Chapter 6. Developments in the Industrial Countries
- International Monetary Fund
- Published Date:
- September 1967
During the course of 1966 the levels of economic activity in the industrial countries 1 changed markedly. For most of these countries, where output was rising rapidly in late 1965 and early 1966, there was a definite slackening in the rate of growth after the first few months. In Italy and Japan the rate of economic expansion picked up considerably during the year. In France the expansion was rapid from the second half of 1965 through the third quarter of 1966 but has continued more slowly since then.
In the United States, Canada, Germany, and some other industrial countries, the pace of economic expansion, which had become exceptionally strong in late 1965, was maintained at a high level during the early months of 1966. In most of these countries this rapid expansion put pressures on available resources and prices showed an upward trend. To varying degrees and at different times, the authorities became concerned with growing inflationary pressures and took progressively more severe measures aimed at restraining domestic demand. Partly as a result of these measures, industrial output during the course of the second half of 1966 leveled off in the United States and Canada and declined in Germany. In the United Kingdom total output had been rising slowly at the end of 1965 and beginning of 1966, but balance of payments difficulties and inflationary pressures called for further corrective measures in May and July; the peak in activity touched in the first quarter of 1966 was not attained during the rest of the year. In general, economic expansion in the other countries of this group also slowed down after the first few months of the year. On the other hand, in Japan the rate of economic growth was comparatively low during 1965 and the early part of 1966. But in response to measures of stimulation, some of which had been taken earlier, it expanded more rapidly during the second half of the year and in early 1967.
The policy measures which contributed to the slowdown of economic expansion in industrial countries were largely monetary in nature. During the period, capital markets were faced with large demands for funds for financing business investments and government expenditures. They were also subjected to the effects of programs of the United States aimed at restraining capital outflows from that country. Against this background a primary reliance on monetary policies produced severe strains on money and capital markets. Interest rates rose to their highest levels in a long time and there were major changes in the direction of international capital flows. The outflow of funds from the United States was markedly reduced during the year. Germany experienced a substantial inflow of capital. Despite large capital outflows from Italy and Japan, these developments put particular pressure on the United Kingdom and contributed to the sterling crisis in July.
The United Kingdom was the only major country restraining demand in 1966 to suffer a sharply increased outflow of capital, including short-term capital, and was also exceptional in some other respects. While it acted like the United States, Canada, and Germany to restrain demand after the first few months of 1966, it did so somewhat later than those countries. Among those acting to restrain demand, the United Kingdom was also the only country which relied heavily on fiscal and incomes-policy measures, along with monetary measures, to achieve its objectives. The other countries which made substantial use of fiscal (as well as monetary) measures to influence the course of economic activity—France, Italy, and Japan—did so to stimulate rather than restrain demand.
Output and Demand
Output was rising more rapidly in most of the industrial countries in late 1965 and early 1966 than in the immediately preceding period (Charts 6 and 7 and Table 24). This rise was associated with strong demands in some important countries (e.g., Canada, Germany, the Netherlands, and the United States), where the already high level of capacity utilization at the beginning of 1966 imposed a restraint on the further expansion of output. Even where the rate of growth was slower (e.g., in the United Kingdom), pressures on resources were also strong. As 1966 progressed, therefore, the advances of total output in most of the industrial countries slowed down and this tendency extended into 1967. However, in some countries (e.g., France, Italy, and Japan) there was unutilized capacity available at the end of 1965 and output could grow more rapidly in 1966 without creating strains. Partly as a result of a decline in the rate of growth in its exports, the advance in output became somewhat slower in France toward the end of 1966 and in early 1967. In Italy and Japan output continued to rise rapidly through the first part of 1967.
In the United States the pace of economic advance picked up sharply after the middle of 1965. Real gross national product increased at the very high annual rate of 7 per cent over the three quarters ended March 1966. The pressure put on domestic resources by this rapid advance was reflected in a fall in unemployment and a faster rise in prices. Partly as a consequence of measures to restrain the pace of economic expansion, the growth of real national product declined to an annual rate of about 3.5 per cent in the remaining three quarters of the year; in the first quarter of 1967 there was a slight decline in real product. The rate of increase in consumer prices slackened toward the end of 1966. Throughout the year military expenditures increased rapidly, and business fixed investment also was an expansionary force. The most pronounced slackening of demand after the first quarter of 1966 was in residential housing.
Chart 6.Selected Areas and Countries: Industrial Production, Seasonally Adjusted, 1963–April 1967
At the beginning of 1966 real gross product was rising rapidly in Canada, chiefly in response to rising business investment and government expenditures. Partly because of the measures introduced in the March budget to restrain demand, economic activity grew more slowly thereafter. However, the average unemployment rate of 3.6 per cent in 1966 was the lowest since 1956.
The rate of increase of total output in the United Kingdom picked up slightly in late 1965. Under the impact of the deflationary measures introduced during 1966, however, the economic advance decelerated considerably. For the year as a whole industrial production increased by only about 1 per cent in 1966, compared with 3 per cent in 1965. There was a surge in consumer expenditure during the first quarter of 1966, partly in anticipation of increased taxation in the May budget and partly because of sharp increases in wage rates and, temporarily, in dividend payments. During the rest of the year consumer expenditure in real terms declined as credit restraints were tightened and as real personal disposable income fell as a consequence of rising prices, increased taxes, and lower dividend payments. Business investment also declined after the third quarter, but there were steady increases, in public sector investment. The change in the tempo of economic activity and in short-run business expectations was reflected in the substantial increase of unemployment, which until mid-1966 was lower than it had been for almost a decade.
Chart 7.EEC Countries: Industrial Production, Seasonally Adjusted, 1963-April 1967
In the European Economic Community output increased at a slower pace in 1966 than in the previous year. In three members of the Community—Belgium, Germany, and the Netherlands—the authorities were concerned over the existence of high pressures on domestic resources during the early part of the year and took measures designed to restrain economic expansion. In Germany the export sector expanded rapidly during 1966, mainly as a result of the economic recovery in France and Italy and strong import demand in the United States. All other sectors, however, expanded at a slower rate than in 1965. As a result, there was a reduction in the rate of growth of real gross product—and an actual decline in the level of industrial production—in the second half of the year. In Belgium-Luxembourg the rate of growth in total output, which had already slowed markedly in 1965, declined slightly further in 1966. External demand and both public and private consumption increased, in real terms, at a lesser pace in 1966. However, gross fixed capital formation (mainly that by foreign enterprises) expanded relatively more than in 1965. While the industrial production index increased by 3.5 per cent in the first half of 1966, the increase in the second half was only slightly over 1 per cent. In the Netherlands, although the 4.5 per cent increase in real gross product in 1966 was relatively high, it was lower than the 5.4 per cent increase registered in 1965. There was some deceleration in the rate of output growth in the second half of 1966, though this was less sharp than in Germany and Belgium-Luxembourg. In the Netherlands, because of a combination of special factors and slackening pressures in some of its important trading partners, exports grew at a slower rate in 1966. As in Belgium-Luxembourg the impetus for economic expansion came from gross fixed investment.
The French and Italian economies, following the economic slowdowns that had occurred earlier, recorded relatively high advances in output in 1966. Both countries experienced increases in real gross national product, as well as in industrial production, that were substantially higher than in 1965. In France, partly because of added fiscal incentives, fixed asset formation led the pace of expansion. The impetus to expansion stemming from export demand slackened in the latter part of 1966, largely because of the economic recession in Germany. In Italy, where the 1964-65 recession was more severe, the expansion has been more vigorous. All the major elements of demand strengthened during 1966.
In Japan the recovery in 1966 from the relative stagnation that had been experienced since the fourth quarter of 1964 was spurred by strong external demand and by a rapid increase in domestic investment, resulting from an actively expansionary budget, which tended to encourage private consumption. The index of industrial production, which had remained static in 1965, advanced by 20 per cent during 1966. Contrary to the situation in most other industrial countries, the economic advance in Japan during 1967 is expected to remain rapid.
Prices and Wages
In the early months of 1966, prices in most industrial countries were rising at exceptionally high rates. However, the slowdown in the tempo of economic activity that occurred in later months of the year and in early 1967 tended to induce some deceleration in the rate of price rise (Chart 8). Even so, the increases in the cost of living that occurred in some industrial countries were the highest in many years. In the United States and Canada the increases in the cost of living index during 1966, although not large in comparison with those in other countries, were the highest recorded since 1952. Relatively high rates were similarly recorded in Switzerland (highest since 1949) and in Sweden (highest since 1953). In the other industrial countries, the increases in the cost of living index in the course of 1966 were approximately the same in France, Germany, and Belgium as in 1965, while in Austria, Denmark, Italy, Japan, the Netherlands, Norway, and the United Kingdom the increases were less than a year earlier.
Chart 8.Selected Areas and Countries: Cost of Living 1963-May 1967
On the whole, the relative movements in wholesale prices (Chart 9) were similar to, but less rapid than, those in the cost of living. There were, however, some instances of divergent movements. Whereas in Sweden and Switzerland the rise in the cost of living accelerated in 1966, the rate of increase of wholesale prices moderated slightly. In Japan the rise in wholesale prices was greater in 1966 than a year earlier.
Chart 9.Selected Areas and Countries: Wholesale Prices, 1963-May 1967
Wage rates in the United States increased somewhat more in 1966 than in 1965. In the latter part of 1966 a number of important contract negotiations resulted in agreements which provided wage and fringe-benefit increases considerably in excess of the 3.2 per cent standard suggested by the wage-price “guideposts” outlined in the 1962 Annual Report of the Council of Economic Advisers. This development, together with the accelerated rise in the cost of living during 1966, was one of the factors causing the Council, in effect, to attach rather less importance to the 3.2 per cent standard in its 1967 Annual Report. Advances in wage rates have been faster in Canada than in the United States; the index rose by 6.1 per cent during 1966, compared with 4.0 per cent the year before. In the United Kingdom wage rates were advancing rapidly during the first half of 1966, at a pace which would have resulted in a large increase during the year as a whole if it had been allowed to persist. To halt the inflationary spiral, the Government announced in July that any further increases in wages and salaries, and (with a few strictly defined exceptions) in prices were prohibited, and Parliament approved the measure in September. On the Continent wage rates on the whole increased at a slower pace during 1966 than in 1965. In France, Germany, Italy, the Netherlands, and Sweden, the increases in the wage rate indices during 1966 were less than those recorded in 1964 and 1965. This development probably reflected the slightly easier conditions prevailing on the labor markets of those countries. In Italy the pressure which the increasing rate of economic expansion during 1966 might otherwise have put on the labor market was mitigated by the reduction in the employment of Italian labor in Germany as the growth of output there slackened in the latter part of the year. In Belgium-Luxembourg and Switzerland, however, increases in wage rates accelerated. In Japan, contrary to the situation in the two cyclically expanding European economies (France and Italy), wage rates advanced at a slightly higher rate than in the previous year.
Chart 10.Selected Areas and Countries: Wage Rates, 1963-April 1967
In most of the countries for which information on wage costs per unit of output is available, the relation of wage increases to increases in productivity in 1966 reflected, in part, the patterns of cyclical developments in the economies (Chart 11). In Italy wage costs per unit of output declined markedly, and in France and Japan productivity increases during the year seem at least to have matched increases in wages. In the United States unit wage costs, after declining somewhat from 1963 to 1964, were stable in 1965 and then increased in 1966 to their 1963 level. In Canada such costs rose sharply from mid-1965 through 1966—more than in the United States. In Germany unit wage costs advanced as industrial production declined. In the United Kingdom a substantial advance of wage costs took place during the first half of 1966; thereafter such costs fell back a little.
Chart 11.Selected Countries: Wage Cost per Unit of Output in Manufacturing, 1963-First Quarter 1967 Chart 12.Selected Areas and Countries: Export Prices, 1963-April 1967
For some time export price indices have tended to rise less than indices of domestic commodity prices.2 The pattern of relative stability for these prices persisted in the United States, Sweden, and Japan. In Italy, the export price index even declined. In Germany the rate of increase moderated. In the United Kingdom, Canada, and France, however, the relative increase in export prices was higher during 1966 than in 1965.
Expansion of government expenditures in most of the industrial countries during 1965 and 1966 was an important source of the increased demands outlined above. These expenditures generally rose by more than 6 per cent in real terms in 1965 and, with few exceptions, by not much less in 1966. The largest increases in expenditures—except in the United States in 1966—were incurred on behalf of local governments and public corporations. The relative increases in government sector spending were in most cases, particularly in the United Kingdom, Germany, and the Netherlands, considerably in excess of the over-all rise in total expenditure, so that a marked shift occurred in the government sector’s share of total outlays. Under the generally buoyant demand conditions which were characteristic of most of the industrial countries in 1965 and the first half of 1966, the substantial rise in public sector expenditures added to the strain on domestic resources.
The causes of the increases in total government expenditure in 1965 and 1966 in the main industrial countries differed markedly as between countries. They reflected not only specific expansionary fiscal policies, as in Italy, Japan, and to a lesser extent France, but also important political and social objectives which had to be met at times of rising prosperity. For example, the substantial increases in government consumption in Belgium, Canada, Germany, Italy, the Netherlands, and Sweden were accounted for largely by increases in the wage bill of the government itself, and higher net social security payments, both of which reflected the general wage inflation which these countries were experiencing. In France, Italy, and Germany there were substantial increases in loans and advances to the government corporations and industry in general. The bulk of the increase in government expenditure in the United Kingdom was accounted for by lending to the local authorities and government corporations to finance higher investment. In the United States the rise in military expenditures in 1966 accounted for a very large proportion of the increased expenditures by the Federal Government. Japanese Government expenditures rose sharply not only under the impact of higher social security payments but also, in line with the general reactivation policy, of public works outlays.
Despite the general rise in public expenditures (particularly in the form of advances to private and government-owned enterprises), programs of retrenchment of expenditures by the governments were undertaken in some countries. In the United Kingdom, for example, though the budget of May 1966 was concerned mainly with increasing taxation, the economic measures of July 1966 were largely intended to depress demand including that generated by government expenditure. Steps were taken to reduce proposed government expenditures by £ 150 million in the fiscal year 1967/68 through reductions in investment expenditure by central and local governments and the public corporations. In the Netherlands, in June 1966, the authorities imposed a postponement of most public investment expenditures and a freeze on civil service employment. The Belgian Government cut back certain programs. The United States also implemented a program of “stretching out” public expenditures. In general, however, the retrenchment programs only slightly moderated the increase of expenditures.
The means by which the rising government expenditures were financed increased their inflationary impact. In almost all cases, even though rising national incomes resulted in higher tax receipts, government revenues rose less than enough to eliminate the deficits in 1966, and governments continued to absorb financial resources from the rest of the community (Table 25). In the Netherlands, Germany, and Canada direct taxes were reduced in 1965. In most cases, however, tax increases took the form of increased indirect taxes, which, in a number of cases, exacerbated the rise in domestic prices and, to a lesser extent, some domestic costs. Undoubtedly, the main financial impact of increased government demand for resources was felt in the capital markets in the form of increased official borrowing, at a time when these markets were already under strain from the private sector.
Only in the United Kingdom, where excessive demand was accompanied by a protracted balance of payments deficit, was taxation increased to the extent needed to curb domestic demand effectively. The selective employment tax (i.e., a wage tax on all employment, offset by equal rebates to some employers, such as central and local governments, and by greater rebates to manufacturing industries) was also intended to increase the relative profitability of, and thereby encourage the expansion of, export-type industries.
In the United States fiscal receipts rose rapidly with the expansion of the economy. Although the collection of corporate and personal withholding taxes was accelerated, there were few changes in tax rates or assessment regulations, except for increases in social security contributions (which were to be offset in part by increased social security payments). Previously authorized reductions in excise tax rates were canceled in March 1966, and in September 1966 the 7 per cent investment tax credit was suspended for 15 months. The changed outlook in early 1967 induced the Administration to ease the restraint by recommending the reinstatement of the investment credit from March.
In view of the continuing pressure of demand on resources in Canada, most of the reduction in taxes on individual incomes which had been sanctioned in 1965 was withdrawn in early 1966 and several measures were taken to cut down, and stretch out, the projected expansion in business capital outlays. By early 1967, however, a less restrictive policy appeared appropriate. The refundable levy on corporate profits was suspended in March; the capital cost allowances that had been reduced in 1966 were restored as of April 1; and, in accordance with a proposal in the June 1 Budget Speech, the elimination of the sales tax on production machinery removed an incentive—no longer desired—for postponement of business investment expenditures.
Indirect taxes were increased in Sweden in both the 1965/66 and 1966/67 budgets. The budget measures of 1965/66, however, also included a reduction in income taxes effective from January 1, 1966. In the 1966/67 budget indirect taxes were again raised in order to check the growth of consumption and to reduce imports. To cover the extraordinarily large increase in government expenditure in 1965 and reduce the size of the budget deficit, the Belgian Government raised indirect taxes in 1966.
In those countries with excess capacity in their economies—France, Italy, and Japan—public expenditures were increased and, in Japan, taxes were reduced.
In most industrial countries chief use was made of monetary policy to restrain demand in early 1966 and to stem the economic slowdowns later in the year. The widespread restrictiveness of monetary policy during most of 1966 is indicated by the fact that all the changes in central bank discount rates were increases (Chart 13 and Table 26). In the first half of 1967 all the changes were decreases. In 1965 there had been movements in both directions. On the whole, the other changes in monetary policy during 1966, until the autumn, tended to fit the pattern of tightening. Thus, fractional reserve requirements against liabilities of certain financial institutions were raised in five countries, and reduced in only three. Six countries either intensified or introduced quantitative restrictions on domestic credit. In Belgium, such restrictions were suspended in 1965, reintroduced in 1966, and finally abolished in June 1967. In addition, the authorities in most industrial countries paid considerable attention to the use to which domestic credit was put.
Chart 13.Discount Rates, 1963–June 1967
|Date||Increase or Decrease 1|
(Per Cent Per Annum)
|January 1 to December 31, 1966|
|South Africa||July 8||1.00||6.00|
|United Kingdom||July 14||1.00||7.00|
|January 1 to June 30, 1967|
|United Kingdom||January 26||−0.50||6.50|
|United States||April 7||−0.50||4.00|
In many countries the authorities were concerned to ensure that the increasing cost of credit resulting from steps taken by them did not affect export finance adversely. Five countries changed existing provisions or introduced new provisions to ensure that the cost and availability of finance formed no obstacle to the expansion of their export trade.
Until the end of 1965, U.S. monetary policy had been oriented toward stimulating domestic demand while also working toward balance in the international accounts. At that time, problems associated with relatively full utilization of resources began to appear more urgent, and the discount rate was raised from 4.0 per cent to 4.5 per cent in December. Thereafter, monetary policy became increasingly restrictive. Pressure was applied to bank reserves through open market operations and by twice raising reserve requirements on longer-term deposits; to control bank loans, moral suasion was exercised at the Federal Reserve Banks’ discount window. There were rapid declines in security prices in August and early September and these led some observers to believe that security markets were on the brink of a crisis, though such a crisis did not ultimately emerge.3 By November 1966 it seemed that the policy measures taken earlier had contained the domestic demand pressures and that the maintenance rather than the restriction of demand might be a problem in 1967. Consequently, monetary policy became less restrictive and then expansionary. Reserve requirements for certain savings deposits and small time deposits were reduced and, following reductions in discount rates in a number of industrial countries in the first quarter of 1967, the U.S. rate was reduced on April 7 from 4.5 to 4.0 per cent, the level which had prevailed prior to the increase in December 1965.
At the beginning of 1966 inflationary pressures were strong in Canada. In mid-March the Bank of Canada’s discount rate was raised from 4.75 per cent to 5.25 per cent. During most of the year the Bank’s open market and other operations tended to be directed toward restraining the strong demands for finance. Toward the close of 1966, however, these pressures appeared to be abating, and a less restrictive monetary policy was adopted. The Bank’s discount rate was reduced to 5 per cent late in January 1967 and to 4.5 per cent in April.
Perhaps the most dramatic combination of monetary and fiscal restraint during 1966 was seen in the United Kingdom. The bank rate, which had been lowered in June 1965 to 6 per cent, was raised again in July 1966 to 7 per cent to meet the balance of payments crisis. Also in July the amount of special deposits which the banks are required to maintain with the Bank of England was doubled. At the same time, the limit imposed on the power of the financial institutions to grant credit to the private sector, which had not been increased when it was reviewed in February 1966, was extended unchanged to March 1967. A number of fiscal and other measures to restrain demand were also taken in July. All these measures contributed to the dampening of domestic demand and to a resultant improvement in the balance of payments. As a consequence, it became possible to lower the bank rate to 6.5 per cent in January 1967, to 6.0 per cent in March, and to 5.5 per cent in May. These changes were in line with the general policy of most countries to work toward lower interest rates in the prevailing circumstances. In the April 1967 Budget Speech it was announced that the limit on credit from the London clearing banks and the Scottish banks had been removed, and that in future the activities of these banks would be influenced by official guidance on the direction of lending and by a more flexible use of special deposits. For other banks and finance houses the limit would be retained, while other arrangements were being worked out; they would also be subject to guidance on the direction of lending.
Domestic inflationary pressures were also a major source of concern to the German authorities through most of 1966. The chief burden of containing these pressures was placed on monetary policy. In May the central bank discount rate was raised from 4 per cent to 5 per cent and bank rediscount quotas were reduced by between 10 per cent and 12½ per cent. In the course of the year there was a decline in the rate of economic expansion, and stagnation rather than inflation became the main problem facing the German authorities. As a consequence, monetary policy was made easier toward the end of 1966. In December it was announced that the usual seasonal reduction in bank reserve requirements (except those relating to savings deposits) of approximately 9 per cent would not be reversed. Further reductions of 10 per cent, 5 per cent, and 8 per cent were decreed effective in March, May, and July 1967, respectively. Effective January 1, 1967, the compensation privilege on banks’ holdings of foreign deposits was removed in order to reduce the banks’ incentives to hold foreign assets rather than to make domestic loans.4 In the first five months of 1967, the Bundesbank’s discount rate was reduced by a total of 2 percentage points in four equal steps.
Several other European countries took monetary steps to restrain demand in 1966. Central bank discount rates were raised in Belgium, the Netherlands, Sweden, and Switzerland. Belgium, Denmark, Finland, the Netherlands, and Norway either introduced or maintained their quantitative controls over domestic credit. Toward the end of 1966 the outlook appeared easier in most of these countries. As a result, there were moves toward less restrictive monetary policy during the first half of 1967, as exemplified by the lowering of central bank discount rates in Austria, Belgium, the Netherlands, and Sweden.
While most of the industrial countries were faced by inflationary pressures in 1966, there were important exceptions to this generalization—France, Italy, and Japan. Here stimulation of economic activity was the main problem to which the authorities addressed themselves.
Of the three countries, France introduced the most extensive policy changes. Commercial banks were authorized to accept deposits on more than a two-year term; savings banks were permitted to make nonhousing loans to their depositors; all banks were authorized to regard certain medium-term loans as reserve assets, as the authorities sought to stimulate the supply of longer-term loans. These measures also served to reduce the marked compartmentalization of the French financial system. Further, in July 1966, all restrictions on the opening of deposit accounts denominated in foreign currencies were removed; in the same month the 25 per cent withholding tax on foreign interest payments on French securities was markedly reduced. These developments set the stage for the suppression of exchange controls and the relaxation of credit regulations that were implemented in January 1967. At the end of 1966, the authorities were still continuing their market-liberalizing and stimulative program. In December, for example, they granted a tax reduction on life insurance premium payments.
In 1966 the Italian authorities continued the general approach to monetary policy which had been adopted in mid-1964. This was based on a liberalization of domestic credit and an encouragement of capital export. For example, in January restrictions on direct investment in all OECD countries were removed, whereas previously only the EEC countries had been exempted.
Domestically the Japanese authorities faced a set of problems in 1966 similar to those in Italy. On external account, the surplus on Japan’s current account was offset in part by outflows of short-term and long-term capital resulting from the influence of structural factors in the Japanese economy and from the tight money situation in the United States. The authorities concentrated on further measures to remove the shortfall of domestic demand, which had not responded to the measures of monetary ease taken in 1965. While maintaining the policy of monetary ease and improving the techniques of monetary policy to make it more effective, for the first time in many years the Japanese authorities deliberately used fiscal policies for contracyclical purposes. In this connection, in January 1966 the Government made its first issue of long-term bonds in the domestic market since 1946, to cover a shortfall in fiscal receipts.
Money and Securities Markets
The various national capital markets were dominated by the changes in the demand for business investment and government finance and by the effects of monetary policy. Business borrowings tended to rise from 1965 through mid-1966 and then to ease later in the year. In most countries the financing of government deficits put pressures on the national capital markets. In addition there was some evidence of a weakening of personal savings. Consequently, the markets were subject to extreme pressures which were increased rather than eased by the monetary policies adopted in most countries that in a few cases brought them close to crises. These strains in national markets had repercussions in the international markets.
In late 1965 and early 1966, the rapidly rising business outlays for the expansion of plant and equipment were not matched by increases in allocations for depreciation and undistributed income in most countries. This rising excess of expenditure over available funds was covered by increasing business borrowings through the first three quarters of 1966, except in countries such as Germany and Japan where investment demand was slack. At present sector financing data are available for only a few countries, and are subject to considerable errors of estimation. For most such countries, net business borrowing was larger in 1965 than in 1964 (Table 27). In Canada and the United States this borrowing was still larger in 1966. Even in the United Kingdom where economic progress was not particularly rapid, pressures on company profits were also translated into pressures on capital markets. In Germany some relief of financial pressures was provided by the abatement of company demands after mid-1966. In Japan there was an upturn in the third quarter. In France, while investment was rising, at least through the third quarter, and companies had larger needs for capital market financing, most of these needs were covered by bank financing rather than by security issues. In most of the smaller industrial countries of Europe, particularly in Belgium-Luxembourg, the Netherlands, and Sweden, corporate liquidity deteriorated sharply, and in the Netherlands and Sweden the rise in investment in the private sector was financed mainly by an expansion of bank credit but at progressively higher interest rates. In summary, private businesses were exerting rising pressures on the financial markets through mid-1966 in those countries where output was expanding (i.e., most of the industrial countries). Toward the end of the year, however, the slackening of investment demand in most of these countries was reflected in a decline in private financial demands.
|Canada||Germany||Japan||United Kingdom||United States|
|Business 2 net financing||Business 2 net financing||Business 2 net financing||Identified net financing 3||Identified net financing 4|
The sources of the strong pressures exerted on most capital markets by the requirements for government finance were outlined above and in Chapter 3.
Particularly in the early part of 1966, there were signs of weakening in personal saving. In the United Kingdom total personal saving was 6 per cent lower in 1966 than it had been in 1965. There was a marked decline in Germany, where household saving fell from the first half of 1965 high of 12.1 per cent of disposable income to 9.9 per cent (i.e., back to the level of the second half of 1963) in the first six months of 1966. The rise of this ratio, in the second half of 1966, to its early 1965 level is probably accounted for by the large increase in savings deposits consequent on year-end interest payments on savings accounts at the high rates prevailing after July. In the United States the ratio of personal saving to disposable income in the first three quarters of 1966 was appreciably below the 1965 level. In Canada personal saving declined (in the second and third quarters of 1966) from its record first-quarter rate. For the other industrial countries, indirect evidence (such as the increases in purchases of consumer durable goods in Italy) suggest that the pattern of declining personal saving ratios was widespread.
The restraints and restrictions on the expansion of bank credit during the first three quarters of 1966 limited the finance available from this source to meet the large borrowing demands coming on the capital markets. In the United States this limitation was mitigated by the fact that the banks were able to draw in funds from abroad. One result of this conjuncture of influences was a marked increase in security issues which reached record levels during 1966 in Canada, Italy, the Netherlands, Sweden, and Switzerland and continued to be large in the United Kingdom and the United States (Table 13, p. 28).
These pressures on domestic capital markets had important international repercussions. The tensions in the domestic U.S. market were reflected in levels of private capital outflow during the first, second, and fourth quarters of 1966 well below those prevailing in earlier years (Table 40, p. 88) and a large inflow during the third quarter. This reduction in the flow of finance to other countries served to generalize the financial stringency throughout the industrial and other more developed parts of the world. It must be recognized, however, that the withdrawal of short-term funds from Europe exerted pressures on bank liquidity which were consistent with the objective being pursued by the monetary authorities in most countries.
In several instances financial markets appeared to be close to disorganization at certain points in the year. Reference has already been made to the severe stringency in the U.S. market in August and September 1966. In Germany, the yields on long-term bonds moved from the 6 per cent to the 7 per cent range in late 1965 and passed into the 8 per cent range in July 1966. This increase in bond yields involved a fall in bond prices from January 1965 to August 1966 that was typically not much less than 13 percentage points, with almost 6 points of this decline taking place in 1966. These rapid movements in bond prices put great pressure on the liquidity positions of certain financial institutions and contributed to the uncertainty which prevailed in the year. The situation was brought under control by reductions in government expenditure and by agreement of all official issuers in May to refrain from issuing securities. Even so, severe stringency persisted in the German capital market until August.
In brief, with rising private investment and government demands for finance, a less rapidly rising flow of funds for investment by the personal sector, and a decline in the flow of international capital from the United States to Europe, the financial markets in the industrial countries were subjected to severe strains during 1966.
The changing pressures of demand and their associated financing requirements, together with the policies adopted to cope with them, resulted in large changes in interest rates from late 1965 through early 1967. In some countries these rates not only advanced rapidly until mid-1966, but reached historically high levels (Charts 4 and 5, pp. 27 and 28). In the United States the yield on long-term government securities, at its peak in November, was more than 14 per cent above its level of 12 months earlier. This rise in rate implied a decline of almost 6 per cent in the market value of long-term issues. Even 3-5 year bond prices fell by over 5 per cent in these 12 months. For most of 1966 the yield on treasury bills was at a level which had been touched only briefly during the crisis of late 1929, and that on government bonds was higher than at any time since shortly after World War I.
Although interest rates in the United Kingdom were high by international standards at the beginning of 1966, the discounts on sterling in the forward markets were greater than the comparable interest differentials in the money markets. Hence, the relatively high U.K. rates were relatively low on a covered basis (Chart 14). Further, in the first half of 1966 U.K. interest rates did not participate fully in the general upward movement. Partly as a result, the pressures on sterling increased until July. The monetary and other measures taken in that month led to a sharp rise in rates. At their August 1966 peak, long-term rates were over 1.0 percentage point higher than in September 1965. This increase involved more than a 12 per cent decline in the market price of perpetual securities. Yields on shorter-dated issues (5-year issues) rose by 0.9 percentage point from their November 1965 to their August 1966 peak.
The most dramatic movements, which were reviewed in the previous section, occurred in Germany. Canadian rates tended to move in line with U.S. rates, although the range over which they moved was narrower. Interest rates in most other industrial countries showed the general pattern of increases in the first half followed by stability or declines toward the end of the year.
Short-term Interest rates in the United States moved sharply upward in December 1965 and January 1966, after the December increase in the discount rate, and continued upward in subsequent months. This upward course reached its peak at the end of August and beginning of September 1966.
The effectiveness of the high rates, particularly in the United States, may well have been enhanced by the fact that in most markets they were expected to be temporary, as is suggested by the changes in the term structure of rates on government securities after December 1964. Whereas in the earlier period the yield curve showed the more usual distribution of rising yields as the time to maturity increased, the 1965 and 1966 curves showed continuous declines in yields for successively longer maturities starting with 1 year, or a less rapidly rising curve (Chart 15). The pattern of costs to preferred private borrowers conformed to this shift, short-term bank loans in the United States having an estimated effective cost of over 7 per cent in late 1966 in contrast to the 6.1 per cent yield on new issues of highest grade private bonds. With rates expected to decline, the incentive to postpone investment was increased.
Chart 14.United Kingdom: Short-Term Interest Differentials, 1963-June 1967
While the general trend of interest rate movements was upward until late 1966, there were certain important exceptions. In the three countries where policies were directed toward an expansion of output, interest rates did not follow the general trend. In Italy rates even tended to fall; in Japan they remained stable at the relatively low levels to which they had fallen in 1965; in France they rose only moderately until the fourth quarter of 1966, when short-term rates showed a marked increase.
The yield on private bonds tended to rise during 1966 by one and a half times the increase in yields on government bonds except in Germany and the United Kingdom, where both private and government yields rose by approximately the same amount (Chart 16). Hence, the impact of tightness in the credit markets on industrial borrowing was greater than is indicated by most interest rate data. A part of the larger increase in the yields on private bonds may have arisen from the fact that the duration of the private debts was on average shorter than that of the government securities, at a time when medium-term rates had risen more than long-term rates. In the easier-money countries there was a rise of ½ percentage point in private bond yield in France, and a fall of ¼ point in Italy.
Chart 15.Term Structure of Interest Rates
In general, the yields that had to be offered to make newly issued securities acceptable to the market rose by more than the yields on outstanding issues. In the United States, where large private borrowers have ready access to the long-term market, the cost of current borrowing rose much more than the rate on outstanding issues. In contrast to a 0.9 point rise in yields on outstanding high-quality private bonds, the yield on new high-quality private issues rose by 1.2 percentage points from the end of 1965 to the peak in September 1966.
Although interest rates moved generally higher during 1966, there were some important differences in timing as between increases in different countries, and these partly accounted for the large short-term capital movements which occurred during the year. The slower increase in interest rates in the United Kingdom during the first half of the year has been mentioned earlier as contributing to the outflow of capital from that country prior to July 1966. Canadian short-term interest rates also increased somewhat less than U.S. rates after mid-year, and the shift in rate relationships contributed to the flow of short-term capital from Canada to the United States in the third quarter of 1966.
With the changes in the degree of monetary restraint and, in some instances, in the direction of policy in late 1966 and early 1967, interest rates responded quickly. By March 1967 short-term rates in the United States had fallen back to the level prevailing before the December 1965 increase in discount rate. In the United Kingdom they were back to their early July 1966 levels. Rates had fallen back to where they had been in June 1966 for Switzerland, in May for the Netherlands, in March for Belgium-Luxembourg and France, in December 1965 for Canada, and early 1965 for Germany. Long-term bond yields showed a similar pattern of change. By March 1967 U.S. and U.K. yields were back to their December 1965 levels. Yields had fallen back to their March 1966 level in the Netherlands, to their November 1965 level in Canada, and the substantial rise of German rates after November 1965 had been wiped out.
The high interest rates that had prevailed through most of 1966 induced some potential borrowers to postpone the issue of securities. The declines in rates in the early months of 1967 encouraged companies in Canada, the United Kingdom, and the United States to rebuild their liquidity by making long-term bond issues, notwithstanding the sluggishness of investment. As a consequence, particularly in the United States, there was an upsurge of private bond issues, and long-term interest rates moved back close to their 1966 levels. In some parts of the corporate bond market, U.S. rates even surpassed the 1966 peaks. French long-term rates also rose; on the other hand, in Germany, Japan, and Switzerland interest rates remained stable or continued to decline slowly.
Chart 16.Selected Countries: Industrial Bond Yields, 1962-May 1967
Euro-dollar rates, being subject to influences in all the important capital markets, as described in Chapter 3, responded markedly to the changing pressures outlined here. The London rate on three-month deposits rose from an August-September 1965 low of 4.4 per cent to over 5.0 per cent by the end of the year. By the end of June 1966 it had reached 6.0 per cent. It rose rapidly to over 7.0 per cent at the end of September and touched a peak of 7.2 per cent at the beginning of December. Thereafter it declined, partly in response to the intervention by several central banks and the Bank for International Settlements. By mid-April this rate was below 5.0 per cent, but subsequently it rose slightly.
Restraints on International Capital Movements
At the beginning of 1966 international capital movements were free from various forms of official restraint in only a very few industrial countries. On balance, official controls over international capital transactions were increased during the year. The United Kingdom and the United States both responded to their continued balance of payments difficulties by further restraining capital transfers to other developed countries. The most notable move toward greater freedom for capital transactions was the French announcement that in early 1967 most of the controls on inward and outward movements of capital would be lifted.
The U.S. program of voluntary restraint on total foreign loans and investment continued in effect throughout the year, and was renewed in December. The 1967 program provides the same ceiling for total credits to developed countries by commercial banks for the year as a whole as had been set for 1966. As the tight U.S. monetary policy had induced the banks to curtail foreign lending through most of 1966, there was a leeway of $1.2 billion available to them on October 1, 1966. The easing of monetary policy late in 1966 coincided with a seasonal increase of approximately $300 million in their foreign credits. In order to guard against a sudden outflow, the banks were asked to limit the increases in their foreign lending in 1967 to not more than 40 per cent of the October 1, 1966 leeway by March 31, 60 per cent by June 30, and 80 per cent by September 30. Nonfinancial corporations also were requested, in effect, to limit direct investment expenditures from their own resources (i.e., transfers of capital and reinvestment of earnings, but not use of funds borrowed abroad) to approximately $400 million more than their 1966 total. This would bring these expenditures back to approximately their 1964 level, but, with the growth in this investment and the consequent increase in normally retained earnings since 1964, it implies a limitation of capital transfers to something like their 1966 total. Early in 1967 the Administration requested extension of the interest equalization tax for a further two years, amended to give the President discretion to vary the rates charged under it to provide levies equivalent to interest rates from nil to 1.5 per cent a year on financial claims, the acquisition of which is subject to the tax. This increase in the possible effective rates of the tax increased the scope for lowering U.S. long-term interest rates relative to rates in other important capital markets without repercussions on capital flows from the United States.
In May 1966 the United Kingdom announced a voluntary program with the aim of confining direct investment transfers to the more developed countries of the sterling area—Australia, New Zealand, South Africa, and the Republic of Ireland—to those which promised an early, substantial, and continuing benefit to the U.K. balance of payments. Direct investments outside the sterling area involving less than £25,000 and those over that sum which held a similar promise could continue to be financed through the investment currency market; all other investments could be made only if they were financed by appropriate borrowing outside the sterling area. In addition, institutional investors were asked to exercise voluntary restraint on investment in portfolios of securities denominated in the currencies of non-sterling area countries and in the currencies of the four countries mentioned above. Borrowing in the United Kingdom by residents of these four countries that required consent under the Control of Borrowing Order had to meet the criterion of an early, substantial, and continuing benefit to the U.K. balance of payments. Restrictions continued to be imposed on borrowing for fixed investment purposes by U.K. nonresident-controlled companies. As part of the July stabilization program, other exchange control restrictions on capital transfers were tightened.
Canada continued its voluntary program aimed at discouraging any change in policy by companies controlled from outside the country that would involve a reduction in their rate of reinvestment of earnings on Canadian operations.
In November the French Government announced that it would make fundamental changes in the system of exchange control over capital transactions. In principle the system would become one of free convertibility. However, French direct investment abroad and foreign direct investment in France still have to be declared to the authorities, who have the right to request their postponement. Borrowing abroad by French firms other than banks has to be authorized. Foreign issues on the French capital market are subject to the same regulations as French issues, namely, a date for the issue must be set with the agreement of the Treasury. These changes were implemented early in 1967.
For convenience of analysis this Report employs the classification, industrial countries and primary producing countries. Industrial countries in this grouping are Austria, Belgium, Canada, Denmark, France, Germany, Italy, Japan, Luxembourg, the Netherlands, Norway, Sweden, Switzerland, the United Kingdom, and the United States; primary producing countries are all of the remainder with the exception of Soviet countries and Mainland China, generally not covered in the Report because of the absence of data. The category of primary producing countries is subdivided into more developed countries (Australia, Finland, Greece, Iceland, Ireland, New Zealand, Portugal, South Africa, Spain, Turkey, and Yugoslavia) and less developed countries (all others).
It is recognized that no simple classification, such as that adopted in this Report, can reflect the full nature of each economy. For example, industrial countries, such as Canada and the United States, are also important producers and exporters of primary products; some countries classified as primary producers, such as Australia, have significant industrial capacity; and, in a few instances, some less developed primary producing countries may have relatively high per capita incomes.
For some purposes in this Report, it has also been useful to distinguish between developed countries and less developed countries. When this is done, the term developed countries covers both industrial countries and more developed primary producing countries.
There are several reasons for this divergence. The competition on international markets tends to be more severe than on domestic markets. Also, the increasing government incentives for exports have been reducing the risks in exporting and thereby driving down the profit margins that are acceptable to exporters. The relative ease of obtaining export credit, compared with other types, has worked to the same end. At the same time, exports from the industrial countries tend to be concentrated on those commodities which can be produced most economically and in which recent productivity gains have been greatest. Moreover, exports have also tended, in recent years, to be concentrated on the output of those industries which have been expanding most rapidly and, hence, where investment (including cost-reducing investment) has also been greatest.
The Federal Reserve System was in close touch with the situation. On July 1, 1966 the Board of Governors agreed to make credit available to mutual savings banks and other depository-type institutions, in order to permit such institutions to meet unusual withdrawals of funds. This authority was continued until March 1, 1967. On August 23, 1966 the Open Market Committee changed its directive regarding the management of the open market account to emphasize the importance of maintaining orderly money market conditions and to provide for the moderation of unusual liquidity pressures. This clause, or a similar one, was maintained in the directive until November 1. (See Board of Governors of the Federal Reserve System, Annual Report, 1966.)
See Chapter 7, page 90.