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Rebuilding America's Financial Liquidity
Remarks of Robert P. Mayo,
President of the Federal Reserve Bank of Chicago
before the Investment Analysts Society of Chicago
February 4, 1971
In the present atmosphere of controversy on vital issues--foreign and
domestic, social and economic--there is one area of all but universal agreement.
It is that 1971 should see a continuous, quarter-by-quarter, rise in business

Substantial disagreement exists, however, as to the extent of the

recovery, and the degree of success that will be achieved in moderating the
twin evils of price inflation and unemployment.
It is my purpose today to outline the evidence that the financial
foundations have already been laid for a sustained recovery.

Easier monetary

policy pursued during the past year has not yet accomplished its purpose.

and facilities, Federal Reserve policy actions will continue to encourage
the growth of bank deposits, other liquid assets, and the av~ilability
of credit.

Acceptance of this view, however, does not imply that mone-

tary ease can be pushed to any length without serious consequences.
Throughout the past quarter century, Federal Reserve policy has
never lacked vigorous critics.

These critics can be divided broadly into

two groups--those who desire a more stimulative policy and those who
prefer a more restrictive policy.

The former tend to emphasize the

problem of full employment, the latter the problem of inflation.


certainly is no secret, now that the proceedings of the Federal Open
Market Committee are published, that both points of view are always
present within the councils of the System.

Clearly, grave dangers exist

in following one objective to the exclusion of the other.
Federal Reserve Bank of St. Louis

Like the

- 2 yang and yin of oriental philosophy, the joint objectives of moderating
unemployment and restraining inflation are opposed, but also complementary.

As we have seen several times since World War II, excessive price increases
inevitably cause imbalances, reduced productivity, and added unemployment.
It is the responsibility of the monetary authorities to find the most
appropriate path to stable growth and prosperity.
as it is in their power.

I should add, insofar

Monetary policy is not omnipotent.

There are

no precise relationships between monetary developments, however measured,
and the course of economic activity.

Our markets and institutions are

far too complicated to be finely tuned by one or more controlling levers.
When the Federal Open Market Committee, of which I am now a
member, met in January 1970 it was apparent that the economy as a whole
had leveled off.

Declines were occurring in some sectors, particularly

housing and defense, but "prices were continuing to rise at a rapid

In accord with this understanding, the FOMC communicated to

the "desk" at the Federal Reserve Bank of New York, which conducts open
market operations in government securities for the entire System, its
"desire to see a modest growth in money and bank credit . . . " as its
paramount objective.

In February 1970, this directive was strengthened

to read "moderate growth of money and bank credit . . .. "
I will not take time here to review all of the steps taken by
the System to encourage growth of money and credit in 1970.

Aside from

open market operations, these included reductions in the discount rate,
cuts in margin requirements on stock purchases, adjustments of reserve
requirements, and liberalization of the rates commercial banks can pay
on time deposits.

Rather, I shall emphasize the quantitative evidence

of the year-long trend to easier monetary and credit co~ditions.
Federal Reserve Bank of St. Louis

- 3 - •

In the week ending January 27, 1971, Federal Reserve credit
outstanding averaged $66.6 billion, up almost $5 billion from a year
earlier--an increase of 8 percent.

System holdings of government securities,

which account for the lion's share of Reserve Bank credit, were up $6.3
billion, or 11 percent.

Member bank borrowings, also included in Reserve

Bank credit, were less than $400 million, only one-third as large as
a year earlier.

The lower level of borrowings, of course, reflects

reduced reserve pressures on banks.

On the other side of the System's

balance sheet, Federal Reserve notes (which now account for virtually
all of the nation's paper currency) were up 7 percent.
reserves rose 6 percent.

Member bank

These reserves, "high powered dollars," provide

the base for expansion, not only of commercial bank credit, but the
entire financial structure of the nation.
Increasingly, the rate of change in the money stock (defined
narrowly as currency and demand deposits in the hands of the public)
is used as a symbol for the overall thrust of monetary policy, sometimes


the Friedman effect. 11

In December, the money supply was $215

billion (seasonally adjusted, daily average basis), up 5.4 percent from
a year earlier.

This increase compares with a 3.1 percent rise in 1969

(with practically no increase in the second half of that year).


rise in the money stock in 1970 was less than in 1967 or 1968, but
it was larger than in any previous post-World War II year, except 1951.
Useful as the money stock concept may be as an analytical tool,
it must be remembered that it is not only overly simplified--but it
is also a heterogeneous quantity.

For example, the past decade has

witnessed a substantially greater proportional rise in currency outstanding
Federal Reserve Bank of St. Louis

- 4 than in demand deposits, for reasons that are not completely clear.
In individual years, however, demand deposits have increased faster
than currency.

Within the currency component, for example, the rise

in $100 bills in the past decade has been twice the rise for the total
money stock. - At present, almost $12 billion worth of $100 bills are

Note, I do not say "in circulation" because some of these

bills apparently are held as a store of value.

There are almost 120

million hundred dollar bills outstanding, but there probably are none
at all in the wallets of this audience!
You might also be interested in the fact that about $6 billion
of coin is now outstanding--about $30 in change for each of us.
I doubt if anyone in the audience is that "loaded."


Coins outstanding

increased four times as fast as the total money stock in the past decade.
The Kennedy half dollars are one factor.

From 1964 through 1969, almost

1.3 billion Kennedy halves were coined and issued, about as many half
dollars as had been issued in the entire period of U.S. coinage from
1792 through 1963.

About 10 percent of the Kennedy halves were issued

through the Federal Reserve Bank of Chicago.

Unlike the earlier Franklin

halves, they seldom come back to us for recirculation.

Simple arithmetic

tells us that six Kennedy halves have been issued for every man, woman,
and child in the United States.

(I know many have gone abroad.) Very

soon the public's appetite for Eisenhower dollars is to be tested.
Demand deposits account for more than three-fourths of the money

It is often said that 90 percent of all transactions are made

by check.

But that is only a wild _guess.

Probably by far the largest

share of purchases, certainly business purchases, are made on credit,
Federal Reserve Bank of St. Louis

- 5 and are settled later by check.

But qualification is impossible on

the basis of present knowledge.
A substantial share of all demand deposits is represented by
compensating balances in banks, held to reimburse these banks for services
rendered. we · do not know the total amount of compensating balances,
how strictly requirements are enforced, or the extent to which these
arrangements vary with changes in credit conditions.

But compensating

balances are part of the money stock, as defined, often referred to
as the "active money supply."

At the other end of the spectrum are

the overdraft arrangements _now offered by many banks.

Individuals are

encouraged by those banks to keep their demand balances in the red.
The money stock of people using such arrangements is negative.
Sometimes commercial bank time accounts are included in a broader
concept of the money stock, commonly referred to as "M2."

The usefulness

of this concept has been undermined by the rapid development and recent
sharp fluctuations in the negotiable certificates of deposits (CDs)
issued by large banks.

From an investor's standpoint, CDs are closely

akin to other liquid assets such as Treasury bills or commercial paper.
In 1969, total time and savings deposits of commercial banks declined
5 percent, mainly because banks were prevented by Regulation Q ceilings
from paying competitive market rates for CD money.

Because restrictions

were eased in 1970, and because short-term market rates declined sharply,
the rebound in time and savings accounts was dramatic.

For the year

as a whole,commercial bank time and savings accounts were up more than
18 percent, a record increase.

The recovery in outstanding CDs was

augmented by an upsurge in other time and savings accounts.
Federal Reserve Bank of St. Louis

Deposits at savings and loan associations rose 8 percent in

- 6 1970, compared to 3 percent in the previous year.
in S&L deposits set a new record.

The $11 billion rise

Deposits of mututal savings banks,

important in the East, rose 7 percent in 1970, compared to 4 percent in
the previous year.

At most banks and other savings institutions inflows

of time and savings funds were especially strong in the final months
of 1970.

Apparently, this trend continued in January 1971.
The more rapid increase in deposits of financial institutions

in 1970 was accompanied by comparable increases in their earning assets.
In the case of commercial banks, total loans and investments (adjusted
for sales of loans to affiliates) increased 7.4 percent last year, almost
twice as much as in 1969.

Loan demand was very weak in the final quarter

of the year partly because of the slower pace of the economy, and the
auto strike, but _primarily because of refundings of loans through sales
of securities.

For the year as a whole, bank loans rose less than 4

percent, compared to a 10 percent rise in 1969.

But bank holdings of

governments and municipals rose 12 and 20 percent, respectively.


1969, banks liquidated 16 percent of their governments, and merely
maintained holdings of municipals, to help them to accommodate heavy
loan demand~
Most of the increase in deposits at S&Ls, and half of the increase
in deposits at mutual savings banks, was reflected in larger holdings
of mortgage loans.

Resources of S&Ls in 1970 were supplemented by a

rise in borrowings from the Federal Home Loan Banks.

(Under similar

circumstances in 1967 borrowings from the Home Loan Banks declined.)
The improvement in the lending power of thrift institutions contributed
to the sharp uptrend in housing starts in the second half of 1970.
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As you all know, the securities markets absorbed an enormous

- 7 -

volume of new issues in 1970.

Despite especially heavy flotations in

the fourth quarter, long-term interest rates declined significantly
late in the year .
New corporate capital issues, more than 70 percent nonconvertible
bonds, totaled almost $39 billion last year, up 45 percent from the
record total of 1969.

New issues of long-term municipals rose 50 percent

. to $18 billion, a total that exceeds the 1968 reco rd .

Thus far in 1971,

offerings of both corporate and municipal securities have substantially
exceeded the levels of early 1970.

The large volume of corporate securities

sold in 1970 helped to improve the balance sheet liquidity ratios of
many firms.

It now appears that the long-t erm decline in the ratio

of corporate liquid assets to short-term li ab ilities was halted and
reversed last year.

Unfort unate ly, the available data on corporate

holdings of liquid assets l eave much to be desired.

A recent survey

of business holdi ngs of liquid assets is currently being evaluated by
statisticians at the SEC.

Hop efully, the information developed will

shed needed light on this sector.
· Attempts to analyze the various aspects of the financi al markets
often lead one to wander through the trees looking for the forest.
Fortunately, the staff of the Board of Governors of the Federal Reserve
Sys tem , constructs a body of data under the heading, the _"Flow of Funds,"
that relates the national income accounts to developments in the financial
sectors of the economy.

Estimates of financial flows--funds raised

and funds invested--are not yet available for the fourth quarter of
1970. Nevertheless, data for the first three quarters of the year provide
an instructive overview of financial developments in the crucial period
under review.
Federal Reserve Bank of St. Louis

- 8 -

Total funds raised by the nonfinancial sectors of the economy
(i.e., excluding intermediaries), both public and private, totaled $88
billion in 1969, down from $97 billion in 1968.

The peak quarterly rate

for this aggregate in 1969, $93 billion, was reached in the third quarter,
coincident with the peak of business activity.
Total funds raised by the nonfinancial sectors declined to an
annual rate of $80 billion in the first quarter of ·l970.

In the second

quarter, however, the rate jumped to more than $100 billion, and it
reached $103 billion in the third quarter.

Except for the effects

of the GM strike, this extremely high rate of financing probably continued
in the fourth quarter.
The most pronounced shift in the 1969-70 period in the Flow of
Funds reflected the shift in the federal sector.

From a surplus in the

first half of 1969 the federal government moved to a deficit position,
mainly because of reduced revenues that required raising funds at a
$19 billion annual rate in the third quarter of 1970.

One does not

have to be identified either as a "monetarist" or as a "fiscalist" to
foresee an expansion in business activity in 1971.
A review of the course of interest rates in the past year suggests,
once again, the need for caution concerning generalization in this area.
Short-term rates declined through most of 1970, but long-term rates
reached peaks about midyear.

The rate on three-month Treasury bills, the

nearest market approximation to a "pure" interest rate, was at an all-time
high of 8 percent at the start of 1970.

By late January 1971, the bill

rate had declined to 4.2 percent--the lowest since mid-1967.

The drop

in the rate banks pay to borrow each other's excess reserves--the federal
funds rate--was even sharper, from 9 percent to less than 4 percent.
Federal Reserve Bank of St. Louis

- 9 Commercial paper rates, at 8 percent as recently as last sunnner, are
now below 5 percent.

Commercial banks have cut their prime rate from

8.5 percent in February 1970 to 6 percent currently, with an unprecedented
flurry of reductions since last September.

Rates on new issues of

high-grade corporate bonds dropped from 9.2 percent last June to about
7.5 percent recently.
Interest rates are the price of credit, and reflect, like other
prices, the interaction of supply and demand.

In recent months, most of

the downward pressure apparently has come from the supply side, because
the total volume of funds raised has been large.

But one should not

assume that the monetary authorities can determine the course of interest
rates through long periods of time.

Unlike prices of goods, the price of

credit cannot be _forced down indefinitely by increasing the supply.
Because of price inflation, lenders demand, and borrowers are willing
to pay, a premium to compensate for erosion of the purchasing power of
the dollar.
You may have noted that in this discussion of liquidity I have
made only passing reference to ratios that purport to measure liquidity
in an objective sense.

This is because I regard liquidity more as a

state of mind than a concept subject to quantification.

Liquidity is

ample when an individual, business, or institution is confident that
funds will be available to pay bills when they come due.

Current and

prospective income, the collection rate on receivables ., and the extent
of unused lines of credit are all important considerations.

A man with

a substantial bank account who thinks his job is in jeopardy is less
willing to spend and to assume new commitments (feels less liquid) than
a man with a negative bank balance who has just been promoted.
Federal Reserve Bank of St. Louis

- 10 The shock to the confidence of many individuals administered
by the recession (mild perhaps, but recession nonetheless) of 1969-70
has had far more to do with the erosion of liquidity than changes in
any financial aggregates.

The psychological impact of the recent

business deciine, I believe, was more severe than in any of the previous
postwar recessions, which featured much larger declines in activity and

Partly, this is because the balloon of endless expansion

inflated in the 1965-68 period has burst.

Partly, it is the drop in

the stock market, the Penn Central failure, and the problems of the
brokerage industry--problems which many of you are all too aware of.
Partly, it is the persistence of inflation in the face of lower profits
and slower growth in incomes.
Confidence will be rejuvenated only when it becomes evident
that a pronounced recovery in business activity is underway.
encouraging signs that such evidence is near at hand.
construction activity is extremely vigorous.
December and January.

There are


Retail sales improved in

The end of the auto strike has revived affected

sectors of that industry.

Total employment ceased to decline in late 1970,

and probably is rising in early 1971.

Personal income continued to rise

quarter-to-quarter through the slowdown in activity.
saving at historically high rates.

Consumers have been

The growth of liquid assets, and

the availability of consumer credit, .indicates that the potential to
spend is very large.

The consumer is the real key to sound economic

revival in 1971.
Earlier in my talk I described the financial developments that
have laid the foundations for a return to prosperity.

Most of us are

disappointed that clearer signs of an improvement in economic conditions
Federal Reserve Bank of St. Louis

- 11 -

have not already appeared.

The fact that there are lags between monetary

policy actions and their effects is well known.
lags is still somewhat unpredictable.

But the timing of the

The lags apparently are longer

this time--certainly longer than in 1967 when the slowdown in activity
was reversed within a six-month period.
Disappointment with the results of monetary policy thus far
must not lead to incautious excesses that may be harmful rather than
beneficial to economic recovery.

An even sharper increase in the growth

of money and cre dit at this time will not quickly revive the nation's
depressed psychology which is already on the mend. That will take time ..
The available funds are there today.

And if credit unavailability is

threatening to hamper recovery, you can be sure that the monetary authorities
will act swiftly and surely.
Each of us could draw up a list of episodes of the 1969-70
period that might have been recalled as harbingers of disaster if the
economic adjustment had snowballed into a deeper recession. The fact
that such a prospect was not realized bears testimony to the basic
strength of our business and financial structure.

With a proper balance

of fiscal and monetary policies, plus responsible union and management
policies in industry, I firmly believe that the Seventies will go down
as the greatest decade in American history.
Federal Reserve Bank of St. Louis