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JULY/AUGUST 1997
ECONOMIC PERSPECTIVES
A review from the
Federal Reserve Bank
of Chicago
Reversal of fortune:
Understanding the
Midwest recovery
Accounting for the
federal government's
cost of funds
FEDERAL RESERVE BANK
OF CHICAGO
Contents
Reversal of fortune:
Understanding the Midwest recovery............................................................ 2
William A. Testa, Thomas H. Klier,
and Richard H. Mattoon
Has the Midwest been good or lucky in its recent recovery?
In this article, the authors assess the internal and external
factors that have contributed to the revival of midwestern
economic fortunes over the last decade.
Accounting for the federal
government's cost of funds........................................................................... 18
George J. Hal, and Thomas J. Sargent
This article describes and defends the authors’ corrections
to the federal government’s flawed measure of its cost of
funds. Further, it examines how the maturity structure
of the debt influences the way inflation risk and interest
rate risk are shared by the government and its creditors.
ECONOMIC PERSPECTIVES
July/August 1997, Volume XXI, Issue 4
President
ECONOMIC PERSPECTIVES is published by
the Research Department of the Federal Reserve
Bank of Chicago. The views expressed are the
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Senior Vice President and Director of Research
William C. Hunter
Research Department
Financial Studies
Douglas Evanoff, Assistant Vice President
Macroeconomic Policy
Charles Evans, Assistant Vice President
Microeconomic Policy
Daniel Sullivan, Assistant Vice President
Regional Programs
William A. Testa, Assistant Vice President
Editor
Helen O’D. Koshy
Production
Rita Molloy, Kathryn Moran, Yvonne Peeples,
Roger Thryselius, Nancy Wellman
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ISSN 0164-0682
Reversal of fortune:
Understanding the Midwest recovery
William A. Testa, Thomas H. Klier,
and Richard H. Mattoon
The Midwest economy has
received considerable attention in recent years as it has
shed its image as the Rust
Belt and reemerged as a
strong regional competitor both on the national
and international stage. This reversal of fortune
has surprised some analysts, and explanations
of the region’s resurgent strength have often
been more anecdotal than empirical. In this
article, we take a more systematic approach
to analyzing the elements that have contributed
to the region’s recovery since the mid-1980s.1
Specifically, we describe the contribution of
external and internal factors to the economic
revival of the Midwest and identify the challenges and opportunities the region now faces.
Charting the turnaround
A region’s economy can be represented
by many diverse measures. Unemployment
rates are perhaps the most widely recognized
indicators of both economic progress and
participation of the region’s population in the
economy. Looking at the aggregate unemployment rate for the Midwest versus the nation
from the 1980s to date, two remarkable features
can be seen.2 First, from an average annual
rate that exceeded the nation’s by 3 percentage
points in 1983, the Midwest’s unemployment
rate had fallen to a full percentage point below
the nation’s by 1996 (see figure 1). The same
year marked the fifth consecutive year that
the rate remained below the nation’s. A second
feature of the labor market reflected by the
unemployment rate is the behavior of the
2
Midwest economy during the most recent
(1990–91) recession. In prior recessions, the
highly cyclical nature of the Midwest economy,
combined with the region’s eroding share of
national production, resulted in a more rapid
rise in Midwest unemployment relative to the
nation. In contrast, during 1990–91, the underlying secular strength of the region’s economy
allowed its labor market to continue to gain
on its national counterpart and, ultimately, to
experience a more fully employed work force.
Despite the Midwest’s tight labor markets,
its growth of employment and population are
not, in general, exceeding the nation’s. The
Midwest turnaround has been characterized
by a convergence in the pace of employment
growth with that of the nation. Job growth in
the early 1990s was especially strong relative
to the nation, but has now probably eased to
a pace that is on par with the nation. Because
the region’s work force is approximately at
full capacity, any further supranational employment growth cannot reasonably be expected
unless population growth increases sharply.
Although recent employment gains in the Midwest have been accompanied by population
William A. Testa is assistant vice president and
team leader of regional programs and Thomas
H. Klier and Richard H. Mattoon are senior economists in the Economic Research Department
of the Federal Reserve Bank of Chicago. This
article is drawn from the Bank’s “Assessing the
Midwest Economy” study that began in the fall
of 1995. The authors wish to acknowledge the
contributions of the numerous participants in
this study in helping to frame the issues presented
in this article.
ECONOMIC PERSPECTIVES
Heightened work force participation appears to be reviving
Unemployment rates
the incomes of Midwest residents.
percent
Per capita income relative to the
13
nation had dipped sharply from
a superior position in the late
1970s to an inferior position by
the early 1980s. However, the
10
region’s relative position began
to improve in 1991 and slightly
Midwest
exceeded the national average in
1994 and 1995, the latest year
7
available (see figure 2). Median
U.S.
household income, measured in
constant purchasing power,
4
largely parallels this pattern.
1978
’81
’84
’87
’90
’93
’96
After dipping to parity with the
Note: Unless otherwise noted in tables and figures, Midwest refers to the
states of the Seventh Federal Reserve District—IL, IN, IA, MI, and WI.
nation from 1980 to 1983, MidSource: U.S. Department of Labor, Bureau of Labor Statistics.
west income continued on par
with the nation through 1994,
and is now showing preliminary
growth, reflecting a turnaround from a net outsigns of strength relative to the nation.
flow in the 1980s to a net inflow in the 1990s,
Midwest income continues to flow from
the Midwest continues to lag other regions
the region’s traditional industries. The Mid(especially most of the Sun Belt) in terms of
west remains markedly more concentrated
population growth.
than the nation in its mainstay industries—
This combination of strong employment
durable goods manufacturing and agriculture
growth and lagging population accounts for
(see figure 3). Examining industry composithe marked improvement in the Midwest’s
tion at a finer level of detail does little to alter
labor force participation relative to the rest
this conclusion.
of the nation. From a deficit position during the
It is not surprising, then, to find that the
1980s, the region’s ratio of employed, aged 16
revival in Midwest job and production growth
and above, to population (at 0.65) has surpassed
has been led by manufacturing and agriculture.
the U.S. average (0.63).
The Midwest lost 2.5 percentage points in its
share of the nation’s manufacturing employment from 1977 to
FIGURE 2
1983 (going from roughly 19.5
Per capita income
percent to 17 percent). It has since
index, U.S.=100
regained 2 percentage points and
108
the rate of gain has accelerated in
the 1990s. Manufacturing industries such as autos and steel have
reconcentrated in the Midwest.
104
For example, the region had 31
Midwest
auto plants in 1996, compared
with 27 in 1979. Although nine
Midwest auto plants closed be100
tween 1979 and 1996, 13 new
plants opened.
Rural areas have benefited
from
both the rising manufac96
1971
’75
’79
’83
’87
’91
’95
turing tide and the recovery of
Source: U.S. Department of Commerce, Bureau of Economic Analysis.
production agriculture. Over the
past 15 years, rural growth in
FIGURE 1
FEDERAL RESERVE BANK OF CHICAGO
3
in-migration. Midwestern metro
areas experienced a modest outPersonal income by industry, Midwest/U.S.
migration from 1990 to 1994,
location quotients
even as employment continued
0.0
0.5
1.0
1.5
2.0
to grow. Some workers may be
Agriculture
choosing to reside in adjacent
1994
1977
Construction
counties, while commuting to
jobs in metro areas.
Manufacturing
Metro areas continue to be
Nondurable
manufacturing
magnets
for jobs, but the nature
Durable
manufacturing
of jobs is changing: Many
Transportation
midwestern metro areas are
and public utilities
successfully transforming from
Wholesale trade
manufacturing centers to service
Retail trade
centers (see table 1).6 Important
Finance, insurance,
and real estate
industries of the service and
Personal
information economy of the
services
Business
U.S.
average
1990s include producer services,
services
such as management consulting,
Government
advertising, accounting, and
Note: A quotient of 1.0 indicates the same relative importance of an industry
business and legal, as well as
for the Midwest as for the U.S. as a whole.
trade, travel, and financial serSource: U.S. Department of Commerce, Bureau of Economic Analysis.
vices. Midwest metro areas have
been very successful in attracting
these industries and, in some cases, developing
manufacturing jobs has outpaced metropolitan
a service industry niche, such as sports-oriented
growth. Meanwhile, the recovery of the farm
travel centers (Indianapolis), convention tourism
sector from the debt overhang and sagging mar(Appleton–Oshkosh), health services and insurkets of the late 1970s and early 1980s has lifted
ance (Peoria), air freight/air maintenance cenfarmland prices. Grain prices are high by historters (Indianapolis), financial services/insurance
ical standards and demand from developing
(Des Moines), automotive R&D (Detroit), and
countries has buoyed world markets for grains,
convention–business meeting centers (Chicago).
meat products, and some processed foods.
Industrial restructuring has differed by size
Emergence of these goods-producing
of metro area, with large metro areas tending
industries in rural areas—especially manufacto transform to a greater degree away from
turing—has translated into an improvement in
manufacturing toward business and financial
population growth and a turnaround from net
services.7 Manufacturing losses in large metro
out-migration to net in-migration.3 In Midwest
rural counties, population declined by 2.2 percent
areas, especially core counties, have been sharp.
from 1980 to 1990, with 70 percent of counties
Smaller metro areas have tended to lose out
experiencing declines in absolute terms. From
on some business-oriented services such as
1990 to 1994, rural Midwest counties recorded
financial service industries, while picking up
population gains of 2.4 percent, with 74 percent
the slack, in general, as preferred manufacturreporting gains during this period. 4
ing locations. As a result, the Midwest’s ecoDespite the dramatic swings in rural fornomic recovery, as reflected in relatively low
tunes, the Midwest’s and nation’s population
unemployment rates, has been pervasive across
continues to shift to metropolitan (metro) areas,
metro areas.
much as it has done throughout this century.
Timing and depth
By 1994, metro areas’ share of population was
From 1947 to 1987, the Midwest’s (defined
approaching 80 percent in the nation and 76
in
this
case as Illinois, Indiana, Michigan, Ohio,
percent in the Midwest. However, the pace
and
Wisconsin)
share of national manufacturing
of the shift appears to be slowing considerably
declined
from
30
percent to 22.1 percent.8 To a
in the 1990s, harkening back to the rural–urban
large extent, this reflected a natural process of
turnaround of the 1970s.5 In metro areas, the
population deconcentration within the continental
natural population increase continues to dominate
FIGURE 3
4
ECONOMIC PERSPECTIVES
After a languid recovery in
1983, the Midwest economy
Personal income derived from labor and proprietor
showed some vigor in 1984,
earnings (indexes of concentration)
supported by strengthening auto
Midwest/U.S.
demand. However, in 1985 and
1969
1977
1985
1994
1986, the dollar value of overall
export sales from the region
Manufacturing
remained flat despite depreciation
Large MSAs
1.31
1.35
1.29
1.30
of the value of the dollar against
Core counties
1.28
1.34
1.22
1.20
currencies of trading partners.10
Medium MSAs
1.52
1.63
1.70
1.70
Small MSAs
1.41
1.48
1.55
1.68
Domestic markets for capital
Nonmetro
1.10
1.19
1.34
1.62
goods, other than computer-related
purchases from coastal regions,
FIRE
Large MSAs
1.00
1.09
1.14
1.15
also continued to disappoint.
Core counties
1.12
1.22
1.37
1.32
Beginning in 1987, the MidMedium MSAs
0.70
0.71
0.70
0.78
west’s capital goods sectors began
Small MSAs
0.71
0.73
0.71
0.72
to recover late in the expansion
Nonmetro
0.60
0.62
0.51
0.47
and exports began to grow. In the
Business services
agricultural sector, farm equipment
Large MSAs
1.06
1.07
1.16
1.13
purchases and exports began to
Core counties
1.13
1.02
1.01
0.97
show some life and balance sheets
Medium MSAs
0.52
0.58
0.63
0.75
Small MSAs
0.43
0.51
0.54
0.61
began to strengthen.
Nonmetro
0.49
0.53
0.44
0.40
Many observers believed that
the
shakeout
of the early 1980s
Note: An index value of 1 signals the same importance of an industry
for the Midwest as for the U.S. That is, an index value of 2.0 could be
was so severe that it destroyed a
obtained from a 40 percent share of manufacturing in Midwest metro
large portion of the most inefficient
areas divided by a 20 percent share of manufacturing in U.S. metro areas.
Source: U.S. Department Of Commerce, Bureau of Economic Analysis,
and antiquated physical capital
Regional Economic Information System.
stock. Accordingly, the renewed
strength of the Midwest in the
second half of the decade was
interpreted as an inevitable bounce-back in
U.S. For example, the Southeast developed
production and productivity, albeit from a much
manufacturing industries as its work force was
lower baseline level.11 Even as other regions
released from agriculture, and improvements in
technology, infrastructure, and transportation
such as the Southwest and New England began
opened up previously isolated areas in many
to experience economic setbacks, few believed
parts of the country.
that these setbacks would continue for very
Recessionary periods were particularly
long. Although the high-tech industry, the
difficult for the Midwest because of its condarling of the decade, was toppling in New
centration in capital goods and consumer
England, along with defense-related industries
durables, which were most vulnerable to a
there and elsewhere, many believed that a
falloff in demand.9 Furthermore, the region’s
bounce-back in high technology was only a
technology and physical stock of capital
matter of time, and that the Midwest was at
tended to be of earlier vintage (and often
a disadvantage because the fastest growing
lower efficiency) than in other regions of the
sectors were almost nonexistent in the region.12
U.S. and abroad. Consequently, when demand
It also took some time before the extent of overslackened, it was more cost-effective to conbuilding in real estate in other regions could be
tinue remaining production at newer (lower
fathomed. The coastal regions and parts of the
cost) plants elsewhere. During the 1979–83
Southwest struggled through the overbuilding
period, as the nation passed though two recesand savings and loan debacles to a significantly
sions in quick succession, the Midwest lost
greater extent than the conservative and still
over one-fifth of its manufacturing work force
“shell-shocked” Midwest. Through the distorted
at the same time that the rural agricultural
lens of these events, fundamental changes undereconomy experienced its worst times since the
lying a sustained turnaround of the Midwest
Great Depression.
were difficult to distinguish.
TABLE 1
FEDERAL RESERVE BANK OF CHICAGO
5
Today, it is evident that the signs of strength
in the Midwest economy of the mid- to late 1980s
were more than the anticipated snap-back from
the restructuring of the early 1980s. Much of
the adjustment had taken place by 1985 and the
transitory shocks in other regions have significantly dissipated. Yet, the pace of economic
growth in the Midwest remains strong and
capacity utilization remains high. The Midwest
economy has been changing from within during
the past ten to 15 years, and these changes have
been supported by favorable external conditions
and trends.
External conditions
External factors in the Midwest’s economic
turnaround include technological and organizational changes in the automotive industry,
which have favored its reconcentration in the
midsection of the nation; the geographic pattern
of federal defense spending; declining real
energy prices, important both as an input to
the region’s industries and as a determinant
of demand for its products; and, from the mid1980s until recently, a declining dollar, which
improved the international competitiveness of
the region’s companies.
Changing geography of the
auto industry
U.S. auto assembly plants have
tended to reconcentrate in the Midwest over the 1980s and 1990s.
Auto supplier plants had tended to
disperse over the three decades to
1990, but this trend appears to be
reversing during the 1990s (see
figure 4) as more technologically
advanced and innovative automotive parts and services providers
continue to locate in the Midwest.
The reconfiguration of auto assembly, the continued preference of
supplier R&D operations to locate
close to Detroit, plus evidence of
spatial clustering of tier 1 supplier
plants around their assembly plant
customers suggest a strengthening
of agglomeration effects in the
auto industry.
As discussed in Rubenstein
(1996), the reconcentration of auto
assembly has resulted from broad
changes in the industry’s product
mix that, consistent with neoclassical
6
location theory, have changed the economics
of plant location in favor of the midsection of
the country. The costs of distributing the final
product to the customer have always been
important in deciding the location of auto assembly plants. Henry Ford opened far-flung
branch assembly plants to produce identical
Model T cars closer to the population centers
outside the Midwest; it was cheaper to ship
parts to branch assembly plants than to ship
finished automobiles across the country from a
centrally located assembly plant. Soon, General Motors and Chrysler emulated that strategy.
However, by the 1960s the proliferation of car
and truck models meant that location strategy
was no longer optimal. The number of different car and truck models sold in the U.S.
increased eightfold, from 30 in 1955 to 241
in 1995, while sales only doubled from about
eight million units to about 16 million in
1995. With reduced output per individual
model, the entire output would best be produced at one plant. Consequently, the geographic argument for an interior location
became compelling; that way the company
could minimize the cost of distributing the
output to a national market. As a result, during
the past 16 years auto producers have opened
assembly plants in the interior, especially
FIGURE 4
Auto supplier plants by region and start-up date
percent
80
60
Midwest
40
Southeast
20
West
Northeast
0
prior to
1950
’50-59
’60-69
’70-79
’80-89 ’90-95
Note: The Midwest refers to IL, IN, MI, OH, and WI. The Southeast refers
to AL, AR, FL, GA, KY, LA, MS, NC, SC, TN, TX, VA, and WVA. The Northeast
refers to CT, DE, ME, MD, MA, NH, NJ, NY, PA, RI, and VT. The West refers to
all other states.
Source: James Rubenstein, “The evolving geography of production—Is
manufacturing activity moving out of the Midwest? Evidence from the auto
industry,” Assessing the Midwest Economy Working Paper Series , No. SP-3,
Federal Reserve Bank of Chicago, 1996.
ECONOMIC PERSPECTIVES
along the I-65/I-75 corridor, and
closed coastal plants. While freight
costs can account for the reconcentration of auto production in the
Midwest, variables such as the
local labor climate, access to highways, and general costs of doing
business influence the selection of
particular communities or sites.
Federal spending patterns
FIGURE 5
Per capita federal expenditures
percent of U.S. per capita levels
110
U.S.
100
IA
90
IL
Historically, the Midwest has
not fared well relative to other
80
regions in terms of receiving money
WI
IN
from Washington. Measured as a
MI
percentage of U.S. per capita lev70
1985
’87
’89
’91
’93
’95
els, federal expenditures were beSource:
Kerry
Sutten,
“Federal
spending
in
the
Northeast
and
Midwest:
low the national average in each of
Fiscal 1995,” Northeast–Midwest Institute, Washington, DC, June 1996.
the five states of the Seventh Federal
Reserve District from 1985 to
1995, with the exception of Iowa in
1988 (see figure 5). First, because of the small
and highway infrastructure funds) than many
concentration of defense-related industries,
other regions. According to data compiled by
federal procurement spending in the region is
the Northeast–Midwest Institute, in fiscal 1994
particularly weak. For example, in fiscal 1995,
federal transfers on average represented 27.7
Illinois ranked 47th and Indiana and Wisconsin
percent of total state budgets in the U.S.14
tied for 46th on per capita military procurement
Federal transfers comprised 25.8 percent of
expenditures. In addition, the relatively small
the Illinois budget, 28.4 percent of the Indiana
number of military bases in the region keeps
budget, 25.7 percent of the Iowa budget, 25.4
military spending on wages and salaries signifpercent of the Michigan budget, and 24.4 percent
icantly below the U.S. average. Spending by
of the Wisconsin budget.
the federal government for grants, federal salaries
Energy
and wages, and direct payments in the Midwest is
Delivered prices of all major fuels have
generally below average on a per capita basis.
declined in the Midwest since the early to
Over the past ten years, however, regions
mid-1980s (Bournakis, 1996). Despite recent
that depended heavily on federal dollars have
price run-ups, national real gasoline prices are
been particularly affected by program cuts.
currently lower than in 1967 and 25 percent
Defense spending reductions and the difficulty
lower than their peak in the latter half of the
of converting defense industries to nondefense
1970s. At that time, high petroleum-based
functions have damaged economies in Califorfuel prices exerted a significant drag on Midnia and New England. Figures on U.S. military
west industry and hampered sales of domestic
procurement spending from 1985 to 1996 and
automakers. Recently, midwestern energy
projected to 2002 demonstrate the spending
prices have been edging down relative to
boom in states with concentrations of defensenational energy prices (see figure 6). Why
related industries in the 1980s ($80 billion in
these prices have eased is not clear but may
1991) and the rapid decline in expenditure
be due to external developments, such as
levels in the 1990s (an estimated $40 billion in
deregulation of the U.S. natural gas market
1998). A study of the Chicago economy sugsince the mid-1980s, or regional issues, such
gests that even those industries in the Midwest
as state–local tax and regulatory policies.
that have traditionally done business with the
federal defense establishment may convert to
Exports
civilian products relatively easily.13
Exports now account for 13 percent of
The Midwest is also less reliant on federal
U.S. gross domestic product, compared with 8
transfers (primarily Medicaid, social welfare,
percent in 1987 and 5 percent in 1971. From
FEDERAL RESERVE BANK OF CHICAGO
7
markets in Asia and South
America.16
Ratio of Midwest to U.S. fuel prices
Currency swings since the
ratio
dollar’s peak in early 1985 are
1.18
often cited in the popular press
as having boosted midwestern
1.12
exports and shielded domestic
Natural gas
Distillate fuel
markets from displacement by
foreign imports. The Midwest’s
1.06
Coal
share of Big Three auto production has increased since 1991.
1.00
Thanks to the reconcentration of
domestic automakers and the
Motor gasoline
0.94
presence of Japanese automakers,
Electricity
the region’s share of domestic
0.88
car production has climbed from
1983
’85
’87
’89
’91
’93
45 percent in 1981 to more than
Source: Athanasios Bournakis, “Energy and environmental issues for the
Midwest economy,” Assessing the Midwest Economy Working Paper Series,
56 percent.17 However, the
No. SP-5, Federal Reserve Bank of Chicago, 1996.
drop-off in the dollar’s value
was completed by 1987. Over
the past nine years, aggregate
trade-weighted dollar indexes suggest that the
1992 to 1995, exports from the Midwest grew
currency-influenced terms of trade have reeven more dramatically than exports from the
mained mostly flat, even as exports have conU.S. as a whole (see figure 7). Exports from
tinued to climb. Moreover, recent research by
the region’s telecommunications, farm machinHervey and Strauss (1996) suggests that the
ery, construction machinery and equipment,
dollar has appreciated rather than depreciated
machine tools, and specialized capital goods
against currencies of nations to which the Midsectors, as well as the agriculture sector, have
west exports.18
grown rapidly during the past ten years to meet
growing demand from developing markets
Changing how we do business
worldwide.15 The lion’s share of future trade
(internal adjustments)
expansion is expected to derive, not from trade
The Midwest’s constancy in line of busiwith developed nations, but from emerging
ness and evidence of productivity gains driven
by internal private and public
sector actions suggest that internal
FIGURE 7
factors have also been important
sources of regional revival. In
Total exports
particular, midwestern industry
index, 1990=100
has adopted new technologies
160
and modes of business operation,
and the region’s relative cost
position has improved. The pubMidwest
140
lic sector has facilitated regional
competitiveness by prudent taxaU.S.
tion and spending policies, by
focusing spending on value120
producing services and public
infrastructure, and, more recently,
by adopting innovative delivery
of public services. So too, the
100
region’s “institutional capital”—
1990
’91
’92
’93
’94
’95
public and private organizations,
Source: Massachusetts Institute for Social and Economic Research.
including universities, research
FIGURE 6
8
ECONOMIC PERSPECTIVES
centers, and business and civic organizations—
proved responsive in the face of economic crisis.
setting is the U.S. auto industry. Successful
auto assembly operations have been transplanted
to the U.S. environment by companies such
Technology and organization
as Toyota, Honda, and Mitsubishi. In some
There is substantial evidence that the Midcases, existing assembly plants, such as GM’s
west has changed the way it does business—its
NUMMI venture with Toyota in California,
organization, mode of operation, and technology.
have been transformed through organization
As discussed in Klier (1996), implementation
and technology alone.
of best manufacturing practices, notably lean
The extent to which this experience is
manufacturing technologies, has helped revitalize
characteristic of manufacturing in general
Midwest manufacturing. Lean manufacturing,
was addressed in two large-scale studies.19
which gained widespread attention in the early
Both Statistics Canada (Baldwin, Diverty, and
1980s, combines aspects of both craft and mass
Sabourin, 1988) and the U.S. Census Bureau
production, ranging from teamwork on the
(1988 and 1994) administered surveys of manshop floor, to emphasis on low inventory and
ufacturing technologies to measure the extent
flexible production equipment, to close relaand type of advanced manufacturing technolotionships with suppliers. The most familiar
gies used in their respective country’s manufacturing plants. Both surveys
found that the application of
TABLE 2
advanced manufacturing technoloApplication of some advanced technologies
gies was widespread across plants
and industries, typically with mulFMC/
CAD/
Interco.
FMS
CAE
network
tiple technologies applied per
(----percent of plants using----)
establishment (see table 2). These
results indicate that advanced
Plant employment
manufacturing techniques are
20–99
7.6
49.5
12.0
reshaping manufacturing on a
100–499
21.4
76.4
28.4
broad scale. In the Midwest, more
500+
40.4
87.2
47.1
concentrated in manufacturing
Age of plant
than any other region, these techLess than 5 years
13.4
63.5
15.0
nological advances have tended
5–15
13.3
62.0
18.0
16–30
13.4
64.4
20.5
to boost the economy.
Greater than 30
15.2
63.1
22.0
At the same time, the region’s
industries are outside those (mostly
Major industrial groups
Fabricated metal products
9.5
46.5
16.7
defense) sectors that require both
Industrial machinery
a change in product mix and a
and equipment
11.8
64.1
15.4
transformation in technology.
Electronic and other
Regions specializing in declining
electric equipment
17.0
64.2
21.9
industries, such as defense-oriented
Transportation equipment
15.5
53.9
23.4
manufacturing, must change not
Instruments and related
only how business is conducted
products
14.2
65.5
15.3
but the entire product mix. To
Notes: The table reports information on three of the 17 advanced
date, for several regions that commanufacturing technologies surveyed. They are defined as follows:
pete with the Midwest, the barriers
Flexible manufacturing cells and systems (FMC/FMS): two or more
of changing both “how” and
machines with automated material handling capabilities controlled by
computers or programmable controllers, capable of single/multiple
“what” have been too high to bring
path acceptance of raw material and single/multiple path delivery of
finished product.
about the resurgent experience of
Computer-aided design and engineering (CAD/CAE): use of computers
the Midwest.
for drawing and designing parts or products and for analysis and
testing of designed parts or products.
Intercompany computer network (Interco. network): use of network technology to link subcontractors, suppliers, and/or customers with the plant.
Source: U.S. Department Of Commerce, Bureau of the Census, Current
Industrial Reports: Manufacturing Technology: Prevalence and Plans for
Use, 1994, tables 4D and 4E.
FEDERAL RESERVE BANK OF CHICAGO
Costs of business operation
The neoclassical view in
economics suggests that firm location is significantly driven by the
search for low costs of operation.
9
FIGURE 8
Real per worker earnings
thousands of 1994 dollars
29
Midwest
28
U.S.
27
26
25
1980
’82
’84
’86
’88
’90
’92
Source: U.S. Department of Commerce, Bureau of Economic Analysis.
Labor costs commonly comprise the largest
share of operating costs to business enterprises.
This implies that capital investment flows
toward regions with low wage costs and that
job openings grow in tandem with capital investment. In many instances, labor does not migrate, as might be expected, toward high-wage
areas, because job openings are absent due to
rigid wages and, perhaps, institutional features
such as unionization.20 As a result, economies
with low wage costs can experience economic
growth of capital and labor.
Evidence from the past ten to 15 years is
consistent with this theory in partly explaining the Midwest turnaround. The Midwest
has long been reputed as a high-wage locale,
especially for manufacturing. But over the
past ten to 15 years, workers in the Midwest
have apparently eased their wage demands
relative to those of their national
counterparts. Real per worker
earnings approached national
levels from 1980–82 and continued to converge throughout
the 1980s (see figure 8).21 While
these figures are merely suggestive of labor costs, changes in the
level of hourly wages of workers
in the manufacturing sector point
in the same direction (see table
3).22 Adjusting for differences in
industry mix, Midwest manufacturing wages eased from 17
percent above national levels in
the early 1980s to a 13 percent
’94
premium in the 1990s.
As mentioned earlier, energy prices in the region have also
eased relative to national prices,
including prices of coal and natural gas, which
the region consumes in greater proportion than
the nation.23 The region has also taken measures
toward greater energy conservation and efficiency; at the same time, industry composition
has shifted away from energy-intensive sectors.
Today, the Midwest consumes much less energy relative to gross state product than 20 years
ago (see figure 9). Thus, Brown and Yücel
(1995) suggest the region would experience
dramatically milder responses to potential oil
price shocks (less than half of 1980 levels).
The public sector
Some analysts suggest that the Midwest
has assisted its own revival through judicious
fiscal policies. The region followed a conservative fiscal path characterized by minimal
increases in levels of taxation (even during the
1990–91 recession) and conservative spending
policies. At the same time, public
spending was generally above
TABLE 3
national levels in areas that are
Index of relative wages in manufacturing:
seen as contributing to economic
Midwest versus U.S.
growth, such as education and
1979
1983
1989
1993
1995
highway expenditures, while
spending was below national
Illinois
1.09
1.10
1.07
1.03
1.02
levels in areas less associated
Indiana
1.16
1.14
1.12
1.12
1.13
with economic growth, such as
Iowa
1.16
1.14
1.03
1.04
1.03
government administration, corMichigan
1.30
1.32
1.29
1.31
1.32
rections/prisons, and welfare exWisconsin
1.09
1.11
1.03
1.04
1.03
penditures (see figure 10).
Midwest
1.17
1.17
1.13
1.13
1.13
It is hard to say to what extent
Source: U.S. Department of Labor, Bureau of Labor Statistics.
this behavior contributed to the
10
ECONOMIC PERSPECTIVES
to be influential to regional
growth. In her 1995 book World
Midwest energy consumption and gross state product
Class, for example, Rosabeth
quadrillion Btu
trillions of 1992 dollars
Moss Kantor suggests the places
20
1.00
that succeed in the new global
economy often do so because
Gross state product
they have created and supported
(right scale)
organizations, their so-called
15
0.75
institutional capital.26 These
organizations are often found
in the not-for-profit sector and
10
0.50
include public–private partnerEnergy consumption
(left scale)
ships and councils, nonprofit
organizations of business leaders,
public–private development
5
0.25
1971 ’73 ’75 ’77 ’79 ’81 ’83 ’85 ’87 ’89 ’91 ’93
councils, foundations, trade assoSource: See figure 6
ciations, chambers of commerce,
research centers at local universities, and research institutes.
The Midwest has fostered a
Midwest’s economic revival, since the relationrich
endowment
of
organizations
that form its
ship between public spending/taxation and ecoinstitutional
capital
stock,
contributing
to a varinomic growth has not been definitively demonety
of
regional
economic
development
efforts.
strated. Beneficial effects between state–local
In
the
case
of
state
and
local
economic
develgovernment fiscal health and private sector
opment
planning,
for
example,
communityeconomic growth run in both directions, thereby
based organizations and local business associamaking it difficult to discern cause from effect.
tions provide important information to publicThe Midwest’s current prosperity is evident
sector decisionmakers on which efforts and
in its state and local sector, as midwestern state
programs work best and often promote soluand local governments have, in general, rebuilt
tions that fall outside of narrow political
their budget balances and improved their fiscal
boundaries.27 For example, several multistate
position. While the national average state fund
efforts have addressed environmental challengbalance (as a percentage of state expenditures)
es in the Midwest. One such effort is aimed at
was slightly more than 5 percent in 1996, Indiunderstanding the atmospheric science and
ana recorded a fund balance of 20 percent;
fashioning compliance solutions to the ozoneIowa, 15 percent; and Michigan, 13 percent.
related ambient air quality standards of the
The recessionary period of the early 1980s
Clean Air Act Amendments.28 Another arises
reduced the region’s fiscal capacity and induced
from the Great Lakes Water Quality Initiative, a
states to strain their capacity to fund public
basin-wide approach to reducing toxic contamispending. However, Midwest states are seen
nation of the Great Lakes system.29 Proactive
to have begun easing the strain on their fiscal
development initiatives at a multistate level
capacity by the mid-1980s. 24 The fiscal expehave been no less common, including tourism
rience of District states followed the same
and export promotion and efforts to broaden
break with the past that has characterized the
skill standards and certification.30
economic performance of the region. Unlike
FIGURE 9
previous recessions which had usually forced
dramatic tax increases in the region, the
national recession of 1990–91 had a relatively
shallow impact.25
Institutional capital
Nonprofit institutions and organizations
that engage in economic growth and development policies and programs are often believed
FEDERAL RESERVE BANK OF CHICAGO
What does the future hold
for the Midwest?
This article has identified developments
that have restored the region’s luster. With ten
to 15 years hindsight it is evident that, while
business cycle timing and external factors have
been very important, profound changes have
taken place in the way midwestern businesses
and governments compete and conduct their
11
affairs. Although it is impossible to discern the
relative contribution of these forces with a
great deal of precision, it is clear that the Midwest is partly responsible for its own recovery.
The challenges and opportunities facing
the region can be discussed in terms of two
important characteristics of this economic
recovery: the resurgent strength of the region’s
FIGURE 10
State and local public sector spending per $1,000 personal income, 1993
Total state/local spending
Total education expenditures
dollars
250
dollars
100
200
75
150
50
100
25
50
0
IL
IN
IA
MI
WI
Midwest Rest of
U.S.
Corrections spending
0
IL
dollars
40
6
30
4
20
2
10
IL
IN
IA
MI
WI
Midwest Rest
of U.S.
Administration spending
dollars
12
0
6
6
3
3
IN
WI
Midwest Rest
of U.S.
IA
IL
IN
IA
MI
WI
Midwest Rest
of U.S.
IA
MI
WI
Midwest Rest
of U.S.
MI
WI
Midwest Rest
of U.S.
dollars
12
9
IL
MI
Interest on debt
9
0
IA
Public welfare expenditures
dollars
8
0
IN
MI
WI
Midwest Rest
of U.S.
Total state/local debt
0
IL
IN
Highway expenditures
dollars
240
dollars
25
20
180
15
120
10
60
0
5
IL
IN
IA
MI
WI
Midwest Rest
of U.S.
0
IL
IN
IA
Source: U.S. Department of Commerce, Bureau of the Census, “State and local government finance estimates,
by state,” Internet at www.census.gov/govs/www/index.html, March 17, 1997.
12
ECONOMIC PERSPECTIVES
mainstay industries and the increase in labor
force participation. First, production agriculture
and manufacturing exhibited startling resilience
during this period by improving productivity,
regaining market share, and aggressively targeting export markets. In this regard, there is
reason for optimism. Following the shocks of
the 1980s, the region’s firms will most likely
stay on their guard with regard to changing
technology and the benchmarks of global competition. So too, much of the future growth in
export markets is expected to derive from developing countries, whose needs for the region’s
products—capital goods and agricultural products—are expected to continue to grow.
Second, the region’s labor force faces an
important challenge. Will work force numbers
and skills be adequate to sustain the growth
that the region has experienced in the 1990s?
In achieving recent growth, the region has drawn
from both new work force entrants and adults
who were unemployed or underemployed.
However, this pool of skilled workers is now
showing signs of strain. Currently tight labor
markets suggest the need for midwestern workers
who no longer are seen as disproportionately
expensive relative to other regions. Labor supply may become further strained in the years
ahead, because the work force in the Midwest
is reported to be older than in the nation, so
loss of workers through retirement is likely to
be relatively high in the region.31
Insofar as the region’s two industry mainstays—agriculture and manufacturing—continue
to shed labor, a lower level of growth in the
work force may be needed. If so, natural population growth, upgrading of skills, and work
force innovations to bring more people into the
labor force may suffice. For example, job networking of workers from the inner city to the
suburbs and moving welfare recipients into the
workplace may ease labor market pressures.
Furthermore, some workers may decide to
defer retirement, especially if the rewards of
working become more attractive.32
In-migration of population could provide
another “release valve” to labor market pressures. In most parts of the Midwest, the cost of
living does not present a barrier to in-migration.
The median home price in the Midwest is the
lowest of any of the four regions defined by the
National Association of Realtors; the association’s index of housing affordability is also more
favorable here than in other regions. However,
significant in-migration to the region has not
occurred to date, although out-migration has
been stemmed. Moreover, regions from which
the Midwest might expect to draw workers,
such as the West Coast and the Northeast, are
experiencing labor market tightening.
An alternative approach to easing labor
shortages is the upgrading of skills of the existing and emerging work force. This is a preferred
approach, because higher skills tend to be
rewarded in the form of higher wages and
income for Midwest residents. For this to come
about, workers must act to acquire needed
skills or credentials and policymakers must
act to create publicly assisted training, educational, and job-assistance programs or increase the effectiveness of existing programs.
Young adults continue to enter the work
force, but there is concern that some training/
educational programs have fallen into disrepair or were abandoned during the early
1980s, when one in five manufacturing jobs
evaporated in the region and growth in other
sectors stagnated. As a result, a renewed push
is needed to reestablish school-to-career and
other programs in selected skill areas. In the
absence of such initiatives, the region’s residents could miss opportunities for better and
higher paying jobs and the region’s businesses
and property owners could miss significant
income-generating opportunities.
NOTES
1
For a more detailed summary of this work, see Testa,
Klier, and Mattoon (1997). Unless specified otherwise,
Midwest refers to the states of the Seventh Federal Reserve
District—Illinois, Indiana, Iowa, Michigan, and Wisconsin.
2
See Allardice and Bergman (1996).
3
See Johnson (1996).
FEDERAL RESERVE BANK OF CHICAGO
4
Surprisingly, net migration into the rural Midwest exceeded
population gains derived from natural increase, that is,
births minus deaths. Throughout this century, population
gains in rural counties have generally been realized
through natural increase concurrent with net out-migration of young adults. By the 1990s, the resulting aging of
the population, coupled with in-migration, resulted in a
13
notable reversal; in-migration gains were leading those
achieved by natural increase in rural counties of the nation
and the Midwest.
from a favorable expansion and pattern of expansion in
foreign markets and from improving productivity.
19
5
See Johnson, op. cit.
6
See Groshen and Robertson (1993).
7
For further industry-specific analysis, see Testa (1992).
Other authors note the further spatial division of labor by
size of metro area according to industries or facilities
characterized by routinized or “back office” operations and
those engaged in “command and control,” operations such
as corporate headquarters or highly specialized business
and legal services. For further discussion, see Atkinson
(1996) and Federal Reserve Bank of Chicago (1996a).
8
Kim (1996).
9
Howland (1984).
Baldwin, Diverty, and Sabourin (1994); U.S. Department of Commerce, Bureau of the Census (1994).
20
A popular exposition of the neoclassical theme with
regard to the recent Midwest experience can be found in
Swonk (1996). For a discussion of the possible effects of
one such institutional feature, that is, right-to-work laws,
see Holmes (1995); also Kendix (1990).
21
Such figures are merely suggestive and not definitive,
assuming, for example, the shift between part-time and
full-time workers across regions does not distort the
findings, and that the findings are not similarly distorted
by regional differences in labor force growth.
22
10
Languishing total dollar volume of exports is somewhat
expected in this instance because rising physical quantities
of exports may be slight or insufficient to make up for
lower dollar prices per physical unit, that is, the “J-curve”
effect. Of course, other forces, especially changing economic growth of export destinations, also determine
export sales.
The evidence is also consistent with falling wages having
resulted from a shrinking economy (and shrinking labor
demand). The early period strongly suggests the falling
wages were caused by loss of manufacturing and attendant
high-paying jobs and by excess supplies of willing workers.
It is unclear, as yet, whether lower wages have helped
revive investment and employment in the region.
23
See Bournakis (1996).
24
11
A more farsighted view of the region is attributed to
Annable (1985) and Swonk (1991).
12
For example, Browne (1983).
13
Research completed by Philip Israilevich on defenserelated businesses in the metro Chicago economy found that
less than 1 percent of the total output of goods and services
in the Chicago economy was related to military procurement
expenditures in 1987 (during the height of the military
spending boom). Furthermore, electrical machinery, business
services, food, and control instruments were the industry
groups that accounted for 73 percent of the procurement
funds that the metro economy received. These industry
groups can serve civilian as well as defense markets without
the difficult transition associated with prime contractors,
such as ship builders, plane manufacturers, or weapons and
munitions firms. See Israilevich and Weiss (1992).
14
Sutten (1996).
Fiscal capacity measures of a state are constructed by
comparing a state’s per capita tax base to the nation’s,
aggregated across all commonly used tax bases, for example, sales, income, and property value. See U.S. Advisory
Commission on Intergovernmental Relations (1989).
25
See Mattoon and Testa (1992).
26
See Kantor (1995). The hypothesis that long-developed
regions will necessarily have an advantage in sustaining
growth during a period of adversity or shock remains
contentious. For an opposing hypothesis, see Kendix, op.
cit. For a balanced and wide-ranging discussion of the role
of such institutions in economic development, see Bonser
(1995). For an in-depth discussion of state and local
government development initiatives and concepts in the
1980s, see Eisinger (1988).
27
For example, see Ameritrust Corporation (1994), Wisconsin Strategic Development Commission (1985), Iowa
Business Council and Federal Reserve Bank of Chicago
(1987), and the Commercial Club of Chicago (1984).
15
See Aguilar and Singer (1995) and David Walters’
comments in Federal Reserve Bank of Chicago (1996d).
16
Walters, ibid.
28
To understand and facilitate compliance with urban
ozone regulations, the Lake Michigan Air Directors
Consortium has been studying regionwide atmospheric
chemistry; see Gerritson (1993).
17
The share of production has slipped during 1996. Some
analysts partly attribute this slippage to the climbing value
of the dollar versus the yen. See Meredith (1997).
29
The Council of Great Lakes Governors has been active
in shaping the new environmental guidance for protecting
the basin’s water quality. See DRI/McGraw Hill (1993).
18
Hervey and Strauss (1996) constructed foreign currency
measures against the dollar that are specific to the Midwest’s export composition. They found that the Midwest’s
export success has run counter to deleterious trends in the
exchange currencies of the region’s major export destinations. It is likely that the region’s export success derives
14
30
For a review of such efforts, see McNulty (1991).
31
McAlinden, Smith, and Cole (1995).
32
Judy and D’Amico (1997).
ECONOMIC PERSPECTIVES
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Eisinger, Peter K., The Rise of the Entrepreneurial State, Madison: University of Wisconsin
Press, 1988.
Atkinson, Robert, “Technology and the future
of metropolitan economies,” Assessing the Midwest Economy Working Paper Series, No. MA-4,
Federal Reserve Bank of Chicago, 1996.
Federal Reserve Bank of Chicago,
“Midwestern metropolitan areas: Performance
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Baldwin, John, Brent Diverty, and David
Sabourin, “Technology use and industrial transformation: Empirical perspectives,” paper presented at the conference, Technology, Information and Public Policy, held by Statistics Canada at Queen’s University, November 1994.
Bonser, Charles F., ed., Proceedings: The
Role of NGOs in Economic Development,
Bloomington, IN: Indiana University, Institute
for Development Strategies, 1995.
Bournakis, Athanasios, “Energy and environmental issues for the Midwest economy,”
Assessing the Midwest Economy Working Paper Series, No. SP-5, Federal Reserve Bank of
Chicago, 1996.
, “The changing rural economy of
the Midwest,” Assessing the Midwest Economy
Workshop Summary, No. 3, Federal Reserve
Bank of Chicago, 1996b.
, “Work force developments: Issues for the Midwest economy,” Assessing the
Midwest Economy Workshop Summary, No. 4,
Federal Reserve Bank of Chicago, 1996c.
, “Global linkages to the Midwest
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Workshop Summary, No. 6, Federal Reserve
Bank of Chicago, 1996d.
Brown, P.A., and Mine Yücel, “Energy prices
and state economic performance,” Economic
Review, Federal Reserve Bank of Dallas, No. 2,
1995, pp. 13–21.
Gerritson, Stephen, “The status of the modeling of ozone formation and geographic movement in the Midwest,” in Cost Effective Control of Urban Smog, W. Testa, R. Kosobud, and
D. Hanson (eds.), Chicago: Federal Reserve
Bank of Chicago, 1993, pp. 32–42.
Browne, Lynn E., “Can high tech save the
Great Lakes states?,” New England Economic
Review, Federal Reserve Bank of Boston,
November/December 1983, pp.19–33.
Groshen, Erica, and Laura Robertson, “Are
the Great Lakes cities becoming service centers?,” Economic Commentary, Federal Reserve Bank of Cleveland, June 1, 1993.
FEDERAL RESERVE BANK OF CHICAGO
15
Helms, Jay, “The effect of state and local
taxes on economic growth: A time series–cross
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Hervey, Jack, and William Strauss, “A regional export-weighted dollar: A different way
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Holmes, Thomas J., “The effects of state
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Howland, Marie, “Age of capital and regional
business cycles,” Growth and Change, April
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Johnson, Kenneth M., “Recent nonmetropolitan demographic trends in the Midwest,”
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16
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17
Accounting for the federal
government’s cost of funds
George J. Hall and Thomas J. Sargent
The press routinely reports
extraordinarily large government deficits, mainly consisting of interest costs, for countries experiencing high rates
of inflation.1 For example, the New York Times
reported that in 1993 Brazil’s government deficit
was 30 percent of the country’s gross domestic
product (GDP).2 Most of this deficit was accounted
for by interest costs. In the late 1980s, less
dramatic but still large government interest
costs (around 12 percent of GDP) were reported
for Italy. These large ratios are computed by
dividing a government’s nominal interest payments by nominal GDP. Financial specialists
know such figures to be substantial overstatements because they fail to account for the real
capital losses that government creditors experience during high inflation.3
Every year, an equally flawed ratio is
reported in the federal budget of the United
States. Figure 1 reports these official interest
expenses as a percent of federal outlays over
the period 1960 to 1995.4 The figure displays
the well-known 1980s growth in interest payments as a fraction of outlays, a hallmark of
Reaganomics. Figure 2 displays our corrected
estimates of federal interest expenses as a fraction of federal outlays. Compared with the
official numbers, the true figures are much
more variable, and lower on average.
It is timely to note that section 7 of the
recently proposed balanced budget amendment
explicitly includes the official interest payments
on the federal debt as expenditures. 5 We are
not necessarily suggesting that the framers of
the amendment are unaware that this measurement is flawed from an purely economic standpoint. The current measure tends to overstate
18
interest payments more the higher the inflation
rate is. By including the official measure of
interest costs, the amendment’s framers may
intend to add incentives to lower both inflation
and expenditures.
This article describes and defends our
corrections to the official series. After showing
how to do the accounting correctly, we calculate how the interest costs of the government
would have been affected had it used a different
debt-management strategy. We simulate the
consequences of particular versions of shorts
only and longs only debt-management policies,
two classic policies that have been advocated.
A flawed measure of the government’s
cost of funds
When investors compute the real return
on an equity or debt investment, they take into
account dividend and coupon payments, the
change in price of the stock or bond, and the
effect of inflation on the general price level.
So should the government in accounting for
its interest costs to the public.
In each time period, the government repays
its debtholders in two ways: explicitly in the
form of coupon payments and principal repayments, and implicitly in the form of real capital
gains on outstanding debt stemming from the
diminished term to maturity of the debt, interest
rate changes, and inflation. To measure the
government’s cost of funds, one must account for
George J. Hall is an economist at the Federal
Reserve Bank of Chicago. Thomas J. Sargent is a
senior fellow at the Hoover Institution at Stanford
University, the David Rockefeller Professor of
Economics and Social Sciences at the University
of Chicago, and a consultant to the Federal Reserve
Bank of Chicago.
ECONOMIC PERSPECTIVES
FIGURE 1
Net interest costs as a share of
government spending
percent
20
10
0
-10
1960
’65
’70
’75
’80
’85
’90
’95
Source: U.S. Department of Commerce, Bureau of
Economic Analysis, National Income and Product
Accounts, various years.
the capital gains and losses on all outstanding
Treasury securities.
The federal government reports an incorrect measure of its cost of funds. It records an
imperfect measure of its explicit interest costs
and ignores its implicit interest costs. The
government computes its cost of funds by forming the sum of current coupons on long-term
FIGURE 2
Total cost of funds and interest costs
as a share of government spending
coupon bonds and the appreciation on shortterm discount bonds.6 This measure of the
government’s cost of funds, shown in figure
1, is a remarkably smooth series, and it is
always positive.
The following example illustrates how the
government’s methodology mismeasures its
cost of funds. Consider two bonds that would
raise the same value for the government at time
t = 0, assuming no uncertainty and a constant
real interest rate, r. One is a pure discount
(zero-coupon) bond with ten periods to maturity, paying off P0 at time 10; the second is a
coupon bond with coupon c, paying off P1 at
time 10. From the net one-period interest rate we
can compute the discount factor, 1/(1 + r). The
value of the pure discount bond p0(t) satisfies
p0(t) = (1 + r)–1p0(t + 1), for t = 0, 1, . . . , 9,
where p0(10) = P0. Evidently, for the pure
discount bond, interest accrues through the gradual appreciation in the value of the bond from
p0(0) = (1 + r)–10 P0, at time 0 to p0(10) = P0 at
time 10. The rate of appreciation equals the
gross interest rate:
1+r =
.
p0(t)
The value p1(t) of the coupon bond satisfies
p1(t) = c + (1 + r)–1 p1(t + 1), t = 1, . . . , 9 and
p1(0) = (1 + r)–1p1(1), where p1(10) = P1. The
interest rate satisfies
1) 1 + r =
percent
20
p0(t + 1)
c
p1(t)
+
p1(t + 1)
p1(t)
for t = 1, . . . , 9.
10
Interest cost
0
Cost of funds
-10
1960
’65
’70
’75
’80
’85
’90
Note: The cost of funds was calculated using equation 5.
Sources: Authors’ calculations and U.S. Department of
Commerce, Bureau of Economic Analysis, National
Income and Product Accounts , various years.
FEDERAL RESERVE BANK OF CHICAGO
’95
For coupon bonds of finite maturity with a
principal payment at the end (really a last big
coupon), interest payments (that is, the left-hand
side of equation 1) include more than the coupon. Hence, it is not appropriate to measure the
interest costs associated with coupon bonds by
simply adding up the coupons due this period.
Indeed, coupon payments do not represent pure
interest in an economic sense; they are partly a
repayment of principal. Furthermore, part of the
return to investors, and of the cost to the issuer,
is in the form of capital gains or losses on bonds
as time passes. Any bond with a large final
19
payment is partly a pure discount bond with a
significant portion of its return coming in the
form of capital gains or losses over time.
Our example indicates some but not all
of the corrections that we want to make in the
government’s accounting for its interest costs.
The other adjustments have to do with the treatment of inflation, the time variation in interest
rates, and the existence at any moment of a
variety of bonds with various coupon schedules
and maturities. Next we expand our example to
incorporate all of these features and show how
to do the accounting properly.
Doing the accounting right
We can build a system for properly counting
the government’s real interest costs by carefully rearranging the government’s period by
period budget constraint. We manipulate the
budget constraint algebraically to isolate explicit and implicit interest expenses. Explicit
interest expenses are the real capital gains on
one-period discount bonds; implicit interest
expenses are the capital gains to the public
from holding longer term bonds.
First we need to convert nominal yields
to maturity on government debt into prices of
claims on future dollars in terms of current
goods. The modern theory of the term structure
of interest rates prices a coupon bond in three
steps: 1) viewing the coupon bond as a bundle
of pure discount bonds; 2) unbundling it into
the constituent pure discount bonds and valuing
these components; and 3) adding up the values
of the components to attain the value of the
bundle. The theory thus strips the coupons
from the bond, and prices the bond as though
it is a weighted sum of pure discount bonds of
maturities 1, 2, . . . , j. (The market and the
government have followed theory: pre-stripped
zero-coupon bonds, or STRIPS, themselves are
available in the market.)
Let sjt be the number of dollars at time t + j
that the government has promised to deliver, as
of time t. To compute sjt from historical data,
we have to add up all of the dollar principalplus-coupon payments that the government has
promised to deliver at date t + j as of date t.
Let ajt be the number of time t goods that
it takes to buy a dollar in time t + j. We work
with a real (inflation-adjusted) price, ajt, denominated in units of time goods (so-called dollars
of constant purchasing power) and not time t
dollars, because we want to keep track of the
20
government accounts in real (in goods) terms.
We can calculate the prices ajt from
2) ajt =
νt
(1 + ρjt ) j
,
where νt is the value of currency (the reciprocal of the price level, measured in goods per
dollar), and ρjt is the yield to maturity on a
j-period pure discount bond.7 Equation 2 tells
how to convert the yield to maturity ρjt on a
j-period nominal pure discount bond into the
real price of a promise, sold at time t, to one
dollar at time t + j.
Let deft be the government’s real net-ofinterest budget deficit, measured in units of
time t goods. We can write the government’s
time t budget constraint as:
n
3)
a s
Σ
j=1
jt jt
n
=
a
Σ
j=1
s
j–1,t j,t–1
+ deft ,
where it is understood that a0,tm ≡ νt and n denotes
the longest years to maturity for bonds.8 The
left-hand side of equation 3 is the real value of
the interest bearing debt at the end of period t,
determined by multiplying the number of time
t + j dollars that the government has sold in the
form of j period pure discount bonds, sjt, by
their price in terms of time t goods, ajt, and then
summing this product (or value) over all such
outstanding bonds, j = 1, . . . , n. The right side
of equation 3 is the sum of the current net-ofinterest real deficit, deft, and the value of the
outstanding debt that the government owes at
the beginning of the period, which in turn is
simply the value this period of the outstanding
promises to deliver future dollars, sj ,t–1, that the
government issued last period.
Equation 3 can be rearranged to take the form
n
4)
a s
Σ
j=1
jt jt
n
=
(a
Σ
j=1
j–1,t
– aj,t–1)sj,t–1 +
n
a
Σ
j=1
s
j,t–1 j,t–1
+ deft .
These two forms of the budget constraint
are algebraically equivalent. We have remarked how equation 3 expresses the real
value of total debt with which the government
n
leaves a period t, Σ j=1 ajt sjt as the sum of the
real value of obligations with which it enters
ECONOMIC PERSPECTIVES
FIGURE 3
Capital gains on zero-coupon bonds
unit cost
0.15
0.10
7-year
0.05
1-year
-0.00
-0.05
14-year
-0.10
1960
’65
’70
’75
’80
’85
’90
’95
Note: Capital gains are calculated per unit on a year t +
j – 1 dollar, as of date t, measured in time t dollars. The
authors converted the capital gains to current dollars
by multiplying aj – 1, t – aj,t – 1 by the time t price level, vt–1.
the period, Σj=1 aj–1, t sj,t–1, and the government’s
net-of-interest deficit, deft. Equation 4 breaks
the first term on the right side of equation 3
into an interest component and a previous
value component. Again, the left-hand side of
the budget constraint in equation 4 is the real
value of government debt that the government
has outstanding at the end of period t. The first
term on the right-hand side of the budget constraint in equation 4 represents interest on the
government debt, and can be decomposed as
n
occur during periods of rising inflation or rising
interest rates. Second, the capital gains and
losses of bonds of different maturities move
together. So the government could not have
eliminated the inflation and interest rate risk
inherent in its portfolio by manipulating the
maturity structure of the debt. Third, the longer
the maturity of the bond, the greater the volatility
of the capital gains. Increasing (or decreasing)
the average maturity of the outstanding debt
increases (or decreases) the government’s and
the public’s exposure to inflation and interest
rate risks.
In figure 4 we report our breakdown of the
total interest costs on the marketable federal
debt between explicit and implicit real interest
costs. In general, the explicit interest costs were
relatively small and relatively constant from
1960 to 1995. In contrast, the implicit interest
costs were substantial, variable, and often negative. Since the real value of the outstanding debt
was growing over this period, sjt was growing
over time. So the per dollar capital gains are
being multiplied by increasingly large numbers.
Thus the implicit interest cost became more
volatile throughout the sample period.
We compute the total interest costs born
by the federal government by simply adding
up the explicit and implicit interest costs. Total
interest costs as a percent of government outlays
are plotted in figure 2. The explicit, implicit,
and total interest costs, as well as the total debt
outstanding, in millions of 1983 dollars are
reported in table 1. In contrast to the Treasury’s
n
5) (νt – a1,t–1)s1,t–1 + Σ (aj–1,t – aj,t–1)sj,t–1.
j=2
The first term in equation 5 is explicit interest
and the second term is implicit interest or the
capital gain to the public on its claims on the
government. Thus, the term νt – a1, t–1 is the per
dollar real capital gain accruing to one-period
discount bonds issued at time t – 1. The term
aj–1, t – aj, t–1 is the change in the price in terms
of goods between t – 1 and t of a claim to one
dollar in time t – 1 + j; multiplying this change
in price by the dollar value of time t – 1 + j claims
outstanding, sj,t–1 at time t – 1, and summing over j
gives the capital gain to the public.
These capital gains are not trivial. In figure 3
we plot the per dollar nominal capital gains,
n
Σj=1(aj–1,t – aj,t–1), for one-year, seven-year, and
14-year zero-coupon bonds. There are three
things to note. First, capital losses can be quite
large, and they occur frequently. These losses
FEDERAL RESERVE BANK OF CHICAGO
FIGURE 4
Real interest costs
percent
20
10
Explicit
costs
0
Implicit costs
-10
1960
’65
’70
’75
’80
’85
’90
’95
Sources: See figure 2.
21
TABLE 1
Federal government’s interest costs
in millions of 1983 dollars
Year
Explicit
Implicit
Total
1960
1961
1962
1963
1964
1965
1966
1967
1968
1969
1970
1971
1972
1973
1974
1975
1976
1977
1978
1979
1980
1981
1982
1983
1984
1985
1986
1987
1988
1989
1990
1991
1992
1993
1994
9,358
4,886
5,484
3,916
7,536
5,809
4,523
5,370
3,440
2,027
6,780
5,174
2,501
–9,354
–13,212
–3
3,596
–4,796
–5,321
–6,629
–2,081
10,887
27,383
18,009
23,430
24,336
31,339
7,496
12,637
19,623
6,981
20,768
7,037
5,884
6,882
0
3,863
10,142
394
7,593
–2,738
3,325
–7,843
–3,733
–7,477
13,596
8,640
–1
–7,662
–9,568
539
10,573
–10,077
–16,504
–17,580
–17,979
–3,618
57,556
8,730
37,918
87,049
101,356
–20,884
19,428
73,032
12,851
105,116
40,695
90,648
–73,186
9,358
8,748
5,626
4,310
15,129
3,071
7,848
–2,472
–293
–5,449
20,376
13,813
2,500
–17,016
–22,780
536
4,169
–14,874
–21,825
–24,208
–20,060
7,269
84,939
26,739
61,349
111,385
132,696
–13,388
32,066
92,655
19,832
125,884
47,732
96,532
–66,304
1995
28,537
173,862
202,399
Evaluating alternative portfolio
strategies
Assuming that postwar U.S. interest rates
had remained unchanged, how would
the government’s interest expenses have been
affected if it had followed a different debtmanagement policy? If we restrict the government to issuing from its historically observed
menu of instruments, this question can be
answered by mechanical calculations. We
compose alternative hypothetical portfolio
strategies, and track the net costs the government would have incurred at historically realized interest rates.10 Below we describe how
these costs can be calculated, and perform
some of these calculations.11
Given historical time series data on {ajt , sjt ,
deft , νt}Tt=t 0 we can use equations 4 and 5 to
account for interest payments on the government debt. Given {ajt , deft, νt}Tt=t 0, we can evaluate the effects on the government budget of
portfolio strategies {sjt}Tt=t 0 other than the historical one. These alternative portfolio strategies
must be constructed to respect the government
budget constraint in equation 3.
The alternative strategies are:
1. Shorts only: Set sjt = 0 for j > 1, ∀t.
2. Tens only: Set sjt = 0 for j ≠ 10, ∀t.
3. Longs only: Set sjt = 0 for j < n, ∀t, where n
is the longest bond priced by the McCulloch
and Kwon (1993) dataset.
The first and third policies represent the
poles of proposed debt-management policies.12
For an economy with only nominal interest
bearing debt, the class of feasible financing
rules is
akt skt
calculations plotted in figure 1, our computed
costs of funds are quite volatile.9 These costs
were negative during periods of large capital
losses in the Treasury bond market (for example,
the high inflation episodes of the 1970s and the
dramatic fall in bond prices in 1994).
Ultimately how volatile the federal government’s interest costs are depends on how
the government shares inflation risk and interest rate risk with the public. The Treasury and
the Federal Reserve can alter this risk-sharing
arrangement between the government and the
public by manipulating the maturity structure
of the outstanding debt. To illustrate this, we
run three counterfactual portfolio strategies.
6)
22
ECONOMIC PERSPECTIVES
n
deft + Σ aj–1,t sj,t–1
= fk t ,
j=1
and
n
7)
Σf
k=1
kt
= 1.
In words, fkt is the fraction of the outstanding
debt at time t that is due at time t + k.
Restrictions in equations 6 and 7 are algebraic implications of the government budget
n
constraint in equation 3. Let Σ j=1 aj–1,t sj,t–1 ≡ Vt
be the value of interest bearing government
debt at the beginning of period t. Given a
policy fkt, k = 1, . . . n, together with observed
interest rates, equation 5 can be solved for
skt, k = 1, 2, . . . n:
skt =
fkt
(a ) (def + V ).
t
t
kt
This equation can be solved recursively
to build up records skt and decompositions of
interest cost under alternative hypothetical
debt-management rules.
The first two policies fall into the set of
simple rules that are time invariant, that is,
fit = fj ∀ t .
For the bills only policy, f1t = f1 = 1 and
fkt = fk = 0 for all k ≠ 1. For the tens only policy
f10t = f10 = 1 and fkt = fk = 0 for all k ≠ 10. Our
third policy, longs only, is a time varying policy,
which depends on the maturity of the longest
bond outstanding each year during our sample
period. For each of these policies, the entire
debt is purchased and resold to make sure all
the debt is held in either one-year bills, ten-year
zero-coupon bonds, or n-year zero-coupon
bonds (depending on the experiment).
For any feasible specifications of fjt , we
can evaluate the implicit and explicit interest
costs of financing a stream of government
deficits. Our three policies will have quite
different effects, largely through the behavior
of the value of currency, νt.
December observation of each year to create
the annual pt series.
The yield to maturity series, ρjt, is constructed by point sampling end-of-month data
from McCulloch and Kwon (1993) and Bliss
(1996) containing the zero-coupon yield curve
implicit in U.S. Treasury coupon bond prices.
Hence ρjt is the yield to maturity on a j-period
pure discount bond as of December 31 of year t.
We calculate the prices, ajt, using equation 2:
ajt =
νt
,
(1 + ρjt )j
where j = 1, 2, . . . , 30 and t = 1960, . . . , 1995.
In constructing our counterfactual debtmanagement figures, we use equations 4 through
7 with the appropriate time-invariant fit. We imputed
the real net-of-interest deficit series, deft, from the
government budget constraint, equation 3, using
the actual ajt and sjt series.
The results
Below, we discuss some of the properties
of the actual sjt and fjt series, review the historical paths for inflation and the term structure of
interest rates, and report the results of our
experiments.
Figure 5 shows the average maturity for
our calculated sjt series. Its variations generally
match those of the average maturity of the
federal debt series reported by the Treasury,
though the levels differ. We believe there are
The data
The sjt series are computed using data from
the CRSP Government Bonds Files. For each
Treasury note and bond outstanding, CRSP
reports the maturity date, the coupon rate, and
the face value held by the public. The original
source for these data is table PDO-1 of the Treasury Bulletin. Since neither the Treasury Bulletin
nor CRSP reports the face value of Treasury
bills held by the public, these data are backed
out of table FD-5 of the Treasury Bulletin. All
data are as of December 31 of each year.
The value of the currency, νt, is computed by:
100
νt = p ,
t
where pt is the price level. The price level is
the monthly series CPI—all items, from the
Bureau of Labor Statistics. The base for the
CPI series is 1982–84 = 100. We sample the
FEDERAL RESERVE BANK OF CHICAGO
FIGURE 5
Average maturity of constructed
pure discount bonds
years
5
4
3
2
1
1960
’65
’70
’75
’80
’85
’90
’95
23
FIGURE 6
FIGURE 7
Maturities of federal debt due in j years
percent
100
1975
Inflation rate
percent
15
1965
75
10
50
5
1995
25
0
5
10
15
20
25
30
0
1960
’65
’70
’75
’80
’85
’90
’95
Sources: U.S. Department of Labor, Bureau of Labor
Statistics and Federal Reserve Board of Governors.
some problems the Treasury’s series (for example, it confines itself to marketable securities only after 1975) and prefer our methodology of reducing each bond to a zero-coupon
basis by allocating coupons to the year in
which they fall due.
The average maturity falls from the mid1960s to 1975 and rises steadily for about
thirteen years before leveling off at four years
for the last seven years of the sample. The
steady fall in the average maturity during the
late 1960s and early 1970s is partly the consequence of federal legislation, repealed in
1975, which prevented the Treasury from
issuing long-term instruments paying interest
above a threshold rate that market rates were
then exceeding. As we shall see, by causing
the Treasury to shorten the average maturity
of its debt during the high inflation years of
the 1970s, this law prevented the government
from fully benefiting from the negative implicit real interest it managed to pay through
inflation.13
Figure 6 plots the percentage of the federal
debt due within j years for 1965, 1975, and
1995. This figure was constructed by taking a
cumulative sum of the observed f jt series for
each of the three years. Throughout the period
we studied, the federal debt was heavily
weighted toward securities with maturities of
one year or less. In 1995, almost 40 percent of
the government’s portfolio was due within one
year. Only a tiny fraction of the federal debt is
financed with long-term bonds.
24
Figure 7 plots the percentage change in the
price level, the inflation rate, and is dominated
by the high inflation rates of the 1970s. The
spread between the ten-year bond rate and the
one-year bond rate is plotted in figure 8. When
this difference is positive, the yield curve is
upward sloping. When it is negative, the yield
curve is inverted. In general, the inflation rate
and the slope of the term structure moved in
opposite directions. The yield curve tended to
FIGURE 8
Ten-year rate minus one-year rate
basis points
400
200
0
-200
1960
’65
’70
’75
’80
’85
’90
’95
Source: J. McCulloch and H. Kwon, “U.S. term structure
data, 1947–1991,” Ohio State University, working paper,
No. 93-6, 1993; and R. Bliss, “Testing term structure
estimation methods,” Advances in Futures and Options
Research, 1996.
ECONOMIC PERSPECTIVES
FIGURE 9
FIGURE 10
Interest as a share of total government
expense, bills only
Marketable debt as a share of gross
domestic product, bills only
percent
20
percent
45
10
30
Bills only
interest
Bills only
marketable debt
0
15
Total
marketable debt
Total interest
-10
1960
’65
’70
’75
’80
’85
’90
’95
Sources: See figure 2.
flatten or become downward sloping during
periods of rising inflation.
Figures 9 and 10 display the results of our
first experiment: a bills only policy. Figure 9
shows that the realized total real interest (explicit
plus implicit) would have been somewhat
higher during the late 1960s and most of the
1970s under the bills only policy than under
the actual policy followed. During the late
1960s the yield curve was inverted, so longterm rates were below short-term rates. But,
more importantly, the high inflation of the
1970s substantially decreased the real value
of the federal government’s outstanding obligations.14 However, this pattern reversed in the
early 1980s; in the second half of the sample,
as inflation fell and the yield curve became
consistently upward sloping, the interest costs
under the bills only policy would have been
lower than under the actual policy.
Figure 10 shows that under the bills only
policy the real value of the marketable interestbearing debt would have been higher through
the mid-1980s. But by the end of the period
the real value of marketable interest-bearing
debt would have been lower under the bills
only policy than under the actual policy. Had
the bills only policy been followed, the outstanding debt would have been 34 percent of
GDP. In 1995, the actual debt to GDP ratio
was 41 percent.
FEDERAL RESERVE BANK OF CHICAGO
0
1960
’65
’70
’75
’80
’85
’90
’95
Sources: See figure 2.
Figures 11 and 12 show what would have
been the total real interest costs and the real
value of marketable debt had a policy been in
place of leaving only ten-year bonds outstanding
at the end of each year. Figure 11 shows that
relative to the actual policy, real interest costs
would have been much more variable year to
year and would have been negative for many
years, especially during the inflationary years
of the 1970s. Note that as the size of the federal
debt grew, following such a policy would have
substantially increased the volatility of the
federal government’s cost of funds. Figure 12
shows that under a tens only policy, real government debt would have been 53 percent of
GDP in 1995.
Figures 13 and 14 show the total real interest
costs and the real value of the debt under a
policy of issuing the longest available maturity
(that is, the longest maturity that was actually
priced in McCulloch and Kwon’s (1993) data
set). We see more variable interest costs but
less accumulation of debt under the longs only
policy than under the tens only policy. Note
that in the 1970s, due to the high inflation, the
real value of the outstanding debt would have
been substantially lower under the longs only
than under the actual policy. However, by the
end of the sample period, the ratio of the outstanding debt to GDP under the longs only
policy would have been considerably higher
than the ratio under the actual policy.
25
FIGURE 11
FIGURE 12
Interest as a share of total government
expense, tens only
Marketable debt as a share of gross
domestic product, tens only
percent
50
percent
60
25
40
Total
interest
0
Total
20
Ten-year
bond policy
Tens only
interest
-25
1960
’65
’70
’75
’80
’85
’90
’95
0
1960
Sources: See figure 2.
’65
’70
’75
’80
’85
’90
’95
Sources: See figure 2.
These results indicate that debt-management policies weighted toward longer maturities would have led to lower interest costs and
less accumulation of debt over the period from
1960 to 1980. After 1980, debt-management
policies weighted toward shorter maturities
would have generally lowered interest costs
and led to less accumulation of debt. From
figure 5 it is clear that the Treasury and Federal Reserve reduced the average maturity of
outstanding debt throughout the 1960s and
early 1970s; they then increased the average
maturity during the late 1970s and throughout
the 1980s. Our analysis indicates that to have
minimized its borrowing costs, the government
should have engaged in the opposite strategy.
Of course, with hindsight we could have
found the portfolio-share policy that would have
minimized the government’s cost of funds.
However, the purpose of these counterfactual
FIGURE 13
FIGURE 14
Interest as a share of total government
expense, long bonds only
Marketable debt as a share of gross
domestic product, long bonds only
percent
60
percent
90
60
40
30
Total
interest
Total debt
0
20
-30
-60
1960
’65
’70
Sources: See figure 2.
26
Longs only
debt
Longs only
interest
’75
’80
’85
’90
’95
0
1960
’65
’70
’75
Sources: See figure 2.
ECONOMIC PERSPECTIVES
’80
’85
’90
’95
exercises is not to engage in “Monday morning
quarterbacking” but to illustrate how the maturity structure of the debt affects how the government and bondholders share inflation and
interest rate risk.
Moreover, caution is in order in interpreting the results of an evaluation of a counterfactual debt-management policy. Interest rates are
a random process, and the result of following
a given strategy is too. What most drives the
outcome of our counterfactual exercises is the
outcome for inflation. In issuing nominal securities, the government is offering the public a
risky instrument whose real return is sensitive
to the rate of inflation over the life of the bond.
Our results indicate that from 1960 to 1995,
inflation came in high with sufficient frequency
to let the government often pay negative real
interest and sometimes substantially negative
real interest. These high inflation rates make
the longer maturity portfolio policies come in
with lower interest costs during the 1970s.
Clearly, the outcome would have been different had inflation come in much lower.
Conclusion
This article makes two points. First, the
federal government reports a flawed measured
of its own cost of funds. Second, the maturity
structure of the debt influences the way inflation risk and interest rate risk are shared by the
government and its creditors.
The first point is not just nit-picking. By
ignoring the effects of inflation and changes
in interest rates on the value of the outstanding
federal obligations, the official interest payment calculations make it difficult to evaluate
the true cost of various proposals. For example,
the introduction of index bonds will change
how the government shares inflation risk with
its creditors since the government can not
induce capital losses on these bonds through
inflation. How these bonds can be expected
to influence to government’s cost of funds is
beyond the scope of this paper; but it should be
clear that the Treasury’s accounting methods
are inappropriate for evaluating the costs of
these new bonds.
The second point is a word of caution regarding periodic calls for the Treasury to “painlessly pare billions from its interest bill by refinancing the government’s existing debt with
bonds that mature more quickly.”15 While our
counterfactual experiments demonstrate that
shortening (or lengthening) the average maturity
of the U.S. debt can at times save the Treasury
billions of dollars, these savings depend on the
future paths of interest rates and inflation—two
series which are notoriously hard to predict.
And if the government bets the wrong way, the
mistake can be quite expensive.
NOTES
1
This article extends estimates and arguments from Sargent (1993).
2
See the article by Nash (1993).
3
See Ljungqvist and Sargent (1997) chapter 8, exercise 1;
and Blanchard and Sachs (1981).
8
See Sargent and Wallace (1981) for a discussion of this
form of the government budget constraint, in particular
for a defense of the use of pre-tax real yields on government debt and a net of interest government deficit. Sargent and Wallace use a ‘crowding out’ assumption to
justify the use of pre-tax yields.
9
4
The series plotted is net interest paid by the federal
government from the National Income and Product
Accounts. The figure displays a series which is remarkably smooth and always positive.
5
The Treasury’s calculations include some assets (chiefly
savings bonds and some securities issued to state and
local governments) that are not included in our analysis.
So these two graphs are not strictly comparable. Nevertheless, we expect that adding these assets to our analysis
would not change the results in any meaningful way.
See H.J. Resolution 1, 105th Congress, 1st Session.
10
6
The Department of the Treasury calculates the net interest as the sum of coupon payments, accrued interest on
bills and zero-coupon bonds, and interest on nonmarketable debt.
Under the assumption that historical interest rates would
have been unaffected by the switch in debt policy, this
accounting exercise involves no use of economic theory.
To infer the government’s costs had it issued different
assets, for example indexed bonds, we would need a
theory about the price of pure discount indexed bonds.
7
We use the yield to maturity series for pure discount bonds
constructed by McCulloch (1990) and McCulloch and
Kwon (1993). These data were updated by Bliss (1996).
FEDERAL RESERVE BANK OF CHICAGO
11
The standard theory of the term structure of interest rates
assumes that interest rates on all maturities would be
27
unaffected by alterations in the maturity structure of the
government’s debt. This assumption can be justified by
appealing to the logic of the Modigliani-Miller theorem
from finance.
13
This is the type of law that Missale and Blanchard
(1994) suggest as a device that governments with a large
ratio of debt to gross domestic product use to assuage
investor inflation fears by reducing the government’s
returns from inflation.
12
Actually, not quite the extreme poles. Milton Friedman
(1948) advocated the policy that the government finance
its deficits and surpluses only by issuing or retiring currency. This is a ‘shorts only’ policy in which only j = 0
maturity debt is issued. At the other end of the spectrum,
the classic British policy was to issue only consoles,
which are infinite maturity bonds, which amount to an
infinite stream of pure discount bonds, one for each date
in the future.
14
Recall that a Treasury bond is a promise to pay a certain
number of nominal dollars at a future date. When inflation
increases, the real value of those nominal dollars falls.
15
The quote is from Blinder (1992). Also see Forsyth
(1993) and Passell (1993).
REFERENCES
Blanchard, Olivier Jean, and Jeffrey Sachs,
“There is no significant budget deficit,” New
York Times, March 6, 1981, p. 26.
McCulloch, J. Huston, and Heon-Chul Kwon,
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State University, working paper, No. 93-6, 1993.
Blinder, Alan, “Let’s start the new year by
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13, 1992, p. 18.
Missale, Alessandro, and Olivier Jean Blanchard, “The debt burden and debt maturity,”
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28
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