Tape 21 - International Financial Picture: Reduction of United States Exchange Controls, Credit Restraint Euro-Dollars / Paul A. Samuelson papers, 1933-2010 and undated / Duke Digital Repository

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Hello, this is William Clark of the Chicago Tribune

0:02

welcoming you again on behalf of Instructional Dynamics

0:05

to another visit with the distinguished economist,

0:09

Professor Milton Friedman of the University of Chicago.

0:11

Dr. Friedman, I see that the Administration

0:15

did announce some easing off

0:17

in controls on foreign investment.

0:19

Does this raise any problems for the dollar?

0:22

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No, I think it raises no problems.

0:24

My concern with it is that it isn't enough.

0:26

Or, I shouldn't say enough,

0:30

it isn't as much as we could have done.

0:31

As you recall, Mr. Nixon, during the campaign,

0:32

promised to eliminate exchange controls,

0:35

restrictions on foreign payments,

0:38

as inconsistent with a free economy.

0:41

And I'm delighted that the Administration has taken

0:44

the first step in that direction.

0:47

Personally, however,

0:49

I believe they could have wiped them completely out.

0:50

Instead, they made a substantial easing.

0:52

So far as investment control was concerned,

0:55

the easing occurs by raising the minimum amount

1:00

that a subject control from something like 200

1:05

or in 50,000 to about a million dollars.

1:07

And this means that several thousand firms that before were,

1:11

had to check with the Commerce Department

1:14

no longer have to do so.

1:16

To that extent it's a very real easy.

1:17

In addition, as you know, they lowered the (mumbles) tax

1:19

and they also eased up on

1:22

the foreign credit granting powers of the banks.

1:24

All of this is to the good.

1:29

And I do hope it will turn out to be but the first

1:32

of a series of steps which will in due course,

1:36

and not such long course,

1:40

finally get rid of this whole mess of undesirable controls.

1:42

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Now this suggest some further comment might be in order

1:46

on the international financial picture, Dr. Friedman.

1:48

I understand that while you were abroad recently,

1:51

you attended a meeting in Switzerland.

1:54

Was it Lugano, Switzerland?

1:56

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That's right.

1:58

A lovely place on the shore of Lake Lugano.

1:59

I highly recommend it to you

2:01

as a place for meetings and vacations.

2:02

(laughing)

2:05

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Sounds beautiful.

2:06

Well, I understand there were a number of academicians

2:07

and international bankers at the meeting

2:09

and I wonder if you would comment

2:12

on what impressions you brought away from it?

2:13

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Well, this meeting is one of a series

2:16

that has been held over recent years

2:19

as a way of trying to get some interchange between

2:21

the academic world of economists

2:24

and the central banking world,

2:26

but it happened to be the first of the series

2:28

I had been able to attend

2:30

and I found it a fascinating meeting.

2:31

And we were able to get from the officials

2:33

of the various countries,

2:36

a fairly good off the record discussion

2:37

of what the situation in each country was.

2:40

And a very extensive and heated discussion

2:43

about alternative methods of resolving

2:45

the general problem of a sounder

2:48

and more efficient international financial system.

2:50

So far as the individual companies,

2:54

countries are concerned,

2:56

the main outlines are those that are reasonably well-known,

2:59

the currency which is accumulating reserves most rampantly,

3:02

which is in that sense strongest

3:08

as it still remains the German mark.

3:09

And the Germans are, of course, very aware of the situation.

3:12

The central bankers from Germany,

3:16

the economic advisors from Germany,

3:19

they were all last fall in favor of a reevaluation

3:21

of the German mark, that is appreciating the German mark

3:25

so that it would be more expensive

3:29

in terms of foreign currencies,

3:31

which would mean to reduce exports from Germany

3:32

and increase imports.

3:35

However, as you recall,

3:37

they did not take this step primarily

3:38

for domestic political reasons.

3:40

The major domestic political reason had to do with something

3:42

that at first sight seems very far removed

3:46

from international currency arrangements,

3:48

namely agricultural price supports.

3:51

But there is an agricultural price support program

3:53

in Europe which is run by the Common Market.

3:56

In which, you know, the Common Market is regarded widely

4:00

as a means of promoting freer trade

4:03

but in many respects it's had

4:05

the opposite effects.

4:07

And one of the worst aspects of it has been

4:08

that it's been introduced into Europe

4:10

on a European wide form,

4:11

the kind of program of agricultural price supports

4:16

that has caused us so much difficulty in this country.

4:18

They're following exactly our past mistakes

4:21

and they're having exactly the same problems.

4:23

Butter is accumulating until it's coming out of their ears

4:26

and other commodities are producing surpluses

4:28

and they're going to go through the same process.

4:31

But at the moment, the situation is that the prices fixed

4:33

for agricultural products are specified

4:38

in the Common Market agreement

4:41

in terms of, essentially, dollars.

4:42

If the Germans were to appreciate their currency,

4:46

this would have the effect of making

4:55

the legal fixed prices lower in terms of marks.

4:56

Because the same number of dollars would be fewer marks,

5:00

and so it would mean that the German farmer

5:02

would be up in arms at the idea

5:08

that the government had lowered his price control.

5:09

And, consequently,

5:12

since an election was coming up this September,

5:13

it was widely felt by the political authorities in Germany

5:15

that they couldn't agree to a appreciation

5:18

of the mark without doing something

5:20

to compensate their farmers

5:21

and that seemed to be difficult to do within

5:23

the terms of a common agreement.

5:25

And that was probably the major political consideration

5:27

that led the Germans last fall,

5:30

instead of appreciating the mark directly,

5:32

to do so indirectly by changes

5:35

in import taxes and export subsidies.

5:38

But none of this seems to have stopped

5:41

the enormous in-flow of marks,

5:42

the German mark position continues to accumulate,

5:45

I mean the Foreign Exchange Position,

5:50

the extent of foreign exchange that Germans are getting,

5:52

and as a result the pressure is there

5:55

and as a result I think you can predict

5:57

with a high degree of confidence

5:58

that some time within the next six months,

6:00

maybe either just before the election

6:02

or just after the election,

6:05

the price of the German mark,

6:06

in terms of the U.S. dollar, will be raised.

6:08

It's hard to see that there can be any other possibility,

6:10

any other outcome.

6:13

The only other possibility would be if

6:14

the Germans were willing to inflate very rapidly internally

6:16

in order to make the mark less valuable.

6:19

I find it inconceivable

6:22

that they would be willing to do that.

6:23

The Germans have had ever since

6:25

the hyperinflation of World War I, which occurred maybe,

6:27

it occurred 50 years ago

6:31

but it's still a very strong influence.

6:33

And the post-World War II inflation is another.

6:36

Ever since that the German people are very, very unwilling

6:39

to experience inflation

6:42

and it's been a very unpopular course.

6:44

And as a consequence,

6:46

I don't believe the Germans will do that.

6:47

Therefore, as I say,

6:49

I think German appreciation is inevitable.

6:50

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Well, is this one of the impressions

6:53

that you carried away from that meeting, Dr.?

6:54

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Yes, indeed.

6:56

I don't mean to say that anybody there said this.

6:57

You know, the officials are very careful

7:00

and nobody is going to say anything like that

7:01

but I myself would think the odds are five to one.

7:03

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I see.

7:07

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Sometime within the next six to nine months

7:08

you're going to see an appreciation in the German mark.

7:10

Now the French franc is a much more complicated situation.

7:13

It was, as you know, scheduled to be devalued.

7:16

Everybody thought it was going to be devalued.

7:19

All of the officials in the French government thought

7:21

it was going to be devalued,

7:24

but then General de Gaulle stepped in and decided otherwise.

7:25

I'm not sure he was entirely wrong,

7:28

but as of the moment it's not clear whether

7:30

that decision will, in fact, stick.

7:33

The French franc has experienced some improvement recently.

7:36

Prices within France, that's the critical question

7:41

of how well they were going to be able

7:44

to control internal French prices in face

7:45

of the large labor unrest that they had a year ago.

7:47

The prices in France have been surprisingly slow to rise.

7:50

They haven't risen much,

7:54

only about 2 to 3% in the past year,

7:55

which is low by French standards.

7:57

Productivity has gone up very sharply

8:00

and they have been able to absorb a large fraction

8:02

of the price increase, the wage increase, in productivity.

8:04

Right now there are uncertainties around it

8:07

but as of the moment,

8:10

the French situation is still very much of a gamble.

8:12

There's no certainty at all that the devaluation will,

8:15

in fact, occur, but neither is any certainty

8:18

that it'll be able to be avoided.

8:21

I would say that's a great big question mark

8:22

and part of it may depend on whether

8:24

there's a general reshuffling.

8:26

The other weak currency of Europe is the pound sterling.

8:29

And there is no sign in the picture

8:33

that that has gotten very much stronger.

8:34

So you have both the franc

8:37

and the pound sterling which are still weak,

8:38

they're still questionable.

8:40

It's not possible to exclude

8:41

that there will be another devaluation

8:43

of the pound sterling sometime in the next six months or so.

8:45

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This is a possibility?

8:48

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This is a possibility.

8:48

But again, it's by no means a certainty.

8:49

These are things.

8:51

There's no doubt that the earlier devaluation

8:52

of the pound sterling did have favorable effects

8:55

on the British Balance of Payments.

8:58

It did have an effect of reducing imports,

9:00

increasing exports.

9:02

The question is whether it's had enough of an effect,

9:04

whether the internal inflation that domestic politics seem

9:06

to be forcing on the British government

9:10

will be so large as to wipe it out.

9:12

If the British do change,

9:15

if they do get it a real difficulty,

9:17

I think it's very unlikely that they will again devalue.

9:19

I think what they will do this time is to float the pound,

9:22

to let it be a free market rate.

9:25

That's what they should have done before.

9:26

But you know, government always has a difficulty

9:28

in doing the same thing over and over again.

9:30

I'd like to do something new

9:32

and I kind of suspect this is what it would do new.

9:33

The other really strong currency

9:36

in Europe is the Italian Lira.

9:37

Of course, I'm leaving out of the account

9:40

the Swiss franc which is a special place.

9:41

It's a highly strong currency.

9:43

It's had an enormous strength by it

9:45

because Switzerland is a favored place for capitol

9:49

to come into and people to hold funds in a way which is free

9:52

of control and secret accounts,

9:56

which are no information is given, high interest rates.

9:59

It's a very attractive place for funds.

10:02

And they've also been having a very,

10:04

very cautious economic policy

10:06

with relatively little inflation.

10:08

So that Switzerland is, of course, strong.

10:11

But the Lira is another strong currency in Europe.

10:14

It has been very, at a very favorable value,

10:17

a very good balance of payments.

10:23

I say good and favorable.

10:24

This is the usual terminology whereby imports are bad

10:25

and exports are good,

10:29

which is the opposite of the economic case.

10:30

But from the financial point of view,

10:34

the Italian Lira seems to be in the strong position.

10:36

The only problem with it seems to be that the people

10:39

in Italy have apparently found holding funds outside

10:44

of Italy very much more attractive

10:47

than holding them in Italy.

10:49

So there's been a substantial surplus on the current account

10:50

which has been balanced by an outflow of capitol

10:53

on the out-flow funds on the capitol account.

10:55

And, apparently, the Bank of England is going to try

10:58

to get some of those funds transferred,

11:01

from the Bank of Italy, I meant,

11:04

from abroad back to Italy.

11:06

And this may involve a drain on the Eurodollar market

11:08

because one of the forms in which the Italians

11:11

have been holding their funds

11:14

has been it's deposits at the Eurodollar Banks.

11:15

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I see.

11:17

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Well, that roughly is a survey of the main countries.

11:18

And the general prognosis overall is that,

11:21

I think you can be pretty sure that the rates of exchange

11:26

of European currencies a year from now

11:31

will not be the same as they are today.

11:34

That's for sure, I think.

11:35

Of that, the surest is that

11:38

the German mark will be appreciated.

11:39

The next most likely is that

11:42

the French franc will be depreciated.

11:43

And the next most likely that the British pound will be.

11:46

That's sort of about the situation.

11:48

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Well, Dr. Friedman, coming back to our dollar now,

11:50

what does all this mean as far as the likelihood of a,

11:53

say, a run on the dollar is concerned?

11:56

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Well, I don't believe

11:59

there's any possibility of a run on the dollar.

12:00

I think that, in my own opinion,

12:01

and this was confirmed by my impressions,

12:03

the impressions gained at the European meeting,

12:08

also the impressions gained at an earlier meeting

12:10

in this country and Oyster Bay with some of the same people

12:12

but mostly with commercial bankers from other countries,

12:15

my feeling can be summarized as follows.

12:18

The one thing the U.S. doesn't have to worry about

12:20

is it's balance of payments,

12:22

despite all the talk to the country.

12:24

Now, why not?

12:25

The reason it doesn't is

12:27

because the world is today on a dollar standard.

12:28

That's a fact.

12:31

Nobody will say it, nobody likes to pronounce it.

12:32

But the fact is that the only currency in the world,

12:35

which is sufficiently widely held,

12:39

which is sufficiently widely used in international payments,

12:41

to be an international standard, is the dollar.

12:44

A great bulk of all international transactions

12:47

are denominated in dollars, a very large fraction of them.

12:49

The Eurodollar market in Europe is an example of a way

12:53

in which people are using the dollar as a currency,

12:55

even though the transactions

12:59

may involve no Americans at all.

13:01

That is to say, if Argentina makes a deal with Germany,

13:03

it's very likely that that deal will be stated in dollars,

13:08

settled and paid for by dollars,

13:11

even though the dollar is the currency

13:12

of neither Argentina nor Germany.

13:14

So the world is on a dollar standard

13:16

and given that we follow any kind of sensible monetary

13:18

and fiscal policies in this country, that is,

13:20

given that we avoid in this country substantial inflation,

13:23

the world's going to remain on a dollar standard.

13:26

Now, the next question is, does everybody admit that?

13:28

The answer is no.

13:33

Why not?

13:34

And this where the problem of whether

13:36

there's gonna be a run on the dollar comes in.

13:38

It's for political purposes.

13:39

The European Central Banks know perfectly well

13:42

that they're on a dollar standard, effectively.

13:45

But they don't want to say that to their people.

13:48

De Gaulle wouldn't like to announce that publicly.

13:49

The German public would not like to think

13:52

that Germany is on a dollar standard.

13:53

Italians.

13:56

And so the central bankers much prefer

13:57

to say we're on a gold standard.

13:59

Well, so that brings us back to this question

14:01

of how can you have a run on the dollar?

14:04

And let me see if I can tie this into it.

14:05

You might say, well, you can have a run on dollars

14:08

by people trying to convert from dollars into gold.

14:10

Well, how can they do that?

14:15

They can buy gold in London.

14:16

That can drive up the price of gold in London.

14:17

And the price of gold in London has, of course,

14:19

been rising as it's going to keep on rising.

14:21

But that only transfers dollars from one person to another.

14:23

And so that's not a run on the dollars,

14:27

it just means that the person who buys

14:28

the gold transfers his dollars

14:30

to the person who sells the gold.

14:32

How else can people try to get out of dollars?

14:34

Well, people can convert from dollars into marks

14:37

or into pound sterling and to francs,

14:39

but in the present set-up that means

14:42

that they sell the dollars to the Central Banks,

14:45

the German Central Bank, or the Italian Central Bank,

14:47

or the Bank of England gets the dollars.

14:50

Alright, well, then you might say,

14:52

but we have an agreement with all of these banks

14:53

and we will sell them gold at $35 an ounce.

14:55

Can't we have trouble in a run-on gold

14:58

because the Germans decided they have too many dollars

15:00

and they come to us with the dollars

15:02

and say give us gold at $35.

15:03

And you'll say to me, isn't that especially tempting when

15:06

the market price is $43 or $44.

15:08

The answer is yes, but there's a catch to it.

15:11

The Germans, the Italians, the French,

15:14

the English know very well that if they were to come

15:17

and ask us for a small amount of dollars,

15:20

if they come and ask for 20,

15:23

50 million dollars worth of gold, we'll give it to them.

15:24

We just gave Italy recently $200 million.

15:27

But suppose they came and asked for a billion

15:29

or two billion dollars worth of gold.

15:31

They know, as well as anybody does,

15:33

that the mostly likely outcome is

15:36

that the Treasury would say, sorry boys.

15:37

Or really they would do it more diplomatic.

15:40

And what the Treasury would say is,

15:42

are you sure you want that much gold?

15:44

Can you make a strong case in terms

15:48

of your monetary needs for that much gold?

15:50

Don't you want to go home and think it over again?

15:52

And if they, nonetheless,

15:54

insisted the chances are very high we would say, sorry,

15:56

we are required to give you gold only for monetary purposes.

15:59

We have come to the finding

16:02

that your request is not for monetary purposes.

16:04

Sorry, no go.

16:06

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I see.

16:07

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Now that would no us no harm.

16:07

It wouldn't make a bit of difference to us

16:09

but from the point of view from the European Central Banks

16:10

it would strip away the cloak

16:13

that now protects them from the political pressure

16:15

that would arise if they were

16:19

to announce they were on a dollar standard.

16:20

I mean, let's suppose that happened.

16:22

Let's suppose we close down the window.

16:24

Then what would they do with their dollars?

16:26

Well, they would have the choice then either

16:29

of just hanging on to the dollars

16:31

or of changing their own exchange rates.

16:33

We don't have to do anything.

16:35

There's nothing we have to do.

16:36

But they would have the choice if the wanted to

16:38

of appreciating or floating their currencies

16:41

or trying to go on a different kind of a gold standard.

16:43

From the point of view of the Central Bankers,

16:46

not from the point of view of what I think

16:48

is desirable for them, but from their point of view,

16:49

what most of them would prefer to do would be

16:52

to peg their currencies to the dollar it that circumstances.

16:55

Go and worn in there as a cloak,

16:58

they would be likely, nonetheless,

17:00

to try to keep their currencies linked to the dollar

17:02

the way the Canadian dollar is linked to the U.S. dollar now

17:04

without having to do much with gold.

17:06

And consequently,

17:10

the only people who would be hurt in this scenario,

17:12

by our closing the window,

17:15

would be the European Central Banks.

17:17

Well, they're not about to do that.

17:18

And therefore, I think there's almost no chance

17:20

that they are going to try to pull the plug.

17:23

They can pull at any time but that's up to them.

17:25

And consequently, as I say,

17:28

I think one thing we don't really have to worry about

17:30

is the balance of payments problem.

17:33

That's a problem for Germany.

17:34

It's a problem for France.

17:35

It's a problem for Britain.

17:37

But so long as we can maintain a situation in which

17:38

the dollar is the dominant international currency,

17:41

we don't have to worry about it.

17:44

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Well, that's very interesting.

17:46

I had never thought of that way in which the Treasury could,

17:47

in effect, refuse a request for gold without (mumbles).

17:51

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Well, there are two different sets

17:56

of laws involved in this.

17:59

And the legal situation is a little complicated.

18:00

There are the IMF rules and then there's the U.S.,

18:02

the law, the U.S. law.

18:04

And so far, as the U.S. law is concerned, and I think also,

18:06

though here I'm a little less certain, the IMF,

18:10

we are required to give gold

18:12

for $35 an ounce only for monetary purposes.

18:14

-

I see.

18:17

-

That's why you see we're not required

18:18

to sell to private people.

18:19

-

Yes.

18:20

-

We only sell it to foreign central banks

18:21

in foreign governments.

18:23

Now, obviously there are many people that will argue

18:25

that there will be leakages out of the two-tiered system

18:28

by central banks getting gold

18:31

and reselling it on the market.

18:33

And there's some possibility and temptation for that.

18:34

But I think that's very small

18:37

because it's not hard to check on whether central banks

18:38

are selling gold on the private market.

18:43

And the amount of gains to be made this way are too small

18:45

for any significant country,

18:48

in any significant way, to want to make itself

18:51

a black sheep in the eyes of the American government.

18:54

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I see.

18:57

Dr. Friedman, coming back to a little closer to home again,

18:59

very recently the Federal Reserve turned the screws

19:02

a little bit tighter on credit

19:05

by raising the discount rate

19:08

and raising a reserve requirements.

19:09

Is this going to have a major effect

19:13

on the banks of our country?

19:14

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I don't believe so.

19:16

This is a continuation of the policy

19:17

which the Fed has been following.

19:19

As I emphasized in last week's tape,

19:21

I believe that we are definitely

19:25

and clearly embarked on a program of monetary re-strength.

19:27

We'll keep on that program and indeed

19:30

that there is some danger we'll go too far.

19:33

At the moment I think it's somewhat too far.

19:37

But I don't believe that

19:39

this particular turn in the screw changes things much.

19:40

Separate out the two measures.

19:43

So far, as the discount rate is concerned,

19:44

the discount rate was way out of line with the market rate.

19:47

It was far below the rate on Treasury bills.

19:50

It was below the short term rate

19:53

on commercial bill, paper, and so on.

19:55

But that's not a very sensible situation.

19:57

It means that restraints on borrowing have to be holding

20:01

in terms of the qualitative control

20:05

of the Feds being nasty to people who come in to borrow.

20:07

It makes much more sense

20:14

if there is going to be a discount rate,

20:15

for the discount rate to be in touch with the market.

20:17

The rise in the discount rate, therefore,

20:20

is a case of the Fed catching up with the market,

20:22

not of the Fed influencing the market.

20:24

And the higher rate is one

20:26

that's still below the market rate.

20:27

So I think this is purely a sort of a housekeeping thing.

20:30

Much more significant is the rise in the reserve requirement

20:33

which freezes about $600 million of reserve funds.

20:37

That's not a major amount given the magnitude

20:41

on which our banking system is operating,

20:45

but it's a substantial amount.

20:46

However, as it so often happened in the past,

20:48

the immediate effect of this on the market

20:51

will undoubtedly be offset by the Fed

20:53

through open market purchases.

20:55

That is to say, the main effect of this is that

20:58

the banks convert, as it were, $600 million dollars.

21:01

The simplest way to think of it is,

21:05

let's suppose the banks take $600 million

21:06

in government bonds and sell them to the Fed.

21:07

Then the banks in every respect is in the same position

21:11

as they were before,

21:14

except that they have lost the interest

21:15

on that $600 million of government bonds.

21:16

Well, to a first approximation that's what's happening

21:18

because what the Fed always does

21:21

when it makes these reserve requirement changes is that

21:23

in the first instance,

21:25

because otherwise it would be too sharp an impact,

21:27

in the first instance it offsets these effects by going into

21:30

the market and buying a roughly corresponding

21:34

amount of government bonds.

21:36

And that provides the reserves to meet

21:37

the higher reserve requirements without requiring

21:39

a reduction in total deposits and the like.

21:42

And that's undoubtedly what's happening this time.

21:47

Now, it does lay the groundwork

21:50

for bringing more gradual pressure later on

21:52

because the Fed may buy these $600 million now

21:56

and then gradually over coming weeks sell them off again.

22:00

In order to convert this one shot effect into

22:03

a gradual restraining effect

22:06

and that's what I think we're going to see happen.

22:07

But they could have done

22:09

that without raising the reserve requirement

22:10

The reason why they raise reserve requirement instead

22:12

of simply proceeding on the basis

22:15

of the purchases in the open market,

22:18

really had little to do with aggregate restraint,

22:21

and had more to do with the Feds opinion

22:26

about the distribution of that restraint.

22:29

Let me see if I can explain that a little more.

22:31

The people at the Fed felt, in a way, erroneously, I think,

22:33

that the run off of CDs,

22:38

which in their opinion was bringing pressure on the market,

22:41

was being imposed almost entirely

22:44

on the large money market banks,

22:46

the banks in New York, Chicago.

22:49

The banks that have the major about of CDs.

22:51

And they were of the opinion that it was desirable

22:56

to spread the pressure over banks all over the country

22:59

rather than have it concentrated in these two cities

23:02

and then spread out over the country.

23:04

By a change in the reserve requirement, they took a measure,

23:06

which affects banks all over the country at the same time.

23:09

And I believe that that was the main motive for their action

23:13

rather than fundamentally any further turn of the screw.

23:15

A subsidiary motive, I think, was,

23:20

I think the Fed has been a little annoyed at the fact

23:22

that people don't seem to be taking it seriously.

23:26

That they are not crediting the degree of restraint.

23:28

I think part of this was to do something dramatic,

23:34

which would make people take them seriously.

23:36

-

I see.

23:39

-

But so far it's only economic effect is concerned,

23:40

I think that does depend entirely on whether

23:43

the Fed continues to hold down the rate of growth

23:45

of the monetary magnitudes at about

23:48

the same rate they've been holding it down before.

23:50

-

Dr. Friedman, you mentioned the Eurodollars awhile back

23:53

and this business of the banks seeking ways

23:56

to ease their position,

23:59

suggest the subject of Eurodollars again

24:02

because the papers are so full of stories about how

24:04

the banks draw on Eurodollars for this purpose.

24:07

Is that a fair picture?

24:10

-

This is what the papers say

24:12

but it's not a fair picture of what they do.

24:14

The problem is that people,

24:17

including banks and including papers,

24:20

always have difficulty in understanding

24:22

a fractional reserve banking system.

24:24

The difference between what happens for the individual bank

24:28

and what happens for the system as a whole.

24:31

And one of the things, for example,

24:34

and this we'll come back in this

24:36

if people find it hard to understand,

24:37

is how it is that if the banks get

24:39

an extra dollar in currency,

24:41

let's say you take a dollar into currency into a bank,

24:42

the economist will immediately say,

24:46

well, that means that the banks

24:47

as a whole can expand deposits by three or four dollars.

24:49

And no banker really believes that.

24:53

And the individual bank can't of course do so.

24:55

If by the bank whom you deposited

24:58

that dollar can only lend out a dollar or a little less

25:00

than the dollar 'cause it has to keep reserves.

25:02

However, when it lends it out the person who borrows it

25:04

redeposits the funds in another bank

25:07

and the second bank is now making an additional loan.

25:09

And as a result the effect on the banking system

25:12

as a whole is very different than on the individual bank.

25:14

Well, that's part of what happens in the Eurodollar market.

25:17

One bank, the National City Bank, might say,

25:22

I'm gonna borrow in the Eurodollar market.

25:26

I'm gonna borrow a million dollars in Europe, in London.

25:29

Let me for a moment say

25:33

that this is not what's really going on,

25:34

but if you read the papers,

25:38

this is what you would think was going on.

25:39

So let me take that gate.

25:40

So let's suppose I borrow it from Lloyd's of London,

25:42

not an American branch,

25:44

not from a branch of Chase Manhattan

25:45

but from Lloyd's in London.

25:48

How does Lloyd's in London pay for that?

25:49

How do they transfer a million dollars to Chase Manhattan?

25:51

Or First National, I guess I started with, First National.

25:54

Well, Lloyd's of London,

25:57

the simplest way would be that it has some deposit at,

25:58

let's say, Chase Manhattan.

26:01

So it writes a check on Chase Manhattan,

26:02

which it gives to First National,

26:05

which First National deposits.

26:07

The results of that is that the deposits

26:09

at Chase Manhattan go down by a million,

26:12

the deposits at First National go up by a million.

26:14

Neither one gets any reserves.

26:16

There's been no change in the situation at all.

26:18

All there has been is a transfer of deposits

26:20

from one bank to the other.

26:22

So borrowing the Eurodollar market does not provide banks

26:24

in the United States with any additionary reserves.

26:27

Unless, somehow or other, what the borrowing is paid for,

26:32

by a check on the reserve bank.

26:38

The one way that could happen is if Lloyd's of London,

26:41

in order to get the million dollars,

26:44

didn't have enough on deposit in New York

26:45

and so it took pound sterling,

26:47

went to the Bank of England

26:49

and acquired from the Bank of England

26:50

a claim to U.S. dollars,

26:52

which the Bank of England was holding

26:54

in the form of a deposit at the Federal Reserve Bank.

26:56

In that case, there would be an increase

26:59

in the real reserves of the American banking system

27:01

through this transfer of a federal reserve deposit,

27:04

of high powered money, as opposed to simple deposit.

27:07

But even in that case it's likely that wouldn't happen

27:10

because the Bank of England

27:12

doesn't really hold most of it's dollars

27:14

in the form of deposits at the Federal Reserve.

27:16

It holds them in the form of Treasury bills

27:18

or in the form of bonds.

27:21

And so what the Bank of England would do would be to sell

27:22

a Treasury bill in New York,

27:24

which would mean that it would maybe be bought by Chase,

27:26

to take the same example.

27:29

And again, it would just simply be a deposits,

27:31

a transfer and deposit.

27:33

Well, then the mystery is how does

27:35

the Eurodollar market help at all?

27:36

Well, the answer is, and it's an altogether different thing

27:38

than we've now been talking about.

27:41

It helps mostly as a kind of a bookkeeping arrangement

27:42

rather than as a real transfer of funds.

27:45

And let me see if I can illustrate that.

27:48

Let's suppose for a moment that,

27:50

unfortunately this isn't true,

27:53

but let's suppose for moment that you had a CD

27:54

on First National Bank of a million dollars.

27:57

As I say, it's too bad it isn't true.

28:00

-

(mumbles) I suppose.

28:02

-

But let's suppose you did.

28:03

And you're not satisfied with the interest rate

28:05

which the First National Bank is paying you.

28:07

And so you come to the First National Bank and say,

28:10

I would like to withdraw that CD,

28:13

I'd like to be paid off.

28:17

First National Bank says, now, hold on for a moment.

28:18

We're not going to pay you.

28:23

Let me suggest to you a better deal.

28:25

Instead of my paying you off,

28:27

why don't you take a Certificate of Deposit

28:29

on our London branch, in London, of a million dollars

28:32

and instead of paying you 6% on that,

28:36

we'll pay you 8% on that.

28:38

And you say fine, okay.

28:40

Now what's happened?

28:42

So far, as the combined operations as the bank is concerned,

28:43

it's in the same position.

28:47

It owes exactly as much money as it did before,

28:48

only now that's recorded on the books of it's London banks,

28:50

a million dollars more on it,

28:53

New York bank a million dollars less.

28:55

Both the deposit certificate in it's London bank

28:57

requires no reserve requirements in the U.S.

29:00

The deposit certificate in New York does.

29:03

And therefore,

29:05

by inducing people to hold Eurodollar liabilities

29:06

instead of New York dollar liabilities,

29:10

the banking system can conserve it's reserves.

29:12

And in this way can partly meet the crunch.

29:16

And that's the main function

29:18

which the Eurodollar system has been playing and enabling

29:20

the American banks to escape some of the squeeze.

29:25

-

Thank you very much Dr. Friedman.

29:29

If you would like to suggest questions

29:31

that Dr. Friedman might respond to on future tapes,

29:34

or suggest subjects that he might discuss,

29:37

I hope you will do so by writing to Instructional Dynamics,

29:40

that's Instructional Dynamics,

29:44

166 East Superior Street,

29:46

Chicago 60611.

29:49

This is William Clark.

29:53

We'll be visiting again with Dr. Friedman

29:54

of the University of Chicago next week.

29:57

Tape 21 - International Financial Picture: Reduction of United States Exchange Controls, Credit Restraint Euro-Dollars

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