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STABILIZING BUSINESS AND BANKING STABILIZING BUSINESS AND BANKING Lecture by Dr. Edison H. Cramer, Chief of the Division of Research and Statistics, Federal Deposit Insurance Corpo ration, before the Students and Faculty of the Economics Department, The Citadel, Charleston, South Carolina, February 13, 1958» In discussing the topic, "Stabilizing Business and Banking", I will use economic theory, such as you are studying, and focus it on one of the important problems facing the free world— how to avoid general business depression on the one hand and price inflation on the other. done. Many businessmen and some economists think that this cannot be You will recall that George Humphrey, then Secretary of the Treasury, was reported to have said about a year ago that we might have a depression that would "curl your hair". Professor Sumner Slichter, one of our great economists, advocates a slowly rising price level to avoid depression. There are two main reasons for the belief that capitalism is inherently unstable and subject to alternating periods of depression and prosperity. One of these is the historical fact that it has al ways been that way. Throughout our history, periods of full employment and prosperity have been followed by unemployment and stagnation. These periods in turn have been followed by prosperity, in a round of events that is commonly called "The Business Cycle". The last great depression was in the early 1930's, when millions of people were without work in the midst of vast productive - powers and unused resources. 2 - I do not suppose you are old enough to remember those years, but your fathers and mothers are and they can tell you of the horrors of depression. Then during World War II there was widespread apprehension about our ability to find jobs after the war for the millions of young men in the Armed Forces, and many pre dicted a postwar depression of the first magnitude. As a matter of fact we have had two minor recessions— 19^*8-^9 and 1953-5^. appears that the third postwar downturn is now under way. It Will this develop into a major depression? The other reason for the belief that capitalism is inherently unstable has its roots in the very nature of the economy, with its seeming lack of coordination, direction, and control. In a totali tarian state, basic plans and decisions are made by a few people, and these plans and decisions are directed and controlled by governmental machinery. In a competitive private enterprise economy* the government exercises very little conscious direction and control. Decisions re garding production plans and the operations of factories and other types of producing enterprises are made by a multitude of persons, either on their own account as individual businessmen or as officers of business enterprises. Isn’t it inevitable, some people ask, that these plans and decisions will be poorly coordinated and will result from time to time in the kind of a mess we call a business depression? The question does indeed arise as to how the multitude of decisions by hundreds of thousands of separate business enterprises - 3 - are coordinated so that there is a reasonable degree of order in the economic system. To see how this coordination takes place we need to look at business arrangements for the purchase of materials, the hiring of labor, and the sale of goods and services. Those arrangements, or contracts, are made in terms of prices and premises to make payments in money. The prices represent the number of units of money, in the form of currency or of checks on a bank account, which will be paid for a given amount of material or labor or for a given quantity of goods or services. The system of prices which these contracts produce becomes a kind of impersonal central regulator of the economy. If businessmen make inappropriate decisions and base their contracts upon them, they find that their goods remain unsold or can be sold only at a loss. They discover that other types of goods which are comparatively scarce command relatively high prices. Consequently the prospect of making profits as a result of producing such goods acts as a force inducing businessmen to shift labor and materials to their production and away from making those types of goods which are relatively abundant and have been found to be unprofitable. The prices which eventually govern these decisions of business men are those which individuals are willing to pay for the final products of the economy. As economists have often remarked, consumers cast their votes for some goods and services and against others as they go shopping every day in the market places. Thus the choices and decisions not merely of business enterprises but of all the people, expressed as prefer ences in the market, produce a price system which becomes the governor or - k regulator of production. Professor Wallis of the University of Chicago in a talk before the Citizens Board of the University of Chicago made this statement: ”The price system has two outstanding features. First it is by all odds the most efficient system of social organization ever conceived. It makes it possible for huge multitudes to cooperate effectively, multitudes who may hardly know of each other's existence, or whose personal attitudes towards one another may be indifference or hostility. Second, it affords a maximum of individual freedom and a minimum of coercion. And since people can cooperate effectively in production even when their atti tudes on other issues are hostile, there is no need for unity and conformity in religion, politics, recreation, and language--or even in patriotism and good-will except in the very broadest senses." i f The supply of money. As we think about the importance of prices in this economic system, the question arises in our minds as to why they sometimes get out of Older. We know from experience that in depression, as in time of inflation, prices do not seem to function well as a regulator of our economic activity. Why not? Could it be that there is something wrong with our monetary system rather than with the price system itself? That is to say, is the well-known erraticism in the value of money the cause rather than the result of business instability? Certainly it is worthwhile to examine this hypothesis. In making an examination of this hypothesis we may start with the fundamental economic principle, the law of supply and demand, and ask the question: Is this principle applicable only to the various types of goods and services which are bought and sold In the economy, or is it applicable also to the circulating medium or money which is — Tf Allan Wallis, '"Tbs’Meeibanism o f a free Enterprise Economy,w Marquette Memo, Sept., 1950. - 5 used in Quaking payments and fulfilling contracts? latter question is yes. The answer to the When money is in great supply relative to the need for it, as measured in an appropriate manner, it tends to fall in value each unit becomes worth less and less in buying goods and services; if money becomes scarce relative to the need, it tends to rise in value and fewer units will be required to buy a suit of clothes, an automobile, or a television set. That is to say, a decline in the value of money due to an excessive increase in its quantity is the same as a general rise in prices. This is what we call inflation. Similarly, a rise in the value of money due to a decrease in its quantity is simply another way of describing a general fall or deflation of prices# Neither inflation nor deflation occurs instantaneously. In each case seme prices go up or down and this produces pressure on other prices. Moreover, many prices are fixed by contract or custom or for other reasons are rigid and do not move readily. tortions in the price structure. This creates dis Generally speaking, in inflation these distortions are such as to make business unusually profitable and thereby to stimulate businessmen to feverish activity. Likewise, the distortions of the price structure during deflation tend to make business unprofitable, whereupon businessmen find it necessary or at least expedient to reduce their working forces, thus producing unemploy ment. These remarks on the role of the price system as a governor or regulator of a private enterprise economy, and on the character and impact of inflation and deflation, lead us back to the problem of - ■business instability. 6- If the money supply, which nowadays consists primarily of bank deposits but also includes the currency which ve carry around in our pockets, does not remain stable in quantity with a reasonable increase in line with the growth of the economy, occasional periods of inflation and boom on the one hand, and of deflation and depression on the other, appear to be inevitable. Some economists who have studied the operations of our banking and monetary system have concluded that the banking system has been responsible in the past for many erratic changes in the money supply, and that those changes in the quantity of money have been the basic cause of business instability. Consequently, they have concluded that maintenance of monetary stability with a reasonable rate of growth is the key to economic stability. Bank reserves. If an unstable quantity of money is the leading factor in producing business fluctuations, what forces initiate changes pn the quantity of money? Since bank deposits fora the bulk of the money supply, this is a question of what forces affect bank operations and result in fluctuations in the amount of bank deposits. Without taking time to go into a detailed examination of this question, I will simply say that banks find it profitable to maintain their operations close to the limit permitted by their reserve position. When banks have excess reserves, they can acquire additional assets and thus in crease their incomes; when they have insufficient reserves, they have to dispose of assets even though income is lost in doing so. When banks increase their assets, they automatically increase their deposits; and when they dispose of assets, they thereby decrease their deposits. - 7 That Is to say, the quantity of bank deposits depends almost exclusively on the quantity of reserves available to banks. The only exception to this Is when reserves expand with great rapidity, as in the latter half of the 1930’s, and the sequential expansion by the banks is at a slower pace« Since 1917# Federal Reserve policies have largely determined the amount of reserves available to banks. When the Federal Reserve banks acquire additional assets, the reserve balances of member hanks are thereby increased; and when they dispose of assets, member bank reserve balances are decreased. Moreover, the Federal Reserve banks have enouraous powers of acquiring additional assets, or of relinquish ing assets which they hold; and the amount of assets actually acquired or relinquished is dominantly influenced by the terns set by the Federal Reserve authorities themselves. It follows that if the Federal Reserve Is going to be held responsible for controlling inflation and deflation, it must be left free to set the terms on which it will acquire or re linquish assets. Postwar adjustment. The theory that business fluctuations are the result of inappropriate variations in the quantity of bank reserves and Ik&t these variations in reserves result from Federal Reserve policies is supported by the historical facts that are available* To illustrate, let me review the changes in reserves, prices, and business during and since the beginning of World War II. In 19^2 Federal Reserve authorities announced that the System would provide the banks with all the reserves they might need as a result of increasing their holdings of Government obligations. 8 * During the war years banks acquired a huge volume of Government obligations , and the amount of bank reserves and the quantity of bank deposits increased rapidly. Reserves continued to increase, though more slowly, for two years after V-J day. From the end of 19^1 to the end of 19^7 Federal Reserve bank assets nearly doubled, and member bank reserves, adjusted for changes in percentage requirements and other factors affecting their effectiveness as a base fo r deposit expansion, increased by about 60 percent. She money supply, measured by the Federal Reserve series of 'deposits adjusted and currency”, more than doubled. The money supply expanded more rapidly than effective reserves, because the extraordinarily large gold imports immediately preceding the war penaitted the banking system to enter the war with substantial excess reserves. between This great increase in the money supply 19^1 and 19V? led to sane rise in prices during the war and to a rapid rise when wartime controls were removed. The wholesale price level rose about two-thirds and the consumers price index by about onehalf from the first six months of 19^2 to the first six months of 19UQ. This increase in prices reflects the impact of the excess of monetary expansion over the growth of production. In the latter half of 19^7 and the early months of 1 9 ^ various measures were taken for the purpose of preventing any further increase in the money supply. These measures impinged on bank reserves. By the end of 19^7 the expansion of bank reserves was halted and turned into contraction. Between that date and the end of April 19^*9/ the - 9 - effective amount of bank reserves was reduced by the normal rate of growth. 15 percent relative to Bank deposits also declined substantially though not by so large a percentage. The price level turned down and business activity slackened in the fall of 19^ , several months after the peak in reserves, repeating the typical sequence and lag which pre vailed between the World Wars. By the Spring of 19^9 unemployment became serious, and fears were arising that a serious postwar depression was at hand. At this point the Federal Reserve authorities reversed their pressure on reserves. Early in May they started a series of reductions in percentage reserve requirements, thus stepping the contraction in effective reserves and in deposits. In the summer and autumn business sentiment became more favorable, several of the leading indicators of revival appeared. rDeposits adjusted and currency" increased $k billion during the second half of 19^9 and at the end of the year reached $170 billion, which was the peak in the money supply reached at the end of unemployment reached a postwar high of 19^7 * Early in 1950 ^.7 million and then dropped rapidly and the fear of a deep depression subsided. The Federal Re serve authorities had stopped the wartime inflation and at the same time avoided a depression sufficiently severe to be a threat to our economy. Then in June 1950, the Red forces of North Korea invaded South Korea, and it was decided that the United Nations could not mit the unprovoked act of agression to go unchallenged. per Soon American - 10 soldiers, under the banner of the United Nations, were fighting side by side with the South Koreans. The widespread belief that large government deficits were unavoidable and that they would inevitably result in inflation led to a vast amount of anticipatory and specu lative buying. This, together with hurried acquisition of supplies by the government to pursue a military campaign for which it was unprepared produced substantial rises in the price indexes during the last half of 1950. moreover, the Federal Reserve hesitated to change from the easy money policy it had used to stop the deflation of the year before. Deposits adjusted and currency increased from $170 billion at the end of 19^9 to $177 billion at the end of 1950. Doubtless, during this time the Federal Reserve authorities were weighing the advantage to the Treasury of low interest rates against the evil of inflation if the easy money policy was continued. The famous accord between the Federal Reserve and the Treasury early in 1951 was not fully appreciated at the time. The Joint announce ment on March k, 1951# stated: “The Treasury and the Federal Reserve System have reached full accord with respect to debt-management and monetary policies to be pursued in furthering their common purpose to assure the successful financing of the Government's requirements and, at the same time, to mini mize monetization of the public debt.” This policy of minimizing the monetization of the increase in the public debt meant a continuation of the monetary policies that had been in effect since 19^7» That is to say--provision of enough growth in the money supply to assure full employment in an expanding economy but not enough to result in price inflation. - 11 Events following the accord Indicate that the Federal Reserve authorities have been remarkably successful. reserves Increased 4.0 percent and In 1951 and 1952, effective 5*0 percent respectively. Even though these increases made liberal allowance for the normal growth in the output of the economy, they were small enough to bring to a halt the Inflation in evidence during 1950* The Wholesale Price Index, which was at an all time peak in March of 1951# at 116*5 percent of the 194-7-49 average, slowly declined and was 110*0 percent two years later. The Consumer Price Index, which was also at an all time peak at the time of the accord, continued to increase but at a much slower rate than it had during the last six months of 1950. A peak of 115*4 percent was reached in October, 1953# which was not surpassed for three years. During 1951 and 1952, business was booming and most of the time unemployment was less than 2 million. The presistence of in flationary pressures through these years indicated bank reserves were growing faster than necessary, and the Federal Reserve authorities adopted restrictive policies early in 1953* effective reserves were increased less than For the year as a whole, 2 percent. This stopped the inflation but also brought on the slight recession of 1954— the second one since the end of the World War« Unemployment reached a peak of 3*7 million in March of 1954* Effective reserves were Increased over and deposits adjusted and currency increased from 6 percent in 1954, $200 billion to - $209 billion during the year. decreased. 12 Business quickly revived and unemployment When inflationary pressures again developed, a restrictive monetary policy was called for. For three years now a moderately restrictive policy has been followed, and again inflation has been stopped. Now some sighs point to the possibility of the third minor recession. It is my judgement that it will not be severe enough to be a threat to our economy. For the Federal Reserve authorities are ag^in taking steps to give commercial banks more reserves. With conspicuous stability, business and banking have gone from an all out war economy in 19U 5 to practically all out peace, then to the Korean episode and the cold war. In my opinion, the stability of the economy during these periods of transition demonstrates that the free enterprise system is not inherently unstable. When it is given stability in its medium of exchange, it is extremely flexible and responsive to changing conditions and changing times. Bo far as we can see Into the future, there is good reason to believe that the monetary authorities can continue to use the powers given to them by the Congress in a manner that will result in banking stability, without price inflation, and thus in business stability. TABLE 1 MEMBER BANKING SYSTEM CONDENSED STATEMENT OF CONDITION (In Billions) Liabilities Resources Legal reserves: Required Excess Loans and investments Other assets Deposits Capital funds Other liabilities $ 20.4 0 20.4 $170.0 14.0 3-0 l40.0 26.6 $107.0 $107.0 (1 ) 12 point, from Central bank reduces reserve requirements one percentage to 11 percent. Reserves: Required Excess Loans and investments Other assets Deposits Capital funds Other liabilities $ I8.7 1.7 20.4 $ 170.0 14.0 3.0 l40.0 26.6 flSTTo $187:0 (2) Member banks acquire assets to extent permitted by new reserve position. Reserves: Required Excess $ 20.4 0 20.4 Loans and investments Other assets 155 a 26.6 $202.4 Deposits Capital funds Other liabilities $ 185.4 14.0 3.0 $202.4 Loans and investments increased $15*4 "billion and deposits $15*4 billion. TABLE 2 MEMBER BANKING SYSTEM CONDENSED STATEMENT OF CONDITION (In Billions) Liabilities Resources Legal reserves: Required Excess Loans and investments Other assets 20.4 $ Deposits Capital funds Other liabilities 0 20.4 11*0.0 26.6 $ 170.0 14.0 3*0 $187.0 iiWTïï a) Central bank acquires enough government bonds ($2.1 billion) from non bank investors to permit loans and investments of member banks to increase $15.1+ billion. Reserves: Required Excess Deposits Capital funds Other liabilities $ 20.7 1.8 2^.5 Loans and investments Other assets $ 172.1 14.0 3*0 ik o .o 26.6 $189.1 $189.1 ( 2) Member banks acquire assets to extent permitted by new reserve position. Reserves: Required Excess Loans and investments Other assets $ 22.5 0 22.5 Deposits Capital funds Other liabilities $ 187.5 l4.0 3*0 155*4 26.6 $204.5 $20**.5 Loans and investments increased $15*4 billion and reserves $2.1 billion; deposits increased $17*5 billion. TABLE 3 MEMBER BARKING SYSTEM CONDENSED STATEMENT OF CONDITION (in Billions) Liabilities Resources Legal reserves: Required Excess Loans and investments Other assets Deposits Capital funds Other liabilities $ 20.4 0 20.4 $ 170.0 14.0 3.0 l40.0 26.6 $ 107.0 $ 107.0 a) Central bank acquires enough government bonds ($2.1 billion) from member banks to permit their loans and investments to increase $15 .4. Reserves: Required Excess Loans and investments Other assets $ 20.4 2.1 22.5 Deposits Capital funds Other liabilities $170.0 14.0 3.0 137.9 26.6 $187.0 $187.0 ( 2) Member banks acquire assets to extent permitted by new reserve position. Reserves: Required Excess Loans and investments Other assets $ 22.5 0 22.5 Deposits Capital funds Other assets $187.5 14.0 3.0 155 26.6 $204.5 $20475 Loans and investments increased $15.4 billion and reserves $2.1 billion; deposits increased $17.5 billion. TABLE 5 MEMBER BARKING SYSTEM CONDENSED STATEMENT OF CONDITION (In Billions) Liabilities Resources Legal reserves: Required Excess Deposits Capital funds Other liabilities $ 20.5 0 $ 170.0 15.0 3.0 ' 20.5 Loans and investments Other assets iko.o 26*6 $ 187.0 $ 187.0 (1 ) Central bank lends $1.8 billion to the member banks. Reserves: Required Excess Deposits Borrowed money Capital funds Other liabilities $ 20.5 1.8 2à.é Loans and investments Other assets $170.0 1.8 15.0 3.0 ihO.O 26.6 $18878 $18878 ( 2) Member banks acquire assets to extent permitted by new reserve position Reserves: Required Excess $ 22.2 0 22.2 Loans and investments Other assets Deposits Borrowed money Capital funds Other liabilities $185.5 1.8 l5.0 3.0 155 A 26.6 $20572 $2o5.£ Loans and investments increased $15-5 billion and reserves $1.8 billion deposits increased $15.5 billion and borrowed money $1*8 billion» TABLE 5 MEMBER BANKING SYSTEM CONDENSED STATEMENT OF CONDITION (In Billions) Liabilities Resources Legal reserves: Required Excess Deposits Capital funds Other liabilities $ 20.4 0 $170.0 14.0 3.0 20.4 Loans and investments Other assets l40.0 2 6 .6 $187.0 $107.0 a ) Member banks sell stock or retain earnings to permit increasing loans and investments $15*4 billion. Reserves; Required Excess Loans and investments Other assets Deposits Capital funds Other liabilities $ 18.5 1.9 20 A $154.6 29.4 3.0 i4 o .o 2 6 .6 $ 187.0 $187.6 (2 ) Member banks acquire loans and investments to extent permitted by new reserve position. Reserves: Required Excess $ 20.4 0 Deposits Capital funds Other liabilities $ 170.0 29.4 3.0 20.4 Loans and investments Other assets 15 5 a 2 6 .6 $202.4 $202.4 Loans and investments increased $15 .4 'billion and capital funds $15.4,
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