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Federal Reserve Bank o f Minneapolis
1993 Annual Report

The High Cost of Being Fair

by P reston J. M iller
Vice President and Monetary Adviser

Government interventions in the name of fairness distort the
incentive structure. These distortions reduce growth and create
the possibility that recipients of the government’ redistribution
s
schemes eventually would be better off without them: a small slice
of a big pie could eventually exceed an equal slice of a small pie.

The views expressed in this annual report are solely those o f the author;
they are not intended to represent a formal position o f the Federal Reserve System.

President’s Message

Since the fall of the Ancien Regime, governmental policy­
makers, especially in democratic societies, have debated
values. Looking back at this debate and then bringing it
forward to today, it seems that arguments fall roughly into
four categories: our highest priority should be an egalitarian
world characterized by fairness and equality, or we must
seek the greatest utility through efficient decisions, or we
must allow markets to operate freely because that will yield
the greatest benefit to the most people, or nothing has a
higher value than the quality of life so that we must always
be mindful of the environment.
These competing values have been present in the
political consciousness of our lawmakers in varying forms
since the early days. As time passes, one value may rise
above the others, and then be supplanted by another as the
political landscape changes. At all times, though, none has
fallen away completely.
In the following essay, Preston Miller takes a hard
look at an important aspect of the value conflict I have just
described. As an economist, his interest brings him to the
questions of the marketplace and efficiency. He asks about
the costs of consistently favoring one value over another and
his answer is clear.
There is much to learn from Preston’s examination
of free market outcomes in comparison with governmental
intervention. And the lessons transfer well to other value
clashes like that between development and the environment.
As a national policymaker, I have become convinced that
the “best solution” seldom means mutual exclusiveness,
but rather involves searching for the policy that honors, not
necessarily equally, competing values.

President




Federal Reserve Bank o f Minneapolis
1993 Annual Report

The High Cost of Being Fair

by Preston J. Miller
Vice President and Monetary Adviser

It’s been a little over 30 years since Milton Friedman published Capitalism and
Freedom. In this book, which was cited in Friedman’s Nobel prize award, he argues pas­
sionately and cogently in support of free markets. He stresses that government interven­
tions in markets generally restrict individuals’ freedom of choice and impair the efficiency
of the economy.
Friedman, and later his critics, pointed out that efficiency is not the whole story.
Although free markets generally lead to efficient outcomes, that alone is not sufficient to
guide policymaking. Policymakers must be guided by other social objectives—namely,
fairness, or equity. Friedman’s critics argued that efficient outcomes are not necessarily fair
because some individuals can receive too little of the economy’s goods or services.
Policymakers, then, can be viewed as facing a trade-off between efficiency and
fairness. According to this common view, increasing government intervention in markets
leads to more fairness at the cost of less efficiency. But, because government interventions
in the economy have been allowed to expand, the public must view the cost of this lost effi­
ciency as low.
However, a lot has happened since Capitalism and Freedom was published. New
knowledge and evidence have accumulated on the relationship between economic perfor­
mance and government involvement in the economy. These new developments suggest that
the costs of government interventions typically are higher than formerly thought. Such
interventions not only result in one-time losses in economic efficiency, as is commonly
thought, but they typically also reduce growth over time.




2

If the costs of achieving fairness are higher than formerly thought, government
interventions to achieve that goal ought to be scaled back. The public must realize that the
trade-off between efficiency and fairness is not so favorable when viewed in a dynamic, or
growth, context.
To make my arguments concrete, I examine just three of the many ways the gov­
ernment intervenes in markets: trade protection, redistributive taxes and transfers, and
social security. (Of course, I could have also included government interventions in health
care, agricultural price support policies, industrial policies, and so on.) In each case, I
explain why the government has intervened to make things fairer and then show how the
new tools and research reveal much higher economic costs to these interventions than has
been commonly thought. The case of social security is slightly different. Some government
intervention in annuity markets can be defended on efficiency grounds. But actual govern­
ment operation of the social security system can be defended only on fairness grounds. So
the argument here is that once the efficiency concerns are addressed, the costs of govern­
ment operation of the system are much higher than commonly thought.
I begin with the trade-off between efficiency and fairness as it is usually argued.
A key reason the standard analysis fails to capture all of a policy’s costs is that it usually
considers costs at a point in time rather than costs over time. The difference between the
two can be dramatic.
Restoring the balance between efficiency and fairness is simple economically,
but difficult politically. Economically, the solution is to scale back government interven­
tions made in the name of fairness by better targeting benefits to the poor and needy. How­
ever, politically, that is hard to do. Government programs spread benefits widely to low-,
middle-, and high-income people in order to buy support for the program. But there is no
clear rationale for the government to intervene in the name of fairness and distribute bene­
fits to middle- and high-income people. People in these income classes must be convinced
that such interventions are not in their collective best interests. Until they are, politics sug­
gests that the government’s role in the economy will continue to grow.



The Cost of Government Interventions in Theory . . .

The Public Demands Fairness . . .

were justified because it would be unfair to cause workers

By alm ost any m easure, the governm ent’s role in the

in these industries to lose their jo b s or receive less

economy has been growing. For example, the ratio of

income. Recent changes in the income tax structure are

total government expenditures to gross domestic product

another example. The Clinton administration’s 1993 tax

has risen steadily in the last 30 years, from less than 28

bill was justified on the grounds that it was taking income

percent in 1963 to more than 34 percent in 1993. And

from those who had profited (unfairly) from the 1980s tax

even these figures vastly understate the government’s role

cuts and giving the proceeds to the less fortunate. And

in the economy because they exclude mandates, regula­

finally, the greatest expansion in federal governm ent

tions, tax subsidies, and other types of interventions. The

expenditures over the last number of years was in entitle­

government’s role has expanded even though economists

ments, which exist primarily to give more income or ser­

since the time of Adam Smith have agreed that, except in

vices to the poor or unfortunate; that is, they owe their

special cases, private unfettered markets are the most effi­

existence to the public’s support of the goal of fairness.

cient way of delivering goods. So why the expansion?
The short answer is that the public wants to be fair.

. . . But What’s Fairness?

Admittedly, some interventions can be attributed to spe­

Although policies seek to achieve fairness, there’s a sur­

cial cases. Examples include interventions in decreasing

prising lack of agreement among both economists and

cost industries, such as price controls in the cable televi­

noneconomists on what fairness really means and on how

sion industry; interventions because of externalities, such

important it is relative to other social goals. Yet most

as pollution abatement programs; and interventions in cer­

defenders of government interventions in the name of

tain private information, insurance environments, such as

fairness do tend to hold some similar views. They typi­

the mandate of automobile insurance for all drivers. But

cally agree that fairness does not require everyone to get

these special cases cannot explain the extent of the expan­

the same size slice of the economic pie, but they argue

sion. Rather, the increase in government interventions

that market outcomes are often unfair because some peo­

reflects a dissatisfaction with the ability of markets to pro­

ple get too little. Defenders also agree that fairness is not

vide fair outcomes. Departures from free trade are one

all that counts. They argue that efficiency, or the size of

example. Concessions under the North American Free

the pie, counts too. However, between two systems pro­

Trade Agreement (NAFTA) to individual industries such

ducing the same size economic pie, they agree that the

as sugar beet growers, textile producers, and truckers

one with slices of more equal size is better.




4

(CBO) finds that removing the barriers to trade with
Mexico would lead to little gain in output in the United
States (CBO 1993, p. 23). It follows that the existence of
these barriers costs little in terms of lost efficiency. Sim­
ilarly, another study finds that the tax distortion costs of
the U.S. redistributive income tax system are no larger
than the compliance and collection costs—a modest 5-10
percent of revenues collected (Slemrod 1992, p. 46).

Costs Are Small Initially . . .

The defenders have a strong case. Under unfettered mar­
kets, individuals would be rewarded according to their
contributions to the economic pie. The rewards for some,
however, would be too small to afford them a minimal
standard of living. Changes in the reward system under
unfettered markets could also be very harsh. Since indus­
tries decline as they become obsolete or noncompetitive,
workers in those industries would lose their jobs. Since
the public appears to demand fairer outcomes, govern­
ment intervention is seen as a desirable way to bolster
the standard of living of low-income individuals and to
protect the jobs of individuals in threatened industries.
But the defenders of this type of intervention recog­
nize that interventions incur costs. As economist Arthur
Okun (1975) put it many years ago, there is a trade-off
between equity and efficiency. Efficiency is generally
best served under unfettered markets. In a market sys­
tem, prices signal how to allocate resources, and rewards
provide individuals with the proper incentives. Govern­
ment interference in markets alters the price and reward
structure and causes inefficiencies.
The trade-off is easily seen in an extreme case. Sup­
pose initially that a market economy generates a wide
distribution of income. Suppose next that the govern­
ment intervenes by taxing all individuals earning above
the average (or mean) income and transferring the pro­
ceeds to those whose income is below the average—in
essence making everyone’s income the same. Individu­
als would then have little incentive to work because they
would get the same income whether they worked or not.
In this case, total income, or the size of the economic
pie, would shrink considerably.
In actual practice, though, the loss of efficiency from
interventions is typically seen as modest. That is a major
reason for their proliferation. Okun likened government
redistribution schemes to leaky buckets that carry water
from the haves to the have-nots. Although some water is
lost in transit, the task is still worthwhile because the
unfortunate end up with more than they had before (1975,
pp. 91-106). Empirical studies generally confirm that
the costs of such interventions are small. For instance, a
recent study done by the Congressional Budget Office




. . . But Huge Over Time

Although I have no quarrel with the argument that some
government interventions are necessary to provide ade­
quate income or services to the poor and unfortunate, I
do quarrel with the common assessment of their costs. If
resources are being taken from one group and given to
another based on the income of each, the redistributions
necessarily distort. That is, these interventions necessari­
ly alter the reward structure and thereby alter incentives.
The common view of the costs of these distortions to
incentives, such as that in the two studies above, is
based on an essentially static, or point-in-time, analysis.
However, interventions based on fairness not only lead
to static distortions, but they also can reduce growth—an
effect that can only be measured over time. Such inter­
ventions typically reduce the rewards to innovation and
investment in human and physical capital. The costs of
underinvestment in developing new methods, new skills,
and new equipment can become staggering. It is possi­
ble that the recipients of the government’s redistribution
schemes eventually would be better off without them: a
small slice of a big pie could eventually exceed an equal
slice of a small pie. That is essentially what happened
under Eastern European socialism, leading to the fall of
Communism. Although this brand of socialism was
intended to promote fairness, the economic pie in this
part of the world became relatively so small that the
middle class there became worse off than the poor in
capitalist countries.
Restraining government interventions made in the
name of fairness could lead to more growth by encour­
aging more innovation and investment. More growth is
desirable because it can provide larger slices of the eco­
nomic pie for everyone in the society.

5

. . . And in Practice

The ability to raise both efficiency at a point in time and
growth over time by restraining government is not just a
theoretical possibility. It’s a real option. The next three
sections illustrate how government interventions get

competitive in a global marketplace to industries that
are experiencing a greater demand for their goods or
services.
A gainst this tem porary cost, standard economic

started, how much damage they actually do, and how
they could be scaled back.

analysis suggests the need to consider the benefits of a
more efficient economy. The efficiency gain is thought
to come from comparative advantage (Gould, Ruffin,

Trade Protection

and Woodbridge 1993, pp. 1-2). The idea of compara­
tive advantage is that each country is relatively better

On many different occasions and in many different
ways, the U.S. government has erected barriers to the
free exchange of goods and services across its national
borders. The governm ent, for example, has placed
explicit import quotas on textiles and voluntary import
quotas on Japanese automobiles, collected tariffs on
liquor and taxes on high-priced autos (the incidence of
which falls predom inantly on foreign im ports), and
enacted anti-dumping laws to limit Japanese computer
chips. The prim ary reason these barriers exist is to
maintain the jobs and incomes of those in the protected
industries. For instance, Ross Perot [with Pat Choate
(1993, p. 29)] argues against NAFTA because it “will
accelerate the loss of manufacturing jobs in the United
States . . . . Eventually, companies that choose to stay in
the U.S. will need to reduce employee wages and bene­
fits.” Economists point out that Perot’s argument is not
balanced. He cites some of the costs but ignores all of
the benefits to the U.S. economy from free trade with
M exico. Standard econom ic analysis suggests that
although moving to freer trade may indeed cause some
temporary job displacement, it leads to greater econom­
ic efficiency.

than others at producing some goods or services and so
should specialize in producing what it does best and
then trading. For example, Canada is better off special­
izing in growing wheat, exporting it, and using the pro­
ceeds to purchase oranges rather than growing oranges
at home.
Under standard analysis, the policy issue is this: Do
the benefits of freer trade, in terms of more efficiency,
outweigh the costs of tem porary job displacem ent?
Although economists using the standard analysis typi­
cally favor moving to freer trade, empirically it tends to
be a close call. The costs of lost jobs and income in
some vulnerable industries are readily apparent, while
the comparative advantage gains are usually found to be
fairly small.
Standard analysis, however, understates the costs of
protectionism. It fails to consider how barriers to trade
impede growth. Thus the standard approach will find
only modest advantages to opening U.S. markets. Stan­
dard analysis considers com parative advantage, but
sees only a once-and-for-all efficiency gain. After that
is realized, standard analysis suggests there is no rea­
son why economic growth should be affected. That is
because standard analysis assumes that the rate of tech­
nological advance is unaffected by barriers to trade.
New theory and new observations are not consistent
with that assumption. They indicate that freer trade
p ro m o tes te c h n o lo g ic a l adv an ces and econ o m ic
growth.
In recent years, m acroeconom ists have becom e
in cre asin g ly in te re ste d in why som e c o u n trie s ’
economies grow faster than others. Their studies con­
clude that differences in economic growth across coun­
tries cannot be explained simply by differences in inputs

Standard economic analysis also suggests that only
a minimal connection exists over time between a coun­
try’s level of employment and the openness of its mar­
kets. A country can have full employment if it is an
island economy that doesn’t engage in any foreign
trade or if it is an open economy that is completely free
of barriers to foreign trade. The difference in employ­
ment between the economies would be not in the total
number of jobs but in the types of work the jobholders
do. This analysis suggests that moving to freer trade
can have some temporary costs because workers will
be relocated from industries that have become less




6

Barriers to trade can affect growth by slowing down the rate o f technological
innovation. Protected industries do not have to discard their outmoded technologies,
and this resistance to change can reduce economic growth.




i

of labor and capital (Lucas 1988 and Schmitz 1993). But
economists are not in agreement on what other factors
explain differences in economic growth. Some cite vary­
ing degrees of resistance to adopting new technologies.
Such resistance can come from capitalists or workers
who have stakes in maintaining old technologies. (See,
for example, Holmes and Schmitz 1994.) Others cite dif­
ferences in human capital, that is, in the education,
training, and experience of workers that affect their
skills and competency (Lucas 1988).
Recent work by economist Robert Lucas (1993) out­
lines a model that illustrates both of the above explana­
tions. He begins by examining differences in human
capital across countries and finds that they are not due
just to disparities in formal education. Countries which
are similar with respect to labor and capital inputs and
formal education still can have significantly different
growth rates. Lucas argues that the essential differences
in human capital across countries are due to disparities
in leaming-by-doing on the job.
Lucas’s theory suggests that economic growth is
affected by the amount of leaming-by-doing on the job.
It also indicates a route by which trade barriers can lead
to lower growth, and recent evidence confirms that this
route exists.
It follows from leaming-by-doing that a relationship
should be observed between the productivity of workers
and the length of their experience working with a given
technology. Lucas examines how the number of worker
hours to com plete a given project varies as worker
experience grows. In particular, he refers to a Labor
Department study of worker hours needed to produce
Liberty ships (cargo-carrying ships built for the United
States and its allies during World War II). If that rela­
tionship (which is input per unit of output) is inverted, a
picture emerges of how worker productivity (that is,
output per unit of labor input) varies with worker expe­
rience. The pattern seems intuitive and general. When
workers begin a new technology, their productivity is
quite low. Everything is new to them. However, after a
slow start, their productivity climbs rapidly as they
become more familiar with their tasks and learn better
ways of carrying them out. Eventually, productivity lev-




The Learning-By-Doing Pattern
Experience reduces the time workers need
to do a job,. . .
Number of Worker Hours Needed to Produce One Liberty Ship
Monthly, December 1941-December 1944

Source: Searle 1945, p.1135

. . . which means they become more productive.

A shift to a new technology reduces productivity
— temporarily.

In the 1980s and 1990s countries in East Asia and Latin
America that opened their markets experienced rapid
growth. A study done at the Dallas Federal Reserve
finds that “outw ard -o rien ted p o licies are a much
stronger conduit for economic growth and advancement
than protectionist import substitution policies” (Gould,
Ruffin, and Woodbridge 1993, p. 4). It cites an analysis
of 29 episodes of trade liberalization which finds that
growth increased in manufacturing and agriculture fol­
lowing the liberalizations (Papageorgiou, Michaely, and
Choksi 1991).
Other empirical studies, both formal and informal,
support the conclusion that freer trade promotes growth.
One formal study finds a positive relationship between
openness and growth and concludes that

els off as workers master the bulk of the necessary
skills and procedures.
It also seems intuitive that productivity will initially
fall as a firm moves up the technology ladder. When a
new technology is adopted, productivity initially falls
because workers must learn new skills and procedures.
However, with the new and improved technology, pro­
ductivity will eventually surpass what it was with the
old one.
This pattern of leaming-by-doing suggests that eco­
nomic growth depends on how fast old technologies are
discarded and new ones adopted. If technologies are dis­
carded too rapidly, economies absorb the initial costs of
switching to new technologies but do not exploit the
gains from rapidly rising productivity on existing tech­
nologies. This, in fact, seemed to be the experience of
Singapore (Young 1992). However, if technologies are
kept for too long, economies are faced with slow pro­
ductivity growth because workers’ learning-by-doing
has plateaued. This, in fact, seemed to be the experience
of Great Britain. Thus there is a rate of technological
innovation that maximizes growth.
Barriers to trade, then, can affect growth by slowing
down the rate of technological innovation. Protected
industries do not have to discard their outmoded tech­
nologies. Theoretically, these barriers could promote
growth if, without them, a country’s rate of technologi­
cal innovation were too fast. In contrast, they could
lower growth if, without them, a country’s rate were
about right or too low.
Thus the relationship between growth and trade barri­
ers becomes an empirical issue. The new observations
and new statistical studies strongly suggest that freer
trade promotes higher growth. The evidence comes from
casual observation, careful historical review, and formal
econometric analysis.
Since Friedman’s Capitalism and Freedom was pub­
lished in 1962, many new observations on the link
betw een fre e r trad e and econom ic grow th have
amassed. During the 1950s, 1960s, and 1970s econo­
mists persuaded developing countries to erect trade bar­
riers to protect their infant industries (Edwards 1993).
The economies of these countries generally stagnated.




when openness and the level of public infrastruc­
ture are taken into account, physical investment
becomes quantitatively more important in the
growth process, implying that a better quality of
investment is encouraged by a more liberal inter­
national trade regime and by more government
fixed investment. Particularly for the developing
countries, investm ent in human capital also
becomes more quantitatively important when a
more open trading environment and a better pub­
lic infrastructure are in place. (Knight, Loayza,
and Villanueva 1993, p. 536)
Similarly, another recent study finds that economic
growth was stimulated in France by a freeing of trade
within the European Community (Coe and Moghadam
1993). Finally, an extensive survey of historical studies
and econometric analyses relating growth and trade pro­
tection in developing countries was recently published
(Edwards 1993). While critical of all of the studies cited,
the survey finds a positive relationship between freer
trade and growth in almost all of them.
The message from the new theory and evidence is
clear: trade protection inhibits growth. Thus, in erecting
or maintaining trade barriers, the fairness benefit of pro­
tecting workers should not be weighed against just the
one-time cost of lower efficiency due to reduced com­
parative advantage. It also is necessary to include the
cost of lower economic growth.

9

income quintiles. A little less than half the members of
the bottom quintile moved up into a higher quintile, and
about half the members of the top quintile fell out of that
quintile” (Sawhill and Condon 1992, p. 3).
A U.S. Treasury Department study (1992) finds that a
significant degree of household mobility over time is
explained by the life cycle pattern of earnings. In their
early years individuals typically invest in acquiring
skills and furthering their education and thus earn low
incomes. In their later years they earn progressively

Redistributive Tax and Transfer Policies

Redistributive taxes and transfers is a second area where
government interventions made in the name of fairness
could be scaled back to promote higher growth. It is
generally observed that in the 1980s the rich got richer
and the poor got poorer (McKenzie 1992). The govern­
ment responded with changes to federal income tax and
transfer policies (beginning with the 1986 tax reform) to
counter this increase in income disparity (CBO 1994,
pp. 54-57). In 1993, for example, marginal tax rates
were raised significantly on higher-income families and
the earned income tax credit was greatly expanded for
lower-income families. These changes were defended
based on fairness arguments.
Standard economic analysis recognizes that these
changes, especially to higher marginal tax rates, had costs
in terms of lower efficiency. Higher marginal tax rates on
the wealthy were seen as distorting investment decisions
by encouraging the use of tax shelters. A more progres­
sive tax system also was seen as reducing the supply of
labor, primarily that of households’ secondary income
earners. However, these costs were seen by policymakers
as low relative to the benefits of a fairer income distribu­
tion, and so the policy changes were enacted.
The standard measure of redistribution costs under­
state the true costs because they fail to include the cost
of lower growth. The costs are m easured under the
assumption that the income distribution is static—the
same individuals are either unemployed or working at
the same jobs year after year. Costs to redistribution,
then, are thought of in terms of how they affect individu­
als in given income classes. (These classes are usually
defined by quintiles, which each contain one-fifth of the
population.)
Recent research indicates that the static assumption is
false and provides a new way to think about the income
distribution. Suppose income quintiles are hotel rooms
and individuals are the occupants (Sawhill and Condon
1992). Standard analysis assumes the same individuals
are in the same rooms year after year. But, in fact, recent
studies indicate that a significant amount of room-chang­
ing is occurring over time. It is reported that in both the
1970s and 1980s “some three out of five adults changed




higher incomes as they realize the returns to their invest­
ment in human capital.
Thus, for many people, progressively higher marginal
tax rates represent reductions in the rate of return to their
human capital. In their early adult years they must sacri­
fice income to invest in their human capital by taking time
to study and train. They are willing to invest because they
foresee an adequate return in terms of higher future
income. Progressively higher marginal tax rates reduce
the return to their human capital investment by removing
progressively larger chunks of their future income.
There is good reason to believe that people’s career
decisions are affected by changes in returns; that is, they
go where the money is. For example, one study reports
that in the 1980s there were large increases in the rela­
tive supplies of most of the types of workers whose rela­
tive w ages increased (B ound and Johnson 1992).
Another study finds a large enrollment response to a
change in the return to higher education (Blackburn,
Bloom, and Freeman 1991). These and other studies
suggest people respond to rewards as theory and com­
mon sense suggest. Thus lowering the returns to invest­
ment in human capital will lower the amount of time and
effort people put into training and education.
The argum ent that redistribution lowers growth
depends on the existence of significant mobility across
income classes, as is true in the United States. In the
United States, progressive taxes are mainly just higher
taxes on the same individuals as they move through their
careers, causing them to invest less in their human capi­
tal. The argument need not hold for other countries
which have little m obility across classes. For those
countries, taking money from the few rich and giving it

10

The market is signaling higher returns to acquiring skills and education. When
these signals are clearly received, individuals are encouraged to develop greater
skills, such as computer training, and to acquire more schooling, such as a college
degree. Higher progressive taxes mute those signals, however, and they decrease the
incentives to invest in these types o f hum an capital. This reduction in investment
will slow growth.




to the many poor could allow the poor to invest more in
their human capital, such as schooling, thus raising total
human capital investment and growth. But, again, in the
United States, where schooling is available to all and
mobility is high, this possibility seems remote.
That there is a conflict between fairness, or equity, and
growth can be seen clearly in the current U.S. environ­
ment. By almost all accounts the income distribution has
widened, and that in itself has brought calls for a greater
use of redistributive taxes and transfers. However, this
widening in the income distribution can be traced primari­
ly to changes in real, or technical, factors. Thus greater
redistribution, which mutes the message of markets, limits
individuals’ response of either investing in the skills or
going to the jobs where the returns are highest.
Most studies conclude that the major cause of the
widening U.S. income distribution in the 1980s was a
growing inequality in real earnings. Tax and other policy
changes caused little of the widening. In fact, one study
finds that m ost advanced in d u strialized countries
showed increases, often large, in wage inequality during
the 1980s (Davis 1992). Thus other industrial countries
experienced similar income distribution changes as in
the United States even though their policy courses were
very different.
The changes in real earnings, meanwhile, are general­
ly thought to be due to changes in technology (Bound
and Johnson 1992). In the 1980s low-skilled jobs suf­
fered a decline in real wages, while high-skilled jobs
experienced a rise in real wages. The changes in real
wages reflect a higher return to education, training, and
experience. The most likely explanation for the changes
in returns is the use of advanced technology that substi­
tutes for the work of low-skilled workers and at the same
tim e m akes h igh-skilled w orkers m ore productive
(Bound and Johnson 1992). One study finds that workers
who do use more advanced technology get paid higher
wages (Dunne and Schmitz 1992). Another study finds
that the evolving use of the computer can explain much
of the measured technological advance (Krueger 1993).
Since the changes in income distribution were largely
technology-induced, the government’s effort to dampen
the associated changes in the reward structure certainly
will slow growth. The market is signaling higher returns




to acquiring skills and education. When these signals are
clearly received, individuals are encouraged to develop
greater skills, such as computer training, and to acquire
more schooling, such as a college degree. Higher pro­
gressive taxes mute those signals, however, and they
decrease the incentives to invest in these types of human
capital. This reduction in investment will slow growth.
Social Security

The social security system is the final example I use to
illu stra te my point that scaling back governm ent
interventions made in the name of fairness would pro­
mote growth.
Social security serves a valuable function in society
by assuring that all older individuals have a modest
amount of income when they retire. But flaws in the way
the system is designed and administered make it both
inefficient and growth-stifling. Correcting these flaws is
feasible, and the result would be gains in economic effi­
ciency and growth.
The government’s social security program is financed
differently than a private pension system. The program
is financed pay-as-you-go: current workers are taxed,
and the proceeds are distributed to current retirees. The
federal government does not accumulate assets to meet
its future obligations as a private pension system does. If
it did, social security now would be recording a surplus
as a trust fund, while the federal budget with the social
security trust fund removed would be in rough balance
on a present-value basis. However, current budget pro­
jections indicate that the federal budget deficit excluding
social security will grow steadily from $242 billion in
fiscal 1995 to $304 billion in fiscal 1999 (CBO 1994, p.
26). Presumably, this deficit will continue to grow into
the next century. The implication is that instead of social
security revenues net of expenditures being used to
acquire assets, they are being used to finance other gov­
ernment expenditures. Thus future obligations under
social security will have to be financed by taxes on
future generations of workers.
Because of the way social security is financed, its
future appears much less rosy than its past. In the past the
program steadily increased payments to retirees and paid
retirees many times what they put into the plan. This

expansion in benefits was financed by rising social secu­

income redistribution. It defines benefits for retirees, and

rity tax revenues fed by increases in the percentage of the

those benefits are only loosely tied to contributions. This

workforce paying into the plan and in both the social

has allowed the system to redistribute income from the

security tax rate and tax base. However, in the future the

newer generations to the older generations and among

return to retirees looks much less favorable. Since the

individuals in the same generations.

program now applies to virtually all workers, no substan­

The social security system, then, can be thought of as

tial increases in coverage are possible. Demographics are

a mandatory, unfunded pension system and a complicat­

also turning less favorable. In the 1980s there were five

ed tax/transfer system. Because of the fairness aspects of

workers supporting each retiree. By 2050 that 5-to-l ratio

the system, the governm ent has chosen to operate it. I

will fall to 2-to-l. These facts suggest that in the future

argue that the United States would be better off with pri-

retirees will be getting less back from the plan than they
put in (Goodman and Musgrave 1992, chap. 13).
This unsettling future gives good reason to consider

How Adverse Selection
Affects Annuity Markets

reforms of the system. Two reforms are readily suggest­
ed: first, back future obligations with funds of assets,
and second, turn over the management of those funds to

The adverse selection problem in annuity markets is easy

the private sector. Because these reform s would make

to see. Suppose an insurance company offers an annuity

the system more market-oriented, they would likely lead

which pays a fixed sum of money per month to individuals

to greater efficiency and higher growth.

at age 60 for as long as they live and which charges a pre­

Under this proposed privatization scheme, the gov­

mium based on the population's average life expectancy.

ernment would still have a role in the social security sys­

Then individuals who have sound, and in part private,
information which suggests that they will live longer than

tem. That role is dictated on efficiency grounds. Due to

average would have an incentive to buy the annuity. How­

adverse selection problems (which are explained in the

ever, those who expect to live shorter than average would

sidebar), unfettered private annuity markets are unlikely

have an incentive not to buy the annuity. Thus those who

to be able to provide adequate protection to workers.

buy the annuity would have life expectancies longer than

However, the governm ent can address these problems

the population average, costing the insurance company

without managing the system.

more than it had planned and forcing it to raise its premi­
um. But then those with poorer health who were willing to

Thus the social security example is a little different

buy before would no longer want to buy at the higher pre­

from the previous two. The argument is not that unfettered

mium. This adverse selection process could continue until

annuity and pension markets are most efficient. In fact,

it becomes unprofitable for the insurance company to

some government intervention seems necessary for effi­

offer any annuity at all. This could occur even though the

ciency. However, it is not necessary that the government

public were better off with active annuity markets. (See,

operate the system. The argument, then, is that changing

for example, Eckstein, Eichenbaum, and Peled 1985.)
The government can help attenuate the adverse selec­

the g o v ern m en t-o p erated system to a p riv ately run,

tion problem. It need only issue two simple edicts:

funded system will increase both efficiency and growth.

■ In s u ra n c e co m p an ies ca n n o t d is c rim in a te in

The government, o f course, could have opted for a

their premiums based on the perceived health of

privately run social security system at the outset, but

the applicants.

instead it chose to operate the system itself. Since it

■ All individuals must buy some m inimal amount

could have addressed the adverse selection problem s

of annuities.

w ithout m anaging the system, it m ust have had other

Edicts of this type are common in other types of insur­

reasons for doing so. It appears that the other reasons are

ance. For instance, they are included in the administra­

based on fairness— fairness dictated a government-run,

tion's health care plan to address the sim ilar adverse

pay-as-you-go system.
The social security system aims for fairness through

selection problems in health insurance markets.




13

vate operation of a funded pension system subject to
government edicts addressing adverse selection and with
an explicit tax/transfer policy targeting income to the
older poor.
The government-run system is less efficient than the
one I am advocating. Under the government-run system,
workers view their social security contributions as a tax.
In fact, this is a major reason why the CBO (1991, pp.
71-75) argues that social security payments and contri­
butions should be consolidated with ordinary government
expenditures and taxes. Workers view their contributions
as taxes because their future benefits are not closely tied
to those contributions. Their future benefits are promised,
but the government at times changes them. In fact, those
benefits depend not only on economic and demographic
developments that affect future real income and the size
of the future workforce, but also on the willingness of
future workers to continue to participate in the plan.
In contrast, workers contributing to a private plan
would own their pension/annuity and thus be less prone
to view it as a tax. Benefits would depend on the amount
they contribute and on the return to their investment.
Their payoff would be uncertain only because the rate of
return to their investm ent would be uncertain. There
would be no uncertainty with respect to the willingness
of future generations to participate.
Society might still want to redistribute income on
fairness grounds even with a privately run system. But
then the government would have to make explicit the
taxes and transfers for carrying out the redistribution.
Making the redistribution explicit would likely make it
less pervasive and better targeted.
The privately run system is likely to lead to greater
economic efficiency than a government-run system for
two reasons. First, privately run funds would have to
compete among themselves and would likely be more
efficient than a monopolistic, government-run fund. Sec­
ond, the redistribution scheme used with a privately run
system would likely be more limited, which would lead
to smaller disincentives to work and save.
Probably more important, though, a privately run sys­
tem would lead to higher growth. That is because the
rate of return to investment in a privately funded system



would be greater than the rate of return to contributions
in a pay-as-you-go system. In a paper written well after
Friedman’s Capitalism and Freedom, economist Martin
Feldstein (1987) examines the economic consequences
of shifting dollars from an unfunded to a funded system.
He finds that an extra dollar placed in a funded system
would yield to retirees the pretax rate of return on pri­
vate capital, which might be expected to lie in the 10-15
percent per year range, as it has in the last 40 years.
However, an extra dollar contributed to the unfunded
social security system would yield a rate of return equal
to the rate of growth of the economy, which most ana­
lysts now expect to be around 3 percent per year. This
suggests that growth would be increased if resources
were shifted from the low-yielding social security sys­
tem to a higher-yielding privately funded system.
Although shifting to a privately funded system would
increase growth, it would not make every generation
better off. The shift requires that society as a whole save
more by paying less to current retirees. Thus the current
old generation would be made worse off. Feldstein
shows that under reasonable assumptions and using stan­
dard ways of weighting the welfare of different genera­
tio n s, the gains to the cu rren t young and fu tu re
generations would greatly exceed the losses to the cur­
rent old generation. Nevertheless, current retirees would
be hurt by the shift. This suggests that if dollars are
shifted out of social security, the shift should be made
gradually, and the dollars should be taken from those
most able to fend for themselves—the people with high
incomes and wealth.
This proposal to shift to a privately run social securi­
ty plan will strike many as unrealistic, if not ridiculous.
However, it should be noted that such a shift is being
made in other countries. Chile gave workers the option
to put their money either in the state-run system or in
private funds. Most workers have been choosing the pri­
vate funds, so the state-run system is gradually being
phased out. Moreover, the Chilean plan has proved so
successful that other Latin American countries either
have adopted similar programs (Mexico and Peru) or are
in the process of doing so (Argentina, Bolivia, and
Venezuela) (Survey 1993).

Growth would increase i f resources were shifted from the low-yielding social security
system to a higher-yielding privately fu n d ed system.




15

The task confronting society is to develop systems that target benefits to the poor
while interfering as little as possible with the private markets’ ability to foster
efficiency and growth.




16

Public Attitudes Must Change

My argument that the costs of government interventions made in the name of
fairness are costlier than commonly thought does not suggest that they should be eliminat­
ed. Rather, it suggests that they should be scaled back. Economically, restraining or scaling
back government redistributions seems straightforward and easy to do. Politically, it seems
difficult. That is why public attitudes toward government redistributions must change first.
Economically, all that is required is that programs to redistribute resources be
better targeted. The economic rationale for these programs is to provide resources to the
poor and needy. No economic rationale exists for providing resources to individuals in the
middle- and upper-income classes. Yet that’s where most of the money goes. A study of
how federal benefits are distributed across income classes finds that the benefits scarcely
redistribute income at all (Howe 1991). In fact, over 40 percent of the 1991 benefits went to
households earning over the average (median) cash income, which was three to four times
the poverty threshold for a family of two.
By making transfers to those who are not needy, the amount of redistribution is
much larger than it has to be for fairness. This excess unnecessarily raises the costs to the
economy in terms of inefficiency and slow growth. Economically, interventions made in
the name of fairness can then be easily restrained by making all benefits means-tested, that
is, making sure the benefits go only to people whose wealth and income are below some
threshold levels.
Politically, this remedy may be hard to apply. The benefits of government redis­
tributions tend to be spread widely because that is what the public wants. In order to get
public support for such programs, politicians find it necessary to distribute their benefits far
beyond just the truly needy. Many people have the attitude that if they pay for a program,
they deserve some of the proceeds. As long as the public feels this way, there will be little
support for reining in government programs and interventions.
The public, however, has it dead wrong. If the government is to intervene based
on fairness, its role is to redistribute resources from the middle- and upper-income classes




17

to the poor. Period. People in the middle and upper classes would be much better off if the
amount of taxes used for their own benefits was eliminated and they used the increase in
their after-tax incomes to arrange privately for their benefits. In this way fairness could still
be served, but the government’s role and the resulting inefficiencies could be diminished.
Milton Friedman was right to stress the advantages of unfettered markets. Yet his
critics also were right to point out that some individuals in society cannot attain an accept­
able level of existence without help. The task confronting society is to develop systems that
help the poor while interfering as little as possible with the private markets’ ability to foster
efficiency and growth. That means targeting redistributions carefully. It means the public
must become aware of the high cost of extending benefits to those who do not truly need
them. It also means that failure to change could cause society to pay an increasingly high
cost as time goes by.




18

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argument for comprehensive “means-testing.” Policy Paper 3.
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Knight, Malcolm; Loayza, Norman; and Villanueva, Delano. 1993.
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19







Federal Reserve Bank of Minneapolis

Statement of Condition

Earnings and Expenses

Directors

Officers

Federal Reserve Bank of Minneapolis




Statement of Condition (in thousands)
December 31,
1993

December 31,
1992

Assets

Gold Certificate Account
Special Drawing Rights
Coin
Loans to Depository Institutions
Securities:
Federal Agency Obligations
U.S. Government Securities
Cash Items in Process of Collection
Bank Premises and Equipment
Less Depreciation of $42,172 and $39,475
Foreign Currencies
Other Assets
Interdistrict Settlement Fund

$ 243,000
186,000
15,365
4,300

$ 195,000
186,000
15,746
1,400

106,173
7,599,809

84,354
4,597,670

465,435

414,847

43,626
585,294
172,676
(1,003,850)

42,374
565,807
110,165
2,554,661

$8,417,828

$8,768,024

$7,048,384

$7,458,324

676,876
3,642
5,327

721,109
3,656
5,374

Total Deposits

685,845

730,139

Deferred Credit Items
Other Liabilities

435,376
66,535

390,367
29,256

8,236,140

8,608,086

90,844
90,844

79.969
79.969

181,688

159,938

$8,417,828

$8,768,024

Total Assets
Liabilities

Federal Reserve Notes1
Deposits:
Depository Institutions
Foreign, Official Accounts
Other Deposits

Total Liabilities
Capital Accounts

Capital Paid In
Surplus
Total Capital Accounts
Total Liabilities and Capital Accounts

1 Amount is net o f notes held by the Bank o f $1,171 million in 1993 and $733 m illion in 1992

Earnings and Expenses (in thousands)

For the Year Ended December 31,

1993

1992

$347,125
32,740
1,749
41,659
129

$255,108
56,066
1,301
40,733
449

423,402

353,657

43,306
10,513
2,728
5,814
500
2,143
2,431

37,950
8,560
2,266
5,738
458
2,074
2,161

866
1,149
1,046
1,440

923
1,244
939
1,167

970
5,130
3,029
3,945
(870)
2,048

687
5,108
2,673
4,131
429
1,752

Current Earnings

Interest on U.S. Government Securities and
Federal Agency Obligations
Interest on Foreign Currency Investments
Interest on Loans to Depository Institutions
Revenue from Priced Services
All Other Earnings
Total Current Earnings
Current Expenses

Salaries and Other Personnel Expenses
Retirement and Other Benefits
Travel
Postage and Shipping
Communications
Software
Materials and Supplies
Building Expenses:
Real Estate Taxes
Depreciation—Bank Premises
Utilities
Rent and Other Building Expenses
Furniture and Operating Equipment:
Rentals
Depreciation and Miscellaneous Purchases
Repairs and Maintenance
Cost of Earnings Credits
Net Costs (Distributed)/Received from Other FR Banks
Other Operating Expenses
Total Current Expenses

86,188
(6,893)

3,431
6,643
4,682
228,762

$ 10,875

$ 10,143

$ 79,969
10,875

$ 69,826
10,143

$ 90,844

Transferred to surplus

(26,635)

3,739
8,021
5,321
303,003

Net (Deductions) or Additions2
Less:
Assessment by Board of Governors:
Board Expenditures
Federal Reserve Currency Costs
Dividends Paid
Payments to U.S. Treasury

280,296

(13,148)

Current Net Earnings

73,361

344,107

Net Expenses

(4,899)

79,295

Reimbursed Expenses'

78,260

$ 79,969

Surplus Account

Surplus, January 1
Transferred to Surplus—as above
Surplus, December 31

1 Reimbursements due from the U.S. Treasury and other Federal agencies;
$1,890 was unreimbursed in 1993 and $1,958 in 1992.
2 This item consists mainly o f unrealized net gains or (losses) related to
revaluation o f assets denominated in foreign currencies to market rates.




23

Directors

Federal Reserve Bank of Minneapolis

Delbert W. Johnson
Chairman and Federal Reserve Agent

Helena Branch

Gerald A. Rauenhorst
Deputy Chairman

James E. Jenks
Chairman

Class A Elected by Member Banks

Lane W. Basso
Vice Chairman

Susanne V. Boxer
President
Houghton National Bank
Houghton, Michigan

Appointed by the Board of Governors

Lane W. Basso
President
Deaconess Medical Center
Billings, Montana

Charles L. Seaman
President and Chief Executive Officer
First State Bank of Warner
Warner, South Dakota

James E. Jenks
President
Jenks Farms
Hogeland, Montana

William W. Strausburg
Chairman and Chief"Executive Officer
First Bank Montana, N.A.
Billings, Montana
Class B Elected by Member Banks

Appointed by the Board of Directors
Federal Reserve Bank of Minneapolis

Duane E. Dingmann
President
Trubilt Auto Body, Inc.
Eau Claire, Wisconsin

Beverly D. Harris
President
Empire Federal Savings and Loan Association
Livingston, Montana

Dennis W. Johnson
President and Chief Executive Officer
TMI Systems Design Corp.
Dickinson, North Dakota

Donald E. Olsson, Jr.
Executive Vice President
Ronan State Bank
Ronan, Montana

Earl R. St. John, Jr.
President
St. John Forest Products, Inc.
Spalding, Michigan

Nancy McLeod Stephenson
Executive Director
Neighborhood Housing Services
Great Falls, Montana

Class C Appointed by the Board of Governors

Delbert W. Johnson
President and Chief Executive Officer
Pioneer Metal Finishing
Minneapolis, Minnesota
Jean D. Kinsey
Professor of Consumption and Consumer Economics
University of Minnesota
St. Paul, Minnesota
Gerald A. Rauenhorst
Chairman and Chief Executive Officer
Opus Corporation
Minneapolis, Minnesota

Federal Advisory Council Member

John F. Grundhofer
Chairman, President and Chief Executive Officer
First Bank System, Inc.
Minneapolis, Minnesota

December 31, 1993




24

Officers

Federal Reserve Bank of Minneapolis

Gary H. Stem
President
Colleen K. Strand
First Vice President
and Electronic Payments
Product Director

John H. Boyd
Senior Research Officer

S. Rao Aiyagari
Research Officer

Kent C. Austinson
Supervision Officer

Scott H. Dake
Vice President

Robert C. Brandt
Assistant Vice President

Marvin L. Knoff
Supervision Officer

Sheldon L. Azine
Senior Vice President

Kathleen J. Erickson
Vice President

Marilyn L. Brown
Assistant General Auditor

Robert E. Teetshom
Supervision Officer

Ronald E. Kaatz
Senior Vice President

Creighton R. Fricek
Vice President

James T. Deusterhoff
Assistant Vice President

James M. Lyon
Senior Vice President

Karen L. Grandstrand
Vice President

Debra A. Ganske
Assistant Vice President

Arthur J. Rolnick
Senior Vice President
and Director of Research

Caryl W. Hayward
Vice President
and Electronic Payments
Product Manager

Jean C. Garrick
Assistant Vice President

Melvin L. Burstein
Executive Vice President,
Senior Advisor and General Counsel

Theodore E. Umhoefer, Jr.
Senior Vice President

Peter J. Gavin
Assistant Vice President

William B. Holm
Vice President

Linda M. Gilligan
Assistant Vice President

Ronald O. Hostad
Vice President

Jo Anne F. Lewellen
Assistant Vice President

Bruce H. Johnson
Vice President

Susan J. Mendesh-Fitzgerald
Assistant Vice President
and Assistant Electronic
Payments Product Manager

Thomas E. Kleinschmit
Vice President
Richard L. Kuxhausen
Vice President

H. Fay Peters
Assistant Vice President
and Assistant General Counsel

David Levy
Vice President
and Director of Public Affairs
and Corporate Secretary

Richard W. Puttin
Assistant Vice President
Paul D. Rimmereid
Assistant Vice President

Susan J. Manchester
Vice President

David E. Runkle
Research Officer

Preston J. Miller
Vice President
and Monetary Advisor

Claudia S. Swendseid
Assistant Vice President

Susan K. Rossbach
Vice President and
Deputy General Counsel

Kenneth C. Theisen
Assistant Vice President

Charles L. Shromoff
General Auditor

Richard M. Todd
Assistant Vice President

Thomas M. Supel
Vice President

Thomas H. Turner
Assistant Vice President

Warren E. Weber
Senior Research Officer

Mildred F. Williams
Assistant Vice President

December 31, 1993




25

Helena Branch

John D. Johnson
Vice President
and Branch Manager
Samuel H. Gane
Assistant Vice President and
Assistant Branch Manager

Public Affairs
Federal Reserve Bank of Minneapolis
250 Marquette Avenue
Minneapolis, MN 55401-2171

Designer: Philip E. Swenson
Associate Designer: Beth Leigh Grorud
Illustrator: Brian Cronin
Photographer: Peter Tenzer
Essay Editors: Kathleen A. Mack
Kathleen S. Rolfe
Martha L. Starr





Federal Reserve Bank of St. Louis, One Federal Reserve Bank Plaza, St. Louis, MO 63102