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The Euro and the European Central Bank

Jeffrey M. Wrase

The Euro and the European
Central Bank
Jeffrey M. Wrase*

I

n order to form a more perfect economic union,
establish a single financial market, provide a
high level of employment, promote convergence
of economic performance, and secure the benefits of sustainable and noninflationary growth,
11 European countries have established a common currency and a European Central Bank.
The formal introduction of the new monetary

*Jeff Wrase is a senior economist in the Research Department of the Philadelphia Fed.

unit, called the euro, occurred on January 1, 1999.
On that date, the old national currencies officially became subunits of the euro, much as the
nickel and quarter are subunits of the dollar. (See
Table.)
Fifteen countries passed a major milestone on
the road to monetary union in 1992, when they
signed the Treaty on European Union, commonly
called the Maastricht Treaty, which outlined a
basic structure for the alliance. Of those 15, only
11 actually joined the European Monetary Union
(EMU): two opted out for now, and two others
have not yet met the economic criteria established
3

BUSINESS REVIEW

NOVEMBER/DECEMBER 1999

TABLE
Conversion rates between the national currencies of the 11 member countries and the new
euro were irrevocably fixed at midnight, local
time, on December 31, 1998. Between January
1, 1999, and June 30, 2002, one euro will be
equivalent to the following amounts of each
of the 11 currencies:
Austrian shilling 13.7603
Belgian franc 40.3399
Dutch guilder 2.20371
Finnish markka 5.94573
French franc 6.55957
German mark 1.95583
Irish punt 0.787564
Italian lira 1936.27
Luxembourg franc 40.3399
Portuguese escudo 200.482
Spanish peseta 166.386
Thus, a German mark is a bit over half a
euro, and a French franc is a bit more than 15
euro cents.

for membership in the union.1 The EMU countries decided that the benefits of having one common currency instead of 11 different ones will

1
The 11 countries are Austria, Belgium, Finland,
France, Germany, Ireland, Italy, Luxembourg, the Netherlands, Portugal, and Spain. Denmark and the United
Kingdom opted not to join initially. Greece did not meet
the criteria for inflation, long-term interest rates, and
ratios of government debt and budget deficits to GDP;
all were too high. Movements in the foreign exchange
value of Sweden’s currency were deemed incompatible
with the necessary conditions for adoption of the euro,

4

outweigh the costs, especially given the amount
of travel and trade that takes place between these
countries.2
To facilitate adoption of a single currency, the
EMU countries also established, after a great deal
of preparation, a European Central Bank (ECB)
that sets a single monetary policy for the 11 members. (See Foundations of and the Legal Framework
for the Euro.) The new setup is similar in some
respects to that in the United States, in which
the states share a common currency (the dollar)
and central bank (the Federal Reserve). The ECB
took responsibility for monetary policy on January 1, 1999. We’ll have more to say about its
functions and operations later.
THE TRANSITION PERIOD
In the transition period — January 1, 1999, to
December 31, 2001— a consumer can use the
euro for noncash transactions, but euro notes and
coins will not yet circulate. To buy something
with euros during the transition period, a consumer can use a credit card or traveler’s check,
or she can make an electronic funds transfer or
write a check. Euro-denominated bank accounts,
credit cards, and traveler’s checks have been
available since January 1, 1999.
During the transition period, the “optional
use principle” applies: no one can be forced to
use the euro or be prevented from using it. For
example, a bank customer with an account de-

as was the statute of the Swedish central bank. In any
case, the Swedish government, citing lack of popular
support, decided that Sweden would not introduce the
euro at the beginning of monetary union in 1999. See the
European Monetary Institute’s 1998 convergence report
for details of the economic criteria and evaluation of the
individual countries.
2

For a discussion of the economic and political benefits and costs of European monetary union and policy,
see the articles by Barry Eichengreen, Gwen Eudey, Martin Feldstein, Maurice Obstfeld, and Ed Stevens. The
book by Peter Kenen provides a broad description of
European monetary and economic union.
FEDERAL RESERVE BANK OF PHILADELPHIA

The Euro and the European Central Bank

Jeffrey M. Wrase

Foundations of and the Legal Framework
for the Euro
There have been many steps toward European economic and monetary integration, dating back
at least to 1951 when the treaty that established the European Coal and Steel Community was
signed. The history of monetary integration in particular began with the Werner Report, published
in 1971, which set out a blueprint for the stage-by-stage realization of economic and monetary
union. In 1979, the European Monetary System was established: bilateral exchange rates among
all currencies in the system were to fluctuate only within narrow preset margins.
In 1989, the Delors Report, which had been commissioned by heads of government at the 1988
meeting of the European Council in Hanover, Germany, laid the foundation for the euro.a The
report insisted that Europe’s economic union, monetary union, and the single market were inextricably linked. It advocated a monetary union characterized by the complete liberalization of
capital movements, the full integration of financial markets, the irrevocable fixing of exchange
rates via a progressive tightening of the European Monetary System, and the completion of the
single market for goods and services. The Delors Report also envisaged a fully independent
institution to set the union’s monetary policy. The report was endorsed by governments at the
European Council summit held in Madrid in 1989.
The Treaty on European Union was agreed to in December 1991 and was signed on February 7,
1992, in Maastricht. This treaty entered into force on November 1, 1993, after it was ratified by all
member countries. It forms the basis for economic and monetary union. Annexed to the Treaty
on European Union is the statute of the European System of Central Banks and of the European
Central Bank.
At a summit held in Madrid on December 15-16, 1995, the heads of government reconfirmed
that monetary union would begin on January 1, 1999, and agreed on euro as the name of the single
currency. At the same time, they adopted firm dates for the transition period (January 1, 1999 to
December 31, 2001) and the final period (January 1, 2002 to July 1, 2002 at the latest).
Early in May 1998, in Brussels, leaders of the European Union formally approved the launch of
a single currency on January 1, 1999. After consulting the European Parliament, the European
Monetary Institute, and the European Commission, the European Council determined which
countries had met the convergence criteria and would therefore be founding members of the
European Monetary Union.b The method for permanently fixing bilateral exchange rates among
the 11 member countries was set, and members of the Executive Board of the European Central
Bank were recommended (and subsequently accepted by the European Monetary Institute).

a
The Delors Report was produced by a committee of all European Union central bank governors; the
then-president of the European Commission, Jacques Delors; and a number of independent experts.
b
The European Monetary Institute, the precursor of the European Central Bank, was set up in accordance with the terms of the Maastricht Treaty to prepare for establishing the European Central Bank’s
functions and monetary policy operations.

5

BUSINESS REVIEW

nominated in German marks may work for a
company that has chosen to pay employees in
euros. The customer can choose to switch to a
euro account, if the bank offers such accounts,
but the bank may not convert the account against
the customer’s wishes.3
Also during this period, many merchants in
the 11 member countries of the EMU are marking prices in both the national currency and euros. However, merchants are not legally obligated to show two prices. And although using
euro-denominated checking or credit card accounts while still using a national currency may
be confusing, it’s part of the cost of monetary
transition.
There are other costs, aside from shopping
inconveniences. For example, Europe’s three
million plus vending machines will need to be
reconfigured at an estimated cost of between
$100 and $500 per machine, depending on the
machine’s age. Every ATM machine will also
have to be converted to dispense euros rather
than a national currency.
Regulations implementing the Maastricht
Treaty forbid contracting parties from altering
or terminating contracts because of the introduction of the euro.4 For example, a contract
denominated in French francs will remain in
force during and after (if applicable) the transition period, and its terms will be unaltered by

3

There are exceptions to and restrictions on the principle. For example, if a national law stipulates the use
of a national currency unit for certain transactions with
the public sector, such as tax payments, citizens and
enterprises must respect the use of this denomination.
Anyone wishing to purchase new debt issued by member countries of the EMU must use euros, because all
such debt is denominated in the new currency. In addition, some issues of private bonds are denominated in
euros.
4
This continuity principle does not apply if a contract
contains a clause specifically allowing for renegotiation
or termination because of the introduction of the euro.

6

NOVEMBER/DECEMBER 1999

the euro’s introduction, except that payment may
be made in euros.
Overall, legislation governing the euro and
transactions made with euros provides a framework to ensure acceptability of the new currency.
So far, the transition period has proceeded without major difficulties, a situation that reflects the
extensive planning that took place well before
the EMU member countries entered into the
union.
THE FINAL PERIOD
In the final period, which will begin on January 1, 2002, and will end on July 1, 2002, at the
latest, national currency notes and coins will be
withdrawn from circulation and euro notes and
coins will start to circulate. The old notes and
coins will continue to be legal tender during the
final period, unless an individual member country decides to remove legal-tender status from its
currency before July 1, 2002.5
Parallel circulation will pose practical problems for consumers in Europe, who will need to
keep two separate sets of notes and coins, and
for shopkeepers, who will need two tills. Methods are being sought to shorten the parallel-circulation period, perhaps by stocking cash dispensers with euros only; by giving change in
euros only, regardless of the unit of payment; or
by removing legal-tender status from the old
notes and coins very quickly.
An important determinant of the success of
the monetary union is the performance of the
institution controlling monetary policy, the European System of Central Banks, including the
European Central Bank.

5
According to the European Commission, EMU member countries are discussing withdrawal of legal-tender
status for national currencies earlier than July 1, 2002,
because of the difficulties of maintaining dual circulation for a full six months. See the question-and-answer
database “Quest” at the commission’s website: http://
europa.eu.int.

FEDERAL RESERVE BANK OF PHILADELPHIA

The Euro and the European Central Bank

ORGANIZATION OF THE EUROPEAN
SYSTEM OF CENTRAL BANKS
The European System of Central Banks consists of the European Central Bank (ECB), headquartered in Frankfurt, Germany; the 11 national
central banks of the EMU member countries; and
the four national central banks of the European
Union countries not currently EMU members.6
Except for the inclusion of central banks from
outside the monetary union, the structure of the
European System of Central Banks looks similar
to the setup of the Federal Reserve System. The
Eurosystem, composed of the ECB along with
the 11 national central banks of countries that
have adopted the euro, bears an even closer resemblance to the Board of Governors and 12 regional Federal Reserve Banks. As we’ll see, however, there are some important differences.
The most important decision-making body
within the ECB is the Governing Council. The
Governing Council consists of an Executive
Board (six members, including the president and
the vice president of the ECB, appointed by common accord of the governments of the 11 EMU
countries) and the central bank governors of the
11 EMU countries (appointed by their respective
governments).7 The tasks of formulating and
6

The four countries not in the EMU (Denmark, Sweden, the United Kingdom, and Greece) will be allowed
some input into the European System of Central Banks
but will not participate in decisions about monetary policy
for the 11-country “euro zone.”
7

Another organization in the European System of
Central Banks, the General Council, does not have a parallel in the Federal Reserve System. The General Council
gives some representation to the four European countries that haven’t yet joined the EMU. This council is
made up of the president and vice president of the ECB
and the governors of all 15 European national central
banks. The General Council’s tasks are to provide input
concerning monetary and exchange-rate policies for European countries inside and outside the EMU; to collect
statistical information; to prepare the ECB’s reports and
financial statements; and to establish rules for standardizing accounting and reporting of operations undertaken
by the national central banks.

Jeffrey M. Wrase

implementing monetary policy are assigned to
the Governing Council. In the U.S., these tasks
are performed by the Federal Open Market Committee (FOMC), which consists of the Federal
Reserve’s Board of Governors (seven members,
including the chairman and vice chairman, appointed by the President of the United States and
confirmed by the Senate) and five Reserve Bank
presidents.8
The ECB’s Governing Council makes key decisions affecting the availability and cost of
money and credit in the EMU countries, similar
to the task performed by the FOMC. At their
respective meetings, the Governing Council and
the FOMC make decisions about targets for interest rates and money growth by majority vote.
They also vote on the policy to be carried out
during the interval between meetings.9 Each
member of the ECB’s Governing Council has one
vote, so the six-member Executive Board has
fewer votes than the governors of the participating countries’ central banks. In contrast, on the
FOMC, the seven-member Board of Governors
has more votes than the five Reserve Bank presidents.10
MONETARY POLICY STRATEGY
AND IMPLEMENTATION
According to its president, Willem
Duisenberg, the ECB will pursue “a stability-

8
The five Reserve Bank presidents are the president of
the Federal Reserve Bank of New York and four other
Reserve Bank presidents who serve one-year terms on a
rotating basis.
9

The Governing Council of the ECB has agreed to
hold its meetings on alternate Thursdays. The FOMC
holds eight regularly scheduled meetings per year at intervals of five to eight weeks. Special FOMC meetings or
telephone conferences take place if circumstances require
discussion or action between regular meetings.
10
For more details on the institutional structure of the
European Central Bank, see Mark Wynne’s article, or
look at the ECB’s website: http://www.ecb.int.

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BUSINESS REVIEW

oriented monetary policy.” The major goals of
the ECB, as set forth in the Maastricht Treaty, are
price stability (the primary goal); support of general economic objectives such as high employment; and establishment and maintenance of a
stable, credible euro in an open market economy
with free competition. These objectives are similar to the goals U.S. law sets for the Federal Reserve: maximum sustainable employment and
price stability.
The Governing Council of the ECB has
adopted the following definition of price stability: “Price stability shall be defined as a year-onyear increase in the Harmonised Index of Consumer Prices (HICP) for the euro area of below
2%.”11 At the same time, the Maastricht Treaty
recognizes that the ECB cannot be held responsible for short-term movements in inflation because there are lags between a change in monetary policy and its effect on prices. In the short
term, inflation may also reflect temporary or external shocks over which the ECB has no control.
The Governing Council of the ECB agreed on
the main elements of its policy strategy in October 1998. This strategy focuses on the money
supply, in particular the growth rate of a broad
monetary aggregate labeled M3.12 Recognizing
that too rapid money growth is a primary cause
of inflation, the ECB sets a target for average
money growth. For 1999, the target is 4.5 percent. On a week-to-week basis, however, the ECB

11

See the speech “Monetary Policy in the Euro Area,”
by ECB President Duisenberg on the Internet at http://
www.ecb.int/key/sp990125.htm. The HICP is simply a
price index using data constructed in similar fashion by
statistical agencies of different member countries.
12

In the EMU, M3 consists of currency in circulation,
overnight deposits, deposits and debt securities with
agreed maturity up to two years, deposits redeemable
at notice up to three months, repurchase agreements,
and money market fund shares. Technically, the ECB
focuses on “Harmonised” M3; see footnote 11.
8

NOVEMBER/DECEMBER 1999

does not attempt to control M3 growth directly.
Instead, like the Fed, the ECB conducts monetary
policy in the very short run by managing shortterm interest rates. By raising or lowering these
interest rates, the ECB can indirectly manage
money growth.
What will the ECB do if money grows faster
or slower than the target? It won’t necessarily
change short-term interest rates to hit the M3
target; instead, like the Fed, it will try to determine if the difference between actual money
growth and the target is due to special factors or
is an indication that monetary policy has been
too easy or too tight.13 The results of this analysis and its impact on monetary policy decisions
are explained to the public through speeches and
published reports.
Before we look at the tools the ECB uses to put
monetary policy into effect, let’s consider the
basics of how the Federal Reserve typically executes monetary policy in the United States.
Federal Reserve’s Monetary Policy Actions.
The Federal Reserve executes monetary policy
in pursuit of its goals mainly through the use of
open market operations—the sale or purchase
of previously issued U.S. government securities.
By purchasing government securities, the Fed
increases the supply of reserves in the banking
system; by selling them, it reduces the supply.
(Reserves consist of cash that banks hold in their
vaults along with banks’ balances on deposit at
the Federal Reserve.) Banks need reserves to
settle payments among themselves and to satisfy legal requirements that they hold reserves
equal to 10 percent of most balances in checking
and other transaction accounts.

13
In accordance with the Humphrey-Hawkins Act of
1978, the FOMC sets ranges for annual growth of the
U.S. money supply. In recent years, however, rapid financial innovation has made money growth an unreliable indicator of future economic developments in the
U.S., so the FOMC has de-emphasized money growth
ranges.

FEDERAL RESERVE BANK OF PHILADELPHIA

The Euro and the European Central Bank

Banks that have excess reserves often try to
lend them in the federal funds market, generally
overnight. Banks that have a shortage of reserves
usually try to borrow some in the same market.
In the federal funds market, supply and demand
interact to determine the quantity of reserves that
banks borrow or lend and at what interest rate—
the federal funds rate.
The supply side of the federal funds market is
influenced by transactions undertaken by the
Federal Reserve Bank of New York at the direction of the FOMC—the buying and selling of securities as noted above. The Fed’s day-to-day
objective is to engineer a supply of reserves that,
in conjunction with banks’ demand for reserves,
achieves a federal funds rate equal or close to a
target determined by the FOMC. The target for
the federal funds rate depends on the state of the
economy relative to the Fed’s long-term goals.14
ECB’s Monetary Policy Actions. The ECB
enacts monetary policy through 11 national central banks that buy and sell securities to influence the interbank interest rate. Consequently,
the ECB’s implementation of monetary policy is
slightly more complicated than that of the Federal Reserve System. But its approach is not fundamentally different from the Fed’s.
The ECB has three tools for conducting monetary policy: reserve requirements called “minimum reserves,” open market operations, and
provision of standing facilities.
Minimum reserves. Reserve requirements are
applied to a wide range of financial intermediaries in the euro area.15 Each intermediary’s re-

14

Additional details of the Fed’s activities in the federal funds market can be found in the book by AnnMarie Meulendyke.
15

More specifically, the ECB imposes reserve requirements on monetary financial institutions, defined by the
ECB and European Community law as resident financial institutions whose business is to receive deposits
and close substitutes for deposits, to grant credit, or to
make investments in securities. This includes not only

Jeffrey M. Wrase

serve requirement is determined in relation to its
balance sheet. Currently, each intermediary must
hold reserves in an amount equal to or exceeding 2 percent of its total amounts of these liabilities: overnight deposits, deposits with maturities of up to two years, deposits redeemable at
notice of up to two years, debt securities issued
with agreed maturities of up to two years, and
money market paper.16 Compliance with the reserve requirement is determined on the basis of
an intermediary’s average daily reserve holdings over a one-month maintenance period.
The Federal Reserve, by law, also imposes reserve requirements, though only on deposit-taking institutions.17 Since January 1999, each institution subject to reserve requirements must
meet a requirement of 3 percent applied to net
transaction accounts totaling between $4.9 and
$46.5 million; a 10 percent rate is applied to net
transaction accounts above $46.5 million. 18
While these required reserve rates are higher than
those imposed by the ECB, they apply to a narrower class of liabilities and a narrower class of
financial institutions. We can see the difference
if we compare average daily required reserves

banks but also money market mutual funds and some
leasing companies. A list of monetary financial institutions subject to reserve requirements is available at the
ECB’s website at http://www.ecb.int.
16

A lump-sum allowance of 100,000 euros is deducted
from an institution’s reserve requirement so that banks
with 5 million euros or less of reservable liabilities will
not have to hold minimum reserves.
17
In the United States, only depository financial institutions are required to hold reserves. According to the
Monetary Control Act of 1980, this term covers commercial banks, mutual savings banks, savings and loan associations, credit unions, agencies and branches of foreign banks, and Edge Act corporations.
18

Compliance with U.S. reserve requirements is generally determined on the basis of an institution’s average
daily reserve holdings over a two-week maintenance period.
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BUSINESS REVIEW

held in March 1999: more than 100 billion euros
(almost $109 billion) were held as required reserves in the EMU and around $42 billion were
held in the U.S.19
Banks and other financial intermediaries in
the EMU have to hold a larger amount of reserves
than financial institutions in the United States
because the ECB assigns reserve requirements a
more prominent role in monetary control. The
need to hold more required reserves increases
the demand to hold reserve deposits at the central bank. By ensuring a large demand for reserve deposits, the ECB can more easily control
short-term interest rates by managing the supply of reserves.
In contrast to the Federal Reserve, which cannot legally pay interest on required reserves, the
ECB pays interest on minimum reserve holdings.
The interest rate reflects short-term money market interest rates prevailing over the reserve
maintenance period. Paying interest on required
reserves helps to make up for the income banks
could otherwise earn by lending the reserves.
Without payment of interest on the large quantity of reserves required by the ECB, banks in the
euro area might suffer a competitive disadvantage.
Open market operations. Open market operations consist of the purchase and sale of securities initiated by the ECB and executed by the 11
EMU national central banks. In contrast to the
Federal Reserve, the ECB accepts a wide range
of assets in the conduct of monetary policy operations and does not focus trading on any particular government’s securities.20

19
The average exchange rate in March 1999 was 1.0886
dollars per euro.

NOVEMBER/DECEMBER 1999

Like the Federal Reserve, the ECB uses open
market operations to inject more reserves into or
extract reserves from the banking system. By
doing so, the ECB keeps the average interbank
interest rate, called the EONIA, close to the ECB’s
target overnight rate, called the main refinancing rate. The ECB’s most important open market
instrument is a reversing transaction, which can
be used to make temporary changes in the supply of bank reserves. Suppose, for example, the
ECB needs to change the supply of bank reserves
for three days. It will instruct national central
banks to engage in reversing transactions: the
central banks agree to purchase securities from
or sell securities to dealers who agree to repurchase or resell them at a specified price three
days later. Purchasing securities adds euros to
the banking system’s reserves; selling them
drains euros from the banking system’s reserves.
When the reversing transactions mature, the initial injection or drain of euros is automatically
reversed.21 Reversing transactions serve as a
convenient way for the ECB to deal with shortterm pressures on the interbank interest rate,
since transaction costs for reversing transactions
are low.
The Fed, too, frequently uses reversing transactions called repurchase agreements, or repos,
and matched sale-purchase transactions, or
MSPs, to deal with short-term pressures on the
interbank interest rate. Thus, the ECB and the
Fed use the same types of transactions, but give
them different names.
The ECB also has other types of open market
operations at its disposal: (1) outright transactions
(operations in which the ECB buys or sells assets in the financial markets to make changes in
the supply of euro bank reserves that do not automatically reverse); (2) issuance of debt certificates
(in which the ECB issues its own debt rather

20

Precise definitions of eligible assets for monetary
policy operations, as well as eligibility requirements for
counterparties in asset transactions, are given in the ECB’s
September 1998 publication. The list of eligible assets
can be found on the ECB’s website; it includes private
debt and equities as well as government securities.
10

21
The interest rate on regular reversing transactions,
called the main refinancing rate, is also the rate of interest the ECB pays on required reserves.

FEDERAL RESERVE BANK OF PHILADELPHIA

The Euro and the European Central Bank

than selling some of its assets to absorb euros
from the banking system); (3) foreign exchange
swaps (in which the ECB buys or sells a foreign
currency and simultaneously agrees to sell or
buy that currency at a specified future date); or
(4) collection of fixed-term deposits (in which the
ECB, to absorb euros from the banking system,
invites eligible depositors, such as banks, to
make interest-bearing fixed-term deposits at national central banks). These operations would
produce long-term changes in the supply of euro
bank reserves. Of these operations, the Federal
Reserve uses only outright transactions.22
Standing facilities. Standing facilities are outlets through which eligible banks can borrow
from or lend to the national central banks overnight. Standing facilities provide reserves (when
banks borrow) or absorb reserves (when banks
lend). The ECB uses standing facilities to signal
the general stance of monetary policy and to provide upper and lower bounds for overnight market interest rates.
The ECB provides two types of standing facilities. Any eligible bank can use a marginal
lending facility to obtain overnight loans from its
national central bank. Under normal circumstances, there are no credit limits or other restrictions on banks’ access to the facility apart from a
requirement to present sufficient assets as collateral.23 The interest rate on the marginal lend-

22
The Fed does have the ability to maintain reciprocal
currency arrangements (sometimes called swap facilities) with other central banks, but does not use them to
implement monetary policy. Currently, under NAFTA,
the Fed maintains swap facilities with Canada and
Mexico.
23

The Federal Reserve also provides a lending facility
called the discount window. Eligible depository institutions can borrow from the discount window, typically
overnight but sometimes for longer periods, when they
face a temporary need for liquidity and cannot readily
raise funds from other sources. As is true of the ECB’s
marginal lending facility, institutions must post collateral to borrow at the discount window. But in contrast to

Jeffrey M. Wrase

ing facility is higher than the ECB’s target interbank rate; it normally provides a ceiling for the
overnight market interest rate, since banks
wouldn’t borrow from each other overnight at a
higher interest rate than that offered at the marginal lending facility.24
Any eligible bank can use a deposit facility to
make overnight deposits with its national central bank. The interest rate on the deposit facility is lower than the ECB’s target interbank rate;
it normally provides a lower bound for the overnight market interest rate, since banks wouldn’t
lend to each other overnight at a rate lower than
the interest rate at the deposit facility.
A plot of the overnight rate shows its movements over the first half of 1999 (see the Figure).
Also shown are the marginal lending rate and
the marginal deposit rate, as well as the ECB’s
target rate (the main refinancing rate). Note that
the overnight rate sometimes differs from its target, since the ECB can’t control it precisely. The
overnight rate always lies between the lower
bound provided by the marginal deposit rate and
the upper bound provided by the marginal lending rate.
Implementation. On April 8, 1999, the ECB’s
president provided an example of how the ECB
monitors M3 growth relative to its target value

the ECB, the Fed lends at a rate that is usually slightly
below policymakers’ target for the interbank interest rate,
for approved purposes only, and at its own discretion —
banks and other depository institutions are not free to
borrow as much as they might wish.
24
In addition to its normal discount window facility,
the Fed has chosen to provide a Century Date Change
Special Liquidity Facility, from October 1, 1999, to April
7, 2000, as a precaution against unusual funding pressures around the century date change. This special liquidity facility is much like the ECB’s marginal lending
facility. Eligible depository institutions will be able to
borrow as much as they wish from the Fed, provided
they have sufficient collateral, at an interest rate 1.5 percentage points above the FOMC’s target for the federal
funds rate.

11

BUSINESS REVIEW

NOVEMBER/DECEMBER 1999

FIGURE

ECB Interest Rates and
Money Market Rates

within the ECB’s definition
of price stability; and the
prospects for overall
growth in the euro area,
which had weakened.
Although the tools
available to the ECB allow
it to pursue its objectives,
what ensures that it can
pursue those objectives
without facing undue
short-term political pressures?

INDEPENDENCE AND
ACCOUNTABILITY
OF THE ECB
The Maastricht Treaty
explicitly set up the ECB as
an independent institution
free from short-term political pressures. Arguably,
the ECB is, by design, one
of the most independent
central banks in existence.
Members of its Governing
EONIA is the euro overnight index average, a weighted average of interest
Council all have relatively
rates on all unsecured overnight lending transactions in the interbank market in the euro zone. The main refinancing rate is the ECB's target interbank
long terms of office. Each
rate.
member of the Executive
Board serves a nonrenewable eight-year term, and
the central bank governors
and how it uses tools of monetary policy. At a of the 11 EMU countries serve renewable fivepress conference that day, President Duisenberg year terms. Moreover, the ECB’s mandate makes
discussed a decision to cut the ECB’s target for clear that institutions such as the European Parthe interbank interest rate from 3.0 percent to 2.5 liament and the governments of EMU member
percent and to cut the interest rate on the mar- countries may not give instructions to the ECB,
ginal lending facility from 4.5 percent to 3.5 per- nor is the ECB allowed to follow instructions or
cent, as well as that on the deposit facility from suggestions from others. However, indepen2.0 percent to 1.5 percent. The figure shows the dence does not imply lack of accountability.
changes in all three interest rates. The decision
Proceedings of the Governing Council’s meetto cut rates took into account the rate of growth ings are kept confidential, to guard against shortof M3, which remained close to the ECB’s target term political pressures on individual members.
value; inflation, which had been below 1 per- However, just as the Federal Reserve’s FOMC
cent (per year) for several months and thus announces decisions made at each meeting on
12

FEDERAL RESERVE BANK OF PHILADELPHIA

The Euro and the European Central Bank

the day of the meeting, the ECB’s Governing
Council holds a press conference immediately
after its first meeting every month. At that time,
it releases the “President’s Introductory Statement,” which is a summary of the council’s conclusions from its assessment of economic conditions.25
In addition, the ECB publishes other reports
to communicate its policy objectives, intentions,
and actions. The president of the ECB presents
an annual report to the European Parliament,
the Council of Ministers, and the European Commission, and the ECB publishes monthly and
annual reports, as well.26 Similarly, the Chairman of the Federal Reserve Board delivers semiannual reports on monetary policy to the U.S.
Congress, and the Federal Reserve publishes
monthly and annual reports. Also, the presi25
The "President’s Introductory Statement" is similar
to the minutes of FOMC meetings. The FOMC publicly
releases minutes of each meeting about six weeks afterward, and it releases transcripts from FOMC meetings
after five years.
26
The Maastricht Treaty requires the ECB to publish
quarterly and annual reports covering monetary policy
and its other activities. The ECB goes beyond this requirement and, like the Federal Reserve, publishes a
monthly bulletin. The ECB also releases weekly financial
statements, as does the Fed.

Jeffrey M. Wrase

dent of the Governing Council and the other
members of the Executive Board of the ECB, at
their own initiative or on request, may be heard
by committees of the European Parliament. Like
the Federal Reserve, the ECB has made clear its
willingness to engage in dialogue concerning
its own and other institutions’ policies with responsible authorities.
Thus, the ECB is accountable for its policy
actions within an institutional structure that
provides substantial independence.
CONCLUSION
After decades of planning, the euro was born
on January 1, 1999. This new currency is shared
by the 11 member countries of the EMU, an economic area whose portion of world output of
goods and services, at around 20 percent, is second only to that of the United States. The EMU
member countries are now in transition to sole
reliance on the euro as the single currency of the
union. Guiding the EMU through and beyond
its transition phase is the job of the European
System of Central Banks, including the new European Central Bank that determines monetary
policy for the 11 countries that have adopted the
euro. The ECB’s policymaking body and tools
for setting and conducting monetary policy are
similar in several ways to those of the Federal
Reserve but also have certain differences.

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NOVEMBER/DECEMBER 1999

REFERENCES
Eichengreen, Barry. “European Monetary Unification,” Journal of Economic Literature, 31, September 1993.
Eudey, Gwen. “Why Is Europe Forming a Monetary Union?” Federal Reserve Bank of Philadelphia Business Review, November/December 1998.
European Central Bank. “The Single Monetary Policy in Stage Three: General Documentation on ESCB Monetary Policy Instruments and Procedures,” September 1998.
European Monetary Institute. “Convergence Report: Report Required by Article 109j of the
Treaty Establishing the European Community,” March 1998.
Feldstein, Martin. “The Political Economy of the European and Monetary Union: Political
Sources of an Economic Liability,” Journal of Economic Perspectives, vol. 11, no. 4, Fall 1997.
Kenen, Peter B. Economic and Monetary Union in Europe: Moving Beyond Maastricht. Cambridge:
Cambridge University Press, 1995.
Meulendyke, Ann-Marie. U.S. Monetary Policy and Financial Markets. Federal Reserve Bank of
New York, 1997.
Obstfeld, Maurice. “EMU: Ready, or Not?” National Bureau of Economic Research Working
Paper No. 6682, 1998.
Stevens, Ed. “The Euro,” Federal Reserve Bank of Cleveland Economic Commentary, January 1,
1999.
Wynne, Mark A. “The European System of Central Banks,” Federal Reserve Bank of Dallas
Economic Review, First Quarter 1999.

14

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The Euro and the European Central Bank

Jeffrey M. Wrase

Patent Reform: A Mixed Blessing
For the U.S. Economy?

A

t the end of the 1990s, it seems ironic to
question the performance of the American patent
system. Spending by industries on research and
development, measured in inflation-adjusted
dollars or as a percent of gross domestic product, has never been higher (Figure 1). Patenting
activity in the U.S. has never been higher (Figure
2). The rate of technological advance in sectors
such as drugs, computer hardware, and software
is simply amazing. Yet there is evidence that

*Bob Hunt is an economist in the Research Department of the Philadelphia Fed.

Robert Hunt*
devoting even more resources to R&D could further improve our standard of living.1
Twenty years ago, the perspective was quite
different. Reacting to the most severe recession
since World War II, and observing the rapid emergence of Japanese and other foreign competitors
in the computer and other high technology sectors, policymakers became increasingly concerned about the technological competitiveness
of American companies. There was reason for

1

See, for example, the article by Charles Jones and
John Williams.
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BUSINESS REVIEW

NOVEMBER/DECEMBER 1999

FIGURE 1

Spending on Research and Development
(in dollars and as percent of GDP)

Source: Bureau of Economic Analysis: National Income and Product Accounts; National Science Foundation;
and author's calculations.

this concern. During the 1970s, private R&D
spending and the number of patents issued to
U.S. residents stagnated at a time when both were
growing rapidly abroad. Productivity growth
declined in most developed economies in the
early 1970s, but it looked particularly anemic in
the United States. From the late 1970s to the mid
1980s, the market share of important industries,
such as steel, automobiles, and semiconductors,
held by foreign companies increased dramatically.
These pressures prompted a re-examination
of the American system of intellectual property
law, which resulted in many significant legislative changes and important changes in the way
federal courts decide patent cases. This article
considers the effects of an especially important
aspect of these changes: many more inventions
16

qualify for patent protection than before. On its
face, this would appear to be a good thing, since
it might encourage businesses to devote additional resources to developing new products and
processes. But economic analysis suggests that
the effects of these changes are more complicated
than they at first appear. It may well be the case
that, in some industries, the rapid technological
advances seen in the 1990s have occurred not
because of these changes in patent law, but in spite
of them.
THE NATURE OF THE U.S. PATENT SYSTEM
The U.S. Constitution grants Congress the
power “to promote the progress of science and
useful arts, by securing for limited times to authors and inventors the exclusive right to their
respective writings and discoveries.”2 Thus, the
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The
Euro
and the
CentralforBank
Patent
Reform:
A European
Mixed Blessing
the U.S. Economy?

FIGURE 2

Patent Activity

Source: U.S. Patent and Trademark Office

Constitution permits the government to offer an
incentive, in the form of a temporary monopoly,
to artists and inventors. Congress quickly took
advantage of these powers, passing the first
patent act in 1793. The act was drafted by Thomas Jefferson, who was himself a prodigious
inventor.
The role of patents envisioned in our Constitution essentially follows economic intuition. It
usually costs more, in terms of effort and money,
to discover something new than it does to duplicate someone else’s discovery. Inventors may
work on their discoveries for a variety of rea-

2

U.S. Constitution, Article I, Section 8. To be precise,
a patent grants the right to exclude others from producing a product or using a process covered by the patent’s
claims.

Jeffrey
M. Wrase
Robert
Hunt

sons. But so long as one of the motivations is the prospect of financial
reward, inventors will be concerned
about the possibility that others will
imitate their discoveries. If an invention can be imitated quickly, the inventor will soon be forced to compete with other suppliers, ones that
did not incur the development costs
he or she bore. This competition will
reduce, possibly even eliminate, the
profits an inventor can earn from his
or her discovery. In such an environment, then, a discovery not protected by a patent gives the inventor
only a fleeting advantage over his or
her competitors. Obtaining a patent
can reduce this competition because
it gives the inventor a temporary monopoly to produce his or her invention. Thus, by helping to ensure a
reasonable economic return to inventive activity, patents provide an important incentive to engage in research and development.3
But patents also create inefficiencies. Since patent holders have a monopoly
over the patented technology, they can charge a
higher price than they could charge in a competitive market. In most cases, there will be some
consumers willing to buy the product at the competitive price, but unwilling to pay the higher
price charged by the patent holder.
Another sort of inefficiency sometimes arises
from patents. In many industries, making the
best product or using the most advanced pro-

3

The significance of patents as an incentive for inventors is sometimes exaggerated. Economic research verifies that patents do provide benefits to inventors, but it
has also shown that other factors, such as trade secrets
or simply having a head start on the competition, are
often just as important. See, for example, the articles by
Mark Schankerman; Richard Levin and others; and Edwin
Mansfield and others.
17

BUSINESS REVIEW

cess may require using ideas developed by many
different people. Some of those ideas will be
patented, so using them requires the consent of
the patent owner. While developers and users of
technologies have an incentive to reach an acceptable licensing arrangement, the cost of doing so is sometimes quite high. In some cases,
an acceptable arrangement is not reached and
the parties may resort to litigation.
Two notable examples of this kind of failure
include the airplane and the radio in the early
years of the 20th century.4 In both instances, several companies obtained patents covering important aspects of these highly valuable inventions. Unfortunately, they were unable to reach
a satisfactory cross-licensing arrangement, and
this failure precluded the manufacture of the
most advanced aircraft or radios in the U.S. These
impasses were broken by the intervention of the
U.S. government during the First World War. In
the case of aircraft, a successful system of crosslicensing was established, and it continued after the war. In the case of radio, patent rights
were essentially suspended for the duration of
the war. After the war, the U.S. Navy encouraged the formation of the Radio Corporation of
America, which soon held rights to virtually all
the important radio patents and a near monopoly position in the emerging industry.
To limit the effects of these kinds of inefficiencies, economists argue that patents should be
granted only for novel and valuable discoveries.
That is precisely what the American patent system is designed to do. To qualify for protection
under U.S. patent law, an invention must be
novel, useful, and nonobvious. While the first
two criteria are straightforward, the third criterion is less clear. It requires that an invention
represent more than a trivial advance over what
is already known. This requirement, awkwardly

4
For details on the history of these disputes, see the
article by Robert Merges and Richard Nelson and the
article by Paul Schaafsma.

18

NOVEMBER/DECEMBER 1999

referred to as nonobviousness, is typically the most
difficult of the three to satisfy.
The idea that only nonobvious inventions
should be patentable occurs in some of the earliest patent cases. In a famous 1851 decision,
Hotchkiss v. Greenwood, the Supreme Court invalidated a patent on doorknobs made of porcelain
or clay, arguing that the substitution of these
materials for wood or metal was obvious. Thus,
the judicial concept of nonobviousness was at
least a century old when, in 1952, Congress
amended the Patent Act to include a comparable
statutory requirement.
In a 1966 case, Graham v. Deere, the Supreme
Court described how courts should decide
whether an invention satisfies the statutory requirement of nonobviousness. First, the court
must determine the level of skill of an ordinary
practitioner in the field. Next, it must identify
the relevant knowledge that existed at the time
the invention was made; this is called the prior
art. The court must then identify any differences
between the claimed invention and the prior art.
Finally, the court must determine if those differences would have been obvious to a practitioner
of ordinary skill in the relevant field. Other indicators of nonobviousness might also be considered, for example, a long-felt need for the invention, the failure of others to perfect the invention,
or commercial success.
How stringent is this requirement of
nonobviousness? In Graham v. Deere, the Supreme Court invalidated a patent on a combined
sprayer and cap used on bottles of household
chemicals. The cap, which covers the sprayer,
protects the pump and seals off any leaks. The
essential elements of the sprayer had been developed by others, but they had never been assembled in this particular way, which made possible the use of automated bottling equipment
and reduced handling costs. As a result, the product was highly successful. While the Supreme
Court acknowledged that long-felt need and
commercial success might suggest the invention
was nonobvious, in the end it decided otherwise
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The Euro
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Mixed Blessing
the U.S. Economy?

because the differences between the product’s
design and that of preexisting ones were minimal.
A more recent example involves semiconductor chips used in computers and other electronic
devices. In the early 1980s, courts treated the
layout of most semiconductor chips in the same
way they treated dress designs: unpatentable
variations of a single idea—despite the fact that
even minute differences in the layout of a computer chip can significantly improve its performance. In testimony before Congress, Harvard
Law Professor Arthur Miller went so far as to
say that “as a practical matter, the layout of a
chip...will rarely, if ever, satisfy the standard of
invention. A chip may be the product of millions
of dollars and thousands of hours of effort, but it
is the result of hard work, not ‘invention.’”5
WHAT HAPPENED IN THE 1980s?
During the late 1970s and early 1980s, businessmen and policymakers became increasingly
concerned about the apparent deterioration of
America’s comparative advantage in high technology industries, such as the semiconductor
industry. In fact, trends within that industry
became a catalyst for dramatic changes in the
way the U.S. protects intellectual property.
Semiconductors were invented by American
scientists in the late 1940s, and from its beginnings in the 1950s, the semiconductor manufacturing industry was dominated by American
companies. The industry’s growth was phenomenal. Between 1972 and 1982, the dollar value
of semiconductor shipments increased more
than 450 percent. If the decline in prices of computer chips during this period is taken into account, shipments in 1982 were 17 times higher
5

See the Senate report on S. 1201, one of the versions
of the Semiconductor Chip Protection Act considered in
the 98th Congress. It should be emphasized that while
the layout of computer chips was generally unpatentable, new circuits or new processes for making computer
chips could, and often did, qualify for patent protection.

Jeffrey
M. Wrase
Robert
Hunt

than in 1972. Also, employment in the industry
increased 71 percent.
So at least until the late 1970s, it would be
difficult to argue that the development of the
American semiconductor industry was seriously
hindered by the lack of patent protection for most
semiconductor designs. Indeed, some scholars
argue that the industry’s rapid technological
development could be a consequence of limited
patent protection.6 In industries where technology is advanced by cumulative improvements,
the fact that companies are able to copy many of
the improvements made by rivals could be beneficial. A healthy amount of reverse-engineering
allows a firm to incorporate the most advanced
technologies, irrespective of their origin, in new
designs of its own. Of course, reasonable people
may disagree about what they think is a healthy
amount of this kind of imitation.
Within the U.S. semiconductor industry, reverse-engineering was a well-established practice. But by the late 1970s, American firms objected to similar behavior by Japanese firms when
they began to increase their market share in the
more standardized products, such as computer
memory chips. The level of competition eventually became so intense that, by the mid 1980s,
most American companies abandoned these segments entirely.
When it became clear they could no longer
dominate Japanese firms on the basis of production technology alone, American firms attempted
to consolidate their comparative advantage in
research and development. To do this, they
would have to find ways of reducing their competitors’ ability to reverse-engineer their products. To that end, American companies began to
lobby Congress to increase intellectual property
protection for their semiconductor designs. In
1984, Congress created a new form of intellectual property right, called mask rights, specially

6

See, for example, the article by Robert Merges and
Richard Nelson.
19

BUSINESS REVIEW

tailored to address the needs articulated by the
industry.7 A critical difference between these
mask rights and patents was that the level of
originality required to qualify for a mask right
was substantially lower than what was implied
by patent law’s requirement of nonobviousness.
Thus, many more semiconductor designs were
likely to qualify for protection under a mask right
than under a patent.
What was occurring in the semiconductor
industry was also being felt in many other industries. By the late 1970s, there was considerable dissatisfaction with how federal courts were
deciding patent cases, especially the frequency
with which the courts were invalidating patents.
In addition, there is some evidence that patents
were being treated differently by federal courts
in different parts of the country. This impression
contributed to forum shopping by litigants, increasing the cost and delay associated with
patent cases. In 1982, Congress created a new
federal appeals court, the Court of Appeals for
the Federal Circuit, to hear all appeals of patent
cases and certain other cases.8 It was hoped that
a single court of appeals would contribute to
more uniform decisions by federal district courts
across the country. But the decisions of this new
court also changed the way federal courts apply
the test for nonobviousness.
The early decisions of this new court accomplished many things. In particular, these decisions increased the attention that courts pay to
secondary factors, such as long-felt need or commercial success, when evaluating the obviousness of an invention. While these factors had
long been considered by the courts, the traditional view was that secondary factors would
rarely, if ever, overcome the conclusion of the

NOVEMBER/DECEMBER 1999

multipart inquiry described earlier. For example,
in one case, a federal district court considered
the validity of a patent for a fastener used to attach shelves to the inside walls of refrigerators.
The court concluded the invention was an obvious combination of features contained in existing fastener designs and invalidated the patent.
The court refused to consider secondary considerations, in particular the product’s commercial
success, arguing those factors could not overcome the conclusion reached in a review of the
prior art. On appeal, the new court reversed this
decision, arguing that secondary factors must
be considered and that, in this case, they outweighed the conclusion reached in the traditional
three-step analysis. The new appeals court
reached similar conclusions in a number of other
decisions.9
It wasn’t long before it was clear that the new
court was deciding patent cases differently from
the appeals courts that preceded it. In the first
25 years after the passage of the 1952 Patent Act,
patents issued by the U.S. Patent and Trademark
Office were subsequently invalidated in 60 percent of the cases decided by federal courts of
appeal.10 A 1985 study found that in a majority
of patent cases reviewed by the newly created
appeals court, the court determined the patent
in question was nonobvious. That rate stands
in contrast with the lower courts, where 30 percent of the patents reviewed were found to be

9
For example, in a 1983 decision, Stratoflex, Inc. v.
Aeroquip Corporation, the court stated: “Indeed, evidence
of secondary considerations may often be the most probative and cogent evidence in the record. It may often
establish that an invention appearing to have been obvious in light of the prior art was not.”
10

7

Mask rights were created by the Semiconductor Chip
Protection Act of 1984, 17 U.S.C. 901-914.
8

The Federal Courts Improvement Act of 1982, 28
U.S.C 1295.
20

This statistic is based on an unpublished study cited
in Steven Szczepanski’s article. One should be careful
about reading too much into statistics of this sort. Only
a small fraction of all patents are involved in some form
of litigation, and only a small fraction of those cases are
appealed.
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The Euro
and the
European
Central
Patent
Reform:
A Mixed
Blessing
forBank
the U.S. Economy?

nonobvious. So it is hardly surprising to learn
that the new court was twice as likely to reverse
a lower court’s finding that an invention was
obvious than to reverse a finding of
nonobviousness by a lower court (31 percent vs.
14 percent, respectively).11
What is the significance of all these decisions?
About a decade after its creation, one practitioner wrote, “Many patent attorneys believe that
the obviousness defense is dead and that the
cause of death lies in the decisions of the Court
of Appeals for the Federal Circuit.”12 Another
expert argued that “as a result of these changes,
patents today are more likely to be held valid
than, perhaps, at any time in our history.”13
ARE MORE PATENTS
NECESSARILY BETTER?
Do these changes explain the recent surge in
R&D activity and the improvement in U.S. competitiveness? Many believe that the federal
circuit’s decisions reduced uncertainty about the
enforceability of patents, a belief that, in itself,
would make them more valuable. A number of
decisions increased the presumption of patent
validity—that is, courts now require more evidence before concluding a patent is invalid.
Other decisions made it easier for a patent holder
to obtain preliminary injunctions, court orders
banning a potential infringing activity before the
question of infringement is definitively decided.
And it does appear that centralizing the appeals
process for patent cases has succeeded in reducing disparities in the treatment of patents across

11

See Donald Dunner’s 1985 article. These findings
are re-confirmed for the 1982-94 period in Dunner’s 1995
article.
12

See Ronald Coolley’s 1994 article. The title of Robert Desmond’s 1993 article—“Nothing Seems Obvious
to the Court of Appeals for the Federal Circuit”—is also
suggestive.
13

See Lawrence Kastriner’s 1991 article.

Jeffrey
M. Wrase
Robert
Hunt

federal district courts.
Probably the greatest single impact of the federal circuit’s decisions during the 1980s was to
make patents easier to obtain by relaxing the
nonobviousness requirement. Wouldn’t this also
encourage additional private investment in
R&D? Somewhat surprisingly, the answer is
unclear. In fact, it is possible that making patents easier to obtain might actually reduce R&D
activity, especially in high technology industries.
What explains this paradoxical result?
R&D Investments Are Related to Their Expected Return. Companies, and at least some
individual inventors, make decisions about their
R&D activities in the same way they make other
investment decisions. In other words, they calculate how much they can expect to earn from
different R&D projects and allocate their resources to the ones with the highest expected
returns. The higher these expected returns are,
the more a firm will be willing to invest in that
project.
The expected return from an R&D project is
determined by a variety of factors: the cost of the
R&D, the chances of making a significant discovery, the likelihood it can be patented, and the
flow of profits earned over the life of a patent.
The timing of those profits matters because the
sooner they are earned, the sooner they can be
used to reward investors or reinvested in new
projects. This means that profits earned in the
near term are more valuable than profits expected
to be earned far into the future.14
Changing Patent Law Affects the Return to
R&D. Patent law matters because it affects the
expected return to an R&D project in two ways:
it determines the probability that a given discov-

14

In other words, inventors discount the value of future profits to take into account the time value of money.
Discounting allows inventors to compare the revenues
earned in the future to dollars being spent today. The
longer they must wait to earn profits on an invention, the
more heavily they will discount those profits.
21

BUSINESS REVIEW

ery can be patented, and it also influences the
flow of profits earned over the life of a patent.
Relaxing patentability criteria, in particular
adopting a weaker standard of nonobviousness,
will have two opposing effects on the return to
R&D. As patentability criteria are relaxed, a
larger share of future innovations will qualify
for patent protection. Firms enjoy the benefit of
being able to protect more of their inventions from
imitation. But firms also lose, because their ability to imitate their rivals’ inventions is reduced.
Each firm must now compete with rivals that,
over time, will receive more patents of their own.
As a result, the profits earned from a given patent
tend to be smaller and may not last as long. Hence,
the value of a patent declines.15
The question for policymakers is: which of
these two effects is more important? If the probability of obtaining patent protection rises more
than the value of patents declines, the expected
return to R&D will increase. This should stimulate additional R&D investments and more innovation. On the other hand, if the probability of
obtaining patent protection rises less than the
value of patents falls, the expected return to R&D
will fall. This would discourage firms from engaging in R&D, which, in turn, would reduce
the rate of innovation.
Weaker Patentability Criteria and High Technology Industries. It turns out that the effect of
relaxing patentability criteria on R&D activity
in a given industry depends on the initial rate of
innovation in that industry, which, in turn, depends on the opportunities for technological
improvement and the resources devoted to per-

15

Formal models that illustrate this point include my
1999 working paper and the paper by Ted O’Donoghue
and the one by Olivier Cadot and Steven Lippman. It
should be noted that this research is not saying that
inventions have become intrinsically less valuable. They
continue to make possible better or less costly products,
or both. But an increase in competition reduces the profits that can be earned on them.
22

NOVEMBER/DECEMBER 1999

fecting those improvements. Some industries
innovate more rapidly than others. In the semiconductor industry, for example, entirely new
generations of computer processors and the technology to make them are developed every few
years. In other industries, such as steel, it may
take several decades to develop a new technology and replace an existing one.
Consider an industry that, prior to a change
in the patent system, innovates slowly. In this
environment, competition from new technologies takes a long time to develop, so a patentable
invention is likely to be highly valuable. In such
an industry, relaxing the standard of
nonobviousness increases the chances that a
firm will obtain a patent that is likely to generate
profits for a long time. In addition, it will take a
relatively long time before other firms make even
the marginal discoveries that would now qualify
for patent protection. So the loss of profits to this
increased competition won’t occur until far into
the future. The effect of this increased competition on the value of patents is likely to be small,
then, because profits earned far into the future
are worth a lot less to the firm than profits earned
today. So in the case of an industry that initially
innovates slowly, the effect of an increase in the
probability of obtaining a patent is probably more
important than the decline in the value of patents. So a weakening of patentability criteria is
likely to increase the expected return to R&D,
and therefore R&D activity and the rate of innovation, in industries that initially innovate
slowly.
Now consider the case of an industry that,
prior to a change in the patent system, innovates
more rapidly. In this environment, new technologies are invented more frequently and, if protected from imitation, very soon compete with
the existing technologies. An invention in this
industry generates less profits, over less time,
than an invention of comparable significance in
an industry that innovates more slowly. Consequently, other things equal, individual patents
in this industry are less valuable. As a result,
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firms do not stand to gain as much from an increase in the likelihood of obtaining patent protection. But once patentability criteria are relaxed,
a firm’s rivals are able to patent their inventions
more easily, which increases their ability to become a market leader. This further reduces the
value of the firm’s own patents. In the case of an
industry that initially innovates rapidly, the decline in patent values is likely to be more important than the increase in the probability of obtaining a patent. So a weakening of patentability criteria is more likely to reduce the expected
return to R&D, and therefore R&D activity and
the rate of innovation, in industries that initially
innovate rapidly.
In sum, any positive effect on the expected
return to R&D and the rate of innovation resulting from weaker patentability criteria is most
likely to occur in industries that originally innovated more slowly. Any negative effect on the
expected return to R&D and the rate of innovation is most likely to occur in industries that originally innovated more rapidly. Thus, relaxing the
nonobviousness requirement of patent law may
not be a very effective way to encourage more
rapid advancement in high technology industries.
BUT WHAT ABOUT THE SURGE
IN R&D ACTIVITY?
The timing of the changes in patent law, the
subsequent surge in R&D activity, and the apparent improvement in American technological
competitiveness convinced many attorneys and
policymakers that these changes worked as intended.16 But determining whether weaker patentability criteria really explain those improvements is a difficult empirical question. One problem with associating cause and effect is that

16
The articles by Lawrence Kastriner and Gerald Sobel
are good examples of the optimistic perspective in the
legal community.

Jeffrey
M. Wrase
Robert
Hunt

patent law changed in so many ways during the
1980s. Outside of a few technology fields, it
would be difficult to identify exactly which
change in the patent system was the cause of
some desirable or undesirable outcome. In addition, during the 1980s, the U.S. economy experienced very large swings in macroeconomic
conditions and a dramatic restructuring of its
manufacturing sector. Finally, during this same
period, a large and sophisticated venture capital market emerged, significantly increasing access to capital for start-up companies in certain
industries. Separating all of these influences is
no easy feat.
For example, what do we make of the surge in
patenting activity in the U.S. during the 1980s
and 1990s? Are inventors patenting a higher
share of their discoveries? Or are they making
more discoveries and patenting many of those?
Or is it both? One way to sort out these explanations is to look at the trend in patenting across
countries. Evidence that patenting surged in the
U.S., but not elsewhere, might be explained by
the relaxation of patentability criteria in the
1980s. A surge of patenting in the U.S. by foreign inventors might reinforce this conclusion,
especially if there was no comparable increase
in patenting abroad. Conversely, a surge of patenting activity in many countries might be better
explained by an increase in technological opportunities worldwide. And evidence that U.S.
inventors increased their patenting abroad as
much as they increased their patenting at home
might be better explained by an increase in technological opportunities in the U.S.
In a recent article, economists Samuel Kortum
and Josh Lerner examined trends in patenting
in the U.S., Europe, and Japan. They found that
European inventors increased their patenting in
the U.S. in the late 1980s, but that trend was not
sustained in the 1990s. Japanese inventors significantly increased their patenting activity, both
at home and abroad, during the 1980s. But this
is a continuation of a trend evident from the
1960s. Meanwhile, American inventors signifi23

BUSINESS REVIEW

cantly increased their patenting activity in the
U.S. and abroad. The authors concluded these
changes in aggregate patenting activity were
better explained by an increase in technological
opportunities in the U.S. than by a change in the
treatment of patents by U.S. courts.
Kortum and Lerner also looked for evidence
of a change in the value of patents during the
1980s. Unfortunately, there is not a great deal of
information about the initial value of patented
inventions. But there are ways to infer something
about the value of patents as they get older. In
the U.S. and in a number of European countries,
patent owners must pay “renewal fees” to keep
their patents in force the first few years after they
are issued. In the U.S., patents issued after 1980
are subject to renewal fees in the fourth, eighth,
and 12th years of the patent. Paying these fees is
not mandatory, but if they are not paid, the patent
expires at the renewal date rather than at the
end of the patent’s full term (20 years in the U.S.).
If an owner chooses to pay a renewal fee, it is
probably because he or she believes the patent
remains sufficiently valuable to justify bearing
the cost of the fee.17
Kortum and Lerner cited recent evidence that
patent renewal rates fell during the first half of
the 1990s, which suggests a decline in the residual value of patents.18 This drop-off in renewal rates is consistent with the argument that
making patents easier to obtain in the U.S. caused

17
The articles by Ariel Pakes and Mark Schankerman
explore the relationship between patent renewal decisions and the remaining value of patents. Patent owners
will always choose to renew their most valuable patents,
but they may choose not to renew their less valuable
ones. The profitability of different patents varies dramatically. The vast majority of patents are of little value,
while a small proportion of patents are extremely valuable.
18
Patent renewal fees increased significantly in 1990,
so the authors reported changes only for years after the
fees increased.

24

NOVEMBER/DECEMBER 1999

the profits earned on patents to erode more
quickly. But that is only one of many possible
explanations for an apparent decline in the
value of patents. Since patent renewal rates have
declined in other countries, perhaps other explanations may be more important.
Changes in patentability criteria could affect
the rate of innovation by changing the expected
return to R&D. So it may be helpful to look at
more direct evidence of changes in the expected
return to firms’ R&D programs, for example, the
stock market’s valuation of R&D investments
made by publicly traded companies. To derive
estimates of this sort, economists use what is
called the hedonic approach, which attempts to
allocate a firm’s stock market value to various
characteristics, including its tangible and intangible assets.19 An important component of a
firm’s intangible assets is its investments in
R&D.20 Investors presumably value a firm’s R&D
investments based on their assessment of the
potential output: new technologies that contribute to the growth and profitability of the firm.
The stock market’s valuation of R&D investments should respond to changes in patent law
that affect the profitability of developing new
products and processes.
Economist Bronwyn Hall has reported that
the market value of R&D investments made by

19
This approach is described more thoroughly in
Bronwyn Hall’s 1999 working paper and Zvi Griliches’
1990 article and his 1984 book.
20
In the U.S., firms’ spending on research and development is expensed, i.e., deducted from revenues when
calculating current profits. Some economists argue that
it is more appropriate to think of R&D expenditures as
an investment that contributes to a firm’s stock of intangible capital. Standard accounting does not report a
stock of intangible capital so this measure must be constructed using a firm’s R&D expenditures and an assumption about the rate of depreciation of these investments. For details, see my 1996 working paper and
Leonard Nakamura’s 1999 article in the Business Review.

FEDERAL RESERVE BANK OF PHILADELPHIA

The Euro
and the
CentralforBank
Patent
Reform:
A European
Mixed Blessing
the U.S. Economy?

about 1000 publicly traded companies increased
throughout most of the 1970s, then began to decline after 1983. The decline was especially pronounced in the electrical and computing industries, a fact Hall attributed to more rapid technological obsolescence and the competitive effects
of entry by new firms.21 Around 1990, the
market’s valuation of R&D investments began
to rise again. Hall’s findings are the result of
many factors, but they provide scant support for
the idea that changes in patent law increased
the market value of R&D investments during the
1980s.
In previous research, I examined the market
valuation of R&D investments made by a dozen
American semiconductor companies from 1976
to 1994. I found that if only a firm’s own R&D
investments were taken into account, there was
a significant increase in the market value of those
investments, but that it occurred after 1989—
more than five years after the significance of the
changes in the patent system were widely
known. While it is possible that those changes
explain this increase, the long delay between the
alleged cause and its effect suggests that alternative explanations cannot be ruled out.
In the semiconductor industry, the R&D activity of a company’s rivals is very important.
The widespread practice of reverse-engineering
suggests that firms learn a great deal from each
other’s products, which are themselves the result of considerable research and development.
That suggests the possibility of a spillover — the
value of a company’s own research might be affected by the research conducted by its rivals. Of

21

It might at first appear that Hall’s finding conflicts
with the fact that private spending on R&D increased
significantly during the 1980s. But a decline in the value
of R&D investments amid rising R&D spending can be
explained by an increase in the supply of funds available
for investment in R&D projects. If the cost of funding
R&D investments declined, firms would be able to invest
in R&D projects that would otherwise be unprofitable.

Jeffrey
M. Wrase
Robert
Hunt

course, the firm’s rivals are doing the same thing,
and that means they could soon be producing a
similar chip that competes directly with the firm
in the product market. That competition is likely
to depress prices and, therefore, profits, which
could reduce the market value of the firm.
In a 1996 study I analyzed three types of effects that R&D investments might have on a
firm’s market value: a direct effect, measured by
the firm’s own R&D investments; a competitive
effect, measured by the R&D investments of its
rivals; and a spillover effect, measured by the
interaction of the firm’s own R&D investments
with those of its rivals. Using statistical techniques and data on a dozen American semiconductor companies, I was able to confirm that a
change in the relationship between these variables and the firms’ market value did occur at
some point in the 1980s.22
In the early part of the decade, the R&D activities of its rivals tended to reduce a firm’s
market value (the competitive effect). During this
period, the contribution to a firm’s market value
made by its own R&D investments (the direct
effect) was quite small, but this contribution was
higher the more the firm’s rivals spent on R&D
(a positive spillover). These results can be explained in a number of ways, but they are cer-

22

To be precise, I regressed the ratio of each firm’s
market to book value on a constant, the ratio of the
firm’s R&D capital to its physical capital, a comparable
ratio for its rivals, and an interaction of these two ratios.
The direct effect is captured by the coefficient on the
firm’s ratio of R&D capital to physical capital. That
should tell us something about the value of its R&D
investments relative to its investments in physical capital. The competitive effect is captured by the coefficient
on the comparable ratio for the firm’s rivals. That should
tell us something about the extent of any loss in market
value attributable to reverse-engineering by its competitors. The spillover is captured by the coefficient on the
interaction of the two ratios. That should tell us something about the contribution of the firm’s own reverseengineering efforts to its market value.
25

BUSINESS REVIEW

tainly consistent with an environment in which
firms were able to reverse-engineer improvements embodied in each other’s designs and
incorporate them in new designs of their own.
At some point in the late 1980s or early 1990s,
circumstances began to change. R&D investments made by a firm’s rivals no longer reduced
its own market value (the competitive effect), and
in some cases actually increased it. At the same
time, a firm’s own R&D investments contributed
significantly more to its market value than before. In other words, the direct effect had increased. But now there was a negative spillover:
R&D investments made by its rivals reduced,
rather than increased, the market value of a firm’s
own R&D investments. These changes are consistent with a shift from an environment of significant reverse-engineering to one relying more
heavily on patent protection. One interpretation
of the reversal of the competitive effect is that
firms shifted away from competing directly in
product markets and, more often than before,
were supplying state-of-the-art components for
their rivals’ products. One interpretation of the
reversal of the spillover effect is that firms were
now able to use patents to preclude rivals from
developing certain technologies.
The overall effect of these changes was that,
once the spillover effect is taken into account,
the market value of R&D investments for this
group of semiconductor companies during the
late 1980s and early 1990s was either the same
as or lower than it was in the early 1980s. These
results do not support the idea that granting
mask rights or otherwise making patents easier
to obtain raised the expected return to R&D
among established firms in the U.S. semiconductor industry.
Nevertheless, both private R&D spending and
patent activity in the industry increased significantly during the 1980s and early 1990s. It may
be that other factors were more important than
changes in the treatment of patents by U.S. courts.
For example, a number of scholars point out that
most American manufacturers retreated from
26

NOVEMBER/DECEMBER 1999

certain industry segments and concentrated on
products that were less susceptible to reverseengineering.23 Others argue that companies
adapted to changes in the patent system in ways
not anticipated by supporters of those changes.
For example, Bronwyn Hall and Rose Marie
Ham describe what they see as a trend toward
strategic patenting, in which firms try to assemble large patent portfolios in the hopes of
gaining leverage in cross-licensing negotiations
with their competitors.24
CONCLUSION
Economic intuition in itself cannot tell us
whether the weaker nonobviousness requirements adopted in the 1980s resulted in less R&D
activity than would have occurred without those
changes. But it does show that such an outcome
is possible and that it is more likely to occur in
rapidly innovating industries. Consequently,
these changes tend to favor traditional industries over high technology ones. If policymakers
remain concerned about encouraging innovation in high technology industries, they should
also be concerned about whether the changes
adopted in the 1980s advanced or retarded
progress toward that goal.
The relatively small amount of empirical research that has been done so far is not favorable
to the view that the recent, and impressive, increases in private R&D spending and patenting
can be explained by the changes in patent law
that occurred in the 1980s. A great deal more
research needs to be done to reach a definitive
conclusion about the effects of adopting weaker
patentablity criteria. But the theoretical and
empirical work we have available today suggests
there is good reason to exercise caution before
adopting similar changes in the future.
23
See, for example, the articles by Steven Kasch, John
Rauch, and Robert Risberg.
24

See their 1999 working paper for an examination of
patenting activity within the semiconductor industry.
FEDERAL RESERVE BANK OF PHILADELPHIA

The Euro
and the
European
Central
Patent
Reform:
A Mixed
Blessing
forBank
the U.S. Economy?

Jeffrey
M. Wrase
Robert
Hunt

REFERENCES
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Paper 97/73, INSEAD (1997).
Coolley, Ronald B. “The Status of Obviousness and How to Assert It as a Defense,” Journal of the
Patent and Trademark Office Society, 76 (1994), pp. 625-44.
Desmond, Robert. “Nothing Seems Obvious to the Court of Appeals for the Federal Circuit: The
Federal Circuit, Unchecked by the Supreme Court, Transforms the Standard of Obviousness
Under the Patent Law,” Loyola of Los Angeles Law Review, 26 (1993), pp. 455-90.
Dunner, Donald R. Introduction to “The United States Court of Appeals for the Federal Circuit—The
First Three Years,” AIPLA Q. J., 13 (1985), pp. 185-94.
Dunner, Donald R., J. Michael Jakes, and Jeffrey D. Karceski. “A Statistical Look at the Federal Circuit’s
Patent Decisions, 1982-1994,” Federal Circuit Bar Journal, 5 (1995), pp. 151-80.
Griliches, Zvi, ed., R&D, Patents and Productivity. Chicago: University of Chicago Press, 1984.
Griliches, Zvi. “Patent Statistics as Economic Indicators: A Survey,” Journal of Economic Literature,
XXVIII (1990), pp. 1661-1707.
Hall, Bronwyn. “Industrial Research During the 1980’s: Did the Rate of Return Fall?” Brookings Papers:
Microeconomics, 2 (1993), pp. 289-343.
Hall, Bronwyn. “Innovation and Market Value,” Working Paper No. 6984, NBER (1999).
Hall, Bronwyn, and Rose Marie Ham. “The Patent Paradox Revisited: Determinants of Patenting in
the U.S. Semiconductor Industry, 1980-94,” Working Paper 7062, NBER (1999).
Hunt, Robert M. “Nonobviousness and the Incentive to Innovate: An Economic Analysis of Intellectual Property Reform,” Working Paper 99-3, Federal Reserve Bank of Philadelphia (March 1999).
Hunt, Robert M. “The Value of R&D in the U.S. Semiconductor Industry: What Happened in the
1980s?” mimeo, 1996.
Jones, Charles I., and John C. Williams. “Measuring the Social Return to R&D,” Quarterly Journal of
Economics, 113 (1998), pp. 1119-35.
Kasch, Steven P. “The Semiconductor Chip Protection Act: Past, Present, and Future,” High Technology
Law Journal, 7 (1992), pp. 71-105.
Kastriner, Lawrence G. “The Revival of Confidence in the Patent System,” Journal of the Patent and
Trademark Office Society, 73 (1991), pp. 5-23.
Kortum, Samuel, and Josh Lerner. “What Is Behind the Recent Surge in Patenting?” Research Policy, 28
(1999), pp. 1-22.

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REFERENCES (continued)
Levin, Richard C., Alvin Klevorick, Richard R. Nelson, and Sidney G. Winter. “Appropriating the
Returns from Industrial Research and Development,” Brookings Papers on Economic Activity, 3
(1987), pp. 783-820.
Mansfield, Edwin, Mark Schwartz, and Samuel Wagner. “Imitation Costs and Patents: An Empirical
Study,” Economic Journal, 91 (1981), pp. 907-18.
Merges, Robert P., and Richard R. Nelson. “Market Structure and Technical Advance: The Role of
Patent Scope Decisions,” in Thomas M. Jorde and David J. Teece, eds., Antitrust, Innovation, and
Competitiveness. New York: Oxford University Press, 1992.
Miller, Arthur R. Statement before the Subcommittee on Patents, Copyrights, and Trademarks of the
Senate Committee on the Judiciary, quoted in Semiconductor Chip Protection Act of 1984, S. Rpt.
98-425 on S. 1201 (May 2, 1984).
Nakamura, Leonard. “Intangibles: What Put the New in the New Economy?” Federal Reserve Bank
of Philadelphia Business Review, July/August 1999.
O’Donoghue, Ted. “A Patentability Requirement for Sequential Innovation,” RAND Journal of Economics, 29 (1998), pp. 654-79.
Pakes, Ariel, “On Patents, R&D, and the Stock Market Rate of Return,” Journal of Political Economy, 93
(1985), pp. 390-409.
Rauch, John G. “The Realities of Our Times: The Semiconductor Chip Protection Act of 1984 and the
Evolution of the Semiconductor Industry,” Journal of the Patent and Trademark Office Society, 75
(1993), pp. 93-124.
Risberg, Robert L., Jr. “Five Years Without Infringement Litigation Under the Semiconductor Chip
Protection Act: Unmasking the Spectre of Chip Piracy in an Era of Diverse and Incompatible
Process Technologies,” Wisconsin Law Review, 24 (1990), pp. 241-77.
Schaafsma, Paul. E. “Patent Mapping: A Graphical Model of Patent Rights,” Journal of the Patent and
Trademark Office Society, 77 (1995), pp. 953-71.
Schankerman, Mark. “How Valuable Is Patent Protection? Estimates by Technology Field,” RAND
Journal of Economics, 29 (1998), pp. 77-107.
Schankerman, Mark, and Ariel Pakes. “Estimates of the Value of Patent Rights in European Countries
During the Post-1950 Period,” Economic Journal 96 (1988), pp. 1052-76.
Sobel, Gerald. “The Court of Appeals for the Federal Circuit: A Fifth Anniversary Look at Its Impact
on Patent Law and Litigation,” American University Law Review, 37 (1988), pp. 1087-1139.
Szczepanski, Steven Z. “Licensing or Settlement: Deferring the Fight to Another Day,” AIPLA Q.J., 15
(1987), pp. 299-323.

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FEDERAL RESERVE BANK OF PHILADELPHIA

The Euro
and the
European
Central
Patent
Reform:
A Mixed
Blessing
forBank
the U.S. Economy?

Jeffrey
M. Wrase
Robert
Hunt

CASES CITED
Hotchkiss v. Greenwood, 11 How. 248, 13 L.Ed. 683 (1851).
Graham v. Deere, 383 U.S. 101 (1966).
Simmons Fastener Corporation v. Illinois Tool Works, 739 F.2d 1573 (Fed. Cir. 1984).
Stratoflex, Inc. v. Aeroquip Corp., 713 F.2d 1530 (Fed. Cir. 1983).

29