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- | Hello, this is Instructional Dynamics inviting you | 0:02 |
to another of our biweekly interviews | 0:05 | |
with Dr. Milton Friedman, Professor of Economics | 0:07 | |
at the University of Chicago. | 0:10 | |
We are taping this interview on Thursday, September fourth. | 0:12 | |
There will be an interruption in these biweekly tapes | 0:17 | |
because Professor Friedman will be out of the country | 0:20 | |
for a number of weeks. | 0:23 | |
By the way Professor Friedman, your subscribers | 0:24 | |
might be interested in where and why you're going. | 0:27 | |
- | Well I am going first to Venezuela Caracas | 0:31 |
for a meeting of the Mont Pelerin Society | 0:34 | |
which is an international society of economists, | 0:36 | |
clinical scientists, journalists and other interested | 0:41 | |
and responsible citizens established some 20-odd | 0:44 | |
years ago with the aim of providing an international forum | 0:48 | |
for people concerned with the preservation | 0:52 | |
and strengthening of a free society of free enterprise, | 0:56 | |
free political society. | 0:59 | |
After that, and the main purpose of my trip is | 1:02 | |
to go to Japan for several weeks. | 1:05 | |
The reason I'm going to Japan is that there is a | 1:08 | |
university there, Rikkyo University, | 1:10 | |
which has been engaging in a series of monetary studies | 1:12 | |
that designed a study for Japan, the relations | 1:15 | |
between money and income and money and price | 1:18 | |
as money and interest rates comparable | 1:21 | |
to the studies that we have made for the United States. | 1:25 | |
I have been serving as an advisor for this study | 1:28 | |
and had been following with great interest the results. | 1:30 | |
The fascinating thing to me is how closely that the | 1:35 | |
relationships that we have found to hold | 1:38 | |
for the United States hold also for Japan. | 1:40 | |
Indeed in many ways, it is easier and more striking | 1:44 | |
to see these relationships in the Japanese data | 1:48 | |
than in the United States data, particularly | 1:51 | |
in post World War Two period because Japan has moved | 1:53 | |
more sharply one way or the other. | 1:56 | |
And consequently there is less doubt about the precise | 1:59 | |
dates at which you have moved from a rapid | 2:03 | |
to a slow rate of increase in the quantity of money. | 2:05 | |
So this is the main reason why I have been so interested | 2:08 | |
in this Japanese study. | 2:13 | |
I may say that one of the interesting features about Japan | 2:15 | |
is the fact that its banking institutions are very similar | 2:19 | |
to and indeed were largely copied | 2:23 | |
from the American institutions. | 2:25 | |
The social arrangements, the attitudes of the people, | 2:28 | |
the long traditions and history are all together different | 2:32 | |
and therefore it is fascinating to see | 2:35 | |
how the same institutions operate in a very | 2:37 | |
different environment. | 2:39 | |
For example about the banking system, the Japanese | 2:41 | |
banking system was reorganized and reestablished | 2:46 | |
after the Meiji Restoration in 1867. | 2:50 | |
They did so by copying word for word, the National | 2:54 | |
Banking Act as it was first passed in the United States. | 2:59 | |
It so happened that that first Act as it was passed | 3:03 | |
in the United States, and it was not very successful | 3:06 | |
because one of its provisions was that all banks | 3:09 | |
had to be designated solely by number. | 3:12 | |
The first bank in a city that became a national bank | 3:15 | |
was the First National Bank. | 3:19 | |
The second was supposed to the Second National Bank, | 3:20 | |
the third, The Third National Bank and so on. | 3:22 | |
Well many banks didn't mind being the first national bank | 3:25 | |
but very few banks were willing to give up | 3:28 | |
long-established names and become the 14th National Bank. | 3:31 | |
As a result, few banks were established and that Act | 3:38 | |
was very quickly revised, I think within two years | 3:41 | |
or so after its initial passage. | 3:44 | |
To provide that a bank could retain its former name | 3:49 | |
provided they put the word, national, somewhere | 3:54 | |
in its title. | 3:56 | |
And that is why we have things like The Continental | 3:59 | |
Illinois National Bank. | 4:02 | |
As it happened, Japan copied the first version of this | 4:04 | |
and did not alter it to permit other kinds | 4:08 | |
of names to come into existence until very, very much later | 4:11 | |
than we did. | 4:15 | |
As a result, I remember some years ago | 4:16 | |
when we were in Japan being at a discussion | 4:18 | |
at a bank in the northern part of Japan, | 4:24 | |
which if I remember rightly was Bank Number 66. | 4:27 | |
That was its name, the 66th National Bank of Japan. | 4:32 | |
Well that's a particular example which shows how closely | 4:36 | |
the Japanese banking institutions were copied | 4:40 | |
from the United States. | 4:44 | |
By now of course they have changed drastically | 4:45 | |
and there are many differences between them. | 4:48 | |
For example, reserve requirements in Japan are | 4:50 | |
very, very low. | 4:53 | |
They're 1-1/2, 2% of deposits, not like our own | 4:54 | |
17-1/2% of demand deposits. | 4:58 | |
Similarly the arrangements whereby commercial banks | 5:02 | |
are financed by the central bank is rather different | 5:08 | |
than in our own and there are direct lines of credit | 5:11 | |
from the central bank, the Bank of Japan | 5:14 | |
to the commercial bank. | 5:17 | |
The major part of monetary policy in Japan is what they | 5:20 | |
call window guidance, that is explicit qualitative | 5:23 | |
control by the central bank over the loans | 5:28 | |
and investments of the commercial bank. | 5:31 | |
So that there are many differences in detail | 5:33 | |
and yet as I say, the fascinating thing is | 5:36 | |
that the overall relationships between changes | 5:38 | |
in the quantity of money and changes in the national income | 5:41 | |
come out of the same class and are cut | 5:44 | |
to much the same pattern as the relationships | 5:47 | |
for the United States or for Great Britain | 5:50 | |
for other western countries. | 5:52 | |
- | Professor Friedman, controversy seems to be continuing | 5:55 |
about whether the administrations anti inflationary policy | 5:58 | |
is working. | 6:02 | |
Do you see any reason to change your own views on it? | 6:04 | |
- | No, I see none whatsoever. | 6:07 |
It seems to me that everything is more or less | 6:09 | |
on schedule. | 6:13 | |
That is, we had a shift toward monetary restraint | 6:14 | |
about seven or eight months ago, | 6:19 | |
and we have been seeing in the last couple | 6:21 | |
of months after the usual lag in reaction, | 6:23 | |
the effects of that shift in the economy. | 6:27 | |
The latest signs are a current report | 6:32 | |
by the Commerce and SEC of a decline in capital spending | 6:37 | |
plans by business enterprises. | 6:45 | |
This Commerce SEC survey had initially indicated | 6:49 | |
that capital spending in 1969 would rise by 14% from '68. | 6:55 | |
That was cut in an earlier survey to 12-1/2%. | 7:01 | |
It's now been cut to about 10-1/2%. | 7:06 | |
Well a cut for the year as a whole in the rise | 7:09 | |
in capital spending over 1968 of that magnitude | 7:13 | |
given that you have already had an increase | 7:17 | |
in capital spending in the early months of the year, | 7:20 | |
is very likely to mean either no rise at all | 7:23 | |
or indeed an actual decline in the final six months. | 7:28 | |
Similarly the various other indicators have also | 7:31 | |
been showing consistently weakness. | 7:34 | |
The leading indicators went down and they have been | 7:36 | |
horizontal or slightly declining since something | 7:40 | |
like January. | 7:42 | |
So that all told I am inclined to believe | 7:43 | |
that we are in the early stages at the moment, | 7:47 | |
of an economic slowdown, which is manifesting itself | 7:49 | |
mostly in the real GNP and real magnitudes | 7:53 | |
that will shortly move over and manifest itself | 7:57 | |
in prices, that the final months of this year | 7:59 | |
will see a slackening of the rate of price rise | 8:02 | |
but without anything like a elimination of price rises | 8:04 | |
we'll be fortunate, as I've said again and again | 8:08 | |
if by the end of the year the rate of price rise | 8:10 | |
is down to 4%. | 8:13 | |
- | In light of recent developments, are you still concerned | 8:16 |
about the possibility of overkill? | 8:19 | |
- | Yes, indeed. | 8:22 |
As I emphasized last time, despite the revision | 8:25 | |
of the figures by the Federal Reserve, there appears | 8:28 | |
to have been significant tightening of monetary restraint | 8:31 | |
beginning some time about April or May. | 8:36 | |
We have now two more weeks of figures | 8:40 | |
since I last reported and they show the same pattern. | 8:42 | |
Let me cite a couple of numbers. | 8:46 | |
If you take the period from December to the end | 8:49 | |
of April, money supply narrowly define currency | 8:51 | |
and demand deposits went up at the rate of 3.7%. | 8:56 | |
From then to now it has gone up at the rate of 1.8%. | 9:00 | |
If we take a broader total of currency plus demand deposits | 9:05 | |
plus time deposits but excluding the large certificates | 9:09 | |
of deposits because of the bookkeeping operations | 9:12 | |
that have enabled banks to offset their decline, | 9:15 | |
we find that that total was rising from December | 9:18 | |
to April at the rate of 5% a year. | 9:22 | |
It has actually been declining from April to now | 9:26 | |
at the rate of 1-1/2% a year. | 9:28 | |
And I should stress that these numbers are based | 9:30 | |
on the newly revised figures of the Federal Reserve | 9:33 | |
including their revision for the Euro dollar problem | 9:36 | |
but not including what is still to come, | 9:39 | |
a further revision on seasonal account. | 9:42 | |
Looking at these figures plus a host of other figures, | 9:45 | |
the impression I gain, I get is that there clearly | 9:49 | |
and definitely has been a further tightening | 9:53 | |
of monetary restraint in the past three months. | 9:56 | |
I believe this is a very unfortunate development | 9:59 | |
and one that is capable of having serious consequences. | 10:02 | |
If the present rate of monetary growth is continued, | 10:05 | |
if this more restrained policy is followed, | 10:09 | |
it seems to me almost inevitable that you will see | 10:13 | |
a significant contraction of economic activity in 1970, | 10:16 | |
that you will have the most severe recession | 10:25 | |
since at least '58, '59 and maybe since before that | 10:30 | |
in the post war period. | 10:33 | |
That is still capable of being avoided | 10:36 | |
if the fed eases off, but as yet they have shown | 10:38 | |
no signs whatsoever of easing off. | 10:41 | |
This will manifest itself not only in a still slower rate | 10:44 | |
of growth of real output than had been anticipated, | 10:49 | |
not merely a slowing of the rate of growth | 10:52 | |
but probably an absolute decline. | 10:55 | |
It will also manifest itself in a more considerable decline | 10:57 | |
in profits than has been anticipated. | 11:01 | |
There is reason to believe that if this rate | 11:03 | |
of monetary growth were to continue, profits will be down | 11:06 | |
by recessionary magnitudes by something | 11:10 | |
of the order of 30, 35% perhaps over the next | 11:13 | |
six or nine months. | 11:17 | |
Let me emphasize, these are not absolute predictions. | 11:20 | |
They are statements about what will happen | 11:24 | |
if present policies are continued, were to continue. | 11:26 | |
I know that there is great concern in Washington | 11:30 | |
and in many circles about this outcome. | 11:32 | |
The Federal Reserve Board, the other agencies | 11:35 | |
do not desire this outcome and therefore I still remain | 11:38 | |
optimistic that the recent period will turn out | 11:42 | |
to have been a temporary phase, that you will have | 11:47 | |
some easing off of Federal Reserve policy | 11:50 | |
which will permit the quantity of money to resume, | 11:53 | |
grow at a rate that can be maintained for a long period | 11:55 | |
a rate somewhere about four or 5%. | 12:00 | |
- | Professor Friedman, I have a question | 12:04 |
from a subscriber who happens to be a lawyer | 12:06 | |
that I believe will interest other subscribers as well. | 12:09 | |
He writes, "Dear Dr. Friedman, on the tape | 12:13 | |
"of your August 7th interview, you stated | 12:16 | |
"that allowance of an interest paid deduction | 12:19 | |
"for computing taxable income is one | 12:21 | |
"of the devices which can be most readily used | 12:25 | |
"to convert ordinary income to capital gains. | 12:28 | |
"Would you please explain your reasoning | 12:31 | |
"and expand your statement?" | 12:33 | |
- | There are a great variety of devices of this kind | 12:37 |
which can be used. | 12:42 | |
Let me outline one just to illustrate the | 12:43 | |
main principle involved. | 12:46 | |
For simplicity, I'll use a particular case | 12:48 | |
at a particular operation, this time involving | 12:51 | |
a commodity. | 12:55 | |
Consider the, for example, the silver market, | 12:56 | |
let us suppose that a taxpayer were to buy silver spot | 13:00 | |
and store it. | 13:09 | |
At the present time, the future price of silver is higher | 13:13 | |
than the spot price of silver. | 13:16 | |
That is the price of silver for delivery six or nine months | 13:18 | |
from now is higher than the spot price | 13:21 | |
and it is higher by an amount which roughly covers | 13:25 | |
interest costs plus the storage costs in the interim. | 13:28 | |
Of course the reason it is higher is because people | 13:34 | |
anticipate that the price of silver will be going up. | 13:37 | |
Silver is a commodity whose price was pegged | 13:40 | |
until a few years ago by the Treasury Department | 13:42 | |
which bought and sold at a fixed price. | 13:46 | |
That peg was dropped and had to be dropped | 13:49 | |
as silver supplies went down, and as you know, | 13:51 | |
silver has almost disappeared from our coinage. | 13:54 | |
Coins are worth more as silver, many of them | 13:58 | |
as they are as money and consequently Gresham's law | 14:01 | |
is in operation and they are being melted down | 14:05 | |
or otherwise taken off the market. | 14:07 | |
The treasury is still holding down the price | 14:12 | |
of silver by selling from its residual stocks. | 14:14 | |
It is widely anticipated that this will come | 14:17 | |
to an end fairly shortly and this shows up | 14:19 | |
in the market prices and the fact that future prices | 14:23 | |
are above present prices. | 14:25 | |
Well that's the background. | 14:27 | |
Let's go back to the operation. | 14:28 | |
You buy silver spot and store it. | 14:30 | |
At the same time to hedge yourself so that what you are | 14:33 | |
doing is in fact to convert ordinary income | 14:37 | |
into capital gains and not to take a risk, | 14:39 | |
you sell silver futures, let us say for nine months | 14:42 | |
from now. | 14:48 | |
The purchase of silver has to be financed | 14:53 | |
and you finance it by borrowing on the security | 14:56 | |
of the silver and paying an interest rate on it. | 14:59 | |
The future requires only a small margin, | 15:03 | |
let's say a 10% margin and again, suppose that you have | 15:06 | |
assets on which you can borrow that in order | 15:12 | |
to meet the margin requirement. | 15:15 | |
Now nine months go by, your future contract is up. | 15:18 | |
Let us suppose the simplest case which is | 15:22 | |
that the spot price then is equal to the futures price | 15:25 | |
at which you sold short. | 15:31 | |
In that case you can close out your futures contract | 15:34 | |
with neither a gain nor a loss on the future contract. | 15:40 | |
On the other hand, your spot silver will have | 15:43 | |
risen in price. | 15:46 | |
You can now sell that spot silver at the higher price. | 15:49 | |
The difference between the price at which you sell it | 15:52 | |
and the price at which you bought it is a capital gain. | 15:55 | |
Counterbalancing that capital gain is the interest cost | 15:59 | |
on the borrowing and the cost of storing the silver. | 16:03 | |
By assumption, this sum is almost precisely equal | 16:07 | |
to the capital gain. | 16:12 | |
So it looks at firsthand if there were no tax effects | 16:13 | |
involved at all, it's all a wash transaction. | 16:16 | |
You have gained nothing. | 16:20 | |
You have paid in full for whatever you gained. | 16:22 | |
However we now look at the tax sign. | 16:24 | |
The interest that you pay, plus the cost | 16:27 | |
of storing the silver is a current expense | 16:30 | |
and is deductible from current income. | 16:32 | |
The capital gain on the silver, under present law | 16:35 | |
is a long-term capital gain because you held the silver | 16:38 | |
more than the present holding period of six months. | 16:41 | |
Of course if the Ways and Means Committee proposal | 16:44 | |
goes into effect to increase the holding period | 16:46 | |
from six months to a year, the situation would be different | 16:50 | |
and you would have to hold the silver more than a year | 16:53 | |
in order to pull this particular transaction. | 16:55 | |
However under present law, you have a capital gain | 16:59 | |
which is taxable at half either a maximum rate | 17:03 | |
of 25% or half the rates. | 17:08 | |
And on the other hand you have a deduction | 17:11 | |
from ordinary income of interest and storage costs. | 17:13 | |
The effect is that you have converted a certain amount | 17:19 | |
of ordinary income into capital gains | 17:22 | |
and you have saved taxes on the transaction. | 17:24 | |
Well, this is a particular device. | 17:26 | |
Let me say one more thing. | 17:28 | |
Let's suppose that the silver price, the price | 17:29 | |
of the silver did not move in accord | 17:32 | |
with the futures price at the time you sold it | 17:36 | |
in starting the transaction. | 17:39 | |
Then you would have either a gain or a loss | 17:41 | |
on the silver future. | 17:44 | |
Let's suppose that the price of silver rose | 17:46 | |
even more than was indicated. | 17:50 | |
In that case you have a loss on your silver future. | 17:52 | |
You promised to sell it at a certain price | 17:56 | |
and you now have to terminate the contract | 17:58 | |
at a higher price, that is to say you in effect have | 18:00 | |
to buy back silver at a higher price | 18:03 | |
than you promised to sell it for. | 18:05 | |
However this is completely hedged and offset | 18:06 | |
by the fact that you have a still larger gain | 18:09 | |
on your spot silver. | 18:13 | |
So you're still back just where you were before. | 18:15 | |
Similarly, suppose the price of silver did not rise as much. | 18:17 | |
Suppose it's below the price at which you sold it. | 18:22 | |
Then you have a gain on your future contract | 18:25 | |
which is also a capital gain and you have, | 18:27 | |
but you have a smaller gain on your spot contract. | 18:31 | |
So this combination of a hedge transaction | 18:34 | |
does not involve you in any risk on silver prices | 18:37 | |
but is a way in which you can convert ordinary income | 18:41 | |
into capital gain. | 18:43 | |
Of course there are costs in doing it. | 18:45 | |
You have to pay the charges for buying and selling silver. | 18:47 | |
You have to go through the nuisance of arranging | 18:53 | |
for storing it. | 18:55 | |
You also will have to borrow more than 100% | 18:57 | |
because of the problem of providing for a margin | 19:01 | |
on your future contract. | 19:04 | |
But yet for people in high tax brackets, | 19:08 | |
this is a very widely used device which can convert | 19:11 | |
ordinary income into capital gains. | 19:16 | |
As I emphasized, it's one of a great class. | 19:18 | |
The general principle in all of these that underlies | 19:20 | |
all of them is the purchase of an asset | 19:24 | |
which pays little or nothing in current income | 19:28 | |
but which is expected to appreciate in capital value | 19:33 | |
exactly the same thing can be accomplished | 19:37 | |
for example by buying a security just after | 19:39 | |
it has paid its dividend or its interest coupon | 19:46 | |
if it's bond and selling it just before it's scheduled | 19:49 | |
to pay another one. | 19:52 | |
Alternatively if you can buy stocks of companies | 19:55 | |
which do not pay current dividends, which plow back | 20:00 | |
their earnings, that is still another way | 20:04 | |
in which the same principle can be applied | 20:06 | |
because such a stock is expected to appreciate | 20:08 | |
in price over a period of time as a result | 20:11 | |
of the plowed back earnings independently | 20:14 | |
of what happens to stocks on the market in general. | 20:15 | |
Now in these cases, it is somewhat more difficult | 20:19 | |
to carry out the kind of perfect hedging | 20:23 | |
that I talked about on the pure case of the silver future. | 20:25 | |
But the general principle is exactly the same. | 20:29 | |
- | I have another question from a subscriber | 20:34 |
who happens to be a bank president, and he writes, | 20:36 | |
"Dear Dr. Friedman, I would be very interested | 20:40 | |
"in hearing a discussion of the rediscount policy | 20:42 | |
"of the Federal Reserve. | 20:45 | |
"It seems to be that the original intent | 20:46 | |
"of the Federal Reserve Act was far different | 20:50 | |
"from the manner in which the rediscount function is | 20:53 | |
"presently being used and that it should not be used | 20:55 | |
"to restrict the extension of credit | 20:59 | |
"as is now the case." | 21:01 | |
- | The subscriber is quite right, that the rediscount | 21:03 |
function has changed its character very much | 21:07 | |
since it was initially introduced. | 21:10 | |
When the Federal Reserve Act was first established, | 21:13 | |
was first passed in 1914, the whole purpose | 21:17 | |
of the rediscounting facility was to provide a lender | 21:23 | |
of last resort to commercial banks. | 21:27 | |
At that time the US was on a gold standard. | 21:31 | |
It was anticipated that we would remain | 21:35 | |
on a gold standard in a much fuller sense | 21:37 | |
than we ever returned to it after World War One, | 21:39 | |
that it, it's in a sense in which the quantity | 21:42 | |
of money was going to be determined by international | 21:45 | |
transactions and the Federal Reserve's role | 21:47 | |
was not thought of, and was not intended to be one | 21:50 | |
of determining the quantity of money in the country | 21:54 | |
but solely of providing a mechanism for easing the ups | 21:56 | |
and downs over short periods for enabling banks | 22:01 | |
in difficulties for particular purposes | 22:06 | |
to get liquidity to meet the demands of customers. | 22:10 | |
The event which stimulated and set off | 22:16 | |
and crystallized the Federal Reserve Act was | 22:20 | |
of course the banking panic of 1907. | 22:22 | |
And what it was intended to avoid was a situation | 22:25 | |
in which banks as in 1907 stopped paying out cash | 22:28 | |
to their customers. | 22:34 | |
They continued, they kept their doors open. | 22:35 | |
They continued transferring checks among customers | 22:38 | |
and making credits and debits to deposit accounts, | 22:41 | |
but they refused to convert deposits into currency. | 22:44 | |
It was for this kind of a situation | 22:50 | |
that the Federal Reserve was really established | 22:52 | |
and the rediscounting facility was intended to be a way | 22:55 | |
in which banks could as it were, convert their assets | 22:58 | |
into liquid cash funds to meet the demands of depositors. | 23:02 | |
It was not really intended to be a device | 23:08 | |
for permanent financing of banks. | 23:11 | |
It was intended to be a device to stimulate | 23:13 | |
or permit or to restrict the extension of credit | 23:17 | |
but solely for this purpose of enabling banks | 23:19 | |
to have a lender of last resort. | 23:22 | |
The rediscount facilities were patterned after those | 23:26 | |
established by the Bank of England. | 23:31 | |
Indeed many of the features of our Federal Reserve system | 23:33 | |
were patterned after the Bank of England. | 23:35 | |
And one of the great issues that arose in the early days | 23:37 | |
was whether we should follow the Bank of England | 23:40 | |
by having the interest rate be a penalty, | 23:43 | |
the discount rate, the rate at which the Federal Reserve | 23:46 | |
made loans to member banks be a penalty rate. | 23:50 | |
In the British example the Bank of England in fact | 23:54 | |
does rediscount from the commercial banks directly. | 23:57 | |
There is an intermediary to bill brokers | 24:01 | |
and in fact there's a roundabout route whereby | 24:04 | |
the banks get to the Bank of England. | 24:07 | |
We need not go into those details but there's one | 24:09 | |
crucial point about it which is that historically | 24:11 | |
the discount rate of the Bank of England was always | 24:14 | |
higher than the market rate on comparable loans. | 24:17 | |
As a result, it was costly for the bill brokers | 24:24 | |
to discount at the Bank of England | 24:29 | |
and as a result they tended to use it only | 24:30 | |
for temporary accommodation in time of need. | 24:32 | |
For a variety of reasons, this particular issue | 24:36 | |
was settled by having the discount rate | 24:39 | |
in the United States be lower than the rate | 24:43 | |
on comparable market instruments. | 24:46 | |
As a result in the early years of the Federal Reserve, | 24:49 | |
it was extremely profitable for banks to borrow | 24:51 | |
from the Federal Reserve. | 24:54 | |
And the result was that quite unintentionally | 24:55 | |
and without anybody having designed it that way, | 24:59 | |
in the early days immediately after the end | 25:01 | |
of World War One, the Federal Reserve system | 25:05 | |
turned out to be an instrument for financing | 25:08 | |
of private expansion of bank credit. | 25:11 | |
The inflation after World War One from 1918 to 1920, | 25:14 | |
about one-third of the total price rise | 25:18 | |
during the way occurred during that period, | 25:21 | |
was produced by a very rapid increase in loans | 25:24 | |
by the Federal Reserve to member banks | 25:31 | |
used to extend credit to the business community in general. | 25:33 | |
Indeed in early 1920, the borrowings of member banks | 25:38 | |
at the Federal Reserve exceeded their | 25:42 | |
total reserve requirements. | 25:45 | |
They were operating entirely so far as reserves | 25:47 | |
were concerned, with borrowed funds. | 25:49 | |
That's why the Federal Reserve's tightening of credit | 25:51 | |
through raising the discount rate in early 1920 | 25:54 | |
had such a dramatic and drastic effect | 25:59 | |
on the quantity of money and subsequently | 26:02 | |
on the economy. | 26:03 | |
But to go back to the rediscounting case, | 26:05 | |
this episode caused a great deal of concern | 26:07 | |
in the banking community at large and again raised | 26:10 | |
the whole argument about whether you should have | 26:14 | |
a discount rate that was below or above the market rate. | 26:17 | |
One solution that was attempted was a graduated | 26:20 | |
discount rate. | 26:23 | |
One of the banks, I believe it was the Federal Reserve Bank | 26:24 | |
of St. Louis, experimented with the idea | 26:29 | |
of having a certain range of borrowing | 26:31 | |
for member banks which would be at one rate | 26:35 | |
and then a higher range for that bank | 26:36 | |
which would be at a higher rate and so on, | 26:39 | |
up the lot until the final rate would be a penalty rate. | 26:41 | |
But this aroused a great deal of controversy, | 26:45 | |
was not very well liked and so on, and so it was dropped. | 26:50 | |
Although recently the proposals along this line | 26:53 | |
have been revived. | 26:56 | |
The solution that was adopted was then adopting the idea | 26:57 | |
that discounting was a privilege and not a right | 27:02 | |
and the use of qualitative pressure and moral suasion | 27:05 | |
and whatever other fancy term you wanna use | 27:09 | |
for heavy handed guidance, what the Japanese | 27:11 | |
as I said earlier call window guidance of the member banks. | 27:16 | |
And the introduction of this doctrine was employed | 27:21 | |
in order to keep the amount of borrowing | 27:25 | |
by member banks to a lower amount | 27:28 | |
than would in fact have been in their own interest | 27:32 | |
to borrow given the discount rate. | 27:34 | |
Well this was a situation until the 1930s. | 27:36 | |
In the 1930s market rates fell so low | 27:41 | |
that even very low discount rates were penalty rates | 27:45 | |
and discounting almost disappeared. | 27:48 | |
In post World War Two period as market interest rates | 27:51 | |
have risen, rediscounting is again come into the fore, | 27:56 | |
again it became profitable for banks to discount | 27:59 | |
and again the way in which, and the only way | 28:02 | |
in which discounting has been kept down is | 28:04 | |
by the pressure of the Federal Reserve | 28:08 | |
on the member banks. | 28:10 | |
My own belief about discounting is that it is | 28:13 | |
now an anachronistic survival of an earlier period. | 28:17 | |
The initial function it was designed for | 28:21 | |
no longer exists. | 28:23 | |
The reason it no longer exists is because | 28:25 | |
the Federal Deposit Insurance Corporation is in effect | 28:27 | |
prevented a situation in which a failure | 28:30 | |
or a run at one bank caused other banks to fail. | 28:34 | |
There is no longer any need for rediscounting | 28:37 | |
in that initial function. | 28:40 | |
My own solution has always been that we should | 28:42 | |
completely abolish rediscounting. | 28:44 | |
It serves no function and that it would be better | 28:46 | |
if the Federal Reserve exerted all of its influence | 28:50 | |
on money market condition through its open market | 28:52 | |
operations and buying and selling government securities | 28:55 | |
and not through its lending practices. | 28:58 | |
This is a rather long explanation but the question | 29:00 | |
that is asked is a very important | 29:04 | |
and very sophisticated question. | 29:07 | |
- | Thank you very much, Professor Friedman. | 29:09 |
Remember subscribers, if you have any questions | 29:11 | |
or comments for topics you would like | 29:14 | |
to hear discussed in this series, please send them | 29:16 | |
to Instructional Dynamics, Incorporated | 29:19 | |
166 East Superior Street, Chicago, Illinois 60611. | 29:22 | |
Because as we have mentioned, Dr. Friedman | 29:28 | |
will be out of the country for some weeks, | 29:30 | |
we will not be visiting with you again | 29:32 | |
until early October. | 29:34 |
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