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______ POLICY


Certain m onetary, fiscal and institutio na l
changes are essential to the future health o f the
housing industry, says Mr. Balles. A disciplined
m onetary policy over time means a reduction in
the inflation rate, and in turn a reduction in the
level o f m ortgage and other interest rates. A
disciplined fiscal p o licy means m uch less
crow ding-out o f home purchasers from credit
markets. And various institutio na l changes
should help keep home prices from rising at a
m uch steeper rate than the general level of
prices. ‘‘By im plem enting such proposals, we
should see m uch more stability in cred it flows
available to the housing market, and thus the
end o f the vast swings in hom ebuilding activity
which have driven up housing costs so


In my conversations with business leaders
th roughout the West, I’ve frequently been told
that the problems of your industry can be laid
directly at the d oor of the Federal Reserve
System. For that reason, I’m grateful fo r the
opportunity to state the Federal Reserve’s case
— namely, that w hile the Fed may be part of the
short-run problem, it is a m ajor part of the
long-term solution. The d ifficulties of the
forest-products industry of course reflect the
problems of the housing industry, and the latter
in turn reflect a host of fiscal, m onetary and
institutional problem s that have developed over
the past 15 years or so. I’d like to review fo r you
today the developm ents in each of those areas,
and wind up w ith several proposals designed to
ease the housing industry's problems. But first,
le t’s consider the present state of the industry.
Problems Afflicting Housing
Dem ographic figures show that household
form ations have been running at alm ost two
m illion units per year, while annual housing
starts are running at around one m illion or less.
On the surface, this indicates the existence of a
severe shortage. However, the housing
industry’s problem s are related to the volatility of
housing activity; in the 1973-75 slump, and again
in the 1978-81 dow nturn, housing starts declined
by half or more. Indeed, we are now com pleting
a third straight year of declining starts, so that
1981 may be the lowest housing year since
World War II.
We must not forget, however, that the present
slump follow ed a trem endous upsurge in
housing activity. The housing stock increased 28
percent (to 88.3 m illion units) during the 1970’s,
compared w ith an 1 1 12-percent rise in the total
population (to 226.5 m illion). Because of this
and the housing boom of earlier decades, the
num ber of persons per household dropped
sharply over this period. The quality of the
housing stock also improved considerably,
measured by increases in flo o r area per
occupant or by improvements in such amenities

as garage space or central air-conditioning. In
fact, the average new home today is twice as
large as its counterpart of the early post-W orld
War II era, and the typical m obile home today is
as large as the typical single-fam ily home of that
earlier period.
Moreover, housing increased its share of credit
flows during the past decade — accounting for
21 percent of the total in the 1970’s, as
compared w ith 19 percent of all credit flows in
the 1960’s. Also, m ortgage-credit flows were
several times greater in 1979 than they were a
decade before. But by the middle of this year,
less than 14 percent of total-credit flows was
going into housing — in dollar terms, 36 percent
less than housing claimed at the 1978 peak. This
reflects once again the vast fluctuations in credit
flows that have always afflicted this
feast-or-famine industry.
This problem, in turn, reflects the severe
structural problem s now confronting the
m ortgage-lending industry. Over the years, th rift
institutions built up large p ortfolios of long-term
fixed-rate m ortgages, but financed those
investments w ith short-term deposits such as
passbook accounts and savings certificates.
Today the th rifts are paying more than 15
percent on 6-m onth m oney-market certificates,
although 60 percent of the m ortgages on their
books carry yields of less than 10 percent. Thus,
as w e’ve seen, the industry is having severe
earnings problems.
Let’s also consider the problem from the
hom ebuyer’s standpoint. A fam ily earning the
median income in 1980 had to pay over 33
percent of its income to buy the 1980
m edian-priced house. In contrast, the ratio was
only 15 percent of income back in 1965. This
drastic change partly reflects the fact that
housing prices have risen faster than inflation,
spurred on by dem ographic factors and the
preferential tax treatm ent of housing. A more
im portant factor, however, is the combined

effect of inflation expectations and the
conventional fixed-rate mortgage.
Expected inflation requires that lenders be
compensated for the expected deterioration in
the purchasing power of money. Moreover, the
conventional fixed-rate m ortgage requires that
payments be spread evenly over the duration of
the mortgage, so that dollar payments remain
constant. Today s conventional m ortgage thus
imposes a significant cash-flow problem fo r the
homebuyer, especially the first-tim e homebuyer.
In this context, then, reducing inflation is a
crucial part of the fig h t to restore the health of
the housing industry.
In 1981, of course, housing is severely
depressed, at least partly because m ortgage
rates have been running 4 to 5 percentage points
above the supposed threshold of 13 to 131
percent for potential homebuyers. Interest rates
of that m agnitude mean im possibly high
m onthly payments fo r most people, especially
when they are tied to fixed-rate mortgages many
years into the future. But remember that interest
rates are only one fa cto r in the high price of
housing. As I’ve just noted, the com bination of
inflation expectations and institutional barriers
(especially the fixed-rate mortgage) makes it
prohibitively expensive fo r first-tim e
homebuyers to break into the m arket today.
The core of the problem is inflation, which
means that we can only bring down interest
rates if we are successful in our overall fig ht
against inflation. This year, we have begun to
see some progress in the form of declining
inflation — and declining interest rates.
Although that progress has been slow and
halting, it does suggest that the worst may be
about over.
Interest Rates and Policy
Interest rates are determ ined by many factors —
including, but not mainly, the actions of the
Federal Reserve, w hich can control only the

supply of money and not the demand. Certainly
the Fed has some effect on rates in the short run,
because of its efforts to control the am ount of
reserves in the banking system and the amount
of money in the hands of the public.
However, business-cycle conditions also
influence rates, as credit demands rise and fall
with the cycle. And above all, price expectations
heavily influence rates, frequently offsetting
other m arket influences. Today, fo r example, if
people expect prices to rise by (say) 10 percent a
year, lenders w ill demand that 10-percent
inflation premium plus some “ real” underlying
interest rate of perhaps 3 to 4 percent to protect
themselves against an expected loss in the
purchasing power of their money.
In the realm of anti-inflationary monetary tactics,
the Federal Reserve shifted its operating
procedures tw o years ago to emphasize
money-growth control rather than interest-rate
control. Our experience has clearly
dem onstrated that during periods of heavy
(private plus government) credit demands,
attempts to dampen rising interest rates result in
rapid money growth. And history has also shown
that rapid money grow th eventually leads to
inflation — accom panied by high interest rates.
By the same token, history shows that
reductions in m oney-supply growth definitely
reduce the inflation rate over time, usually with
the lag of a year-and-a-half to two years. This
suggests, then, that the Fed should continue to
fo llo w the path of gradual deceleration adopted
in O ctober 1979.
The evidence fo r 1981 indicates some progress
against inflation, despite a third-quarter price
upsurge created by an acceleration of food and
(especially) housing prices. The consum er-price
index, which increased by 12 1 percent during
1980, has been rising on average at about a
10-percent rate to date in 1981. The broader GNP
price index (deflator), follow ing its 10-percent
increase during 1980, has been rising at about a

9-percent rate over the first three quarters of
1981. The battle, of course, remains as tough as
ever, as we can see from the past quarter’s price
upsurge. Yet, overall, I have no doubt that a
policy of gradual deceleration in money growth
w ill mean a fu rthe r deceleration in inflation over
the next several years.
Technical Problems
The Fed’s policy task is com plicated, however,
by technical questions of measurement, as the
newspapers have been pointing out in recent
months. In an era of financial deregulation and
innovation, different m onetary measures have
been giving o ff different signals. The narrow
measure of the money supply — currency plus
transaction (check-type) accounts, known as
M1-B — decelerated slightly in each of the past
two years, and sharply thus far in 1981. Recently
it has been running considerably below the
bottom of the 1981 target growth range, as set by
the Fed, of 31 to 6 percent, after adjustm ent for
shifts of savings into check-like NOW accounts.
To com plicate matters, the actual M1-B measure
— before adjustm ent fo r shifts of NOW-account
funds — has been running roughly in the middle
of that 31
/2-to-6 percent range. Moreover, a
broader measure — prim arily currency plus all
depository in stitu tio n s’ deposits (except large
CDs) and money-market fund shares, known as
M-2 — has been running near or above the top of
its 6-to-9 percent target range, although below
last year’s actual growth. Other broad measures
of money and credit also have been expanding
The difference in growth trends can be traced
ultim ately to the effect of high interest rates on
household and business cash-management
practices. High rates have m inimized the use of
traditional transaction balances included in the
M1-B measure, and have stim ulated the growth
of money-market mutual funds and other
com ponents of the broader monetary
aggregates such as M-2.

These technical questions, abstruse as they may
seem, reflect some hard political and econom ic
decisions. As the Wall Street Journal recently
observed, w ith M-2 above its target and adjusted
M1-B below its target, the Fed’s critics have the
option of blam ing the Fed fo r creating money
too rapidly and causing inflation, fo r creating
money too slowly and causing recession, or
perhaps fo r both at once. Some critics recently
have argued fo r an anti-recession acceleration
of adjusted M1-B grow th, to bring it w ithin its
growth range. However, this would require
accelerated money growth, at about a
12-percent annual rate, fo r the rest of this year.
A grow ing body of evidence now indicates that
the unadjusted M1-B figure is a better measure
than the adjusted figure. Briefly, it appears that
the attraction of high interest rates has
considerably reduced the demand fo r currency
and check-type deposits in relation to income. If
this is true, we would be mistaken in policy terms
to accelerate money-supply growth in coming
months, because that would only create more
inflationary tin de r at a tim e when we have made
definite progress against inflation by getting
money growth under control. In that case, we
would only repeat our earlier experience, when
we appeared to have licked inflation in the
m id-1970’s because of a moderate monetary and
fiscal policy, but then threw away our hard-won
gains in the overexuberant atmosphere of the
late 1970’s.
Fiscal Policy Problems
The d isinflationary money path follow ed by the
Federal Reserve in the 1980’s is a necessary
reversal of the inflationary money grow th of the
preceding decade-and-a-half. That policy can be
successful, however, only if it is accom panied by
an equal reversal in the field of fiscal policy. The
Congress and the A dm inistration have made
some progress along this line this year. But
w itho ut further progress, we would be faced
w ith the prospect of large deficits in relation to
the n ation’s savings potential, w ith its inevitable

im plications fo r financial markets and for
housing and other sectors dependent on credit.
The harsh fact is that the past track record has
not been encouraging. The Federal budget has
not recorded a surplus since 1969, and in fact,
has been in deficit in all but one of the past 21
years. In most years also, deficit forecasts have
become larger and larger w ith each new
estimate, giving m arket participants grounds for
increasing skepticism.
Budget deficits also have affected the markets
more directly. After adjustm ent fo r
capital-consum ption allowances — that is, the
am ount necessary to maintain the present stock
of business investm ent and housing — the
nation generated about $185 b illion of savings in
fiscal 1981, largely in the form of
business-retained corporate earnings,
household savings, and state and local
pension-fund contributions. That amount
represented the funds available to add to our
plant and equipm ent, to inventory, to housing —
and to finance the Federal Government. But
Federal d eficit and off-budget financing, when
com bined, totalled over $80 b illion — nearly
one-half of the n atio n ’s total savings.
Now, you could argue that our budget deficits
are relatively small by international standards,
when measured in relation to total production.
This is true, but unfortunately our savings are
also small, and it is the relation between the two
that is crucial. For example, in the last
half-decade, U.S. net savings amounted to less
than 5 percent of the n ation’s total output. In
contrast, the savings ratio was more than twice
that large in most m ajor European nations, and
almost fo ur tim es that large in Japan.
Now, any econom ist w ill tell you that the effect of
budget deficits on the econom y and capital
markets should be judged differently at different
stages of the business cycle. There is little
danger of "cro w d in g -o u t” in a period when we
have high actual savings, falling investment

demands, and low interest rates. But surely, that
is not the situation confronting us today, when
com peting demands clash so strenuously in the
marketplace. Thus, we see the Federal
Government crow ding-out other borrowers —
households, hom ebuilders, farmers, small
businesses, and state and local governments —
who cannot afford to pay the interest rates that
the Federal Governm ent is w illing and able to
pay. Surely, this massive Federal presence in
credit markets must be considered a m ajor
cause, along w ith high inflation, of the high
interest rates now underm ining the housing
Policy Proposals
Let me summarize my argument, therefore, by
making several policy proposals, beginning with
the continued need fo r a disciplined monetary
policy. The path of wisdom calls fo r a policy that
w ill keep all of the m ajor monetary aggregates
from straying too far off course. For the
remainder of 1981 — according to Chairman
Volcker’s latest Congressional testim ony — the
Federal Reserve thus is w illing to hold adjusted
M1-B growth near the bottom of its range, and
M-2 growth near the top of its range. For 1982,
the Fed tentatively has again reduced its
projected growth range fo r M-1 (a single narrow
aggregate) to between 2 V2 and 51 percent, w hile
m aintaining a 6-to-9 percent range for M-2.
Thus, by carrying out our “ game pla n ” of
reduced money growth in 1981, and projecting
sim ilar discipline next year, we should add
credibility to the n atio n ’s anti-inflation program
and help to reverse long-standing expectations
of continued high inflation.
Next, we must make every e ffort to reduce
Federal d eficit-financing pressures on the
markets, and thereby reduce the crow ding-out
of borrowers. I’ve been impressed this year by
the jo in t Adm inistration-Congressional efforts to
reduce taxes and spending in tandem. However,
we are still left w ith the prospect of substantial
deficits in fiscal 1982 and subsequent years. In

passing, I m ight note an estimate that if half the
funds required for financing the fiscal ’81 deficit
had gone instead into housing, we would be
back again at the 1978 peak level of
hom ebuilding activity.
I believe, therefore, that a vital “ phase 2” w ill be
needed to ensure further reductions in Federal
deficits. W ashington policy makers are now
actively discussing ways of accom plishing this
goal, through both further expenditure cuts and
tax measures. With regard to expenditures,
many observers believe that Congress should
take a hard look at various entitlem ent
programs, since large budget deficits in recent
years have mostly reflected the inflation-indexed
upsurge in payments for Social Security and
other such programs. With regard to tax
measures, the Adm inistration has proposed
some increases in taxes other than on income,
and in particular, some Congressmen have
discussed deferring the income-tax cuts now
scheduled for mid-1982 and mid-1983. It may be
necessary to work on both expenditure
reductions and added tax-revenue measures to
head off a very unhealthy surge in the Federal
Third, we should support various
m ortgage-financing innovations which help
first-tim e homebuyers leap the hurdle to
homeownership. These innovations — such as
the variable-rate mortgage, the
graduated-payment mortgage and the
shared-appreciation mortgage — mean that
both borrowers and lenders share the risks and
the benefits of inflation. But this approach also
enables mortgage borrowers to obtain more
housing services over tim e — especially because
initial payments would be lower than they are
under the terms of fixed-rate mortgages.
Finally, we should elim inate the various state
and local restrictions which have made housing
prices rise even faster than the general rate of
inflation in recent years. These include local

building codes, lim itations on land use, and
other restrictions w hich drive building costs up
at a substantial rate year-in and year-out. Some
observers believe that we also need a Federal
override of state-court decisions which p rohibit
enforcem ent of due-on-sale clauses in
mortgages and w hich thus perm it homebuyers
to assume low-rate m ortgages on existing
homes. Realtors and buyers of existing homes
may welcome this assum ability feature, but it
has aggravated the th rift institutio ns’ problem of
m aking funds available fo r new housing
construction, and also of im proving the return
on th eir m ortgage portfolios. Too many
pressures as it is are forcing th rift institutions
away from their basic responsibility of financing
housing. Thus, I would welcome any action
which would ease the th rifts ’ task of carrying out
their basic hom e-financing role.
In sum, I believe that these monetary, fiscal, and
institutional proposals are essential to the future
health of the housing industry. A disciplined
monetary policy over tim e means a reduction in
the inflation rate, and in turn a reduction in the
level of mortgage and other interest rates. A
disciplined fiscal policy means much less
crow ding-out of home purchasers from credit
markets. And the various institutional changes I
have suggested should help keep home prices
from rising at a much steeper rate than the
general level of prices. By im plem enting such
proposals, we should see much more stability in
credit flows available to the housing market, and
thus the end of the vast swings which have
driven up housing costs so severely. And
needless to say, by accom plishing those goals,
we should be able to reduce the vast swings in
building activity w hich have driven up your
industry’s costs in turn.