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American Academy of Political and Social Science

Problems of the Postwar Capital Market


Author(s): Cecil L. Dunn
Source: Annals of the American Academy of Political and Social Science, Vol. 248, Labor
Relations and the Public (Nov., 1946), pp. 251-259
Published by: Sage Publications, Inc. in association with the American Academy of Political and
Social Science

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Problems of the Postwar Capital Market


L. DUNN
By CECIL
HERE is an increasingtendencyto desire to make a quick profit on specusegregate investment into two main lative appreciation. It is with these
blocks, one of which is relatively free normal business risks that we are conof risk and the other more hazardous. cerned, as speculative ventures are of
The size of the former apparently has little significance in the "long pull" of
undergone steady expansion in recent industrial development.
years. The funded obligations of esOF SMALLBUSINESSES
tablished firms, preference shares which DISADVANTAGE
are often indistinguishable from such
A major portion of our interest will
obligations, and even their common be directed toward the requirements of
stocks have become increasingly attrac- new, and especially small, businesses, as
tive to investors seeking security. The it is here that the risk element is presinherent element of risk is overlooked, ent, or thought to be present, in such a
and only those funds which are em- degree as to influence the judgment of
ployed by relatively untried firms are the ordinary investor.
It is much more difficult for small
regarded as "venture" capital.
Although this distinction is quite enterprises than for large ones to secure
commonly made, it has little value for capital. The vast technological changes
this study. Its use would introduce the that have taken place have widened the
necessity for classifying investments in outlook of private investors, and they
accordance with a scale of the risk in- tend to place their money in what
volved, a process which is virtually im- they consider the safe security issues of
possible, and which would require the large corporationsor government bonds.
introduction of judgments which might "Thus the large concern is generally
able to secure money indirectly from
cast doubt on the conclusions.
Our definition, therefore, is the tra- the individual private investor far more
ditional one, now so little used-veneconomically than the small concern can
ture capital is equity capital. If the obtain it directly." 1
The conclusion to be drawn is that
hazards of ownership are present, the
essential characteristic of a venture is venture capital for small enterprises
must come from the personal resources
present.
However, an important distinction is of their proprietors, from earnings, or
that which exists between speculative from a variety of external sources which
risks and the normal hazards of a are poorly organized and unduly expermanent venture. An enterprise of pensive.
the latter type, representing the effort
This study will trace the extent to
of its proprietors to make long-run which these factors are important to the
profits, will be managed with a view to- economic life of California, and apward establishing a place in the market praise, in relation to its well-being, the
and accumulating resources of sufficient many proposals which have been made
size to protect it from the consequences
1 Donald Wilhelm, Jr., "How Small Busiof cyclical fluctuations, unrealized ex- ness Competes for Funds," Law and ConProblems (Duke University Quarpectations, and errors of judgment. It temporary
Vol.
terly),
XI, No. 2, p. 220. See also W. C.
will therefore tend to be free from that
Louchheim, Jr., "The Problem of Long Term
internal hazard which rises from the and Equity Capital," ibid., p. 248.
251

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252

THE ANNALSOF THE AMERICAN


ACADEMY

to find solutions for the problems which


are inherent in them.
ORGANIZATION
OF THECAPITAL
MARKET
Recent years have witnessed many
changes in the organization of the market for business credit. Some of those
changes, especially the growth of factoring and the growth of term lending
by banks, are to be regarded as the
formalization of practices which had
been developing informally for some
time. Although credit of this kind is
usually regarded as resting on a secured obligation, a portion of that security is the real capital of the business,
and the problem of credit therefore
bears a close relationship to the problem of equity capital. Any business
must normally have access to both, and
the supply of credit must be looked
upon as a part of the problem of capital
for postwar California businesses.
The capitalization of prewar California industry is very well described,
at least insofar as major businesses are
concerned, by the usual sources of investment data. The influence of the
war period is reflected in the data published by the Securities and Exchange
Commission in its "Survey of American
Listed Corporations," and in the reports of the Bureau of Program and
Statistics of the War Production Board.
These reports are of particular value
because they detail changes in the capital structure of individual firms, indicating the source of the funds employed, and because they give a very
complete breakdownof wartime changes
in industry in California. The names
of firms, industry classifications, nature
of facilities, locations, and source of
funds all are detailed, giving a complete
record of the war experience of the firms
participating in the war production program. Data on the war experiences of
other firms are more difficult to secure,

and have to be sought from the organizations themselves.


PROSPECTIVE
POSTWAR
OPERATIONS
Data relating to prospective postwar
operations and financing have been collected by a variety of agencies. The
Bureau of Foreign and Domestic Commerce of the United States Department
of Commercehas issued recent bulletins
on the capital outlay plans of different
groups of industries. A survey of business plans of particular interest to
California was published in February
1945 by the Federal Reserve Bank of
San Francisco. A summary of the findings of the survey appears in Table 1.
Chambers of commerce and the local
committees of the Committee for Economic Development have surveyed the
plans of their members and of firms
within their communities; banks and
investment banking firmshave discussed,
and in some cases formulated, definite
plans for individual firms. Prospective
action, of course, must be interpreted in
a different light than actual accomplishment, but a summary of the estimates
through these methods may be interesting.
A second approach to the postwar
capital market may be made through
estimates of the volume of postponed
investment in different industries. Although it is difficult to justify such estimates without reservation, they may be
regarded as reasonable if such basic assumptions as the rate of population
growth, the stability of locational quotients, and the persistence of trends in
technological development and costs are
accepted. In fields such as housing and
retail and wholesale trade, in which the
persistence of demand is a commonsense proposition, such estimates may
have a high degree of validity; but a
conclusive estimate by this method of
investment in industries which are new
to the state is an obvious impossibility.

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253

PROBLEMS OF THE POSTWAR CAPITAL MARKET

TABLE 1-ESTIMATED POSTWAROUTLAYSOF WEST COASTMANUFACTURERSo


By selected industry groups
Total
Outlaysb
(millions of
dollars)

Purchase
of
New
govern- plant
Mini- Maxi- ment
conmum mum owned strucstrucplant
tion
and
equipment

Industry

Food and kindred products


Lumber and timber basic products
Furniture and finished lumber
products
Chemicals and allied productsc
Products of petroleum and coal
Stone, clay, and glass products
Iron and steel and their products
Machinery (except electrical)
Electrical machinery
Aircraft and parts
Ships and boat building and
repairing
All other

Total

Purpose of Outlays
(per cent)

26
70

36
80

10

10
21
5
16
21
3
77
2

20
29
10
19
22
6
139
9

48
2

1
3
5
17
2
10

Source of Funds
(per cent)

AccuStrucmulatural Retion
addi- toolof
All
re- Banks All
tions
ing work- other sources
re- Banksother
and
ing
invenrepairs
tories
23
42

10
2

3
52

16
2

72
96

25
3

19

25

50

82

18

52
60
14
23
11
1
2

29
40
43
13
5
6
4
31

10

33
22
30
22
18
26

2
28
38
34
54
28

8
11
11
20
20
5

89
43
64
76
72
50
47
42

35
21
6
18
34
58

3
1

3
57
1
3
22
32
19

33

53

25

18

12

22

22

71

13

16

291

433

16

20

14

36

12

67

19

14

a Excluding steel mills and nonferrousmetals.

bWith respect to postwar outlays, reportingfirmsin each industry were classifiedin three
groups: (1) those reporting planned outlays, (2) those reporting no outlays planned, and (3)
those not reportingor uncertain. Maximumestimates are based on the assumption that firms
in group 3 will spend proportionatelyas much as those in group 1; minimum estimates are
based on the assumption that firms in group 3 are comparablewith those in group 2 and will
have no postwar outlays.
c Including oil production, transportation, and storage, as well as
refining. Source:
Federal Reserve Bank of San Francisco.

In this connection it should be pointed


out that some of the most widely entertained hopes for new industrial activity in California involve not only industries which are new to this region,
such as steel, but others which are new
to the whole realm of business: electronics, synthetics, and even large-scale
small airplane production.
WARTIME
CHANGES
Of first importance, then, is a review
of the changing capital position of California industry during the war years.
The pattern of both industrial organization and capital structure has been
profoundly altered by the unprecedented need for expansion of manu-

facturing facilities. A tremendous volume of new investment has been required to provide necessary additions to

plant capacity. In discussing the types


of plant capacity created, this report
utilizes the following definitions:
a) New Plant: Entire new establishments, includingstructuresand equipment,
located near existing plants of the operator
or at a new location.
b) Expansions: Existing plants expanded

to manufacturethe same products as in

peacetime.2
2 Whereverthe term "expansion"is enclosed
in quotation marks, it will have the specific
meaninggiven here. Otherwise,where the balance of the context is clear, it will be used to
denote the total of all three types of plant
capacity discussedabove.

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254

THE ANNALS OF THE AMERICANACADEMY

TABLE 2-SUMMARY OF FACILITIESEXPANSIONSAUTHORIZED


TO MAY 31, 1944, CALIFORNIA
COUNTIES,SOURCESOF FUNDS AND TYPE OF FACILITYEXPANSIONS
(000 omitted)
Source of Funds

Type of Expansion

Total

All
Plants

State Total
California

$1,335,698

Public

Private

Expansions
of Old
Plants

New Plants

Conversions

$931,931

$403,767

$337,270

$891,610

$106,818

47,583

22,774
271
13,406
354

41,173
825
121,439
1,463

1,455

93,857
793

17,819
1,096
41,915
1,059

4,408
274
369,452
17,350
2,000

1,343
5,449
1,552
263,369
72
1,179

1,218
248
106
138,203
72
884

1,027
2,304
1,222
3,359
17,043
12,034
2,348
5,783
1,130
9,933

511
496
2,813
22,873
18,304
863
274
387
1,066

112,798
41,772
43,165
11,043
2,172
962
57,723

107,888

2,960

Alameda
Calaveras
Contra Costa
Fresno

65,402
1,096
135,772
1,852

Humboldt
Kern
Kings
Los Angeles
Marin
Monterey

1,343
9,857
1,826
632,821
17,422
3,179

Napa
Orange
Riverside
San Bernardino
San Diego
San Francisco
San Joaquin
San Mateo
Santa Barbara
Santa Clara

1,577
2,534
1,222
115,678
64,645
62,449
12,120
5,837
1,349
60,454

112,319
47,602
50,415
9,772
54
219
50,521

110,858

110,848

14,357

13,280

1,077

721

13,636

404

3,785
7,869

3,538

3,734
4,535

Solano
Stanislaus

Ventura
All others

3,785
8,273

550
230

c) Conversions: Alterations to existing


plants either by structural and equipment
additions, or the latter alone, to convert
from normal peacetime production to the
production of war goods.3
In the Nation as a whole, from July
1940 through May 1944, 13,126 plants
("new," "expanded," or "converted"),
with a total value of 20.3 billion dollars, were added to productive capacity.
Although some relocations of industrial
plant occurred, the heaviest concentration of expansion took place generally
in those areas where specific industries
a "GeographicalDistribution of Manufac-

turing Facilities Expansion," War Production


Board, June 1, 1945, p. 1.

83
9,564
1,720
397,623
17,350
2,295
1,577
1,998

927
35

42
45
96,995

25
726
67
980
214
3,391
1,665

51
200

had chiefly operated before the war.


Major types of war product manufactured in California were aviation gasoline, aircraft, ships, petroleum products,
and processed foods, with the total
value of authorized facilities in all industries amounting to $1,335,698,000 in
the period from July 1940 to May
1944.4
The greater expansion in California
as compared with the Nation as a whole
comprised the building and equipping
of "new" plant, although the average
cost (and presumably the amount) of
"new" construction in the Pacific region
was less than the national average.
4 Ibid., p. 12.

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255

PROBLEMS OF THE POSTWAR CAPITAL MARKET

From July 1940 to May 1944, 1,056


plants of various types were built in
California; value of "new" plant was
$891.6 million, "expansion" $337.3 million, and "conversion" $106.8 million.5
Value of facilities expansions in California counties, source of funds, and
types of expansion are shown in Table
2. Expansion was heaviest in shipbuilding, chemicals and petroleum products, and aircraft. Facilities expansion
in the aircraft industry was highly important in Los Angeles and San Diego
counties; shipbuilding led in Solano,
Contra Costa, San Francisco, and Alameda counties as the primary factor in
their expansion programs, and was also
of importance in the Los Angeles area.
TABLE

3-ESTIMATED
BY WPB

OVER,

tion of "new" plants. In the period


covered by Table 2, "conversions"were
more often privately financed than publicly financed, resulting in a higher percentage of private financing in California than in most other states of comparable size and industrial development.
Approximately 30 per cent of total
financing in California was private.7
In Table 3 is shown estimated cost of
authorized manufacturing facilities in
various industrial areas in California
established by the War Production
Board. Cost of facilities in the Los
Angeles area is the largest, with approximately $404.3 million provided
publicly and $280.3 million provided
privately.

COST OF WAR MANUFACTURING


FACILITIES AUTHORIZED,
$25,000 OR
REGION AND INDUSTRIAL
AREA, SOURCE OF FUNDS AND PURPOSE

1940 THROUGHDECEMBER1944
(000 omitted)

OF AUTHORIZATION,
JUNE

Public

Total
Region X
Los Angeles
San Diego
San Francisco
Remainder

Private

Grand

Region

Bay

$1,686,019
684,736
69,259
493,940
438,084

$1,216,576
404,354
50,055
388,772
373,395

Structure
$577,361
159,411
27,533
214,268
176,149

Equipment
$639,215
244,943
22,522
174,504
197,246

Total
$469,443
280,382
19,204
105,168
64,689

Structure
$130,461
69,962
12,497
23,575
24,427

Equipment

Other

$295,375
189,125
4,839
69,897
31,514

$43,607
21,295
1,868
11,696
8,748

Source:War ManufacturingFacilities Authorizedthrough December,1944, Vol. 1,


WarProductionBoard,June 15, 1945.
In the Nation as a whole, of the
Expansions in chemicals and petroleum productswere generallywidespread $18.2 billion of war manufacturing fathroughout the state, with the heaviest cilities added from July 1940 to May
concentrations occurring in Los Angeles 1944, $14.4 billion, or 79 per cent of
the total, was financedby Federal funds.
and Contra Costa counties."
In the Pacific region (Washington,
It is evident from Table 2 that public funds were the principal source of Oregon, and California), a total of
financing for wartime expansion. In $1.666 billion was expended from July
Solano County, where all funds were 1940 to May 1944 on expansion of
provided by government, investment oc- manufacturingplant, $1.225 billion repcurred chiefly in the "expansion" of resenting "new" plant and $441 million
existing plants. In San Bernardino representing"expanded"plant. Of this
County, where more than 97 per cent total, the value of Federally financed
of funds came from public sources, the plant was $1.275 billion, "new" plant
money went primarily for the construc- accounting for $1.012 billion and exa
panded plant for $263 million. Grand
WPB, op. cit., p. 17.
6 Ibid., p. 54.

7WPB, op. cit., pp. 20-21.

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256

THE ANNALS OF THE AMERICAN ACADEMY

total for the Pacific Region represents


The increasing ability of corporations
9 per cent of the national total; 77 to finance their own capital expendiper cent of facilities expansion in this tures is paralleled by the wartime
region was Federally financed.8 The growth of individual holdings of saved,
greater part of Federal funds was pro- and presumably investable, funds. No
vided under construction contracts and, argument that all such holdings are a
to a less extent, through loans and sup- source of investment funds could be reaply contract advances.9
sonably made, so the point will not be
labored. The wartime growth of bank
resources, in both demand and time deACCUMULATION OF CAPITAL
posits, is well known, and is a simple
War expansion of the type which has index of the increasing availability of
been detailed in the preceding para- money for all purposes, including ingraphs has obviously created a large vestment.
amount of at least partially useful fixed
BANKS AS SOURCES OF CAPITAL
capital in this as in other regions, but it
has been the source of earnings from
Obviously, savings banks are not a
which funds for conversion and new source of venture capital, and the rise
capital can be provided. Many busi- in savings deposits occasioned by the
nesses which heretofore have not been war cannot be regarded as a potential
capable of supplying capital needs from stimulus to equity financing. The erinternal sources have unquestionably ratic increase in demand deposits and
attained that status during the war checks payable simply reflects the exyears.
pansion of industrial activity and the
Renegotiation has apparently had lit- use of bank funds to provide working
tle effect in reducing the net earnings capital and finance conversion of fawhich are the source of such surpluses. cilities. Demand and time deposits
Corporate refunds to the United States were the largest in the San Francisco
Treasury were frequently made from Metropolitan Area and the Los AnWar and Related Contingency Funds geles Metropolitan District, in accordaccumulated for the purpose. Accord- ance with the general pattern of waring to a survey by the Securities and time expansion.
Commercial banks have generally
Exchange Commission of seventy firms
in 1943,
been the most significant institutional
sources of venture
and yet
gross refunds of $2,410,000 were made small businesses find itcapital,
difficult and infrom accumulated funds amounting to
$22,030,000. Withinthis groupnet profits advisable to secure capital from such
before income taxes and renegotiation sources. Nothing in our analysis of
amountedto $369,014,000and after taxes wartime developments would indicate
and renegotiationto $118,583,000. Income that this problem has been lessened or
taxes in excess of $123,000,000are obvi- solved in recent years, except insofar
ously the most importantfactor in reduc- as the improvement in financial posiing surplus.'0
tion experienced by many concerns will
8 "Characteristics of
make it easier to obtain bank credit.
Manufacturing Facilities Authorized, July, 1940 to May, 1944," Fundamentally, the securing of equity
WPB, Jan. 22, 1945, p. 20.
capital from commercial banks remains
9 Ibid., p. 8.
as difficult and impracticable as in the
10 Survey of American Listed Corporations,
prewar years.
Data on Profits and Operations, 1942-1943,
SEC, March 15, 1945, p. 1.
What, then, are we to conclude with

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PROBLEMS
OF THE POSTWAR
CAPITAL
MARKET
respect to the postwar capital market
in California? The large firms which
have shared in the war boom have obviously done well, improving their position for internal financing and strengthening their already sound claims for
the attention of the regularly organized
capital market. Many minor firms have
had a similar experience insofar as the
growth of assets is concerned, while increased savings of all classes indicate
the availability of funds if only the
market can be organized to serve their
needs. How can this be achieved?

257

of these accommodations, which range


from one and a half to six times the
cost of bank loans to small business,
also makes expansion difficult. The
high operating costs which such loans
entail make the accumulation of equities a feat which only a few businesses
can accomplish.
California, with its relatively high
per capita income, has seen a considerable development of the agencies of the
investment capital market. The laws
of the state have been favorable to
sound corporate development, and securities markets have escaped both
EXISTING CREDIT AGENCIES
onerous control and the neglect of reguCalifornia does not lack well-organ- lation which leads to fraud. The
ized markets for capital funds. In healthy climate which has existed for
fact, especially with respect to sources investment has, however, encouraged
of bank credit, the state is particularly the growth of agencies with a primary
well provided with sound institutions orientation toward the national securimanaged with vigor, imagination, and ties market, and purely regional or inan eye to the well-being of the business trastate investment facilities are no betcommunity as a whole. This circum- ter developed here than in other parts
stance, however, does not offset the facts of the United States.
that bank credit must rest to a conThis circumstance has led to the disiderable degree upon the proprietor's version of much of the investment of
equity in a business, and that when the people of California into firms
equities are inadequate, credit is hard whose domiciles and operations are elseto secure and expansion, or even routine where. Except insofar as certain California corporationsattract the attention
operation, becomes difficult.
The banks of the state, with the ex- of investors in the national market,
ception of a few institutions which have there has been no offset to this condiclung tenaciously to traditional prac- tion. Local firms in need of long-term
tices, have made good use of the devices funds find themselves in competition
which make relatively liberal commer- with big users, on terms which leave
cial credit, installment loans, term them at a great disadvantage. In fact,
loans, and management advisory serv- it may be said that true competition
ices. There are, of course, other agen- does not exist, since the small or purely
cies offering short-term credit to busi- local firm finds that the capital facilities
ness, and these have also expanded the which serve the large user are not open
scope of their operations to keep pace to it.
with the demands of business in the
OBSTACLES TO SMALL BUSINESS
state. Factors, dealers in acounts reand
chattel
Small businesses in California thereceivable,
mortgage lenders
have shown themselves willing to supply fore confront the same situation which
credit to many businesses at relatively faces such firms everywhere. With the
high cost when the qualifications for major areas of the capital market closed
a bank loan did not exist. The cost to them, they have but two resources

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258

THE ANNALSOF THE AMERICAN


ACADEMY

available. They must build capital


from within by "plowing back the
profits of operation," or they must find
willing investors whose demands upon
the firm will not be too severe. The
former process is traditionally slow, but
relatively free from danger, though it
has other disadvantages, not the least
of which is that it may keep out of
the firm persons whose abilities would
improve its management. The latter
method, finding investors willing to take
an interest in the firm, brings in equity
capital with greater speed, but involves
many difficulties.
The first obstacle in the way of external equity financing of small business is to be found in the organization
of the capital market. As has been emphasized above, its present machinery
meets the needs of large firms in the national market, but excludes the others.
There are no specific small-business
financing facilities except in those cities
with so-called "industrial foundations,"
and none of them are in California.
Equity capital for the small firm depends upon informal "catch-as-catchcan" financing.
A second obstacle is to be found in
the attitudes of investors. The twin
objectives of security and liquidity,
which are more readily obtainable in
widely traded, seasoned corporate issues
or government bonds than in the shares
of a small firm, are of such dominant
importance that only a speculative
buyer can be persuaded to purchase the
issue of a small business. The speculative attitude nevertheless dominates the
small-business capital market, and the
result is a heavy burden on the firms
which must depend upon it. The sale
of an equity involves either the payment of a high rate of return, approximately a speculative profit, an opportunity for a quick turnover with such a
profit, or a share of ownership (and
usually control) so large as to constitute

a gross overvaluation of the funds provided. It is not surprising that many


small-business proprietors regard equity
capital from outside as unavailable or
impossibly expensive.
PROPOSALS FOR IMPROVEMENT

Proposals for the improvementof the


capital market take essentially two
forms, those contemplating the refinement and extension of existing institutions, and those looking toward the
creation of publicly financed and controlled agencies. With respect to these
alternatives the writer has four recommendations:
1. The creation of voluntary, community-sponsored business financing corporations on the pattern of the "industrial foundations"should be encouraged.
A major function of these agencies
should be the provision of a meeting
ground for investors and businesses in
need of funds. The contracts between
such parties should be uniformly drawn,
with their major provisions subject to
the decision of the agency. The existence of this service should be widely
publicized, and every effort should be
made to draw the attention of investors
to local opportunities. This proposal
envisions a practice somewhat different
from that of the existing foundations,
which are investment trusts rather than
clearing houses. An agency of the type
suggested should not be difficult or expensive to operate, and it should succeed, perhaps after an initial period of
subsidized operation, in bringing funds
to businesses in need of equity capital
at a far lower cost than that now required of small firms.
2. Banking institutions should make
available research, advisory, and management services which will permit them
to liberalize lending with little hazard to
liquidity.
3. Banks should create joint loan insurance funds in a form somewhat like

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PROBLEMS OF THE POSTWAR CAPITAL MARKET

a credit pool to permit the liberalization


of lending practices, especially with respect to term and installment loans.
4. The question of publicly financed
and managed agencies should be made
the subject of further study to be undertaken in the light of the success of
the voluntary measures proposed and
in consideration of the probable (or
possibly demonstrated) effects of pend-

259

ing Federal legislation to extend the


lending services of the Reconstruction
Finance Corporation to equity investments in small businesses.
And we must conclude with a recommendation bearing on a subject to
which this paper has given little attention: a careful examination should be
made of the tax structureand its impact
on investment.

Cecil L. Dunn, Ph.D., is associate professor of economics and chairman of the Department of Economics and Sociology, Occidental College, Los Angeles, California. The
present paper is an outgrowth of a study made under the direction of Dr. John B. Condlife and Dr. Frank L. Kidner for the California State Reconstruction and Re-employment
Commission on a temporary appointment as Research Fellow of the Bureau of Business
and Economic Research of the University of California, Berkeley.

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