Full text of Economic Perspectives (Federal Reserve Bank of Chicago) : March/April 1992, Volume XVI, Issue 2

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MARCH/APRIL 1992

ECONOMIC PERSPECTIVES
A review from the
Federal Reserve Bank
of Chicago

D eterm ining m argin for futures
co n tracts: the role of private interests
and the relevance of e x ce ss volatility
State and local governm ents'
reaction to recession




A
FEDERAL RESERVE BANK
OF CHICAGO

Contents
D eterm ining m argin for futures
co n tracts: the role of private interests
and the relevance of e x ce ss v o la tility........................................................2
Jam es T. M oser

Do lower margin levels cause increased stock
price volatility? The author argues against this
view and suggests that a different theory may
explain the relation between margin levels and price
volatility: futures exchanges raise margin levels
when volatility increases, in order to compensate
for their increased risk.

State and local governm ents'
reaction to re ce ssio n ...................................................................................... 19
Richard H. M atto o n
and W illiam A . Testa

During economic contractions, state and local
governments often manage to maintain spending
in the face of decreased revenue growth and
requirements to balance their budgets. The authors
explain how they do it.

ECONOMIC PERSPECTIVES

March/April 1992 Volume XVI, Issue 2

Karl A. Scheld, Senior Vice President and
Director of Research

ECONOMIC PERSPECTIVES is published by
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studies, Herbert Baer, financial structure and regulation,
Steven Strongin, monetary policy,
Anne Weaver, administration
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ISSN 0164-0682

Determ ining m argin for futures contracts:
the role of private interests and the
relevance of excess volatility

Jam es T. M oser

Margins should be made con­
sistent to control speculation
and financial leverage.
—Brady Report
On Monday, October 19, 1987, the Dow
Jones Industrial Average declined 508 points.
The marketplace on the following day is usual­
ly described as melting down. This analogy to
a runaway nuclear reaction reflects the fear
during the morning hours of October 20, 1987
that overheated trading activity had over­
whelmed trading systems. Studies were com­
missioned to investigate the events of these two
days and to propose remedies. One of these
studies, the Brady Report, recommends raising
margins on stock index futures contracts in
order to reduce the chances of a future financial
meltdown.1
Support for the higher margins proposed by
the Brady Report stems from the view that low
margins result in greater speculation which, in
turn, leads to greater volatility. According to
this view, volatility produced by speculative
trading can be controlled by regulating margin.
I call this view the Excess Volatility Argument.
Another explanation of the link between vola­
tility and margin levels is founded on the recog­
nition that stock and futures exchanges face
increased risk when stock market volatility
increases. According to this view, stock and
futures exchanges raise margin levels when
volatility increases in order to compensate for
the increased risk. I call this view the Pruden­
tial Exchange Hypothesis.


2


This article examines the relation between
volatility and margin levels in order to assess
the plausibility of the Excess Volatility Argu­
ment and the Prudential Exchange Hypothesis.
The next section discusses the private interests
involved in setting margin levels and their
relevance to the justification of the Prudential
Exchange Hypothesis. The Excess Volatility
Argument is critiqued in the following section.
Analysis of the theory underlying the Excess
Volatility Argument, a review of existing evi­
dence on the links between margin and volatili­
ty, and new tests of the theory all fail to support
the proposition that raising margins leads to
reductions in volatility. Evidence for the Pru­
dential Exchange Hypothesis is mixed. Tests
relating margin changes to previous levels of
volatility fail to confirm the hypothesis. A
cross-sectional approach to test this hypothesis
is introduced and some preliminary results are
reported. Conclusions concerning the Pruden­
tial Hypothesis and the Excess Volatility Argu­
ment are summarized in the last section of the
article.
P riva te in tere sts in d e te rm in in g
m arg in re q u irem e n ts

According to the Prudential Exchange
Hypothesis, stock and futures exchanges both
have an interest in managing their exposure to
James T. Moser is a senior econom ist at the Feder­
al Reserve Bank of Chicago. The author is indebted
to Janet Napoli and Jeff Santelices fo r research
assistance. Comments from Herbert Baer, Ramon
P. DeGennaro, Douglas Evanoff, Virginia Grace
France, Carolyn McMullen, Janet Napoli, and
Steven Strongin have been especially helpful.

ECONOMIC PERSPECTIVES

risks from trades routed through their exchange.
Margins are an important means to this end.
However, the nature of the risk in stock and
futures markets differs hence, margin require­
ments play different roles in stock and futures
markets. The next two subsections develop this
distinction.
The role of private interests in
determining stock margin

In stock markets, brokerage firms some­
times lend money to investors for the purchase
of stock (see Box 1 for an explanation of how
margin lessens the risk of stock brokers). Lend­
ing benefits brokerage firms because it increas­
es trading, thus increasing revenues from bro­
kerage fees. The risk inherent in lending is
controlled by collateralizing these loans with
stock. Brokerage firms further reduce risk by
requiring investors to pay a portion of the pur­
chase price in cash. The amount of cash put up
by the investor in a leveraged stock transaction
is called margin. In particular, the amount of
cash required when the position is initiated—
the “down payment”—is referred to as the
initial margin.2
Margin loans expose brokers to the risk
that a stock price decline will produce losses in
excess of the amount of posted margin. This
risk increases both as the degree of leverage in
the position increases and as the volatility of
stock—the collateral—increases. Prudence
motivates brokers to closely examine the ability
of investors holding margined positions to
cover their debt obligations. Increasing margin
reduces the risk taken by the broker’s extension
of credit. Thus, it is in the broker’s interests to
require a prudential level of margin.
The interests of the broker also include fees
from trades executed on behalf of his or her
customers. Lending facilitates trading by
increasing the size of positions which can be
held given the investor’s level of cash. Higher
margins result in smaller loans, hence lower
trading levels, other things equal. Thus, in­
creasing margins lessens brokerage fee income.
Stock brokers set margin by considering both
risk and profit, choosing the level of margin
which is expected to yield a competitive return
for the level of risk.
Stock exchanges take the interests of bro­
kers into account when setting limits on margin
lending. Exchanges consistently acting against
the interests of their brokers lose business as


FEDERAL RESERVE


BANK OF CHICAGO

brokers find more favorable routes for trades.
Thus, the Prudential Exchange Hypothesis
predicts that a stock exchange sets margin lev­
els which are consistent with the interests of
stock brokers affiliated with the exchange.
These interests, as previously identified, lead to
levels of margin which balance revenues from
trading activity with the risk of losses on credit
extended to clients.
The role of private interests in
determining futures margin

Determination of margin requirements for
futures contracts raises concerns which are
similar to those of the stock broker. Like stock
brokers, futures exchanges, acting on behalf of
their members, set futures margins to control
their risks. However, the risks faced by the
stock broker and the members of the futures
exchange are not identical. In this section, I
use a hypothetical futures contract on a stock
index to develop the role of margin for futures
positions.
Futures contracts trade on a variety of
assets. Examples are contracts on wheat, fro­
zen pork bellies, foreign exchange, Treasury
bonds, and stock indexes. Contracts are distin­
guished by the price of the asset or commodity
used to determine payments to the parties in the
contract. As an example, consider the follow­
ing hypothetical contract. Over the next three
months, for every point the Standard and Poor
(S&P) 500 rises from its present level, Mr.
Short will pay Ms. Long $1,000. For every
point it falls from this level, Ms. Long will pay
Mr. Short $1,000.3
Mr. Short and Ms. Long are referred to as
counterparties in the futures contract. The
counterparties are further identified as holding
the long or short side of the contract. In this
contract, Ms. Long holds the long side, which
commits her to make payments when the fu­
tures price falls and entitles her to receive pay­
ments when the price rises. Conversely, Mr.
Short holds the short side, which entitles him to
receive payments when the futures price falls
and commits him to make payments when the
price rises. Payments between the counterpar­
ties are determined by marking the contract to
the current price of other futures contracts on
the same underlying basket of commodities or
assets. This mark-to-market procedure is con­
ducted daily. Futures contracts feature terms
serving two purposes. First, contract terms

3

determine the usefulness of contracts. Second,
contract terms enable the exchange to manage
customer insolvency problems.
Futures are useful as low cost substitutes
for transactions in the underlying asset. To see
this, note that by carefully specifying a particu­
lar group of assets for determination of the final
settlement price, the futures price will move
closely with the price of the asset group. Thus,
changes in the futures price for the S&P 500 are
closely linked with changes in the prices of the

500 stocks used by Standard and Poor in con­
structing that index. The alignment of these
prices is useful to individuals and firms seeking
low cost means of altering the sensitivity of
their portfolios to price changes.
To see the usefulness of futures contracts,
suppose Mr. Short owns a portfolio of stocks,
many of which are included in the 500 stocks
comprising the S&P Index. This portfolio is
called his cash position to distinguish it from
the futures contract. When the prices of stocks

BOX 1

Leverage, risk, and the role of margin
The relation among leverage, risk, and the role
of margin is most easily illustrated in the case of
stocks. Borrowing to purchase stocks has leverage
implications for both the borrowers (investors) and
lenders (brokerage firms). This point can be illustrat­
ed with a simple T account.
Market value
of shares
purchased

$10,000

$6,000

Loan from
broker

$4,000

Equity
placed
by purchaser

In the example, the initial margin requirement
is 40 percent.1 Stock valued at $100 per share
requires the purchaser of 100 shares to pay $4,000
of their purchase price. The broker lends the pur­
chaser $6,000. This combination of funds produces
$10,000 paid to the seller of the stock.
To see the consequences of leverage for borrow­
ers and lenders, we examine the effect of stock
price changes. First, suppose the stock price rises to
$110. After this price change, the T account looks
as follows:
Market value
of shares
purchased

$11,000

$6,000

Loan from
broker

$4,000

Equity
placed
by purchaser

$1,000

Gain on
stock

Thus, the $4,000 invested has gained $1,000 for
a 25 percent return on invested funds. Had the inves­
tor not purchased the stock on margin; and paid the
full $10,000 for the stock, the rate of return would


4


have been only 10 percent. The margined position
earns 2.5 times the percentage change in stock prices
(2.5 x 10 percent = 25 percent). These gains can
be realized by selling the shares for $ 11,000, repay­
ing the loan balance of $6,000 from the proceeds,
leaving $5,000.
Examining the potential downside from a mar­
gined purchase explains why most stock purchases do
not use margin. Suppose the stock price declines to
$90. Now the T account looks like this:
Market value
of shares
purchased

$9,000

$6,000

Loan from
broker

$4,000

Equity
placed
by purchaser

($1,000)

Loss on
stock

The $4,000 invested results in a loss of $1,000
for a 25 percent loss. Had the purchase price been
paid in cash, the percentage loss would have been
only 10 percent. The alternative way of seeing this
is to recognize that the ability to hold 2.5 times more
shares implies that any losses will be magnified by
2.5. Further, as shown later, equity balances must
be restored when these balances fall below a preset
level. Compliance with this rule may require inves­
tors to sell other asset holdings to meet the call for
additional equity.2 Thus, from the investor’s per­
spective, margined stock purchases lever up risk.
The leverage factor is 1 + Loan/Equity. For the
initial position, this is 1 + 6,000/4,000 = 2.5.
Now consider the above transaction from the
lender’s point of view. The lender will also have an
interest in this leverage factor. Suppose the stock
price declines to $60, so that the T account is:

ECONOMIC PERSPECTIVES

in the portfolio decline, the value of Mr. Short’s
cash position declines. However, his short
futures contract position entitles him to receive
payments from Ms. Long when stock prices
decline. These payments lessen the extent of
losses realized from the cash position. Thus,
futures contracting can reduce an investor’s
sensitivity to price changes. This use of futures
contracts is called hedging.
Ms. Long finds the contract useful for a
different reason. Generally, her cash position

Market value
of shares
purchased

$6,000

$6,000

Loan from
broker

$4,000

Equity
placed
by purchaser

($4,000)

Loss on
stock

The broker faces a problem. Liquidating the
position at its current market value insures that the
outstanding balance of the loan is paid off. Not
liquidating the position puts the broker at risk that
the stock price will decline further and that the inves­
tor will not be able to make up the difference from
other sources. If the latter case occurs, the broker
suffers a loss. The extent of this loss depends on the
additional decline in stock price and the amount the
broker can recover from the other resources of the
investor. Thus, once the investor has lost the equity
in the position, the broker relies on estimates of the
extent of these other sources. To avoid the risk
inherent in these estimates, the broker establishes a
maintenance margin requirement. When the level
of equity falls below the maintenance margin re­
quirement, a call for additional margin is made.
Receipt of the called-for funds decreases the broker’s
reliance on estimates of other sources of wealth.
Once funds are received, the broker’s risk is reduced.
An additional decline in stock price will, with cer­
tainty, be absorbed by the investor up to the new
margin deposit.
’Currently initial margin requirements are 50 percent. The
example uses 40 percent to clarify which portion is required
from the investor (40 percent) and which is lent by the
broker (60 percent).
bankruptcy law prevents access to certain assets to meet
financial obligations.


FEDERAL RESERVE


BANK OF CHICAGO

consists mostly of low risk bonds. At times she
has concluded that stocks are undervalued.
Taking the long side of a futures contract al­
lows her to increase the sensitivity of her port­
folio to changes in stock prices. In particular,
when her assessment that stocks are underval­
ued proves true, she realizes gains from her
futures position. This use of futures contracts is
called speculation.
These uses of futures contracts are a cost
effective means to the respective ends of Mr.
Short and Ms. Long. Both results could be
accomplished using transactions in the stocks
themselves. Mr. Short could reduce his sensi­
tivity to stock price changes by selling stocks
and investing the proceeds in low risk assets
such as Treasury bonds. Ms. Long could in­
crease her sensitivity to stock price changes by
selling some of her bonds and buying stocks.
Each prefers to accomplish his or her respective
end at the lowest possible cost. Futures con­
tracts often provide the least costly route to
adjusting portfolio sensitivity.
However, contracts which are not depend­
able will not be useful. In the stock index fu­
tures contract described above, both Mr. Short
and Ms. Long find the contract advantageous in
the sense that it represents a low cost means of
altering their sensitivities to changes in a broad
measure of the stock market. However, Mr.
Short might regard such a contract as worthless
if he had reason to believe that, should prices
fall, Ms. Long would be unable to make the
required payment.4 Similarly, Ms. Long’s
concerns about Mr. Short’s ability to pay lower
her assessment of the value of such a contract.
Except for this insolvency issue, both find the
contract useful. Thus, each party has an inter­
est in resolving the insolvency problem at rea­
sonable cost.
Resolution of the insolvency problem is the
role of the exchange. Exchanges fulfill this
role by requiring that all contracts clear through
members of the clearing association affiliated
with the respective exchange. In this process,
the clearing association becomes counterparty
to each side of all contracts traded on the ex­
change. Should either the long or short side fail
to perform its obligations, the loss is realized by
the clearing association rather than the original
counterparty. Continuing the above example
and introducing the role of the exchange, sup­
pose the stock market rises ten points. Mr.
Short owes Ms. Long $10,000. If he has be­

5

come insolvent, the contract guarantee assures
that Ms. Long is paid the $10,000.5 This per­
formance guarantee removes the respective
credit risk concerns and focuses the attentions
of the counterparties on contract price. Neither
party finds it necessary to expend resources to
evaluate the credit risk of the other party. This
resolution of the insolvency problem increases
the value of futures contracting for both parties.
Performance guarantees provided to the coun­
terparties are clearly costly. The exchange,
acting to maintain the solvency of its clearing
association, attempts to manage its potential for
loss. This is accomplished by managing the
exchange’s exposure to the credit risk stem­
ming from each participant in the contract.
Management of the exchange’s credit risk uses
an overlapping system of solvency require­
ments, mark-to-market arrangements, and mar­
gin requirements. To see the role of the com­
ponents of this system, I begin with an ideal
characterization of the marketplace, then relax
various assumptions in order to explain how
each of these components is used to manage the
credit risk of a futures exchange.
Evidence of solvency is the first level of
protection. We can see the role of solvency
requirements by imagining an ideal market­
place where monitoring of the wealth of each
party is perfect and continuous. With the addi­
tional assumptions of immediate access to the
wealth of these parties and unlimited liquidity
in markets where assets can be immediately
and costlessly sold off; no counterparty would
be exposed to risk. Under these conditions, at
the instant when a party is determined to be
insolvent, that party’s assets would be immedi­
ately attached, their futures positions closed
out, and assets sold with the proceeds used to
cover shortfalls arising from the futures posi­
tion. Thus, with this characterization of the
marketplace, the exchange avoids all risk of
loss by relying on its legal authority to close out
futures positions as counterparties become
insolvent.
Relaxing the assumption of costless asset
liquidation, the exchange incurs transactions
costs in liquidating positions. This is readily
resolved by applying “haircuts” to asset values
when computing net worth for solvency purpos­
es. That is, the value of each asset in the inves­
tor’s portfolio is reduced—haircut—by the
amount of transaction cost incurred on sale.


6


Thus, solvency requirements are sufficient for
the exchange to manage its exposure with this
characterization of the marketplace.
If the assumption that assets can be liqui­
dated immediately is dropped, exchanges prefer
asset holdings which can be used to settle pay­
ment obligations. On determining that a coun­
terparty has become insolvent, the exchange
seeks to avoid risk by closing positions and
disbursing payments quickly. Delays encoun­
tered in the liquidation of assets increase the
exchange’s risk of realizing further losses.
Since futures contracts require that positions
realizing gains be paid in cash, exchanges have
a strong preference for asset holdings in cash or
readily convertible to cash. This enables the
exchange to attach assets which can be immedi­
ately applied to fulfill its required payments of
gains. Thus, margin requirements amend the
solvency requirement by stipulating that futures
positions be supported by liquid asset holdings.
The requirement that margin balances be de­
posited with the exchange further enhances this
liquidity requirement: funds are immediately
available to the exchange.
Mark-to-market arrangements augment the
arsenal of exchange protections against credit
risk by substituting for perfect monitoring of
wealth. Frequent marking to market creates a
flow of information to the exchange on the
solvency of counterparties. To see this, recall
that mark-to-market rules require positions
incurring losses to cover these losses with cash
payments. Cash paid by customers to brokers
is forwarded to the clearing member and then to
the clearing association. Brokers observing the
payments made by their customers can infer
their ability to continue to cover losses. Like­
wise, by observing delays in payments made by
clearing members, the clearinghouse can infer
their members’ abilities to continue to cover
losses. Delays in making mark-to-market pay­
ments reveal liquidity problems which may
develop into solvency problems. The cost of
obtaining this information is decidedly less than
the cost of direct monitoring systems which
might be regarded as nearly ideal.
As the frequency of marking contracts to
market increases, the exchange approximates
the ideal case of continuous monitoring of
counterparty wealth. However, this approach is
costly. Reducing the mark-to-market frequency
places the exchange at risk that the counter­

ECONOMIC PERSPECTIVES

party has become insolvent since the position
was previously marked to market. Thus, fu­
tures margin balances are used to collateralize
the completion of the obligation to make markto-market payments. Margin balances bond the
performance of contract holders to make the
cash payments required when contracts are
marked to market.5 Failure to complete this
obligation creates an exercisable claim on the
margin account. By exercising this claim while
simultaneously closing out the futures contract,
the maximum loss of the exchange is the loss
on closing out the futures position netted
against the margin balances for the account.7
Thus, futures exchanges rely on solvency,
mark-to-market arrangements, and margin to
control the credit risk inherent in futures con­
tracting. Margin provides the clearinghouse
with liquid assets which lowers the cost of
making payments to contract holders. Mark-tomarket arrangements provide a signal of the
level of liquidity available. The combination of
mark-to-market arrangements and margin limits
the credit risk exposure of the exchange. This
combination of lower credit risk, lower costs of
transacting, and the presence of an information
generating process for customer liquidity low­
ers the cost of providing guarantees against
counterparty risk. This increases the usefulness
of futures contracting by increasing its depend­
ability.
Distinctions in margin assessments provide
additional support for the idea that futures ex­
changes rely on multiple avenues to manage
their exposure to credit risk. For example,
qualified hedgers have long or short cash posi­
tions in the asset underlying the futures con­
tract. Because losses and gains on futures posi­
tions are offset by changes in the value of the
underlying asset, hedgers expose the exchange
to less credit risk exposure than do speculative
positions. Recognizing their exposure is less,
futures exchanges specify lower margin re­
quirements for qualified hedgers than for more
speculative positions.8 Clearing members of
the exchange are another category of partici­
pants having reduced margin requirements.
Clearing associations closely monitor the risk
of clearing member insolvency. Having in­
curred the cost of this additional monitoring
activity, the clearing association increases its
reliance on these solvency assessments and,
consequently, reduces the level of margin re­
quired for clearing member positions.


FEDERAL RESERVE


BANK OF CHICAGO

Private interests and the Prudential
Exchange Hypothesis

The above discussion shows that private
interests motivate both the stock broker and the
futures exchange to require margin. Use of
margin facilitates trading of stocks and futures
contracts, thereby increasing revenues from
fees paid to stock brokerage firms and to mem­
bers of futures exchanges. However, inade­
quate margin levels for stock positions increase
the riskiness of loans made by brokerage firms.
Inadequate margin levels for futures contracts
increase the cost of contract-performance guar­
antees. In both cases, the risk of loss encourag­
es the affected parties to reduce these risks by
increasing margin levels. Both stock and fu­
tures exchanges have incentives to keep mar­
gins at an optimal level at which fees from
increased trading provide an adequate return for
the risks they bear.
Clearly, an increase in stock price volatility
increases the potential losses of investors and
hence increases the risk of insolvency. Thus, it
would make sense for exchanges to respond to
increased volatility by increasing margin re­
quirements. This might reduce revenues from
trading activity, but will clearly decrease the
risk of losses from insolvency. Conversely, a
decrease in volatility lessens the threat of insol­
vency. So, it would make sense for exchanges
to respond to decreased volatility by lowering
margin requirements in order to increase reve­
nues from trading activity. The Prudential
Exchange Hypothesis is the hypothesis that
exchanges do indeed act in the way just de­
scribed, raising margins in response to in­
creased volatility and lowering margins in
response to decreased volatility. A positive
association between observed changes in vola­
tility and subsequent changes in margin levels
would be evidence in favor of the Prudential
Exchange Hypothesis. Below I describe the
results of research investigating the relation
between changes in volatility and changes in
margin levels and discuss the implications for
the Prudential Exchange Hypothesis.
M arg in d e te rm in a tio n and th e Excess
V o la tility A rg u m e n t

While the Prudential Exchange Hypothesis
suggests that increases in volatility should lead
to increases in margin, the Excess Volatility
Argument suggests that increases in margin
should lead to decreases in volatility. The

7

Excess Volatility Argument originated as an
argument to justify the regulation of margin on
stocks.9 The argument is frequently extended
to margins for futures contracts. This section
explains the Excess Volatility Argument as it is
applied to stocks. I then demonstrate problems
with the argument.
Federal regulation of margin requirements
on stocks began with the Glass-Steagall Act of
1934. The act empowered the Federal Reserve
to specify margin requirements for stock.10
This portion of the act was motivated by con­
cern that margins prior to the 1929 stock mar­
ket crash had been too low. Following the
1929 crash, proponents of the Excess Volatility
Argument felt that low stock margin require­
ments encouraged speculation which exacerbat­
ed price swings. The claim that there is a direct
relationship between speculation and volatility
is based on the view that trends in market prices
can be identified as they occur and that specula­
tors respond to these trends by taking positions
which profit from near term anticipated price
changes. This combination produces a band­
wagon effect or speculative bubble. For exam­
ple, according to this view, if speculators per­
ceive markets as rising, they think that easy
profits can be had by buying into the market
quickly to take advantage of the next round of
price increases. The added pressure of these
orders to buy elevates prices further. Each
round of profits increases interest in “jumping
on the bandwagon.”11
Proponents of the Excess Volatility Argu­
ment believe that private brokerage firms can­
not be relied on to limit speculation by requir­
ing high margins on stocks because high mar­
gins would decrease trading volume and the
profits from brokerage fees. The solution to the
problem of excessive volatility, according to
the Excess Volatility Argument, is to move
control of margin from the securities industry to
government. By raising the cost of speculative
positions, episodes of excessive speculation
could be managed by officials who do not ben­
efit from increased trading activity. Further,
these officials are answerable to the public for
their decisions, making them sensitive to the
concerns of the public.
Problems with the Excess Volatility Argument

The Excess Volatility Argument as applied
to stocks depends on a number of implicit as­
sumptions. First, investors are assumed to


8


ignore the risk of participating in speculative
excesses. Second, brokerage firms are assumed
to ignore their risks in facilitating the trades of
these investors. Third, investors are assumed to
lack opportunities to avoid margin require­
ments. If any of these implicit assumptions are
not plausible, then the argument is less credible.
First, consider the assumption that most
investors ignore the risk involved in specula­
tion. According to the above scenario, inves­
tors buy in response to price increases produced
in previous rounds of buying. They ignore
fundamentals, such as the ability of the firm to
make expected dividend payments, which de­
termine the fundamental value of stocks. For
the scenario to work, investors must ignore the
fact that as stock prices rise they become fur­
ther removed from fundamental values.12 In­
vestment motivated by this reliance is risky.
The larger the distance from the stock price to
its fundamental value, the greater the necessary
correction. Buy orders which increase upward
pressure face the risk of increasingly large
losses. Thus, investors placing these orders are
ignoring the risk that the price correction will
produce a loss. As risk averse investors raise
their assessments of risk, they require higher
returns. However, in this case, expected returns
must decline as the size of the necessary correc­
tion increases. It is not plausible to claim that
in general, investors ignore the risks of specula­
tion in this way.
The Excess Volatility Argument also ne­
glects the incentive of brokerage firms to set
margins prudentially. As previously demon­
strated, individual brokerage firms face the risk
that margin loans will not be repaid if customer
losses exceed available funds. To control this
risk, brokerage firms have incentives to raise
margin levels. These incentives mitigate the
higher revenues from increased trading activity.
The exchanges recognize that brokerage
firms near bankruptcy may compete for broker­
age fees by lowering margins. These firms will
be more willing to require lower margin be­
cause lower margin increases the number of
orders placed through these firms and increases
revenues from brokerage fees. This additional
business prevents bankruptcy provided the
realized losses from insolvent customers are
small relative to the additional revenue from
fees. The incentive to take this chance is great­
est for firms which have the least to lose; that
is, brokerage firms which are nearly bankrupt.

ECONOMIC PERSPECTIVES

However, this form of competition harms via­
ble brokerage houses in three ways. First, com­
petition for business reduces the immediate
revenues from brokerage fees for viable firms.
Second, bankruptcy of a brokerage firm lessens
industry good will.13 This intangible asset is the
capitalized value of trading activity which
stems from confidence that brokers properly
represent customer interests. Evidence that
brokerage firms are aggressively pursuing their
own interests damages this confidence, reduc­
ing the value of their good will. Third, brokers
must be confident that commitments made with
other brokers will be honored. Insufficient
margining by individual brokerage firms less­
ens confidence in the completion of these com­
mitments. This leads to increased costs as
brokers replace the surety afforded by adequate
margin balances with increased monitoring of
the financial well being of the other brokers.
To reduce these costs, exchanges, acting in the
interests of the industry, set minimum margin
requirements. These minimums prevent nearly
bankrupt firms from increasing their risks to
attract additional brokerage fees at the expense
of the remainder of the industry.
Third, for margin regulation to work as
proponents of the Excess Volatility Argument
suggest, investors must lack alternative sources
of funds. Margin requirements specify the
amount of collateral which must be deposited
for loans which are collateralized by stocks
purchased with the funds provided. These
requirements can be understood as restrictions
on leverage which can be avoided. For exam­
ple, individuals can avoid margin restrictions
by seeking loans on their other sources of
wealth, such as funds from a second mortgage
or borrowing against the cash value of insur­
ance contracts. These sources can be used to
create “homemade” leverage at higher levels
than those allowed using credit collateralized
with stock holdings. In addition, Fishe and
Goldberg (1986) point out that if leverage pref­
erences exceed those available under margin
regulations, firms can increase their debt to
provide any desired level of leverage. The
ability to avoid restrictive margin requirements
suggests that the regulation will be relatively
ineffective.14
The above objections show that the Excess
Volatility Argument as applied to stock markets
has a number of weaknesses. Consequently, it

FEDERAL RESERVE



BANK OF CHICAGO

does not present a strong case for the claim that
controlling margin will influence the volatility
of stock prices. Proponents extend the Excess
Volatility Argument to futures markets.15 This
extension ignores the differing roles of margin
in the respective markets. The objections de­
scribed above also hold for the Excess Volatili­
ty Argument as it applies to futures markets.
Furthermore, there may be additional difficul­
ties for the case of futures markets since margin
plays a different role in futures contracts than in
stock transactions. Analysis of the terms of
futures contracts reveals no compelling reason
to expect margins to control volatility in futures
markets.
In this section, I have described some of
the conceptual difficulties for the Excess Vola­
tility Argument. In the next section, I consider
the empirical evidence concerning the effects of
margin changes on the volatility of prices.
Evidence o f th e e ffe c ts o f m arg in
changes on v o la tility

A number of empirical findings do not
support the claim that margin levels affect
volatility. First, in order to have an effect on
stock price volatility, equity positions funded
by margin loans would have to constitute a
sizable portion of investments in the stock
market. Figure 1 graphs the dollar value of
securities margin loans on equities as a percent­
age of the market value of corporate equity
over the period 1968 to 1988. The dollar value
of margined securities positions are a small
portion of total stock holdings. Thus, attemptFIGURE 1

Extent of margin positions: NYSE
margin as a percent of market value

9

ing to decrease the number of margined securi­
ties positions by raising the cost of holding
these positions would influence stock prices
only if speculative activity affecting a small
portion of stock holdings could have a signifi­
cant impact on prices for both margined and
unmargined stocks. With such a large percent­
age of equity holdings unaffected by the level
of required margin, policies influencing the
level of margin required to purchase equities
are unlikely to significantly affect volatility.16
Considerable empirical research examines
the links between margins on securities and the
volatility of security prices. This literature is
extensive and is not reviewed here.17 A repeat­
ed finding is that changes in equity margins are
not related to subsequent changes in stock price
volatility.18
Similar research for a wide array of futures
contracts shows that margins on futures con­
tracts are an ineffective tool for reducing vola­
tility. Previous work by Furbush (1988) com­
pares S&P 500 volatility before and after mar­
gin changes on the S&P 500 futures contract,
and finds no significant change in volatility.
On the other hand, Kupiec (1990) finds a posi­
tive association between daily volatility esti­
mates for the S&P 500 index and previous
initial margin rates (the amount of margin di­
vided by contract value) for that contract. Both
results contradict the negative association pre­
dicted by the Excess Volatility Argument.
In this section, I present additional evi­
dence that raising futures margins does not
lower the volatility of the futures contract price.
As with any literature testing for a nonzero
effect, econometric difficulties can bias the test
toward finding no effect. Recognition of this
problem encourages careful researchers to try
alternative approaches and repeated testing of a
nonzero effect. My evidence improves on the
existing literature in several ways. First, I use a
new econometric technique to obtain volatility
estimates. The procedure uses a method which
improves the measurement of volatility and
isolates changes in margin from changes in the
level of futures price. Second, I test both the
Prudential Exchange Hypothesis and the Excess
Volatility Argument.
My procedure consists of testing the hy­
pothesis that margin changes are associated
with the volatility of two financial futures con­
tracts (see Box 2 for details of this procedure).
Using leads and lags of the margin change

10



variables allows a determination of the time
ordering of the relationship between margin
changes and volatility. That is, using Equation
2 (see Box 2), we can determine whether
changes in volatility come before or after
changes in margin. The approach utilizes the
persistence of volatility to associate margin
changes occurring around a volatility shock.19
The test employs rates of margin changes
which occur before the date of observed volatil­
ity (margin change “lags”) and rates of margin
changes which occur after the date of observed
volatility (margin change “leads”) in a regres­
sion having volatility as the dependent variable.
The coefficients on these before and after mar­
gin changes are relevant to two quite different
hypotheses about the relationship between
margin changes and volatility. According to
the Prudential Exchange Hypothesis, futures
exchanges respond prudentially to higher vola­
tility by increasing margin requirements. If this
hypothesis is correct, then margin changes
should occur after shocks to volatility. For
example, if volatility of a futures price rises due
to an oil crisis, margins on affected contracts
should rise in response. Thus, there should be
positive coefficients on margin changes occur­
ring after observed volatility. That is, positive
coefficients on margin changes occurring after
observed volatility indicate that futures ex­
changes, acting to protect their interests, raise
margin when exchange officials observe in­
creases in volatility. Thus, positive coefficients
on margin changes occurring after observed
volatility can be taken as evidence affirming
the Prudential Exchange Hypothesis.
Proponents of the Excess Volatility Argu­
ment expect margin increases to reduce volatili­
ty. Evidence that volatility is persistent implies
that volatility will not change unless a subse­
quent shock produces a change. Proponents of
the Excess Volatility Argument argue that
margin changes shock volatility by raising the
cost of holding speculative positions. Thus,
increases in margin lower volatility and de­
creases in margin raise it, according to propo­
nents of the Excess Volatility Argument. A
finding of negative coefficients on margin
changes occurring before observed volatility is
consistent with this expectation.
A related question concerns the length of
time separating futures margin and volatility
changes. The low cost of futures trading sug­
gests that responses to a change in margin are

ECONOMIC PERSPECTIVES

likely to be quickly observed. This suggests the
time between margin changes and observed
volatility need not be long. Alternatively, if
margin changes produce purely transitory ef­
fects, they would not be a particularly useful
policy tool.20 This motivates examining a long­
er interval. In order to test the Excess Volatili­

ty Argument, I looked at margin changes that
occurred up to twelve trading days before ob­
served volatility. Twelve trading days are more
than one-half month, so it seems reasonable to
expect that any effects from a margin change
would be observed during this interval. Also, if
margin changes produce effects which persist
BOX 2

Procedure to test association of margin changes and volatility
Davidian and Carroll (1987) introduce a meth­
od later extended by Schwert (1989) to calculate
daily volatility estimates. Schwert and Seguin
(1990) show that, assuming normality, this proce­
dure gives unbiased estimates of daily return stan­
dard deviations. The procedure iterates between a
specification for mean returns and a separate speci­
fication for volatility. Equation 1 gives the specifi­
cation for the mean return from a futures contract as
follows:
(1) r =X\ 6 + 8,;
where rt is the continuously compounded return for
a futures contract at time t. This return is condition­
al on information available at t such as the month of
the year and previous returns. This information set
is represented by X. The residual, £f, captures the
effects on returns from unanticipated events occur­
ring at time t. The parameter B summarizes the
contribution of information items in the determina­
tion of returns. The variance of Ef summarizes the
volatility due to unanticipated events over the sam­
ple period. Under certain conditions e is an effi­
cient estimator of the true volatility.1 One of these
conditions is that volatility is unchanging or homoskedastic.
If the error terms are heteroskedastic, then we
need to identify the source of heteroskedasticity in
order to correct for it in Equation 1. That is, we
need a theory which can be tested about the deter­
minants of volatility in futures returns. The Excess
Volatility Argument is a testable theory that margin
affects volatility. Equation 2 expresses the relevant
theory as follows:
(2) le I = Y\ a +

k
Z
x dmi+i + p ,;
i = -k,
i*0

where l£(l is the absolute value of the residual from
Equation 1, F are information-set variables which
might affect the volatility of returns, and dmt are
percentage changes in margin requirements at time
t. The parameters a and y. summarize the impact of


FEDERAL RESERVE


BANK OF CHICAGO

these variables on volatility. Nonzero values for
these parameters imply that volatility is affected by
the associated variable. Of primary interest here are
the y. which summarize the effect of margin changes.
A negative coefficient implies that margin increases
are related to lower volatility, a positive coefficient
implies that margin increases are related to higher
volatility.
Variables included in the information set, X for
Equation 1 and F in Equation 2, require additional
explanation. Lags of futures contract returns are
included in Equation 1 to capture short term shifts in
expected returns. Inclusion of indicator variables for
the months of the year incorporates effects on returns
from seasonal or contract life-cycle effects. Finally,
since returns at time t are dependent on risk assess­
ments, after the first iteration twelve lags of the vola­
tility estimate from Equation 2 are included as a
measure of risk. The F variables in Equation 2 in­
clude the indicator variables for months of the year
and twelve lags of volatility from Equation 1. The
motivations for these inclusions differ from those in
Equation 1. Including the months of the year is moti­
vated by Samuelson’s (1965) theory which implies
that the volatility of futures prices changes over the
life of the contract. Lags of volatility are included
to accommodate the persistence of volatility shocks.
French, Schwert, and Stambaugh (1987), Poterba
and Summers (1986), and Jain and Joh (1988) pro­
vide evidence for this persistence in asset returns.
Finally, it is necessary to iterate the procedure.
Iteration is necessary because the hypothesized het­
eroskedasticity in Equation 1 implies the £( are ineffi­
cient. The problem can be corrected by using predict­
ed values from Equation 2 as weights in a weighted
least squares re-estimation of Equation 1. Each
iteration improves the efficiency of the £ estimates.
Davidian and Carroll (1987), using Monte Carlo
experiments, find that two iterations are sufficient to
resolve efficiency problems. I found that the earlier
iterations often produce some negative predictions.
To ensure positive weights are used, I iterate five
times to avoid this problem.
‘Efficient in the sense that the information set is being used
to the fullest extent possible.

11

for less than one-half
TABLE 1
month, they would be
Summary of tests for the Excess Volatility Argument
relatively useless policy
_____________ Coefficient t statistics
tools. For similar rea­
sons, I looked at margin
Deutschemark contract
S&P 500 contract
Trading days
changes during the 12
after a margin
Hedge
Speculative
Speculative
Hedge
change
positions
positions
positions
positions
days following observed
volatility in order to test
1
-1.78
-1.08
-2.59
-1.53
the Prudential Exchange
2
-0.41
0.68
-1.71
0.59
Hypothesis. It is reason­
0.49
3
0.82
0.98
1.85
able to reject the Pruden­
4
2.02
0.60
0.51
-1.20
tial Exchange Hypothesis
-0.17
5
-0.80
-0.78
0.59
if exchange responses to
6
-0.05
1.05
-0.63
0.11
increased volatility occur
7
-0.40
2.37
0.57
-0.08
more than twelve busi­
8
1.14
1.33
1.13
-0.16
ness days after a substan­
0.42
9
0.85
0.13
-0.12
tial increase in volatility.
-0.44
10
2.44
0.16
-0.91
The data consist of
11
-1.75
-2.74
-0.49
0.46
daily prices for two finan­
12
-0.33
0.32
-1.22
-0.36
cial futures contracts
traded at the Chicago
Coefficient sums
0.0001
0.0003
0.0001
-0.0008
Mercantile Exchange: the
1.62
F statistic
0.16
0.06
1.12
deutschemark and the
(hypothesis that
S&P 500 futures contract.
coefficient sum
equals zero)
Sample periods are from
June 30, 1974, to Decem­
(p value)
(0.69)
(0.80)
(0.20)
(0.29)
ber 31, 1989, for the
deutschemark contract
and from June 30, 1982,
to December 31, 1989, for the S&P 500 con­
seventeen changes in initial margin for the
tract. This sampling interval gives 3,811 obser­
deutschemark and nineteen changes of initial
vations for the deutschemark contract and 1,842
margin for the S&P 500. These margin chang­
observations for the S&P 500 contract. On any
es are expressed as continuously compounded
sample date, futures contracts for several deliv­
rates of margin change. This approach produc­
ery months trade simultaneously. This implies
es zeroes where no margin change has occurred
that the prices of any of these contracts might
and small positive or negative values else­
be used to compute returns. Following industry
where.23 These data are from the CME clearing
norm, I use prices for contracts which are near­
association.
est to delivery. The nearest-to-delivery con­
Table 1 reports coefficients of margin
tract is generally the heaviest traded and, hence,
changes before observed volatility used to test
regarded as most representative of that day’s
the Excess Volatility Argument. Recall that the
trading.21 As contracts approach expiration, this
Excess Volatility Argument predicts that there
procedure requires that expiring contracts be
should be a negative association between vola­
replaced by the subsequent contract. Thus, on
tility and previous changes in margin. Individ­
the last day of the month prior to a delivery
ual coefficient t statistics for speculative and
month, I roll out of the nearby contract and into
hedge positions in both contracts do not support
the next delivery month. This procedure avoids
the Excess Volatility Argument. For the deut­
making inferences which are unique to the
schemark, one speculative margin change coef­
delivery month.
ficient (lag 4) differs reliably from zero at the
Continuously compounded rates of returns
conventional 5 percent level, but has the wrong
from these price series are matched to the effec­
sign. Two individual coefficients for the S&P
tive dates of changes in initial margin require­
are significant for both speculative positions
ments for speculative and hedge positions.22
(lags 1 and 7) and hedge positions (lags 10 and
Over the respective sample periods, there were
11), but these are of opposite sign. Coefficient


12


ECONOMIC PERSPECTIVES

sums are examined because the effect of a
margin change may be spread across several
days, producing a cumulative effect not evident
on any one day. Three of the four coefficient
sums are positive, indicating that volatility rises
following a margin increase. To determine the
significance of these coefficient sums, they are
tested against 0 with an F test. Asymptotic
critical values for this test are: 3.84, at the 5
percent confidence level and 6.63, at the
1 percent confidence level. In each case, the
coefficient sums do not differ reliably from 0.
Thus, the results do not indicate a negative
association between margin changes and vola­
tility realized after these changes, as implied by
the Excess Volatility Argument.
An alternative to associating margin
changes with the size of price changes is to
examine the frequency distribution of price
changes. Figure 2 charts the frequency of S&P
500 futures price changes for each level of
margin over the sample period. Price changes
are categorized as more than 1 percent, more
than 2 percent, etc. Thus, horizontal bars in the
chart depict the percentage of price changes
larger than a given size which were observed
for the indicated level of margin. If high vola­


FEDERAL RESERVE


BANK OF CHICAGO

tility is more likely when margin levels are low,
then a greater percentage of large price changes
should be observed in the low margin regions.
Examining each price change row, it appears
that large price changes are equally likely to
occur at each level of margin observed. Thus,
the evidence of this test does not show that low
margin levels lead to high volatility.24
Table 2 summarizes coefficients on margin
changes after observed volatility used to test the
Prudential Exchange Hypothesis. Recall that
the Prudential Exchange Hypothesis predicts a
positive association between volatility and
subsequent margin changes. Signs of individu­
al coefficients are mixed and their magnitudes
are generally insignificant. No important dif­
ferences appear to exist between speculative
positions and hedge positions, indicating that
exchange responses to volatility do not differ
between these two classifications. Coefficient
sums for the deutschemark contract are posi­
tive. This is indicative of a positive association
between past volatility and margin changes as
predicted by the Prudential Exchange Hypothe­
sis. However, F test results indicate these coef­
ficient sums do not reliably differ from 0. Co­
efficient sums for the S&P 500 contract are

13

The negative signs
for the S&P are opposite
Summary of tests for the Prudential Exchange Hypothesis
those expected. This
Coefficient t statistics
motivates further exami­
nation of volatility and
Deutschemark
contract
S&P
500
contract
Trading days
S&P margin levels.
prior to a
Hedge
Speculative
Hedge
Speculative
margin change
positions
positions
positions
positions
Volatilities obtained
from the above iterative
1
0.62
1.22
0.35
-2.35
procedure are restated to
-1.37
-2.44
2
0.76
0.20
obtain the dollar volatil-1.41
-0.66
2.05
0.38
3
ity per day of the S&P
4
-0.37
1.10
2.38
0.63
contract. These volatili-0.47
0.77
0.03
-2.10
5
ties and the level of
0.44
-0.26
-1.40
-0.33
6
speculative margin are
0.37
-0.24
0.01
0.58
7
graphed in Figure 3.
0.44
1.34
2.43
0.83
8
The graph shows that
1.57
-0.06
0.39
-0.96
9
the level of required
-1.32
-2.67
-0.07
-0.33
10
margin has remained
1.24
0.22
-1.21
11
1.10
high while volatility for
-0.44
-0.47
-0.67
-0.16
12
most of the period after
1987 fell to 1986 levels.
0.0004
-0.0001
-0.0009
0.0003
Coefficient sums
Dividing margin re­
1.24
0.89
0.99
1.65
F statistic
quirements by dollar
(hypothesis that
volatility
gives the level
coefficient sum
of coverage obtained by
equals zero)
the exchange. Compar­
(0.34)
(0.27)
(0.32)
(0.20)
(p value)
ing the pre-1987 period
with the post-1987 peri­
od, margin levels since
negative, but F test results indicate they do not
October 1987 provide the exchange with 51
significantly differ from 0. F test results fail to
percent greater coverage than previously. This
support the Prudential Exchange Hypothesis.
greater coverage lessens the need of the ex-

14



TABLE 2

ECONOMIC PERSPECTIVES

change to raise margin in response to volatility
increases. In other words, the exchange does
not need to raise margins in response to higher
volatility because margin requirements are
already high enough to cover its increased risk.
This may explain the lack of evidence for the
Prudential Hypothesis.
Another way to test the Prudential Ex­
change Hypothesis is as follows. Prudential
exchanges can be expected to set margin levels
for contracts according to the risk of losses
from insolvency. Since high price volatility
places the exchange at greater risk, levels of
margin required for contracts should rise with
the anticipated price volatility of these con­
tracts. One way to observe anticipated volatili­
ty is to use the volatility implied by observed
prices on futures options. Thus, I hypothesize
that margin levels will be positively associated
with implied volatilities.
To demonstrate this approach, implied
volatilities were computed for closing prices on
futures options traded on September 9, 1991.
The contracts used were: soybean, com, and
Treasury bonds from the Chicago Board of
Trade; and S&P 500, live cattle, Swiss franc,
deutschemark, and Japanese yen from the Chi­
cago Mercantile Exchange. Volatilities are
stated on a per day, dollar basis.25 This gives,
in dollars, the largest up-or-down change which
can be expected in a single day with probability
.33. Thus, setting margin levels at three times
this volatility provides these exchanges with 99
percent confidence that margin balances will be
sufficient to cover losses realized in one day by
either long or short positions. Figure 4 graphs
margin required for these contracts on our vola­
tility estimates. The predicted positive associa­
tion is demonstrated by the graph. The simple
correlation between margin levels and volatility
is .92 which does provide some evidence for
the claim that margin levels are positively asso­
ciated with the level of exchange risk. The
evidence from a single sample date presented in
this article is not sufficient for a test of the
Prudential Exchange Hypothesis, however, the
positive result suggests that further testing may
provide stronger evidence.
Summarizing the evidence, my tests for the
link between futures margin and volatility do
not support the Prudential Exchange Hypothe­
sis. However, this result may be due to the
relatively higher margin requirements after

FEDERAL RESERVE



BANK OF CHICAGO

1987. My tests do produce further evidence
against the Excess Volatility Argument.
C onclusions

The Excess Volatility Argument implies
that higher margin can be used to control spec­
ulation resulting from excessive volatility. This
article presents several arguments suggesting
that this argument is flawed, as well as new
evidence indicating that the volatility of futures
prices is not reduced by raising futures margin.
The evidence that changes in futures mar­
gin do not lead to changes in volatility is quite
compelling, consequently, the Excess Volatility
Argument should not be a consideration in the
government regulation of margins. It is clear
that private interests in setting margins do exist.
I have described the prudential interests of the
futures exchanges. These interests provide
some support for the view that exchanges are
motivated to set margins at prudential levels.
Effective public oversight of margin set­
ting for futures contracts requires policymakers
to identify the interests which are best served
by changing margins. Otherwise, financial
markets risk being encumbered by unnecessary
regulation. Margin regulation is unlikely to
reduce the volatility of futures prices. Howev­
er, other roles for margin, including the public’s
interest in the safety of futures clearing houses
and the payments system, warrant additional
research.

15

FOOTNOTES
‘The Brady Report is the name generally given to a report
prepared by the January 1988 Presidential Task Force on
Market Mechanisms headed by Nicholas Brady, Secretary
of the Treasurer.
2Since 1934, the Federal Reserve Board of Governors has
set margins for stock by specifying the initial margin
required for stock purchases. Margin regulation is motivat­
ed by the Excess Volatility Argument which is explained
later. At this point, it is important for the reader to realize
that, in addition to this regulatory activity, private interests
are also at work in determining margin.
3T o avoid a technical problem, I oversimplify by assuming
the cost of carry for the cash asset is zero. Costs of carry
are the financing costs net of returns from holding the cash
asset. They determine the difference between futures prices
and current prices for the cash asset. For the purposes of
this example, they can be ignored.

4Further, resources would be expended to make this deter­
mination. Thus, the ability of counterparties to avoid this
cost will weigh in their assessment of the worth of futures
contracting.

correction. Note that this is an assumption that exit can be
perfectly timed. Relaxing the perfect-timing assumption
introduces the risk of being late and incurring losses during
the correction. Risk averse investors will take on this risk
only if it is compensated. Since the risk is costlessly avoid­
ed by not participating in the bubble, it is not compensated.
Thus, if investors are risk averse, bubbles are not possible.
13The presence of performance guarantees offered by the
exchange makes these costs more explicit. The member­
ship is contractually obligated to make good on defaults of
its nonperforming members.
14The effectiveness of regulating margin becomes depen­
dent on the relative costs of leverage obtained through
margin loans and leverage obtained from other sources;
that is, homemade leverage. If homemade leverage is
relatively costly, then raising margin requirements increas­
es the cost of obtaining leverage and may decrease specula­
tive activity.
15A clear case of extending the Excess Volatility Argument
to futures markets can be found in the Brady Report.
16Salinger (1989,Table 1) also makes this point.

5This description is somewhat oversimplified. Edwards
(1982) goes into more detail. Essentially, the clearing
association guarantees payments between the clearing
members of the exchange. Were the hypothetical contract
made through a single clearing member, Ms. Long would
face the risk that the clearing member would be unable to
make good on the payment should Mr. Short be insolvent.
The clearing association is not obligated to fulfill commit­
ments between a clearing member and any other party.
6Fenn and Kupiec (1991) point out that increasing the
frequency of marking contracts to market serves as a
substitute for raising the level of margin.
7This loss may be further reduced by proceeds from the sale
of assets going to the exchange.
8The Chicago Mercantile Exchange presently determines
margin requirements of positions using its Standard Portfo­
lio Analysis of Risk (referred to as “SPAN”). The system
evaluates the risk of the individual after netting out posi­
tions in several markets and determines the level of margin
required for the net position.
9See Kindleberger (1989) and Chance (1990).
I0Federal Reserve Regulations T, U, X, and G state current
margin requirements.
" Kindleberger’s (1989) history provides an excellent
description of the events preceding and following the 1929
crash from an Excess Volatility perspective. Similar
arguments have also been made regarding the role of
margins on stock index futures in the 1987 crash. For an
example, see the Brady Report.
^Alternatively, it might be argued that these investors all
believe they can exit the market prior to the necessary

16



17Chance (1990) and France (1990) review the literature of
the relationship between volatility and stock and futures
margin.
18Hardouvelis (1988) is a notable exception. Hsieh and
Miller (1990) point out that the Hardouvelis procedure is
susceptible to problems with persistent variance. Kupiec
(1988, Table 5) replicates the Hardouvelis procedure. He
finds that much of the effect traces to the last half of the
1930s.
19That is, it is assumed that changes in volatility due to
shocks are permanent, not temporary. For example, if the
volatility of futures prices increases due to an oil crisis, the
assumption is that volatility will remain at the new level
until another shock occurs. This assumption is important
for determining the cause of observed changes in volatility.
For example, if volatility responses to shocks were tempo­
rary rather than permanent, then an observed change in
volatility might be the result of volatility returning to its
previous level after a temporary response, rather than a
response to a new shock. This assumption is supported by
the evidence from Schwert (1989). Additionally, the results
from the specifications used in this paper support volatility
persistence.
20For transitory effects from margin changes to be useful,
regulators must be willing to change margin requirements
frequently.
21France and Monroe (1991) investigate the effects of
futures margin on the less heavily traded contracts expiring
on later delivery months. This approach investigates the
importance of liquidity on the margin-volatility association.
^Continuously compounded rates of change are computed
as the difference in the log of prices. I am indebted to

ECONOMIC PERSPECTIVES

Bjorn Flesaker who suggested this approach to obtain
symmetry between rates of increase and decrease.

24Using margin as a percentage of contract value in place of
margin levels does not change this conclusion.

23Signed dummy variables were also tried in place of
percentage changes of margin. The results were similar to
those reported here, however, the level of significance was
lower. This suggests that the amount of margin change
provides information in addition to the information that
margin changed and the direction of that change.

^Volatilities were implied using the Black-Scholes option
model for options on futures nearest to expiration and at the
money. This procedure obtains an annualized volatility for
rates of change. Annualized volatilities were restated to
dollars per day by dividing them by the square root of 365
and multiplying by the dollar value of the contract.

REFERENCES
Chance, Don M., “The effects of margin on
volatility of stocks and derivative markets: a
review of the evidence,” manuscript, Virginia
Polytechnic and State University, 1990.
Davidian, Marie, and Raymond J. Carroll,
“Variance function estimation,” Journal of the
American Statistical Association 82, 1987, pp.
1079-1091.
Edwards, Franklin, “The clearing association
in futures markets: guarantor and regulator,”
Conference paper presented at the Industrial
Organization of Futures Markets: Structure and
Conduct, Columbia University, New York City,
November 4-5, 1982.
Fenn, George, and Paul Kupiec, “Prudential
margin policy in a futures-style settlement
system,” Finance and Economics Discussion
Series Paper No. 164, Federal Reserve Board,
Washington, D.C., 1991.

Furbush, Dean, “The regulation of margin
levels in stock index futures markets,” working
paper, Office of Economic Analysis, United
States Securities and Exchange Commission,
1988.
Hardouvelis, Gikas, “Margin requirements and
stock market volatility,” Federal Reserve Bank
of New York, Quarterly Review, 1988, pp. 8089.
Hseih, David, and Merton Miller, “Margin
regulation and stock market volatility,” Journal
of Finance 45, 1990, pp. 3-29.
Jain, P., and G. Joh, “The dependence be­
tween hourly prices and trading volume,” Jour­
nal of Financial and Quantitative Analysis 23,
1988, pp. 269- 283.
Kindleberger, Charles P., Mania, panics, and
crashes: a history of financial crises, Basic
Books, Inc., 1989.

Fishe, Raymond P. H., and Lawrence G.
Goldberg, “The effects of margins on trading
in futures markets,” Journal of Futures Markets
6, 1986, pp. 261-271.
France, Virginia Grace, “The regulation of
margin requirements: a survey,” University of
Illinois at Urbana-Champaign Working Paper
No. 90-1670, 1990.
France, Virginia Grace, and Margaret A.
Monroe, “The effects of margin requirements
on futures trading,” mimeograph, University of
Illinois at Champaign-Urbana, 1991.
French, K.R., G. W. Schwert, and R. F.
Stambaugh, “Expected stock return and vola­
tility,” Journal of Financial Economics 19,
1987, pp. 3-29.


FEDERAL RESERVE


BANK OF CHICAGO

Kupiec, Paul, “Initial margin requirements and
stock return volatility: another look,” Journal
of Financial Services Research 3, 1988, pp.
287-301.
___________ , “Futures margins and stock
price volatility: is there any link?,” Finance
and Economics Discussion Series, Board of
Governors of the Federal Reserve System,
1990.
Moser, James T., “Evidence on the impact of
futures margin specifications on the perfor­
mance of futures and cash markets,” Federal
Reserve Bank of Chicago Working Paper No.
WP-90-20, 1990.
___________ , “The implications of futures
margin changes for futures contracts: an inves­

17

tigation of their impacts on price volatility, mar­
ket participation and cash-futures covariances,”
Review of Futures Markets, forthcoming.

regulation of stock index futures,” Journal
of Financial Services Research 3, 1989, pp.
121-138.

Poterba, J. M., and L. H. Summers, “The
persistence of volatility and stock market fluctua­
tions,” American Economic Review 76, 1986, pp.
1142-1151.

Samuelson, Paul A., “Proof that properly an­
ticipated prices fluctuate randomly,” Industrial
Management Review 6, 1965, pp. 41-49.

Presidential Task Force on Market Mecha­
nisms, “Report of the presidential task force on
market mechanisms: January 1988,” excerpt
reprinted in Robert J. Barro, Robert W. Kamphius, Jr., Roger C. Kormendi, and J. W. Henry
Watson, eds., Black Monday and the Future of
Financial Markets, Homewood, IL, Irwin, 1989,
pp. 127-203.
Salinger, Michael A., “Stock market margin
requirements and volatility: implications for

18



Schwert, G. William, “Business cycles, finan­
cial crises and stock volatility,” CarnegieRochester Conference Series on Public Policy
31, 1989, pp. 83-126.
Schwert, G. William, and Paul Seguin, “Heteroskedasticity in stock returns,” Journal of
Finance 45, 1990, pp. 1129-1150.
Telser, Lester G., “Margins and futures con­
tracts,” Journal of Futures Markets 2, 1981, pp.
225-253.

ECONOMIC PERSPECTIVES

State and local governm ents'
reaction to recession

Richard H. M atto o n
and W illiam A . Testa

Despite the recent economic
malaise, state and local gov­
ernments in the Seventh Dis­
trict largely avoided drastic
tax hikes and spending cuts.
Instead, governments have drawn down their
reserves, trimmed spending, and deferred pay­
ment of bills in the hopes that robust economic
recovery will make tax hikes unnecessary. The
same strategy was attempted during the re­
gion’s economic troubles of the early 1980s,
and it is a common strategy for state and local
governments during a contractionary period.
Nevertheless, this strategy failed District gov­
ernments in the early 1980s when major tax
rate hikes ultimately became necessary and
were subsequently implemented after the U.S.
economy hit bottom during the fourth quarter of
1982. This time around, owing to the extended
economic weakness, the history of the early
1980s may repeat itself in the form of severe
belt tightening and significant tax hikes during
fiscal years 1992 and 1993.
In this article we examine the behavior of
the state and local sector during the business
cycle, paying particular attention to those dis­
cretionary actions such as tax hikes and spend­
ing cuts that are typically taken by state and
local government to maintain fiscal balance in
response to business contractions. In particular,
we focus on the discretionary fiscal actions of
the five Seventh District states (Illinois, Indi­
ana, Iowa, Michigan, and Wisconsin). No two
business cycle episodes are identical, especially
for the state and local sector which must cope
with sharp changes in the direction of federal

FEDERAL RESERVE



BANK OF CHICAGO

grant-in-aid programs. This time around, state
and local fiscal pressures are arising from spend­
ing pressures as much as from lagging revenues.
In response, solutions to budgetary stress are
likely to focus on spending cuts as well.
The secto r's response d u rin g th e
business cycle

Business cycle contractions are usually ac­
companied by escalating state and local govern­
ment fiscal stress and budget crises. Much of
the budget stress is taken on willingly by state
and local governments as they try to maintain
spending commitments without heaping new
taxes onto overburdened workers and faltering
businesses. In this way, the tax and spending
behavior of the state and local sector helps to
cushion business cycle contractions; govern­
ments build up reserves during business cycle
expansions and draw down these reserves or
borrow during contractions.
Often, taxes are ultimately raised and spend­
ing cut during the later stages of a business
cycle contraction or during the recovery period.
State and local governments often cannot or will
not build up sufficient reserves to see them all
the way through business downturns. Further­
more, their ability to take on debt to fund opera­
tions is limited so that stop gap fiscal measures
become exhausted as contractions wear on.
In the aggregate and on net, state and local
behavior has been countercyclical during every
Richard H. M attoon is a regional econom ist and
W illiam A. Testa is a senior regional econom ist and
research officer at the Federal Reserve Bank of
Chicago. The authors thank David R. Allardice for
his comments.

19

business cycle contraction since
TABLE 1
World War II. In examining state
State and local responses to business cycles
and local expenditures from peak
(Annualized percent change)
to trough over each contraction,
Contractions
expenditures rise relative to receipts
peak to trough
Expenditures
Receipts
Grants
(see Table 1). This comes about
as the rate of revenue growth de­
1948:4 to 1949:4
15.2
8.7
4.5
clines more than the rate of expen­
1953:3 to 1954:2
10.7
4.8
0.0
diture growth.
1957:3 to 1958:2
11.9
8.9
44.4
Revenues have tended to slow
1960:2 to 1961:1
9.9
7.8
12.1
or decline immediately following
1969:4 to 1970:4
14.6
11.1
16.8
the peak in the cycle. State and
1973:4 to 1975:1
14.7
9.6
16.9
1980:1 to 1980:3
8.3
8.2
7.4
local government revenue sources
1981:3
to
1982:4
6.4
5.7
-1
.6
are highly sensitive to economic
1990:3
to
1991:1"
7.4
4.7
21.4
aggregates such as spending, prof­
its, and income.1 Receipts from
Expansions
such tax sources as personal and
trough to peak
corporate income quickly turn
1949:4 to 1953:3
7.9
10.3
5.8
sluggish following the peak of
1954:2 to 1957:3
10.9
10.8
15.4
business conditions. In the case of
1958:2 to 1960:2
6.6
10.0
8.9
corporate income, the profit decline
1961:1 to 1969:4
14.9
16.1
21.3
which typically accompanies a
1970:4 to 1973:4
14.4
11.6
19.6
downturn in the business cycle
1975:1 to 1980:1
11.3
13.5
14.7
1980:3 to 1981:3
6.9
8.9
-3 .0
translates into a precipitous decline
1982:4 to 1990:3
10.5
9.7
6.9
in corporate tax revenues. In the
case of personal income, recession"Trough not yet determined for this period.
related declines in employment and
SOURCE: U.S. Department of Commerce, Bureau of Economic
Analysis, National Income and Product Accounts (NIPA), Table
diminished payrolls translate into
9.4, "State and local government receipts and expenditures."
slower personal income growth and
sluggish state income tax revenues.
Because state and local govern­
ments try to maintain expenditures in the face
obvious reason for this is that the underlying
of declining receipts during contractions, their
tax bases accelerate along with the economic
liquid reserves are frequently exhausted or
recovery. This is reflected by the historic
close to exhaustion toward the trough of a busi­
growth in the national economy during the first
ness downturn. For this reason, state and local
full year of recovery (see Table 2). GNP
governments quickly rebuild budget balances in
growth in the first four quarters following the
the quarters following the recession, as is re­
trough of a recession has been very robust,
flected by the inverse relation between receipts
particularly following the 1975 and 1982 reces­
and expenditures (see Table 1 and Figure 1).
sions. But a second reason is that if tax rate
Annual expenditure growth generally slows
during the expansionary period following a
TABLE 2
recession. Expenditure cuts and spending con­
Real
GNP
following
business cycle trough
trols put in place to relieve state and local fiscal
(Annualized
percent
change)
stress during the recession tend to take hold at
the tail end of the contraction or during the
02
Trough
Q1
03
Q4
early recovery, thereby reducing the rate of
M arch 1975
4.0
6.8
5.6
7.6
expenditure growth. Also, demand for social
programs such as Medicaid and General Assis­
J u ly 1980
5.2
7.6
-1 .2
1.6
tance tend to abate with the recovery.
N o vem b er 1982
3.6
9.2
6.0
7.2
But a far greater contribution toward re­
SOURCE: U.S. Department of Commerce, Bu­
building reserves is exerted from the revenue
reau of Economic Analysis, N a tio n a l In c o m e a n d
side as receipts grow much faster during the
P ro d u c t A c c o u n ts o f th e U .S ., 1957-88.
expansion than during the contraction. One

20



ECONOMIC PERSPECTIVES

FIGURE 1

State and local expenditures and receipts
quarterly percent change

quarterly percent change

quarterly percent change

quarterly percent change

NOTE: Two-quarter moving average, nominal dollars.
SOURCE: Bureau ot Economic Analysis, Department of Commerce, NIPA.

hikes have been adopted at the tail end of a
recession, the rate hikes often take hold after
the recession. The combination of robust eco­
nomic growth in the tax base and higher tax
rates often lifts state tax receipts dramatically.
Explaining the sector's behavior

The federal government has a legislated
policy to ease the impact of cyclical swings in
the economy,2 while the state and local sector
has no such legislative requirement. Neverthe­
less, state and local governments are responsi­
ble for public health and related functions
which are heavily demanded during business
cycle contractions.3
As the economy sours and unemployment
rises, demands for Medicaid, General Assis­
tance, and other state aid programs increase.


FEDERAL RESERVE


BANK OF CHICAGO

State and local transfer payments grew at a
nearly 14 percent annual rate during the 197375 recession and again during the 1980 reces­
sion. Rising Medicaid expenses, which can be
attributed to both recessionary demands and
rising program costs, have proven particularly
unyielding and will continue to exert pressure
as they eat up larger and larger shares of state
spending. The relentless climb in Medicaid
costs is demonstrated by state Medicaid spend­
ing per $100 of personal income, which more
than doubled from 1976 to 1990 (see Figure 2).
The jump in Medicaid spending has continued
with FY92 state general fund spending estimat­
ed to increase by nearly 22 percent.4
There are also a host of institutional rea­
sons which help to explain state and local coun­
tercyclical behavior. States are often unable to

21

FIGURE 2

State spending per $100 of personal
income—Medicaid
dollars

adopted. For example, a reported estimate of
$25 billion5 in combined spending reductions
and tax increases by state governments did not
take effect until FY92, four quarters after the
peak in the business cycle.
H o w s ta te and local g o ve rn m en ts
spend beyond th e ir m eans

•Estimate.
SOURCE: U.S. Health Care Financing Administration.

retrench at the outset of a business cycle con­
traction because the length and nature of the
budget cycle permits little adjustment to unan­
ticipated changes in economic conditions.
Thus, when recessions are short in duration or
unexpected, state and local governments have
difficulty adjusting in a timely fashion. One
reason for the readjustment problem is that state
budgets are based on economic forecasts which
are generated many months before the fiscal
year begins. But while the economic condi­
tions underlying the budget may change, com­
ponents of the budget such as wages and pro­
gram expenses may be locked in by contracts,
agreements, and program plans.
One example of the impact of the state
budget cycle on fiscal adjustment occurred with
the onset of the recent contraction. Having
begun in July of 1990, the contraction’s onset
coincided with the first month of the new fiscal
year for 46 states. Few of the state budgets,
which had been developed and submitted in the
late winter or early spring of 1990, had antici­
pated a downturn, so that state spending plans
were adopted without any significant revision.
Once the downturn began, the budget cycle
made it difficult to make more than marginal
adjustments to the spending plan which was
already underway. Accordingly, unless the
economic decline is unusually steep in a given
state, major fiscal adjustment is often put off
until the next fiscal year, when programs can be
evaluated and budget cuts and tax hikes can be


22


Governments have a variety of tools at
their disposal which allow them to spend more
than they receive in revenues for a limited
period of time. These range from explicit mea­
sures, such as drawing down fund reserves, to
less visible actions such as various types of
fiscal accounting maneuvers. Such measures
allow governments to buy time before having to
make fundamental adjustments to their spend­
ing and revenue systems.
Short of tax rate hikes or spending cuts, the
most straightforward method governments have
to bridge deficits is to draw down available
fund balances. This can take two forms. First,
state and some local governments can use accu­
mulated general fund reserves to help close
budget gaps. Some states are required to run a
surplus in their general fund on an annual basis.
Wisconsin, for example, is required to end each
fiscal year with at least a 1 percent general fund
balance. This surplus can provide a cushion if
an unexpected downturn arises. Other states try
to maintain informal cash balance targets. Illi­
nois, for example, tries to maintain a general
fund cash balance of $200 million as a reserve
to pay for budget gaps. Nevertheless, few
states seem able or willing to maintain the
suggested reserve level of 5 percent of general
fund expenditures recommended by the bond
rating agencies and investment banks. During
the generally strong fiscal years of the late
1980s, year end general fund balances as a
percentage of state general funds averaged 1.7
percent in 1987, 2.0 percent in 1988, and 1.0
percent in 1989.6
In addition to attempts to build a surplus
directly from the general fund during periods of
robust economic growth, 37 states have moved
since the late 1970s to adopt so-called “rainy
day” funds. These funds are often patterned
after Michigan’s “Counter-cyclical Budget and
Economic Stabilization Fund.” As originally
designed, the fund was to permit deposits and
withdrawals based on growth in Michigan’s
adjusted personal income. Money would be
paid into the fund when the annual rate of per­

ECONOMIC PERSPECTIVES

sonal income growth exceeded 2 percent. For
funds to be withdrawn from the account, an
economic contraction would have to be severe
enough to cause personal income growth to fall
below zero or the unadjusted unemployment rate
to exceed 8 percent.7
Rainy day funds have proven to be a disap­
pointment to some observers. Budget stabiliza­
tion funds are seldom sufficient to provide long
term fiscal relief.8 While 37 states technically
maintained rainy day funds in FY89, nine of the
funds contained no reserves. Furthermore, only
5 of the states had built up reserves as large as 5
percent of state expenditures.9 By the end of
FY91, virtually all of the funds were exhausted.10
Sometimes states prefer not to run down
their fund balances at the outset and turn to socalled accounting maneuvers to relieve immedi­
ate fiscal pressure. One such maneuver is a fund
transfer, which usually entails transferring the
liability for a particular expense from the general
fund to a dedicated fund such as transportation
or infrastructure. When transfers to dedicated
funds are unavailable (often due to legal restric­
tions or the insolvency of the dedicated fund),
states often reclassify certain operating expenses
as capital expenditures, thereby using bond
money to pay for the expense rather than tax or
other revenue.
Another stop gap measure is to change the
actuarial assumptions underlying state pension
fund contributions. This permits the state to
reduce its level of pension contribution, thereby
freeing revenues for other purposes. Two other
popular techniques involve deferring expendi­
tures and accelerating tax payments. By defer­
ring spending liabilities, states act to roll over
expenses incurred in one fiscal year into the next
fiscal year. This allows the state to end a fiscal
year with a balanced budget even if it has out­
standing bills. In the case of accelerating tax
payments, the schedule for taxpayer payment or
user fees is moved up. Annual payments become
quarterly, quarterly become monthly, and so on.
This technique improves cash flow and can add a
one time extra payment during the fiscal year in
which the change is made.
With some limitations, states can also re­
lieve fiscal pressure by issuing short term debt.
This can improve a state’s immediate cash flow
while a state is waiting for revenues. States can
also take actions to increase non-tax revenues
such as fees, permits, and user charges which can
often be increased less visibly because they im­

FEDERAL RESERVE


BANK OF CHICAGO

pact only particular constituencies. Finally,
states sometimes sell specific assets in order to
raise cash. Often these asset sales consist of
selling a state asset to a quasi-government
agency which then leases the facility back to
the government.
Why the sector sometimes falters

Despite the extent of both explicit reserves
and implicit reserves which are tapped during
business cycle contractions, there often comes a
time when states exhaust their reserves. At that
time, discretionary behavior switches to re­
building government surpluses through tax
hikes and spending cuts. The particular timing
of this transition from maintaining spending
levels and tax rates to rebuilding surpluses is
dependent not only on the extent of the business
cycle contraction, but also on special conditions
such as trends in federal aid and the disparity in
regional conditions.
Evidence that the state and local sector can
spend beyond its means for only a limited time
can be seen from the aggregate behavior of
expenditures and receipts following the trough
of the contractions. In all three cases beginning
with the 1973-75 recession, receipts have
shown rapid growth in the first several quarters
following the trough while expenditure growth
either flattens or turns down (see Figure 1). A
number of conditions explain if, how, and when
a state or local government moves from expan­
sionary to contractionary behavior.
Federal aid

Federal aid has sometimes acted as a
counter balance to falling own-source revenues
during business cycle contractions. However,
the behavior of federal aid over the last four
contractions has been far from consistent (see
Table l).11 During the current contraction, this
behavior has taken an about face with grants up
over 21 percent largely due to a surge in federal
Medicaid support.
Election cycle

Another special factor influencing the state
and local response to recession is the election
cycle. Some analysts claim that the odds that
tax increases will be passed in a given year
depend in part on where the year falls in the
state election cycle.12 Assuming that elected
officials behave as incumbency maximizers and
that tax increases are unpopular with voters, tax
increases will be approved in those years in

23

which approval will have the least repercussion
on incumbency. In terms of the election cycle
it means that tax increases are most likely in the
year following the gubernatorial election. The
next most likely choice is the year following
the mid-term legislative elections.
The 1 9 9 0 -9 1 recession

During the recent recession, state and local
discretionary actions with regard to revenues
point up yet another set of special conditions
which influence the timing and extent of state
and local behavior with respect to contractions.
Unlike the previous two downturns, state gov­
ernments made significant discretionary moves
to raise tax rates, expand tax bases, and raise
user fees in the year preceding the 1990-91
recession. According to estimates, $5 billion in
discretionary revenues were raised in both
fiscal 1989 and fiscal 1990.13
A skewed and out-of-sync deterioration in
regional economies accounts for much of this
behavior. The U.S. economy began to slow in
1989, especially (and earlier still) in the New
England and MidAtlantic regions. Moves to
hike tax revenues were undertaken at the begin­
ning of calendar year 1990. A distinct North­
east incidence of discretionary revenue moves
can be discerned. Massachusetts, New Jersey,
New York, and Vermont all expanded individu­
al income tax rates or bases, or accelerated
withholding. Discretionary sales tax actions
were undertaken by New Jersey, Massachusetts,
Rhode Island, and New York.
Rapidly rising costs of health care in the
later 1980s also helped to create the need for
discretionary revenue hikes. The cost of pro­
viding public health care through Medicaid rose
inexorably along with the costs of providing
health care as a fringe benefit to public employ­
ees. Finally, the prison population doubled
during the 1980s so that expanded prison capac­
ity could no longer be delayed.
The build-up in fiscal pressures prior to the
contraction, along with continuing regional
problems in the Northeast and expanded fiscal
travails in defense oriented states such as Cali­
fornia, ensured that discretionary revenue hikes
were once again undertaken during fiscal 1991.
An estimated $5 billion in additional revenue
hikes were carried out in fiscal 1991. A widely
accepted prognosis for a tepid economic recov­
ery all but ensures that states will embrace
discretionary measures again in 1992. Short of


24


an unexpected robustness occurring during the
economic recovery, the recent period will be
remembered as one in which the discretionary
revenue actions of state governments were
carried out prior to, during, and subsequent to
the recession.
But even more than revenue actions, the
extended length of fiscal stress has induced
discretionary spending cuts by state and local
governments. Perhaps this should not be sur­
prising given that rising program costs have
been an important source of fiscal stress; gov­
ernments have attempted to short circuit fiscal
pressures from the very programs that have
been rising the fastest. For example, the State
of Michigan has eliminated General Assistance
aid to nearly 80,000 state residents and Massa­
chusetts has trimmed the number of Medicaid
benefits it offers.
While it is too early to be definitive, there
is reason to believe that a fundamental change
in direction has taken place once again for the
sector. Much as the federal government has
moved away from the idea that it should be all
things to all people, state and local govern­
ments may be looking toward an era of shrink­
age rather than expansion. Payroll employment
has levelled off over 1991, while many more
state and local governments are planning future
cutbacks (see Figure 3). In response to an eco­
nomic recovery period characterized by weak
overall job growth, the citizenry will continue

ECONOMIC PERSPECTIVES

to look to state and local government to provide
services, but their willingness to pay for those
services will be closely guarded. As a result,
there will be greater pressures on governments
to provide existing services with cheaper deliv­
ery mechanisms or to come up with more inno­
vative services themselves.
Seventh District reactions to the
1990-91 recession

With the onset of the recession, budgetary
stress in the District ranged from severe in
Michigan to mild in Wisconsin. When the
current contraction began in the third quarter of
1990, four of the five District states had already
begun their 1991 fiscal year. As budgetary
stress began to accelerate, potential fiscal ac­
tion focused on changes in the FY92 budget.
After considerable discussion, none of the five
District states passed any major tax increases.
Taxes such as income and sales were largely
untouched. For example, Illinois’ most signifi­
cant tax increase was an extension of the state’s
personal income tax surcharge (raising the
permanent rate from 2.5 to 3 percent) which
had been in effect since 1989.14 Iowa’s only tax
increase was a hike in its state cigarette tax.
Indiana, aside from transferring some program
expenses to bond funds, enacted no major tax
hikes although it did renew a vehicle tax that
had been set to expire. Wisconsin passed a
biennial budget for FY92 and FY93 which calls
for no significant tax increases. Even Michi­
gan, whose economy has been hard hit by the
slump in the auto industry, has adopted a FY92
budget that does not contain major tax increas­
es. District fiscal actions so far appear to mir­
ror District state behavior during the 1980 and
1981-82 recessions, when District states put off
major tax hikes until the second half of FY83.15
The behavior of the District states during
FY91 and the first half of FY92 appears to
represent the early stages of adapting to the
contraction. Having initially been less impact­
ed by the recession than other parts of the na­
tion, most of the states entered FY91 with rea­
sonable budget reserves and fiscal flexibility.
As conditions worsened, most of the states
turned to accounting and other fiscal maneuvers
to balance their books. Illinois for example
chose to roll Medicaid expenses and some other
vendor payments into the 1992 fiscal year.
Indiana transferred $40 million in prison expen­
ditures from the General Fund to bond funds.


FEDERAL RESERVE


BANK OF CHICAGO

Michigan has favored employee furloughs to
balance expenditures. All of the states adopted
hiring freezes and travel restrictions.
Critical budgetary pressures are now build­
ing for the sector in general and are forcing
some states to revise their FY92 budgets. Fis­
cal conditions were deteriorating prior to the
falloff in general business conditions so that the
reserve position of state governments is weak or
nonexistent. District states budgeted for 1992
under the assumption that economic recovery,
however modest, would help to lift revenues
and maintain expenditures. However, recent
indications from statehouses are that 1992 reve­
nue projections have been too sanguine, so that
elected officials are mapping out a change of
course.16
How will District governments
respond in the future?

District states would like to refrain from
draconian spending cuts and major revenue
hikes during the coming months. The results of
regional and, in particular, District government
action during the early 1980s suggests that,
even under severe fiscal stress, state and local
governments can sometimes forestall such
budget-balancing actions through one or more
fiscal years. Despite both economic stress and
sharply falling aid from the federal sources in
the 1980s, for example, Seventh District gov­
ernments refrained from the most dramatic
discretionary moves until well after the down­
turn’s trough. Nevertheless, the recent environ­
ment suggests that District governments have
more than likely breached the thresholds which
require more profound fiscal remedies. Many
governments in the District are already cutting
payrolls and programs so as to preserve a mini­
mum of fiscal integrity.
Today’s budgetary pressures in the District
differ from those of the early 1980s. To a
greater extent, pressures are arising from the
spending side of the ledger as much as from
revenue shortfalls. Accordingly, as budget
remedies become necessary during 1992 and
beyond, spending cuts rather than tax hikes will
be favored. Either cuts in spending or increases
in state and local revemues are likely to act as a
drag on the rate of recovery in the District
during 1992.
Some of the spending pressures, such as
spiralling health care costs and the need for
suitable prison space, are partly beyond state

25

government control. Even so, governments
will need to identify and reach a concensus on
spending programs that can be reduced. Never­
theless, as spending cuts become deeper and
therefore more difficult to agree on, such a

strategy may prove inadequate. At that time,
District governments will once again consider
major tax hikes and other revenue enhance­
ments in order to balance their budgets.

FOOTNOTES
‘Crider (1978), p. 9. Also, Shannon (1985) p. 341.
zHumphrey-Hawkens, “Full Employment and Balanced
Growth Act of 1978.” The bill defines the role of federal
policy as encouraging full employment.
3Few would argue that state and local governments should
carry the primary responsibility for economic stability.
Insofar as the benefits of local fiscal action spill over local
boundaries, such a decentralized system could easily result
in an inadequate countercyclical stimulus. Nevertheless,
state and local governments in many states and regions are
reportedly accelerating capital spending plans as an eco­
nomic growth measure which is intended to address the
current economic sluggishess. See Enos (1992), p. 1.
4National Conference of State Legislatures, State Budget
and Tax Actions 1990.
sState Policy Research, Inc., 1991.
6National Association of State Budget Officers/National
Governors Association, Fiscal Survey of the States, 1988,
p. 15.
’Advisory Commission on Intergovernmental Relations,
Significant Features of Fiscal Federalism, Vol 1, 1991.
8For further discussion of rainy day fund behavior see Testa
and Mattoon (1992).

’National Association of State Budget Officers/National
Governors Association, Fiscal Survey of the States, Sep­
tember 1989.
10State Policy Research Inc., 1990.
"See Gold (1991).
,2See Mikesell.
"National Association of State Budget Officers/National
Governors Association, Fiscal Survey of the States,
various years.
"Illinois made permanent the 1989 income tax surcharge
which had been scheduled to expire. The 20 percent
surcharge may be reduced to 10 percent in FY94. Revenue
raised through the surcharge will be distributed to educa­
tion, municipalities, and the state. The surcharge on the
state’s corporation business tax was also extended.
lsFor more on Seventh District behavior in the 1980 and
1981-82 recessions see Testa and Mattoon (1992).
16For example, the Illinois legislature recently approved the
Governor’s plan to close an impending gap in the 1992
budget. Under the plan, the state will cut $273 million in
services, and it borrowed $500 million to pay a backlog of
unpaid bills. Aside from transfers, no revenue features
were included in the plan.

REFERENCES

Advisory Commission on Intergovernmental
Relations, Significant Features of Fiscal Fed­
eralism, Vol. 1, 1991.

Mikesell, John, “Election periods and state
policy cycles,” Working Papers in Public Fi­
nance and Economics, Indiana University.

Crider, Robert A., The Impact of Recession
on State and Local Finance, Academy of Con­

National Association of State Budget Officers/National Governors Association, Fiscal
Survey of the States, various years.

temporary Problems, Urban and Regional De­
velopment Series No. 6, Columbus, Ohio, 1978

National Conference of State Legislatures,
Enos, Gary, “Governors: bring back the
WPA,” City & State, January 27, 1992.

State Budget and Tax Actions 1990, Denver,

Gold, Steven, “Changes in state government
finance in the 1980s,” National Tax Journal,
Vol. XLIV, No. 1, 1991, pp.1-19.

__________________ , State Bud­


26


1990.

get and Tax Actions 1991, Denver, 1991.

ECONOMIC PERSPECTIVES

Shannon, John, “The impacts of the cyclical
behavior of the economy on the finances of
federal, state and local government,” Federal
and State Fiscal Relations, Department of the
Treasury and the Advisory Commission on
Intergovernmental Relations, Washington,
D.C., September 1985.
State Policy Research, Inc., State Policy
Reports, Volume 8, Issue 8, 1990.

_________________ , State Budget
and Tax News, Volume 10, Issue 18, 1991.

Swonk, Diane C, “The Great Lakes economy:
a regional winner in the 1990s,” in William A.
Testa, ed., The Great Lakes Economy Looking
North and South, Federal Reserve Bank of
Chicago, April 1991, pp. 148-157.
Testa, William A., and Richard H. Mattoon,
“State and local government and the business
cycle,” in Issues in State and Local Government
Finance, Collected Works From the Federal
Reserve Bank of Chicago, William A. Testa,

ed., Federal Reserve Bank of Chicago, 1992,
pp. 13-24.

Related publications
Issues in State and Local
Government Finance:
Collected Works from the
Federal Reserve Bank of Chicago
This compendium of research in the area of
state and local finance is both timely and
relevant to the current policy debate. Issues
examined range from tax policy and the value
of tax incentives in business development to
factors influencing the behavior of state and
local governments.

The Great Lakes Economy
Looking North and South
This volume examines the region’s economic
structure and outlines challenges and opportuni
ties for the future.

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Chicago IL 60690-0834
or telephone 312-322-5111


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BANK OF CHICAGO

27

Credit Markets in Transition



The 28th Annual Conference
on Bank Structure and Competition,
May 6-8,1992

T h e F e d e r a l R e s e r v e B a n k o f C h i c a g o w i l l h o l d its 2 8 t h A n n u a l C o n f e r e n c e
on

B a n k S tru c tu re a n d C o m p e titio n

at th e W e s tin

H o t e l in C h i c a g o ,

Illin o is , M a y 6 -8 , 1 9 9 2 .
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each

y e a r by several h u n d re d

a c a d e m ic s , re g u la to rs , an d

fin a n c ia l in s titu tio n e x e c u tiv e s , th e c o n fe r e n c e s e rv e s as a m a jo r f o r u m
fo r th e e x c h a n g e o f id e a s re g a rd in g p u b lic p o lic y t o w a r d th e fin a n c ia l
s e rv ic e s in d u s try .
The

1 9 9 2 c o n f e r e n c e w ill fo c u s o n th e c h a n g in g

s tru c tu re o f c re d it

m a r k e t s a n d its i m p l i c a t i o n s f o r t h e b a n k i n g i n d u s t r y a n d t h e e c o n o m y .
F e d e ra l R e s e rv e C h a ir m a n A la n G r e e n s p a n w ill s e rv e as th e k e y n o te
sp eaker.

T o p ic s fe a t u r e d a t th is y e a r 's c o n f e r e n c e w ill in c lu d e :

p e r fo r m a n c e o f n e w c re d it m a r k e t in s tr u m e n ts
c re d it m a r k e ts d u rin g th e " c re d it c ru n c h "
th e c re d it m a r k e t

■ th e

■ th e p e rfo rm a n c e o f

■ t h e f u t u r e r o l e o f b a n k s in

■ t h e s ta t u s a n d f u t u r e o f t h e life i n s u r a n c e in d u s t r y

■ m a n a g in g th e c o n s o lid a tio n o f th e b a n k in g in d u s try .
T h e firs t d a y o f th e c o n fe r e n c e w ill b e d e v o t e d to te c h n ic a l p a p e r s o f
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d e s ig n e d to a p p e a l to a m o re g e n e ra l a u d ie n c e .

In v ita tio n s to th e 2 8 th

B a n k S t r u c t u r e C o n f e r e n c e w i l l b e m a i l e d in m i d - M a r c h .

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y o u r n a m e a n d a d d re s s to :
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