Full text of Review (Federal Reserve Bank of St. Louis) : July 1971

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FEDERAL RESERVE BANK
OF ST. LOUIS
J uly 1971

Vol. 5 3 , No. 7







ANNOUNCEMENT
Homer Jones, Senior Vice President and Director of
Research, retired from the Federal Reserve Bank of St.
Louis on June 30, 1971. Mr. Jones has been head of the
Research Department since 1958, after serving many
years with the Federal Deposit Insurance Corporation,
the Committee for Economic Development in Washing­
ton, D .C ., and the Board of Governors of the Federal
Reserve System.
Leonall C. Andersen assumed the duties of Director
of Research and Senior Vice President, effective July
1,1971.

Dollars, Deficits, and the
International Monetary System
J .H E U.S. balance-of-payments deficit, according to
most of the commonly used definitions, has reached
record magnitudes in the past two years. Within the
last several months, the persistence of large deficits
has aroused sharp controversy both in official and
private circles. For example, the Bank for Interna­
tional Settlements (B IS), in its latest Annual Report,
commented in the following manner on the U.S.
balance-of-payments situation:1
Apart from technical measures to contain the
outflow of funds, the Administration had no plans
for curing the U.S. payments deficit. The Council
of Econom ic Advisers declared in its Annual Re­
port that unilateral policy action by the United
States cannot eliminate the deficit so long as other
countries insist on running surpluses over and above
their SDR allocations. This attitude seems rather
far removed from the spirit — and the letter — of
the Bretton Woods system, which SDRs are sup­
posed to be preserving.

This brief statement touches certain sensitive areas
of international monetary relations that are currently
receiving considerable attention. First, and most ur­
gent, are the problems of foreign countries, and in
particular their central banks, in dealing with a huge
influx of dollars. This large flow of dollars is partially
a result of the reduction in U.S. borrowings from the
Eurodollar market, and of the decline of interest rates
in the United States.2 In addition, a “multiple expan­
sion” of Eurodollars occurred as European central
banks placed dollar balances with the BIS. Second,
the balance-of-payments deficit of the United States
is being reappraised in light of the policies of the
Administration and in view of the prospects for im­
provement in the U.S. balance-of-payments position.
Third, there is a new sense of urgency in the search
for alternatives to the continued accumulation of dol­
lars by foreigners, especially central banks. One pos­
sible solution, which has not received full considera­
tion, calls for a U.S. policy of stable noninflationary
monetary growth. These issues will be examined at
length in this article.
xBank for International Settlements, Forty-first Annual Report,
(Basel, 1971), p. 20.
2For an illuminating analysis of the Eurodollar market, see the
immediately following article by Professor Milton Friedman,
“The Eurodollar Market: Some First Principles,” reprinted
by permission from the Morgan Guaranty Survey, October



As is generally the case in international monetary
policy matters, these difficulties have little likelihood
of quick resolution, although Germany and the Neth­
erlands have attempted to meet their immediate
dollar inflow problems by allowing their currencies
to float. Austria and Switzerland have revalued their
currencies.3 The following article reviews recent is­
sues and developments in international monetary
affairs, and discusses some proposed measures to im­
prove conditions.

Europe’s Dollar Problem
U.S. Interest Rates and
Short-term Capital Flows
Private foreigners have accumulated large amounts
of dollars to hold as liquid assets and as a medium
of exchange for world trade. Many foreigners have
chosen to hold these liquid dollar balances as deposits
in European banks (Eurodollars) rather than as di­
rect deposits in U.S. banks. Extremely high Euro­
dollar interest rates encouraged private foreigners to
channel currently accruing dollar receipts into Euro­
dollar deposits, especially in 1968 and 1969. Private
foreigners also converted their domestic currencies
into dollars for the same purpose. Foreign central
banks, obligated to maintain fixed exchange rates,
supplied these dollars by drawing down their official
reserve holdings of dollars, and even sold $1 billion
of gold to the United States in order to obtain dollars
in 1969. In addition, central banks themselves have
been attracted by high interest yields, and have lent
funds in the Eurodollar market through the Bank
for International Setdements, which acted as an
intermediary.
In large measure, the upward pressure on Euro­
dollar interest rates was transmitted by U.S. banks
borrowing on a “nondeposit” basis in the Eurodollar
market. Eurodollar interest rates normally rise and
fall with U.S. short-term rates. In 1968 and 1969,
Eurodollar rates were also pushed up, as U.S. banks
sought to find alternative sources of cash. The rise in
U.S. short-term rates above existing interest rate ceil­
ings had made it extremely difficult for banks to raise
funds through the sale of negotiable CDs. With the
3A country that revalues raises the price, in terms of foreign
currency, at which it buys or sells its own currency. A
country that devalues does the opposite.
Page 3

FED ER AL RESERVE BANK OF ST. LOUIS

J U L Y 1971

decline in U.S. interest rates that began in early 1970,
and the removal of interest ceilings on large 30- to
89-day maturity CDs in June 1970, U.S. banks once
more were able to issue CDs at attractive rates, and
U.S. Bank Borrowing in Eurodollar M arket
Reflects Relative Cost and Availability
of CD Funds
Per Cent
14

no longer found it profitable to compete for reserves
in the Eurodollar market. The accompanying chart
shows how the volume of CDs and Eurodollar bor­
rowings of U.S. banks have fluctuated in response to
CD interest rate ceilings and relative interest costs of
obtaining funds in the two competing channels. As
Eurodollar borrowings by U.S. banks were repaid,
interest rates on Eurodollars declined sharply. Private
foreigners then sought more attractive returns in do­
mestic European money markets, and converted dol­
lars back into European currencies through foreign
central banks.

The Mark-Dollar “Crisis”

'Three-Month Certificate of Deposit
Primary Market Rale
Adjusted for Reserve Requirements*

1964

1965

1966

1967

1968

1969

1970

1971

Billions of D ollars
32

Billions of D ollars
32

28

1

Cert ficafes of Deposit

24

24

!

20

/

16

/

r"
\ i
\

iV

/

i

\
\\

rJ- ^ V* /

u
12

28

/ '

/

Eur idollar Ho dings of I.S. Bank:

i
v

1965

1966

1967

1968

1969

16

i
12

A \

/
1964

20

ii

\
\
\

1970

1971

S o u rc e s : B o a rd o f G o v e rn o rs o f th e F e d e ra l R ese rve S ystem , C o n tin e n ta l Illin o is N a tio n a l B ank
a n d T rust C o m p a n y o f C h ic a g o , a n d M o rg a n G u a r a n ty Trust C o m p a n y
* The c e r tific a te o f d e p o s it m a r k e t r a te is b a s e d o n th e le g a l c e ilin g ra te s d u r in g th e
f o llo w in g p e r io d s : J a n . 1 ,1 9 6 4 - N o v . 2 3 , 19 64 : 4 p e r c e n t o n 9 0 - d a y d e p o s its

In West Germany, where the Bundesbank at­
tempted to cool inflationary pressures by following a
restrictive monetary policy, domestic interest rates
were above Eurodollar interest rates by mid-1970,
contrary to previous years. This induced German
companies, which have free access to the Eurodollar
market, to borrow funds from it, converting the dollar
proceeds into marks. Multinational corporations and
other investors were likewise encouraged to exchange
dollars for marks which could earn attractive yields
when placed on deposit in German banks or lent in
German money markets. The following chart shows
how German banks and enterprises increased their
net foreign liabilities sharply in 1970, as Eurodollar
interest rates fell below domestic German rates.
As a result, the Bundesbank was obliged to pur­
chase approximately 3 billion dollars between Jan­
uary and April in support of the official markdollar parity. The Bundesbank’s dollar reserves grew,
increasing expectations that official action would be
taken to stem the inflow by adjusting upward the
value of the mark. Conversion of dollars into marks
by those in position to speculate on exchange rates
then swelled the German central bank’s dollar re­
serves even further, especially after official support of
the dollar in forward exchange markets was sus­
pended on April 28.
In just two days, before the foreign-exchange mar­
kets were temporarily closed on May 5, the Bundes­
bank was forced to acquire an additional 2 billion
dollars in order to maintain parity on the “spot”
exchange market.4 Finally, on May 10, the decision
was announced that official dollar-mark convertibility

N o v . 2 4 ,1 9 6 4 - D e c . 5 ,1 9 6 5 : 4 p e r c e n t o n 8 9 - d a y d e p o s its
N o v . 8 , 1 9 68 - J a n . 2 0 , 1 9 7 0 : 5 .7 5 p e r c e n t o n 8 9 - d a y d e p o s its
J a n . 2 1 ,1 9 7 0 - J u n e 2 3 , 1 9 7 0 : 6 .5 p e r c e n t o n 8 9 - d a y d e p o s its
N o te : T h re e -m o n th E u ro d o lla r le n d in g ra te s fo r 1/1966-11/1971 a r e d e r iv e d b y M o r g a n G u a r a n ty
T rust C o m p a n y o f N e w Y o rk b y a d d in g 7 / 8 p e r c e n t to th e ir th re e -m o n th E u ro d o lla r d e p o s it
rate s. T he le n d in g ra te s p r io r to 1966 a re d e riv e d b y this b a n k b y a d d in g 7 / 8 p e r c e n t to th e
th re e -m o n th E u ro d o lla r d e p o s it ra te s o f th e B o a rd o f G o v e rn o rs , F e d e ra l R eserve System .

Digitized for Page
FRASER
4


4The spot exchange market involves trading of currencies for
current delivery. Trading of currencies for future delivery
is conducted in “forward’ exchange markets. For an exposi­
tion of these terms, see Alchian and Allen, University
Econom ics (Belmont: Wadsworth Publishing Co., 1967),
pp. 686-690, 753-760.

FEDERAL RESERVE BANK OF ST. LOUIS

JU L Y 1971

German Net Eurodollar Borrowings
Reflect Their Cost Relative to Domestic Funds 11
12

12

a

10

Three-Month Eurodollar
Lendino Rate
.

V
1 i1\ j

Vv\

fh \ AN
/
y yh{/ v.
/
"Jt
\
AJ
r i/
\
A
Vy'
y
Sr7
A

10

a

1hree-Monln lime Deposit Kate
of West German Commercial Banks

1 1 1
1964

1965

1966

1967

1968

1969

1970

1971

Billions of
Deutsche M ark
12

Billions of
Deutsche M ark
12

r
of West German Enterprises
*

Short-term Capital Flows and
Monetary Stabilization

"J A^ -\\ }
V

A

1

et Foreig Short-Ti rm Borro wing
of West Ge rman Contmercial Banks^
-8

-12

1964

1965

Opposition to a revaluation of the mark stems from
several industries, including German exporters of au­
tomobiles and machinery and import-competing in­
dustries, such as textiles, chemicals and electrical
equipment. Revaluation of the mark by nine per cent
in 1969 is still fresh in mind, and further appreciation
might hurt the international competitive position of
some German goods. Subsidized German agriculture,
whose price support levels are geared to dollar
equivalents under the European Economic Commu­
nity ( EE C ) Common Agricultural Policy, stood to re­
ceive lower prices and incomes until assured that
compensating adjustments in support levels and sub­
sidies would be made.

lr

Ne

---

sary or unwise. Some reports suggest the mark might
be permitted to float for as long as six months or
more until speculative sentiment wanes, after which
the old parity might be restored. Recent accumula­
tions of dollars due to short-term capital inflows are
assumed by some officials to be temporary and revers­
ible. The recent rise in Eurodollar lending rates may
reduce the incentive for Germans to borrow
Eurodollars.

1966

1967

iii
1968

1969

1970

4
1971

-12

So urces: M o n th ly R e p o rt o f th e D e u ts c h e B u n d e s b a n k a n d M o r g a n G u a r a n ty T rust C o m p a n y
Q These o b s e rv a tio n s a re c e n te re d on e n d -o f-p e rio d d a ta o f th e se c o n d m o n th o f e a c h q u a rte r.
l2 B a la n ce o f s h o rt-te rm lia b ilitie s m inu s s h o rt-te rm assets.
N o te : T h re e -m o n th E u ro d o lla r le n d in g rate s fo r 1/1966-11/1 971 a r e d e r iv e d b y M o r g a n G u a r a n ty
T rust C o m p a n y o f N e w Y o rk b y a d d in g 7 / 8 p e r c e n t to th e ir th re e -m o n th E u ro d o lla r d e p o s it
rate s. The le n d in g ra te s p r io r to 1966 a re d e r iv e d b y this b a n k b y a d d in g 7 / 8 p e r c e n t to th e
th re e -m o n th E u ro d o lla r d e p o s it rate s o f th e B o a rd o f G o v e rn o rs , F e d e ra l R eserve System .

at 27.3 cents per mark was suspended for an indefinite
period. Since then, the dollar price of the mark has
fluctuated in the free market at a spot price ranging
from two to five per cent above the old parity. Per­
mitting the mark to float reduced the incentive for
speculative conversion of dollars into marks.
German officials are apparently not unanimously
agreed that an early revaluation is out of the ques­
tion. Although a sharp improvement has occurred in
1971, some German officials point to their 1968-1970
balance-of-payments deficits ( “basic balance”) as evi­
dence that a mark revaluation may be either unneces­



One of the advantages claimed for fixed exchange
rates and free convertibility among currencies is that
they tend to promote close international linkages
among markets. These linkages pose certain monetary
control problems, however. The mobility of short­
term capital, in response to interest rate differentials
among countries, diminishes the leverage of foreign
central banks in pursuing independent domestic mon­
etary policies. Inflows of dollars into a given country
tend to expand its monetary base, leading to faster
growth in domestic money supply, easier credit con­
ditions in the short run, and when resources become
fully employed, to inflation and ultimately higher in­
terest rates.
A monetary authority that seeks to prevent this
must either discourage the inflow of dollars or offset
the impact of the inflow on the domestic money
supply through restrictive policies. But efforts to dis­
courage the inflow of dollars may involve exchange
controls and other interferences with markets. Restric­
tive monetary policies that temporarily result in
higher domestic interest rates may actually tend to
increase the inflow of dollars seeking short-term in­
vestment. Moreover, if the inflows are due, in part, to
a favorable balance of trade, restrictive monetary
policies will postpone, rather than hasten, the reduc­
Page 5

JU L Y 1971

FED ER AL RESERVE BANK OF ST. LOUIS

tion of exports relative to imports that would be re­
quired to restore balance-c f-payments equilibrium.
Among the more frequently used methods for dis­
couraging dollar inflows are: (a) central bank opera­
tions ( frequently on a preferential basis with domestic
commercial banks) to drive the price of the dollar
upward in forward exchange markets so as to increase
the “covered interest” rates on Eurodollar loans rela­
tive to interest rates on domestic loans; ( b ) reduction
of central bank discount rates for the same purpose;
(c) prohibition of interest payments to foreign own­
ers of domestic bank deposits; (d) raising reserve
requirements on such deposits; (e) exchange con­
trols to limit the conversion of dollars into “resident”
domestic currency; (f) capital restraints on the
amount of foreign borrowing by domestic banks, other
financial institutions and business firms; (g) lowering
of tariffs and other barriers to imports; and (h) re­
laxation of restrictions on foreign investment by do­
mestic individuals and companies.6
During the recent dollar-mark “crisis,” West Ger­
many, in order to discourage capital inflows, dis­
continued its operations in the forward exchange
market, lowered its bank rate from seven and onehalf to five per cent, and stopped interest payments
and doubled reserve requirements on foreign-owned
bank deposits. Until now, West Germany has avoided
direct controls of type (e) and (f), but the British
Treasury recently prohibited additional short-term
Eurodollar borrowing by British companies for do­
mestic use.
The Japanese, who are currently running a balanceof-payments surplus, have maintained an extensive
system of exchange controls to discourage short-term
inflows of dollars. Opposition to yen revaluation is
strong, so other measures to alleviate upward pres­
sure are being adopted. Recently, the Japanese gov­
ernment announced an eight-point program that in­
cludes lower import barriers and complete liberaliza­
tion of foreign investment by Japanese citizens and
firms. Other actions have included lowering the cen­
tral bank discount rate, relaxing controls on private
ownership of dollars, and subsidizing banks desiring
forward cover on dollar holdings.
Attempts to stem the flow of dollars into and out of
central bank reserves have generally been ineffective
or insufficiently vigorous. Therefore, in order to neu­
tralize the effects of these movements on domestic
spending, a somewhat different set of tactics has
sometimes been adopted. To limit expansion of the
“George W. McKenzie, “International Monetary Reform and
the ‘Crawling Peg,’ ” this Review (February 1969), pp. 15-23.

Page 6


domestic monetary base, some central banks have, on
occasion, adjusted discount rates upward, liquidated
their holdings of government securities, and raised
commercial bank reserve requirements. Governments
have sometimes increased their deposits at central
banks. The leading practitioner of this general ap­
proach to dealing with recent dollar inflows has been
France. The rates on loans and discounts at the
Bank of France have been raised, taxes have been
placed on bank deposits of foreigners, and reserve
requirements have been increased. In West Germany,
reserve requirements have been raised across the
board on domestic bank deposits by 15 per cent.
The Bundesbank in the past has been able to neutral­
ize a high proportion of the changes in its foreign
reserves through offsetting adjustments of the do­
mestic sources of the monetary base.8
Governments at times have also raised taxes, in­
creased their borrowing, or undertaken other fiscal
actions in support of these efforts. The German Fed­
eral budget for 1971 and commitments for funding
future spending programs each have been cut by one
billion marks.
If a country desires to maintain a fixed exchange
rate, and finds it cannot prevent the accumulation
of foreign exchange reserves or offset their effect on
the domestic monetary stock, then the ultimate ad­
justment must be through changes in aggregate do­
mestic demand, prices and interest rates. There is
evidence that this has occurred in a number of in­
stances. As world short-term capital markets become
more closely linked, through the Eurodollar market
and other transmission mechanisms, surplus and defi­
cit countries will have less latitude to postpone these
ultimate balance-of-payments adjustments. The pres­
ent international system imposes a discipline on each
country to foster a domestic price trend at a rate that,
in the long run, is roughly consistent with the average
for all trading nations. To some foreigners it appears
more and more that this long-run average will be
determined by the United States.

When a Eurodollar Becomes a
Dollar of Reserves
The Eurodollar market has been blamed for ac­
centuating the problems of central banks by increas­
ing the mobility of short-term funds. There is reason
6Manfred Willms, “Controlling Money in an Open Economy:
The German Case,” this Review (April 1971), pp. 10-27. In
1969 and again this year, however, when the extremely
large size of the inflows was due in part to speculation on
revaluation, German monetary authorities made exchange
rate adjustments.

F E D ER AL RESERVE BANK OF ST. LOUIS

to believe, however, that these problems may have
been aggravated partly by some of the central banks’
own actions. As Table I indicates, in December 1970,
recorded foreign exchange assets of central banks
were $13.4 billion greater than dollar and sterling
liabilities to foreign central banks, as recorded by
the United States and England. No less than $6 billion
of this discrepancy appeared in 1970 alone. Since the
bulk of official foreign exchange reserves are dollars,
and most of the remainder is sterling, the discrep­
ancy has been attributed to a kind of “multiple count­
ing” of dollar claims on the United States which arises
out of central bank lending in the Eurodollar market.
Attracted by high yields on Eurodollars, a number
of foreign central banks deposited dollars with the
Bank for International Settlements (B IS), which in
turn redeposited these funds with Eurobanks.7 After
Eurobanks lent these deposited funds, some borrowers
exchanged the dollar proceeds of the loans for foreign
currencies obtained from central banks. The dollars
that foreign central banks originally placed with the
BIS became the basis for creation of new Eurodollars,
some of which were acquired by central banks. In­
stead of counting as reserves only those dollars which
are liabilities of the United States, the central banks
counted some created liabilities of Eurobanks as well.
From the point of view of reconciling official cen­
tral bank records of assets and liabilities, it is as if
foreign central banks counted some of their true dol­
lar claims on the United States twice (or possibly
more times, in the case of Eurobank created dollars
that were again fed back into the Eurodollar market).
Unless offset by other actions, when these Euro­
dollars were converted into domestic currencies, for­
eign central banks would increase their domestic
money supplies. There is little doubt that the willing­
ness of central banks to supply funds to the Euro­
dollar market supported multiple expansion of Euro­
dollar deposits. It may also have kept Eurodollar in­
terest rates lower than they otherwise would have
been.
Realization of the extent to which Eurodollars have
been recycled in this manner is very recent. Some
estimates suggest that at least $5 billion of foreign
official dollar reserves have been generated in this
way.8 The BIS has confirmed the intention of central
7Eurobanks are banks located outside the United States
(including foreign branches of U.S. banks) which accept
deposit liabilities denominated in dollars.
8Fritz Machlup, “The Magicians and Their Rabbits,” Morgan
Guaranty Survey (May 1971), pp. 3-13.



JU L Y 1971

Toble 1

INTERNATIONAL LIQUIDITY
(B illio n s of D ollars)
1960

1965

1967

1969

1970

Liquid Assets Recorded by C entral Banks
Gold

$ 3 8 .0

$ 4 1 .9

$ 3 9 .5

$39.1

SDR's

—

—

—

—

IM F Reserve Position

$ 3 7 .2
3.1

3 .6

5 .4

5 .7

6 .7

7 .7

Foreign Exchange Assets

18.6

2 3 .6

2 8.9

3 1 .9

4 3 .9

Total Reserve Assets

6 0 .2

7 0 .9

74.1

7 7 .7

9 1 .9

Liabilities to O ffic ia l Foreigners Recorded by
C entral Banks o f Reserve Currency Countries
U .S . D ollar Liabilities
U .K . Sterling Liabilities
Total Dollar and Sterling
Liabilities
Difference between Foreign
Exchange Assets and
Total D ollar and
Sterling Liab ilitie s1

11.1

15.8

18.3

16 .0

2 3 .9

7.1

7.1

8 .3

8.9

6 .6

18.2

2 2 .9

2 6 .6

2 4 .9

3 0 .5

.5

.6

2.4

7 .0

13.4

JFigures may not add because of rounding.
Source: International Financial Statistics, IM F (Monthly)

banks to withdraw funds from the Eurodollar market
“when such action is prudent in the light of market
conditions.” Quick withdrawal of funds might drive
Eurodollar rates up, causing contraction of the Euro­
dollar borrowing.
It is not surprising in fight of these discoveries that
many international monetary officials are now calling
for regulations on Eurodollar banking. There has
been conjecture about imposing reserve requirements
on Eurodollar deposits. Unless these are made uni­
form and universal, opposition may be forthcoming,
particularly from the British. About half of such Eurobanking is conducted in London, and uneven applica­
tion of regulations might result in loss of some of this
market to other countries.

U.S. Balance of Payments
Balance-of-Payments Policies
The recent upheaval in foreign exchange markets
disturbed a calm that had prevailed over the inter­
national financial system since the 1969 mark revalua­
tion. Except for strong disapproval of the use of
exchange rate adjustments as an instrument of shortrun domestic cyclical control,9 responses to the cur­
rent mark-dollar crisis among U.S. officials have been
9Speech by Arthur Bums, Chairman, Board of Governors of
the Federal Reserve System, before the International Bank­
ing Conference, Munich, May 28, 1971.
Page 7

FED ER AL RESERVE BANK OF ST. LOUIS

JU L Y 1971

restrained. Administration spokesmen have acknowl­
edged a concern over controlling the size of the
“basic” balance-of-payments deficit,10 which specifi­
cally excludes short-term dollar flows that have been
the source of recent unrest. Some foreign observers
have been prompted to accuse the present Admin­
istration of pursuing a policy of “benign neglect”
toward its balance-of-payments deficits.11 While U.S.
international monetary policy has not been materially
modified in the light of recent events, it is incorrect
to describe the United States as responding com­
pletely passively to the build-up of dollars in official
foreign hands.

have, in fact, contributed to improved international
stability. Continuance of tight money, it is felt, not
only might weaken the U.S. economy, but depress
our demand for imported goods to the point of
plunging the rest of the world into serious economic
contraction. The Vice-President of the United States
expressed it bluntly when he said, “We will not . . .
put the United States through the wringer in order to
deal with a temporary situation.”13 Ironically, the
recent low interest rates, of which Europeans com­
plained, were substantially the result of previous tight
U.S. monetary policies, which led to a weakening in
demand for credit.

Last December, the Federal Reserve attempted to
encourage banks to maintain their Eurodollar “re­
serve free base” liabilities by raising reserve require­
ments on liabilities in excess of this base from 10 per
cent to 20 per cent. In an effort to push up Euro­
dollar interest rates relative to rates in other foreign
money markets, the Export-Import Bank between
January and April borrowed $3 billion from foreign
branches of U.S. banks. The U.S. Government paid
almost a two percentage point premium for such
funds over comparable U.S. short-term interest rates.
According to Federal Reserve Governor Dewey Daane,
the Federal Reserve and the Treasury also undertook
a mild revival of “operation twist,” emphasizing pur­
chase of coupon issues to restrain long-term rates
from rising while issuing short-term debt to exert up­
ward pressure on short-term rates.12 As a further
step, announced in June, the Treasury would ex­
change $5 billion of short-term Treasury securities
held by the German Bundesbank for higher yielding
medium-term securities.

There seems to be an inclination of U.S. policy­
makers to assign to other countries some of the re­
sponsibility for our balance-of-payments deficits. The
United States, it is maintained, cannot succeed in
reducing its payments deficits if other countries are
determined to follow policies that enable them to
have surpluses. Chairman Arthur Bums of the Fed­
eral Reserve has called upon foreign countries to relax
their import restraints and capital investment controls,
and to use fiscal policy more actively in domestic
stabilization. Citing the excessively stringent mone­
tary policies conducted by European countries in the
past year, Dr. Bums advised these countries to co­
ordinate their monetary policies more closely with the
requirements for stabilization of international short­
term capital flows.14 Proposals that the United States
arrange somehow to devalue the dollar with respect
to other major currencies have made little headway.
Administration leaders have, in turn, suggested that
some foreign currencies may be undervalued.15

Beyond this, the reaction of some officials to foreign
criticism that more should be done has been to em­
phasize that by reducing inflationary pressures, the
restrictive monetary policies of 1969 and early 1970

The U.S. Balance of Payments in Retrospect

10Speech by Paul A. Volcker, Under Secretary of the Treasury,
before the joint meeting of the American Economic, Finance,
and Statistical Associations, Detroit, December 29, 1970. The
“basic” balance is the sum of: (a ) the current account
balance; (b ) the balance on long-term U.S. and foreign
private capital; and (c ) the balance of U.S. and foreign
government capital other than changes in U.S. and foreign
official reserve holdings.
1'A policy of “benign neglect” by the U.S. of its balance-ofpayments deficits has been advocated in two recent articles;
Gottfried Haberler and Thomas D. Willett, A Strategy for
U.S. Balance o f Payments Policy, American Enterprise
Institute for Public Policy Research (February, 1971), and
Lawrence B. Krause, “A Passive Balance-of-Payments Strat­
egy for the United States,” Brookings Papers on Econom ic
Activity, Volume 3, 1970.
12Speech by Dewey Daane, Member of the Board of Gov­
ernors, Federal Reserve System, before the Bankers’ As­
sociation for Foreign Trade, Boca Raton, Florida, April
27, 1971.
Digitized for Page
FRASER
8


The U.S. balance of payments (on a liquidity basis)
has been in deficit in all but two years since 1950 —
the year the Korean War began and one year after
most major currencies underwent major devaluations
with respect to the dollar. Until the last three years
of the Eisenhower administration, these deficits were
generally small and aroused no great concern among
13Speech by Vice President Spiro Agnew, before the Business
Council, Hot Springs, Virginia, May 8, 1971, as reported
in the W all Street Journal (May 10, 1971).
14Testimony by Arthur Bums before the Senate Banking
Committee, May 19, 1971, as reported in the New York
Journal o f C om m erce (May 20, 1971).
15Testimony by John Connally, Secretary of the Treasury,
before the Senate Finance Subcommittee, May 17, 1971,
as reported in the New York Journal o f Com m erce (May
20, 1971). Also see Annual Report of the Council of
Economic Advisers, Econom ic Report o f the President,
1971, p. 152.

FEDERAL RESERVE BANK OF ST. LOUIS

policymakers. By 1959, however, our balance of pay­
ments had become a problem that called for, and
received, corrective treatment in the form of a restric­
tive monetary policy. In the wake of the 1960-61
recession, the economy operated below capacity for
several years. Inflation, which had accelerated be­
tween 1955 and 1958, was brought under control.
Wholesale prices, for example, did not increase at all
between 1960 and 1964, compared with a 1.9 per cent
average increase for the other major industrial coun­
tries. Along with this improved price performance
came somewhat reduced balance-of-payments deficits,
largely because our exports expanded faster than
our imports. In 1964 the current account balance
reached a surplus of $5.8 billion, the highest it had
been since 1947.
The benefits of monetary restraint during the late
1950’s and early 1960’s were not fully reflected in the
balance of payments, owing to increasingly large out­
flows on long-term capital account. Long-term net U.S.
foreign investment exceeded $4 billion in both 1964
and 1965 and had risen steadily from $1.6 billion in
1959. Direct and portfolio investment in the Common
Market countries of Europe was largely responsible
for this increase. Congress enacted the interest equali­
zation tax in 1964 to discourage borrowing by foreign
corporations in U.S. money markets. Restrictions
on foreign lending were imposed on banks and
other financial institutions in 1965. Voluntary con­
trols on direct investment abroad by American
corporations were imposed in 1965 and made manda­
tory in 1968.
While the capital controls program served to reduce
the outflow of long-term funds in the latter half of
the 1960’s, the U.S. current account surplus began
to shrink after 1964. By 1968 it had become a deficit
of $0.4 billion. Again, relative trends of prices at
home and abroad had a telling impact. Expansive
monetary policies created substantial inflation in the
United States beginning in 1965. U.S. wholesale prices
advanced at 2 per cent annually between 1964 and
1968, compared with 1.4 per cent for other industrial
countries. The increase in direct U.S. overseas military
expenditures from $2.9 billion in 1964 to $4.5 billion
in 1968 was another factor contributing to the smaller
balance on current account. Between 1968 and 1970,
however, wholesale prices in other major countries
increased more rapidly than corresponding U.S. prices
(4.2 versus 3.2 per cent, respectively); the U.S. bal­
ance of payments on current account showed only
slight further weakening in 1969 and improved in
1970.



JU L Y 1971

Capital flows became the dominant factor causing
changes in our balance-of-payments position during
1969 and 1970. Increased net outflows on long-term
capital account contributed $1 billion of the $1.5 bil­
lion increase in the “basic” balance-of-payments deficit
in 1969. Our “net liquidity” deficit rose in 1969 to $6.1
billion from $1.6 billion the previous year. Most of
this change could be accounted for by: (a) imper­
fections in the balance-of-payments statistics related
to transfers of deposits to Eurobanks;16 (b) reduc­
tion in purchases of U.S. stocks and bonds by private
foreigners; and (c) lessened growth in non-liquid
short-term foreign borrowing by U.S. businesses. The
“official settlements” balance, which reflects changes
in foreign official net dollar claims, showed a surplus
of $2.7 billion in 1969, mainly because private for­
eigners, seeking high interest returns available on
Eurodollars, converted their domestic currencies into
dollars at foreign central banks, thus causing a de­
crease in official foreign holdings of dollars.
With the decline in U.S. interest rates in 1970,
unrecorded transfers of deposits to the Eurodollar
market by U.S. individuals dropped sharply. This,
plus the initial SDR allocation to the U.S., combined
to cut the net liquidity deficit to $3.9 billion. Improve­
ment in the current account balance was offset by an
increase in our deficit on long-term capital account,
so that the “basic” balance-of-payments deficit was
slightly larger in 1970. The fall in U.S. interest rates
brought about a decline in Eurodollar interest rates,
which led to a huge conversion of dollars into local
currencies by private foreigners. As liquid dollar
holdings of foreigners were shifted from private to
official hands, the official settlements deficit reached
$9.8 billion, compared with a surplus in the previous
year.

Short-Run Prospects
Expansion of the domestic economy at a pace
faster than foreign economic expansion tends to carry
with it an increase in demand for imports relative to
exports, and a deterioration of the balance of pay­
ments on current account. Consequently, a weaken­
ing of our balance of payments might seem to be in
prospect, as the U.S. economy recovers from the
1969-70 recession. U.S. imports may be stimulated by
rising domestic incomes. Our excess of exports over
imports, after reaching a seasonally adjusted annual
16A substantial volume of deposits transferred by Americans
from U.S. banks to foreign branches were not recorded
as increasing our liquid assets, but the simultaneous borrow­
ing of these funds by U.S. banks from their foreign branches
was recorded as increasing our liquid liabilities.
Page 9

J U L Y 1971

FED ER AL RESERVE BANK OF ST. LOUIS

rate of $2.7 billion in the first three quarters of 1970,
shifted to one-quarter of this rate in the six months
ended March 1971.
Although this smaller trade surplus is traceable
mainly to rapid expansion of imports relative to ex­
ports, there are disturbing signs that demand for our
exports may deteriorate because a number of im­
portant trading nations are now encountering eco­
nomic slowdown. Industrial production indexes for
France, Italy, and Germany have levelled off since
the second quarter of 1970, while Japan’s industrial
growth began to decelerate in the fourth quarter.
Unemployment has increased in all of these countries
since 1969. British industrial production has been
moving erratically upward, but unemployment re­
mains relatively high. In the year ended fourth quar­
ter 1970, wholesale prices in the United States rose
2.8 per cent, compared with 4.5 per cent in other
major industrial countries. However, with a business
expansion underway in the United States and eco­
nomic slowdown occurring in other major trading
countries, the forces that recently have moved the
relative price trend in our favor may not continue.
Upward adjustment of the value of the mark (float­
ing), guilder (floating), Austrian schilling (revalued
5.05 per cent), and Swiss franc (revalued 7.07 per
cent) will help, but very little. The effect of adjust­
ments made so far would be to reduce the relative
prices of American goods and services in world mar­
kets by well under one per cent on average.
This emphasis on imports and exports fails to take
into consideration cyclical forces whose influences on
the capital account are opposite to their influences on
the current account.17 International flows of short­
term capital have become highly sensitive to interest
rate differentials among countries, and have tended
to exercise a powerful influence on short-run fluctua­
tions in the U.S. balance of payments. As the ac­
companying chart shows, capital account changes
have frequently more than offset current account
changes. The dominance of capital flows has been
especially evident since 1968.
In the first quarter of 1970, our balance-of-payments
deficit, on an official settlements basis, reached a
seasonally adjusted annual rate of $22.1 billion; on a
net liquidity basis the deficit was more than $10.4
billion. These deficits were among the largest ever
recorded, and refleoted speculative outflows and a
17The balance of payments on current account includes all
transactions involving exports and imports of goods and
services and transfer payments. The capital account, as
used here, consists of all private transactions in assets and
liabilities, whether classified in the balance-of-payments as
long-term, short-term, nonliquid or liquid.
Digitized forPage
FRASER
10


very sharp decline in U.S. and Eurodollar interest
rates. Speculative movements of funds may have al­
ready diminished, and if the domestic economy ex­
pands faster than foreign economies, there will be a
rise in domestic interest rates relative to those over­
seas. Short-term rates in the United States have al­
ready risen substantially from their February lows.
The cyclical upswing in interest rates can be held in
check only temporarily by an exceedingly expansive
monetary policy, and such a policy will ultimately
result in even higher interest rates.
U.S. B alan ce of Paym ents and Com ponents
(+) S u rp lu s, (-] D e fic it

lyData

S e a s o n a lly A d ju s e d A n n u a l R ates
Q u a r te

Billions Of D ollars

Billions o f D ollars

40

40
E«Ports(G nods)
%

30

20

■

t RADE

10

ALANC

n

30

20
Imi orts(GoodO

—

N e ll alance on Curren Acco jn t 11

10

4

A
0

A

\V/

-10

0

> K.
\
1 A
/ v
' " 'w
\i
1
Net Balance on Capital Accou nt &
1

A,

\

V

/

iA
V \

-10
t

-20

I

-20

-30

-30

10

10
1.

Offi :ial Settleme nts Balance - A
A

0

\

A

J
Gross Liqui lity Bi lance

-10

Ac

0

n

Net Liquic ity Ba ance

\ /
i

i/0

-10

V

i

-20

-20

-30
1960 1961 1962 1963 1964 1965 1966 1967 1968 1969 1970 1971
Source-. U.S. D e p a r tm e n t o f C o m m e rc e
( J J h e c u r r e n t a c c o u n t in c lu d e s g o o d s a n d serv ic e s , G o v e r n m e n t g r a n ts a n d tr a n s fe rs , a n d
p r iv a te tra n s fe rs .
[2 T he c a p ita l a c c o u n t in c lu d e s a ll p r iv a te lo n g - a n d sh o rt-te rm c a p ita l flo w s , G o v e rn m e n t
lo a n s , a llo c a tio n s o f SDR s, e r r o r s a n d o m is s io n s , a n d c h a n g e s in n e t U .S. liq u id
lia b ilitie s to fo re ig n p r iv a te h o ld e rs .
[3 The o ffic ia l se ttle m e n ts d e fic it is th e d e c re a s e in U.S. o f fic ia l re s e rv e a sse ts p lu s th e
in c re a s e in U.S. liq u id a n d c e rta in n o n liq u id lia b ilitie s to o f fic ia l fo re ig n e rs ; a ls o e q u a ls
sum o f n e t b a la n c e s o n c u r r e n t a n d c a p ita l a c c o u n t.
[4 F ro m 1/1 9 6 6 to 1 /1 9 7 0 the n e t liq u id it y d e fic it is th e o f fic ia l s e ttle m e n ts d e fic it, p lu s th e n e t
d e c re a s e in r e c o rd e d U S . p r iv a te sh o rt-te rm liq u id asse ts, p lu s th e in c re a s e in U.S. liq u id
lia b ilitie s to p r iv a te fo re ig n e rs .
[5 F ro m 1/1962 to 1/1 9 6 6 th e g ro s s liq u id ity d e fic it is th e o ffic ia l s ettle m e nts d e fic it, p lu s th e
in c re a s e in U.S. liq u id lia b ilitie s to p r iv a te fo re ig n e rs , le ss th e in c re a s e in n o n liq u id U.S.
lia b ilitie s to o ffic ia l fo re ig n e rs .

JU L Y 1971

FEDERAL. RESERVE BANK OF ST. LOUIS

Forces are therefore operating once again to make
short-term investment in the United States relatively
attractive to foreigners, and short-term foreign invest­
ment less attractive to Americans. Long-term foreign
investment in the United States, although modest in
comparison with overseas long-term asset acquisitions
by U.S. investors, has also begun to recover from the
low levels of the first half of 1970. If recent perform­
ance is any guide, the favorable swing in the capital
account could outweigh the deterioration of the cur­
rent account, so that the U.S. balance-of-payments
position, on both the official settiements and liquidity
balance basis, might soon improve.

Proposed Alterations to Present
International Monetary Arrangements
The large flow of dollars into foreign central banks,
and the decision to allow the mark to float, touched
off a new round of diagnoses of the problems in
managing the present international monetary system.
These ranged from warnings of the impending col­
lapse of the entire system, to enthusiastic approval of
recent developments as demonstrations of progress
toward greater exchange rate flexibility.
The system being reappraised is the product of
central bank adherence to International Monetary
Fund (IM F) rules. The effect of these rules has been
(a) to reinforce the United States’ commitment to
redeem on demand in gold at $35 per ounce all
official foreign dollar claims, and (b) to induce other
individual governments, to maintain, for long periods,
fixed parity prices of dollars in terms of their own
currencies. In recent years, foreign central banks, with
few exceptions, have avoided exercising their gold
conversion option.18 A foreign central bank, if it
wishes to continue supporting the price of the dollar
in terms of its own currency at the existing exchange
parity, must be willing to absorb as reserves what­
ever dollars are offered to it. As the “dollar standard”
has evolved, with discretion for monetary growth
lodged in U.S. hands, foreign governments would face
inflationary pressures should U.S. monetary and fiscal
actions persistently take an excessively expansive
course. On the other hand, in the short-run, dollar
flows may be erratic and create difficult problems of
economic stabilization for foreign governments.
18Germany has not purchased gold from the U.S. since 1964.
France recently obtained $282 million, but has been a net
seller to the U.S. since 1966. The U.K. has international
financial obligations which make it an unlikely potential
purchaser of gold. Canada, despite strong balance-of-pay­
ments surpluses, has been selling gold as a producer nation.
Japan last bought U.S. gold in 1966. Among major in­
dustrial nations, only the Low Countries and Switzerland
frequently exercise their gold conversion option.



Raise the Dollar Price of Gold?
Foreign reactions to this dilemma have therefore
been directed toward finding viable alternatives to
present international monetary arrangements. One
option advocated at times —devaluation of the dollar
in terms of gold —has been losing support. Five years
ago, when dollar claims held by foreigners were per­
haps no more than twice as large as the U.S. gold
stock, it was possible to give serious consideration to a
doubling of the dollar price of gold (which would
double the dollar value of our gold stock) as a means
of restoring U.S. ability to meet all dollar claims at a
fixed gold price. Now that total foreign official and
private liquid dollar claims are more than three times
as large as our gold stock, as shown in Table II, the
required threefold increase in the price of gold is
beyond reasonable probability of adoption.19 The tre­
mendous gains from such a change in the official gold
Table II

U.S. OFFICIAL RESERVES AND LIQUID LIABILITIES
(B illio n s of D ollars)

Gold Stock
SDR's

1960

1965

1967

1969

1970

$ 1 7 .8

$14.1

$12.1

$ 1 1 .9

$11.1

—

—

—

—

.9

IM F Gold Tranche
Position

1.6

.6

.4

2.3

1.9

Foreign Exchange

0

.8

2.4

2.8

.6

Total O fficia l
U.S. Reserves

1 9.4

15.5

14.9

1 7.0

14.5

U .S. Dollar Liab ilitie s1
to O fficia l Foreigners

11.1

15.8

18.3

16.0

2 3 .9

U .S. Liquid Liabilities
to Private Foreigners

7 .6

1 1 .5

15.8

2 8.2

2 1 .8

1 8 .7

2 7 .3

34.1

4 4 .2

4 5 .7

Total U .S. Liquid Liabilities
to Foreigners

inclu d es nonmarketable securities
Source: International Financial Statistics, IM F (Monthly)

price would be very unequally distributed among na­
tions. A devaluation would penalize those countries
which have cooperated with the United States by
refraining from exercising their gold conversion op19Since the abandonment of the London Gold Pool in 1968
and its replacement by the “two-tier” gold market, only
foreign central banks have even pro form a rights to pur­
chase gold at the official price of $35 per ounce. All other
demands must be met in the free London gold market.
The “two-tier” system effectively eliminated private specu­
lative runs on gold as a source of direct pressure on official
gold reserves. However, in measuring U.S. dollar liabilities
to foreigners, it should be recognized that insofar as foreign
central banks maintain convertibility of foreign currencies
into dollars at par, dollar liabilities to private foreigners
can readily become liabilities to official agencies. The recent
large scale conversion of Eurodollars into foreign currency
is an illustration of this.
Page 11

FED ER AL RESERVE BANK OF ST. LOUIS

tion. Gold producers would benefit a great deal from
this devaluation; in 1968 South Africa supplied 76.8
per cent of the world’s gold output.

More “Paper Gold”?
Another alternative is to place greater reliance on
paper gold, that is, Special Drawing Rights. A major
criticism of the present system is that dependence on
dollar deficits as a source of additions to international
liquidity is an unreliable and erratic device for con­
trolling growth in the world’s monetary reserves. It
has even been suggested that there is paradox in a
system in which growth in the supply of dollars is
greatest when U.S. balance-of-payments deficits are
the largest. Confidence in the “soundness” of the dol­
lar may then be weakest. As confidence lessens, the
demand for dollars would be reduced. Shifts in the
supply and foreign private demand for dollars as
international currency may be inversely related. This
might tend to magnify domestic instability of countries
that adhere to fixed exchange rates, since their central
banks would be forced to acquire dollars that private
foreigners do not want. The problems of maintaining
control over the domestic money supply in the face of
large dollar flows have been discussed previously.
Under the present de facto dollar standard, a vari­
ety of emergency credit facilities have been provided
for countries under temporary balance-of-payments
pressure. These arrangements include the following:
(a) currency “swap” agreements, arranged by the
Federal Reserve, which permit the central banks of 14
major countries limited lines of credit to borrow each
other’s currencies for periods up to one year; (b)
IMF quotas which permit members to draw, for pe­
riods up to five years, fund currencies in amounts
equal to their 25 per cent IMF gold contribution
( “tranche”) on demand, and their 75 per cent do­
mestic currency contribution with IMF permission;
and (c) emergency lending commitments of the
“Group of Ten” large trading nations to come to the
aid of countries in liquidity crisis when other credit
facilities are inadequate.
The international monetary system has been
criticized by those who believe that neither the exist­
ing conditions under which dollars are supplied nor
these emergency credit arrangements satisfactorily
provide for stable growth in international liquidity.
For this reason, the expansion of Special Drawing
Rights (SDRs)20 and quotas in the IMF has been
20SDRs are allocated by the IMF to its members. Title to
SDRs can be transferred from one member to another in
exchange for convertible currency, which can then be used
in settlement of balance-of-payments deficits. Each member
country initially receives SDR “allocations” in proportion
to its subscribed quota in the IMF, and agrees to accept
Digitized forPage
FRASER
12


JU L Y 1971

advocated. So far, IMF members have agreed to the
allocation of $9.4 billion of SDRs; $3.4 billion were
issued on January 1, 1970 and $3 billion each on
January 1, 1971 and 1972. Negotiations on additional
allocations will begin next year.
Two features of SDRs deserve emphasis. First,
they are intended to substitute for gold as an ultimate
means of settling balance-of-payments deficits. Since
SDRs can be created by a weighted 85 per cent
majority of the voting members of the IMF, shortages
of international liquidity, such as might arise if gold
production were the only source of new international
reserves, can in principle be eliminated by inter­
national agreement to allocate additional SDR s —a
simple bookkeeping operation.
Secondly, SDRs can substitute for dollars as an
international reserve currency. Instead of being a
fortuitous by-product of U.S. balance-of-payments
deficits, as some critics describe the present situation,
the creation of additional reserve currency can be
made a matter of international planning and agree­
ment on the long-run rate of growth of world liquid­
ity. Potentially, the growth in international currency
reserves could be rendered more stable.21

Greater Flexibility of Exchange Rates?
Broader recognition of the extent to which present
arrangements based on pegged exchange rates reduce
the monetary autonomy of individual countries has
recendy sparked an unprecedented amount of dis­
cussion and experimentation concerning increased
flexibility of exchange rates. West Germany’s decision
to allow the mark to float is the second in less than
two years. An important prelude to the more recent
of these actions was a unanimous report by five pri­
vate German economic research institutes advocating

additional SDRs (upon request of the IMF, and in ex­
change for its own currency) up to twice its own cumulated
SDR allocation. Each member country pays interest on its
cumulated allocation, and receives interest on all SDRs
held. A country whose cumulated allocation exceeds its
holdings of SDRs will be a net payer of interest; one
whose noldings exceeds its allocation will be a net recipient
of interest. See Michael Keran, “A Dialogue on Special
Drawing Rights,” this Review (July 1968), pp. 5-7.
21Also, each country can share in the seigniorage benefits
of liquidity creation in proportion to ;ts quota in the IMF.
These benefits now accrue to the United States insofar as
it is the supplier of reserve currency to the world. Seigniorage
is received if the interest paid to holders of international
reserve assets is less than the monetary yield such holders
could earn on other assets. The interest paid on SDRs is
1.5 per cent per year, which is considerably less than the
average interest paid on dollar claims.

FED ER AL RESERVE BANK OF ST. LOUIS

JU L Y 1971

Flexible Exchange Rates
The case for flexible exchange rates is very similar
to the case for free unregulated competitive markets
in other contexts:1 markets would be cleared without
rationing, subsidies, or stockpiling. An automatic
mechanism is provided for achieving balance-of-pay­
ments equilibrium through adjustment of relative price
and cost levels of imports and exports rather than
through quantitative controls or adjustments of
domestic price and cost levels. Most importantly,
flexible exchange rates eliminate the balance of pay­
ments as a serious constraint on the use of monetary
and fiscal policy to pursue domestic economic stabil­
ization objectives. Restrictions on free movement of
goods, services and capital across frontiers would no
longer be justifiable because of the balance of
payments.
iFor an extended discussion, see Harry Johnson, “The Case
for Flexible Exchange Rates, this Review (June 1969),
pp. 12-24.

that the mark be allowed to float to determine a new
exchange rate —a report which was termed “construc­
tive” by West German Economics Minister Schiller.
The guilder was also allowed to float at the same time
as the mark. In June 1970, Canada returned to a
floating rate, after a lapse of eight years. This year the
U.S. Council of Economic Advisers voiced approval
of “greater flexibility of exchange rates within the
framework of the present system established at Bretton Woods.”22 Treasury Secretary Connally, in a re­
cent speech in Munich, suggested that consideration
be given to incorporating additional elements of
flexibility of exchange rates into the present system.23
Against this background, the international financial
community awaits with interest the IMF’s first major
study of floating rates.24
The principal objection to a system of flexible ex­
change rates remains a practical one —it has never
been tried on a sufficiently widespread scale, under
sufficiently normal worldwide economic conditions,
to justify the claims made for it (or against it). If
progress toward freeing exchange rates is to be made,
22Annual Report of the Council of Economic Advisers,
Econom ic Report o f the President, 1971, p. 145.
23Speech by John Connally before the International Banking
Conference, Munich, May 28, 1971, as reported in The
American Banker (June 1, 1971), p. 16.
^International Monetary Fund, Annual Report, 1970, p. 14.



Critics of exchange rate flexibility often have rec­
ognized its theoretical virtues as an automatic adjust­
ment mechanism, but have raised practical objections
related to (a) the possible destablizing effects of
speculators on exchange rates, and (b) the discour­
agement to international trade and investment from
increased uncertainty with respect to future exchange
rates. The first objection rests on the mistaken assump­
tion that speculators can, in the aggregate, derive
profits by driving exchange rates away from their
equilibrium levels. The second objection fails to allow
for development of forward markets in foreign ex­
change that could provide hedging facilities to elim­
inate uncertainty with respect to trade and short-term
capital transactions. As for long-term capital trans­
actions, the present system’s mixture of exchange
controls, special taxes, and periodic exchange rate
adjustments provides no greater certainty and re­
liability than would a flexible exchange rate system —
perhaps less.

it may therefore evolve within the present system
which, despite its weaknesses, provides a known,
agreed-upon organizational and procedural frame­
work.
Two major steps that could be implemented, if
present IMF rules were modified, would be (a) to
widen to as much as 5 per cent, from the present
1 per cent band, the permissible margins around
parity within which each country’s exchange rates
could vary; and (b) to permit smaller and more
frequent changes in parity levels. Since, even now, the
IMF concurs in parity adjustments whenever these
are necessary to correct a “fundamental disequilib­
rium,” the IMF itself could establish criteria that
would encourage such adjustments. For example, al­
though rejected in the past, the IMF might still
adopt the “crawling peg” proposal, under which the
parity level would be a continuously adjustable mov­
ing average of recent past market exchange rates,
appreciating if the currency had previously tended
to sell at its “ceiling” level, and depreciating if it
had tended to sell at its “floor” level.
Measures are being taken or proposed which could
undermine adherance to and support for IMF “adjust­
able peg” policies. Aside from the actions of Canada,
Germany, and the Netherlands, Belgium has modified
its “two-tier” system, so as to maintain a fixed ex­
Page 13

FED ER AL RESERVE BANK OF ST. LOUIS

change rate on current account transactions, while
permitting the exchange rate on a wider range of
capital transactions to float. Other countries are re­
ported to be considering similar measures. Another
possibility would be the coalescing of national cur­
rencies into two or more “key currency” blocs, whose
respective national currencies would exchange at
fixed rates within the bloc, and at fluctuating rates with
respect to currencies in other blocs. The reported
German proposal for a “concerted float” of all EEC
currencies against the dollar is a step in this direction.
A floating rate against the dollar might be required if
a common EEC currency unit and monetary policy,
now planned for 1980, is to be achieved. Alteration of
the IMF’s operating rules may therefore become nec­
essary if it is to play an influential role in guiding the
future course of international monetary organization.

Stable Monetary Growth and the
Dollar’s Role as a Key Currency
In recent years, the dollar reserves of foreign cen­
tral banks have been subjected to sharp variations,
due to changes in the willingness of private foreigners
to hold dollars. Fluctuations in U.S. interest rates
were largely responsible for these variations in de­
mand for dollars. These interest rate movements
were, in turn, ultimately attributable to wide swings
in the growth rate of the U.S. money supply. As a
result, foreign central banks have found it difficult to
control the growth in their own domestic money
stocks in the face of fluctuations in their dollar re­
serves. Unsteady inflows of dollars under fixed ex­
change rates are viewed by some foreign govern­
ments as a serious impediment to successful pursuit
of their domestic economic stabilization policies.
The 1971 Annual Report of the Council of Eco­
nomic Advisers asserts that . . . “inconsistency of bal­
ance-of-payments goals [among countries] cannot,
in short, be solved through unilateral policy action
by the United States.” Instead, says the Report, . . it
requires multilateral action by the members of the
International Monetary Fund.”25 Interpreting this
passage broadly, it seems to deny that there is any
policy the United States could alone undertake which
would provide a fully adequate foundation for a
stable, non-inflationary international monetary system.
The present international position of the dollar as
a reserve currency and liquid asset makes it an
alternative to any reserve currency (such as SDRs)
2SEconom ic Report o f the President, 1971, p. 151.

Page 14


J U L Y 1971

that might be created by international agreement.
In order for the dollar to achieve an acceptable
position as an international reserve currency, how­
ever, two conditions must be fulfilled. First, the pur­
chasing power of the dollar in terms of goods and
services must not be subject to rapid and unpredict­
able erosion that might impair its attractiveness as
a liquid asset. Second, the stock of dollars used as
international currency should grow at a stable rate, so
that the dollar reserves of foreign monetary authori­
ties may expand at a reasonably steady rate.
These requirements might appear to pose an exces­
sively burdensome constraint on the exercise of dis­
cretionary power by U.S. monetary authorities. Yet,
there is mounting evidence that efforts at discretion­
ary monetary management have increased, rather
than reduced, instability of domestic aggregate de­
mand. More often than not, this instability has been
associated with unsuccessful attempts by the Federal
Reserve to manipulate interest rates (or money mar­
ket conditions) instead of concentrating on the pro­
vision of moderate, steady growth in monetary ag­
gregates, such as the money supply. The paradox of
the more aggressive discretionary “contracyclical” U.S.
monetary management of the past five years is that it
has produced procyclical results, including wider fluc­
tuations in monetary growth, interest rates, and final
demand, as well as faster inflation. Insofar as unstable
U.S. monetary growth in the past five years has re­
sulted in increased fluctuations in our interest rates
and economic conditions, relative to those abroad,
the U.S. balance-of-payments position has also fluc­
tuated more widely —especially compared with the
results of the less variable monetary policies of the
previous five years.
There is no evidence of an inherent conflict be­
tween the goals of a stable noninflationary interna­
tional monetary system and a stable U.S. economy.
Steady, non-inflationary growth in the U.S. money
supply would appear to serve both objectives very
effectively. Under such a program of steady monetary
growth, the problem of removing inconsistencies be­
tween other countries’ balance-of-payments policies
and our own, could, with justification, be considered
the responsibility of other countries to correct. In­
creased stability of the U.S. economy would lessen
U.S. short-term cyclical interest rate fluctuations and
would tend to reduce short-term capital flows now
caused by these interest rate fluctuations. Increased
domestic U.S. price stability would help preserve
the attractiveness of the dollar as a liquid asset.

FED ER AL RESERVE BANK OF ST. LOUIS

Under more stable conditions in the United States,
some foreign countries might find it advantageous to
maintain fixed parity values of their currencies in
terms of dollars. The monetary policies of such na­
tions could then be geared to steady expansion of
their domestic money supplies at rates that would
maintain balance-of-payments equilibrium with the
United States. A pattern of price stability similar to
the United States is very likely to develop in such
countries.
On the other hand, countries that found such ac­
commodation to be difficult or undesirable could
maintain balance-of-payments equilibrium and pur­
sue independent monetary policies by permitting the
exchange value of their currencies, relative to the
dollar, to adjust freely in the foreign exchange mar­
ket. Yet, even for such countries, the very stability
of U.S. monetary growth would foster an interna­
tional monetary environment less subject to external
shocks and uncertainty. There would therefore be
little reason to expect the policies of the United
States to be conducive to widely fluctuating ex­
change rates. There would be still less reason for such




JU L Y 1971

countries to resort to direct controls on capital or
current account transactions to protect their domestic
economy from the effects of U.S. policy on the world
economy.
In the view of many of its proponents, the funda­
mental appeal of the gold standard was the protec­
tion it afforded against rapid inflation, and the auto­
matic mechanism it provided for expansion of the
world money supply through new gold production.
Before World War I, the great financial prestige of
the United Kingdom supported the gold standard.
No multilateral negotiations were necessary —each
country adopted the gold standard or abstained, as
it saw fit. The maintenance of a steady, moderate
rate of monetary growth by the United States can
offer the advantages of a gold standard more reliably
and at less cost in real resources. Moreover, such a
“dollar standard” could, through voluntary and piece­
meal adaptation by individual nations, become the
basis for a stable international monetary system, with­
out the negotiations, stalemates, compromises, and
makeshift agreements that inevitably accompany mul­
tilateral efforts to reform the present system.

Page 15

The Euro-Dollar Market: Some First Principles
by MILTON FRIEDMAN
Increasing concern over recurring U. S. balance-of-payments deficits has
prompted authorities, both here and abroad, to re-examine some aspects o f the
international monetary system. One of the most elusive and probably least under­
stood aspects of this system is the Eurodollar Market.
The following article by Professor Milton Friedman o f the University of
Chicago is presented in the R e v i e w to provide the general reader with a basic
understanding o f the Eurodollar market. This article was first published in the
October 1969 “Morgan Guaranty Survey”. W e wish to acknowledge and thank
Professor Friedman and the Morgan Guaranty Trust Company for permission to
reprint this article. In granting his permission to reprint this article, Professor
Friedman stressed that much of the apparent controversy in discussions since his
article was first published is due to the failure of subsequent writers to distin­
guish clearly between Eurodollar creation and the Eurodollar multiplier. This
distinction is explained in the section under the heading, “Some Complications”,
appearing on page 20 in this R e v i e w .

I HE Euro-dollar market is the latest example
of the mystifying quality of money creation to even
the most sophisticated bankers, let alone other busi­
nessmen. Recently, I heard a high official of an
international financial organization discuss the Euro­
dollar market before a collection of high-powered in­
ternational bankers. He estimated that Euro-dollar
deposits totaled some $30 billion. He was then asked:
“What is the source of these deposits?” His answer
was: partly, U.S. balance-of-payments deficits; partly,
dollar reserves of non-U.S. central banks; partly, the
proceeds from the sale of Euro-dollar bonds.
This answer is almost complete nonsense. Balanceof-payments deficits do provide foreigners with claims
on U.S. dollars. But there is nothing to assure that
such claims will be held in the form of Euro-dollars.
In any event, U.S. deficits, worldwide, have totaled
less than $9 billion for the past five years, on a
liquidity basis. Dollar holdings of non-U.S. central
banks have fallen during the period of rapid rise in
Euro-dollar deposits but by less than $5 billion. The
dollars paid for Euro-bonds had themselves to come
from somewhere and do not constitute an independ­
ent source. No matter how you try, you cannot get $30
billion from these sources. The answer given is pre­
cisely parallel to saying that the source of the $400
billion of deposits in U.S. banks (or for that matter
the much larger total of all outstanding short-term

Page 16


E d ito r's N o te : F o llo w in g fir s t p u b lic a tio n o f this a rticle , th e size o f th e E u ro d o lla r m a rk e t has
increased. A s the c h a rt b e io w show s, lia b ilitie s o f E u ro d o lla r ba nks in e ig h t E u ropean
cou n trie s w ere $ 5 8 .7 b illio n in D ece m b er 1970

Assets and Liabilities
of Eurodollar Banks*

S o u rc e : B a n k fo r In t e r n a t i o n a l S e ttle m e n ts , A n n u a l R e p o r t 1971
•T h e r e p o r tin g E u r o d o lla r b a n k s a r e lo c a te d in th e f o llo w i n g c o u n trie s :
B e lg iu m - L u x e m b u r g , F r a n c e , G e r m a n y , It a ly , N e t h e r la n d s , S w e d e n , S w it z e r la n d ,
a n d th e U n ite d K in g d o m .
N o te : S e m i- a n n u a l d a t a IV /1 9 6 6 - IV /1 9 6 8 .
Q u a r t e r ly d a t a 1 /1 9 6 9 - IV /1 9 7 0 .

FEDERAL RESERVE BANK OF ST. LOUIS

claims) is the $60 billion of Federal Reserve credit
outstanding.
The correct answer for both Euro-dollars and lia­
bilities of U.S. banks is that their major source is a
bookkeeper’s pen.1 The purpose of this article is to
explain this statement. The purpose is purely ex­
pository. I shall restrict myself essentially to principle
and shall not attempt either an empirical evaluation
of the Euro-dollar market or a normative judgment
of its desirability.
Another striking example of the confusion about
Euro-dollars is the discussion, in even the most sophis­
ticated financial papers, of the use of the Euro-dollar
market by U.S. commercial banks “to evade tight
money,” as it is generally phrased. U.S. banks, one
reads in a leading financial paper, “have been willing
to pay extremely high interest rates . . . to borrow
back huge sums of U.S. dollars that have piled up
abroad.” The image conveyed is that of piles of dollar
bills being bundled up and shipped across the ocean
on planes and ships —the way New York literally did
drain gold from Europe in the bad —or good —old
days at times of financial panic. Yet, the more dollars
U.S. banks “borrow back” the more Euro-dollar de­
posits go up! How come? The answer is that it is
purely figurative language to speak of “piled up”
dollars being “borrowed back.” Again, the bookkeep­
er’s pen is at work.

What are Euro-dollars?
Just what are Euro-dollars? They are deposit liabil­
ities, denominated in dollars, of banks outside the
United States. Engaged in Euro-dollar business, for
example, are foreign commercial banks such as the
Bank of London and South America, Ltd., merchant
banks such as Morgan Grenfell and Co., Ltd., and
many of the foreign branches of U.S. commercial
banks. Funds placed with these institutions may be
owned by anyone —U.S. or foreign residents or citi­
zens, individuals or corporations or governments. Euro­
dollars have two basic characteristics: first, they are
short-term obligations to pay dollars; second, they are
obligations of banking offices located outside the U.S.
■The similarity between credit creation in the U.S. fractional
reserve banking system and in the Euro-dollar market has of
course often been noted. For example, see Fred H. Klopstock, “The Euro-Dollar Market, Some Unresolved Issues,”
Essays in International Finance, No. 65 (Princeton, March,
1968), p. 6. A recent excellent analysis is given in an article
by Joseph G. Kvasnicka, “Euro-Dollars —an Important Source
of Funds for American Banks,” Business Conditions, Fed­
eral Reserve Bank of Chicago, June, 1969. A useful but
analytically less satisfactory examination of the Euro-dollar
market is Jane Sneddon Little, “The Euro-Dollar Market:
Its Nature and Impact,” New England Econom ic Review,
Federal Reserve Bank of Boston, May/June, 1969.



JU L Y 1971

In principle, there is no hard and fast line between
Euro-dollars and other dollar denominated claims on
non-U.S. institutions —just as there is none between
claims in the U.S. that we call “money” and other
short-term claims. The precise line drawn in practice
depends on the exact interpretation given to “short­
term” and to “banks.” Nothing essential in this article
is affected by the precise point at which the line is
drawn.
A homely parallel to Euro-dollars is to be found in
the dollar deposit liabilities of bank offices located in
the city of Chicago —which could similarly be called
“Chicago dollars.” Like Euro-dollars, “Chicago dollars”
consist of obligations to pay dollars by a collection of
banking offices located in a particular geographic
area. Again, like Euro-dollars, they may be owned by
anyone —residents or nonresidents of the geographic
area in question.
The location of the banks is important primarily
because it affects the regulations under which the
banks operate and hence the way that they can do
business. Those Chicago banks that are members of
the Federal Reserve System must comply with the
System’s requirements about reserves, maximum in­
terest rates payable on deposits, and so on; and in
addition, of course, with the requirements of the
Comptroller of the Currency if they are national
banks, and of the Illinois State Banking Commission
if they are state banks.
Euro-dollar banks are subject to the regulations
of the relevant banking authorities in the country in
which they operate. In practice, however, such banks
have been subject neither to required reserves on
Euro-dollar deposits nor to maximum ceilings on the
rates of interest they are permitted to pay on such
deposits.

Regulation and Euro-dollars
The difference in regulation has played a key role
in the development of the Euro-dollar market. No
doubt there were minor precursors, but the initial
substantial Euro-dollar deposits in the post-World
War II period originated with the Russians, who
wanted dollar balances but recalled that their dollar
holdings in the U.S. had been impounded by the
Alien Property Custodian in Wrold War II. Hence
they wanted dollar claims not subject to U.S govern­
mental control.
The most important regulation that has stimulated
the development of the Euro-dollar market has been
Regulation Q, under which the Federal Reserve has
Page 17

F E D ER AL RESERVE BANK OF ST. LOUIS

fixed maximum interest rates that member banks
could pay on time deposits. Whenever these ceilings
became effective, Euro-dollar deposits, paying a
higher interest rate, became more attractive than U.S.
deposits, and the Euro-dollar market expanded. U.S.
banks then borrowed from the Euro-dollar market
to replace the withdrawn time deposits.
A third major force has been the direct and indirect
exchange controls imposed by the U.S. for “balanceof-payments” purposes —the interest-equalization tax,
the “voluntary” controls on bank lending abroad and
on foreign investment, and, finally, the compulsory
controls instituted by President Johnson in January
1968. Without Regulation Q and the exchange con­
trols —all of which, in my opinion, are both unneces­
sary and undesirable —the Euro-dollar market, though
it might still have existed, would not have reached
anything like its present dimensions.

Fractional reserves
Euro-dollar deposits like “Chicago deposits” are in
principle obligations to pay literal dollars —i.e., cur­
rency (or coin), all of which consists, at present, of
government-issued fiat (Federal Reserve notes, U.S.
notes, a few other similar issues, and fractional
coinage). In practice, even Chicago banks are called
on to discharge only an insignificant part of their
deposit obligations by paying out currency. Euro­
dollar banks are called on to discharge a negligible
part in this form. Deposit obligations are typically
discharged by providing a credit or deposit at an­
other bank —as when you draw a check on your bank
which the recipient “deposits” in his.
To meet their obligations to pay cash, banks keep
a “reserve” of cash on hand. But, of course, since
they are continuously receiving as well as paying
cash and since in any interval they will be called on
to redeem only a small fraction of their obligations
in cash, they need on the average keep only a very
small part of their assets in cash for this purpose. For
Chicago banks, this cash serves also to meet legal
reserve requirements. For Euro-dollar banks, the
amount of literal cash they hold is negligible.
To meet their obligations to provide a credit at
another bank, when a check or similar instrument is
used, banks keep deposits at other banks. For Chicago
banks, these deposits (which in addition to facilitating
the transfer of funds between banks serve to meet
legal reserve requirements) are held primarily at
Federal Reserve banks. In addition, however, Chi­
cago banks may also keep balances at correspondent
banks in other cities.
18
Digitized forPage
FRASER


JU L Y 1971

Like cash, deposits at other banks need be only a
small fraction of assets. Banks are continuously re­
ceiving funds from other banks, as well as trans­
ferring funds to them, so they need reserves only to
provide for temporary discrepancies between pay­
ments and receipts or sudden unanticipated demands.
For Chicago banks, such “prudential” reserves are
clearly far smaller than the reserves that they are
legally required to keep.
Euro-dollar banks are not subject to legal reserve
requirements, but, like Chicago banks, they must
keep a prudential reserve in order to be prepared
to meet withdrawals of deposits when they are de­
manded or when they mature. An individual bank
will regard as a prudential reserve readily realizable
funds both in the Euro-dollar market itself (e.g.,
Euro-dollar call money) and in the U.S. But for the
Euro-dollar system as a whole, Euro-dollar funds
cancel, and the prudential reserves available to meet
demands for U.S. dollars consist entirely of deposits
at banks in New York or other cities in the U.S. and
U.S. money market assets that can be liquidated
promptly without loss.
The amount of prudential reserves that a Euro­
dollar bank will wish to hold —like the amount that
a Chicago bank will wish to hold —will depend on its
particular mix of demand and time obligations. Time
deposits generally require smaller reserves than de­
mand deposits —and in some instances almost zero
reserves if the bank can match closely the maturities
of its dollar-denominated liabilities and its dollardenominated loans and investments. Although a pre­
cise estimate is difficult to make because of the
incompleteness and ambiguity of the available data,
prudential reserves of Euro-dollar institutions are
clearly a small fraction of total dollar-denominated
obligations.
This point —that Euro-dollar institutions, like Chi­
cago banks, are part of a fractional reserve banking
system —is the key to understanding the Euro-dollar
market. The failure to recognize it is the chief source
of misunderstanding about the Euro-dollar market.
Most journalistic discussions of the Euro-dollar market
proceed as if a Euro-dollar bank held a dollar in the
form of cash or of deposits at a U.S. bank correspond­
ing to each dollar of deposit liability. That is the
source of such images as “piling up,” “borrowing
back,” “withdrawing,” etc. But of course this is not the
case. If it were, a Euro-dollar bank could hardly afford
to pay 10% or more on its deposit liabilities.

F ED ER AL RESERVE BANK OF ST. LOUIS

J U L Y 1971

A hypothetical example
A Euro-dollar bank typically has total dollar assets
roughly equal to its dollar liabilities.2 But these assets
are not in currency or bank deposits. In highly
simplified form, the balance sheet of such a bank —or
the part of the balance sheet corresponding to its
Euro-dollar operations —must look something like that
shown below (the numbers in this and later balance
sheets are solely for illustrative purposes).
It is the earnings on the $9,500,000 of loans and
investments that enable it to pay interest on the
$10,000,000 of deposits.
Where did the $10,000,000 of deposits come from?
One can say that $700,000 (cash assets minus due
to other banks) came from “primary deposits,” i.e.,
is the counterpart to a literal deposit of cash or trans­
fer of funds from other banks.3 The other $9,300,000
is “created” by the magic of fractional reserve bank­
ing —this is the bookkeeper’s pen at work.
Let us look at the process more closely. Suppose
an Arab Sheik upens up a new deposit account in
London at Bank H (H for hypothetical) by deposit­
ing a check for $1,000,000 drawn on the Sheik’s de­
mand deposit account at the head office of, say,
Morgan Guaranty Trust Company. Let us suppose
that Bank H also keeps its N.Y. account at Morgan
Guaranty and also as demand deposits. At the first
stage, this will add $1,000,000 to the deposit liabilities
of Bank H, and the same amount to its assets in the
form of deposits due from New York banks. At Mor­
gan Guaranty, the transfer of deposits from the Sheik
to Bank H will cause no change in total deposit
liabilities.
E uro-D ollar Bank H o f London
Assets
Cash assets*
Dollar-denom inated
loans
Dollar-denom inated
bonds
Total assets

Liabilities
$ 1 ,0 0 0 ,0 0 0
7 ,0 0 0 ,0 0 0

Deposits

$ 1 0 ,0 0 0 ,0 0 0

Due to other
banks

3 0 0 ,0 0 0

C apital

2 0 0 ,0 0 0

accounts

2 ,5 0 0 ,0 0 0

$ 1 0 ,5 0 0 ,0 0 0

Total liab ilitie s $ 1 0 ,5 0 0 ,0 0 0

♦Includes U .S. currency, deposits in N .Y . and other banks, and
other assets immediately realizable in U .S. funds.

2Which is why it is not subject to any special foreign ex­
change risk simply by operating m the Euro-dollar market.
The balance sheet of its Euro-dollar operations balances in
dollars; if it is, for example, a British bank, the balance sheet
of its pound sterling operations balances in pounds. It is
operating in two currencies but need not take a speculative
position in either. Of course, it may take a speculative posi­
tion, whether or not it operates in the Euro-dollar market.
3Note that even this is an overstatement, since most of the
deposits at N.Y. banks are themselves ultimately “created”
rather than “primary” deposits. These are primary deposits
only vis-a-vis the Euro-dollar market separately.



But Bank H now has excess funds available to lend.
It has been keeping cash assets equal to 10% of
deposits —not because it was required to do so but
because it deemed it prudent to do so. It now has
cash equal to 18% (2/11) of deposits. Because of
the $1,000,000 of new deposits from the Sheik, it will
want to add, say, $100,000 to its balance in New
York. This leaves Bank H with $900,000 available
to add to its loans and investments. Assume that it
makes a loan of $900,000 to, say, UK Ltd., a British
corporation engaged in trade with the U.S., giving
corporation UK Ltd. a check on Morgan Guaranty.
Bank H’s balance sheet will now look as follows
after the check has cleared:
Assets
Cash assets
Dollar-denom inated
loans
Dollar-denom inated
bonds
Total assets

Liabilities
$ 1 ,1 0 0 ,0 0 0
7 ,9 0 0 ,0 0 0

Deposits

$ 1 1 ,0 0 0 ,0 0 0

Due to other
banks

3 0 0 ,0 0 0

C apital accounts

2 0 0 ,0 0 0

2 ,5 0 0 ,0 0 0

$ 1 1 ,5 0 0 ,0 0 0

Total liab ilitie s $ 1 1 ,5 0 0 ,0 0 0

We now must ask what UK Ltd. does with the
$900,000 check. To cut short and simplify the process,
let us assume that UK Ltd. incurred the loan because
it had been repeatedly troubled by a shortage of
funds in New York and wanted to maintain a higher
average level of bank balances in New York. Further
assume that it also keeps its account at Morgan
Guaranty, so that it simply deposits the check in its
demand deposit account.
This particular cycle is therefore terminated and
we can examine its effect. First, the position of Mor­
gan Guaranty is fundamentally unchanged: it had
a deposit liability of $1,000,000 to the Sheik. It now
has a deposit liability of $100,000 to Bank H and one
of $900,000 to UK Ltd.
Second, the calculated money supply of the U.S.
and the demand deposit component thereof are un­
changed. That money supply excludes from “adjusted
demand deposits” the deposits of U.S. commercial
banks at other U.S. commercial banks but it includes
deposits of both foreign banks and other foreigners.
Therefore, the Sheik’s deposit was included before.
The deposits of Bank H and UK Ltd. are included
now.
Third, the example was set up so that the money
supply owned by residents of the U.S. is also un­
changed. As a practical matter, the financial statistics
gathered and published by the Federal Reserve do
not contain sufficient data to permit calculation of the
U.S.-owned money supply —a total which would ex­
clude from the money supply as now calculated cur­
Page 19

FEDERAL. RESERVE BANK OF ST. LOUIS

rency and deposits at U.S. banks owned by non­
residents and include dollar deposits at non-U.S.
banks owned by residents. But the hypothetical trans­
actions clearly leave this total unaffected.
Fourth, Euro-dollar deposits are $1,000,000 higher.
However, fifth, the total world supply of dollars
held by nonbanks —dollars in the U.S. plus dollars
outside the U.S. —is $900,000 not $1,000,000 higher.
The reason is that interbank deposits are now higher
by $100,000, thanks to the additional deposits of
Bank H at Morgan Guaranty. This amount of deposits
was formerly an asset of a nonbank (the Arab Sheik);
now it is an asset of Bank H. In this way, Bank H
has created $900,000 of Euro-dollar deposits. The
other $100,000 of Euro-dollar deposits has been trans­
ferred from the U.S. to the Euro-dollar area.
Sixth, the balance of payments of the U.S. is un­
affected, whether calculated on a liquidity basis or
on an official settlements basis. On a liquidity basis,
the Arab Sheik’s transfer is recorded as a reduction of
$1,000,000 in short-term liquid claims on the U.S. but
the increased deposits of Bank H and UK Ltd. at
Morgan Guaranty are a precisely offsetting increase.
On an official settlements basis, the series of trans­
actions has not affected the dollar holdings of any
central bank or official institution.4
4It is interesting to contrast these effects with those that
would have occurred if we substitute a Chicago bank for
Bank H of London, i.e., suppose that the Arab Sheik had
transferred his funds to a Chicago bank, say, Continental
Illinois, and Continental Illinois had made the loan to
UK Ltd., which UK Ltd. again added to its balances at
Morgan Guaranty. To simplify matters, assume that the re­
serve requirements for Continental Illinois and Morgan Guar­
anty are the same flat 10% that we assumed Bank H of
London kept in the form of cash assets (because, let us say,
all deposit changes consist of the appropriate mix of demand
and time deposits).
First, the position of Morgan Guaranty is now funda­
mentally changed. Continental Illinois keeps its reserves as
deposits at the Federal Reserve Bank of Chicago, not at
Morgan Guaranty. Hence it will deposit its net claim of
$100,000 on Morgan Guaranty , at the Chicago Fed to meet
the reserves required for the Sheik’s deposit. This will result
in a reduction of $100,000 in Morgan Guaranty’s reserve
balance at the New York Fed. Its deposits have gone down
only $100,000 (thanks to the $900,000 deposit by UK Ltd.)
so that if it had no excess reserves before it now has
deficient reserves. This will set in train a multiple contraction
of deposits at Morgan Guaranty and other banks which will
end when the $1,000,000 gain in deposits by Continental
Illinois is completely offset by a $1,000,000 decline in
deposits at Morgan Guaranty and other banks.
Second, the calculated money supply of the U.S. and the
demand deposit component thereof are still unchanged.
However, third, the money supply owned by the residents
of the U.S. is reduced by the $900,000 increase in the
deposits of UK Ltd.
Fourth, there is no change in Euro-dollar deposits.
Fifth, there is no change in the total world supply of
dollars.
Sixth, the balance of payments of the U.S. is affected if
it is calculated on a liquidity basis but not if it is calculated
on an official settlements basis. On a liquidity basis, the
Digitized forPage
FRASER
20


J U L Y 1971

Clearly, there is no meaningful sense in which we
can say that the $900,000 of created Euro-dollar de­
posits is derived from a U.S. balance-of-payments
deficit, or from dollars held by central banks, or from
the proceeds of Euro-dollar bond sales.

Some complications
Many complications of this example are possible.
They will change the numbers but not in any way the
essential principles. But it may help to consider one
or two.
(a)
Suppose UK Ltd. used the dollar loan to pur­
chase timber from Russia, and Russia wished to hold
the proceeds as a dollar deposit at, say, Bank R in
London. Then, another round is started —precisely
like the one that began when the Sheik transferred
funds from Morgan Guaranty to Bank H. Bank R now
has $900,000 extra deposit liabilities, matched by
$900,000 extra deposits in New York. If it also follows
the practice of maintaining cash assets equal to 10%
of deposits, it can make a dollar loan of $810,000. If
the recipient of the loan keeps it as a demand deposit
at Morgan Guaranty, or transfers it to someone who
does, the process comes to an end. The result is that
total Euro-dollar deposits are up by $1,900,000. Of
that total, $1,710,000 is held by nonbanks, with the
other $190,000 being additional deposits of banks ( the
$100,000 extra of Bank H at Morgan Guaranty plus
the $90,000 extra of Bank R at Morgan Guaranty).
If the recipient of the loan transfers it to someone
who wants to hold it as a Euro-dollar deposit at a
third bank, the process continues on its merry way.
If, in the extreme, at every stage, the whole of the
proceeds of the loan were to end up as Euro-dollar
deposits, it is obvious that the total increase in Euro­
dollar deposits would be: 1,000,000+900,000-1-810,000
-+- 729,000 + ..................= 10,000,000. At the end of
the process, Euro-dollar deposits would be $10,000,000
higher; deposits of Euro-dollar banks at N. Y. banks,
$1,000,000 higher; and the total world supply of dol­
lars held by nonbanks, $9,000,000 higher.
deficit would be increased by $900,000 because the loan by
Continental Illinois to UK Ltd. would be recorded as a
capital outflow but UK Ltd.’s deposit at Morgan Guaranty
would be regarded as an increase in U.S. liquid liabilities
to foreigners, which are treated as financing the deficit. This
enlargement of the deficit on a liquidity basis is highly mis­
leading. It suggests, of course, a worsening of the U.S. pay­
ments problem, whereas in fact all that is involved is a
worsening of the statistics. The additional dollars that UK
Ltd. has in its demand deposit account cannot meaningfully
be regarded as a potential claim on U.S. reserve assets.
UK Ltd. not only needs them for transactions purposes; it
must regard them as tied or matched to its own dollar
indebtedness. On an official setdements basis, the series of
transactions does not affect the dollar holdings of any central
bank or official institution.

FED ER AL RESERVE BANK OF ST. LOUIS

This example perhaps makes it clear why bankers
in the Eurodollar market keep insisting that they do
not “create” dollars but only transfer them, and why
they sincerely believe that all Euro-dollars come from
the U.S. To each banker separately in the chain
described, his additional Euro-dollar deposit came in
the form of a check on Morgan Guaranty Trust Com­
pany of New York! How are the bankers to know
that the $10,000,000 of checks on Morgan Guaranty
all constitute repeated claims on the same initial
$1,000,000 of deposits? Appearances are deceiving.
This example (involving successive loan extensions
by a series of banks) brings out the difference be­
tween two concepts that have produced much con­
fusion: Euro-dollar creation and the Euro-dollar mul­
tiplier. In both the simple example and the example
involving successive loan extensions, the fraction of
Euro-dollars outstanding that has been created is
nine-tenths, or, put differently, 10 Euro-dollars exist
for every U.S. dollar held as a cash asset in New York
by Euro-dollar banks. However, in the simple exam­
ple, the Euro-dollar multiplier ( the ratio of the
increase in Euro-dollar deposits to the initial “pri­
mary” desposit) is unity; in the second example, it
is 10. That is, in the simple example, the total amount
of Euro-dollars goes up by $1 for every $1 of U.S.
deposits initially transferred to Euro-dollar banks; in
the second example, it goes up by $10 for every $1
of U.S. deposits initially transferred. The difference
is that in the simple example there is maximum
“leakage” from the Euro-dollar system; in the second
example, zero “leakage.”
The distinction between Euro-dollar creation and
the Euro-dollar multiplier makes it clear why there is
a definite limit to the amount of Euro-dollars that
can be created no matter how low are the prudential
reserves that banks hold. For example, if Euro-dollar
banks held zero prudential reserves —as it is some­
times claimed that they do against time deposits —
100% of the outstanding deposits would be created
deposits and the potential multiplier would be in­
finite. Yet the actual multiplier would be close to unity
because only a small part of the funds acquired by
borrowers from Euro-dollar banks would end up as
additional time deposits in such banks.5
(b)
Suppose Bank H does not have sufficient de­
mand for dollar loans to use profitably the whole
$900,000 of excess dollar funds. Suppose, simultane­
ously, it is experiencing a heavy demand for sterling
loans. It might go to the Bank of England and use
5This is precisely comparable to the situation of savings and
loan associations and mutual savings banks in the U.S.



J U L Y 1971

the $900,000 to buy sterling. Bank of England de­
posits at Morgan Guaranty would now go up. But
since the Bank of England typically holds its deposits
at the New York Federal Reserve Bank, the funds
would fairly quickly disappear from Morgan Guar­
anty’s books and show up instead on the Fed’s. This,
in the first instance, would reduce the reserves of
Morgan Guaranty and thus threaten to produce much
more extensive monetary effects than any of our other
examples. However, the Bank of England typically
holds most of its dollar reserves as Treasury bills or
the equivalent, not as noninterest earning deposits
at the Fed. It would therefore instruct the Fed to
buy, say, bills for its account. This would restore the
reserves to the banking system and, except for de­
tails, we would be back to where we were in the
other examples.

The key points
Needless to say, this is far from a comprehensive
survey of all the possible complications. But perhaps
it suffices to show that the complications do not affect
the fundamental points brought out by the simple
example, namely:
1. Euro-dollars, like “Chicago dollars,” are mostly
the product of the bookkeeper’s pen —that is, the
result of fractional reserve banking.
2. The amount of Euro-dollars outstanding, like the
amount of “Chicago dollars,” depends on the desire
of owners of wealth to hold the liabilities of the
corresponding group of banks.
3. The ultimate increase in the amount of Euro­
dollars from an initial transfer of deposits from other
banks to Euro-dollar banks depends on:
(a) The amount of their dollar assets Euro-dollar banks choose to hold in the form of cash assets
in the U.S., and
(b ) The “leakages” from the system —i.e., the
final disposition of the funds borrowed from Euro­
dollar banks (or acquired by the sale of bonds or
other investments to them). The larger the frac­
tion of such funds held as Euro-dollar deposits, the
larger the increase in Euro-dollars in total.
4. The existence of the Euro-dollar market increases
the total amount of dollar balances available to be
held by nonbanks throughout the world for any given
amount of money (currency plus deposits at Federal
Reserve Banks) created by the Federal Reserve Sys­
tem. It does so by permitting a greater pyramiding
on -this base by the use of deposits at U.S. banks as
prudential reserves for Euro-dollar deposits.
Page 21

FED ER AL RESERVE BANK OF ST. LOUIS

5. The existence of the Euro-dollar market may
also create a greater demand for dollars to be held
by making dollar balances available in a more con­
venient form. The net effect of the Euro-dollar market
on our balance-of-payments problem ( as distinct from
our statistical position) depends on whether demand
is raised more or less than supply.
My own conjecture —which is based on much too
little evidence for me to have much confidence in it —
is that demand is raised less than supply and hence
that the growth of the Euro-dollar market has on the
whole made our balance-of-payments problem more
difficult.
6. Whether my conjecture on this score is right or
wrong, the Euro-dollar market has almost surely raised
the world’s nominal money supply (expressed in dol­
lar equivalents) and has thus made the world price
level (expressed in dollar equivalents) higher than
it would otherwise be. Alternatively, if it is desired
to define the money supply exclusive of Euro-dollar
deposits, the same effect can be described in terms
of a rise in the velocity of the world’s money supply.
However, this effect, while clear in direction, must
be extremely small in magnitude.

Use of Euro-dollars by U.S. banks
Let us now turn from this general question of the
source of Euro-dollars to the special issue raised at
the outset: the effect of Regulation Q and “tight
money” on the use of the Euro-dollar market by U.S.
banks.
To set the stage, let us suppose, in the framework
of our simple example, that Euro-dollar Bank H of
London loans the $900,000 excess funds that it has
as a result of the initial deposit by the Arab Sheik to
the head office of Morgan Guaranty, i.e., gives Mor­
gan Guaranty (New York) a check for $900,000 on
itself in return for an I.O.U. from Morgan Guaranty.
This kind of borrowing from foreign banks is one of
the means by which American banks have blunted
the impact of CD losses. The combined effect will
be to leave total liabilities of Morgan Guaranty un­
changed but to alter their composition: deposit liabili­
ties are now down $900,000 ( instead of the $1,000,000
deposit liability it formerly had to the Sheik it now
has a deposit liability of $100,000 to Bank H) and
other liabilities (“funds borrowed from foreign banks”)
are up $900,000.
Until very recently, such a change in the form of
a bank’s liabilities —from deposits to borrowings —
had an important effect on its reserve position. Spe­

Page 22


JU L Y 1971

cifically, it freed reserves. With $1,000,000 of demand
deposit liabilities to the Arab Sheik, Morgan Guar­
anty was required to keep in cash or as deposits
at the Federal Reserve Bank of New York $175,000
(or $60,000 if, as is more realistic, the Sheik kept his
$1,000,000 in the form of a time deposit). With the
shift of the funds to Bank H, however, and com­
pletion of the $900,000 loan by Bank H to Morgan
Guaranty, Morgan Guaranty’s reserve requirements at
the Fed fell appreciably. Before the issuance of new
regulations that became effective on September 4 of
this year, Morgan Guaranty was not required to keep
any reserve for the liability in the form of the I.O.U.
Its only obligation was to keep $17,500 corresponding
to the demand deposit of Bank H. The change in the
form of its liabilities would therefore have reduced
its reserve requirements by $157,500 (or by $42,500
for a time deposit) without any change in its total
liabilities or its total assets, or in the composition of
its assets; hence it would have had this much more
available to lend.
What the Fed did effective September 4 was to
make borrowings subject to reserve requirements as
well. Morgan Guaranty must now keep a reserve
against the I.O.U., the exact percentage depending
on the total amount of borrowings by Morgan Guar­
anty from foreign banks.6 The new regulations make
it impossible to generalize about reserve effects. A
U.S. bank losing deposits to a Euro-bank and then
recouping funds by giving its I.O.U. may or may not
have additional amounts available to lend as a result
of transactions of the kind described.
If Bank H made the loan to Chase instead of to
Morgan Guaranty, the latter would lose reserves and
Chase would gain them. To Chase, it would look as
if it were getting additional funds from abroad, but to
both together, the effect would be the same as before
—the possible release of required reserves with no
change in available reserves.
The bookkeeping character of these transactions,
and how they can be stimulated, can perhaps be
seen more clearly if we introduce an additional fea­
ture of the actual Euro-dollar market, which was
not essential heretofore, namely, the role of overseas
branches of U.S. banks. In addition, for realism, we
shall express our example in terms of time deposits.
Let us start from scratch and consider the head
office of Morgan Guaranty in New York and its Lon­
6The required reserve is 3% of such borrowings so long as
they do not exceed 4% of total deposits subject to reserves.
On borrowings in excess of that level the required reserve
is 10%.

FED ER AL RESERVE BAN K OF ST. LOUIS

J U L Y 1971

don branch. Let us look at hypothetical initial balance
sheets of both. We shall treat the London branch as
if it had just started and had neither assets nor
liabilities, and shall restrict the balance sheet for the
head office to the part relevant to its CD operations.
This set of circumstances gives us the following
situation:
N e w York H ead O ffice
Assets

Liabilities

Deposits at F. R.
Bank of N Y
$ 6 ,0 0 0 ,0 0 0

Time certificates
of deposit
$ 1 0 0 ,0 0 0 ,0 0 0

O ther cash assets

4 ,0 0 0 ,0 0 0

Loans

7 6 ,0 0 0 ,0 0 0

Bonds

1 4 ,0 0 0 ,0 0 0

Total assets

$ 1 0 0 ,0 0 0 ,0 0 0

Total liab ilitie s $ 1 0 0 ,0 0 0 ,0 0 0

(N o te: Required reserves,
$ 6 ,0 0 0 ,0 0 0 )

Hypocrisy and window dressing

London O ffic e
Liabilities

Assets
$

$

0

0

Now suppose a foreign corporation (perhaps the
Arab Sheik’s oil company) which holds a long-term
maturing CD of $10,000,000 at Morgan Guaranty
refuses to renew it because the 6)i% interest it is
receiving seems too low. Morgan Guaranty agrees
that the return should be greater, but explains it is
prohibited by law from paying more. It notes, how­
ever, that its London branch is not. Accordingly, the
corporation acquires a time deposit at the London
office for $10,000,000 “by depositing” the check for
$10,000,000 on the New York office it receives in re­
turn for the maturing CD —or, more realistically, by
transfers on the books in New York and London. Let
us look at the balance sheets:
N ew York Head O ffic e
Assets

Liabilities

Deposits at F. R.
Bank o f N Y
$

6 ,0 0 0 ,0 0 0

O ther cash assets

4 ,0 0 0 ,0 0 0

Loans

7 6 ,0 0 0 ,0 0 0

Bonds

1 4 ,0 0 0 ,0 0 0

Total

assets

Clearly, if we consolidate the branch and the head
office, the books are completely unchanged. Yet these
bookkeeping transactions: (1) enabled Morgan Guar­
anty to pay a rate in London higher than 6/4% on
some certificates of deposit; and (2) reduced its re­
quired reserves by $600,000 prior to the recent modifi­
cation of Regulation M. The reduction in required
reserves arose because until recently U.S. banks were
not required to keep a reserve against liabilities to
their foreign branches. With the amendment of Reg­
ulation M, any further reduction of reserves by this
route has been eliminated since the Fed now re­
quires a reserve of 10% on the amount due to branch
offices in excess of the amount due on average dur­
ing May.7

$ 1 0 0 ,0 0 0 ,0 0 0

Time certificates
of deposits
$ 9 0 ,0 0 0 ,0 0 0
Due to London
branch

10,000,000

This example has been expressed in terms of a
foreign corporation because the story is a bit more
complicated for a U.S. corporation, though the end
result is the same. First, a U.S. corporation that
transfers its funds from a certificate of deposit at a
U.S. bank to a deposit at a bank abroad —whether
a foreign bank or an overseas branch of a U.S. bank
—is deemed by the Department of Commerce to
have made a foreign investment. It may do so only
if it is within its quota under the direct control
over foreign investment with which we are still un­
fortunately saddled. Second, under pressure from the
Fed, commercial banks will not facilitate direct trans­
fers by U.S. corporations —indeed, many will not
accept time deposits from U.S. corporations at their
overseas branches, whether their own customers or
not, unless the corporation can demonstrate that the
deposit is being made for an “international” purpose.
However, precisely the same results can be accom­
plished by a U.S. holder of a CD making a deposit
in a foreign bank and the foreign bank in turn making
a deposit in, or a loan to, the overseas branch of
a U.S. bank. As always, this kind of moral suasion
does not prevent profitable transactions. It simply
produces hypocrisy and window dressing—in this case,
by unnecessarily giving business to competitors of U.S.
banks!

Total liab ilitie s $ 1 0 0 ,0 0 0 ,0 0 0

(N ote: Required reserves, before issuance of new regulations,
$5,400,000; since issuance of new regulations, between $5,400,000
and $6,400,000).

The final effect is precisely the same as in the
simple example of the foreign corporation. That ex-

London O ffic e

7An amendment to Regulation M effective September 4 estab­
lished a 10% reserve requirement on head office liabilities to
overseas branches on that portion of such liabilities in excess
of the average amount on the books in the four-week period
ending May 28, 1969.

Assets
Due from N . Y .
office

Liabilities
$ 10,000,000




Time certificates
of deposit

$ 10,000,000

Page 23

FED ER AL RESERVE BANK OF ST. LOUIS

ample shows, in highly simplified form, the main
way U.S. banks have used the Euro-dollar market and
explains why it is that the more they “borrow” or
“bring back” from the Euro-dollar market, the higher
Euro-dollar deposits mount. In our example, borrow­
ing went up $10,000,000 and so did deposits.
From January 1, 1969 to July 31, 1969 CD deposit
liabilities of U.S. banks went down $9.3 billion, and
U.S. banks’ indebtedness to their own overseas
branches went up $8.6 billion. The closeness of these
two numbers is not coincidental.
These bookkeeping operations have affected the
statistics far more than the realities. The run-off in
CD’s in the U.S., and the accompanying decline in
total commercial bank deposits (which the Fed uses
as its “bank credit proxy”) have been interpreted as
signs of extreme monetary tightness. Money has been
tight, but these figures greatly overstate the degree
of tightness. The holders of CD’s on U.S. banks who
replaced them by Euro-dollar deposits did not have
their liquidity squeezed. The banks that substituted
“due to branches” for “due to depositors on time
certificates of deposit” did not have their lending
power reduced. The Fed’s insistence on keeping Reg­
ulation Q ceilings at levels below market rates has
simply imposed enormous structural adjustments and
shifts of funds on the commercial banking system for
no social gain whatsoever.

24
Digitized forPage
FRASER


Correcting a misunderstanding
A column that appeared in a leading financial paper
just prior to the Fed’s revision of reserve require­
ments encapsules the widespread misunderstanding
about the Euro-dollar market. The Euro-dollar mar­
ket, the column noted, has:
“. . . ballooned as U.S. banks have discovered that
they can ease the squeeze placed on them by the
Federal Reserve Board by borrowing back these foreign-deposited dollars that were pumped out largely
through U.S. balance-of-payments deficits. Of this pool
of $30 billion, U.S. banks as of last week had soaked
up $13 billion . . .
“Thanks to this system, it takes only seconds to
transmit money — and money troubles — between
the U.S. and Europe . . . The Federal Reserve’s
pending proposal to make Euro-dollar borrowing more
costly to U.S. banks might make their future demands
a shade less voracious, but this doesn’t reduce con­
cern about whether there will be strains in repaying
the massive amounts already borrowed.”
Strains there may be, but they will reflect features
of the Euro-dollar market other than those stressed
by this newspaper comment. The use of the Euro­
dollar market by commercial banks of offset the de­
cline in CD’s was primarily a bookkeeping operation.
The reverse process —a rise in CD’s and a matching
decline in Euro-dollar borrowings —will also require
little more than a bookkeeping operation.

Proposed Solutions to InflationEffective and Ineffective
Speech by DARRYL R. FRANCIS, President, Federal Reserve Bank
of St. Louis, at the University of Mississippi School of Banking,
Oxford, Mississippi, June 13, 1971

I AM GLAD to have this opportunity to speak to
Mississippi bankers about some vital issues relating to
inflation and price stabilization. The numerous pro­
posals advanced in the past year to stabilize prices
indicate the wide concern of this nation for the infla­
tion problem. Some persons view the continuing rise
in prices and the large wage increases negotiated in
some sectors as evidence that monetary and fiscal
actions have been ineffective. They suggest that other
measures must be applied to stem the tide of rising
wages and prices. Such proposals include Govern­
mental admonishment, wage and price guidelines, and
mandatory wage, price, and credit controls.
The Committee for Economic Development (C ED ),
a proponent of voluntary wage and price controls, in
a recent discussion of measures for controlling infla­
tion stated,
. . while appropriately stabilizing fis­
cal and monetary policies are clearly essential for
the containment of inflation, it seems doubtful that
these policies alone can fully succeed in reconciling
price stability and high employment.”1 The CED
further stated, “. . . that the United States should
include voluntary wage-price policies among its tools
for reconciling price stability and high employment.”2
I find, however, that in May 1946, near the end of
that period of mandatory controls, the CED issued a
statement which represents a different view. At that
time it concluded, “. . . prices cannot be centrally
controlled for any sustained period without ineffi­
ciency, inequity, breakdown of respect for law, and
most important, serious danger to our personal and
political freedoms.”3 “TJie government has a respon­
sibility to supplement and supplant price control by
iCommittee for Economic Development, Research and Policy
Committee, Further W eapons Against Inflation Measures
to Supplement G eneral Fiscal and Monetary Policies (New
York, November 1970), p. 12.
2Ibid., p. 22.
3Committee for Economic Development, Research Committee,
The End o f Price Control —H ow and WhenP ( New York,
May 1946), p. 4.



anti-inflation measures which do not restrict the full
and free operation of the American productive system.
In the traditional governmental functions of taxation,
public expenditure, and monetary control we can find
the necessary tools.”4
I prefer the Committee’s 1946 statement made
while experiencing the impact of direct government
controls on wages and prices. It then recognized that
the mandatory controls interfered with the profit in­
centive and led to a breakdown of respect for law.
I see no reason why voluntary controls will engender
greater respect for law or governmental authority than
mandatory controls.
It is my view that the general stabilization measures
will work if applied with patience. Neither official
admonishments, voluntary controls, nor direct con­
trols are workable; they are useless as substitutes for
or long-run supplements to less expansive monetary
actions. The elimination of inflation requires great
patience; with ideal monetary policies it takes longei
than most of the public realizes.

Direct Controls Not Workable
in United States . . .
Our most extensive experience with “jawboning,”
“moral suasion,” and direct controls on wages and
prices was during World War II and a short period
following the war. Beginning in early 1941, the fore­
runner to the Office of Price Administration (OPA)
issued schedules setting maximum rents and prices
on other “critical” items.5 Although these schedules
were issued on the basis of dubious legal authority,
this deficiency was remedied in early 1942 following
the United States declaration of war. Retail prices of
*Ibid., p. 10.
5U.S. Office of Price Administration, Chronology o f th e Office
o f Price Administration, January 1941 - N ovem ber 1946, pre­
pared by Lawrence E. Tilley under the direction of Harvey
C. Mansfield, Chief, Policy Analysis Branch (Washington,
D.C.: Government Printing Office, November 30, 1946).
Page 25

F E D ER AL RESERVE BAN K OF ST. LOUIS

J U L Y 1971

most items were frozen at the March 1942 level, and
mandatory price controls remained in effect for most
items until October 1946.8 However, as a result of
excessive monetary growth, demand for goods and
services grew rapidly.

rium levels, consumers will want to purchase more
goods and services than are available, and output
must be rationed.

During the initial period of jawboning and price
schedules (January 1941 to March 1942), the stock
of money rose at a 16 per cent annual rate and the
consumer price index at a 12 per cent annual rate.7
While mandatory controls were in effect ( March 1942
to October 1946), the stock of money rose at an 18
per cent rate and consumer prices at a 6 per cent rate.
Such data, however, tend to underestimate the real
increase in prices since they exclude numerous black
market transactions and deterioration of quality.

The foreign experience with direct controls has
been no more favorable than our own. A study for
the President’s Council of Economic Advisers of the
experience with controls in Western Europe following
World War II reports, “Holders of public office . . .
have sought . . . to avoid the excessive exercise of pri­
vate power, not by eliminating the source of such
power but by preventing its full exploitation. This is
the essence of what has come to be known as incomes
policy.”8 It was concluded that none of the methods
used were very effective, and public disillusionment
was reflected in the decline or abandonment of such
controls in most of these nations by the end of the
last decade.

The number of workers required to operate and
enforce this direct controls program was staggering.
By 1944, 325,000 price control volunteers, in addition
to 65,000 paid employees, were being utilized. This
was a period when the country was faced with a labor
shortage, and most of these people could have worked
at productive jobs, thereby contributing to an increase
in total output and a lower rate of inflation. In addi­
tion to the number of employees required directly by
OPA, the program was a burden to all business estab­
lishments. For example, the banking system was han­
dling 5 billion ration coupons per month in 1944.
By the end of the war most Americans had become
disenchanted with rationing, price controls, empty
grocery shelves, and queuing up for purchases. After
a year of postwar domestic crises, including numerous
strikes and food shortages combined with a high rate
of inflation, direct controls were largely ended. During
the three years following the termination of controls
on most items in October 1946, money rose at less than
a one per cent rate, and consumer prices increased
at a 4 per cent rate.
We have no way of knowing how much inflation
would have occurred during World War II had free
market conditions prevailed, nor how stable prices
would have been following the war had controls con­
tinued. Generally accepted economic theory does tell
us something about such controls. If prices or wages
are arbitrarily set above equilibrium levels, sales will
decline and fewer workers will be employed. On the
other hand, if wages and prices are set below equilib­

6Ibid.
'Money stock data through 1946 from Milton Friedman and
Anna Jacobson Schwartz, A Monetary History o f the United
States 1 8 6 7 -1 9 6 0 (Princeton: Princeton University Press,
1963), Appendix A, Table A -l; 1947-71 from Board of
Governors of the Federal Reserve System. Consumer price
data from U.S. Department of Labor.

Page 26


. . . Nor in Western Europe

Typical of the experience with direct controls in
Western Europe is that of the Netherlands where
these methods received their most determined and
innovative support.9 The Dutch Government passed
a labor relations act in 1945 which provided mediators
with stringent powers to control labor markets and
wages. With the Socialists in power the incomes policy
in the early postwar period was quite effective, but
the honeymoon did not last long. The guidelines kept
all wages below equilibrium rates as intended. In
1951, with a balance of trade deficit and a high rate
of inflation, real wages actually fell. Labor shortages
developed, and considerable pressure built up for ad­
ditional labor resources, especially in the high profit
industries. The willingness of employers to grant wage
increases in excess of the legal limits began, to under­
mine the guidelines. Black market wages were com­
mon, and prosecutions, fines, and even jail sentences
followed.
When union leadership agreed to a wage increase
of only 3 per cent in 1955, members began to criticize
their leaders for supporting the guidelines, an unusual
action in the Netherlands. As a result, the wage nego­
tiating agency failed to function, and the government
was forced to grant higher wages through arbitration.
In 1957, with wages rising 8 to 9 per cent per year
and a balance-of-payments crisis developing, the union
leadership again accepted a policy of extreme re­
8Lloyd Ulman, University of California, Berkeley, and Robert
J. Flanagan, University of Chicago, “Wage Restraint: A
Study of Incomes Policies in Western Europe” (unpublished
study made possible by grant from Council of Economic
Advisers, 1971), p. i.
9Ibid., Chapter 1.

J U L Y 1971

FED ER AL RESERVE BANK OF ST. LOUIS

straint. This time, however, the leadership could not
carry the members with them. The new policy re­
quired that all wage increases in excess of 3 per cent
come out of profits, but it failed as both wages and
prices soared above guideline rates, and the balance
of payments worsened.
The Labor government was replaced in 1959 by a
more conservative government which espoused greater
freedom in wage determination. More flexible limits
on wage settlements and increased use of collective
bargaining were permitted at the industry level. This
policy achieved more government regulation but failed
to control wages and prices. A 1961 law limited wage
increases to increases in productivity. It acknowledged
no role for interoccupational wage differences, how­
ever, and ran into difficulty almost immediately.
A new wage policy, based on the Central Planning
Bureau’s econometric model, was adopted in 1963.
The model was no more competent to establish wages
than the mediators. It implied a wage increase of 1.2
per cent, but this was arbitrarily raised to 2.7 per
cent. Pressure for higher wages developed within the
unions, and employers, short of help at the estab­
lished scale, openly announced plans to pay more.
As a result, wages and salaries rose 13 per cent in
1963, 15 per cent in 1964, and 11 per cent in 1965.
No agreements were reached in 1966 and 1967, and
by the autumn of 1967, all factions of labor refused
to participate in the policy any longer.
In response to these challenges, the Government
decided in 1969 to introduce more stringent legisla­
tion which gave it formal authority to freeze wages
after consultation with the Social and Economic Coun­
cil and the Foundation of Labor. The measure, finally
passed in 1970, was strongly opposed by the unions,
and they withdrew from the Social and Economic
Council and from central bargaining. The minister
in charge was warned that Parliament had given him
nothing but a “paper sword.”
Thus, the Sixties witnessed the collapse of an am­
bitious attempt by the Netherlands Government to
supervise a private incomes policy, and the Seventies
revealed the failure of a policy based on compulsion.
The formal incomes policies adopted in the United
Kingdom and Denmark have likewise been less than
successful, and the more limited attempts to admin­
ister wages or prices in France, West Germany, and
Italy have generally failed. Yet, the incomes policy’s
popularity in principle has thus far proved almost as
durable as the problem which it was designed to
solve.



Stable Prices Not Inconsistent with
Current Economic Structure
Despite the failures of direct controls in other coun­
tries, the arguments for their use in the United States
continue. Such arguments are generally based on the
belief that a large portion of the labor and commodity
markets is comprised of noncompetitive elements and
that prices of goods and services sold in such markets
are not sensitive to a reduction in demand. Most ana­
lysts admit that demand for goods and services can be
increased by public policies. Nevertheless, some con­
tend that after periods of excessive demand, the non­
competitive elements in labor and business can con­
tinue to push prices upward despite less expansive
monetary policies.
It is my view that in the absence of excessive
demand average prices cannot be pushed up signif­
icantly, even by noncompetitive elements. The price
lag relative to declining demand probably reflects
imperfect information in forming price expectations
rather than monopolistic power. Current wage settle­
ments are being made on the basis of recent price
trends rather than on conditions likely to prevail
during the period covered by the agreements.
When the rate of monetary growth is reduced,
consumers and business firms find themselves with
less money than anticipated. They reduce their rate
of spending in an attempt to maintain cash balances.
Some producers will find themselves with excessive
inventories. They may first attempt to cut costs by
reducing hours worked or overtime. Then, if the price
incentive is not sufficient to maintain current output
at current wage rates, producers will lay off workers
or reduce their work force through attrition until out­
put clears the market at a profitable price. Most
workers who are unemployed because of excessive
wage settlements will eventually find acceptable jobs.
Thus, the restricted output and increased prices in
specific sectors resulting from noncompetitive ele­
ments are partially offset by increased output and
lower prices elsewhere.

Economy Still Subject to Competitive Forces
Even if large unions and business firms could induce
price changes, we have no evidence that they have
greater power than during the period 1953 to 1961
when the postwar inflation was slowed to a one per
cent rate, as measured by the consumer price index.
Let me quickly add that I do not condone monopolis­
tic power, either in the hands of unions or of busi­
nesses. It has without doubt caused misallocation of
resources and higher levels of unemployment, but we

FED ER AL RESERVE BANK OF ST. LOUIS

have no evidence that such power has been an im­
portant factor contributing to the current inflation.
For example, following the high rate of inflation dur­
ing World War II and the Korean War, the rate of
inflation was reduced from 1953 to 1961 with a slower
rate of monetary growth. The stock of money during
this period rose only 1.4 per cent per year and prices
only 2 per cent as measured by the GNP price de­
flator, or only 1 per cent as measured by the wholesale
and consumer price indices. This slower rate of infla­
tion was achieved despite the fact that a larger per
cent of the labor force was unionized than is the case
today. The share of nonagricultural workers in unions
declined from 34 to 28 per cent and the total labor
force in unions from 25 to 23 per cent during the
period 1953-68.10 Such data suggest that the non­
competitive elements in the labor market have not
increased.
We likewise have no evidence of an increase in
monopoly power in commodity markets since the mid1950’s. The fifty largest manufacturing firms had 23
per cent of value added in 1954, 25 per cent in 1963,
and 25 per cent in 1966.11 Shipments accounted for
by the largest four firms in each of twenty-two selected
industries showed little change in concentration from
1947 to 1966. The share of the largest four firms
increased in half the industries and declined in the
other half. Furthermore, any tendency toward domes­
tic concentration has been more than offset by the
rising competition from manufacturing firms abroad.
In addition, if greater competition is desired, there
are actions which the government can appropriately
take within a free market framework to improve both
labor and commodity markets. I suggest further re­
laxation of tariffs and other import controls. The re­
sulting increase in worldwide competition would tend
to stabilize prices for all goods and services traded
in international markets. The removal of archaic build­
ing codes would aid the construction industry.
Action should also be taken to reduce restrictions
on entry into unions. Relatively higher pay scales for
trainees after attaining moderate skills might be help­
ful in attracting more labor into some sectors. Where
bottlenecks to entry are retained through union ac­
tion, I suggest the application of anti-trust legislation.
Minimum wage laws which restrict the employment
of students, the unskilled, and the handicapped should
10U.S. Department of Commerce, Bureau of the Census,
Statistical Abstract o f the United States, 1970. For a further
discussion of this point see Alfred L. Malabre, Jr., “Troubled
Unions,” W all Street Journal, June 25, 1971.
11Statistical Abstract, 1970.

Page 28


J U L Y 1971

be repealed. An incomes policy that includes only
these actions will not only improve the functioning
of the labor and product markets but will also en­
hance output of goods and services for the entire
community.

Excessive Money Growth: Cause
of Inflation
In contrast to the view that imperfect labor and
commodity markets are an important cause of infla­
tion is my belief that an excessive rate of monetary
growth is the chief culprit. All substantial and pro­
longed general price increases throughout history have
been associated with a rapid increase in the stock
of money per capita. Following successive debase­
ments, the precious metal content of the Roman coin
had been reduced until it was almost worthless in the
early 300’s. Prices had increased four to eight times
their former level. Through price and wage edicts,
an incomes policy was established which quickly failed
because people began to make most payments, in­
cluding taxes, with commodities or other nonmoney
assets.12
A similar debasement followed by a rapid rise in
prices occurred in England under Henry VIII in the
early 1500’s.13 Landowners who had long-term cropshare leases maintained their living conditions of prior
years. Many, however, had long-term fixed payment
leases, and their real rental returns were reduced
while their tenants received a windfall.
A hyper-inflation in Germany following World
War I can be traced to monetary growth. From July
1922 to June 1923, the quantity of money rose 86-fold,
and the cost of living (food) rose 137-fold. By June
1923, German money was worth less than one per cent
its value a year earlier.14
Our experience with excessive money growth and
inflation has been consistent with the experience else­
where. Many of you are doubtless familiar with the
excessive money creation and the consequent inflation
in the Confederate States during the Civil War. By
January 1864 the stock of currency in circulation had
increased about elevenfold, and prices had increased
faster as a result of declining output of goods and
12Paul-Louis, Ancient Rome at W ork (New York: Alfred A.
Knopf, 1927), pp. 313-315.
13William Cunningham, T h e Growth o f English Industry and
C om m erce During th e Early and M iddle Ages, 5th ed.
(Cambridge: At the University Press, 1910-27), p. 543.
14Constantino Bresciani-Turroni, The Econom ics o f Inflation;
A Study o f Currency D epreciation in Post-W ar Germany
1914-1923, translatea by Millicent E. Sayers (New York:
Barnes & Noble, Inc., 1937), p. 35.

FEDERAL RESERVE BANK OF ST. LOUIS

services.15 One contemporary reporter observed, “Be­
fore the war I went to market with the money in my
pocket and brought back my purchases in a basket;
now I take the money in the basket and bring the
things home in my pocket.”18
Our more recent inflations, although on a much
smaller scale than these hyper-inflations, can be traced
to the same causal forces. For example, from 1915 to
1920 the stock of money rose at the annual rate of 14
per cent and wholesale prices 17 per cent. From 1938
to 1948 the stock of money rose at a 14 per cent rate
and wholesale prices at a 7 per cent rate, despite the
sharp increase of resource utilization during the pe­
riod.17 In the recent inflation from 1965 to 1970 the
stock of money grew at a 5 per cent rate, wholesale
prices at a 3 per cent rate, and the general price index
at a 4 per cent rate. The leveling off or a prolonged
decline in the stock of money likewise is associated
with a leveling off or decline in prices. For example,
in 1920 and early 1921 both the stock of money and
prices declined, a pattern which was repeated in the
period 1929-33.18 The decline in the stock of money
in this latter period was sufficiently prolonged and
intense to cause a major depression.

Slower Money Growth the Solution
The solution to inflation is the elimination of its
cause. Actions were taken in early 1969 to slow the
rate of money growth. The stock of money rose only
about 3 per cent during the year, down from an 8
per cent rate in the previous two years. In response
to slower money growth, spending on goods and
services began to moderate late in the year. Such
spending rose at a 4 per cent annual rate from the
third quarter of 1969 to the end of 1970, following
an 8 per cent rate of advance in the previous five
quarters. Consistent with past experience, however,
the momentum of the inflation continued following the
reduced rate of spending growth.
By mid-1970 the rate of inflation began to decline.
Since last June consumer prices have risen at the
annual rate of 4 per cent, compared with a 6 per cent
rate in the previous year. While the rate of inflation
was slowing, the nation was paying for the previous
excesses. Unemployment was rising, and real product
was down. The immediate impact of a change in
15Margaret G. Myers, A Financial History o f the United
States (New York: Columbia University Press, 1970), p. 169.
16Harold Underwood Faulkner, American Econom ic History,
7th ed. (New York: Harper, 1954), p. 357.
17Friedman and Schwartz, M onetary History; Board of
Governors; Department of Labor.
18Friedman and Schwartz, M onetary History, Chart 62.



JU L Y 1971

monetary growth was on spending and output, but
there was a lagged effect on prices.
Early last year monetary policies were relaxed
as a consequence of the decline in output and higher
unemployment. During the year the stock of money
rose 5 per cent, but the recovery of spending and
production may have been delayed a few months by
the automobile strike last fall. Early this year the
growth rate of money again accelerated. In the last
three months it has risen at a 13 per cent annual rate
—the highest rate of any three-month period since
1950. Recovery is now underway. Retail sales have
risen markedly, housing starts have increased, and
industrial production is up. Again an early impact of
monetary growth on economic activity is observed,
while prices are affected only in the longer run.

Expectations Have Exceeded Possibilities
The relatively long lag between monetary actions
and their impact on prices has probably been the
major disappointment with the progress made in slow­
ing the rate of inflation to date. Most people fail to
recognize the length of time required for monetary
actions to have a significant impact on average prices.
Monetary restraint first induces a slower rate of growth
in cash balances relative to money demand. Indi­
viduals and firms reduce their rate of spending in an
attempt to build up cash balances to desired levels.
This reduction in spending growth reduces nominal
GNP growth and the growth rate of overall demand
for goods and services. Expectations based on past
trends in prices and wages, however, continue to pro­
vide inflationary momentum until offset by basic sup­
ply and demand conditions. The lag between appro­
priate monetary actions and the achievement of
relatively stable prices may thus be expected to ex­
tend over a period of three or four years, following a
prolonged and relatively high rate of monetary ex­
pansion, as in 1967 and 1968.
The slowdown is aggravated by imperfect function­
ing of labor markets as reflected by a relatively high
unemployment rate. In addition to higher unemploy­
ment in the civilian sector, unemployment has been
aggravated by a sharp decrease in some types of de­
fense expenditures. Aircraft manufacturers on the
West Coast have made sharp cutbacks.
In some occupations unemployment was further in­
creased by the sufficiently strong bargaining power of
unions. Excessive wage rate settlements relative to
supply and demand conditions tend to reduce the
number employed.
Page 29

FED ER AL RESERVE BANK OF ST. LOUIS

It takes time for the laid-off workers and the new
entrants into the labor market to find jobs. Time is
also required for business firms to adjust to a change
in demand. During this adjustment period the nation’s
resources are underutilized, and production of goods
and services is well below potential levels. This is
the price we pay for reducing inflation. It is a cost
which we must accept, and it cannot be legislated
into nonexistence through the provision for nonworkable controls on our economic system.

Conclusion
In summation, direct controls on wages and prices
have been tried both here and abroad and found
unworkable. They may suppress the rate of inflation
for a short period under favorable conditions, but the
inflationary pressures soon build up, and the controls
are usually abandoned. Furthermore, all attempts to
control inflation by such methods have led to a reduc­
tion in economic efficiency and a breakdown of re­
spect for the law.
The argument that inflation can no longer be mod­
erated by monetary actions is not valid. Non-com­
petitive elements in the labor and commodity markets
were probably stronger in the early 1950’s, when a
similar inflation was slowed.
Excessive money growth is the cause of inflation,
and a slower rate of money growth is the solution to
the problem. Money has an early impact on spending
and production, but a longer period is required to


Page 30


J U L Y 1971

slow an inflation. The length of this period has been
misjudged by many people who have concluded on
the basis of recent experience that monetary actions
are ineffective. If we exercise the patience to wait
for the economy to adjust to a slower rate of demand
growth and maintain appropriate monetary policies,
I am sure that we can again stabilize prices at a
relatively low rate of unemployment.
Stabilization can be attained at higher levels of
employment and output if we adopt policies to elimi­
nate sharp changes in the rate of monetary growth and
reduce barriers to a more rapid adjustment to market
forces. The stop-and-go method of monetary actions in
recent years tends to reduce both output and
employment.
Expectations of future price trends must be changed
before reduced demand growth can have a major
impact on prices. This changed outlook, first evident
about mid-1970, has caused the momentum of the
current inflation to slacken. I am vitally concerned,
however, about the rapid rate of money growth in
recent months. There is great danger of rekindling
the flames of inflation.
Furthermore, if we attempt to halt the inflation
through direct controls, I fear that we will not exer­
cise the necessary monetary restraint and will lose
much of the gain achieved from the slower rate of
money growth in 1969. In addition, such controls will
mean further losses of freedom for individual action
which has through the years provided us with the
world’s most efficient economy.

FED ER AL RESERVE BANK OF ST. LOUIS

JU L Y 1971

Publications of This Bank Include:
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U. S. FINANCIAL DATA

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REVIEW
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QUARTERLY ECONOMIC TRENDS
FEDERAL BUDGET TRENDS
U. S. BALANCE OF PAYMENTS TRENDS

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ANNUAL U. S ECONOMIC DATA
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FOR TEN INDUSTRIAL COUNTRIES
(QUARTERLY SUPPLEMENT)

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For information write: Research Department, Federal Reserve Bank of St. Louis,
P. 0 . Box 442, St. Louis, Missouri 63166.




Page 31

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