchange between a member nation's known as the "Beatles." An increased will currency and the currency units of other ingness to acquire pounds would manifest member countries. To illustrate, the U. S. itself in a shift of the demand curve to the exchanges dollars for gold or gold for dollars right (see the accompanying chart); that is, at each dollar-pound exchange rate, Ameri for official foreign holders at a price of $35 an ounce; if Great Britain were to do the cans would seek more pounds than previously. same, it would be at a price of £ 1 2 /10s ($35 = one ounce gold = £ 1 2 /10s; and $2.80 = £1). Similar relationships can be worked out for all other member countries, although not all countries buy and sell gold in the market. Though member nations are required to maintain stable rates of exchange between their own currencies and those of other countries, this requirement does not apply in situations where "fundamental disequili brium" exists. That is, when it becom es evi dent that the prevailing exchange rate no longer would becom e unmaintainable; the demand corresponds closely to a market- determined rate reflecting long-term supply for pounds would exceed the supply of pounds. Unsatisfied demanders of the pound would drive up the pound's price in terms of dollars. 11 Actual spot rates of exchange are permitted to vary by as much as one percent in either direction from the official exchange rate. Thus, while the dollar price of Only at some new figure, perhaps at £1 = the pound may fluctuate between $2,772 and $2,828, $3.20, would a new equilibrium rate be found. the actual limits have been somewhat narrower. 29 ECONOMIC REVIEW and demand forces, the IMF will permit or dollars. For example, suppose South Mo exchange rate adjustments. The IMF, how rango was suffering a deficit in its interna ever, has never made explicit, or given sub tional balance of payments. That is, the de stance to, the term "fundamental disequili mand for foreign currencies to make desired brium," though what is n o t meant has been purchases and investments abroad exceeds made quite apparent. A ccording to one well- the supply of such currencies made available known economist closely associated with as a result of sales (of either goods, services, the IMF: or long-term debt instruments) by South Mo- No attempt has ever been made —nor per rangoans to foreigners. In this type of situa haps could it b e —to define fundamental tion, there would be a n a tu ra l ten d en cy , all disequilibrium precisely. But it is clearly things being equal, for the m ora n g to fall in intended to exclude merely ephemeral value. To prevent this, and thus maintain the balance of payments disequilibria, due established rate, the authorities must make to temporary factors of a seasonal, spec either gold or dollars available at the official ulative, price.13 or possibly even of a short cyclical type. . . . Moreover . . . it was The problem, obviously, is that South probably implicit in the articles that ex Morango can neither print dollars (and for change rates should be adjusted only at that matter any currency other than the infrequent intervals.12 m orang) nor manufacture gold. Because its Consider what it means for a nation to reserves of foreign currencies and g o ld —as guarantee to maintain a fixed rate of exchange those of any nation—are limited, there are between its own currency and a specified amount of gold or, what comes to the same of balance of payments deficits that South thing, another country's currency, such as Morango could withstand without lowering the U. S. dollar. The situation facing a hypo the value of the m ora n g to make purchases in thetical country like South Morango can be South Morango relatively more attractive. used as an example. Assume that that country Sufficient monetary reserves (or adequate has declared that 60.0 units of its currency, international liquidity) are essential to any the m ora n g will exchange for one U. S. dol system of fixed exchange rates. constraints as to the magnitude and duration lar, or, put otherwise, that the m ora n g is Establishment of the IMF, in 1946, in effect equivalent to 1.667 cents. South Morango provided additional international liquidity; has also established fixed rates of exchange member countries could now borrow foreign between the m ora n g and the currency units of all other member countries. To maintain 13 As a general matter, operations to stabilize exchange rates are carried out through the use of gold and U. S. these exchange rates, the monetary authori dollars. Gold, of course, is an internationally acceptable ties in South Morango should stand ready to medium of exchange. The dollar, because it is fully buy and sell u n lim ited amounts of gold an d/ convertible into gold at $35 an ounce, is also, therefore, a means of international payment. To a somewhat lesser 12 See Marcus J. Fleming, The In ternation al M on eta ry extent the same applies to sterling and, in some cases, Fund: Its Forms and Functions, International Mone to other strong European currencies such as the tary Fund, Washington, D. C., 1964, p. 8. D eu tsch e mark. 30 SEPTEMBER 1965 exchange from the Fund to meet temporary deficits. Thus, for example, South Morango would be allowed to borrow up to a specified amount from the IMF to cover a temporary disequilibrium in her payments facing the clothing chain referred to earlier (page 25). The reader will recall that the question was whether the purchase of a par ticular style of men's suit should be made position. in this country or in Great Britain. With The foregoing points up the fact that inter assured stability of exchange rates, the de national liquidity presently consists not only cision could be made quite simply; all things of gold and foreign exchange, particularly being equal, all the purchasing agent had to dollars and pounds sterling, but also of bor do was convert the price of the British-made rowing rights on the IMF. Insofar as a system garment into dollars and compare this price of fixed exchange rates rests upon the exist ence of adequate international liquidity, the with that asked by the American manufac turer. But suppose the exchange rate varies Fund has clearly made such a system more monthly, weekly, and perhaps daily. By the viable than it would otherwise be. time payment is made to the British manu facturer the dollar price of the pound may FIXED V S . FREELY FLUCTUATING EXCHANGE RATES have risen sufficiently to wipe out any price advantage originally received, that is, it Defenders of fixed exchange rates—and would cost the purchaser more dollars than therefore of some variant of the present inter originally anticipated. To be sure, traders national monetary system—offer a number can hedge (cover) against adverse exchange of arguments in support of their position. Two rate fluctuations, but such protection must seemingly strong econom ic arguments are be paid for and thereby increases the costs discussed here. The first is that fixed ex of engaging in international commerce. Fur change rates are an important element in ther, there are well-developed and efficient promoting maximum trade between nations. forward cover markets in only a few currencies. The second, which is actually related to the Finally, many types of transactions call for first, is that private capital movements (es long-term financing; here hedging possibili pecially of a long-term nature) across national ties are almost entirely absent. frontiers —which are essential if capital is Similar problems confront individuals and to be most efficiently utilized —require stable enterprises considering investing money capi rates of exchange between national currency tal abroad. Such investments usually involve units. elements of risk not generally found at home. Commerce between nations is a complex However, under normal circumstances, capi affair. Yet, it is necessary if the full benefits tal will usually go abroad when the expected of specialization and division of labor are to interest return exceeds the return desired be by the investor after considering domestic realized. Fluctuating exchange rates, which would mirror temporary changes in rates of return and his own risk expectations. supply and demand conditions, would add Risks are compounded when exchange rates further to the complexities of international are left free to fluctuate. Suppose a U. S. trade. Consider, for example, the situation investor has a choice between making an 31 ECONOMIC REVIEW investment of $280,000 at home yielding 5 growing out of the theoretical developments percent and an investment of equal size in in econom ic thinking during the past 30 years, Britain yielding 10 percent. At the end of that the maintenance of fixed rates of ex one year the investment at home would be change may not, at all times and in all cases, worth $294,000 ($280,000 x 1.05). What be compatible with prevailing domestic goals the investor would actually receive had he of full-employment, price stability, and high invested in Britain depends upon the pre rates of econom ic growth. In other words, vailing exchange rate at the time the funds it is argued that countries often find them (investment plus interest) are repatriated. If selves in situations where their commitment originally the exchange rate was $2.80, the to maintain the value of their currency in investor acquired £100,000 when converting terms of gold or other currencies is at vari dollars to invest in Britain. On this he would ance with internal objectives. earn £10,00 0 as interest. With a stable rate The argument can be more completely of exchange between the dollar and pound presented by considering a hypothetical sit he would bring home $308,000 (110,000 x uation in which a country, say G reece, may $2.80), or a "net profit" of $14,000 over find itself. Suppose, in some initial period, what could have been earned at home. But the Greek economy can boast of having no what if the value of the pound at the time of serious unemployment problem, no signifi repatriation, in terms of dollars, had fallen cant price inflation, a socially and politically to £1 = $2.00? The investor now would acceptable rate of econom ic growth, and bring home basic balance in its balance of payments (ig only $220,000 (110,000 x $2.00), a net loss of $74,000 when consid noring equilibrating capital flows). Suppose ered against the alternative investment in for some reason—say a reduced desire on the U. S. and a net loss of $88,000 when con the part of foreigners for grapes produced sidered against what he had originally ex in G r e e c e —that exports were to decline pected to earn on his British investment. markedly.15 The Greek balance of payments Thus, the potential investor of funds abroad u The danger is particularly acute in the case of capital must speculate —sometimes far into the fu flows to underdeveloped nations. Most of these countries ture —about the probable course of exchange are presently limited in their exports to one or two rate movements. (This is also true under a primary products, the demand for which varies greatly relatively fixed-rate system, but not to the in response to conditions in the industrial economies. Thus, the external value of their currencies will tend same extent.) To be sure, exchange rates can to fluctuate considerably, which they have even under fluctuate to the investor's advantage, but in existing arrangements. This has added to the already sofar as investors try to avert risks of loss numerous risks attached to the investment of funds in there is a real danger that the international flow of capital will be lessened.14 Opponents of fixed exchange rates also these areas. 15 It is assumed that the loss of employment and Gross National Product resulting from the decline in exports is offset by various domestic factors —for example, a present an imposing set of arguments. Prob fortuitous construction spurt at home. Thus, it is also ably the major source of opposition is a belief, assumed that the previous import level is maintained. 32 SEPTEMBER 1965 would therefore move into deficit position. The financial authorities must now (if G reece by exerting a depressing influence on the domestic econom y.18 In the way of illustra were under a fixed-rate system) gear them tion, consider first the effects on the home selves to the defense of the drachm a (the cur sector. By the pursuit of restrictive monetary rency unit of G reece). That is, the country's and fiscal policies, domestic price and in limited international reserves ($264 million come levels would most probably decline. in the first quarter of 1965) would have to be This course would, therefore, manifest itself made available in support of the official inter in growing unemployment among workers, national value of the drachm a .16 If the Greek a falling price level causing hardship to the deficit were only transitory the problem would business and agricultural sectors, and a less not be serious; G reece would lose some of than satisfactory domestic rate of growth. her international reserves, but in time these But, a restrictive monetary and fiscal policy losses would probably be offset. What, how may be an effective means of combatting ever, if the disequilibrium were more long G reece's balance of payments deficit. Thus, lasting? What if the Greek authorities have insufficient international liquidity to maintain the authorities are confronted with the de cision to trade off in part domestic objectives the international value of the d rach m a? (It against international objectives. A lowering will be remembered that borrowing rights on of prices in G reece relative to prices abroad the IMF are included in the total of G reece's makes purchases in G reece more attractive: international reserves.) In such a case the Greeks may now find it desirable to buy at authorities must take remedial action or else home goods that were formerly imported; the value of the drachma will decline by default. to do more of their shopping in G reece. Thus, What would the authorities be likely to do? price effects would most likely lead to some First, it should be apparent that there is no improvement in G reece's exports and some simple solution. Clearly, they would attempt curtailment of her imports. Further support to stimulate exports and curtail imports.17 As would come about as a result of reductions one alternative, although not always the most in money incomes (following from declines propitious, both objectives may be attainable in money wage rates and the level of employ similarly foreigners may now find it desirable ment). Reduced money incomes would likely 16 Thirty drachm a = $1; 1,050 drachm a = one ounce gold. 17 Were Greece to have a relatively well-developed money market, the monetary authorities would also seek, by raising short-term interest rates, to attract funds from lead to a decline in imports since individuals have less purchasing power and therefore would spend less on most goods and services, imports included. foreign money markets. At present, outside of the U. S., Critics of fixed exchange rates argue that only several major European nations, Canada, and it is unnecessary for a nation to compromise Japan, have even reasonably mature money markets to the extent they could conceivably rely upon short-term 18 Another alternative, which is not considered here, capital flows to offset a part of balance of payments would be to have a once-and-for-all devaluation of the deficits. drachma. 33 ECONOMIC REVIEW — or trade off —on its domestic goals because ments —some of a quasi-moral or ethical na of balance of payments considerations. To ture, some of a political or "practical" nature, these critics, disequilibrium in a country's and still others of a highly theoretical or tech international nical nature. payments position can and For example, some oppose should be rectified by permitting the exchange flexible exchange rates on the grounds that rate to fluctuate freely in response to chang governments may becom e "irresponsible" in ing supply and demand conditions. After all, their financial affairs once they can safely they argue, since a private enterprise econ ignore the "discipline" imposed by the bal omy relies upon the price mechanism to ance of payments. On the other hand, some eliminate disparities between supply and de oppose fixed exchange rates on the grounds mand in most domestic markets, why not let that such a system is incompatible with a free the price mechanism bring about balance in market economy. Both of these arguments the foreign exchange market? If, at the pre appear to have moral or ethical implications. vailing exchange rate, Greeks wish to spend On a totally different level, the debate focuses more foreign exchange abroad than is received on such highly theoretical matters as the from abroad why not, the critics of fixed value of freely fluctuating exchange rates in exchange rates ask, let the price of foreign mitigating the effects of externally generated exchange rise in terms of the d rach m a? This business cycles and whether flexible rates would make foreign purchases more costly, are really able to eliminate balance of pay thus tending to reduce imports; and because the d rachm a could be more cheaply obtained ments disequilibria.19 in terms of foreign currencies, Greek exports CONCLUDING COMMENTS would be stimulated. Putting the matter most A system of flexible exchange rates has not simply, the critics argue that balance of pay been widely advocated by government offi ments disequilibrium should be eliminated cials here and abroad. But the fact that such not by reductions in domestic price (and a system is being discussed in econom ic income) levels, but by automatic reductions literature does suggest a growing interest in in the external value of the home currency. balance of payments problems throughout If this prescription is followed, the critics see the world, and indicates the willingness of no reason for the domestic econom y having many analysts to consider various alterna to bear the burden of deficits in a country's tives, even those with limitations, to handling external transactions. The controversy between the major econom ic issues that confront the advocates of world economy. fixed exchange rates—the existing system — and those of freely flexible exchange rates is not likely to be resolved on the basis of the 19 To give the reader some insight into the debate centered around this last-mentioned issue, reconsider carefully the discussion contained in paragraph 3, arguments presented above. Both sides bring page 26. Would flexible rates bring about an equilib to the debate a number of additional argu rium under all demand and supply conditions? 34 SEPTEMBER 1965 RECENTLY PUBLISHED BOARD OF GOVERNORS OF THE FEDERAL RESERVE SYSTEM, WASHINGTON, D. C. 20551 RECENT CREDIT AND MONETARY DEVELOPMENTS Federal Reserve Bulletin, July 1965 INTEREST RATES ON CAPITAL MARKETS Federal Reserve Bulletin, August 1965 FEDERAL RESERVE BANK OF CHICAGO, ILLINOIS 60690 WHERE’S ALL THE CURRENCY? Business Conditions, August 1965 FEDERAL RESERVE BANK OF KANSAS CITY, MISSOURI 64106 MORE ON CORRESPONDENT BANKING Monthly Review , July and August 1965 FEDERAL RESERVE BANK OF MINNEAPOLIS, MINNESOTA 55440 U. S. BALANCE OF PAYMENTS: ALTERNATE METHODS OF MEASUREMENT Monthly Review , August 1965 FEDERAL RESERVE BANK OF NEW YORK, NEW YORK 10045 INTERREGIONAL INTEREST RATE DIFFERENTIALS Monthly Review , August 1965 35 Fourth Federal Reserve District
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