1960, Bogen, The Causes and Effects of Higher Interest Rates PDF

The causes and effects of higher interest rates, by Jules I.
Bogen
and Paul S. Nadler. A banking research program study by the Graduate
School of Business Administration of New York University.
Bogen, Jules I. (Jules Irwin), 1903-1963.
New York, 1960
http://hdl.handle.net/2027/mdp.39015031382560
Generated for Aidan Thomas McLoughlin (Northwestern University) on 2015-07-10 14:46 GMT / http://hdl.handle.net/2027/mdp.39015031382560
Public Domain, Google-digitized

Public Domain, Google-digitized / http://www.hathitrust.org/access_use#pd-google
http://www.hathitrust.org/access_use#pd-google
We have determined this work to be in the public domain,

meaning that it is not subject to copyright. Users are
free to copy, use, and redistribute the work in part or
in whole. It is possible that current copyright holders,
heirs or the estate of the authors of individual portions
of the work, such as illustrations or photographs, assert
copyrights over these portions. Depending on the nature
of subsequent use that is made, additional rights may
need to be obtained independently of anything we can
address. The digital images and OCR of this work were
produced by Google, Inc. (indicated by a watermark
on each page in the PageTurner). Google requests that
the images and OCR not be re-hosted, redistributed
or used commercially. The images are provided for
educational, scholarly, non-commercial purposes.
HB
54-5
B67
m.
875,804
^^^^^^^^^^^^^^^m
AllTES
I
SCIENTIA
VEBI
f**
The Causes and Effects of
Higher Interest Hates
i Banking Research
Program Study by the
Graduate School of Business idministration of
\ri< York I
Directed by Dr. Jules I. Bogen, Professor of Finance
^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^H
The Causes and Effects of
Higher Interest Hates
by: Jules V. Bogen
PROFESSOR OF FINANCE,
GRADUATE SCHOOL OF BUSINESS ADMINISTRATION
NEW YORK UNIVERSITY
and
Paul S. Nadler
ASSISTANT PROFESSOR OF BUSINESS ADMINISTRATION,
SCHOOL OF BUSINESS ADMINISTRATION
RUTGERS UNIVERSITY
5 45"
l&-2of 3^3
Preface
The rise in interest rates of the past few years has presented
questions and problems which are unfamiliar to a generation
of Americans accustomed to the low interest rates of the
depressed 1930's and the pegged interest rates of the 1940's.
The Graduate School of Business Administration, as part of

its continuing program of research into key economic problems,
has sought in this study to analyze the causes of the rise in
interest rates and its effects on the major classes of borrowers,

as well as on the economy as a whole. Consequences likely
to follow the adoption of measures that have been proposed
to hold down interest rates are analyzed, and experience with
such expedients in other countries summarized.
The emphasis in this study has been placed upon the under
lying demand and supply forces in the market for loanable
funds, rather than on central bank policy which must adapt
itself to these underlying forces and which affects directly but
one major source of the supply of funds, the commercial bank
ing system.
This research project was planned and conducted by Dr.

Jules I. Bogen, Professor of Finance at the Graduate School
of Business Administration, and Dr. Paul S. Nadler, Assistant
Professor at the School of Business Administration of Rutgers
University. They were ably assisted by research personnel of
the Graduate School.
The Graduate School of Business Administration received

a grant from the Association of Reserve City Bankers to finance
this research project. The assistance of the Association is
gratefully acknowledged.
Joseph H. Taggart
Dean, Graduate School of

Business Administration
March 15, 1960

TABLE OF CONTENTS.
Page
Preface
I. The Behavior of Interest Rates 7
II. Causes of the Post- War Rise in Interest Rates 9
III. Effects of Higher Interest Rates on Borrowers 15
IV. The Effect of Higher Interest Rates on the

Economy 21
V. Alternatives to Higher Interest Rates 25
VI. Higher Interest Rates and Commercial Banks 31
Vn. Interest Rate Behavior in Other Countries 33
Summary and Conclusions 37

I The Behavior of Interest Rates
Wide fluctuations have characterized the be Duration
Period (Years) Economic Characteristics
havior of interest rates throughout economic his
1927-1933 6 The boom of the late
tory. 1920's and its aftermath
1946-1959 13 Rapid expansion following
During the hundred years 1859-1959, as World War II
shown on Chart I, there were four periods of The periods of falling or low interest rates and
rising or relatively high long-term interest rates, their salient economic characteristics were:
as measured by long-term bond yields, and four Duration
periods of falling or relatively low long-term in Period (Years) Economic Characteristics
1859-1864 5 Check to economic growth
terest rates. The periods of rising or high long-
due to Civil War
term interest rates and their salient economic 1873-1905 33 Savings and funds from
characteristics were: public debt redemption
outpace demand for funds
Duration 1920-1927 7 Increased volume of
Period (Years) Economic Characteristics savings and redemption
of public debt swell
1864-1873 Rapid expansion of post-
Civil War period supply of funds
1933-1946 14 Depression of 1930's and
1905-1920 15 Expansion and inflation of wartime "pegging" of
World War I period interest rates
PER CENT
11.0
10.0
9.0
6.0
7.0
6.0
5.0
"** i L
4.0
3.0
2.0
1.0
CHAICE
SOURCE:AMERICANRAILROADBONDS,MACAULEY 0F BONOYIELDS,MOODY.S
SOURCE:AAA CORPORATE
SE«its
1859 1864 1869 1874 1879 1884 1889 1894 1899 1904 1909 1914 1919 1924 1929 1934 1939 1944 1949 1954 1959
CHART I.
LONG-TERM BOND YIELDS, 1859-1959
Sources: 1859-1919 — Index ofyields on American railroad bonds, from F. R. Macauley, "The Movements of Interest Rates,
Bond Yields and Stock Prices in the United States Since 1856," National Bureau of Economic Research,
1938, pp. A141-157.
1919-1959 — Average yield on Aaa corporate bonds, Moody's Investors Service.
7
Short-term interest rates, more sensitive to erate a vigorous demand for funds. Conversely,
changes in economic conditions, have similarly interest rates fall in periods of depression, when
reflected the trend of business activity, in peace the demand for funds contracts.
time the chief determinant of the demand for The one major exception to this tendency oc
short-term funds. The behavior of prime com curred in the 1940's, when interest rates were
mercial paper rates over the century 1859-1959
pegged at the level prevailing during the depressed
is shown in Chart II. In their study of 19 1930's through the readiness of the Federal Re
periods of business expansion between 1854 and serve banks to purchase all Government securi
1933, Burns and Mitchell found that commercial
ties offered them at or above par. The pegging
paper rates rose in 18 instances and declined in of interest rates led to a near tripling of the
only one. Similarly, in 20 periods of business nation's money supply, a development that was
contraction, they found that commercial paper
the root cause of the rise of more than 100% in
rates declined in 17 instances and rose in three.
the cost of living that occurred during the 1940's

The experience of the past century has shown and 1950's. Inflation was the price paid by the
that both long-term and short-term interest rates nation for wartime Treasury financing at pegged
tend to rise in periods of prosperity, which gen low interest rates.
CHART II.
SHORT-TERM INTEREST RATES, 1859-1959
PER CENT
12
k
V
J1
V k
\\V V i
A
h
SJ S\ 4 A
T,A.
\
A
/viA
t
r L[A
V
•
A
U1/
M
K\
II
n
/>
i
r
1
HE* SERIES
-o»;t
1925-
1859 1864 1869 1874 1879 1884 1889 1894 1899 1904 1909 1914 1919 1924 1929 1934 1939 1944 1949 1954 1959
Sources: 1859-1923 — Average monthly rate on choice 60-90 day two name paper, from Macauley, op. cit., pp. A141-158.
1924-1925 — Average monthly rate on 4-6 month prime paper, from Macauley.
1925-1959 — Average of daily rates, prime bankers acceptances, 90 days, from Federal Reserve Bulletin.
8
II Causes of the Post-War Hise in Interest Hates
Interest rates, after declining abruptly during at a compounded rate of 3.2% per annum during
the Great Depression of the 1930's and being these 14 years. Economic growth at this rate
pegged at a low level by the Federal Reserve requires borrowing on a vast scale to finance
banks during World War II, have been in a ris expansion of both production and consumption.
ing trend since 1946.
2. Inflation of the price level. The near
Interest rates are the prices paid for the bor
doubling of the level of commodity prices during
rowing of money. Like all prices, they rise and
these 14 years correspondingly increased the
fall in response to changes in demand and sup
sums that had to be borrowed to finance the
ply. The causes of the rise in interest rates since
acquisition of assets for both production and con
1946 are to be found in the post-war changes
sumption.
that have taken place in the demand for and sup

ply of loanable funds. In addition to these two basic developments
which swelled the demand for funds, powerful
The Huge Demand for Funds economic and social influences have greatly in
creased particular kinds of borrowing.
The prime cause of the rise in interest rates
that began in 1946, and that was markedly ac Debt is divided into four major classes in the
celerated during the decade of the 1950's, has statistics compiled by the Department of Com
been the huge demand for loans that developed merce. The increase in each class of debt be
in the post- World War II era. tween the end of 1945 and 1959 was as follows
(in billions):
Private and public debt outstanding increased
%of
from $406 billion at the end of 1945 to over 1Outstand Outstand Total Debt
ing End ing End Increase Increase
$827 billion at the end of 1959, according to the Type of Debt oJl945 of 1939 1946-1959 for Period
U. Department of Commerce (estimate for

S. Business debt (in
1 959 by the Council of Economic Advisers ) . In cluding farm
production
the 14 years 1946-1959, the increase in debt in 88 44
loans) $ $275 $187
this country was thus larger than during the en
Mortgage debt ... 36 191 155 37
tire history of the United States to the end of
1945. A
doubling of debt in so short a time
Consumer and
personal finan
inevitably exerted strong upward pressure upon cial debt 16 63 47 11
interest rates as borrowers sought funds in such
Government debtf 266 298 32 8
huge volume.
Total debt $406 $827 $421 100
Two economic developments have swelled the
demand for funds in the post- World War II years, t Outside of $27 billion increase in Federal debt held
by U. S. Government trust funds and agencies.
and so have tended to push the whole structure
of interestrates to higher levels. These have Demand for Funds by Business
been:
Business debt was expanded from $88 billion
1. The rapid growth of the American econ at the endof 1945 to $275 billion at the end of
omy. Gross national product at constant prices, 1959, more than a threefold increase. This ex
which measures the volume of output of goods cludes real estate mortgage loans of businesses,
and services by the nation's economy, expanded which are included with mortgage debt.
The borrowing needs of American business 3. The intensified desire for home ownership
during this period have been magnified by: that has been fostered by high personal incomes,
automobile transportation and increased leisure.
1. Expenditures aggregating $370 billion on
new plant and equipment to expand and modern Consumer Credit
Demand for
ize the nation's productive facilities. The great
technological advances of the post-war era also Consumer debt increased from less than
have made necessary plant and equipment out $6 billion in 1945 to $52 billion at the end of
lays on an unprecedented scale to produce new 1 959. The ninefold rise reflected:
products and services.
1. Greatly increased purchases of durable
2. A tripling of business inventories. goods by consumers.
3. A fourfold expansion of accounts receiv 2. The use of credit to finance consumer pur
able due to the widening use of trade credit, par chases on a far larger scale by a much greater
ticularly by small business and consumers. proportion of the population due to the general
rise in the size and stability of personal incomes.
Mortgage Funds As a result, people have been willing to borrow

Demand for
for consumption and lenders have been ready to
While business debt expanded threefold be lend for this purpose on a scale never contem
tween 1945 and 1959, mortgage debt was almost plated before.
five and one-half times as large at the end of
1959 as at the end of 1945. Nearly three-fourths
Liberalization of credit terms and wide
3.
of the growth in mortgage debt was accounted
spread advertising by lenders, particularly for
for by the increase in mortgages on 1-4 family purchases of automobiles and other consumer
houses. durables.
Home mortgage borrowing in the post- World
War II years was stimulated by: 4. The great increase in the number and
variety of consumer lending institutions.
1.Ready availability of FHA insurance and
VA guarantees of home mortgages. Never before
has the Federal Government used its credit to

Government Borrowing
stimulate private borrowing on a scale remotely The increase in Government debt between
resembling the FHA and VA programs. The 1945 and 1959 was concentrated in the state
results have been a broadening of the institutional and local sectors, which experienced a fourfold
market for mortgages and a liberalization of lend expansion. Federal debt held outside Govern
ing terms as lending institutions have shifted ment trust funds and agencies increased rapidly
emphasis from the quality of the loan to the only in 1958 and 1959, while there was a sub
underwriting by the Federal Government. stantial decline in the years immediately following
the end of World War II
as excess cash balances
2. The growth in the market for homes. A of the Treasury and budget surpluses were used
37% expansion in the number of households to retire debt.
occurred between 1945 and 1959, while large-
scale shifts of population, especially to the Expanding demands for schools, roads and the
western and southern states, further swelled the many other public facilities required by a growing
need for new homes. population and rising standards of living have
10
Increase In
put strong pressure on state and local governments Loans and Loans and Loans and
Class ol Saving or Bonds Held, Bonds Held, Bonds Held,
to incur more debt. Investing Institutions End of 1945 End ol 1959 1946-1959
(in billions)
The Sources of Supply of Fundi Life insurance companies $41 $101 $60
Savings and loan associ
The effect of an increase in outstanding debt
ations 8 58 50
upon interest rates depends in large measure Commercial banks (in
upon the sources from which the funds are crease in savings and
obtained by borrowers. other time deposits
only) 30 66 36
Of the
increase in business debt of $187 billion
Mutual savings banks 16 38 22
between 1945 and 1959, some $70 billion or
State and local govern
almost two-fifths represented an increase in ac ment investment funds 8 30 22
counts payable to trade creditors and in expense Corporate pension funds 2 16 14
accruals. An increase in this type of debt does Fire and casualty insur
not affect interest rates

directly. Similarly, ance companies 4 14 10
Credit unions *
about $10 billion or over a fifth of the $46 billion 3 3
increase in consumer debt was held by retailers. Total $109 $326 $217
Another $15 billion of consumer borrowing was * $300 million.
provided by sales and other finance companies
that borrow the funds as businesses in order to Savings flowing through these eight classes of
relend them to consumers, and so is counted twice financial institutions thus provided only two-
in the debt statistics. thirds of the additional loanable funds required
by the American economy during these 14 years.
Deducting tratie payables, expense accruals
and sums owing financing company intermedi
Commercial Bank Credit Expansion
aries, the volume of added debt incurred by the
in 1946-59
period approximated
A second source of loanable funds is credit
economy the
expansion by commercial banks over and above
$326 billion. These sums were obtained by bor
the increase in their savings and other time de
rowers from three main sources — savings institu
posits.
tions, commercial bank credit expansion and
individual and miscellaneous investors. Commercial banks function like other savings
The effect of the demand for loans upon in institutionswhen they receive savings deposits
that are loaned out or invested in bonds. But
terest rates depends to a large extent upon the

relative proportion of funds that is drawn from when they expand loans and investments in an
each of these three sources, and particularly the amount that exceeds their gains in savings de
third: individual and miscellaneous investors. posits,an increase in demand deposits results
which tends to monetize the growth of debt.
Institutional Savings During the 14 years 1946-59, commercial
By far the largest source of loanable funds in banks expanded their loans and investments by
our economy are the savings that are loaned out $67 billion. Since their savings and other time
or invested in bonds through financial institutions. deposits increased by $36 billion in that period,
In the 14 years 1946-59, some $217 billion, or as shown in the table above, bank credit expan
67% of the $326 billion increase in net borrow sion in excess of the gain in savings deposits pro
ing, was provided by eight classes of savings and vided $31 billion of additional loanable funds.
investing institutions. The contribution of each Including billion expansion in the Gov
the $3
class of institution to the supply of loanable funds ernment security portfolio of the Federal Reserve
during this period was as follows: banks, financial institutions, inclusive of the corri
11
mercial banking system, supplied $251 billion demand for loanable funds and the supply from
for the borrowing needs of the economy during savings institutions and commercial banks, there
these 14 years. fore, substantially higher interest rates must be
There thus remained a "gap" between the in offered. The return offered must be high enough
stitutional supply of loanable funds and the total to be regarded as a real "bargain" by the investor.
demand of some $75 billion that had to be filled The nation-wide rush of individuals to subscribe
by attracting funds from individuals and miscel to the Treasury's offering of 5% notes in Octo
laneous investors such as foreign banks and busi ber, 1959, after a long period of apathy to direct
ness corporations having liquid funds for invest investment in Government obligations, was a
ment. dramatic illustration of this tendency, so much
so that the issue was dubbed the "magic fives".
The Effect on Interest Rates
Savings institutions, which credit interest on and special groups of investors
Individuals,
funds entrusted to them for the time held, are such as foreign banks and corporations having
under pressure to invest promptly the money they investable balances, provide the marginal source
receive. As a result, they are eager to keep fully of loanable funds in the capital market. They
loaned up or invested. When these institutions can be attracted in large numbers into the bond
receive savings in volume sufficient to satisfy the and mortgage markets only by substantial in
bulk of the demand for funds, therefore, interest creases in interest rates. During 1959, for ex
rates will be low because institutional investors ample, individuals, including personal trust ac
will readily absorb the available supply of bonds counts, increased their holdings of U. S. Gov
and mortgage loans. ernment securities by some $6 billion, business
Commercial banks similarly are eager to ex corporations by over $5 billion and foreign
accounts by almost $4 billion in response
pand loans and investments when they possess
reserves substantially in excess of legal reserve
to the attraction of the sharp advance in
yields on such issues in that year. When top
requirements, especially when this is accom
panied with ample liquidity and a relatively high grade obligations give high yields, savings insti
tutions in turn are placed under pressure to raise
ratio of capital funds to risk assets. Under such
circumstances, bank lending rates also will be the rates of return they pay to discourage large-
scale withdrawals of funds by savers who are at
relatively low.
tracted to the bond market.
If savings institutions and commercial banks
together are in position to satisfy the bulk of the

demand for loanable funds, therefore, interest Federal Lending Agencies
rates will tend to be relatively low. Such a situa Of the savings "gap" of $75 billion between
tion prevailed during the 1930's. domestic demands for loanable funds and the
Individual investors, on the other hand, are supply from all financial institutions for the years
under no such pressure to invest in bonds and 1946-1959, $13 billion was provided by Federal
mortgages. The great majority of individuals lending agencies like the Federal National Mort
ordinarily place their savings in financial institu gage Association and the Commodity Credit Cor
tions or, where they invest directly, buy equities poration. Since their lending is determined by
or real estate. Moreover, once a pattern of per political and social rather than financial consid
sonal saving habits has been established, there is erations, there is not the same direct effect upon
as a rule considerable reluctance to change. interest rates paid by the borrowers as when an
To attract a larger volume of savings from in equal volume of funds must be attracted from
dividuals when a wide gap exists between the private lenders or investors.
12
The chief impact of an expansion of lending Commission (derived from S.E.C. estimates of
by Federal agencies upon interest rates is to re individual purchases of all securities for years
quire an increase in borrowing by the Treasury before 1952):
or the Federal agencies concerned. At a time Net Purchases of Bonds
by Individuals
when total demands for funds exceed the avail Year (in billions)
able supply, loans by Federal agencies that would 1946 $0.6
not be made otherwise do widen the savings 1947 3.1
"gap" and so add to the pressures lifting interest 1948 2.8
rates high enough to attract individual investor 1949 2.6
1950 1.4
purchases of Government or Federal agency se
1951 —0.9
curities in the required volume. 1952 2.3
1953 2.9
Sources of Funds and Interest Rate Changes
1954 —0.5
A close correlation exists between the volume 1955 5.4
of funds that must be attracted from individual 1956 3.7
and miscellaneous investors to balance the supply 1957 5.2
1958 —0.8
of loanable funds with the demand and the direc
♦1959 10.0
tion of interest rate movements.
* Based on 9 months S. E. C. estimate.
Net purchases of bonds and other fixed inter
est securities by individuals since 1946 were esti Chart III
compares the supply of loanable
mated as follows by the Securities and Exchange funds from institutional and individual investors
CHART III.
INSTITUTIONAL AND INDIVIDUAL INVESTORS AS SOURCES OF LOANABLE FUNDS, 1946-1959
$ BILLIONS
36
ipd
12
NET PURCH/SESOFBOND
L INVESTORS
BYINDIVIDIH
NETINCREASESI LOANS
ANDBONDHOLDINGS
BY INSTITUTIONAL
INVESTORS
II
1946 1947 1948 1949 1950 1951 1952 1953 1954 1955 I95S 1957 1958 1959
Institutional investors include insurance companies, savings and loan associations, mutual savings banks,
corporate pension funds, state and local investment funds, credit unions and the increase in savings and other
time deposits of commercial banks.
Individual investor net bond purchases as estimated by the Securities and Exchange Commission.
13
for the 14 years 1946-1959. The marginal role ceeds the institutional supply is the chief reason
of individual investors in bonds is evident. In for the marked volatility of interest rates.
1958, for example, when it was not necessary to
A second reason is the inelastic character of
draw funds from individual investors because in
the demand for loanable funds.
stitutional savings and commercial bank credit
The demand for any good or service is said to
expansion sufficed to satisfy the demands for
be elastic when it responds promptly to a change
funds, individuals were not sellers of bonds as
in price. Such an elastic demand pattern tends
yields declined to discouragingly low levels. Con
to narrow price fluctuations, since a rise in price
versely, in 1959, when the demand for funds ex
curtails demand and a lower price spurs buy
panded sharply and far exceeded the supply from
institutional and commercial bank sources, bond ing. Thus the demand for steak is elastic because
housewives will step up buying when the price
purchases by individuals reached much the high
est level in the 14-year period and established a drops, but will shift purchases to other foods
as the price rises. This elasticity of demand less
new high record for a peacetime year.

ens price fluctuations for steak.
Net bond purchases by individuals and fluctua
tions in the average yield of marketable long- The demand for loanable funds is inelastic,
term taxable U. S. Government bonds are com since it usually shows little or no response to
pared on Chart IV for the period since 1951, changes in interest rates. Because the demand
when the pegging of Government bond prices by is inelastic, interest rates can advance sharply
the Federal Reserve banks was ended. without discouraging
borrowing substantially,
and decline abruptly without stimulating much
The Volatility of Interest Rates expansion or borrowing.
The need for offering rates of return high The reasons why the demand for borrowed
enough to attract individual investment funds in funds is so inelastic are clarified in the follow
greatly increased volume into the bond market ing section, which analyzes the effects of higher
when the demand for loanable funds largely ex interest rates upon the major classes of borrowers.
CHART IV.
NET BOND PURCHASES BY INDIVIDUALS AND U. S. GOVERNMENT BOND YIELDS, 1951-1959
$ BILLIONS PERCENT
10 4i
14
Ill Effects of Higher Interest Hates on Borrowers
An increase in interest rates, as was seen in ing companies were at an annual rate of over
the preceding section, is a symptom of an under 23% before taxes and 12.5% after taxes on
lying condition, an excess of demands for funds stockholders' equity, according to estimates of
over the available supply. the Federal Trade Commission and Securities
and Exchange Commission.
Compared to such
Higher interest rates impose little added bur
average rates of profit, even the highest rates of
den on most borrowers because of factors which
interest that have been charged on business loans
modify or neutralize their effect. The factors
by banks have been moderate, and have not
are analyzed in this section.
been a deterrent to borrowing for expansion or
When boom conditions in the economy cause modernization.
the demand for loans to expand far beyond the
2. The very high corporate income tax rates

available supply of funds, even sharply higher
interest rates will not attract sufficient lenders largely neutralize the effect of increases in inter
to satisfy all would-be borrowers. est rates, since interest payments are deducted
Those who
are not able to obtain the loans they want are from taxable income. Money borrowed at 6%
affected by unavailability involves a net cost after the 52% Federal income
of funds, rather than
tax of only 2.88% to the corporation. Com
by the increase in interest rates. Many of the
menting on the influence of high taxes on the
complaints against high interest rates are actu
cost of business borrowing, a study of the Office
ally directed at the unavailability of funds to
some borrowers.
of Business Economics of the Department of
Commerce concluded:
In analyzing how higher interest rates affect
the several classes of borrowers, the conse Long-term borrowing costs to corpora
quences of both the increased cost of borrow tions are not far from the average prevail
ing and the limited availability of funds which ing in the twenties, and a number of par
caused the cost to go up must be taken into ticular rates are currently above those
account. reached in that earlier period. It must be
noted, however, that the net borrowing costs
Effects on Business Borrowers to corporations may still be considered
American business enjoyed rapid growth and relatively low in historic perspective if one
attained new profit records during the 1950's takes account of the higher tax rates cur
in the face of a major rise in interest rates. The rently prevailing. Since interest is deduc
most prosperous years, such as 1957 and 1959, tible for tax purposes, the net cost to cor
were those in which interest rates reached their porations in terms of after-tax earnings is
highest levels in a quarter century or longer. roughly halfthe nominal rate, since the
tax on profits is close to 50 per cent. The
The impact of higher interest rates on busi
comparable tax in the twenties ranged
ness borrowers is minimized by two factors:
around 10 per cent of profits.1
The cost of borrowing, even when inter
1.
Despite the great increase in business debt and
est rates are high, is quite low by comparison
the rise of interest rates since 1946, interest pay
with the prevailing rate of profit earned on
ments absorbed only 13% of profits before in
capital funds by business when conditions are
1 B. Kenadjian and Gardner F. Derrickson, "Business Fi
favorable. In the prosperous second quarter
nancing in 1959", Survey of Current Business, October,
of 1959, for example, profits of all manufactur 1959, p. 15.
15
come taxes of business corporations in the first The Board of Governors of the Federal Re
half of 1959. In the late 1920's, interest pay serve System, in surveys of business loans on
ments were almost 30% of such profits. The October 5, 1955 and October 16, 1957, found
current burden of interest payments is further interest rates on loans of one year or less com
reduced by the greatly increased cash flow from pared as follows for borrowers of different size:
depreciation allowances, which exceeded $20
billion for all corporations in 1959 or about Size of Borrower Net Increase
(Assets in thousands 1955 1957 1955-1957
three times aggregate interest payments of busi of dollars) % % %
ness corporations. All sizes 4.2 5.0 0.8
Less than 50 5.5 6.1 0.6
Availability of Funds to Business 50-250 5.0 5.6 0.6
That availability of funds rather than the cost 250-1,000 4.6 5.4 0.8
is the chief consideration of business borrowers 1,000-5,000 4.1 5.1 1.0

is indicated by the market expansion of factor 5,000-25,000 3.7 4.8 1.1
ing and accounts receivable financing that
25,000-100,000 3.4 4.6 1.2
occurred during the 1950's. The volume of
100,000 or more 3.2 4.4 1.2
funds advanced by factors and commercial
finance companies increased almost threefold
from the end of 1949 to the end of 1959, despite "Between the summer of 1955 and the sum
costs of such financing and related service mer of 1957", the Federal Reserve Bulletin
ranging from 10% for accounts receivable concluded from this survey, "when average in
financing and 12% for factoring to substantially terest rates on all new loans rose from 4.2 to
higher figures in most cases. 5.0 per cent, average rates on short-term loans
to large borrowers rose twice as much absolutely,
All classes of business borrowers can turn to and even more relatively as on loans to small
a number of alternative methods of financing borrowers. . . .
if sufficient funds cannot be secured through
usual borrowing channels. These include greater "During this two-year period, bank require
retention of profits, sale of preferred or common ments that borrowers maintain compensating
stock, the leasing of assets in lieu of purchase balances also became more widespread and more
and contracting for additional production in stringent. Since these requirements apply
lieu of expanding the enterprise's owned mainly to large borrowers, it is likely that differ
capacity. ences in effective interest rates charged large and
small borrowers narrowed even more than the
pure interest rate data indicate".2
Effects on Small Business
It has been asserted that a period of high With respect to availability of bank credit, the
interest rates affects small business much more Federal Reserve survey found that "between
than large, on the ground that the latter are 1955 and 1957 loans to large businesses in most
favored by lenders at a time when the demand industries expanded much more in dollar volume
for funds outpaces the supply. than loans to smaller businesses". The dollar
volume of loans increased as follows for business
Surveys of business financing during periods borrowers of various size groups:
of rising interest rates and credit stringency indi
cate this is so only to a limited degree, if at all. 2 Federal Reserve Bulletin, April, 1958, pp. 393-411.
16
Percentage crease in the use of liberal sales credit policies
Size of Borrower Change in
(Assets in thousands Amount of Loans, and terms as a competitive weapon by larger
of dollars) 1955-1957
concerns at a time when loanable funds have
All borrowers 31.9
been less available. In addition, smaller busi
Less than 50 — 3.0
nesses have been aided in financing their re
50-250 16.7
quirements by separate sales finance subsidiaries
250-1,000 24.8
that have been set up by a number of large
1,000-5,000 21.3
road building, printing and other equipment
5,000-25,000 24.7
25,000-100,000 51.1
manufacturers. Another development that has
100,000 and more 66.4 lessened the impact of tight money has been the
very rapid spread of the practice of leasing,
The Federal Reserve Bulletin added, however, rather than buying, machinery and equipment
that in classifying businesses for this analysis no
by small as well as large concerns.

allowance was made for the growth in assets of
most concerns between 1955 and 1957. Hence, One indicator of the effect of higher interest
"some borrowers classified in 1955 in the smallest ratesand lessened availability of borrowing for
asset group (under $50,000) undoubtedly were small business is the number of concerns in
classified in larger size groups in 1957". operation. The Department of Commerce re
The Federal Reserve Survey also found that ports there were 3,941,000 businesses, chiefly
small concerns, in operation at the end of 1949,
"large banks generally expanded their loans to
small and medium-sized businesses more than and 4,666,000 at the end of 1959, an increase
smaller banks". An American Bankers Asso of 725,000 during a decade of rising interest
rates. Between June, 1956 and June, 1957, a
ciation survey in 1957 indicated that the large
majority of bankers felt that small businesses period of credit stringency, the number of busi
nesses in operation increased by 35,000. The
were generally getting the credit to which they
were entitled, despite the prevailing tightness of number increased by 63,000 in the first nine
months of 1959, when interest rates advanced
money.
substantially. The evidence shows that influ
A significant development that has greatly ences other than the level of interest rates or
reduced the impact of higher interest rates and of loans determine the number of
availability
lessened availability of bank credit on small and
businesses in operation.
medium-sized business has been the largely in
creased amount of trade credit and instalment about the inadequate
Complaints availability
credit utilized by such concerns. The Quarterly of funds to small business have been chronic,
Financial Report for Manufacturing Corpora long pre-dating the period of rising interest rates
tions, issued by the Federal Trade Commission in the late 1950's. Inquiries into this question by
and Securities and Exchange Commission, shows bodies and economists have shown
Congressional
that the excess of accounts receivable over ac that a lack of long-term funds and equity capital,
counts payable of all manufacturing corporations rather than short-term loans, in the chief finan
increased by $5.7 billion between 1954 and 1958. cial problem of small business. Congress has
Unincorporated businesses were the chief benefi recognized this problem by enacting the Small
ciaries of this great increase in the net amount of Business Investment Act of 1958 under which a
trade credit extended by manufacturing corpo number of small business investment companies,
rations.
organized in most cases by banks and finance
The growing excess of accounts receivable companies, have been licensed by the Small
over accounts payable has reflected a marked in Business Administration.
17
Effects on Mortgage Borrowers interest rates, more than are other classes of
borrowers. As a result, bitter complaints about
Rising interest rates did not lessen the demand
the impact of tight credit conditions on the mort
for homes and for mortgage borrowing during
gage market have been registered by home build
the 1950's, which was maintained throughout
ers legislators and Government housing
with
the decade at levels never reached before 1950.
Builders usually require forward com
officials.
Mortgage debt on 1-4 family homes registered
mitments from lending institutions to take up
much the largest increase on record in 1959,
mortgages on the homes they plan to build and
when interest rates on mortgages rose to the high
sell before starting on a new housing develop
est level in many years.
ment. Inability to arrange mortgage commit
A number of developments in mortgage lend ments thus prevents builders from proceeding
ing have lessened the effect of higher interest with planned developments.
rates on the borrowers. These include:

The chief handicap of mortgage borrowers
The higher ratio of mortgage loans to
1. in competing for funds in a period when the
property values, which lessens down payments demand for loanable funds exceeds the supply
required from home buyers. With the universal is the absence of a broad market for mortgages
adoption of the amortized mortgage, a large among individual investors such as that which
down payment has become a much greater finan exists for Government, tax-exempt and corpo
cial burden to home buyers than the modest rate obligations. Some individuals habitually
increase in monthly payments caused by a higher invest in mortgages, but even the relatively small
interest rate. number who do so want individual mortgage
loans. Hence, once the institutional supply of
2. of mortgage maturities.
Lengthening As
funds seeking mortgage outlets has been ex
repayment of principal is spread over a longer hausted, would-be borrowers cannot turn to
period with 25 and 30 year mortgages, monthly individual investors to attract additional funds in
amortization is reduced. This offsets the effect
large volume as do issuers of bonds.
of an increase in mortgage interest rates upon the
monthly payments required of home owners. Evenamong financial institutions, mortgages
have appealed to four groups — savings and loan
3. Rising personal incomes. An increase in
associations, life insurance companies, commer
family income enables home owners to carry

cial banks and mutual savings banks. Such fast
larger periodic mortgage service payments,
growing institutional investors as corporate pen
whether due to an increase in the principal
sion funds and state and local retirement funds
amount borrowed, higher interest rates, or both.
have not acquired mortgages in large amounts to
The rising trend of personal incomes has made
date because of the greater convenience of invest
increased interest rates much less of a deterrent
ing in bonds. This further limits the ability of
to home mortgage borrowing.
mortgage borrowers to tap additional funds when
The effect of higher interest rates on multi- the "big four" mortgage lending institutions can
family and commercial mortgage borrowers is not keep pace with the demand for such funds.
reduced by the same factors that lessen their
Availability of mortgage loans has been lim
impact on business borrowers.
ited also by artificial interest rate ceilings on
FHA insured and VA guaranteed mortgages.
Availability of Mortgage Funds
Such fixed interest rates, which have no logical
Mortgage borrowers are affected by lessened place in a free market economy, prevent bor
availability of funds, as distinct from higher rowers on Government-underwritten mortgages
18
from competing for funds on an equal basis lated on a net annual basis, the availability of
with other borrowers ready to pay higher inter such credit is affected only to a very limited extent
est rates when funds are in short supply. This by a rise in other interest rates. In fact, advo
is all the more true because life insurance com cates of selective controls over consumer credit
panies have been reluctant to acquire Govern cite the fact that consumer lending is so little
ment-underwritten mortgages at large discounts affected by changes in the cost or availability of
from face value for public relations reasons. In credit generally to support their claim that specific
periods of higher interest rates, therefore, bor controls of consumer credit terms are desirable
rowers find and VA mortgages particularly
FHA to make over-all monetary management more
hard and there is greatly increased
to place, effective.
resort to conventional mortgage loans in conse
quence. All
home mortgage borrowers are simi Effects on Federal Borrowing
larly handicapped in states where usury laws Higher interest rates increased interest pay
limit the rates that may be charged on such mort ments on the public debt from $4.7 billion or
gages to a level below prevailing yields available 7.8% of all Federal budget expenditures in 1946
to lenders elsewhere and on other investments. to $7.6 billion or 9.4% of total budget outlays in
the 1959 fiscal year. Of the $7.6 billion paid in
This inability to tap supplementary sources
interest in the latter year, $1.3 billion or 17% was
of funds to satisfy the demand for mortgage loans
paid to Treasury agencies. The balance of $6.3
explains why there is recurring agitation to ex
billion was paid to the millions of savers who own
pand mortgage buying by the Federal National
Government securities directly, and to the larger
Mortgage Association, and why builders and
numbers who have placed their savings in banks
mortgage bankers have sought to broaden insti
and insurance companies that hold Treasury ob
tutional investment
in mortgages by attracting
ligations in their portfolios. Since the interest on
pension funds and others to invest in mortgages
Government obligations is taxable for the most
on a larger scale. Solution of the prob
part, the net cost of borrowing to the Federal
lem of mortgage fund availability in times of
Government is reduced by the income taxes col
credit stringency may require the development
lected on the interest income received by investors
of instruments to facilitate large-scale direct in
in these issues.
vestment by individual investors in obligations
backed by real estate mortgages, as well as the Interest rates do not affect the volume of bor
broadening of institutional demand by increasing rowing by the Federal Government. The amount
the relative attractiveness of yields offered by of borrowing is determined rather by Congres
mortgage loans. sional actions on Federal spending and taxation.
A period of credit stringency affects Govern

Effects on Consumer Borrowers
ment financing by making it far more difficult for
Increases in the general level of interest rates the Treasury to sell issues of longer-term bonds
have virtually no effect on consumer borrowers, to investors other than commercial banks. Sales
since rates charged for consumer credit reflect of short-term Treasury issues to commercial
service as well as money costs. Charges for con banks in large volume result in an inflationary
sumer credit tend to be standardized, and changes expansion of bank credit that can seriously under
because of fluctuations in other interest rates are mine both economic and price stability, as the
quite infrequent. wartime experience demonstrated.
Because consumer credit charges are substan The Federal Government, despite its very high
tially higher than other interest rates when calcu credit rating, has found itself under a handicap
19
in bidding for savings through of long-term
sales by corporations from the corporate income tax,
obligations at times when demands for funds ex exemption from income taxation of interest on
ceed the available supply. stateand local but not on Federal obligations,
and ready availability of FHA insurance and VA
Business borrowers are able to outbid the
guarantees on mortgages enable these classes of
Treasury since the effective cost of borrowing to
borrowers to bid successfully for funds against
them is only 48% of the interest rate paid under
the Treasury when savings have not been ade
a 52% income tax with interest deductible from
quate for all would-be borrowers. The statutory
taxable income. Mortgage borrowers, through
4V4 % ceiling on interest rates on Treasury bond
FHA insurance or VA guarantees, can offer in
offerings imposed a serious added handicap on
stitutional investors obligations backed in effect
the Government's ability to sell long-term issues
by the credit of the United States Government
when the market level of high-grade bond yields
but yielding a higher rate of return than do direct
rose well above AlA % in 1959.
Treasury obligations. Stateand local govern

ments offer obligations on which interest is ex The Treasury has found, however, that it can
empt from income taxes. When the United attract liquid savings funds of individuals in vol
States Government seeks to sell bonds to investors ume during a period of credit stringency by offer
in large volume by offering higher rates of return, ing shorter-term obligations at yields substantially
therefore, other classes of borrowers are able to higher than those being paid by thrift institutions.
outbid the Treasury by raising the rates of return In 1959 and 1960, yields of 5% on short and
they offer. intermediate-term obligations attracted liquid
savings of individuals out of thrift institutions,
During the 1950's a decade when demands
since the latter could not pay competitive rates
for funds exceeded the supply, institutional in
because they hold chiefly long-term investments
vestors were large sellers of Government secur
acquired when interest rates were lower.
ities on balance because they found other bonds
and mortgages more attractive. Between the end
Effects on State and Local Government
of 1949 and the close of 1959, insurance com Borrowing
panies reduced their holdings of U. S. Govern The higher cost of borrowing has not inter
ment issues by over $8 billion and mutual savings
fered with a growing volume of financing by
banks by $4.5 billion. Sales of Government
State and local governments, as the following
obligations in such volume by these institutions

table shows:
substantially increased availability of funds to Average Gross Proceeds,
mortgage and corporate borrowers during this State and Local New State and
Government Municipal
decade. The Government obligations liquidated Bond Issues —
were absorbed chiefly by Treasury Year Yield— (%) (millions)
trust funds,
State and local government funds and foreign 1950 1.94 $3,532
1951 1.98 3,189
investors, which have not been significant sources
1952 2.22 4,401
of funds for private borrowers. 1953 2.82 5,558
1954 2.46 6,969
The United States Treasury's inability to sell
1955 2.57 5,977
long-term bonds in large volume to investors dur
1956 2.94 5,446
ing the 1950's thus resulted primarily not from 1957 3.56 6,958
the general rise in interest rates or an over-all 1958 3.36 7,449
unavailability of funds, but from the advantages 1959 3.74 7,681
that other borrowers have derived from tax and
Sources: Moody's Investors Service and Securities and Ex
housing laws. Deductibility of interest payments change Commission.
20
The volume of State and local government Net Purchases of
State and Local
financing reached record levels in the latter years Government Securities
by Individuals
of the 1950's when interest rates on such issues Year (billions)
had risen substantially. The need for new facili
1950 $0.7
ties such as highways, schools and the like, rather
1951 0.4
than the level of interest rates, has determined
1952 1.0
the volume of financing by State and local govern
1953 1.8
ments.
1954 0.6
Interest payments have accounted for only a 1955 1.6
quite small and very slowly rising proportion of 1956 1.5
State and local government expenditures. Total 1957 2.2
outlays of these governments have expanded 1958 1.2
with the growth of the economy, as the following
1959 f3.1
table shows:
Source: Securities and Exchange Commission.
State and Local Governments
Direct Interest Proportion of t Projection based on 9 months data.
'
Expenditures Payments Interest
Year (millions) (millions) Payments (%)
In 1959, when total demands for funds largely
1950 $27,905 $ 613 2.2 exceeded the available supply of loanable funds
1951 29,384 649 2.2 and interest rates rose to the highest levels in
1952 30,863 724 2.3 decades, individual investors absorbed well over
1953 32,968 798 2.4
half the estimated $5.3 billion net increase in
1954 36,607 916 2.5
State and local debt outstanding for the year.
1955 40,375 1,059 2.6
1956 43,152 1,220 2.8 It is true that higher interest rates have made
1957 47,634 1,365 2.9 financing with revenue bond issues of some mar
1958 53,857 1,523 2.8
ginal public works projects impractical because
Source: Bureau of the Census, annual report, Summary of the projected income would not cover the added
Governmental Finances, except expenditures for
1951 which were estimated. interest cost. Yet revenue bond issues in 1959,
the year when interest rates reached their highest
The expansion of State and local government level in many years, were the largest on record,
borrowing to peak levels in the late 1950's shows except for 1954 when a vast volume of turnpike
that funds have remained readily available to such financing was consummated on the basis of traf
borrowers. The reason has been the great appeal fic projections that proved overly optimistic in
that tax exemption of interest on these bonds some cases. Moreover, even some marginal proj
has for individual investors. Net purchases of ects that could not be financed separately have
State and local government obligations by indi been built where authorities could arrange to
viduals have been estimated by the Securities service the bonds sold to finance them with excess
and Exchange Commission as follows: revenues of other projects.
IV The Effect of Higher Interest Hates on the Economy

The well-being of the economy requires a each of these objectives of higher interest rates,
vigorous rate of growth, moderation of cyclical and particularly of the underlying cause of higher
fluctuations and reasonable stability of the price interest rates— a limited availability of funds
level. This section considers the impact upon because demands from borrowers exceed the
21
supply of loanable funds from savings and a level at which they were pegged at the end of
moderate rate of bank credit expansion. 1946 did not inhibit growth in real output of the
economy.
Interest Rates and Economic Growth
Influences other than the level of interest rates,
The historical evidence indicates that the level
it is apparent, have determined the rate of
of interest rates is not a determining influence
growth of the American economy. High interest
upon the rate of growth of the economy.
rates did not prove a deterrent to rapid economic
During the twentieth century, long-term inter
growth in the 1920's and 1950's. Declining
est rates were highest in the decade 1916-1925,
interest rates did not bring about net growth of
an era of unusually vigorous economic growth.
the economy for the decade of the 1930's.
The most rapid decline in interest rates took
place in the 1930's, a decade in which no net Availability of Funds and Economic Growth
growth in output occurred.
While the level of interest rates does not

Again, of interest rates since
the rising trend
determine the rate of economic growth, unavail
1946 has coincided with a rapid rate of growth
ability of loanable funds for some borrowers has
for the economy. Chart V compares eco
been blamed for slowing up or halting such
nomic growth since 1946, as measured by gross
growth on a number of occasions.
national product at constant prices, with the
trend of long-term interest rates during this It is true that the demand for funds increases
period. The rise in interest rates from the low with growth of the nation's economy. But
CHART V.
ECONOMIC GROWTH AND LONG-TERM INTEREST RATES, 1946-1959

$ BILLIONS PER CENT
480 6
360
240
LONG-TERMINTERESTRATES
(NOODT.SAAA CORPORATES)
120
0
1946 1947 1948 1949 1950 1951 1952 1953 1954 1955 1956 1957 1958 1959
22
growth of the economy also enlarges the volume symptom, function asregulators of economic
of savings and creates conditions favorable to activity. While they have not prevented healthy
expansion of bank credit. Hence, an expanding economic growth, as has been seen, they do
volume of loanable funds becomes available to tend to discourage and prevent the excesses of
satisfy the increasing credit demands of a grow borrowing and expansion which, in booms like
ing economy. that of the late 1920's, become major threats
to the stability as well as the growth of the
There are times, however, particularly after
economy.
prolonged periods of rapid economic expansion,
when widespread optimism and speculative
enthusiasm act as a powerful stimulant to bor The limited availability of funds in a boom
rowing, so that demands for funds substantially period has the following effects:
exceed the available supply. The inability of
1. It lessens the danger that, under the
some would-be borrowers to obtain the funds

they want then seems to cause the rate of growth stimulus of excessive optimism, economic activity
of the economy to be slower than it would be if will be accelerated for a time to a pace that
all borrowing demands could be satisfied. But cannot be sustained, culminating in the "boom
if productive resources are being utilized at and bust" pattern made familiar by economic
capacity, such additional borrowing would not history. To the extent that lessened availability
bring about growth in output, but only a rise of loanable funds restrains a boom, the sub
in prices as borrowers bid against each other for sequent corrective recession will be correspond
limited supplies of equipment, materials and ingly moderated.
labor. Moreover, rising prices and undue opti
mism stimulate excessive anticipation of future 2. Classes of borrowers who are most sensi
requirements and so lead to unbalanced economic tive to unavailability of funds, such as home
expansion. buyers, will defer their spending into the future,
thus providing a backlog of future expenditure
The faster growth that would come from such
to sustain the economy when a recession develops
a rapid acceleration of borrowing would not be
and funds become freely available again. Chart
sustainable, and so would cause wide cyclical
VI shows the contracyclical behavior of new
fluctuations in the economy. Booms financed
housing startsduring the 1950's, in large part
with a very heavy volume of what is often ill-
a consequence of the lessened availability of

considered borrowing breed depressions that may
funds for home building when other demands
result in a halt to economic growth for extended
expand and of the plentiful supply of mortgage
periods. The only decade in which the Ameri
money that becomes available when other classes
can economy did not grow, apart from the Civil
of borrowers curtail their borrowing.
War decade of the 1860's, was the 1930's. The
economic maladjustments created by the boom
of the 1920's, many of them related to excessive Effects on the Price Level
or unstable expansion of security loans, mort Reasonable stability of the price level is an
gages and other types of debt, produced a essential prerequisite for both the stability and
depression so severe that the volume of output the growth of the economy over the long run.
in 1939 was about the same as that of 1929. Chronic inflation, by discouraging savings and
stimulating a large-scale flight into goods and
Effects on Economic Stability equities to escape depreciation of the purchas
Higher interest rates, and particularly the ing power of the currency, breeds a "boom and
limited availability of funds of which they are a bust" pattern of exaggerated proportions.
23
Limited availability of funds and higher commercial system, provided with ex
banking
interest rates lesseninflationary pressures by cess reservesby the Federal Reserve System at
holding down demands for goods and services all times, bought whatever part of successive
financed with borrowed money. Government security offerings other institutional
and individual investors did not absorb. Since
The single inflation threat in a mod
greatest
the survival of the nation was at stake, inflation
ern economy arises from unrestrained expansion
was not regarded at the time as too high a price
of bank credit to satisfy freely demands for funds
to pay to have the Treasury's needs for funds
when they exceed the supply of savings that can
satisfied promptly at pegged interest rates. The
be attracted from institutional and individual
commercial increased their holdings of
banks
investors. Funds then are made available in
U. S. Governmentsecurities by over $74 billion
volume adequate to meet the demand only be
between 1939 and 1945, and thereby expanded
cause of a large-scale inflation of the money sup
their demand deposits more than threefold, from
ply by the banking system. This is the modern
$33 billion to $106 billion. A rapid inflation
counterpart of printing press inflation of the cur

of commodity prices and depreciation of the
rency such as occurred during the American and
purchasing power of the dollar inevitably fol
French revolutions.
lowed this inflation of the money supply when
Such unrestrained credit expansion occurred wartime price controls broke down with the
in this country during World War II, when the return of peace.
CHART VI.
NEW HOUSING STARTS AND INDUSTRIAL PRODUCTION, 1950-1959
FRB INDEX OF DWELLING UNITS

INDUSTRIAL PRODUCTION STARTED (MILLIONS)
160 1.6
DWELLINGUNITS STARTED
INDUSTRIALPRODUCTION
150
140 .4
1
\
\ i
/
\
/*
130
\
\
\
/
/\ /
t
/
1.3
\ / \ /
\ * \ /
\ * \ /
/
/J
\ *
\ * \ /
\ /
\ t
4 \ t
/
120 1.2
\ t
»
• \
\ / \ t
t
-'
* \
f //
\
\ \ t
t
»- /
\ /
110
\
' ,»'
- /
/
I.I
X
/
/
/
100 1.0
1950 1951 1952 1953 1954 1955 1956 1957 1958 1959
Sources: Dwelling units started as estimated by Bureau of Labor Statistics.
Industrial production index of the Board of Governors of the Federal Reserve System (1947-49 = 100).
24
Wartime inflation, all its problems, is
with even a substantial rise in interest rates causes
regarded by a people as one more of the disrupt a negligible increase in the total cost of doing
ing but temporary consequences of war. Chronic business, particularly as the rise in interest pay
peacetime inflation has been proven in other ments in periods of prosperity is accompanied
countries to be an intolerable price to pay for by sharp increases in both sales and expenses.
keeping the supply of loanable funds freely avail On the other hand, an increase in interest
able to all classes of borrowers by unrestrained rates reflects the fact that the volume of savings
bank credit expansion. is not sufficient to satisfy all the burgeoning de
mands for credit of a period of prosperity.
Higher Interest Rates as a Cost Limitation of demand is the chief contribution
Interest paid for borrowed money is one of that can be made to price stability when industry
the costs of doing business. It has been argued is operating close to capacity and economic re
by some critics of high interest rates that they sources are being fully utilized under boom con
contribute to inflation by raising costs of borrow ditions. When the supply of loanable funds is
ing concerns, and so causing them to increase expanded freely through large-scale bank credit
prices of the goods and services they sell. expansion to satisfy all demands so that interest
The added cost of doing business due to higher rates are prevented from rising, as during World
interest rates can be readily estimated from De War II, rapid inflation of the price level follows
partment of Commerce statistics of corporate because of the irresistible upward pull on prices
sales and profits. In 1958, corporate sales in from the resulting swollen demands for goods.
all industries, excluding banks and insurance Total demands for goods and services then tend
companies, aggregate $643 billion dollars. Since to expand far beyond the capacity of the economy
corporate profits before taxes for that year were to produce.
$37 billion, costs and expenses approximated The historical experience indicates that un
$606 billion. Interest payments by business availability of funds for some borrowers in boom
corporations aggregated some $7 billion, or periods, when total demands for credit far ex
slightly over% of total expenses.
1 In that year, ceed the supply of savings and a restrained
wage and salary payments by corporate business amount of bank credit expansion, is a necessary
aggregated $159 billion, or almost 23 times prerequisite for stability of the price level, as well
as large as the interest payments, and purchased as of the economy as a whole. Alternatives that
goods and services, representing wage and salary have been proposed to higher interest rates and
costs of the suppliers to a large extent, accounted limited availability of credit at such times are
for the bulk of the remaining costs. Obviously, considered in the following section.
V Alternatives to Higher Interest Hates

There are four alternatives to higher interest 2. Lending by the Government or Govern
rates and limited availability of funds, the normal ment agencies to favored classes of borrowers,
economic consequences when borrowing demands usually at relatively low rates of interest.
largely exceed the supply of loanable funds. 3. Selective restraints on some types of bor
These are: rowing in order to increase the supply of funds
that will be available to other borrowers.
1. Expansion of bank credit to the extent
needed to satisfy most or all demands for loans 4. Legal ceilings on interest rates.
of credit-worthy borrowers, the alternative that Each of these alternatives is considered in this
has been tried most frequently. section.
25
Expansion of Bank Credit danger that the stimulation of demand by bank
credit inflation will raise commodity prices signifi
An expansion of bank credit sufficient to satisfy
cantly.
substantially all borrowing demands would pre
vent a rise in interest rates. Such bank credit On the other hand, rapid bank credit expan
expansion requires a Federal Reserve policy sion in a period of prosperity and near-capacity
which provides member banks with net free re output in major industries does involve the twin
serves under boom conditions. dangers of a boom-and-bust cycle and commodity
price inflation. In time of war, as during the
Between 1941 and 1951, interest rates were
years 1941 to 1945, direct controls imposed
held down and funds were made readily available
on production, trade and prices tend to lessen or
to borrowers through pegging of the Government
defer these consequences. But such controls have
security market by the Federal Reserve banks.
not proved effective in time of peace in countries
During that period, whenever an increase in the
where they have been tried, except under some
demand for funds and consequent sales of Treas

completely totalitarian economic systems. More
ury issues threatened to push Government security
over, large scale debt monetization in peacetime
prices below par, holders would sell them to the
will tend in time to lead to high interest rates,
Federal Reserve banks and so cause the creation
of commodity prices swells borrow
as inflation
of additional reserves for the banking system.
ing demands and discourages saving.
This procedure, which shifted from the Federal
Reserve authorities to holders of Government An Adequate Money Supply
securities the power to determine how large mem While large-scale expansion of bank credit in
ber bank reserve balances should be, paved the times of prosperity leads to both economic insta
way for unrestrained inflation of bank credit bility and price inflation, a gradual increase of
during World War II. Commercial banks were the money supply is required to keep pace with
thereby assured of ample excess reserves at all the long-term growth of the economy.
times, and the huge amounts of Government
securities they purchased to put these reserves In the 14 years 1946-59, the output of the
to use did not give rise to either liquidity or American economy as measured by gross national
capital ratio problems. Gross bank credit in product at constant prices increased by 3.2%
flation on such a scale has never occurred in this per annum. Bank demand deposits increased
country in peacetime. by less than 3% per annum, but the velocity of
turnover of deposits in banks outside New York

The Federal Reserve System can stimulate
rose by almost 5% a year. The rise in velocity
bank credit expansion by member banks either
of turnover of deposits in New York banks was
through open market purchases of Government
even greater. Since an increase in turnover of
securities or reduction in legal reserve require
demand deposits has the same effect on economic
ments. These measures were adopted on a limited
activity and the commodity price level as an
scale in 1953 and 1954, and again in 1957 and
increase in their volume, full allowance must be
1958, to combat business recession. Ready avail
made for the higher velocity of deposits in judg
ability of bank credit at relatively low interest
ing the amount of the increase in the money
rates, and the expansion of bank deposits that
supply required to keep pace with economic
is likely to result, do not stimulate economic activ
growth.
ity unduly in recessions and so do not tend to
cause a "boom and bust" pattern in the economy. Taking both the volume and velocity of bank
Moreover, since output is generally well below demand deposits into account, the expansion in
capacity to produce in a recession, there is little the period 1946-59 approximated 8% a year.
26
This was more than double the rate of growth in response to the easy credit policy pursued by
of physical output of the economy, as Chart VII the Federal Reserve banks at such times and
shows. It exceeded as well the rise in gross large-scale Government security purchases by
national product at current prices, which reflected banks that accompany Treasury deficit financing
the increase in the price level of over 3% a characteristic of recessions. If expansion of the
year that occurred between 1946 and 1959. The money supply is to be geared to the long-term
money supply, allowing for increased velocity, growth rate of the economy, it must be held at a
was thus more than adequate to keep pace with minimum during prosperity periods to offset the
the growth of the economy during this period. rapid increase of recession years.
Two considerations make it highly desirable A second and very important reason for limit
for the welfare of the economy to hold bank ing bank credit expansion in periods of prosperity
credit expansion to a minimum during a period is the tendency for the velocity of turnover of
of prosperity. One is the tendency of the money bank demand deposits to rise under the stimulus
supply to expand substantially during recessions of good business and expanding incomes.
CHART VII.
GROWTH IN NATIONAL OUTPUT AND INCREASE IN BANK DEMAND DEPOSITS ADJUSTED FOR CHANGES IN VELOCITY, 1946-1959
INDEX
NUMBER
280
260
240
220
BANK DEMANDDEPOSITS.ADJUSTED-^^
FOR VELOCITY CHANCE
(1946=100)
200
180
160
140
X*^ CNP AT CONSTANTPRICES

(1946=100)
120
100
1946 194-7 1948 1949 1950 1951 1952 1953 1954 1955 1956 1957 1958 1959
27
An acceleration of bank credit expansion in to large-scale stimulation of home building both
recessions, and a slackening of such expansion to relieve an acute housing shortage and to raise
in prosperity, are required both to offset velocity housing standards for social reasons.
changes that occur during the business cycle
and to lessen the amplitude of cyclical fluctua When aggregate credit demands largely ex
ceeded the supply of savings in the 1955-57
tions in the economy.
period, and again in 1959, the objective became
one of channeling more loanable funds into
Lending by Government or Government home mortgages. The Federal National Mort
Agencies gage Association bought Government-under
written mortgages in large amounts under
One of several purposes for which the Fed
special assistance programs authorized by Con
eral Government has entered the lending field
gress. The Federal Home Loan banks largely
has been to make funds available at low cost
expanded their advances to member savings and
to favored borrowers in a period of credit

loan associations to add to the supply of mort
stringency.
gage funds.
Most lending and underwriting of private loans
by the Federal Government and its agencies have
In a period of credit stringency, it is logical
had other motives. to expect that eligible borrowers will seek to
One objective has been to
make fuller use of available Federal lending pro
counteract depressions. Another purpose has
been to aid particular classes of borrowers at all grams.
times with more plentiful or cheaper loans than
To expand their lending at a time of credit
they can get from private sources on the basis
stringency, the Federal Government and its agen
of their credit standing and other factors. Loans
cies in turn must bid in the market for the funds
and insurance of loans to such groups as farm
they lend. To the extent that these funds are
ers, home owners, exporters and shipowners are
drawn from institutional and individual invest
examples of loans made to give preferential
ors, the supply of funds available to other bor
treatment to particular groups or industries for
rowers will be correspondingly reduced and the
national policy reasons.1
credit stringency intensified for them. If the
A
Federal lending program, started as an anti- Treasury and its agencies borrow from com
depression measure or a chronic aid or stimu mercial banks, the result is either a curtailment
lant to a particular industry, may be used in a of the banks' ability to finance other borrowers
period of credit stringency to keep credit readily or an expansion of bank deposits that can con
available at low cost to a favored group of bor tribute to economic instability and inflation.
rowers. This has happened particularly in hous
Lending by the Treasury or its agencies on
ing. The Federal Government entered the field
a large scale to relieve a shortage of funds thus
of home mortgage credit with the establishment
benefits favored borrowers at the expense of
of the Federal Home Loan banks in 1932 and
others who seek funds or causes undesirable bank
the Federal Housing Administration in 1934 at
credit expansion. Diversion of available funds
a time when encouragement of home building
to particular groups may not prove beneficial
was urgently sought to combat the depression.
to the economy as a whole. More serious is
After World War II, the emphasis was shifted
the fact that Federal lending in a period of credit
1 See Saulnier, Halcrow and Jacoby, Federal Lending and stringency could conflict with and undermine
Loan Insurance, Princeton University Press, 1958, for the
results of a comprehensive study of this subject by the
efforts to prevent inflationary over-all bank credit
National Bureau of Economic Research. expansion. Where Federal lending assumes
28
large proportions at such times, it could lead borrowers. Such qualitative credit restrictions
to heavy sales of Treasury and agency securities have been strongly opposed by the classes of
to commercial banks at the very time when ex borrowers who would be affected. Selective
pansion of other credit demands may threaten restraint of consumer credit, for example, would
economic and price stability. discriminate against lower and middle income
groups that are the chief users of such credit,
as well as the industries that count on consumer
Selective Restraints on Credit credit to finance purchases of their products.
Upward pressure on interest rates can be The use of selective credit restraints to curb or
lessened through selective restrictions on particu prevent some types of borrowing, so as to make
lar types of borrowing, so as to increase the credit more available at low rates to other
supply of loanable funds that will be available favored groups of borrowers, would substitute
for other borrowers.
for the free market for loanable funds the judg

Selective credit controls have hitherto been ment of those who administer the restraints.
used primarily for purposes other than to hold Experience with
rationing in other fields
does
down the level of interest rates. The chief aim not provide assurance that credit rationing by a
of minimum margin requirements on security Government authority or central bank would or
loans has been to prevent the extremely rapid could be administered to the advantage of the
expansion and subsequent contraction of such economy. Substitution of bureaucratic decisions

credit that a major stock market advance may for the action of the market place in the rationing
precipitate. Before margins were regulated, a of credit in tight money periods is a dubious
large-scale pyramiding of security loans could expedient.

occur as rising stock prices enabled people to
borrow more on stocks owned to make addi Legal Ceilings on Interest Rates
tional security purchases. This resulted in The crudest way to combat a rise in interest
an expansion of security loans unrelated to rates is to impose legal ceilings by statute or
economic needs for more credit. The extremely regulation. This is comparable to statutory price
rapid expansion of security loans during the fixing for commodities without regard to supply
late 1920's, and their even more drastic con or demand conditions.
traction after 1929, contributed considerably to
So long as market rates of interest are below

both economic and stock market instability at
the ceilings, the latter are without practical signi
that time.
ficance. But when a shortage of loanable funds
Selective controls of consumer and home mort drives interest rates above the ceilings, funds
gage credit, terminated in 1952, were designed become unavailable for the borrowers affected
primarily to lessen inflationary pressures on the unless ways can be found to get around the law.
economy and to minimize interference with
In the case of FHA insured and VA guaran
defense production, rather than to hold down
teed mortgages, the ceilings have been avoided
interest rates and make credit more available
in many cases through acquisition of such mort
to other borrowers.
gages by lenders at substantial discounts. The
Proposals have been advanced that selective ceiling of 414 % on new Treasury bond offerings
restraints be imposed on consumer, mortgage caused the Federal Government to limit new
and even business borrowing, when total demands offerings in 1959 to issues maturing in less than
for funds exceed the supply, to hold down interest 5 years because the ceiling was not applicable
rates and increase availability of funds to other to them. In consequence, huge new offerings
29
of Treasury bills and note issues lifted short- such alternatives as bank credit inflation or large-
term rates well above long-term Government scale lending by the Government and its agencies,
bond yields in 1959 and 1960. This not only and present no comparable threat to the stability
distorted the structure of interest rates, but also of the economy or the price level.
unbalanced the pattern of public debt maturities.
The Good Alternatives
Legal ceilings on interest rates are inconsistent
A beneficial and certain way to hold down
with a free market economy, and work to the
interest rates and make credit more available to
marked disadvantage of borrowers affected in a
all classes of borrowers would be the use of a
period of shortage of funds when the ceilings
large Federal budget surplus in time of prosperity
become effective.
to retire public debt. The same objectives could
The Benefits of a Free Market be achieved also through curtailment at such times
The alternatives discussed above to higher of Government programs that stimulate private
interest rates in a period when the demand for
borrowing. Curtailment of activities of agencies

funds outstrips the supply are open to very serious like the Federal Home Loan banks, the Federal
objections. National Mortgage Association and the Com
Of all the proposed alternatives to higher modity Credit Corporation, to the extent that it
interest rates, expansion of bank
large-scale would lessen the total demand for loanable funds,
credit is the most costly and, in time, the would reduce upward pressure on interest rates.
most disastrous to the economy. It undermines
A large Federal budget surplus in periods of
both economic and price stability. Lending by
prosperity would not only make credit more avail
the Government or its agencies does not add to
able at relatively stable interest rates to other bor
the volume of savings, and so either diverts funds
rowers, but would also contribute to over-all
from borrowers not so favored or leads to large-
stability of the economy and the price level by
scale bank credit expansion through sales of
lessening absorption of economic resources by
Treasury or agency obligations to commercial
the Federal Government at a time when private
banks. Selective credit restraints may unduly
demands for these resources are particularly
limit types of borrowing that are desirable eco
heavy.
nomically and socially. Legal interest rate ceil
ings that make specified types of loans and Stability of the price level in itself tends to
investments unattractive to lenders will merely hold down interest rates and to make funds more
With the
shut off such borrowing when the available available to all classes of borrowers.
supply of funds is inadequate, where ways to commodity price level stable, demands for funds
in periods of economic expansion will increase
get around the ceilings are not available.
substantially less than if inflation swells the
Each of these alternatives is an unsatisfactory
amounts that must be borrowed to acquire wanted
if not an economically dangerous substitute for
assets. At the same time, abatement of inflation
the free market as a means of distributing avail
fears will stimulate the flow of savings into thrift
able loanable funds when the demand largely ex
institutions and bond investment, and so expand
ceeds the supply. It is true, as seen in Section
the supply of loanable funds.
III,that the functioning of the market for loan
able funds is affected by such artificial influences From the viewpoint of the national economy
as tax exemption of State and municipal bonds as a whole, additional loanable funds are best
and the deductibility of interest payments from provided by an increase in savings relative to
taxable income of businesses. These influences current consumption expenditures. More sav
affect the functioning of the market for funds only ings provide added loanable funds for all classes
to a limited extent, however, as compared with of borrowers without bank credit inflation. At
30
the same time, restraint on consumption makes to save more and spend less, they cause a shift
available additional economic resources to the in the utilization of resources from consumption
borrowers who utilize these savings. To the to investment purposes.
extent that higher interest rates induce individuals
VI Higher Interest Hates and Commercial Banks

Commercial banks are the chief lending insti pared with average net profits of 7.73% for the
tutions in the economy. Over 83% of their quarter century since the Federal Deposit Insur
operating earnings comes from interest on loans ance Corporation was established.
and investments. It is widely assumed, therefore,
Interest rates reached their highest level during
that banks derive major advantage from a rise in
this 25-year period in 1957 and 1959. Insured

interest rates, and that they favor high interest
commercial banks reported net profits of 8.30%
rates out of self-interest.
on capital funds in 1957, or little better than the
This assumption can be readily tested. If it is average. For 1959, member banks of the Fed
true, commercial bank profits should rise when eral Reserve System reported net profits equal to
interest rates are high and should fall when an annual rate of only 7.9% on their capital
interest rates are low. This has not been the case. funds, as compared with 9.7% reported for 1958,
a year of relatively low interest rates.
Bank Profits and Interest Rates The assumption that commercial banks real
There have been only two years since the Fed ize larger net profits when interest rates are high
eral Deposit Insurance Corporation was estab and smaller net profits when they are low thus
lished that insured commercial banks have re simply does not accord with the facts of the past
ported net profits after taxes, reserves and security two decades. Chart VIII compares the ratio of
profits and losses of over 10% on their capital net profits to capital funds of insured banks with
funds. These were 1945 and 1946, years in the trend of the interest rates charged by com
which interest rates were at the lowest level mercial banks on business loans for the 20 years
reached during the century 1859-1959, as Chart 1939 to 1958. It can be seen that the highest
I showed! That net profits of commercial banks rates of return on capital funds were earned in
have reached the highest rates on capital funds in years when interest rates were low, while lower
years of low interest rates is often overlooked r-tes of return were realized when interest rates
because net current operating earnings of banks were high.
do rise with an expansion of loans and an in
Why have bank profits behaved in this seeming
crease in interest rates. But expansion of loans anomalous fashion?
in periods of credit stringency and high interest
rates results inevitably in liquidation of securities
Why Bank Profits Rise with Low
and realization of capital losses that reduce net
Interest Rates
income. Conversely, as interest rates fall banks
can expand total earning assets and realize se Two reasons account for the increase in net
curity profits that add substantially to their net profits reported by commercial banks when in
income. terest rates have been low.
Net profits on capital funds of insured banks In the first place, commercial banks have
of 10.87% in 1945 and 10.01% in 1946 com excess reserves at such times to support an expan
31
sion of earning assets. If interest rates are low cause bond prices to rise. In 1945, insured com
because of a limited demand for loans, commer mercial $267 million in capital
banks realized
cial banks can increase earnings by purchasing gains on securities sold or redeemed, and in 1946
Government and other securities in volume. This they realized $209 million from this source.
happened in 1954, a year of low interest rates, Long-term capital gains cause a more than pro
when loans showed little increase but commercial portionate rise in bank net profits because they
banks added $7.2 billion to their investment port are subject to a much lower tax rate than operat
folios. If interest rates are low because the Fed ing earnings.
eral Reserve System provides member banks with
Why Bank Profits Decline with High
ample reserves in the face of a heavy demand for Interest Rates
loanable funds, both loans and investments can
be expanded, as was done for example in 1945
High interest rates reduce bank profits by
curbing expansion of earning assets and causing
when loans increased by $4.5 billion and invest
ments by $14 billion for all commercial banks. capital losses on securities.
Interest rates rise in response to an increase
Secondly, commercial banks realize capital in the demand for funds. To limit bank credit
gains on securities when declining interest rates expansion, with its inflationary consequences, at
CHART VIII.
BANK PROFITS AND INTEREST RATES ON SHORT TERM BANK LOANS TO BUSINESS, 1939-1958
PER CENT
(NET PROFITS TO PER CENT
CAPITAL FUNDS) (INTEREST RATES)
12 6
RATIOOFNET PROFITSTOCAPITALFUNDS-ALL INSUREDBANKS
,.
>*
/ .--"
*""^1 .++'
/ ,4 .*.
**
*--. '-«..
.*.*•*
™ .''
\average interest rates on short-tern
bank loans to business in 19 cities
0
1939 1940 1941 1942 1943 1944 1945 1946 1947 1948 1949 1950 1951 1952 1953 1954 1955 1956 1957 1958
Sources: Ratio of net profits to capital funds of insured banks from Annual Reports of Federal Deposit Insurance Corpora
tion.
Interest rates on short-term bank loans to business from the Federal Reserve Bulletin.
32
such times, the Federal Reserve authorities keep Commercial bank earnings tend to be reduced
member banks short of reserves and earning asset in a period of high interest rates also by higher
expansion is checked. Commercial banks seek interest payments on savings and other time
nevertheless to
satisfy the heavy borrowing deposits. Keener competition for savings from
demands of their customers, but to do so they both thrift institutions and high yielding gilt-
must sell securities at the lower prices caused edge obligations available in the security mar
by the rise in interest rates. kets puts pressure on commercial banks to
pay higher rates to hold their time deposits, as
How bank earnings are reduced in a period
well as to attract new savings. Increased interest
of high interest rates was shown by the expe
payments on savings deposits are particularly
rience of the first half of 1959, when interest
burdensome on banks with a large proportion of
rates moved upward briskly. Member banks
such deposits that were invested in bonds and
of the Federal Reserve System expanded loans
mortgages when substantially lower yields pre
by $5.2 billion during the six months ended
vailed.
June, 1959, but simultaneously reduced their
holdings of Government obligations by $5.1 It is no coincidence, therefore, that net profits
billion. Total loans and investments were thus of commercial banks have increased when inter
virtually unchanged. True, the average rate of est rates have been low, and have decreased when
return received on earning assets rose, but real interest rates have been high. Profits have risen
ized losses of $323 million on securities sharply because of expansion of earning assets and the
reduced net profits to an annual rate for the six realizing of capital gains on securities when
months of 7.6% on capital funds. interest rates fell. Profits have declined because
earning asset expansion has been curbed and
The profit showing of the first six months of
capital losses have been incurred on securities
1959 contrasted markedly with that of the first
when interest rates rose.
half of 1958, a period of declining interest rates.
In the six months ended June, 1958, member In terms of narrow self interest, without regard
bank loans rose by $1.2 billion, but investments to the welfare of the economy, commercial banks
expanded by $8.1 billion. This expansion of might be expected to favor large-scale credit ex
earning assets, and even more gains of $258 pansion, with concommitant low interest rates, in
million realized on securities sold or redeemed the light of the earnings record. But such an
at the high prices caused by falling interest rates, attitude would be short-sighted because the well-
enabled member banks to report net profits at being of banking over the long run is so closely
the annual rate of 11.2% on their capital funds tied to that of the economy as a whole, and bank
for the first half of 1958, one of the highest rates credit inflation undermines the stability and in
of profit ever reported by commercial banks. time the growth of the economy.
VII Interest Rate Behavior in Other Countries

Interest rates undergo wide fluctuations in all During the 1950's, the demand for funds out
countries with free economies, in response to ran the supply and interest rates advanced in
changes in demand and supply of loanable funds. virtually all free economies, as they did in the
In Communist countries, where organs of Gov United States. This can be seen by comparing
ernment conduct the borrowing and lending of the highest yearly average of 3 -month Treasury
money along with nearly all other economic ac bill rates, or other key interest rates where
tivities, interest rates, like other prices, are set by Treasury bill rates are not available, for a number
the State as part of its planning of the economy. of countries.
33
In the United States, the highest yearly average ments with these alternatives to high interest
for 3-month Treasury bill rates was 3.405% rates are summarized in this section.
reached in 1959. The highest annual average
for key interest rates for other countries, and the Large-Scale Bank Credit Expansion
years when these rates were reached, were: By far the most commonly used expedient to
hold down interest rates and maintain a plentiful
Yearly
Highest supply of loanable funds has been large-scale
Country Type of Interest Rate Average Year
bank credit expansion, such as occurred in the
Great Britain Treasury bills 4.93 1956
United States World War II. To help
during
Germany Call money finance of their shattered econ
reconstruction
(interbank) 6.02 1951 omies, rapid expansion of bank credit occurred
France Discount rate 5.00 1957 in a number of western Europe countries during
Government bonds
the years immediately following the war. The
Italy
6.81 1957
annual rate of expansion of bank loans and invest
Netherlands Treasury bills 4.07 1957
ments in the five years 1946-50, and the conse
Belgium Treasury bills 3.40 1958
quences for commodity prices and official cur
Sweden Discount rate 5.00 1957 rency exchange rates despite direct production
Switzerland Government bonds 3.64 1957 and price controls and rationing, were as follows:
Canada Treasury bills 4.85 1959
Australia Short-term Govern BANK CREDIT EXPANSION, WHOLESALE

ment bonds 5.03 1956 PRICES AND CHANGES IN OFFICIAL
EXCHANGE RATES, 1946-50
The range of annual averages of the key in Annual Increase
Rate of in
terest rates listed in the above table in these 10 Increase, Whole
countries and the United States for the 1950's is Bank Loans sale
and Prices, Effect on
shown in Chart IX. This chart shows that fluc Investments 1946-50 Official
Country (%) (%) Currency Rate
tuations of interest rates over a considerable range
Great Britain 6 55 Devaluation in
has been a characteristic of all these free econ
1949
omies. Interest rates have risen to much higher France 29 452 Severe Devalu
levels than shown in particular months when ex ations, 1948-
demands for funds have pressed most 1949

panding
Italy 59 138 Devaluations,
heavily upon the available supply. In the United
1946-49
States, the 3 -month Treasury bill rate reached its
Netherlands —3 •36 fDevaluation,
highest monthly average of 4.572% for the 1949
1950's in December, 1959. The highest monthly Belgium 2 17 fDevaluation,
average for the Treasury bill rate was 6.60% in 1949
Great Britain in October, 1957, and 5.815% in Sweden 5 17 fDevaluation,

1949
Canada in August, 1959. —1
Switzerland 6 No devaluation
When the demand for loanable funds has ex Canada 5 60 No devaluation
ceeded the available supply, other countries have Australia 12 61 Devaluation in
1949
resorted on occasion to the expedients described
in Section V above to hold down interest rates * Cost of Living index.
t To adjust to devaluation of the pound sterling.
and to make credit more available to borrowers.
Their experiences with such expedients provide The two countries in the above tabulation
valuable lessons. Results of some of the experi that did not devalue their currencies in this
34
period were Switzerland and Canada, and in Large'Scale Bank Credit Expansion in
each case bank credit expansion was held to the 1950's
moderate proportions. The Netherlands, Bel The inflationary effects of large-scale bank
gium and Sweden, other countries that limited
credit expansion have been so apparent that
bank credit expansion, devalued their currencies
European countries have generally refrained
primarily to bring them into line with the de from using this expedient, once their economies
valued pound sterling in 1949 in order to avoid
had surmounted the initial post-war reconstruc
adverse effects on their foreign trade position.
tion phase.
In Great Britain, the rise in prices and devalua
tion were belated consequences of the expansion France has been an exception. Claims of
of credit during the war years, which was not the commercial banks on the Government and
reflected in commodity prices at the time due to sectors of the economy increased by
private
price controls and rationing. 220% between 1950 and 1958, or at an annual
CHART IX.
RANGE OF FLUCTUATION OF KEY INTEREST RATES IN FREE ECONOMIES, ANNUAL AVERAGES, 1950-1959
PER CENT
UNITED GREAT GERMANY FRANCE ITALY NETHERLANDS BELGIUM SWEDEN SWITZERLAND CANADA AUSTRALIA
STATES BRITAIN
Source: International Financial Statistics, published monthly by Statistics Division, International Monetary Fund.
35
rate of nearly 15%. The cost of living rose more than fourfold rise in the cost of living and
by 57% between 1950 and 1958, and the franc drastic depreciation of the peso on the foreign
was devalued in 1957 and again in 1958 as its exchange market between 1950 and 1958.
purchasing power declined sharply in relation to
A number of countries have utilized the two
its rate of exchange with other leading currencies.
other expedients discussed in Section V — selec
Rapid expansion of bank credit in Latin tive credit restraints and interest rate ceilings — to
American countries during the 1950's has pro influence the availability and cost of borrowing.
duced similar adverse effects on price and mone These expedients have not affected the level of
tary stability in a number of countries. interest rates or the supply of loanable funds to a
major extent, except where combined with large-
Large-Scale Government Lending scale expansion of bank credit or Government
Lending by the Government or its agencies on lending.
in most countries to
a limited scale is carried on

The record of the post-World War II period
aid particular of the economy such
segments as
has demonstrated that stability of both the price
agriculture, export trade or home building.
level and the economy is seriously undermined
In some cases, lending through such channels when nations resort to large-scale expansion of
has been expanded on a large scale to assure the bank credit or Government lending to prevent a
availability of loanable funds and hold down rise in interest rates or unavailability of loanable
interest rates. An example of this has been funds because the demand for credit outruns the
Argentina, where Government-owned mortgage available supply. As a result, the countries of
banks expanded their loans from 7 billion to 33 western Europe and other economically advanced
billion pesos between 1951 and 1958. The nations are generally refraining from the use of
mortgage banks secured these funds from the such expedients, permitting interest rates to rise
central bank. These and other measures to when demands for funds exceed available savings
expand the supply of loanable funds caused a and a moderate rate of bank credit expansion.
36
Summary and Conclusions
Interest rates in the United States have fluctu deductible from taxable income. Where loans
ated over a wide range during the past century. are not available in the volume sought, a number
They have advanced in periods of vigorous of alternative methods of raising money are
growth of the economy, and have declined in available. Pages 15 to 16.
times of depression and economic stagnation.
Interest rates on loans to small business have
Pages 7 to 8.
risen less than on large business loans, a Federal
Reserve Survey indicates. The effect of a credit
The Post-War Rise in Interest Rates stringency on small business is lessened by the
greatly increased use of trade credit by smaller
A huge demand for funds has been the prime
concerns, wider resort to factoring and accounts
cause of the rise in interest rates since 1946.
receivable financing, and the trend towards leas

Private and public debt has increased more since
ing of equipment. Pages 16 to 17.
the end of World War II than in the entire pre
ceding history of the United States. Page 9. The effect of higher interest rates on mort
gage borrowers has been offset by increased ratios
Business borrowing has received added stimu
of loans to property values and lengthening of
lus from recordplant and equipment outlays;
mortgage maturities, as well as by the great rise
mortgage borrowing from the spread of home
in personal incomes. Mortgage borrowers have
ownership and favorable lending terms fostered
been more affected by lessened availability of
by Federal insurance and guarantees; consumer
funds than other classes of borrowers, how
borrowing from the rapid rise of personal in
ever, due to the huge amounts of money they
comes and the increased demands for consumer
require and their dependence upon four classes
durable goods that accompany rising standards
of savings institutions for the bulk of the funds
of living. Pages 9 to 10.
they obtain. Mortgage borrowers are not now
The supply of loanable funds from savings able to attract funds in volume directly from
institutions and moderate bank credit expansion individual investors, as do the classes of borrow
has not increased sufficiently to satisfy these de ers that sell bond issues. Pages 18 to 19.
mands. Higher interest rates have been re
Consumer borrowing is relatively little affected
quired to attract funds in large volume from

by higher interest rates and reduced availability
individual investors, foreigners and business cor
of loanable funds because rates charged at all
porations. Pages 11 to 14.
times are relatively high and standardized, since
they include a large element of payment for serv
How Higher Interest Rates Affect Borrowers ice as well as interest for the money borrowed.
Many of the complaints against higher inter Page 19.
est rates are actually directed at the unavailabil
Long-term financing by the Federal Govern
ity of credit to some borrowers because total
ment has been hampered by the advantages which
demands for funds outrun the available supply.
tax and housing laws give competing classes of
Page 15.
borrowers far more than by the over-all credit
Business borrowers are little affected by in stringency. The AlA% interest rate ceiling on
creased interest rates on their borrowing because Treasury bond offerings prevented long-term
the return on capital funds averages much higher Government financing when prevailing yields rose
than interest rates paid, and because interest is above that ceiling rate. Pages 19 to 20.
37
State and local government financing has A growing economy requires a gradual expan
reached new peaks despite higher interest rates sion of the money supply. The increase in de
and limited availability of funds. Interest pay mand deposits should be limited in times of pros
ments are still less than 3% of the direct ex perity, however, both because bank deposits
penditures of States and municipalities, while usually undergo rapid expansion during recessions
tax exemption of interest paid makes higher due to Treasury deficit financing and easy money
yields the more effective in attracting individual action by the Federal Reserve System, and be
investment funds to such issues. cause the velocity of turnover of bank deposits
Pages 20 to 21. increases when business is good.
Pages 26 to 28.
How Higher Interest Rates Affect the Economy Lending by the Federal Government and its
The rate of growth of the economy is deter agencies does not of itself expand the supply of
mined by factors other than the level of interest loanable funds. Funds may thus be provided
favored borrowers who could not otherwise ob
rates, since periods of more rapid growth are
In tain the money they want. When the Govern
normally accompanied by high interest rates.
fact, large-scale bank credit expansion to hold ment sells securities to raise the money, it either
down interest rates leads to a "boom and bust" diverts funds from less favored borrowers or, if
A severe depression the Treasury issues sold are absorbed by com

pattern in the economy.
can check growth for a time, as happened in the mercial banks, gives rise to bank credit expansion
when, for the health of the economy, restraint
1930's. Pages 21 to 23.
may be required. Pages 28 to 29.
Higher interest rates and lessened availability
of funds in boom periods, lower interest rates and Selective credit restraints to hold down interest
rates and make credit more available to other
increased availability of funds in recessions, make
for a more stable economy. Page 23. borrowers substitute a system of rationing, with
its rigidities, distortions and other defects, for the
Higher interest rates and lessened availability action of the free market in allocating available
of funds, at times when demands for goods and loanable funds when the demand exceeds the
services tend to outrun the nation's capacity to
supply. Page 29.
produce them, contribute to price stability.
Pages 23 to 25. Legal interest rate ceilings make credit un
available to affected borrowers when market

rates are a very small element in
Interest rates of interest rise above the maximum rates
total business costs. The effect of higher interest fixed, except where expedients are available for
rates on business costs and selling prices is neg getting around the ceilings. Pages 29 to 30.
ligible compared with the upward pull on prices
that would result from large-scale bank credit Higher Interest Rates and Commercial Banks
expansion designed to hold interest rates down.
Page 25.
Net profits after taxes, security gains and losses
and additions to reserves of commercial banks
Alternatives to Higher Interest Rates have increased in periods of low interest rates
and have declined when interest rates have risen.
Large-scale bank credit expansion to satisfy
Pages 31 to 32.
borrowing demands, the most frequently tried
alternative to high interest rates, leads in periods Banks have realized a higher rate of return on
of prosperity both to a boom and bust pattern their capital funds when interest rates have been
for the economy and price inflation. Page 26. low because of expansion of earning assets and
38
the realizingof capital gains on securities at such 1958, and the rapid bank credit inflation there
times. Added profits from these sources have before 1958 caused grave consequences for her
more than offset the decline in average interest price level and her currency. Pages 35 to 36.
rates earned on assets. Conversely, the rate of
Government and Government agency lending
return on capital funds has fallen when interest
on a large scale to prevent interest rates from
rates have advanced because earning asset ex
rising have been tried in Argentina. Runaway
pansion then is slowed or halted and losses are
price inflation and drastic devaluation of the peso
incurred on securities. Pages 32 to 33.
ensued. Page 36.
Interest Rates in Other Countries The Good Alternatives
Interest rates widely in re

have fluctuated Interest rates will be held down and funds made
sponse to expansion or contraction in the demand more available for all classes of borrowers in
for funds in all countries with free economies. periods of prosperity and expanding credit de
In a number of countries, interest rates have risen mands if the Federal Government has budget
higher than in the United States in recent years. surpluses and retires public debt at such times.
Pages 33 to 35. Such a policy limits advances in interest rates
without adverse economic consequences.
Large-scale bank credit expansion to finance
Page 30.
reconstruction and hold down interest rates was
tried by a number of European countries in Stability of the price level contributes to sta
the immediate post-war years. Price inflation bility of interest rates and greater availability of
and currency devaluation followed in most credit, both by limiting demands for funds and
cases. European countries have refrained from increasing the supply through encouraging the
using this alternative to high interest rates flow of savings into thrift institutions and bonds.
in the 1950's. France was an exception until Pages 30 to 31.
39
i!
zJE

1960, Bogen, The Causes and Effects of Higher Interest Rates PDF

Transféré par

Informations du document

Titre original

Copyright

Formats disponibles

Partager ce document

Partager ou intégrer le document

Options de partage

Avez-vous trouvé ce document utile ?

Ce contenu est-il inapproprié ?

Droits d'auteur :

Formats disponibles

1960, Bogen, The Causes and Effects of Higher Interest Rates PDF

Transféré par

Droits d'auteur :

Formats disponibles

The causes and effects of higher interest rates, by Jules I.

Public Domain, Google-digitized

We have determined this work to be in the public domain,

The Causes and Effects of

Higher Interest Hates

Program Study by the

Graduate School of Business idministration of

Directed by Dr. Jules I. Bogen, Professor of Finance

by: Jules V. Bogen

GRADUATE SCHOOL OF BUSINESS ADMINISTRATION

NEW YORK UNIVERSITY

ASSISTANT PROFESSOR OF BUSINESS ADMINISTRATION,

SCHOOL OF BUSINESS ADMINISTRATION

The Graduate School of Business Administration, as part of

interest rates and its effects on the major classes of borrowers,

This research project was planned and conducted by Dr.

The Graduate School of Business Administration received

Dean, Graduate School of

March 15, 1960

I. The Behavior of Interest Rates 7

II. Causes of the Post- War Rise in Interest Rates 9

III. Effects of Higher Interest Rates on Borrowers 15

IV. The Effect of Higher Interest Rates on the

V. Alternatives to Higher Interest Rates 25

VI. Higher Interest Rates and Commercial Banks 31

Vn. Interest Rate Behavior in Other Countries 33

Summary and Conclusions 37

the cost of living that occurred during the 1940's

that have taken place in the demand for and sup

U. Department of Commerce (estimate for

Mortgage Funds As a result, people have been willing to borrow

has the Federal Government used its credit to

not affect interest rates

terest rates depends to a large extent upon the

together are in position to satisfy the bulk of the

new high record for a peacetime year.

2. The very high corporate income tax rates

Less than 50 5.5 6.1 0.6

Availability of Funds to Business 50-250 5.0 5.6 0.6

is the chief consideration of business borrowers 1,000-5,000 4.1 5.1 1.0

by small as well as large concerns.

rates on the borrowers. These include:

family income enables home owners to carry

A period of credit stringency affects Govern

Treasury obligations. Stateand local govern

obligations in such volume by these institutions

IV The Effect of Higher Interest Hates on the Economy

While the level of interest rates does not

ECONOMIC GROWTH AND LONG-TERM INTEREST RATES, 1946-1959

some would-be borrowers to obtain the funds

a consequence of the lessened availability of

counterpart of printing press inflation of the cur

FRB INDEX OF DWELLING UNITS

V Alternatives to Higher Interest Hates

demand for funds and consequent sales of Treas

turnover of deposits in banks outside New York

X*^ CNP AT CONSTANTPRICES

to favored borrowers in a period of credit

for the free market for loanable funds the judg

expansion and subsequent contraction of such economy. Substitution of bureaucratic decisions

large-scale pyramiding of security loans could expedient.

So long as market rates of interest are below

borrowing. Curtailment of activities of agencies