The funda mental instabil ity of capit al ism is upward. After func tion ing well for a time a capit al ist economy devel ops a tend ency to explode, to become
“euphoric.” This is so because an initial condi tion is a world with uncer
tainty, and in such a world success feeds back upon expect a tions and pref er
ence systems so as to increase 1) the desired stock of capital, 2) the desired debtequity ratios for owners of real capital, 3) the will ing ness to substi tute earning assets for money, and 4) the rate of invest ment. That is, instead of start ing from “. . . an Elysian state of moving equi lib rium . . .” [Friedman and Schwartz, 9, p. 59], we start from an economy that is now doing well, better than in the past.
In a world with uncer tainty, a distinc tion between inside and outside assets is mean ing ful. Inside units are those whose beha vior is determ ined by the perform ance of the economy—house holds, busi ness firms, and finan
cial inter me di ar ies. Outside units are those whose beha vior is inde pend ent of the perform ance of the economy (except to the extent that a theory of economic policy guides their beha vior)—govern ments, central banks, etc.
The nominal (dollar) cash flow that an outside asset will gener ate is inde
pend ent of the perform ance of the economy and no inside unit is commit ted to make payments because this asset is its liab il ity. The nominal cash flow that an inside asset will gener ate depends upon the perform ance of the economy and for finan cial assets some inside unit is commit ted to make payments because this asset is its liab il ity. Government debt, gold, and fiat
money are all examples of outside assets; real capital, corpor ate bonds, and install ment debt are all examples of inside assets. In addi tion there are mixed assets: an F.H.A. insured mort gage is an inside asset except that once the insur ance becomes effect ive the asset becomes an outside asset to its owner;
simil arly, to a depos itor fully covered by deposit insur ance, depos its are outside assets although the bank may own inside assets [Tobin, 23; Gurley and Shaw, 11; Minsky, 17].
The price of a repres ent at ive unit of the fixed stock of real and finan cial inside assets is determ ined, for a given uncer tain stream of cash receipts, by the relat ive weight of outside and inside assets in the economy. That is, the mixture of uncertaintyfree and uncertaintybearing assets determ ines the price of the uncertaintybearing assets, given that the price of govern ment or gold dollars is fixed at $1. Abstracting from the finan cial layer ing process, the funda mental inside asset is the capital stock and the funda mental outside asset is the govern ment debt money supply. Thus the price per unit of a fixed capital stock is a rising func tion of the amount of outside money, other things constant: the money supply determ ines the price level of the stock of capital goods11 [Turvey, 24; Tobin, 23; Brainard and Tobin, 2].
The other things constant include the amount of fixed assets. An increase in finan cial inter me di ation and of govern ment endorse ments will tend to raise the price per unit of capital as a func tion of the outside money supply.12 Preferences and expect a tions will also posi tion the price of capital func tion and as these can be sens it ive to the perform ance of the economy, these subject ive elements can induce sizable shifts in the func tion. That is, the price of capitalmoney supply func tion, which is the analogue to the liquid ity pref er ence func tion, is under partic u lar circum stances unstable. An upward and perhaps accel er at ing migra tion of the func tion will take place after a period of sustained prosper ity without deep depres sions. A sharp down ward shift will take place after a finan cial crisis. The crisis is not an exogen ous or acci dental event. The way in which invest ment and posi tions in the stock of assets are financed during the upward migra tion of the price of capital func tion sets the stage for the crisis.
Iv. THE EFFECT IvE NESS OF MONET ARY POLICY IN THE RECENT PAST
Before the aptness or effect ive ness of monet ary policy can be judged, it is neces sary to determ ine the constraints upon the monet ary author it ies. The
United States “Central Bank” is a pecu li arly decent ral ized insti tu tion. Specialized organ iz a tions such as the Federal Deposit Insurance Corporation and the Home Loan Bank Board as well as the Federal Housing Authority are, along with the Federal Reserve System, part of this “Central Bank.” The Federal Reserve may be the leading member of this syndic ate, but it is constrained by the need to make sure that the special ized insti tu tions can carry out their mandates.
The need to main tain “insti tu tional integ rity” is a constraint upon the Central Bank. That is, whereas the Federal Reserve is willing to see partic u lar, isol ated, moder ately sized banks and nonbank finan cial insti tu tions fail, it cannot stand by without trying to prevent the failure of entire classes of insti tu tions. This is so because the author it ies believe, rightly or wrongly, that disrupt ing insti tu tions will have dire consequences for the economy and because it is the will of Congress that partic u lar sets of insti tu tions survive and prosper. Thus the need to prevent any escal a tion of the obvious diffi culties of savings banks and the closely related housing industry into a general collapse of the system and industry was, and remains, an effect ive constraint upon monet ary policy.
With present usages Mutual Savings Banks and Savings and Loan Associations are poorly equipped to cope with rapidly rising interest rates. These insti tu tions hold longterm fully amort ized mort gages which carry interest rates that were current at their date of issue. These savings inter me di ar ies finance their posi tion by emit ting shortterm or call liab il it ies. That is, their liab il it ies must meet the market on a wellnigh daytoday basis while their assets lag, often by many years, behind current market terms.
There are two roads to ruin (negat ive net worth) for these savings insti
tu tions. One via a revalu ation of assets, the second via the accu mu la tion of oper at ing losses.
By conven tion, mort gages not in arrears are carried on the books of savings insti tu tions at face value. As a result, no mort gage inter me di ary will be declared insolv ent by the author it ies as a result of falling market prices of its mort gages. On the other hand, if an insti tu tion needs to make posi tion by selling such assets at the market such “paper” losses are real ized; the net worth of the organ iz a tion must be adjus ted to reflect this loss. Thus central bankers must prevent any large scale encash ment of depre ci ated mort gages or they must provide some way for mort gage holders to obtain the face value of these depre ci ated assets if encash ment is forced.
In addi tion, even though the fiction of face value is main tained, the cash flow these mort gages gener ate reflects the lower, past interest rates. On the
other hand, the cost of money for deposit insti tu tions is determ ined by current interest rates. A rise in deposit interest rates can trans form a hitherto profi t able insti tu tion into one suffer ing losses. Given the thin equity posi
tion of savings insti tu tions, they cannot endure losses on the carry for very long. However, as the assets are longlived, the turning over of the port fo lio so that it yields returns consist ent with the higher cost of money takes time.
As a result, with any given initial set of assets there exists a maximum to the cost of money which can be estab lished and sustained, for each assumed course of total depos its and initial net worth, that will permit the survival of the insti tu tion. Thus the author it ies must try to constrain deposit rates to levels consist ent with the exist ing port fo lios.
Thus there are two ways to bank ruptcy: a quick execu tion, by revalu ing assets at market or real iz ing losses in an effort to make posi tion, and a slow bleed ing to death, as losses accu mu late on income account. The author it ies need to prevent both paths from oper at ing in periods when interest rates have risen. In 1966 at the time of the crunch the author it ies obtained and used the power to discrim in ate by size of deposit in setting ceiling rates on time depos its. This success fully aborted a switch of savings depos its from savings to commer cial banks, which would have forced a large scale encash
ment of mort gages. In addi tion this discrim in a tion has succeeded in lower ing the effect ive cost of money to savings banks below what it would have been, thus decreas ing the losses on income account.
Since the crunch of 1966, a constant threat of disin ter me di ation has existed due to the large gap that has developed between longterm market rates and deposit rates. The unanswered ques tion is how large a gap is consist ent with the main ten ance of depos its in savings insti tu tions. That the retail ing of corpor ate bonds does not seem to have increased signi fic antly is an import ant indic a tion of the value of deposit insur ance and the strength of memor ies of the 1930s. Nevertheless, with the threat of disin ter me di
ation ever present, it is not surpris ing that the Federal Reserve is seeking ways of making discount facil it ies avail able to mort gage holders, thus provid ing means for “encash ment” at face or close to face value.13
It is easy for an academ i cian to char ac ter ize these constraints upon the exer
cise of monet ary powers as being based upon ground less fears. But the pref
er ence func tion of the author it ies must contain some tradeoff between the rate of increase of the price level and the subject ively determ ined like li hood of a run (disin ter me di ation) on the savings insti tu tions. An attempt to moder ate the rise in interest rates by increas ing the rate at which the reserve
base increases is an appro pri ate use of monet ary policy, even at the consid er
able risk of added price pres sures.
REFERENCES
[1] Board of Governors of the Federal Reserve System. Reappraisal of the Federal Reserve Discount Mechanism: Report of a System Committee.
July 1968.
[2] william C. Brainard and James Tobin. “Pitfalls in Financial Model Building.” American Economic Review, May 1968.
[3] Karl Brunner. “The Role of Money and Monetary Policy.” Federal Reserve Bank of St. Louis, Review, July 1968.
[4] P. Cagan. “A Commentary on Some Current Issues in the Theory of Monetary Policy.” In Brennan, M. J. (ed.) Patterns of Market Behavior;
Essays in Honor of Philip Taft. Providence, 1965.
[5] R. Clower. “The Keynesian Counterrevolution: A Theoretical Appraisal.” In Hahn, F. H. and Brechling, F. P. R. (eds.) The Theory of Interest Rates. New York, 1965.
[6] J. Duesenberry. “The Portfolio Approach to the Demand for Money and Other Assets.” The Review of Economics and Statistics, February 1963.
[7] I. Fisher. “The Debt Deflation Theory of Business Cycles.” Econometrica, October 1933.
[8] M. Friedman. “The Monetary Theory and Policy of Henry Simons.”
The Journal of Law and Economics, October 1967.
[9] M. Friedman and A. Schwarz. “Money and Business Cycles.” Review of Economics and Statistics, Supplement, February 1963.
[10] —— The Great Contraction. Princeton, 1965.
[11] J. Gurley and E. Shaw. Money in a Theory of Finance. washington, 1960.
[12] J. R. Hicks. “Mr. Keynes and the ‘Classics’: A Suggested Interpretation.”
Econometrica, April 1937.
[13] J. J. Kaufman and C. M. Lotta. “The Demand for Money: Preliminary Evidence from Industrial Countries.” Journal of Financial and Quantitative Analysis, September 1966.
[14] J. M. Keynes. “The General Theory of Employment.” Quarterly Journal of Economics. February 1937.
[15] —— The General Theory of Employment, Interest and Money. New York, 1936.
[16] Axel Leijonhufvud. “Keynes and the Keynesians: A Suggested Interpretation.” American Economic Review, May 1966.
[17] H. P. Minsky. “Financial Intermediation in the Money and Capital Market.” In Guilio Pontecervo, Robert P. Shay, and Albert G. Hart, Issues in Banking and Monetary Analysis. New York, 1967.
[18] —— “Financial Crisis, Financial Systems and the Performance of the Economy.” In Commission on Money and Credit Private Capital Markets. Engiewood Cliffs, N.J., 1964.
[19] —— “The Crunch and Its Aftermath.” Bankers’ Magazine, February, March 1968.
[20] R. v. Roosa. Federal Reserve operational in the Money and Government Securities Market. Federal Reserve Bank of New York, 1956.
[21] G. L. S. Shackle. “Recent Theories Concerning the Nature and Role of Interest.” In American Economic Association, Royal Economic Society, Surveys of Economic Theory, Vol. 1.
[22] H. C. Simons. “Rules versus Authorities in Monetary Policy.” Journal of Political Economy, 1936; reprin ted in Simons, H. C., Economic Policy for a Free Society. Chicago, 1948.
[23] James Tobin. “An Essay on Principles of Debt-Management.” In Commission on Money and Credit, Fiscal and Debt Management Policies. Englewood Cliffs, N. J., 1963.
[24] R. Turvey. Interest Rates and Asset Prices. London, 1960.
[25] —— “Does the Rate of Interest Rule the Roost?” In Hahn, F. H. and Brechling, F. P. R. (eds.), The Theory of Interest Rates. New York, 1965.
[26] J. viner. “Mr. Keynes on the Causes of Unemployment.” Quarterly Journal of Economics, November 1936.
[27] J. G. witte, Jr. “The Micro Foundation of the Social Investment Function.” Journal of Political Economy, October 1963.
NOTES
1 For an example of the current “contro versy” liter at ure see Brunner [3]. A fairly complete bibli o graphy can be derived from Brunner’s cita tions.
2 Friedman in his Henry Simons lecture [8] recog nizes that Simons proposed thor oughgo ing reform of the finan cial system whereas his own view is that all that was really wrong is the way in which the central bank exer cises its control of the money supply. Simons, being a skeptic, even ques tioned the adequacy of thor oughgo ing reform: “Banking is a pervas ive phenomenon, not some thing to be dealt with merely by legis la tion direc ted at what we call banks. The exper i ence with the control of note issue is likely to be repeated in the future; many expedi ents for controlling similar prac tices may prove inef fect ive and disap point ing because of the reappear ance of prohib ited prac tices in new and unpro hib ited forms” [22, p. 172 in Economic Policy in a Free Society]. Note that Simons had a finan cial system rather than a narrow monet ary view of the “Banking” problem.
3 There is a minimum set of finan cial char ac ter ist ics which an economy must possess for it to be capit al ist. I don’t believe this ques tion has ever been prop erly faced. The obvious char ac ter ist ics of private owner ship of the means of produc tion and decent ral ized decisions implies, in a complex
society, that finan cial instru ments exist which permit both indir ect and layered owner ship. In addi tion, the exist ence of a wide array of permiss ible liab il ity struc tures and a large menu of finan cial assets is neces sary; as well as insti tu tions which facil it ate the chan ging of port fo lios and the adjust- ment of liab il ity struc tures [Keynes, 15, Chapter XII]. Thus markets in finan- cial assets must exist and these markets for, so to speak, the finan cing of posi tions in second hand assets must also be avail able for finan cing the creation of new tangible—and intan gible—assets.
In addi tion, as a corol lary to the encour age ment of innov a tion in produc- tion, innov a tion in finan cial usages must be permiss ible [Minsky, 17].
4 The concept of “making posi tion” is central to an under stand ing of how banks and other money market insti tu tions operate in a soph ist ic ated finan cial system. The “posi tion” is a set of assets (loans and invest ments for banks, govern ment debt for bond dealers, etc.) title to which needs finan cing. The need to finance posi tion may take the form of a need to acquire reserve money—either to pay for an acquis i tion or to meet a clear ing drain, etc. The acquis i tion of a deposit via a certi fic ate of deposit, the borrow ing of reserves via the Federal Funds market, the sale of Treasury bills are ways in which posi tions can be made.
Position-making thus takes the form of liab il ity manage ment or trans ac- tions in money market assets. During the post-war period substan tial changes in the instru ments and markets used by money market banks in posi tion making have occurred.
Failure to make posi tion can lead to a forced sale of other assets and thus substan tial losses.
5 Awareness of the possib il ity of a finan cial crisis and a recog ni tion of the Board of Governors’ respons ib il ity in that even tu al ity is evident in the recent Board of Governors’ review of the oper a tions of the discount appar atus [1].
6 Shackle [21] emphas izes the import ance of Keynes’ rebut tal to viner, refer- ring to it as the 4th of Keynes’ great contri bu tions. This restate ment by Keynes of his views has been ignored by the domin ant contem por ary
“Keynesian” econom ists.
7 “This stand ard model [that derived from Hicks’ “Mr. Keynes and the Classics”] appears to me a singu larly inad equate vehicle for the inter pret a- tion of Keynes’ ideas” [Leijonhufvud, 16, p. 401].
Clower refers to “. . . The Keynesian Counterrevolution launched by Hicks in 1937 and now being carried forward with such vigor by Patinkin and other general equi lib rium theor ists” [5, p. 103]. Most “Keynesian”
econom ists are devoted agents of the coun ter re volu tion.
8 “The evid ence presen ted indic ates that income is an import ant compon ent of the demand for money in all leading indus trial coun tries. In addi tion income elast i cit ies were found to be inversely related to the state of devel- op ment of the money markets in the respect ive coun tries, being highest in Italy and Japan—coun tries with the least developed markets, and lowest in