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J U L Y / A U G U S T
1 9 9 5
•
V O L U M E
77,
N U M B ER
4
E M U : W ill It Fly?
C hanges in In v e n to ry
M a n a g e m e n t a n d the
Business Cycle
Is Th e re a Case fo r
" M o d e r a t e " In fla tio n ?
E va lu a tin g the Efficiency
of C o m m ercial B anks:
Does O u r V ie w of W h a t
Banks Do M a tte r?
President
Th om a s C. M e lz e r
Director o f Research
W illia m G . D e w a ld
A ssociate Director o f Research
Cletus C. C o u g h lin
Research Coordinator and
Review Editor
W illia m T. G a v in
Banking
R. A lto n G ilb e rt
D a v id C. W h e e lo c k
International
C h ristoph e r J . N e e ly
M ic h a e l R. P a k k o
P a tricia S. P o lla rd
M acroeconom ics
D o n a ld S. A lle n
R ichard G . A n d e rso n
Ja m es B. B u lla rd
M ic h a e l J . D u e k e r
Joseph A . R itter
D a n ie l L. Th o rn to n
P eter Yoo
Regional
M ic h e lle A . C la rk
K e v in L. K liesen
A d a m M . Z a re ts k y
Director o f Editorial Services
D a n ie l P. B re n nan
Managing Editor
Charles B . H enderson
G raphic Designers
B ria n D . E b ert
Inocencio P. Boc
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REVIEW
JULY/AUGUST
1995
27 Is Th e re a Case fo r
" M o d e r a t e " In fla tio n ?
A lv in L. M a rty a n d D a n ie l L. T h o rn to n
V o lu m e 7 7 , N u m b e r 4
3
E M U : W ill It Fly?
P a tricia S . P o lla rd
W ill a monetary union be established
in Europe before the end of this century?
Prior to the establishment of a mone
tary union within the European Union,
countries are expected to meet desig
nated criteria regarding their interest
rates, inflation rates, government
finances and exchange rates. These
criteria were designed to ensure a com
m itm ent to price stability and economic
convergence among potential entrants.
Patricia S. Pollard examines the progress
that has been made in fulfilling these
criteria and the countries’ prospects for
meeting the entry criteria. Furthermore,
she examines the options available to the
European Union if there aren’t enough
countries to fulfill the criteria before the
target date for monetary union.
17 C hanges in In v e n to ry
M a n a g e m e n t a n d the
Business Cycle
D o n a ld S. A lle n
The change in business inventory has
always played a major role during down
turns in the business cycle. Innovations
in inventory management, such as “justin-tim e” methods and computerized
stock management using bar code scan
ning, have become more popular over
the last decade. Donald S. Allen looks
at whether these changes are expected
to have a major impact on the amplitude
or duration o f the business cycle.
Two objections to making price stability
the primary objective of monetary policy
are: (1) Moderate inflation is good for
the economy and (2) It is less costly to
live with moderate inflation than to
eliminate it. Reviewing the first objec
tion, Alvin L. Marty and Daniel L.
Thornton consider four arguments,
namely, that moderate inflation enhances
econom ic stability, increases output per
person, increases the efficiency of inter
industry wage adjustments, and enhances
the efficacy of countercyclical monetary
policy. Considering the second point,
they argue that concern for transitional
unemployment is a frail foundation for
a policy of moderate inflation.
39 E v a lu a tin g the Efficiency of
Com m ercial B anks: Does O u r
V ie w of W h a t B anks Do
M a tte r?
D a v id C. W h e e lo c k a n d Pawl W . W ils o n
An inefficient business wastes resources,
either by producing less than the feasible
level of output from a given amount
of input or by using excessive input
to produce a given amount of output.
Researchers often find that banks are
quite inefficient, but don’t agree on
how best to measure that inefficiency,
or even how to measure bank produc
tion. David C. W heelock and Paul W.
W ilson show that the average estimated
inefficiency, and even the ranking of
banks by their inefficiency, is sensitive
to whether bank loans and deposits
are measured in dollar amounts, or the
number of loans and accounts. Their
research indicates that in the absence
o f a standard view o f how to measure
bank production, the extent to which
banks are inefficient will remain an
open question.
REVIEW
JULY/AUGUST
1995
Patricia S. Pollard is an economist at the Federal Reserve Bank of St. Louis. Jerram C. Betts provided research assistance.
EMU: W ill It Fly?
treaty creates a series of criteria which coun
tries must meet to jo in the monetary union.
These criteria are designed to ensure that
potential entrants share a commitment to
that union.
Much has been written critiquing
the usefulness of econom ic convergence
prior to monetary union.2 Some papers,
such as De Grauwe (1 9 9 4 ), focus on
whether the convergence indicators detailed
in the treaty are the proper indicators to
ensure a well-functioning monetary union.
This article does not enter this discussion;
rather, given the criteria established by the
M aastricht Treaty, it assesses the progress
of the members of the European Union
in meeting these criteria. After illustrating
the lack of progress of the EU in meeting
them, I consider the two main alternatives
available to the member states that hope to
achieve monetary union in the near future.
One is to allow latitude in the application
of the convergence criteria and the other is
to view the starting date for monetary union
as flexible.
Patricia S. Pollard
n December 1991, the leaders of the
member states of the European Union
met in Maastricht, the Netherlands, to
conclude the negotiations on a Treaty on
European Union. The M aastricht Treaty, as it
is commonly known, encompasses a wide
range of issues, from foreign affairs and secu
rity policy to citizenship, health and tourism.
Primarily, however, the M aastricht Treaty is
known for formalizing the intentions of the
member states of the European Union to cre
ate an economic and monetary union (EMU)
by the end of this century. The main features
of EMU are the creation of a single monetary
policymaking body and a single currency for
the European Union.
W hile EMU seemed certain in December
1991, within a year the outlook had turned
much bleaker. In a referendum in June
1992, Danish voters rejected the treaty. This
was followed by a series of exchange rate
crises affecting the European Union in 1992
and 1993. Despite these setbacks, the
Maastricht Treaty was ultimately approved
by all member states (a second referendum
passed in Denmark in 1993) and the treaty
entered into force on November 1, 1993.
In accordance with the treaty, the European
Union is laying the groundwork for monetary
union: creating the institutions and studying
the technical details necessary to meld as
many as 14 independent monetary policy
making bodies into one cohesive system.1
Furthermore, to make themselves eligible for
entry into EMU, countries are undertaking
policies aimed at achieving econom ic con
vergence across the European Union.
This economic conversion is seen as an
integral part of the process toward monetary
union. Indeed, the M aastricht Treaty is
based on the idea that econom ic convergence
is a prerequisite for monetary union. The
I
BACKGROUND
Serious discussion in Europe of a
move to monetary union began in 1988
with the decision of the European Council
to create a Committee for the Study of
Econom ic and Monetary Union. This
committee was chaired by Jacques
Delors, the president of the European
Commission.3 The Delors Committee,
as it was commonly known, was given a
mandate to examine the issue of EMU
and to develop a program aimed at its imple
mentation. In 1989, the committee issued a
report stating:
“Econom ic and monetary union
in Europe would imply complete
freedom of movement for persons,
goods, services and capital, as well
as irrevocably fixed exchange rates
between national currencies and
3
1 Belgium and Luxembourg already
operate in a monetary union.
2 See, for example, De Grauwe
(1 9 9 2 ) and Portes (19 9 3 ).
3 See the shaded insert, "Institutions
of the European Union" on
page 2 for an explanation of the
institutional structure of the
European Union.
REVIEW
JULY/AUGUST
1995
INSTITUTIONS OF THE EUROPEAN UNION
The European Com m ission is the executive
branch of the European Union government.
The president of the commission, who serves a
two-year renewable term, is chosen by the
European Council. The other 19 commissioners
are appointed by their national governments for
four-year renewable terms. France, Germany,
Italy and the United Kingdom each appoint two
commissioners and the remaining 11 EU coun
tries each appoint one commissioner. Although
the president of the commission has no control
over the selection of commissioners, he does
control the selection of the portfolios assigned
to each commissioner. During their term in
office, the commissioners are expected to repre
sent the interests of the European Union, not
those of their home countries.
The Council o f Ministers consists of the
representatives of the national governments.
The composition of the Council of Ministers
depends on the issue being considered. For
example, issues related to the Common
Agricultural Policy are addressed by the agri
cultural ministers of the member states, where
as finance matters are addressed by the finance
ministers. W ithin the Council of Ministers,
each country is allocated a number of votes
based loosely on the size of its population.
France, Germany, Italy and the United
Kingdom have 10 votes each. Spain has eight.
Belgium, Greece, the Netherlands, Portugal and
Sweden have five votes each. The remaining
countries, Austria, Denmark, Finland and
Ireland, have three votes each. In sum, there
are 85 votes. To pass by qualified majority, a
measure must receive at least 61 votes. Thus,
two large states and two small states can form a
blocking coalition.
The European Council consists of the heads
of state or government of the member coun
tries. The president of the European
Commission is a non-voting member o f the
European Council. The presidency of the
European Council rotates among the member
states on a six-m onth basis. The European
Council holds a meeting at the end of the
six-month period (in December and Jun e).
The European Parliam ent is the legislative
branch of the European Union. The 626
members o f Parliament are elected in national
elections and serve renewable five-year terms.
In the Parliament, members are grouped
according to their party affiliation, not their
nationality. The European Parliament is the
weakest institution within the European
Union, having mainly consultative powers.
The exception to this weakness is in budgetary
issues, over which it has considerable control.
The European Parliament may dismiss
the European Commission en masse, but
cannot dismiss individual members of
the Commission.
In the plan suggested by the Delors
Report, and incorporated in the Maastricht
Treaty, EMU was to be achieved in three
stages. Broadly speaking, stage one would
emphasize econom ic convergence and stage
two would emphasize institutional conver
gence. The final steps to full EMU would
occur during stage three.
During stage one, which began in July
1990, the member countries of the European
Union were to achieve greater convergence
in econom ic performance through increased
policy coordination. Stage one was also to
be characterized by the completion of the
single internal market and removal of all
finally, a single currency. This, in turn,
would imply a common monetary policy
and require a high degree of compatibility
of economic policies and consistency
in a number of other policy areas,
particularly the fiscal field. These poli
cies should be geared to price stability,
balanced growth, converging standards
of living, high employment and external
equilibrium” (Committee for the
Study of Econom ic and Monetary
Union, 1989, p. 17).
The recommendations of the Delors
Committee formed the basis for the negotia
tions on EMU in the Maastricht Treaty.
NK OF ST . L OU I S
4
REVIEW
JULY/AUGUST
the monetary union, acting in consultation
with the European Commission and the
European Central Bank, will determine the
exchange rates at which currencies are to be
fixed. The determination of these fixed
exchange rates requires the unanimous con
sent of the member states. As the final step
to EMU, individual currencies will be replaced
with a common currency. Monetary policy
decisions will be made by the independent,
supranational European Central Bank.
According to the Maastricht Treaty, stage
three must start by January 1, 1999.
The exact starting date will be deter
mined as follows. By December 1996, an
inter-governmental conference comprised of
the leaders of the European Union countries
must meet to determine if EMU is ready to
commence. Prior to this meeting, the
European Commission and the EMI are
to issue reports detailing the progress
made by each country in meeting the
convergence criteria. These reports will
be sent to the Council of Ministers. The
Council of Ministers will use these reports
to determine:
capital controls.4 In addition, all currencies
would be linked in the Exchange Rate
Mechanism (ERM ), and procedures would
be established for budgetary policy coordina
tion.3 The goals for the completion of stage
one have yet to be met because the currencies
of five countries do not participate in the ERM.
In accordance with the Maastricht
Treaty stage two began o n janu ary 1, 1994.
During this stage, the member states are to
make their central banks independent. As
part of the steps toward independence, central
banks are prohibited from providing overdraft
facilities to their governments and from
directly financing the government debt.
The European Monetary Institute (EMI)
began operations at the start of stage two.
It is charged with ensuring cooperation
between national central banks and strength
ening the coordination of national monetary
policies. The EMI is also to begin prepara
tions for a single currency and the conduct
of a single monetary policy. Perhaps most
importantly in this regard, it is to create
the instruments and procedures necessary
for the operation of a single European
monetary policy. Also, during stage two,
countries are to achieve further economic
convergence, as detailed by the criteria in
the Maastricht Treaty.
The most important role of the EMI is
to ensure that the technical barriers to EMU
are removed prior to the start of stage three.
These barriers include cross-country differ
ences in the conduct of monetary policy,
financial regulations, payments systems and
currencies. The EMI is studying issues related
to the conduct of monetary policy. For
example, should the future European Central
Bank target the money supply as the German
Bundesbank does, or should it target infla
tion, as the Bank of England does? Another
issue being studied by the EMI is the design
and implementation of the single currency
system. This is a politically volatile issue
because each country has an interest in hav
ing the new currency resemble its own.
Stage three will mark the final transition
to a full-fledged monetary union. At the
start of stage three, exchange rates between
member countries will be permanently fixed.
The governments o f the member countries of
1995
• whether each member state
fulfills the necessary conditions
for the adoption of a single
currency; and
• whether a majority of the
member states fulfill the necessary
conditions for the adoption of
a single currency ( Treaty on
European Union, Article 109j.2).
The decisions of the Council of Ministers
will be made on the basis of a “qualified”
majority vote. The determinations of
the Council of Ministers will be forwarded
to the European Parliament, which will
make its own recommendation on the
readiness of the member states to move to
the final stage of monetary union.
Taking into account the decisions
of the Council of Ministers and the
European Parliament, the European
Council at the inter-governmental
conference must then decide, again by
qualified majority:
FEDERAL RESERVE B A N K OF ST. L OU I S
5
4 In accordance with the Maastricht
Treaty, Greece was allowed to
maintain capital controls until the
end of June 1994.
5 The Exchange Rate Mechanism,
created in 1979, set narrow
margins for exchange rate fluctua
tions between member countries.
Normally, each currency was
allowed to fluctuate by
± 2.25 percentage points agoinst
any other member currency. Some
currencies, however, were given
wider margins of fluctuation
( ± 6 percentage points) to smooth
their transition upon entering the
ERM.
REVIEW
JULY/AUGUST
1995
according to the treaty, EMU will commence
for those countries (however few) that meet
Progress in M e e tin g C o nve rgence C rite ria
the entry conditions.
The countries that do not meet the entry
Number of Criteria Met
conditions and are excluded from EMU will,
1990
1991
1992
1993
1994
according to the Treaty, be referred to as
“member states with a derogation” ( Treaty on
Belgium
2
3
33
3
European Union, Article 109k.2). This exclu
Denm ark
5
4
43
3
sion, however, need not be permanent. At
France
5
5
4
4
4
least once every two years, following the
Germ any
5
4
4
3
5
guidelines outlined above, the European
Greece
0
0
0
0
0
Council will decide by qualified majority
Ireland
4
4
4
3
3 which member states with a derogation have
Italy
0
00
0
0
fulfilled the entry criteria and admit them to
Luxembourg
5
5
54
5
the monetary union.
T a b le 1
Netherlands
3
34
Portugal
Spain
11
3
00
United Kingdom
3
Austria
4
3
0
0
1
1
3
4
0
CONVERGENCE CRITERIA
0
2
2
3
2
Finland
2
2
1
Sweden
2
3
21
Num ber meeting criteria
4
2
1
0
2
• whether a majority of the member
states meet the necessary conditions
for monetary union;
• whether it is appropriate ... to
enter the third stage; and if so,
• set the date for the beginning of
the third stage ( Treaty on European
Union, Article 109j.3).
s See Protocolon the Convergence
Criteria referred to in Article 109j of
the Treaty Establishing the
European Community (1 9 9 2 ) and
Protocol on the Excessive Deficit
Procedure (19 9 2 ).
If no date for the start of monetary
union has been set by the end of 1997,
the treaty obligates the leaders of the
European Union countries to meet by July 1,
1998, to determine, based on the same
procedure outlined above, which member
states fulfill the conditions for monetary
union. These states are then to enter the
third stage o n janu ary 1, 1999. For m one
tary union to begin prior to 1999, a majority
of countries must meet the criteria established
by the M aastricht Treaty. However, in 1999,
As noted above, entry into EMU is
3
dependent upon the fulfillment of what
the M aastricht Treaty calls “necessary condi
3
tions.” W hat are these conditions? First, to
1
2
facilitate the common monetary policy, each
1
member must guarantee the independence of
its central bank and pass national legislation
in accordance with the protocol establishing
the European Central Bank. Second, in mak
ing their reports on the progress of countries
in meeting the necessary conditions, the
European Commission and the EMI are to
consider the progress made in developing a
comm on currency, “the results of the integra
tion of markets, the situation and development
of the balances of payments on account and
an examination of the development of unit
labour costs and other price indices” (Treaty
on European Union, Article 1 0 9 j.l).
Most attention, however, has been focused
on the conditions that the Maastricht Treaty
says are designed to ensure “the achievement
of a high degree of sustainable convergence”
( Treaty on European Union, Article 1 0 9 j.l).
Convergence must be achieved in exchange
rates, inflation rates, long-term interest rates
and government finances. The treaty and two
separate protocols detail these convergence
criteria as follows:6
• The currency of each member
state must have remained within
the normal fluctuation margins
of the ERM for a least two years prior
NK OF ST.
6
LOUIS
REVIEW
JULY/AUGUST
Union improved slightly with Germany and
Luxembourg meeting all five criteria.
As the performance of the countries in
1990 and 1994 is compared, only Belgium
improved its overall performance on the cri
teria. In contrast, six countries met fewer
criteria in 1994 than they met in 1990. This
worsening performance reflects the crises in
the ERM and a deterioration in the public
finances of many countries.
to the examination. Specifically,
a member state may not have
devalued its currency against
any other currency within the ERM
on its own initiative.
• The average inflation rate for
any member state during the year
prior to the examination by the
European Commission must have
been no more than 1.5 percentage
points above the average rate of
inflation in the three best-performing
countries during this same period.
Exchange Rate Criterion
Although the ERM had functioned
smoothly since 1987, it was beset by a series
of crises during 1992 and 1993. These crises
resulted in the September 1992 withdrawal
of the British pound and the Italian lira from
the ERM, and the February 1993 devaluation
of the Irish pound. The Portuguese escudo
and the Spanish peseta were devalued several
times throughout 1992 and 1993. As a result
of these crises, fewer countries met the
exchange rate convergence criterion in 1994
than in 1990 (see Table 2).
The exchange rate crises ended in
August 1993 with the expansion of the bilat
eral bands from ± 2 .2 5 percent to ±15 percent
for all pairs of currencies with the exception
of the Dutch krona/Deutsche mark. The
consensus within the European Union is that
these wider bands have reduced currency
speculation and thus have lessened the
prospects for exchange rate crises within
the ERM. Thus, no return to the narrow
margins is likely. The maintenance of the
expanded margins presents no problem for
the fulfillment of the convergence criteria as
long as the European Commission and the
European Council agree that the treaty’s ref
erence to “normal fluctuating margins”
means margins of ±15 percent.
In March 1995, the currencies within the
ERM again experienced sharp fluctuations.
The movement in the exchange markets
away from dollars and into Deutsche marks
caused problems for weaker currencies within
the ERM. As a result o f this turbulence, the
escudo and the peseta were both devalued.
In the absence of any further devaluations,
only eight of the 15 member countries of the
European Union would meet the exchange
• The long-term interest rate
(on government bonds or
comparable securities) of any member
state during the year prior to the
examination by the European
Commission must have been no
more than 2 percentage points above
the average long-term interest rate
of the three countries with the
lowest inflation rates during this
same period.
• The government budget deficit
of any member state may not
exceed 3 percent of that country’s
GDP at the time of the examination.
• The government debt of any
member state may not exceed
60 percent of the country’s GDP
at the time of the examination.7
Table 1 summarizes the performance
of each current EU member state in fulfilling
the convergence criteria during the years
1990-94. As this table shows, the path
toward convergence has not been smooth.
On the basis of these five criteria, more
countries met the eligibility requirement in
1990, the year before the treaty was conclud
ed, than in any subsequent year. Denmark,
France, Germany and Luxembourg met all
five convergence criteria in 1990.8 The
number of countries fulfilling the criteria
declined in each following year, reaching a
low of zero in 1993. In 1994, the perfor
mance of the members of the European
1995
7
7 As discussed in ttie Protocol on the
Excessive Deficit Procedure, the
deficit and debt ratios ate based on
general government budgets, that
is, the central government, regional
or local governments and social
security funds. Commercial opera
tions of the public sector are
excluded. The deficit is defined as
net borrowing by the government.
Net borrowing excludes any portion
of the deficit that is used for "the
acquisition of loans or other finan
cial assets" by the government.
Thus, for example, the funds bor
rowed by the German government
that were in turn lent to agencies in
eastern Germany do not show up in
these deficit figures (Collignon ond
others, 1 994). Privatization pro
ceeds connot be used to reduce the
deficit, although some countries ore
trying to change this provision.
Whereas the deficit ratio is based
on net borrowing, the debt ratio is
based on gross debt.
8 If Austria had been o member of
the European Union, it too would
have met all five convergence crite
ria in 1990. Although it was not a
member of the ERM, its currency
has shadowed the Deutsche mork.
REVIEW
JULY/AUGUST
countries met the inflation criterion in 1990.
This number fell to five in 1993, but
rebounded strongly with 11 countries meet
ing the criterion in 1994. Greece, Italy,
Portugal and Spain were the countries with
yes
inflation rates exceeding the criterion in
1994. yes
Although these four countries have
not met the criterion in any year, each
yes
country has made progress in lowering its
yes
inflation rate over the period in question.
n.m
The econom ic recovery currently under
no
way in Europe is expected to lead to a slight
n.m.
increase in inflation in most member countries
yes
by 1996. Because the criterion is based on
yes
the performance of the three countries with
no
the lowest inflation, a general increase in the
no
rate of inflation will not affect the overall
n.m.
performance o f countries. As shown in
Table 3, the increase in the inflation forecast
for n.m. is not expected to reduce the num
1996
ber n.m. countries satisfying the inflation
of
criterion. Moreover, the inflation perfor
n.m.
mance of the countries not currently meeting
the criterion is expected to improve over the
6
next two years.
Ta b le 2
C o nve rgence In dicators: Exchange Rate
1990
1991
1992
1993
1994
Belgium
yes
yes
yes
yes
Denm ark
yes
yes
yes
yes
France
yes
yes
yes
yes
Germ any
yes
yes
yes
Greece
n.m.
n.m.
Ireland
yes
yes
yes
n.m.
n.m.
yes
no
Italy
no
no
no
Luxembourg
yes
yes
yes
yes
yes
yes
yes
n.m.
n.m.
no
no
Netherlands
Portugal
n.m.
yes
Spain
no
no
no
no
United Kingdom
no
no
no
n.m.
Austria
n.m.
n.m.
n.m.
n.m.
Finland
n.m.
n.m.
n.m.
n.m.
Sweden
n.m.
n.m.
n.m.
n.m.
Num ber meeting criterion
7
7
7
6
Notes: n.m. indicates that the country w as not a member of the ERM during any part of the
relevant year.
The Irish pound wos devalued by 1 0 percent in February 1 9 9 3 .
The Italian lira wos devalued by 3.7 percent in January 1 9 9 0 when it was incorporated
into the narrow (2 .2 5 percent) bands. The lira left the ERM in September 19 9 2 .
The Portuguese escudo w as devalued by 6 percent in November 1 9 9 2 and by 6.5
percent in M o y 19 9 3 .
The Spanish peseta w as devalued by 5 percent in September 1 9 9 2 , by 6 percent in
November 1 9 9 2 and by 8 percent in M a y 19 9 3 .
1995
Interest Rate Criterion
The interest rate criterion has been the
one that countries have usually found easiest
to meet. Furthermore, the member coun
tries showed steady improvement over the
period 1990-94. In 1990, as shown in Table
4, nine countries had long-term interest rates
within the lim it set forth in the Maastricht
Treaty. This number rose to 10 in 1991 and
increased to 11 in 1993. In 1994, however,
the number of countries meeting the interest
rate criterion slipped back to 10. In 1994,
Greece, Italy, Portugal, Spain and Sweden did
not meet this criterion. The former four have
never met the criterion.
rate criterion at the end of 1996. The
currencies of five countries — Finland, Greece,
Italy, Sweden and the United Kingdom— are
not participating in the ERM and therefore
will not meet the two-year rule by the end of
1996. As a result of the recent devaluations
of their currencies, Portugal and Spain will
not meet the criterion by the end of 1996.
Public Finance Criteria
Inflation Criterion
The two public finance criteria have
caused the biggest problems for countries in
their quest to jo in the EMU. In 1990, nine
Comparing 1990 to 1994, the perfor
mance of the EU countries with regard to
the inflation criterion has improved. As
shown in Table 3, seven of the present 15 EU
of the current 15 EU countries met the
deficit criterion while only three met it in
1994. Similarly, nine countries met the gov
ernment debt criterion in 1990 but only four
NK OF ST. L O U I S
8
JU1Y/ AUGUST
1995
Ta b le 3
: Inflatio n
C onvergence
P e rc e n t
1990
1991
Belgium
3.7
2.5
Denm ark
2.7
2.4
1.8
3.2
2.4
France
2.8
1992
1994
1993
2.4
2.6
2.1
1.9
2.2
1.7
2.3
1.8
1.0
2.8
4 .0
4.7
3.8
2.7
18 .8
15.1
10.9
13 .6
Ireland
1.4
2.5
Italy
5.9
6.9
Luxembourg
3.6
2.9
2.8
Netherlands
2.2
3 .2
3 .0
11 .7
12 .5
10 .0
Spain
6.5
6.4
6.4
United Kingdom
5.5
7.4
4.7
Austria
3.1
3.4
Finland
6.0
5.6
Sweden
9.6
10 .2
2.2
5.8 .0
3
Convergence criterion
3.6
4.0
3.6
3.13.4
Number meeting criterion
7
8
7
5
11
Portugal
2.8
1.6
3.6
2.1
3.9
2.1
2.3
5.6
2.5
8.9
9.6
3.0
2.9
2.7
5.2
2.2
2.2
7.9
5.1
4.5
4.5
4.5
3 .0
3.3
1.6
2.5
2.2
4.9
3.4
2.5
3.5
4.5
2.3
1.8
5.1
3.9
4.1
2.7
5.14.7
5.2
2.4
1.9
19 .2
Germany
Greece
1996
1995
2.8
1.7
3.0
2.9
3.3
3.2
3.2
3 .3
3.7
11
11
Notes: Prior to 1 9 9 2 , data for Germany is for western Germany only.
Data for 1 9 9 5 and 1 9 9 6 are forecasts
Convergence criterion is based on data for the 12 member states prior to 1 9 9 5 and the 15 states thereafter.
SOURCE: European Economy (April/May 1 9 9 5 , Supplement A, Table 1 0 )
did in 1994. Much of this decline can be
attributed to the expansionary nature of
fiscal policies in reaction to the recession of
the early 1990s, from which Europe is ju st
beginning to recover. The effect of the reces
sion on public finances can be seen by
considering the example of Finland. Output
growth in Finland fell from 5.7 percent in
1989 to -7 .1 percent in 1991. Consequently,
Finland’s government budget balance
declined from 5.4 percent of GDP in 1990 to
a low of -7 .8 percent in 1993. The govern
ment budget deficit shrank in 1994 as its
economy moved out of recession.
The econom ic recovery currently under
way in Europe is expected to lead to a grad
ual improvement in the budget balances of
the EU countries. Nevertheless, only six of
the 15 countries are expected to meet the
budget deficit criterion in 1996. The recovery
is expected to have less of an effect on
countries’ performance with respect to the
debt criterion. The ratio of debt to GDP
is expected to increase through 1996 in
m ost countries.
The criterion limiting the government
debt to 60 percent of GDP has been the
most difficult for countries to meet. Only
Luxembourg has a debt ratio well below that
level. The other three countries that met
this criterion in 1994 (France, Germany and
the United Kingdom) all have debt-to-GDP
ratios close to 50 percent. Among those
countries not meeting the criterion, some
have debt ratios so high that they would
have to run substantial budget surpluses for
a number of years to meet it. For example,
Buiter, Cosetti and Roubini (1 993) calculat
ed that based on the 1991 debt levels and
assuming a 5 percent nominal GDP growth
9
m i n i m
JULY/AUGUST
Ta b le 4
C o nve rg ence In dicators: Lo n g -Te rm
Interest Rates
P e rc e n t
1990
Belgium
10.1
Denm ark
1991
11.0
1992
9.3
8.9
8.6
18.5
Ireland
10.1
Italy
Luxembourg
8.8
9.5
7.0
9.0
8.0
18.8
9.2
18.2
9.1
7.7
13.0
8.2
7.5
6.3
17.7
13.4
8.6
7.2
10.1
10.4
Germany
1994
8.6
10.1
France
Greece
1993
n.a.
1995
most member states are expected to improve
through 1996, the debt ratios are unlikely to
show significant improvement. Turning to
the exchange rate criterion, five countries are
not members of the ERM and thus do not
meet the convergence criterion. For the
remaining 10 counties, although the wider
7.8
bands eliminated tensions within the ERM
8.5
between August 1993 and March 1995, there
is now evidence that even these bands can
not 6.7
prevent pressure from accumulating on
weak currencies.
8.1
13.7
7.9
11.3
6.9
10.6
PROSPECTS FOR EMU
6.4
6.7For the 1996 inter-governmental confer
7.2
ence to set a date for monetary union, eight
Portugal
15.4
16.8
18.3
12.5
10.0
countries must fulfill all of the convergence
12.4
Spain
14.7
12.2
10.2 9.7
criteria. If there are no further devaluations
United Kingdom
11.8
9.9
9.1
7.8
8.2
within the ERM, eight countries— Austria,
Belgium, Denmark, France, Germany,
Austria
8.7
8.6
8.3
6.6
6.7
Ireland, Luxembourg and the Netherlands—
Finland
13.2
11.9
12.1 8.4
8.2
will fulfill the exchange rate criterion in
Sweden
13.6
10.9
10.4
8.5
1996. Thus, if9.5
EMU is to get off the ground
prior to 1999, all eight of these countries
Convergence criterion
12.0 11.5
11.2
9.7
9.4
must meet the other four convergence crite
Num ber meeting criterion
9
10
10
11 ria. However, the debt/GDP ratios of four
10
of these countries— Belgium, Denmark,
Ireland and the Netherlands— are not
SOURCES: European Economy (1 9 9 5 , Number 59, Table 54 )
expected to be close to the 60 percent refer
and OECD Economic Outlook (June 1 9 9 5 , Number 57, Annex Table 3 6 )
ence value by the end o f 1996.
Thus, based on the five convergence
criteria, it is almost certain that a majority
rate, Belgium needs a government surplus of
of the EU countries will not be ready for
more than 9 percent of GDP a year for each
monetary union when the inter-govemmental
year through 1996 to meet the convergence
conference is held in 1996. If EMU is
criteria. To meet the criteria by the end of
postponed, the next issue is: How many
1998, Belgium would need an annual gov
countries will be eligible at the start of
ernment surplus greater than 5 percent of
1999, the last possible date for monetary
GDP.
union in accordance with the treaty? Barring
unforeseen econom ic shocks, Germany
and Luxembourg should both be eligible
Summary on Convergence
for monetary union. The eligibility of the
To summarize, the data indicate that
remaining 13 countries is less certain, even
inflation and interest rate convergence are
leaving aside the uncertain future o f the
ERM. Austria and France are the most likely
taking place in the European Union. The
outlook for the next two years anticipates
additional candidates. Both, however, could
run into problems meeting the government
further convergence with respect to these
budget requirement, and Austria is not
two criteria. In contrast, the public finances
of the EU members have worsened since the
expected to meet the debt criterion.
Belgium and Italy have public debts
establishment of the convergence criteria.
Although the government budget balances of
totaling more than 100 percent of their
Netherlands
9.0
8.7
8.1
N K OF ST. L OU I S
10
REVIEW
JULY/AUGUST
Responses to the Lack of Progress in
Meeting the Convergence Criteria
respective GDPs. It will be many years
before these debt ratios come close to
meeting the 60 percent limit. Denmark,
Finland, Ireland, the Netherlands and
Sweden also have high debt ratios unlikely
to fall within the target range by the end of
the century. The Dutch central bank last
year calculated that if the Netherlands
limited its annual public sector deficit to 1
percent of GDP, and achieved an average
nominal GDP growth of 4 percent a year, it
would still take 10 years to reach the 60 per
cent public debt target (Financial Times,
January 17, 1995). W hile 4 percent was the
average nominal GDP growth for the
Netherlands during 1985-94, its average
yearly budget deficit has been more than
double 1 percent of GDP over the last
10 years.9
Portugal and Spain are likely to have
difficulty meeting several of the criteria.
Although they both have substantially low
ered their inflation rates in recent years, the
5.1 percent Portuguese and Spanish inflation
rates remain outside the ceiling. The debt
ratios of both countries also have grown
recently and that of Spain is likely to remain
a problem as long as it maintains its high
unemployment rate (estimated at more than
22 percent in 1994). No one expects that
Greece will be a candidate for monetary
union for many years to come. It alone
among the EU countries still has double
digit inflation.
The remaining country, the United
Kingdom, is a good candidate for meeting
all of the eligibility requirements for
monetary union, except the exchange rate
criterion. The United Kingdom is unlikely
to rejoin the ERM in the next few years.
Even ignoring this problem, opposition
to EMU is strong within the British govern
ment and Britain is one of two European
Union countries that have the right to
refuse entry into the monetary union.10
A change in the government from the
ruling Conservative party to the opposition
Labour party is likely to increase the
prospects for Britain joining EMU
simply because the latter is much more
amenable to the idea o f monetary union
than the former.
1995
The reality that a m ajority o f countries
will not meet the convergence criteria in
1996, and that most, including some key
countries, are unlikely to meet the criteria in
1998, has generated three responses within
the European Union. One reaction has
been to label the idea of monetary union
impractical. A second suggests that the pub
lic finance criteria for monetary union can be
and should be interpreted with some leeway.
A third reply suggests that the timetable for
monetary union should be interpreted with
some flexibility.
Abandoning EMU
Those who have reacted to the difficulty
in meeting the convergence criteria by label
ing EMU impractical are basically opposed to
the idea of monetary union. They see the
lack of progress in meeting the criteria as a
means to gain support for the idea of aban
doning the treaty. Proponents of this view,
most notably some members of the British
Parliament, have reacted to each crisis within
the ERM with predictions of the demise of
monetary union. For example, British Prime
Minister Joh n Major responded to the August
1993 widening of the bands of the ERM with
the statement that the Maastricht timetable
for monetary union was now “totally unrealis
tic.” The reaction of Norman Lamont, the
former chancellor of the exchequer in
Britain, was even more pointed. He claimed
that the crisis in the ERM meant “the end of
monetary union in Europe” (Financial Times,
August 3, 1993). In practice, this group sup
ports strict adherence to the convergence
criteria, since this will delay the starting date
for monetary union.
Flexibility in Interpreting the
Convergence Criteria
In opposition to this group are those
who not only support EMU but believe that
the earlier the starting date the better. This
latter group favors a liberal interpretation of
the convergence criteria. One reason for
11
’ A reduction in public debt cun occur
through several meons besides a
government surplus. Both nominal
GDP growth and a reduction in
interest rates on government debt
will reduce the debt/GDP ratio.
Nominal GDP growth may be
achieved through growth in output
or inflation. This might lead one to
think thot inflating oway the debt
would be a compelling option.
Such o strategy, however, will only
work in the short run. An increase
in inflation raises the interest rote
at which the government must bor
row to finance its debt. The shorter
the maturity of the outstanding
debt, the shorter the period of time
before which the engineered infla
tion will affect the interest rate on
the debt. Furthermore, any such
attempt by the government to
meet the debt convergence criterion
through inflation is likely to have
long-term repercussions for the
interest rate ot which the govern
ment borrows by reducing the
government's credibility.
10 In Maastricht, the United Kingdom
refused to conclude negotiations on
the treaty unless it was given the
right to opt-out of EMU. Denmark
is the other country with the right
to opt-out of monetary union. It
negotiated this right following the
rejection of a referendum on the
treaty. After securing the opt-out
provision, a new referendum
approved the treaty.
REVIEW
J
u ly
/
a u g u s t
supporting a quick move to monetary union
is the belief that a long transition period may
itself be the source of instability. A proponent
of this view is Portes (1993). In addition
to arguing that a long transition period
creates instability, Portes contends that
the convergence criteria are unnecessary
because “monetary union will deliver
convergence— at least the extent required to
maintain it.” De Grauwe (1994) takes this
argument one step further by claiming that
the convergence criteria cannot be met prior
to EMU.
Although support for a quick move to
monetary union is generally tied to the belief
that convergence is not a necessary prerequi
site for EMU, support for a flexible approach
to the criteria is based on additional reasons.
One is to provide a wide participation in
EMU. Another is the fear among countries
that have little chance of meeting the
requirements that non-participation in EMU
will be cosdy both politically and econom i
cally. In the political sphere, countries are
afraid that remaining outside EMU will
reduce their political power within the EU,
particularly as the inner core of countries
(the members of EMU) become more inter
dependent. In econom ic terms, countries are
concerned that exclusion from EMU may be
viewed as a mark against them, and result in
a higher interest rate premium and a weak
ness in their currencies.
Supporters of a flexible approach to the
convergence criteria make reference to the
M aastricht Treaty to bolster their case. The
treaty provides an opening for a relaxation of
both the deficit and the debt criteria. The 3
percent deficit/GDP ratio and the 60 percent
debt/GDP ratio are referred to in the treaty as
reference values, not fixed limits as are the
criteria for inflation and interest rates. The
treaty says that these reference values must
be met unless, in the case of the deficit:
" During the Maastricht negotiations,
several countries proposed adopting
a concept of cyclically adjusted
deficits. The proposal was rejected
because of measurement problems
(Bini-Smaghi and others, 1994).
1995
and temporary and the ratio remains
close to the reference value ( Treaty
on European Union, Article 104c.2.a).
In addition, in preparing its report on
whether an excessive deficit exists, the
Commission is to take into account:
• whether the government deficit
exceeds government investment
expenditure (gross fixed capital
formation); and
• all other relevant factors, including
the medium-term economic and
budgetary position of the Member
State ( Treaty on European Union,
Article 104c.3).
These clauses provide the commission a
means by w hich to relax the deficit require
ment. As noted by Collignon and others
(1 9 9 4 ), the treaty could be interpreted as
applying the deficit criterion to only the part
of the deficit not accounted for by govern
ment investment, and only requiring the 3
percent ratio to be met “when the economy
was near full capacity” Looking at the data
in Table 5, one could argue that Austria,
Denmark and the Netherlands all meet the
deficit criterion since their budget deficits
remain close to the reference level, and that
the elevated levels are merely temporary —
caused by the recession.1
1
W ith respect to the debt criterion, the
Maastricht Treaty states that the reference
level (60 percent debt/GDP) is binding
“unless the ratio is sufficiently diminishing
and approaching the reference value at a
satisfactory pace” ( Treaty on European Union,
Article 104c.2.b).
The debt levels of all the countries, with
the exception of Ireland and the Netherlands,
have increased between 1990 and 1994, as
shown in Table 6 . In Ireland’s case, substan
tial progress has been made in reducing its
debt ratio. Ireland has m et the deficit con
vergence criterion in every year and has
reduced its debt ratio from 97 percent of
GDP in 1990 to 90 percent in 1994. In the
fall of 1994, the European Council, assessing
the progress of countries toward the
• either the ratio has declined
substantially and continuously
and reached a level that comes
close to the reference value; or
• alternatively, the excess over the
reference value is only exceptional
N K OF S T . L O U I S
12
REVIEW
Y/AUGUST
1995
Ta b le 5
C onvergence Indicators: G o v e rn m e n t B udg et Balance
1990
1991
-6.5
-5.4
Denm ark
-1.5
France
-1.6
Germany
-2.1
-3.9
-3.3
-14 .0
-6.7
-2.2
Belgium
-11.6
Greece
Ireland
Italy
luxem bourg
Percent of GDP
1993
1992
-2.1
5.9
2.3
Netherlands
-5.1
-2.4
0 .8
-3.3
-5.5
-3.9
United Kingdom
-1.5
-2.6
Austria
-2.2
-2.4
-2.0
Finland
5.4
-1.5
Sweden
4.2
Convergence criterion
-3.0
Number meeting criterion
9
-3.3
-7.5
-6.1
-3.0
-4.63.9
2
-1.1
-9.1
-3.0
-3.0
5
view. In May 1994, the then-commissioner
for econom ic and monetary affairs stated
that it had “always been understood that
the judgem ent on whether a member
state fulfills the conditions for participation
in stage 3 would be based on an assessment,
and not on a mechanical application of
the convergence criteria” (Financial Times,
May 16, 1994). In contrast, the president
of the current commission, Jacques Santer,
in his first speech before the European
Parliament, pledged that the commission
would insist on strict application of the
criteria (Financial Times, January 18, 1995).
Flexibility in the Starting Date for
Monetary Union
In contrast to those who have responded
to the lack of progress in meeting the con
vergence criteria by suggesting that the
F EDERAL RESERVE B A N K OF ST. L OUI S
13
-5.8
-3.0
34
Notes: Prior to 19 9 1 the data for Germany are for western Germany only.
Data for 1 9 9 5 and 1 9 9 6 are forecasts.
SOURCE: European Economy ( April/M ay 1 9 9 5 , Supplement A, Table 21).
M aastricht criteria, accepted the
recommendation of the commission
and determined that Ireland met the debt
criterion. This decision indicates some
willingness on the part of the European
Union to reward countries that are making
efforts to control public deficits yet remain
outside the numerical targets. However,
it does not mean that such a policy will
be followed at the inter-govemmental
conference in 1996. The decision that
Ireland met the debt convergence require
ment was not without controversy.
Germany, in particular, had severe reserva
tions about the exemption. Furthermore,
while the previous European Commission,
the term of which ended in December 1994,
supported a flexible interpretation of the
convergence criteria, it is not clear that the
present commission also supports this
-4.8
-2.9
-5.6 5.0
-10-13.4
.4
-7.8
-3.0
-6.6
-4.0
-7.8
-3.2
-5.64.7
-6.0
-4.8-6.9
-7.8
-4.1
-1.1
1.5
-2.5
-5.8
-4.2
-2.6
-8.1
-9.0
-3.1
-7.0
-5.9
-4.9
-2.8
-7.9
1
2.3 .4
2.1
-6.5
Portugal
Spain
-10 .2
-2.3
-9.6
-3.9
9
-11.3
-9.5
-2.9
-3.9
-2.4
-2.1
-13.212 .5
-2.4
-10.2
-1.2
-2.5
-3.3
-12 .3
-2.2
-1.9
-6.04.9
-6.1
-2.9
-3.9
-4.2
-5.3
-4.54.0
-2.9
1996
1995
-6.6
-2.1
-10.9
1994
-3.0
6
UGU
T a b le 6
C o nve rgence Indicators: G o v e rn m e n t D e b t
P e rc e n t o f G D P
1990
1991
1992
Belgium
13 0 .8
59 .6
35 .4
3 5 .7
1 3 7 .2
6 4 .6
France
131.1
130.1
Denmark
1993
1994
8 0 .3
4 1 .5
Greece
8 2 .6
86.1
Ireland
9 696 .9
.8
9 7 .9
9 4 .2
Luxembourg
5.4
Netherlands
78 .8
Spain
45.1
5.7
41 .9
6.9
6 2 .3
6 2 .8
7.2
78.1
6
70 .59 .2
48 .5
58 .4
8 6 .8
1 2 4 .4
8 1 .4
66 .6
5
48 .39 .9
4 5 .8
84 .6
1 2 4 .9
1 2 5 .4
79 .9
61 .7
3 5 .0 3 5 .7
United Kingdom
114.1
1 1 6 .2
89 .8
1 1 9 .4
52
50.1
1 1 5 .2
11 5 .3
9 7 .0
4.9
76.1
51 .2
4 8 .2
9 2 .3
78 .9
6
68 .69 .3
Portugal
75 .6
4 8 .5
44.1
1 0 8 .4
10 1 .3
1 3 4 .33 2 .3
1
4 5 .8
4 3 .8
1996
136.1
6 9 .0
39 .6
Germany
Italy
1995
70 .7
6 4 .6
50.1
6 5 .2
51 .5
Austria
5858 .7
.3
Finland
3
142.5 .0
4 1 .5
57.1
60.1
64 .4
Sweden
4 3 .5
67.15 3 .0
76 .2
79.1
8
8 4 .65 .7
Convergence criterion
6 0 .0
Number meeting criterion
9
6 0 .0
8
6 4 .5
6 0 .0
7
66 .2
51 .5
6 0 .0
4
6
6 7 .4
6 0 .0
4
Notes: Data for the United Kingdom in 1 9 9 0 ore based on OECD calculations of general government gross financial
liabilities. All other data are based on the Maastricht Treaty's definition of public debt.
Prior to 19 91 the dota for Germany are for western Germany only.
Data for 1 9 9 5 and 1 9 9 6 are forecasts.
SOURCES: European Economy (April/May 1 9 9 5 , Supplement A, Table 2 2 ) and
OECD Economic Outlook (June 1 9 9 5 , Number 57, Table 34 ).
convergence criteria be treated with flexibility
are those who believe that the 1999 deadline
should be viewed as flexible. The propo
nents of a flexible timetable believe that
strict adherence to the convergence criteria is
a necessary condition for a well-functioning
monetary union. Thus, rather than relaxing
the criteria to guarantee that an optimal
number of countries will participate in EMU,
they suggest that the date for monetary
union be delayed if the criteria are not met
by a sufficient number of countries. German
Chancellor Helmut Kohl was the first leader
to publicly address this issue. In 1993,
he stated that strict adherence to the
convergence criteria might delay monetary
union beyond 1999.
The October 1993 ruling of the German
Constitutional Court supported those who
argue that the timetable for monetary union
is more flexible than the criteria. The
court, in ruling on the constitutionality
of the M aastricht Treaty, wrote that strict
adherence to the convergence criteria was
essential to Germany’s participation in EMU.
In other words, the criteria could not be
weakened without the consent of the
German parliament.
The German central bank, the
Bundesbank, has been perhaps the most
vocal advocate of a strict application of the
convergence criteria. Both Hans Tietmeyer,
the current president of the bank, and his
predecessor, Helmut Schlesinger, have made
statements on several occasions favoring a
strict interpretation of the Maastricht criteria
while claiming that the criteria are them
selves not strict enough. For example, the
14
6 4 .6
6 0 .0
4
REVIEW
JULY/AUGUST
states (Protocol on the Statue o f the European
System o f Central Banks and the European
Central B ank, Article 2 1 ), and declares that
neither the central bank nor other countries
shall be liable for or assume the financial
commitments of any member states (Treaty
on European Union, Article 104b. 1), there are
those who believe there would be pressure
on the central bank to bail out countries
experiencing financial difficulties.14
Bundesbank has favored an absolute lim it on
inflation rather than a relative one, the latter
based on the behavior of other countries.
The reason for this is to ensure not simply
convergence in inflation rates, but also a
commitment to price stability. The
Bundesbank has also attacked the deficit cri
terion as setting too high a ceiling.
Specifically, Mr. Tietmeyer has stated that the
ceiling for the deficit ratio is at least double
what it should be. He also has emphasized
that the deficit criterion should be met
throughout the business cycle (Financial
Times, November 5, 1 9 9 4 ).12 This statement
contrasts with a study prepared for the
European Parliament that suggests that “It
would be keeping with the spirit of the
Treaty, if 3 percent were taken as the ‘full
employment’ deficit during periods of
econom ic expansion” (Collignon and
others, 1994, p. 76).
As noted above, the emphasis on a strict
interpretation of the convergence criteria is
based on the belief that adherence to them is
necessary for a well-functioning monetary
union. The proponents o f strict criteria
argue that for EMU to succeed, the member
states must show a prior commitment to
price stability and follow sound government
budgetary policies. Specifically, the empha
sis on a strict interpretation of the deficit
criterion is based on the idea that “a sound
budget position is an indispensable precon
dition for a successful anti-inflationary
monetary policy.”1 There is a concern that
3
within a monetary union, expansionary
national fiscal policies (as evidenced by bud
get deficits in excess o f 3 percent of GDP)
could conflict with the monetary policy of
the supranational central bank. Such a con
flict would not only create difficulties for the
central bank in its effort to maintain price
stability, but also could cause tension among
the participants in the monetary union.
Would the participants of a monetary union
be willing to accept a recession brought
about by the anti-inflationary polices of the
central bank in an effort to combat the fiscal
laxity o f other members? Furthermore,
although the Maastricht Treaty prohibits the
central bank from extending credit to, or
directly purchasing the debt of, member
19
CONCLUSION
Despite the many setbacks that have
occurred since the December 1991 conclusion
of the Maastricht Treaty, most of the countries
of the European Union remain committed
to monetary union. This commitm ent, how
ever, has not been enough to produce the
econom ic convergence prescribed by the
treaty. Many countries have made progress
in reducing their inflation rates, and the
divergence in long-term nominal interest
rates is declining. On the fiscal side, however,
the number of countries meeting the conver
gence criteria has declined. The recent
recession in Europe resulted in a deterioration
in the fiscal balances o f most countries. In
addition, the 1992-93 exchange rate crises
resulted in a reduction in the membership
of the ERM. Thus, the European Union is
further away from a fulfillment of the
convergence criteria today than it was in
the year prior to the negotiation of the
Maastricht Treaty.
By the end of 1996, the member states of
the European Union must decide if a majority
of countries are ready to proceed to EMU
in 1997. As detailed above, it is implausible
that a majority of countries will have fulfilled
the convergence criteria by the end of 1996.
EMU will m ost certainly be delayed beyond
its earliest possible starting date. The
M aastricht Treaty states that the final stage of
EMU must begin by January 1, 1999, with
the membership decided by July 1998. Even
by this date, few countries are likely to satisfy
the convergence criteria.
Given the lack o f progress in meeting
the convergence criteria, the European
Union faces two options if it is to continue to
pursue EMU: Relax the criteria or relax the
FEDERAL RESERVE B A N K OF ST. L OU IS
15
12 Others hove claimed that even a
government that has a balanced
budget during upturns could have o
budget deficit exceeding the
Maastricht limit during a recession.
See, for example, Eichengreen
(1 9 9 2 ) and Kenen (199 2 ).
Eichengreen orgues that it may
even be optimal for disciplined gov
ernments to occasionally hove
deficits exceeding 3 percent of GDP
(p. 50).
13 Tietmeyer (September 9, 1994).
M Support for this view is given by
Frationni, von Hagen and Waller
(1 9 9 2 ) and (raig (199 4 ).
REVIEW
JULY/AUGUST
Craig, R. Sean. "W h o Will Join E M U ? Impact of the Maastricht
Convergence Criteria on Economic Policy Choice and Performance,"
Board of Governors of the Federal Reserve System
International
Finance Discussion Papers No. 4 8 0 (September 1 9 9 4 ).
timetable for monetary union. W hich option
it chooses will likely not be decided until the
July 1998 deadline for determining the mem
bership of EMU. The choice taken by the
EU will undoubtedly be influenced by the
two countries without whose participation
EMU will not occur: France and Germany.
Germany has strongly opposed a relax
ation of the convergence criteria.15 If it
maintains this position, few countries are
likely to meet the membership requirements
for EMU by the end of the decade. More
importantly, two countries considered among
the core group of EU countries — Belgium
and the Netherlands — are not expected to
meet the criteria.16 W ithout the participation
of the core group, monetary union may not
be feasible. Thus, it is likely that EMU, like
its avian namesake, will remain grounded.
De Grouwe, Paul. "Towards European Monetary Union Without the
E M S ," Economic Policy (April 1 9 9 4 ), pp. 147-85.
_ _ _ _ _ _ _. I/ie Economics of Monetary Integration. Oxford University
Press, 19 9 2 .
The Economist. "The Unpopularity of Two-Speed Europe"
(September 1 4 , 1 9 9 1 ) .
Eichengreen, Barry. "Should the Maastricht Treaty Be S a v e d ? "
Princeton Studies in International Finance (December 1 9 9 2 ).
Fratianni, Michele, Jurgen von Hagen and Christopher Waller. "The
Maastricht W ay to E M U ,"Essays in International Finance
(June 1 9 9 2 ).
Gawith, Philip. "Tietmeyer Sets Out Tough Line on EMU Convergence
Criteria," Financial Times (November 5 , 1 9 9 4 ) .
REFERENCES
Marsh, David. "E m u Strain Begins to S h o w ."
Financial Times
(January 1 7 , 1 9 9 5 ) .
Barber, Lionel. "Sa nter steers middle course for EU ,"
Financial Times
(January 18, 1 9 9 5 ).
Bini-Smaghi, Lorenzo, Tommaso Podoo-Schioppo ond Francesco Papadia.
"T he Transition to EMU in the Maastricht Treaty,"
Essays in
International Finance (Number 19 4 , November 1 9 9 4 ),
Princeton University.
Collignon, Stefan with Peter Bofinger, Christopher Johnson and
Bertrand de Maigret. Europe's Monetary Future. Printer
Publishers, 19 9 4 .
Committee for the Study of Economic and Monetary Union.
Report on Economic ond Monetary Union in the European Community.
Office for Official Publications of the European Communities, 19 8 9 .
negotiations on the Maastricht
Treaty, Germany resisted setting a
fixed date for the commencement
of monetary union. It believed that
fixing a dote would result in a loose
application of the convergence crite
ria (The Economist ; September 14,
1991).
16 The other members of this
core group ore France, Germany
and Luxembourg.
Owen, David. "M a jor S a y s Timetable for Monetary Union
Unrealish'c," Financial Times (August 3, 1 9 9 3 ).
Portes, Richard. 1 9 9 3 . "E M S and EM U After the Fall," World
The
Economy (No, 1, 1 9 9 3 ) pp. 1-16.
Tietmeyer, Hans. Speech at the Association for the M onetary Union of
Europe in Frankfurt/Main, September 9 , 1 9 9 4 . Printed in Bank for
International Settlements, BIS Review (October 1 4 , 1 9 9 4 ) .
Buiter, Willem, Giancarlo Corsetti ond Nouriel Roubini. "Excessive
Deficits: Sense and Nonsense in the Treaty of Maastricht,"
Economic
Policy (April 1 9 9 3 ), pp. 57 -100 .
15 It is interesting to note that in the
1995
Council of the European Communities, Commission of the
European Communities. Protocol on the Convergence
Criteria Referred to in Arhcle 109j of the Treaty Establishing the
European Community. Office for Official Publications of the
European Communities, 19 9 2 .
_ _ _ _ _ _ _. Protocol on the Excessive Deficit Procedure. Office for
Official Publications of the European Communih'es, 1 9 9 2 .
_ _ _ _ _ _ _. Protocol on the Statue of the European System of Central
Banks and of the European Central Bank. Office for Official
Publications of the European Communities, 1 9 9 2 .
_ _ _ _ _ _ _. Treaty on European Union. Office for Official Publications
of the European Communities, 19 9 2 .
16
REVIEW
JULY/AUGUST
1995
Donald S. Allen is an economist at the Federal Reserve Bank of St. Louis. Thom as A. Pollmann provided research assistance.
■
Changes in
Inventory
M anagem ent
and the
Business Cycle
Since the 1970s, many firms have made
notable changes in their inventory manage
ment methods. In particular, large movements
in interest rates in the early 1980s and
increased global trade have combined to
motivate firms to reduce inventory levels
relative to sales as part of larger downsizing
efforts. More efficient inventory management
has been realized by implementing “just-intim e” (JIT ) management techniques and the
use of bar codes. W ill these innovations in
inventory management decrease the effect of
inventory movements on the business cycle?
This article investigates the extent of the
changes in inventory management and
makes some observations regarding inventory
movement and the business cycle. There is
evidence to suggest that the use of these
innovative inventory control methods is on
the rise, but the net effect on the business
cycle remains ambiguous.
In the first two sections, I review the
role of inventory investment in postwar
recessions and the motivations for holding
inventory. Next, I document some of the
innovations in inventory management that
firms have adopted over the last 10-15 years.
Finally, I discuss the potential impact of
these changes on the business cycle.
Donald S. Allen
“I rem ember one day in the summer o f 1975
when a CBO [Congressional Budget Office]
staffer returned from a congressional hearing
with som e am azing news. Alan Greenspan,
then President G erald Ford’ ch ief econom ic
s
adviser, had ju st testified that the recession was
mostly an inventory correction. We all snickered
at the idea that w hat was, up to then, the deep
est recession since the Great Depression could
have been ‘on ly’ an inventory cycle. W hen I
subsequently studied the data m ore carefully,
however, I learned that Greenspan had been
right. L ike most o f the recessions before and
since, the 1973-5 contraction was dom inated
by changes in inventory investment. ”
Alan S. Blinder, introduction to Inventory
Theory and Consum er B ehavior (1990)
THE ROLE OF INVENTORY
IN POSTWAR RECESSIONS
The stocks of materials and supplies,
partially completed goods and finished goods
in the possession of a firm are income-producing assets. These stocks are held temporarily
before being sold. As inventories are
increased or decreased between the begin
ning and the end of a period, they add to or
subtract from the investment component of
GDP Unlike fixed investment, which is
assumed to be the result of specific plans by
firms, inventory stocks fluctuate as a result
of both active decisions by firms and errors
in forecasted demand. This dual effect tends
to make inventory investment especially
volatile around contractions, usually going
he change in business inventories is
usually less than 1 percent of total Gross
Domestic Product (GDP), yet during cycli
cal contractions this component contributes
disproportionately to the change in GDP
As a result, most cyclical contractions have
been referred to as inventory cycles. These
inventory cycles are characterized by an
unanticipated drop in demand resulting in
unplanned increases in inventories. Firms
respond by cutting production to reduce
inventory. This cut in production can
exacerbate the downturn by reducing
demand further.
T
17
REVIEW
.Y/AUGUST
1995
below the desired level, causing increased
production to replenish inventory The
U .S . In v e n to ry In vestm ent M o ve m e n ts in
degree of undesired accum ulation and decu
P ostw a r Recessions
mulation is a function of the accuracy of
Change in
firms’ demand projections. This inventory
inventory
cycle phenomenon has been of varying inter
Investment as
est to economists, and research in this area
Change in
a Percentage
Recession Period
Change in
Inventory
of Change in
has ebbed and flowed like the business cycle.
Peak to Trough1
Real GDP2
Investment2
Real GDP
Metzler (1 9 4 1 ) showed analytically how
inventory cycles could be generated when
1948:4 - 1949:4
-1 4 . 5
-2 8 .3
195.2
decisions on production levels are based on
expected levels of sales, and income and
1 9 5 3 :2 - 1954:2
-3 6 .9
-2 0 .0
54.2
demand are determined by production levels.
1 9 5 7 :3 - 1958:1
-6 1 .1
- 2 1 .1
34.5
Blinder and M accini (1 9 9 1 ) provide a good
1960:1 - 1960:4
- 1 5 .8
-4 5 .5
288.0
survey and bibliography of research in inven
tory cycles since Metzler’s work.
1 9 6 9 :3 - 1970:4
-3 2 .2
287.5
-1 1 . 2
The role of inventory investment in
1 9 7 3 :4 - 1975:1
-1 3 5 .1
-8 4 .7
62.7
business cycle contractions has been well
1980:1 - 1980:2
-9 8 .2
- 1 0 .7
10.9
documented. Coincident declines in GDP
1 9 8 1 :3 - 1982:3
-1 1 0 .1
-3 5 .0
31.8 and inventory investment are empirical regu
larities of postwar business cycles. Blinder
1 9 9 0 :2 - 1991:1
- 7 5 .1
-4 4 .5
59.3
and M accini (1 9 9 1 ) show that the average
Mean
113.8
movement in inventory investment during
recessionary periods in the postwar era
1 Peaks and troughs correspond to peaks and troughs of real GDP and do not always coincide with official
account for 87 percent of Gross National
NBER recession dates. .
2 Billions of 1 9 8 7 dollars.
Product (GNP) movement from peak to
trough. Computed another way, the relative
movement is even greater. Table 1 shows
peak-to-trough movement in inventory
from positive at the beginning as a result of
investment compared to the peak-to-trough
unintended accumulation, to negative due to
change in GDP in all postwar recessions.'
The average percentage change in inventory
deliberate reduction.
Inventory investment averages less than
investment to change in GDP is 113.8 per
1 percent of GDP, but changes in inventory
cent. Admittedly, this method computes the
investment can account for a substantial
difference between the highest quarterly
increase in business inventory and the highest
portion of the change. In 1994, for example,
inventory investment was $47.8 billion (in
quarterly decrease in business inventory on
1987 dollars) or 0.9 percent of GDP. This
an annualized basis, capturing the widest
swing. However, it is evident that inventory
level of inventory investment reflected an
investment has been a significant contributor
increase of $ 32.5 billion over 1993 or
1 The National Bureau of Economic
15.5 percent of the $209.5 billion increase
to changes in GDP during contractions.
Research (NBER) typically has iden
in GDP in 1994.
Figure 1 compares the change in GDP and
tified a recession as a period with
The typical inventory cycle begins with
the change in business inventories since
two consecutive quarters of decline
an unexpected reduction in demand which
1948. Recessions are shown by shaded bars.
in GDP. The peak of the cycle is the
leaves firms with inventory above their
Inventory level movement by itself is not
quarter prior to the first quarter of
desired levels. Production is reduced to
the complete story. It is necessary to know
decline. The hough is the last quar
lower inventory levels, which can result in
whether movements are active responses to
ter of negative growth. The peoklayoffs and further reduction in demand.
changes in the level of demand or reflect
to-trough movement in inventory
As inventory falls back to desired levels and
errors in forecasting. The ratio of inventory
investment in Table 1 is the differ
to sales, defined as total stocks divided by
demand resumes, production may be insuffi
ence between the maximum and
cient to meet demand and maintain inventory
monthly sales, gives some indication o f the
minimum inventory investment dur
ing the recession period.
nature of these movements. If we assume
levels. The result is that inventory can fall
Ta b le 1
18
R IE
IVW
JULY/AUGUST
that firms plan to maintain a relatively
constant level of inventory to sales, major
deviations in this ratio can give clues to
whether movements are planned or unplanned.
If inventory accumulation is accompanied by
an increasing inventory-to-sales ratio, then
the accumulation may be inadvertent because
inventory is rising faster than sales. If inven
tory accumulation is accompanied by a con
stant inventory-to-sales ratio, then the accu
mulation may have been planned in response
to increasing sales. An increase in inventory
can also be accompanied by a decrease in the
inventory-to-sales ratio, indicating that sales
are increasing faster than inventories.
The total business inventory-to-sales
ratio in the postwar period is shown in
Figure 2, with recessions indicated by shaded
bars. It is also evident from this figure that
the ratio peaks around the contractions, mak
ing it a relatively reliable coincident indica
tor. Although it cannot be claimed that
inventory changes cause the business cycle,
any imbalance which occurs between expect
ed and actual sales shows up in inventory,
and correcting this imbalance can exacerbate
the cycle. Even if we do not consider inven
tory investment to be a causative force but
simply a barometer of forecast accuracy,
most recessions appear to be marked by an
inventory correction.
1995
F ig u r e 1
C han ge in G D P C o m p a re d to the
C han ge in Business In ve n to rie s
1948
52
56
60
64
68
72
F ig u r e 2
Total Business In v e n to ry -to -S a le s R atio
1.8
1.7
1.6
1.5
1.4
1.3
1948
52
56
60
64
68
72
76
SOURCE: U.S. Department of Commerce, Bureau of Economic Analysis.
W H Y HOLD INVENTORY IN
THE FIRST PLACE?
Inventory stocks represent a major
utilization of resources. At the end of
1994, manufacturing and trade inventories
totaled $832 billion (1 9 8 7 dollars) or
12.4 percent of annual sales. At the
current prime rate, the opportunity cost of
holding the 1994 level of inventory stocks
amounts to more than $70 billion. This
financing cost compares to the 1994 annual
increase in GDP of roughly $200 billion.
The capital tied up in financing inventory
could also be converted into fixed invest
ment in more productive capital equipment.
But rational firms are motivated to hold
inventory as long as the expected cost of
holding it is less than the expected penalty
92
76
SOURCE: U.S. Department of Commerce, Bureau of Economic Analysis.
(lost revenue or market share) for running
out of stock. In other words, the optimal
level of inventory in the face of uncertain
sales and random supply interruption is
not always zero, and there is a lim it to
the savings which can be realized by
lowering inventory.
The motivations for holding inventories
are diverse and firm-specific. Some firms
minimize their delivery costs, some smooth
production in the face of uncertain demand,
and others stockpile against potential
interruptions or anticipated price increases
by suppliers. Most retailers are forced
to hold inventory to accommodate the
FEDERAL RESERVE B A N K OF ST. L OU IS
19
I
1995
REVIEW
JULY/AUGUST
1995
INVENTORY MODELS
Production Smoothing
(S,s) Rule
The accompanying figure on page 21 illus
trates the production smoothing motivation when
increasing marginal costs exist. If Q1 and Q 2
represent the demand in periods 1 and 2 , respec
tively, then point A represents the average cost if
Q1 is produced in period 1 and Q2 is produced
in period 2. Point B represents the average cost if
(Ql+Q2)/2 is produced in both periods, with the
excess produced in period 1 carried over to peri
od 2. The trade-off is between the cost of storage
for one period versus the saving from smoothing.'
The difference between A and B must be greater
than the cost of holding inventory to justify
smoothing. Note also that if mean demand is
expected to decrease below current production
for an extended period (that is, Q2 is current
demand and Q1 is next period’s expected demand),
then it becomes optimal to reduce production
and serve part of current demand from inventory.
Thus, production smoothing motivation can lead
to level changes if forecast sales change direction.
If costs are linear, as in the case when
marginal costs are constant, and there is a
significant fixed cost o f purchasing in each
period, then it can be shown that “lumpy”
adjustment is preferred to smoothing. An
economic batch run, or a purchase which
minimizes the total expected cost including
the cost of storage of excess inventory, and
the cost of lost sales can be determined. The
inventory management technique used under
these circumstances is referred to as (S,s) and
entails determining maximum (S) and minimum
(s) levels o f inventory.2 W hen inventories
fall below (s), purchases are made to bring
inventory up to (S), as long as inventories are
between (S) and (s), nothing is done. The (S,s)
parameters will define the upper and lower
bound of inventory movement. It can be shown
that the (S,s) margin is more sensitive to the
mark-up of price over marginal cost than to
interest rates.
1 Holt, Modigliani, Muth and Simon (1 9 6 0 ) provide the details of the production
smoothing model.
2 Scarf (1 9 6 0 ) proves the optimality of the (S,s) rule under specific conditions.
INVENTORY INNOVATIONS
wide range of preferences and sizes of
consumers. Generally, inventories are a
hedge against uncertainty or a means
of minimizing production costs.
There are two competing models for
inventory decisions, depending on the
assumption about production costs. W hen
firms operate in a region of increasing mar
ginal costs, it becomes more economical to
smooth production than to adjust to changing
sales. W hen marginal costs are constant, but
there are fixed costs associated with delivery
or production, batch runs or bunching
spread these fixed costs over larger quantities.
(See the shaded insert above for discussion.)
Wholesalers, retailers and manufacturing
purchasers o f raw materials and supplies
are more likely to face non-negligible
delivery costs and therefore more likely
to use batch purchasing.
Is JIT Changing the Face of
Inventory in America?
As businesses focused on streamlining
operations in the 1980s, one of the targets
has been inventory stocks. Over the last
15 years, there seems to have been major
shifts in the methods used to manage inven
tory. In particular, many U.S. companies
have studied and adopted the Japanese
kanban (or JIT ) method of inventory man
agement. The objective of the JIT system is
to minimize the stock of parts and compo
nents by having them delivered ju st in time
for production, and to limit the inventory of
finished goods by producing them ju st in
time to fill demand. The monthly National
Association of Purchasing Management
survey indicates that as much as 26 percent
20
REVIEW
JULY/AUGUST
1995
Just-in-Time Inventory
foster the use of JIT. Intuitively, deregulation,
Just-in-tim e (JIT) inventory control
which reduces the econom ic lot-size of shipment,
attempts to match production as closely to sales
allows more continuous streams of shipment.
as possible and thereby minimize the costs of
holding inventory. This method, called
kanban in Japan, is characteristic of Japanese
industry in general and the auto industry
in particular. JIT can be optimal
when convex costs of production
C o n v e x P r o d u c t io n C o sts
exist but storage costs exceed
savings from smoothing or
when linear costs exist but the
low mark-up, low variance of
sales, low fixed costs of delivery or
high costs of storage result in low
values of (S,s). If firms can meet
demand without holding invento
ries, then inventories become
superfluous. JIT can exist only in
an atmosphere in which suppliers
are reliable enough to minimize
the risk o f stock-outs. Larson
(1991) argues that deregulation of
the transportation industry has
resulted in innovations which
of the respondents reported purchasing mate
rials “hand to mouth” in January 1995, com
pared to as little as 4 percent in February
1970. This suggests that the JIT philosophy
has made major inroads into U.S. manufac
turing. Bechter and Stanley (1992) find
empirical evidence of improved inventory
control along with faster speeds of adjust
m ent to desired inventory levels.
Prima facie evidence of the success in
reducing manufacturing inventory is also
seen in the consistent decline in the aggre
gate inventory-to-sales ratio (shown in
Figure 2), which has dropped from a peak
o f approximately 1.7 during the 1990 reces
sion to 1.44 in December 1994 — the lowest
in about 20 years. The manufacturing sector
has been reducing inventory at all stages
of production. Figure 3 shows the manufac
turing sector inventory-to-sales ratios by
stage of processing for 1970 to 1994. The
work-in-process and materials and supplies
are at a low point for the last two decades,
after a steady decline since the early ‘80s.
Some of this decline may be attributable to
factors other than JIT. For instance, a closer
look shows that materials and supplies
increased rapidly relative to sales during the
1973-75 recession and did not return to ear
lier levels until recently. This could indicate
an end to a post-oil-embargo tendency to
stockpile, motivated by inflation expecta
tions and sensitivity to interruptions.
Some industries have been more success
ful than others in lowering inventory levels
relative to sales. Table 2 shows the summary
statistics for the inventory-to-sales ratio by
stage of processing for four manufacturing
industries which have experienced significant
declines in ratio. The December 1994 ratio is
F EDERAL RESERVE B A N K OF ST. I O U I S
21
REVIEW
.Y/AUGUST
the retail and wholesale levels. The cost of
financing high levels of inventory is a m ajor
cost of doing business. In the early years of
the industry, finance companies took on the
dual role of providing credit to wholesalers
and buying consumer loans initiated by deal
ers. It seems appropriate, therefore, that the
push to reduce inventory levels should take
place in the auto industry. Minimizing
inventory reduces financing needs and thus
increases the competitive edge. The downside
is greater vulnerability to interruptions such
as strikes or to unanticipated surges in
demand. U.S. automobile manufacturers
appear to have embraced JIT and currently
hold less than two weeks worth of sales in
inventory, down from a high of 1.3 months.
Figure 4 shows the changes in inventory-to-sales ratios in the motor vehicle industry
by stage of processing for the period 197094. It is apparent that there has been much
success in reducing inventory levels over the
last 10 years.
Figure 4 also reveals that the reduction
occurred primarily at the work-in-process,
and materials and supplies stages of produc
tion with very little change in the level of
finished goods relative to sales. The burden
of reduced inventory has been placed on the
intermediate input stage of production.
As an example of the downside of lower
inventory holdings, however, General
Motors in 1994 experienced the shutdown
of several assembly lines because of an inter
ruption at a drivetrain component plant. If
they had held higher levels of inventory, they
would have been able to reduce the scale of
the shutdown.
F ig u r e 3
M a n u fa c tu rin g In v e n to ry -to -S a le s Ratios
b y S ta g e of Processing
SOURCE: U.S. Department of Commerce, Bureau of Economic Analysis.
provided for comparison. Motor vehicle mate
rials and supplies, and work-in-process
inventory stocks have declined from peak
ratios of over 70 percent of monthly sales each
to 19 percent and 14 percent, respectively, in
December 1994. In all four industries and for
all stages of processing, December ratios are
well below the mean for the entire period.
The use of JIT tends to shift the burden
of responding to uncertainty to the suppliers
and to require speedy delivery methods.2
Some analysts believe that significant changes
in the transportation industry, fostered in part
by deregulation and increased competition,
contributed to the viability of JIT. In partic
ular, if a manufacturer wishes to maintain a
continuous flow of materials, deliveries must
take place more often in smaller batches.
The deregulation in the trucking industry,
which allowed competitive pricing for lessthan-truckload deliveries, and increased
competition in air freight help reduce the
cost of smaller, more frequent deliveries.
Bar Coding
The computer industry revolution and
proliferation of bar coding has streamlined
the inventory process in all sectors of the
economy. Many retailers now use automatic
scanning computer registers to record sales
and track inventory immediately. These
innovations have had the spillover effect of
providing almost instant marketing informa
tion regarding the rate of sale or use of prod
ucts. The increased use of bar code scanning
and more sophisticated electronic systems
JIT in the Auto Industry
2 The recent eorthquoke in Kobe,
Japan, emphasized the potential
disadvantage which this system
produces, when many Japanese
manufacturers, who were otherwise
unaffected, hod to shut down
because of interruptions to suppliers
and transportation.
1995
The evolution of the structure of the
U.S. automobile industry is relatively unique
and was motivated primarily by the need to
smooth production, combined with a limited
ability to hold inventory (see Olney, 1989).
The relationship between manufacturers,
wholesalers and retailers ensures that the
storage of finished goods occurs primarily at
NK OF ST . L OU I S
22
REVIEW
T a b le 2
In v e n to ry -to -S a le s R atio (J a n u a ry 1 9 7 0 - D ecem ber 1 9 9 4 )
Stage of
Processing
Mean
Maximum
Minimum
Dec. 1994
Finished Goods
Motor vehicles
Primary metals
Electrical
Non-Electrical
0.147
0.635
0.564
0.664
0.261
1.032
0.709
0.972
0.099
0.372
0.481
0.442
0.115
0.545
0.511
0.452
Work-in-Process
Motor vehicles
Primary metals
Electrical
Non-Electrical
0.298
0.862
0.960
0.878
0.730
1.338
1.174
1.123
0.137
0.564
0.676
0.614
0.139
0.677
0.689
0.614
Materials & Supplies
Motor vehicles
Primary metals
Electrical
Non-Electrical
0.366
0.863
0.679
0.647
0.762
1.365
0.893
0.185
0.567
0.541
0.437
0.185
0.605
0.554
0.514
0.886
1990:4) support the notion that inventory
management methods changed significantly
beginning in the ’80s. Similar work by
Bechter and Stanley (1 9 9 3 ) detects changes
in the speed of adjustment and desired
inventory-to-sales ratio after 1981 in a
buffer-stock model.
The evidence supports the assertion that
inventory innovations have impacted not
only the quantity but also the quality of
inventories held by allowing firms to more
closely match patterns of use. Manufac
turing has been more successful in reducing
the quantity of inventory relative to sales, but
the innovations in the wholesale and retail
sectors should also lim it the accumulation of
unplanned inventory through more direct
feedback of marketing information. As a
result, the innovations in all three sectors
should tend to lim it the error portion of
inventory accumulation.
over the last 10 years has led to more efficient
retail (and wholesale) inventory manage
ment. This increased efficiency has not
necessarily manifested itself as lower inventory
levels, but allows more precise selection of
stock items. In the retail sector, the inventory-to-sales ratio has actually increased slightly
in contrast to the aggregate. The reasons for
this increase are not obvious, but retailers
must keep visible inventory on hand to stim
ulate sales, and therefore have less flexibility
in inventory levels. In addition, an increase
in the total number of stores3 may have also
contributed to the increase in aggregate
retail inventory.
There have been efforts at limiting inven
tories at the retail level. “Quick Response” is
the retail equivalent to JIT. Some retailers
try to limit inventory by streamlining cus
tomer orders. The effectiveness of these
efforts has been limited and so far appears
to have had little impact on the level of
aggregate retail inventory relative to sales.
Little (1992) uses quarterly manufactur
ing and trade data from 1968 through
1990 to test for structural changes in
inventory management. Results of
regressions o f the data divided into two sub
periods (1968:1 to 1982:3 and 1982:4 to
IMPACT OF INNOVATIONS
ON THE BUSINESS CYCLE
Inventory influences business cycle con
tractions primarily through unintended
increases.4 How do the structural shifts in
inventory management affect unintended
23
3 The Economist (March 4 ,1 9 9 5 )
reported in its retail survey that
1 9 9 3 total shopping center space
in the United States was 18.5
sguare feet per head, compared
with 13.1 square feet per head in
1980, according to the Schroder
Reol Estate Associates.
4 Some analysts suggest that higherthan-average growth during the
recovery part of the cycle reflects
planned inventory investment in
anticipation of increased demand.
rebounded was offset by the continuing
effort to reduce inventory-to-sales ratios.
M o to r Vehicles In v e n to ry -to -S a le s R atio
Bechter and Stanley (1 9 9 3 ) use estimated
b y S tag e of Processing
parameters from their buffer-stock model to
0.8 t *
simulate inventory investment and conclude
that the new parameters lead to larger inven
tory swings for a one-time shock in sales.
0.6
Filardo (1 9 9 5 ) uses an atheoretical vector
M a te ria ls and
autoregression (VAR) method and a model0.4
based method to test empirically whether the
changes in inventory management have
muted the business cycle. He concludes
0.2
there is no evidence of a reduced role for
inventory in the business cycle. As Little
0
. ■ ..............................................................
(1 992) suggests, however, the innovations
1970
72
74
76
78
80
82
84
86
88
90
92
1994
are still being implemented and may not
SOURCE: U.S. Department of Commerce, Bureau of Economic Analysis.
have saturated the market. In this case, there
is an insufficient sample size to evaluate the
business cycle impact empirically.
F ig u r e 5
It is difficult to separate the effect of
those firms using JIT from those which do
N o m in a l ln v e n to ry-to > S a le s Ratios
fo r Ja p a n a n d the U n ite d States
not. One approach is to see if the industries
that have converted to JIT now contribute
less inventory investment during the reces
sion. Primary metals, electrical machinery,
non-electrical machinery and m otor vehicles
have shown significant decline in their
inventory-to-sales ratios in the last 10-15
years. I looked at the 1980, 1982 and 1990
recessions to determine the contribution of
these industries during the quarter with the
biggest reduction in inventory. Together, the
four industries contributed a net 22 percent
to the third quarter 1980 change in business
SOURCES: U.S. Department of Commerce (Bureau of Economic Analysis) and The Bank of Japan.
inventory, a net 29 percent to the fourth
quarter 1982 change in business inventory,
but only net 1.6 percent to the fourth quarter
1990 change in business inventory. The
inventory build-up? Morgan (1 9 9 1 ) sug
remaining manufacturing industries con
gests that a move to JIT produces a faster
reaction to sales shocks and therefore will
tributed 33 percent, 19 percent and 36 per
cent to the change in business inventories
not result in the levels of unplanned accu
mulation previously observed. He also
during these periods. These four industries
argues that as the use of JIT increases, the
that have reduced their inventory-to-sales
ratios significantly over the past two decades
impact will be to lessen the inventory swings
contributed less to inventory swings in the
during recessions. Others have tried to
1990 recession than in 1980 or 1982.
directly assess the impact on the business
Despite the reduction in contribution by
cycle. Little (1 9 9 2 ), for example, focuses on
these industries, the change in business
the transitory nature of the changes and
inventory contributed a higher proportion to
suggests that the ongoing effort to reduce
the change in GDP during the 1990-91
inventories were a drag on the recovery por
downturn than in 1980 or 1981-82, but the
tion of the 1990-91 recession. The expected
magnitude of the decline in GDP was less in
inventory accumulation after demand
F ig u r e 4
1990-91 than in 1980 or 1981-82. On the
surface, it appears that JIT may help reduce
the magnitude of the inventory swing.
Another way to test the impact of JIT on
business cycles is to compare the Japanese
with the U.S. experience. First, we can
look for evidence that Japan does maintain
lower inventory levels. Figure 5 shows the
inventory-to-sales ratio for the Japanese and
U.S. manufacturing sectors. The Japanese
ratio is lower than the United States during
the 1980s, but both ratios have converged as
the United States’ decreased and Japan’s
increased somewhat.
Assuming that the lower inventoryto-sales ratio in Japan confirms the higher
usage of JIT there, how does Japan’s
business cycle experience compare with
the United States’? Unfortunately, an exact
comparison is not possible because Japan
has not recorded many periods of declining
output. Using dates from Japan’s Research
Bureau Econom ic Planning Agency,5
Japan’s business cycles have had longer
contractionary periods in the postwar
era, averaging 16 months, compared
with 11 months for the United States.
Japan recorded 10 business cycles after
World War II, compared to the United
States’ nine. The average duration of Japan’s
business cycles (50 months) and the expan
sion periods (33 m onths) were shorter
than the United States’ (63 months and
52 months, respectively).
Table 3 shows the changes in Japanese
business inventory compared to changes in
GDP during its last six contractions. Three
of these six contractions had countercyclical
inventory movement. Similar data for the
United States (Table 1) shows unambiguous
procyclical movement in business inventory.
The data suggest that inventory changes may
play a lesser role in GDP fluctuations in Japan
than in the United States. How much of this
is attributable to inventory management
methods and how much is due to the differ
ence in business cycle definition is uncertain.
Even if the use of JIT inventory manage
ment methods can dampen business cycles,
this method is most applicable at the manu
facturing level. The contribution of manu
facturing, wholesale and retail inventories to
Ta b le 3
Changes in Jap a n e se In v e n to ry In vestm ent
D u rin g Business Cycle Troughs
Change in
Real GDP2
Recession Period
Peak to Trough
Change in
Inventory
Investment2
Change in
Inventory
Investment as
a Percentage
of Change in
Real GDP
-5 2 7 .0
1 9 7 0 :3 - 1970:4
-1 5 8 .5
1 9 7 3 :4 - 1974:1
-5 2 9 6 .8
1 9 7 7 :2 - 1977:3
1417.0
1980:1 - 1980:2
-4 5 3 .0
4.3
1 9 8 5 :4 - 1986:1
-3 3 1 9 .0
952.2
1992:1 - 1993:4
-5 0 9 7 .0
332.5
7304.7
-1 3 7 .9
-4 9 9 .5
-3 5 .3
-0 .9
-2 8 .7
-2 8 0 7 .4
55.1
Mean
30.8
1 Peaks and trough correspond to peak ond trough (or minimum growth) of real GDP
during the contractions listed by the Research Bureau of the Economic Planning
Agency of Japan, but do not always coincide with the peak and trough of the period.
2 Billions of 1 9 8 5 Yen (SAAR).
total trade inventories has been changing
over the last two-and-a-half decades. More
recently, manufacturing’s share has declined
from 56 .8 percent to 4 3 .8 percent. Retail
inventories have increased from a share of
24.3 percent to 31 percent. W holesale
inventories’ share of the total has increased
from 18.9 percent to 2 5.2 percent. The
increased retail inventory-to-sales ratio and a
greater retail share o f the aggregate inventory
may offset the gains in dampening the cycle
from JIT at the manufacturing level.
CONCLUSION
The data support anecdotal evidence
that inventory management methods in
the United States have changed significantly
over the past decade or two. The result
of these changes is evident in the reduced
business inventory-to-sales ratio, driven
almost entirely by lower inventories of
work-in-process, and materials and supplies
rather than finished goods. The impact
25
5 The Japanese agency uses the
Lucas (1 9 7 7 ) definition, which
loosely defines the business cycle in
terms of deviation from trend
growth. For most of the contrac
tionary periods listed, Japan's GDP
grew less than trend but did not
experience a decline.
REVIEW
JULY/AUGUST
19
Larson, Paul D. "Transportation Deregulation, JIT, and Inventory Levels,"
The Logistics and Transportation Review (June 1 9 9 1 ), pp. 9 9 -1 1 2 .
of these changes in inventory management
techniques on business cycles is ambiguous.
All other things being equal, inventory
management innovations should reduce
the probability o f unintended accumulation.
But as long as firms overestimate or
underestimate future demand, inventory
cycles will persist. And if cutbacks in
production are required to reduce inventory,
then the resulting reduction in income
could result in lower demand and further
inventory buildup. Inventory management
innovations are not a panacea for taming
business cycles, but in the long run these
innovations can contribute to a faster
response of production to changes in
demand, which in turn can reduce the
boom -bust cycle in the econom y
Little, Jane Sneddon. "C ha nges in Inventory Management: Implications
for the U.S. Recovery," Federal Reserve Bank of Boston England
New
Economic Review (November/December 1 9 9 2 ), pp. 37-65.
Lucas, Robert E., Jr. "Understanding Business Cycles," in Karl Brunner
and Allan H. Meltzer, eds.,Stabilization of the Domestic and
International Economy. Carnegie Rochester Conference Series, vol. 5.
North-Holland, 19 7 7 .
Metzler, Lloyd A. "The Nature and Stability of Inventory Cycles,"
Review
of Economic Statistics (February 1 9 4 1 ), pp. 113-29 .
Morgan, Donald P. "W ill Just-In-Time Inventory Techniques Dampen
R e ce ssion s?" Federal Reserve Bank of Konsos City
Economic Review
(March/April 1 9 9 1 ), pp. 21-33.
Olney, Martha L "Credit as a Production-Smoothing Device: The Case of
Automobiles, 1 9 1 3 -1 9 3 8 , The Journal of Economic History (June
"
1 9 8 9 ), pp. 3 7 7 -9 1 .
"Retailing" Survey, The Economist (Morch 4, 1 9 9 5 ), pp. 3-18.
REFERENCES
Scarf, Herbert E. "T he Optimality of (S,s) Policies in the Dynamic
Inventory Problem," in Kenneth. J. Arrow, Samuel Karlin and Patrick
Suppes, eds., Mathematical Methods in the Social Sciences, 1 9 5 9 .
Stanford University Press, 1 9 6 0 , pp. 1 9 6 -2 0 2 .
Bechter, Dan M., and Stephen Stanley. "Econom ic Stability in the
1 9 9 0 s: The Implications of Improved Inventory Control,"
Business
Economics (January 1 9 9 3 ), pp. 35-8.
_ _ _ _ _ _. "Evidence of Improved Inventory Control," Federal
Reserve Bank of Richmond Economic Review (January/February
1 9 9 2 ), pp. 3-12.
Blinder, Alan S. Inventory Theory and Consumer Behavior. University of
Michigan Press, 19 9 0 .
_ _ _ _ _ _and Louis J. Maccini. "T he Resurgence of Inventory
Research: W hat Hove We Le a rne d ?"
Journal of Economic Surveys
(No. 4 , 1 9 9 1 ) , pp. 2 9 1 -3 2 8 .
Filardo, Andrew J. "Recent Evidence on the Muted Inventory Cycle,"
Federal Reserve Bank of Kansas City Economic Review (second quar
ter 1 9 9 5 ), pp. 27 -43.
Holt, Charles C., Franco Modigliani, John F. Muth and Herbert A. Simon.
Planninq Production. Inventories, and Work Force. Prentice-Hall, Inc.,
1960.
26
REVIEW
JULY/AUGUST
1995
Alvin L. M a rly is a professor of economics and finance at the Center for Business and Government, Baruch College, City University of New York.
Daniel L. Thornton is an assistant vice president at the Federal Reserve Bank of St. Louis. Jonathan Ahlbrecht provided research assistance.
The authors would like to thank, without implication, Phillip Cagan, David Laidler and Allan Meltzer for comments on an earlier draft.
Is There a Case
for "M o d e ra te "
Inflation?
A lvin L. M arty and
Daniel L. Thornton
he proposition that inflation is a mone
tary phenomenon is more widely
embraced now than it was three decades
ago. Moreover, it is more widely accepted
that inflation is subject to long-run control
by the central bank. In recent years, the cen
tral banks of the United Kingdom, New
Zealand and Canada have placed increased
emphasis on reducing their long-run infla
tion rates. In the United States, former
Rep. Steven Neal, D.-N. Carolina (House Joint
Resolution 55. January 5, 1993), and
Sen. Connie Mack, R.-Florida, have pro
posed making stable prices the primary
objective of the Federal Reserve.
Nevertheless, considerable opposition
remains to making price stability the overrid
ing objective o f U.S. monetary policy. Some
argue that the benefits of price stability do
not warrant the cost of achieving it. For
example, although extolling the virtues of
price stability, Howitt (1990) is uncertain
whether the benefits are worth the costs in
terms of lost output (temporary, and perhaps
permanent, due to hysteresis effects).
Although we are skeptical whether the
empirical and theoretical analyses to date
have correctly identified all of the benefits of
price stability, this article addresses an issue
that is logically prior to this one. Specifically,
it addresses the question: If the inflation rate
were zero, could society benefit from a high
er rate of inflation? In other words, is mod
erate inflation preferable to price stability?
Several arguments have been advanced that
the economy benefits from moderate infla
tion. Recently, DeLong and Summers (1992)
T
and Summers (1 991) have suggested several
rationales for why a central bank would
choose moderate inflation over price stability
as its long-run policy goal.
This article addresses four reasons that
have been suggested to prefer moderate to
zero inflation:
1. Moderate inflation enhances the stability
of the economy.
2. Moderate inflation results in a higher
steady-state level of output per person.
3. Moderate inflation increases the efficiency
of inter-industry labor market adjustments.
4. Inflation enhances the efficacy of counter
cyclical monetary policy by allowing the
real rate of interest to be negative, thereby
stimulating effective demand in periods
of recession.
The first two of these arguments are wellknown to economists, but have received
scant attention in public debates. Moreover,
they are framed within specific, although
quite different, theoretical models, so it is
possible to provide a rather definitive evalua
tion of their merit. The remaining two argu
ments have received considerable attention,
and may play a role in any public policy
debate regarding the desirability of making
price stability the primary monetary policy
objective. The conceptual frameworks for
these arguments are not well-specified, how
ever, so we try to shore up their analytical
footing by proposing specific interpretations.
Before proceeding, several issues should
be clarified. First, the hypotheses that there
are econom ic benefits from moderate infla
tion considered here implicitly argue against
a so-called Friedman Rule (Friedman, 1969),
that is, the “optimal” rate of money growth is
one that generates steady-state deflation.
Nevertheless, this article is not specifically
about the Friedman Rule. Analyses of a
Friedman Rule generally have been carried
out in well-specified model economies.
Second, although the last two arguments
for moderate inflation lack explicit theoreti-
REVIEW
JULY/AUGUST
cal foundations, this has not prevented them
from achieving an intellectual status among
some economists and policymakers. The
lack of theoretical foundations forces our
analysis to range from the fairly technical to
the somewhat conjectural, so that we may
not provide a definitive evaluation o f these
arguments. In this case, we are content to
present an analysis of these arguments.
Third, the arguments for moderate infla
tion analyzed here are based on the assump
tion of a fully anticipated, steady-state infla
tion. Although such inflations do not char
acterize real-world economies, we make this
assumption until it is relaxed when we dis
cuss the reasons why price stability is prefer
able to moderate inflation.
Fourth, the phrase “moderate inflation”
is not well-defined. Some might consider
moderate inflation to be 2 to 3 percent. For
others, any rate under 5 percent could be
moderate. Still others may deem anything
less than double-digit inflation moderate.
We suggest 5 percent as the break point for
moderate inflation in the United States.
Finally, although we used the phrases
price stability and zero inflation interchange
ably, we are aware that price stability is dif
ferent and more stringent than zero inflation.
Price stability implies that jum ps in the price
level are reversed; zero inflation need not.
1995
holdings of real balances, prices rise still fur
ther, fueling expectations of further inflation.
This reduces the quantity of real balances
demanded still further, giving rise to a fur
ther increase in prices and so on. The ques
tion is: Under what conditions will this
sequence converge?
The answer is: Self-generating inflation
cannot occur if, as the price level rises, its
rate of change declines. Holding the growth
of the money supply constant, this condition
is illustrated in Figure 1, w hich shows two
plots o f the change in the log of the price
level, against the price level itself, P. In one
case, the slope of the curve rises with P. In
this instance, the sequence will not converge
and the ultimate solution is the trivial one;
the demand for real money balances
approaches zero. In the other case, the
slope of the curve decreases as P increases,
so that the sequence converges to a steady
rate of inflation.
The argument that inflation enhances
econom ic stability is an argument about the
demand for money. To see this argument,
assume that the demand for real money bal
ances is solely a function of the nominal
interest rate, whereby the nominal interest
rate equals the constant real interest rate
plus the actual rate of inflation (which is
fully anticipated). Cagan (1 9 5 6 ) showed
that the rate of inflation decreases as the
price level rises if a/3 < 1. The parameter a
is the semi-log slope of the demand for real
money balances with respect to the nominal
interest rate, that is, percent change in the
demand for real money balances per percent
age point change in the money interest rate
(d In(M /P)/di). The parameter (3 is the rate
at which individuals revise their expectations
of inflation under adaptive expectations,
dE/dt = (3(/rr - E), where rr and E are the actu
al and expected rates of inflation, respectively.
If a/3 < 1 and the expected rate of infla
tion is initially greater than the actual rate,
expected inflation falls until a stable steady
state is reached at which the expected rate of
inflation is equal to the actual rate. If, how
ever, a [3 is greater than unity and actual
inflation is initially greater than expected
inflation, both expected and actual inflation
grow without lim it with real balances falling.
THE CASE FOR MODERATE
INFLATION
Is Stability of the Economy
Enhanced b y Moderate Inflation?
The first argument for moderate infla
tion is that certain stability conditions are
sturdier at a high-money (nominal) rate of
interest, making the economy less vulnerable
to various shocks. Understanding this argu
ment requires an understanding of the
notion of stability upon which it rests. To
illustrate, suppose that the real rate of inter
est suddenly rises, say, because of an increase
in expected future profits. Given the under
lying rate of inflation, this raises the money
rate of interest, reducing the quantity of real
money balances that individuals desire to
hold. As individuals attempt to reduce their
28
REVIEW
JULY/AUGUST
1995
tion.2 This suggests that the underprediction
was due to a being higher at low rates
of inflation.
That a is inversely related to the steadystate inflation rate is plausible, but this does
not imply that stability is more likely at
higher rates of inflation. For example, it is
plausible that individuals revise their expec
tations of inflation more rapidly at higher
rates of inflation, that is, that f3 is positively
related to the inflation rate. Indeed, Bruno
(1 9 8 9 ) provides some empirical support for
a positive association between [3 and the rate
of inflation. Consequently, it is not necessari
ly the case that stability is greater at high
inflation rates. An inflation-induced fall in a
might be ju st offset, or perhaps more than
offset, by an inflation-induced rise in /
3.
Using adaptive expectations, no general con
clusion can be reached about the stability
conditions and the steady-state inflation rate.
F ig u r e 1
Log of th e Price L eve l V s.
A ctu a l Price Level
A log P
initially less than expected inflation, both
actual and expected inflation fall without
limit. The steady state at which the actual
and expected rate are equal is unstable.
Stability Through Moderate Inflation
Getting on the W rong Side of the
Laffer Curve
If a and / are constants, the stability
3
conditions will be invariant to the steadystate inflation rate. Consequently, the sug
gestion that the stability conditions are stur
dier at non-zero rates of inflation is an argu
ment that either a or / is inversely related to
3
the steady-state inflation rate. Specifically, it
was argued that a should be smaller at high
er rates of money interest. That this may be
so comes from noting that the elasticity of
the demand for real money balances with
respect to the money interest rates, em is
,
equal to a i, where i is the money interest
rate. Thus,’ if e m is constant, a will decline as
’
the rate of inflation and, hence, the money
interest rate rises.1 All other things the same,
the stability condition is more likely to be
satisfied at higher rather than lower rates of
money interest if the interest elasticity
demand for real money balances is constant.
The widely used Cagan (1956) moneydemand function assumes that a is indepen
dent of the nominal interest rate. Cagan’s
function significantly underpredicted real
money balances during periods when prices
were or had been relatively constant, but
performed well during periods of high infla
Bruno and Fischer (1 9 9 0 ) have revisited
Cagan’s stability condition in the context of
financing a given budget deficit solely
through seigniorage from money creation.
Although assuming that the deficit is
financed solely through money creation is
not realistic in developed economies like the
United States, where other forms of taxation
are available, the Bruno and Fischer assump
tion is a useful theoretical device which
allows stability conditions to be anchored by
two equilibria on either side of the Laffer
curve. The Laffer curve is the recognition
that tax receipts do not increase continuous
ly with the tax rate. Beyond some point,
receipts decline as a further increase in the
tax rate results in a significant erosion of the
tax base. Consequently, except at that
unique tax rate where tax revenue is m axi
mized, there are two alternative tax rates and
tax bases that generate the same tax revenue:
a low tax rate and a high tax base, or a high
tax rate and a low tax base. Bruno and
Fischer demonstrate that if a/3 < 1, a stable
equilibrium is at the socially desirable low
tax rate-high tax base point. If a)3 > 1, an
equilibrium is at the socially undesirable
29
1 Note that em is constant if the
m
money demand function is in dou
ble log form: M
/P=ik o
,s
e=ai=k.
m
2 See Bailey (1 9 5 6 ) and Friedman
and Schwartz (1 9 6 3 ) for a discus
sion of the issue of the empirical
validity of Cagan's moneyilemand
equation.
REVIEW
point on the Laffer curve. Consequently, the
argument is not whether the system is stable
or explosive, but whether equilibrium is
achieved at a socially desirable point on the
Laffer curve.
money balances and physical capital are sub
stitutes. A higher anticipated rate o f inflation
induces individuals to economize on their
holdings o f money balances, freeing up sav
ings for capital accumulation. This leads to
a higher steady-state capital/labor ratio,
resulting in higher consumption per person
so long as the steady state is not pushed
beyond the point where consumption per
person is maximized (the so-called Golden
Rule point).
The Tobin effect, that higher inflation
induces higher levels o f capital, output and
consumption per worker, is open to a number
of objections. For one thing, it is dependent
on Tobin’s assumption that savings are a con
stant proportion of income. If the savings
rate is directly reduced by higher inflation,
the Tobin effect can be reversed— even in the
framework of Tobin’s model (Dornbusch and
Frenkel, 1973). Moreover, the Tobin effect is
model-specific. The effect is absent in
Ramsey-type models, in which the marginal
product of capital is tied to the representa
tive agent’s rate of time preference. In such
models, the marginal product of capital
defines a unique steady-state capital\labor
ratio w hich is independent of the level of
real money balances. It is now generally rec
ognized that the results of both Tobin- and
Ramsey-type models are sensitive to small
changes in assumptions. Moreover,
Orphanides and Solow (1 990) show that
different models or small changes in assump
tions in a particular model deliver disparate
conclusions about the Tobin effect.
Consequently, it is impossible as a matter of
pure theory to make a compelling case that
inflation increases real output.
A crucial reason for the fragility of these
results is that, by their very nature, these
money-growth models are the wrong vehi
cles for analyzing the role of money in the
economy and, hence, the effect of inflation
on the economy. A striking example of this
is provided by Tobin’s model, which predicts
that the highest level of output per person
occurs in a barter economy, in which hold
ings of real money balances are nil. This
result stems from not taking money serious
ly. Real money balances reduce transaction
costs. They do this by overcoming the dou-
What If Expectations Are Rational?
From the condition that E = t t , it is easy
to see that rational expectations are the lim
iting case of adaptive expectations. Adaptive
expectations approach rational expectations
as / — cc. Consequently, if expectations are
3 »
rational, the condition a(3 < 1 cannot be sat
isfied for any value of a . In Cagan’s world,
the system explodes. In the Bruno and
Fischer world of a fixed real deficit, a stable
equilibrium (if it exists) is achieved at a high
inflation rate on the wrong side of the Laffer
curve. Under rational expectations, any
affect on a is completely overwhelmed by /3,
which is infinite.
It appears that nothing remains of the
argument for stability through inflation. In
the case of adaptive expectations, any possi
ble reduction in a due to inflation may be
offset by an increase in /3. If expectations are
rational, an infinite / swamps any effect of
3
inflation on a . Indeed, the stable equilibri
um is at the socially undesirable side of the
Laffer curve, that is, at a high rate of infla
tion (tax rate) and a low level of real cash
balances (tax base). In particular, no argu
ment can be made that moderate inflation
produces stability on the socially desirable
side of the Laffer curve.
Does Moderate Inflation Lead to a
Higher Level of Output?
The second argument for moderate infla
tion, that it leads to a higher level of steadystate output and consumption, was first for
mulated by Tobin (1965). The essence of
Tobin’s model is that in a growing economy,
non-interest bearing real money balances
augment disposable income. Given that the
propensity to save out of disposable income
is less than unity, an increase in real bal
ances, all of which must be saved, gives rise
to smaller saving in the form of physical cap
ital. In Tobin’s portfolio-balance model, real
30
REVIEW
we must deal with how inflation interacts
with real-world institutions. It has been
shown that the interaction of inflation with a
less-than-fully indexed tax system works to
discourage capital accumulation (Feldstein,
1976, 1979; and Tatom, 1976).
The bottom line is that even within the
framework of theoretical-growth models, the
Tobin effect is subject to small changes in
assumptions. W hen real-world institutions
are included in the analysis, the weight of
evidence is that inflation discourages capital
accumulation. The Tobin effect is reversed.3
W hen capital is defined more realistically to
include human capital, the effect of inflation
is to continually reduce the levels of output
per person below what they would have been
under stable prices.
ble coincidence of wants associated with
barter and by conveying information (for
example, Brunner and Meltzer, 1971).
Compared to a barter economy, the reduction
in total transaction costs permits society to
devote more of its scarce resources to produc
tion, raising output and the consumption of
goods and leisure. By reducing marginal
transaction costs, money also results in a
higher level of trade and correspondingly
higher levels of output. Although the devel
opment of Solow-type growth models was an
important first step in the analysis of growing
economies, it is not surprising that these onecommodity models fail to capture the impor
tant role that money plays in real-world
economies.
Thus far, we have contrasted money and
non-monetary barter economies. In princi
ple, similar effects occur when individuals
are induced by a rise in anticipated inflation
to reduce their holdings o f real balances. If
inflation induces individuals to hold fewer
real balances, even if one were to accept
Tobin’s argument that inflation increases out
put per person, any increase would be at the
expense of a loss to society of the services of
real balances. In fact, if money enters the
production function, the Tobin effect may
well be reversed; inflation then reduces out
put per person, as in Stockman (1981).
Inflation may not only reduce the steadystate level of per capita output, it may reduce
the growth rate of output itself. For if capital
is appropriately defined more broadly to
include human capital, as is done in recent
endogenous-growth models, inflation reduces
investment in human capital, as well as in
physical capital. Reduced investment in
human capital lowers the growth of efficien
cy per person, which reduces the growth rate
itself (for example, Lucas, 1988; King and
Rebelo, 1990; and Dotsey and Ireland, 1993).
A small but permanent reduction in the
growth rate due to inflation has an adverse
effect on output levels. This continual effect
on output levels is more significant than any
effect o f inflation on the one-time altering of
the level of output per capita explored in ear
lier exogenous-growth models.
Once we leave purely theoretical-growth
models, and look at real-world economies,
Does Moderate Inflation Enhance
Relative Real-Wage Adjustments?
The third argument for moderate infla
tion (Tobin, 1972; Schultze, 1985; Lucas,
1989; DeLong and Summers, 1992; and
Summers, 1991) asserts that declines in the
price of commodities and in the real wage of
workers specialized to a particular industry
can be made with less friction in a world
with moderate inflation than in a world of
stable prices. It is argued that under moder
ate inflation, the decline in a product’s price
and in the real wage rate of workers can be
accomplished through a rise in prices and
money wages elsewhere.
The belief that inter-industry adjust
ments are smoother under a regime of mod
erate inflation rests on the view that laborers
prefer a rise in the prices of wage goods to an
absolute reduction in money wages. But
why should this be the case? W orkers expe
rience an identical decline in real wages in
both cases.
One answer depends on the existence of
a money illusion: A decline in real wages
brought about by a rise in the prices of wage
goods is incorrectly perceived as smaller
than the same decline in the real wage that
occurs through a reduction in money wages.
The persistence of money illusion in a steady
state of anticipated moderate inflation is dif
ficult to rationalize. Moreover, recent evi-
NK OF ST. L OU I S
31
3 After o survey of theoretical mod
els, Blanchard and Fischer (1 9 8 9 )
conclude: "Calculations suggest,
however, that the effects of
changes in the inflation rote on cap
ital accumulah'on in models of the
type developed in this chapter are
very small. If inflation has system
atic effects on copital accumulation
(and there is empirically a negative
association), it is probobly for rea
sons not included so for. One likely
reason is that the tax system is not
neutral with respect to inflation."
REVIEW
dence (McLaughlin, 1994; and Lebow,
Stockton and Wascher, 1993) suggests there
is no dearth of nominal wage cuts, even dur
ing periods of moderate inflation.
Furthermore, firms in a declining indus
try may adjust workers’ compensation with
out cutting wages. Compensation includes
benefits and perks which can be adjusted rel
atively easily relative to wages in cases in
w hich workers have an irrational fear of
nominal wage cuts. In any event, we believe
that for the resistance to nominal wage
cuts to be widespread, it must be motivated
by considerations deeper than a pure
money illusion.
One possible rationale for such resis
tance is that workers feel they have some
control over money wages but no control
over the general price level. Consequently,
the same reduction in the real wage rate
due to reduction in money wages brings into
play factors that workers believe they can
negotiate, in contrast to an increase in
the prices of wage goods, which they are
powerless to affect.
The second possible motivation would
interact with the first. Workers may have
less knowledge of demand than do employ
ers. Consequently, when the industry
demand declines, workers may be concerned
that the employer is misrepresenting the true
state of nature to force an unnecessary
reduction in money wages. In this case, a
fall in the real wage rate due to a rise in the
prices of wage goods elsewhere avoids trig
gering a signal-extraction problem.
We have endeavored to make the best
possible case for moderate inflation as a
device for smoothing inter-industry wage
adjustments, but in doing so, we have
ignored the existence of a cushion on money
wage declines even in a regime of stable
prices. If we were to introduce technical
progress, even under price stability, the aver
age level of money wages would rise at a rate
equal to the average increase in output per
person. This provides a cushion mitigating
the need for an absolute decline in the
money wage.
Finally, we suggest the hypothesis that
workers’ resistance to nominal wage cuts is
not independent of the inflation regime in
which they live. Under stable prices, such
cuts may become more frequent and workers
will become more accustomed to and less
distrustful of money wage cuts. Accordingly,
any “lubricant” that moderate inflation may
provide to ease labor market frictions will
become increasingly unnecessary in a zeroinflation regime.
Although the claim that moderate infla
tion facilitates inter-industry wage adjust
ments cannot be definitively rejected, it does
not rest on compelling theoretical or empiri
cal foundations. In any event, monetary pol
icy is an inappropriate and ineffective instru
ment for dealing with labor market prob
lems, such as market frictions or the sub
optimality of the natural unemployment rate.
The latter may be due to taxes on wages
which make the after-tax real wage smaller
than the before-tax marginal product of
labor. The socially optimal amount of
employment equates the disutility of labor to
the before-tax real wage so that after-tax
employment is sub-optimal. Moreover, high
unemployment compensation increases time
spent in “search unemployment.” The drift
to higher unemployment in Europe and
Canada is unlikely to reflect a movement up
a short-run Phillips curve produced by unan
ticipated deflation, but rather is due to an
upward drift in the natural rate of unemploy
ment. In this case, appropriate policies to
reduce unemployment are reforms in taxes
and unemployment compensation, not mon
etary policy.
Moderate Inflation Enhances the
Countercyclical Efficacy of
Monetary Policy
A fourth argument for moderate steadystate inflation is that it enhances the counter
cyclical efficacy of monetary policy by
enabling the Federal Reserve to make the
real rate of interest negative. The argument
that the efficacy of monetary policy is
enhanced by a moderate rate of steady-state
inflation stems from the recognition that the
money rate can never be negative, so that in
a non-inflationary environment, in which the
real and money rates are equal, the best that
monetary policy can do is to drive both the
32
REVIEW
JULY/AUGUST
real and nominal rates of interest to zero.4
DeLong and Summers (1992) and Summers
(1991) argue that in a zero inflation
regime, monetary policy will be unable to
produce a sufficiently large reduction in the
real interest rate to restore full employ
ment in times of large adverse shocks to
aggregate demand.
Is this an important argument for mod
erate inflation? There are several reasons to
think not. First, the argument is based on
the belief that the monetary authority can
exert considerable influence over real inter
est rates through the so-called liquidity
effect, and that monetary policy works pri
marily, if not solely, through its ability to
influence the real interest rate. According to
this view, an expansionary monetary policy
drives real interest rates down, inducing an
increase in spending. But the extent and
duration of the effect of monetary policy on
short-term real interest rates is controversial,
theoretically and empirically. The exchange
between Ohanian and Stockman (1995) and
Hoover (19 9 5 ) highlights the difficulties
with theoretical models of the liquidity
effect. The empirical evidence on the liquid
ity effect is mixed. W ork by Reichenstein
(1 9 8 7 ), Thornton (1 9 8 8 ), Gordon and
Leeper (1994) and Pagan and Robertson
(19 9 5 ) suggests the liquidity effect is rela
tively weak and short-lived, although
research by Christiano and Eichenbaum
(1991, 1992), Cook and Hahn (19 8 9 ) and
Romer and Romer (1990) suggest a more
sufficiently at very low but positive interest
rates, the efficacy of monetary policy is not
impaired by a zero lower bound on the real
interest rate. Bailey’s argument suggests that
credit demand becom es very large (essential
ly infinite) at very low real interest rates, so
that the real longer-term interest rates do
not have to be negative to significantly
increase investment.
Finally, despite the empirical evidence
to the contrary, there appears to be a fairly
widespread belief that the Federal Reserve
exerts considerable influence over real short
term interest rates, but much less influence
over longer-term interest rates (see, for
example, Goodfriend, 1993; and Greenspan,
1993). If monetary policy cannot make the
long-term rate negative, it is natural to ask:
Is there any gain from the possibility that the
Federal Reserve may be able to make short
term interest rates negative for temporary
periods? In markets in which there are few
impediments to the flow of funds between
the long and short end of the market, consis
tency of expectations requires that the cur
rent long-term interest rate be equal to the
expected average of future short-term rates
plus a risk premium. The risk premium
is affected by a num ber o f things, including
uncertainty about future short-term
interest rates.
If the market believes that the policy
does not signal an increase in policymakers’
desired steady-state inflation rates, people
know that today’s policy must give rise to
reversals later. W hether the difference in the
magnitude of the decline and subsequent rise
in short-term interest rates in the zero and
moderate inflation regimes will result in sig
nificantly different paths for real long-term
interest rates under the two regimes is
impossible to determine, a priori. Indeed, it
is as easy to conjecture scenarios in which
there would be no difference in the response
of long-term real interest rates under the two
steady-state inflation regimes as it is to con
jecture scenarios in w hich there would be a
significant difference.5
Given that it is unlikely that moderate
inflation will enable the Federal Reserve to
have a significantly larger effect on long-term
real interest rates, and that very low or zero
significant effect of m onetary policy on real
short-term interest rates.
Second, it is difficult to argue that suffi
cient investment opportunities will not exist
unless the real rate is negative. The issue is
whether the economic outlook can become
sufficiently pessimistic that the expected real
return on longer-term investments is nega
tive. That DeLong and Summers (1992) and
Summers (1991) have raised it again sug
gests that this old debate is far from settled.
Bailey (1971) argues that there will always
be some investments that yield a small non
negative return, even if a depressed economy
were not expected to return to its steadystate growth path for a period of 10 to 20
years. If investment opportunities increase
1995
33
4 No one would willingly trade a dol
lar for, say, 9 5 cents a year from
now, so long as the same dollar
could be held for a year at zero
carrying cost.
5 Indeed, Fuhrer and Madigan
(1 9 9 3 ) simulate the effect of more
aggressive policies that result in
negative short-term interest rotes
and find very small changes in
long-term rates.
REVIEW
JULY/AUeUST
real interest rates are likely to be sufficient
for the Fed to offset adverse aggregate de
mand shocks, the argument that moderate
inflation enhances the efficacy of monetary
policy seems doubtful. If some role for infla
tion uncertainty is factored in, the idea that
moderate inflation enhances the efficacy of
monetary policy becomes even more tenuous.
1995
financial service industries expand relative to
other employment of resources such as
industrial output, and households sacrifice
leisure to reduce their real balances when the
inflation tax rises. These effects call into
question the notion that, by penalizing the
consumption of priced commodities, infla
tion reduces work effort and increases leisure.
Although it is difficult to quantify the
degree to which inflation impairs the ability
of the price system to signal correct informa
tion, there is no doubt that the price system
allocates resources most efficiently in the
absence of inflation.
Moreover, zero inflation is preferable to
moderate inflation because inflation, even
moderate inflation, distorts accounting, legal
contracts and the tax system. Inflation also
distorts the true cost of inventories, the
depreciation o f plant and equipment, as well
as the time profile of real mortgage pay
ments, and other fixed-dollar denominated
contracts.
O f course, this analysis assumes that
taxes and private contracts are not indexed
against inflation. Why, it may be asked,
don’t the authorities index taxes against
changes in the price level so that real pay
ments are unaffected? Why, in turn, doesn’t
the private sector index wages and finan
cial contracts to nullify the impact of
price changes?
In fact, the tax code is now partly
indexed against inflation. Indexation, how
ever, is often taken as a signal that the
authorities are giving up the battle against
inflation. This was the basis for the outspo
ken opposition to indexation by former
Federal Reserve Chairman Arthur Burns and
why the Bank of Canada has opposed index
ation. It is easy to construct examples in
which inflation-mitigating schemes, such as
indexation by reducing the marginal costs of
inflation, lead to an increase in the aggregate
inflation rate. Moreover, foregoing indexa
tion may be a help in developing a reputa
tion for credibly pursuing anti-inflation poli
cies (see, for example, Fischer and Summers,
1989). For these reasons, it is not clear that
indexation of tax codes is desirable.
In the private sector, indexation is
unlikely to occur. At the heart of the diffi-
W h y Zero Inflation Is Preferable
Although many estimate the output loss
es of moderate inflation to be modest, this
issue is far from settled. In addition to the
usual problems of measuring the permanent
output losses, Dotsey and Ireland (1993)
have shown that in a general-equilibrium
analysis, the usual effects of inflation (the
inefficient economizing on real money bal
ances, substituting market activity for
leisure, and redirecting resources from goods
production to financial activities) compound
to produce a significant output loss. Dotsey
and Ireland’s result stems in part from the
fact that inflation lowers real output growth.
Although the effects on output growth
appear small, compounded over time, they
are significant.
Another compelling reason to prefer
zero inflation is that higher inflation is asso
ciated with increased variability of both
inflation and relative prices. The increased
variability of inflation and consequent infla
tion uncertainty shorten contract lengths,
thereby increasing contract costs. The
greater variability also contaminates price
signals, so the price system conveys less
information. As the variability of inflation
(associated with higher inflation) increases,
it becomes more difficult to determine
whether a particular commodity price
change reflects a movement in the general
price level, or a real shift in supply or demand
resulting from taste and productivity shocks.
In addition, inflation and the higher
variability of the general price level cause a
reallocation of resources from the production
of goods to financial services for the sole
purpose of hedging against inflation. Even if
there is no reduction in conventional mea
sures of output, inflation produces a distor
tion o f output. The banking system and
34
r e v i e w
JULY/AUGUST
This asymmetric behavior extends to
supply shocks as well.8 Adverse shocks will
be accommodated; favorable ones will be
ignored. Although the price level depends
on many factors, including the relative inci
dence of positive and negative shocks, con
cern for transitional unemployment leads a
central bank to pursue policies that will
cause the price level to be higher than it
would be otherwise.
This asymmetric behavior creates an
inflationary bias with the potential for accel
erating inflation. As inflation increases, the
monetary authority may be forced to tolerate
transitional unemployment to bring the
inflation down. Indeed, this appears to be
what happened in the United States in the
late 1970s and on a smaller scale in the late
1980s. The best way to avoid such disrup
tions is to commit to a policy of stable prices.
culty is a coordination problem. To be suc
cessful, indexation must be implemented by
a large number of diverse firms facing different
information. For example, are price changes
due to nominal or real variables? It is wellknown that indexing money wages to changes
in prices due to real shocks is undesirable.6
Are price changes permanent or transitory?
Are the price changes industry-specific or
global? It is unlikely that individuals will
agree on the cause of a price change and
then coordinate their actions. Given these
obstacles, indexation in the private sector is
difficult and, hence, fairly rare. Moreover, in
instances in which private indexation is fair
ly widespread, as in Israel, it reduces the
resolve to fight escalating inflation.
Finally, it is impossible to fully index
real cash balances against inflation, as previ
ously discussed, because inflation leads peo
ple to hold fewer cash balances and results in
a loss of their services.7 For these reasons,
indexation is a frail reed on which to rest
hopes of mitigating inflation’s effects.
SUM M ARY AND
CONCLUSIONS
We have reviewed several arguments in
favor of moderate inflation and we find them
to be lacking theoretically and, in some
instances, empirically. The first argument,
that moderate inflation enhances economic
stability, is subject to compelling objections.
If expectations are adaptive, any decline in
the semi-elasticity of money demand associ
ated with a higher inflation may well be off
set by a more rapid revision of inflationary
expectations. If expectations are rational,
this must be the case.
The argument that inflation leads to a
higher level of output is based on theoretical
models that are not robust to small specifica
tion changes. W hen real-world institutions
are taken into account, the weight of the evi
dence is that inflation discourages capital
accumulation. W hen capital is defined to
include human capital, inflation may reduce
not only the level o f output per capita but its
rate of growth as well.
Also suspect is the proposition that
moderate inflation increases the efficacy of
monetary policy by allowing the central
bank to make the real rate of interest nega
tive. Sufficient investment opportunities are
likely to exist at very low but positive real
Price Stability as the Objective of
Monetary Policy
Reducing an established moderate infla
tion trend may disrupt econom ic activity,
producing temporary output and employ
ment losses. Given an established moderate
inflation rate, Howitt (1990, p. 104) argues
that despite the desirability of zero inflation,
the cost of achieving it probably outweighs
the benefits. This argument against moving
to price stability ignores the inflationary bias
(and resulting uncertainty) that characterizes
policy regimes motivated by concerns for
transitional output and employment losses.
In the absence of a commitment to sta
ble prices, a central bank concerned about
transitional unemployment is likely to
respond asymmetrically to shocks— tempo
rary or permanent. This asymmetric behav
ior has clear implications for the price level
in the case of demand shocks. A monetary
authority concerned with transitional unem
ployment will be less willing to offset a
demand shock that raises prices and employ
ment than to offset an adverse demand shock
that lowers prices and employment.
1995
35
6 The authorities in Israel indexed
money wages to a price index
which included imported goods. In
fact, imported goods should be
excluded since changes in import
prices reflect changes in a real vari
able, the terms of trade. Later on,
this mistake was rectified and
terms of trade effects were exclud
ed from the price index.
7 In principle, to maximize the ser
vices of real bolances, it would be
desirable to have prices fall at the
real rate of interest and set the
money rate of interest to zero.
People would then be induced to
hold the satiety quantity of real bal
ances. It would take us too far
afield, however, to discuss the mer
its of deflation at the real rote in
comparison with stable prices.
Therefore, we confine our attention
to a comparison of zero with mod
erate inflation.
8 In the case of the oil shock in the
1 9 7 0 s (an adverse supply shock
which tended to raise inflation and
reduce output), a number of econo
mists advocated a quantum
increase in the stock of money to
offset a potential increase in unem
ployment. On the other hand, how
many voices were raised in favor of
a reduction in the money stock
when OPEC collapsed?
HEVItN
interest rates. Consequently, negative real
rates are not required to make monetary pol
icy effective. Also, even if positive inflation
enabled the Fed to make real short-term
interest rates negative, such actions may not
lower long-term interest rates.
The proposition that moderate inflation
eases inter-industry wage adjustments is
weak too. One argument rests on the exis
tence of a money illusion; we see no econom
ic rationale for money illusion in the steady
state. If the asserted resistance to nominal
wage cuts is based on a deeper motivation,
we suggest that it should disappear entirely
as the regime of zero inflation persists.
Moreover, the evidence suggests that nominal
wage cuts are frequent even during periods of
moderate inflation. Hence, the conjecture
that workers resist nominal wage cuts lacks
both theoretical and empirical justification.
Finally, we argue that a policy of living
with inflation cannot be rationalized on the
grounds that there are transitory output
costs associated with reducing inflation. A
policy motivated by concern for transitional
unemployment is likely to have inflationary
bias that will erode a commitment to any
price objective.
_ _ _ _a n d_ _ _ "Identification and the Liquidity Effect of a
M onetary Policy Sho ck ," National Bureau of Economic Research
Working Paper No. 3 9 2 0 (1 9 9 1 ).
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McLaughlin, Kenneth J. "Rigid W a g e s ?Journal of Monetary
"
Economics (December 1 9 9 4 ), pp. 3 8 3 -4 1 4 .
Ohanian, Lee E., and Alan C. Stockman. "Theoretical Issues of Liquidity
Effects," this Review (M ay/June 1 9 9 5 ), pp. 3-25.
Thornton, Daniel L. "The Effect of M onetary Policy on Short-Term
Interest Rates," this Review (M ay/June 1 9 8 8 ), pp. 53-72.
Tobin, James. "Inflation and Unemployment," American Economic
The
Review (March 1 9 7 2 ), pp. 1-18.
Orphanides, Athanasios, and Robert M . Solow. "M oney, Inflation and
Growth," in Benjamin M. Friedman and Frank H. Hahn, eds.,
Handbook of Monetary Economics, vol. I. North-Holland, 19 9 0 .
_ _ _ _ _ _ _ _ _ _ _ _ _ . "M o n e y and Economic Growth,"
Econometrica
(October 1 9 6 5 ), pp. 6Z 1 -84.
Pagan, Adrian R., and John C. Robertson. "Resolving the Liquidity
Effect," this Review (M ay/June 1 9 9 5 ), pp. 33 -54.
1 9 9 5
UIS
37
KEVIN)
JULY/AUGUST
1995
David C. Wheelock is a senior economist at the Federal Reserve Bank of St. Louis. Paul W. Wilson is an associate professor of economics at the
University of Texas at Austin. Heidi L. Beyer provided research assistance.
Evaluating the
Efficiency of
Commercial
Banks: Does
O ur V ie w of
W hat Banks Do
M atter?
estimation techniques have been proposed,
each with advantages and disadvantages.
The problem is complicated by the myriad
of different services that commercial banks
perform. Researchers deal with complex
issues in measuring bank production: Is a
deposit an input to the production process,
or an output? Should outputs be measured
in terms of the number of a bank’s accounts,
the number of transactions it processes or
the dollar amounts of its loans or deposits?
Perhaps not surprisingly, estimates of com
mercial bank inefficiency vary considerably
across studies that use different techniques,
conceptions of bank production and data
samples.
This article investigates the sensitivity
of efficiency measures to broadly different
conceptions of how banks operate. We use
a single-estimation technique and a common
pool of banks to compare efficiency measures
based on alternative views of bank production.
We find substantial differences in mean
efficiency across models and low, though
statistically significant, correspondence in
the rankings of banks by efficiency scores
across models.
First, we discuss why measuring
commercial bank efficiency is useful,
some alternative measures of efficiency
and techniques for estimating efficiency.
A description of the approach we take,
our data and our results follow.
David C. W heelock and
Paul W . Wilson
n the past 15 years, the banking industry
has faced growing competition from other
financial service firms and financial mar
kets and, at the same time, has undergone
substantial deregulation and change.
Proponents of further deregulation, such as
the removal of barriers to the commingling
of commercial and investment banking,
argue that such changes would enhance the
efficiency and viability of American banks.
The impact of competitive and regulatory
changes on banks can be judged by gross
measures of performance, such as profitability
and failure rates. Econom ists are also inter
ested in how such changes affect the efficiency
with which banks transform resources into
various financial services. Inefficiency implies
that resources are wasted, that is, that firms
are producing less than the feasible level
of output from the resources employed,
or are using relatively costly combinations
of resources to produce a particular mix
of products or services. Thus, a goal of
policymakers, as well as stockholders and
managers, is to devise policies that improve
the efficiency o f commercial banks.
Unfortunately, economists do not agree
upon the appropriate methodology for mea
suring the efficiency of banks. Several
I
W H Y DO W E CARE AB O UT
THE EFFICIENCY OF
COMMERCIAL BANKS?
The performance of firms is often
described in terms o f their efficiency. The
measured efficiency of a production unit
(a firm or plant) is generically interpreted
as the difference between its observed input
and output levels and the corresponding
optimal values. An output-oriented measure
of efficiency compares observed output with
the maximum output possible for given input
levels. Alternatively, an input-oriented
39
REVIEW
JULY/AUGUST
efficiency measure compares the observed
level of inputs with the minimum input that
could produce the observed level of output.
These are measures of technical efficiency,
and as such ignore the behavioral goals
of the firm.
Measures of allocative efficiency com
pare the observed mix of inputs or outputs
with the optimal m ix that would minimize
cost, maximize profit or obtain any other
behavioral goal. Allocative efficiency can
be combined with technical efficiency to
measure overall efficiency. In addition,
measures of technical efficiency can be used
to construct measures of scale efficiency,
which involve comparison of observed and
optimal scale, or size, of the firm. One can
also measure scope efficiency, which involves
comparison of the cost of producing the
observed m ix of outputs in a single firm
with the costs that would prevail if each
output was produced in a separate firm.
Researchers have found that banks suffer
more from technical inefficiency than from
scale or scope inefficiency (for example,
Berger and Humphrey, 1991).
The efficiency of commercial banks is
important for at least two reasons. First,
efficiency measures are indicators of success,
by which the performance of individual banks,
and the industry as a whole, can be gauged.
Banks face growing competition, both from
other banks and from firms and markets out
side the industry (see W heelock, 1993), and
presumably banks will be more successful in
maintaining their business if they operate
efficiently. Berger and Humphrey (1992)
find that during the 1980s high-cost banks
experienced higher rates of failure than more
efficient banks. Similarly, in a study of bank
failures during the 1920s, W heelock and
W ilson (1995) find that the less technically
efficient a bank was, the greater its likeli
hood of failure.
A second reason to investigate the effi
ciency of commercial banks is the potential
impact of government policies on efficiency.
One might gauge the impact of a regulatory
change by measuring its effect on commer
cial bank efficiency, or examine efficiency
among banks in different states to measure
the effect of differences in branching restric
1995
tions or other regulations. Recent proposals
to end the Glass-Steagall separation of com
mercial and investment banking stem in
part from a view that broader powers could
enhance the efficiency of banks and other
financial institutions. Obviously, this change
could enhance the scope efficiency of banks
if there are complementarities in the produc
tion of commercial and investment banking
services. Conceivably, such change could
also improve scale or overall efficiency.
Improved efficiency is also one argument
made in support of interstate branching and,
indeed, Grabowski, Rangan and Rezvanian
(1 9 9 3 ) find that branch banking organiza
tions are more efficient than multiple-office
bank holding companies.
Other studies have considered whether
bank mergers enhance efficiency. Using dif
ferent approaches, Rhodes (1 9 9 3 ) finds that
mergers have not generally improved effi
ciency, though Fixler and Zieschang (1993)
conclude the opposite. Shaffer (1 9 9 3 ), on
the other hand, evaluates potential mergers
and concludes that they could significantly
reduce inefficiency for many banks of less
than $10 billion of assets.
The im pact of ownership or manage
ment structure on efficiency has also been
studied. Pi and Timme (1 9 9 3 ), for example,
find that banks whose chief executive officer
also serves as board chairman are less effi
cient than other banks, and Mester (1993)
shows that mutual savings and loan associa
tions are more efficient than stock S&Ls.
MEASURING COMMERCIAL
BANK EFFICIENCY
The efficiency of commercial banks has
been studied using a variety of techniques
and samples, and, as noted above, has been
used to address numerous policy issues.
Recent studies typically use techniques that
accommodate the multiple outputs of banks
and measure the efficiency of individual banks
relative to a standard set by peer institutions.
Readers interested in a survey of this research
can refer to Berger, Hunter and Timme (1993).
To date, no technique for measuring
efficiency has been generally accepted and
different methodologies appear to generate
40
JULY/AUGUST
considerable differences in measured effi
ciency, even when common bank samples
are used. Variants of four techniques are
common in the literature. The “stochastic
cost frontier” approach is an econometric
methodology in which deviations of a firm’s
actual cost from predicted cost are presumed
to be due to random error and inefficiency,
each of which is assumed to have a particular
statistical distribution (usually the normal
distribution for the random error and a half
normal for inefficiency). The “thick frontier”
approach is a variant in which deviations
from predicted cost within the lowest average
cost quartile of banks are assumed due to
random error, and the differences between
the predicted costs of banks in the highest
and lowest quartiles are assumed to be due
to inefficiency. The “distribution-free”
approach is applicable when data for more
than one year are available. It assumes that
inefficiency is stable over time, while random
errors average out over time. That is, a bank’s
inefficiency for a span of years is taken to be
the mean of its measured inefficiency across
all years within the period. Finally, “Data
Envelopment Analysis” (DEA) is a non-parametric methodology in which linear pro
gramming is used to measure the distance
of individual banks from the efficient, or
“best-practice,” frontier. All deviations
from the efficient frontier are assumed
to be due to inefficiency.
Researchers have found that estimates
of inefficiency are sensitive to the choice of
technique. Ferrier and Lovell (1990), for
example, apply the stochastic cost frontier
and DEA techniques to a common sample
of banks and arrive at different estimates of
inefficiency. Berger (19 9 3 ) finds substantial
differences in measured efficiency from two
variants of the distribution-free approach.
A second reason why different studies
of commercial bank efficiency often reach
seemingly contradictory findings might
stem from differences in how a banking
firm is modeled. Regardless of which of
the four measurement techniques is used,
the researcher must specify a list of inputs
and outputs. The question, “W hat do banks
produce?” is not simple to answer. Banks
provide a variety of services, from loans
1995
and deposit accounts to trust services, safe
deposit box rentals, mutual fund sales and
foreign exchange transactions. Moreover,
changes in regulation, technology and cus
tomer demands have caused the types of
services that banks perform to change over
time. For example, banks now provide a
variety of securities-related services, such
as underwriting and mutual fund sales,
which regulators forbid a few years ago. To
tractably measure efficiency, researchers are
forced to begin with simplified models of
the banking firm. Unreliable estimates of
efficiency can stem from the use of models
that omit key features of bank production.
Some researchers view banks as producers
of loans and deposit accounts, and measure
output by either the number of transactions
or accounts serviced. This view is referred to
as the “production” approach. Others argue
that a bank’s output should be measured in
terms of the dollar volume of loans or deposits
it provides, a view known as the “intermedi
ation” approach. Most studies of inefficiency
use the intermediation approach, in part
because the necessary data are more readily
obtained. We are aware of only one recent
study taking the production approach (Ferrier
and Lovell, 1990), though in the 1970s and
early 1980s such studies were more common
(see Gilbert, 1984). The production approach
focuses on operating costs and ignores interest
expense. The intermediation approach, on
the other hand, includes both operating and
interest expenses, and hence may be of more
interest for studying the viability of banks
(see Berger, Hanweck and Humphrey, 1987;
or Ferrier and Lovell, 1990). For analysis of
the operating efficiency of banks, however,
the production approach may be of interest.
Among those who use the intermedia
tion approach are researchers who hold the
view that banks produce various loans and
other investments from deposits, other fund
ing sources, labor and materials. This “asset”
approach has been criticized because it
ignores the fact that banks expend consider
able resources supplying transactions and
savings deposits (Berger and Humphrey, 1992).
Some researchers apply empirical criteria
to determine what services to consider as bank
outputs and what to consider as inputs.
F E DE RA L RESERVE B A N K OF ST . L OU I S
REVIEW
JULY/AUGUST
Berger and Humphrey (1 9 9 2 ), for example,
classify activities for which banks create high
added value, such as loans, demand deposits
and time and savings deposits as important
outputs, with labor, physical capital and pur
chased funds classified as inputs. Alternatively,
Aly, Grabowski, Pasurka and Rangan (1 9 9 0 ),
Hancock (1991) and Fixler and Zieschang
(1993) adopt a “user-cost” framework, whereby
a bank asset is classified as an output if the
financial return on the asset exceeds the
opportunity cost of the investment, and a lia
bility is classified as an output if the financial
cost of the liability is less than its opportunity
cost. Even though their details differ, the two
approaches empirically tend to suggest simi
lar classifications of inputs and outputs. The
main exception is classification of demand
deposits as an output in most user-cost stud
ies, and as both an input and an output when
the value-added approach is used (see Berger
and Humphrey, 1992, for more detail).
Table 1 summarizes six recent studies of
commercial bank production efficiency.
Although representative, this list is far from
exhaustive. These studies employ a variety
of estimation techniques and include a variety
of different inputs and outputs in modeling
the banking firm. The studies typically report
inefficiency measures by bank-size grouping
and for more than one type of inefficiency,
though for brevity we report ju st the mean
overall inefficiency. The reported percent
ages indicate the extent to which the average
bank overused inputs to produce a given
level of output. Thus, the 35 percent ineffi
ciency found by Aly and others (1 9 9 0 ) indi
cates that the average bank could have pro
duced the same level of output with ju st
65 percent of the input levels actually used.
Measured inefficiency clearly varies with
estimation technique, model specification
and, probably, the sample of banks used by
the researcher.
In the remainder of this article, we
investigate the extent to which measures
of efficiency and the rankings of individual
banks depend on whether the intermediation
approach or production approach is employed.
Because we are interested in the impact of
the approach taken on measured efficiency,
we use a single technique— DEA— applied
1995
to a common pool of banks. Our findings
might, of course, be different if we used another
technique or sample, but the purpose of this
article is to investigate how sensitive efficiency
measures are to the model of bank production
employed.
M ETHO D OLO G Y
We trace our measures of efficiency to
the work of Debreu (1951) and Farrell (1957).
Boles (1966) was one of the first to use linear
programming methods to measure efficiency
in production using their ideas. Other exten
sions have collectively come to be named
Data Envelopment Analysis (DEA), a term
coined by Chames, Cooper and Rhodes (1978).
Lovell (1 993) summarizes this literature.
Details about the efficiency measures
used in this article are contained in the shad
ed insert on page 6 . The essential ideas,
however, are illustrated in Figure 1, which
considers the case of a sample of firms pro
ducing a single output from two inputs, x l
and x 2. Suppose firms A, B and C each pro
duce a given level of output; A and B lie on
the production frontier XX ', while C lies in
the interior of the production set. The fron
tier XX' is the set of all combinations of
inputs which can produce the same level of
output, and where the reduction of at least
one input necessarily causes output to fall.
Hence, firms A and B are regarded as effi
cient, whereas firm C is regarded as ineffi
cient. Inefficient firms such as C may lie in
the interior of the production set due to
imperfect information, managerial incompe
tence or perhaps other reasons. For firm C,
input weak technical efficiency (iW E) is
defined as the ratio of distances OC'/OC in
Figure 1. By reducing the input quantities
used by firm C by this amount, the firm
could move to point C' and would be consid
ered efficient in the IW E sense.
Next, we define input overall efficiency
(IO E). In terms of Figure 1, the isocost line
is given by PP'. For firm C, the IOE score is
given by the ratio of distances OC"/OC.
Although the point C " lies outside the pro
duction set boundary, and hence is not feasi
ble, input costs at C " are the same as at B,
which is a feasible point. Hence, if firm C
F E D E R A L RESERVE B A N K OF ST. L OU I S
42
REVIEW
JULY/AUGUST
1995
T a b le 1
Selected Studies of Com m ercial B a n k Production Inefficiency
Study, Technique, Approach
Inputs
Outputs
Sample
Aly and others (1990);
DEA;
intermediation
labor, physical capital,
loanable fu nd s1
real estate loans, com random , 3 2 2
m ercial loans, consum er banks, 1 9 8 6 data
loans, all other loans,
d em and deposits
overall
inefficiency: 3 5 %
Berger and Humphrey
(1991);
thick frontier;
intermediation
labor, physical capital,
purchased fu nd s7
d em a nd deposits,
all banks, 1 9 8 4
retail time and sa vin gs data
deposits, real estate
loans, com mercial loans,
installm ent loans
total inefficiency3:
2 4 % (branching
states), 1 9 % (unit
b a n kin g states)
Elyasiani and Mehdian
(1990);
DEA
intermediation
labor, physical capital,
d em a nd deposits,
tim e and savings
deposits
securities held, real
191 b a n k s with
estate loans, commercial assets over S 3 0 0
loans, all other loans
million, 1 9 8 0
data
technical
inefficiency: 1 0 %
Ferrier and Lovell
(1990)
DEA and stochastic cost
frontier;
production
labor, occupancy
costs, expenditure
on material
5 7 5 banks, 1 9 8 4
num ber of: dem and
data
deposit accounts, time
and sa v in g s deposit
accounts, real estate
loans, installm ent loans,
com mercial loans
overall
inefficiency: 2 1 %
(DEA), 2 6 %
(stochastic cost
frontier)
Hunter and Timme
(1995)
distribution free;
intermediation
labor, physical
capital/ purchased
funds, transactions
accounts/ non-transactions accounts
under S I 0 0 ,0 0 0 4
com mercial and security
loans, consum er loans,
all other loans, n on
interest income
overall inefficiency:
3 0 - 5 4 % (depend
in g on m odel); 2 3 3 6 % (om itting 1%
extrem e values)
Kaparakis and others
(1994);
stochastic cost frontier;
intermediation
labor, physical capital,
interest bearing
deposits under
$ 1 0 0 ,0 0 0 , non-interest bearing deposits/
purchased funds
loans to individuals, real 5 ,5 4 8 b a n k s with
estate loans, commercial assets over S 5 0
loans, other5
million, 1 9 8 6
data
3 1 7 b a n ks with
assets over $1 bil
lion, 1 9 8 5 -9 0
data
Results
overall
inefficiency: 1 0 %
1 time and savings deposits, notes and debentures and other borrowed funds.
2 federal funds purchased, time deposits over 51 0 0 ,0 0 0 , foreign deposits and other borrowed funds.
3 includes inefficiencies due to excessive deposit interest paid and purchased fund interest paid.
1 input treated as "quasi-fixed ," that is, not variable in the short run.
5 fed funds sold, securities held, securities and other assets in trading accounts.
were to become efficient in the IOE sense,
its input mix would have to be altered; the
IOE score, however, can be obtained by
considering the hypothetical proportionate
reductions of inputs represented by
point C".
In terms of Figure 1, allocative efficiency
for firm C is given by the ratio of distances
OC'VOC'. Allocative inefficiency arises from
using a combination of inputs that does not
minimize total cost, as opposed to technical
inefficiency, which is a proportionate overuse
of all inputs.
Finally, we can determine scale efficiency
by comparing IW E computed under the
assumption that the firm is operating at
constant returns-to-scale with IW E obtained
previously. A score of unity implies that
the firm is operating under constant returns.
W hile a score other than 1 does not translate
43
REVIEW
JULY/AUGUST
1995
A MATHEMATICAL DESCRIPTION OF EFFICIENCY
MEASUREMENT
We use measures of efficiency discussed
by Fare, Grosskopf and Lovell (1 9 8 5 ).
First, we compute the input weak technical
efficiency (IW E) score for the ith firm in a
sample by solving the linear programming
problem:
where X, Y, x, and y, are defined as in
equation 1, p( is a (1 X m) vector of input
prices, and x * is an (m X 1) vector of effi
cient inputs to be computed. The IOE
score may be defined as
(3)
min Wj
subject to
(1)
X qi < W ix i
Oi = p ix ; / p ix i.
The constraints in equation 2 are
similar to those in 1. The same reference
technology is defined by the constraints in
2 , but instead of proportionately reducing
inputs until the ith firm lies on the refer
ence technology inputs are further reduced
proportionately until the firm lies on the
isocost plane tangent to the production
set boundary.
An allocative efficiency score, Af, may
be defined by dividing the IOE score by
the IW E score:
Yq i > y t
Iq, = i
q,e9l?,
where n firms produce s outputs using m
inputs, q t is a (N X 1) vector of weights to
be computed for the ith firm, 0 < W, £ 1 is
a scalar, X; is a (m X 1) vector of inputs for
the feth firm, y { is a (s X 1) vector of out
puts for the fcth firm, X = [x, ,...,x-V
]
is a (m X N) matrix of observed inputs,
Y = [y!,...,yN is a (s X N) matrix of observed
]
outputs and I is a ( 1 X N) vector of ones.
The minimand V , in equation 1 mea
V
sures the input weak efficiency of the ith
firm. The inequality constraints in equa
tion 1 define a reference technology with
strong disposability of inputs; constraining
the weights in q to sum to unity allows the
reference technology to exhibit variable
returns to scale. For the ith firm, W,
gives the proportion by which inputs
can be reduced to move the firm from
the interior of the production set onto
the piecewise-linear boundary of the
production set corresponding to the
reference technology in 1.
Next, we compute input overall effi
ciency (IOE) score O, for the ith firm by
first solving the linear program:
(4)
Ai = O i / W t.
The efficiency scores obtained from 1
measure technical efficiency as the dis
tance to the relevant isoquant, but do not
consider where the firm is situated along
the variable-returns production frontier.
To measure scale efficiency, equation 1
must be recomputed for each firm, first
assuming constant returns to scale by
removing the restriction C qt = 1, and then
assuming non-increasing returns-to-scale
by imposing the restriction Cq, < 1 . In
the case of IW E, this produces efficiency
scores W ™5 and W.V S, respectively, for
,R
the ith firm. The scale efficiency score
corresponding to 1 is then defined as
(5)
min ptx'
S, as W,C 5/W,.
R
X*
subject to
Clearly, 0 < S( ^ 1 since WtC S£ WiN S < W,.
R
K
If Sj= 1, then the ith firm is scale-efficient,
that is, the firm is operating at the point of
constant returns on the production frontier.
If Sj < 1, then the firm is scale-inefficient due
to either decreasing returns if W;M
RS=W,, or
increasing returns if WiN S< W,.
K
Xq t < x ‘
Yqi > y i
(2)
lq,=l
qt e X
x; e X
FEDERA L RESERVE B A N K OF ST. L OU I S
44
REVIEW
Y/AUGUST
easily into a specific percentage deviation
from constant returns, the scores are useful
for ranking firms by the extent of their
inefficiency.
Each of the efficiency scores described
above measures efficiency in an input orien
tation; efficiency is measured by holding
output fixed and determining the maximum
feasible reduction in inputs. Efficiency can
also be measured by holding inputs fixed
and determining the maximum feasible
expansion of outputs. Since the efficiency
measures we use do not imply underlying
assumptions regarding the behavior of firms,
the choice between input and output orien
tations is somewhat arbitrary; one might
compute both types of efficiency measures
to get more information than can be obtained
from either the input or output orientations
alone. Note that both IWE and IOE are radial
measures of efficiency, that is, in each case
efficiency is measured along a ray emanating
from the origin and passing through the
firm in input-output space. Consequently,
the efficiency scores are independent of the
units of measurement used for both inputs
and outputs, which is advantageous since
units of measurement may always be defined
arbitrarily. Fare and others (1985) observe
that some DEA formulations do not share
this property.
F ig u r e 1
M e a s u rin g Technical,
A llo c a tiv e a n d
O v e ra ll Efficiency
age total assets at the end of 1993 for FCA
program banks was $1 6 3 .6 million, with a
range from $8 .0 million to $ 2 ,6 0 2 .8 million,
average total assets were $ 3 0 0 .7 million,
with a range from $1.0 m illion to $1 0 8 ,2 2 3 .0
million, for all U.S. commercial banks (as
reported in the Federal Deposit Insurance
Corporation Reports of Condition, that is, the
“Call Reports”). The average return on assets
of 1.15 percent for the banks in our sample,
however, was approximately the same as the
average for all banks ( 1.12 percent).
Nevertheless, because our sample of banks is
not random, the efficiency measures calculat
ed here should not be interpreted as reflecting
the efficiency of commercial banks in general.
For the production approach to modeling
bank activities, we construct variables using
definitions from Ferrier and Lovell (1 9 9 0 ):
EMPIRICAL
IMPLEMENTATION
For our empirical analysis of commercial
bank efficiency, we use a sample of banks
participating in the Federal Reserve System’s
Functional Cost Analysis (FCA) program for
1993. Participants in this program supply
information about their operations and costs
which are not generally available for banks,
and which are necessary to measure efficien
cy using the production approach. After
eliminating observations with missing values
and observations for depository institutions
other than commercial banks, data for 269
banks remain.
Because participation in the FCA pro
gram is voluntary, the banks in our sample
may not be representative of the industry
as a whole. For example, whereas the aver
1995
Outputs:
y l = number
y 2 = number
y 3 = number
y4 = number
y 5 = number
of demand deposit accounts
of time deposit accounts
of real estate loans
of installment loans
of commercial loans
Inputs:
X! = number of employees
x2 = occupancy costs and expenditure on
furniture and equipment
x3 = expenditure on materials
F EDERAL RESERVE B A N K OF ST. L OU I S
45
AUGUST
1995
T a b le 2
D escrip tive Statistics
Variable
Mean
Standard Deviation
Minimum
Maximum
y
,
7 9 0 2 .9 1
1 3 0 9 1 .7 6
4 6 9 .0 0
1 7 3 3 6 2 .0 0
Yl
7 6 1 8 .4 3
1 0 6 8 0 .6 4
4 1 3 .0 0
1 0 6 8 2 1 .0 0
Yi
9 9 8 .2 3
1 5 0 3 .9 9
0.00
1 3 4 5 6 .0 0
Y
*
3 1 3 4 .0 1
6 9 1 8 .6 3
4 4 .0 0
87 79 4.00
8 9 9 .6 3
1 7 4 4 .3 7
0.00
2 3 9 9 8 .0 0
4 0 7 6 4 3 1 6 .6 0
6 0 0 2 0 7 0 0 .0 9
1 3 8 7 9 6 3 .0 0
65 35 190 00.0 0
Y
9 9 2 7 2 7 7 5 .8 9
1 4 4 1 4 1 8 9 0 .7 9
5 1 0 3 0 0 0 .0 0
1 6 1 6 6 9 1 0 0 0 .0 0
Y
4 2 0 3 8 3 3 1 .6 1
5 4 5 1 2 3 7 6 .3 8
0.00
37 74 4 9 0 0 0 .0 0
y
1 6 2 5 4 8 3 2 .7 7
4 3 8 3 8 0 4 2 .2 4
1 2 7 8 9 0 .0 0
6 1 7 1 3 6 0 0 0 .0 0
Y
s
2 8 5 5 3 7 7 5 .5 2
6 4 1 9 7 1 9 4 .1 7
0.00
8 9 5 4 7 1 0 0 0 .0 0
*1
88.02
1 4 4 .0 9
3.8 9
1 7 3 0 .0 7
x,
7 7 63 04.50
1 2 6 0 9 2 0 .3 7
7 9 0 .0 0
1 3 0 9 0 8 3 4 .0 0
h
3 3 0 1 0 6 .6 1
5 7 69 12.53
1 1 8 5 9 .0 0
6 9 4 8 5 5 2 .0 0
»i
30 82 7.13
5 9 0 5 .6 5
1 9 2 2 2 .3 8
6 7 83 2.63
Ys
Y\
0 .0 0 5 4
0.0001
0 .0 270
0 .0 0 2 3
*2
0 .0 0 2 5
0 .0 0 0 7
0.0010
0 .0 0 5 7
30 82 7.13
5 9 0 5 .6 5
1 9 2 2 2 .3 8
67 83 2.63
rz
5 2 .0 6
4 8 .4 3
0 .7 5
7 1 5 .1 7
r,
21.88
1 1 .69
2 .3 6
1 3 1 .8 6
1 7 0 4 5 .2 0
3 7 1 4 0 .7 1
1 6 6 .0 0
4 3 1 2 2 7 .0 0
5 4 4 1 7 .5 3
9 6 1 4 4 .1 6
2 1 3 .0 0
1 2 7 9 9 6 2 .0 0
1 6 7 5 5 .4 0
2 9 2 8 2 .6 0
9 3 .0 0
2 7 0 4 8 0 .0 0
5 9 8 0 .0 3
1 2 0 4 8 .5 1
100.00
1 3 7 3 0 0 .0 0
1 1 0 4 9 0 .9 8
1 5 8 7 6 5 .4 7
5 1 3 8 .0 0
1 8 9 4 4 7 7 .0 0
4 1 0 2 4 9 .0 0
w
;
1 8 3 2 3 .8 6
43 31 2.12
200.00
"3
89.32
150.08
4 .0 0
1 8 5 6 .0 0
«
4
3008.39
5 2 5 2 .8 5
1 3 .0 0
4 7 5 1 1 .0 0
0 .0 3 4 7
P2
0 .0 0 4 8
0 .0 143
0 .0 3 9 2
P
i
0.0110
0 .0 0 6 6
0 .0 4 8 9
0.1000
P3
31.11
6 .1 8
2 0 .3 8
77.91
P4
0 .3 4
0.31
0 .0 8
2 .8 3
Input prices:
Outputs:
V! = loans to individuals for
household, family, and other
personal expenses
v2 = real estate loans
v3 = commercial and industrial loans
v4 = federal funds sold, securities
purchased under agreements
to resell, plus total securities held
in trading accounts
Wi = total expenditure on salaries and
fringe benefits/Xj
w2 = x 2/level of deposits
w , = x 3/level of deposits
For the intermediation approach to
bank production, we construct variables
using definitions from Kaparakis, Miller
and Noulas (1994):
F E D E R A L RE S E RV E B A i : K OF ST. L O U I S
46
REVIEW
JULY/AUGUST
RESULTS OF EFFICIENCY
MEASUREMENT
Inputs:
uj = interest-bearing deposits except
certificates of deposit greater than
$ 100,000
u2 = purchased funds (certificates of
deposit greater than $ 100,0 0 0 ,
federal funds purchased, and
securities sold plus demand notes)
and other borrowed money
u3 = number of employees
u4 = premises and fixed assets
We compute the various efficiency mea
sures for the five models summarized below:
Model
Inputs
Outputs
Input
Prices
1
x ,-x 3
Y\-Ys
w-w,
2
X i-X j
y~Ys
w\-
3
x ,-x 3
Y’
-Ys
HV - w 2
4
x ,-x 3
Y'-Yi
w\- Wi
5
Input prices:
p 1 = average interest cost per dollar of
p 2 = average interest cost per dollar of u2
p3 = average annual wage per employee
p4 = average cost of premises and
fixed assets.
u-1/4
A -ft
Models 1 and 2 correspond to the Ferrier
and Lovell (1 9 9 0 ) specification, with alterna
tive price definitions. Models 3 and 4 provide
a bridge to the intermediation approach by
replacing the number of accounts and loans
in the output variables with dollar amounts.
Model 5 is the Kaparakis and others (1994)
specification.
Table 3 presents the mean scores for
each type of efficiency described in the
preceding section. Note that since the same
inputs and outputs are used in models 1
and 2, and models 3 and 4, the technical and
scale efficiency scores are the same for these
models. For each efficiency measure, Table 3
also shows the standard deviation of the scores
across the 269 banks in the sample, the
number of banks having an efficiency score
of unity (labeled “Number Efficient”), that
is, the number of banks operating on the
efficient frontier, as well as 90 and 95 percent
confidence intervals for the mean. Given
the large number of banks with efficiency
scores of unity, particularly in the case of
technical efficiency, and since all of the effi
ciency scores are defined to lie between
zero and 1, the underlying distributions of
the individual efficiency scores are clearly
non-normal. Results from Atkinson and
W ilson (1 9 9 5 ), however, suggest that our
sample size of 269 is easily large enough for
us to rely on the asymptotic normality of the
sample means implied by the central limit
theorem, and thus to compute confidence
intervals based on a normal distribution.
In several cases, the confidence intervals
for the means reported in Table 3 overlap.
In addition, Kaparakis and others
also define quasi-fixed input, non-interest
bearing deposits, for which there is no corre
sponding price. Other studies adopting the
intermediation approach have ignored this
item, as we do in the results reported below.
Including non-interest bearing deposits as
a fifth input when measuring technical or
scale efficiency seems to have little effect
on the results.
To form a specification midway between
the production approach represented by the
Ferrier and Lovell (1990) specification and
the intermediation approach represented by
the Kaparakis and others (1994) specifica
tion, we define y'v ...,y'5 as the dollar amount
of each account or loan corresponding to
y x,...,y5, respectively. Because outputs are
now measured in dollar amounts, this model
is best classified as representing the interm e
diation approach, even though the choice
of variables is based on Ferrier and Lovell
(1 990). In addition, we define an alternative
price system, Wj, w2, w', for the Ferrier and
Lovell specification, where
= w1; and
w and W are computed similarly to w2
'2
3
and w3 except that level of deposits is replaced
by the num ber of time and demand deposits.
This seems to us to make the mapping of
inputs and outputs under the production
approach more consistent. We report sum
mary statistics for each of the variables
in Table 2.
1 9 9 5
F EDERAL RESERVE B A N K OF ST. L OU I S
47
REVIEW
JULY/AUGUST
1995
T a b le 3
Efficiency Scores ( 2 6 9 o b se rva tio n s)
M odel
M e a n Stan d ard
E rro r
Technical e ffic ie n c y ( W k):
Num ber
E ffic ie n t
9 0 % C o n fid e n c e
In t e r v a l
9 5 % C o n fid e n c e
In t e r v a l
1,2
0.6348
0.0141
42
0.6115
0.6581
0.6071
3,4
0.7675
0.0103
52
0.7505
0.7846
0.7472
0.0107
75
0.7911
5
0.8088
0.8265
0.7877
0.6626
0.7879
0.8299
S c a le e ffic ie n c y ( S k):
1,2
0.8833
0.0067
32
0.8723
3,4
0.9452
0.0047
49
0.9374
5
0.9414
0.8943
0.9530
0.8701
0.8964
0.9359
0.9545
0.9527
7 0.9319
0.9509
0.9301
0.7562
0.7833
0.7536
0.4814
0.5170
0.4780
0.5204
7 0.7812
0.0057
0.8036
0.7790
0.8057
A llo c a t iv e e ffic ie n c y ( A k):
1
0.7698
0.0082
7
4
2
0.4992
0.0108
3
0.7924
0.0068
4
0.6340
0.7838
7 0.6162
0.0108
5
0.0080
13
0.7706
0.6518
0.7970
0.6128
0.7680
0.7860
0.6552
0.7996
O v e r a ll e ffic ie n c y ( 0 k):
1
0.4835
0.3356
7 0.4644
0.0116
4
0.5026
0.4607
0.5063
0.3607
0.3146
0.3567
0.3105
3
0.6053
0.0095
7 0.5897
0.6209
0.5867
4
0.4928
0.0121
7 0.4727
0.5128
0.4689
0.6144
0.6496
0.6110
2
5
0.6320
0.0128
0.0107
13
We test for significant differences among
the means of each efficiency measure across
different models. At the 0.05 significance
level, we are unable to reject the null hypoth
esis of equivalent means in the following
cases: (1) scale efficiency for models 3, 4
and 5; (2) allocative efficiency for models 1
and 5, and models 3 and 5 (we do reject the
null hypothesis when comparing allocative
efficiency among models 1 and 3 ); and (3)
overall efficiency for models 1 and 4. In all
other instances, we reject the null hypothesis
of no difference. Even the seemingly
innocuous modification of redefining the
input prices between models 1 and 2 , and
between 3 and 4 has a large effect on mean
allocative and overall efficiency. Note also
that for the m ost extreme comparison,
models 1 (the production view) and 5
0.6239
0.5166
0.6529
(the intermediation view), we reject the null
hypothesis of equal levels of technical and
overall efficiency. This suggests that, at least
for this sample of banks, average efficiency
does depend on the view of bank production
assumed by the researcher. We find that
average technical and overall efficiency is
higher under the intermediation approach
(model 5) than under the production
approach (model 1). Our finding for overall
inefficiency of 37 percent using model 5 is
similar to what Aly and others (1 9 9 0 ) found
for their sample, though substantially greater
than what Kaparakis and others (1994)
found for theirs (see Table 1).
It is possible to determine whether a
particular bank lies on the increasing (IRS),
constant (CRS) or decreasing (DRS) returns
portion of the technology. Table 4 shows
48
R E V I E W
JULY/AUGUST
the results of this analysis, considering only
banks that were found to be technically effi
cient.1 Thus, for example, 16 banks, or 38.1
percent of all technically efficient banks,
operated on the constant-returns portion of
the technology under models 1 and 2 .
We test the null hypothesis of no associ
ation among the rows and columns of the
matrix represented by Table 4 using Pearson’s
chi-square test, the likelihood ratio chi-square
statistic, and Fisher’s exact test.2 For the
entire matrix, all three tests reject the null
hypothesis of no differences in the propor
tions in each row and column. However,
when we perform pairwise tests by deleting
individual rows from Table 4, we fail to
reject the null hypothesis of no difference
for models 3, 4 and 5, and for models 1, 2
and 3, 4. Each of the three tests fail to
reject at the 90 percent level.
In the case of models 1, 2 and 5, we
reject the null hypothesis of no difference
in the proportions at greater than 99 percent.
Thus, while we find evidence of similarity
in terms of returns-to-scale when comparing
models 3, 4 with either models 1, 2 or 5,
models 1, 2 and 5 appear different in terms
of returns-to-scale. More banks appear to be
operating under constant returns-to-scale
when the intermediation approach is taken
(model 5) than when the production approach
is used (model 1). Since returns-to-scale
at a given location on the production frontier
depend upon the shape of the variablereturns technology, these results indicate
that the technology implicitly estimated
by models 3, 4 is similar to the technologies
implied by models 1, 2 and 5, which in turn
are significantly different. This is consistent
with our view of models 3, 4 as a bridge
between the production approach represent
ed by models 1, 2 and the intermediation
approach represented by model 5. The
result also suggests that differences between
the two approaches might be due not only to
use of number of accounts and loans versus
dollar amounts, but also to the treatment of
time deposits as an output or an input.
In addition to comparing mean efficiency
scores, we use the W ilcoxon matched-pairs
signed-ranks test, a sign test for equality of
medians and Kendall’s T-statistic to further
1995
T a b le 4
Returns to Scale
Model
1,2
CRS
DRS
16
24
(3 8 .1 % )
3,4
(4 .8 % )
20
(5 9 .6 % )
1
(3 8 .5 % )
48
(6 4 .0 % )
2
(5 7 .1 % )
31
5
IRS
(1 .9 % )
21
(2 8 .0 % )
6
(8 .0 % )
examine the similarity of efficiency scores
across the five models. We report the results
of these tests in Table 5 .3
The W ilcoxon matched-pairs signedranks test analyzes the equality of distribu
tions without making assumptions regarding
the form the distributions might take. The
values shown in parentheses in the second
column of Table 5 give the two-tailed normal
probabilities associated with the test statistic.
Hence, we fail to reject the null hypothesis
of identical distributions when comparing
scale efficiency scores from models 3, 4 and
5, when comparing allocative efficiency
scores from models 1 and 5, and from mod
els 3 and 5, and when comparing overall effi
ciency scores from models 1 and 4. In all
other cases, we reject the null hypothesis.
It appears that, for the most part, the distrib
utions of the various efficiency scores do
vary across models.
The sign test for equivalence of medians
yields a two-tailed binomial probability, which
we also report in Table 5. In only two instances
do we not reject the null hypothesis of equal
medians: when comparing scale efficiency
scores from models 3, 4 and 5, and when
comparing allocative efficiency scores from
models 3 and 5. These results are consistent
with our finding that, in most cases, average
efficiency varies across models.
Finally, rather than comparing the
distributions of efficiency scores from different
models, we use the scores to rank banks in
terms of their estimated efficiency Kendall’s
X-statistic measures the correlation among
the ranks of banks from two models and
provides a statistical test of the null hypothe
sis of no association between two sets of
F EDERAL RESERVE B A N K OF ST. L OU I S
49
1 Since we ate using an input
orientation, we could also examine
whether inefficient banks would
lie on the increasing-, constantor decreasing-returns portion of
the technology if inputs were pro
portionately contracted to move
the bank to the frontier. However,
since the path a bank might actually
toke to reoch the frontier if the
sources of inefficiency were
removed depends upon behavioral
goals, we ignore technically ineffi
cient banks here.
1 Details on these computations moy
be found in the Stala Reference
Manual: Release 3 .1, Stato
Corporation (199 3 ).
3 See Snedecor ond Cochran (1 9 8 9 )
and Kendall and Gibbons (1 9 9 0 )
for o discussion of these tests.
Computational details are given
in the Stata Reference Manual:
Release 3.1, Stata Corporation
(19 9 3 ).
REVIEW
JULY/AUGUST
1995
T a b le 5
T a b le 5 (c o n t.)
Statistical C om parison of
Efficiency Scores
Statistical C om parison of
Efficiency Scores
(p ro b a b ility v a lu e s in parentheses)
(p ro b a b ility va lu e s in parentheses)
M odel
W i lc o x o n
S ig n e d - R a n k s
S ig n T e st
K e n d a ll's r
W i lc o x o n
S ig n e d - R a n k s
M odel
S ig n T e st
K e n d a ll's r
O v e r a ll e ffic ie n c y ( 0 t ):
T ech nical e ffic ie n c y ( I V J :
(2 ,2 )/(3 ,4 )
-8 .2 4
(0.0001)
0.0000
0.2513
(0.0000)
(1,2)
12.31
(0.0001)
0.0000
0.5874
(0.0 0 0 0 )
(1 ,2 1 /5
-8 .9 0
(0.0001)
0.0000
0.0909
(0.0262)
(1,3)
-9 .0 8
(0.0001)
0.0000
0.2518
(0.0 0 0 0 )
(3 ,4 1 /5
- 3 .2 5
(0.0012)
0.0034
0.1081
(0.0082)
(1,4)
- 1 .0 6
(0.2903)
0.0327
0.3072
(0.0000)
(1,5)
-9 . 1 7
(0.0 0 0 1 )
0.0000
0.1329
(0.0012)
(2,3)
-1 2 .7 4
(0.0001)
0.0000
0.1704
(0.0 0 0 0 )
(2,4)
- 1 1 .6 2
(0.0001)
0.0000
0.5000
(0.0000)
(2,5)
-1 2 .3 6
(0.0001)
0.0000
0.0405
(0.3222)
(3,4)
9.76
(0.0001)
0.0000
0.4128
(0.0000)
(3,5)
- 2 .6 7
(0 .0 0 7 6 )
0.0015
0.1034
(0.0115)
(4,5)
-9 .0 1
(0.0001)
0.0000
0.1831
(0.0000)
S c a le e ffic ie n c y ( S 4):
(1 ,2 )/(3 ,4 )
-9 .4 6
(0.0001)
0.0000
0.2333
(0.0000)
(1 ,2 )/ 5
- 7 .5 8
(0.0001)
0.0000
0.1114
(0.0065)
!3 ,4 )/5
-0 .3 2
(0.7482)
0.4644
0.1805
(0.0000)
A llo c a t iv e e ffic ie n c y ( 4 t ):
(1,2)
12.88
(0.0001)
0.0000
0.0068
(0.8680)
(1,3)
- 3 .5 8
(0.0003)
0.0003
0.4179
(0.0000)
(1,4)
8.40
(0.0001)
0.0000
-0.0964
(0.0185)
(1,5)
- 1 .4 5
(0.1481)
0.0327
0.0934
(0.0225)
(2,3)
-1 3 .3 9
(0.0001)
0.0000
0.0267
(0.5135)
(2,4)
-1 2 .2 8
(0.0001)
0.0000
0.5661
(0.0000)
-1 3 .0 3
(0.0001)
0.0000
0.0342
(0.4036)
0.0000
-0.0047
(0.9092)
(2,5)
(3,4)
10.23
(0.0001)
(3,5)
0.32
(0.7515)
0.6258
-1 0 .4 9
(0.0001)
0.0000
x
4N + 10
VAR(t ) = ---------------,
9 N (N —1)
where N gives the number of observations.
By definition, the statistic lies between -1
and + 1, taking a value of +1 if rankings are
in complete agreement, or -1 if the ranks are
completely reversed.
Kendall and Gibbons (1 990) suggest
that the T-statistic may also be viewed as a
measure of concordance. Any two pairs of
ranks (u;,V;) and (uj, Vj), i, j = 1,...,N, i # j, are
defined as concordant if v, < v( when uf< uf or
vi > vj when ul > u J. Similarly, they are defined
as discordant if V;<Vj when u ,> u ( or vl > v j
when Uj > U j . The total number of pairs is
0.0627
(0.1255)
(4,5)
rankings. The statistic is approximately
normally distributed, with zero expected
value and with variance
0.1648
(0.0001)
F EDERAL RESERVE B A N K OF ST. L OUI S
50
HEVIEW
JULY/AUGUST
N (N -1)/2, and t can be shown to be equiva
lent to the proportion of concordant pairs
minus the proportion of discordant pairs.
The last column of Table 5 gives the
r-statistic for the various pairs of models for
each measure of efficiency, along with signifi
cance levels as shown in parentheses. We
fail to reject the null hypothesis of no associ
ation among ranks in only five instances
when comparing allocative efficiency scores.
(In particular, we fail to reject the null
hypothesis for the following pairs of models:
1, 2; 2, 3; 2, 5; 3, 4; and 3, 5, and in only one
case when comparing overall efficiency
scores— for models 2 and 5). In all other
cases, we reject the null hypothesis
of no correlation.
Note, however, that when we reject the
null hypothesis of no association, the
t-statistic is usually rather small in absolute
terms; the largest value of the statistic shown
in Table 5 is 0.5 8 7 4 (in the case of overall
efficiency for models 1 and 2). As is typical
in classical hypothesis testing, rejection of
the null hypothesis does not necessarily
imply acceptance of an alternative hypothe
sis. That is, our statistical test may reject the
hypothesis that the rankings are not associated,
but that does not necessarily imply that the
rankings are associated-the test is simply not
that powerful. Figure 2 plots the rankings of
overall efficiency scores for model 1 against
those for model 5. Note that the value of
Kendall’s T-statistic for this comparison is
significantly different from zero at the 0.0012
level, indicating that the two sets of rankings
are not discordant. The low value of the test
statistic (0 .1 3 2 9 ), however, suggests that nei
ther are they concordant.
Our results based on the W ilcoxon
matched-pairs signed-ranks test and the
sign test for equivalence of medians are
consistent with our observations on the
differences of mean efficiency scores across
the models discussed earlier. Taken together,
our results indicate that different model
specifications are likely to produce different
measures of the level of inefficiency among a
sample of banks, but not necessarily dissimi
lar rankings of individual banks in terms
of measured efficiency. For our data, the
rankings are similar enough to reject the
1995
F ig u r e 2
R a n k in g s of O v e ra ll Efficiency Scores
M odel 1
M odel S
null hypothesis of no association, but in
many cases are far from being in complete
concordance. Concordance is relatively high
for the technical and scale efficiency mea
sures, which do not rely on price data. The
introduction of price data to measure alloca
tive and overall efficiency might also intro
duce more sources of noise or error.
CONCLUSION
Like other studies of commercial bank
efficiency, we find considerable inefficiency
among banks in our sample. Other studies
have found substantial variation in efficiency
measures in applying different estimation
techniques to a common pool o f banks. We
find that measured efficiency also depends on
the researcher’s conception of what banks do.
In this article, we measure various types of
production efficiency under two very differ
ent views of banking. We find that, on aver
age, technical and overall efficiency is higher
under the intermediation view of the bank
ing firm than under the production view.
Mean allocative efficiency is, however, similar
N K OF S T . L O U I S
51
RVW
EIE
JULY/AUGUST
1995
Fore, Rolf, Shaw na Grosskopf and C. A. Knox Lovell.The Measurement
of Efficiency of Production. Kluwer-Nijoff Publishing, 1 9 8 5 .
under the extreme versions of each approach.
Under the intermediation view, we also find
somewhat less scale inefficiency and more
banks operating on the constant-returns por
tion of the efficient frontier. Despite the dif
ferences in mean measured efficiency across
the different conceptions of how banks oper
ate, however, we find some similarity in the
rankings of efficiency scores of individual
banks. Further research will, of course, be
necessary to determine how sensitive these
findings are to the particular dataset and esti
mation techniques employed in this article.
Farrell, M . J. "The Measurement of Productive Efficiency,"
Journal of
the Royal Statistical Society, Series A (1 9 5 7 ), pp. 25 3 -8 1 .
Ferrier, Gary D., and C. A. Knox Lovell. "M easuring Cost Efficiency in
Banking: Econometric and Linear Programming Evidence,"
Journal of
Econometrics (October/November 1 9 9 0 ), pp. 2 2 9 -4 5 .
Fixler, Dennis J., and Kimberly D. Zieschang. "A n Index Number
Approach to Measuring Bank Efficiency: An Application to M ergers,"
Journal of Banking and Finance (April 1 9 9 3 ), pp. 4 3 7 -5 0 .
Gilbert, R. Alton. "B a n k Market Structure and Competition: A Survey,"
Journal of Money, Credit and Banking (November 1 9 8 4 ), pp. 61 7 -4 5 .
Grabowski, Richard, Nanda Rangan and Rasoul Rezvanian. "Organizational
Forms in Banking: An Empirical Investigation of Cost Efficiency,"
Journal of Bonking and Finance (April 1 9 9 3 ), pp. 531-38 .
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