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ECONOMIC

PERSPECTIVES




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The internationalization of Uncle Sam
Fiscal policy and the trade deficit
The impact of geographic expansion in
banking: Some axioms to grind

ECONOMIC PERSPECTIVES
Volume X, Issue 3

Contents

May/June 1986

Karl A. Scheld, senior vice president and
director of research
Edward G. Nash, editor
Anne Weaver, administrative coordinator
Gloria Hull, editorial assistant
Roger Thryselius, graphics
Nancy Ahlstrom, typesetting
Rita Molloy, typesetter

is
published by the Research Depart­
ment of the Federal Reserve Bank
of Chicago. The views expressed are
the authors’ and do not necessarily
reflect the views of the management
of the Federal Reserve Bank.
Single-copy subscriptions are
available free of charge. Please send
requests for single- and multiplecopy subscriptions, back issues, and
address changes to Public Informa­
tion Center, Federal Reserve Bank
of Chicago, P.O. Box 834, Chicago,
Illinois 60690, or telephone (312)
322-5111.
Articles may be reprinted pro­
vided source is credited and The
Public Information Center is pro­
vided with a copy of the published
material.
Economic Perspectives

ISSN 0164-0682




The internationalization of
Uncle Sam

3

Jack L. Hervey
Trade deficits caused by natural economic
forces should be dealt with by increased
competition and productivity, not
protectionist distortions...

Fiscal policy and the trade deficit

15

The impact of geographic expansion
in banking: Some axioms to grind

24

David Alan Aschauer
...but when a fiscal deficit produces a
trade deficit, spending cuts may be a
better choice than tax hikes for restoring
the trade balance.

Douglas D. Evanoff and Diana Fortier
Conventional wisdom on the perils of
interstate banking does not hold up when
the data are examined critically.

The internationalization of Uncle Sam
Jack L. Hervey
For well over two decades after the end
of World War II the international trade of the
United States was primarily viewed by Ameri­
cans as a one-way street synonymous with rap­
idly expanding markets abroad for U.S. goods
and services and the rapid acquisition of foreign
assets by U.S. investors. Critics called it eco­
nomic imperialism. By the late 1960s a hint of
change was in the wind. Import growth began
to exceed export growth. The rate of increase
in foreign direct investment in the United
States outpaced that of U.S. direct investment
abroad. By the late 1970s the growing presence
of foreign goods and services and foreign in­
vestment on U.S. shores was beginning to force
a reassessment of the U.S. place in the inter­
national economy.
Over a relatively short span the U.S.
economy experienced a transition from a state
of high level self-sufficiency to one of consider­
able international interdependence with respect
to the provision of goods, services, and capital.
Consumers, from the household to the man­
ufacturer, increasingly looked for the “foreign
brand” that signified quality and a competitive
price. As a result, businesses and workers (in
many cases those same householders and man­
ufacturers) grudgingly have become aware that
they are competing in a worldwide market.
The competition for sales and jobs no longer
comes only from across the street or across state
lines but from an apparel shop in Hong Kong,
a steel mill in Brazil, a wheat farmer in
Australia, or a computer chip manufacturer in
Japan.
The new competition is coming from
countries where wage standards, capital costs,
economic and social structures, and govern­
ment involvement in the economy may be
vastly different from the economic environment
of the United States. At the same time U.S.
consumers and businesses increasingly are tak­
ing for granted, and loath to give up, the ben­
efits of lower price, improved quality, and
extended selection derived from the intensified
foreign competition. Many U.S. manufactur­
ers now depend on foreign-made components
in order to remain competitive—in terms of
price and quality.
Federal Reserve Bank of Chicago




Some industries, firms, and workers suffer
injury in the short-term and possibly long-term
by the increasing international involvement of
the U.S. economy. But in the aggregate the
economic benefit of internationalization out­
weighs the economic costs.
Various interest groups and economic
sectors may quarrel over the associated benefits
and costs, the necessary economic adjustments
and dislocations, and how the rewards and
burdens are to be distributed in response to the
transition to greater international interdepen­
dence. Such conflicts are inherent in the rapid
development of the international sector. As the
adjustments become more difficult for larger
and more vocal sectors of the economy the
conflict becomes more intense. As a conse­
quence, emotional and political content has
been loaded onto terminology historically used
to define specific international trade relation­
ships. These economically neutral but increas­
ingly value-laden relationships have become
the focus of proposed political action manifest
in the form of intensified pressures for
interventionist trade policies by government
that are outside the existing framework of fiscal
and monetary policy.
As a result, the economic content of such
relationships as the trade deficit (the relation­
ship between aggregate value of exports and
imports) or the debtor/creditor position of the
United States for the most part has been lost.
Indeed, it is of concern to this author that these
terms have become widely used by politicians,
business and labor leaders, the business press,
and others as code words synonymous with an
implied need for and, not so coincidentally,
providing a justification for direct government
intervention. The cry that “this country needs
a trade policy” too often may be translated to
mean this country needs increased import
tariffs, a general import surcharge, export sub­
sidies, adjustment assistance to domestic work­
ers and firms, capital controls, depending upon
the persuasiqn of the speaker.
Jack L. Hervey is a senior economist at the Federal Re­
serve Bank of Chicago.
3

Such “solutions” to the “trade problem”
implicitly assume that existing economic dis­
tortions can be corrected by the imposition of
additional market distortions, which unwit­
tingly lessen the incentives to adjust to the new
environment. Ignored are the consequences of
critical economic relationships between the do­
mestic and international sectors that are based
on past and present governmental fiscal and
monetary policy and business and labor policy.
These relationships underlie the recent surge in
the U.S. international trade deficit and the fact
that the United States recently became a net
debtor to the rest of the world (foreign owner­
ship of U.S. assets now exceeds U.S. ownership
of foreign assets).

Figure 1

International trade share of U.S. output
increases during the 1970s
percent of GNP-output (nominal dollars)

The internationalization—a background

The combined value of U.S. trade in
goods and services, net unilateral transfers
abroad by the U.S. government and private
individuals (the current account), and net cap­
ital transactions abroad by U.S. residents and
net capital transactions in the United States by
foreigners rose to a record $1 trillion in 1985.1
A similar compilation for 1970 totaled $146
billion. This seven-fold increase in U.S. inter­
national activity occurred during a span of only
16 years.2
As dramatic as the growth in U.S. inter­
national activity has been, it appears even
more so when placed in juxtaposition to GNP
growth. While such a compilation of interna­
tional activity does not represent the depen­
dence of the U.S. economy on foreign markets
it does provide, nonetheless, an indication of
the increasing relative importance of the inter­
national sector to the overall economy. During
the period 1970-1985 nominal GNP grew, on
average, 9.5 percent per year, while at the same
time the nominal value of international activity
rose, on average, 14 percent per year.
A more conventional measure of the in­
creasing involvement of the international sector
in the U.S. economy becomes apparent when
we relate the value of the merchandise trade
component of the current account to the value
of the nation’s production of goods. The
greater the proportion of exports or imports to
the value of GNP goods-output (excluding
structures) the more dependent the economy is
on foreign markets. Throughout the 1960s
U.S. merchandise exports as a percent of
4




goods-output (in current dollars) fluctuated in
a range of 7 to 8 percent. During the 1970s
U.S. export markets grew rapidly and in 1980
exports were equivalent to 19 percent of U.S.
output—a peak. Since then sluggishness in
world markets and competitive problems for
U.S. goods has resulted in a fall-off in the ex­
port measure to 13 percent in 1985.
During the same span of time, merchan­
dise imports as a percent of goods-output in­
creased from about 51/2 percent in the early
1960s to about 8 percent late in the decade.
The percentage continued to increase during
the 1970s, rising to a peak of 21 percent of
output in 1980 before the slackening in
1981-1982. The surge in imports resumed
during the 1983-1984 recovery-expansion and
pushed the imports-to-output figure back up to
nearly 21 percent in 1985. In sum, U.S. mer­
chandise trade has become substantially more
important, relative to the goods-output sector
of the economy, during the past two-and-onehalf decades.
The current account

The current account records international
transactions involving merchandise and services
Econom ic Perspectives

and unilateral transfer payments such as gov­
ernment and private gifts and pensions.
is the largest component.
In each year from the end of World War II
until 1971, the United States exported more
goods than it imported. Beginning in 1971,
however, merchandise imports exceeded ex­
ports in every year but two—1973 and 1975.
During the period 1971-1976 imports exceeded
exports by an average of $2.3 billion each year.
This was a period during which multiple in­
creases in the value of petroleum imports dom­
inated merchandise trade developments.
During 1977-1982 imports exceeded exports by
an average of $30.2 billion each year. By 1981
nonpetroleum imports were more than double
their 1976 level, as were exports. But imported
oil prices in 1981 were nearly three times those
of 1976, further increasing the margin of im­
ports over exports.
The continued appreciation in the value
of the dollar during the early 1980s (a devel­
opment that began late in 1980 following a
substantial depreciation the previous three
years) contributed to a decline in the
competitiveness of many U.S. goods. This, in
combination with the worldwide recession of
1982, resulted in a decline in U.S. merchandise
exports.
Despite the recession, however, U.S. non­
petroleum imports remained steady in 1982,
and in 1983 through 1985 advanced as U.S.
economic growth resumed and the appreciating
dollar further enhanced the competitive posi­
tion of foreign-produced goods. In 1983, im­
ports, excluding petroleum, exceeded exports
by 12 billion. In 1984, nonpetroleum imports
exceeded exports by $57 billion and in 1985 the
margin expanded to $74 billion. Exports re­
ceded again in 1985 following a 9 percent gain
in 1984. They remained 10 percent lower than
in 1981. As a result, the total value of mer­
chandise imports exceeded exports by $124
billion in 1985 (balance of payments basis).

Merchandise trade

the other major compo­
nent in the current account, is sometimes re­
ferred to as trade in “invisibles.” It also
increased in value by more than six-fold since
1970.
Exports have exceeded imports
throughout the period. The margin increased
steadily from $3 billion in 1970 to a peak of
more than $41 billion in 1981. Thereafter the

Trade in services,

Federal Reser\'e Bank o i Chicago




margin dropped yearly, to $18 billion in 1984
before recovering to $21 billion in 1985. In
1985 the export and import of services totaled
$146 billion and $124 billion, respectively.
Throughout the 1970s and early 1980s,
increasing positive balances on the services ac­
count provided a substantial offset to the neg­
ative balances recorded in merchandise trade.
As a result, the cumulative current account
balance for the period 1970-1981 was a positive
$3.8 billion. But since 1981, progressively
smaller positive balances in services provided a
diminishing offset to increasingly negative bal­
ances in merchandise. Consequently, the cur­
rent account balance in 1984 dropped $67
billion to a negative $107 billion and deteri­
orated further in 1985 to a negative $118
billion—by comparison, the current account
recorded a $6 billion positive balance as re­
cently as 1981.
A major factor in the deterioration in the
services balance has been the large increase in
U.S. payments to foreigners of income derived
from their holdings of U.S. assets. Such pay­
ments of income are financial services provided
to the United States by foreigners and are
counted as imports of services in the current
account. They are generated by direct invest­
ment in U.S. industry, lending to U.S. banks
and other firms, portfolio investment in U.S.
companies, and lending to government and in­
dividuals. Payments to foreigners through this
portion of the services account increased 30
percent from the 1983 level to $68.5 billion in
1984 and declined slightly to $65.8 billion in
1985 (partially in response to lower interest
rates), after holding steady at about $53 annu­
ally during 1981-1983. As recently as 1977,
U.S. payments to foreigners derived from their
asset holdings in the United States totaled only
$14 billion.
Not only has the absolute value of income
paid for financial services rendered by
foreigners increased but the category has in­
creased substantially as a proportion of total
services imports—from 27 percent in 1970 to 53
percent of the $124 billion total in 1985. The
major portion of that increase is attributable to
increased foreign holdings of U.S. financial as­
sets (and increased payments due to higher in­
terest rates). Significantly, much of this
development in the services account is rooted
in the relationship between merchandise ac5

F igure 2

U.S. intern ation al tra d e balances
billion dollars

count transactions and capital account
transactions—an issue discussed below.
U.S. exports of services have also in­
creased substantially during the past 15 years,
as the continued positive balance on the service
account implies. However, following a peak in
1981, services exports declined in 1982 and
1983 and the modest increases recorded in 1985
resulted in a services export total only 5 percent
higher than in 1981. As a consequence the
services balance in 1984 was at its lowest level
since 1975 and the $3 billion increase in 1985
still left the balance lower than that recorded
in 1977.
As with imports, considerable restructur­
ing in the composition of services exports has
occurred during the past 15 years. Historically,
income derived from U.S. holdings of foreign
assets has been a larger proportion of total ex­
ports of services than was the comparable item
on the import side. During 1985 exports at­
tributable to holdings of foreign assets were $90
billion—about 62 percent of the $145 billion
total. As was the case with service imports, the
proportion of services exports attributable to
6




income on foreign assets has trended
upward—from around 50 percent in the early
1970s.
Income derived from U.S. direct invest­
ment abroad is also counted as part of services
exports in figuring transactions balances. In­
deed, this source of income was the dominant
factor in the growth of service exports
throughout the 1970s. But in more recent years
income to U.S. residents on portfolio holdings
of foreign financial assets increased sharply in
response to a rapid increase in such holdings
during the late 1970s and early 1980s. Re­
flecting that change, U.S. private and govern­
ment income derived from holdings of foreign
financial assets exceeded income derived from
direct investment for the first time in 1981.
Income from such portfolio (non-direct) invest­
ment assets totaled $55 billion in 1985, down
from $64 billion in 1984, but still well above
the $35 billion in direct investment income.
Unilateral transfers, the final category
making up the current account, is a relatively
small item. Net transfers to foreigners totaled
$14.8 billion in 1985, up from $11.4 billion in
1984. During the first half of the 1970s such
payments averaged $4.4 billion per year. They
increased to $5 billion per year during the sec­
ond half of the 1970s and for the period
1980-1985 they averaged $9.5 billion per year.
But they accounted only for about 2 percent of
current account transactions in the early 1970s,
less than 1 percent in the late 1970s-early
1980s, and about 1.8 percent in 1985.
The capital account

The capital account is the final major
component of the recorded international ac­
counts. Recorded capital account activity (de­
fined as net U.S. acquisitions abroad plus net
foreign acquisitions in the United States) plus
“statistical discrepancy” totaled $194 billion in
1985, up from $142 billion in 1984 but, still
below the more than $210 billion annual aver­
age for the period 1980-1982 (see footnote 1).
Of special interest is the recent abrupt
change in composition of the capital account
transactions. Throughout the 1970s and the
early 1980s the recorded net acquisition of for­
eign assets by U.S. residents accelerated,
reaching a peak of $119 billion in 1982. The
recorded net acquisition of U.S. assets by
Econom ic Perspectives

foreigners also increased rapidly then held in
the $80-$95 billion range during 1981-1984
before moving sharply upward again in 1985
to $123 billion. However, U.S. residents’ net
additions to assets abroad decelerated dramat­
ically from the 1982 peak—to $20 billion in
1984 before recovering somewhat to $38 billion
in 1985. Recorded capital transactions shifted
from a net outflow of funds (net increase in
U.S. claims on foreigners) equal to $24 billion
in 1982 to a net inflow of funds (net increase in
foreign claims on the U.S.) equal to $77 billion
in 1984 and $85 billion in 1985.
The largest component
of this shift was the change in lending and
borrowing activities of U.S. banks. For the
second consecutive year, and only the fourth
time in the past 26 years, U.S. banks were net
borrowers abroad in 1984—by $36 billion.
Substantial change occurred on both sides of
the ledger. The increase in foreign lending by
U.S. banks was only $6 billion in 1984, the
smallest increase since 1972. It compares with
an increase of $111 billion in 1982.3 Continued
international debt repayment problems of sev­
eral Latin American countries have contrib­
uted to a sharp curtailment in banks’
willingness to extend additional credits to these
countries—countries that had been large takers
of new funds through 1982. In addition, the
rapid economic expansion in the United States
during 1984 and continued heavy borrowing
by the federal government in 1985 resulted in
strong domestic demand for funds. This also
contributed to a contraction in lending abroad.
On the other side of the ledger, U.S.
banks’ net additional borrowing from
foreigners has slowed in comparison with the
early 1980s. Liabilities to foreigners reported
for 1984 and 1985 increased $32 billion and
$41 billion, respectively, but were well below
the increases of $49 billion in 1983 and $66
billion in 1982 (see footnote 3).

Activities o f banks.

Foreign investment is the second
major component of capital transactions and is
composed of direct investment transactions and
securities investment transactions.
Direct investment transactions (invest­
ment in plant, equipment, and land) in recent
years have taken a turn contrary to the histor­
ical relationship.4 Throughout the post World
War I period, net increases in U.S. direct in­

Investment.

Federal Reserve Bank of Chicago




vestment abroad (funds outflows) exceeded net
new foreign direct investment in the United
States (funds inflow) by substantial amounts.
As recently as 1979 the net capital outflow
(U.S. direct investment abroad minus foreign
direct investment in the United States) totaled
$13 billion. What historically had been a net
capital outflow shifted to a net capital inflow
in 1981—by nearly $14 billion. From 1981
through 1984 foreign direct investment in the
U.S. continued to exceed U.S. direct invest­
ment abroad. In 1984 net new U.S. direct in­
vestment abroad totaled $4.5 billion as
compared with a net addition in foreign direct
investment in the United States of $22.5
billion. During that four-year period net for­
eign direct investment in the U.S. outstripped
U.S. direct investment abroad by a cumulative
total of $58 billion. However, in 1985 the his­
torical pattern reemerged with U.S. direct in­
vestment abroad, at $19 billion, exceeding by
a relatively small margin the $16 billion in
foreign direct investment in the United States.
The recent direct investment pattern has
occurred during a period of conflicting eco­
nomic and political pressures. The dollar has
appreciated in foreign exchange markets and
the cost of capital in the U.S. has been rela­
tively high—both developments that would
tend to encourage U.S. investment abroad and
discourage foreign investment in the United
States.
But, the rate of growth in U.S. economic
activity has been strong in comparison with
most other markets, especially during the 1983
recovery and the 1984 expansion, although that
pattern was reversed in 1985. Further, inter­
national debt repayment problems have dis­
couraged direct investment in the developing
countries. At the same time strong pressures
have developed within the U.S. to restrict a
wide range of imported products. These de­
velopments have favored investment in the
U.S. relative to investment abroad, and en­
couraged foreign investors to develop facilities
within the United States to forestall being
closed out of a major market. Foreign invest­
ment in the automotive, consumer electronics,
and metals industries are prime examples of
this phenomenon.
Capital flows into the securities markets
have also recorded marked change in recent
years. As noted earlier, during each of the last
five years total foreign acquisition of U.S. assets
7

F igu re 3

U.S. intern ation al transactions
Funds inflow resulting from the U.S. sale of goods
andservices abroad and the foreign net acquisition
of U.S. assets.

i----------r~

600

500

“ I—
400

300

100

200

Funds outflow resulting from the U.S. purchase of foreign
goods and services, net unilateral transfers abroad, and the
U.S. net acquisition of foreign assets.

0

0
—

billion dollars
— i

l—

1 97 2

_
_
'

100

~~T~

—I—
200

300

500

600

u n re c o rd e d
tra n s a c tio n s ,
n e t o u tflo w

1973

197 4

-

1 97 5

1 97 6

1977

_________
___ 11____

1983

have hovered in the $80-$ 120 billion range and
yet since 1982 the rate of increase in new for­
eign claims on U.S. banks has decelerated
appreciably. Part of the resulting “slack” has
been picked up by direct investment inflows.
More important, however, has been an increase
in foreigners’ acquisition of U.S. Treasury se­
curities and corporate stocks and bonds.
Drawn by high interest rates, changes in the
8




____

withholding tax law, and increasing stock
prices, net new acquisitions by “non-official”
foreigners totaled $72 billion in 1985 ($21
billion of which were U.S. Treasury securities),
double the $35 billion ($22 billion Treasury) in
1984, and seven times the $10 billion ($3 billion
Treasury) in 1981.
It is apparent that foreign capital is once
again playing an important role in the financEconom ic Perspectives

F ig u r e 4

In te rn a tio n a l in v e s tm e n t p o s itio n o f th e U n ite d S ta te s
dollars

billion dollars
1,200

1,000

800

- 600

- 400

-

1970

1972

1974

1976

1978

1980

1981

1982

1983

1984P

200

1985e

PPrelipiinary.
eEstimated.

ing of U.S. capital markets. The yearly net
foreign acquisition of U.S. Treasury securities
has increased seven-fold since 1981. Still, the
proportion of the gross public debt of the U.S.
Treasury held by foreigners has declined rela­
tive to the total size of the Treasury’s debt, a
point sometimes cited to support the contention
that foreigners have not contributed signif­
icantly to financing the recent dramatic in­
crease in government debt. Indeed, at midyear
1985 the proportion of U.S. Treasury debt held
by foreigners stood at 11.3 percent, the lowest
since 1971, and down from a peak of 17.5 per­
cent in 1978. Significantly, this recent decline
is due primarily to relatively less activity by
foreign official institutions. Approximately 66
percent ($137 billion) of the $209 billion in
foreign holdings of U.S. Treasury debt was held
by foreign official institutions at the end of
September 1985, down from an 84 percent
share as recently as 1981. Conversely, the
proportion of total foreign holdings of U.S.
Treasury debt held privately increased from 14
percent to 35 percent ($72 billion) between
1981 and September 1985. As a proportion of
total Treasury debt, foreign private holdings
increased from less than 1 percent in 1981 to
Federal Reserve Bank of Chicago




nearly 4 percent at the end of the third quarter
of 1985.
This relative decline in foreign holdings
of the federal debt is not what it appears on its
face, however. Indeed, “funds are fungible”
as the saying goes. Coincident with the surge
in aggregate demand for borrowed funds by
government (state, local, and federal) was an
acceleration in private demand for investment
funds. Foreign investors had numerous alter­
natives for placement of their funds: With a
rapidly expanding private economy in 1983
and 1984 and the consequent increase in pri­
vate credit demand it made little difference
whether the influx of foreign capital financed
private debt or public debt. What the inflow
did do was reduce the incidence of “crowding
out” in private markets by government bor­
rowing and facilitated larger private invest­
ment at lower interest rates than would
otherwise have been the case—assuming the
government deficit remained the same.5
The importance of foreign capital in fi­
nancing U.S. private and public demand for
investment funds is reflected in the proportion
of the total demand for investment funds (pri­
vate and public) accounted for by net capital
inflows. Empirically, this may be derived from
9

data available in the National Income and
Product Accounts. An approximate measure
of investment funds is represented by: 1) gross
private domestic investment plus 2) the excess
of government (federal, state, and local) ex­
penditures over receipts. Net foreign invest­
ment equals: 1) net exports minus 2) net
transfer payment to foreign recipients minus 3)
interest paid by government to foreigners—a
negative result indicates a capital inflow to the
U.S. From these data we see that net foreign
investment in the U.S. has not only increased
substantially in absolute terms but also became
a source of funds to finance the economic ex­
pansion and the expanding government deficit
during 1983-1985.
In 1980-1981, the U.S. provided net
funds abroad. But in 1982 a shift occurred.
In that year net foreign investment in the
United States accounted for a scant 0.2 percent
of U.S. private and public demand for invest­
ment funds. That proportion increased mark­
edly to 5.2 percent in 1983, surged to 11.6
percent in 1984, and stood at 13.7 percent in
1985. This dramatic increase indicates that the
large capital inflow was requisite to financing
the private investment boom and the large
government deficit. On the other side of the
coin it follows that for that net capital inflow
to occur the large trade and current account
deficits during the 1983-1985 period were a
necessity.
As noted in the discussion on the services
account the recent rapid increase in U.S. in­
come receipts from foreigners and U.S. pay­
ments to foreigners is related to developments
in the capital account. These income receipts
and payments are derived from investment ac­
tivity, as recorded in the capital account. As
foreign direct investment and foreign capital
claims on banks, government, and other issuers
of securities have increased so have U.S. pay­
ments of income to foreigners on holdings of
those assets. As net capital inflows increase so
will the net funds outflow through payments to
foreigners in the services account.
Of course the same relationship holds for
U.S. direct and capital investment abroad and
its impact on the U.S. export of services. It is
significant, however, that the recent shift in
capital flows—the U.S. becoming a net
importer of capital—has and will further accel­
erate the relative growth of service imports over
70




Figure 5

F oreig n c a p ita l c o n trib u tio n to U .S .
in v e s tm e n t increased ra p id ly d u rin g

1982-1985*
percent

'The percentages are derived from the National Income and Product
Accounts. Investment is defined here to include gross private
domestic investment plus the excess of government expenditures
over receipts. Foreign capital is net foreign investment in the
United States. During the period 1973-1981, the U.S. provided
net investment funds abroad, except in 1977 and 1978.

service exports. This will in turn tend to fur­
ther reduce net exports of services.
or “statistical dis­
crepancy,” is a final component in the makeup
of international transactions. This “balancing
item” between the current account and the
capital account was equivalent to a $33 billion
capital inflow in 1985—an amount equal to 28
percent of the nearly $118 billion current ac­
count outflow. The large magnitude of the
unrecorded transactions is not totally new.
During the previous six years unrecorded
transactions averaged a $24 billion annual in­
flow, and at least for the period 1980-1983 the
unrecorded inflow was well above the $9 billion
average current account outflow.
The emergence of the large unrecorded
transactions category is a bedeviling develop­
ment to international trade observers. Some
have suggested that changing corporate struc­
tures and intra-company capital movements
within multinational financial and nonfinancial
institutions may contribute to part of the in­
crease observed in recent years. In addition,
Unrecorded transactions,

Economic Perspectives

international debt servicing difficulties of nu­
merous less-developed countries have prompted
an increase in barter and counter trade in
goods and services. Such transactions may
distort trade valuations and consequently
understate or overstate the value of exports or
imports. To the extent this occurs a portion of
these unrecorded transactions should be
charged to the current account and conse­
quently the funds outflow implied in the cur­
rent account deficit might be overstated, or
understated.
The relationship between the current
and capital accounts

The relationship between current account
transactions and capital account transactions
is one of the more confusing aspects of interna­
tional trade. It is instructive, therefore, to ex­
amine these relationships before we look again
at what appears to be happening in the U.S.
international accounts.
Consider a situation in which a U.S. resi­
dent exports goods to a foreign buyer. In the
process of exchange the foreign buyer pays for
the goods; in so doing the foreign buyer has
exchanged an asset funds (a general claim
against future resources) for a specific asset
goods (a current resource). The U.S. exporter
has exported goods (real resources) and ac­
quired funds (a claim against the future real
resources of the foreign country). In sum, there
has been a transfer of real resources from the
U.S. to the foreign country in exchange for a
U.S. claim on future real resources of the for­
eign country. A U.S. import from a foreign
seller reverses the transaction.
If a country’s merchandise trade is in
balance during a specified period residents of
that country have exchanged (sold and pur­
chased) real resources of equal value. Over any
given time period only a highly unusual set of
economic circumstances would result in such a
balance. Rather, under “normal” circum­
stances a country’s merchandise trade account
would be expected to be in “surplus” (sold
more abroad than purchased from
abroad—acquired net claims on the future pro­
duction of foreigners) or “deficit” (sold less
abroad than purchased from abroad—assumed
net liabilities against future domestic pro­
duction in favor of foreigners). An example
similar to that for merchandise could be devel­
Federal Reserve Bank of Chicago




oped for trade in services with the result tend­
ing either to offset or augment the result of a
positive or negative merchandise balance.
Again, only rare circumstances would result in
a zero balance between services exports and
imports.
The trade account examples above essen­
tially assume instantaneous offsetting trans­
actions. However, as noted, a zero balance at
any given time is highly unlikely. A positive
or negative balance on trade transactions is one
of two bases for a capital account transaction
to occur. Indeed, implicit in a trade trans­
action is a capital transaction. They are the
two sides of the same coin. It is when export
and import trade transactions do not balance
(during any given period) that a net capital
inflow/outflow takes place. The U.S. import
of goods initially results in a foreign-owned
U.S. deposit resulting from a U.S. payment to
the foreigner for the goods (alternatively, U.S.
balances abroad might be reduced by the
amount of the transaction). It is in this sense
that a negative balance on the trade account
must be financed by an infusion of funds
through the capital account.
Capital account transactions may take
numerous forms, including: acquisition or liq­
uidation of bank deposits, purchase or sale of
stocks and other private securities, direct in­
vestment purchases or sales of plant and
equipment (see footnote 4), and the purchase
or sale of government obligations.
Recognizing the various forms of capital
transactions helps place in perspective the
interrelationship between the trade and capital
accounts. It becomes apparent that an indi­
vidual with funds available is faced with a
range of alternatives—the purchase of goods
and services domestically or from abroad, in­
vestment domestically or abroad, or some
combination of those alternatives based on rel­
ative cost, expected return, and time prefer­
ence. Time preference is particularly relevant
in understanding capital account transactions
that are not initiated in direct association with
a trade transaction.
Thus emerges the second basis for capital
flows—investment. Consider a capital trans­
action: The U.S. government or a private resi­
dent wishes to borrow funds and thus sells a
security. A foreign individual evaluates his sit­
uation and decides to acquire the security as
the best alternative use of his available funds.
11

The U.S.-originated security, in effect, is ex­
ported. The exported security represents a
claim by a foreigner against the future pro­
duction of the U.S. issuer-exporter. (In the
case where U.S. goods or services were ex­
ported, the goods represented a claim against
an immediate, or past, U.S. output.) Thus, in
the capital transaction the foreign buyerimporter has exchanged funds that represent a
general claim against future resources for a
claim against the future resources of the United
States. The foreigner has only changed the
form of its claim (assets) against the future. As
far as the U.S. is concerned, the sale (export)
of the security represents an obligation to
transfer real resources from the U.S. to the
foreign country at some time in the future. In
the meantime, there has been a transfer of
funds from abroad to the U.S.—funds which
may be used immediately or in the future to
purchase goods and services or securities (do­
mestic or foreign).
The key difference that emerges between
the trade account and the capital account is the
timing in the transfer of real resources. In ef­
fect, interaction of the two accounts—trade and
capital—facilitates different time preferences
between countries with respect to the inter­
country transfer of real resources.
Determinants of trade balances
and capital flows

During any given period a constellation
of economic determinants—relative rates of
economic growth, domestic price change, in­
terest rates, exchange rates, productivity, and
so forth—interact such that a country may be
a net importer of real resources (and an
exporter of securities-importer of capital), a net
exporter of real resources, or in balance. Resi­
dents of the net importing country must un­
derstand that, as a result of the net real
imports, the foreign exporters of those real re­
sources are acquiring claims against the goodsimporter’s future output. The goods-importer,
thus, is “exporting” claims against its future
real production. These claims represent output
which cannot be utilized in the domestic market when
the claim falls due.
Looked at from the other side of the coin
the above situation may be viewed as follows:
The constellation of economic determinants are
such that residents of one country prefer to
72




forgo current consumption or domestic invest­
ment in favor of saving abroad (acquiring fu­
ture claims on the real resources of a second
country). Thus, they “import” securities rather
than goods. If the relationships between the
economic determinants change (e.g., relative
interest rates, or exchange rates, or security
holders’ views about the economic stability of
the country whose securities are being ex­
ported), the change will feed into the time
preference function of the securities importers
and an adjustment between the capital and
current accounts will occur. With the appro­
priate relative mix between countries of do­
mestic real growth, inflation, productivity,
interest rates, exchange rates, and so forth resi­
dents of the securities-importing country will
prefer to convert those future claims on foreign
production (represented for example by their
holdings of securities issued abroad) to claims
on current foreign production. Likewise, the
time preferences of those who were formerly net
importers of real resources will change as they
look forward to an environment of net acquisi­
tion of claims on future foreign production and
current net exports of real resources.
The critical economic issue from the per­
spective of the capital-importing country is:
How is the imported capital being utilized in
the domestic economy? It is the same basic
question that faces any borrower of funds. In
the simplest terms from a consumer’s point of
view borrowed funds are used to increase cur­
rent consumption at the expense of future con­
sumption. If borrowed funds are used to
improve productivity and increase output in a
business the debt can be serviced and paid back
in the future out of the resultant increase in real
income, with a balance remaining that con­
tributes to a net real increase in income to the
borrower. Thus, current and future consump­
tion both may be increased. On the other
hand, the borrowed funds may be expended on
current consumption or nonproductive en­
deavor so that when the liability comes due the
real income of the borrower has not increased
sufficiently to service and pay off the debt.
Then the level of living (capital base) of the
borrower must be depressed in order to satisfy
the payment of interest and the repayment of
principal.
A net inflow of capital (imports of goods
and services exceed exports of goods and ser­
vices) is not inherently undesirable. Indeed, it
Economic Perspectives

may result not only in an increase in the cur­
rent level of living for the importers but also in
the future level of living for residents of the
capital-importing country.6 But, the key issue
is: To what use is the imported goods-servicescapital directed?
Where stands the United States?

In the current economic environment the
critical concern relative to the trade and capi­
tal accounts of the United States is not so much
that imports exceed exports and that capital
inflows exceed capital outflows but rather
whether that net import of capital is being uti­
lized to finance nonproductive consumption
and government expenditures rather than to
enhance the productive capacity and compet­
itive position of the United States vis-a-vis the
rest of the world. In 1983, 1984, and 1985
foreign capital financed an economic expansion
in the United States that otherwise would have
been less robust. But the recovery/expansion
was not uniform across the economy. In fact,
export industries and import-competing indus­
tries bore the brunt of the surge in the govern­
ment deficit and the transfer of resources that
permitted the increased net capital inflow from
abroad.
Other questions that must be addressed,
in addition to the burgeoning government def­
icit, are: Does government policy, legislation,
and regulation facilitate increases in produc­
tivity and investment or does it contribute to
distortions in the economy that discourage
productivity and competitiveness? Are man­
agement and labor pursuing practices that
promote or detract from increased productivity
and competitiveness? Is the vision of govern­
ment, business, and labor capable of looking
past the next election, annual report, or wage
negotiation to promote a less parochial view of
the economic environment in which we now
live, or, will the short-term view prevail, to the
detriment of living standards in the not-sodistant future? The U.S. propensity for “buy­
ing time” (viewed by some as providing more
rope for the hangman) does not inspire opti­
mism as to the outcome.
The United States has been a world
power for the better part of this century. But
it has only recently begun to experience the
growing pains of becoming a full-fledged inter­
Federal Reserve Bank of Chicago




national economy. That process, having be­
gun, means the United States does not control
its economic destiny to the same degree it did
15 or 20 years ago. It means that numerous
adjustments must be made to accommodate its
new role in the international economy. Re­
version to isolationism is not an option. Mar­
ket forces can effectively facilitate the
adjustments necessary to integrate the domestic
and international sectors, but only within the
constraints set by government fiscal/monetary
policy and the distortions introduced through
the myriad regulations controlling commerce.
Tinkering with trade cannot cure these ills, but
it can make them worse. Instead, it is the basic
issues associated with the distortions imposed
on productivity and competitiveness and the
central issue of the influence of the
fiscal/monetary policy environment and the
impact of regulatory distortions on economic
activity that must be addressed. If not soon,
then indeed the economy of the United States
faces leaner times ahead as additions to future
real income are siphoned off to pay for the ex­
cesses of today.1
1 The summation (using absolute values) of the
various individual components of international
transactions—exports and imports of goods and
services (excluding military grant programs), uni­
lateral transfers (excluding military grants), net
acquisition of assets abroad by U.S. residents, net
acquisition of U.S. assets by foreigners, the allo­
cation of SDRs (special drawing rights) by the
IMF, and unrecorded transactions (“statistical dis­
crepancy”)—is used here only as a relative gauge
of internationalization of the U.S. economy. From
an analytical view such a compilation includes
substantial double counting; most obvious, to the
extent that either exports or imports exceed the
other, the offsetting entry on the capital account is
counting the second side of the same coin. On the
other hand, capital transactions and unilateral
transfers are recorded as net inflows or outflows,
thus as a measure of the volume of transactions the
reported capital transactions are undercounted.
2 Looking at only trade in goods and services the
increase (in nominal value) from 1970 to 1985 was
about 6'/ -fold. Capital transactions (in nominal
value)—net acquisition of assets abroad by U.S.
residents plus net acquisition of U.S. assets by
foreigners (including various unrecorded
transactions)—were 12 times larger in 1985 than in
1970. The increase in unilateral transfers was
5-fold.
2

13

3 Capital flows reported by U.S. banks, in partic­
ular for 1982, are inflated due to changes in regu­
lations and tax laws that encourage U.S. parent
banks to handle international banking operations
through a domestically located International
Banking Facility (IBF) instead of through foreign
located branches. IBFs were allowed to commence
accepting deposits from and making loans to for­
eign residents on December 3, 1981. As a result
U.S. banks transferred substantial assets and liabil­
ities of their foreign branches to their domestic
IBFs. Consequently, banks’ claims on foreigners
(loans to) and liabilities to foreigners (deposits by)
increased. For a detailed discussion of early devel­
opment of IBFs see Sydney J. Key, “Activities of
International Banking Facilities: The early expe­
rience,” Economic Perspectives, Federal Reserve Bank
of Chicago, Fall, 1982; reprinted in Readings in
International Finance, second edition, published by
the Federal Reserve Bank of Chicago, September
1984.

74




4 Direct investment is defined as ownership of 10
percent or more of the voting stock or other means
of control over an enterprise by an individual or
corporation. Ownership of less than 10 percent of
the stock is defined as a portfolio investment.
5 This is not a limiting assumption for had not the
accelerated rate of private investment occurred the
government deficit would have been even larger
than it actually was because of lower tax receipts
stemming from the lower level of economic activity
and larger government expenditures—both a re­
sponse to higher interest rates.
6 Developing countries have historically been capi­
tal importers. High rates of return on investment
resulted in an ability of such economies to service
rapidly increasing levels of debt. Problems can re­
sult, however, if the magnitude of the debt and its
servicing costs outrun the country’s ability to pay
as we have recently observed in numerous Latin
American and African countries when the econo­
mies are forced to accept reduced current levels of
living to pay for past excesses.

Economic Perspectives

Fiscal policy and the trade deficit
David. Alan Aschauer
This article explores the relationship be­
tween the fiscal stance of the public sector and
the current account of the international bal­
ance of payments.1 The 1980s have been years
of both massive public sector budget
deficits—driven by a combination of tax cuts
and increased government expenditure—and
current account deficits. Traditional macroeconomic analysis views the public sector defi­
cit, regardless of its cause, as a major reason for
the trade deficit as the government’s demand
for loanable funds induces a capital inflow, a
rise in the value of the dollar, and a falling off
of net exports. A conventional resolution of the
trade problem, then, involves eliminating the
public sector deficit by whatever economic
means available.
Throughout the article, the terms “cur­
rent account” and “trade account” will be used
interchangeably. The former exceeds the latter
to the extent that the U.S. receives net interest
income from foreigners.
The argument in this article is that the
traditional analysis, while to some degree cor­
rect, does not recognize the important dis­
tinction to be drawn between various ways of
creating a public sector deficit—via tax cuts and
increases in spending—and thereby sketches an
inaccurate picture of the relationship between
fiscal policy and the balance of payments. The
paper contains a simple and highly stylized
model to demonstrate that cuts in government
spending may well be substantially more
efficacious than tax increases in reducing a
trade deficit. Further, the model suggests that
a temporary tax increase to close a fiscal deficit
may actually worsen the trade deficit.
A neoclassical model of fiscal policy
in an open economy

In this section we construct a simple
model of the open economy. Although highly
stylized, the model will allow for an analysis of
the effects of various fiscal policy actions on
domestic output, employment, and the balance
of trade. The world of the model is a single
country composed of a public sector (govern­
ment) and a private sector. The private sector
Federal Reserve Bank of Chicago




is represented by an infinitely lived agent with
preferences captured by the utility functional
U = u(cQ,no
) , «i).
(1)
Here, total utility, u, is the sum of present util­
ity, u(cq, W), and discounted future utility,
q
u(cx , nj), where the discount factor equals the
inverse of the rate of subjective time
preference.2 Momentary utility is taken to in­
crease, at a decreasing rate, with consumption,
c„ and to decrease, at an increasing rate, with
work effort, nt.
It is assumed that the private sector agent
maximizes his well-being (“utility”) by choos­
ing levels of work effort and the consumption
of goods. The agent must balance his
work/consumption account over a period of
time in the face of government spending and
two kinds of government taxation—“lump
sum” taxation, which is applied across-theboard on all taxpayers, and “distortional” tax­
ation, which is levied on certain kinds of goods
and activities or goods and not on others.
The agent is constrained in his choice of
consumption and work effort over time by the
budget equation
co

+

= 0 — T0) / ( « o ) — ^

(2)

(1 - H )/(«i) - *1
r*
which equates the present value of consump­
tion to the present value of after-tax returns to
work effort? Here, zt is the tax rate on output
in period t, t, are lump sum taxes in period t, r*
is the interest rate on borrowing and lending,
assumed to be determined in the world capital
market, and J\n,) is a neoclassical production
technology whereby output rises, at a dimin­
ishing rate, with increases in work effort. It
should be noted that the form of equation (2)
implies that the individual visits the domestic
and/or international capital markets to the exDavid Alan Aschauer is an assistant professor of economics
at the University of Michigan and a visiting scholar in the
Research Department, Federal Reserve Bank of Chicago.
15

tent that his desired consumption and work ef­
fort do not yield an equality between current
consumption and after tax labor earnings.
The agent is assumed to maximize utility,
as formulated in the objecdve function (1),
subject to the intertemporal budget constraint
(2). This yields the following first order condi­
tions (along with (2) itself):
»,(• 0) =-£-*,(• 1)

(3)

!i,(-0) = - ( i - T „ r ( - 0 K ( - 0 )

(4)

«.(•!) = —(1 —T j n - 1K(- 1).

(5)

Equation (3) insures that the individual chooses
consumption optimally over time. The re­
duction, in the current period, of consumption
by one unit reduces current utility by uc{ • 0)
but allows an increase of r* units of consump­
tion in all future periods, which raises future
utility by-^j- u.c(' 1). To be on an optimal path,
the individual must have adjusted consumption
so that such gains and losses cancel on the
margin. Conditions (4) and (5) require that the
individual chooses consumption and work effort
optimally at each point in time; the loss in
utility from working another hour, un(m,), must
equal the gain to utility through the consump­
tion of the net return to the labor service,
(1 -T ,)/'fa k (* /)•
The government taxes in each period in
both a lump sum and distortional fashion to
raise revenue for the purpose of the acquisition
of goods and services, gt. Its intertemporal
budget constraint is given as
, g\ _ r(
, , Tl / ( “l) + l\
()
6
go + — ~ To/fa>)^ + *o + -------p ------which equates the present value of expenditures
to the present value of revenues.4 As with the
private agent, to the extent that current reve­
nues do not match up with current revenue
needs, the public authorities may visit the do­
mestic and/or international capital market to
obtain claims to goods, subject only to the
overall constraint (6) that such borrowing and
lending must balance over time.
To close the model, we define the trade
deficit as the amount by which domestic con76

sumption, c, + gt , exceeds domestic production,
/fa), or
<> = c + gt ~ /fa)
it
t
(7)
which, as the balance of payments must bal­
ance, may also be taken to be the capital ac­
count surplus. Thus, to the extent that the
current account is in deficit, (f)t > 0, the repre­
sentative agent and the public sector are bor­
rowing from foreigners to finance the
acquisition of foreign goods. Summation of
equations (2) and (6) and use of the definition
(7) yields the condition that the current ac­
count must balance intertemporally, or




< 0 + -^ r = 0.
/>

(8)

Equilibrium

We now obtain a set of equations which
fully characterize the model’s general equilib­
rium. First, use equation (7) to substitute for
c0 and q in equations (3), (4), and (5). Next,
use equation (8) to substitute for </q in the re­
vised versions of equations (3) and (5). This
leaves three equations in the three unknowns,
% »!, and <>
/ 0:
“//fa )) - £o + 0O> “o)
r*
= —

«//(«i)

~ g

l-

(9)
r*(f>

o, «i)

- «*(/(«o) - £o + $ o> «o)
(10)
= (1 - T0)/'fa)K (/fa)) - go + /o> «o)
- “«(/(«l) - g\ - r*<t>0, n\)
(11)
= (1 - *l)/'(«lK (/(»l) - g \ - r*(j>o, »i) •
These equations may be manipulated to
obtain the effects of changes in government
spending and taxes on the levels of domestic
employment and output as well as the current
trade deficit. This analysis is pursued in the
next section.
Economic Perspectives

Fiscal policy in the open economy

An important fiscal policy result may be
obtained immediately. As the equation set
(9)-(l 1) is not dependent upon lump sum taxes,
a “pure” public sector deficit, driven by a re­
duction in current lump sum taxes, has no effect
on domestic employment, output, or on the
trade deficit. This arises because the optimiz­
ing agent recognizes the future tax liabilities
implicit in the current borrowing by the public
sector—from either domestic or foreign
agents—and saves the tax cut. This eliminates
any possibility of excess demand pressure in the
goods market and prevents any effect on ex­
ports or imports. Such a fiscal policy action is
said to be neutral with respect to all real vari­
ables of the open economy model. Therefore,
we must investigate deeper to uncover the fun­
damental aspects of the relationship between
fiscal policy and the trade account.
Consider, next, the impact of a change in
distortional taxation. We define a temporary in­
crease in the tax rate as a current reduction
which keeps the present value of tax rates con­
stant; consequently, future tax rates by neces­
sity would be lowered.5 The system (9)-(ll)
may be used to find that current employment
falls and the trade deficit rises in response to a
temporary rise in income taxation, while future
employment rises.6 The reasoning is straight­
forward. The increase in the current tax rate
reduces the incentive to engage in market ac­
tivity and promotes a reduction in employment
and output as well as a reduction in consump­
tion expenditure.7 However, as the increase in
the tax rate is temporary, the individual at­
tempts to maintain a fairly smooth time path
of consumption and there arises an excess de­
mand for goods which is satisfied by an inflow
of foreign goods—a trade deficit.
Figure 1 explains these effects graphically.
Figure la graphs domestic aggregate demand,
C + g0, and domestic aggregate supply, y0,
q
against the interest rate, r*. As 1 + r* is the
relative price of current commodities, aggre­
gate demand slopes negatively and aggregate
supply positively. At any particular value of
the interest rate, the horizontal gap between
aggregate demand and aggregate supply rep­
resents the trade deficit. Figure lb plots the
trade deficit against the interest rate; it has a
negative slope as the excess demand for goods
depends inversely on the interest rate. We as­
Federal Reserve Bank of Chicago




sume, originally, that the trade account is bal­
anced in constructing Figure 1.
Now consider the effect of a rise in income
taxation. This reduces aggregate supply from
y to f and reduces aggregate demand from
y d to y d' . As the former effect dominates—the
individual attempting to smooth out fluc­
tuations in consumption—there is an excess de­
mand for goods equal to C + g0 —j 0 which
q
spills over as a trade deficit equal to (f)'.
On the other hand, a permanent rise in the
tax rate (assumed to be rebated via lump sum
transfers) has different effects on the open
economy.8 As before, aggregate supply and de­
mand both decline in the face of the rise in the
tax rate and consequent reduction in the return
to market activity. However, in this case, the
fall in aggregate supply is less than before—as
the relative return to current vis-a-vis future
production is now unaffected—and the fall in
aggregate demand is greater than before—as
the individual recognizes it is not possible to
smooth out the permanent change in taxes. The
benchmark case where the rate of time prefer­
ence, p, equals the real interest rate, r*, yields
the result that the reduction in output and de­
mand are equal and, consequently, there arises
no effect on the trade account.9 This case is
shown below in Figure 2.
It is important to note, however, that
output and employment have been reduced
even though the trade balance has been left
unaffected. This points out the role of the trade
account as a vehicle by which economic agents
can smooth out temporary discrepancies be­
tween desired output and consumption levels;
in the case of a permanent change in produc­
tive opportunities, however, there is no reason
for such a discrepancy between supply and de­
mand to arise and, therefore, no effect on the
current account.
We now consider the impact of a tempo­
rary rise in government spending, i.e., a current
rise such that the present value of expenditures
is left unchanged.10 Again, the equilibrium
equations (9) - (11) may be utilized to find that
output remains unchanged while the trade
deficit worsens. Here, the economic agent re­
sorts to the market in international goods to
sustain his original choice of consumption and
work effort in the face of the extraordinary,
transitory demand for resources. In terms of
Figure 3, aggregate demand rises from yd to
77

Figure 1

A temporary tax rate increase
r

r

Figure 2

A permanent tax rate increase
r

78




r

Economic F
’erspectives

y d', while aggregate supply is unaffected; this
causes a trade gap equal to the difference be­
tween these quantities, represented by a shift in
the trade account locus from (f)0 to 0 O
Finally, we consider the case of a perma­
nent rise in government spending, financed by
a rise in lump sum taxation. In the benchmark
case where the subjective rate of time prefer­
ence equals the interest rate, the result is an
increase in output but no effect on the balance
of trade. Here, the individual responds to the
reduction in his wealth—as the government’s
share of output has permanently increased—by
reducing consumption (shifting aggregate de­
mand from y d> to y d") and by increasing work
effort (shifting aggregate supply to y'). As the
rise in aggregate supply and the fall in aggre­
gate demand are sufficient to provide for the
increased government spending, the trade bal­
ance is left unchanged.
The effects of the various fiscal policies
are summarized in Table 1. A “pure” govern­
ment deficit, driven by a reduction in current
lump sum taxes, has no effect on the economy’s
wealth and, therefore, no effect on output, em­
ployment, or the trade account. A public sec­
tor deficit caused by a temporary reduction in
tax rates, however, raises output and causes a
trade account surplus while a government def­
icit induced by a temporary rise in government
spending brings about a trade deficit. Finally,
permanent changes in tax rates and govern­
ment spending have no effect on the trade ac­
count, at least in the benchmark case where
p = r*.
Current fiscal policy, output,
and the trade deficit

The major theme of the Reagan
Administration’s political philosophy has been
to reduce the size of the federal government.
A characterization of fiscal policy followed

during the Reagan years—past, present, and
future—consistent with this ideological corner­
stone is that the tax cuts initiated in 1981 were
permanent in nature, designed to bring about
a permanent reduction in the level of public
expenditure.11 The current public sector deficit,
then, is a consequence of temporarily high
government spending in the face of perma­
nently lower tax revenues.
The combined effect of this permanent
reduction in tax rates and temporary rise in
government spending has been to raise em­
ployment and output, as well as to induce a
deficit in the current account (see Table 1). In
figure 5, the permanent reduction in tax rates
has shifted aggregate supply to f and aggre­
gate demand to_^' while the temporary rise in
government spending has further raised aggre­
gate demand to yd” . The current excess de­
mand for goods has spilled over to cause a trade
deficit as the trade account locus has shifted to
0o •
Consider, now, possible resolutions to the
government deficit and their impact on the
current account. First, the present level of
government spending could be reduced to a
level consistent with a balanced public sector
budget at the existing structure of income tax
rates. This would eliminate the excess demand
for goods inherent in the temporarily high level
of government spending, thereby eliminating
the trade deficit, while keeping output at a
level permanently higher than before the tax
reductions began in 1981. In this particular
case, the balancing of the public sector deficit
would help to bring about a closing of the gap
between exports and imports.
Second, the contemporaneous level of
taxation could be raised to meet the currently
high level of public expenditure. If the present
level of government spending then were per­
ceived by the representative individual as a
temporary upsurge, the after tax return to cur-

Table 1
P o lic y

Im p a c t o n :

L u m p sum
ta x c u t

T a x r a te c h a n g e

G o v e r n m e n t s p e n d in g c h a n g e

T e m p o ra ry

P e rm a n e n t

T e m p o ra ry

P e rm a n e n t

E m p lo y m e n t/o u tp u t

0

-

-

0

+

T r a d e d e fic it

0

+

0

+

0

Federal Reserve Bank of Chicago




19

Figure 3

A tem porary rise in governm ent spending
r

r

Figure 4

A perm anent rise in government spending
r

20




r

Economic Perspectives

Figure 5

Current fiscal policy

rent market activity would be seen to be low
due to the high current relative to future rate
of taxation. Current employment and output
would fall as production would be shifted to the
future in anticipation of the high after tax re­
turns in later periods, and the trade deficit
would worsen. Curing the public sector deficit
in this way would only enlarge the deficit on
current account. On the other hand, if the
agent believed that the rise in the current rate
of taxation were to be made permanent, sup­
porting the higher level of government spend­
ing into the indefinite future, the trade deficit
would be closed as current and future goods
then were deemed to be equally scarce. How­
ever, as the tax rate would be permanently
higher, the overall level of economic
activity—measured by employment, output,
and consumption—would be permanently
lower. Attacking the public sector budget def­
icit in this way would be successful in bringing
exports and imports in line with one another,
but at the cost of a higher tax distortion and
reduced domestic economic activity.
Thus, the possible ways in which the
government deficit may be eliminated have
differential effects on the levels of domestic
economic activity and the trade deficit. A tax
Federal Reserve Bank of Chicago




increase would reduce the returns to domestic
production and would lower output, and would
only eliminate the trade deficit if the tax in­
crease were viewed as permanent by the repre­
sentative agent. A decrease in spending, on the
other hand, would eliminate the trade deficit
while keeping in place the beneficial incentive
effects of a low rate of income taxation.
Conclusion

This article is an investigation into the
relationship between the public sector deficit
and the position of the current account in the
international balance of payments. In contrast
to the predictions of conventional macroeco­
nomic models, the model presented here sug­
gests that tax cuts and changes in public
expenditure have qualitatively different im­
pacts on the trade balance. In particular, in
the case of a temporary increase in income
taxes, the trade deficit would worsen rather
than improve. This suggests that the policy of
raising tax revenues to cover the high present
level of government spending might not be an
effective device to close the trade gap. In con­
trast, the model presented here suggests that a
27

reduction of government spending would re­
duce the trade deficit.
1 Throughout the article, the terms “current ac­
count” and “trade account” will be used inter­
changeably. The former exceeds the latter to the
extent that the U.S. receives net interest income
from foreigners.
2 Implicitly, we are assuming that all periods 1, 2,
..., oo are identical so that we may write
u = (=0 ( ,1 +P. Vu(ct, nt)
Z !
= u(co, no) + j ]_ - [a fa , «i) +
I T p

= «(<<), no) + t |
= “fa, «o) + y

1 -r P

u(c2, n2 + )

[a(cl5 »i) + 1 p u(cx, nx) + «fa, «i) ■

3 As in footnote 2, all periods 1, 2, ..., oo are as­
sumed identical so that we may transform the
intertemporal budget constraint
EC
t=o 1 + r" -)'«* = (=0 1 + ^ -)' [(1 - ?t)f(nt) ~
into equation (2). Also, in obtaining an
intertemporal constraint as above, a solvency con­
dition has been imposed such that as time nears
infinity the present value of the individual’s stock
of debt goes to zero; this rules out the possibility of
perpetual debt finance or, more popularly, a “Ponzi
scheme.”
4 An analogous argument to that in footnote 3
holds.

22




5 Notationally, a temporary tax increase is given
by dx0 > 0, d(x0 + xx/r*) = 0.
6 This “comparative statics” exercise proceeds by
totally differentiating the system (9)-( 11) to obtain
the matrix equation A-x = B-z where x' =
(dno dnxd<j)Q z' = (^t0 dxxdg0 dgx), A is a 3x3 matrix
),
of coefficients on the elements of x and B is a 3x4
matrix of coefficients of z. For details in a similar
model, see Aschauer, D. and Greenwood, J.,
“Microeconomic Effects of Fiscal Policy,” Carnegie
Rochester Conference Series on Public Policy, November
1985.
7 Throughout the subsequent analysis, it is assumed
that consumption and leisure are normal goods,
e-g-, ucc(- ) - uc(■ )ucn(■ )/«„(• ) < 0.
8 A permanent rise in the tax rate is dx0 = dxx > 0.
9 If the subjective discount rate were to exceed the
interest rate, p > r* the individual would place a
higher subjective premium on the utility to be gained
from current consumption than must be paid on the
market. In this case, the individual would choose
to bear the excess burden of higher taxation rela­
tively more in the present and there would arise an
excess supply of goods and a trade surplus. Simi­
larly, if p < r* a trade deficit would be encouraged.
However, for international trade to balance
intertemporally, we must assume (in this model)
that/> = r*. One way to rationalize the latter as­
sumption is by making the more fundamental,
symmetric assumption that all (representative)
agents across countries have the same subjective
rate of time preference. Then the world equilib­
rium interest rate would equal this common rate
of time preference.
10 Notationally, dg0 > 0 and d(g0 + gx/r*) = 0 .
11 Here “levels” of taxation and government
spending should be taken as ratios to gross national
product.

Economic Perspectives

N O W A V A IL A B L E

Toward Nationwide Banking

O ne of the m ajor issues facing the financial industry today is that of interstate
banking. T o w a rd N ation w ide B anking, recently published by the Research
D epartm ent of the Federal Reserve Bank of Chicago, examines this timely
topic from a variety of perspectives.
• Is there a need for interstate
banking?
• What is the driving force
behind interstate banking?
• W hat are the implications
of various provisions of interstate
banking legislation?
• How will banking law liberalization
affect local market structure?
• Where have nonbanks chosen
to locate and why have they
selected these locations?
• Who will be the acquirers and
who will be acquired when
banking laws are liberalized?
• How will the new interstate
banking laws affect the viability
and independence of small banks?
The research contained in T o w a rd N ation w ide B anking should be of valuable
assistance to bankers, legislators, academics, and consumers who are con­
cerned about this emerging development. T o w a rd N ation w ide B anking is
available from the Federal Reserve Bank of Chicago, P.O . Box 834, Chicago,
IL 60690 at $10 a copy. M ake checks payable to Research D epartm ent,
FRB Chicago.

f ederal Resewe Bank of Chicago




23

The impact of geographic expansion in
banking: Some axioms to grind
Douglas D. EvanoJJ and Diana Fortier
In recent years the potential impact of
relaxing geographic restrictions on banking or­
ganizations has been actively debated. Propo­
nents argue that the ability to expand into new
markets will produce efficiencies enabling
banks to offer improved services at preferred
prices. Opponents counter that expansion will
result in increases in concentration and market
power leading to higher prices and inferior
service, and, eventually, impairing the safety
and soundness of the industry. The opposing
groups have supported their positions
relentlessly with the same unchanging argu­
ments. As a result there have evolved several
almost axiomatic statements concerning the
impact of relaxed geographic restrictions.
This article provides evidence on the va­
lidity of a number of these popular “axioms.”
Past research on geographic barriers to intra­
state expansion is reviewed and new evidence
is introduced to determine whether these pop­
ular conceptions are sound or are overstated
arguments. The findings should aid legislators
and may help the industry avoid the continual
imposition of inefficient market restrictions
aimed at avoiding situations which, in fact,
have little probability of occurring.
Among the arguments commonly pre­
sented in opposition to geographic expansion
in banking are: 1) Geographic expansion will
lead to significant increases in market concen­
tration. Over time, a relatively small number
of institutions will gain control of the local
marketplace. 2) Antitrust legislation is not ef­
fective in curtailing concentration increases in
banking. 3) Banking organizations which
compete with each other in a number of mar­
kets will, in effect, collude with one another by
avoiding aggressive competition in one market,
expecting similar behavior by rival firms in
other markets (the mutual forbearance hy­
pothesis). 4) Small banks are not able to com­
pete with large banking organizations.
Therefore, if increased geographic expansion is
allowed, a significant number of bank failures
will occur, and the number of small indepen­
dent banks will significantly decline. 5) Re­
24




moving restrictions on geographic expansion
will lead to excessive market power resulting in
an inferior level of banking services. 6) Allow­
ing expansion will lead to higher bank service
prices. 7) Service accessibility will decline if
geographic expansion is allowed. Additionally,
the number of bank alternatives from which fi­
nancial services can be obtained will decline.
8) Geographic expansion will not significantly
aid, and may actually hinder, rural areas be­
cause expansion will take place only in more
attractive urban markets.
The recent development of regional
banking compacts, modified state laws, inter­
state stakeout agreements, and limited service
banks has heightened the controversy over the
validity of the preceding statements. The evi­
dence presented here indicates that some of the
arguments posed against geographic expansion
have little basis in reality.
Axiom f f l : Market structure will
become significantly more
concentrated.

Perhaps the foremost concern with respect
to interstate banking is the potential for in­
creased concentration of banking resources.
An aversion to the concentration of financial
and economic resources has been a major
theme in the history of the United States and
was in part the impetus behind the Sherman
and Clayton Acts and, with respect to banking,
the Bank Holding Company Act (BHC Act).
The major goals of the BHC Act are the pre­
vention of an undue concentration of resources
and the preservation of competition in banking.
Economic theory holds that increased
concentration results in reduced competition.
That, in turn, leads to a suboptimal allocation
of resources and a distortion in the distribution
Douglas D. Evanoff is a senior financial economist and
Diana Fortier is a regulatory economist at the Federal Re­
serve Bank of Chicago. A more comprehensive discussion
of issues related to geographic expansion in banking can be
found in Toward Nationwide Banking, Federal Reserve Bank
of Chicago, 1986.
Economic Perspectives

of income. That is, the probability of non­
competitive behavior can be inferred from the
number and size distribution of firms in the
market.1 This perceived relationship prompted
antitrust legislation to prevent the concen­
tration of markets and the resulting higher
prices, higher profits, inferior services, and re­
duced output. The adverse effects associated
with concentration are of particular concern in
markets where customers are limited to local
service providers. In banking this primarily
means the market for retail financial services
since the wholesale market (e.g., corporate
loans) is already regional or national in scope.2
The ultimate impact of geographic bar­
rier removal depends on two opposing forces.
First, barriers create an anticompetitive envi­
ronment by preventing new entry into a mar­
ket. Lifting them should result in increased
potential and actual market entry. Potential
entry is important because the mere threat of
new entry may be sufficient to induce procompetitive behavior. Markets in which firms
continue to behave anti-competitively would
soon be serviced by new entrants.
Most bank expansion occurs, however,
through acquisition, rather than de novo. This
creates a concern that the elimination of entry
constraints may lead to extensive acquisition
activity, increased concentration, and possibly
collusion among large institutions. Although
these two opposite considerations pose a di­
lemma, numerous studies generally support the
hypothesis that a relaxation of geographic re­
strictions has procompetitive effects/
The removal of geographic restrictions is
expected to affect concentration of the industry
at the national and/or state level differently
than that at the local market level. For our
analysis, the impact at the local market level is
most relevant because measures at broader
levels can frequently mask the local situation.
For example, the concentration level could,
hypothetically, be 100% in all local banking
markets (i.e., controlled by one firm) but be
relatively low at the state level. To analyze
local market conditions, nonmetropolitan
county and metropolitan area boundaries were
used as approximations of banking markets in
the United States.
Between 1970 and 1983 the HerfindahlHirschman Index (HHI), a measure of local
market concentration, declined significantly;
see Table 1. This decline occurred in local
Federal Reserve Bank of Chicago




markets regardless of branching restrictions.
However, the greatest deconcentration oc­
curred in areas allowing relatively liberal
branching.4
A closer evaluation of the variation in the
HHI between areas with different branching
laws indicates that the absolute level of con­
centration was essentially the same in 1983 ir­
respective of branching status. However, this
is a substantial change from earlier years. In
1970, local markets allowing branching were
significantly more concentrated than were
markets permitting unit banks only. Over the
next ten years the decline in concentration in
branching markets was much greater than the
decline on average. Apparently, increased
market entry, a result of the ability to branch,
served to generate the current lower levels of
concentration.
The data in Table 1 also indicate the ab­
solute level of concentration differed substan­
tially between metro and non-metro markets.
The average HHI has historically been ap­
proximately 50 percent lower for metro areas
because these markets are better able to sup­
port a larger number of competitors. The rel­
atively smaller number of competitors in
non-metro areas results in a comparatively high
HHI. However, regardless of the absolute lev­
els of concentration, both types of markets have
experienced a decline in concentration.
The impact of branching has also been
different in metropolitan and nonmetropolitan
areas. The variation in the average HHI be­
tween markets with different branching status
is rather minimal in nonmetro areas. However,
the index is significantly lower for metro mar­
kets in unit banking states than for those in
branching states. This difference has declined
over time as the metro markets allowing
branching have experienced the greatest con­
centration decline.
The HHI is a comprehensive measure of
market concentration in that it takes into ac­
count the market shares of all firms in a mar­
ket. Alternatively, the one-, three-, and
five-firm concentration ratios consider only the
largest firms in the market. These ratios are,
however, the more commonly reported statistic.
An analysis of concentration in local
markets using the three-firm concentration ra­
tio, C3, produced results very similar to those
found using the HHI. The concentration trend
has been downward with the greatest declines
25

Kjs
C
T
Table 1
Local m arket structure data by branching status

States not
changing branching status 1

All states 1

Unit
Banking

All
states

Limited

46 93t
42 23t
4145 t

4466
4226
4140

3895
3569
3546

3306
3140
3132

5098
4036
3995

90.0%
88.4%
88.0%

91,2t
89.4%t
89.1 %t

88.5%
87.1%
86.6%

83.4%
81.8%
81.7%

78.8%
78.3%
78.2%

94.7%
85.6%
85.5%

4468
4426
4340

4856
4483
4398

5018t
45311
4444t

4659
4426
4340

4153
3818
3797

3402
3238
3236

5213
4535
4490

91.1%*
88.5%*
88.5%

88.4%
89.2%
88.8%

92.0%
90.8%
90.5%

93.6 t
92.2t
91.9t

90.1%
89.2%
88.8%

85.8%
84.7%
84.7%

79.7%
79.4%
79.4%

95.3%
91.2%
91.2%

2731*
2024*
1986*

2293*
2077*
2065*

1973
1711
1625

2368
2024
1982

2514
21611
2139t

2035
1711
1625

2081
1815
1782

2038
1842
1771

2837
1801
1786

79.2%*
66.8%*
65.7%*

71.0%
68.6%*
68.8%*

66.4%
61.2%
59.6%

73.1%
67.6%
67.0%

75.5 t
70.5 t
70.2 t

67.6%
61.2%
59.6%

66.7%
61.7%
61.0%

66.9%
63.5%
62.4%

81.7%
61.0%
60.4%

Type of market

Concentration
measure & year

All
states

Statewide

All markets

HHI

1970
1980
1983

4441
4081
4013

c3

1970
1980
1983

HHI

Unit

All
states

4918*
4054
3946

4387
3979*
3947

4267
4226
4141

4594
4224
4143

88.6%
87.0%
86.6%

93.2%*
87.4%
86.8%

88.5%*
86.6%
86.6%

86.6%
87.1%
86.6%

1970
1980
1983

4706
4341
4269

5257*
4489
4367

4708*
4187*
4154

1970
1980
1983

90.7%
89.5%
89.2%

95.3%*
91.8%*
91.3%*

HHI

1970
1980
1983

2297
1972
1933

C3

Metropolitan
areas

Limited

c3

Nonmetropolitan
counties

States changing
_______ branching status 1

1970
1980
1983

71.5%
66.2%
65.5%

Branching

Statewide

Economic Perspectives

1 States changing branching laws refers to those changing status between 1960 and 1983. (In 1960 there were 16 statewide, 16 limited and 18 unit banking states. In 1970 there
were 19 statewide. 16 limited and 15 unit banking states. In 1980 there were 23 statewide, 16 limited and 11 unit banking states. In 1980 and 1983 there were 23 statewide, 16 limited
and 11 unit banking states. States changing from unit to limited were Arkansas, Iowa, Minnesota, and Wisconsin. States changing from limited to statewide were New Hampshire,
New Jersey, New York, Maine, and Virginia. Florida changed from unit to limited in 1977 and from limited to statewide in 1980. South Dakota changed from unit to statewide in 1968.)
Metropolitan areas crossing states with different branching laws in any year were deleted from the sample. The same number of markets were analyzed for each year by branching status
in the given year.
'Mean for statewide or limited branching states is signficantly different at the .05 level from the mean for the given year for unit banking states.
tMean for branching states not changing branching laws is significantly different at the .05 level from the mean for branching states changing status (i.e.. status changing from unit
to limited or statewide, and from limited to statewide.
SOURCE: FDIC Summary of Deposit data as of June 30, 1970, 1980 and 1983.




in markets with liberalized branching laws.
The only apparent difference is the amount of
decline in concentration in nonmetropolitan
areas. The C3 would not detect entry unless
the entrants obtained a significant share of the
market. The HHI, however, would account for
a new entrant regardless of the market share
obtained. This difference between the mea­
sures produces a significant decline in the HHI
in nonmetropolitan areas over the period ex­
amined without a corresponding significant
decline in the C3. Given this difference, the
HHI may be the preferred measure of market
concentration.5
Trends toward increased concentration
are of prime concern in markets that are al­
ready highly concentrated. Separating local
markets by level of concentration (based on
HHI data not presented in the tables) shows
that highly and moderately concentrated mar­
kets became less concentrated between 1970
and 1983. This is true regardless of branching
status or changes in branching laws. More­
over, the number of highly concentrated local
markets has fallen, and, correspondingly, the
number of moderately concentrated local mar­
kets has increased.
The above analysis of concentration uses
the traditional cluster approach in that it in­
cludes only commercial banks as purveyors of
the relevant line of commerce. As a result of
deregulation and technological developments,
other depository institutions compete or have
the ability to compete with commercial banks
along several service lines. The inclusion of
these additional organizations in the relevant
line of commerce, in particular, thrifts, will al­
ter absolute concentration measures. In most
cases it is expected to lower the level of con­
centration without affecting the general down­
ward trend in local market concentration.6
In summary, concentration in banking
has decreased over time. Markets in branch­
ing states have shown a greater decrease than
have unit banking markets. Concentration
levels in non-metropolitan markets do not differ
significantly with branching status. However,
concentration in metropolitan areas is higher
when branching is allowed. Yet, it is in these
very markets that concentration decreases have
been the greatest.
Federal Reserve Bank of Chicago




Axiom f f 2: Antitrust laws are not
effective in preventing
concentration increases.

The existing evidence does not support
the hypothesis that interstate banking neces­
sarily leads to more concentrated local markets.
However, for markets in which this could oc­
cur, the critical issue is whether antitrust laws
can adequately prevent substantial anticom­
petitive effects. There has been significant dis­
agreement on the effectiveness of antitrust laws.
One way of evaluating that impact is to com­
pare concentration levels in states introducing
branching before and after the 1960 Bank
Merger Act.
Table 1 subdivides bank structure data
into markets located in states which enacted
branching laws prior to the 1960 Bank Merger
Act and those that did not. Mergers occurring
in the latter period were subject to approval
by the principal federal regulatory agency and,
more importantly, were subject to antitrust
laws. If antitrust provisions were effective,
anticompetitive mergers would occur less fre­
quently in the latter period. The data in Table
1 suggests that markets allowing branching in
the earlier period are indeed more concentrated
than those introducing it in the latter period.
Statistical tests indicate the difference is signif­
icant.
Additional analysis accounting for demo­
graphic differences indicate that factors deter­
mining the business attractiveness of a banking
market, e.g., high population and income lev­
els, produce lower concentration levels. Simi­
larly, the more stringent local regulators are in
allowing the chartering of new institutions, the
higher the resulting HHI. After accounting for
these factors, the impact of branching was
considered and, again, was found to influence
concentration measures positively only if it was
allowed prior to the imposition of antitrust laws
in 1960. In markets introducing branching af­
ter this period, concentration has not been sig­
nificantly influenced.7 Thus, in preventing
concentration increases resulting from excessive
merger activity the evidence suggests antitrust
enforcement has had a significant impact.
An alternative means of evaluating the
effectiveness of antitrust legislation is to evalu­
ate its impact on the number of banking or­
ganizations in local markets. Studies evaluating
27

the change over time in states changing to a
more liberal branching status found that the
number of organizations did not decline.
However, numerous cross-sectional studies have
found that significantly fewer organizations ex­
ist in areas with more liberal branching.8
The cross-sectional studies have been
criticized for failing to consider demographic
differences and to account for the length of time
that branching had been allowed. Addi­
tionally, areas allowing branching prior to 1960
can be expected to have fewer organizations
than areas in which branching was later intro­
duced.
To evaluate the validity of these criti­
cisms, additional analysis was performed. First,
data for the average number of banking or­
ganizations in local markets in 1970 and 1980
were obtained. Data presented in Table 2 in­
dicate that the number of organizations (i.e.,
customer alternatives) was less in states allow­
ing branching. This difference was negligible
by 1980. A closer analysis of those areas al­
lowing branching prior to 1960, and those in­
troducing it later reveals substantial differences.
The average number of organizations is signif­
icantly less in regions where branching was in­
troduced in the earlier period. In fact, areas
with the most liberal branching laws intro­
duced after 1960 actually had more banking al­
ternatives.
The data in Table 2, while supporting the
argument that the branching impact has been
different in the pre- and post-Bank Merger Act
period, ignore demographic factors. These are
probably the most important factors determin­
ing the number of banking options. To ac­
count for these factors a series of estimates were
obtained.9
After controlling for demographic factors,
the changing imposition of antitrust enforce­
ment over time, and the length of time
branching had been allowed, the findings sug­
gest that initially branching does adversely in­
fluence the number of organizations in the
market. However, branching is shown to have
had a much larger impact if allowed prior to
the Bank Merger Act. Most important, the
variable included to account for the length of
time that branching had been allowed indicates
that the initial negative impact of branching is
essentially offset in approximately three years
as organizations branch into new markets.
28




Table 2
Average num ber o f banking organizations
per local m arket
Organizations per
banking market*
Totals

1970

1980

All markets

5.32

6.06

Unit banking markets

5.55

6.06

Branching markets
Legislated after 1960
Legislated before 1960

5.15
5.72
5.06

6.05
7.96
5.29

Unlimited branching markets
Legislated after 1960
Legislated before 1960

4.84
4.30
5.06

7.60
9.45
6.57

Per capita (x 1000)
All markets

.236

.232

Unit banking markets

.327

.342

Branching markets
Legislated after 1960
Legislated before 1960

.167
.258
.152

.171
.227
.150

Unlimited branching markets
Legislated after 1960
Legislated before 1960

.191
.270
.158

.186
.283
.160

"Banking markets are defined as counties.
SOURCE: FDIC Summary of Deposits.

The preceding discussion suggests that
antitrust law has had an important impact on
the structure of local banking markets. If there
is significant concern over potential increases in
concentration, existing guidelines can be uti­
lized or new guidelines can be introduced to
preclude it.
Axiom f j 3 : Firms competing in several
markets will collude to avoid
competition.

With interstate banking, more merger
cases will likely involve market extensions, i.e.,
non-horizontal mergers, rather than combina­
tions within the same market. The resulting
potential for anticompetitive behavior associ­
ated with linked oligopoly or mutual
forbearance is a concern. The issue is whether
multi-market firms competing with each other
in several markets will behave collusively
rather than competitively for fear of retaliation
in other (weaker) markets. Such collusion
could offset any benefits resulting from the
elimination of entry barriers. For this behavior
to be effective, the rival firms must hold signif­
icant market shares and be among relatively
Economic Perspectives

few firms in the market. The basic premise is
that competitive behavior of rivals is interde­
pendent, i.e., each firm acknowledges that its
competitive behavior will adversely affect its
rivals, which will react in kind. The optimal
behavior, therefore, may be to cooperate with
or not compete aggressively against the rival
firm.
However, interstate expansion need not
lead to collusive behavior. Competition may
actually be strengthened as firms try to out­
guess the strategy of their competitors. Indeed,
the majority of empirical studies of the linked
oligopoly hypothesis do not support it, but in­
stead findings indicate that multimarket links
result in increased market competition.10 Even
if firms were to have multi-market links across
the nation, competition would likely increase
in these markets. With broader expansion, a
substantial number of competitors and geo­
graphically dispersed markets would diminish
the ability of firms to behave collusively. Since
the largest and most attractive markets are
likely to be metropolitan areas, it is in these
markets that consumers are most likely to gain
benefits.

Bank performance data by size
and branching status*
Figure 1

Bank ROAs
percent

< $ 5 0 mil.

$ 5 0 -9 9 mil.
$100 mil.— bit
1
size class

>$1 bit

Figure 2

Loan behavior
ratio
.90

Axiom f f 4: The viability of small banks
and the safety of the industry
will be jeopardized.

Bank performance is the final element of
the structure-conduct-performance paradigm,
and an important factor indirectly affecting the
consumer. It is often alleged that a liberali­
zation of branching laws may threaten the vi­
ability of the small bank, and, more
importantly, the general safety and soundness
of the banking system. However, the evidence
does not support either of these allegations.
Data summarized in Figure 1 support the
contention that small banks can compete effec­
tively with larger organizations. In fact, small
banks have generally outperformed or kept
pace with the larger banks. Across all branch­
ing categories, it is the larger banks that have
performed below average and below that of the
smallest banks as measured by return on assets
(ROA). Additionally, the experience of
California and New York, two large states with
over ten years of statewide branching experi­
ence, suggests that small banks can survive un­
der liberalized branching laws.11
Federal Reser\'e Bank of Chicago




lo a n s ' to a s s e t s

I ____I___________I___________1 __________ I
_
< $ 5 0 mil.

Figure 3

$ 5 0 -9 9 mil.
$100 m il.-l bit
size class

> $ 1 bit

Fed funds activity
ratio

"The impact of branching is understated because banks changing
status in 1984-85 had little time to adjust.
SOURCE: Data are 6-year averages from Reports of Condition. June
30, 1980-1985. ROA data are annualized.

29

The increased level of competitiveness as­
sociated with branching is also evident from the
data. Institutions located in branching states
have a lower average ROA than do banks in
the same size class in unit banking states. Sta­
tistical tests indicate the differences are signif­
icant. These data reflect more competitive
markets in the more liberal branching states
wherein potential competition hinders the
ability of organizations with significant market
shares to reap above-normal profits. The re­
laxation in branching laws is, therefore, likely
to have the greatest impact on bank perfor­
mance in unit banking states. Banks in these
states will no longer be able to use their pro­
tected markets to earn higher rates of return.
Bank failure has been shown to be more
closely related to management expertise than
to the structure of banking laws. Nonetheless,
data presented in Table 3 indicate that since
1970 the number of failed banks corresponds
directly with the extent of geographic branch­
ing restrictions. That is, over this period, 23
percent, 32 percent, and 45 percent of failed
banks were in statewide branching, limited
branching, and unit banking states, respec­
tively. The majority (74 percent) of failed

banks were unit banks, and the percentage of
these failed unit banks corresponds directly
with the extent of restrictions on branching,
i.e., statewide branching states had the fewest
unit bank failures. Additionally, the percent­
age of unit banks failing between 1970 and
1983 was twice that of branch banks, i.e., 0.1%
and 0.05%, respectively. One possible expla­
nation for this disparity is the competitive ad­
vantage of branching banks resulting from
geographic and customer diversification.
Another concern raised with respect to
geographic expansion is the threat to the fi­
nancial health of expanding banking organiza­
tions, and, potentially, the banking system.
Some fear that an environment of extensive
acquisition activity may cause overly ambitious
organizations to pay excessive premiums, over­
leverage their capital, spread management too
thin, or enter into new types of operations and
lending activities in which management is rel­
atively inexperienced. However, bank regula­
tory agencies already impose controls on bank
mergers and acquisitions to prevent such be­
havior. The Federal Reserve has denied pro­
posed acquisitions on both financial and
managerial grounds.12 Regardless of interstate

Table 3
Number of banks closed because of financial
difficulties by branching status (1970-1983)*
S t a t e w i d e b r a n c h in g s ta te s
U n it
Year

T o ta l

banks

L i m i t e d b r a n c h in g s ta te s
U n it
banks

0
0

0
0

4

3

0

0

6
4

0
0

1
1

10

1

13
4

1970
1971

6
6

1972
1973
1974
1975
1976
1977

banks

B ra n c h in g

B r a n c h in g
banks

U n i t b a n k in g s ta te s
U n it
banks

2

1

0
0
1

5
1

1
2

0

4

0

1

0

1

2

6

0

4
0

1
1

2
2

6

0

3

0
2

2
5
6

1

1

1978
1979

5

0

10

0

0
1

1980

9

1

0

1

1

1981
1982

9
41

1

3

2

0

3

3

7

4

17

1983

47

9

7

10
6

11

14

173

15
8 .7 %

24

36

25

73

1 3 .9 %

2 0 .8 %

1 4 .4 %

4 2 .2 %

T o ta l
(% o f t o ta l)

100%

2

'Excludes banks not in the continental United States, Hawaii or Alaska. Data were not available by branching status for nine banks:
one in 1970, 1977, 1980 and 1981; two in 1975; and three in 1976.
SOURCE: FDIC Annual Reports 1970-1983.

30




Economic Perspectives

banking laws, financial and managerial stan­
dards governing acquisitions will continue to
protect the financial health of banks and the
banking system.
Some small banks will fail or be acquired
if geographic expansion is allowed. Some may
be perfectly willing to sell to expanding orga­
nizations or may simply not be able to com­
pete. However, most of the studies of the
profitability and viability of small banks sug­
gest many will continue to thrive. Finally, the
empirical evidence suggests that regardless of
institution size, branching results in a lower
return on assets. This is indicative of a more
competitive market for financial services.
Axiom #5: The range and level of
financial services will be inferior.

From a social welfare point of view, per­
haps the most pertinent factor to be considered
with the geographic expansion of banking is the
potential impact on consumers concerning ser­
vice offerings, prices, and availability.13 One
measure of the level of service provided by
commercial banks is the range or array of ser­
vices made available. Perhaps the most im­
portant variable influencing service offerings is
institution size. Large institutions can justify
new services because they generally have a
larger customer base and can more readily
generate the necessary service volume required
for profitability. More services are also offered
by larger institutions because they frequently
compete by introducing tangential services
aimed at acquiring new, or maintaining exist­
ing, customers.
Evidence from previous studies tends to
support the view that large banks provide a
larger array of services.14 Table 4 summarizes
findings from a recent study analyzing bank
survey data. The percentage of institutions of­
fering the services increases with institution
size. This increase holds true for both con­
sumer and business services.
The available evidence suggests that
branching status also affects the array of service
offerings. Early studies found trust services,
special checking accounts, payroll services, and
foreign exchange transactions all to be more
commonly offered at small branch banks than
at small unit banks. Recent studies have sub­
stantiated that finding. Larger institutions
tend to offer a more complete banking package,
Federal Reserve Bank oi Chicago




thus, branching status does not have as signif­
icant an impact on their offerings.
Liberalizing geographic expansion coultj,
thus, increase the array of services available to
consumers for two reasons. First, smaller insti­
tutions would expand their offerings as they
branched into new markets, or as they retained
their unit bank status and expanded offerings
to compete with new branch bank competitors.
Secondly, larger institutions, the ones most
likely to expand into new regions, would bring
with them a larger array of services as they
enter new markets. Since unit banking states
are characterized by numerous small banking
organizations, the benefits would be greatest in
these areas.
In addition to leading to a larger array
of services, geographic expansion should also
influence the supply of bank services. By
opening branches or acquiring banks in new
markets, banks would be more geographically
diversified and less susceptible to deterioration
in local economic conditions. Thus, their flow
of deposits should be more stable. Similarly,
these institutions can be expected to develop
new loan customers and, be less susceptible to
individual customer failures and resulting loan
losses. Both geographic and customer diver­
sification will, therefore, decrease an
organization’s risk, allowing it to hold fewer
highly liquid assets. This will enable it to in­
crease the size of its loan portfolio. Thus, ceteris
paribus, diversification should enable an institu­
tion to better serve its customers’ loan needs.
Figure 2 provides data supporting this
hypothesis. The loan-to-asset ratio increases
with bank size suggesting the banks most likely
to branch will tend to offer more loans. The
presence of liberalized branching also produces
a higher loan-to-asset ratio in all but the very
largest size groups. Liberalized branching
areas also have the highest non-corporate
loan-to-asset ratios indicating that branching
leads to improved servicing of consumer loan
needs. Figure 3 presents additional informa­
tion on the liquidity of bank assets. The “fed
funds sold plus Treasury securities” -to-asset
ratio decreases with institution size, suggesting
that liquid assets at smaller institutions are re­
placed by loans at larger institutions. Branch­
ing status is again shown to be important in
determining the ability of banks to make loans.
In all but one size category, banks located in
the most liberal branching areas hold fewer
31

Table 4
Percentage o f sample banks o fferin g special
custom er services—arrayed by bank size*

B a n k d e p o s it s in m illio n s
U nder
T y p e o f s e r v ic e s

$10

O ver
$ 1 0 -2 5

$ 2 5 -5 0

$ 5 0 -1 0 0

$100

A.

C o n s u m e r d e p o s i t s e r v ic e s

5 3 .4

6 1 .3

7 1 .6

7 4 .2

7 8 .6

B.
C.

B u s in e s s d e p o s i t s e r v ic e s
C o n s u m e r & b u s in e s s s e r v ic e s

4 4 .4

5 3 .9

6 5 .4

6 7 .2

4 7 .5

4 8 .5

5 3 .5

5 8 .8

8 1 .8
6 7 .1

E x a m p le s
T r u s t s e r v ic e s

2 2 .4

4 0 .9

6 9 .6

8 0 .0

9 7 .1

D r iv e u p w i n d o w s
S p e c ia l n o - m i n i m u m c h e c k i n g

7 8 .4

9 2 .2

1 0 0 .0

9 8 .6

3 8 .1

4 0 .8

9 9 .1
5 5 .4

5 4 .4

6 6 .2

R e v o lv in g c h a r g e c a r d
S p e c ia l c h e c k s e r v ic e s f o r b u s in e s s e s

2 4 .5
3 6 .5

3 5 .2
5 0 .0

5 0 .5
7 5 .2

6 8 .4
7 6 .3

7 8 .3
9 5 .5

L o c k e d b o x s e r v ic e s
F o r e ig n e x c h a n g e s e r v ic e

1 3 .9
4 1 .7

2 7 .0
4 7 .6

4 2 .0
6 0 .2

3 9 .4

7 4 .2

6 4 .1

7 9 .7

‘ Sample data are from Rose, Kolari, and Riener. "A Nationwide Survey Study of Bank Services and Prices Arrayed By Size and Struc­
ture," in Journal of Bank Research (Summer 1985) pp. 72-85. Percentages presented for business and consumer services are averages
of a longer list of services provided in the original article.

liquid assets. Again, this indicates they are
making more loans.
Geographically diversified institutions
may also be better able to allocate resources,
efficiently transferring funds between areas of
low demand and excess demand. In fact, this
is a major reason for expansion. This ability
would be even further enhanced with interstate
banking because regions with surplus or deficit
funding do not necessarily correspond to state
boundaries. While the same transfer could be
made between independent unit banks or by
way of a correspondent bank relationship, ad­
ditional costs may be introduced by the middle
agent.
This reallocation of resources, however,
may not benefit local customers if their loan
demands are not met because deposits are
skimmed off and directed elsewhere. Addi­
tionally, opponents of branching argue, funds
may be directed to large borrowers only. Thus,
this efficiency could lead to funds being di­
rected toward the main office of the bank. Be­
cause these offices are usually located in large
metropolitan areas, funds may be drained from
rural areas. However, with a sufficient branch
network, the funds could as easily shift between
rural areas. The transferring to urban areas
would only occur if the expected return on in­
vestments in these areas was higher than that
expected in the rural areas. Although agricul­
32



tural loans have not performed well in recent
years, the evidence does not suggest that rural
investments earn an inferior return. The evi­
dence on this skimming phenomenon is some­
what limited, frequently dated, and imposes
rather restrictive assumptions, but generally
does not support the hypothesis that funds are
drained from rural areas.15 Additionally, one
could argue that the tendency for unit and
small banks to sell a substantial amount of fed
funds is also a means of skimming funds away
from the local market.
Whether branching organizations ade­
quately service the needs of smaller businesses
that are usually limited to local market alter­
natives is an additional consideration. Larger
institutions tend to have larger loan-to-asset
ratios, which makes their availability of loans
greater. However, they may also deal almost
exclusively in large loans, which could leave
small businesses with few options. A number
of studies have indicated that small businesses
may be adversely affected by bank concen­
tration, and many believe that branching may
lead to more concentrated local banking mar­
kets, particularly in nonmetropolitan areas.16
Statistics also suggest that a large portion of the
dollar value of large bank loans is provided to
larger borrowers, while most small bank loans
are to small borrowers. However, the statistics
are not very meaningful in determining if the
Economic Perspectives

smaller borrowers would be shunned by larger
branch organizations. Large banks make large
loans because they have the ability to do so,
while small banks do not.
A more appropriate way to view this issue
is to analyze small loan requests. A recent
study surveying small, independent business­
men, after accounting for business type, size,
recent growth trends, and demographic factors,
indicates that the credit needs of smaller busi­
nesses tend to be denied more, or not as ade­
quately met, when liberal branching is
allowed.17 However, when credit needs are met,
the terms are generally considered satisfactory.
The study may have implications concerning
the objectivity of branch bank management in
applying credit rating criteria. Smaller busi­
nesses may suffer somewhat if branching or­
ganizations rely more on financial statements
and credit scoring models, and less on the
character of the borrower and specific circum­
stances surrounding the loan request. From an
economic viewpoint, these less subjective crite­
ria would be appropriate. Additionally, the
argument can still be made that if credit­
worthy borrowers are not being adequately
serviced, a regional institution willing to spe­
cialize in this area will enter and profitably
service this group.
Axiom 6 : Deposit rates will be lower
and/or loan rates higher.

If banking markets were perfectly com­
petitive, each facility would sell homogeneous
services (e.g., loans, deposit options) at costdriven prices, and free entry would eliminate
any excess profits. These two conditions obvi­
ously do not characterize the U.S. banking in­
dustry. Significant barriers to entry, non-price
competition, market power, and operating effi­
ciencies lead to deviations from purely com­
petitive prices.
Restricted geographic expansion is an
obvious impediment to market entry and one
reason to expect prices to differ between
branching and nonbranching institutions. It
has already been shown that relaxation of ge­
ographic restrictions eases entry and lowers
profitability. It would be logical to assume this
lower profitability results from lower loan rates
and/or higher rates on deposits.
There are several reasons for expecting
branch banks to have lower prices. If cost ef­
Federal Reserve Bank of Chicago




ficiencies exist with branching, branch banks
could offer better prices than independent
banks. While most studies evaluating econo­
mies of scale in banking have found them fully
exhausted at relatively low output levels,
branch banks may have an advantage in that
they can keep the size of each branch near the
cost efficient level by opening new branches.
Studies have, however, found cost advantages
as a result of offering an array of services that
can efficiently be produced in conjunction with
one other (i.e., economies of scope).18 As shown
previously, branch banks tend to offer a wider
array of services. Prices could also be affected
if the process of shifting funds between ge­
ographic areas is more cost efficient between
affiliated banks than between independent
banks. The geographic and customer diversifi­
cation discussed earlier could also produce effi­
ciencies resulting in preferred prices.
Most of the empirical work analyzing the
impact of organizational structure on service
prices is dated and frequently fails to account
adequately for non-structural factors. Con­
flicting results are also found. Service charges
on demand deposits were found to be higher
with branch than with unit banks. However,
more recent studies found little or no difference.
Conflicting results also occur when determining
if branch banks pay higher interest rates on
time and savings accounts. Finally, similar in­
consistencies have been found when evaluating
the rates charged on loans.19 The conflicting
results suggest that the various assumptions and
assertions made in these studies significantly
affect the findings. There simply is no conclu­
sive evidence that branching affects service
prices.
Axiom f f 7: Service accessibility will
be adversely affected.

Improved customer service may be the
most commonly cited advantage associated
with branch banking. Branches can be con­
veniently distributed and provide basic ser­
vices, while specialized services may be
provided only at the head office or at a limited
number of offices. The larger array of services
provided by branch banks was discussed ear­
lier. An important element of customer service
is the level of service accessibility, i.e., the
number of offices available to meet customer
needs. Branching can be expected to lead to
33

greater service accessibility for a number of
reasons. Perhaps the major one is that a par­
ticular market may be capable of supporting a
branch office, but not a new bank. Addi­
tionally, accessibility is a form of non-price
competition which only branch banks can
practice.
Early studies evaluating the impact of
branching on service accessibility found little,
or even an inverse, relationship between
branching and the population per banking of­
fice. However, many of these studies failed to
account for demographic and market differ­
ences. The results from more recent studies
viewing either the number of offices or the
number of offices per capita suggest that
branching does indeed lead to improved acces­
sibility. One study found that if all states had
allowed statewide branching in 1975, the
number of bank offices in the United States
would have increased by 1275, "or 4 percent.
However, another recent study found that one
of the most commonly acclaimed benefits of
branching—improved service accessibility in
rural areas—could not be supported.20
An alternative way to view accessibility
is to analyze the number of offices per square
mile in branching and nonbranching states af­
ter taking demographic factors into account.
Since customer convenience is most accurately
measured as the required time and distance to
access services, a measure incorporating the
geographic area will be more appropriate. For
example, in a study based on the number of
offices per capita, a decline in the number of
offices would imply a deterioration of service
adequacy. However, an actual deterioration
would occur only in the extreme case wherein
offices became more congested, had longer
lines, and imposed time-consuming hardships
on customers. Utilizing the office-per-area
measure and taking demographic differences
into account, findings indicate that branching
significantly improves accessibility in both
metropolitan and nonmetropolitan areas. In
fact, while results differ slightly depending on
the service area considered (i.e., county, met­
ropolitan areas, etc.), service accessibility has
been shown to be over 50 percent greater when
branching is allowed.
To evaluate thoroughly the impact of
branching on service accessibility, the number
of alternative banking organizations should
also be considered. While an increase in the
34



number of offices may lead to improved acces­
sibility, variety and competition will be lacking
if most of the offices are affiliated. Most studies
indicate that the number of organizations in a
state decreases with the presence of branching.
This could be expected at the state level be­
cause most expansion would be accomplished
by acquisition of existing banks instead of de
novo. Thus, although the number of offices may
remain relatively constant, the offices would be
controlled by fewer organizations. However,
we have already shown in the discussion of
Axiom #2 that at the local level branching may
actually increase the number of organizations
after an initial adjustment period. This occurs
because organizations branch into new mar­
kets. It is this local level that is most important
in evaluating service accessibility.
Axiom f t 8: Benefits from branching will
not be realized in rural areas.

Stated or implied in many of the argu­
ments against geographic expansion has been
a concern about the fate of rural markets. Will
local market concentration increase in rural
areas, leading to inferior market prices and
service levels? Will funds be drained away
from rural markets so that local demand for
loans is not adequately met? Will funds be re­
invested in more lucrative metropolitan mar­
kets? Such effects of interstate banking would
obviously impair the growth of the local rural
economy.
As we have seen, however, local market
concentration in rural areas is not related to
branching status. Similarly, the improved ar­
ray of services and level of service accessibility
resulting from the presence of branching was
not limited to metropolitan areas. Indeed,
many of the benefits of branching are realized
in rural markets also. In fact, the potential for
improvements from geographic expansion is
very significant in rural areas. Organizations,
whether currently present in the market or not,
have greater ability to respond to changing
market conditions with liberalized branching
laws. Rural areas in which the demand for
services is not sufficient to warrant a new unit
bank may merit expansion via a branch office.
The more vehicles of entry available, the larger
the number of potential entrants and the
greater the probability that entry will occur.
Econom ic Perspectives

Given this potential for new entry, and its
resulting benefits, whether or not it actually
occurs will depend entirely on economic fac­
tors. Banking organizations will evaluate the
demand for loan and deposit services and, if
justified, introduce a new office. It should also
be emphasized that market forces cannot be
eliminated by regulation. For example, nu­
merous states which have approved or are
considering entry by out-of-state banks have
“protected” local customers by imposing rein­
vestment requirements. These requirements
however, affect the attractiveness of the new
market, and, perhaps more importantly, the
entering bank’s pricing decisions. If state reg­
ulations require a larger reinvestment in the
local market than market factors would gener­
ate, the entering bank will compensate by
charging local customers higher loan rates and
offering lower deposit rates. The higher loan
rates will be of limited value to the community
because existing banks would have similar or
lower ones. Lower deposit rates will encourage
customers to utilize alternative, perhaps nonlo­
cal institutions, thus, again causing funds to
leave the local marketplace. Market forces, not
legislated restrictions, determine the viability
of banking markets.
That banking organizations do indeed
respond to market forces is supported by anal­
ysis of market growth data. The absolute and
percentage change in the number of banking
offices and organizations is positively correlated
with population growth in all markets. To the
extent that population is an adequate proxy for
market attractiveness, market entry appears to
have been based on market conditions. In ru­
ral areas where branching was allowed there
was a somewhat closer association between
population growth and entry—measured as new
offices.21 The essence of this analysis is that
branching apparently has not negatively af­
fected the entry of banks in rural areas. In fact
it may have helped it.
Summary and conclusions.

Over time, a number of arguments
against liberalizing geographic expansion in
banking have come to be accepted almost as
axioms. Several of the statements are shown to
be inaccurate and little evidence exists to sup­
port the remaining ones.
Federal Reserve Bank of Chicago




In evaluating these statements our basic
findings suggest:
1) The trend in local banking market
concentration has been downward. This de­
concentration trend has been greatest in mar­
kets allowing liberal branching activity. The
absolute level of concentration in non­
metropolitan areas does not significantly differ
as a result of branching, although the absolute
level is higher in metropolitan areas when lib­
eral branching activity is allowed. However, it
is in these metropolitan areas that the decline
in concentration has been the greatest.
2) Stringent antitrust laws can be rela­
tively effective in preventing non-competitive
behavior in banking. Evidence suggests that
concentration and the number of banking or­
ganizations in local markets have been signif­
icantly influenced by the imposition of antitrust
laws on the banking industry in the early
1960s.
3) To date, there is little support for the
contention that liberalized branching will lead
to collusive behavior by banking organizations
as proposed by the linked oligopoly, or mutual
forbearance hypothesis.
4) Lower average returns on assets suggest
that competition is greater in more liberal
branching markets. Additionally, evidence
does not support the contention that liberaliz­
ing geographic expansion will threaten the vi­
ability of smaller banks.
5) Branch banks and larger institutions,
those most likely to branch if allowed, provide
a wider array of financial services.
6) There is no substantial evidence sug­
gesting that branching results in service prices
that differ from those of unit banks. However,
branch banks engage in more lending and have
lower profit rates. This suggests that branching
induces more intense competition.
7) Service accessibility is superior in mar­
kets allowing branching activity—including ru­
ral areas. Although the number of alternative
service providers may initially decline when
branching is introduced, this trend will be re­
versed over time as entry occurs.
8) Rural areas also stand to benefit from
branching in the form of increased market
entry, a wider array of services, improved ac­
cessibility, and increased competition.
Given these findings, some of the standard
criticisms of geographic expansion in banking
are shown to be of questionable merit. Realis­
35

tically, attempts to prevent expansion will
probably not be.effective if bank management
perceives the benefits to be substantial. The
fact that numerous institutions have gained an
interstate presence via regional compacts,
emergency mergers, and regulatory loopholes
suggest the perceived benefits are indeed sig­
nificant. The benefits to the customer also ap­
pear to be substantial, suggesting further
deregulation of geographic restrictions would
be warranted.
A final comment should be made con­
cerning the increasing number of state legisla­
tures considering proposals to develop regional
compacts allowing expansion across specific
state lines. Response at the national level has
been slow, suggesting that liberalization will
probably continue to result from action by state
governments. When proposals are made, the
feasibility of including a trigger to move to na­
tionwide expansion is often considered. To
date, a number of state laws have excluded this
provision. It should be emphasized that the
benefits of geographic expansion are not lim­
ited by state boundaries. Thus, strong consid­
eration should be given to incorporating these
triggers in future legislation.1
1 Joe S. Bain, Industrial Organization, (John Wiley
and Sons, 1959), pp. 98-101 and 295. For a review
of structure-conduct-performance studies in bank­
ing see Stephen A. Rhoades, “StructurePerformance Studies in Banking: An Updated
Summary and Evaluation,” Staff Studies, 119,
Board of Governors of the Federal Reserve System,
1982. These studies conclude that relative to other
industries, in banking the importance of structure
on performance is small.
2 That concentration is of particular concern in lo­
cal markets was stated in U.S. v. Philadelphia Na­
tional Bank 359 U.S. 31(1963), U.S. v. Phillipsburg
National Bank 399 U.S. 363-4 U.S. 350 (1970). A
case study of interstate mergers suggests that the
most significant factor influencing such mergers is
the desire to acquire an extensive retail distribution
network. See Dave Phillis and Christine Pavel,
“Interstate Banking Game Plans: Implications for
the Midwest,” in Toward Nationwide Banking, Fed­
eral Reserve Bank of Chicago, 1986.
3 See Alan S. McCall and Manferd O. Peterson,
“The Impact of De Novo Commercial Bank
Entry,” Compendium of Issues Relating to Branching by
Financial Institutions, Subcommittee on Financial
Institutions of the Committee on Banking, Housing
and Urban Affairs, United States Senate, October
36




1976, 499-521; and Donald R. Fraser and Peter S.
Rose, “Bank Entry and Bank Performance,” Journal
of Finance, March 1972, pp. 65-78. Bernard Shull,
“Structural Impact of Multiple-Office Banking in
New York and Virginia,” The Antitrust Bulletin (Fall
1978) pp. 511-50. Samuel H. Talley, “Recent
Trends in Local Banking Market Structure,” Staff
Economic Studies 89 (Board of Governors of the
Federal Reserve System, 1977). Arnold A.
Heggestad and Stephen A. Rhoades, “An Analysis
of Changes in Bank Market Structure;” Atlantic
Economic Journal, vol. 4 (Fall 1976), pp. 64-69).
These studies were conducted based on 1960-70
data and for that reason may be less conclusive
than more current studies because antitrust
enforcement was more stringent in the 1970s.
4 A study by Stephen A. Rhoades on local market
concentration across states with different branching
status also took into account the relative presence
of multibank holding companies. The study con­
cluded that the extent of MBHC activity makes
little difference in local market concentration ex­
cept in the case of unit banking states with MBHCs
accounting for less than 50 percent of state deposits.
See Stephen A. Rhoades, “Concentration in Local
and National Markets,” Economic Review, Federal
Reserve Bank of Atlanta, March 1985.
3 A relatively high C3 may be of concern if, for ex­
ample, the dominant firm in the market is able to
affect market price through its output decisions.
6 For a discussion of the ‘cluster approach’, see
“The product market in commercial banking:
Cluster’s Last Stand?” Harvey Rosenblum, John J.
Di Clemente and Kathleen O’Brien, Economic Per­
spectives, January/February 1985, Federal Reserve
Bank of Chicago. John J. Di Clemente, “The
Inclusion of Thrifts in Bank Merger Analysis,” Staff
Memoranda 83-7, Federal Reserve Bank of
Chicago, 1983.
7 This discussion was based on the following re­
gression results:
CR = 14.32 - ,29(Pop) - ,36(Y) - ,18(S) + .02(B) + ,02(Pre60)
(43.1) (-44.4) (-9.4) (-5.7) (.91) (10.9)

where CR is the HHI, pop = population in the
area, Y = per capita income in the area, S = de­
grees of regulatory stringency measured as the state
charter approval rate during the previous three
years, B is a branching binary = 1 if branching is
allowed in the market, 0 otherwise, and Pre 60 = B
if branching was allowed prior to 1960, zero oth­
erwise. Numbers in parentheses below the esti­
mates are t values. Tests for homoskedasticity
could not be rejected.
8 See Board of Governors Staff, “Recent Changes
in the Structure of Commercial Banking,” Federal
Reserve Bulletin (March 1970) pp. 195-210; and
Econom ic Perspectives

Shull, “Structural Impact of Multioffice Banking in
New York and Virginia.”
9 First, the number of banking organizations in lo­
cal markets in 1980 was estimated ignoring any
influence from differing degrees of antitrust
enforcement over time. The estimates suggest that
branching had a significant negative impact on the
number of banking organizations. The estimates
were arrived at via an ordinary least squares esti­
mate of a double log form equation, i.e.,
Orgs =

-8.85 +.47 (Pop) + .62 (Y) + .20 (S) - .28 (B)
(-31.3) (6.92)
(18.7)
(6.6)
(-16.0)
R 2 = .72
F = 1914

where Orgs = number of organizations and the
remaining variables are as defined in the previous
footnote 7. t values indicate that the impact of
each individual variable is statistically significant.
However, this significant negative impact is over­
stated if antitrust legislation was not enforced uni­
formly prior to and after the Bank Merger Act.
This was tested by reestimating the same equation
for two groups of local markets, i.e., those having
1980 branching laws in place prior to 1960, and
those changing after this period. The two sets of
estimates were significantly different. For markets
with laws in place prior to 1960, branching de­
creased significantly the number of banking orga­
nizations. However, for the second group the
branching impact was not important. More pre­
cisely, the estimates below are for the subgroup
with branching status determined (1) prior to 1960,
and (2) after 1960, respectively:
(1) pre-1960 subgroup: Orgs =
-7.70 + .48 (pop.) + .48 (Y) + .17 (S) - .38(B)
(-22.1) (65.2)
(11.9)
(5.0) (-20.1)
R 2 = .71
F = 1531

(2) post-1960 subgroup: Orgs =
-8.05 + .45 (pop.) + .56 (Y) + .48 (S) - .42 (B)
(-12.6) (31.2)
(9.1)
(6.5)
(-1.0)
R 2 = .78
F = 504

Finally, an attempt was made to account for dif­
ferences in the two time periods and for th^ length
of time branching had been allowed—i.e., an ad­
justment period. Different degrees of antitrust
enforcement were again accounted for with a bi­
nary variable, Pre60. Assuming ten years was the
maximum time needed for the impact of branching
to be realized, the adjustment period was accounted
for with Lth = length of time branching had been
allowed (0,1,2,...10). The results of OLS estimates
are presented below.
Federal Reserve Bank of Chicago




Orgs =

-8.04 + .48 (Pop.) + .52 (Y) + .22 (S)
(-28.6) (71.5)
(15.6)
(7.2)
-.27(B) -.34 (Pre60) +
(-4.1)
(-11.7)

.10 (Lth)
(2.8)
R 2 = .73
F = 1384

Reestimating and varying the maximum value of
Lth resulted in similar results.
10 See David D. Whitehead and Jan Luytjes, “Can
Interstate Banking Increase Competitive Market
Performance? An Empirical Test,” Economic Review,
Federal Reserve Bank of Atlanta, January 1984;
and Donald L. Alexander, “An Empirical Test of
the Mutual Forbearance Hypothesis: The Case of
Bank Holding Companies,” Southern Economic Jour­
nal, (July 1985), pp.122-140.
11 Analysis for individual years generally resulted
in similar findings. For an analysis of 1984 data see
Douglas Evanoff and Diana Fortier, “Geographic
Expansion in Commercial Banking: Inferences
from Intrastate Activity,” in Towards Nationwide
Banking. See statement by Paul Volcker before the
Subcommittee on Financial Institutions, Super­
vision, Regulation and Insurance of the Committee
on Banking, Finance and Urban Affairs; U.S.
House of Representatives, April 24, 1985. 71, Fed­
eral Reserve Bulletin 430 (1985). Additional studies
evaluating small banks’ ability to compete include
Rhoades, Stephen A. and Donald T. Savage, “Can
Small Banks Compete?” Bankers Magazine, vol. 164
(Jan.-Feb. 1981), pp. 59-65; Leon Korobow, “The
Move to Statewide Banking in New York and New
Jersey,” The Banker, September 1974, pp. 11-33.
12 For an example of a denial on financial grounds,
see Corporation for International Agricultural
Production Limited 70 Federal Reserve Bulletin 39
(1984). For an example of commitments made in
light of financial concerns see IVB Financial Corp.
70 Federal Reserve Bulletin 42 (1984).
13 See Jack M. Guttentag and Edward S. Herman,
Banking Structure and Performance, New York Uni­
versity, February 1967; also Robert Weintraub and
Paul Jessup, “A Study of Selected Banking Services
by Bank Size, Structure, and Location,” Subcom­
mittee on Domestic Finance of the House Commit­
tee on Banking and Currency, Washington, 1964.
For a more recent and comprehensive review of the
impact of branching on various aspects of the
banking industry see Larry Mote, “The Perennial
Issue: Branch Banking,” Business Conditions (Febru­
ary 1974) pp. 3-23; and Gary Gilbert and William
Longbrake, “The Effects of Branching by Financial
Institutions on Competition, Productive Efficiency
and Stability: An Examination of the Evidence,”
Journal of Bank Research (Part I - Autumn 1973, Part
II - Winter 1974) pp. 154-167, 298-307; Larry
Frieder, et. al., Commercial Banking and Interstate Ex­
37

pansion - Issues, Prospects, and Strategies, Ann Arbor,
UMI Press, 1985; and U.S. Department of the
Treasury, Geographic Restrictions on Commercial Bank­
ing in the United States, January 1981. In the present
study, the analysis of the potential impact of inter­
state activity on the customer is based on the ac­
tivity occurring via branching activity. If
geographic expansion proceeds by bank holding
company expansion the impact on the customer
could differ.
14 Pete Rose, James Kolari, and Kenneth W.
Riener, “A National Survey Study of Bank Services
and Prices Arrayed by Size and Structure,” Journal
of Bank Research (Summer 1985) pp. 72-85.
15 For a discussion and evidence on this issue see
Donald Fraser and Pete Rose, “Bank Entry and
Bank Performance,” Journal of Finance (March,
1972) pp. 67-78; also Donald Jacobs, “The Inter­
action Effects of Restrictions On Branching and
Other Regulations,” Journal of Finance (May 1965)
pp. 332-49. Also Verle Johnston, “Comparative
Performance of Unit and Branch Banks,” in Pro­
ceedings of a Conference on Bank Structure and Competi­
tion, Federal Reserve Bank of Chicago, March
1967. For an analysis which considers both the
source and use of funds, see Constance Dunham,
“Interstate Banking and the Outflow of Local
Funds.” New England Economic Review, (Federal Re­
serve Bank of Boston, March/April 1986), pp. 7-19.
16 See Robert A. Eisenbeis, “Local Banking Mar­
kets for Business Loans,” Journal of Bank Research
(Summer 1971) pp. 30-39; and Donald P. Jacobs,
Business Loan Costs and Bank Market Structure. New
York: Columbia University Press, 1971; and also
Paul A. Meyer, “Price Discrimination, Regional
Loan Rates, and the Structure of the Banking In­
dustry,” Journal of Finance (March 1967) pp. 37-48.
17 Peter L. Struck and Lewis Mandell, “The Effect
of Bank Deregulation on Small Business: A Note,”
Journal of Finance (June 1983) pp. 1025-1031.
18 See Thomas Gilligan, Michael Smirlock, and
William Marshall, “Scale and Scope Economies in
the Multi-Product Banking Firm,” Journal of Mon­
etary Economics (May 1984) pp. 393-405. For other
discussions of economies of scale see Jeffrey A.
Clark, “Estimates of Economies of Scale in Banking
Using a Generalized Functional Form,” Journal of
Money, Credit, and Banking, (February 1984) pp.
53-68; and George Benston, Gerry Hanweck, and
David Humphrey, “Scale Economies in Banking:
A Restructuring and Reassessment,” Journal of

38



Money, Credit, and Banking (February 1984) pp.
435-56.
19 See Mote or Gilbert and Longbrake for a review
of past studies. See also Rose, Kolari, and Riener;
and Donald T. Savage and Stephen A. Rhoades,
“The Effects of Branch Banking on Pricing, Profits,
and Efficiency of Unit Banks,” Proceedings of a Con­
ference on Bank Structure and Competition, Federal Re­
serve Bank of Chicago, 1979, pp. 187-95. Prices
could also be impacted by market pre-emptive be­
havior. Branch banks could “flood” the market
with offices aimed at minimizing the potential
market for new entrants. This behavior could in­
crease costs that would be passed on to the cus­
tomer. See Douglas Evanoff, “The Impact of
Branch Banking on Service Accessibility,” Staff
Memoranda 85-9, Federal Reserve Bank of
Chicago, 1985.
20 See Donald Savage and David Humphrey,
“Branching Laws and Banking Offices,” Journal of
Money, Credit, and Banking (March 1979) pp. 153-60
and William Seaver and Donald Fraser, “Branch
Banking and the Availability of Banking Offices in
Nonmetropolitan Areas,” Atlantic Economic Journal
(July 1983) pp. 72-8. Other studies evaluating the
impact of branching on service accessibility include
Robert F. Lanzillotti and Thomas A. Saving,
“State Branching Restrictions and the Availability
of Branching Service,” Journal of Money, Credit, and
Banking (November 1969) pp. 778-88; William
Seaver and Donald Fraser, “Branch Banking and
the Availability of Banking Services in Metropol­
itan Areas,” Journal of Financial and Quantitative
Analysis (March 1979) pp. 153-60. For a discussion
of service accessibility measured in a spatial context
see Evanoff, op. cit.
21 The correlation coefficients supporting this are
as shown below (* indicates that the correlations
are not significantly different from zero.)
Change in population ( p e ^ n tlg e >
Metro
Rural
Change in ____________ ' n
______ 5_____ # of banks (—e rre n ta ^ —)
e
Branching areas
offices
organizations
Unit banking areas
offices
organizations

.26/.41
.09*/.34

.53/.26
.31/.30

.34/.04*
.17*/.23

.34/.31
.38/.34

Econom ic Perspectives

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