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FEDERAL RESERVE BANK O '1 PHILADELPHIA
F

A com m ercial bank w ill m ake a loan to an
individual w ithout security even though the
bank know s relatively little about the bor
rower. A Federal R eserve bank cannot le
gally m ake a loan to a m em ber bank w ithout
security even though the Fed know s a great
deal about the borrow er. Why this double
standard? The reason is that law som etim es
responds very slow ly to changing condi
tions and view s.

W hy Collateral
Requirements?
by Ira Kaminow

Law books are haunted by ghosts from the past,
by laws that were adopted in response to the
real or imagined needs of yesterday, but that
serve no apparent function in the contemporary
environment. Discussion of these laws can be
fascinating and fruitful. It can be fascinating
because the laws are often living fossils of oncepowerful social forces. It can be fruitful because
legislative inertia often works against repeal of
these laws despite their current irrelevance and
not infrequent propensity for harm. Continued
discussion of outdated laws keeps the spotlight
on potential dangers in our legislative structure
and encourages useful changes.
One legal anachronism that merits discussion
on both these counts concerns an aspect of the
nation’s financial system. When commercial
banks borrow from the Federal Reserve, they
are required to place on deposit with the Fed
some kind of collateral. This requirement can be
costly for both the borrowing bank and the
Fed because the relevant laws are quite complex.
Compliance can require a good deal of work at
both professional and clerical levels. Even ignor
ing the costs of legal interpretations and form
filling, the physical effort of as mundane an
activity as locating, transporting, and storing
collateral can be great.
Once, collateral requirements were thought
to be integral parts of the operation of the
Federal Reserve System. Today, the environ
ment that precipitated this belief is gone. Like
the human appendix, the requirements outlived
their original contex, and are redundant at best,
downright harmful at worst.

BUSINESS REVIEW is produced in the Department of Research. Evan B. Alderfer is Editorial Consultant; Ronald B.
Williams is Art Director. The authors will be glad to receive comments on their articles.
Requests for additional copies should be addressed to Public Information, Federal Reserve Bank of Philadelphia, Philadelphia,
Pennsylvania 19101.

BUSINESS REVIEW

Why isn’t something done about the situa
tion? Since 1963, the Federal Reserve System,
with the support of leading experts has been
trying to get one relatively minor liberalization
built into the law. Although the reform has
been passed by the Senate on several occasions,
it has never gotten out of committee in the
House. It seems likely, therefore, that a com
plete overhaul of the law will require a good
deal of work.
HISTORICAL BACKGROUND

Laws almost always stem from compromise
and, so, rarely reflect the views of any particu
lar group. Moreover, even when compromise is
unnecessary or minimal, support may come
from many diverse groups, each of which favors
the legislation for quite different reasons. Be
cause of space limitations, we will try to capture
only the “ main currents of thought” that pre
vailed. We will ignore all the subtle (and some
not so subtle) points of disagreement about
both content and emphasis.
Panic, Currency Elasticity, and Eligibility Re
quirements. The post-Civil War National Bank

ing Act had provided the Nation with a highly
restrictive monetary system and a currency sup
ply that was unresponsive to the demands of
the public. To most observers of the day, the
periodic financial crises following the Civil War
stemmed from this monetary system. Sharp in
creases in the demand for currency led to de
posit withdrawals. Banks, finding their fixed
currency reserves depleted, suspended with
drawal privileges, and the panic was on. Each
suspension resulted in a further decline in con
fidence until credit dried up and the economy
succumbed.
In the winter of 1907, the Nation was facing
its fourth severe panic since the end of the Civil
War. The situation bordered on national dis

aster, “ and it seemed likely that, unless the
hysterical rush for liquidity could be stopped,
economic transactions would return to the bar
ter state.” 1 The public was getting fed up; the
cry for an elastic currency supply, responsive to
demand, grew louder. From 1907 to 1912, a
major economic reform was planned. It culmi
nated in the Federal Reserve Act— “ An Act . . .
to furnish an elastic currency. . . .” 1
2
The elastic currency was to be provided by
allowing banks to sell promissory notes they
held against loans to the Federal Reserve Banks.
( The sale was made at a discount from the face
value; hence, the process was called discount
ing. ) When banks needed currency to meet
increased withdrawals, they could go to the
Fed to swap notes for currency.
The Federal Reserve Act, however, attempted
to do more than provide an elastic currency
supply. An elastic currency required only that
banks have an opportunity to convert their non
currency assets into currency; it really didn’t
matter what assets were sold to the Fed. With
an eye toward influencing banks’ portfolios and
contributing to economic and financial stability,
however, the framers of the Act limited assets
eligible for discount to so-called real bills— in
the words of the Act, to short-term “ bills of ex
change issued or drawn for agricultural, indus
trial, or commercial purposes.” By limiting the
class of eligible assets, legislators made the
eligible assets more attractive to banks. Banks
were encouraged to hold real bills for two rea
sons. First, because real bills mature quickly,
1 Paul Studenski and Herman Kroos, Financial His
tory of the United States, (N ew York: McGraw-Hill
Book Company, Inc., 1963), p. 253.
2 This quotation comes from the title of the Act. The
full title reads “ An Act to provide for the establishment
of Federal reserve banks to furnish an elastic currency,
to afford means of rediscounting commercial paper, to
establish a more effective supervision of banking in the
United States, and for other purposes.”

NOVEMBER 1969

banks that hold them experience a rapid turn
over. Every day some loans are maturing and
providing the bank with an inflow of funds.
This rapid turnover was considered a highly
desirable property in bank-held assets because
the majority of bank liabilities were payable on
demand; unexpectedly large withdrawals could
be met by the inflow of funds from a constant
stream of maturing real bills. Second, real bills
were created to finance “ productive” activities.
The Act, consequently, was believed to encour
age “ productive” loans at the expense of “ non
productive” loans, particularly loans to finance
speculative activities.3
*
Eligibility requirements were supposed to do
more than merely encourage prudent banking
practices and contribute to a socially desirable
allocation of credit. In 1913, there was consider
able sympathy for the view that eligibility require
ments would contribute to economic stability.
It was believed that sharp economic fluctuations
could be avoided if bank holdings of eligible
paper grew and shrank with business activity
and that the volume of real bills in bank port
folios would fluctuate in the desired fashion.

There is currently less than complete agree
ment on why linking bank ownership of eligible
paper to business activity was considered sta
bilizing. Most of the earlier arguments, how
ever, seemed to consider this relationship as the
first link in a rather round-about connection
between business activity and the volume of
currency, or reserves, or money, or credit (de
pending on the version of the theory— these
four magnitudes were not always clearly dis
tinguished). The proposed linkage went some
thing like this ( see the accompanying diagram):
The level of business activity would control the
quantity of real bills in bank portfolios, the
quantity of real bills in bank portfolios would
control the volume of discounting, the volume
of discounting would determine the quantity of
currency and/or reserves in the system, and
finally the quantity of currency and reserves
would control the volume of credit and/or
money. Through this complicated mechanism,
eligibility requirements were supposed to serve
a crucial role in fostering a semi-automatic con
nection between business activity and currency,
reserves, credit, or money.

3 It is not clear whether speculative loans were to be
discouraged because speculative activities were to be dis
couraged, or because the issuance of credit and/or money
to finance speculation and other “non-productive” activ
ities would lead to an over-supply of money and/or
credit.

The Fed and the War. Clearly, much was ex
pected of eligibility requirements. They turned
out to be incapable of handling the burden they

BUSINESS REVIEW

were designed to bear. Renunciation of eligi
bility requirements as a bulwark of financial
stability was hastened by the onset of World
War I.
The war broke out only months before the
Federal Reserve Banks opened their doors. In
1915 and 1916, it was becoming increasingly
evident that the United States would not remain
neutral. And by late 1916, wartime prepara
tions were under way. To facilitate financing
the anticipated rise in Government borrowing,
Congress amended the Federal Reserve Act to
allow banks to borrow money from Reserve
Banks on pledge of Government securities. This
change was designed to increase the desirability
of Government bonds. At this time, member
banks were also given the option of borrowing
from the Fed on the security of eligible paper
instead of discounting that paper. Member-bank
borrowing became another vehicle for obtaining
currency in time of emergencies. Limiting the
kinds of assets eligible as collateral was no more
related to currency elasticity than similar re
quirements on assets eligible for discount. In
deed, nothing in the concept of currency elas
ticity suggests the need for collateral at all.
Collateral requirements, like the requirements
on discounting, were designed to influence bank
portfolios and to link the level of discounting
borrowing to the level of business activity. This
latter link was severely weakened,4 of course,
when Government securities were made accep
table as collateral.
Real Bills and Real Disaster. During and after
the war, the Fed followed a liberal discountloan policy and kept interest rates low on
member-bank borrowing and discounting. The
4 The link probably was not very strong to begin with.

enormous bank borrowing that followed con
tributed to the inflation that lasted until 1920.
It was this experience with large-scale bank
borrowing that prompted both the Fed’s atti
tude of discouraging member-bank borrowing
except on a temporary basis, and a reluctance
on the part of banks to borrow. By 1929, the
tradition against member-bank borrowing had
hardened considerably, and when the crash
came, the discounting mechanism was rusty
and unprepared.
There is general agreement today that the
depression of the thirties would have been
milder if the Fed was more willing to lend and
commercial banks more willing and able to
borrow. Some banks may have been unable to
borrow because they lacked enough eligible
paper.
In an effort to override the restrictive lending
policies of some Reserve Bank officials, to bring
more banks to the discount windows, and to
make more assets acceptable as collateral, Con
gress passed the Glass-Steagall Act in 1932 which
liberalized collateral requirements.5
The Act permitted banks to use any collateral
acceptable to the Fed. The use of “ ineligible”
collateral, however, was seen as an emergency
measure only, and carried a one per cent per
annum penalty. In the Banking Act of 1935,
the emergency nature of the change was lifted,
and the penalty was reduced to the current one-

5 Milton Friedman and Anna J. Schwartz, in A Mone
tary History of the United States, Princeton University
Press, Princeton, 1963, argue that Congress passed the
Act mainly to encourage more member bank visits to
the Fed discount window and that there was no lack of
eligible paper in the System. In the hearings relating
to the Banking Act of 1935, however, Governor Marriner
Eccles, of the Federal Board argued that the GlassSteagall Act was passed “after a great many hanks had
gone to the wall at least partly because of lack of eligible
paper. . . .”

NOVEMBER 1969

half of one per cent. Roughly, this is where the
law stands today.
ELIGIBILITY AND COLLATERAL
REQUIREMENTS IN 1969

Nineteen-sixty-nine is not 1913. Our economic
environment is different today from what it was
in 1913, not only because the world has changed,
but also because our perception of it is no longer
the same. Because of the way the world has
changed, even the original proponents of eligi
bility requirements would probably reject them
in the context of current banking institutions.
Because of the change in our perception of the
world, modern economists would reject the
requirements in almost any context.
In 1913, experts felt that the main source of
instability in the System was an inelastic cur
rency supply. Today, modern central banking
techniques make currency famines impossible.
In 1913, bank reserves were to be determined
mainly by member-bank discounting. Today, the
main source of variation in member-bank re
serves is open market operations. In 1913,
member-bank portfolios were concentrated heav
ily in eligible commercial paper. Today, this
paper probably accounts for less than 15 per
cent of member-bank loans and investments.
In 1913, it was anticipated that banks would
make extensive use of their borrowing privi
leges. Today, bank borrowing is trivial when
compared with total bank liabilities. In 1913,
banking authorities considered an increase in
bank holdings of real bills desirable. Today,
these authorities recognize that many other
assets appropriately belong in bank portfolios.
Collateral Requirements and Economic Sta
bility in 1969. Are there any reasons to maintain
collateral requirements in the current system?
To answer this question, one must first recog

Digitized for6
FRASER

nize that the driving force of the Fed is to
protect the economy, not its own investments.
The Fed’s collateral requirements cannot, there
fore, be judged on the same grounds as a private
bank’s collateral requirements. The Fed’s ac
tions can only be judged by their contribution to
the nation’s economy. On these grounds, almost
all economists and bankers would agree that
collateral requirements serve no useful purpose.
The original attempts to tie discounting to
business activity through real bills were based
on two misconceptions. First of all, there is
nothing desirable about varying currency, re
serves, money, or bank credit with the level of
business activity. Increasing any of these quan
tities during a boom frequently will fuel smol
dering inflationary fires. Cutting back on any
of them during a slowdown frequently will
add to the downward pressure. Second, even if it
were desirable to relate the level of discounting
to the volume of business activity, it is by no
means clear that the real bills mechanism is an
adequate conduit. Banks need not increase dis
counting simply because they hold more real
bills and businesses need not borrow from banks
simply because production increases— they may
go to other suppliers of credit.
Collateral Requirements and Bank Portfolios
in 1969. There is general agreement today that
collateral and eligibility requirements cannot be
defended on grounds of their contribution to
economic stability. What about their influence
on bank portfolios? The answer to this question
is most properly, “ What influence?” The con
ditions that would permit eligibility require
ments to exert substantial influence on bank
portfolios do not exist in 1969. In the postWorld War II period, member-bank borrowing
has rarely accounted for more than one-half of

BUSINESS REVIEW

one per cent of liabilities of member banks. More
over, since 1932, any asset acceptable to the Fed
may be used as collateral. There is, therefore, a
very real, and probably low, limit on the extent
to which banks are willing to alter portfolios just
to beef up balances of eligible paper. Why should
bank portfolios be very different with or without
eligibility requirements?
Not only do collateral and eligibility have
just a marginal impact on member-bank port
folios, it is far from obvious that their impact
is in the right direction. Eligibility require
ments were written in 1913. What seemed
appropriate in 1913 may not be appropriate in
1969. To whatever extent eligibility require
ments influence portfolios, they can be expected
to do so by enticing banks to hold more eligible
paper than otherwise. This enticement would be
translated into more Government securities in
bank portfolios; more short-term loans; fewer
personal loans, because these loans are ineligible;
and less open-end consumer credit, like credit
cards, because these loans, too, are ineligible.
Each of these tendencies runs counter to current
trends in bank portfolio practices.

ernment collateral has been presented.6
Not all the costs of complex collateral re
quirements can be easily measured in terms of
dollars and cents. Unnecessary obstacles to mem
ber-bank borrowing may hurt relations between
the Fed and member banks. Small banks espe
cially may be intimidated by the apparent com
plexity of the collateral requirements.
Clearly, for all these reasons, operations of
the Fed’s lending mechanism could be sig
nificantly improved if collateral requirements
were removed from the law. In 1963, the
Federal Reserve System took a first step toward
this end by proposing legislation that would
eliminate the distinction between eligible and
ineligible collateral.7 The bill has received the
support of leading experts, and its adoption has
been urged by the American Bankers Associa
tion, Federal Deposit Insurance Corporation,
Treasury Department, Independent Bankers As
sociation of America, and others. To date, the
bill has not been passed, but it is hoped that
the Congress will soon pass it and thus start
on the road toward complete elimination of
collateral requirements.

On Changing the Law. The main effect of re

6 It is much easier for all concerned when banks pre
sent Government securities as collateral, because this
collateral obviates the need for complex credit-checking
procedures as well as the need to check for eligibility.
Unfortunately, banks don't own as many Governments
as they once did, and this has resulted in fewer Govern
ment securities available as collateral.
7 The date 1963 is chosen because it represents the
start of the most recent attempt to get the law changed.
Actually, a similar proposal was made in 1935 by Gover
nor Marriner Eccles of the Board of Governors of the
Federal Reserve System. In the version of the original
Federal Reserve Act passed by the Senate, the Fed was
authorized to make advances on any “ satisfactory securi
ties” in an emergency. This authorization was not in the
House version, and it was subsequently dropped from
the final Act.

quiring banks to put up security is to increase
the costs of running the banking system. Mem
ber banks which want to borrow must find ap
propriate collateral and bring it to the Fed.
The Reserve Banks must judge the eligibility
and soundness of the collateral, interpret the
law, and write the necessary regulations. The
law has been particularly irksome in recent
years when the volume of bank borrowing has
been rising and more hard-to-process non-Gov

NOVEMBER 1969

Appalachia:
Back from the Brink?
by Shirly A. Goetz*

In the early part of the decade, the hopeless
poverty of 18 million Americans captured na
tional attention. Magazines and newspapers
featured stories and photographs of bleak towns,
lonely “ hollers,” underdeveloped economies,
and wasted lives that made up the 13-state
region known as Appalachia.
National attention became national concern,
and the country sought a way to help the people
of Appalachia. The question was ( and is )
whether Appalachia could achieve, with help, a
self-sustaining economy capable of providing its
population with jobs, incomes, and standards of
living similar to those in the rest of the United
States. Or would money be better spent in pro
viding Appalachians with the means and the
skills to try their luck in other parts of the U.S.?
In 1965, Congress made its decision: the Ap
palachian Regional Development Act. Since that
time, three-quarters of a billion dollars has been
appropriated to revitalize the Appalachian
economy.
It is, of course, too soon to estimate the im
pact of the Act itself on the economy of Appala
chia. It is worthwhile, however, to look at what
has happened to the region during the sixties to
see how well Appalachia stacks up against the
nation.
Over the decade, the region has progressed.
Unemployment declined much more rapidly in
Appalachia than in the nation. In the Pennsyl
vania portion of Appalachia, the jobless rate fell
almost twice as much as it did for the country
as a whole.
Nevertheless, severe problems remain. In the
Pennsylvania counties of Appalachia, for in* The author expresses appreciation to the Appala
chian Regional Commission and to the Pennsylvania
Bureau or State and Federal Economic Aid for infor
mation upon which much of this article is based.

BUSINESS REVIEW

stance, employment grew at only half the
national rate during the sixties. The labor force
increased by only 1 per cent compared with a
13 per cent gain in the U.S. Consequently, the
sharp drop in the local unemployment rate
stemmed not only from expanded job oppor
tunities, but also from a large out-migration of
the working-age population. Furthermore, the
differential between local and national rates of
employment growth has not improved since the
passage of the Appalachian Act. These facts
raise some questions as to how adequate the
progress of the sixties has been.
To put this progress into perspective, we
first need to understand the roots of the eco
nomic problems of Appalachia. Why was this
region singled out by the Federal Government
for special assistance? What kind of special
assistance is Appalachia receiving? What is
behind the upswing in the area’s economy since
the start of this decade? Where does Appalachia
go from here?

A P P A L A C H IA —W H E R E IS IT?

Appalachia cuts diagonally through 13 states from southern New
York to northern Alabama and Mississippi. Located between the
East Coast and Midwest, the region includes 52 of Pennsylvania's
67 counties (all except the southeastern corner), and one-half of
the state’s population. Overall, Appalachia is home for 16 million
people, or one out of every 11 Americans.

CAUSES OF THE PROBLEM
Geographic isolation. Appalachia is strategi
cally located between the industrialized East
Coast and Midwest, with prosperous Atlanta to
the South (see map). However, mountainous
terrain has isolated the region geographically
and restricted Appalachians from realizing the
potential of their location.
Economic isolation. Appalachia has been called
a “ region apart”— apart not only geographically,
but economicly. Cut off from the mainstream
of American growth and prosperity, the area has
known poverty for decades. Conditions, how
ever, worsened in the 1950’s. Statistics on
health, housing, and income in some areas of
Appalachia resembled those of an underdevel

oped country rather than a part of the United
States. In 1960, for instance, average annual
income per person in Wolfe County, Kentucky,
was $435— about the same as in Jamaica.
Much of the poverty has been related to
Appalachia’s natural resources. These resources
include almost all of the nation’s anthracite
coal, two-thirds of all bituminous coal mined in
the United States, large forests, scenic moun
tains, and abundant rainfall.
Dependent on its natural resources, the Appa
lachian economy climbed and crashed with their
development. When steam locomotives gave
way to diesels, and when long-distance natural
gas and oil pipelines were installed, demand for
Appalachian coal suffered significantly. Replace

NOVEMBER 1969

ment of labor with both underground and strip
mining machinery further reduced the number
of people employed in mining.
Appalachian timber had been used for rail
road ties, mine-supports, furniture, and con
struction. But over the years, the demand from
railroads and mines has been exhausted, and
Appalachian hardwood has had to compete with
labor-saving substitutes in the furniture and
home-building industries.
Land also has caused economic problems.
First and foremost, the mountains make trans
portation expensive and difficult, and second,
topography severely limits agricultural produc
tivity. Rugged Appalachian land usually makes
mechanization impractical. Yet, without mech
anization, farmers often find it impossible to
compete in food markets. Furthermore, Appala
chia has few natural lakes to catch mountain
runoff. Consequently, runoff pours from the
mountains causing soil erosion and floods. In
addition, years of soil neglect and improper
cultivating techniques have taken their toll on
fertility.
Another source of trouble stems from Appa
lachia’s reliance on the railroad. Like mining,
forestry, and agriculture, the railroad industry
was an economic mainstay in parts of Appala
chia, such as Altoona, Pennsylvania. But in the
decade of the fifties, rail employment plum
meted as, once again, technology and competi
tion erased many jobs.
Although employment in manufacturing,
trade, and service industries increased in the
1950’s, gains in these sectors were below the
national performance. In manufacturing, for in
stance, employment grew at only two-thirds the
rate of the rest of the country. Service jobs
expanded at only one-half the rate of the rest of
the nation. Consequently, these employment in

Digitized for10
FRASER

creases did not counteract losses in mining,
agriculture, and rails. The impact of this net
loss of employment hit home in the Pennsyl
vania portion of Appalachia, and the unemploy
ment rate in some Pennsylvania counties neared
25 per cent in the late 1950’s.
Lack of job opportunities was only one of
Appalachia’s problems. In 1960, Appalachia
lagged behind the nation in virtually every in
dicator of economic and social well-being—
employment, income, education, health, and
housing. Almost one out of three Appalachian
families had an income less than $3,000 a year.
Only one out of five in the rest of the United
States had an income that small. Many people
were moving out, especially those of prime
working age and their dependents. Not only was
there an erosion of human resources, but physi
cal resources deteriorated, and communities
were unable to provide needed services. Under
these conditions, the people left behind in
Appalachia could not strengthen their own econ
omy and break out of the circle of poverty.
Only the Federal Government had the financial
muscle and the authority to cope with the
poverty of this multi-state region.
UNCLE SAM TO THE RESCUE

In 1965, Congress passed the Appalachian
Regional Development Act. The Act embodies a
six-year program designed “ . . . to assist the
region in meeting its special problems, to pro
mote its economic development, and to estab
lish a framework for joint Federal and state
efforts toward providing the basic facilities
essential to its growth. . . .” 1 Major sections
of the Act provide Federal assistance for trans
portation and for improvement and develop
1 Appalachian Regional Development Act of 1965,
Public Law 89-4, 79 Stat. 5, Sec. 2.

BUSINESS REVIEW

ment of natural and human resources. Programs
include an expressway system, mine reclamation,
land stabilization, educational facilities, low-cost
housing, and health centers.
To implement these programs, the Act pio
neered a new approach to Federal, state, and
local cooperation. Traditional approaches to co
ordination would not suffice because of the
diversity of problems facing Appalachia. For
example, Appalachia is predominantly rural, but
the Pennsylvania portion is almost two-thirds
urban, and contains the nation’s ninth largest
metropolitan area— Pittsburgh. Even within
states, problems and potentials differ. Many
Pennsylvania cities seek to fill the void left by
the decline in coal, steel, or rails. Pittsburgh, for
example, is concentrating on industrial research,
while people in the anthracite area around
Wilkes-Barre, Hazleton, and Scranton are ex
ploiting their proximity to major markets by
developing manufacturing and distribution facil
ities. In some parts of the state, such as the
sparsely-settled highlands, tourism and recrea
tion offer the most promise.
Because of vast differences throughout subregions of Appalachia, the Federal Government
guards against superimposing solutions from
Washington. Individual states and local areas
are given a large role in planning, implementing,
and administering projects. Usually after con
sultation with officials of local areas, state
authorities submit goals and projects to the
Appalachian Regional Commission. That Com
mission, which is composed of a representative
from each Appalachian state and a Federal ap
pointee of the President, must approve projects
before the Federal Government releases any
funds.
To increase the effectiveness of Appalachian
aid, top priority usually is given those geo

graphic areas which have the greatest potential
for development. To determine developmental
potential and the most beneficial project for
local areas, each state has set up multi-county
units called local development districts. Counties
within each district have common economic
and social ties and similar growth possibilities.
LD D ’s, as they are called, are the basic planning
units for Appalachian programs.
Pennsylvania has seven of these districts.
Each of the seven has its own board made up
of regional planners, tourist promoters, and in
dustrial and local government leaders. These
boards engage in several regional programs
under the direction of the state. For instance,
the Economic Development Council of North
eastern Pennsylvania, which combines the resort
area of the Poconos and the coal country of
Wilkes-Barre, Hazleton, and Scranton, is work
ing on water resources, the highway system,
tourist development, local education, and the
problem of auto junkyards.
The highway approach. In spite of emphasis

on local initiative for development measures,
Congress did dictate the major thrust of the
overall program. It is transportation. Under the
Appalachian Act, $1,015 billion was authorized
for highways over a six-year period and $335
million for non-highway programs through 1969.
While a total of only $765 million was actually
appropriated through fiscal 1969, over 60 per
cent was for roads, as shown in Table 1.
In Pennsylvania, 48 per cent, or about
$53 million, has been allocated to highway
development through fiscal 1969. An additional
$25 million has been committed to the high
way program in Pennsylvania for fiscal 1970
and 1971, bringing highway grants under the
Appalachian Act to $78 million.

NOVEMBER 1969

TA B LE 1
How Funds Provided by th e A ppalachian Act W ere Used
(Fiscal 1 9 6 5 -1 9 6 9 )
Project

Appalachia

Natural Resources...........................
Mine re c la m a tio n ..........................
Land stabilization ........................
O ther ................................................

Supplemental Aid
Other .................................................
Total .................................................

4 8 .2 %
22.3
1 9 .2 %
1.0
2.1

3 .2 %
2.1
1.7
11.7

Human Resources...........................
Vocational e d u c a tio n ...................
Housing f u n d ..................................
Health dem onstration projects .

Pennsylvania

6 1 .5 %
7 .0 '

H ig h w a y s

7.0
6.8
0.2
0

5.5
0.3
5.9
18.5
1.3
1 0 0.0%

21.1
1.3
1 0 0 .0 %

Source: Appalachian Regional C om m ission and Pennsylvania Bureau of State and
Federal Economic Aid.

The reason for this emphasis was clearly
stated by the President’s Commission on Appa
lachia:
. . remoteness and isolation . . . is the
very basis of the Appalachian lag” and “ devel
opmental activity in Appalachia cannot proceed
until the regional isolation has been over
come.” 2 The Commission believes the region
must be opened up for industries having na
tional markets; links between major centers
within and without Appalachia must be estab
lished; residents must be able to commute to
jobs and health and educational services. To
meet these requirements, Congress authorized a
2,700-mile system of highways which, when
completed, would put 93 per cent of the resi
dents within one hour of a highspeed road.
The priorities set by the President’s Com
mission are being seriously questioned, how
ever. Some students of Appalachian problems
challenge the idea that geographic isolation

2 Appalachia, A Report by the President's Appalachian
Regional Commission 1964, p. 32.

is at the root of the region’s problems.3 They
1
*
emphasize indigenous social and economic weak
nesses, such as poor use of resources, an un
skilled population, and a lack of all types of
social and human investment in education,
health, and housing. One critic, John Munro,
even questions whether the region actually is
under supplied with highways. He finds that Ap
palachia has more rural highway miles in rela
tion to its area and population than the U.S.,
and he claims that the present highway system
in the region is an adequate means of industrial
transportation.4
If isolation is not the main cause of the lag
in Appalachian development, a sizable com
mitment to transportation may not help the
area unless investment in transportation facili
3 See Niles M. Hansen, "Some Neglected Factors in
American Regional Development Policy: The Case of
Appalachia,” Land Economics, February, 1966, pp. T9,
and John Munro, “ Planning the Appalachian Develop
ment Highway System: Some Critical Questions,” Land
Economics, May, 1969, pp. 149-161.
1 Munro, Land Economics, pp. 157-160.

BUSINESS REVIEW

ties generates increased demand for local goods
and services. Recent studies in other countries
point out that transportation investment by it
self may not stimulate the local economy to
any great extent5. Transportation investment,
like any other type of investment, may be a key
element in specific cases of development. How
ever, it possesses no magical qualities, and can
not be depended upon to initiate sustained
growth in every depressed area. In short, ac
cess will accomplish little if people and industry
do not take advantage of it.
In addition, improved access could have un
anticipated effects on the Appalachian economy.
Many forget that roads go two ways. Although
new highways will open Appalachia to the
nation, the nation will also be opened to Appa
lachia. Better highways will make it easier for
Appalachian families to shop outside the region.
Then too, as Appalachian residents become
familiar with other areas and with improved
transportation, out-migration might rise further.
Whether out-migration would be good or bad
depends upon one’s viewpoint. If the Appala
chian economy cannot support adequately its
present population, as some people believe, Ap
palachian residents may improve their standard
of living by moving to other parts of the
country. However, many Appalachian migrants
would be ill-equipped for life outside of Appala
chia, especially in the big cities. Furthermore, if
Appalachia develops a self-sustaining economy,
as the Appalachian Act intends, the region will
need a labor force. Even today, in parts of the
Appalachian portion of Pennsylvania, past out

5 George W . Wilson, et al., The Impact of Highway
Investment on Development, (Washington, D .C.:
Brookings Institution, 1966). Niles Hansen, “ Regional
Planning in a Mixed Economy,” Southern Economic
journal, October, 1965, pp. 176-190.

migration has created a bottleneck to develop
ment.
It is too soon to tell whether the “ highwayfirst” program will be successful. As of June,
1968, only 4 per cent of all Appalachian De
velopment Highways had been completed.
Nevertheless, new roads have already cut down
travel time and opened up new job opportuni
ties in at least some areas. The experience of
Hazard, Kentucky, is an example. Hazard is a
mountain community with an excess labor sup
ply. But before 1968, it took three and a half
hours to drive from Hazard to Lexington, an
industrial area with a tight labor market. Today,
travel time is down to one and one-half hours,
putting Lexington within commuting distance
of Hazard. In this case, job opportunities have
been brought closer to Appalachian workers
through highway development.
The program does not stop with highway
construction. The Appalachian Development
Highway System and the Interstate Highway
System serve as the framework for other public
expenditures in Appalachia. For instance, Penn
sylvania, Maryland, and West Virginia are
jointly building a recreation center close to two
Appalachian expressways. The expressways will
connect the center to the Baltimore-Washington
and Pittsburgh-Cleveland areas. Along Interstate
80 in north central Pennsylvania, a 50,000-acre
resort is planned for a previously isolated area.
Close by, 14,000 acres are being developed as
industrial sites. Whether public investment in
highways also will stimulate private develop
ment on a large scale remains to be demon
strated.
Reclaiming

resources— natural

and

human.

Although highway development has been given
top priority, a large block of Appalachian funds

NOVEMBER 1969

has been used to improve natural resources. In
Pennsylvania, mine reclamation has been of
primary importance.
Mine fires are one major problem. The Laurel
Run fire in the Wilkes-Barre area has been
burning since 1915. During the sixties, three
mine fires in the Carbondale-Scranton area en
dangered over 200,000 people and $60 million
in property. At the same time, fires in the
Shenandoah-Centralia area threatened over
77,000 people and property valued at $118 mil
lion. The expense of controlling or extinguishing
these fires may exceed several million dollars.
Four and a half million dollars have been spent
on a mine fire in Scranton alone. The depth of
the mines, the difficult topography, and the
problem of shutting off surface oxygen make
control costly.
Cave-ins also pose a serious threat in mine
areas. Deep underground mining has been prac
ticed for over 100 years. Consequently, many
houses, stores, and streets are located over mine
tunnels and shafts. Cave-ins may occur at any
time, as shorings give way. The solution is to
drill holes from the surface and pump non
combustible material into the mines.
Still another problem is soil erosion. Under
the Appalachian Act, individual farmers can
contract with the Federal Government to con
serve and build up the soil. Last year, average
contracts ranged from $315 in North Carolina
to $1,784 in Pennsylvania. Other environ
mental funds have been used for timber devel
opment, water resources, and sewage treatment.
About 12 per cent of expenditures under the
Appalachian Act has gone directly to reclaim
human resources. Need for this reclamation is
great. Statistics can only hint at the wide gulf
between the quality of life in Appalachia and
that in the rest of the nation. In education, for

example, the drop-out rate before high school
graduation is 50 per cent higher in Appalachia
than in the nation. The percentage of high
school graduates continuing their education is
50 per cent lower. Currently, schools offering
62 vocational courses from horticulture to weld
ing are being aided in order to provide young
Appalachians with saleable skills.
Poor housing is also a basic fact of Appala
chian life. About one out of every four families
lives in a substandard dwelling. Generally,
money is lent to sponsors of low- and middleincome housing projects. These loans are used
for initial planning costs necessary to obtain
financing under the National Housing Act. Of
the 1,298 units approved thus far, one-third are
in Pennsylvania.
Demonstration health programs have been
set up in eight states, not including Pennsyl
vania, on the basis of need. These programs
provide comprehensive health care to persons
who did not previously have access to medical
services.
The largest remaining category of funds is
supplemental aid. As shown in Table 1, this
category amounts to 18 per cent of total funds
provided by the Appalachian Act to the region,
or almost $142 million. This aid helps to
finance everything from airports to water sys
tems. Supplemental funds enable Appalachian
states to participate in traditional Federal grantsin-aid, which require states or local areas to
share project costs with the Federal Gov
ernment. Because of depressed economies and
inadequate tax bases, many Appalachian com
munities, prior to the Act, were unable to pay
their share. Too often state funds were not
forthcoming, so communities could not take
advantage of these grants. For instance, under
the grant-in-aid program, the Federal Govern

BUSINESS REVIEW

ment pays 30 per cent of the construction cost
of sewage treatment plants for communities in
the United States. Although there was often
need for these plants, many Appalachian com
munities were unable to raise the remaining
70 per cent. Today, the Appalachian Act brings
the Federal share up to 80 per cent for almost
all grant programs. In Pennsylvania, 89 per cent
of supplemental funds, or more than $20 mil
lion, has been invested in human resources—
education and health (see Table 2).
Finally, about 1 per cent of money channeled
to Appalachia has been used for regional re
search and for setting up local development
districts.
WHAT’S THE PAYOFF?

A little over three-quarters of a billion dollars
has been appropriated for Appalachia since
1965. In Pennsylvania, over $110 million has
been invested through the Act. Associated funds
push the total public commitment in the state
past $350 million. At the same time, the na
tion has been enjoying the longest period of
r,

:,-t. v ; ti : ft
.

........ ’ ■ > i .......... >:

economic prosperity in its history. Have na
tional growth and public investment led to
any improvement in economic conditions in
Appalachia?
Economically, Appalachia is better off today
than in 1960. In the region as a whole and in
Pennsylvania in particular, employment has
increased and unemployment declined. As the
national economy boomed, demand for Appala
chia’s traditional products of coal, steel, and
timber increased. The number of jobs in con
struction and services also climbed.
In Pennsylvania’s Appalachia, unemployment
plunged from 10.1 per cent in 1960 to 3.6
per cent in 1968, almost double the drop in the
U.S. rate. Furthermore, the unemployment rate
posted last year equalled the national rate.
While employment fell in the fifties by 1
per cent, it grew by 8 per cent from 1960 to
1968, as shown in Chart 1. Every category of
employment except finance, insurance, and real
estate performed better in the sixties than in
the fifties. Greatest growth occurred in construc
tion and in government.
: ft

ft ft ■■

< ' ' !' :

(

TA B LE 2
How Supplem ental Aid Was Used in Pennsylvania
(Fiscal 1 9 6 5 -1 9 6 9 )
Distribution

Project
Human Resources........................................................
Elem entary and secondary education ...................
Higher e d u c a tio n ..........................................................
Vocational education ..................................................
Libraries ........................................................................
Hospitals and nurses t r a in in g ..................................
M ental h e a lth .................................................................

8 8 .6 %
2 .0 %
23.7
12.3
6.9
37 3
6^4

Natural Resources........................................................
Sewage tre a tm e n t .......................................................
Small w ater s h e d s .......................................................
W ater s y s te m s ..............................................................

6.8
2.9
1.0
2.9

Airports ..........................................................................
Total ..............................................................................

4.6
10 0.0%

Source: Pennsylvania Bureau of State and Federal Economic Aid.

NOVEMBER 1969

CHART 1
Em ploym ent Growth in the A ppalachian Portion of Pennsylvania
W as Better in the Sixties Than in the Fifties.
Per Cent Change
-6 0

-4 0

-2 0

Source: Estimates based on data from U.S. Dept, of Labor and Penna. Dept, of Labor and
Industry.

The rise in job opportunities in Pennsylvania
prevented the labor force from declining as in
the fifties. However, the work force grew by
only 1 per cent compared with a 13 per cent
gain nationally. This small increase in the local
labor force indicates a continued out-migration
of the working-age population. If, instead of
this out-migration, the labor force had grown
at the national rate, a quarter of a million more
people would have had to have been employed
in the Appalachian portion of Pennsylvania in
1968 than were actually at work last year in

order to have held the unemployment rate at
3.6 per cent.
Such a large increase in employment was not
forthcoming ( see Chart 2 ). Only in construction
jobs did Pennsylvania surpass the United States.
Therefore, the dramatic drop in the unemploy
ment rate was caused not only by increased job
opportunities but also by a large out-migration of
people who could not find work in Appalachia.
Although the region is far from healthy, it
has improved over the last nine years. What
proportion of this improvement can be traced

BUSINESS REVIEW

CHART 2
Em ploym ent in the A ppalachian Portion of P en nsylvania Failed
to In crease at the N ational Rate From 1960 to 1968.
Per Gent Change
-4 0

-2 0

n i
t

GOVERNMENT
CONSTRUCTION
SERVICES
FINANCE, INSURANCE,
AND REAL ESTATE
TRADE

■ ■

MANUFACTURING
TOTAL EMPLOYMENT
TRANSPORTATION
AND PUBLIC UTILITIES
M IN IN G

Appalachian Portion
of Pennsylvania
United States

Source: Estimates based on data from U.S. Dept, of Labor and Penna. Dept, of Labor and
Industry.

to the Appalachian Act?
Appalachian Act— success or failure? At this
early stage, it is impossible to determine defini
tively whether the Act has been a success or a
failure. To ascertain precisely even the short-run
influence would require a controlled test with a
comparison of growth rates in the region during
the same time period with the Act in effect and
without the Act in effect. Unfortunately, this
test cannot be made. The Appalachian Act be
came law in 1965 and has remained law ever

since. There is no way of knowing exactly what
growth, if any, would have occurred in the
region if the Act had not been in force.
However, we can compare rates of growth in
the Pennsylvania portion of Appalachia with
those of the nation for the 3 years preceding the
Act (1962-1965) and the 3 years following the
Act (1965-1968) to see what changes have
occurred.
Employment climbed 6 per cent in Pennsyl
vania’s Appalachia from 1962 to 1965 and 5
per cent in the 1965-1968 period. Comparable

NOVEMBER 1969

U.S. rates were 7 per cent in both periods.
The nation grew 1 percentage point faster in
the period before the Act, and 2 percentage
points faster in the period after the Act. Thus,
the gap widened slightly.
Table 3 shows employment gaps for major
industries in the two periods. A negative num
ber means that the U.S. did better than the
Appalachian portion of Pennsylvania, and a posi
tive number means that the Appalachian portion
of Pennsylvania did better. From 1962-1965,
local employment increased faster than national
employment in manufacturing and construction.
Job gains in both durables and nondurables sur
passed the U.S. Construction growth also was
greatest in industry, as demand for Pennsyl
vania’s metals, machinery, and other manufac
tured goods rose with national prosperity.
From 1965-1968, only construction employ
ment increased at a faster rate in the Pennsyl
vania portion of Appalachia than in the nation.
In this period, institutional, educational, and
industrial building rose. This widespread growth
in construction in a period when building ac

tivity across the nation was low may reflect the
impact of Appalachian spending. But the Penn
sylvania portion of Appalachia improved its
relative performance in only two areas other
than construction— finance, insurance, and real
estate, and services. The better relative standing
in these sectors may or may not be the result
of Appalachian spending, since the figures in
Table 3 show only what happened to employ
ment before and after the Act, and not why
changes occurred. However, Table 3 does indi
cate that, as yet in Pennsylvania’s Appalachia,
the Act has not succeeded in its purpose of
closing the gap in economic growth between
the nation and the region. The Pennsylvania
portion of Appalachia still has a lot of catching
up to do.
For the region as a whole, employment in
formation is more limited, but more encourag
ing. In the three years preceding the Act,
employment growth in Appalachia matched that
of the nation. From 1965 to 1967, regional job
growth exceeded that of the U.S. by about onehalf of one percentage point. This indicates a

TA BLE 3
Gaps in Em ploym ent Growth between the Pennsylvania Portion of
A ppalachia and the N ation
Industry
All industries ..........................................................
Manufacturing
Mining .....................................................................
Construction ............................................................
Transportation and public u tilitie s ......................
Trade
Finance, insurance, and real estate ....................
Services
Government ............................................................

Percentage Point Difference
1965-1968
1962-1965
+
+
-

1
1
5
7
4
4
5
6
2

- 2
- 5
-1 5
+ 14
- 7
- 4
- 2
- 3
- 3

Source: Estim ates based on data from U.S. Departm ent of Labor and
D epartm ent of Labor and Industry.

Penna.

BUSINESS REVIEW

slight narrowing of the gap. Whether this small
improvement is a result of programs begun
under the Act is hard to discern. All we can say
for sure is that both Appalachian investment
and the gain in employment occurred at the
same time.
However, as was already indicated, invest
ment under the Appalachian Act was not the
only different factor, and therefore, not the only
factor that might have influenced employment
growth. For instance, the U.S. economy may
have affected the Appalachian economy. While
both time periods were prosperous nationally,
the pull of national growth may have been
stronger in the second time period (19651967) than in the first (1962-1965). With con
tinued expansion, the U.S. economy requires
more and more resources. Eventually, in order
to meet this growing national demand, marginal
resources, such as those in Appalachia, are
pressed into service.
This reasoning would seem to be consistent
with the conclusion of the Appalachian Com
mission: “ Most measurable improvements in the
Appalachian economy since the Act passed in
1965 can be attributed mainly to the sustained
growth of the national economy. . . . ” 6
However, it is really too soon to ascertain the
full effects of the Act. Not all of the money
authorized by Congress has been appropriated.
A mere one-quarter of the 1,000 projects ap
proved has been completed. Only 4 per cent of
the Development Highway System, upon which
so much of the program depends, is finished.
In addition, many of the problems which the
Act seeks to correct are environmental— such as
geographical isolation, mine fires, soil erosion,
6 Annual Report 1968, Appalachian Regional Com
mission, pp. 5-6.

inadequate health and educational facilities, and
a lack of all types of public services. The effects
of improvement in these areas may not show up
for many years.

WHAT OF THE FUTURE?

The recovery potential in the Pennsylvania por
tion of Appalachia appears more hopeful than
in the past. Old problems in mining and rails
are believed to have run their course. Economic
diversification is starting to become a reality in
parts of the region. Pennsylvania communities
are making progress in revitalizing themselves,
improving public services, and developing in
dustrial sites. New highways place many Appa
lachian towns on a direct route from New York
to Chicago, offering opportunities for indus
trialization, distribution, and recreation. Pockets
of prosperity, such as those near State College
and in the Poconos, already exist. With con
tinued growth, this prosperity may permeate
the surrounding area.
One potential hinderance to sustained growth
in parts of the region is out-migration. While it
reduced joblessness in the fifties and sixties, this
exodus may restrict job growth in the future.
Just as people need employment to remain in
an area, so industry needs a labor supply to
expand in an area, fn the near future, some
areas in Pennsylvania may have difficulty with
industrial growth because of labor shortages.
The state government is trying to keep Penn
sylvanians at home by emphasizing vocational
education. To a certain extent, training and
mobility are last-resort substitutes. If local jobs
are available, but require new skills, an unem
ployed worker has two choices— either to move
someplace else where his present abilities are
in demand or to retrain for a job in his home

NOVEMBER 1969

town. Pennsylvania hopes to tip the scales in
favor of training by providing ample oppor
tunity for people to learn new skills. Training
will aid individuals to find employment. At the
same time, a skilled labor force could make the
area considerably more attractive to industry.
As jobs become more abundant, people will be
less likely to leave, and eventually in-migration
may come about.
Whether all or most of Appalachia will
achieve this type of sustained growth in jobs

and population we do not yet know. Certainly,
the Appalachian Act is trying to foster a vig
orous economy, but it is not a cure-all. It is
only an aid in removing the region’s worst
handicaps. Once Appalachia has adequate ac
cess, a healthy physical environment, and a
skilled labor force, the area still will have to
compete with the rest of the nation for jobs and
income. However, if Appalachians are able to
succeed, bleak towns and wasted lives will exist
only as dark memories.

N O W A V A IL A B L E :
G U ID E T O IN T E R P R E T IN G
FE D ER A L RESERVE REPO RTS
A 43-page booklet entitled, “ Guide to Interpreting Federal R e
serve R epo rts,” has been prepared in the R esearch D epartm ent
of the F ederal R eserve Bank of Philadelphia. This booklet is d e
signed to aid readers in understanding significant financial and
econom ic developm ents as reflected in two Federal R eserve
reports which receive w ide circulation— the W eekly Condition
Report of Large Com m ercial Banks and the Consolidated S tate
ment of A ll Federal R eserve Banks.
C opies of the booklet are available upon request to the Public
Inform ation D epartm ent of the Federal R eserve Bank of Phila
delphia, Philadelphia, Pennsylvania 19101.

BUSINESS REVIEW

The cost-of-living in Philadelphia is an im
portant asp ect of the area’s attractiveness
as a labor m arket. It affects the real value of
each w orker’s paycheck, and, consequently,
partly determ ines the am ount of money em
ployers in Philadelphia m ust pay to attract
w orkers to the area. Here the cost of living
at a high stan dard in Philadelphia is com
pared to the cost of living at the sam e
stan dard in other large cities for the spring
of 1967.*

The Philadelphia metropolitan area compares
favorably with large east coast cities and with
regions throughout the nation in total cost of
living.

TO TA L BUDG ET
(100 = $13,050)
90

100 105

The Value of the
Philadelphia Dollar

“ I------1-----1
NEW YORK
BOSTON

by Anne M. Clancy

110 115

NORTHEAST
WASHINGTON

□

WEST
NORTH CENTRAL
PHILADELPHIA

BALTIMORE
SOUTH

* The high standard corresponds, approximately, to
the level of living of highly-trained professional, techni
cal, and management personnel who are most locationally sensitive to differences in living costs. Data for
1967 are the most recent available.
* * The total family budget represents the estimated
dollar cost required to maintain a family of four, con
sisting of a husband, age 38, who was employed full
time, his wife who was not employed outside the home,
a boy 13, and a girl 8 years of age, at a high standard
of living.

NOVEMBER 1969

The two biggest pluses behind Phila
delphia’s position are personal taxes

H O U S IN G
(About 25% of total; 100 = $3,340)
90

I I

100

110

120

I I I I

I
BOSTON
NEW YORK
NORTHEAST
NORTH CENTRAL

and housing, which together account
for 40 per cent of all spending.

WASHINGTON
WEST
PHILADELPHIA
BALTIMORE
SOUTH

BUSINESS REVIEW

FO O D
(100 = $2,750)
90
95
100

105

110

"i— r~
NEW YORK
BOSTON
^

j '.- ,

t »

» A / ^ '* A '

NORTHEAST

: r: ?; ; : ' - PHILADELPHIA

Expenditures for food, amounting to 20 per cent
of consumer spending, partially offset the saving
on housing and taxes.

WASHINGTON
0

WEST
NORTH CENTRAL
BALTIMORE
SOUTH

T R A N S P O R T A T IO N
(A bout 8 % of to ta l; 100 = $1,127)
95

100

105

110

115

1 i— r
—
BOSTON
WEST
NORTH CENTRAL
NEW YORK
SOUTH

Costs in Philadelphia for other major items are

PHILADELPHIA
NORTHEAST
WASHINGTON
BALTIMORE

BUSINESS REVIEW

C L O T H IN G A N D
PERSONAL CARE
(1 1 % o f to ta l; 100 = $1,446)
95

100

105

110

----- 1
WEST
NEW YORK

more in line with the other areas.
WASHINGTON
NORTHEAST
NORTH CENTRAL
BALTIMORE
PHILADELPHIA
BOSTON
SOUTH

M E D IC A L
(About 4 % of total; 100 = $497)
90
100
110
120

~ l
WEST
NEW YORK
BOSTON
NORTHEAST
WASHINGTON
PHILADELPHIA
SOUTH
BALTIMORE
NORTH CENTRAL

BUSINESS REVIEW

O T H E R F A M IL Y
C O N S U M P T IO N *
(A bout 8 % of to ta l; 100 = $967)
100

105

110

NEW YORK
BOSTON
NORTHEAST
WEST
PHILADELPHIA
NORTH CENTRAL
WASHINGTON

]
_

SOUTH

BALTIMORE

This favorable standing for Philadelphia in
1967 has probably been maintained, as the
area’s index of consumer prices has grown at a
rate roughly comparable to that of other urban
areas in the nation.
Source: Three Standards of Living, U.S. Depart
ment of Labor Bulletin No. 1570-5.
* Other family consumption consists of reading, recrea
tion, education, tobacco, alcoholic beverages, and other
costs of leisure.

NOVEMBER 1969

Balance of PaymentsIn Deficit or Surplus?
by Mark H. Willes

When an individual looks at his income and ex
penditures for the past month and finds that
they do not match, it does not take an ad
vanced degree in mathematics to conclude that
he is either in the red or black, not both.
This is not true in the international area.
When the United States looked at its interna
tional receipts and expenditures for the three
months ending June 30, 1969, it found it had
a deficit of $3.7 billion and a surplus of $1.2
billion. And that sounds tricky. It is not so
strange as it appears, however. Things like
this can happen because analysts have devised
more than one way to measure the international
payments position of a country. The result often
is confusion about where the U.S. actually stands
in its international dealings.
LIQUIDITY VS. OFFICIAL SETTLEMENTS
DEFICITS

Today, primary attention is focused on two
gauges of the U.S. balance-of-payments position
— the liquidity and official settlements measures.
To understand the differences in these two mea
sures, consider the case of the individual who
has just calculated his income and expenditures
for the preceding month and finds he has run
a deficit. He has had to finance that deficit in
one of two ways: (1 ) by reducing his assets
(for example, by drawing down the average
balance in his checking account), or (2 ) by
borrowing (perhaps formally at a bank or de
partment store or informally by running up a
bill with his doctor).
While he may not like the result, there is
no ambiguity about his position. In balance-ofpayments accounting, things are not so straight
forward. The disagreement comes in defining
which international transactions give rise to the
deficit and which ones finance the deficit. Dif
ferences in treatment can be seen in the table.

BUSINESS REVIEW

U.S. BALANCE OF PAYMENTS
Second Quarter 1969
(M illio ns of Dollars)

Transactions

Goods and S e rv ic e s ..............
U nilateral T ransfers and
U.S. G overnm ent grants .
Errors and o m is s io n s ............
U.S. Private Capital O utflows:
Long-term A s s e ts ..............
Short-term Assets ............
Foreign Capital Inflows:
Long-term Liabilities
Except to O fficial
Foreign A g e n c ie s .........
Long-term Liabilities to
O fficial Foreign
Agencies ........................
Short-term Liabilities:
To Foreign Com m ercial
Banks ........................
To O ther Private
F o re ig n e rs .................
To International and
In te rre g io n a l
O rganizations ..........
To Foreign O fficial
Agencies ...................
U.S. O fficial Reserve Assets .
TOTAL

Liqu idity
Basis’
Net
Financing
Balance
Item

O fficial S ettlem ents
Basis2
Financing
Net
Balance
Item

722

- 1 ,7 6 1
698

- 1,761
698

- 1 ,5 2 4
535

- 1,524
535

507

4,567
-

147
82

-3 ,6 4 8

556
299

4,567
-

147
82

556
299
3,647

359

1,213

- 1,214

’ L iqu idity d e ficit is the sum o f increases in liquid lia b ilitie s to all foreign accounts
and decreases in o fficia l reserve assets.
O ffic ia l settlem ents d e ficit is the sum of increases in lia b ilitie s to o ffic ia l foreign
accounts and decreases in officia l reserve assets.

Everyone agrees that flows of funds related to
exports and imports of goods and services,
transfer payments, and Government grants are
part of the receipts and expenditures which give
rise to the deficit. Most observers also agree
that most flows of funds associated with long
term capital movements are in this category too.
Each of these categories, therefore, has an entry
on the left side of the columns in the table, in
dicating that each helps determine the size of
the deficit.
There is also complete agreement that gold,
convertible foreign currencies, and borrowing

rights at the International Monetary Fund
(IM F )— that is, official reserves— are assets
which can be used to finance a deficit. This is
indicated by the entries on the right side of the
columns in the table.
Disagreement comes primarily over how funds
flows associated with short-term capital move
ments are treated.1 On both the liquidity and
1One area of disagreement not discussed in the text
relates to the treatment of long-term liabilities to official
foreign accounts. Usually they are relatively minor.
On the liquidity basis it is considered as part of the
deficit, while on the official settlements basis, it is put
into the financing category, as seen in the table.

NOVEMBER 1969

official settlements bases, short-term capital out
flows are considered part of the transactions
which give rise to a deficit. Short-term capital
inflows are treated quite differently under the
two methods, however.

Those who prefer the liquidity basis as a
measure of the U.S. payments position argue
that non-official holders of short-term dollar
claims can easily turn them into their central
bank, so that these claims, too, represent a sig
nificant potential claim on gold. Consequently,
these analysts argue that a deficit is financed
not only by borrowing from foreign official
agencies, but also by short-term borrowing (in
other words, increasing short-term liabilities)
from private foreign individuals and organiza
tions as well, as shown in the table.
SCHIZOPHRENIC 1969

The divergent behavior of the liquidity and of
ficial settlements measures can be seen in Chart
1. While both indicated an improvement in the
international payments position of the U.S. dur-

CHART 2
L IA B IL IT IE S T O O F F IC IA L
F O R E IG N A C C O U N T S H A V E
D E C L IN E D
M illions o f Dollars

Analysts who consider the official settlements
basis as the best measure of the U.S. payments
position argue that a deficit is financed by
drawing down official reserve assets or by bor
rowing ( increasing liabilities) only from foreign
official agencies. The rationale is that dollar lia
bilities held by official foreign agencies represent
the only direct claim on U.S. reserves, since the
U.S. will only sell gold to such agencies, not to
private individuals or firms.

BUSINESS REVIEW

ing most of 1968, for the first half of 1969 the
measures moved in opposite directions.
Chart 2 shows a sharp decline in liabilities to
official foreign accounts occurring in 1969. This
decline in borrowing from official sources was
the “ cause” of the surplus on the official settle
ments basis. Chart 3 shows the marked increase

CHART 4
L A R G E C O M M E R C IA L B A N K S ’
B O R R O W IN G F R O M T H E IR F O R
E IG N B R A N C H E S H A S S O A R E D
Millions of Dollars

CHART 3
L IQ U ID L IA B IL IT IE S T O
F O R E IG N C O M M E R C IA L B A N K S
H A V E C L IM B E D R A P ID L Y
Millions of Dollars
45 0 0
40 00
35 00
3000
2500

2000
1500

1000
500

0
-5 0 0

-1 0 0 0
1966

1967

1968

1969

in liquid liabilities to private foreign commer
cial banks during the first half of this year, re
flecting primarily increased liabilities of U.S.
banks to their foreign branches which, for

balance-of-payments purposes, are considered
foreign banks (see Chart 4 ). This increase in
liabilities was the primary “ cause” of the deep
liquidity deficit in the first half of 1969.
Both the decrease in liabilities to official for
eign accounts and the increase in liquid liabil
ities to foreign commercial banks were caused
by vigorous bidding by U.S. banks for Euro
dollars as they sought funds in a period of
restrictive monetary conditions. By bidding for
Euro-dollars, U.S. banks boosted liabilities to
foreign commercial banks and, at the same time,
attracted into the Euro-dollar market (because
of high rates) some funds that otherwise would
have gone into the holdings of foreign central
banks. The result is a worsening of the liquidity
deficit and an improvement in the official settle
ments deficit.

NOVEMBER 1969

One additional factor that helps explain the
worsening of the liquidity deficit is the Gov
ernment’s decision not to engage in “ special
transactions.” In earlier periods, these special
transactions primarily stemmed from efforts to
get foreign holders of short-term liabilities of
the United States to switch into liabilities with
maturities of more than one year, thereby
taking them out of the liquidity deficit. As seen
in Chart 5, the volume of these special trans
actions has declined sharply in 1969, removing
a prop from under the liquidity deficit.

CHART 5
“ S P E C IA L ” G O V E R N M E N T
T R A N S A C T IO N S H A V E
DROPPED O FF
M illions of Dollars

WHERE ARE WE?

When the two measures of the U.S. payments
position give conflicting signals, the question is:
What is the real position? While any estimate is
hazardous, the answer probably is that the true
position is somewhere in between the liquidity
and official settlements markers.
On the one hand, the payments position has
probably not been so rosy as suggested by the
official settlements measure. The account on

CHART 6
BALANCE ON G O O DS AND
S E R V IC E S C O N T IN U E S T O
SLUM P
M illions of Dollars

goods and services is weaker now than it has
been for years (Chart 6 ). Although the long
term capital account was strong for a while
as foreign investors rushed funds into a rising
stock market, these inflows have dropped off
in the last few months ( Chart 7 ). Extremely
high Euro-dollars rates have lured dollars away
from official foreign accounts, but this might be
only a transitory by-product of the current as
sault on inflation. The basic long-run position
has not been so strong, therefore, as it should
have been.
On the other hand, the international position

CHART 7
F O R E IG N P U R C H A S E S O F U .S .
S E C U R IT IE S ( E X C L U D IN G
T R E A S U R Y IS S U E S )
M illio ns of Dollars

1500

r^\

1000
500
*

p v
1966

1967

i
1968

x
1969

BUSINESS REVIEW

of the U.S. has not deteriorated so much this
year as the liquidity deficit suggests. For some
time prior to this year, special Government trans
actions made the liquidity deficit look better
than it was. In 1969, lack of these special trans
actions has artificially caused the deficit to wor
sen. The change in the fundamental position of
the U.S. between 1968 and 1969 has not been
so great, therefore, as the figures suggest. In
addition, high Euro-dollar rates have caused
some short-term funds which would otherwise
have stayed here to flow out of the U.S. into the
Euro-dollar markets. Presumably this outflow

is a temporary phenomenon which will be re
versed once Euro-dollar rates fall more in line
with domestic rates. In the meantime, this out
flow will continue to make the liquidity deficit
appear larger than it otherwise would be.
Solid figures for the third quarter of 1969 are
not yet available. Early indications are, however,
that the U.S. must continue to wrestle with the
stubborn problem of correcting its international
payments position. And to compound the diffi
culty, this effort must often proceed in the face
of considerable uncertainty as to how big the
problem really is.

FOR THE RECORD

Manufacturing

Third Federal
Reserve District
Per cent change
SU M M ARY

United States
Per cent change

9
mos.
1969
from
year
ago

Sept. 1969
from
year
ago

mo.
ago

Sept. 1969
from
mo.
ago

year
ago

Employ
ment

9
mos.
1969
from
year
ago

LOCAL
CHANGES

Production ..............
Electric power consumed
Man-hours, total* ...
Employment, t o t a l___
Wage income* .........
CONSTRUCTION” ......
COAL PRODUCTION ....

+ 3
+ 2
- 1
- 1
0
-1 9
- 2

+ 9
0
0
+ 7
-5 4
- 6

+ 7
0
- 3
+ 7
+ 2
- 1

+ 5

1
5

+ 12
- 4

Altoona ......

Harrisburg ...

1
1
2
5
1

+
+
+
+

0
+ 8
- 4
-1 4
+ 5

+ 7

5
11
3
7
11

+ 1
+ 1
- 1
- 3
0

0
+ 12
- 7
-1 7
+ 2

+
+
+
+

5
13
1
9
9

Lancaster

...

Lehigh Valley.

+ 4

+ 2

4- 2

+ 36

mo.
ago

year
ago

+ 3

+ 6

+ 17

+ 4

+ 8

+ 16

+ 7

+ 8

4- 6

+ 16

+ 2

+ 10

+ 6

+ 24

+ 6

+ 16

+ 12

+ 2

+ 12

+ 9

+ 20

+ 10

+ 9

+ 10

7
2

’ Production workers only
* ’Value of contracts
’ ’ ’ Adjusted for seasonal variation

+ 6t

+ 5t

0
0

+ 4
+ 6

+ 4
+ 5

1 15 S M S A 's
^Philadelphia

+ 5

+ 14

R ea d in g......

+ 2

+ 4

+ 16

+ 10

Scranton ___

year
ago

mo.
ago

Per cent
change
Sept. 1969
from

+ 6

+ 4

4- 4

+ 2

Wilkes-Barre .

Philadelphia

Per cent
change
Sept. 1969
from

Johnstown ...
4+

year
ago

Total
Deposits’ ”

+ 2

Trenton ......
-2 1
- 2

PRICES
Wholesale ................
Consumer ................

mo.
ago

Atlantic City..

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

Wilmington ..

Per cent
change
Sept. 1969
from

year
ago

mo.
ago

MANUFACTURING

Check
Payments”

Payrolls

Per cent
change
Sept. 1969
from

Standard
Metropolitan
Statistical
Areas*

Banking

+ 2

+ 8

+ 14

-2 0

Y o r k ...........

+ 3

+ 10

+ 9

+ 20

+ 1

’ Not restricted to corporate limits of cities but covers areas of one or
more counties.
’ ’ All commercial banks. Adjusted for seasonal variation.
’ ’ ’ Member banks only. Last Wednesday of the month.