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- | Hello, this is Instructional Dynamics | 0:02 |
inviting you to another of our bi-weekly interviews | 0:05 | |
with Dr. Milton Friedman, professor of | 0:08 | |
economics at the University of Chicago. | 0:10 | |
We are taping this interview on Thursday, July 10th. | 0:12 | |
Professor Friedman, are there any monetary developments | 0:17 | |
you would like to discuss this morning? | 0:20 | |
- | Yes, there are. | 0:22 |
I noted two weeks ago in my tape | 0:24 | |
that monetary policy seemed to require little comment, | 0:27 | |
and we had a continuation of a | 0:31 | |
relatively slow rate of monetary growth. | 0:33 | |
As the next two weeks figures came out | 0:37 | |
and as I studied the figures a little bit more in detail, | 0:39 | |
it looks to me now as if that judgment should be modified. | 0:43 | |
It looks to me now as if in the past two or three months | 0:48 | |
the Federal Reserve has turned the screw | 0:52 | |
of monetary tightness another notch. | 0:54 | |
Now, the figures are so erratic and bounce around so much, | 0:58 | |
that it is very hard to be sure of that judgment. | 1:02 | |
It may be that in the next several | 1:05 | |
weeks or in the next month, the figures | 1:06 | |
will go back on up again and cause | 1:10 | |
a return to the rate of growth | 1:13 | |
that prevails since past December. | 1:17 | |
at it as it stands now, | 1:21 | |
it looks to me as if from December of | 1:24 | |
last year until about March or early April | 1:28 | |
of this year, you had a policy which involved a rise in the | 1:33 | |
in the quantity of money narrowly | 1:37 | |
defying currency and demand deposits. | 1:40 | |
Or more broadly defined but excluding the large | 1:42 | |
CDs, on either of those totals, | 1:45 | |
it looked to me as if you had a policy of a-- | 1:48 | |
which had the effect of a rate of-- | 1:51 | |
annual rate of increase of about 3% in those totals. | 1:53 | |
From that point to this on net there | 1:57 | |
has been essentially zero growth. | 1:59 | |
The quantity of money that is currency plus adjusted demand | 2:02 | |
deposits, M1, for the week ending June 25th, | 2:07 | |
was almost identical with the quantity of money | 2:12 | |
for the week ending April 2nd or twelve weeks earlier. | 2:16 | |
Over that twelve week period, there has been | 2:19 | |
essentially zero growth in M1. | 2:22 | |
This as I say, was concealed by the fact | 2:26 | |
that in those twelve weeks there have been | 2:29 | |
several sharp ups and down zigzags. | 2:31 | |
The quantity of money, which both twelve weeks ago and now | 2:35 | |
was roughly 195 billion dollars, | 2:39 | |
reached 198 billion at one point during that twelve week | 2:43 | |
period and was as low as 193 billion in another week. | 2:47 | |
But these gyrations have been settling down | 2:51 | |
and looking at it over the span of a twelve week period | 2:54 | |
it looks as if you have had an | 2:57 | |
essentially horizontal development of M1. | 2:59 | |
M2, that is including CDs, has gone down sharply. | 3:04 | |
It's gone down by something close | 3:09 | |
to 3% or 4% a year. | 3:12 | |
But for reasons which I have indicated at length, | 3:15 | |
in earlier tapes, I believe M2 right now is highly | 3:17 | |
misleading because of the inclusion of the large CDs, | 3:21 | |
where the decline in which is in considerable | 3:25 | |
measure of bookkeeping change. | 3:28 | |
The commercial banks are able to offset that decline | 3:30 | |
by inducing their customers essentially to transfer | 3:35 | |
CDs to their branches in Europe. | 3:39 | |
It's more interesting, therefore, to look at | 3:44 | |
the broader money supply currency plus adjusted time | 3:47 | |
demand deposits, plus time deposits at | 3:51 | |
commercial banks, minus these large CDs. | 3:53 | |
That total has gone up a trifle | 3:58 | |
in the twelve week period I'm speaking of, | 4:00 | |
from 377.6 billion dollars to 378.4 billion dollars | 4:02 | |
or by eight tenths of a billion dollars. | 4:08 | |
But that's at an annual rate of less than 1% a year. | 4:10 | |
So whether you look at the narrower or the broader total, | 4:14 | |
it looks, at the moment, as if the Federal Reserve | 4:17 | |
has tightened monetary policy another notch. | 4:20 | |
If this is so it seems to me highly unfortunate. | 4:25 | |
As you know, I have been of the opinion | 4:28 | |
that the earlier rate of tightening was, | 4:31 | |
if anything, a little too much. | 4:33 | |
Because of the delayed impact of monetary policy. | 4:35 | |
Because a change in monetary policy does not have its effect | 4:37 | |
on the economy for something like six | 4:40 | |
months, or sometimes nine months, | 4:42 | |
it's necessary to have a great deal of patience | 4:46 | |
in the use of monetary policy. | 4:49 | |
Apparently, the Fed's patience has been beginning to wear | 4:54 | |
thin and it is yielding to the | 4:57 | |
impulse of stepping too hard on | 4:59 | |
the brake, and has been doing so. | 5:02 | |
I trust that this will not continue but if it should, | 5:04 | |
it portends a more serious recession. | 5:09 | |
A more serious decline in income and industrial production | 5:12 | |
than I, at least, had been anticipating | 5:16 | |
on the basis of the earlier performance. | 5:19 | |
- | Can you see any special effects | 5:22 |
of this further tightening? | 5:24 | |
- | Well, it's very hard to see | 5:26 |
such effects very soon. | 5:29 | |
You've gone only-- it's only about a twelve week period | 5:32 | |
with sharp ups and downs but there are two | 5:35 | |
two phenomenon which, now by hindsight, | 5:38 | |
interpreted in the light of this | 5:42 | |
change, might be attributed to it. | 5:44 | |
One is the sudden intensification | 5:46 | |
of the stock market decline. | 5:49 | |
Which would be the result to be expected | 5:51 | |
from this kind of a further tightening. | 5:53 | |
However, that I may say is a very conjectural statement | 5:56 | |
because the stock market obeys laws of its own. | 5:59 | |
It's a very hard thing to predict and, while on the average, | 6:03 | |
monetary changes do have their impact on the stock market, | 6:06 | |
as yet we have been unable to pin that down in such detail | 6:09 | |
that I could have any great confidence. | 6:13 | |
I have a little bit more confidence in another effect | 6:15 | |
that may show up as a phenomenon. | 6:18 | |
That has to do with the behavior | 6:22 | |
of long term interest rates. | 6:24 | |
Those of you who follow long term interest rates, | 6:27 | |
or for that matter short term interest rates, | 6:30 | |
treasury bill rates, closely, realize that some time | 6:32 | |
around the end of May, these interest | 6:36 | |
rates more or less peaked out. | 6:39 | |
They hit, what for then, was a record peak | 6:42 | |
and in the next few weeks they started to go down again. | 6:47 | |
As I looked at that phenomenon, | 6:52 | |
and as I commented in these tapes, | 6:55 | |
it seemed to me we might be seeing the typical pattern. | 6:56 | |
A delayed impact of the tighter money. | 7:01 | |
As I mentioned before, the general experience is | 7:05 | |
that when the rate of monetary growth is slowed down | 7:09 | |
the immediate initial effect is to raise interest rates. | 7:13 | |
But that initial effect tends to last only | 7:16 | |
it lasts for about six months or so, | 7:19 | |
and there after the effect is to lower interest rates. | 7:21 | |
The reason for this opposite long term effect, | 7:26 | |
by comparison with the short term | 7:30 | |
effect ,is, as I've stressed before, | 7:31 | |
the fact that the tight money tends to produce | 7:33 | |
a slowing down in the demand for | 7:36 | |
loans and, therefore, to take the | 7:37 | |
pressure off of the interest rate. | 7:38 | |
Well at the time, I was inclined to interpret this peaking | 7:42 | |
and the subsequent slight decline | 7:45 | |
in the interest rates, as perhaps signaling | 7:47 | |
the turn and the delayed long term effect. | 7:49 | |
Subsequently, the long term interest rates | 7:53 | |
turned back up again and they are now, again, at an all time | 7:56 | |
record and are, have not yet peaked. | 7:59 | |
And it may well be that this reversal is the effect, | 8:04 | |
the impact of the short term effect shows up. | 8:10 | |
The short term effect of the, what I'm now | 8:15 | |
interpreting as a further tightening of monetary policy. | 8:20 | |
That took place, if I'm right, about twelve weeks ago | 8:25 | |
but it may well be that its impact on the market was delayed | 8:29 | |
by these very erratic gyrations. | 8:33 | |
The very, you know, high rise and then sharp decline. | 8:35 | |
So that it may be that what we are seeing in this | 8:40 | |
sort of double peaking of interest rates is a further impact | 8:44 | |
of that renewed tightening. | 8:50 | |
Now, where those long term interest rates will go | 8:53 | |
from here on out depend very much | 8:56 | |
on whether this renewed tightening that I see | 8:59 | |
is a deliberate act of policy by the Fed | 9:02 | |
which they are going to continue. | 9:05 | |
Whether, observing what's happening, | 9:07 | |
they're gonna like the result, | 9:08 | |
and going to go on at a zero rate of growth, | 9:09 | |
or, whether, as I hope will be the case, | 9:12 | |
on observing what they've been doing | 9:15 | |
they will recoil a little from it | 9:16 | |
and start expanding the money supply. | 9:18 | |
I may say that this further tightening | 9:22 | |
is a distressing sign that the Fed | 9:25 | |
may not have been learning as much as I had hoped. | 9:28 | |
Because in the past, what has tended to produce | 9:33 | |
excessive tightness has been the | 9:35 | |
Fed's preoccupation with interest rates in the sense | 9:38 | |
that when the long term effect of monetary | 9:41 | |
of the tightening showed up so | 9:44 | |
that interest rates started to come down a little, | 9:46 | |
the Fed intuitively interpreted this | 9:49 | |
as an easing of monetary policy, | 9:51 | |
it leaned against the decline, | 9:53 | |
and pulled out money and caused it to slow down. | 9:54 | |
And I am disturbed to find that this fits | 9:57 | |
the present pattern I have been arguing, | 10:00 | |
that the Fed has learned a good deal and it is now paying | 10:03 | |
far more attention to current monetary | 10:07 | |
magnitudes and, therefore, that it is | 10:11 | |
unlikely to repeat its mistake of past | 10:13 | |
years and overshoot drastically. | 10:17 | |
But, unfortunately, these figures raise some doubt about | 10:20 | |
that and as a result I am afraid | 10:24 | |
I'm going to have to pull | 10:29 | |
back and say that I am no longer so confident as I was | 10:30 | |
before that the peak in interest rates | 10:33 | |
is in the very near neighborhood. | 10:35 | |
If they should continue this policy | 10:37 | |
it would be another two or three months | 10:39 | |
before you would have the real peak. | 10:40 | |
- | While we are discussing interest rates, this might | 10:43 |
be a good point-- good place to | 10:46 | |
introduce a subscribers question. | 10:48 | |
The question is, "The prime rate is now 8.5%, but I | 10:52 | |
understand that few banks will lend at this | 10:56 | |
rate without requiring a compensating | 10:59 | |
balance of about 20% of the loan. | 11:01 | |
Doesn't that mean that the real rate is over 10%? | 11:04 | |
- | Yes, it does mean that the real rate is over 10%. | 11:08 |
However, that's misleading. | 11:12 | |
The rate of interest, the market rate of interest on | 11:14 | |
loans in the market is somewhere in the neighborhood of 10% | 11:19 | |
for the kind of loans that commercial banks make, | 11:23 | |
and it is perfectly true that a | 11:26 | |
that this is concealed by a loan at 8.5% | 11:30 | |
that requires a compensating balance. | 11:34 | |
However, what's misleading about this is that it | 11:36 | |
it doesn't make clear what the function | 11:41 | |
of the compensating balance is. | 11:43 | |
To state it that way makes it sound | 11:45 | |
as if the purpose of the compensating balance | 11:47 | |
is in order to enable the banks to charge a higher interest | 11:49 | |
rate than they otherwise could, | 11:51 | |
while not seeming to do so. | 11:55 | |
(clears voice) | 11:57 | |
There have been times when that was the | 11:59 | |
function of the compensating balance. | 12:01 | |
For example during the 1920's the compensating balance | 12:03 | |
was very frequently used as a way to get around | 12:07 | |
the usury ceiling on interest rates | 12:09 | |
imposed by various state laws. | 12:12 | |
A loan could be made at less than the ceiling interest rate, | 12:14 | |
than the usury interest rate, and yet yield more than that | 12:18 | |
by virtue of the compensating balance. | 12:22 | |
But in recent years, in my opinion, the compensating balance | 12:24 | |
has served a very, very different function. | 12:27 | |
Its function has been to enable banks to pay interest | 12:30 | |
on demand deposits in a rather round about way. | 12:33 | |
As you know, as a result of laws | 12:37 | |
passed in 1933 and 1935, commercial banks are prohibited | 12:39 | |
from paying interest on demand deposits. | 12:44 | |
Now, the fact that they are prohibited from paying | 12:47 | |
interest explicitly on demand deposits. | 12:51 | |
All it leads, in this instance and in all other cases | 12:55 | |
where you have prohibitions of this kind, | 12:57 | |
to pressure to find ways around it. | 12:59 | |
To pay interest on demand deposits in an indirect way. | 13:01 | |
And one indirect way in which this occurs | 13:06 | |
is through the compensating balance. | 13:10 | |
Let me see if I can explain that. | 13:12 | |
If the compensating balance, which the borrower was required | 13:15 | |
to keep, was a minimum amount, | 13:20 | |
the minimum balance he had to keep | 13:21 | |
could more plausibly be interpreted | 13:24 | |
as a way of charging higher interest rates. | 13:27 | |
But the compensating balance is | 13:30 | |
almost never expressed as a minimum. | 13:32 | |
It is almost always expressed as an average balance. | 13:34 | |
The actual balance can be below that, it can be above | 13:37 | |
that, provided it averages out. | 13:40 | |
That makes clear that what's involved is not a | 13:42 | |
is maybe, or is, at least in part, | 13:46 | |
inducing people to keep their working balances | 13:51 | |
at the bank in which they make a loan. | 13:54 | |
Here it is, I would like to pay you | 13:56 | |
interest on your demand deposits. | 13:59 | |
One way I can do so is by offering you a loan at a lower | 14:01 | |
rate than the market interest rate. | 14:05 | |
The difference between the rate at which I make the loan to | 14:07 | |
you and the market interest rate is then a payment to you. | 14:09 | |
But if I as a bank am going to pay you interest | 14:13 | |
on demand deposits, that way I have to be sure | 14:15 | |
you keep your demand deposits with me. | 14:17 | |
Because I might do that on the assumption | 14:19 | |
that you're going to keep your deposits with me | 14:22 | |
and then you'd withdraw your deposits from my | 14:24 | |
bank and put'm some where else. | 14:25 | |
Well one way to do that is through the | 14:28 | |
compensating balance requirement. | 14:30 | |
That means that you will be required to keep, | 14:32 | |
at least a large fraction of your balances | 14:38 | |
or a substantial amount of your balances with me. | 14:40 | |
As you know, what I've described is only part of the story. | 14:43 | |
Banks in general are much more willing | 14:48 | |
to accommodate their regular depositors | 14:51 | |
than they are people who come in from outside. | 14:55 | |
If you have no deposit account at a bank | 14:56 | |
and you come into a bank for a loan | 14:58 | |
you will have a hard time borrowing money, | 15:00 | |
unless you can offer particularly good security | 15:02 | |
and unless you're willing to pay | 15:05 | |
a particularly high rate of interest. | 15:06 | |
Well this is a more indirect way and a less formal way | 15:08 | |
in which banks link together the making of | 15:11 | |
loans and the holding of deposits. | 15:14 | |
Alright, now let look at it from that point of view. | 15:16 | |
Let us suppose that you are a depositor at a bank, | 15:19 | |
that the bank makes you a loan of $1,000 at 8.5%, | 15:22 | |
when the market rate you would have | 15:27 | |
to pay otherwise would be 10%. | 15:30 | |
Well in that case you're getting a loan, | 15:33 | |
on the basis of that loan you're getting paid $150. | 15:36 | |
at the rate of $150 a year the difference between | 15:39 | |
the interest rates you would have to pay in the market | 15:41 | |
and the interest rates you are actually paying. | 15:44 | |
Let us suppose as a result of this | 15:46 | |
you were keeping in the bank, on | 15:48 | |
the average, $200 of deposits. | 15:49 | |
Well that means that you are in | 15:53 | |
affect earning 7% on your deposit. | 15:54 | |
7% would be a much higher rate on the average | 15:57 | |
than banks would really be willing to pay on deposits | 16:00 | |
if they were paying them explicitly. | 16:04 | |
So this example misrepresents the situation a little. | 16:06 | |
The reason it does is because if there's a | 16:09 | |
compensating balance requirement of 20%, you are in fact, | 16:11 | |
on the average, going to keep more than that. | 16:14 | |
You would never calculate it so nicely. | 16:16 | |
And I figured 7% on an average balance of $200. | 16:19 | |
But in fact, suppose you have an average balance | 16:22 | |
of about $300, and that reduces it to about 5%. | 16:24 | |
That's, in any event, I don't wanna be stuck with the | 16:28 | |
particular figures, but that is the way in which | 16:30 | |
you can use the compensating balance requirement | 16:34 | |
as a means of paying interest on deposits | 16:38 | |
rather than as a means of simply | 16:41 | |
charging a higher interest rate. | 16:42 | |
- | Well, this is a fine interpretation, | 16:45 |
but do you have any evidence to support your judgment? | 16:48 | |
- | The evidence is very clear, if one looks at the | 16:52 |
figures on the earnings of banks. | 16:55 | |
Let's suppose that | 16:59 | |
the interest prohibition, | 17:02 | |
the prohibition of the payment of | 17:07 | |
interest on demand deposits, was 100% effective. | 17:08 | |
Let's take the extreme view. | 17:11 | |
Now, and let's consider 1968 for a moment, | 17:13 | |
from which we happen to have reported figures | 17:16 | |
on the earnings and expanses of all member banks. | 17:19 | |
During that year the interest prime rate | 17:24 | |
was about 6% / 6.5%, let's suppose it was 6%, | 17:28 | |
take a conservative number, and member banks had demand | 17:33 | |
deposits running in the neighborhood of 150 billion dollars. | 17:38 | |
A little less than that, but roughly, | 17:41 | |
again to get a round figure. | 17:42 | |
If the interest, prohibition of the payment of interest | 17:44 | |
on demand deposits had been fully effective, | 17:47 | |
this means they would have had about nine billion dollars | 17:49 | |
of, uh, as it were, interest earnings on | 17:52 | |
150 billion dollars in demand deposits. | 17:56 | |
Of course, that nine billion dollars | 17:59 | |
wouldn't be free and clear. | 18:00 | |
It would have to be used to pay expenses | 18:02 | |
in running the bank, of operating it, | 18:05 | |
of clearing checks, and so on. | 18:07 | |
But nine-- but most of that would be available for earnings. | 18:10 | |
Yet total member bank earnings in 1968, | 18:15 | |
before taxes, totaled only five billion dollars. | 18:19 | |
And I should emphasize. And when I say they, banks, had 150 | 18:23 | |
billion in demand deposits, I'm leaving out | 18:26 | |
completely all of their time deposits. | 18:28 | |
They had an even larger total of time deposits. | 18:30 | |
Right now they have about, roughly 150 billion in demand | 18:33 | |
deposits and 200 billion in time deposits. | 18:38 | |
Banks earn money from their time deposits. | 18:42 | |
They also got receipts from service charges. | 18:45 | |
So, uh it's very hard to believe | 18:48 | |
that that interest ceiling on interest prohibition on demand | 18:53 | |
deposits is completely effective. | 18:58 | |
It's hard to reconcile that with the member bank earnings. | 18:59 | |
I should say, in the respect, that the payment | 19:02 | |
of the use of compensating balances | 19:04 | |
is only one device whereby member banks | 19:07 | |
find a method of paying interest on demand deposits. | 19:10 | |
A much more obvious method, the method that everybody is | 19:14 | |
aware of is through providing services free of charge. | 19:17 | |
For example, banks with substantial | 19:20 | |
for customers with substantial balances, | 19:23 | |
few banks charge service charges on checks and on deposits. | 19:25 | |
That is they are providing those services | 19:28 | |
without charge in lieu of interest. | 19:30 | |
In addition, banks will perform many many | 19:32 | |
other services for their customers. | 19:35 | |
From advising on investments and so on, | 19:37 | |
to scouting out new opportunities for them, | 19:44 | |
to wining'm and dining'm when they come to New York | 19:46 | |
and all sorts of things that my subscribers, | 19:50 | |
who are more intimately associated with this activity | 19:53 | |
than I am, probably know far better than I do. | 19:56 | |
Well that was that's one piece of | 19:58 | |
evidence is the earnings for 1968. | 20:00 | |
But let me give you another piece of evidence, | 20:02 | |
which I think is, at least as striking. | 20:04 | |
And that is the change between 1968 and 1969. | 20:07 | |
The prime interest rate has gone up at least | 20:11 | |
two percentage points since 1968. | 20:13 | |
So for 1969, for this year, if the prohibition | 20:16 | |
of the payment of interest on demand | 20:20 | |
deposits were completely effective, | 20:22 | |
that source of earning should have gone up | 20:24 | |
another three billion dollars. | 20:26 | |
That is to say, you would have had a two percentage points | 20:28 | |
on 150 billion dollars or three billion dollars. | 20:32 | |
That would have been, if they could have kept ahold of that, | 20:35 | |
that would have been a 60% increase in earnings. | 20:37 | |
Yet they're-- if you look at the reports in the Wall Street | 20:40 | |
Journal, of what's happening to the earnings of commercial | 20:43 | |
banks, even the most prosperous of them, | 20:45 | |
those who have done best have only shown | 20:50 | |
increased earnings of about 10%. | 20:52 | |
- | But haven't their costs also been | 20:54 |
going up as a result of inflation? | 20:56 | |
- | Yes, that's entirely true and I should have allowed for | 20:58 |
that, however, if you look into the figures | 21:01 | |
it turns out that that does, that reduces a, | 21:02 | |
the dramatic character of this change | 21:05 | |
but it doesn't really eliminate it. | 21:08 | |
Their total costs in 1968 were 16 billion dollars. | 21:10 | |
Prices have gone up about 5%. | 21:13 | |
Let's say 6%. | 21:15 | |
That would be about a billion dollars extra | 21:17 | |
costs on account of price increase. | 21:19 | |
That would use up one out of that three billion dollars. | 21:21 | |
It would still leave'm with two billion dollars net, | 21:24 | |
which would be a 40% increase in earnings | 21:27 | |
and yet they've been showing something like 10%. | 21:29 | |
It's clear that in order to compete for demand deposits | 21:31 | |
they have had to pass on to their customers | 21:34 | |
most of that increase in the prime rate. | 21:37 | |
- | Thank you very much Professor Freedman. | 21:40 |
Remember subscribers, if you have questions or comments | 21:43 | |
or suggestions for topics you would like to hear discussed | 21:46 | |
in this series, please send them | 21:49 | |
to Instructional Dynamics Inc. | 21:51 | |
166 East Superior Street, | 21:53 | |
Chicago, Illinois 60611. | 21:56 | |
Doctor Friedman will be visiting | 22:00 | |
with you again in two weeks. | 22:01 |
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