Full text of Review (Federal Reserve Bank of St. Louis) : December 1966

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D e w m m J s

CONTENTS
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Cow /ro/..............................

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7966

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Review

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— 7966 . . .

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a n d

T /t e t r

C o n t r o l

I N E T E E N S IX T Y -S I X w as th e sixth con secu tive year of
expansion in spending and production. In each year since 1960
total dem and for goods and services has risen rapidly enough to
red u ce the proportion o f w orkers unem ployed and the proportion
o f p lan t ca p a city unused. T h e year 1966 differed from th e p revi­
ous five, how ever, in several significant respects.
A ggregate
/or goof%s an6? services
excessfue during
m ost of th e year. In th e 1961-64 period dem and rose sufficiently
to b rin g th e econ om y stead ily closer to its p oten tial ou tput and,
on th e w hole, in a m od erate and orderly fashion, avoiding the
creatio n of undue problem s o f resource allocation and inflationary
pressures. D u rin g 1965 th ere was a m uch m ore rapid grow th of
total dem and, acco m p an y in g th e acceleratio n of activ ity in V iet
N am , b u t m ost o f th e rise w as m atch ed by an in crease in output.
D u rin g m ost o f 1966 th e rise in dem and con tin u ed to b e rapid
and sign ifican tly ou tp aced th e ab ility o f th e econom y to produce.

Vo)ume48

*

Number 12

FEDERAL RESERVE BANK
OF ST. LOU!S
P. O. Box 4 4 2 , St. Louis, Mo. 6 3 1 6 6




77te y ear 7 9 6 6
one o/ m ^a^on. D u rin g the first fou r years
of th e business expansion, sales and p rod u ction rose in p arallel
fashion, and ov erall p rices ch an g ed little on b alan ce. B eg in n in g
ab ou t m id -1965 to ta l d em an d rose m ore vigorously than real ou t­
put, and rises in p rice indexes b ecam e n o tab le. In 1966 dem and
co n tin u ed to rise rap id ly, and, w ith th e econ om y at v irtu al c a p a c ­
ity, ab o u t h a lf of th e rise w as tran slated in to higher p rices.
FerferaZ &tv<7ge% p o^ cy ttxis m ore sfim tJa fiu e to to tal dem and
in th e last h a lf o f 19 6 5 and in 1966 th an it had b een in over a

decade. From a relatively restrictive stance in 1960
budget policy became progressively more expansionary
through tax cuts, additional welfare programs, and
acceleration of the war in Viet Nam. Such develop­
ments are believed to have been major forces in the
growth of total demand from an inadequate level in
the early 1960's to the excessive level of 1966.
Monetary francs changed wiar&et^y during the year.
In mid-1960, several months before the cyclical up­
turn, the money stock began rising moderately, at
about a 3 per cent annual rate compared with an aver­
age 2 per cent rate in the previous decade, and con­
tinued to rise at this pace until mid-1964. From the
summer of 1964 to the spring of 1965 money rose at
an expansionary 4 per cent rate, and from the spring
of 1965 to the spring of 1966 it went up at a very
stimulative 6 per cent rate. This marked expansion
was probably a significant factor in the strong rise in
total demand during 1965 and 1966. From April
through November money declined on balance, acting
as a restraining force on total demand in the last half
of 1966.
Znferesf rafes rose rapidly from mid-1965 to the
spring of 1966 and then spurted yet more rapidly until
September, reaching the highest levels in over thirty
years. Higher yields were reAected in a decline of
bond prices and exerted a depressing influence on the
value of common stocks, real estate, and other capital
assets. The rise in rates resulted primarily from a huge
demand for funds accompanying Federal budget policy
and the strong demand for goods and services. Since
yields on market securities rose much more than in­
terest rates offered by banks and savings and loan
associations, a greater share of the public's funds than
in many years flowed directly from savers to investors
without passing through an intermediary.
nation's &a?ance o/ payments
of/ter cotinfnes c?efenorafet% in some major respects but improved
in others. On the one hand, the strong domestic de­
mands for goods and services, the higher prices in this
country, and the shortage of some items domestically
caused a jump in our imports and a marked reduction
in our trade surplus. On the other hand, the higher
interest rates in this country were helpful in reducing
the net outflow of capital and money market funds
from the United States. F or a fuller analysis and some
background on the balance-of-paym ents problems, see
"1966 Balance of Payments in Perspective," on page
17 of this RetMett;.
Zn ?afe J9 6 6 fhere
!H(%icafions fTiaf
increase
in fofa% tfemanff t^as yno^erafmg. Spending was less
bouyant, credit demands were less vigorous, and in­
terest rates receded from the peaks reached in the early
Page 2



interest Rates
H ighest G r a d e C o r p o r a t e Bonds

fall. The abrupt shift in the thrust of monetary vari­
ables, which turned from expansion to restraint in the
spring of 1966, may have been a major restraining
force on total demand later in the year.
Total demand serves as a convenient theme for
analyzing economic conditions. All of the above de­
velopments, together with many others, were related
to the excessive total demands for goods and services
during 1966. This article examines: 1) public policy
factors affecting the demands, 2 ) the resulting de­
mands for goods and services and the accompanying
rises in production, employment, and prices, 3 ) credit
and interest rate developments, and 4 ) some economic
trends, prospects, and choices developing in late 1966.

Public Policy Factors Affecting
Total Demand
The two chief factors influencing the course of
spending are fiscal and monetary developments. Some
analysts see fiscal policy as dominant, while others
view monetary policy as more effective. D irect Gov­
ernment spending and taxing are commonly thought
to play more important roles in determining total de­
mand than their size might indicate for two reasons:
1) Government spending and taxing are based largely
on political, military, and welfare considerations and
are not directly a function of current or expected in­
come, and 2 ) a one dollar change in Government
spending or taxing will generally lead to more than a
one dollar change in total spending because of the
effects on disposable incomes of consumers and busi­
nesses, which, in turn, influence their spending.
Monetary actions may have as great or greater
im pact on economic activity. Changes in the stock of

money held by individuals and businesses relative to
their desire to hold it as an asset influence spending.
Linkages between money and spending may be through
such variables as interest rates, credit availability, and
liquidity.

Since mid-1965 the U. S. Government, through its
current taxing and spending programs, has exercised
a strongly stimulative influence on total demand for
goods and services. The overall relation between tax
rates and the provision for expenditures has been the
most stimulative in over a decade. At the same time,
total tax receipts of the Government have been rising
rapidly, largely because of the growth in private in­
comes. As a result, the total impact of the Federal
budget, including the effect of the so-called automatic
stabilizers, has been less stimulative than current pro­
grams alone would indicate.
Recent Federal Government fiscal developments
may be examined in the light of alternative ways of
measuring receipts and expenditures of the Federal
Government.* There are four budgets of the Govern­
ment in common usage. The administrative budget is
the basic planning document of the Government. The
cash budget measures the cash Row between the Gov­
ernment and the rest of the economy. The national
income accounts budget summarizes the receipts and
expenditures of the Federal Government sector as an
integrated part of the recorded activities (i.e., the na­
tional income accounts) of all sectors of the economy.

I960

1961

1962

1963

1964

1965

1966

iF o r a fuller discussion of various budget measures, see Keith
M. Carlson, "Budget Policy in a High-Employm ent Econom y,"
in the April 1966 issue of this Reuiett).




The high-employment budget is an estimate of the
national income accounts budget which would prevail
at a specified rate of resource use.
On an adwiwisfrafiDC
basis, the deficit rose
from $4.6 billion in calendar 1965 to an estimated $8.9
billion in 1966 (see table on pages 12 and 13). This
budget is the basic planning document of the Gov­
ernment but has serious shortcomings as a measure of
impact on the economy ( as noted below in the discus­
sion of other budgets). Expenditures are estimated at
$119 billion in 1966, up 17 per cent from $101 billion
in 1965. Spending for national defense, reflecting the
acceleration of war in Viet Nam, rose from about $53
billion in 1965 to an estimated $65 billion in 1966.
Other outlays increased from $49 billion to roughly
$54 billion, reflecting pay increases to Government
employees and other price increases and new welfare
programs. Net budget receipts increased from $97
billion in 1965 to an estimated $110 billion in 1966, or
14 per cent, as incomes and profits rose, excise tax rates
were increased, and tax collections were accelerated
in a move toward a pay-as-you-go system.
The consoM afe^ cash &M6?gcf also indicated a great­
er net Government deficit in 1966 than in 1965, rising
from $4.5 billion to an estimated $7.5 billion. The cash
budget, which includes the activities of Government
trust funds, provides a broader measure than the ad­
ministrative budget of the cash flow between the Gov­
ernment and other sectors of the economy. Cash
receipts of the Government rose from $123 billion
in 1965 to an estimated $145 billion in 1966, 17 per
cent. Higher social security tax rates were a factor
causing the greater rise in receipts on a cash basis than
on an administrative basis. Cash payments to the pub­
lic went up 19 per cent, from $128 billion in 1965 to
an estimated $152 billion in 1966. Medicare payments
and more liberal social security benefits as well as the
greater outlays included in the administrative budget
were chief causes of the increase.
The
income accoMnfs
is a broad
measure relating the Federal Government sector to the
consumer, business, state and local government, and
international sectors of the national income and pro­
duct accounts. It reflects the impact of current
changes in tax rates and provisions for expenditure
by the Government as well as the built-in stabilizing
effects of existing laws as applied to changing eco­
nomic developments.^
^Differences of opinion exist as to whether it is better to include
or exclude the effect of automatic stabilizers in analyzing fiscal
policy. There is an extensive literature on the value of the
automatic stabilizers. However, since the impact of these
stabilizers is chiefly determined by developments in the private
Page 3

On the national income accounts basis, the budget
has shown a surplus at an average annual rate of about
$0.4 billion during the past 18 months. This was less
stimulative than in the period 1961-64, when the deficit
averaged a rate of $2.5 billion. This measure of Gov­
ernment action, which indicates about the same stance
in 1966 as in 1965, is generally thought to be a better
indication of the relationship of the Government to
total spending than either the administrative or cash
budget. The national income accounts budget is de­
signed to include only factors which have a direct
impact on the flow of current income. This is accom ­
plished by such devices as excluding transactions in
existing assets and accruing tax receipts. The some­
what greater restriction indicated by this budget for
1965 and 1966 than for the preceding four-year period
resulted in large part from the impact on Government
tax receipts of the rise in economic activity and in­
comes—the chief automatic stabilizer. In view of the
high level of economic activity and the excessive rate
of increase in total spending, the budget appropriately
should have registered a larger surplus in the last 18
months if it were to act as a restraining force on total
spending.
The
indicates the influ­
ence of changes in tax rates and in provisions for
Government expenditures upon the national income
Fisca! M e a s u r e s
Federa! Budgets

accounts budget and abstracts from the major built-in
stabilizer effects. It is thus a better measure of changes
in fiscal policy.
On a high-employment budget basis the Govern­
ment operated at a surplus of about $0.5 billion an­
nual rate in the 18 months from mid-1965 to the end
of 1966. This was the smallest surplus, and therefore
the most stimulative, in over a decade. Figures pre­
sented in this budget are hypothetical, but relative
levels are believed to provide the best single measure
of the relative impact on the economy of current
Government fiscal actions. The high-employment budg­
et differs from the national income accounts budget
primarily by eliminating the effect of changes in eco­
nomic activity on Government receipts. It measures
the impact of changes in tax laws and legal provision
for expenditure, at an assumed rate of use of resources,
rather than actual tax receipts and expenditures.
Government tax and expenditure policies as m ea­
sured by the high-employment budget were a
substantial drag on total spending in 1960, were mod­
erately and on the whole increasingly stimulative
from early 1961 to early 1965, and became verv stim­
ulative in late 1965. The marked shift in the posture
of the Government since 1960 resulted from the
investment tax credit and liberalized depreciation
guidelines in 1962, tax cuts in 1964 and 1965, increas­
ing expenditures for the Viet Nam conflict, and greater
outlays on welfare programs.
Government actions were probably even more stim­
ulative in late 1965 and early 1966 than indicated by
the high-employment budget. Government outlays are
recorded in this budget when goods are delivered;
yet the economic impact begins soon after orders are
placed. The defense build-up was accelerating rap­
idly because of the war in Viet Nam. Contracts were
let in great volume, production increased markedly,
and employment rose, but deliveries of goods were
relatively small in the early months of the build-up.^

1964

1965

1966

sectors, others believe that these movements may be mis­
leading. The differences of opinion are similar to those of de­
ciding whether to use interest rates and free reserves (w hich
are influenced by both the monetary authorities and demands
for credit in the rest of the* econom y) or to use aggregate
reserves and money (w hich are controHed by the monetary
authorities) in measuring monetary actions.
Page 4




Government debt-management operations were also
expansionarv during 1966. Because of the legal max­
imum interest rate of 4% per cent on new issues with
maturities of over five years, the Treasury was forced
to finance with relatively short-term issues, adding
to the liquid assets of the public. Average maturity
of the publicly held Federal debt declined from 63
months in 1965 to less than 59 months in the JanuaryOctober 1966 period.
3 A detailed analysis of this effect was presented by Murray
W iedenbaum in a paper entitled "T h e Federal Budget and
the Outlook for Defense Spending" at the University of M ich­
igan Econom ic Outlook Conference on November 18, 1966.

Econom ic analysis during the past two or three
decades has generally indicated that fiscal policy is
the major public policy influence on total demand.
Judged by this view, public policy has been extremely
stimulative during the past 18 months. Recent eco­
nomic analysis has put increasing emphasis on mone­
tary policy as a major determinant of total demand.

M o n e y Stock
Bi l l i o n s o f D o l l a r s

Bi l l i o ns o f D o l l a r s

M o n e t a r y D e v efo jo y y tem ts
Monetary expansion was rapid from mid-1964 to
the spring of 1966 and then came to an end. Both
member bank reserves and the money stock, which
had been rising sharply, showed net declines from
April to November. Typically, changes in these mon­
etary variables have had their greatest impact on
economic activity after a brief time lag.
Monetary developments are measured variously by
changes in the stock of money, interest rates, bank
credit, and other measures. For the sake of simplicity
and because it is a widely used policy indicator, par­
ticular attention is given here to changes in the stock
of money.
The money stock (demand deposits and currency)
has decreased at an annual rate of 1.5 per cent since
last spring after increasing 6 per cent in the preceding
year and at a 4 per cent rate from mid-1964 to April
1965. From mid-1960 to mid-1964 money rose at a
3 per cent rate, and in the 1950's, at a 2 per cent rate.

"^4 JVofe oft Vmterpretiytg M om ctary
A s the nation's central bank, the Federal Reserve System has responsibility for managing
the monetary system in a way that helps achieve
the broad goals of economic policy. W hile the
general nature of the role of the Federal Reserve
in monetary management is not difficult to ex­
plain, it is difficult to explain the specifics of how
that role should be performed: for example, how
monetary policy should be designed, how the
variables to be influenced should be selected, and
how the results should be measured. One fun­
damental and practical problem involved is the
presentation, use, and measurement of basic sta­
tistical information.
In the lead article of its November
the Federal Reserve Bank of Cleveland
discusses the problems involved in measuring
and interpreting monetary variables. A copy of
the November 1966 issue may be obtained free
of charge by writing to the Research Depart­
ment, Federal Reserve Bank of Cleveland, Cleve­
land, Ohio 44101.




1959

1960

1961

1962

1963

1964

1965

1966

The sharp expansion in the money stock from mid1964 to early 1966 was probably a significant factor
in the rapid rise of spending during 1965 and early
1966. To the extent that actual cash balances ex­
ceed desired cash balances, upward pressures are
placed on spending. Evidence indicates that changes
in the rate of spending have usually followed marked
and sustained changes in the rate of growth of the
money stock after a few months' lag.^ The decline in
money since April has probably exerted a restraining
influence on aggregate demand in late 1966.
The demand deposit component of money has de­
clined at a 3 per cent annual rate since spring following
a 5 per cent rate rise from mid-1964 to spring 1966.
By contrast, the currency component has increased
at a 4 per cent rate since spring compared with a 6
per cent rate in the preceding period. The amount
of currency held is probably related to the volume of
transactions which typically utilize currency. Changes
in the rate of growth of currency have tended to co­
incide with movements in total spending or to lag
slightly behind them. Rates of growth of demand de­
posits have been related to changes in member bank
reserves available for private demand deposits. Marked
and sustained changes in the growth rates of demand
deposits have usually preceded changes in economic
activity.s
Changes in the money stock have reflected in large
measure changes in member bank reserves. Member
bank reserves (adjusted for changes in reserve re­
quirements) declined at about a 2 per cent annual
rate from April to November this year. Reserves,
which are composed of deposits with Reserve Banks
^See "M oney Supply and Tim e Deposits, 1914-1964," in the
Septem ber 1964 issue of this
" S e e "Currency and Demand Deposits," in this Reixetf, March
1965.
Page 5

and cash in bank vaults, are the major determinant of
the level of demand deposits. From April 1965 to
April 1966 bank reserves rose about 5 per cent. By
comparison, reserves increased at a 4 per cent rate
from 1960 to 1965 and at an average rate of about 2
per cent per year in the 1950's.
Re se r v es of M e m b e r Ban k s

from 1960 to 1965 and at a 7 per cent rate from 1951
to 1960.
Growth of each of the three major components of
commercial bank time deposits has followed a different
course in 1966. Recent trends are most exactly known
for the large banks which report weekly. These banks
hold about $88 billion of total time deposits of $157
billion. Divergence of trends of different kinds of time
deposits has probably been greater at these large
banks than at other banks.
At these large banks passbook savings deposits,
which now amount to about $47 billion, have declined
at an 8 per cent annual rate since last Decem ber after
rising 11 per cent during 1965. The chief cause of the
changed trend was that with higher interest rates on
competing instruments banks found more difficulty in
attracting and holding passbook accounts at the F ed ­
eral Reserve's Regulation Q rate ceiling of 4 per cent.
Large CD's (certificates of deposit), which rose 12
per cent in the year ended in August and had increased
about a third each year for several earlier years, have
since declined at a sharp 50 per cent rate to about $15
billion in early December. The Regulation Q maxi­
mum of 5% per cent on these funds has made it in­
creasingly difficult for banks to hold them.

The rapid expansion of reserves from mid-1964 to
the spring of 1966 resulted from Federal Reserve Sys­
tem net purchases of Government securities totaling
$6 billion and an increase of $400 million in member
bank borrowing from Reserve Banks. Partially offset­
ting factors were a movement of currency into circula­
tion and net sales of gold by the U.S. Treasury. The
decline in effective reserves since last spring has re­
flected both a rise in reserve requirements on time de­
posits and a slower rate of net purchase of Govern­
ment securities by the System.
Reserves available to support private demand depos­
its (total reserves less reserves required for deposits
not counted as part of the money supply) have de­
creased at a 3 per cent rate since spring after in­
creasing 5 per cent in the preceding year. These
reserves rose at a 1.5 per cent rate from 1960 to 1965,
about the same as in the 1950's. Movements in private
demand deposits and the money stock are usually more
closely associated with these reserves than with total
reserves.
Tim e deposits in commercial banks rose at a 10 per
cent annual rate from November 1965 to August this
year and since have shown little net change. By com­
parison, these deposits increased at a 15 per cent rate
Page 6




Smaller, consumer-type CD's at the large banks have
risen 51 per cent since a year ago compared with a 20
per cent rate earlier in 1965. Recently these deposits
have amounted to about $26 billion. The recent rapid
growth rate of these deposits reflected increased bank
aggressiveness in seeking these funds for which reg­
ulations permitted payment of effectively competitive
interest rates. Since September of this year, when the
maximum rate on these CD's was lowered from 5%
per cent to 5 per cent, the amount outstanding has
changed little on balance.
Money stock plus time deposits at all commercial
banks declined somewhat from September to Novem­
ber after growing at a 4 per cent rate from June to
September, at a 9 per cent rate from March 1965 to
June 1966, and at an 8 per cent rate from 1961 to 1965.
In the 1950's this broader measure of money went up
at an average 3.4 per cent rate.
A particular net stimulative or restrictive effect on
the economy may be obtained with various mixes of
monetary and fiscal policies. During most of 1966 the
particular combination of policies prevailing was one
of relatively expansive fiscal developments and rela­
tively restrictive monetary actions. This mix required
larger borrowing by the Federal Government and a
lesser growth in money than a mix with more restric­
tive fiscal action and less restrictive monetary action




Federal Reserve Credit'
Annual Rates of Change
D ec. 1965- Apr. 1966Apr. 1966 Nov. 1966

Federal Reserve CreditFederal Reserve Holdings of U.S. Government Securities
Total Reserves of Member Banks
Reserves Available for Private Demand Deposits

+9.3%
+ 8 .0
+ 6 .9
+ 4.1

+3.2%
+ 3 .4
—2.3
—3.1

Discount Rate
In effect January 1, 1966
In effect December 20, 1966

4%%
4%

Reserve Requirements
Per Cent of Deposits
Tim e Deposits
All Member Banks

Demand Deposits
Reserve

In effect January 1, 1966
July 14,3 21,4 ig ee
September 8,3 15,* 1966
In effect December 20,1966

AU Other

^

Other Tim e Deposits

16%

12

4

4

16%

12

4

4

4
g
6
6

Margin Requirements on Stocks
In effect January 1, 1 9 6 6 .....................................................................................................70%
In effect December 20, 1 9 6 6.............................................................................................. 70

Maximum Interest Rates Payable on
Time and Savings Deposits
Savings Deposits

Other Time Deposits
30 Days or More Maturity
Under
$ 1 0 0 ,0 0 0

In effect January 1, 1966
September 26, 1966
In effect December 20, 1966

4%
4
4

5%%
5
5

$ 100,000
or More

5%%
5%
5%

Loan Policy
On Septem ber 1, 1966 the Presidents of the Fed eral Reserve Banks sent a letter to all member
banks regarding growth in overall bank credit, the increase in business loans, and administration
of Federal Reserve credit assistance to mem ber banks through the System's discount facilities.
Excerpts from the letter are as follows:
". . . credit financed business spending has tended towards unsustainable levels and has
added appreciably to current inflationary pressures . . . . [T h isl expansion is being financed
in part by liquidation of other banking assets and by curtailm ent of other lending in ways
that could contribute to disorderly conditions in other credit markets . . . . M ember banks
will be expected to cooperate in the System's efforts to hold down the rate of business loan
expansion . . . and to use the discount facilities of the Reserve Banks in a manner consistent
with these efforts . . .
*Adjusted for reserve requirem ent changes.
-Fed eral reserve credit excluding float and a few minor items.
^Effective date for reserve city banks.
^Effective date for all other mem ber banks.

Page 7

and tended to place upward pressure on interest rates.
The higher rates were of some benefit in keeping the
country's balance of payments from deteriorating since
they reduced the incentive to seek higher rates abroad.
On the other hand, higher interest rates adversely
affect some sectors of the economy, such as housing.

Demand, Production, and Prices
D em and
The demand for goods and services was very strong
in 1966, although it declined moderately from the
exceptionally high 1965 rate. Total dollar spending,
which had risen at a very rapid 9 per cent annual rate
from late 1964 to early 1966, grew at a somewhat more
moderate 7 per cent rate from the first to the third
quarter of 1966. These rates of increase in spending
were substantially above the estimated 4 per cent rate
of growth of productive potential. The stimulative fis­
cal actions during 1965 and 1966 and the rapid mon­
etary expansion from the summer of 1964 to the spring
of 1966 contributed to the large demand for goods and
services of the past two years.
^

^ ^

D e m a n d a n d Production

Rt

s

!

the total expense of owning a home, higher interest
rates increase the effective price of house services
more than the price of consumer goods in general.
Consequently, the amount of housing demanded
declines greatly.
Inventory buying continued large in the first half of
1966 but added little to increased total demand. Net
purchases of business inventories during the first half
of 1966 ($10.6 billion rate) remained close to the
fourth quarter 1965 rate ($10.4 billion). Inventory
purchases rose rapidly in 1965 from $4.7 billion in
1964, reflecting both the greater How of goods in the
private economy and the build-up of war goods for
Viet Nam. In the third quarter of 1966 inventory buy­
ing declined slightly, to a $9.9 billion rate. Factors in
the slowdown may have been the higher costs of cred­
it, unavailability of some items, and the greater de­
livery of war goods to the Defense Department relative
to production of these items.
Business spending on plant and equipment, in
contrast to inventory investment, continued to rise dur­
ing 1966. These outlays increased at an estimated 15
per cent rate in the first three quarters of 1966 com­
pared with an average 9 per cent rate in the previous
five years. Profit anticipations were optimistic, and de­
mands for defense goods were great. Interest costs,
although up nominally, did not impose much restraint
on demand since growing inflationary pressures led to
expectations that repayments would be made in
cheaper dollars.
Government expenditures jumped at an average 14
per cent annual rate during the first three quarters of
1966 compared with growth at about a 9 per cent rate
from late 1964 to late 1965 and a 5 per cent rate from
1962 to 1964. Defense outlays accounted for most of
the gain, but welfare programs of the Federal Gov­
ernment and spending by state and local governments
continued to rise.

HGNPmcurrentdollars.

Sourc:U.S .D .partm.ntofCommerc.

[2 G NP in )9 3 8 d o lla rs.

The growth pattern of spending changed markedly
during 1966. Private investment, which had risen at
a 15 per cent annual rate from the third quarter of
1964 to the second quarter of 1966, declined in the
third quarter of 1966. Outlays on housing declined
from $27.8 billion in 1965 to an annual rate of $24.8
billion in the third quarter of 1966. Since housing is
consumed over a relatively long period, current spend­
ing on new construction can be curtailed without
greatly reducing the amount of housing services avail­
able. Since interest cost is usually a major portion of
Page 8




Consumer outlays, which rose at about a 9 per cent
rate from late 1964 to early 1966, increased at a 6.4
per cent rate in the second and third quarters of 1966.
The slower rate was caused primarily by a decline in
durable goods purchased during the second quarter as
automobile sales decreased, reflecting higher excise
taxes, greater witholdings for personal income taxes,
and discussions of automobile safety. Nevertheless,
personal income, a measure of purchasing power, has
continued to rise at about an 8 per cent rate in 1966.
P r o d u c t i o n amc? EyM jp foyw teytt
Growth in real output of the economy slowed in
1966, trending downward from a 7 per cent growth

during 1965 to a 6 per cent rate in the first quarter of
1966 and a 3 per cent rate in the second and third
quarters. By comparison, output rose at an average
rate of 5 per cent from late 1960 to late 1964. Produc­
tive potential is estimated to increase about 4 per
cent a year.
The reduced rate of growth in production during
1966 resulted in large part from resource limitations
and from problems of readjustment as the economy ran
into bottlenecks and shifted to greater military effort.
Total demands for goods and services were strong, and
spending rose about twice as fast as production, caus­
ing prices to rise. Many plants were at virtual capac­
ity, and shortages of skilled workers were wide­
spread. W hen a high rate of resource use is achieved
in the economy, the rate of increase of total real prod­
uct necessarily falls back to about the rate of growth
of productive potential.
Total employment, after growing at about a 4 per
cent annual rate in the last half of 1965, rose at about
a 2 per cent rate in the first 11 months of 1966. This
shift is accounted for by the exhaustion of the supply
of employable labor and the How of manpower into
the armed forces. From 1961 to 1965 the 2 per cent
rate of increase of employment was much greater than
the 1.3 per cent rate of growth of population of working-force age (1 8 to 64 years). In 1966 the gain in
employment approximated the 1.6 per cent growth of
this population group. Since the number of men in
the labor force has recently increased little, growth
of employment has been dependent in large measure
on entrance of women into the labor force.
E mp lo ym e n t
Rati o S c a t e

Ratio S c a t e

Unemployment was at a relatively low level during
the year. Over 98 per cent of the married men looking
for work had jobs in the first 11 months of 1966 com­
pared with 97.6 per cent in 1965 and 95.4 per cent in




1961. A large portion of married men out of work in
1966 could be accounted for by seasonal unemploy­
ment, those changing jobs, and those without skills or
aptitudes marketable at prevailing wage rates.
Total unemployment was about 4 per cent of the
labor force in the first 11 months of 1966 compared
with 4.6 per cent in 1965 and 6.7 per cent in 1961.
The paradox of about one in twenty-five of those
wanting a job being idle at a time of strong labor de­
mand may be partially explained by minimum wage
laws. Unemployment was greatest among those with­
out skills or experience and with little education, par­
ticularly those in the 14 to 18 age group. The value
of the product of many of these workers is less than
the legal minimum wage, and incentives are great for
firms to avoid engaging in activities for which these
workers are fitted or to replace such workers through
automation.
P r ic e s
Inflationary pressures erupted during 1966. More
than half of the rise in total spending was translated
into higher prices and less than half was matched by
increases in goods and services. By comparison, in the
previous year about 20 per cent of the rise in spend­
ing resulted in higher prices, and 80 per cent was
matched by additional output.
Higher prices reflected primarily demands for goods
and services exceeding the economy's ability to pro­
duce with the given supply of land, labor, capital,
and technology. Price rises tended to be sharpest in
areas where goods and services were in shortest sup­
ply relative to demand. The transfer of resources from
private production to build war supplies in late 1965
and in 1966 was accomplished primarily by bidding up
wages and other prices.
Prices of consumer goods moved up sharply. From
late 1965 to October 1966 average consumer prices
rose at a 3.7 per cent annual rate after going up at a
1.3 per cent rate from 1958 to the fall of 1965. The
acceleration of price increases may have been even
greater than implied by these figures. In the earlier
period, quality improvements may not have been taken
adequately into account, and the fixed market-basket
approach did not allow for gains to consumers from
substitute commodities. More recently, with strong
demands for goods and with shortages developing,
discounts have been eliminated, and there have been
deteriorations in quality which may not have been
recognized in computing the index.
Prices of most consumer items rose. Food prices
went up at a sharp 5.4 per cent rate in the first 10
Page 9

Prices

B a n k Credit

1957-59=100

1957-59=100

1 2 0 ;-------

120

DoHars

400°"' °'

3 0 7 .3

t.5

2 3 4.8

Consumer
+!.3%
0 5 .9

105

1959

1960

1961

1962

1963

1964

1965

1*

1966
1959

months of 1966. Fees and charges for consumer serv­
ices (excluding rent) also increased at a 5.4 per cent
rate. Rent and prices of nondurable goods other than
food increased less rapidly. Prices of durable goods
crept up slightly.
W holesale quotations rose 3 per cent from the fall
of 1965 to the fall of 1966. By comparison, these prices
increased at a 2.3 per cent annual rate from mid-1964
to the fall of 1965 after being stable from 1958 to mid1964. W holesale prices of farm products and pro­
cessed foods rose about 5 per cent from the fall of
1965 to the fall of 1966, reflecting limitations of pro­
duction, exhaustion of stocks, large demands for ship­
ment abroad, and high personal incomes. Industrial
prices rose 2.3 per cent.

Credit and Interest Rates
Accompanying the strong demand for goods and
services, a substantial volume of credit was extended
in 1966. W ith incomes high and rising during 1965
and 1966, the amount of private saving was large, and
monetary expansion was very rapid during much of
this period. The demand for funds was even stronger
in response to optimistic business expectations and re­
quirements of governments. The demand for credit
apparently decreased somewhat after early September,
and the How of funds contracted.
Commercial bank credit rose at a 10 per cent an­
nual rate from November 1964 to August 1966 com­
pared with an 8 per cent rate in the economic
upswing from late 1960 to late 1964 and a 4 per cent
average rate in the late 1950's. From August to
November this year such credit declined at a 2 per
cent rate.
Page 10




1960

19 61

1962

1963

1964

1965

Strength centered particularly in business loans,
which increased 18 per cent from August 1965 to
August 1966. From August to November these loans
increased at only a 7 per cent annual rate. Banks pur­
chased municipal securities at a 12 per cent rate from
September 1965 to June 1966; from June to November
these holdings were reduced at a 1 per cent rate. Bank
real estate loans increased at a 13 per cent rate from
January 1965 to March 1966 and then at a reduced 8
per cent rate from March to November. The rate of
increase of bank loans to consumers declined from 14
per cent in the year ending in April 1966 to 8 per cent
in the April-September period and then to 4 per cent
from September to November.
The rate of increase of consumer instalment credit
outstanding both at commercial banks and elsewhere
has declined significantly since a year ago. After in­
creasing at a rate of 12 or 13 per cent a year in 1964
and 1965, this credit grew at an 11 per cent rate from
Decem ber 1965 to March 1966, at a 10 per cent rate
from March to August, and at a 7 per cent rate from
August to October.
The decline in the rate of increase of total instalment
credit reflected primarily a considerably more marked
decline in the rate of increase of automobile credit.
After growing about 12 per cent in 1964 and 15 per
cent in 1965, this credit expanded at a 10 per cent
annual rate from Decem ber 1965 to March 1966, at a
7 per cent rate from March to September, and at a
5 per cent rate from September to October.
Interest rates rose markedly during the last half of
1965 and the first four months of 1966. After April
the rate of increase accelerated, and by early fall most

rates reached their highest levels since the 1920's.
The rise reflected a sharper increase in the demand
for credit than in the available supplies from saving
and bank credit creation. The sharp upward move­
ment in interest rates from April to September accom­
panied the initial period of monetary contraction.

M o n e y M a r k e t Ra t e s

From Septem ber 1966 to early Decem ber interest
rates declined moderately. The decline in rates after
September may reflect a decline in the fundamental
demand schedule for loan funds. Alternatively, some
of the rapid increase of the summer may have been
primarily speculative because of inordinate expecta­
tions of still higher rates, and the October declines may
have been of a technical nature. Responding to the
high level of rates in the fall compared with the first
half of the year, the declines of credit extentions may
have reflected a decline in the amount of funds de­
manded rather than in the demand schedule.
Yields on highest grade corporate bonds, which had
averaged 4.35 per cent in the 1961-64 period and had
risen to 4.50 per cent by mid-1965, rose to 4.96 per
cent in April this year and then to 5.49 per cent in
September. Rates on Government bonds and on highgrade municipal bonds moved in a roughly parallel
fashion.
PerCent

Ca pi t a ! M a r k e t R at es

Per Cent

In the short-term market, yields on three-month
Treasury bills worked up from 2.35 per cent in 1961
to 3.80 per cent in June 1965, to 4.61 in April 1966,
and to 5.36 per cent in September. Quotations on
prime 4- to 6-month commercial paper followed a
similar course.




The higher interest rates were reflected in price
declines for many capital assets. A rise in rates means
lower prices on existing bonds and preferred stocks.
A rise in rates also tends to push down the present
value of a given expected return from real estate and
common stocks.
Interest rates on market instruments rose more rap­
idly in 1965 and 1966 than did rates paid by financial
intermediaries. Market yields quickly reflect changed
demand and supply conditions, while rates paid by
commercial banks on time deposits and dividends paid
on savings and loan shares are much more rigid. F re ­
quent moves in the latter rates are practically im­
possible. Since reduction of institutional rates offends
customers, there is a reluctance to raise rates until it
becomes clear that the higher level might be main­
tained for a period. Financial intermediaries have a
further reluctance to increase their interest costs b e­
cause new rates apply to previously obtained funds as
well as to new funds and resources of an intermediary
are invested in previously purchased lower yielding
assets.
Supervisory authorities have used their influence to
resist higher rates on funds supplied to intermediaries,
fearing deterioration of lending and investing stand­
ards or responding to a public opinion that increases
in such rates encourage higher general market interest
rates. Maximum rates which commercial banks have
been permitted to pay under Regulation Q have ex­
ercised a restraint on aggressive banks. In early Sep­
tember Regulation Q controls were tightened, limita­
tions on rates paid by savings and loan associations
Page 11

FEDERAL GOVERNMENT BUDGETS
BiHions of DoHars
SeasonaHy Adjusted Annua! Rates
RECEiPTS

Quart ers

Administrative
Budget'

SURPLUS (dcftcit)

EXPENDtTURES

Cash
Budget

Nat i ona!
tncome Accounts
Budget

HighEmptoymcnt
Budget

Administrative
Budget'

Cash
Budget

Nat i ona!
t ncome Accounts
Budget

HighEmptoyment
Budget

Administrative
Budget'

Cash
Budget

Nat i ona!
tncome Accounts
Budget

HighEmptoyment
Budget

1964
1

96.4

117.2

115.3

124.5

95.6

122.4

117.2

116.6

0.8

5.2

-

1.9

7.9

2

100.0

114.4

112.3

120.3

99.6

119.2

119.1

118.5

0.4

4.8

-

6.7

1.8

3

80.8

113.6

115.4

122.9

95.6

120.0

118.4

118.0

14.8

6.4

-

3.0

4.9

4

77.6

115.2

117.2

124.1

96.8

119.2

117.7

117.3

19.2

4.0

-- 0.5

6.8

1

97.2

118.9

124.0

126.9

91.6

120.7

119.6

119.2

5.6

1.8

4.5

7.7

2

117.2

130.6

125.0

127.3

1 0 2 .0

129.6

120.6

120.3

15.2

1.0

4.4

7.0

3

88.8

122.4

123.8

125.6

1 0 2 .8

128.4

126.3

126.1

14.0

6.0

2.5

0.5

4

84.0

122.8

126.9

126.9

109.2

132.4

127.0

127.0

25.2

9.6

- 0.2

0.1

1

104.4

134.8

136.0

135.2

108.8

147.6

133.7

133.8

4.4

12.8

2.3

1.4

2

141.6

158.4

141.0

140.9

107.2

143.2

137.1

137.1

34.4

15.2

3.9

3.8

3

101.6

145.3

145.4

145.4

132.8

160.2

145.1

145.1

31.2

14.8

0.3

0.3

92.8

141.1

148.5

148.5

127.2

158.5

150.0

150.0

34.4

17.4

1.5

1.5

1964

88.7

115.0

115.1

123.0

96.9

120.3

118.1

117.6

8.2

5.2

3.0

5.4

1965

96.8

123.4

124.9

126.7

101.4

?27.9

123.4

123.2

4.6

4.5

1.6

3.5

110.1

144.9

142.7

142.5

119.0

152.4

141.5

141.5

8.9

7.5

1.3

1.0

1964

89.5

115.5

115.5

124.8

97.7

120.3

116.9

115.7

8.2

4.8

1.4

9.1

1965

93.1

119.7

120.6

125.3

96.5

122.4

118.3

118.7

3.4

2.7

2.3

6.6

1966

104.6

134.4

131.9

132.2

106.9

137.6

131.0

131.0

2.3

3.2

0.9

1.2

1965

-

1966

4 e

-

Ca t e n d a r Years

1966 e
Fisca! Years ( e nde d June 3 0 }

c - Estimated
' \ o t scasonaHv adjusted.
SoM/'rrv: U . S . D e p a r t m e n t o f C o m m e r c e . U . S . T n - a s n r v D e p a r t m e n t . C o u m- i ! o)

Page 12




H r o n o n t i c \d\i s crs . a nd i ' c d c r a t i t r ^ r r v r B a n k o! St. L o ui s .
!'am- ] )

were formalized while liberalized, and more formal
restraints were placed on mutual savings banks.
An exceptionally small share of the total Row of
funds went through financial intermediaries in 1966.
In 1964 and 1965, 44 per cent of the net sources of
credit in the economy Rowed through time and sav­
ings accounts of deposit-type Rnancial institutions.
In the first quarter of 1966 these institutions received
30 per cent of available funds, and in the second and
third quarters they received 26 per cent. With mar­
ket rates higher than interest rates paid by banks,
savings and loan associations, and other intermediaries,
there was an incentive for suppliers of funds to place
them in stocks, bonds, commercial paper, and direct
loans. This diversion tended to favor the larger sup­
pliers of funds and the large borrowers, notably the
U. S. Government, large state and municipal borrow­
ers, and m ajor businesses, which obtain funds in a
national market. Sm aller savers generally received
lower rates than large suppliers, while less well-known
borrowers, who must usually rely on local Rnancial
institutions, had few er funds for which to compete.

O n ijP M t
The rate of growth in real output has also declined.
Total output, measured in constant dollars, increased
7 per cent in 1965, at a 6 per cent annual rate in the
Rrst quarter of 1966, and at a 3 per cent rate from
the Rrst to the third quarter. Industrial production,
which had risen at an 11 per cent rate from September
1965 to June 1966 and at a 7 per cent rate from June
to August, increased very slowly in the autumn.
Achievement of essentially full employment, develop­
ment of bottlenecks, and problems of substantial
shifts from civilian to military production have neces­
sitated some reduction in the rate of real growth. A
softening of demand also may have developed.
Steel was produced at a slightly slower pace in the
July-O ctober period than in the previous four months.
Construction put in place, after reaching a peak dur­
ing the Rrst four months of the year, has since fallen
signiRcantly.

New Construction
Bittions of Dottars

s.,,„„,a)ty A d ju r e d

of DoHars

A n n u o ) R a te s

Econom ic Trends Late in the Year
+ !5 .5 %

Available evidence indicates that the demand for
goods and services may have moderated during the
summer and fall. Total spending rose from the Rrst to
the third quarter at a 6.6 per cent annual rate, down
from the 9.5 per cent rate of the preceding Rve quar­
ters (see chart, p. 8). W hether, in view of resource
bottlenecks and problems of shifting to more military
production, there has been adequate reduction in the
excessive demand of late 1965 and early 1966 remains
to be seen.
Growth of several elements of total demand for
goods and services has slackened considerably. The
rate of growth of retail sales has declined from 13 per
cent in the last half of 1965 to 5 per cent during the
Rrst half of 1966 and has since shown little net change.
The increase in net business outlays for inventories,
which was at a $12 billion annua! rate from the Rrst
to the second quarter, slowed to a $10 billion rate from
the second to the third quarter. Expenditures on new
homes, which were about unchanged from the Rrst
to the second quarter, fell at an annual rate of $5 bil­
lion from the second quarter to October. Large offsets
to these declines have been provided by increasing
Government outlays and by more business spending
on equipment. Personal income, a measure of pur­
chasing power, has been rising at about an 8 per cent
rate in recent months.
Page 14



7 1 .8

M o r.6 6
"

I

1

1964

"°t =

i

i

!

,

1965

i

,

r

1

it )

Oct 6 6
!

!

!

!

i

if l

!

1966

Prtces
The slowing in the pace of spending also may have
been reRected in price developments, though inRationary pressures remain. Since August wholesale prices
have declined, after rising at about a 4 per cent rate
earlier in the year. The industrial price component
has risen only slightly since July, after rising at a 3.4
per cent rate during the previous seven months. Prices
of farm products and processed foods fell from August
to November but remained about 3 per cent higher
than a year earlier. Consumer prices have continued
to rise at the disturbing 4 per cent pace which has
prevailed since the fall of 1965.
O t h e r D e r e / o p y n e m ts
The amounts of credit demanded and possibly the
fundamental demands have lessened since early fall.
Extensions of loans and net purchases of securities by

financial intermediaries have slowed. In part this has
reflected the lack of success of deposit-type institu­
tions in attracting savings and the inability of banks
to expand credit, caused by the decline in reserves.
Since early fall there are indications that direct finan­
cing also has been less.
Some interest rates, after rising to peak levels in
early September, declined moderately during the fall
despite a lack of monetary expansion in the period.
Yields on highest grade corporate bonds declined from
5.49 per cent in September to 5.37 per cent in early
Decem ber. Three-month Treasury bill rates de­
creased from 5.36 per cent to 5.10 per cent during the
same period.
C au sa/ F a c t o r s
The pronounced shift in monetary trends beginning
last spring may have exercised some restraint on the
excessive demands for goods and services. Both bank
reserves and money, which had been rising before
April at the fastest rate in over a decade, have since
been contracting. Usually such a marked and sustained
change in the course of bank reserves and money has
been followed after a brief lag by a significant slowing
in spending.

idly relative to deliveries as in the earlier period. Late
in the year the 7 per cent investment tax credit and
accelerated depreciation benefits were withdrawn,
making private investment somewhat less attractive.
In November the Treasury replaced maturing securi­
ties with five-year obligations, reducing somewhat the
liquidity of the public. At the beginning of 1967
another increase in social security tax rates is
scheduled.
The nature of our productive process may have
contributed to a slowing of aggregate demands for
goods late in the year. During 1965 and early 1966,
as demands for goods of the producers of final prod­
ucts expanded, derived demands on the suppliers of
these concerns rose even more sharply. The suppliers
not only had to produce materials for the products
which were ultimately sold but also to provide the
final producers with inventories and other investment
goods to expand. W hen many final producers reached
capacity operations in 1966, they had to slow their rate
of expansion even though final demand continued in
excess of capacity. The slower growth in real output
of final producers meant an actual reduction in both
dollar and effective demands for materials from some
suppliers.

C h a n g e s in M o n e y Stock
fo r S e i e c t e d P e r i o d s
PerCent

PerCent

4

2

4
1951 to 1966

J ul y 1 95 7

N o v . 1959
toMayl960

Nov. 1966

+ 2 . 2%

2

+ 0 .2%

0

0
-

-2

1. 2 %

-2
-3.3%

-4

-4

Federal fiscal influence, on the other hand, has ev­
idently continued to be expansive in late 1966. Total
Government outlays have been expanding signifi­
cantly, and both the national income accounts measure
of total fiscal impact and the high-employment mea­
sure of current Government actions have continued to
indicate stimulation. There were some evidences,
however, supplementing the formal budget measures,
that the Government may have been a little less stimu­
lative in late 1966 than in the previous year. New or­
ders for war materials were probably not rising so rap­




At the beginning of 1966 economic stabilization
required containing excessive demands for goods and
services, thereby moderating inflationary pressures. In
the early months of the year, the problem was aggra­
vated by rising contracts and expenditures for the Viet
Nam conflict and a reluctance either to reduce social
programs or to increase tax rates. Monetary actions
also were stimulative, partly because the huge de­
mands for funds caused rapid expansion of commercial
bank demand deposits even at rising levels of interest
rates.
In the fourth quarter of the year the major task may
have shifted from one directed primarily to restrain­
ing exuberance to one of maintaining an optimum
growth in total demand. By late 1966 total demand
had lost some of its strength, and concern was being
expressed over whether adequate expansion of total
demand and of real product would be continued in
1967.
The problem of achieving appropriate total demand
in 1967 is complicated by cost-push inflationary pres­
sures which are strong at the end of 1966 and which
could be easily reinforced by excessively expansive
fiscal and monetary actions. Even if total demand is
one which in the long run might be considered op
Page 15

timal, many prices are likely to increase seriously in
1967 because of the excessive total demand and price
increases of the past year. Prices do not always rise
immediately in response to demand-pull forces; some
have been held back because of guideposts, and others
have been restrained because of contracts (including
wage contracts). Many wage rates and other prices
are expected to be marked up in 1967 because of the
excesses of 1966; these increases will place cost-push
pressures on other prices, and it is unlikely that there
will be enough offsetting price declines to prevent
undesirable general price increases.
At year-end it appears that the combination of mon­
etary and fiscal developments may not have to be so
restrictive in the coming year as it has been since the

Page 16



spring of 1966. Total demands for goods and services
have probably slowed, and a further reduction might
cause an unwarranted contraction of employment and
real product.
The mix of policy actions must also be selected. If
lower interest rates are judged desirable in order to
stimulate areas such as housing and other private in­
vestment and to foster real growth in the private
economy, emphasis might be placed on a combination
of restrictive fiscal policies with expansive monetary
actions. If large declines in interest rates are believed
undesirable because of a likelihood of increased out­
flows of funds from the country, reliance might be
placed on a policy mix with relatively stimulative
fiscal actions and quite limited monetary expansion.

1966 Balance of Payments in Perspective

D
E V E L O P M E N T S in the domestic economy exerted a dominant inRuence on the U. S. balance of
payments during 1966. Under the inRuence of high
total demand pressures, merchandise imports rose 20
per cent from the third quarter of 1965 to the third
quarter of 1966, while merchandise exports increased
9 per cent in the same period. The overall balance-ofpayments deRcit on a liquidity basis was $0.9 billion
in the Rrst three quarters of 1966, a slight improvement
over the $1.0 billion deRcit for the same period in 1965
and a considerable improvement over the $1.4 billion
deRcit in the Rrst three quarters of 1964.
The United States has experienced chronic balanceof-payments deRcits averaging close to $3 billion a year
since 1958.* Until recently, the deRcit was considered
to be structural, i.e., due to a secular shift in relative
economic positions of the United States vis-a-vis
Western Europe. Lately, business cycle conditions in
the United States have played an important role in the
continuance of the deRcit. Although there has been
some improvement in the balance of payments in
1965 and 1966, the ofRcially optimistic projections of
balance-of-payments equilibrium, i.e., a deRcit or sur­
plus of not more than $250 million, made on the basis
of the various government actions taken in 1965 have
not been realized. However, if the cyclical domestic
inHationary pressure can be successfully contained by
restrictive monetary and Rscal policy, a major correc­
tive force for eliminating the balance-of-payments
deRcit may be provided.
I The measurement of the balance of payments is essentially a
double entry bookkeeping procedure, and therefore the defini­
tion of a deficit depends upon which items are considered
capital items and which items are considered financing items.
Thus, there is a variety of ways of defining the deficit or
surplus. This definitional problem is compounded when
the country's currency is also held by foreigners (as is the
case with the dollar), either by private persons to finance
trade or by official institutions as international reserves. The
definition of the balance-of-paym ents deficit used here is
measured by decreases in U .S. gold and foreign currency
holdings plus increases in holdings of liquid dollar assets by
foreigners (called "balance of payments on liquidity basis").
T he other measure of the balance of payments is the official
settlements basis. The m ajor difference between the two is that
increased holdings of liquid dollar assets by private foreigners
are excluded from the latter measure of the deRcit.




The postwar history of the U. S. balance of payments
can be divided conveniently into three time periods:
1946-57, when the United States dominated the Free
World economic scene; 1958-64, when the relative
economic position of the United States vis-a-vis Europe
weakened; and 1965-66, when domestic inRation in this
country has been an important factor bearing upon the
balance of payments.
From 1946 to 1957 the United States appeared to
have an overwhelming economic advantage, and con­
cern was expressed about a chronic international short­
age of dollars. In this setting this country assumed a
wide range of economic, political, and military respon­
sibilities to reconstruct and defend W estern Europe,
requiring large spending abroad. W e were able to do
this and still maintain equilibrium in the balance of
payments because of the tremendous and largely unsatisRed foreign demand for American products and
dollar balances. Any increase in the amount of dollars
in the hands of foreigners was matched by an equal
increase in the ability of foreigners to satisfy part of
this demand for American products or dollars. The de­
mand for American goods and dollar balances was even
greater than the quantity supplied bv all of the aid
and other programs, and as a result an average of
$231 million in gold was sold to the United States an­
nually to acquire additional dollar balances (see table.
Row 9).
In the second period, from 1958 to 1964, W estern
Europe had recovered her prewar economic position
and had entered a period of rapid growth under the
umbrella of the Common Market (EEC ). W ith inter­
national convertibility of its currencies the Common
Market also becam e a safe as well as an attractive
place for U. S. investment. As a result, there was a
substantial increase in U. S. capital outHow (table,
Row 5). But while the economic position of Europe
became more favorable, the economic, political, and
military obligations which the United States had as­
sumed in the earlier period were still largely main­
tained. This is reRected in the continued large deRcit
Page 17

U. S. BALANCE OF PAYMENTS
1946 - 1966
BiHions of Dottars

1946-57

1958-64

1. Tr ade ba t a n c e
Me rc ha n d is e exp ort s . . .
M e rc h an d i se imports . . .

4. 3
+
+ 13.9
— 9.6

2. Ser vi ce b a t a n c e
Receipts .................................
Exp end itures ......................

+
+
—

0 .2
4 .6
4 .4

3. Tr ansfer p a y m e n t s ' ...........

—

4. Ba tan ce on current a c ­
count ( 1 + 2 + 3)
5. Private capi ta) (net)
Long-term capi ta) ...........
Short-term c a p i t a ) ...........
6. G ov er n m en t
("et)3

1965

1966*

4. 4
20.0
— 15.6

4. 8
+
+ 26.3
— 2 1 .5

3 .5
+
+ 29.3
— 25 .8

+
+
—

0.1
8.8
8.7

2.2
+
+ 12 .7
— 10.5

+

1.8

3.2

—

2.6

—

2.8

—

3.0

+

1.3

+

1.9

+

4.2

+

2.3

—
—
—

1.3
1.1
0. 2

—
—
—

3.3
2.4
0. 9

—
—
+

3. 5
4. 4
0.9

—

1.0

—

1.1

—

1.6

—

1.6

7. Errors an d o m i s s i o n s ------

+

0 .6

—

0. 5

—

0.4

8. Ba ta n ce on liquidity basis
( 4 + 5 + 6 + 7) ...................
C h a n g e in go)d stock**. .
9.

—

0. 3
0.2

—

3.0
1.1

—

1.4
1.7

—

1.2
0.5*

+
+

tr ansactions

.......................

+

—

—

—

in the Government sector of the balance of payments
(table, Row 6). The Europeans did assume increased
international responsibilities, especially in aid to un­
derdeveloped countries, but the amount was small in
terms of Europe's economic potential.
After 1957 the U. S. military and economic grants
of dollars to foreigners plus the dollars received from
U. S. imports and long-term capital spending abroad
was not matched by a corresponding increase in the
demand for American products and dollars. Products
were available from other sources which, at the going
exchange rates, were cheaper or available more quick­
ly than competing American products. Consequently,
the large supply of dollars which Rowed into private
and official institutions in Europe was in excess of
European demand for dollar balances to hold and the
surplus holdings were used to purchase an average
$1.1 billion per year in gold from the United States.^
2 Only foreign central banks and other ofHcial institutions are
eligible to purchase gold from U .S. Government stocks. In
most cases foreign private persons can sell their holdings of
dollars to their central bank for local currency. This, in effect,
means that all foreign holdings of dollars represent a potential
Page 18




The third period was 1965-66. During the last two
years the United States balance of payments has been
affected adversely by emergence of high domestic
total demand relative to supply and increasing prices.
The trade surplus (exports minus imports), which had
averaged $5.3 billion from 1960 to 1964, declined to
$4.8 billion in 1965, a $4.0 billion annual rate in the
first half of 1966, and a $2.9 billion rate in the third
quarter. The trade surplus for all of 1966 is estimated
at $3.5 billion, the smallest since 1959. This phenom­
enon is due to the recent acceleration in our imports,
which was largely effected by growth in total demand
in this country. The current account surplus will de­
cline even more sharply, from $4.2 billion in 1965 to
an estimated $2.3 billion in 1966, largely because of
the increased foreign exchange cost of Viet Nam.
The close relationship of imports and total demand
from 1959 to 1966 is indicated in Figure 1. The annual
per cent changes in imports are shown in relation to
the annual per cent changes in total demand. V ar­
iation in total demand explains 95 per cent of the
variation in U. S. imports.^ This is not surprising
since it is reasonable to expect that the growth in de­
mand for foreign products should be roughly in line
with the growth in total demand for all products.
Indeed, as the years 1959, 1965, and 1966 indicate,
when the economy is operating close to capacity and
total demand is growing at rates close to 8 per cent,
there is a more than proportionate growth in imports.
claim on the U .S. gold stock. However, this is not as danger­
ous as it may look because most foreign private holdings of
dollars are for working balances to finance international trade.
So in the absence of a major shift in trade patterns or prefer­
ences, the foreign private holdings of dollars should be con­
sidered rather stable.
^Using a standard statistical test (least squares regression) of
the relation betw een imports and total demand gives the fol­
lowing results:
Per cent change in imports = -18.5 + 4.2 (Per cent change in
total demand)
r- —.95
This illustrates that, if the growth in total demand in the United
States is zero for one year, U .S. imports will decline by 18.5
per cent in that year:
[ - 18.5 + 4.2 (0) = - 18.5 1
A 4.4 per cent growth in total demand will lead to a zero
growth in imports:
[ - 18.5 + 4.2 (4.4) = 0 1
For each 1 per cent growth in total demand in excess of 4.4
per cent, imports will grow by 4.2 per cent:
[ - 1 8 .5 + 4.2 (5.4) = 4.2 ]
[ - 18.5 + 4.2 (6.4) = 8.4 1
In spite of the good statistical Bt, because observations are
from only the most recent business cycle, these particular
values of the relationship should not be taken as holding for
all business cycles. However, the basic structure of the re­
lationship betw een total demand and imports is unlikely to
change.

This is because, as industries approach capacity, do­
mestic bottlenecks are eased by purchases from foreign
sources. Since foreign sources of supply may be less
secure (because of long transportation time), there is
also an incentive to increase inventories of materials
from foreign sources. In addition, with domestic price
rises, foreign products becom e, at least temporarily,
more competitive.
Just as U. S. imports are in general related to domes­
tic total demand, U. S. exports are largely related to
total demand in the rest of the world (given the ex­
change rate and level of technology in the United
States). Measuring total demand in the rest of the
world is a difficult procedure; however, the growth in
world imports exclusive of that of the United States
may be an approximate indicator.

tion in imports of the rest of the world explains 87 per
cent of the variation in U. S. exports. Since growth
in demand for imports by the rest of the world was
weaker in 1965, the growth in U. S. exports was also
weaker than in the immediately preceding years. Al­
though the growth in U. S. exports is estimated to have
recovered considerably in 1966 (11.5 per cent versus
3.9 per cent in 1965), it is still well below the estimated
1966 growth in imports (20 per cent). Our exports also
registered a low growth rate in 1965 because of a dock
strike in the first quarter. This tended to make the
Figure 2

Reiation of U.S. Exports to W o r ! d imports
Pe r C e n t C h a n g e f r om P r e v i o us Y e a r
W o r ! d imports
Less U.S. i mpor t s

In Figure 2, growth in U. S. exports is compared to
growth in import demand of the rest of the world. In
this relation, per cent changes in U. S. exports are
plotted against per cent changes in imports of the rest
of the world. One statistical test* shows that variaFigure 1

Reiation of U.S. imports to I o t a ! Demand
P e r C e n t C h a n g e f r om P r e v i o u s Y e a r
U.S. I o t a ! D e m a n d

U.S. Ex por t s

U.S. i mpor t s
Note. Regression fine shows the av e rag e per cent change in
imporfs associated with a 1 per cent change in totaf
demand.

^The same statistical test was applied to exports as to imports
(see footnote 3). T h e results are as follows:
Per cent change in U .S. exports = -7,2 + 1,7 (Per cen t change
in rest-of-world imports)
= .87
This illustrates that if rest-of-world imports are unchanged, U .S.
exports will decline 7.2 per cent in that year. I f rest-of-




Note. Regression fine shows the av erage per cent change in
U.S. exports associated with a 1 per cent change in
worid imports.

world imports increase 4.2 per cent, U .S. exports will remain
unchanged:
[ - 7 . 2 + 1 . 7 (4.2) = 0 1
But for every 1 per cent increase in rest-of-world imports
beyond 4.2 per cent, U .S. exports will increase 1.7 per cent:
[ - 7.2 + 1.7 (5.2) = 1.7 1
Page 19

growth in exports in 1966 larger than could be ex­
plained by the growth in imports of the rest of the
world. W ith acceleration of imports in response to
domestic growth in total demand unmatched by simi­
lar growth in exports, the U. S. trade surplus has de­
teriorated both in 1965 and 1966.

deterioration in the balance of payments starting in
1958, the realization emerged that the United States
must take some corrective actions to eliminate its def­
icit position. Because the weakness in the balance of
payments in the late 1950's occurred simultaneously
with a period of concern about domestic unem­
ployment and growth prospects, there was a conflict
between the achievement of two desirable targets,
external balance and domestic expansion. The clas­
sical remedy to eliminate the balance-of-payments def­
icits would have been restrictive domestic policies.
But primary consideration was directed to achieving
domestic goals,^ which required application of rela­
tively expansionary monetary or fiscal policies.^ At
the same time, restrictive monetary and stimulative
fiscal policies kept European interest rates high. This
made solution of our balance-of-payments problem
more difficult.

In spite of this weakness in the trade position, the
overall balance of payments has shown a smaller de­
ficit in 1965 and 1966 than in the 1958-64 period. Look­
ing at the balance of payments on an annual basis (see
chart), there may be some optimism concerning the
basic trend of the balance of payments. The deficit on
a liquidity basis moved from $4 billion in 1959 and
1960 to just over $1 billion in 1966. On an official
settlements basis, the improvement was from a $3.5
billion deficit to a $0.6 billion surplus in the first three
quarters of 1966. However, an investigation of quar­
terly data (chart) shows sharp up-and-down move­
ments in both measures of the balance of payments
through 1964. Only since the last half of 1965 has the
balance of payments looked consistently better than
in previous years. There is considerable question
whether the improvement of the last two years repre­
sents an underlying favorable trend or whether it is
due to special circumstances.

W ith the major monetary and fiscal tools directed
elsewhere, the balance of payments was dealt with by
a series of particular actions by the Government to
correct deficits in individual segments of the balance
of payments. Econom ic aid to developing countries
was "tied" to American sources of supply rather than
being open to worldwide competitive bidding (1959);
countries in which American military forces were sta­
tioned (such as Germany and Italy) were asked to
make military purchases from the United States rough­
ly equivalent to foreign exchange cost of maintaining
these troops (1961). On the private side, long-term

C o r r e c tiv e M e a s u r e s
For more than a decade after the war (1946-57), the
U. S. Government, as a matter of policy, encouraged
imports and American capital exports. This policy, to­
gether with economic and military aid, helped rebuild
the devastated countries of Western Europe. With the

^It is theoretically possible that two conflicting policies could
be achieved simultaneously by application of an appropriate
c o m b i n a t io n of different p o lic y tools. If
each tool is applied to the target on which
it has the strongest impact, it is conceivable
that both targets could be obtained. However,
such desirable results are difficult to obtain in
practice. The required movement in the policy
tool may be larger than would be desirable for
the smooth functioning of the economy. For
example, balance-of-paym ents equilibrium may
call for tight money, with interest rates in excess
of average postwar levels, together with easy
fiscal policy. As the U .S. financial system has
operated on the basis of relatively low interest
rates, it may be badly shaken when rates move
up significantly in a relatively short period.
T here was fear expressed in some quarters that
the U .S. financial system was being subjected to
great stress when long-term rates rose rapidly
in the summer of 1966.

United S t a t e s B a ! a n c e - o f - T r a d e
and Batance-of-Payments Positions
( + ) S u rp !u s ; (-)Deficit

-

-

32

29.4
2 6 .7 -

M e r c h a n d ise

24

E x p o rts LL

-

-

V

16
M ercha n d ise

)m[ o rts

-

-

J M t ic ia t

S e ttie m e

!

-8
1959

t

!

4.0

ts P o s it i on ^

%

..L .1

1960

Page 20




1 96 1

!

L iq u id it y

t

!

!

1962

P o s it io n 3

!

1 t

1963

. 1. [

/
i

1964

!

z-7 ^ - 9
V
1 1

1965

!

!

!

1966

60

62

64

66

^Some economists have argued that the relatively
m oderate monetary expansion from 1960 to 1964
was a policy response to the balance-of-payrnents deficit. Perhaps this is true. However,
for such a policy to have affected the balance
of payments, it would have had to attract U .S.
capital from foreign to domestic needs. As a
m atter of record, the 1960-64 period was one
of unprecedented increase in U .S. capital outflow
in spite of the healthy growth in domestic
investment opportunities.

portfolio investment abroad was discouraged by the
interest equalization tax (IE T ) (1963, 1965). This was
designed to raise the cost of borrowing by foreigners
in United States financial markets by roughly 1 per
cent per annum. In addition, a whole range of other
administrative actions was taken to encourage exports,
foreigners' travel in the United States, the use of
American instead of foreign ships, etc.
These actions in some cases had significant impact
on the particular components of the balance of pay­
ments toward which they were directed; but the over­
all deficit was not significantly reduced, as items not
subject to control experienced larger deficits or smaller
surpluses. This was probably because the major com­
ponents of the balance of payments (imports, exports,
and private capital) are so large and important in the
economy that only application of major policy tools
can effect a significant change in them. Such steps
were not taken in the 1958-64 period because it was
believed that to do so would have conflicted with
achievement of domestic objectives.?
R e c e n t D e r e f o jp y n e n t s
Because a piecemeal policy had obviously been
unsuccessful, it was decided in February 1965 to in­
troduce a more comprehensive but "voluntary" pro­
gram to limit the outflow of funds, which was consid­
ered the major cause of the deficit. This program was
designed to encourage banks and corporations with
extensive foreign commitments to reduce their rate of
growth. The program has had some success. Bank
commitments are now actually below that permitted
by the voluntary program while corporations have
shifted much financing of direct investment from U. S.
capital markets to foreign capital markets. This has
reduced the capital outflow considerablv in 1965-66.
However, as these actions have taken place at a time
when U. S. capital markets are tight and interest rates
high, it is impossible to sav how much of this improve­
ment was due to the voluntary program and how much
to the natural forces in the market place.
The heavy domestic demand for credit, which has
pushed some interest rates to their highest level in
forty years with loan deposit ratios at record highs,
has caused commercial banks to take defensive steps
which affect the capital account: (1) domestic credit
^Another reason for not applying stronger medicine to the
ailing balance of payments was the conviction that the prob­
lem was only temporary and that fundamental corrective
forces were operating. This optimism was based on increasing
European price levels and stable U .S. price levels in the 195964 period. Thus it was considered that only actions which pro­
duced short-term improvements in the balance of payments
were needed.




rationing has resulted in only the best and largest
customers of many banks receiving most of their credit
needs. Foreigners, along with other marginal custom­
ers, are being rationed out of the market. As a result,
short-term and long-term bank credit outAows have
been curtailed to a level which is now $1.2 billion b e­
low the voluntary guideline established in February
1965. (2) U. S. banks, faced with a curtailment of do­
mestic sources of loan funds, have turned to the Euro­
dollar market to an increasing degree. In the first
three quarters of 1966 U. S. banks increased their
borrowing from foreign banks (largely through their
branches in London and Paris) by about $1.9 billion
versus $0.1 billion in all of 1965. However, these
favorable developments in the capital account have
led to only moderate improvement in the overall
balance-of-payments position because of the decline
in the current account surplus.
The unusually tight domestic credit conditions in
the late summer, coupled with the fear of sterling
devaluation in July and August, were major factors
in the $1.5 billion increase in borrowing from foreign
banks in the third quarter. This is recorded as a short­
term capital inflow in the ofRcial settlements measure
of the balance of payments. This official settlements
measure has averaged slightly smaller than the liqui­
dity balance-of-payments measure of the deficit. Offi­
cial settlements excludes from the deficit increased
holdings of dollars by private foreigners. The rationale
for using this measure is that foreign private holdings
of dollars represent a real demand for international
liquidity which holders presumably believe can best
be achieved with dollar balances. Because these dol­
lars are satisfying a normal foreign demand (like the
export of any good or service) their increase should
not be treated in the balance of payments as an in­
crease in the deficit. The sharp increase in dollar
holdings of private foreigners in 1966 has pushed the
official settlements measure of the balance of payments
into surplus during the first three quarters of the year.
On this basis, our balance of pavments will show sub­
stantial improvement in 1966 compared with previous
years, while the liquidity measure is estimated to
register only a small improvement over last year.
The factors which contributed to a surplus in the
ofRcial settlements measure of the balance of payments
in 1966 may not continue in 1967. The three factors
which largely influence private foreign holdings of
dollars are the growth in world trade, the interest
rate incentive of holding dollar assets compared with
alternative international liquid assets, and the degree
of uncertainty foreigners have regarding the major
alternative sources of international liquidity. In 1966,
Page 21

especially in the third quarter, U. S. interest rates
registered an unusually sharp increase, from which
they are now retreating, and at the same time there
was a sharp speculative attack on the other major re­
serve currency, the pound sterling. Both events at­
tracted foreign private holdings of dollars. Since these
or similar developments are unlikely to occur again in
1967, a sharp increase in private foreign holdings of
dollars cannot be relied upon to provide the degree of
support for the balance of payments that was achieved
in 1966.
In spite of a wide range of administrative measures
and the recent short-term capital inflow, the United
States continues to experience a serious balance-ofpayments problem. There is, however, one ray of hope
regarding the future. The previous conflict between
simultaneously achieving domestic and international

Page 22




goals did not arise in 1966. The primary domestic
problem has been excessive demand, calling for mon­
etary and fiscal restraint. These same policies are most
appropriate to eliminating the balance-of-payments
deficit. W ithin the context of an overall policy of
restricting total demand, having monetary policy re­
latively more restrictive than fiscal policy holds interest
rates higher and thereby adds to the favorable balanceof-payments impact of a restrictive policy.
If the monetary restraint which has been applied in
the United States since the second quarter continues,
some further inflow of short-term funds may be en­
couraged. And if these tight credit conditions bite into
the growth in total demand, imports will decline and
the trade surplus will be enlarged. Thus, future pros­
pects for the balance of payments depend to a large
measure on monetary and fiscal developments.

RFV FEW
Month
of Issue

Jan.

!N D E X —

Month
of Issue

Title of Article

AioweAiry Grot^/^

July
/I P ^ e t p o/

7963
F^rw 7wrow^ P/i^i Ai^r^^^/y
Feb.

7i Fo^7 D^7M4M^ Too
P ^ o r ^ Ff4?crd/ P^y^r^c B^M^ o/ S/.
Lon;;, 7963

Mar.

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Fw^rgc^rc o/
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PWrcy
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Fro^ow/r Tr^M;7i

May

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P ^ 7 Grotr/^?
Fc^rd/ P^y^r^^ 0/?cw Ai^r^^ O/^cr^oMy
7963.*
^[f^OMy^
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Title of Article

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7w^d/^OM
F^cr/ o/ To^Z

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Aug.

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Sept.

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BdMj6i
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June

1966

P age 2 3




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