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nificantly because of the capital losses which develop on their portfolios. In some instances, investment managers are undoubtedly reluctant to show realized losses to their boards of directors; in other cases, the fear of even greater losses from a declining market may cause more liquidation. Under existing bank examination procedure, high-grade securities may be carried at cost even if the market price is lower, and this may lead to holding when losses begin to develop.

Different investor classes may react quite differently to the question of capital losses and to the question of whether they should be realized by the sale of the securities involved. Commercial banks may not be as vulnerable to such losses since they hold largely short-term securities which are more stable than long-term issues. Institutional investors other than banks may be much more afraid of capital losses since they hold largely long-term issues which are subject to much wider price swings than short-term issues as interest rates change.

It may be noted that the influence of losses goes beyond the mere dollar changes involved. The development of capital losses destroys some of the liquidity of the whole portfolio of an investor. On the other hand, an emerging capital gain due to interest rate declines would tend to add liquidity and strength to a whole portfolio. 6. Expectations of Changes in Interest Rates

The answer to Question 26 covers in part the question of the extent to which expectations with respect to interest rates influence the demand for Government securities by nonbank investors. Much of the discussion in that answer is relevant here.

The influence of anticipated further changes in interest rates is more significant in the long-term than in the short-term capital markets. Short-term borrowers and lenders both have little to gain by waiting. Long-term borrowers may delay borrowing if they expect lower rates or may hasten or anticipate future needs if they expect higher rates. Long-term investors or lenders may adjust the average maturities of their portfolios depending on their forecast of future rates, i. e., shortening their maturities when they expect higher rates and lengthening them when they expect lower rates.

The difficulty is that widespread expectations of changes in rates under certain circumstances may have little or no effect on the decisions of important investor groups; or they may have too much effect and may cause repercussions which go far beyond the sectors of the economy which the initial credit restraint was intended to reach. Furthermore, once anticipations of changes in one direction have been established, it may be very difficult to reverse such anticipations and to offset unwanted results.

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In conclusion, I should like to stress again that this question is a very complex one and it is difficult to generalize as to how the credit mechanism would work and what the probable results would be under certain assumptions. Some of the other questions have an important bearing on this subject and I have referred to them in this answer. It is particularly important to refer to the answers to Questions 30 and 31 for a discussion of how changing conditions have altered the appropriateness and efficiency of traditional Federal Reserve methods of credit control; to Questions 35-36 and 39 for a discussion of proposed methods to tighten bank reserves to restore greater control to

the Federal Reserve; to Questions 23-25 for a discussion of general credit tightening, selective credit controls and direct physical controls as methods of coping with inflationary pressures; to Question 27 for a discussion of the advantages and disadvantages of a stable longterm Government bond market; to Questions 28 and 29 for a discussion of Treasury actions and views regarding interest rates; and, finally, to Questions 17 and 18 for a discussion of policy agreements and disagreements with the Federal Reserve in recent years and the nature of the accord reached by the two agencies in March 1951.

23. Evaluate the effectiveness of a general tightening of credit (and the consequent increase in interest rates) in restraining inflation as compared with other factors (a) when the principal threat of inflation comes from an increase in private business activity; (b) when the principal threat of inflation comes from increased expenditures by the Federal Government.

Questions 23, 24 and 25 are all concerned with the effectiveness of credit controls and should, therefore, be read together. Question 23 is concerned with the effectiveness of a general tightening of credit, Question 24 is concerned with the relative merits of selective credit controls versus general credit restraint, and Question 25 is concerned with how credit controls are affected in the present situation by the use of direct physical controls.

When a general tightening of credit is effective, it operates in the first instance to curb loan expansion. It is this immediate effect which will be given principal consideration here, although it is recognized that general credit controls also may have secondary_repercussions through an effect on the liquidity position of investors. It is difficult to evaluate, with any precision, the effectiveness of a general tightening of credit. (See discussion in the answer to Question 22.) Inflation probably can, in principle, be prevented or halted by stringent enough general credit restraint. There is always the danger, however, that measures may turn out to be too severe and may, therefore, have adverse repercussions upon the economy. I might add-as is noted in the answers to Questions 30 and 31-that the use of general credit restraint has been restricted over the years by the growth of the Federal debt and by other significant changes occurring in the economy. In the present answer I am, of course, allowing for these factors.

1. "When the principal threat of inflation comes from an increase in private business activity"

The comparative effectiveness of general credit tightening in curbing an inflationary threat generated by private business activity depends largely upon the other control measures which are undertaken at the same time. In the absence of a defense or war emergency, direct controls over prices, wages, and materials are generally considered to be incompatible with our system of private enterprise. It would be more appropriate to rely on a combination of fiscal and monetary measures. On the fiscal side, this would include adequate taxation, proper debt management, a national savings campaign including savings bonds, and the elimination of all nonessential Government expenditures. On the monetary side, general and selective credit controls, plus the direction of other Government policies, so far as possible, to anti-inflationary ends, would be appropriate.

The following considerations may be noted in reference to general credit tightening in a situation in which the principal inflationary pressures come from an increase in private business activity:

(a) General credit control in an inflationary period has as its main goal the placing of over-all restraints on further rises in credit and the money supply-thereby limiting the expansion of total spending. In boom conditions this may mean a direct attack on capital outlays-frequently one of the main causes of booms.

(b) If the chief inflationary impulse comes predominantly from special sectors of the economy-such as speculation in commodities or securities, construction, or consumer credit-an attempt to reach these sectors by means of severe general credit tightening may work undue hardships on the rest of the economy without, perhaps, achieving its aim. Selective credit controls would be more effective in attacking individual areas of inflation, although on some occasions there may be some advantage in supporting them with a cautious use of general credit measures.

(c) General credit restraint presents certain advantages of easy maneuverability, which serve to complement effective Federal Government budget policy as an anti-inflationary weapon. Budget policy is not always easy to change; past experience has shown that our legislative process does not allow changes to be brought to bear quickly nor recalled soon. There are, nevertheless, certain automatic responses to any given structure of tax rates which may have important anti-inflationary effects in a period of rising income. A combination of effective budget policy, efforts to increase savings, proper debt management, and general and selective credit controls provide more flexibility and strength than reliance on general credit restrictions alone.

(d) The prospect that in a business boom the Treasury may have a budget surplus suggests that under such conditions there may be obstacles to increasing taxes further. This may make it necessary to rely more heavily upon general and selective credit controls.

(e) A certain amount of general credit restraint in a boom period will help to work against the undermining of the anti-inflationary effects of effective budget policy and of selective credit controls. If the economy has too much money or too much liquidity, an anti-inflationary budget policy might be offset by the ability of many taxpayers to borrow or to draw on liquid assets. Likewise, the effectiveness of selective controls, like Regulation X on real estate and Regulation W on consumer credit, would be cut down if it were made easy to raise money to circumvent these restraints.

(f) General credit tightening must be used with caution and restraint when there is a large public debt, and particularly when there is a larger volume of early maturities. (For further discussion, see the answer to Question 30.)

(g) The considerations which have been discussed above make it clear that general credit restraint is not an "either-or" proposition. In one sense it represents one of the weights that can be used to hold down the balloon of inflation-or to keep it from rising in the first place. It will seldom be a big enough weight to do the job by itself, and it involves certain problems if we try to rely too heavily on it. The important thing is to achieve a coordinated anti-inflationary program which is reasonably balanced in its impact on the whole economy.

2. "When the principal threat of inflation comes from increased expenditures by the Federal Government"

a

It may be assumed that the expenditures under this alternative are largely for military purposes, and the Government, under such conditions, may be running à deficit. Depending upon the magnitude of the financing problem, credit policy would have to be conducted increasingly with this in mind. Direct controls over prices, wages, materials, and consumption would probably be put into play to support the Government's call on productive resources. Under such condi-tions, the following may be said about general credit restraint:

(a) To obtain a maximum of output in these circumstances, particular areas of the economy need special consideration. Our production goals during the present defense period, for example, are probably achieved better with selective controls than with extensive use of general credit tightening, which might restrict essential defense loans along with nonessential lending. At present, efforts are made through V-loans and other devices to provide credit for firms engaged in defense production when they cannot get credit through ordinary channels. Further efforts are being made through the Voluntary Credit Restraint Program to assure that credit restraint does not interfere with the flow of credit to defense firms. If banks were kept so tight that they rejected a good part of all additional loan requests, there is a possibility that they would first take care of old customers, regardless of whether their work was essential or not, and reject many applications of newcomers, some of whom might be expanding defense firms. In some cases, potential defense contractors would be discouraged in their plans. In other cases, the demands made upon the Government for loan assistance would increase. This would create a prospect of otherwise unnecessary intervention by the Government in the credit machinery of the country.

(b) General credit controls certainly must not be used in such a way as to impede the financing of an all-out war.

(c) However, some cautious use of general credit restraint may be possible and desirable in order to reduce the strains placed on other control measures during a war or defense emergency.

(d) Some degree of general credit tightness may be needed in a defense or war economy to keep interest rates from becoming so distorted by the abnormal investment situation as to create serious problems for certain investor groups (such as nonbank financial institutions) which had adjusted their operations to an earlier level of rates. 24. Discuss the appropriate role of general credit controls and of selective credit controls under each of the hypotheses mentioned in the preceding question. What selective controls do you consider appropriate under present circumstances?

Before discussing the appropriate role of general and of selective. credit controls under each of the hypotheses mentioned in Question 23, I should like to summarize briefly what I feel to be the general advantages and disadvantages of these two methods. During most of the period since the close of World War II inflationary tendencies have been present, and I shall therefore direct the discussion mainly to measures undertaken in order to promote credit restraint rather than credit ease. As noted in the answer to Question 22 general credit restraint

is a fairly broad instrument that is designed to hold down the over-all volume of bank loans and the money supply. In earlier years the Federal Reserve used changes in the discount rate as the principal weapon of general credit restraint. Such restraint is achieved at the present time mainly through actions to influence bank reserves by (a) open-market sales by the Federal Reserve System and (b) increases in reserve requirements of member banks. While the first of these methods provides considerable flexibility to the Federal Reserve, selective credit controls have been developed over the past two decades to permit desired actions in particular areas. Three types of selective credit controls are now used by the Federal Reserve: namely, Regulations T and U over stock market credit, Regulation W over instalment credit, and Regulation X over real estate credit. The Voluntary Credit Restraint Program also constitutes a kind of selective control.

Selective controls in combination with general credit restriction have a further advantage over general credit control measures alone by directly covering credit extended by nonbank lenders as well as banks. Thus Regulation W covers all instalment sales whether credit is granted to the buyer by a storekeeper, a bank, or other financial institution. Regulations T and U cover all stock market credit, and Regulation X covers all defined real estate credit whether or not extended by a bank. The principle of broad coverage of all types of lending institutions is important in view of the changes in the economic environment which are discussed in the answers to Questions 30 and 31. Also, as is noted particularly in the answer to Question 30, the growth of the public debt has made it somewhat less practicable to rely on general credit controls alone.

Selective credit controls, however, have certain disadvantages. They involve administrative difficulties and are subject to a certain amount of evasion. If used to block spending in certain areas, the result may be to increase to some degree spending pressure in other

areas.

Furthermore, it may be argued that selective credit controls, which are limited to certain types of goods, are in a sense discriminatory in the manner of an excise tax, or involve effects similar to rationing. Consequently, there is often a demand to relax them at the very time when they may be most needed. Finally, the question has been raised whether selective controls are socially equitable in their effect on various income groups.

The programs of Government guarantee of residential mortgage credit and related programs may be thought of as a type of selected credit "control" in reverse. Under inflationary conditions programs of this sort should be re-aligned in harmony with general antiinflationary goals. Only special cases should be exempted. At present, the extraordinary needs for housing in defense areas merit generous credit insurance and guarantee terms, where these are needed to stimulate necessary construction. But other insurance and guarantee programs need to be restrained so as to reinforce the objectives of Regulation X.

This summary of the general advantages and disadvantages of the two types of credit control mentioned in the question gives some background for the discussion of the use of such measures under various circumstances. I will now turn to a brief résumé of the

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