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Content AN ANALYTICAL AND DESCRIPTIVE STUDY OP INTEREST RATES, THEORIES' AND POLICIES IN THE UNITED STATES PROM 193S to 1948 A Thesis Presented to The Faculty of the Graduate School of the Department of Economics The University of Southern California In Partial Fulfillment of the Requirements for the Degree Doctor of Philosophy in Economics By Gerald Kenneth Sharkey August 1949 UMI Number: DP23243 Alt rights reserved INFORMATION TO ALL USERS The quality of this reproduction is dependent upon the quality of the copy submitted. In the unlikely event that the author did not send a complete manuscript and there are missing pages, these will be noted. Also, if material had to be removed, a note will indicate the deletion. Dissertation Publishing UMI DP23243 Published by ProQuest LLC (2014). Copyright in the Dissertation held by the Author. Microform Edition © ProQuest LLC. All rights reserved. This work is protected against unauthorized copying under Title 17, United States Code ProQuest LLC. 789 East Eisenhower Parkway P.O. Box 1346 Ann Arbor, Ml 48106- 1346 «. i I ' cf FK, D , lc^> s 5 " 3 i This dissertation, w ritten by Gerald Kenneth Sharkey under the guidance of h F a cu lty Com m ittee on Studies, and approved by a ll its members, has been presented to and accepted by the C o u n cil on Graduate Study and Research, in p a rtia l f u l fillm e n t of requirements fo r the degree of D O C T O R O F P H I L O S O P H Y i 7Z4-L D ate.. Committee on Studies phMrman . TABLE OE CONTENTS CHAPTER PAGE I. THE PROBLEM AND ITS DEVELOPMENT........... 1 The problem............ 1 Statement of the problem. ....... 1 Importance of the study.......... 2 Present status of the problem ..... 3 Organization of remainder of the thesis . 4 Development of the thesis • 4 Statement of procedure ...••••• 5 II. DEVELOPMENT OP ORTHODOX DOCTRINE........... 7 Classical School • 7 Concept and resulting controversy . . . 7 Determination ...................... 12 Function............................. . • 15 Justification . . . . . . . . . . . . . 17 Summary............ IS Marginal School! ............. • 19 Concept ............... ........ 21 Determination. ....................... 22 Function .............................. 25 Justification. ......................... 26 Summary. . . . . . . . . . . . . . . . . 27 Neo-Classical School ............. .... 28 CHAPTER PAGE Determination................ • • . • 31 Function • ........... ....... 40 Justification................ 47 Summary.......... 48 Conclusion 49 III. THE NEW ECONOMICS..................... 52 Concept ...... ............. ... 53 Determination .. 57 Function. 71 Justification . • • • • • • • . . • • • 86 Summary .............. 88 IV. DEPRESSION AND RECOVERY POLICIES......... 91 Policy background . . . . . . . . . . . 92 Historical background 102 The legislative period 1933-1935. . . . 114 Short-rate vs. long-rate............. 120 Policy . . ....................... 122 Rates of Interest .......... 126 Banking Act of 1935 . 131 Recovery fully launched ............. • 142 Gold flow and excess reserves .... 142 Low interest rates .......... 149 Debt policy .............. 151 Full employment and recovery. .... 154 iv CHAPTER PAGE Recession • . . . . . . . . . . . . . . . 159 Bank examination ..... ... . . ..... • • 162 Ca sh balanc e... . . . . . . . . . . ... 163 Continued Low interest.. . . . •• .... . . . 163 Recapitulation .............................. 167 Appraisal . . . . . . . . . . . . . . . . 169 Fiscal aims 174 Counter-cyclical action ...........• • . • Cash velocity. *:. . . . . . • . ... ... . • Conclusion ............... . . . . 182 V. WAR FINANCE . . . . . . . . . ............... 185 Transition ............................. 185 Low interest ................... . 186 Government bonds 188 Gold .......... 190 Treasury operations. .......... 191 Defense finance... 194 Credit .. . . . . . . . . . . . 196 Government policy. • . . . . • • • • « • • 198 Increasing tempo •••.•• ... .... 203 Anticipated controls • .. . . . . . . . • 207 Summary ................ • 210 Financing the war. 211 Economic controls............ 211 CHAPTER PAGE Credit policy ............. ..... 212 Taxation.............. 216 Crddit controls 218 War debt • • . . . . . . * • . • • • 228 Post-war considerations ....... 231 Conclusion.............. 240 VI. POST-WAR FINANCE AMD INFLATION........... 248 Review 248 Post-war period 253 Inflation threatening .......... 261 Inflation ......... ......... 266 Policy differences. ......... 269 Inflation arrested. . . . 285 Conclusion. 293 VII. FISCAL POLICY ............ 298 Public Expenditures ........... .... 298 Budget . . . . . . . . . . . . . .. 299 Principles of expenditures. ..... 303 Causes of expenditures. ••..... 306 Purposes of expenditures. ...... 307 Classification of expenditures. . . . 309 Government spending ••*•••.•• 310 Timing of government expenditures . • 314 Limitsof public expenditures......... 315 vi CHAPTER PAGE Compensatory fiscal policy . • . . . • 316 Other aspects., cash balance • • • • • 319 Federal agencies.. .. ... ... . . • 320 Government bevels.................. 321 Fiscal controversy ........... . . . 322 Debt . .............. 324 Keynote. • • • 324 Debt management. ..•••...•• 328 Rate structure................... 330 Historical developments. . . . . . 331 Debt management policies ..... 334 Principles and considerations. • • 336 Taxation . . . . . . . . . . . . . . 339 General treatment. . . . . . . . • 340 Specific taxes ............ 348 Intergovernmental relations. . . . 356 Timing 357 Tax policy............. 359 Conclusions in fiscal policy .... 362 VIII. SUMMARY AND CONCLUSIONS. . ........... 369 Summary....................>•••• 369 Classical school. ... ...... 369 Monetary development . • . • . . . 370 Keynesian theory. . ........ 372 vii CHAPTER PAGE Synthesis ............ . 575 Policy developments . . . . . . . . . 378 Conclusions , 382 ’ ’Futures5 1 rate of interest . 382 Fiscal measures .................... 387 Monetary demand • • • • • • • • • • • 389 Demand for money. ......... ..... 392 BIBLIOGRAPHY . . . . . . . . . . . . . 397 APPEHDIX....................................... 409 LIST OP TABLES TABLE PAGE I* Public debt Outstanding June, 3,0, 1934 139 II. Public debt outstanding June 30, 1939 166 III. Public debt outstanding June 30, 1944 237 IV. Composition of the Federal Debt on August 1, 1948 288 V. National, Income and Federal General Fund Balance and 1122 Corpo.ration Cash Balance 410 VI. Open Market Rates in New York City 411 VII. Bond Yields on Open Market Per Cent Per Annum 412 LIST OF CHARTS CHART PAGE I. Bond Yields* Excess Reserves and Bank Deposits , 143 II. Selected Business Series 156 III. Wholesale Prices and Gross National Product 272 IV. Yields on United States Government Securities 297 V. Bank Deposits and Currency 413 CHAPTER I THE PROBLEM AND ITS DEVELOPMENT It is the task of this study to describe the major developments of interest rates as applied to banking and credit institutions and to the fiscal operations of the government* It adheres as closely as possible to an economic analysis, especially in regard to the monetary aspects of the interest rates. However, it cannot be unaware ©f the political factors as are indicated by government policy developments* This study is necessarily confined in scop© to dealing with the interest rate as a price of particular importance due to its function in the economic system. The deductive analyses of theorists who have attempted to explain this price are incorporated into this work as background wherever policy developments indicate. Particular attention is devoted to the government policies adopted with respect to interest rates in the economy during the past fifteen years since 1933. THE PROBLEM Statement of the problem. It was the purpose of this study (1) to clarify the two major theories of interest, the Heo-Classieal and the Keynesian, by tracing their growth and development from the time of Adam Smith in 1776 to the recent year of 1948; (2) to relate the Glassical and Marginal Theories of interest to their modern counterpart, the Neo-Classical; (3) to develop these four theories of interest on the basis of concept, function, determination and justification, and to indicate the interest rate policies derived from these concepts by the economic theorists; (4) to analyze the interest policies of the United States Government during the years 1933-1948 in which this country faced a depression, a war and a post-war adjustment period; and (5) to relate this whole problem of the interest rate to the broad fiscal and monetary operations of the government* Importance of the study* The rate of interest assumed large proportions in the great controversy that still goes on In professional and political circles concerning Keynes’ treatment of interest in his General Theory of Employment, Interest and Money* Repercussions are still echoing through out the economic world regarding Keynesian policy in its broader outlines and policy implications* Great emphasis must naturally be put upon interest in view of the task set down in the title of this subject* However, it is recognized as not being the all important element in the entire price structure of the economy, although under particular circumstances it may very well be# It assumes a greater importance under an expanding and active economy than under a slow moving, relatively inactive economy# Yet it certainly cannot be relegated to an unimportant element once it has been greatly reduced by some controlling agency unless one assumes a permanently static level of activity. It is a part of the theory of distribu tion of income, and recent developments have intimately related it to business cycle theory, and even more recently to national income problems as well as to policy action for control* Present status of the problem* Many studies have been made regarding interest rate policy in the United States; other studies have been devoted to interest theory and banking developments. Two studies which might be mentioned for example are C* 0* Hardy*s Credit Policies of the Federal Reserve System, published in 1932, and S. E# Harris* Twenty Years of Federal Reserve Policy, published in 1933* Hardy*s treatment is very similar to Harris*, and both deal with function of the Federal Reserve as originally conceived and the various measures devised to cope with the problems of that period. These two studies deal particularly with policy with little regard to the theoretical aspects underlying such, policy. Two other studies partially covering the period of this study are A. W. Crawford*s Monetary Management under the Hew Peal, which deals with total monetary manipulation during the first 8 years of the Roosevelt administration, and J. E. Reeve's Monetary Reform Movements. This second study has traced the historical development of the monetary reforms of the period, tooth those suggested and those finally adopted* Articles in the professional journals have treated specific aspects of policy for a limited duration, or have discussed theoretical developments isolated largely from policy. Hone of these studies or articles referred to, or any other similar studies, as far as is known, has attempted to toring together the major theory and policy developments of the past fifteen years. ORGANIZATION OP REMAINDER OP THE THESIS Development of the thesis. As an introduction to this study, the traditional doctrine of interest and interest rates is briefly reviewed. The main body of the text covers the recent developments in interest theory, the policy development in the United States since 1933, and the relation ship between fiscal policy and interest rate theory and policy as put into practice by the government during the period under survey. The final part of this study summarizes the findings of the theory and policy, reveals a possible gap in interest rate theory that might be filled by a futures market, and discusses in further detail the present status of interest rate theory which has evolved regarding short- and long-term rates of interest. Statement of procedure. In this study the historical method of investigation was employed in its three major phases, namely, the collection of data, the criticism and analysis of this data and finally its presentation and Interpretation. The techniques of research used in the collection of data for the study were (1) analytic for interpreting the facts on an economic basis in light of the whole problem of this study, (2) the statistic for compiling this type of data from pertinent government publications, and (3) the quantitative in the use of figures to arrive at and support the conclusions of the paper. The sources of information in this study were necessarily confined to documentary evidence, such as government publications, national research studies in Economics, reports, articles and periodicals. Both primary and secondary sources were used in compiling this data, for example, government publications and statements of officials for the first type, and books and studies by authorities for the second. In the selection of these materials both external and internal criticism was used, the first in determining whether or not a writer was qualified as an authority in his field, and the second, in critically analyzing the problem as presented by the writer in light of the economic, situation and the economic reasoning involved in the solution of this problem# This study is organized on an historical and analytical basis; it begins with the basic theories and develops them in time and in growth. These theories are criticized as to their inadequacies to explain and define the economic concepts of the interest rate and its relation to the total economic phenomenon. The nature of the task outlined prescribes heavy reliance on historical development for presentation and organization of the materials in such a way as to bring out the constant shift, growth and expansion of interpretation of the theories and objective data as applied to the interest rate. CHAPTER II DEVELOPMENT OP ORTHODOX DOCTRINE It would seem appropriate to begin this treatise with a brief survey of what has been said of interest rates and their implications for the whole economy. In this chapter, the theories of the three major orthodox sehools (the Classical, the Marginal and the Neo-Classical) will be analyzed as to the concept of interest, the determination of interest rates, and the function and justification of interest. The policy questions which have evolved from these theories will be treated in a later chapter of this work, A further examination of the subject of Interest rates reveals four main points of controversy among the Classical economists deriving from the traditional concept of interests (1) Should money be included in a definition of capital? (2) What is meant by the term savings? (5) Should interest be distinguished from profits? and (4) What is the justification for interest? CLASSICAL SCHOOL Concept and resulting controversy. Since Adam Smith is well recognized as being the father of the modern science of Economics, it would be appropriate to begin this study with his definition of interest. He stated that £revenuej a fund *z? a person who does not employ it himself but lends it to another is called the interest for 2 the use of money*” In other words, while this interest is actually derived from the revenue of the borrower, it may be considered as belonging partly to the lender who has afforded him the opportunity of making this additional return# Smith’s definition of interest was apparently derived from the idea that income or production arises In part from the amount o f capital in the economy. He found that as capital goods increased, profits and interest were reduced# His concept of interest makes little distinction between capital as a fund and capital as a stock of physical good. As a consequence, money does not enter Into consideration as having an influence on Interest# Smith was also aware of the fact that other forces might affect Interest, for example, the fluctuations in prices which affected wages and profits, or the reduction In profits due to an increase of stock or capital goods which 1 The words In brackets throughout this paper are those of the writer, being used to fill in the needed gaps, and are taken from the context whence the quotation was drawn. "derived [from 2 Adam Smith, Wealth of Nations. (New York: E. P. Dutton andUompany, 1929), p. 46# caused interest to fluctuate accordingly. "The increase in 3 stock which raises wages tends to lower profits.” Ricardo, who followed Smith set down the explanation of economic phenomena in more logical terms so that Smithes theories would he formed into a more consistent whole. He agreed with Smith regarding the effect of increased capital on the interest rates, but enlarged that relationship when he said, "Interest rises only when the means of employment for capital bears a greater proportion than before to the capital itself, and falls when the capital bears a greater 4 proportion to the arena . . . for its employment.” Apparently the means of employment Is considered as opportunity for the employment of capital at a profit. It may be noted that, like Smith, Ricardo defined capital in terms of physical goods when he stated that, "Capital is that part of the wealth of a country which is employed in production, and consists of good, clothing, tools, raw materials, machinery, etcetera, necessary to give 5 effect to labor.” 3 Ibid., pg. 78. 4 Bonar and Hollander, Editors, Letters of D. Ricardo to Hutches Trower (London: Clarendon Press, 1^97, pp. 4-5* 5 David Ricardo, Principles of Political Economy and Taxation (New York: E.P. DuttonanH Company, lSSSj, p. S3. 10 Yet elsewhere when explaining fluctuations of prices generally to his friend Trower, Ricardo wrote: ^rather than the price of gold^. • • "it is really to the high or low rate of interest that we should look in order to ascertain the proportion which the circulation bears to the demands of 6 the people." There is evidence here in Ricardo’s exposition as well as in Smith’s that there is confusion of thought, or at least an inadequate distinction between stocks of goods as capital and money as capital. Apparently, therefore, the amount of money is determined by the amount of goods extent in the system, so that no distinction is necessary* The climax of the school of thought known later as the Classical came in the writings of John Stuart Mill whose synthesis of the Smith-Ricardian economics is considered the best. Mill made the necessary distinction in the different types of capital when he called capital a fund or, more specifically, a disposable fund. This fund is usually repre sented by bank notes or currency which are a part of the general loan fund. For the use of these funds a price must be paidj this price is called interest. Specifically, Mill stated, "This combination of a fresh demand for loans with a curtailment of the capital disposable for them raised the 6 Bonar and Hollander, op. oit., p. vii. See Arthur W. Marget, Theory of Prices, Vol l! THew Yorks Prentice Hall, 1942). 11 rate of interest and made it impossible to borrow except on 7 the very best security.1 1 The major conflict over the concept of interest has sprung from the writings of Jean Baptiste Say. He had argued for a distinction between profits and interest. As has already been pointed out, Smith had recognized the relation of interest to profits, but had failed to make the possible distinction between these two portions of revenue when he had explained: At present the rate of interest, in the improved parts of Europe, is nowhere higher than 6$, and in some of the most improved it is so low as four, three and two percent. Though that part of the revenue of the inhabitants which is derived from the profits of stock is always much greater in rieh than in poor countries, it is because the stock is much greater: in proportion to the stock the profits are generally much less.8 Say took Smith to task for failing to distinguish between interest and profits, for he argued, nThe profit of the speculator on whose account this operation has been effected, deducting the interest of the capital which he may have employed, represents the remuneration for his time and 9 talent. • .” He went on to explain that this risk taker is one of the necessary producers of goods, and his profits form 7 John Stuart Mill, Principles of Political Economy (Hew York: Appleton and Company, 1^9577 Vol. 11, p. 72. 8 Smith, op. oit., p. 299. 9 Jean Baptiste Say, Letters to Mr. Maithus, Edited by John Richter. (London: Sherwood, ^eeTy and Jones'," 1821),p. 14 part of the necessary charges of production* 12 Determination, The Classical School has explained the determination of interest on the basis of the supply and demand analysis. Smith explained interest in the following manner: If there be a few who have it in their power to lend money and a great number of people who want to borrow It, the price of interest must be high but if the quantity of stock on hand be so great as to enable a great number to lend, it must fall proportionately, 10 Ricardo’s analysis more expressly explained the determinants when he argued that demand for capital rests on a comparison between the rate of profits from the use of capital and the rate at which the banks are willing to lend this capital. He recognized that temporary alterations in the interest rate may be caused by abuses in banking and by the discovery of new methods of production and new sources of raw material. He seemed to believe that as prices went up due to an increase in money, wages would also rise, so that profits would Increase only temporarily until the new ratio established between profits and wages would be identical with the old*. Thus, the rate of Interest would return to its original position* 10 Adam Smith, Lectures on Justice, Police, Revenue and Arms, Edited by Edwin Oanaan. (London: Oxford Press, ISSeTTp. 220. 13 "Ricardo treated interest under the head of profits as a residual share after the deduction of rent and wages, 11 and he offered no other explanation of it.” Malthus agreed with his predecessor Smith and his distinguished contemporary Ricardo on their assumptions of individual initiative and free competition and on their analysis of supply and demand as determinants of prices* However, he could not seem to agree with Ricardo’s explana tion of the smooth process of adjustment throughout the economic system* He had observed a condition which was not fully explained by the Ricardian exposition, for he notedj And when the public creditors of a government consent to the great fall in the interest which they had before received rather than be paid off, it is a most decisive proof of a great difficulty in the means of employing capital profitably and a most decisive proof of a low rate of profits. 12 These four economists of the Traditional School, Smith, Ricardo,.Malthus and Say, reached a unanimity on the point that the supply and demand were the determinants of price, and, more particularly, of interest. Say went a step further in his analysis by becoming more explicit and stating that it was the supply and demand of disposable capital which determined interest* He further explained the 11 William A* Scott, Development of Economics (Hew York; Century Company, 1933), p* 363* 12 Robert Malthus, Principles of Political Economy (Reprinted London School oFTJconomlc’ s and Political Science from the 1936 edition, Wm. Pickering, Editor, 1936), p* 285*. 14 character of this capital of which the owners have the power 13 and will to dispose hy saying that: • . .interest is larger in proportion as the supply of capital for loans is less. . .demand for capital . . .is the greater in proportion to the more numerous and more lucrative employments of capital. 14 Mill took up Say’s idea of disposable capital, and stated more clearly that, "A portion of capital employed in trade may be supplied by a class of professional money 15 . lenders.” Because of the fluidity of this type of capital, Mill felt that a ’ ’fluctuation in the rate of interest arises 16 from variations either in the demand for loans or the supply. He explained that the whole mass of loaned capital effects the permanent interest rate, the fluctuations depending almost entirely upon the portion in the hands of bankers; it is that portion almost exclusively which, being loaned for short terms only, is continually in the market seeking investment. Mill was conscious of the accumulation of capital when he noted that there might be an habitual excess of competi tion on the lender's part; the interest rate partly determined by an accumulation of savings by those who eould 13 Jean Baptiste Say, Political Economy. Edited by C.C. Biddle, (Philadelphia: Grigg and Elliott, 1836) pp. 348-349. 14 Loc. c it. 15 Mill, 0£. cit., p. 72. 16 Loc • c it * 15 not employ them would hear low proportion to the profit rate. Smith argued for Increased savings to Increase wealth. He stated also that the more capital or savings available, the greater the amount of labor used. This increased amount of labor and capital in use would cause an increase in wealth. Lauderdale, a contemporary of Smith, felt that savings was not the main cause of an increase in capital. Smith contended that savings accomplished by frugality and parsimony were necessary for increase in capital. Lauderdale felt that it was the demand for capital engendered by know ledge of work capable of being performed by capital instead 17 of savings was the cause for this increase in capital. Function. Smith held that if the interest rate is fixed above the market rate, borrowing would be reduced, for only speculators would borrow; if it is fixed below the market rate, added risk of breaking the law would reduce borrowing. A decline in interest would create more demand for labor which in turn would increase the wealth. lalthus felt that if the interest rate declined, it might tend to stimulate an over demand for capital that might not be used effectively; he argued that,"It is equally vain with a view to the permanent increase of wealth to continue converting revenue into capital when there is no adequate 17 Scott., op. cit., pp. 190-191. 16 18 demand for the products of such capital*” He is quoted further as saying: The question is whether this stagnation of capital# and subsequent stagnation in the demand for labour arising from increased production without an adequate proportion of unproductive consumption on the part of the landlords and capitalists# could take place without prejudice to the country, without occasioning a less degree both of happiness and wealth than would have occurred if the unproductive consumption of the landlords and capitalists had been so proportioned to the natural surplus of the society as to have continued uninterrupted the motives to production, and prevented first an unnatural demand for labour and then a necessary and sudden diminution of such demand* 19 He has argued that a better balance between savings and consumption cannot be adjusted as smoothly as might be expected from the exposition of Ricardo* It was Mill who stated clearly what he considered to be the main function of interest: to establish equality between the supply and demand of capital* He added another function which he ascribed to the interest rate; namely, that”* • *the rate of interest determines the value and price of all those saleable articles which are designed and bought not for themselves but for the income they are capable of 18 Malthus# o£. oit,* pp. 116-117* 19 John Maynard Keynes, The General Theory of Employment, Interest and Money* TNew York: Harcourt, Brace an? TJoiapSay# TS'36) , ’ P7 3 6 5 7 ^ 17 20 yielding.” The rate of interest which evaluates the worth of these goods is the market rate of interest on money. Thus, the value of land and the value of all other sources of income are determined by the rate of interest. The income for a given period of time is equivalent to the rate of interest for thatperiod. In other words, the Income is equal to that portion of the total income expressed as a rate which the good is capable of producing. Apparently Mill has elevated the rate of interest to a position of prime importance in the functioning of the economy. It seems to be important to him, especially in short-term functioning. In this capacity It has a large influence on the dynamic forces which determine the level of activity In the economy. Justification. No justification of interest was particularly attempted by most of the Classical writers. Smith borrowed largely from Hume in explaining the return to capital. This explanation was based largely on the idea of waiting, and was accepted by Ricardo who added little to it. Say made risk an important consideration in the price paid for the use of loanable capital, and consequently included the importance of having capital readily available. Senior 20 Mill, op. cit., p. 213 18 justified interest as necessary on the basis of abstinence from consumption. This abstinance was disagreeable, and must therefore be called into existence by prospect of remuneration. Mill adopted the same explanation as Senior for the justification of interest. Another justification which has been hinted at by the classical writers was the contribution of capital to production which merited a reward; this reward for the use of capital was called interest. This theory of justification for interest brought criticism of the Classical position by the Socialists, who argued that there should be no return for capital since capital was merely a form of production used to produce more goods. The Socialists further stated that labor was being deprived of its rightful product because it wasn’t receiving the full return for its exertion. In other words, they felt that by this deprivation labor was being exploited, Sismondi presented his justification on the basis of the accumulation of the fruits of past labor which deserved a return. A better explanation of the justification of interest was to await the advent of the Marginalist School, Summary. The Classical group regarded interest as a payment for capital* The writers of this traditional school failed not only to clerly define capital but to distinguish < 19 between interest and profits as well. It was unanimously agreed by the Classical economists that the rate of interest was determined by the supply and demand for capital. The supply of savings resulted from abstinence from consumption; this abstinence was encouraged by offering a rate of interest as a return for these savings. The demand for capital was determined by the opportunity to employ the savings at a profit. It remained for Mill, the last of the Classical writers, to emphasize the use of money as capital or loanable funds in the determination of interest. He further elaborated the function of interest in the economy, and showed particular interest in its short term effects as well as its peculiar role of adjusting the supply and demand of capital. He assigned to interest the function of estimating the value of all sources of income on the basis of their return, expressed as a rate of percentage of their capacity for producing income over a period of time. The Classical School did not to any great extent attempt to justify interest. Thi3 failure remained one of the most vulnerable points in the whole structure of their theory. THE MARGINAL SCHOOL The early beginnings of the Marginal School of 20 economic analysis was a contemporary growth with the Classical School. This school had its origin in the writings of Von Thunen and Gossen, both of whom wrote in the early part of the nineteenth century. Their theories of production were almost identical. They developed the earliest form of the theory of marginal productivity; the idea of an increase in production resulting from the least important increment of a factor of production. Oddly enough, the gern of this idea may also be found in the works of James Mill and Nassau W. Senior. This additional unit analysis or marginal analysis was used also with reference to consumption, and it was Gossen who explained, ”* . .with increase in quantity, the value of each added unit must undergo a continuous decrease 21 until it sinks to nil.” Another of the forerunners of this school was the English economist Jevons who particularly emphasized the free and necessary flexibility in the economic system during the proeess of adjustment. These ideas of freedom and flexibility show a close affinity to the Classical analysis which emphasized competition as being necessary for the proper adjustment of the economic forces in the system. 21 Scott, op. cit., p. 452. 21 Concept. The concept of interest developed by this school of thought was that the price of capital depends on the price of goods that it can produce. This idea differed very little from the Classical; the element involved here, of course, is that the demand for the fruits of production determines the amount of return which the contributing factors will receive. Since capital is recognized as being a factor of production, the return it will receive is determined by its contribution to production* The development of this explanation of the value of capital by Menger and Yon Wieser, founders of the Marginal School, was known as the process of imputation. It may be explained that capital derives its value from the goods of the first rank (consumption goods) for the production of \ which capital (second*rank) is essential, and not vice versa; and that goods of each rank higher up is derived from that of those in the next rank below for the production of which they are essential, not vice versa. For example, value is not imputed to bread because it is produced from valuable wheat, but value is imputed to wheat because it produces 22 bread which has value. A further interesting development from this school was made in the writings of Bohm-Bawerk. He added nothing 22 Scott, op. cit., p. 342 22 to the Idea of the price of capital, but he broadened the 23 definition of capital to include money more specifically than the Classical writers had* It was Walras who emphasized the element of money in the idea of interest when he stated, ”The price of the service of money is established by the height or depth of that cash-balance desired fencaisse desiree / Is greater or less relative to the quantity of money.” Determination. Jevons as the precursor of the school had explained the determination of the rate of interest in this manner,". . .the ratio which this increment (of produce) bears to the increment of. investment will determine 25 the rate of interest." Thus the element of time is injected 23 E.V. Bohn-Bawerk, Positive Theory of Capital, Trans, by ffia. Smart. (New York: steckert ancT Company, Reprint 1923) p. 65. He speaks of SocialCapital (1) produc tive improvements on land, (2) productive buildings, (3)tools and machines, (4) useful animals, (5) raw and auxiliary materials, (6) finished goods in stock and (7) money* Private capital as those goods used In exchange is distinguished from acquisitive capital which Is purchasing power or money. Productive capital: goods used to produce other goods. 24 L. Walras, Elements D» Economie Politique Pure (Paris: R. Pi chon et ft. i)u r a nd*”Au z i a a, 1926), p. oil. He sets up his equation so that Fusjffi*. The sjaabol Pu is equivalent to the present price of money and Pul is the anticipated price divided by the i which means the height of the equilibrium net revenue. When this equation means unity, there is equilibrium. 25 G. Stigler, Production and Distribution Theories* (New York: The MacMillan Company, l94l), pp. 2§. Stigler adds,". • .Jevons merely adds one further element, the irarl'abllity of the production period to provide a determinant of the rate of Interest." However, he comments that such analysis is even an instantaneous approach, through an instant Increment to both production and investment. 23 into the determination of interest, but from a productivity explanation rather than from a waiting or abstinence explanation. Bohm-Bawerk was to take up this explanation even more specifically, and was to base his whole theory of interest on this time element. He emphasized that, ”It is the 26 influence of time on the human valuation of goods** that explains interest. He went even further in the use of the time concept when he elaborated that interest is the differ ence in popular estimation and valuation between present and future goods. The idea of futurity which he emphasized has importance for the determination of interest although he did not mkke this clear in explaining the process of production. He had explained that when the employer borrows at a particular rate and the resulting production gives him a light return, he will borrow no further. He assumed that the rate of interest was determined in the ususl manner of all prices, by supply and demand. The use of capital in production involves the idea of a round-about process which in effect increases production, but which he seemed to feel also increases the production period. This explanation of the production period was faulty in light of Jevon*s analysis. 26 E.V. Bohm-Bawerk, Capital and Interest. Trans, by Wm. Smart. (New York: Bretanos, 1922), pp. xix-xx. 24 Bohm-Bawerk1 a idea of futurity in the evaluation of present goods at a greater price than future goods was taken up, however, by Walras, who apparently threw the emphasis for the determination of interest on the market for new capital* Walras explained this determination in a system of equations: • • .in which* • *the prices of the services of new capital goods are determined by the theories of exchange and production ^supply and demand[7, the quantities made of these new capital goods are determined by the condi tion of equality of the sale price and the supply price and may be one with the rate of revenue which is also the condition of their maximum utility, , .the sum of savings is determined by the comparison which each saver makes of the respective utilities which savings have for him at current prices for services and goods; this comparison may be equal to the immediate consumer along with the rate of interest to the consumer from year to year. 27 This explanation result s in the idea of anticipation of pro fits, so familiar to the Classical analysis. Hence, not only the higher valuation on present goods but the anticipated increased revenue from borrowing determine the price for capital. The emphasis of this sehool is mainly, if not solely, upon demand as a determinant of all prices. Von Wieser, however, has explained that, "production value is practically return value or rather anticipated 28 return value,” so that interest is determined not only by 27 Walras, op*oit., p. xviii. Since there is no English translation available, the writer must depend on his own mastery of the language for a workable translation. 28 P. von Wieser, Natural Value, Edit, by Wm. Smart; Trans, by C.A. Malloeh. (Hew York: Stechert and Company, 1930), p. xii. 25 demand but by estimated future demand for goods resulting from production, Bohm-Bawerk elaborated this development with his own which may be expressed briefly as follows: that an equilibrium tends to be established between the rate of wages, the length of the period of production and the volume of capital! and that the magnitude of the interest rate IS fixed by the productiveness of the process thus determined# Function, Very little is revealed by the Marginalists concerning the function of interest in the economy. While they all seem to recognize the interdependence of all economic phenomena, they seem to attribute the changes in the economic system to changes in demand rather than to changes in price. Von Wieser has noted that with the rise of the rate of interest the value of goods is eventual, ly 29 expected to fall# Among the Marginaliat economists, probably the one who focused the most attention on the function of the interest rate was Walras. He explained this function in the following manner: Perhaps, then, circulating capital would be excessive. The rate of interest on this capital would be weak low in proportion to the rate of interest on fixed capital, and savings in formation instead of . 29 Von Wieser, op# cit., p# 151# 26 circulating would be fixed. One would withdraw deposits from the banks to buy securities on the stock exchange* 30 If some conclusions may be drawn from the analysis of Walras, it might be said that if there were a change in the future valuation of goods, this change would effect a change in the interest rate. The result of this change in the rate of interest would affect savings. However, little dynamic analysis along these lines was attempted by the Marginalists. Justification. Emphasis was placed by the Marginalists on the productive contribution imputable to eapi- 31 tal* This imputation resulted from the atomistic approach of this school in attempting to analyze the contribution of the factors of production. Von Wieser felt that if capital were to receive a return, this return should be based on the increased production resulting from the use of this capital* In other words, if capital cannot be considered a separate factor of production, it does not deserve a return. Bohm-BawerkTs justification of interest depended upon his explanation,of interest. He justified a return to 30 Walras, op. cit., p. 420. 31 L. Haney, History of Economic Thought. (New York; The MacMillan Company, 1&45), pp. 469-470. 27 capital on the basis of the increased production resulting from the use of capital# in a round about or indirect process of production. He explained that the technical superiority of present goods over future goods was due to the fact that present goods could be used in production and were more in demand that future goods. Both these explanations used in conjunction with the underestimation of future needs justified interest. Summary. When the concept of interest held by the Marginal School is compared with that held by the Tradition alists, the two ideas are found to be very similar. The Marginalists, however, emphasized the idea of futurity in the determination of the rate of interest. In their analysis of production# they sought to discover the contribution of the various factors of production; the result was a justification of interest on the basis of productivity. This interest or return was also justified on the basis of the greater demand for present goods over future goods. The premium paid for the use of present goods or for the reduction of consumption of these present goods, along with the resulting increase in production, is the marginal explanation»for the rate of interest. NEO-CLASSICAL SCHOOL 28 The development of the science of Economics was marked at the end of the nineteenth century by the great synthesis of Marshall* He attempted to reconcile and bring together the major contributions and developments of the two preceding schools of thought, namely the Classical and Marginal Schools. At the same time, Marshall broadened the applica tion of the economic principles that had been developed by his predecessors in the science in order to include the contemporary developments of the economic system. It isfrom his great synthesis that the modern developments of economic analysis have flowed. Another development similar to Marshall’s and contemporary with Marshall is the analysis of Fisher. Yet Fisher defies classification into the Neo-Classical School because he had largely concentrated on monetary developments; these developments Marshall had tended to relegate to a relatively unimportant position. Undoubtedly Fisher’s approach to the explanation of economic pehnomenon flowed more directly from that of Bohm-Bawerk. The simultaneous treatment of these two developments will fit in more properly with the method of presentation adopted by this investigation. Concept. Marshall’s treatment of the concept of interest is noticeably more detailed than that of his 29 predecessors* Interest remained the return for the use of capital, but when he wrote concerning the general rate of interest, he used the term only as it applied to the anticipated net earnings from new investment of free capital* He synthesized the ideas concerning interest by saying that net interest is the reward for waiting, which harkens back to Smith and Ricardo's explanation: gross interest is the charge which varies for the relevant risk involved in each case of lending and the cost of doing the business of lending capital* This gross interest, therefore, varies con siderably, but the net interest on loans tends toward equality upon the same basis as any other prices 32 presumably. • Marshall explained another type of interest by stating that interest derived from capital already invested is properly a quasi rent, and can be regarded as interest on the assumption that capital value has remained unaltered. In other words, contract interest was similar to rent because of the permanence of the fixed investment; for this reason, he called that type of interest quasi-rent. Fisher defined the rate of interest as simply the market price for the exchange of present for future income 32 A. Marshall, Principles of Economica (London: The MacMillan and Company, Ltd., 8th ^3Ttion, 192V), p. 588 or servicesj.capital is merely a source of future income or services. He made another distinction with regard to interest rates; he called attention to the dynamic aspect of interest by observing the fact that when prices rise, interest rates also rise. He argued, however, that this parallel rise was not actually so, and that a distinction must be made between the two types of interest; the first, he called the nominal, rate, which was the actual rate and fluctuated as prices fluctuated; the second, he called the real rate, which he defined as the anticipated return of capital over cost. This distinction explains the parallel movement of the price level and the interest rate. When the nominal rat© falls along with the price level, it has actually risen rela tive to the real rate. This relative rise in the nominal rate causes a decline in the investment and income. The Neo-Classical concept of the interest rate may be expressed briefly in the words of Knight, who is probably the most prominent of the contemporary Neo-Classical writers. ^The general theory of the yield of capital must conclude that the normal price of capital goods if fixed by the demand 33 for the existing supply. • •M 33 P.H. Knight, Capital and Interest. (Philadelphia: Blakiston and Company, 154C), p. 400 31 Petermina11on. As is characteristic of the Classical and Neo-Classical Schools, the major emphasis in the determination of price is supply. Supply is much more difficult to adjust than demand, and takes more time for its adjustment. This explanation of supply is classical, and was particularly emphasized by Say. Marshall stated that: It is true that in almost any business there is a constant increase in the amount of capital required to make a fair start, but there is much more rapid increase in the amount of capital which is owned by people who do not want to use it themselves and are so eager to lend it out that they will accept*a constantly lower and lower rate of interest for it. Much of this cppital passes into the hands of bankers who promptly lend it to anyone of whose business ability and honesty they are convinced, to say nothing of the credit that can be got in many, businesses from those who wupply the requisite raw material or stock in trade. • • 34 Now, on the other hand, after examining capital more closely, he concluded, ", , • a strong balance of evidence seems to rest with the opinion that a rise in the rate of interest or demand prices for saving tends to increase the volume of 35 saving. • Marshall's definition of capital was not as broad as that of Bohm-Bawerk, for it apparently did not include money specifically. Marshall advised that, "if we are seeking a definition that will keep, realistic economics in touch with 34 Marshall, op. oit., p. 308. 35 Ibid., p. 574 32 the market place. . .in case of doubt, that course is to be preferred which is most in accordance with tradition.” 36 Marshall explained that the demand for capital was largely determined by the prospectiveness and productiveness; these two factors also controlled the supply side of capital. However, he noted that, "Further, the influences of which changes in the purchasing power of money do exert on the terms of which loans are arranged are most conspicuous in 37 the market for short loans." His description of the fluctuations of interest rates seemed to rest on the supply or quantity of money so that the rates vary directly with the quantity of money. Thus, "• • .slackening gold supply and lowered interest; but now it (rate of interest) is rising again partly in consequence of any increase in gold 38 supply." This would seem to be in disagreement not so much with the history of interest rates as it is with the theory 39 of interest expressed by Wicksell. 36 Ibid., p. 790. Although Marshall approaches Bohm-Bawerk’s definition of capital, he never hits it quite so hard as Walras. Yet of course he always emphasizes that he is trying to stay within the limits of common usage in the market place. He feels that in practical matters theoretical completeness may be purchased at too great a cost. Generalizations need not take into consideration the unimportant details, which were unimportant in the time of Marshall* 37.Ibid., p* 595. 38 Ibid., p. 681. 39 See Wicksell, op»cit»,Vol. II. See also Chapter III. 33 Mdgwiek, a contemporary of Marshall who followed the Marshallian analysis very closely has stated rather precisely; "Still it is only the supply of capital actually floating that can be regarded as directly operative in 40 determining the rate of interest," He continued in the same vein but optimistically as compared to some theorists today, "That each new investment of capital tends, . • to diminish the remaining field; but itmay easily operate, , • by 41 creating new opportunities,” It may be noted that he closely paralleled Wicksell along lines of money and interest. For example, he felt that the banks gain thro ugh the greater demand for their commodity, or money, derived often from mistaken beliefs that tend to inflate prices; however, the danger ©f the collapse when the mistake is discovered decidedly outweigh^ the gain in the first place. He definitely assigned the idea of money to a major position in economic thinking* Therefore, he believed, the average rate of interest in the money market or the current rate of discount will not generally tend to coincide with the average yield of invested capital. The divergencies between the fluctuations 40 Henry Sidgwiok, Principles of Political Economy (London; The MacMillan and Company, TSOI), p. 275, 41 Ibid*, p. 277. 34 of these two rates will probably be still more marked since the former is more sensitive to the vicissitudes of trade; while the latter rate is affected secondarily and in ordinary cases only slightly. Differences in the rate of interest obtainable at any given time on different fresh investments are mainly due to differences in the generally estimated prospects of change in the interest or selling value of the respective 42 securities. These thoughts concerning money rates of interest reflect current thinking along these lines, and are evident in the further analysis of modern economists. These thoughts reflect the idea of futurity which Bohm-Bawerk emphasized so strongly in his theory of interest rates. Sidgwick showed an affinity for another contemporary of the Marginal School when he tied together in Walrasian fashion the operation of the whole system by concluding that the yield on old capital tends to be the same as the yield on the cost of producing the same capital new. Furthermore, this equality depends on the price system, and affects , interest thereby. Perhaps the best example of post-Marshallian economic thinking is that of Pigou who succeeded to Marshall’s chair at Cambridge. The contemporary development drew on newer 42 Ibid., p. 266-268 35 ideas, and increased the depth and breadth of the doctrine handed down, Pigou under such influence was to note that, ”, • .modern practices in the matter of money and banking renders the supply of new capital available to businessmen more elastic in response to given variations (whether warranted or not) in their outlook than it would be in the 43 absence of much practice,n The idea of "floating” capital was assuming more prominence in the eyes of economic thinkers. Other phenomena, such as business fluctuations, were appearing with some regularity rather than as mere random fluctuations!, these may have been related to the matter of "floating” capital, Pigou, having noted this "floating” capital, was forced to recognize the matter of "hoarding", as Menger and Walras called it, or the cash balance. This cash balance indicated a demand for money which would directly influence the demand for floating capital as well as the velocity of money, and therefore would affect not only the credit created but also the price for that credit. Thus, the supply of credit would be affected, so that income and prices would be affected in turn. The all importance of the rate of interest to Fisher was shown by his regarding it as a necessary link in the 43 A.C. Pigou, Industrial Fluctuations, (London: The MacMillan Company, Ltd,, 1929), p. 136. 36 chain of causation. Impending on Marshall1a analysis, he indicated that a change in fashion has tremendous influence not only on the rate of interest but on the distribution of wealth itself. It is also important to note that capital’s price is influenced by capital's future expected income. However, this expected income is not the sole determinant of interest for, recalling Senior, the rate of interest is equal to-the degree of impatience upon which the community may concur in order that the market of loans m§ry be exactly 44 cleared# It seemed to Pisher that In a land of no remote opportunities for income, such as investment in mines and natural resources, the Interest rates would be high, and where there are those opportunities, it would be low. The implications of this statement are broad, but one in particular is evident: when population encroaches on the limits of natural resources, interest rates will rise, or reach an irreducible minimum which will discourage long range investment# Still, this analysis leaves out of consideration many other factors which have to be assumed constant for the conclusion to be valid# The effect resulting from a rise in interest rate is 44 Irving Pisher, The Theory of Interest (Hew York: The MacMillan' Company, ItaTgOj, p. 88, 120# 37 only temporary so long as the rate of return above cost continues to be high and so tempts society to distort greatly its income stream in time shape, that is, society would be sacrificing or investing present income* Soon interest would go down as real incomes increased, and would remain at a constant level; the rate of time preference (impatience to spend) would go down; supply then becomes the dominant factor. The above treatment is a very definite incorporation of Marshallian analysis into interest theory. Thus, the theory enunciated is that the rate of interest depends on impatience and investment opportunity. Any cause which increases or decreases impatience for immediate income tends to increase or decrease the rate of interest. Any cause which increases opportunity to secure returns on investments in excess of the existing rate of return tends to increase the rate of interest, and vice versa. The existence of a wide variety of available income streams acts as a sort of governor or balance wheel which tends to check any excessive changes in the rate of interest. Interest cannot fall or rise unduly; any such fluctuations would correct themselves through the choice of appropriate income streams. The wide variety of income choices is the reason why interest should not suffer very violent fluctuations. 38 It is true that natural processes are regular enough to prevent sudden and great changes in the income stream; it is also true that man constantly aims to prevent such changes. Society as a whole is flexible due to the adaptability and versatility of capital. The individual is free not only to choose among innumerably different employments of capital, but to sele ct the various ways of exchanging with other individuals* This power to exchange is power to trade 45 incomes* Pisher claimed that money by its instability affects interest rates, both money and real, more than the more * fundamental and normal causes connected with income, namely, 46 impatience and opportunity* It would appear that money influences are more immediate, and affect interest rates more directly; even price changes resulting from money changes do. 45 Note also Fisher’s analysis of equilibrium and summary of his theory of interest and prices. He breaks them down into six principles: Two market principles, (l) market cleared with respect to every interval of time, (2) d^ats must be paid. Two impatience principles; (1) individual preference depends on prospective income, its size, its time shape, and risk; (2) individual preferences tend to equalize with market rate at the margin. Two opportunity principles: (1) opportunities many, (2) rate of return over cost of immediate income at the margin equals market rate for money. It need only be appended to the second of the impatience principles that it not only tends to equalize but does so in order to have a static timeless equilibrium of classical vintage, and the dynamic process may be built on these principles expressed so ably in simultaneous equations of the Walrasian system. Changes may be traced to individual preference resulting in market changes. 46 Pisher, op* c&fc., 447-457. 39 after several years and with the intermediation of changes in profits and business activity, affect interest very profoundly. If money were capable of scientific adjustment, interest would follow the three fundamental causes. The adjustment of money would require world cooperation on the monetary level, commensurate with the whole level of economic activity of which a country is capable. It would seem to Pisher, therefore, that since this cooperation may prove to be impossible of attainment, that some manipulation must develop naturally. Yet this manipulation need not be extensive if done correctly and scientifically. It would seem that even Marshall would not disagree, as quoted 47 elsewhere. Both Sidgwick and Wicksteed, an English economist who followed the Marginal analysis, exp? essed a serious consider ation of the limits to which interest might go. Sidgwick felt that there was a point considerably above zero below which the rate of interest could not long remain. Wicksteed, on the other hand, said, ”It is well to observe that with increasing intelligence, integrity and providence {j3uppljl we have no means of fixing on any definite limit above zero 47 See Marshall, supra. 48 to the fall of the Interest rate.” 40 Function. The searching analysis to which the Neo- Classical School subjected most economic phenomena resulted in much more emphasis being placed upon the function of the various forces. Consequently, Marshall expressed the dominant opinion in the science when he stated, "... a strong balance of evidence seems to rest with the opinion that a rise in the rate of interest or demand prices for 49 saving tends to increase the volume of saving." So It is only by degrees that the rise in the rate of interest will increase the total stock of capital. Yet It may be recalled that Marshall had admitted that the supply of capital increases more rapidly. It seemed that the Neo-Classical analysis assigned to price the function of equating supply and demand. Thus, it may be stated as Pigou has done that, • .in the money market demand and supply were adjusted through the rate for money. . and even under a proper standard, ". • .the currency position is always a consequence of the discount 50 policy and not sometimes a cause of It." 48 Stigler, op. clt., p. 57, quoting from Conuaonsense of Political1 Economy, p. 301* 49 Marshall, op. cit., p. 574. 41 Although the emphasis here is on money, the entire function of interest may be similarly stated: that the rate of interest tends to equate the supply and demand for capital. Therefore, the characteristic of its interest rate may be its power to direct investment. If the rate is too high, it will encourage investment in quickly returning incomes, whereas a low rate of interest will encourage long term investment with slow returning incomes. Probably the role of the interest rate has been best expressed by Ellis, a current Neo-Classical writer. He felt that the balance between present consumption and investment for future con sumption is maintained by, "the one indispensable index which we possess as to the permissible degree for burdening the 51 present in favor of the future.” Another function of the interest rate which Mill has established and with which Marshall agreed was the function of capitalization by means of the rate of interest. Capitalization is the estimation of the value of capital goods arrived at by dividing the annual earnings of the investment by the current rate of interest. In other words, the annual income is a proportion of the total return 50 Pigou, op. cit., p. 269, 296* - 51 H.S. Ellis, German Monetary Theory. (Cambridge, Mass.: Harvard 'University Press, 1934), p. 369. 42 equivalent to the rate of interest. Davenport, the American populizer of Marshall, emphasized the capitalization function by expressing it as the summary of the various forces in the market. These forces arrive at the valuation of each property by balancing one against the other so as to 52 equalize the objective and impersonal advantages of each. Another approach to the function of interest rates stemming from Marshall is that of the statistician Giffen. Ee concentrated more on the explanation of the capital market, and focused his attention on interest rates as such. Giffen found that as interest rates decline, there is a tendency to keep money in hand, and to invest it directly. If the rate rises, however, there is a tendency among bankers and others to withdraw money from investment, that is, to sell bonds, and to relend the same money to enable borrowers to hold stocks. Giffen also recognized the influence of the short term rate of interest which affects old securities, as was explained above. This rate in the capital market thereby affects the capital structure in the economy in terms of debt and equity structure. Sidgwick, too, was aware of the short-term capital 52 J. Davenport, Economics of Enterprise. ^Eew York: The MacMillan bompany,""T9l3}, p. 468. 43 market rate and the average rate of interest which was the rate on old investments. He stated that both rates tend to move together, and went on to explain this phenomena in the same fashion as Giffen. A fall in both rates will induce bankers to purchase bills at a lower rate of discount as they will gain less by investing in other securities, and will render the borrowers of their money less disposed to pay the old price for its use. Similarly, a fall in the rate of discount occurring independently of a fall in the yield of capital generally will increase the inducement to buy, and decrease the inducement to sell securities yielding a fixed return. This increased buying of securities, therefore, will cause a fall in the rate of interest actually received 53 in such investments* The assumption underlying such action is the classical one and is generally accepted as valid; namely, that men is merely trying to get the most return he can in the security market or any other market, and that if anyone prefers an investment that at present yields a lower interest than another, it is because he either considers it safer or expects it to rise hereafter* Pisher was also conscious of the affects of interest rate upon the economy. He discerned what he thought was a casual factor when he observed that if prices are rising at 53 Sidgwiek, op* cit., pp. 250-253 44 the rat© of 2 per cent per annum, the boom will continue until the interest becomes 2 per cent higher than the rate of the rise of prices per annum. Thus, if the rate of interest lags behind in either direction of movement, that movement will continue* Pisher continued this analysis by stating further that a fall in the rate of interest may and often does produce a rise in prices and in business activity almost immediately. This effect may be continued for many months until increased prices again become dominant and pull the interest rates up again. In so far as the rate of interest is cause and the price movements are effect, the correspondence is just the opposite of that which occurs in so far as the price movements are cause, and the interest 54 movements, effect* So, in effect, the initiation of change has the opposite effects, but a prolonged movement in one direction forces both factors to move in the same direction. The all pervasive function of interest rate goes something like this, according to Pisher: the price of any good is equal to the discounted value of its expected future (income producing) service, including disservices as negative services. If the value of these services remains the same, a rise or fall in the rate of interest will consequently cause a fall or rise respectively in the value of all the wealth or property* The extent of this fall or rise will be 54 Pisher, op* cit*, pp* 425,444-445* 45 the greater, the further into the future the services of wealth extend. Thus, land values from which services are expected to accrue uniformly will be practically doubled if the rate of interest is doubled; the very perishable commodities like fruit will not be sensibly affected in price by a variation in the rate of interest, assuming that all the expected services remain unchanged. Drawing on his predecessors, Pisher thought that it was not the values of all articles of wealth but was their intermediate services which are dependent on the value of final enjoyable uses. Capital values and values of final uses are linked by the rate of interest. This rate affects most those values which are the most distant from final services, assuming of course a competitive market free from legal and other restrictions. However, the affect of a change in the rate of interest will be more pronounced where 55 lengthy processes are usually employed than in one where „ 56 the shorter ones are common* Pisher dealt with more concrete facts regarding prices and interest, and was in sympathy with WicksellTs analysis. He found a high correlation between prices and 55 See Marget’s Theory of Prices, Vol I, Chap. II for his time analysis, particularly regarding Bohm-Bawerk. 56 Pisher, op* cit., pp. 325-330. 5f interest and change pari passu* He explained further that a direct relation exists between price changes and interest rates; the price changes usually preceded and determined like changes in the interest rates. This direct relation must mean that they go up and down together. Sidgwick interjected another note of caution very similar to that of Marshall’s in his broad discussion of interest that has stuck a responsive chord today anong political economists. He stated, ”. . .it is probable. • • there is a point considerably above zero below which the rate of interest could not long remain wthout some great chsi ge in the intellectual, moral and economic condition of 58 the community.” The opposite viewpoint from this analysis would be that a high rate would indicate a change without precedent in the state of the arts. The enthusiasm which Pisher manifested for interest was tempered by his realization that any analysis of one part of the economic organism must include an analysis of the whole organism* For this reason, a complete interest theory would have to include also price theory, wage theory and all 57 Ibid., p. 443. He emphasized this in a footnote, , ! Professor Wicks ell was one of the first to recognize the influence of interest rates upon prices. • .Professor Gassel, Professor Marshall. . .Chairman of the Midland Bank, Mr. Hawtrey. • . and many other well known economists, bank ers and business men have emphasized that business activity is influenced and may be largely controlled by manipulation of the discount rate* 58 Sidgwick, op. eit., p. 280. 47 other economic theory. In this respect he was again recalling the lesson of the ^Austrians#" Still, time and again he was swayed toward the over all dominance of the price of capital as exemplified by the words, "Interest plays a central role In the theory of value and prices and in theory of distribution. The rate of interest Is fundamental and indispensable in the determination of the value of 59 wealth, property and services." Ellis, who was largely influenced by Fisher's theories, perceived an important aspect of interest rates. Whereas Fisher had emphasized the importance of interest rates for long term investment, Ellis emphasized that inter est rate changes determine production and should be important for the short run. Ellis feared that continued injections of credit at progressively lower interest charges or the purchase and storage of unmarketable products by the state would signify a nationalizing of industry, and that even such drastic measures-would only intensify the final debacle, increasing in degree the longer they persisted* Justification. The justification of interest in the Neo-Classical School does not seem to have caused much comment. Probably most of the members of this modern school have accepted the doctrine of Marshall on this point, 59 Fisher, op, clt., p. 325, ‘ Marshall did not think too highly of the doctrine of marginal productivity, but he did recognize that this explanation throws into clear light the action of one of the causes that governs the return to a factor. He did not deny that there would be some savings without interest, but he seemed to feel, and in. this he was in agreement with Bohm- Bawerk, that the rate of interest would stimulate savings. Therefore, both Marshall and Pisher would seem to agree that it was the superiority of present over future goods which justified interest. Pisher termed it the impatience to spend, which was merely another expression for the time preference of Bohm-Bawerk. Justification of return to the factors is established by the various opportunities for their use which would follow from Marshall's law of substi tution as applied to the factors of production and Fisher’s opportunities for investment as applied to capital. Summary* The Neo-Classical concept of interest added little to the basic concept already derived from previous developments in the field. Interest, like any other price, was determined by the supply and demand* The confusion of interest with profits was conspicuous by its absence in the Neo-Classical analysis* Marshall had designated that business organization should be considered a factor in production, a concept which had been 49 recommended by Say* and adopted by American economists# Further developments in Neo-Classical investigation did bring out the realization that there were certain types of interest rates, A more systeramatic investigation of economic phenomena led to a greater appraisal of the various functions of the different forces. This type of analysis was particularly effective in bringing interest rates to the fore in economic analysis as a whole. It was Fisher who followed the monetary analysis which had been intimated so strongly by Bohm-Bawerk, whereas Marshall had dealt with more general economic phenomena relegating money to a secondary position. Interest was justified according to the Austrian analysis of Bohm-Bawerk, and little was added by the Neo- Classical treatment, CONCLUSION The concept of Interest as a price for the use of capital was adopted by the Classical Schoolas the definition for the rate of interest. The term capital was vaguely applied in the traditional analysis: at one time it Included goods, at another time, money; the use of the term was inconsistent. Interest was treated as a residual item in the classical analysis over and above costs. The Classical writer Say recommended a better distinction concerning the 50 idea of interest by dividing that return into interest .and profits, with profits as the remuneration to the risk taker. The Marginal analysis added little to this concept of interest, but the Neo-Classical treatment broadened this concept to include other types of return for capital, such as a return for past investment, a return for risk and a return for the use of money. There seemed to be a unanimity in-the development of analysis from the Classical through the Neo-Classical Schools concerning the determinants of the rate of interest. Demand for capital governed by the expected profit from the use of capital was considered one of the determinants for the rate of interest, while savings determined by waiting and abstinence from consumption was considered as the other determinant. The Marginal analysis elaborated the determination of interest on the basis of demand for present goods over future goods. This preference governed the demand for capital. The Neo-Classicists adopted the previous ideas of both the Marginal and Classical Schools which were related to the determination of interest. While the Classical analysis devoted little attention to the function of interest generally, Malthus indicated that interest might influence savings and consumption. The Marginal School adopted a similar position with regard to 51 the effect of interest on savings. This function was further elaborated by the Neo-Classical School which adopted a more Malthusian analysis* The justification of interest adopted by the Classical School was based on the premise that capital deserved a return because it contributed to production, and further, that there must be.a return to call forth abstinence from consumption. This position was attacked by the Social ists who deemed that capital was merely the fruits of past labor of which the laborers were being denied. The Marginal School through its analysis of the factors of production adopted a position similar to the Classical School regarding justification of interest. They placed their emphasis on the increased production due to capital and the higher valuation of present goods over future goods. This latter thesis was substantially adopted by the Neo- Classical School* CHAPTER III THE HEW ECONOMICS It is not the purpose herein to discuss at great length the Keynesian theories, but the study will be forced to recognize their immediate importance. It is the great contribution of Keynes that he has stirred economic thinkers, and given them renewed vigor to clarify, modify and strengthen the body of economic doctrine which contains the principles and knowledge which make up the science* It is too early to assess the Keynesian contribution to this body of "received doctrine," but Keynes efforts will not be forgotten. This portion of the study is devoted to the modern theories of interest. However, as modern theory does not develop in a vacuum, some attention must be given the fore bears of the modern ideas. It is certain that these theories have played an important role in the development of contemporary ideas. The treatment of the Keynesian theories as well as the controversies thede theories and those who adopted these theories provoked will follow the pattern of the preceding chapter. The discussion will take up the Keynesian concept of interest, the determination of interest and its function according to this school, and the justification of interest 53 as Interpreted by the Keynesian economists. The development of these four points will also include the controversies centering about these basis ideas of the Keynesiaa. theory. Concept* One of the earliest examples of a concept which was to be adopted in modern economics is found in the work of Henry Thornton, a London banker and contemporary of Adam Smith, He recognized that the price at which exchange takes place would depend on two facts: first, on the pro portion between the supply and demand for the particular commodity; and second, on the proportion between the supply and demand for the circulating medium. Thornton thereby concluded that there was a connection in part between government securities and bank note price (price of credit), especially in a crisis. It is evident that Thornton wished to emphasize the price for money, or the circulating medium. This concept of Thornton’s differed little from Smith’s concept, except that the interest rate was emphasized here as a price for money rather than capital. Another predecessor of Keynes who may be deemed responsible for the development of the Keynesian concept is Cassel. His idea of interest was that the explanation of it must be sought in the relative scarcity of the available disposal in proportion to the demand for it. He defined capital largely in terms of money; for example, ’ ’Capital 54 which savers make available is expressed in the exchange 1 economy by a certain sum of money.1 1 The distinguished contemporary of Cassel who more than anyone else is held responsible for establishing the foundations for the modern theory was Khut Wicksell. He assumed that the rate of interest in evidence was the price . for money# He developed what he also called the natural rate of interest. This natural rate was the rate of interest 2 which equalized savings and the demand for new capital# This definition would seem to include an anticipated profit to be made by the use of a money loan# Keynes1 concept of interest was quite definite. There was no equivocation when he said, referring to the rate of 1 Gustav Cassel, Theory of the Social Economy. Transl# by J. McCabe. (New YorlTr Harcourt',' ferace and Co#, 1924), pp# 198, 188. This wa3 also a prelude to a famous Knight-Hayek controversy about the period of production which Marget describes very well, as weight a change in capital or output or both, expressed in terms of analytical time rather than clock time. 2 Jp?thur Marget, Theory of Prices, Vol. I# (New York; Prentice Hall, 1942T7 P* 262m Besides the definition in the text some others are; the "natural rate of interest1 1 is (1) approximately equal to the real profit of enterprise, (2) the rate which discourages any borrowing of money or credit that might lead to a rise in prices, and which encourages precisely the amount of borrowing necessary to prevent a fall in pricesj it is, in other words, the rate that keeps the price level stable, (3) a covering term for all factors affecting the borrowing of money, other than changes in the money supply and consequent changes in the money-rate of interest. 55 interest, "it is the price which equalibrates the desire to hold wealth in the form of cash with the available quantity 3 of cash." This demand for cash Keynes described as a liquidity preference. Apparently it was derived from the cash balance of Wicksell and the encaisse desiree of Walras* This desire for money is derived from many motives. These motives will be discussed later under the subject of the determination of interest. It will suffice to say here that liquidity preference is merely a desire to hold money for convenieice rather than some other asset* Keynes explained further that any commodity may have its own rate of interest. This own rate of interest is expressed in terms of itself by its own yield plus the convenience of holding it minus its cost for holding it* The peculiar importance ef the rate of interest on money, according to Keynes, is that of its reluctance to decline as output increases due to its inelastic quantity, substituta bility and liquidity. Thus the equilibrium rate of interest is that rate of interest for money which is equal to the greatest rate among the marginal efficiencies of all assets* Marginal efficiency is defined as the rate of expected profit t for an additional unit of new investment. This expression 3 John Maynard Keynes, General Theory of Employment, Interest and Money. (New York: Harcourt, Brace and Company, 1936), p. 117, 56 of equilibrium is very Walrasian, One other concept developed by Hicks, who has carried the Keynesian theory to much greater theoretical limits, is that of the relation between the long rate and the short rate of interest. He explained this ooncept in the following manner. The money rate of interest is of first importance, that is, the money rates differ according to time and risk. An example of Hick’s analysis might be that a contract to deliver goods at monthly intervals over a period of six months is equivalent to a spot transaction and a series of forward transactions! similarly, a loan for six months is equivalent*!; to a loan for one month combined with a series of forward transactions, each renewing the loan (re-lending the principal or principal and interest) for a successive month, ”The long rate is the arithmetic average between the 4 current short rate and the relevant forward short rate,” This is abstracting from compounding interest. As may be noted the question of futurity is emphasized in this whole concept of interest developed by the Keynesian school and its predecessors, Keynes himself has said, ”, , , for the importance of money essentially flows from its being 5 a link between the present and the future,” Apparently 4 John Hicks, Value and Capital, (London: Oxford- Clarendon Press, 1939ft p, 147 5 Keynes, op, cit,, p, 293, 57 this link is forged through the liquidity function of money. Pet ermine t ion. A better understanding of the Keynesian method of determination of interest is derived if the beginnings of the Keynesian analysis are traced back to Thornton. He explained that the amount of credit demanded depends on the comparison of the current rate of interest with the rate of profit. This rate of profit, in turn, is dependent upon the supply of capital. It is clear that expected profit determines the demand for money, in Thornton's analysis. The rate of profit is seemingly a function of the quantity of capital. Apparently he used theterms, capital and money, interchangeably* Ca®el, who followed Trhornton's analysis consciously or unconsciously, stated: For shorter periods, as we saw, it is mainly tenden cies on the side of demsn d for capital-disposal which cause changes in the rate. . .as the rate of interest in turn regulates the demand, the whole movement of the economic life is seen to be a continuous interaction of the rate of interest and production of fixed capital. Closer study of this interaction, or of conjuncture-movements as we shall call them, belongs to the dynamics of the economic life. * * 6 This explanation, it may be noted, is closely related to Thornton's explanation of the determination of interest. If Keynes* definition of interest is kept in mind, and if it may be considered correct, then the quantity of 6 Cassel, op. cit., p. 243. 58 money in conjunction with liquidity preference determines the rate of interest in given circumstances. This statement may be said to be the essence of the Keynesian Theory of the determination of the interest rate, although Keynes is conscious of the fact that there is more than one interest rate in the economy. He explained liquidity-preference in terms of motives for holding cash, but seemed to put the 7 emphasis on a speculative motive. He added that if there is a negligible demand for cash from the speculative motive, an increase in the quantity of money will have to lower the rate of interest almost forthwith, in whatever degree is necessary to raise employment and the wage unit sufficiently to cause additional cash to be absorbed by the transactions 8 motive and the precautionary motive. His conclusions were, therefore, that an increase in the quantity of money wouid reduce the rate of interest, but 7 Keynes, op, oit., p, 170, ”The three divisions of liquidity preference which we have distinguished above may be defined as depending in (1) the transactions-motive, i*e, the need for cash for the current transactions of personal and business exchanges £pr (a) for income (b) forbusinessj; (2) the precautionary motive, ie, the desire for security as to the future cash equivalent of a certain proportion of total resources; and (3) the speculative motive, ie, the object of securing profit from knowing better than the market what the future will bring forth,” This is going into greater detail on the average cash balance approach of Wicksell, or the ”encaisse desiree” of Walras, 8. Ibid., p. 171. 59 not if liquidity were increasing even faster than the rate was declining. A decline in the rate of interest would increase investment, but not if the schedule ofthe marginal efficiency of capital were falling more rapidly. An increase in investment would increase employment, but not if the propensity to consume were falling and the price level began to decline. So thatas employment rises prices rise, government by supply and wages, and the liquidity preference rises so that in order to maintain the rate of interest, more money is constantly needed. This is the cumulative process of Wicksell. The Classical theory neglected to say, according to Keynes, that the level of income must be the factor which brings the amount saved to equality with the amount invested. It must assume that an automatic change in the wage-unit of an amount is just sufficient in its effect on liquidity preference to establish a rate of interest which would just offset the supposed shift, so as to leave output at the same level as before. The Classical theory has not been conscious of the relevance of changes in the level of income, 9 or that income is possibly a function of investment. Keynes insisted that savings and investment are the determinates of the system, not the determinants. T&ey work 9 Ibid., pp. 173-180 60 through employment and income to the rate of interest. He defined investment as expenditure on capital goods in a period of time. Savings is defined to mean income minus consumption in the same period; therefore, savings equals investment. These definitions have provoked many other definitions of which only three need be mentioned; all, however, more or less agree with Keynes as to the position of these components in the system. Robertson, An English contemporary of Keynes, has defined savings as income earned yesterday minus today’s consumption. His definition of investment is the same as Keynes1, however. The Stockholm School makes a distinction between realized and expected savings, ’ Bhich they term savings ex post and savings ex ante respectively. Investment is defined similarly. The difference between investment ex ante and savings ex ante is the unexpected depletion of stocks plus unexpected income. Hawtrey, another contemporary of Keynes and an economist of some repute, made the distinction between active and passive with regard to savings and investment. His emphasis was upon the idea of active investment being greater than active savings which causes an increase in income. All definitions other than Keynes’ seem to agree that, 61 at least for equilibrium, savings and investment whether active or unexpected or yesterday's must be equal* Keynes' definition would indicate equilibrium at all points of time* Thus, Robertson, Hawtrey and the Stockholm School would explain change by means of unexpected income, investment and unintentional savings* Keynes would explain change by means of the multiplier which is determined by the change in investment and consumption. These two changes bring about a simultaneous change in come. Keynes argued that the determinants of the system are the propensity to consume and the marginal efficiency of capital as well as the rate of interest. He recognized, however, that there is not merely a rate of interest, but a structure of interest rates made up of long and short term rates* Apparently, he felt that the short term rate was a monetary phenomena determined by monetary fluctuation s. On the other hand, he felt that the long rate was a highly 10 conventional rather than a highly psychological phenomenon. This latter seemed to imply that liquidity preference is a peculiar phenomenon of great influence only under special circumstances. The conventional aspect led him to remark that it is the institutional and psychological factors which might 10 Ibid., pp. 197, 202, 203. 62 prevent the rate of interest (long-term) from falling below a minimum to secure full employment; this minimum appears to be at about 2 or 2.5 percent. If, he continued, this minimum rate should prove to be a facet, there may soon be realized that awkward circumstances of an increasing stock of wealth where the rate of interest can fall no further under laissez-faire. However, he declared emphatically, if everyone prefers cash to holding a debt which yields so low a rate of interest, such a condition is the limiting case. “But whilst this limiting case might become practically Important in the future, I know of no example of it 11 hitherto." Nevertheless, the rate of interest declines more slowly, according to Keynes, because Its production expands very little and because it cannot be substituted for other assets. Hence, the money rate of interest tends to decline more slowly than the marginal efficiencies of other capital 12 assets measured in terms of it. This action of the rate of interest is explained predominantly by the liquidity- # factor. Although Keynes1 main attack was on the rate of interest, he realized that it was not a panacea. Thus, unless we import considerations from outside, the money rate 11 Ibid., p. 207. 12 Ibid., p. 236. 63 of interest is indeterminate, for the demand schedule for money is a function of its supply and the rate of interest depends in addition on the marginal efficiency of capital assets other than money. This seems a recession from the theories of the General Theory when the rate of interest is determined by the quantity of money and liquidity pre- 13 ference# Hansen, who is the American counterpart of Keynes, adopted Keynes’ ideas and added some of his own. He found that the extraordinary willingness to hold cash in recent years, a function partly of the greatly increased supply of money, partly of increased risk and uncertainty throughout the world, and partly of inadequate investment outlets, has affected profoundly the short-term rate and the rate of guilt-edged securities. Hansen also attributed to technological processes an influence in determining the rate of interest along with the price system. Hence, even he is dissatisfied with the Keynesian development of the determination of the interest rates. He borrowed a good deal from Hawtrey in examining capital development when he explained that if the ratio of real capital to real income remains constant, there is not 13 John M. Keynes, ’ ’The Theory of the Rate of Interest,” The Lessons of Monetary Egyerience, (New York: Farrar and ITInehart, TsZTT), p.4S0. Ee reiterates that, ’ ’Marginal efficiency of money in terms of itself is, in general, a function of its quantity (Though not of its quantity alone), just as in the case of other capital assets. Hence, it is indeterminate unless the demand and other assets are known. * 64 any deepening of capital; but if this ratio remains constant, 14 and real income rises, then there is a widening of capital since capital and output are increasing apace. Though the deepening process, which is more capital per unit of output, is all the while going on in certain areas, elsewhere capital- saving inventions are reducing the ratio of capital to output. He felt-that capital widening has been the main force of the economy. This capital widening in itself would seem, following Hawtrey’s analysis, to raise the long-term rate of interest, thus causing a spread between the long-term and the short-term rate of interest. This widening, in turn, influences the deepening process, and brings about an increase in activity or recovery. Hansen’s explanation of equilibrium centered about the interest rate. He reasoned that an appropriate balance between non-interest bearing assets, cash and earning assets, depending on what one regards as a desirable rate of interest, is attained by creating money. The increase of money tends to make one hold more cash and reduce the rate of interest, since the rate of interest is an insurance premium for the principal. It must be around here that all 14 A. H. Hansen, Fiscal Policy and Business Cycles. (New York: Norton and Co., 1941J, pp.335-366. Hawtrey defines a widening of capital as increasing amount of capital used for the total amount of output, and the deepen ing of capital as the increasing amount of capital per unit of output. 65 desires of equal force are satisfied; if some which are stronger remain unsatisfied, then according to Walras there is a tendency to disequilibrium or change. There seems to be a common realization among those who have followed Keynes that there is an important part played by banks and public authorities in determining the system of interest rates* This important part has a great bearing upon the possibility of controlling that system, a 15 possibility much exploited in recent times, due to Lord Keynes, it might be added. Mr. Hicks, however, recognized that the banking function entails some risk. This risk is a definite consideration in the determination of the interest rates in the market. His explanation regarding the structure of interest rates was particularly important from the banking standpoint. On the basis of substitutability of assets, he thought that the shortest of short rates must equal the relative valuation at the margin between money and 3uch short-dated bills. The bills stand at discount mainly because of the convenience and security of holding money. The long rate can only rise either because trade improves and income expands or because trade gets worse and desire for liquidity increases. This analysis would seem to lead 15 Hicks, Q£. olt., p. 170. 66 to the explanation that the cause of high interest on land or mortgages id due to the high risk and the non- marketability of these instruments. This high rate of interest brings a low price for mortgage paper in the market. However, the opposite condition would follow on different sites of land, the higher the price, the lower the risk. Hicks also reasons along the Keynesian line that this risk factor causes the spread in interest rates between the 16 short and long term. As has been stated before in other terms, one factor which would limit the action of the interest rate in the market would be an increase in the inducement to invest which, because it would merely caLl forth idle funds, would not raise this interest rate. How the range in which interest is affected is that in which demand for money does not increase as fast as the money itself increases, or vice versa. This range is in the realm of the Classical School. Another limit on the action of the interest rate in the market would be a case in which money increases but there is no longer an increase in the demand for money. When this second limit is in effect, there is inflation# It may be seen, therefore, that the demand for money 16 See Robertson*s "liquidity trap*. Keynes would argue that the mass psychology of the market must eventually lead to a rigid trap for liquidity, as did Hicks. 67 must be a function of the idea of expectations to that even futures prices and forward rates are largely reciprocals of the interest rates. This expectation will also tend to bring about an equality between the short-term and the long term rate of Interest. Another development in the Keynesian School regarding interest rates was made by Lerner who reasoned that many different rates of interest exist because of risk, liquidity, time, competition, and the quantity of money, as well as the liquidity yields from holding different assets. The yield on money proper Is entirely in the form of liquidity convenience. There is a certain rate of money yield in assets, or a differential rate of interest which will induce the public to hold earning or other assets and money in the proportions in which they exist in the economy. A particu lar rate is the differential rate between the asset and the asset money, and the rate for partial sacrifice of liquidity is determined in the same way as for total sacrifice of liquidity. The modifications of the Keynesian determination of interest was continued in this country by Pellner, who followed more or less the Hicksian analysis, when he stated, ”The actual behavior of rates on money loans in the face of downward shifting expectations must be explained largely with reference to the behavior of the liquidity 68 17 function,” (liquidity preference). Rigidity of rates in even an upward direction can be overcome by shifting the quantity of money to the left. As long as there is a possibility of a fall in security prices or a rise in rates of interest, a decline in the available entrepreneural safety margins must be assumed to produce preferences for short term as against long term securities. It must also be assumed to produce preferences for safe as against risky securities, and for cash as against securities in general* The differentials in favor of risky rates rise for the additional reason that the risky security is more risky than it used to be. Here again is the consciousness of liquidity preference and the interrelation of capital funds loans and markets, the element of difference being risk* One other modification might be mentioned and that is the one made by Lutz. He explained that borrowers usually like to borrow long, while lenders prefer to lend on short term because of the risk in the case of the long rate* These outlooks tend to keep the long rate higher than the short rate, and to make the short rate more flexible. As a consequence, the long rate follows the short rate in changing. Intermediate rates are largely influenced by cost and risk. 17 William Fellner, Monetary Policies and Full Employment, (Los Angeles: University of California' Press, IBITT,'' ppT 172-173. 69 The difference in securities, Lutz thought, depends on the chance of gain if sold. He calls the liquidity factor the 18 element of differentiation* Certainly much dissatisfaction has been expressed concerning the Keynesian determination of interest. Robertson has indicated that over a long period, it was not the liquidity preference and quantity of money concerning the rate of interest but fahat Marshall referred to as productive ness and prospectiveness, which are the main factors of supply and demand influencing the rate of interest. He concluded* The most obvious difference between the Keynesian and the Neo-Marshallian approached is. . .in the farmer the schedule of liquidity preference is exhibited as one of the determinants of the rate of interest; in the latter the rate of interest is exhibited as one of the determinants of the proportion K 4 K in turn helping to determine not the rate of interest at all but the general level of prices and money incomes* 19 Robertson’s further analysis of the market based on highly individualistic thinking led him to feel that the same forces of increased confidence which make some people desire to part with money for commodities, make other people desire to part with money for bonds, and so lowers the rate 18 E*A*Lutz, ’ ’Structure of Interest Rates,” op* cit,, Readings in Theory of Income Distribution, pp* 500-"525* 19 D.H* Robertson, ”Mr. Keynes and the Rate of Interest,” op* cit*, Readings in the Theory of Pistribution of Income, p* 450* 70 20 of interest on bonds throughout the market. One further influence in the market must be considered in the determination of interest, and that is government investment. The Government’s operation on the interest rate through investment is likely to affect the yield on e±isting enterprises, and thus affect the price of their securities. The rate of interest derived1 from this factor may or may not be important, but must be remembered in considering the determination of interest. Similar to the influence of government investment on the interest rate may be other government operations. Marget has sought to add other measures influencing liquidity preference, such as taxation and government control, and the position of the conomy with regard to the cycle as influencing the precautionary motive of liquidity affecting the entrepreneur and, following Hawtrey, the banks. If bank liquidity preferences rise, interest rates rise and reduce the loss on the part of the banks. This action on the part of the banks, as well as the other reasons mentioned above, may increase entrepreneural liquidity. This increase in liquidity drives the interest rate above the profit rate. Taxation may cause seasonal variations. The general movement of business will be accentuated by all these causes 20 Ibid., p. 446. 71 whether on the downswing or the upswing. Developments after Keynes conoernlng the determination of interest have emphasized not only liquidity preference in the quantity of money but expectations, risk, competition and government fiscal operations. One, several or all of these enumerated forces may affect the interest rate at any time. Function. The function of the rate of interest according to those who preceded Keynes and were more directly responsible for his theory should be noted. One of these predecessors, Thornton, having examined the operation of the economic system, decided that the amount of credit demanded depends on a comparison of the rate of interest taken at the Bank with the current rate of mercantile profit. This mercantile profit is the profit which is usually the highest, and regulates in great measure the rate in all other cases. But the rate of mercantile profit depends on the quantity of this bona fide £real?^7 capital and not on the amount of the nominal value. Thornton aLso recognized that if there is an increase in the issue of credit, the antecedently idle persons will be given employment and additional industry will result. 21 Marget, 0£. cit., pp. 191-192, 223. 72 Therefore, the low rate of interest does not mean ’ ’forced savings” necessarily, but may mean more employment. Forced savings can only result when there is a rise in price with unemployed workers. A price rise will ordinarily result from a low rate of interest only if there is full employment* Should interest be fixed considerably below mercantile profit by law at 5 per cent, creditors, not being allowed more than 5 per cent from their debtors, would be apt at particular junctures to call in their money for the sake of taking to themselves the extraordinary benefit to be 22 obtained by the use of capital* He concluded: This subject of the rate of interest. . .it seemed to him to be a very great and turning point. . . the danger of excess was aggravated in proportion to the business of the rate of interest at which discounts were afforded* 23 A Swedish economist closely allied with Thornton and his distinguished colleague Wicksell in his thinking was Cassel. He recognized the importance of the interest rate* He thought it could be assumed that a permanently low rate 22 Henry Thornton, The Paper Credit of Great Britain, Edit, with Intro, by Hayek. (Wew York: Farrar and Minehart, Inc., 1939), pp* 257-258. Here can be detected a slight difference from Smith because he argued this has the effect of raising the rate of interest for the added risk in charging more for the loan. ¥/icksell seems to agree with Thornton that since the rate of interest is fixed below the ? rofit rate, capitalists will become entrepreneurs, increas- ng capital and presumably lowering the profit rate to coincide with the fixed rate. 23 Ibid., p* 335* 73 of interest on the whole rather restricts the formation of capital. He defended the interest price against complairte that it slowed down economic activity by explaining that it was to keep within.certain limits the entire economic activity that makes demands for capital disposal. It is precisely because the rate of interest always keeps the fluctuating demand for capital disposal adjusted to the limited supply that it is the general regulator of the up 24 and down movements of the economic life* For shorter periods, as we saw, it is mainly tenden cies on the side of demand for capita 1-disposal which cause changes in the rate.-• .as the rate of interest in turn regulates this demand, the whole movement of the economic life is seen to be a continuous interaction of the rate of interest and production of fixed capital* Closer study of this interaction or of conjuncture- movements, as we shall call them, belongs to the dynamics of the economic life. • • 25 Therefore, conscious of the short run effects, Cassel turned quite naturally to long run trends. Following the theories of his predecessors, he felt that a cessation of population increase, declining technological demands and the lengthening of life tended to reduce the consumption of capital within certain indefinable limits. He further stated 24 Cassel, op. cit., p* 240. Here, it may be noted, are thought and terminological similarities with certain distinguished successors, such as D.H. Robertson and H* Ellis. Nevertheless, also, it reveals a community of ideas with Thornton* 25 Ibid., p. 243. 74 that if the rate of interest were too low, economic society would be revolutionized; however, as it was reduced each 26 small step would encounter an increasing resistance. Cassel recognized the importance of the rate policy of the banks, and knew that the control of this policy led indirectly to control of the price level. He believed that it was the function of the interest rate to equate the supply and demand for capital-disposal, which is in the form of money. Any artificial reduction of this rate must lead to a forced increase of saving on the part of the idle and those on fixed income in the community. Again the reappearance of ”forced savings” derived from Thornton, showing the emergency of his influence, is evident. Thus, Cassel felt that to a great extent the rate of interest is a decisive factor in the economic possibility of 27 providing permanent capital objectives. This opinion, of course, involves both the short and the long run rates of interest, and is more decisive in the long run rate. Wicksell based his idea of the function of interest on his famous hypothesis of the existence of the natural rate and the money rate. Since the money rate of interest in 26 Ibid., p. 246. This is quite similar to Wick- steed's analysis of long run trends but added a new note of the lengthening of life as an influence on economic society. 27 Ibid., p. 615. 75 conjunction with the natural rate is the strategic price, according to Wicksell, the money rate relative to the natural rate must, on that basis, control the operation of the economic system, Keynes in consideration of the rate of interest and its function stated that, ,fThe influence.of changes in the rate of interest on the amount actually saved is of paramount importance, but it is in the opposite direction to that 28 usually supposed,” His reasoning ran something like this: assuming that the schedule of demand for investment remains the same, as the rate of interest rises, investment diminishes. This decreased investment diminishes income which, in turn, diminishes savings. This effect of interest rate increase is contrary to the classical idea which held 29 that savings increased as interest rose. If the rate of interest were so governed as to maintain continuous full employment, virtue would resume her sway; the rate of capital accumulation would depend on the weakness of the propensity to consume. Thus once again the tribute that the classical economists pay to her is due to their concealed a°ssumption that the rate of interest always is so governed, 30 He also believed that a decrease in the rate of interest would increase investment, but not if the expected profit rate on capital were falling more rapidly than the decline 28 Keynes, op, cit., p. 110, 29 See Tarshis, L., ’ “Exposition of Keynesian Economics,” American Economic Review, 38:261-272, May, 1948. 30 Keynes, op. cit., p. 112, 76 in the rate of interest* Keynes feared that the rate of interest was incapable of falling below a certain level. This failure to decline would result, according to his analysis, in less than full employment. He felt that the necessary level of the rate of interest, which will allow a reasonable average level of employment is one so unacceptable to wealth owners that it cannot readily be established merely by manipulating the quantity of money. Thus, Keynes’ theory shows a marked similarity to those theories of Thornton and Wicksell# Hansen recognized the function of the interest in its affect on investment. He warned that if the discount rate is to be raised sufficiently high to choke off the new developments which are the driving force of the investment boom, the more stable segments of the economy (consumption and consumer goods) will be choked off by a degree of contraction quite incompatible with the aim to level off and stabilize. He noted, interestingly enough, that; A characteristic interest rate pattern is the narrowing of the spread between short-term and long term yiehs as recovery develops. In an intense boom the short rate may even rise above the long rate, while in deep depression the short-term rate is normally far below the long-term rate, and indeed in extraordinary depression approaches the zero limit* Thus the intensity of the boom can be measured, in a degree, by the relation of the short-term rate to the long-term rate 77 and similarly the intensity of the depression# 31 The function of a pattern of interest rates would seem to be a measure for a trend in cyclical activity. He is forced to conclude that cheap money can encourage investment if conditions are favorable, but it will not of itself produce an adequate volume of investment and consumption. This inadequacy is the famous credit deadlock of Hawtrey as well as the liquidity preference of Keynes and operations of banks 32 in Thornton’s scheme# A high degree of liquidity in the banks is apparently of little avail# Therefore, the inadequacy of interest as a control, Hansen has argued, lies in the fact that in conditions of high income, consumption appears to be fairly constant# Hansen affirmed Keynes’ original idea that such consumption appears to be fairly constant. He affirmed also Kenyes1 original idea that such consumption Is deeply rooted in the customs, habits and traditions of the people, and in institutions which are not changed, and indeed are very 33 frequently not desirable to change# Such analysis indicated 31 Hansen, o£# cit#, p#79. This statement seems to conjure up some inheresting possibilities in the development of interest and monetary policy# 32 Ibid., pp# 79, 80, 82. See Hawtrey*s, Capital and Ekaployment. 33 Ibid., p. 237. In fairly high income years 88$ is consumed and 12$ saved. Gross saving (depreciation) and absolescence 22.8$. 78 that so long as this condition persists the economy is geared to high investment maintained at a high level by a low interest rate as only one factor in order to achieve full employment. Hansen felt that a lasting depression due to the 34 "credit deadlock" needed to be shoved off dead center by pump-priming or deficit spending or by government spending or investing. His analysis led him to believe that there are institutions that impose obstacles to the smooth adjustments of the rate of interest which the new situation calls for. This adjustment is achieved only with a long institutional lag which may well extend over several generations. Here again the maturity of the economy seems to be caused not by lack of investment opportunities which he has argued for, but rather by institutional restraints and the consequent induced expectations. In the classical sense, the propensity to save is not purely a function of the rate of interest but is also a function of the size of 35 the income determined by the institutional influences. One of the specific problems that has been irksome for the war and post-war period has been housing and its 34 Credit-deadlock means that no matter how low the interest rate is at the bank, businessmen will not borrow because of poor or no profit expectations. 35 Ibid., p. 408 79 ramifications throughout the economic system* "Housing is not only the most important field for private investment; it is also the area in which a low rate of interest is most 56 effective," Here is a fertile field for government activity. The government’s lending and guarantee agencies have made only a beginning in the implementation of low rates of interest in various areas affecting private investment. Hansen again reiterated the conclusions of Keynes in his own words when he concluded that generally a low rate of interest throughout the whole economy helps to promote a high wage-low profit system. A low rate of interest tends toward a more equal distribution of income and higher consumption economy. He strongly advocated, therefore, a low rate of interest not only as a stimulus to outlays on new investment, especially housing, but also as a stimulus, thereby, to consumption. This low rate, he felt, would continue the 37 economy at a high level of activity. However, Hansen’s study in fiscal policy led him to conclude that future adjustment of tax rates may, as a 36 Ibid., p. 131. 37 This development is drawn from the passages cited in the preceding footnote. counter-cyclical device, take the place formerly occupied by a variation in the rate of interest. Taxation would not affect speculation, but would affect only the more sound part3 of the economy. One of the defects of manipulation of interest is that it strikes with most force at just the wrong place. But variation in the rate of interest has never been effective as a control mechanism and, he felt, could not be because if conditions favor an inventory boom, a rise in the rate of interest has virtually no effect. The prospective gains from a rise in inventory prices enormously overshadow any deterrent effect from an increase in the rate of interest. This lack of a deturrent effect is only one inadequacy. Another inadequacy of the interest rate which should be mentioned is the preclusion from a variable rate of inter est because of the vast holdings of securities by the public generally, by business concerns and by financial institutions. Fluctuations in the value of these vast holdings caused by varying interest rates are not tolerable because of the violent fluctuations which would be set up in the whole system* A low interest rate would bring about not only a low profit condition but changing conditions of obsolescence which would force further flotation of securities. Nevertheless, Hansen recognized the function of the rate of interest as an insurance premium for the principal. For 81 Hansen reasoned: If a certain part of one’s assets is secured in this manner, one can put the rest in the form of earning assets. . .the lower the rate of interest, the more necessary it is, in order to safeguard the principal, to hold a large part of one’s assets in cash. Conversely, a condition of high liquidity, the creation of a large money supply by central bank and treasury action, will induce the purchase of securities in order to reestablish the desired ratio of cash to earning assets. Thus an increase in money supply will tend to lower the rate of interest. A functional relationship, therefore, exists between the rate of interest and the volume of money that the public wishes to hold, 38 The rate of interest, therefore, on government bonds determines the balance in the economy, leaving aside institutional restrictions which delay the adjustment perhaps for generations. Explicitly a normal idea of expectations must also be established that over a period of time expectations are being fulfilled. Hicks has elaborated even further that interest is too weak to have much influence on the near future; risk is too strong to enable interest to have much influence on the far future. How far interest can find a place depends on the strength of the risk factor. This risk factor is largely a psychological question, and a range will probably be left, between the extremes where interest is ineffective, in which 39 it can have certain significant influence. 38 Ibid., p. 229. 39 Hicks, op. cit., p. 226. Lerner has stated that, ”The rate of interest depreciates the dollar at the same rate at which products and factors depreciate, and this prevents the money prices 40 of products and factors from falling.” He claimed the rate of interest is not related to the price level but to the rate of change in the price level. It would appear that so long as the rate of interest expresses the rate of change in all the various related price levels or the average of these, there is equilibrium. Lerner agreed with the general opinion that the lower the rate of interest, considered on the average, the greater would be the demand, the output of investment, and the rate of investments, expressed as a schedule of marginal 41 efficiency of investments* Lerner repeated the generally accepted equillibrium Idea of Walras that the individual adjusts the quantity of capital assets in his possession to the rate of interest by buyingor selling them, borrowing if necessary, until the marginal productivity of each capital asset is equal to the rate of interest. Fellner, on the other hand, is forced to conclude on 40 A. P. Lerner, Economics of Control. (New York: The MacMillan Corapany,"T944'), p. 93. 41 Ibid., p. 334. 83 the strength of his own analysis that the downward adjust ment of interest rates will not serve the purpose of increasing output to its original level because of the increase in' desire for cash. Thus, he accepted liquidity preference as the standard theory flowing from Thornton and Keynes. Interest rate is an effective influence so long as liquidity does not become too elastic. A highly elastic liquidity function would cause severe slackening of business activity or depression by preventing a fall In the rate of interest. This condition may be explained as a limiting case and a warning of what to expect if allowed to go that far and cause a change in institutions. Ohlin, who is not so sympathetic to Keynesian doctrine but rather WIcksellian, adhered closely to the Keynesian theory when he said, ”to maintain revenue prices, wage rates and interest rates in such a relation to one another as to guarantee sufficient investment-changes in 42 interest levels are perhaps the most direct means.” Joining with Hansen because of Sweden’s experience in economic affairs, Ohlin has added that other measures may be used to supplement the interest rate, however* 42 S.E. Harris, The New Economics (Hew York: Alfred A. Knopf, 1947), p. 138. He also added emphasis that was perhaps misplaced that over a wide range of cases, the marginal efficiency of money is determined by forces partly appropriate to itself and that prices move until other assets fall into line with the rate of interest. 84 Unlike Hansen, Samuelson, an economist and mathematician as well, has stated unequivocably that: The rate of interest is enormously important in the effective implementation of fiscal policy, , .but as a means of increasing purely private investment, it could only be of great importance as a determinant of income and employment if the marginal efficiency schedule were very highly elastic. . .by reducing as far as possible the rate of interest. This method obviously from the long run stand point is non-recurring here he agrees with Hansen and quickly runs out. The movements along the marginal efficiency curve would be a "once for all” movement were it not for the upshift of the marginal schedule that provides the outlet for a continuing flow of investment. 43 Machlup’s analysis brought him to the conclusion that private investment is affected on four counts: first, becau.se of changes in effective demand; second, because of changes in the state of confidence; third, because of changed production costs; fourth, because of changes in interest rates and in the availability of capital. Interest rates are only one factor in the determination of investment, according to his analysis. The Neo-Classical position expressed by Ellis recognized that the persistence of an abnormally low bank rate and inflation may turn resources into investments and away from consumer's goods fast enough to offset a deflating from the first harvest of output. This analysis draws upon Schumpeter's gestation period, and the consequent decline 43 Ibid., pp. 138-139. 85 44 in price. The Classical economists assumed that the established rate of money interest equates capital outlay with savings, provided that all savings come into the market. Keynes disputed this, for all earnings do not come into market. Money held for motivies of speculation is idle money, and for other reasons, active money. Income determines active money, but the savings-investment equality adjusts income. Speculative money determines interest which in turn determines investment, while the monetary policy determines the amount of money. Hawtrey agreed , too, that a sufficiently low rate of interest affords inducement to supply more capital for a given output, the "deepening of capital,” assuming a prospect of profit; a high rate of interest will cause a withdraw! of capital. Hawtrey thought that equilibrium in the investment market could be obtained better by a refusal to float more enterprises than the market can absorb rather than varying the rate of interest. This is because as the rate fails, risk rises because of divergence from the "Safe" level. It is the rate of interest minus the risk of loss that is 44 H. S. Ellis, German Monetary Theory 1905-1951. (Cambridge: Harvard University Press, 1 9 3 4 p. 349 ff. 86 important on long term debt. If interest stays above that risk, there will be investment; the risk entails a consideration of what is considered a safe 3e vel of interest* Here again Hawtrey agreed with Keynes, but differed on 45 terms. He accused Keynes of attributing too much power to the short rate, and of determining the long rate by action on 46 idle balances* The Keynesians attributed to the rate of interest the function of equating the supply and demand for money. The Keynesian function differed, therefore, from the Classical which had stated that savings and investment were equated by the interest rate. The Keynesian idea did state, however, that the Interest rate In conjunction with the marginal propensity to consume did determine the amount of employment in the economy. Income in turn determined the amount of savings and investment. Justification. The Classical justification of interest has been found in the necessity of providing sufficient inducement to save. It has also been argued that interest is needed to check the demand for capital. The Neo- 45 Ralph Hawtrey, Capital and Employment (Londons Longman1s, Green and Co.,’1937), p. 188. See Keynes, General Theory, p. 169, for his treatment of disappointments as well as risk. 46 Ibid., p. 191 87 Classical writers have even argued that it is necessary as a control device for the economy, Keynes does not justify interest on this basis. His justification is stated in the following passage: I feel sure that the demand for capital is strictly limited in the sense that it would not be difficult to increase the stock of capital up to a point where its marginal efficiency had fallen to a very low figure. This would not mean that the use of capital instruments would cost almost nothing, but only that the return from them would have to cover little more than their exhaustion by wastage and obsolescence together with some margin to cover risk and the exercise of skill and judgment. In short, the aggregate return from durable goods in the course of their life would, as in the case of short-lived goods, just cover their labour- costs of production plus an allowance for risk and the costs of skill and supervision, 47 Further, Keynes justifies interest on the basis of a return to offset risk due to fluctuations inthe money market. Another justification is the cost of bringing borrowers and lenders together in the market. The theme of justification of interest emphasized by the followers of Keynes is that if risk and cost. Hicks would explain that if the long rate of interest is too low to compensate for the risk of capital loss, investors begin to go into short-term securities, and if the short rate is too low to compensate for the risks involved even there, they hold cash. The liquidity factor weighs most heavily in the balance. This analysis also reasons along the Keynesian , lines that this risk factor causes the spread in interest rates between short and long term investments. 47 Keynes, 0£. cit., p. 375. 88 Lutz has also elaborated the justification of interest on the basis of risk and cost. He has explained that a consideration of interest must include the costs of shifting from one type of investment to another, brokerage fees and taxes on such transactions. On this basis, the cost for short-term investment is a higher percentage of the price, nevertheless, as a consequence of risk involved, the tendency is for the long rate to be higher as the element of loss weighs more heavily than the change for gain. One other consideration must be kept in mind regarding justification for interest, and that is the demand for money. The satisfaction of this demand will involve a cost that will also justify interest. Thus, the Keynesian justifica tion for interest is in terms of risk, cost and liquidity rather than as an inducement to save. Summary. The Keynesian concept of interest was explicit and definite as compared to the Classical concept. Keynes’ definition of interest as the price for money was similar to the definitions of both Thornton and Wicksell. The determinants of interest as ascribed by Keynes showed a sharp break with Classical tradition. Keynes claimed, as did his followers, that the demand for money motivated largely by liquidity preference and the quantity of money established a rate of interest in the market. 89 Classical analysis, on the other hand, claimed that it was the supply and demand for capital that determined interest, Keynes held that savings and investment were always equal. This equality he established by definition. The identity of savings and investment in the Keynesian analysis provoked a heated controversy which has not yet been stilled. The function of interest in the Classical analysis was equating the supply and demand for capital. Again the Keynesian analysis differed sharply with tradition, Keynes claimed that the rate of interest along with the marginal efficiency of capital and the propensity to consume determine the amount of employment in the economy. He also felt thatthe rate of interest did not serve as an inducement to invest and that it did not maintain the balance between savings, investment and consumption but rather that it served, because of institutional restrictions preventing it from falling, to bring about the necessary balance in the economy. Keynes justified the rate of interest not on the Classical basis as an inducement to save or as a restraint on investment but rather on the basis of the risk of investment. The cost of bringing borrowers and lenders together on the market and as a cost of meeting the demand for money. It Is generally accepted that Keynes has done a ^reat deal to advances the study of interest and bring it into closer harmony with the money market* CHAPTER IV DEPRESSION AND RECOVERY POLICIES The interest and monetary theories of the major schools of economic thought, which were discussed in the previous chapters of this investigation, were a decided factor in the sequence of events leading up to the period 1933-48, and during the early years of this period. Government policy and action at this time, although necessarily dictated by circumstances, was nevertheless somewhat influenced first by the economic theories of the orthodox schools and perhaps later by the Keynesian theories. An historical treatment of the years just prior to 1933 is necessary for a better comprehension of the era to follow.* The Keynesian theory and policy which was formulated in 1936 became a somewhat important consideration in later policy developments. It would seem convenient to divide the era under survey into three periods, although actually there is no sharp line of demarcation. The first period from the days of the early New Deal which began in 1933 to the financing of defense in 1940 will be examined in this chapter. The main sources of information will be government publications, writings of authorities and some brief statistical data. Government policies and actions during this time will be recorded with some analysis, and their relationship to the theories which have been discussed in the preceding sections m 11 be incorporated. It will be noted that fiscal activities began to assume greater importance as the period developed* POLICY BACKGROUND The beginnings of policy of the early capitalistic era date from Adam Smith. He had pointed out that while interest had been setby the government, it always seemed that the regulation followed the market rate or the price at which people of good credit borrowed. Unquestionably, Smith's concept of interest set by supply and demand influenced his idea of interest regulation. He recognized that the interest rate could be set by law but that it ought to be slightly above the market rate as an upper limit. Apparently he was influenced by the danger of usury. An interest rate that was set too high would diminish the use of capital and reduce the increase of wealth; a rate that was set too much below the market rate would raise the market rate even more because of the risk of breaking the law; this would also reduce borrowing. No law can reduce the common rate of interest below the lowest ordinary market rate at the time when that law Is made, for it will only be evaded. I 93 As a follower of Smith, Ricardo threw off the last vestige of direct control of the market, especially where capital was the subject bf the exchange, in his protest: But in all countries from mistaken notions of policy the state has interfered to prevent a fair and free market rate of interest. . .The rate of interest, though ultimately and permanently governed by the rate of profit, is, however, subject to temporary variations from other causes. 1 Say, the Classical French economist, agreed heartily with Smith. Neither Malthus nor Sismondi were completely satisfied with the policy expressions of either Smith or Ricardo, and felt that a complete free play of market forces would not be entirely satisfactory, and might discredit principles as totally inapplicable to practice. John Stuart Mill agreed with the concept and policy of Smith and Ricardo generally. His experience with economic crisis led him to question the virtue of the monetary system. He felt that the delayed relaxation of credit prices was something to be avoided. It was true that credit expansion is often followed by high interest rates which in turn forces a contraction of the whole credit structure, especially when gold flows out. It is only later with the return flowcof gold that the remedy is provided to overcome the contraction. He continued, "The machinery of 1 David Ricardo, Principles of Political Economy and Taxation. (New York! E.P. DutToh and Company, 192 6), ------- 94 the system withholds until for many purposes it comes too late, the very medicine which the theory of t£ce system 2 prescribes as the appropriate remedy,” He would seem to advocate that the credit structure should not be contracted so sharply. This explanation would seem to indicate that the interest rate under such circumstances should be adjusted to prevent collapse, Walras, a member of the Marginal School, has expressed the underlying theme of both the Marginal and Classical Schools when he stated: It is the moral theory of the distribution of the wealth of society to say this; and this fact only, the economic theory of the production of the wealth of society will be able to follow strictly in detail the application of the principle of free competition in agriculture, industry, commerce, banking and speculation, 3 The conclusion that is apparent from this statement is that Walraa1 policy is practically identical withthat of Say and Ricardo, Any specific policy action would be based on the safeguarding of the principle of free competition, Marshall did not specifically state his policy regarding interest. His concept of interest differed little from that of his predecessors. His overall policy was very 2 L, Walras, Elements Df Economic Politique Pure (Paris: Pichon et R, Durand Auzias, 1926), p, 287, 3 J. S. Mill, Principles of Political Economy (Hew York: Appleton and Company, 1695), Vol. ll, p. 230, 95 similar to Walras1* He was well aware of the dangers of Economic freedom that might degenerate into license* He was not, however, adverse to handling particular problems as they arose. To him the problem and the goal was to devise deliberately and promptly remedies adaptedto the quickly changing circumstances of modern industry* Most modern policy has stemmed from Marshall and Mill* One of Marshall’s contemporaries, Sidgwick, warned, however, that there were limits to the control of interest* Sidgwick felt that too low a rate of interest would cause great changes in society* It was Irving Pisher who became more explicit regarding policy measures. He was familiar with certain measures which had been taken to relieve credit stringency in times of crisis* He felt that the change in rediscount rates remain in the same relative position to the expected profit rate, the manipulation of the rediscount rate need not be great in the normal course of events* Pisher also felt that if money were capable of scientific adjustment, interest would adjust itself quite freely. He reasoned, however, that the adjustment of money would require world cooperation, but since this was virtually impossible, some manipulation must develop naturally* Fisher’s concept of interest as a price for money led him quite easily to the possibility of the manipulation of the 96 rat© of interest. Most Neo-Classical writers have recognized the position of the state and its power to affect interest rates. They recognized the danger of political influence in economic markets. The powerful influence of interest as a strategic price in the structure of prices led them to a wholesome fear of government intervention in this sphere. It has been recognized, however, that circumstances may sometimes dictate intervention by the government regarding interest rates. But the Neo-Classical writers have also realized that such intervention by the government ca©not3 cure all the ills of the economic system. Early progenitors of the Keynesian theory had expressed opinions regarding policy that were rather similar to the modern viewpoint derived from Keynes. One of these forerunners, namely Thornton, believed that neither the wishes of the government nor the solicitations of merchants should determine the amount of credit in the system. He realized the great power of ppper credit when he said: And our experience of its power of supplying the want of gold in times of difficulty and peril, is a circumstance which though it ought not to encourage a general disuse of coin may justly add to future confidence of the nation. 4 4 Henry Thornton, The Paper Credit of Great Britian, Edit., with Intro, by Hayek. ' (New York: Farrar and Rinehart, Inc., 1939), p. 276. 97 Thornton seemed to be addressing himself more to the credit policy of the banking system than to the government. He advised that the Bank of England, the capstone of the private banking structure in the England of his day, could find no safety for itself, except by seeking it in the safety of the commercial world, in the general support of government 5 credit, and of the general prosperity of the nation. Cassel, a Swedish economist, recognized the importance of the rate policy of the bank and knew that the bank's control led indirectly to the control of the price level, and thereby to most economic activity. Like Pisher, Cassel was conscious of the monetary supply as well as credit policy. He advocated that the monetary supply must be kept at a certain level, and grow at a continuous rate relative to total supply in order to maintain stability. He feared that this would not occur, and that this condition would necessitate rational regulation of monetary demand for gold. This appraisal of Cassel's seemed to lead him to turn to the strategic direction of investment, bank policy and stable currency, thereby placing great importance upon the interest rate as a decisive factor. Wicksell, whose ideas were to become more dominant in monetary theory and policy, based his policy on the 5 Ibid., p. 286. 98 attainment of the stable price level. He reasoned that so long as prices remain unaltered the bank rate of interest should remain unaltered. If prices rise, the rate of interest is to be raised; if prices fall, the rate of Interest is to be lowered, and the rate of interest is henceforth to be maintained at Its new level until a further movement of prices calls for a further change in one direction or another. It must be remembered that he assumed competition in the classical sense and was not too interested in the time which must be allotted for prices to be assumed stable. Wicksell was well aware that changes in quantity of money brought about by interest rate changes would have effects where the impact of additional money was first felt; the effects of additional money would consequently ramify throughout the economy in ever-widening but lessing waves of intensity. Keynes1 policy which he developed grew out of his concept of determination of interest. He declared that the rate of interest is determined by liquidity preference and the quantity of money. His stated objective was full employment. Therefore, he advocated an increase in the money supply which would consequently lower the rate of interest. This lowered rate of interest plus the possibility of necessary investment by the government would aid in 99 obtaining the goal of full e m p l o y m e n t # n£s statement of policy was expressed in the following manner: The State will have to exercise a guiding influence on the propensity to consume partly through its scheme of taxation, partly by fixing the rate of interest, and partly, perhaps, in other ways. Furthermore, it seems unlikely that the influence of banking policy on the rate of interest will be sufficient by itself to determine an optimum rate of investment. I conceive, therefore, that a somewhat comprehensive socialisation of investment will prove the only means of securing an approximation to full employment. 6 Hansen, who adopted the Keynesian theory and policy in America, agreed with the assumptions of Keynes that a decline in the rate of pupulation growth and the disappearance of the frontier may be responsible for the lack of investment in the economy of the present day. Therefore, Hansen said, ". • .we have a choice only between 7 democratic planning and totalitarian regimentation.” Hansen appreciated the influence of the interest rate on investment and his examination of interest rate conditions led him to believe that there was a pattern of interest rates for each phase of the business cycle. These observations led him to formulate a policy somewhat along 6 J. M. Keynes, The General Theory of Employment, Interest and Money (New YorlcI Hare our t, Brace and Com) any, iS3rff)7“ p.“37a’ ; — 7 A.H.Hansen, Fiscal Policy and Business Cycles. (New York: Norton and Company, 1941')', pp. 49. 100 the following lines* He advocated that the interest rate be kept low, closely approximating the pattern of interest rate on government paper* Thus, short-term interest would remain below long-term rates. This government interest rate will have a tendency to establish the interest rate throughout the market• Hansen feared little danger of excessive flotation of securities of a genuine character in the capital market in view of the internal financing which has developed over the years. This development will continue for a few years, but is not a long run development; eventually conditions of obsolescence would force flotation of securities. Hansen advocated an increase of differentiation of government securities available to the banks and to the public. He also advocated that the short-term rate be raised while-maintain ing the spread between the short- and long-term rate of interest. This latter policy seems incompatible. There would be a tendency for banks to shift to high yielding long term paper. Resort would have to be made to limiting bank holding. Hansen reasoned that the long-term rate would stimulate large scale investment which would be necessary to maintain a high level of activity and full employment. His defense against inflation would be taxation as a compensatory 101 8 fiscal device, if necessary. Lerner1s policy, following Keynes lead, may be simply stated as increasing the amount of money in the system as conditions indicate to maintain full employment and using taxation to control direction of activity. It should be added that the Keynesians generally advocated more than mere monetary controls and taxation. They have even advocated wage and price control in order to bring the economy to better adjustment. Critics of the Keynesian Theory and policy have recognized the political dangers of such control, and have not advocated the extremes in policy exemplified.by the Keynesian school. Hawtrey, who represents the best In monetary economic circles, has suggested constant credit control to prevent inflation and deflation, provided such control be timed correctly. But he would apply more control in the consumer goods market. Traditional doctrine has argued emphatically that in a free market an attempt to keep the money rate down will soon be abandoned. This does not mean to say that no controls should be exercised, rather they would be exercised promptly and temporarily. 8 A. Hansen, Economic Policy and Full Employment (New York: McGraw-Hill Book do., Inc., I'd47), p. 2S4-&86. ® n$v© r s t t y of Southern California LlfcrafSi 102 Williams has argued regarding the interest policy from Keynes and Hansen that: So far as the term risk is concerned, our experience with a frozen pattern of rates demonstrates that rates on long-term governments would fall progressively toward the shortest. Butso far as income risk is concerned an easy money policy widens the gap in the interest rate structure and suggests the need of other attacks. . .an all out easy money policy. . .carries both short-run inflationary dangers (as we now recognize) and longer run dangers of undermining the whole fabric of the private capitalist economy. 9 HISTORICAL BACKGROUND The Federal Reserve System, one of the two main organs of the government’s financial operations, was founded in 1914. Because the country was forced into World War I and the exigencies of war finance just had to be met, the Federal Reserve System was unable to operate as anticipated, ie, to facilitate commercial banking. The burden of financing until 1918 fell largely to the banking system# As a consequence of the primacy of war finance, the credit policy seemed to be inchoate. An analysis of the credit policies behind these early operations prior to and during the war revealed that: Of the theory of credit or credit control, it would be difficult to find any traces; while of rate policy 9 J.H. William, ”An Appraisal of Keynesian Economics," American Economic Review, 38:257, May, 1948. 103 or rate leadership, we find nothing save possibly a rather crude disposition to follow the supposed practice of the Bank of Ehgland. 10 Under the exigencies of war, the period was one of credit expansion, which was not very sound. The aftermath was a struggle to reassert the commercial function for which the system had been set up but,according to Willis, even this failed. Rates of discount tended to be uniform with slight local variations. The best indication that the system was not carrying out its alleged commercial function was the growth in the holdings of government obligations, while commercial paper declined during the years 192 5-1929. The close link between the Treasury and the Federal Reserve, a link which had been intended in the Federal Reserve Act and fostered by the war, began to be felt in peace time. On the initiative of the Treasury, an open market committee was formed by the governors of the Reserve banks to coordinate the purchasing activities of the 11 System. This committee began to function in 1922,” The authorities realized that effective credit control required co-ordination of the open market policy and the 10 H. P. Willis, "Credit Policies of the Federal Reserve System — a Retrospect," Annals of American Academy of Political and Social Science, 171:95, January,' 1934. 11 0*0. Hardy, Credit Policies of the Federal Reserve System, (Wgshington, D.C.i Brookings Institute, 1632;,p. 39. 1 0 4 discount rate policy; its first use was in 1923, Federal Reserve holdings of government securities dropped, and the rediscount rate was raised in certain areas. This was 12 reversed in 1924 due to a sharp but brief depression* This action has been frequently described as being very aggressive* The year 1926 seemed to be an anomaly, for although there was an increase in business activity, prices declined* Then in 1927 there was a decline in business, but a rise in security prices. "About the middle of the year the Federal Reserve Board adopted for the second time since 1922 a 13 definite policy of easing the money market," in order to help business and foreign purchases. Later the same year open market purchases were discontinued largely because of the fact that in the absence of demand for additional credit from trade and industry, there had been a continued and rapid growth in the volume of member bank credit used in 14 investments and in loans on securities. The Federal Reserve centered its energies in 1928 on 12 Ibid., p. 40 ff. The rediscount ran to 2 per cent and holdings of government securities in the system went up to 590 million dollars* 13 Ibid., p. 47. 14 Ibid., p. 11, This passage draws largely from the Annual Report of the Federal Reserve Board (Washington. D*G* ty.S• Gove'rnment Printing Office,' 1927), 105 curbing speculation; it raised its rediscount rates to 5 per cent, and liquidated its government securities. Call and time money rates for the New York money market went to 7 and 8 per cent, but corporations and individuals began to replace banks as the source of call and time loans. Direct pressure was resorted to in 1929• Rediscount rates continued to rise and acceptance holdings fell to the lowest in history. The New York Reserve Bank buying rate on acceptances fell to 5,125 per cent, but rediscount rose to 6 per cent in an effort at compromise between the needs of business and the demands of the situation to control speculation. Following the crash in 1929, an easy money policy was adopted by the Federal Reserve System, with lower rediscount rates and the buying of government securities. However, these measures were unavailing. Money in circulation rose to more than five and a half billion dollars. Rediscounting was unpopular with commercial banks exoept as an extreme emergency measure; consequently, open market operations of the Federal Reserve had to be the main weapon in the first years after the crash. The reason that the banks were afraid to rediscount was that they thought that a bad impression would be made on the public whfen their statements appeared. Much controversial writing has appeared about this crucial period in banking and credit policies. As one writer 106 has explained, referring to the latter part of 1928: A partial explanation for the hesitancy on the part of the board ^Federal Reserve^ at this time, in the absence of proposals for action from the reserve banks, may be found in the Federal Reserve Act itself and in the tradition that had grown up in the system. This tradition was that initiative in credit policy should originate with the federal reserve banks, and that the boardfs function ordinarily should be to approve or disapprove proposals brought forward by the banks.15 The writer felt that it sought too late to restrict credit by direct pressure or qualitative control, not rediscount rates* The fault did not lie wholly with the Federal Reserve for other factors were involved: gold imports were stimulated by raised rates; banks did not keep cash on hand as usual; after all, prices remained stable and consumer installment credit was popular, reducing the necessity of cash; demand deposits of considerable amount were used as 16 time deposits, thereby reducing reserve requirements* 15 A*G* Miller, "Federal Reserve Policies 1927-29," American Economic Review, 25:442-458, September, 1935* Miller ' continued: ^'That it did not err in its judgment from a public point of view seems sufficiently established by the fact that several of the most important amendments written into the Banking Act of 1933 with regard to the Federal Reserve System were based on the attitude of the board as expressed in 1929 and the procedures then develop ed*" 16 R. A* Young, The Banking Situation in the United ' States in 1932, (New York City: National Industrial Conference Board, 1936), pp* 1-18* 107 Another point of dispute was the compromise already alluded to of the difference in rates on rediscount and acceptances. The failure to reduce the discount rate below the market rate for acceptances may have precipitated a 17 larger deflation than necessary for fear of gold outflow* The banks discount rate was reduced to 1*5 per cent in 1951, but the gold outflow occasioned by this reduction resulted in a rise of the rate in the latter part of the year to 3*5 per cent. Yet even this did not help to allow the outflow. The situation had deteriorated here and abroad in 1931, and the bankers in a joint cooperative effort set up the National Credit Corporation to rediscount paper of longer maturity than that eligible at the Reserve banks. This idea was later incorporated in the Glass- Steagall Act of 1932, The Administration began a series of measures in 1932 to bring about recovery. In the spring of that year the Federal Reserve launched a bold program of open market purchasing but advocates of open market policy have always allowed for a three-to-six months lag before expecting results to show up. The low was reached in July 1932, However, under the inflation policy, Federal Reserve open 17 H.H. Villard, "The Federal Reserve Systems Monetary Policy in 1931 and 1932,” Journal of Political Economy, 45:721-39, December, 1937, 108 market operations were treated as important but not as sufficient in itself to increase activity. One commentator was forced to make a remark about the policy that harkens back to a previous statement about Federal Reserve policy that, namely: The Bank of England philosophy has looked primarily to the external value of currency as measured by the stability of the exchange rates as a criterion of policy. • .but when price levels drifted to the point where some countries went fascist and others were threatened with social revolution, the exponents of do-nothing-ism lost their hold on officialdom. 18 Other efforts on the part of the Administration were more direct. It formed the Reconstruction Finance Corporation and the government purchased its capital stock. The purpose was to help out the financial institutions, and with the approval of the ICC, the railroads. The Federal Home Loan Bank Act set up banks of that name to make advances to the housing finance organizations, and the banks could issue 3.375 per cent bonds with bank note circulation privileges. Excess reserves in the banks had sunk to 35.4 million dollars in 1932, but were increased by Federal Reserve Bank purchases to 450 million dollars by the end of the year due to bond purchases by the Federal Reserve. Most interest 18 L.D* Edie, "Federal Reserve and the Frice Level,1 * Annals of the American Academy of Folitical and Social Science. 171:104-106, January, 1934. 109 rates were down except customer rates on commercial paper. Demand and time loan rates on securities were above 4,5 per cent. This rate does not take into consideration the proportion that must be kept on deposit and not available for borrower’s use. The banks had doubled their holdings of government bonds. The Treasury was saving money in interest payments by carrying so large a part of the public debt in floating short term paper which unduly burdened the banks since the banks prefer to sell longer term securities to individual investors. Still the importance of interest rates, though not all important, could not be denied as a factor: Interest rates are not the sole factor which determin ed the uses of loanable funds or bank credit, psychological considerations of security and business confidence affecting both willingness to lend and desire to borrow are often equally important. But the price of money is a factor in its use at all times, even though bankers are accustomed to insist that money is the only thing the consumption of which is not increased by lowering its price, 19 Banks because of low rates had been buying government bonds which are riskless. No change in Reserve Policy by way of reducing excess member bank reserves was expected for the rest of the year. That policy would mean more bonds would be available and rates would be low. 19 “Business Pays for its Money”, Business Week, p, 3, November 16, 1932, 1 1 0 A glance at the hanking situation in 1932 revealed, some important changes* It is a well known fact that with the growth of hank reserves from* 1922-1932, there has come about an increasing indirectness of the relationship of hanks to production and trade and a significant decline in hanking liquidity, as the term is commonly understood. That is to say, banks had tied up an increasing share of their growing resources in loans and investments that are many degrees remote from immediate transactions in goods and services, on which the hulk of bank credit extension is traditionally supposed to rest. On the other hand, bank deposits had undergone a chaige in character, a larger share being composed of savings or time rather than demand deposits which Indeed permits a reduction of hank liquidity, but at the same time stimulates a more rapid growth of bank credit because of lower reserves required against them. The traditional functions of the commercial banks lending to business on short term had been to mobilize liquid capital resources, keep them constantly disposable, guide them into the most profitable channels, and maintain their funds for return to their owners. The banks were strategic to economic operation but that meant due public responsibilityBanks are usually typed by function, and the main classification, the one under discussion, is the commercial bank. However, all banks are related by common Ill currency, the Federal Reserve System, clearing houses and correspondent relations. From an operating standpoint, perhaps the greatest degree of unification and coordination is brought about in the United States banking organization as a whole by the Federal Reserve System. The system controlled one third of the commercial banks and three quarters of all resources of commercial banks. National banks must belong to the system, state banks may belong, and 20 savings banks do not belong. Open market and discount activities of the Reserve Banks "may affect the aggregate reserves processed by all banks and the interest rates that they receive on their loans and investments and may thus affect the earnings on various 21 bank assets." The depression affected all banks during the years 1929-1933, but the small unit banks suffered most, the majority of these were state banks outside the system. Not all the causes for failure were due entirely to external causes, but rather to bad management and other individual causes, and even quite possibly to the changing structure of banking, such as the rise of chain and group banking. 20 Young, o£. cit., p. 18. Banks may also be classified by owner ship' int o unit banks, branch, chain or group banks. 21 Ibid., p. 24 1 1 2 The general changes apparent in banking of 1920-33 period were the rise of illiquid assets and a decline of the commercial function; paralleling this was the growth of savings accounts in the commercial banks. City banks were becoming department stores of banking; country banks were confined generally to agricultural credit, and lacked diversification. There was a decline in financing inventories because industry was doing its own short term financing; the banks were forced to make security loans. Consumer financing had increased and time deposits were growing. These changes were to be extended in the next decades. During this period, 1920-1932, another source has noted that the increased use of securities on the part of brokers in the stock exchange had brought about the "need for cash balance for brokers and buyers and sellers of 22 securities is a rising need with a rising market.* * Securities transactions and losses on them was a definite contributing factorto the failure of the banks in the depression. A few further remarks will suffice for background for the period following, which is of course the major interest of this study. It has seemed that the Reserve 22 Hardy, op. cit., p. 162. 113 System never set rediscount rates on the basis of Treasury needs but instead cooperated by buying Treasury certificates in the market, perhaps to the injury of the commercial 23 paper market. The deficit in the Treasury for the fiscal year ending June 1932 was close to three billion dollars due to public works, postal deficiency, and purchase of capital stock in the Reconstruction Finance Corporation and the Federal Land Banks, and the world wide depression. The Glass-Steagall Act of 1932 aided monetary policy by allowing government bonds to be used as collateral reserve behind the Federal Reserve notes. Administrative policy may be gammaadd up in the following manner. However painful it maybe, government expenditures must be drastically cut when owing to extra-ordinary circumstances, the government finds that within a comparatively short period its resources have been cut in half with little prospect of substantial improvement 24 in the near future. The Treasury also lengthened the- average maturity on debt as the rates fell on the short term paper in 1932 instead of taking advantage of the low rate. The immediately proceeding years, 1929-1933, seem to 23 Ibid., pp. 278-291. 24 This passage was largely dependent on the Annual Report of the Secretary of the Treasury for the Fiscal Year 1931-327” 114 have been an era of drift in policy in both the Reserve System and the Treasury. The deficit finance of the government forced the Federal Reserve to buy government paper in the open market, and the Reserve System, in turn, seemed to ignore the principle of liquidity upon which it 25 was founded. THE LEGISLATIVE PERIOD 1933-1935. i Some Idea of the catastrophe proceeding the inauguration of the Few Deal may be gathered from this statement: On June 30, 1929 the combined loans and Investments of national and state commercial banks amounted to 49 billion dollars. The comparable figure for June 30, 1933 was 30.2 billion dollars. • .these figures are a reflection of the most extreme and prolonged period of bank credit liquidation in the history of the United States. 26 The banks felt another crisis early in 1933. The number of bank failures between January and March 1933 was 389. Not only were these increasing failures due to a lack of unified banking system, but to lack of confidence on the part of the public and the consequent withdrawl of currency as well. Action was delayed until after the Inauguration. 25 Annals, op. cit., p. 102. 26 Lewis Kimmel, The Availability of Bank Credit 1935- 58. (New York: National industrial Conference Board, 19S9')', p. 1. 115 The Emergency Banking Act gave sanction to the President's declaration of a banking holiday in order to straighten out the banks, and put them on a sound basis. Shortly afterward, Congress put through the first banking reform patterned after the Glass-Steagall Act, but much wider in its reform, the Banking Act of 1953. This provided that government bonds were to be used as collateral for Federal Reserve notes as in the former act, but in addition the Federal Reserve Banks were authorized to purchase 3 billion dollars directly from the Treasury. Direct loans of Federal Reserve Banks were extended, as under the Act of 1932, with proper security. Commercial and investmentbanking were separated. Legislative control over interest was enacted so that either the interest rates were fixed at 1 per cent above the Federal Reserve rate, or the states were allowed to control. In the cases where there was no controlling state law, the maximum was fixed at eight 7 percent or 1 per cent above the Reserve rate. Speculative loans were limited; however, this regulation had questionable effectiveness. One of the most fundamental changes in the act was the limitation of the interest periods on savings accounts. It also changed the time of maturity on loans made from the Federal Reserve Banks to member banks on collateral from 15 days to 90 days. 1 1 6 The principle of insurance was applied to all deposits, and it was in 1934 that the Federal Deposit Insurance Corporation was formed, and made a part of the Federal Reserve Act, However, its activities were independent of the Federal Reserve Board, Statutory blessing was given to a practice begun in 1922 when centralized control of open market operations were written into the law. Thus, some sweeping changes came into being under great pressure from economic conditions. As time passed more reformatory measures were enacted; it is little wonder, with the great changes taking place, that policy at the executive level seemed somewhat nebulous. The foregoing measures were adopted to provide means of exchange and to liberalize credit in order to stimulate economic activity. The use of government bonds as security for currency increased the government's ability to create more currency and consequently to supply more money in order to bring the Interest rates down, as traditional interest theory indicated. Certain selective controls of the credit system were added to give greater control and more direction to capital flow, thereby preventing excuses that might arise. Banking reform was- needed undoubtedly: It is asserted that as long as banks do not accept their proper responsibilities, government has no 117 alternative and must attempt to supply the void in existing credit facilities. 27 Thus began a march of federal credit agencies to supply financing throughout the thirties aimed at helping small business. A study has revealed that the small and very small cone ernes together accounted for over 80 per cent of 28 all credit refusals or restrictions. Direct loans by the Reconstruction Finance Corpora tion and the Federal Reserve amounted to about 1,5 per cent of all loans to business in the five year period; liberalization of credit in the last half of 1938 increased the amount outstanding. By amendment to the 1 aw in 1934 the maturity on loans made by the Federal Reserve Bank was extended to five years. Apparently the standards of these government agencies were as rigid or perhaps more so than the commercial banks. In October of 1938 the rates charged on advances to commercial and industrial borrowers ranged from 3.5 per cent to 6 per cent, A survey was made of business concerns regarding their 27 Ibid., p. 47. 28 Ibid., p. 66. Very small concerns classified as $50,000 capitalization; small concerns capitalized at $500,000. Such types and refusals were found mostly in metal, machines, gla ss, lumber, and miscellaneous manufacturing. The survey covered 1,755 industrial units of which approximately 170 had credit difficulties. Probably most of their needs were met soon after the survey. 118 opinions as to the necessity of government lending agencies. More than 1,000 replied; of these, slightly more than 2.5 per cent felt that government agencies were necessary* Those concerns that had difficulty borrowing were in the majority in favoring government agencies. Many complains were listed by all concerns regarding banking facilities, but high interest was only point out of fourteen made against the government agencies; one of these complains was the undistributed profits tax which led to increased demand for term loans after 1936, for this tax worked particular hardship against the smalland new firms. Thes© suggestions led in 1938 to revised tests for banks on the pant of bank examiners which allowed term loans to be classified as liquid rather than slow. The reporting firms in the survey made several sug gestions for changes, such as an extension of one-year term loans; the setting up of regional credit pools by banks for the purpose of intermediate and long term loans to industry; and the forming of an industrial finance corporation which would be allowed to buy stock in industry; and lastly, the insurance of loans. This last item seemed unnecessary as the Federal Deposit Insurance Corporation had been set up under the Banking Act of 1933. There is a very definite and close relationship existing between banking developments and federal fiscal 1 1 9 policy. In fact, the easy money policy of the Federal Government had an adverse affect on bank earnings; these in turn affected both the ability of the banks to allocate substantial amounts to reserves and surplus, and the 29 attitude of the bankers in regard to risk taking* Commer&ial loans did not begin to show an upward trend until 1935* Government bond holdings of banks increased greatly in 1934* Low rates prevailed on the money markets because of Treasury borrowing and the fact that it was the considered policy to maintain low rates in order to aid recovery. Long term rates in government bonds were higher, but considerably lower at 30 that than those of private bonds* 29 This and the preceding paragraphs are dependent on the work of L. Kimmel, cited in the preceeding footnote* 30 L. Kuvin, Priva te Debt and Long Term Investment (New York: N.I.C.B.," 1936), pp* 49-5(3". Rates varied on the average over a period of years from 6.25 per cent on urban mortgages to 4.65 per cent for mining. The highest seems to be the stickiest. A considerable portion of the private debt had no market for rediscount, that on urban and farm mort gages amounting 55 per cent of total private debt had no capital market, p. 15* Further comments along this line by the author are of interest for he comes to certain conclus ions. MIn an economy In which investment of capital is f uided by profit opportunity as judged by borrowers and enders the rate of interest on long term debt is an index of the state of business. Gomparison of the rates of one economic division with those In others and of changes in rates paid by the same division with those in others and of changes in rates paid by the same division at different periods of time convey quantitative information concerning the relative position of their divisions in the economy as a whole. Comparison of rates on accumulated debt are contrast ed with rates of interest, serve a distinct purpose. Rates of interest on accumulated debt reflect the economic status of enterprise in its entirety, whereas rates on new obligations are indications primarily of current market conditions.” p. 48 1 2 0 Actual us© had. shown that short-term debts by continued renewals frequently serve the same purpose as the long-term kind. Such renewals may be employed to finance capital investment or to release funds for that purpose, which would otherwise be used for working capital. Short-rate vs, Long-rate, The very mention of the relation in practice of the short-term debt to the long indicates the thinking of the times, and a digression here would be worth while, A controversy was waging among the theorists, and it called forth this comment from Keynes: Before a very abnormal situation has been allowed to develop, however, much milder methods including control of the short-term rate of interest, may sometimes be 31 sufficient whilst they are seldom or never negligible, Riefler’s conclusions are similar, for he said: The close similarity of money-rate movements in the several important markets short-term open market, short term customer market, and long term open market, when these movements are compared in terms of relative changes furnishes striking evidence of the existence of a national unified money market which expands throughout to changes in demand and supply of funds, 32 This does not mean there was entire unanimity of opinion, for another economist wrote, signifying at least in part his not 31 J.M, Keynes, ”Mr, Keynes Control Scheme, a Reply to Professor Edward A, Simmons*1, American Economic Review, 23:675, December, 1933, 32 W.W, Riefler, Money Rates and Money Markets in the United States, (New York: Harper and Bros,, 1930), p, 1 S'• " " " 1 2 1 complete disapproval when he said: Up. Keynes and Mr. Riefler both speak of the long term rate as reflecting the short-term rate. The suggestion is that the long-term rate is determined by the short-term. Probably a different analysis will better explain the behavior of the long and short term rates, namely, that each rate is determined by its own set of factors some of which, however, may be.common to both. 33 Such controversy could not hide the new insight into interest rates that economists had received. This brought to the foreground the wider implications involved in the volume of indebtedness as a casual and unstabilizing factor, and brought into sharp relief the role of the short-term rate of interest as a force in the movement of commodities and prices. The meeting of short term obligations by entrepreneurs forces commodities into the market, and brings prices down. Nevertheless, long-term debt obligations charges must be met. These had been determined in currency of less value and at maturity have increased in value. Long debt maturity acts as an obstacle to adjustment that is less dramatic, but more pervasive and persistent than short-term securities. "The crisis may be more largely due to short term debt and depression to long-term and related obstacles 34 to readjustment. 33 Edw. C. Simmons, "Mr. Keynes Control Scheme,*1 American Economic Review, 23:272, June, 1933. 34 G.P. Watkins, "Economics of Saving," American Economic Review, 23:77,footnote 16, March, 1933. 1 2 2 However, the idea of the influence of the short-term rate was gaining support among the economists, for still another wrote: "It would seem equally reasonable, however, to assert that every commercial bank credit deflation must result in an investment credit deflation and this causes indirectly all the evils of the latter in addition to its 35 own.” Policy* Early in 1933 after the banking crisis and before the bank holiday, a Utah financier named Marriner S. Eccles advocated deliberate unbalancing of the budget by a vigorous public works program, accompanied by other thorough going economic measures. Many other proposals were bruited about, such as devaluation, expansion of credit, and silver purchase. The Committee for the National composed of business executives came out for inflation, and suspension of gold payments. The Gold Revaluation Act was one of many direct attempts of the Administration during the next few years to increase economic activity by raising prices. The administration increased the price of gold in terms of dollars; this action was influenced by the theories of Warren and Pearson that if the value of gold were varied in 35 B.P. Beckworth, "Social Aspects of Commercial Banking Theory," American Economic Review, 23:675-6, December 1933. 123 terms of dollars, the price level would vary in the same direction. Warren and Pearson argued that if the number of dollars were increased and the gold content reduced, prices would rise automatically. They acted on the Fisherine formula of the quantity of money, MV=*PT. However, this formula was not the theory itself, but merely a graphic representation of it. This theory of Warren and Pearson which the adminis tration adopted failed, for this relationship of prices to the amount of gold in the dollar would only take place in the long run, as Gassel had argued. Warren and Pearson had presumed an immediate relationship between a rise in prices and increased number of dollars for a given amount of gold. The revaluation influenced imports as well because the purchasing power of the dollar in foreign markets was reduced. This reduction of the purchasing power of the dollar did not aid world recovery. The Warren-Pearson theory was based on the increase of money, but it forgot that the velocity of the money market must also be increased to bring about the desired result which could occur only in the long run. Jesse Jones, Head of the Reconstruction Finalce Corporation, in August of 1933 announced a plan for investment of 1 billion dollars of Reconstruction Finance Corporation funds in preferred stocks of banks in order to 124 reinforce their capital sufficiently to warrant increased credit extension to their customers. Later he spoke before the American Bankers Association convention in September and bluntly condemned "hoarders of available credit." He presented a three fold program: short-term loans to banks at 3 per cent, a reduction in the rate of interest on long term Reconstruction Finance Corporation loans to 4 per cent, and loans to projected community-mortgage companies to be secured by assets sLower than banks were willing to accept, 36 Liberalize credit was his theme. He urged continually, in numerous letters and speeches, to make all possible loans and to solicit Reconstruction Finance Corporation participa- 37 tion or loans when necessary. Two other aspects of credit policy deserve some mention. One of these, the Thomas Amendment to the Banking Act of 1933, provided for the purchase of bonds by the Federal Reserve Banks. "It was further provided that operations under this section should not require any automatic increase in the rates of interest and discount 36 J.E. Reeve, Monetary Reform Movements,(Washington, B.C.: American Council on Fubli'c Alffair's, 1943) pp. 37-86. These events are related in this book. C.O. Hardy and J. Viner are represented as having proposed some liberaliza tion of the direct lending policies of the Federal Government through the RFC or a new intermediate credit system. Similar to the view of T.N. Beckman of Ohio State University. 37 Ibid., p. 117. 38 charged by the Federal Reserve Banks.” 125 The restriction on speculative credit had been included in the Banking Act of 1933, and had precipitated quite some discussion. Carl Snyder was moved to state: . . .the true key to business and economic stability is clearly the limitation of credit expansion to the rate of increase of industry and trade--the physical increase. When that is achieved any outburst of speculation promptly defeats itself by forcing high interest rates. And speculation is acutely sensitive to these high rates of interest (having never survived the equivalent of a 6 per cent discount rate) while the effect on business is Slow and lagging and very easily and quickly repaired. 39 Yet sometime before he had written this, another economist had commented that: The obstacle to speculation would presumably show itself in the form of higher interest rates. The assumption underlying this reasoning that speculators are more sensitive to interest rate changes than are any other class in the economy. No assumption could be further from the facts. If our experience in 1928-29 proves anything* 40 This difference of opinion reveals that the economists were unsure of the exact role of interest rates in the economy, though it appears as a control device of some validity. 38 A. W. Crawford, Monetary Managernent under the New Deal (Wash. D.C.: American Cbuncil on Public Affairs, 1940) , p. 43 39 Carl >%yder, ’ ’Monetary and Economic Stability” Quarterly Journal of Economics, 200:220, February, 1935. 40 L.B. Currie, "Member Bank Reserves and Bank Debits," Quarterly Journal of Economics, 47:354, February, 1933. 126 Rates of interest. Attention may now be turned to the development of interest rates in the market over this period of two years. Early in 1933 the Federal Reserve noted a reduction in rates and volume of loans by the banks, this • . .represents a decrease in the demand for funds because of the low level of business activity rather than a shortage in the supply. That open market funds are available in large volume is indicated by the fact that the rates charged for them are the lowest on record. 41 Soon thereafter, discount rates rose, and the demand for currency increased, so it was reported, because of the 42 uncertain condition of business. Rates were increased again in April, but not to their former level, and gold ejp ort control was imposed. This maneuver showed a change in policy, but such changes did not contribute to stability in the market. By June the rates were back to their former low level. Further easing of credit was developed by the purchase of bonds in the open market by the Federal Reserve during the first half of the year. Purchases totaled a billion dollars, "a sum then sufficient not only to counterbalance withdrawls and hoarding but also to provide member banks with substantial excess 41 Federal Reserve Bulletin, 19:356, January, 1933. 42 Ibid., 19:134, March 1933, Discount rates rose from 2*5 to 3.5, and bankers acceptances rose to 5/8 per cent from 3/8. 127 43 reserves," A decline in deposits occurred after the middle of June following the prohibition laid down by the Banking Act of 1933; this became effective June 16, on the paynent of interest by member banks on deposits which were payable on demand, but which probably shifted to time deposits in part, hpon which interest is also paid# Money rates remained at their low levels during the summer months, which were the lowest in recent years, but the velocity of demand deposits turned over more rapidly because of the anticipated increase in prices under the codes of the National Recovery Administration. September 44 rates declined to the lowest on record to date# One writer was disposed to says "♦ • .but the main emphasis for recovery in 1933 was on monetary policy especially on raising the price of gold, with the repeatedly announced goal of raising prices to the 1926 45 level." Another comment along the same line is even more 43 Ibid., 19;356, June 1933. Federal Reserve Bulletin for July revealed excess reserves at § billion, an increase " of 150 million in a month, reflecting in part the increase in reserve balances held and in part a reduction in required reserves resulting from a decline in net demand deposits# 44 Federal Reserve Bulldin, 19s594, October 1933. The prevailihg i*At"4's "5TT"caTl’ ToaHs continued at 3/4 per cent, the rate of 90 day bankers acceptances of i per cent and the yield on short term obligations of the U. s. Government at a nominal figure of 1/10 per cent. 45 J.H. Williams "Deficit Spending," Readings in Business Cycle Theory, (Philas Blakiston Co., 1940), p# 271# 128 pointed: economists felt that monetary policy during the first year of the Roosevelt administration has deliverstely aimed at redistribution of the national income by means of reflation, that is, by such an expansion of the supply of circulating media, relative to demand as would be required 46 to restore the price level of the predepression period* The rates on government bonds for medium term increased, but the short dated securities declined slightly, #iile the long-term was unchanged at the end of the fiscal year of 1933. Bond rate stood at 3*3 per cent and the Treasury lengthened maturity on the outstanding debt at the same time offering a little more variety of issues to meet the needs of investors* The first quarter of 1934 showed a continued decline in rates at the Federal Reserve Banks. However, reserve balances of the meaber banks increased moderately because of a return flow of gold from abroad, a reduction in United States Government deposits with Reserve banks, and a return from circulation of currency. Excess reserves rose to 900 47 million dollars* A summarization of excess reserve balances since 1932 revealed that they have been in 46 F* Mills,"Economic Recovery,* * American Journal of Sociology, 39:378-380, May, 1934* 47 Federal Reserve Bulletin, 20:146, March, 1934* 129 considerable and growing volume chiefly in United States Government securities by the Federal Reserve Banks in pursuance of an open market policy adopted for the purpose of promoting easy conditions in the money market. Further comment is enlightening. It was felt that: East in the money market has reached a point where even the low published quotations no longer reflect the true rate at which loans are being placed. Actual rates are now so close to zero that many individuals with ample collateral are borrowing without definite use for the money--merely in the hope that they may find a chance to employ it at a profit above the small interest asked. The conditions that are creating this ease in the commercial departnents are also affecting savings banks. Chicago banks joining the lists of those reducing rates of payment to savings depositors will cut from 2.5 to 2 per cent effective July 1st. The rate was cut from 3 per cent about a year ago. 48 Reading between the lines, it would seem that such low rates would lead to excesses. It was evidence that such an interpretation was not far fetched for the Federal Reserve Board when it felt it was necessary to mention a proposal made in 1931. Conditions, it was stated, may develop when in order to prevent a recurrence of speculative excesses, it becomes important for the system to be a position to absorb rapidly the excess reverses. At such a time, it would be desirable to have reserve requirements, and to make these requirements depend not only upon the volume of a member bank’s deposits, but also upon the turn over rate of these 48 Business Week, p. 32, April 28, 1934 150 49 deposits. Reserves continued to increase, gold poured in, and bond prices (governments) rose with yields declining from 50 their already record low level. In may the excess reserves reached 1.7 billion dollars and yields on bonds were the lowest since the World War. Congress passed an act authorizing the.Federal Reserve Banks to lend directly to industry and commerce for working capital on the basis of five year maturity. Initial appropriation was 280 million which was to be increased as 51 the loans were retired. The Securities Exchange Act was passed about this time, to prevent too much inadequate reporting of prospective issues. The Silver Purchase Act was also infUa tionary as was the authorization of direct 49 Reserve Bulletin, 20:252, April, 1934. The above proposal, said Governor Black, • .would result in an automatic increase of reserve requirements when boom conditions arise and an automatic decrease of reserve requirements in times of depression#, , p. 206. 50 Ibid., p. 252. Short term rates at ^ per cent and 1 per cent; 90 day bills at .08 per cent and 182 day Treasury bills at .19 per cent. 51.Federal Reserve Bulletin, 20:631, October, 1934. Regarding margin requirements In the act: ”The general principle laid down in this connection In the law is that the board Federal Reserve Board shall prescribe rules and regulations with respect to margin requirements for the purpose of preventing the excessive use of credit for the purchase or carrying of securities.” Limits the extent of pyramiding speculative profits on securities for further speculation* 1 2 1 loans; it was intended to maintain silver at one quarter of the monetary stock of the country* In November a reduction of rates from 3 per cent to 2*5 per cent on time and savings deposits was ordered. Market rates remained relatively stable. At the end of the year, government banking activities were continuing to increase, while the excess reserves had risen to over 2 billion. Rates were stable except for seasonal volatility. Early in 1935 the President extended for two years the authorization of government bonds as collaterial security for Federal Reserve notes granted under the Glass-Steagall Act. Gold continued to flow in from Europe and was taking on the aspects of a f , flight of capital.” Banking Act of 1955. Congress was again contemplat ing action on banking reform in the early part of the year. One of the business periodicals was moved to report that Eccles, who had become chairman of the Federal Reserve Board, would exercise these controls under the pending bank bill by stressing regulation of credit, but only as one of three elements necessary to stabilize economic conditions along with price regulation through monetary policy. It was further stated that he felt that it would be necessary to govern the distribution of income not only through taxation but to provide emergency income through public 132 52 works* Eccles position had not changed much, but he did inject taxation as a supplemental control to monetary policy. Another bill which had been suggested to Congress, known as the Fletcher-Steagall Bill, had provided for the 1 1 * * .power to fix rates of discount and interest charged by 53 the Reserve Banks,” to be given to the Federal Reserve Board. This bill was incorporated in the Banking Bill under discussion* Meanwhile reserves had risen to 4.8 billion and excess reserve to 2.3 billion dollars by June 1935. These were the highest in the history of the system, gold inflow was an important factor. Rates for the stock exchange in Mew York were at *25 per cent and for bankers acceptances and Treasury bills at .125 per cent. Customer rates at banks had been reduced further and lower than at any time in the post-war era. There appeared to be a greater variation in rates than usual, a number of loans being made at rates between 5 and 6 per cent with a few large loans being made 54 at between 1 and 2 per cent. The volume of securities offered was the largest since 1931 for the 4 month period through March, over a 02 Business Week, p. 37, March 16, 1935* 53 Crawford, op. oit., p. 129. 54 Federal Reserve Bulletin, 21:334, June, 1935* 133 billion dollars worth being sold although nearly 70 per cent was for refunding purposes; this exceeded even 1928 and 1929. Domestic corporations, farm loan and other federal agencies and state and local governments all participated in the process. The private corporations did more than at any time since 1931. The decline in rates on time deposits should have a tendency to bring about a decline in the cost to borrowers and to encourage depositors to seek investment for their idle funds. A more favorable capital market may be expected to create a more favorable mortgage market as well as to encourage refunding operations and the undertaking of new capital projects generally, a development 55 essential to recovery. The treasury also participated in refunding operations, since that is its usual procedure to take advantage of market conditions. As a consequence the first six months of 1935 revealed the greatest refunding in the history of the 56 Treasury took place. As may be noted, interest rates have been assumed set by the supply and demand for capital by the authorities. However, the effects on money markets have been in the 55 Ibid., p, 369. It was also claimed that no other country had given the central bank such wide powers over time and savings deposits rates. 56 Federal Reserve Bulletin, 21:416, July, 1935, 134 background as well as the effects on money supply* Nevertheless, the traditional view of interest rates as a control factor of investment, savings and consumption begun 57 with Malthus and dominant since then has received rude shocks by modern developments. These developments have called forth reappraisal of the theory at this stage, and led to some pertinent remarks by one outstanding economist: 1 1 As a cost factor, the interest rate has real significance only as it applies to 58 new investment in fixed equipment." It applies through the capitalization of production, price and income expecta tion, and affects especially the longer-lived capital goods. However, The capitalization of non-existing profit-prospects does not result in higher values of capital equipment however, the interest rate may be reduced. Hence, no interest policy can succeed In stimulating while the maladjustment in cost-price relationships persists; in other words, if the costs of labor and mat erial fail to readjust themseles, low interest rates cannot do anything for creating investment* 59 57 See Chapter I supra* 58 Fritz Machlup, "Rate of Interest as a Cost Factor and as a capitalization Factor," American Economic Review, 25:462, September, 1935. 59 Ibid*, p* 465* This viewpoint was later sustained by Earl Rolph in an article published In the Journal of Political Economy, August 1939: "Discounted Margins 1 Uoctrine although the latter felt that as a method of appraising marginal productivity theory it was useless, interest rate could still be a capitalization factor. Hawtrey’s views explaining the "credit deadlock" are similar. See Chapter II. 135 The Banking Act of 1935 became law on Alagust 23,1935. It changed the title of the Federal Reserve Board to the Board of Governors of the Federal Reserve, signifying more central control. The main provision under the law was that the Federal Reserve Banks must submit to the Board of Governors for its approval every fourteen days, as or, if deemed necessary by the Board, more frequently the rates of discount which they wish to establish in their districts. These rates which are rediscount rates to the public cannot become effective without the approval of the Board of Governors. This makes it incumbent upon the Board and the \ Banks that the rates be revised every two weeks, and thus bring them under the control of tlae Board more effectively. Another provision was for the liberalization of real estate credit standards to enable member banks to participate in the financing of building activity, the 60 resumption of which was an essential factor in recovery* Eccles defense of the Act was called forth by some criticism, and he is quoted to the effect that: The need for public control of the function of supplying the medium of exchange for the people of the United States, both by issuing currency and by regulating the volume of bank deposits seems to be almost a non-controversial matter. 61 60 Federal Reserve Bulletin, 21:560, September,1935. 61 E.V. Bell, "Who Should Rule the Money Market”, Current History, 42:354, July 1935. 136 Tliis occurred during a heated, debate on the Bill in Congress, There was disagreement, on the other hand, from outstanding economists, one of whom said: We cannot accept the proposed Eccles Bill because it reserves every known principle of sound and safe banking and because it threatens a political domination of our bank resources which has already made large headway and resulted in dangerous innovations that must not be allowed to continue and grow more pronounced*62 A third provision of the Act allowed member banks to borrow on their own notes secured to the satisfaction of their Federal Reserve Banks for periods not exceeding 4 months at a rate .5 per cent above the highest prevailing discount rate. It removed the requirement that the borrowing must be for emergency purposes. It should be noted that only paper of the usual commercial loan type could serve as note 63 collateral. The Federal Open Market Committee was reorganized, its membership now consisting of the seven members of the Board of Governors and five representatives elected from the Federal Reserve Banks. It was given complete control over 62 H.P. Willis, “Eccles Bill and After," Vital Speeches, 1:633, July 1, 1935. This opinion was concurred • by W* Kemmerer and Spahr. 63 Edw. C. Simmons, "Elasticity of the Federal. Reserve Note," American Economic Review, 26:683:690, December, 1936* This provision had' been' added In the Glass-Steagall Act to the Federal Reserve Act, was changed by the Emergency Banking Act, and now changed again. 64 open market operations; prior to 1932 open market purchasing by the Federal Reserve Banks had been employed to accomplish some one of these purposes: The object had been either to increase the earning assets of the Federal Reserve System, or to ease the money market and loosen short-term credit, or to offset substantial movements of funds out of the money 65 market. Operations in the money market had developed into a major weapon of credit control and its execution was made more effective by the legisla tion. One of the advisors on the staff of the Board of Governors had written previously: A close relationship has developed in this country between the stock market and the money market because of (1) the widespread practice of margin trading in securities and (2) the need especially under a system of small unit banks foruaqliquid money market where banks may employ reserves and temporary surplus funds, 66 However, he was led to revise this somewhat, when he contin ued: The recent developments of a large market for short term treasury bills, which now total nearly 2 billion supplementing the supply of bankers bills, might also be an influence in detracting from the impotance of strict loans in the employment of liquid funds of 64 W. Wyatt, ’ ’Federal Banking Legislation,” Banking Studies, Bd, of Governors, Fed, Res, System, (Baltimore: Waverly Press, 1941), pp, 59-60, 65 J.D, Dolley, ’ ’Open Market Buying and the Bond Market,” Journal of Political Economy, 41:514, August, 1933, 66 W, Thomas, "Use of Credit Security Speculation," Amarioan Economic Review, 25:21, March 1935, 158 banks, 67 Later developments that year showed little change; excess reserves continued to break records, but long-term rates began to rise revealing that the revivial of the capital market begun in the early months of the year was continuing unabated. Treasury status at the end of the fiscal year 1934- 1935 might be noted. Receipts for the year total 3.8 billion dollars with a slight increase from income taxes. Expenditures were 7.37 billion dollars due to increased recovery and relief measures as the major item. Bonds and notes were retired and refunded at lower cost; short-term Treasury paper remained about the same. The average rate on the public debt was reduced from 3.1 to 2.71 per cent. An increase in the capital structure of certain corporate 68 agencies of the government was authorised. Total debt in 1935 reached 28.7 billion dollars, an increase of almost 2 billion dollars over 1934 and almost 3 billion dollars 67 Ibid., p. 2. He explained; "Because of certain established customs in handling commercial credits, a large bill market did not develop in this country, and the New York call money market has not effectively supplied the needed medium for the employment of liquid funds." p. 24. 68 Annual Report of the Secretary of the Treasury, for the Fiscal Year 1934-35, p. 26. Other figures revealed an unexpected increase in revenue of over a billion. Tk© increase was due to social security taxes, process taxes, special carrier and coal taxes and increase in estate(death) taxes and gift taxes. See adjoining table for outstanding debt in June 19 34. 139 TABLE I PUBLIC DEBT OUTSTANDING JUNE 30, 1934* Debt Millions Interest bearing debt— Open market issues Pre-war bonds # 753,320,130 Liberty bonds 6,345,774,250 Treasury bonds 9,332,732,350 Treasury notes 6,653,111,900 Certificates of indebtedness 1,517,245,000 Treasury bills 1,404,035,000 Special issues for trust funds and postal savings Postal saving bonds 78,030,240 Treasury notes 278,439,000 Certificates of indebtedness 117,800,000 Mat’d debt, interest has ceased 54,266,830 Debt bearing no Interest 518,386,714 Total gross debt #27,053,141,414 -^•Annual Report of the Secretary of the Treasury for the fiscal year, 1933-34, p* 7, i m over 1933. "There was no indication, however, then or for several years la ter that the government was deliberately 69 pursuing a deficit policy as a major means to recovery**' Ho discussion, of the period could be complete without mention of the Gold Reserve Act of 1934, which raised the mint price of gold from $20.67 to $35.00. This act was based on the theory of Warren and Pearson that there is a close and direct relationship between commodity price levels and the price of gold in dollars over both the short and long run; this disagreed with Cassel's theory, as has 70 already been mentioned* The profit on revaluation was used both as a stabilization fund and to help finance initial Federal Deposit Insurance Corporation needs. Gold Reserve Act was an added measure for recovery. An appraisal of the period under review would serve to summarize findings. The era may be characterized as an era of cheap money. Such measures as dollar develuation, 69 Williams, op* cit*, p* 270. He continued; some date the beginning of conscious policy from Keynes' visit to this country in 1934 whom Williams related, had said that a net monthly deficit of four hundred million would bring full recovery. 70 See part on Cassel, Chapter II supra. "Commodity prices will lag somewhat behind the price of gold, but unless sufficient offsetting factors develop, they will catch up eventually." Quoted from J.D* Paris, Monetary Policy of United States 1932-1958, (Mew York; Columbia Univ. Press, 1938), p . ' " viii. This authority took the long run view of Cassel* 14 1 large open market operations, government spending, silver purchase, direct loans to business, reduced interest rates were all typical of the period. The first step in the attack on depression was in the substitution of federal obligations for gold in partial backing for Federal Reserve notes. Government bonds increased as the deficit began to grow, even to overloading banks as some critics thought. In one way or another, the progress of inflation in banking is thus witnessed through the enlargement of the investment side of the portfolio, and the relative, sometimes absolute decline of the paper on the current loan side of the portfolio* • *thus a change in the form of the portfolio is a usual accompaniment of so- called Inflation in banking, and quite normally characterizes the movement of bank portfolios antecedent to panics and crisis* 71 Nevertheless probably a new element has been added to the picture for the type of paper in the portfolio was now government bonds lending stability to the banks’ position, even though it might make them more vulnerable to interest 72 rate changes* However, as the situation was developing it seemed that interest rate changes were controlled by this very factor. Banking developments since 1933 have been 71 Willis and Chapman, Economics of Inflation (New York: Columbia Univ. Press) 1935, p. 25* 72 J. D* Paris, op. cit., p. 8. See also Kimmel, op* cit* p* 26* Member "bank investments were increased by about 7.8 billion. All but 1 billion of the increase was accounted for by U. S. Government securities. 142 influenced by federal fiscal policies to an unprecedented ext ent • Finally the other government programs, such as the refinancing of mortgages for distressed homeowners (HOLC) and its investment of funds in the securities of private home financing units, the organization of the Federal Home Loan Bank, and the chartering of the Federal Savings and Loan Insurance Corporation to ease the risk of financing; all these programs contributed to an easy money policy, RECOVERY FULLY LAUNCHED? Gold Flow and Excess Reserves, One of the dominant features of the money and Gredit picture in the thirties and especially after 1935 was the inflow of gold. It became a source of constant comment, but it was not without effects on the banking system. The Board of Governors of the Federal Reserve Banks was forced to remark when excess reserves reached over 3 billion dollars: The present volume of member bank reserves which have been greatly increased by imports of gold from aborad, continues to be excessive, far beyond the present or prospective requirements of credit for sound business expansion. • • Excess reserves has had and will continue to have the unremitting study and attention of those charged with the responsibility for credit policy in order that appropriate action may be taken as soon as it appears to be in the public interest, 73 Federal Reserve Bulletin, 22:1, January, 1936. See adjoining chart. CHART I 143; ■» BOND YIELDS, EXCESSIVE RESERVES AND BANK DEPOSITS Monthly Average of Daily Figures Per cent easut»y Bor d Yields £. Feieral Rese L s cto.u_d_t- Ra-tlaS-' 've D, 1936 1940 1928 1932 Billlona of dollars Rxees 3 Rese rves orrov ed Re serve -2 1940 1928 1936 1932 60 50 40 To1al Deposits anc Curr >ney 1928 1932 1 936 1 940 *Annual Report of Board of Governors of the Federal Reserve. 19^0, p."8. 1 Derived from tables from the Federal Reserve Bulletins of the period. 144 Such an easy credit situation bred uneasiness among the authorities, and the spectre of a recurrence of speculative activity was constantly before them. They were anxious to defend the margin authority given to the Board of Governors under the Securities Exchange Act of 1934. Such an instrument exercises a restraint on speculation without limiting or raising the cost of credit to agriculture, trade and industry. During the early months of 1936, excess reserves declined below the 3 billion dollar mark, and may have called forth such concern. However, short term rates in the money market remained stable^ and bond prices and yields were at a new high and low respectively; government bonds were paying a little better than 2,5 per cent. Private banking concerns evidenced some deep interest in the credit conditions which were then prevalent. It was reported at this time that: A controversy rages now between banking giants as to Whether or not excesses of credit supplies should be plowed under like crops. J.P. Morgan and company partners are saying that plentiful and cheap credit is prerequisite to full recovery. Two canyons up from 23 Wall, at the Chase National Bank headquarters, the opposite view is held and expanded. Winthrop W. Aldrich chairman of the Chase Board is irging that the Federal Reserve authorities jump reserve requirements so as to mop up excesses on deposit to the credit of member banks. 74 74 Business Week, p. 38, April 11, 1936. 145 Word was anticipated from the Federal Reserve Board in a short time. Subsequently, excess reserves were increased 50 per cent due to the continued high rate or inflow of gold and an expected increase of excess reserves to 4 billion. Fear of inflation precipitated the action, It was felt that it was far better to stabilize part of these superfluous reserves while they were still unused than to permit a credit struc ture to be erected upon them, and then withdraw the foundations. The Board was quick to announce in August that the raising of reserve requirements ”, , .does not constitute a reversal of the easy money policy which has been pursued by 75 the system since the beginning of the depression. Additionally the board felt that the traditional means of credit control, namely discount policy and particularly through open market operations would continue tobe the method of credit control. It was officially noted that long-term interest rates which have been an important factor in the revival of the capital market have been due principally to the large accumulations of idle funds in the hands of individuals and institutional investors. Conditions indicated that the supply of investment funds was in excess of the demand. 75 Federal Reserve Bulletin, 22:614, August 1936. 146 This statement at least showed that the traditional viewpoint of economics on the determination of long-term interest rates is determined by the supply and demand for 76 capital funds. The government, as it was noted elsewhere, had brought down rates on farm mortgages to 4.5 per cent from 6 per cent by eliminating renewal charges and commissions by allowing longer term mortgages. The federal debt continued to increase and stood at 35.778 billion dollars at the end of the fiscal year 1935- 1936. Refunding had continued, and the last of the liberty bonds were redeemed with new issues; the average rate of interest on debt declined to 2.55 per cent from 2.71 per cent, even so the average maturity on debt lengthened. Federal agencies increased their authorized capital, and relief spending was high. Taxes were increased, especially on income, estate, and gift taxes. The Revenue Act of 1935 was beginning to reap a return on its ’ ’soalh the rich” provisions. Receipts were expected to increase even more in the ensuing year. The Farm Credit Act of 1935 was aimed at reducing rates on mortgages to 3.5 per cent. Direct loans of the Reconstruction Finance Corporation and the Federal Reserve Banks increased, but were an insignificant part of credit facilities, or total credit extended to business and 76 Business Week, pp. 38-39, April 11, 1936. 147 commerce. Money was still easy by the avowed policy of the Federal Government. The remainder of 1936 gave strength to the remark of Secretary Morganthau before a Senate committee when he stated in reply to Senator Vandenberg, ”• . .the revaluation of the dollar contributed to the maintenance of low interest rates 77 so essential to recovery.” Although rates on short-term debt showed a slight flurry in August because of change in reserve requirements, long-term rates on government bonds continued to decline. Excess reserves continued to climb, and were at their highest since the reserve requirements had been changed. The year was thus marked by a continued rise in the stock of gold flowing from abroad and by the continued fall of interest rates* The advent of 1937 saw no radical changes in any situation regarding banking. Certain taxes connected with the illegality of the Agricultural Adjustment Act had disappeared with little effect on the government picture, but the authorities of the Treasury was growing ooncerned about the continued increases of gold going to the Treasury. It planned to accomplish this by the sale of additional public- debt obligations, the proceeds of which would be used for the purchase of gold, and by the purchase or redemption of 77 Crawford, op. cit., p. 331. 148 outstanding obligations in the case of movements in the reverse direction. The effects on the reserves of additions to the gold supply, either from imports or from new production, irouB be offset by the sale to the public of an equivalent amount of United States Government obligations, and by setting aside in an inactive account in the Treasury the proceeds of such sales. This proposed action was in no way to affect the large volume of excess reserves already 78 present in the system. Naturally such action would have had to take place with the full cooperation of the Federal Reserve System. Action on the excess reserves was forthcoming from another area in 1937. An order was released on January 31=Bt which said in part: "The Board of Governors of the Federal Reserve System today increased reserve requirements for 79 member banks by 33.33 per cent., , This in effect raised o reserve requirements to the legal limit all along the line, half the increase effective on March 1st and the other half on May 1st. The Board also let it be known that this was not the limit of its power, for such other reserve action as might need be taken in the public interest could be effected 78 Federal Reserve Bulletin, 23:1 , January, 1937. 79 Federal Reserve Bulletin, 23:95, February, 1937. 149 through th© open market operations, a more flexible instru ment for keeping the reserve position of member banks currently in close adjustment to credit needs. However, the Board allayed any doubts of further action on its part with respect to reserve requirements by stating that it had no intention of going to Congress to solicit additional authority to absorb excess reserves by this means. ”4t the same time the Reserve System will be in a position to take promptly such action as may be desirable to ease or tighten credit conditions through open market 80 and rate policy.*1 Low Interest Rates. A considered estimate of the situation by the Federal Reserve explained current conditions that had varied little from preceding years. Low money rates prevailing in recent years had been the result of the large supply of funds seeking profitable use and the small demand from acceptable borrowers. Excess reserves of banks had been the principal factor of supply in the short-term market, and had also been an important influence in the 81 decline in long-term rates. This indicated that risk taking on the partof bankers had been and still was less than could be hoped in the movement toward recovery. It recognized th© 80 Ibid., p. 95. 8-^ Federal Reserve Bulletin, 23:179, March, 1937. 150 relationship of the short-term markets with the long and necessarily the effect of movements of rates of one upon the other as had been brought out in this portion of the study, and in previous parts. The report continued that the abundant supply of available funds, together with the small demand far loans, had encouraged banks to buy large amounts of securities, particularly Government obligations. The abundant supply of investment funds held by others than banks had also been a factor on the low yields on long-term obligations. Insurance Companies, other institutional investors, corporations, and individuals had in recent years held a large volume of idle deposits awaiting investment. However, restoration of confidence and improved corporate earnings resulting from continued'obusiness recovery encouraged to some extent the active investment of these funds. Many investors holding idle funds awaiting the return of what they might consider as normal interest rates had gradually decided to put funds to use at prevailing rates. Analysts of the American economy had certainly recognized hoarding before Keynes. This idea could not very well be attributed to him, but it is certain that the idea 82 of normality was his rediscovery, if Thornton is recalled. 82 See Chapter III supra. 151 If the public begins to feel that rates will not change, this will tend to increase investment; however, in some areas such as banks, a low rate may also increase the need for liquidity, expressed either in the form of holdings of short-term Treasury paper which Is equivalent to money except for slight interest return or in the form of cash itself. During February and March the rates in the market showed advances because of the adjustment to reserve requirements. Rates all through the market were effected, giving further evidence of the close tie existing between all markets. Although there Is a disparity in rates for areas, types of loans and banks, this difference reveals a struc ture of interest rates on the whole significantly lower than before the depression, varying from 2 to 5 per cent. These figures were derived from a survey made for the Board of Governors, Debt policy. Another noteworthy occurrence took place which indicated a broader policy on the part of the authorities. It was one of the first statements regarding a policy that was to become a dominant one in the years to follows With a view (l) to exerting its influence toward orderly conditions in the money market and (2) facilitating the orderly adjustment of member banks to the increased reserve requirements effective May 1, 152 1937, the Open Market Commiteeeof the Federal Reserve System is prepared to make open market purchases of United States Government securities for the account of the Federal Reserve Banks in such amounts and at such times as may be desirable* 83 The principle enunciated of ’ ’exerting its influence toward orderly conditions in the money market” was much later to assume greater significance and has been oft repeated since its initial statement in 1937, Excess reserves were still a problem and could easily disrupt the whole fabric of credit control. So long as member banks had a volume of reserves far in excess of legal requirements the customary instruments of credit policy, open market operations and discount rates, were wholly ineffective. The elimination of considerable of these excess reserves brought the Federal Reserve System into closer and closer contact with the market, and was newly placed in a position where sales or purchasing in the open market could tighten or ease credit conditions in accordance with the public interest. The policy was reiterated that the system proposed to continue to work toward the maintenance of easy money conditions for the encouragement of full economic recovery* The Treasury reported increased returns that met Federal Reserve Bulletin, 23:377, May, 1937* This and tiie following passages are largely dependent on this publication* 155 expectations, and were the highest returns since the 1932-33 fiscal year. The income tax both corporate and individual accounted for 41 per cent of federal income, some of which was due to the surtaxes on undistributed profits and the subjection of dividends to the normal tax. Excise taxes accounted for 41 per cent of the total revenue. Expenditures dropped but debt increased to almost 36 billion dollars, a net increase of 2.7 billion dollars. Treasury estimates of receipts and expenditures for the fiscal year had been accurate, but the task was nonethe less formidable when it is considered that any accuracy is established at all. There is a necessary and inevitable uncertainty in connection with such forecasts. It is based on current legislation and estimates of profits of all businesses and the aggregate income of all individuals and its distribution among the various net income classes as well as the consumption and importation of commodities upon which taxes are levied. Yet such estimates could be very important for the timing of fiscal action on whatever policy it ma y be based. As an important element in revenues the income of the population is difficult to estimate for any future period that might be useful. It is also important for tax purposes and appropriations of Congress. Incomes do not vary in direct proportion to either changes in the volume of business 154 activity or to the general price level. In a decline of activity profits and income drop more than proportionally to the decrease due to the inflexibility of certain costs. This fluctuation is transferred to fluctuations in government 84 revenue, and is accentuated by progressive tax system* This progressive rate then acts as an acceleration in a decline, and promotes difficulty in working out the policies for recovery. Thus, recognition is beginning to be paid to other elements in overall policy that need coordination in order to be more fully effective in gaining fiscal and policy objectives. The debt cost rose slightly in the fiscal year to an average rate on the debt of 2.58 per cent. The average maturity of the debt was lengthened considerably. This type of fiscal maneuver was.to be worked with telling effects later. Bonds used as collateral security for Federal Reserve notes was extended another two years and was a periodic occurrence. Full Employment and Recovery. Although short-term rates had risen in the spring of the year by September the Board of Governors found it necessary to reduce discount rates at several Federal Reserve banks to continue the 84 Annual Report of the Secretary of the Treasury* 1956-57, p. 29. 155 condition of monetary ease, thereby making the system's credit readily available to member banks for the accommoda tion of commerce, business and agriculture. It was done, so it was said, to bring rates into closer relation with the interest rate structure generally prevailing at the time, and 85 to promote the continuance of recovery* I k new note was injected into policy statements of the Board of Governors in the latter part of 1937. Drawing on lessons of the past, particularly of the twenties with price stability and unemployment, it was moved to say: The Board is concerned, however, that the broader objective of maximum sustainable utilization of the nations resources cannot be achieved by attempting to maintain a fixed level of prices and that, therefore, price stability should not be the sole or principle objective of monetary policy. • .correspondence between price stability is not sufficiently close, therefore, to make it desirable to restrict the objective of monetary policy to price stability.86 No doubt monetary measures have their contribution to make to stability by maintaining a flow of funds conducive to as full use of resources as can be sustained and still keep banking monetary machinery in a sound condition. But it certainly is not the job of monetary authorities and could not be to maintain that condition single handedlyj it would also have been impractical. However, the influence of the Reserve Bulletin, 23:819, September, 1937. 86 Ibid., p. 827. See adjoining chart for pertinent data. Chart II. 156 CHART II SELECTED-BUSINESS SERIES 14 0 Stock Prices 120 100 80 wasC Prices Wholesale Commodity 60 1'9'35 1 936 1 937 1 938 1 939 140 a,l Production Industri 120 100 ■ 9 2 . 5 - r 1925= yLO 80 1935 1 936 1 937 1938 1 939 Billions of Dollars Monthly Basis Annual Basis 7 Income Payments 6 5 1936 1938 1935 1937 1939 *Annual Report of the Board of Governors of the Federal Reserve 1941, p. 11. 157 Federal Reserve System on the interest rate structure has an important bearing on business activity, but it may be offset entirely by other factors* Practical experience over a period of years was beginning to leave doubts in the minds of the authorities as to the efficacy of interest rates as a control device* This has already been mentioned in several other places but is worth repeating for is one of the contentions of this thesis that interest rates can be very useful. The recognition of monetary authorities of the needs of the economy for short term uses of money was noticeably present in the fall of 1937. In view of the expected seasonal demands on the banks for currency and credit during the coming weeks the open market committee authorized its Executive committee to purchase in the open market from time to time sufficient amounts of short term United States Government obligations to provide funds to meet seasonal withdrawals of currency from the banks and other seasonal require ments. Reduction of the additional holdings in the open market portfolio is contemplated when the seasonal in fluences are reversed. 87 This recalls traditional functions for which the system was originally set upl It also brings out sharply the realization of monetary needs of the economy which may go farther than merely seasonal needs. A request was made to release from the Treasury 300 87 Federa1 Reserve Bulletin, 23:965, October, 1937. 158 88 million on inactive account to continue monetary and economic.ease. It was explained that this would facilitate the financing of orderly marketing of crops and of autumn trade. This was done in conjunction with the reduction of discount rates to enable the banks to meet the credit needs of the situation, and to maintain the condition of easy money which had prevailed since 1932, The guiding principle underlying the discount policy of the system was the advancement of the public interest. It considered not only the quality of paper submitted but also whether or not it would be in the public interest to place additional funds at the disposal of the member banks in question. This is an explanation of the function of a system which is supposed to take not only the immediate needs into consideration, but als o the longer run implica tions of action which is always incumbent upon policy makers, but not always recognized. Further, the system was to think not only of the economic conditions but the financial conditions of the member banks. Surveillance of their other activities was also a part of the system’s function in order to see that the member banks were not extending an undue amount of credit for speculation in securities, real estate or commodities, or any other activities inconsistent with 88 J.E. Reeve, op. cit., pp. 112-113. 159 maintaining a sound credit condition. Credit regulations regarding eligible paper must look to the character of the paper rather than to the form in a deflationary period, but still must lend with the greatest freedom consistent m th safety. Under such circumstances technical limitations on the character of eligible paper endanger rather than safegaard the banking structure. ;Such. policy would encourage member banks to give their communities the financial services they require. Thus the paramount consideration was the public interest which meant the relative stability of the economic situation with sound finance taking a secondary but nonetheless important 89 position. Recession. The situation in the Nation had deteriorated late in the year, as is revealed in this report: The Treasury is concerned over business statistics showing that consumer .purchases are way below consumer income, and yet that the money is not going into savings banks; there is no direct evidence of serious hoarding, but there is a suspicion that low interest rates by the banks plus memories of the 1933 headache may be partly responsible for the situation, 90 89 Crawford, op. cit., p. 236. Quoting C.O. Hardy from "Government and Economic Life:” Whereas 20 years ago concern was constantly, expressed lest banking and currency policy should be subordinated to fiscal policy; the question now is how far fiscal policy should be subordinated to monetary control. . .this issue is the most important of the frontier questions.” Business Week, p. 57, October 2, 1937. 160 This may have precipitated a liberal ruling on consumer installment paper at this time, and its discounting with the Federal Reserve Banks. Recession was definitely acknowledged in the latter part of the year. Still, the interest rates remained low, and the long rates were stable; excess reserves were 1 billion approximately. The turn of the year and the first months of 1938 brought about continued decline in rates and in activity due to seasonal factors, and the long term rate declined below 2.5 per cent. Secretary Morganthau announced on February 14, 1938 that gold imports up to 100 million dollars per quarter would no longer be sterilized, but would be allowed to have 91 their ’ 'normal” effect on bank reserves and prices. Excess reserves continued to climb in the spring but although short term rates continued to decline, the long term rates started to rise. The Board of Governors announced in April: As a part of the governments program for encourage ment of business recovery the Board of Governors has reduced reserve requirements on all classes of deposits for all member banks effective at the opening of business on April 16, 1938. By this action excess reserves of member banks will be increased by about |;750,000,000. . .raising the total to about $2,500,000,000. The Treasury discontinued the inactive gold account and deposited with the Federal 91 J. E. Reeve, op. cit., p. 112. 161 Reserve Banks 1.392 billion of gold previously held in that account and in the working balance. 92 History seemed to Iw e proved that the easy money policy of low Interest rates was not adequate to maintain a recovery. This feeling was to gain credibility as time progressed. The fluctuations in the bond market during the spring months up to the time of this change in policy seemed to indicate increased uncertainty in the business world which may have been attributable to a variety of causes other than monetary; it is idle to speculate here on them. Bond yields rapidly declined after the Middle of April from the high on the first of the month. The yield on notes hit a new low, and Treasury bills were practically on a no yield basis because of the sharp increase in money supply. Other rates on the market remained unchanged. This process continued the following month. Monetary authorities apparently had hoped to put a brake on rising business activity and had pursued a course of action to slow recovery In 1937 by raising the reserve requirements and by significantly not planning to increase government expenditures for the fiscal period 1937-38. In fact, results showed that the budget was almost in balance. It had been hoped that business would have gathered enough 92 Federal Reserve Bulletin, 24:343, May, 1938. 162 momentum to carry itself along in a continued and sustained movement to recovery. A banker was disposed to remark at this juncture,”. • but I wish to indicate that for the time being the Government has the power, if it has the desire, to keep interest rates down. To be sure this cannot be done 93 indef init ely." Bank Examination. A hew link was forged in the chain of monetary developments in 1938 when the Reserve System decided to liberalize its practices of inspection and examination in order to bolster the practice of easy credit.' It was stated that the purpose of the program was to encourage the private banking system of the country to adapt its lending and investment functions to present-day requirements of commerce, industry and agriculture. It was designed to afford the banks a broader opportunity for service to community and for profitable outlet for some of their abundant idle funds. As the banks availed themselves of the opportunity, the necessity would be diminished for ^ 1 Speeches, 5:534, June 15, 1938. W. Lichtenstein, Vice-tresident, First National Bank, Chicago, in his article, "The Future of Interest Rates," further explained bank liquidity on the basis of returns on earning assets. If the rate is low, then $50 earning assets account for one dollar return, if rate is high, a greater loss of earning assets can be withstood because adequate reserve can be built up on a high rate of interest and return. 163 the creation of governmentalagencies to furnish credit 94 facilities which the banks should provide. Gash balance. Another measure of credit control which came into view necessitated by circumstances was the general fund account of the Treasury. This had been large since 1934, and with the inactive gold account used to maintain easy credit, it could not be overlooked. In releasing money from the inactive account which had accumulated because, of the gold inflow, the economists noticed a definite effect. When this inactive account was deposited with Federal Reserves and then spent, these deposits were transferred to member bank reserves which provided an additional base for credit expansion. This could have been accomplished just as easily by depositing with depository banks; however, it would not have been diffused as rapidly. Thus the General Fund of the Treasury looms as another monetary measure to add to the sheath of controls. As a consequence of such action, excess reserves began to climb near to the former maximum before the reserve requirements were raised. Continued low interest. Monetary ease continued into 94 Federal Reserve Bulletin, 24:564, July, 1938. This was part of the recommendations brought forward by C.O. Hardy, on the reclassification of slow assets to liquid assets and the extension of term loans requested by business. 1939; short term bills were on practically a no-yield basis, and government bonds reached their lowest level in the modern era* All through the money and security markets yields declined to new lows. It was a period of unparalleled ease. The Munich Agreement had been reached the previous Septem ber, and Czechoslovakia had not yet succombed to the Nazi onslaught. But prices declined during this period;1 this seemed to discourage the Reserve authorities who said, "In view of these factors the Board finds it impossible to believe that orices can be controlled by changes in the 95 volume and cost of money." Undoubtedly other factors were at work at this time which should have been viewed with apprehension rather than the relative effectiveness of monetary controls. The so-called debacle of 1937-38 of monetary policy coupled with the insufficiency of measures at their disposal for the attainment of the broad objectives' of policy led to a statement in May, 1939, that the Board ". . .recognized the importance of making every effort to achieve the under- 95 Federal Reserve Bulletin, 25:256, April, 1939, In a press statement the Board said in part: "In view of all these considerations, the Board does not favor the enactment of any bill based on the assumption that the Federal Reserve System or any other agency of the Government can control the volume of money and credit and thereby raise the price level to a prescribed point and maintain it there," p. 259. No doubt its views were tinged with political practicality as well as realism. 1 6 5 lying objectives, which, broadly speaking, is the fullest practicable utilization of the country's human and material 96 resources Interest rates on government paper declined to 2.25 per cent, and excess reserves went to a record high level in May, and then proceeded to go even higher in June, when the interest rates began to rise. The deficit increased by 3 billion dollars, and the total debt attained the height of 97 40 billion dollars# A slight change may be noted in open market operations in the summer cf 1939. Since the Treasury bills were at almost a no-yield basis and seemed not to be meeting demand by an adequate supply, the system decided to let holdings of the bills decline; however, it was quick to say that this did not indicate any contemplated change in general credit policy. At the same time, Treasury refunding was going on, in which the average maturity was lengMiening on the debt. This man^euver seemed to indicate a policy of optimism on the part of the Treasury, as well as to reduce money in the market. Nevertheless, the rate had been a3s o reduced on the 96 Federal Reserve Bulletin, 25:363, May, 1939. 97 Annual Report of the Secretary of the Treasury for the Fiscal Ydar 1956-39, p. 12. fiata and chart are derived "from same source"! Chart is on adjoining page. Bonds authorized as collateral for Federal Reserve notes for two more years# 166 TABLE II . . & PUBLIC DEBT OUTSTANDING- JUNE 30, 1939 Debt Millions Interest bearing public issues— marketable Pre-war and postal savings bonds Treasury bonds Treasury notes Treasury bills # 196.5 25,218.3 7.242.6 1.307.6 Non-marketable issues U.S* Savings bonds Adjusted service bonds 1945 1,868.1 282.9 Special issues Adjusted service bonds, Gov't life insurance fund series Treasury notes Treasury certificates of indebtedness 500.2 1,983.2 1,286.5 Total interest bearing debt Matured debt, interest ceased Debt bearing, no interest 39,886.0 142.3 411.3 Total gross debt #40,439.5 ■^Annual Report of the Secretary of the Treasury for the Fls oa'X' "yea r 1 9, p. 9. 167 debt, the average rate at this point being 2.5 per cent. This represented a decline from 3.75 per cent in 1930 to 3 per cent in 1934. Itwas also noted that there was increased liquidity of commercial banks which reflected less demand for short term loans. This forced these banks into competition with insurance companies and other institutions. It was characteristic of the period since 1930 that commercial paper had declined in use as have stock exchange loans. Treasury bills and notes had increased, and the phenomenon of negative interest had appeared, probably because of the desterilization of gold. The Federal Reserve Bulletin carried this laconic statement in the October issue: The Board of Governors of the Federal Reserve System announces that in view of current developments in the international situation, the Federal Reserve banks are prepared at this time to make advances to member and non-member banks on Government obligations at par at the rates prevailing for member banks. 98 As the prices on government bonds declined, the yields increased to the 1938 level. Commercial loans began to expand, and rates continued to rise at the end of the year, RECAPITULATION The year 1940 makes it convenient to bring this 98 Federal Reserve Bulletin, 25:840, October, 1939, 168 portion to a close as events were to bring on a new type of finane e in the next few months. It would not be erring to say that during this period discount rate changes made by the Federal Reserve Banks were necessarily conditioned by the prevailing state of rreirket rates of interest for short 99 term money, at least during the early thirties. Neverthe less, it was remarked by one authority that: The new monetary and banking system is based on gold but designed in theory to. • .the attainment of national economic objectives. • .these objectives. . . are the full employment of the country’s productive resources at permanently higher and more stable price levels* 100 There was no question but that the Federal Reserve System could exercise influence over interest rates and thereby have a direct bearing on business activity; this may have been entirely offset by other factors such as taxation, lending, expenditures, foreign trade, agriculture, and labor conditions. The Board exerted all its powers to 99 Young, op. cit., p. 15. This was the traditional method which Adam SmitKT*had pointed out. 100 Ibid., p.v. He said also: "So important indeed are these executive powers granted by the legislature that they are sufficient to establish. . .an unusual degree of influence over the policies of the Federal Reserve System in the future, especially as these policies may affect the quantity of the total monetary supply and to render the Federal Reserve System in fact, if not in law, a mere agency of the execution of policies determined by the executive • • "Manipulation of the currency supply is the means to be employed in the accomplishment of this larger national aim." pp« 26-7, 30, 169 provide a constant and ample flow of money at reasonable rates to meet the needs of commerce, industry and agriculture; the open market operations were valuable toward this end. The growth of excess reserves aided this program and although this was inconsistent with the gold standard upon which both interest rates and prices depended, the gold that has flowed had also been inconsistent with the gold standard. The reserve requirements may be affected by the open market operations, tut in 1939 due to unfavorable reactions of the war in Europe, the policy enunciated was one of maintaining an orderly market for bonds, and was thereby a steadying influence throughout the capital market. Appraisal, ”The most distinctive achievement of monetary management under the New Deal undoubtedly is the establishment of an unprecedented condition of monetary ease. . .increased credit in the banking system has mounted 101 to enourmous totals,” The low interest rate policy was 101 Crawford, op. cit., p. 350. He went further, ”While the Treasury had had a similar objective in fulfill ment of its monetary function, it has been actuated in the performance of its fiscal duties by a desire to hold interest rates at a low level as a means of financing deficits. In its easy money policy the administration has followed the theory of Keynes who holds that employment depends upon the amount of investment and that this can be influenced by a low interest rate or by government spending.” p, 231. 170 criticized severely on the grounds that the reduction of interest greatly injured those dependent on investments; that because of an inevitable loss if interest rates are forced to a higher level, it has jeopardized the position of the banks and other holders of government securities and corporate bonds; that the stabilizing effects of rates dependent upon the demand forand supply of money are absent; and finally, that the failure of industry to take advantage of the cheap money available at the banks has shown its 102 fallacy. It was generally recognized, so it was said, that whatever may have been the defects of central bank policy, the main trouble lay in the inadequacy of the interest rate by itself, to control investments and the cycle. Rates may be too high and too low at the same time: too low for institutions and individuals, thus not stimulating investment, and too high so as to retard investment in other directions, 103 such as in housing. Yet it is mainly the demand for the more durable forms of capital equipment that is stimulated by a fall in the rate of interest and the amount of labor dis placed will only be a small fraction of that employed which the new capital equipment is actually being produced. And a fall in the rate of interest also has effects increasing capital and income, in that it will stimulate the production of those goods in the price of 102 Ibid., p. 231. 103 J.H. Williams, o£. cit., p. 273, 171 which to the consumer the factor of interest forms a specially large proportion. • .houses. • .recent American experience has shown that though the demand does respond it may not reach the normal level, 104 which meant full employment. It would be of some importance to attempt to determine the outlook of the businessmen on this important considera tion of interest rates and interest rate policy. Contrary to the traditional view that, "a low interest rate will serve as a greater stimulant to rainy day saving than a 105 higher one. • • in true Fisherine and Keynesian form It was also said that, • .If the outlook for business is poor low interest rates may be insufficient to give stimulus to expansion. At such times perhaps not even an interest 106 rate of 0 per cent would attract borrowers. . ." Bank's deposits will increase, it was added, but their velocity will be zero. Interest rate would have to be nagative to stimulate borrowers. The authors of these statements seem to have accepted the economists point of view that it is the entrepreneur who is unstable because of the risk he takes. The interest rate does have some importance, however, 104 Hawtrey, op. cit., pp. 138-139. 105 Dennison, Pilene, Flanders, and Leeds, Toward Full Employment, (Whittlesey House: New York, 1938), p. 191. 106 Ib*<U> p. 110 172 for long term loans and bonds for business which, unlike manufacturing or general merchandising, can forecast more or less accurately their profit posibilities, and, as a result operate on a closer margin, such as public utilities, apartment houses and residential construction, et cetera. For the vast majority interest rates are not decisive and are not, therefore, of any great importance as a measure of 107 control. It should be added that low interest does make refinancing possible, and this may be a stimulant for plant expansion; however, this does not seem important. In Dennison's opinion it would seem that the interest rate 108 becomes an effect rather than a cause. This is a rather shrewd analysis of the interest rates. The negative approach seemed more fruitful for if there is too little savings or too much taxation, then the high interest rates may be considered a danger signal. A more theoretical approach was taken from another source who noted that interest rates of certain kinds are inflexible over the whole span of a cycle, that "custom or 109 oligopoly tend to rule customer interest rates. The 107 Ibid., p. Ill 108 Ibid., p. 192. The writer responsible for this viewpoint is Dennison. This is definitely a forerunner of later interest theory developments. 109 Reeve, o£. cit., p. 309. 173 remarks continued that the significance of low interest rates come rather from the expansion in long term capital investments brought by higher bond prices and improved conditions in the investmaats market. This may be important for contemporary developments on this very basis. Before looking at the broader aspects within which interest is but one factor, one other point shouM be mentioned in this appraisal, that is the question of margin controls to assure funds being directed toward business rather than toward speculation. Hansen had advocated margin controls to prevent capital funds being shunted away from 110 producers goods capital market. This is in line with statutory enactment under the Securities and Exchange Act, but he would supplement them with taxes on stock transfers. Toward the end of the period the broader implications of the easy money policy were being realized along with the fact that a single measure will not suffice as the solution. At first the borrowing of funds was looked upon as a necessity that was unfortunate. "More recently deficit financirg has been regarded by a school of economists conspicuous in the New Deal as a highly desirable method of 110 Arthur Gayer, The Lessons of Monetary Experience, or Essays in Honor of Irving Fisher. (New York: Farrar and Rinehart, 1937), p. 94. 174 1 1 1 Increasing the supply of credit and currency. • in order to meet the needs of the various areas of the economy. This policy had been furthered by the existence of enormous excess reserves, for this reason the expedient of printing greenbacks authorized by the Thomas Amendment was not needed. The Treasury in selling securities in the market had provided the means, and the banks had actually converted these obligations into credit and currency; these in turn contributed to the increase in bank deposits. Fiscal policy had become almost subordinate to monetary policy. Fiscal aims. The authority also noted that because of the vast amount of government securities outstanding, it had become necessary for the government to support these obligations, for fluctuations could be disastrous for the banks. This prevents the restoration of the gold standard of which the interest rate is an important mechanism. Fiscal policy h®s wider implications in which credit policy plays an important part, for as one authority has said from experience, "total money income. • .may be manipu- 112 la ted by expanding and contracting credit." But in order 111 Crawford, op. cit., p. 235. This and the following pa ssage are dependent on the same author, p. 236, 351. 112 J. Pederson, "Monetary Policy and Economic Stability" The Lessons of Monetary Experience. (New York: Farrar and Rinehart, 193^7), p. 189. 175 to do this, timing becomes all important; with public spending at the right time along with lower discount rates, open market operations and lowered revenue requirements ”♦ « should this new departure become a regularly organized future of public business controls, we may expect that its deterrent effect on people's willingness to spend will be 113 greatly diminished.*’ This is further supported by a newspaper comment,*1. . .that the liquidation of the debt was unnecessary and undesirable and that the important question was not the amount of the debt but the amount of 114 the interest burden in comparison of the national income.** It was argued, however, that low cost might increase the interest burden of the debt even in terms of income because of laxity in authorities that might result. If deficit expenditures are to be effective they must be worked in conjunction with other appropriate monetary and fiscal policies, including revision of the tax structure so as to stimulate private investment, especially equity investment; if the expenditures are for public 113 Dennison, Pilene, etc., op. cit., p. 118* 114 Reeve, op. cit., p. 215. Quoted from the New York Times, • .recent experience, however, has shown that adroit management of banking and fiscal policies will permit relatively large deficits to be incurred for a succession of years. . .also experience seems to indicate that, once started emergency expenditures tend to persist long after the emergency has passed into history.” p. 217. 176 construction they should not invade the field of private investment if they wish to accomplish the objective. Such public expenditure, ithas been suggested, should be treated 115 as a capital budget expenditure which could be self- liquidating; in addition, the idea of balancing the budget over the cycle has been suggested. The objective of fiscal policy as it developed was the attainment and maintenance of full employment; in this period it seemed quantitative rather than both quantitative and qualitative. When the depression had come in 1937, the emphasis with much insistence was still on central bank policy and the interest rates. Open market operations were not large enough, nob begun soon enough or not continued long enough; this only resulted in excess reserves so that speculation was rampant as to how much it would take to break down bankers liquidity complex. Interest rates sank to new low without desired action taking place; something had to be done. Deficit finance and the spread of interest 116 rates caused some new capital investment, but the period 115 Ibid., p. 116. . .the president sent a letter to Senator J.F.Byrnes of South Carolina suggesting. . .the federal government might better authorize low interest loans for self-liquidating projects. 116 Williams, 0£. cit., pp. 273-275. Keynes is also quoted from the New Republic: ”It appears to be politically impossible for a capitalistic democracy to organize expendi ture on the scale necessary to make the grant experiment which would prove my case--except in war condition.” 177 of 1935-37 was marked by very few capital issues. The depression in 1937 turned from pump-priming to compensatory finance. Yet another study reported different conclusions: The pump-priming program announced in April 1938 and made effective by legislation approved in June, represents perhaps the outstanding application of the consumer-purchasing power approach to the economic problem in the entire period of deficit financing* 117 This latter writer came to the general conclusion that during this period fiscal policy was largely speculative, Williams conclusion perhaps resulted from his taking the long view of the period, and with this perspective he was able to see a little more clearly the shifts in policy. Counter-oyclical action. Naturally the cyclical implications for the period are Important , and some remarks along this line should be noted. One of the top administra tive economists expressed himself along policy lines that could make fiscal policy an important weapon in combating business activity fluctuations, but even here the interest rate cannot be denied an important place. If, for instance, prices and wages and the total value of output were rising to such an extent as to produce a rise in the rate of interest, it could not only be dangerous but also fruitless for the monetary authorities to seek to 117 L. Kimmel, og. cit., 42, 178 restrain the rise of interest rates by creating more money, if they felt that the marginal efficiency of capital was destined to rise or remain high for a considerable period. If on the other hand, signs multiplied that the growth of productive capacity in important lines was outstripping probable long-term normal growth requirements, that inventories were increasing relatively to sales,.that vacancies In housing accommodations were appearing, so that a fall in marginal efficiency of capital appeared imminent, the implication of Keynes treatment is that it would not only be safe but also desirable for the monetary authorities to create more money to ease interest rates even though production and prices were still rising. There is abundant evidence that the lowering of interest rates and the response of investment to interest rate changes is a much more time consuming process than the fall In the marginal efficiency of capital that preceeds a 118 slump. Just how long it is before the effect of interest rates takes place is a moot question. It has been stated that: It is not altogether unlikely that in 1937, the Federal Reserve Board by raising the re serve requirements instead of decreasing slowly the amount of government 118 L.Currie, Economic Doctrines of J»M, Keynes (New York; N.I.C.B., 1938), pp, 6-27, This Tssupported by conclusion of Kimmel, op, cit., p, 24, ’ ’Commercial loans did not begin to show an upward trend until 1935." 179 securities lie Id by the Federal Reserve Banks produced an unnecessary rise in long term interest rates and curtailed some Investment. 119 It has been conceded that open market operation and interest rate control have been contributing to smoothing out fluctuations threatened by war, such as maintaining orderly conditions in the market. ’ ’When used with caution they may help to smooth the peaks and valleys of the business cycle and to establish a firm basis for normal activities, domestic and international of trade, industry, 120 finance and agriculture.” Chairman Eccles of the Board of Governor’s revealed his thinking on the important question of recovery in his testimony before a Senate Committee. His views may be summarized briefly. He felt that three important things were necessary for recovery, and that any one of these or all may be the solution: First, an unforeseen or unfore seeable very large outlet for investment must develop in new or in old industries to bring d>out prosperity, second, consumption must be increased considerably, or third, the government must provide an outlet for idle funds through deficit financing of work relief, public armaments and so 119 Ibid., p. 72. Article by Firtz Lehman on the role of the multiplier and interest rate in Keynes’ General Theory. 120 Crawford., op. cit., p. 382 180 forth. A possible alternative program may be a socially and economically desirable non-profit-making but largely self- liquidating investment. If none of these take place, and if all the so-called deterrents to business are removed, the stimulants to business however contrived will not bring about the objective of fill employment. Adequate outlets for savings must be provided to raise national income to a satisfactory level. It is only by this means that tax revenue adequate to balance the budget can be achieved. The first solution is unpredictable, and it is useless to wait and to hope that it will materialize, although much could be done to stimulate private activity in the field of housing. The second to increase consumption should be a m|jor policy, but it is a slow process. The third way is the only direct, immediate and feasible plan at our disposal 121 for the achievement of badly needed improvements. Cash velocity. One other question of more than theoretical importance which has not been dealt with adequately enough to date deserves some mention here. It 121 Ibid., pp. 236-237. ' ‘During his testimony Mr. Eccles was told frankly by Senator Glass that the Federal Reserve System had nothing to do with the question which he has been discussing." "Mr. Eccles has in mind an objective of economic stability while others regard price stabilization as the immediate goal. . .while Mr. Eccles would accomplish his objective through orthodox borrowing the other groups would resort to more unorthodox inflationary methods." was noticed that the very low rate of turn over by bank deposits throughout the period of the New Deal is evidence of a definite limitation in the powers of monetary management. Without an outside impetus to industry and agriculture, the most skillful manipulation of currency and credit is unable to accomplish results. It was also true that member bank borrowings at the Federal Reserve Banks were almost 122 negligible during most of the period. If lack of demand for investment funds caused the existence of excess reserves, "Our failure to realize the vulnerable position of the government bond market in 1936 and 1937 may be traceable to our neglect of the important question of why excess reserves, which in turn reflects our failure to analyze adequately the nature of the demand for 123 money." This particular concept has been explained with remarks during the discussion of Walras, Wicksell and Keynes. It appearsto be important enough for further treatment later. It will be sufficient to say here that money may sometimes be treated as something in demand by all units of the economy at all times. Since the demand for money changes with the expectations by these units concerning 122 Kimmel, op. cit., p. 33. 123 Salant, "Demand for Money and Income Velocity," Journal of Political Economy^ 49:420, June 1941. 182 the economy, it becomes one of the most volatile demands In the economy. Its change may have effects throughout the whole economy. Bankers, therefore, are strategic in their influence cn money as well. The demand for money may be influenced by the productive forces in the economy as well as being affected by them. Money is likewise intimately related to interest rates and to income. Conclusion. This vital period which has been under discussion will be concluded here with some broad generalizations concerning this era. One of the most important figures at our policy-making level has said: The very continuance of our individualistic profit system in economic life and of our democracy in political life depends on measures being taken to lessen the boom and depression from which we have suffered in the past. 124 It would appear that during this period of trial the economic question became one of paramount important© to sustaining our way of life, rather than letting "nature take its course." Certainly our economic system is so vastly complex and so delicately balance that It would be less than intelligent to let it run down or destroy itself without attempting to remedy the causes. 124 Gayer, op. cit., p. 3. Eccles pointed out that the least the monetary authorities can do is maintain favorable conditions for the functioning of the economic system, aided by taxes to bring idle money out of hoarding. 183 Another outstanding economist has said: In nearly all countries there has also been a downward pressure on interest rates. It may be pointed out that most of these measures which were undertaken to promote economic recovery can be regarded as forms of monetary policy in the broad sense now usually given the latter terms. . . Indeed tentative steps are already being taken to control the next boom* 125 Another source reporting on the general picture of the wofeld situation has claimed it was an indispensable condition for the maintenance of economic and financial equilibrium that interest should be brought down from the relatively high post-war level to rates more in conformity with those ruling before World War I. It was even argued that because of a stable population in the western world and the downward tendency of prices since 1924, this policy was correct, especially for the United States* . . .the transformation to a creditor nation as well endowed with capital as any other country necessitated a downward adjustment in the interest structure, the more difficult to achieve as there was no precedent for really low rates or, rather none outside the short term market in New York; and moreover, the important field of mortgage financing suffered from a serious lack of organization, impeding the necessary adjustment. 126 The report continued that manipulation of Interest rates are or can be important but only as a mechanism but 125 J,W. Angell, HThe General Objective of Monetary Policy,1 1 The Lessons of Monetary Experience. (New York: Farrar and Rinehart, 1937), p. 52. 126 Federal Reserve Bulletin, 25:749, September, 1939. Annual report of the Bank for International Settlements, 184 for the psychological effects as well. Thus, If such had been done 1936, to raise the rate of interest, a warning would have been issued which would have caused hesitation; a more balance position would have been maintained, and a great decline in interest and employment would have been avoided, so it was claimed. The MacMillan Committee urged that central banks should not be afraid of small and frequent changes in the bank rate and would accustom the public not to attach undue importance to any necessary 127 adjustment* These conclusions seem reasonable, at any rate they fit as a justification for world wide policy. More specifi cally the suggestion of constant fluctuations of interest would sound like a passage out of Y/icksell. Surely interest rates have not been reduced to unimportance at this stage of development. 127 Ibid., p. 750 CHAPTER V WAR FINANCE Tills division of the study shall deal with the period of war finance which begins in 1940 under the guise of defense finance. The war in Europe which began the matter part of 1959 was not to have immediate effects on the internal economy of the I United States for some time. The fall of Franc© precipitated defense financing early in 1940. This section will depend largely on the facts and figures published by the government with statemaits and published policy. Where possible, some analysis will be included of outstanding figures and economists of the period. Monetary measures will be discussed, and any changes or additions to methods will be recorded along with the theoretical developments allied with such policy. TRANSITION The beginning of the year brought no great changes in the financial situation. The most startling fact of the new year was that excess reserves were at record high by the end of February. Easy credit was still the main objective of the monetary policy, with liberalized standards for bank examinations an important consideration. 186 The government agencies were participating or guaranteeing loans to an increasing extent. National income had 3hown no appreciable change over 1937, but had dropped almost 10 per cent over 1938. Full recovery had not been attained, but prospects were brighter due to war abroad. Low Interest. How important a factorthe low interest, easy money policy had been, quantitatively speaking, it would be difficult if not impossible to ascertain; for up to and including 1938 of nearly 8 billion dollars of bonds outstanding only one billion had been privately issued. The statement of the Federal Reserve may go unquestioned that, ”the cost of money is at times a factor of some importance, especially in the field of long-term borrowing 1 as on mortgages or through bond issues.” It seemed experience had taught that it was not the all important question for recovery, or for control as it may have been envisioned. One of the most inflexible rates in the whole pattern of interest rates has been that of home and farm mortgages. It has been part of the policy of the administration to provide safeguards for these loans for the benefit of the lender, for this reason, they may be - * ■ Federa 1 Reserve Bulletin, 26:197, March, 1940. 187 reduced even lower than they have been in the recent past. It was being recognized at this time that in this field low interest could be a real benefit, forit is a large factor in the cost of home building# Some stimulation has been 2 injected into building because of this factor. The emphasis at this date on the long term rate might indicate a basic change in policy or a more specific attack on particuhr rates. The only possible weapons the reserve system ha s to aid a specific policy of this kind, however, were the effects of a low rate of interest In the long-term capital market and the shifting of funds to areas that migjat facilitate loans of this kind. Other agencies had the power, and in cooperation with the system more direct pressure could be brought into this market. However, care must be used in this matter, for it has been advised that: The downward revision in the market of the interest rate In recent years had undoub tedly been caused to a great extent by predetermined and arbitrary action of government. At the same time, the adjustment appeared to be warranted as a correction of a previously high level, caused in large measure.by the inadequacy of the financing mechanism to service home owners. But the danger of over correction must be equally recognized. To determine whether or not we are approaching this point it Is appropriate to test the adequacy of existing rates to carry the regular and 2 Ibid., pp. 197-198. 188 3 recurring cost of operation, Not cnly ha s the enhancing of funds going into this market brought down rates, but also there have been changes made in the methods of operation. One of these changes was the doing away with frequent renewals and allowing for amortization, thus bringing down the cost of operation. Another provision was for the discount of such papers as is approved by government agencies. Government bonds. Changes in finance brought about by the government in recent years was reflected in the bond market. Price variations, it was advised, reflect primarily variations in interest rate rather than doubt or uncertainty regarding coupon p^ments or return of the primipd. at maturity. As long as the banks do not have to sell their holdings of bonds, they can ignore price fluctuations. Banks in the past seemed not to have treated bonds as long term investment! this attitude on the part of banks led to a change in Federal Reserve Policy. Banks were adjusting reserves by bond transactions at this time, thus affecting assets of all banks. Thus the government bond market ha s become the country's central money market, which is the medium in which Reserve policy may first find expression . • • 3 Wm. H. Husband, ’ ’Interest Rates and Home Financing," Amerlean Economic Review, 30:280, June, 1940. 189 and also study the capital market in general* 4 It may be noticed by the above statement that the avoidance of fluctuations of the long-term interest investment market is one of the important policies of the government. A growing recognition of the value of such a situation as conducive -to long-term investment might have been behind such a policy* Another aspect of credit policy in 1940 which had been growing in recent years was the provision of ea:sl£trr terms for small businesses. Here again the amortization principle was applied, with an attempt at lower rates for risky loans. The'industrial credit corporation idea 5 received official recognition* This idea had been recorded in the previous chapter as having been the suggestion of business itself foran intermediate regional credit organ set up by the banks to afford more sources of funds. It was advocated now as a partial guarantee and lender of first resort under certain circumstances, but otherwise was to work in cooperation with the banks. It would either be a voluntary association of banks or a government corporation* Meanwhile a refunding operation announced at the same time of Treasury notes to take advantage of lower rates 4 Federal Reserve Bulletin, 26:198, March, 1940, 5 Ibid., p. 169. 190 drove up the price of long term bonds so that the yield on bonds dropped to a new low in the system’s history. Gold. The ever present problem of gold was evidenced by a report in April of 1940: "In the recent period the principal problems facing the System have been the restoration and preservation of a soundly functioning banking system and the avoidance if possible of harmful repercussion in the future from the continuing inflow of 6 gold#" In fact, it had been claimed by the Federal Reserve that this inflow of gold had been the major influence in the decline of interest rates. It was adctitted that, Federal Reserve policy, which, in the early years of the depression, had. been directed toward easing credit conditions and combating a disastrous deflation, has for many years had little if any part in the continued decline in rates. 7 This inflow of gold had been caused for the most part by the disturbed economic, financial and political conditions in foreign countries all over the world since the very early thirties. It cannot be denied, however, that the authority extended under the Glass-Steagall Act of 1932, by which the Federal Reserve Banks bought government securities from the 6 ibid., p. 280, April, 1940 7 Ibid., p. 315, May, 1940. 191 member ban!© enabling them to meet their obligations, had also contributed to this condition of excess reserves* Steps taken to reduce these excess reserves, such as the raising of reserve requirements, must be viewed as precautionary measures taken with reference to future developments, and not designed to immediately restrain or restrict credit expansion. This has already been noted in the last chapter. Measures were taken to prepare for the inflation that might be expected from the continued easing of monetary conditions* Closely related to this policy had been the open market operations of recent years, to smooth out fluctuations of business activities in the short run, and endeavor thereby to maintain orderly conditions in the capital market. This stabilization has been felt in other fields, such as the mortgage money market because of the■activities of other 8 government agencies* Treasury operations. Prominent as had been the credit policy of the government in the years since 1932 up to 1940, notice must now be paid to other operations of the government. It will suffice to mention here that over the 8 years considered, relief and work relief had amounted to 8 Federal Reserve Bulletin, 26:388, May, 1940. 192 9 15.507 billion dollars. This relief was an important factor in easing credit conditions and contributed to any success the Federal Reserve System might have had. The debt increased by over 3.5 billion dollars for the fiscal year; this brought the total debt up to 44 billion dollars approximately at the end of the fiscal year 1940* Another aspect of Treasury financial operation which is of particular interest to this study is the changing issues of government paper. Uhile certificates of indebtedness constituted an extremely useful instrument of short-term Treasury financing, they have been displaced by Treasury bills since 1934. The prominence of government paper in the financial markets of recent years made them instruments of more than passing importance. The sale of discount obligation through competitive bidding enabled the Treasury to take full advantage of the extremely low rates of interest on short-term securities obtaining in the market. This low rate allowed the Treasury to observe the condition of the money market, and afforded it an accurate gauge of money flow, which could be an aid not only to fiscal operation but to credit operation of both the Treasury and the Federal Reserve. 9 Annual Report of the Secretary of the Treasury for the Fiseal year' 1959-40, p. 24* 193 Such paper found a ready market on the financial centers, for short-term discount obligations permitted bill offerings to be timed very accurately with the Treasury's need for funds. The availability of weekly issues of Treasury bills permitted the Treasury to undertake large scale borrow ings at its own convenience and to postpone such operations for temporary periods during unfavorable market conditions. The relatively small amount of each individual issue offered permitted the Treasury to schedule tax date maturities so as to provide the greatest assistance to the 10 money market. Thus, the short term 91 day bill tempered the impact of Treasury tax operations as well as served to steady an otherwise unsteady market. It served also to keep in touch with the monetary conditions by the process of investors submitting bids fora certain amount of funds at less than face value, for value value return at maturity was invaluable as a device for preventing the monetary authori ties from losing contact with the monetary market, and could aid considerably in timing fiscal operations so as to aid in stabilizing the financial market. The short-term rate of interest on government obli gations had been noteworthy also for another reason, as 10 Ibid, pp, 58-59, 194 brought out by a survey made by the Treasury in 1940* Unquestionably all rates had declined since 1932, but the short-term rate bad declined relative to long-term yields* This movement which had been in progress since the first World War had been markedly accelerated in the past few years. The reason given for the relative decline of the short rate was the extreme demand, which had existed, and which came mainly from the banks; it was very largely the 11 growth of excess reserves pressing for investment. Thus again the influence of foreign gold was apparent. This gold came in on a demand short-term basis, and it would have been unsound banking to invest such deposits in anything but short-term paper. The government paper afforded the b©st riskless investment in the money market, and the only outlet for the banks on such volatile funds* Excess reserves reached a total of 6 billion dollars in May of 1940. Yields on government bonds rose as prices dropped, and the Open Market Committee operated to maintain orderly condition in the market. Prance fell in May of that year* DEFENSE FINANCE After the initial flurry in the government bond 11 Annual Report of the Secretary of the Treasury for the Fiscal 'Year 1959-46, p.' 6V, 195 market in May and June things settled down in the summer of 1940. Gold continued to flow.into the Treasury from abroad. In order to maintain Uniformity .of rates in various sections in the period 1939-40, it had borrowed heavily in New York City from banks and other investors, and spread the proceeds to other sections of the country. The New York banks had substantially increased their holdings of govern- 12 ment obligations* The Treasury cash balance was used for this purpose. "To meet the prospective deficit due to defense 13 activities. • .open market salee of direct obligations" was begun in August. These bond rates were very low, down to 2.25 per cent, which aided and facilitated such operations. The commercial banks were cooperating with the government in this operation and aiding in the effort by standing ready to lend 3 billion dollars to manufacturers for emergency defense plant construction, as reported by the Federal Reserve. Standing in good stead at this time was the develop ment of American Banking law which had recently been putting emphasis on sound business loans rather than on loans of highly liquid character. Almost everywhere the basis of central bank credit had been widened, at any rate as regards 12 Federal Reserve Bulletin, 26:908, September, 1940. 13 Ibid., p. 911. 14 short-term transactions. 196 Credit. Now in addition, contract assignment was allowed as security for loans; this as well as the tremendous reserves available made this financing relatively easy even on such a. scale as already indicated. This method was welcomed by business, for it was reported: In view of the security afforded by the contracts and current money market trends, industrial borrowers will be able to obtain those loans at rates materially below the 4 per cent charged by the Reconstruction Finance Corporation and in addition will deal with their local banks rather than with bureau officials in Washington. Bank rates on small commercial loans were at 2.12 to 5.75 per cent at this time. It was explicitly stated that the Federal Reserve Board would help financial operations in the defense program. By December money market rates" had 16 declined to 2.12 per cent and short term rates also declined. However, credit was extraordinarily easy and the Reserve authorities were worried about inflationary forces in the economy that were potentially explosive. They were aware of defects in the credit control machinery, and so submitted a plan to Congress to be enacted immediately to forestall the alleged impending infla tion. 1 14 Federal Reserve Bulletin, 26:1091, October, 19 40. 15 Newsweek, p. 40, October 7, 1940. federal Reserve Bulletin, 26:1279, December, 1940. 197 This program may be summarized here briefly. Some measure of Congress was necessary to absorb a large part of the seven billion dollar excess reserves then in the banking system. This could be done by increasing the reserve requirements to the limit of the law, but the authorities suggested that the Open Market Committee be empowered to double these or to make such changes as circumstances would indicate. In addition, they wanted the committee, or some other body formed to have this authority, to have power over reserves and open market operations. They wanted such rulings on reserves to apply to all banks, not merely members of the system. These added reserves, it was suggested, were to be exempt from Federal Deposit Insurance Corporation assessments. Lastly, regarding Reserves, various sources of potential excess reserves were to be removed including the unused power of further devaluation of the currency, insulate further gold inflows from the banking system, draw on present deposits in the defense financing rather than the creation of new deposits. Two further suggestions were made regarding defense financing which had broader implications. It was also recommended that the budget be balanced at full employment, so that no new reserves could be created. Essential to any program of this nature aimed at reducing and if possible avoiding a galloping inflation was the coordination 198 of various government bodies that deal in credit matters and 17 financial operations. Government policy. The policy of the administration for the defense effort was to draw on the private productive resources of the nation as much as possible, as Mr. Eccles said: The great bulk of that employment is and must be provided by private enterprise. Public policy, therefore, should be directed to creating an economic climate that will give the greatest possible incentive to private initiative and private enterprise that is consistent with orderly and continuous national progress. 18 He had been a constant defender of the stability in the economy, and had argued often and ably for a recovery which would avoid necessary adjustments later. This was the reason he defended the easy money policy of the government, and was such an influence in the carrying out of that policy as Chairman of the Board of ©d.verhors• However, he admitted that: Federal Reserve Bulletin, 27:1, January, 1941. 18 Ibid., p. 15. Mr. Eccles continued: ”While fundamental principles of government policy do not change, policies must vary as economic conditions change. . .1 have continuously advocated a policy of monetary ease as the appropriate accompaniment of a period of under employment but I have never favored artificially low rates such as have been brought about through an uncontrolled surplus of excess reserves. . .although some interest rates have become extremely low, rates in the house and farm mortgage field have been relatively slow to respond to the general decline and are not now too low in my judgment.” 199 Excessively low rates do not contribute to stability any more than do excessively high rates. Neither is fair to lender or to borrower. It is one thing to have interest rates low as the result of the pressure of savings or investment funds on the market. It is a quite different thing to depress the interest rat© structure abnormally through excess reserves created by causes extraneous to our economy. I have always contended and reiterate now, that these abnormal pressures should be removed and they must be removed as an essential element of defending the economy 19 against possible inflationary over expansion later on. The whole question of interest rates, investment and increased employment was subjected to study by the Temporary National Economic Committee which dealt with the matter that interested Mr. Eccles in the above quotations. If saving and investment are excessive, by what standard are they excessive? It would seem that the important questions is 20 whether they are excessive at reasonably full employment. The amount saved seemed to be large if excess reserves are any indication, as it is likely to be at high 19 Ibid., p. 16. 20 Temporary National Economic Committee, Saving, Investment and National Income, (Washington, D.C.: U. S. Government Printing Office, TS^l), Monograph No. 57, p. 6. 0. L. Altman of the National Resources Planning Board said: “The difference between gross national product and gross capital fund (investment) represents consumption. Accordingly the difference between current income before deduction of depreciation and depletion allowances (whether paid out or retained in business) and outlays for consumption represents saving. But though, according to these definitions, saving is equal to investment--as in an accounting sense it must be--the important question considering the level of income and employment is at what level are both equal.” 200 income level. It is necessary that equally large outlets b© available for these savings in equipment and plant expansion and in residential and public construction. Otherwise, these tremendous savings become a force for instability in the economy. Many factors effect savings. Perhaps consumption is sacrificed to increase production, but the volume of savings is affected much more by a change in national income than by a change in interest rates. There seems to be more saving with a high level of national Income and low interest rates than with a low national income and high interest rate. But it must be noted that when interest rates fall, dividends on life insurance fall, and policy holders are expected to increase the premium payments. It is unlikely that these increases in premium payments are 21 offset in full by decreases in other forms of saving. So besides the banks, insurance companies have become large holders of savings; these savings are as important an influence on interest rates as on investment, national income and employment. Insurance has in part, along with government agencies, therefore, reduced somewhat rates on 21 TNEC, op. cit., pp 26-27. The report continued; "The larger the stake In such contracted forms of saving, the harder it is to decrease saving when rates of interest fall. . .another indication is that the branches of life insurance business which have grown, most rapidly in the past decade 1931-1940 despite the fall in interest rates are those where the savings element is greatest: annuities and investment of balances.1 1 201 mortgage loans especially the better type of mortgages* Nevertheless, insurance companies were earning 4*74 per cent on mortgages as compared with 3.47 per cent on bonds. Unaccountably insurance cash balances had increased in 700 22 ' million dollars in 1938. This, it may be explained, arose from the need for cash reserves or for transactions carried on frequently by insurance companies as for precautionary reasons, as in the Keynesian analysis, which is intimately related to the liquidity preference. The ability of corporations to carry on their own financing had led to further increase in cash balances. Intercorporate investment, the flow of funds to savings institutions which must invest and the increased preference for debt instead of equities has, besides the government 22 Ibid., p. 50. ,fConcentration of insurance companies Ea s ma de it possible. . .to divert part of flow of earnings into cash balances--idle cash hoards.1 1 It may also be noted that the failure of the interest rate to reduce savings had been brought under full discussion in the American Economic Review of December, 1936, pp. 619-20, by &.G-. Moulton in reply to R. T.Bye, speaking of an earlier period. ’ ‘If the interst rate did in fact automatically regulate the savings process, then no maladjustment between the volume of money savings entering investment channels and the flow of new security issues for purposes of capital expansion could ever occur, since the facts clearly show that there was a wide discrepancy, the interest rate was evidently not as effective a regulator*1 1 He further stated that, "After the supply of new issues has been absorbed the alternatives for investors are (1) hoarding and (2) buying securities already out standing.1 1 202 policies and practices led to a decline in yields on bonds rela tive to stocks. The period under consideration would seem to bear out thewords of an economist: As long as the artificial expansion of demand for government securities has a greater effect in increasing prices of government securities than the continued rise of commodity prices has in reducing demand, the government will succeed, ceteris paribus, in preventing a rise in the rates of interest. 23 The JoLe of interest has been emphasized in this analysis, for its function in relation to money savings and investment and consumption is one of the large areas of economic 24 cont roversy. Another aspect of the interest rate question, which 25 is closely allied with the Hicksian analysis, has been called forth from the experience of the times. The interest rate as a control device had not worked satisfactorily to bring about the rate of recovery expected. It is worth mentioning that it had neither the effect on saving expected, or on investment and, therefore, on consumption. An attempt at such an explanation was developed by Samuelson at this 23 S.E. Harris, Inflation and the American Economy (New York': McGraw Hill -book Co., 1945’ )'/ p. 238. 24 This statement is well brought out in the book by R.T. Bye and W.W. Hewett, Applied Economics, (N.Y.: Crofts & Co., 1947) 4th Edision, Chapter 10. 25 See Chapter II supra. 203 time: 1 1 The interest rate and asset price structure serve to equilibrate the holding of new and old securities of all 26 kinds•“ This would not imply any tendency for the rate of interest to fall to a level which would induce an amount of net investment sufficient to produce full employment. The Marginal efficiency of capital would have to be elastic concerning interest rates or negative rate would be necessary 27 to produce the desired effect* Increa sing tempo* Attention was also called to the fact that funds had tended to increase in the New York market by means of deposits from the so-called country banks which served no useful purpose in New York but forces short-term rates to unnecessarily low levels. The over concentrating had reduced the competitive position of these depositing banks. It also forced the Treasury to redeposit these funds back in those areas. Thus it would seem to be advocated that short-term rates be raised; ”If this is done,” (after excess reserves are adjusted), said Mr. Eccles, ’ ’the rate on government bills and short-term notes would be llkelyy to increase sufficiently to attract the large amounts of idle corporate balances representing reserves of various kinds 26 P.A. Samuelson, “Theory of Pump Priming Reexamined”, American Economic Review, 30:493, September, 1940. 27 Samuelson, Ibid., p. 493* 204 28 that have accumulated.” The annual budget deficit was exported to increase to 9 billion dollars by June of 1942, and total debt was expected to be as high as 5.84 billion dollars by that time under plans for defense then being carried on. Long term bond yields which had fallen to 2.03 per cent rose again in January to 2.16 per cent with short-term rates relatively low. The defense program called for both monetary and fiscal policies. Thus there should have been borrowing and taxation in such proportions that borrowing would decline 29 and taxation would increase when the national income rose. This was necessary to facilitate the program, and made it easier to tax later, and also to supply the needed money. As the defense program increased in tempo, it was noticeable by April that ommmercial loans had increased, and that medium and long-term loans on an amortization basis were growing. The Treasury's fiscal operations were causing 28 Federal Reserve Bulletin, 27:16, January, 1941. He discussed revision of the tax structure when full employment is attained, an excess profits tax of anything over 10 percent of invested capital with allowance for new business and eliminate tax free securities. He also recommended capital investment by the government and then tax for amortization, operation, and maintenance. He suggested also that baby bonds be issued to individuals as a post defense cushion, somewhat like Keynes', "How to Pay for the War," against depression and use those funds to retire other bonds# 29 Federal Reserve Bulletin, 27:95-98, February, 1941. 205 • substantial temporary fluctuations in the Treasury’s 50 deposits and in the volume of excess reserves, presumably the Treasury was also manipulating its cash balance with depositing banks. The passage of the Lend-Lease Act in March, it could be foreseen, would add considerably to the cost of defense operations. This and the rest of the defense program which had gathered considerable momentum before and after this led the monetary authorities to issue a warning* Rather a primary concern of defense financing is to avoid an increase of the means of payment, that is, of money in the banks of those who would spend it faster. than our economy could produce goods. . .It means avoidance of unneeded expansion of bank credit which adds to the supply of money and thus of purchasing power* 31 The matter of easy credit was no longer the dominant concern of monetary authorities. In their judgment there were ample money supplies in the economy. Fiscal policy involving both this type of government financing and taxation and even direct controls were far more important at that time,”* • * taxation is the most important single means of maintaining stability in the economy and of preventing either general 32 inflation or deflation.” The taxes which were suggested for 30 Federal Reserve Bulletin, 27:287, April, 1941. 31 Federal Reserve Bulletin, 27:506, June, 1941* 32 Ibid., p. 507. control were those on corporate income, individual income and excess profits. The tax program had a four fold purpose (1) preventing a general rise in prices, (2) mobilizing re sources for the effort, (3) seeing to it that everyone bears a fair share of the burden, and (4) driving sufficient revenue to defray two-thirds of the expense of the war* The expansion of bank credit which creates new funds was inflationary, and the suggestion of Chairman Eccles is here repeated: that savings bonds should be used for the added purpose of reducing purchasing power and storing it up for future use. The author!tes favored a rise in short term rate on issues available to the banks. This last could be effective in raising short-term rates outside the government market, and cause a rise on them to compete with government rates. The long-term rate for government paper of 2.5 per cent was considered a fair rate, and could almost be counted on to be maintained by the monetary authorities. Savings bonds were highly favored, for idle deposits are put back in circulation while government borrowing from banks creates new deposits while the old ones are still available. Under the defense program the old question of stimulating investment and consumption was eliminated as unnecessary so that borrowing from banks was to be avoided. The corollary would hold that certain types of private consumption and investments must be curtailed. 207 Anticipation controls. Taxes on government securities went into effect in February, 1941, as suggested by Mr. Eccles, with a consequent increase in revenue the next fiscal year. The deficit increased 5 billion dollars to a total of nearly 49 billion dollars. The average rate of interest on the debt rested at about 2.51 per cent with an indicated lengthened maturity on the debt because of more bonds and special issues: outstanding. The Public Debt Act of 1941 amending the 2nd Liberty Bond Act increased the legal debt limit to 65 billion dollars. Bonds were to continue as 33 collateral security behind Federal Reserve notes until 1943. The summer of that year was the time the Treasury brought forth its tax savings plan under which two-year notes non-transferable were to be bought by individuals, at interest, as advance payments on the succeeding year’s income. This plan was part of the overall monetary and fiscal policy to prevent inflation by reducing purchasing power disposable at the time. Defense savings bonds could 34 be used for the same purpose, 33Annua1 Report of the Secretary of the Treasury for the Fi seal YearJ* 194Q~^!T, p. 2 6. All tEese figures are taken from this' source. The major public debt operations included five offerings of bonds, three of notes, weekly offerings and redemptions of bills and continued sale of U. S. Savings bonds. Investors other than banks increased holdings of government obligations. 34 Federal Reserve Bulletin, 27:728, August, 1941. 208 September marked the time when the Board of Governors issued Regulation W relating to credit payable in installments on consumer durable goods other than housing; "civilian demand must be adjusted as closely to supplies available for consumption. • .help avoid inflation. . • 35 offset a postwar slump." This regulation did not apply to open book accounts over one thousand dollars, and not on loans repayable in full on a fixed date. Commercial loans continued to expand and excess reserves declined 2.0 billion dollars, from the all time high of 7 billion dollars. The liberalization of credit to allow for contract assignments as security forloans has helped defense program considerably. The reserve requirements were increased to their statutory limits, and the excess reserves were thereby reduced to 4 billion dollars. The main objectives of defense financing were to build an impregnable war machine, and to provide adequate breastworks against inflation by the accumulation of purchasing power to be used when the emergency subsided. Rates, both long- and short-term, were steady, but the intermediate rates on 3 to 5 year Treasury notes declined. By November, the long-rates had declined somewhat, and some lengthening of maturity of the debt 35 Federal Reserve Bulletin, 27:826, September, 1941 209 occurred. Short-term rates rose but slightly-. It appeared that more debt in the defense program was needed than was first anticipated. The monetary authorities requested that the state and local governments should decrease their expenditures and leave their tax structure untouched, but at the same time retire their outstanding debt with the increased revenues. ’ ’This would be anti-inflationary and in harmony 36 with the governmental policy." The maintenance of economic balance is important for maximum effort. This is best attained by the citizens of debtor-sareas having enough money income to accomplish two things: (1) to maintain interest, amortization and other payment s on their obligations to investors in the creditor areas, and (2) to maintain at a high level their purchases of the output of the factories of the credit areas. They must maintain their standing both as good credit risks and as good customers. In October, long-term bond yields dropped to the lowest on record: 2.01 per cent. Excess reserves continued to drop, and reached 3,5 billion dollars. As the full effect of the new reserve requirements was felt , the rates on money markets became stable in November, just prior to Pearl Harbor. 36 Federal Reserve Bulletin, 27:1098, November, 1941. 210 Summary. It would be fitting at this point to summarize the policies of the time under discussion, as well as to note the shift in policy which took place during these years. The shift toward taxation was a notable one in the defere e period, although a rather inconsistent policy had been followed by the Administration. Let Mr. Eccles summarize the policy situation as published in the Federal Reserve Bulletin: Fiscal and monetary action, properly used can go far towards correcting the basic causes of economic breakdowns. These overall functional powers, of which taxation is the most important single instrument — need to be supplemented by some direct controls at all times, particularly, in a time like the present when we have an acute shortage of strategic materials. However, the more wisely and effectively overall controls are applied the less will be the area in which there will be need for direct measures* But I deny that in a day when capital is over abundant in relation to the outlets for its private investment it is wise public policy to encourage its accumulation in stagnant pools. Rather I have favored during the decade of the ’30's tax policies that tended to maintain the flow of purchasing power In the economy by forcing idle funds back into the circulating stream. That is a departure from the older orthodoxy to be sure, but it involves no less of fundamental liberties. It is not a threat to democratic Initiatives. Rather, it is absolutely essential for their preservation. Similarly, I have favored the appropriate accompanying monetary policies. Thus during the depression, I favored making the supply of money abundant and interest rates low in order to create an anti-deflation climate which could be favorable for recovery provided positive action were taken at the same time in the fiscal field. By the same reasoning I favor such anti-inflationary fiscal and monetary policies as are possible at this time. . • 37 37 Federal Reserve Bulletin, 27:1102, November, 1941 FINANCING THE WAR 211 Economic controls. War carme to the United States in December of 1941, and with it came a change in finances. It was one of degree rather than substance. The Treasury would have to continue to borrow to support the government’s post war operations, taxes would have to be increased and as a consequence there would be more money in the system. However, at the same time, there was likely to be a gap between consumer income and the goods available for consump tion. This would call for more direct measures of control in the economy, of a more specific nature. The monetary authorities were quick to state this policy: The system is prepared to use its powers to assure that an ample supply of funds is available at all times for financing the war effort and to exert its influence toward maintaining conditions in the United States Government Security markets that are satisfactory from the standpoint of the Government’s requirements. Continuing the policy which was announced following the outbreak of war in Europe, the Federal Reserve Banks stand ready to advance funds on United States Government Securities at par to all banks. 38 Conditions, insofar as it was in the power of the monetary authorities to control, were to remain as before with as little disturbance to existing conditions as possible. Short-term rates rose in December, but leveled 38 Federal Reserve Bulletin, 28:2, January, 1942. 212 off in the following month. Long-term rates decreased, and then rose in January. The extent of governmait operations in the monetary market may be understood by the revised budget estimates of 19 billion dollais in fiscal 1942, and 39 35 billion dollars in fiscal 1943. The Office of Price Administration was inaugurated in January to control prices; wages were exempt. This direct regulation was to be of invaluable aid to monetary authorities in controlling their area of the economy and in enabling them to preserve their continued policy of easy money. To implement this policy the Board of Governors ruled that the Reserve Banks could make advances both to member and non-member banks on their promissory notes secured by direct obligation of the United States for 40 periods not exceeding 90 days. Credit policy. Another measure adopted to secure easy credit were the loans guaranteed by Army, Navy and 39 Federal Reserve Bulletin, 28:95, February, 1942. 40 Federal Reserve Bulletin, 28:211-212, March, 1942. Some discussion of this ruling resulted from the section in the Federal Reserve Act, which seemed to authorize only 15 day advance to member banks, in another paragraph of the same section, it allowed advance to any individual, partnership, or corporation for 90 days secured by the direct obligation of the United States subject to interest at rates fixed from time to time by the Federal Reserve Banks subject to review by the Board of Directors* 213 Maritime Commission. These were similar to assignment of “contracts,1 1 but were a more direct measure for war time easing of credit. The limit on Federal Reserve Bank holdings of Government obligations purchased directly from the Treasury was set at 5 billion dollars; this was also a measure to ease credit, and facilitate quick financing of the war effort. Another fact of import which came to the attention of the authorities at this time was the withdrawal of currency by the public in the twelve preceding months; this withdrawal had led to the reduction in member bank reserve balances, which had in turn contributed to bringing the reserve position of the banks nearly within the range of the control of the authorities. As long, as demands remain consistent within a pattern they can be an aid to monetary authorities, who must formulate such plans in anticipation of events with some degree of accuracy. It does, however, affect at the same time their ability to control the monetary forces in the economy, and complicates the whole picture. Yet it is fundamental that the currency demands of the economy be understood to formulate effective policy. Part of the credit policy which was publicized to aid monetary authorities was the advice of discouraging credit and installment buying, and of encouraging the paying of 214 N debts, mortgages and other obligations. This was similar to the policy suggested for local and state governments; it was new applied to individuals. Installment credit regula tions were made more rigorous by calling for more down payments and less time to pay; the coverage was also broadened. Certain credit avenues were being tightened, while others that could help the war effort were being eased. It was beginning to be a policy of selective controls, and the government under the stress of war was taking over more and more the function of banking. Treasury policy was formulated along similar lines, as it was stated: Policies followed by the Treasury in its borrowing program are formula ted with a view to raising the necessary funds to as large an extent as possible by selling securities to investors other than commercial banks. The purpose of this policy is twofold: first, to divert q portion of the public's growing income from the purchase of commodities and property to helping In the war effort and, second, to reduce as much as possible the expansion of the already large volume of bank deposits. 41 Such policy would fit in with reducing credit along the same lines as well as helping to ease the problem of funds for the Treasury war operations. Taxes would also aid in this objective. Following this policy, special bonds were issued that were not to be available to commercialbanks for 10 years; the market for them were mostly the insurance 41 Federal Reserve Bulletin, 28:525, June, 1942. 215 companies. They were not to be transferable for 60 days, and would be callable In 20 years. Seven to nine year bonds were issued in not less than 10,000 dollar lots. This was the beginning of what some har e alluded to as the oompart- mentalization of the market. This may yet be of valuable assistance in fiscal policy; it is worthy of consideration. Short-term issues by the Treasury began to increase in order to present banks with needed liquid investments. These issues facilitated the smooth functioning of the money market, and the rates were increased to get more fluidity into the market and more funds. It appeared that the Treasury and Reserve authorities were looking to a tightened market, and wished for more funds in this sector to ease the situation later., ^t also had the effect, or the beginning of the effect, to shorten the average maturity on the public debt • The exclusion of non-taxable issues from further operations by law had reduced the partially tax exempt issues rates below 2 per cent, while taxable bonds were at 2,35 per cent. Credit remained easy with over 3 billion dollars in excess reserves. One announcement of importance was that of the Open 42 Market Committee on April30, that the FederaL Reserve Banks 42 Federal Reserve Bulletin, 28:553, June, 1942, 216 stand ready to purchase all Treasury bills offered at *375 per cent. This pegged the price of treasury bills, and was to be a very effective aid in setting up a pattern of interest rates on government securities. As may be inferred, government paper was becoming the dominant factor in the money and capital markets; it was unquestionably a necessity under the exigencies of war. Treasury policy was henceforth, for the duration at least, to be Federal Reserve Policy. For the time being, the Treasury stated it would continue its policy of accepting the highest bids on its shortest paper* Taxation. Taxes were increased all along the line by the Revenue Act of 1941, with income taxes to be the main source. Yet the debt increased to 72.42 billion dollars in the course of the fiscal year. Sudden demands of war finance which had to be met quickly were largely accountable for the increase in debt which was composed mostly of bonds and savings bonds. The average rate on the debt declined from the previous 2,51, indicating that rates were still falling and that maturity may have been shortened. The limit on the public debt was set at 125 billion dollars by Act of Congress. A step toward simplification of control of the debt structure was the centralization of funds, for federal agencies were to be handled by the Treasury, and the sale of guaranteed obligations was to cease# 217 Generally speaking, however, the Treasury policy for the war was enunciated by Secretary Morganthaui Our task is more than raising a huge amount of new revenue. . .it is to facilitate the maximum production of war materials, hasten the mobilization of our resources, strengthen the unity of our people for the waging of total war and prepare us for the new economic and social problems that will face us when the war is won. . .We should, therefore, tax so as to withdraw the greatest volume of purchasing power at this time, when money incomes are high and the quantity of goods for civilian use is shrinking day by day because of the demands of our war effort. 43 This meant raising the rates of taxes and removing special privileges; it also meant large borrowing for the needs of 44 the government. This was being done by trying to get as large a portion of its funds as possible from current con sumer's income. This objective was furthered by a new form of note--the tax-anticipation note— which was to be used to increase the effectiveness of the income tax as a check on current purchasing power. 43 Annual Report of the Secretary of the Treasury for the Fis c al~Tejr~l'51Tl~g,~p."563. 44 Ibid., p. 354. Secretary Morganthau at an earlier date had said that "Borrowing should be kept at a minimum to maintain our fiscal strength. The rise in the Federal debt means merely that the taxpayer's burden is being postponed that both principal and interest must be paid later out of higher taxes collected at a time when they may be harder to pay and less willingly paid than now. . .increased taxation is needed also to maintain economic stability. . .this larger needed revenue shouM come from all sources where there is ability to pay--that's what an "all out" tax program means." 218 Credit controls. The Treasury's credit policy, generally was to control hank credit, and to create controls over selected capital expenditures. This policy was aided by priorities control from the Office of Production Manage ment . The Treasury advocated low interest rates, and advised against bankers charging unreasonable rates. The Treasury emphasized that it would continue the policy of the Federal Reserve System, and suggested a pattern varying from .375 per cent on short-term bills to 2.5 per cent on the long term bonds. It issued some short-term paper in these months of 1942 in order to provide liquid paper for reserves of depreciation and depletion, and to maintain a fluid money market• This policy was backed up by the Federal Reserve System; it was explained that these short-term issues were to allow banking and business to earn a reasonable return on such funds as are temporarily idle. This attitude showed that the authorities were aware of the cash demands of the economy. It also indicated that these funds temporarily idle could be used to help to finance the war. A measure was passed in July 194-2 by Congress allowing member banks to make loans and pay dividends when its reserves were below required minimum. At the same time, the method of figuring reserves was changed so as to use an average over a one-week period. The Board of Governors were 219 also empowered to change the reserve requlrem.ents of the central reserve city banks, without changing all reserve 45 requirements in the system. Two measures which were taken to ease the credit condition were (1) the central reserve city bank reserve requirements were reduced to 24 per cent of net demand deposits, and (2) the short-term rates were raised to draw idle money into the money market. Excess reserves declined. Open Market Committee purchases of short-term paper were increased to supply needed revenues to banks. Interest rates for certificates and notes rose slightly. One interpretation of these financial manoeuvers was tha t: Banks still have 2.25 billion in excess reserves, and the authorities want to cut that down before they relax their grip. They are afraid that pumping new reserves Into the system now would make monetary control just that much harder in the post-wan period. . .Since April the Reserve banks have been steady purchasers in the Open market. So far they have taken up 1 billion dollars worth of government securities* 46 Rather than pump new reserves into the system, the reserve requirements in the central reserve city banks were reduced to 20 p>er cent beginning in early October. Excess reserves rose as a consequence to 3 billion dollars, due to this as 45 Federal Reserve Bulletin, 28:739, August, 1942. 46 Business Week, p. 94, August 15, 1942. 220 well as to the Treasury operations. Rates remained steady. Discount rates on advances to member banks were established at .50 per cent if loans were secured by the United States Government obligations maturing or callable in one year or less. Loan rates at banks were investigated by the Federal Reserve in this period; the conclusions arrived at by the investigators were that differences in rates depended on the size of the borrower, size of the banl£, the geographic area, and the size of the city. The average rate on the long term to big borrowers was higher than the short-term, but overall the long-term rate was lower because the bulk of the loans went to large borrowers on long-term. Another faGtor causing the difference in interest rates was the cost of making these loans to big and small borrowers, the cost to the latter being in higher proportion to the loan as a consequence. Risk is another factor to be considered, and is due to the nature of the borrower’s business which in turn affects rates; this latter type of loan has failed to decline relatively as much as the others. Nevertheless, although there has been a lag, such types of rates have declined along with all interest rates over a long period of 47 time. 47 Federal Reserve Bulletin, 28:1075, November, 1942. 221 Excess reserves declined to 2.4 billion dollars after the reserve requirements were reduced as ordered by October 3rd. Government borrowing increased in November to 9 billion dollars a month, and the government debt passed the 100 billion dollar level; it had been largely financed by 2.5 per cent bonds and securities of lesser maturity at lower rates. 4 peculiar feature of the situation was the rise in the demand for currency, for which the authorities couM give no adequate explanation, except that: the demand for currency both for active use and for other purposes is being readily met by the banking system. • .This may be due to previous lack of need for such facilities, to bank service charges, or to disruption of established banking and credit connection because of shifts in residence. 48 It had been claimed that it was substantiated in those regions where war plants were set up. It seemed to this writer that the previous lack of need for such amounts would be a better explanation. This analysis would follow the Keynesian explanation.that cash balances could readily broaden the scope of liquidity preference rather tba n as originally defined for speculative motive. This broader interpretation leans toward a Wicksellian explanation, and its relationship to interest rates. The post-war conditions were already beginning to 48 Federal Reserve Bulletin, 28:1179, December, 19 42 222 concern the monetary authorities because of the rise in income and cash-balances. It was felt that more emphasis should be given to long-term borrowing, which was relatively low. Further, it was felt that it would be better for the government to continue financing at a higher cost in order to ease the problem of monetary control in the post-war era, 49 The role of interest as a capitalization factor in determining the value of capital was an important function along with its normal one of influencing the direction of production. Even here, however, the control of interest resulted in the necessity for providing large cash balances to commercial banks in order that they might buy government 49 These remakrs were later tkane up by two other economists, the first was M.Moonitz, who said: "In addition to measuring and eliminating costs, the rate of interest serves as a capitalization factor, . .even though interest is not of great importance as a cost factor, the role of interest as a capitalization factor would seem capable of restoring it to a position of prominance." Journal of Political Economy, 51:354, August, 1943. The second economist was F.A, Lutz, who said: "Economists and monetary authorities. . .regarded interest policy as an effective instrument by which the volume of investments would be contracted or expanded. Even today the view has not been abandoned, although the emphasis has definitely shifted away from the interest policy toward variations in public expenditures," F.A.Lutz, "Interest Rate and Investment in a Dynamic Economy," American Economic Review, 35:811, December, 1945. Lutz also said: "A fall in the interest rate is, therefore, most likely to affect those Industries with equipment of long durability and a high ratio of machine costs to operating expenses," p. 821. 223 Issues to keep the rate down. Here was felt the clash between monetary and fiscal policies, alluded to before, concerning the higher cost of government operations. Even beyond that, confidence in money militates against excessive supply, and therefore against prices. In this way price policy becomes an important adjunct of monetary policy, which under such conditions must be conrdinated with 50 fiscal policy. The burden of the public debt depended, however, not only upon interest rates but upon prices both now and after the war and, indeed, upon all the factors affecting the national income. It will kikewise depend upon the size of the debt, which will increase or prevent lowering of taxes to some extent. The problem of fiscal financing in this period during 1943 was mainly one of choosing the most effective way to reduce current income. The method agreed upon, in addition to taxation, was that of selling government securities to non-bank investors; the reason for this was the fact that the more bonds that were sold to the banks,' the more money became available to the economy. This decision let to increased action on the part of all government authorities 50 Federal Reserve Bulletin, 29:22, January, 1943. This discussion was taken from the 1 1 Annual Report of the Bank for International Settlements." 224 in selling bonds to the public and in reducing to a minimum the borrowing from the banks. This tactic was very success ful; there was a rapid growth of holdings by non-banking investors. Along with this type of financing was the increased variety of government issues to meet the needs of as many different types of investors as was feasible. This financing was done in cooperation with the Federal Reserve System. Purchases were sought from the smallest wage earner as well as from the largest institutions. As a result of this coordinated drive, Reserve Bank holdings of government 51 securities fell below 6 billion dollars in February, 1943. The effects of these shifts in industry to meet the war needs, and the continued efforts of the Treasury to spend funds resulted in an increase of both deposits and security holding in the rural areas. Excess reserves were ever shifting to the country banks. The currency demands were also increasing in these areas. Provisions at this time were made for special deposits at the member banks which would not require reserves. The purpose of these deposits was to reduce the impact of the war savings bond drives on the money market. This operation was accomplished by shifting individual’s deposits on the 51 Federal Reserve Bulletin, 29:141, February, 1943. 225 bank books Into war loan accounts which required no reserves. The banks were allowed to sell Treasury bills to the Federal Reserve Banks with a repurchase option, which was provided to steady conditions in the money market, Another method of lessening fluctuations in the money market which was resorted to was the reissue of one-day certificates in lieu of anticipated taxes. The Treasury issued these certificates at a large initial sum; as the tax. payments poured in, they reduced the issue daily until the flood of taxes subsided. The first four months of 1943 revealed that the banks had bought 41 per cent of the total issued for the period. It was the announced policy at this time that in future bond drives the banks' purchases would be held down to 35 per cent of the issue in the next four months, and reduced to 25 per 52 cent by the end of the year. The Treasury was disposed to note the increasing demand for currency; Under-Secretary Bell remarked! "- - -the great war time expansion in the economy require s— even at a constant price level— a great increase in the available supply of currency and bank deposits; this increase under our existing institutions and under war time conditions can be supplied only by 52 Federal Reserve Bulletin, 29:377, May, 1943, It was also announced during this period that currency had increased from approximately 4 billion in 19© to nearly 17 billion by May of 1943, 226 53 an increase in Government borrowing. Thus it was that the debt increased by the same amount as the preceding year, but the average rate on the debt declined to 1.92 per cent. Tax rates were increased to the extent that although expenditures increased, a more than equal increase on the debt by the amount of increased expenditure was prevented. The excess of Federal spending over Federal taxes is equal to more than one-quarter of the gross national product. They felt that it would be imprudent not to hold down the growth of the debt by buying the goods with as large an amount in taxes as possible, which could be done without risk of unemployment of men or resources. Treasury policy at this time may be summarized as follows; necessary funds should be raised in such a manner as to minimize the risk of Inflation; the liquidity of the nation's financial institutions should be maintained and increased, thereby placing them in a strong position to confront the problem of the post-war period; small investors in government securities should be protected against losses; the cost of the war should be kept at a reasonable level. One of the ways the Treasury pursued this policy was 53 Annual Report of the Secretary of the Treasury for the Fiseal YeaFT9~^-lg,~pT 227 54 to seek the broader markets of non-bank investors, and to issue non-negative securities to prevent panics and maintain orderly conditions in the money market. Contributing to this was the issue of bonds of not over 10 year-maturity to the banks. Finally, we have endeavored to finance the war at a reasonable level of interest rates. We have received in this endeavor the whole-hearted cooperation of the Federal Reserve System, the commercial, banks, and the public generally; and I believe that the results which have been obtained are a tribute to the democratic method of war finance and will contribute immeasurably to the stability of the economy in the post-war period. 55 This last was written by the Secretary of the Treasury as the capstone of his discussion of Treasury policy. Stability and liquidity in the money market was aided, as has already been mentioned, by the exemption of war loan accounts from reserves, by the use of one-day certificates, by the increased use of short-term securities which were to be employed for prompt adjustment of reserves to deposits, and finally by the posted buying rate on bills at £3$S5per cent; it was felt that this last measure contributed to the ease of the money market. 54 Ibid., p. 5. Under-Secretary Bell said: ’ *I have tri^d to emphasize that it is our firm belief in the Treasury that we should borrow from commercial banks only on a residual basis--that is to resort to the commercial banks only after every effort has been made to finance the deficit from other sources.” p. 277. 55 Ibid., p. 8. 228 Under the Revenue Act of 1942, taxes were to be collected at source; this accomplished the two-fold program of stabilizing the money market by avoiding huge flows of funds periodically, and of reducing inflationary income at its source. It also accomplished a major reform in tax collection, and helped to simplify taxes for a vast majority of individuals. War debt. The debt stood at 136.696 billion dollars at the end of the fiscal year 1943, and the war cost was 92 per cent of the total budget. Bonds were authorized as collateral security until 1945. The average rate on the debt remained at 1.98 per cent despite the cessation of tax- exempt issues. The debt limit was raised to 2L0 billion dollars. In spite of the huge debt and its further anticipated increase, the rates of interest seemed to remain relatively steady in the pattern decided upon by the authorities. So great was the debt that the Secretary of the Treasury thought it advisable to remark on the subject: While an internal debt, such as outs will be, serves neither to ©nrich nor to Impoverish a nation. . . there will be the problem of what kind of taxes to employ to service and repay the debt. . .It will also involve the impact of taxes on investment, consumption and therefore, the national income- - -raise problems in regard to banking and currency policy. 56 56 Ibid., p. 395 229 It might also be added that such a debt, if it shall not impoverish the nation, means that it is imperative that full employment and high national income be maintained. Liquidity of the banks was the main objective of this period, as the excess reserves were just slightly over a billion dollars. Treasury bill holdings were increased in the banks, but these holdings were now confined by the authorities to short-and intermediate-term paper, so that the issues to be eligible for the banks must have a maturity not over 10 years. These were preferable at any rate for institutions whose liabilities are largely payable on demand. The war loan drive of July, 1943 was aimed at selling 15 billion dollars in bonds to individuals and institutions other than banks; the banks were to be offered a special issue after this drive. The excess reserves at the banks continued to decline, and customer rates continued to rise from a low of 2 per cent the preceding year to 3 per cent 57 at this time. This indicated that loans were increasing as well as deposits and cash balances# This drive was successful; rates in the money market were stabilized, and reserves were maintained with the aid of repurchase option on Treasury bills# It was able to be reported that reserves and yields on government paper were Federal Reserve Bulletin, 29;712, August, 1943# 230 consistent with the requirements estimated by the authorities. Excess reserves were no lcnger considered a major item, having been able to substitute liquidity of government issues by maintaining their rates for actual cash and reserve needs of the banks. The pattern of interest rates were preserved over a period of two years, and from the language used by the authorities, it seemed that a major victory had been won in the financial struggle to maintain 58 stability and meet the requirements of war. Other measures, however, such as taxes and price control, had aided the authorities• Nevertheless, borrowing had to continue; this merely shifted the allocation of the burden of the debt of future taxes which in turn were to have been paid more by those who have born the real burden of the war in the armed services, A much more equitable distribution would have been accomplished by higher taxes. Therefore, to this end, the taxes were increased in 1943, Care was taken in the financing of the war not to tax away funds that were needed to keep the war machine 58 Federal Reserve Bulletin, 29:1146, December, 1943, The report "continued! "The general result of these operations and of those to supply reserves has been that the Reserve Banks have purchased from member banks short-term, low-rate securiti es--Treasury bills and cert ificates--and during this year have actual, ly sold notes and bonds,” 231 functioning smoothly, so these funds when possible were favored# Funds were left untouched that would add to incentive, and whose demands for currency were manifest; borrowing was used to supply these* By the beginning of 1944 it could be said that war borrowing hqd cost the government an average of 1,75 per cent; this was far lower than the first World War which had cost 4.25 per cent. In addition, rates remained stable during the war period, and there was confidence that this situation could be continued. This confidence was manifest in the success of the war loan drives to date, revealing at least partly that investors were not anticipating any 59 increase in rates. Post-war considerations. A partial program for the early post-war years was suggested in 1944. Attention was called to the funds of corporations at the great heights of 20 billion dollars in bonds and 30 billion dollars in deposits which would act as a cushion for the post-war reconversion to precede production. Renegotiation and cancellation of contracts were to be carried out as quickly as possible to facilitate reconversion with ready funds. Loss-carry-forward provisions in the revenue acts would 59 Federal Reserve Bulletin, 30:32, January, 1944 232 enable business to gain possession of funds needed for reconversion with a minimum of inconvenience* Taxes were to be as high as possible, and controls were to be maintain ed as necessary until supply caught up with demand in this post-war period. Excess reserves of member banks continued to rise, as did the commercial loans. Government financing was expected to reach the 100 billion dollar mark for the fiscal year, of which 60 billion dollars was estimated to be borrowed; rates on government paper were stable. The borrowing was to come mostly from individuals, which would reduce inflationary pressures and bring about a xvide distribution of the debt. The banks shortened the maturity on the debt they held , and this may have been in anticipation of increased demand for currency. The need for taxes was apparent from the figures given above; these assets also had effects through out the whole system on consumption, saving and investments. The disproportion between these assets and goods may cause fluctuation and most certainly would build up pressure against controls. More and more it was becoming evidence that monetary author ites were turning their energies toward solving the post-war problems, having considered the financial battle of the war already won. Chairman Eccles made this clear when he said: 253 . . .every attempt should be made to balance the budget at the earliest possible moment after the war • . .a balanced budget, on the other hand, will encourage the owners of governments bonds to retain their holdings because it will assure them that the purchasing power of their money invested in bonds will be preserved. . .merely making funds available, however, low the cost will not induce expansion unless business is assured of a market for its increased production. • .the import of fiscal policies on the spending stream is far more direct and powerful. • • by wise policy correctly timed, the government can thus be a balance wheel and a stabilizing influence in helping to maintain a high level of production and employment. 60 Eccles seemed to feel that the full employment objective is accomplished by maintaining a high level of consumption outlays. This was to have been accomplished by income taxes, expanded social security, reduction of double taxation, loss-carry-forward and back provisions, increase of small enterprises, public patent pools, and a flexible tax structure. This thinking had apparently involved a major emphasis for greater flexibility on fiscal operations as well as a recommendation of the same for the whole economy. The situation, interest-rate-wise, remained stable at the end of the fiscal year, but the excess reserves of member banks showed fluctuations and were below a billion dollars for the first time in years. The government borrowing operations continued in July, 1944 with commercial 60 Federal Reserve Bulletin, 30:224, March, 1944. 234 banks excluded from purchasing government bonds, as they had been the previous year, except for purchases for savings accounts. Currency increased in the economy. Borrowing by the government for the fiscal year was approximately one- half the gross national product* Taxation in the fiscal year 1943-1944 was emphasized in the Treasury report for the fiscal year, and the Treasury authorities warned that unless taxes remained high relaxation would jeopardize the success of the stabilization program. On the other hand, too great a delay in adjustment of taxes might jeopardize the maintenance of high levels of employment and business activity. The Treasury's report continued: It should be a major object of fiscal policy in the post war period to reduce the amount of the debt insofar as this is compatible with the maintenance of full employment. . .continued low interest rates will be a major contribution to economic stability and the maintenance of full employment after the war, for low interest rates stimulate business and encourage new enterprises* 61 Bond selling operations of the Treasury were emphasized as contributing to stability of the economy by varied issues of securities to meet the needs of the investors, aided of course by open market operations. The composition of the debt aided in releasing the purchasing 61 Annual Report of the Secretary of the Treasury for the Fiscal Year 19 43-44, p.“77 235 power at the proper time by staggering maturities, and could therefore contribute to stabilization. The importance of the short-term security issues for the Treasury is obvious, and will not be reduced in peace time. In fact, the shifting by banks out of short-term securities would merely increase the cost of the debt, and would add to the risk of the private investors In future changes of the interest rates. In fact, a refunding of this nature would tend to increase the danger of changes in Interest rates, and reduce the Treasury’s ability to stabilize the economy at high levels of income and employment. This was not the whole story, for as one author!ty has said: Business knows that fiscal policy alone cannot produce a healthy condition of high employment and high production. In addition to a sound fiscal policy there must be government stability, protection against illegal aggression, confidence in the outlook for profitable relationships between volume, cost, and prices, access to markets and to capital, and to the means of production. But sound fiscal policy will aid strongly in getting the high production and high employment we all want. . .it Is inescapable that the national state through a clear and workable fiscal and monetary policy, must complement and supplement the activities of private business in the maintenance of high production and high employment. 62 62 Beardsley Ruml, "Post-War Potentials,” Vital Speeches, 10:566, July 1, 1944. He also suggested"f that tax rat;e structure be stabilized to balance the budget at high, level of employment; lower the income tax but retain progressive tax on income and estates, stabilize construc tion of industry through public loans, and keep only the important excise taxes. Foreign loans should be coordinated. The Social Security out-go and income should be balanced at a high level with the proper rates* 236 The cash balances of the Treasury must be accorded some notice at this point, fir they had reached at the end of fiscal year 1943-44 an all-tim© high of over 20 billion dollars, necessary it was claimed to meet the requirements of so many transactions being carried out by the Treasury. It would seem that even the government finds it necessary, ignoring war needs, to carry a larger cash balance when activities are at high levels. Since 1934 the cash balance has been below 2 billion dollars only twice and then only slightly. The debt had increased to over 200 billion dollars by the end of the fiscal year 1943-44; 40 per cent of this amount was held by banks. The dominant issue was bonds, but certificates and bills were a much larger part of the debt 63 than during prewar times. The monetary policy continued along Its traditional lines of stabilization and adequate reserves. Interest rates on government securities were expected to be steady perhaps because of arbitrary government action, and a rise unlikely In the post-wqr period because of the large supply of investment funds such as there would b© after the war. Bank holdings, for instance, matured in five years, that is 63 See adjoining table of Outstanding Debt of the Fiscal Year 1943-1944. 237 TABLE III * PUBLIC DEBT OUTSTANDING JUNE 30, 1944 Debts Millions Interest bearing public issues marketable Postal savings bond, authorized by Act prior to April 6, 1917 . $ 196 Treasury bonds 79,244 Treasury notes 17,405 Certificates of Indebtedness 28,822 Treasury bills 14,734 Non-marketable Issues U.S. saviqgs bonds 34,606 Depository bonds 474 Adjusted service bonds 217 Treasury notes, tax series 9,557 and savings series Special issues to trust funds 14,283 Total interest bearing debt 199,543 Matured debt, interest ceased 201 Debt bearing, no interest 1,259 Total gross debt #201,003 • ^Annual Report of the Secretary of the Treasury for the Fiscal Year 1944, p. 68. 238 60 per cent did, while only 14 per cent would have to wait 10 years. The low interest rates protected the banks from a deterioration of their assets because a rise in the rate of interest would have meant a reduction in the value of the bonds held by the banks* Additionally, this nation became a greater creditor than ever before. This denoted a surplus of capital which is not consistent with high interest rates. It was thought that banks having these assets at low interest rates would be stimulated to pioneer new fields of 64 lending* Since interest rates were low and the prospects were / that they would continue to be low, the burden of the debt was thereby reduced. It was argued that £js,the national income increases the debt may be larger without increasing the burden of the debt. Generally this is true, and for further supplementation, it was necessary to issue debt obligations in such a way as to reduce inflationary pressures. This latter method was an integral part of the financing principle of the monetary authorities. Thus the cost of the government debt had been kept down by the manoeuver to refund into low cost short-term securities at the proper times. It is the stated policy of the Treasury to continue such practices and to keep the interest rate down. 64 Federal Reserve Bulletin, 30:871-873, September, 1944, 239 However, since the control of the market has been so well established, the control of interest rates was relegated to an insignificant position. Mainly, the amount of borrowing has been the interest of the authorities since that time. Reserves of member banks had been preserved by reliance : on sales by banks of short-term securities to Federal Reserve Banks. .Deposits had noticeably been spread throughout the country, bringing greater equalization of financial resources. Reserves were constantly dropping, and it was thought by the end of 1945 that there would be need of some measures to restore adequacy to reserve funds. The demand for currency was held largely responsible for this inadequacy. One report revealed that there was a controversy over the reduction of gold backing the 64 currency from 40 per cent to 25 per cent and over the reduction of gold behind deposits in the Reserve Banks, which was to be reduced to 25 per cent from a former 35 per cent. The March, 1945 issue of the Federal Reserve Bulletin entered a report for the first time in a year on bond yields. Long-term rates were at 2.39 per cent which was the lowest since 1941, with intermediate-term rates at 1.78, a decline from a previous high of 1.92 per cent. 64 Business Week, pp. 54-57, February 17, 1945. 240 Conclusions. The theory of interest and the policy of monetary yieM s had undergone great change in the years 1939-45. The effects of theory changes were beginning to be felt in policy circles, as has already been recorded. There are six major groups of conclusions concerning interest rates and policy development which may be derived from a study of this period# (1) Interest rates# Some doubt has been cast upon the traditional role of interest as a regulator of the econ omy. Low interest or cheap money had failed to sustain the high level of economic activity in the period 1937-8. How important low interest rates were quantitatively, it is difficult to determine since we cannot ascertain how much investment would have been undertaken at a higher rate of interest. Apparently a low rate had failed to stimulate the economy as much as had been expected. It has been concluded that some long-term investment was stimulated, ©specially in housing. Heavy capital investment, however, was aided directly by other measures, such as direct loans, and government lending agencies. The second major element of development in interest policy was the emphasis on short-term rates of interest. The relation of the short-term rate to the control of the long-term rate was rediscovered by the theorists in the thirties, and appropriated by the policy makers to facilitate 241 monetary and fiscal policy.. Theory had placed the short term rate in a strategic position to control the structure of interest rates. It was used as the major weapon of monetary authority as time progressed in the late thirties, and remained so throughout the rest of the period covered by thi s study. It was also contended in theory developments during these years that it was not interest that controlled saving. This contention that savings vary to a degree with income has been supported by statistical data. The degree of correlation which exists between income and savings remains a question for greater research. It is, however, a plausible theory that savings does depend to a certain degree on income as well as interest rates. This contention has been supported by Secretary Morganthau, who stated: Personally I do not anticipate a rise in interest r£tes in the foreseeable future. Savings are abundant and promise to be adequate to meet all likely needs. We believe, therefore, that we shall be able to refund our obligations, as they come due, at rates comparable to those now prevailing. Thus, the saving to the Treasury will continue over a long period of years . . . 67 (2) Gold. Intimately related with the interest question \vas the gold problem. The inflow of gold experienc ed by this country, it has been argued, would have kept S'7 Annua 1 Report of the Secretary of the Treasury for the Fiscal Year 1944-45, p.414-4X5'. Address given Tri Los Angeles October ±4, 1944• He added that he saw no need for funding into long term issues because of cost and would also shift the risk to others than the government of changing rates. 242 interest rates down by providing more money regardless of policy. It was certainly an aid to the monetary authorities, in maintaining low interest. (3) Folicy changes. The effect of war tension and war itself was certainly a stimulant to american industry. As economic activity increased in 1938-9, more loans were necessary to supply the needs of business, and a marked Increase took place. The threat of inflation was recognized by the monetary authorities, and a shift in policy resulted. The short-term rate of interest was allowed to rise in order to restrain credit expansion. This rise in the rat© reflected undeniable recognition of the traditional function of interest as a control of demand for funds for investment. The advent of war in 1941 made it incumbent upon the government to supply the necessary funds for the successful persecution of the war. The supply of credit was aided by the direct purchase of Treasury bonds by the Federal Reserve banks, and war loan savings accounts were exempted from reserve requirements. Thus in the short period of eighteen months monetary policy was forced to shift back to easy money as a necessary measure of financing the war quickly and adequately. (4) Specific measures. Many specific measures were adopted by the monetary and fiscal authorities to obtain their objectives. As has been noted, these objectives 243 varied with the economic and political circumstances. Credit to small businesses at low rates was consistently the objective of the authorities. Special efforts were continually being made to help this important segment of the economy to vih ich credit was so necessary. This policy was to be continued in the post-war era. The late thirties and the war years brought about concerted action by the authorities to stabilize and maintain orderly condition in the money market. To do this the rediscount rate, open market operation and reserve require ments were so regulated. This policy meant supplying credit when the need indicated. it was one of the original ideas embodied in the Federal Reserve System to maintain an elastic currency supply. The Treasury cooperated by fixing the interest pattern on government debt paper, the use of bills was emphasized in order to keep a part of the debt flexible and to maintain.contact with market conditions. Starting ih 1935 the Treasury issued savings bonds. The purpose of these bonds was to reduce excess purchasing power, to provide an investment outlet for savings and to prevent overdependence on bank financing. During the war these bonds were publicized to stimulate bond sales to the public, thereby avoiding excessive credit expansion through the banks. 244 (5) Cash balance. One important development of recent years was the recognition of the need for cash balances of the various economic units in the economy. It may also be noted that the Treasury’s cash balance grew rather consistently over the years. Treasury’s cash balance may have been core idered a necessity or a substitute for open market operations. (6) Policy appraisal. There was undoubtedly a recognition that fiscal and monetary action needed to be coordinated at every level as the Secretary of the Treasury added: The need for welling together the separate parts of the Federal Fiscal program is great today and will assume even more importance after the war when the preservation of delicate balances between taxation, borrowing, spending and lending will be essential to a healthy internal economy, and to fulfilling of our international responsibilities. 68 War time control of interest rates at a low level had been highly successful since 1942. Only in 1945 was the full extent of the control realized. Possibly the high point of war finance came in 1942. It has been remarked by several sources with appropriate comments that maybe reproduced here: Not many bankers realized it at the time (October, 1942, borrowing by the Treasury of a 2 per cent 10 year bond) but with that operation the Treasury set up its 68 Ibid., p. 430. 245 schedule of interest rates for war time borrowing and served notice that the banks would have to do business on its terms. 69 This operation undoubtedly helped; this period in late 1942 seemed to be crucial in the opinion of the authorities. Another more considered opinion revealed much the same thing when an economist remarked, when the Treasury guaranteed the rate structure in 1942: . . .it is to be wondered that there was not a greater shift to higher yielding bonds. Apparently the government's guarantee was not understood or taken seriously. In addition, banks were forbidden to participate directly in the later Victory Loan drives and the new longer issues were barred to commercial banks (except for smallamounts as related to savings deposits) for considerable periods of time. . • When in November 1944 the British gave the easy money screw another twist by replacing the 2.5 per cent 52-50 with 1.75 per cent 50, the American money market belatedly realized that the United States Treasury had a firm grip on the money market and was in a position to push for lower rates. . .since then banks and other investors have been reaching out for the longest maturities available to them. 70 This meant in effect that interest rate control was apparently firmly in the hands of the Federal Government. The ability of the government to sell to individuals since 1944 in particular was invaluable aid in this control. It 69 Business Week, p. 77, May, 1945. 70 P.A. Samuelson, MThe Turn of the Screw,1 1 American Economic Review, 55:675, September, 1945. 246 appeared considering the vastness of the debt that this 71 control would remain undisturbed for years to come* One of the major weapons in the government credit policies has been the short-term security. It provided liquidity and shiftability without strain on the markets. It could be and had been used for tax payments and reconversion reserves. The government, however, comprises such a large segment of the total market and has such a high degree of responsibility with respect to the remainder that so far as government securities are concerned, market values are essentially the same thing as cash redemptions* 72 Thus the government was conscious of the fact that the operation of forces in the- short-rate were very important throughout the capital market. Since it was such a force it had a great responsibility to the rest of the market. This manipulation of the short-term rate proved to a certain extent the Keynesian theories of regulating interest rates, and using the short-term rate as a major control device* However, an important consideration had been emphasized by the authorities, and that was that a rise in ^ Business Week, p. 78, May, 1945. Selling of part of vast deh't to indl~vlci.ua 1 s, ’ ’This means that the country's banking and credit system will operate under strict Federal control for many years after the war, probably permanently. 72 Annual Report of the Secretary of the Treasury for the Pis cal Year 19'4'4-'4B'., ppT 411-412. 247 the rate of interest might cause a large exodus from government securities, and could almost precipitate panic conditions as well as the very thing that was to be avoided inflation. It would not suffice to hold back spending in the immediate post war era1 . The low interest rate certainly made the economy highly vulnerable to inflation. Such policy had been advocated by Keynes and his followers, but in a hi^ily liquid economy such a policy might lead to drastic consequences. This is a major element of weakness in the Keynesian policy and the government’s policy in the ensuing post-war period. Taxation was to loom up as a major control which might be effective in preventing a serious inflation, and apparently was the only counter-inflationary measure considered important in preventing the inflation that low interest which was to be maintained might foster. The low interest rate reduced the cost of the government debt, but at the same time it also reduced the returns on fixed investment which were largely subscribed to by financial and other institutions and other investors. These fixed income recipients would have to bear the brunt of any inflation. This would be a necessary consequence of the Keynesian theory and the government policy which had developed since 1933* CHAPTER VI POST WAR FINANCE AND INFLATION This section completes the period under investigation, especially regarding policy intentions as they affect interest rate developments. Cognizance of the conflicting theories and pressures will be - concluded. The sources will be largely the same as in previous chapterp, but greater public awareness of the problem will be developed from current periodicals, and further statistical figures will be included. The developments noted will be related to theoretical implications and to the problem of the aftermath of war finance. REVIEW The realization that a policy was necessary for the post-war to prevent an unstable economic situation has already been mentioned. .This question was assuming more importance as the war approached its conclusion. The public itself was concerned with its solution, and one of the periodicals contained this comment from one of the leading authorities: The main implementation of monetary stabilization should be found In changes of the relative flows of federal revenues and expenditures. If large changes prove necessary, they should take mainly the form of 249 large revenue shifts around the relatively stable flow of federal spending. 1 Related intimately with this overall statement, however, was the questicn of monetary policy which although relegated to a lesser position during the war, was to begin to present problems for solution as the war reached its anti climax with the surrender of the Japanese. This is not the place to do more than mention how the reduction in the interest rates and the increase in money was achieved. The Federal Reserve Banks by open market operations made large amounts of cash available to banks. These banks by using up their excess reserves and by their willingness to risk a rise in long-term rates succeeded in bringing about an increase in currency. The purchase by member banks of large amounts of low yielding, short-term securities was encouraged* A brief review reveals that under the Hew Deal as under Hoover, "net borrowing operations continued, Treasury note issues supplying the bulk of the funds until later in 2 1935 when bond financing began." Although the certificates issued on a quarterly basis were eliminated slowly after 1' Simons, H.C., "The United States Holds the Cards," Fontune, 30 p. 158, September, 1944. 2 Edw. C. Simmons, "Position of the Treasury Bill on The Public Debt," Journa1 of Political Economy, 55:335, August, 19 47. 250 1934, they were revived during the war and along with bills constituted a large amount of the debt during the war. Bills issued weekly allowed more flexibility. These bills had repurchase provisions to help meet reserve requirements, and were given preferential rights to new issues, which resulted almost in a negative yield, and certainly gave the bills high liquidity. Furthermore, there had been a deliberate Treasury policy of tailoring yields to the market requirements of the different groups with some savers being privileged to buy relatively high yielding issues while the banks were confined 3 to lower yielding ones. Monetary policy was, additionally, interested in providing enough money to assure low rates of interest, and it was evident that it was very successful. This money was also a convenience to the banking system, besides ” the existence of a floating debt serves to reduce the overall -interest burden of the debt since short-term rates are 4 usually below long-term rates.” It was further stated that 3 S.E. Harris, MA One-Percent War,’ 1 Auerican Economic Beyiew, 35:668, September, 1945. Elsewhere Harris has said: ”The war taught the govern ment to isolate markets. . .current policy must above all be protected by price control if the low interest rate policy is to be effective.” The Interest return was low to banks and high to the small investors. Harris, Inflat ion and the American Economy, p. 240. 4 Simmons, op. oit., p. 342. 251 the short-term issue was a Treasury measure to minimize cost. Recently such issue had become a leading factor in debt policy. The question concerning this large volume of liquid assets was whether it was stabilizing to the economy. This remained to be seen. Direct dealings between the Treasury and the Federal Reserve Bank could have accomplished the low^ rates, but was looked upon with disfavor. This operation could have lowered discount rates to member banks, or further control of the Federal Reserve System might have been necessary in raising discount charges. A closely related question was the possibility of the public disgorging, at the end of hostilities, its vast holdings of securities. If this occurred, the government would have no alternative but to have the banks purchase them; it would have been in the latter's Interest not to allow a rise in the rate of interest which could have meant a fall in the price of theirassets of short-term securitie s. The debt which had increased to 256 billion dollars at the. end of fiscal 1945 was carried at a rate just below 2 per cent. This rate indicated the predominance of short term issues, and revealed both the expansion of monetary supply and the demand for greater liquidity. Here price control along with the large supply of money and liquid 252 securities had helped to keep rates down. The maintenance of such stability was the problem at the end of the war and the periods immediately thereafter. The critical issue is not solely or even primarily as it is sometimes argued, whether interest rates on the public debt should be stabilized or whether there should be flexibility in market rates; the structure of the debt itself--that is, the types of securities that evidence the debt, is equally important. With the present debt structure, dominated by short-term marketable debt and by non-marketable issues redeemable virtually on demand, neither a stable nor a flexible interest rate policy will establish the conditions of monetary stability. The policy maintaining stability of interest rates and prices of government securities makes virtually the whole public debt equivalent to money, 5 The public debt of such vast magnitude presented a problem for the whole economy that could not be lightly passed over, and placed the monetary question clearly with the Treasury and Federal Reserve System. It necessarily put the banks under their control and put them more than ever in a position 6 of public responsibility. 5 R.I. Robinson, ‘ ’Monetary Aspects of National Debt Policy,” Viewpoints in Public Financ e, (Henry Hold and Company New York,' 1947), p,634, Extract of a study for the Board of Governors of the Federal Reserve, 1945* 6 Ibid., p, 638. He said; “In modern economic systems the supply of money must be subject to government regulation, if monetary instability is to be avoided. Because money has come to consist predominantly of the demand deposit obliga tions of commercial banks, these institutions — though privately owned— are unavoidably in the public sector; they must be subject to public regulation to a degree that is time of no other part of the business community.n He would except savings banks and savings department of Commercial banks. He also advocated stable purchasing power bonds along with insurance handled by the Treasury as helpful possibilities. 253 Just prior to the end of the war there was a noticeable shift on the part of banks, to medium-term paper and a decline in their yields. This shift might be helpful in restraining expansion of bank credit to prevent an outbreak of inflation. The Board of Governors raised margin requirements for stock exchange trading to 75 percent as an anti-inflation move. The end of the war brought about no price changes for that period or immediately thereafter* Government expenditures continued at a high level that would have led to 100 billion dollars in expenditures if the pace continued throughout the fiscal year. Excess reserves were rising, and holdings of short-term bills and certificates declined while the bond holdings increased* POST-WAR PERIOD The government’s position at the close of the war was the major factor to be considered In the adjustment of production to a peace time basis, for this could not be accomplished overni^it. Business finance during the war had been largely on a short-term basis, which consequently made it liquid and flexible; hence, the government timing of receipts and expenditures became highly important. Some aid in the process of reconversion came from the Contract Settlement Act which provided for termination of contract loans on a liberal basis giving business some measure of 254 cushion to fall back on for the financing of working capital and reconversion problems. The Government had guaranteed loans under twenty-five thousand dollars to small business by means of the Small War Plants Corporation to distribute the benefits of government war business and keep alive small businesses. This was to prove a help to these small plants to conyert to peace time production with a minimum of adjustment and loss. Expansion was anticipated in capital investment and in working capital from the high liquid resources and savings of business. Tax credits for losses in the post-war period were provided by revenue acts. The Victory Loan drive for 11 billion dollars was begun in September, and 30 per cent was to be sold to individuals to reduce the danger of expansion by banks, had they been allowed to buy the whole issue. The loan was to supply the Treasury needs for cash to be used in handling contract settlements and the needs of business resulting in the redemption of bonds. The government was also prepared at this time to set in motion a refunding operation to take advantage of the rise in bond prices and lower rates resulting from this rise; the authorities anticipated a decrease in business activity and thereby a decrease in the need for liquidity or cash balances. Such shifts in holdings of government securities, it was felt, would reflect the savings-investment 255 policies and cash needs of the variolas holders. It is interesting to note the acknowledgement of the Wicksell- Keynes theories of the cash-balance needs of the economy in a period of decreasing activities. The debt was not expect- 7 ed to increase in the 1945-46 fiscal year* The expectation cf'declining monetary needs was slackened, and the rate of monetary expansion declined, showing the decline in government expenditures. Excess reserves went over the 1 billion dollar mark for the first time in many months. The budget message of 1946 warned of drastic cuts in government expenditures, but requested no tax reduction in order to reduce the debt with the continuing high level of revenue that would result. The rise on the amount of interest payments on the public debt indicated an increase in the public debt. A rise of prices especially in securities on the stock exchange was anticipated, and margin requirements were raised to 100 per cent, revealing that the monetary authorities expected the first surge of post-war inflation would come from this sector as the alleged barometer of future conditions in the economy. Monetary expansion was also of paramount importance to the economy, Chairman Eccles of the Board of G-b.vernors of 7 Federal Reserve Bulletin, 31:1095, November, 1945 256 the Federal Reserve stated emphatically: It is imperative that the process of further monetizing of the public debt through the banking system be ended so that the rate of return on investments would be stabilized and would reflect the supply of savings and investment funds in relation to the demand instead of reflecting an increasing amount of bank credit,*, check further unnecessary expansion of commercial bank holdings, 8 Thus, in effect, he made it known that bank purchases of public debt pap er was to continue to be restricted and thereby to restrain any possible rises through the economy. Neverthe- 9 3e ss, in another section VT loans were used to ease adjust ment of reconversion. These loans had been set up first to ease adjustment to war, and now were used to make conditions easily available for business to hasten the increase of production In order to meat the back log of demands. However, the government was doing its best to reduce unnecessary monetary expansion by reductions of the debt wherever possible; nearly 3 billion dollars of the debt was liquidated in March of 1946. Monetary expansion in one quarter was halted in the 8 Federal Reserve Bulletin, 32:121, February, 1946. 9 The VT loan arrangement, announced on September 1, 1943 was a direct outgrowth of the V loan. It provided for guaranteed loans by private institutions to war contractors, not merely to supply working capital needs for war production but also to enable contractors to obtain the use of their working capital upon termination of their government contracts. 257 first months of the year by a cessation of government deficit financing caused by the war. The budget was very close to balancing. Debt retirement .was largely by the redemption of government obligations held by the Federal Reserve Banks and the commercial banks. Bond prices rose, and yields consequently declined even in the early months of 1946 due to less liquidity needs and less bonds available; however, the reverse had set in by April. The borrowing of the government which had shaped the course of the money market had ceased, and new forces were entering the market. The decline in medium- and long-term bonds yield s had narrowed the differentid. in the interest rate structure, and had reduced the incentive for banks to shift from short-to medium-term holdings. Debt retirement tended to reduce the supply of bank reserves and placed vast restriction on 10 further credit expansion. 10 Federal Reserve Bulletin, 32:461 ff. This is related to the Theory and policy of Hansen in Chapter III. He advocated the differential in short- and long-term rates as necessary to continued expansion of the economy, as banks could turn in short-term and buy long-term to keep the long-term rate down as an incentive to production. The operation of redeeming bqnk held bonds was merely a can cellation of Treasury deposits with banks derived from tax funds and retirment of bonds. This reduced bank holdings, wiped out deposits at Federal Reserve banks and reduced reserves. So long as these were excess reserves this tended to restrain banks. If there were none, it would cause a contraction of credit outstanding because of the fractional reserve basis of the banking system, of approximately 5 to 1 on present reserve requirements. > 258 An implementation of reducing inflationary pressures as part of the post war policy would have been to cancel the preferential rate on bank borrowing secured by government obligations due or callable in not more than 1 year. This rate was .5 per cent. This regulation had been in effect since 1942 and had been an aid in expanding the purchases of banks of government obligations to aid the war effort. The huge cash balance of the Treasury vshich was used to reduce the debt outstanding added tothe policy of restraint adopted by the Reserve authorities. The Treasury cash balance had risen to 24 billion dollars in 1945, and was reduced to 14 billion dollars by the close of the fiscal year 19 46. This reduction in cash balance aided in a sharp contraction of the debt. A report about this time revealed that there was some disagreement among policy makers as to the proper steps to pursue and from which direction the chief causes of infit tion might come. Apparently Secretary of the Treasury Vinson was not alarmed about the amount of the debt held by the banking system. This was in contrast with the views of the Chairman of the Board of Governors, Marriner Eccles who felt that this was the primary source of the inflationary pressures. The report continued: The Treasury Secretary argues that new bank loans are just as inflationary as bank purchasing of shcr t-terms obligations. He also contends that there is no assurance 259 that long-term bonds sold to non-bank investors will not later be bought by the banks. 11 Policy was in the formative stage, and with the rapidly changing personnel at the policy level there was bound to be a somewhat indecisive period. This indecision was at least partially resolved by Mr. Snyder’s acceptance of the post of Secretary of the Treasury. His program received the support of the Administration which was largely a banking policy. Some of his objectives agreed with the Eccles policy. Thus it was reported: Mr. Snyder accepts the program offered by the American Banker's Association. Their program is in line with administration policy. It calls for a four point drive against inflationary trends: a balanced budget, an intensified drive to sell United States Savings Bonds to the public, a continuation of the program of debt retirement out of banks, and steps to reduce speculation in United States securities. Mr. Snyder can be expected to follow the low interest policy-stabilizing yields and not increasing cost of the debt beyond budget allotments. 12 Apparently there was more agreement at the policy level;; however, while the main thing for the Treasury was the case of the debt; Mr. Eccles, on the other hand, was more interested in the broad aspects of overall monetary and fiscal policy. United States News, 20:62, April 12, 1946. 12 United States News, 20:60, June 14, 1946. 260 The movement of the banks was into longer term bonds in 1945 so that they substantially increased their holdings while adding little to their holdings of short-term securities. At the end of the year, there was the usual seasonal inflow of currency to the banks, and a small inflow of gold was recorded. Excess reserves declined below a billion dollars during the early months and member banks began to borrow; Treasury spending in April increased, and so reserves increased again. Short-term obligations became popular in early 1946 but so did bonds, and bond yields declined. March and April yields rose on bonds. The pronounced reduction of differential in yields on short- and long-terms reduced the profit from the shift. The short term were sold to the Federal Reserve to obtain increased reserves for further expansion of holdings of government obligations. This narrowing of difference in rates reduced 13 bank credit expansion. Deposits were up for individuals and down for corporations, indicating that savings were up for the former and the latter were in the process of reconversion and building up inventories; the goods had not 13 Federal Reserve Bulletin, 32:467, May, 1946. It was also noted from 'another source at that time: "Increasingly in 1944-46 banks and others tended to reduce short-term holdings and add to long-terms. The results were manifest in the sales of bills and certificates to the Reserve Banks and in the rising prices of longer-term Governments of types banks were allowed to buy. 261 yet reached the market. Long-term rates on government’s remained stable. InfUa t ion thr ea tening. However, in May bond holdings of banks increased but short obligations’ yields began to rise. The rise in the short-term market was putting pressure on bonds for a higher yield to maintain the differential. Mr. Eccles was forced to state in May: Higher interest rates would make for serious complications in the government bond market and would greatly increase the cost of carrying the public debt. No reduction in buying power and no increase in production would result and there are basic causes of the problem. . .we should not reduce taxes further while this danger exists. 14 Open Market operations were being used tostabilize the long rate at least; this stabilization was almost necessary to preserve earning assets of the banks as well as other 15 investors large and small. Now apparently the maintenance of orderly conditions was uppermost in the minds of the authorities, after maintaining the pattern of interest rates during the war. The problem of controlling credit expansion 14 Federal Reserve Bulletin, 32:573, June, 1946. 15 C.R. Whittlesey, ’ ’Federal Reserve Policy in Transition,” Quarterly Journd of Economics, 40:346, M.ay,1946. This authority divides open market operations into four phases ”. . .namely to obtain earning assets for the Reserves of Banks (soon after World War I) to influence the volume of member bank reserves in order to control credit, to preserve orderly conditions in the security market, and to maintain a fixed pattern of interest rates on Treasury obligations.” 262 was indeed the problem for the • monetary authorities# Proposals of greater credit control were beginning to rise in banking circles. Others of longer and older standing were being revived. The credit and money problem was becoming acute. One such proposal, noted by an authority, came from the President of the Federal Reserve Bank of Chicago to the effect that, first, a special non-raarketable issue of Treasury obligations for ownership by banks only be put out, second, holdings of Treasury obligations of banks with Reserve Bank Credit be redeemed, third, a corresponding increase in reserve requirements be established as deposits increased 16 combined with the payment of interest on reserve balances. 17 Another proposal accorded recognition was by another authority who suggested much the same thing, with cash reserves against demand deposits as set by the Federal Reserve authorities, within limits allowed by Congress and make all banks subject to these requirements. These proposals were criticized by another authority who was quoted as saying: The Seltzer plan is fundamentally another proposal for monetary management by the Federal Government. . • The unfortunate results which the world has seen again and again when a nation’s banking structure has been 16 Whittlesey, op. cit., p. 346. This was Professor Leland’s plan as President-^ Chicago Federal Reserve Bank. 17 H.L. Seligman, "Excessive Commercial Bank Earnings” Quarterly Journal of Economics, 40:365-389, May, 1946. 265 coordinated with Treasury policy constitute a dark chapter in monetary and fiscal history. 18 So these proposals were not too popular although they were to appear again* A new problem was to confront the monetary authori ties as anticipation grew that the Office of Price Administration was soon to fall into discard. They were forced to try monetary control without the support of price control in a period of inflation. Already under attack was the low interest rate policy: "Treasury Secretary John W. Snyder declares that a study of the interest-pattern and its relation to the fight against price rises has been undertaken by the Treasury. He is reported to feel that a higher proportion of the debt must be shifted to non-bank investors. 19 That would be one measure; another would be to allow short term rates to rise and reduce the shifting thereby to long- terms . The value of maintaining the rate on long-term government bonds was ably argued by Hansen, who said: . . .it follows that the interest rate on high grad© corporate bonds will also continue low in line with the government interest rate. This, to be sure, means that corporations can secure funds in the capital market on 18 Newsweek, 24:63, July 8, 1946. 19 United States News, 21:61, July 12, 1946. Mr. Snyder also proposed Higher taxes if the price rose sharply. 264 20 very favorable terms. Blit Hansen had reckoned without price control, or rather he had assumed price control which would holdthe line where scarcities were concentrated, and thereby permit savings adequate to finance private capital formation without resort 21 to any inflationary monetary expansion. The debt reached 269 billion dollars by the* end of the fiscal year 1946; the deficit was 21 billion dollars for the year, but the total debt was reduced out of the general fund from 271 billion dollars, and this reduction was mostly at the banks which at this time held 84 billion dollars. The average maturity of the debt was lengthened by the process and the average rate on the debt rose to 1.99 per cent. The Treasury policy was steadfast and it stated: The maintenance of stable interest rates during the transition period has contributed to the underlying strength of the bond market and has eased the problem of reconversion, not only for the government but also for industrial and business enterprises of the country. This stability has promoted business confidence and has been of great importance in attaining a high level of employment and production during the reconversion period. No anti-inflation purpose would be served by raising interest rates at the present time. President Truman has again emphasized in his budget message, the desirability of the continuation of low interest 20 A.H. Hansen, Economic Policy and Full Employment (New York: McGraw-Hill Book Company, 19 47), p. 150 21 Ibid., p. 38. 265 22 rates* The size of the debt also raised the question of taxation. Former Secretary of Treasury Morganthau had said taxes might be reduced if income were maintained. Secretary Snyder argued: I recognize, of course, that present tax rates are high. I am anxious that these rates be reduced as rapidly as possible, but I believe that, under present circumstances first priority must be given to effecting a substantial reduction in the public debt. . • reduction tax rates should be concentrated in those areas where they will be the most useful in maintaining purchasing power and in providing the incentive necessary for a continued high level of production throughout the economy. 23 Yet Mr. Snyder had said when the demise of price control was imminent that taxes should be raised if prices rose sharply* It would seem that monetary and fiscal policy would coordinate now at interest controland taxation; the former was limited by economic factors, the latter by economic and political factors; both were measures of control* 22 Annual Report of the Secretary of the Treasury for the Risoal Year 1945-46, p. 3. Elsewhere in the same report, Undersecretary Bell was quoted to the effect, ’ ’Not as evidence but just as valid is that low interest rates— what the economists call a cheap money policy— benefits the people as consumers, as workers, and as citizens. Low interest rates, for example, will be an important factor in making possible the better homes, the better industrial plants, and the better public facilities which will make our country tomorrow more productive and a better place than it was yesterday,Mp. 384. 23 Ibid.,pp. 1-2 266 Inflation. There was a sharp decline in holdings of commercial banks in the summer of 1946 as reserves dwindled, and Federal Reserve Banks purchases of government obligations increased. The treasury policy of reducing banks1 holdings continued and the Treasury used its cash balance to re tire 24 those bonds held by the banks, in order to restrain bank credit extension. Interest rates declined on long-texm but steadied at 2.4 per cent, while short-term and call money rates rose slightly. It was reported that Mr. Snyder held that to raise rates would interfere with the stability of the govern ment bond market and would create uncertainties, which themselves might contribute to inflation. Moreover, he argued, that higher rates might tend to increase rather than decrease, deposits and money because the investors reaction 25 might be "wait and see" rather than "run and invest." So it would seem that interest rates were to be kept down after all, despite pressure, in the hopes that continued investments would eventual, ly bring supply up to demand. Yields on bonds rose as the shift from short-term declined and resulted in reduction of extreme ease, but credit was still easy. Tbs Treasury was continuing to 24 Federal Reserve Bulletin, 32:1020, September, 1946. 25 United States News, 21:56, October 4, 1946. 267 reduce bond holdings of securities in an attempt to restrain credit expansion. This was done by reducing short-term holdings of banks. Loans and cash payments to individual security holders continued to expand however. The average maturity of the debt lengthened due to decline in short-term 26 outstanding. Thus the quantity of money continued to rise, a study at this time alleged that an increase in the quantity of money of 5 per cent was normal, that from mid 1933 to the end of 1946, and from mid 1938 to mid 1945 the quantity of money (currency and deposits) increased and was accompanied. by rising activity and rising prices. A contraction of money or less than normal growth over a year or more is accompanied or followed by business depression; its length and decree is associated with like changes in the quantity of money. The study also remarked that change in the velocity or rate of rise of money led to minor upward or downward trends as the result of monetary expansion or deficiency and only 27 intensified but did not originate movements. If these conclusions are accurate then cheap money policy, low interest rates and credit control toward that end was successful. 26 Federal Reserve Bulletin, 32:109, October, 1946. 27 C. Warburton, "Quantity and Frequency of Use of Money,” Journal of Political Economy, 54:150-163, October, 1946. 268 Certainly more consciousness and public interest has been stimulated along these lines. At least, much discussion has been stimulated. It has been noted that the low interest rate policy and cheap money was used to stimulate the economy, during both the thirties and the war period, supplemented by the desire of the Treasury to keep down the cost of the expanding debt* In order to reduce the rate which the Treasury had to pay on its debt, Treasury and Federal Reserve policy had to affect all interest rates. Thus in a generation the return paid to savers by Hew York savings banks was cut from 4 per cent to 1.5 per cent or less* 28 There was also the pressure to raise interest rates In order to tighten credit which has already been mentioned. Neverthe less, during September short-term rates held steady, while bond yields had been raised as banks were forced to sell to replenish reserves but still hold short-term and remain liquid. =Stock market loans had been held down by margin requirements; other rates had been nominal with a slight rise in banker’s acceptances. Apparently short-term rates had been held steady by open market operations. Folicy differences. The policy of the Federal Reserve was expressed by Mr. Eccles late in 1946: If short term rates were permitted to rise sharply there would also be pressure to drive long-term rates up. This would jeopardize the savings bond sales program and cause wholesale redemption. • .(the program is) the offering of long-term non-market able securities, the yield on which would be 2.5 per cent, If held to maturity. This would avoid the danger of 269 future additions to long-term holdings of banks. . .In my opinion this long-term rate should not be permitted to go up, and, if need be, the market must be supported by the Federal Reserve. 29 He felt that lengthening the maturity of the debt would make it inflexible. This would also occur with sales to private individuals but would be on a redeemable basis which would prevent loss of capital, with:, only slight loss of interest. He advocated large amounts of debt in short-term for frequent refunding, feeling that the public interest required a supported market because of the size of the debt. He also stated: While I would not like to see an increase in interest rates at this time neither would I like to see a further rate reduction. The decline in the price of . . . . longer terms issued since spring and the resulting increase in yields has been altogether satisfactory as has been the general stability of security prices. 30 He realized that this policy might weaken funds for the market and so suggested other outlets for long-term funds, such as mortgages and securities of the World Bank. He was also against reducing margin requirements from 100 per 28 M.S. Rukeyser, f tThe Trend of Interest Rates,’ * Banking 39:40-41. He continued: "As Townsend expressed the change: ’Even the die-hard believers in governmental omnipotence are not stating that, although the government could hold the rate whereever it wished, it might be a good thing to let it rise.’ Thus the logic of the market place is dethroning the late Lord Keynes. . ." 29 Federal Reserve Bulletin, 32:231, November, 1946. 30 Ibid., p. 1233. 270 cent at this time. He also emphasized that taxes should not he reduced. A resume report revealed that the pattern of interest rates had changed since the end of the fiscal year. The shift has been acknowledged by Mr. Eccles and was specifically stated: Since last summer the rate on three-month Treasury bills has more than doubled, the rate on one-year govern ment borriwing has moved up from #875 per cent to nearly 1.125 per cent. Yields on medium term United States bonds and on municipal and state bonds have been going up. . .but it is clearly evidence that a vast upserge in the demand for private capital has occurred. . .To date the Treasury and the Federal Reserve authorities have moved with caution. They have given some encouragement to rising interest rates. 31 The question seemed to be whether there would be a split in policy between the Treasury and the Federal Reserve or whether the Treasury policy would be the one to dominate. Treasury policy had been largely interested in the cost of the government debt and the use of taxation while keeping interest rates fixed. The Federal Reserve to restrain credit had permitted a rise in short-term rates, had raised discount rates, had placed limitations on the terms of consumer installment credits and had increased the reserve requirements. The whole subject of credit policy was evoking broad discussion throughout the nation, and it may warrant a 31 Fortune, 32:3, editorial, December, 1946. 271 digression here to bring out the broad outlines of such discussion. The traditional reasons according to classical economics were put forth by the publication of the American Bankers Association in a commentary on a study by Leonard P. Ayres: Government controls applied to interest rates according to the study, have circumvented the normal tendency in wartime for the laws of supply and demand to operate. This resulted in large interest savings to the government, but it ha s had other results as well, for in the process of keeping interest rates low, the Reserve system has had to pump out money into the spending stream, and this has itself built the sub stance of inflation at the source. 52 Thus, it would argue that the market should be allowed to determine the rates of interest. On the other hand, a not so dogmatic position was taken by an authority that: Appropriate credit control or credit policy in the sense of a loan control or loan policy may therefore be entirely different from appropriate credit control or credit policy in the sense of monetary control or monetary policy. 33 He went on tOc explain that when there is a desire for more currency for whatever reason the monetary authorities should automatically take over an equal amount of bank assets upon 32 Banking, 39:112, Januaiy, 1947. "Inflation at the Source," aii aditorial discussion of a study by L.P. Ayres. Some idea of the inflation may be derived from the accompanying Chart III. 33 C. Warburton, "Monetary Control Under the Federal Reserve Act," Political Science Quarterly, 6:523, December, 1946. * 272 CHART III * WHOLESALE PRICES 1926-100 160 140 120 100 : 80 60 1943 1947 1941 1945 1939 GROSS NATIONAL PRODUCT Annual Rates i Billiotfsr 200 150 100 50 1939 1941 1943 1945 1947 *Annual Report of the Board of Governors of the Federal Reserve 1947. p. 31. **Ibld.. p. 28. 273 which the monetary supply is based and not disturb the banks' reserves. In an emergency they should reduce or suspend the reserve requirements. Under other circumstances a decline in credit may merely be a desire to reduce indebtedness, and the monetary authorities should not do anything. Two other aspects worth mentioning were the growth of term loans and the rates on these which vary with the size of the loan. The larger loans fit in generally with the pattern of rates, but the smaller loans show considerably 34 the deviation from other rates. The mortgage loan market followed the trend of rates but as had been pointed out: The Federal Reserve Board has never shaar n much enthusiasm for the idea of regulating mortgage loans as an instrument of credit policy. Unless and until the Board does show some interest in the matter the chances are that nothing will be done. 35 It might be remarked here that other agencies of the government had tried to deal with this problem, while the Federal Reserve had been confined to the commercial loans and acting as fiscal agent forthe government. Even in the mortgage market rates declined because of government agency 34 Federal Reserve Bulletin, 33:507, May, 1947. 35 Banking, ”The control of Credit Control,1 1 39:35, February, 1047. 274 activities, but they were probably the highest rates of any paper handled by the government agencies. The. official position remained about the same concerning interest rate policy. It is reported that Mr. Eccles said that a rise in short-term rates would be preferable to another expansion of credit through the banking system. However, such a rise should be permitted only in the event a credit expansion should develop after the 56 present debt retirement program ends. Howbver, it is probable that considering the enormity of the debt the Treasury policy would continue to dominate the interest rate structure. Thus, the two main aspects of the credit control picture are clearly brought out in the following statements: . • .interest rates should have enough freedom of movement to permit credit control policy to play an appropriate part in curbing inflation or resisting deflation; also rates should hav e some freedom of movement if they are to perform their economic function of maintaining a balance between the supply of savings and the demand for investment funds at a high and increasing level of national income. Above all, government influence over interest rates should not weaken but serve to strengthen the play of individual initiative. 37 This statement seems to agree with Chairman Eccles policy. The other side of the question, however, was indicated: ^ tfaifred states Hews, 22:58, March 34, 1947. 37 Banking, 39:102, May, 1947. 275 If the government uses its control simply to hold down the service charge in the debt and Ignores other aspects of interest rates, asserts the study, it will sacrifice to expediency of the budget an important part of an Americans incentive to save with results that may be delayed but extremely dangerous when they catch up with us, 38 Thus, the banking system would seem to favor the Federal Reserve policy rather than the Treasury's, Nevertheless, it may have been that the Treasury’s stand was weakening, for it was noted that the excess earnings of the Federal Reserve Banks were to be returned to the Treasury through an Interest charge levied on Federal Reserve notes issued. In this way the Treasury would recapture - the bulk of the money it paid out in interest on 59 securities held by the Federal Reserve Banks, These banks were at that time large holders of Treasury bills so that any increase In the bill rate would not hurt the Treasury, The bill market was relatively steady with little change in bills because of the refunding on the basis of new bills for old. Bank holdings of government securities continued to decline, and by the end of the fiscal year were reduced by 16 billion dollars. The debt itself was reduced by 11 38 Loo, cit, 39 United States News, 22:55, May 9, 1947, 276 billion dollars, largely out of the cash balance in the general fund. The pattern of rates on government securities remained the sa®, but the average rate of interest on the debt rose to 2.1 per cent, indicating a lengthening in maturity of the debt, and a holding of the debt by different types of investors according to the program of selling savings bonds. The budget showed a surplus of 754 million dollars. The debt was at 258 billion dolla rs at the end of 40 the fiscal year 1946-47. The reduction of bank holdings of government debt was a policy of both the Treasury and the Federal Reserve since the war, and it seemed to meet with the unanimous approval of all sides. As one authority put it: The immediate Trea sury policy is clearly wise in retiring bank debt, to take debt out of the banking system, and in promoting the sale of savings bonds to the general public. As to interest rates the problem is very complicated. The balance of advantage, I believe, is in moving toward a larger play of free economic forces, but at the same time taking care that there shall not be any sidden or drastic reduction in the price of securities because the effects could be bad. 41 Yet the Treasury had seemed adamant, for Snyder had said: . . .interest rates will be kept at present low levels through the continued cooperation of the. Treasury 40 Annual Report of Secretary of the Trea sury for the Fiscal Year 1946-4*7, p. 2. 41 Arthur N. Young, 1IA Financial Advisor Looks at the United States,” Vital Speeches, 14:501, June 1, 1947. 277 42 Department and the Federal Reserve System* The policy was under attack, however, as an outstanding authority stated: The greatest danger of all In our present situation is the abnormally low rates of interest based on the Federal Reserve Bank manipulation, • ,The existing low interest rates have been made possible only by a substitution on a wholly unprecedented scale of bank credit for the savings of the people in financing the war. This, in turn, has made possible only by the gigantic purchase of government securities by the Federal Reserve Banks themselves, 43 Therefore, that such an increase in credit should cease appeared to be his suggestion which may be partly accomplished 42 Annual Report of the Secretary of the Treasury for the Fiscal Year 1946-47*, p. 169, 43 B, M, Anderson, “Management of Public Debt,” Vital Speeches, 14:557, July 1, 1947. Xn interesting theoretical development might be brought out at this point concening the idea of normality and risk of change. In a recent discussion from Survey of Contemporary Economics, Edited by Howard S. Ellisj (Phila: Blakiston" Company, 1^48), p. 336: “In the Generd. Theory besides the obvious risk of default, we have seen that Keynes placed great stress on the risk of future changes in interest rates. Hicks believes that this in an incomplete formulation and that interest cannot be explained by risk-premiums alone. For even if there is no risk of default or of changes in interest rates there would remain: (1) the cost of converting money into securities (i.e. investment costs) and (2) the cost of rediscounting the security of money comes to be more desired before the security matures (i.e. possible disinvestment). Hence the interest rate in equilibrium must be high enough to cover these costs for the marginal lender, as well as risks of rate changes and default." This would back up Anderson's statement of abnormally low interest rates at least in part if the height of interest could be determined that would do this, considering others matters as well," 278 by reducing bank holdings . But he would also seem to advocate a rise in interest rates set by the savirgs of individuals rather than controlled rates. This, of course, is debatable. Probably the best defense of the low rate of interest was put forth by Goldenweiser who was attached to the staff of the Federal Reserve Board# It would be well to paraphrase what he wrote. Since the long-term rate is fixed at 2.5 per cent the field of general credit regulation through the interest rate is limited to such changes in the shorter-term rates as can occur without affecting the long term rate. This leaves some scope for action. Goldenweiser argued that past experience demonstrated that the existing spread between the short- and long-term rates is not a normal condition; it is a freezing of a relationship which developed during a period of large gold imports and extreme monetary ease, on the one hand; and a low line of activity and reluctance to make long-term committments in view of the inactivity of the business outlook, on the other. He claimed that short-term rates have been above long-term rates more frequently than below them. There is, therefore, considerable room for credit policy action on the short-term rate even though the long term is fixed. Goldenweiser concluded that a narrowing of the spread 279 between the rates would result in diminishing the incentive for banks to sell shcr t securities to the Federal Reserve and thereby acquire reserves which would be the basis of . 4 4 purchases of a multiple amount of bonds. Thus, so long as the government has the resources it could control the structure of interest rates. Another aspect of control closely related to the interest rate policy was the taxation program. Snyder had come out against the tax reduction and even fcaran increase in taxes if prices rose. He argued, f , A stable tax structure with necessary flexibility confined largely to changes in tax rates and exemptions will make it easier for business 45 and government to plan the future.” The report went on to explain that tax reduction would delay the readjustment of prices and wages necessary to maintain this high prosperity. Tax reduction would lead to an even higher levelof prices for consumer goods, and would increase the danger of recession. Taxes should provide the funds to government to carry out its committments, balance the budget and allow for debt retirement. Taxation should be designed to provide stability rather than instability in the economy and should 44 E.A. Goldenweiser, “Federal Reserve Objectives and Policies,” American Economic Review, 57:335-6, December, 1947. ' 45 Annual Report of Secretary of the Treasury for the Fiscal Year 1946~-47, p. 238. 280 46 be properly timed for that purpose. Snyder’s view represented the view of the Administration, and has added a function to taxation that revealed a change in attitude on the part of government; as one authority put its The objectives of public revenue and expenditures policies go beyond their traditional service and redistribution functions . Budget policy, alls o, is vitally important as a positive instrument of economic control. It is this'latter function which is usually referred to as fiscal policy. . . 47 It had become obvious by this time in the post-war period that the job of stabilization was not to be a single act or single agency job of the government. What was required was coordination at all levels of government policy and action to provide a modicum of stability. Apparently the Reserve authorities won their way because in the summer and early fall of 1947, interest rates on short-term governments began to rise, and rose as noted to 1 per cent on one year notes, and . 8 percent on 3 months 48 bills. Commercial paper rates rose to 1.125 per cent. It was also noted that this increase in rates would cost the 4 6 Ibld., p. 247. 47 R.A. Musgrave, ’ ’Fiscal Policy in Prosperity and Depression,” American Economic Review, 37:382, May, 1947. 48 United States News, 23;50, October 24, 1947. 281 government in service on the debt upwards of ten billion dollars in five years. The reasons for this move have already been given, and Mr. Eccles merely reiterated his stand when he stated: In fact, in recent months we have cooperated with the Treasury in permitting some moderate corrective rise from war time levels of interest rates on short-term government securities. This adjustment was made to reduce the wide differential prevailing between short term and long-term interest rates. Such a large differentialwas having the effect of encouraging banks to sellshcr t-term securities, which the Federal Reserve bought, and to buy long-term securities in the process thereby encouraging multiple credit expansion. The differential in rates was a ho exerting a strong downward pressure on yields of long-term securities. We were aware that this decline was artifically induced by investment policies of the banking system known as monetization of the public debt and resulted in bank credit expansion. 49 Yet Mr. Eccles was not satisfied, and had asked Congress for additional powers to raise the reserve requirements and provide for special reserve requirements for the banks* These special reserves which would not exceed 25 per cent of demand deposits or 1 0 per cent of time deposits would take the form of cash or short-term government securities. Interest rates on short-terms had already been allowed to rise, but longer term Issues were maintained at 2.5 per cent; maintenance was in accord with the Treasury’s views. Others whose views were opposed to Mr. Eccles 49 Federal Reserve Bulletin, 33:1460, December, 1947. See chart at end of Chapter for Summary of Data* 282 advocated that interest be allowed to seek its own level. Still there was much disagreement among bankers. Mr. E. E, Bross of the 1st National Bank of Chicago felt that the bond market should be supported. Some feared that any increase 50 would lead to deflation and might even cause depression. Indirectly, others reported, any credit control was dubious. Such a position was reasoned, thusly: . . .that bank credit deflation as encouraged by the Federal Reserve Board. . .has an important three-way adverse affect on business which is delayed six months. First, a change in the long-term interest rate lowers the capitalization of current profits. Secondly, monetary deflation almost immediately affects profits adversely. Thirdly, as a result of increasing unemployment and consequent increase in productivity (decrease in unit money wage cost) non farm prices drop more rapidly than prices metals and metal products. In consequence the demand for investment goods collapses about six months after the Reserve Board has initiated deflationary policies. Because of the six months lag is this never actually in control. 51 Obviously the control against an inflation is present; the question of a revival had already been tested, however, and found less than adequate in the recovery during the thirties. Other measures that remind one of the measures of the late twenties was the rise of voluntary restrictions advocated by the monetary authorities. Banks were to be under increasing pressure from the government to reduce 50 Nation, “When Bankers Disagree,” 165:68, December 20, 1947. 51 C.F. Ross, "Demand for Investment Goods,” American Economic Review, 57:317, December, 1947. 283 their holdings. Congress preferred voluntary measures to 52 the special reserves of the Eccles proposal. Other proposals were to raise the rediscount rate to 1.25 from 1 per cent, to raise gold reserve from 25 per cent on deposit s and currency to 35 per cent on deposits and 40 per cent on currency or to return to the old ratio that had existed for most the war and the prewar eras. Open market operations continued by the Board of Governors, but the banks had taken advantage of the spread in rates to sell short-term and buy long-term, and to use 53 this as a basis for further credit expansion. This shift from short-term to long-term paper had already moved the Board to ask Congress for more powers. Such pwwers had not been granted; consequently the rise in short-term rates which had been allowed was the considered policy on the part of the Federal Reserve* The period of the post-war developments had not set in until early 1946, and then that spring the cost of capital'and credit began to rise from the extremely low levels prevailing because of the persistent and strong demand forfunds in excess of the supply of savings available for investment. The excess savings was further emphasized 52 United States Hews, 23:51, December 5, 1947. 53 Federal Reserve Bulletin, 34:11, January, 19 48. 284 by the action of fiscal and monetary authorities to reduce availability of bank reserves and to increase the cost of credit. Aftermid 1947 the demand for capital grew at an accelerated rate, and there was a general rise in interest rates. It was then that rates on short-term government securities were allowed to rise above 1942-46 levels. The object of the recent shift in policy was to diminish further the inducement for banks to sell short term governments to the Federal Reserve in order to make loans or to purchase longer-term securities in the market, 54 The first change had come when rates had risen from their record lows in 1946, The preferential rate on loans to member banks secured by government obligation had been discontinued, but rates remained stable until September of 1947. Further action resulted in January when discount rates were raised at Reserve Banks to 1,25 per cent, and reserve requirements were raised to 22 per cent for New York and Chicago banks. It was anticipated that demand would bring about a rise in credit because savings were declining. The hope was that some voluntary restraint would be exerted by lenders and borrowers. The policy continued of allowing a rise in short- terms and discounts so long as long-term rates were not 54 Federal Reserve Bulletin, 34:94, August, 1948. 285 affected; the reported suggestions by the Reserve System for increased reserve powers still were unrewarded. It was requested that reserve requirements be allowed to rise with the addition to reserves at least. Specific controls were still used, such as installment credit and margin controls, as much as possible. Inf la t ion arrest ed? Then on June 11, 1948 the Board of Governors raised reserve requirements in the central reserve.city banks to 24 per cent following the order of May 31st, Chairman McCabe who had succeeded Eccles justified this move before Congress in July 1948 regarding a bill to give additional powers to the Federal Reserve# , , ,that the use of its powers over the supply of resources under present conditions should be directed toward restraining further credit expansion and not toward forcing liquidation of the outstanding to lume of credit. The Federal Reserve System was established to provide for flexibility in our monetary system. It was not designed to make available any amount of money that borrowers might demand without regard to the productive capacity of the economy and the speculative nature of the committments. The system would be derelict in its duty if it did not exercise a proper measure of restraint# 55 The Treasury, however, served notice that it would not try to curb credit before September, 1948, if then, Mr# Snyder attached great importance to the voluntary campaign of the American Bankers Association to discourage 55 Federal Reserve Bulletin, 34:94, August, 19 48# 286 56 inflationary loans, it was reported* The organ of the Association reported, however, in July, 1948 that: In the judgment of the most of the priminent bankers and economists who participated in the symposium for Banking, higher rates for short-term treasury borrowing would help to curb inflation. • .increases in short-term rates may restrain inflationary tendencies in two different ways: through their effects Upon the market for long term capital and through their effects upon bank loans. 57 The report also stated that opinion was far from unanimous that the exi sting level of most interest rates Is undesirably low from the standpoint of lorg.range economic well being. Apparently the short-term rate is to be used as a short-term measure to fit the circumstances but that as a long run policy the rates should be kept low to stimulate investment and production. The Treasury reported a surplus for the fiscal year 1947-48 of 8.4 billion dollars which was about the size of the decrease in marketable debt. Commercial banks held about 64 billion dollars of the debt and the Federal Reserve banks about 21.4 at the end of the fiscal year. Rates on short- and medium-term paper of the Treasury was up to 1 per cent and 1.125 per cent respectively. Savings bond redemptions have declined, indicating the debt is being more 56 United States News, 22:58, June 11, 1948. 5 7 Banking, 40:75, July, 1948. 287 widely distributed. The debt stood at 252.4 billion 58 dollars. *Since July 1947 the Treasury had indicated that it was in accord with gradual upward revisions of short-term rates. The dominant policy of the post war period of the Treasury has been to maintain stability in the capital and money markets -because of the responsibility of the Treasury dae to the great increase on the debt. Confidence in the credit of United States Government which is reflected in the condition of the market for our Government securities has become the keystone upon which rests the economic structure of the world. 59 The character of the debt-management policy of the Treasury had been anti-inflationary. This anti-inf3a tionary measure had been accomplished by means of budget surplus, trust fund issues and sales of savings bonds to reduce bank held debt. The budget surplus had been important, but with the reduction of taxes by the Revenue Act cf 1948 this surplus was threatened with a returning deficit in the coming fiscal year which would reduce the policy to competency. It was felt in Treasury circles that interest rate 58 See table adjoining for compensation of the debt. 59 Annual Report of Secretary of the Treasury for the Fiscal Year 1947-48., p. 2. 288 TABLE IV COMPOSITION OP THE FEDERAL DEBT ON AUGUST 1, 1948 Issues Rate Maturity Outstanding in billions Bonds-callable Bank eligible 1*-5-3.125 1948-72 $ 62.7 Bank restricted 2,25-2.25 1959-72 49.6 Redeemable savings bonds Series A-D 2.9 1948-51 2.5 Series E 2.9 1951-58 31.8 Series P 2.53 1953-60 3.5 Series G 2.50 1953-60 16.8 Investment series 2.50 1965 1 . 0 Other-armed force leave bonds 2.50 1947-1951 • 6 Special issues for Government trust funds 1.875-4.0 33.8 199.3 Notes Treasury notes 1.0-1.5 1948-49 11.4 Treasury savings notes 1.07- 1948-49 4.4 15. S Treasury bills .99 1948 13.3 Certificates .825-1*125 1948-49 22.3 35.6 Other Internat’l bank and internat’l monetary fund none demand 1 . 2 Miscellaneous o.0-3.0 1961 Total 1 . 6 $' 253.6 -^Treasury Bulletin July, 1948; this table was derived from pag©s 30-31. 289 rises would injure the capital assets of savings institutions, might threaten their stability and might undermine the confidence of owners of savings bonds. The Treasury further commented: However monetary authorities are not omnipotent. In the long run there is a real natural rate of interest, and a departure from this rate will collect its own toll. The natural rate of interest in this sense is that rate which is high enough to hold down the amount of capital formation to the currently acruing savings of the economy, yet low enough to prevent the savings made at a high level of employment to be fully inverted* 6 0 This certainly could not be construed as the Keynesian position which is supposed to have dominated policy even in these years. Throughout these years expediency rather than Keynesianism seems to have dominated. Although this is true, the recognition of a low rate of interest seems to have taken hold to a wide degree of even those who are not Keynesians* The inflexibility of the long-term rate reduced the effective ness of credit control (unless the low rate is considered as such), but has effects through the size, cost and ownership of assets to the debt* It is in the field of the short-term rqtes that the monetary authorities seem able to operate most effectively. Under Secretary Wiggena of the Treasury showed the unanimity of recognition of this measure of control, for he qgreed with Goldenweiser when he said: 60 Ibid., p. 369 290 In the short-term interest field, there i s some greater latitude. In that area, financial and economic considerations present a reasonable adjustment of that rate up or down as the needs develop. It’s a delicate mechanism with vast potentials and should be used with great prudence and keen understanding of the effect of every move, 61 It would seem that policy has been forced back to the tradi tional theories of using the short-run as a means of monetary controls was contemplated in the original intent of the Federal Reserve System in setting up an elastic currency. The one thing that may have been effectively learned is the necessity of supplying the sufficient amount of money beyond the ordinary and extraordinary demands for currency. Time also will reveal whether or not monetary authorities will recognize this need. Congress reduced taxes in April 1948 and then supplemented this bolstering of inflationary pressures by allowing more control to monetary authorities over the reserve requirements. These requirements had previously been 3D to 26 per cent for reserve city and central reserve city banks. They were now raised to 24 and 30 per cent respectively. It would seem that general monetary controls were being substituted for direct controls such as taxation and price control. In addition, temporary controls over installment credit and margin requirements could be 61 Ibid., p. 370, 291 used with, some discretion by the monetary authorities. Inflation still continued In the fall of 1948. It stimulated further suggestions by those connected with the reserve authorities. A scheme suggested was to freeze all reserves at the present level and allow no further increase unless individual banks reduced reserves thereby allowing other banks to increase reserves. This scheme would put a ceiling on the amount of credit to be issued by banks, and would be almost, in effect, a 1 0 0 per cent reserve condition. Szymezak’s plan would work something like this: two accounts would be set up, one, a regula r reserve, the other an excess reserve or optional ceiling reserve. The latter would be deducted from total deposits; the remainder would be the basis for required reserves. If banks did not meet these requirements, they would have to buy reserves from 62 other banks or the Federal Reserve Banks. This scheme has the flavor of the traditional 1 0 0 per cent reserve plan; the special reserve would be discretionary upon the authorities, as they saw fit to use them. Needless to say this plan has not been adopted at the present writing, but It indicates that the reserve authorities are not satisfied with their powers while the inflation continues. Business Week, p. 98, October 23, 1948. It was a suggestion of Mr. M.8 . Szymczak, one of the members of the Board of Governors. 292 Short-term rates continued to rise in September on Treasury obligations and throughout the market. This likewise followed the Eccles policy which had been unexpected ly supported by Senator Taft on the floor of the Senate, although be accused the Treasury of not wanting short-term rates to rise; this was not strictly true although the 63 Treasury may have left that impression with the Senator5. Mr. Taft showed unusual acumen in his knowledge of the point at issue regarding short- and long-term rates of interest; he said: It is the general opinion, I think, that it (interest rate on short-term governments) should be raised to 1.5 per cent on short-term governments without affecting the 2.5 per cent rate on long-term governments. . .today, I believe we could raise the short-term rate to 1.5 per cent without endangering the holding of the 2.5 per cent rate. That would be an Important factor in restraining bank credit. That and the raising of the rediscount rate and the increase in reserves could all be used 5 4 together to do that if the government wanted to do it. Thus even Congress seemed to accept the credit controls as a definite part of the economic picture of the future, and its important place for stabilizing the economy. 63 Forum, "Songress Debates Fiscal Policy," 110:175, September, 1948* Quoting from Mr. Taft speaking on the floor of the Senate, "As I have pointed out before, because it Is perfectly apparent that although the Federal Reserve Board wants to do something in that direction, the Secretary of the Treasury has insisted on holding down the interest rates on short-term paper." 64 Loc* cit. 293 One other suggestion ought to be mentioned concerning this period which has recurred before, that is, that government intermediate- and long-term debt should be funded into perpetual consolidated debt like the British Consols bearing a rate sufficiently high to induce invest ment* The author of the scheme suggested that taxes and government expenditures be reduced, and that the monetary 65 authorities let interest rates find their own levels* Thus, even at the end of this period the question of interest rates is still one of the most important questions in the economy, and although its powers of regulation may not be as great as once thought, it is not without its supporters. Conclusions* A few tentative conclusions may be drawn from the survey of the brief post-war period* (1) Policy controversy. The credit policies of the post-war period were distinguished by a conflict between the Treasury and the Federal Reserve System. The Federal Reserve authorities advocated allowing a rise in the short-term rates of interest, for they realized the pent-up demand for investment should be restrained. The Federal Reserve still wished to maintain the long-term rate at a low level in order to sustain a large amount of heavy investment. The Treasury on the other hand wished for a time to 294 maintan low interest rates throughout the market for government paper. At first the Treasury was adamant, but as inflation developed the Treasury was persuaded to relent, and its policy was largely adjusted to coincide with that of the Federal. Reserve. The rise of the short-term rate of interest under the circumstances was a definite revival by the authorities of the traditional idea of interest determined in a free market and a belated recognition of its contribution to the control of inflation. Time alone will reveal its effectiveness. Certainly the low rates of interest had made the economy more vulnerable to inflation. Bankers have also advocated some monetary control, even if only voluntary upon the part of bankers, to restrain credit expansion in order to slow the rising inflation and curb it, if possible. (2) Qualitative credit control. Margin requirements have become well established as a necessary credit control for stock exchange activity, and were used extensively in the post-war years 1945-1948. The non-marketable issues of the Treasury, in order to meet the needs of the various investors, was used to drain off excess purchasing power. These issues could by means of varying interest rates be used to attract even more 295 savings and effect a restraint of inflationary pressures. Aid to smallbusiness continued to be part of government policy. This aid was effected by liberal loan arrangements, by government partial guarantee of such loans and by special aid to housing loans. However, these measures created mare credit in the system and thereby aided inflation* (3) Taxes. Fiscal authorities, it was hoped, could aid in controlling inflationary sources by means of high taxes. It was well established that taxes could reduce purchasing power and inflationary investment. These taxes could supplement interest rate control to restrain the economy. However, Congressicnal policy soon reduced generaliz ed controlby means of taxes and eliminated price control, leaving only a residue of monetary control. The continued low interest rate policies emphasized the need for more qualitative credit control. (4) Interest rates. It has been held that under most circumstances a low long-term rate of interest is necessary to sustain economic activity. The short-term rate thus becomes the main instrument of monetary control. This follows the traditional theory of regulating the elasticity of money. The short-term rate is als o related to the long term rate and the latter's increase of the supply of money 296 over a long period. Thus, not only production is important foran economy, but also the supply and elasticity of money is intimately interwoven throughout the fabric of an economy. Unquestionably the danger of inflation by the low interest rate policy is still continued, especially when the economy is faced with vast surpluses of purchasing power relative to available goods. This condition increases the danger of a subsequent recession and collapse when the goods become available and purchasing power has been absorbed under infla tion. 297 CHART IV * YIELDS ON U.S. GOVERNMENT.SECURITIES Per 2.5 2.0 1.5 1.0 .5 0 1942 1945 1944 1945 1946 1947 1948 Billions of d 25 20 15 10 5 0 , 1940 1 942 1 944 1 946 1 948 ^Annual Report of Board of Governors of the Several Reserve 1947,p.4, Federal Reserve Charts on Bank Credit. Money Rates and Business 1949. p. 29. ----- Annual Report. Ibid.. pp. 7,4. MEMBER BANK RESERVES p-llars ------------ Morey in Circulatio ired Resijx- veir Excess Reserves Treasur,j Bonds, taxable J Jl ..“ ’ ■/ * ■X cable Borids >9m jggatfs J ► Discount Rate I'ederal Ile serve | ^ * » « Cert iiicate oj' ^Jndebtedne JLjg; 0 / * ■ 12 ,B$SP. • O j e « > O O® o • e • ^rgasurM J . W l • • • e o • D 0 0 CHAPTER VII FISCAL POLICY This part shall deal with the connections between monetary policy and the broad field of fiscal policy. It shall be confined to a discussion of fiscal operations as based on the thoughts concerning public finance. The writings of accepted authorities shall be the main part of the chapter with current applications to. monetary policy of the period under investigation included therein, and the necessary broader approach will be used rather than relying upon the interest rate approach alone. The major points will be those rela ted to public expenditures, debt and taxation as affecting the field of interest rate policy in the years 1933-48 and their implication for the whole economy, PUBLIC EXPENDITURES The subject of fiscal policy is a part of the much broader subject of public finance, and herein some attempt has been made to join monetary policies which have been discussed in previous sections of this study. As monetary policy is a lesser part of fiscal policy, so is the latter a lesser part of the whole science of public finance, A word should be said on the latter briefly by way of 299 introduction. Public finance had been defined as embracing, "the divisions of expenditures, the raising of revenues by taxation, borrowing and other methods, and the financial 1 administration." This statements shows its relation to this study, for these operations in finance must ultimately affect monetary field. The application of the principles of public finance must be done through a course of action usually determined on these same principles. This is the subject of fiscal policy which is related to: . . .what used to be called public finance, budget policies, government expenditures, revenue and borrowing . . .fiscal policy, it has been1 said, is public finance guided by consideration of the economic implications of public expenditures, revenue and borrowing. 2 Budget. Probably, since fiscal policy is a financial operation of which accounting must be made, it would be worth while to state that the budget is the hub from which an understanding of government financial operations ramifies. The budget is usually a detailed statement of the financial operations of government, for the stated period of time X. A.G. Buehler, Public Finance (New York: McG-raw Hill Book Company, 1940}, p. 5. 2. H.D. Smith, "Fiscal Policy and Budget Operations in War and Peace," Viewpoints in Public Finance, (New York: Henry Holt and Compan y, 1947), p. 669. 300 prepared in advance by designated officials. This idea of a budget is a recent development in the United States dating back to 1921. Nevertheless, it has been said: The old school of public finance scholars devoted considerable attention to the budget, and they found many technical aspects to examine, such as those relating to comprehensiveness in the presentation of budgetary documents. But principle interest in federal budgeting is now associated with the new attempt to make the Bureau of the Budget a planning agency and the budget an instrument for financing steady and full employment. This leads at once to the zone of fiscal policy. 3 So that even a recert development apparently has undergone great changes in the last generation. The first requirement of a budget is that it should include both current operations and the capital outlay program. It should show all the revenues to be received and all the expenditures to be made, and further it should be adapted to the practice of the legislative body which may use its own e^p erts. The plan embraced in the budget should be 3 Ibid., p. 660. Groves has defined the budget as "The term is used to describe a considerable number- of different step3 in fiscal procedure. Often it is used to designate a proposed or adopted financial plan. It is also used to designate a document which states the plan. Sometimes it is employed to describe a bill or severalbills which the legislation considers and an act or acts which it passes. Occasionally to cover a message which the executive delivers to the legislature. Functionally, it is always, however, imperfect an instrument of financial planning and of education for the legislature, the administration officials, and the lay public." p. 585, "Financing Government by Harold Groves, (New York, Henry Holt and Company^ 1945). 301 efficient, made so by central purchasing and control of the 4 allotment of funds* The most important violation of the rule of comprehensiveness and unity in budget procedure would be that which confines the budget to expenditures and takes no account of revenues* The pioneers in experiments with the budgets were the Swedish fiscal authorities who developed the two budget system* Such a procedure ". . .leads logically to the proposition that governments should have a balance sheet (of assets and liabilities) as well as an operating statement 5 (of expense and income)." The Swedish operated so that capital outlay was financed by borrowing since it was over the normal reinvestment on old capital projects, but the increased outlay was automatically provided for by self liquidation in the operating or running budget. Non-self- liquidating projects were amortized on a yearly basis instead of all at once, being carried as a running budget deficit in a special equalization fund until liquidated on a 4 H.L* Lutz, Public Finance (New York: D* -Applet on- Century Company, 19 4777 4td Edit., pp. 653, 54, 56. This practice was not followed in the U.S., separate committees handling appropriations and revenues were not coordinating. This was remedied in 1947. 5 H.M. Groves, Financing Governments (New York: Henry Holt and Company^ 1945), p7 549." 6 five year basis of 20 per cent a year. Ordinarily debts should be confined to irregular expenses such as those on capital account. Where this rule is followed, debts may not be incompatible with a balanced budget, according to one definition of that term. Some have argued for balancing of budgets over a period of years corresponding with the business cycle. Others hold that planned deficits are required to stimulate business during the low ebb of the business cycle. Deficits may happen automatically if the tax rates and exemptions are kept at a 7 constant level during a business cycle. The United States Treasury attempted this capital budget procedure in 1934. The segregation into a new emergency catagory, of expenditures made in conjunction with the recovery program ha s created the need for a special budget to be ■M financed entirely by credit. The elimination of the emergency items from the general outlay has enabled the Treasury to approach a balance between expenditures and revenues. 8 However, Treasury accounting seemed not to find this method suitable. At any rate, this method of showing deficits did not continue, and the Treasury was soon back to its old method of showing deficit on current account. 6 G-unner Myrdal, ' ’Budgetary Techniques," Viewpoints in Public Finance. (New York: Henry Holt and Co•, 1947) p7 375=351" 7 Groves, op. cit., p. 594. 8 J. Wilner Sundelson, "Emergency Budget of the Federal Government," American Economic Review, 24:53,March 1934 305 One Swedish spokesman regarding fiscal budgetary policy has put it this way: The most we can righteously request from fiscal policy is that it shall in a general and rather ridig way be adjusted to react contrary to the cyclical movements . - . .for t^c ing care of the more individualized and concrete troubles of the day or month. Other means must be found. • .but this day to day policy, broadly monetary policy, will have its way paved if the fiscal policy is built into a strong counter cycle movement.9 Here is the long-run view of fiscal policy with monetary policy fitting in with the short-run as a dynamic factor of adjustment. Each of these dupplement the other as the aid to a smooth functioning free enterprise system. Principles of Expenditures. The economic implications of public expenditures are just as important as m y other actitijry in affecting the whole economic system. They are financial and productive operations just as well as investment and consumption and should be looked upon as such. Awareness is always necessary, of course, that public expenditures may be disruptive and non-productive. "If the service can be performed more economically through public cooperation than through individual initiative or voluntary private cooperation, the state agency is said to be relatively productive. Otherwise, it is relatively 9 Myrdal, op. cit., p. 677. 304 10 unproductive." Thus the element of cost must enter into such considerations, and the effect of taxes to pay for such activity must be estimated intelligently. Another aspect of public production and expenditures which must also be considered is that regarding the creation of public utilities by public expenditures as desirable . .if they operate to increase the productive output of business and are undesirable if they restrict production . . Some economists have called government a leading agency of 11 production, along with land, labor, capital and management.1 1 Thus, the principle of public expenditures may be expressed another way: Public investmaits should be selected and budgeted so that they will pay for themselves, so far as possible, over the period of their own usefulness. Through direct collection from the beneficiaries of the investments, and indirect collection through the tax system each item of outlay should contemplate a closed circle of outgo and intake. 12 Herein is expressed the idea of economic productiveness and the limitations of expenditures within the tax resources of the system over a reasonable period of time. Recently another principle of public expenditures has been expressed somewhat along these lines. The fundamental 10 H.W. Peck, ’ ’General Theory of Public Expenditures,” Viewpoints in Public Financ e, op. cit., p. 550. 11 Buehler, o£. cit., p. 168. 12 Groves, H.M., op. cit., p. 506. 305 rule of government finance to which only minor qualifica tions exist, is that nothing shall be decided on financial 13 grounds. The basic realities of the economy are resources, (labor, raw materials, management, plant and equipment), and the wants of the people of the economy for both a high standard of living and for useful employment, gained with freedom of choice and equal opportunity. Since money is a means of governmental finance and as such is only a tool for the effective utilization of these resources toward fulfilling these wants, it must be considered. And like other tools money may get out of order, and can be used skillfully or badly. The Government can, through its monetary authority and revenue and expenditure policy, exert a considerable influence on the flow of money in the economy. The government affects the allocation of resources to one use or another as well as how many of them are or are not used. Following them the principles of economy, efficiency and cost, it would seem logical to say that: • • ,each item of government expenditure has to be examined in terms of the groups that receive the income, 13 T, Morgan, Income and Saployment (New York: Prentice Hall, 1947), p, 212. This and the following passage are derived from this same source. The statement indicated by the footnote' was derived from the London Economist, 506 and each kind of tax has to be scrutinized in terms of the income groups paying the tax before a more accurate estimate of the effects of the total of fiscal activities can be made. . . 14- Other considerations must also be included, such as the specific effect of certain kinds of taxes such as income taxes upon incentive to invest in opportunities not attrac tive for their average yields but because of their potentially large prizes which are rare. The expenditures should be curative, but so far as possible, in areas not in 15 direct competition with private enterprise,, Pauses and expenditures# Probably the growth of public finance has undergone one of the most striking changes in the economic system in the twentieth century. This growth has been brought about for many reasons, the more obvious of which are war, depression, and the need for more community services provided by the government because of urbanization and communication. More specifically, in the thirties government expenditures rose because of relief, social security and political pressure or patronage. Add to these the involv ed government machinery that was growing and the overlapping of functions of various agencies at all 14 Boddy, P.M., and others, Applied Economic Analysis. (New York: Putnam Publishing Company, 1948), p. 288. 15 Groves, op. cit., p. 614, 307 levels of government, and one will obtain some idea of the causes of vast public expenditures* It would seem that some policy is necessary for public expenditures in order that they nay be determined by the people, may conform to some standard of efficiency and may be publicized. Planning at long range seems necessary in view of the enormity of the operation# Purposes of expenditures. A statement of the causes of the Increase in government expenditures revealed many of the purposes of government spending. Beyond the routine spending for governmental operations, however, government finance has taken on a much broader aspect. Government expenditures are used to counter the cyclical fluctuations of the economy and even more, it has been suggested as an . . .attack on chronic unemployment by means of public expenditures financed by a continually rising public debt which is essentially a conservative proposal. This is true in the respect that it does not necessarily involve a redistribution of Income unfavorable to property owners# 16 Closely allied with that purpose, an added feature of government expenditures may mean, "for the state an increase of expenditures may frequently increase the total national 17 income and improve the fiscal position of the state." 16 Hansen, A.H. Fiscal Policy and Business Cycles# (New York: Norton and Company, Inc., 19 41), p. 181. 17 Ibid., p. 140# 308 The author of this statement, however, was quick to warn that this operation may not be likened to the individual; for the individualit is important this his expenditures be kept within the limits of his income at least. There is a great deal of difference in how the expenditures are increased, for the raising of a loan by the state is not a mere accounting phenomenon, such as would be the transfer of sums of money from one account to another within a given enterprise; on the contrary, the process has far reaching consequences upon production and distribution. Its actual significance accrues from the fact that like all other financial transactions of the state, it is a means of influencing production and distribution of income. Incidentally, it increases the money supply either by adding it or by temporarily at least raising its velocity. If current expenditures were wholly financed by means of regressive taxes, they would have no expansionary effect, since they would merely direct a part of the income stream from p±ivate consumption to community expenditures. But if financed from progressive taxation, thereby tapping a stream of savings which might not have found outlet in productive activity, adequate expenditures may be expected to drive up the national income by a cumulative process to the full income and full employment level. 309 It must be kept well in mind, however, that the closer one approaches full employment, the less effective expenditures become in raising the national income without causing a committant rise in prices. The higher the level reached the smaller the effect on employment and the greater 18 the effect on prices. Classification of expenditures. Public expenditures may be classified presumably on their productiveness or utility creating power as had been suggested by one authority according to the types of debt. One might be dead weight debt which has not resulted in creation of utilities, such as war expenditures; another might be considered as passive debt which does not produce income but supplies certain needs, such as recreation facilities. A third type might be active debt which is income producing and self-liquidating. That type of classification is not too useful, however, for the indirect effects of one upon the other may make all of 19 them indirectly income producing. Another classification has been suggested by Hansen as follows: Public investment just as with private investment may be merely utility creating or it may be efficiency 18 Ibid., pp. 142, 182, 183. This and the preceding passages are derived from the same source. 19 Ibid., p. 144. Paraphrased from U.K. Hicks, The Financing of Srit ish Government 1920-1936. 310 creating, . .In addition to being (a) utility-creating and (b) efficiency creating, public expenditures may also be (c) income-creating in the sense that they tend currently to expand income and employment, 20 Further classification of the latter type might be made in this manner: income-creating from government production which results in induced private investment called secondary effects, and induced further private investmait or tertiary effects of government investment. Government must be careful, however, for these effects to take place only in such a way that they do not compete in the private area of the economy generally. Government spending. Government is actually one area of the economy which fits into the whole picture of the economic system, so that government expenditures that are increased as taxes are increased, only tend to distort or adjust the functioning of the whole system. However, if government expenditures derived from taxation pull a certain amount of idle money into the circulating stream, the effects may be worth while in stimulating increased activity through the whole economy. This is not, however, something to be counted on by an Increase In taxes and expenditures; 21 the results are small and uncertain at best. 20 Ibid., p. 150. 21 M, New Comer, Taxation and Fiscal Policy (New York: Columbia University Press, Ftf40), pp. 73-TH 311 Expenditures financed by borrowing have been tried and have called forth a great deal of discussion. The United States tried this type of financing in the thirties. It was variously known as deficit spending and pump-priming. One comment on the United States experience of this type was: The flood of federal spending produced an artificial prosperity by 1936 which promptly turned into a severe reaction in 1937-1938 when the spending slackened. Instead of proving, as some assumed, that continued spending was essential to the maintainence of business activity, the whole experiment demonstrated that no vital and enduring forward movement can be achieved by such means. 22 The other side of the argument might be that expenditures were not great enough in degree to bring on the necessary stimulation. This view has been expressed by both Hansen 23 and Keynes. The failure of pump-priming h a a been ascribed to a variety of reasons; it caused a slow down in velocity of money; it increased the uncertainty of business due to concommittant tax policy; it unsettled world conditions and increased uncertainty; and finally, the policy of the 24 government of raising costs faster than prices, did not contribute to a sustained recovery. 22 H.L. Lutz, 0 £. cit. p. 43. 23 See Chapter IV, footnote 69. 24 Newcomer, op. cit., p. 74. 312 An appraisal of pump-priming has revealed the advantages and disadvantages of such a method. If it Is done without taxation, it may add to the purchasing power of the system. If there is not too much unused capacity and there is confidence of future profit, pump-priming may induce secondary and tertiary private investment. If it saps business confidence, spending may accomplish nothing. It must be enough in quantity, or it is only a palliative. It most certainly must not hinder an adjustment of prices by keeping some prices out of line with others. Other govern ment levels must act in the same direction* Too many imports 25 will certainly reduce its effects also* On the whole, government expenditures designed to raise income must be carefully worked out and done in the right business climate, or they will be less than effective. This calls for coordination with other policies of government* Thus an important consideration, if ”, • .deficit spending for public works can be anticipated if and when the economy falls short of providing adequate employment opportunity . • •” is that, • .it should be emphasized that all other reasonable efforts to revitalize business 26 ought to take precedence over deficit spending.” 25 W.J. Shultz and C.L. Harriss, American Public Finance (New York; Prentice-Hall Inc., 1949), p. 36. 26 Groves, Financing Government, op. cit., p. 614. 313 Nevertheless it must be remembered that: . . .to stimulate business, expenditures financed by credit are vastly more effective than expenditures financed by increased taxes of such sorts as would be available at such times. Thus consistency requires that credit policy should be coordinated with public works policy. 27 Further, policies on wages and prices, on the position of the economy in the cycle and on the necessity for such measures must be considered. As deficit financing developed in this country. . . .various aspects of government’s monetary and fiscal policy combined to create large excess bank reserves. This condition was maintain ed by continuous manipulation, and it increased the deceptive attractiveness for deficit financing by permitting a demonstration to be made of the extremely moderate cost of adding to the public debt. 28 Here again must be noted the close connection between interest rate policy and government spending. Although interest rates may vary considerably without markedly influencing businessmen’s decisions to expand dr contract their enterprises, it may affect them indirectly, for these things may be important to banks. "Increased interest rates would tend to restrict bank credit expansion. But increases in interest rates would also tend to reduce the value of fixed interest securities. . .increasing rates might also 27 J.M. Clark, "Economics of planning Public Works," Viewpoints in Public Finance, op. cit., p. 570. 28 Lutz, ££. cit., p, 49. 314 29 be an unpopular move,* Not only does Interest have effect that way, but it also effects the velocity of money as well as the quantity over a longer period of time which in turn will affect income. Timing of government expenditures, The most obvious way for the government to spend outside of the ordinary operations and the legislative responsibilities put upon it by legislative action is through public works, but to be effective, . . .such program should be timed carefully with reference to the most propitious stage of the business cycle and should also be coordinated with other expedients like the control of bank credit. • .At best, however, planned public works cannot along stop the wild excesses of prosperity or end depression • • .it is also probable that a public works program, if it is undertaken too soon will tend to prolong a depression because it will sustain prices which should drop and will retard necessary liquidations in business. 30 It would seem therefore, that, . . .the conclusion must be that to attempt to stagger public works, to absorb unemployment from private industry will not result in a satisfactory solution of the problem. Since large expenditures are made for public works and since many projects can be postponed any effective plan which eases them into the cycle of private business will of course be beneficial* 31 29 E.D. Allen and O.H. Brownlee, Economics of Public Finance (New York: Prentice-Hall, Inc., 1947), p. 84. 30 Buehler, op* cit., pp. 180-181. 31 M.H. Hunter and H.K. Allen, Principles of Public Finance, (New York: Harper and Bros., 1940), p. 46* 315 This method need not be the only method of timing public expenditures. Certain types of taxes and responsibilities ^vill automatically be timed for business fluctuations such as the social security program contemplates; provided a given level of government expenditures is sustained, the tax system itself will provide elasticity of policy so that government expenditures may have a stimulating effect. Limits of public expenditures. It is undeniable that public spending supported by borrowing may accelerate consumption and production. Remembering also the justification of public operations on the basis of efficiency and cost • . ,public spending may have a limited usefulness in inducing economic recovery, but that it must be widely controlled if it is not to degenerate into unbridled spending. The -necessity of balancing the budget must also be kept in view, because a valid prosperity cannot be founded upon a permanently unbalanced governmental budget, 32 How far public expenditures along with taxes may go in an economy is undecided. The implication of these operations go far afield, and it has been stated by an authority, Every expenditure whether it is so Intended ornot, has some influence upon the personal incomes of the members of the community, . .while these new expendi tures have been met by various revenues, tax systems have commonly placed relatively heavier burdens on 32 Buehler, op. cit., p. 183 316 the lower incomes than on the higher and have to some extent offset the effects of the expenditures. • . it is uncertain how fiscal systems can be employed as a part of a program of social reform, and how far governments should go in equalizing income. 33 Clearly, then, such important operations as govern ment expenditures along with taxes are enough to destroy the system. Control of public expenditures, therefore, requires a combined approach to be wisely operated; it must be able to handle the various factors which are interwoven; economic, political, p.sychological, educational, and ethical. Compensatory fiscal policy. Probably the best known of all fiscal policies is that of compensatory fiscal policy. It is under this policy that the government acts as a stabilizer for the economy. Yet this idea is not new. This statement is found in the early days of the new deal and is worth while quoting in full; The budget is not intended to constrain financial programs, rather it is designed to require advanced planning of both expenditure and revenue activities. Presumably precedent consideration will be given to the nature and social effects of public outlays and revenue- gathering operation. If the government is to use its peculiar facilities to counter-balance excesses in private enterprise, it must plan for restraint upon such activities in times of prosperity. The execution of such a program not only would forbid annual budget balancing but would require the adjustment of revenue 33 Ibid., p. 184. 317 34 and expenditure over the trade cycle. In other words, when there is a decline in business activity, the government spends on a planned basis to stimulate activity, and in a rise of activity the government taxes itself out of debt and incidentally controls the excesses in the system. Further writers hav © unearthed the fact that compensatory fiscal policy was ". . .the recommendation which is best known and upon which there is complete unanimity of opinion in the long range planning of public 35 works In relation to cyclical fluctuations.1 ' Apparently, it was urged alike by radicals and conservatives, by socialists and capitalists. Specifically it was pointed out that Sweden was the only one to put a compensatory public works into practice. Ordinary public works were sepaiebed from reserve work;: the latter were to be used as previously as a means of work relief, while the former, carried out under ordinary business conditions, were to be used to counteract cyclical fluctuations. Deficits 34 J.B. Canning and E.G. Nelson, "The Relation of Budget Balancing to Economic Stabilization: A suggested Federal Treasury Policy," American Economic Review, 24:26-7, March, 1934, 35 C . J. Anderson, "The Compensatory Theory of Public Works Expenditures," Journal of Political Economy, 53:258, September, 1945. QuotIng in part from S.Feldman, enclosed in single quotes, writing in 1925. 318 during depression years are considered "sound financial policy,” and are to be balanced by surpluses during good years. Sweden had taken an inventory of suitable projects and plans for these projects had been made. The 1938-1939 budget included an emergency budget of 230 million Kroner, which was to be spent mostly for public works in the event of an emergency, and which comes into operation without 36 further approval by the Riksdag. This experiment has not as yet bean called upon to function, for was has intervened and the post-war prosperity continues today. Another view of compensatory fiscal policy is that if such policy is designed to aid private investment, however, it will be impracticable, Decisions with respect to private investment are based upon long run considerations. Modifications in the tax system may encourage private investment in the Iqq g run, although such modifications do not assume continuous full employment. 37 Hence, the best measure deemed capable of such stimulus has been the long term rate of interest, as brought out in another section of this study. Fiscal policy designed to influence markets must be largely short run and this cannot be expected to act 36 Ibid., p. 258. These passages are largely taken from this article. 37 Allen and Brownlee, op. cit., p. 64. 319 directly upon private expenditures for investment goods. Private investmait is more likely to be stable, however, if consumption markets are kept stable . 38 Here the monetary function of open market operations and ' rediscount policy come into play, since the short-run is largely the dynamic factor which follows the long run in direction, not in pace. Other aspects— oash balance. Other ways of influencing the economy (one of the short run variety, such as the cash balance and the other, government agencies with long run purpose) may be considered briefly. Although many factors other than financial and business conditions influence the size of the Treasury's general balance, changes in it must be included in a listing of fiscal mechanism, and must be looked on a mechanism that is potentially if not actually of very great importance, 39 The cash-balance of the Treasury has at times been of enormous proportions and can be a powerful instrument. It may act as a good substitute for open-market operations of the Federal Reserve Banks, As it has been observed: By varying the size of the balance which it carries with the Federal Reserve banks the Treasury can effectively control the reserve position of the member banks, , ,in recent years movements of Treasury deposits have been an important shcr t-run factor in the money market, Thereois some evidence that some of these 38 Loc, cit. 39 G.C. Abbott, Management of the Public Debt (New York: McGraw-Hill Book Company, Inc.), 1946, p. 61, 320 movements have been deliberately induced in order to control the volume of member bank reserves* 40 Supplementing open market operations as it does, the cash balance gives the Treasury extended control over interest rates, because the use of the cash balance can be more selective in area, at least. The withholding method of income tax has permitted employers to deposit the taxes directly into government accounts at depository banks. ’ ’The Federal Government has maintained only a fraction of its current balance on deposit with Federal Reserve Banks— the 41 proportion in 1948 was about one half.” Federal agencies. Another aspect of governmental financial expenditures which should be mentioned is the growth of the government credit and spending agencies. They first began after World War I and have attained a phenomenal growth under the last Democratic administration, especially government corporations. Many of them enjoy a degree of financial autonomy carefully withheld from government departments and bureaus, such as independent borrowing power, 40 Loc. cit. This is quoted from Edw. Simmons, ’ ’Treasury Depos'if; and Excess Reserves,” Journal of Folitical Economy, 48:325, June, 1940. It might be added TEiat such shifts of deposits to member banks from Federal Reserves and back again is the method involved. This is reminiscent of the "pet-banks” of the Jacksonian era. 41 Shultz and Harris^ op. cit., p. 124 321 establishment of a revolving fund and freedom from auditing and budgeting control. Financial autonomy, however, implies a shift in fiscal responsibilities from the government to its instrumentalities. . ,their prerogatives can greatly hamper* a consistent fiscal policy and even conceal the government's financial status• 42 Thus Congressional authority is weakened,and the budget is something that is lost in the shuffle for a balance budget loses its function. The number and variety of these agencies can affect business in many different ways, and in this sense government activity becomes debt activity. Government levels. The tremendous financial activities of the federal government involves all individuals and all lesser government organizations. Federal aid to the local and state administrations has grown over the years. Unfortunately, the states have apparently not kept up with the problems involved. The present situation on federal grants to state and local governments is extremely chaotic, and a direct city-federal axis has arisen. The Bureau of the Budget and the Treasury Department have been forced to consider the effects of federal taxation and expenditure on state and local finance, and the reciprocal effects of stqte and local expenditure on federal finance. "The problem is to substitute a flexible 42 Abbott, 0£. cit., pp. 154-155. 322 organization permitting cooperative action among the three levels of government. . .without resorting to the iron hand 43 of national centralization." Fiscal controversy. One of the major controversies of fiscal operations is that concerning the type of financing or spending done by the government. What will be the net contribution of government expenditures or how much income producing effects will a given expenditure have? This contribution can only be determined by assuming that it is either spent for relief or for public works. The statistical material is too inadequate to determine such effects at the present time. Hansen has covered the subject well in his line of development which will be followed closely. The net contribution is determined after one has deducted that amount financed from consumption taxes and not from savings or from new bank funds, and cannot be considered along with private investment as an outlet for savings. Relief expenditures are likely to be less effective in stimulating employment even than public works expenditures. 4,3 W. Kilpatrick, "Neglected Aspects of Intergovernmen tal Fiscal Relations,5 1 American Political Science Review, 41:458, June, 1947. The preceding passages on the subject are also derived from this source. 323 Relief funds will be quickly spent since they are put into the hands of needy individuals. This will not stimulate employment to the fullest extent and at once because of unused capacity and part time work. Public works expendi tures are used primarily to pay off debts at banks or elsewhere, or held idle and will not stimulate as much immediately. Relief spending is certainly quicker in circu lating money, but only In the first round of expenditures. The storekeepers, In the second round of expenditures, will probably pay off debt. So that relief differs only slightly from public works. The induced effects are the important ones. The additional purchases by reliefers, so the argument goes, are spread over the vast consumption industries, giving little stimulus to increased production because there is sufficient slack in the consumption industries to permit the additional output without taking on additional workers, and frequently without increasing part time employment. Public works are likely to have a greater induced effect because of the fact that construction and leavy industries are seriously depressed, employment is far below what it is during the boom, and output is at low capacity. But when orders come in for construction projects workers are reemployed and the plant is reconditioned. Public works expenditures of$4 billions or $5 billions would have a tremendous effect upon reemployment and 44 upon capital expenditures. It was because of the failure to realize this depres sion in construction that contributed to the failure of government spending in the thirties in the United States. The government had failed to nske plans for filling the gap left by the receding tide of private investment. Another suggestion has been made by another authority to the effect that, It should be apparent that the establishment of wage rates at a level which would sustain a maximum amount of employment through the depression would to that extent relieve government from the obligation to provide assistance. . .-by keeping the people employed. To this end primary attention must be given, by management, labor, and government to non-fiscal policy. 45 Hansen at an even later date has admitted that in order to avoid an excessive inflation, and to avoid bottlenecks in production some sort of anti-trust action and even wage control might be necessary. DEBT Keynote. The public debt has always been a topic of discussion for any government, but particularly so in modern times. In defense of the public debt, alexander Hamilton 4# Hansen, op. cit., p. 92. This passage paraphrases Hansen’s argument which has caused so much controversy in profession literature since. 45 Lutz, ojd, cit., p. 688. 325 argued: . . .that merchants would by reason of the public debt be enabled to invest their unemployed capital in government bonds. This would yield an added source of revenue and so enable them to trade for smaller profits. 46 This debt meant a greater supply of liquid assets, that for certain purposes bonds were the equivalent of money and so would lower the rate of interest, ”. . .for this is always in a ratio to the quantity of money and to the quickness of 47 circulation." Similarly, Hansen argued that England's debt which was increased tremendously by the Napoleonic war,”. . • created a haven of refuge for capitalists both in England and abroad-- for the investment of funds in a period of risk and 48 uncertainty created by the international upheaval*” However, during the 19th century private issues increased even up to World War I, but thereafter due to conditions left in the wake of war and the subsequent depression, . .public credit as an instrument of economic policy has again come 49 powerfully to the fore.” Taxation, too, has grown in influence since the first 46 Hansen, o£. cit., p. 163. 47 Ibid., p. 164. 48 Ibid., p. 112. 49 Ibid., p. 116. 326 World War due to the increase in governmental activities and the ncessity of servicing the public debt. National defense has shown the possibilities of taxation to accomplish far reaching ends. Public debt like taxation may serve certain collateral and non-fiscal purposes. It provides a safe and liquid medium of investment. . .On the other hand, it seems very doubtful whether the governments should make these decisions concerning debt retirements turn on the non fiscal consideration of investment opportunities. 50 Especially the post war period of the contemporary era revealed that debt management depended on such things as employment and income. Debt retirement with unemployment was likely to aggravate the situation. "In the last analysis, the best protection of the borrower and of public credit consists in peace, well-balance prosperity and intelligent 5i government.1 1 The second consideration of fiscal policy as treated herein is the problem of government debt. It may, in fact, become the keystone of fiscal policy in this country in the near future. The only questions that are likely to outweigh it are those of war and defense, of employment and of sustained prosperity. Students of public debt, just as other students of other questions, are likely to consider 50 Groves, Financing Government, op. cit., p. 552. 51 Ibid., p. 561# 327 It the main instrument of public policy, "Actually debt policy is but a part, albeit, a most important part, of fiscal policy. Debt management can act as a stabilizing, a 52 regulatory, ora stimulating framework.” There are unquesticn ably good reasons for public debt, but there is a danger In public debt that must be recognized, namely, the tendency of government to spend too much. A warning was sounded when the following was written in 1940. Nevertheless, there are weak spots in our present position. For the time being, there are securities enough for the banks and private investors. We have let one period of prosperity come and go without balancing the budget even once. We already have a ten year period of continuous deficits. Once the standard of a definite accounting period is abandoned In favor of the indefinite period of the business cycle, or in favor of never paying debts at all, there is no fixed day of reckoning, for those in control. This increases the danger of political irresponsibility. 53 How muchmore true it is today, although we have recorded a surplus in the budget in the post war period. Since the public debt must be services by an interest rate and eventually repaid, it constitutes a burden on the economy. There are, however, important offsets that have already been mentioned to which others may be added. One of these offsets is the liquid assets which may contribute to the maintenance of demand in deficient periods; another is 52 Abbott, op. cit., p. 136. 53 Newcomer, ojd. cit., p. 78. 328 the provision of money when necessary. If the tax burden is greater with a debt, the capital assets are also greater. On the basis of such functioning a debt could be assumed,, as necessar y. Once the economist in a more realistic mood, allowed for unemployment, assumed elasticity in monetary supplies, and agreed that government expenditures couh be productive and need not be wasteful the case for public borrowing was strengthened# 54 Debt management. The primary problem that World War II has bequeathed is the management of the public debt. All that it involves goes much further than mere debt for, like government spending, it not only has fiscal implications but broad national and international economic effects. As has been said debt management involves control of the composition of the debt in terms of bills, notes and bonds, the relative holdings of government securities by the banks and the public, the supply of money and the structure and levelof 55 the rate of interest. The composition of the debt has some sidelights that may become Important as instruments of policy. Tax-exempt securities which were discontinued in 1941 have cost the government a loss of taxes, beyond that they 11. • .create a privileged money class which becomes a parasite to the 54 S.E.'Harris, The National Debt and the New Economics (New York: McGraw-Hill "Book Co., Inc., 1947), p. 4# 55 Hansen, Economic Policy and Full Employment (New York: McGraw-Hill'"Book Co. " , Inc., 1947"), pp# 282'-'3# 56 general taxpayers of the country." These tax-exempt securities would also serve as a basis for unfair competition with private security issues. They are being retired, but may be revived as a temporary expedient for relieving the pressure for higher interest 57 rates. Another possible weapon in an inflation that may be useful in debt management, and is increasing in use, is the non-marketable security. This security is used to reduce bank-hejd debt by using the proceeds of such sales to retire bank holdings. It has been suggested that these non- marketable securities be issued at higher rates to secure wider differences of ownership along with some redemption 58 of debt owned by banks. Non-marketable securities in trust funds of government have a rate of interest fixed by 59 statute. These types of issues serve to differentiate the securitie s, Within limits, special issues, for separate classes of investors can serve a useful purpose. Carried top 56 S.Matsushita, Economic Effects of Public Debt. (New York: Columbia UniversTty”"Press, 1929), pp 113-114. 57 Abbott, op. cit., p. 38. 58 H.L. Lutz, Guideposts to a Free Economy (New York: McGraw-Hill Book Co, TncT, lT45)7pp.“T3S-IsSr~* 59 Abbott, op. cit., p. 34. 330 far it would so compartmentalize the debt that the structure of the interest rates would no longer be subject to market forces. 60 Rate structure. The composition of the public debt has a broad influence on the whole structure of interest rates in the money and capital market. One method of accomplishing the effect is issuing the non-marketable securities of like maturity with the marketable i ssues. It enables the government temporarily to affect specific inter est rates, and to determine effects of financial operation. Regulations affecting the debt also affect interest rates; two examples which have been suggested are to require the banks to hold a reserve against their deposit obligations in addition to the current cash reserve, and to permit them to hold only a limited amount of long term securities in 61 proportion to assets. Such differentiation allows the government to operate on the short term rate of interest with relatively little cost, and with qhich effect. It also permits the Treasury to alter maturity with funding operations at less cost or to bring about adjustments in the structure of Interest rates by taking advantage of the preference of investors while 60 Sansen, Economic Policy and Full Employment, op. cit., p, 142. 61 Ibid., p. 142. maintaining a maximum of flexibility. However, it presents certain advantages to banks when there is a wide enough differential in rate.s on various maturities, such as there was in 1948, to sell short-term securities, and buy bonds to use them as credit expansion. This differential reveals the close connection between debt policy and interest rates. This subject brings up the question of refunding in connection with monetary policy. If a low interest rate policy is to be followed with a huge debt on hand, other controls will be necessary. If a high interest rate is allowed, a check to essential risk taking and less govern ment service is to be foreseen. Under modern monetary controls refunding should not be difficult. The Federal Reserve System can be relied up to work efficiently to support any policy. Conversion of short-term paper into bonds, the withdrawal of this paper from the banks and the placement of these bonds into the hands of individuals seems the best policy; this conversion thereby, raises the short term rate of interest. The opposite procedure should be 62 followed in a deflationary period. Historical developments. The problem of the present 62 Groves, Financing Government, op. cit., p. 549. This passage is derived from here. 332 debt began back in 1936. A new policy was inaugurated by the Treasury that summer when harassed by constant refunding operations of short-term bills and notes, it began to shift to bonds, and 4 billion dollars of notes was refunded into bonds; the volume of bills was reduced. The beginning of defense finance, however, brought about renewed short-term issues. Activity was beginning to rise due to the defense impetus. It has been remarked, "the tendency of the public debt to cause eitherinflation or deflation by increasing or decreasing the quantity of money may be readily offset by 63 the adoption of compensatory monetary policies." Monetary authorities resorted to certain actions at this time to forestall an excessive inflation; this has already been recorded in this study. The war, however, brought on the immediate need for other measures to supple ment monetary controls, such as price controls, priorities, and rationing. The first of eight big war loan drives was begin in December of 1942, and raised nearly 13 billion dollars. There were two drives in 1943, three in 1944, and two in 1945, the last being the victory loan drive. The average rate on the debt fell from 2.52 per cent to 1.94 per cent 63 W.Withers, The Public Debt (New York: The John Day Company, 19 45), p. 39. 353 from 1940 to 1945. The commercial banks held 94 billion dollars of government securities in 1946, but these, due to Treasury policy, were reduced to 64 billion dollars by the end of 1948. This reduction was brought about by sales of bonds to individuals rather than to banks. The revenue from these sales was used to redeem the bank holdings as was the cash balance of the Treasury. The cash balance was reduced by almost 20 billion dollars. Rates were controlled from 1942 to 1945 on government securiti esi When, finally, later in 1945 the market was partly tested— the budgetwas nearly in balance and large additional issues of 2-g-'s could not be counted on--the price for government securities rose in a spectacular fashion.64 The ending of the war brought little change after that in 1946 to the government security market. Savings declined, private investment rose tremendously and money contracted sharply. The latter was a sign of encouragement for the monetary authorites. The years 1947-48 have brought great pressures for a rise in interest rates so that some break in the pattern of government interest rates was permitted as short-term rates were allowed to rise, but time alone can reveal the efficacy of such control. 64 Harris, op. cit., pp. 15-16* 334 Debt management policies. The three major policies of wartime debt management were, according to Secretary Morganthau, that funds should be raised in such a manner as to minimize the risk of inflation, that the securities offered should meet the needs of the investors.to whom they are sold and that the cost of financing the war should be kept to a reasonable level. A more complete list of policies pursued during the war in the management of the debt would include: a steady tough recently very gradual reduction inthe average interest cost of the debt; a continuous decline in the average maturity of the debt; an increasing reliance upon redeemable but non-marketable obligations; the elimination of tax-exempt securities; an increase in the number and kinds of securities outstanding; and because of the nature of the situation, a continuance of commercial banks and federal reserve banks in the position of residual underwriters for the federal deficit; . . .the reduction, at least relatively, in the volume of intermediate and long-term issues eligible for bank purchases. 65 The fact that commercial banks were used so extensively to ' finance the war has resulted in a low rate of interest, far lower than that of World War I. More than that, it has resulted in the increase of new money, an increase in the demand forbonds and an increase in the supply of funds seeking investment. The post-war situation has called for more controls, however, of a monetary nature and has led to the reduction 65 Abbott, op. cit., pp. 14-15. This and the preceding passage are taken from this source. 335 of bank holdings by almost a third. This action has been largely debt management, but monetary factors have played a large hand. Monetary weapons can, indeed, be applied effectively to check an expansion, but they have to be applied with rigor. Care must be used not to contract the more stable elements which underly the economy if stabilization is to be attempted. Hence, the long-term rate of interest in the post-war period has been controlled to remain at a relatively stable low level, in order to stimulate activity where this rate isan important factor. One matter of importance that has recurred throughout this study has been the question of the short-term rate of interest. It has received much attention in theoretical circles and recently in policy circles. The latter may be inferred fromthe discussion and action taken by the monetary authorities. The flexibility that the Treasury has achieved in this sectbr by the use of the floating debt is admirable. It springs no doubt from the confidence the Treasury has in withstanding any money market crisis. The lack of fear apparently signifies a Treasury intention to carry a cash balance sufficiently large to permit it to meet any sudden or unexpected demand for redemption without going to capital markets. 66 This cash balance could be explained by the precautionary 66 Ibid., p. 21. 336 motive of Keynes, and the broader cash balance approach of WIcksell. It can have an effect on interest rates that can be readily seen, and broadens the concept of liquidity preference and the demand for money. Thus to insure these operations the Treasury must have an ample cash balance and securities of the type used in open market operations. The latter, of course, is already present because of the debt composition. "Throuthout the World War II period and to the time of present writing the Treasury maintained a cash balance that varied between $4 and $25 billion— more than ample as a 67 stabilization reserve.” Principles and considerations. One of the great authorites on fiscal policy, Hansen, has seen fit to say that: There are four basic principles of responsible debt management: (1) government securities must be made a safe and dependable investment promptly repaid at maturity and readily convertible into cash; (2) the value of money must be maintained, avoiding both inflation and deflation; (3) the public debt should be held as widely as possible by the entire citizenry, so as to promote in conjunction with a progressive income-tax structure, an equitable distribution of income; (4) the budgetary control of federal expendi tures, taxes and borrowing should have as a primary objective a continuous growth in the real national income* 68 67 Ibid., p. 21 68 Hansen, Economic Policy and Pull Employment, op, cit., p. 263. 537 The debt is, therefore, an investment, a monetary control and an economic control in cooperation with other fiscal ins trument s. As has already been mentioned when there is uncertain ty in the economic sphere, a public debt may be a refuse for funds. It may become therefore a platform from which it is safe to venture into more risky investments since some income isassured, and so may help in improving the productive 69 capacity of the economy. Government borrowing, it has been recognized, is a necessary expedient in times of low income for the national economy. But this very operation has the function of increasing through the banking system the needed money supply which can be a favor in a recovery. The limits on such borrowing, of course, depend on the taxable capacity of the economy over a period of time and on the rate of interest in the debt so created. However, careful consideration must be taken of the effect of such borrowing on private investment souroes. Certainly a proper balance must be kept in mind, of the portfolios of financial institutions between equity holdings 69 Hgnsen, Business Cycles and Fiscal Policy, op* cit., p. 154. He quoted fromthe Committee on National Debt and Taxation, the ”fact that a man holds a good block of war loans, and can rely on a nucleus of safe income may sometimes induce him to seek higher but less safe return on his other savings. * * 338 and debt holdings, so that the debt can be used to aid financing equities and still achieve a proper balance in the private debt-private wealth ratio. If stimulation is necessary to major segments of the economy, borrowing should be done from the banks to keep the interest rate low. Borrowing from the public should also be used but the proportion of both public and bank borrowings should be in accordance with fluctuations of business. Borrowing from banks when activity is low and from the public when it is high would seem to be the proper policy. The present situation which derived directly from the war has presented us with a phenomenal growth of liquid assets that require special management for this era. However, once production has regained its full capacity in all lines, these assets will be very useful in carrying us forward for a long period of prosperity. Certainly the experience gained in the past two decades concerning credit controls will stand us in good stead for the future, in perhaps helping us to avoid the pitfalls of another prolonged readjustment period, such as was experienced in the thirties. There has thus emerged a new aim of fiscal policy which is vigorously assailed by some and staunchly defended by others: the aim of insuring the full employment of the 339 factors of production. This full employment may be attained by the use of public debt, adequate central bank policy, low rates of interest, wider distribution of income and progressive taxation as well as a balanced budget once full 70 employment is attained, and a feasible reduction of debt in a sustained prosperity. Such ends, however, require more than fiscal policy; other policies must be further, such as an adequate price structure which requires the cooperation of business, labor and government for the good of the whole economy. TAXATION The problem of taxation has been left until last in connection with this study because its modern development has tended to bring it into direct competition with the traditional ideas concerning interest rates as the controlling elements in the economy. Taxation is being used or is deemed by quite a few as capable of usurping the position of interest rates and giving a more efficient 70 Withers, op. cit., p. 45* He commented; wAs the economic system becomes rigid and the public debt begins to assume its modern role as the primary means of keeping the economic system upon an even keel, complete debt retirement is no longer necessary and, in fact may be injurious. Public debt retirement must now be related to the functioning of the economic system as a whole. It is not desirable for its own sake.** 340 performance. It is not the task of this study to refute that idea but it is rather, at least, the task to bring into the study the developments related to its major objective. Taxation will be dealt with broadly as an instrument of policy with some space allotted to its structure, but no exhaustive discussion of taxation is contemplated as the subject is tremendously complex. General treatment. Many definitions of taxes have been given but the two presented here will serve to point up the development fromthe traditional to the modern view of taxes. One authority has said, "The definition of a tax as a compulsory contribution to meet the costs of government overlooks the important uses for non-revenue purposes or for 71 regulation.1 1 Berhaps a betterdefinition would be that a tax is a compulsory payment levied by a governmental authority without regard to the specific benefits the taxpayer may receive. Taxes are the major source of revenue for the government, and normally are the major means of financing government operations. Since government services have grown, taxation has assumed a position of major importance in the economy. When revenue requirements are of major proportions, It is necessary that the taxable capacity be preserved, and be consistent with that end; yet such is 71 Bgtehler, op. clt., p. 326. 341 all too frequently not the case, for example: Governments may thus, at the same time, be aiding the unemployed with various relief measures and be aggravating their plight with taxes upon their dwellings and the articles they must of necessity consume. 72 Taxes are of many kinds and with many different effects, but such diversity tends to make the revenue of the government stable under varying conditions if these conditions are too extreme. Such a tax system complicates the task of fiscal authorities for it has been said, Diversity of tax sources calls for a skillful balancing of so-called direct and indirect taxes or taxes upon income, property, inheritance, commodities and otha? objects. Each tax possesses some advantages and suffers some disadvantages. A wise blending of taxes will tend to balance their effects. 73 Generally government financing is done by four methods, according to Hansen: by borrowing from the banks, by borrowing fromthe public, and by progressive taxation, and by regressive taxation. The first method creates mere money, while the second may increase velocity. The other two methods are as follows: If the outlays are financed by progressive taxation, the effect is mainly to tap the savings of the wealthy without encroaching significantly upon consumption. If financing is by regressive taxation (for example, sales taxes), income may expand by the amount of the increased outlays but not by a magnified amount. Thus the expansionist effect of government outlays will vary 72 Buehler, op. cit., p. 341. 73 Ibid., p. 337. 342 according to the method of financing. 74 It may be concluded that if government financing is to be expansionary, the borrowing method is best; higgler rates on lower incomes or rggressive taxes are the worst methods for attaining this end. Principles of taxation have followed as much as possible the rules of certainty of time and manner of payment at the least cost and at the greatest convenience as to the taxpayer. Under special circumstances, such as war, other principles have been added; namely, taxation of subsistence should be avoided, and taxes should be of maximum assistance In avoiding Inflation; they should be equitable and defray the cost of war as much as possible. Under other circumstances the only principles changed would be to avoid 75 deflation and defray the ordinary costs of government. Specific developments in tax policy have been noted by one student in the field who wrote regarding Congress: it seemsthat Congress is • • .no longer satisfied with Adam Smith's four canons of taxation. The theories of Lord Keynes are cited in House debate. They ha’ te advanced beyond the stage where the levy of taxes for social or economic 74 A.H. Hansen, Monetary Theory and Fiscal Policy (Hew York: McGraw-Hill and Co., 1^34), p. 157.' 75 Groves, Financing Government, op. cit., pp. 615- 616. This passage was partially derived from this source. 343 control is a heresy. They concede, for instance that taxes may and should be levied to control inflation . . . 76 Some light may be thrown on what was transpiring in Congress by recalling what Keynes had said: Insofar as the inducement to the individualto save depends on the future return which he expects, it clearly depends not only on the rate of interest but on the fiscal policy of the government. Income taxes, especially when they discriminate against * unearnedf income. Taxes on capital-profits, death, duties and the like are as relevant as the rate of interest, whilst the range of possible changes in fiscal policy may be greater, in expectation at least, than the rate of interest itself. If fiscal policy isused as a deliberate instrument for the more equal distribution of incomes, its effect in increasing the propensity to consume is, of course, all the greater. 77 Although Congress was aware of the accepted purposes of taxes, they were apparently also becoming aware of other possible uses of taxes. Congress in 1943 was interested in curbing inflation. ^t may be said therefore that, ”. . .the limitation or actual curtailment of private spending lies behind the mere raising of funds and is the fundamental purpose of taxation and borrowing in war f inane e.T I 78 76 M. Newcomer, 1 1 Congressional Tax Policies in 1943,” American Economic Review, 34:752, December, 19 44. Comments regarding debate on Revenue Act of 1943. 77 J.M. Keynes, General Theory of Employment, Interest and Money, (New York: Harcourt, Brace and Co. 1936), pp. 94- 95. 78 W.L. Crum, J.F. Fennelly, and L.H. Seltzer, Fiscal Planning for Total War, (New York: N.B.E.R., 1942), p. 72. 544 therefore, one of the most important aspects of taxation is its effects. The effects of taxation will naturally depend on the character of the tax system, that is, upon the characteristic s of the taxes levied, on their rates and on the manner of their administration. 79 The main effeot of taxes to be considered is that on the maintenance and increase of the stock of capital, for"A sound financial policy will preserve the patrimony of the state(which) consists in a flourishing condition of private 80 industries. • ." Generally the effects of taxation have been looked upon in recent times as measures of broad effects on economic activity; however, an authority has warned that , *It cannot be too often repeated that any characterization of taxation as deflationary or the reverse is meaningless unless the 81 assumption that is made about the budget is clearly stated." For it must remanbered that: As long as the budget is in balance, the processes of taxing and spending are practically neutral so far as concerns the price level and the income level. It is not without significance that the advocates of government control through fiscal policy have an aversion to a balanced budget. . • Fiscal policy for 79 Lutz, Public finance, op. cit., p. 509. 80 Ibid., p. 516. Quoted from H.G. Adams, The Science of Finance. 81 Ibid., p. 518. 345 82 them is debt policy. Carrying the general analysis a little further with regard to relative prices and taxation, the effects of a tax seem to indicate: • • .that it is virtually impossible to conceive a tax that will not, in some way, change the long run allocation of resources from that which would have prevailed in the absence of the tax, , .Even the personal income tax may alter the distribution of an individual’s time between work and leisure and thus affect wage rates. 83 The expenditure side of government affects the pattern of production and income as well. It may also be ppinted out that taxes and expenditures may likewise affect the marginal efficiency of capital, and consumption, whereas ”0n net balance, it is not thought today that interest rate changes have through their incentive effect any significant influence 84 on consumption.” One of the most controversial areas in the field of taxation is that of tax shifting. It is also one of the most complicated. Little attempt is made herein to treat it except in broadest outlines. Tax shifting is the passing of the burden of the tax onto someone else. The theory and logic of tax shifting indicate that in the long run taxes which burden capital or the income from capital will be shifted for the reason that an 82 Ibid., p. 521. 83 F.M. Boddy, and others, Applied Economic Analysis, op. cit., p. 307. 84 Morgan, op. cit., p. 99. 346 inadequate return mil cause the supply of* capital funds to decline and production to fall off, thus ultimately bringing about a price for goods that will provide the necessary return after taxes. 85 However, another authority would qualify the above statement: The inelasticity of the supply of capital and of entrepreneurial ability, prolonged depression and a relatively great abundance of capital as compared with investment opportunities would operate to retard shifting. 86 The ideas of tax shifting are closely related to cost analysis as well as demand analysis, income and other considerations. Further analysis along fiscal lines revealed that: The shifting of taxes is dependent not only upon the various factors already cited but also on the effects of public expenditures. . .if public expenditures increase the demand for a taxed commodity, tax shifting may occur without a decrease or sometimes with an increase in the number of units sold. 87 Taxation on business may, of course, represent value received from government services, as such no shift would occur or be desired. Nevertheless, the taxes should be flexible enough to encourage an accumulation of resources in goods for the bad years. This accumulation would be and has been useful to carry through the cost of reconversion. Yet the burden of taxes falls upon the investor or owner of the capital, ”. • .unless there is available for such equity, 85 Lutz, op. cit., p. 522. 86 Buehler, op. cit., p. 357. 87 Ibid., p. 369. 347 after all taxes, a return that is sufficient to attract new equity capital to the extent that new capital may be 88 required.” A suggestion along broad lines has been made that in order to ascertain the impace of taxes, they ”... should be direct rather than indirect since we have no assurance that the final impact of indirect taxes will fall where we think 89 they should.” It is a most difficult problem to determine the incidence of any particular tax. Perhaps the most important tax of all Is the income tax. This tax brings taxation out of the economic field and puts it in the political field, as no other tax has ever done. ”The limits of individual income tax are mainly political. . • The limits of the taxation of business profits 90 on the other hand are economic to a higher degree.” Direct taxation seems to have too low an upper limit to be an effective control for inflation. Under such circumstances of inflation other types of taxes that tend to be largely regressive are needed. Income taxation has become the greatest single source of federal revenue, so that over the years certain loopholes have been closed to enhance this 88 Lutz, Guideposts to £ Free Economy, op.cit., p. 36. 89 Newcomer, op. cit., p. 32. 90 W. Fellner, A Treatise on War Inf la tion (Berkeley: Univ. of Calif. Press, 1942F, p. TT9. 348 source of revenue. Tax exempt securities have been a major loophole and have been largely eliminated except for local and state bond Issues, and some maturing federal Issues, Taxation which is a levy on national income from 20 to 25 per cent must have important effects on production incentives. It has become a factor for size alone, but more than that its effects are far reaching on consumption. Unfortunately, taxation, like other fiscal measures, is difficult to apply with precision and discrimination, and is often exceedingly slow in the working. Further investigation of taxes revealed this complication. Specific taxes. If the income tax is the most important tax in federal revenue sources, then the corporation income tax is the most controversial. Taxes on corporations, exclusive of fees, are an income tax imposed on corporations which in turn distribute that income to their stockholders, who are subsequently taxed again on the same income. For this reason, it has been favored that such corporation taxes be abandoned. A certain minimum of taxes is required on corporations, however, in order to prevent tax avoidance through corporate reserves, and to compensate for the heavier load of property taxes paid by farmers, small home owners, and small business men. Taxes should be devised to prevent unncessary accumulation of reserves, and the use of personal holding 349 companies and other corporate devices to avoid taxation. . .after all this is done, however, the personal income taxes can be used as the chief form of taxation. 91 Other taxes on corporations have caused controversy, one of which is the excess profits tax. This was used in the war, and taken off in the post-war period at the end of hostilities. It has an appeal to the public, and quiets labor. The war levy was on profits in excess of 8 per cent of invested capital or on anything above a pre-war average of profits. It should be remembered that, *. . .the marginal tax burden should not be so heavy as to remove the encouragement afforded by expectation of profit after taxes 92 to the maximum productive activity vital to the war effort." Nevertheless, a graduated tax on excess profits add little more to revenue than a fht rate would. There has been much discussion of the undistributed profits tax which was put on the books in 1936 and repealed in 1939. This tax proposed to force the corporation to spend their income rather than hold it idle, or distribute it to their stockholders. This was to provide stimulation for new investment but prevented certain discriminations on the part of management. This tax along with the capital 91 Withers, op. cit., p. 103. 92 Crum, et al, op. cit., p. 198. 350 gains tax has not been popular with business, and therefore tends to prevent the normal flow of business. It is claimed by business that these taxes take funds out of business that would be used for expansion and profitable investment. Thus, the normal growth of business and trade is hindered and reduces efficiency# The capital gains tax is not exactly a strong source of revenue. Besides being unpopular, it is not exactly clear that a fair capital gains tax with loss offsets is likely to be of much benefit to the Treasury over the long- run unless there is a period of long and sustained expansion with a rising trend of prices; otherwise, the losses will 93 largely offset the gains, and bring in very little revenue. Irregular income was finally recognized as a problem of corporation income, and in 1939 a loss carry overwas provided for income after 1939 on a two year carry over of net operating losses* In order to provide for reconversion problems of the aftermath of war, loss carry back provisions were allowed for tax credits to ease financing of reconversion, and loss carry forward provisions for two years were extended also. There seems to be general agree ment on this modification of tax laws, for two outstanding 93 Hansen, Fiscal Policy and Business Cycles, op. cit., p. 391. This idea is derived from this passage* 351 authorities agree, with minor modifications. Randolph Paul said: The limited characterof the loss provisions of tax law may be as much, if not more, responsible than high rates for business inertia. More generous loss offset provisions are a necessary step forward in the taxation of corporations and individual businesses. I belfeve the present carry-back provision should be eliminated and the existing provision for a two-year carry-forward of net operating los ses should be extended to at least five years. 94 And H.L. Lutz has said: On the other hand, the carry forward of net business losses presents certain advantages. . .Business looks to the future rather than to the past. 95 Certainly such provisions will be easier on the administration of those taxes as it will bring about the elimination of refunding on carryback provisions. These provisions should make business men more prudent in their estimates of risk, and should make them take a more reasonable attitude toward the future. The individual net income tax has rapidly developed into the major source of revenue for the federal government since its constitutionality was verified by an amendment in 1913. Until 1943 income taxes were paid in the year subsequent to income being earned; thereafter income taxes were paid at the source wherever possible, and current 94 R. Paul, Taxation for Prosper ity, (Indianapolis: Bobbs, Merrill and do., 194777 pT 375. 95 Lutz, G-uideposts to a Free Economy, op.oit. ,p. 63. 552 collection became the law. One of the difficult problems of this type of taxation has been to decide what was income and what part of this income was to be subject to tax. The tax was to be based on ability to pay and on the principle of diminishing marginal utility of incremental income with a progressive rate as the best manner of regulating rates of tax on income. This theory of taxation has been followed generally but in consideration of all taxes the middle bracket incomes have been definitely favored. In fact, it has been said: It was one of the crying scandals of the first two Roosevelt administrations that in spite of persistent deficits so little was done until 1940 to draw upon the taxable resources of the people with incomes of less than §10,000. • .The notion that all the costs of wars and depressions can be shoved off on the rish is an irresponsible illusion. 96 Little was done along that line although surtax minimum net income bracket was reduced to §4000 in 1934, and the surtax rate raised. This was raised sharply until in 1944 it reached 91 per cent on incomes over .§200,000 with a minimum of 20 per cent on the first dollar of surtax net 97 income. This was reduced in 1945. Another aspect of the income tax which has added to the annoyance of the taxpayer who never or hardly ever 96 H.M. Groves, ”The Mext Pour Years,* ' The Hew Republic, 104:75, January 20, 1941. 97 Lutz, Tublie Pinaa ce, op. cit., p. 327. 353 enjoys paying taxes has been its complicated forms. These were simplified in 1944 though it cost "the government some 60 million dollars which seemed to be considered justified 98 in the interest of simplification. Closely .paralleling the income tax and corporation taxes is the undistributed profits tax. Groves has argued: . • .that what a business invests for the stockholders is treated for tax purposes exactly like what the stockholder invests for himself. That is the stockholder should be taxed on his pro rata share of what the corporation earns but does not distribute* 99 , J -'here seems little dl spute about the progressiveness of income tax rates, and under modern interpretation "The intelligent application of the formula would preserve purchasing power and limit saving to absorbable amounts 100 , . *" It was further stated, "Our estate and gift taxes should be integrated with each other and correlated with the income tax in such a way as to close avenues of avoidance 101 and prevent overlapping." Excise taxes are the most important part of indirect 98 Paul, op. cit., p. 168. 99 Groves, op. cit., p. 76. 100 Paul, op. cit., pp. 416-417. 101 Loc. cit. It has also been remarked that • death may be a more strategic time to tax wealthy persons than when they or their fortunes are actively engaged in producing wealth." Prom Groves, Postwar Taxation and Economic Progress. See next footnot e. 354 taxes as well as being the second major source of revenue to the federal government. These taxes directly affect consumption through price effects, and therefore careful consideration should be given as to their imposition. The rates should be judged by the relative importance of the taxes commodities to a prosperous economy# Their social consequences cannot be ignored. During the war excise taxes were used to reduce consumption of goods that were in shcr t supply to civilians, to aid in price control and to allocate resources. They have also been used to deter consumption in an inflationary period, and may be an important factorin control of fluctuations. Jlnother form of taxes that is not popular either among tax experts, economists or the public is the sales tax. This is regressive in effect, for it hits at all types of consumption and absorbs even the income of those who can least afford it. Other taxes such as payroll taxes and social security taxes have been a source of controversy. These taxes are largely counter-cyclical in purpose. The imposition of this type of taxes is not disputed so much as tbeiruse. It is now argued that reserves should not be used, but that taxes be at such rates as to cover present costs and disbursements, rising as the need arises to a certain level and remaining there as a balance is achieved between payments and taxes. 355 A proposed tax which has been suggested is one that will affect idle money in banks, but this strikes at sound finance and would merely be getting at a symptom, not a cause; this type of tax would be an incentive tax similar to the undistributed profits tax and the loss carry forward provisions* Property taxes are mainly the province of local governments, and may have effects on allocation of resources in the long run* These taxes are rather complicated and need more simplification and efficient administration* This discussion by no means covers the various taxes in the system, but some conclusion may be drawn from the precedir^; statements. The burden of taxes is recognized, and to reduce this burden without reducing necessary government revenue is the prime objective of the government. The burden may be reduced by eliminating or deemphasizing business taxes with their double burden on the risk taker, by offering concessions to the reinvested earnings of new small enterprisers, by allowing a carry over of business losses, by applying some system of averaging to personal 102 income, and by eliminating tax exempt securities* Taxes can make their contribution to stability; this 102 H.M. Groves, Postwar Taxation and Economic Progress (New York; McGraw-Hill book (Jo., Inc., 1946), p. 3V7T" 356 is easily observed for their effects are widespread. The prudent and conservative course is to gear out basic revenue structure not to a deflationary situation but to make it sufficiently flexible to meet changing economic conditions as they arise. If we pursue this course, in an acute Inflationary situation, the problem will not be to change the structure but merely the rates of tax. 103 Intergovernmenta1 relations. If we can assume the necessity of expansionary action on the part of fiscal policy, then a necessary reform is apparent in the whole structure of taxation. This would necessitate reduction wherever possible in taxes that tend to reduce consumption. For as Hansen said, major reform of our whole federal, state and local tax structure designed to reduce consumption taxes would be of crucial importance in any program aiming n 104 to enlarge the outlets for private investment. Furthermore, a debt such as this country has at the present time makes federal aid to the lower levels of government a major problem. If the federal government is to continue these grants, it will necessitate higher taxes; this Increased taxation will make taxes an even greater burden to the public and a threat to lasting prosperity. Otherwise, If taxes are unfeasible, greater debt is the |,03 Paul, op. cit., p. 224. 104 Hansen, Fiscal Policy and Business Cycles, op. cit., p. 398. 357 outcome. Fortunately states are far better off than they were, and have cash surpluses on hand. Good management and sustained production and employment will largely eliminate such federal aid, except that which is indispensable. Federal aid is dangerous also for it tends to make the local unit careless about spending. Such limitation on state and local debt would seem advisable; this limitation based on a percentage of revenues and flexible taxes on the issue of their obligations. This field also needs a great deal more study. Timing. The most important aspect of taxes other than their effects Is the matter of timing. This timing directly relates taxes to fiscal policy, and some discussion is warranted. One authority has said this: The timing of taxes is always important. For instance in the case of forest resources, tax techniques have been levied which postpone levies on growing timber and recoup when the crop is harvested. In general, muoh can be accomplished by lightening levies when especially creative economic activities are being carried on and compensating for this leniency when these activities cease. This accounts for the enphasis here given to death taxes and the application of the income tax to capital gains. 105 Another tax that has aided fiscal timing was the shift to 105 Groves, op. cit., p. 13. Fellnerhas said: t*Generally speaking"“the effectiveness of an anti-inflation program depends on the close cooperation of direct controls with fiscal policies. . .they are complements of, not substitutes for truly energetic fiscal policies. op. cit., p. 147. 558 current collections which will aid in combating inflation. Along this line it has been suggested that sales taxes deserve careful consideration over higher rates on income. This gives diversity and serves to reduce discontent in 106 concentrating efforts in only one direction. Deflation would call for other timing or other kinds of tax imposition. Even stability at a high rate of activity might necessitate lower sales and excise taxes. The progressive income tax need not be changed - because it fits the needs of flexibility so that it has brought aboht the expression of ^built-in flexibility.M As for a general policy Droves has said that, ”. . . we would need to establish greater stability of rates before we achieved a procedure for manipulation to counteract the 107 business cycle.1 1 The aim should be for a surplus only at high levels of income with special allowances in extreme depression years. Eccles, on the other hand, has said: The government can so shape and time its tax and expenditure policies as to offset variations in the income stream due to variation in the volume of private expenditures. By wise policy, correctly timed, government can thus be a balance wheel and a stabilizing influence in helping to sustain a high level of production 106 hutz, op. cit., pp. 100-101. 107 Groves, op. cit., p. 362. 359 108 and employment. It is apparent there is diagreemont among the authorities on this point as well as on mai y others, but there is a certain general agreement that taxes may be timed correctly if we are intelligent on this score. One more statement on this point is pertinent: Regardless of what type of taxes are included in the tax system or whether the anti-inflation or anti depression weapons are taxation, public expenditures or monetary policy, decisions have to be made as to when to take action* • .Such decisions necessitate forecasting what is likely to happen as a result of various courses of action • . .difficulties in forecasting suggest also that policy must be fairly flexible and built upon short term rather than long-term forecasts. 109 Tax policy. It is true that there can be no tax policy that Ignores all other policies, but nevertheless tax policy is an important aspect of the question of taxation, as it Is for the whole fiscal picture and the functioning of an efficient economic system. Traditionally it has been recognized that taxation could be a stimulant. Ricardo believed that taxes would stimulate production up to a certain point, for taxes tended 108 M.S. Eccles, "Possibilities of Postwar Infla tion and Suggested Taxation,1 1 Curbing Inflation; Symposium conducted by the Tax Institute, (New York": Tax Institute, Inc., 1944), p. 233. 109 Boddy, o£* cit., Applied Economic Analysis, p.338. 360 to increase the accumulation of capital through saving and desire to produce, but excessive taxation would reduce both production and saving. McCulloch also believed this and felt that taxation to pay off debt would stimulate production and saving. However, this type of incentive retarded investment of risk capital, .promoted large scale enterprise and increased saving by increasing the inequality of wealth. It was pointed out that such debt retirement as took place in the twenties in the United States led to a shift toward 110 conservative investment, namely, state and municipal bonds, and later to speculation in 1928-29. The traditional view of taxation has changed little in recent times except to become somewhat broader, as may be seen from this statement: Policy makers in the tax field, h<wever are usually more concerned about the effects taxes will have on employment, production and the conditions of the economy generally than they are on ability to pay, although, the latter is not disregarded. . .taxes would be kept relatively low at those points where taxes interfere with production and made relatively high at those points where such taxation would not interfere with production. Ill 110 Withers, og. cit., pp. 39, 63. This passage is derived directly from this" work. He went on to explain the assets behind the public debt after World War II were the greatest in history. His total is upwards of 65 billion dollars in government plants, private plants, lend-lease, RPC and lending agencies1 assets and the stabilization fund. 111 R. Blough, "Conflict and Harmony in Taxation,1 1 Viewpoints in Public finance, op. cit., p.' 719. 561 Taxes, therefore, sh ould be chosen for their desired effect and imposed when that will be attained most readily and easily. The equity of such taxes must be obvious. The traditional theory of interest rate has been found not to affect saving qs originally thgught. Savings is determined from the modern point of view rather by income by its distribution and by the willingness of people to provide for their futures. "However, the oversaving hypothesis has enough plausability to warrant a tax system that would tend to correct rather than aggravate the problem should it turn 112 out to be real." This may present tax policy makers, with a dilemma, namely, how to reduce savings, say, by progressive income taxes yetat the same time foster investment and broaden the market. It is a fundamental problem that must be solved if tax policy is not to be out of line with fiscal policy and a balanced economy. ”In the future the adjustment of tax rates may as a counter-cyclical device, take the place formerly occupied 113 by variations In the rate of interest.” This will necessitate flexible tax rates which must subject to administrative control, for legislative action is too slow. 112 Groves, Financing Government, op. cit., pp. 610- 6i:u 113 Hansen, Economic Policy and Full Employment, op. cit., p. 141. 362 This power would have to be circumscribed by law, and would not affect the structure of tax rates but merely the basic rate, as has been suggested by Hansen. The effects of taxation on a broad basis must always be necessarily considered in any viewpoint for tax policy. This viewpoint requires a knowledge of total population, wealth, income and the distribution of wealth and income. Taxes are only necessary to defray the expenditures of government. The problem of controlling the costs of govern- 114 ment is far broader. Obviously the formula fora dynamic economy is not discoverable by taxes alone. "What is required is that we build a tax system which is intelligently directed toward creating and maintaining the kind of world we want. . .Our choice of taxes is always a selection of 115 means to that end*1 1 CONCLUSIONS IN FISCAL POLICY The thread of fiscal policy has run through all this discussion. The immensity of government operations has created a condition that can no longer be Ignored by economists, and makes the science assume a distinct flavor 114 Buehler, op. cit., pp. 691, 693. This idea is drawn from him. 115 Paul, op. cit., p. 207. 363 of politics, which has moved many to disinter the old name of political economy and give it added luster. Fiscal policy in this country in the period covered has undergone reappraisal, readjustment and growth as has the whole science of economies. A few biref statements may be made to summarize the era. The fiscal year 1940 marked the transition from a period of about eight years during which the fiscal policy was concerned primarily with the problems arising out of the depression to a period in which it appears that the emphasis is likely to be placed, upon fiscal problems connected with the country's rearmament program* 116 The defense period was closely followed by a period of war finance when the main fiscal problem was making the financial resources meet the needs of winning the war by supplying the money to attain the production necessary for this end. The post-war era engaged fiscalauthorities in the problems of inflation, reconversion and the broader question of stabilization. Public finance policy in the postwar years will doubtless reflect a conscious effort to select a pattern of taxation and of borrowing or debt retirement that will promote a high average level of efficient employ ment under private enterprise. This responsibility can scarcely be escaped; the amount of money passing through the Treasury will be so large relative to the money flow in the economy as a whole that even small 116 Annual Report of the Secretary of the Treasury for the FI seal Year 1935 -40., p. '1. 364 percentage variations in deficits or surpluses, in the yield of a major tax, and so on, will change substan tially the total money stock, its distribution and transfer, 117 The broader responsibility of government toward the functioning of the whole economy has gradually been reorganized by statesmen': and government officials. This recognition is present in their thinking and writing, and has been brought out in the monetary phase of government policy. The broader responsibility of government toward the functioning of the whole economy has gradually been reorganized by statesmentand government officials. This recognition is present in their thinking and writing, and has been brought out in the monetary phase of government policy. The fiscal policies of the state cannot be conceived in terms of the calculations of private enterprise but in terms of regulation and control, in terms of the impace of public policies upon the functioning of 117 G. Shoup, ’ ’Problems in War Finance,1 1 American Economic Review, 33:90 , March, 1943, 365 118 the economy as a whole. However, fiscal policy may not be based on such concepts as a greater distribution of wealth that might approach equality. Such distribution could be done in order to raise the level of consumption by taking from the high income receivers and giving to the low income receivors. The increase in consumption by much greater redistribution of income would be rela tively small* Complete equality of distribution probably would result in a decidedly smaller income to distribute. 118 ^ansen, Fiscal Policy and Business Cycles, op, cit., p. 142. To explain this Hansen quoted Pederson: ” " " T r We may therefore conclude that the financial transactions of the state, that is the spending of money for certain purposes, the collection of taxes, the issuance of loans, and the creation of means of payment, the fixing of rates and prices for state-controlled goods and services, are not economic decisions arrived at with a view to the balance sheet of the business of the state as such. We conclude that such a balance sheet tells us nothing about the appropriateness or economic soundness of the measures taken. Such measures must rather be undertaken with a view of achieving an economic balance for the economy as a whole. Their appropriateness or soundness can be determined only in terms of their effect upon the welfare of the community as a whole. Politicians and statesmen are obsessed by the ideology of private business, and their good conscience therefore requires that their financial transactions correspond as far as possible to the require ments and practices of private business management. Through the force of circumstances they are often compelled to deviate seriously from this ideal* but such deviations are glossed over as much as possible. This ideological prejudice causes great damage, because it prevents statesmen from acting with conscious knowledge of the real aims of public policy and on the basis of the requirements of the relevant economic considerations.” 366 There have been many fiscal policy proposals: deficit financing to promote economic recovery, surplus financing to check inflation, automatic stabilizing fiscal programs to maintain economic balance, deficit financing to maintain full employment, compensatory debt management and certain expenditure and tax policies directed toward economic ends. Probably the most outstanding are the balanced budget, the varying of expenditures and the varying of tax rates. The balanced budget policy calls for reducing expenditures when tax receipts rise and raising expenditures when income declines. Thus the budget is balanced over the cycle.; this is compensatory fiscal policy. If the budget were to be balanced annually and the economy maintained on an even keel, it would necessitate that the government be a large producer. Oh if the budget be balanced annually, it would probably lead to great Inequality of distribution of income in an inflation and great equality of income in a deflation. The Committee for Economic Development has proposed fixed tax rates at all levels of employment, but the budget would be balanced at approximately 93 per cent of the estimated laborsupply; at 96 per cent employed there would be a surplus, and at below 93 per cent there would be a deficit. Hansen has criticized this proposal as Inadequate because there is no tendency for full employment and because 367 once a recession starts, it is difficult to stop as we 119 understand the nature of the boom so little. Such a plan contemplates a public works program which may compete with private investment, and the use of unemployment funds to keep consumption at a high level. Another suggestion has been made to vary tax collections and do away with public Investment. Although tax rate flexibility is attained, negative taxation or grants of income seem to be favored under this proposal. Hansen has his own proposal that he offered which he called the managed compensatory plan. It would call for long range development projects that would be flexible; tax rates would also be flexible but would be limited by presidential authority granted to him by Congress; he included expanded federal reserve controls. Congress will have the final decision in such policies. Flexibility is necessary for any fiscal policy, especially in expenditures. How far tax flexibility can be carried is debatable. It may be that the structure of the tax system should be stable and the rates should vany, or that only certain rates should vary. If other conditions arise, then the shortcomings of fiscal policy can be visualized. Certainly fiscal policy is not the sole answer, 119 Hansen, Monetary Theory and Fiscal Policy, op. cit., pp. 175-176. but intelligent fiscal policy is necessary. The question of a debt necessarily arises in any fiscal policy discussion, especially under present conditions, and a balanced budged has been long-standing dogma. Governments have frequently violated the standard, but such violations have not been followed invariably by disaster and have even on occasion proved beneficial. Still the balanced budget is a good rule of thumb to keep expenditure under control. Adam Smith’s classic reply to a friend who lamented the growing debt fearing that the nation would be ruined was, aBe assured, my young friend, that there is a 120 great deal of ruin in a nation.” 120 J. Viner, nA Short and Long View in Economic Policy,” American Economic Review, 30:10-11, March, 1940. CHAPTER VIII SUMMARY AND CONCLUSIONS SUMMARY Classioal school. Adam Smith’s treatise put the known doctrines of economic thought into a cohesive and logical whole that was ably modified by his successors, Ricardo, Mill and Malthus. These men were interested in the development of the principles of the science. They were greatly concerned with the determination of value as expressed In terms of money as a price, with the supply and demand for capital, as well as for any commodity, determining this price. It was therefore, in effect, both a return on the supply of that capital and the cost of such capital. The main determining factor was supply. It was Malthus who alluded more specifically to the peculiar position of the Interest rate as an influence on savings, investment and consumption. Malthus' position much later was to assume greater importance. The contribution of the Marginal School was the switch of emphasis from supply to demand. Instead of abstinence from consumption, vtrhich was Senior's explanation of the supply of capital, the Austrians who developed the 370 Marginal School of thought emphasized that it was the demand for present consumption over future consumption that determined the necessary premium for the borrowing of capital* Although Smith had distinguished between the different types of capital, he had not specifically included money as such, but had included it in his references to a supply of savings in the form of circulating capital, in which money was implicit. Bohm-Bawerk, on the other hand, had made capital all inclusive except for goods for immediate consumption. The first great synthesis of all economic thought relating to modern economic doctrine came with Marshall. He injected the relation of demand to the short-run and supply to the long-run as the determinants of value, the supply and demand for capital determining the rate of interest. Modern theory had not as yet subjected capital to a closer scutiny. It was in the analysis of Pisher, who for a long time dominated American thinking, that monetary phenomena was revealed as having a clear relation to the working of the system. Pisher merely advanced the doctrines of Bohm- Bawerk, but placed the emphasis on the monetary approach. Monetary development. It must not be forgotten, however, that the development of the monetary and credit 371 approach was begin back in the days of Adam Smith by a belatedly recognized authority, Henry Thornton. He took a different position from Smith on the question of money, and though highly respected in his contemporary world, was largely lost from view because of the grea ter reputation of Ricardo and Malthus. It was almost a century later when he was given due accord by Wicksell, the distinguished Swedish economist, who modified this modern idea of money and credit using the Thornton approach, and went on to become distinguished in his own right for greater refine ments. Wicksell's theoretical approach to interest was noteworthy, but he too languished until contemporary scholars rediscovered him in seeking a solution to the problems of the world today. Wicksell decided that there was a natural rate of interest determined by profit rate expectation and a money rate of interest determined by the demand and supply for money in the market. He explained further that some account must be made for cash balances which were used in carrying on the affairs of business. Both Thornton's and Wicksell*s analysis had policy implications. Thcmton suggested that in times of money scarcity, the bankers should meet the needs of the economy by extended borrowing. Wicksell' suggested that the money rate could be used to determine economic activity by keeping it above or below the 372 natural rate, which was not evidenced in the market. Both economists emphasized the normal conditions of the market as important for the proper functioning of the economy. John Stuart Mill also contributed to the theory of interest by emphasizing the importance of money as a determinant of the rate of interest. The necessary demand for funds coupled with the supply of loanable funds derived from savings, which found their way into the hands of the credit institutions of the economy, determined the rate of interest. He also concluded that interest was the factor determining the value of capital goods, for the interest rate estimated the future income for the life of these goods derived from their productive contribution. This became known as the capitalization factor which was later emphasized by Davenport* Keynesian theory. Keynes claimed that a particular type of detnai d for money determined, along with the supply of money, the rate of interest. This type of demand was a speculative demand which increased when the rate of interest was expected to rise or when the rate of interest according to the market was below normal. As long as this policy predominated, cash would be held idle, thus reducing its velocity and therefore the quantity of money. While Keynes also recognized other demands for money, 373 speculative demand apparently was the major determinant. Thus, he abandoned the idea of the loanable funds doctrine that interest equating savings and investment. It was largely because of this position that he was attacked generally. Liquidity preference has also been attacked as too special an explanation of the rate of interest. The Keynesian theory of the preference of money over other goods or investments, coupled with contemporary developments regarding interest, was derived from the Walrasian formula of reducing the economic system to a series of simultaneous equations, in which money had to be included, and hence was treated as a commodity. Mathematically a system requires as many equations as there are unknowns; if money is ignored, the system is incomplete and incapable of solution. Walras expressed it as the general interdependence of all factors. This was the general interdependence of all factors. This was the general equilibrium theory that was to be' taken up in recent economic thinking. The Hicksian analysis was developed from Keynes’ liquidity preference, the Walrasian interdependence, and an even more acute analysis of the different types of demand and supply of funds and the closer Interpretation of interest not as a rate butas a structure of rates determined by the' various needs for funds. Thus the long 374 rate of interest was defined as a sort of average of the current rate and relevant future short rates. The difference between the two would be the liquidity preference, measured as a rate. These ideas had developed from studies in the thirties regarding the relationship of rates. Keynes broadened the determinants of Wicksell1s natural rate and Fisher’s expected rate of return over cost into the marginal efficiency of capital. This concept represented the demand for investment, and with the supply of money, the interest rate being fixed, it determined in conjunction with the marginal propensity to consume the income of the economy and employment. Thus it has been shown in this study that money factors affect both the supply and demand which in turn determine interest rates. The classical theories and their modern offspring seemed to have assumed full employment while the monetary approach seemed at least in Thornton and possibly in Fisher to have taken cognizance of the full employment equilibrium. It remained for Keynes to call attention to the possible explanation of unemployment, concurrently with the experience throughout the world of mass unemployment and the driving necessity of doing something about it; from these the further developments evolved* 375 Synthesis. As an aid to better understanding of recent interest theory developments a brief resume of two outstanding authorities may be worth while. Each represents an attempt at synthesis; ten years separate their expressions in time. Each represents a different school of thought: the first, Fredrick von Hayek, the Neo-classical, and Alvin H. Hansen, the Keynesian. The two, it ?/ill be seen, are not too far apart. Hayek has held that whatever particular explanation of interest rates the individual may subscribe to, all agree that the function of interest is that of equalizing the supply of capital with the demand arising in various branches of production; in other words, to keep the supply of capital goods in equilibrium with consumption goods is its primary function. He felt that an investigation of the field showed that the rate of interest depended, apart from the demand for loan capital, only on the supply of newly produced or reproduced capital. Although interest rate changes affect heavy industry more than other types, there seemed to Hayek to be no reason why an increase in the rate of saving could not be more than offset by both a reduction in the rate of interest and changes in the technique of production so as to make production more profitable* 376 However, he recognized that changes in the velocity of money or its demand will deflect the rate of interest from this equilibrium position; this explanation is the superimposition of monetary dynamics on the rate interest. Therefore, he concluded, that before incomes can rise with a given quantity of money, a rise in returns must occur to induce somebody to reduce idle balances; it is only in consequence of a previous increase in investment that incomes and fiscal demand will increase, and in turn affect the investment demand schedule. Thus even in the shortest of short runs the investment demand schedule has a direct influence on the rate of interest, and any changes in the former will lead to the latter. The liquidity preference analysis is a short run monetary factor which is not primary in the determination of the rate of profit and interest, except in the very short run. The changes brought about by the economic structure of production can best be adjusted by a monetary policy that will take up the slack in the self-correcting forces of the price mechanism so as promptly to reduce reper- 1 cussions of delay that multiplies the need for readjustment* 1 P.V. Hayek, Pure Theory of Capital (London: MacMillan and Co., Ltd., 1941); The liberty has been taken here of paraphrasing what appeared to be the essence of the theory. 377 Thus the Keynesian idea is reduced to a short run monetary phenomena grafted on the classical theory; it is nothing more than that. More attention is paid to the structure of production than to Keynesian analysis, but more attention could have been paid to liquidity preference and its effects upon profit expectation. Hansen's thesis has broadened the Keynesian analysis; it may be briefly stated that the rate of interest and the level of income are mutually determined by the marginal efficiency of capital influenced by productivity and expectations, and the ratio of the change in consumption to the change in income is influenced by savings, liquidity preference schedules, and the quantity of money. A change in thrift will affect the consumption function, and in this way influence the level of income wh ich will in turn affect 2 liquidity preference and therefore the rate of interest. An alternative way of explaining Hansen's thesis would be that a change brought about by the upward shift in the marginal efficiency schedule will effect the rate of interest through its effect on income which, in turn, will affect the liquidity preference and the rate of interest* Unless, however, Hansen's definition is broadened to include 2 A.H. Hansen, Monetary Theory and Fiseal Policy (New York: McGraw-Hill and' dompany, 1949) The text gives writer's own analysis of Hansen's theory. 378 a cash balance approach, his analysis while true is deceptive. Demand for money may increase while liquidity preference in the Keynesian sense declines considerably* Hansen's development intimated that liquidity preference would take on a broader function, in fact the money function would better be used in the statemoit than liquidity preference. He suggested that there is a high correlation between the interest rate and the income velocity of money which is determined by the relation of income to adjusted demand deposits* Obviously both representative views are indicative of the modern emphasis of theory and policy, the development of which has been attempted in this study* Policy developments. Recent policy developments in the period covered by this study have emphasized both the importance of the monetary, aspects of the economy and the necessity of recognizing these aspects as a phase of the whole economic process* The government from early New Deal days permitted bonds to be collateral security behind federal reserve notes. The general concern over the shortage of funds in. the thirties led to the development of a long list of government lending agencies. The revaluation of gold was a step caused by the emphasis on money as the wole cause of economic disruption. Banking reform as was established in the early thirties was to aid in the lending of capital funds, to curb certain excesses, and to give more monetary control to the monetary authorities. Money was injected into the system by means of government borrowing and, with the inflow of gold, caused interest rates to decline throughout the various markets of the economy. The increase in government debt combined with this gold inflow contributed to tremendous excess reserves that continued to rise until World War II began, and then declined to what Is today (1949) considered a normal level of excess reserves. Pressure by monetary authorities to ease the standards of lending for banking institutions resulted in legislation being passed for this purpose. It became the conscious policy of the government to maintain easy money or low interest rates. The policy makers were conscious of the fact that there was a structure of interest rather than merely one interest rate; they made use of this-knowledge to effect the short term rate In such a way that the whole structure was affected. Any monetary or banking developments which were brought about on the policy level were largely government action. Those principles which has been advocated by certain economists, namely Thornton and Wicksell, and men of affairs for over a century had at long 380 last become an Influence in the carrying out of policy* The government's action during this time, (1933-1938), was determined by events? it wasn't until later that the Keynesian analysis was adopted, even then the course of events rather than Keynes dictated the necessary policy. It was not until just before World War II that an attempt at rationalization of such policy was made. It is true that the Keynesian theory with modificsations fit into the policy, but whether this has justified all the claims made forthe theory as the true explanation for continued policy remains doubtful in this writer's mind. Before the Keynesian theory could be tested for its validity, war intervened; as a consequence it is only now during this present period that this theory as well as the associated policy is undergoing its ordeal by fire. Fiscal policy, which had as one of its terminals debt policy, was well established by the Glass-Steagall Act of 1932. This act led to the later expression ”the monetization of the public debt,” which the Keynesian theory had defended on theoretical grounds. However, it was Congressional rather than Keynesian policy that presented this tool to the monetary authorities. Other instruments have developed with circumstances, for the greater familiarity v/ith economic questions necessitated that policy makers forge new weapons. However, 381 modern refinements of theory were preceded by even these newer weapons, for example, the increasing differentiation of government securities, and the growing need and use of a government cash balance. These two examples can be and are valuable instruments for credit and monetary control. These instruments may be blunted, however, by poor use. The constant struggle of the monetary authorities to cope with the problems resulting from business fluctuations has led to a new conscious policy on the part of government to avert those drastic fluctuations. This determination was not in any way altered by World War II, and as this conflict drew Into its final stages, greater attention was focused on the problems of the post war deflation. Various programs were suggested but with a debt of such gargantuan proportions, it was quickly discerned that the money and debt policy of the government would be a powerful factor for good or evil in the years ahead. The necessity of keeping the price of governmait securities stable, which ha s also meant keeping the interest rate low, has presented fiscal authorities with a dilemma. If the rate of interest is kept low, then inflationary forces are turned loose. If the rate of interest is allowed to rise, the last of the large government debt becomes extremely burdensome. This was a problem created not only by the debt but by the policy apparently followed of keeping the interest rate low that was supported by the Keynesians, 582 It was readily apparent that a responsible fiscal policy that includes taxation and public investment must be geared to solve these problems of business fluctuations* While public works may be used to stimulate activity in the economy, their use is limited by the effects upon private investment. Taxation should pay for government expenditures; however, intelligent policy is cognizant of the fact that taxation may have offsetting effects to expansionary public action. Fiscal policy, which has or should have as its main objective the maintenance and efficient functioning of private enterprise has assumed a greater role in the economic system. It is becoming increasingly more important that an accurate knowledge of its scope and Influence be required of those who deal in monetary and fiscal policy. If this requirement is not enforced, the effects of the policy-makers’ actions may be other than anticipated, and may result in another depression cycle. It has become only too clear during the past two decades that all phases of government policy must be coordinated, as well as all facets of fiscal policy, to the attainment of the common end established by the consent and agreement of the people. CONCLUSION'S "Futures rate" of interest. One of the most striking 385 things about interest theory is its preoccupation with the future. Economists have recognized the fact that the interest rate controls to some extent investment which in turn influences further production. Yet at the same time it is curious that no market has developed for an estimate of the future needs of money. If one would follow the Walrasian analysis, which considers money as a commodity, it would be easier to look upon the money market as being similar to any other commodity market. Many other commodi ties have futures markets while money has figured in only one, and then only incidentally, in the forward exchange market • Modern theory has brought out the relationship between the short- and the long-term rate of interest. The latter is the arithmetic average of the current short rate and the relevant future short rates, with any difference explained by liquidity preference or the demand for money. It would, therefore, seem logical that a futures market for money would be the natural development. This market should reveal, theoretically, the expected movements of shcr-ht-term interest rates. These rates would then also affect the long term rate for a like period. If the futures rates extended to 3, 6, or 9 months of the year, then the average of the current and futures rate should reveal the long-term interest rate for the same period. 384 The data that has been compiled by statisticians has revealed a definite correlation of the call money and time money rates, but while these two rates have not been consistent with theory, they have been strikingly close. No economist would deny the importance of expectations in economic activity, and such futures markets that exist are useful, so long as speculation serves to stabilize particular prices without manipulation. Such markets are peculiarly subject to manipulation by powerful groups and to the use of rumors because of the uncertainty of the future. Yet such markets have rather accurately reflected, in general, the future developments in their particular area s. Certainly the development of a money market along the lines suggested would be difficult. If such a thing were to become common practice, rules regulating the membership in such a market would be drawn up. However, only those who would be dealing in such transactions on a public basis would have need of such facilities, and it would be to serve their purpose that these rules would be limited. It is likely that those participating would be limited in actual practice to banking houses, dealers in such futures paper 3 P.R. Macaulay, Bond Yields, Interest Rates and Stock Prices, (New York: Nationa'Y "Bureau of Economic Research 1938). See Chapter II, particula rly p* 35ff. 385 and other organizations which would have need of such a market. Close supervision would be necessarily entailed because of the peculiar factor of easy manipulation of the market. Cognizance must also be taken of the fact that the government's control in the money market would prevent it from having the free play of a capital or money market as part of the capitalistic system. Futures markets have developed slowly in the economic system, the earliest dating back no farther than the nineteenth century. This market would of necessity be one peculiarly adapted to the risk takers. Since it must concentrate on the expectations of the near future, it would seem to be a logical development of the capitalistic system and business enterprise which constantly operate on the basis of expectations of the market. In the lightcof critical study it would seem that such a market would adequately fill the gap which is now present, and would fulfill to a limited extent a need that has been indicated by theoretical developments* As a suggested market of this type must necessarily be limited by the number of participants who would be able to utilize such facilities, it would consequently be limited in its resources; yet at the same time it would serve a useful purpose in establishing a professional opinion of the movements in the money market. This opinion would be of invaluable aid to businessmen in helping them to acquire a more rational outlook on the future. Such a market would tend to reveal the short-term demand for money, and in this way would aid the monetary authorities in maintaining a more stable condition. However, it seems improbable under conditions of stress that this market could be able to function as conceived. The reason for this break-down would lie in the limited participation because of the fact that people become cautious and refuse to operate in the market when conditions become uncertain. This results in the necessary operating funds being unavailable, and the market completely goes out of control or else fails to function. The chances are that this market will be subjected to fluctuations as are other markets, and such fluctuations would tend to reveal anticipated conditions. These fluctuations would furnish information as to the opinion prevalent in the market upon which the monetary authorities might base their actions. Thus the operations of such a futures money market might be considered a barometer of anticipated conditions. Its value would like in the fact that in giving an opinion of these developments, it would serve as an additional source of data for monetary decisions and fiscal activity which must be based on forecasts of future business expectations. Apparently the main barometer used at present 387 by fiscal authorities is the amount of unemployment that develops in the economy. This fact is presented by the market as it actually happens; in other words, it is ex post data rather than ex ante, but it is the latter upon which economic action is based. If additional fore knowledge of such developments is obtained to an even limited degree and if the anticipated continued development of such a trend can be revealed in a futures money market, then the fiscal authorities may be better equipped to cope with an anticipated crisis before it occurs. Since the reaction of such anticipations is usually slow, ample time is afforded for preventative measures. Interest rate changes have been estimated as having a delayed action of from six to nine months, and if futures can reveal expected conditions six to nine months in advance, an added instrument will be forged to aid in diagnosing the economic conditions. Proper use of this instrument will result in more intelligent decisions on the part of all. Fiscal measures. Fiscal policy developments of recent years have led to the discovery of new techniques in the matter of general controls. These controls have not been fully developed either because only a few were aware of their possibilities, or because others were conscious of the political dynamite which might be involved in their use. 388 One of the notable examples of such weapons would be the cash balance of the Treasury. Jls has already been stated in this study, this cash balance may be used to affect the reserves of the member banks of the Reserve System by using their deposits to ease or tighten credit in these banks, and it may even be used to ease or tighten credit in certain geographical areas of the economy. The Treasury may do this by shifting its deposits to member banks which under the fractional reserve system are allowed to expand credit, or must contract credit if they lose their deposits. When Treasury deposits are allowed to be held by the Federal Reserve Banks, these banks are afforded deposits with which to extend credit to the member banks, thereby easing rediscount rates to the member banks. If it is deemed necessary, the Treasury might relieve banks of the necessity of carrying reserves behind its deposits by legislative action. This relaxation of reserve requirements has not been used in peacetime, but the Federal Reserve Act has allowed such leniency for the purposes of the Treasury. If the Treasury has a sufficient surplus above current, or temporary needs, these foregoing measures may relieve a credit stringency; in other words, the Treasury must have a surplus over both current and temporary needs in order to work this manipulation. Another weapon of the fiscal authorities, namely the differentiation of securities, was relatively untried until recent times. These securities were differentiated as to eligibility of investors and their marketability as well as maturity. If the interest return on these bank ineligible securities is allowed to rise, it will put pressure on other interest rates causing them to rise, and may in this manner serve as an inflation control. Meanwhile, bank held securities may be maintained at any desired price level, thus doing away with any necessary action to influence bankers directly. The manipulated rate on bank ineligible securities would act as eight an Inflationary or a limited deflationary control. In other rords, such an operation affects the quantity of funds disposable forinvestment or consumption outside of banking by raising the interest rate to attract investors while at the same time maintaining or lowering the bank rates. The first action would be deflationary, and the second, inflationary. These may.take place simuHaneously. This manipulation may be construed as a form of qualitative credit control. Monetary demand. An important aspect of fiscal policy has been the use of taxation in'attempting to control inflation during the period immediately preceding F/orld War II. Taxes as well as Interest rates should be raised in anticipation of inflationary developments, so it was argued, to control the rising activity. This action would tend to throw the emphasis of economic analysis upon the control of a rise in activity in order to avert a necessary deflationary adjustment later. Such action must necessarily depend on the analysis of the authorities in determining the strength of such inflationary sources. If it is deemed that rising activity will lead to inflationary conditions, the action Indicated by informed opinion seems to be that consumption must be limited in some manner. This opinion has led to the use of taxation. Such an opinion depends for its foundation on the doctrine of ^forced savings1 1 as a cause of cyclical activity, that is, that consumers will buy less of the goods because of the higher prices which are a result of anticipated consumption and investment without a corresponding increase in income. The preceding process leads to profit and further investment and gradually to oversaving out of profits for lack of investment. The result is under consumption because the consumers have already used their income, fftien the increased Investment produces the additional goods, these are consequently priced lower because of the increased volume, and subsequently cause a downswing of business activity. Thus, it is argued that the government should tax consumption on the upswing 391 as the movement approached full employment to reduce consumption in order to approach a more balanced increase. Hansen has argued that actually the dovmswing is caused by underinvestment and bottlenecks of investment goods. While Iiayek has argued for forced savings on the basis of higher prices. Thornton, however, pointed out that forced savings can only come from underemployment; otherwise the increased income from investment will be absorbed by the income receivers' purchasing of goods, and only those on fixed income will suffer; thus any danger of oversaving is eliminated. The idea of added spending out of oversaving is eliminated. The idea of added spending out of increased income would lead to the conclusion that overconsumption* without the connotation of full employment and oversaving is the cause of the fluctuation of business activity. This conclusion tends to support Hansen's contention of under investment; consequently, it necessitates a much closer investigation of the characteris tics of each particular type of rising business activity. Each major swing would require an estimate of the time involved in the process of all production so as to bring about an increase in production, in order that consumption would be restrained until such increase was available. Thus with consumption increasing, a continuing investment is necessary. These increases of consumption and production are 392 aided by a necessary rise in the quantity and velocity of money with price increases where additional production is required. Continued rising activity seems to be the objective of the theoretical explanation of the policy makers and the reason for their actions. Deiaad for money. Recent developments have revealed that theoreticians have become conscious of a phase of economic development that has been largely ignored or given little emphasis, namely the cash holdings of economic units. Walras had already indicated the demand for cash in his expression "encaisse desiree,” and Wicksell had called attention to the cash balance of businesses related to their activity, Keynes stimulated further analysis with his explanation of cash holdings of particular kinds, with emphasis upon cash holdings for speculative or liquidity preferences, It would seem, hew ever, that a further analysis reveals that not only is there some validity to liquidity preference, but that a broader explanation of the demand for money along Walras-Wicksellian lines is needed. Such an explanation seems to indicate a rising demand for money. Individuals with greater income hold greater amounts of cash in their pockets for greater convenience. The government has shown a greater need for cash balances either 393 for control purposes or for meeting unexpected contingen cies. Business units have also revealed an unusual use of 4 cash balances in recent times. These holdings of cash would indicate an increased demand for money that cannot be wholly explained by liquidity preference. But a broader use of the term as a cash balance would apparently argue for a need for money with the rise of activity. This has been called by Hansen the monetary function. If money is treated as a commodity but with peculiar characteristics of a good that is readily exchanged for other commodities, as such it would indicate that as the demand for goods increases generally, the demand for money increases. If the supply of money does not increase, then the Interest rate or price for money must rise, but owing to the peculiar function of money as an exchange medium, this would affect all other goods more immediately than the scarcity of any other particular good. Therefore, since the demand for money is related to the demand for other goods, if the supply of money is insufficient for the exchange with other goods, then the deficiency of money would bring about an.insufficien t demandofor all other goods. Thus it is imperative that the supply of money meet not only the needs See Appendix for SEC report on cash holdings of over 100 corporations in the past 10 years up to 1948. 394 of exchange to absorb the production of goods in the economy but must also meet the demand for money as such* The demand for money is determined by the amount of goods and services produced as well as the needs or desires for money itself by individuals in the economy* The interest rate as the price for money must assume a greater importance in the economy because of this explanation of the demand for money. It may now indicate the rise and fall of supply and demaa d for money as such. If money is so important, then its price is proportionally important. The demands for money are motivated by needs which Keynes has ascribed to the holding of cash, namely for transactions which include business and income purposes. as well as for precautionary and speculative purposes. The above analysis would emphasize the income and transactions explanation as the important consideration for the rising 5 demand for money as income increases. 5 A diagrammatic analysis might be envisioned somewhat like this: As demand for goods and money increased, or g as the economy as a whole reached higher o and higher phases of total utility satisfac- o tion, a balanced economy would require that d goods and services increase as well as s money. The line represented by ’ ’Y1 1 would be the income line which is just tangent to the indifference curve which would give maximum satisfaction with the goods, services and money available at these levels of satisfaction. The dotted line might be interpreted to be the monetary function at the various levels of income and demand, the direction of the demand for money and goods indicate it to be In proper balance. 395 Memory of past experience has been a large influence on the demand for money. Traditionally the view was taken that money served merely to circulate, and that as such it facilitated the economic activities and rarely influenced operations. The modern analysis has emphasized money as an important factor of influence, not merely an adjunct of the system. The older analysis expected that investment would continue, the only restriction being on the supply of capital which determined the movemait and direction of the system. The supply was conditioned therefore on the expectation of the continued flow of money because of investment and the confidence of continued investment. As rude shocks have been suffered by the system in recent years, the demand formoney may have increased because of the uncertainty of modern conditions. Risk taking that is required to keep money in continuous flo\<? has been reduced. The reduction may be due to uncertainty, to the rise of government controls, to the almost universal manipulation of money by governments, to the consequent restraint on the potentital rewards of investment, to the psychological reactions of the people in their economic activities, and to the possible search for some stability that the holding of money seems to give. Thus, this explanation of the desire to hold money might reveal a lack of risk taking and the desire for money 396 as a refuge against the vicissitudes of the economic system. If this is a fact, it would represent a radical change in outlook for the capitalistic system from the adventuresome spirit that is so necessary for its proper functioning. 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Williams, J.H., "Deficit Spending,” Readings in Business Cycle Theory, Philadelphia: Blakiston Co., 1944. Tp. 270-29(1: Wyatt, W., "Federal Banking Legislation," Banking Studies. Board of Governor’ s, Federal Reserve System. Baltimore: Waverly Press, 1941. Pp. 39-64. 408 D. GOVERNMENT PUBLICATIONS Annual Report of Secretary of the Treasury, 1933-1948* Annual Report of the Federal Reserve Board, 1927,. 1939, Federal Reserve Bulletin, January, 1933 to December, 1948. Temporary National Economic Committee, ’ ’Saving Investment and National Income,” Monograph No. 37. Washington, D.C.: United States Government Printing Office, 1941. 127 pp. APPENDIX TABLE V 1 NATIONAL INCOME AND FEDERAL GENERAL FUND BALANCE 2 AND 1122 CORPORATION CASH BALANCE Year Nat’l Inc. Billions of Dollars Federal Balance 1122 Corp. Bal* 1933 39.6 .862 1934 48.6 2. 58 1935 56.8 1.84 1936 64.7 2 . 6 8 1937 73.6 2.58 1938 67.4 2 . 2 1 1939 72.5 2.83 4.316 1940 81.3 1.89 1941 103.8 2.62 5.430 1942 136.5 2.99 1943 168.3 9.50 7.735 1944 182.3 20.16 7.255 1945 182.8 24.69 6.987 1946 178.2 14.23 6.963 1947 3.30 7.430 1, Derived from Economic Almanac-1948 (New York: NICE,1947) National income is net national income. 2. Derived from EEC report, November 30, 1948. 411 TABLE VI 3 5 * OPEN MARKET RATES IN NEtf YORK CITY (1933 - 1946) Prime Commercial Paper. 4<?6mo. Prime Bankers Acceptances 90 days Stock Exchange Time Loans Short-t erm Government-*- Obligations U.S. Treasury Bills 33-1.73 .63 1 . 1 1 .26 .515 34-1.02 .25 .90 228 .256 35- .76 .13 • 56 .17 .137 36- .75 .16 1.16 .17 .143 37- .94 .43 1.25 .28 .447 38- .81 .44 1.25 .07 .053 39- .59 .44 1.25 .05 .023 40- .56 .44 1.25 .04 .014 41- .54 .44 1.25 .13 .103 42- . 6 6 .44 1.25 .326 43- .69 . 44 1.25 Not .373 44- .73 . 44 1.25 Avaliable * .375 45- .75 . 44 1.25 .375 46- .81 .61 1.50 .375 1 3-6 months Treasury Notes and Certificates through 1933# Dealer quotations on 3 month bills 1934-1941* 2 Average rate of new issues during period. Tax exempt bills prior to March 1941. Tax bills thereafter from 1941 to date? 3, month bills. Earlier Years mo>4Ly 3 month bills. # From Economic Almanac 1948 (New York: National Industrial Conference hoard), pT 39* 41 2 TABLE VII BOND YIELDS ON OPEN MARKET PER GENT PER ANNUM (1953-1946) TJnited Stated Trea sury Bonds 1 Ta^:able Yr. Aaa Baa Partially tax exempt 7-9 yrs. 15 or more 33-4.49 7.76 3.31 34-4.00 6.32 3.12 35-3.60 5.75 2.79 36-3.24 4.77 2.65 37-3.26 5.03 2 . 6 8 38-3.19 5.80 2.56 39-3.01 4.96 2.36 40-2.84 4.75 2 . 2 1 41-2.77 4.33 2.05 42-2.83 4.28 2.09 1.93 2.46 43-2.73 3.91 1.98 1.96 2.47 44-2.72 3.61 1.92 1.94 2.48 45-2.62 3.29 1 . 6 6 1.60 2.37 46-2.53 3.05 a 1.45 2.19 a No partidly exempt due or callable in 15 years or more. 1 To 1940 all bonds due or callable in more than 12 years. 1941 to d&te partially tax exempt bonds due or callable in more than 15 years. 2 Beginning December 15, 1945 include Treasury Bonds of June, 1952-54, June 1952-55 and March 1956-58. - i s - Prom Economic Almanac-1948. (New York: National Conference Board, 1947), p. 43. CHART V 180 160 140 120 90 60 30 BANK DEPOSITS AND CURRENCY Tota1 Depi>slts and 3urrency - i ✓ V. * i i ' ■ ? 0 / f I 0 f • i i . • ‘f jl i« > Sxcl Oover Bepo iding iment 3its ■ C ' ii (i . • it ty • s' /’ / smand AdJ Depo usted Jita^ \ \ \ S ^ * ** * 'ime I ✓ / ✓ ‘ epos! ts t o' c o S s' / » ©0 "\ ° Currc __ou1 *©e®< noy^ side >o*e®a banks »a___ ✓ S .-..m » r, u.s irernmi Depos: * ? • % mt .ts 1930 1 934 1 938 1 942 1 946 ^Annual Report of Secretary of Treasury. 1947. p. 19. H E fn taBrstty oi S outhern C alifornia U B M fl

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