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Foreign currency futures: reducing
foreign exchange risk
Small-issue Industrial Revenue Bonds in the
Seventh Federal Reserve District
Index for 1982
Economic stagnation and the resurgence
of trade restrictions

New Year, New Look
A n e w ly d e sig n e d

Economic Perspectives

w ill r e t u r n

to its

c u s to m a ry b im o n t h ly s c h e d u l e w ith th e

n e x t i s s u e , j a n u a r y - F e b r u a r y 1983.
T h e e d i t o r s h a v e b e e n s t u d y i n g t h e r e s u lts o f t h e M a y 1982 s u r v e y o f

Economic Perspectives


C o m m e n t s w e r e v e r y la r g e ly f a v o r a b le a n d s u g g e s t that o n l y m i n o r m o d i f i c a t i o n s in t h e m a g a z i n e s a rtic le
m ix a re r e q u i r e d to satisfy t h e n e e d s a n d in t e r e s t s o f t h e r e a d e r s h ip .

Foreign currency futures: reducing
foreign exchange risk
The rapid growth o f the currency
futures market suggests that it is m eet­
ing an important financial need.

Small-issue Industrial Revenue
Bonds in the Seventh Federal
Reserve District



The use o f this nonconventional
form o f financing has greatly increased
in recent years, particularly in urban

Index for 1982


Economic stagnation and the
resurgence of trade restrictions


W hether tariffs or quotas, trade re­
strictions can be costly, and those costs,
most often borne by the consum er,
should be considered by policymakers.
W inter 1982, Volume VI, Issue 3
Economic Perspectives is published by the Research Department of the Federal Reserve Bank of
Chicago. The views expressed are the authors’ and do not necessarily reflect the views of the management
of the Federal Reserve Bank of Chicago or the Federal Reserve System.
Single-copy subscriptions are available free of charge. Please send requests for single- and multiplecopy subscriptions, back issues, and address changes to Public Information Center, Federal Reserve Bank of
Chicago, P.O. Box 834, Chicago, Illinois 60690, or telephone (312) 322-5112.
Articles may be reprinted provided source is credited and Public Information Center is provided with a
copy of the published material.

Foreign currency futures: reducing
foreign exchange risk
K a r e l V. C h a l u p a

The wide fluctuations in foreign exchange
rates since the 1971 breakdown of the Bretton
Woods System of fixed exchange rates have
introduced a new element of risk into inter­
national transactions. The possibility of large
losses has forced most corporations to turn to
the forward market to limit the adverse effects
of exchange rate movements. Major interna­
tional banks have traditionally provided for­
ward cover to their international customers as
a means of hedging foreign exchange expo­
sures. In recent years, however, the Interna­
tional Monetary Market in Chicago has
emerged as a significant alternative facility for
reducing foreign exchange risk by offering
contracts in foreign currencies for future
A hypothetical transaction is helpful in
demonstrating the nature of this risk. Sup­
pose that a U.S. firm, through its foreign sub­
sidiary, had contracted at the beginning of
1982 to sell machine tools to a Japanese firm
for 200 million yen, the tools to be delivered
and paid for at the end of June. At the yen/
dollar exchange rate prevailing in early Jan­
uary, the total revenue received by the U.S.
firm, after selling the yen for dollars in the
foreign exchange market, would have been
200 million yen divided by 218.45 yen/dollar,
or $915,541.31. Assuming production and
transportation cost of $800,000, the sale would
have yielded a profit of $115,541.31. However,
at the exchange rate prevailing at the end of
June when payment in yen was actually made,
254.95 yen/dollar, the revenue received by
the U.S. firm would have been only $784,467.54
turning what otherwise would have been a
substantial profit into a not inconsiderable
net loss of $15,532.46.
To have specified that the payment be

Federal Reserve Bank o f Chicago

fixed in dollars would not have eliminated the
risk, but would only have transferred it from
the U.S. firm to the Japanese firm. Clearly, the
risks associated with movements in exchange
rates are too large to be ignored in business
decision making. An overview of foreign
exchange market trading in general and of
currency futures in particular illustrates how
these contracts can help reduce such risks.
Fixed and floating exchange rates
An exchange rate is simply the price of
one country’s currency in terms of another.
Like the prices of other goods and commodi­
ties, exchange rates are determined by market
forces of supply and demand. Unlike other
goods and commodities, however, foreign
currencies are not generally purchased for
their own sake; they are used as a medium of
exchange for foreign goods, services, and
The quantity of foreign goods and ser­
vices demanded varies over time due to
changes in prices and tastes. These changes
alter the demand and supply of foreign cur­
rencies and thus their prices. Because
exchange rates reflect basic economicforces,
they are inherently unstable in a world of
unexpected economic changes.
Instability of exchange rates traditionally
has been viewed as an important deterrent to
international commerce. Varying exchange
rates cause the effective prices of foreign
goods and services to fluctuate, introducing
an element of uncertainty and risk into inter­
national transactions. The desire to reduce
this uncertainty led to the adoption of the
Bretton Woods International Monetary Sys­
tem of relatively fixed exchange rates in 1945.


While the fixed exchange rate system
may have been desirable from a commercial
viewpoint, its rigid exchange rates failed to
reflect the divergent economic trends in the
postwar world. The resulting pressures
brought the system down in 1971. After a
period of turmoil that lasted from 1971 to
1973, an international monetary system based
on relatively freely fluctuating exchange rates
The exchange rate volatility that charac­
terized the resulting system increased the
need for foreign exchange facilities capable
of protecting operating capital from the risks
of adverse exchange rate movements. That
need was met by the expansion of the for­
ward market in foreign currencies.

Figure 1: The dollar rose sharply
against other major currencies
in the first half of 1982

exchange rate, $C/$

exchange rate, DM /$






The forward market
The interbank forward market developed
as a medium for hedging foreign exchange
risks incurred by banks. Trading takes place
on a 24-hour worldwide market with participants
linked by telecommunications. Access to the
market is generally limited to financial con­
cerns dealing in very large quantities of for­
eign exchange at a “ wholesale" level. Major
banks in the United States and other coun­
tries, along with some multinational corpora­
tions and wholesale brokers, form the core of
the interbank market.
The two basic types of foreign exchange
operations on the interbank market are “ spot"
and “ forward" transactions. In a typical spot
transaction, a bank’s customer may require
one million Deutsche marks to settle an
import bill. He requests Bank A in Chicago to
purchase the marks for him. The bank pur­
chases the marks from Bank B in Frankfurt,
West Germany, at a rate of S.5000/DM. Bank
A credits $500,000 to Bank B's acdount on its
books (DM1,000,000x$.5000/DM) while Bank
B credits one million Deutsche marks to Bank
A’s account in Frankfurt. Bank A then settles
its customer's bill by transferring the balance
from its DM account at Bank B to the account
of the German exporter at Bank C in Bonn,
Germany. This transaction typically takes two
days to complete.
A forward transaction differs from a spot
transaction in that the delivery date of a par­
ticular amount of foreign currency takes
place at a specified date in the future. The
maturity of a forward contract can be days,
weeks, or months in the future, with the size
and delivery date of the contract tailored to
the individual needs of the customer. The
ability to contract future delivery of a cur­
rency eliminates foreign exchange risk.
Consider for example, an importer in the
United States who wants to purchase 500
motorcycles from a German manufacturer.
He places an order on June 1 with payment in
marks due September 1. He is faced with the
possibility that the German mark may appre­
ciate against the U.S. dollar between June and

Econom ic Perspectives

September, raising the importer’s costs in
terms of dollars.
To avoid the risk, the importer can enter
into a contract in June to have the marks
delivered in September at an exchange rate
that is fixed at the time the contract is made.
The importer's bank would either use its own
resources or arrange with another bank for
the delivery of marks on September 1. On the
maturity date of the contract, the U.S. bank
accepts delivery of the marks at a German
bank and makes the balance available to the
importer who then settles his import bill. By
hedging his exchange exposure through a
forward transaction, the importer locks in an
exchange rate and frees himself from the risk
of an adverse exchange rate movement.
Forward contracts created by banks tra­
ditionally provided good protection against
foreign exchange risk at minimal cost for
many corporations involved in international
transactions.1 Access to the forward market,
however, was limited to those customers who
maintained regular banking relationships with
banks writing the forward contracts. Smaller
companies involved in international transac­
tions and those wishing to take a position in
foreign currencies for speculative and other
nontrade purposes were largely excluded
from the market.
An alternative: futures in foreign exchange
Futures trading in foreign currencies was
introduced by the Chicago Mercantile
Exchange through the establishment of the
International Monetary Market (IMM) as an
alternative to the regular forward contracts
offered by commercial banks. The IMM was
conceived as an extension of the already well-*
nA currency may be sold for future delivery at a rate
that may be either higher or lower than the spot rate of
that currency, depending mostly on the relative interest
rates on assets denominated in the two relevant curren­
cies. For exam ple, if interest rates were higher in G er­
many than in the United States at the time the forward
contract is executed, the German mark for delivery in
three months would most likely be sold at a discount
from the spot rate, say, at S.4980/DM rather than at the
spot rate of $.5000/DM.

Federal Reserve Bank o f Chicago

Figure 2: Currency futures trading
has grown rapidly on the IMM
millions of contracts traded, 1981 (one side only)
7 “










SO U R C E: IM M Division of Chicago M ercantile Exchange.

established commodity futures markets in
which specific quantities of corn, wheat, soy­
beans, and other commodities were bought
and sold for delivery at specified future dates.
Trading in futures contracts in foreign ex­
change began in May 1972.
Trading on the IMM has grown rapidly,
particularly since the system of freely floating
exchange rates of major currencies was
adopted in early 1973. The number of cur­
rency contracts traded on the IMM reached
436,000 in 1973 and grew to more than 6 mil­
lion by 1981.
The growth in foreign currency futures
trading indicates that the IMM has fulfilled a
market need that was not fully met by major
foreign exchange trading banks. The IMM
has grown by catering to individuals, busi­
nesses, and financial concerns that find the
interbank market impractical or unsuitable
for their needs.
The structure of IMM
The International Monetary Market is a
division of the Chicago Mercantile Exchange
(CME). Futures contracts traded on the CME


include major agricultural commodities such
as pork bellies and cattle. The IMM division
provides trading facilities for the purchase
and sale for future delivery of precious metals
such as gold, and financial instruments such
as foreign currencies and U.S. Treasury bills.
The IMM operates within the organiza­
tional structure of the CME. The CME itself is
composed of the Exchange administration,
members, clearing members, and the Clear­
ing House. Each plays a specific role in the
operation of the markets.
The Exchange administration is respon­
sible for the day-to-day operation of trading
facilities. Professional staff and employees in
its five major departments collect and distrib­
ute data on the various markets, ensure the
technical operation of trading facilities, and
enforce regulations necessary to maintain
orderly markets and preserve the financial
integrity of the Exchange.
There are approximately 600 CME mem­
bers and 700 IMM members who act as floor
brokers in the execution of trades. Members
have trading floor privileges and voting rights,
may serve on Exchange committees, and, as
associate brokers of member firms, receive a
percentage of trading commissions. Members
who trade for accounts other than their own
must be licensed by the Commodity Futures
Trading Commission (CFTC). All members
must carry accounts with clearing members in
order to conduct personal transactions.
A clearing member is one of approxi­
mately 85 firms that have qualified for mem­
bership in the CME or IMM Clearing House.
Clearing members represent major securities
and commodities firms, subsidiaries of bank
holding companies, and commercial trading
organizations. Clearing firms play a central
role in the operation of the market since all
trades must be carried on the books of a clear­
ing member. The CME does not deal directly
with public customers. All trading activity is
conducted through clearing members. They,
in turn, deal directly with the Exchange.
The Clearing House is an important regu­
latory body of the CME and a guarantor of the
Exchange’s financial integrity. The Clearing


House is party to all trades, and guarantees
performance on all contracts by assuming the
opposite side of each transaction in an inter­
mediary role. At the conclusion of each trad­
ing session, clearing firms (which the Clearing
House regards as the actual buyers and sellers
of contracts since all public transactions are
ultimately carried on the books of clearing
members) settle their accounts with the
Clearing House.
The Clearing House verifies and matches
all transactions by assuring that clearing firms
on both sides agree. It then redistributes
money from "losers" to "winners." Custom­
ers’ accounts are settled daily in cash to
reflect real profits or losses, thereby limiting
debt exposure to one day's market fluctua­
tions. Since the Clearing House becomes, in
effect, buyer for every seller, and seller for
every buyer, customers need not concern
themselves with the identity of the party
assuming the opposite side of a transaction.
Each party may liquidate its position without
contact with the individual with whom the
original trade was made.
The currency futures contracts

The basic unit of foreign exchange on the
IMM is the currency futures contract. The
futures contract provides for the future deliv­
ery of a specified amount of a foreign cur­
rency at a particular date, time, and place.
Fulfillment of a contract, depending on
whether one is a buyer or seller, is satisfied by
accepting or by making delivery of the speci­
fied currency on the value date of the con­
tract. A buy or sell position can also be closed
out by making an offsetting purchase or sale
of an equivalent contract prior to the expira­
tion of trading for the contract.
Every futures contract must be backed by
a margin deposit. Margin is simply a security
deposit that guarantees performance on one's
side of a contract. The exchange sets initial
margin requirements and subsequent main­
tenance levels based on the price volatility of
the various commodities. An adverse price
movement greater than the difference be-

Econom ic Perspectives

Figure 3: Trading on the IMM is
heaviest in German mark, Swiss franc,
and British pound
millions of contracts traded (one side only)

--- 1---- 1----1---- 1---- 1---- 1---- 1---- 1---- 1


German mark
Swiss franc
British pound
Japanese yen
Canadian dollar |
Mexican peso
French franc
Dutch guilder


•Few er than 5,000 contracts.
S O U R C E : IM M Division of Chicago M ercantile Exchange.

tween the initial margin and the maintenance
margin would require the trader to bring his
account balance uptotheinitial margin level.
Foreign exchange trading on the IMM is
limited to eight major currencies, with con­
tract sizes and minimum and maximum daily
price fluctuations specified by the Exchange.
Contracts are set for delivery on the third
Wednesday of March, June, September, and
December. Price quotations are in terms of
U.S. dollars per unit of foreign currency.
Hedgers and speculators

Participants in futures trading are divided
between hedgers and speculators. Foreign
exchange hedgers include banks, brokers,
multinational corporations, and other com­
mercial and financial concerns that require
protection against adverse exchange rate
movements. The hedger expects his profits to
come from managerial skill in conducting his
business activities, not from incidental fluc­
tuations in exchange rates. The hedger uses
the futures market as a management tool for
fixing the exchange rates that affect his busi­
ness activities. For the hedger, the currency
futures contract works as an insurance policy.

Federal Reserve Bank o f Chicago

A hedger may place his contract with
another hedger who wishes to cover his
currency needs in the opposite direction.
Typically, however, the other party to the
contract is a speculator. The speculator plays
a vital role in the futures market by assuming
the risk of the hedger. His presence gives the
market liquidity and continuity and eases
entry and exit. The speculator buys and sells
currency contracts in the hope of profiting
from exchange rate movements.
Speculation offers potentially large prof­
its due to the highly leveraged nature of
futures trading. Since margin requirements
are typically about 5 percent of the value of a
contract, it is possible to control large amounts
of currencies with relatively little capital. For
example, a contract for delivery of 125,000
German marks may be controlled for $1,500.
If a speculator bought a German mark con­
tract at a price of $.5000/DM, a rise in the
value of the DM of 2 percent would result in a
profit to the speculator of $1,250. However,
the same leverage could lead to equally sub­
stantial losses.
Futures trading

Like a forward contract, a currency futures
contract can be used to fix the level of an
exchange rate for some time in the future. For
example, consider the IMM contract in
Deutsche marks (DM). The contract is for
DM125,000. At a rate of $.5000/DM the con­
tract’s current value would be $.5000/DM x
DM125,000, or $62,500. An import company
needing DM125,000 three months from now
would purchase a contract through a broker
after depositing an initial margin of $1,500.2
The value of the contract would fluctuate
daily based on the movement of the exchange
rate as determined in the market.
Suppose the German mark begins to rise
in value relative to the dollar on the world’s
foreign exchange markets. The futures price
2Brokers may require account levels significantly
higher than the minimum margin levels set by the


on the IMM would typically move in sym­
pathy with the movement of the spot ex­
change rate. Suppose that the price of the
German mark for delivery in March rises from
S.5000/DM to $.5060/DM, the maximum daily
fluctuation permitted under the rules of the
Exchange. As a result of the appreciation, the
value of the DM125,000 contract is now
$63,250, $750 higher than the initial price of
If the price of the German mark remains
at that level until March, the individual who
sold the contract to the importer must spend
$63,250 to purchase the amount of marks he
contracted to deliver. The clearing member
through which the contract was sold will
require him to add $750 (the amount by
which the value of the contract has increased)
to his account. The money is then channeled
through the Clearing House to the broker
who arranged the contract for the import
company. Such settlements take place daily
based on price fluctuations that occur as the
contract progresses to maturity.
Suppose that, at the time the contract
matures, German marks can be purchased on
the world's spot foreign exchange market at
an exchange rate of $.6000/DM. The import
company has two options: (1) it can ask the
seller of the contract to deliver DM125,000 to
the company for $62,500 as contracted; (2) it
can liquidate the contract on the last trading
day. Choosing the latter option, the company
would “ sell back’’ or liquidate the contract by
obtaining from the broker the deposit (less
some agreed-upon commission) plus the
$12,500 that the broker collected from the
seller as the value of the contract appreciated.3
The company then enters the spot market
and purchases the DM125,000 it needs at a
cost of $75,000. This is $12,500 more than the
same amount of marks cost three months ago
when the rate was at $.5000/DM. The increase
in cost exactly matches the amount that the
company received from the resale of the con­
tract ($75,000 - $62,500 = $12,500). By using a
^Accrued profits are available at any tim e, not exclu ­
sively at the time the contract is offset.


futures contract, the company has achieved
its goal of protecting itself against a possible
loss arising from a fluctuation in the exchange
rate in essentially the same way as if it had
purchased the currency for future delivery in
the forward market.
While the principle of protection against
currency price fluctuations is the same in the
future and forward markets, there are two
major features that differentiate the two
markets.4First, the forward market offers con­
tracts for specific amounts of currencies tai­
lored to particular needs, while the futures
market offers only standardized contracts in
the predetermined amounts noted in the
table above. As a result, a customer wanting
to protect his account payable of, for exam­
ple, DM200,000 could only cover a portion of
the risk (DM125,000) in the futures market but
could arrange for full coverage in a single
contract in the forward market.
The second difference concerns the
maturities of forward and futures contracts. A
forward contract can be written for the exact
date when the foreign currency is needed or
is to be disposed of. The futures contract has a
standardized delivery date. If a user wishes to
lift his hedge before the expiration date of the
futures contract, he must be prepared to
assume some risk of a currency price fluctua­
4Several other differences arise from the particular
structural features of the futures and forward markets.
First, most forward contracts are settled by actual delivery
of a specific currency on the value date of a contract. In
contrast, since the futures market offers only four major
delivery dates each year, most futures contracts are liqui­
dated prior to their expiration dates. Second, the futures
market, unlike the forward market, has a central clearing
body. Custom er’s accounts are settled daily upon the
conclusion of trading to reflect real profits or losses. Debt
exposure is limited to one day’s market fluctuations.
M oreover, the Exchange guarantees performance on all
contracts. Performance on a forward contract, in con­
trast, is contingent upon the financial integrity of the
party assuming the opposite side of the contract. Third,
information costs may be lower in the futures market
than in the forward market. For exam ple, if a bank is
asked to write a forward contract for a customer, it might
contact several different banks and brokers in search of
the best exchange rate. In the futures market, however, a
customer need not search for the best rate since the
market rate on the most recent futures transaction is the
best rate available to the customer at that time.

Economic Perspectives

tion between the time when the foreign cur­
rency is actually needed for the settlement of
the transaction and the delivery date of the
contract. However, since prices in the spot
and futures markets generally move in the
same direction by similar amounts due to
arbitraging between the two markets, this risk
can be minimized in a properly structured
hedge, as the following examples illustrate.

How this risk is covered is illustrated below.
Suppose that by March 1 the Swiss franc
has appreciated and is selling in the spot for­
eign exchange market at a rate of $.6442/SF.
On the futures market, the price of the Swiss
franc for delivery on March 15 has risen to
S.6450/SF so that the contract for delivery of
125,000 Swiss francs now trades for $80,625.
The importer takes the following actions:

Forward pricing hedge

March 1

On December 1, a firm in the United
States is considering importing 5,000 Swiss
watches at a cost of SF125,000 with payment
and delivery due on March 1. The Swiss cur­
rency is presently selling for S.5395/SF in the
spot market and $.5417/SF in the futures
market for delivery next March 15. Given the
other costs of marketing the watches, the
importer decides that the futures exchange
rate is low enough for him to purchase the
watches and make a profit on the transaction.
However, the importer must pay for the
watches on March 1, though the expiration
date of the futures contract is March 15. He
can hedge most of his exposure by purchas­
ing a March Swiss franc contract on December
1 with the intention of lifting the hedge on
March 1.
December 1
Spot market

Futures market
(for M arch 15 delivery)

Fxchange rate:



Cost of




Purchase M arch 15 contract

Action taken:

At the existing futures market price of
$.5417/SF, the importer has now assured him­
self that the cost of SF125,000 will be $67,712
(SF125,000 x $.5417/SF) on March 15. He has
locked in the approximate cost of the watches
that he is importing. The only risk he still faces
arises from the difference in the value of the
contract on March 1 when he must liquidate
it, and its value on its March 15 maturity date.

Federal Reserve Bank o f Chicago

Spot market

Futures market
(for M arch 15 delivery)

Exchange rate:
Cost of
Action taken:





Buy SF125.000

Sell M arch 15 contract

On March 1, the importer purchases
SF125,000 in the spot market and settles his
import bill. The $80,525 expenditure for spot
francs, however, is higher than the $67,712.50
approximate anticipated cost based on the
futures contract he purchased on December
1 ($80,525 - $67,712.50). However, the value of
the futures contract he sold on March 1 is
$12,912.50 higher than its original value on
December 1. The $12,912.50 gain from the
futures transaction more than offsets the dif­
ference between his anticipated cost and his
actual cost. The risk that the importer assumed
on December 1 by purchasing a contract
whose maturity did not coincide with the
March 1 usage date of the currency resulted
in a windfall gain of $100. The gain arose from
the difference between the spot rate and the
futures rate (the "basis") prevailing on the
day the contract was liquidated (SF125,000 x
The basis, unlike the spot exchange rate
itself, is relatively stable and narrows toward
zero as the contract moves toward maturity.
For example, the basis on December 1 was
$.0022/SF ($.5417/SF - $.5395/SF) while by
March 1 it had shrunk to $.0008/SF ($.6450/SF$.6442/SF). The degree of uncertainty about
the futures price diminishes further as the
contract approaches its March 15 expiration


date. On that date, the futures price coincides
with and, in effect, becomes the spot ex­
change rate.
In the preceding example the S.0008/SF
basis on March 1 accounted for the windfall
gain of $100. This gain might easily have been
a loss of a similar magnitude had the exchange
rate of the Swiss franc depreciated during the
period in which the contract was outstanding.
The important point, however, is that the
importer was protected from any major loss
regardless of exchange rate movements. For
example, if the importer had not purchased
the futures contract and instead waited to buy
the necessary SF125,000 on the day he needed
them (March 1) the watches would have cost
an additional $12,812.50.5Aside from the rela­
tively minor risk associated with changes in
the basis, the futures contract protected the
importer just as a purchase of forward cur­
rency in the foreign exchange market would
have done.

sequently falls in value. The following table
summarizes the transaction:
D ecem b er 1
Spot market

Futures market
(for M arch 15 delivery)

Exchange rate:
Cost of
Action taken:





Bought £500,000

Sold M arch contracts for

*£500.000 principal plus £25.000 anticipated interest earnings.

Suppose that by March 15 the British
pound has depreciated so that on thedaythe
investor’s contract matures the exchange rate
is $1.8500/£. The investor undertakes the fol­
lowing transactions:
March 15

Selling hedge
Futures market

Spot market

Another use to which the forward and
futures markets in foreign currencies may be
put is in hedging a future sale of currency.
Suppose that on December 15 a Chicago
investor decides to invest $1 million in excess
funds in a three-month British sterling certifi­
cate of deposit (CD) presently yielding 20
percent at an annual rate. He expects to real­
ize a $50,000 return on his investment, more
than he could have realized by investing in
the domestic market. The investor buys Brit­
ish pounds in the spot market and purchases
the CD from a British bank. At the same time,
he sells enough British pounds in the futures
market to cover the principal and accrued
interest at the time of maturity of the CD. By
hedging his exposure, he effectively locks in
an exchange rate for three months in the
future and assures that the income from the
deposit will not be lost in reconverting back
to U.S. dollars even if the British pound sub­
5Of course, had the Swiss franc depreciated, his prof­
its would have been higher than anticipated.


(for M arch 15 delivery)
Exchange rate:
Cost of
Action taken:




Sold £525,000

Bought matured contracts
for £525,000* (offset)

The $81,375 difference between the cost of
the contract when it was sold in December
and the cost at which it was liquidated in
March ($1,052,625 - $971,250) is more than
enough to compensate the investor for the
lower-than-expected receipt from his spot
transaction. Had the investor not hedged his
investment, he would have suffered a loss of
$28,750 on the transaction ($1,000,000 $971,250). By locking in the higher $2.0050/£
exchange rate on the future British pound in
December, he realized the anticipated return
of $50,000 on his investment and alsoobtained
a windfall profit of $2,625 ($81,375 gain on
futures transaction minus $50,000 accrued
interest minus $28,750 loss on spot trans­

Econom ic Perspectives

C o nclusio n

The establishment of the International
Money Market by the Chicago Mercantile
Exchange some ten years ago has proved to
be a milestone in the evolution of futures
markets. The introduction of futures trading
in foreign currencies represented a dramatic
departure from the traditional use of futures
markets as mechanisms for hedging the price
risk of transactions in commodities such as
wheat, corn, and soybeans.
Futures trading in foreign exchange
marked the beginning of futures markets in a
wide range of financial instruments, includ­

ing Treasury Bills, government notes and
bonds, Eurodollars, bank certificates of de­
posit, and stock market indexes. The rapid
growth of trading on these markets indicates
that the innovation of financial futures satis­
fied a real and growing need.
The development of foreign currencies
futures trading has provided a valuable sup­
plement to the forward market by offering a
lower-cost hedging facility to users who find
the forward market impractical or unsuitable
for their needs. Accordingly, the IMM has
contributed to the expansion of international
commerce and, in doing this, has benefited

An ongoing review of economic conditions in the
Midwest and the issues that face the region is pro­
vided in M idwest Update, published monthly by the



Federal Reserve Bank of Chicago. M idwest Update
emphasizes developments in manufacturing, trade,
construction, agriculture, and finance in the five state
area served by the Bank: Illinois, Indiana, Iowa,
Michigan, and Wisconsin. The newsletter includes a
table of selected economic indicators.
Subscriptions to M idwest Update are available
free of charge through the Bank. Call or write the
Public Information Center, Dept. EP, Federal Reserve
Bank of Chicago, P.O. Box 834, Chicago, Illinois 60690.
Tel. (312) 322-5112.

 Reserve Bank o f Chicago


Small-issue Industrial Revenue Bonds in
the Seventh Federal Reserve District
D avid R. A lla rd ice

On September 3,1982 the Tax Equity and
Fiscal Responsibility Act of 1982 was signed
into law. In part, the act repealed the tax
exemption that had been available for smallissue industrial revenue bonds (IRBs), effec­
tive for obligations issued after 1986. Other
provisions of the act were intended to limit
the use of IRBs issued prior to 1986.
For years the Congress, the Internal Rev­
enue Service, and others have expressed
growing concern over the economic ineffi­
ciencies, resource misallocation, and poten­
tial loss of tax revenue to the U.S. Treasury
that were considered to be the direct result of
the rapidly expanding use and growing level
of IRB financing. While these concerns have
been the basis for the recent legislation limit­
ing the use of IRBs, interest groups with
strong views concerning the merits of IRB
financing have prevented the passage of leg­
islation that would totally abolish the use of
this method of raising capital.
With these legislative changes and public
concerns in mind, the Federal Reserve Bank
of Chicago examined the background and
use of industrial revenue bond financing. The
use of these obligations within the five states
(Illinois, Indiana, Iowa, Michigan, and Wis­
consin) of the Seventh Federal Reserve Dis­
trict may shed some light on the overall
national utility and desirability of IRBs.

become a significant source of nonconventional financing, especially for small busi­
nesses. Since small-issue IRBs are tax-exempt,
businesses have been able to use the obliga­
tions to finance projects at rates below con­
ventional commercial loan rates. Annual sales
of IRBs have grown from about $24 million in
1969 to $8.4 billion in 1980. This dramatic
growth partly reflects the subsidy that financ­
ing through IRBs offers. In recent years IRBs
have financed businesses at interest rates
between 4 and 7 percentage points below the
cost of conventional financing.
Since most IRBs are placed privately with
local banks, it is difficult to obtain reliable
data at state and local levels. Because of this,
the Federal Reserve Bank of Chicago under­
took a study to determine the amount of IRB

Figure 1: Annual industrial revenue
bond sales in the District States
million dollars

IRB financing—the background
Forty-seven states currently permit local
governmental units to sell tax-exempt rev­
enue bonds and channel the funds derived
from such sales into private and quasi-public
endeavors. Commonly referred to as indus­
trial revenue bonds, these obligations have


Econom ic Perspectives

financing in the District states from 1975
through 1980.1
Based on data from various state agencies
and surveys of local municipalities, the study
found that IRBs issued in the five District
states between 1975 and 1980 approximated
$3.3 billion.* Moreover, the annual amount of
IRBs issued in all District states rose rapidly
during this period. Indiana issued the largest
number and dollar volume of IRBs, amount­
ing to 1,059 obligations worth $1.04 billion.
History of IRB financing

Depletion of certain natural resources,
changes in the cotton industry, and the impact
of the Depression left southern states with
little industry and a surplus of agricultural
labor by the mid-1930s. In 1936, the state of
Mississippi established the “ Balance Agricul­
ture with Industry Program." Launched on
the idea that industrial employment and de­
velopment were in the public interest, this
program authorized cities and counties in the
state to incur general obligation indebted­
ness to construct buildings for leasing to pri­
vate enterprise. In 1938 the city of Durant,
Mississippi, issued the first such obligation in
the amount of $85,000 for the construction of
the ReaIsiIk Hosiery M ill.3
The use of local government bonds to
finance industrial expansion grew modestly
for two decades. Through the mid-1950s the
annual volume of new IRB issues never ex­
ceeded $10 million. But growth accelerated in
the 1960s. In 1962, new IRB issues approxi­
mated $84 million, or 0.10 percent of all tax-

^ o r a more detailed discussion of the study’s find­
ings see: David R. A llardice, Industrial Revenue Bond
Financing in the Seventh Federal Reserve D istrict, W ork­
ing Paper 82-2, June 1982, Federal Reserve Bank of
2This represents the minimum dollar amount of IRBs
that have been issued, since not all municipalities were
surveyed and not all of those responded.
3O lin S. Pugh, Industrial-A id Bonds as a Source of
Capital for D eveloping Regions, (University of South
C aro lina: Bureau of Business and Economic Research,
1971), p. 1.

Federal Reserve Bank o f Chicago

exempt bonds issued. By 1968 the volume
reached $1.6 billion, or 10 percent of all taxexempt bonds issued.4 The rapid growth in
the 1960s has been attributed to interstate
competitive pressures to attract industry and
to increases in the cost of raising funds in the
capital market.
This growth led to increasing concern
about the potential abuses of such financing
and the loss of tax revenues resulting from the
increased use of IRBs. The Congress re­
sponded by passing the Revenue Expenditure
and Control Act of 1968. This act removed the
tax-exempt status of all IRBs, except those
used to finance “ exempt activities," “ indus­
trial parks," and those sold under a “ smallissue" exemption.
This act significantly curtailed the expan­
sion in IRB financing for several years. How­
ever, IRB use began to increase again as the
small-issue exemption was modified. Initially,
the small-issue exemption pertained to IRBs
of $1 million or less. Several months later, the
act was amended. The amendment permitted
IRB issues of $1 to $5 million to retain the
tax-exempt status, provided the funds were
used to finance a firm that limited its capital
expenditures in the local area to no more
than $5 million during a six-year period cen­
tered on the date the IRBs were issued. Unless
the firm complied with the capital expendi­
ture limitation, the small-issue exemption
was lost.
A decade later the Congress, responding
to arguments that inflation had reduced the
value of the ceilings, raised the $5 million
small-issue exemption to $10 million. The Tax
Reform Act of 1978 also established a special
capital expenditure rule for small-issue IRBs
used in connection with Urban Development
Action Grants. On such issues the six-year
capital expenditure limit was increased to $20
The higher small-issue exemption and
the rising cost of capital triggered renewed
4Alan Rabinow itz, M unicipal Bond Finance and
Adm inistration (New Yo rk: W iley-lnterscience, 1969), p.


growth of IRB financing and heightened con­
cern about alleged IRB abuses. The abuses
that attracted the most attention were the use
of industrial revenue bonds to finance such
non public ventures as massage parlors, coun­
try clubs, and race tracks.
The Internal Revenue Service published
guidelines in August 1981 for determining
whether a pooled offering of IRBs would be
treated as a multiple or single bond issue, for
purposes of applying the small-issue exemp­
tion. In general, the obligations were to be
considered a single issue if they were sold
under a common plan of marketing, at about
the same time and interest rate, and a com­
mon or pooled security was available to ser­
vice the debt. Treatment of the pooled offer­
ing as one issue often reduced the availability
of tax-exempt IRB financing for many firms
and squelched the rapidly building interest
shown by many states in using IRB issues
backed by pooled real estate assets to finance
young farmers.
Congressional concern over IRB financ­
ing is reflected in the Tax Equity and Fiscal
Responsibility Act of 1982. In addition to elim­
inating the tax-exempt status of small-issue
obligations issued after 1986, the act removes
the tax-exempt status of obligations, effective
year-end 1982, when more than 25 percent of
the bond proceeds are used for a facility
primarily providing retail food and beverage
services, automobile sales or service, or for
the provision of recreation or entertainment.
In addition, the small-issue exemption does
not apply to about 12 specific types of enter­
tainment and recreation projects, such as
country clubs, tennis clubs, racquet sports
facilities, and racetracks.
The new law in effect overrides the 1981
Internal Revenue Service ruling with respect
to pooled securities. Pooled issues of IRBs will
now be treated as separate issues (and thus
tax-exempt) unless the obligations are used
to finance two or more facilities that are
(1) located in more than one state or (2) have
the same person or related persons as the
principal user.
The new law also establishes require­


ments for the reporting and public approval
of IRB issues. Effective December 31, 1982,
IRB sales will be reported quarterly to the
Internal Revenue Service and public approval
of such financing must be obtained. The pub­
lic approval requirement may be satisfied by
either (1) a public hearing followed by ap­
proval by the issuer's elected official or (2) a
voter referendum.
IRB financing: pro and con

Studies and opinions vary widely as to the
advantages and disadvantages of industrial
revenue bond financing. No consensus exists
on whether the one outweighs the other.

Most studies agree that the bulk of the
benefits from IRB financing go to the firms
that receive the interest rate subsidy from
tax-exempt IRB financing. IRBs aid firms in
the construction of plant and equipment by
serving as a supplemental source of capital
and by lowering the average cost of capital to
the firm. The difference between conven­
tional loan rates and rates on IRB financing
has been significant, particularly in recent
years. The difference has typically ranged
from 2 to 3 /2 percentage points, but widened
to a range of 4 to 7 percentage points in the
early 1980s.5
Local government officials cite numer­
ous advantages in IRB financing. They argue
that IRBs can attract new industry, thereby
improving—at little cost to the local govern­
ment—the economic base of the community.
This advantage is frequently cited as a useful
tool to stimulate development in economi­
cally depressed communities. It is also argued
that on a dollar-for-dollar basis IRB financing
is less costly to local governments than other
community development options. If IRBs do
attract industry to a local community, then
the community may well benefit by increases
5ma// Issue Industrial Revenue Bonds. Congress of
the United States, Budget O ffice, April 1981, p. 18.

Econom ic Perspectives

in employment, income, and local economic
growth. These improvements, in turn, may
strengthen the local government by broaden­
ing the tax base and by promoting labor use in
areas where labor may be relatively immo­
bile, unemployed, or underemployed.
If such benefits to the community are, in
fact, produced by IRB financing, then there
are obvious political advantages to be gained
from these programs. At very little explicit
cost to the local community, local govern­
ment officials can cite newly attracted firms,
increased employment, and an expanded tax
base as examples of their public management
Bondholders, especially those in upper
income tax brackets, benefit from the taxexempt status of IRBs. And the expanded use
of IRBs may drive up interest rates on all taxexempt securities, thus increasing returns to
all holders.
The expanded use of IRBs has generated
an increasing number of arguments and objec­
tions against this form of financing. In gen­
eral, opponents argue that IRB financing
results in a misallocation of labor and capital.
They contend that a firm requiring a subsi­
dized loan is by that fact shown to be less
efficient than those not requiring a subsidy.6
It is further argued that firms not receiving
IRB financing are placed at a cost disadvan­
tage relative to those receiving the subsidy
from IRB financing.7
Others oppose IRB financing because of
the federal tax revenues that are foregone
6Ralph Gray, “ An Economic View of M unicipal Sub­
sidies to Industry/' M unicipal Finance, vol. 36 (May 1964),
p. 156.
7This disadvantage raises questions other than those
related to equity. The United States Supreme Court has
held that local governments are not automatically exempt
from the operation of antitrust laws. City of Lafayette,
Louisiana and City o f Plaquem ine, Louisiana v. Louisiana
Pow er and Light Com pany, 435 U.S. 389, 55 L. Ed.2d 364,
98 S. Ct. 1123 (1978). Thus, refusal to provide IRB financ­
ing for a com petitor of a m unicipally owned utility might
provide a basis for an antitrust suit.

Digitized forFederal Reserve Bank o f Chicago

due to the bonds’ tax-exempt status. That loss
may be substantial. The Congressional Bud­
get Office (CBO) estimated that the federal
tax revenue loss due to IRB financing amount­
ed to $700 million in fiscal 1980.8 However,
some contend that the revenue loss was only
one-sixth the CBO estimate; still others hold
that the economic activity generated by IRBs
has produced net increases in tax revenues
for all levels of government, including the
federal government.9
Another possible disadvantage is the im­
pact of IRB financing on cost and the ability of
local governments to raise funds for more
traditional public purposes. If the demand for
tax-exempt securities is downward sloping,
an increase in the supply of these obligations
will lower the price—raise the interest rate—
of the bonds issued. If the higher interest
rates on IRBs attract funds that would other­
wise have gone into other municipal obliga­
tions, it may become more costly to raise
funds for public investments that are consid­
ered to be of a higher priority and of greater
social value.
While IRBs are intended to attract and
retain industry in a local community, some
observers argue that IRB financing is an inef­
fective tool. Studies of factors affecting the
location decisions of larger firms show that
such factors as energy costs and proximity to
raw materials, customers, and labor tend to
outweigh financing costs in most business
location decisions. To the extent that local
authorities everywhere use IRBs to compete
against one another in attracting or retaining
business firms, any regional benefits to pri­
vate businesses are eliminated and such
financing functions simply as a conduit to the
tax-exempt market.
Questions about the appropriateness of
local governments subsidizing private indus­
try have surfaced since the inception of IRBs.
Opponents of IRB financing increasingly raise
this issue as the scope of projects that are
aSmall Issue Industrial Revenue Bonds, p. 40.
9Report on Tax-Exempt "Small Issu e" Industrial
Revenue Bonds, Committee Print W M CP: 97-12, 97
Cong. 1 Sess., July 9, 1981, pp. 5-6.



Figure 2:
Typical industrial revenue bond transaction

•Issuing authority typically assigns to bank all the rights and interest in the financing agreement or other security.
**An agreement between user and corporate trustee to insure adequate administration of the bond issue. Insures
that trustee receives payments from company and pays principal and interest on the bonds to the bondholders.

deemed to serve a "public purpose" grows
ever wider.1
Opponents of IRB financing also point to
the issue of "plant pirating." Firms induced to
relocate by IRB financing leave behind unem­
ployment, reduced purchasing power, higher
costs for certain social services, and a lower
tax base. From the perspective of the national
economy, the benefits to the acquiring com­
munity must be weighed against the costs to
the community losing the firm before a con­
clusion can be reached that the public was
better served by the relocation.

,0A landmark court decision in 1937 addressing the
question of public purpose held that “ the states, by their
constitutions and laws, may set their own limits upon
their spending power— but the requirements of due
process leave full scope for the exercise of a wide legisla­
tive discretion in determining what expenditures will
serve the public interest.” Carm ichael v. Southern Coal
and Coke C o., 301 U.S. 495, 81 L.Ed. 1245 (1937).


State enabling acts
Each state must pass enabling legislation
before IRBs can be issued. The laws vary, but
they frequently specify the type and/or loca­
tion of business or activity that can be fi­
nanced by such bonds, the total dollar size
(maximum or minimum) of each issue, report­
ing requirements, controls, and any other
provisions desired. All but three states
(Hawaii, Idaho, and Washington) have passed
legislation authorizing the issuance of indus­
trial revenue bonds.1
The states vary greatly in the details of
their enabling legislation. In some states,
(Rhode Island, for example) the issuance of
IRBs is under the control of a state agency. In
11Background Inform ation for Hearings on Taxexem pt “ Small Issu e” Industrial Revenue Bonds, Com­
mittee Print 97-6, 97 Cong. 1 Sess., April 7, 1981, p. 4.

Econom ic Perspectives

most states—43—control rests with local lev­
els of government and industrial develop­
ment authorities. Some states require “ proof
of net economic benefit’’ arising out of the
issuance of IRBs.

Dollar volume of industrial revenue bond sales
in Illinois by municipal size class
M unicipal
size class

Dollar volume of
reported IRB sales

(num ber of persons)

($ millions)


IRBs in the District states

According to recent studies, in 1980 the
five Seventh District states accounted for
about 12 percent of all small-issue IRB sales in
the United States. However, the same data
show that from 1975 through 1980 the growth
in I RB financing in the District states has been
at about a 70 percent annual rate. This was
below the national average of almost 90 per­
cent per year. The following reviews the sta­
tus of IRB financing in each of the District

Industrial revenue bond sales in Illinois
are not reported to any central body, nor
does their issuance require the explicit ap­
proval of any state agency prior to their sale.
The following information on IRB sales in Illi­
nois is therefore based on a survey of all
municipalities in the state with a population
in excess of 500 persons, based on 1980 census
Of the 1,274 municipal governments in
Illinois, 881 were surveyed. About 88 percent

Population of Illinois municipalities issuing
industrial revenue bonds, 1975-1980
M unicipal
size class

M unicipalities issuing IRBs

(num ber of persons)
1- 1,000
1,001- 2,500
2,501- 5,000
50,001 and over





Federal Reserve Bank o f Chicago

1- 1,000
1,001- 2,500
2,501- 5,000
50,001 and over

$ 46.98




of those contacted responded to the survey.
Of the 779 respondents, only 128 munici­
palities—16 percent—indicated that they had
issued one or more IRBs between 1975 and
1980. Overall, these municipalities issued 340
IRBs between 1975 and 1980 with an aggre­
gate dollar volume of $567 million.
In 1975, only 19 municipalities issued
IRBs. By 1980 the number of municipalities
that had issued such obligations had risen to
128. The annual dollar volume of IRBs issued
in Illinois ranged from less than $29 million in
1975 to a high of $196 million in 1980.
In terms of both dollar volume and
number of issues, the city of Chicago has
been the largest municipal issuer of IRBs in
Illinois since 1975, although Chicago did not
begin to issue IRBs in any meaningful amount
until 1977. From 1977 through 1980 Chicago
issued 39 IRBs worth $66 million.
Municipalities with populations in excess
of 5,000 persons were the major issuers of
IRBs in Illinois. Of the 128 responding munic­
ipalities in Illinois that had issued IRBs, 71
percent had populations exceeding 5,000.
These municipalities accounted for 83 per­
cent of the IRBs issued in Illinois from 197780. It is noteworthy that only 20 percent of all
municipalities in Illinois have populations in
excess of 5,000 persons.
IRB sales were concentrated in the major
metropolitan areas within Illinois. The 128
municipalities that issued IRBs were located


in just 50 of the 102 counties in Illinois. Cook
County dominated, with 24 municipalities sell-1
ing 100 IRBs worth over $170 million.
Of the 50 counties having municipalities
that issued IRBs, 36 percent are located in
Standard M etropolitan Statistical Areas
(SMSAs)—major metropolitan centers within
the state. Municipalities located in the state’s
18 SMSA counties sold $459.8 million, or 81
percent, of all IRBs reported sold in Illinois
from 1975 to 1980.

Cities, towns, and counties in Indiana
have the authority to establish economic
development corporations (EDCs), which can
issue industrial revenue bonds to finance
industrial, commercial, and manufacturing
facilities. Once established, EDCs must report
annually to the Indiana Department of Com­
merce the volume of IRBs issued.
Data from the Department of Commerce
show that 133 municipalities and four coun­
ties had issued industrial revenue bonds be­
tween 1975 and 1980. This represented only
about 20 percent of the county and municipal
governments in Indiana.
Some 1,060 IRBs were issued in Indiana
between 1975 and 1980. The aggregate dollar
volume of these bonds amounted to just over

Indiana EDCs issuing industrial revenue bonds
by municipal size class
size class

EDCs issuing IRBs

(num ber of persons)




1- 1,000
1,001- 2,500
2,501- 5,000
50,001 and over

*Does not sum due to rounding.


Indiana industrial revenue bond sales
by municipal size class
size class

Dollar volume of
IRB sales

(num ber of persons)

($ millions)

1- 1,000
1,001- 2,500
2,501- 5,000
50,001 and over






*Does not sum due to rounding.

$1 billion, making Indiana the largest IRB
issuer of the District states. The average dollar
size of IRBs issued in Indiana from 1975
through 1980 was slightly less than $1 million
($983,000) per obligation.
The largest issuer of IRBs in Indiana has
been South Bend, which issued a total of 136
obligations worth $113.3 million between
1975 and 1980. Other larger issuers include
Fort Wayne ($82.2 million), Indianapolis ($71.7
million), Evansville ($75.6 million), and Elkhart
($45.0 million). These five municipalities ac­
counted for 37 percent of the dollar volume
of IRBs issued in Indiana from 1975 through
As in Illinois, municipalities that issued
IRBs in Indiana from 1975 through 1980
tended to be the larger municipalities. Of the
563 municipalities in Indiana only 18 percent
have populations greater than 5,000. But the
66 percent of IRB-issuing municipalities that
were of this size accounted for 91 percent of
all IRBs issued by municipalities in Indiana.
IRB issues—in terms of both the number
and the dollar volume—were concentrated
most heavily in Indiana’s urban counties.
About 75 percent of the number and the dol­
lar volume of all IRBs issued in Indiana in
1975-80 came from local governments lo­
cated in the 12 SMSAs in Indiana. Thus, only
about one-fourth of the total number and

Econom ic Perspectives

dollar volume of IRBs sold by municipalities
in Indiana were issued by municipalities lo­
cated in rural (non-SMSA) counties, although
non-SMSA counties in Indiana account for 33
percent of the population of that state.

Industrial revenue bond sales
in Iowa by city size class

State law permits incorporated cities and
counties to issue industrial revenue bonds.
These obligations may be issued to finance
manufacturing, processing, or assembling fa­
cilities for agricultural and manufactured
products. They may also be issued for com­
mercial enterprises engaged in storing, ware­
housing, or distributing products of agricul­
ture, mining, or industry.
Issuers of IRBs in Iowa are required to
report their sales annually to the state of Iowa.
These data reveal that from 1975 through 1980
a total of 125 Iowa cities or counties, out of a
total of 1,054 cities and counties in the state,
had issued IRBs. In the aggregate, these enti­
ties issued $330.8 million of IRBs. County enti­
ties accounted for $26.3 million of the total.
The largest individual municipal issuer of
IRBs in Iowa was the city of Davenport, which
issued 11 obligations amounting to $20.0 mil­
lion. The next largest municipal issuers were
Mason City ($16.2 million), Cedar Rapids
($14.8 million), and Des Moines ($13.7 mil­
lion). Combined, these four cities accounted

Population of Iowa cities issuing industrial
revenue bonds, 1975-1980

City size class

Cities issuing IRBs

(num ber o f persons)
1- 1,000
1,001- 2,500
2,501- 5,000
50,001 and over

($ millions)

1- 1,000
1,001- 2,500
2,501- 5,000
50,001 and over






•Does not sum due to rounding.

for approximately one-fifth of the dollar volume of all IRBs sold in Iowa between 1975and
Most of the Iowa cities issuing IRBs
between 1975 and 1980 were small. About 80
percent of the 115 cities issuing IRBs had
populations of less than 15,000 persons. These
cities accounted for 58 percent of the IRBs
issued. These figures reflect the small size of
Iowa municipalities, 92 percent of which have
populations of less than 15,000 persons. IRBs
were issued—either by cities or county enti­
ties—in 77 of Iowa’s 99 counties from 1975
through 1980. Three counties (Polk, Scott,
and Cerro Gordo) accounted for approxi­
mately 28 percent of all the IRBs sold in Iowa.
Iowa is the only District state in which
rural (non-SMSA) counties accounted for the
majority of IRBs issued. Cities or counties in
SMSAs issued only 39 percent of the dollar
volume and 41 percent of the number of IRBs.
M ichigan





•Does not sum due to rounding.

Federal Reserve Bank o f Chicago

Dollar volume of
IRB sales

(num ber of persons)


City size class

Analysis of industrial revenue bond sales
in Michigan from 1975 through 1980 is com­
plicated by the fact that the IRBs were issued
under three separate statutes. Moreover, eco­
nomic development corporations (EDCs) in
Michigan were not required until recently to
report their annual sales of IRBs to any state
authority. While some data were available,


they were not considered complete. As a
result, a mail survey of the 312 Michigan EDCs
was necessary to determine the dollar volume
and number of IRBs sold by the EDCs from
1975 through 1980.
The survey found that IRB sales in Michi­
gan grew very rapidly in 1979 and 1980. From
1975 through 1978, the annual volume of IRBs
issued in Michigan averaged about $39 mil­
lion. Then, IRB issues jumped to $249 million
in 1979 and $374 million in 1980, due in part to
rising interest rates and a greater reliance on
EDCs. The dollar volume of IRBs issued in
1980 was more than seven times the 1975
volume. Over the six-year period under study,
some $781 million in IRBs were issued in
Most of Michigan’s IRBs were issued in
the Lower Peninsula and in the state’s major
metropolitan areas.1 The largest dollar vol­
ume of IRBs was issued in Wayne County
($112.8 million), followed by Kent ($97.5 mil­
lion), Oakland ($61.0 million), and St. Clair
($56.8 million) Counties. These four counties
accounted for 42 percent of the dollar volume
of all IRBs issued in Michigan.
Counties in SMSAs accounted for 81 per­
cent of the IRBs issued in Michigan during the
six-year period. The Michigan experience
provides added evidence that IRB financing
in the District states, except for Iowa, is mainly
an urban phenomenon.

million for industrial, commercial, and recre­
ational purposes from 1975 through 1980.
The largest single municipal issuer of
IRBs in Wisconsin, both in number of bonds
and dollar volume, was the city of Milwaukee.
Milwaukee issued 47 IRBs amounting to $66.8
million. Other major municipal issuers in­
cluded the cities of Sheboygan ($26.5 mil­
lion), Janesville ($20.8 million), Appleton
($18.4 million), and Oshkosh ($16.1 million).
These five municipalities accounted for 26
percent of the dollar volume and 22 percent
of the number of IRBs issued in Wisconsin
during the six years under study.
Over half (57 percent) of the municipali­
ties issuing IRBs from 1975 through 1980 had
populations of less than 5,000 persons. How­
ever, 83 percent of Wisconsin’s 576 munici­
palities have less than 5,000 persons, which
indicates that this municipal size class is
underrepresented in IRB sales. Large munici­
palities—those with populations in excess of
50,000 persons—accounted for 6 percent of
the municipalities issuing IRBs during the
period under study. However, municipalities
with over 50,000 persons make up only about
1 percent of all Wisconsin municipalities.
While Wisconsin municipalities with less
than 5,000 persons made up the majority of
municipalities issuing bonds in terms of num­
ber of bonds issued, these same municipali­
ties accounted for only about one-fifth (22

W isconsin

Cities, villages, and towns in Wisconsin
are authorized to sell industrial revenue
Issuers of IRBs in Wisconsin must report
their sales to the Wisconsin Department of
Business Development. The data reveal that
191 municipalities in Wisconsin issued a total
of 590 IRB obligations amounting to $571.3

12Data on IRB sales by m unicipal size class are not
presented because the sale of IRBs in Michigan is spread
across county, township, and municipal governments. As
such, the data are not comparable with the four other
District states.


Population of Wisconsin municipalities issuing
industrial revenue bonds, 1975-1980
size class

M unicipalities issuing IRBs

(num ber o f persons)




1- 1,000
1,001- 2,500
2,501- 5,000
50,001 and over

‘ Does not sum due to rounding.

Econom ic Perspectives

Wisconsin industrial revenue bond sales
by municipal size class
M unicipal
size class

Dollar volume of
IRB sales

(num ber o f persons)

($ millions)

1- 1,000
1,001- 2,500
2,501- 5,000
50,001 and over


$ 24.31




♦Does not sum due to rounding.

percent) of the dollar volume of IRBs sold.
Municipalities with over 50,000 persons ac­
counted for 28 percent of the dollar volume
of IRBs sold from 1975 through 1980.
From 1975 through 1980 IRBs were issued
in 50 of Wisconsin’s 72 counties. Eighteen of
these 50 counties make up all or part of an
SMSA. Municipalities within SMSA counties
accounted for 73 percent of the dollar volume
of all IRBs sold in the state during this period.
IRB financing in Wisconsin is tied more to the
urban and less to the rural economy.

and commercial enterprises located in re­
development areas.
Eight out of every 10 dollars in funds gen­
erated from IRB sales in Wisconsin were used
by firms already located in the state. Only 12
projects using IRB financing attracted out-ofstate firms. These findings tend to support
otherstudiesthat have concluded thatfinancing costs are not one of the primary factors
influencing a firm’s location decision. They
also weaken the argument of those that con­
sider IRBs to be an effective tool in the inter­
state “ pirating” of new industry.
Studies of the Wisconsin IRB program
also found that 40 percent of the firms using
IRB financing had fewer than 50 employees
and only about 26 percent of the firms using
such financing were subsidiaries of larger
corporations. Thus, there is a basis upon
which to conclude—at least in Wisconsin—
that IRBs are often used as a tool to finance
small, local business in major urban areas.
From the Wisconsin studies it is also
known that commercial banks have been the
major purchasersof IRBs in Wisconsin. About
75 percent of all the IRBs issued in that state
were purchased by banks. Most of these
banks were headquartered in Wisconsin.

W isconsin’s experien ce

Wisconsin is the only District state in
which various state agencies have studied the
growth and impact of the state’s IRB financing
program.1 These studies found that approxi­
mately 86 percent of the dollar amount of
IRBs sold in Wisconsin were issued for in­
dustrial purposes. The remaining 14 percent
were issued to assist the financing of national
or regional business headquarters; recre­
ational, hotel, and convention facilities; ser­
vice, warehouse, and distribution facilities;
13Richard Kotenbeutel, Econom ic Impact o f Indus­
trial R evenue Bond Usage in W isconsin, (M adison: Wis­
consin Department of Business Development, May 1980),
and Industrial Revenue Bonds: An Evaluation by the
State o f W isconsin Legislative Audit Bureau, Madison,
May 1981, processed.

Federal Reserve Bank of Chicago

The dramatic growth in industrial rev­
enue bond financing in the Seventh Federal
Reserve District may be attributed to the high
cost of conventional business financing and
attempts on the part of states and municipal­
ities to attract or retain business.
The study of this financing technique
reveals widespread use and diversity within
the District states. IRBs are primarily used by
municipalities located within major metro­
politan areas, except in Iowa where their use
is centered in the rural communities. This ex­
ception is best explained by Iowa’s predom­
inantly rural makeup rather than by any differ­
ence in policy.
The study also found a lack of central
reporting of IRB sales in certain District states.
The lack of adequate data can result in inac­


curate conclusions being drawn about the
use and trends of such financing. Centralized
reporting is desirable if lawmakers are to
establish sound public policies on the use of
such obligations.
The combined effect of the recent de­
cline in interest rates and the passage of the
Tax Equity and Fiscal Responsibility Act of
1982, with the provision to eliminate the

small-issue exemption after 1986, will be to
reduce the future volume of IRB sales in the
District and nationwide. However, public
financing of private projects remains an op­
tion for certain borrowers for certain types of
projects. Furthermore, the history of such
financing shows that their use tends to ebb
and flow with political and economic

E C O N O M IC PERSPECTIVES— Index for 1982
Banking, credit, and finance
The effects of usury ce ilin g s................................................................. ....................
Deregulation of the financial se cto r............................................... ....................
Small-issue Industrial Revenue Bonds in the
Seventh Federal Reserve D istrict.................................................... ....................







Economic conditions
Review and Outlook ................................................................................ ....................


Government finance
Small-issue Industrial Revenue Bonds in the
Seventh Federal Reserve D istrict....................................................






international trade and finance
Activities of International Banking Facilities:
the early experience ................................................................................ ....................
Foreign currency futures: reducing
foreign exchange risk ........................................................................... ....................
Economic stagnation and the resurgence
of trade restrictions ................................................................................ ....................
Money and monetary policy
Lagged reserve accounting and the
Fed’s new operating procedure .................................................... ....................
Monetary policy objectives for 1982............................................... ....................
Reserve targeting and discount p o licy ............................................. ....................









Econom ic Perspectives

Economic stagnation and the resurgence
of trade restrictions
J a c k L. H e r v e y

The recession that has plagued the global
economy during the past three years has
given rise to a worldwide wave of protection­
ism. Confronted with stagnant economic activ­
ity and high and rising unemployment, many
countries have turned increasingly to restric­
tions on imports, or to special subsidies that
increase the price competitiveness of their
products in international markets. The im­
mediate concerns of policy makers about
depressed output and high unemployment
have contributed to the diversion of their
attention toward trade-distorting policies.
These policies are perceived by some as
remedies for the economic ills of unemploy­
ment and u n d e r-u tiliz a tio n of plant
and equipment, but at best such policies only
mask the symptoms and are likely to be met
by offsetting distortions by another country's
Meanwhile, the underlying rationale for
why countries engage in international trade is
lost. The economic basis for trade is that by
specializing in the production and export of
goods for which a country has a comparative
advantage and importing those goods for
which it does not have a comparative advan­
tage, the trading countries mayeach increase
their total income.
A view of the world that supports the
restriction of trade has a long history and in
fact was a basic tenet of economic thought
during the mercantilist period of the 16th18th centuries. Governments sought to acquire
wealth (gold and silver) through the export of
high value goods and through restrictions on
imports. In more recent history, protection­
ism became an important component of
trade policy in the early 1900s and reached a
peak in 1930 with the Smoot-Hawley tariff.

Federal Reserve Bank o f Chicago

Smoot-Hawley was initially conceived prior
to the Great Depression as a means of protect­
ing U.S. agriculture, which during the 1920s
had become depressed relative to the rest of
the economy. With the onset of the Depres­
sion, the narrowly conceived legislation be­
came a “ Christmas tree” on which to hang
greatly increased tariff rates to protect the
domestic employment and output of other
industries. Foreign competitors responded
with increased protectionism of their own.
Widespread unilateral attempts to stimulate
employment and income by restrictions on
trade failed and contributed to a marked
deterioration in world trade, thus exacerbat­
ing the effects of the Depression worldwide.
Current economic conditions and pres­
sures for protection do not compare with
those of the late 1920s and early 1930s. How­
ever, the prolonged economic stagnation
currently being experienced by the world's
economies and the resulting consequences
for employment and income have brought to
a standstill, and threaten to reverse, the postWorld War II trend toward freertrade. Recent
examples of trade-restrictive actions include:
Japan’s imposition of import duties on U.S.
aluminum allegedly “ dumped” in the Japa­
nese market; imposition of “ voluntary” limits
on car exports from Japan to Canada, the
United States, and several European coun­
tries; restrictions on imports of steel by the
European Common Market (EC); tightening
of restrictions on textile exports from the
developing countries to the industrial coun­
tries under the provisions of a recent revision
in the international textile agreement; in­
creases in export subsidies on surplus agricul­
tural commodities by the EC; a marked in­
crease in non-tariff trade barriers within the


EC; and many others.
The United States has not been immune
to these pressures. In the recent past, numer­
ous bills calling for restrictions on imports
have been introduced in the Congress. Where
administrative actions are permitted by exist­
ing legislation, pressures for using them have
intensified. In several instances, these pres­
sures have resulted in action. Of particular
note are three measures taken by the U.S.
government in recent months.
U.S. quotas on sugar imports

In May 1982, the President ordered quo­
tas on imports of sugar into the United States.
Under this quota system, the administration
determines the total amount of sugar to be
admitted into the country. Each foreign coun­
try exporting sugar to the United States is
allocated a share of that total based on the
average annual shipments into the United
States for the years 1975 through 1981.
The quota system is in addition to exist­
ing import duties that, at the President’s dis­
cretion, can range up to 2.81 cents per pound
on raw sugar, and fees, set by the Secretary of
Agriculture. The administration's decision to
impose sugar quotas was triggered by a series
of domestic events, combined with the de­
velopments in the world's sugar markets in
late 1981 and early 1982.
The Agriculture and Food Act of 1981
established a price support program for U.S.produced sugar that set a floor under the
price received by U.S. producers. The govern­
ment set the floor by agreeing to purchase
raw sugar through the Commodity Credit
Corporation (CCC) at a price of 16.75 cents
per pound from December 22,1981, through
the first quarter of 1982. The legislation also
directed the CCC to extend nonrecourse
loans to cover sugar production during the
4-year period from October 1982 through
September 1986. Loans to sugar producers
were to be secured by the commodity and
based on a support price for sugar that would
increase gradually from 17 cents per pound in
the first year of the program to 18 cents per


Tariff and quota restrictions on trade

Import restrictions fall into two cate­
gories: 1) tariffs and 2) nontariff barriers to
trade, which are divided into a) quantita­
tive restrictions, typically quotas, and b)
other non-tariff barriers to trade. Since
World War II a series of seven multilateral
trade negotiations have reduced tariff rates
to such a degree that they are compara­
tively minor impediments to trade. Partly
as a result of the reduced protection afford­
ed by tariffs, more of the pressure for pro­
tection from imports has been applied in
the area of nontariff barriers—quotas and
other nontariff barriers such as “ buy domes­
tic’’ legislation and domestic content re­
Theoretically, for every quota there is
a tariff that would provide the same degree
of protection. (As a matter of practice, it is
difficult to ascertain precisely the level of
the tariff that would achieve this result.) In
a simple case, the figure below shows what
happens when import restrictions are im­
posed on a product. The relationship beprice

import quantity

Econom ic Perspectives

tween the quantity of the product imported
and its price (demand) is represented by
the curve DD' and the relationship between
the quantity supplied by the exporting
country and price (supply) is shown by
curve SqSq. The quantity demanded equals
the quantity supplied at the equilibrium
point A, resulting in a market price of Pq
and a quantity of Q q.
Assume now that it is desired to reduce
the quantity of the product imported from
Qo to Q-j. This could be achieved either by
setting an import quota of Q-j—i.e., for­
bidding imports greater than that amount—or
by imposing a tariff, BC, which raises the
price to domestic consumers to
reduces the price received by exporters to
Pf. In effect, imposition of the tariff would
shift the supply curve up from SgSgto SqSq.
A major difference between a tariff
and a quota providing equivalent protec­
tion is the beneficiary of the "rent" repre­
sented by the area BCPfPj. (It should also
be recognized that the trade restriction
results in a net loss to the system, shared by
exporters and domestic consumers repre­
sented by the area ACB.)
If the restriction is a tariff, the govern­
ment imposing the restriction gains the re­
venue BCPfPj. If the reduction in imports
is attributable to a quota, the distribution
of the rent depends on how the govern­
ment imposing the quota chooses to imple­
ment it. If the government sells importers
the right to buy abroad, the government
either will capture all of the rent itself or
will share it with the importers, depending
on the price at which the right was sold. If
the government gives the import licenses
away, the importers will obtain all of the
rent. Finally, if the government gives export

Federal Reserve Bank o f Chicago

licenses to foreign governments or export­
ers, then they will capture the rent.
The negotiated or "voluntary" quotas
favored by governments in recent years do
not allow the importing country to capture
the rent resulting from the restriction.
Rather, the foreign government, which in
this case controls the licensing of exports,
reaps all or a portion of the rent by selling
export licenses to exporters. It can, alterna­
tively, give the licenses to exporters, allow­
ing them to capture all of the rent. Thus,
under quotas, consumers in the importing
country face the worst of several possible
worlds. They not only pay higher prices,
but are prevented from increasing their
consumption of the imported goods regard­
less of their willingness to pay. Still worse,
they may actually be subsidizing foreign
Quotas possess several other charac­
teristics that are particularly distasteful to
most economists. Effective quotas elimi­
nate the impact of market forces on the
output of the product. An upward shift in
demand or an increase in efficiency in
supply would affect only the price of the
product—the quantity is fixed by quota.
Thus, only the comparatively inefficient
protected firms reap the benefits of an
increase in domestic demand. Finally, quo­
tas insulate domestic producers from world
market forces and tend to promote the
continuation of inefficient operations.
Offsetting these negative factors some­
what, at least from the importing country's
perspective, are the short-term gains that
may occur in domestic employment in the
affected and related industries. The use of
import quotas clearly involves political as
well as economic considerations.


pound in fiscal year 1985-86.1 However, be­
cause the Congress failed to appropriate
funds for the program in the 1982 federal
budget, the Office of Management and Bud­
get directed the CCC not to purchase surplus
The failure of the government to imple­
ment the floor price for domestically pro­
duced sugar left the price of U.S.-produced
sugar to be determined in the world market.
In the meantime, world sugar production
soared to a record 105.6 million short tons in
1981 and year-end stocks increased 32 per­
cent from 1980 to 1981. As a result, the world
price of raw sugar fell from a high of 41 cents
per pound in October 1980 to 6 cents per
pound in October 1982. The landed New
York price (including duties, fees, and freight)
declined from 411 cents per pound in
October 1980to 151
/2cents in September 1981.
In an attempt to protect comparatively high
cost domestic sugar producers from falling
prices, the President raised import duties on
raw sugar in December 1981 to their legal
maximum of 2.81 cents per pound. The import
duties and fees brought the total import tax
on raw sugar up to 4.95 cents per pound, and
the New York duty-paid price stabilized
around 17-18 cents per pound .1 Fees were
raised further and in April 1982 the total
import tax was 6.88 cents per pound. Given
the state of the world’s sugar markets in early
1982, the tariff was not high enough to main1With a nonrecourse loan, the sugar producer ac­
quires a loan from the C C C based on the loan rate per
pound of sugar. The sugar is held as collateral for the
loan. If, during the course of the year, the market price of
the sugar under loan sufficiently exceeds the loan rate,
the farmer may pay off the loan and sell the sugar on the
open market. If, by the end of the year, the market price
remains below the loan price, the farmer may choose to
turn over the title to the sugar to the C C C , thus canceling
his obligation to repay the loan. The C C C must then
assume storage costs of the sugar and may not sell its
holdings in the open market unless the market price
exceeds the loan rate by a specified percentage.
2ln 1981 one-quarter of the nearly 5 million short
tons of sugar imported were eligible for duty free treat­
ment under the Generalized System of Preferences (GSP)
applicable to U.S. imports from developing countries.
During the first half of 1982 nearly 60 percent of the 1.2
million tons imported were eligible for GSP treatment.


Figure 1: U.S. and world sugar prices
diverge in 1981, as protectionist
policies take hold
U.S. cents per pound

million metric tons

1972 73 74 75 76 77 78 79 ’80 ’81 '82
I------------------- annual average----------------------l-m o nth ly-l
‘ Estimated.

tain the U.S. price of sugar above the legis­
lated floor price in the absence of a viable,
well-funded purchase program.
The administration was left with three
choices: 1 ) abandon the price support pro­
gram; 2) obtain a budgetary allocation to
fund it; or 3) impose additional restrictions on
foreign suppliers as a means of raising domes­
tic prices. The first course was deemed unde­
sirable for political reasons—the termination
of the price support program would alienate
the powerful sugar producers’ lobby in the
Congress. The second choice would have
been difficult to implement because of the
tight budget. So the administration chose the
last alternative and imposed import quotas.
The quota increases the price that U.S.
consumers will pay for sugar. In effect, it
transfers the cost of the sugar support pro­
gram from the taxpayer to the sugar consum­
er. Early estimates by the U.S. Department of
Agriculture indicated that the quotas would
add 2 to 4 cents per pound to the price of
sugar. Assumingdomesticconsumption holds
at the 1981 level of 9.8 million tons, the addi­
tional cost to consumers would be $400 mil­
lion to $800 million per year. In addition to

Econom ic Perspectives

higher sugar prices, the prices of nonsugar
sweeteners are expected to increase, further
boosting the consumer’s costs.
In addition to the consequences for
domestic prices of sweeteners, the imposi­
tion of the quota system may have important
international repercussions. Approximately
50 percent of the sugar consumed in the
United States came from foreign sources in
1981. Except for Australia, the major supplier
countries are low- or middle-income devel­
oping countries.
Brazil and Argentina, among the more
advanced developing countries, provided
nearly 30 percent of U.S. sugar imports in
1981. Lower-income developing countries in
Central America and the Caribbean islands,
where sugar is a major export commodity,
provided nearly one-third of U.S. sugar im­
ports. In 1980, sugar accounted for nearly 40
percent of the Dominican Republic’s and
nearly 30 percent of Panama’s exports to the
United States. The quota system may create
severe problems for these countries.
“Voluntary” restraint on exports of
Japanese cars to the United States
For one year beginning April 1,1981, the
Japanese government limited exports of auto­
mobiles (including vans and station wagons)
to the United States to 1.76 million units. In
light of the continued depressed state of the
U.S. auto market in 1982, the restraint was
extended at the same level for a second year.
In October 1982the U.S. government request­
ed that the limits be extended for a third year.
The decision of the Japanese govern­
ment to reduce car exports (from 1.91 million
units in 1980) to the United States came after
months of growing political pressure within
the United States to temporarily restrict auto
imports as a means of providing some support
to the industry. It was assumed that such tem­
porary protection would assist the industry as
it went through a transition phase of produc­
tion reallocation towards smaller and more
fuel-efficient cars and attempted to adjust its
production to a more efficient mix of labor

Federal Reserve Bank o f Chicago

Figure 2: Japanese imports increase
their share of a declining U.S.
auto market
million units


and capital, better enabling the U.S. auto
industry to compete.3
The restraint would give the U.S. auto
industry a "breathing spell” from foreign
competition during which it could restore
profitability and reduce its unemployment. It
was estimated that a restriction-induced in­
crease in sales of U.S.-produced autos would
increase before-tax revenues for U.S. auto
companies by about $1.9 billion per year, thus
generating additional funds to aid the re­
covery and long-term viability of the industry.4
Employment in the auto industry was
expected to increase over what it otherwise
^Although the U.S. International Trade Commission
(ITC) had previously issued a ruling that growing auto
imports were not the principal cause of the plight of the
U.S. auto industry, the movement toward restraining
imports gained considerable momentum.
4“ CEA Calculations of the Impact on the Economy of
a Japanese Autom obile Import Restraint,” The Effect of
Expanding Japanese A utom ob ile Im ports on the Dom es­
tic Econom y, Hearings before the Subcommittee on Eco­
nomic Stabilization of the Committee on Banking, Hous­
ing, and Urban Affairs, United States Senate, A pril, 1980,
96th Congress, 2nd Session (Governm ent Printing O ffice,
1980), p. 83.


would be in the absence of the import cut­
back. According to studies conducted by the
U.S. Department of Labor and the United
Auto Workers (UAW), an increase in auto
production by five units adds one employee
to the work force, directly and indirectly. The
anticipated 150,000 unit reduction in Japa­
nese imports (assuming that it translated into
a one-for-one increase in U.S. auto produc­
tion) was expected to reduce U.S. automotive
unemployment by about 30,000 workers.
On the other hand, the restraint was
expected to impose costs on U.S. consumers.
In principle, the “ voluntary" export restraint
imposed by the Japanese government would
have the same impact as legislated import
quotas by the U.S. government: a restriction
on the number of autos allowed to enter the
U.S. market tends to increase the prices of
autos bought by U.S. consumers and to limit
their choice of available models.
Furthermore, economists generally ex­
pected that the Japanese producers would
change their product mix and increasingly
concentrate their shipments to the U.S. mar­
ket in the higher-priced, higher-profit mod­
els at the expense of less expensive models,
thereby limiting U.S. consumers' choices and
raising the average price of landed imports.
Moreover, the limited supply of imported
cars, especially the lower-priced models, was
expected to make it possible for dealers to
increase the delivered price of these autos.
The available statistics tend to bear out
those expectations. During the first year of
restrictions, Japanese car makers sold 1.81
million units in the U.S. (versus 1.91 million
units in 1980). The excess over 1.76 million
primarily reflected a drawdown in invento­
ries built up in anticipation of the imposition
of restrictions. During the first six months of
1982, sales ran at an annual rate of 1.77 million
units, only marginally above the restriction
Japanese manufacturers have sought to
maintain sales revenues by raising prices and
by increasing the proportion of higher-priced
cars in their export mix, confirming the pre­
dictions of many economists when the re­


strictions were introduced. The average unit
value of Japanese cars at U.S. ports of entry
was about $4,700 in 1980, about $5,300 during
the first six months of 1981, and almost $5,600
during the first half of 1982.5
Sales reports by the major Japanese auto
companies confirm the shift toward more
expensive models. During the first six months
of 1982, the number of cars priced at $6,500 or
less sold by the two largest Japanese manufac­
turers declined 30 percent from the same
period in 1981. During the same period the
number of cars priced between $6,500 and
$11,000 increased 15 percent. Sales of cars
priced at more than $11,000 rose by 60
Despite the export restrictions and the
shift in the export mix toward more expensive
cars, Japanese car makers have continued to
hold their own in the depressed U.S. market.
Japanese cars accounted for about 22 percent
of all cars sold in the United States in both the
first half of 1981 and the first half of 1982. In
the April-August 1982 period, they had a 26
percent share.
A much more severe restriction on trade
in cars would occur if some form of domestic
content requirement legislation such as that
introduced in the 97th Congress were to
become law. In its most restrictive form, the
proposed legislation would require that by
1985 companies selling cars in the United
States have a minimum of 25 percent local
content if annual sales ranged between 100,000
5From April 1981 to mid-October 1982, the dollar
appreciated by about 18 percent in terms of the yen.
Together with an increase of about 6 percent in the
average U.S. price of a Japanese car, this exchange-rate
change has meant that the average yen price of a repre­
sentative Japanese car exported to the United States has
risen more than 24 percent since April 1981. Clearly, this
increase has materially aided profit margins of Japanese
A cco rd in g to W ard’s Autom otive Reports, during
the period in question, sales by these two manufacturers
of cars priced at $6,500 or less declined from about
349,650 units to 213,450 units; sales of those priced
between $6,500and $11,000 increased from about 164,680
units to 189,320 units; and sales of those priced in excess
of $11,000 increased from about 53,650 to 85,770. Total
sales by these manufacturers declined from about 567,980
to 488,540 units.

Econom ic Perspectives

and 150,000 units. Local content require­
ments would range up to 90 percent for car
manufacturers with annual sales of 500,000
units or more.
Such legislation would effectively pre­
clude major foreign auto makers from selling
in the U.S. market. Foreign auto makers that
establish plants in the United States typically
do not produce all models in their U.S. facili­
ties and it is unlikely that they would be wil­
ling to source such a high proportion of auto
components domestically. Even U.S. auto
companies commonly source major compo­
nents such as engines and transmissions
abroad and sell foreign- assembled cars under
U.S. nameplates.
Such restrictions are bound to limit con­
sumers’ choices and raise car prices. Auto
makers would be forced to accept the higher
domestic production costs that have 1 ) led
U.S. firms to foreign sources for components
in the first place and 2) discouraged foreign
firms from locating facilities in the United
States. U.S. Trade Representative William
Brock has condemned the bill as a serious
threat to the international trading system and
tothewell-beingofthe U.S.economy. Never­
theless, the bill gained strong support in the
Congress during 1982 as the U.S. economy
remained stagnant and the expected recov­
ery of the depressed auto industry was pushed
further into the future. More importantly, the
strong support for such legislation reflects a
widespread mood that protecting domestic
industry from import competition is neces­
sary to generate more jobs in this country.
Restrictions on steel imports and the
U.S. steel industry
On October 21, 1982, officials of the
United States government and the European
Economic Community reached an agreement
limiting EC steel producers' exports to the
United States of carbon and alloy steel and
steel pipe and tube to 5.46 percent and 5.90
percent, respectively, of the projected U.S.
market for these products. The quotas went
into effect November 1, 1982, and extend

Federal Reserve Bank o f Chicago

through 1985. The agreement by the EC to
accept “ voluntary” export quotas shortcircuited by only one day the U.S. govern­
ment’s imposition of countervailing duties on
steel imports from the EC and may have fore­
stalled the imposition of anti-dumping duties
later in the year. The imposition of these quo­
tas is the latest development in a troublesome
controversy over “ unfair trade practices” in
the world steel market.
Foreign competition in the steel industry
has long been a sensitive issue worldwide.
During most of the period 1969 through 1974
agreements to restrict steel shipments “ volun­
tarily” were negotiated between the U.S. and
Japan, the U.S. and the EC, and the EC and
Japan. These agreements protected the U.S.
industry from Japanese and European steel
and the European industry from Japanese
steel. When world steel demand soared in the
mid-1970s the agreements were allowed to
lapse except for the import quotas imposed
by the U.S. on specialty steel imports from the
EC in 1976. At the same time, Japan agreed to
a voluntary restriction on shipments of spe­
cialty steel to the United States.
World demand for steel slowed later in
the 1970s. Rates of capacity utilization fell,
employment declined, and new pressures for
restrictions on trade began to appear. In June
1977, the U.S. Steel Corporation filed a coun­
tervailing duty petition against European steel
producers charging that the Europeans were
providing illegal export subsidies. In Sep­
tember 1977 anti-dumping charges were filed
against Japanese steel exporters. That same
month, the U.S. government granted trade
adjustment assistance to about 15,000 steel
workers who were certified as having lost
their jobs because of increased imports. Addi­
tional dumping charges were filed later in the
year. In 1977 steel imports surged to 19.3 mil­
lion short tons from 14.3 million tons in 1976.
The trigger price mechanism
In December 1977 the administration
announced plans for a “ trigger price mecha­
nism” (TPM) which provided a schedule of


Price for ho! rolled sheet by source, 1981







dollars p er ton
Average f.a.s. import price







Estimated c.i.f. price (cost,
insurance and freight)







General import tariff at
7.1 percent on f.a.s. price













Estimated price in
New York

•Price com parisons for steel products are open to question because of a lack of publicly
available data for com parable products. Industry sources indicate that hot rolled sheet com es
close to being a uniform product although even in this category quality and size variations occur
that make price com parisons tenuous.
♦•Mill base price at midwestern locations— price does not include discounts or premiums.

minimum prices at which steel imports would
be admitted into the United States.7 The U.S.
industry received the TPM coolly, primarily
because the trigger prices were tied to the
estimated costs of production in the more
efficient Japanese industry. Consequently,
the level of protection was low. Nevertheless,
the U.S. industry agreed to withdraw dump­
ing charges. Dissatisfaction with the TPM con­
tinued to build, however, and came to a head
in March 1980 when domesticsteel producers
filed antidumping petitions against European

producers once again.8 The Commerce De­
partment responded by suspending the TPM.
Under an agreement with the domestic
industry reached in October 1980 the U.S.
government reinstated theTPM,atsomewhat
higher minimum prices, with the stipulation
that the dumping petitions be withdrawn. At
about the same time the EC imposed produc­
tion quotas on its steel industry, which suf­
fered from excess capacity, in an attempt to
restructure the industry and weed out ineffi­
cient capacity. The EC also took action to re-

These minimum prices were based on the dollar
cost of steel production by the Japanese steel industry—
the w orld’s most efficient steel producers. So long as
foreign steel met the trigger price level, according to the
TPM , the domestic industry would refrain from making
dumping charges. If imports came in at a price below the
trigger price, the U.S. authorities would initiate a dump­
ing investigation. The TPM went into operation in early
1978. Despite the trigger prices, steel imports increased
to a record 20.8 million tons in 1978. From the beginning,
the U.S. steel industry was unhappy with the TPM.
Because trigger prices were based on Japanese costs of
production, it was asserted that the less efficient Euro­
pean producers could sell steel in the U.S. market at a
price above the trigger price, thereby being in com ­
pliance with the TPM , and still be in technical violation of
antidumping laws—that is, foreigners selling in the U.S.
market at less than their costs of production.

8Dumping is defined in U.S. statutes as the practice
by a foreign exporter of selling goods in the U.S. market
at less than "fair valu e ." This means that the goods must
not be sold in the export market at a price lower than in
the home market. The statutes also state that if the home
market price does not realistically reflect the cost of
production, plus a reasonable profit margin, the home
market price may be disregarded and a cost of produc­
tion plus profit figure may be constructed and used in
place of the home market price to determine whether
dumping is taking place. The Com m erce Department has
responsibility for determining whether dumping is tak­
ing place. Before antidumping duties can be imposed,
providing dumping is found, the dumping must be
shown to be causing "m aterial in jury" to the U.S. indus­
try. The investigation and determination of injury arethe
responsibility of the U.S. International Trade Commis­
sion (ITC).


Econom ic Perspectives

strict steel imports in 1981, renewed these
restrictions for 1982, and recently extended
the restrictions through 1983.
Nonetheless, by the end of 1981 the U.S.
industry was again complaining about rising
imports and administration of the TPM. Steel
imports increased to 20 million tons in 1981,
only about 1 million tons less than the 1978
record. The strength of the dollar in foreign
exchange markets tended to nullify the pro­
tectionist effects of the TPM .9In an attempt to
forestall a broad-scale “ unfair trade prac­
tices” petition by the steel industry, the
Commerce Department in November 1981 began
an investigation of steel imports from Roma­
nia, Belgium, Brazil, France, and South Africa.
Nonetheless, in January 1982 several U.S.
steel companies brought an “ unfair trade
practices” suit against 14 countries. In re­
sponse to the petition the Commerce Depart­
ment again suspended the TPM on the affected
products. During the next several months
domestic producers filed additional charges
covering a broader range of products and
expanded the country list to 15—Austria, Bel­
gium, Brazil, France, West Germany, Italy,
Japan, Luxembourg, the Netherlands, Roma­
nia, South Africa, South Korea, Spain, Sweden,
and the United Kingdom.
The June 1982 countervailing duty
On June 11,1982, the U.S. Department of
Commerce announced that nineforeign gov­
ernments—Belgium, Brazil, France, West Ger­
many, Italy, Luxembourg, the Netherlands,
South Africa, and the United Kingdom—were

9ln O ctober 1980 the average trigger price for steel
imports was about $400 per ton. This was equivalent to
about 1,700 French francs per ton at the then prevailing
exchange rate. The average price of French steel at that
time was about 1,800 francs per short ton or about $420—
well above the trigger price. The French franc price of
steel increased about 27 percent to 2,300 francs per ton
between October 1980 and the end of 1981. However,
because of the more than 30 percent appreciation of the
dollar during the year, the average dollar price of French
steel had declined to about $400 per ton at the end of
1981—just at the threshold of the trigger price.

Federal Reserve Bank o f Chicago

subsidizingtheir steel exports. Pending a final
determination of whetherthe U.S. steel indus­
try had suffered “ material injury” as a result
of the subsidies, Commerce announced
countervailing duties on the appropriate steel
imports to offset the subsidies.10 In the final
determination reported in August the Com­
merce Department substantially reduced its
estimates of the export subsidies. The coun­
tervailing duties were correspondingly re­
duced to marginal levels for German steel
and from a maximum of 40 percent for U.K.
steel to 20 percent. Further complicating the
issue, the Commerce Department ruled in
August that EC steel was being “ dumped” in
the U.S. market.
In October 1982, the International Trade
Commission ruled that the EC’s subsidies to
steel producers caused “ material injury” to
the U.S. steel industry. Consequently, the
countervailing duties determined by the Com­
merce Department investigation were sched­
uled to be imposed beginning October 22,
1982. The ITC’s ruling on injury due to dump­
ing was scheduled for December.
Response by the steel exporting
The initial response of the EC's top trade
officials to the countervailing duty decision
was to announce that the EC would develop a
list of imports of industrial goods from the
United States that benefit from U.S. tax breaks
and other subsidies, such as the Domestic
International Sales Corporations (DISCs), so
that the EC could retaliate against the United
States by imposing its own set of countervail10The Tariff Act of 1930, as amended, is the basic
legislation governing the imposition of countervailing
duties (the Trade Agreement Act of 1979 contains the
most recent revisions of the provisions). Countervailing
duties may be imposed to offset a foreign government's
subsidy on exports that result in “ material injury” to the
comparable U.S. industry. The U.S. Department of Com­
merce is responsible for determining whether an export
is subsidized and by how much. The International Trade
Commission determines whether U.S. industry suffers
“ material in jury” as a consequence of the subsidized


Figure 3: The volume of imported iron and steel products declines
in 1982, while their value holds steady

million short tons

Value by source

billion dollars

•January through September at an annual rate.
SO U R C E: Am erican Iron and Steel Institute and U.S. Departm ent of Com m erce

ing duties.11 Alternatively, officials indicated
that such a list might be used to help convince
the U.S. government that it too has much to
lose in a trade war.
On July 22 the EC countries offered to
reduce steel exports to the U.S. voluntarily,
but the U.S. rejected the proposal. In midAugust U.S. and EC officials reached agree­
ment on quotas limiting EC carbon steel to an
average of 5.75 percent of the U.S. market for
the covered products. However, U.S. steel
producers refused to drop their unfair trade
practice suits and, consequently, the agree­
ment did not go into effect.
Negotiations resumed and on October
21, the day before the U.S. countervailing
duties were to be imposed, U.S. and EC offi­
cials reached an agreement on quotas that
was acceptable to the U.S. steel industry. The*

''Dom estic International Sales Corporations (DISCs)
are special corporate entities whose sole purpose is to
channel goods into the export market. Their establish­
ment was authorized by the Revenue Act of 1971 in the
hope of stimulating U.S. exports. The act gives DISCs
certain tax advantages that make it attractive for U.S.
companies engaged in exporting to establish such corpo­
rations and use them as conduits for foreign sales.


Europeans agreed to limit shipments of car­
bon and alloy steel and steel pipe and tube
products to 5.46 percent and 5.90 percent,
respectively, of the projected U.S. market.
That the U.S. steel industry accepted the
revised agreement and agreed to withdraw
the unfair trade practice charges was, in part,
the result of the EC's acceptance of a slightly
smaller market share for carbon steel (5.46
percent versus 5.75 percent in the August
1982 agreement) and the inclusion of quotas
on tube and pipe, which had been excluded
from the earlier agreement.
In addition, from the U.S. steel industry's
viewpoint the quotas apparently provide
greater relief from imports than would the
increase in import duties, especially consider­
ing the downward revised countervailing du­
ties. Consider, for example, Germany, the
largest European exporter of steel to the
United States. Quotas will be more effective
than countervailing duties in reducing Ger­
man steel shipments to the U.S. because
government subsidies to the German steel
industry are negligible and, consequently,
the countervailing duties would have been only

Econom ic Perspectives

The situation in the U.S. steel industry
During the first nine months of 1982 the
U.S. capacity utilization in the production of
raw steel averaged 51 percent. This compares
with an average of 82 percent during the same
period in 1981. Current demand is low by
historical standards and inventories are being
worked down. Imports (which were at high
levels during the first two months of the year)
have declined about 9 percent from a year
ago. Raw steel production, which totaled 120
million short tons in calendar 1981, was down
to an annual rate of 75 to 80 million tons
during the first nine months of 1982. Total
blast furnace and foundry employment, which
averaged 710,000 in 1981, declined from
714,000 in January 1981 to less than 550,000 in
July 1982.

Figure 4: As U.S. steel consumption
dropped, import share rose
million short tons


’ January through June at an annual rate.

Impact of the quotas
In 1981, EC countries shipped about 6.4
million tons of steel to the United States and
supplied 6.1 percent of U.S. steel consump­
tion. At a comparable level of consumption,
the new agreement would limit EC shipments
to about 5.7 million tons.

The state of steel in the Seventh District
Seventh Federal Reserve District states
accounted for an estimated 34 percent of
U.S. steel production, or about 41 million
short tons, in calendar 1981. Employment
in District states is in about the same pro­
portion. Thus, current steel industry employ­
ment in District states is estimated to be
about 190,000—down about 50,000 workers
from January 1981. Despite the substantial
decline in steel output and employment in
the District states, these states appear to
have been hit less hard by plant closings
than some other areas. As a result, the Dis­
trict’s share of output and employment has
risen several percentage points during the
past two or three years.

Federal Reserve Bank o f Chicago

Despite the weak steel market, the quota
restrictions will put some upward pressure on
prices paid by U.S. steel consumers. Imported
steel will continue to enter the U.S. market
under the umbrella of higher U.S. prices. The
restrictions on shipments from the EC will
tend to push the foreign steel supply curve
back so as to “ slide up’’ the U.S. demand
curve for foreign steel, thereby producing
higher steel prices. Prices for non-EC imported
steel as well as for U.S. steel might be expected
to strengthen as a result of the quotas. Alter­
natively, given the large amount of unused
capacity in the steel industry worldwide, nonEC steel producers might choose to increase
production to fill the void left by reduced EC
shipments, holding prices near current levels,
or they could opt for a combination of higher
prices and somewhat higher production. In
the United States higher prices will probably
take the form of smaller discounts from the
list price than are currently in force. Higher
list prices are not expected until there is a
marked improvement in the overall demand
for steel.
The increased prices paid by consumers
of steel will be transferred, in the form of


increased revenues, primarily to steel pro­
ducers, both foreign and domestic. The over­
all cost of the quota restrictions to the resi­
dents of the U.S. can be expected to be
somewhat higher than if the same degree of
protection for the industry had been achieved
by increasing duties. Higher prices for imports
resulting from higher duties would have pro­
duced increased tax revenues to the U.S.
government. Under quotas, in particular those
imposed by exporting nations, higher prices
for imported steel typically result in a transfer
of revenue from U.S. consum ers to
The negotiated settlement has tempered
a potentially explosive trade conflict between
the United States and its major trading part­
ners. Nonetheless, protectionist pressure,
fostered by worldwide economic stagnation
and growing unemployment, continues to
Whether unilaterally imposed or nego­
tiated, import/export quotas still constitute
restrictions on trade and result in higher
prices to consumers and misallocation of
resources. It appears, moreover, that the U.S.EC agreement is not the end of the steel
controversy. After the argument was con­
cluded, the EC announced that it will restrict
its own imports of steel in 1983 by an addi­
tional 10 percent, or more, in order to help its
domestic producers whose sales will be re­
duced by lower shipments to the United
States. In addition, U.S. steel industry repre­
sentatives have indicated that they will press
for restrictions on imports of steel from both
Japan and third-world countries. These coun­
tries have increased their penetration of the
U.S. market substantially during the past dec­
ade and are in a position to fill the gap left by
reduced EC shipments.
To the degree that increased trade ten­
sions might result in a succession of trade
restrictions, Seventh District states would
suffer from the secondary effects of these re­
strictions. EC retaliation against industrial and
capital goods and agricultural shipments
would potentially have an adverse impact on
a much broader segment of the Midwest


economy than is encompassed by the steel
industry. Exports are a major factor in the
economic output of the area. About 8V2 per­
cent of the District's industrial production is
estimated to have been exported in 1980 and
exports of agricultural products accounted
for one-third of the cash receipts from farm
marketings in 1980.
U.S. measures in perspective
Trade barriers to “ protect” domestic in­
terests from foreign competition exist in all
countries. Indeed, an assertion often encoun­
tered in the current drive to protect the U.S.
steel industry from European competition is
that the U.S. industry is simply retaliating
against foreign governments’ alleged subsidizingof theirdomesticsteel industries. None­
theless, the quotas on exports by the Euro­
peans serve to distort the market by masking
the economic signals necessary to enable the
U.S. steel industry to adjust to underlying
market conditions so as to compete in the
world market.
Other governments have a long history
of protectionism with respect to agriculture,
an industry where the United States, on the
whole, is highly competitive. Japan, for
example, sharply limits imports of U.S. pro­
duced beef and citrus products. These restric­
tions have been a persistent source of conflict
between the two governments.
The European Economic Community,
through its common agricultural policy, sup­
ports the prices received by its domestic grain
and livestock farmers at levels well above
world market levels. Imports of competing
farm commodities are taxed at the border to
prevent them from undercutting domestic
prices. In turn, excess domestic production
encouraged by the EC’s high price supports is
sold on the world market with the aid of
government subsidies, which enable EC pro­
ducers to compete with the other more effi­
cient foreign agricultural producers, such as
those in the United States, Canada, and Aus­
tralia. The EC’s export subsidies on farm prod­
ucts have recently provoked increasing pres­

Econom ic Perspectives

sures by U.S. agricultural interests for retalia­
tion in kind.
Measures restricting trade are often pre­
sented as reasonable and necessary actions
taken to protect certain domestic industries
that are, for whatever reason, experiencing
hardship. Restricting imports that compete
with such industries appears to be a simple
solution. But, as shown in the three examples
analyzed above, such solutions have distinct
costs attached to them, costs that must be
borne by the society as a whole.
The question then arises whether another
means of aiding the depressed industry, per­
haps less costly than trade restrictions, may be
a more efficient way of dealing with the prob­
lem of an industry having difficulty adjusting
to foreign competition. Such a question is
especially relevant when other indirect but
very real costs are taken into consideration.
These costs may arise from retaliation by the
affected countries abroad.
The likelihood of such retaliation in­
creases in direct proportion to the degree of
distress being experienced by the world
economy: the more depressed the economic
conditions abroad are, the greater is the
chance that countries that lose markets be­
cause of restrictions imposed on their exports,
will attempt to redress the setback by impos­
ing restrictions on the offending country’s
goods. When that happens, the benefits gain­
ed (at some cost) from trade restriction in one
segment of the economy, may be more than
offset by losses suffered by other segments
whose exports are restricted by retaliation. In
the end everybody loses as international
trade diminishes and economic efficiency
deteriorates under the impact of restrictions.
In recent years international trade has
become increasingly important to the U.S.
economy. In 1981 U.S. exports of merchan­
dise as a proportion of the production of
goods (measured by final sales adjusted for
changes in inventories) stood at 18 percent,
compared with less than 10 percent in 1970.
Imports were equivalent to 20 percent of final
goods sales in 1981, compared with less than
10 percent in 1970. While these figures are

Federal Reserve Bank o f Chicago

well below those for the trade-intensive coun­
tries of Western Europe, where the propor­
tions are 50 percent or more, they are none­
theless substantial.
A more dramatic picture of the impor­
tance of international trade to the overall
economy emerges when changes in net
exports—that is, exports minus imports—are
related to changes in GNP. In any given year,
international trade will tend to either stimu­
late or retard overall economic activity, de­
pending on whether net exports are in sur­
plus (assuming less than full employment) or
deficit, respectively. Moreover, year-to-year
changes in net exports affect GNP, regardless
of whether the overall trade balance is in sur­
plus or deficit. It is the marginal impact that is
In 1981, for example, real net merchan­
dise exports (i.e., exports valued in constant
1972 dollars) declined $7.9 billion from the
1980 level. Real GNP increased $28.6 billion.
Various econometric studies have indicated
that the impact on GNP, or multiplier effect,
of a change in net exports may range from
plus two to plus three. Thus, at the margin,
the impact of a $7.9 billion decline in real net
exports may have reduced real GNP growth
in 1981 by $16 billion to as much as $24 billion.
Had net merchandise exports in 1981
remained unchanged from the 1980 level,
real GNP would have increased between $45
billion and $53 billion, rather than by the less
than $30 billion actually recorded. Instead of
a real GNP growth rate of 1.9 percent, as
recorded, GNP would have increased by 3 to
3.7 percent.
Clearly, the impact of international trade
on U.S. GNP is of potentially great signifi­
cance. Government policies which reduce
trade flows and affect net exports may, at the
margin, induce substantial secondary changes
in the nation's output, employment, and
1Jlf there is no change in the size of the balance from
one period to the next then clearly there is no marginal
impact on GNP. Even in thiscase, however, there may be
econom ic efficiency gains as a result of an increase in
trade or losses due to a reduction in trade.


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