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FOR RELEASE CO' DLLIVERY
THURSDAY, OCTOBER 30, 1975
1:00 P.M. EST




INFLATION AND LIQUIDITY
Remarks by
Henry C. Wallich
Member, Board of Governors of the Federal Reserve System
at the
Symposium on Liquidity
of the
National Association of Accountants
in
New York City
Thursday, October 30, 1975

INFLATION AND LIQUIDITY
Remarks by
Henry C. Wallich
Member, Board of Governors of the Federal Reserve System
at the
Symposium on Liquidity
of the
National Association of Accountants
in
New York City
Thursday, October 30, 1975

My topic today is inflation and liquidity.

In dealing with this

subject before a group of accountants, whose work calls for a higher
degree of precision than usually is required or expected of
economists, it seems appropriate that I address myself first to
the liquidity problems of the individual firm, which can be
examined in full detail.

I shall turn later to the macroeconomic

relationships that are the stock-in-trade of monetary economists
like myself.
My specific concern will be with the impact of inflation
upon liquidity.

Inflation has been defined as too much money

chasing too few goods.

That would suggest that inflation is a

condition of excessive liquidity.

At the corporate level, as we

all know, that is far from the truth.




We have

aLl observed how

-2 -

the inflation of recent years has in fact severely drained corporate
liquidity.

It has done so through a variety of channels.
Inflation has caused corporate profits to be overstated,

through inventory profits (except for firms on LIFO) and through
underdepreciation.
flow.

Neither form of pseudo-profits generates cash

Inventory profits must be reinvested in inventory if the

firm is to maintain its scale of operations.

Underdepreciation

yields no cash because depreciation charges only affect the

allocation

of the current gross cash flow without affecting the flow itself.
The pseudo-profits thus created by inflation nevertheless
have consequences that indeed influence liquidity.

Most obvious

among them is the reduction in liquidity through added taxes except,
as noted, in the case of LIFO inventory.

Beyond that, however,

there are more subtle effects such as the temptation for unwary
directors to pay out some part of these supposed profits in higher
dividends.

Such "profit illusion" may also induce labor and

management to reach higher wage agreements, and may predispose
management to price unrealistically, that is, to allow true profit
margins to shrink, as has happened in recent years.
When inflation is accompanied by price controls, as it
has been temporarily in the United States, it may drain liquidity
away from business if the controls do not allow a full pass through
of mounting costs.

This seems to have been a more important factor

in British inflation than in American.




-3At the present time, we have two major accounting devices
that tend to compensate for the dehydrative effects of inflation:
LIFO for inventories, and accelerated depreciation for fixed assets.
Both help economize taxes and, by presenting a more realistic picture
of profits, tend to encourage conservation of liquidity through more
realistic dividend, wage, and price policies.

With respect to taxes,

however, both entail deferral only, not forgiveness.

Taxes on

appreciated inventories become due when a company has to reduce its
inventory (or some pooled part of it), while taxes postponed owing
to accelerated depreciation become due if the firm reduces its
scale of annual investment.
This arrangement, awkward as it is, nevertheless seems
to me to contain an element of essential tax justice.

Inventory

profits and profits from rising replacement cost and hence rising
current value of fixed assets represent, after all, an increase
in the net worth of the firm and should be taxed.

Of course this

is true only to the extent that the growth in net worth exceeds
the rate of inflation —
real terms.

up to that point there is no gain in

At the same time, these gains on inventory and fixed

assets represent not ordinary income, but a capital gain.

Even though

technically realized when inventory is turned over or fixed assets are
used up, the gain remains unrealized economically so long as the firm
needs the inventory or the annual investment in order to maintain its
scale of operations.

It has been a rule in our tax system that capital

gains are taxed only when realized.




-4The principal drawback of using accelerated depreciation
as a substitute for replacement cost depreciation is that, at high
rates of inflation, depreciation must be accelerated very sharply
indeed in order to hold taxes down to the level corresponding to
true replacement cost depreciation.

This makes accelerated methods

look like a major concession to business when they may barely
enable business to maintain its equipment.

The investment tax

credit, to the extent that it merely offsets underdepreciation ,
creates an even more exaggerated picture of favors to business.
The accounting profession is now coming forward with
various techniques designed to overcome the distorting effects of
inflation on corporate balance sheets and income statements.

In

the United States, the Financial Accounting Standards Board (FA.SB)
has published its exposure d r aft 9 Financial Reporting in Units of General
Purchasing P o w e r , for comment.

If the FASB proceeds with its proposal,

every enterprise will have to file supplementary information on this basis
in its annual report.

In England, the Sandilands Committee has published a

report, Inflation Accounting, recommending another and quite different set
of adjustments which would require major British corporations to publish
their regular corporate reports in accordance with the principles of
current cost accounting.

In Australia, the Mathews Committee (Committee

of Inquiry into Inflation and Taxation) has published a report.

Meanwhile,

the U.S. Securities and Exchange Commission (SEC) seems to favor replace­
ment cost accounting in the footnotes to financial statements.

The Cost

Accounting Standards Board also has put out tentative proposals on
depreciation.




-

5-

I shall make a few brief comments on some of the general
principles involved in various adjustment
they affect liquidity.

techniques, so far as

I must note right at the outset, however,

that this may not be their most significant aspect.

A. more

fundamental question, it would seem to me, is whether the adjusted
statements are to serve for the assessment of corporate taxes, in
lieu of statements derived by conventional accounting principles.
So far as I know, neither the FA.SB nor the Sandilands Committee
propose such a drastic change, which of course would require massive
changes in the tax laws.
Absent such use for tax purposes, the adjusted accounts
would principally serve to enhance the understanding of corporate
management, directors, labor, and the public concerning the true,
or at least more nearly true, state of corporate profits.

With the

tax law remaining unchanged, the principal effect of such
enlightment should be more realistic policies with respect to
dividends, prices, and wages, as well as with respect to investment
in inventory and fixed assets.
The restatement of "nonmonetary11 assets and liabilities
in terms of constant dollars, which is the first i&ajor step in
the adjustment proposed by the FASB, typically -- though not
necessarily -- leads to a reduction in stated profits.
major step —

The second

adjustment of the profits figure so derived by the net gain

or loss from the firmfs net debtor or creditor position -- produces




-6 -

an inflation profit for firms that are net debtors, i.e., whose
monetary liabilities exceed their monetary assets.

Nonfinancial

corporations usually, though not necessarily, are net debtors.

This

gain, of course, rises in step with the net debtor position, which in
turn tends to rise with the degree of leverage in the fir m fs capital
structure.
As an example, application of the technique by Davidson and
Weil to the thirty Dow-Jones Industrials had the effect, in the first
step -- constant dollar adjustment —

of reducing the reported profits

of the median firm to 64 per cent of reported profits.
step —

involving the net debtor position —

The second

brought adjusted profits

back to about 88 per cent of reported profits, with wide variations
among companies.

For a sample of 44 other major corporations studied

by Davidson and Weil the corresponding figures were 72 per cent and
93 per cent, again with a wide range.
It is particularly noteworthy to see, from the work of
Davidson and Weil, that the profits of utilities after the two adjust­
ment steps, thanks to their heavy leverage, often far exceed reported
profits*

Since the verdict of the stock market clearly has been that

utilities have not fared well in inflation, the FASB approach seems to
be somewhat at odds with the views of the market.
My purpose here is not, however, to comment on the F A S B fs
approach and its usefulness in general.
upon liquidity.




It is to examine its impact

Clearly, since monetary items, which represent the

-7main elements of liquidity, are not adjusted for balance sheet
purposes, and since taxes paid are not affected, there is no direct
liquidity effect.

The impact is indirect, vi a the effect of

restated profits on corporate policies with respect to dividends,
prices, wages, and on the scale of corporate operations that flow
from the perception of these profits.
The perception encouraged by the FASB technique is that
unrealized capital gains are profits just like other profits.

But

while the firm indeed is richer, it is not richer in cash, and it
generally cannot convert any of its unrealized gains into cash if it
wants to continue its scale of operations.

As far as liquidity is

concerned, therefore, restated profits are likely to be almost as
misleading as the profits that are actually being reported.
A realistic statement of profits, from the point of view
of liquidity, in my opinion, would be to keep the gain from the net
debtor position out of the profits account and to carry it to a
reserve account.

This broadly is the approach of the Sandilands

Committee, which, moreover, bases its adjustments not on the
general rate of inflation, but on a revaluation related to current
cost.

In addition, the Sandilands Committee recommends a sources

and uses of funds statement, to alert readers to the liquidity needs
of the firm.

The approach reflects the principle that the enterprise

should be protected as an operating entity.

The restatement of

profits should not require or encourage payment of taxes or dividends
that, for reasons of price movements alone, would interfere with the
continued operation of the business.
persuasive.




I find this basic philosophy

-8 -

Let me briefly apply the principles of the FASB to the
banking industry.

It is here that, in my view, the approach has a

good deal of validity because it reveals that inflation has affected
the profits of banks in a way that is not shown up by conventional
accounting.

In the case of banks, whose principal assets and

liabilities are monetary, there is little scope for the various
adjustments relating to nonmonetary assets and liabilities.
Instead, there is one major fact:

most banks are in a net creditor

position, in contrast to the typical nonfinancial corporation which
is a net debtor.

The reason, of course, is that b a n k s 1 monetary

assets exceed their monetary liabilities, capital being treated as a
nonmonetary " l i a b i l i t y T h e capital of banks, being invested in
monetary form (except perhaps for the b a n k s 1 own building and the
like) suffers from inflation.

Some banks* profits, which have

seemed to increase in recent years, are found to look a good deal
less favorable.

It will take substantial current earnings to

make up for the injury that inflation has been inflicting upon
bank capital.

The liquidity of the banking system, however, is

not affected by these considerations.
I now would like to turn to some broader aspects of
liquidity.

Y o u of ten bear it said that it is the central b a n k fs

function to supply liquidity to the economy.

If this statement

is interpreted to mean that the central bank, by increasing the money
supply, thereby increases liquidity, it becomes very misleading.




-9an inflationary environment, and especially one where inflation
unfortunately is deeply embedded in peoples1 expectations, an increase
in the money supply, or in its rate of growth, increases liquidity
only until prices begin to respond.
reduces liquidity.

Inflation, as we have seen,

The ultimate effect -- and not so very ultimate --

of more money, therefore, paradoxical though it may seem, is less
liquidity rather than more.
Lasting liquidity can be achieved only through appropriate
policies and conduct of individual decision makers -- business firms,
financial intermediaries, and households.

Ever since World War II,

business firms have allowed their liquidity to decline.

That is true

whether we measure liquidity as the ratio of liquid assets to short­
term liabilities, or to corporate gross product.

The ratio of liquid

assets to short-term liabilities has declined from 59.4 per cent in
1950 to 23.6 per cent at the end of 1974.

Relative to corporate gross

product, liquid assets equaled 15.2 per cent last year as contrasted
with 26.6 per cent in 1950.
For a long period, this reduction in liquidity probably
reflected a deliberate policy, aimed at profit maximization and
encouraged by the tax law.

Finally, in the late 6 0 fs and early 70*s,

many business firms found their liquidity inadequate and struggled to
rebuild it.

But by then they were caught in the throes of inflation

which tended to drain away liquidity.
In addition to the deliquifying mechanisms I have already
mentioned, corporations found themselves in the last few years pushed




-1 0 -

increasingly toward short-term debt by growing difficulties in
floating long-term debt.

Inflation, with the very high interest

rates that it engenders, tended to sap firms* credit standings as
the traditional multiple coverage of interest by earnings became
harder to achieve.

The rise in debt/equity ratios which went on

with only a few brief interruptions, while essentially a solvency
factor, also gives evidence of diminishing liquidity.
With regard to this particular ratio, it can be said that
the high book profits of the inflation period, overstated as they
were, nevertheless helped to convey a somewhat more positive and,
with respect to solvency, not entirely misleading impression.

This

relatively better picture on the books of corporations unfortunately
is contradicted by the frequently low valuation of corporate equity
in the market, which lenders presumably take into account in
evaluating a firm*s credit standing.
In recent months there has been some improvement in a
number of the measures of business liquidity.

Liquid assets to

short-term liabilities have climbed from a low of 23.6 per cent in
the fourth quarter of 1974 to 25.9 per cent at mid-1975.

Similarly,

liquid assets are now 15.8 per cent of corporate gross product
compared to 15.2 per cent late last year.
bonds and paid off short-term bank debt.
materially.

Corporations have issued
Cash flow has improved

The growing proportion of firms using LIFO accounting

implies that a growing proportion of inventories is being carried
at a very conservative valuation and that simultaneously the quality
of reported profits is improving.




-1 1 -

B a n k s 1 liquidity likewise has improved.

Holdings of

short-term Treasury securities have increased, reliance on
purchased funds has diminished.

A heavy inflow of time and savings

deposits has aided the liquidity both of banks and: thrift
institutions.
Finally, consumers have improved their liquidity by
increasing their savings.

Since 1972, the savings ratio has risen

from 6.6 per cent to 10.6 per cent at m i d - 1975.

Consumer credit

extensions have failed from a peak of 117.3 per cent of repayments
to a current 104.4 per cent.

Total liquid assets of consumers

have risen from 1.45 times total consumer liabilities in 1972 to
1.57 times liabilities in the second quarter of 1975.
All this adds up to a significant improvement in the
structural liquidity of the economy.

In 1974 <*nd 1975, the liquidity

of the economy has been tested as it had not been since the
depression in the 1930fs.

Some of the consequences of inadequate

concern with liquidity remain to be worked off.
picture unquestionably has shown improvement.




But the overall