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Postwar Changes in the American Financial Markets

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Postwar Changes in the American Financial Markets This PDF is a selection from an out-of-print volume from the National Bureau of Economic Research Volume Title: The American Economy in Transition Volume Author/Editor: Martin Feldstein, ed. Volume Publisher: University of Chicago Press Volume ISBN: 0-226-24082-7 Volume URL: http://www.nber.org/books/feld80-1 Publication Date: 1980 Chapter Title: Postwar Changes in the American Financial Markets Chapter Author: Benjamin M. Friedman, Milton Friedman, A. W. Clausen Chapter URL: http://www.nber.org/chapters/c11295 Chapter pages in book: (p. 9 - 100) 1 Postwar Changes in the American Financial Markets /. Benjamin M. Friedman 2. Milton Friedman 3.A.W. Clausen 1. Benjamin M. Friedman Financial markets are an integral part of the modern economy. The many and varied activities of financial markets both mirror and induce events in the economic system at large. Only rarely, however, do they serve as ends in themselves. Instead, they facilitate earning and spend- ing, saving and investing, accumulating and retiring, transferring and bequeathing—all activities at the core of economic life. In principle people could do all of these things without financial markets. In practice well-functioning financial markets enable people to do them more effi- ciently, and few economic events take place without financial counter- parts. Financial markets in fact constitute an essential vehicle through which the millions of different participants in the nonfinancial economy continually interact with one another. The needs and resources, as well as the objectives and concerns, that people bring to financial transactions are always changing. Greater pref- erences for homeownership, reduced concerns for providing for one's own or one's children's future, or the desire to take advantage of a new production technology, will influence what people seek from the finan- cial markets and hence what takes place there. New public-policy initia- tives, and the persistent advance in the technology (especially commu- nications technology) on which the financial markets rely in conducting Benjamin M. Friedman is professor of economics, Harvard University. I am grateful to Christopher Piros and Michael Burda for research assistance; to James Duesenberry, John Lintner, Sanford Rose, William Silber, Stephen Tay- lor, and James Tobin for helpful discussions and comments on an earlier draft; and to the National Bureau of Economic Research and the Alfred P. Sloan Foun- dation for research support. 10 Benjamin M. Friedman/Milton Friedman/A. W. Clausen their own business, may also effect change in the financial market. Moreover, because every transaction has two sides—a buyer and a seller, or a borrower and a lender—changes in what some people bring to the financial markets necessarily imply changes in what others find there. Hence financial markets act to transmit, not just absorb, the chain of events that originates in the nonfinancial economy, and in so doing they also importantly influence these events. Observing the financial markets therefore provides an additional perspective for understanding nonfinan- cial developments, even if the more basic origin of those developments is itself entirely nonfinancial. The experience of the American financial markets in the era since World War II, when compared to the corresponding prewar experience, presents both continuities and contrasts. A time-traveler from 1940, or even 1900, would probably feel more nearly at home on first disembark- ing in the financial markets than in most other major arenas of 1980 American economic activity. He would immediately recognize major classes of financial market participants and their chief activities, includ- ing banks taking deposits and making loans, insurance companies spreading risk and investing in securities, corporations borrowing to finance capital spending, and individuals both saving for their retirement and borrowing to buy houses. The chief items issued and exchanged in these markets are still currency and deposits, stocks and bonds, bills and IOU's. Even the principal financial events that are news today— large government financings, episodes of tight money, stock market ral- lies, or bulges in the corporate underwriting calendar—are happenings that attracted attention forty and in some cases eighty years ago. Much of this immediate familiarity, however, would pertain to the surface only. Behind the sameness of the players and their working vocabulary, in many respects the American financial markets are per- forming (or misperforming) their various functions differently today than they did years ago. Some changes have reflected the changing re- quirements placed on the financial markets by the nonfinancial economy, while others have reflected government actions, and in a few cases the primary impetus to change has been innovation within the financial markets themselves. The pace of change has not been uniform either. Some differences between today's financial markets and those of forty years ago represent a contrast between the prewar years and the post- war period as a whole, but others represent instead the ongoing process of change that has occurred throughout the postwar era. The object of this essay is to gain an overview of developments in the American financial markets since World War II, with particular atten- tion to changes that have occurred either between the prewar and post- war years or within the past several decades. Inevitably such an effort must be selective. The primary emphasis here is on the interaction be- tween the financial markets and the nonfinancial economy, in the sense 11 Postwar Changes in the American Financial Markets of the demands that the nonfinancial economy has placed on the finan- cial markets and the ways in which the financial markets have responded to these demands. In addition, much of this essay focuses on the evolv- ing role of government in the financial markets and on the changes that it has brought about. Questions pertaining to the internal organization of financial markets and financial institutions, and to financial innova- tions per se, are also important, but they will receive less attention here. Section 1.1 briefly sets the background for this analysis by reviewing some significant differences in the underlying economic climate between the prewar and postwar periods. Section 1.2 examines in detail the changes that have taken place in the financing of the economy's nonfi- nancial activity. Here the dominant trend of the postwar period has been the increasing tendency toward an economy financed by private rather than public debt. Section 1.3 explores changes in the ways in which fi- nancial markets have met these needs, with particular attention to the role of financial intermediaries and changes in patterns of intermediation. The dominant trend of postwar developments in this regard has been a continuing increase in the economy's reliance on financial intermedia- tion which, together with a series of innovations, has reduced barriers and frictions interfering with efficient capital allocation. Section 1.4 focuses on changes in the role of government in the financial markets. The major expansion of the federal government's financial activities during the postwar years has been in guaranteeing and intermediating the private sector's debt, as well as in regulating private financial trans- actions. In addition, section 1.4 provides a brief qualitative account of the ways in which both the conduct of monetary policy and its percep- tion by financial market participants have evolved during the postwar period. Finally, section 1.5 summarizes the principal conclusions of this survey and reemphasizes the interconnections among them. 1.1 Changes in the Underlying Economic Climate Although the focus of this essay is on changes in financial markets, it is helpful to begin by noting briefly a few of the major changes that have taken place in the underlying climate of nonfinancial economic activity.1 Three such changes are of particular relevance for understand- ing what has happened in the financial markets. First, the American economy in the postwar era has enjoyed much greater stability and prosperity than in the earlier decades of this cen- tury. Despite widespread early fears that "secular stagnation" would follow the country's demobilization after World War II, real output and incomes in the American economy in the postwar era turned out to be both stronger and steadier than in the corresponding prewar experience. As the first two columns of table 1.1 show, the postwar years—espe- cially the 1960s—have displayed not only greater economic growth on 12 Benjamin M. Friedman/Milton Friedman/ A. W. Clausen Table 1.1 Measures of United States Economic Conditions Rise in Growth of Real GNP Change in Equity Prices Consumer Price Index Years Mean S.D. Mean S.D. Mean S.D. 1911-20 1.7 5.2 -1.1 9.6 8.1 7.4 1921-30 3.1 7.9 11.5 17.0 -1.7 4.0 1931-40 2.6 8.8 -2.1 27.3 -1.6 5.0 1941-50 4.9 8.2 6.3 14.8 5.6 4.8 1951-60 3.3 3.2 12.4 12.6 2.1 2.3 1961-70 4.0 2.2 4.6 10.1 2.8 1.8 1971-78 3.4 3.1 2.6 13.6 6.7 2.5 Sources: U.S. Department of Commerce, Standard and Poor's, and U.S. Bureau of Labor Statistics. This table is in part adapted from Baily (1978). Note: Data are means and standard deviations, in percentage per annum. average (as measured by real gross national product) but also a smaller variability of that growth. The pattern of the business cycle, indicated in table 1.2 by the peak-to-trough decline in real gross national product for the thirteen cycles that occurred during the past sixty years, also highlights the increased stability of the postwar period.
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