the differential effects of tight money

8/14/2019 The Differential Effects of Tight Money

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American Economic Association

The Differential Effects of Tight MoneyAuthor(s): G. L. Bach and C. J. HuizengaReviewed work(s):Source: The American Economic Review, Vol. 51, No. 1 (Mar., 1961), pp. 52-80Published by: American Economic AssociationStable URL: http://www.jstor.org/stable/1818909.

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THE DIFFERENTIAL EFFECTS OF TIGHT MONEYBy G. L. BACH AND C. J. HUIZENGA*

Restrictive monetary policy is widely opposed because of its allegedundesirably discriminatory effects. Tight money, it is claimed, lets bigborrowersgo free while shutting off little ones. It restricts constructionactivity while letting investment in plant and equipment boom. Con-versely, it restricts investment so sharply it induces recession. It runsup interest costs to those least able to pay. It penalizes new borrowersat the expense of old established customers.All these claims, and manymore, have been urged upon Congress, by economists and by others, aspowerful reasons against reliance on restrictive monetary policy tocheck moderate inflation.Given substantially full employment, any restrictive policy is dis-criminatory in the sense that it charges the allocation of resourcesfrom what would have prevailed in the absence of the restriction.Assume full employment with excess demand (inflationary pressure)and some given allocation of resources. If monetary policy is now usedto produce a smaller money supply than otherwisewould have existed,a different allocation of resources may result. It is this shift in re-sources which is presumably meant when critics speak of the discrim-inatory (or differential) effects of tight money. We shall use the termin this sense.The following pages describe an investigation of the "discrimina-tory" effects of tight money which isolates these effects by studying thedifferential lending-investing policies during the 1955-57 period of"tight" banks in contrast to those of "loose" banks which were other-wise substantially identical but where there was little or no pressureoftight money.

*The authors are, respectively, professor of economics at Carnegie Institute of Tech-nology and acting assistant professor of business economics at the University of Cali-fornia, Los Angeles. We are indebted to the Ford Foundation for faculty research anddoctoral fellowships which made this research possible, and to the Commission on Moneyand Credit for financial support. WVe re equally indebted to the Board of Governors ofthe Federal Reserve System for making available the basic data, for extensive statisticalwork in restructuring data to fit the needs of the study, and for discussions of theanalytical problems. In the latter connection, James Eckert, Albert Koch, Roland Robin-son and Edward Snyder were especially helpful, as were our colleagues Edwin Mansfield,Allan Meltzer and Franco Modigliani.


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BACH AND HUIZENGA: TIGHT MONEY 53I. Design of Study

Identification of possible discriminatory effects of tight money dur-ing any period of credit restraint is difficult. In 1955-57, for example,we know that commercial bank lending to large borrowers rose muchmore than that to small borrowers. But this fact is not necessarily evi-dence that tight money led banks to discriminate against small bor-rowers. Instead, the observed results may have arisen largely fromthe demand side of markets rather than from the supply side, andindeed there is much evidence that such was the case in that particularperiod. The problem is to devise a method of isolating the supplyeffects (that is, the discriminatory effects of tight money in restrictinglending) as distinct from the effects of differing demands for credit.To isolate the effects of tight money on the behavior of lenders, thefollowingbasic design was used. First a period was chosen when moneywas generally agreed to be tight and growing tighter-October 1955to October 1957. Then a large sample of banks (about 1700) waschosen, large enough to permit stratification so that substantial num-bers of banks in all majorcells were presumably substantially identicalin all respects (including potential loan demand) except for the dif-ferential impact of tight money upon them. Then the banks weredivided into three subgroups-"tight," "medium," and "loose," de-pending on the degree of tightness induced in them by the over-alltightness of money. The tightest quartile of banks was placed in thetight group, the next two quartiles in the medium group, and the loosestquartilein the loose group.The loose banks, as is explained below, wereselected so that it would be agreed that they were loose by almost anyreasonabletest-for example, they were not tight by standard tests atthe beginning of the period, and they gained more deposits over theperiodthan they increasedtheir loans and investments.'Then the lending and investing behavior of these three groups ofbanks was compared over the period, with the presumption that thetight quartile would reflect the differential impact of tight money onthe supply side, when compared with the loose quartile which appar-ently felt little if any pressure of tightness. This comparisonbetweenthe tight and loose quartiles seems especially apt to isolate the dif-ferential effects of tight money, since loose banks were clearly quiteloose and there is little evidence that they refused any borrowersbe-cause of shortage of lending power or for any reason other than failureof borrowers to meet general banking standards of credit-worthiness.

The terms tight, medium and loose are intended as brief terms to indicate relativestatus. They are not intended to convey absolute status with any precision, except, as isnoted below, that the loose banks were demonstrably loose by almost any reasonablestandard.


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54 THE AMERICAN ECONOMIC REVIEWIn testing different hypotheses about possible discriminatoryeffects oftight money, banks were stratified by size and other major characteris-tics within each of the three tightness groupings, to assure compara-bility on factorsother than tightness.A. Nature of Sample and Information Obtained

The basic sample consisted of about 1700 Federal Reserve memberbanks, with identical banks reporting in October 1955 and October1957. Reporting banks held nearly 90 per cent of all commercial andindustrial loans at member banks. The sample provided almost com-plete coverage of all central reserve city and reserve city banks, withabout one-fourth of all country memberbanks. The sample was drawnon a stratified basis by the Federal Reserve System for its two majorstudies of commercialand industrialloans in 1955 and 1957. All sampledata were then "blown up" to cover all commercialmemberbanks inthe United States.2Information in both years was collected on the following items:(1) complete call report data for each reportingbank, includinginfor-mation on all major asset and liability items; (2) the following infor-mation on individual commercial and industrial loans on the books ofeach reporting bank as of October 5, 1955 and October 16, 1957:(a) business of borrower (13 categories); (b) total assets of bor-rower; (c) form of business organization-incorporated or unincorpo-rated; (d) amount of loan outstanding; (e) original amount of loan;(f) whether loan was a term loan; (g) whether loan was secured orunsecured; (h) interest rate on loan.B. Measures of Bank Tightness

For explaining banker (lender) behavior, how tight a bank is de-pends on how tight the banker (the decision-maker) feels it is. Onebank may be extremely tight for lending purposes, even though it hasa large volume of excess reserves and liquid securities, if the bankerbelieves that these reserves and securities are essential to the soundoperationof the bank.Anotherbank may be loose for lendingpurposes,even though it has very small excess reserves and only a modest supplyof liquid securities, if the banker feels that he nevertheless has morereserves and more securities than he needs for normal operating pur-poses (assuming that he is within standard examination regulations).Thus, standard measures like excess reserves and free reserves are notreliable measures of bank tightness for lending purposes.This point becomes clearer if one remembers that the individual

2 Details of the sampling procedure and the reporting forms were published in theFederal Reserve Bulletin [9, 10].


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BACH AND HUIZENGA: TIGHT MONEY 55banker can alter his volume of excess reserves (and hence his lendingpower) with relative freedom by restructuringhis asset portfolio-sayby selling off bills or bonds. Thus one must consider the whole assetportfolio-not just a simple measure of excess or free reserves-if he isto have a reasonable measure of how tight the individual bank is. Andthe banking system as a whole can similarly increase its excess reservesby selling securities to others, though to a lesser extent since it must findnoncommercial-bank uyers, a limitation which the individual bank doesnot face.This poses difficultproblems of measuring the tightness of individualbanks and of the banking system. We cannot peer into the banker'smind to see what makes him feel tight or loose. Indeed, the banker'sown word is possibly not to be accepted. So we need to search forsurrogatemeasures.Banking System as a Whole. Over the period from October 1955to October 1957, it is widely agreed that money was tight and becom-ing increasingly tighter for the banking system as a whole.3 At leastfour types of evidence support this belief.First, Federal Reserve authorities, bankers, and virtually all ob-servers in the financial press spoke out on the increasing tightness ofmoney. While such statements are of course not conclusive, their gen-eral uniformity was striking.4Second, over the period commercial banks shifted heavily out oflong-term bonds into short-term government securities and loans. Be-tween October 1955 and October 1957, loans at all members banksincreased from $67 billion to $80 billion while bonds of 5 years orlonger maturity declined from $24 billion to $10 billion. This shift wasa clear indication of increasing pressure on the banking system so faras the ability to makeloans was concerned.

Third, interest rates had risen substantially by the beginning of theperiod, and continued to rise through it, as is indicated by Table 1.Fourth, there was virtually no growth in the money supply, althoughthe volume of transactionsto be financedand population rose substan-tially over the period. Currency and demand deposits outside bankstotaled $132 billion in October 1955, and only $134 billion in October1957. At the same time gross national product rose from $392 billion'The exact dates chosen (in October of each year) were dictated by the availability ofdata-both call-report data and, more important, data on the large-scale Federal Reserve

commercial loan surveys which were available for only those two specific months. Ac-tually, a period ending a few months earlier, in the summer of 1957, would have beenbetter, since apparently the peak of tight money occurred some time in the late summer.However, there was no substantial easing of money over the few months before October.4 See, for example, the annual reports of the Board of Governors of the Federal ReserveSystem [7]; "Bank Credit and Money" in [5] [6]; the Newv York Times financial pages[12]; and Business Week [8].


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56 THE AMERICAN ECONOMIC REVIEWTABLE1-INTERESTRATES,OCTOBER955-OCTOBER957

Average for 1954 October 1955 October 1957U. S. Treasury bills .9 2.2 3.6Prime commercial paper 1.6 2.7 4.1Aaa corporate bonds 2.9 3.1 4.1

(annual rate) for the third quarter of 1955 to $440 billion (annualrate) for the thirdquarter of 1957.5Clearly, there have been other periods when money was tighter, andin part the increasingtightness was a return to morenormaltimes fromthe very low interest rates of the preceding decades. For purposes ofthis study, however, it is important merely that money was tightenough to put the tighter banks under substantial pressure to refusesome otherwise acceptableborrowers,and that it was becomingtighter.These conditions were clearly present. Nor do the findings depend onthe extent to which this tightness reflected conscious Federal Reservepolicy. Since the money supply remainedroughly constant, the increas-ing tightness obviously reflected mainly increasing demand for money.Individual Banks. To test tight money hypotheses, we ranked allindividual banks by degree of tightness as of October 1955, and byincrease in tightness between October 1955 and October 1957. A moresatisfactory measure than excess or free reserves appeared to be theratio:excess reserves - borrowing + government bills and certificates

depositsWe call this a looseness ratio, since an increase in the ratio means thatthe bankhas become looser for lendingpurposes.This ratio was used to rank individual banks as of October 1955.The ratio reflects the fact that banks consider short-termgovernments

?The traditional measures of excess reserves and "free" reserves provide little help inassessing the tightness of the banking system over the period in question. Excess reservesaveraged about $500 million during October of each year. This reflected the fact thatexcess reserves were substantially at their operating minimum by 1955, given the mores ofmany bankers about excess reserves. Thus they could not practically be reduced further.Free reserves (excess reserves minus borrowing) averaged -$360 million in October1955 and -$344 million in October 1957. Banks that were willing to borrow at the Fed-eral Reserve were doing so substantially by October 1955, and again to about the sameextent in October 1957. Both the free and the excess reserve figures emphasize that manybanks nowadays manage their portfolios so as to hold excess and free reserves at whatthey consider reasonable minimum levels, especially when interest rates are high. Thus,whether money is loose or tight, excess reserves for the system stay at about the samelevel. Free reserves are more volatile and are significant for many large banks. But theytoo provide a very imperfect measure of the tightness of the system, for the reasons notedabove and because only a small fraction of banks view borrowing at the Federal Reserveas a significant device for adjusting their reserve positions.


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BACH AND HUIZENGA: TIGHTlfMONEY 57as secondary reserves, only slightly differentiatedfrom actual reserves.Moreover, this ratio varies appreciably at individual banks withchanges in economic conditions, at the same time that the ratio of ex-cess reserves, or even free reserves, to deposits varies little for mostbanks. The ratio falls (indicates tightening) for the banking system asa whole and for most individual banks over the 1955-57 period, whenwe know that money was tightening for the system as a whole. On theother hand, the ratio has weaknesses. For example, it does not reflectthe fact that interbankdeposits provide a special source of liquidity tosome banks; thus, most small country banks were probably relativelylooser than the ratio shows. Neither is vault cash included. Nor arenear-maturitysecurities other than bills and certificates. Most impor-tant, it does not includelonger-termgovernmentsecurities,but there areconvincing reasons for this exclusion.6XVehave no clean-cut objective basis for selecting the looseness ratioused. The case is that it is a reasonablemeasure a priori, and that allthe likely alternatives have serious drawbacks. The ratio was testedagainst other measures,including excess and free reserves.For example,the ratio of loans to governmentsecurities was examined, on the theorythat the higher the loan ratio becomes the tighter the bank will besince it has less opportunity left to shift from government securitiesto loans. This measure, like the looseness ratio including governmentbonds, proved of limited usefulness because it mainly reflected thelending-investmentpreferences of individual banks, rather than serv-ing as a fundamental measure of tightness for the rank-orderingofbanks.To measure the change in tightness between October 1955 and Octo-ber 1957 two tests were initially applied. First, all individual bankswere ranked by the decrease in the looseness ratio between October1955 and October 1957. Second, banks were ranked according to thepercentageincrease in their deposits over the period. For the individualbank, as distinguished from the banking system, it is primarily gain orloss of deposits which makes the bank looser or tighter for new lendingand investing. Therefore, the simplest measure of whether an individ-ual bank is growing looser or tighter is the extent to which it is gainingor losing deposits. Thus, all banks were rankedby percentage increase

Government bonds, which are not included in the numerator, obviously help increaseliquidity and hence decrease the tightness of a bank. While individual banks can obtainfunds for loans by selling government securities, holdings of long-term governments atmany banks are so large relative to bills, certificates, and free reserves, that their inclusionwould swamp the ratio. Thus the ratio with long-term government securities includedwould tend to reflect primarily the investment preferences of individual banks and wouldlose most of its virtue as a measure of tightness for ranking individual banks.To avoid the danger that the deposits and reserve figures in the ratio would be thrownoff by special temporary factors, monthly averages were used, rather than one-day figures.


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58 THE AMERICAN ECONOMIC REVIEWin deposits over the two-year period. Banks with the greatest loss ofdeposits showed the greatest increase in tightness, with others rankedin order of deposit gain.Broadly, the rank-order results for individual banks were similarusing these two methods over the 1955-57 period. However, thechange-in-deposits method both seemed more significant in explainingindividualbank lending-investmentbehavior and offereda moresharplydiscriminating measure as among individual banks. This is becausechanges in the tightness ratio were quite small for most banks, so thatthe individual bank ranking might be considerablyinfluenced by smallspecial circumstances, while differences in the rate of deposit growthwere large. Thus, we decided to use the second measurealone-changein deposits between October 1955 and October 1957-as the criterionof the extent to which banksbecame tighteror looser.7To obtain the final tightness ranking of all individual banks, theranking as of 1955 and the ranking by increase in tightness for the1955-57 period were combined in the following way. First, banks weredivided into the tightest and loosest halves on the basis of the loosenessratio as of October 1955. Then, all banks in the tightest half for 1955were rank-ordered by the degree to which their tightness increasedover the succeeding two years, as measured by relative deposit loss orgain. The tight group for the study (the tightest quartile) was then ob-tained by taking the 50 per cent of the tight half as of 1955 whichshowed the greatest further increase in tightness by 1957. Similarly,the loosest half as of 1955 was rank-ordered by change in tightness,and the 50 per cent showing the greatest increase in looseness was con-sidered the loose group for the study. The remainingtwo inner quar-tiles were consideredthe mediumgroup.8This test combines tightness as of the beginning of the period withchange in tightness. In principle, there need be no relationshipbetweenthese two measures. On the other hand, the purpose was to segregateat the two extremes banks which both were tight in absolute level andbecame tighter, from those that were clearly loose in absolute level andbecamelooser. The procedurefollowedachievedthis result.Thus, banksin the loose quartile had looseness ratios of 3 per cent and higher inOctober 1955, as compared to only 1+ per cent for all banks. More-

' A further study was made to test the significance of using both measures. Limitationof the tight group to banks that were in the tightest quartile by both the change-in-loose-ness ratio and the change-in-deposits tests eliminated only a small fraction of the banks.This further refinement was therefore dropped.

8 Since large city banks were heavily concentrated in the tight group, about 40 per centof total commercial bank assets were included in that group. About 45 per cent were inthe medium group, and about 15 per cent in the loose group in which smaller countrybanks predominated.


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BACH AND HUIZENGA: TIGHT MONEY 59over, their gain in deposits ranged from 8 per cent to over 100 per centfor the two-year period, compared to only a 4.5 per cent increase forthe bankingsystem as a whole-while about half the banks in the tightgroup actually lost deposits over the two-yearperiod.9Most important,the loose banks as a group gained more deposits over the period thanthey expanded their loans and investments. Thus, they obtained morenew funds for loans and investments than they used. Under this cir-cumstance it is hard to see how these banks can have felt themselvesseriously restrained by tight money.'0C. Hypotheses Investigated

Using this analytical approach, five general hypotheses were con-sidered: (1) That tight money inducedbanks to shift fromgovernmentsecurities to loans. (2) That tight money led banks to discriminateagainst small borrowers n lending to businesses. (3) That tight moneyled banks to differentiatein favor of particular industry groups amongbusiness borrowers. (4) That tight money was effective in checkingloans especially to those firms which were primarily responsible forthe 1955-57 investment and inventory boom. (5) That tight money ledbanks to raise interest charges especially to small borrowers and toparticular industry groups against which they wished to discriminate.The succeeding sections examine these hypotheses in turn.

II. Effects on Bank Lending and InvestingTable 2 compares the behavior of tight, medium,and loose banks inextending loans and investments over the 1955-57 period as moneygrew tighter. The left-hand portion of the table shows the percentageincreases of total loans and investments and all major subclasses atloose, medium, and tight banks. Percentage increase figures are used

because absolute figures would overweight the large banks in what-ever groups they fell (largely the tight and medium groups). Theright-hand portion of the table shows the relative increases (or de-creases) in loans and investments at loose, medium, and tight banks.Though only relative changes are shown, the absolute amounts in allcells are large.Studies were made of the differences in groupings obtained by using either the as-of-1955 or the 1955-57 change measure alone. Surprisingly, not very great changes wereobtained in the tight and loose groups by limiting the test to the situation as of October

1955 or by taking the change-in-deposit ranking alone. Thus, it appears that, in a broadsense, the 'banksthat were already tight in late 1955 were the ones that tended to becomeeven tighter over the following two years."This same excess of new deposits over new loans and investments was shown by allsmall (country) banks as a group. There was a massive shift of deposits (and lendingpower) from very large to small banks. See [11, p. 424].


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BACH AND HUIZENGA: TIGHT MONEY 61behavior at tight and loose banks were greatest within the loan cate-gories. Tight banks increasedreal estate loans much less than did loosebanks. But still more, they squeezed security and agricultural loansheavily to obtain funds for modest expansions in other loan categories.On the other hand, security and agricultural loans have never beendominant parts of the loan portfolio of the banking system, and theactual dollar shift of loans was more modest than might appear fromthe relative increases.12It may be surprisingthat the tight banks did not shift more heavilyfrom low- to high-yield assets under the pressure of tight money. Theexplanation is probably found largely in the force of traditional stand-ards of banking practice. Most bankers, even when very tight, are re-luctant to go beyond certain widespread notions of portfolio balance,which vary substantially by class and location of bank. For example,loans amounting to much more than 50 per cent of total assets appar-ently seem excessive, or at least of dubiouspropriety, to many bankers.Moreover,bankersunderstand their needs for liquidity and do not con-sider loans very liquid, in spite of the technical availability of theFederal Reserve rediscount window. Federal Reserve informal andformal actions reinforce this reluctance to rely extensively on redis-counting except in special temporarycircumstances.Thus, many bank-ers continue to be the generally careful, cautious people they are com-monly reputed to be in determiningtheir portfolio balance, even whenprofits beckon in, say, higher automobile or real estate loans.13If we assume that loose banks felt little or no restraint from tightmoney (as is stronglysuggestedby the evidence onpages 58-59), thenthe

"It mright appear that this differential behavior of tight and loose banks is explainednot by differing tightness, but merely by the fact that the expected mean value of thelending-investing behavior of the two groups is similar so that they will both tend tomove toward it-the so-called "regression fallacy." In Table 2, the greater shift fromgovernment securities to loans at loose banks might simply represent a movement of theloose and tight banks back toward a common portfolio balance after the tight group hadby chance inicreasedtheir loans more rapidly. But examination of the nine asset categoriesin Table 2 shows disparate behavior that is not explained by the regression fallacy. Whilewe cannot be sure that the observed lending-investing differences between tight and loosebanks are explained by differing tightness, the behavior is generally consistent with whatwe would a priori expect to observe from the tight-money hypothesis; and we findno other reasonable hypothesis to which the observed behavior can be attributed." For a summary of banker interviews on the extent to which tight money changedlending policies, see [11, p. 431 ff.]Apparently bank examination standards per se did not significantly limit bank loanexpansion during the period. In an unpublished doctoral dissertation at Carnegie Instituteof Technology, David Chambers found that even tight banks (using our groupings) gen-erally stayed well within the formal examiners' limits. Other tests confirmed this generalconclusion. But widespread knowledge of examiners' expectations, of course, may havehelped mold bankers' mores as to how far they can reasonably go in shifting to loans, andto higlher-yield risky loans within the loan category, when money becomes tight.


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62 THE AMERICAN ECONOMIC REVIEWTABLE3-INCREASE IN ASSETSATBANKSOFDIFFERENTIZES,OCTOBER955-OCTOBER957

Relative Increase, with PerPer Cent Increase at: Cent Increase at LooseAssets at Banks of Banks= 100Different Sizesa Loose Medium Tight Loose Medium TightBanks Banks Banks Banks Banks BanksTotal Loans and InvestmentsAll banks 23 9 1 100 39 4Under $10 million 31 10 1 100 32 3$10-100 million 19 4 4 100 21 21$100-1,000 million 23 13 0 100 54 0

Over $1 billion (b) 8 1 100 15Bills and CertificatesAll banks 87 85 242 100 98 278Under $10 million 127 91 938 100 72 739$1O-100 million 78 86 211 100 110 271$100-1,000 million 43 91 338 100 212 790Over $1 billion (b) 66 85 100 129Other Government Securitiesunder 5 YearsAll banks 36 26 12 100 72 46

Under $10 million 41 19 9 100 46 22$1O-100 million 32 25 27 100 78 85$100-1,000 million 38 26 11 100 68 29Over $1 billion (b) 35 7 100 19Government Securities over5 YearsAll banks -49 -52 -52Under $10 million -48 -48 -45$1O-100 million -51 -52 -55 (c) (e) (e)$100-1,000 million -47 -51 -50Over $1 billion (b) -"56 -52Other SecuritiesAll banks 34 5 -10 100 15 - 29Under $10 million 55 17 3 100 31 1$10-100 million 27 12 7 100 44 26$100-1,000 million 23 5 -18 100 21 - 76Over $1 billion (b) - 8 -17 (e) (c)Commercial and IndustrialLoansAll banks 47 33 25 100 70 53Under $10 million 68 18 4 100 26 6

$10-100 million 36 24 16 100 67 44$100-1,000 million 51 31 19 100 60 37Over $1 billion (b) 47 30 100 64^All categories by bank size are based on deposits as of October, 1955.b No banks over $1 billion deposits in the loose category.e Decrease in all groups.


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BACH AND HUIZENGA: TIGHT MONEY 63TABLE 3-Continued

Real Estate LoansAll banks 32 16 6 100 50 19Under $10 million 35 19 13 100 54 37$10-100 million 31 13 8 100 42 26$100-1,000 million 23 20 6 100 84 25Over $1 billion (b) 14 3 100 22Security LoansAll banks 154 22 -20 100 14 -113Under $10 million 1248 542 948 100 43 76$10-100 million 13 68 16 100 523 123$100-1,000 million 54 - 1 - 1 100 - 3 - 2Over $1 billion (b) 1 -32 100 -467Agricultural LoansAll banks 4 3 -10 100 75 -250Under $10 million 2 8 - 5 100 400 -250$10-100 million 8 -27 9 100 -338 113$100-1,000 million 13 22 -25 100 175 -202Over $1 billion (b) 1 -77 100 -1316Loans to IndividualsAll banks 30 24 11 100 80 37Under $10 million 28 22 14 100 79 50$10-100 million 25 21 14 100 84 56$100-1,000 million 42 31 11 100 75 27Over $1 billion (b) 18 7 100 39

comparativedata for tight banks provide a direct measure of the dif-ferential impact of tight money. Even if the loose banks felt some re-straint, since the tight banks clearly were much tighter the comparativedata still provide direct evidence on the "discriminatory"effects oftight money on bank lending and investing behavior.Attributing the differences in Table 2 to tight money implies thatbanks of comparablesize in the three groupswere substantially identi-cal on other grounds, particularly in the loan denmandshey felt. Webelieve this was substantially true.14The 1700 banks in the sample, asindicated above, provide substantially complete coverage of large- andmedium-sized banks; and the sample of small banks was carefullystratified geographically and in terms of other significant bank char-acteristics. Lending-investing behavior varied at banks of different

"4This is, of course, a crucial assumption. Otherwise, observed differences between thebehavior of tight and loose banks cannot necessarily be attributed primarily to differencesin tightness. We can only report that, in addition to the careful sampling procedure fol-lowed, we have examined the bank groups in detail for other characteristics that mightexplain a significant part of the observed differences, and have been unable to find any-for example, geographical or urban vs. country location. It is important to remember,however, that separate analysis of banks of different sizes is important at several pointsbecause of the relative concentration of large, city banks in the tight group and small,country banks in the loose group.


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64 THE AMERICAN ECONOMIICREVIEWsizes. Table 3 provides complete data, comparable to Table 2 above,for banksof different sizes.

Another possible objection to this interpretive pattern is that tightmoney may have driven some borrowers away from tight banks, butthat these borrowersreadily obtained the desired loans at loose banks(which were under little restraint), so the apparent differential effectsat tight banks were just offset at loose banks. This hypothesis dependson the assumption of high mobility of borrowersbetween tight and loosebanks. While some such mobility certainly existed, it was far fromperfect. For large borrowers, oose banks of adequate size to make largeloans were very scarce; there were no banks of over $500 milliondeposits in the loose category. For smaller borrowers geographicalmobility is limited, and even within given areas small firms find itharder to move readily from one bank to another for credit. It seemsunlikely that the apparent impact of tight money at tight banks wascompletely, or even substantially, offset by shifts to loose banks.'5

III. Discrimination by Size of Business BorrowerOne of the commonestobjections to the use of tight money to checkmoderate inflation is that this policy discriminatesagainst small busi-

nesses. During the 1955-57 period as shown in Table 4, loans to bigbusinesses did indeed expand much more than those to small busi-nesses. This does not, however, necessarily mean that tight money ledto discriminationagainst small borrowers.Instead, the pattern of loansmay have reflected differingdemands from large and small borrowers,where the loan demands of credit-worthy large borrowers (as judgedby commercialbanking credit standards) rose more rapidly than thosefromcredit-worthysmall borrowers.In fact, the recent major Federal Reserve study of lending to smallbusiness arrives at this conclusion.This study found that most bankerswere ready and willing to lend to small businesses whenever smallbusinesses met normal standards of credit-worthiness.The demand forbank credit rose much less rapidly at small businesses between 1955and 1957 than at largrebusinesses, and the study reports that this wasthe main apparent reason for the differentialgrowth in lending. Littleevidence was found of discriminationagainst small borrowers,exceptin so far as refusal of loans because of inability to meet traditionalbanking credit standards is considered discrimination.But even here,there was little evidence of a substantial increase in potential smallborrowers urnedaway over the period of tight money."6

1 For an analysis of the effect of monetary restraint on different sectors of the economy,which includes noncommercial bank lenders, see W. L. Smith [4, pp. 362-941."'For summaries of the evidence on a variety of tests, see especially [11, pp. 368-69,


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BACH AND HUIZENGA: TIGHT MONEY 65TABLE4-BANK LOANSTOBUSINESSESa

Asset Size of Borrowerb Per Cent Increase in Loans(000's omitted) October 1955-October 1957

All borrowers 31.9Less than $50 - 3.0$50 to $250 16.7$250 to $1,000 24.8$1,000 to $5,000 21.3$5,000 to $25,000 24.7$25,000 to $100,000 51. 1$100,000 or more 66.4a Reproduced from [11, p. 371. Data cover commercial and industrial loans at all memberbanks, plus real estate loans to businesses.b As of October 1955.

While the evidence generally fails to support the hypothesis thattight money leads banks to discriminate against small business bor-rowers, the argument has not been unmistakably refuted. We thereforeconducted the following test of the hypothesis. The same groupingsofbanks into tight, medium, and loose were continued. To improve com-parability banks were further divided into five different size-groups(based on volume of deposits). For this and all succeeding analysesof business loans, data include all commercialand industrial loans plusreal estate loans to businesses at all member banks. The increase inloans to borrowersof different sizes was compared at tight, loose andmedium banks, both for all banks combined and for banks in each ofthe five size-groups. If tight banks increased loans relatively more tolarge (compared to small) borrowersthan did comparable oose banks,this test says that tight banks discriminated against small borrowers.Since the demand for loans was presumably substantially identical attight and loose banks within bank size-groups and since loose bankswere not restrainedsignificantly by tight money, the analysis presumesthat any such discriminationby tight banks would be attributable totight money.Table 5, for example, shows that at medium-sized banks loans toborrowers of all sizes rose more at loose than at tight banks, with thebehaviorof medium banks intermediate.We might say that tight banksdiscriminated against borrowers of all sizes, but they surely did not374-81, 427-31, and 436-391. The entire Part II of this volume, prepared by theFederal Reserve staff, provides a well-rounded analysis of the total problem of possiblediscrimination against small borrowers; it concludes that most evidence fails to supportthis criticism of tight money. A strong statement of the counterview is presented by J. K.Galbraith [1]; but without extensive empirical data to support his argument. Data con-tradicting the Galbraith argument are presented by Allan Meltzer [2].


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66 THE AMERICAN ECONOMIC REVIEWTABLE 5-INCREASE IN LOANS TO BUSINESS BORROWERS AT AADIU1I-

SIZED BANKS, OCTOBER 1955-OCTOBER 1957a

Assets of Borrower Per Cent Increase in Loans at:(000's omitted) Loose Banks Medium Banks Tight BanksUnder $50 21 -11 -13$50-250 76 10 5$250-1,000 72 25 25$1,000-5,000 72 50 30$5,000-25,000 90 49 30$25,000-100,000 266 104 14$100,000 and over 25 30 22

Commercial and industrial loans plus real estate loans to businiesses at all member bankswith total deposits of $100-500 million as of October 1955.discriminateespecially ag,ainstsmall borrowers.On the contrary, com-pared to loose banks, they discriminatedespecially against most largeborrowers. That is, loose banks increased their loans to large bor-rowers by percentages far in excess of the increases of loans to smallborrowers,while tight banks increased their loans to large borrowersonly somewhat more than to small borrowers. Since borrower loan-demand was presumably substantially identical at loose, medium,andtight banks, this evidence appears, at least for these medium-sizedbanks, clearly to reject the hypothesis that tight money led banks todiscriminateespecially against small borrowers.17Figures 1 through 6 are intended to facilitate examination of com-parative increases in loans to different sized borrowers at loose,medium,and tight banks. Figure 1 shows the data for the entire bank-ing system; the others show the data for banks in five different sizegroups. When the curves slope upward,large borrowersreceivedlargerpercentage increases in loans than did small borrowersover the two-year period. When the curves slope downward, the reverse was true.Least-squares lines have been fitted to facilitate these visual com-parisons. For example, Figure 4 shows the same data as are presentedin Table 5 above.'8In Figure 1, for all banks combined,the upwardslopes of the curvesfor tight, medium and loose banks are very similar, indicating similar

"'In Table 5, as in Table 4, the fact that loans rose more to large than to small bor-rowers does not necessarily indicate discrimination against small borrowers, because theobserved differences may reflect primarily differences in loan demand from different sizedborrowers. Only a test like that in the text to eliminate possible demand differences canisolate possible lender discrimination.' In Figure 1, total business loans in 1957 to all borrowers were $40.8 billion. Loans toborrowers with assets under $50,000 were $1.5 billion; those to each other size group ofborrower shown in Figure 1 ranged from about $5 billion to $8.8 billion.


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BACH AND HUIZENGA: TIGHT MONEY 67treatment of small and large borrowers by all three groups of banks.The tight-bank least-squares line slopes upward slightly more thanthe other two, reflecting primarily as is explained below, the behaviorof banks in the $1000-$1,000 million deposits size-class. But we in-

300 PERCENT INCREASE IN TOTAL BUSINESS LOANSBY SIZE OF BORROWER,955-1957.:ALL BANKS

z0en J . A~~~~~~~~~~~~~~~~.Z 200 -TIGHT BANK. .......MEDIUM BANKoLOOSE BANK /wIzzw

-100 50 250 1000 5000 25000 OVERTO TO TO TO TO 100,000250 1000 5000 25000 100,000ASSET SIZE OF BORROWER (IN ooo's)

FIGURE 1terpret the data as substantially reject'ingthe hypothesis that tightmoney led banks to discriminateespecially against small business bor-rowers. Special allowance must be made for a crucial point on theloose-bank curve which is based on inadequate data," and the chartsfor the different bank size-groups strengthenthis interpretation.

"The final point on the loose-bank curve (loans to borrowers with over $100,000,000assets) pulls the loose-bank least-squares line down substantially. Since nearly all banksbig enough to have such large borrowers were in the tight and medium groups, this par-ticular point is based on a small number of relatively small loans, and has very limited


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68 THE AMERICAN ECONOMIC REVIEWFigures 2 and 3 show the behavior of very large and large banks(over $500 million deposits), which included no loose banks. In this

comparison between tight and mediumbanks, tight banks in the $500-$1,000 million deposit class did discriminate more against small bor-300 PERCENT INCREASE IN TOTAL BUSINESS LOANSBY SIZE OF BORROWER, 1955 - 1957

BANKS WITH MORE THAN 41 BILLION DEPOSITS

zo.j 200 TIGHT BANKz MEDIUMBANKa:

zZ 100

-100 50 250 1000 5000 25000 OVERTO TO TO TO TO 100,000250 1000 5000 25000 100)000ASSET SIZE OF BORROWERIN $1000'S)

FIGURE 2rowers than did medium banks of the same size. But Figures 4, 5 and6 show no such discrimination at other banks where tight and loosebanks could be compared directly. On the contrary, at these banks,tight money led to discrimination especially in favor of smallerborrowers.significance. A least-squares fit omitting this one point would give a loose-bank line risingmore sharply than the tight-bank line, and would thus remove the small amount of all-bank evidence appearing to support the hypothesis of discriminatior. against small bor-rowers.


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BACH AND HUIZENGA: TIGHT MONEY 69Similar comparisons of loans by tight, medium and loose banks todifferent sized borrowers were made, breaking businesses into 13 dif-

ferent industry groups-five groups in manufacturingand mining,pluswholesale trade, retail trade, commodity dealers, sales finance com-panies, public utilities, construction, real estate, and services. Thecomparisonsindicate a wide diversity of lending behavior to borrowers300 PERCENT INCREASE IN TOTAL BUSINESS LOANS

BY SIZE OF BORROWER,1955-1957BANKS WITH $500- $1.000 MILLIONDEPOSITS

z-j 200 TIGHTBANKz ........ MEDIUMBANKwlLU

z 100

-100 50 250 1000 5000 25000 OVERTO TO TO TO TO 100,000

250 1000 5000 25000 100,000ASSET SIZE OF BORROWER (IN $1000'S)FIGURE 3

in differentindustries and at banks of differentsizes. No clear patternsemerge as between different industries at all banks combined or atbanks of different sizes separately. This is not surprising, since thereis no a priori reason to expect such size-of-borrowerdifferencesas be-tween differentindustries.20

20Basic data showing separtely each industry's borrowing from each bank size-groupare available for inspection in our files.


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70 THE AMERICAN ECONOMIC REVIEWIn summary, the size-of-borrower data reject the hypothesis thattight money led banks to discriminate substantially against small bor-

rowers in favor of large. Only at banks in the $500-$1,000 million de-posit size-group are the data consistent with this hypothesis of sub-stantial discrimination; for the banking system as a whole and for allother size-groupsof banks, either the differentialbehavior at tight and300 PERCENT INCREASE IN TOTAL BUSINESS LOANSBY SIZE OF BORROWER,1955-1957:

BANKS WITH $100-$500 MILLIONDEPOSITS

z I I?200 TIGHT BANKz -- MEDIUM BANK \LOOSE BAKz iZi- a;0

00,

-100 50 250 1000 5000 25000 OVERTO TO TO TO TO 100,000250 1000 5000 25000 100,000

ASSET SIZE OF BORROWERIN $1000'S)FIGURE 4

loose banks was slight or it was in favor of small borrowers.Crudely,the data suggest that bankers tended under tight money, as would havebeen expected, to meet their strongest credit-worthy loan demandswhile in the main adhering to their regular criteria of credit-worthi-ness; and that in so far as limited discrimination occurred on otherbases, bankers may well have tended to care especially for their bestcustomers-at large banks especially larger businesses and at small


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BACH AND HUIZENGA: TIGHT MONEY 71300 PERCENTINCREASEIN TOTAL BUSINESS LOANSBY SIZE OF BORROWER,955-1957:

BANKS WITH $10- $100 MILLIONDEPOSITS

CA)zI 200 - TIGHTBANK

z ..... MEDIUMBANK-- LOOSE BANKC,)w

0-z 100w0w0.

-100 50 250 1000 5000 25000 OVERTOTO TO TO TO IOOlOOO250 1000 5000 25000 IOO,OOOASSET SIZE OF BORROWER (IN $ ooos)

FiGURE 5banks especially smaller buisinesses.2'But this last sentence is basedmore on the "feel" of the data and on interviews with bankers than onrigorous analysis of the data; and the central fact of lack of substan-

21Nearly all bankers, however, deny that they discriminate against small borrowers perse but instead base credit extension on the credit-worthiness and general "goodness" of theapplicant, regardless of size. [See 11, pp. 401-21. Bankers we have interviewed are surpris-ingly consistent in holding that the most important criterion of a "good" customer is thesize of deposit balance he will maintain over the long run, assuming, of course, that hemeets the traditional standards of credit-worthiness on individual loans, as most reasonablygood customers do.Some large branch bankers emphasize that lending procedures clearly lead to discrimi-nation in favor of small business. Under tight money all large loans must be reviewedby the central loan committee, which is highly sensitive to the scarcity of funds for lend-ing. But branch managers are often left substantially free, under decentralization policies,to make all loans that seem good without central loan committee review as long as theloan is below some prescribed size, for example $25,000.


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72 THE AMERICAN ECONOMIC REVIEW300 PERCENTINCREASE IN TOTALBUSINESS LOANSBY SIZE OF BORROWER,955-1957

BANKS WITH UNDER $10 MILLIONDEPOSITS

z0-j 200 - TIGHT BANKZ ...... MEDIUMBANKLOOSE BANKLi A

w~~~~~~~~~~~~~~~~~~~~~~0IJ~ ~ ~ ~ ~ ~~. .'*z *FZ 100 / *.)X- f

-100 50 250 1000 5000 25v00 OVERTO TO TO TO TO 100,000250 1000 5000 25000 1oo,OOOASSET SIZE OF BORROWER (IN $000So)

FIGURE 6

tial lender discriminationby size of borrower is the one that emergesfrom the data.It is useful to ask directly: Who were the marginalborrowersturnedaway under tight money-large or small businesses? At loose banks,and at small banksas a class, apparentlyneitherlarge nor small credit-worthy borrowers were turned away to any substantial extent. Re-memberthe evidence on page 59 that these banks gained more deposits(lendable funds) than they used in extending new credit over theperiod. In the tight group, large banks and hence large borrowerspre-dominated. Thus, although tight banks probably squeezed both largeand small borrowerssomewhat, for the banking system as a whole alarger proportionof small than of large borrowersapparently escapedcompletely the pressure of tight money on their bank borrowing.A more complete picture of tight money's effects on borrowersof


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BACH AND HUIZENGA: TIGHT MONEY 73different sizes would need to take into account lenders other than com-mercial banks. During the 1955-57 period, small-business borrowingin total rose much more rapidly than is indicated by the commercialbank data, since big firms extended a large amount of additional tradecredit to smaller firms. These credits arose mainly through the exten-sion of open-book accounts, but also through other forms of creditfrom vendors to buyers. Two major studies agree that the rapid risein trade credit to small from large businesses accounted for a very largesum. This fact, although outside the immediate purview of the presentstudy, adds further weight to the refutation of the claim that tightmoney discriminatedespecially against small-business borrowers.22

IV. Busines's of Borrower and the Investment BoomTable 6 shows, for all banks combined and for tight, medium, andloose banks separately, the percentage increase in loans to borrowersin different industry groups. The first column indicates that for allbanks combined loans to metal and metal products, petroleum-coal-chemicals, and transportation-public utilities companies showed thelargest increases. Indeed, nearly half the total increase in loans to allbusinessborrowersover the two years was accounted for by these three

groups. At the other extreme sales finance, construction, real estate,and textiles companies showed the smallest increases. In general, loansto manufacturing firms increased more than to other types of businessborrowers.23It is striking that the rapid growth of loans in the metals, petroleum-rubber-chemicals,and public utilities industry groups was in preciselythose areas where the 1955-57 investment boom was strongest. In atight-moneyperiod, banks generally increasedtheir loans most to thoseborrowerswho had the strongest loan demands,and in general to thosewhose business was best and expanding most rapidly. The data thusgenerally support the propositionthat loans were expandedmost whereloan demand grew most rapidly. For example, within the constructionindustry loans rose rapidly to large constructionfirms, whose businessrose rapidly during the period, but only slightly to small constructionborrowers concerned largely with residential construction, which de-clinedover the period.Broadly speaking, tight banks under the pinch of tight money usedavailable funds to expand loans where-in manufacturingand public

22 See especially Allan H. Meltzer [3] and [11, pp. 363 and 482].X The data in Table 6 for all business loans do not agree precisely with those in Table 2for commercial and industrial loans as to relative increases at tight, medium and loosebanks. Part of the difference is due to the inclusion of real estate loans to businesses inthe "business loan" figures but not in the "commercial and industrial loan" figures. Theremay be other factors involved, but if so we do know what they are.


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74 THE AMERICAN ECONOMIC REVIEWTABLE 6-PER CENT INCREASE IN BUSINESS LOANS, OCTOBER 1955-OCTOBER 1957

Relative Increase, WithPer Cent Increase At: Per Cent Increase AtLoose Banks= 100Business of Borrower All Loose Medium Tight Loose Medium TightBanks Banks Banks Banks Banks Banks Banks

(1) (2) (3) (4) (5) (6) (7)All borrowers 52 52 46 56 100 88 108All manufacturing and mining: 66 71 56 76 100 79 107Food, liquor and tobacco 48 8 62 46 100 775 575Textiles, apparel, etc. 31 1 4 53 100 400 5300Metal and metal products 98 132 71 118 100 54 89

Petroleum, chemicals, etc. 67 42 49 82 100 117 195Othermanufacturingand mining 59 35 71 53 100 203 151TradeWholesale 43 65 19 75 100 29 115Commodity dealers 36 37 12 51 100 32 138Retail 48 62 45 45 100 73 73Sales finance companies 27 41 20 28 100 49 68Public utilities, transportation, etc. 89 23 56 126 100 243 548Construction 29 33 40 14 100 121 42Real estate 33 81 41 15 100 51 19Services 40 56 52 16 100 93 29

utilities-banks as a whole expandedloans most. But the shift of tightbanks away fromother businessesto these groups was more pronouncedthan at loose banks. This is shown especially by column 7, which indi-cates the big relative increases at tight banks in loans to most manufac-turing subgroupsand to public utilities as compared with loose banks.Conversely,the tight banks showedvery small relative increasesin loansto construction, real estate, services,and sales financecompanies.Again,the evidence is consistent with the proposition that loans rose mostwhere the borrowerdemand was greatest. The main apparent excep-tions are textiles, and food-liquor-tobacco irms, where very large rela-tive increases are shown by column 7 although their aggregate invest-ment growthwas moderate. These are both cases wherevery small per-centage increases were reported by loose banks, so even moderate in-creases at tight banks appear as very large relative increases.It may be surprisingthat tight banks increasedtheir commercialandindustrial loans more than loose banks over the period, in total, formost of the manufacturing groups, for wholesale trade and commoditydealers, and for public utilities. This was accounted for by the very


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BACH AND HUIZENGA: TIGHT MONEY 75large banks-those with deposits over $1 billion-none of which fellin the loose group. At all other tight banks, business loans increasedsubstantially less than at loose banks. Data comparing the lending pat-terns of tight, medium and loose banks separately for banks in fivesize classes are presented in Table 7, which is comparable to Table 6above.The Table 7 breakdown by size of bank shows substantial diversity;but no pattern of differencesin lending behavior at banks of differentsizes. This may not be surprising, since there is no a priori reason tosuppose that banks of different sizes would react differently in asystematic way to loan demands from different industries. In each of

TABLE 7-PERCENTAGE INCREASE IN BUSINESS LOANS AT DIFFERENT SIZEBANKS, OCTOBER1955TO OCTOBER1957aBusinessof Borrower

E MWanufacturing Milling X O .SizeofBank Deposits)1 | .e ?|.~~ ~ ~ ~ ~ ~~~~~~~~~. _, i~__ 30 - ) Oat 1 '- 0 -

Over$1billion:c% ncreaseinloanst:Medium banks 79 93 119 -25 77 88 210 -13 - 2 46 138 131 38 141 90Tight banks 105 121 81 76 200 118 83 101 74 91 76 193 30 35 37Relative increase at:Mediumbanks 100 100 100 100 100 100 100 100 100 100 100 100 100 100 100Tight banks 133 130 68 504 260 134 40 977 3900 198 55 147 79 25 41

S500-$1,000million:e% Increasen oans t:Medium banks 41 54 51 8 81 36 59 34 93 71 -21 25 92 - 6 57Tightbanks 14 12 27 - 18 15 -30 50 18 380 11 -25 91 -19 - 6 18Relative ncrease t:Mediumbanks 100 100 100 100 100 100 100 100 100 100 100 100 100 100 100Tight banks 34 22 53 -225 19 -83 85 53 409 15 81 364 -21 100 32$1004500 million:% ncreaseinoans t:Loosebanks 75 89 20 - 23 312 56 23 126 21 132 - 3 -10 65 169 48Mediumbanks 39 45 52 17 78 32 27 37 -19 45 16 22 58 39 50Tight banks 27 27 2 32 39 40 26 65 12 35 20 14 2 8 -2

Relative increase at:Loose banks 100 100 100 100 100 100 100 100 100 100 100 100 100 100 100Medium banks 52 51 260 274 25 57 117 29 -90 34 733 420 89 23 104Tight banks 29 30 10 339 13 71 113 52 57 27 867 340 3 5 -4$10$100 million:% ncreaseinloanst:Loosebanks 37 24 -2 24 19 32 48 29 52 37 121 48 22 55 54Medium banks 29 22 8 16 33 21 22 31 19 42 6 39 11 30 38Tight banks 16 22 17 21 o7 26 6 27 -10 40 -24 26 25 11 8Relative increase at:Loose banks 100 100 100 100 100 100 100 100 100 100 100 100 100 100 100Medium banks 78 92 600 67 174 66 46 107 37 114 5 81 50 55 70Tight banks 43 92 1050 88 195 88 13 93 -19 108 -20 54 114 20 15Under $10 million:% ncrease n loans at:Loose banks 47 19 -14 8 10 41 35 54 30 42 41 116 31 63 64

Medium banks 24 11 -8 6 19 55 5 31 54 29 7 49 15 22 27Tightbanks 15 1 24 - 43 -17 40 17 21 35 15 - 7 108 45 2 11Relative increase at:Loose banks 100 100 100 100 100 100 100 100 100 100 100 100 100 100 100Medium banks 51 58 143 75 190 134 14 57 180 69 17 42 48 35 42Tightbanks 32 5 371 -537 -170 98 49 39 117 36 +17 93 145 3 17a Forcorrespondingll-bankdata, see text Table5.b Depositsas of October1955.No banks n the Over$1 billionand the $500-$1000milliondepositclasses ell in thel oosegroup


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76 THE AMERICAN ECONOMIC REVIEWthe industry groups, small as well as large firms are represented, al-though in different proportions at different size-groups of banks.In summary, these data suggest that increasingly tight money dur-ing the 1955-57 period was reflected in significantly differentincreasesof loans for different industry groups; and that especially at tightbanks, as well as for the banking system as a whole, the loan expansionwas greatest to those industries which were expandingmost rapidly interms of plant and equipment expenditure, inventory accumulation,and general level of activity. Thus, broadly speaking, banks increasedtheir loans most where the credit-worthy loan demand was greatest.This does not, of course, say that the rapidly expanding industriesnecessarily received the most credit relative to their loan demands.2"But it was not true that bank loans uniformlyexpandedmost rapidlyto those indtistries whose business was growing most rapidly. For ex-ample, sales finance companies, whose business expanded rapidly overthe period, obtained only a modest increase in bank loans. This wasprobably in part because they had fairly ready access to the moneynarket through other channels. But it also apparently was becausebanks generally do not consider sales finance companies highly pre-ferred customers, since finance companies generally do not promiselarge long-run deposit balances to the extent that many manufacturingand commercialborrowersdo.

V. Interest RatesSmall businesses generallypay higher interest rates at banks than dolarge businesses, primarily reflecting differences in size of loan. Smallbusinesses usually borrow small amounts, and investigation charges,servicing charges, and related expenses bulk relatively much largerthan on the large loans customarilyobtainedby large businesses.Large

businesses often pay lower interest rates on comparablesize loans thando small businesses, but the differencesare small and probably reflectmainly differences in risk and in loan-administrationcosts.Table 8 shows interest rates paid by borrowers of different sizes in1955, in 1957, and the net increase over the two-year period. In both1955 and 1957, the average interest rate paid varied inversely with thesize of borrower.But as interest rates rose with tight money over thetwo-year period, rates to large borrowerswere increased considerablymore than rates to small borrowers.Over the two years, the spreadbetween average rates to the largest and smallest borrowers declined4The Federal Reserve interview study of bankers in 1957 found "almost completeabsence" of any indication of bank policy changes as to the type of industry most de-sirable to accommodate. Decisions continued to be made on prevailing criteria, thoughthe actual loan distribution shifted with the shifting positions of potential borrowers, See[11, p. 436].


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BACH AND HUIZENGA: TIGHT MONEY 77from 2.5 to 2.1 per cent. While the average rate on all new loans rosefrom 4.2 to 5 per cent, that on loans to large borrowers rose nearlytwice as much absolutely, and even more relatively, as that on loans tosmall borrowers. During the period, moreover, bank requirementsthatborrowers maintain compensating balances also became more wide-spread. Since these requirements apply primarily to large borrowers25it is probable that differences in effective interest rates narrowed evenmore than the data in Table 8 indicate.

TABLE8-INTEREST RATESONBUSINESSLOANS,BY SIZEOF BORROWER"

Asset Size of BorrowerAverage Interest Rate (per cent per annum)

(000's omitted) 1955 1957 Absolute IncreaseAll borrowers 4.2 5.0 .8Under $50 5.8 6.5 .7$50 to $250 5.1 5.7 .6$250 to $1,000 4.6 5.4 .8$1,000 to $5,000 4.1 5.1 1.0$5,000 to $25,000 3.7 4.8 1.1$25,OO to $100,000 3.4 4.5 1.1$I00,000 and over 3.3 4.4 1.1Size of borrower as of October 1955. Rates are average rates charged by reporting banksover the July-October period for 1955 and 1957. More detailed data, for loans at differentsize banks, are presented by the Federal Reserve in [11, pp. 388-89].

This greater increase in rates to large borrowersprobably reflectd,at least in part, the fact that small borrowers by 1955 were alreadypaying rates near the customary or legal upper limits for nonconsumerloans at many banks. These legal limits are as low as 6 per cent ineleven states, including New York, New Jersey and Pennsylvania, andrange up to 15 per cent in others. Thus as interest rates rose, rates tolarge borrowers could be increased without violating the customary orlegal upper limit, while rates to small borrowers could be raised littleor not at all. In any case, for the banking system as a whole, it is clearthat interest rates to small borrowers rose less than those to large bor-rowers. In the aggregate tight money did not lead to discriminationininterest costs against small borrowers.To what extent did tight banks, under the pinch of tight money, usehigher interest rates as a device for discouraging especially particularclasses of borrowers?Figure 7 shows the change in the distribution ofbusiness loans made at different interest rates by tight, medium andloose banks over the 1955-57 period.The average interest rate charged rose at all three classes of banks.

2 See [11, p. 433].


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78 THE AMERICAN ECONOMIC REVIEWLoans made at less than 4 per cent declined at all classes, as the ratestructure moved up. The largest percentage increase at both tight andmedium banks was in the 4.5-4.9 per cent range, while that for loosebanks was in the 5-5.9 per cent range. The apparent differences be-tween tight and loose banks reflect primarily the larger proportion oflarge banks (and large loans) in the tight group, where rates in the4.5-5 per cent range represented a large increase for large borrowers.At tight banks, nearly half the total loan volume was in loans of $1million or more, as compared to less than 5 per cent at loose banks.

PER CENTINCREASEN BUSINESS LOANSMADEAT DIFFERENT NTEREST RATES:1955Tol957

400 - TIGHTBANKS... . MEDIUM ANKSLOOSEBANKS

300

oo20

0100

0

-100 _-LESS THAN 3.50 4.00 4.50 5.00 6.00 8.00 12 OR3.5 3.99 4.49 4.99 5.99 7.99 11.99 OVERINTERESTRATE PERCENT)

FIGURE 7

By 1957, two-thirds of these larger loans at tight banks were made at4 or 4.5 per cent, while in 1955 nearly two-thirds were made at ratesbelow 3.5 per cent.2"Data showing separately changes in loans made at different interestrates on loans of differentsizes at tight, medium and loose banks indi-cate that tight, mediumand loose banks raised interest rates over theperiod by similar amounts for loans of the same size-though withsomewide differences hat appearto be random.'In summary, therefore, there is little evidence of much differential

'Most borrowers pay about the same rate of interest on their loans, regardless of thesize of the bank from which they borrow. See [11, p. 389].7 Charts comparable to Figure 7 have been prepared for loans in six different size groups.Copies will be provided on request.


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BACH AND HUIZENGA: TIGHT MONEY 79interest rate behavior at tight and loose banks during the period ofincreasingly tight money. This finding is consistent with the hypothesisthat the pattern of interest rates at banks is set by general marketforces, and that banks generally follow a policy of price leadership inestablishing interest rates, rather than using them as a device to dis-criminate among borrowers. The hypothesis that tight money raisedinterest costs especially to small borrowers is clearly rejected by thedata.

VI. ConclusionWhat is the significance of these findings for the use of restrictivemonetary policy in the future? Tight money in 1955-57 apparently ledthose commercial banks which felt its impact to alter their asset port-folios significantly; they shifted to obtain funds to increase loans toprofitable borrowers, especially business firms, even at the cost ofliquidating government securities on a declining market. Discrimina-tion amongst borrowers was apparently largely on traditional bankingstandards of credit-worthiness and goodness of borrowers,with differ-ing changes in loans to various borrower groups reflecting primarilydifferencesin loan demands, rather than discrimination by lenders on

other grounds, once standards of credit-worthiness were met. Wide-spread criticisms of tight money as unfairly discriminating againstsmall borrowers, both in availability of loans and interest costs, arenot supportedby the data.On the other hand, the fact that increasingly tight banks continuedto increaseloans to good business customers,whose demandfor moneyreflected partly heavy investment outlays and inventory carrying costs,meant that tight money did not act to deter especially these primemovers in the investmentboom. Thus, although tight money in 1955-57may have led to little "unfair" discriminationagainst particular bor-rower groups, it did permit funds to go extensively to the same bor-rowers wlhowould have obtained them in the absence of tight money.Whether the marginal borrowersshut out by tight money would havecontributed significantly to either undesirable investment or inflationcannot be told from these data. Probably at least as much (more, onthe objective evidence) of the marginal credit shut off was to large asto small firms,but no comparablegeneralizationas to industry is possi-ble from these data.28

Overall, tight money in 1955-57 appearsnot to have changed greatlythe allocation of bank credit among major classes of business borrow-' Unfortunately, the Federal Reserve obtained separate information on loans to newbusinesses only in the 1957 survey. Thus it was impossible to test the hypothesis that tightmoney leads banks to discriminate against new businesses. For some evidence on the point,see [11, pp. 390ff.].


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80 THE AMERICAN ECONOMIC REVIEWers from what it would have been with looser money, certainly not bysize of firm and only moderately by industry-partly because moneywas not tight enough to limit seriously loans to credit-worthy custom-ers at a substantial proportionof all banks. Tight money's main effectwas apparently to hold down the total volume of credit while inducingcredit rationing at tight banks mainly in response to relative strengthof demand among "good" bank customers.Whether one evaluates thisconclusionas strengtheningor weakeningthe case for restrictive mone-tary policy may depend largely on his taste for direct controls asagainst market forces. Tight money helped to restrict total spendingand keep the price level down while doing relatively little directly toreallocate resources-the traditional objective of general monetarypolicy. It apparently did not especially check the industriesat the coreof the investment boom.

REFERENCES1. J. K. GALBRAITH, "Market Structure and Stabilization Policy," Rev.Econ. and Stat., May 1957, 39, 124-33.2. A. H. MELTZER, "A Comment on Market Structure and StabilizationPolicy," Rev. Econ. Stat., Nov. 1958, 40, 413-15.3. , "Mercantile Credit, Monetary Policy, and Size of Firms," Rev.Econ. Stat., Nov. 1960, 42, 429-37.4. W. L. SMITH, "MonetaryPolicy and Debt Management," n Employment,Growth, and Price Levels, Staff report prepared for the Joint EconomicCommittee,86th Cong. 1st sess., Dec. 24, 1959. Washington 1959.5. "Bank Credit and Money," Fed. Res. Bull., Feb. 1956, 42, 97-105.6. ,Fed. Res. Bull., July 1957, 43, 753-58.7. Board of Governorsof the Federal Reserve System, Annual Report, 1955,1956 and 1957.8. Business Week, Oct. 15, 1955, p. 200 and Sept. 21, 1957, p. 26.9. Federal Reserve Bulletin, Apr. 1956, 42, 338-39.10. , Apr. 1958, 44, 410-11.11. Financing Small Business. Report to the Committees on Banking andCurrency and the Select Committees on Banking and Currency, 85thCong., 2nd sess., by the Federal Reserve System. Parts 1 and 2. XVashing-ton 1958.12. New York Times, Nov. 11, 1955 and May 17, 1957.

the differential effects of tight money

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