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0 Federal Reserve Bank of Philadelphia IS S N 00 07-70 11 NOVEMBER-DECEMBER 1977 and Commodity Agreements: The Haves vs. The Have-Nots? NOVEMBER/DECEMBER 1977 WHY BANKERS ARE CONCERNED ABOUT NOW ACCOUNTS H ow ard K een . . . NOW accounts may not be a picnic for commercial bankers, but they aren’t likely to be as damaging as many bankers fear. COMMODITY AGREEMENTS: THE HAVES VS. THE HAVE-NOTS? Ja n ice M oulton W esterfield Federal Reserve Bank of Philadelphia 100 North S ixth Street (on Independence Mall) Philadelphia, Pennsylvania 19106 The B U SIN E SS REVIEW is published by the Department of Research every other month. It is edited by John J. Mulhern, and artwork is directed by Ronald B. Williams. The REVIEW is available without charge. Please send subscription orders, changes of address, and requests for additional copies to the Department of Public Services at the above address or telephone (215) 5746115. Editorial communications should be sent to the Department of Research at the same address, or telephone (215) 574-6418. The Federal Reserve Bank of Philadelphia is part of the Federal Reserve System —a System which includes twelve regional . . . The developing countries want agree ments that will give them higher-than-market prices for the raw materials they export. The author suggests that these agreements might not produce the expected benefits and pro poses other ways to encourage economic de velopment. banks located throughout the nation as well as the Board of Governors in Washington. The Federal Reserve System was estab lished by Congress in 1913 primarily to manage the nation’s monetary affairs. Sup porting functions include clearing checks, providing coin and currency to the banking system, acting as banker for the Federal g ov ern m en t, su p e rv isin g co m m ercial banks, and enforcing consumer credit pro tection laws. In keeping with the Federal Reserve Act, the System is an agency of the Congress, independent adm inistratively of the Executive Branch, and insulated from partisan political pressures. The Federal Reserve is self-supporting and regularly makes payments to the United States Treasury from its operating surpluses. FEDERAL RESERVE BANK OF PHILADELPHIA Why Bankers Are Concerned About NOW Accounts By Howard Keen* If your local banker seems a bit pre occupied these days, don’t be surprised. Chances are he’s concerned that the competi tive world as he’s known it may be coming to an end. In that world, the law gave com mercial banks a near monopoly on checking accounts. But pressure for reform may intro duce a change in America’s financial system which would sweep away the checking monopoly. This change is the authorization of nego tiable order of withdrawal (NOW) accounts for commercial banks and other financial institutions throughout the country. NOW accounts are interest-bearing checking ac counts for nonbusiness depositors. They cur rently are authorized in New England, and proposals in Congress would extend them nationwide. Advocates of NOW accounts claim that consumers will benefit from them, but bank ers worry that these gains will be at their expense. A look at how NOW accounts might affect commercial banks reveals why bankers are showing this concern, and why some are showing more than others. It also suggests, however, that NOW accounts may not be the disaster that many bankers fear. BATTLING FOR BUCKS NOW accounts are sure to affect competi tion for family funds. Households ordinarily keep funds they want to have readily avail able in three basic forms—currency, check ing accounts, and savings accounts. The three together come to about $1 trillion—a tidy sum. Currency and checking accounts are most convenient for making payments, but they have their drawbacks. Carrying large sums of cash can be risky, and funds that are held as cash or in checking accounts *The author, an Economist at the Philadelphia Fed, specializes in banking and regional business conditions. 3 NOVEMBER/DECEMBER 1977 BUSINESS REVIEW earn no explicit interest.i By contrast, a savings account may be less convenient for making payments but it produces interest income for its owner; and it’s relatively safe. How family funds are divided among these forms depends on the tradeoffs people make among safety, convenience, and interest in come. If, for example, it became much easier to switch funds from savings to currency or checking accounts, we would expect to see more funds held in savings accounts and less in currency and checking. Thus, in effect, currency competes against savings and check ing accounts for household funds. Commercial Banks and Their Rivals. Dif ferent fin an cial institutions also compete for household funds. Savings accounts, for ex ample, can be held both at commercial banks and at thrift institutions such as mutual savings banks (MSBs), savings and loans (S&Ls), and credit unions (CUs). With some exceptions, checking accounts can be held only at commercial banks, but there is a host of commercial banks to choose from. Thus, in trying to attract funds into checking ac counts or savings accounts, commercial bank ers face competition on two fronts. First, they compete as a group against currency and against savings accounts at thrifts. Second, they compete among themselves for the de- iFor an analysis of the comparative advantages of currency and checking accounts, see Donald L. Kohn, “Currency Movements in the United States,” Monthly Review, Federal Reserve Bank of Kansas City, April 1976, pp.3-8. HOW CONSUMERS MIGHT GAIN FROM NOWs NOW accounts might bring several benefits to consumers. First, consumers could hold a checking-type account at many more financial institutions than they can now. And this wider choice could save them time and effort. Being able to bank at a thrift located around the corner instead of at the nearest commercial bank 10 blocks away makes more time available for other activities. Even where banks and thrifts were equally convenient, consumers could avoid the costs involved in switching funds from savings to checking—as they must do now if they want to earn interest on their spendable funds. By offering a savings and checking account rolled into one, NOW accounts could save consumers the time, hassle, and monetary costs of this kind of transaction. Further, consumers could gain more from the payment of explicit cash interest than from implicit interest in the form of banking services. As more and more banking services are provided to depositors, they tend to get less additional benefit from further increments of these services. Cash, however, can be used to purchase other, preferred goods and services. The total value that depositors receive could be higher if interest payments were substituted for some banking services. Consumers could benefit also from the more intense competition of financial institutions that NOWs would permit. These gains are likely to be larger during the intitial phase of NOW accounts when banks and thrifts are trying to establish their market shares. Even after market shares stabilize, however, competition could result in consumers’ receiving more for their funds than before. It’s likely that opportunities for gains would be different for different consumers. Depositors pay no taxes on banking services as they do on cash interest received, and this tax difference can affect the comparative values that consumers attach to these two forms of payment. The higher the depositor’s marginal tax rate, the less attractive is payment in cash. At the same time, it’s possible that some customers might end up paying more under NOWs than before. Depositors who are accustomed to write a lot of checks while holding low balances, for example, could find that continuing to do so would cost them more in service charges than they receive in interest. 4 FEDERAL RESERVE BANK OF PHILADELPHIA against other bidders. And by helping to keep costs down, the restrictions may have given a boost to bank profits. posits that households might decide to hold at commercial banks. Nature of Checking Account Competition. The law has given commercial banks an inside track in the competition for household funds. Most of the money Americans spend is spent by check, and commercial banks have been nearly the only institutions allowed to provide the checks. Their monopoly on checking accounts has made it easier for them to attract nonchecking deposits, because it’s more convenient for the consumer of bank services to handle all his transactions at one institution. Only those who can afford the inconvenience are likely to be won over by the higher maximum interest rate allowed on savings at thrifts.23 But while banking is competitive, it’s also regulated, and so bankers can’t compete freely. They’re barred, for example, from paying interest on checking accounts, and they have to cope with interest-rate ceilings on savings accounts. Thus about the only way they can compete is by providing more services, such as free or subsidized checking, to their customers. These services cost the banker something, and in many cases his costs are greater than the service charges that depositors pay. So an inducement is being paid for checking account dollars, but it’s in the form of banking services rather than cash .3 Nonetheless, the restrictions on entry into this checking account market may have al lowed some banks to attract funds at a lower average cost than if they had to compete WHAT NOWs COULD DO NOW accounts, as authorized in New England and as proposed in Congress for the rest of the country, are considered in law to be savings accounts.4 But the negotiable orders of withdrawal are, in essence, checks, so that for all practical purposes, NOWs are interest-bearing checking accounts. Under the proposals to legalize the extension of these accounts nationwide, all depository institutions could offer what amounts to a checking account, and commercial banks, as well as the rest, would be allowed to pay interest on these accounts. Since these pro posals would eliminate the checking account monopoly as well as the prohibition against paying interest on checking accounts, it’s likely that commercial banks would feel some impact. As it turns out, bank profits could be affected by NOW accounts in sever al ways. NOWs Could Cut Bank Costs . . . One of the key features of NOW accounts—permis sion to pay interest on checking accounts— might tend to lower the costs of some banks. Why? Because banks probably can attract a certain volume of funds at a lower cost if they can pay for them with interest in cash than if they have to pay for them with banking services alone. The reason is that, at some point, paying interest becomes cheaper than providing bank services. As the depositor is provided more and more of a service, the value to him of each further bit of the service goes down. People may find it valuable, for example, to receive a statement every month which lists their deposits and checks written. But getting a ^^Regulations on passbook savings accounts, for ex ample, set the ceiling a quarter of a percentage point higher at MSBs and S&Ls than at commercial banks. CUs are subject to different regulations which permit even higher rates to be paid. 3For a discussion of this implicit interest, see John H. Boyd, “Household Demand For Checking Account Money,” Journal ol Monetary Economics 2 (1976), pp. 81-98, and James M. O'Brien, “Interest Ban on Demand Deposits: Victim of the Profit Motive?” Business Review, Federal Reserve Bank of Philadelphia, August 1972, pp. 13-19. 4 Since reserve requirements are lower for savings than for checking, this legal classification of NOW accounts will reduce the reserves that banks are required to hold. 5 BUSINESS REVIEW NOVEMBER/DECEMBER 1977 statement every three weeks, then every two, and then every week, probably would be of little value to most depositors. By the same token, many customers would find the extension of closing time from six o’clock to seven o’clock a useful added attraction But each further hour tacked on probably would be valued less than the last. This charac teristic—that each added unit of a service contributes less to total consumer satisfac tion—is not unique to banking. In fact, it holds after some point in all kinds of business. Further, after some level of services is reached, the bank will have to spend more than a dollar to give depositors extra services which they will value at a dollar. As the bank uses more and more resources to provide banking services, and as the cost for each additional unit of service rises, it becomes increasingly expensive for the banker to attract checking account funds or to hold on to them in the face of added competition. Thus a bank may find that it can retain or attract depositors at a lower cost if it pays for funds with interest rather than with more and more services. In short, having the option of paying depositors with cash rather than with banking services may be a valuable weapon for banks in their competitive strug gle for funds.5 BOX 1 SOME ALTERNATIVES TO CHECKING ACCOUNTS AT COMMERCIAL BANKS The following are the most frequently discussed thrift institution alternatives to commercial bank checking accounts: Payment of bills by direct transfer of funds out of thrift savings ac counts. In pre authorized ver sion, thrifts auto matically pay bills on regular basis af ter initial authori zation by consum ers. In telephone version, consum ers telephone thrifts each time a pay ment is desired. The road to lower costs, however, is not without its potholes. In fact, bankers could find that NOWs tended to inflate costs. In the first place, banks can’t realize the benefits of paying cash interest overnight or by standing pat. If banks which are providing services at no charge to depositors hope to attract the same amount of funds at a lower cost, they must do two things. In addition to paying their depositors explicit interest, they must institute an appropriate charge for Off-Premise Electronic Terminals — Deposit and with draw! from thrift savings account at off-site location. In some cases, con sumers can make direct transfers from own to mer chants’ accounts. Share Drafts — Check-like pay ment from credit union deposit or share accounts. Checking Accounts —Traditional check ing account trans actions (noninter est-bearing NOWs— NINOWs). 5Tax considerations can play a role in the way that depositors value cash and services. The fact that no taxes are levied on services would make this form of payment more attractive to depositors than it would be otherwise. services they previously provided for free. But discovering the right combination of interest rates and charges may take time. . . . But NOWs Also Could B oost Costs. 6 FEDERAL RESERVE BANK OF PHILADELPHIA And during the transition, bankers may be spending more, rather than less, to attract the same amount of funds. Further, removal of the ban on cash interest could heat up the battle for funds. Banks would be able to compete by offering interest as well as services. If each bank in the market were to pay only cash and to provide no free services, it’s possible that the costs of each and every bank would fall. But the individual banker can’t be sure that his rivals will do as he does. And the actions of his rivals can affect his profits. A banker who decides to continue offering free services and paying no interest while his rivals offer both services and interest may have to revise his decision rather quickly to avoid losing deposits. Thus his profits, as well as those of his rivals, might turn out to be less than if every bank paid only cash interest. So removal of the ban on cash interest, while providing an opportunity for lower costs, also provides an opportunity for rival banks to offer more for deposits. No banker would intentionally offer a package that would cut into his profits, but his rivals could offer a package that would do the job for him. It’s possible that banks may compete away some profits because each and every banker wants to protect himself against the possibility of losing even greater profits. And while there is no way to tell with any precision to what degree this might occur, the mere prospect that it might is enough to worry many bankers. Finally, because NOWs would allow thrifts to offer checking account services to con sumers, it would be easier than before for these institutions to compete with commer cial banks for funds.6* More competition would bring about an increased demand for BOX 2 HOW W IDESPREAD IS THE AUTHORITY TO OFFER CHECK-LIKE SERVICES?* Preauthorized Bill-Paying Telephone Bill-Paying Federally chartered S&Ls nationwide. S&Ls in 8 states and D. C.; MSBs in 9 states. Off-Premise Electronic Terminals r Federally chartered S&Ls nationwide; S&Ls in 20 states; MSBs in 10 states; Federally chartered CUs in 10 states. — Federally chartered Share Drafts CUs nationwide; CUs in 27 states. Checking Accounts — S&Ls in 6 states; MSBs in 12 states; CUs in 3 states. ’ Establishment of the authority for these services does not guarantee that they actually are being offered at the present time. SOURCE: American Bankers Association press release of June 14. 1977. U/'Uv I g A these funds and thus higher interest rates paid to checking account customers (Boxes 1 , 2) . 6 NOW accounts do not provide the only opportunity for thrifts to offer checking account services. Changes in payments technology along with regulatory rulings and interpretations already have given thrifts the author ity to enter what was exclusively a commercial bank domain. In short, commercial banks could feel the effects of NOW accounts in several ways. These might raise but also might lower the average cost of funds to bankers. Unless the efficiency benefits of paying depositors with 7 BUSINESS REVIEW NOVEMBER/BECEMBER 1977 cash outweighed any higher costs brought about by increased competition, the average cost of funds to commercial banks would rise. more to lose from NOW accounts. All things considered, these banks pay less for personal funds than they would if the market were highly competitive. This helps keep costs down and gives them larger profits. The greater are a bank’s profits that arise from paying less than competitive rates for these funds, the greater are the profits that might be eliminated through additional competition. Thus banks in less competitive deposit mar kets have more to lose from additional com petition than do banks where competition is stronger. Although the degree of competi tion can vary greatly among the local markets, banking markets in areas with larger popula tions tend as a rule to be more competitive than those in areas with smaller popula tions.8 Overall, then, smaller banks in less populated areas have more at stake when it comes to NOW accounts. This does not mean that banks with these characteristics are guaranteed a worse time than other banks.9 Nevertheless, having more at stake is enough reason for added concern over an uncertain outcome. SOME BANKS HAVE MORE AT STAKE Bankers have no way to predict the net im pact of NOW accounts with any precision. But with the competitive rules of the game changing, no prudent banker can avoid being concerned to some degree. And on top of this, there are certain conditions that make some bankers more apprehensive than others. Sources of Funds Make a Difference. Since NOW accounts apply to nonbusiness deposits only, banks that rely to a greater extent on households for their sources of funds would be affected more by changes in costs for these deposits. The greater the percentage of total funds that comes from households, the greater any impact of NOW accounts on bank costs. Smaller banks typically rely more on these household sources. According to a 1976 Federal Reserve survey, nonbusiness check ing account funds made up 41 percent of the total at small banks, 37 percent at medium sized banks, and 25 percent at larger banks. A similar pattern holds for the ratio of house hold checking deposits to total deposits.7 Because of this heavier reliance on nonbusi ness deposits, many smaller banks would experience a bigger percentage change in costs than larger banks. The heavier this reliance, the greater the impact on a bank’s total cost of funds from a change in the cost of nonbusiness deposits. On average, then, smaller banks stand to gain or lose more from NOW accounts than do larger banks. Degree of Competition Matters, Too. Banks that face little competition for household funds under the current system also have 8 See “Recent Changes in the Structure of Commercial Banking,” Federal Reserve Bulletin, March 1970, pp. 195-210. 9 Profits are affected by the demand for loans and by the aggressiveness of competing institutions as well as by costs. All things considered, the more inelastic is the demand for loans, the less will be the reduction in profits from some given increase in costs, At the same time, a bank’s cost of funds will be pushed up less, the less aggressive are competing institutions in offering NOW accounts. For an analysis of the decision to offer NOW accounts by MSBs as well as by commercial banks, see Donald Basch, “The Diffusion of NOW Accounts in Massachusetts,” New England Economic Review, November/December 1976, pp. 20-30. As Basch’s analysis shows, predicting the behavior of financial institutions is no easy task. There is another feature of less competitive markets, however, that could make the road rougher for commercial banks. It’s possible, for example, that entry by thrifts may be encouraged by lower rates paid to depositors by com mercial banks. Since these rates would be lower in less competitive deposit markets, banks in these markets may feel stiffer competition from thrifts. 7See Functional Cost Analysis: 1976 Average Banks, p. 7.6, and “The Impact of the Payment of Interest on Demand Deposits,” Board of Governors of the Federal Reserve System, January 31, 1977, p. 48. 8 FEDERAL RESERVE BANK OF PHILADELPHIA that chose not to offer NOWs and experi enced a runoff of deposits, were particularly hard hit. Out of 226 banks in the two states, 16 were in the former group and 15 in the latter. Another study examined the 22 Massa chusetts banks with negative earnings in 1976 and concluded that these negative earnings were not explained by the percentage of total deposits in NOW accounts. In short, it appears that while some banks have had a lot of adjusting to do, NOWs over all have not severely damaged the position of commercial banks in New England. NOWs in the Rest of the U.S. While bank ers may not find complete reassurance in the estimated impact of NOWs in New England, there are reasons to believe that banks in the rest of the country may not find the going as rough. For one thing, bankers have the New England experience to learn from. And if the learning that comes from the inevitable trial and error is costly, then bankers in the rest of the U .S. may be able to avoid some costly mistakes. One lesson, for example, is that the pricing of NOW accounts is of prime importance. Whether NOW accounts are profitable or unprofitable can depend upon the pricing package that bankers devise. A comparison of banks in Massachusetts in 1976 showed that banks that offered NOWs with service charges had average earnings rates almost double those of banks not offer ing NOWs. A third group—the one with banks offering free NOWs—had the lowest. Banks do not have to pay depositors more for their funds than banks can earn on them, and the proper pricing structure can help banks avoid losing money. Another lesson from New England is that the transition period described earlier may not last more than a few years. In M assa chusetts and New Hampshire, aggressive competition for NOWs was beginning to ease a bit less than two years after the introduction of NOWs. And with the New England experience to learn from, it may be shorter elsewhere. LESSONS AND PROSPECTS Although nationwide NOWs could make life tougher for some bankers, it’s difficult to predict just how much tougher. Against the opportunity for more intense competition and its likely impact on bank costs is the prospect of a gain in efficiency from paying depositors with cash. Moreover, what bankers do in terms of charging for services and how aggres sively thrifts enter the market for NOWs will have an important bearing on the outcome. NOWs in New England. Commercial banks and thrifts (except CUs) have had the authority to offer NOW accounts in Massachusetts and New Hampshire since 1974 and in the rest of New England since 1976. Several studies have been done to try to estimate the impact of NOW accounts on commercial banks there. For the most part, these studies have focused on Massachusetts and New Hampshire, since NOWs have been author ized in these two states for the longest time. It’s been estimated, for example, that for all banks in these two states, NOW accounts reduced after-tax earnings by about two and a half percent in 1974 and by a little over eight percent in 1 9 7 5 .10 Within this aggre gate group of banks, however, were some that experienced larger percentage declines in earnings. One group of banks with low earnings to begin with, and another group 10 For estimates of the impact of NOW accounts on all commercial banks in Massachusetts and New Hamp shire, see John Paulus, Effects of “NOW” Accounts on Costs and Earnings of Commercial Banks in 1974-75, Staff Study No. 88, Board of Governors of the Federal Reserve System, 1976. Estimates of the impact on particular groups of banks are given in Ralph C. Kimball, “Impacts of NOW Accounts and Thrift Institution Competition on Selected Small Commercial Banks in Massachusetts and New Hampshire, 1974-75,” New England Economic Review, January/February 1977, pp. 22-38. See also U.S., Congress, Senate, Subcommittee on Financial Institutions of the Committee on Banking, Housing, and Urban Affairs, NOW Accounts, Federal Reserve Membership, and Related Issues: Hearings on S.1664, S.1665, S.1666, S.1667, S.1668, S.1669, and S.1873, 95th Cong., 1st sess., 20, 21, 22, and 23 June 1977, pp, 1124-1133. 9 BUSINESS REVIEW NOVEMBER/DECEMBER 1977 A stronger position in the competition with thrifts likewise may ease the cost pres sures on bankers. There is some evidence on depositor loyalty which suggests that many depositors may prefer to hold a NOW account at an institution they’ve dealt with in the past. Although thrifts have an interest-ceiling advantage on savings, locational convenience and a wider menu of financial services still are strong selling points for commercial banks. If customers stay loyal, then current shares of savings may indicate how competi tive banks might be in the struggle for NOW accounts. In New England at the end of 1975, banks held only 20 percent of savings deposits and of time deposits totaling $100,000 or less, while thrifts held 80 percent. Nationally, however, banks are in a stronger competitive position, with 45 percent of the total compared to 55 percent for thrifts.11 Proposals now before Congress (S. 2055 and H.R. 8981] also could serve to ease the earnings pressure that commercial banks might feel from NOW accounts. One pro posal is for the Fed to pay interest on required reserves, and a second would allow reduc tions in the required reserve ratio on certain checking and savings deposits. While non member banks in many states have the op portunity to hold their required reserves in earning assets, member banks do not. Pay ment of interest on reserves and reductions in required reserve ratios would provide added revenue to these banks which could help offset any increase in costs. A third proposal is designed expressly to help ease cost pressures during the initial phase of NOW accounts. It calls for maxi mum interest rates on NOW accounts equal to the maximum allowed on passbook savings at commercial banks. The proposal allows, however, for the interest rate ceiling on NOWs to be set below this maximum and then to rise gradually over a period of several years. Such a gradual phase-in procedure would reduce the likelihood of sharp increases in the cost of funds and would give bankers a little breathing room in their search for a desirable pricing plan. A final provision calls for the NOW account package to take effect one year after it is signed into law, and this delay would give bankers additional time to gear up for NOW accounts. Each of these proposals represents another advantage that bankers around the country would have that their New England counterparts did not. BANKERS’ CONCERNS IN PERSPECTIVE After examining the ways that NOW accounts could affect commercial banks, it seems safe to say that bankers have solid reasons for concern over these new accounts. They are faced with the prospect of paying interest where they paid none explicitly before as well as with the prospect of added competi tion for funds. Understandably, bankers are worried that all of this will mean higher costs for them. But several advantages of financial reform could help offset the cost pressures from added competition. Paying interest in cash can be more efficient than paying in the form of bank services. And with an appropriate pricing plan, paying cash interest actually could lower bank costs. Moreover, the initial phase of NOW accounts may be easier than many bankers think. Bankers have the New England experience with NOWs as a guide line, they may be in a stronger competitive position with thrifts than banks in New England, and they might enjoy the benefit of a gradual phase-in of interest ceilings on NOWs. At the same time, member banks may begin to earn interest on required reserves. All of this could help mitigate any higher costs that banks might feel from NOW ac counts. Banks in Massachusetts and New Hampshire didn’t have any of these advan tages, but most of them have fared reason ably well. In short, while NOW accounts may not be a picnic for bankers, neither are they likely to be as damaging as many bankers fear. H “The Impact of the Payment of Interest,” p. 47. 10 FEDERAL RESERVE BANK OF PHILADELPHIA Commodity Agreements: The Haves vs. the Have-Nots? By Janice Moulton Westerfield* The industrialized nations soon may be transferring more of their wealth when they buy raw materials. Even now, the develop ing countries are trying to arrange interna tional agreements which would raise the prices of 19 basic commodities and stabilize them at higher-than-market levels. In the past, commodity agreements have been limited to a single resource, such as tin or coffee. The present push toward a blanket agreement covering many commodities comes from countries that are rich in raw materials but haven’t developed the industrial base to turn them into finished goods. These coun tries are dissatisfied with having their econo mies depend on the actions of the market place. Moreover, they watched the OPEC cartel pile up huge revenues from oil, and they would like to use commodity agreements to emulate OPEC’s earning performance. Spokesmen for the developing countries claim that commodity agreements would guarantee the industrialized nations access to raw materials and at the same time promote economic development and the redistribution of wealth. Representatives of the developed countries reply that letting market forces operate would produce the largest output for everyone while intervention in commodity markets will lead to economic waste and misallocation of resources. Thus the issues raised by commodity agreements concern both the size and the manner of income transfers from the have countries to the havenots. The developed countries, because of their interest in maintaining harmonious re lations, are likely to go along part way. But they will continue to seek more efficient ways to expand trade and to improve condi tions in the developing countries. ‘ Janice M. Westerfield, who joined the bank in 1973 and received her Ph.D. from the University of Pennsyl vania the following year, writes frequently on inter national finance and trade. 11 BUSINESS REVIEW NOVEMBER/DECEMBER 1977 WHAT ARE ICAs? There’s nothing new about attempts to stabilize commodity prices. What is new is the fervor with which the developing nations are urging their case for commodity agree ments as the preferred method of transferring income. International commodity agreements (ICAs] have certain features in common. Their mem bership includes both producing and con suming countries. (The OPEC cartel, for example, is not an ICA because consumer countries do not participate.] They have certain stated objectives, such as stabilizing prices, assuring adequate supplies to con sumers, and promoting the economic develop ment of the producers. A typical statement of objectives can be found in the coffee agreement: “to achieve a reasonable balance between world supply and demand on a basis which will assure adequate supplies of coffee at fair prices to consumers and markets for coffee at remunerative prices to producers [and] to avoid excessive fluctuations in levels of world supplies, stocks and prices which are harmful to both producers and con sumers.”! Finally, an ICA is administered by a central council which represents the mem bers. ICAs fall into three kinds—quota, buffer stock, and multilateral purchase arrange ment. A quota arrangement, such as the coffee agreement or sugar agreement, speci fies quantities to be exported by each pro ducer. B u ffer sto ck s (inventories of com modities] may be used alone or in conjunction with a quota system, as with tin. The buffer stock system attempts to stabilize prices by buying up the commodity when the price nears an agreed-upon floor and selling the commodity when the price approaches the ceiling. The third type of agreement—a multi lateral contract such as the wheat agreement— sets up ranges of intervention for commodity prices. Consumer countries agree to purchase certain amounts of the commodity at no less than the minimum price while producer countries agree to sell certain amounts at no more than the maximum price. The market mechanism functions between these limits. The wider the price range, the closer the system approximates a free market; the nar rower the range, the more the system ap proaches a quota system with guaranteed prices. (For a history and analysis of the tin agreement, see Box.] These three kinds of agreements have a strong attraction for the developing countries, especially because of the way these countries perceive their own position in the international trading arena. HOW THE DEVELOPING COUNTRIES SEE IT The developing countries are interested in having international economic relations work more in their favor, and high on their list is the stabilization of their export earnings. Many of the developing countries depend heavily on export earnings from one or two commodities. When prices for these com modities fluctuate, ongoing economic develop ment programs become hard to sustain, and long-range efforts become more difficult to plan. These countries argue not only that their trade position is disadvantageous but also that it is deteriorating. They claim that because the ratio of export prices to import prices— the terms of trade—has declined over time, their traditional exports now buy fewer im ports from the developed countries. In order to prevent further slippage, they’ve proposed that raw material prices be indexed to prices of manufactured goods. That way, the prices of the raw materials they export would keep pace with the prices of manufactured imports. Along with stabilization of export earnings and improvement in the terms of trade, the developing countries are looking for easier access to the markets and technology of their industrialized trading partners. Access to these potentially large markets currently is international Coffee Agreement 1976, p. 2. 12 FEDERAL RESERVE BANK OF PHILADELPHIA BOX INTERNATIONAL TIN AGREEMENT Some form of international control of tin production has been in effect for over 50 years. Initially, only the producing nations were parties to the agreement. Several attempts were made by the members to include the consuming nations, but none was successful until the early 1950s, when the U. S. stopped buying tin for its strategic stockpiles.* This withdrawal from the market and the resulting price decline helped spur negotiations for a new agreement. The First International Tin Agreement became effective in July 1956 for five years. Subsequent agreements, also of five years’ duration, were negotiated, and the U. S. became a member of the Fifth Agreement. The main objective of the agreement has been to adjust world production and consumption of tin so as to “prevent excessive fluctuations in the price and export earnings of tin.” The central provisions to attain these goals—buffer stocks and export controls—have remained unchanged. The International Tin Council administers the buffer stock operations to maintain prices within a target zone. When prices reach the floor of the target zone, the Council buys tin until the market price rises above this level or the funds are exhausted. When prices approach the ceiling, tin stocks are sold as long as the stocks last. Buffer stocks are considered the first line of defense; export quotas are held in reserve for situations that the buffer stock can’t control. Export quotas can be tightened to shore up the floor price, and penalties can be imposed on countries that exceed their export quotas. These controls have been operative about one-quarter of the time. The tin agreements have been quite successful in maintaining the floor price. Only once, in September 1958, has the price fallen below the floor level. And that price decline was caused mainly by sales of tin by the U .S.S.R., a nonmember. Maintaining the ceiling price has been more difficult. Ceiling prices were exceeded in 1961, 1963-66, and in the 1970s, and they would have been broken more often if they had not been raised. In recent years, the buffer stocks were exhausted, export quotas were suspended, and prices still remained above the ceiling of the target zone. The buffer stock was doubled in the Fifth Agreement, which became effective provisionally in July 1976. Though the agreements may have contributed somewhat to a more stable tin price, average prices probably have been higher than they would have been without the agreements. ‘ Through the years, critics have objected that the price was set so high that even mines with high production costs were able to operate at a profit. High prices also stimulated the search for substitutes. Shortly after World War II, new methods of tin plating, food storage (freezing), and competition from aluminum and synthetic products all acted to dampen demand. restricted by quotas, tariffs, and other barriers. Actually, many developing countries are guaranteed access on a basis of equality—for example, at the same tariff level—with other nations. 2 But they want more than just equal access; they want free entry for the products of their fledgling industries. Preferential treatby the rules of the General Agreement on Tariffs and Trade. One important exception is the customs union, which may reduce or eliminate all trade barriers for members. A second is the Generalized System of Prefer ences which the U.S. implemented in January 1976. This program grants duty-free entry to selected imports from eligible developing countries, subject to quantity restrictions. 2The most-favored-nation clause extends tariff reduc tions granted to one country to all other countries with which the first exchanges most-favored-nation treatment. This approach has been used for commodities covered 13 NOVEMBER/DECEMBER 1977 BUSINESS REVIEW ment is required, they claim, if they are to compete with developed countries that al ready have well-established customs unions and other arrangements for trading their goods. The developing countries look to interna tional commodity agreements as the answer. ICAs, they believe, would raise the relative prices of their exports, stabilize those prices, and enable them to develop their productive resources. In short, ICAs would start wealth flowing their way, as, they believe, other forms of economic assistance have failed to do. But outside the developing countries, many people have doubts about the value of ICAs. They take a different view of what has been happening to commodity price stability and they emphasize the drawbacks of commodity agreements. They believe that a clearer per spective on these matters ought to precede a decision for or against ICAs. export price index for manufactured goods rose from 78 to 213. Since these indexes take 1963 as the base year (= 100], they indicate that from the base year on, prices of primary products have outrun prices of industrial goods. Thus while some countries may face worsening terms of trade, a close look at the evidence does not support a case for overall deterioration. 3 Further, the evidence for price instability for primary products is far from conclusive. Most of the primary commodities except cocoa have seen a lessening of price fluctua tions since midcentury. Large groups of commodities show less price fluctuation in the third quarter than in the first half of this century, and the same goes for an important commodity subgroup.4 But since 1950, primary commodity prices have fluctuated on average about 1.5 percent per year more than prices for manufactured goods. While overall price instability for primary products probably has been overstated by those who favor ICAs, it remains true that some primary commodities may suffer severe price fluctuations. And since some nations may depend on one or two export commodi- HOW SOUND ARE THE ARGUMENTS FOR ICAs? The arguments about price instability and terms of trade demand special attention, for they lie at the heart of the developing coun tries' case for commodity agreements. It’s important to know also which are the pro ducing and which the consuming nations, as well as how likely it is that commodity agreements would accomplish what they’re designed for. Movements in Commodity Prices. The evidence for the terms of trade argument depends upon the time period chosen. It appears that over the first half of this century, commodity prices were trending upward. During the decade after the Korean War, prices of most primary products fell while those of manufactured goods were rising slightly, but the next decade saw the terms of trade improve for the developing countries. Overall from 1950 to 1975, the United Nations export price index of primary commodities (excluding oil] rose from 105 to 225 while the 3From 1972 to mid-1974 the U.N. index of export prices of all primary commodities increased by over 100 percent. The other side of the picture is the sharp decline in commodity prices observed the following two years (followed by another price rise in 1976], Nevertheless, commodity prices in general outstripped manufactured goods prices from 1972 to 1976. Indexing commodity prices to manufactured goods prices would have resulted in smaller revenues for commodity producers. 4The U.N. price index for 22 primary commodities had an average annual fluctuation of 14.5 percent over the first half of this century. The average fluctuation dropped to 4.5 percent for the period 1950-62 and then rose slightly to about 7.5 percent for the period 1963-75. The average annual price change for the ten core commodities (excluding hard fibers) fell from +14.7 percent in the first half-century to +11,3 percent for the period 1950-75. Dae Yong Choi assisted in calculating these figures from Instability in Export Markets o f Underdeveloped Countries (New York: United Nations Department of Economic Affairs, 1952) and from various issues of the U. N. Monthly Bulletin o f Statistics. 14 FEDERAL RESERVE BANK OF PHILADELPHIA case to see which countries would benefit from the higher prices ICAs would bring. It’s likely that commodity agreements would make the U .S., the U .S .S .R ., and other resource-rich developed countries the major beneficiaries and would bring small benefits to the developing countries. 6 In short, agree ments on large groups of commodities could give the developing nations the promise of economic improvement without the return they expect and end up benefiting mainly the developed countries. Are ICAs Workable? Even if the terms of trade were unfavorable to the developing countries, and even if the developing coun tries were the main commodity producers and thus the main prospective beneficiaries of ICAs, these agreements still might not work out very well. Economic conditions favorable to commodity agreements are dif ficult to maintain over the long haul. Indeed, a recent M IT study found that commodity cartels which put through large price hikes lasted an average of only four to six years. 7 The difficulties are less severe when fewer ties for a large part of their income, a drop in the price of either or both may be extremely troublesome, even if the average price for a group of primary products holds much more stable. This lack of diversification in a develop ing nation’s economic base may be at the heart of the drive toward ICAs. It’s likely that individual commodity price fluctuations could be reduced much more efficiently in other ways—for example, by developing markets that deal in future purchases and sales of primary commodities. But the developing countries continue to argue in favor of ICAs, believing that the terms of trade have deteri orated and that primary product prices have been destabilized overall. Who Are the Commodity Producers? Fur thermore, the division into producers and consumers of primary commodities is not as simple as appears at first sight. Consumers cannot be identified with developed countries nor producers with developing countries. OPEC is a revealing example: here the inter ests of the developing countries that don’t produce oil are aligned with those of the consumer nations. In primary commodities, the principle producers are the d ev elop ed countries. In fact, the developed nations produce about 70 percent of the commodities under discussion at UNCTAD (United Nations Conference on Trade and Development) and account for nearly 50 percent of the exports. 5 The U .S., for instance, leads the world in cotton exports. Wheat and rice are other commodities heavily imported by the develop ing countries. Because different countries produce dif ferent primary products, perhaps the list of commodities should be examined case by 6The developing countries want to improve their eco nomic position in relative as well as absolute terms. But because the developing countries consume a large portion of the world’s raw materials and export signifi cant quantities of manufactured goods, higher com modity prices may not improve their net foreign earnings as much as they hope. The gains anticipated by the developing countries will be reduced to the extent that they import costlier raw materials and export relatively inexpensive manufactured goods. Moreover, because commodity agreements constrain the total supply of goods, such agreements may reduce the size of the economic pie available to be divided. Nevertheless, because some developing countries have not been able to diversify their exports, they tend to be concerned with the prices of only a very few commodities. A few primary products may generate a sizable portion of their export earnings while money spent on imports is spread over a whole basket of goods. Thus they see it as their interest to concentrate on the few export prices that have a strong effect on their own economies. 7 P. L. Eckbo, “OPEC and the Experience of Previous International Commodity Cartels,” Working Paper No. 75-008WP, MIT Energy Laboratory, August 1975. ^The primary products under discussion at the NorthSouth talks were cocoa, coffee, tea, sugar, jute, cotton, natural rubber, copper, bananas, iron ore, bauxite, beef, sisal, vegetable oils, oil seeds, tropical woods, manganese, phosphate, and zinc. The UNCTAD dis cussions cover ten core commodities [the first eight listed above plus hard fibers and tin) as well as bananas, iron ore, bauxite, meat, wool, wheat, and rice. 15 NOVEMBER/DECEMBER 1977 BUSINESS REVIEW producers are parties to the agreement be cause detecting attempts to cheat and policing the agreement are simpler then. Reaching a consensus on barriers to keep competitors out of the market may be easier, too. But entry barriers and policing still have to be taken care of. One cause of the fragility of commodity agreements is technological innovation which leads to the substitution of synthetics for natural products. Commodity agreements are effective in keeping prices up only so long as no cheaper substitutes can be found for the protected item. When the supply of natural rubber was restricted in the 1920s, for example, synthetic rubber was brought onto the market. And when natural fibers, such as silk, cotton, and wool, became scarce or very costly because of war or production cutbacks, chemical companies produced man made fibers to fill the demand. Metals also have given way to substitution, by cheaper metals and plastics. Further, each kind of ICA has its own characteristic weaknesses. Quota systems specify amounts to be exported by each producer. But producers may try to circum vent their quotas if they see gains to be made from increased production and sales. And reallocation of quotas among producers has proven difficult. Nor do quotas keep produ cers outside the agreement from expanding their production. The buffer stock system also has draw backs. The main drawback with a buffer stock is that it may require extensive financ ing by member countries to acquire the commodity and support its price. If the fund isn’t large enough, buffer stock operations won’t have much effect on prices. Price ceilings, especially, have proven hard to maintain. Further, the market in which the manager buys and sells the commodity must be well organized. The establishment of intervention points—floor and ceiling prices— requires forecasting a market-clearing price that anticipates future developments. If pro ducers are to receive a net benefit, members then must negotiate an average price which is higher than the market-clearing price if they are to bring about a transfer of income from consumers to producers. Other difficulties confront the manager of a buffer stock. If the floor price is set too high, producers step up production, especially if convinced the buffer stock manager will support the price. In this case, too many resources will be used in production of the commodity, and surpluses will result.8 Fur ther, a manager must be able to distinguish short-term fluctuations from long-term trends in prices. A secular price increase that is offset continually by sales from the stock pile, for example, will deplete the buffer stock and leave the manager unable to defend the ceiling price. Even a buffer stock which exhibits no systematic imbalance in pur chases or sales can be costly to operate. Storage costs, brokerage fees, and general operating expenses may be sizable.9 Thus, in short, the history and practical 8 Critics argue that commodity agreements are ineffi cient mechanisms for allocating resources. If a com modity price is supported above the equilibrium price, high-cost producers will be subsidized. They will respond by expanding production, and their extra production will be purchased for the buffer stock. The result will be a surplus of the commodity—to be stored or destroyed. Meanwhile, consumers will respond to the artificially high prices by buying less and shifting their demand to substitutes. Because the developing countries do not appear to dispute the inefficiencies of commodity agreements, it's hard to see why they are so adamant about them. It would be more efficient economically to develop futures markets in commodities to smooth price fluctuations and then to transfer wealth to the developing countries as a separate operation via direct aid or loans. 9A recent study estimated that the maximum initial capital outlays to establish buffer stocks for eight agricultural commodities would be $8.3 billion. This estimate assumes buffer stocks large enough to keep price fluctuations within 10 percent of the target level. Pooling the capital outlays for the buffer stocks would reduce the amount of capital required if the commodity prices tend to move independently of one another. For further discussion see P. A. MacAvoy and D. L. McNicol, “Commodity Agreements and the New International Economic Order,” Council of Economic Advisers, June 1976. 16 FEDERAL RESERVE BANK OF PHILADELPHIA the commodity would be sold. But the integra tion of the individual commodity agreements has not been agreed upon. One approach would have the common fund lend money to individual commodity councils which would own and trade the stocks. Then the common fund, through the commodity councils, could channel money received from sales of one commodity into purchases of other commodi ties for the buffer stocks. Both economic and political considerations, as well as humanitarian ones, appear to dictate some sort of an affirmative response to the developing countries’ pleas for aid. The developed nations already have sunk huge investments into the developing countries, and they want those investments to be pro ductive. Maintaining harmonious relations is likely to discourage nationalization and to forestall boycotts and other obstacles to mutually beneficial trade. Further, the Third World countries vastly outnumber the devel oped countries, and their growing political power makes them a force to be reckoned with. The question is what sort of response is most appropriate. economics of commodity agreements justify only modest hopes for their success. More over, there is no conclusive evidence avail able for the alleged deterioration in commodity price stability and in the terms of trade. CURRENT STATUS OF ICAs In light of these facts, it is not surprising that negotiators for the developed countries have shown some reluctance toward the ICA proposals. At the recent North-South talks in Paris, for example, the 27 participant coun tries could agree on only 20 of 41 subjects under discussion, according to their joint communique. The developed countries clearly haven’t bought the argument that commodity agreements will provide consumers with ready access to supplies at reasonable prices. Most developed countries, and especially the U. S., are reluctant to endorse the ideology behind the ICAs. TheU .S. position has shifted from vaguely favorable to cool and back again over the years. In 1961, President Kennedy pledged that the U. S. was ready to examine commodity market difficulties on a case-by-case basis. But not much was agreed upon until President Carter started the ball rolling again by stating in New York that the U. S. was “willing to consider with a positive and open attitude, the negotiation of agree ments to stabilize commodity prices, including the establishment of a common fund . . . .” Since then, at the Conference on Interna tional Economic Cooperation (CIEC) in Paris, the U .S. has agreed to the principle of a common fund to support commodity prices. Further negotiations are scheduled for the current UNCTAD meeting (November 1977). The common fund, indeed, has been the main stumbling block in these negotiations. The developing countries have argued for a $6-billion fund to stabilize the prices of the 19 primary commodities. Basically, this com mon fund would be used to establish a buffer stock for each commodity. Under this system, when the price of a commodity threatened to fall below the floor, the commodity would be purchased; when the price reached the ceiling, OTHER WAYS TO TRANSFER WEALTH Perhaps all the rhetoric about commodities has obscured the real issue—income redistri bution towards the poorer developing coun tries. Many people believe that it should be possible to transfer wealth to these countries in a way which avoids the pitfalls of price supports—unwanted surpluses, artificially high prices, and misallocation of resources that may accompany interference with the pricing mechanism. One alternative favored by the U .S. is to expand the IM F Compensatory Financing Facility. This IMF facility already is available to member countries suffering from balanceof-payments deficits. It’s role could be extended to provide larger drawing rights for member countries that have shortfalls in export earn ings from primary products. To the extent that the economic malaise of the developing countries stems from price 17 NOVEMBER/DECEMBER 1977 BUSINESS REVIEW instabilities caused by lack of diversification rather than from an overall, long-term deteri oration in the terms of trade, a balance-ofpayments financing facility may provide the remedy. Another alternative, advocated by the Europeans, would be to expand the Stabex program of the European Community. At present, Stabex is a half-billion-dollar fund which provides support for export earn ings from several basic commodities and is available to some 50 countries associated with the EC. Other options include expanding loans from the World Bank and other interna tional institutions. Direct aid to the developing countries may be extended through either foreign aid or special action funds. Back in 1968 at the Delhi session of UNCTAD, the industrial countries accepted the goal that 1 percent of their GNP be devoted to aid through public and private transfers. This goal was reiterated as part of the Paris agreement when the industrial countries agreed to work toward a target rate of 0.7 percent of a country’s GNP as direct aid. Countries like Canada and Sweden agreed to write off the debt of certain distressed countries to the tune of $254 million. The participating countries also agreed upon a special action fund to help the poorest countries.io A PEEK AT THE FUTURE Policymakers in the developed countries have accepted the premise that they must share more of their countries’ wealth with the developing nations. But both the extent and the method of redistribution are far from settled. They definitely do not want raw material prices indexed to prices of manu factured goods. They may, however, go part way toward preserving and increasing the purchasing power of other countries. So, for example, they are willing to allow entry of some goods imported from the developing countries on a preferential basis. Similarly, they are ready to commit funds to develop ment projects, as long as those projects are well laid out. It’s likely, then, that the devel oped countries will pledge some further aid, even if it’s less than the 1 percent of GNP demanded by the developing countries. As new pressures for commodity agree ments are brought to bear, most of the developed countries will accept limited inter ference with the pricing mechanism because they think they have no choice. But over the long haul, they can be expected to push for alternative forms of aid—forms that preserve the efficiencies and economic growth that market forces can foster. 10The U. S. pledged $345 million to the special action fund, a sum which needs Congressional approval to be effective by fiscal year 1978. The European Community pledged $385 million, Japan $114 million, Canada $51 million, Sweden $29 million, Switzerland $26 million, Australia $18 million, and Spain $2 million. 18 NEW From the Philadelphia FED... ECONOMIC M AN vs. SOCIAL MAN AND O TH ER TALKS By David P. Eastburn Copies of this new publication are available without charge from the Department of Public Services, Federal Reserve Bank of Philadelphia, 100 North Sixth Street, Philadelphia, Pennsylvania 19106. _______ FEDERAL RESERVE BANK OF PHILADELPHIA BUSIN ESS REVIEW • CONTENTS 1 9 7 7 agl l■ : l |: ig ill H Sm I JANUARY/FEBRUARY JULY/AUGUST John J. Seater, “Coping With Unemploy ment Anthony M. Rufolo, “Local Government Wages and Services: How Much Should Citizens Pay?” Table of Contents 1976 Annual Operations and Executive Changes Donald J. Mullineaux, “Inflation Expec tations in the U.S.: A Brief Anatomy” Helen F. Peters, “The Mortgage Market: A Place for Ceilings?” The Fed in Print SEPTEMBER/OCTOBER • MARCH/APRIL Nonna A. Noto, “The Economics of muting in a Higher Cost World” Nariman Behravesh, "The World 1 Cycle: Is It Here To Stay?” Nonna A. Noto and Donald L. "Philadelphia’s Fiscal Story: The City and the Schools” BOB NOVEMBER/DECEMBER MAY/JUNE Jam es M. O’Brien, “A Case for Market Interest Rates” Stewart Schw ab and John J. Seater, “The Unemployment Rate: Time to Give It a .. 1 Rest?” ^ ^ amasmmmamm on Independence M all 100 North Sixth Street Philadelphia, Pa. 19106 a m B Howard Keen, “Why Bankers Are Con cerned About NOW Accounts” Janice M. Westerfield, “Commodity AgreeI ments The Haves vs. the Have-Nots?” Table of Contents i§ ' v ii .. S §s !1977 _ _ Ltufta : . .......................
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