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