Full text of Business Review (Federal Reserve Bank of Philadelphia) : March 1972

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Wage Pressures on City Hall: Philadelphia's
Experience in Perspective
The 72 Unemployment Puzzle
Bank Bond Management: The Maturity Dilemma
The Fed in Print

FEDERAL RESERVE BANK of PHILADELPHIA

M n m review




Wage Pressures on City Hall: Philadelphia's
Experience in Perspective
. . . The substantial wage increases of Phila­
delphia's City employees have outstripped
those of other major cities, but national
trends, it seems, overshadow the influence
usually accorded union and other local
pressures.
The '72 Unemployment Puzzle
. . . If '72's unemployment rate is to drop
appreciably, more newly-created jobs will
have to be developed relative to the expan­
sion of the labor force.
Bank Bond Management: The Maturity
Dilemma
. . . Like a tightrope walker, a bond portfolio
manager performs an act fraught with pitfalls
as he delicately balances risks against re­
turns for his bank.

On our cover: Carpenters' Hall was built in 1770 by the Carpenters' Company — an association of the
master carpenters of Philadelphia organized in 1724 — which still owns and maintains it. The First
Continental Congress met here in September 1774.

BUSINESS REVIEW is p ro d u c e d in th e D e p a r tm e n t o f R e s e a rc h . R o n a ld B. W illia m s is A r t D ir e c to r a n d M a n a g e r,
G ra p h ic S e rv ic e s . T h e a u th o r s w ill be g la d to re c e iv e c o m m e n ts on th e ir a r tic le s .
R e q u e s ts fo r a d d itio n a l c o p ie s s h o u ld be a d d re s s e d to P u b lic In fo rm a tio n , F e d e ra l R e s e rv e B a n k o f P h ila d e lp h ia , P h ila d e lp h ia ,
P e n n s y lv a n ia 1 9 1 0 1 .




FEDERAL RESERVE BANK OF PHILADELPHIA

Wage Pressures
on City Hall:
Philadelphia's
Experience
in Perspective
By James L. Freund

Rapid payroll growth is not peculiar to
Philadelphia. City halls throughout the
country as well as higher levels of govern­
ment also have experienced large increases
in payrolls as their workers have chalked up
sizeable wage gains. Many commentators
blame rising government wages on such
forces as the spiraling costs of living, union­
ization, and "catch-up" increases. Yet, the
underlying problem may be inherent in gov­
ernment itself rather than in these popular
notions. If this is the case, taxpayers are in
for some tough decisions.

Fiscal woes have plagued America's cities
for generations, but only in recent years
have the crises become so painfully acute.
At the same time that citizens are demand­
ing more and better services, school systems
are forced to shut early, roads are falling
into disrepair, and capital spending plans
are shelved. Philadelphia, like other large
cities, has had its problems compounded by
uphill efforts to meet its chronic social ills.
And, while demands on the City govern­
ment have increased, soaring costs have
heightened pressures on the budget. The
major source of Philadelphia's increased
costs in recent years can be attributed to
the City's constantly expanding payroll.1

WAGE PRESSURES ON CITY BUDGETS
Philadelphia's Growing Payroll. During the
past twenty years, the total wage bill — the
payroll the City pays its workers — has
grown dramatically; in fact, it more than
doubled in the period between 1952 and
1965 (see Chart 1).2 Between 1965 and 1970

1 Last year the Federal Reserve Bank of Philadelphia
conducted an exhaustive study that projected a grim
future of mounting costs and lagging revenues for
both the City and the School District. The report
singled out the City's ever-increasing payroll as the
primary cause of the cost increases (see David Lyon,
"The Financial Future of City and School Govern­
ment in Philadelphia," Business Review, March 1971,
pp. 3-71).




2 The information in this study regarding payrolls
3

BUSINESS REVIEW
CHART

MARCH 1972

from 22,000 to over 35,000. The burgeoning
payroll can only partially be attributed to
increases in employment, however. Increases
in the wage rate of city workers also have
put great upward pressure on the payroll.
As shown in the lower frame of Chart 1, the
average monthly salary of City workers has
climbed continuously since the early 1950s.
In 1952 the monthly salary of a City worker
averaged about $291; in 1970 it was up to
$835 — a jump of 187 percent.
Over three-fourths of this increase in
monthly earnings occurred between 1965
and 1970. Chart 2 shows the estimated pay
increases of all City workers for each of
these years. (Box details the statutory history
of recent wage settlements in Philadelphia.)
The yearly rise in per worker wage cost for
the City ranges from 5.4 percent (between
October 1966 and October 1967) to well
over 20 percent (between the same months
in 1969 and 1970). Over the entire five-year
span annual gains averaged 12.4 percent.
While these increases in monthly earnings

1

P H IL A D E L P H IA ’S
PAYROLL

M O U N T IN G

SOARED

. . .

Millions of Dollars

CHART
C IT Y

SALARY
* October

2

W ORKERS
G A IN S

SCORED
D U R IN G

S IZ E A B L E
1 9 6 5 -7 0

Percent Change

Source: City Employment in 1952 . . . 1970,
GE-No. 1, U.S. Department of Commerce,
Bureau of the Census.

the City's monthly wage bill increased at
even a greater rate — from about $12 mil­
lion to just under $30 million.
One reason for the payroll increases is
expansion in City employment. Since the
early 1950s the City's work force has swelled
and earnings in city governments was derived from
data in City Employment in 1965 and City Employ­
ment in 1970. U.S. Department of Commerce, Bureau
of the Census. CE-No. 1 and GE-70 No. 2. It is
important to note that this study deals with only
employees of the governments involved and not with
teachers and other school-related employees. Data
limitations made it impossible to include the latter
group.




* October to October
Source: City Employment in 1965 . . . 1970,
GE-No. 1, U.S. Department of Commerce,
Bureau of the Census.

4

FEDERAL RESERVE BANK OF PHILADELPHIA

R E C E N T IN C R E A S E S IN EA RN IN G S FO R P H IL A D ELP H IA
C ITY GO VERN M EN T W O R K ER S
Date

Amount of Increase

Groups Receiving Increase

July 1965

$500

Police and Fire Fighters

January 1966

$145

Police and Fire Fighters

Increases averaging
10-15%
January 1967

Municipal Nonuniformed Employees

$294

Police and Fire Fighters

3%

Municipal Nonuniformed Employees

January 1968

8%

All Municipal Employees

January 1969

$900

Police and Fire Fighters

$600

Municipal Nonuniformed Employees

Reduction of steps per
salary level

Municipal Nonuniformed Employees

July 1969
January 1970

Police and Fire Fighters

$600
July 1970

$671

Municipal Nonuniformed Employees

$900, plus differentials for
all grades above patrolmen
$1000

Police

$800
Longevity increases of $100
per 5 years added to salary

Municipal Nonuniformed Employees
All Municipal Workers

January 1971

July 1971

$200
$100

Fire Fighters

Police
Fire Fighters

$750
6-14% differentials to
create rank differentials

Police and Fire Fighters
Fire Fighters

$650

Municipal Nonuniformed Employees

Source: Philadelphia Municipal Employees, Compensation Chronology, 1953-1971. Regional Report
No. 3, November 1971, U. S. Department of Labor, Bureau of Labor Statistics.




5

BUSINESS REVIEW

MARCH 1972

ever. Nonwage benefits to City employees,
the other part of the burden, have also risen
substantially over the last five years (see
Box). Consequently, the total increased cost
to the City of Philadelphia over the period
has been even greater than 12.4 percent an­
nually.

were affected by such things as seniority
gains, the types of employees hired during
the period, and overtime payments, they
have been caused primarily by frequent and
substantial boosts in City workers' salaries.
Payroll figures do not represent the entire
burden to the City of its employees, how­

INCREASES IN NONMONETARY BENEFITS FOR EMPLOYEES OF
THE CITY OF PHILADELPHIA — 1965-1971
I. PENSIONS
A large chunk of the City of Philadelphia's budget is contributed to its employee's
pension fund. The increased burden on the City budget in recent years has been sub­
stantial (see "The Financial Future of City and School Government in Philadelphia,"
Business Review, March 1971, pp. 33-34). One reason for this increased burden has
been liberalization of the pension benefits in 1967 and again in 1971. In 1967 the plan
underwent a major overhaul. Employee benefits were increased; and the eligibility
age was lowered. In July 1971 the retirement age for service pensions was again re­
duced. The Pennsylvania Economy League estimates that pension costs to the City
could increase by about a third as a result.
II. WORKING CONDITIONS
Several adjustments were made over the last five years that added to City costs by
improving conditions under which municipal employees work. The number of workers
eligible for overtime increased substantially over the period; all workers earning
$14,258 and below now may receive monetary benefits for overtime. The limit on
holiday pay was raised for nonuniformed municipal employees in 1965. Firemen and
policemen also experienced increased holiday benefits; in particular, in 1965 firemen
received a 50 percent hike in paid holiday time. A further improvement was the reduc­
tion of the workweek for policemen from 42 to 40 hours in July 1971.
III. OTHER FRINGE BENEFITS
The costs to the City of health insurance, sick leave, and vacations for its workers
have increased in recent years. Vacation benefits have been liberalized several times in
recent years. Nonuniformed employees received three extra noncumulative vacation
days in 1969 and, in 1970, had the maximum allowable vacation raised from three weeks
to four weeks. The minimum seniority level at which the maximum vacation benefit
accrues was lowered twice. Uniformed workers received similar increased vacation
privileges.
Benefits paid at retirement for accumulated sick leave were substantially liberalized
both in 1969 and 1970. Both percent of the salary paid and the number of days which
could be accumulated were increased. Conversely, in July 1971 the annual days of
allowable sick leave for policemen were reduced from 21 to 20.




(Continued on next page)

6

FEDERAL RESERVE BANK OF PHILADELPHIA

Finally, life insurance and health benefits have been increased for City workers. In
July 1971 the City upped the benefits on the noncontributory, double indemnity policy
it provides its employees from $2500 to $4000. Likewise, the contribution of the City
for health benefits for its workers has increased steadily since 1966. After five increases,
the maximum municipal contribution for the employee health plan is $310, representing
a 496 percent increase for uniformed workers and a 158 percent increase for nonuniformed workers.
Source: Philadelphia Municipal Employees, Compensation Chronology, 1953-1971. Regional Report
No. 3, November 1971, U.S. Department of Labor, Bureau of Labor Statistics.

than the Quaker City's. Of the nation's
major cities, Philadelphia was one of four
in which monthly earnings increased more
than 10 percent annually (see Chart 3). At

Is Philadelphia Alone? While the gains of
Philadelphia's workers have been large,
those of workers in comparable cities have
also been substantial — some barely slower

CHART

3

P H IL A D E L P H IA
IN

RECENT

HAS

OUTPACED

OTHER

LARG E

C IT IE S

YEARS

Annual Average Percent Change

12
|

|

^

M ^O NTH LY

E A R N IN G S

PER

W ORKER^

1 9 6 5 -7 0 ^

11
10
9
8
7

6
5
4

3

2

1
0

Source: City Employment in 1965 .
Bureau of the Census.




1970, GE-No. 1, U.S. Department of Commerce,

7

MARCH 1972

BUSINESS REVIEW

Dallas, and Atlanta — reporting annual in­
creases almost as great, also ranked com­
paratively low on the pay scale in 1965.

the other end of the scale, cities such as
San Francisco, Detroit, and Cleveland posted
rates of increase less than half the size of
Philadelphia's.
Part of the difference among cities may
be attributed to "catch-up" increases. As
seen in Chart 4, City salaries were fairly low
when compared to those of some northern
and western cities in 1965. By 1970, how­
ever, Philadelphia's relatively large in­
creases lifted it to a level more typical of
these similar cities.3 Other cities— Houston,

WAGE PRESSURES ON CITY HALL:
SOME POPULAR VIEWS
"Catch-up" increases only partially ex­
plain wage changes and only apply to a few
time workers, and the composition of the work force.
Therefore, Philadelphia could have been low in 1965
partly because it did not employ as many relatively
high-paid workers (such as policemen) as other cities.
More important, these figures do not reflect nonwage
benefits such as pensions, health plans, and holidays
that could be much higher in Philadelphia.

3 It must be remembered, when comparing average
monthly earnings across cities, that these figures
reflect such factors as overtime, the number of partCHART

4

E A R N IN G S
OF

OF

S IM IL A R

C IT Y

W ORKERS

MOVED

UP

TO

THE

LEVEL

C IT IE S

Dollars
Los Angeles

950

A V E R A G E M O N T H L Y E A R N IN G S P E R W O R K E R

Chicago
PHILADELPHIA

Detroit

750

Dallas
650

Houston

At anta

450

350

250

-

*
Source: City Employment in 1958 . . . 1970, GE-No. 1, U.S. Department of Commerce,
Bureau of the Census.




8

FEDERAL RESERVE BANK OF PHILADELPHIA

sized cities (those over 50,000) averaged in­
creases of about 7 percent per year.
Philadelphia's municipal government is
one of the nation's largest. Only New York,
Los Angeles, and Chicago employ more
people. While employees in all of these
urban governments experienced average an­
nual wage gains greater than 7 percent over
the period 1965-1970, only Chicago (8.9
percent) and Philadelphia (12.4 percent)
posted much higher increases than other
large cities. Thus, it is difficult to attribute a
dominant part of Philadelphia's wage pres­
sure to its size.
Unionization and Wage Increases. Phila­
delphia's government is highly unionized.
The City negotiates with spokesmen of three
groups that form the bulk of its work force
— the general employees, the policemen,
and the firemen. Philadelphia is not alone
in the degree of unionization of its workers,
however. In recent years unions have or­
ganized workers at all levels of government,
especially in large urban areas. Many per­
sons blame the increasing wage pressures
in the public sector on union activity.
Unions may affect wages by organizing
employees so that they will not work unless
wages are raised.4 While studies of union
influence have not been conclusive, they
have shown that the effect of unions is
strongest over short periods, especially in
times when unionism is growing. The im­
pact of public sector unions in Philadelphia
and other cities in which unions have been
aggressive has yet to be established. The
influence of public sector unions should,
however, be related to the same measures
of union power which apply to their indus­
trial counterparts: the legal status they have

cities. For Philadelphia and most other
cities, additional forces influence earnings
changes. Popular notions abound concern­
ing these forces, but few have been verified.
Some persons contend that skyrocketing
wage costs are a consequence of the size of
large cities. Others argue that the cost of
living has increased more in large cities and
that government wages reflect this. The most
widely-held opinion, however, is that union
activity caused the lion's share of recent
wage boosts.
Cost of Living Pressures. Since the cost of
living has increased substantially in recent
years, wages could be expected to increase
accordingly. Between 1965 and 1970 Phila­
delphia's cost of living rose at an average
rate of about 4 percent per year. Obviously
the City's 12.4 percent average boost in
earnings can be only partially justified on
these grounds.
Moreover, cities with the largest change
in the cost of living are not those where
government earnings have risen the most.
Chart 5 compares average annual changes
in the cost of living to similar changes in
earnings in several large cities. For example,
Detroit and New York — cities where the
cost of living has risen most during the last
five years — had relatively small increases
in earnings over the same period. While
Kansas City, Los Angeles, and Pittsburgh —
cities where cost-of-living increases averaged
only a half percent less than Philadelphia's
— experienced wage changes a full 3 to 5
percent less per year. In short, over the
five-year period, differences in salary hikes
for government workers in the Quaker City
and other large cities bore little relationship
to differences in changes in the cost of
living.
City Size and Labor Costs. Contrary to
popular notions, large city governments as
a group do not have much higher wage
growth rates than smaller areas. Chart 6
shows that, except for very small cities, the
average annual increase in earnings varied
little with city size. All groups of larger-




4 Wage increases are only one facet of union activ­
ity. Unions may affect work rules and procedures,
nonmonetary benefits, and even hiring and firing pro­
cedures. On the other hand, economic theory also
tells us that if unions are effective in increasing wages,
they will have an adverse effect on the number of
jobs available. This study is concerned, however, only
with the limited question of the union's effect on the
size of wage increases in recent years.
9

ART

5

REASED

S A L A R IE S

HAVE

O U T S T R IP P E D

COST

OF

L IV IN G

CHANGES

jal Average Percent Change in Monthly Earnings, 1965-70

• PHILADELPHIA
12

• ATLANTA
11

10

9
• KANSAS CITY

• BALTIMORE

8
LOS ANGELES
WASHINGTON, D.C.
7

.

* PITTSBURGH

HONOLULU
• ST. LOUIS
• NEW YORK CITY

SAN FRANCISCO •

6

5
* DETROIT

4

3

0




---- 1------------------- 1------------------- 1------------------3

4

5

Annual Average Percent
Change in Local
Consumer Price Index

:: Data supplied directly by U.S. Department of Labor, Bureau of Labor Statistics.

10

FEDERAL RESERVE BANK OF PHILADELPHIA
CHART

6

E A R N IN G S

JU M P ED

Cities,
Under
50,000

IN

C IT IE S

OF

ALL

Cities,
50,000500,000

Cities,
500,000

5 The data in this study, upon which statements
and conclusions about the effects of union activity
are made, are based on a survey conducted by the
International City Management Association. The sur­
vey, "Public Employee-Employer Relations in Local
Governments," was sent to all major U.S. city gov­
ernments in 1969. It asked for information on city
background, number of organized employees, in addi­
tion to local laws, policies, and practices regarding
local public sector unions. The results derived in this
study from the survey are, naturally, limited by the
usual problems of sampling. Statistical tests were ap­
plied to all comparisons made to determine whether
the differences in question were significant.
11

Cities,
Over

1, 000,000

achieved, the extent to which workers have
been organized, the frequency of work dis­
ruptions a city has suffered.5
If the legal right to organize and the ex­
tent of unionization are accurate measures
of government unions' effectiveness, then
the common belief that they are the culprits
in recent wage increases is not valid. For
cities of at least 250,000 population, the fact




S IZ E S

1 , 000,000

that authorities were legally permitted to
sign negotiated agreements with their em­
ployees did not tend to affect wage settle­
ments as much as other influences. Cities
in which written agreements were legal
averaged a 6.9 percent annual increase in
earnings over the period 1965-1970, as op­
posed to 7.7 percent in cities where such
agreements were illegal.
However, cities that could legally nego­
tiate with single representatives of large
groups of their employees experienced
slightly higher wage growth. Cities that dealt
with their public safety and general em­
ployees as single negotiating units had an
average of 7.6 percent increases between
1965 and 1970. Municipalities that could
not legally negotiate with unions in this
manner registered annual increases averag­
ing 6.8 percent. Although other factors tend
to obscure the exact relationships, it would
appear that the ability to represent workers

BUSINESS REVIEW

MARCH 1972

not been the case. Large cities that have
been disrupted by strikes, slowdowns, or
picketing do not appear to have had signif­
icantly higher wage increases than other
large cities (see Chart 7). In cities where
negotiations have broken down and work
disruptions have occurred, earnings in­
creases averaged 7.8 percent as opposed to
7.2 percent for those without strikes. If there
were positive gains from striking after all
other factors worked themselves out, then
they were not very large ones. Furthermore,
local governments facing recalcitrant unions
that required binding arbitration in negotia­
tions had wage increases at the rate of 7.4
percent — almost the same as of those
parties that did not have arbitration.
The averages cited in all these compari­
sons reflect more than just militancy. The
salient point is that cities with strong and
active unions do not as a class register
higher wage increases than those with less
aggressive unions. It is certainly possible that
unions have caused wages in Philadelphia
or other large cities to be higher than they
would have been had workers never organ­
ized. It seems, however, that unions have
hardly constituted the dominant force for
wage increases in large city governments in
recent years.

in a /arge unit may provide a more impor­
tant avenue of union power than simply the
ability to negotiate.
Perhaps the most commonly held belief
about government employee unions is that
the more organized they are, the more
powerful they are, the higher the wage in­
creases they can negotiate. There is no ac­
curate yardstick of the strength of public
unions in large cities. Available information
does provide a general idea of union mem­
bership, however.
Among large cities there are no over­
whelming wage effects associated with the
extent of unionization (see Table). Cities re­
porting a completely unionized work force
registered, as a group, the lowest average
annual wage change. Highly unionized cities
(above 50 percent but less than 100 percent
of their work force unionized) posted the
highest average annual increase — 7.9 per­
cent. Moderately unionized cities (including
only two cities that reported no union ac­
tivity) also experienced large wage advances.
In short, the degree of unionization alone
did not have enough effect on the rate at
which wages increased to overwhelm other
forces which affect wages.
Because of their widespread impact on
the public, work disruptions and other
'labor troubles" have received much atten­
tion in recent years. If some public sector
unions have been aggressive enough to dis­
rupt government operations and successfully
influence wages, cities that have experi­
enced such problems should have registered
the largest increases. Apparently, this has

WAGES IN THE PUBLIC SECTOR:
A UNIVERSAL PROBLEM
Since popular notions about local govern­
ments do not fully explain why the wages
they pay have risen, other possibilities must
be considered. Wages in the public sector

D E G R E E O F UNIONIZATION AND R E C E N T W A GE C H A N G ES
IN LA R G E C IT IE S
Reported Degree of
Unionization

Number of
Cities Reporting

Average Annual Rate of
Wage Change, 1965-1970

9

7.0

Highly Unionized

18

7.9

Moderately Unionized

25

7.3

Completely Unionized




12

FEDERAL RESERVE BANK OF PHILADELPHIA
CHART
W AGE

7
CHANGES

SHOW

With

L IT T L E

IM P A C T

U N IO N

With

Without

A C T IV IT Y

Without

ability for the outcome is often split. The
executive branch of the government nego­
tiates or decides upon wage settlements,
while the legislative branch passes on the
funding. For administrative and political rea­
sons, the legislative branch is unlikely to
reject or refuse to fund negotiated or prom­
ised wage boosts, thereby weakening resist­
ance to such upward thrusts.6
*
Other economic forces may have gen­
erated additional pressure for spiraling gov­
ernment wages generally and those of city
governments such as Philadelphia. Unlike
most private sector jobs, a government posi­
tion is viewed by most workers as a secure
one because the chances of being fired or
laid off are slim. This aspect of civil service

are determined differently than are those
in the private sector, and the attitudes of
government employees in part differ from
those of other workers. Moreover, all levels
of government are subject to interrelated
demands and revenue sources. Conse­
quently, growth in municipal wages may be
subject to forces largely shaped by gen­
eral characteristics of governments. Increas­
ing wage burdens throughout the public
sector indicate that the underlying reasons
for budgetary pressures on local govern­
ments do pervade higher levels of govern­
ment as well.
Public Sector Wage Determination. Al­
though economists do not fully understand
what causes wage changes in the public
sector, there are several characteristics
unique to wage determination in govern­
ments that may help explain recent wage
increases. For example, unlike a private firm,
a governmental unit does not operate under
the profit motive. Therefore, the incentive
for holding labor costs down may not be as
strong as that in private firms where higher
costs may be immediately translated into
lower profits. Another aspect of public
sector wage determination is that account­




FROM

6 The recent experience of the City of Philadelphia
is illustrative. The previous Mayor's Administration
negotiated a lowering of the pension age in August,
and the City Council had little choice regarding the
funding of it this past January. For Philadelphia and
all local governments the issue of how public sector
wage decisions are reached is even broader. Many
commentators consider the union's political role in
municipal decision processes as a serious factor in
wage determination. For instance, see Harry H. Well­
ington and Ralph K. Winter, Jr., The Unions and the
Cities (Washington: Brookings Institution, 1971).
13

BUSINESS REVIEW

MARCH 1972

has traditionally led government workers
to accept low wages in return for security.
In the 1960s the economy expanded stead­
ily. Since most workers could find jobs
easily, the security of a government posi­
tion was not as attractive as before. Conse­
quently, government workers at all levels
may have received raises to compensate
them for the loss of this advantage.7 Finally,
some wage gains in the public sector as a
whole can be attributed to increased de­
mand for government workers. In recent
years employment in the public sector has
been expanding faster than most other areas
of the economy, and all governments have
found that wage increases are necessary to
attract capable personnel.
The Record. Philadelphia and other local
governments were hardly alone in the late
1960s. Governments at all levels have ex­
perienced substantial earnings gains. While
these increases fell somewhat short of Phila­
delphia's, they were in line with those of
workers in most large municipalities (see
Box).
Like Philadelphia's employees, other
public workers have made real absolute
progress. The wages paid by all levels of
government have increased at a rate well
above the average annual cost-of-living in­
crease of 4.5 percent. Relative to workers in
other industries, government employees
have fared quite well. Only the "hard hats"
of the construction industry have achieved

wage gains in the same range as govern­
ment workers. Except for the construction,
mining, and service sectors, most other in­
dustries experienced wage increments at an
average annual rate of 5 percent or less
from 1965 to 1970 compared to the above
6 percent gains by government workers (see
Box for details).
While the reasons behind the gains of
public sector workers are unclear, it does
seem that all levels of government have
been suffering from wage pressures on their
budgets. Everyday concepts about why cities
are under wage pressures at best have ex­
plained the variations from the general
trend among cities. Unless the underlying
trend of economic forces affecting wages
in the public sector is radically reversed, no
city government should expect to be im­
mune from rising wage demands.8
INCREASING WAGE BILLS
AND THEIR CONSEQUENCES

7
Pressure from workers on this issue and the notion
that government workers have been doing otherwise
comparable work for less pay than other workers ap­
parently has been held by many besides public sector
union leaders. For instance, Congress evidently held
this view. An increase of Federal salaries was man­
dated by Congress in 1962 in order to attain com­
parability between Federal workers and those in sim­
ilar jobs in private industry. The average earnings
increases of Federal workers over the last five years
reflect this process. It is likely that many state and
local governments have raised wages for this same
reason. See Jerome Roskow, "Government Pay Trends,"
The Conference Board Record (New York: National
Industrial Conference Board) 7 (July 1970): 15-22.




14

Continuing Pressures. Although wage
pressures will continue in Philadelphia,
there are reasons to expect a partial easing.
General movement in government wages
may not create as strong an upward momen­
tum as in the past. This is especially true in
one area. Since recent gains by government
workers have made earnings more compar­
able to those in the private sector, such ad­
justments should not be as important in the
future. Likewise, local conditions indicate
wage pressures on Philadelphia's City Hall
may not be as great as before. If some of
the past growth was, in fact, a "catch-up"
gain, the future rate should be less than that
of the past few years. Moreover, future
8 Generally one would expect that local govern­
ments in areas with depressed labor markets could
escape upward wage adjustments by hiring locally.
However, like most other employers in the economy,
either union influence or feelings of "fairness" do not
allow government units to use low-priced labor when
it is available. Often governments give wage increases
to workers when there are many local workers who
would be willing to work at the old wage.

FEDERAL RESERVE BANK OF PHILADELPHIA

wage settlements will certainly be affected
by the City Administration's attitude at the
bargaining table and by Phase II regulations.
Still, there is little doubt that the problem
of intensified budget pressure because of
increases in the wage bill will be with Phila­
delphia and other cities for quite some
time.9
9 The
unions for
the press.
consistent

Wage hikes are burdensome to all eco­
nomic units that use labor, but they work
a particular hardship on local governments.
This results from the fact that local govern­
ments, such as Philadelphia, are what econ-

preliminary “ demands" of Philadelphia's
next year have been made known through
Although a limit of 5.5 percent would be
with Phase II guidelines, it has been re-

W AGES

HAVE

R IS E N

AT

Annual Average Percent Change,

ALL

LEVELS

ported^hat the “ demands" are for greater amounts,
more in line with those of past years. Policemen are
reported asking for about 23 percent, firemen want a
20 percent wage hike plus increased fringe benefits,
and representatives of the general city employees are
said to be asking for about a 9 percent increase plus
fringe benefits.

OF

G O V E R N M E N T ,..

1965-70

The boom in wage costs that Philadelphia and other large cities experienced has
affected all levels of government. Since only 1960 the payroll ( ■ ) for the entire
public sector has soared from $3.3 billion to $8.3 billion. Like Philadelphia, the growth
rate for all governments has been most rapid over the period from 1965 to 1970. In
fact, the plight of many governments was greater than that of large municipalities —
the growth of state and Federal payrolls exceeded that experienced at local levels.
Expanding employment (
), especially in state governments, explains much of
the growth in payrolls. Ftowever, not unlike Philadelphia, pay increases of employees
during the last five years inflated wage bills at all levels of government. While average
monthly earnings in the Federal Government increased on the average by about
8 percent per year, state and local employees received annual average increases of 6.9
and 6.3 percent respectively ( ■ ). These large, continuous increases have accumulated
into substantial gains for workers.
Source: Public Employment in 1965, GE No. 2, U.S. Department of Commerce, Bureau of the Census;
Public Employment in 1970, GE 70 No. 1, U.S. Department of Commerce, Bureau of the Census.




(Continued on next page)

15

BUSINESS REVIEW

AND

MARCH 1972

GOVERNMENT

A C H IE V E D

REAL

W ORKERS

AT

ALL

LEVELS

HAVE

G A IN S

Annual Average Percent Change

8

7

6

5

4

3

2

1
0
Federal

State

Local

All
Finance, Services
Contract
Industries Insurance,
Construction
Real Estate

GOVERNMENTS

PRIVATE SECTOR

Government workers at all levels achieved average monthly earnings gains well in
excess of the cost of living. During the period 1965-1970 they also made gains relative
to workers in other industries. The average gain in monthly earnings in the private
sector was 4.7 percent per year — well below all gains in the public sector. While some
industries such as contract construction posted gains comparable to those in the public
sector, earnings changes in industries with occupational structures similar to those of
governments did not increase as much. For instance, annual increases in earnings in
finance, insurance, and real estate — an industrial class with a work force similar to
many governmental units — averaged 5.1 percent over the last five years. This is a full
percent below the average for any level of government.
Source: The estimates of earnings changes for the private sector are based on data on average weekly
earnings, Table C-5, Employment and Earnings, U.S. Department of Labor, Bureau of Labor Statistics.
Comparisons here are tempered because growth in workers earnings in the private sector are affected
more by changes in hours worked per week than those of government workers. Thus, average hourly earnings
of government workers probably did not exceed those of private sector workers as much as did monthly
earnings over this period.




16

FEDERAL RESERVE BANK OF PHILADELPHIA

performing them. There is a limit to how
much of this adjustment is possible, how­
ever. The policeman or the buildings in­
spector can probably never be replaced by
a machine. Where this is the case, the
burden must be borne by taxpayers.
When a firm's costs rise and internal
economizing is unsuccessful, it must receive
higher prices from consumers or accept
lower profits. Since large city governments
don't make profits, they must receive higher
"prices" to continue operating at the same
level. Governments "raise prices" by increas­
ing taxes — the price of public services to
citizens. This solution has fallen on hard
times, however. Taxpayers across the land
are "revolting" against increased levies.
Philadelphia's Mayor Rizzo has emphatically
ruled out tax increases. If this adjustment
cannot be made, another solution would be
to have someone else — the State or the
Federal Government — pick up the tab for
increased wage payments in the form of
government aid. However, this is often
easier said than done and in the past has
been only a temporary solution.
If no other source of funds can be tapped,
the only alternative for a government is to
slash expenditures and services. If the price
of theater tickets or dinners goes up, people
generally go out less often. In sum, the tax­
payers of large cities face a Hobson's choice.
If wage changes raise the cost of police pro­
tection and city taxpayers refuse to fork
over higher taxes, "somebody else" — the
state house or even the White House —
must foot the bill or there will be less pro­
tection. The same goes for schools, streets,
and social welfare. The laws of economics
apply just as clearly to governments as to
firms. Public employees can not be paid
more unless greater sacrifices are made. ■

omists call 'labor intensive." That is, their
budgets are heavily weighted toward wage
payments. In Philadelphia more than twothirds of current general expenditures are
for the money wage bill alone. Any increase
in the wage rate, therefore, places a heavy
burden on the budget.
The Choices Facing Local Taxpayers. Like
any ‘business firm experiencing increased
wage costs, governments must adjust. One
way is greater efficiency. If growing de­
mands could be met by increased produc­
tivity from the City's labor force, the City
could be relieved of the financial burden
of new hiring and could more easily "afford"
higher wages. Although gains can probably
be made in this area, it is unlikely that they
will offset the bulk of budgetary pressures.
Thus, other adjustments will have to be
made. One painful solution is cutting back
on the use of the item — in this case labor
— which is causing increased costs. An al­
ternative course of action would be to pass
the burden on to the consumer, either by
higher taxes or reduced services.
The first alternative is a standard eco­
nomic adjustment, but it may be of limited
use to government. If wage costs are rising,
a firm will attempt to use less labor and
substitute more capital in the production
process. It may be less expensive to buy a
new machine than to hire several new
workers. If wages keep rising in govern­
ment, it may be cheaper to buy more street­
cleaning machinery than to hire men to
hand-sweep the streets. Or, alternatively, an
expensive fire truck may take the place of
several men and be more economical in
the long run. Another possibility is that it
may prove cheaper to farm out contracts
for entire services such as recordkeeping or
billing, rather than have government workers




17

BUSINESS REVIEW

MARCH 1972

The 72
Unemployment
Puzzle
By L Christine Grad

The unemployment rate is quickly prov­
ing itself to be one of the most intractable
of all domestic economic problems. While
some progress has been made in fighting
inflation, significant improvement in the un­
employment picture has not materialized.
The reasons for this are fairly clear. The un­
employment rate depends on two things —
the number of persons in the job market
and the number at work. And, since govern­
ment has little control over the size of the
labor force and only indirect control over
the number employed, its direct influence
on the unemployment rate is limited.
Although the unemployment rate usually
makes the headlines, its determinants — the
civilian labor force* and the number of em­
ployed persons — often go unnoticed. The
gap between labor supply (measured by the
civilian labor force) and labor demand
(measured by those having jobs) is the num­
ber of unemployed persons. This difference
has increased since early '69. Similarly the

unemployment rate — which simply states
what proportion of the civilian labor force
is out of work— has risen substantially from
a low of 3.4 percent in the first quarter of
'69 to the 6 percent range during 71.

C H A R T

D IS P A R IT Y
O F
A N D

R EFLECTS

B ETW EEN

PEO PLE
TH O SE

IN

TH E

TH E
JO B

H O L D IN G

TH E

NU M BER
M ARKET

JO B S.

M illions of Persons

*The civilian labor force comprises the total of all
civilians 16 years of age and over classified as em­
ployed or unemployed, in accordance with specific
criteria determined by the Bureau of Labor Statistics.
The civilian labor force does not include members
of the armed services and those not actively seeking
jobs.




1

U N EM PLO YM EN T

* Seasonally adjusted.
Source: U.S. D epartm en t of Labor, Bureau
of Labor Statistics, Em ploym ent and Earnings,
February '72.

18

FEDERAL RESERVE BANK OF PHILADELPHIA
C H A R T

2

R E L A T IV E
LA BO R

CH A N G ES

FO RC E

IN

TH E

D E T E R M IN E

G R O W TH
TH E

O F

JO B S

U N EM PLO YM EN T

A N D

TH E

RATE.

Percent

Percent C h ange*

3

2

1

0

-1
1 96 9

1970

1971

* Annual changes are based on year-end averages of seasonally adjusted data.
Source: U.S. D epartm en t of Labor, Bureau of Labor Statistics, Em ploym ent and Earnings, February 7 2 .

Merely achieving growth in employment will not reduce the unemployment rate. In fact,
job opportunities must expand at a faster pace than the labor force if both the currently
unemployed and new entrants are to find work. For example, in 1970 the general economic
slowdown brought about a severe cutback in the demand for labor, causing layoffs and
leaving new entrants without employment opportunities. The result — a jump of 2.6 per­
centage points in the unemployment rate between December '69 and December 70. While
the number of new jobs created in 71 nearly matched the 1.6 million increase in the labor
force, too few jobs were added to make up for those lost during the previous year. Hence,
the unemployment rate remained at a high level for the year.




19

BUSINESS REVIEW

C H A R T
TH E

MARCH 1972

3

SAM E

RULE

A P P L IE S

IN

'7 2 .

Percent

UNEM PLO YM ENT

RATE

TARGET FOR U N EM PLO Y M E N T RATE 5 .1 %

4

-

*

A
____L

J____L

1971 „
.
1972
Percent Change

EM PLOYM EN T
3

—
CIVILIA N
LABOR

1 -

1971

I V — 1 9 7 2 IV

Success of policies aimed at reducing the unemployment rate this year will depend,
therefore, on how fast job offerings grow relative to the expansion of the labor force. Over
the last decade, normal growth in the civilian labor force has been about 2 percent per year
— or approximately 1.8 million persons in '72. If this labor supply expansion materializes,
then the Administration's goal — reducing the unemployment rate to "near 5 percent by
the end of the year"* — will require about 2.4 million newly-created jobs during 1972.
*"Near 5 percent by the end of the year” has meant for our calculations an unemployment rate of 5.1 percent
for the fourth quarter of 1972.




20

FEDERAL RESERVE BANK OF PHILADELPHIA
C H A R T

4

H O W EV ER ,

U N P R E D IC T A B L E

G R O W TH

O F

TH E

LABO R

FO RC E

.

.

.

M illions of Persons

* Seasonally adjusted.
* * Based on average annual growth of 2 percent over the last decade.
Source: U.S. D epartm en t of Labor, Bureau of Labor Statistics, Em ploym ent and Earnings, February '72.

If, however, the civilian labor force expands more rapidly — as could easily occur — even
more new jobs will be needed for the same target level of unemployment to be realized.
The volatility of labor supply is, undoubtedly, a source of uncertainty. In 1971, for instance,
the labor supply, although bouncing around, remained virtually unchanged during the first
half of the year, and then increased by 1.6 million persons in the last half. Population growth,
military manpower requirements, and fluctuations in the proportion of the population desir­
ing employment (the labor force participation rate) are the key factors which will determine
the number of people looking for jobs in '72. If, for example, the labor force participation
rate increases as unemployment falls — as has happened in the past — then policymakers
will have to get additional mileage out of measures designed to spur employment expansion
in order to reduce the unemployment rate.




21

BUSINESS REVIEW

MARCH 1972

C H A R T
AN D
IN

’7 2 ,

LESS

5

U N C E R T A IN T Y
M AKE

TH A N

A

ANY

A B O U T

TH E

P R E D IC T IO N S

M A G N IT U D E
ABO UT

TH E

O F

JO B

RATE

E X P A N S IO N

O F

U N EM PLO YM EN T

S H O O - IN .

Percent Change in E m p lo ym en t*

* Based on year-end averages of seasonally adjusted data.
* * 1971 IV to 1 9 7 2 IV; necessary to achieve a near 5 percent rate of unem ploym ent with average growth
in the labor force.
Source: U.S. D e partm en t of Labor, Bureau of Labor Statistics, Em ploym ent and Earnings, February '72.

Even if the labor force does grow by an average amount, the number of jobs will have to
grow about 3 percent — an above average gain — to reach an unemployment rate near 5
percent. Indeed during the '60s, jobs increased by 3 percent or more in only one year —
1965. And, even the growth of labor demand required to achieve a more modest unemploy­
ment goal of, say, 5.5 percent is above the average.
Nevertheless, a performance similar to that of '65's is possible. Much excess capacity exists
within the economy, and there is ample room for creating jobs for the presently unemployed
and upcoming entrants into the labor force. Too much stimulus, of course, will rekindle
inflation. But, clearly, more than a small dent needs to be made in the number of unemployed.




22

FEDERAL RESERVE BANK OF PHILADELPHIA

Bank Bond
Management:
The Maturity Dilemma
by Ronald D. Watson

SETTING THE STAGE:
BANK LIQUIDITY MANAGEMENT

Had Gilbert and Sullivan been as familiar
with managing bank investments as they
were with policemen and pirates, they might
well have intoned "a banker's [policeman's]
lot is not a happy one."1 The meter of this
change of phrasing might have caused them
some problems, but those difficulties pale
when compared to the headaches of man­
aging millions of dollars of government se­
curities investments in today's financial mar­
kets. Recently bank investment officers have
become aware that this complex job re­
quires more than simply understanding the
financial markets in which they ply their
trade. They must also discern how their
superiors will measure the success of their
bond management performance. Recent de­
velopments in banking research suggest that
the bond management script may need to
be rewritten before future performances. At
a minimum there are ways to make the
leading role — that of the bond account
manager — easier to play.
1 William S. Gilbert and Arthur Sullivan, The Pirates
of Penzance; or the Slave of Duty, Act II.




23

Banks, just like any other business, come
upon times when they could use more hard
cash. When a bank wants money, say to
meet a cash outflow, it has many sources to
tap. Cash balances not currently held to
meet reserve requirements might be re­
duced, additional deposits solicited, loan
outflows curtailed, temporary borrowings
made from the Federal Reserve Bank, or
portions of the bond portfolio sold. As this
incomplete list of possibilities indicates,
management can convert earning assets into
cash or acquire new liabilities to meet cash
demands. The choice depends on the rela­
tive cost of the alternatives. This process is
called liquidity management.
Before the mid-1960s, techniques for
managing bank liquidity focused on selling
assets, such as bonds, to generate additional
cash. However, considerable attention has
been devoted recently to solving these li­
quidity problems exclusively by buying short­
term liabilities in the money markets as

BUSINESS REVIEW

MARCH 1972

funds are needed. This strategy is known as
liabilities management. Awareness and use
of this option has added a new dimension
to managing a bank's liquidity. Bankers now
have more flexibility in meeting unexpected
cash demands because this borrowing
power enables them to avoid selling bonds
or other assets when they find that prices
are unfavorable.
However, the simple fact that these money
markets are now well-developed sources of
financing doesn't make them the most
economical method for alleviating every
financial pinch. The credit crunches of '66
and '70 showed the folly of presuming that
money markets can accommodate all the
banking community's liquidity demands at
the borrowing rates it is willing to pay.
Thus, bank assets, particularly government
securities, and the men who control them
continue to play key roles in bank liquidity
management.

more practical source of liquidity. These
bonds are formal obligations of borrowers
who are financially sound, which can be
traded in relatively well-organized markets.
Some are more marketable than others, of
course, but all can be converted into cash
with little difficulty. The Treasury security,
because of its ready marketability, has be­
come the most common source of asset
liquidity used by the men who manage bond
portfolios at commercial banks.
The Role of the Bond Portfolio Manager.
The man running the bond portfolio show
has to be a first-rate director. His job is bal­
ancing the bank's liquidity requirements
against bank earnings. An important part of
this balancing act involves shaping the ma­
turity distribution of bonds — the balance
of short-, intermediate-, and long-term is­
sues— in the securities portfolio.
There are no easy rules that will allow a
banker to set a maturity distribution which
enables him to meet cash outflows at a min­
imum cost. Sometimes short-term borrow­
ings will be the cheapest and easiest source
of funds. At other times the banker may be
unable to use that market at all. Irregular­
ities in the securities markets may make it
advisable to raise cash by selling long-term
rather than short-term bonds. A desire to
take capital gains or capital losses for tax
purposes may affect the selection of matur­
ities to sell. Further, the choice of bonds to
sell might depend on what the banker wants
to leave in his securities portfolio for future
liquidity protection. Despite the diverse cir­
cumstances, a bond portfolio manager's job
in shaping the maturity distribution of the
portfolio ultimately comes down to match­
ing returns against risks.

The Role of Government Bonds. Cash,
U.S. Treasury securities (bills, notes, and
bonds), government agency bonds, munic­
ipal bonds, and loans all have some value
for meeting liquidity needs. Just as a playbill
lists actors in order of appearance, the bal­
ance sheet ranking above suggests the prob­
able order in which assets would be con­
verted to cash and applied to satisfying a
liquidity problem.
Cash is the most readily usable liquid
asset, but much of a bank's cash is likely
to be tied up meeting legal reserve require­
ments. Justifying an increase in the cash
account beyond minimums required for re­
serves and daily business is difficult because
the bank receives no income from this asset.
At the other extreme, loans are a costly
source of liquidity. There is no formal mar­
ket in which to dispose of these obligations
cheaply and easily. Hence, using loans to
meet a liquidity pinch is impractical except
as a last resort.
The assets which remain — the bank's
portfolios of government securities — are a




ACT ONE: THE UNCERTAIN WORLD
OF THE ACCOUNT MANAGER
The curtain rises with the bond manager
at his desk scratching his head over the
bewildering choice of bond maturities be­
fore him. In choosing which assets to hold
24

FEDERAL RESERVE BANK OF PHILADELPHIA

and how long to hold them, he is out to
achieve the highest possible returns for the
bank without exposing it to unwanted risks.
But this task is easier said than done. It is a
simple fact of life that a portfolio which
offers the expectation of above-average re­
turns — either in the form of interest or cap­
ital gains— normally brings higher risks. The
uncertainty of future interest rates lies be­
hind much of this problem of balancing
risks and returns.

bond, and its market price would be bid
down until its effective yield matched the
current market rate. Whether or not the
account manager has to record or "realize"
this capital loss would depend on whether
he has to sell any long-term bonds to cover
cash drains on tbe bank. If he does have to
sell, say, a 15-year bond yielding 5 percent
in a market where the current yield has
risen to 6 percent, he will have to swallow
a capital loss of nearly 10 percent.
Thus, by attempting to avoid the first risk
of interest income fluctuation, our account
manager falls victim to the second risk, cap­
ital loss, all because of the fickle nature of
interest rates. Consequently, a portfolio
manager's outlook for interest rates must
necessarily shape his selections for the gov­
ernment bond account. Honing the accuracy
of his interest rate predictions allows him
to reduce capital losses or increase capital
gains while still meeting the bank's liquidity
demand. Moreover, top management could
help by making its interest rate expectations
clear. Senior management can hardly set the
level of future interest rates by decree. How­
ever, interest rate forecasts have a strong
impact on the maturity distribution appro­
priate for the portfolio. It only makes sense
to insure that top management's expecta­
tions are considered in formulating portfolio
policies so that these policies are consistent
with those followed in other areas of the
bank's operations.
To the extent that the portfolio manager
is uncertain about future interest rates, he's
likely to "hedge" his bets when balancing
risks against returns by planning for a variety
of contingencies.3 The manager hedges by

A Problem with Interest Rates. Changes in
interest rates cause changes in bank earn­
ings and in the value of the portfolio. Thus,
the vagaries of interest rates involve the
portfolio of the manager in two kinds of
troublesome risks: 1) the variations occur­
ring in the interest income earned on bond
investments, and 2) the capital losses result­
ing from an upward shift in market interest
rates.2 Managing these risks can be partic­
ularly difficult because reducing the port­
folio's exposure to one often increases ex­
posure to the other.
For example, suppose an account man­
ager seeks to reduce exposure to the first
risk, fluctuating interest income. He may be
able to do this by putting more of his port­
folio in longer-term maturities. Long-term
bonds offer a steady flow of coupon or in­
terest income as long as they are held. And
since their rates tend to fluctuate less than
short-term rates, reinvestment income is
also more stable.
But what happens if interest rates in the
market shift upward after this move to long­
term bonds is made? Our manager has that
unsettling experience of seeing his portfolio
drop in value. This change in interest rates
results in a loss because more interest in­
come could now be earned with the same
investment in a newly issued bond. Hence,
no one would pay the old price for the

3 An important element of the portfolio maturity
decision is the structure that is assumed for future
interest rate movements. Until recently it had been
common to presume that bond yields would generally
rise as the maturity of the bond increased. Such an
assumption implies that there will be a long-term
improvement in a portfolio's income (after capital
2
Falling interest rates create capital gains. However, gains and losses) if maturities can be lengthened. In
this form of income instability is not viewed as a
the last few years, short-term yields have exceeded
"problem" by portfolio managers.
long-term rates so frequently, that some bond man­




25

BUSINESS REVIEW

MARCH 1972

putting some of his assets in long-term
bonds while keeping others in short-term
bonds. This provides some income stability
plus a ready supply of emergency liquidity
free of capital loss risk. In short, the hedg­
ing manager won't lose big, but he won't
win big either.
Uncertainty for Top Management. Not
only does an account manager run into un­
certainty from interest rates but also from
top management. Portfolio managers may
be unsure as to how their bosses weigh the
risks of unstable portfolio income as op­
posed to capital losses. That is, how much
management is willing to forego in poten­
tial earnings to avoid or reduce exposure to
each type of risk.
Quite likely those evaluating a bond man­
ager's performance will be less than elated
by significant capital losses, and some will
be even more unhappy if the capital losses
have to be "realized." These bankers usually
try to keep realized losses at a minimum,
because such losses stand out in the income
statement. Thus, reporting them creates un­
favorable publicity and embarrassment. This
forces the portfolio manager to hold enough
short-term securities (for instance, Treasury
bills which are virtually free of capital loss
risk) to cover any cash outflow likely to
come down the pike.
Other portfolio managers may have to
please bosses (or possibly stockholders) who
are more concerned with the steadiness of
the bank's overall income than with capital
losses. This will encourage the portfolio
manager to select more long-term bonds
for the account. However, as income stabil­

ity improves, the risk of capital losses climbs.
Therefore, he will lengthen his maturities
only as long as the combined effects create
a more stable net income.
But often an account manager is uncer­
tain as to the weight management attaches
to these alternative forms of risk. As in the
case of uncertainty about future interest
rates, the manager is likely to shape the
maturity distribution of the portfolio to
hedge his bets. He will hold a supply of
short-term securities sufficient to cover most
cash drains without severe capital losses. He
will also keep some longer maturities to
steady the portfolio's interest earnings. Thus
uncertainty about management's views on
risk poses a difficult problem for the ac­
count manager in terms of balancing risks
against returns.
ACT TWO: MANAGEMENT TECHNIQUES
Surrounded by the uncertainty of which
risks his bosses most want to reduce along
with a great deal of uncertainty about what
the future holds for interest rates, the ac­
count manager seeks some method to guide
him in plying his trade. The technique often
chosen for selecting the bond portfolio is
the "liquidity reserve classification system"
(see Box).
Liquidity Reserve Approach. Under the
most common form of this system, each
kind of investment is categorized (primary,
secondary, tertiary, and investment) accord­
ing to how liquid it is. Cash, of course, is
the most obvious source of liquidity, but
most of it is needed to meet the bank's
reserve responsibilities. The short-term Treas­
ury bill becomes part of the bank's second­
ary reserves which are held as the next line
of defense against outflows. Long-term
bonds are an investment reserve to be sold
or "cashed in" when the bank is under the
pressure of extended funds outflows.
Under this layered system of reserves the
greatest concentration of invested funds
occurs in the short-maturity Treasury bills
and notes. However, some reserve funds

agers are beginning to doubt the wisdom of trying to
extend the portfolio's average maturity. The longerterm bonds still seem to offer an opportunity for
more stable income flows, but their net return may
not be higher. To the extent that one believes that
interest rate movements will more closely mirror the
recent past than the overall experience since 1951,
the following discussion will have to be modified.
Funds normally invested in long-term bonds, because
their yield was expected to be high, might be shifted
into shorter maturity issues.




26

FEDERAL RESERVE BANK OF PHILADELPHIA

THE LIQ UIDITY RESERVE SYSTEM FOR PORTFOLIO MANAGEMENT
The most common scheme for managing the bond portfolio's distribution is the
reserve system. It is characterized by the wide variety of bond maturities included in
the portfolio. According to this method of portfolio management, both the kinds of
liquid assets available for bank investment and the sources of instability in the bank's
cash flows are grouped into several categories. Assets needed for maintaining the bank's
liquidity can be safely allocated to cash, short-term government securities, other short­
term securities that are also highly liquid, and long-term government bonds. Paralleling
this asset structure, sources of cash flow uncertainty are divided into daily, weekly,
seasonal, and cyclical cash flows. Net cash inflows represent a liquidity problem for
the bank only in an opportunity-cost sense, but net outflows are presumed to have
specific causes and are met from specific sources of reserve funds.
The primary reserve is the part of a bank's cash account that exceeds its legally
required reserves: ready money for meeting net outflows that occur in the normal
course of the bank's daily activities. This reserve must be large enough to allow the
bank to meet its current obligations without encountering embarrassing cash shortages.
Yet primary reserves must be kept at a working minimum because they earn no interest.
The secondary reserve is composed of short-term, highly marketable government
securities. Paramount is the requirement that these assets be readily convertible into
cash at little or no risk of capital loss. Generally, the most suitable security for this
purpose is the Treasury bill. However, Treasury notes of less than two years to maturity
or even government bonds which mature in the near future satisfy these requirements.
This reserve provides a useful source of liquidity for seasonal cash outflows such as
crop cycles, holiday periods, and tax deadlines.
A tertiary reserve might be held by the bank for protection against major cyclical
outflows associated with either loss of deposits or with the heightening of loan de­
mand, both phenomena occurring over a long period of time. The reserve for this kind
of outflow need not be as liquid as the primary or secondary reserves, so it is generally
composed of securities of somewhat longer maturities and higher yields. Government
securities with maturities of two to five years could normally qualify for this reserve
designation.
To the extent that bonds of still longer maturities have a reserve function, they are
said to be part of the investment reserve. Securities of this type can be held to provide
an additional cushion in case of severe financial stress. Combining assets held for each
of these reserve purposes produces a spaced maturity portfolio.
Seldom is this one-to-one correspondence of reserve to function followed very
rigorously in the banking community. Any sensible banker needing to convert a portion
of his reserves to cash would analyze his portfolio to determine the most advantageous
sale. However, the liquidity reserve system provides a banker with a rough tool for
measuring his reserve needs for cash outflows and for protecting himself from serious
losses in bond account dealings.




27

BUSINESS REVIEW

MARCH 1972

of the script for portfolio managers. It has
uncovered a split maturity strategy as an
alternative to the liquidity reserve approach
to bond management. This recent addition
to the banker's repertoire was uncovered by
computer analysis, using techniques from
operations research.4 The preliminary results
merit careful analysis for they contradict the
liquidity reserve system under certain as­
sumptions.
This research discloses that the bond ma­
turity distributions which produce the most
attractive combinations of risks and returns
are structures comprised of either all short­
term bonds, all long-term bonds, or combi­
nations of the two (split maturity structures).5
These maturity distributions contain no
bonds maturing between five and fifteen
years. This result depends heavily on the
presumption that there is a yield advantage
to investing in long-term bonds.
Split maturity strategies contradict the
basic approach of the liquidity reserve sys­
tem. Rather than trying to produce a "suffi­
cient" return without heavy capital loss
risks, the split maturity structures result from
attempts to earn the highest return possible
while controlling probable losses. These

are spread over a wide range of maturities
to increase the average return on the port­
folio and to stabilize the flow of interest
income. By advocating an extension of a
portion of the portfolio's investment funds
into intermediate- and long-term securities,
this management approach assumes that, on
the average, short-term yields will be lower
than long-term ones. Moreover, it implicitly
assumes that stabilizing interest income is
desirable as long as capital losses are under
control. Avoidance of losses is the key to
this philosophy as evidenced by a heavy
concentration in short-term securities. At­
taining a "reasonable" level of income with­
out incurring high capital loss risks, rather
than seeking high income, is the name of
the game.
The problem with the liquidity reserve
approach is that it is not designed to find
a bank's best bond maturity distribution. It
serves only to suggest one that will suffice.
Therefore, the portfolio manager may be
missing chances for higher returns that
would not increase the bank's risks. Another
difficulty encountered in following the li­
quidity reserve system is deciding which in­
termediate and long maturities to include in
the portfolio. Specialists in the field sharply
differ in their willingness to include matur­
ities of more than five years because of the
heavy capital losses that can occur in tenand fifteen-year bonds. If long-term govern­
ment bonds are held only as a backstop
against catastrophic outflows, the longest
maturities are suitable. "Forced sales" and
hence realized capital losses will rarely
occur. Ftowever, if these bonds are to be
used frequently in absorbing cyclical liquid­
ity demands, the chances of realizing capital
losses are higher, and some authorities are
reluctant to suggest commitments longer
than five to seven years. In either case, the
liquidity reserve approach yields a portfolio
that is hedged with intermediate maturities.

4 A detailed description of this research can be
found in Charles R. Wolf, "A Model for Selecting
Commercial Bank Government Security Portfolios,"
Review of Economics and Statistics, 5 (1969): 40-52 (a
nonlinear mathematical programming model); Dwight
B. Crane, "A Stochastic Programming Model for Com­
mercial Bank Bond Portfolio Management," journal
of Financial and Quantitative Analysis, 6 (1971): 955976 (a probabalistic linear programming model); Ron­
ald D. Watson, "Tests of Maturity Structures for Com­
mercial Bank Securities Portfolios — A Simulation
Approach" (unpublished D.B.A. dissertation, Indiana
University, Bloomington, Indiana, 1971) (a simulation
model).
5 For purposes of this discussion short-term bonds
are defined as those being less than five years to
maturity, intermediate from five to ten, and long-term
from ten to fifteen years. In addition, this result is
predicated on: 1) the bank's management being averse
to taking risks, 2) the unequal trade-off of capital
losses and increasing bond maturities, 3) the assump­
tion that long-term interest rates normally exceed
short-term rates.

Split Maturity Strategy. Some recent re­
search may result in an eventual rewriting




28

FEDERAL RESERVE BANK OF PHILADELPHIA

managing of the bond account's maturity dis­
tribution. These decisions can be simplified
when top management makes the ground
rules clear, but it's still a delicate balancing
act.

results suggest that it may be more efficient
for a manager to control capital loss risks
by investing only in the shortest maturities
available and to seek income by investing
in the maturity offering the highest expected
yield rather than spreading investments over
many maturities. The manager would then
be investing in a portfolio of "balanced
risks and returns" rather than one that is
hedged with intermediate maturities.
A further point highlighted by this split
portfolio research is the importance of the
account manager's measure of risk. When
the risk measure used in the analysis was
"capital gains and losses/' the entire short­
term portion of the portfolio was invested
in the shortest available maturity. However,
altering the concept of risk to include both
capital value changes and income instability
made it more efficient to spread the short­
term investments over a range of short ma­
turities (up to four or five years to maturity).
Extension of some short-term investments
over several years increases the portfolio's
capital loss risks, but it more than compen­
sates by reducing interest income uncertain­
ties. But even with this concept of risk,
there remains a gap between the short and
long maturities in the portfolio.
The split maturity strategy may help the
portfolio manager improve his performance
in the face of changing interest rates, but it
isn't a cure-all. He must still weigh the risks
of capital losses versus income stability in
allocating his investable funds. He must also
make the decision of how risky he wishes his
portfolio to be (relative to the bank's liquid­
ity requirement). Finally, he must incorporate
expectations of future interest rates into the




FINALE
Again, to paraphrase slightly Messrs. Gil­
bert and Sullivan, the portfolio manager's
lot is certainly not a happy one. The per­
formance of his bond portfolio is subject
to forces beyond his control — the bank's
liquidity requirement and the vagaries of
interest rates. Estimating both of these is a
tricky business. He may also face the di­
lemma of having his performance rated by
a criterion that is unknown to him.
A bank's top management has a responsi­
bility to reduce the difficulty of this job by
helping the portfolio manager cope with
this uncertainty. It should first decide how
his performance will be evaluated (with a
full understanding of the implication of each
criterion) and make him aware of the deci­
sion. Then it should work out with the port­
folio manager a set of interest rate projec­
tions to be used in managing the bond ac­
count. These two acts will enable the bond
account manager to devise a strategy that
is consistent with the objectives and ex­
pectations of the bank as a whole. When
the plot has unfolded, the strategy could
well be a split maturity structure. However,
the important point is that the bond account
manager should understand the constraints
under which he must make his decision. If
this can be done, the portfolio manager's
lot will be a much more happy one.

29

BUSINESS REVIEW

MARCH 1972

The Fed in Print

,

Business Review Topics
Fourth Quarter 1971,
Selected by Doris Zimmermann
BANK COSTS
Checking account costs — trends and
composition among small banks,
1966-70 — Chic Oct 71 p 2
BANK DEPOSITS
The changing flow of funds at District
member banks — Atlanta
Oct 71 p 193
BANK HOLDING COMPANIES
Foreign bank holding companies —
F R Bull Nov 71 p 931
BANK HOLDING COMPANY ACT 1956
The 1970 amendments to the Bank
Holding Company Act: One year
later (Mayo) — Chic Dec 71 p 2
BANK LIABILITIES
Liability management banking: Its
practice in the Sixth District —
Atlanta Dec 71 p 218
BANK LOANS
Revision of bank credit series —
F R Bull Dec 71 p 971
Encountering loan demand — San Fran
Nov 71 p 198
Determinants of commercial bank growth
— St. Louis Dec 71 p 11

Articles appearing in the Federal Reserve
Bulletin and in the business reviews of the
Federal Reserve banks during the fourth
quarter of 1971 are included in this com­
pilation. To receive copies of the Federal Re­
serve Bulletin, mail sixty cents for each to
the Federal Reserve Board at the Washington
address on page 34. You may send for busi­
ness reviews of the Federal Reserve banks,
free of charge, by writing directly to the
issuing banks, whose addresses also appear
on page 34.
ALABAMA
Alabama: Out of the doldrums? —
Atlanta Dec 71 p 225
BALANCE OF PAYMENTS
The travel and transportation
components of the United States
balance of payments — Cleve
Oct 71 p 13
BANK ACCOUNTING
Functional cost analysis: Functional
profitability varies with size of
bank— Dallas Nov 71 p 5
BANK CAPITAL
Bank capital notes and debentures —
Rich Dec 71 p 8
BANK COMPETITION
The banking structure: What it means
and why it matters — Rich Nov 71 p 2




30

FEDERAL RESERVE BANK OF PHILADELPHIA

BANK LOANS — FARM
Performance of rural banks and changes
in bank structure in Ohio — Cleve
Nov 71 p 3
BANKING STRUCTURE
German banks as financial department
stores — St. Louis Nov 71 p 8
BRANCH BANKING
Bank expansion in N.Y. State: The 1971
statewide branching law — N.Y.
Nov 71 p 266
BRIMMER, ANDREW F.
Regional and multilateral dimensions of
the United States balance of
payments — St. Louis Nov 71 p 21
BURNS, ARTHUR F.
Statement to Congress, Nov 1,1971
(interest rates) — F R Bull Nov 71
p 917
BUSINESS CYCLES
1971 — year of recovery and controls —
St. Louis Dec 71 p 2
BUSINESS FAILURES
Business mortality: A necessary evil? —
Phila Oct 71 p 3
BUSINESS FORECASTS AND REVIEWS
Financial developments in the third
quarter of 1971 — F R Bull Nov 71
p 871
BUSINESS INDICATORS
Cyclical indicators of economic activity:
Part II — Rich Dec 71 p 11
CHRISTMAS TREES
About Christmas trees — Phila Dec 71
P 11
COMMERCIAL POLICY
New England manufacturing and the
import surcharge— BostNov71 p18
CONSUMER CREDIT
Consumer credit cranks up — Atlanta
Oct 71 p 186
CONSUMER EXPENDITURES
The all-important consumer— Rich
Oct 71 p 10
CONSUMER PROTECTION
Banking in the consumer protection age:
Part I — Rich Dec 71 p 2




CORRESPONDENT BANKS
Part III: Account analysis — Kansas City
Dec 71 p 3
DEBT PUBLIC
The Treasury debt: Someone else's assets
— Atlanta Oct 71 p 182
DEMAND DEPOSITS
Ownership data in G.11 — F R Bull
Nov 71 p 953
DISCOUNT RATES
Change Nov 10, 1971 — F R Bull
Nov 71 p 953
Change Dec 13, 1971 — F R Bull
Dec 71 p 1046
ECONOMIC STABILIZATION
Economics of instability (Coldwell) —
Dallas Oct 71 p 1
The state of confidence: Short and long
run (Eastburn) — Phila Nov 71 p 3
1971 — year of recovery and controls —
St. Louis Dec 71 p 2
EDGE ACT
Interpretation: Credit extended by
foreign branches to domestic
subsidiaries — F R Bull Dec 71 p 1001
EDUCATION — FINANCE
Capitalism in the classroom: Education
vouchers — Phila Dec 71 p 3
FARM INCOME
Farmers' off-farm incomes exceed farm
earnings — Chic Oct 71 p 12
FEDERAL RESERVE BANKS BRANCHES
Miami office opens — Atlanta
Oct 71 p 185
FEDERAL RESERVE BANKS DIRECTORS
Election of Class A and Class B
directors — F R Bull Dec 71 p 1044
FEDERAL RESERVE DISTRICTS
Change in boundaries— F R Bull
Dec 71 p 1047
31

BUSINESS REVIEW

FEDERAL RESERVE FOREIGN EXCHANGE
Treasury and Federal Reserve foreign
exchange operations — N.Y. Oct 71
p 214
FINANCIAL INSTITUTIONS
Comparative asset structure of selected
financial institutions —
Rich Oct 71 p 15
FOOD STAMP PLAN
The Food Stamp Program —
Rich Nov 71 p 11
FOREIGN EXCHANGE RATES
The gliding band for variations of
exchange rates — Bost Nov 71 p 2
The flexible exchange rate: Gain or loss
to the United States (Francis) —
St. Louis Nov 71 p 14
GOLD
Part I: An historical perspective —
Chic Nov 71 p 12
Part II: Future without glitter —
Chic Dec 71 p 12
IMMIGRATION
Factories on the border — San Fran
Dec 71 p 212
INCOME DISTRIBUTION
Income distribution and its measurement
Part II: Distribution among families
— Rich Oct 71 p 2
INCOME PERSONAL
Income and employment in the Fifth
District— Rich Nov 71 p 8
INCOMES POLICY
Monetary policy and relative prices in an
incomes policy — St. Louis
Nov 71 p 2
INFLATION
Slowing in money growth: The key to
success in curbing inflation —
St. Louis Oct 71 p 2
INVENTORIES
Inventory investment and economic
activity — Cleve Nov 71 p 17




MARCH 1972

LIVESTOCK INDUSTRY
Cattle feeding: Banks participate heavily
in industry's expansion —
Dallas Nov 71 p 1
Expansion in beef cattle leads advance
in 1971 — Dallas Dec 71 p 6
LOANS, INDEX-LINKED
Part II: Index-linked loans — Kansas City
Nov 71 p 9
LOUISIANA
Pelican state buffeted by adverse
economic headwinds — Atlanta
Oct 71 p 188
METROPOLITAN AREAS
Blueprint for metropolitan reform —
Phila Oct 71 p 12
The metropolitanization of the Tenth
District — Kansas City Dec 71 p 18
MOBILE HOMES
District banks: An important source of
financing for mobile homes —
Atlanta Dec 71 p 231
MONETARY POLICY
The lag in the effect of monetary policy:
A survey of recent literature — N.Y.
Dec 71 p 289
MONEY SUPPLY
Defining money: Problems and issues —
Cleve Oct 71 p 3
Money stock control and its implications
for monetary policy — St Louis
Oct 71 p 6
Revision of the money stock— F R Bull
Nov 71 p 880
Money supply measures — N.Y.
Nov 71 p 255
OCEANOGRAPHY
Carving up the seas: Problems of ocean
ownership — Phila Nov 71 p 10
OPEN MARKET OPERATIONS
Record of policy actions, July 27, 1971 —
F R Bull Nov 71 p 925
Record of policy actions, Aug 24, 1971 —
F R Bull Dec 71 p 989

FEDERAL RESERVE BANK OF PHILADELPHIA

SHERRILL, WILLIAM W.
Resignation Nov 15, 1971 — F R Bull
Dec 71 p 1043
SILVER
The semiprecious metal — San Fran
Dec 71 p 205
SOCIAL SECURITY
Benefits continue to rise, but so do
revenue needs — Dallas Dec 71 p 1
STATE FINANCE
Southeastern state and local expenditures:
How do they stack up? — Atlanta
Nov 71 p 205
Planned and actual long-term borrowing
by state and local governments —
F R Bull Dec 71 p 977
STRIKES
Dock strike — San Fran Nov 71 p 196
TIME DEPOSITS
Time-deposit pendulum — San Fran
Oct 71 p 180
Changes in time and savings deposits,
Apr-July 1971 — F R Bull
Nov 71 p 895
UNEMPLOYMENT
The coming upsurge in employment —
Chic Nov 71 p 2
VOLUNTARY FOREIGN LOAN
CREDIT RESTRAINT, 1965
Revised guidelines — F R Bull
Nov 71 p 906
■

POLLUTION
Paying the pollution bill — Phila
Nov 71 p 7
POPULATION MIGRATION
People and places: A decade of Southern
change — Atlanta Nov 71 p 198
PRICE CONTROL
Start of Phase II — San Fran Oct 71 p 173
Entering the new era — San Fran
Nov 71 p 189
PRICES
In 1971 — F R Bull Dec 71 p 957
REGULATION G
Supplement to Regulation G, Dec 6,1971
— F R Bull Dec 71 p 1000
REGULATION T
Supplement to Regulation T, Dec 6,1971
— F R Bull Dec 71 p 1000
REGULATION U
Supplement to Regulation U, Dec 6, 1971
— F R Bull Dec 71 p 1000
REGULATION Y
Amendment Dec 1, 1971 — F R Bull
Nov 71 p 931
REGULATION Z
Truth in lending amendment Dec 31,
1971 — F R Bull Dec 71 p 1000
RESORT INDUSTRY
Ponder snow on Tenth District ski slopes
— Kansas City Nov 71 p 3




33

MARCH 1972

BUSINESS REVIEW

FEDERAL RESERVE BANKS AND BOARD OF GOVERNORS
Federal Reserve Bank of Kansas City
Federal Reserve Station
Kansas City, Missouri 64198

Publications Services
Division of Administrative Services
Board of Governors of the
Federal Reserve System
Washington, D. C. 20551

Federal Reserve Bank of Minneapolis
Minneapolis, Minnesota 55440

Federal Reserve Bank of Atlanta
Federal Reserve Station
Atlanta, Georgia 30303

Federal Reserve Bank of New York
Federal Reserve P.O. Station
New York, New York 10045

Federal Reserve Bank of Boston
30 Pearl Street
Boston, Massachusetts 02106

Federal Reserve Bank of Philadelphia
925 Chestnut Street
Philadelphia, Pennsylvania 19101

Federal Reserve Bank of Chicago
Box 834
Chicago, Illinois 60690

Federal Reserve Bank of Richmond
P.O. Box 27622
Richmond, Virginia 23261

Federal Reserve Bank of Cleveland
P.O. Box 6387
Cleveland, Ohio 44101

Federal Reserve Bank of St. Louis
P.O. Box 442
St. Louis, Missouri 63166

Federal Reserve Bank of Dallas
Station K
Dallas, Texas 75222




Federal Reserve Bank of San Francisco
San Francisco, California 94120

34

FOR THE R E C O R D ...
BILLIONS t

Third Federal
Reserve District

January 1972
from

January 1972
from

BANKING
(All member banks)
Deposits ...................
Loans ........................
Investments ................
U.S. Govt, securities . .
Other ......................
Check payments***

year
ago

- 1

+ 3

2

-

- 1
- 3
-2 6
-1 1

mo.
ago

year
ago

+1
-

2

- 3
+ 5
6
-1 7

3
1
- 3
1
- 4

+ 3

-

0
0

month
ago
. ..

2

-

-

2

0
4

+1
N/Af

+ 13
+ 9
+ 19
+ 7
+ 25
N/Af

- 1
- 1
- 1
-

3

+1
N/A

“Production workers only
""Value of contracts
"""Adjusted for seasonal variation




+ 3t

year
ago

month
ago

year
ago

-

-

2

-1 0

-

4

N/A

N/A

9

+ 12

+ 2

+ 4

+ 15

N/A

N/A

0

+ 30

Bridgeton ......

0

-

4

N/A

N/A

N/A

N/A

N/A

N/A

1

-

3

-

1

+ 4

N/A

N/A

+

1

+ 13

-

-

1

+ 10

+6

........

+ 43
6

Altoona

........

0

Harrisburg . . . .

0

-

5

+ 2

+ 2

N/A

N/A

0

+

+ 5

N/A

N/A

4

-1 1

+ 8

N/A

N/A

1

0

+ 11

4

+ 11

-

1

-

Lancaster ......
+ 11
+ 10
+ 11

....

-

2

-

5

-

3

+ 5

N/A

N/A

0

+ 16

0

-

3

-

5

+ 7

N/A

N/A

0

+ 16

Lehigh Valley . .

-

Philadelphia

-

2

-

3

-

3

+ 6

N/A

N/A

3

+ 12

+1

Reading ........

-

1

-

1

-

3

+ 4

N/A

N/A

0

+ 9

+ 18
N/A

Scranton

-

1

+ 2

-

2

+ 8

N/A

N/A

0

+ 18

-

1

-

-

3

+ 6

N/A

N/A

0

+ 23

......

Williamsport

ot

month
ago

i

Wilkes-Barre
PRICES
Wholesale
Consumer

month year
ago
ago

Percent
Percent
change
change
January 1972 January 1972
from
from

0

Johnstown
-

-

year
ago

Percent
change
January 1972
from

Total
Deposits""*

Atlantic City . .

Trenton

-

Check
Payments**

Percent
change
January 1972
from

Standard
Metropolitan
Statistical
Areas*

Wilmington

Banking

Employment

LOCAL
CHANGES

Percent change

mo.
ago
MANUFACTURING
Production
Electric power consumed
Man-hours, total* . . . .
Employment, t o t a l......
Wage income* ...........
CONSTRUCTION"* ......
COAL PRODUCtlON ......

Manufacturing

United States

Percent change

SUMMARY

MEMBER BANKS, 3RD. F.R.B.

+ 4
+ 3
1 15 SM SA 's
^Philadelphia

..

York ............

2

-

N/A

N/A

N/A

N/A

N/A

N/A

N/A

N/A

-

+

-

+ 9

N/A

N/A

0

+ 13

1

1

3

"Not restricted to corporate limits of cities but covers areas of one
or more counties.
""A ll commercial banks. Adjusted for seasonal variation.
"""M em ber banks only. Last Wednesday of the month.