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Central Banking and Money Market Changes Author(s): Hyman P.

Minsky Reviewed work(s): Source: The Quarterly Journal of Economics, Vol. 71, No. 2 (May, 1957), pp. 171-187 Published by: Oxford University Press Stable URL: . Accessed: 14/02/2012 18:35
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May, 1957


No. 2

I. Introduction, 171.- II. Two recent institutional changes, 173; the federal funds market, 173; the financingof government bond houses: sale and - III. Implications repurchase agreements with nonfinancialcorporations, 176. IV. 181.for of these changes Implications of the expectamonetary policy, tion that institutionswill change, 185. I. INTRODUCTION

The ability of a centralbank to achieve its objectives depends that make up the the variouselements upon how its operationsaffect of any particulartechniqueof moneymarket. Hence, the efficacy and usages monetary policy depends upon the financialinstitutions do not changesignificantly, institutions then, that exist. If financial is established, ofthe variouscentralbank operations once the efficacy ofmonetary in discussions can be ignored institutions financial policy. or in the mode in However,ifa periodof rapid changes the structure of central marketsoccurs,thenthe efficacy offinancial offunctioning bank actionshas to be re-examined. and money-market usages are Changes in financialinstitutions or evolution. the resultof eitherlegislation Legislatedchangestypiof the cally are the result of some real or imaginedmalfunctioning are and hence accompanied they usually system monetary-financial oftheirimpact. Evolutionarychangesoccurtypically by discussions in response to some profitpossibilitieswhich exist in the money market. As the evolved changesoftencenteraroundsome technical behaviorand as theyusuallystarton a small detail ofmoney-market at the for ignored policyis generally scale, theirsignificance monetary a some later at occur. first time they malfunctioning date, Only if, of the financial systemis imputedto such an evolved money-market willit be discussed,and thenthe discussionusually occurs institution
* The observations upon which Part II of this paper is based were made while I was in New York City on a fellowshipsponsored by the Joint Committee on Education of the American Securities business. I wish to thank J. Margolis, R. Miller and R. Roosa forhelpful comments and suggestions. 171



of the conditions as a preludeto "corrective" legislation. Awareness whichinduce institutional changesin the moneymarketand knowlofsuch institutional changesshouldenable edge of the typicaleffects eitherto take preauthorities the Federal Reserve or the legislating the effects of a "crisis" ventivemeasuresor to be ready to minimize whenone occurs. and usages are institutions As evolutionary changesin financial the result of profit-seeking activities,the expectationis that such financialchanges will occur most frequently duringperiods of high demand rates. Such ratesare evidenceofa vigorous interest or rising relativeto the available supply. They act as a signal forfinancing to seek ways of using the available to money-market professionals lendingabilitymoreefficiently.1 Essentially,the relationsupon whichthe monetaryauthorities thata given are predicated base theiroperations upon theassumption of the authorand usages exists. If the operations set of institutions in that theyinduce changesin financial instituitieshave side effects tionsand usages, then the relations"shift." As a result,the effects can be quite different from thosedesired. To ofmonetary operations evolutionis induced by high or rising the extentthat institutional whenthe central interest significant rates,thiswould be particularly in an effort constraint to halt inflationary bank is enforcing monetary

In the recentpast (1954 to date) short-term ratesin the interest United States have been relativelyhigh and rising. During this period at least two changes in the Americanmoney market have and growthof the federalfundsmarket; occurred:the development
of financialinstitutionsis the mobilization of the 1. "The basic functioning financialresourcesof the economy in support of economic activity, and I suggest that when credit conditionsare tightenedand the creation of new money through the financialmachineryof the countryautomatithe banking systemis restricted, cally begins to work in such a way as to mobilize the existing supply of money it to do most of the work that would have been thus permitting more effectively, done by newly created money had credit conditions been easier" (Warren L. Smith, "On the Effectivenessof Monetary Policy," American Economic Review, utilization of a XLVI (Sept. 1956), 601). Smith's point that the more effective given monetary supply counteracts, at least in part, tight credit conditions is well taken. However, the assertions that it automatically begins to operate and that it occurs within an unchanging institutional framework are, I believe, incorrect. 2. "Moreover, any risein interestrates broughtabout perhaps by a combination of restrictivemonetary policy and accumulating debt creates the opportuto offer more expensive attractionsto creditors nities fornon-bankintermediaries and hence to compete more actively withbanks" (JohnG. Gurley and E. S. Shaw, "Financial Aspects of Economic Development," AmericanEconomicReview,XLV (Sept. 1955), 532). Gurley and Shaw deal with the evolution of financialinstitutionsin a growthcontextand hence they tend to take forgrantedthe inducements to, and the facts of, institutionalchange.



in and the increase in the importanceof nonfinancial corporations In II bond houses. two evolved Section these financing government are describedand examined,in Section III the implicadevelopments tions of these particular changes for Federal Reserve policy are formonetary taken up, and in Section IV the implications policy of the expectation that money-marketinstitutionswill change are investigated.

There is no singletradingcenterwherethe fullscope of the federal fundsmarket can be observed. One brokeragehouse in New York has formany years,however,played an important role in the market.3 The best possible view of the market, fromany single vantage point, is probably that obtained by observingthis firm's operations. At theend ofJune,1956,Garvin,Bantel and Companyhad some banks and 14 otherfinancial as clientsfor 79 commercial institutions in federalfunds. Not all sales or loans of federalfunds transactions ofthisfirm. A substantial are clearedthrough thebrokerage facilities volume of transactionsoccurs,forexample, throughthe networkof relationsamong banks, at times in the formof direct correspondent loans between banks. However, for the transactionswhich do not of Garvin,Bantel and Company the rate the worksheet pass through is thoughtto be typicallythe same as that which emergesfromthe and bids broughttogether offerings throughtheiroffice.4 Reserves at the Federal Reserve Banks are the commodity in whichthefederalfundsmarketdeals. The transaction is an unsecured loan between banks.5 Among New York City banks this overnight is accomplished by an exchangeof checks,the lendingbank gives the bank a drafton the Federal ReserveBank, and the borrowborrowing
3. I wish to thank George Garvin and Ralph de Paola of Garvin, Bantel and Company fortheirkindness in explaining theiroperations to an academician. The followinganalysis of the characteristicsof their clients is based upon their worksheet. I wish to emphasize that only the segment of the national market which relies upon the brokerage facilities of that firmis described here. I alone am responsible for the reportingand the interpretationwhich follows. For a good introduction to the mechanics of the federal funds market see Nadler, Heller and Shipman, The Money Market and Its Institutions(New York: The Ronald Press, 1955). 4. A more comprehensivesurvey of the entire market was reportedlyundertaken by a special committee of the Federal Reserve System some time in 1956. Pending the completion of that study, which has been kept on a confidentialbasis to generalize with any certaintyabout up to the time of this writing,it is difficult the market as a whole. 5. At times, governmentbond houses, as the result of a sale of bonds to the Federal Reserve System, will lend (sell) federal funds.



ing bank gives the lendingbank a checkdrawnon itself. As it takes balance bank's overnight one day fora checkto clear,the borrowing at the Federal Reserve Bank is increasedby this transaction.6 For of reservebalances transfer non-NewYork City banks, a telegraphic of reserve in one directiontoday is offset by a telegraphictransfer at the openingof the nextbusiness balances in the oppositedirection between transferred balances can be and are freely day. These reserve Federal Reserve districts.7 Obviouslya loan of federalfundsdecreasesthe reservebalance balance oftheborrowing bank and increasesthereserve ofthelending a bank which bank. During a period of negative free reserves,8 in thismarketaims at nothavingexcessreserves, activelyparticipates than the unitoftransactions.Also over the averagingperiod,greater a bank active in this market might not borrow fromits Federal fundsavailable. The benefit ReserveBank unlessthereare no federal on what would have to the lendingbank is obvious: it earns interest in not havingto bank benefits been an idle balance. The borrowing fora bank not in the federal bank. In contrast, borrowat its reserve resultsin its eithersellingassets fundsmarket,a reservedeficiency excessofreserves at the reserve or borrowing bank,and any short-run remainson its books. rate on federalfundsis nevergreaterthan the disThe interest count rate. During periods when there are sizeable negative free the federalfundsrate usually is equal to the discountrate. reserves, Most banks average theirreservesover the assignedperiodby buildofthe averagingperiod positionat thebeginning ingan excessreserve thelatterpart to accumulateduring deficits and thenallowingreserve of of the period so that, as a result of the dominance the weekly memberbanks in the federalfundsmarket,a rate pattern reporting the has developed. During periodsof sizeable negativefreereserves, rate the to discount federalfundsrate is equal except, perhaps,on rate. There is the discount is than lower Wednesdaywhen it often to were banks some 1956 some evidence that by midyear beginning rate pattern. play this interest Of the 79 commercialbanks which actively participatein the federalfundsmarketby using the facilitiesof Garvin, Bantel and
the deposits are taken as of the begin6. In computingreserverequirements, ning of a business day whereas the reservesare calculated as of the close of the day. 7. When the discount rate is not the same in all districts,some banks will not lend reserves fromlow to high discount rate districts. Also some New York banks will not allow theirfederalfundsto be loaned outside the New York district. 8. Free reservesare excess reservesminus borrowingsat the Federal Reserve Banks.



24 are Companyforall or part of theirfederalfundstransactions, CentralReserve City Banks, 39 are Reserve City Banks and 16 are CountryBanks. Of course, the largest and most active group of are the 24 New banks usingGarvin,Bantel and Company'sfacilities York and Chicago banks.9 The large numberof Reserve City and is evidencethat the marketis national. Countrybanks participating or not a bank factor whether The effective determining limiting will take part in the federalfundsmarketis the size of the bank. to take part: thetimeofan officer, It does costsomething phonecalls, etc. The brokercharges 1/16 of 1 per cent "each way" to banks forstockand outsideofNew York Citywhichdo notuse his facilities bond business. As the loan is an overnight loan, the interestat 23 per cent on one milliondollars forone day is $76.389 and the on a one milliondollar loan (1/16 of 1 per cent broker'scommission the unit of each way) is $3.472. As a resultof such considerations and each million one-half around was 1956 in dollars, trading midyear in deal several Since to units. the was bank expected participating allowable loan to any one borrower maximum (excludingthe federal by a National Bank is 10 per cent of the bank's capital government) and surplus,no National Bank withless than fivemilliondollars of capital accounts can participate. An examinationof the balance sheetsof banks showsthisto be the case.' thebroker In additionto thecapitallimitation, expectseach bank several such halfeitherto borrowor lend, with some regularity, bank must oftenhave a milliondollar units. Thus a participating one or two milliondollar excess or deficitreserveposition. Of the 79 bankslistedby Garvin,Bantel and Companyonly4 had less than $100 millionsin deposits and another 14 had deposits of between $100 and $200 millions. Six of these 18 smallerbanks were in the area and 4 werein Chicago. New York metropolitan of the federal fundsmarketmakes a givenvolume The existence in supporting more efficient of reserves deposits. If each bank deals withtheFederal ReserveBank on thebasis ofits ownneeds,thenthe ofsome banks are not available to supportdepositsat excessreserves deficitbanks, which are forced either to borrow at the Federal
9. Because of the peculiarIllinoisunitbanking law, someof the smallest are in in thefederal funds market banks(ranked participate by deposits)which Chicago. about the bankslistedon Garvin,Bantel and Company's 1. Information was obtainedfrom worksheet Moody'sBank and FinancialManual, 1956,especiallythe table "The Three HundredLargestBanks in the United States," pp. a 22-23. banksare as ofDecember All ofthedata citedaboutparticular 31, 1955.





Reserve Bank or to sell securities. If a perfectly federal functioning from the Federal ReserveSystem fundsmarketexisted,no borrowing would take place while therewere excess reservesin any bank, and no bank would have excess reserveswhile some other bank was borrowing. As a result of the developmentof the federalfunds marketa ofa parC,of basic changehas takenplace in the operations thebanking bank it is not its own reserveposition system. For a participating or not it willborrow at the Federal Reserve whichdetermines whether Bank, and no longerdoes borrowing by a particularbank implythat excess reservesare being generatedin the system. To illustratethe and Bank A argument,assume a 20 per cent reserverequirement to have a $10 millionclearingloss to Bank B, so that Bank A has a in reserves. Withoutparand Bank B an excessof $8 millions deficit ticipationby thesebanks in the federalfundsmarket,Bank A would borrow$8 millionsfromits reservebank and Bank B would make $8 millionsof loans or investments:hence total demand deposits increase. However,if both Bank A and B participatein the federal fundsmarket,then Bank A willborrowand Bank B willlend $8 millions throughthe market. If the market is tight, some residual deficitbank will end up borrowing at the Federal Reserve: but it is the marketsituationratherthan the behavior of a particularbank whichleads to this borrowing.2 Bond Houses: Sale and Repurchase B. The Financingof Government withNonfinancial Agreements Corporations In midyear1956 sale and repurchase withnonfinanagreements bond cial corporations were a major source of fundsforgovernment the contract houses. Although betweenthe bond house and the nonis ostensiblya sale of government financialcorporation debt instruis a a in transaction with tied truth the ments repurchase agreement, collateralloan callable both ways. The lendingcorporation does not earn the interestaccruals on the "purchased" debt instruments, earns a stated contractualinterest rate. ratherthe corporation In additionto these sales and repurchaseagreements withnontheir financial corporations, bond houses can finance government and their own sales resources, repurchase inventory (position)by by agreementswith the Federal Reserve System (presumablyat the at cominitiativeof the open marketcommittee), and by borrowing
and the funds market between the federal 2. Thereare obvioussimilarities and in particular in thepartplayedby Garvin, classicalLondondiscount market Bantel and Companyand by Gurneys. See W. T. C. King, The History of the London Market Discount (London,1936).



mercialbanks. The bond houses' own resourcescan financeonly a therefore the behaviorof the bond small portionof theirinventories; bond marketdependsupon the houses and hence of the government of thesedifferent sourcesof funds. characteristics bond house,securedby government A call loan to a government a in asset to a Treasurybill. Hence, one is manyways superior debt, rate on sale and repurchase wouldexpectthat theinterest agreements between governmentbond houses and nonfinancialcorporations is would be lowerthan the rate on Treasurybills. This expectation bond houses notborneout by thefacts:therate at whichgovernment is greaterthan the bill rate, borrowfromnonfinancial corporations is than rate bond houses it lower the at which government although the rate chargedby banks.3 Apparently, borrowfromcommercial is low enoughso that the government bond nonfinancial corporations than issueswitha higher housesdo notlose on carrying yield Treasury bills. Sale and repurchase agreementsbetween governmentbond houses and the Federal Reserve are almost always at the discount is withtheFederal Reserve,suchaccommodarate.4 As theinitiative bond tions are a privilegerather than a rightof the government houses.5 Hence, to the bond houses,such fundsare unreliableand in the expectation that theywillbe theywillnot make commitments at the ReserveBanks.6 accommodated
is that the premium rate on sales and repurchase 3. My own explanation and theriskdue to the reflects boththenewness oftheseagreements agreements thatthebondhousescan replacesuchcall loansby tapping lack of a guarantee theFederalReserve. as ofAugust 4. The authorization, 2, 1955,by theOpenMarketCommittee between bond housesand the forsales and repurchase agreements government be at a rate Federal ReserveSystemprovidesthat: "In no eventshall [they] is thelower of (1) thediscount rateoftheFederalReserve Bank belowwhichever rateon the mostrecent on eligible commercial paper,or (2) the averageissuing
issue of threemonthTreasury bills, .. ." However, this is withthe "understand-

in entering wouldbe used sparingly intorepurchase agreeingthattheauthority mentsat rates below the discountrate" (Forty-Second Annual Report of the Reserve BoardofGovernors oftheFederal System, pp. 102-3). a proposal to "... 5. In July, rejected 1955,the Open MarketCommittee establishat the Federal ReserveBanks an open windowforuse in financing rate" (ibid., dealersat ratespreferably above,but not lowerthan,the discount pp. 100-1). 6. Around theendofJune, 1956,theFederalReserve"openedthewindow" in sale and repurchase it be known thatit was willing to enter agreeby letting ments with bondhouses. My interpretation ofthiseventis that thegovernment at thistime funds were withdrawn from thegovernnonfinancial being corporation due to tax needs, 30this a published balance ment bondhouses and,becauseJune banksdid notwantto be sheetdate forcommercial banks,thegiantcommercial forced from theFederalReserve to finance thebondhouses. This intoborrowing a shift unstable market situation forced in theinitiative for potentially repurchase theFederalReserveto thegovernment bondhouses. from agreements



The bond houses always have lines of creditopen at the large commercial banks: in fact these banks are the bond house's "lender oflast resort." In midyear1956theinterest ratecharged bondhouses these commercial from banks cent to 312 per cent. by 31 per ranged This was a "penal" rate as it was approximately 1 per cent greater thantheyieldon Treasurybillsand 2 per centgreater thantheyield on othergovernment debt. In thissituation, whengovernment bond houses financed frombanks,theywould theirpositionby borrowing lose moneyon the carry. Hence by midyear1956,government bond houses did not financetheir position by borrowing at commercial banks unless theywereforcedto do so by the unavailability of other funds. In contrast,duringthe easy moneydays, government bond houses financed theirpositionby borrowing at the giant commercial rate structure was suchthattheymade money banks,and theinterest on the carry. In midyear1956,the interest rate patternrelevantto the operations of government bond houses was (in order,beginning with the lowestinterest rates): (1) Treasurybills with nonfinancial (2) sales and repurchase agreements corporations (3) discountrate debt (4) longer-term government bond houses (the lowest bank bank loans to (5) government interest rate). As the yield on Treasurybills was muchlowerthan the interest rate bond houses commercial was there considerable by charged banks, pressureforbond houses to use and develop alternativesources of funds. Due to the intermittent patternof tax, dividend and interest have periodicneeds for payments,giant nonfinancial corporations largeamountsofcash whichtheysatisfy accumulating by "liquidity" out of earnings. Amongthe forms in which"liquidity"can be held are: (1) demanddeposits (2) Treasurybills (3) sale and repurchase agreementswith governmentbond dealers (4) loans to sales finance companies. As commercialbanks are forbiddento pay intereston demand such holdings yieldno income. Given the veryeasy money deposits, interest rateswhichruled positionand the associatedlow short-term



from 1935 to the early1950's,the holdingofdemanddepositsdid not interest mean any substantialloss ofincome. The developing higher ofthe 1950'smeansthatincreasingly thesubstantial cash ratepattern in of been invested nonfinancial have shortbalances corporations of nontermliquid assets. As a resultof the abilityand willingness of to hold the financial Treasurybills, holdings Treasury corporations banks have decreasedfrom$7.0 billionsin 1952 billsby commercial to $2.2 billionsin 1956,as shownin Table I.
OF TREASURYBILLS, 1952-19561 OWNERSHIP (in billions of dollars)
Held by Date Total Outstanding Commercial Banks OtherInvestors (includesnonfinancial

Dec. 31, Dec. 31, Dec. 31, Dec. 31, June30,

1952 1953 1954 1955 1956

21.7 19.5 19.5 22.3 20.8

7.0 4.4 4.4 3.6 2.2

12.5 11.4 12.1 16.0 17.1

ofUnitedStates Government Market1. FederalReserveBulletin:Table titled"Ownership Securities"(variousissues). able and Convertible

ofotherinvestors On the otherhand the holdings (whichinclude from have increased $12.5 billions the nonfinancial corporations) in 1952 to $17.1 billions in 1956. The same trend is evident in the ownershipof marketablesecuritiesmaturingwithin one year (Table II).

(in billions of dollars)

Held by Date Total Outstanding Commercial Banks OtherInvestors (includesnonfinancial corporations)

Dec. 31, Dec. 31, Dec. 31, Dec. 31, June30,

1952 1953 1954 1955 1956

57.0 73.2 62.8 60.6 58.7

17.0 25.1 15.7 7.7 7.4

23.5 29.0 26.3 30.8 29.2

1. Federal ReserveBulletin(variousissues).



can also hold liquidityin the form The nonfinancial corporations bond housesand withgovernment ofsales and repurchase agreements the paper of sales financecompanies. The paper of sales finance companiesearns a higheryield and can be tailor-madeto suit the needs of the lender,but it is neitherso liquid nor so respectablean to hold as Treasurybills. Sales asset fora nonfinancial corporation and and repurchaseagreementsbetween nonfinancial corporations bond houses are veryliquid and can be tailor-made. The agreement to an outright does seem to be superior purchaseof Treasurybillsby is to theiroutright and it certainly superior thecorporations, purchase As was stated issues. of longerterm earlier,by midyear1956 such funds were,as faras couldbe judged,the majorfinancing corporation for bond houses. the source government ofshort-term the shift debt and Both developments, government bond houses fromcommercial banks of government of the financing bank to have freed resources finance nonfinancial to corporations, other activities. As far as the ability of the banking system to thesedevelopments are equivalentto finance expansionis concerned, an increasein bank reserves. sales and corporation Expansionofthebond houses' nonfinancial to If nonfinancial corseems occur. likely repurchaseagreements of to bond houses to find loans should preferable ownership porations bills on would increase rates the then the and Treasury Treasurybills, would decrease relativeto rate on sales and repurchaseagreements otherrates. The "fullydeveloped" marketwould be in equilibrium was fractionally when the rate on sales and repurchaseagreements lowerthan or equal to the bill rate. The discountrate would remain higherthan the bill rate. In this event, the bond houses would be dealers. ofthemarket detailedabove? structure Whatare theimplications force the bond of will withdrawal government corporation money Any banks. With the presentinterest houses to borrowfromcommercial makes it riskyforbond houses to take this contingency rate pattern, fundsare withdrawn from bond a position. In additionif corporate this will be associated with houses because of economicconditions, ofTreasurybills. downofcorporation thesale or therunning holdings bond houses are 6nlyguaranteedexpensivecommerAs government in a falling market. cial bank financing, theyhesitateto take a position to carrythe bond Hence, unless the Federal Reserve acts promptly rateswillriserapidly. As the housesor to buy Treasurybills,interest downof Treasurybillsby nonfinancial sale and running corporations indicatesthat they desireincreasedliquidity (which could be assoin the investment shift ciated witha downward schedule)such a rise



in interestrates would occur at the "wrong" time. To counteract lendingby nonthis,a moneymarketwhichis based upon short-term financialinstitutionsrequires a device which automatically feeds reservesinto the systemwhen the lendersdesireincreasedliquidity, is needed whichautomaticallyincreasesthe quane.g., a mechanism tityofmoneyto compensatefora decreasein the velocityof money; and vice versa. Thereare otherconsiderable dangersin nonfinancial corporations bond houses deal the bond houses. Almostall government financing are in othertypes of paper as well. Once nonfinancial corporations the debt as collateral, habituatedto making"loans" withgovernment loans usingnongovernment existsthat collateralized paper possibility would entail greaterpossibilities will develop.7 Such a development the of capital losses in a liquiditycrisiswhich,in turn,would affect of the nonfinancial corporations. stability A seemingly simplesolutionto the problemsraised by nonfinanwith theiridle balfinancialinstitutions cial corporations financing on to demanddeposits. banks interest is to commercial ances allow pay fordeposits,the rate To eliminatethe "dangers"of banks competing in whichlarge could be tied to the discountrate. A rate structure rate demand depositspay about 1 per cent less than the rediscount and the the redisbetween number rates there are a of (and deposit count rate) seems to be more conduciveto financial abilitythan the a rate structure such rate structure. requires However, existing eithera much higherTreasurybill rate or a special source of financof a withnonfinancial corporations.As the development agreements instituradical for could bond houses entail setup special financing the seemingly tional changes,8 simplesolutionto the problemsraised bond houseshas quite complex nonfinancial financing corporations by implications.
III. IMPLICATIONSOF THESE CHANGES FOR MONETARY POLICY ing for government bond houses to replace the sale and repurchase

Two conclusions stand out as a resultofthe institutional changes sections: describedin the preceding (1) a givenvolume of reservesnow supportsmore deposits;
7. Sales finance corporations do tap corporate cash balances. At present (late 1956) the largest potential source of funds is such corporate balances, and if tight money continues I believe that new type financialinstitutionswill develop which would use these cash balances. 8. For example, the rightto rediscount could be withdrawnfromthe giant commercial banks, and, simultaneously, the government bond houses could be given the rightto sale and repurchase agreements. Such a British system would lead to a rate structure compatible with commercial banks paying interest on demand deposits.



(2) a givenvolumeof demanddepositsnow supportsmorebank loans to business. These changeswhichhave increasedthe volumeof businessactivity can finance have notresulted from thatthebanking legislation system or Federal Reservepolicy. Rathertheyhave been the resultofreacin the moneymarket. forprofit tionsto opportunities bank reserves Centralbank constraint during upon commercial is due to a beliefthat any increase a perioddiagnosedas inflationary ratesthe interest ofbank loans wouldfeedinflation. Since at present than the supply,thesecentralbank condemandforloans is greater rates. The higherinterest straintsresultin higherinterest rates,in in have market which the induce institutional changes money turn, of increasing These institutional the effect changes lendingability. increasein financing abilityto may or may not lead to a sufficient if there as would have occurred the same increasein financing effect had been no centralbank constraint. a rise in interest rates Withina stable institutional framework, conservetheircash baltendsto make householdsand businessfirms ances. As an increasein velocityincreasesloanable funds,it will at of a tightmoneypolicy;but, unlessthe the effects least in part offset in a of excess is state moneysupplyof a liquiditytrap type, economy as a posiwill not be complete. This can be represented this offset and an and the interest between curve rate, velocity tively sloped increase in velocity representsa "permanent" increase in lending is stable,a tight framework money ability. Hence, iftheinstitutional to whatever will rise rate and interest the will be effective policy to the demand forfinancing extentis necessaryin orderto restrict inelasticsupply. the essentially rates feedsback upon the instituHowever,the rise in interest rates the incentivesto find tional framework. With risinginterest forcash assets new ways to financeoperationsand new substitutes increase. The money marketis highlycompetitiveand, as larger returnsare almost always available fromsome new way to play interestrates, new ideas tend to get a hearing. Hence differential innovations. Since forinstitutional thereis a favorableenvironment innovations institutional the significant duringa periodof monetary will be thosewhichtend to increasevelocity,theycan be constraint rate relationto the right. the velocity-interest as shifting represented rate relationis the sum of the The resultantvelocity-interest institutional of a change in interestrates withinunchanging effect of changes in institutions. While an and the effects arrangements innovationin the money market is workingits way institutional



the economy,the net effect is as if the velocitycurvewere through elastic. The resultantvelocity-interest rate relationis a infinitely as in FigureI. If I is theoriginal rate stepfunction, velocity-interest a risein the interest rate from the liquiditytraprate roto rl relation, will induce institutional innovation I' which, in time, shifts the raterelation to II. As a resultat a constant interest velocity-interest






/ /



/ I

/ /




associatedwitha risein velocity rate,theamountofadditionallending a to b will be effected from duringthe time that it takes the institutionalinnovation to workits way through the economy. Of course, increasesin the interest duringthis time, there may be short-run rate above ri,iftheshort-run demandforfinancing increases by more than the increase in financing implicitin the rate at which the institutional is changing.9 framework
9. Actually a fall in the interestrate below ri will usually not result in the end of the institutionwhose introductionshiftedthe velocity relation; so that the effective relation is not infinitely elastic with respect to a fall velocity-interest in interestrates; the movementfroma to b is irreversible. Also the interestrate which induces the innovation may be higher than the rate necessary to sustain the institutionalchange so that the line a'b' may be negativelysloped ratherthan



Wheneversuch an institutional change in the moneymarketis its way through the economy, restrictive working monetary policy,to be effective, mustoffset the risein velocityby decreasing the quantity ofreserves. Purelypassive constraint whichoperatesby not allowing the quantityof moneyto increasewill not be effective in preventing inflation. Therefore, to decrease unlessthe centralbank acts strongly the moneysupply,monetarypolicy has only a very limiteddomain in controlling of effectiveness inflationary pressures. The asserted of monetary in constraining an policy (that it is effective asymmetry inflationand ineffective in constraining a depression) is not true; both in constraining monetary policyis of verylimitedeffectiveness a depression. an inflation and in counteracting The reverseside of the coin to the increase in velocityis that every institutionalinnovation which results in both new ways to financebusiness and new substitutesfor cash assets decreases the liquidityofthe economy That is, even thoughthe amountofmoney does not change,the liquidityof the community decreaseswhengovof commerdebt is replacedby privatedebt in the portfolios ernment cial banks. Also, when nonfinancial corporations replace cash with bonds and then government bonds with debts of bond government ofliquid assets implies houses,liquiditydecreases. Such a pyramiding or even tempothat the risksto the economyincrease,forinsolvency rary illiquidityof a key nonbank organizationcan have a chain the solvencyor liquidityof many organizations. reactionand affect monetary If, duringa long prosperity, policyis used to restrain ofsuchvelocity-increasing and liquidity-decreasing a number inflation, innovations willtake place.1 As a result,the decrease money-market in liquidityis compounded. In time,thesecompoundedchangeswill result in an inherentlyunstable money market so that a slight a financial can trigger crisis. reversalof prosperity
horizontal. The relations among velocity curves are analogous to the relations among an industry's short-runand long-run supply curves, excepting that the than the price which will induce price which will induce investmentseems firmer innovation. Gurley and Shaw (op. cit.) in discussing nonbanking sources of financing state that "Because money becomes a smaller share of total financial assets, velocity becomes a less reliable index of interest rates" (p. 533). They fail to rate relation with constant institutions distinguishbetween the velocity-interest and the effectof high interestrates in inducing money-marketinnovations. 1. "In the 1920's nonbank intermediariesgained on banks at an especially rapid rate. The ratio of their assets to assets of banks rose from .77 in 1922 to 1.14 in 1929" (Gurley and Shaw, op. cit., p. 533, footnote 19).




thusfarhas shownthatmoney-market institutions The argument associated with tightmoney, do evolve, especiallyunder conditions in the moneymarkettendto counteract and that such developments a strong rates a tight boom,interest moneypolicy. As a resultduring will not rise verymuch forthe supply of financing is, in fact,very elastic. Associatedwiththe abilityof the moneymarketto finance an inflationary expansionis a declinein the liquidityof households and firms. To the extentthat eitherthe mostliquid assetsleave the or the institutions ofotherfinancial forthe portfolios banking system institutions enter debts of the newlygrownand developedfinancial of banks, the liquidityof the bankingsystemdeclines. the portfolios and businessfirms has Decliningliquidityof banks, households, ratiorises. The other worth twoattributes. One is thatthe debt-net assets to a fall in value of money-market is that the vulnerability each increases. The two attributesof decliningliquidityreinforce other so that the chances of insolvencyand illiquidityincrease simultaneously. factorto the declinein the value ofany asset is A majorlimiting the termsor the price at whichit will be monetizedby the central bank. However, the evolutionarychanges in the money market instituresultin both new kindsof assets and new kindsof financial tions. One view of the centralbanks' money-market responsibilities oftheliquidityofthebanking limitsthemto themaintenance system in the government bond market. A central conditions and orderly wouldnot bank withsuch a view ofits money-market responsibilities or discounting them.2 stabilizethe new assets eitherby purchasing On a priorigroundsneitherthe operatorsin the moneymarket knowthe limitations of new institunor the centralbank authorities in a boom they are not partions and paper. And, unfortunately, of a financial with the possibility crisis. Hence ticularlyconcerned will be exploitedto such an the newly found profitopportunities extentthat the money marketbecomes unstable. In an unstable has widespreadrepercusmarketa slightdeviationfromequilibrium market evolves into such an unstable sions. Hence, once the money
II willbe stabilized inthetwomoney-market takenup inSection involved changes these bank. Hence no real financial can resultfrom instability by the central changes. Howeverother,perhapsstill potential,changes (forexample,the can of techniques by which"small" cash balancesof corporations development combusiness the financing of sales finance be used to finance or,alternatively, funds)are notprotected by theFederalReserve. paniesby corporation
2. The asset (governmentbonds) and the institution (commercial banks)



a financial crisiscan be expected. The collapseofa portion situation, of the financialmarket resultsin both a loss of net worthand of and other financialinstituliquidityby households,business firms crisisis not generalized, tions. Even if the financial economicunits will revise theirview and desiremore liquidity. A tendencyto use savingsto liquidate debt and hence to increasethe ratio of net worth effect to debt willarise; thishas a depressing upon income. Thus the sectorcan create a situationwhichleads "shock" fromthe financial of an expansionby increasing to a deep depression. The financing crisisand velocitytendsto createa situationin whichbotha financial a deep depression are possible. of the The attitudesof both centralbankersand othermembers a boom can be characterized as a versionofthe moneymarketduring ofthe againsttheimperfections Maginotlinementality. The defense that was revealedin previousdepressions is now mechanism financial is now working themoneymarket well,hencethereis no need perfect, of the moneymarketare conthe institutions to worry.3 However, stantlychangingand as a resultof these institutional innovations, crisiswill neverbe just like the last one. What is the next financial of such evolutionary the effects requiredto counteract developments and a clear recogis a broadenedview of centralhank responsibilities nitionthat,in spiteof corrective steps,themoneymarketwillalways to the stretch breakingpoint duringa boom. liquidity To date the Federal Reserve Systemis a lenderof last resortto a commercial bank in distress. It is not a lenderoflast resortto the In contrast, the classical Bank of England position market. money the discount was as a lenderoflast resortto a financial intermediary, of the in terms the paper available, deeplypenetrated houses,which, Britishmoneymarket. A broad view of a centralbank's responsibilities includes the maintenanceof the stabilityof, and acting as a lender of last resortto, a broad segmentof the financialmarket. institutions Hence as new financial developand as new typesofpaper and paper would not institutions on such the moneymarket, appear in bank of crisis. Hence aid time for central be necessarily ineligible the central bank would prevent the widespread loss of liquidity froma crisisin one segmentof the market.4 resulting
3. In this connectionnote that ifthe great depressionof the 1930's is imputed to the stock market boom of the 1920's which, in turn,is imputed to widespread margin trading,the Federal Reserve today has control over margintrading. On the other hand, if stock market collateral is very importantin the financialstructure, should not the central bank's responsibilityinclude the maintenance of its value? 4. Gurley and Shaw (op. cit., pp. 536-38) write of Financial Control as an alternative (or adjunct) to Monetary Control. Essentially our perspectives are



would still induce institutional A policy of monetaryconstraint whichwouldresultin stretching innovations liquidity. Howevereven after the money market becomes unstable, the central bank, by thevulnerable asset,can prevent monetizing widespread repercussions ifa money-market institution or from occurring. After stabilization, it because leads to is considered undesirable instainevitably usage bility,then it could be got rid of by legislativeor administrative measures. That the effort inflation abets the by the centralbank to control in the moneymarketmay seem of unstable conditions development to be a dismal conclusion. Actually,it is too much to expect that a such as thoselabeled monetary set ofoperations trivial policyor fiscal policy will always succeed in maintainingstabilityin a dynamic innovationis one aspect of a dynamiceconeconomy. Institutional innovationsoccur in responseto the needs omy and money-market of a growing economy. That these changeswill tend to undermine of growth. of stabilizationpoliciesis a by-product the effectiveness However,the roleof the centralbank is not reallydiminished by in preventing of its ineffectiveness inflation as well as the recognition is to act as a in stemming deflation.JThe centralbank's function to limitthe losses due to the finanlenderoflast resortand therefore induced by the innovacial crisiswhichfollowsfromthe instability of rapid centralbank action tionsduringthe boom. iA combination and rapid fiscalpolicyactionto increase markets to stabilizefinancial ofthecrisisupon willminimize therepercussions liquidity community and investment expenditures, Thus a deep depression consumption is not to can be avoided. The functionof centralbanks therefore stabilize the economyso much as to act as a lender of last resort. This theyare able to do.5

the same except that Gurley and Shaw seem to hold hopes that financialcontrol can aid in achieving stable growth; whereas I maintain that financialinstability in boom timesis inevitable but that a properlydesigned and operated centralbank can ameliorate its effects. Essentially the differenceis one of problems and intuitions. 5. This perspective on central bank abilities is not unlike that of L. W. .\ints, Monretary Society(New York, 1950) and H. Simons, Policyfora Competitive "Rules Versus Authoritiesin Monetary Policy," Journal of Political Economy, XLIV (1936), 1-30.