COMPENSATORY CYCLICAL BANK ASSET ADJUSTMENTS*

Abstract

MANY STUDENTS OF monetary policy have remarked in recent years on the problem of commercial bank dumping of U.S. government securities during periods of tight money. To put it briefly, the argument points out that short-term government securities may be shifted with a minimum of capital loss when interest rates are high; hence banks, faced with a rapidly loan demand and little or no increase in reserves, may expand their loan portfolios by liquidating Treasury bills. If the new holders of the Treasury bills had previously held idle demand deposits, then idle money is converted to active money via this process. The result is a rise in velocity and hence a weakening of the effectiveness of monetary policy. It is not the purpose of this note to quarrel with the substantive conclusions of the argument cited above. Rather, the point to be made here is that this argument incorporates an erroneous description of the adjustment process of commercial banks-an error that involves some serious consequences for monetary policy. The error lies in the belief that it is primarily their short-term securities that banks liquidate in tight-money periods. Thus, e.g., Warren Smith holds that rising interest rates do not seriously deter commercial banks, which commonly hold large portfolios of short-term government securities, from selling such securities to meet a demand for loans.1 And G. L. Bach and C. J. Huizenga remark that bankers are generally thought to draw first on short-term government securities to obtain loan funds when reserves become tight.2 It will be shown in Section I that it is, in fact, their longer-term governments that banks tend to liquidate during tight-money periods. Section II will consider some of the consequences of this distinction.