- Hello, this is Rose Friedman inviting you, on behalf of Instructional Dynamics, to another of our biweekly conversations with Milton Friedman, professor of economics at the University of Chicago. We are taping these conversations on Wednesday, June 26th, 1974. Would you want to comment on the current situation in any way? - I can do so very quickly because there seems to me to be no substantial change in the situation in the past few weeks. Monetary growth continues along the trendline marked out by the last three years. That is, until at a rate which hovers around the trendline of close to 10% annual rate of growth. And one, around a trendline that hovers about, something like 6.7% annual rate of growth. These rates fluctuate from week to week and over a period of several weeks, a recent speeding up in m one, slowing down in m two, but I see no evidence whatsoever that their anything more than perturbations about that longer term trend, up to the moment. So far, as the economy is concerned, it continues, rather sluggish. The very rapid, very substantial decline in GNP in the first quarter, reflecting largely, the special impact of the oil situation in automobiles will not be repeated in the second. But all of the indicators are that there will be a very slow rate of growth, if any, from the first to the second quarter. I see no reason to suppose that there will be any sharp pickup in the economy in the next couple of quarters. I believe the predictions that we had already come to a turn we're going to be in the sharp uprise are premature, and will not be realized for some time. I think we will continue to see, therefore, this kind of a sluggish performance of the economy, we will continue to see unemployment rising, somewhat over coming months. We will continue to see high but declining rates of inflation, with the rate of inflation coming back down to something like 6 or 7%, by the end of the year. - The Wall Street Journal, this morning, has an interesting quotation from Ralph Saul of the First Boston Corporation. Quote, "During the past several months, "we have had a situation "when some corporations have been foreclosed "from using the public securities market "to raise long-term capital. "Some lower rated utilities have been almost "cut off from these markets "and it has been difficult to market "most industrial bond issues, "except for the highest quality companies. "The problem this time isn't the outright availability "of financing, but its high cost. "High interest rates and inflation "have created uncertainty among "both users, issuers, and investors." Says Mr. Saul. "Under these circumstances "corporations other than those "with the highest credit rating "may be forced to avoid the long-term market "until the return of lower rates." - What this quotation reflects is a phenomenon that I think is of very great importance for the coming years. It reflects, I believe, the fact that primarily, not essentially the point that Mr. Saul is emphasizing, but the point that seems to me much more fundamental, the deficiencies of fixed interest rate securities in a time of variable inflation. Up until recently, borrowing on fixed-rate bonds was a very profitable thing for enterprises to do. The reason for this was because the long-term interest rate lagged behind inflation and did not fully take it into account. As a result, anybody who borrowed long over the past 10 years or so, has gotten away with murder. In many cases, has a rate of interest, which with present rates of inflation leaves him with a negative real cost. That is he is being paid in real terms for borrowing money. To some extent that is still the situation. The present rate on high-grade securities have something like nine percentage points, does not provide very large allowance for inflation, given that the Federal Reserve policy for three or four years has been implicitly if not explicitly directed at producing something like 6% per year inflation. A 9% corporate bond rate means a real rate of 3% which is low by historical standards. However, this is for high-grade securities. For lower-grade securities, the inflation premium may be the same. But risk differentials have been going up. Because the uncertainty about future inflation about what will be the course of inflation in the future, is added to the uncertainty about the fundamental soundness of the company, about the possibility of it paying back. And thus, I have the impression, though I cannot document this, and maybe it's wrong, that the differentials between high and low quality securities have risen. However, from the point of view of the borrowing firm, even though it has to pay a high rate because lenders figure with the probability that the firm will go broke. The borrowers hardly going to figure along those lines, and so he is stuck with that high rate. And the result is what Mr. Saul describes. The situation in which, firms are very unwilling to enter into the market and borrow funds at the prices they would have to pay in the current market to get them. This hesitancy in borrowing at these terms in the market is reinforced and must be reinforced by two other considerations. One consideration is the amount of capital investment which is being required by pollution and environmental considerations. Which yields no return in the form of income to the company in question. The effect of this is, as it were, to reduce the real yield on capital investment. If you are a utility or a chemical company or a manufacturing company, or any kind of company which now has to spend a large sum of money in a way which is completely unproductive from the point of your income statement. This certainly reduces the net attractiveness to the business and makes it less attractive for you to expand. It hence reduces the price that you are willing to pay to borrow funds in the long-term market. The second factor working in the same direction is the extremely low level of equity stock prices. Indeed, the stock market is a real mystery. If you are a paper company and you want to get new facilities, as an individual company you would like to get a new factory, why in the world should you build one at high cost when you could buy one from another paper company at low cost. That is if you look at the market price of the stocks of corporations in effect that is a market evaluation of the selling price of existing capital goods. That market evaluation of the selling price of existing capital goods is a great deal lower, in most cases than the cost of reproducing, of adding to capital. Indeed, it is a mystery to me, from this point of view, that capital expenditures by enterprises have stayed up as high as they have. At any rate, these two factors, the extra cost being imposed on companies which are not productive, and the low value of equity in companies reinforce the effect of high and variable inflation rates on the unwillingness and inability of enterprises to borrow in the long-term capital market. What is a way out of this? I must say Mr. Saul's way out suggested at the end of the Wall Street Journal is not one that appeals to me. He wants more of the hair of the dog that bit him. He talks about the government setting up something like a new counterpart to the Federal Reserve system to control capital allocations. I shudder at what that would lead us into. We are indeed heading in a way in that direction in the way of government capital allocation. One of the problems in the market is that, as I've emphasized before, an increasing fraction of all new savings are being preempted by government either directly to finance its deficit or indirectly in the form of government guaranteed investments for this that or the other thing. But I think that there is a much more immediate and direct way out that will be appearing and has already started to appear. And that is, through a change in the form of borrowing. What is called for, is a form of borrowing which does not commit an enterprise that borrows to a high nominal interest rate, regardless of future events. You will be immediately aware of where I'm going, because this has been a theme that I have been stressing over and over again. What it calls for is a purchasing power security, inflation adjusted bonds. What public utilities and other enterprises are going to have to do, if they are going to reduce their risks of getting stuck with very high nominal rates, is they're going to have to offer securities in which the rate of interest is linked either to some short term market rate of interest or to a cost of living escalator. The first sign of this has made its appearance. City Corp, the holding company for National City Bank of New York, has announced that it is issuing six year debentures Five year debentures, I believe, in which the rate of interest will be adjusted every six months, to a market rate. If my memory serves me right, they are going to link their rate of interest to the rate of interest on treasury bills. But for the moment it doesn't matter what the details are. The basic idea is essentially to have a variable interest rate security which doesn't freeze either City Corp or its borrowers. Over the past 20 years or so, that arrangement would have been very close to a purchasing power security. Short-term interest rates have pretty well adjusted for the rate of inflation. And have moved up and down with the rate of inflation. So that this is in a way an equivalent to a purchasing power security. It is the first major move along this line that I've come across, although undoubtedly there have been smaller, more minor moves. I think we shall see many more moves along this line in the coming years. Indeed, I hope we shall. Because I believe it will be a race between whether these arrangements develop fast enough or whether the government extends its heavy hand, increasingly over capital allocations. - While we're on the subject, do you have any reaction to the articles that have been appearing on escalator clauses? - Well first, I have been fascinated by the extraordinarily large number of such articles and the amount of attention that escalator clauses have been receiving. Two of the most recent were lengthy analysis by Walter Heller in the Wall Street Journal, which in large part was simply a repetition of an analysis which is being issued by a Minneapolis Bank for which he serves as a consultant. And an article which has not yet appeared, but which is coming out shortly in the Morgan Guaranty Survey, of which I saw an advance copy in their amusing Mouseville series. Which talk about Mouseville having a meeting to discuss the possibility of a purchasing power escalator clause arrangement. Aside from the frequency of such discussions, one thing about them really does bother me very much. And this is a personal matter. I am the scapegoat in most of the discussions of opposition to escalation, and the particular point that both of these two I mentioned jump on, is the fact that my most recent Newsweek support of escalator clauses came in the course of a column in which I discussed the Brazilian case. Both Heller and the Mouseville piece, take it for granted that somehow the Brasil case had an important part in shifting me to be in favor of indexation, of escalator clauses. And both of them jump on that as a red herring, and proceed to analyze, well at least Heller analyzes at great length, the Brazilian experience, Mouseville doesn't analyze it at great length but refers to it, in a rather less than favorable way. Now I believe we can learn from Brasil. And I have no objection to an analysis of Brasil both what it has to say in favor of and opposed to escalator clauses. What bothers me about it is something very different. I have long been in favor of wide spread escalation and indexing. I have discussed the matter in Newsweek columns originally in 1969, long before I ever made any trip south to Brasil. I used the Brazilian experience to illustrate the advantages of indexing, rather than, as an argument as a fundamental argument or as a major argument, or as a primary argument for indexing. There are many features of the Brazilian system that I would not carry over to this country. There are many features of the Brazilian economic and political arrangement that I find objectionable. But it is clear that in my opinion the indexing has served a very important function in Brasil in permitting Brasil to combine rapid growth with a reduction in the rate of inflation. As such it seems to me to be an excellent illustration of the possible virtues of indexation, without being either a conclusive argument for it, or its adverse affects being a conclusive argument against indexation. In an article of mine which will appear in the July issue of Fortune which treats in a more systematic and lengthy fashion the problem of indexation, I have gone out of my way to avoid referring to Brasil except in one side reference in which I inserted the remark that Brasil has gone farther in this direction than I would recommend. But somehow or other I've discovered from experience, if people cannot attack your argument at it's strongest point, they will look for whatever red herring is available with which to do so. - But why do they really oppose indexation? - Well, curious, I have been fascinated by the people who have come out against indexation, because they form a curious coalition of both the left and the right. On the left, the strongest opponents of indexation have been people like Walter Heller, Joseph Pechman, Arthur Okun, who in most respects would be identified with the left. On the right, Central Bankers, who are generally identified with the right have been strong opponents of indexation. The person writing in Morgan Guaranty Survey. It's an anonymous article, but it's clearly somebody whose general sympathies would be regarded as on the right. The gold standard advocates are on the whole against indexation. So the conservative hard money men, seem to be against indexation. One example, which is rather different from either of these categories, but fits somewhat into this pattern is William Fellner of the Council of Economic Advisors, who certainly is on the right by comparison with people like Heller, Okun, and Pechman. Well one explanation, of course, of a coalition of the right and the left is that they're correct. And that they are just united in being against error. Needless to say, it's not a view I accept. And especially I am strengthened in that by the long line of great economists over the last century who have taken the same position as I have on the virtues of escalation and indexation as a way to ease the pangs of fluctuations in general prices. Well then we look for another explanation. And here I think the explanation is very different on the two sides. I think the fundamental reason why the left is opposed to indexation is because they are in favor of bigger governments under whatever cause, whatever reason, whatever circumstance. They recognize, quite properly, that a major source of expansion in the size of government has been inflation. It has caused an expansion in the role of government directly, by increasing the yield of taxes and thus enabling governmental expenditures to expand as a fraction of income without requiring corresponding explicit increases in taxes. It has promoted the expansion of the scale of government because every time you have had measures such as wage and price control, or other direct controls to stem inflation, that has lead to an expansion of the role of government. Moreover, by removing, by reducing the occasion for labor disputes and the like, you would also indirectly reduce the role of government in that area. Thus I believe their basic objection to indexation is an implicit or explicit recognition that the substitution of an automatic arrangement of that kind would reduce the scope of explicit governmental intervention into the economy in a variety of ways. Now that's certainly is not the explanation for the people on the right. And here I believe the explanation for the people on the right is primarily conservatism in the literal sense, of the status quo. Of a difficulty of adjusting their minds to something new and something different. This is a phenomenon which I observed so strikingly with respect to flexible exchange rates. Every bank in the United States, almost, was opposed to, almost is needed because Mr. Wriston of the National City Bank who was pioneering on variable interest rates securities was also a great exception in this area. He was a proponent of floating exchange rates. Almost alone against the combined phalanx of commercial bankers. But now that we have floating rates, the commercial bankers find it fine and almost all of them are in favor of them. In the same way, as soon as a capital market develops so that purchasing power securities become widespread and built into the system, you will find that many of the people who today are the strongest opponents of it, will become defenders. The other major explanation I think for people in the right is their general continued hope and desire, one which I certainly share, that we can get off the inflation kick and back down to a zero inflation kick. They are afraid that anything which makes it easier in some ways to live with inflation will delay the cure. That may be true. I believe that it's very difficult to know whether widespread adoption of escalation will improve the chances of action to control inflation or reduce them from the point of view of the incentive to do so. I have no doubt that widespread escalation would make it politically feasible to undertake the measures necessary to reduce inflation. But I believe that the people I've designated as on the right are inclined to overemphasize the negative effects which indexation would have on the will to reduce inflation. And to underestimate it's positive effects. - I believe we have time to answer one of the two questions that we received from Mr. Parker, Chairman of the National Bank of Sarasota. His second question is, "in your latest tape, and on a least one previous occasion, "you made a statement with which I wish to take exception. "As I recall, you said that at stock market bottoms, "there was high volume and that this high volume resulted "from a difference of opinion. "I wish to submit that neither the records "nor my own recollection confirm this statement. "For example, at the market turn in 1949, "the volume was exceedingly low and it was followed "by about three years of up-market. "Again this occurred during the end of "1953, 57, 60, 62, 65, 66, and 1970. "On the way up to this exceeding high point, "the volume expanded in every instance on the way. "And in almost every instance the volume contracted "at the extreme high, but was still far above "the following low point. "And this is a well-known phenomenon. "My question is, why do you repeatedly say "that volume increases at low points?" - Well that's a very pertinent and thoughtful question. And I really have very little defense of myself. The one point on which I have great confidence, is that the volume of trading is a reflection of difference of opinion. If everybody is of the same opinion, if everybody believes, for example, that a particular stock is under priced there will be no purchases or sales or very few, but there will be a sharp rise in price with very little trading. Similarly if everybody believes that a stock is overpriced, the price will drop with very little trading. There can be a good deal of trading of buying and selling only if some people think, the security is worth more than other people think. Now I must confess that I went too quickly from that proposition to the proposition that Mr. Parker questions. I took it for granted, I suppose, the difference of opinion must be at a peak when the market is at its low or its high point. But I really cannot argue that that must be the case, and from the figures which Mr. Parker quotes and I may add that he sent me some charts documenting his statement. It appears that apparently what I thought was true is not true. That indeed, volume is low at relatively low points in the market. Which would suggest that the difference of opinion is also low at that point. Now I suppose there's no reason why that couldn't be so. That what happens is, right now for example with the market being very low, there is not a great deal of difference of opinion, in the sense of some people who think strongly that the market's going to go way down and some people who think strongly that the market is going to go way up. Perhaps a low point in the market simply reflects an offsetting affect that everybody has come to the conclusion that he doesn't quite know which way the market is going to go and holds no strong opinions on it either way. And what the evidence that Mr. Parker refers to suggests is that as a market goes up opinions begin to differ. That some people interpret the rise in the market as appropriate and right and other people as going against what they think are the basic views. And so as the market rises, differences of opinion increase, and then to follow through his analysis, it would imply that when you get toward the top of the market, once again, differences of opinion decline. So in substance, in sum, I will stop saying what I've been saying and concentrate simply on the relation between volume and difference of opinion which I think is clear and obvious and not on the relation between difference of opinion and high and low prices in the market. - Thank you very much. Remember subscribers, if you have any questions or comments, please send them to Instructional Dynamics, 450 Ohio Street, Chicago, IL 60611. We shall be visiting with you again in two weeks.