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For use in Afternoon Papers
of Tuesday, November 12, 1974


Board of Governors
Federal Reserve System

to the
Fall Conference
of the
Robert Morris Associates
Atlanta, Georgia

November 12, 1974


There was once a proposal that should have originated in
Washington, even if it did not.

It was to the effect that a book

could be written containing brief texts on every imaginable subject pro, con and noncommittal -- and that each of these little master­
pieces of bureaucratic pronouncement would be numbered.

A companion

volume would have numbered introductory remarks for all imaginable
types of occasions on which speakers need to be introduced, ranging
from cool to enthusiastic.

Practically everyone who made or

listened to speeches would have these volumes.
Persons chairing meetings would stand up and say, simply,
"Ladies and gentlemen, we have with us today Mr. -- or Mrs. or Ms.
-- Blank," and would add the speaker's title or position, after
which the chair person would only have to say, "Number 741" to
concludc the introduction.

The speaker would need only to say

"Thank you" in an appropriately grateful or distant manner according
to the degree of enthusiasm of introductory remarks Number 741, and
add, as his speech, "Number 836."

Following this, all could retire

to comfortable surroundings and engage in possibly

highly produc­

tive personal or small group exchanges of ideas during the time
that otherwise would have been taken up in delivering speech
Number 836.



I mention this not becausc I think thc.t, even in our
present time of participation by everybody in everything it is an
idea that will have a rebirth and acceptance.

Or. the contrary, I

am afraid that it is the kind of idea that is doomed to be shunned
as taking all the fun out of life.

I mention it because the choice

of tit?.e for my talk today recalled the proposal.
"A Firm No to Credit Allocation."

The title is

I really could stop right there,

and you would have my message: having piven the subject of credit
allocation a good deal of thought —

and even though I began with

some sympathy for the idea arising from the nation's obvious need
to employ its resources wisely -- consideration has led me to a
firm conclusion that it is neither an acceptable, nor even a
feasible, idea.
If this were Speech Number 836 you would have my reasons
as well as my conclusion.

Since you do not, and since crodit allo­

cation has the appeal of a seemin&ly simple solution to our -- and
the world's -- complex economic problems, I will try to explain my

I should add that —

although the Board has pronounced

itself opposed to governmental allocation of credit -

I am express­

ing my personal reasons, today, for opposing it.

The Proposal for Allocation of
Credit by the Federal Reserve
Legislation has been proposed that would give the Federal
Reserve authority to induce banks that are members of the Federal
Reserve System to make loans defined by law, and by Board decision,



to be of priority importance to the nation.
"National Priority

Loans and Investments."

These would be called
Under one proposal,

the Board would encourage "National Priority" loans —

and dis­

courage others -- by granting reserve credits in relation to loans
and investments in several fields stated in the bill as having
high priority in national interests, and by imposing supplemental
reserve requirements in relation to all other loans and investments.
That is not quite how it is put in the bill, but that is what it
adds up to —

a carrot in the form of reduced reserve requirements

to member banks for making loans and investments falling in the
preferred fields, and a stick in the form of supplemental reserve
requirements for making loans and investments in other fields.
The size o£ the reserve credits and supplemental credits
would be determined by the Board.

For example, as I understand it,

if a member bank's nonpriority loans totalled $50 million, the
Board could require that bank to supplement its required reserves
by —

say —

3 per cent of the total, or, in this case, $1.5 million.

The same percentage requirement would apply to all member banks.
In the same way, the Board could give a reserve credit —

that is,

reduce required reserves -- for making "good" loano.
"National Priority Loans and Investments" are defined in
the proposed legislation as any loan or investment which, in the
opinion of the Federal Reserve Board, is made for, or used for,
any of the following:

-4 -

--Useful capital investments, with particularly useful types
of credits being those that would finance additions to
capacity, conservation of energy, enhancement of the
environment, and increases in productivity.
— Low or middle income housing.
--State or local government facilities.
--Financing of small business.
--Any other kind of financing which the Board determines -with the approval of the Congress -- to be a matter of
national priority.

Some Specific
The proposed legislation specifies tha.t reserve credits
to any bank may not exceed supplements.

Thus, the amount of benefits

for "good1 financing would be limited by the amount of "bad" loans
a member bank made.

Consequently, no individual member bank could

reduce its over-all required reserves.

But, if the bank were not

careful in Its portfolio planning, its required reserves could go

There Ls thus little real incentive to make national priority


However, there is no limit to the penalties for the bank

that does not do so.

In my view, that is a departure from the

basic incentive drive of free enterprise.

And it would run contrary

to the valuable experience we have before us of the world's regi­
mented socities where a great deal of attention has been paid in
recent years to replacing penalties with incentives as a way to
achieve national economic goals.

-5 -

I have noted repeatedly -- and with design -- that this
legislation applies to member banks of the Federal Reserve System.
The logic, I assume, is that member banks have most of the nation's
bank deposits -- currently, about 78 per cent.

Also, that the Federal

Reserve Act allows the Board to set reserve requirements only for
member banks.

However keen the logic, the upshot would be a highly

discriminatory burden on the nearly 6,000 -- out of nearly 14,000 -banks that choose, through membership in the Federal Reserve System,
to assist the making of economic policy for the nation by being subject
to Federal Reserve reserve requirements.

I cannot imagine any credible

argument that could be used for explaining away this penalty for
helping in one of the nation's prime economic tasks.

Such a burden

on membership could only ¿let as a further stimulus for banks to
leave the System.

That would erode the basis oC monetary policy,

blunting the System's efforts to carry out its task of containing
inflationary forces, or stimulating economic activity, according
to circumstances.
If rules for credit allocation were to he equitable among
banks, they would have to apply to all commercial banks, if the
means to do so legally could l e found.

Perhaps the only practical

approach would be adoption of the Board's recommendation to the
Congress that all commercial banks be subject to uniform Federal
Reserve reserve requirements.

In my view, that would bo doing the

right thing for a very wrong reason.

-6 -

But even if the credit allocation mechanism

were made

equitable among banks, it would still discriminate against banks in
favor of other lenders.

To be equitable as among all financial

institutions, therefore, it would have to apply to all institutions
that make loans and investments.
That is, once its feet were set upon this path, the
allocating authority would have to be endowed with power to influence
every loan and every investment of every kind of financial insti­
tution unless very large gaps in the allocation of credit were to be

And this assumes that the enforcement power of the

allocator would be effective, a highly dubious assumption.
But the centralization of economic power could not stop

It would have to extend also to market sources of funds,

such as the use of the proceeds of the sale of commercial paper,
acceptances and the like.

It would have also to extend to the use

of the proceeds of all long-term commercial bonds, and to equity

All this would be necessary because money is fungible.

Block its use by one financial institution, or one type of finan­
cial institution, or several types of institutions, and the money
will flow into whatever channels will lead it to the most profitable
Consequently, only a complete dictatorship of money,
extending to every possible way in which money could be used, would

provide the basis for a successful .system of governmental credit

But such an administrative centralization of economic

pov/er is not necessary.

The price system —

including the price of

money, the interest rate -- is a credit allocating mechanism, and
an efficient one, reaching all the uses of money, when it is
allowed reasonable freedom to work.

The price/interest rate mech­

anism functions as a system of locks in the financial irrigating
network, that directs money -- in a well-functioning free enter­
prise economy —

to those outlets where money can be used most

And -- again -- that is why incentives, rather than

penalties, are the preferred influence for controlling the use of

Incentives are as fungible as money.

Punitive authority,

on the contrary, is as vulnerable as human ingenuity in getting
around it.

We must assume that wlial the mind of man can Revise, the

mind of man can circumvent.
Other defects could


marshalled against the proposal

that the Federal Reserve -- or any other agency -- be supplied with
the power to decide what is a good and useful use of finance, and
what should be discouraged.
The already exceedingly difficult task of controlling the
monetary aggregates would be accentuated under any system of credit
allocation resting upon differential use of reserve requirements.


The basic reason is simple:


any change in the composition of a

bank's portfolio would change its reserve requirements.

Thus, both

banks, and the monetary authority, would have an almost infinite
set of unknowns and variables, shifting from day to day, to take
into account in foreseeing the behavior of the money supply.

The Basic Fault —
Loss of the Efficiencies
of Freedom
The objections to credit allocation by fiat that I have
raised thus far are technical in part —

and whether a plan is tech­

nically feasible is always a primary consideration.

In part also,

they have concerned the adverse impact of such a system on the con­
trol of credit through the price system and especially interest rates.
No one would deny that the free enterprise system has serious flaws,
that it is a system searching for ways to embrace other than merely
material goals, that it is in the process of revision and reform; a
system that should, and, to its credit, is being, and will be improved.
But the basic fact is that nothing invented to date works as well, in
terms of efficiency, humaneness or equity.

Economic systems that

have tried to substitute human committee decisions for the autonomous
decisions of the price-interest rate system in directing credit to
its most productive use have had to use immense punitive forces to
achieve compliance.

And, as I have indicated, the limited success



they have had has driven them to invent surrogates for free prices
and interest rates.
That, in my mind, is the crux of the matter.

No single

human mind, nor any committee, has yet shown itself able to collect
and master enough information to determine with any acceptable degree
of accuracy where investment should go, and when.

At the Federal

Reserve we have neither the data nor the wisdom to undertake such
an Olympian task and believe me, at 20th Street and Constitution
Avenue, N.W., we probably have more data than most.


the job is not only technically difficult and socially repugnant -it is beyond human capability.
human capacity.

Nor does the computer bring it within

The computer can only amass and manipulate data, it

cannot point, as prices and interest rates can, when they are allowed
to work, to what is wanted, where it is wanted and how much one thing
is wanted, or needed, in comparison to all others.
In summary then, these are my reasons for casting a very
firm vote against governmental allocation of credit, at least in
any way that has yet been proposed.

It is technically so difficult

that it would require a truly gigantic bureaucracy to operate.


only chance to succeed would be under full authoritarian conditions,
extending throughout the entire economy and into every use of funds.
But even if these objections were overcame -- or overridden —

in the

name of a national need for the best use of scarce resources -- the


task should still not be undertaken, because it is not within human
capabilities to do it well.
Does that mean we can only relax and wait until we have
evolved sufficiently as people and as societies to undertake success­
fully central economic control?

That is not what I am saying.

There is a probable answer.

Its name is institutional

Its objective is to permit autonomous factors to tell us

where and when investment should take place.

But such institutional

reform can and should be undertaken with two controlling conditions
in mind.

The first is that we cannot turn the clock back to the

days of laissez faire and let matters take their course, heedless of
human suffering.

Together with reform of our financial system for the

more efficient marshalling of credit, we must, in parallel, adopt
measures to avoid waste of human talent and energy —

unemployment —

and to avoid the waste of scarce capital by making a scapegoat of
any economic sector, such as housing and the mortgage market.
Further, institutional reform should permit flexibility that would
yield the kind of growth and diversification that people want in their

There is much more to be said here, but I do not want to get

into philosophy —

I think my point is made that I am not talking

about cold efficiency, but, rather, of avoiding waste or misuse of
human and other resources, so that they may be used to best advantage
to yield what society desires.



I have said repeatedly that the competitive market system,
when allowed to function in relative freedom, can go a long way
toward solving the problem of credit allocation.


key here is

the proviso that it should permit prices and interest rates freedom
enough to do their job of indicating what is the most desired, and
most desirable, use of credit.

Consequently, a prime objective in

arriving at national priority use of credit is the removal,
through institutional reform, of obstacles to the market determina­
tion of prices and interest rates.
A good deal of thought has been given recently to the
problem of institutional reform of our financial system.


proposals we have before us in most immediately usable form -the proposed Financial institutions Act based on the Hunt Commission
recommendations —

may not be perfect.

But this should not keep us

from starting the necessary restructuring and revision of the system
by which we bring funds to market, and put them to work.

It is

true that the best can be the enemy of the good.

Let me, then, indicate some of the changes in our
financial system that seem to be most needed now.

I believe that

these changes represent the best and quickest way to obtain the
most desirable use of scarce capital.
First on my agenda is the unhobbling of interest rates.
By this, I have in mind doing away with governmentally imposed


interest rate ceilings -- chief ly, usury ceilings,
out and suspension of ceilings on time deposits.

and a phasing
An interest rate

is a financial sensory apparatus, indicating, by its rising and
falling levels, changes in preferences for various types of invest­
ment, and where funds are most needed, or wanted, in comparison to
all other uses.

But interest rates can only do this if the

bureaucratic hand does not smother the responsiveness of rates to
economic conditions and desires.

Such smothering eventuates in

serious economic mistakes, distorting incentives and causing waste­
ful investment.

The result may be a failure to produce capacity or

product where and when needed, or the over-production of capacity
or product, wrong job training, failure to carry out needed
research and investment in unproductive research, and a long list
of other economic wrongdoings.

Two current and painfully evident

mistakes are the withholding of capital from utilities and from
home-building, the one due to regulation distorting the price
incentive to invest, the other due directly to ceilings on the
interest that may be paid for savings that go into mortgage invest­
ment .
Second, the depository base of thrift institutions should
be expanded, and the allowable investment alternatives should be

For example, thrift institutions should be permitted

to put at least a significant portion of their funds into short­
term assets, primarily in the consumer loan field.

This would help


to cure one of the worst difficulties the thrift institutions face
in meeting smoothly —

despite rising and falling of interest rates

that are not under control —

the need for mortgage money.


would be able, through such short-term investment, to adjust their
earnings to better compete with the earning power of other financial

Presently, the thrift institutions are locked into

housing loans that, in times of high interest rates, make their
portfolio a relatively low-earning conglomerate of interest rates
reaching back, on the average, some eight years.
Further, I am certainly in record with the expressed
conviction of the Federal Reserve Board that the variable rate
mortgage should be most seriously looked into, again as a means of
permitting thrifts to adjust their earnings base as other interest
rates rise and fall.
The fourth item on the agenda should be a variable, rather
than a fixed, investment tax credit, so that the tax structure
could provide additional incentive to invest, or reduce the incen­
tive to invest, contra-cyclically.
These are a few of the specifics of institutional reform
that I think stand at the head of the list.

There are many other

candidates, and the list should include methods to accomplish the
removal of each and every blockage to the free formation of prices
and interest rates.

Where adjustments might temporarily damage

existing institutions, phase-in programs, govermental assistance


and tax incentives can be used to assist the transition.

The same

types of devices could be of assistance where the passage to a freer
price structure threatens established industries and established

1 think such transitional incentives should be used

with a free hand, because I do not think some people, some industries
or some institutions should be asked to bear the burden of reform
that will benefit us all.
of the reform*

All of us should contribute to the cost

And, I am convinced, the cost will be small by

comparison to the vast gains that are in store for the free enter­
prise society that finds a way to try free enterprise.

One of

the chief benefits will be good allocation of our scarce resources.