Markets are becoming more interconnected. Financial instruments are becoming more complex: Distinctions between banks and other financial intermediaries are blurring; integration of economies and financial markets is increasing.[1]

Alan Greenspan (1993)

Ex-Chairman of the Federal Reserve System

 

A maze of state and federal laws historically limited competition among bankers. Rural banks once depended primarily on local customers and nearby farmers, while banks in big cities catered to their own neighborhoods. The expansion of interstate trade generated pressure for legal reforms to allow banks to merge and to establish branches. Thus, banking is increasingly concentrated in the hands of bigger banks, many of which are owned by bank-holding companies that operate what are effectively branch banks located across state lines. However, pressure for financial reform continues, largely because of growth in international competition.

 

            The growth of international trade is apparent in our diets, the clothes we wear, and the cars we drive. Internationalization of financial markets is proceeding at an even faster clip. Annual GDP in the United States is roughly $7 trillion, and annual gross world product is about $35 trillion, but every day, almost $1 trillion in foreign currencies is traded in foreign exchange markets. Exchange rates (the relative prices of different currencies) for some of the world's more important currencies are shown in Table 3. Arbitrage and speculation to ensure that exchange rates are virtually identical in all countries underpin the bulk of these vast international flows of funds. Some of these flows, however, reallocate economic investment from countries with net saving into countries where investments in

physical capital appear more profitable.

 

Table 3  Foreign Exchange Rates---Key Cross-Currency Exchange Rates for Major Countries Late New York Trading May 8, 1991 (to be updated)
	Dollar	Pound	SFranc	Guilder	Yen	Lira	D-Mark	FFranc	CdnDollar
Canada	1.36	2.02	0.94	0.70	0.00	0.00	0.66	0.19
France	5.86	10.08	4.00	3.00	0.04	0.00	3.38		5.08
Germany	1.73	2.97	1.18	0.88	0.01	0.00		0.29	1.50
Italy	1282.00	2204.80	875.68	656.76	9.27		740.01	218.58	1112.30
Japan	138.30	237.85	94.46	70.85		0.10	79.83	23.58	119.99
Netherlands	1.95	3.35	1.33		0.01	0.00	1.12	0.33	1.69
Switzerland	1.46	2.51		0.75	0.01	0.00	0.84	0.24	1.27
U.K.	0.58		0.39	0.29	0.00	0.00	0.33	0.09	0.50
U.S.		1.71	0.68	0.51	0.00	0.00	0.57	0.17	0.86
Source:  Telerate   These tables showing cross exchange rates appear in the Wall Street Journal and other major newspapers almost every day.  Note that, paralleling Table 1 in Chapter 12, the numbers below the blank diagonal are reciprocals of numbers above the diagonal. For example, the U.S. dollar's exchange rate for the Canadian dollar is shown in row 1, column 1, while the Canadian dollar's exchange rate for the U.S. dollar is in the last row, last column.

 

            The accelerating speed at which money changes hands in international money markets has been accompanied by dramatic changes in international banking. In 1970, all of the world's 10 largest banks were headquartered in the United States. Erratic inflation, the dollar's loss of dominance in world money markets, the growth of other economies, and a host of other factors have created pressures for change. Today, the United States holds approximately 20 percent of the world's banking giants. Although the dollar remains the world's most important medium of exchange, other currencies have now become more important in world money markets.

 

            Major deregulation intended to increase competitiveness in financial markets was enacted in 1980, but many reforms were phased in gradually. Deregulation enabled many banks to become virtual "money supermarkets," but it also opened the doors for expanded lending activity by such firms as General Electric, Sears, Ford, and AT&T. Although financial transactions continue to expand rapidly, banks' shares of total lending in the United States fell from roughly 40 percent in 1960 to about 28 percent in 1993. Even greater losses of competitive advantage were experienced by savings and loans and credit unions. Banks and similar institutions must be flexible to survive and serve the public in our changing financial environment, but, as Focus 2 indicates, the specific forms taken in some deregulation that were intended to increase financial competitiveness may have contributed to recent problems in the financial sector.

 

Proposals to Reform the FED

 

            Renewed recognition of the power of monetary policy has generated pressure for the FED to be "politically accountable." Many regulatory agencies are seen as controlled by the industries they are supposed to oversee. The FED is often accused of being a captive of banking interests and of following monetary policies that benefit bankers without regard for the public interest. The FED has mounted a multifaceted defense of its independence and discretion over policy. The fear of politicizing policy is a central issue. The FED argues that it should be free to follow what it perceives to be the best monetary policies possible, not policies based on political considerations.

 

            What incentives do the governors of the FED have to follow policies most beneficial for the economic well-being of the American people? Banks that "invest" in the FED are limited to 6 percent rates of return, and political checks on FED governors are weak. The FED responds that its officers and administrators are public-spirited people who simply want the satisfaction of knowing that they are doing the best job they can for the American public. This answer satisfies few economists, who believe that the most powerful of human motivations is self-interest. However, subjecting the FED to political pressure is not a very appealing alternative to relying on the FED management's interest in the public welfare. Nevertheless, critics charge that the FED is too powerful to be consistent with democratic government, and the tools in its armory, too diverse. These charges echo the fears of the founding fathers who resisted Alexander Hamilton's desires for a central bank.

 

            One possible reform entails separating monetary policy from the regulation of financial institutions. In 1993, the Clinton administration proposed continuation of the FED's control over monetary policy, but regulation of financial intermediaries would be unified under the umbrella of a super federal agency. Among other powers, this consolidated agency would assume the bulk of the auditing functions currently performed by (a) the FED, (b) the Federal Deposit Insurance Corporation, (c) the Comptroller of the Currency, (d) the Office of Thrift Supervision, and (e) various agencies of state government. In addition, this unified agency would charter new banks and thrift institutions, and review and approve any proposed mergers of banks or S&Ls. But this is only one of many proposals for reforms of financial regulation. Will the role of the FED change? Should it? If so, how? Only time will tell.

 

            We have discussed the most regulated major American industry in this chapter. These regulations, which grew rapidly during the Great Depression, stem from recognition that controlling monetary aggregates is necessary to control aggregate economic activity. The FED uses three main tools to alter the money supply:  reserve requirements, open-market operations, and discounting operations.

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