Tape 146 - Franklin National, Flexible Exchange Rates, Ideas vs. Experience / Paul A. Samuelson papers, 1933-2010 and undated / Duke Digital Repository

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Hello, this is Rose Friedman

0:02

inviting you on behalf of Instructional Dynamics

0:04

to another of our bi-weekly conversations

0:07

with Milton Friedman, Professor of Economics

0:09

at the University of Chicago.

0:11

We are taping this on Monday, May 20th, 1974.

0:14

This is a little late for this tape

0:19

because we attended a conference in Williamsburg

0:21

on flexible exchange rates.

0:23

We'll discuss that conference somewhat later on,

0:25

but, the most important monetary event of this,

0:29

of recent days has been the difficulties

0:31

of the Franklin National Bank.

0:34

Would you like to comment on that?

0:36

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The two events are not entirely unrelated.

0:39

According to the newspaper stories

0:41

the source of the difficulty

0:43

of the Franklin National Bank

0:45

was, were massive losses in the estimated range

0:47

from something like 17 million dollars

0:51

to 40 million dollars.

0:54

Massive losses in foreign exchange speculation

0:55

allegedly by a trader who was not authorized

0:59

to operate on such a magnitude on his own.

1:03

These are really tremendous amounts

1:08

because the foreign exchange business

1:11

operates on very narrow margins.

1:13

A one or 2% move on a foreign exchange rate

1:16

is a large move, so, a loss of 17 million

1:19

means that operations were being carried out

1:23

in the sums that must've amounted to 50 times that

1:25

or three or four hundred million dollars.

1:29

It's inconceivable, almost inconceivable

1:31

that any official of a trader of a bank

1:35

could have been authorized to take positions

1:38

of that magnitude, to commit his bank

1:40

to positions of that magnitude without authorization.

1:42

But, the interesting question is not that,

1:45

the interesting question is why should this have been

1:48

the occasion of so much concern?

1:50

Many an industrial or a financial enterprise fails

1:52

without it being the occasion of stories

1:55

throughout the press about the danger

1:58

of a great financial panic,

2:00

without the Federal Reserve being moved

2:01

to issue public statements,

2:03

the New York Federal Reserve Bank

2:04

getting in to the act and so on.

2:06

To take an example of recent history,

2:08

equity funding

2:11

failed as a result of fraud some time back.

2:13

I don't know,

2:17

I don't remember what the actual numbers are

2:18

but the total amount of money lost

2:20

was far greater than any amount of money

2:22

that it was, was conceivably capable of being lost by,

2:24

certainly by innocent people

2:29

in the Franklin National Bank case.

2:31

Being a national bank, it was a member

2:33

of the Federal Deposit Insurance Corporation,

2:34

deposits were guaranteed,

2:36

there certainly would've been very little or no loss

2:39

to depositors, even if it had closed down

2:41

and not been re-financed and continued in operation.

2:43

The explanation for the far greater concern

2:49

for Franklin National Bank

2:53

than for the equity funding

2:54

is

2:58

not the size of the losses

3:00

but the historical fact that, in the past,

3:02

on many an occasion

3:06

the failure of a bank has been the trigger

3:09

that has produced

3:12

a wide-scale banking panic.

3:15

For example, one of the most famous

3:18

historical cases was the failure

3:21

of the Knickerbocker Trust Company

3:22

in New York, in 1907,

3:24

which was the occasion for the

3:26

the Panic of, so-called Panic of 1907,

3:30

when you had a concerted agreement

3:33

by all banks that they would not pay out

3:35

gold or currency over their counters,

3:38

that all checks were marked for,

3:41

to be settled at the clearing house only.

3:44

I described it in that complicated way

3:49

because the actual term that was then implied was,

3:51

that was then used, was to say that banks

3:54

had suspended payments.

3:55

If you used that expression today you would think

3:57

that the bank had closed,

4:00

but that isn't exactly what had happened.

4:02

They had suspended payments in the sense

4:03

of not agreeing to pay out cash over the counter.

4:06

But the banks continued open for business

4:10

and people could

4:12

make payments back and forth to one and other by check.

4:15

The problem for the banks then

4:19

was that they were required to pay gold

4:20

over their counter in return for a deposit,

4:24

and with a great run on the banks

4:27

because the Knickerbocker Trust failed

4:31

and there were rumors that other banks

4:34

were fail, were going to fail and there was the usual

4:35

contagion of fear that deposits

4:40

would not be convertible in to cash,

4:43

there was a great considered run on them

4:45

and they suspended payments in that sense

4:47

in order to stay open.

4:50

But that did trigger, of course, a decline

4:51

in the quantity of money, it did trigger a very,

4:54

very sharp panic

4:57

and severe recession.

5:00

And that was the kind of pattern

5:03

that had been followed many times in the past.

5:04

It was repeated again in a different form

5:08

in the 1930s,

5:10

when the most prominent case

5:12

was the failure of the Bank of the United States

5:15

on December 11th,

5:17

1931.

5:19

It too triggered a widespread fear

5:22

that banks were going to collapse,

5:25

caused a great run on banks and led to a,

5:26

it was really the climactic event, the date,

5:33

the shift in the character of the Great Depression

5:37

from being a rather ordinary,

5:40

but extremely, though extremely severe recession

5:42

to being a major catastrophe.

5:45

It is these memories of the past

5:47

that cause an event such as the danger

5:49

to the Franklin National Bank

5:52

to be greeted with the concern that it was greeted with.

5:54

It's not clear that that concern is any more justified

6:00

because we now have what we did not have then,

6:03

namely the Federal Deposit Insurance Corporation

6:05

which assures that the failure of one bank

6:08

does not lead to the losses by its depositors

6:12

and which has been extremely effective

6:15

in the course of time in preventing isolated

6:16

bank failures from leading to runs.

6:19

But, whether justified or not,

6:21

the reaction was one of widespread concern

6:23

and panic that there might be financial catastrophe,

6:26

and the Federal Reserve Board was induced

6:29

to come out and say that it was going to serve

6:31

as lender of last resort,

6:33

that it was to make announcements

6:34

that Franklin National had large volume

6:37

of assets which were eligible for discount

6:39

at the bank and that the bank would make the discounts.

6:42

It led the Federal Reserve Bank of New York

6:45

to make announcements of a similar kind

6:48

and I understand, though this is not in the papers,

6:52

to engage in advance arrangements

6:55

and negotiations trying to set up a merger

6:57

between Franklin National Bank and another bank

6:59

in order to see that it continued operating.

7:02

This is likely, it looks at the moment

7:09

as if this will prove a Tempest in a Teapot,

7:11

the Franklin National Bank is apparently

7:13

going to be recapitalized and will survive,

7:16

the stockholders have agreed to

7:19

put, eddy up

7:21

enough money to make good the capital efficiency.

7:23

However, that doesn't mean that it will not have any effect.

7:27

The operations of the Federal Reserve

7:30

during the past week will probably mean

7:32

that we shall see a short, but at least a short,

7:34

maybe more than a short, but we will see

7:37

a sharp increase in the quantity of money

7:39

in the next month or two as a result

7:43

of the operations of the attempts

7:45

by the Federal Reserve to assure

7:47

the financial markets that there is going to be

7:48

no financial collapse or financial panic.

7:51

This reminds you of what happened

7:54

in May of 19 -

7:56

In May 1971 on the occasion of the failure

7:58

of the Pan Central which was

8:01

different from both the Franklin National

8:05

and the equity funding because the failure

8:08

of the Pan Central

8:11

meant

8:14

that a lot of market paper,

8:16

a lot of financial

8:18

bills,

8:24

commercial paper,

8:27

which had been issued by the Pan Central

8:28

suddenly became of doubtful value

8:30

and it meant that not only that but there was a great shock

8:32

to the confidence in the commercial paper market.

8:36

It was very difficult for even eminent

8:39

first-rate corporations to raise money

8:41

in the commercial paper market

8:44

and therefore they turned to the banks

8:45

and the banks suddenly had a large demand

8:46

for additional demand for loans.

8:48

And on that occasion, the Fed prides itself

8:51

on the rapidity with which it came to the rescue,

8:54

on the large amounts of funds that it poured

8:56

into the market, on the fact that this event

8:58

was absorbed without any major financial consequences.

9:00

A similar phenomenon is under way now

9:05

in making the, assuring the market

9:08

that Franklin National will not be allowed

9:11

to multiply and accelerate.

9:14

The Fed will be pouring high-powered money

9:16

in to the market, they have been doing so already,

9:17

and this will come out undoubtedly

9:20

in a very sharp increase in the quantity

9:22

of money over the next month or so.

9:24

That will add to the problems which the Fed will have

9:26

in bringing it back down to the more moderate

9:29

rate of increase in the quantity of money that,

9:33

on the one hand, has been their announced objective

9:36

and on the other has been their actual

9:39

performance over the past 3 or 4 years.

9:41

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Let's go back and discuss the conference a little bit.

9:45

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Well, as all of you know,

9:49

in the, within the past year or so

9:52

there has been a dramatic change in the character

9:55

of the International Financial System,

9:57

from a system which was ostensibly

9:59

erected on the basis of fixed parodies,

10:03

fixed exchange rates supported by governments,

10:06

to a system of rather freely floating exchange rates.

10:09

In the course of the past four or five year, five years

10:15

there has been a group of people who have met

10:17

from time to time in connection with this issue,

10:19

they have called themselves the Burgenstock Group

10:22

simply because Burgenstock was one of the places

10:24

in Europe at which the group met, although

10:27

the first meeting was held in Long Island at Oyster Bay.

10:30

This group has been organized by three people,

10:34

Fritz Machlup

10:38

formerly of Princeton,

10:43

now retired from Princeton and teaching at NYU,

10:44

Fred Bergsten of the Brookings Institution,

10:47

and Bob Roosa who was at one time

10:50

under-secretary to the treasury and more recently

10:52

has been a partner of Brown Brothers and Harriman.

10:54

The aim of this, these conferences,

10:57

which have been supported by foundation funds

11:00

has been to bring together academic people

11:02

on the one hand and what were called practitioners

11:04

on the other, by practitioners meaning people

11:07

in the banks or in financial institutions

11:10

or in multi-national corporations

11:13

who are involved in day-to-day exchange,

11:15

foreign exchange transactions, but also officials

11:18

of central banks of various countries.

11:21

The idea of the original series of meetings was to

11:24

examine

11:29

the problems

11:31

that would be raised by flexible exchange rates,

11:33

it was an attempt to try to bridge the gap

11:35

to some extent between the academic group

11:38

and the practicing group,

11:42

the academic group having by this stage

11:43

largely become persuaded that floating exchange rates

11:47

were both inevitable and desirable.

11:50

The practicing group, looking with horror

11:53

in the main at that prospect,

11:57

having adjusted themselves to operating

11:58

in a world in which exchange rates

12:00

were being fixed and kept in line

12:02

by governmental bodies, by central banks, and the like.

12:04

And the idea of the conference was to explore

12:09

what were the problems

12:12

that would arise

12:15

in

12:17

getting to a flexible rate system.

12:19

The series of conferences serves

12:21

an extremely useful function in instructing

12:23

both the academic people

12:27

about some of the practical problems

12:28

and in bringing home to the practical people

12:30

that there were no, there was no really effective

12:33

alternative to a greater measure

12:36

of flexibility of exchange rates and help,

12:38

therefore, to pave the ground,

12:40

ground for the developments that did occur.

12:42

The meeting this time was the first meeting

12:45

since floating exchange rates had become a reality,

12:47

and the aim of the meeting was,

12:50

the title of the meeting, the subject matter was

12:52

"What have we learned

12:55

"from a year of flexibility of exchange rates?"

12:56

I found it an extremely interesting

12:59

and fascinating conference

13:01

as someone who had all along been in favor

13:02

of floating exchange rates,

13:05

it was interesting to see how it had worked.

13:07

A number of conclusions

13:10

were very clear from the discussions running over three days

13:13

among this group.

13:19

In the first place there was, by this time,

13:21

essentially unanimous agreement on everyone's part,

13:25

theorist, practitioner in the private world,

13:28

central bank official,

13:34

there was essentially unanimous agreement

13:35

that

13:37

it's hard to conceive how the world

13:40

could've gotten through the past year

13:43

with any system other than floating exchange rate.

13:46

Given the

13:49

blows which were struck

13:50

on the International Financial Mechanism

13:52

by

13:56

worldwide inflation at differential rates

13:58

in different countries, by the Middle East war,

14:01

by the oil crisis, there seemed to be unanimous

14:04

agreement that whether floating exchange rates

14:08

were a good system or a bad system

14:11

for the long pull they had been an absolute

14:13

necessity for that year.

14:16

In the same place, it was widely agreed

14:18

that businesses had found it surprisingly

14:22

easy to adjust to it.

14:25

That they had learned to operate the system

14:28

and it had not interfered significantly

14:29

with the course of trade,

14:33

with the course of,

14:34

with the volume of exchange among countries.

14:37

However,

14:44

on the,

14:46

those were the two main positive findings.

14:46

On the negative side, there was a good deal

14:50

disappointment, of disappointment expressed

14:53

that the fluctuations in the exchange rates

14:55

had been as wide as they had been.

14:57

And the

15:00

argument was made

15:03

particularly, mostly by the practitioners,

15:05

and here one has to distinguish

15:08

between different kinds of practitioners.

15:10

Here, on the one hand,

15:12

you have the people in the banks

15:13

who are engaged in the day-to-day trade

15:15

who are making the market,

15:17

on the other hand we had representatives

15:19

of multi-national corporations

15:21

who are in the, who are faced with the necessity

15:22

of adjusting funds in different currencies,

15:25

the customers in a way being the multi-national banks,

15:30

the providers of the service

15:34

being the multi-national corporations,

15:35

the providers of the services being the banks.

15:38

And here there was widespread agreement

15:41

that the banks in particular had been unable

15:43

to take a very long-range position,

15:47

that they were involved in day-to-day trading

15:48

and that they had tended to develop,

15:51

rather than, a stabilizing speculation

15:53

rather than going against the market,

15:56

they had had to follow the policy

15:59

of essentially what was called a Bandwagon Effect,

16:01

of going with the market, and as a consequence

16:04

the argument was that one of the hopes

16:07

that had been expressed by proponents

16:11

of flexible exchange rates, like myself,

16:13

had been that speculators by,

16:15

private speculators would stabilize the market

16:18

and keep the fluctuations in the exchange rate

16:21

from being as wide as they otherwise would.

16:23

Well, at least for the first year,

16:26

this hope seems not to have been realized.

16:27

The banks have been unable

16:30

to take any substantial position,

16:32

the experience of Franklin National

16:34

was cited several times as to what happened

16:35

when banks did take a substantial position.

16:37

There had been developed a private market

16:42

in the form of the International Money Market

16:44

in Chicago, where private speculators

16:45

might come in and take positions

16:49

but while this had been, had grown very rapidly

16:51

in its own terms it had not really taken off

16:54

in the sense of amounting to any substantial

16:56

contribution to the total of all the international

16:58

exchange transactions, those were still in the main

17:01

been done on an interbank basis.

17:04

There were some comments by the customers,

17:07

by the multi-national corporation people

17:09

that after all the banks were better off,

17:14

the traders were better off when rates did fluctuate,

17:17

that was the business they were in.

17:21

And there were comments made about the total,

17:23

the very large volume of profits which banks

17:27

had made out of their foreign exchange speculation.

17:28

This subject never really got itself resolved

17:34

but, I guess, part of the emphasis

17:37

was that one year was a very short time,

17:40

that this was a learning period,

17:43

that it would take a longer period of time

17:45

before the thing settled down

17:48

and particularly before you discovered

17:50

where there were sources of

17:53

stabilizing speculation.

17:56

Another issue that was discussed was,

17:59

and that had been of much concern was whether,

18:02

what was gonna happen to the cost

18:04

of exchange transactions.

18:05

Now this cost really consists of two different things,

18:08

one is a bid-ask spread and is the commission

18:10

in which the dealers take,

18:14

and the other part from a private point of view,

18:16

which is of cost, is that if you have a payment

18:18

to make in pounds, let us say six months from now,

18:21

you may now go in to a forward market

18:25

and buy pounds

18:27

and this will

18:28

enable you to cover that obligation

18:31

without undertaking an exchange risk,

18:34

without being subject to the possibility

18:36

that the exchange rate will change.

18:37

This cost is not really a social cost

18:41

because if you pay a premium on that score

18:43

in the future while somebody else

18:46

is on the other side of it and is getting the gain.

18:47

So that, but nonetheless

18:52

the question not so much of the cost in that area

18:55

as the availability of such hedging markets

18:57

was discussed and it was widely agreed

19:00

that futures markets had not developed,

19:03

had not become any greater or more widespread

19:05

or any, to any significantly greater extent

19:08

that they had been before that,

19:11

in this first year at least.

19:13

The possibility of hedging in making

19:16

forward transactions for long periods

19:18

had not developed as many people had hoped it would.

19:20

There was a great deal of controversy

19:25

about the question of whether at this stage

19:27

the central banks should come back in or not,

19:30

whether, maybe, it was the central banks

19:33

who could provide the stabilizing speculation

19:36

and it was kind of a curious thing,

19:38

some of the bankers and businessmen

19:40

thought they could but it was,

19:42

as I expressed a view there,

19:45

it was like wanting some more

19:46

of the hair of the dog that bit you, the real problem

19:48

that you got in to was exactly because of the,

19:51

what turned out to be destabilizing

19:54

speculation of the banks.

19:56

We had a very interesting story told

19:58

about what had happened in Japan

20:00

over the last year or two,

20:02

by some of the Japanese participants,

20:03

and that is really a striking example

20:06

where you had ostensibly floating exchange rates

20:08

but not really floating exchange rates.

20:10

What happened was that the Japanese

20:13

Central Bank,

20:19

the Bank of Japan, and the government first,

20:20

in the early stages of the floating,

20:24

tried to keep the exchange rate of the yen

20:26

from appreciating and in the process they accumulated

20:29

something over 10 billion dollars of additional reserves.

20:32

And then, after it had appreciated, and went too far,

20:36

they tried to keep it from depreciating

20:40

and we made some very rough calculations

20:43

that were really fascinating but it seems

20:45

that in the past year and a half

20:47

the Central Bank of Japan

20:48

lost something like a billion and a half dollars

20:52

in exchange speculation,

20:55

that is to say in order to keep the yen from appreciating

20:57

it paid something like 300 yen per dollar

21:00

for 10 billion dollars.

21:04

And then, some months later,

21:06

for a period of six months it sold

21:09

yen at 265 yen to the dollar,

21:11

so it bought dollars at 300,

21:16

I say sold Yen, it sold dollars.

21:17

It bought dollars at 300, and it sold dollars at 265,

21:19

so it lost something like close to 15% on every trade

21:24

and it accumulated in the first instance

21:29

10 billion and then it sold NET 10 billion dollars

21:31

so that means it lost about a billion and a half dollars

21:35

and nobody knows who benefited, who gained,

21:38

or whatnot from that episode.

21:40

The other main topic that was discussed extensively

21:46

was the question of the implications

21:50

for the market of the oil crisis.

21:51

There are the estimates of the very large

21:53

flows of funds that are alleged

21:58

to go to the oil companies that,

22:00

perhaps, something in the order

22:02

of 150 billion dollars a year,

22:03

I've talked about that on these tapes before

22:04

and you will know that I am very sceptical

22:06

that any such sums will eventuate.

22:10

But nonetheless a question was raised

22:12

and I may say among the people who were present

22:14

were some officials of oil companies

22:16

so that we had some expertise on this subject,

22:18

the question was raised about the feasibility

22:21

of transferring such substantial funds

22:23

and what that would do to the foreign exchange market,

22:26

to the flexible rates,

22:29

to the breadth of the market and so on.

22:30

I cannot say that there was any very definite conclusion

22:32

that was drawn on this.

22:35

Some of the participants were quite optimistic

22:37

about the possibilities of the euro-dollar

22:39

market handling it,

22:41

others or the participants were quite pessimistic.

22:43

One thing can be said for sure,

22:50

on the basis of this discussion,

22:52

whatever dissatisfaction was expressed with the system

22:56

of floating exchange rates there was essentially

22:59

no belief whatsoever that it was likely to be replaced

23:02

in the near future

23:05

by

23:08

any very different system.

23:11

-

We have a question from Kerry Ridgeway,

23:14

who's an assistant Professor of Economics

23:17

at the University of Nevada, Las Vegas,

23:19

and the, this question sort of fits in

23:22

to the spirit of this, the discussion

23:23

we've just been having.

23:25

Mr Ridgeway writes, several years ago

23:27

you participated in a seminar

23:29

Tape 146 - Franklin National, Flexible Exchange Rates, Ideas vs. Experience

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