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Business
Review
Federal Reserve Bank of Philadelphia
July • August 1995




ISSN 0007-7011

auction toda*

There’s
More than
One Way
to Sell
r
Do You *
c
h
^
B
a
Security:
Know How Mi
Money Is in Y<
I Treasury’s
Public Purse
1
Auction
Robert P. Inman
^ Experiment
Loretta J. Mester

Business
Review

The BUSINESS REVIEW is published by the
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edited by Sarah Burke. Artwork is designed
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Digitized for2 FRASER


JULY/AUGUST 1995

THERE'S MORE THAN ONE WAY TO
SELL A SECURITY: THE TREASURY'S
AUCTION EXPERIMENT
Loretta J. Mester
In the wake of Salomon Brothers' ac­
knowledgment of serious violations of
the auction rules, the Treasury began
experimenting with a new way to auction
its securities in 1992. While the Treasury
has used auctions to sell securities since
1929, auctions can take many forms, and
determining which format produces the
most revenue isn't an easy task. Conse­
quently, the Treasury has, from time to
time, experimented with different for­
mats. Loretta Mester explains some of
the factors involved in auctions and dis­
cusses the Treasury's previous and cur­
rent experiments with auction formats as
well as evidence from auctions in other
countries.
DO YOU KNOW HOW MUCH MONEY
IS IN YOUR PUBLIC PURSE?
Robert P. Inman
Most of us know how our various gov­
ernments are doing in areas like educa­
tion, road maintenance, and tax collec­
tion, but few of us know how much money
is in our public purse— that is, each
citizen's share of the national savings and
wealth controlled by federal, state, and
local governments. Bob Inman describes
the various components that make up
our national wealth and demonstrates
how our governments' net worth affects
our economic future. Furthermore, he
points out that knowing what's in our
public purse is a good starting place if we
want more rational and considered pub­
lic tax and spending policies.

There's More than One Way
To Sell a Security: The Treasury's
Auction Experiment
Loretta ]. Mester *

TX o finance a deficit of over $200 billion and
to refinance maturing debt, the U.S. govern­
ment sold more than $2 trillion of Treasury
securities in 1994 at regularly scheduled auc­
tions. The ability of the government to con­
tinue to borrow in this way depends on there
being a well-functioning market for govern­
ment securities. Such a market benefits the
taxpayers by lowering the government's bor­
rowing cost. In addition, it provides a conve­
nient way for the Federal Reserve to imple­
ment monetary policy. The health of the Trea-

*Loretta Mester is an assistant vice president and head of
the Banking and Financial Markets Section in the Philadel­
phia Fed's Research Department. She is also an adjunct
assistant professor of finance at the Wharton School, Uni­
versity of Pennsylvania.




sury security market depends on participants'
perception that it isn't subject to manipulation.
However, the integrity of the Treasury se­
curities auction market was called into ques­
tion when Salomon Brothers, Inc., admitted in
August 1991 to serious violations of the auc­
tion rules during 1990 and 1991. This led to
Congressional hearings and a review of the
market by the Treasury, Federal Reserve Sys­
tem, and the Securities and Exchange Com­
mission.1Following one of their recommenda-

1See The Activities of Salomon Brothers, Inc., in Treasury
Bond Auctions, Hearings Before the Subcommittee on Securities
o f the Committee on Banking, Housing, and Urban Affairs, U.S.
Senate, (September 11-12, 1991), and Joint Report on the
Government Securities Market, Department of the Treasury,
Securities and Exchange Commission, Board of Governors
of the Federal Reserve System (January 1992).

3

BUSINESS REVIEW

JULY/AUGUST 1995

tions, in September 1992, the Treasury began
selling two-year and five-year Treasury notes
using a uniform-price auction, in which all win­
ning bidders pay the same price, rather than a
discriminatory-price auction, in which winning
bidders pay what they bid.
The choice of auction format is important,
since the format can affect the amount of rev­
enue the government will raise in an auction
and, therefore, the government's borrowing
costs. In its announcement on September 3,
1992, the Treasury stated that it would con­
sider the uniform-price auction a success if "it
reduces the U.S. government's finance costs,
whether by encouraging more aggressive bid­
ding by auction participants or by attracting
more bidders to the auctions."2 Auction theory
provides a basis for determining which format
to use and provides a rationale for the experi­
ment. Yet the theory is based on simple mod­
els, and the world is not a simple place. Thus,
empirical analysis is needed to ultimately de­
termine which format is better. While analyses
of the data from previous experiments both in
the United States and abroad are inconclusive,
most favor the uniform-price auction. Since
the current experiment is quite young, it, too,
has not yet produced conclusive evidence, but
the results thus far do support continuing the
experiment so that more data can be collected.

have maturities of more than a year), using
methods that set the price before the sale of the
securities.3 But increased volatility of interest
rates made such methods risky for the seller
and for buyers. So the Treasury began using a
modified auction method for notes and bonds
in 1970 and a more standard auction method in
1974.
The Primary Market. The Treasury sells
securities at regularly scheduled auctions,
which constitute the primary market: 13- and
26-week bills are sold weekly, one-year bills
are sold every four weeks, two- and five-year
notes are sold monthly, three-year and 10-year
bonds are typically sold at the quarterly
refinancings, and 30-year bonds are sold semi­
annually. The gross amount issued has grown
through time and was over $2 trillion in 1994
(Figure 1). About one week prior to the auc­
tion, the Treasury announces the dollar amount
of the particular security it wishes to sell at the
auction and invites tenders (sealed bids) for a
specified dollar amount of these securities.
Bids are due by a specified time on the day of
the auction, and the Treasury usually publi­
cizes the results later that afternoon. The
securities are then issued to successful bidders
within a few days to about a week after the
auction.4

HOW TREASURY SECURITIES ARE SOLD
Auctions have been used to sell Treasury
bills (that is, Treasury securities with maturities
of a year or less) since they were introduced in
1929. But auctions are not the only way the
Treasury could issue its debt. Until the early
1970s, the Treasury sold notes and bonds (which

3Appendix A of the joint Report on the Government
Securities Market, Department of the Treasury, Securities

2In "Managing the Public Debt," in this Business Re­
view (July/August 1994), Keith Sill discusses why the
government might want to minimize its interest costs:
lower costs mean lower taxes, and if taxes are distortionary
to economic activity, then lower taxes provide an eco­
nomic benefit.


4


and Exchange Commission, Board of Governors of the
Federal Reserve System (January 1992) provides an excel­
lent overview of the history and current operation of the
government securities market, and is the source of much of
the information in this section. See also James F. Tucker,
Buying Treasury Securities at Federal Reserve Banks (Federal
Reserve Bank of Richmond, October 1993) and Loretta J.
Mester, "Going, Going, Gone: Setting Prices with Auc­
tions," this Business Review (M arch/April 1988), pp. 3-13.
4For 13- and 26-week bills, the Treasury announces the
weekly offerings on Tuesday, auctions the bills on the
following Monday, and issues the bills on the Thursday
following the auction. For 52-week bills, it announces on
a Friday, auctions on the following Thursday, and issues

FEDERAL RESERVE BANK OF PHILADELPHIA

There's More than One Way to Sell a Security: The Treasury's Auction Experiment

Loretta J. Mester

auction awards to private
investors and over 90 per­
cent of note and bond
Gross Issues
awards, despite the fact
of Marketable Treasury Securities
that, on average, only about
75 to 85 bidders submit com­
Trillions of Dollars
petitive bids, while there are
nearly 20,000 noncompeti­
tive bidders per auction.
Money market banks, deal­
ers, and other institutional
investors who purchase
large quantities of securi­
ties typically submit com­
petitive bids. These ten­
ders indicate the amount of
the security they want to
purchase and the price they
are willing to pay. This price
is stated in terms of the yield
Years
(or the discount rate for
bills) that investors are will­
ing to accept for investing
Source: U.S. Department of Treasury, Office of Market Finance
in the security: higher yields
Two different types of bids can be submit­ mean lower prices paid by the investor, and
ted in Treasury auctions: competitive and non­ hence, higher borrowing costs to the Treasury.
competitive.5 The awards to competitive bid­ Competitive bidders are permitted to submit
ders account for the larger percent of total more than one bid, but no single bidder is
awards: they average about 80 percent of bill allowed to win more than 35 percent of the
total amount of the security being sold.6 This
rule is intended to prevent any bidder from
on the Thursday following the auction. For two- and fivecornering the market in a particular security.
FIGURE 1

year notes, it usually announces on a Wednesday in mid­
month, auctions a week later, and issues on the last day of
the month. For three- and 10-year notes, it usually an­
nounces on the last Wednesday of January, April, July, and
October, auctions during the first full week of February,
May, August, and November, and issues on the 15th of the
auction month. Auctions of 30-year bonds follow the same
schedule but are offered just twice a year, in January and
July. (See Tucker, p. 25.) The Treasury stopped selling
seven-year notes after April 1993; prior to this the Treasury
offered them quarterly with the three- and 10-year notes.
The minimum denominations sold are $10,000 for bills;
$5000 for two- and three-year notes; and $1000 for other
notes and bonds. Securities are sold in $1000 increments
above the minimum denominations. (See Tucker, pp. 11 &
17).




5Bids can be submitted at Federal Reserve Banks and
most of their branches and at the Treasury's Bureau of the
Public Debt. Competitive bids are usually due by 1 pm on
the day of the auction and noncompetitive bids by noon—
these two types of bids are described in the text below. In
addition to private bidders, the Federal Reserve also buys
securities at the auctions to replace maturing issues in its
own account and on behalf of foreign governments. The
Fed is treated as a noncompetitive bidder.
6While a single bidder can submit bids for more than 35
percent of the offering at one yield, the Treasury does not
recognize the excess. See p. A-5 of the Joint Report.

5

BUSINESS REVIEW

JULY/AUGUST 1995

A significant group of competitive bidders and five-year notes.7 Once the bids are in, the
in Treasury auctions are the so-called primary Treasury sets aside the amount of securities
government securities dealers. Currently there requested by the noncompetitive bidders. The
are 39 such dealers, whose role is to ensure that remainder is allocated to the competitive bid­
there is wide participation in the Treasury ders, beginning with those who bid the highest
security auctions. They purchase large amounts price (that is, lowest yield) and then working
of Treasury securities in the auctions for their down, until the total amount is issued. A win­
own accounts, and they also purchase securi­ ning competitive bidder pays a price equal to
ties for their customers. The Federal Reserve what he bid, which is what makes this a dis­
buys and sells securities from these dealers in criminatory-price auction. During the past five
conducting monetary policy. In general, these years, about 35 to 45 percent of the dollar
dealers account for over two-thirds of awards volume of bids submitted in each auction by
over $1 million. But they typically do not hold private investors were accepted, that is, won
the securities they have purchased; often they securities, with the higher percentage occur­
have made arrangements prior to the auction ring in auctions of longer maturities, since
to sell the securities they will win. (See the there is a lower volume of bids in these auc­
discussion of the when-issued market below.) tions (Figure 2).
The other type of bids in Treasury auctions,
noncompetitive bids, are made by smaller or
7The Treasury also experimented with a uniform-price
less experienced investors. By placing a non­ bond auction from 1973-76.
competitive bid, the bid­
der is assured of winning
FIGURE 2
the amount that he indi­
cated on his tender, up to
Total Volume of Submitted & Accepted Bids
the $1 million limit placed
on such bids for bills and
(excluding Federal Reserve tenders)
the $5 million limit placed
on such bids for notes and
□ Two-Year Notes
Billions
bonds. The tender does
□ Three-Year Notes
of Dollars
□ Five-Year Notes
not indicate the price,
600
■ Seven-Year Notes
since a noncom petitive
□ Ten-Year Notes
□ Thirty-Year Notes
bidder agrees to pay the
quantity-weighted aver­
age of the accepted com­
petitive bid prices.
Submitted
Until the current auc­
- / Bids
tion experiment, the Trea­
Accepted
sury had relied on dis­
Bias
criminatory-price auctions
to determine the winners
and the prices they paid in
all of its security auctions,
1989
1990
1991
1992
1994
1993
and it continues to use this
m ethod for secu rities
other than the two-year
Digitized for
6 FRASER


Source: Treasury Bulletin, U.S. Department of Treasury, various issues

FEDERAL RESERVE BANK OF PHILADELPHIA

There's More than One Way to Sell a Security: The Treasury's Auction Experiment

This primary auction market does not stand
in isolation. Other related markets can affect
the strategies bidders use in the primary auc­
tion market.
The When-Issued Market. Even though
the auction market is called the primary mar­
ket for Treasury securities, it isn't the first
place a particular security is bought or sold. In
fact, between the time the auction of a particu­
lar security is announced until the time the
security is issued, traders can buy or sell that
security in a forward market called the whenissued market.8 In this market, sellers contract
to deliver a particular security on its issue date
at a certain price. Notice that such trading can
(and does) occur before the auction, and so
occurs before sellers know whether they have
won the security in the auction and before they
know the winning prices. Unlike competitive
bidders in the auction, the buyers in this mar­
ket know the amount of the security they will
receive on the issue date and the price they will
have to pay.9
The existence of when-issued trading can
affect the strategies bidders use in the auctions
because it affects bidders' positions as they go
into the auction: bidders who have bought the
security in the when-issued market before the
auction go into the auction with long positions
(that is, they already own some of the securi­
ties) and bidders who have sold the security in
8For example, the weekly auction of 13-week Treasury
bills is announced on Tuesday; the auction is held the
following Monday, and the bills are issued on Thursday.
So the when-issued market for this bill runs from Tuesday
to Thursday of the following week.
9For further discussion of the when-issued market, see
Suresh Sundaresan, "An Empirical Analysis of U.S. Trea­
sury Auctions: Implications for Auction and Term Struc­
ture Theories," First Boston Working Paper Series, FB-9237, Graduate School of Business, Columbia University
(November 1992); and Kjell G. Nyborg and Suresh
Sundaresan, "Discriminatory Versus Uniform Treasury
Auctions: Evidence from When-Issued Transactions,"
mimeo (October 1994).




Loretta J.M ester

the when-issued market go into the auction
with short positions. Another reason the whenissued market can affect bidders' strategies is
that it serves a "price discovery" role. By par­
ticipating in this market and seeing the prices
at which trades are being made, traders gain
information on the strength of demand for an
issue and on the disparity of participants' views
about the issue, which can be useful when they
prepare their own bids. On the other hand,
participants who feel they have some very
valuable private information concerning the
value of the issue (for example, they have what
they believe is a more accurate forecast of
interest rate changes) might refrain from trad­
ing in this market so that they can keep the
information private and use it in preparing
their bids.
The Secondary Market. Once a Treasury
security is issued it can be traded in a second­
ary market. This market is mainly an over-thecounter market in which dealers, brokers, and
other investors make trades over the phone;
the most active trading is in the most recently
issued securities. The existence of the second­
ary market also affects the strategies bidders
use in the auction. In fact, it can affect the
choice of participating in the auction in the first
place, since it provides another place in which
to purchase the security.10
THE AUCTION EXPERIMENT
AND ITS RATIONALE
One of the Treasury's aims is to maximize
the revenue it receives or, what is the same
10Another important market in which Treasury securi­
ties are traded is the repo market. Dealers are able to buy
or sell Treasury securities for short-term periods (usually
overnight) using repurchase agreements ("repos"). A repo
seller provides securities in exchange for funds and agrees
to repurchase the securities at the price and date specified
in the repo contract. The market can be used to finance
securities' positions, to obtain securities temporarily to
complete other transactions, or to invest idle cash bal­
ances. (See Joint Report, pp. A11-A12.)

7

BUSINESS REVIEW

thing, lower its borrowing cost. But it isn't
enough to consider which auction format will
maximize revenue from a single auction—
selling securities isn't a one-shot game; the
Treasury has to determine the long-run impli­
cations from using a particular format. While
one format might lead to more revenue than
another when a single auction is considered, if
the format is more vulnerable to manipulation
by a single bidder or collusion by a group of
bidders, it may lead to decreased participation
in future auctions, which has negative implica­
tions for revenue over the long run. If partici­
pants feel the auction is unfair or that more
informed bidders can take advantage of less
informed bidders (perhaps by colluding), the
demand for securities in the auction may de­
cline. Uninformed bidders might decide to
wait to purchase the securities they need in the
secondary market, which would mean less
revenue for the government. Similarly, if one
type of format is more vulnerable to collusion,
it, too, might not be the best choice, even if in
the absence of collusion it might be the type of
auction that maximizes the government's rev­
enues.
In September 1992, the Treasury announced
that it would conduct a uniform-price auction
experiment, including all auctions of two- and
five-year notes from September 1992 through
August 1993. The experiment has been ex­
tended twice, the second time on August 3,
1994, for all two- and five-year notes indefi­
nitely. In the uniform-price auction, the win­
ners are determined in the same way as in the
discriminatory-price auction, but instead of
paying the price they bid, all winners pay the
same price, which is the highest rejected bid
(or what is the same thing for Treasury auc­
tions, the lowest accepted bid).1112
On the face of it then, it would seem that the
Treasury would make more revenue from sell­
ing its securities via a discriminatory-price
auction, since those submitting higher bids
would pay the amount they bid for a security,

8


JULY/AUGUST 1995

while in a uniform-price auction they would
pay less. But the auction format can also affect
demand for securities; if uniform-price auc­
tions increase demand, this may more than
compensate for the loss of revenue due to a
single price. And as discussed above, some
auction formats are more susceptible to ma­
nipulation or collusion than others, which can
directly affect revenue and indirectly affect
demand and, therefore, revenue.
Some Simple Auction Theory. Arguments
in favor of the uniform-price auction for Trea­
sury securities are based on what has been
learned from economic models of auctions.*123
Economists model an auction as a game with
bidders playing against each other. The object
of the game is to win the object being auctioned
at the lowest possible price, and each bidder
devises a strategy with this in mind. A bidder's
strategy will depend on what information the
bidder has. Some information will be available
to all bidders (for example, the Treasury an­

n In Treasury auctions these two prices are the same,
since there is always excess demand for Treasury securi­
ties at the lowest accepted bid.
12This was not the first time a uniform-price auction
had been recommended or used in U.S. financial markets.
In 1960, Milton Friedman, who later won the Nobel Prize
in economics, recommended that the Treasury switch to a
uniform-price auction to sell Treasury bills; others dis­
puted his recommendation. In six auctions between Janu­
ary 1973 and May 1974, the Treasury sold long-term bonds
this way. In the wake of the Salomon Brothers scandal,
Friedman reiterated his recommendation for the uniformprice auction (see Wall Street Journal, August 28, 1991, p.
A8).
13Most of the models have focused on the auctioning of
a single object. For nontechnical discussions of auction
theory see Mester (1988); Paul Milgrom, "Auctions and
Bidding: A Primer," Journal o f Economic Perspectives, 3 (Sum­
mer 1989), pp. 3-22; Sushil Bikhchandani and Chi-fu Huang,
"The Economics of Treasury Securities Markets,"/ouraa/ of
Economic Perspectives, 7 (Summer 1993), pp. 117-34; John
McMillan, "Selling Spectrum Rights," Journal of Economic
Perspectives, 8 (Summer 1994), pp. 145-62.

FEDERAL RESERVE BANK OF PHILADELPHIA

There's More than One Way to Sell a Security: The Treasury's Auction Experiment

nounces the auction date and size of the issue
before each auction, and the auction rules are
known to all), but other information is pri­
vately held by each bidder. The assumptions
made in theoretical models about the nature of
bidders' private information range along a
broad spectrum. At one end of the spectrum,
models assume each bidder knows for certain
how she values the object and that this infor­
mation is totally private, reflecting her indi­
vidual taste for the object—this is called a
private values auction. At the other end, models
assume that the object is worth the same to all
bidders but that they are unsure of this value—
this is called a common values auction. A
bidder's private information might tell her
something about the true market value of the
object, although not enough to be certain. At
the time of bidding, no bidder knows the mar­
ket value for sure and each makes an estimate
of this value based on her private information.
Treasury auctions are more like common
values auctions than private values auctions,
since the value of the security is largely deter­
mined by its value in the secondary market. A
bidder in a common values model would like
to discover the private information of other
bidders not only because it would tell her
something about how those other bidders are
likely to bid, but also because it would reveal
something more about the likely market value
of the object, which is what each bidder is
trying to estimate. Also, the bidder's profit is
determined by her private information—if all
information is public, then the winner will not
earn any profit in the auction; the rewards to
bidding in a common values auction depend
on the value of the bidder's private informa­
tion.
Common values auctions are subject to the
"winner's curse," which affects bidders' strat­
egies and therefore the revenue that a seller,
like the Treasury, can expect to receive in the
auction. Each bidder is unsure of, but forms
some estimate about what the object being sold



Loretta J.M ester

is worth; in Treasury security auctions it would
be the price of the security in the secondary
market. If she bids her estimate and wins, this
tells her that everyone else thinks the object is
worth less than she did. On average, the
winner who bids her estimate will pay more
than the object is worth on the open market.
Hence, winning is a curse! To avoid the curse,
each bidder should shade her bid down from
what she thinks the object is worth. But shad­
ing the bid below her estimate can affect the
bidder's probability of winning. Hence, the
amount a bidder shades from her estimate
depends on how many other bidders there are
and also how the bidder feels about the risk of
losing. When there are fewer bidders, a bidder
can shade down her bid more without affect­
ing her probability of winning, because there is
less chance that someone else's bid lies just
below hers. If a bidder is risk-averse, she will
care very much about the risk of losing the
object and will shade down her bid less than if
she were risk-neutral, as a kind of insurance
against losing: a risk-averse bidder is willing
to pay more to avoid the loss from losing. The
amount of bid shading is also affected by the
degree of information differences across bid­
ders.
The winner's curse also gives bidders the
incentive to gather more information about the
value of the object being sold. As explained
above, in Treasury auctions this information
can be garnered in the when-issued market.
Hence, when the winner's curse is severe, it is
likely that there will be more trading in the
when-issued market. It also means that bid­
ders have more incentive to pool their bids,
since this helps them get a better estimate of
the common value, and the use of dealers who
pool bids and place large orders will be higher.14
Rationale for the Experiment. One ration­
14See Vincent Reinhart, "An Analysis of Potential Trea­
sury Auction Techniques,"Federal Reserve Bulletin, 78 (June
1992), pp. 403-13.

9

BUSINESS REVIEW

ale for switching to a uniform-price auction
from a discriminatory-price auction is that,
when bidders are risk-neutral, the uniformprice auction is less susceptible to the winner's
curse. In a discriminatory-price auction, a riskneutral bidder will tend to shade down her bid
more than in a uniform-price auction because
her bid is also what she pays when she wins; if
other bidders estimate the value to be much
lower than she does, the winning bidder will
be paying much too high a price. In a uniformprice auction, on the other hand, the winning
bidder need not be too worried about paying
way too much; she can bid high to improve her
chance of winning, but she doesn't have to pay
this high price. (Recall, she only has to pay the
lowest accepted bid.) In other words, bidders
bid more aggressively in the uniform-price
auction than in the discriminatory-price auc­
tion. In fact, when bidders are risk-neutral and
only one object is being sold, the price paid by
the winner in a uniform-price auction is higher
on average than the price paid by the winner in
a discriminatory-price auction. This theoreti­
cal result for auctions of single objects plays a
large role in arguments made for switching to
uniform-price Treasury auctions, despite the
fact that in Treasury auctions more than one
object is being sold.
The other line of argument for changing
auction formats is based on the potential for
manipulation or collusion afforded by differ­
ent auction techniques, which can affect auc­
tion revenues. Collusion is bad from the seller's
viewpoint if it involves bidders' conspiring to
keep prices down. Several economists have
argued that collusion might be more difficult
in the uniform-price auction than in the dis­
criminatory-price auction. They argue that
because the winner's curse is less severe in the
uniform-price auction, less informed bidders
will be less disadvantaged, which should en­
courage participation. Collusion would be
more difficult, as the number of bidders would
be larger.15*Either shading down bids to avoid

10


JULY/AUGUST 1995

the winner's curse or colluding with others to
keep bids down will lead to less revenue for
the Treasury. So if the uniform-price format
alleviates the winner's curse and makes collu­
sion less likely, it should be the preferred
format.
Theory and Practice. But the real world of
Treasury-security auctions isn't as simple as
the theory discussed above may suggest. First,
even in the simple models, if bidders are riskaverse, one can't predict which auction for­
mat—uniform-price or discriminatory-price—
will yield the higher expected revenue. Al­
though it is likely that most bidders in Trea­
sury auctions are risk-neutral, since any one
auction represents a small percentage of their
assets, the fact that many come to the auction
with a significant short position (from selling
in the when-issued market before the auction)
can make them act in a risk-averse manner,
since losing would be costly if they are unable
to obtain the securities they want at a reason­
able price in the secondary market.
Second, Treasury auctions are multiple-ob­
ject auctions in which bidders desire more
than one unit of the item being auctioned, but
there has been little analysis of these kinds of
auctions. As in single-unit auctions, a uniform-price auction of multiple units will yield
greater revenue on average than a discrimina­
tory-price auction when each bidder just de­
mands a single unit. But this is not generally
true when bidders want to win more than one
unit. In auctions where bidders demand mul­
tiple units, Kerry Back and Jaime Zender (1993)
show that bidders will tend to play strategies
in uniform-price auctions that will curtail price
competition, and thereby hold down revenue.
In some cases this effect will be strong enough
so that the discriminatory-price auction will
15See Kerry Back and Jaime F. Zender, "Auctions of
Divisible Goods: On the Rationale for the Treasury Experi­
ment," Review o f Financial Studies (Winter 1993), pp. 733-64
and Friedman (1991).

FEDERAL RESERVE BANK OF PHILADELPHIA

There's More than One Way to Sell a Security: The Treasury's Auction Experiment

generate more revenue than the uniform-price
auction when bidders demand multiple units,
even though the opposite occurs in single-unit
auctions. (See Steeper Bids Can Curtail Price
Competition in Uniform-Price Multiple-Unit Auc­
tions.)
A third complication is the impact of the
when-issued and secondary markets on bid­
ders' strategies, which has not been well stud­
ied. In th eir th eo retical m odel, Sushil
Bikhchandani and Chi-fu Huang (1989) show
that accounting for the secondary market can
be important in that it can lead bidders to bid
more aggressively in uniform-price auctions
to indicate to secondary-market participants
that the securities are valuable. This suggests
that for Treasury auctions, the uniform-price
auction might generate more revenue for the
Treasury.16
Finally, the argument that uniform-price
auctions are less susceptible to collusion or
m anipulation than d iscrim inatory-price au c­

tions doesn't seem that strong. It's hard to
believe that the competitive bidders in a Trea­
sury auction are uninformed—under either
auction format, the uninformed bidders are
better off placing noncompetitive bids (see
Bikhchandani and Huang, 1993). And in either
format, collusion among a group of bidders
would be hard to sustain, since one of the
group could deviate from the agreed upon
price, bid a slightly higher amount, and win a
large share of the amount auctioned (subject to
the quantity limits set by the Treasury). In fact,
Bikhchandani and Huang (1993) have argued
that it might even be easier to sustain collusion
in uniform-price auctions than in discrimina­
tory-price auctions.17189
Manipulation by a single bidder is more
likely to be a potential problem than collusion
16See Sushil Bikhchandani and Chi-fu Huang, "Auc­
tions with Resale Markets: An Exploratory Model of Trea­
sury Bill M a r k e ts Review o f Financial Studies,2 (1989), pp.
311-39.




Loretta J.M ester

by a group of bidders. So long as there are
those who need securities but do not bid in the
auction and so must purchase in the secondary
market, there is the potential for manipulation.
A well-capitalized bidder might try to corner
the market in a Treasury issue, and profit by
selling to anyone who sold short in the whenissued market and decided to purchase the
issue in the secondary market instead of at the
auction. While the Treasury might gain in the
short term (since to corner the market, the
bidder would have to bid high in the auction),
if such manipulation is widespread and occurs
often, it would tend to drive participants from
the market and this would lead to losses for the
Treasury in the long term.1819 While it is illegal
to corner the market, the auction format might
have an influence on the ability to (illegally) do
so. Bikhchandani and Huang (1993) argue that
a uniform-price auction is more vulnerable to
17Bikhchandani and Huang (1993) point out that in
discriminatory-price auctions, any profitable collusive
arrangement involves every bidder agreeing to bid only at
low prices. But then deviating and bidding a slightly
higher (but still low) price yields a short-term gain. Prof­
itable collusion in the uniform-price auction need not
involve all bidders bidding at low prices (since they pay
the highest accepted or lowest rejected bid and not what
they themselves bid). Therefore, a deviation from the
collusive arrangement in a uniform-price auction might
involve bidding at a high price; such a deviation would not
necessarily be profitable. Hence, the collusive arrange­
ment might be easier to sustain in the uniform-price auc­
tion than in a discriminatory-price auction. In other words,
discriminatory-price auctions might be less susceptible to
collusion.
18Bikhchandani and Huang (1993) and Reinhart (1992)
discuss the potential for manipulation in different auction
formats.
19In August 1991, Salomon Brothers, Inc., admitted to
placing unauthorized bids in some auctions in 1990-91 in
an attempt to gain a larger share of the securities being
sold. See Press Release o f Salomon Brothers, Inc., August 9,
1991; the Joint Report, Appendix C; and "Statement of
Salomon, Inc. Submitted in Conjunction with the Testi­
mony of Warren E. Buffett," Hearings (1991), pp. 256-312.

11

Steeper Bids Can Curtail Price Competition
in Uniform-Price Multiple-Unit Auctions
How might a discriminatory-price auction of multiple units generate more revenue for the seller than
a uniform-price auction, even though in auctions of single items (with risk-neutral bidders) the opposite
revenue ranking occurs? Back and Zender (1993) point out that when bidders demand more than one unit,
they can play strategies in uniform-price auctions that essentially curtail price competition. The reduced
price competition can lead to diminished revenue for the
Nick's Initial Bid Schedule
seller, making the discriminatory-price auction a better choice
in multiple-unit auctions.
Price ($)
A simple example illustrates this. Suppose there are four
martini glasses being sold via a uniform-price auction to two
bidders, Nick and Nora, and they both believe that after the
auction each glass will be worth $13. Nick and Nora submit
bids describing the quantities and prices of the glasses they
want to purchase. Suppose Nick submits the following four
bids: $10 for one glass, $8 for one glass, $7.50 for one glass, and
$6 for one glass, and suppose Nora also submits these bids.
The auctioneer will award the glasses starting with the highest
bid-price and working down until all four glasses are awarded.
So the bids Nick and Nora have submitted essentially describe
what each is willing to pay for each additional glass they might
win. For example, each knows that the $8 bid won't be accepted unless the $10 bid is accepted, and so
on. Given their bids, in a uniform-price auction, Nick and Nora would each receive two glasses, and they
would pay $8 per glass (the lowest accepted price).3 Since they expect the glasses to be worth $13 apiece,
each would earn an expected profit of $10 [= 2x($13-$8)] on their winnings.
Now suppose Nora wanted to win all four glasses. To win four, she would have to increase the prices
in all four of her bids to $10.01, since she would need to beat Nick's bid of $10 and drive him out of the
market. With this new set of bids, Nora's total profit would increase to $11.96 [= 4x($13-$10.01)], so it pays
her to change her bids.b And the seller would receive $40.04 [- 4x$10.01] in revenues.
But suppose Nick had submitted a steeper schedule of bids. That is, suppose he had bid $11, instead
of $10, for one glass and left the rest of his bids the same. Nothing would change in the uniform-price
auction; again, Nick and Nora would each receive two glasses
Nick's New, Steeper Bid Schedule
and pay $8 per glass. But for Nora to increase her winnings
from two to four, she would now have to beat Nick's $11 bid.
So she would have to increase the prices in all four of her bids
to $11.01. Nora's total profit with her new set of bids would
be only $7.96 [= 4x($13-$11.01)], and it would not be profitable
for Nora to change her bids.c Hence, the seller's revenues
would remain $32.
Thus, by submitting steeper bid schedules, bidders can in
effect "collude" to keep down the prices they pay. And in a
uniform-price auction, such a strategy is costless—Nick did
not have to pay the $11 he bid to win the first glass, whereas in
1st
2nd
3rd
4 th
the discriminatory-price auction he would have had to.
Glass Glass
Glass
Glass
aWe use the lowest accepted price as the uniform price instead of the highest rejected price, since that is what is
specified in the Treasury experiment. The analysis is similar using the highest rejected price as the uniform price.
bThis occurs because the value of the two additional glasses is greater than the marginal cost of purchasing the extra
glasses. The additional glasses are worth $26 [= 2x$13], and to win four glasses instead of two, Nora would have to pay
only an additional $24.04 (= the cost of the two new glasses [= 2x$10.01], plus the extra cost for the first two glasses
[= 2x$2.01]).
cThis occurs because the value of the two additional glasses is now less than the marginal cost of purchasing the extra
glasses. The additional glasses are worth $26 [= 2x$13], but to win four glasses instead of two, Nora would have to pay
an additional $28.04 (= the cost of the two new glasses [= 2x$11.01], plus the extra cost for the first two glasses
[= 2x$3.01]).


12


FEDERAL RESERVE BANK OF PHILADELPHIA

There's More than One Way to Sell a Security: The Treasury's Auction Experiment

manipulation than a discriminatory-price auc­
tion, since in the discriminatory-price auction
if a bidder bids high to corner the market, he
has to pay what he bid. This also means it is
more costly in discriminatory-price auctions
to build a reputation for aggressive bidding,
which can be manipulative.20
The divergence between simple auction
theory and auction practice means that it is
really an empirical question as to which auc­
tion format is best; hence, the need for the
Treasury's auction experiment. The results will
very likely be interesting for theoretical econo­
mists as well as the Treasury because the re­
sults will suggest which differences between
reality and theoretical models are the eco­
nomically important ones and, therefore, worth
further study.
WHAT WE HAVE LEARNED
FROM AUCTION EXPERIMENTS
We can look to some previous empirical
studies as well as the data gathered so far from
the current Treasury experiment to assess the
likely impact of switching to the uniform-price
auction.21 Figure 3 helps keep track of the
results.
The Treasury's Previous Experiment. Stud­
ies that examine the Treasury's previous ex­
periment in the 1970s might give us an idea of
what to expect this time (although there have
been many innovations and regulatory changes
in financial markets since that experiment was
run). In an unpublished Treasury Department
study, Che Tsao and Anthony Vignola found
that in the six single-price auctions out of 16

20If one bidder is known to bid aggressively, it can deter
others from doing so by making the winner's curse worse—
if a bidder beats the aggressive bidder it means he's really
paid too much. See Bikhchandani and Huang (1993) for
further discussion.
21Back and Zender (1993) have a helpful review of
some of the empirical studies.




Loretta J. Mester

auctions from January 1973 through August
1976, demand from nondealers increased some­
what, and the authors concluded that the Trea­
sury would have saved about $60 million by
using a uniform-price auction for the 10 issues
sold via discriminatory-price auctions. This
study is often cited by those advocating the
uniform-price format, but David Simon (1994a)
reports that the authors told him that their
results should be viewed as preliminary be­
cause of important data problems they subse­
quently discovered.22
Simon's own study re-examined the early
experiment and found that the Treasury did
better with the discriminatory-price auctions
than with the uniform-price auctions. He found
the markup of the average accepted rates in the
auctions over rates in the when-issued market
shortly after the auctions were a statistically
significant 7 to 8 basis points higher at uni­
form-price auctions than at discriminatoryprice auctions, holding constant the effects of
other factors. This markup measures the pre­
mium the Treasury has to pay to issue new
debt. The when-issued rate is the rate market
participants require to purchase the security; a
lower rate means they are willing to pay a
higher price. Therefore, the higher the markup,
the higher the Treasury's borrowing costs and
the higher the profits that go instead to dealers
who sell to these market participants after the
auction. Simon estimated that the early single­
price auctions cost the Treasury about 0.75
percent of the face value of the auctioned
securities in lost revenue.
Evidence from Other Countries. Evidence
from other countries that switched auction

22See Che S. Tsao and Anthony J. Vignola, "Price Dis­
crimination and the Demand for Treasury's Long Term
Securities," unpublished manuscript, U.S. Department of
Treasury (1977); and David P. Simon, "The Treasury's
Experiment with Single-Price Auctions in the Mid-1970s:
Winner's or Taxpayer's Curse?" Review of Economics and
Statistics, 76 (November 1994a), pp. 754-60.

13

JULY/AUGUST 1995

BUSINESS REVIEW

FIGURE 3

Empirical-Study Score Card
Study

Results Favor
DiscriminatoryPrice
Auction

UniformPrice
Auction

Tsao and
Vignola (1977)

16 U.S. Treasury bond auctions,
January 1993-August 1976
(data problems subsequently
discovered)

Simon
(1994a)

16 U.S. Treasury bond auctions,
January 1993-August 1976

Umlauf
(1993)

Mexican Treasury bill auctions,
1986-91

X

Tenorio
(1993)

Zambian foreign exchange market
auctions, October 1975-January 1987

x

Nyborg and
Sundaresan
(1994)

U.S. Treasury when-issued market,
July 1992-August 1993

x

U.S. Department
of Treasury

U.S. Treasury securities,
June 1991-May 1994

formats suggests a different story. Steven
Umlauf (1993) studied bidding in Mexican
Treasury bill auctions over the period 198691.23 In 1986, the Mexican government began
auctioning its Treasury bills using rules simi­
lar to the ones used in the United States. In 1990
its Treasury substituted uniform-price auc­
tions for discriminatory-price auctions to try

23He focused on one-month peso-denominated zerocoupon securities called CETES. See Steven R. Umlauf,
"An Empirical Study of the Mexican Treasury Bill Auc­
tion," journal of Financial Economics, 33 (1993), pp. 313-40.


14


x

x

inconclusive

to combat collusion and to increase auction
revenues. Umlauf found that before the switch,
the six largest bidders, who accounted for very
large shares of the auction purchases, were
colluding and making profits. But these profits
were eliminated after the switch.24 These re­
sults suggest (but don't prove) that there was

24In the 181 discriminatory-price auctions analyzed,
aggregate competitive bidder profits averaged $36,000
per auction, with the six largest bidders earning over 80
percent of total competitive auction profits. But in the 26
uniform-price auctions analyzed, aggregate competitive

FEDERAL RESERVE BANK OF PHILADELPHIA

There's More than One Way to Sell a Security: The Treasury’s Auction Experiment

Loretta J.M ester

collusion in the discriminatory-price auctions
but not in the uniform-price auctions, and they
favor the uniform-price auction from a rev­
enue standpoint. (Although since only 26
uniform-price auctions are included in the
sample and they span only 10 months, it is
debatable whether the bidders had enough
experience with the new auction to make the
results a certainty.)
Rafael Tenorio (1993) analyzed data from
foreign exchange market auctions held weekly
in Zambia from October 1985 to January 1987.25
Funds that were auctioned came mainly from
export proceeds and from foreign aid. At the
start, Zambia used uniform-price auctions, but
after authorities became alarmed about what
they considered an excessive depreciation of
the Zambian currency (Kwacha), the authori­
ties switched to a discriminatory-price format
with the 43rd auction. The difference between
the supply and demand of currency grew so
much that the auctions had to be suspended
after the 68th. Tenorio found that uniformprice auctions yielded higher revenues than
discriminatory-price auctions because there
was greater participation (as measured by the
number of bids and the total quantity de­
manded); had participation been the same in
both auctions, his results suggest there would
have been no significant difference in rev­
enues. Tenorio also found that it takes a while
for bidders to adapt to a new auction format.

The Current U.S. Treasury Experiment.
Kjell Nyborg and Suresh Sundaresan (1994)
studied the period July 1992 to August 1993
using data on all the transactions in the whenissued market executed by Garban, one of the
four most active interdealer brokers in the U.S.
Treasury market. They found that for dis­
criminatory-price auctions, the average ac­
cepted yield in the auction was higher then the
average rate in the when-issued market during
the half-hour before the auction, but for uniform-price auctions, there was no difference.
This suggests that dealers were shading down
their bid prices (and so bidding at higher yields)
in discriminatory-price auctions but not in
uniform-price auctions, which is consistent
with the theoretical result for single-unit auc­
tions that the winner's curse is more severe in
discriminatory-price auctions. Hence, the uni­
form-price auction should produce more rev­
enues for the Treasury.26*
Nyborg and Sundaresan also show that with
uniform-price auctions, when-issued rates were
highly volatile before bidding but fluctuated
less after the auction, while with discrimina­
tory-price auctions, volatility increased after
the auction. This suggests that more informa­
tion is released in the when-issued market
before the auction when the uniform-price
format is used than when the discriminatoryprice format is used. And it suggests that in
discriminatory-price auctions, dealers are bet-

bidder profits averaged -$3000 per auction (essentially
zero). And the average profits of the six largest bidders
were essentially zero, too. The weighted-average profit
margin (that is, the quantity-weighted average spread
between the resale price and auction price) was 1.84 basis
points for discriminatory-price auctions and -0.3 basis
points for uniform auctions. This difference across auction
format is statistically significant at the 1 percent level.

26For the discriminatory-price auctions of two- and
five-year notes, the markup ranged from 0 to 1 / 2 of a basis
point, and was statistically different from zero. For the
uniform-price auctions, the markup ranged from - 1 / 2 to
3-1 / 2 basis points and was not statistically different from
zero, since it fluctuated a great deal. The markup's higher
volatility in the uniform-price auctions occurs because
there are more trades in the when-issued market prior to
the auction when the auction format is uniform price than
when it is discriminatory price, indicating greater liquid­
ity of the when-issued market when the auction is uniform
price. See Nyborg and Sundaresan (1994) for further de­
tails.

25See Rafael Tenorio, "Revenue Equivalence and Bid­
ding Behavior in a Multi-Unit Auction Market: An Empiri­
cal Analysis," Review of Economics and Statistics, 75 (May
1993), pp. 302-14.




15

JULY/AUGUST 1995

BUSINESS REVIEW

ter able to trade strategically, masking their
private information (that is, knowledge of their
customers' orders) prior to the auction and
trading on it after the auction, thereby induc­
ing higher volatility in the when-issued rates.27
The greater level of information released in
uniform-price auctions means there is less dis­
parity in information held by bidders, which
can lessen the severity of the winner's curse;
this might encourage participation and so lead
to a higher selling price and, therefore, rev­
enues for the Treasury.
Based on the data collected on the experi­
ment through May 1994, the Treasury Borrow­
ing Advisory Committee, which advises the
Treasury on the amount to auction, feels that
the uniform-price auction is neutral with re­
spect to Treasury borrowing costs.28 The data
do show that the two- and five-year notes may
be more widely distributed under the uni­
form-price format than under the discrimina­
tory-price format. Broader participation and

less concentration suggest less chance of collu­
sion and manipulation. The average share of
large competitive awards (based on bids of at
least $1 million) to primary dealers in the
September 1992 to May 1994 experiment pe­
riod fell to about 66 to 67 percent of total
private awards from about 69 percent in the
June 1991 to August 1992 period when dis­
crim inatory-price auctions w ere used; the share

to their customers rose to 25 to 26 percent from
about 21 percent.29 (Note, however, that these
changes aren't statistically significant.) By
contrast, the awards to dealers of three- and
10-year securities rose between the two peri­
ods, and awards to their customers of threeyear notes were unchanged and of 10-year
notes were down about 13 percentage points.30

29These data are reported in "Charts on the UniformPrice Experiment," attached to the "Committee Charge,"
U.S. Department of Treasury (August 2,1994).

FIGURE 4
27Simon also found evidence of
trading on private information in
discriminatory-price auctions. See
David P. Simon, "Markups, Quan­
tity Risk, and Bidding Strategies at
Treasury Coupon Auctions ,"Journal
of Financial Economics, 35 (February
1994b), pp. 43-62. ButBikhchandani
and Huang (1992) found no evidence
of collusion in discriminatory-price
auctions of 13- and 26-week Trea­
sury bills from Feb ru ary 1986
through February 1988. See Sushil
Bikhchandani and Chi-fu Huang,
"The Treasury Bill Auction and the
When-Issued Market: Some Evi­
dence," WP #3467-92 Sloan School
of Management, MIT (September
1992).
28See "Report to the Secretary of
the Treasury from the Treasury Bor­
rowing Advisory Committee of the
Public Securities Association" (Au­
gust 3,1994).

Digitized for
16FRASER


Yield Spreads
Spread Between High & Low Accepted Bids
Spread in Basis Points

Source: Treasury Bulletin, U.S. Department of Treasury, various
issues
FEDERAL RESERVE BANK OF PHILADELPHIA

There’s More than One Way to Sell a Security: The Treasury's Auction Experiment

Loretta J.M ester

tive answer as to whether a discriminatoryprice auction or a uniform-price auction would
result in lower borrowing costs for the U.S.
Treasury. Thus, we must rely on empirical
work to make a choice of auction format. Stud­
ies of an earlier Treasury auction experiment,
auctions in other countries, and the current
U.S. experiment are inconclusive as to which
auction format is better, but most favor the
uniform-price format. While data from the
current experiment have not shown that the
uniform-price auction format has produced
WHICH FORMAT IS BETTER?
higher revenues for the Treasury, they also
Auction theory cannot yet provide a defini-03 have not shown that it has resulted in lower
revenues than the discriminatory-price auc­
tion. And there is some evidence that partici­
30Similarly, the concentration of competitive awards to
pation is higher under the uniform-price for­
the top 10 dealers and their customers was reduced by 4 to
mat, which might ultimately lead to higher
9 percentage points for the two-year and five-year uni­
revenues for the Treasury. As the experiment
form-price auctions, but their share increased by 11 per­
continues and further data are collected, per­
centage points for the three-year notes and remained un­
changed for the 10-year notes.
haps a more definitive answer can be obtained.

The data also show that transaction volumes in
the when-issued market on days of uniformprice auctions have increased notably, sug­
gesting improved liquidity, which can lower
borrowing costs. And as auction theory would
predict, the spread between the highest and
lowest yield of accepted bids has increased in
the two- and five-year note auctions since the
uniform-price auction has been adopted, while
in the three- and 10-year auctions there has
been little change (Figure 4).




17

Philadelphia /RESEARCH
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.
95-1

Satyajit Chatterjee and Dean Corbae, "Valuation Equilibria with Transactions Costs"

95-2

Sherrill Shaffer, "Structural Screens in Stochastic Markets" (supersedes Working Paper No.
92-23)

95-3

Franklin Allen and Douglas Gale, "A Welfare Comparison of Intermediaries and Financial
Markets in Germany and the U.S."

95-4

Franklin Allen and Douglas Gale, "Financial Markets, Intermediaries, and Intertemporal
Smoothing"

95-5

Gregory P. Hopper, "The Dynamics of the Exchange Rate Under a Crawling Peg Regime: A
Game Theory Approach"

95-6

Franklin Allen and Douglas Gale, "Universal Banking, Intertemporal Risk Smoothing, and
European Financial Integration"

95-7

Paul Calem and Michael Stutzer, "The Simple Analytics of Observed Discrimination in Credit
Markets"

95-8

Joseph Hughes, William Lang, Loretta Mester, and Choon-Geol Moon, "Recovering Tech­
nologies That Account for Generalized Managerial Preferences: An Application to Non-RiskNeutral Banks"

95-9

Ana Castaneda, Javier Diaz-Gimenez, and Jose-Victor Rios-Rull, "Unemployment Spells and
Income Distribution Dynamics"

95-10

Paul Calem and Loretta J. Mester, "Consumer Behavior and the Stickiness of Credit Card
Interest Rates" (Supersedes No. 92-24/R )

95-11

Richard Voith, "Parking, Transit, and Employment in a CBD"

95-12

Gary Gorton and Richard Rosen, "Banks and Derivatives"

95-13

Sherrill Shaffer, "Translog Bias Under Declining Average Costs"

95-14

Alberto Trejos and Randall Wright, "Toward a Theory of International Currency: A Step
Further"


18


FEDERAL RESERVE BANK OF PHILADELPHIA

Do You Know How Much Money
Is in Your Public Purse?
Robert R Inman*
I n the fall of 1990, the City of Philadelphia
almost fell into bankruptcy. In the summer of
1994, Orange County, California, lost approxi­
mately $2.5 billion because aggressive invest­
ments in financial derivatives turned sour. In
January 1995, a Superior Court judge in Cali­
fornia ruled that the state owed its public
employee pension plan $900 million in past
payments due, a burden that now sits atop the
state's already estimated $5 billion deficit for
fiscal year 1995-96. And after decades of de­

*Bob Inman is a professor of finance and economics,
Wharton School, University of Pennsylvania. When he
wrote this article, he was a visiting scholar in the Research
Department of the Philadelphia Fed. Bob thanks Ted Crone,
Len Nakamura, and Dick Voith for very helpful comments
on an earlier draft. This article should be read as a compan­
ion piece to Dean Croushore's 1990 article in the Business

Review.



dining, the ratio of the federal debt to national
income has now risen to its highest level since
1955.
While we all know how our governments
are doing when it comes to teaching our chil­
dren, protecting our lives and property, re­
moving our trash, maintaining our roads, and
collecting our taxes, few of us know that local
and state governments and the federal govern­
ment also control an important share of our
national savings and wealth. Do you know
how much money is in your public purse? For
a typical family of four in Philadelphia in 1990
my estimate is $41,696.
HOW DO GOVERNMENTS
SAVE YOUR MONEY?
When calculating your family's financial
net worth, your accountant will total all your
family's assets and then subtract all liabilities.
19

BUSINESS REVIEW

Assets will include all the money in your check­
ing and savings accounts plus all the money in
your retirement account plus the market value
of your tangible assets such as your car, your
home and property, and other possessions.
Liabilities will include all the money your
family owes for short-term loans on credit
cards and cars and long-term loans for a home
mortgage or college tuition. Your assets minus
your liabilities defines your net worth. This
will be the amount of money in your private
purse. The more you save and the less you
borrow, the more you have in the family's
private purse. Your family's net worth—along
with your future income—will be an impor­
tant determinant of your family's future con­
sumption; the higher your net worth today, the
more you can consume tomorrow.
In calculating your net worth your accoun­
tant does not consider what's in your public
purse. But a government's assets and liabili­
ties—the contents of your public purse— are
no less important to the average American
family's economic future than its private net
worth. Because Philadelphia allowed the city's
short-term debt to become excessive, the aver­
age city resident has suffered sharp reductions
in public services and a 1-percentage-point
increase in the local sales tax. Residents of
Orange County, California, are likely to face
similar declines in their service levels over the
next few years as they recover from an invest­
ment loss of $2.5 billion. The average Califor­
nian faces additional budget cuts as the state
seeks to solve its current deficit problem, exac­
erbated by past underfundings of its public
employee pension plan. Finally, paying inter­
est on the federal debt and controlling its
growing burden on private incomes will re­
quire reduced federal spending, higher fed­
eral taxes, or both.
Your share of your governments' net worth
is your money, and it holds important conse­
quences for your economic future.1 When a
government's net worth declines—possibly

20


JULY/AUGUST 1995

even becoming negative—you will see either
higher taxes or lower services in the future.
When a government's net worth increases,
your future services can be increased or your
taxes can be reduced. Either way, your family
is better off.
Governments create net worth by adding
savings and tangible assets to the public purse
and by limiting those activities that take money
from the purse, such as new debt or contrac­
tual liabilities. By definition, government Net
Worth equals Savings in financial assets plus
the value of Tangible Assets minus the present
value of future Government Debt and future
government contractual Liabilities:
Net Worth = Savings+Tangible Assets
-Government Debt-Liabilities.
Financial Savings and Tangible Assets.
State and local governments save in five ac­
counts: an unrestricted savings account, often
called a "rainy day" fund; a bond fund, which
holds the proceeds of government borrowings
until they are spent on government investment
projects; a sinking fund, which holds savings
for future repayments of government debt; a
state insurance trust fund, which holds private
employers' tax contributions to cover state
payments for unemployment benefits and
workers' compensation; and a pension fund,
which holds government and employee con­
tributions to cover future pension payments to
state and local employees. The federal govern­
ment saves in three ways: a general cash sav­
ings account; various pension fund accounts,
which hold government and employee contri­
butions to cover future pension payments to
federal employees and military personnel; and
the Social Security trust fund, which holds

’ Not every one gets an equal, per person share of a
government's net worth. I will present estimates for the
average resident. Your share will be determined by your
use of public services and by your share of your govern­
ments' tax burdens. You may receive more or less than the
average resident in your community.

FEDERAL RESERVE BANK OF PHILADELPHIA

Do You Know Hoiv Much Money Is in Your Public Purse?

payroll taxes to cover future payments to retir­
ees. State and local governments typically in­
vest their savings funds in stocks, corporate
bonds, and U.S. Treasury bonds. Federal gov­
ernment pension funds and the Social Security
Trust Fund invest their savings in U.S. Trea­
sury bonds. When included in the public purse,
such public savings should be valued at their
current market prices.
Governments' investments in public schools,
public hospitals, roads, bridges, public lands,
and military equipment add to the tangible
assets in the public purse. These tangible pub­
lic assets create economic wealth in much the
same way that private tangible assets create
wealth: by contributing to the production of
valuable goods and services. Schools provide
education, and hospitals provide health care.
Roads and bridges facilitate transportation.
Public lands provide mineral resources and
scenic beauty. Tanks, planes, and ships protect
our economic wealth from foreign expropria­
tion. Each of these public assets should be
valued in the public purse for the stream of
economic benefits it creates.
Government Debt and Contractual Liabili­
ties. Offsetting the value of government finan­
cial and tangible assets are the future obliga­
tions on the government from previous bor­
rowing and other contractual promises. Debt
liabilities equal the future stream of interest
and principal repayments required to service
the government debt. This stream of payments
needs to be expressed in today's dollars, how­
ever. In effect, the present value of the debt
measures what the government would have to
pay current bondholders in the open market to
buy back— or "defease"—the government's
debt obligation. Alternatively, this lump sum
payment equals what current holders of the
government's debt would have to put out
today for an identically risky alternative in­
vestment that provided the same stream of
future payments.
In addition to the promise of debt repay­



Robert P. Inman

ment, local and state governments and the
federal government promise other future pay­
ments as well. Those promises can take either
of two forms: contractual or political. Contrac­
tual promises are enforceable in court; politi­
cal promises are not. For this analysis, only
contractual promises are included as a govern­
ment liability.
At the state and local levels, the important
contractual obligation of government is the
promise of a pension for public employees.
The discounted present value of these prom­
ised p en sion paym ents m easures the
government's pension liability. Again, this is
equal to what the government would have to
pay the beneficiaries of these promises—cur­
rent and future retirees—so they could invest
and earn an identical stream of future pay­
ments.
At the federal level, the important contrac­
tual liabilities include promised pension pay­
ments to government employees, including
military personnel, and the promised pay­
ments to depositors of failed banks and sav­
ings and loan institutions whose accounts are
insured by the federal government.
MEASURING GOVERNMENT
NET WORTH
Government savings is the market value of
the cash and security holdings of the govern­
ment. Annual surveys of city and state govern­
ment finances provide estimates of their cash
and security holdings.2* The financial assets
held in state and local governments' rainy day
funds, bond funds, sinking funds, and insur­
2The surveys are part of the U.S. Census of Government.
There is an important question as to whether the reporting
state and local governments provide "market value" or
"book value" estimates of their cash and security holdings.
Even if the governments report only book value, however,
city and state governments turn over assets in their ac­
counts every year or two. Thus, book values will closely
approximate true market values, and the difference from
market value in the survey reports is likely to be small.

21

BUSINESS REVIEW

ance trust funds are combined into a single
savings account for these governments.3Table
1 reports estimates of the average real (1990
dollars) per capita savings for all 50 states and
a sample of local governments in each of the
fiscal years, 1972-90. Savings were estimated
for all states but for only 41 of the largest U.S.
cities.4 The estimated state and local savings
reported in Table 1 represent the per capita
state savings plus the per capita city savings of
the sample of 41 large cities.5
The value of tangible assets held by state
and local governments is estimated by the
replacement value of all publicly owned capi­
tal in all U.S. states and in 36 of our largest
cities.6 The replacement value of the public

fin an cial assets held by state and local governments
for their public employee pensions are deducted from
pension liabilities and reported separately as the state or
local government's unfunded pension liability; see foot­
note 11.
4While savings, assets, debt, and pension liabilities
could be estimated for all state governments, only a sample
of local governments could be included in the analysis.
Large U.S. cities for which full financial data could be
obtained from the U.S. Census of Government surveys con­
stitute the local government sample. Table 1 lists the 41
included cities. These cities represent approximately 15
percent of the U.S. population in 1990. Of the $12,539 per
resident in total state and city net worth in 1990, the
average city contributed $8626 per resident (69 percent)
and the average state contributed $3913 (31 percent). At
the time this study was done, thell.S. Census of Government
surveys were complete only to 1990.
5We do not know how representative the large city
estimates of savings, assets, debts, and pension liabilities
will be for all U.S. cities and towns. Furthermore, county
government assets and liabilities have been excluded from
the analysis. It is likely that each of the components of net
worth is larger in our sample cities than for an average U.S.
community, but the difference between assets and liabili­
ties—the net worth estimate— may reasonably approxi­
mate net worth in the average community. Until a full
analysis is done, however, the conclusions from Table 1
must be limited to the states and the large cities in our
sample.


22


JULY/AUGUST 1995

asset—a bridge, a road, or a public building—
is an estimate of what it would cost in real
(1990) dollars to replace the asset at its current
quality if it were destroyed. The replacement
value of a public asset adjusts for the deprecia­
tion over time in the stock of that asset.7 Thus,
an old bridge or roadway has a lower replace­
ment value than a new bridge or road. The
replacement value of state and local govern­
ment assets is not the same as the assets'
market value—that is, the value that a pur­
chaser of an asset would offer for its use.
Market values are the preferred measure of the
true worth of any asset, but unfortunately,
public capital is not bought and sold in an open
market. Thus, published measures of the mar­
ket value of state and local public assets do not
now exist.8 Like all previous estimates of the
value of government assets, the estimates in
Table 1 rely on the replacement cost measure.9

6A complete series of investment data for the years
1902-90 needed to estimate assets could not be obtained
for five of the sample's 41 cities: Birmingham, Louisville,
Norfolk, Rochester, and St. Paul.
7Replacement values of the public infrastructure in our
sample cities and states were estimated using the per­
petual inventory method, which defines the capital stock
at time t as: K{ = Kf l - 6 K{ 1+ It, where is the replacement
value estimate of the capital stock in period t, K( is the
replacement value of the capital stock in the previous
period, 8 K( is the depreciation in that capital stock over
the previous period, and It is the level of gross investment
made by the city or state in period t. Kt, K( y and I{ are all
measured in constant (1990) capital goods prices. The
capital stock series reported in Table 1 is the aggregate of
state and city investments in construction, equipment, and
land. See Boskin et al. (1989) for a discussion of this ap­
proach to public capital stock measurement.
8In a creative study of the effects of public capital stocks
on local land prices using the database summarized in
Table 1, Haughwout (1994) has estimated the marginal
benefit of an additional dollar of public capital spending.
He finds that new public capital investment has a positive
rate of return in growing cities and a negative rate of return
in declining cities.

FEDERAL RESERVE BANK OF PHILADELPHIA

Robert P. Inman

Do You Know How Much Money Is in Your Public Purse?

The reported estimates of
assets in Table 1 are there­
fore the average replace­
ment values of state and
city public assets per resi­
dent for the residents of
the largest U.S. cities.
Debt liabilities o f state
and local governments
are measured as the dis­
counted present value of
all future interest and
p rin cip al repaym ents
owed to the holders of
the governments' debt.
The present value mea­
sures the current worth
of the future stream of
prom ised interest and
principal repayments. If
the government were to
buy back—or defease—
its debt, it would have to
pay bondholders this cur­
rent value. This current
market value, therefore,
measures the financial li­
ability of the govern­
ments' debt. As current
interest rates rise, the
market value of existing
debt falls because bond
buyers could purchase
newly issued bonds with
the same total interest
paym ents for a lower
price. Conversely, as cur-9
9Important previous studies
using the replacem ent cost
m ethodology include Musgrave's (1986) ongoing work
estimating the national stock of
public capital and Boskin et al.'s
(1989) study of government as­
sets and liabilities.




TABLE 1

Average State and
City Government Assets and Liabilities*
Year Savings

+

Tangible - Government
Debt
Assets

1972

$2576

$13,720

$3302

- Unfunded
Pension
Liabilities

=

Net
Worth

$3341

$9651

1973

2714

13,915

3401

4021

9166

1974

2826

14,113

3502

4477

8902

1975

2815

14,320

3221

4381

9479

1976

2755

14,478

3280

4250

9649

1977

2561

14,573

3179

4568

9391

1978

2765

14,552

3138

4627

9558

1979

2785

14,612

2680

4979

9727

1980

2897

14,750

2456

5119

10,079

1981

2708

14,851

2038

4785

10,740

1837

4567

11,214

1982

2717

14,880

1983

2979

14,902

2345

4093

11,469

1984

3148

14,926

2474

4537

11,096

1985

3296

14,975

2532

4113

11,664

1986

3749

15,050

3148

3862

11,840

1987

4114

15,169

3638

4261

11,458

3448

4121

12,235

1988

4395

15,319

1989

4451

15,463

3571

3727

12,701

1990

4537

15,621

3710

3989

12,539

* The Savings, Government Debt, and Unfunded Pension Liabilities columns are
based on all 50 states and a sample of 41 cities: Atlanta, Baltimore, Birmingham,
Boston, Buffalo, Chicago, Cincinnati, Cleveland, Columbus (Ohio), Dallas, Denver,
Detroit, Ft. Worth, Houston, Indianapolis, Kansas City (Missouri), Long Beach, Los
Angeles, Louisville, Memphis, Milwaukee, Minneapolis, Newark, New Orleans,
New York City, Norfolk, Oakland, Oklahoma City, Omaha, Philadelphia, Phoenix,
Pittsburgh, Portland, Rochester, San Antonio, San Diego, San Francisco, Seattle, St.
Louis, St. Paul, and Toledo. Unfortunately, the Tangible Assets and final Net Worth
columns could only be estimated for a restricted sample of 36 cities; see footnote 6
in text. Because of the differences in column samples, the Net Worth column will not
exactly equal the sum of Savings and Tangible Assets minus Government Debt and
Unfunded Pension Liabilities.
Source: Author's calculations.

23

BUSINESS REVIEW

rent interest rates fall, the market value of
existing debt rises. The Debt column of Table 1
reports estimates of the real (1990) market
value per resident of outstanding short- and
long-term state and local government debt for
residents of the largest U.S. cities for the period
1972-90.10
The other important contractual liability of
state and local governments is their promise to
pay pension annuities to their current and re­
tired workers.11 The discounted present value
of all promised annuities to current and retired
government employees is the total pension
liability of the governments, where future an­
nuities are discounted at the rate of return
available to government investment. Offset­
ting this total pension liability are all the assets
currently held by the government in its pen­
sion account and the required contributions of
the employers and employees eligible for the
promised benefits. The difference between to­
tal pension liabilities and total pension assets is
called the unfunded liability of the gov­
ernment's pension plan.12 The column entitled
Unfunded Pension Liability in Table 1 pro­
vides estimates of the real (1990) dollar value
of unfunded state and local pension liabilities
per resident in the sample 41 largest cities,
again for the period 1972-90.
Together, the Savings, Assets, Debt, and
Unfunded Pension Liability columns of Table

10The estimates of the market value of state and local
government debt use the methodology described in
Butkiewicz (1983).
n Not included as a contractual obligation of state gov­
ernments are possible liabilities within the state unem­
ployment insurance trust fund and the state's workers'
compensation trust fund. These funds are best seen as
political rather than contractual liabilities. For a careful
analysis of state unemployment systems from the perspec­
tive of the public purse, however, see Vroman (1986).
12The methodology used to estimate state and city
unfunded pension liabilities is described in Inman (1986).


24


JULY/AUGUST 1995

1 provide an estimate of the per capita net
worth held by state and local governments for
residents in the average large city in the United
States for the years 1972-90 (see Net Worth in
Table 1). Real government net worth for our
sample states and large U.S. cities has been
rising modestly since 1972, at a rate of about 1.9
percent per year. Importantly, state and city
governments make a significant positive con­
tribution to family net worth. For an average
family of four, the public purse was richer by
about $50,156 in 1990 (= $12,539 x 4) because of
past and current fiscal policies of state and city
governments. (For how Philadelphia and the
Third District states compare with other cities
and states, see How Much Money Is in A
Philadelphian's Public Purse? and How Much Is
in the Public Purse o f Delaware, New Jersey, and
Pennsylvania? in the Appendix.)
What has the federal government contrib­
uted to the public purse? Table 2 summarizes
Bohn's (1992) estimates of federal government
assets and liabilities for the sample period
1972-89. While our nation's states and cities
were putting money into our public purse over
the sample period, the federal government
was taking money out. Federal government
net worth has been consistently negative be­
cause federal government liabilities exceeded
federal government assets over the sample
period.13
Included in federal government savings
(Table 2, Column 1) is the market value of all
government cash and deposits, gold and offi­
cial foreign exchange, and credit market in­
struments held by the government. Included
in federal government tangible assets (Table 2,
Column 2) are estimates of the replacement
value of all physical assets, including military
equipment, the market value of government
13Croushore's article was based on estimates by Robert
Eisner and Paul Pieper, who did not consider unfunded
federal pensions. Hence, that analysis showed a positive
federal net worth in some periods.

FEDERAL RESERVE BANK OF PHILADELPHIA

Robert P. Inman

Do You Know How Much Money Is in Your Public Purse?

TABLE 2
__________________________________________________

Federal Government Assets
and Liabilities3
Year Savings + Tangible Assets

Gov’t - Pension - Other = Net
Debt
Liabilities Liabilities Worth

1972
1973
1974

$6073
6233
6830
6733
6861
7062
7285
7598

$5027

1975
1976
1977
1978
1979

$1516
1631
1803
1651
1761
1776
1955
2461

1980
1981
1982

2520
2152
2177

8194
8881
8787

4914
4964

1983
1984

2138
2135
2310
2424
2352
2078
1937

8637
8401
8218
7488
7464
7177
7244

5946
6599
7448
8672
9784
9666
9752
10,179

-

-

-

1985
1986
1987
1988
1989
1990

4756
4408
4994
5527
5583
5487
5117

$4657
4964
5074
5151
5290
5391
5420
5354

$289
329
402
364

5292
5119
5209

799
1011

5464
5429
5253
5204
5070
5072
5168
-

426
399
504
659

873
729
687
774
922
905
1081
1003

”

-$2384
-2185
-1251
-2125
- 2621
-2535
-2171
-1071
-291
-61
-1064
-2017
-3028
-4171
-5998
-5825
-6650
-7169
-7307b

aSource: Bohn (1992) adjusted to real (1990) dollars per capita. Bohn's data do not
contain estimates for 1990.
bAuthor's calculation. See footnote 16.

land, and the market value of governmentowned mineral rights. The replacement value
of the federal government's physical assets is
calculated by the same methods used to esti­
mate replacement values for state and city
governments. Federal government debt (Table
2, Column 3) is an estimate of the market value
of government debt, using the same methodol­
ogy employed for the state and city estimates.
Federal government liabilities are divided into
its two components: aggregate pension liabili


ties (Table 2, Column 414)
and "other" contractual
liabilities (Table 2, Coiumn 5), the largest of
which, over our sample
period, is deposit insurance guarantees.15 All
assets and liabilities are
reported in real (1990)
dollars per U.S. resident.
Federal government
net worth (Table 2, Column 6) is the sum of Savings and Tangible Assets
minus Government Debt
minus Pension Liabilities
minus Other Liabilities.

14The pension liability esti­
mates in Table 1 are state and
city aggregate liabilities less
state and city pension fund assets. These net liabilities are
reported in Table 1 as the un­
funded pension liability. Bohn's
accounts of federal assets and
liabilities, however, report only
the aggregate pension liability;
pension fund assets are in­
cluded as part of aggregate Sav­
ings in Table 2. Importantly,
since the net worth calculation
does subtract all liabilities from
all savings, the final estimates
of Net Worth in the federal sec­
tor are unaffected.

15Excluded from other liabilities are future federal So­
cial Security payments to current and future retirees. Boskin
et al. (1989) argue that because the promise is politically
uncertain and benefits can be adjusted at any time, Social
Security liabilities should not be counted within the same
ledger as other government assets or government debt. On
the other hand, Feldstein (1974) and Bohn (1992) have
argued that Social Security should now be a promise as
binding as any legal contract. Unfortunately, compelling
estimates of the true value of this liability are not available.
Bohn (1992) provides one estimate that effectively doubles
the 1990 liabilities of the federal government!

25

BUSINESS REVIEW

Over the sample period, federal net worth has
been consistently negative. The net worth of
the federal government did improve over the
1970s, largely because of increases in govern­
ment savings and nonmilitary tangible assets.
The 1980s, however, saw a major decline in net
worth, and the central cause was the large
increase in federal government debt. Aver­
aged over the entire two decades, federal net
worth has been declining at the rate of 6.7
percent a year.16
Together, state and city government net
worth plus federal government net worth de­
fines all the money in an average family's
public purse. For residents of our largest cities,
total public net worth (= Net Worth from Table
1 plus Net Worth from Table 2) is always
positive, equaling $7267 per resident in 1972 (=
$9651 - $2384), rising to a peak of $10,679 per
resident in 1981 (= $10,740 - $61), and then
falling to a low of $5232 by 1990 (= $12,539 $7307).17 Table 2 reveals clearly that the last
d ecad e's large in crease in the fed eral
government's debt liabilities is the cause of
this large decline in our public wealth.
SHOULD WE BE WORRIED?
Should we as a society be concerned about
the decline in our public wealth over the past
decade? If these large federal government bor16There is no reason to think federal net worth has
improved since Bohn finished his study. On the contrary,
government debt has only gotten larger since 1989, and
federal tangible assets have only gotten smaller because of
the reductions in military spending. (Even though military
assets have declined, we are surely better off now that the
old Soviet nuclear threat has been reduced.) Aggregate
pension liabilities and other liabilities are probably un­
changed. If we assume all other columns except Govern­
ment Debt have remained constant in real terms from 1989
to 1990 and then subtract 1990's actual real (1990) level of
government debt per capita of $10,317, we obtain a pre­
liminary estimate of federal government net worth in 1990
of -$7307.
17See footnote 15.


26


JULY/AUGUST 1995

rowings of recent years had been allocated to
increase public-sector capital stocks at the lo­
cal, state, and federal levels or if they had been
placed in a government savings account, there
would be little reason for concern. As Tables 1
and 2 make clear, however, this was not the
case. Since 1980, federal tangible assets have
declined with the shrinking of the defense
budget w hile the stock of public capital at the
state and city level has grown only slightly.
Federal cash and security holdings have also
fallen. The only recent good news in Tables 1
and 2 is the growth of state and city savings,
both generally (Table 1, Savings) and in the
pension fund (Table 1, Unfunded Pension Li­
abilities).18 On balance, however, these state
and local savings gains do not offset federal
borrowings. There are three practical reasons
to be worried about these trends: government
bankruptcy, future fiscal inefficiencies, and
intergenerational inequities.19*
Government bankruptcy occurs when the
18Metcalf (1990) and Gramlich (1991) provide two al­
ternative studies of state and local government savings
behavior.
19And there's one theoretical argument why not to
worry. Under the economic theory of "Ricardian equiva­
lence," it does not matter whether government net worth
is large or small. The Ricardian view of public finance,
developed in Barro (1974), assumes:(l) taxpayers antici­
pate fully the economic implications of a richer or poorer
public purse; (2) there are no fiscal inefficiencies in moving
dollars between the public and private sectors (i.e., gov­
ernments use "lump-sum" taxes); and (3) parents care as
much about their children's economic fortunes as they care
about their own. In the Ricardian economy, taxpayers fully
understand that increased government net wealth means
more public services an d /or lower taxes in the future and
rationally adjust their savings and private wealth down­
ward to share in some of those benefits today. Taxpayers
also understand that reduced public wealth means less
public or private consumption in the future and thus
rationally adjust their savings and private wealth hold­
ings upward. Thus, private wealth adjusts dollar for dollar
to changes in public wealth. The current empirical evi­
dence goes against the strict Ricardian view of public
finance; see Bernheim (1989).

FEDERAL RESERVE BANK OF PHILADELPHIA

Robert P. Inman

Do You Know How Much Money Is in Your Public Purse?

contractual obligations of the government to fects on private-sector investment, new busi­
bondholders and pensioners exceed the ability ness formation, and work effort. Again, Phila­
of the government to raise taxes to pay for delphia offers a telling example. In the 1980s,
these obligations. A useful first indicator of 19 tax increases pushed the city to the point
how close a government is to falling into bank­ where any additional increase in property or
ruptcy is the ratio of the government's debt to wage tax rates would generate virtually no
its tax base. When that ratio is too high, the new revenues.23
Perhaps the largest worry, however, is what
government can no longer service its debt and
must default. While the estimates summarized our declining public net worth means for fu­
in Tables 1 and 2 allow us to conclude that ture generations of taxpayers. Increased pub­
government bankruptcy is not now a threat to lic debt and reduced public savings and in­
the U.S. public sector, this does not mean that vestment today means more consumption for
individual local or state governments cannot today's taxpayers but less consumption for
fall into trouble. Philadelphia's recent fiscal tomorrow's taxpayers. If the recent declines in
government net worth continue for one or two
crisis is a case in point.20,21
Of greater concern are the fiscal inefficien­ more decades, our children will face not only
cies forced upon us today by yesterday's deci­ higher taxes because of larger public debts and
sions to reduce our public net worth. When lower public savings but also lower incomes
government net worth declines—either be­ because productive public capital per worker
cause of large increases in debt or large reduc­ has been reduced.24 Taking dollars from the
tions in savings and tangible assets—meeting public purse to increase the consumption of
current service needs and contractual debt and today's adults lowers government net worth
pension obligations will require potentially without increasing private net worth and, if
significant tax increases. To maintain public continued, will mean fewer dollars in the purse
services at their 1980 levels yet meet govern­ and lower consumption for our children when
ments' new contractual obligations in 1990, the they are adults tomorrow. Thus, a declining
combined average local, state, and federal tax pu blic net w orth sign als a p oten tial
rate would have to rise from an average rate of intergenerational redistribution.25 What goes
19.1 percent to an average rate of 20.6 per­ into the pockets of today's taxpayers comes
cent.22 Such tax increases, if continued over directly from the public purse we might pass
many years, can have significant adverse ef- on to our children. Unless replaced, the decline
in the public net worth during the 1980s has
cost our heirs approximately $5400 per person
20See Abel (1992).
in future consumption.26
21See Inman (1995).
22The tax rate of .191 was calculated as that tax rate on
1990 income needed to buy the 1980 bundle of local, state,
and federal governments’ services and transfers and to
service the 1980 level of local, state, and federal Net Debt
(= Debt + Contractual Liabilities - Savings) at the 1990 10year Treasury interest rate of .071. The tax rate of .206 was
calculated as that tax rate on 1990 income needed to buy
the 1980 bundle of local, state, and federal services and
transfers and to service the 1990 level of local, state, and
federal Net Debt (= Debt + Contractual Liabilities - Sav­
ings) at the 1990 10-year Treasury interest rate of .071.




23See Inman (1992).
24What is relevant for the production of private income
is the ratio of public capital to labor, and this ratio has been
declining steadily over the past two decades.
25See Auerbach, Gokhale, and Kotlikoff (1991).
26This approximation is based on the decline in public
net worth from $10,679 in 1981 to $5232 in 1990, a loss to
the public purse of $5447 per citizen. If public capital earns

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BUSINESS REVIEW

CONCLUSION: WHAT SHOULD WE DO?
The public purse holds a significant share of
every family's total savings. The estimates in
Table 1 show that in the average U.S. city for
the average family of four, state and city gov­
ernments in 1990 held $50,156 per family (=
$12,539/resident x 4) in net wealth. The esti­
mates in Table 2, updated to 1990, show that
the federal government imposed a net liability
on this same family of $29,228 (= - $7307 x 4).
Together, all governments in the United States
have accumulated a public-sector net worth of
$20,928 per family. Hence, public net worth is
significant.27
What should we do if we want to increase
the size of our public purse? Clearly, the state
and local sectors have been the main public
the competitive rate of return and there is no population
growth, this lost public net worth would have generated a
future consumption stream whose present value just equals
$5447 per future resident.
27For comparison, by 1989 a typical (median) U.S. fam­
ily had accumulated a private net worth of $47,800 (in 1990
dollars); see Kennickell and Starr-McCluer (1994; Table 3).
The average U.S. family, which includes the very wealthy,
had a private net worth of $183,800 in 1989. These esti­
mates do not include expected Social Security receipts.
One must be careful not to simply add together esti­
mates of public and private net worth, however. There is
the possibility of significant double counting. State and
local government net worth— $50,156 per average fam­
ily—constitute assets that households potentially buy and
sell when they relocate from one community or state to
another. If markets ivork perfectly— possibly a big "if"—
market competition will force households and businesses
moving into a new location to pay the current owners of
homes and businesses for the value of the city's and the
state's public net worth. In this case, private land prices
will fully reflect the value of state and local government
net worth, and adding together private and public net
worth would be double-counting.

Digitized for
28 FRASER


savers in our economy, and the federal govern­
ment the main public borrower. Why? There
are two possible explanations. First, we may
want the federal government to run deficits
and the state and local sector to save. The
economic theory of federalism assigns the fed­
eral government the responsibility to use defi­
cit policy for the management of cycles in our
macro economy. Furthermore, to the extent
that there are significant economic spillovers
across state lines from the provision of public
capital, the federal government should bor­
row and use the proceeds to subsidize the
formation of state and local capital. However,
sound fiscal policy requires the federal budget
to be balanced over the business cycle, and this
clearly has not happened. Nor is there any
compelling economic evidence that state gov­
ernment investments create significant eco­
nomic spillovers across state lines.28 Alterna­
tively, state and local governments simply
may be more fiscally responsible, perhaps be­
cause they are constitutionally required to run
balanced budgets. Yet Vermont, one of the
states with the highest level of per capita net
worth, is also the only state without a bal­
anced-budget requirement.
There is no easy answer to why some gov­
ernments save and others borrow, and thus no
easy solution for how we might act to increase
funds in our public purse. Ultimately, whether
a government saves or borrows turns on what
its citizens want. If we want a more rational
and considered public policy toward our eco­
nomic futures, a good place to start is for each
of us to know what's in his or her public purse.

28See Holtz-Eakin (1994).

FEDERAL RESERVE BANK OF PHILADELPHIA

Do You Know How Much Money Is in Your Public Purse?

Robert P. Inman

APPENDIX

How Much Money Is in a Philadelphian’s Public Purse?
Net Worth per Resident

This figure illustrates the levels and time paths of the estimated net worth of Philadelphia and
Pennsylvania compared with the level and time path of the net worth of all state and large city
governments over our sample period, 1972-90. Philadelphians followed the national average rate of
accumulation over most of this period until 1985. By 1990, residents in other states and cities had
accumulated $12,539 per resident in public wealth (see Table 1, page 23), while Philadelphians had
collected $10,424 per resident, about 20 percent less than the national average. For a typical family of four

living in Philadelphia, the family's public purse contained an estimated $41,696.
But what caused the sharp decline in the value of the public purse since 1985? The answer is the fall
in the net worth of Philadelphia. From a peak of $9013 per resident in 1985, cash and security savings were
systematically reduced and government borrowing and unfunded pension liabilities were systematically
increased so that, by 1990, net worth had been reduced to $7201 per resident, a 20 percent decline over the
intervening five budget years. In hindsight, this run on city savings and buildup of public debt were clear
indicators of the city's 1990 fiscal crisis.




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JULY/AUGUST 1995

BUSINESS REVIEW

APPENDIX

How Much Money Is in the Public Purse of Delaware,
New Jersey, and Pennsylvania?

72

74

76

78

80

82

84

86

88

90

This figure illustrates the levels and time paths of the estimated net worth of the three state
governments of the Third District compared with the per capita net worth of all state governments.
Pennsylvania follows closely the average net worth of all other state governments while Delaware is
significantly above the average for all states and New Jersey is significantly below. New Jersey falls below
the average for all states because of its larger-than-average levels of government debt and pension
underfundings. Delaware exceeds that average because of its significantly larger-than-average level of
tangible public assets per resident. Pennsylvania resembles averages for all states in all its accounts—
savings, tangible assets, debt, and pension underfunding.


30


FEDERAL RESERVE BANK OF PHILADELPHIA

FEDERAL
RESERVE BANK OF
PHILADELPHIA
Business Review Ten Independence Mall, Philadelphia, PA 19106-1574