minsky - central banking an money market

7/29/2019 Minsky - Central Banking an Money Market

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Central Banking and Money Market ChangesAuthor(s): Hyman P. MinskyReviewed work(s):Source: The Quarterly Journal of Economics, Vol. 71, No. 2 (May, 1957), pp. 171-187Published by: Oxford University PressStable URL: http://www.jstor.org/stable/1883812 .

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THEQUARTERLY JOURNALOF ECONOMICSVol. LXXI May,1957 No. 2CENTRAL BANKING AND MONEY MARKET CHANGES*

By HYMANP. MINSKYI. Introduction, 171.- II. Two recent institutional changes, 173; thefederalfundsmarket, 173; the financingof governmentbond houses: sale andrepurchaseagreementswithnonfinancialcorporations,176. - III. Implicationsof these changes formonetarypolicy, 181.- IV. Implications of the expecta-tionthat institutionswill change, 185.

I. INTRODUCTIONThe abilityof a centralbank to achieve its objectivesdependsuponhow tsoperations ffecthevariouselements hatmakeup themoneymarket. Hence, the efficacyf any particular echniqueofmonetary olicydependsupon the financial nstitutionsnd usagesthatexist. If financialnstitutionso notchange ignificantly,hen,oncetheefficacyf thevariouscentralbankoperationss established,financialnstitutionsanbe ignoredndiscussions fmonetary olicy.However, fa periodofrapidchanges n the structure rin themodeoffunctioningffinancialmarkets ccurs, hentheefficacyfcentralbankactionshas to be re-examined.Changesin financialnstitutionsnd money-marketsages aretheresult feither egislation r evolution. Legislatedchangestypi-cally are the resultof somereal or imaginedmalfunctioningf themonetary-financialystem nd hencetheyusually are accompaniedbydiscussions ftheirmpact. Evolutionarychangesoccurtypicallyin responseto some profitpossibilitieswhich exist in the moneymarket. As the evolvedchangesoften enter roundsome technicaldetailofmoney-marketehavior nd as theyusually tarton a smallscale,their ignificanceormonetary olicy s generallygnored t thetimetheyfirst ccur. Onlyif,at a laterdate, somemalfunctioningofthefinancial ystem s imputed o suchan evolvedmoney-marketinstitution ill tbe discussed, nd thenthe discussion suallyoccurs* The observations upon which Part II of this paper is based were madewhile was in New York City on a fellowship ponsoredby theJointCommitteeon Education ofthe AmericanSecuritiesbusiness. I wish to thank J. Margolis,R. Miller and R. Roosa forhelpfulcommentsand suggestions.

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QUARTERLY JOURNAL OF ECONOMICSas a prelude o "corrective"egislation. Awareness fthe conditionswhich nduce nstitutionalhanges n themoneymarket nd knowl-edgeof thetypical ffects f such nstitutionalhanges houldenabletheFederalReserveor thelegislating uthorities ither o take pre-ventivemeasuresor to be readyto minimize heeffectsfa "crisis"whenoneoccurs.As evolutionaryhanges n financial nstitutionsnd usages arethe resultof profit-seekingctivities,the expectation s that suchfinancial hangeswill occur mostfrequently uringperiodsofhighorrisingnterest ates. Such rates re evidence f a vigorous emandforfinancingelativeto the available supply. They act as a signalto money-marketrofessionalso seek ways of usingthe availablelending bilitymoreefficiently.1Essentially, he relationsupon which themonetary uthoritiesbase their perationsrepredicated pontheassumption hata givensetof nstitutionsnd usagesexists. If theoperations fthe author-itieshave sideeffectsn thatthey nducechanges nfinancialnstitu-tionsand usages,then the relations shift." As a result, he effectsofmonetary perations an be quitedifferentrom hosedesired. Tothe extentthat institutional volution s inducedby highor risinginterest ates,this wouldbe particularly ignificant henthecentralbank s enforcing onetary onstraintn an effortohalt nflationarypressures.2In the recentpast (1954to date) short-termnterest ates ntheUnited States have been relativelyhigh and rising. During thisperiodat least two changesin the Americanmoneymarket haveoccurred: hedevelopment nd growth fthe federalfundsmarket;1. "The basic functioning f financial nstitutions s the mobilizationof thefinancialresourcesofthe economy n supportofeconomicactivity,and I suggestthatwhencreditconditions re tightened nd the creationof newmoneythroughthebankingsystem s restricted, he financialmachinery fthe country utomati-cally begins to workin such a way as to mobilize the existingsupply ofmoneymoreeffectively,huspermittingt to do most of thework that would have beendone by newly created money had credit conditionsbeen easier" (Warren L.Smith, "On the Effectiveness f Monetary Policy," AmericanEconomic Review,XLVI (Sept. 1956), 601). Smith's point that the more effective tilizationof agiven monetary supply counteracts,at least in part, tight credit conditionsiswell taken. However, the assertions that it automatically begins to operate andthat it occurs within an unchanging institutional frameworkare, I believe,incorrect.2. "Moreover,any rise n interest atesbrought bout perhapsbya combina-tion of restrictivemonetary policy and accumulating debt creates the opportu-nitiesfornon-bank ntermediaries o offermoreexpensiveattractions to creditorsand henceto competemoreactivelywith banks" (JohnG. Gurleyand E. S. Shaw,"Financial Aspectsof Economic Development," AmericanEconomicReview,XLV(Sept. 1955), 532). Gurleyand Shaw deal with the evolution of financial nstitu-tions n a growth ontext nd hencetheytend to take forgrantedthe nducementsto, and the factsof, nstitutionalchange.

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CENTRAL BANKING AND MONEY MARKET CHANGES 173and the increase n the importanceof nonfinancial orporationsnfinancing overnment ondhouses. In SectionII thesetwo evolveddevelopmentsredescribed nd examined,nSection II the mplica-tions of these particularchanges for Federal Reserve policy aretakenup, and in SectionIV the implications ormonetary olicyofthe expectationthat money-marketnstitutionswill change areinvestigated.

II. Two RECENT INSTITUTIONALCHANGESA. The Federal Funds MarketThere s no singletrading enterwhere hefull cope ofthe fed-eral funds marketcan be observed. One brokeragehouse in NewYorkhas formanyyears,however,played an important olein themarket.3 The best possible view of the market,fromany singlevantage point, is probablythat obtained by observingthis firm'soperations.Atthe endofJune,1956,Garvin,Bantel and Companyhad some79 commercial anks and 14 otherfinancialnstitutionss clients ortransactionsn federalfunds. Not all sales or loans offederal undsarecleared hroughhebrokerage acilities fthisfirm.A substantialvolumeof transactions ccurs,forexample,through he network fcorrespondentelations mongbanks,at times n theform fdirectloans betweenbanks. However,forthe transactionswhichdo notpass through heworksheet fGarvin,Bantel and Companythe rateis thought o be typically he same as thatwhichemerges rom heofferingsnd bids brought ogether hrough heiroffice.4Reserves at the Federal Reserve Banks are the commoditynwhich hefederal undsmarket eals. The transaction s an unsecuredovernightoan between banks.5 AmongNew York Citybanks thisis accomplished yan exchangeofchecks, he endingbankgivestheborrowingank a draft ntheFederalReserveBank,and the borrow-

3. I wish to thank George Garvin and Ralph de Paola ofGarvin,Bantel andCompany for heirkindness n explainingtheiroperationsto an academician. Thefollowing nalysis of the characteristicsoftheir clientsis based upon their work-sheet. I wish to emphasize that only the segmentof the national marketwhichrelies upon the brokerage facilities of that firm s described here. I alone amresponsibleforthe reporting nd the interpretationwhichfollows.For a good introduction to the mechanics of the federal fundsmarket seeNadler, Heller and Shipman, The Money Market and Its Institutions New York:The Ronald Press, 1955).4. A morecomprehensivesurveyof the entire market was reportedlyunder-taken by a special committee of the Federal Reserve System some time in 1956.Pending the completionofthat study,which has been kept on a confidential asisup to the time ofthiswriting, t is difficult o generalizewithany certainty boutthe marketas a whole.5. At times,governmentbond houses, as the resultofa sale ofbonds to theFederal Reserve System,will lend (sell) federalfunds.


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QUARTERLY JOURNAL OF ECONOMICSingbankgivesthe endingbank a checkdrawnon itself. As it takesoneday for checkto clear,theborrowing ank's overnight alanceat the Federal ReserveBank is increasedby thistransaction.6Fornon-NewYorkCitybanks,a telegraphic ransferfreserve alancesin one direction oday is offset y a telegraphic ransfer f reservebalances in theoppositedirection t theopening fthenextbusinessday. Thesereserve alancescanbe andarefreelyransferredetweenFederal Reservedistricts.7Obviouslya loan offederalfundsdecreasesthe reservebalanceofthe ending ankand increases he reserve alanceoftheborrowingbank. During a period of negativefreereserves,8 bank whichactivelyparticipatesn thismarket imsat nothaving xcessreserves,overtheaveraging eriod,greater hanthe unitoftransactions.Alsoa bank active in this marketmightnot borrow from ts FederalReserveBank unless here renofederal unds vailable. The benefitto thelendingbank is obvious: it earns nterest nwhatwouldhavebeen an idle balance. The borrowing ankbenefitsn nothavingtoborrow t itsreserve ank. In contrast, or bank not nthefederalfundsmarket, reservedeficiency esults n its either elling ssetsorborrowingt thereserve ank,and anyshort-runxcessofreservesremains n itsbooks.The interest ateon federalfunds s nevergreater hanthe dis-count rate. During periodswhen thereare sizeable negativefreereserves, hefederal undsrateusually s equal to the discountrate.Most banksaveragetheir eserves ver theassignedperiodbybuild-ingan excessreserve osition t thebeginningftheaveraging eriodandthen llowing eserve eficitso accumulateduring he atterpartof the period so that, as a resultof the dominanceof the weeklyreportingmemberbanks in the federalfundsmarket, ratepatternhas developed. During periodsofsizeablenegativefree eserves, hefederalfundsrate is equal to the discountrate except,perhaps,onWednesdaywhen t often s lowerthanthe discountrate. There issomeevidencethat by midyear1956 somebankswerebeginning oplay this nterest atepattern.Of the 79 commercialbanks whichactivelyparticipate n thefederalfundsmarketby using the facilities f Garvin,Bantel and

6. In computingreserverequirements, hedepositsare takenas ofthebegin-ningof a businessday whereasthereserves re calculated as of the closeoftheday.7. When the discount rate is not the same in all districts, ome banks willnot lend reservesfrom ow to highdiscount rate districts. Also some New Yorkbankswill notallow theirfederalfundsto be loaned outsidetheNew York district.8. Free reserves re excess reservesminusborrowings t theFederal ReserveBanks.

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CENTRAL BANKING AND MONEY MARKET CHANGES 175Companyforall or part of theirfederalfundstransactions, 4 areCentralReserveCityBanks, 39 are ReserveCityBanks and 16 areCountryBanks. Of course,the largestand most active groupofbanksusingGarvin,Bantel and Company'sfacilities re the24 NewYork and Chicagobanks.9 The largenumber f ReserveCity andCountry anksparticipatings evidence hatthe market s national.The effectiveimiting actordetermining hether rnota bankwilltake part in the federalfundsmarket s the size of the bank.It does costsomethingotakepart:thetimeof n officer,honecalls,etc. The brokercharges1/16 of 1 per cent "each way" to banksoutside fNewYorkCitywhichdo not usehisfacilities or tock ndbond business. As the loan is an overnightoan, the interest t23 per cent on one milliondollarsforone day is $76.389 and thebroker's ommissionn a one milliondollar oan (1/16of 1 percenteach way) is $3.472. As a resultof such considerationshe unitoftradingnmidyear 956was aroundone-halfmillion ollars, nd eachparticipating ankwas expectedto deal in severalunits. Since themaximum llowable oan to any oneborrowerexcluding he federalgovernment)ya NationalBank is 10percentof thebank's capitaland surplus,no National Bank with ess thanfivemilliondollarsofcapital accounts can participate. An examinationof the balancesheetsofbanksshowsthis to be thecase.'In addition othecapital imitation,hebroker xpects achbankeitherto borrowor lend,with some regularity,everal such half-milliondollarunits. Thus a participating ank must oftenhave aone or twomilliondollar excessor deficit eserveposition. Of the79banks istedbyGarvin,Banteland Companyonly4 had less than$100 millions n depositsand another14 had depositsof between$100 and $200 millions. Six ofthese 18 smallerbanks were n theNew Yorkmetropolitanrea and 4 were n Chicago.The existence fthe federal undsmarketmakesa givenvolumeofreservesmore efficientn supporting eposits. If each bank dealswith heFederalReserveBank onthebasisof tsownneeds, hen heexcessreserves fsomebanksare notavailableto support eposits tdeficitbanks, which are forced eitherto borrowat the Federal

9. Becauseof thepeculiar llinoisunitbankingaw,some of the smallestbanks ranked ydeposits)which articipaten the federal undsmarketre nChicago.1. Informationboutthebanks istedon Garvin,Banteland Company'sworksheet as obtained romMoody'sBank andFinancialManual,1956, spe-ciallythe table "The ThreeHundredLargestBanks in the UnitedStates,"pp.a 22-23.Allofthedata cited boutparticularanks reas ofDecember 1,1955.


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QUARTERLY JOURNAL OF ECONOMICSReserveBank or to sell securities. If a perfectlyunctioningederalfundsmarket xisted,no borrowingrom heFederal ReserveSystemwould take place whiletherewereexcess reserves n any bank, andno bank would have excess reserves while some other bank wasborrowing.As a resultof the development f the federalfundsmarketabasic changehas takenplace intheoperations f parC,ofhebankingsystem. For a participating ank it is not its ownreservepositionwhichdetermines hether rnot t willborrow t theFederal ReserveBank, and no longerdoes borrowing y a particular ankimply hatexcessreserves re beinggenerated n thesystem. To illustrate heargument, ssume a 20 per cent reserverequirementnd Bank Ato have a $10 million learing oss to Bank B, so thatBank A has adeficitnd Bank B an excessof$8 millionsnreserves. Withoutpar-ticipationbythesebanks in the federal undsmarket,Bank A wouldborrow 8 millionsfrom ts reservebank and Bank B would make$8 millionsof loans or investments:hence total demand depositsincrease. However, fbothBank A and B participate n thefederalfundsmarket, henBank A willborrow nd Bank B will end$8 mil-lions through he market. If the marketis tight,some residualdeficit ank will end up borrowingt theFederal Reserve: but it isthe market ituationratherthan the behaviorof a particularbankwhich eads to thisborrowing.2B. The FinancingofGovernmentond Houses: Sale and RepurchaseAgreementsithNonfinancial orporations

In midyear1956sale and repurchase greementswithnonfinan-cial corporationswerea majorsourceoffundsforgovernment ondhouses. Although he contract etween hebond houseand the non-financial orporations ostensibly sale ofgovernment ebt instru-mentswith tiedrepurchase greement,n truth hetransactions acollateral oan callablebothways. The lending orporation oesnotearn the interestaccruals on the "purchased" debt instruments,rather he corporation arnsa statedcontractual nterest ate.In additionto these sales and repurchase greementswithnon-financialcorporations, overnment ond houses can financetheirinventory position)by theirownresources, y sales and repurchaseagreementswith the Federal Reserve System (presumably t theinitiative ftheopenmarketcommittee), nd by borrowingt com-2. There re obvious imilaritiesetween he federal undsmarketnd theclassicalLondondiscountmarketnd inparticularnthepartplayedbyGarvin,Banteland Company nd byGurneys. See W. T. C. King,TheHistory fthe

London iscountMarketLondon,1936).

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CENTRAL BANKING AND MONEY MARKET CHANGES 177mercialbanks. The bond houses' ownresources an finance nlyasmallportion f their nventories;hereforehe behaviorof the bondhousesand henceofthegovernmentondmarketdependsupon thecharacteristicsf these differentourcesof funds.A call loan to a governmentondhouse, ecuredbygovernmentdebt, s inmanywaysa superior sset to a Treasury ill. Hence,onewouldexpect hat the nterest ateonsale andrepurchasegreementsbetweengovernmentbond houses and nonfinancial orporationswouldbe lowerthantherate on Treasurybills. This expectationsnot borne utbythefacts:the rate at whichgovernmentondhousesborrow romnonfinancialorporationss greater hanthe bill rate,although t is lowerthantherate at whichgovernmentondhousesborrowfrom ommercial anks.3 Apparently, he rate chargedbynonfinancialorporationss lowenough o that thegovernmentondhousesdonot oseoncarryingssueswith higher ield hanTreasurybills.Sale and repurchaseagreementsbetween governmentbondhouses and the Federal Reserve are almostalways at the discountrate.4 Asthe nitiative s with he FederalReserve, uchaccommoda-tions are a privilegeratherthan a rightof the government ondhouses.5 Hence, to the bondhouses,suchfunds re unreliable ndtheywillnot makecommitmentsntheexpectation hattheywill beaccommodated t theReserveBanks.6

3. My ownexplanations that thepremiumateon sales and repurchaseagreementseflectsoth he newness fthese greementsndthe risk uetothelack ofa guaranteehatthe bond houses anreplace uch call loansbytappingthe FederalReserve.4. Theauthorization,s ofAugust , 1955, ytheOpenMarketCommitteefor alesand repurchasegreementsetween overnmentond houses nd theFederalReserveSystemprovides hat: "In no event hall [they] e at a ratebelowwhicheversthe ower f 1) thediscount ateof heFederalReserve ankoneligible ommercialaper,or (2) theaverage ssuing ateon the mostrecentissue of threemonthTreasurybills, .. ." However,this s with the "understand-ing hat heauthority ouldbe usedsparinglynenteringntorepurchasegree-ments t ratesbelowthe discount ate" (Forty-SecondnnualReport f theBoardofGovernorsf he ederalReserveystem,p. 102-3).5. In July, 955, heOpenMarketCommitteeejected proposal o "...establish t the FederalReserveBanks an openwindow oruse in financingdealers t ratespreferablybove,but not ower han, hediscount ate" (ibid.,pp. 100-1).6. AroundheendofJune, 956, heFederalReserve opened hewindow"bylettingt be known hat t waswillingo entern sale andrepurchasegree-mentswith hegovernmentondhouses. Myinterpretationf his vent s thatat this imenonfinancialorporationundswere eingwithdrawnrom hegovern-ment ondhouses uetotaxneeds, nd,becauseJune 0th sa publishedalancesheet atefor ommercialanks, hegiant ommercialanksdidnotwant o beforcedntoborrowingrom heFederalReserve o finance hebondhouses.Thispotentiallynstablemarket ituation orced shiftnthe nitiative or epurchaseagreementsromheFederalReserve o thegovernmentondhouses.


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QUARTERLY JOURNAL OF ECONOMICSThe bond housesalways have linesofcreditopen at the largecommercial anks: in fact thesebanks are the bondhouse's "lender

of ast resort." Inmidyear 956the nterest atecharged ondhousesbythese commercial anksrangedfrom 1 percent to 312 percent.This was a "penal" rate as it was approximately percentgreaterthan theyieldonTreasurybillsand 2 percentgreater hantheyieldon othergovernmentebt. In thissituation,whengovernmentondhouses financed heirpositionbyborrowingrom anks,theywouldlosemoneyon thecarry. Hence by midyear1956,governmentondhouses did not finance heirpositionby borrowing t commercialbanksunlesstheywereforced o do so bytheunavailability fotherfunds. In contrast, uring he easy money days, governmentondhousesfinanced heirpositionby borrowingt thegiantcommercialbanks, ndthe nterest ate structure as suchthattheymademoneyon thecarry.In midyear 956,the nterest atepattern elevant o theopera-tionsofgovernmentondhouses was (in order,beginningwiththelowest nterest ates):(1) Treasurybills(2) sales and repurchase greementswithnonfinancialorpora-tions(3) discountrate(4) longer-termovernmentebt(5) bank loans to government ond houses (the lowestbankinterest ate).As theyieldon Treasurybillswas much owerthanthe nterest atechargedbond housesby commercial anks, therewas considerablepressure or bond houses to use and develop alternative ourcesoffunds.Due to the intermittentatternof tax, dividendand interestpayments,giantnonfinancial orporations ave periodicneeds forlargeamounts fcashwhich hey atisfy yaccumulating liquidity"out ofearnings. Among he formsnwhich"liquidity"can be heldare: (1) demanddeposits(2) Treasurybills(3) sale and repurchaseagreementswith governmentbonddealers(4) loans to sales finance ompanies.As commercialbanks are forbidden o pay intereston demanddeposits, uchholdings ieldno income. Given thevery asy moneyposition nd theassociated ow short-termnterest ates whichruled

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CENTRAL BANKING AND MONEY MARKET CHANGES 179from 935totheearly1950's,theholding fdemanddepositsdidnotmeananysubstantialossof ncome. The developing ighernterestratepattern fthe 1950'smeansthat ncreasinglyhesubstantial ashbalances of nonfinancialorporations ave been invested n short-term iquidassets. As a resultoftheability nd willingnessfnon-financialorporationso holdTreasury ills, heholdings fTreasurybillsby commercial ankshave decreasedfrom 7.0 billions n 1952to $2.2 billions n 1956,as shown n Table I.

TABLE IOWNERSHIPOF TREASURYBILLS, 1952-19561

(in billions of dollars)Held by

Total Commercial Other nvestorsDate Outstanding Banks (includesnonfinancialcorporations)Dec. 31, 1952 21.7 7.0 12.5Dec. 31, 1953 19.5 4.4 11.4Dec. 31, 1954 19.5 4.4 12.1Dec. 31, 1955 22.3 3.6 16.0June 0, 1956 20.8 2.2 17.1

1. FederalReserveBulletin:Table titled Ownership fUnitedStatesGovernmentMarket-able and Convertible ecurities" various ssues).Onthe otherhandtheholdings f other nvestorswhichncludethe nonfinancial orporations)have increasedfrom$12.5 billions

in 1952 to $17.1 billions n 1956. The same trend s evident nthe ownership f marketablesecuritiesmaturingwithinone year(Table II). TABLE IIOWNERSHIP OF MARKETABLE ISSUES MATURING WITHIN ONE YEAR, 1952-19561(in billions ofdollars)

Held byTotal Commercial Other nvestorsDate Outstanding Banks (includesnonfinancialcorporations)

Dec. 31, 1952 57.0 17.0 23.5Dec. 31, 1953 73.2 25.1 29.0Dec. 31, 1954 62.8 15.7 26.3Dec. 31, 1955 60.6 7.7 30.8June 0, 1956 58.7 7.4 29.21. Federal ReserveBulletin various ssues).


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QUARTERLY JOURNAL OF ECONOMICSThe nonfinancialorporationsan alsohold iquidityntheformof alesandrepurchase greements ithgovernmentondhousesandthe paper of sales finance ompanies. The paper of sales financecompaniesearnsa higheryield and can be tailor-made o suit theneedsofthelender,but it is neither o liquidnorso respectable nassetfor nonfinancialorporationo hold as Treasurybills. Salesand repurchase greements etween nonfinancial orporations ndbond housesarevery iquidand can be tailor-made. The agreementdoes seem to be superior o an outright urchaseofTreasurybillsbythecorporations,nditcertainlyssuperiorotheir utrighturchaseof onger erm ssues. As was statedearlier,by midyear1956 suchcorporationundswere, s far s couldbe judged,themajorfinancingsourcefor hegovernmentond houses.Bothdevelopments,he shift fshort-termovernmentebt andofthefinancingfgovernmentond housesfrom ommercial anksto nonfinancial orporations, ave freedbank resources o financeotheractivities. As far as the ability of the banking systemtofinance xpansion s concerned,hesedevelopmentsreequivalentto

an increase n bankreserves.Expansionofthebond houses' nonfinancialorporationales andrepurchase greements eems likelyto occur. If nonfinancial or-porations houldfind oansto bond housespreferableo ownershipfTreasury ills, hen heratesonTreasury illswould ncrease ndtherate on sales and repurchase greementswould decreaserelativetootherrates. The "fullydeveloped"marketwouldbe in equilibriumwhenthe rate on sales and repurchase greementswas fractionallylower hanorequal to thebillrate. The discount ate would remainhigher han thebill rate. In thisevent,thebond houses would bedealers.Whatare the mplicationsf hemarket tructureetailed bove?Anywithdrawal fcorporationmoneywillforce hegovernmentondhousesto borrow rom ommercial anks. With thepresentnterestratepattern, hiscontingencymakes trisky orbond housesto takea position. In addition fcorporate unds re withdrawn rom ondhousesbecause of economic conditions, hiswill be associatedwiththe sale or therunning ownofcorporation oldings fTreasury ills.As governmentond housesare 6nly guaranteed xpensive ommer-cial bankfinancing,heyhesitate o takea positionna fallingmarket.Hence,unless theFederal Reserveacts promptly o carry hebondhousesortobuyTreasury ills, nterest ateswillriserapidly. As thesale and running ownofTreasurybillsbynonfinancialorporationsindicatesthat theydesire ncreased iquidity whichcould be asso-ciatedwith downwardhiftn the nvestmentchedule)sucha rise

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CENTRAL BANKING AND MONEY MARKET CHANGES 181in interest ates would occurat the "wrong"time. To counteractthis, moneymarketwhich s baseduponshort-termending ynon-financial nstitutions equiresa device which automaticallyfeedsreservesnto the systemwhen the lendersdesire ncreased iquidity,e.g.,a mechanisms needed which utomaticallyncreases hequan-tityofmoney o compensate or decrease n thevelocity fmoney;and vice versa.Thereare other onsiderable angersnnonfinancialorporationsfinancinghe bond houses. Almost ll governmentond housesdealin other ypesofpaper as well. Once nonfinancialorporationsrehabituated omaking loans" withgovernmentebtas collateral, hepossibilityxists hat collateralizedoansusingnongovernmentaperwilldevelop.7 Such a developmentwouldentailgreater ossibilitiesofcapital losses in a liquidity risiswhich, n turn,wouldaffect hestability fthenonfinancialorporations.A seemingly imple olution o theproblems aisedby nonfinan-cial corporations inancing inancial nstitutionswith their dle bal-ances s toallowcommercial ankstopayinterest ndemanddeposits.To eliminate he"dangers"ofbankscompeting ordeposits, heratecould be tied to the discountrate. A rate structuren which argedemanddepositspay about 1 per centless than the rediscount ate(and there re a number fratesbetween hedepositand theredis-countrate) seems to be moreconducive o financial bilitythantheexistingrate structure. However, such a rate structure equireseither muchhigherTreasurybill rate or a special sourceof financ-ing forgovernment bond houses to replace the sale and repurchaseagreementswithnonfinancialorporations.As thedevelopment f aspecial financingetup forbond houses could entail radical institu-tionalchanges,8heseeminglyimple olution o theproblems aisedbynonfinancialorporations inancingond houseshas quite compleximplications.

III. IMPLICATIONSOF THESE CHANGES FOR MONETARYPOLICYTwo conclusionstandout as a result fthe nstitutionalhangesdescribed n thepreceding ections:(1) a givenvolumeofreservesnowsupportsmoredeposits;

7. Sales financecorporationsdo tap corporate cash balances. At present(late 1956) the largestpotential source of funds s such corporatebalances, and iftightmoneycontinuesI believe that new type financial nstitutionswill developwhichwould use these cash balances.8. For example, the rightto rediscountcould be withdrawnfromthe giantcommercialbanks, and, simultaneously,the governmentbond houses could begiventhe rightto sale and repurchaseagreements. Such a Britishsystemwouldlead to a rate structurecompatible with commercial banks paying interest ondemand deposits.


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QUARTERLY JOURNAL OF ECONOMICS(2) a givenvolumeofdemanddepositsnowsupportsmorebankloans to business.

These changeswhichhave increased hevolumeofbusiness ctivitythatthebanking ystem an finance avenot resulted romegislationorFederal Reservepolicy. Rathertheyhave been theresult freac-tionsto opportunitiesorprofitn themoneymarket.Centralbank constraint pon commercial ank reserves uringa perioddiagnosed s inflationarys due to a belief hatanyincreaseofbank oanswouldfeed nflation.Since at presentnterest atesthedemandfor oans is greater han thesupply, hesecentralbankcon-straints esult n highernterest ates. The highernterest ates, nturn, nduce nstitutionalhanges n themoneymarketwhichhavethe effect fincreasingending bility. These institutionalhangesmay ormay not lead to a sufficientncrease n financingbilitytoeffecthe same increase n financings wouldhave occurredftherehad beenno centralbank constraint.Within stable institutional ramework, rise n interest atestendsto makehouseholds nd businessfirmsonserve heir ashbal-ances. As an increase n velocity ncreases oanablefunds, twillatleast inpartoffset heeffectsfa tightmoneypolicy;but,unlesstheeconomys in a stateof excessmoney upplyof a liquidity rap type,this offsetwill notbe complete. This can be representeds a posi-tively sloped curvebetweenvelocityand the interest ate, and anincrease n velocity represents "permanent" ncreasein lendingability. Hence, fthe nstitutionalrameworks stable, tightmoneypolicywill be effectivend the interest ate will rise to whateverextent s necessary n orderto restrict he demandforfinancingotheessentiallynelastic upply.However,the rise n interest ates feedsback upon the institu-tionalframework.Withrising nterest ates the incentives o findnewways to finance perations nd new substitutes orcash assetsincrease. The moneymarket s highly ompetitive nd, as largerreturns re almost always available from ome new way to playdifferentialnterest ates,new ideas tendto get a hearing. Hencethere s a favorable nvironmentor nstitutionalnnovations. Sincethesignificantnstitutionalnnovations uring periodofmonetaryconstraint ill be thosewhich end to increasevelocity, hey an berepresenteds shiftinghevelocity-interestaterelation o theright.The resultantvelocity-interestate relation s the sum of theeffect f a changein interest ateswithinunchangingnstitutionalarrangementsnd the effects f changes n institutions.While aninstitutionalnnovation n the moneymarket s working ts way

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CENTRAL BANKING AND MONEY MARKET CHANGES 183through heeconomy, he net effects as ifthevelocity urvewereinfinitelylastic. The resultantvelocity-interestate relation s astepfunction,s inFigure . If I is theoriginal elocity-interestaterelation, rise nthe nterest ate from he iquidity rapratero orlwill induce institutionalnnovation ' which, n time,shifts thevelocity-interestaterelation o II. As a result t a constantnterest

I Il: mI / /o I / /4- I / /U) I /I /I/

/

o b

/

VelocityFIGURE IINSTITUTIONAL CHANGES AND VELOCITY

rate, he mount f dditional ending ssociatedwith rise nvelocityfrom to bwillbe effecteduring hetime that t takesthe nstitu-tional nnovation o work tsway through heeconomy. Ofcourse,during his time,theremay be short-runncreases n the interestrateaboveri, ftheshort-runemandfor inancingncreases ymorethan the increase in financingmplicit n the rate at which theinstitutionalrameworks changing.99. Actually a fall in the interestrate below riwill usually not result n theend oftheinstitutionwhose introduction hifted hevelocityrelation;so that theeffective elocity-interest elation is not infinitely lastic with respect to a fallin interestrates; the movement from to b is irreversible. Also the interestratewhichinduces the innovationmay be higherthan the rate necessaryto sustain

theinstitutional hangeso that the linea'b' may be negatively loped ratherthan

f


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QUARTERLY JOURNAL OF ECONOMICSWhenever uch an institutional hange n themoneymarket sworkingtswaythroughheeconomy, estrictivemonetary olicy, obe effective, ustoffsethe rise nvelocity ydecreasing hequantityofreserves. Purelypassiveconstraintwhich peratesbynotallowingthe quantityofmoneyto increasewill notbe effectiven preventinginflation.Therefore,nlessthecentralbankactsstronglyodecreasethemoney upply,monetary olicyhas onlya very imiteddomainof effectivenessn controllingnflationary ressures. The assertedasymmetryfmonetary olicy thatit is effectiven constrainingninflation nd ineffectiven constraining depression) s not true;monetary olicy s ofvery imited ffectivenessoth n constrainingan inflation nd in counteracting depression.The reverse ide of the coin to the increase n velocity s thatevery institutional nnovationwhichresults n both new ways tofinancebusiness and new substitutesforcash assets decreasestheliquidity ftheeconomy That is,eventhough heamountofmoneydoesnotchange, he iquidity fthecommunity ecreaseswhengov-ernment ebt s replacedbyprivatedebt ntheportfoliosfcommer-cial banks. Also,whennonfinancialorporations eplacecash withgovernment onds and thengovernment onds withdebts ofbondhouses, iquidity ecreases. Sucha pyramidingf iquidassets mpliesthat therisks o theeconomyncrease, or nsolvency reventempo-rary illiquidityof a key nonbank organizationcan have a chainreaction nd affect he solvencyor liquidityofmanyorganizations.If,during longprosperity,monetary olicy s used to restraininflation,number f uchvelocity-increasingnd iquidity-decreasingmoney-marketnnovationswill takeplace.1 As a result, hedecreasein liquiditys compounded. In time, hesecompounded hangeswillresult in an inherently nstable money marketso that a slightreversal fprosperityan trigger financial risis.

horizontal. The relations among velocity curves are analogous to the relationsamong an industry's short-run nd long-runsupply curves, excepting that thepricewhichwill induce investment eems firmer han the pricewhichwill induceinnovation.Gurley and Shaw (op. cit.) in discussing nonbanking sources of financingstate that "Because money becomes a smaller share of total financial assets,velocity becomes a less reliable index of interest rates" (p. 533). They fail todistinguishbetween the velocity-interest ate relationwith constant institutionsand the effect f highinterest rates in inducing money-marketnnovations.1. "In the 1920's nonbank intermediariesgained on banks at an especiallyrapid rate. The ratio of their assets to assets of banks rose from 77 in 1922 to1.14 in 1929" (Gurley and Shaw, op. cit.,p. 533, footnote19).

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CENTRAL BANKING AND MONEY MARKET CHANGES 185IV. IMPLICATIONS OF THE EXPECTATION THATINSTITUTIONS WILL CHANGE

The argumenthusfarhas shown hatmoney-marketnstitutionsdo evolve,especiallyunderconditions ssociated withtightmoney,and thatsuchdevelopmentsn themoneymarket endto counteracta tightmoney olicy. As a result uring strong oom, nterest ateswillnot riseverymuchforthe supplyoffinancings, in fact, veryelastic. Associatedwiththeabilityof themoneymarket o financean inflationaryxpansion s a decline n the liquidityof householdsand firms.To the extent hateither hemost iquidassets eave thebanking ystem or heportfoliosf other inancialnstitutionsrthedebtsofthenewlygrown nd developedfinancialnstitutions ntertheportfoliosfbanks,the iquidity fthebanking ystemdeclines.Declining iquidity fbanks,households, nd businessfirms astwoattributes.Oneis thatthe debt-networth atiorises. The otheris that the vulnerability fmoney-marketssets to a fall in valueincreases. The two attributes f declining iquidityreinforceachother so that the chances of insolvencyand illiquidity ncreasesimultaneously.A major imiting actor o the decline nthevalue ofanyasset sthetermsor thepriceat which t willbe monetizedby the centralbank. However, the evolutionary hanges in the moneymarketresult n bothnewkindsof assetsand newkindsoffinancial nstitu-tions. One viewofthecentralbanks'money-marketesponsibilitieslimits hem othe maintenance fthe iquidity fthebanking ystemand orderly onditionsn thegovernment ondmarket. A centralbankwith ucha viewof tsmoney-marketesponsibilitiesouldnotstabilize henewassetseither ypurchasing rdiscountinghem.2On a priorigroundsneither heoperatorsn themoneymarketnor the centralbankauthorities nowthe imitations fnew nstitu-tionsand paper. And, unfortunately,n a boom theyare not par-ticularly oncernedwiththepossibility f a financial risis. Hencethe newlyfoundprofit pportunitieswill be exploitedto such anextentthat the moneymarketbecomesunstable. In an unstablemarket slightdeviationfrom quilibrium as widespread epercus-sions. Hence,once themoneymarket volves nto such an unstable

2. The asset (governmentbonds) and the institution commercial banks)involvednthe womoney-markethangesaken p n SectionI will estabilizedbythecentral ank. Henceno real financialnstabilityan result rom hesechanges. Howeverother,perhapsstillpotential, hanges forexample, hedevelopmentftechniques ywhich small"cashbalancesofcorporationsanbe usedto finance usiness r, alternatively,hefinancingfsales finance om-paniesby corporationunds) re notprotectedytheFederalReserve.


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QUARTERLY JOURNAL OF ECONOMICSsituation, financial risis an be expected. The collapseof portionof the financialmarketresults n both a loss of net worth and ofliquidityby households,businessfirms nd other financial nstitu-tions. Even ifthefinancial risis s notgeneralized, conomicunitswillrevisetheirview and desiremore iquidity. A tendency o usesavingsto liquidatedebtand henceto increase heratioofnetworthto debt willarise;thishas a depressingffectpon ncome. Thus the"shock" from he financial ector can createa situationwhich eadsto a deep depression. The financingf an expansionby increasingvelocity endsto create situationnwhichboth a financial risis nda deep depression re possible.The attitudesofbothcentralbankers nd othermembers fthemoneymarket uring boomcan be characterizeds a version ftheMaginot inementality.The defense gainstthe mperfectionsfthefinancialmechanism hatwas revealed npreviousdepressionss nowperfect,hemoneymarket s nowworkingwell,hencethere s noneedto worry.3 However,the institutionsfthemoneymarket re con-stantlychanging nd as a result of these institutionalnnovations,the nextfinancial risiswillneverbe just like the ast one. What isrequired o counteract heeffectsfsuchevolutionary evelopmentsis a broadenedviewofcentralhankresponsibilitiesnd a clearrecog-nition hat, nspiteofcorrectiveteps, hemoneymarketwillalwaysstretchiquidity o thebreaking oint during boom.To date the Federal ReserveSystem s a lenderof ast resort oa commercial ankindistress. It is nota lenderof ast resort o themoneymarket. In contrast, he classical Bank ofEngland positionwas as a lender f ast resort o a financialntermediary,hediscounthouses,which, n terms f thepaperavailable,deeplypenetrated heBritishmoneymarket. A broadviewofa centralbank'sresponsibil-ities includesthe maintenanceof the stabilityof,and acting as alenderof last resortto, a broad segmentof the financialmarket.Hence as newfinancialnstitutionsevelopand as newtypesofpaperappear on themoneymarket, uchinstitutionsnd paperwouldnotnecessarily e ineligible or entralbankaid in timeofcrisis. Hencethe centralbank would preventthe widespread oss of liquidityresulting rom crisis n one segment fthemarket.43. In this connectionnotethat fthegreatdepressionofthe1930's is imputedto the stock marketboom ofthe 1920's which, n turn, s imputed to widespreadmargintrading,the Federal Reserve today has control over margintrading. Onthe otherhand, if stockmarket collateral is very mportant n the financial truc-ture, should not the central bank's responsibilitynclude the maintenance of itsvalue?4. Gurleyand Shaw (op. cit., pp. 536-38) write of Financial Control as analternative (or adjunct) to Monetary Control. Essentially our perspectivesare

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CENTRAL BANKING AND MONEY MARKET CHANGES 187A policyofmonetary onstraintwouldstill nduce nstitutionalinnovationswhichwouldresult nstretchingiquidity. However venafterthe moneymarket becomes unstable, the centralbank, bymonetizinghevulnerable sset,canpreventwidespread epercussionsfrom ccurring.After tabilization,f a money-marketnstitution rusage is considered ndesirablebecause it inevitably eads to insta-bility, hen it could be got rid of by legislativeor administrativemeasures.That theeffortythe centralbankto controlnflationbetsthedevelopment funstable conditionsn themoneymarketmay seemto be a dismal conclusion. Actually, t is too muchto expectthatatrivial etofoperationsuch as those abeledmonetary olicyorfiscalpolicywill always succeed in maintaining tability n a dynamiceconomy. Institutionalnnovation s one aspectofa dynamic con-omyand money-marketnnovations ccurin response o the needsofa growing conomy. That thesechangeswilltend to underminetheeffectivenessf stabilization olicies s a by-productfgrowth.However, heroleofthecentralbank s notreallydiminished ytherecognitionf tsineffectivenessnpreventingnflations well asin stemming eflation.JThe centralbank's functions to act as alender f ast resort nd thereforeo limit he ossesdue to the finan-cial crisiswhichfollows rom he instabilitynducedby the innova-tionsduring he boom. iAcombination frapidcentralbank actionto stabilizefinancialmarkets ndrapidfiscal olicy ction to increase

communityiquiditywillminimize herepercussionsfthe crisis ponconsumptionnd investmentxpenditures,Thus a deep depressioncan be avoided. The function f centralbanks therefores not tostabilizethe economyso muchas to act as a lenderof last resort.This they re able to do.5 HYMAN P. MINSKY.BROWN UNIVERSITY ANDUNIVERSITY OF CALIFORNIA, BERKELEY

the same except that Gurleyand Shaw seem to hold hopes that financialcontrolcan aid in achieving stable growth;whereas I maintain that financial nstabilityinboom times s inevitable but thata properlydesignedand operatedcentral bankcan ameliorate its effects. Essentially the difference s one of problems andintuitions.5. This perspective on central bank abilities is not unlike that of L. W..\ints,Monretaryolicyfora Competitiveociety New York, 1950) and H. Simons,"Rules Versus Authorities n Monetary Policy," Journal of Political Economy,XLIV (1936), 1-30.

minsky - central banking an money market

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