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Minsky’ s Financial Instability

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					Review of Political Economy, Volume 11, Number 4, 1999

A Political± Economic Critique of Minsky’ s Financial Instability Hypothesis: the case of the 1966 ® nancial crisis
E DW IN D ICKENS
Department of Economics, Drew University, M adison, New Jersey 07940 , USA .

According to M insky’ s ® nancial instability hypothesis, ® nancial crises are caused by increasing debt burdens. The purpose of this paper is to argue instead that ® nancial crises are caused by class and intra-class con¯ ict. The 1966 ® nancial crisis is particularly signi® cant, from the perspective of M insky’ s ® nancial instability hypothesis, because it divides the postwar Golden Age of US capitalism from the current period of recurrent ® nancial crises. After show ing that increasing debt burdens do not account for the 1966 ® nancial crisis, this paper explains the 1966 ® nancial crisis in terms of class and intra-class con¯ ict.

1. Introduction: Financial Crises and Financial Instability
Since 1966, the US econom y has been characterized by both ® nancial crises and increasing ® nancial instability. This sim ultaneous emergence of ® nancial crises and ® nancial instability has prom pted many m onetary theorists to argue that ® nancial crises are sym ptom s of ® nancial instability.1 Section 2 shows how the 1966 ® nancial crisis, the ® rst ® nancial crisis of the postwar period, is explained as an indication that the ® nancial system had become unstable. The purpose of this paper, however, is to argue that ® nancial instability is an important problem , but is not the cause of ® nancial crises. It is thus shown in Section 3 that the 1966 ® nancial crisis is not adequately explained in term s of ® nancial instability. Sections 4 and 5 then argue that ® nancial crises are caused by class and intra-class con¯ ict rather than ® nancial instability. Section 4 shows that, in the 1960s, there was intra-class con¯ ict between the large New York banks and the large regional banks over m onetary policy. In section 5 this intra-class con¯ ict over monetary policy is placed within the context of a con¯ ict between capital
I would like to thank Jim Devine, Dorene Isenberg, Marc Lavoie, Tracy Mott, Mario Seccareccia and the anonymous referees of this journal for their comments on earlier versions of this paper. 1 See Wolfson (1986) for an exposition (and attempted synthesis) of the extant theories of ® nancial crises. Wolfson makes clear how the current theories of ® nancial crises are subordinated to (con¯ ated with?) the theories of ® nancial instability.
0953-8259/99/040379-20

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1999 Taylor & Francis Ltd

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and labor over the best way to control in¯ ation. This, it is argued, provid es a more satisfactory explanation of the 1966 ® nancial crisis. Section 6 provid es a summ ary and conclusions.

2. The Financial Instability Hypothesis
Financial crises occur when relatively large group s of people panic in a ® nancial market, disposing of assets in order to m eet paym ent obligations, or in response to the threat of a ® nancial institution becoming insolvent, or to the threat of an asset market collapse (see Dickens & O’ Hara, 1999) . The 1966 ® nancial crisis began on 17 August when large group s of people panicked at the threat of an asset m arket collapse. The crisis cam e down to the fact that m any bond dealers, unwilling to hold inventories of bonds , stopped quoting bid prices for bonds on a routine basis. On 29 August, bond dealers began to build inventories of bonds again. On 30 August, when this fact became widely known , the bond m arket rallied and the 1966 ® nancial crisis ended. In contrast to the above, ® nancial instability is caused by the fact that househo lds and ® rm s take on debt-paym ent comm itments during economic expansions that they do not have adequate incom es to service during periods of slow growth.2 W hen looked at as a problem of ® nancial instability, ® nancial crises arise either the mom ent signi® cant num bers of creditors realize that the build-up of debt burden s is unsustainable and m odify their behavior accordingly (see, for exam ple, Guttentag & Herring, 1984) or the m oment when tight monetary policy forces creditors to curtail their investm ents abruptly (see, for example, W ojnilower, 1980) . Financial-instability theorists conclude that central banks must intervene as lenders of last resort in order to prevent ® nancial crises from devolving into debt-de¯ ations.3 For Martin H. W olfson (1986 , ch. 4), the foremost theorist of ® nancial crises in term s of the problem of ® nancial instability (see also Minsky, 1982, 1986, pp. 3±10), the 1966 ® nancial crisis was an example of tight m onetary policy forcing creditors (e.g. the banks) to curtail abruptly their investments. W olfson surveys the build-up of debt by non-® nancial corporations during the econom ic expansion of the mid-196 0s. He then points out that banks obtained the funds needed to m ake new loans by issuing large-denomination negotiable tim e deposits. In July 1966, the banks bid the secondary market yields on tim e deposits above the interest-rate ceilings that the Federal Reserve m aintained on the yields banks could offer on new time deposits. Maturing tim e deposits could
2

See Minsky (1982) for the most widely accepted version of the ® nancial instability hypothesis whereby psychological factors cause ® rms to overextend themselves. Wolfson (1986) substitutes a falling rate of pro® t for psychological factors to explain why ® rms overextend themselves. Pollin (1987) augments Minsky’ s account with the argument that declining real incomes have caused households to overextend themselves as well. 3 See, for example, Andrew S. Carron (1982, p. 418) who concludes a survey of ® nancial crises in the postwar United States as follows: It appears that m onetary policy has been controlled so as to force the economy through a ® nancial crunch into the early stages of a crisis. But that is as far as the Federal Reserve seems willing to go.

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not be rolled-over at interest rates held by adm inistrative ® at below m arket interest rates. Wolfson argues that the 1966 ® nancial crisis thus occurred in late August because participants in the ® nancial m arkets panicked at the threat that banks would have to sell bonds in order to replace funds lost as tim e deposits matured (see also W ojnilower, 1980, p. 287). In order to prevent the 1966 ® nancial crisis from devolving into a debtde¯ ation, W olfson (1986 , p. 50) concludes that the Federal Reserve abandoned its tight monetary policy at the 23 August 1966 m eeting of the Federal Open Market Com mittee (FOMC).4 Since the ® nancial m arkets rem ained jittery even after the Federal Reserve had eased m onetary policy, W olfson argues further that, on 1 Septem ber, the Federal Reserve sent a letter to the banks assuring them of access to the discount window for all the funds they wanted. According to W olfson, this letter calm ed the ® nancial markets and brough t the ® nancial crisis to an end.

3. Critique of the Financial Instability Hypothesis
The m ajor problem with efforts to understand the 1966 ® nancial crisis as a consequence of ® nancial instability is that the crisis is reduced to a panicked response by ® nancial-m arket participants to the prospect of banks selling bonds because maturing time deposits could not be rolled-over. This interpretation is a problem sim ply because there was no prospect that banks would have to sell-off their bond portfolios. As W olfson and other ® nancial-instability theorists emphasize, in July 1966 banks bid the secondary-market yields on time deposits above the interest-rate ceilings they could offer on new time deposits. However, for the banking system as a whole, outstanding time deposits increased by $680 m illion in August and $949 m illion in Septem ber.5 Banks may choose to sell bonds under such circum stances but there was no danger that they would be forced to sell bonds. There was a run-of f of $193 m illion in tim e deposits at the large New York banks in August, followed by a $511 million decrease in tim e deposits at the large New York banks in Septem ber. However, this $704 m illion run-of f of tim e deposits was offset by $686 m illion that the large (m ostly New York) banks borro wed from their foreign branches in the Eurodol lar m arket during the August±Septem ber period.6 Moreover, the large New York banks could have
4

The Federal Reserve System (the US central bank) is composed of 12 regional banks and the Board of Governors. The Federal Open Market Committee is the policymaking council within the Federal Reserve System. The perm anent members of the Federal Open Market Committee are the seven mem bers of the Board of Governors and the President of the Federal Reserve Bank of New York. The 11 non-New York Regional Bank presidents rotate through four seats on the Federal Open Market Committee so that, at each meeting, there are 12 voting members. 5 Data on outstanding time deposits at all banks are from Citibase. The other data referred to in this paper, on outstanding time deposits at the large New York banks, on interest rates and interest-rate ceilings, are from the Federal Reserve Bulletin, various issues. 6 Chase Manhattan Bank, First National City Bank and Manufacturers Hanover Trust Company accounted for most of the borrowing of Eurodollars by US banks in the late 1960s (see Kelly, 1977, p. 98). If Bank of America, Bankers Trust Company and Morgan Guaranty Trust Company are added

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obtained all the funds they wanted in the Eurodollar m arket. Again, there was no danger that they would be forced to sell bonds. Perhaps m ost damaging to the hypoth esis that the 1966 ® nancial crisis was a panicked response to the prospect of banks selling bonds because m aturing tim e deposits could not be rolled-over, is the fact that in February 1966 there was a $410 m illion run-off of tim e deposits at the large New York banks that was not offset by bank borro wings of Eurodol lars. W hy would a run-of f of dom estic tim e deposits that was offset by a build-up of tim e deposits in the Eurodol lar m arket cause a ® nancial crisis in August 1966, when a run-of f of dom estic tim e deposits that was not offset by a build-up of Eurodol lar deposits failed to cause a ® nancial crisis in February 1966? Moreover, on 19 August 1966 there was no danger of a forced sell-off of bank-b ond portfolios. This was explicitly stated in a front-page article in the New York Times. It should be dif® cult to argue that ® nancial-m arket participants caused a ® nancial crisis because they were ignorant of readily available facts. W olfson and other ® nancial-instability theorists com pound their dif® culties when they attribute the end of the 1966 ® nancial crisis to an easing of m onetary policy at the 23 August m eeting of the Federal Open Market Comm ittee, an easing of m onetary policy that was allegedly reinforced by a letter to the banks on 1 September. The problem here is that the Federal Open Market Comm ittee did not ease m onetary policy until its m eeting on 4 October. At its meeting on 23 August, the central question of concern to the Federal Open Market Comm ittee was whether the next step in implem enting monetary restraint should be an increase in the discount rate, an increase in reserve requirements or stricter criteria for member-banks’ access to the discount window (see, for example, FOMC Minutes, 23 August 1966, pp. 7 and 53). The Federal Open Market Comm ittee decided to increase m onetary restraint by m eans of an increase in reserve requirements and stricter criteria for member-bank access to the discount window. This fact was clearly stated in the New York Times on 29 August (pp. 41 and 43). W hat is m ore, the letter from the Federal Reserve to the banks on 1 Septem ber was irrelevant to the 1966 ® nancial crisis. The crisis began on 17 August when bond dealers, unwilling to hold inventories of bonds, stopped quoting bid prices for bonds on a routine basis. On 29 August, bond dealers began to build inventories of bonds again. On 30 August, when this fact becam e widely known, the bond m arket rallied and the 1966 ® nancial crisis was over. Monetary policy was still tight and the letter from the Federal Reserve to the banks had not yet been written. In short, Wolfson and other ® nancial-instability theorists cannot explain both why the 1966 ® nancial crisis began on 17 August and why it ended on 30 August.

Footnote continued

to this list, or at a maximum if Chem ical Bank, Continental Illinois, First Chicago National Bank, Marine Midland Bank and the First National Bank of Boston are also added then practically all US bank Eurodollar borrowings in the late 1960s are probably accounted for (see Kelly, 1977, pp. 15, 147).

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4. The Intra-Class Con¯ ict Underlying the 1966 Financial Crisis
Contributing to the 1966 ® nancial crisis was a shift by the large New York banks in the early 1960s from asset managem ent to liability managem ent. The banks ® nanced the Second W orld W ar by borro wing funds from the Federal Reserve in order to purchase govern ment securities at prem ium prices (see Eccles, 1951, pp. 360±366). During the late 1940s and 1950s, banks could sell the govern ment securities accum ulated during the Second W orld W ar whenever that wanted to make new loans. `Asset m anagem ent’ denotes this change in the composition of the banks’ assetsÐ from portfolios heavily weighted towards govern ment securities to portfolios heavily weighted towards com m ercial loans. Banks must hold govern m ent securities as collateral against any govern ment revenues placed on deposit with them , including deposits by State and local govern ments. By the early 1960s, large New York banks had reduced their holdings of govern m ent securities to the m inimum needed to meet pledging requirements against such deposits. In order to m ake additional loans, large New York banks had to resort to `liability managem ent’ : that is, they had to issue new liabilities whenever they wanted to raise funds to make new loans. The ® rst type of new liability that the large New York banks cam e up with was large-denom ination negotiable time deposits (see, for exam ple, W olfson, 1987; Moore 1988, p. 27; Goodhar t, 1989, pp. 30±32; and Dickens, 1990, p. 4).7 Negotiable time deposits were ® rst introduced in February 1961 by First National City Bank (now Citibank). By July 1963 Citibank, and other large New York banks, bid the interest rates on tim e deposits up to the interest-rate ceilings on them . In July 1963Ð and when the large New York banks bid the secondarymarket yields on tim e deposits up to the interest-rate ceilings on them for a second time in November 1964Ð an expansionary open-market policy was provid ing a large reservoir of liquid funds that the large New York banks could tap into by simply notching up the return they offered on new tim e deposits (see, for exam ple, Goodhar t 1989, pp. 30±32). Consequently, the large regional banks acquiesced to requests by the large New York banks for the Federal Reserve Board to increase the interest-rate ceilings on tim e deposits. The situation was different in Decem ber 1965, the third time that large New York banks bid the interest rates on time deposits up to their ceilings. By December 1965, liquid funds had been drained from the banking system by a contractionary open-m arket policy that the Federal Reserve had begun in February 1965. Given the illiquidity created by the contractionary open-m arket policy, when the large New York banks tried to obtain additional funds by offering higher and higher interest rates on tim e deposits, they were effectively trying to bid away the deposits of the large regional banks. Archie K. Davis, President of the American Bankers Association and Chairperson of the largest
7

There was nothing new about large-denomination tim e deposits in the early 1960s. What was new was that the large-denomination time deposits were `negotiable’ . That is to say, the banks developed a secondary market where these time deposits could be easily sold prior to maturity, thereby making them a viable alternative to Treasury bills for corporate-® nance of® cers seeking a return on idle working capital. As we will see in Section 5, the large New York banks also issued small-denomination time deposits.

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bank in the south-east, the W achovia Bank and Trust Company, called the combination of contractionary open-m arket policy and large New York banks bidding for tim e deposit funds `highly destructive and undesirable com petition’ (New York Times, 1 February 1966, p. 49). In spring 1966 the large New York banks attempted to placate the large regional banks. They reduced their dem and for funds in the m arket for tim e deposits by telling their clients to draw on lines of credit with the large regional banks. But the large New York banks m iscalculated the effect on their regional rivals of what was ostensibly a conciliatory gesture. As Edward A. W ayne, President of the Federal Reserve Bank of Richm ond, put it at the 22 March 1966 meeting of the Federal Open Market Com mittee:
Banks in his District though t the New York banks had acted imprudently, and they were strongly critical of the New York banks for suggesting, when they ran short of funds, that their customers draw on credit lines outside of New York and thus relieve the pressures on them. The hope had been expressed to him that the [Federal Reserve] System would not raise Regulation Q ceilings again because banks could not be relied on to exercise prudence in setting tim e deposit rates (FO MC, M inutes, 22 M arch 1966 , p. 61).

`Regulation Q’ was the statute under which the Federal Reserve Board administered interest-rate ceilings on tim e deposits. The other Regional Bank presidents expressed sim ilar sentiments at the 22 March 1966 meeting of the Federal Open Market Com m ittee. For exam ple, W atrous H. Irons, President of the Federal Reserve Bank of Dallas, said that
like M r. W ayne he had heard from a few banks some rather sharp and severe criticisms of the New York banksÐ not only for suggesting to custom ers that they `go west’ for accomm odations, but also for working up the rates on [time deposits] ¼ some ¼ bankers ¼ had comm ented that they hoped there would be no further revisions in Regulation Q (FOM C, M inutes, 22 March 1966 , p. 77).8 ¼

In spring 1966 the Federal Reserve thus found itself unable to implement a high-interest rate policy on term s acceptable to both the large regional banks and the large New York banks. That is, whereas the large New York banks wanted a contractionary open-m arket policy only so long as the interest-rate ceilings on tim e deposits were raised when they bid m arket interest rates on tim e deposits up to those ceilings, the large regional banks wanted a contractionary open-m arket policy only so long as the interest-rate ceilings were not raised. W e will see in the next section that, because of the disprop ortionate in¯ uence of the large banks on US monetary policy,9 the inability of the Federal
8

See FOMC (M inutes, 22 March 1966, pp. 43, 61±62, 74, 77) for similar statements by other Regional Bank presidents. 9 The large banks exercise a disproportionate in¯ uence on US m onetary policy through their control of the boards of directors of the regional Federal Reserve banks. That is to say, there are three bankers and three banker-appointed non-bankers on the nine-member boards of directors of the 12 regional Federal Reserve banks. The Regional Bank presidents on the FOMC report directly to their boards of directors. In addition, the large banks exercise in¯ uence on US monetary policy through the Federal Advisory Council, composed of 12 bankers, one appointed by the board of directors of each of the 12 regional Federal Reserve banks. The Federal Advisory Council meets with the Federal

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Reserve to implement a high interest-rate policy acceptable to both the large New York banks and the large regional banks generated a shock to the ® nancial system. That shock devolved into the 1966 ® nancial crisis.

5. The 1966 Financial Crisis
To explain the 1966 ® nancial crisis, the con¯ ict between the large New York banks and the large regional banks over interest-rate ceilings on tim e deposits must be analysed in the context of a con¯ ict between capital and labor over the distribution of incom e. The latter con¯ ict also came to a head in 1965±66 and unleashed in¯ ationary pressures. 10 The in¯ ationary pressures unleashed in 1965±66 had their origins in what Mike Davis (1986 , ch. 2) calls the `Treaty of Detroit’ , a 1950 agreement between General Motors and the United Automobile Workers (UAW ) that becam e a model for union contracts in all organized branches of industry (see also Gordon , et al., 1987, p. 48). In the Treaty of Detroit, General Motors agreed to tie wages and bene® ts to the rate of produc tivity growth in the automobile industry and the cost of living in exchange for the UAW ’ s consent to m anagerial control of investm ent decisions and the labor process (see Lichenstein, 1989, pp. 141±142). The Treaty of Detroit was designed to put an end to the labor insurgencies that began in 1933, when the industrial proletariat organized itself into a cohesive force for the ® rst and only time in US history. At the peak of its strength, from the sit-down strikes in Detroit in 1936±37 to the national strikes in the immediate postwar period, the industrial proletariat sough t som e form of democratic national planning to redress m ass unem ploym ent (see Davis, 1986, ch. 2; Fraser, 1989; Brinkley, 1995, pp. 207, 212±213, 218±219, 224).11 But the need for greater econom ic democracy was called into question in 1938 when, for the ® rst time, the govern ment used stabilization policies to pull the econom y out of a recession (see Brinkley, 1995, pp. 83±85). Leading factions of capital seized upon stabilization policies as a putative solution to the unemployment problem
Footnote continued

Reserve Board prior to each FOMC meeting. Dickens (1998a) shows that the advice given by the Federal Advisory Council to the Federal Reserve Board at these meetings is a statistically signi® cant determinant of US monetary policy (see also Epstein, 1992). 10 It is often argued that in¯ ation is caused by excessive growth of the stock of money rather than by capital±labor con¯ ict over the distribution of income (see, for example, Friedman, 1966). Reducing the rate of growth of the stock of money by tightening monetary policy will reduce in¯ ation, but only by reducing output and employm ent. Therefore, concentrating on excessive monetary growth is not so much an alternative to concentrating on class con¯ ict as the cause of in¯ ation, as it is a stratagem for resolving the capital±labor con¯ ict in a way m ost bene® cial to capital. In contrast to tight monetary policy, an incomes policy could reduce in¯ ation and m aintain full-em ployment levels of output (see, for example, Ackley, 1966, p. 69; Goldthorpe, 1978; Dickens, 1996; 1997; Burdekin and Burkett, 1996, ch. 1). 11 As Richard Hofstadter (1955, p. 308) put it: The demands of a large and powerful labor movement, coupled with the interests of the unemployed, gave the later New Deal a social-democratic tinge that had never been present before in American reform movements. And, one might add, a `social-democratic tinge’ that has not been present since.

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that would not impinge on their prerog atives in the way that democratic national planning would (see W eir and Skocpol, 1985; Brinkley, 1989, 1995, p. 229). The opport unity to underm ine further the m ovem ent toward democratic national planning cam e after Republicans won the 1946 Congressional elections and passed the Taft±Hartley Act of 1947. After using the Taft±Hartley Act to purge unions of radicals and to prevent inter-union solidarity, in 1948 General Motors propos ed what would becom e the Treaty of Detroit (see Katznelson, 1989, p. 191; Lichenstein, 1989, pp. 133±134). In 1948, the UAW rejected the proposed Treaty on the ground s that it was a produc t of war-induced prosper ity and that som e form of democratic national planning was still required to solve the unem ploym ent problem in a capitalist econom y not at war. However, during the 1948±49 recession, the govern ment once again used stabilization policies to ameliorate unem ploym ent and thus once again created the impression that dem ocratic national planning was not necessary to ensure full employm ent. Consequently, in 1950, the UAW was lulled into accepting the Treaty (see Davis, 1986, pp. 52, 85±87; Brinkley, 1989, p. 110; Gerstle & Fraser, 1989, p. xv; Lichenstein, 1989, pp. 123, 142; Brinkley, 1995, pp. 223±224).12 The Treaty of Detroit had the potential for unleashing in¯ ationary pressures because, by the late 1950s, unions tried to match the wage and bene® t gains of the UAW regardless of the rates of produc tivity growth in their industries. Following Jackson et al. (1972 , p. 26), the source of these in¯ ationary pressures can be form alized as follows: ( D W/W)i 5 a i ( D W/W )*, i 5 1, ¼ , n; a , 1 (1)

where W is the average nom inal wage (including bene® ts), * denotes the autom obile industry and there are n other industries. To the degree that other unions matched the wage and bene® t gains of the UAW , a i had a value close to 1. The Treaty of Detroit, which tied the UAW ’ s wage and bene® t increases to the rate of produc tivity growth in the autom obile industry, can be represented as follow s: ( D W/W )* 5 ( D v/v)* (2)

where v is the value added per worker. Substituting into Equation (1) from Equation (2), it follows that the average change in the nom inal wage in the ith industry was som e fraction (a i) of the rate of produc tivity growth in the autom obile industry:
12

Davis (1986, pp. 111±112) reports an editorial in Fortune that interpreted the Treaty of Detroit as a basic `af® rmation ¼ of the free enterprise system.’ First, the autoworkers accepted ª the existing distribution of income between wages and pro® ts as `norm al’ if not as `fair’ º . Second, by explicitly accepting `objective economic factsÐ costs of living and productivityÐ as determining wages’ , the contract threw ª overboard all theories of wages as determined by political power, and of pro® t `as surplus value’ º . Finally, `it is one of the very few union contracts that expressly recognize [s] both the importance of the management function and the fact that management operates directly in the interest of labor.’

Critique of M insky’ s Financial Instability Hypothesis ( D W/W )i 5 a i ( D v/v)*

387 (3)

That the Treaty of Detroit, as institutionalized in the late 1950s, had the potential for unleashing in¯ ationary pressures can be derived as follows: ( D p/p) i 5 ( D W /W)i 2 ( D v/v) i (4)

where p is the price level in each industry. Substituting into Equation (4) from Equation (3), it follows that ( D p/p) i 5 a i ( D v/v)* 2 ( D v/v) i (5)

The econom y-wide price level (P) is the sum of the sectoral price levels, weighted by their share in total value added (V): ( D P/P) 5 o ( D p/p) i V i/V (6)

Substituting into Equation (6) from Equation (5), it follows that: ( D P/P) 5 o [a i ( D v/v)* 2 ( D v/v) i] V i/V (7)

As institutionalized in the late 1950s, the Treaty of Detroit thus had the potential for unleashing in¯ ationary pressures to the degree that a i had a value close to 1 and the rate of produc tivity growth in the automobile industry was greater than the average rate of produc tivity growth. Until 1965±66, international com petition kept a i low. In 1958 there were the ® rst signi® cant imports of cheap foreign cars, such as Volkswagen, and steel imports exceeded exports for the ® rst time. A uni® ed proletariat could have demanded an incom es policy both to prevent in¯ ation, by tying wage increases to produc tivity growth in different industries, and to alleviate the adverse effect of international competition on Am erican living standards by ensuring that foreign industries exporting goods to the United States paid wages comparable to the wages received by US workers in the same industries. However, preventing in¯ ation and m anaging international com petition in this way would have entailed the democratic national planning that labor eschewed in favor of the Treaty of Detroit. W ith the autom obile industry reacting to international competition by threatening a general lockout, and organized labor incapacitated by its concessions in the Treaty of Detroit, workers were beginning to
mimic the position of the business com munity that higher wages were causing in¯ ation. One unemployed worker suggested that ® rms would not produce good s in the United States with wages 50 cents an hour lower in foreign countries. He concluded that unions had to start worrying about creating jobs and stop worrying about getting higher wages for people who already had jobs (New York Times, 28 October 1958 , p. 29; see also Strauss, 1962 , pp. 81±83; Davis, 1986 , p. 123).

On the assumption that international com petition would hold down prices, if only the Governm ent held down wages, the Kennedy Administration prom ulgated an incom es policy designed to weaken labor further by making wage

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increases inversely propor tional to labor’ s collective bargaining power.13 Until the outbreak of war in Vietnam in July 1965 created excess demand pressures that began to reverse the situation, 14 labor became so weak that the Kennedy Adm inistration tried to renege on General Motor’ s original offer to tie wages to the cost of living as well as produc tivity (see, for exam ple, Shultz & Aliber, 1966, p. 3; Solow, 1966, p. 42; Ross, 1966, pp. 119, 122, 124±125; footno te 12). Prior to July 1965, the only exception to the Kennedy and Johnso n Adm inistrations’ exclusive concern with wage increases was in 1962 when President Kennedy confro nted Roger Blough of US Steel over a steel price increase. However, in the face of the excess dem and pressures generated by the American war in Vietnam, by the end of 1965, the Adm inistration felt com pelled to force both the alum inum and the copper industries to rescind announced price increases. Otherwise, workers could not be expected to exercise restraint and a wage±price spiral seem ed inevitable (see, for exam ple, Ackley, 1966, p. 71; Dickens, 1990, p. 10 and passim ). Like other businesses facing rising costs and excess dem and, the large New York banks wanted to preserve pro® t m argins by raising prices. In Decem ber 1965, the large New York banks bid the cost of new funds, the m arket yield on large-denom ination time deposits, to equality with the interest rate at which they lent to their corporate custom ers. The lending rateÐ the prim e rateÐ had been 4.5% throug hout the early 1960s. By increasing the discount rate, 15 the Federal Reserve gave the banks justi® cation for increasing it to 5% (see FOMC, M inutes, 23 November 1965, p. 86; Epstein, 1987, p. 248; Epstein, 1990) . Since higher interest rates increase the likelihood of recession, and thus hold out the prospect that a replenished reserve arm y of unemployed will hold dow n wages, 16 Federal Reserve head W illiam McChesney Martin Jr. justi® ed raising the discount rate in Decem ber 1965 by arguing that
there was a difference ¼ between interest rates, steel, alum inum and copper prices. But without arguing the wisdom , or lack of wisdom ¼ on the part of the Adm inistration in rolling back aluminum and copper prices ¼ if one was going to roll back those prices because of a fear of in¯ ation, one also ought ,

13

The Kennedy Administration’ s incomes policy prescribed wage increases greater than productivity growth in industries where they were low `because the bargaining position of workers had been weak’ and wage increases less than productivity growth in industries where they were high `because the bargaining position of workers has been especially strong’ (Council of Economic Advisors, 1962, p. 189). 14 The Government increased defense orders by $4 billion during the second quarter of 1965Ð an amount equal to the total cost of its low-intensity warfare in Vietnam since 1954. During the second half of 1965, the Government increased defense orders by another $7 billion, to $62 billion (see Eckstein, 1978, p. 23; Baker et al. 1996, p. 39). 15 The discount rate is the interest rate at which the Federal Reserve lends to m ember banks. It serves as a ¯ oor for market interest rates. 16 Boddy & Crotty (1975, pp. 9±10); Kalecki (1971, pp. 139, 141±142, 144); Marx (1976, pp. 769±72, 784, 786) are the classical explanations of why capitalist states sometimes act to replenish the reserve army of unem ployed. For the Federal Reserve’ s role in engineering recessions, see Dickens (1995b, 1999a, 1999b, and 1999c).

A Political± Economic Critique of Minsky’ s Financial Instability Hypothesis
at the sam e time, to permit an adjustment of interest rates to restrain in¯ ation. The two things were com patibleÐ not incompatibleÐ as operating techniques (FOM C, M inutes, 23 Novem ber 1965 , p. 85).

389

At the sam e tim e, if the Administration could not stop the large New York banks from preserving their pro® t m argins by raising the prim e rate, then it could not justify trying to stop other businesses from preserving their pro® t m argins by raising the prices of their produc ts. 17 In the wake of the December 1965 discount-rate increase, the Adm inistration thus accepted in silence a rash of price increases in chem icals, paper, cigarettes and metals (see Dickens, 1990, pp. 10, 21±23). In an effort to coax the Federal Reserve into lowering interest rates, the Adm inistration also tightened ® scal policy. On 13 January 1966, President Johnson called for a tax increase, what Martin ostensibly wanted in order to lower interest rates (see New York Times, 16 March 1966, pp. 57, 66). And in testim ony before the Joint Econom ic Com mittee of Congress on 1 February, Gardner Ackley, Chairperson of the Council of Economic Advisors, expressed Adm inistration acceptance of the Federal Reserve’ s policies (see US Congress, 1966a, p. 17). The tightening of ® scal policy proved ineffective on 15 March when, barely two weeks after the new taxes Johnso n had called for became law, 18 Martin told reporters at the closing banquet of the Eighth International Savings Congress that m ore tax increases would be necessary before he would consider lowering interest rates. His words were repeated verbatim by J. Dewey Daane, a Martin loyalist on the Federal Reserve Board, in a speech to the Investm ent Bankers Association on 12 May (see New York Times, 13 May 1966, p. 57). However, between Martin’ s off-the-cuff rem arks to reporters and Daane’ s speech, the con¯ ict between the large New York banks and the large regional banks over interest-rate-ceiling policy broke out (on 22 March), creating an opening for the Administration to try to revive its incomes policy. In a speech to the Association of Reserve City Bankers on 5 April, Treasury Secretary Henry H. Fowler proposed that the Federal Reserve exercise monetary restraint without raising interest rates (see New York Times, 6 April 1966, p. 55). In a speech to a joint meeting of the Am erican Society of Business Writers and a National Mortgage Conference of the Am erican Bankers Association (ABA) on 9 May, Under Secretary of Treasury for Monetary Affairs Frederick L. Deming then
17

For this reason, Federal Reserve Board member Sherman J. Maisel responded to Martin by arguing that he still hoped that incomes policy, as opposed to m onetary policy, would continue to be used at this point. In his judgement the Administration had properly been using incomes policy. If a change were made now to monetary policy, that would amount to giving up. It would amount to saying that the [Federal Reserve] System did not favour the present way of handling national policy and, therefore, was going to use monetary policy ¼ It should be clear that he felt that not changing interest rates was very de® nitely a part of the economics of full em ployment (FOMC, Minutes, 23 November 1965, p. 85).
18

Excise taxes on cars and phone services were passed, as well as provisions for more rapid collection of corporate taxes and increased withholding taxes on personal incom e.

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explained how such m onetary restraint could work through lim itations on the `overly aggressive behavior on the part of some banks in competing for tim e deposits’ (New York Times, 10 May 1966, p. 66). Of all Adm inistration of® cials, Deming was the m ost in¯ uential within the Federal Reserve System. He had resigned from the Federal Open Market Comm ittee (FOMC) in order to become Under Secretary of Treasury. Indeed, it was at the next m eeting of the FOMC, on 10 May, that Federal Reserve Board members Arthur F. Brim m er, Sherm an J. Maisel and George Mitchell, with the acquiescence of the non-New York Regional Bank presidents, resolved to use reserve requirements to pursue the objectives speci® ed by Fowler and Deming (see, for example, FOMC, Minutes, 10 May 1966, p. 79 and passim ). The Adm inistration then turned to Congress for suppor t in bringing down interest rates. Congressional opposition to high interest rates was never in doubt. For example, W illiam Proxm ire, Democrat from W isconsin and Chairperson of the Senate Banking Com mittee, reacted to the Decem ber 1965 discount-rate increase by telling reporters it was imperative
to determine what action m ust be taken to prevent this creation of Congress [i.e. the Federal Reserve] from endangering the nation’ s prosperity and from doing so in de® ance of the President of the United States (New York Times, 7 Decem ber 1965 , p. 74).

W right Patm an, Democrat from Texas and Chairperson of the House Banking and Currency Comm ittee, was no less adam ant in his reaction to the December 1965 discount-rate increase. He told reporters that
Congress should m ove imm ediately ¼ to put an end to Mr. Martin’ s power to thumb his nose at the President, the Congress and the Am erican people. Once again we are seeing the folly of allowing a handful of banker-dominated mem bers of the Federal Reserve dictate the economic future of the country (New York Times, 7 Decem ber 1965 , p. 74).

Consequently, there was widespread elation on Capitol Hill in May when John E. Horne, Chairperson of the Federal Home Loan Bank Board, endorsed legislation to bar com m ercial banks from issuing small-denom ination tim e deposits (see New York Times, 12 May 1966, p. 65; and 17 May 1966, p. 69) 19 and Fowler expressed sym pathy to the House Banking and Currency Comm ittee for legislation that would prevent comm ercial banks from paying m ore than 5% on sm all-denom ination tim e deposits (see US Congress, 1966b , p. 136). Martin bent under the pressure, telling the ABA on 25 May that he understood the President’ s reluctance to advocate further tax increases `until he knows where we are going in Vietnam ’ (New York Times, 26 May 1966, p. 1). But the large New York banks were m ore recalcitrant. In direct rebuttal of
19

Whereas the large New York banks bid for large-denomination tim e deposits at the expense of the large regional banks, they bid for small-denomination time deposits at the expense of the small commercial banks, mutual savings banks, credit unions and Savings and Loan Associations. It was the latter who had the m ost in¯ uence in Congress.

Critique of M insky’ s Financial Instability Hypothesis

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Martin on 26 May, David Rockefeller, Chairperson of Chase Manhattan Bank and the m ost in¯ uential voice on W all Street, went before the annual m eeting of the Am erican Iron and Steel Institute, which was adam antly opposed to tax increases, and insisted that tax increases were necessary (see New York Times, 27 May 1966, p. 61). Rockefeller’ s intervention back® red. It prompted a `high of® cial in the Johnson Adm inistration’ to telephone H. Erich Heinem ann, a leading correspondent on ® nancial affairs, in order to say that, as Heinem ann reported it, `the legislation [to impose m andatory interest-rate ceilings on small-denom ination tim e deposits] was considered ª a priority m easureº ¼ ª W e hope to get a meeting of minds in the next day or twoº ¼ ’ (New York Times, 31 May 1966, p. 59). To derail the m om entum toward legislated interest-rate ceilings, in testimony before the House Banking and Currency Com mittee on 8 June, Martin asked for the discretionary authority to pursue the reserve-requirem ents policy outlined by Brim m er, Maisel and Mitchell on 10 May (see US Congress, 1996c, p. 483). The result was a $400 million increase in reserve requirements on large-denom ination time deposits effective 26 June. On 26 June, the large New York banks had once again bid the m arket yield on large-denomination tim e deposits to equality with the prime rate and restored their pro® t m argins by increasing the latter to 5.5% . W all Street wanted the Federal Reserve to do the sam e thing it did in December 1965 and suppor t the large New York banks with a discount-rate increase. When the Federal Reserve increased reserve requirements instead, signaling that there would be no m ore increases in the price of m oney, the Adm inistration was able to revive its incom es policy, which it did on 12 July by forcing Am erican Climax Incorp orated to rescind a 5% increase in the price of molybdenum .20 Nonetheless, the increase in reserve requirements failed to slow large New York bank lending to corpor ations (see New York Times, 26 June 1966, p. 69; and New York Times, 29 June 1966, p. 1). Consequently, when the Administration reactivated its incom es policy on 12 July, it also renewed its call for legislation prescribing interest-rate ceilings (see New York Times, 13 June 1966, pp. 1, 48). In response, on 15 July the Federal Reserve reduced interest-rate ceilings to 4% on `m ultiple m aturity deposits’ , i.e. on automatically renewable tim e deposits that were payable only after written notice of withdrawal. On 25 July, by which tim e it was clear that the Federal Reserve had again failed to slow down large New York bank lending (see New York Times, 16 July 1966, p. 21; and New York Times, 29 June 1966, p. 66), legislation cleared the House Banking and Currency Comm ittee to impose interest-rate ceilings on different
20

Molybdenum is an alloy used with iron in the production of high precision machine tools. As Brimmer explained, the Federal Reserve needed to increase reserve requirements rather than the discount rate on 26 June because it was important ¼ to let the marketÐ and especially the larger banksÐ know that the [Federal Open Market] Committee did not subscribe to a pattern of activity in which those banks competed for funds to relend to their custom ers (FOMC, M inutes, 28 June 1966, p. 75).

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types of deposits then to give the Federal Reserve authority to raise them but only with the approval of the President (see New York Times, 26 July 1966, p. 43). The concerted assault on their fundin g operations prom pted the large New York banks to seek an accomm odation with the large regional banks by shifting their demand for new funds from the domestic m arket to the Eurodol lar market. From May 1967 the large New York banks would agree to accept a contractionary open-m arket policy without increases in the interest-rate ceilings on domestic tim e deposits as long as the Federal Reserve guaranteed them unhind ered access to the Eurodol lar m arket (see Dickens, 1995a, p. 61 and passim ). Already in July 1966, by shifting the bulk of their fundin g operations off-sho re, the large New York banks ameliorated their con¯ ict with the large regional banks suf® ciently to gear up the Am erican Bankers Association (ABA), as well as other bank lobbies, in order to stop the interest-rate ceiling legislation (see, for example, New York Times, 23 July 1966, p. 35; New York Times, 26 July 1966, p. 43; and New York Times, 28 July 1966, p. 43). However, Inland Steel Com pany jum ped the gun on 2 August when it concluded from the Adm inistration’ s retreat on interest-rate-ceiling legislation that the Adm inistration would also acquiesce to an increase in the price of steel by 2.1% . On 4 August, by which tim e the rest of the steel industry had m atched Inland Steel’ s price increase, the Adm inistration launched a campaign to force the steel industry to rescind the price increases. All eyes then turned to the Federal Reserve to see if it would once again sustain W all Street’ s demand for in¯ ation, as it had done in December 1965, by raising the discount rate. 21 On 16 August, in exasperation at the Federal Reserve’ s implicit suppor t for the Adm inistration’ s efforts to sustain full employm ent with price stability, the large New York banks took matters into their own hands and raised the prime rate to 6% , its highest level since 1929. The large New York banks thus relieved the pressure on the steel industry by prom pting the Administration to re-direct its ® re toward them. The question that trans® xed W all Street, the question that made participants in the bond m arkets reluctant to quote bid prices, was whether or not the Federal Reserve would relieve the pressure on the large New York banksÐ after all, that’ s what Federal Reserve independence m eans. If W all Street wants higher prices despite the Adm inistration’ s efforts to hold them down, then the Federal Reserve is supposed to have the autonomy to take W all Street’ s side against the Government. To prevent the ® rst ® nancial crisis of the postwar period, all the Federal Reserve had to do was signal its suppor t for the new in¯ ation by increasing the discount rate. W hen it sided with the Adm inistration instead, by increasing reserve requirements from 5 to 6% on time deposits of $5 million or more, W all Street panicked. And the panic did not subside until President
21

See New York Times (1 Septem ber 1966, p. 49) where Robert V. Roosa, form er Vice-President of the Federal Reserve Bank of New York and Under Secretary of Treasury in the Kennedy and early Johnson Administrations, sums up the 1966 ® nancial crisis as `the critical phase in the confrontation between the new in¯ ation and the New Economics’ .

A Political± Economic Critique of Minsky’ s Financial Instability Hypothesis

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Johnson personally and emphatically af® rm ed that the Federal Reserve was free to take W all Street’ s side against the Governm ent, if it chose to do so. 22

6. Sum m ary and Conclusions
According to Minsky’ s ® nancial instability hypoth esis, rising debt burden s create a fragile ® nancial environment that is increasingly susceptible to shocks. Applying Minsky’ s hypoth esis, W olfson argues that falling rates of pro® t caused rising debt burden s in 1966. In addition, tight m onetary policy provid ed the shock that precipitated the crisis on 17 August. Banks bid the m arket yields on tim e deposits above the interest-rate ceilings that the Federal Reserve m aintained on new tim e deposits. Maturing tim e deposits could not be rolled-over at interest rates held by adm inistrative ® at below m arket interest rates. Participants in the ® nancial m arkets allegedly panicked at the threat that banks would have to sell bonds in order to replace the funds lost as tim e deposits matured. The crisis then purpor tedly ended on 30 August when ® nancial-m arket participants were assured that the Federal Reserve had abandoned its tight monetary policy in favor of provid ing the banks with all the funds they wanted. There are four major reasons to question W olfson’ s application of Minsky’ s ® nancial instability hypoth esis to the 1966 ® nancial crisis. First, even though secondary m arket yields on tim e deposits were above the interest rate ceilings on them, in both August and Septem ber tim e deposits for the banking system as a whole increased. Banks m ay choose to sell bonds under such circumstances but there was no danger that tight m onetary policy would force them to sell bonds. Second, even though there was a run-off of large-denom ination tim e deposits at the large New York banks in August, this run-off of domestic tim e deposits was offset by the new funds the large New York banks obtained by issuing tim e deposits in the Eurodol lar market. Moreover, the large New York banks could have obtained all the funds they wanted in the Eurodol lar market.
22

After the 16 August prime-rate increase, Fowler issued the following statem ent: Raising the price of money should not be the sole means of determining who gets credit. When dem and exceeds a bank’ s resources, credit expansion can and should be restrained by banker’ s saying `no’ to borrowers on criteria other than that of who is willing to pay the highest rate (New York Times, 17 August 1966, p. 58).

Since this statement, unlike Fowler’ s earlier comments on monetary policy, was an explicit reaction to a speci® c development, it raised the specter of the Administration m eddling in affairs that Wall Street considered the Federal Reserve’ s exclusive preserve. The crisis reached its nadir on 28 August when former President Truman issued a statement saying either interest rates had to be lowered or irreparable harm would be done to the econom y (see New York Times, 29 August 1966, p. 1). It seemed unimaginable that Trum an would issue such a statement without being personally asked to do so by the President. As Heinemann reported in the New York Times (30 August 1966, pp. 1, 53), Trum an’ s statement thus seem ed to have been inspired by the Johnson Administration as the opening shot in an all-out political attack on the independence of the Federal Reserve System. As Heinemann also notes, it was only after President Johnson made very public and very explicit assurances to the contrary, that Wall Street breathed a collective sigh of relief, ending the 1966 ® nancial crisis.

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Again, there was no danger that tight monetary policy would force the banks to sell bonds. Third, in February 1966 there was a run-of f of domestic tim e deposits at the large New York banks that was not offset by bank borrowings of Eurodol lars. W hy would a run-of f of dom estic tim e deposits that was offset by a build-up of tim e deposits in the Eurodol lar m arket cause a ® nancial crisis in August 1966 when a run-off of domestic time deposits that was not offset by a build-up of Eurodol lar deposits did not cause a ® nancial crisis in February 1966? Finally, the Federal Reserve did not ease m onetary policy until 4 October. How could an easing of monetary policy end the crisis if no such easing occurred? W e m ay conclude from this paper that the 1966 ® nancial crisis resulted from class and intra-class con¯ ict rather than rising debt burden s and tight monetary policy. Class con¯ ict cam e to a head because the excess dem and pressures generated by the outbreak of war in Vietnam in July 1965 rem oved the price constraint that, since the late 1950s, international com petition had imposed on American businesses. The Governm ent was thus caught between W all Street’ s dem and for in¯ ation, as the best way to preserve pro® t margins, and its comm itment, underlying the Treaty of Detroit, to stablize the econom y at full employment with price stability. The Governm ent initially respond ed to the outbreak of war by extending its incom es policy from wages to prices. But this so antagonized W all Street that, in Decem ber 1965, the Federal Reserve decided to challenge the Govern ment’ s handling of national economic policy by raising the discount rate. By increasing the discount rate in December 1965, the Federal Reserve challenged the Governm ent’ s efforts to sustain full employm ent with price stability because the higher interest rates increased the likelihood of recession in the long run and, in the short run, justi® ed the efforts of the large New York banks to preserve their pro® t margins. It was in Decem ber 1965 that the large New York banks, for the ® rst time since undertaking liability m anagem ent in the early 1960s, bid their cost of new funds (i.e., the market yield on largedenom ination time deposits) to equality with the interest rate at which they lent to their corpor ate customers (i.e., the prime rate). If the Governm ent could not stop the large New York banks from preserving their pro® t m argins by raising the prim e rate, then it could not justify trying to stop other businesses from preserving their pro® t m argins by raising the prices of their produc ts. Therefore, in the wake of the Decem ber 1965 discount-rate increase, which m ade a prim e-rate increase unassailable, the Government had to acquiesce to a rash of price increases. In June 1966, after m onths of rising interest rates, rising prices and increasing concerns that a recession was imm inent, the large New York banks once again bid the yield on large-denom ination time deposits to equality with the prim e rate and, once again, tried to preserve their pro® t margins by increasing the latter. But this time the Federal Reserve did not increase the discount rate because it was no longer able to implem ent a high interest-rate policy on term s acceptable to both the large regional banks and the large New York banks. That is to say, whereas the large New York banks wanted a contractionary open-

Critique of M insky’ s Financial Instability Hypothesis

395

market policy only so long as the interest-rate ceilings on tim e deposits were raised when m arket yields on tim e deposits reached this point, the large regional banks wanted a contractionary open-m arket policy only so long as the interestrate ceilings were not raised. The con¯ ict between the large New York banks and the large regional banks over the proper term s for a high interest-rate policy ended up prom pting the Federal Reserve, in late June 1966, to opt for exercising m onetary restraint by increasing reserve requirements rather than the discount rate. The intra-class con¯ ict thus allowed the Adm inistration to revive its strategy for sustaining full employment with price stability, in early July, by extending its incom es policy from wages to prices. After their con¯ ict with the large regional banks took the form of an increase in reserve requirements in June 1966, the large New York banks respond ed to the criticism s of their liability m anagem ent by shifting their demand for new funds from the domestic money market to the more expensive Eurodol lar m arket. This shift provid ed the basis for a reconciliation between the large New York banks and the large regional banks in May 1967Ð the large New York banks agreed to accept a contractionary open-market policy without increases in the interest-rate ceilings on dom estic time deposits as long as the Federal Reserve guaranteed them unhind ered access to the Eurodol lar market. However, W all Street jum ped the gun, in July 1966, when it concluded that the large New York banks and the large regional banks had resolved their differences over m onetary policy just because they joined forces to stop legislation setting m andatory interest-rate ceilings on sm all-denomination tim e deposits. On 17 August Wall Street realized its error, and panicked, after the Federal Reserve once again increased reserve requirements rather than using a discount-rate increase to con® rm a prim e-rate increase by the large New York banks. In short, if the Federal Reserve had increased the discount rate on 17 August, rather than reserve requirements, then the 1966 ® nancial crisis would not have occurred. Therefore, it was not, as ® nancial-instability theorists argue, because of tight monetary policy that the ® nancial crisis occurred. On the contrary, the 1966 ® nancial crisis occurred because m onetary policy was not tight enough for Wall Street. Nor did the crisis end because m onetary policy was eased, as ® nancialinstability theorists argue. It ended because the President assured W all Street that he would not let the Adm inistration’ s strategy for sustaining full employment with price stability impinge upon the Federal Reserve’ s independence. In other words, the 1966 ® nancial crisis cam e to an end when the President held out the prospect of higher interest rates in the future.

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