How to Control Credit

September 1, 1958

Within a period of ten days the Federal Reserve authorities illustrated first the wrong and then the right way to control inflation. On Aug. 14 they raised the margin requirements for buying stocks from 50 to 70 percent. On Aug. 14 they permitted the Federal Reserve Bank of San Francisco to raise its discount rate from 1¾ to 2 percent. The first method is what is called “selective” credit control. The second is what is called general credit control. Only the second is equitable and effective.

The targets of selective credit controls are always politically selected. The stock market is the No. 1 target because those with no understanding of its role and function in the American economy regard it as a sort of glorified gambling casino. As G. Keith Funston, president of the New York Stock Exchange, said in a speech last October:

“I sometimes wonder at our sense of proportion. A man can borrow up to 75 percent to buy a car, 100 percent to buy a washing machine, and 94 percent to buy a house. But he can borrow only 30 percent to buy an interest in the company that makes the car, the washing machine, or the house. We have made it much easier to borrow in order to spend, than to borrow in order to save.”

THE CREDIT FLOOD

In addition to being discriminatory, these rigid restrictions on stock-buying margins are also in the long run futile. We cannot encourage a general inflationary flood and then expect to dam off its effects in one direction. Credit, like water, seeks its level and leaks through every crack. If a man is determined to buy shares, and does not have the required legal margin, he can mortgage his house or other assets and use the proceeds in the stock market.

Raising stock-market margin requirements seldom has the intended effects. No statistics can show, of course, what might have happened to stock-market credit or prices if margins had not been changed. But most margin increases have shown little effect on stockmarket credit.

Nor is it easy to justify the latest rise of margin requirements on this ground. As Funston has pointed out, customers’ net debit balances on June 30, 1958, totaled $3.1 billion, which represented only 1.4 percent of the market value of all stocks listed on the New York Stock Exchange on the same date, a ratio almost exactly the same as it was a month earlier or a year before. He might have gone on to point out that it was only half the ratio of 2.8 percent that prevailed in 1955, in the whole period from two to six months after margin requirements had been raised to 70 percent in April.

RED LIGHT

Increases in margin requirements have sometimes temporarily halted the upward movement of stock prices, but never for more than a month or two. In fact, in every instance of a margin increase from February 1945 through April 1955, stock prices six months later averaged at least 12 percent higher than in the six months before the margin change. That is what we might have expected. The price that people pay for stocks is primarily determined by the expected yield from those stocks and the capitalization of that yield as affected by interest rates.

But because the increases in legal stock margin requirements have not had their intended effect, it does not follow that they have done no harm. Their main effect, careful comparisons show, has been to reduce the volume of trading—sometimes as much as 25 percent. This does not merely mean that brokers lose commissions. It reduces the liquidity of the market and throws a damper on the willingness and ability of corporations to raise new money through stock issues.

An increase in the Federal Reserve discount rate is a move in the right direction. Yet it is not the Fed’s bad judgment in forcing the discount rate down to 1¾ percent that is being criticized by the apostles of inflation, but its return toward mild restraint. It is an ominous sign—on both sides—when the majority of standard common stocks sell at a lower yield than long-term government bonds. Some brokers are calling this a “flight from the dollar.” We will disregard this red light at our peril.