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RAILROADS, REGULATIONS,
AND PUBLIC POLICY
SDR: SUPER-DUPER RESERVE?
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FEDERAL RESERVE
JULY 1971
BUSINESS REVIEW is produced in the Department of Research. Ronald B. Williams is Art Director. The authors will
be glad to receive comments on their articles.
Requests for additional copies should be addressed to Public Information, Federal Reserve Bank of Philadelphia, Philadelphia,
Pennsylvania 19101.
FEDERAL RESERVE BANK OF PHILADELPHIA
Railroads,
Regulations,
and Public Policy
by James L. Freund
and Richard W. Epps
The news of Penn Central's financial col
lapse last year sent a chilling scare through
investors and general public alike. Railroads
have been in some kind of financial diffi
culty since their earliest days. But never has
so large and apparently wealthy a line as
Penn Central threatened to close up shop.
Although few roads are in the bind in
which Penn Central found itself in the sum
mer of 1970, most share some fundamental
maladies — slow growth or decline in op
erations and low earnings. All told, the rail
road system of the nation hauls only a little
more tonnage of freight now than it did 50
years ago — and a lot fewer passengers.
Partly reflecting this slow growth, earnings
of railroads have remained, for a number of
years, among the lowest of all industries.
The rate of return on assets held by the
nation's railroads has averaged about 3.5
per cent throughout the last 20 years —
about the yield an individual might have
received on a passbook savings account in
the mid-fifties.
The poor growth and earnings records
impair the appeal of railroads to investors.
Even a novice investor can find a number of
ways to get a better return on his money
than that promised by railroads. Further
more, slow growth among the roads leaves
investors with little hope of a rosier future
for rails. This lack of appeal to investors has
begun to deal capital starvation to the roads
— a slow death compared to the drama of
Penn Central's end, but a death nonetheless.
It is unlikely that railroads will be allowed
to waste away. It is in the national interest
to maintain an efficient transport system —
one that moves the nation's goods at min
imum cost. Rails presently are the most effi
cient means of transport for a number of
commodities and regions.
However, the future form of the rail sys
tem is in doubt. Passenger transportation
was pushed in the direction of greater pub
lic control this Spring by the formation of
Amtrak, a public corporation with the re
sponsibility of operating inter-city passenger
3
JULY 1971
BUSINESS REVIEW
rail rates on manufactured products are
relatively high, loss of freight tonnage to
trucks has had a more-than-proportionate
impact on rail revenues.
While competition has slowed the growth
of freight tonnage and revenues, the capac
ity of the industry has increased sharply.
Railroads have installed technological im
provements in an attempt to bolster their
competitive positions that, in turn, have
raised the potential productivity of both
labor and capital. Such services as unit trains
and piggy-back operations are among the
most notable innovations. By raising the
potential output of the plant and facilities
of rails, they have made existing capacity
larger than the amount needed to handle
the traffic that the roads receive, given the
present structure of rates.
An increase in the number of unprofit
able lines has compounded the problem of
underutilization of capacity. As the com
petitive position of the industry has changed,
new geographic areas have experienced
growth, and other regions have declined,
the railroads have found themselves bur
dened with an increasing number of lines
which no longer pay their own way.
Many critics see regulation as a partial
cause of both the slow growth of rail out
put and of the tendency of the roads to
maintain substantial excess capacity. The
ICC certainly has played a large role in both
areas — setting the prices of rail services,
and deciding which roadbeds the railroads
must keep and which they may eliminate.
(For a description of the powers of the ICC,
see box.)
Pricing in Transport. Railroads have a
cost structure that allows a number of dif
ferent pricing rules. A large share of railroad
costs — expenditures on maintenance of
roadbed, for example — is relatively fixed
or not directly associated with the move
ment of any particular shipment or set of
shipments. Thus, the direct and identifiable
costs of moving each shipment normally add
up to far less than total costs. So, deciding
trains. Freight service may move in the
opposite direction. Many critics maintain
that the principal source of trouble for rail
road freight operations is the large degree
of intrusion by public authorities — intru
sion in the form of regulation. If some of
the regulations surrounding pricing and
routes were removed, they argue, then
other troubles of the roads, such as the
inflexibility of their workforces, would seem
less foreboding.
Government officials are being pressed to
develop solutions to ease the immediate
financial difficulties of railroads. In the
short run, a number of stop-gap remedies
may be required. However, it is important
that as solutions are developed, an eye is
kept to the long-run objective of improving
the efficiency of the nation's transport
system.
SORTING CAUSES
Like other industries, railroads have suf
fered in recent years from an increasingly
severe cost squeeze as prices of labor and
materials have spiraled upward. But a couple
of special factors have complicated the
squeeze for the rails. First, as other modes
— principally trucks — have impinged upon
the railroad domain, growth of revenues has
slowed. Second, as technology and the com
petitive situation have changed, a large
share of rail capacity has become redundant,
and an increasing number of routes have
become unprofitable.
Since 1940, the railroad share of the
freight transportation market has dropped
by a third. One of the reasons for the de
cline is a change in the types of goods
shipped — for example, from solids to
liquids and gases. Pipeline companies and
water carriers have rushed in to pick up
this freight. Also, competitors have muscled
into the movement of goods that railroads
traditionally have shipped. The most im
portant competition has come from motor
carriers who have taken over much of the
movement of manufactured goods. Because
4
FEDERAL RESERVE BANK OF PHILADELPHIA
INTERSTATE COMMERCE
COMMISSION
and express agencies all are
subject to regulation.
The Interstate Commerce
Commission (ICC) was estab
lished by Congress in 1887.
It continues to operate as an
independent regulatory com
mission.
Functions: The ICC rules on
all rates and charges among
competing and like modes
of transportation. It also de
termines fees of shippers and
receivers of freight. With re
gard to corporate matters, it
must approve mergers, con
solidations, acquisitions of
control, sale of carriers, and
the issuance of securities. The
Commission also grants the
right to operate or abandon
service with respect to both
geographic and commodity
considerations.
Purpose: The ICC is empow
ered to regulate, in the pub
lic interest, carriers engaged
in interstate commerce.
Jurisdiction: Railroads, truck
ing companies, bus lines,
freight forwarders, water car
riers, transportation brokers,
ket, rails lost much of the freight that paid
high rates. Therefore, they have been left
with low-rate bulk shipments which barely
cover the total cost of running the railroads.
Moreover, this pricing approach has pro
duced what may be a rather inefficient divi
sion of business between rails and trucks.
Public interest dictates that each mode
should haul those shipments it can carry
most cheaply. In this way total transport
services will be produced at the lowest
possible cost to society. Within the present
rate structure, it is likely that rails haul
relatively fewer manufactured goods than
considerations of economic efficiency would
suggest. Students of railroads have estimated
that the cost to society of this misallocation
may be as much as $300 million annually.2
Unprofitable Lines. Analogous to the way
revenues from high-value goods have been
used to subsidize the movement of low-
how to set rates to cover the remaining
costs is a problem.
"Value of service" pricing is the solution
the ICC developed in the 1880's.1 Under this
approach rates are set in proportion to the
value of the product being moved — not in
relation to the cost to the railroad of mov
ing the good. In general, this price structure
includes high rates for manufactured prod
ucts that have high value per unit and low
rates for bulk goods such as coal or ore.
The notion behind this pricing approach
is that since transportation costs are small
in relation to the price of high-value goods,
shippers of these goods can better bear the
burden of high rail rates than can shippers
of low-value goods. But as trucks began to
compete in the high-value part of the mar-
1
The ICC has developed a number of rules to sup
plement that of “ value of service" — such as making
sure each mode receives a share of the freight or
2 See, for example, Ann F. Friedlaender, "The Social
assuring the continued health of all elements of the
Cost of Regulating the Railroads," American Economic
rail industry. However, "value of service" pricing has
Review, May 1971, pp. 226-234.
been the single most pervading principle in rate setting.
5
JULY 1971
BUSINESS REVIEW
value goods, the ICC has imposed a system
under which earnings from profitable routes
are used to subsidize unprofitable routes.
The idea is that earnings from more profit
able routes can be used to pay for those
that cannot support themselves, while the
industry as a whole is supposed to earn a
normal profit on the entire operation.
In the earlier days of the industry, most
lines were profitable, and the burden of
supporting less profitable lines as a "public
service" was not unbearable. As times have
changed, however, more lines have gone
into the red. Over the last five years, the
ICC has been petitioned to consent to the
abandonment of almost 9,000 miles of road.
Permission has been granted for about
6,800 miles, representing about 3.3 per cent
of the nation's total trackage. And indica
tions are that more trackage might be aban
doned if there were no constraints against
doing so. For instance, Penn Central Trus
tees recently have stated that about 40 per
cent of the carrier's freight lines might well
be dropped. Each of these lines, the Trustees
argue, fails to pay its own way, and expenses
must be charged against the remaining
profitable lines.
roads. In the long term, the primary interest
of the nation is to create an environment
in which transportation resources are used
most efficiently — an environment in which
special capabilities of each mode are real
ized, and the whole industry is made selfsupporting.
Pricing and the Problem of Unallocable
Costs. To achieve this efficient use of re
sources, the price of each shipment should
equal the cost added to the transport sys
tem by that shipment. Then, when a shipper
is trying to decide between rail, truck, or
water transport, the prices he faces will also
represent the cost to society of moving his
shipment. When he quite naturally chooses
the least expensive mode, he would min
imize the total amount of resources used in
transportation.
However, a large share of rail costs is not
tied to any particular shipment. Where com
petition among modes is strong, the inclu
sion of these unallocable costs could lead
shippers to choose a less efficient mode
over one that is more efficient. For example,
a manufacturer trying to choose between
rail and truck services will choose truck
when its rate is lower. If, as may be the
case, the rail rate is much higher than the
level of assignable costs, the manufacturer
may ship by truck even though the direct
cost to society of making his shipment by
rail is lower. For resources to be allocated
rationally, fixed and unallocable costs should
be covered by rail fees charged only to
those shippers whose decisions are not par
ticularly sensitive to transport expenses —
shippers that would not be driven to ineffi
cient modes.
Towards More Competitive Pricing. If
railroads were allowed to set prices them
selves— without the review of regulatory
authorities — they naturally would tend to
charge low rates to customers whose deci
sions would be strongly affected, and to
cover the unallocable costs by charging high
rates to shippers who are less affected by
transport fees. This would maximize rail
RATIONALIZING REGULATION
Although it is an oversimplification to
argue that regulation is the only problem of
railroads, regulation certainly has contrib
uted to the development of some of the
troubles of the roads. The rate structure for
manufactured goods dictated by regulatory
authorities has slowed growth of revenues.
Further, limitation on the ability of roads
to close down unprofitable lines has caused
the roads to maintain their substantial and
expensive excess capacity.
With the current financial problems of
railroads providing strong motivation, Con
gress, regulatory authorities, and industry
leaders are subjecting transportation regu
lations to close scrutiny. Regulatory changes,
however, must be made with an eye to
more than the present plight of the rail
6
FEDERAL RESERVE BANK OF PHILADELPHIA
goods. Trucks can effectively compete with
rails for movement of most manufactured
goods. Water transport is effective competi
tion for many nonmanufactured goods. But
in areas having no water transport, there is
no effective competition for movement of
many bulk goods. The only limit on rail
prices in these areas is the amount that final
consumers are willing to pay for bulk goods.
A second barrier to the effective operation
of competition is the structure of govern
ment aid currently provided to the various
modes. For competition to result in an eco
nomically rational division of freight among
modes, each must bear an equal proportion
of its own costs of production. As things
stand, non-rail carriers receive substantial
subsidies in the form of fixed facilities —
facilities such as public highways or publicly
maintained waterways. Current subsidies to
the rail system, in contrast, are small. There
fore, if rates were allowed to seek com
petitive levels and the current subsidies to
non-rail modes were continued, there would
revenues and profits. One step towards an
efficient pricing structure, therefore, would
be largely to remove regulation from rate
setting. Without the rigorous hearings and
administrative treatment of a regulatory
agency, rates could be made to adjust
quickly to changes in the economy. More
over, the abundance of information which
regulators must now painstakingly develop
would be created automatically in the mar
ket if the various modes were allowed to
compete freely.
As rails stand today, however, the promise
of deregulation may exceed its realization.
Two kinds of difficulties would hamper
realization of the advantages of free-market
pricing: imperfections in competition, both
among roads and between railroads and
other modes; and differences in the extent
to which the various carriers benefit from
public subsidies.
Head-on competition within the railroad
industry is only scattered. An important
reason for this sparsity is the large cost
that any road m ust undergo to en te r a new
be a te n d e n cy fo r no n-rail carrie rs to receive
market. Right-of-way must be purchased
and rails constructed — expenditures that
few firms are willing to shell out in small
areas that have barely enough demand to
support existing rail facilities.
Intra-rail competition might not work
smoothly even in areas that have more than
one railroad. Where the roads are of vastly
different size — the Great National vs. the
Fifty-Seventh Street Short Line, for example
— the larger road may eliminate its small
competitors by "predatory pricing." That is,
in any locality, large roads may price their
services below cost in order to drive lesser
lines out of business. In fact, this practice
was one of the evils that the ICC was set
up to guard against.
In the many localities that have access
to only one rail system, competition must
be provided by trucks, water transport, or
air carriers. While the economic rivalry pro
vided by these alternatives is intense for
many products, it is often limited for bulk
an overly large share of the freight.
These difficulties put some significant
stumbling blocks in the way of effective
operation of competition in the transport
system, and together act as an argument for
maintaining some degree of regulation.
However, some of the problems may be
avoided by restructuring public policy or
by altering the nature of the rail industry
itself. For example, one method of reducing
barriers to the entrance of competitors
might be to separate the operation of trains
from ownership of roadbeds. Under such a
system every rail operator could move over
any roadbed and compete in every location,
making it difficult for any rail company to
eliminate its competition through such prac
tices such as "predatory pricing." Roadbeds
could be owned either by government, as are
highways and waterways, or by private road
bed companies. Roadbeds could be sup
ported by tolls or fees charged to users, by a
general tax on users, or by some combination.
7
BUSINESS REVIEW
JULY 1971
Abandoning Unprofitable Services. If
many of the regulatory restrictions upon
rails were removed, it is likely that there
would be rather large-scale abandonments
of unprofitable rail lines. A competitive
structure of rail rates may put some routes
into the black that previously accumulated
losses. However, from a strictly economic
point of view, those lines that continue to
ways. As a general rule, if the benefits of
any government action can be assigned to a
group of people, they should pay for them.
For instance, a toll road benefits those peo
ple who use it. Therefore, they are asked
to pay tolls. If a community or region feels
that railroad service is necessary for its de
velopment or that the loss of service would
cause severe consequences, it could tax its
residents to pay for it. Likewise, firms who
benefit from rail service (and benefit most
from continued operation) could be assessed
an extra fee to pay for at least part of the
cost of maintaining service. One possible
plan would entail an arrangement similar to
the way highways are funded, in which a
state or city could be asked to pay part of
the cost, while the Federal Government
picks up the remainder of the tab. In short,
there are many ways of financing those rail
road operations which are not justified on
pure efficiency grounds — ways that do not
endanger the railroads themselves.
be u n p ro fita b le sho uld be ab an d o n ed . In
an economy which is based on criteria of
efficiency, there is a strong presumption
that undertakings should “ pay for them
selves."
However, certain broad arguments are
raised for saving particular lines, arguments
such as the need to move military personnel
and equipment in a time of national emer
gency. While the extensive development of
other modes may be sufficient to handle
transportation requirements, it is possible
that certain defense commodities could
move only by rail.
A more often-heard point is that shut
downs would mean an exodus of firms from
some local communities and, hence, un
employment. While the short-run adjust
ment costs may be substantial in some
areas, over longer periods there seems
little reason why adaptation cannot be
made. The technology of transportation has
changed from the heyday of the railroads in
the 19th Century. Now there are at least
two viable alternatives for shippers in most
areas — trucks and airplanes. The vast de
velopment of the national highway system
in the last 50 years, for example, has made
all regions more accessible.
If railroads are to be required to provide
unprofitable service, it makes little sense to
make them absorb the costs. Likewise, there
seems to be no reason to make rail users
in one region pay for unprofitable opera
tions in other areas. If the general public
decides that these lines should be subsi
dized, it is more sensible that subsidies be
based upon general levies.
Subsidies could be designed in several
"SAVING" THE RAILROADS
If railroads are to be put on a sound
footing, some fundamental changes must be
made in the scheme of regulating the roads
or in the structure of the industry itself.
Recently, several prominent Federal officials
have proposed substantial deregulation as
a solution to the underlying problems
plaguing the nation's railroads.3 Many of
those in the transportation industry and in
government who believe some regulation is
necessary have suggested major changes to
eliminate obsolete rules and inefficient pro
cedures.
The course of deregulation appears to be
a promising route. However, it should be
pursued with care. The Government might
want to retain regulations concerning safety
3 In a speech in January, Assistant Attorney General
Richard McLaren urged more substantial reliance on
competition. The 1971 Annual Report of Economic
Advisers advocated the same course of action.
8
FEDERAL RESERVE BANK OF PHILADELPHIA
their continued operation.
Most of these difficulties may be skirted
by careful development of policy. It will be
in the long-term interest of the nation to
aim changes at developing an efficient trans
port system for the future and not just at
solving the immediate cash-flow problems
of certain railroads. If appropriate changes
are made, the rails may efficiently fulfill a
large role in the nation's transport system. ■
standards, as it does for many other indus
tries. Moreover, it may be important to re
tain protection against monopolistic prac
tices which might develop within the current
structure of the industry. Finally, deregula
tion would cause a number of areas to lose
rail services altogether. If public leaders feel
that these routes should be maintained, then
some sort of subsidy program should be
devised to compensate the railroads for
9
BUSINESS REVIEW
JULY 1971
NOW
IN D E X
TO
A V A IL A B L E :
FEDERAL
BANK
RESERVE
R E V IE W S
Articles which have appeared in the Reviews of the 12 Federal
Reserve Banks have been indexed by subject by Doris F. Zimmermann, Librarian of the Federal Reserve Bank of Philadelphia. The
index covers the years 1950 through 1970, and is available upon
request to the Department of Public Services, Federal Reserve
Bank of Philadelphia, Philadelphia, Pennsylvania 19101.
10
FEDERAL RESERVE BANK OF PHILADELPHIA
SDR: SuperDu per Reserve?
by Alan J. Krupnick
There's an old rusty bucket on the porch.
It carries water to quench the thirst of a
growing, impatient family. The family thinks
it's a good bucket, but occasionally it leaks,
and must be patched. This bucket— the
International Monetary System — has been
serving the needs of the "family" of nations
for a long time. It has helped them double
their trade in the last ten years — but not
without needing major repairs. A new
"leak," sprung by insufficient reserve growth,
meant another patch: Special Drawing Rights
(SDR's). Put into effect January 1, 1970, the
SDR Plan gave each participating country
a "free" increase in its reserves and helped
make 1970 a calm year for international
finance. Yet, even as the SDR has begun to
fulfill its promise, a new danger threatens.
Some fear that the growing stock of another
reserve asset — the U.S. dollar — will not
only put the SDR in jeopardy but also may
deal a sharp blow to the present interna
tional monetary system.
11
JULY 1971
BUSINESS REVIEW
WHY COUNTRIES HOLD RESERVES
When a nation's payments
on international transactions
exceed receipts,* a "deficit"
in the balance of payments
results; when receipts exceed
payments, a "surplus" occurs.
Every country experiences
temporary imbalances in the
normal course of international trade and finance. Paying out or receiving reserves
fills in these gaps, allowing
trade to continue unfettered.
Occasionally, a country has
a chronic deficit — year after
year it pays out more reserves
than it takes in. Recurring
deficits (and recurring surpluses) result from fundamental imbalances in the international economy. The
more reserves deficit coun-
tries accumulate, the longer
trading nations may defer acting on these problems.
Countries use reserves to
help maintain the value of
their currencies. They stand
ready to buy their currency
when its price threatens to fall
below some floor — usually
determined with the advice
and consent of the International Monetary Fund (IMF).
In the mid-1960's, when confidence in the pound floundered, the British government
used its dollar reserves to buy
pounds when too few private
buyers were willing to pay the
minimum price. This action
tem porarily satisfied the
pound sellers and stabilized
its price as buyers realized
there would be no bargains.
In general, the more reserves
a country can accumulate, the
longer it can withstand pressure to lower the value of its
currency (devaluation) and
the more time it has to attack
fundamental problems.
^Receipts for international transactions can occur from exports and
foreign investment in the domestic
economy. Payments can arise from
imports and investment abroad. Payments and receipts used in this sense
do not include transfers of reserves.
..... _ _ : _
_
TRADE IS THE LOSER
the amount it wants helps mold its foreign
economic policy. Should a country find its
reserves greater than the desired level, it is
more likely to take a "liberal" attitude to
wards the international economy — lower
ing tariffs and quotas, encouraging lending
abroad, increasing imports. Countries that
have fewer reserves than they want may
well take defensive action to garner more
Reserve assets, which consist primarily of
gold, U.S. dollars, and reserve positions
(automatic credit lines) with the IMF can be
used by a country for many purposes (see
box above).
A country's perception of the gap be
tween the amount of reserves it has and
12
FEDERAL RESERVE BANK OF PHILADELPHIA
reserves — restricting trade, tourism, or
loans out of the country, or creating export
subsidies.1 For example, the U.S., reacting
to repeated balance-of-payments deficits,
adopted the Voluntary Program and then
the Involuntary Program restricting direct
investment abroad in an attempt to stem
the flow of dollars to foreigners. For the
same reason, restrictions on American travel
abroad were contemplated, and legislation
for new tariffs and quotas drew strong
support.
In the 1950's, European central bankers
readily accepted the dollar as the primary
source of reserve growth. But as dollars
held in foreign reserves (mainly European)
practically doubled in the '60's, the same
central bankers accepted more dollars with
growing trepidation. For one thing, steady
drains on the U.S. gold stock meant only
one-quarter of the foreign-held dollars were
covered by gold — damaging the credibility
of the U.S. "gold for dollars" guarantee.
Further, severe inflation in the U.S. steadily
cheapened the dollar at home, and so fueled
fears of a dollar devaluation abroad.
As far back as 1963, both Europeans and
Americans realized that relying on dollar
deficits to buttress reserves was not the
long-run answer. A new patch on the bucket
was needed to allow more controlled growth
in reserves.
THE UNPLEASANT FACTS
Even though the value of world trade has
more than doubled throughout the 1960's,
this desire of countries to accumulate re
serves may have restricted trade's growth.
Total reserves grew only 27 per cent from
1960 to 1969, as gold held by central banks
inched upward from $38 billion to $39 bil
lion, and "automatic" credit from the Inter
national Monetary Fund rose from $3.6 bil
lion in 1960 to $6.7 billion in 1969. But
reserve currencies, especially U.S. dollars
provided by repeated U.S. balance-of-pay
ments deficits, were the principal source of
new reserves.
ENTER SDR'S
Founded on interdependence and the
common goal of facilitating trade among
the participating nations, the Special Draw
ing Right took the stage on January 1,
1970.2 This new reserve asset added a free,
2 For a complete discussion of the background of
SDR's, see Fritz Machlup, Remaking The International
Monetary System: The Rio Agreement and Beyond
(Baltimore: Johns Hopkins University Press, 1968).
1 If these defensive actions fail, devaluation of the
currency may follow.
13
JULY 1971
BUSINESS REVIEW
If you usually have hefty surpluses of
"greenbacks," you would certainly want a
guarantee of the "bluebacks' " value, assur
ances that "greenbacks" will be available
to you if you ever get caught in a pinch,
and ample safeguards against the misuse
of "bluebacks."
Special Drawing Rights are the "blue
backs" of the International Monetary Sys
tem, created to "meet the global need" for
reserves. Those countries deemed by the
IMF to be "overdrawn" — experiencing
severe balance-of-payments or reserve diffi
culties— can use their SDR's to obtain cur
rency3 from other countries "designated" by
the IMF to receive SDR's. In order to avoid
surprises, a list of designated countries is
drawn up by the IMF at the beginning of
each quarter. Countries on the list should
have strong balance-of-payments or re
serve positions. Exchanges of SDR's for cur
rency may bypass the IMF if two countries
privately concur.
"strings attached" credit to the reserves of
participating countries of $3.4 billion with
the promise of $6 billion more over the
next two years. Perhaps the best way to
glimpse its nature is through an analogy.
Suppose someone offered to give you, for
free, ten blue $10 bills to put in your
savings account alongside your "regular"
money ("greenbacks"), provided you agreed
to abide by some rules. First, your "bluebacks" could only be used to buy "green
backs," and then, only when you needed to
balance an overdrawn checking account;
second, you must be willing to exchange
your "greenbacks" for the "bluebacks" of
the overdrawn person when you have a sur
plus in your checking account. Would you
take the deal? You would probably answer,
"Yes" — if you thought everyone would
work together and no one would abuse his
privileges. But your enthusiasm would be
hinged to the status of your checking ac
count. If your checking account is regularly
or irregularly overdrawn, you would be all
for the idea. If you bought more goods than
you could pay for, you would simply cash
in your "bluebacks" for "greenbacks" to
pay for the extra goods.
3 Eight currencies are currently available: U.S. dollar,
British pound, French franc, German mark, Belgium
franc, Netherlands guilder, Mexican peso, and Italian
lira.
MORE ABOUT THE PLAN
run for "basic" periods — the
first one ends in 1972. Eightyfive per cent of the voting
power must approve all rules
governing operations, transactions, allocations, and cancellations. (Each country's
voting power equals 250 votes
plus one additional vote for
each part of its quota equivalent to $100,000.) The Managing Director and the Executive Directors will make proposals and guide the group's
policymaking.
Members of the IMF who
have decided to participate
in the Plan receive their aliocation of SDR's according to
their quotas with the IMF.
(Quotas are deposits of gold
and a member's own currency with the Fund to serve
as a pool of reserves available to needy member nations.) Roughly, the wealthier
the country, the larger its
quota, and the more SDR's
it receives. Decisions on the
amount of total allocations
14
FEDERAL RESERVE BANK OF PHILADELPHIA
SELLING THE SDR
As an added safeguard against abuse, any
country that seems to the IMF to misuse its
SDR privilege continually and flagrantly may
be designated to accept SDR's regardless of
its payments or reserve position. Refusal to
give up currency in exchange for SDR's may
result in suspension from the Plan.
Moreover, no nation need accept more
than twice its total allocation of SDR's from
user countries during the first basic period.
This provision assures each country that it
will not become overburdened with the
SDR from repeated designations.
To ask for acceptance of untried SDR's
without offering incentives would be like
trying to sell a washing machine without a
guarantee that the machine will work. For
tunately, the Plan is chock-full of incentives.
First, the new asset is tied to gold — one
SDR is equal in value to a specified amount
of gold. This provision assures holders of
SDR's that even if the price of currencies
roller coasters and speculators turn inter
national finance into a game of roulette,
the SDR will maintain its value in terms of
gold.4 Thus, countries holding currencies in
reserve may be persuaded to hold more
SDR's.
Second, in one respect, SDR's appear
more desirable than gold. The IMF will pay
interest of 1.5 per cent to those countries
holding more SDR's than their total alloca
tion. (Likewise, they will levy a charge of
1.5 per cent if holdings fall below this
figure.) Since interest cannot be earned on
gold, countries may look more towards
SDR's to satisfy their reserve desires.
All participating countries may conduct
certain IMF business with their SDR's. Pay
ing charges owed the Fund and repurchas
ing their currency from the IMF used to
require a surrender of highly prized foreign
exchange or gold. Now, at the discretion of
the Fund, SDR's can be used instead.
The Plan guards against the possibility
that any nation will try to cash in all its
SDR's. Over the first three-year basic period,
a nation must keep on hand an average of
30 per cent of its total SDR allocation. At
the end of this period, countries trading in
over 70 per cent of their SDR's will be re
quired to use their gold and foreign ex
change to "buy back" the required amount
of SDR's. Forcing countries to replenish
some of their supply of SDR's should limit
long-term abuse of the Plan.
WHO GAINS FROM SDR'S?
4
Presently, and in the near future, linking the SDR
to gold is believed to be a positive feature. However,
if many currencies revalue, this may not be the case.
15
SDR's offer to all countries the benefits
of expanded world trade through controlled
growth in reserves. But at least two groups
of countries — the developing countries and
chronic deficit countries — are sometimes
singled out as possible special gainers from
the Plan.5
Aid For Development. Developing coun
tries should have little trouble exchanging
their "free" allocations of SDR's for "hard"
currency. Their continual balance-of-payments and reserve difficulties make them
natural, recurring candidates for this tradein. And the currency freely received can be
used to buy much-needed foreign goods
and services which might otherwise have
been denied them.
These countries surprised no one by
rapidly trading in their SDR's for U.S. dol
lars, marks, and other strong currencies.
After only one year, 34 out of 79 develop
ing countries dipped under the 30 per cent
lower limit of SDR holdings. They ex
changed almost half their original SDR allo
cation ($371 million out of $853 million) to
"buy" foreign currency or to "buy b.ack"
their own currency from the IMF. Since they
were able to pay with SDR's, they held on
to "hard" currency. Whether this currency
— acquired or saved — was used for devel
5 Machlup, op. cit., pp. 66-74.
BUSINESS REVIEW
JULY 1971
However, it is likely that the current level
of SDR allocations is too low to affect seri
ously most countries' policies. As the coun
try whose deficit is "heard 'round the
world," the U.S. provides a good example.
The U.S. received $867 million of SDR's,
which fostered more speculation that cor
rection of its deficit would now be slower
in coming. Although deterioration, rather
than improvement, characterized the U.S.
deficit in 1970, SDR's played an insignificant
part in improving the situation. The 1970 def
icit was $5 or $10 billion (depending on the
measurement used). Even if the U.S. used all
its SDR's to reduce this deficit, such action
would probably not have a major impact on
U.S. policies, since a huge imbalance would
remain.8
opment or was simply added to reserves
eludes detection. But it is a good bet
that the attractiveness of using SDR's to
strengthen their domestic economies could
not be resisted.
When SDR's are used this way, a special
kind of developmental aid is conferred —
special because both the donor and recip
ient are anonymous. Developing nations
can employ SDR's to acquire currency.
When this currency is used to purchase
goods and services abroad, the selling nation
certainly gives up resources. However, it
may use the proceeds of the sale to pur
chase goods from other nations, which may
buy goods from still other nations, and
so on. Therefore, the ultimate supplier and
the original buyer of goods are unknown
to each other. Because of this anonymity,
the political tone of the receiving country
can bear no consideration in the donor's
aid decision. And removing aid from the
budget of the donor country makes it less
vulnerable to legislators' disenchantment.
Block aid from industrialized countries to
developing countries has been suggested
before as an alternative to the problems
arising from identifiable donor-recipient re
lationships. But now, through the "back
door" of a Plan designed for entirely differ
ent purposes, it has a chance to work.
Aid For Adjustments? Some have specu
lated that SDR's will allow chronic deficit
countries more time to make fundamental
adjustments.6 One incentive for adjustment
comes when a chronic deficit country finds
its reserves disappearing or claims against its
reserves mounting. But the more reserves a
country possesses, the longer these pressures
will seem manageable. And, depending on
your point of view, the country either has
less incentive for adjustment or more
"breathing space."7
TOO SOON TO TELL?
Whether SDR's will help developing
countries to grow and allow deficit coun
tries more time for making fundamental ad
justments are but two parts of the story. Of
more importance is the SDR's impact on
global reserves and, hence, on world trade
and other international concerns. Total re
serve assets can be expected to expand with
each yearly addition of SDR's, although
some countries may neutralize a portion of
the allocation by using SDR's to retire their
currencies held in foreign reserves9 (or the
supply of other reserve assets may contract).
Actually, the question is not whether re
serves will expand with future allocations,
7 While SDR's allow deficit countries to defer acting
on fundamental imbalances, adjustment for the whole
system need not be slowed. Chronic surplus coun
tries, faced with increasing reserves, may find more
incentive to speed up adjustments.
8 Since the U.S. appeared on the designated list for
three out of four quarters in 1970, it was, for the
most part, ineligible to exchange its SDR's within the
6
Examples of fundamental adjustments are devalua usual IMF user-designator framework. But in five
tion, revaluation, and attempts to alter the domestic
privately arranged transactions, the U.S. exchanged
$260 million in SDR's for foreign-held dollars, taking
price level to regain balance in a country's interna
some pressure off its deficit problem.
tional payments.
16
FEDERAL RESERVE BANK OF PHILADELPHIA
SDR's debut. Not even a minor monetary
crisis broke the quiet, as the participating
nations let their positive actions with SDR's
take over the arena from the noisy disturb
ances of prior years. But the calm was not
pervasive: old problems waiting in the wings
called insistently for resolution. Dollars had
not stopped their surge into Europe as the
U.S. deficit wore on and as falling interest
rates at home sent dollars to more profitable
areas abroad. Nineteen-seventy saw dollars
in central banks grow $7.6 billion!
Now, tempers are simmering. Some Euro
peans, satiated with dollars, complain of too
many reserves. They believe that responsi
bility rests with the U.S. Further, they accuse
the U.S. of pursuing a policy of "benign
neglect" of its balance-of-payments deficit
for domestic reasons, allowing Europe to
suffer the consequences. On the other side,
the U.S. argues that because of the "re
serve currency" status of the dollar, it is
impossible for it to redress its deficit with
out complementary action by European and
other countries to correct their recurring
surpluses. After all, the argument runs, sur
pluses and deficits are weights on either
side of a scale. The scale may tip down on
the deficit side, but saying, "The deficit side
is too heavy," is the same as saying, "The
surplus side is too light," and just as mean
ingful. If many countries pursue policies to
obtain balance-of-payments surpluses, some
countries must have deficits.
Meanwhile, SDR's are caught in the cross
fire. In a world with too many reserves,
SDR's, the last to come, may be the first to
go. Some Europeans have already suggested
that SDR allocations be halted after 1972.
but how much this expansion should be.
International economic policymakers know
relatively little about the policy effects of
reserve levels and changes. In the future,
political considerations may further cloud
the correct course. But, by 1972, $9.4 billion
SDR's will have been funneled into global
reserves and their impact will be more
easily assessed.
Likewise, the newness of the Plan makes
it hard to determine if the SDR has begun
to shed its image as an unproven newcomer.
On occasion, some countries have shown a
preference for SDR's. The U.S., Canada, and
Denmark accepted $67.5 million worth of
SDR's instead of gold rightfully due them
from the IMF. Yet the U.S. turned and ex
changed some of the SDR's just received
for Belgium-held dollars. This example re
veals the problems in generalizing about the
status of the SDR.
CAUGHT IN THE CROSSFIRE
A fragile, superficial calmness settled on
the international monetary stage during the9
PROMISE IN JEOPARDY?
9 For instance, if the U.S. is allocated $100 of SDR's,
world reserves increase by this amount. Should the
U.S. then “ buy" 100 dollars held in foreign reserves
with its SDR's, world reserves would fall by $100,
resulting in no net gain or loss to total reserves.
17
The SDR experience to date reveals, if
anything, the broad range of problems con
fronting the international monetary system
and the difficulty of dealing with only one
problem at a time. The SDR plan appears
to work. Yet, the SDR may be jeopardized
JULY 1971
BUSINESS REVIEW
as fundamental adjustment problems in the
system threaten to thwart the Plan before it
has a chance to mature. But if allowed to
mature, the SDR may prove its promise. It
adds to reserves painlessly and can be ad
justed to the desires of its participants. It
carries a bonus with it to developing coun
tries. And some futuristic thinkers even see
the SDR as the forerunner of a world
currency.
■
18
FOR THE REC O R D ...
2 YEARS
AGO
YEAR
AGO
MAY
1971
Third Federal
Reserve District
Per cent change
SU M M ARY
United States
Per cent change
5
mos.
1971
from
May 1971
from
mo.
ago
year
ago
May 1971
from
Manufacturing
mo.
ago
year
ago
year
ago
+ i
year
ago
-
-
MANUFACTURING
Electric power consumed
Man-hours, total* ...........
Employment, t o t a l..............
Wage income* ......................
CONSTRUCTION** ..............
COAL PRODUCTION ...........
- i
+ 2
0
+ 2
-3 6
+ 1
0
6
6
+ 1
+ 112
+ 5
+ i
- 8
- 7
- 1
+ 19
+ 6
2
Employ
ment
3
Standard
Metropolitan
Statistical
Areas*
Wilmington
Payrolls
Check
Payments * *
Total
Deposits***
Per cent
change
May 1971
from
LO C A L
CH A N G ES
5
mos.
1971
from
Per cent
change
May 1971
from
Per cent
change
May 1971
from
Per cent
change
May 1971
from
month
ago
year
ago
month year
ago
ago
-
3
+ 4
+ 13
_
4
+ 3
+ 4
6
+ 1
+ 1
+ 6
Atlantic City
0
-
2
4
+42
+ 2
+ 11
+ 10
1
3
2
2
3
+ It
+
+
+
+
+
+
16
12
27
12
38
4f
+ 15
+ 10
+ 25
+ 11
+ 34
+ 2t
+
-
1
1
1
2
0
5
+ 15
+ 8
+ 21
+ 11
+ 27
+ 11
+ 15
+ 6
+ 23
+ 17
+ 26
+ 14
0
0
+ 3
+ 4
+ 3
+ 5
Flarrisburg . . . .
-
2
-
3
+ 1
-
3
-
-
-
....
.............................
+ It
•Production workers only
••Value of contracts
•••Adjusted for seasonal variation
+
6t
+ 6t
f 15 SMSA’ s
^Philadelphia
year
ago
month year
ago
ago
+ 1
+ i
+ 24
1
-
2
4
+ 8
+ 3
+ 30
+ 49
+ 4
2
+ 11
+ 5
+ 2
+ 14
2
-
1
+ 5
1
+ 11
6
+ 8
-
5
+ 8
+ 2
+ 19
1
-
+ 5
+ 7
+ 3
+90
1
+ 5
+ 3
+ 17
+ 16
-
7
Lehigh Valley . .
0
-
6
0
Philadelphia
-
3
2
1
-
..
0
-
7
+ 2
0
+ 5
+ 1
Reading .............
0
_
5
0
-
1
+ 4
+ 18
0
+ 12
Scranton ...........
0
-
8
+ 2
-
3
3
-
2
0
+ 18
+ 2
+ 8
-
1
+ 3
+ 16
0
0
+ 3
+ 2
-4 0
Wilkes-Barre . .
PRICES
Consumer
1
Lancaster ...........
+
+
+
+
+
month
ago
-
... + i
Johnstown
BANKING
(All member banks)
Deposits ................................
Loans ........................................
Investments ...........................
U.S. Govt, securities . .
Other .....................................
Check payments*** . . . .
Banking
0
+ 1
York
0
_
...................
5
+ 1
-
8
+ 6
•Not restricted to corporate limits of cities but covers areas of one
or more counties.
••All commercial banks. Adjusted for seasonal variation.
•••Member banks only. Last Wednesday of the month.
@FedFRASER