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Speech by Darryl R. Francis
at the
23rd Annual Conference of Bank Correspondents
First National Bank in St. Louis
Stouffer's Riverfront Inn
November 13, 1969
The use of selective credit controls for economic
stabilization is not of recent origin. The eligible paper
provisions of the Federal Reserve Act passed in 1913 are a form
of selective credit. They provide for easier Central Bank
credit terms to borrowing member bank* who offer short-term
commercial paper as collateral. This provision implies that,
if bank credit is limited to short-term commercial loans,
monetary conditions will approach an optimum.
Selective credit controls were given a major boost
in 1934 with the passage of the Securities Exchange Act, which
delegated authority to the Board of Governors to control margin
requirements (Regulations G, T and U) on securities traded on
the major exchanges.— This control was provided for the
purpose of preventing the "excessive" use of credit for
purchasing or carrying securities. It was generally believed
that a large volume of bank credit led to a major increase in
stock prices and the ultimate collapse of the stock market in

1/ Securities Exchange Act, 1934. P. 222 of Federal
Reserve Act as amended through Oct. I, 1961.

the late 1920's and early 1930's.—

it was assumed that

the expansion and contraction of stock market credit was a
major factor contributing to the great depression of the 1930's.
Another boost to selective credit controls was
provided by the passage in 1933 and 1935 of interest rate
restrictions on demand and time deposits. Under authority
granted by this legislation both member and nonmember
banks were prohibited from paying interest on demand
deposits. This legislation also authorized the Federal
Reserve Board and the F.D. I.C. to limit the rates that
banks could pay on time and savings deposits. At that
time it was contended that these restrictions would tend
to reduce rates charged bank customers, slow the movement
of funds from smaller to larger communities where it was
believed that they were used for "speculative" purposes,
and prevent the excessive bidding up of rates and thereby
reduce bank failures. More recently, time and savings
deposit rate controls have been intended to reduce competition
with savings and loan associations and thereby speed the
flow of funds into the housing market, rather than permit
free competition between these agencies and commercial banks.
This move implies that it is better for the nation to have

2 / See John J. Abele, "BlackTuesday,'29: Forgotten
Lesson?" in the New York Times, Oct. 26, 1969 for a
discussion of this view.

-3larger credit flows to the housing industry than to bank
creditors who may use the funds for plant and equipment
expenditures and other purposes believed to be less worthy.
In 1941 the Board of Governors was authorized
by an executive order of the President to restrict the use
of credit for consumer purchases (Regulation W). This was
done by requiring a minimum down payment and a
maximum time to maturity for such credits. The immediate
reason for the restriction was to reduce the inflationary
danger during the war by restricting the demand for
consumer goods. But actually the legislation was
associated with the thought that excessive consumer credit in the
1920's had contributed to the 1929-33 depression.
Restrictions on real estate credit were imposed
in 1950 as part of a program to check inflation after the
start of Korean fighting (Regulation X). These restrictions
followed the general pattern of consumer credit controls
by requiring minimum down payments and maximum
maturities on new one and two family houses. Credit
restrictions were later extended to other real estate.
As an indication of the wide interest in selective
credit for controlling inflation, Time Magazine, in discussing

3/ Charles R. Whittlesey, Arthur M. Freedman Edward
S. Herman, Money and Banking: Analysis and Policy
(New York: Macmillan Co., 1963), p. 256.

-4the reluctance of the Administration to impose price controls,
reported that "Credit controls, which were last imposed
on the U. S. during the Korean War, might work more
selectively to restrain lending, and in turn, demand for
some kinds of goods.' —

In recent testimony before a

Senate subcommittee, the president of the National Association
of Home Builders stated that "we are now convinced that
some type of credit controls must be undertaken". 5/
The argument for selective credit controls rests
primarily on the assumption that restrictive monetary
actions cause high interest rates and that high interest
rates have an unduly harsh impact on some sectors of
the economy such as residential construction.


of selective controls believe that the "undesirable" impact
of aggregate monetary controls can be eliminated by controlling
the volume of credit used for specific purposes.
The view that credit controls in a specific sector
will have an impact on total credit outstanding and total
demand for goods and services may be looked upon as a
variant of the income - expenditure approach to economic
activity. For example, if one viewed total economic activity
as resulting from autonomous expenditures in each of the
4/_ Time, Oct. 10, 1969. p. 87.
5/ U.S., Congress, Senate, Subcommittee on Financial Institutions
of the Committee on Banking and Currency, Hearings on S-2499
and S-2577, 91st Congress, 1st Session, 9 September 1969, p. 17.

-5separate sectors of the economy, a variation of expenditures
in any one sector would have an impact on total expenditures
and total income. This is consistent with the fiscal view of
economic stabilization which asserts that an increase in
government spending on goods and services results in an
increase in total expenditures and total income. I do not
mean to imply that all proponents of fiscal stabilization,
however, would recommend the use of selective credit
controls for stabilization purposes.
In contrast to the income - expenditure approach
to economic activity, I hold to the view that the stock of
money is a major influence on total demand and the
course of spending. Preferences for specific goods and
services determine amounts that consumers will spend in
each sector. If specific credit controls or other non-market
controls are applied in any one sector, I believe that any
reductions achieved will be offset by higher expenditures
for other goods and services.
Despite the merits attributed to selective credit
controls, I believe that they are socially undesirable.
I. They are useless in controlling inflation. 2. Most of
the hardships attributed to general monetary restraint are
actually caused by selective controls or self-imposed rigidities.

-63. Selective credit controls are difficult to enforce. 4. They
are biased in favor of the wealthier groups. 5. To the
extent that such controls reduce demand for particular
goods and services, they also reduce national welfare.
6. In addition, they are a restriction on individual freedom.
Selective Credit No Substitute for
Quantitative Controls
The argument that selective credit controls
will restrain inflation is not consistent with the functioning
of our monetary mechanism and the principles of total demand.
Given our fractional reserve system of banking, the volume
of bank credit is strongly influenced oy total reserves and
the reserve ratio requirements. Within limits, total credit
is determined by the Federal Reserve System simultaneously
with the determination of bank reserves and the stock of money.
With fixed reserve ratios, other monetary multipliers, and
a given level of bank reserves, credit restrictions on some
purchases are fully offset by credit expansion for other
purchases. Thus the total stock of money or credit remains
unchanged after application of the restrictions. Money
created by one type of credit expansion is equal in quality
to money created by another type of credit, and total demand is
Even if one subscribes to the idea that monetary
management exercises its influence primarily through the

-7credit market rather than through the money stock , selective
credit controls are not a solution to the problem of excess
demand. Credit restrictions on some purchases will cause
rising demand for uncontrolled goods and services. Prices
for uncontrolled goods will rise faster and resources will,
in turn, flow from the production of controlled to uncontrolled
goods. Output will be enhanced in the uncontrolled sectors
and reduced in the controlled sectors, but prices for all
goods will continue up, assuming excessive credit and
monetary expansion has been permitted.
The argument that quantitative controls are
perverse and create undue hardships in some sectors implies
that the judgment of the controller is superior to market
decisions. To the extent that the controls work, the
controller is essentially transferring to others his own
values as to what the nation should produce and sell. I
contend that the market place can determine with least
welfare loss which goods and services should be produced
at slower or accelerated rates as a result of stabilization
actions. Consumer purchases of goods and services under
aggregate monetary controls are determined by utility at
the margin, thus providing greater welfare than purchases
arbitrarily determined for specific products through
selective credit restrictions. Furthermore, appropriate

-8monetary policies will reduce the wide swings in demand
of recent years. A reduced amplitude of demand fluctuations
would eliminate the unevenness of the effect of controls on
total money and credit.
Credit used for purchasing and carrying common
stocks has been given major attention because of the widespread belief that stock market credit and stock prices
tend to trigger major swings in economic activity. Proponents
of this view contend that speculators, when borrowing to
make stock purchases, bid up stock prices to excessive
levels and the following sharp declines tend to produce
recessions. I believe that both the impact of credit on
stock prices and the impact of stock prices on economic
activity have been greatly over-estimated.
Much of the fluctuation in the stock prices
can be traced to the unevenness of aggregate monetary
controls. Stock prices may be influenced temporarily by
the volume of credit extended for security purchases.
Reverse causation, however, is more likely the case. In
other words, movements in stock market credit are influenced
by changes in stock orices. Statistical analysis tends to

-9demonstrate this reverse causation. —
Causation likewise runs from economic activity
to stock prices. Rather than being an important factor
contributing to the Great Depression as some contend, the
sharp decline in the stock market in the late 20's and
early 30's was mainly the result of a decline in earnings
and in earnings expectations. This outlook for earnings
can be traced to a decline in demand for goods and services,
which can, in turn, be traced to a sharp reduction in the
stock of money.
Carrying the securities market analysis a step
further, we can assume that business capital will expand
according to profit incentives and the cost of capital to

6l_ Statistical analysis of the Standard and Poors 425
Industrials and of the 500 stocks gives better results for the
hypothesis that changes in stock values cause changes in credit
for stock purchases than the reverse causation -hypothesis;
The hypotheses were tested by regressing first differences of
monthly data (stock price indices and credit extended to margin
customers by banks plus customers' net debit balances at member
firms of the New York Stock Exchange) on current and three lagged
periods. The time period used was February 1953 to July
1969. The response of credit to changes in stock values was
positive and significant for the current plus the first and second
lagged month for each index. In contrast, the hypothesis that
stock market credit causes stock prices to rise gave positive and
significant results only in the current period. The coefficients
were negative in the first and second lagged month for both indices.

-10entrepreneurs. If margin restrictions restrain the
opportunity for raising capital through security sales,
business will likely resort to borrowing directly from
financial institutions to meet capital demands. I can
see little difference between making loans to corporations
and making them on securities which represent ownership
of corporations. Furthermore, like other credit restrictions,
if margin requirements alter credit or monetary flows, they
also reduce national welfare as indicated by individual
expenditure preferences.
Apparent Need for Selective Credit Controls
Result of Other Useless Restrictions
Most of the hardships attributed to general
monetary restrictions by advocates of selective credit
controls would disappear if other useless impediments to
credit flows were eliminated. Quite often the alleged
victims of financial market imperfections are actually
the victims of other controls. First, let's look at the
argument that restrictive monetary actions discriminate
against residential construction. Recent studies indicate
that relatively slow rates of monetary growth do not cause
excessive cutbacks in spending on homes. Conversely, all
marked and sustained declines in housing starts began in
periods of rapid monetary expansion after excessive demands

-IIfor goods and services had driven up prices and interest
rates. The sharp rises in costs and interest rates were
the major factors in reducing housing demand, and the
reduced flows of funds into housing during these periods
of high rates can be traced in part to such market
impediments as usury laws, interest rate ceilings, and
other regulations on financial intermediaries. When
market rates reached these imposed ceilings, funds were
diverted to other uses where rates could move to marketdetermined levels.
An additional side effect of this diversion
of credit from its normal flows through intermediaries
is its bias against small savers and borrowers. Small
savers are relatively unable to place their savings in
funds and securities and are relatively limited to controlled
rates. These rates are lower than market-determined rates
and small savers are the losers. Similarly, small-borrowers
are limited to the use of financial agencies for credit, and
when credit dries up here because of rate regulations, small
borrowers are, for all practical purposes, banned from the
credit market. In contrast, large borrowers can oarticipate
in the capital markets through either new common stock
offerings or other securities.

-12Self-imposed rate restrictions by state and local
governments and rate restrictions on public utilities likewise reduce their expenditures during periods of high
market rates. Rather than serving to reduce interest costs,
the restrictions simply serve to postpone the expenditures
until supply and demand conditions for credit cause
market rates to return to levels that these spending
units can or are willing to pay.
Enforcement Difficult
Selective credit controls are extremely difficult
to enforce uniformly among all groups. Enforcement officials

can apply restrictions on a basis of the collateral offered
as security, on the borrower's declaration of intended use
of proceeds, and on the indicated use of proceeds. None
provides a sure test of the use of loan proceeds. If proceeds from loans are commingled with other income such as
salaries, wages, commodity sales, or other funds, one cannot
determine which funds were used for the various expenditures.
For example, if an individual wants to use his salary, wages,
or other sources of income to purchase securities, he may
borrow funds to make home payments or provide for other
living expenses. The borrowed funds are similar to the
other funds and the destination of the respective funds is
difficult to trace.


-13The collateral offered is likewise a poor indicator
of how loan funds are used. Proceeds from loans on common
stocks or real estate may be used for medical payments, to
purchase automobiles, or for numerous other purposes having
no connection with stocks or real estate.
Trade-ins are also a means of by-passing down
payment requirements of selective credit controls.


anything that can be considered a trade-in item, the
prospective buyer and seller can get together and make a
mutually satisfactory deal by setting up a fictitious
down payment which meets both legal and personal
Selective Credit Biased in Favor of Wealthy
Selective credit controls are biased in favor of
wealthy groups and against those with limited assets. Real
and financial assets can always be used as collateral for
loans. From such proceeds down payments on purchases
of controlled items can be made unless each dollar can be
traced to its ultimate use. Furthermore, those with assets
for collateral can avoid instalment credit restrictions
altogether by obtaining commercial credit and purchasing
consumer items with the proceeds. In addition, those with
wealth are also likely to have sufficient cash flows to mingle


-14with Borrowed funds to make fund tracing almost impossible.
Control officiate cannot determine whether the borrowed
money was used for down payments on controlled items or
whether other cash flows were used for such purchases.
On the other hand, those without assets are forced
to use purchased items as. collateral. Thus, to the extent
that selective credit controls serve to retard demand in a
particular sector of the economy, they are a boon to persons
with assets, providing them with products at lower prices,
while those without assets for collateral are frozen out of
such markets until the necessary down payments can be
Selective Credit Control Distorts Resource
Use and Reduces Welfare
Fortunately, most selective controls are not readily
enforceable. To the extent that they reduce demand and
production of goods and services in any sector, they tend
to reduce welfare. The welfare of an individual is
maximized, other things being equal, when he can spend
both proceeds from loans and funds from other sources
without restrictions or impediments. Each expenditure
then provides him with maximum satisfaction at the margin.
On the other hand, the capricious use of restrictions to
alter individual spending, either in the form of higher
down payments or shorter terms, requires consumers to
make less desirable choices. Fewer goods and services


are purchased in terms of their usefulness for the same
level of expenditures. An economy operating under
selective credit restrictions fails to produce an optimum
amount of some goods and overproduces other goods, with
a consequent loss in total welfare.
Selective Credit Reduces Freedom
Equally as important as the economic considerations
is the useless infringement of selective credit controls
on freedom. We can easily moralize as did the Medieval
rulers that the poor should stay out of debt or that someone
should set limits on their loan terms in order to assure
that their credit is used for "appropriate" purposes. It is
my belief, however, that man is happier when subject to
the market forces rather than to abitrary decisions of one
or a few individuals. Freedom did not come easily to mankind,
but we tend to take it for granted. Yet, in most of the periods
since man's early history, he has been forced to bow in
both thought and action to harsh taskmasters. In my view,
we should not take losses of freedom lightly, despite the
fact that controls are imposed upon us only a fraction at a time.
In summation, the current inflation has brought
to the forefront practices and proposals for using selective


-16credit controls to stabilize prices and prevent the allegedly
perverse effects of aggregate monetary restraint.
Despite the possibility that selective controls
may reduce the volume of credit used for specific types
of purchases, they do not achieve the announced stabilization
goals of the controllers. They do not restrain total demand
for goods and services. Dollars created by one type of
bank credit have the same purchasing power and the same
impact on demand as dollars created by another type of
credit. It is the total amount of credit and money created
that determines average prices for all goods and services.
Actually, to the extent that selective controls cause misallocation of resources, they have an inflationary impact.
Selective credit controls are almost impossible
to enforce with equal results among all groups of individuals
and businesses. Their use imposes much greater credit
restraint on the small borrower, who is without other
assets for collateral or large cash flows which can serve
to disguise the actual use made of borrowed funds.
To the extent that selective credit controls are
effective in changing credit flows, they reduce total output
of goods and services and national welfare. Furthermore,
they are an infringement on freedom by imposing restraints
on how one can utilize his credit resources.


-17Last but not least is the fact that selective
credit controls tend to provide their own breeding grounds.
One control must ultimately lead to another as market
forces tend to bypass each new regulation. The proliferation
of ceilings on time and savings deposits is a good example.
First, the ceilings were established uniformly on all
accounts. Then there was a "need" to segregate deposits
by size because of major losses of larger deposits.
Smaller deposits could be paid less under monopolistic
pricing because of lack of alternative investment
opportunities. Rates to small savers were seldom changed.
They remain at levels insufficient to cover the rate of
inflation. Permissible rates on the larger accounts were
raised at intervals as market rates continued up . Observing
an opportunity to capture funds, bank holding companies and
bank affiliates began to issue savings-type instruments
which were not covered by the regulations. Now controls have
been proposed in this leakage area. These attempts to cover
all bypasses are like the man who built a dam to curtail the
normal flow of a stream and discovered a leak. He used his
finger to plug the hole. As water backed up, however, other
leaks were sprung requiring more fingers. The process of
leak springing and finger plugging continued until the
builder ran out of fingers.


-18Infiations can be controlled, but not through
the use of specific controls on arbitrarily selected goods
or services. The solution to inflation lies in the adoption
and maintenance of appropriate monetary policies. It
requires an appropriate rate of growth in the stock of
money. We moved toward a reduced rate of monetary growth
near the end of last year and a still slower rate last June.
I am confident that these actions will soon reduce the
excess demand which was created by overly rapid monetary
expansion in 1967 and 1968.