Central banks' thinking at test: the unexpected birth and fate of the “Availability Doctrine”

By Pierrick Clerc (Swiss National Bank) and Eric Monnet (Bank of France, PSE, CEPR)

This draft. May 2019 Very Preliminary

Bridging the gap between history of economics and history of economic thought is an important venture. It requires considering economic knowledge produced outside academia, in governments, international institutions and central banks. This leads us to explore what sociologists of science call the “boundaries of science” (Gieryn 1983, Cartwright 1999, Lamont and Molnar 2002) and to investigate the relationship between academic and non-academic production of economic discourses. Even in countries with a strong postwar academic community of economists like the US, policy institutions produced economic thinking which was integrated into policy discourses, public or parliamentary debates and, sometimes, then, in academia. Central banks hired some economists and researchers but they did not have to meet academic requirements.

During the postwar period, we know at least three examples of economic doctrine shaped by economists in central banks and which eventually had a strong influence on national academic debates: the 1959 Radcliffe Report in England, the Économie d'endettement in France in the 1970s, and the “Availability Doctrine” in the United States in the 1940s-1950s. These doctrines were based on the work of central banks economists attempting to build their own theory so as to describe monetary policy implementation and formulate guidance for policymakers. They criticized mainstream monetary theory of their time for being too abstract and undocumented about the true process of money creation. They also blamed its incapacity to account for institutional differences in financial systems and monetary policy operations across countries. Most of these works were published in reports or documents rather than scientific journals. They however gained recognition in academia, by being reviewed and discussed by economists in scientific journals, textbooks and included in course syllabuses. As we will discuss in the last section of this paper, a similar story can be told today about the work that developed at the BIS in the early 2000s – and which became extremely influential after the 2008 financial crisis – on macroprudential policy and the risk taking channel of monetary policy

1 transmission (Borio & Zhu 2008). In the past and today, these approaches have in common that they criticize conventional monetary theory in academic circles because it is too disconnected from the implementation of monetary policy and it does not take into account the importance of the composition of financial institutions' balance sheets for both monetary policy transmission and financial stability.

Our research focuses on the Availability Doctrine, which was notably developed by Robert Roosa at the New York Federal Reserve in the late 1940s. Roosa served as Acting Manager of the Research Department since 1950 and was then Vice President of the New York Fed, in the Research Department, when he left this institution for the Treasury in 1961. The Availability Doctrine gained wide recognition in academia in the early 1950s, particularly through hearings at the US Congress (on credit controls and monetary policy) where it was debated. The published Congress hearings were considered as such an important piece of economic discourse that they were reviewed by James Tobin in the Review of Economics and Statistics. The Availability Doctrine was a narrow theory about monetary policy implementation but – as recognized by Jaffee and Stiglitz (1990) – eventually gave birth to the now standard theory of credit rationing which emerged in the 1960 and 1970s (Acosta 2016).

The distinctive feature of the Availability Doctrine is the change in emphasis, on the loanable funds market, from borrowers' to lenders' behavior. Its proponents argued that, due to changing institutional structures on this market and the large holding of public debt by banks after the war, lenders became strongly sensitive to variations in the yields on government securities. Therefore, contrary to a widespread belief at that time, monetary policy would have important effects on aggregate demand: even if the demand for funds were quite interest inelastic, monetary policy would nevertheless operate through the large response of the amount of funds made available by lenders to movements in yields on government securities.

The main message of the Availability doctrine was that quantities (rationing of bank assets) were much more important than prices (interest rates) for the transmission of monetary policy. Hence the term “availability” denoted the emphasis on “quantities”. Such conclusion relied on a detailed analysis of the shift in the composition of the assets of banks after a monetary policy shock. This shift was driven by market imperfections which were missing from standard models. The “doctrine” went against standard theories which focused on the money base or interest rates. It reasoned with the main concerns of policymakers at that times, that is the interaction between monetary policy and public debt management.

2 The Availability Doctrine cannot be understood without the institutional and historical context of postwar monetary policy (which notably had to deal with a massive amount of government securities in bank balance sheets). This doctrine was not supposed to be a general and full fledge theory that could be applied in all situations. Instead, it was very context-specific and recognized as such. It was indeed a “doctrine”, whose main objective was to set rules for policy actions. In a 2002 speech, Paul Volcker remembers that when he started as a young economist at the Fed in the early 1950s, “the idea that was promoted by this particular institution at the time was something called the availability doctrine”. 1 Moreover, even though its theoretical foundations were weak, the Availability Doctrine played a key role in showing the limits of mainstream academic models and in formulating new areas for research. As such, the historical study of the Availability Doctrine we aim to provide here is not only interesting for historians of monetary policy in the US. It is also an important, but underestimated, milestone of postwar economic thought. It also shows the limits of the usual interpretation of postwar monetary thinking as a mere fight between monetarists and Keynesians. The Availability Doctrine, as other central bank’ doctrines, cannot be understood on the basis of these usual categories (Monnet 2018).

Why was the Availability Doctrine developed at the New York Federal Reserve? We particularly stress two reasons. First, as acknowledged by Roosa, it was motivated by the perceived weaknesses of the leading monetary theories in the 1940s and 1950s as well as the evolution in the practice of central banking that occurred at that time in the US. Secondly, economists of the US central bank were looking at the experience of credit controls in European countries as a way to renew their thinking about the transmission of credit and monetary policy. This remains an hypothesis – as it was not explicit in Roosa’s writings – but the work of Roosa on French quantitative credit controls in the the late 1940s (at the time when the US Fed policies depended on open-market operations and reserve requirements only) might have led him to recognize the importance of the availability of credit for the transmission of monetary policy. Hence, international comparisons – which were an active task of the NY Fed research department in the 1940s – might have helped to design a theory especially adapted to the US context, but influenced by foreign experience with quantitative controls. Interestingly, Donald Hodgman - the University of Illinois Professor who made the connection between the Availability Doctrine and the modern theory of credit rationing in a 1960 article in the Quarterly Journal of Economics (Jaffee & Stiglitz 1990, Acosta 2016) – later became the most prominent US specialist of credit controls in Western Europe during the 1960s and 1970s (Hodgman 1971, 1972, 1973, 1974).

1 https://www.newyorkfed.org/research/economists/medialibrary/media/research/epr/02v08n1/0205volck.pdf 3 After 1945, economist became a profession in its own right, but through different institutions across countries (Fourcade 2002). Hence, institutions such as central banks played a key role of intermediary between economists and policymakers. In the US, the Federal Reserve of New York played such a key role as early as the 1940s. Some academic journals, like the Journal of Finance, devoted a large part of their publications to the description of monetary policy implementation and engaging debates on the means of intervention of the Federal Reserve in the money market. In times of major negotiated reforms of the international monetary system (Bretton Woods), central banks were also immediately exposed to the influence – if not of foreign economic thinking – of the diversity of monetary experiences and institutions in the Western world.

What were the relationships between the Availability Doctrine and academic research? We first discuss how this doctrine became legitimate among academic circles in the 1950s. We believe it was the case since the Availability Doctrine was elaborated within an important central bank, and that the NY Fed and Roosa had strong academic connections. Then, we detail the successive steps which led the Doctrine to gain recognition in this world, from the hearings of the Patman commission to the famous survey of Harry Johnson in 1962. We notably show that its increasing recognition was far from being linear and consensual, in particular because of its lack of theoretical underpinnings. A survey of the American Economist in 1965 shows that key articles of the Availability Doctrine still appeared in 3 out of 4 reading lists in monetary theory and policy (Thomas Kane at Princeton, Donald Hodgman at Univ. Illinois, Henry Wallich at Yale); only Milton Friedman (at that time Professor at Columbia Univ.) did not include it.

Looking further at the evolution of the Availability Doctrine and its differences with the other monetary theories, we argue that the Doctrine played an important role since it proposed a theory for which monetary policy affected aggregate demand independently from any interest rate mechanism, and in which finance and money interacted. Therefore, both monetarists (who insisted on the quantity of money) and Keynesians (most of whom considering that aggregate demand was interest inelastic) could have adhered to this doctrine. It was the case for leading neo-Keynesians (especially Franco Modigliani, Paul Samuelson and Tobin). Monetarists (such as Friedman, Karl Brunner and Allan Meltzer), however, hardly mentioned it since, on the whole, they perceived the Availability Doctrine as dealing with credit (rather than monetary) policy .

Besides its indirect (and unexpected) influence on the modern microeconomic theory of credit rationing through Hodgman (1960), the main influence of the Availability Doctrine on postwar 4 economic thought was probably on the various theories that developed in the 1950 and 1960 on the role of financial intermediaries, prominently the influential work of John Gurley and E.S. Shaw (1955, 1960).

The context of the Availability Doctrine: a growing research department and international influence

A key aspect of the Availability Doctrine is that it was not born as a pure academic debate. It circulated between Congress reports and debates, comments in academic journals and discussions at the Federal Reserve System [Fed]. The two papers that are usually seen as the key building blocks of the Availability Doctrine were written by Roosa in 1951 (at the time when his name was still spelt “Rosa”) (Roosa 1951a, 1951b), in the context of the “Douglas hearings”.2 These 1949-1950 hearings at the US Senate anticipated the March 1951 Accord between the US Treasury and the Federal Reserve System that would give independence back to the System by ending the peg of interest rates. The Douglas hearings took place because the Fed was criticized for not raising interest rates during the recovery of 1949 (Meltzer 2003, p.685-689). The problem of not being able to raise rate would become more blatant after the outbreak of the Korean War in mid-1950, which caused a massive rise in inflation. Discussions in the Congress, which echoed debates among practitioners and specialists of the Fed in other circles – summarized in Roosa’s 1951 essays - focused on the tools that the Fed could use to influence money and credit creation, once interest rates would be liberalized. Roosa surveyed these discussions and pointed out that they shaped a “revival of monetary policy” (Roosa 1951b).

The 1951 Accord did not end the discussion on monetary policy tools and the interactions between public debt management and monetary policy. The “Patman hearings” followed the Accord and gave rise to an increase participation of academics in the debates of monetary policy implementation. It is during these hearings that Paul Samuelson commented on Roosa’s argument and first formulated the link with credit rationing (Acosta 2016). These debates were notably surveyed by Tobin (1953) and continued to be often quoted in academic publications in the 1950s (see below).

Distinctive aspects of Roosa’s arguments were the focus on open-market operations and on the availability (quantity) of credit rather than interest rates. It became building blocks of the policy of Fed, as recognized by the institution in the Compendium of the Patman Hearings (Tobin 1953), and all the

2 81st Congress, 2d Session, Report of the Subcommittee on Monetary, Credit, and Fiscal Policies of the Joint Committee on the Economic Report, Senate Document No. I29 (Washington, U. S. Government Printing Office, I950). 5 more after the Federal Funds market became the main market for open market interventions of the Fed in 1954 (Meltzer 2010, vol 1, p.115) Contrary to other contemporaries, Roosa thought that it was sufficient to reconcile the objectives of debt management and monetary policy (Roosa 1952b). The success of the Availability Doctrine and its influence within economic circles until the late 1960 (see for example Kane & Malkiel 1965; Johnson 1962) was not only that it offered a good description of the policy of the Fed and its increasing reliance on open-market operations and the Federal Funds market. The Doctrine also provided a simple framework to think about monetary policy debates, even about instruments that were not implemented by the Fed. It was the case, for example, in the debate on “secondary reserve requirements”, that is a ratio of liquid assets (i.e government securities) that banks had to hold in proportion to their portfolio. First proposed by academics in 1940 (Riddle & Reierson 1946), it was then endorsed by Fed officials in 1945 and 1948, under the names “special” or “secondary” reserve requirement (Federal Reserve Bulletin, January 1948, Willis 1948, Romer and Romer 1993, Meltzer 2003 (p.645-650)), but the US Congress turned it down. Finally, such proposals emerged again in the late 1950s, especially motivated by European central banks experience with liquidity ratios (Fousek 1957, Ascheim 1958, McLeod 1959). As in other countries, these proposals aimed to define a set of liquid assets (Treasury bills, certificates, or notes, balances with Federal Reserve Banks, cash, etc.) and impose a requirement of such liquid assets calculated as a percentage of the deposits of banks. The objective of such tools were clearly to control inflation through credit restrictions; in the postwar context, financial stability was not an issue but credit expansion was seen as the primary source of inflation: “In order to provide a more effective means of restraining inflationary expansion of bank credit, the Board of Governors of the Federal Reserve System proposes that Congress pass legislation granting the System’s Federal Open Market Committee temporary authority to impose gradually as conditions may warrant a requirement that all commercial banks hold a special reserve” (Federal Reserve Bulletin, January 1948, p.14). As in foreign countries, the main rationale behind a US securities-reserve requirement was to avoid that banks sold government securities to obtain additional liquidity and increase their loans to the rest of the economy (Monnet 2018, Monnet & Vari 2018). Roosa was skeptical about this proposal (Roosa 1952a) and though that open-market operations could be sufficient to do achieve the same purpose. However, in the debates around the secondary reserve requirements, the main ingredients of the Availability Doctrine were often put forward, and especially the focus on the asset substitution within bank portfolio.

The debates on the secondary reserve requirements and the comments on the availability doctrine also reveal that, during this period, detailed policy contributions on the implementation of monetary 6 policy were published in academic outlets, especially in the Review of Economics and Statistics and, mostly, the Journal of Finance (and somewhat in British outlets: Economic Journal and Oxford Economic Papers). The articles published in the Journal of Finance were free of references to major theoretical works on monetary policy but were strongly rooted in institutional details (Miller 1950, McCraken 1953, Murphy 1953, Carson 1957, Ascheim 1958, McLeod 1959, Tussing 1966).

It is noteworthy that Roosa had published his first essay in a collective book written with academics and central bankers (1951a), and the other one in the Review of Economics and Statistics (1951b). Roosa moved the debate on monetary policy implementation outside of policy circles. He was in the position to do so because, in 1950, the research department of the New York Fed had already strong established connections with academic circles. It is striking in the book where Roosa (1951a) was published. This collective book (published in 1951, but the chapters were completed before June 1950) was edited in honor of John Henry Williams, who has been a key actor for building ties between the NY Fed and economics departments in major universities. Williams was a Professor at Harvard since 1933 and had joined, the same year, the New York Fed as Economic Adviser. In 1936, he became Vice- President of the NY Fed, in charge of developing the research department (while serving as a Dean of Harvard’s Graduate School of Administration). During these years, the research department attracted many economic advisors and, most of all, promising Phd economists trained in major universities (Robert Triffin, Richard Musgrave, Albert Hirschman, Henry Wallich, Charles Kindbleberger are examples who later joined academia as Professors of Economics). The 1951 book in honor of John Williams featured contributions by Roosa, Wallich and Allan Sproul - who were economists at the NY Fed - , by Musgrave, Triffin, Kindlberger - who used to work as the Fed -, and by Samuelson and Tobin. Roosa had obtained his PhD in economics from the university of Michigan in 1942 and joined the Fed in 1946.

If one looks at Roosa’s writings before his 1951 articles, two essays stand out as being possibly influential on his monetary thinking. First, Roosa wrote in 1947 a detailed study on the impact of the war on the portfolio of New York banks. Entitled “Impact of the war on member banks, 1939-1946”, it was published in the n°8 of “Postwar economic studies”, a series published by the Board of Governors of the Federal Reserve System.3 This study clearly highlights how banks allocated their portfolio between Treasury bills and loans. The substitution between these two types of assets, as well as the focus on the portfolio of lenders, would later become key ingredients of the Availability Doctrine.

3 https://fraser.stlouisfed.org/files/docs/historical/federal%20reserve%20history/bog_publications/pes_8_1947.pdf

7 Second, Roosa wrote an article with Albert Hirschman on French credit controls in 1949 (Roosa also wrote a more general – single authored - article on French postwar recovery, Roosa 1949)4. At that time, the French central bank was not yet using ceilings on credit growth (encadrement du credit), but mostly relied on rediscount ceilings, that is a limit on the funds banks can borrow at the central bank. It also implemented a minimum ratio or government securities for banks (equivalent to what was known in the US as “secondary (or securities) reserve requirement”). The rationale of this so-called “floor” of government securities was to fight inflation by preventing banks from selling government securities and increase their loans to firms. Roosa and Hirschman described in great details the implementation of these new measures in autumn 1948, their success to fight inflation and how they marked a shift from qualitative credit controls to quantitative credit controls. In retrospect, it is striking how this article contains a description of the key mechanisms that Roosa would later introduce in the US context to shape new arguments about the effect of open-market operations on the availability of credit. About rediscount ceilings, they wrote: “The ceilings are likely to restrain bank lending considerably. A bank receiving new deposits when its rediscounts are not far below its ceiling will lend cautiously because each additional bill will be an illiquid investment. The rediscount ceiling can in this way bring strong pressure on the banks to keep an increasing percentage of their new deposits in the form of cash or short-term Government securities. In this respect, therefore, this ceiling may be a more potent restraint on credit expansion than are reserve requirements, which (from the individual bank's point of view) tie up the same proportion of deposits however large their increase” (p. 355). Roosa never advocated the use of rediscounting ceilings by the US Federal Reserve and he firmly opposed the introduction of a floor of government securities (named “secondary reserve requirements” in the US) (Roosa 1951a, 1952a). He knew that contrary to Europe, open-market operations were al- ready the main instrument of interventions of the Federal Reserve. US banks financed themselves on the money market whereas European banks were mainly indebted towards their central banks (Monnet 2018). So – even if he did not formulate explicitly the comparison - Roosa was convinced that the same effect as rediscount ceilings could be obtained in the US through open-market operations. Interestingly, Roosa and Hirschman were thinking about the US context when they wrote their article on France be- cause they compared the French rediscount ceilings to “reserve requirements” (denoting cash-reserve requirements, not “secondary reserve requirements”). Cash reserve requirements were the key mone-

4 In the late 1940s, the New York Fed and the Federal Reserve Board participated actively to the strong interest of the US administration in the recovery of the European economy. Many publications dealt with this topic (focusing on economic recovery and halting hyper inflation) and appeared in the Federal Reserve Bulletin or in the Fed journal Review of Foreign Developments https://www.federalreserve.gov/pubs/rfd/1948/

8 tary tool of the Federal Reserve since 1933 (together with growing open market operations), but it was not used in France. Hence, when they claimed that “this ceiling may be a more potent restraint on credit expansion than are reserve requirements” they were explicitly suggesting that the French experience could provide a more effective tool than the traditional US reserve requirements. Roosa continued to criticize reserve requirements in his subsequent writings (1951a, 1951b), whereas he was looking for open-market operations to have the same effects as the French rediscount ceilings.

The Availability Doctrine, monetarists and neo-Keynesians

In this section, we first provide a formal description of the Availability Doctrine. We then review the reactions of leading neo-Keynesians and monetarists to this latter in the 1950s and 1960s. a) A formal description of the Availability Doctrine

Our presentation of the Availability Doctrine closely follows the one delivered by John Kareken (1957).5 We consider four economic agents and three financial assets. The economic agents are the government, the monetary authority, private lenders (and especially commercial banks) and private borrowers. The financial assets are cash (i.e. the medium of exchange, issued by the monetary authority), government bonds (issued by the government) and private bonds (issued by private borrowers). The monetary authority realizes open-market operations: in the market for government bonds, the central bank either sells or purchases (against cash) such bonds to private lenders, generating movements in their yield (i.e. in the government rate of interest). An open-market sale, for instance, produces a rise in the government rate of interest. At the same time, private lenders operate in the market of private bonds (henceforth the 'private market'). There, they supply funds (cash) against private bonds. Conversely, private borrowers demand funds and issue private bonds. The private market is represented by Figure 1. It is assumed that the supply of funds by private lenders is a positive function of the private rate of interest rp (i.e. the yield on private bonds) while the demand for funds by private borrowers is a negative function of this rate. Moreover, supply and demand for funds in the private market can also depend on the government rate

6 of interest rg. For simplicity, we take the demand for funds as insensitive to this rate of interest.

5 Lindbeck (1966) also proposed an extensive treatment of the Availability Doctrine and considered additional effects. 6 Lindbeck (1966: 41) notably showed that variations in rg generates three effects (in opposite directions) on the demand 9 Instead, the supply of funds is assumed to depend on rg. The elasticity of the supply of funds with respect to the government interest rate is one of the crucial issues raised by the Availability Doctrine.

The proponents of the Availability Doctrine put forward essentially two mechanisms explaining why an increase in rg would generate a fall in the supply of funds in the private market (i.e. a negative elasticity of this supply with respect to rg). First, there would be some “lock-in” or “pin-in” effect. A rise in rg means a fall in the price of government bonds. This implies that private lenders, who hold government bonds, would realize capital losses if they sold these bonds at the new lower price. The reluctance to realize such losses decreases the willingness of private lenders to switch out of government bonds and into private bonds. Secondly, there would be some uncertainty or “wait and see” effect. A rise in rg would create a feeling of uncertainty about the future course of interest rates and economic activity. Subjective estimates of the risk of specific loans are therefore revised upward, making private lenders less willing to supply funds in the private market. Hence, both the “lock-in” and

7 the “wait and see” effects entail a fall in this supply. In Figure 1, a rise in rg (from rg to rg' thus induces a leftward shift in the supply curve of funds (from S to S').

Two structural changes, occurring in the aftermath of World War II, would have raised the (negative) elasticity of this supply with respect to rg. First, the increase in the volume of funds handled by private lenders, associated with their enhanced professionalism, would have make them more reactive to variations in relative yields. Secondly, the growth of public debt implies that more private lenders are directly affected by movements in rg. In this connection, Johnson pointed out that the “widespread holding of public debt, particularly by financial institutions and corporations, facilitates monetary control by transmitting the influence of interest-rate changes effected by open-market operations throughout the economy” (1962: 371). As a result, both of these structural changes would have amplified the shifts of the S curve in response to a given variation in rg. In other words, a given shift in the supply curve of funds could now be obtained through smaller changes in rg.

According to the proponents of the Availability Doctrine, the arguments of the two last paragraphs would lead to the following conclusion: monetary policy can have a strong impact on aggregate demand, whatever the sensitivity of aggregate spending to interest rates. A small rise in rg entails a strong fall in the supply of funds available to borrowers, inducing a fall in aggregate spending even if

for funds which are roughly offsetting. 7 Roosa (1952b) however made clear that the second of these effects would be much more important than the first one. 10 this latter is insensitive to rp. Hence, a tight monetary policy can curb inflation through small increases in rg. Large increases in this rate are not required to stem inflationary pressures, therefore allowing to avoid the potentially dramatic rise in the burden of public debt often emphasized by the opponents to monetary policy at that time.

However, as notably stressed by Kareken (1957), this line of argumentation has an important weakness. Indeed, the volume of funds actually traded in the private market crucially depends on the slope of the demand curve D. If the elasticity of this curve is low (i.e. a D curve almost vertical in Figure 1), a shift of S to the left will leave the volume of funds exchanged almost unaffected, thus limiting the effectiveness of monetary policy. This is the kind of criticism addressed by early Keynesians (such as Hansen) to monetary policy (the so-called “elasticity pessimism”). In the words of Kareken: “the possibility that borrowers may be highly insensitive to changes in private yields raises the same problem for this theory that it did for other theories” (p.300-301). It is for this very reason that a third mechanism (besides the “lock-in” and “wait and see” effects) is essential for the Availability Doctrine: that of credit rationing.

Credit rationing means that in the private market, the supply of funds is, at the current rp, lower than the demand of funds. For some reasons, lenders decide to restrict the volume of funds made available to borrowers, rather than to increase rp so as to clear the market. In Figure 2, this situation occurs when,

1 1 for the curves S and D, the volume of funds traded is Qs (at the rate rp ) rather than Q* (at the rate rp*).

1 1 Credit rationing thus amounts to the gap between Qd and Qs . By itself, credit rationing does not allow to raise the effectiveness of monetary policy. This can be seen from Figure 2. In response to a rise in rg, S shifts (due to the “lock-in” and “wait and see” effects)

2 2 towards S'. If rp is perfectly flexible, the volume of funds exchanged is Qs (at the rate rp ). The degree

2 2 1 1 of credit rationing is not affected (Qd – Qs = Qd – Qs ). Consequently, the volume of funds traded

2 1 display the same variations as would happen without credit rationing (Qs – Qs = Q** – Q*).

Moreover, the elasticity of borrowers with respect to rp is still critical to the effectiveness of monetary policy. Credit rationing is, however, an important ingredient since it prepares the ground for the introduction of the crucial feature, namely the stickiness in rp. Indeed, the assumption that this interest rate does not adjust instantaneously to shifts in S and D is often introduced along with credit rationing.

In Figure 2, combining credit rationing and a sticky rp implies that (in response to a rise in rg) the

3 volume of funds exchanged becomes Qs . In this case, the volume of funds traded is independent from the interest-elasticity of borrowers and the effectiveness of monetary policy is substantially enhanced.

11 b) Neo-Keynesians and monetarists on the Availability Doctrine

In his review of the Patman Inquiry, Tobin argued that “The important varieties of monetary theory espoused to the committee may be... classified into three schools” (1953: 122). The first one “whose intellectual headquarters is Chicago, believes that aggregate spending is sensitive enough to the rate of interest, and hoarding insensitive enough, to make the quantity theory a good approximation”. The second “agrees that the issue hinges on the sensitivity of spenders and hoarders to interest rates. But this group is skeptical about the interest-elasticity of spending and is impressed more with the variability than with the constancy of monetary velocity”. The third “has developed and spread rapidly in recent years... According to this theory, monetary controls work much more through restricting the availability of credit than through increasing its cost, much more through restraints on lenders than through reactions of borrowers”. The first school is obviously that of monetarists (called at that time “quantity theorists”), the second that of neo-Keynesians: “In the panel discussion... Milton Friedman and Paul Samuelson represented ably these two points of view”. The third school “Under the leadership of Robert V. Roosa and others” embodies the proponents of the Availability Doctrine.

Here, we describe the reactions to the development of the Availability Doctrine of three leading neo- Keynesians (Samuelson, Tobin and Modigliani), three leading monetarists (Friedman, Brunner and Meltzer) and of an economist who had (more or less) a foot in each camp (Johnson). We shall see that neo-Keynesians laid a particular emphasis on the imperfect competition aspect of the Availability

Doctrine, namely credit rationing with sticky rp. On the other hand, monetarists completely disregarded this doctrine, mentioning it only sparsely (and with a negative tone).

Samuelson pointed out very early the critical role played by credit rationing in the Availability Doctrine.8 In 1952, Samuelson participated in one of the many hearings held before the Patman committee. There, he stressed that the usual mechanisms associated with the Availability Doctrine (i.e. the “lock-in” and “wait and see” effects) are not enough to ensure the effectiveness of monetary policy. He thus argued that “we have to go to a different aspect of this argument, which is a more subtle one,

8 Acosta (2016) shows that the importance of credit rationing in the Availability Doctrine was raised by Samuelson and not by Roosa. 12 and is an ancient one, but has been resurrected in recent years - and I think properly so - namely, that the market for borrowing funds is an imperfectly competitive one... The imperfect competition aspect of banking is absolutely crucial for the recently fashionable doctrine that the central bank gains its leverage not through its effects upon the cost of credit but by its effects upon the availability of credit” (1952: 695-696). By “imperfect competition”, Samuelson obviously meant credit rationing. He also made clear that what matters for the effectiveness of monetary policy is not this imperfect competition per se, but the fact that this latter increases in response to a tightening in monetary policy: there would be “good reasons why in the short run in an imperfectly competitive market you will not change your charges but simply increase the frequency with which you arbitrarily say 'No' to people” (p.697). This increased imperfection would nevertheless be only short-lived since private lenders would shortly raise rp (in response to an increase in rg), inducing the market to return to its initial degree of credit rationing.

In his review of the Patman Inquiry, Tobin also highlighted the prominence of credit rationing (with sticky rp) for the Availability Doctrine: “Second, and more important, the increase in yield makes government securities more attractive relative to alternative investments because the rates on other assets are kept from rising by institutional rigidities in the market. Lenders will, therefore, ration credit to private borrowers, and some willing borrowers will simply not be accommodated” (p.123). Tobin also concurred with Samuelson about the short-run dimension of such a mechanism: “This argument relies, as Professor Samuelson pointed out, on an increase in the imperfection of the market as a consequence of the initial rise in bond yields. There must be more rationing of credit than there was before. The importance of the argument depends on the persistence of the increase in imperfection. If the rates available to private borrowers are fixed for a long period, the theory uncovers important new potentialities for monetary control. If these rates are within a short time free to adjust upward to compensate for the increased yield and attractiveness of government securities, the contribution of the new theory is more modest”. However, even if short-lived, these effects “may be exceedingly useful to a central bank which wishes to dampen spending without raising interest rates much, or fears that demand is in any case not very responsive to the level of rates. If the inflationary pressure which the central bank wishes to oppose is itself temporary, the transient effects may be enough to do the job”.

Modigliani entitled the fifth section of his 1963 article “Imperfections in the capital markets – the Availability Doctrine”. There, he claimed that it was “the merit of the availability doctrine, advanced in the postwar period, that it made a convincing case for the proposition that disregard of certain

13 institutional imperfections of the capital market leads to an unsatisfactory and seriously distorted view of the modus operandi of monetary policy and its consequences” (p.97, italics in original). In a similar way as Samuelson and Tobin, Modigliani put forward the critical role of credit rationing combined with sticky rp : “Here we shall be concerned primarily with one argument which seems to have the greatest validity and general applicability: the proposition that interest rates charged to borrowers by financial intermediaries are largely controlled by institutional forces and slow to adjust at best; and that the demand for funds is accordingly limited not by the borrowers' willingness to borrow at the given rate but by lenders' willingness to lend - or, more precisely, by the funds available to them to be rationed out among the would-be borrowers” (p.98). After having introduced these ingredients into a reframed version of his 1944 (IS-LM) model, he concluded that “It appears from the above analysis that the recognition of the role of intermediaries and market imperfections in the guise of sluggish lending rates and of direct rationing rather than price rationing has certain significant implications. First, it helps to account for fluctuations in market lending rates which appear rather modest in relation to likely cyclical swings in the return from investment. Second, it implies that monetary policy may affect aggregate demand without appreciably affecting lending rates, at least in the short run” (p.100). The third implication is, however, more surprising: “Third, it suggests that monetary policy - understood now as the control over the power of banks to create money rather than over the actual money supply - may break down under less stringent conditions than those of the original Keynesian case”. Indeed, when the return from investment falls significantly below sticky lending rates, an increase in the volume of funds made available to borrowers would not induce these latter to borrow.

Intuitively, one would believe that monetarists displayed some interest in the development of the Availability Doctrine: its stress on quantities (rather than on interest rates) and its consideration of a larger range of financial assets fit well with the tenets of monetarism (see, for instance, Friedman 1970: 10-11). But this intuition tuns out to be misleading. To the best of our knowledge, Friedman did not even mention the Availability Doctrine in his writings. The very reason can be found in a paper first published in 1964 (and reprinted in his 1969 book), where he carefully distinguished “monetary” from “credit” policy: “I think this is a distinction of first rate importance, and yet one which is much neglected... When I refer to credit policy, I mean the effect of the actions of monetary authorities on rates of interest, terms of lending, the ease with which people can borrow, and conditions in the credit markets. When I refer to monetary policy, I mean the effect of the actions of monetary authorities on

14 the stock of money - on the number of pieces of paper in people’s pockets, or the quantity of deposits on the books of banks” (Friedman 1969: 77). Under this taxonomy, therefore, the Availability Doctrine belongs to credit policy, not to monetary policy. It is small wonder that Friedman disregarded it.9 Furthermore, Friedman went on to argue that the confusion between monetary and credit policy had had dramatic consequences: “The distinction that I am making between credit and monetary policy may seem like a purely academic one of no great practical importance. Nothing could be farther from the truth. Let me cite the most striking example that I know; namely, U.S. experience in the great depression from 1929 to 1933. Throughout that period the Federal Reserve System was never concerned with the quantity of money. It did not in fact publish monthly figures of the quantity of money until the 1940’s... Prior to that time... (t)here was much emphasis on the availability of loans, but there was no emphasis and no concern with the quantity of money. If there had been concern with the quantity of money as such, we could not have had the great depression of 1929-33 in the form in which we had it” (p.78). He restated this conclusion a decade later: “In my view, the confusion between credit policy and monetary policy has been a major factor in essentially every mistake in monetary policy since the Federal Reserve System was established ” (Friedman 1972: 193). Two other reasons could explain Friedman's lack of concern about the Availability Doctrine. The first reason is related to one of the main components of the Doctrine, namely credit rationing. Discussing the concept of “capital rationing” in 1951, Friedman claimed that his “own judgment is, however, that (capital) market imperfections are not very significant” (Friedman 1951: 190, brackets added). The second reason deals with the weak place devoted to the demand for money in the Availability Doctrine. By contrast, the demand for real balances is a key element in Friedman's monetary framework.

Brunner and Meltzer, on their side, mentioned the Availability Doctrine on two occasions. The first one dates back to 1961, when Brunner declared: “In the late forties belief in the effective operation of monetary policy surged up again, nurtured to a good extent - as it should be - by the Federal Reserve authorities. The resurgence was associated with the emergence of the so-called availability doctrine, an idea intended to exhibit the structure of monetary processes and thus provide a cognitive basis for a rational belief in the efficacy of monetary policy. Unfortunately, it was more doctrine than adequately formulated theory, more impressionistic fragment than meaningful hypothesis. No wonder, therefore,

9 In this connection, it is worth recalling that, among the 4 reading lists in monetary theory and policy we have mentioned in the Introduction, Friedman's list is the only one which mentions neither the Availability Doctrine nor Roosa's contributions. 15 that a new skepticism grew in the second half of the past decade” (p.605). The second one can be found in Volume II of Meltzer's History of the Federal Reserve: “Robert Roosa (1951) challenged the orthodox view at the time, claiming that since banks held a large volume of government securities, the central bank was 'capable of reaching any segment of the rate structure'. This accorded with New York's position that operations should be conducted at all maturities. Roosa highlighted 'availability'. By reducing availability and raising interest rates, he claimed the Federal Reserve made lenders less willing to lend. Availability, or its absence, dominated the rate change; and Roosa’s emphasis is on the desire of lenders to lend, not on the willingness of borrowers to borrow or the cost of capital relative to the return on investment. Rising interest rates affected investors by creating uncertainty, thereby inducing investors to shift into short-term securities. Roosa’s conjectures remained incomplete and, as noted by Robertson (1956), required borrowers and lenders to draw opposite inferences from a change in interest rates” Besides its lack of theoretical underpinnings, there is certainly another reason which explains why Brunner and Meltzer disregarded the Availability Doctrine. These authors built, in the 1960s and 1970s, alternative variants of a model devoted to formalize the transmission mechanism of monetary policy put forward by monetarists (see, for instance, Brunner and Meltzer 1972). The crucial feature of this mechanism lies in the variations of the relative price of existing real capital and newly produced real capital (equivalent, to some extent, to Tobin's Q). In response to an increase in the growth rate of the money base, it is the resulting increase in this relative price which induces producers to substitute newly produced for existing real capital, generating a rise in output. In one of their variants, Brunner and Meltzer considered financial intermediation (see notably Brunner and Meltzer 1990) but showed that the basic mechanism remains the same. Even if the Availability Doctrine enlarges the range of assets encompassed, it does not, however, involved existing real capital. The central feature of the Brunner and Meltzer's model is therefore absent.

Let us finally turn to Harry Johnson. It is rather difficult to rank him among either neo-Keynesians or monetarists. Moggridge raises that in the context of the 1960s-1970s, Johnson “looked monetarist and was usually so regarded” (2010: 320). Nonetheless, Moggridge convincingly shows that Johnson actually “maintained his own brand of consensus Keynesianism” (p.329), so that “he did not align himself with the monetarists”. David Laidler had previously developed the same viewpoint, arguing that Johnson “never became a 'monetarist' as the term is understood in North America” (1984: 593).

16 This ambivalence in Johnson's position is reflected in his treatment of the Availability Doctrine. He devoted almost three pages to this doctrine in his famous 1962 survey. Johnson notably stressed that “the doctrine and discussion of it have helped to popularize the concept of 'availability of credit' as one of the main variables on which monetary policy operates” (p.371). Importantly, “The emphasis on the availability of credit as a determinant of expenditure has led to a critical re-examination of the business-attitude survey findings that formerly were used as evidence that business investment is insensitive to monetary policy. In addition, monetary theorists have tended to raise their estimates of the sensitivity of business investment to changes in the cost of credit. These reassessments have been based on the opinion that investors' expected profits are more finely and rationally calculated than used to be thought, rather than on any impressive new empirical evidence of such sensitivity” (p.372). However, he recognized some important weaknesses, especially “a doubtful asymmetry between the reactions of lender and borrower expectations to interest-rate changes... as well as to involve some logical inconsistencies” (p.371).

Johnson’s statements are reminiscent of those of Gurley and Shaw in their influential paper on the role of financial intermediaries for economic development (Gurley and Shaw 1955): “This availability doctrine acknowledges the parallelism between banks and other intermediaries. It imposes on the central bank responsibility for supervision over indirect finance generally rather than over indirect finance through banks alone. We cannot be sure that it is based on a sound estimate of intermediaries' portfolio practices, but we do regard it as a provocative step in the transition to theorizing about financial control as distinct from monetary control” (p.538). These remarks converge towards a key role of the Availability Doctrine in the studies that attempted to introduce into academic thinking a better description of the role of financial intermediaries.

From the availability doctrine to the risk-taking channel

In the current post-2008 context where the importance of market imperfections and portfolio rebalancing is recognized as a key channel for monetary policy transmission, the availability doctrine may offer some interesting insights. While the availability doctrine was mostly conceived to interpret the impact of restrictive monetary policy (an increase in the central bank’s interest rate and sales of government securities), a similar reasoning can be apply to today’s unconventional expansionary monetary policy. The main contribution of the availability doctrine was to show that a small increase in

17 the interest rate could have a large effect, because of a greater shift in quantities (the availability of credit). When applied to expansionary monetary policy in the current context, it would mean that a small decrease in the interest rate of the bank (even near the zero lower bound) can have large effect if it is accompanied by purchase of government securities (quantitative easing). The availability doctrine relies on two key market imperfections. First, government securities and loans are not substitute in the portfolio of policymakers (this assumption was frequent in Tobin's work and also key in the toy model of Bernanke & Blinder 1988). When the price of government securities increase (i.e the interest rate on those securities falls), financial institutions expect a capital gain and sell their bonds to the central bank. They expect to benefit from a higher return by lending at a higher rate than the rate on government securities. Second, for this increase in the supply of loans to have an effect on the aggregate volume of loans, there must be credit rationing, so that the demand for credit usually exceeds supply. Applied to current quantitative easing, it means that the effect of purchases of government securities by the central bank will increase the supply of loans through a shift in the portfolio of banks. If there is credit rationing, this effect can occur even if the decrease in the interest rate is small. Another implication of the availability doctrine is that quantitative easing can work only if government securities are purchased by the central bank. The observed sharp increase in housing credit in recent years seems consistent with the predictions of the availability doctrine. Since the loans of today’s banks are mostly housing loans, and that there is evidence of credit rationing of consumers in the housing loan market, it seems natural to see an effect of quantitative easing on the increasing supply of housing credit. Such mechanism is exactly the one described in Kandrac and Schlusche (2017). However, if – as it in fact happened – banks prefer to deposit with the central bank as excess reserves the cash that they received from selling government securities, it would be interpreted as an absence of credit rationing. There is no demand to meet the increase in the supply of loans. Kandrac and Schlusche (2017) nevertheless show that the increase in excess reserves has been accompanied by an increase in lending. Fuerst (1994) provided a recent model of the “availability doctrine” but focuses only on the credit rationing part (through an early costly state verification mechanism) rather than on the substitution between government bonds and loans in the portfolio of banks. So, if we want to find recent work that incorporates the key insights of the availability doctrine, we need to look elsewhere. The substitution between government bonds and loans which is at the heart of the availability doctrine has been reintroduced in the recent literature as a “risk taking channel” (Borio & Zhu 2008;

18 Dell”Ariccia et al. 2017): when safe assets earn little, banks turn to assets and loans with a higher return. Interestingly the “risk-taking channel” share other similarities with the availability doctrine. First, it was developed by economists in a central bank (C.Borio at the BIS) who – as Rosa – where unsatisfied with the unability of current models of monetary policy to take into account the impact of substitution between bank assets on the transmission mechanism of monetary policy. Second, the “risk taking channel” emphasizes the importance of risk perception, in a way which is reminiscent of the “wait and see” channel of the availability doctrine. Third, both the availability doctrine and the risk taking channel are well suited to understand the potential interaction between monetary policy and bank regulation. Debates that originated in the US in the 1950s on the secondary reserve requirements (i.e liquidity ratios, see Monnet & Vari 2019) were enlightened by the availability doctrine. The current work on the risk taking channel has also clear implications on the interaction between capital regulation, liquidity regulation and monetary policy transmission (Borio & Zhu 2008; Adrian & Shin 2010). Current work should benefit from the insights of the availability doctrine and the theoretical discussions that followed the work of R. Rosa. They clearly explained the market imperfection that were necessary for this mechanism to be at play, and – most important – tried to think at a general equilibrium level by taking into account the demand of credit. This is missing in the work on the risk taking channel of monetary policy.

Conclusion

Can the history of the Availability Doctrine suggest general conclusions about the diffusion in the academic world of theories established in an economic policy context? First of all, it should be noted that Roosa was not a complete outsider of academic research, nor a policymaker who would have written without reference to the theories in progress in the academic world. The entry of the Availability Doctrine into the academic debate must be understood in the context of the rise of the legitimacy of the New York Fed's research department from the end of the 1930s onwards and its connections with university research. Moreover, many American academic journals (notably the Review of Economics and Statistics and the Journal of Finance) devoted articles and comments to institutional discussions and very specific debates on the implementation of monetary policy, where formalized theory was completely absent. In this sense, the history of the Availability Doctrine is really illustrative of the functioning of economic research in the United States in the 1950s and 1960s, with strong interactions between various circles (as evidenced in publications in academic journals and in

19 professional backgrounds). In many respects, parallels can be found with the research work developed at the IMF in the 1960s, for example, and its many interactions with academic research in international economics.

The history of the Availability Doctrine also shows how a theory can have diverse and unexpected influences. It is perhaps on this point that more general conclusions can be drawn. We see how the success of the Availability Doctrine was due to the fact that it described empirical mechanisms that were absent from the academic literature. It thus appeared to many authors - even those who criticized its lack of theoretical foundation - as a necessary perspective from the world of administration and political implementation. It seemed that the academic literature was admitting its need to be influenced by thinking closer to the actual functioning of financial markets and banks. Thus, the Availability Doctrine continued to be presented in the various articles as a pathbreaking central bank point of view, but not as an academic theory.

In the end, it is clear that, beyond its indirect influence on the subsequent microeconomic literature on credit rationing, it had an important influence on the work of the 1950s and 1960s that tried to reconcile a monetary and financial approach (particularly in line with the influential publications of Gurley and Shaw on financial development, or with the emphasis of Tobin and Mogliani on the imperfection of financial markets and the importance of portfolio rebalancing). One may wonder whether the rise in legitimacy of monetarism and – later – real business cycle theory, did not dismiss too much this strong intellectual tradition alive in the post-war debate. In this respect, we believe that it is worth drawing parallels between the availability doctrine and the recent work promoted under the guidance of the BIS which emphasizes the interlinkages between monetary policy and financial stability (and especially the so –called “risk taking channel”). Both were formulated outside academia and – rather and a full-fledged theory – aimed at addressing key policy issues based and a contextualized approach of the interactions between monetary policy and the state of the balance sheets of financial institutions

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r p

S'(r ' ) g

Figure 1: the Availability Doctrine without credit rationing

S (r ) g

'

D 24

Q

25

Figure 2: the Availability Doctrine with credit rationing and sticky rp

r p

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S (r ) g

r 2 p r * p

' r 1 p

D

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26