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!Federal R eserv e Bank o f Philadelphia
July • A ugust 1 9 9 4

ISSN 0 0 0 7 - 7 0 1 1


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D. Keith Sill
The government is issuing less long-term
and more short-term debt. In fact, the
Treasury is moving toward borrowing
primarily at maturities of less than three
years. Can the government save money
on interest payments by altering the aver­
age maturity of the debt? What other
things, besides interest costs, need to be
considered? Keith Sill looks at various
aspects of managing the public debt.
James McAndrews
The option of making payments through
the Automated Clearinghouse (ACH) has
been available for quite a while. Yet, in
spite of the advantages of paying via the
ACH—speed, lower processing costs—
many individuals and companies have
been slow to exercise the option. Why?
James McAndrews outlines other consid­
erations, such as perceptions of control
and adopting a standard communication
format, that need to be weighed when
comparing these two methods of pay­


Managing the Public Debt


X JL s the Clinton administration and Con­
gress wrestle with government spending and
deficit reduction, the size of the public debt and
interest payments on it are much in the news.
The administration, in its 1993 budget plan "A
Vision of Change for America," claimed that
the government could save about $11.5 billion
over the next four years if it issued less long­
term debt and more short-term debt to finance
deficits, because short-term debt generally has
a lower interest rate than long-term debt. In
May 1993, the Treasury Department announced

* Keith Sill is an economist in the Research Department
of the Philadelphia Fed.

D. Keith Sill*
that it would begin reducing the amount of
long-term debt that it issued. As a result, the
Treasury now offers 30-year bonds semiannu­
ally (instead of quarterly) and has eliminated
issues of seven-year notes. The Treasury is
m oving tow ard borrow in g prim arily at
maturities of less than three years.
By altering the average maturity of the debt
the government hopes to save money on inter­
est payments. Does the average maturity of the
debt really matter? Should governments issue
short-term debt or long-term debt or maintain
a balance between the two? Are there other
considerations besides interest costs that are
important to consider in choosing an average
maturity of the debt?



great deal in the postwar period, ranging from
The deficit, or the excess of government a high of 124 months in 1946 to a low of 29
expenditures over its revenues, is the amount months in 1975 (Figure 1). Also, during this
of new borrowing the government must under­ period the average maturity of the debt de­
take in a year; the debt is the accumulation of all clined when the debt-to-GDP ratio declined
past deficits. At the end of 1993, the interest- and rose when the debt-to-GDP ratio rose. In
bearing portion of federal government debt 1992 average maturity was about 70 months.
held by the public stood at slightly over $2.9 The Treasury's recent changes will shorten the
trillion. The federal government ran a deficit of average maturity of the debt some 12 months
$254.7 billion in 1993, a number much smaller (to 58 months) by 1998. So, even though the
than the size of the public debt. If the govern­ Treasury is reducing the average maturity of
ment persistently runs deficits, the public debt the debt, it will still be about twice as high as the
accumulates. If the government runs budget postwar low in 1975.
surpluses, the public debt declines.
Most of the government debt is in the form DOES DEBT MATURITY MATTER?
How does a change in the average maturity
of Treasury securities such as Treasury bills,
Treasury notes, and Treasury bonds. In 1992, of the public debt affect the economy? Econom­
for example, such securities accounted for about ic theory says that under certain circumstances
86 percent of private-sector holdings of inter­ the average maturity of the debt is irrelevant for
est-bearing public debt. The remaining 14 economic welfare. In this case debt manage­
percent was composed of private-sector hold­ ment policy is neutral with respect to the econ­
ings of savings bonds and holdings of certain omy.
types of securities issued
by agencies of the U.S. gov­
ernment such as the Feder­
al Housing Administration
Debt/GDP Ratio and Average Maturity
and the Federal Deposit
of Debt
Insurance Corporation.
The size of the public
debt relative to the size of
the U .S. econom y has
show n fairly d ram atic
m ovem ent since W orld
War II. If we look at the
public debt relative to
Gross Domestic Product
(GDP), the ratio has varied
from less than 20 percent to
over 100 percent (Figure 1).
The maturity of a securi­
46 50 54
58 62 66
70 74 78 82 86 90
ty is defined as the length
of time until payments from
the security expire. The
Note: The public debt used in computing debt/G DP ratio is the total interest-bearing
average maturity of the
public securities held by private investors.
public debt has varied a
Source: Treasury Bulletin, various issues, Department of the Treasury.



Managing the Public Debt

D. Keith Sill

This debt neutrality proposition depends on trality proposition is a useful starting point
whether households and investors can trade in from which to consider debt maturity policies.
securities in such a way as to completely offset The extent to which departures from neutrality
any actions that the government takes regard­ occur is an empirical matter.1
ing the mix of debt and taxes that it uses to
finance its expenditures. If households can
trade in securities so as to undo the financing
mix put in place by the government, any partic­
1The empirical results on the effects of debt management
ular financing mix will be irrelevant in the sense policies are mixed. Two representative studies are present­
that household consumption and savings deci­ ed in the 1992 volume by Agell, Persson, and Friedman. The
study by Agell and Persson finds that debt management
sions are unaffected by how the government policies have little consequence for relative asset yields.
finances its spending. (See A Case o f Debt The study by Friedman finds a much more significant im­
Neutrality for an example of this neutrality pact of debt management on asset yields.
H ow ever, this strong
A Case of Debt Neutrality
neutrality result relies pri­
marily on three assump­
Assume that the three assumptions for debt neutrality hold. Suppose
tions, some of which clearly
the government issues debt in the form of one-year and two-year discount
do not hold in reality: (1) bonds, each of which pays $1 at maturity. Assume further that the current
households correctly recog­ price of the one-year bonds is $0.95 and the current price of two-year
nize the link between the bonds is $0.90. For simplicity we will allow fractions of a bond to be
government budget con­ bought and sold. If the government issues one additional one-year bond
straint and household bud­ and uses the proceeds ($0.95) to buy back 1.055 units of two-year bonds
get constraints as well as (since $0.90 times 1.055 is $0.95), there is now more one-year debt and less
the relationship between two-year debt, and government spending and taxes are unchanged.
Households, in aggregate, have purchased one additional unit of onecurrent debt and future tax­
year debt for $0.90 and financed that purchase by selling back to the
es, (2) tax rates do not affect
government 1.055 units of two-year debt (which raises the $0.90 needed
the relativ e prices that
to buy the one-year debt). Aggregate consumption by the households is
households face (such taxes
unchanged initially. At the end of the first year, the government has to
are called nondistortionary), raise $1 in taxes to pay off the new one-year debt that it issued. But
and (3) the set of investment households can use the proceeds ($1) of their purchase of one-year debt
portfolio choices available to pay the higher taxes. Hence, at the end of the first year households can
to households is unaffected maintain the same level of consumption as before the average maturity of
by the government action.
government debt was shortened. At the end of the second year, house­
If these assumptions are holds have $1,055 less coming in because of their sale of two-year bonds
violated, a change in the way back to the government. But government liabilities have fallen by $1,055
government spending is fi­ because less two-year debt is outstanding. The government could thus
nanced will change relative lower taxes by $1,055, and again, household consumption at the end of the
prices in the economy and second year would be no different than it was prior to the government
hence redirect resources. In
Since households are able to undo the change in government financing,
this case the financing mix any particular mix of debt and taxes the government uses to finance its
is not neutral, and a change spending will not affect household consumption and savings decisions.
in the average maturity of Households will merely readjust their portfolios in response to the
the debt can affect the econ­ government action. In this situation the debt structure is neutral; it has no
omy. Nonetheless, the neu­ real effects.




INTEREST RATES AND DEBT MATURITY slope of the yield curve changes over time. In
Bearing in mind the debt neutrality proposi­ 1954 and 1990 the yield curve had an upward
tion, why might the government try to lower slope, indicating that the interest rate on long­
the interest costs of its debt? If taxes distort term debt exceeded that on short-term debt. In
economic activity, lower interest costs mean 1965 the yield curve was approximately flat:
less distortion, since tax revenues are used in long-term debt paid about the same interest
part to pay interest on the debt. The interest rate as short-term debt. In 1980 the yield curve
rate that the government must pay on its bonds was downward sloping, indicating that the
often changes with the time to maturity of the interest rate on long-term debt was lower than
bonds. If the government's objective in manag­ that on short-term debt.
Is there a "normal" shape, or slope, to the
ing the public debt is to minimize interest costs,
perhaps altering the average maturity of the yield curve? If we compare short-term and
long-term interest rates over time, we see that
debt can achieve it.
Term Structure of Interest Rates. The yield generally long-term rates exceed short-term
curve conveniently summarizes the relation­ rates, suggesting that the normal shape of the
ship between the term to maturity of govern­ yield curve is upward sloping. The steepness of
ment debt and the interest rate (Figure 2). This the yield curve, which is measured by the gap
relationship between yield and maturity is called between the two lines in Figure 3, varies quite
the term structure of interest rates. The hori­ a bit, but there are few episodes in which the
zontal axis shows the time to maturity of the yield on short-term government bonds exceeds
security, and the vertical axis shows the interest that on long-term government bonds.
A Theory of the Term Structure. Econorate, which is measured by yield to maturity.2
Notice that the relationship
between yields and ma­
turities changes over time.
For one thing, when com­
Treasury Yield Curves
paring the yields for 1954,
1965, and 1980, we see that
the yield curves shifted up
over time, reflecting a gen­
eral trend of rising interest
rates. Next, we see that the

2Yield to maturity is defined
as the interest rate that answers
the following question: if an in­
vestor were to buy a bond and
hold it until it matured, what av­
erage annualized return would he
get over the life of the bond? For
example, if an investor were to
pay $100 for a bond that pays $121
in two years, the yield to maturity
would be 10 percent. This follows
from the fact that $100 x 1.10x1.10
= $



Maturity (years)
Source: J.H. McCulloch and Heon-Chul Kwon, "U.S. Term Structure Data, 1947 1991," Ohio State University Working Paper 93-6.


Managing the Public Debt

D. Keith Sill

conclusion follows if investors expect the yield
on one-year bonds to average 5 percent per
year, but don't know for sure. If investors
know that one-year interest rates will rise above
5 percent per year in the future, the yield to
maturity on the 10-year bond should be above
5 percent. Absent a risk premium, an upwardsloping yield curve means that investors be­
lieve future short-term interest rates will rise,
while a downward-sloping yield curve sug­
gests that traders believe future short-term
interest rates will fall.
The risk premium can arise because inves­
tors typically do not like bearing risk. Long­
term bonds are risky because future interest
rates are uncertain and because uncertainty
about future interest rates translates into un­
certainty about future bond prices. That un­
certainty could work in investors' favor, or it
could work against them.
The manner in which long-term bonds act as
3An excellent survey of theories of the term structure is
the 1990 article by Robert Shiller.
a hedge against future income uncertainty de­
termines whether the risk
premium is positive or neg­
ative. For example, sup­
pose investors could hold a
Interest Rates of the United States
bond whose price is high
1946 -1992
when income is unexpect­
edly low and whose price is
low when income is unex­
pectedly high. Investors
would be willing to pay a
premium for such a bond
because it offers them some
insurance against their un­
certain income: in a year
when income is low, the
investor could cash in the
bond and receive a capital
gain (since the price at
which he sells the bond is
higher than the price at
46 50 54 58 62 66 70 74 78 82 86 90
which the bond was pur­
chased), helping him to
Source: J.H. McCulloch and Heon-Chul Kwon, "U.S. Term Structure Data, 1947 maintain his level of con­
1991," Ohio State University Working Paper 93-6, and the Federal Reserve System.

mists have developed and tested several theo­
ries to explain why the term structure of inter­
est rates behaves as it does over time.3 One such
theory is called the expectations theory of the
term structure, which states that the yield to
maturity on a long-term bond is equal to a
weighted average of expected future short­
term interest rates plus a risk premium. It
seems reasonable to suppose that the yield on
long-term bonds is related to expected future
short-term interest rates. Suppose investors
know that the interest rate on one-year bonds
will average 5 percent a year over the next 10
years. In this case the risk premium would be
zero, and investors will buy and sell 10-year
bonds until their yield to maturity equals the
average of those expected one-year rates, or 5
percent. Absent a risk premium, the same



sumption. Such a bond would have a negative
risk premium. A bond with a positive risk
premium would be one whose price is low
when income is unexpectedly low. In this case,
when the investor receives low income and
cashes in the bond, he will take a capital loss.
Thus, an investor would have to receive some
compensation, in the form of a higher return,
for investing in such a security. In this case the
risk premium would be positive.4
Although theory suggests that the risk pre­
mium on long-term bonds can be either posi­
tive or negative, the normal, upward-sloping
shape of the yield curve suggests that the pre­
mium is positive.5
Minimizing Interest Costs. If the yield
curve is upward sloping, should the govern­
ment borrow long or short to minimize interest
costs? First, suppose there's no uncertainty
about future short-term interest rates (which

4An alternative theory about why the yield to maturity
on a long-term bond may differ from the average of expect­
ed one-year interest rates is called the preferred habitat
theory. This theory, which was developed by Franco
Modigliani and Robert Sutch (1966), states that investors
have preferred maturities that correspond to their invest­
ment horizons. For example, if you were investing for a
child's college education, you may choose to invest in a
long-term bond rather than a series of short-term bonds.
The premium (negative or positive) associated with a par­
ticular maturity then depends on the supply and demand
for funds at that maturity. Suppose that lenders prefer to
lend with a short-term commitment and borrowers want to
borrow long term. Then there would need to be a positive
premium on long-term debt to get lenders to loan funds for
a longer period than they would otherwise want to.
5In the absence of a risk premium, the usual upward
slope of the yield curve suggests that short-term interest
rates are expected to rise. In actual practice, short-term
interest rates are usually just as likely to rise as to fall. If the
risk premium were indeed zero, this suggests that bondmarket traders are making persistent errors in forecasting
interest rates, which seems unlikely. On the other hand, if
the risk premium is positive, the yield curve would tend to
have a normal upward slope, and persistent errors in fore­
casting future interest rates need not occur.



implies that the risk premium will be zero). The
expectations theory implies that future short­
term interest rates will be higher than current
short-term interest rates. In this case, even
though short-term rates will be higher in the
future, it does not matter whether the govern­
ment borrows short or long— the interest cost
will be the same.
A simple example will help to make this
clear. Suppose the one-year interest rate today
is 5 percent, and the one-year interest rate one
year from today will be 10 percent. The govern­
ment decides to borrow $1000 and repay the
borrowing at the end of the second year. If the
government borrows using one-year debt, at
the end of the first year it must repay $1050. If
the government rolls over the debt, at the end
of the second year it will have to pay interest on
the $1050, so that total interest and principal
due at the end of the second year is $1155.
What would the government's cost be if it
used two-year debt instead? Since there is no
risk, investors would demand the same return
on the two-year bond as on the sequence of oneyear bonds. Using the expectations theory, the
yield to maturity on the two-year bond is the
average of the one-year interest rates, which is
7.5 percent. At the end of two years, the total
cost of borrowing for two years is the same
($1155), regardless of whether the government
borrows short or long.6
If we introduce uncertainty, the picture be­
comes more complicated. Now bond-market
traders form expectations of future interest
rates. Further, the introduction of uncertainty
brings the risk premium into the picture. If the
risk premium is positive, on average the gov­
ernment will have a lower interest cost by

6The exact formula for the two-year rate gives an interest
rate slightly lower than 7.5 percent because of the effects of
compounding interest. In an environment with no risk the
formula for the implied two-year rate is given by (l+ i2 r)2 =


Managing the Public Debt

borrowing short term. But the lower average
interest cost comes at the price of higher uncer­
tainty concerning the final payment.
Suppose again that the government borrows
$1000 today. The one-year interest rate today is
known to be 5 percent, but the one-year interest
rate one year from today is not known. Sup­
pose bond traders believe that there's a 25
percent chance that the interest rate next year
will be 8 percent, a 50 percent chance that it will
be 10 percent, and a 25 percent chance that it
will be 12 percent.
Consider first the strategy of borrowing short
term. At the end of the first year the govern­
ment will owe $1050 with certainty. If it rolls
over the debt, at the end of the second year,
there's a 25 percent chance that the government
will owe $1134, a 50 percent chance that it will
owe $1155, and a 25 percent chance that it will
owe $1176. On average, the government will
owe $1155.
Now suppose the g overnm ent decides to
borrow using two-year debt. What will its cost
be in this case? If we assume that the expecta­
tions hypothesis is true and that there's a pos­
itive risk premium, the yield to maturity on a
two-year bond will be the average of today's
one-year interest rate and the expected oneyear interest rate in the second year, plus the
risk premium. The average of the short-term
rates is 7.5 percent (the average of 5 percent and
the expected 10 percent). Thus, the yield to
maturity on the two-year bond is 7.5 percent
plus the risk premium. Let's assume the risk
premium is 0.2 percent, so the yield to maturity
is 7.7 percent. Then, the interest and principal
that has to be repaid at the end of two years is
$1159.93 ($1000 x (1.077) x (1.077)) = $1159.93).
Should the government borrow long term or
short term? In the example, the expected inter­
est cost to the government of borrowing short
term is $155. If the government borrows using
two-year debt, the interest cost will exceed
$155. This result seems to favor short-term
borrowing. However, by borrowing short­

D. Keith Sill

term the government faces a risky outcome. In
the example, there's a 25 percent chance that
borrowing short term will cost $176, which
exceeds the cost of borrowing using two-year
debt. On average, the cost of borrowing short
term will be lower than the cost of borrowing
long term, but the lower interest cost comes at
the price of a risky outcome.7
We have seen that if the government tries to
manage the public debt to minimize interest
costs, it can lower its interest cost, on average,
by borrowing short term rather than long term,
but at the price of bearing greater risk. Aside
from this interest rate minimization issue, are
there other factors that the government should
consider when planning the average maturity
of its debt?
Debt Maturity and Insuring Against Risk.
Economic theory suggests that debt of different
maturities may offer investors different oppor­
tunities to insure against economic uncertain­
ty. We will frame this discussion in terms of a
simple economic model in which consumers
live for two periods.8 We can think of the first
period of life as the working years and the
second period of life as retirement. In the first
period, consumers work and invest in an asset
that is risky in the sense that the return is
unknown to investors at the time of invest­
Investing in the risky asset is like buying
corporate stocks to save for retirement. How­
7We have neglected to mention transactions costs. By
having a shorter average maturity of debt, the government
rolls over the debt more frequently and thus pays more in
transactions costs. For example, if the government bor­
rowed for 10 years, it could make one transaction by issuing
one 10-year bond, or it could make 10 transactions by
issuing 10 one-year bonds. The higher transactions costs
must also be considered in assessing the extent to which the
government saves money by issuing short-term debt.
8This argument is based on an article by Douglas Gale.


ever, in any period only one of the two gener­
ations alive at that date bears the risk of the
investing, namely the retirees. Everyone would
be happier if some of the asset risk could be
transferred from the retirees to the workers.
This intergenerational risk-sharing can be
accomplished by introducing government debt
into the economy. Suppose the government
introduces one-period debt into the economy.
This debt offers young investors a safe asset to
invest in. Since investing in public debt carries
no risk, it allows the young to attain, with
certainty, some amount of consumption when
they retire. If investors don't like risk, they may
be better off if they have the opportunity to
guarantee some amount of consumption when
they retire, compared with investing all of their
savings in the risky asset.
By issuing one-period bonds, the govern­
ment allows intergenerational risk-sharing in
the following sense. Buying a one-period gov­
ernment bond is like buying a claim on the next
generation. When the young buy bonds, they
hold them until they retire; the bonds are then
paid off by the government. But the govern­
ment pays off the bonds by transferring re­
sources from the new young generation of
workers to the retirees. Thus, by transferring
resources from the young to the old, the debt
serves to guarantee retirees some level of con­
Debt of maturity longer than one period
would be more risky for these investors be­
cause of capital gains and losses that can occur
when economy-wide rates of return change.
But under certain circumstances this riskiness
of long-term debt could be advantageous to
investors even if one-period debt is not. Sup­
pose that investors observe that the return to
the risky asset is high, and further, they expect
the return on risky assets to be high next period.
In this situation the current price of a twoperiod bond will be low.9 Similarly, if the
return to the risky asset is currently low, the
price of two-period bonds will be high. How­



ever, if the price of bonds is high when the
return to investment is low, the two-period
debt is a better hedge against the risky invest­
Why is this so? The argument is much the
same as that in our discussion of the risk premi­
um. Take the case of investors who purchased
both two-period bonds and the risky asset to
save for their retirement. At retirement, these
investors will want to sell their bonds (which
have become one-period maturity bonds) to
the new young generation. If the return on the
asset turns out to have been low, new investors,
seeing that the return to the asset was low,
expect a low return to their investment in the
asset (remember that we are assuming a posi­
tive correlation in investment returns). There­
fore, the new investors will want to buy bonds
from the retirees, bidding up the price of those
bonds. These retirees get a capital gain (an
appreciation in the bond price) that in part
compensates them for the low return on the
risky asset. No such capital gain would be
realized if the retirees had purchased oneperiod debt instead of two-period debt.
This argument is not limited to two-period
bonds. Thus, the economy could be better off
if investors had the opportunity to invest in
long-term debt securities because long-term
debt might provide better insurance against the
uncertainty associated with risky assets.1 *

9Returns on bonds and returns on the risky asset will be
linked by investors' demand for the two alternatives. If the
expected return to the asset rises, while the uncertainty
associated with the asset return remains unchanged, then
investors have an incentive to shift their investment funds
toward the risky asset and away from bonds. As investors
shift funds out of bonds, the price of bonds falls and the
return on bonds rises.
10Referring to the discussion of debt neutrality on page
5, the reason that debt maturity matters in the example just
given is that trading in government securities offers inves­
tors opportunities that they otherwise would not have and
so assumption (3) is violated.


Managing the Public Debt

Confidence Crises. Another argument in
favor of governments' issuing long-term debt
can be made. Long-term debt can raise inves­
tors' confidence that the government will be
able to meet its obligations in the event of a
crisis. A 1990 paper by Alberto Alesina,
Alessandro Prati, and Guido Tabellini devel­
ops this argument using a case study of the
public debt in Italy. The Italian debt-to-GDP
ratio is close to 100 percent, and the Italian
government has to pay a steep premium to
borrow long term. Alesina and associates show
issuing long-term debt may be beneficial to the
government, even though it is more costly than
short-term debt, because long-term debt can
help to avoid confidence crises.
A confidence crisis could occur if govern­
ment bondholders thought that the govern­
ment might have difficulty making payments
on the debt. Suppose the government finances
its borrowing by issuing only one-year debt. In
that case, a large quantity of the debt comes due
each year, and the government must borrow a
large quantity each year, both to finance any
current deficit and to roll over the existing debt.
If investors thought the government might
have difficulty repaying its debt obligations,
they could all demand repayment of their debt
holdings. The government would find itself
unable to borrow to roll over existing debt. The
government would have to either raise taxes
substantially to pay off debt holders or default
on the debt.1
On the other hand, if the government issued
long-term debt and had an evenly concentrated
amount of debt coming due each year, it could
diminish the likelihood of a confidence crisis.
By issuing long-term debt to finance deficits,

11If taxes are distortionary, economic theory suggests
that governments should try to smooth taxes over time.
Distortionary taxes and tax smoothing are the reason that
the maturity structure of the government debt matters in
this model.

D. Keith Sill

the government has a smaller quantity of debt
that comes due each year. Therefore, this strat­
egy may raise investor confidence in the gov­
ernment's ability to meet its obligations, and
runs on the government debt may become less
likely. In the case of the Italian debt, Alesina
and associates note that by issuing long-term
debt and reducing the risk of a debt crisis, the
government could lower the risk premium on
the entire maturity structure of the debt and,
therefore, lower debt-servicing costs.1 *
We have examined several different theories
that point out some of the costs and benefits of
both short-term and long-term debt. An opti­
mal debt maturity structure takes these factors
into account, as well as the incentives that
current government policy places on the poli­
cies of future governments.
Time-Consistent Policy. Economists have
considered how the maturity of the public debt
can be used as part of a strategy to implement
a fiscal policy that is optimal over time. In a
dynamic environment, fiscal policy takes the
form of a plan for both the present and the
future. If today's government forms a fiscal
plan, that plan has implications for future tax
rates, future government spending, and future
borrowing. But can we guarantee that some
future government will find it optimal to stick
to the plan that we develop today? In general,
the answer is no, so we say that the plans are not
The issue of time-consistent plans is dis­
cussed in more detail in a 1985 article by Herbert
Taylor in this Business Review. For our purposes
a simple example will help clarify the idea. The
United States incurred a large debt when it

12The confidence crisis story is less applicable to the U.S.
than to countries such as Italy. In the U.S. the default
premium on government debt is considered to be virtually



fought the war for its independence. The gov­
ernment was able to borrow because it prom­
ised to repay the debt after the war. However,
once the war was over, many Americans advo­
cated defaulting on the debt because repaying
creditors would require an increase in taxation;
thus, the government had an incentive to devi­
ate from the policy im plemented earlier.
Alexander Hamilton, the first Secretary of the
Treasury, argued against this time-inconsisten­
cy, realizing that in the future the new govern­
ment would likely need to borrow again. Had
the government defaulted on the war debt,
borrowing in the future would have been more
difficult and costly.
Debt Maturity and Optimal Fiscal Policy.
In general, successor governments will have an
incentive to deviate from an optimal fiscal
policy put in place by today's government. But
economic theory suggests that the maturity
structure of the public debt can help provide
incentives for future governments to stick to a
fiscal plan developed today. This happens
because a government that inherits a public
debt has reduced flexibility: it must pay interest
on the inherited debt and either pay off debt
coming due or roll it over.1 If a government
inherits a large quantity of public debt that
comes due during its time in office, its incen­
tives, say, with respect to taxation, may be
different than if the inherited debt is long term
and thus not all coming due during the govern­
ment's tenure.
Suppose today's government believes high­
er taxes and higher inflation reduce economic
welfare. The government might then form a
fiscal plan that tries to set current and future
taxes and inflation in a way that increases
society's well-being. A strategy for the public

13We are assuming that the costs of defaulting on the
debt are so high that future governments do not consider
defaulting as a policy option.



debt could be a key part of this calculation,
since debt allows governments to smooth taxes
over time and to reduce the temptation for
future governments to deviate from the fiscal
The maturity of the public debt can be used
to lessen the government's incentive to try to
use inflation to reduce the value of its debt.1
Consider the case of a government that inherits
a stock of long-term, fixed-rate debt. The gov­
ernment recognizes that since the debt was
issued in the past, the interest payments on that
debt are fixed in dollar terms. This gives the
government an incentive to increase the rate of
inflation so that it can pay off its inherited debt
in cheaper dollars. This inflation acts like a tax,
and the nominal debt comprises part of the tax
base. The real value of the payments that
investors receive from their bond holdings de­
clines when the price level rises.1
By reducing the average maturity of the
debt, current governments can reduce succes­
sor governments' incentives to increase infla­
tion. A government that inherits short-term
debt will gain little by increasing the inflation
rate. When the debt is short term, it is rolled
over frequently, giving the government little
opportunity to pay off the debt in cheaper
dollars. In addition, any attempt to raise infla­
tion will be quickly reflected in higher interest
rates on short-term debt; investors will de­
mand to be compensated for higher anticipated
inflation. In effect, a greater quantity of short­

14This discussion is based on the work of Guillermo
Calvo and Pablo Guidotti.
15This argument applies to debt with a fixed nominal
face value, which is the predominant form of debt issued by
governments. The government has an incentive to raise
inflation even if the gains from doing so are illusory in the
sense that bondholders, at the time they purchased the
bonds, demanded an inflation premium in the form of a
higher interest rate.


Managing the Public Debt

D. Keith Sill

term debt lowers the inflation tax base available
to the government and, therefore, lessens the
incentive to use inflation to raise revenue.
Deciding on a preferred maturity structure
of the public debt involves many consider­
ations. On the one hand, the maturity structure
of the debt may be largely irrelevant for the
economy if departures from the neutrality prop­
osition are small. On the other hand, if the
departures from neutrality are significant, then
the choice of a debt maturity structure may be
guided by factors such as interest cost minimi­
zation, risk-sharing arrangements, confidence

crises, and reinforcing incentives for future
policymakers. Economists have not yet reached
agreement on the questions of whether there is
an optimal maturity of the debt and, if so, what
factors are involved.
The U.S. Treasury is engaging in a strategy to
reduce the average maturity of the public debt.
Our analysis suggests that on average, this
strategy should reduce the costs of borrowing,
but the government also takes on more risk,
since future interest rates are uncertain. The
shorter average maturity may also weaken the
incentives future governments have to use in­
flation to raise tax revenue.

Agell, Jonas, Mats Persson, and Benjamin M. Friedman. Does Debt Management Matter? Oxford: Oxford
University Press, 1992.
Alesina, Alberto, Alessandro Prati, and Guido Tabellini. "Public Confidence and Debt Management: A
Model and a Case Study of Italy," in Rudiger Dornbusch and Mario Draghi, eds., Public Debt
Management: Theory and History. Cambridge: Cambridge University Press, 1990.
Calvo, Guillermo A., and Pablo E. Guidotti. "Credibility and Nominal Debt," IMF Staff Papers 37
(September 1990), pp. 612-35.
Gale, Douglas. "The Efficient Design of Public Debt," in Rudiger Dornbusch and Mario Draghi, eds., Public
Debt Management: Theory and History. Cambridge: Cambridge University Press, 1990.
Modigliani, Franco, and R. Sutch. "Innovations in Interest Rate Policy," American Economic Review 56 (May
1966), pp. 178-97.
Shiller, Robert J. "The Term Structure of Interest Rates," in Benjamin M. Friedman and Frank H. Hahn, eds.,
Handbook o f Monetary Economics, Volume I. Amsterdam: Elsevier, 1990.
Taylor, Herbert E. "Time-Inconsistency: A Potential Problem for Policymakers," this Business Review
(M arch/April 1985).
Tobin, James A. "An Essay on the Principles of Debt Management," in Fiscal and Debt Management Policies.
New Jersey: Prentice-Hall, pp. 143-218. (An early, excellent reference on managing the public debt)


Working Papers
The Philadelphia Fed's Research Department occasionally publishes working papers based on the current
research of staff economists. These papers, dealing with virtually all areas within economics and finance,
are intended for the professional researcher. The papers added to the Working Papers series thus far this
year are listed below. To order copies, please send the number of the item desired, along with your address,
to WORKING PAPERS, Department of Research, Federal Reserve Bank of Philadelphia, 10 Independence
Mall, Philadelphia, PA 19106. For overseas airmail requests only, a $3.00 per copy prepayment is required;
please make checks or money orders payable (in U.S. funds) to the Federal Reserve Bank of Philadelphia.
A list of all available papers may be ordered from the same address.


Loretta J. Mester, "Efficiency of Banks in the Third Federal Reserve District"


George J. Mailath and Loretta J. Mester, "A Positive Analysis of Bank Closure" (Supersedes No.
93-10/R )


Dean Croushore, "The Optimal Inflation Tax When Income Taxes Distort: Reconciling MUF
and Shopping-Time Models"


Arthur Fishman and Rafael Rob, "The Durability of Information, Market Efficiency, and the
Size of Firms"


Shaghil Ahmed and Dean Croushore, "The Marginal Cost of Funds With Nonseparable Public
Spending" (Supersedes No. 92-2/R )


James McAndrews and Rafael Rob, "Shared Ownership and Pricing in a Network Switch"


Shaghil Ahmed and Dean Croushore, "The Importance of the Tax System in Determining the
Marginal Cost of Funds" (Supersedes No. 92-15/R )


Joseph P. Hughes and Loretta J. Mester, "Bank Managers' Objectives" (Supersedes No. 93-17)



The Automated Clearinghouse System:
Moving Toward Electronic Payment
James McAndrews*
I n the late 1960s, when a group of California
banks first suggested the idea of an electronic
system to make low-value, recurring pay­
m en ts— the A utom ated C learin ghou se
(ACH)—some people predicted that the ACH
would overtake checks as the main way of
making payments. Why then are relatively few
payments made through the ACH? After all,
the competition between checks and an elec­
tronic form of payment seems like a race be-

* James McAndrews is a senior economist in the Research
Department of the Philadelphia Fed.

tween a turtle and a hare. Checks (the turtle)
have to be physically moved by hand, truck,
and air from place to place to reach the checkwriter's bank, while electronic payments (the
hare) move in a flash over telephone wires.
Electronic payments have a speed advan­
tage over checks. In addition, each electronic
transaction is cheaper to process than a check.
Nonetheless, other considerations give the triedand-true technique of payment by check an
edge in the contest with its electronic rival.
First, the difficulty of finding cheap and effec­
tive ways to electronically communicate which
particular bills have been paid by ACH has
slowed its acceptance. Second, creating and


maintaining the ACH has required large, fixedcost investments by both banks and corporate
users, which can offset the per-item cost advan­
tage of ACH processing. Third, a person who
pays by check can benefit from the time be­
tween when the check is written and when
funds are finally transferred from her account;
this is called float.
Expectations that ACH payments would
overtake checks were too optimistic, but many
specific uses of ACH have proven successful.
Most notably, an estimated 30 percent of the
U.S. work force now have wages and salaries
directly deposited into their bank accounts by
ACH payment. WeTl explore why this and
some other uses of ACH have been successful
and discuss the history, organization, and cur­
rent developments in ACH to get a sense of
direction for the future of this payment system.
To do so, we first need to understand how ACH
The Automated Clearinghouse (ACH) is an
electronic system that connects banks so that
they can transfer funds between accounts in
different banks. While it was not always so,
today's ACH system is all electronic: banks use
computers linked to a computer at the process­
ing center and relay payment information over
telephone lines.1
The ACH system was designed for small,
repetitious payments such as payrolls, mort­
gage installments, insurance premiums, and
utility bills. Repetitious payments are well
suited to ACH because they allow the one-time
costs of setting up the authorization for pay­
ment to be spread over multiple transactions.2
The ACH was also designed so that, like checks,
’See the March 1986 and the April 1986 issues of the
Economic Review of the Federal Reserve Bank of Atlanta for
information on the history and problems of implementing



ACH transactions can be returned, for exam­
ple, due to insufficient funds. To allow for
returns, money actually changes hands from
one to four days (depending on the nature of
the transaction) after the payer's bank is noti­
fied of the ACH transaction to be settled.3
ACH transactions can be one of two types:
credit or debit. A credit transaction is initiated
by the payer: the customer of an electric compa­
ny, for instance, relays to her bank her account
number at the electric company along with the
electric company's deposit account number
and bank. Each month the customer can then
phone the bank and initiate an ACH credit
transaction that will transfer the amount of her
bill to the electric company. In the case of a set
billing amount, the customer can arrange for
that amount to be sent automatically every
month. Alternatively, a debit transaction is pre­
authorized by the payer but is initiated by the
payee. In this case the customer signs a form
authorizing the utility to debit her account each
month. The utility sends her a bill and then
initiates payment for the bill at some agreedupon date.
Including the costs of accounting, mailing,
processing, and transportation (but not includ­
ing the benefits of control of timing or the
information costs of a payee's attempting to
determine who paid their bill in a credit trans­
action), the cost of an ACH transaction is esti­
mated to be roughly half the cost of a check

2The costs to enroll a person in a federal government
direct deposit program were estimated to total $6.94 in
1981; $1.32 of this cost was incurred by the depository
institution, and the rest was incurred by the federal agencies
using the program. See William Dudley, "A Comparison of
Direct Deposit and Check Payment Costs," Staff Studies No.
141, Board of Governors of the Federal Reserve System,
November 1984.
3Another electronic payment system, the Fedwire— the
Federal Reserve System 's high-value funds transfer
network—does not allow returns and transfers money the
same day the bank is notified.


The Automated Clearinghouse System: Moving Toward Electronic Payment

transaction.4 A recent survey, conducted for
the National Automated Clearing House Asso­
ciation, shows that, for the respondents to the
survey, the total bank processing cost of an
ACH item averaged 5.7 cents, while the total
bank processing cost of a check averaged 10.5
cents.5 Bank processing costs for check-writing
or for ACH bill-paying services are reflected in
the fees, explicit or implicit, that banks charge
their customers. The payer of a check, howev­
er, may derive benefit from float (float is the
value of money between the time the payee's
bank account has been credited and the time the
payer has money removed from her bank ac­
count), which means the payer may prefer a
check even though the cost of processing an
ACH transaction is lower than the cost of pro­
cessing a check.6
The idea for an automated electronic clear­
inghouse for interbank payments was devel­
oped in 1968 when the San Francisco and Los
Angeles clearinghouse associations formed a
committee to study how to create an electronic
clearinghouse. This led to the first automated
clearinghouse, operated by the Federal Reserve
Bank of San Francisco, in 1972. During the
1970s other regional automated clearinghouses
were also formed. The Federal Reserve System
supported these private-sector developments
4See David B. Humphrey, The U.S. Payments System:
Costs, Pricing, Competition and Risk (Monograph Series in
Finance and Economics, nos. 1 and 2, New York University,
5See Direct Payment Market Analysis, prepared for the
National Automated Clearing House Association, Herndon,
Virginia, by the Payment Systems Institute, January 1994.
6Scott E. Knudson, Jack K. Walton II, and Florence Young,
in "Business-to-Business Payments and the Role of Finan­
cial Electronic Data Interchange," Federal Reserve Bulletin,
April 1994, pp. 269-78, calculated that the value of float to
businesses in 1993 ranged from about $0.86 to $1.12 per

James Me Andrews

by operating most of the clearinghouses. The
private-sector clearinghouses developed the
rules and procedures for making ACH transac­
In 1974 the American Bankers Association
formed the National Automated Clearing
House Association (NACHA). Its charter was
to develop an interregional network, establish
uniform rules nationally, and expand the types
of transactions then available. By 1978 the
national network, managed by the Federal Re­
serve System, was operational. Today it pro­
cesses transactions for well over 20,000 depos­
itory institutions.
Three regional clearinghouses, Arizona, New
York, and Hawaii, process their own regional
ACH transactions. Visa, the credit card associ­
ation, created an ACH that began competing
with the Federal Reserve's system on a national
basis in 1991.
In 1995 the Federal Reserve will consolidate
its ow n ACH activ ity into a single clearing­
house facility, which, along with the improved
computing equipment now available and the
revised software for ACH, is expected to re­
duce costs. With the consolidation of the Fed­
eral Reserve ACH system into one national
clearinghouse, the private-sector ACH opera­
tors recognized the need to establish a national
clearinghouse to adequately compete with the
improved system of the Federal Reserve. (Visa
has operated its system nationally since 1991,
but the majority of its users are from the West.)
As of April 1994, the private-sector ACH ex­
change (PAXS), consisting of the Visa ACH and
the New York and Arizona clearinghouse asso­
ciations, offers its members a national ACH
service. (See Private vs. Public ACH.)
The number of ACH transactions has nearly
tripled since 1986 and their value has more than
tripled.7 (See Figure, p. 19.) Most of this growth
has come in private, rather than government,
transactions because the federal government



Private vs. Public ACH
The private-sector ACH exchange (PAXS) began offering national ACH processing in competition with
the Federal Reserve System in April 1994. If the banks whose customers are party to the ACH transaction
are both using PAXS, settlement will occur using the Visa settlement system. If only one of the banks
involved is using PAXS, the transaction is settled using the Fed's system.
A notable difference between the Fed's system and Visa's is that the Fed's system settles by an exchange
between the parties of the gross amount of funds owed, while Visa's settles by the parties' exchanging only
the net amount of funds owed. A bank makes a payment to another bank by sending funds, typically
balances on deposit at the Fed, to the other bank. In a gross settlement system the banks that are party to
offsetting transactions must hold sufficient balances to exchange the gross amounts of the underlying
obligations when payment is made. In a netting system the parties take advantage of offsetting transactions,
and only the party that owes the larger amount needs to send funds.
Netting by using PAXS reduces the amount of deposits that banks need to hold at the Fed. For example,
if First Bank owes Second Bank $50,000 in one transaction and Second Bank owes First Bank $200,000 in
another transaction, gross settlement means First Bank will have to hold at least $50,000 in deposits, and
Second Bank will have to hold at least $200,000 in deposits before the transaction settles.3 Netting means
only Second Bank would have to hold deposits when the transactions are settled, and only $150,000, the net
amount owed when payment is made. Banks find it desirable to reduce the amount of deposits they must
keep at the Fed because they could place those funds in alternative investments that pay higher returns.
Banks that send and receive large numbers of ACH transactions would be attracted to a netting service.b
But netting can also expose the parties to increased risks, precisely because fewer reserves are available
in a time of liquidity crisis.c If a large member of a netting group were to fail to settle on a given day, the
other members of the group would be forced to quickly find extra reserves, or they too would be unable
to settle. This might lead to a cascade of failures to settle.
Unlike the Fed, which can stem such a cascade by creating bank reserves, a private-sector settlement
system must plan on some other way to stem the spread of such failures to settle, should such occur. Under
certain circumstances, the Visa system relies on unwinding.1 In an unwinding, if a particular bank should
fail to settle at the time appointed for the bank to deposit the amount it owes other banks in the system, Visa
would remove that bank and all its associated transactions from the day's settlement. After doing this
unwinding, Visa would recast settlement with the other banks in the system. If a settlement failure occurs
a second time, Visa would not attempt net settlement again, sending all the transactions to the Federal
Reserve for settlement instead.
While unwinding transactions in a large-dollar-value settlement system poses a significant risk of
systemic failure, it's less of a problem for transactions in a small-dollar-value system such as ACH. For
example, the July 1992 transactions data for the Third District (described in footnote b) indicates that the
system could have settled via unwinding each day had the largest net debtor failed.

aThis simple example presumes that banks do not overdraw their accounts at the Fed during the day. Although banks
may overdraw to a limited extent, the Fed encourages them not to exceed those limits. See George R. Juncker, Bruce J.
Summers, and Florence M. Young, "A Primer on the Settlement of Payments in the United States," Federal Reserve Bulletin,
November 1991, pp. 847-58, for a discussion of the settlement process of the Fed.
bThe reduction in reserve account balances in moving from gross to net settlement appears to be substantial. For the
10 banks that were the largest users of ACPI in the Third Federal Reserve district and all the banks in the U.S. that had ACH
transactions with at least one of these, the average daily gross payments for July 1992 were $1.34 billion; multilateral net
payments were only $214 million, just 16 percent of the gross payments.
cSee Patrick Parkinson and others, "Clearance and Settlement in U.S. Securities Markets," Board of Governors of the
Federal Reserve System, Staff Study 163 (March 1992), for an extended discussion of the risks in settlement systems.
dIn addition to unwinding in a settlement failure, Visa uses an extensive array of risk-control devices. The description
of Visa's system is taken from "Proposal to the Board of Governors of the Federal Reserve System for a Net Settlement
Account for the VisaNet Automated Clearing House System, May 1990," provided to me by Visa.



The Automated Clearinghouse System: Moving Toward Electronic Payment

James McAndrews

was an early convert to ACH. Today, ACH ment, and to pay for purchases from private
transactions are concentrated in four types.
Direct Deposit of Payrolls. As mentioned
Government Payments. The federal gov­
ernment has been a leader in using ACH. The earlier, an estimated 30 percent of the U.S. work
Social Security Administration, the Department force uses ACH for direct deposit of their
of the Treasury, and the Department of Defense wages, an increase from just 4 percent in 1984.
have expanded the use of ACH considerably. This makes direct deposit the most common
Over 85 percent of Social Security benefits are use of ACH and the one with which people are
paid by ACH. The federal government began most familiar. Direct deposit of payroll is an
using ACH for direct deposit of payrolls as example of a credit transaction.
Both parties often prefer direct deposit. Stud­
early as 1975.
In addition to being a leader in paying Social ies have found that direct deposit is less costly
Security benefits and wages through ACH, the than check payment, making ACH attractive to
U.S. Treasury and the Department of Defense employers.8* Furthermore, an employer could
both have programs under way to convert to
ACH most payments to their vendors and
8Dudley, 1984 (see footnote 2 for complete reference),
contractors. In the Treasury's program, called
Vendor Express, over $61 billion in payments and David B. Humphrey and Allen N. Berger, "Market
were made through the ACH, compared with Failure and Resource Use: Economic Incentives to Use Dif­
ferent Payment Instruments," in David B. Humphrey, ed.,
$44 billion made by check (and $209 billion by The U.S. Payment System: Efficiency, Risk and the Role o f the
wire transfer— used for high-dollar-value pay­ Federal Reserve (Kluwer Academic Publishers, 1990), pp.45ments) in fiscal year 1992. In the Department of 86 .
Defense program over 28
percent of major contract
paym ents are currently
ACH Transaction Volume
made by ACH.
The fed eral gov ern ­
Number of Transactions
Dollar Values
ment's use of ACH is likely
to expand, since one of the
recommendations of Vice
President Gore's National
Performance Review for
the federal government is
to use ACH to reimburse
expenses for its employees,
to make payments to other
agencies of the govern-

7Transaction volume for the
ACH was about 2 billion payments
in 1992, with a value of $7.8 tril­
lion (see Figure). This compares
with 57 billion checks written in
1991 for a dollar value of $66 tril­








Note: All dollar values in trillions
Source: National Automated Clearing House Association




cause hardships for its employees if it attempt­
ed to exploit float by drawing checks on an outof-state bank, for example, to take advantage of
the time between when the checks were written
and when the money was actually transferred
to their employees' accounts. The long-term
nature of the employment relationship miti­
gates employers' incentive to exploit this ad­
vantage of checks. Employees frequently pre­
fer ACH because, with direct deposit, they
avoid trips to the bank to deposit paychecks.
Often, such trips can take place only at lunch
time when banks are congested, so direct de­
posit avoids a waste of time and energy.
Consumer Bill-Paying. Paying bills by ACH
is potentially a major convenience for people.
According to NACHA, of the almost 2 billion
ACH transactions made in 1992, 800 million
were consumer bill payments, twice the num­
ber of 1989.9 However, this represents a small
share of the approximately 20 billion bill pay­
ments made annually by consumers. About
half of all ACH bill payments are for insurance
premiums, while the remaining payments are
evenly split among mortgage loans, utility pay­
ments, and auto and other loans.
Customers can benefit from this service be­
cause it reduces time and postage in preparing
and sending bill payments. Companies can
benefit by reducing processing costs through
handling fewer checks and obtaining payment
in a timely fashion, which allows the company
to better manage its cash needs.
Corporate-to-Corporate Payments and Cash
Concentration. The main business use of ACH
has been for "cash concentration." This ACH
transaction allows units of a widely dispersed
company to send money to a central deposit
account. By doing this the company can econ­
omize on deposits, rather than having a large
amount of money in several accounts across the

country. ACH has allowed companies to do
this much more quickly and at a lower cost than
was possible by check.
The payment of bills by one company to
another, while a potentially beneficial use of
ACH, is still overwhelmingly done by check.
According to NACHA, in 1992, of the more
than 10 billion trade payments made, fewer
than 10 million were made by ACH.1

9These data on transaction volumes were supplied by

10These data on transaction volumes were supplied by


While government use of ACH and the use
of ACH for direct deposit of payroll have seen
impressive growth, the growth of ACH in con­
sumer bill payment and corporate trade pay­
ments has been slow. Partly this reflects tech­
nological advances that have increased the
speed of check collection and processing. Be­
cause of technological developments in auto­
mated reading and sorting machines, a great
deal of electronic sophistication is now used in
processing checks. More rigid collection times
and disbursement times for check availability,
mandated under the Expedited Funds Avail­
ability Act of 1988, along with improved tech­
nology, have reduced delays in check collec­
tion, reducing float and increasing the accept­
ability of checks to payees.
In the case of consumer bill-paying and cor­
porate trade payments, ACH payments also
have some unique features that have made it
difficult for ACH to gain ground on checks.
Whose Bill Is It? Paying bills using ACH has
encountered two primary difficulties in gain­
ing acceptance. F irst, in settin g up a
preauthorized debit transaction, in which a
company directly debits the customer's ac­
count, the customer gives up the freedom to
delay payment if she is temporarily short of
funds. Instead she must make sure the money


The Automated Clearinghouse System: Moving Toward Electronic Payment

is in her account before the company initiates
the ACH debit transaction, which may require
greater attention on the customer's part; this
effort may not be worth the savings in time and
postage of writing and mailing checks. In
addition, for many people, writing a check acts
as a reminder to verify checking account bal­
ances and to put money into their checking
accounts to ensure that the balance is large
enough to cover the checks they have just writ­
The second difficulty of making bill pay­
ments occurs with credit transactions. Many
companies do not accept bill payments by
ACH— only a check will do. The bill-payment
service of Germantown Savings Bank in Phila­
d elp hia v iv id ly illu stra tes this point.
Germantown Savings has had a telephone bill­
paying service since 1979, and many customers
use it. Over 45,000 payments are made each
month through the service to more than 21,000
different firms. However, only 172 of these
firms accept payments by ACH. For all the
other firms, Germantown Savings must write
checks to pay the bills.
Why do many firms choose not to accept bill
payment by ACH? Because they are not likely
to reap any cost savings by doing so. A credit
transaction could arrive on any day of the
month, and to easily find out the account num­
ber of the customer making payment, the com­
pany needs a computer link with its bank so that
the bank can transfer the invoice information in
machine-readable form. Even then, the firm
must learn how to interpret the standardized
account information encoded into the ACH
payment, information which, with check pay­
ment, would arrive with the check on the com­
pany's own customized invoice. Furthermore,
the company must maintain a system to read
this information and update its accounts in
response to the payment information. This
process of learning and maintaining systems to
read new ways of conveying information can be
costly: witness the difficulty the U.S. has had in

James Me Andrews

attempting to convert to the metric system of
measurement. Thus, the total cost to the com­
pany of an ACH transaction may end up being
higher than the cost of accepting payment by
As a result of these control and information
cost considerations, consumer bill payment has
not made as much progress in displacing checks
as many had hoped. Some new attempts at
solving these problems are being made, espe­
cially in utility-bill payments. Utility payments
are repetitive, and most important, only a small
amount of information needs to be sent along
with payment—the account number of the cus­
Several of the regional automated clearing­
house associations have taken the lead in pro­
moting the use of ACH for the payment of
utility bills. In particular, the Hawaiian ACH
Association, the Mid-America Payment Ex­
change in Omaha, and the Mid-America Auto­
mated Payment System in Cleveland all have
conducted marketing efforts to promote the
use of preauthorized automated utility-bill pay­
The Hawaii program has probably been the
most successful: more than 20 percent of the
customers of the Honolulu Board of Water
Supply, for example, now pay their bills through
ACH, compared with a national average of less
than 3 percent of utility bills paid by ACH.
Furthermore, about half of all signups between
September 1990 and September 1991 took place
during the three months of an advertising cam­
Pacific Bell has created another innovation
in paying utility bills through ACH. Its system
allows a consumer to call a telephone number,
review the amount of her bill, and then instruct
the company to debit her account on a particu­
lar day. This system solves the problem of the
consumer's feeling that she doesn't control the
timing of her payment in a debit transaction,
while it preserves the merchant's preference,
when choosing between debit and credit trans­



actions, for the easier-to-process debit transac­
Your Format Is Not Talking to My Format.
For corporate trade payments a different prob­
lem arises.1 Whenever payment is separated in
time from delivery of the purchased item, in­
formation must accompany the payment to
match it to the corresponding delivery. Often
the information can be quite complex. Correc­
tions to the invoice may be needed, or multiple
invoices may correspond to a single payment.
Until the early 1980s ACH was unable to con­
vey such potentially large amounts of informa­
tion along with the payment instructions.
The problem facing ACH was choosing a
standard format for the information accompa­
nying a payment. For example, suppose a firm
wishes to send payment information to another
firm. To do so, the first firm (or its bank) must
translate its own internal format for the infor­
mation into a standardized format, and the
receiving firm must then translate the stan­
dardized information into its internal format.
If the standard chosen by the ACH is cumber­
some or not widely used by firms in other
applications, the translation step could be cost­
ly and would ultimately inhibit the use of ACH.
At the time that the ACH was created, firms
were just beginning to engage in electronic data
interchange (EDI). NACHA recognized the
need to send information along with payment
and, in 1983, created a type of transaction,
called the corporate trade payment (CTP), to
include both payment and invoice information.
However, the CTP turned out to be incompat­
ible with the direction of the emerging stan­
dards used in EDI; therefore, a receiving firm's
computer could not understand the message
sent. NACHA soon understood that the CTP
format was flawed. By 1985 NACHA devel­

oped another format for information, the cor­
porate trade exchange (CTX), which was com­
patible with the new standards in EDI and
which has proven much more successful, its
use growing, according to NACHA, by 153
percent in 1992.1 Undoubtedly, the difficulty
in finding a standard and the slow acceptance
of the agreed-upon standard have slowed the
acceptance of ACH for trade payments.

n See Scott E. Knudson, Jack K. Walton II, and Florence
Young, 1994 (see footnote 6 for complete reference), for a
comprehensive overview of the issues raised in this section.

12See Bernell K. Stone, One to Get Ready: How to Prepare
Your Company fo r EDI (CoreStates Bank, 1988), for more on
the development of the CTX transaction.


Check-processing technology has improved
over time, with the use of lockboxes spreading
and with progress in developing check trunca­
tion using digital imaging. Developments in
electronic payment systems have occurred as
well, including point-of-sale systems and cor­
porate credit cards. All of these potentially
could compete with ACH.
Lockboxes have become an important meth­
od for firms to collect payments. With a lockbox,
a company directs its customers to send their
payments to a post office box. The firm's bank
then collects the mail, deposits the enclosed
checks, and then sends the firm information
about who paid. The information sent by the
bank to the firm is sometimes sent electronical­
ly by having the customer enclose with pay­
ment a document that can be read with an
optical scanner. When payment is received, the
bank scans this document and then sends this
machine-readable information to the firm. This
form of collection quickens the availability of
checks and, in some cases, takes advantage of
electronic processing.
Check truncation, which involves taking a
digital image of the check at the bank of first
deposit and, thereafter, simply sending the
digital image electronically to the payer's bank,


The Automated Clearinghouse System: Moving Toward Electronic Payment

reduces the transportation cost of a check. If the
imaging technology becomes more developed,
and if use of the system grows enough to allow
the high capital costs of the system to be spread
over a large number of items, the processing
cost could be less than that of processing a
paper check. And truncation would offer con­
sumers the benefits of familiarity and control
that they enjoy with check-writing, although
their checks would not be returned to them.
However, the challenge of creating a successful
system is similar to that of developing the
system for corporate trade payments by ACH:
agreeing on, developing, learning, and main­
taining technologies to convey payment and
invoice information electronically; and ensur­
ing that such technologies are sufficiently easy
to use that they will be adopted on a wide­
spread basis.
Point-of-sale (POS) systems are becoming
more popular in grocery stores and gas sta­
tions, places where both cash and checks are
used, and for payments that are less repetitive
than those primarily suited to ACH. The POS
systems often settle their interbank balances by
ACH, so to that extent they are complementary
to ACH.
Corporate credit cards that feature monthly
bills providing detailed information (sometimes
available in electronic form) that a business
needs to monitor and account for the purchases
it makes are now being offered by banks. Such
a service eases many problems in making lowvalue purchases by reducing the time and effort
it takes to process and verify invoices. The
transactions feature of corporate credit cards is
another competitor for payments that are less
repetitive than those best suited for ACH.

James McAndreivs

While the Automated Clearinghouse has not
eliminated the check as a means of payment,
specific uses of ACH have been successful. In
particular, direct deposit of payrolls and the
government's use of ACH have shown signifi­
cant growth.
In consumer bill-paying and
corporate trade payments, obstacles to greater
use of ACH are gradually being overcome.
The obstacles to more widespread use of the
ACH include the difficulty of agreeing on,
developing, learning, and using new ways of
communication that can easily convey invoice
information, and issues of consumer control of
the timing of payment.
These obstacles are being overcome in spe­
cific types of payments: utility payments re­
quire little additional information to be con­
veyed, are repetitive, and are an area of healthy
growth in the use of ACH; corporate trade
payments are also an area of growth, in part
because of the adoption of the CTX transaction
format, which is compatible with other, more
commonly used forms of electronic communi­
cation. However, many corporate payment
invoices are complex and require that a large
amount of information accompany payment,
and these payments, even if repetitive, are less
likely to be made by ACH.
New methods of payment are now being
developed that have specific advantages over
ACH for certain kinds of transactions. Thus it
appears that the future will hold not just one
type of payment method but many, including
paper checks, lockboxes, check truncation,
point-of-sale systems, and the Automated Clear­


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