of the added spending must be financed externally since corporate cash flow will not grow nearly as fast. In fact, corporations have been relying more and more on external financing in the last few years. In 1963 and 1964, only 20 percent of total corporate investment was externally financed. In the next 4 years, the figure jumped to 28 percent. The added pressure on credit markets will leave less credit available for housing, State and local governments, and small business.

Fourth, the inflationary investment boom seems completely unsustainable in view of the fact that we are only utilizing 84 percent of our industrial capacity. Because of the investment tax credit, we may have reached the saturation point for new business investment, but nonetheless, the boom goes unchecked.

Part of the reason why the inflationary business investment boom has gone unchecked has been due to the ability of large commercial banks to circumvent the monetary policy established by the Federal Reserve Board. For example, during the last 3 months the Fed cut the annual growth rate in Federal Reserve Bank credit to 0 percent compared to a 10.6 percent growth rate during the first 11 months of 1968. Likewise, the annual growth rate in the money supply dropped to 4 percent in the last 3 months compared to 6.4 percent for the first 11 months of 1968. But despite these tightening actions, commercial bank loans expanded at an annual rate of 12 percent during the last 3 months compared to an annual growth rate of 11.7 percent during the first 11 months of 1968. In other words, tight money has had absolutely no effect on bank lending.

How can commercial banks circumvent the Federal Reserve's monetary policy? The following figures will tell the story. During the period from December 4, 1968, to March 12, 1969, large commercial banks with deposits of over $100 million lost a total of $6.9 billion in deposits, both demand and time. This period roughly coincides with the period of tightening monetary policy. The deposit loss indicates the Fed's policy was partially effective. If all other conditions remained the same, these large banks would have had to curtail their lending by a similar amount.

But all other things did not remain the same. These banks were able to obtain $10.2 billion from other sources to more than offset the $6.9 billion deposit loss. Where did they get the money? One, they got $4.5 billion by dumping Treasury securities; two, they got $2.4 billion by borrowing in the Euro-dollar market; three, they got $1.6 billion by borrowing from others including the Fed itself; and four, they got $1.7 billion from all other portfolio adjustments.

The difference between the $6.9 billion deposit loss and the $10.2 billion offset is $3.3 billion. All of these funds were used to increase industrial and commercial loans. The ready availability of bank credit is one more reason why corporate treasurers are confidently planning to increase their investment spending by 13.9 percent in 1969.

The purpose of these hearings is not to point the finger of blame at the large banks. After all, they are profit-making institutions responsible to their stockholders and have no duty to carry out monetary policy. Instead we want to find out how monetary policy can be more effective. The argument is not between a tight versus easy money policy. Granted the need for a tight money policy, the question is how can that policy be made more effective, how can it be more selective in its

impact, how can it work to restrain the inflationary elements in the economy without sending interest rates sky high, without clobbering the housing industry and without creating a disastrous credit crunch similar to 1966?

In this connection, I would like to read a list of questions sent by the chairman of this committee, Senator Sparkman, to the Federal Reserve Board and other agencies of the administration.

(1) Is there any evidence that the recent increase in the commercial bank prime lending rate was dictated by a profit squeeze on the banking industry?

(2) What will be the impact of higher interest rates on the economy in general and on specific sectors of the economy?

(3) What evidence is there that higher interest rates are effective in restraining the business-corporate sector of the economy from using the credit markets to finance investment?

(4) Are the traditional tools of monetary policy effective enough in restraining commercial bank business lending activity in a timely manner?

(5) What measures can be taken to insure a more equitable allocation of the impact of a restrictive monetary policy?

(6) Does borrowing in the Euro-dollar market by the large New York banks impair the efficiency of monetary policy, and, if so, what steps can be taken to restore Federal Reserve control? In this connection, are there specific approaches that you would care to discuss on this question?

(7) Does the sale of U.S. Treasury and State and local obligations by commercial banks weaken monetary control, and, if so, what steps can be taken to prevent such circumvention?

(8) How effective has the technique of "moral suasion" been in restraining commercial bank lending activities? Does the Federal Reserve contemplate the use of this technique in the future?

(9) Is it necessary to revive regulation W type selective controls over the credit demands of large corporations? How effective would such measures be in keeping down interest rates and in insuring a more equitable distribution of credit?

(10) Are there any institutional changes that could be made to insure that the housing, small business, State and local, and agricultural sectors of the economy do not bear the brunt of a restrictive monetary policy?

(11) What specific steps does your agency contemplate over the next few months to halt the escalation of interest rates?

(12) What specific steps does your agency contemplate over the next few months to restrain the credit demands of corporate business firms?

I can understand how the administration and the Federal Reserve Board might be reluctant to antagonize our large commercial banks and corporations by requiring them to assume their fair share of the anti-inflationary burden. After all, these are large and powerful organizations who know how to fight back whereas home buyers, small businessmen, consumers, and municipal treasurers are diverse and unorganized.

But unless we come up with a better way of executing monetary policy, the Federal Reserve Board and the administration are going to

reach a head-on confrontation with the Congress. Congress wasn't kidding when it established as a national goal the construction of 26 million housing units over the next decade, of which 6 million would be for low- and moderate-income families.

These are national goals and are binding on every officer of the Government. It is not enough for our monetary officials to shrug their shoulders and disclaim responsibility. They are responsible. And as the ranking majority member of this committee, I, for one, intend to hold them accountable.

And, so I hope that the Federal Reserve Board and the Treasury will respond to the questions of this committee and will indicate how monetary policy can be made more effective and equitable in its impact. It is high time we stopped the nonsense that the Federal Reserve Board cannot or should not influence the allocation of credit to help. achieve the national goals laid down by Congress and the American people. It is high time that the administration and the Fed devise an effective means of slowing the highly inflationary borrowing of large corporate business without ruining homebuilders, small business, and

farmers.

I guess I took about 10 minutes. I apologize to our distinguished witnesses, but I wanted to leave no doubt where I stand on this matter. We will start off with the distinguished Chairman of the Federal Reserve Board, Mr. Martin.

STATEMENT OF WILLIAM MCCHESNEY MARTIN, JR., CHAIRMAN, BOARD OF GOVERNORS OF THE FEDERAL RESERVE SYSTEM; ACCOMPANIED BY J. C. PARTEE, ASSISTANT DIRECTOR OF RESEARCH

Mr. MARTIN. Today I am pleased to appear before this committee to discuss with you recent developments in financial markets and especially the trend of interest rates over the past several years. I have frequently testified that I would like to see interest rates as low as we can have them without inflation. And I would add now that the way to get interest rates down is to end the inflation that has been raising them.

Let me set forth a few of my own ideas as to why interest rates have risen to the present unprecedented levels, and what must be done if we are to see a return to a level of interest rates consistent with satisfactory rates of investment over the long run in such areas as housing and plant and equipment.

To begin with, the current period of high interest rates needs to be viewed in the longer run perspective of interest rate trends over the period since World War II. While there have been short-run swings in interest rates over these past two decades, in response to variations in the tempo of economic activity, several major factors have contributed to the persistent upward trend that we have experienced.

The most important contributing factor has been the extraordinarily high rate of technological progress occurring both in the United States and abroad. It scarcely seems possible that 20 years ago television sets, synthetic fibers, and plastic containers were products that existed largely in the minds of engineers and chemists, or that the use of com

puters and the automation of production processes were just beginning to affect business thinking and planning. As Apollo 8 was circling the moon I was reminded that the first manned flight of any kind took place only a little more than 60 years ago. And much of the progress symbolized by that leap forward has occurred during the past three decades.

The technological discoveries of this period have required extraordinarily large investments to be incorporated into new products and processes, and this, of course, has meant heavy demands for financing. Earlier in the postwar period, businesses were able to draw heavily on internally generated funds and on stocks of liquid assets built up during World War II to help finance these projects. As the postwar period proceeded, however, they had to rely increasingly on external sources to meet financing needs.

High rates of investment are, as we are all aware, a principal source of gains in productivity, in real income, and in our standards of living. Rarely has any society been as fortunate as ours in realizing the benefits of almost continuous economic prosperity over the past 20 years. Per capita disposable income in the United States in real terms is fully 50 percent higher now than it was at the end of World War II. And our consuming public has chosen to enjoy the fruits of material progress in ways that put heavy demands on the credit markets. Consumers have demanded more and better homes, and a wider and more varied stock of durable goods. To purchase these assets, consumers depend significantly on mortgage and installment credit.

Another factor in the long upward trend of interest rates in the postwar years has been the major change that has occurred in asset portfolios of financial investors. Both institutional and other investors entered the postwar period with exceptionally large holdings of liquid assets, accumulated largely as a result of wartime deficit spending. Consequently, even though interest rates were at exceptionally low levels, investors were anxious to switch from liquid assets into mortgages, consumer loans, and corporate and municipal securities. The abundance of available loan funds held interest rates down in the first postwar decade, but as the backlog of liquidity was worked off, greater interest rate incentives were required to encourage investors to supply funds to finance economic expansion.

As the postwar years unfolded, investors also began to show heightened preferences for equity investments as contrasted with fixed income securities. To some degree this reflected the failure to follow stabilization policies that might have kept inflation under better control. But it also resulted from the degree of success we did enjoy in avoiding the deep declines in economic activity that occurred prior to World War II.

To an important degree, then, the general upward trend in postwar interest rates has been symptomatic of the vigor of economic expansion. Yet, it seems quite clear to me that even in prosperous times we can have lower and relatively more stable interest rates than prevail today. We enjoyed interest rate developments of that kind during the early years of the 1960's. Indeed, interest rates on some kinds of financial assets, such as mortgages, declined a little over the first 5 years of the present decade. But beginning about the middle of 1965, the cost of

credit began to rise and we are still seeing increases going on today. What accounts for this abrupt change in the demand-supply equation in financial markets during the past three and a half years?

The answer to that question is not, I think, hard to discover. Since mid-1965, except for a brief respite in early 1967, we have had an overheated economy and growing expectations of inflation. Private spending decisions have been influenced in fundamental ways. We received word just recently that businesses are planning to raise their expenditures for plant and equipment by 14 percent in 1969 over the 1968 level. That is the same 13.9 you referred to in your statement. While the size of the anticipated growth in capital outlays was larger than many observers had expected, the news that plans for the period ahead were strong should not have come as a great surprise. With wages increasing at rates well beyond the growth of productivity. with costs of capital goods rising, and with expectations developed over the past several years that higher costs can sooner or later be passed on in the form of higher prices, why shouldn't we expect businesses to do what they can to introduce cost-cutting methods and to put new capacity in place at today's prices?

This recent announcement of upward revisions in business investment plans for 1969 is a continuation of developments that became evident around the middle of last year, when the rate of business investment began to strengthen measurably, despite the fact that rates of capacity utilization in manufacuring were not especially high, and stern measures of fiscal restraint had just been adopted.

We also experienced a large rise in housing starts in the latter half of last year, even though interest rates on mortgages were at record levels and rising-while flows of funds through transitional sources of mortgage finance were falling off.

Let us consider for a moment the cost-price developments that businesses and consumers have had to take into account in making their investment decisions. From the middle of 1965 to the end of 1968, consumer prices rose at an annual rate of 312 percent compared with a 12-percent rate in the previous 311⁄2 years; for wholesale prices, the figures are 2 percent for the recent period, and three-fourths of 1 percent for the prior 311⁄2 years; for construction costs, 41⁄2 percent and 2 percent for average hourly compensation in manufacturing, 51⁄2 percent compared with 334 percent, and for unit labor costs in manufacturing. 4 percent in the past 312 years compared with no change in the prior 311⁄2 years.

Is it any wonder that consumers want to buy houses now to avoid paying higher prices later? Should we be surprised that businesses are trying to find some method of holding down the rise in production costs and are searching for labor-saving investments as a means to do so?

Financing the high level of private investment has increased greatly the demands on money and capital markets. From 1960 to 1964, nonfinancial businesses and consumers together borrowed new funds at an average rate of about $38 billion a year. Since 1965, the annual average has been $59 billion-or more than 50 percent higher-and in 1968 the figure rose to $67 billion. In the past 3 years nonfinancial corporations raised new capital through bond issues in amounts averaging nearly $13 billion a year, about three times as much as during the previous 3

years.