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CAPITAL FORMATION IN AN UNCERTAIN FINANCIAL ENVIRONMENT

Remarks of

Philip E. Coldwell
Member
Board of Governors
of the
Federal Reserve System

Before
the
58th Annual Meeting of the American Gas Association

Los Angeles, California
October 11, 1976

Capital Formation in an Uncertain
Financial Environment______

In keeping with the forward look of the theme of this
Convention, my comments will focus upon the financial environment
of the future and the uncertainties we face in meeting the capital
requirements of this nation.

The starting point will be a review

of demand and supply in several different contexts.

Following

this, I shall look at the principal factors that will affect
capital markets over the next quarter century.

Of course, I speak

only for myself not the Federal Reserve or my associates at the
Board.
It almost seems unnecessary to say that the capital re­
quirements of the world over the remainder of the Twentieth
Century are staggering.

The needs and expectations of the develop­

ing nations alone will require capital infusions on a massive scale
if they are to realize a significant improvement in standards of
living.

Similarly, the high technology race underway in the

industrial nations will continue to require heavy capital expen­
ditures to provide the plant and equipment to maintain the
technological substitution of equipment for labor and the increasing
efficiencies of modern methods of production.
It may seem somewhat strange to a few of you that I have
started with the global demands for credit, but I do so, not only




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because capital markets are worldwide and often interchangeable,
but because t h e m are some lessons to be drawn from foreign
experience.

With many foreign nations competing for capital in

the U.S. market, both by direct issues and by borrowing from
financial institutions, the worldwide demand for capital is of
importance to the industries of the United States.

Just in the

first seven months of 1976 bond issues of foreign entities in the
U.S. market have totaled $5.5 billion or more than 10 percent of
total capital issues ia our market.

There have been $1.3 billion

of new issues marketed in the United States by international
financing institutions such as the World Bank, Asian Development
Bank, and the Inter-American Development Bank.

Moreover, estimated

foreign lending by U.S. banks has risen $10 billion thus far
in 1976.
It seems clear from the foregoing that U.S. capital
markets have been a major source of financing for other nations
and foreign businesses.

It is also true that U.S. enterprises have

obtained financing abroad, both by Eurodollar loans and Eurobond
issues and U.S. banks have drawn sizable amounts of new funds from
foreign sources, especially the OPEC nations.

Moreover, foreign

governments and nationals have purchased sizable amounts of U.S.
\

Treasury issues in all maturity ranges as well as stocks of U.S.




-3-

corporations.

Foreign official institutions hold almost a fifth

of total U.S. Government debt in the hands of private investors.
The net effect, of capital exports and imports and security invest­
ments here and abroad appear to reflect a continuing export of
capital to other nations, especially when new plant construction
and expansion abroad by U.S. firms are taken into account.

One

important feature of our international relationships in the capital
area is the high volatility, at the margin, in the demand and
supply of funds flowing in both directions.
The demand for capital abroad is quite large, par­
ticularly from the less-developed nations.

But some of these

very nations are ones where effective demand may be questionable.
First, the LDC's who must import oil, generally have had a
significant increase in balance of payments deficits and have
borrowed heavily to meet such deficits.

As a group, the non-oil

L D C fs have borrowed more than $65 billion in the past two years
and debt burdens for some have reached a problem level.

For a

few such nations, credit-worthiness has been impaired and future
borrowings will be costly and difficult to obtain unless adequate
stabilization policies are in force.
Secondly, for a few countries, recent nationalizations
have dampened capital inflows and reduced effective demand in




-4-

world markets.

Political shifts have made some countries less

acceptable risks in the U.S. capital market, and a few have boycott,
human rights, or debt arrearage problems.
Thirdly, for certain industries, capital expansion is
unlikely due to heavy overhangs of unutilized capacity, weak
demand, low prices and generally poor prospects for profit.

Shifts

in labor costs, higher taxes, restrictions on currency conversion
of profits, and directed priority capital controls have reduced the
effective demand for some industries.
Finally, in a number of less-developed and even developed
countries, the inflation rate is steadily eroding their capacity to
borrow in the world markets.

A few nations attempt to balance

their international accounts by sequential devaluations designed to
neutralize the affect of domestic price increases on their position
against foreign currencies.

Others have attempted to hold their

exchange rate relationships but mount increasing borrowings to
make up for the higher costs of imports and development at home.
For both types, the fundamental problem is the inflation rate and
its impact on domestic and international financial positions and
capacity to borrow.
Domestic demand for capital in the U.S. has been estimated
in the trillions of dollars over the coming years to the turn of the
century.




One scarcely knows where to start to describe the capital

-5-

needs of the U.S. public and private sectors.

We know that our

Federal Government has required $68 billion in new financing just
to meet its deficit of the past fiscal year, but more than that,
Federal Government needs for financing capital expansion of its
physical plant and equipment represent an enormous drain on the
capital markets.

Just to finance a new bomber program, the

Department of Defense needs more than a billion dollars.
The state and local government demands for capital to
finance new streets, schools, industrial parks, recreation
facilities, and the host of other needs, continues to draw upon
the available supply of credit.

Just in the first half of 1976,

the state and local governments have issued $17.3 billion of new
long-term debt instruments.

As our population has concentrated

into the larger urban areas, the pressure for increased facilities
is mounting, while such facilities in the rural areas become
increasingly underutilized, if not abandoned.

The massive pop­

ulation move over the past 35 years from farm to city has clearly
brought new financing pressures on the city and state governments.
It is, of course, questionable whether or not such population
concentration will persist over the coming 25 years.

The problems

of big city living are well known and may be enough to at least
dampen the rural to urban move with important consequences for our
capital stock.







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The private sectors of our economy have equally strong
capital needs.

The destructive inflation and subsequent recession

in this country has greatly expanded the needs for protective
capital in many firms, especially financial institutions.

With

heavy losses from defaulted loans impacting on reserves and profits,
accompanied by the sharp expansion of assets over the past five
years, and pressures from regulatory authorities, the financial
institutions have fallen behind in their capital coverage.

Capital

markets in the past few years have been noticeably unreceptive to
new issues from banks and only recently have liquidity and profit
positions permitted a return to the market.
While the trials and tribulations of financial institutions
may be of only passing interest to you, in some ways their problems
have a significant bearing upon the availability of bank credit and
the tone and feel of all financial markets.

Thus to an important

degree, the health of the nation's financial institutions should be
of considerable interest to all borrowers.
Nevertheless, the massive capital needs of other businesses
may constitute your primary competition for capital financing over
the coming years.

It is useless for me to try to spell out for

this audience the capital needs of energy companies.

Your own

association's estimate of a nearly $67 billion capital need over the
next decade at current prices and a nearly $92 billion capital need

-7-

with a six percent inflation rate dramatically shows your require­
ments and the effects of inflation.

Suffice it for me to say that

competition for capital funds over the next 25 years will be intense
even if some foreign borrowers are less-effective demanders of
credit.
The supply of investment capital depends upon savings
of our people and this is probably one of the happier features of
my comments today.

With personal incomes advancing and now moving

up faster than inflation, savings have increased and supplies of
new capital funds are rising.

Simultaneously, the cash flows of

many firms have strengthened materially, so that internal genera­
tion of funds for debt service, additions to liquid assets, or
even capital expansion is becoming a steadily greater portion of
total sources of funds.

Corporate profits have increased sharply

and with cautious inventory policies many firms have been able to
reduce business loan demands at banks, thus increasing their creditline availability.

Even the investment tax credits have encouraged

a few firms to increase capital spending with the prospect of an
earlier write-off.
In a longer time frame, the availability of capital funds
will depend heavily upon government action to encourage earnings,
reduce government competition for funds, improve the tax climate,
and permit profit incentives to work on both investors and borrowers







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by maintaining a certainty of returns and safety and soundness of
credit.

All of these are important objectives, but all are

difficult to achieve and will require dedicated efforts.

Unless

these objectives are met, the environment for capital formation
will suffer and government competition for funds will be stronger.
Moreover, unless government deficits can be reduced, the nation
will face continued inflationary pressures.

To me the greatest

uncertainty confronting the natural gas industry or any industry
in planning for future capital formation, is the rate of general
price increase in the economy.
If inflation can be reduced to pre-1965 levels and,
held there long enough to reestablish confidence in currency values,
industry can plan its capital expansion with assurance of a
reasonably steady value of the dollar.
Beyond the stability of dollar values, slower rates of
inflation would have the salutary effect of reducing interest rates,
especially for long maturity borrowings.

It is well recognized

that an inflation premium is built into interest rates and these in
turn inflate the costs of doing business.

Perhaps of almost equal

importance, a slower rate of inflation could provide the incentive to
investors to place their funds into equities where returns are likely
to be commensurate with basic risks.

-9-

Thus even after the demand and supply curves are analyzed
and various options considered, the fundamental variable is the rate
of inflation.

It is this problem I would like to address for the

remainder of my remarks.

The recent inflationary chaos and

resulting recession may have sufficiently impressed our business
and consumer population of the disruptive effects of inflation,
whether demand or cost induced.

But has the experience of the past

decade sufficiently impressed government to force a change in
spending habits?

On this question, the verdict is still out,

though there are some encouraging signs.

At least Congress is

largely following its own budget reform procedures and there are
hopeful indications of recognition of the problem.
Similarly, there is an increasing awareness of the ties
between wage increases and price advances 0 1 the part of workers
1
and their leaders.

Average wage settlements thus far in 1976

show some moderation of the front end cost and a continued willing­
ness to sign three-year agreements.

It should be noted, however,

that more and more settlements contain cost-of-living escalation
clauses without a cap.

In other words, more workers have their

wages indexed to changes in the cost-of-living.

This alone makes

it imperative that our inflation rate be curtailed before we build
such a base of indexed costs that inflation feeds upon itself.




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Another important feature of cost inflation is the raw
material prices of primary products and energy.

While we in the

United States were largely self-sufficient in our early years,
the Bicentennial finds us heavily dependent upon foreign sources
for many of the primary raw materials and now too for a heavy share
of our oil and gas energy supplies.

We have already seen the

damaging and disruptive results of such dependence, and the in­
flationary costs it can produce.

I suspect that very few of us

believe the U.S. can reverse the course and become self-sufficient
again without some sacrifice in our standard-of-living;

yet the

threat of the present degree of dependency is unacceptable to many
of us.

Thus, it seems to me that some compromise is likely--

giving up some of the frills in our usual living arrangements to
pay for less dependency, particularly in energy sources.

But the

degree of payment again depends upon the rate of price change and
here we are presently unable to entirely control our own destiny.
Among the very dangerous trends of recent years, has been
the formation of producer cartels to dictate terms of availability
and price.

The success of the OPEC cartel has already encouraged

other nations to seek similar restrictive agreements but, so far,
without much success.

If the trend toward cartels should take

hold, the world could break into small groups of nations and world




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trade will be more difficult, even to the establishment of barter
systems.

Personally, I doubt the long-range effectiveness of

such cartels, but they can be quite disruptive in the short-run.
Cost pressures in the past few years have indeed been
a major source of world-wide inflation, but these have been aided
and abetted by demand pressures and made effective by too easy
fiscal and monetary policies.

The pressures of a growing and more

demanding population have pushed governments into greater borrowings
to raise standards of living.

To a considerable extent, these

demand pressures have been responsible for loose fiscal policies and
these in turn have created financial market competition, conducive
to easier monetary policies.

If fiscal policies can be tightened

to reduce deficit financing, then monetary creation can be slowed.
As I survey the damage of the inflationary pressures
over the world and even in the United States, I am even more
determined that the causes of inflation should be corrected and that
our policies should be dedicated to reducing the inflationary rate
in coming years.

Monetary policy can and should do its share in

eliminating this crippling disease but if not helped by appropriate
fiscal, labor, and business policies, our efforts will not likely be
successful.

It is easy to say that a strict monetary policy aimed

at a low rate of money supply creation will eventually restrict growth




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so that only a part of our needs are financed.

But it is clear to

me that such a single-minded statistical approach to monetary policy
runs undue risks of an unacceptably high rate of unemployment and
an equally unacceptably low rate of growth.

Thus, a balanced

approach to monetary policy seems needed, giving weight both to the
long-run needs for funds to finance a non-inflationary growth and to
the short-run cyclical swings in the economy.

For the latter,

monetary policy should recognize the need to stimulate growth in
periods of rising unemployment and slow consumer demand or to
dampen growth when business inventory or spending plans and short
labor supplies threaten price stability.

To me this balanced

policy approach is our only responsible course.
In summary, I believe the capital formation needs of
American business can best be met in a non-inflationary environment
which will develop only if government, labor, business, and consumers
give it high priority in their decision-making and implementations.
I see no insuperable bar to the financing of capital needs of
American business nor to a continued growth in our standard-of-living
through the next quarter century.




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