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Remarks by
Henry c. Wallich
Member, Board of Governors of the Federal Reserve System
at the meeting of the
National Association of Real Estate Investment Trusts
Thursday, June 6, 1974, 12:30 P.M.
at the
International Club
Washington, D.C.

Remarks by
Henry C. Wallich
Member, Board of Governors of the Federal Reserve System
at the meeting of the
National Association of Real Estate Investment Trusts
Thursday, June 6, 1974, 12:30 P.M.
at the
International Club
Washington, D.C.

-------------------------------------------------------------------I am glad to have this opportunity to speak to members of
the National Association of Real Estate Investment Trusts.


Buffington, whom I have known for many years, has pointed out to
me the importance of a free flow of communication at a time when
financial pressures have mounted.

Under such conditions, it is

sometimes useful to stand back a little from the problems of the
day and to look at the course of events in a broader perspective.
That is my intention here today.

At the end of my remarks, I shall,

of course, be glad to listen to anything you may wish to tell me
about the current problems in your industry.
Real estate investment trusts are part of the great wave
of financial innovation that has been in evidence since the early

The design of new technologies is not the exclusive province

of scientists and engineers.

There are important inventions also in


the field of finance.

Properly designed, and managed with care,

they add to the economy's productivity and to the general welfare.
Innovation, however, also involves risks.

Since risk is

not easy to evaluate in advance, we must rely heavily on past
experience and on trial and error.

Past experience suggests that

the willingness to accept risk increases so long as there are no
adverse consequences.

This process involves the danger that the

outer margin of acceptable risk will be approached too closely,
leading to difficulties and to losses, and to a subsequent withdrawal from unduly exposed positions.

Our financial history

records more instances of this process than should have been
For financial institutions that are new in their basic
conception, the problem of judging risk and avoiding excessive
degrees of exposure is particularly difficult:

For each member

of such a group, there may be a temptation to observe what the
others are doing, each institution assuming that it is in safe
condition so long as it is not out of line.

This may be a workable

rule of thumb so long as conditions in and outside the industry do
not change.

But there are two developments with which a new

financial industry that cannot rely on experience derived from a
long history must reckon.



One is the effect of competition.
tions attract followers.

All bright new innova-

A rate of return that originally may have

been well above average is likely to be worked down over time to
no more than what prevails elsewhere.

And secondly:


conditions change with the business cycle, and sometimes with
longer term trends.

During each cycle, typically, financial pressures

tend to rise to some peak and then to subside.

Financial institutions

must be geared to meet the tests posed by these peaks, whatever
their nature may be.
are predictable.

The general contours of this testing process

The. particular circumstances and intensity, of

course, are not.
These problems become compounded if the economy enters
into a stage of severe inflation.
ship of costs and prices.

Inflation distorts the relation-

Real estate investments are among the

most durable of all investments, and also among those where a
precise calculation of future costs and returns is of particular

Inflation plays havoc with these calculations, insofar

as they relate to wages, materials, and expected receipts from an

In the longer run, of course, inflation may benefit

earlier investments by raising the cost of new ones.
Inflation can become even more disturbing by its impact
on interest rates.

All interest rates tend to rise during inflation

as investors seek to protect themselves against loss of purchasing

power while borrowers, anticipating gains from rising values of
assets, feel that they can afford to pay more.

In addition, however,

inflation tends t? twist the relationship between short- and longterm rates.

So long as the markets believe that inflation will be

brought down, long-term interest rates will not fully reflect the
current inflation.

They will be held down by the anticipation of

lower inflation rates and interest rates in the future.
rates are a different matter.


They will tend to reflect principally

current conditions of supply and demand in the financial markets.
They may reflect the going high level of inflation.

Thus they may

well reverse the more usual relationship which, at least according
to experience since the 1930's, has registered short-term rates
below long-term.

For institutions whose interest earnings are in

some degree inflexible, the implications are obvious.
Inflation, it is sometimes said, favors the debtor and
hurts the lender.

But financial institutions are both lenders and

The impact upon them of inflation is unpredictable,

depending on the maturity structure of their assets and liabilities.
Once inflation has reached the levels we are now observing,
its influence on interest rates begins to outweigh that of other
forces, including the central bank.
to halting an inflation.

Monetary policy can contribute

In that way, it can exert a lasting

influence on interest rates.

Any other influences, exerted through

the usual channels of money and credit are likely to be short lived.


Moreover, as I will explain, these short-term influences unfortunately
tend to work in the wrong direction in the longer run.
In the face of strong credit demand which tends to drive
up interest rates when bank reserves are being expanded at a
moderate rate, it is sometimes argued that the resulting market
pressures could be eased by supplying reserves in larger volume.
For a short period this may indeed have the desired effect.


with some lag, a more rapid rise in money is likely to lead to a
more rapid rise in prices.
interest rates.

Faster inflation in turn means higher

In such an inflation there is no way by which

a centrnl bank, through what is called an
can bring rates down lastingly.


easing" of credit,

It can only cause the same problems

and pressures to repeat themselves at still higher levels of inflation and interest rates.
bring down inflation.

The way to achieve permanent relief is to

Unfortunately, this means that the economy

must pass through a period of possibly intense pressures in
financial markets.

There is no other way.

It is the price we must

pay for not having worked as hard as we should have to hold down
inflationary pressures in the past, and for yielding to the temptations of large-scale government spending and too ready creation of
money and credit.

At the same time, we must avoid the risk of

excessive restraint that could bring recession and unemployment.


It should come as no surprise that in a period when the
money supply and credit have been rising at higher rates than in
past periods of relative stability, the need for credit should be
greater than ever.

Inflation itself creates the demand.

Corporate profits have increased statistically, and the cash flow
from them might be expected to take care of good part of financial

But the

underlying facts are otherwise.

good part consist of inventory profits.

Profits in

These are not available

to meet financial demands, because they are already embodied in


To the extent that they generate tax liabilities, they

have a negative influence on liquidity.

Part of the recent rise in

profits is being earned abroad and is not necessarily available for
the domestic needs of American business.

Thus it is not surprising

that the demand for credit has been strong.

The banking system has

met it, at rising interest rates.
Liquidity problems, fortunately, by their nature tend to
be temporary.

Restraint on liquidity restrains inflation, and

diminishing inflation in turn reduces the demand for liquidity.
a more enduring sense, it is solvency that matters.


Our present

experience, to be sure, suggests that there may be exceptions to
the familiar view that solvency also guarantees liquidity, on the
grounds that a solvent institution can always find money.


moreover, can convert what started out as a liquidity problem into
a solvency problem.

The lesson for the future is plain:

it is not

sufficient to seek to assure solvency by observing appropriate ratios


of equity and subordinated capital to liabilities.

Assured methods

of financing will have to be secured if solvency is to be translated
permanently and reliably into liquidity.
The degree to which financing can be assured depends on
a variety of factors, among them the proportion in which short-term
borrowing takes the form of borrowing from the money market and
from commercial banks or other institutional lenders, respectively,
and the extent to which borrowings from the money market are backs topped reliably by credit lines extended by which lenders.


open money market knows no close or permanent relationship between
borrowers and lenders.

It can function efficiently only if punctual

payment is assured beyond the shadow of a doubt.

That is why this

type of financing often is cheaper than borrowing from an institutional
A borrowers relationship with an institution is different.
The lender has, or should have, in depth information about the

The expectation of a continued relationship justifies an

effort on the part of the lender to accommodate the borrower and,
within the limits of prudence, the acceptance of some degree of
The responsibility of lending institutions, such as
commercial banks, can be envisaged as going beyond those arising
from the lender's relationship to any one particular borrower.


The lender has an interest in the proper functioning of the
credit system as a whole.
any single institution.
to all.

No man is an island, and neither is
What happens to one affects and matters

Troubles developing in any individual credit relationship

affect, however remotely, other similar relationships.

To realize

this and to act upon it, prudently but with an understanding of
this enlightened self interest, is what has sometimes been called
financial statesmanship.
Large and small lenders may well have different responses
to the call for statesmanship.

A small institution rarely can, by

its own individual action, influence significantly the general
course of events, the state of the markets, the preservation of

Large lenders have greater scope.

Their decisions

may at times significantly influence the tone of the market and
the state of confidence.

The example of one large lender may set

a pattern for other institutions.

In our financial framework, in

which bigness is sometimes viewed with misgivings, one of the possible
compensations for the concern it arouses, as I see it, is the ability
to demonstrate financial statesmanship.

As our banks continue to

grow, and as their activities expand into wider areas, they are, in
my view, also incurring greater responsibilities.

I find it difficult

to see a justification for increasing command over resources unmatched
by acceptance of a greater obligation for financial statesmanship.


The institutions of the private sector are not alone in
carrying a responsibility.

In every mature financial system, the

central bank traditionally has accepted the role of a lender of
last resort.

This role, of course, describes a responsibility for

the functioning of the financial system as a whole, not for the
welfare of particular institutions.

Moreover, in its role as a

lender of last resort, the central bank deals with problems of
liquidity, not of solvency.

And its ability to provide liquidity

must remain circumscribed by the need to avoid inflationary

A central bank has responsibility for preserving

the strEngth of the currency, domestically as well as internationally.
Neither private nor public financial arrangements and
policies can guarantee success if the economy which they seek to
serve is lacking in fundamental strength.

I have great confidence

in the strength of the American economy, and I believe that events
so far have given evidence of this strength.

The economy has been

subjected to shocks of an unprecedented kind and severity.


energy shortage, our food situation, the international value of the
dollar, our domestic price level all have subjected us to severe

Yet the economy appears to be absorbing these shocks and,

after retreating for a few months, appears to be ready to resume
its earlier pattern of progress and advance.

There has been a questioning of the prospects for future

It has been argued that we are approaching limitations of

supplies of all kinds, constraints imposed by the environment,
impediments to the continuation of trends that have been going
forward for centuries.

I see very little evidence of any such

There are some changes ahead that do seem plausible.

They are imposed by responses to the rising cost of energy,
possibly changing supplies of raw materials, changes in population

But as I look at these prospective changes, they do not

seem to dim the outlook for future growth.

They do point to the

need for massive investments in productive capacity, in equipment
of all kinds, and particularly in construction.

carrying out these

investments will make great demands upon the willingness of the
American people to save and thereby to supply investable resources.
They will also make great demands on, and provide great opportunities
to, our financial system.

The economy's need for the kind of invest-

ments that your industry helps to finance will continue to grow.
Growth will generate demand of consumers for goods and services
of all kinds, with a rising emphasis, very probably, on durable
goods such as housing and consumer goods made with the help of large
capital installations.

Some investments no doubt will turn out to have

been ill advised in the future, as has sometimes happened in the past.
But in a broad view, I believe that confidence in the American economy,
and investments made that rest on this confidence, will prove justified.