View original document

The full text on this page is automatically extracted from the file linked above and may contain errors and inconsistencies.

THE NATION AND NEW YORK

Remarks of
John J. Balles, President
Federal Reserve Bank of San Francisco

Directors Luncheon Meeting - Seattle Branch
Federal Reserve Bank of San Francisco
Seattle, Washington

November 12, 1975

The Nation and New York

I Tm delighted to be here again in the Great Northwest, to share
with you my thoughts about the business scene and the problems that
might hamper the recovery.

To give you my conclusion right at the

start, the recovery from "the worst postwar recession1’ is proceeding on
schedule— but as always seems inevitable in such situations, we will
be faced for some time to come with the wreckage created by the recession
and the preceding inflationary boom.
writers.

You know the list:

It’s been a field day for headline-

W.T. Grant down to its last five-and-dime;

the airlines fast losing altitude; the tanker industry on the rocks;
the jerry-built REITfs crashing to the ground; and New York City
desperately trying to sell Brooklyn Bridge.

Indeed, the nation’s

largest city now appears to be the nation’s largest problem, so I will
devote a good portion of my talk to that particular problem.
Nonetheless, the overall business picture is steadily improving,
although at an uneven pace in certain industries and certain regions
of the country.

Business leaders here in Washington are undoubtedly

more familiar than others with how this type of script unfolds, because
you went through your very own recession-and-recovery scene just
several years ago.

For that matter, your present situation appears

equally instructive, because of the mixture of developments from home
and abroad that are now impacting on the regional economy.
You’ll remember how the severe slump began at the beginning of
this decade, with all of the stateTs major "export” industries—
aerospace, aluminum, farming and forest products— going into a decline




- 2 -

at about the same time.

You’ll remember also how the recovery then

got underway, x^ith first agriculture and then the other key industries
contributing to the upturn.

Well, in some respects the 1975 picture

is similar to that of 1970-71.

Washington’s overall performance has

been somewhat stronger than the nation’s in the recent slump, but
yet, in the past year, we have seen weakness developing in aerospace,
aluminum, and forest products, so that much of the burden of recovery
has been shifted to agriculture.
I think w e ’ll all agree that 19 76 looks like a pretty mixed bag for
the state’s economy.

Aerospace prospects are dimmed by the obvious weakness

of the airline business, but until we see an improvement in air travel,
new defense contracts should continue to come in handy— after all, defense
spending here has been running about twice the level of the early 1970’s.
Aluminum and forest products will improve as the national markets for
their products expand— a slow but almost certain process.
has the problem of what can you do for an encore?

Agriculture

Washington’s cash

farm receipts doubled just between 19 72 and 1974, and it will be hard
to beat that record— and with costs rising, it will be hard to match
the earlier peak in net farm income.

Still, with the present bumper

crops of wheat and apples, and with the heavy worldwide demand for all
of this state’s products, the farm sector looks quite solid.

Add to that

the construction work on the Trident submarine base and— above all—
Washington’s contribution to the Alaska pipeline boom, and you get some
pretty strong pluses in the outlook.

Everything considered, I have

little doubt that Washington xtfill outpace the nation in the late 1970’s,
just as it has in the past several years.




- 3 Factors Affecting the Recovery
Let’s consider now some of the major factors involved in the national
business upturn, because of their importance for the stateTs outlook.
We begin with the realization that the recession was over almost six
months ago.

Unfortunately, whenever any public official makes that

point, h e Ts denounced as a heartless wretch, whereas heTs only stating
an obvious statistical fact.

Certainly itTs true that almost one-third

of the theoretical capacity of the nation1s industrial plant remains
unutilized, and certainly it?s true that roughly one-twelfth of the
labor force remains unemployed.

Nonetheless, the major aggregates of

production and employment have risen substantially in recent months, to
mark indisputably the beginning of the recovery.

Indeed, the percentage

of the working-age population actually employed during this "worst
postwar recession" is somewhat higher than in most earlier recessions,
and is actually near record levels for both adult women and teenagers.
The recovery script was written during the spring months, when
consumer spending rose at more than a 6-percent annual rate (in real
terms), reflecting an unparalleled 22-percent rate of gain in real
disposable income.

Take-home pay was boosted by the front-loading of

the $23-billion Tax Reduction Act* which included not only the tax
reductions but also some increases in social-security and other transfer
payments.

That stimulus was reinforced by a slowing of the inflation

rate to about half of the year-ago level.

Indeed, at present Income

levels, \tfhere a one-percentage-point drop in the inflation rate means
an $11-billion boost to real disposable income, we obtain roughly the




- 4 -

same income stimulus from a two-percentage-point drop in inflation
as we got from the tax-cut legislation.
The strong consumer showing was repeated in the third quarter, and
at that time also, the second major element in the recovery script sur­
faced, in the form of an improved inventory situation.

Business inven­

tories declined at a $25~billion annual rate in the first half of this
year— and at almost half that pace in the third quarter— -so that stock­
room shelves have now been cleared of most of their excess supplies.
Just ending the cutbacks, without any net increase in inventories, would
thus remove a substantial depressant on GNP.

Another important factor

has been our continuing strong foreign-trade balance; as Washingtonians
probably know better than anyone, the nation’s exports have doubled
within the last three years, contributing to a shift in the trade
balance from a $6-billion deficit in 19 72 to a $12-billion rate of
surplus to date in 19 75.

Also, the housing industry, for all its

structural problems, has improved substantially since last x^inter’s lows.
For all these reasons, I can visualize a fairly strong upward
movement for the national economy throughout 1976, along i^ith continued
improvement— but unfortunately a slow improvement— on the unemployment
and inflation fronts,

Let me say a few words about the latter problem,

especially about that development which has been at the root of our
economic miseries throughout the past decade— the impact of soaring Federal
deficits on private markets and public policy.
Deficits and Monetary Policy




The nation was 186 years old before it first recorded a $ 100-billion

- 5 -

budget.

It took nine years to exceed $200 billion, four years to exceed

$300 billion, and it will probably be only two years more before we
exceed $400 billion in Federal spending.

Earlier increases reflected

the costs of past and future x^ars (including interest on the rising debt),
but the recent explosion has largely reflected the vast expansion of
health-education-welfare programs.

To a great extent, this phenomenon

represents the federalization of many functions that were formerly handled
by families, by private agencies, and by state and local governments.
The basic difficulty of course has been the failure of Federal budgetmakers to find the funds to pay for these growing responsibilities, and
it has been aggravated by the impact of inflation on the groining number
of retirement and welfare programs.

The problem threatens to swamp the

nextf Congressional budget committees at the very inception of their
activities, but it is one which they must grasp and bring under control.
More Federal spending would aggravate the pressures already
evident in financial markets, xvrith unparalleled Federal demands piled
on top of gradually reviving private credit demands.
publicized and all-too “-real problem of "crowding out."

This is the wellItTs true that

financial conditions normally ease substantially during a recession and
remain easy even in the initial recovery period.

But if the Federal

deficit substantially exceeds the Congressional budgeteers* $72-74 billion
target, total credit demands could rapidly outrun the available supply
of funds, forcing interest rates higher and crowding many non-Federal
borrox^ers out of the market.




We've already seen interest rates turning

- 6 -

up, xtfhen typically they continue falling during the early recovery
period.

Certainly it’s very unusual at this stage of the cycle to see

Treasury bill rates hovering between 5h and 6 percent, or the prime
business-loan rate betx^een 7% and 8 percent.
Mounting credit demands could be satisfied--at least for a short
time— without an increase in interest rates if the Federal Reserve
accelerated the growth of money and credit.

But if done for too long,

or to an excessive degree, such an action could generate inflationary
pressures xtfhich would soon become imbedded in our ratchet-like price
structure.

And as we have learned, inflation would be accompanied by

high and rising interest rates.
To complicate matters, policymakers at this stage of the recovery
have to be equally alert to the need to provide the financial basis
for continued recovery.

In a word, we must maintain a prudent but not

parsimonious monetary policy.

This stance is seen in the monetary

growth path specified by Chairman Burns last x^eek for the period
between the third quarter of 1975 and the third quarter of 1976— a
groxtfth rate of 5 to 7^ percent in the narrowly defined money supply.
This is roughly in line with the average growth rate actually experienced
over the past half-decade,
Growth within this range is quite appropriate in the present en­
vironment of high unemployment and unused industrial capacity.

On the

other hand, it is on the generous side by long-term historical standards.
Thus, we could endanger the fight against inflation if we continued




- 7 -

expanding the money supply indefinitely at today’s specified pace.
economy returns to higher

^ ^

of ro source util

As the

:arIon, w e ’ll have to

reduce tne rate of monetary and credit ex^.nsion, in order to lay the
foundation for a prolonged c<^ of prosperity without inflation.
This year, the financial community has been gradually regaining
its strength with the help of the supportive monetary policy that I ’ve
described.

Commercial banks, with good reason, have been building up

their loan-loss reserves, because of the necessity to pay today for the
poor decisions of the past decade.

They have been cautious in their

lending policies, and in a strong drive for liquidity, they have sharply
increased their holdings of Treasury securities.

On the deposit side,

they have relied much more heavily on stable consumer-type time deposits
than on purchased CD money.

This increasingly favorable picture is

even more evident among regional banks than at the big money-center
banks, and as a result, lending activity has expanded at a faster pace
at the regional banks.

Yet overshadowing this scene of Increasing

strength is the shadow of New York.
Evolution of New York’s crisis
William F. Buckley described that unhappy situation in these words,
MNew York City Is in dire financial condition, as a result of misman­
agement, extravagance, and political cowardice.

. .New York must dis­

continue its present borrowing policies, and learn to live within its
income, before it goes bankrupt.11 The Interesting thing is that Buckley
said this in his race for mayor ten years ago.

PS.

He lost the election.

A winning candidate for mayor, Abe Beame, recently said, "Substan­
tially all the factors talked about now were known to the financial com­
munity for years.




It was quite well known that deficit financing was

going on.

It was quite well known that items were capitalized which

should have been in the expense budget.n

True enough, but investors

probably never understood the growing magnitude of the problem, nor its
ability to aggravate a financial situation which had already been un­
settled by some of the other problems I mentioned.

Finally everyone

realized that a condition could not continue where, for an entire decade,
expenses increased on the average of 12 percent a year, while revenues
increased less than 5 percent a year.

This occurred even though New

Yorkers are the most heavily taxed people in the country; last year,
New York State residents paid 17 percent of their income in personal
taxes, compared with a 15-percent figure for the nation.
By the end of 1974, New York City’s outstanding debt amounted to
over $13 billion, much of it In the form of obligations maturing in a
year or less.

Faced with dwindling investor confidence, the city found

it ever more difficult to pay current bills and to refinance maturing
obligations, and it thus turned to the state for help.

The state legis­

lature thereupon organized the Municipal Assistance Corporation, substituting Big Ma c ’s good credit for the city’s deteriorating credit.
This agency was empowered to sell up to $3 billion of debt obligations-which were to be backed by certain tax revenues that otherwise x^ould
have gone to the city--and then to make the proceeds of its borrowing
available to the city.

But this approach failed to satisfy a suspi­

cious investment community, and soon even Big Mac’s securities came
under a cloud.

And why were Investors suspicious?

Among other reasons,

because Big Mac bonds were TlmoraI-obligationn securities rather than
"full faith and credit" obligations, and investors had suddenly
become leery of that type of morality when New York State’s Urban




- 9 -

Development Corporation temporarily defaulted on similar obligations last
February*

Incidentally, Governor Carey's request to the Federal Reserve

last week for a $576-million loan involved four state agencies x^hich rely
upon that now-suspect form of financing.
To ward off the city’s imminent default, the state legislature
met in special session in early September to adopt a set of firmer
measures.

First, control of the city’s finances was turned over to a

state-dominated Emergency Financial Control Board.
power to issue debt securities was enlarged.

Second, Big Macfs

Third, the state agreed

to arrange $2.3 billion in financing, including $750 million in state
loans as well as MAC financing.

The package was designed to tide the

city over until early December, at which point the city’s financial
soundness hopefully would be restored under the aegis of the new control
board.

But even this new rescue plan began to come apart because of

investors’ growing suspicion of New York State’s own financial sound­
ness, which then led state and city pension-fund trustees to drag their
feet on participation.

At that point, the final crunch became all but

inevitable.
Impact on the Markets
The New York crisis unsettles a municipal-financing market that
already has had more than its share of troubles.

The enormous volume

of tax-exempt securities coming to market--more than $51 billion of
bonds and notes in 1974 and probably even more this year--has not been
matched by a corresponding increase in demand for such securities.

In

addition, the anticipation of future inflation caused by heavy Federal




- 10 -

deficits has dampened investor interest in committing funds for the long
term.

Finally, the problems of New York City and other jurisdictions

have all accentuated investor awareness of the growing risks in this
-market.
In these circumstances, the municipal market generally has held up
remarkably well.

Traditionally, a 30-percent spread exists between tax-

exempt and taxable issues of comparable quality--say, between long-term
prime municipals and prime utility issues--and that spread has been
maintained until quite recently.

Of course, with the stresses developing

in all segments of the capital market, yields on even the highest-rated
tax exempts are now at record levels.
Still, the most striking aspect of the current scene Is the growing
selectivity of investors, and the resultant widening of yields between
lower- and higher-rated issues.

Thus, the average yield on A-rated

muni bonds exceeds that on Aaa-rated bonds by more than a full per­
centage point, or about three times the risk differential required by
investors during the earlier 1970rs.

Between April and August alone,

the spread almost doubled to 115 basis points.

The deterioration has

been especially marked for any securities with the name New York attached.
The obligations of New York State have been tarnished by the fear that
it can 111 afford to divert resources to the city's aid, being faced
with a $700-m:Lllion deficit of its own, and being entangled with wobbly
state agencies that have issued all those moral-obligation bonds as a
means of avoiding constitutionally-required voter approval for state
borroxtfing.




If the weakness should spread beyond the state1s borders, many

- 11 -

credit-worthy communities and agencies elsewhere could find new financing
to be very costly or even impossible*

Holders of municipals— principally

New Yorkfs but other securities as well--meanwhile could face write-downs
cn their municipal holdings.

The nation's commercial banks could be

affected by the New York problem, since they hold roughly $3 billion-almost one-fourth-~of the city's publicly-held securities.

Moreover,

there are 102 banks throughout the country whose holdings of New York
City obligations exceed 50 percent of their total capital accounts or
net worth.

Altogether, the nation's commercial banks hold about $102

billion in all types of tax-exempt municipal securities--about 14%
percent of their total loans and investments--but of course very few
of these investments are in any question.
Planning for Default
Needless to say, contingency plans have been developed to meet the
emergency.

In recent Congressional testimony, Chairman Burns argued

that neither the Federal Reserve Act nor its legislative history make
any provision for extending Federal Reserve credit directly to financially
troubled communities.

In case of default, however, the System could

provide special loans to commercial banks though the discount window,
and the proceeds of those loans could be used to help other munici­
palities endangered by the repercussions, as well as securities dealers
or other bank customers who find themselves short of cash because of
unsettled market conditions.
A default on a general-obligation bond of course does not mean a
total (or even partial) ultimate loss on the investment.

In contrast to

(say) W. T. Grant, a governmental entity like New York will continue in




- 12 -

existence and its economic tax base will remain as a source of revenue.
New York’s default thus would mean a temporary loss of liquidity for
the investor, and perhaps some loss of current earnings, rather than a
permanent loss of face value on the securities held.
In view of the high probability of ultimate repayment--in viex* of
the fact that the defaulted securities should continue to have a sub­
stantial market value~~the supervisory agencies have agreed that they
would allow as much as six months1 time before requiring that banks write
down the book value of any defaulted holdings to market value.

But for

purposes of accounting and reporting to shareholders, a default which
resulted in unpaid interest or a markdoxvTa of security values would have
to be reflected in the period in which it occurred.

In the case of

interest, which is exempt from Federal taxes, it would be fully reflected
in a bank!s net operating earnings.

In the case of a determination in

loss of value, it could show up either in net operating earnings before
securities transactions or in the bottom-line net income figure, de­
pending on the manner in which the write-down was handled.
Now, we should realize that the amount charged off against a bank’s
capital account is not a projection of ultimate loss, but rather a con­
servative judgment to assure that the bank’s capital is adequate for the
other purposes to be served*

In any event, such a charge-off undoubtedly

would be far less than the book value of the securities involved.
As for the broader solution, the Administration (as you know) has
rejected the several Congressional proposals that would provide either
for Federal guarantees of New York securities or for direct emergency
loans.




Instead, the Administration’s plan would grant sufficient authority

- 13 -

to the Federal courts to preside over an orderly reorganization of the
city’s financial affairs.

The plan would prevent the city!s funds from

being tied up in lawsuits; it would provide the framework for a schedule
of payments to creditors to be developed; and it would provide a way for
new borrowing to be secured by pledging future revenues.

During the past

week, several Congressional committees as well as Big Mac’s board have
tried to put together various complex financing plans--but meanwhile, the
clock ticks on.
Concluding Remarks
Let me repeat what I said at the outset-~that despite New York’s prob­
lems and the other difficulties which I mentioned, the business recovery is
proceeding on schedule.

I ’ve noted the strength of those forces which

have generated and sustained the upturn, but also highlighted those coun­
terforces which could yet undermine the recovery.

In particular, I ’ve

suggested the way in which an outsized Federal deficit could endanger the
upturn, either by draining funds from the financial markets that are needed
by private borrowers, or by forcing a shift to an open-handed monetary
policy that could set off another double-digit inflation.
New York is linked to this budget problem, because some of the pro­
posed rescue plans would only add to the deficit while increasing the
already massive central-government presence in city halls and state houses
throughout the land.

Over the past two decades, Federal grants-in-aid

have jumped from $3 billion to $52 billion-~or from 10 to 23 percent of
total state-local government receipts.

The trend may well continue be­

cause of the problems of New York and other troubled metropolitan centers.
But if it does, it could endanger our present efforts to bring the Federal
budget under control, and could undermine a long and honorable tradition
of metropolitan home-rule.