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fo C
o

ECONOMIC

PERSPECTIVES




A review from
the Federal Reserve Bank
of Chicago

NOVEMBER/DECEMBER 1987
Is th e S even th D is tric t's
econom y d ein d u s trializin g ?
Som e m acro e co n o m ic e ffe c ts of
t a r if f policy
The fe d e ra l s a fe ty net:
N o t fo r banks only
Index fo r 1987

ECONOMIC PERSPECTIVES
November/December 1987

Volume XI, Issue 6

Karl A. Scheld, senior vice president
and director of research
Editorial direction

Edward G. Nash, editor
Herbert Baer, financial structure
and regulation
Steven Strongin, monetary policy
Anne Weaver, administration
Production

Roger Thryselius, graphics
Nancy Ahlstrom, typesetting
Rita Molloy, typesetter
Gloria Hull, editorial assistant

E con o m ic P e r sp e c tiv e s 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
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ISSN 0164-0682




Contents
Is the Seventh District’ s economy
deindustrializing?

Robert H. Schnorbus and
Alenka S. Giese
Yes—at least in the sense that the Midwest
has experienced an absolute decline in
manufacturing output since the early 1970s.

Some macroeconomic effects
of tariff policy

David Alan Aschauer
Among the likely effects of increased tariffs:
A reduction in domestic production and
a drop in the world level of employment.

The federal safety net:
Not for banks only

George G. Kaufman
Federal insurance and loan guarantee
schemes now go far beyond the original
bank insurance plans and taxpayers who
bear the ultimate risk may not realize
just how big is their liability.

Index for 1987

Is the Seventh D istrict’ s econom y
deindustrializing?
Robert H. Schnorbus and Alenka S. Giese
The Seventh Federal Reserve District is
located on the western flank of what has been
called the nation’s “rustbelt.” It is easy to see
how this characterization might be applied to
the Seventh District. The District’s economy
is heavily specialized in a number of troubled
industries: automotive (Michigan), steel and
machine tools (Illinois, Indiana, and
Wisconsin), and a set of industries closely
linked to the production and processing of food
(Iowa). All of these have been adversely af­
fected by structural changes in the national
economy arising from international trade, such
as the rising tide of auto and steel imports and
the fall of grain exports, or changing product
demand, such as the emergence of the com­
puter. Indeed, an image of idle factories and
massive blue-collar unemployment that seems
to pervade the Seventh District has raised fears
of nationwide deindustrialization, or an abso­
lute decline of output produced in the nation’s
manufacturing sector.
Through analysis of manufacturing em­
ployment and output for the Seventh District
between 1955 and 1984, this article offers new
evidence that deindustrialization has in fact
been occurring in the Seventh District, but only
since 1970. The study shows how evidence of
deindustrialization has been obscured by
lumping economically diverse regions into a
national aggregate. Also, by identifying a
dramatic break in the growth trend of manu­
facturing output around 1970, the study ex­
plains why previous studies of regional
deindustrialization, which have been limited to
data only through 1978, were less conclusive.1
In contrast, claims of deindustrialization
for the nation as a whole, have been refuted by
convincing research.2 Treating the nation as a
single homogeneous region has allowed analysts
to show that the popular view that the econ­
omy is reducing its manufacturing sector and
replacing it with hamburger stands and
laundromats is largely a myth. For example,
far from declining, manufacturing output na­
tionally has been on a rising trend for many
years. More importantly, manufacturing’s
Federal Reserve Bank of Chicago




share of gross national product (GNP) has been
remarkably stable at roughly 25 percent over
the post-World War II era (allowing for devi­
ations over the business cycle).
But, when regions are analyzed as sepa­
rate and distinct (though interdependent)
economies, what begins to emerge is a dichot­
omy between regional economies that are still
growing and those that are not. Each region
has its own economic history, each has its own
specialization of products, and each has a dif­
ferent sensitivity to national and world eco­
nomic events. The purpose of this article is to
put the concept of deindustrialization into its
proper perspective as a regional issue.
What is deindustrialization?

The term deindustrialization can cause
confusion if used too loosely. For example, one
definition that has been offered is “widespread,
systematic disinvestment in the nation’s basic
industrial capacity.”3 Using the level of invest­
ment as a measure, however, may be too re­
strictive to find evidence of deindustrialization
except in the nation’s aging urban centers. In
another recent study, deindustrialization was
equated with a decline in regional manufac­
turing output relative to the whole national
economy.4 However, the manufacturing sector
of the entire “rustbelt” has been a declining
share of the nation’s manufacturing sector since
the turn of the century?
Definitional problems have not been the
only source of confusion in understanding de­
industrialization. Distinguishing between an
underlying trend that is distinct to a region and
a national influence that is affecting all regions
more or less equally is another problem. A
decline in a region’s manufacturing sector over
a given period of time may be due solely to a
Robert H. Schnorbus is an economist and Alenka S. Giese
is an associate economist at the Federal Reserve Bank of
Chicago. Acknowledgements: Philip Israilevich and
Randall Merris for their assistance with the empirical work,
and Gary Garofalo (University of Akron) for providing the
LED data.
3

hypersensitivity to the national business cycle.
Indeed, both manufacturing employment and
output in the nation have for the most part
been declining since 1979, which is over­
whelmingly a short-term business-cycle phe­
nomenon. As such, the period from 1979 to
1984 should not be interpreted as prima facie
evidence of deindustrialization. A careful
analysis of a region’s economy must put recent
events into an historical perspective that can
distinguish between cycle and trend.
A final problem with analyzing regional
trends is that, with the exception of employ­
ment measures, economic data for the manu­
facturing sector are at best fragmented. The
Census of Manufacturers (CM) and the Annual
Survey of Manufactures (ASM) provides a rich
source of data on a region’s manufacturing
base. However, three critical years are missing
from the ASM, preventing time-series analysis
beyond 1978. The problem can be overcome
by approximating values for the missing obser­
vations of the manufacturing output and for
nonmanufacturing output (see box).
Employment trends—overstating
the decline

Given the completeness of regional em­
ployment data, it is not surprising that the im­
age of District trends has been heavily shaped
by the relative and absolute performance of
manufacturing employment. Although highly
cyclical in nature, manufacturing employment
in the United States has been virtually flat
since the mid-1960s.6 In contrast, the Seventh
District’s manufacturing employment has been
declining visibly over the same period (see Fig­
ure 1). Moreover, once the District’s trend is
removed from the national data, the rest of the
nation can be seen to continue expanding
manufacturing employment (again, taking into
consideration cyclical swings).7
Three problems occur with drawing con­
clusions about regional deindustrialization that
are based on employment trends. First, be­
cause the District has a high proportion of both
mature and cyclically sensitive industries, some
of the observed weakness in the District’s econ­
omy may be attributed to its industrial mix.
Obvious examples are the decline of the do­
mestic steel industry, heavily concentrated in
the Chicago-Gary area, and of the automotive

4




Figure 1
M a n u fa c tu rin g e m p lo y m e n t tre n d s
index, 1956=100

1957

'61

'65

'69

'73

'77

'81

'85

SOURCE: Department of Labor, Bureau of Labor Statistics.

industry, concentrated in the Detroit area.
Since virtually all of the District’s industries
have lagged their national counterparts, how­
ever, the problem is clearly not confined to an
unfavorable industrial structure.8
Second, some of the states in the District
could account for all of the decline in the Dis­
trict, while other states were expanding em­
ployment. Iowa, for example, is much more
of an agriculturally oriented state than the rest
of the District and its manufacturing employ­
ment growth up until the late 1370s was ex­
ceptionally stronger than any of the other
states.9 Wisconsin has also experienced aboveaverage employment growth for a District
state. In the three biggest District states, how­
ever, manufacturing employment has been de­
clining. So, even within the District there
existed a split at least until the 1980s between
states that were industrializing and states that
were deindustrializing.
The third problem with focusing on em­
ployment is that, if labor is becoming more ef­
ficient, employment can be declining at the
same time that output in the region is rising.
Alternatively, a region may shift its production
processes away from labor without sacrificing
output by substituting capital for labor or by
purchasing more business services.10 Finally,
the region may be expanding its capital stock
more rapidly than its employment.1 In each
of these cases, labor productivity could rise

Economic Perspectives

Filling in the blanks

The Bureau of the Census did not publish regional data in the ASM for the years
1979, 1980, and 1981. Data for value added of total manufacturing by state for 1980
was obtained upon request from the Bureau, but estimates had to be made for the re­
maining years. Estimates of hours worked for all three years were also needed to
compute labor productivity. The Longitudinal Establishment Data (LED) file (which
was developed by the Bureau of the Census) provided the basis for estimating these
missing observations. The LED file contains all of the information originally in the
1972 and 1977 CM and the 1978-81 ASM. From the LED file, a sample of all firms
with over 100 employees was obtained. Depending on the state and the particular
variable, this LED sample represented between 60 and 80 percent of the ASM data
for the years in which the two series overlapped (1972 to 1978). (For further infor­
mation see James L. Monahan, “Procedures for Using the Longitudinal Establishment
Data File,” Technical Motes, Bureau of the Census, April 1983.)
The formula applied to the LED data for nominal value added (NVALED) to
approximate the missing ASM data (NVAASM) during a given year, using 1979 and
the Seventh District (7G) as an example, was:
NVA7G19 = NVALED19* NVAASMUS79
NVALEDUS79

z

NVAASMUS,1 j|c MVALEDGt
NVAASM7Gt
NVALEDUSt
/ =72
7

aproximated values, NVA__, were then deflated by the Producer Price Index for all
commodities and converted to their log values to get the final estimated measure of
output (LJVVA__) that was entered in the model.
The formula is a modification of a simple formula that would compute the av­
erage ratio of LED to ASM data during the overlapping years (1972 to 1978) and as­
sume that the ratio holds for the missing years. Because the ratio is known at the
national level during the missing years, its inclusion provides useful information for
those years. The assumption is that the regional ratio of LED to ASM moves in the
same direction as the ratio for the nation. In addition, the inclusion of the national
data provides a more stable ratio upon which to estimate the missing regional obser­
vations.
enough to offset declines in employment, so
that the region’s output continues to expand.
In the case of the Seventh District, labor
productivity in manufacturing has been rising
steadily throughout the post-World War II era.
However, its productivity has lagged the rest
of the nation. Labor productivity in the Dis­
trict grew 2.0 percent annually between 1955
and 1984 (but only 1.3 percent if Iowa and
Wisconsin are excluded). In contrast, the rest
of the nation expanded labor productivity at a
2.2 percent annual rate. The question now
becomes whether the growth in productivity
was enough to offset employment declines in
Federal Reserve Bank of Chicago




manufacturing, so that manufacturing output
continued to expand. If so, the District’s
economy could still be industrializing in terms
of output, if not in terms of employment.
Output trends—nearer the mark

Observing the underlying trend in the
District’s manufacturing output from the raw
data is more difficult than was the case with
employment data (see Figure 2). What is ob­
vious from the data is first that manufacturing
output had been trending upwards in both the
District and the rest of the nation at least until
5

Figure 2
T re n d s in m a n u fa c tu rin g o u tp u t
index, 1955 = 100

SOURCE: Department of Commerce, Bureau of the Census.

the early 1970s. Second, manufacturing output
in the District has yet to surpass its 1973 peak.
Recessions in both the early 1970s and 1980s
account for some of the difference before and
after the early 1970s. But, unless the business
cycle can explain all of the difference, the
weakness since the early 1970s signals a funda­
mental break in the underlying output trend.12
Separating the influence of business-cycle
fluctuations from the underlying trend can be
achieved through regression analysis. A model
was constructed to determine if there was any
period of statistically significant decline in the
District’s manufacturing output (using value
added deflated by the Producer Price Index as
a proxy for output). The basic form of the
model was:
LAVA.
where LAVA__
LNGNPCHG
T
D71

6




+ <ZoD71 +

bLNGNPCHG + c j +
c
2D71*T + e
natural log of real value
added in manufacturing
change in the natural log
of real gross national
product (the business
-cycle variable)
time trend
dummy variable (D71 =
1 beyond 1970 and 0
otherwise).

By testing a variety of years to serve as the di­
viding point of the dummy variable in the
model, the year 1971 was found to give the best
statistical results.13
Because the model in effect has two slopes
and two intercepts, the actual year of the break
in trend may differ from the year chosen for the
dummy variable. Therefore, the model must
be solved for the break, which was usually
during 1970 or 1971 for the Seventh District
and its five states. The causes for the break are
associated with such factors as technological
changes and shifting product demand, whose
impact may have been building for several
years prior to 1970. It is interesting to note
that, while the energy shocks in 1973 and 1979
certainly contributed to the decline, the break
occurred about three years prior to the onset
of the energy crisis.
The results of the regression analysis show
that, after growing on average at an annual
rate of 4.4 percent up to 1970, manufacturing
output in the District has since been declining
at a 1.4 percent annual rate (see Table 1). In
other words, even after accounting for the cy­
clical weakness of the 1970s and 1980s, there is
significant evidence that the District has been
deindustrializing.
In contrast, the rest of the nation was still
edging upward at 0.2 percent per year over the
post-1970 period. While that growth rate was
not large enough to be significantly different
from zero, it supports the argument that the
rest of the nation was not deindustrializing.
More importantly, the disparity between the
District and the rest of the nation helps explain
why evidence of deindustrialization has not
been discovered at the national level. From a
long-term perspecdve, the level of manufactur­
ing output for the nation as a whole was virtu­
ally flat between 1970 and 1984. As in the case
of employment, opposing regional trends in
manufacturing output are roughly offsetting
each other.
Variations in output performance within
the District followed a pattern similar to the
one found in employment (see Figure 3). De­
clines in manufacturing output during the
post-1970 period were most pronounced in
Illinois, Indiana, and Michigan. Both Iowa
and Wisconsin behaved more like the national
average by flattening out rather than reducing
their level of manufacturing output. Both
Economic Perspectives

Tab le 1
Regression results: A b so lu te change in m a n u fa c tu rin g valu e added
Dependent
variable

Independent variables
D71

Intercept

LN G N P C H G

Break in
t

D71 *t

R2

trend
(year)

LN VA 7G

11.42
(.0001)

.95
(.0001)

2.17
(.0001)

.044
(.0001)

-.058
(.0001)

.83

m id-1970

LN V A U S

12.91
(.0001)

.76
(.0001)

1.41
(.0001)

.048
(.0001)

-0.48
(.0001)

.92

1970

LN V A U SX

12.64
(.0001)

.71
(.0001)

.049
(.0001)

-.045
(.0001)

.93

1970

(.002)

LN V A IL

10.43
(.0001)

.96
(.0001)

1.50
(.004)

0.41
(.0001)

-0.59
(.0001)

.74

1971

LN VA IN

9.63
(.0001)

2.30
(.0001)

.049
(.0001)

-.062
(.0001)

.86

mid-1970

(.0001)

1.02

1.21

LN V A IA

8.37
(.0001)

.93
(.0001)

1.06
(.02)

.061
(.0001)

-0.56
(.0001)

.92

1971

LN VAM I

10.15
(.0001)

1.09
(.0001)

3.57
(.0001)

.045
(.0001)

-.065
(.0001)

.80

1971

LNVAW I

9.37
(.0001)

.69
(.0001)

1.47
(.0004)

.042
(.0001)

-.041
(.0001)

.92

1971

NOTE: Figures in parentheses are levels of significance. A level of less than or equal to .05 (i.e. 5%) indicates that the variable has a
significant impact on the dependent variable.
To correct for 1st-order serial correlation, a two-step full transformation method was applied.
The dependent variables: LN VA__= natural log of real value added for the Seventh District (7G), the U.S., the US excluding the 7G
(U SX), Illinois (IL), Indiana (IN), Iowa (IA), Michigan (Ml), and Wisconsin (Wl)
The independent variables: D71
LN G N PCHG
t
D71*t

=
=
=
=

dummy variable for years > 1971.
change in natural log of real GNP.
the time trend.
the product of the time trend (t) and D71 (i.e., growth rate post 1971).

states began to plateau about the same time as
the national slowdown, rather than one to two
years before when the other three states began
to decline. In addition, the model was able to
explain only 70 percent of the variation in the
data for Michigan and Illinois, compared to
about 90 percent for the nation, which suggests
that other factors that are unique to these states
have been influencing their growth.
It is interesting to note differences in sen­
sitivity to the business cycle, which help ob­
scure the differences in trend growth among the
District states. On average, the District (with
an elasticity of 1.78) is about two and a half
times more sensitive to the business cycle than
the rest of the nation (with an elasticity of
0.72). Iowa again turns out to be more similar
Federal Reserve Bank of Chicago




to the rest of the nation, while Michigan is
more than four times as sensitive as Iowa to
swings in national business-cycle activity.
The variations in behavior with respect
to both cycle and trend raise the possibility that
differences in industrial structure may account
for the District’s poor output performance rel­
ative to the nation. For example, the domestic
auto and steel industries are both highly cy­
clical and mature industries. The District’s
declining manufacturing output might simply
be due to the exceptionally high concentration
of these two industries in the Seventh District.
The data used in this study do not adjust for
structural differences among regions. Other
estimates of District output, such as the Mid­
west Manufacturing Index (MMI), can be ad7

Figure 3
S e v e n th D is tr ic t m a n u fa c tu rin g o u tp u t
tre n d s by state
index, 1955=100

justed for industrial structure. However,
adjusting the MMI shows a similar (but less
severe) pattern of decline since the early
1970s.14 Thus, an unfavorable mix of industries
(i.e., industries that are performing poorly
across the nation, but are concentrated in the
Seventh District) can not alone explain the de­
cline in the District’s manufacturing output.
Another concern is the extent to which
productivity differences between the District
and the rest of the nation may account for the
District’s declining manufacturing output. In­
deed, if labor productivity for the rest of the
nation were applied to the District’s level of
manufacturing employment, the hypothetical
level of District output that is attained does not
show a statistically significant decline during
the post-1970 period. However, the District
would still have experienced more of a slow­
down during that period than the rest of the
nation. This finding indicates that productivity
differences are important in explaining the
District’s deindustrialization, but are not the
only explanation. Competitive disadvantages
of District producers, often attributed to wage
rate differentials, unionism, and shifting re­
gional markets, are also important.15
Some qualified answers

The volatile behavior of the Seventh
District’s economy in recent years has raised
many questions and concerns about its future
viability. Among the most pressing is whether
8



deindustrialization is a valid description of
what is afflicting the District’s economy. This
study provides evidence that since 1970 the
Seventh District’s manufacturing sector has
been producing fewer and fewer goods. This
decline represents deindustrialization in the
sense of an absolute decline in output.
The exact causes of the District’s dein­
dustrialization are complex and beyond the
scope of this study. The fact that growth of
manufacturing output in the District has been
lagging the nation over the past four decades
or so indicates that the stage was being set for
absolute deindustrialization whenever the na­
tional economy faltered. And, indeed, a break
in the trend since 1970, which represented a
national slowdown in the growth of manufac­
turing output, finally translated into an abso­
lute decline in the District’s output. Of course,
a resurgence in the national economy might
provide a short-term solution to the District’s
decline in output by literally pulling the Dis­
trict out of its deindustrialization.
A strong national expansion, however,
would not change the underlying factors in the
District’s economy that have caused the
District’s manufacturing sector to lag the na­
tion. Viewed from this perspective, the period
of deindustrialization has been a culmination
of underlying factors that became the dominant
forces shaping regional growth after 1970.
Further research in identifying these factors
and quantifying their impact on regional
growth patterns may help state and local gov­
ernments design policies to help District pro­
ducers improve their competitiveness and to
reverse the District’s current trend in manu­
facturing output.
1 Studies o f regional deind ustrialization to date
have generally been inconclusive and often differed
as to w hat they m eant by deindustrialization. See,
for exam ple, B luestone, 1984 and B artholom ew , et
al., 1986.
2 See L aw rence, 1984, for the m ost persuasive ar­
gu m en t on the subject to date.
3 See B luestone, 1984, p. 39.
4 See B artholom ew , et al., 1986.
3 See N orth and R ees, 1979.
6 See T atom , 1986, for a detailed discussion o f
m anufacturing em p loym en t trends at the national
level.
Economic Perspectives

T ak in g a sim ple regression o f em p loym en t levels
over tim e and con trollin g for the business cycle in­
dicates that the D istrict w as d eclin in g at a 1.1 per­
cent rate, com pared to a 0.3 percent grow th for the
nation exclud ing the D istrict, w hile the nation as a
w hole w as virtually flat.
8 For an exten sive set o f d ata that com pares indus­
try grow th rates by state w ith their national
counterparts, see The Iowa Economy: Dimensions of

Change, 1987.

9 For m ore details o f Io w a ’s econ om y, see

Economy: Dimensions of Change, 1987

The Iowa

10 A good exam p le is the case o f G eneral M otors
(G M ) acquiring E lectronic D ata System s (E D S).
W hen G M transfered app roxim ately 6000 o f its
em ployees to E D S, it reduced its labor force w ith ­
out affecting outpu t, w hich caused its productivity
to show a rise.
11 H u lten and S chw ab, 1984, attribute m uch o f the
regional differences in ou tp u t grow th to expansion
o f labor and cap ital, rather than to differences in
efficiency o f the work force.
12 Joh n son , 1981, also cites the effects o f a w eak
econ om y on investm ent and cap ital form ation in
the 1970s.
13 In this m odel, the slope o f the tim e trend in the
p o st-1970 period w ould be the sum o f the tim e

trend coefficient, cls and the dum m y variable times
the trend coefficient, c2. A separate m odel was
necessary to test w hether the coefficient for the time
trend after 1970 w as significantly different from
zero. In the second m od el, separate dum m y vari­
ables were incorporated for pre-1971 and post-1970
in both the in tercept and the tim e trend variable.
C oefficients for the p o st-1970 trend variable were
significantly different from zero at the 0.05 proba­
bility level for Illinois, In dian a, and M ichigan.
H ow ever, the m od el using pooled data for the D is­
trict states (w ith du m m y variables controlling for
the states) did confirm that the coefficient for the
trend w as significantly different from zero after
1970. T ests to see if a d u m m y variable should be
applied to the cycle variab le (i.e., if cycles were
m ore intense in the post-70 period than the pre-71
period) proved n egative and , therefore, were not
included in the final m odel.
14 T h e M id w est M an u factu rin g Index is a w eighted
com bin ation o f 17 m an ufacturing industries. T o
see the effect o f industrial structure, the D istrict
w eights w ere replaced w ith national w eights. T he
resulting com b in ation o f D istrict industries w ould
then reflect the D istrict’s perform ance, if it had the
sam e proportional m ix o f industries as the nation.
For a discussion o f the In d ex, see Schnorbus and
Israilevich, 1987.
13 See H ekm an and Strong, 1980.

R eferen ces
B artholom ew , W ., P. A. J o ra y , and P.
K och anow ski, “T h e D eclin e o f M an ufactur­
ing in the M idw est: A Sh ort-R un or L ongR un P roblem ,” Indiana Business Review,
J an -F eb , 1986, p p .7-12.
B luestone, B., “ Is D ein d u strialization a M yth?
C apital M ob ility versus A bsorptive C apacity
in the U .S . E co n o m y ,” The Annals, A m erican
A cadem y o f P olitical and Social Science, V ol.
475, Septem ber 1984, pp. 39-51.
H ekm an, J . S., and J . S. Strong, “ Is T h ere a Case
for P lant C losing L aw s?,” New England Eco­
nomic Review, J u l-A u g . 1980, pp. 34-51.
H u lten, C. R . and R. M . S chw ab, “R egion al Pro­
d u ctivity G row th in U .S . M anufacturing:
1951-78,” American Economic Review, V ol. 74
# 1 , M arch 1984, pp. 152-162.
Joh n son , D ., “ C apital F orm ation in the U n ited
States: the P ostw ar P erspective,” in Public
Policy and Capital Formation, Board o f G over­

Federal Reserve Bank of Chicago




nors o f the Federal R eserve System , 1981, pp.
47-58.
L aw rence, R . Z ., Can America Compete?, T he
Brookings In stitution, W ashington, D .C .,
1984.
M arshall, J . M ., “L inkages B etw een M anufactur­
ing Industry and Business Services,” Environ­
ment and Planning, vol. 14, 1982, pp.
1523-1540.
N orton , R . D . and J. R ees, “T h e Product C ycle
and the Sp atial D ecen tralization o f A m erican
M an u factu rin g,” Regional Studies, V ol. 13,
1979, pp. 141-151.
Schnorbus, R . and P. Israilevich, “T h e M idw est
M an ufacturing Index: T h e C hicago F ed’s
N ew R egion al E conom ic In d icator,” Economic
Perspectives, V o l. 11, N o. 5, S ept-O ct, 1987,
pp. 3-7.
T atom , J . A ., “W hy H as M an ufacturing E m ploy­
m ent D eclin ed ?,” Review, Federal R eserve
Bank o f St. L ouis, D ecem b er 1986, pp. 15-25.

9

Some m acroeconom ic effects o f ta riff policy
David. Alan Aschauer
The exchange value of the dollar against
the currencies of most of the United States’
major trading partners—especially Japan and
West Germany—has fallen significantly since
reaching a peak in early 1985. Yet U.S. cur­
rent account deficits with these countries have
yet to show substantial reductions. Impatience
on the part of export industries has been re­
flected in some recent protectionist legislation,
with the promise of more to come.
A typical argument for protectionist leg­
islation emphasizes two supposed results from
higher tariffs. First, by making foreign goods
more expensive, tariffs cause imports to fall and
thus improve the current account. Second, as
domestic residents shift expenditure patterns
from foreign to domestic goods, home employ­
ment and production are stimulated. Fewer
Americans driving Toyotas and BMW’s mean
more jobs for blast furnace operators in Gary,
for tire producers in Akron, and for assembly
line workers in Flint.
This article explores some of the effects of
tariff policy on the macroeconomic levels of
employment, output, and the trade deficit
within a simple model that describes our econ­
omy functioning over a period of time. This
model allows us to manipulate economic factors
to analyze the effects of various policies (see
box). The focus of the analysis is on the valid­
ity of the two asserted results of import taxation
listed above. Although it is possible for tariff
policy to engineer a reduction in the trade def­
icit, by altering the structure of foreign goods
prices over time, it is crucially important to
distinguish between tariffs which are temporary
and those which are permanent. Indeed, per­
manent tariffs may have little discernible im­
pact on the trade deficit.
Also, the likely associated effect of in­
creased tariffs will be a reduction in the level
of domestic production. The taxation, via
tariffs, of the consumption of foreign-produced
goods will ultimately encourage a substitution
into nonmarket activities, such as leisure and
household production, and away from market
activities of labor force participation, employ­

70




ment, and measured production. Thus, the
basic conclusion of this article is that it may be
well to avoid protectionist policies if the goals
of macroeconomic policy are to sustain high
levels of employment, output, and exports.
Macroeconomic effects of tariffs

Using the model described in the box on
pages 12 and 13, we can examine some of the
effects of temporary and permanent tariffs.
Figure 1 shows how tariffs affect the levels of
domestic consumption of domestic goods (C in
q
the figure) and imported goods (cq) ; of domes­
tic output (y0); and of the balance of trade
(</>0). The level of domestic demand
{yo = + co) depends negatively on the world
rate of interest (r) because a higher rate of in­
terest implies a higher cost (in terms of future
goods forgone) of current consumption. For
instance, higher credit rates induce some con­
sumers to postpone buying both domestic and
import goods. On the other hand, the aggre­
gate supply of domestic goods (jo) depends
positively on the world rate of interest because
a higher rate of interest implies (in terms of fu­
ture goods) a higher return to current pro­
duction. For example, by producing when
interest rates are high, a company could invest
the net revenues from production in financial
assets and get a higher payoff in the future.
The current trade deficit equals the difference,
at any interest rate, between the aggregate de­
mand curve (jq) and the aggregate supply curve
(?o) as by definition it equals the amount we
consume above what we produce. For an in­
terest rate below r, a trade deficit arises because
the low rate of return has raised the quantity
of goods demanded while lowering the quantity
of goods supplied. However, for an interest
rate above r a trade surplus arises since the
higher interest rate has the opposite effect on
production and demand. Thus, the trade deficit
depends inversely on the rate of interest; it is
graphed as the </>0 curve.
David Alan Aschauer is a senior economist at the Federal
Reserve Bank of Chicago.

Economic Perspectives

Figure 1
D o m e stic c o n s u m p tio n , o u tp u t, and th e b a la n ce o f tra d e
Domestic consumption and output

NOTE: yd = domestic consumption (home and foreign goods); ys
a trade deficit, < < 0 a trade surplus); r = world interest rate.
p

r

Balance of trade

domestic production: c = trade balance (0 > 0 denotes
j>

Figure 2
A te m p o ra ry t a r iff
Domestic consumption and output

A temporary tariff

Consider, now, the effect of a temporary
tax on the importation of goods so that /a0 > 0
while /ij = 0.
This tariff raises the
contemporaneous price of foreign goods and
induces a substitution into current homeFederal Reserve Bank of Chicago




Balance of trade

produced goods and, over time, into future
home- and foreign-produced goods. Thus, on
net, the tariff will reduce the consumption of
current foreign goods by more than it raises the
consumption of domestic goods and the total
demand for goods falls. In Figure 2, the yd
curve shifts from y d to y d' reflecting this incom77

A macroeconomic model of an open economy

In this box a model is constructed for
the purpose of analyzing the macroeco­
nomic effects of tariffs. The model econ­
omy is composed of a representative agent
with an infinite planning horizon who
chooses levels of consumpdon of domestic
and foreign goods as well as the level of
work effort over all periods. These choices
are made to maximize the utility funcdon
♦

1

*

« = “ too. co> «o) + y

M(f b

I « l)

where q = consumpdon of domesdc goods
in period i, q = consumption of foreign
goods in period i, rq work effort in period
i, andp = a subjective rate of time prefer­
ence such that 0 < p < 1 . The momen­
tary utility function u{q, q, nt) is assumed
to depend positively on the consumption
of home and foreign goods and negatively
on work effort. Further, the function is
characterized by the feature that succes­
sive unit increases in consumption (work
effort) raise (lower) utility by lesser
(greater) amounts. Implicitly it is assumed
that all “future” periods 1,2... are identical
so that it is appropriate to consider period
0 as the present and period 1 as the fu­
ture.*
The agent’s opportunities are sum­
marized by the intertemporal budget con­
straint
C\
Hl )q
co + (1 + P-o)co -------------fini) T t\
= A no) + to H
-------------(2)
*

+

(1

which states that the present value of ex­
penditures on home and foreign goods
must equal the present value of income
from production and transfers from the
domestic government to domestic resi­
dents. Here, fi, is the tax rate imposed on
foreign goods in period i, q are transfers in
period i, and/(/z,) is production in period
i, accomplished with the use of labor in-

72




(1)

put. The production technology is as­
sumed to be characterized by a positive
but nonincreasing return to labor. The
form of equation (2) implies that if the
individual’s planned consumption and
production levels do not match for a par­
ticular period, he may visit the domestic
or international capital markets to borrow
or lend at the world rate of interest r,
subject only to the constraint that such
borrowing and lending cancel over time.
In this section, the world rate of interest
is assumed to be unaffected by actions
taken by the domestic economic agents.
The maximization of the objective
function subject to the budget constraint
leads to the first order necessary conditions
«,(•>) = - f ’(.i)Uc(.i) 1 = 1,2

(3.1, 3.2)

“(*(•0 = (1 + H,WCU) 1 = 1,2

(4.1, 4.2)

«((.0)=yf/e(.l)

(5)

along with the budget constraint (2).
Equation (3) states that the marginal dis­
utility of work effort in any period, Un ,
must be equal to the marginal return to
work effort, f ', times the marginal utility
of the consumption of that return, Uc.
Equation (4) dictates that the marginal
utility of the consumption of foreign
produced goods, CJ*, must be equal to the
foregone utility from consumption of do­
mestic goods, (1 4- (i)Uc. Finally, equation
(5) ensures that the individual chooses
consumption over time in an optimal
fashion; by forgoing a unit of current con­
sumption the utility loss would be £/c(.0) ,
which must be matched by the utility gain
of r extra units of consumption in all future
periods, (r/p)£/f(.l) .
The government derives revenue
from the taxation of foreign goods, which
could be used to purchase goods and ser­
vices. However, to isolate the pure effects

Economic Perspectives

of tariff policy, it is assumed here that the
government transfers the tariff revenues in
a lump sum way to the private sector.
Accordingly, its intertemporal budget
constraint is given by
♦
* iUi£i
t]
/*o co "*
----7— — k) + ~
(6)

equation (8) to eliminate 0 T in these re­
vised equations. This yields

which equates the present value of tariff
revenue to the present value of transfers.
The form of this constraint allows the
government to borrow or lend in the
international capital market on the same
terms as the private agent.**
The model is closed by defining the
trade deficit to be equal to the difference
between total consumption and total pro­
duction, or

Un(f(n j) - c* - r 0 O, c{, rq) =

(t>i = Ci + c* -/(rii). (7.1, 7.2)
For instance, if the consumption of home
produced and foreign produced goods
were to equal domestic production, ex­
ports ( / fa) —q) and imports (q) would
be balanced and the trade deficit ((f),)
would be zero. Alternatively, one may
view (f)j as the surplus in the capital ac­
count because, if the current account is in
deficit, individuals must be borrowing
(exporting bonds) in an equivalent amount
for overall balance in international pay­
ments, f Lastly, equations (2), (6), and (7)
imply that the trade account must balance
intertemporally, or
0,
00 d--- — = 0
(8)
Equilibrium

The model’s general equilibrium is
described by equations (3), (4), (5), (7),
and (8) in the endogenous variables
fa, <o, «o, c\, £*, «i,-0o, (f>\) These can be
reduced to five equations by first using
equation (7) to substitute for C and cx in
q
equations (3), (4), and (5) and then using

Federal Reserve Bank of Chicago




Unifino) - CO + 00, <0> *o) =
- / '( « b ) W W ~ co + 0o, co, «o)

-/'(ni)^c(/(«l) - c* - r 0 o, c*, n,)
Uc*{f{n o)

(9)

(10)

- cq + 0 O, q), «o) =

(1 + Ho)Uc( / ( tiq) — c0 + 0o, c0 >”o)

(11)

Uc*{f{ni) - c* - r 0 o, c*, «j) =
(1 + M i ) U

CW

M

-

c*

Ue( f W ~ c0

- r 0 o,c*,n1)

(12)

+ 00, co, no) =

y Uc(f(n {) - C* - r0o, c*, «i) (13)
which are five equations in current and
future imports, current and future em­
ployment, and the current trade deficit.
Comparative statics techniques may be
used to determine the impact of changes
in tariff policy on these endogenous vari­
ables.
*See Aschauer (1985) “Fiscal Policy and the Trade
Deficit.”
**As it turns out, whether or not the government ac­
tually runs a surplus or deficit is irrelevant to the
analysis. This is because lump sum transfers do not
appear in the set of equations (9) through (13) which
describe the economy’s general equilibrium. Hence
the timing of the transfer of tariff revenue back to the
private sector is irrelevant.
fAs there is no initial debt in this model, in the first
period the trade and current accounts are equivalent.

13

Figure 3
A perm anent t a r iff
Domestic consumption and output

plete current substitution of home for foreign
consumption goods.
On the supply side of the economy, an
effect of the tariff is to raise the price of im­
ported consumption goods relative to leisure;
this promotes a shift away from the market ac­
tivity of production, because the return to cur­
rent production as measured by the ability to
purchase foreign goods has been diminished.
For example, rather than working as much and
spending his earnings at an expensive restau­
rant serving Japanese beef, a lawyer may in­
stead buy cheaper domestic beef and use the
time to cook at home. In Figure 2, this effect
is illustrated by a shift in aggregate supply from
y to y '.
The net effect of the temporary tariff is to
reduce the total demand for goods by a larger
amount than the fall in the level of domestic
production. This is because individuals recog­
nize that the tariff is a temporary tax on total
consumption and increase savings in order to
shift consumption to the future where con­
sumption goods are now relatively less expen­
sive. This, in turn, creates a capital account
deficit and a current account surplus equal to
0O = jo ~Jo • S°> th* temporary tariff has the ef­
fect of improving the trade account.
The improvement in the trade account,
however, comes about by a reduction in do­
mestic production. Along with the result that
74



r

Balance of trade

the consumption of domestic goods has risen,
we see that exports
*0 = Jo -

c0

must fall in response to the temporary deficit.
The current account improves because the re­
duction in import demand dominates the re­
duction in exports.
In summary, a temporary tariff acts as a
tax on foreign goods, domestic production, and
exports, and as a subsidy to domestic goods
consumption and leisure. In the formulation
of public policy, it is important that these gen­
eral equilibrium effects on production, exports,
and so on, be kept in mind so as to avoid sig­
nificant policy blunders. In particular, the ar­
gument that a tariff will have the effect of raising
domestic employment and output is found to be errone­
ous in this particular model.
A permanent tariff

Now let us investigate the impact of a
permanent tariff on foreign goods. As before,
the rise in the price of foreign goods relative to
home goods causes a demand shift away from
foreign products and toward domestically
produced consumption goods. On net, the
level of total demand for consumption goods
falls and, in Figure 3, they d curve shifts toy a' .
Also, the return to production as measured in
Economic Perspectives

Figure 4

Figure 5

W orld eq u ilib riu m in te res t rates
and tra d e flo w s

U.S. te m p o ra ry t a r if f
(no re ta lia tio n )

units of foreign goods has fallen; this induces a
decrease in domestic production, which shifts
y to y .
The major qualitadve difference between
a temporary and permanent tariff is reflected
in the fact that the former brings about a
change in the price structure of foreign goods
over time. A permanent tariff raises the rela­
tive price of foreign goods in all periods so that
there is no reason for agents to reallocate re­
sources over time in the pursuit of relatively
cheaper goods. Thus, the shifts to total con­
sumption demand and supply are equal to one
another and the permanent tariff has no effect
on the trade account.
Although net exports are left unaffected,
this is accomplished through a mutual, equal
reduction in imports and exports. In this sense,
a permanent tariff, as a tax on imported goods,
is identical in its effect on the trade balance as
would be a tax on exports. This points out,
dramatically, the likely fruitlessness of a policy
of tariffs: The net result of a policy of imposing and
sustaining higher tariffs is to reduce employment and
output while leaving the trade balance virtually un­
changed.
Finally, note that the logic of the model
implies that the anticipation of an increase in
tariffs in the future will bring about an increase
in the current trade deficit as agents attempt
to avoid the tax on future foreign goods by
importing and consuming in the present. The

expectation by economic agents that the gov­
ernment will respond to a trade deficit of a
certain magnitude by future tariff legislation
may very well help to increase the severity of
the external trade imbalance. Of current rele­
vance, it may partially explain why the trade
account appears to be taking such a long pe­
riod of time to respond to the large depreci­
ation of the dollar since early 1985.

Federal Reserve Bank of Chicago




World equilibrium, interest rates,
and retaliation

In order for the analysis to be relevant to
the current situation in the international econ­
omy, two assumptions of the model must now
be relaxed. First, as the United States is a
major player in international capital markets,
it is unreasonable to maintain that world in­
terest rates generally will be unaffected by U.S.
tariff policies. Second, the analysis so far as­
sumes that foreign economies respond passively
to any changes in their net exports as a result
of U.S. tariffs.
We may conceive of the rest of the world
as being aggregated into a second “country”
with much the same characteristics as those of
the home economy. Let us denote variables
determined in the foreign economy by a caret
(for example, foreign consumption of homeproduced goods—our exports—is given by c * ).
15

Figure 6
T em porary t a r iff w ith fo reig n re ta lia tio n

Now, the world interest rate changes in such a
way as to clear the world market for goods, or
0o = 9o + = 0
(14)
in the world economy, which means that a do­
mestic current account deficit must be matched
by a foreign current account surplus.
Next, consider Figure 4, wherein the
world level of interest rates and the pattern of
trade is determined graphically. Here, the
curve (30 isA as derived in Figure 1. However,
the curve $0 is plotted differently. MeasureA
ment of the quantity (J0 is such that to the left
of the vertical line the foreign current account
is in deficit while to the right it is in surplus.
The intersection of the two lines is the graph­
ical counterpart of equation (14), that is, world
equilibrium.
We restrict our attention to the impact of
a temporary tariff. The result depicted in Fig­
ure 2 when translated to Figure 5 implies that
the world level of interest rates declines in the
face of a transitory tariff imposed by the U.S.
The fall in world interest rates reestablishes
equilibrium in the world economy by raising
demand—and by reducing supply—in both the
domestic and foreign economies. In this fash­
ion, the negative effect of tariffs on U.S. employment
is transmitted to the foreign economy, with the result
that the world level of employment falls. Still, the
76



pattern of trade has shifted in favor of the U.S.,
in the sense that in the world equilibrium the
U.S. current account has shifted into a surplus
position.
However, the implied fall in foreign em­
ployment would very likely be cause for retaliadon on the part of the government of the
foreign economy. This would have the effect,
shown in Figure 6, of restoring the world pat­
tern of trade to its pre-tariff position (assuming
the exact extent of retaliation required) but of
reducing the level of world interest rates even
more significantly. This is because the foreign
tariff also works to reduce foreign consumption
by more than it reduces foreign production, just
as in the domestic case. Thus, at the initial
level of interest rates, the foreign tariff creates
a surplus of goods world-wide. To eliminate
this surplus, world interest rates must fall by
more than before, which further reduces both
home and foreign production and employment
levels. As an example, U.S. tariffs on Japanese
autos and Japanese tariffs on U.S. autos have
the effect of creating a general surplus of autos.
As the prices of both U.S. and Japanese cars
rise, a reduction in interest rates would be
needed to stimulate purchases. As world in­
terest rates fall, car purchases will expand and
production will fall (because future production
becomes more profitable relative to present
production) until equilibrium is reestablished,
with the same direction of trade flows. Thus,
accounting for the possibility of foreign retaliatory
legislation allows for further skepticism of the pre­
sumed favorable impact of U.S. tariffs on the position
of the U.S. trade balance.
Conclusion

The analysis of the effects of tariffs within
a simple intertemporal optimizing model leads
to the following conclusions. Abstracting from
foreign retaliatory protection, a U.S. tariff
which is perceived by private agents as a tem­
porary measure will, by distorting the
intertemporal pricing structure, bring about an
improvement in the trade account. However,
such improvement is at the expense of a re­
duction in employment, output, and gross ex­
ports; the trade deficit falls because agents
purchase debt to shift consumption of foreign
goods to future periods when they will be rela­
tively less expensive. In a more detailed model,
this attempt to save would also drive down the
Economic Perspectives

Temporary and permanent tariffs, a technical example

The impacts of temporary and per­
manent tariffs are here reported for the
particular case of logarithmic utility
\ n { c 0 C Q {n

u =

-

Uq ) )

while a permanent tariff leaves the trade
account unaffected

+

■ jf M q q fa - nj)

The results listed in the table are for the
case of zero tariffs in the original equilib­
rium.
For the case where
0 < p0 < 1, 0 < /ij < 1, some qualifications
to the analysis above arise. For example,
a permanent tariff now has the following
effect on the trade account:
9 *
^>o \_
d[L A 1 + p ■ (Mi ~ Mo)

(T)

and linear technology y, = an,. The
maximization yields the following set of
five equations in (0O % «l5 C , c*) :
,
q
2ano - cq + 0O= an
(9')
2awj — Ci -f r(j>Q= an
(10')

(2 +

+ a/iQ —<> = 0
/0

(2 + p{)ci —a«i + r(f)o —0

A

(IT)
(12')

H q ) cq

00 - ■

A

where A < 0 . Suppose, for instance, that
the original equilibrium entailed a higher
tariff in the future than in the present.
Then, raising the tariff by equal amounts
in the present and future would reduce the
distortion in the intertemporal relative
price of foreign goods. Consequently,
there would be a relative shift away from
current consumption into future consump­
tion which would require a capital ac­
count deficit (the purchase of debt
instruments) and would induce a current
account surplus, i.e.,

•; [«(-7-»i - «o) -

(-rc‘ =0
<13')
Totally differentiating this system of
equations and using standard comparative
statics techniques leads to the results in the
table below. For instance, a temporary
tariff has the effect of lowering the trade
deficit in the amount
^00
1 6a V
Q
dp
A 1+ p
temporary tariff
dp0 > 0
00
1
A

6 a 2Co

1+ p

Co

1
A

6 a 2Co

1 +p

T*

4 a 2Co
1

+ p

-1
A

c0
2a2pc'0
1 + p

1

A

Yo
2oc2pc'0
1 + p

1

A

*0
Aoc2pc0
1

+ p

permanent tariff
dp0 = dp 1 > 0

0

1

A

4 a 2Co

1
A

2 a 2Co

1
A

2 a 2Co

1
A

4 a 2Co

A = a2iP ~ 1)/(1 + p) < o

Federal Reserve Bank ol Chicago




77

spread between domestic and foreign in­
terest rates, induce a move toward a capi­
tal account deficit and, as the balance of
payments must balance, a fall in the dollar
to accomplish the reduced trade account
deficit. A temporary tariff would help
bring down the dollar, but also would re­
duce the gross volume of exports and do­
mestic production.
On the other hand, a tariff which is
viewed by the private sector as more or
less permanent will have little or no im­
pact on the current account position in the
balance of payments, while lowering do­
mestic production and exports. The ab­
sence of any significant impact on the
trade account arises because foreign goods
have now been made equally costly across
time through the permanent rise in their
after-tax price and, as a result, agents do
not attempt to shift resources, by saving,
to the future. In a more elaborate model,
there would be no downward pressure on
domestic interest rates, no effect on the
dollar, and no impact on the status of the
current account.
Allowing for the likelihood of higher
foreign tariffs in response to raised U.S.

78



tariffs further offsets the ability of pro­
tection to have a positive net effect on the
trade position of the U.S. Indeed, given
complete retaliation, the result of a “tariff
war” would be to lower world interest
rates, employment, and output levels while
maintaining the level of net capital flows.
Consequently, from the perspective
of positive analysis, the model indicates
that if tariff policy is to be successful in
reducing the trade deficit it is essential
that tariff legislation be such as to leave
the perception that the imposed taxes on
foreign goods will be of only short duration
and not induce retaliation by foreign gov­
ernments.
From the viewpoint of normative
analysis, tariffs—temporary or permanent
in nature—should be avoided since what
effects they do have on macroeconomic
variables come about by a distortion of
resources both contemporaneously and
across time. Unless particular examples
of market failure to which tariff policy is
an appropriate response can be cited, such
distortions of market activities typically
will culminate in a reduction in aggregate
social welfare.

Economic Perspectives

The federal safety net: Not for banks only
George G. Kaufman
In 1985, the financial insolvencies of some
larger thrift institutions in Ohio and Maryland
led to widespread runs on these institutions. A
consequence was the insolvency and disap­
pearance of the state-sponsored deposit insur­
ance agencies that insured them. In 1987, after
many years of increases in the number and size
of savings and loan association failures, Con­
gress was forced to recapitalize the Federal
Savings and Loan Insurance Corporation
(FSLIC) in order to keep it in operation. Al­
though solvent, the Federal Deposit Insurance
Corporation (FDIC) has been weakened by the
large number of commercial and savings bank
failures. In addition, serious attention is being
devoted to a possible merger of the FDIC and
FSLIC, if the capital infusion to the latter
proves insufficient.
This article does not consider why the
deposit insurance funds are in trouble nor the
potential solutions. This has been examined in
a large number of other studies. Instead, it
documents the history and scope of federal
guarantees. It argues that the problems faced
by deposit insurers are not unique and that the
real policy debate is not “Should bank deposits
be insured?” but “Should the federal govern­
ment engage in insurance activities of any
kind?”
In the United States, bank deposits ap­
pear to have been the first financial claims to
be insured either directly or indirectly by gov­
ernmental agencies. The first bank deposit in­
surance in the United States was adopted by
New York State in 1829. This plan fully
guaranteed bank deposits and circulating notes.
All New York state-chartered banks (federal
charters were not available until 1863) were
required by statute to join the system upon re­
newal of their charters and to make contri­
butions scaled to their capital into a safety
fund. Depositors and noteholders of failed
banks were reimbursed by the fund for the dif­
ference between the par value of their claim
and the pro rata recovery value from liqui­
dation of the banks’ assets. Deposit insurance
was subsequently adopted by other states and,
in 1933, by the federal government.1
Federal Reserve Bank of Chicago




Today, a wide variety of private financial
assets and claims carry some form of govern­
ment insurance or guaranty. More or less
modeled after federal bank deposit insurance is
insurance of deposits at thrift institutions
(1934), share capital at credit unions (1970),
customer credit balances and the market value
of security holdings at security brokers and
dealers (1970), and employee claims on defined
benefit pension programs (1974). In addition,
federal guaranteed lending programs are oper­
ated by numerous federal government depart­
ments, bureaus, and agencies, independent
agencies, off-budget agencies, and so forth.
More than 125 such programs are listed in a
Catalog of Federal Loan Guarantee Programs pub­
lished by the House Committee on Banking,
Finance and Urban Affairs in 1982 and in a
catalog of Federal Credit Programs and Their In­
terest Rate Provisions published by the General
Accounting Office, also in 1982 (see Table 1).
But even these lists omit programs, such as the
Federal National Mortgage Corporation,
which have limited de jure power and almost
unlimited de facto power to borrow from the
U.S. Treasury. In addition, Congress is cur­
rently considering the establishment of a Fed­
eral Agricultural Credit Corporation (to be
nicknamed “Farmer Mac”) to guarantee the
creditworthiness of farm loans sold by com­
mercial banks and other lenders on the sec­
ondary market. It would have a SI.5 billion
line of credit with the U.S. Treasury. Thus,
federal government guarantees of deposits at
depository institutions are exclusive neither in
scope nor in dollar coverage.
The historical justification for each pro­
gram differs and reflects the pressing economic
and political concerns of the day, particularly
the existence of an actual or perceived national
or regional crisis. The rationale generally was
put in terms both of protecting the individual
lender or borrower and of protecting or pro­
moting the corresponding industry or sector.
The degree of coverage, the size of the
George G. Kaufman, the John F. Smith, Jr., Professor of
Economics and Finance at Loyola University of Chicago, is
a consultant to The Federal Reserve Bank of Chicago.
19

government’s liability in case of default, the
fees or premiums charged, and the forms of
administration also differ greatly from program
to program.
The pace of new federal government in­
surance and guarantee programs is accelerat­
ing. About one-half of the programs listed in
the 1982 Congressional catalogue had been es­
tablished since 1967.
Background

The first bank insurance program was
adopted by New York State in 1829.2 The
chief sponsor of the plan was Joshua Forman,
a Syracuse businessman. He attributed his idea
to a scheme among the Hong merchants in
Canton, China, who had exclusive rights to
trade with foreigners, in which all participants
were liable for each other’s debts. Forman
reasoned that by virtue of receiving a charter,
banks received a similar exclusive arrangement
allowing them to issue notes that served as a
circulating medium. As a result, they should
be similarly obligated to redeem each other’s
notes. By 1837, more than 90 percent of all
New York State commercial banks were mem­
bers of the note insurance plan. The New York
plan was followed shortly by six other states
before the Civil War. The success of these
plans varied considerably.
The motivations for these plans also dif­
fered, but focused primarily on the need to
preserve the circulating medium in a commu­
nity and to protect small noteholders. After
reviewing the legislative debates leading up to
the adoption of the state plans, Carter H.
Golembe, an authority on bank history, con­
cluded that the
primary object has not been to guard the individual
depositor or noteholder against loss but, instead, to
restore to the community, as quickly as possible, cir­
culating medium destroyed or made unavailable as a
consequence of bank failures. In this view, bankobligation insurance has a monetary function, and the
protection of the small creditor against loss is inci­
dental to the achievement of the primary objective.

Golembe buttressed this conclusion by
quoting from Supreme Court Justice Oliver
W. Holmes in a 1911 decision upholding the
constitutionality of later state deposit insurance
plans:
Few would doubt that both usage and preponderant
opinion give their sanction to enforcing the primary
20



conditions of successful commerce. One of these con­
ditions at the present time is the possibility of payment
by checks drawn against bank deposits, to such an
extent do checks replace currency in daily business ...
the primary object of the required assessment is not a
private benefit ... but ... is to make safe the almost
compulsory resort of depositors to banks as the only
available means of keeping money on hand.

The same rationale appears to underlie
the implementation of the proviso of the Na­
tional Bank Act of 1863 that collateralized na­
tional bank notes with U.S. Treasury securities.
The government decided that the notes would
be guaranteed by the Treasury at full face
value at all times regardless of the market value
of the collateral Treasury securities at the issu­
ing bank. In his first report to Congress, the
Comptroller of the Currency stated:
If the banks fail, and the bonds of the government are
depressed in the market, the notes of the national
banks must still be redeemed in full at the Treasury
of the United States. The holder has not only the
public securities b^yt the faith of the nation pledged for
their redemption.

Soon after the National Bank Act was
enacted, national bank notes in circulation
were about equal in dollar magnitude to total
bank deposits.6 State bank notes were taxed
out of existence by an amendment to the Act
in 1865. Although it is not possible to distin­
guish statistically between demand and time
deposits at that time, the Treasury’s policy in­
sured, at a minimum, 50 percent of the nation’s
circulating media. But the rapid growth of
bank deposits soon reduced the relative impor­
tance of national bank notes as a medium of
exchange and thereby also reduced the signif­
icance of the guarantee for protecting the
money supply. By the 1880s, national bank
notes were only 25 percent as important as
total bank deposits and insurance covered only
20 percent of notes and bank deposits.
State insurance funds for bank liabilities,
all of which had disappeared with the outbreak
of the Civil War, started to reappear again fol­
lowing the bank crisis of 1907. Even before
this, a growing number of bills calling for fed­
eral deposit insurance were introduced in Con­
gress. By 1933, the total number of such bills
had reached 150.7 Federal deposit insurance
finally was enacted in 1933 as part of the com­
prehensive Banking (Glass-Steagall) Act effec­
tive January 1, 1934. The initial de jure
account limit was $2,500. At that time, the
total maximum dollar amount of insured deEconomic Perspectives

T a b le 1
F e d e ra l Lo a n G u a r a n te e P r o g r a m s

A gency and program

Year
adopted

Department of Agriculture:
Alcohol fuels and biomass loans (guaranteed/insured) ...................................... 1979-80
Business and industrial loans (guaranteed/insured) ........................................... 1971-72
Community antenna television loans (guaranteed) .............................................. 1971-72
Com munity antenna television loans (insured) ..................................................... 1971-72
Community facilities loans (insured) ........................................................................ 1971-72
Domestic farm labor housing loan program (insured) ......................................... 1965-66
Emergency disaster loans (insured) .......................................................................... 1971-72
Farm operating loans (guaranteed) .......................................................................... 1961-62
Farm operating loans (insured) ................................................................................. 1961-62
Farm ownership loans (guaranteed) ........................................................................ 1971-72
Farm ownership loans (insured) ............................................................................... 1971-72
Grazing association loans (insured) ........................................................................ 1971-72
Indian tribe acquisition loans (insured) ................................................................... 1967-68
Irrigation, drainage and other soil and water conservation
(insured) ........................................................................................................................ 1971-72
Low to moderate income housing loans (insured) .............................................. 1949-50
Recreation facilities loans (insured) ........................................................................ 1971-72
Resource conservation and development loans (insured) ..................................1961-62
Rural electrification loans (guaranteed) ................................................................. 1935-36
Rural electrification loans (insured) ........................................................................ 1935-36
Rural housing site loans (insured) .......................................................................... 1965-66
Rural telephone loans (guaranteed) ........................................................................ 1935-36
Rural telephone loans (insured) ............................................................................... 1935-36
Soil and water loans to individuals (guaranteed) .............................................. 1971-72
Soil and water loans to individuals (insured) ....................................................... 1971-72
Water and Waste Disposal Systems for Rural Communities
(insured) .......................... ,............................................................................................ 1971-72
Watershed protection and food prevention loans (insured) ............................... 1953-54
Department of Commerce:
Business development loan guarantees (guaranteed) .........................................
Coastal energy impact program (guaranteed) .......................................................
Federal ship financing guarantees (guaranteed) ..................................................
Fishing vessel obligation guarantee program
(guaranteed/insured) ................................................................................................
Trade adjustment assistance for communities (guaranteed) .............................
Trade adjustment assistance for firms (guaranteed) ..............................................

1965-66
1971-72
1971-72
1971-72
1973-74
1961-62

Department of Defense:
Defense Production Act (guaranteed) ...................................................................... 1947-48
Foreign military credit sales (guaranteed) .............................................................. 1967-68
Department of Education:
Guaranteed student loan program (guaranteed) (including parent
loans for undergraduate students program) .......................................................... 1965-66
Department of Energy:
Alcohol fuel loan guarantees (guaranteed) ............................................................
Loan guarantees for alternative fuels development
(guaranteed) ................................................................................................................
Biomass loan guarantees (guaranteed) ...................................................................
Coal loan guarantee program (guaranteed) ............................................................
Electric and hybrid vehicle loan guarantees (guaranteed) ..................................
Geothermal loan guarantee program (guaranteed) ..............................................
M unicipal waste energy project loan guarantees (guaranteed) ........................
Loan guarantees for synthetic fuels development
(guaranteed) ................................................................................................................
Urban wastes demonstration facilities guarantee program
(guaranteed) .................................................................................................................

Federal Reserve Bank of Chicago




1979-80
1973-74
1979-80
1975-76
1975-76
1979-80
1979-80
1979-80
1973-74

21

T a b le 1 (c o n t in u e d )
F e d e r a l Lo a n G u a ra n te e P r o g r a m s

A gency and program

Year
adopted

Department of Health and Human Services:
Health education assistance loans (guaranteed) .................................................. 1975-76
Health maintenance organizations (guaranteed) .................................................. 1973-74
Medical facilities construction (guaranteed) ......................................................... 1969-70
Department of Housing and Urban Development:
Armed services housing for civilian employees, sec. 809
(insured) ........................................................................................................................ 1955-56
Armed services housing in impacted areas, sec. 810
(insured-inactive) ....................................................................................................... 1973-74
Community development block grant sec. 108 loan guarantee program
(guaranteed) ................................................................................................................ 1973-74
Construction or substantial rehabilitation of condominium projects,
sec. 221 (i) (insured-inactive) ................................................................................. 1967-68
Construction or substantial rehabilitation of condominium projects,
sec. 234(d ) (insured) ............................................................................................... 1963-64
Combination and mobile home lot loans, title I (insured) ................................. 1973-74
Cooperative financing mortgage insurance, sec. 203(n)
(insured) ....................................................................................................................... 1947-48
Development of sales-type cooperative projects, sec. 213
(insured) ....................................................................................................................... 1947-48
Experimental homes, sec. 233 (insured) ................................................................ 1961-62
Experimental projects other than housing, sec. 233 (insured) .......................... 1967-68
Experimental rental housing, sec. 233 (insured) .................................................. 1961-62
Graduated-payment mortgages, sec. 245 (insured) ............................................. 1973-74
Group practice facilities, title XI (insured) .............................................................. 1965-66
Historic preservation loans, title I (insured) ............................................................ 1933-34
Homes assistance considerations, sec. 203(b) (insured) .................................... 1933-34
Homes for certified veterans, sec. 203(b) (insured) ........................................... 1933-34
Homes for disaster victims, sec. 203(h) (insured) ................................................ 1933-33
Homes for low and moderate income families, mortgage, insurance,
sec. 2 2 1 (d )(2 ) (insured) ....................................................................................... 1933-34
Homes for lower income families, sec. 2 35(i) (insured) .................................... 1967-68
Homes in military impacted areas, sec. 238(c) (insured) .................................... 1973-74
Homes in outlying areas, sec. 203(i) (insured) ..................................................... 1933-34
Homes in urban renewal areas, sec. 220 (insured) ........................................
1953-54
Housing in older, declining areas, sec. 223(e) (insured) .................................... 1967-68
Investor sponsored cooperative housing, sec. 213 (insured) ............................. 1955-56
Land development, title X (insured) ........................................................................ 1965-66
Management-type cooperative projects, sec. 213 (insured) ............................. 1933-34
Mobile home loans, title I (insured) ........................................................................ 1933-34
Mobile home parks, sec. 207 (insured) ................................................................... 1955-56
Mortgage insurance for hospitals, sec. 242 (insured) ......................................... 1967-68
Mortgage insurance for servicemen, sec. 222 (insured) .................................... 1967-68
Multifamily rental housing supplemental loan insurance, sec. 241
(insured) ....................................................................................................................... 1967-68
New communities loan guarantees (guaranteed—inactive) ............................... 1967-68
Nursing homes and intermediate care facilities, sec. 232
(insured) ........................................................................................................................ 1959-60
Property improvement loan insurance for improving all existing
structures and building of new nonresidential structures,
title I, sec. 2 (insured) ................................................................................................ 1933-34
Purchase by homeowners of fee simple title from lessors, sec. 240
(insured) ....................................................................................................................... 1967-68
Purchase of sales-type cooperatives, sec. 213 (insured) .................................... 1949-50
Purchase of units in condominiums, sec. 2 34(c) (insured) .................................. 1961-62
Purchase or refinancing of existing multifamily housing projects,
sec. 223(f) (insured) ............................................................................................... 1973-74
Rehabilitated housing for low income families, sec. 221 (h)
(insured) ....................................................................................................................... 1965-66
Rehabilitation mortgage insurance, sec. 203(k) (insured) .................................. 1933-34

22




Economic Perspectives

T a b le 1 ( c o n t in u e d )
F e d e ra l L o a n G u a r a n te e P r o g r a m s
Year
adopted

A gency and program
Rental housing mortgage insurance, sec. 207 (insured) ....................................
Rental housing for the elderly, sec. 231 (insured) ................................................
Rental housing for moderate income families, sec 221 (d )(4 )
(insured) ........................................................................................................................
Rental housing in urban renewal areas, mortgage insurance,
sec. 220 (insured) .......................................................................................................
Rental and cooperative housing for low and moderate income families,
sec 221 ( d ) (3) (insured) ...........................................................................................
Single family home mortgage coinsurance, sec. 244 (insured) ........................
Special credit risks mortgage insurance, sec. 237 (insured) .............................
Department of the Interior:
Guarantee of certain obligations of the Guam Power Authority
(guaranteed) ................................................................................................................
Guarantee of Virgin Islands Bonds (guaranteed) ..................................................
Guarantee of Virgin Islands Loans (guaranteed) ..................................................
Indian loans—economic development (guaranteed) ...........................................
Department of Transportation:
Emergency Rail Services Act of 1970 guarantee of trustee certificates
(guaranteed) ................................................................................................................
Loan guarantees for purchase of aircraft and space parts
(guaranteed) ................................................................................................................
Loan guarantees issued under the Rail Passenger Service Act of 1970
(guaranteed) ................................................................................................................
National Capital Transportation Act revenue bond guarantee program
(guaranteed) ................................................................................................................
Railroad rehabilitation and improvement (guaranteed) ......................................

1937-38
1957-58
1957-58
1953-54
1953-54
1973-74
1967-68

1975-76
1975-76
1975-76
1973-74

1969-70
1957-58
1969-70
1969-70
1975-76

Department of the Treasury:
Chrysler Corporation loan guarantees (guaranteed) ........................................... 1979-80
New York City loan guarantees (guaranteed) ....................................................... 1977-78
A gency for International Development:
Agricultural and productive credit and self-help community development
program (guaranteed) ................................................................................................ 1969-70
Housing guaranty program (guaranteed) .............................................................. 1969-70
Environmental Protection Agency:
Loan guarantees for construction of treatment works
(guarantee) ................................................................................................................... 1975-76
Export-Import Bank:
Cooperative financing facility (C F F )—participating financial
institution guarantees and guarantees on certificates of loan
participation (guaranteed) ......................................................................................
Financial guarantees (guaranteed) ..........................................................................
Medium-term commercial bank guarantees (guaranteed) ..................................
Medium-term export credit insurance (insured) ..................................................
Short-term export credit insurance (insured) .........................................................
General Services Administration:
Federal building loan guarantees (guaranteed)
Overseas Private Investment Corporation:
Foreign investment guarantees (guaranteed)

..................................................... 1953-54
....................................................... 1969-70

Small Business Administration:
Bond guarantees for surety companies (guaranteed) .........................................
Disaster assistance to nonagricultural business (guaranteed) ..........................
Economic injury disaster loans (guaranteed) ..........................................................
Economic opportunity loans for small businesses (guaranteed) ......................
Handicapped assistance loans (guaranteed) ..........................................................

Federal Reserve Bank of Chicago




1945-46
1945-46
1945-46
1945-46
1945-46

1957-58
1969-70
1957-58
1957-58
1957-58

23

T a b le 1 (c o n t in u e d )
F e d e ra l Lo a n G u a ra n te e P r o g r a m s
Year
adopted

A gency and program
Physical disaster loans (guaranteed) ........................................................................
Small business loans (guaranteed) ..........................................................................
Small business energy loans (guaranteed) ............................................................
Small business investment companies (guaranteed) ...........................................
Small business pollution control financing guarantees
(guaranteed) .................................................................................................................
State and local development company loans (guaranteed) ...............................

1957-58
1957-58
1977-78
1957-58
1975-76
1957-58

U.S. Railway Association:
Loans for railroads in reorganization (guaranteed) .............................................. 1973-74
Loans to state, local, or regional transportation authorities
(guaranteed) ................................................................................................................. 1973-74
Veteran's Administration:
Veterans housing loans (guaranteed andinsured) .................................................. 1943-44
Veterans mobile home loans (guaranteed) ............................................................ 1969-70
Source: Catalog of Federal Loan Guarantee Programs. Subcommittee on Economic Stabilization.
House Committee on Banking. Finance, and Urban Affairs. 97 Cong. 1 Sess. (GPO, 1981).

posits plus the dollar amount of national bank
notes represented about 50 percent of the sum
of currency and bank deposits, about the same
percentage as had initially been insured by the
National Bank Act 70 years earlier.
The debate on federal deposit insurance
in Congress was long and emotional. It was
strongly opposed by the Roosevelt adminis­
tration; many bankers, particularly from larger
banks; and most bank regulators. Golembe
concluded that the primary reasons for the ul­
timate adoption of the program were a desire
to end the destruction of the medium of ex­
change and to preserve, or at least not end ab­
ruptly, the existing structure of independent
unit banks. To achieve the latter purpose, the
proponents of deposit insurance had to engage
in a political tradeoff with larger banks, who
favored, among other things, wider branching.
Thus, ironically enough, the Act also expanded
the ability of national banks to branch on the
same basis as state banks in the home state.
The FDIC served as an impetus for other
federal insurance programs. In 1934, the
FSLIC was established by the National Hous­
ing Act with basically the same powers as the
FDIC. But it was placed within the Federal
Home Loan Bank Board rather than created
as a separate and independent agency. The
primary intent of deposit insurance at savings
and loan associations appears to have been less
to preserve the money supply and structure of
the industry or to protect small depositors as to
24




preserve the channeling of household funds into
the residential mortgage market. It was feared
that households would transfer their funds from
uninsured savings and loan associations to in­
sured commercial banks and that this would
reduce the flow of funds for household mort­
gages. Thus, protecting SLAs was a means, not
an end. A study prepared for the Federal
Home Loan Bank Board concluded that Con­
gress established FSLIC more to “stimulate
additional home mortgage credit through in­
creased capitalization of S&L’s than in pre­
venting the demise of these institutions.”8
The national concern with housing at this
time was also reflected in the large number of
federally guaranteed loan programs for housing
adopted at the same time. All of the 10 federal
loan guarantee programs enacted by the 73rd
Congress in 1934-35 were located in the prede­
cessors of the Department of Housing and Ur­
ban Affairs. These included housing loans to
veterans, disaster victims, and to low- and
moderate-income families as well as for coop­
erative projects and rehabilitation projects.
In 1970, federal deposit (share capital)
insurance was extended to credit unions
through the National Credit Union Share In­
surance Fund (NCUSIF) in the National
Credit Union Administration. In contrast to
the environment at the time of the establish­
ment of the FDIC and FSLIC, the NCUSIF
was established at a time of no unusual finan­
cial problems either for credit unions or the fiEconomic Perspectives

nancial system as a whole. Rather, its creation
appears motivated purely by a desire for com­
petitive equality with federally insured com­
mercial banks and thrift institutions. Contrary
to the battle lines at the enactment of the
FDIC, smaller institutions opposed creation of
NCUSIF, primarily out of fear of increased
federal regulation, while larger institutions fa­
vored it, primarily for competitive reasons rel­
ative to commercial banks and thrift
institutions. The majority of credit unions had
successfully blocked creation of federal deposit
insurance from 1956 until 1970.
In 1970, federal insurance was also ex­
tended to customer credit balances and security
holdings at security dealer and broker firms by
the Securities Investor Protection Act which
established the Securities Investor Protection
Corporation (SIPC). In contrast to the lengthy
debates and earlier failures surrounding the
adoption of federal insurance for depository in­
stitutions, SIPC was established only two years
after the first bill for such insurance was intro­
duced in Congress. The Act was adopted in
response to a sudden jump in the number of
failures of brokerage houses with significant
losses to customers. The Report accompanying
the bill from the Senate Committee on Banking
and Currency states that
The Securities Investors Protection Corporation
(SIPC), like the Federal corporations that ensure
savings and demand deposits, is intended to serve
several purposes: to protect individual investors from
financial hardship; insulate the economy from the
disruption which can follow the failure of major fi­
nancial institutions; and to achieve a general upgrad­
ing of financial responsibility requirements of brokers
and dealers to eliminate, to the maximum ^xtent pos­
sible, the risks which lead to customer loss.

It is evident that, as with the previous insur­
ance plans, the objectives of SIPC insurance
are multiple.
In 1974, employee claims on defined
benefit employer pension funds were federally
insured by the Pension Benefit Guaranty Cor­
poration (PBGC) established by the Employ­
ment Retirement Income Security Act
(ERISA). The Act defines the purposes of the
insurance to 1) encourage the maintenance of
private pension plans and 2) provide for the
timely and uninterrupted payment of pension
benefits. The program was enacted after a
number of failed firms had sold the pension
funds’ assets which they were administering.
Federal Reserve Bank of Chicago




As a result, the employee’s pensions were re­
duced or wiped out altogether.
An examination of the federal loan guar­
antee programs enacted by the 96th Congress
in 1979-80, the latest included in the Congres­
sional catalog cited earlier, suggests that the
emphasis was on encouraging or preserving
particular industrial sectors or firms, such as
alternative energy sources and Chrysler Cor­
poration, rather than on protecting the finan­
cial security of households or of the nation as a
whole.
Conclusions

The above analysis shows that the federal
insurance safety net is not unique to banking.
The net has been spread under a progressively
increasing number of activities. This has im­
portant implications for understanding both
the behavior of activity in the insured sectors
and the potential pressures on the federal gov­
ernment budget. By its very nature of reducing
the cost of loss to the insured, insurance of any
kind changes the behavior of the insured by
making them unintentionally a little less care­
ful. Thus, persons are less likely to double
check whether they have locked their car doors
or to install burglar alarm systems after they
acquire theft insurance than before or to install
fire alarms and sprinkler systems after they ac­
quire fire insurance than before. This change
in behavior attributable to insurance is termed
“moral hazard.”
Private insurance firms generally attempt
to protect themselves against moral hazard on
the part of their customers by scaling their
premiums to the risk assumed, by including
provisions for rate reductions if the insured
agrees to accept specified precautions, such as
installing burglar or fire alarms, and by ex­
cluding certain types of events, such as floods
and wars. If the premiums and their provisions
are structured correctly, the insured will have
less incentive to take additional risk and the
insurer will be compensated for any additional
risk that the insured does take. The premium
will represent the actuarially fair value of the
expected loss.
Like private insurance, government in­
surance and guarantee programs are apt to
lead to additional risk taking by the insured.
However, unlike private insurers, government
insurers rarely scale their premiums to the
25

The Pension Benefit Guaranty Corporation:
A Case in Point

The federal deposit insurance pro­
grams are not the only federal guarantee
programs currently experiencing severe fi­
nancial difficulties. Indeed, the number
of troubled programs is large and increas­
ing rapidly, and the dollar magnitude of
the losses is mounting even faster. Most if
not all of the programs appear to suffer
from the same underlying problem—a se­
rious design flaw that produces incentives
for the insured to take excessive risks and
passes most of the resulting frequent and
large losses through to the insurance or
guarantee agency. The two most seriously
troubled programs appear to be the Farm
Credit System and the Pension Benefit
Guaranty Corporation (PBGC).* This
box discusses the PBGC.
The PBGC, which was established
by the Employee Retirement Income Se­
curity Act of 1974 (ERISA), guarantees
up to a potential maximum of nearly
$2,000 per month per individual partic­
ipant in all defined benefit pension pro­
grams in the United States. The program
currently covers more than 30 million
participants in some 110,000 pension pro­
grams. For this service, the PBGC charges
the plan sponsor a fixed premium per
pension plan participant, regardless of how
well or poorly the particular plan is
funded. Thus, as with the FDIC and
FSLIC structure, there is an incentive for
sponsors to underfund their pension plans
in order to use the resources elsewhere.
Also, as with the federal deposit insurance
programs, better funded plans subsidize
more poorly funded plans. But although
PBGC’s premium structure resembles
those of the federal deposit insurance
agencies, its enforcement and claimant
powers are considerably weaker.
Unlike the FDIC and FSLIC, the
PBGC has effectively no selection, moni­
toring, supervisory, and regulatory powers
over the pension funds it insures. It can
neither disqualify plans nor influence the
funding behavior of the plans. Indeed, it

26



has little ability even to monitor the on­
going performance of the funds. Also un­
like the FDIC and FSLIC, its ability to
borrow from the U.S. Treasury is severely
restricted, amounting to only $100 million.
In case of plan termination, the Corpo­
ration has a first claim only up to 30 per­
cent of the sponsor’s net worth (which is
frequently negligible as the plan is termi­
nated because of the bankruptcy of the
sponsor) and a second less valuable claim
against the sponsors’s recoverable assets up
to 75 percent of the loss less any amount
previously recovered from positive net
worth. However, because the PBGC has
de facto paid less than the full potential of
the monthly benefits lost, it may encour­
age greater monitoring and discipline by
the pension plan participants than is ex­
erted by depositors at federally insured
commercial banks and particularly thrift
institutions.
The PBGC has operated with deficit
net worth (i.e., the present value of its li­
abilities exceed that of its assets) almost
from its inception. The deficit ballooned
in 1985 when both Allis-Chalmers and
Wheeling-Pittsburgh terminated their
large and underfunded pension plans and
jumped substantially further in 1986 when
LTV terminated its pension plan, which
was underfunded by some $2.5" billion.
This increased the present value of
PBGC’s liabilities to almost $4 billion. (In
September, PBGC announced that it was
returning responsibility for LTV’s pension
plan to the Company. LTV is contesting
the transfer. If PBGC is successful, the ef­
fect would be to reduce PBGC’s deficit by
half to near $2 billion.) It is of interest to
note that, at present, nearly 80 percent of
PBGC’s deficit is attributable to the iron
and steel industry. But, because it was
operating on a cash flow surplus until re­
cently, actions to correct the deterioration
were delayed in Congress until 1986 when
annual premiums were more than tripled
from $2.60 to $8.50 per participant. This

Economic Perspectives

was the first increase since 1978. How­
ever, even this substantial increase was
enacted before LTV’s plan termination
and has proved to be inadequate. As a
result, the PBGC has been forced to sell
investment assets to meet its scheduled
payments.
In April 1987, the Reagan adminis­
tration, at the urging of PBGC, proposed
legislation that would scale the premiums
to the insured plan’s risk of default as
measured by the degree of underfunding.
Under the proposal, employees with in­
sured plans that are funded below 125
percent of the plan’s vested liabilities
would pay an annual surcharge of $6 per
$1,000 of underfunding up to a maximum
of $100 per employee. The surcharge
would affect an estimated 8 percent of
employers. The surcharge would be ad­
justed every three years according to ac­
tual loss experience. In addition, all
premiums would be indexed to inflation.
If enacted by Congress, the surcharge
scheme may be expected to encourage
employers to reduce underfunding in order
to reduce their expenses.
As was the case for the federal de­
posit insurance programs, the flaw in the
insured’s risk exposure. Explicit premiums are
generally a fixed flat percentage of the insured’s
asset, activity, or loan-size base. The FDIC
and FSLIC, for example, both charge premi­
ums that are a flat percentage of the total do­
mestic deposits of the insured institutions.
When the insurance agencies attempt to
control risk, they generally do so by imposing
minimum standards or regulations that specify
the types of activities in which the insured may
engage. In addition, the bank agencies super­
vise and periodically examine their institutions
to ensure conformity with the regulations.
However, it is unlikely that such provisions will
be as effective in offsetting moral hazard as
risk-based premiums. As a result, one would
expect to see greater risk taking by those in­
sured by federal programs than by those in­
sured by private programs and thereby greater
losses to federal insurance agencies. The very
large losses experienced by FSLIC, estimated
to be in excess of $40 billion, that would have
Federal Reserve Bank of Chicago




design of the PBGC’s structure and the
resulting potential dangers were identified
and analyzed a number of years before the
seriousness of the problem became evident
to the public. In her article “Guarantee­
ing Private Pension Benefits: A Potentially
Expensive Business,” published in the New
England Economic Review of the Federal
Reserve Bank of Boston in 1982, Alicia
Munnell concluded that “since the agency
has little control over the industry that
provides the benefits it guarantees .... the
PBGC will always remain financially vul­
nerable and the federal government may
well end up as the insurer of the nation’s
private pension system.” In addition, un­
like the FDIC and FSLIC, the PBGC itself
went public with its concerns early and
proposed, among other things, that its in­
surance premiums be scaled to the degree
of underfunding of each pension plan.
Nevertheless, as with the FDIC and
FSLIC, these warnings were not heeded
sufficiently by policy-makers to prevent or
at least mitigate the magnitude of the later
crisis.*
*The market value deficit in the Farm Credit System
has been estimated to be as high as S9 billion.

driven it into insolvency if market value ac­
counting were applied, and the moderate de­
cline in FDIC reserves, if the same standards
were applied, support this hypothesis.
Additional support is provided by the
economic insolvencies of the Farm Credit Sys­
tem and the Pension Benefit Guaranty Corpo­
ration, both of which also effectively charge flat
insurance premiums. Because the insured and
other creditors of the insurance program per­
ceive the federal government as supporting all
demands on the insurance agencies, these
agencies can continue to function even though
they may be insolvent. The losses will eventu­
ally be borne in large part or in total by the
taxpayers.
The broadening of the insurance safety
net beyond banking to other financial activities
may thus be expected to increase both risk
taking in our society and the liabilities of the
federal government. Whether and to what ex­
tent this is desirable, is a choice for the
27

electorate to make. They are likely to do so
more intelligently if the benefits and costs of
these programs were carefully and explicitly
quantified.
The United States was the second country’ to
adopt federal government bank deposit insurance
after Czechoslovakia in 1924.
Thorough histories of deposit insurance in the
United States appear in Carter H. Golembe, “The
Deposit Insurance Legislation of 1933,” Political
Science Quarterly (June 1960), pp. 181-200 and
George J. Benston, “Bank Examination,” Bulletin
of the Institute of Finance (89-90), New York Univer­
sity (May 1973).

3 Golembe, p. 189.
4 Golembe, p. 192.
5 Federal Deposit Insurance Corporation, Annual
Report, 1952 (Washington, D.C.: 1953), p. 6.
6 This was about the same percentage as in 1820.
Federal Deposit Insurance Corporation, Annual Re­
port, 1950 (Washington, D.C.: 1951).
7 “Predecessors of the Federal Deposit Insurance
Law,” FDIC, Annual Report, 1950, pp. 63-101.
8 Federal Home Loan Bank Board, Agenda for Re­
form (Washington, D.C.: 1983), p. 34.
9 Securities Investor Protection Corporation Report, Senate
Committee on Banking and Currency, 91 Cong. 2
Sess. (GPO, 1970), p. 4.

E C O N O M IC P E R S P E C T IV E S -In d e x fo r 1987
B a n k in g , c re d it, and fin a n c e
Futures market regulation.....................................................................................................................
Costs and competition in bank credit cards...............................................................................
Why commercial banks sell loans: An empirical analysis.............................................................
Would banks buy daytime fed fu n d s? ..............................................................................................
Global banking, financial integration major conference them es................................................
Standby letters of cre d it.......................................................................................................................
The Federal safety net: Not for banks o n ly ....................................................................................

Issu e
Jan /Fe b
Mar/Apr
M ay/Jun
M ay/Jun
Ju l/A u g
Ju l/A u g
Nov/Dec

Pages
3-15
3-13
3-14
36-43
23-27
28-38
19-29

E c o n o m ic c o n d itio n s
Economic events of 1986—A ch ro n o lo g y...................................................................................
The minimum wage: No minor matter for teens......................................................................
Tax reform looks low risk for econom y............................................................................................
Crosscurrents in 1986 bank performance.........................................................................................

Mar/Apr
Mar/Apr
M ay/Jun
M ay/Jun

14-18
19-27
1 5-22
23-25

R e g io n a l e c o n o m y
The Midwest M anufacturing Index:
The Chicago Fed's new regional economic indicator.................................................................
Technology and manufacturing in the Seventh D istrict...............................................................
Service sector growth in the Seventh D istrict................................................................................
Nothing is forever: Boom and bust in Midwest farm in g.............................................................
Economic development efforts in the Seventh District.................................................................
Is the Seventh District's economy deindustrializing?....................................................................

Sep/O ct
3-7
Sep/O ct 8-14
Sep/O ct 15-26
Sep/O ct 27-31
Sep/O ct 32-37
Nov/Dec
3-9

M o n e y and m o n e ta ry p o lic y
The international value of the dollar: An inflation-adjusted in d e x ...........................................
The new dollar indexes are no different from the old o n e s.........................................................
Some macroeconomic effects of tariff policy..................................................................................

Ja n /Fe b 17-28
Ju l/A u g 3-22
Nov/Dec 10-18

28



Economic Perspectives

C all fo r

papers

The 24th Annual

Conference on Bank Structure
and Competition
Chicago, Illinois, May 11-13, 1988
The Federal Reserve Bank of Chicago w ill hold its
24th annual Conference on Bank Structure and Com­
petition in Chicago, Illinois, May 11-13, 1988. The
Conference provides a forum for the exchange of ideas
among academics, regulators, and industry partic­
ipants with a strong interest in public policy toward
the financial services industry. The 1988 conference
w ill examine in detail the nature and importance of
systemic risk, specific measures for dealing with it,
synergies in the production of financial services and
the effects of regulation on bank competitiveness. It
w ill also feature a discussion of several recent pro­
posals for restructuring the financial system to expand
the powers of commercial banks and alter the scope
of the federal safety net. However, papers on other
issues in financial structure and regulation are also
welcome. Completed papers or abstracts should be
submitted by December 31, 1987. Send two copies
of the paper or abstract to Larry Mote, Program
Chairman, Research Department, Federal Reserve
Bank of Chicago, P.O. Box 834, Chicago, Illinois
60690-0834.

Federal Reserve Bank of Chicago




29

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ECONOMIC
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