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8-1964

Public and Private Financial Institutions: A Reviewof Reports from Two Presidential CommitteesAllan H. MeltzerCarnegie Mellon University, am05@andrew.cmu.edu

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Published InThe Review of Economics and Statistics , 46, 3, 269-278.

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Reprinted from THE REVIEW OF ECONOMICS AND STATISTICS

Published by Harvard University Copyright, 1964, by the President and Fellows of Harvard College

Vol. XLVI, No. 3, August 1964

PUBLIC AND PRIVATE FINANCIAL INSTITUTIONS: A REVIEW OF REPORTS FROM

TWO PRESIDENTIAL COMMITTEES * Allan H. Meitzer

THEORIES of monetary and financial markets are generally concerned with the

behavior of broad aggregates. As yet, econo-mists have not successfully blended the rich variety of institutional details that make up the financial markets with the theory of rela-tive prices. Perhaps as a result of our proce-dures and the state of knowledge, our policy recommendations are often suggestions for per-vasive changes in institutional arrangements. Many of our perennial policy debates are con-cerned with issues such as whether or not the Federal Reserve should be replaced by an im-mutable rule or whether banks should be pre-vented from independently creating money.

The discussions of "practical" men most often emphasize those institutional details that economists ignore. Practitioners (and many economists as well) generally fail to recognize that appraisals of existing or new institutional arrangements have relevance only within the context of validated hypotheses. Their con-cern is with the details of financial arrange-ments, and their proposals treat of such details, dismissing our theories as cavalierly as we dis-miss many existing details.

The men charged with administration of federal credit programs or involved in govern-mental operations affecting financial markets and institutions have now presented their rec-ommendations. The reports and proposals of the two committees1 considered here appear to

•The author readily acknowledges his debt to Karl Brunner. Both joint work with Brunner and independent work by Brunner have been used in the discussion that follows. After several years of collaboration, it is no longer possible for me to separate my ideas in this area from his, so he must share in the responsibility for any errors that remain. Discussions with Eli Shapiro were most helpful in formulating the suggestion for deposit insurance premiums graduated with asset risk. I wish also to acknowledge the research support of The Ford Foundation Faculty Research Fellowship, the National Science Foundation and the Grad-uate School of Industrial Administration, Carnegie Institute of Technology who have supported much of the research that forms the background of this review.

1 The Report of the Committee on Federal Credit Pro-

be the work of "practical" men. Few of the proposals emerge from a detailed analysis of the monetary system or from the validated hypotheses that we currently possess in mon-etary theory.

Those who were "disappointed" by the na-ture of the recommendations and the absence of suggestions for sweeping changes in the re-port of the Commission on Money and Credit2

will be similarly discouraged by these reports. There are few indications that major institu-tional rearrangements would be desirable. In-deed Financial Institutions goes in the opposite direction. It, ". . . offers reassurance that our financial system, for the most part, functions soundly and efficiently to promote the growth and stability of our economy." 8 While there is a warning that, ". . . it would be unfortu-nate to confuse lack of urgency with lack of importance," one of the reports cautiously suggests that the recommendations made, ". . . are not so compelling as to command the high-est priority in the President's legislative pro-gram."4 This suggestion was duly noted by the late President who took steps to implement the recommendations in Federal Credit but allowed time for most of the suggestions in Financial Institutions to mature further.

The two reports differ in more than their implementation. Federal Credit is primarily a series of guidelines for the executive depart-ments and agencies that administer loan and guarantee programs or engage in secondary market operations. There are occasional glances at Congress, but most of the recom-grams to the President of the United States and The Report of the Committee on Financial Institutions to the President of the United States (Washington: Government Printing Office, Febr., and April, 1963), 67 and 66 respectively. The former report is referred to as Federal Credit, the latter as Financial Institutions.

'Commission on Money and Credit, Money and Credit — Their Influence on Jobs, Prices, and Growth (New Jer-sey: Prentice-Hall, 1961), hereafter the CMC.

* Financial Institutions, v. 'Ibid., 3.

[269]

270 THE REVIEW OF ECONOMICS AND STATISTICS mendations deal with the arrangements that should be adopted if new programs are ap-proved, the criteria for choosing between loans and guarantees, the relation of credit programs to the economic policy of the government, cri-teria for the participation of private lenders, methods of coordinating administrative opera-tions, and similar matters that do not require new legislation. Financial Institutions is con-cerned with a number of matters that either cannot or will not be solved without legislative direction. Among the more interesting issues discussed are the magnitude and form of re-serve requirements for commercial banks, the application of reserve requirements to financial institutions other than banks, the payment of interest rates on demand deposits, and the cur-rently heated question of supervision, regula-tion, and branching of commercial banks. Some of these issues are considered in more detail below.

The composition of the two committees dif-fered also. For reasons that are not immediate-ly obvious, a four-man team consisting of the Secretary of the Treasury, the Director of the Bureau of the Budget, the Chairman of the Council of Economic Advisers, and the Chair-man of the Board of Governors was charged with responsibility for recommendations affect-ing the federal credit programs. Agencies op-erating in the lending field, particularly hous-ing and farm credit agencies, were appointed to the Committee on Financial Institutions but not to the Committee on Federal Credit.5 How-ever, representatives of the agencies were per-mitted to discuss and comment upon a pre-liminary report by the Federal Credit Commit-tee, and the final report, to some unknown ex-tent, represents a consensus of available view-points.

The late President offered both committees the opportunity to use the recommendations of the CMC as a starting point. Neither group went much beyond the specific questions raised

6 The Committee on Financial Institutions included the four members of the Federal Credit Committee plus the Attorney General, the Secretary of Agriculture, the Comp-troller of the Currency, and the Chairmen of the Home Loan Bank Board, the Housing and Home Finance Agency, and the Federal Deposit Insurance Corporation. The Sec-retary of Health, Education, and Welfare was not originally designated as a member by the President but appears to have been a member and signed the report.

by the President's memoranda establishing the committees, nor beyond the issues discussed by the CMC. It is particularly noteworthy that Federal Credit, like the CMC, does not suggest any new lending programs, although it com-ments on the desirable administrative arrange-ments and financing methods when such pro-grams are established, and notes that the "po-tential for credit programs as an effective tool of public policy will be substantial."6 The Committee did not choose to get into the sub-ject of the desirability of particular programs, new or old, and the reader must decide for himself whether or not the CMC and Federal Credit represent a consensus of leading busi-nessmen and government officials that such programs should be expanded slowly, if at all.

In this review, only a few of the approxi-mately SO recommendations in the two reports can be discussed. Since the underlying issues raised by the recommendations are sufficiently different, I will treat the two reports separately and will direct principal attention to some of the recommendations in Financial Institutions. Where the recommendations overlap topics dis-cussed in an earlier report of the CMC or a committee established by the Comptroller of the Currency, I will comment on some of the latter suggestions as well.7 Although the con-clusions regarding the desirability and/or type of change are different in the CMC, Advisory Committee, and Financial Institutions reports, some of the discussion applies to all three.

Recommendations Directly Affecting Federal Reserve Monetary Policy Operations

Financial Institutions makes a number of suggestions that would alter prevailing ar-rangements shaping the transmission mecha-nism for monetary policy. It was determined: (1) that reserve requirements on demand de-posits should be based on volume of deposits rather than location of banks, (2) that require-ment ratios for demand and time deposits should be made applicable to all commercial banks whether or not they are members of the

• Federal Credit, 9. 7 National Banks and the Future, Report of the Advisory

Committee on Banking to the Comptroller of the Currency (Washington: Government Printing Office, 1962). This re-port will be referred to as Advisory Committee.

FINANCIAL INSTITUTIONS 271 Federal Reserve, (3) that all commercial banks should have access to the discount window, and (4) however, membership in the Federal Reserve System should continue to be voluntary for state chartered banks. Additional recom-mendations concerning the regulation of in-terest rates on demand and time deposits and the supervision of commercial banks were also made, but these can be more fruitfully dis-cussed below in another context.

There is disagreement about the particular recommendations among the three groups. The Advisory Committee and the CMC urged uni-form reserve requirements for all banks, al-though they differed about the desirable range within which the authorities might vary the requirements. Both the CMC and the Advisory Committee concluded that reserve require-ments against time deposits should be elimi-nated, but they differed about compulsory mem-bership in the Federal Reserve System. Only the CMC supported compulsory membership for all commercial banks. Only Financial In-stitutions desired to retain reserve require-ments for time deposits.

Much of the discussion ostensibly supporting the recommendations for change consists of plausible assertions, augmented by some fac-tual references and some factually incorrect statements.8 But the effect of the proposed changes in institutional arrangements cannot be fully appreciated without reference to an explicit frame of validated theory. Unfor-tunately, we possess no carefxilly developed, highly validated theory, integrating economic analysis and those monetary arrangements in which changes are proposed, that has been tested against alternative theories. But some work has been done in recent years to develop

8 For example, we read on page 8 of Financial Institu-tions that the Federal Reserve was inhibited from using reserve requirements as an anti-inflationary weapon because of the "possibility that banks would withdraw from mem-bership." But if we consider the use that was made of power to alter reserve requirements in the early postwar period, we find that changes in reserve requirements were almost always compensated or overcompensated by open market operations in the opposite direction. The net effect of such actions was expansionary with respect to the money supply in periods deemed to be inflationary (1948) and contractionary in periods of recession (1949). For a more complete discussion, see Brunner and Meltzer, An Analysis of Federal Reserve Monetary Policymaking, prepared for the House Committee on Banking and Currency (1964).

and test hypotheses connecting policy arrange-ments with the behavior of the money supply.9

These hypotheses are adequate for a prelimi-nary appraisal of the proposed changes and per-mit a more detailed evaluation than is provided in Financial Institutions.

Moreover, the hypotheses permit us to ex-amine the content of such remarks as, "open market operations and discount policy would have their effect even in the absence of re-quired reserves" but, "most members of the Committee believe that monetary policy is strengthened by uniform reserve requirements for all commercial banks." 10

Some of the policy issues can be analyzed using the theory referred to in footnote 9. Equation (1) expresses the money supply as the product of a policy variable, the adjusted monetary base (B"), and the behavior of the banks and the public summarized in m.11 A number of the proposed changes would alter prevailing reserve requirements, incorporated as r in equation (2). To more fully bring out the specific effects of the proposed changes in reserve requirements on the money supply, equation (3) presents r as a weighted average.12

• I will rely on three papers in particular. Karl Brunner, "A Schema for the Supply Theory of Money," International Economic Review (Jan., 1961), Karl Brunner, "The Struc-ture of the Monetary System and the Supply Function for Money," paper presented to the December 1960 meetings of the Econometric Society, and Karl Brunner and Allan Meltzer, "Some Further Investigations of Demand and Supply Functions for Money," paper presented at a joint meeting of the Econometric Society and the American Finance Association, December 1963 and to be published in the Journal of Finance (May 1964). The interested reader is referred to these papers for a more complete de-velopment of the underlying structure.

10 Financial Institutions, 8. 11 The latter term is specified by equation (2). Each of

the elements kt t, e, and b in m is itself a function of per-tinent interest rates, costs and yields, and wealth position; k and t reflect the public's desired holdings of currency and time deposits relative to demand deposits; e and b incor-porate the desire of banks to hold reserves in excess of required reserves and to borrow from Federal Reserve Banks; r is a weighted average of reserve requirements against time and demand deposits given by (3) of the text; i f is the sum of currency and demand deposits; and Ba is the sum of currency held by the public and unbor-rowed reserves of commercial banks.

™D and T are demand and time deposits; rd and r* are the applicable requirement ratios; v is the amount of vault cash held at non-member banks since 1960; 8 and r sum-marize variations in the proportion of demand and time deposits that are liabilities of member and non-member banks.

272 THE REVIEW OF ECONOMICS AND STATISTICS M = mB*

m — 1 + k

r =

(r + e - b)(l + t) +k fdW + rtrT+v

D + T

(1)

(2)

(3)

dM " IT

dB* dr* Ba

¿6

0 df* Q C 2 - — + € 3 — -

db dt e b t (4)

It can be seen that the changes proposed by the various committees would alter r* or r* and would remove 8 and r from equation (3). The initial effects of these rearrangements occur through the changes induced in the money multiplier, m. The elasticities of m with respect to i4 and r* are approximately —2.2 r6 and — 1.15 r*.13 These values permit us to obtain the approximate changes in the money multi-plier resulting from changes in r* and r* if values are assigned to m and the two policy variables.

Repeated applications of data to the money supply hypothesis suggest that m has remained in the neighborhood of 2.S in the postwar period.14 If r% is reduced from its current value, .04, to zero, as proposed by the CMC, the direct effect on the money supply would be to raise the elasticity of m with respect to r* from its current value, — .046, to zero. Similarly, a re-duction in the weighted average of required reserves against demand deposits to a uniform value of .10 would raise the elasticity of m with respect to r* by approximately .10 to —.22.

Neither change would have a substantial effect on the relation between policy operations and the money supply or on the size of the money multiplier, m, in equation (2). The hy-pothesis implies that the two requirement ratios are related to the rate of change in the money supply in an approximately linear way.15 Spe-cifically, logarithmic differentiation of equa-tions (1) and (2) shows that we obtain the policy variables and other elements multiplied by an appropriate elasticity, e*.

"See Karl Brunner and Allan Meltzer, op. cit.y table 2. 14 It should be stressed that m is not a constant, but

depends on the behavior of the banks and the public as well as on the policy choices made by the monetary authorities.

" T h e relation is only approximately linear because we assume that the e* are constants. Detailed analysis suggests that major changes in these elasticities have occurred pri-marily when there are changes in reserve requirements.

A reduction in r* or the elimination of r1, would not eliminate any of the parameters ex-pressing the behavior of the banks and the public that are components of the elasticities, €*', in equation (4). However, each c* changes when there are adjustments in the requirement ratios, since the weighted average r is a com-ponent of the Thus the proposal to set r* = 0 would remove one minor source of variation in the relation connecting the policy variables and the allocation ratios, k, t, e, and b with the money supply. But this would be true for any constant value of rincluding the present value.18 Lowering r* (or r') would raise the growth rate of the money supply, but this could be accomplished, of course, by open market operations, i.e., by changing Ba.

By a very similar procedure, the money supply hypothesis can be used to evaluate some effects of other proposed changes in monetary arrangements. Doing so, we would find that the application of equivalent reserve require-ments to member and non-member banks would have a small effect on the size of the money multiplier also. The weighted average of re-serve requirements, equation (3), would be raised by this action, offsetting in whole or part, the reduction of reserve requirements to a lower level (the 10% proposed by the Advisory Committee) or the introduction of marginal

16 It should be noted that the influence of changes in rd

and r* on the money supply or the money multiplier is in-dependent of the definition of the money supply as inclusive or exclusive of time deposits at commercial banks. Financial Institutions (p. 14) suggests that the two questions are related and that the choice of a definition of the money supply (or bank credit) has some bearing on the question of the appropriate level of r*. This appears to be a con-fusion between r* and t. The latter reflects the public's allocation to time deposits and has an important «ffect on the magnitudes of the multipliers connecting Ba with the al-ternative definitions of money supply.

Given the present size of the adjusted base, a small change in m will produce a larger change in the money supply or its growth rate. I abstract from this problem for two reasons: (1) As noted briefly in the text, there are other means of altering the growth rate of M that do not require legislative action or administrative rearrangements; (2) the Committee does not use this argument to support the proposed changes.

FINANCIAL INSTITUTIONS 273 reserve requirements graduated by deposit size in place of the present system. Whatever net effect these changes in policy arrangements might have would appear through the €*' in equation (4). The lasting significance for the rate of change of the money supply of adopting the proposed regulations depends on the ex-tent to which changes in reserve requirements are used in the future as a policy instrument. If the requirement ratios are maintained at the lower (higher) level, the growth rate is perma-nently higher (lower). Financial Institutions is silent about future discretionary changes; the Advisory Committee seems to favor limitation of the power of the Federal Reserve to intro-duce large fiat changes in the requirement ratios.

Some additional effects of imposing mem-ber bank reserve requirements on non-member banks must be considered in a careful analysis. The report suggests that uniform, compulsory requirements for banks of equal deposit size would achieve most of the aims of compulsory Federal Reserve membership. It does not clearly indicate what these aims are. However, we can infer that membership in the FDIC or par collection of all checks are not an important part of the aim, since the report does not re-quire either.17 Nor does the report give much consideration to the effect on the income of non-member banks, and the consequent reduc-tion in their number. While the aggregate ef-fect on the money supply of the elimination of such banks is perhaps minuscule, the effect on the local communities that these banks serve should be compared to the gain, if any, in monetary control.

Furthermore, it should be noted that the so-called slippage in monetary policy resulting from non-uniform requirements occurs prima-rily in the very short run. Evidence supporting the money supply theory outlined above sug-gests that the influence of policy changes on the money supply can be predicted closely within the framework described. There is little evidence that shifts of deposits from member to non-member banks (or from country to reserve city banks) seriously impaired the degree of control in the postwar period. To the extent

"Both the CMC and Advisory Committee suggested steps to stamp out non-par collection.

that such problems arise, they are of extremely short-term — daily or weekly — significance. The proposal for marginal reserve requirements that increase with deposit size would produce similar disturbances when deposits are redis-tributed from banks with low marginal reserve requirements to banks with high marginal re-quirement ratios. But why should the Federal Reserve or the Committee be concerned about these changes in the reserve position of indi-vidual banks? 18

It is difficult to demonstrate that the Federal Reserve has used its power to alter reserve re-quirements wisely or well. I have already re-ferred to the overcompensation of changes in requirements that was a feature of early post-war policy. Compensation for reserve require-ment changes by offsetting open market opera-tions also has been a feature of several of the post-Accord changes in the requirement ratios. Even if we disregard the misuse in 1936-1937 of the power to alter reserve requirements, we are left with the question of the desirability of retaining the power to vary these requirements and the rationale for such changes. Moreover, the present size of the government security portfolios of the reserve banks and the financial institutions vitiates the hoary argument that the market or the reserve banks will not have a sufficient volume of securities with which to engage in open market operations. The failure of the Federal Reserve to analyze the position of the requirement ratios in the monetary mechanism, the availability of alternative policy instruments, and the increased stability of the that would result suggest that the two ratios might usefully be frozen. The precise levels for these ratios can then be decided after a detailed analysis of the competitive aspects of ihe bank-ing industry and the probability of increased or curtailed service to the public in small or single bank communities associated with par-ticular arrangements.19

"There is considerable evidence in the published state-ments of ranking officials and staff members and in the Record of Policy Actions that they are concerned. For a discussion of this question, see Brunner and Meltzer, An Analysis of Federal Reserve Monetary Policymaking.

10 In Brunner and Meltzer, op. cit.t we find that the effectiveness of changes in rediscount rates or in reserve requirements depends directly on the interest elasticity of the supply of assets to banks by the public (including fi-nancial intermediaries). If this elasticity is zero, neither

274 THE REVIEW OF ECONOMICS AND STATISTICS

The report makes few suggestions designed to improve the adequacy of existing arrange-ments for transmitting monetary policy. If there is a lag, as is widely believed, between the effect of open market operations cm bond rates and the effect on mortgage markets, institution-al rearrangements might usefully contribute to the reduction in the length of the lag. Restrict-ed use of open market operations in mortgages — e.g., FHA 20- or 25-year mortgages — by the Federal Home Loan Banks could be used to speed the transmission of monetary policy to the housing market. In addition to whatever desirable effect this might have on the trans-mission mechanism of monetary policy, such operations would doubtless aid in the develop-ment of a secondary mortgage market. Fur-thermore, by reducing illiquidity premia or transactions costs on certain classes of mort-gages, the development of a secondary market might contribute to the adoption of a more uniform mortgage contract and the reduction of the legal barriers to a uniform contract im-posed by several states. Faced with the choice of their present law or higher interest payments for their citizens, many states may become more willing to review their existing mortgage laws than they have been in the past.20

Regulatory Equality For Non-Bank Financial Institutions

Perhaps the most controversial recommenda-tion in Financial Institutions calls for the " . . . introduction of a similar reserve require-ment [to banks] for shares at saving and loan associations and deposits at mutual savings banks." (p. 18.) The Committee reached the conclusion opposite to the CMC, although it made use of much of the same information. After rejecting the arguments based on the destabilizing effects of the existence of close reserve requirement nor rediscount rate changes have any effect on the money supply according to the hypothesis developed. However, we find no support for the statement by some Committee members that effective open market operations or discount rate changes depend on the level of reserve requirements or on their application to non-member banks.

20 Federal Credit indicates the desirability of moving in the direction of a secondary mortgage market and a uniform mortgage instrument but seems unaware that legal barriers can be overcome by increasing their cost and thereby stimulating interest in their elimination.

substitutes for money, Financial Institutions chose to favor reserve requirements for reasons of . . liquidity, equity and supervision." For much the same reasons, the Committee decided that interest rate regulation on time deposits should be on a stand-by basis for com-mercial and mutual banks and savings and loan associations.21

The arguments for required reserves for some intermediaries do not reflect serious con-sideration of the issues involved and offer little indication of how the proposed regulations would operate. If the Federal Home Loan Bank (FHLB) raised cash requirements, would the savings and loans (S & L) be expected to sell mortgages? Would time be allowed for the acquisition of reserves through mortgage re-payments? Or would the S & Ls borrow from the FHLB? Under present arrangements, asso-ciations may borrow for as much as ten years and loans of less than one year generally do not need to be amortized. Furthermore, we read that, . . individual institutions should manage their portfolios so that, in ordinary circumstances, they can meet their own liquid-ity needs." (p. 16.) And on the following page, we are told that the cash reserves should be used for advances to the members only in case of substantial and widespread withdrawals of funds. How then would the requirements help to meet the variable day-to-day demand for cash assets by savings institutions? What purpose would the requirements serve? The report answers by suggesting that the power to impose reserve requirements would strengthen the hand of the FHLB when requesting higher liquidity ratios from the member associations. The members". . . would become more acutely conscious of the role of the Federal Home Loan Bank System as a governmental institution operating in the public interest." (p. 17.)

The report suggests that "awareness," by 21 The Committee elected to continue the prohibition of

interest payments on demand deposits. A split vote (eight to three) is recorded. The primary reasons for maintaining the prohibition are: (1) to prevent competition for demand deposits, (2) to prevent the banks from " . . . reaching out for unsound assets in order to increase earnings" and, (3) the banks and the public are adjusted to the present system. A study by George Benston, "Interest Payments and Bank Failures" has considered point (2) in detail and found no evidence to support the argument. Has anyone presented any detailed evidence supporting the arguments presented?

FINANCIAL INSTITUTIONS 275 which they apparently mean an increase in ad-ministrative power, would encourage the sav-ings associations to consider more carefully the requests of the FHLB that they acquire non-interest earning assets or maintain a greater proportion of their portfolios in government bonds. While analogies are often rightly sus-pect, it should be noted that few would argue that Federal Reserve "moral suasion" has had much impact on bankers or that Federal Re-serve exhortations have been responsible for increases in the capital/deposit ratios of com-mercial banks.

The liquidity and "awareness" arguments do not seem to be fully developed. The "equity" argument is even weaker. The report suggests that there is an inequity because commercial banks maintain reserves against time and sav-ings deposits while savings associations do not. Since the Committee does not wish to follow the CMC and eliminate reserve requirements for commercial bank time and savings deposits, "equity" is achieved by imposing the require-ment on savings institutions. By such argu-ments administrative powers can continually grow. It is generally accepted in our society that the growth of power by administrative agencies should, at a minimum, be supported by reference to some desirable, public purpose and by some evidence that the proposed ad-ministrative arrangement is somehow related to the public interest.

If some insured savings institutions or com-mercial banks take risks that might lead to failure, is it the business of government to pro-tect the institutions? The report correctly notes that simultaneous failure of a large number of financial institutions is a problem that can only be handled by an increase in the monetary base. The low rate of failures of commercial banks and savings institutions, and the high profit rates of many savings institutions in the recent past, suggest that there may be large elements of monopoly resulting from the chartering and supervisory practices of the regulating authori-ties. If this is the case, more competition rather than more supervision is the recommendation that would seem to follow from economic an-alysis.

The report suffers from the viewpoint of agencies like the FDIC that equate protection

of the public with protection of the financial institutions. If the insurance system is pres-ently unable to cope with the problem of vary-ing attitudes toward risk among the member associations and incomplete coverage of the public's deposits or share accounts, that prob-lem should be met directly by full insurance coverage and premiums that increase with port-folio risk. It is surprising that none of the re-ports suggested that insurance of deposits or shares should be graduated according to man-agement's decision about the extent of desirable risk taking.

Transition to a system of insurance with premiums graduated by the risk of the asset portfolio would not be difficult in principle. All insured financial institutions are subject to periodic audits and scrutiny of their assets. Formulas have been developed to assign assets to classes roughly corresponding to risk. Man-agement would be faced with explicit marginal costs that rise with the acceptance of greater risk. With 100% insurance of deposits or shares and premiums graduated according to risk, institutions need not be protected from the consequences of decisions by the manage-ment.

The Committee's proposal to remove inter-est rate ceilings and substitute stand-by con-trols is a desirable step in the direction of great-er competition among financial institutions. But the Committee does not follow this pro-posal with a suggestion for substantially great-er freedom for financial institutions to invest in assets of their choice. Only a few hesitant steps are made in this direction. The Com-mittee does not take a position on freedom of investment policy as a means of increasing competition. Nor does the Committee seem aware that the cost of administering and offer-ing a wide range of services and of obtaining information about the characteristics of par-ticular instruments would impose a limit on the extent of diversification.

It is most unlikely that unrestricted rights to acquire assets would destroy the specialized financial institutions that the Committee deems to be desirable. Information is costly and search is expensive. Specialized knowledge ac-quired for use in the mortgage market, e.g., techniques of property valuation, knowledge

276 THE REVIEW OF ECONOMICS AND STATISTICS

of future development of local areas, of legal and institutional restrictions on building, etc., are not easily applicable to the problems of consumer credit, municipal bonds, or business loans. Testimony to this effect is clearly given by the rich variety of specialized financial in-stitutions marketing or distributing various securities and the variations in the amount and kinds of services offered by particular com-mercial banks. The expected Míe of institu-tions that ignored such costs and plunged head-long into portfolio diversification would not be long.

Unrestricted portfolio choice for financial institutions coupled with deposit or share in-surance that is graduated according to asset risk would induce more competition among financial institutions and eliminate some of the haphazard institutional restrictions that pres-ently exist. It is unfortunate, in my view, that the Committee on Financial Institutions re-treated from the start made in this direction by the CMC and seemed more concerned about increasing administrative power than in pro-viding a more rational set of institutional ar-rangements.

The Committee shows no clear awareness that restrictions previously imposèd on the fi-nancial system have played a dominant role in determining the relative growth rates of the various intermediaries. It is inclined to treat such problems in terms of equity rather than economics. Given the larger wealth elasticity of the public's demand for time and savings deposits than for demand deposits, increasing wealth implies a fall in the ratio of money to money plus time and savings deposits. Restric-tions of the growth rate of the monetary base help to produce periods of relatively high in-terest rates. During such periods, the prohibi-tion or limitation of payment of interest on demand and time deposits, or the limitation on portfolio acquisitions encourage the relative growth of unrestricted or less restricted inter-mediaries. Should we not expect that new or continued regulations that reduce the compet-itive position of mutuals, savings and loans or commercial banks relative to insurance com-panies, credit unions or some new type of in-termediary will ultimately lead to the relative decline of existing institutions and the relative

growth of alternative financial arrangements? Present arrangements that impose different costs or reduce revenues for particular inter-mediaries suggest a positive answer to the ques-tion posed. Since little or no validated analysis justifying the restrictions has been presented, it would appear that the CMC reached the more appropriate conclusion: Remove the source of the "inequity"; do not compound it by further administrative restrictions.

In the present controversial areas of branch-ing and bank supervision, the Committee did not take a strong stand. It called for more study and closer coordination but did not ac-cept the recommendations of either the Ad-visory Committee or the CMC. The latter groups proposed some liberalization of branch-ing in the interests of increased competition and the consolidation of supervision within one or two agencies to reduce interagency disagree-ments. Doubtless, the presence of representa-tives of the FDIC, the Comptroller, and the Federal Reserve and our inadequate knowledge contributed to the difficulty of obtaining agree-ment.

Studies now under way or recently completed by the House Banking and Currency Commit-tee and the State of New York should assist in the development of a more appropriate policy in this area. Information not available to the Committee — the early evidence from New York — seems to suggest that more liberal branching policies would contribute to compe-tition among banks and improved service for the public.22

Federal Credit Agencies While both private financial institutions and

federal credit agencies are shaped in varying degrees by government action, the two types of intermediaries are essentially different. One group emerges to satisfy demands in response to profitable market opportunities. The other most often is chartered because of the supposed failure of the private market to satisfy partic-ular types of borrowers by offering a "suffi-cient" volume of loans at rates deemed by

22 New York State Banking Dept., Branch Banking, Bank Mergers, and the Public Interest —A Summary Report (Jan., 1964).

FINANCIAL INSTITUTIONS 277 Congress to be sufficiently low. There is, of course, a feedback from one type of institution to the other. The development of new federal credit agencies, or the provision of guarantees for particular types of loans, alters the risks and returns faced by private lenders. Similarly, the development of specialized private financial institutions, or changes in the lending practices of existing institutions, reduce the area in which federal credit agencies operate.

Credit programs have been a popular device (possibly second only to tax adjustments) by which Congress has aided particular groups or programs in accordance with its judgments about desirable public purposes. At their best, these programs reduce information costs about the risks inherent in particular types of loans, undertake experiments designed to improve market arrangements, reduce transaction costs, and permit external economies to become in-ternalized. The pioneering work of the FHA in the mortgage market is perhaps the best known case of reduction in private cost at close to zero social cost.28

The CMC suggested a number of guidelines for existing programs and criteria applicable to new programs. Federal Credit augments the earlier report and attempts to make some of the suggested guidelines operational by indi-cating some standards and procedures for ex-isting programs. As noted above, President Kennedy accepted the principal conclusions and took steps to see that they were applied.

Space does not permit any detailed treat-ment of the recommendations. In general, the report favors solutions to credit problems by the private economy or the participation of private lenders in government programs, flex-ible interest rates on programs under govern-ment guarantee, the elimination of disguised subsidies masked as loans, no new programs that guarantee tax-exempt securities, the elim-ination of provisions that permit private lend-ers to shift insured securities to the government when they decline in market value, and similar suggestions designed to eliminate hidden sub-sidies.

"Economists interested in externalities could greatly enhance our validated knowledge about the effects of changes in information costs, etc., by using the data avail-able from the records of these agencies for their tests.

The report makes frequent references to the "imperfections of the private credit system." Hopefully, we will at some time in the future have an operationally useful definition of this commonly used term. It is perhaps too much to ask that a report of this kind would attempt such a definition, but it does seem to have im-portant bearing for the choice between direct subsidies, government loans or guarantees, and private credit.

Conclusion Judging from many of the reviews, econo-

mists tended to dismiss the recommendations of the CMC as inconsequential or lacking in imagination because they failed to suggest any major institutional changes. But the report was not without impact. It stimulated a great deal of attention to present financial arrangements within the government, gave rise to a number of other reports, to congressional interest and proposals for new legislation, and was partly responsible for the renewed attention to the details of existing arrangements and studies of the structure of the banking system.

The two reports discussed here are a direct outgrowth of the CMC recommendations. The suggestions of the Committee on Federal Credit Programs parallel many of the CMC guide-lines, provide the details necessary for their application, but leave the decision about new programs to Congress. Steps have now been taken to carry out the recommendations and to assure their continued application. It seems reasonable to conclude that the CMC was largely successful in achieving its aims with respect to federal credit programs.

Many of the modest changes prpposed by the CMC in the area of financial institutions were not acceptable to the agencies represented on the Committee on Financial Institutions. In general, the Committee retreats from the CMC suggestions with the notable exception of a poorly supported recommendation for re-serve requirements for non-bank savings in-stitutions.

Most of the suggestions in the Committee report have not been implemented. It would seem desirable that before such changes are made, economists might usefully attempt to

278 THE REVIEW OF ECONOMICS AND STATISTICS provide a more fully validated framework blending present arrangements into monetary theory so that we may more fully appreciate their significance. Since it is unlikely that any-one would deliberately design a financial sys-tem like that of the United States, future changes might improve the present financial arrangements in a number of ways, e.g., by in-creasing competition, eliminating arbitrary and poorly used administrative power and improv-ing the transmission mechanism connecting monetary policy with the pace of economic activity.

Toward those ends this reviewer offers a few suggestions falling within the area encompassed

by the Committee reports. These include: (1) elimination of Federal Reserve authority to change member bank reserve requirements; (2) deposit insurance premiums graduated with asset risk and accompanied by (3) remov-al of restrictions on asset portfolios of lenders; and (4) open market operations in mortgages by the Federal Home Loan Bank Board. Hope-fully, these suggestions (and others) will one day be appraised within a validated theory con-necting monetary and financial institutions with economic theory so that we will be in a better position to carry out the task that the President assigned to his committees and to review the conclusions.

/

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(Continued)

125. Systems Evaluation and Repricing Theorems, by A. Charnes and W. W. Cooper. Manage-ment Science, October 1962.

126. Duality in Semi-Infinite Programs and Some Works of Haar and Carathlodary, by A. Charnes, W. W. Cooper, and K. Kortanek. Management Science, January 1963.

127. The Purpose of Ijcmsing, by Thomas G. Moore. The Journal of Law and Economics. Oc-tober 1961.

128. An Experimental Analog to Two-Party Bargaining, by Myron L. Joseph and Richard H. Willis. Behavioral Science, 1963.

129. Programming with Linear Fractional Functionals, by A. Charnes and W. W. Cooper. Naval Research Logistics Quarterly, September-December 1962.

130. Demonstration of a Relationship Between Psychological Factors and Brand Choice, by Alfred A. Kuehn. The Journal of Business of the University of Chicago, April 1963.

131. The Speed of Response of Firms to New Techniques, by Edwin Mansfield. The Quarterly Journal of Economics, May 1963.

132. Breakeven Budgeting and Programming to Goals, by A. Charnes, W. W. Cooper, and Y. Ijiri Journal of Accounting Research, Spring 1963.

133. The Demand for Money: The Evidence from the Time Series, by Allan H. Meltzer. The Journal of Political Economy, June 1963.

134. Most "Efficient" Solutions to Communication Networks: Empirical versus Analytical Search, by Harold J. Leavitt and Kenneth E. Knight Sodometry, June 1963.

135. Economic Literacy: What Role for Television, by John R. Coleman. American Economic Association, 1963.

136. The Place of Financial Intermediaries in the Transmission of Monetary Policy, by Karl Brunner and Allan H. Meltzer. The American Economic Review, May 1963.

137. Some Monte Carlo Estimates of the Yule Distribution, by Herbert A. Simon and Theodore A. Van Wormer. Bshavioral Science, 1963.

138. Predicting Velocity: Implications for Theory and Policy, by Karl Brunner and Allan H. Meltzer. The Journal of Finance, May 1963.

139. Some Experiments in Planning and Operating, by Bernard M. Bass and Harold J. Leavitt. Management Science, July 1963.

140. A Heuristic Program for Locating Warehouses, by Alfred A. Kuehn and Michael J. Ham-burger. Management Science, July 1963.

141. The ABCs of the Critical Path Method, by F. K. Levy, G. L. Thompson, and J. D. Wiest. Harvard Business Review, September-October 1963.

142. The Impact of Atlantic-Gulf Unionism on the Relative Earnings of Unlicensed Merchant Seamen, by Leonard A. Rapping. Industrial and Labor Relations Review, October 1963.

143. The Demand for Money: A Cross-Section Study of Business Firms, by Allan H. Meltzer The Quarterly Journal of Economics, August 1963.

144. Rejoinder to Professor Eisner, by M. Bronfenbrenner and Thomas Mayer. Yet Another Look at the Low Level Liquidity Trap, by Allan H. Meltzer. Econometrica, July 1963.

145. Experiments with a Heuristic Compiler/by Herbert A. Simon. Journal of the Association for Computing Machinery, October 1963.

140. The Acquisition of Experience in a Complex Management Game, by William R. Dill and Neil Doppelt. Management Science, October 1963. ,

147. Economic Elements in Municipal Zoning Decisions, by Otto A. Davis. Land Economics, November 1963.

148. Human Acquisition of Concepts for Sequential Patterns, by Herbert A. Simon and Ken-neth Kotovsky. Psychological Review, 1963.

149. A Linear Programming Model for Budgeting and Financial Planning, by Y. Ijiri, F. K. Levy, and R. C. Lyon. Journal of Accounting Research, Autumn 1963.

150. Management Games, Information Processing, and Control, by Kalman J. Cohen and Mer-ton H. Miller. Management International, 1963.

151. Comment: Firm Size and Rate of Growth, by Herbert A. Simon. The Journal of Political Economy, February 1964.

(Continued on back cover)

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The present series begins with articles written by the faculty of the Graduate School of Industrial Administration and published daring the 1957-58 academic year. Single copies may be secured free of charge from: Reprint Editor. GJ3JJL, Carnegie Institute of Technology, Pittsburgh, Pa. 15218. Additional copies are 50 cents each, unless otherwise noted.

(Continued) 152. A Heuristic Approach to Solving Travelling Salesman Problems, by Robert L. Karg and

Gerald L. Thompson. Management Science, January 1964. 153. Technological Change in U. S. Agriculture: The Aggregation Problem, by Lester B. Lave.

Journal of Farm Economics, February 1964. 154. Determinants of Inventory Investment, by Michael C. LovelL ModeU of Income Determin-

ation, 1W1. 155. Organizational Psychology, by Harold J. Leavitt and Bernard M. Bass. Annual Reoeiw of

Psychology, 1964. 156. Individual Choice Under Uncertainty—An Experimental Study, by F. Trenery Dolbear, Jr.

Yale Economic Essays, 1964. 157. An Analytical Study of the Pert Assumptions, by Kenneth R. MacCrimmon and Charles A.

Ryavec. Operations Research, January-February, 1964. 158. Decision-making, by William R. Dill. National Society for the Study of Education, 1964. 159. Business Firm Growth and Size, by Yuji Ijiri and Herbert A. Simon. American Economic

Review, March 1964. 160. Division of Labor and Performance Under Cooperative and Competitive Conditions, by

Stephen C. Jones and Victor H. Vroom. Journal of Abnormal and Social Psychology, March 1964.

161. SomeFurther Investigations of Demand and Supply Functions for Money, by Karl Brunner and Allan H. Meitzer. The Journal of Finance, May 1964.

162. On the Concept of Organizational Goal, by Herbert A. Simon. Administrative Science Quarterly, June 1964.

163. A Comment on Alternative Derivations of the Two Input Production Function with Con-stant Elasticity of Substitution, by M. I. Kamien. Zeitschrift für Nationalökonomie, 1964.

164. A Note on Complementarity and Substitution, by M. I. Kamien, International Economic Review, May 1964.

165. Inflation—Danger Ahead? by G. L. Bach. Harvard Business Review, July - August 1964. 166. Critical Path Analyses Via Chance Constrained and Stochastic Programming, by

A. Charnes, W. W. Cooper and G. L. Thompson. Operations Research, May-June 1964. 167. Planning ss a Practical Management Tool, by H. Igor Ansoff. Financial Executive, June

1964. 168. Argus: An Information-Processing Model of Thinking, by Walter R. Reitman, Richard

B. Grove, and Richard G. Shoup. Behavioral Science, July 1964. 169. The Role of Financial Planning in Production Management, by John Bossons. An appendix

in Martin K. Starr, Production Management: Systems and Synthesis (Englewood Cliffs, N. J.: Prentice-Hall, Inc., 1964).

170. The Stopped Simplex Method: 1. Basic Theory for Mixed Integer Programming; Integer Programming, by Gerald L. Thompson. Revue Française De Recherche Operationneue, 1964. '

171. The Future of Business Education, by Richard M. Cyert and William R. Dill The Journal of Business of the University of Chicago, July 1964.

172. Information Processing in Computer and Man, by Herbert A. Simon and Allen NewelL American Scientist, September 1964.

173. Public and Private Financial Institutions: A Review of Reports from Two Presidential Committees, by Allan H. Meitzer. The Review of Economics and Statistics, August 1964.