View original document

The full text on this page is automatically extracted from the file linked above and may contain errors and inconsistencies.

Capital spending—the national
need

3

S o lu tio n s fo r th e n a tio n 's m a jo r
e c o n o m i c p r o b l e m s re ly h e a vily o n
in c r e a s e d o utla y s b y b u s in e s s o n n e w
p la n t a n d e q u ip m e n t .

CONTENTS

The impact of freer trade—
the Toyko Round and the
Seventh District

7

A m a jo r p u r p o s e o f th e " T o k y o
R o u n d " o f t ra d e n e g o t ia tio n s was to
establish ru le s a n d g u id e li n e s to p r e ­
vent o th e rw ise rea so n ab le d o m e stic
p o licie s o f a c o u n tr y fro m b e c o m in g
u n s e e n b a r r ie r s t o i n t e r n a t i o n a l trade.

November/December 1980, Volume IV, Issue 6

ECONOMIC PERSPECTIVES
Single-copy subscriptions of Economic
Perspectives, a bimonthly review, are
available free of charge. Please send requests
for single and multiple-copy subscriptions,
back issues, and address changes to Public
Information Center, Federal Reserve Bank of
Chicago, P. O. Box 834, Chicago, Illinois
60690, or telephone (312) 322-5112.
Articles may be reprinted provided
source is credited and Public Information
Center is provided with a copy of the
published material.
Controlled circulation postage
paid at Chicago, Illinois.




Electronic funds transfer:
revolution postponed

16

Th e g lo w in g p ro m is e o f e le c tro n ic
f u n d s t r a n s f e r a p p e a r s at last t o b e
c o m in g tru e — ten years after th e p r o ­
p h e c ie s o f an E F T revo lu tio n .

1980 Index

23

Capital spending—the national need
G e o r g e W. C lo o s

Solutions for the nation's major economic
problems—inflation, lagging productivity, com­
petitiveness in world markets, energy strin­
gencies, and unemployment—rely heavily on
hopes for a high and rising rate of business
investment in new plant and equipment.
Large investment outlays are needed to ex­
pand capacity, increase productive efficiency,
improve quality of existing goods and ser­
vices, and introduce new products.
Unfortunately, a four-year uptrend in
business investment was reversed early in
1980, and the slide appears to be continuing
into the new year. Spending has continued to
rise in dollars, but inflation has more than
offset these gains.
Focus on the Midwest

The states of the Seventh Federal Reserve
District have a special stake in developments
in business investment. Illinois, Indiana, Iowa,
Michigan, and Wisconsin, with 15 percent of
the nation's population, manufacture about a
third of its producer equipment. This region
is dominant in motor vehicles, farm equip­
ment, and construction equipment, but it is
also a major supplier of machine tools, en­
gines, mechanical and electrical components,
conveyors, and equipment for the railroad,
mining, oil and gas, and food processing
industries. An important share of the ship­
ments of Midwest capital goods production
goes abroad and helps minimize the nation's
chronic balance-of-trade deficit.
Except for trucks and farm and construc­
tion equipment, hurt by lagging demand and
strikes in 1979, output of most types of capital
goods continued at high levels until last
spring. Since then, order backlogs of most
firms have been eroding. Layoffs have
occurred and hours have been cut back. Cap­
ital goods, overall, are no longer acting as a

Federal Reserve Bank o f Chicago




buffer to weakness in consumer goods indus­
tries prominent in the Midwest, including
autos, light trucks, recreational equipment,
and household appliances.
Capital spending trends

Total spending on new business struc­
tures and equipment, as measured in the
gross national product (GNP) accounts, will
probably exceed $290 billion in 1980. About
two-thirds of this total will be for equipment,
and one-third for structures. The total will be
up about 6 percent from 1979, but down 3
percent to 4 percent after adjustment for
inflation. Total GNP will be up almost 10 per­
cent in 1980, but only about even after infla­
tion. This year's decline in real investment
followed a three-year period when dollar
spending rose about 17 percent annually and
real gains averaged about 9 percent.
Despite the lag in capital spending in
1980, the total will be about 11.2 percent of

Four-year boom in business capital
spending peaked in the first quarter
b i ll io n s of 1972 d o ll a r s

3

GNP, significantly above the 1950-80 average
of about 10 percent. The all-time peak for the
years since World War II was 11.6 percent in
1979. The low point was 9 percent in 1961-63.
The poorest recent year was 1976 with 10.1
percent.
Oil outlays lead

The Department of Commerce (DOC)
conducts a quarterly survey of business capi­
tal spending plans. Nonfarm businesses are
asked to report expected outlays on new
plant and equipment to be located in the
United States that will be charged to fixed
asset accounts. The survey excludes agricul­
ture and all items charged to current account,
both of which are included in the structures
and equipment component of GNP. Intangi­
bles and raw land, which are substantial in
outlays of some industries, are excluded from
both measures.
The capital spending survey published in
December projected an increase of 9 percent
in 1980. This is about the same as the rate of
inflation, indicating no real gain. In March an
increase of 11 percent had been-expected.
Apparently, the sharp dip in activity in the
second quarter did not drastically affect the
implementation of plans already under way.
Recent capital spending trends vary
greatly in strength from industry to industry.
Variations depend principally on requirements
to make new products, pressures to expand
capacity, opportunities to improve quality
and/or efficiency, and outlays mandated by
government regulations. Limitations imposed
by financial capacity set ceilings on outlays in
many cases.
Petroleum industry capital spending, as
tabulated in the DOC survey, will total $20
billion in 1980, up 25 percent from 1979, and
four times as much as in 1973, the year the
Arab oil embargo was imposed. Total invest­
ment spending of the petroleum industry will
approximate $40 billion in 1980, including
overseas programs and domestic outlays
charged to current account such as purchases
of leaseholds and a large proportion of explo­
ration expense.

4




Business investment remains at
high level relative to GNP
percent of GNP in current dollars

8
equipment

6
4

s tr u c t u re s

0
1966

'6 8

70

72

74

76

78

'8 0 *

•Estimated.

Petroleum companies are investing vir­
tually all of their huge cash flow in finding,
processing, refining, and distributing oil and
natural gas. Because of the rapid advance of
oil prices, and the uncertainty of Middle East
supplies, exploration is at a fever pitch. Activ­
ity is limited by availability of engineers and
other technicians, specialized equipment, and
supplies such as line pipe. In no other major
industry are capital spending programs pro­
ceeding with comparable urgency.
Other industries reporting large increases
in capital spending in 1980 include paper,
chemicals, electrical machinery, nonferrous
metals, and commercial buildings. Industries
expecting to reduce spending include elec­
trical utilities, rubber, and building materials.
In each of the industries expecting declines,
estimates of long-term demand have been
scaled down in recent years. In the case of
electric utilities, many projects have been
stalled by regulation and litigation.
The motor vehicle industry expects to
spend $9 billion on plant and equipment in
1980, 9 percent more than in 1979. Motor
vehicle producers plan a high level of outlays
for the next five years in order to produce
more fuel-efficient cars and trucks. Financial
capacity w ill lim it programs of some
manufacturers.

Econom ic Perspectives

Investment must rise

Despite a sluggish pattern recently, busi­
ness capital spending remains at a high level
in proportion to GNP. Even assuming a further
decline in real outlays in 1981, spending on
structures and equipment would still approach
11 percent of GNP, which would exceed the
long-term average. Nevertheless, many ob­
servers believe that a much higher level of
capital spending is necessary if the economy
is to grow and the nation is to improve its
competitive position in world markets. The
reasons are complex, but basically the prob­
lem is that a much larger share of investments
nowadays goes for nonproductive purposes
or merely to maintain the existing capital
stock.
The most important factor eroding the
investment dollar is inflation. Costs of capital
goods have increased even faster than prices
generally. From 1972 to 1980 the price level, as
measured by the GNP deflator, rose 80 per­
cent, while prices of structures and equip­
ment combined rose 89 percent. The main
culprit has been construction, where costs
have been boosted by soaring wages and
prices of materials. Costs of acquiring and
developing land, moreover, have risen even
faster than construction costs, because of the
growing scarcity of suitable sites and restric­
tions on development imposed by regulation
and litigation.
About 5 percent of capital outlays in
recent years has been allocated to facilities to
control air and water pollution. Substantial
investments also have been necessary to
improve safety. Outlays in factories and mines
mandated by the Occupational Safety and
Health Administration have been significant,
but no quantification is available. Far more
important have been design changes required
to improve safety in nuclear power plants fol­
lowing the Three Mile Island accident in
March 1979. As a result of new requirements,
the estimated cost of completing certain
plants doubled, with no change in their
planned output of electric power.
A huge volume of current capital outlays

Federal Reserve Bank o f Chicago




is now directed toward improving energy
efficiency. Such outlays relate both to the
operation of building and equipment and to
the nature of products. Most new aircraft
being purchased by the airlines reflect a need
to cut fuel costs, rather than a desire to boost
capacity. In the auto industry, the great bulk
of current and planned capital outlays is for
the purpose of improving gas mileage on new
cars and trucks.
In the extractive industries, especially gas
and oil, much larger expenditures are now
required to provide a given volume of pro­
duct. Newly discovered deposits of minerals
are usually of smaller size and contain lower
grade ores. Oil and gas deposits are sought in
the Arctic and in the waters of the continental
shelf under adverse conditions that entail
enormous expense for exploration, de­
velopment, and production. To transport oil
and gas from new fields, pipelines are built
for long distances over difficult terrain.
By far the strongest element in the com­
mercial construction sector in 1980 is office
buildings planned for the downtown areas of
large cities. Much of this space will be occu­
pied by lawyers, accountants, publicity firms,
government departments, and other groups
engaging in "social overhead” activities that
do not contribute directly to the production
of privately consumed goods and services.
Many of these activities are mandated by leg­
islation, and, while some clearly satisfy legiti­
mate needs, the social utility of others is open
to serious question.
Finally, and perhaps most important, a
growing volume of capital goods is being
retired from active use each year. The total
man-made capital stock may be declining,
contrary to published U.S. government data
showing continued growth of the capital
stock. These data have not been fully adjusted
to reflect the effects of rising wages, higher
fuel costs, foreign competition, and popula­
tion shifts, which have accelerated obsoles­
cence and abandonments of structures and
equipment. Usually these facilities stand idle
until they are scrapped. This trend is most
evident in the Midwest and Northeast, and

5

particularly in the auto, rubber, and steel
industries.
Financing problems

Corporations obtain funds from a variety
of external sources, including sales of stock
and bonds, short-term borrowings, and trade
credit. Historically, however, they have relied
primarily on funds generated internally
through retained earnings and depreciation
allowances. On average, internal funds, or
"cash flow/' account for about two-thirds of
all funds raised by corporations.
Many companies limit capital expendi­
tures to projections of cash flow so that they
will not have to raise funds in the long-term
credit markets. Cash flow of nonfinancial
corporations exceeded plant and equipment
expenditures every year from 1961 to 1967
and by 10 percent for the entire period. Since
1967, cash flow has averaged 12 percent less
than capital spending. Last year it was 19 per­
cent less, and in the first nine months of 1980
the shortfall was 25 percent. (These aggrega­
tive comparisons are necessarily rough, be­
cause cash flow and capital spending do not
always mesh industry by industry or company
by company.) Despite a huge level of cash
flow by historical standards, therefore, cor­
porations have had to rely more and more
heavily on outside sources of funds for capital
spending and other purposes. Record high
interest rates and low market values for stocks
of major companies have aggravated the
problem.
In the first nine months of 1980, corpora­
tions raised funds in the credit markets at an
annual rate of $97 billion, down from a record
$114 billion in all of 1979. Corporate bond
sales in the first half of 1980 were up about 50
percent from last year, but the rate of new
issues slowed in the late spring and summer as
financial managers deferred scheduled bond
issues because of unfavorable market condi­
tions. Bank loans, which had dropped sharply
in the second quarter, surged back after
midyear, mainly because of the drop in bond
financing.

6



Clearly, financial stringencies are placing
a lid on business capital spending. Earnings in
most industries have been depressed by eco­
nomic conditions. In the credit markets, fed­
eral, state, and local governments and the
residential construction industry have com­
peted for funds. Financial limitations would
be even more severe in 1980 were it not for
reduced needs for funds to carry inventories
and receivables.
Raising the ante

In 1980, unlike 1974-75, there have been
relatively few cancellations of orders already
placed for equipment. There is little evi­
dence, moreover, that established spending
programs have been shelved or curtailed.
However, corporate managements have be­
come increasingly cautious in approving new
programs essential to maintaininga high level
of investment in future years. In the recent
election campaign, leaders of both political
parties expessed their desire to bolster in­
vestment to improve productivity, meet for­
eign competition, and moderate energy
stringencies.
In its coming session, the Congress will
consider measures to stimulate business in­
vestment. Pressures are building to modify
legislation and regulations that prevent or
delay construction of new facilities and
development of new mineral sources. Sup­
port is growing for changes in depreciation
rules to permit faster write-offs in the direc­
tion of the "10-5-3” rule—10 years for build­
ings, five for equipment, and three for vehi­
cles. Reductions in tax rates for both cor­
porations and individuals are urged to provide
additional funds for investment.
Changes in tax rates and depreciation
rules doubtless would increase the pool of
funds available for business investment. But
money is only part of the problem. Major
capital spending programs pay off only after a
period of 10 years or more. Decisions taken
today depend on confidence in a prosperous
general economy and a suitable political and
social environment for many years to come.

E c o n o m ic P e r s p e c tiv e s

The impact of freer trade—the Tokyo
Round and the Seventh District
Jack L. Hervey
For centuries, governments have placed taxes
on imported goods to raise their prices on
home markets and discourage their domestic
consumption. The purpose of these taxes,
called “ tariffs," is to shield domestic produc­
ers and workers from foreign competition.
Historically, the use of tariffs has been
most extensive during times of increasing
domestic unemployment. Governments have
tried to stimulate domestic employment by
limitingthe inflow of foreign-produced goods,
thereby shifting the burden of unemploy­
ment onto their trading partners. Invariably,
such strategies have boomeranged. To pro­
tect themselves against such exportation of
unemployment, foreign trading partners have
imposed tariffs of their own. Such actions and
counteractions were widespread in the 1930s
as nations tried to escape the spreading
worldwide depression. The final outcome of
these trade wars was even higher tariff walls
that increasingly hampered the flow of inter­
national trade.
By the time the world’s trading nations
realized the futility of their tariff actions, vir­
tually all were surrounded by high protective
walls that prevented them from reaping the
benefits of international trade. After World
War II the process of dismantling these barri­
ers began.
The most recent major step toward eas­
ing restrictions on world trade took place
December 17,1979, when representatives of
the major industrial countries and several
developing countries signed a landmark mul­
tilateral trade agreement. That agreement
grew out of negotiations that began in Sep­
tember 1973 under the auspices of the Gen­
eral Agreement on Tariffs and Trade (GATT).
The Multilateral Trade Negotiations (MTN)—

Federal Reserve Bank o f Chicago



also called the “ Tokyo Round" after the city
in which they began—were the seventh round
of international trade negotiations since the
end of World War II.
Three of the seven rounds have been
landmarks in the evolution of world trade
policy. The first round of multilateral negotia­
tions completed in 1947 led to the GATT and
with it a framework of rules governing the
actions of governments in world trade. The
agreement also provided for sanctions to be
applied when the rules were broken. In 1967
the sixth or Kennedy Round of tariff negotia­
tions succeeded after five years in reducing
industrial countries' tariffs by an average of
two-fifths.
The major accomplishment of the recent
seventh round of negotiations was to address,
for the first time since the establishment of
the GATT in 1947, the issue of nontariff distor­
tions in world trade.1 Unlike tariffs, which
were reduced in previous rounds of negotia­
tions to the point where they did not consti­
tute major impediments to world trade,
nontariff distortions continued to provide
governments with a broad assortment of tools
with which to discourage foreign competi­
tion in their home markets. Import quotas,
“ buy domestic" policies, differential product
standards, inspection and licensing require­
ments, health and environmental standards,

1A distinction should be made between the concepts
nontariff “ distortions” and nontariff “ barriers.” Some
government policies may distort trade relationships but
may not be barriers to trade and may in fact increase the
volum e of trade. A case in point dealt with in the Tokyo
Round was the governm ent provision of export subsidies
which distort trade relationships but at the same time
may increase the volume of exports of the subsidized
product.

7

export subsidies2—all proved useful to gov­
ernments intent on maintaining or increasing
the protection from foreign competition
enjoyed by their domestic producers.
As world trade has increased, so has the
importance of nontariff distortions. In part
this is simply because, as tariffs were reduced,
nontariff distortions have looked more im­
portant by comparison. But governments, still
under pressure to protect domestic industry
(in some cases increasingly so because of past
reductions in tariffs), have adopted other
means to restrict and distort trade.
The continued trend toward freer trade
and the success of past negotiations in reduc­
ing tariffs served to focus attention on non­
tariff barriers. At its annual meeting in Tokyo
in 1973, the GATT initiated discussions aimed
toward reducing nontariff barriers. Nearly six
years later, on April 12,1979, representatives
of industrial countries participating in the
Multilateral Trade Negotiations signed an
accord covering major issues of the negotia­
tions. On July 26, 1979, President Carter
signed the Trade Agreements Act, which rati­
fied and implemented the agreements. The
agreements, including reductions in tariffs
also negotiated at the MTN, are scheduled to
be phased in gradually—in some cases, over a
period as long as ten years.

2Many trade distorting practices might appear to be
unrelated to export or import trade and, in fact, restric­
tion of foreign trade may not have been intended. It is
just such practices that are often most effective in restrict­
ing trade and most difficult to remove. For example, a
health department regulation that requires an inspector
on the plant premises but does not allow reciprocal and
comparable inspection by a foreign inspector in a foreign
plant may effectively preclude importation of the foreign
product. “ Buy dom estic" regulations may make it diffi­
cult for a foreign firm to make a competitive bid because
of a required price differential (for example, a foreign bid
must be 10 percent to 15 percent less than a domestic bid
before the foreign bid will be considered). At the
extreme, foreign firms are simply excluded from submit­
ting bids. In still other cases, announcem ents for bids are
made by invitation, rather than through public announce­
ment, and foreign firms are not invited to submit bids.
Such distortions num ber in the hundreds, are difficult to
identify, and, as shown by the duration of the MTN, are
even more difficult to remove.

8




Major provisions of the MTN

The basic purpose of the nontariff nego­
tiations in the Tokyo Round was to establish
rules and guidelines that would prevent other­
wise reasonable domestic policies of a coun­
try, such as quality controls on food or drug
manufacturing, safety requirements, or en­
vironmental controls, from becoming unseen
barriers to international trade. The rules and
guidelines evolved in the form of the follow­
ing codes.
The Countervailing and Antidumping
Duties Codes revised existing guidelines and
regulations pertaining to the distorting effects
of direct export subsidies, domestic subsidies,
and dumping (selling of goods by an exporter
in an import market at prices “ less than fair
value,” generally interpreted to mean sale at
a lower price than in the exporter's home
market or below the cost of production). It
also spelled out and standardized across coun­
tries the actions a government may take to
counter the above practices.
Several changes were made in U.S. coun­
tervailing duty and antidumping law to con­
form with rules agreed upon in the MTN.
Most important was the requirement that
U.S. industry prove that “ material injury” has
resulted from foreign subsidies on goods
imported into the United States before coun­
tervailing duties may be imposed. Under
prior law a determination of “ injury” was not
required for countervailing duties to be im­
posed on dutiable goods but was required on
goods imported free of duty. Prior U.S. legis­
lation pertaining to dumping of goods in the
U.S. market also required an “ injury” deter­
mination. The term “ material” was added to
the concept of “ injury” at the insistence of
other industrial countries to prevent deter­
minations of minor or inconsequential injury
from triggering countervailing or antidump­
ing duties. The 1979 act also required more
expeditious handling of countervailing duty
and antidumping investigations.
The Customs Valuation Code established
a systematic procedure for determining the
value of goods as a basis for imposing import

Econom ic Perspectives

duties. The primary valuation standard is to
be the transaction value of the goods. How­
ever, depending on specific conditions, one
of four alternate methods may also be used.
The standardized valuation procedures elim­
inate the controversial U.S. American Selling
Price valuation (on benzenoid chemicals, cer­
tain rubber-soled footwear, canned clams,
and certain knit wool gloves and mittens) and
certain controversial and arbitrary import
valuation methods used by foreign countries.
The major advantage of standardizing
tariff valuation procedures is that it contrib­
utes toward certainty in trade. Both exporters
and importers will be enabled to predict with
confidence the duty that will be applied to an
item. Because uncertainty in any form is a
major deterrent to trade, the removal of
uncertainty by the customs valuation code
should lead to an expansion of trade.
Implementation of this code will not
change significantly the effective tariff on
goods formerly subject to the American Sell­
ing Price scheme. The tariff rate schedule for
such goods was adjusted so that the effective
rate will remain approximately the same.
The Government Procurement Code
attacked the problem of discrimination
against foreign goods in the purchase of
materials used by governments. The U.S.
government, through formal legislated pref­
erences for domestic producers, has openly
discriminated against foreign suppliers. Most
other countries have discriminated against
foreign suppliers through hidden administra­
tive rules and practices.
The intent of the government procure­
ment code was, first, to establish specific and
visible rules governing government purchases,
bid procedures, and the like and, second, to
grant foreign suppliers increased access to
the large government market for goods. Pro­
visions of this code, as far as the United States
is concerned, took effect upon enactment of
the ratifying legislation in July 1979, except
that certain Presidential waivers were granted
until January 1 of 1980 and 1981.
The Product Standards Code was proba­
bly the most difficult and ambiguous of the

F e d e r a l R e s e r v e B a n k o f C h ic a g o




nontariff codes. It was designed to discourage
the discriminatory application to imports of
quality control standards, testing procedures,
certification requirements, and other similar
domestic health, safety, security, and envir­
onmental rules and regulations. The impor­
tant purpose of this code is to ensure access to
markets to both domesticand foreign suppliers.
The MTN legislation also approved a
number of bilateral agreements on trade in
cheese and other dairy products and meats.
U.S. import quotas on cheese were relaxed,
but the proportion of total cheese imports
subject to quotas was increased. Prior to the
quota increase, about 50 percent of cheese
irr oorts entered under quota while about 85
percent will be subject to the expanded
quota. The minimum level of beef imports
was also increased somewhat, but this is
expected to have little practical effect because
imports have been above the minimum level
in most of the past ten years.
The Trade Agreements Act extended the
negotiating authority of the President per­
taining to nontariff barriers for eight years
until January 3,1988. This will permit the con­
tinuation of negotiations on several issues
that were not settled in the latest round and
will permit negotiations on other types of
nontariff barriers.
Tariff reductions

In addition to lowering some nontariff
barriers, the MTN achieved a significant fur­
ther reduction in tariffs. The Trade Act of
1974, which formally authorized the United
States to participate in the Tokyo Round,
granted negotiating authority for the reduc­
tion of U.S. import tariffs, without further
congressional actions, by up to 40 percent
from the January 1,1975, level. It also author­
ized the elimination of tariffs that were 5 per­
cent ad valorem or less as of that date. Reduc­
tions negotiated outside this range were re­
quired to be approved by the Congress.
Thus, the Trade Agreements Act of 1979
approved certain tariff concessions, such as
the elimination of tariffs on civilian aircraft,

9

Tariff rates reduced in the MTN
(Global rates)1
U.S.

EC

japan

Canada

(percent)
Dutiable imports
Pre-MTN average
tariff levels

8.2

9.8

6.9 (10.8)2

13.1 (15.5)2

Post-MTN average
tariff levels

5.7

7.2

4.6 (5.4)2

ized countries for all goods traded will decline
only about 2 percentage points, from 6.2 per­
cent to 4.3 percent. The tariff reductions are
scheduled to take place over the next eight
years (in some cases it may be up to ten years),
thereby further diluting their rather modest
impact.

8.7 (9.4)2

Implications of the MTN for the United States

Percentage tariff
reduction—industrial
goods

31

27

28 (50)2

Pre-MTN average
tariff levels

6.1

6.3

3.2 (5.0y

9.9 (11.7)2

Post-MTN average
tariff levels

4.2

4.6

2.3 (2.5)2

6.6 (7.1)2

34 (39)2

Dutiable imports
plus duty-free
imports

'Tariff rates are the weighted average of imports from all sources
that have most-favored-nation (MFN) status. The United States, as a
rule, has denied MFN status to communist bloc countries. O nly China,
Hungary, Poland, and Romania have been granted MFN status by the
United States.
’ Canada and Japan had previously reduced tariffs from their
legally permitted rates. The percentages in parentheses reflect the
legal rates.
S O U R C E : O ffic e of the Special R e presen tative for Trade
Negotiations.

which were not provided for in the tariff­
cutting authority of the Trade Act of 1974.
However, most of the tariff concessions nego­
tiated in the MTN did not require congres­
sional approval.
The trade-weighted reduction in current
tariff rates negotiated for dutiable industrial
goods amounted to about 34 percent for
Canada, 31 percent for the United States, 28
percent for Japan, and 27 percent for the
European Community (EC).3 In percentage
terms the tariff cuts were substantial, but
because most tariff rates were already fairly
low, the effective reductions were quite small.
After all of the tariff reductions have been
made, the average tariff rate for the industrial­
3ln some countries tariff rates applied to imports had
previously been reduced unilaterally from the legal rates,
primarily as an anti-inflation measure. In Japan, for exam­
ple, the average tariff reduction on dutiable industrial
goods from the legal, or "b o u n d ,” rate was 50 percent,
considerably greater than the 28 percent reduction from
the rates actually applied. For Canada the reductions
from the bound rate averaged 39 percent as compared to
a 34 percent reduction from the actual rates.

10




The underlying rationale for the U.S.
government's participation in negotiations
aimed at reducing trade distortions and bar­
riers is that the freer trade made possible by
such reductions will result in an increase in
national economic welfare. If this were not
true, it would be difficult for the government
to justify becoming a party to the agreement.
The gains from trade—in terms of increased
income and employment associated with ex­
port industries and the higher employment,
lower cost of goods, and wider selection of
goods resulting from increased imports—
must exceed the losses from the displace­
ment of production and employment in
domestic industries that occur because of
increased imports.
In analyses of the gains and losses attrib­
utable to changes in trade restrictions, the
direct gains and losses in production and
employment typically receive the greatest
emphasis. In part this is because it is extremely
difficultto measure the broader welfare effects
of such changes. The difficulty stems from the
fact that many of the gains from trade due to
reductions in trade restrictions are indirect.
For example, reduced import prices due to
lower tariffs not only benefit consumers di­
rectly, but also result in downward pressure
on domestic prices of competing goods. Fur­
thermore, as import barriers are lowered,
there is a corresponding increase in the range
of choices open to consumers in the market
place. Undoubtedly, the consumer is bene­
fited by both indirect effects, but it is difficult
to quantify them.
More importantly, benefits are diffused
among a large number of consumers, few of
whom are so strongly affected by the changes

Econom ic Perspectives

The distribution of import tariffs tightens as a result of the MTN*
percent of industrial imports

percent of industrial imports

percent of industrial imports

percent of industrial imports

tariff interval

tariff interval

•Percentages are based on the value of industrial imports falling within specified tariff intervals. The tariff interval data are
based on 1976 trade data.
••The tariff intervals for Canada and Japan refer to the rates actually applied.which were lower than the legal rates.

in import barriers as to take an active interest
in them. In contrast, cutbacks in domestic
output and employment tend to be concen­
trated within relatively few companies and
affect only a small number of workers. These
companies and workers have strong incen­
tives to oppose changes that adversely affect
them. Consequently, the adverse effects on
domesticoutput and employment that would
result from a reduction of import barriers are
more closely studied and receive more atten­
tion than the often greater, but highly dif­
fused, benefits to consumers.
Assuming that the overall welfare impact
of the MTN agreement on the U.S. economy
can be determined, there are several reasons

Federal Reserve Bank o f Chicago




for expecting it to be modest. First, in abso­
lute terms, the tariff reductions are small.
Second, to the extent that the reductions in
nontariff restrictions are quantifiable, they
are quite limited in scope and are small in
comparison with the size of the overall econ­
omy. Third, implementation of the MTN pro­
visions is scheduled to take place over an
extended period, which will greatlydilutethe
impact on overall trade, employment, and
prices in any individual year.
Several studies have been undertaken
that provide estimates of the impact of the
tariff cuts and reductions in nontariff distor­
tions on employment, prices, and trade. One
such study estimates that if all the tariff and

11

nontariff changes were implemented at one
time, the overall economic welfare impact of
the trade agreement would be less than onetenth of one percent of U.S. gross domestic
product.4 Based on the 1976 data used in that
analysis, this would have been a net welfare
gain of $1.0 billion to $1.5 billion. In terms of
1979 data, the net welfare gain for the United
States might have totaled between $1.4 billion
and $2.1 billion.
Reduction in trade barriers
will increase econom ic w elfare1
Percen tag e in crease
in G D P 2

C h an g e in w elfare
based on 1979 G D P 3
(b illio n d olla rs)

U n ited States

.06 to .09

1.4 to

2.1

EC

.13 to .26

3.1 to

6.2

Japan

.03 to .06

0.3 to

0.6

Canada

.17 to .35

0.4 to

0.8

Average of 18
industrial co u n trie s

.08 to .18

5.2 to 11.7

'A la n V . D e ard o ff and R o b ert M . S te rn , M T N S tu d ie s Part 5: A n
E co n o m ic A n alysis o f th e E ffe cts o f th e T o k y o R o u n d o f M u ltilatera.
Trade N e g o tia tio n s o n th e U n ite d States a n d th e O th e r M a jo r
In d u s tria liz e d C o u n trie s , p re p are d for th e Su b co m m itte e on In te r­
n atio n al T ra d e , C o m m itte e on F in a n c e , U n ite d States Senate, 96th
Con gress 1st Session (C P O , Ju n e 1979), p. 103.
C a lc u la tio n s based on gross dom estic pro duct in 1976. Estimates
assum e th e fu ll e ffe ct of th e re d u ctio n s in tariff and n o n tariff
b arriers takes p lace im m e d iate ly.
C a lc u la t io n s , based on D e a rd o rff and Ste rn , assum e the rela­
tio n sh ip b etw ee n the ch an g e in e co n o m ic w e lfa re and gross
d om estic p ro du ct in 1976 holds fo r 1979.

The same study estimates that the trade
agreement may result in a net addition of only
about 11,000 jobs (a net gain of 42,000 jobs in
agriculture and a net loss of 31,000 in other
sectors of the economy). While other esti­
mates differ somewhat, they have in common
the conclusion that the overall impact of the
MTN on employment will be small in compar­
4Alan V. Deardorff and Robert M. Stern, MTN Stu­
dies Part 5: An Economic Analysis of the Effects of the
Tokyo Round of Multilateral Trade Negotiations on the
United States and the Other Major Industrial Countries,
prepared for the Subcommittee on International Trade,
Com m ittee on Finance, United States Senate, 96th C o n ­
gress 1st Session (GPO , June 1979), p. 63.

12




ison to total employment. Furthermore, the
impact, whether beneficial or detrimental,
will be diluted by the considerable length of
the implementation period. Normal changes
in employment—increases in employment
opportunities, increases in the total labor
force, natural attrition dueto retirement, and
regular job turnover—will greatly exceed the
effects of the MTN.
The probable impacts on prices are also
small. The MTN agreement should result in
about a 2.5 percentage point reduction in
average tariff rates on U.S. imports subject to
duties and only about a 1.9 percentage point
reduction in average tariff rates on all U.S.
imports (the combined average rate on goods
subject to duties and goods that are duty
free). According to one estimate, in the
unlikely event that all of the benefit of the
lower tariffs were to be passed along and if all
the tariff reductions were implemented at
one time, this would reduce U.S. consumer
prices by a minute 0.07 percent from what
they otherwise might be.5 Estimates by the
Office of the Special Trade Representative of
the price impact of the tariff and nontariff
agreements are somewhat higher—a reduc­
tion in the price level by as much as 0.6
percent.6
Another complicating factor affecting
the eventual impact on prices in the United
States is the effect of the Tokyo Round on
exchange rates under the present flexible
exchange system. To the extent that the
Tokyo Round results in an increase in U.S.
exports greater than the increase in imports
(contributing toward a net positive trade bal­
ance), the U.S. dollar will tend to increase in
value relative to other currencies and exert
downward pressure on the U.S. price level.
Should imports increase more than exports,
the tendency would be toward a depreciation
of the dollar and upward pressure on prices.
Most observers expect a net increase in
slbid., p. 100.
Exe cu tiv e O ffice of the President, Office of the
Special Representative, Impact of the MTN on Inflation
(Washington, May 11,1979), p. 3.

Econom ic Perspectives

U.S. exports to result from the Tokyo Round,
and thus an appreciation of the dollar that will
reinforce the price-reducing effects of lower
tariffs and reduced trade restrictions. Accord­
ing to estimates in one study, however, net
exports by the United States will be reduced
slightly by the tariff and nontariff concessions
of the MTN.7 If so, the likely results would be
a slight depreciation of the dollar and a cor­
responding upward pressure on prices, off­
setting to some degree the price-reducing
influence of reduced trade restrictions.
Manufacturing, the MTN, and the Seventh
District

According to a 1976 Commerce Depart­
ment survey, Seventh District states contrib­
ute 22 percent of the nation’s total value of
manufactured goods production.8 In two
major categories, nonelectrical machinery
and transportation equipment, the five Dis­
trict states account for nearly one-third and
two-fifths, respectively, of total U.S. produc­
tion. Production in the food processing and
electrical machinery industries is also con­
centrated in the District, but to a somewhat
lesser degree—District states account for
about 23 percent and 25 percent, respec­
tively, of the U.S. total. These four broad
industry categories account for over half of
the total output of manufactured goods in the
Seventh District, as compared with two-fifths
for the United States.
Exports of manufactured goods from
Seventh District states totaled about $36 bil­
lion f.a.s. port of export or about $30 billion
valued f.o.b. plant in 1979, according to esti­
mates based on the 1976 Commerce Depart­
ment Survey. This was 25 percent of the value
of all manufactured goods exported from the
United States. Nonelectrical machinery ship­
ments were particularly important compo­
nents of the District’s exports of manufac­
7Deardoff and Stern, p. 93.
8U.S. Departm ent of Co m m erce, Bureau of the C e n ­
sus, “ Origin of Exports of Manufacturing Establishments,”
Annual Survey of Manufacturing Establishments (Wash­
ington, June 1978), p. 2.

Federal Reserve Bank o f Chicago



tured goods, comprising nearly one-third of
the total. Transportation equipment, primar­
ily autos and automotive equipment ship­
ments to Canada under the U.S.-Canada
Automotive Products Agreement, made up
more than one-quarter of the District's ex­
ports. Electrical machinery accounted for
nearly a tenth of manufactured exports, and
food products made up another 7 percent. In
aggregate, these four broad categories of
manufactured goods—electrical machinery,
nonelectrical machinery, transportation equip­
ment, and foods—accounted for three-quar­
ters of manufactured exports originating with­
in Seventh District states. In comparison,
these same categories accounted for threefifths of U.S. exports of manufactured goods.9
Nationwide, those manufacturing indus­
tries expected to gain the greatest benefit
from the results of the Tokyo Round negotia­
tions are the comparatively high-technology
industries associated with transportation equip­
ment (primarily aircraft), construction and
agricultural machinery, and chemical pro­
duction. Industries expected to be affected
adversely over the eight- to ten-year period
of the MTN’s implementation are clothing
and wearing apparel, radio and television
manufacturing, lumber and wood products,
and miscellaneous manufacturing such as
sporting goods, musical instruments, and
toys.
The primary benefits in terms of output
and employment in manufacturing industries
in the Seventh District states should show up
in the nonelectrical machinery industries.
Some of these gains will be direct in the form
of increased exports and some will be indirect
in the form of increased domestic sales to
support expanded exports of agricultural
commodities that result from the MTN agree­
ments. It would appear, however, that losses
in industries such as miscellaneous manufac­
turing, electronics (especially television out­
put, which is heavily concentrated in Seventh
9For a more detailed discussion of Seventh District
exports, see Jack L. Hervey, “ Midwest— leading export
region,” Economic Perspectives (Federal Reserve Bank of
Chicago, May/June 1979), pp. 10-17.

13

District states), and food processing may re­
sult in a small net reduction in manufacturing
employment in the District.
In any case, the gains or losses are ex­
pected to be small in relation to total employ­
ment within the affected industries—in most
cases less than 1 percent of the total. Estimates
that have been made of the employment
effects of the MTN indicate that normal
growth in the economy and in demand for
manufactured goods is expected to more
than compensate for any depressing impact
caused by the implementation of the trade
agreements over the phase-in period. The
reduction in trade restrictions is not likely to
result in a reduction in total manufacturing
employment, but may retard its growth over
time.
Agriculture, the MTN, and the Seventh
District

Inclusion of the agricultural sector pro­
vides a positive picture of the impact of the
MTN on the economy of the District. Foreign
markets are even more important to Seventh
District agriculture than to manufacturing. In
fiscal 1978 agricultural exports from the Sev­
enth District states totaled nearly $8 billion,
more than 26 percent of the U.S. total and
about 30 percent of the aggregate cash receipts
from farm marketings in the five states.1
0
The most important products produced,
in terms of domestic sales receipts, were live­
stock, feed grains, soybeans, and dairy pro­
ducts. The most important products exported
by District states were feed grains, soybeans,
and meats. The Seventh District agricultural
products that faced the greatest import com­
petition were dairy products, meats, and
fruits and vegetables.
It has been estimated that, as a result of
tariff reductions and increases in quotas, U.S.
agricultural exports would increase by about
2 percent, or $460 million (based on 1976
trade after full implementation of the agree­
ments), with most of the increase in shipwlbid., p. 12.

14




ments going to Japan, the European Com­
munity, and Canada.1 Imports are estimated
1
to increase a little over $100 million, for a net
gain in total U.S. agricultural exports of nearly
$360 million.
The primary gains from foreign trade
concessions would appear to be in meats and
meat products and to a considerably lesser
degree in grains, soybean and oil seed pro­
ducts, and vegetables and noncitrus fruits.
Assuming the Seventh District states benefit
from the MTN changes in these categories in
proportion to their share of U.S. exports of
these broad categories of goods, the MTN
might result in increases in District states'
exports of meat and meat products by $80
million, of grains and soybeans by nearly $6
million, and of fruits and vegetables by about
$3 million. The increase in District states’ agri­
cultural exports attributable to the MTN would
be about $90 million or about 20 percent of
the total increase for the United States.
On the import side, the United States
granted foreign countries a number of tariff
concessions on agricultural products. Only
one of the concessions is of significance to
the District—an increase in quotas on the
importation of cheese. Beginning in 1980, the
annual quota on cheese imports is nearly
109,000 metric tons, an increase from 58,000
metric tons in 1978 and 1979.
The potential increase in imports is far
less than the 51,000 ton difference, however.
Prior to the MTN agreement, some cheese,
referred to as "price break” cheese, could
enter the United States outside the quota if
the import price was sufficiently above do­
mestic support prices. In 1978 cheese imports
totaled about 109,000 metric tons (about 50,000
tons under quota and about 60,000 tons
under "price break” ), or approximately the
same as the 1980 quota, which includes all
cheeses except goat's and sheep's milk

1
1James P. Houck, MTN Studies Part 2: The Tokyo/Geneva Round: Its Relation to U.S. Agriculture, pre­
pared for the Subcommittee on International Trade,
Com m ittee on Finance, United States Senate, 96th C o n ­
gress 1st Session (GPO , June 1979), p. 63.

Econom ic Perspectives

cheeses, French Roquefort, English Stilton,
and soft cured cheese. It has been estimated
that if the entire 1980 quota were filled and
nonquota imports brought the volume up to
124,000 tons, the increase over the volume
actually imported in 1978 would be equiva­
lent to about 0.25 percent of total annual U.S.
milk production—about 0.9 percent of U.S.
cheese production—and would amount to
about 0.5 percent of the $12.7 billion in cash
receipts from U.S. dairy production in 1978,
or about $66 million.1
2
Seventh District states account for about
28 percent of U.S. cash receipts from dairying,
with the state of Wisconsin alone accounting
for over 17 percent of the total. If the increased
quotas were filled and if nonquota imports
brought the total to as much as 124,000 tons,
District state farmers' dairy receipts, which
totaled $3.5 billion in 1978, might be reduced
by as much as $18 million—still only about a
0.5 percent reduction in receipts from dairy­
ing for the District states as a whole.
The projected $11 million reduction in
receipts in Wisconsin, the District's most
important dairy state, would be equivalent to
less than 5 percent of the increase in receipts
from dairying between 1977 and 1978. Given
normal growth in demand, the industry should
be able to adjust easily to the increase in
imports. However, areas heavily dependent
on dairying may be expected to experience
some pressure on farm income.
An area of potential gain resulting from
the MTN derives from the "binding" of tariffs
for certain commodities. For example, Japan
agreed to bind tariffs on soybeans at their
current duty-free base. This means that Japan
will not impose tariffs on soybeans in the
future to restrict the inflow of this rapidly
increasing import. Although there is no im­
mediate direct benefit to U.S. exporters, the
effect is to facilitate access to the Japanese
market in the future. Of total bindings ob­
tained on U.S. agricultural exports worth $1.3
billion in 1976, $1 billion was granted by Japan
12/b/d., p. 69.

Federal Reserve Bank o f Chicago



and five other countries on soybeans and
soybean products.
The measurable net gain in agricultural
exports resulting from the MTN, based on
1976 trade, is estimated at approximately $360
million for the nation as a whole (about 1.6
percent of the total) and $72 million for the
Seventh District states (about 1.2 percent of
the total). Adjusted to the level of 1979 trade,
the net gain for the United States and the
Seventh District states may have been about
$560 million and $110 million, respectively.
The differential impact of the agreement
leaves Seventh District states with a smaller
marginal gain from the MTN (about 20 per­
cent of the gain) than their present overall
share in U.S. agricultural exports (about 26
percent). As was the case with manufactured
goods, the measurable impact of the trade
concessions affecting agriculture obtained by
the United States in the Tokyo Round negoti­
ations will not be large. The impact will be
further diluted by the long adoption period
for many of the concessions.
Conclusion

The conclusion of the MTN will not result
in dramatic changes in U.S. international
trade. On the whole, it appears that the U.S.
economy will derive a net benefit from the
agreements, but any benefits will be diffused
over a substantial period of time and will be
relatively small. After taking into account the
rather small sector gains and losses in produc­
tion and employment, and the impact of the
MTN on prices, the primary benefit from the
Tokyo Round may be the intangible fact that
the participating nations were able to con­
clude some reduction in trade barriers in a
worldwide atmosphere of reemerging pro­
tectionism. The framework for international
negotiations on trade-related issues not only
remained intact but was strengthened. This is
of vital importance to Seventh District states,
which depend heavily on foreign trade to
support economic activity.

15

Electronic funds transfer: revolution
postponed
N. Sue Ford
In the early 1970s it was fashionable to speak
of the future of electronic funds transfer (EFT)
as an inevitability that would be upon us
before we knew what was happening. Such
terms as “ a whole new ballgame” and “ the
checkless society" entered the vocabularies
of bankers and financial writers with little crit­
icism and less resistance. Now, ten years later,
it is clear that the prophecies of a revolution
in EFT were premature. Checks are still with
us and their volume is greater than ever.
Nevertheless, just like Peter's repeated, oftheeded, but finally ignored cry of “ w olf!,"
the glowing promise of EFT appears at last to
be coming true.
A key factor contributing to the emer­
gence of EFT is the growing competition
between different types of financial institu­
tions in offering third-party payment services.
The Board of Governors recently recognized
the substitutability between these services by
redefining the monetary aggregates to include
NOW accounts, ATS accounts, credit union
share drafts, and demand deposits at mutual
savings banks. In addition, the Depository
Institutions Deregulation and Monetary Con­
trol Act passed on March 31, 1980, officially
recognizes and authorizes, for the first time
on a national basis, NOW accounts, ATS
accounts, credit union share drafts, and the
remote service units used by savings and loan
associations.
A major impetus behind the develop­
ment of this commonality of services has
been the dramatic increase in the level of
interest rates over the past several years,
which has induced consumers to seek profit­
able alternatives for their noninterest-earning
demand deposits and has given financial insti­
tutions an incentive to develop substitutes for
demand deposits. As a result, commercial

16



banks must now compete with many types of
financial institutions for these funds. The abil­
ity of these organizations to compete so read­
ily through alternative payment instruments
has been enhanced by developments in the
area generally termed electronic funds trans­
fer, or EFT. In large part, the attractiveness of
EFT to nonbank financial institutions has been
a consequence of the past regulatory envir­
onment, which prevented them from com­
peting in offering paper-based payments ser­
vices, but was less explicit as to limitations on
electronic transfers.
Not only has EFT sped the development
and acceptance of alternative means of pay­
ment, it also has enormous untapped poten­
tial for reducing labor costs and facilitating
the handling of the rising volume of paper
items processed by the banking industry.
Check clearing and collection are fairly laborintensive services and depository institutions,
like other firms, must continually aim to
reduce or hold the line on costs. Much of the
appeal of EFT to depository institutions derives
from the potential cost savings that it offers.
In a number of states, thrift institutions
have taken the initiative in offering EFT servi­
ces. They were early to recognize that they
can compete with commercial banks for new
EFT services, such as direct deposit accounts
and preauthorized payments,1 as well as use
EFT to compete for transaction accounts.
Both the desire of thrift institutions to com­
pete with commercial banks and the compet­
itive pressure on banks to reduce costs have
been important factors in the development of
EFT.
’ R o b e r t E. K n i g h t , “ T h e C h a n g i n g P a y m e n t s M e c h a ­
n i s m : E l e c t r o n i c F u n d s T r a n s f e r A r r a n g e m e n t s , ” M o n th ly

Review , F e d e r a l R e s e r v e B a n k o f K a n s a s C i t y ( J u l y / A u g u s t 1 9 7 4 ), p. 11.

Econom ic Perspectives

Forms of EFT

EFT takes a number of different forms,
each involving a different degree of depar­
ture from traditional means of payment, dif­
ferent costs, and different advantages and
disadvantages to customers and their finan­
cial institutions.
Automated teller machines. One of the
most popular means of transferring funds
electronically is through the use of auto­
mated teller machines (ATMs), which are util­
ized by financial institutions either on or off
premises to perform several basic teller func­
tions electronically. Services typically include
receiving deposits, dispensing funds, trans­
ferring funds between accounts, making credit
card advances, and receiving payments. The
customer usually accesses the machine by
inserting a magnetic stripe card and entering
on a keyboard a unique identification number
known only to the customer.
The popularity of ATMs rests on several
fundamental advantages that they offer. In
many cases, a bank can substitute an ATM for
a more costly full-service “ brick and mortar"
branch. This is particularly advantageous in
those states that place less onerous geogra­
phic and other restrictions on ATMs than on
full-service branches; however, a number of
states treat ATMs just likeother branches. The
ATM also reduces the need for tellers, lower­
ing not only the salary cost to the bank, but
also the cost of employee benefit and pen­
sion plans. Consumers like the reduced wait­
ing time and the extended, often 24-hour,
access. Although initial start-up costs are
high, more intensive use of ATMs will gradu­
ally reduce the average transactions (variable)
cost. Banks can reduce some of the risk of
technical obsolescence by arranging to lease
rather than purchase their machines.
Telephone bill payment. Another method
of effecting funds transfers electronically is
through telephone bill payment. This system
was originally set up for users of touch-tone
telephones, who can communicate their
account numbers and payment amounts dir­
ectly to the bank's computer. Now, several

F e d e r a l R e s e r v e B a n k o f C h ic a g o




depository institutions also offer the service
to rotary dial customers, who convey their
information to an employee of the institu­
tion. The employee, in turn, enters the infor­
mation into the institution's computer system.
This form of EFT has lower start-up and
operating costs and is cheaper and more flex­
ible for the customer than most electronic
alternatives. The main drawbacks to date
have been the limited availability of touchtone phones and resistance from billing com­
panies forced to accept payments in a form
that may not be compatible with their remit­
tance systems.2 A study by the American Tel­
ephone and Telegraph Company shows that,
as of year-end 1979, 38 percent of U.S. resi­
dential telephone customers are touch-tone
users. Because touch-tone will be available
nationwide within five or six years,3 this is
expected to rise to 64 percent by 1984. There­
fore, telephone bill payment is likely to be­
come an increasingly attractive EFT alterna­
tive. Of course, it is also possible that other
technological advances in telecommunica­
tions devices will make telephone bill pay­
ment obsolete before touch-tone service
becomes significantly more widespread.
Automated clearing houses. A number
of EFT services have been made feasible by
the development of the automated clearhouse (ACH). The ACH is like the traditional
clearinghouse in that it is a system for clearing
interbank debits and credits. The difference is
that with the ACH, the information enters the
system in an electronically readable form,
such as magnetic tape. In 1980 the Federal
Reserve processed approximately 230 million
items via the ACH, of which about 70 million
are commercial items.
Direct deposit of payroll has proved to be
one suitable use of the ACH. Under this plan
the employer is authorized by an employee
to deposit his or her wages directly into the
employee's account at a depository institu­
tion. The employer records the payroll in­
2S a n f o r d R o s e , " M i n i m i z i n g L o s s e s o n E F T , " A m e ri­

can Banker, S e p t e m b e r 4 , 1 9 7 9 .
J e f f r e y K u tle r, " B a n k s G e t G o o d N ew s o n T o u c h T o n e P h o n e U s e , ” Am erican Banker, N o v e m b e r 1 5 , 1 9 7 9 .

17

formation on magnetic computer tape and
sends it to the company's bank. The bank
debits the account of the employer and cred­
its the accounts of any employees who use
the same bank as the employer. Payroll in­
formation for employees using other banks is
combined with information from other em­
ployers on a new tape, which is transmitted to
the ACH. A computer then sorts the day’s
transactions for each participating bank, and
a tape is created for each payee bank listing
the accounts and amounts to be credited. The
normal net settlement procedure is followed.
The major advantage of direct deposit to
the employee is that he or she need not
bother picking up a paycheck and transport­
ing it to a depository institution. Funds are
deposited even if the employee is on vacation
or absent for other reasons. Although this use
of the ACH reduces the amount of checks or
paper documents in the system, it does so
only to the extent that it eliminates the initial
distribution of payroll checks. Most partici­
pating employees still make most of their
payments by writing checks. Even so, the sav­
ings to the employer can be considerable. For
example, a recent study showed that two
firms that utilized the ACH for their direct
deposit program experienced percentage cost
reductions of 57 and 77 percent.4 The major
savings were in the costs of clerical and other
labor.
Another use of the ACH that reduces
paper input is preauthorized debits. The cus­
tomer authorizes his bank or other financial
institution to debit his account automatically
for a specified amount on a certain date and
to credit another specified account. The ACH
process for preauthorized debits is similar to
that for direct deposit. Use of this form of EFT
is especially suitable for recurring payments
of fixed amounts, such as instalment, mort­
gage, or insurance payments. In the case of
transactions involving variable amounts, such
as utility payments, consumers have been less

receptive to this system, fearing loss of con­
trol over the scheduling of payments and
errors on the part of the depository institu­
tion and/or the payee.
Another use of the ACH is for check
truncation, which is less a service for consu­
mers than a technological improvement in
the check-clearing system. Truncation does
not reduce the number of paper items in the
system but does shorten their flow. Data from
physical documents, such as checks, are cap­
tured in electronic form upon their entry into
the financial system. The data are then pro­
cessed through the ACH system, and the
bank customer receives a computer-generated
statement in lieu of cancelled checks.
A 1979 study estimates a net savings to the
banking system of 5.15 cents per check trun­
cated, due to reduced postage and statement
preparation costs.5 According to the study,
approximately half of the roughly 40 billion
checks written each year could be truncated
with a potential annual savings of more than
$1 billion. These checks must be stored, how­
ever, and the storage and retrieval costs could
be high.6
Point of sale terminals. A more radical
departure of EFT from traditional modes of
payment is the use of point of sale (POS) ter­
minals. POS is a highly advanced form of EFT
that exists today only in several localized pilot
programs. The terminals are located in mer­
chants' shops, and enable a customer to
complete an immediate transfer of funds to
the merchant, bypassing traditional forms of
payment. When a customer makes a pur­
chase, he or she requests a transfer of funds
by inserting a magnetically coded card, some­
times called a debit card, into the terminal
and entering his or her personal identification
number. The sales clerk enters the amount of
5D r . A l l e n

H.

Lip is, “ C o s t S a v in g s in T r u n c a t i o n , ”

Check Safekeeping, A Proposa l F o r Inte r-Ba nk Check
Tru n c a tio n , A m e r i c a n B a n k e r s A s s o c i a t i o n , 1 9 7 9 , p . 4.
6A l t h o u g h 4 2 b a n k s a r e p a r t i c i p a t i n g in a c h e c k s a f e ­
k e e p in g

4M y r o n L. K w a s t , “ C o s t E c o n o m i e s f r o m A C H U s e b y

pilo t

program

e sta b lish ed

by

the

A m e rican

B a n k e r s A s s o c ia t io n , th e lim ite d s c o p e of th e p ro g ra m

N o n b a n k F i r m s , ” M agazine o f Bank A d m in istra tio n , v o l .

h as p r e c l u d e d r e lia b le e s tim a t e s of s to ra g e a n d retrieval

56 ( J u n e 1 9 8 0 ), p. 54.

costs u n d e r a b r o a d ly a d o p te d t ru n c a t io n p ro g ra m .

18




E c o n o m ic P e r s p e c tiv e s

the transaction, and the terminal requests the
customer's depository institution to autho­
rize a transfer. The customer's funds are veri­
fied and, if they are sufficient, the transfer is
authorized and the proper amount is imme­
diately credited to the merchant's account. If
the customer's depository institution is dif­
ferent from the merchant's, a central switch­
ing center is used to route and direct the
electronic message. Printed copies of the
transaction are generated for the merchant,
the customer, and the depository institutions.
Merchants favor the general concept of
POS as a means of reducing default risk and
facilitating the extension of credit. Several
merchants, especially grocers, have contrib­
uted time and effort to various trials of POS
systems. A recent study indicates that a bank
employing POS terminals may significantly
increase its share of the deposit market.7
However, the true effectiveness and profita­
bility of this EFT alternative cannot be mea­
sured on a small scale. To realize all the
potential benefits of POS, the system would
have to include all merchants and depository
institutions and have a minimum number of
central switches. This suggests the simultane­
ous development of a nationwide on-line sys­
tem, entailing a staggering front-end invest­
ment in equipment. Before such a de­
velopment could be undertaken, a myriad of
regulatory and policy issues would have to be
settled.
An effective POS network will most likely
evolve in stages. It may begin with credit card
authorization services, such as have been
successfully implemented by Wells Fargo Bank
(San Francisco), First National State Bank of
New Jersey (Newark), Maryland National Bank
(Baltimore), Bay Banks (Boston), and the larg­
est banks in Chicago.8 Retailers favor card
authorization networks that connect the banks
and the retailer directly because they reduce
cashier time. Instead of scanning a stolen card
7G a r y G . G i l b e r t a n d D a v i d A . W a l k e r , “ T h e I n f l u ­
e n c e o f E F T S o n C h a n g e s in B a n k M a r k e t S h a r e s , ” Journal

o f Re ta il Banking, v o l . 1 ( D e c e m b e r 1 9 7 9 ) , p . 30.
8" A

D ecade

of D e v e lo p m e n t

Issues

Profitability and pricing. Among the key
considerations of financial institutions in
deciding whether to implement an EFT sys­
tem are profitability and pricing of the ser­
vice. The various EFT alternatives generally
have high start-up costs and long payback
periods. Experience has shown that the earli­
est versions of a new type of equipment, such
as the ATM, may become technically obso­
lete before they are fully depreciated. Promo­
tional costs are high because customers must
not only be made aware that the service
exists, but in addition they must be trained in
its use. EFT is profitable only with a high
transaction volume, and it may take months
or even years to generate that volume.
Pricing of EFT services must assure pro­
fitability—at least in the long run—while
enabling the depository institution to remain
competitive in the short run. This is a task that
will require increasing precision asthe number
of potential competitors grows and the ser­
vices offered by commercial banks and thrift
institutions become more and more similar.
Although the payment of explicit interest on
demand deposits has been prohibited since
1933, competition has led commercial banks
to price their demand deposit services below

Lies A h e a d , Exp erts

S a y , ” A B A Ba nking Jo urna l, v o l . 72 ( J u n e 1 9 8 0 ) , p . 10 0.

Federal Reserve Bank o f Chicago



list or making a phone call, the cashier can
receive bank authorization simply by enter­
ing the credit card number into the electronic
cash register. The use of electronic cash regis­
ters greatly enhances the benefits to be de­
rived from implementation of the system. In
addition, Visa offers an interchange rate which
makes it economically attractive for retailers
to ask for direct interconnection for bank
card authorization, as J. C. Penney did in 1979.
Thus, through step-by-step implementation
of equipment and services, a pure POS system
may soon evolve which will automatically
debit the customer's account and credit the
merchant's account at the time of purchase.9

91
bid.

19

cost as a means of paying implicit interest on
these deposits. In order to compete effec­
tively, thrift institutions have also priced their
demand deposit substitutes, such as NOW
accounts and share drafts, below cost. It has
been suggested that the profit potential of
EFT services has been diminished by the
industry's failure to utilize an analytical and
rational procedure in costing and pricing.1 *
0
Banks have been encouraged to under­
price their demand deposit services by the
direct subsidy of such services that the Fed­
eral Reserve has long provided in the form of
"free" check clearing services. However, as
mandated by the Monetary Control Act of
1980, free clearing will end in 1981 and Fed­
eral Reserve check clearing will become
available to all depository institutions at a
price reflecting all direct and indirect costs of
providing it. The increase in depository insti­
tutions' operating costs resulting from re­
moval of the subsidy will give them added
incentive to adopt explicit pricing of check­
ing account activity. This, in turn, should
make EFT services relatively more attractive to
consumers.
Customer acceptance. Customer attitudes
toward EFT services are clearly crucial to a
depository institution's pricing and service
policies. The utility of EFT to the consumer
consists largely of the added convenience
that it offers. For instance, ATMs have become
popular because they eliminate the custo­
mer's need to wait in long teller lines and may
effectively extend banking hours. Consumers
have been willing to take the time to learn to
use ATMs and incur some loss of funds con­
trol in return for the option of added conven­
ience, usually with no additional service
charge.
However, other forms of EFT such as
check truncation do not offer such obvious
customer benefits. In fact, customers may
consider check truncation undesirable be­
cause it eliminates one service valued by
many consumers, the returned endorsed

check as a receipt and a record of payment.
Until some of the cost savings attributable to
truncation are passed along to customers,
acceptance is likely to be disappointing.
To be sure, truncation has had some suc­
cess. Almost all credit union share drafts are
truncated, and the savings and loan industry
is experimenting with truncation for its NOWs.
Several savings and loan associations in New
Jersey have been successful in marketing
truncation to their customers. In order to
overcome customer resistance to the nonre­
turn of the NOWs, they supply depositors
with NOW books that provide a carbon copy
of each item written. Acceptance has been
good, as evidenced by a customer attrition
rate of less than 5 percent since the program
began in January 1980.1
1
It is said that many consumers will refuse
to use POS and preauthorized payments
because of the loss of control over payments
that these types of EFT entail. This can be
extremely important in cases involving a dis­
pute with the merchant over defective goods
or failure to deliver. Even absent such dis­
putes, consumers value the ability to control
the timing of various payments and, in cases
where they are unable to satisfy all their
obligations on a timely basis, to determine
the order in which payments are made.
Another obstacle to acceptance of EFT is
the loss of float associated with the immediate
debiting of accounts. Although some EFT
users stand to gain from the acceleration of
payments on accounts receivable, surprisingly
strong objections have been raised by those
who would lose by the elimination of float.
However, this advantage of the existing pay­
ments system will largely vanish when, as
mandated by the Monetary Control Act, the
Federal Reserve begins to charge for float and
this is reflected in the pricing of checking
account services.
Consumers in states with liberal branch­
ing laws, like California, have been slower to
accept EFT services, especially ATMs, because

10S t e p h e n J. K o h n a n d C h a r l e s W . S c o t t , “ E f f e c t i v e
P r i c i n g o f E F T S , Bankers M agazine, v o l . 16 3 ( J a n u a r y / F e b r u a r y 1 9 8 0 ) , p. 42 .

20




11“ N e w

Jersey

S&Ls

T ru n c a tin g

NOW

R e co rd s,”

Am erican Banker, A u g u s t 1 3 , 1 9 8 0 .

Econom ic Perspectives

the additional convenience they provide is
less than it would be in unit banking or
limited branching states.1 Only continued
2
EFT Act
T h e E le c t r o n ic F u n d T r a n s fe r A c t, Title XX
of

the

F in a n c ia l

In terest

In stitu tio n s

Rate C o n tro l

R e g u la to ry

and

A c t of 1978, w as p a ssed

b y t h e C o n g r e s s o n N o v e m b e r 1 0 ,1 9 7 8 . T h e act
e n c o m p a s s e s tra n sa ctio n s in v o lv in g P O S te rm i­
n als a n d A T M s , d ir e c t d e p o s it s o r w ith d ra w a ls ,
and

te le p h o n e -in itia te d

transfers.

Both fin a n ­

c ia l a n d n o n f in a n c ia l e n tit ie s that o ffe r E FT s e r ­
v ic e s to t h e p u b l ic a re c o v e r e d by t h e act. M a jo r
a s p e c ts o f E FT c o v e r e d b y th e act a re :

•

C o n s u m e r lia b ility f o r u n a u t h o r i z e d tra n sfe rs ,
in clu d in g

lia b ility lim its a n d

d is c lo s u r e of

loss to t h e fin a n c ia l in stitu tio n .

•

Issu a n ce

of a cce ss d e v ic e s, su c h

as d e b it

c a r d s , b y fin a n c ia l in stitu tio n s .

•

In itia l d i s c l o s u r e to t h e c o n s u m e r of t e r m s
and

•

c o n d itio n s

of

the

EFT

ag reem en t.

D i s c l o s u r e o f s u b s e q u e n t c h a n g e s in t e r m s
a n d e rro r re so lu tio n n o tice .

•

A p p lic a b ilit y o f sta te la w a n d

a d m in istra ­

tive e n f o r c e m e n t p r o c e d u r e s .

B a s i c a l l y , a c o n s u m e r ’s l i a b i l i t y f o r a n u n ­
a u t h o r i z e d t r a n s f e r is l i m i t e d t o t h e l e s s e r o f $ 5 0
or th e a m o u n t of u n a u th o riz e d
o ccurs

b efo re

tra n sfe rs that

t h e f in a n c ia l in stitu tio n

fie d , p r o v id e d

that th e c o n s u m e r

is n o t i ­

n o tifie s th e

in s t it u t io n w i t h i n t w o b u s in e s s d a y s o f h is l e a r n ­
in g o f t h e loss o r theft.
S e c t i o n s r e g a r d i n g c o n s u m e r lia b ility a n d
the

is s u a n c e

of

access

d e v ic e s

have

been

in

e ffe ct sin c e F e b ru a ry 8 ,1 9 7 9 , a n d the re m a in in g
se ctio n s

becam e

e ffe ctiv e

M ay

10, 1980. T h e

re g u la tio n d o e s n o t a p p ly to c h e c k g u a ra n te e
o r a u t h o r iz a t io n s e rv ic e s , w ir e tra n sfe rs, ce rta in
se c u ritie s o r c o m m o d it ie s tra n sfers, a u to m a tic
tran sfers
acco u nts,

from
tru st

p h o n e -in itia te d

sa v in g s

to

acco u nts,
tran sfers

dem and
and

that

d e p o sit

c e rta in

have

not

te le been

p re a u th o riz e d .

12B il l

O rr,

"C a lifo rn ia ,

a

Foot-D ragger

in

A TM s,

experience with EFT and a broader awareness
of the other types of convenience and cost
advantages it offers are likely to overcome
such resistance.
Security. A major policy concern related
to EFT is security. At the individual level, the
consumer is concerned with proper user
identification to prevent illegal manipulation
of funds. The Electronic Fund Transfer Act
(see box), passed in 1978, sets forth consu­
mers' rights and obligations with respect to
EFT. Security has been maintained at the
ATMs through the use of a Personal Identifi­
cation Number, which is generally mailed to
the consumer from a separate office after he
receives a terminal access card.
Legislators and regulators, however, are
concerned with fraud on a much larger scale.
Of major concern is the security of the data
base of the central switch, which contains
personal and financial information on thou­
sands of persons. Maximum security is vital to
prevent invasion of privacy or fraud on a truly
massive scale.
Sharing of terminals. Other regulatory
issues involve the structure of EFT. Often,
several institutions share an EFT terminal,
such as an ATM, to offer customers additional
convenience at minimal cost. In Michigan
and some other states, shared terminals are
not treated as branches under state law, giv­
ing them a distinct advantage over terminals
operated exclusively for the customers of one
institution. Sharing providesa way for smaller
institutions to offer electronic services that
might otherwise be unable to do so because
of cost constraints. Sharing is procompetitive
in so far as it encourages competition from
firms that would have been excluded from
the market. On the other hand, any type of
cooperative arrangement between institutions
in the sale of services increases the probabil­
ity of collusive behavior. The availability of
sharing may also discourage innovative activi­
ty and independent market entry.1
3
13R o b e r t

A.

E is e n b e is

and

B e n ja m in

W o lk o w itz,

C o m e s t o L i f e , ” A B A Ba nking Jo urna l, v o l . 71 ( S e p t e m b e r

" S h a r i n g a n d A c c e s s I s s u e s , ” Bankers Magazine, v o l . 16 2

1 9 7 9 ) , p. 1 3 9 .

( M a r c h / A p r i l 1 9 7 9 ) , p . 48.

Federal Reserve Bank o f Chicago




21

Ideally, the situation should be evaluated
in each banking market by weighing the
competitive effects against the public bene­
fits to be derived. In practice, sharing has
been left to the states to regulate. As of
midyear 1979, 20 states had passed legislation
requiring sharing in some form. A proposed
joint venture involving most of the commer­
cial banks in Nebraska, however, has been
objected to by the U.S. Department of Justice.1
4
Justice has yet to challenge an individual
state's mandatory sharing law, although it has
stated its general opposition to mandated
sharing on competitive grounds.
Ownership. Another regulatory concern
involves ownership of a nationwide EFT sys­
tem. Currently, there exist several national
and international electronic communications
networks. Among them are:1
5
1) ACH (Automated Clearinghouse)—
Automated clearinghouses operate in 32
locations nationwide. Payments between
ACHs are governed by rules published
by the National Automated Clearing
House Association (NACHA). The Fed­
eral Reserve operates 31 of these ACHs.
2) Bank Wire—A cooperative communica­
tions network owned by about 200 sub­
scribing banks, this system supports a
computerized message switching center
for domestic funds transfer through cor­
respondents. Bank Wire plans to offer
same-day availability through its own
net settlement service via access to the
Federal Reserve System by the third
quarter of 1981.
3) Fed Wire—Connects all Federal Reserve
offices for the transfer of reserve funds,
U.S. Treasury instruments, research and
economic data, and other messages. The

14W . L. H o o d , “ H i s t o r y o f I l l i n o i s B a n k i n g L e g i s l a ­
tio n ,” (u n p u b lish e d

m a n u s c r i p t in C o n t i n e n t a l

N atio nal B a n k lib rary, M a r c h

Illinois

1 9 7 8 ) , p . 69.

15“ W h a t ’s A h e a d f o r t h e W i r e S e r v i c e s ? , ” A B A Ba nk­

ing jo u rn a l, v o l . 7 2 ( F e b r u a r y 1 9 8 0 ) , p p . 9 - 9 7 , 10 5.

22




current Culpeper Switch is to be replaced
by a more reliable, efficient, and flexible
communications system which utilizes
several independent switches instead of
the current central switch.
4) SWIFT (Society for Worldwide Interbank
Financial Telecomm unications)—O r­
ganized as a nonprofit organization in
1973 by a group of 239 founding banks
in 11 countries, today it connects more
than 700 of the world's largest banks in
26 countries via a message switching
center for international funds transfer.
5) CHIPS (Clearing House Interbank Pay­
ments System)—Clearinghouse created
by 12 New York banks for domestic and
international funds transfer. Over 100
institutions, including domestic and for­
eign banks and Edge Act corporations,
are participating in the CHIPS telecom­
munications network. Same-day settle­
ment with access to the Federal Reserve
System is scheduled to begin October 1,
1981.
Some or all of these networks are certain
to be part of whatever nationwide EFT system
finally evolves. Just how the Federal Reserve
will fit into that system is not fully defined at
this time, but it is likely to play a key role
because of the unique capacity of the Federal
Reserve to effect settlement between any
number of institutions. Important factors oper­
ating to enhance the role of the Federal
Reserve are the suitability of the ACH
network—in contrast to other existing wire
transfer systems—for processing a large
volume of small transactions, the Board's
announced intention to price ACH services
below current costs to stimulate additional
volume, and the system’s proven reliability
and quality of service. Private EFT systems,
whether operated by depository institutions
or by others, can easily avail themselves of the
Federal Reserve's services through any institu­
tion that maintains a direct account relation­
ship with the Federal Reserve.

Econom ic Perspectives

Geographic restrictions. The develop­
ment and geographical spread of EFT services
are also influenced by market factors such as
state banking law. It has been pointed out
that banks in branching states may use ATMs
as a cheaper alternative to "brick and mortar”
branches. In addition, some states which
prohibit branching permit banks to erect
limited-service EFT facilities, effectively en­
larging the banks' service areas. This estab­
lished tendency of the states to allow the
establishment of EFT facilities at locations that
would be prohibited to the traditional bank­
ing office or branch provides expansionminded financial institutions with an addi­
tional incentive to implement EFT services.
Conclusions

Commercial banks, by not passing the
true cost of checking accounts along to the
consumer, have made it difficult for institu­

tions offering EFT services to compete pro­
fitably for transaction accounts. This has
helped to postpone the long-predicted
emergence of EFT as the primary means of
payment. With the Federal Reserve pricing its
check clearing services and the relaxing and
gradual phase-out of interest rate ceilings on
deposits, it is anticipated that checking
accounts offered by commercial banks will be
priced to reflect their true costs. This will
make competing means of payment more
attractive to consumers. Increased competi­
tion from comparable thrift EFT services will
encourage competitive pricing and provide
additional incentive for all depository institu­
tions to convert to EFT. Although depository
institutions' profits may suffer with the intro­
duction of EFT, over the longer term transac­
tion volumeshould eventually justify the high
start-up costs. The public will benefit through
increased availability of services, added con­
venience, and more competitive pricing.

ECO N O M IC PERSPECTIVES--Index for 1980
Agriculture
Problems facing agricultural banks .......................................
Banking, credit, and finance
Bank funds management comes of age ..............................
Bank funds management comes of age—
a balance sheet analysis ............................................................
Sinking float .....................................................................................
Utilizing the bank holding com pany.....................................
The credit restraint program in perspective .....................
The history of potential competition
in bank mergers and acquisitions .......................................
The Depository Institutions Deregulation
and Monetary Control Act of 1980 .....................................
Electronic funds transfer: revolution postponed ............

Issue
March/April

Pages
19-23

March/April

3-10

May/June
May/June
July/August
July/August

13-18
19-23
3-6
7-14

July/August

15-23

September/October
November/December

3-23
16-23

Economic conditions
Review and outlook: 1979-80 ..................................................
Cyclical downturn in housing..................................................
Capital spending—the national need ..................................

January/February
May/June
November/December

3-31
3-12
3-6

International finance and trade
The impact of freer trade—the Tokyo
Round and the Seventh District ............................................

November/December

7-15

Money and money supply
Monetary aggregates redefined ..............................................

March/April

Federal Reserve Bank o f Chicago




11-18

23