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AN ALTERNATIVE ROUTE TO ECONOMIC STABILIZATION
The St. Louis Chapter
of the Robert Morris Associates
at National City, Illinois
January 21, 1970
The route taken to economic stabilization
in the past year is a subject of great concern to
all of us.

It is of particular concern to bank lending

officers who have taken some severe lumps.

It is

my belief that there is a more equitable route to
stabilization objectives than the one which we have
taken.
I shall begin this discussion with a brief
review of the excesses created in the second half
of the 1960's which led to the need for restrictive
monetary actions last year.

The nation experienced

excess demand for goods and services as a result of
highly expansive monetary policies from 1965 to early
1969.

Money grew at the annual rate of 5.5 per cent

from May 1965 to January 1969.

The stock of money

grew in excess of 7 per cent per year during 1967
and 1968.

In response to excessive monetary growth,

the general price index, which had been increasing
one to two per cent per year in the early 1960's,
accelerated to 5.1 per cent in 1969. Consumer prices
rose in excess of 6 per cent per year during 1969
and are expected to continue up this year, since prices
tend to lag most other indicators of economic activity.
Reflecting expectations of further price increases,
interest rates have risen to record levels in recent
months.




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Public policies were adopted in early 1969
to brake the pace of an overly expansive economy.
Growth of the money stock declined in the first half
of the year to a 4 per cent rate. At midyear monetary
actions became quite restrictive when the growth rate
of money declined to less than 1 per cent.

Restrictive

monetary actions were necessary and their overall impact
on economic activity has been desirable.
Several sensitive indicators suggest the
impact of the slower rate of monetary growth on economic
activity.

Industrial production has declined for five

consecutive months.

The rate of personal income growth

in recent months was only about half the rate of such
growth in 1968. Payroll employment has declined slightly,
whereas such employment rose more than 3 per cent in
1968.

Corporate profits turned down in the third quarter

of last year and retail sales have shown little growth
since last spring.

By the fourth quarter, growth of

total spending had declined to an annual rate of 4
per cent, well below spending rates earlier in the
year.

There are few who question the fact that the

more restrictive monetary actions have been effective
in reducing the rate of growth in total demand for goods
and services.

Despite the continued persistance of

price increases, I am sure that the restrictive actions
will soon have a significant impact on prices and interest
rates.




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Impact of Restrictive Actions Uneven
My remarks, however, shall not be addressed
to the need for restrictive monetary actions or to
their overall impact.

Instead they are concerned

with the particular monetary actions that have been
maintained over this period.
two destinct types.

These actions were of

One type of action was taken to

restrict the growth of such monetary aggregates as total
bank reserves, the monetary base, and the stock of
money - actions that limit total credit in the economy.
A second type of action involved restrictions on rates
that banks and savings and loan associations could offer
for savings.

The impact of interest rate restrictions

is primarily on financial intermediaries with little or
no influence on total credit flows. Attraction of savings
was unduly limited by these actions.

Since January

1969 borrowers who were limited to banks and other financial intermediaries for funds were thus more restricted
by monetary actions than large corporate business which
had access to capital markets.
Financial Intermediaries Overly Restricted
Total bank deposits have declined at a
3 per cent rate and time deposits at a 6 per cent
rate since January 1969.

In contrast to this abrupt

decline, total deposits rose at the rate of 8.5 per cent
and time deposits at an 11 per cent rate from 1960 to
1968.

Demand deposits continued to grow last year,




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but at a slower rate than heretofore.

The sharp

turnabout of time deposits coupled with the slower
rate of growth of demand deposits last year suggests
that something other than general monetary actions
was the primary restrictive force on bank and savings
and loan association lending.

Overall lending capacity

of banks, however, was not diminished quite as much
in 1969 as indicated by the deposit loss.

They

resorted as never before to capital markets by selling
debentures, capital notes, etc.

Through this route

banks were able to increase total bank credit by
1 per cent during the year, all of which occurred
early in the year.

Bank credit has declined in

recent months as a result of the more restrictive
monetary actions since June.
Savings and loan associations were likewise
subject to the same forces as commercial banks.
After having risen at the annual rate of 10 per
cent from 1960 to 1968, shares in savings and loan
associations rose only 3.6 per cent in 1969, and
in recent months there has been no gain in such share
holdings.
Residential Construction and
Small Business Investment Slacken
Reflecting the slower rate of growth of funds
available to financial intermediaries and thus less
mortgage credit, residential building declined during
1969.

Such construction declined from an annual rate

of $25 billion in the first quarter of 1969 to an annual




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rate of $22.6 billion in October.

Lending officers

recognize that some credit remains available for home
purchases, but at: rates and terms which have greatly
reduced the market demand for homes.
A slower rate of capital expenditure also
developed in the noncorporate nonfinancial business.
Capital expenditures by such firms, which account for
about 50 per cent of total nonfinancial business investment,
rose only 3.7 per cent in the year ending with the third
quarter of 1969 from a year earlier.

In contrast, capital

outlays by these firms rose 5.5 per cent per year in
the four years 1964-68. Furthermore, the growth of
such investment declined sharply in the third quarter
1969 as a result of the more restrictive monetary policies
at midyear.

Like the housing industry, these firms

are largely dependent on financial intermediaries for
credit.

Large Corporate Business Expands
In contrast to the severe pinch on the financial
intermediaries, credit to corporate business apparently
continued unabated.

Credit market liabilities by such

firms rose 42 per cent in the first three quarters of
1969 from a year earlier.

Such liabilities rose only

23 per cent per year from 1964 to 1968.

Bank loans

to corporate business did decline as monetary actions became
more restrictive after mid-1969; however, such declines




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were more than offset by sales of commercial paper
and reductions in corporate holdings of government
securities and time deposits. As a result, capital
expenditures by corporations continued up in the first
three quarters of 1969, averaging 16 per cent more
than a year earlier.

Furthermore, capital investment

of such firms continued to rise in each succeeding
quarter through the third quarter 1969 despite the
restrictive monetary actions.

Such expenditures grew

only 10 per cent per year from 1964 to 1968.—

Interest Rate Restrictions Cause of Disparity
I believe that these data are sufficient
to point up the uneven impacts by sector of the combination of public policies used in the 1969 restraint
program.

I am biased neither for nor against big business

per se.

It is evident to me, however, that the particular

set of monetary actions taken in 1969 was heavily weighted
in favor of big corporate business and against small
business and residential construction and consumers.
Regulation Q restrictions in the face of
the restrictive monetary actions were responsible for
intensifying the stabilization problem.

These restrictions

on interest rates caused turmoil in financial markets
and interrupted the ongoing process of credit operations
at commercial banks and savings and loan associations.

1/ Board of Governors of the Federal Reserve System,
Flow of Funds, Seasonally Adjusted Third Quarter, 1969.




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Just as any other price, interest rates are
subject to the forces of supply and demand.

Similar

to controls on other prices, controls on interest
2/
rates lead to other problems of allocation and use.—
When the ceiling rates for savings are set at levels
lower than the market warrants, savers withhold their
funds from these financial agencies, and the flow of
credit to these agencies declines.

It then becomes

necessary either to ration the credit or charge higher
rates to borrowers in order to distribute the shortage.
In a free market the rates would be bid up to a point
where the quantity offered and the quantity taken are
equal.

Interest rate controls are not consistent with

this principle of equating supply and demand.
Ceilings Set Too Low
To demonstrate the impact of interest rate
ceilings, let's discuss for a moment your reaction
as lending officers to usury laws.

When permissible

rates which you can charge on a given type of loan
are less than rates on other types of loans or investments,
you reduce your loans in the controlled areas. You
place your funds in other areas where higher earnings
are permissible.

You try to maximize your returns,

given the usual risk constraints.

2/ For a discussion of interest rate controls, see
Clifton B. Luttrell "Interest Rate Controls — Perspective,
Purpose, and Problems" in the September 1968 issue of the
Federal Reserve Bank of St. Louis Review.




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Evidence indicates that many of your time
and savings depositors invest their savings in the
same manner that you invest your bank funds. They
attempt to maximize returns on such savings, given
their individual liquidity and safety constraints.
When competitive market rates rise above the maximum
rates that banks and savings and loan firms are permitted
to pay, many savers withdraw their funds and invest
them at the higher rates. This is what has happened
during the past year.
Although the latest change in the maximum
permissible rates on savings deposits was in 1964 and
on time deposits in April 1968, the relationship between
these ceiling rates and market rates has greatly changed.
For example, in November 1964 ceiling rates were last
set on all savings accounts at 4 per cent, slightly
above the rate on 90 day Treasury bills and about equal to
the rate on prime commercial paper.

By last December,

-however, the rates on Treasury bills and commercial
paper had increased more than 400 basis points. Since
April 1968, when rates were last increased on time
deposits, average rates on Treasury bills and prime
commercial paper have risen more than 250 basis points.
As a result of the widening disparity in
permissible rates on savings and market rates on other
debt instruments, many savers shifted their savings
from the financial intermediaries where rates are




- 9 controlled to other debt instruments with the higher
yields.

The gap between permissible and market rates

widened with the more restrictive monetary policies
after mid-1969,and the shifting of savings from intermediaries
to other credit instruments picked up momentum.

Total

time and savings deposits at weekly reporting banks
declined from $112 billion in December 1968 to $96
3/
billion in December 1969.—

The shift would have taken

place at these rate differences without the restrictive
monetary policies. The fact that the shift picked
up momentum simultaneously with the more restrictive
monetary policies, however, is not coincidental.

The

more restrictive policies caused a temporary rise in
the market rates, thus contributing to the rate disparity
and to the disintermediation.

Disintermediation Unnecessary
Disintermediation is unnecessary for economic
stabilization.

The total flow of savings into debt

instruments is not greatly retarded by rate ceilings
for bank deposits and savings and loan shares. The
larger savers simply shift from one means of investment to another.

I doubt whether such shifts have

a measurable impact on the velocity of money and on
total demand created by a given money stock.
As indicated earlier, the major result of
these rate restrictions is that some sectors of the

3/ These banks account for over half of all commercial
bank time and savings deposits.




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economy are favored at the expense of other sectors.
The fact that banks and savings and loan associations
are prohibited from bidding up the market price on
funds means that larger supplies of credit are available
to those who are not restricted by ceiling rates. Larger
corporate business has this freedom.

It can issue

relatively safe debt instruments to the public, and,
with the restrictions on banks and a shortage of bank
credit, corporations took advantage of this opportunity
last year by selling more credit market instruments.
In the absence of rate restrictions the banks
and savings and loan associations would have purchased
some portion of the funds which ultimately went to
larger corporations and Government agencies.
higher rates on time and

With

savings deposits and savings

and loan shares, these funds would have continued to
grow.

Some additional credit would have been fed out

to all sectors of the economy and the disparity in
activity among the various sectors would have been
less than it actually was.
In my view, the restrictive monetary policies
cannot be blamed for the sharp cutback in residential
construction and relatively low rate of growth in unincorporated
business.

This was caused by the strangling of our

efficient financial intermediaries through restrictions on rates that they were permitted to pay savers.
In the absence of such controls residental construction
would probably have continued up.

Unincorporated business




- 11 investment would have continued up at a slower rate
than in prior years, but at a somewhat faster rate
than actually occurred.

Larger corporate business

investment would have slowed along with* other sectors
of the economy since part of the funds obtained from
savers through sales of credit market instruments and
other assets would not have been available.

It is

impossible to quantify these amounts because we do
not know the demand elasticities for credit by the
various sectors.
The restrictions on interest rates not only
affect banks and savings and loan associations, but
also create major equity problems. For example, it
seems to me that the potential home buyer should have
the same basic right to the credit market as a large
corporate business.

I see no reason why the demand

of noncorporate business for credit should not be reflected
through financial agencies to savers just as the demand
.by large business can be reflected directly through
sales of commercial paper.

I furthermore see no reason

why small savers should be denied a market rate on
savings.

This proliferation of rate ceilings according

to volume of savings results in market returns to those
savers with higher incomes and below-market returns
to others.

It further widens income distribution caused

by differences in inherited wealth or ability.

To

me this type of regulation is symbolic of an earlier
age

when most people were denied basic market rights,

and has no place in a free democratic society.




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Summary
In conclusion, the restrictive monetary actions
in the past year have been effective in reducing aggregate
demand for goods and services.

Lower interest rates and

a slower rate of growth in prices will follow after
a reasonable time lag.
The reduction in total spending growth was
much greater in some sectors than in others. Sectors
which require large quantities of credit in relation
to total costs and which are limited to banks or savings
and loan companies for their credit were restricted
more than other sectors.

Examples of the more restricted

activities inc3.ude residential construction and small
business investment.

Borrowers in these sectors were

too small to enter the capital markets directly and
were, therefore, cut off from all possibility for growth
when the restrictions began to cause a reduction in
bank and savings and loan balances.

Larger corporations,

however, were able to offset losses in bank credit
with gains in commercial paper sales and a reduction
in their inventory of Government bonds.
Without the rate restrictions, 1 believe
that the impact of the restrictive policies would have
been distributed equally among all credit users. Banks and
savings and loan associations would have obtained more funds
if permitted to pay higher rates to savers.

Some larger

corporations would have reduced their borrowings at
the higher rates and the change in the rate of economic




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activity would have been more nearly uniform among
all major sectors.
In addition to the greater impact of the
interest rate restrictions in some sectors, the equity
considerations of such regulations are important. They
arbitrarily deny small users ofcredit:the opportunity
to compete with big business for funds and small savers
the opportunity of receiving a market rate for their
savings.