IV Domestic Financial and Economic Policy
Author: International Monetary Fund
Language:
English
Keywords:
AR; AREA; dollar; OEEC country; price; country; rising prices; bank rate; velocity of circulation; price rise; call money rate; Yield curve; Monetary expansion; Bank credit; Sovereign bonds; North America; Australia and New Zealand; Europe
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Abstract

The characteristic features of a business boom which had already gone on for fully two years were evident during 1956 both in the more highly industrialized and in many of the less developed countries. There was still a large, and in some countries even an expanding, volume of private business investment. The rate of expansion, indeed, was generally somewhat reduced, and this was not surprising, for in most countries the available labor and other resources were already almost fully employed. Total output continued to increase, but also at a somewhat reduced rate. In many countries, the pursuit of ambitious development plans added substantially to the total volume of investment.

The characteristic features of a business boom which had already gone on for fully two years were evident during 1956 both in the more highly industrialized and in many of the less developed countries. There was still a large, and in some countries even an expanding, volume of private business investment. The rate of expansion, indeed, was generally somewhat reduced, and this was not surprising, for in most countries the available labor and other resources were already almost fully employed. Total output continued to increase, but also at a somewhat reduced rate. In many countries, the pursuit of ambitious development plans added substantially to the total volume of investment.

There was, as a rule, a growing demand for long-term funds to finance this expanding volume of investment. Since the demand often exceeded the flow of current savings, it led to an increase in interest rates in the long-term market. At the same time there was a growing demand for short-term capital to finance an expanding volume of trade; and the movement in long-term rates placed additional pressure on short-term interest rates, since in many countries both public authorities and private enterprises turned increasingly to the banks and other sources of liquid funds for short-term accommodation. In a number of countries, the expansion of credit increased the demand for goods and services with consequent rising prices.

The bargaining position of wage earners became stronger as the demand for labor was stimulated by general boom conditions and expanding credit, and there was a tendency for money wages to increase more rapidly than productivity. Both as a cost element and as a source of increased demand, higher money wages became in turn an additional factor in the upward movement of prices.

The authorities in most countries realized the dangers of further inflationary developments, and often found public opinion increasingly critical of rising prices and ready to accept appropriate anti-inflationary measures. The story of the year is to a large extent a record of the endeavors of governments and central banks, and to some extent of responsible leaders in trade unions and other economic organizations, to devise and apply suitable means for dealing with the recurrent problem of inflationary pressure. The financial authorities have resorted both to traditional methods of fiscal and credit policy and to techniques developed in recent years that involve various types of intervention in particular sectors of the economy. It has been widely recognized that, in times of intense private business investment, speculative and other excesses in the private sector of the economy ought to be resisted and cautious policies pursued in the public sector.

During the course of the current boom, the flow of voluntary savings has generally been well maintained, and there has also been an expansion of bank credit. The demand for both long-term and short-term capital has been so intense, however, that interest rates generally have tended to rise. Now that hardly any central bank seeks to peg government bond prices, the effects of variations in the interplay of supply and demand are more clearly seen in the long-term capital market. It is now generally understood that the expansion of central bank credit for the purpose of holding down long-term interest rates is likely to lead to rising prices and a balance of payments deficit. Moreover, before long, rising prices, which lower the purchasing power of the monetary unit, will reduce the real value of the amounts available for investment, and if such a movement is not checked in time, the volume of real investment may clearly be diminished. If the balance of payments deficit that is likely to appear in these circumstances is financed by drawing on reserves, there is no real net increase in investment, but one form of investment is substituted for another, an increase in domestic investment being offset by disinvestment in exchange reserves. If all these developments are allowed to persist, there will be anxiety among the general public, wage earners will press for increased remuneration, the discouragement to thrift will make people hesitate more about making savings in the form of money or of assets with a fixed value in terms of money, the allocation of the available capital resources will be distorted, and the flow of resources into the money and capital market will shrink, with drastic effects upon the volume of investment.

A rising long-term interest rate, as determined by market forces, is a most significant indicator of increasing demand for funds to finance an expanding volume of investment. There is also normally some connection between the short-term and the long-term markets, but the short-term market is of course affected more particularly by the increasing demand for working capital which arises in the course of a business boom. The stiffer credit policies recently applied by the monetary authorities in most countries, including increases in interest rates, and other forms of restraint placed upon the expansion of credit, should be regarded as essentially the result of real pressures upon the supplies of loanable funds. In their decisions with regard to official discount rates, central banks have to take account of these pressures. A willingness to use more promptly the powers of the monetary authorities to check inflationary trends by stiffening credit conditions might indeed have been helpful in not a few countries during the current boom.

In the more industrialized countries the increase in bank credit in 1956 was generally much greater than the expansion of industrial production (Table 21). Nevertheless, there was considerable tightness in many money markets, and interest rates rose during the year.

Table 21.

Changes in Bank Credit to the Private Sector and in Industrial Production, Selected Countries, 1955 and 1956

(Value figures in millions of U. S. dollars)

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Source: Based on data from International Monetary Fund, International Financial Statistics.

Changes in “other” banks’ (in the United States, all commercial banks; in the United Kingdom, London clearing banks) claims on business and individuals.

Belgium only.

Claims on the private sector of the National Bank plus domestic assets of the deposit money banks.

Manufacturing production.

Changes in commercial banks’ claims on the private sector (domestic). Based on data from De Nederlandsche Bank N.V., Report for the Year 1956.

Changes in other banks’ (i.e., other than the Bank of Japan) claims on the nongovernment sector.

The tendency for wage rates to rise more rapidly than productivity was becoming a cause of concern in several countries in 1956. Owing to boom conditions and growing labor shortages, the bargaining position of labor was strong, and in nearly all of the more industrialized countries money wages rose more than the cost of living.

This was a continuation of the trend evident in the period 1950–55, when real wages had increased in most of these countries. However, in these years wages had in many countries risen at a slower rate than productivity. In 1956 indeed productivity hardly increased in Austria, Finland, and the United States. In the United Kingdom it declined, and in most of the other countries the rate of increase was slower than in 1955.

Partly as a result of these developments and partly because of the uncertainty whether the boom would last throughout 1957, businessmen began more strongly to resist further wage increases, and there were several labor disputes in early 1957. In the United Kingdom, for example, there was pressure for higher wages in nearly all major industries toward the end of 1956. By early 1957, major disputes affecting more than 6 million workers were under negotiation in most of the basic industries, such as building, electricity, engineering, transport, and shipbuilding.

Many governments were concerned about the danger of a wage-cost spiral, especially where wages and prices are closely linked as they are, for example, in Denmark, Finland, and France and in some major industries in the United States. Temporary wage and price freezes were introduced in Belgium, France, Finland, and Iceland during the second half of the year, but were not in all cases rigidly enforced. One purpose of these controls was to give time to governments to enable them to find a way of effectively combating inflation. In Italy and Sweden in the first quarter of 1957, workers and employers reached new agreements for adjusting wages to prices, the agreement in Sweden being for a two-year period.

Under the influence of the boom, prices rose in virtually all of the more industrialized countries during 1956. In a number of countries the price increases, though moderate in size, threatened to disturb the financial stability of the economy, especially when they marked the continuation or the acceleration of an upward trend.

Supply of Credit

Despite the policy of credit restraint which was widely adopted, the supply of bank credit to business increased in 1956 in most countries in response to increasing demands for funds. In Austria, France, and Italy, credit expansion was facilitated by increased central bank lending to the commercial banks. In Canada, the Netherlands, and the United States, the commercial banks reduced their holdings of government securities to finance credit expansion to the private sector.

The rate of expansion of commercial bank credit to the private sector in the United States in 1956 was no more than half of what it had been in 1955, but it substantially exceeded the rate of growth in industrial production and gross national product. Since there was little net change in Federal Reserve Bank holdings of U.S. Government securities, the reduction in commercial bank holdings of government paper did not increase the reserves of the banking system as a whole, and the increase in money supply was held to slightly less than 1 per cent, compared with 3 per cent in both 1954 and 1955.

The effect of credit restraint on expenditures was partly offset in both 1955 and 1956 in most of the more industrialized countries by increased velocity of circulation of money (Table 22 ). Business firms and individuals responded to the shortage of credit and rising interest rates by economizing in the use of their cash holdings, and there were also some shifts of deposits to time and saving accounts. In most of the 15 countries listed in Table 22, there was a noticeable increase in velocity in 1955 compared with 1954, and in 1956 there seems to have been a tendency for velocity to rise farther. So long as confidence in the currency is maintained, there is of course a limit beyond which velocity of circulation will not increase.

Table 22.

Indices of Turnover of Deposits and of Income Velocity of Money, 1 Selected Countries, 1955 and 1956

(1954=100)

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Sources: Based on data from International Monetary Fund, International Financial Statistics: United Nations, Monthly Bulletin of Statistics; Monatsbcrichte des Österreichischen Instituts für Wirtschaftsforschung (Vienna); Dominion Bureau of Statistics, Canadian Statistical Review (Ottawa); Bank deutscher Länder, Monthly Report (Frankfurt am Main), January 1957; Ministero del Tesoro, Relazione Generale sulla Situazione Economica del Paese, 1955 and 1956 (Rome, 1956 and 1957); The Mitsui Bank, Ltd., Monthly Review (Tokyo), March 1957; Economic Survey, 1957 (London, Her Majesty’s Stationery Office, 1957).

Turnover of deposits is the ratio of the monthly average of bank debits or bank clearings to deposit money (average of end-of-month data). Income velocity is the ratio of gross national product to money supply (average of end-of-month data).

Year ended June 30.

Average of end-of-quarter data used for money supply.

Year beginning April 1.

Averages of end-of-quarter data used for deposit money and money supply.

National income used in place of gross national product. See also footnotes 2 and 5.

Before World War II, consumer credit was generally not an important element determining the level of consumer demand, except in the United States. Although still a comparatively small part of total credit, it has been expanding rapidly in many countries since the end of the war. In Canada, outstanding installment credit to consumers has nearly quadrupled in the last five years and in 1956 was equal to about one quarter of the personal and nonfinancial business loans made by commercial banks. In the United Kingdom, France, the Netherlands, Australia, and some other countries, consumer credit has also been growing in the postwar period.

The expansion of the operations of consumer finance companies, which are not subject to the same kind of control that is exercised by central banks over commercial banks, has led to some difficulties in the implementation of monetary policy. These finance companies are in most countries not subject to legal reserve requirements, and they may be less responsive than the commercial banks to moral suasion by the central bank. They cannot indeed create credit in the same manner as the banking system, but the expansion of their operations may have the effect of increasing aggregate demand. In several countries, including the United Kingdom and the United States, there has been public discussion of the desirability of bringing these companies and other nonbank financial intermediaries under control.

In 1956, many countries, including Austria, France, the Netherlands, and the United Kingdom, introduced new regulations, or tightened existing ones, on installment credit for the purchase of consumer goods. The regulations generally related to downpayments and maturities; but in France the lending capacity of each consumer credit institution was restricted by reducing the permissible limit of its loans from ten times to eight times its own resources.

Interest Rates

Market rates of interest rose everywhere during 1956 (Table 23), as a result of market forces and the firm money policy that was being followed in many countries. The central banks of eight 1 of the more industrialized countries raised their discount rates at least once during 1956. Of these countries, Germany alone lowered its discount rate during that year, though not to the level from which it had been raised earlier in 1956. In the first quarter of 1957, the discount rate was lowered again in Germany from 5 per cent to 4.5 per cent, and the rate in the United Kingdom was also reduced. The Bank of France increased its discount rate from 3 per cent to 4 per cent in April 1957, the first increase in that rate since 1951.

Table 23.

Market Interest Rates, Selected Countries, 1955 and 1956

(In per cent per annum)

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Sources: International Monetary Fund, International Financial Statistics; Central Statistical Office, Monthly Digest of Statistics (London); Institut National de la Statistique et des Etudes Economiques, Bulletin Mensuel de Statistique (Paris); Skandinaviska Banken, Quarterly Review (Stockholm); and Konjunkturinstitutet, Konjunkturjournalen (Stockholm).

The discount rate in the United Kingdom was lowered from 5½ per cent to 5 per cent in February 1957. Official statements emphasized that this step was not intended as a signal for the relaxation of credit or for the easing of restrictions on lending. The treasury bill rate had been declining since December 1956, and the reduction in the discount rate was regarded as a technical move designed to keep the bank rate in close touch with the market. It was also expected to continue to provide favorable conditions for funding part of the public debt, with the objective of diminishing the liquidity of commercial banks. The fall in short-term interest rates will, moreover, reduce interest payments on the sterling holdings of overseas countries and will also lower the cost of servicing government securities held domestically.

A new practice of fixing the bank rate every week at a fixed margin of ¼ per cent above the latest weekly average tender rate for 91-day treasury bills was adopted in Canada, effective November 1, 1956. According to the Canadian authorities, this was a step to make the bank rate more flexible and responsive to changing conditions in the short-term money market. The Bank of Canada has indicated that it will feel free to change ¼ the per cent margin between the treasury bill rate and the bank rate or to depart from the system of automatic adjustment of the bank rate if changing circumstances seem to justify such a move.

In the United States, growing investment demand in relation to the supply of loanable funds raised market rates of interest further in 1956. Average rates charged by banks on large business loans rose from 3.75 per cent to 4.20 per cent. The rise was in conformity with the policy of credit restraint adopted by the monetary authorities. The Federal Reserve Banks increased their discount rates by ¼ per cent in April and again by ¼ per cent in August, when all such rates reached 3 per cent.

Other Restraints on Credit

In addition to raising discount rates and placing restrictions on installment purchases, the authorities in many countries took further steps to limit credit expansion. In some countries the reserve requirements for commercial banks and other credit institutions were increased. Thus in Austria, the liquidity requirements and credit ceilings previously enforced on only part of the banking system were extended toward the end of 1955 to additional groups of credit institutions; and in November 1956, credit restrictions were further reinforced by a substantial downward adjustment of the previously established credit ceilings and by other restrictive measures. In Norway, the earlier gentlemen’s agreement on credit expansion was extended in 1956. Changes in reserve requirements in France had some effect in tightening restrictions on commercial bank credit to the private sector, but might also make possible an increase in the amount of funds made available to the Treasury.

In Finland, on the other hand, the cash reserve requirement agreement between the Bank of Finland and the private banks was not renewed when it expired in June 1956, and advance deposit requirements for obtaining import licenses were lowered from 20 per cent to 10 per cent. In view of the continuing inflationary pressures, however, the Bank of Finland expressed the hope that private banks would reduce the amount of rediscounts outstanding.

Other monetary measures included moral suasion and selective credit controls. Many central banks, especially those in the Scandinavian countries, have relied heavily on a general understanding with commercial banks to check any undue credit expansion. In the United Kingdom, moral pressure was used by the Chancellor of the Exchequer when he appealed to the banking community to prevent excessive credit expansion. In July 1956, in a communication to the chairmen of the London clearing banks and other banks, he asked that “contraction of credit should be resolutely pursued.”

Fiscal Policy and Budgetary Developments

The government sector today is a substantial fraction of the economy of practically all countries. In Sweden and the United Kingdom, central and local government expenditures on goods and services equaled approximately one quarter of the gross national product in 1955; and in nearly all the other more industrialized countries, the ratio was between 15 and 20 per cent. Partly because of this fact and partly because in many countries a budget deficit has been one of the expansionary factors, increased attention has been given in recent years to the desirability of supplementing an active monetary policy with measures to reduce the budget deficit or to achieve a surplus.

In the United States, the federal cash budget showed a surplus of $5.5 billion in the calendar year 1956, in contrast to a deficit of $740 million in the calendar year 1955. In 1956 there were smaller budget deficits than in 1955 in Austria, Belgium, Finland, Italy, and Sweden, and in Norway there was a larger surplus. In France, however, the budgetary situation deteriorated in 1956. Many countries, including Canada, Denmark, Italy, Norway, Switzerland, and the United Kingdom, plan in their 1957 budget estimates to reduce the deficit or increase the surplus to help contain inflationary pressures.

Governments have faced many difficulties in attempting to reduce budget deficits. One problem has been presented by the need for an increase in the salaries of civil servants in view of increases in the cost of living and in wages and salaries in the private sector. Another difficulty is presented by the need to maintain large military expenditures in many countries, especially the United States, the United Kingdom, and France. In the United Kingdom, however, steps were being taken to reduce such expenditures in 1957. Another charge which in some countries complicates the problems of cutting the budget is the increased cost of servicing the public debt because of higher interest rates.

In addition to attempting to achieve a smaller budget deficit or a budget surplus, many governments have adopted selective fiscal measures designed to reduce consumption or private investment. Subsidies have been curtailed not only to reduce government expenditures but also to lessen distortions in the consumption pattern attributable to the artificial cheapening of subsidized goods. For example, the Government of Finland substantially reduced subsidies in October 1956. In the Netherlands, in the spring of 1957 the Government decided, as part of a general stabilization program, to reduce the subsidies on milk, to abolish those on sugar, and to increase the rates charged for certain public services; in addition, rents were to be raised by 25 per cent in mid-1957.

In order to restrict private investment, many countries increased taxes on profits or lowered tax deductions for depreciation and investment allowances. In Belgium, for example, a bill was passed in March 1957 imposing a special tax of 5.5 per cent on profits made in 1956 and 1957 beyond a certain level. The proceeds of the tax are to be sterilized in a special central bank account until their final disposition is decided by the Government. In the Netherlands, the Government proposed an increase in the rate of tax on corporate profits and the abolition of tax deductions for investment outlays.

North America

In the United States, resources were already almost fully utilized at the beginning of 1956, and real national output increased by only 2½ per cent from 1955 to 1956, compared with 7 per cent from 1954 to 1955, when the economy had been recovering from a previous mild recession. Despite a large addition to the working population, unemployment remained close to the low level of 1955. The increase in output per man-hour was less rapid than in 1955, but wage rates continued to rise. The general level of prices turned upward after a four-year period of virtual stability. Between December 1955 and December 1956, consumer prices rose by 3 per cent and wholesale prices by 4½ per cent. The decline in wholesale prices of farm products, which had been going on since 1951, was reversed.

Two important U.S. industries in which activity declined during 1956 and early 1957 were automobiles and residential construction. The 1956 output of 7 million passenger cars and trucks was almost 2½ million less than in 1955. Housing starts fell from 1.3 million in 1955 to 1.1 million in 1956.

Gross business savings rose substantially less than business investment and, despite an increase in individual savings and a government surplus, competition for funds through the money and capital markets was intensified. Both short-term and long-term interest rates, which had risen sharply in 1955, continued to increase in 1956. The monetary authorities placed some restraints on credit expansion by increasing the discount rate and by other means. The banks, however, expanded loans by reducing their holdings of U.S. Government securities. Business corporations drew heavily on their cash reserves to finance their investment programs. Furthermore, there was some tendency to shift to share issues in raising new funds, as the spread between the costs of equity and of debt financing (as reflected in yields of shares and bonds) continued to narrow. The shortage of funds affected the terms and availability of mortgage loans, which, together with rising construction costs, were an important factor in the smaller volume of residential construction in 1956.

In Canada, private business investment expanded rapidly during 1956. The monetary authorities had adopted a policy of credit restraint in the summer of 1955. Interest rates rose in the second half of that year, and continued to increase in 1956. Higher interest rates and ample investment opportunities attracted additional foreign capital. Capital inflow reached record levels in 1956; the net inflow of portfolio capital was more than twice the previous record amount, in contrast to a net outflow in 1955. Inasmuch as the private capital inflow was roughly equal to the balance of payments deficit on current account, it had little direct effect on the domestic monetary situation.

The Government realized a considerable budgetary surplus, and through large sales of government securities by the commercial banks, bank claims on the government sector were substantially reduced. Bank loans to the private sector were considerably expanded, but largely from the proceeds of these sales, as the money supply was almost unchanged.

Despite the fact that the money supply did not increase significantly, there were signs of inflationary pressures. Unemployment fell, and wage rates in manufacturing industry increased by 5½ per cent. This increase in wage rates exceeded the growth in productivity and caused some upward pressure on prices. After four years of stability, both the wholesale price index and the cost of living index rose, and in the last quarter of 1956 they were about 3 per cent higher than in the last quarter of 1955.

Sterling Area

Although there was some critical pressure upon the balance of payments toward the end of 1956, the basic economic position of the United Kingdom for the year as a whole improved in response to the disinflationary policies pursued by the authorities. Progress toward financial stability was assisted by the monetary measures of 1955 and early 1956. The increase during the latter year in commercial bank credit to the private sector was small, and installment purchase debt fell by 20 per cent. As a result, consumer expenditure as a whole hardly increased despite larger personal incomes. Total industrial outlay on fixed capital increased by 11 per cent, compared with as much as 18 per cent in 1955. Wages, however, increased more than the cost of living, and labor costs per unit of output appear to have risen more than in 1955.

Partly because of the effectiveness of domestic credit restrictions, but also in some cases because of increased trade and credit restrictions in overseas markets, certain British industries curtailed their production in 1956; in particular, production of automobiles had to be substantially reduced. The easing of total demand was also reflected in the labor market. Unemployment increased toward the end of 1956, reaching 1.9 per cent of the working force by January 1957, and the number of unfilled vacancies at the end of the year was, for the first time since March 1954, slightly smaller than the number of unemployed; the slackened demand for labor was also evident in shorter hours of work. These symptoms were interpreted as indicating that inflationary pressures had been brought under better control rather than as evidence of incipient recession; the authorities continued to emphasize that policies of restraint had to be maintained so as to secure further improvement in the balance of payments.

The budget for the fiscal year ended March 31, 1957 showed an over-all deficit of £331 million, which was substantially above the over-all deficit of £141 million in 1955–56. (The budget for 1956–57 included a large amount of loans to nationalized industries, which previously borrowed directly in the market. There was, however, an almost equivalent offsetting decrease in loans to local authorities, which previously borrowed from the Public Works Loan Board but now obtain in the market most of the funds that they require.)

The 1957–58 budget provides for reduced expenditures, especially for defense purposes, and reductions were made in both direct and indirect taxes, amounting to about £100 million in 1957–58, or to £130 million in a full year. Despite these tax reliefs, revenue was expected to increase as a result of higher incomes. The over-all deficit for 1957–58 was estimated at £125 million.

In Australia and New Zealand, market rates of interest rose during 1956 in response to measures taken by the authorities in late 1955 and early 1956. In the Union of South Africa, interest rates remained stable after February 1956, when the South African Government, instead of following the movement of the bank rate in London, placed restrictions on certain movements of resident capital to other sterling area countries. These restrictions were removed early in 1957, when short-term interest rates in London had fallen. In Australia and New Zealand, commercial bank credit to the private sector declined in 1956, while in the Union of South Africa it remained more or less unchanged. In each of these countries cautious fiscal and monetary policies were followed; the central banks relied to a large extent on cooperation with the commercial banks, while in New Zealand obligatory reserve ratios were also varied during the year, being on the whole stricter than in 1955.

Continental Europe

Boom conditions continued and inflationary tendencies reappeared during 1956 in most countries of continental Europe. These tendencies were most noticeable in Finland and France, where there were both a rise in prices and a fall in foreign reserves. In several other countries, strong demands for long-term and short-term funds were allowed to result in excessive credit expansion, generally accompanied by increases in wages, which also helped to push prices up.

The reappearance of inflationary pressures in France in 1956, after three years of comparative stability, reflected increased demand by both the government sector and the private sector. Government expenditures rose, largely as a result of military outlays, and, notwithstanding some increases in taxes, the budget deficit increased. Private investment, already high in 1955, increased still further, and private consumption rose as substantial wage increases occurred. Domestic credit of the banking system expanded by 15 per cent, and despite a decline in foreign assets the money supply rose by 11 per cent. The upward movement of the cost of living was kept in check by a substantial import surplus and a rise in industrial production, as well as by measures specifically intended to hold down the index. The special measures affecting the index included a freeze of prices of manufactured goods, reductions of indirect taxes on a number of commodities, and larger subsidies. The budget for 1957, voted by Parliament in December 1956, showed a reduction in expenditure from 1956 but did not include any estimate for certain items of military expenditure. With allowance for this expenditure, it seemed likely that the treasury deficit in 1957 would be at least as large as in 1956. The discount rate of the Bank of France, which had been unchanged at 3 per cent since December 1954, was raised to 4 per cent in April 1957, and the interest rate for borrowing by the banks above the ceiling fixed for each bank was raised from 5 per cent to 6 per cent.

In the Federal Republic of Germany, the rate of growth of domestic output tended to slacken in 1956, mainly because of a slowing down of investment activity which was only partly compensated by higher export demand. There was a substantial rise in domestic demand for consumer goods because of increased purchasing power from rising wages and high employment and, toward the end of the year, also because of tax reductions and increased public spending.

The discount rate was lowered to 5 per cent in September 1956 and again to 4½ per cent in January 1957. The main reasons for these decreases were the slowing down of the investment boom, the seasonal decline of economic activity during the winter months, the moderate lending policy of the banks, and the desire to reduce the differentials between interest rates in Germany and in other countries. At the same time, however, the Bank deutscher Länder engaged in extensive open market operations to counteract the excessive liquidity of commercial banks resulting from the balance of payments surpluses. Restrictions on capital exports were relaxed, and the inflow of short-term capital from abroad was discouraged. In April 1957, further measures of monetary policy were taken to counteract in part the effects of the increased liquidity of the banking system.

Economic and financial conditions in Finland deteriorated considerably during 1956. There was an increased budget deficit as subsidies rose and higher salaries were paid to civil servants. Wages rose by 10 per cent and farm income by about 30 per cent, while the gross national product in real terms increased by only about 2 per cent. The cost of living index increased by 17 per cent. In March 1957 a two-year stabilization program was proposed. The fiscal measures which were implemented immediately included reductions of subsidies and increases in taxes. The realization of the rest of the program is dependent upon the passage of certain legislation. Recommendations for the renewal of wage agreements were rejected by the wage earners’ organizations, and for the time being no new wage agreements have been concluded. In the meantime, an emergency program is being prepared to alleviate the Treasury’s cash difficulties. The Bank of Finland has announced that it will introduce rediscount ceilings for each individual bank beginning August 1.

Japan

In Japan there was a major investment boom in 1956 which was stimulated by a rise in both foreign and domestic demand. Manufacturing production increased by 18 per cent, compared with an increase of 9 per cent in 1955. National income in 1956 is estimated to have increased by more than 10 per cent in real terms. The rapid increase in output was made possible because of unemployed labor and the existence of surplus capacity in many industries. Despite heavy demand for credit, the money market eased and interest rates continued to fall in the first half of the year. Although imports increased, foreign exchange reserves continued to rise until the end of the year. From the fourth quarter of 1955 to the fourth quarter of 1956, the cost of living index increased by only 2 per cent; the wholesale price index rose by 7 per cent, largely because of increases in prices of capital goods.

Strains on domestic resources showed themselves in early 1957 in the form of a decline in foreign exchange reserves and a further rise in consumer prices. Market interest rates had begun to increase toward the end of 1956, and in early 1957 the monetary authorities acted to ease the tightness of the money market by purchasing debentures from the commercial banks, apparently on the ground that the investment boom was not dangerous in view of the increases in production. The Bank of Japan raised its basic interest rate from 7.30 per cent to 7.67 per cent on March 20, 1957, but at the same time it reduced the scope of application of the penalty rates on its lending and relaxed the eligibility criteria for the rediscount of trade bills. With the declared objective of pruning excess investment demand, the bank rate was again raised from 7.67 per cent to 8.40 per cent on May 8, 1957.

The Less Industrialized Countries

As in earlier years, inflationary problems in 1956 were most acute in some of the less industrialized countries. Of 31 such countries for which information is available, 8 showed an increase of more than 10 per cent in the cost of living, and in 7 the money supply increased by more than 20 per cent (Table 24). These results are somewhat better than those of 1955, but the improvement was by no means uniform. In several countries, inflationary pressures became more intense in 1956.

Table 24.

Percentage Increase or Decrease (–) in Money Supply and Cost of Living, Selected Countries, 1955 and 1956

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Sources: Based on data from International Monetary Fund, International Financial Statistics, and United Nations, Monthly Bulletin of Statistics.

Changes are from end of one year to end of next year.

Change from November 1955 to November 1956.

Change from May 1955 to May 1956.

Change from September 1955 to September 1956.

Change from October 1955 to October 1956.

The stronger tendency to inflation in the less industrialized countries arises in large part from efforts to increase real income through development. Unfortunately, the low level of income of most of these countries means that the resources available for developmental investment are small. Consequently, governments are led to strain to the limit all sources of financing, and in particular the finance available from the banking system. Although the banking system can provide some finance, the amount that can be obtained through this channel without giving rise to inflationary pressures is strictly limited. After safeguarding the maintenance of essential foreign exchange reserves and providing for working capital for business, the banking systems of most of the less developed countries can offer little or no noninflationary finance for long-term investment.

The objective of combining development and internal financial stability has not been achieved in all the countries where development is an important element in economic policy. The belief is sometimes expressed that rapid development and financial stability are alternative objectives, with the implication that greater development can be obtained by sacrificing price stability. This has not been supported by experience. Inflation discourages savings in the form of money, distorts the production pattern, and usually leads to a capital flight. Its inequities often provoke increasing political unrest and lead governments to adopt many forms of wasteful consumer subsidies in an effort to quiet popular discontent. Disillusionment with inflationary financing has led most countries with a history of inflation to attempt to stabilize.

Some aspects of the general problem of combining economic development with financial stability can be illustrated by the widely varying experiences of a few countries in 1956.

India had conspicuous success in combining development with stability during the period of its First Five Year Plan, from the fiscal year 1951–52 to fiscal 1955–56. National income in real terms is estimated to have risen by 18 per cent, and prices were relatively stable or somewhat declining. There was also a net addition to foreign exchange reserves during the last four years of this period. Against this favorable background, a more ambitious Second Five Year Plan was prepared for the years from 1956–57 to 1960–61; in this Plan, development expenditures, especially for industry and transport, were increased substantially. This increase has led to heavier reliance on bank financing; in fact, credits of the banking system to the government and private sectors expanded by more than one fifth in 1956. The impact was accentuated by a slight fall in agricultural production as a result of unfavorable weather and by a decline in export prices. Foreign exchange reserves were reduced perceptibly, while consumer prices rose by 12 per cent. To cope with the problems which thus arose, the Indian authorities have taken a number of measures. They have attempted to obtain more finance from abroad. They have improved internal financing by substantial increases in taxes and by some rephasing of the expenditure program. Finally, the central bank’s control over the banking system has been strengthened by giving the bank the power to vary reserve requirements and, in February 1957, by increasing the effective interest rate at which it makes advances to the commercial banks. The evident intention of the Indian authorities to maintain financial stability has apparently discouraged speculation, and prices were relatively stable in late 1956 and early 1957. Import controls have been made more restrictive, however, in order to conserve foreign exchange reserves, and this measure may tend to put additional pressure on prices.

Despite the gains that stabilization will ultimately bring, it is by no means easy, either technically or politically, especially in an economy with a long record of inflation, to take the steps necessary for this purpose. Political conditions must also be sufficiently stable to permit the authorities to overcome the transitional difficulties which may threaten severe short-run losses to some sections of the business community, and to carry the stabilization program through to the point at which longer-run benefits will be clearly seen. The political strains may be greatly increased by the apparent harshness of the consequences of stabilization for wage earners. In addition to fiscal and monetary measures, an essential element in any stabilization program must be a limit to wage increases, for prices cannot be stabilized if the major cost element, wages, continues to rise. If stabilization is to be effective, it is usually necessary to hold wage increases to a figure well below the percentage increase in the cost of living that has occurred since the last preceding wage adjustment. Often the wage rates established at the last adjustment will have reflected unrealistic hopes for increases in wage earners’ real income rather than the restoration of a previous level of real wages. A wage adjustment that is to form part of a successful stabilization program should reflect a realistic appraisal of the share of the national product that can be allotted to wage earners. Although the restriction of demand by appropriate fiscal and monetary measures can eliminate speculative profits, and halting the inflation may bring about some immediate increase in output, it is unlikely that a major increase in real wages can be effected at the time of stabilization. Beyond a certain point, higher money wages will not add to the real earnings of labor but will only raise the price level.

Limitation of wage increases was an essential part of the stabilization plan adopted in Chile in 1956. Money wages, in fact, increased by 47 per cent, which was about one-half the rise in the cost of living in the previous year. This was undoubtedly the most important single cause of the reduction in the rate of price increase in Chile in 1956—the increase in the cost of living was substantial, 38 per cent, but it was less than half the increase in the previous year. For 1957, it was decided that further adjustment in wages in general should be limited to 80 per cent of the 1956 cost of living advance, with a somewhat smaller increase for civil servants. The budget, which was still in substantial deficit in 1956, was to be strengthened by increases in sales and exchange taxes. The loss of revenue resulting from lower prices of copper, however, is likely to offset the effects of higher tax rates, and there will continue to be a sizable budget deficit.

While control of wages is usually an essential condition for ending chronic inflation, the core of almost all stabilization plans is the reduction of the deficit of the government sector to a level that can be financed without resort to inflationary credit. The true deficit of that sector is often not revealed by the budget accounts of the government proper. Sometimes the budget deliberately excludes some items; frequently, the deficit arises from the operations of autonomous government agencies or state enterprises. In these circumstances, stabilization requires the establishment of firm central government control over the autonomous agencies, so that the over-all budget deficit can be effectively reduced.

In Bolivia, after a year of very rapid price and wage increases, a comprehensive stabilization program was adopted in December 1956. As in Chile, steps were taken to limit increases in money wages. The exchange system was simplified and exchange controls removed (see Chapter VII). With the help of counterpart funds derived from sales of U.S. aid goods, plans were elaborated for over-all balance in the government sector. The reform of the exchange system also played a major part in the improvement of the finances, for half the deficit of the government sector had originated in the excess of the average payment in local currency for foreign currency earned by exports over the average charge in local currency for foreign currency spent on imports. The financial reform required a thorough review of the budget of the government-owned Mining Corporation, which is responsible for two thirds of Bolivia’s exports, resulting in the elimination of subsidies for the company commissaries and a program for the gradual release of a large number of redundant employees. The other government agencies were subjected to a similar review, with major revisions in their pricing policies, some diminution of their labor force, and substantial reductions of their imports.

Control of inflation of course requires not only that the extension of credit to the government and its agencies be limited, but also that credit to the private sector be controlled. In countries which have suffered from severe inflation, the latter may prove to be a secondary problem, for, unless the liquid resources of the banking system are being continually augmented by a government deficit, the expansion of private credit is more or less automatically limited in most monetary systems. Nevertheless, the control of private credit always has an important part in a stabilization program, and it is often difficult to maintain control of this sector during stabilization. In an inflation, the industrial pattern of production is often badly distorted. For example, in Bolivia the distortion of the exchange rate structure made profitable a sizable export of cotton textiles, which disappeared with stabilization. In Chile inflation greatly stimulated building construction, and this activity dropped sharply with stabilization. Appeals for credit relaxation were made by those who were damaged by the correction of the distorted pattern of production, but in general the authorities were able to resist such pressures.

Stabilization should not be regarded as impossible for any country; however great its difficulties may be, they are exceeded by the gains to be derived from it. Mexico in 1956 provided convincing evidence of the benefits made possible by firm monetary and fiscal policies. In the postwar years to 1954 Mexican prices had doubled, and in April 1954 Mexico had to devalue the peso for the third time. The instability of the currency caused a large capital flight and slowed down the pace of development. The Government was determined to end the previous excessive credit expansion, and in January 1955 it instituted stringent monetary restraints, including a reserve requirement imposed on private banks which sterilized 75 per cent of the increases in their deposits. Credit to government banks—previously the main recipients of central bank credit—was restricted to funds obtainable from outside the banking system. Tax receipts were raised. By the end of 1955, not only was the price rise halted, but foreign exchange reserves had risen to record levels. In 1956, Mexican prices were stable or falling despite the tendency toward higher prices in the United States. Foreign exchange reserves continued to rise, although at a much slower rate than in 1955. The success of the program was attributable largely to restraint in government finance, the government sector continuing in 1956 to reduce on balance its indebtedness to the banking system. A firm monetary policy did not check production, but preserved the favorable cost relationships resulting from the devaluation so that industrial production was able to rise continuously at a rate exceeding the average of previous years. With increased domestic savings and a substantial inflow of foreign capital, investment rose to new high levels.

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Cover International Monetary Fund Annual Report 1957
International Monetary Fund Annual Report 1957
Author: International Monetary Fund
ISBN:
9781616351694
ISSN:
2227-8915
Publication Date:
02 Sep 1957
Publisher:
International Monetary Fund
DOI:
https://doi.org/10.5089/9781616351694.011
Pages:
224