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For release at 12 Noon
Eastern Standard Time
Wednesday, October 21, 1964




Interest Rates at Home and Abroad
Remarks of George W. Mitchell
Member, Board of Governors of the Federal Reserve System
at the
Annual Convention
of the
Iowa Bankers Association
Des Moines, Iowa
October 21, 1964

Interest Rates at Home and Abroad

My subject is monetary policy and the balance of payments.
It is fashionable, today, to express deep concern for the payments
deficit, as I will, but the worried tone and troubled brow that are so often
displayed may be based on a mistaken diagnosis and a misdirected prescription.
One is reminded of the story of the man who sits at home in his Danish chair,
sipping Scotch whiskey, wearing Italian shoes, with a German car in his
garage, a Japanese camera in his closet and a Canadian bond in his safe
deposit box--while complaining about the gold outflow.
Not so many years ago it probably would have been thought incongruous
for anyone to address Iowa bankers on the topic "balance of payments.1 Des
1
Moines is far from a seacoast or seaway and remote, as well, from the
financial institutions whose expertise in foreign exchange and international
finance accommodates our trade and investment abroad.

And in the past only

in the environment of foreign trading and finance were people thought to be
interested and knowledgeable on the balance of payments.
topic without doubts as to your interest and concern.

Today I choose this

I am confident also

that you can enjoy an informed opinion on the economic policy issues involved
without being swamped or intimidated by the technicalities of international
financial transactions.

These are not, in fact, a prerequisite to an under­

standing of the basic economics of trading and investment beyond the
boundaries of one's own economic community.
Let me illustrate what I mean.

It is not difficult to think of

Iowa as a separate economic community where trading among the citizens and
businesses within the State woajtd ijgasui^e^Iowa's self-sufficiency and trading
i iC \

*

with outsiders would measure lloyafte ^ ^ 0 n)d§nce on external trade.




The

- 2 -

situation differs only in degree when we think of the U. S. as the economic
community, which is exactly what we do when we talk about international trade.
You as Iowa businessmen and bankers know that the standard of
living in this State would fall sharply if Iowans were forced to be selfsufficient and consume only what could be produced within the State.

Many

products and services can be more economically produced elsewhere and imported
into Iowa.

Iowans can buy these products and services because the goods they

can produce advantageously can be sold throughout the U. S. and around the
world.
The balance of payments problem is one of keeping these payments for
goods from the "rest of the world" roughly equal to receipts from sales to the
"rest of the world."

Obviously, that doesn't have to be done in such a way as

to equate sales and purchases exactly for some given period.

If sales (exports)

are larger than purchases (imports) Iowans can build up claims on the rest of
the world which they can invest or spend later on

in a variety of ways.

Or

Iowans can borrow from the "rest of the world" if they want to spend and
invest more than they obtain from the sale of Iowa products and services.
This is one way in which trading transactions are converted into investment
and banking transactions.

But it is not the only way.

You, as Iowa bankers, know that within a given community the demand
for credit and capital is seldom exactly equal to the local flow of savings
from individuals and businesses.

You participate daily in the process of

channeling funds from areas where savings exceed local uses to areas where
local opportunities for profitable investment abound relative to savings.




-3-

Without carrying the parallel further I think you can see there is
nothing in the balance of payments that is alien to your own experience as
an Iowa citizen, businessman, or banker.

The alien part comes in the

solution to imbalances in trading and investment flows when we are speaking
of the State or the Nation.
Within the U. S. no Government agency, high or low, is charged with
policing the balance of payment deficits or surpluses of the country's
hundreds or thousands of economic communities.

Mainly, these adjustments

are accomplished by the use of credit extended through financial inter­
mediaries to businesses, governments, farmers, and individuals.

Over the

longer run, areas in deficit may decline in population and activity, but
just as often the deficit areas are those with the greatest growth rates and
bustling activity.

California is a prime example of an area whose balance

of payments deficit undoubtedly runs back beyond the experience of living
men.

Within the U. S. adjustments can take place without too much hardship

because there are no restraints on labor mobility and people can move where
jobs are, if jobs won't move where they are.

Similarly, investors are

unhampered as to where they put to work new savings and reflows from old
saving.

The workings of a free economic system without direction from

anyone solve the balance of payments "problem."
But when we turn to the balance of payments of the Nation, hoping
that normal economic functioning will provide the same automatic solution,
we are disappointed.

A whole host of problems arises, mainly from the fact

that labor and capital resources cannot flow freely from one country to
another seeking the optimum use.

Moreover, the use of credit as an

equilibrative mechanism is impaired by doubts as to political stability in
other countries and by lack of confidence in foreign debtors1 intentions to repay.




-4-

Thus, in contrast to what happens within nations, imbalances among
nations do not necessarily solve themselves in the best possible way.

They

may require government policies.
This is an important reason for addressing myself to the balance of
payments here in Iowa today.

Monetary policy--the actions of the Federal

Reserve in influencing the money supply, bank credit, and interest rates-affects all parts of the United States.

And monetary policy has, for better

or worse, come to be determined in part by the U. S. balance of payments
position.

How much monetary policy should be influenced by the balance of

payments deficit is one of the policy issues I should like to discuss.
The State of the Economy
The major problem of the U. S. economy in the Sixties, in contrast
to most of the Fifties, has been to achieve full use of our resources.

Too

many men and women have been unemployed and too much plant capacity has been
idle.

This condition has been with us, in greater or less degree, since 1957.

In the last eight years we have had two recessions--one in 1957-58 and another
in 1960-61.

Since early 1961, economic activity has risen without a setback,

although in 1962 and a good part of 1963 the expansion of output and employment
was too slow--barely sufficient to absorb the additions to the labor force and
to plant capacity, but not enough to reduce unemployment and idle capacity.
Only in recent months has it been apparent that progress is being made in
cutting down both on the rate of unemployment and on the margin of unutilized
plant capacity.
Substantial credit for the faster expansion of the economy in 1964
goes to the tax cut enacted last spring.

This historic fiscal policy measure,

through its influence on spending and expectations, has so far been highly




-5successful in speeding up the rate of economic activity without generating
inflationary pressures.
Monetary Policy in the Upswing
While the recent acceleration of the economy is attributable to
fiscal policy, monetary policy can take credit for helping to maintain an
uninterrupted 3-1/2 years of expansion, without the excesses of some previous
upswings in our economy.

Certainly monetary policy differed in 1961-64 from

its performance in 1954-57 and 1958-60.

Instead of a slowdown in money and

credit expansion--accompanied by a rapid advance in interest rates--there
has been a relatively steady growth of money and credit and a remarkable
stability in long-term interest rates.
I do not offer this evidence in the spirit of a testimonial.

It

is not that much of a compliment to the Federal Reserve to say that it was
capable of recognizing a significant change in economic conditions in the
early Sixties and that it adapted its policies to that change.

The fact is

that a monetary policy posture like that of 1957-59 was unthinkable in the
past three years, when, in contrast with the 1950fs, prices were stable and
unutilized capacity was persistently large.

A more useful question for debate

regarding monetary policy thus far in the 1960fs is whether a still easier
policy might not have speeded up economic expansion in 1962 and 1963--before
the tax cut was enacted.
The major obstacle to an easier policy has probably been the U. S.
balance of payments problem.

It was feared that Federal Reserve actions to

encourage a more rapid expansion of bank credit and money supply would
inevitably depress short-term interest rates.

This in turn would encourage

funds to move abroad in quest of higher rates, thereby worsening our
payments position.




-

6-

Now that a more satisfactory rate of economic growth has been
achieved, the question is raised whether monetary policy should not be
directed even more to improving the balance of payments.

Although the

payments deficit this year is lower than last year, the problem is far
from solved.

Let us look, therefore, at the character of the balance of

payments problem and ask ourselves whether a more restrictive monetary
policy is the proper means to cope with it.
1/
The Balance of Payments Deficit""
The first point to be made is that the U. S. balance of payments
deficit is not of the traditional or classical variety and therefore does
not call for the "classical medicine.1 We are not buying abroad more than
1
we are selling, in reflection of an excess of purchasing power in the United
States.

On the contrary, our exports exceed our imports by about $6 billion

per year and this surplus has been rising.

Even if aid-financed exports are

excluded, our commercial accounts show a substantial excess of exports over
* 2/
imports.—
Equally significant is the fact that our export surplus has risen
markedly in recent years.

In part our favorable performance in world trade

is no doubt a result of the relative stability of prices here while prices
have advanced elsewhere, notably in Europe.

In these circumstances it is

1/ The United States leans over backward in measuring its deficit. Because the
dollar is a reserve currency, we have felt it appropriate to follow a double
standard in racking up our assets and liabilities. Thus an acquisition of
dollars by foreigners counts as an addition to our deficit. But when Americans
acquire short-term assets abroad, this does not reduce our deficit. For example,
if Americans place time deposits in agencies of Canadian banks in New York and
these agencies purchase U. S. Treasury bills, our deficit increases. But in
what sense is the U. S. worse off as the result of such a transaction?
2/ In contrast, most of the countries of Western Europe have an import
surplus, financed by earnings on services and by capital inflow.




-7-

reasonable to think that our international competitive position has improved.
But this is a very difficult thing to measure.
Sometimes an effort is made to appraise the ability of our exports
to compete in world markets by calculating the U. S. share of world exports,
or of world exports of manufactured goods.

This approach measures competitive

positions by results; in the process it attributes all changes in relative
trade position to competitive power, whereas there are in fact other
important influences on shares of trade.

A striking example is provided

by the large growth of trade among Common Market countries in the last few
years, as these countries have opened their borders to each other and
increased their exports to each other at a rapid rate.

Between 1959 and

1962, for example, manufactures exports of the Common Market countries to
each other increased more than 70 per cent whereas total world exports of
manufactures rose less than 30 per cent.

Inevitably the U. S. share in the

imports of each of these countries declined.

This indicates not that our

exports are any less competitive but that the six countries are giving
preferential advantages to each others1 exports.
To compensate statistically for this structural development--the
integration of the European Economic Community--it is useful to disregard
exports of EEC countries to each other and to compare the combined exports
of these six countries to the rest of the world with U. S. exports.

When

this is done, we find that the U. S. share of manufactures exports--while
showing a marked decline from the early postwar years--seems to have reached
its low point in 1961 and begun to climb again thereafter.

Such a trend is

consistent with what we know about price movements in the United States and
Europe in recent years.




-8 -

It is safe to say, consequently, that this country--earning a
$6 billion export surplus and holding its own, if not enlarging its share,
in world exports of manufactures--does not have the sort of balance of
payments problem that requires that we either change our exchange rate or
reduce our imports by slowing down our economy with a restrictive monetary
policy.
Rather we find that our problem lies in our capital transactions
with the rest of the world.

What is happening is that we are transferring

to the rest of the world in the form of military outlays, foreign aid, and
especially private loans and equity investments a sum of dollars larger
than our export surplus.

The excess of dollar payments abroad accounted

for by those sources is the usual measure of our deficit.
If, for example, an American purchases a foreign 20-year bond and
the foreign seller places the proceeds in a U. S. bank, it is true that our
liquidity position has worsened--for we have increased our short-term
liabilities along with our long-term assets.

To a large extent our balance

of payment problem can be described in this way.

Our international balance

sheet has, in fact, been strengthening, since our foreign assets have been
increasing more than our liabilities.

But our liquidity position has been

weakening, since our short-term liabilities have been rising more than our
short-term assets.

This produces a problem, to the extent that foreign

countries are dissatisfied with being on the other end of the process.
A businessman knows that if he incurs short-term debt in order to
increase his long-term assets he improves his position and may even be
U's
tin
quite comfortable as long as
If, however, his creditors be
squeeze.




-9-

Thus our problem is not that we are dissipating our resources.

We

are not "living beyond our means.1 We are, rather, lending and investing
1
abroad in larger volume than our export surplus can support and are, there­
fore, increasing our short-term liabilities at a larger rate than some
other countries are willing to acquire them.
Government Expenditures Abroad and Private Capital Outflows
It is useful to dissect a little further the Government and private
capital transactions that account for our balance of payments problem as I
have just characterized it.
The Government share consists mainly of military expenditures abroad
and foreign aid.

These programs are based on broad political judgment

involving the national interest and I shall not attempt to justify or explain
them in detail.

What is most relevant for us is that both these types of

expenditure have been so managed in recent years that they generate a
decreasing net flow of dollars to foreigners.

Military outlays are being

offset in various ways and foreign aid is being tied to U. S. exports.
If we turn to examine private capital movements, we find that there
has been, since the mid-fifties, a large increase in both direct investment
abroad and in loans and credits to foreigners.

For this development there

are various explanations.
American firms have found attractive investment opportunities
abroad--in raw material supplies and in recent years in manufacturing
facilities in Western Europe.

Higher interest rates at home would do little

to discourage such investment abroad.
Other forms in which U. S. private capital flows abroad include
new issues of foreign securities in the United States, purchases of out-




-10-

standing foreign securities and money market assets by Americans, and bank
loans and acceptance credits to foreigners.

It is these types of outflows

that have increased substantially in recent years.

And because some of

these flows are thought to be sensitive to interest rates--or to differentials
between interest rates here and abroad, or to differences in the availability
of funds here and abroad--the major controversies regarding the connection
between monetary policy and the balance of payments have centered around
these types of transactions.
The following questions are raised when we begin to focus on
these capital movements: to what extent do they respond to differences in
interest rates; what would be the cost to the domestic economy of an increase
in interest rates sufficient to restrain these capital outflows; are there
alternative methods of discouraging these outflows; would the alternative
methods be more or less objectionable than higher interest rates?
Factors Affecting Private Capital Outflows
Some of those who favor an increase in U. S. interest rates as a
means of improving the balance of payments seem to assume that domestic
borrowing and spending are quite insensitive to interest rates while
international capital flows are quite responsive to interest rates.
this judgment, I disagree.

With

The only way general monetary policy can

substantially cut down on foreign loans and investment is to raise the
entire structure of U. S. interest rates toward levels prevailing abroad.
This would require a tightening in U. S. monetary policy--possibly a drastic
tightening--with serious braking effects on the rate of domestic spending
and income.




-11-

If the U. S. economy were presently subject to excess demand and
inflationary pressure, the story would be quite different.

In that case,

a monetary policy posture appropriate to domestic conditions would also
help the balance of payments by discouraging capital out flows--assuming
that other countries did not raise their interest rates correspondingly.
But as long as there continues to be slack in the economy, a significant
increase in interest rates designed to curb capital flows would have the
unhappy effect of slowing down domestic expansion.
Now there are some observers who take an overly mechanistic view
of our payments problem and claim that capital outflows are the result of
excessive money creation, which seeps out across our borders in search of
higher earnings abroad.

All we need to do, according to this approach, is

to cut down the extra monetary and credit expansion and the outflow of
capital will be taken care of.

It seems to me that this is like saying

that the way to deal with a leak in a garden hose is to shut off the water.
This approach really assumes that a substantial part of foreign
loans and investments by Americans are marginal--that is, they are at the
bottom of the list of preferred borrowers--so that a reduction in the
availability of credit and money would result mainly in less lending to
foreigners, with little effect on the domestic availability of funds.
I have already indicated that direct investment abroad would probably not
be cut significantly--it might even increase--if money were tightened
severely in the United States.

And there is no reason to assume that

American banks and other lenders would cut down on foreign loans first
if their total lending capacity were reduced.




-12-

Those who call for restrictive monetary policy as a means of
dealing with capital outflows sometimes seem to assume, wrongly, that the
United States is merely one among numerous equally-situated countries and
that the push and pull of the forces acting on capital flows are similar
everywhere.

From this they deduce that relative changes in interest rates

are the major influence on capital movements.
capital and money markets are unique.
accessible in the world.

The fact is that the U. S.

They are the largest and most

By virtue of our size, our huge flow of savings,

and the efficiency of our banking facilities, borrowers abroad have many
incentives to seek funds in our markets and from our banks.

Often they

tap our markets not because they need dollars as foreign exchange but as
a means of circumventing credit restrictions in their own countries.

And,

let us remember, the freedom to borrow in our markets is not matched by
similar freedom in other industrial countries.

In Europe and Japan, either

governmental restrictions or exceedingly high interest rates prevent the
free movement of money and capital and lead to a concentration of world-wide
borrowing demands on the U. S. markets.
It was in reaction to this asymmetrical situation, which induced
a flood of foreign security issues in New York in 1962 and 1963, that
President Kennedy proposed the interest equalization tax in July 1963.

This

tax on American purchases of foreign securities has been quite effective-and was so even before its enactment--in raising the cost of foreign long­
term borrowing here without raising long-term interest rates to domestic
borrowers.
This tax seems to me a useful example of the selective approach
to our capital outflow problem.

It is impersonal, avoiding direct rationing,

and relying instead on the price system.




But, most important, it fits the

-

13-

prescription to the disease; it doesn't amputate the leg because an ankle
is dislocated.

And, it should be noted, the tax applies only to U. S.

purchases of securities of industrial countries.

It does not discourage

the flow of U. S. capital to those areas--the less developed countries-that are in real need of productive capital from abroad.
The success of this tax should now lead us to explore similar
techniques for discouraging, as and when necessary, other forms of capital
outflow to industrial countries.
movements as a long run policy.

We do not want to discourage free capital
On the contrary.

Moreover, it is most

appropriate that an advanced industrial country like the United States-and like countries in Europe--should export capital to developing nations.
Capital movements among industrial countries also serve fruitful purposes.
But capital movements can at times be perverse--aggravating rather than
contributing to international balance.

When this happens the continuation

of completely unhampered capital flows may impose a very high cost--namely,
unduly restrictive policies that discourage economic expansion.

This is

why we need to have at hand acceptable devices, like the interest equaliza­
tion tax, to reduce such flows when they threaten to force upon the United
States a monetary policy inimical to the healthy expansion of its economy.
Meanwhile, it is to be hoped that other industrial countries will
take measures, as urged by Secretary Dillon, to develop their own capital
markets, so as to reduce the asymmetry I have referred to.

Better developed,

more accessible, and lower cost capital markets in Europe would make it
possible for these countries to supply their own domestic capital needs,
as is called for by the stage of advancement they have attained.




It would

-

14-

also, and this is equally important, provide a means for other industrial
countries to increase their export of much needed capital to semi-industrial
and less developed countries.
Concluding Remarks
I hope it is clear that what I am preaching is not economic
isolationism.

I recognize the important and reciprocal relationship

between the United States and the rest of the world.

And, though I believe

we could improve, analytically, our way of looking at the balance of payments
deficit, obviously a payments problem remains.
Furthermore, I agree with those who would attack the problem with
monetary policy to the extent they imply that the correction must come mainly
in the capital accounts*

But to discourage capital outflows by raising the

entire structure of U. S. interest rates--and they would have to be raised
substantially to solve the problem--at a time when we are still a considerable
distance from full use of our resources seems to me to be unwise policy.

The

cost in terms of domestic output, income, and employment would outweigh the
benefits in terms of better-balanced international accounts.
For these reasons, therefore, further exploration of the potentiality
for selective approaches to regulating capital flows is very much in order.
These techniques, like the interest equalization tax, would be available,
when needed, to reduce the incentive for such outflows.

This is precisely

the purpose of those who would accomplish it through monetary policy.

The

advantage of selective approaches is that they would permit us to follow,
as appropriate, a monetary policy conducive to high and growing output and
stable prices at home.




-

15-

Controversial issues often lead to an appeal to "look at the facts."
It isn't always easy to get at the relevant facts and just any facts won't do.
Data on the balance of payments are more elusive than most, partly because
their policy conditioning function is not more clearly defined.
Let me end, as I began, with a reference to the Iowa economic
community.
mind.

If we turn back to that parallel we need to keep two facts in

The first essential fact should tell us whether we are buying more

goods and services from outside our community than we are able to sell to
outsiders.

Here we get a clear answer; our sales exceed our purchases by

about 25 per cent--a very sizable surplus.

But this bare fact needs

some qualification--a substantial part of this surplus arises from the fact
that much of our foreign economic and military aid is extended in kind,
directly or indirectly, and this swells our export surplus--i.e., the
surplus in our trading position is larger by virtue of our tied aid program.
But our best estimates--and they are of necessity estimates--indicate that
we would still enjoy a substantial trading surplus without tied aid.

And

that surplus means we are not "living beyond our means."
The second essential is comparable to a question that you as an
Iowa banker might ask a businessman with respect to his balance sheet.

Knowing

that his receipts are larger than his disbursements you want to know what he
is doing with the retained earnings and what he may be doing to expand the
scope of his operations.

If we look at the analogous data on the U. S.

international position we would see that in the past four years we have
invested on a long-term basis an average of $4-1/2 billion annually abroad.
This means that we are plowing our earnings into an expansion of our




-

holdings of foreign assets.

16-

The Department of Commerce estimates that our

total public and private assets abroad at the end of 1963 were $88 billion,
which is almost $17 billion greater than it was in 1960.
But once again these facts need some amplification.

True, our

foreign assets are growing, but what about the composition of those assets
and what about the composition of our liabilities?

American acquisition

of equities through direct investment or purchase of foreign stocks has
been the outstanding development of recent years.

But, in addition,

American financial institutions have been lending large amounts to finance
trade, not only between the U. S. and other countries but among other
countries.

And U. S. institutional and non-institutional investors have

been buying foreign bonds.
All in all we have been investing abroad more than our trading
surplus could cover.

We have, therefore, been borrowing abroad in one way

or another to do so.

Some of the lenders who have been accommodating us

seem reluctant and others do not like the terms.

This, then, is the point

at which our balance of payments deficit has become a problem.
You as bankers recognize, I am sure, that for these conditions
no single cure-all is likely to be at hand and that drastic remedies require
cautious use because of possible undesirable side effects.

But it seems

realistic to me that any lender would want to see only those steps taken
that would preserve the health and good will of a valuable customer.