The Role of the Banking System in the Chilean Inflation

THE CHILEAN ECONOMY has undergone almost continuous inflation since the 1870’s, with only a few major interruptions. The inflation has been particularly severe in the last few years, during which Chile has provided a more or less classical illustration of the operation of the quantity theory of money. Partly because of the stage of economic development, and partly because of lack of confidence in the value of the currency, the Chilean people have been unwilling to hold as savings any appreciable proportion of new additions to the money supply, and therefore such additions have had a pronounced effect on prices. Nevertheless, inflation has never been sufficiently severe to cause a flight from currency as a medium of exchange for settling near-term transactions.

Abstract

THE CHILEAN ECONOMY has undergone almost continuous inflation since the 1870’s, with only a few major interruptions. The inflation has been particularly severe in the last few years, during which Chile has provided a more or less classical illustration of the operation of the quantity theory of money. Partly because of the stage of economic development, and partly because of lack of confidence in the value of the currency, the Chilean people have been unwilling to hold as savings any appreciable proportion of new additions to the money supply, and therefore such additions have had a pronounced effect on prices. Nevertheless, inflation has never been sufficiently severe to cause a flight from currency as a medium of exchange for settling near-term transactions.

THE CHILEAN ECONOMY has undergone almost continuous inflation since the 1870’s, with only a few major interruptions. The inflation has been particularly severe in the last few years, during which Chile has provided a more or less classical illustration of the operation of the quantity theory of money. Partly because of the stage of economic development, and partly because of lack of confidence in the value of the currency, the Chilean people have been unwilling to hold as savings any appreciable proportion of new additions to the money supply, and therefore such additions have had a pronounced effect on prices. Nevertheless, inflation has never been sufficiently severe to cause a flight from currency as a medium of exchange for settling near-term transactions.

In these circumstances, Chile’s history of chronic inflation is very closely related to the policies and activities of its banking system. Although the activities of the banking system have been only one element in the whole complex of forces determining the nature and magnitude of the inflation, they have been a dominating element, and one susceptible to analysis more or less independently of the other forces. Accordingly, the present study is focused on only this one aspect of the Chilean inflation, the role of the banking system.

The Money Supply and Prices

The money supply 1 in Chile increased steadily from 2 billion pesos at the end of 1937 to 18.5 billion pesos at the end of 1950, a rise of over 800 per cent (Table 1). Time deposits, which may be regarded as potential money, increased from 1.15 billion pesos to 4.99 billion pesos, or 334 per cent, over the same period. The expansion in the money supply was accompanied by a 549 per cent increase in the cost of living (Table 2). Wholesale prices rose 472 per cent. The upward movement of prices was continuous over the entire period, with one exception: at the end of 1938, the index of wholesale prices was 4 per cent lower than at the end of the preceding year. The cost of living index, on the other hand, rose by 2 per cent.

Table 1.

Liquid Assets Held by the Public in Chile, 1937-50

(Cols. 1, 2, 3, 5, 7 in millions of pesos)

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Excludes inter-bank deposits and deposits of the Treasury.

Source: International Monetary Fund, International Financial Statistics.
Table 2.

Indices of Wholesale Prices and Cost of Living in Chile, 1937-50

(1937 = 100)

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Source: Computed from indices published in the Boletín Mensual of the Banco Central de Chile.

These movements in the money supply and in the price level should be considered in relation to the growth in real gross national product and to the foreign prices of import goods. Imports are an important part of the total goods and materials consumed by the Chilean economy. Between 1940 (the first year for which an adequate estimate is available) and 1950, the real gross national product, based on the cost of living index, rose 24.5 per cent, an average annual growth (not compounded) of slightly less than 2.5 per cent (Table 3). Unfortunately, there is no reliable index of the foreign prices of Chilean imports; however, the U.S. wholesale price index for manufactured products may serve as an approximation. This index rose 104 per cent from the end of 1940 to the end of 1950. The Chilean money supply increased by 520 per cent over the same period.

Table 3.

Nominal and Real Gross National Product of Chile, 1940-50

(In billions of pesos)

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Deflated on the basis of the cost of living index (col. 3 of Table 2).

Source: Figures for 1940-49 were prepared by the staff of the Chilean Production Development Corporation; 1950 figures estimated by author.

Given the rate of growth in real gross national product and the movement of foreign prices, and on the assumption that changes in the exchange rate are ruled out as an equilibrating mechanism, what policy should the Chilean authorities have adopted with respect to the price level and the money supply? If stability of the domestic price level had been taken as an objective, they would have had to impose a very restrictive monetary policy in order to force down the prices of domestic goods to compensate for the rise in the foreign prices of imported goods. The annual growth in real gross national product would, of course, have reduced the extent to which the money supply would have had to be curtailed. The decline in demand for foreign goods as a result of the shrinkage of money incomes and, to a limited extent, of the substitution of domestic for foreign goods, would have forced importers to reduce their profit margins somewhat; and this would have exerted some downward pressure on the local prices of imported goods, thereby in turn relieving some of the need to depress the prices of domestic goods. Nevertheless, in some years stability of the price level would have required a substantial downward adjustment in money incomes and in the prices of domestic goods to offset the rise in the dollar prices of imports. The effects of such a downward adjustment would have been discouraging to private investment, and would have been at odds with the more basic objective of rapid economic development.

A more reasonable monetary policy, under the assumption of an unaltered exchange rate, would have had a two-pronged objective of permitting prices of domestic goods to rise pari passu with the foreign prices of imports and of preventing prices from falling in years in which real gross national product exhibited a tendency to decline.2 The purpose of the second part of this objective would have been to avoid the danger of setting off a downward price-income spiral. Such a policy would have been much more compatible with a dynamic economy with adequate investment incentives. At the same time, however, the pressures on the balance of payments probably would not have been unduly great and the economy would not have been subjected to the distortions in resource allocation which have resulted from the inflationary policies actually adopted. This does not mean, of course, that the objectives of monetary policy should be directed primarily toward controlling the price level. Much more important are the effects of monetary policy on the volume and pattern of resource utilization. However, it seems reasonable to assume that the price policy objective outlined above would have furthered the broader objectives of monetary policy and would have made possible at least as large a rate of increase in real gross national product as actually occurred.

If such a price policy would have been appropriate for Chile in the period under review, what credit policy would have been called for? And to what extent did the credit policy actually adopted differ from this? Some increase in the money supply would undoubtedly have been necessary. The magnitude of the required increase would depend on what would have happened to the velocity of circulation of money if inflation had been restrained.

In the circumstances which actually prevailed, the ratio of the gross national product to the money supply remained very stable (Table 4). Data necessary to calculate the relationship between bank debits and checking deposits with any degree of accuracy are not available except from 1943 onward. During these years, however, this relationship was also quite stable (Table 5). The stability of these relationships is not surprising. By the end of 1939, inflation had continued for a sufficient number of years so that money was no longer regarded as a convenient store of value. In these circumstances, rational behavior involved holding money only for the purpose of making payments scheduled in a future so near that it was not feasible to invest the funds in the interim. With an average upward movement of 15 per cent annually in the cost of living, there was a cost involved in holding money even during the interim, but the cost was not yet excessive in relation to the inconvenience and cost of shifting into and out of money. It may be worth observing, in passing, that the inconvenience and cost of such shifts are much greater in Chile than in a country like the United States, because Chile has no well-developed securities market and brokers’ commissions are very high. Inflation has not reached a point in which there is a strong compulsion to compress the lag between receipts and expenditures to near zero, as occurred in the hyperinflation of China and Greece. Nevertheless, during the period under discussion, it seems reasonable to believe that Chileans were not willing to hold money much in excess of what they needed for month-to-month requirements. In these circumstances, whenever the money supply increased more rapidly than the supply of goods and services, prices could be expected to rise roughly pari passu with the increase in the money supply.

Table 4.

Product Velocity of Money in Chile, 1940-50

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Table 5.

Annual Velocity of Circulation of Checking Deposits in Chile, 1943-50

(Cols. 1, 2, 4, 5 in millions of pesos)

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Arithmetic averages of end-of-month balances for June and December of the given year and for December of the preceding year. The deposit data include only deposits denominated in Chilean currency.

Source: Data from Banco Central de Chile.

Under the assumption that the annual rate of growth of real gross national product would have remained relatively unchanged, and that the product velocity of money would have remained constant, Table 6 presents a very crude attempt to measure (1) the annual change in the money supply that would have been necessary in each year from 1940 to 1950 to keep in step with the growth in real gross national product, (2) the change in the money supply necessary to permit the price level to rise in synchronization with increases in the foreign prices of imports, (3) the actual increase in the money supply, and (4) the changes in the money supply over and above that consonant with the growth in real gross national product and with increases in foreign prices. Table 6 indicates that, with the exception of three years (1941, 1946, and 1950), the banking system expanded the money supply far beyond what would seem to have been appropriate.3 More-over, in one of the three exceptional years, 1941, the increase in real gross national product seems so large as to make the figure highly questionable. If the increase in real gross national product in 1941 had been of an order of magnitude comparable to the other years in the series, the “excessive” increase in the money supply would have been positive rather than negative.

Table 6.

“Appropriateand Actual Percentage Increases in the Money Supplyin Chile, 1941-50

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Based on cost of living index (col. 3 of Table 2).

Based on U.S. wholesale price index of manufactured products (end of year figures).

The figures in this column are obtained by adding 1.00 to the percentage figures in columns 1 and 2, expressed decimally, then taking their product, and then subtracting 1.00.

Column 4 minus column 3.

Factors Producing Expansion in Money Supply

The increase in the money supply from 2 billion pesos at the end of 1937 to 18.5 billion pesos at the end of 1950 was made possible by a tremendous increase in the assets of the Central Bank which, by providing the other banks with additional reserves, permitted a multiple expansion of credits and deposits.

The reserve position of the banks and their ability to expand the money supply are a result of the interplay of factors tending to create reserves and of factors tending to absorb reserves. Tables 7 and 8 show the magnitudes of these forces in the period from the end of 1937 through 1950. The net acquisition of international reserves (i.e., gold and foreign exchange) accounted for only 1.4 billion pesos, or 15 per cent, of the total increase of 9.0 billion pesos in the factors creating reserves. Of the total increase of 1.4 billion pesos, however, 0.6 billion pesos, or 43 per cent, occurred in the single year 1943, and nearly 0.3 billion pesos, or about 20 per cent, occurred in 1950. There was very little change in the local currency value of international reserves from 1946 through 1949 (Table 8).

Table 7.

Origin and Absorption of Bank Reserves in Chile, 1937-50

(End of year figures, in millions of pesos)

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Includes the railroads.

Includes net claims against International Monetary Fund and International Bank for Reconstruction and Development.

All other liabilities excluding note issue and deposits of other banks.

Consists of Treasury notes according to Law 6640 (see Superintendencia de Bancos, Estadί;stica Bancarίa, December 1942, p. 215).

Table 8.

Changes in Factors Creating and Absorbing Bank Reserves in Chile, 1937-50

(End of year figures, in millions of pesos)

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Includes the railroads.

Includes net claims against International Monetary Fund and International Bank for Reconstruction and Development.

All other liabilities excluding note issue and deposits of other banks.

Consists of Treasury notes according to Law 6640 (see Superintendencia de Bancos, Estadίstica Bancarίa, December 1942, p. 215).

Central Bank credit increased by 7.5 billion pesos over the period, and accounted for 83 per cent of the total increase in the factors creating bank reserves. Of this increase, 2.6 billion pesos, or 35 per cent, represented credit to banks; 1.8 billion pesos, or 24 per cent, credit to official development institutions; 1.7 billion pesos, or 23 per cent, loans to the public; and 1.4 billion pesos, or 18 per cent, credit to the Treasury.

The Central Bank has followed a policy of rediscounting for banks any and all paper meeting the eligibility requirements prescribed in the Central Bank legislation. Thus, it has been purely passive in its rediscounting operations. Moreover, borrowing from the Central Bank has been quite attractive to the banks in view of the fact that over the entire period under review the rediscount rate was maintained at the low level of 4½ per cent for commercial banks and 5 per cent for the Caja Nacional de Ahorros.4 On the other hand, the average rates charged by the banks rose from 7.73 per cent during the first half of 1937 to 10.98 per cent during the second half of 1950 (Table 9).

Table 9.

Interest Rates on Bank Loans in Chile, 1937-50

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In accordance with Law No. 4694 of November 22, 1929, the Superintendent of Banks during the first fifteen days of each half-year must publish in the Diario Oficial the average rate of interest charged by the banks on their loans during the preceding half-year and the maximum permissible rate which any bank may charge during the current half-year. The maximum rate is established by raising the average rate charged by all banks during the preceding half-year by 50 per cent.

Source: Superintendencia de Bancos, Estad:Fstica Bancar㫺 and Boleím Mensual, 1950.

Central Bank credit to the Treasury was a substantial factor in providing bank reserves in only the years 1944, 1945, 1946, and 1950. Credit to official development institutions was a much more persistent source of additions to bank reserves. In only two years, 1944 and 1945, did Central Bank credit to development institutions decline, thereby reducing bank reserves; and in the first of these two years, the decline was of negligible proportions (8.4 million pesos).

Central Bank loans to the public increased every year except 1943, but the growth of these loans was not of importance in adding to bank reserves until 1947. The Central Bank did much more than keep in step with the other banks in extending credit to the public; its rate of expansion exceeded that for the banking system as a whole (i.e., Central Bank, commercial banks, and the Caja Nacional de Ahorros). At the end of 1937, Central Bank loans to the public were less than 1 per cent of total bank loans to the public; by the end of 1950, they represented 9 per cent of the total.

The Central Bank’s loans to the public have carried the rate of 6 per cent, which contrasts favorably with the rates charged by commercial banks, the average of which has ranged from 7.7 to 11.0 per cent. Thus, the rate charged the public by the Central Bank has in effect been a “subsidy rate,” and the Central Bank presumably has had a problem of rationing this low-cost credit among many borrowers eager to receive it. Such a subsidy rate might well have been justified on grounds of specialization on loans for projects having high national priority, such as credit to small and medium-sized farmers; but there is little evidence that the criteria for distributing the Central Bank’s loans to the public have differed significantly from those of the other banks.

Factors tending to absorb bank reserves, thereby reducing the ability of the banks to create credit, may be conveniently grouped in four categories: (1) notes and coins outside banks, (2) official deposits with the Central Bank, (3) deposits of the public with the Central Bank, and (4) other nonmonetary liabilities of the Central Bank (i.e., capital and surplus, reserves, etc.). As shown by Tables 7 and 8, by far the most important factor tending to absorb bank reserves in Chile during the period 1937-50 was the public’s demand for cash.5

Increases in official deposits with the Central Bank were of some assistance in absorbing reserves in seven of the thirteen years of this period; in the other six years, net withdrawals of these deposits added to bank reserves. For the period as a whole, the net effect of changes in such deposits was to absorb a small amount of bank reserves. Increases in official balances with the Central Bank could have played a much larger role, however. Government deposits with the commercial banks soared from 82 million pesos at the end of 1937 to 2,089 million pesos at the end of 1949; and with the Caja Nacional de Ahorros, from 181 million to 2,348 million pesos (Table 10). Thus government deposits with the commercial banks and the Caja combined increased by 4,174 million pesos between the end of 1937 and the end of 1949. Most of this increase, however, took place from about the end of 1946 onward. In 1950, government deposits with the commercial banks and the Caja Nacional de Ahorros were reduced by 1,764 million pesos as a result of the budgetary deficit, but they still amounted to 2,673 million pesos. The reserves of the banks (i.e., currency on hand, deposits with the Central Bank, and certain other legally admissible assets) increased by only 1,736 million pesos from 1937 through 1950 (see Table 11). Thus, much of the bank credit expansion and inflationary pressure in the Chilean economy after 1946 might have been checked or even eliminated by a government policy of keeping a much larger proportion of government deposits with the Central Bank. This statement is based on the assumption, of course, that, had such a practice been followed, the Central Bank would not have expanded its loans to banks and to the public still further. The psychology of the Chilean business community, so long accustomed to the stimulating effects of inflation, and the widespread faith in inflation as an instrument of economic development may, however, make this assumption unrealistic.

Table 10.

Deposits of the Chilean Government and Its Agencies, 1937-50

(In millions of pesos)

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Details may not add to totals because of rounding.

Sources: Superintendencia de Bancos, Estad:Fstica Bancarίa, Boletín Mensual, and Boletín Bimensual.
Table 11.

Reserve Position of Commercial Banks in Chile, 1937-50

(Daily averages, in millions of pesos)

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Includes letters of credit countersigned by the Central Bank and discounted without responsibility by the commercial banks; these may be included in the reserve up to a maximum of 25 per cent of the minimum legal reserve (Law 5185, June 30, 1933). Also includes loans granted to the Treasury, under special legislation, in order to stimulate production; the authorization to grant new loans of this type lapsed in April 1945.

Figures are weekly averages of Central Bank rediscounts to member banks. Taken from Central Bank Annual Memorias.

Total of “Notes and coins” and “Deposits with Central Bank.” Data are not available separately.

Source: Banco Central de Chile, Boletin Mensual, January 1950, p. 30.

Changes in the public’s deposits with the Central Bank alternately absorbed and created bank reserves, from one year to another, in almost perfect rhythm, though with varying pitch (see Table 8). The net effect, over the period as a whole, was for such deposits to increase slightly, and to absorb a corresponding amount of bank reserves. It is of interest to note that Central Bank loans to the public expanded by 1,704 million pesos, but that deposits of the public with the Central Bank rose by only 47 million.

Notwithstanding the magnitude of the factors tending to absorb bank reserves, the cash reserves of the banking system (excluding the Central Bank) mounted from 0.3 billion pesos at the end of 1937 to 2.0 billion pesos at the end of 1950 (see Table 7).

Particularly from the end of 1943 onward, most of the banks expanded credit to the maximum which the legal reserve requirements and their “till money” needs permitted (Table 11). This was to be expected, of course, in a period in which most of the banks were borrowing from the Central Bank. The commercial banks and the Caja Nacional de Ahorros expanded their total loans and investments from 2.8 billion pesos at the end of 1937 to 20.2 billion pesos at the end of 1950 (Tables 12 and 13). The upward sweep of bank loans and investments was without interruption over the entire period.

Table 12.

Loans and Investments of Commercial Banks in Chile, 1937-50 1

(In millions of pesos)

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Details may not add to totals because of rounding.

Development Institutes, Mortgage Credit Institutes, and Caja de Previsión.

Table 13.

Loans and Investments of the Caja Nacional de Ahorros, 1937-501

(In millions of pesos)

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Details may not add to totals because of rounding.

Development Institutes, Mortgage Credit Institutes, and Caja de Previsión.

Commercial bank loans were almost exclusively to the public. Loans to the Treasury and to other government agencies were small and at their peak, in 1950, amounted to only 451 million pesos, contrasted with loans of 12,761 million pesos to the public. Commercial bank loans to other borrowers (see Table 12) were even smaller and never exceeded 130 million pesos.

Loans of the Caja Nacional de Ahorros (Table 13) were also predominantly to the public. Loans to the Treasury and other government agencies reached a peak of 349 million pesos at the end of 1947, compared with loans of 2,900 million pesos to the public in the same year. By the end of 1950, loans to the Treasury and other government agencies had dropped to 147 million, while loans to the public had climbed to 4,938 million.

Securities represent a small part of Chilean banks’ total loans and investments. An inflationary environment makes long-term, fixed income instruments a particularly poor form of investment. For the commercial banks, at the end of 1950, securities represented less than 3 per cent of their total loans and investments. For the Caja Nacional de Ahorros, the proportion was higher (15 per cent) but still small. Capital shares of the Central Bank were the most important type of security held by the commercial banks, and in every year exceeded holdings of government and municipal bonds. The Chilean banks are required by law to hold a certain amount of Central Bank shares, so that these investments are for the most part involuntary. Commercial bank holdings of government and municipal bonds amounted to only 18 million pesos at the end of 1950. The bulk of securities held by the Caja Nacional de Ahorros, however, were governments and municipals; at the end of 1950, such holdings amounted to 794 million pesos out of total security holdings of 979 million.

Bank Credit Expansion and Investment

The expansion in bank credit made possible a large part of the total net investment of Chile during the period under review. To a much greater extent than in the United States, investors in Chile are dependent on bank credit to finance their undertakings. In 1949, for example, increases in the money supply and time deposits were equal to about 52 per cent of total net investment6 in Chile. It is not possible to compute the corresponding relationship in the United States, where government expenditures are not classified as investment and consumption expenditures. A rough comparison, however, may be made with the ratio of the increase in money supply and time deposits to net private investment7 in the United States. In 1949 this ratio was about 5 per cent.

The reasons for the dependence of Chilean investors on bank credit expansion are not difficult to uncover. For one thing, the volume of planned savings is small relative to investment opportunities and investment needs. Planned savings are small because the low levels of real income leave little surplus after the bare needs of subsistence have been satisfied. In addition, very little of the limited volume of savings passes through organized financial markets where prospective investors can freely compete for use of the funds. A large part is used directly by savers themselves to build residential and commercial buildings, which are favorite forms of investment. Another large part is probably ploughed back into the business of the savers. Very little of the savings is used for indirect investments. Savings in the form of life insurance are small. Except perhaps for self-financing, therefore, bank credit is the principal source from which investment is financed. The only other source of any magnitude is the reserves of the social security institutions. Moreover, it takes only a rather small amount of bank credit to utilize the planned savings placed at the banking system’s disposal by the community. For the most part, therefore, bank credit expansion involves lending “newly created” money rather than money saved by the public from incomes received in earlier years.

Chile’s bank legislation places rather strict limits on the maturity of loans which banks may make and establishes a strong preference for short-term self-liquidating commercial loans. This does not mean, however, that the proceeds of such loans are not used to finance investment in plant, equipment, and residential building. In most cases, the proceeds finance such types of investment only indirectly, but finance them none the less. For one thing, the economic activities of the average businessman are less specialized than they are in the United States. It is quite common to find businessmen who are agriculturists, manufacturers, and merchants, and it is far more common to find businessmen who combine at least two of these three types of activities. Banks may believe that they are supplying working capital for the activities of the borrowers when perhaps they are in fact financing the construction of private residences, or apartment buildings, or plant or equipment by freeing the borrower’s own resources from his “bankable” activities and making them available for other purposes. Similarly, loans made for the ostensible purpose of financing the planting, harvesting, or marketing of agricultural products may in reality be financing private construction. In brief, an expansion of bank credit in Chile can probably be counted on to lead to an expansion of investment, and a contraction of bank credit would probably force a reduction in investment. In neither case, because of the absence of any reliable way of determining in advance what the borrower regards as his marginal investments, is it possible to anticipate how the change will be distributed among inventories, residential building, commercial buildings, industrial and agricultural equipment, etc.

Motives for Bank Lending and Private Borrowing

In order to have an expansion of bank credit, two conditions are obviously necessary: (1) borrowers must be willing to borrow more, and (2) banks must be willing to lend more. One of the considerations of greatest importance to borrowers in shaping their decisions to borrow is the “real” rate of interest which they must pay. Under the inflationary conditions which have prevailed in Chile, the real rate of interest from the end of 1936 to date has been negative in all except three years—1938, 1939, and 1945—i.e., in all but these three years the purchasing power at maturity of the principal plus interest of a one-year loan would have been less than the purchasing power of the principal at the time it was lent (Table 14). The average real rate, on this basis, has been minus 4.8 per cent. Under these circumstances, there is an obvious incentive to borrow from the banks. Moreover, the marginal return on new investment would be expected to be high at a time when total effective demand is being pushed up by government deficits, by balance-of-payments surpluses during the war period, and, in the postwar period, by large amounts of domestic investment complementary to the extraordinary importation of capital goods and raw materials.8 Even businessmen who are not seeking to expand the physical volume of their transactions find that they need more and more working capital as prices rise. Thus, whether a businessman is trying to expand the real volume of his transactions or is merely trying to maintain the same volume, he finds that he “needs” more bank credit.

Table 14.

Real and Nominal Rates of Interest in Chile, 1937-501

(per cent)

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The “real” interest rate column is computed by the formula

r={(100+i100+Δp1)}×100.

The figure computed by this formula shows the percentage increase or decrease in the real value of the money returned at the end of the year, compared with that lent.

In such circumstances, the banks are under certain pressures to lend, and stockholders are likely to be quite insistent that the management expand credit to the maximum in order to increase earnings. For one thing, the costs of the banks rise in periods of boom prosperity. If profits are declining because of rising costs, bankers are likely to reassess the factors which made them reluctant to expand credit more rapidly hitherto, and may be willing to make loans and investments which, in the absence of a squeeze on their profits, they would regard as unattractive. Moreover, if the demand for loans is increasing, it becomes even harder for bank managers to justify smaller profits and dividends to the shareholders. This seems to have been the situation in Chile.

The movements of commercial bank revenues and expenses in the period 1937-50 are shown in Table 15. The ratio of bank receipts to expenses was 1.39 in 1950, contrasted with 1.71 in 1937; the entire decline, however, occurred after 1942. It is also evident from Table 15 that the relative share of the principal categories of expenses changed only slightly over the decade.

Table 15.

Annual Receipts and Expenses of the Commercial Banks in Chile, 1937-501

(In millions of pesos)

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Details may not add to totals because of rounding.

Sources: Superintendencia de Bancos, Estadίstica Bancarίa, February and August issues, Table, “Bancos Comerciales; Análisis de la Cuenta de Perdidas y Gananeias.”

Notwithstanding the tremendous expansion in bank credit, bank earnings declined in real terms. The profits of commercial banks rose from 66 million pesos in 1937 to 361 million pesos in 1950 (Table 16), but the “real” value of bank profits in the latter year had dropped, in terms of 1937 prices, to 59 million pesos.9 Bank capital and reserves rose from 647 million pesos in 1937 to 2,827 million pesos at the end of 1950. Of this increase of 2,180 million pesos, it is estimated that roughly 550 million pesos came from retained earnings, and that the remaining 1,630 million came from new stock issues and from upward revaluation of assets. The last was particularly important in 1949 because in that year the banks were authorized by the Superintendent of Banks to revalue their holdings of Central Bank shares and their premises. Despite this increase in bank capital and reserves between 1937 and 1950, the real value of bank capital in 1950, in terms of 1937 prices, was only 464 million pesos.

Table 16.

Capital, Profits, and Capital Return of Commercial Banks in Chile, 1937-50

(In millions of pesos)

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Average for year.

Nominal figures deflated by cost of living index (Table 2, col. 3).

Thus, the squeeze of higher costs and the decline in the real value of their capital and earnings have tended to make bankers willing lenders to eager borrowers.

The joint action of the banks intensifies the very effects which they are endeavouring to escape, but this is not apparent to any individual banker, or, if it is, it does him no good to leave the race. The only thing he can do to protect his shareholders and to maintain the relative standing of his bank is to try to run a little faster than his fellow bankers. Moreover, once the inflationary process is well under way, bankers are likely to fear that any cessation of the inflation process would involve a liquidation crisis and a deflation which would result in many loans turning sour, with consequent losses to the bank. Thus, to some extent, the individual banker finds himself between Scylla and Charybdis. If he does not expand credit at a rapid rate, the rising price level will reduce the real value of his bank’s capital and earnings. On the other hand, each banker “realizes that the more extended is his loan portfolio, the more vulnerable is his bank’s position, because an eventual cessation of the inflationary process may well involve large-scale insolvencies which may severely endanger the liquidity and solvency of the banking system. Nevertheless, once the inflationary process has begun, bankers ordinarily have little alternative but to join in the process provided that they can obtain funds from the Central Bank or elsewhere. The Central Bank of Chile, standing ready to meet the demands of banks and other borrowers at low rates of interest, has not been an effective obstacle to the process of credit expansion by the other banks.

*

Mr. Grove, a graduate of Harvard College, the Harvard Graduate School of Arts and Sciences, and the Harvard Graduate School of Public Administration, is Chief of the Latin American Section, Division of International Finance, Board of Governors of the Federal Reserve System. He has served as advisor on banking legislation and credit policy to a number of Latin American countries and to the Philippines. In the spring of 1950, he was loaned to the Fund by the Federal Reserve Board to be a member of a Fund mission to Chile.

1

The money supply is defined as currency outside banks and local currency checking deposits of the public (i.e., excluding inter-bank deposits and deposits of the Treasury).

2

It may be argued that an even more appropriate policy objective would be to stabilize the prices of domestic goods and to adjust the exchange rate to the extent necessary to neutralize changes in the foreign prices of imports. A discussion of the monetary and credit policies appropriate to such an objective would be inextricably intertwined with questions of exchange policy beyond the scope of this paper. For this reason, the objective mentioned in the text has been taken as a convenient starting point for the ensuing discussion.

3

The calculations of the “excessive” increases in the money supply should not be regarded as providing anything more than very rough statistical verification of the conclusion that the money supply was expanded too rapidly even in relation to a policy objective of maintaining the relationship between domestic and foreign prices without modifying the exchange rate. The calculations, for purposes of simplicity, ignore such relevant considerations as the extent to which an “excessive” increase in the money supply in any given year should be an element in determining the magnitude of the appropriate increase in the money supply during the following year, and the fact that de facto depreciations of the Chilean peso did occur during the period.

4

A government-owned savings and loan bank.

5

Had the expansion of Central Bank credit and of the total money supply not occurred, prices would not have risen so much and the public would not have needed so much currency. Thus, this factor of absorption of bank reserves is very closely related to the factors of expansion, and is not an independent variable.

6

Including government expenditures classified as investment and also including the net foreign balance.

7

Including net foreign investment.

8

The marginal rate of return on investment might be expected to decline in a period in which total investment is being expanded rapidly. This would be true if the new investment were entirely competitive with existing investments. In fact, however, much of the new investment in Chile has been complementary to old investments and has created profitable opportunities for re-groupings of the existing stock of physical capital. In other words, there has been an upward shift in the marginal-efficiency-of-capital schedule.

9

Nominal profits deflated by the cost of living index, with 1937 = 100.