Towards Improving the Efficiency of the Monetary Mechanism

Towards Improving the Efficiency of the Monetary MechanismAuthor(s): James TobinSource: The Review of Economics and Statistics, Vol. 42, No. 3 (Aug., 1960), pp. 276-279Published by: The MIT PressStable URL: http://www.jstor.org/stable/1926374 .

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276 THE REVIEW OF ECONOMICS AND STATISTICS 276 THE REVIEW OF ECONOMICS AND STATISTICS

To some degree, the reduction in required reserves resulting from the decline was permitted to ease the situation. Member bank borrowings (and net borrowed reserves) tended to decline, but in the early weeks of the year they continued large enough to keep the banks under some restraint and to induce them to sell government securities to meet loan demands. In March, Federal Reserve operations eased seasonal pressures and member bank borrowings declined considerably.

The striking new feature that appeared in I960 was a marked decline in interest rates. Most rates - both short and long - declined to the lowest levels since the spring of I959. To some extent this decline in rates may be attrib- utable to seasonal influences, similar to those that have developed following sharp rises char- acteristic of quarterly tax and other settlement periods during the past year or more. To a significant degree, however, it seems to reflect a change in basic forces and in expectations. March was the first quarterly tax payment month since I958 when interest rates did not rise.

Many factors accounted for this decline in interest rates along with a strong loan demand and net liquidation of total bank credit. Cer- tainly one of the most important was the substantial decline in over-all credit demands due to the termination of the large government defi- cits that characterized I958 and I959. Another influence has been the lessened allure of com- mon stocks and the shift from stocks to fixed interest securities. A most significant factor seems to be the desire of the public to hold liquid assets in other forms than cash -a tend- ency initiated by the higher interest rates in I959 but which developed so far as to bring

To some degree, the reduction in required reserves resulting from the decline was permitted to ease the situation. Member bank borrowings (and net borrowed reserves) tended to decline, but in the early weeks of the year they continued large enough to keep the banks under some restraint and to induce them to sell government securities to meet loan demands. In March, Federal Reserve operations eased seasonal pressures and member bank borrowings declined considerably.

The striking new feature that appeared in I960 was a marked decline in interest rates. Most rates - both short and long - declined to the lowest levels since the spring of I959. To some extent this decline in rates may be attrib- utable to seasonal influences, similar to those that have developed following sharp rises char- acteristic of quarterly tax and other settlement periods during the past year or more. To a significant degree, however, it seems to reflect a change in basic forces and in expectations. March was the first quarterly tax payment month since I958 when interest rates did not rise.

Many factors accounted for this decline in interest rates along with a strong loan demand and net liquidation of total bank credit. Cer- tainly one of the most important was the substantial decline in over-all credit demands due to the termination of the large government defi- cits that characterized I958 and I959. Another influence has been the lessened allure of com- mon stocks and the shift from stocks to fixed interest securities. A most significant factor seems to be the desire of the public to hold liquid assets in other forms than cash -a tend- ency initiated by the higher interest rates in I959 but which developed so far as to bring

down the level of rates in I960. To what extent the decline in interest rates may represent an increase in the volume of saving relative to over-all credit demands will be revealed only as more information becomes available.

Accompanying the decline in the money supply in the early weeks of I960 has been a marked increase in the rate of turnover of money. In early I959, an increase in turnover accompa- nied a slackening in the rate of growth in the money supply. After the middle of that year, when economic activity was limited by the steel strike, the volume of money declined slightly and the turnover rate showed little change. On balance, it is evident that expansion in the total volume of monetary transactions and of economic activity generally was not prevented by the decline in the money supply that occurred after last summer.

Conclusion. Restraint on monetary expansion in the face of vigorous credit demands in I959 caused rising interest rates, which in turn attracted into investment savings adequate to finance a substantial economic expansion and a large government deficit with little monetary creation. In early I960 the continued flow of saving into investment, together with termination of the government deficit, resulted in both a contraction of total bank credit and a decline in interest rates, along with a continued high level of economic activity. These developments may be viewed as an indication of the effective- ness of a restrictive monetary policy in permit- ting economic expansion without unsustainable credit development. Freely functioning money and capital markets with flexible interest rates served to bring saving and investment into balance and to allocate financial resources among various claimants.

down the level of rates in I960. To what extent the decline in interest rates may represent an increase in the volume of saving relative to over-all credit demands will be revealed only as more information becomes available.

Accompanying the decline in the money supply in the early weeks of I960 has been a marked increase in the rate of turnover of money. In early I959, an increase in turnover accompa- nied a slackening in the rate of growth in the money supply. After the middle of that year, when economic activity was limited by the steel strike, the volume of money declined slightly and the turnover rate showed little change. On balance, it is evident that expansion in the total volume of monetary transactions and of economic activity generally was not prevented by the decline in the money supply that occurred after last summer.

Conclusion. Restraint on monetary expansion in the face of vigorous credit demands in I959 caused rising interest rates, which in turn attracted into investment savings adequate to finance a substantial economic expansion and a large government deficit with little monetary creation. In early I960 the continued flow of saving into investment, together with termination of the government deficit, resulted in both a contraction of total bank credit and a decline in interest rates, along with a continued high level of economic activity. These developments may be viewed as an indication of the effective- ness of a restrictive monetary policy in permit- ting economic expansion without unsustainable credit development. Freely functioning money and capital markets with flexible interest rates served to bring saving and investment into balance and to allocate financial resources among various claimants.

TOWARDS IMPROVING THE EFFICIENCY OF THE MONETARY MECHANISM

James Tobin

TOWARDS IMPROVING THE EFFICIENCY OF THE MONETARY MECHANISM

James Tobin

A PPRAISAL of the operation of a machine may focus on (i) the purpose for which

the operator is using it, (2) the skill of the operator, or (3) the efficiency of the machine itself. The machinery of American monetary

A PPRAISAL of the operation of a machine may focus on (i) the purpose for which

the operator is using it, (2) the skill of the operator, or (3) the efficiency of the machine itself. The machinery of American monetary

control has been abundantly discussed from the first two points of view, and scarcely at all from the third. The objectives, timing, and techniques of Federal Reserve control are criticized and defended daily. The adequacy of the ma-

control has been abundantly discussed from the first two points of view, and scarcely at all from the third. The objectives, timing, and techniques of Federal Reserve control are criticized and defended daily. The adequacy of the ma-



CONTROVERSIAL ISSUES IN RECENT MONETARY POLICY 277

chinery of control is seldom questioned. This is not because the machinery is of a new design clearly appropriate to its current uses. On the contrary, the mechanism was designed for quite different purposes in I9I3. Neither then nor at the time of emergency repairs in I933-35 was the design related to what is now regarded as the overriding task of monetary control - ac- celerating, damping, or reversing short-run changes in aggregate demand for goods and services. The original objectives were to pre- vent financial crises and panics by providing a "lender of last resort," and to meet the "needs of trade." The remodeling twenty years later had as its principal purpose the prevention of bank failures. Perhaps the only important in- novation adopted to improve the efficiency of monetary control is the power to vary reserve requirements, obtained by the authorities in I935.

Our relevant experience of monetary control is surprisingly short, perhaps no longer than the past decade. Most of the Federal Reserve's forty-seven years have been dominated by the special circumstances of two wars and a great depression. Monetary control of a sort was emerging in the I920's. But the consciousness of the authorities that economic stabilization was their objective and responsibility was far from fully developed, and the environment was very different from today's, especially with re- spect to the size and role of the public debt. For its pioneering efforts of the past decade, the Federal Reserve inherited machinery designed for different purposes in a different economic environment under the spell of different economic ideas.

Yet there is no evidence that the drivers at the wheel during this first decade of modern monetary control have longed for a new or improved machine. Their complacency leaves it up to outsiders to ask whether the monetary mechanism can be made a more efficient engine for accomplishing the goals of the authorities. The best way to encourage thinking in this di- rection is to make concrete suggestions. The two proposals below are advanced, somewhat tentatively, in this spirit. They are of course not exhaustive. It should not be, but perhaps is, necessary to repeat that efficiency is a tech- nical question, distinct from the more important

issue of objectives. Whether the goals of economic policy should be those of Martin, Roosa, Douglas, or Keyserling is not the topic here. Whatever the goals, it is a good idea to have efficient instruments to pursue them.

I. The Federal Reserve Banks should pay interest at the discount rate on member bank reserve balances in excess of requirements. At present a bank earns no interest on positive excess reserves, funds it is lending to the Fed, but must pay the discount rate on negative excess reserves, its borrowings from the Fed.1 The proposal is motivated by more than a simple passion for symmetry. Its purpose is to strengthen the Federal Reserve's control over the tightness of bank credit. The willingness of banks to make loans and the terms which they will offer to borrowers depend on the opportunity cost of loan funds to the banks. This cost is the return the bank can earn by investing in Treasury securities or Federal Funds or by re- ducing its indebtedness to the Fed. The various instruments of monetary control all exert their influence by changing this opportunity cost. But they add up to a loose, uncertain, and pos- sibly quite slow control. The proposed reform would make the discount rate much more effective as the measure of the cost of loan funds. The discount rate would be effective, not only as at present for a bank in debt to the Fed, but equally for a bank with excess reserves. By raising the discount rate, the Federal Reserve would clearly, directly, and quickly make lending less attractive - to all banks, regardless of their net free reserve positions.

It is true that the present Federal Funds market tends to accomplish this same generali- zation of the discount rate. But the market is quite imperfect, and lending in it is not an effective alternative for many banks. Moreover, the Federal Funds rate can fall below the discount rate when net free reserves are large, or even rise above it when borrowing is heavy. Under the proposal, the Federal Reserve itself would make a perfect Federal Funds market at the discount rate.

The discount rate would also become a floor to the rate on Treasury bills and similar short- term paper that banks might hold as secondary

1 On a reserve deficiency not covered by borrowing a bank pays a penalty rate two points above the discount rate.



278 THE REVIEW OF ECONOMICS AND STATISTICS

reserves. The differential of the bill rate above the discount rate would be related to the relative shares of excess reserves and secondary reserves in the liquidity position of the banks. Open- market operations in bills would influence this differential, as at present. But open-market operations would not be essential to "make the discount rate effective." It would never be pos- sible for the money market and the discount rate to lose touch.

Readers who are rightly concerned to avoid techniques of monetary stabilization that unduly enrich bank shareholders should hold their fire at least until they read the second proposal. But the first proposal even by itself is not such a bonanza for the banks as may at first appear. It is true that gains would accrue to banks which now choose, because of imperfections in the money market and Federal Funds market, to hold excess reserves at zero interest. Al- though bank holdings of excess reserves would increase, their holdings of short-term Treasury securities, which banks now use as secondary reserves, would be diminished. These securities and the interest they bear would be absorbed by the Fed. Since excess reserves are a per- fectly liquid demand obligation, banks will hold them at a somewhat lower rate than they require of Treasury securities. An ultimate corrective to excessive enrichment of banks at the expense of the Treasury is an increase in reserve requirements; under the proposal, required reserves would remain barren of interest.

2. Banks should be released from the prohibition of interest payments on demand deposits and from the ceilings on interest rates on time and savings deposits. The second proposal is the logical extension of the first. The purpose of the first is to tighten the control of the Fed- eral Reserve over the marginal cost of bank lending. The purpose of the second is to tighten the Federal Reserve's control over the opportunity cost that bank depositors charge against any alternative investment of funds. Under existing arrangements the advantages of hold- ing bank deposits are the convenience and economy of avoiding frequent transactions between deposits and other assets. The "cost" of a reduction in average bank balances in order to increase investment elsewhere is an imputed and unobservable one, differing widely among

depositors. The monetary authority affects this cost indirectly, increasing it by making deposits relatively scarce in supply and diminishing it by making deposits relatively abundant. But they are operating very much in the dark. They cannot know how, and how soon, a given monetary action will affect the supply of funds by bank depositors to other financial intermedi- aries or the terms on which depositors will be prepared to make direct investments.

If interest on bank deposits is competitively determined and if the discount rate is general- ized as suggested above, the Federal Reserve will have a very tangible control over the attractiveness of deposits. The rate that banks pay depositors will be closely geared to the discount rate, since a bank will always be able to earn a fraction of the discount rate (one minus the required reserve ratio) on a new deposit. By changing the discount rate the central bank will affect both the calculations of banks concerning the relative attractiveness of excess reserves and other assets and the calculations of the public concerning the relative attractiveness of deposits and other investments.

The proposal has several important addition- al advantages. First, it would largely eliminate what is now a real cost of restrictive monetary policy, namely the unproductive efforts devoted to economizing cash in periods of high interest rates. Second, it would replace with price competition some of the existing wasteful and imperfect non-price competition for deposits. Bet- ter to pay depositors interest than to seek their patronage by organ music, free silverware, and plush surroundings. Better to attract deposits by interest than to seek them by the threat and promise of preferred loan treatment to faithful depositors.2 The allocative efficiency of the banking system, and indeed of the entire financial system, in channeling the funds of the ultimate lenders to productive borrowers would be improved. Third, it would reduce the connec- tion between bank profits and the tightness of monetary policy; measures can be appraised for their effects on the economy rather than for their effects on bank stocks.

The circumstances that led to prohibition of interest rate competition for bank deposits in

2This consequence of the prohibition of interest on deposits has been emphasized by Donald Hodgman.



CONTROVERSIAL ISSUES IN RECENT MONETARY POLICY 279 CONTROVERSIAL ISSUES IN RECENT MONETARY POLICY 279

I933 no longer apply. The principal argument for this prohibition as a measure of social policy was that excessive competition for deposits led to insolvency and bank failure. Other measures adopted at the same time, especially of course deposit insurance, give the public ample protection. No doubt commercial bankers have the usual reasons for desiring protection from competition within the industry, although many would welcome the chance to compete for funds that now go to other financial institutions. Small banks would be the main gainers from the first proposal, but perhaps also the main losers from the second. There may be some banks that are able to remain in business only because present federal legislation enables them to capture rents that would otherwise go to their depositors. Should they remain in business? Needless to say, the proper role of the government is to oppose rather than to compel collusive price conventions.

An incidental result of the two proposals would be to simplify the week-to-week operating problems of the Treasury in debt manage- ment. Much of the short-term debt would be transferred from corporations and banks to the Federal Reserve, and these holders would in-

I933 no longer apply. The principal argument for this prohibition as a measure of social policy was that excessive competition for deposits led to insolvency and bank failure. Other measures adopted at the same time, especially of course deposit insurance, give the public ample protection. No doubt commercial bankers have the usual reasons for desiring protection from competition within the industry, although many would welcome the chance to compete for funds that now go to other financial institutions. Small banks would be the main gainers from the first proposal, but perhaps also the main losers from the second. There may be some banks that are able to remain in business only because present federal legislation enables them to capture rents that would otherwise go to their depositors. Should they remain in business? Needless to say, the proper role of the government is to oppose rather than to compel collusive price conventions.

An incidental result of the two proposals would be to simplify the week-to-week operating problems of the Treasury in debt manage- ment. Much of the short-term debt would be transferred from corporations and banks to the Federal Reserve, and these holders would in-

stead lend to the government via the media of member bank and Federal Reserve Bank deposits. The headaches the Treasury now suffers from the weekly maturities of its bill issues would be largely transferred to the Fed and amalgamated with their general headaches concerning monetary policy, in particular the appropriate basic interest rate.

These two proposals would make the discount rate, which it would then be more appropriate to call the Federal Reserve rate, the most powerful tool in the central banker's kit, and a very powerful tool indeed. The reform would be of no avail unless the authorities were prepared to use this tool. To counter the inventory cycle they would have to be ready to change the rate promptly and drastically; counter-cyclical monetary control may well require much wider fluc- tuations in short-term interest rates than we have yet had the courage to try. Those who do not have faith in the values, judgment, or capac- ity of monetary managers in general or in particular will not wish to entrust them with more efficient instruments. But those who believe that a democratic society should seek to control its own economic destiny will wish the government to have the means to carry out its will.

stead lend to the government via the media of member bank and Federal Reserve Bank deposits. The headaches the Treasury now suffers from the weekly maturities of its bill issues would be largely transferred to the Fed and amalgamated with their general headaches concerning monetary policy, in particular the appropriate basic interest rate.

These two proposals would make the discount rate, which it would then be more appropriate to call the Federal Reserve rate, the most powerful tool in the central banker's kit, and a very powerful tool indeed. The reform would be of no avail unless the authorities were prepared to use this tool. To counter the inventory cycle they would have to be ready to change the rate promptly and drastically; counter-cyclical monetary control may well require much wider fluc- tuations in short-term interest rates than we have yet had the courage to try. Those who do not have faith in the values, judgment, or capac- ity of monetary managers in general or in particular will not wish to entrust them with more efficient instruments. But those who believe that a democratic society should seek to control its own economic destiny will wish the government to have the means to carry out its will.

MONETARY POLICY, 1957-59: TOO TIGHT, TOO OFTEN

Sidney Weintraub

MONETARY POLICY, 1957-59: TOO TIGHT, TOO OFTEN

Sidney Weintraub

LIKE the chronic tipsy driver, monetary policy over I957-59 has been too tight - and

sometimes tighter than at other times. Extenu- ating circumstances can be admitted.

I

Tight money. On the premise that unemployment in excess of two million, or at most two and one-half million, is wasteful, it is the task of monetary and fiscal policy to remove the slack. Where fiscal policy is too rigid or too feeble, more of the burden must fall on monetary policy. From this standpoint the I957-59 unemployment outcome, of 2.9 million, 4.7 million, and 3.8 million, respectively, was unsatisfac- tory. Current unemployment stands at about 4 million.

Monetary policy, therefore, fell short of mak-

LIKE the chronic tipsy driver, monetary policy over I957-59 has been too tight - and

sometimes tighter than at other times. Extenu- ating circumstances can be admitted.

I

Tight money. On the premise that unemployment in excess of two million, or at most two and one-half million, is wasteful, it is the task of monetary and fiscal policy to remove the slack. Where fiscal policy is too rigid or too feeble, more of the burden must fall on monetary policy. From this standpoint the I957-59 unemployment outcome, of 2.9 million, 4.7 million, and 3.8 million, respectively, was unsatisfac- tory. Current unemployment stands at about 4 million.

Monetary policy, therefore, fell short of mak-

ing a maximum contribution. With free reserves at minus $500 million it was much too tight in the first half of I957 and bears some responsibility for the subsequent downturn. The slow and inadequate build-up to positive free reserves of about the same sum by the spring of I958 was quickly reversed by a cautious Reserve Board to a small negative figure by the year's end. The negative magnitude of $400-$500

million again prevailed in late 1959 though the recovery was by no means complete.'

Inflation analysis. Throughout the period, there has been a continuing obsession in the Reserve system with inflation and just enough basis for these fears, lacking other control measures, to accept the plea of mitigating circum-

ing a maximum contribution. With free reserves at minus $500 million it was much too tight in the first half of I957 and bears some responsibility for the subsequent downturn. The slow and inadequate build-up to positive free reserves of about the same sum by the spring of I958 was quickly reversed by a cautious Reserve Board to a small negative figure by the year's end. The negative magnitude of $400-$500

million again prevailed in late 1959 though the recovery was by no means complete.'

Inflation analysis. Throughout the period, there has been a continuing obsession in the Reserve system with inflation and just enough basis for these fears, lacking other control measures, to accept the plea of mitigating circum-

'The close money policy can also be read from the fig- ures on money supplies or the loan and investment totals of commercial banks.

'The close money policy can also be read from the fig- ures on money supplies or the loan and investment totals of commercial banks.



Documents

Towards Improving the Efficiency of the Monetary Mechanism